CORPORATE FINANCE

PROF. DR. ERIK THEISSEN I NOV-DEC 2023

 Contact

Prof. Dr. Erik Theissen

University of Mannheim
Finance Area
L9, 1-2 Room 313
68161 Mannheim

Phone: 0621 181-1518

Fax: 0621 181-1519
Email: theissen@uni-mannheim.de
Web: http://finanzierung.bwl.uni-mannheim.de/
 Course Material

• The slides (together with the material for the group

sessions) cover most of the relevant content
• Most recommended text book:
- Hillier, D., St. Ross, R. Westerfield, J. Jaffe and B.
Jordan (HRWJJ): Corporate Finance, Fourth European
edition, Mc Graw-Hill 2020.
• Alternatives:
- Berk, J., P. DeMarzo and J. Harford (BDH): Funda-mentals of Corporate Finance, 4th
edition, Pearson 2018.
- Brealey, R., St. Myers and F. Allen (BMA): Principles of Corporate Finance, 13th
edition, McGraw-Hill 2020.
- Ross, St., R. Westerfield, J. Jaffe and B. Jordan (RWJJ): Corporate Finance, 12th
edition, McGraw-Hill 2019

• A reading list is provided at the end of each slide set.

Course Outline

1. Setting the Stage

2. Equity Financing and
Working Capital
3. Making Investment
Decisions
4. Capital Structure and the
WACC
CORPORATE FINANCE
SLIDE SET 1: SETTING THE STAGE

PROF. DR. ERIK THEISSEN I NOV-DEC 2023

Course Outline

1. The Financial Manager

2. The Governance of Firms
3. Financial Statements
4. Financial Statement
Analysis
5. Economic Value Added
(EVA™)
Course Outline

1. The Financial Manager

2. The Governance of Firms
3. Financial Statements
4. Financial Statement
Analysis
5. Economic Value Added
(EVA™)
The Financial Manager

You consider investing money (equity) into a business.

What (expected) rate of return do you require in order to
be willing to make this investment?
 The Financial Manager

2 1
The firm‘s The financial Financial
operations manager 4a Markets
3 4b

1 Cash raised from investors

2 Cash invested in firm
3 Cash generated by operations of the firm
4a Cash reinvested into firm
4b Cash returned to investors

Source: Adapted from BMA, p. 34

The Financial Manager

Will investors be willing to supply capital to the firm?

• Investors demand an "adequate" rate of return
• Adequate: (At least) equal to the rate of return that is
available elsewhere for "similar" investments ("opportunity
cost of capital")
• "Similar" with respect to risk
- maintained assumption: investors are risk averse

Problem: Identify projects that are better investments than the

"similar" investments available elsewhere
 The Financial Manager

This is where the definition of

Cash the opportunity cost of
capital comes from!

Investment
Investment
Financial opportunity
opportunity Shareholders
manager (financial asset)
(real asset)

Invest Alternative: Shareholders

Pay dividend invest for them-
Source: Adapted from BMA, p. 35 selves
The Financial Manager

Note:
• Divisions of the firm often compete for a fixed budget
• It is important to know how financial managers evaluate
projects
• Project evaluation requires information from many fields
within the firm (e.g. marketing, production, human
resources, procurement, ...) and therefore involves
managers from these areas
Course Outline

1. The Financial Manager

2. The Governance of Firms
3. Financial Statements
4. Financial Statement
Analysis
5. Economic Value Added
(EVA™)
 The Governance of Firms

Firms • These are "typical" cases

• International differences

Sole Proprietorship Partnership Corporation

Owner = Manager Owners = Managers Owners ≠ Managers
Personal liability Personal liability Limited liability
No conflicts of May be closely held or
interest public
Conflicts of interest
possible

Ease with which new

equity can be raised
Control by owner
The Governance of Firms

(Large) German corporation ("Aktiengesellschaft"): Two-tier

board
Shareholders' Meeting
("Hauptversammlung")

Supervisory Board
("Aufsichtsrat")
Employee
Executive Board representa-
tives
("Vorstand")

Firm
The Governance of Firms

The US corporation: One-tier board

Shareholders' Meeting

Board of Directors
Non-executive Directors

Executive Directors

Firm
The Governance of Firms

What is a manager’s objective?

