New Venture Finance: Corp.

Finance Review 1 __________________________________________

Real Sector Corporate Investment Decisions: Utilization of Funds Business Markets The Firm Financial Sector Corporate Financing Decisions: Acquisition of Funds Financial Markets

Products Customers Competitors Employees Tangible Assets Technology

The Firm's Balance Sheet __________________________________________________________ Cash A/P A/R Other Current Inventory Liabilities _________________ _____________________ Total Current Assets Total Current Liabilities Fixed Assets: Plant & Equipment Capital: Debt Preferred Stock Common Equity --Retained Earnings --Common Stock _____________________ Total Liabilities & Equity Savers/ Investors

________________ Total Assets

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Financing (sources of funds) must equal the investment in assets (use of funds). Managers make investment decisions that generate earnings so that investors get a return on investment. Financial Management is defined as the planning for, acquiring, and utilization of funds in a manner that maximizes the firms economic efficiency.

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The Corporate Finance View of the World:
Commercial Sector Bus. Transactions -Customers -Products -Technology $$ -Competitors Firms Balance Sheet Assets Liab. Capital $$ Financial Sector Savers/Investors: -Individuals -Corporations -Partnerships -Banks Return on Investment

Securities

Firms Income Statement Revenue -Expenses -Taxes Net Income Retained Earnings? Dividends?

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The corporation has advantages over the other forms or organization: Unlimited lives that extend beyond the lives of the founders or original managers. Simple transferability of ownership: investors and managers are two separate groups, so investors can buy or sell the common stock without disrupting corporate operations. Limited liability in the corporation: investors can lose only the total amount they invested in the common stock.

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The stock market monitors the publiclytraded corporations performance:

Stock price changes signal whether managerial decisions are good (stock price goes up) are bad (stock price goes down). Because of the requirements to disclose information that publicly-traded corporations face, the stock market can monitor these firms better than it can the other forms of organization.

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The stock market disciplines the firm by causing the stock price to decline. In response, the firm can:
Change strategies. The Board of Directors can replace the managers ( this is called internal governance). The firm can be merged/taken over (this is called the market for corporate control). Declare bankruptcy.

New Venture Finance: Corp. Finance Review 7 __________________________________________ In the Theory of Finance, the appropriate goal of the firm is to maximize the value of shareholder wealth. Shareholders commit part of their wealth to the firm when they buy the firms common stock. Equivalent ways of stating this goal are:
To maximize the market value of the firm. To maximize the stock price of the firm.

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An equation that is central to the Theory of Finance is: A Firms Stock Price = The Present Value of All Future Dividends
DIV1 DIV2 DIV3 DIV DIVt ------------(1 + k)t = ----------- + ----------- + ------------ + ... + ----------- = (1 + k)1 (1 + k)2 (1 + k)3 (1 + k) t=1

New Venture Finance: Corp. Finance Review 9 __________________________________________ This equation says that value (i.e., the stock price) depends on:
The stream of dividends. Risk, reflected in the discount rate, k. The timing of the dividends.

Note that value depends on all future dividends and not only on next quarter's dividends. Where do dividends come from?
Dividends = (Earnings) Earnings = (Revenue, Expenses, Interest Exp.,Other) Revenue = (Business Decisions, Strategy)

New Venture Finance: Corp. Finance Review 10 __________________________________________ Agency Problems and Costs. Investors (principals) provide funds, but managers (agents) formulate and implement strategies and tactics: the problem of separation of ownership and control. The goal is to maximize shareholder wealth, but investors cannot be sure that managers will act in shareholders best interests. Managers might:
Shirk their duties. Use corporate resources to pay for perquisites. Shift funds into higher risk projects than the stockholders desire.

New Venture Finance: Corp. Finance Review 11 __________________________________________ Observability, asymmetric information, & moral hazard:
Investors cannot observe everything managers do. Managers have more information about the firm.

Investors monitor the firm, and the firm incurs monitoring costs.
Investor relations staffs, annual reports, SEC and other regulatory reports consume resources.

If managers actions cannot be observed directly, then periodic disclosure must be made:
Disclosure: information sets become more symmetric. Are bank loan officers' salaries a monitoring cost?

