Corporate Finance 1

Value generation

• Ultimately, the firm must be a cash generating activity. 
• The cash flows produced by the firm must exceed the cash flows from the financial markets (for equal level of risk). 

1. What long-term investments should the firm engage in?
2. How should the firm raise the money for the required investments?
3. How much short-term cash flow does a company need to pay its bills?
4. How to implement the efficient and valuable risk management?

1. Legal personality - firm lives as long as there is capital
2. Limited liability - corporation is separated from owners (separation of ownership and control); the loss is limited to the amount of investment. Individual members of a corporation are not liable in case of bankruptcy.
3. Transferable shares - investors can sell their shares and "exit" the company; low control is only acceptable given the ease of transferability («vote with the feet»)
4. Delegated management - strategy is set by board of directors, operations is delegated to management
5. Investor ownership - investor has the right to control (voting) and to receive net earnings (dividends)

Survival is more important for the managers, since they do not want to be taken over --> they would lose independence and self-sufficiency.
As a shareholder I mainly (or even just) am motivated monetarily and if the best option is to keep going, I do so. However, I can always just sell the company / my shares.

In times of financial distress, the management has an interest in taking investments that have more volatility and they will take on more investments. As the shareholders are not as eager to keep the company going, they have no incentive to overinvest.
Also, by "empire building", management might try to buy more and more around the company, eventhough it does not necessarily align with the firms strategy.

Of course there is also the point of fringe benefits. Management has interest in buying a firms private jet so they can use it, however, the jet won't benefit the company. So it was an investment, which was not necessarily smart for the company. 

Financial decisions can create social costs and benefits which accrue to society as a whole and NOT to the firm making the decision. 

Social costs: environmental costs (pollution, health costs, etc.); quality of life costs (traffic, housing, safety, etc.)
Social benefits: creating employment in areas with high unemployment; supporting development in inner cities; creating access to goods in areas where such access does not exist

Market value of equity + market value of debt

also: FCF/WACC 
(free cash flow / weighted average cost of capital)

Cash Flows to Shareholders / Cost of Equity

Risk free Rate of Return + (Beta * Market Risk Premium)

Interest Payments / Cost of debt

Risk free Rate of Return + Maturity Premium + Credit Risk Premium * Tax Advantage

Business cycles
Economy

The aggregated value is more volatile, since a certain amount of deals will always (have to) be made. 
Also, during economic distress, pharmaceutical companies, for example, are still financially stable. They will use the situation to buy targets at a lower price. 

The number of transactions goes up and for firms it is favorable to finance debt levels during these times. 

Market Value is the current assessment of firm value on the financial market, i.e. price, (e.g., market cap).

The Liquidation Value is the value in case of a split-up of the firm into parts. 

Liquidation is perceived negatively, because many of them are forced and if you liquidate a company, time-pressure causes inability to realize good values since everyone knows that the corporation is about to go down.
One tries to safe parts before going into liquidation. Liquidation is the least favourable way to go out of the market.

The Reconstruction Value is the prize to be paid in order to reconstruct all assets of the firm (mostly limited to tangibles). 

The Going Concern Value is the value of the firm in case of going concern of the oerating activity.
Here, the firm sticks to its values and continues with them. 

The Book Value is the value based on items on the Balance Sheet. 

If there are better oportunities ("real options") you can fine-tune your model in order to make the best decision.
This is incorporated in the market value, however not into the going concern value.

M > B indicates the existance of intellectual capital.

Additivity
Discounting

The principle of Additivity is one of the principles of valuation. 

In a well functioning market the value of the basket equals exactly the sum of the values of the single components. If not, there would be arbitrage. 
Thus, a portfolio values the sum of its components. 

Discounting is one of the two principles of valuation. 

The vale (present value) of a payment due 1 year from now can be calculated by dividing the cash flow by (1 + interest rate). If the value was different, there would be arbitrage. 

In case of cash flows due in T years, the payment is discounted by (1+R)^T. 

Traditional discounting: the expected value of the uncertain payment is discounted with a higher rate - which can be expected from investments with a comparable risk. 
 

In the long run both Free Cash Flow (FCF) and Earnings will (mostly) align. However, in the short run, they can be vastly different due to several factors, such as the following: 

Earnings might be distorted in several dimensions. For example, if I sell something in Oct. 2023 and put it in the books and payment is due until Feb. 2024, but the company owing me money goes bankrupt in the meantime. This results in my books looking very nice but there never was actual free cashflow due to the bankruptcy of the other firm.
Also, if I make an investment, the free cashflow is high and immediate. However in earnings, I divide the amount in 10 parts and discount the full amount by one part per year.

Firm Valuation focuses on the Operating Cash Flow. 

Operating Cash Flow = EBIT + Depreciation - Taxes

1. Cash Flow from operating activities
2. Cash Flow from investing activities
3. Cash Flow from financing activities

With the DCF method, the value of the firm is calculated as the sum of discounted future free cash flows.

FCF = Cash Flow (CF) - Investments (I)

Free Cash Flow is the cash flow that can be paid out without impairing the going concern of business. 

Free Cash Flow (FCF)

NOT earnings!