The Governance of Firms

Separation of ownership and control may be advantageous:

• Owner-managers are capital-constrained
• Potential owner may lack managerial skill
• Changes in ownership do not affect the operations of the
firm
• Large firms with many owners can not be managed by the
owners themselves
The Governance of Firms

BUT managers may have preferences for

• growth ("empire building")
• consumption on the job ("perquisites")
• financial slack
• etc.
→ "hidden action" (moral hazard) problems
Managers may have information that capital providers do not
have
• misrepresentation of expected profits and/or risk
→ "hidden information" (adverse selection) problems
The Governance of Firms

Principal-agent relation - the manager (agent) is hired by the

owners (the principals) to act in their best interest but may
pursue her/his own agenda

How to align incentives?:

• Monitoring by shareholders / the board
• Managerial shareholdings and incentives
• Takeover threats
The Governance of Firms

Corporate Governance: "deals with the ways in which

suppliers of finance to corporations assure themselves of
getting a return on their investment" (Shleifer and Vishny
1997, p. 737)

Note: There is an alternative theory (stewardship theory)

which essentially assumes that managers will as "responsible
stewards" pursue the task they are entrusted with.
The Governance of Firms

A follow-up question:
Should managers only care about shareholder wealth or
should they also reach out to other stakeholders (such as
employees, customers, communities etc.)?
The Governance of Firms

Graham (2022, p. 2030)

The Governance of Firms

Graham (2022, p. 2030)

The Governance of Firms

• Managerial actions aiming at maximizing shareholder value

may impose external effects on other stakeholders
- e.g. pollution
- e.g. laid-off employees
- e.g. costs to creditor when firm engages in risky projects
• Proponents of the stakeholder view argue that the interest
of other stakeholders should be taken into account, e.g. by
- adjusting the objective of the firm (maximize the sum of
all “surpluses”)
- share control (e.g. German co-determination)
The Governance of Firms

The shareholder-value position

• (Most) proponents of the shareholder view share the
concerns and objectives of the stakeholder view
• They disagree on how to reach these goals
• They argue in favour of legal and / or contractual protection
• Once non-controlling stakeholders are sufficiently protected
the owners are the residual claimants
• Their position is thus particularly sensitive to the firm's
decisions. Therefore, they should be awarded the residual
control rights
• We adopt this "modified" shareholder-value view in this
course
Course Outline

1. The Financial Manager

2. The Governance of Firms
3. Financial Statements
4. Financial Statement
Analysis
5. Economic Value Added
(EVA™)
Financial Statements

The basic financial statements:

• Balance sheet (or: statement of financial position)
• Income statement
• Cash Flow statements
• Statement of changes in equity (retained earnings)
• In the EU since 2017: CSR report (large firms only)
Financial Statements

The Balance Sheet:

• Lists all assets and liabilities of a firm
• Relates to a particular point in time
• Balance sheet identity (from FA)

Assets =
Shareholders' Equity (incl. retained earnings) + Liabilities
 Financial Statements

Assets Liabilities

Fixed assets (Shareholders')

(potential long- Equity
term benefit) - contributed capital
-tangible - retained earnings Financial
Invest- -non-tangible claims
ments (Finan-
Liabilities
- bank loans cing)
- corporate bonds
Current Assets
- trade credit
- other

Remember (from FA): Accounting assets ≠ economic assets

Accounting liabilities ≠ economic liabilities
Financial Statements

Note: IFRS balance sheets can be structured

in ascending or descending order

2022 2021 2022 2021

Source: online ppt slides for BDH

Financial Statements

The Income Statement:

• Lists all revenues and expenses of a firm
• Relates to a period of time (year, quarter)

The Cash Flow Statement:

• Lists the sources and uses of cash
• Relates to a period of time

• Income and cash flow can be (and usually are) different

• Even positive net income and negative cash flow (or vice
versa) can occur simultaneously
 Financial Statements

2019
2022 2018
2021

Interest reduces
the pre-tax in-
come
(debt tax shield;
see slide set 4)

what‘s that?
Source: online ppt slides for BDH
Financial Statements

Which of the following relates to a specific point in time?

A The cash flow statement
B The income statement
C The balance sheet? This is the correct answer!
Financial Statements

Why differences between cash flow and net income?