New Venture Finance: Corp. Finance Review 12 __________________________________________ Agency problems can be solved if the interests of managers and investors are aligned, if both managers and investors have the same incentives. Agency theory suggests if managers are bonded to the firm, managers would behave in the shareholders' best interests.
This entails bonding costs. For example, stock options or stock purchase programs (like at 85% of the market price) transform managers into owner/managers. But managers are buying into the firm at below-market prices. The bonding cost is the loss of wealth suffered by other shareholders when the stock is sold cheap.

New Venture Finance: Corp. Finance Review 13 __________________________________________ These costs cause shareholder wealth to be less than if managers didn't pose a moral hazard.
We live in an imperfect world. A perfect world of symmetric information no moral hazards is not attainable.

Financial contracting solutions are often used.

For example, bond indenture contracts often contain restrictive covenants that limit the behavior of managers, like no new mortgages on the assets. Bank loans also contain restrictions, like limitations on paying dividends, the amount of additional borrowing, or a minimum current ratio requirement.

New Venture Finance: Corp. Finance Review 14 __________________________________________ A closer look at financial contracting. Bonds are loan contracts, and common stocks have legal ties to the firm via the firm's charter.
Bonds are fixed income securities that have finite lives: bonds have a fixed maturity date, pay a set amount of interest each period, and borrowings must be repaid. Stocks are variable income securities that have infinite lives. Dividends are not guaranteed and stock never maturesas long as the firm is alive. Stocks can be repurchased by the firm, but that is different: stock can be retired but it does not mature. Stocks represent an equity, or ownership, interest in the firm.

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Security Debt Payment Fixed, periodic interest Par value at maturity Priority Priority in bankruptcy Preference over preferred & common Can force bankruptcy if not paid Paid before common dividends Preference over common
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Preferred Fixed, periodic dividend Stock No maturity date Div. must be declared Common No fixed dividend Stock No maturity date Div. must be declared

Residual position in dividend payment and bankruptcy

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The Relationship Between Discount Rates and Value: Like stock, bond prices also equal the present value of the cash flows that investors expect to receive:
Bond Price Bond Interest Maturity Value = P.V. of interest + P.V. of maturity value = coupon rate X maturity value = $1,000.00; called the bonds principal

Consider a 10% , 1-year bond or a 10%, 5-year bond; both have a maturity value of $1,000. Currently, bond interest rates are 10%, but rates may vary between 8% and 12% over the next few months. How do changing interest rates affect bond values?
Interest = .10 x $1,000 = $100 per year

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k = the Market Rate of Interest 8.0% A. 1-Year bond Present value of : Interest Maturity value Price of bond B. 5-Year Bond Present value of : Interest Maturity value Price of bond $ 399.27 680.58 $1,079.85 $ 379.07 620.93 $1.000.00 $ 360.48 567.42 $ 927.90 $ 92.59 925.92 $1,108.52 $ 90.91 909.09 $1,000.00 $ 89.28 892.96 $ 982.14 10.0% 12.0%

New Venture Finance: Corp. Finance Review 18 __________________________________________ Define k as the Market Rate of Interest. The example shows that that k and a bonds price are inversely related:
Bond prices goes up as k goes down. Bond prices goes down as k goes up.

Note that the bond with the longer maturity (the 5yr bond) has greater price volatility for the same changes in the interest rate.
The 5-yr bond has a higher price at 8% and a lower price at 12% than the 1-yr bond.

New Venture Finance: Corp. Finance Review 19 __________________________________________ Project evaluation techniques. Developing new products or services are essential if a firm is to continue growing. Capital budgeting involves:
Long-term investment opportunities as projects. Conducting a cost/benefit analysis for each project. Accepting projects when benefits exceed the costs. Picking good projects allows the firm to grow and to increase its stock price.

The preferred technique is called Net Present Value (NPV).

New Venture Finance: Corp. Finance Review 20 __________________________________________ NPV =

n NPV = t=1

P.V. of Inflows - P.V. of Outflows

NCFt ------------------- - Cost of the project (1 + MCC)t

where: NCFt = Net Cash Flow at time t MCC = the Marginal Cost of Capital, a risk-adjusted discount rate

New Venture Finance: Corp. Finance Review 21 __________________________________________ This gives rise to the following set of decision rules that are used in capital budgeting:
C r it e r io n A c c e p t NPV IR R N P V O R e je c t NPV < 0

I R R M C C IR R < M C C

IRR is the Internal Rate of Return and is defined as the discount rate that makes NPV = 0.

