Lecture Notes in Introduction to Corporate Finance

Ivan E Brick

• Publisher: WSPC
• Year: 2017
• ISBN:
  9789813149915
• Topic: Commerce
• Subtopic: Expertise

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This volume will introduce the reader to basic topics of corporate finance. The notes will provide an integrative model that will help students evaluate projects, examine financing alternatives and assess a firm.

With problems and detailed solutions at the end of each chapter, this volume will also greatly benefit financial managers and investors. Corporate finance is a discipline from the firm's perspective and addresses the concerns of the Chief Financial Officer of the firm. Additionally, investors need to understand why firms make certain decisions so that they better recognize what drives firm value.

These lecture notes assume no previous knowledge of finance, and are written in conversational style that makes the topics more accessible and easy to comprehend and absorb.

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CHAPTER 1

INTRODUCTION

What is Finance?

Consider a Euro coin. On the right side of the coin are the investors who wish to invest. They invest in financial securities such as stock and debt securities. They also invest in commodities, real estate and derivative securities such as options. Many investors invest their money in banks in the form of deposits. The left side of the coin represents the issuers. The government that supplies Treasury securities and municipal debt are the issuers. Issuers also include corporate entities that issue both stock and debt securities to the public. The proceeds of these sales are used to finance the business operations of the issuers.

The thickness of the coin represents the medium where the two meet. We can think of the thickness of this ‘coin’ as the Financial Institutions. The job of the Financial Institutions is to match the investors demand for investment with the supply offered by the issuing entities. Financial institutions include banks that take savers’ deposits and lend them to a homeowner who wants to buy a house or to a business that uses the money to expand operations. They include investment banks, which “sell” new securities issued by corporations to the public.

Now that you know something about the players of finance, we can now answer the question “What is finance?” Finance studies the interaction of investors and issuers of securities and how it impacts upon the return received by investors and the price obtained by issuers. It examines how investors make decisions regarding the choice of investments. Finance seeks to explain the factors that determine how firms finance their operations and whether to expand or contract. Finance also explains how firms use the markets to learn something about themselves. Finance describes how the organization of financial markets impacts upon the prices of securities. Finally, finance explains the operations of financial institutions as they perform the important function of bundling of investors’ funds and transforming their investments into financing vehicles that are essential for the well-being of firms and governments.

In this course, we provide an introduction to finance. There are chapters that describe some of the financial securities that are available for investors. We will explain how risk and return are related and their impact upon choices made by firms and investors alike. We will provide you with basic tools to make rational decisions. We believe that mastering the subject matter will enable you to do your job better and help you plan your own personal investments. We will examine how firms allocate their resources and how they finance their operations. Finance is somewhat technical and it requires understanding of the use of spreadsheets. We will provide you with a tutorial for that purpose. In addition, you will need to learn accounting fundamentals because the language of firms is accounting and you cannot evaluate firms without understanding income statements and balance sheets. We believe that you will learn much about finance and hopefully, you will enjoy the experience of working through this textbook.

What do Investors Want?

One of the first questions you face as an employee is how you want to allocate the contribution to your 401(k) retirement plan. (Your employer will also ask about health care plans but that is another course. More importantly, you should figure out who will be your mentor and how to manage your career! But that is also for another day.) Your 401(k) retirement plan may offer several alternatives. One plan invests in the stock of your company. Another invests in the US domestic stock market. A third plan invests in overseas equities. A fourth plan only offers choices of treasury securities. A fifth plan invests in corporate bonds. How do you decide which plan is best for you? Before deciding, let us give a brief description of some basic investment vehicles.

Savings Accounts: Most people have their own checking account. Many banks offer a minimal interest rate for keeping money in the checking account. Banks also offer Certificates of Deposits (CDs), with greater yields provided that you are willing to tie up your money for 1 year or more. For the most part, these investments are secure because of government insurance offered by the Federal Deposit Insurance Corporation (FDIC).

Treasury Securities: These securities are offered by the US government and are considered essentially free of any chance of default. Why? Because the government has the unique privilege of being able to run the printing press to pay its bills. They are very liquid and have current maturities from 1 month to 30 years. Treasury Securities with more than 1-year maturity pay interest twice a year and you receive the final principal payment on the last day of maturity. The current yield of 10-year Treasury as of June 6, 2016 is 1.723%. To find the current yield of a 10-year Treasury go to http://finance.yahoo.com/. Why are some bank CD rates higher than the treasury securities? For example, Discover is offering a 7-year CD for 2.10% as of June 6, 2016. One reason is that the CDs are not liquid (cannot be sold by the holder) and banks have to offer a higher yield to attract depositors.

