Corporate Finance

Fundamentals of Financial Management

Dr. Markus R. Neuhaus
Dr. Marc Schmidli, CFA

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Corporate Finance: Course overview
 18.09. Fundamentals (4 hours) M. Neuhaus & M.Schmidli
 25.09 Investment Management M. Neuhaus & P. Schwendener
 02.10. Business Valuation (4 hours) M. Neuhaus & M. Bucher
 09.10. No Lecture No Lecture
 16.10. Value Management M. Neuhaus, R. Schmid & F. Monti
 23.10. No Lecture No Lecture
 30.10. No Lecture No Lecture
 06.11. No lecture No Lecture
 13.11. Mergers & Acquisitions I&II (4 hours) M. Neuhaus & D. Villiger
 20.11 Tax and Corporate Finance (4 hours) Markus Neuhaus
 27.11. Legal Aspects R. Watter
 04.12. Financial Reporting M. Neuhaus & M. Jeger
 11.12. Turnaround Management M. Neuhaus & Markus Koch

 18.12. Summary, repetition M. Neuhaus


• Grade
• Qualification
• Career Development
• Subject-related Exp.
• Lecturing
• Published Literature
• Other professional roles:
Winter Term 2009
Markus R. Neuhaus
PricewaterhouseCoopers AG, Zürich 
Phone: +41 58 792 4000
Email: markus.neuhaus@ch.pwc.com
CEO
Doctor of Law (University of Zurich), Certified Tax Expert
Joined PwC in 1985 and became Partner in 1992.
Corporate Tax
Mergers + Acquisitions
SFIT: Corporate Finance, University of St. Gallen: Tax Law
Multiple speeches on leadership, business, governance, commercial
and tax law
Author of commentary on the Swiss accounting rules
Publisher of book on transfer pricing
Author of multiple articles on tax and commercial law, M+A,
IPO, etc.
Member of the board of économiesuisse, member of the board
and chairman of the tax chapter of the Swiss Institute of
Certified Accountants and Tax Consultants
Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 3

• Grade
• Qualification
• Career Development
• Lecturing
• Published Literature
Winter Term 2009
Marc Schmidli
PricewaterhouseCoopers AG, Zürich 
Phone: +41 58 792 15 64
Email: marc.schmidli@ch.pwc.com
Director
Dr. oec. HSG, CFA charterholder
Corporate Finance PricewaterhouseCoopers since July 2000
Euroforum – Valuation in M&A situations
Guest speaker at ZfU Seminars, Uni Zurich, ETH, etc.
Finanzielle Qualität in der schweizerischen
Elektrizitätswirtschaft
Various articles in „Treuhänder“, HZ, etc.
Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 4
Contents

 Learning targets
 Pre-course reading
 Lecture „Fundamentals of Financial Management“

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Learning targets

 Financial management
 Understanding the flow of cash between financial markets and the firm‘s operations
 Understanding the roles, issues and responsibilities of financial managers
 Understanding the various forms of financing
 Financial environment
 Knowing the relevant financial markets and their players
 Being aware of various financial instruments

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Contents

 Learning targets
 Pre-course reading
 Lecture „Fundamentals of Financial Management“

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Pre-course reading

 Books
 Mandatory reading
 Brigham, Houston (2009): Chapter 2 (pp. 26-50)
 Optional reading
 Brigham, Houston (2009): Chapter 1 (pp. 2-20)
 Volkart (2008): Chapter 1 (pp. 41-68)
 Volkart (2008): Chapter 7 (pp. 565-591)

 Slides
 Slides 1 to 11 – mandatory reading
 Other Slides – optional reading, will be dealt within the lecture

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Contents

 Learning targets
 Pre-course reading
 Lecture „Fundamentals of Financial Management“

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Agenda I

1. Introduction
 Setting the scene
 Who is the financial manager?
 Roles of financial managers
 Shareholder value vs. Stakeholder value concept

2. Financing a business
 External financing
 Internal financing
 Asymmetrical information
 Pecking order theory
 Capital structure

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Agenda „fundamentals of financial management“ II

3. Financial markets
 Different types of markets
 Financial institutions
 Financial instruments
 Efficient market hypothesis (EMH)

4. Q&A and discussion

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Agenda: Introduction

 Setting the scene

 Who is the financial manager?