New Venture Finance: Corp. Finance Review 22 __________________________________________ Who gets the NPV > 0 and how does it achieve the goal of the firm?
Common shareholders, the residual claimants. Bondholders and preferred shareholders get what they expect, and common shareholders get what is left over. The larger the residual, the more wealth common shareholders receive (think of the positive NPV that Intel creates with each new generation of microprocessors.) If managers select all of the projects with NPV > 0, this is the best that shareholders can hope for and the stock price will be maximized. Negative NPVs would make the stock price go down.

New Venture Finance: Corp. Finance Review 23 __________________________________________ Informational efficiency: This important concept is the idea that having accurate information is crucial to making good investment decisions. Financial markets are informationally efficient if security prices fully reflect all information and react immediately to impound new information.
For example, if the financial markets are efficient, then Intels stock price reflects all information about Intel. Any new information about Intel will make its stock price go up or down immediately.

New Venture Finance: Corp. Finance Review 24 __________________________________________ One implication is that it is hard to "beat the market" in an efficient market. The greatest rewards exist for those who have the best information; there is much competition for information.
The "big players" who have the most resources gain information first and grab the available profits first. You and I, who are far from Wall Street and who spend little on information, find it difficult to beat the market. Getting information first, or immediately, is very costly and it is difficult to beat the market and to cover the costs of obtaining information.

New Venture Finance: Corp. Finance Review 25 __________________________________________ Nevertheless, information efficiency is an important concept, and financial markets are pretty efficient in my opinion.
Competitive markets are key: as information becomes available, investors revise their decisions to buy or sell a stock or bond, so there must be markets in which they can actually buy or sell. Economics and finance profs love markets: supply and demand come together and individuals are free to make buy or sell decisions that are in their best own interests. As information arrives, it becomes reflected in prices, so price changes signal good news (prices up) or bad news (prices down).

New Venture Finance: Corp. Finance Review 26 __________________________________________

Source (day = 0)
Insiders know before announcement Industry analysts and informed investors get information "on line Recipients of analysts' reports and less informed investors are next; ther e may be many substages so that there are degrees of being informed You and I come last: since we have low information costs (t.v., radio, press, periodicals, etc.), the information is picked over and its value already extracted by the time we obtain the info.

Complete Dissemination (day = 1)

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In T yp es of fo rm atio na l E ffic ie nc y ho w the Strong Fo rm lines up w ith the first colu mn ab ove (th e s ourc . N ote the S em-S tron g Fo rm line s u p with the m id dle tw o colu m ns, an d the W e ak Form lines up w.ith the la st co lu i Stro ng F o r: m S em -iS trong Fo rm W ea k fo rm a histor ic al C on side rs ll info rma tion C o nside rs apu blic ly av aila ble rm ation from w hen o nside rs o nly ll in fo C se cu rity pric es; the from the in form ationd is m inate d isse by the sou rc e, in cludin g tim e y ou and I re ce ive the insid er informa tio n W a ll St. J ou rna l on our do orstep s, the info rm a tion ha s b ee n fully d is se m ina ted; we h ave a ll is yes te rd ay 's price s T he s trong fo rm d oe s not he se mi tro ng form ha s bee n fou nd to hold pretty he w eak fo rm has b een T -s T ho ld : the re is value to w e ll, b ut no t co mp le te ly fou nd to hold very we ll insid er informa tio n

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A basic principle of Finance: more risk should be rewarded with a higher return. In the Theory of Finance, taking risk is a good thing since it creates new wealth (new products, new technologies, etc.) Thus, there should be rewards for bearing risk.

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Expected Return

Risk-free Rate: kf

Risk premium Time value of money ______________________________________________________________Risk Treasury Bonds Corporate Bonds Common Stock New Ventures, Options, Futures, and other Derivatives

New Venture Finance: Corp. Finance Review 30 __________________________________________ A life-cycle view of the growth of a technologydriven firm. Corporate Finance textbooks typically concentrate on firms that have gone beyond the start-up stage and are publicly-traded.
Publicly-traded firms have developed products and services that generate earnings from the assets in place. Start-ups have no assets in place, and maybe are based on no more than a product or service concept. The value of a publicly-traded firm is based on assets in place, a start-ups value is based on its growth options.

