Financial Management - Introduction

Preliminaries Teaching assistant x Recitations: Monday, Wednesday Grades x Assignments (45%) and final exam (40%) x Class participation (15%) x Add’l practice problems on syllabus (not graded) Today Introduction Overview of the course Introduction Corporate finance x Investment policy How the firm spends its money (real and financial assets) x Financing and payout policy How the firm obtains funds (debt, equity, …) and dispurses of excess cash Balance sheet view of the firm Assets Liabilities and Equity Current Liabilities Current Assets Long-Term Debt Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets Shareholders’ Equity Introduction But we also need to understand … x Capital markets How securities (stocks, bonds, options, …) are traded Pricing Risk and return Market efficiency International markets Financial markets Firms Curr assets Debt Fixed assets Equity Financial Markets Individuals Government Financial Intermediaries Size and stock returns Avg returns (% monthly) 1.40 1.20 1.00 0.80 0.60 0.40 Small 2 3 4 5 6 7 8 Firms sorted by market value (deciles) 9 Big Accruals and stock returns Avg returns (% monthly) 1.20 1.00 0.80 0.60 0.40 0.20 Low 2 3 4 5 6 7 8 9 High Firms sorted by last year's operating accruals (deciles) Introduction Finance is really about value x x x Firms Projects and real investments Securities Central question How can we create value through investment and financing decisions? Merck Medco acquisition (1993) Strategic considerations Positioning Does the acquisition generate competitive advantages? Sustainability Are the competitive advantages sustainable through time? Financial considerations Investment Does the acquisition generate value for Merck? Financing What is the best way to finance it? Types of questions Investment decisions At the end of 2001, GM had $18.6 billion in cash. Should it invest in new projects or return the cash to shareholders? If it decides to return the cash, should it declare a dividend or repurchase stock? If it decides to invest, what is the most valuable investment? What are the risks? General Dynamics 1980s were generally good x x x Strong sales growth ($4.7 billion to $10.2 billion) Reasonable profitability R&D and capital investment Beginning of 1990 x x x End of the Cold War Likely decline in defense spending Strategy?? General Dynamics $ 1.0 0.8 0.6 R&D + CapExp Net Inc 0.4 0.2 0.0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 -0.2 -0.4 -0.6 Value of $100 invested Jan. ‘80 $500 $400 Market $300 $200 GD $100 $0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 General Dynamics Investment, 1980 – 1990 R&D + capital expenditures If invested at 10% $3.7 billion $5.5 billion Ending market value $1.0 billion Value destroyed $4.5 billion Earnings in 1990 = $578 million Investment in 1990 = $711 million General Dynamics 1991 – 1993 William Anders, CEO Divestitures and layoffs Sales, $10.2 to $3.2 billion Employees, 54,050 to 26,800 (cont. operations) Investment cuts R&D, $390 to $33 million Cap exp, $321 to $14 million Cash payouts $3.4 billion to shareholders GD: 1987 – 1997 $ 1.0 R&D + CapExp 0.8 0.6 0.4 0.2 0.0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 -0.2 -0.4 -0.6 Net Inc Value of $100 invested Jan. ‘91 $700 $600 $500 GD $400 $300 $200 $100 Market $0 1987 1988 1989 1990 1991 1992 1993 1994 Types of questions Financing decisions In 1998, IBM announced that it would repurchase $2.5 billion in stock. Its price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response? Your firm needs to raise capital to finance growth. Should you issue debt or equity or obtain a bank loan? How will the stock market react to your decision? If you choose debt, should the bonds be convertible? callable? Long or short maturity? If you choose equity, what are the trade-offs between common and preferred stock? Types of questions Financial markets In the 5 years from Jan. 1995 to Dec. 1999, the U.S. stock market increased in value by 227%. DY on the S&P 500 dropped from 2.90% to 1.17%, and the P/E ratio increased from 14.9 to 32.4. Why? What does this tell us about future returns? How should it affect our financing and investment decisions? From 1946 – 1999, small firms returned 17.8% and large firms returned 12.8%. From 1963 – 1999, stocks with low B/M ratios returned 13.8% and those with high B/M ratios returned 19.6%. What explains the differences? How can we measure a stock’s risk? What does this mean for financing and investment decisions? S&P 500 dividend yield, 1871 – 1999 14% 12% 10% 8% 6% 4% 2% 0% 1871 1887 1903 1919 1935 1951 1967 1983 1999 S&P price-earnings ratio, 1871 – 1999 35 28 21 14 7 0 1871 1887 1903 1919 1935 1951 1967 1983 1999 The course Broad and fairly quick survey Managerial focus (general managers) Empirically-oriented Outline Part1. Valuation Basic principles Capital budgeting and real options Firm valuation Part 2. Risk and return Diversification Measuring risk: CAPM and APT Estimating discount rates Market efficiency Part 3. Financing and dividend policy Debt vs. equity Dividends and stock repurchases A few powerful themes i. Value maximization ii. Cash flows iii. Risk, return, and diversification iv. Market efficiency v. Information asymmetries and signaling