Municipal Bonds: These securities are issued by municipalities like states, counties and cities. The current yield of AAA (triple A) rated 10-year municipal bond as of June 6, 2016 is 1.65%. First, what do we mean by triple A rated? And why are municipal bonds offered at a lower rate than treasury securities?

To answer these questions, one must realize that municipalities can default on their debt. New York City almost defaulted on its debt back in the 1970s. Orange County, California, the wealthiest county in the US as measured by per capita annual income, defaulted in the late 1980s. Remember, the US government can always print money to ensure payment of the loan, but municipalities cannot. If taxes and fees collected by the municipality are insufficient to pay off the loan, the municipality is not required to raise taxes and it has the right to default on the loan. There are rating agencies such as Moody’s and Standard & Poor’s (S&P) that rate the safety of such bonds. Triple A rated bonds are considered to be the safest.

This answers the first question, but what of the second question? Income from municipal bonds are tax exempt from federal taxes and frequently exempt from state and local income taxes. As a result, the required yield of highly rated municipal bonds can be lower than treasury securities because the holder of municipal bonds does not have to pay taxes on the interest income.

Corporate Debt: Most corporate debt securities have original maturities of greater than 5 years, pay interest semi-annually, and repay the principal amount at the final maturity date. Corporations enjoy limited liability, which means if the firm cannot make the payments it owes the debt holders, the owners of the firm do not have to make up the difference. Instead, the corporation can default on its loan obligations. Moody’s, S&P and others agencies provide credit ratings for all of these bonds. The current yield of triple A rated 10-year corporate bond as of June 6, 2016 is 2.28%. To find current yields of triple A rated bonds go to http://finance.yahoo.com/bonds/composite_bond_rates. The average yield of high yield, or “junk bonds”, (bonds that the rating agencies do not regard to be safe bets) as of June 6, 2016 is 7.40%. The source for this yield is the Federal Reserve Bank of St. Louis at https://research.stlouisfed.org/fred2/series/BAMLH0A0HYM2EY.

Common Stock: Holders of common stock are the theoretical owners of the firm. The shareholders appoint the board of directors who oversees management on behalf of shareholders. The return of common stock is made up of two components: dividends and capital gains. Dividends come out of the firm’s earnings. Capital gains represent the percentage change in the stock price from the time of purchase. The average return of stock as measured by the S&P 500 Index has been over 12% per annum since its inception more than 50 years ago. Note that there have been years that the stock returns have been much lower. For example, return for the stock market in 2002 as measured by the percentage price change of the S&P 500 Index was approximately –22.1%.

Retirement Investment Vehicles: One of the earliest private retirement investment vehicles is the Traditional Individual Retirement Arrangements (IRAs). The contributions to the IRA can be tax deferred (and you do not pay taxes on the earnings until you begin withdrawing from the account). Distributions from the IRA may not begin before you are 59.5 years old. No matter what, you must begin withdrawing by the time you are 70.5 years old. The distributions are considered taxable income. The maximum contribution you can make into the Traditional IRA account as of 2013 is $5500 for people younger than 50 and $6500 for people aged 50 and over. Contributions can be used to reduce your taxable income but there are income limitations: In some cases, you can lose the total tax deductibility of the contribution if your income exceeds $69,000. For more information, go to http://en.wikipedia.org/wiki/Traditional_IRA. Note the above is accurate as of January 2013. The law does not restrict the type of investments you make for your IRA. Another type of IRA is known as the Roth IRA. The contributions made to this type of IRA are not tax deductible. Like the traditional IRA, the earnings of these investments are not taxable. Unlike the Traditional IRA, distributions after you reach the age of 59.5 are not taxed at the ordinary income tax rate, and nor do you have to take any distribution once you reach the age of 70.5.

Many companies offer qualified pension retirement plans. Most of the plans in the corporate world are now defined contribution plans. In these plans, you contribute a percentage of your income. Often these contributions are matched by the employer. The contributions to these plans are tax deductible and you do not pay taxes on the plan’s earnings until you begin your withdrawal. The maximum amount one can contribute to these corporate plans is $17,500 as of 2013.

