Week 1: Corporate Finance, Financial Statements and Time Value of Money (Ch. 1, 3, 4)

The first week lays the foundation of the course. Chapter 1 explains what corporate finance is, which decisions a financial manager takes and what the goal of those decisions should be. Chapter 3 shows how to read and analyse the three main financial statements with ratios and the Du Pont identity. Chapter 4 introduces the single most important tool of the whole course: the time value of money (future value, present value, compounding and discounting). Everything that follows (bond and share valuation, NPV, cost of capital) builds on these ideas.

Why corporate finance matters

The lecture opens with real-world examples: the Dutch AEX index over five years, a one-day loss of about 12% on the Japanese stock market (5 August 2024), and the comparison between the revenues and the market capitalisations of car manufacturers. A company with far lower revenues than its competitors can still have a much higher market value (Tesla versus Toyota or Volkswagen), because the market values expected future cash flows, not past sales. Other examples are Elon Musk's takeover of Twitter and the IPO of the restaurant chain Bojangles'. In that IPO the number of shares offered was raised from 6.25 to 7.75 million and the price range from $15 to $17 to $18 to $19 because demand was strong. At $19 the offering would raise about $169 million, but the proceeds went to existing key investors (such as the private equity firm Advent International), not to the company itself. You can only interpret news like this if you understand the concepts of this course (IPO, underwriters, primary and secondary markets, valuation).

The course follows the book by Hillier, Clacher, Ross, Westerfield and Jordan. The outlook: Ch. 1, 3, 4 (financial management, statements and ratios, time value of money), Ch. 2 and 5 (corporate governance, discounted cash flow valuation), Ch. 6 and 7 (bond and stock valuation), Ch. 8, 9 and 10.3 to 10.5 (investment criteria, capital investment decisions, break-even and operating leverage), Ch. 11 and 12 (risk and return, diversification, SML, CAPM), Ch. 13 and 14 (cost of capital, raising capital) and Ch. 20 (financial risk management and hedging).

Accounting versus finance

Financial decision making is about the future. Accounting records the past and works with real, realised amounts. Finance discounts future cash flows and therefore works with forecasts. Accounting presents information that allows management to assess performance and risk (financial accounting) and to make informed decisions (management accounting); in the EU listed firms must follow the International Accounting Standards (IAS) set by the IASB. Finance uses this information, but the decisions it supports concern cash flows that have not happened yet.

What is corporate finance? The three basic questions

Anyone who starts a business must answer three questions. Corporate finance is the study of how to answer them:

1. Investment (capital budgeting): what long-term investments will you make? Which lines of business, which buildings, machinery and equipment?
2. Financing (capital structure): where will you get the long-term financing for these long-term projects? Will you bring in other owners (equity) or borrow (debt)?
3. Working capital management (liquidity): how will you manage everyday financial activities such as collecting from customers and paying suppliers?

The financial manager

In large corporations the owners (shareholders) are usually not involved in day-to-day decisions. They employ managers to represent their interests. The financial manager (finance director, FD, or chief financial officer, CFO) is in charge of the three questions above. The slide summarises the tasks: responsible for investment decisions (capital budgeting), for financing decisions (capital structure) and for short-term financial planning (working capital management); in addition the financial manager oversees the accounting and audit function and ensures the financial welfare of the firm.

In the simplified organisation chart (Figure 1.1) the board of directors sits at the top, with the chairman, chief executive officer, executive directors and non-executive directors. Below the CEO are, among others, the chief marketing officer, the chief financial officer and the chief operating officer. The CFO coordinates two functions:

• The treasurer (finance function): cash manager, credit manager, capital expenditures and financial planning.
• The controller (accounting function): tax manager, cost accounting manager, financial accounting manager and data processing manager.

The goal of financial management

Possible goals are to survive, avoid financial distress and bankruptcy, beat the competition, maximise sales or market share, minimise costs, maximise profits or maintain steady earnings growth. Each has problems. Market share is easy to raise by cutting prices, costs are easy to cut by scrapping R&D, and bankruptcy can be avoided by never borrowing or taking risk, but none of this is necessarily in the shareholders' interest. Profit maximisation is vague: profit this year can be raised by deferring maintenance or running down inventory; 'long-run' profit is unclear; and accounting profit may have little to do with value. The goals fall in two groups (profitability and risk control) that partly contradict each other, so a goal is needed that captures both.

The slide shows this as a funnel: maximise share price, manage risk and avoid financial distress all feed into maximise shareholder (stakeholder) value. The goal is justified because shareholders are residual owners: they receive only what is left after employees, suppliers, creditors and other legitimate claimants are paid. If the residual is growing, everyone else must be winning too. The goal does not justify illegal or unethical actions; value is added by offering goods and services that are valued in the free market. Corporate finance can thus be defined as the study of the relationship between business decisions and the value of the equity.