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Sales /Earnings./C ash Flow

________________ ____________ ___________ _______________ ____________ Time

R&D (S eed & sta rt -up) Early growth Rapid gro w th M aturity (First stage start -up) (Late stage sta rt -up) ---- P ubliclytraded----) ( -

De clin

New Venture Finance: Corp. Finance Review 32 __________________________________________ Venture Economics Stage Definitions: Early Stage
Seed. A relatively small amount of capital provided to prove a concept, maybe involving product development but not initial marketing. Startup. Financing for product development and initial marketing; no product sales, management team assembled, business plan written, market research done. First Stage. Financing for initial commercial manufacturing and sales.

New Venture Finance: Corp. Finance Review 33 __________________________________________ Expansion

Second Stage. Working capital financing provided; likely to have no profits. Third Stage. Financing for plant expansion, marketing, and working capital. Bridge Stage. Financing for firm expected to go public in 6-12 months; often repaid from IPO proceeds.

Management/Leveraged Buyout (MBO/LBO) and Turnaround

later-stage companies: buying out existing firms or financing firms with operational or financial difficulties.

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L a rg e P u blicly de d F ir m s -Tra N e w V en tu re s _ ___ ___ __ ___ ___ ___ ___ __ ___ ___ ___ _____ __ ___ ___ __ ___ ___ ___ ___ __ ___ ___ ___ ___ __ _ __ _ E a sy acc es s to fina nc ia l m:a rk ets , ba nks b on d m arke ts , a nd stoc k m ark ets F in a c ia l m ark ets in ge ne ral ar e not n a cc ess iblen ew ventures pr iv ately h eld : a re

F a ce sc rutiny of fin anc ial m ark ets: F ac e s cr utin y o f V C s: --m uch info rma tio n av ailable ab out firm an --little in fo rm a tion ab out firm o r its con cep t/ide a d ind ustry --V C ha ve to m on a n dinv est itor --a na ly sts p erfo rm mo nitoring func tion an d --V C s are qua si -inside rs , o ften on th e B d. o f D ir. m a kes reco m m en dation s --m a rkets are thindailliquid; s to ck not p ublicly n --pe rio dic d is clos ure ke ep s e veryb od y ha pp y tra de d --stoc k m a rk et diplin es firm s throu gh is c pric e c ha nges force firm to be hav e a s exp ec te d D isc lo su re: throu gh ann ual rep orts , S E C D is clos ur e: ro ug h bu sine ss p la ns, and th an nou nce m en ts a nd dire ct ex am ination by in ves tors --ma rkets a reom "info rm atio na lly e ffic ient" --m arkets are ls "inform atio na lly e ffic ient re es

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Larg e Pu blicly ded Firms -Tra New Ven tu res ____ ___ __ ___ ______ _____ ___ ___ ___ _____ _ _____ ___ __ ___ ______ _____ ___ ___ ___ _____ _ __ Prob lem of sepa ra tion of ow nership an d contro l: h ave more direct mon itoring ability: V Cs --stock options and stock purchase p lan help bon d --En treprene urs keep a large p ercent o f shares m anage rs to firm an d key p erso nnel get sto ck op tion s S ou nd m ana gem ent expected and scru tinized: M anagement development just b eg in ning: --com plex organization s the no rm --VCs kno w what is expected and o ffer netwo rking --reorganizations the norm --understaffed operatio n co ping with exp lo sion of --h ierarchical organ izatio n tasks and function s --lots o f written po licies --what's a policy? --expertise already d evelope d (i.e., hire M BAs)--VCs "groo m" m anage ment Goal is to maximize th e firms' stock price: --it can generate a stream of earn in gs from ongo in g o peration s (or assets -in-place) --it can un dertak e capital bu dgetin g --firm s are in m atu re stag e Go al is to maximize th e firms' stock price: --real goal is IPO o r merger, or harvest, or cash out for VC a nd entrepren eur (a liqu id ity event) --firm s are in rapid gro wth stag e

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Early Stage L ate State Small Publicly Large Publicly Start -up Private Firm -Traded Firm -Traded Firm ________________________________________________ _____________________________
VC invests, monitors, and grooms firm VC prepares firm for liquidity event (i.e. IPO, merger) Liquidity event occurs: VC and entrepreneur harvest

Not what VCs invest in; bank loans proba bly available, but financing still a big problem Financial markets generally available

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