Mutual Funds and ETFs: Investment in the stock market is risky, as evidenced by the 2002 return for the S&P index of stocks. Moreover, many investors would like to leave the investment picking to the professionals. It is also prudent to diversify investments, but the amount of money needed to economically diversify can be substantial. Mutual funds are another investment vehicle that allow diversification. Mutual funds claim to offer both trading expertise and the ability to diversify cheaply. In particular, these funds are actively managed whereby professionals of the fund are trying to buy and sell mispriced stock (or bonds). Most funds specialized by following a specific investment style. There are mutual funds that invest only in equity (Equity Funds), bonds (Fixed Income Funds) or short-term liquid investments (Money Market Funds). Mutual funds also have different risk profiles within a specific category of investment. For example, there are mutual funds that invest in income (dividend) paying stocks, in growth stocks or in international stocks. Some mutual funds track stock indices such as the Dow Jones or the S&P 500 and are therefore passively managed. Mutual funds offer a dizzying set of fees to compensate the mutual fund managers for their time and effort. Fees include a Front-Load Sales Charge (an upfront fee based upon the amount invested with the fund), an expense ratio (the percentage of the value of the investment that is charged by the fund to cover its costs) and/or Back-Load Sales Charge (a fee that is paid upon exiting the mutual fund). Obviously, a fund beating the overall market can charge higher rates than those that do not. On average, mutual funds do not beat the market, especially after taking into account the fees. Nevertheless, mutual funds serve a good social purpose in that most of us do not have the expertise or resources to create a well-diversified portfolio.

Fortunately, there are equity investment vehicles that allow you to cost effectively diversify. One of the cheapest (in terms of transaction costs needed to make a diversified investment) is the Exchange Traded Funds. This is an investment fund that tracks a stock index. One of the more famous of these funds is Standard & Poor’s depositary receipt (SPDR), an investment fund that tracks the S&P index. Vanguard offers VIPERs and Barclays Global Investors offers iShares. These ETF funds cover a wide range of indices and economics sectors. For the most part, these investment funds are passively managed in the sense that the manager is not trying to pick undervalued stocks or sell overvalued stocks. Rather the firm selling these funds is essentially offering services to buy equities that track a particular index or sector. In making your choice, one should learn about how well the funds actually track the particular index and learn about the fund’s expense ratio.

Alternative Investments: There are several alternative investments individuals can consider. The biggest alternative investment is real estate. For many people the investment in residential quarters not only serves as a place to live, but a sizable wealth component of the individual. Investors who are interested in becoming a real estate mogul without committing to millions of dollars can invest in Real Estate Investment Trust (REIT). According to Wikipedia (http://en.wikipedia.org/wiki/Real_estate_investment_trust), “In the United States, a REIT is a company that owns, and in most cases operates, income-producing real estate. Some REITs finance real estate. To be a REIT, a company must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.” Investors can also invest in commodities such as gold, silver or platinum. Finally, investors can speculate on asset prices by buying or selling derivative securities such as call or put options.

A call option is a derivative security which gives the holder the right to buy the underlying security at a specified price (known as the Exercise Price). A put gives the holder the right to sell the underlying security at a specified price. One may view these derivatives as a useful vehicle for speculative investing. If one believes that stock price will rise (decline), one can buy the call (put) option. But one may also use these derivative securities for hedging. For example, you bought IBM at $162 per share. The price is now $182. You are not ready to sell the stock but you want to hedge against IBM falling below $175. You can buy a put option on IBM with an exercise price of $175. Two months hence you wish to sell your IBM stock. Consider two scenarios: Either IBM is worth $150 per share or $200 per share. If IBM is worth $150 per share, you can exercise your put option and make sure that you actually receive $175. But should IBM’s price increase to $200 a share, you simply do not exercise your put option and sell IBM for $200. Note the put option in this case is used as an insurance mechanism.

Your Investment Decision: Assume that you decided to invest a $10,000 signing bonus. How would you invest? Certainly, you will be considering the tradeoff between risk and return. For example, you could put all of your money in the treasury market. Your return will be very certain, but it is not very high. You can earn a lot more by investing your money in the junk bond market or in common stock. But you will also be taking a greater chance of not getting any return should the firm default. You also have to consider the liquidity of your investment. In other words, how easy will it be for you to sell your security at a fair price if you quickly need your money? Similarly, the choice of investment will depend upon your tax bracket, since municipal bonds can offer higher after-tax returns on your investment if your tax bracket is sufficiently high. Finally, you would have to consider the longevity of your investment. Do I want to invest in a 2-year Treasury or 20-year Treasury?

There is no right or wrong answer as to how to invest. You might choose high risk investments because you like the higher expected returns and you are willing to lose your shirt. On the other hand, some of you are very risk averse and will not invest in any...