Financial markets and the corporation

Financial markets bring buyers and sellers of debt and equity securities together and let money flow from those with surplus cash to those that need financing. The cash flow cycle: the firm issues securities and cash flows from the financial markets to the firm (A); the firm invests in current and non-current assets (B); the assets generate cash (C); part goes to taxes (D); part is reinvested (E); the rest is paid back to creditors and shareholders as interest, dividends and repayments (F). Household savings (G) also flow into the markets via financial institutions (H) such as banks, insurers and pension funds.

Primary market transactions are public offerings (sold to the general public, must be registered with the securities regulator such as the AFM in the Netherlands or the FCA in the UK, with considerable accounting, legal and selling costs) or private placements (negotiated sale to a specific buyer such as an insurance company, usually without registration and without underwriters). Secondary markets matter to firms even though the firm receives no money there, because investors are more willing to buy in the primary market if they know they can resell later. Secondary markets are dealer markets (dealers buy and sell for their own account; for shares and bonds called over-the-counter, OTC; most debt trades OTC) or auction markets (exchanges with a physical location whose purpose is to match buyers and sellers, such as the London Stock Exchange or NYSE Euronext). Securities traded on an exchange are listed; listing requires meeting minimum criteria (track record, size, audited accounts, governance).

The book closes Chapter 1 with the case of Google (Alphabet): start-up capital from an angel investor and venture capitalists based on a business plan and cash-flow forecasts (valuation), an all-equity IPO in 2004 (capital structure and raising capital), the need for liquidity and short-term planning, and acquisitions worldwide (international finance). Success requires understanding all areas of corporate finance.

The annual report: three financial statements

Every year a company publishes an annual report with three statements: the statement of financial position (balance sheet), the income statement and the statement of cash flows. Two distinctions are central: accounting value versus market value, and accounting income versus cash flow.

Left side (assets): current assets have a life of less than one year and convert to cash within 12 months (cash, inventory, trade receivables). Non-current assets have a long life and are tangible (trucks, computers, buildings) or intangible (trademarks, patents). Right side: current liabilities must be paid within the year (trade payables); non-current liabilities are due later than one year (such as a five-year loan or bonds); the rest is shareholders' equity. The left side represents the total value of the assets, the right side the total value of the firm to investors.

Worked example (slides): a firm has current assets of £2.346 billion, non-current assets of £8.142 billion (total assets £10.488 billion), current liabilities of £4.142 billion, non-current liabilities of £4.500 billion and equity of £1.846 billion. NWC = 2.346 - 4.142 = -£1.796 billion. The negative NWC signals that current liabilities are not covered by current assets, which deserves attention.

Book value versus market value. Book values follow accounting standards; under IAS most firms use the historical cost model (what was paid for the asset), while the revaluation model shows fair value. Market value is what the assets or the equity would fetch in the market today. For current assets the two are often close; for non-current assets they can differ hugely (land bought a century ago). Valuable assets such as good management, reputation and talented staff do not appear on the balance sheet at all. For the financial manager the market value is what matters.

The market value of equity (£1,100) is almost twice the book value (£600), because equity is the residual: market value of assets £1,600 minus debt £500.

The income statement

Under IAS revenue is recognised when it accrues (recognition or realisation principle: usually at the time of sale, not when cash is collected) and expenses are matched to the revenues they helped produce (matching principle). Therefore income is not cash flow. The most important non-cash item is depreciation: if an asset costing €5,000 is depreciated straight-line over five years, €1,000 per year is deducted as an expense, but the cash left the firm when the asset was bought.

Ryanair example (€ millions):

EBIT (earnings before interest and taxes) is also called operating profit; EBITDA adds back depreciation and amortisation and is a rough measure of cash generated from operations. The lecture also shows the real income statement of Volkswagen 2021 (sales revenue €250.2 billion, operating result €19.3 billion, earnings after tax €15.4 billion).

Taxes: average versus marginal tax rate

• Average tax rate: the percentage of income paid in taxes, i.e. the tax bill divided by taxable income.
• Marginal tax rate: the tax you would pay on one more unit of currency earned.

Dutch corporate income tax is progressive: 2020: 16.5% on the first €200,000 and 25% above; 2021: 15% on the first €245,000 and 25% above; 2022: 15% on the first €395,000 and 25% above. Marginal rates apply only to the part of income in the indicated bracket.

The book gives a similar example: with 20% on the first €200,000 and 25% above, a taxable income of €400,000 gives tax of €40,000 + €50,000 = €90,000, an average rate of 22.5% and a marginal rate of 25%.