 Roles of financial managers

 Shareholder value vs. stakeholder value concept

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Setting the scene I

Company “Environment”

(2) (1)

Capital markets
Firm‘s Financial (equity, debt,
operations (4)
(a bundle of manager bonds),
Shareholders,
real assets) (e.g. CFO)
other stakeholders
(3) (5)

(1) cash raised by selling financial assets to investor

(2) cash invested in the firm’s operating business and used to purchase real assets
(3) cash generated by the firm’s operating business
(4) reinvested cash
(5) cash returned to investors
Source: Brealey, Myers, Allen (2008), 5.

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Setting the scene II

 Managers do not operate in a vacuum

 Large and complex environment including:
 Financial markets
 Taxes
 Laws and regulations
 State of the economy
 Politics, public view, press
 Demographic trends
 etc.
 Among other things, this environment determines the availability of investments and
financing opportunities

 Therefore, managers must have a good understanding of this environment

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Who is the financial manager?

Chief Financial Officer (CFO)

(responsibilities:
e.g. financial policy,
corporate planning

Treasurer Controller
(responsibilities: e.g. cash management, (responsibilities: e.g. preparation of
raising capital, banking relationships) financial statements, accounting, taxes)

Source: Brealey, Myers, Allen (2008), 7.

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Roles of financial managers

 Generally, managers do not own the company, they manage it

 The company belongs to the stockholders. They appoint managers who are expected to run
the company in the stockholders’ interest
 Basic goal is creating shareholder value
 two problems emerge from this constellation

 Agency dilemma: asymmetric information and divergences of interests between principal

(stockholders) and agent (management) lead to the so called agency dilemma which also arises in
the context of financing decisions ( pecking order theory)
 Shareholder value vs. stakeholder value: shareholders own the company. Does a company
merely consider the owners’ interest or the interests of all stakeholders affected by the company’s
business activities?
hires
independence, High salaries

Dividends, control
Empire building,

Stable growth,
Agent Principal

performs
Illustration: Agency dilemma

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Shareholder value vs. stakeholder value I

 Shareholders’ wealth maximization means maximizing the price/value of the firm’s common stock
 Shareholders are considered as the only reference for the company’s course of business and
performance
 Other stakeholders are strategically considered only to the extent they could have an impact on the
stock price, the stockholders’ wealth

Where does the risk in the shareholder value concept lie? ( incentives, sustainability)

Employees

 If a new pharmaceutical product is launched, Suppliers Customers

health considerations will be relevant only to
the extent they could endanger the firm’s stock Value
price (e.g. through a lawsuit)
State
Investors

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Shareholder value vs. stakeholder value II

 Stakeholder value means maximizing the company’s value taking into account every stakeholder
the company affects in the course of its business
 The importance of stakeholder management is continually growing.

How can a company motivate its managers towards a careful handling of the company’s
stakeholders? ( compensation programs, corporate governance)

 If a new pharmaceutical product is about to be

launched, every stakeholder’s interest must be Employees
assessed and the product is introduced only if
every interest can be honored Suppliers Customers
 Does the plant pollute the air? Value
 Could the new product be harmful to
customers?
 Investors State
etc.

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Agenda: Financing a business

 External financing

 Internal financing

 Asymmetrical information

 Pecking order theory

 Capital structure

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Possibilities of financing a business

 The management makes decisions

about which investments are to be
undertaken and how these
investments are to be financed Equity

External
 There are three basic ways of
financing a business
Debt

1. Internal
2. Debt

Internal
3. Equity Internal financing

Pecking order theory diagram

Why would a company prefer debt over equity? ( cost of capital)

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Financing a business – overview

 External financing: a company receives capital from outside the company, e.g. credit, capital
increase

 Internal financing: The major part of a firm’s capital typically comes from internal financing
(retained cash flows, profits from operating activities)

 Liquidation financing: In this context, liquidation financing refers to the liquidation of assets (e.g.
divesting of certain business areas) which have a financing effect

Debt financing Equity financing Liquidation financing

Credit financing Issuing shares

External
Divesting activities
financing
Mezzanine / Hybrid financing

Internal Financing effect from Retained cash flows Financing impact from
financing accruals and profits value of depreciation

Source: Volkart (2008), 567.