Depreciation
• Working capital movements
- e.g. goods bought from a supplier that were not yet paid
(increase in accounts payable)
- e.g. goods sold to a customer, money not yet collected
(increase in accounts receivable)
• While for accounting purposes it is usually preferable to
use the income statement (for reasons discussed in FA),
capital budgeting procedures are based on cash flows
• Remember from FA: There is a direct and an indirect
method to set up the cash flow statement
 Financial Statements

Depreciation - a simple example

• Initial investment € 100,000; straight-line (linear)
depreciation over 4 years
t0 (today) t1 t2 t3 t4
cash flow -100,000 0 0 0 0
change in net 0 -25,000 -25,000 -25,000 -25,000
assets value

• In order to take the time value of money into account we

need to consider payment dates (i.e. cash flows)
• Accounting earnings can be “managed” (e.g. straight-line
versus units-of-production versus accelerated depreciation)
Financial Statements

Text

*Note: Slide taken from FA pre-course

 Depreciation reflects the accountant’s estimate of the cost of equipment
used up in the production process. For example, suppose an asset with a
five-year life and no resale value is purchased for €1,000. According to

Financial Statements
accountants, the €1,000 cost must be expensed over the useful life of the
asset. If straight-line depreciation is used, there will be five equal
instalments, and €200 of depreciation expense will be incurred each year.
From a finance perspective, the cost of the asset is the actual negative cash
flow incurred when the asset is acquired (that is, €1,000, not the
accountant’s smoothed €200-per-year depreciation expense).

Note: „Cash flow from

operating activities“
usually includes chan-
ges in working capital.

However, sometimes
these changes are
listed under „Cash
flows from investment
activities“ (but they
are always included)
 Financial Statements

2022 2021

„Depreciation for
intangible assets“

Depreciation &
amortization are
expenses but are
not cash outflows

Source: online ppt slides for

Berk, DeMarzo and Harford
textbook
Equal to change in cash (2021 to 2022) on the balance sheet
*Note: Slide taken from FA
Financial Statements
 Financial Statements

How does it all relate to each other (FA)? :

Financial Statements

Do we see all assets on the asset side of the balance

sheet? no , company has intellectual capital which cannot be termed as an asset.

Current assets are often called “short-lived assets”. Are they

really short-lived? No, some current assets are termed as inventories which will used during the entire lifecycle!

When you multiply the number of shares outstanding by the

share price of a listed company, you obtain the “market
value of equity”. It is almost always different from the
amount of equity as shown on the balance sheet. Why?
yes and market value is always greater than book value.
Based on future prospects and investor expectations in the future
Financial Statements

Mini Case MVV Energie AG (Annual Report 2000/01, p.

26)
Please comment on the highlighted section of the following
quote:

This is incorrect judgement as depreciation doesn’t affect cash flows at all.

interpret as
depreciation
Course Outline

1. The Financial Manager

2. The Governance of Firms
3. Financial Statements
4. Financial Statement
Analysis
5. Economic Value Added
(EVA™)
Financial Statement Analysis

Financial Statement Analysis

• Evaluation of financial statements to gain an understanding
of the financial health of a firm
• Assumes that the financial statement contains information
that helps to predict the future

Who analyzes financial statements (and why?)

• Current and potential future creditors (banks, suppliers
(trade credit!), ...)
• Rating agencies
• Stock market analysts and shareholders
• Managers of the firm itself
Financial Statement Analysis

Comparing Financial Statements of Different Firms

• Use common-size statements
- Figures are normalized by dividing them by total assets
(balance sheet) and total sales (income statements)
- Thus, all positions are expressed as a percentage of
these items
• Use financial ratios
Financial Statement Analysis

2022 2021 2022 2021

Source: online ppt slides for BDH

Financial Statement Analysis
Financial Statement Analysis

2019 2018

Source: online ppt slides for BDH

Financial Statement Analysis
Financial Statement Analysis

Financial Ratio Analysis

• Considers ratios formed from figures in the balance sheet
and / or income statement
• Ratios can be used (1) for comparison across firms or (2) to
track a firm over several periods
• Ratios make firms of different size comparable
• Focus of the analysis:
- short and long term solvency / liquidity
- asset management / turnover
- profitability
- market value
• We will only consider ratios that are relevant to this course.
 Financial Statement Analysis

Financial Ratio Analysis (contd.)