The statement of cash flows

Cash flow is often the most important item to take from the financial statements. The cash flow identity says that cash flow from the firm's assets equals cash flow to creditors plus cash flow to shareholders. The statement splits total cash flow into three components:

• Operating activities: cash generated by the day-to-day business (revenues minus costs and taxes, adjusted for changes in working capital; depreciation is not deducted because it is not a cash outflow, and interest is treated as financing). Under IAS it can be presented with the direct method or the indirect method (start from profit and remove non-cash items). A negative operating cash flow is often a sign of trouble.
• Investing activities: money spent on non-current assets minus money received from selling them (net capital spending).
• Financing activities: cash raised by issuing debt or equity, minus repayments, share buybacks and dividends.

Two warnings from the slide: cash flow is not working capital (working capital is a snapshot, cash flow is earned over a period) and cash flow is not profit (depreciation decreases profit but not cash flow).

Ratio analysis

Ratios make it possible to analyse a firm's statements and compare them over time and with other firms. Different sources compute ratios differently, so always document your definitions. The five groups: liquidity ratios (short-term solvency), financial leverage ratios (long-term solvency), turnover ratios (asset management), profitability ratios and market value ratios. The lecture focuses on profitability, leverage and market value ratios; the others come from the book.

Liquidity (short-term solvency) ratios matter most to short-term creditors:

• Current ratio = Current assets / Current liabilities.
• Quick (acid-test) ratio = (Current assets - Inventory) / Current liabilities. Inventory is the least liquid current asset and its book value is least reliable; buying inventory with cash leaves the current ratio unchanged but lowers the quick ratio.

Financial leverage (long-term solvency) ratios:

Example (slide): if the total debt ratio is 1/3, then with total assets of 1, debt = 1/3 and equity = 2/3, so D/E = (1/3)/(2/3) = 0.5 and the equity multiplier = 1/(2/3) = 1.5. Tutorial: GNR plc has a total debt ratio of 0.43, so equity is 0.57 of assets, D/E = 0.43/0.57 = 0.75 and EM = 1 + 0.75 = 1.75. If instead the equity multiplier is 1.5, then D/E = 0.5, the total equity ratio = 1/1.5 = 0.67 and the total debt ratio = 1 - 0.67 = 0.33.

Turnover (asset management) ratios measure how efficiently assets generate sales: inventory turnover = cost of goods sold / inventory and days' sales in inventory = 365 / inventory turnover; receivables turnover = sales / receivables and days' sales in receivables (average collection period) = 365 / receivables turnover; payables turnover and average payment period likewise; NWC turnover = sales / NWC; PPE turnover = sales / net PPE; total asset turnover = sales / total assets.

A high profit margin is desirable, but lowering prices usually raises volume while shrinking margins, so a lower margin is not necessarily bad. The lecture illustrates margins with news about Xiaomi's EV unit (15.4% gross profit margin).

A high P/E is often read as strong growth prospects, but a firm with almost no earnings also has a very high P/E. A market-to-book ratio below 1 may mean the firm has not created value for shareholders. Tobin's Q is conceptually better (today's value versus today's replacement cost) but hard to measure.

Shiller P/E (CAPE). The Shiller P/E divides the price by average inflation-adjusted earnings of the previous ten years (the cyclically adjusted P/E). For the S&P 500 the long-run mean is about 17 (median about 16), with a low of 4.8 (1920) and a high of 44.2 (1999); in 2024 to 2025 it stood around 36 to 39, far above the historical average. Evidence (Nate Silver, The signal and the noise): the 10-year trailing P/E has almost no predictive power for one-year S&P 500 returns (a wide cloud of points), but a clear negative relation with 20-year average returns: high P/E ratios are followed by low long-term returns. The P/E is thus useful for long-term, not short-term, forecasts. P/E ratios also differ strongly across countries and sectors (for example information technology far above energy).

The Du Pont identity

Why is a positive ROE always larger than ROA? Because the equity multiplier is at least 1: total assets are always at least as large as equity (assets = debt + equity). With any debt the multiplier is above 1 and ROE exceeds ROA. More debt raises the equity multiplier, but it also raises interest expense and lowers the profit margin, so ROE can go up or down. If ROE is unsatisfactory, the identity shows where to start looking.

Tutorial example (McBig counselling): total assets €40,000, total liabilities €20,000, sales €12,250, net income €4,000. Profit margin = 4,000/12,250 = 32.65%; total asset turnover = 12,250/40,000 = 0.3065; equity = 40,000 - 20,000 = 20,000, so D/E = 1 and EM = 1 + 1 = 2. ROE = 0.3265 x 0.3065 x 2 = 20% (check: 4,000/20,000 = 20%).

Second example: total assets €31,483, liabilities €18,679, sales €17,193, net income €2,026. Profit margin = 11.78%; asset turnover = 0.55; equity = 12,804, D/E = 1.46, EM = 2.46. ROE = 0.1178 x 0.55 x 2.46 = 15.82%.