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Financing a business – external financing

 Debt financing
 Given a solid capital base, the use of debt is reasonable as it broadens the financing base
provided a certain amount of leverage exists and considerable tax advantages 1) can be exploited
 The risk borne by a creditor is the risk of default driven by the company’s market and operational
risks
 Because a bank would not lend money to a company without checking its financial health, a
certain amount of debt gives a positive signal to other business partners

 Equity financing
 Equity serves as the capital base of a company because equity can not be withdrawn or taken
away from the company
 In the case of incorporated companies (e.g. AG), equity bears the major part of the risk
 A company can raise equity capital by selling shares privately or publicly (e.g. IPO or capital
increase)
General rule: Interest expense is tax deductible, dividend distributions not.
1)

Source: Volkart (2008), 569ff.

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Financing a business – internal financing

 Internal financing or self-financing

 Internal financing is determined by the cash flow from operating activities
 Internal financing means generation of cash flows from operating activities without
using external sources
 Internal financing happens “automatically” as a consequence of the operating
activities of a company
 From the company’s perspective, self-financing is the most convenient way of
financing as the company does not have to debate with creditors and the discussion
with equity holders is limited to the question of how much of the profits should be
distributed. ( pecking order theory; see Slide 26)
 As opposed to external financing, internal financing is not fully reflected on the
company’s balance sheet

Source: Volkart (2008), 572ff.

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Asymmetrical Information I

The problem of asymmetrical information does not occur only between principal and agents,
but arises each time financing is needed as the fundamental interests of debt holders and
shareholders differ significantly.

 Shareholders assume that management is negatively influenced by debt holders

towards making “safe” investments in order to minimize the probability of default
 Debt holders will try to establish credit covenants in order to gain more control over
investment decisions and the course of business
 Shareholders, on the other hand, prefer investment opportunities with potentially high
returns as their shares will gain in value as the company’s cash flows grow

 As a result, each party tries to influence the management:

 Debt holders try to establish favorable credit covenants
 Shareholders set incentives through compensation plans

Source: Volkart (2008), 570ff.

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Asymmetrical Information II

 Why do the different parties not get together and solve the problem?
 Game theory ( Nash) shows us that in such strategic situations with conflicts of
interest, each party begins by holding back information in order to strengthen its
negotiating position
 Shareholders do not know about possible credit covenants whereas creditors do not
know anything about the investors’ motivation and decisions
 Law prohibits typically a company to disclose all relevant information

 in conclusion, we find a triangle situation in which each party tries to maintain or

gain as much power and influence as possible in order to secure its interests

Management

Debt holders Shareholders

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Pecking order theory I

 Bridging the problems of asymmetric information can be very expensive. The less information
an investor has, the higher the required rate of return for the investment is. An outflow is the
so called pecking order theory demonstrating the order in which the company prefers to
finance its business
1. Internal financing
 No prior explanations to investors or creditors (except for
level of dividends)
Equity
2. Debt financing
 Banks want information about credit risk
 Management must provide possible creditors with sufficient Debt
and reliable information

3. Equity financing
 Potential shareholders will challenge the “real” share price Internal financing
as they have to rely “blindly” on the information given by
the management
Pecking order theory diagram
 Shareholders will request a low price as they cannot be
sure whether the share is worth the price
 This makes equity capital very expensive for a company
Source: Volkart (2008), 578ff.

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Pecking order theory II

 The importance of the different ways of financing fundamentally changes over the
lifetime of a company
 From the perspective of a major listed company, internal financing is the most
significant kind of financing
 Vital influence on conditions for external financing (stable operating cash flows 
more favorable credit conditions and higher stock prices)
 Without solid operating cash flows, a company will not be able to survive

phase of
start up expansion consolidation
business

- equity
preferred Private equity /
- debt internal
financing Venture capital
- internal

Illustration: how financing preferences can alter over a company‘s lifecycle

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Capital structure

 The decisions on how the assets of a company are financed leads to the question:
 what is the optimal capital structure of a company?
 The relation between debt and equity reflects a company’s risk and is also called
financial leverage
 The optimal capital structure is highly dependent on the industry
 Investors often urge greater financial leverage, and thus more risk, in order to generate
more profit in relation to the equity capital invested. In addition, interests paid are tax-
deductible.
 The capital structure can be defined by the debt to equity ratio
Debt
Debt to Equity  Financial Leverage 
Equity

 Financial risk increases as the company chooses to use more debt

What is the optimal capital structure?