• Some warnings Some disadvantages

- different definitions of ratios exist (e.g. RoA, see below)

- financial ratios cannot easily be compared across
industries
- “structural breaks” may exist (e.g. a recent merger)
- different benchmarks can be used (compare to average
vs. compare to best)
- international comparisons can be difficult because of
differing accounting standards
Financial Statement Analysis

Short Term Solvency / Liquidity Ratios

• Aim to capture the firm’s ability to cover its short-term
(current) liabilities
• Short-term assets (= liquid assets) can be used to cover the
current liabilities
• Ratios have already been introduced in FA (pre-course)
Current assets
CurrentRatio =
Current liabilities
Current assets − Inventory
Quick Ratio (Acid Test) =
Current liabilities
Cash and cash equivalents
Cash Ratio =
Current liabilities
Financial Statement Analysis

Interpretation
• Ratio > 1: Current assets exceed current liabilities
(note: this is equivalent to a positive net working capital)
• Higher ratios are considered as better

Caution:
• How liquid are the current assets? → 3 different ratios
• How “current” are the current assets?
• Short-term liquidity ratios can change quite quickly (e.g.
seasonal inventory changes)
Financial Statement Analysis

The inventory of Volkswagen increased by about 3.8 billion

€ in 2008 (17.8 b up from 14.0 b in 2007)
This is good news for the shareholders.

it might signify that too much of working capital is tied up in the inventory.
True or false? 2008 marked the beginnning of the economic depression as well.
 Financial Statement Analysis

Long Term Solvency / Liquidity Ratios

• Aim to capture the firm’s ability to meet its obligation in the
longer run
• Different ratios look at the relation of debt, equity and total
assets
• Static and dynamic measures
Financial Statement Analysis

Total debt
Total Debt Ratio =
Total assets

Equity  (= 1− Total debt ratio )

Equity Ratio = 
Total assets ( 1 (1+ Debt − EquityRatio ) )
=

Total debt  Total Debt Ratio 

Debt − Equity Ratio = =
Total equity  Total Equity Ratio 

Financial Statement Analysis

Interpretation
• The ratios are related - if you know one, you can calculate
the others
• Creditors like low debt ratios (higher debt means higher
bankruptcy risk, all else equal)
• Debt ratios are related to the firm’s choice of capital
structure (= the mix of debt and equity)
• The ratios are static in nature - they consider the level of
debt, but not the firm’s ability to pay down the debt
Financial Statement Analysis

The interest coverage ratio is

a debt and profitability ratio
Interest Coverage Ratio Ebit used to determine how easily

= a company can pay interest

( = Times Interest Earned Ratio) Interest

on its outstanding debt.

The cash coverage ratio is a calculation that determines a

business's ability to pay off its liabilities with its existing cash. It
is how you can measure a business's liquidity. The cash coverage
ratio includes only cash and cash equivalents.

Ebit + Depreciation
Cash Coverage Ratio = Note: Ebit +
Interest depreciation
serves as a
proxy for cash
Total debt flow
Debt to Cash − Flow Ratio =
Ebit + Depreciation
Financial Statement Analysis

Interpretation
• The first two ratios consider the firm’s ability to pay the
interest out of current earnings - creditors consider higher
ratios to be better
• The third ratio measure how many years it would take the
firm to repay the debt out of the (unchanged) cash flow -
creditors consider a lower ratio as better
Financial Statement Analysis

Asset Management / Turnover Ratios

• Aim to capture the efficiency of the use of the firm’s assets
• Relate inventory and accounts receivable to sales and the
cost of goods sold
• Are closely related to the firm’s working capital and are
therefore discussed in slide set 2
Financial Statement Analysis

Profitability Measures
• Relate measures of income to measures of the size or
activity of the firm
• Very popular
• Note: Measures can be defined using pre-tax income or
after-tax income (check when comparing)
Financial Statement Analysis

Net income
Profit Margin=
Sales

Net income +interest expense

Return on Assets (RoA ) =
Total assets

Net income
Return on Equity (RoE ) =
Equity

Note: Net income here is after-tax profit

Financial Statement Analysis

Interpretation
• Higher ratios are better, all else equal
• RoA and RoE are usually based on book values, not
market values Without leverage

• RoA and RoE are equal for an unlevered firm. For a levered
firm the RoE is higher than [lower than] the RoA whenever
the RoA is larger than [lower than] the interest rate on the
firm’s debt (see slide set 4)
• Note: RoE can be extended to the “DuPont pyramid” (see
below) In case of leverage , the assets increase and value of the denominator
in ROA increases , thus overall fraction decreases in value.
Financial Statement Analysis

Please read the definition below (from Investopedia.com).

What do you prefer
A RoA defined with net income in the numerator or
B RoA defined with interest expenses added back?
What is 'Return On Assets - ROA'
Return on assets (ROA) is an indicator of how profitable a company is relative to its total
assets. ROA gives an idea as to how efficient management is at using its assets to
generate earnings. Calculated by dividing a company's annual earnings by its total assets,
ROA is displayed as a percentage. Sometimes this is referred to as "return on investment".
The formula for return on assets is:

Note: Some investors add interest expense back into net income when performing this
calculation because they'd like to use operating returns before cost of borrowing.