ROA examples: Volkswagen with sales €113,808, total assets €167,919 and a profit margin of 4.173%: net income = 113,808 x 0.04173 = €4,749.2 and ROA = 4,749.2/167,919 = 2.82%. Daimler with sales €200,654, total assets €271,764 and a profit margin of 4.867%: net income = €9,766 and ROA = 3.59%. The total debt figures given in these questions are not needed to compute ROA.

Using financial statement information

(Own reading.) Accounting information is used because market values are often unavailable; when market data exist they take precedence. Ratio analysis is 'management by exception': ratios that deviate most from a benchmark are flagged for further study. Internal uses are performance evaluation (managers are often paid on profit margin or ROE) and planning; external uses include credit decisions, evaluating suppliers, customers and competitors, credit ratings and acquisitions. Benchmarks are the firm's own history (time trend analysis) or similar firms (peer group analysis, or an aspirant group of top firms). Problems: there is no theory saying which ratios matter; firms are rarely identical; different accounting standards across countries; different accounting procedures and fiscal year ends (seasonality); and one-off events such as a profit from an asset sale.

Time value of money: future value and compounding

A euro today is worth more than a euro later, because today's euro can be invested to earn interest. Time convention: we are at the end of year 0 (today); 'next year' is the end of year 1. Cash outflows are shown as negative, inflows as positive on a time line.

Single period: invest £100 at 10%; after one year you have £100 + 10% of £100 = £110. Two periods: after year 2 you have £110 x 1.1 = £121 = £100 x 1.1^2. The extra £1 compared with simple interest (£120) is interest on interest: in year 2 you also earn 10% on the £10 interest from year 1.

Simple versus compound interest. Simple interest is earned only on the original principal. Compound interest is earned on the principal and on interest reinvested from earlier periods. Example: $1,000 for 20 years at 10%. Simple interest: 1,000 + 20 x 100 = $3,000. Compound interest: 1,000 x 1.1^20 = $6,727.50. The graph 'Power of compounding' shows how strongly rate and horizon matter: $100 at 10% for 25 years becomes $1,083; at 15% $3,292; at 20% $9,540; and at 20% for 30 years $23,738.

Five-minute finger exercise: invest €400 at 12%. After three years: 400 x 1.12^3 = €561.97. After seven years: 400 x 1.12^7 = €884.27. Interest earned in seven years: €484.27. Simple interest would be 7 x 400 x 0.12 = €336, so €484.27 - €336 = €148.27 results from compounding.

Compounding more than once a year, APR and EAR

Banks often compound daily, monthly or quarterly. With the same annual rate, more frequent compounding gives more interest. Example: $500 for seven years at 8% per year compounded semi-annually: the rate per half year is 4% and there are 14 periods, so FV = 500 x 1.04^14 = $865.84. With annual compounding FV = 500 x 1.08^7 = $856.91.

The annual percentage rate (APR) in this context indicates the interest paid or earned in one year without compounding; it is also called the nominal or stated (quoted) rate. Two loans with the same APR but different compounding periods are not comparable. To compare them we compute the effective annual rate (EAR): the equivalent rate with annual compounding. (Week 2 treats EAR formally; note that in the EU the legally required 'APR' includes all fees, see week 2.)

Present value and discounting

Single period: you need €70 in one year for a textbook and can earn 10%. You must save 70/1.1 = €63.64 today (check: 63.64 x 1.1 = €70). Multiple periods: €1,000 received in two years at 10% is worth 1,000/1.1 = €909.09 after one year back and 909.09/1.1 = 1,000/1.1^2 = €826.45 today.

Figure 4.3 shows that the present value of £1 falls as the period gets longer and as the discount rate gets higher; at 0% it stays £1. Tutorial examples: an unfunded pension liability of £800 million due in 20 years at 7% has a PV of 800,000,000/1.07^20 = £206,735,202. A €1 million lottery prize paid in 80 years at 12% is worth only 1,000,000/1.12^80 = €115.49 today.

Because PV = FVt/(1 + r)^t contains four variables (PV, FV, r, t), any one can be found if the other three are known. This is the basic present value equation. In Excel: FV(rate, nper, pmt, pv), PV(rate, nper, pmt, fv), RATE(nper, pmt, pv, fv) and NPER(rate, pmt, pv, fv), with a negative sign on either PV or FV.

Finding the number of periods

Finding the necessary rate of return

More tutorial examples: €2,500 invested for 30 years at 6.5% grows with simple interest to 2,500 + 30 x 162.50 = €7,375 and with compound interest to 2,500 x 1.065^30 = €16,535.92. A loan of €10.5 million at a nominal 6% with monthly compounding, on which nothing has been paid for 10 years, grows to 10.5 x (1 + 0.06/12)^120 = €19.1 million. Alder Inc. (net income $403,000, equity $148,000, equity multiplier 10): total assets = 10 x 148,000 = $1,480,000, so ROA = 403,000/1,480,000 = 27.23%.