Source: Volkart (2008), 594ff.

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Agenda: Financial markets

 Different types of markets

 Financial institutions

 Financial instruments

 EMH

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Basic need for financial markets

 Businesses, individuals and governments need to raise capital

 Company intends to open a new plant
 Family intends to buy a new home
 City of Zurich intends to buy a new generation of trams

 Of course, people and companies save money and have money of their own. However,
saving money takes time and has opportunity costs
 Mr. Meier earns CHF 10’000 per month and has expenses of CHF 7’000. If he
intends to buy a home worth CHF 1’000’000, it will take him a long time to save
enough.
But what if he wants to buy this home today?

 In a well-functioning economy, capital flows efficiently from those who supply capital to
those who demand it

Source: Brigham, Houston (2009), 28f.

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Financial markets

 Physical vs. financial markets

 Spot vs. future market
 Money vs. capital markets
 Primary vs. secondary markets
 Private vs. public markets

Recent trends:
 Globalization of financial markets
 Increased use of derivative instruments (especially as hedging and speculation
instruments). The current financial crisis reduced the total size of the derivatives market
substantially. However, it is still far bigger in most areas as for instances in 2001.

Source: Brigham, Houston (2009), 30ff.

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Financial Institutions

 Commercial banks
 Investment banks
 Financial services corporations
 Insurances
 Mutual funds
 Hedge funds

 The trend is clearly towards bank holdings / financial services conglomerates that
provide all kinds of services under one roof. The large investment banks disappeared.

 Against that, in the current environment many banks e.g. UBS are disposing of certain
business divisions and focus on core competences. This trend will continue for
regulatory reasons (lower risks, de-leveraging, …) and some trends towards
nationalization and “home market” focus in the banking sector.

Source: Brigham, Houston (2009), 34ff.

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Financial instruments

 Stock: Unit of ownership which entitles the owner to exercise his voting right on
corporate decisions and receive a certain payment (dividend) each year. No other
obligation, nor any loyalty recquired.

 Bond: The issuer (company) owes the holder (investor) a certain amount of debt and is
obliged to pay the holder a certain interest rate (coupon) and to repay the initial amount
at a pre-determined date

 Option: Financial contract which entitles the buyer to buy (call option) or sell (put
option) a certain underlying asset at a pre-specified price at or before a certain point in
time

 Structured product: Packaged investment strategy, a mixture of different investment

instruments, mostly derivatives which are intended to exploit, for instance a certain
market constellation

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Efficient market hypothesis (EMH)

 The EMH states that

(1) share prices are always in equilibrium
(2) the prices reflect all available information (on opportunities, risks) and everything that can
be derived from it
 Therefore, it is impossible to “beat the market”

 Prices in financial markets react very quickly and fairly to new information

 Share prices are unpredictable as the information that influences prices also occurs by
chance.
 We can analyze past stock price developments, but we cannot foresee any
future results

However, investors are not machines that can process all available information.
This may lead to the fact that irrational factors come into play
 behavioral finance
Source: Brigham, Houston (2009), 46ff.

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Opportunities due to inefficiencies

 Pure luck
 Any investor or individual might just be lucky and have bought stock yielding far
better returns than expected
 Insider knowledge
 If an investor has access to insider information, he can take advantage of it. In order
to guarantee a fair market, insiders must be excluded from trading ( laws against
insider trading)
 Other possible inefficiencies:
 Under-reaction
 Uncertain valuation
 Overshooting

The exploitation of inefficiency leads to efficiency

Source: Spremann (2007), 202.

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Final comments

 As the environment (capital markets, society, suppliers etc.) has significant influence on a
company, the financial managers must have a profound understanding of this
environment in order to make the right decisions

 A financial manager makes decisions about which investments are to be undertaken and
how these investments are to be financed (treasurer) and accounted for (controller)

 Financing can come either from outside (external: debt and equity) or from inside
(internal: internal financing through profit from operating business) the company

 The problem of asymmetrical information arises whenever financing is needed, because

the level of information and the interests of debt holders and shareholders differ
significantly. Bridging these problems can be very expensive and leads to the so called
pecking order theory

 The theory that capital markets take into account all information and all that can be
derived from this information, is called the efficient market hypothesis
Winter Term 2009 Markus Neuhaus I Corporate Finance I neuhauma@ethz.ch 36