(http://www.investopedia.com/terms/r/returnonassets.asp)
Financial Statement Analysis

Market Value Measures

• Use market values instead of book values
• Easily applicable for exchange-listed firms
• Frequently used by stock market investors and equity
analysts
 Financial Statement Analysis

Net income
Earnings per Share (EPS ) =
Shares outstanding
non-diluted / on a
fully diluted basis
Price per share
Price -Earnings Ratio (PE-Ratio ) =
EPS

Market value of equity ( total / per share )

Market - to -Book Ratio=
Book value of equity ( total / per share )
Financial Statement Analysis

Interpretation
• The PE ratio and the market-to-book ratio are based on
market prices and therefore incorporate the market’s
expectations on the future profitability of the firm
• Market values reflect (the market’s assessment of) the
future investment opportunities of the firm
• All else equal, higher PE and MtB ratios are better

Note: Earnings per share are popular in practice but have

recently been critizized because managerial focus on EPS
results in short-termist behavior (Almeida 2019)
 Financial Statement Analysis

We can decompose the RoE: The „Asset Turnover“ relates

sales to total assets and can
(The “DuPont identity”) thus be interpreted as a
measure of the efficiency of
Net income the firm‘s use of its assets
RoE=
Equity
Net income Assets
= ×
Assets Equity
Net income Sales Assets
= × ×
Sales Assets Equity
=Profit Margin×Asset Turnover×Equity Multiplyer
=Profit Margin×Asset Turnover× (1 + Debt − Equity − Ratio )
Financial Statement Analysis

Interpretation
• Decomposition allows analysis of the determinants of the
RoE (and of reasons for changes in the RoE)
• RoE depends on operating efficiency, asset use efficiency,
and financial leverage
• The role of financial leverage will be further discussed in
slide set 4
• The DuPont identity can be extended to a “pyramid” of
ratios
Financial Statement Analysis

Source: Ferris and Pécharot Petitt (2002), p. 22

Course Outline

1. The Financial Manager

2. The Governance of Firms
3. Financial Statements
4. Financial Statement
Analysis
5. Economic Value Added
(EVA™)
Economic Value Added (EVA™)

An opening question:
Financial economists often use the term “cost of equity” -
but there are no contractual interest charges on equity. In
which sense, then, is equity costly?

A firm’s cost of equity represents the compensation

that the market demands in exchange for owning the
asset and bearing the risk of ownership.
Economic Value Added (EVA™)

Characterization
• Developed by Stern Steward (EVA is a trademark)
• Starting point: Net income figures are after interest
payments (= cost of debt) but do not take into account the
cost of equity
• EVA is basically a measure of profit after total financing
costs
Economic Value Added (EVA™) Managerial compnsation/ Required return

=capital*return
Definition:
EVA = NOPAT - WACC*Capital
= (Return - WACC)*Capital

NOPAT: Net operating profit after tax (interest payments are

not deducted)
WACC: Weighted average cost of capital (debt and equity)
(see slide set 4 for details)
Economic Value Added (EVA™)

Interpretation
• EVA is measured in Euros (not as a percentage)
• EVA is popular in practice and used (among other things)
as a basis for managerial compensation
• EVA is not unambiguously defined in the literature
• EVA in fact is a complex system which requires many
“conversions” when going from accounting figures to EVA
 Reading List

Required Reading:
• Hillier, D., St. Ross, R. Westerfield, J. Jaffee and B. Jordan (2020):
Corporate Finance, Fourth European edition, chapters 1, 2, 3.

Supplementary Reading:
• Almeida, H. (2019): Is It Time to Get Rid of Earnings-per-Share (EPS)?
Review of Corporate Finance Studies 8, 174-206.
• Ferris, K. and B. Pécherot Petitt (2002): Valuation - Avoiding the
Winner’s Curse, Prentice Hall, chapter 2.
• Graham, J. (2022): Corporate Finance and the Real World. Presidential
Address, Journal of Finance 77, 1975-2049, also available at
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3994848.
• Harrison Jr., W., C. Horngren, W. Thomas and T. Suwardy (2014):
Financial Accounting, 9th edition, Pearson, chapters 11 and 12.
 Reading List

• Shleifer, A. and R. Vishny (1997): A Survey of Corporate Governance.

Journal of Political Economy 52, 737-783.
(a classic article on corporate governance)
THANK YOU
VERY MUCH!

PROF. DR. ERIK THEISSEN I NOV-DEC 2023