Session 1: Corporate Finance: What is it?

this is the first of 36 sessions in a class that I like to call corporate finance to me Corporate Finance is more than a collection of equations metrics and models it's a set of first principles that govern how we run businesses and in this class I hope to lay out those first principles set up some themes for the class and use it as a road map for the remaining 35 sessions but welcome and I'm glad you've joined me in this class welcome to the introductory session on Corporate Finance in this session what I hope to

do is lay out my vision for what this class is going to be about talk a little bit about the first principles that I think Drive every corporate financial decision set up some broad themes for the class and lay out a road map for what's coming ahead so let me get the show on the road by first giving you my vision of what Corporate Finance is all about if you ask most people what they think Corporate Finance is about you get a variety of answers there are some people who think of corporate finance as an

extension of accounting others think of it as Financial modeling still others might think of it as a banking sub sector that's not what I think about Corporate Finance to me Corporate Finance covers any decision that involves the use of money that's an incredibly self-serving definition because I've just said everything is Corporate Finance and I truly believe this in fact when I teach my class to the mbas and it's a corporate finance class I tell them that everything else they do in this program is in service of my class marketing accounting operations research corporate strategy they're

all pieces of a much larger puzzle which to me is Corporate Finance so with that setup for corporate finance let me lay out the three objectives I have over this 36 session course the first is to give you the tools the techniques the methods and the models that are part of modern Corporate Finance over the last 60 years we have developed lots of tools and techniques and I will present those tools and techniques to you the second and bigger vision is to give you the big picture of corporate finance to show you where these tools

fit and how they work together because all too often in corporate finance you see people who can use the tools but don't get a sense of where they fit in the big picture and there's a third objective I have which is going to sound a little strange I think Corporate Finance is an incredible amount of fun it's like doing a crossw puzzle where the pieces fit together and when you see them fit together you feel an incredible sense of satisfaction so those are my three objectives and perhaps at the end of my 36 sessions we

can come back and see if those objectives were Advanced during the course of these sessions so let me let me set up the corporate finance view of the world to do this I'm going to go back to something that you should be familiar with from accounting it's an accounting balance sheet you've all seen accounting balance sheets right there are assets and there are liabilities on the asset side of the balance sheet you have current assets those are accounts receivable inventory cash Etc you have fixed assets land building equipment machinery you have Financial assets which might

be investments in other companies and you have intangible assets sounds fancy but in an accounting balance sheet that intangible asset is usually just Goodwill which is really not an asset at all it's a plug variable on the liability side of the balance sheet you have current liabilities accounts payable supplier credit deferred taxes deferred other items maybe short-term debt and short-term portion of long-term debt you have long-term liabilities bank loans corporate bonds you have shareholders equity which is really the ultimate backward looking number and increasingly on accounting balance sheets other liabilities have started to show up

underfunded pension obligations underfunded Health Care obligations but that's where we usually start when we get familiar with the company with an accounting balance sheet the accounting mindset though is a backward looking one its job is to record what happened last year or the last two years or The Last 5 Years in finance we'd like to switch Focus we're forward-looking in finance and to help you in this forward Focus I'd like to offer you a financial balance sheet a financial balance sheet at one level is simpler than an accounting balance sheet at another level it's far

more complex there are only two items in each side that makes it simpler but here's what the two items are on the asset side of the balance sheet the first item is assets in place these are investments you've already made as a company so if you've been around a long time you might have quite a bit quite a few investments in Assets in place the other category is mysterious I call it growth assets what's in there this is the value attached to what I expect you to do next year two years from now 5 years

from now forever into the future it's kind of scary I'm giving you credit for Investments you haven't even thought about yet so on the asset side of the balance sheet you have assets in place and growth assets frankly I don't care whether they're tangible or intangible that is a distinction that accountants might think matters but to me in finance it matters very little on the liability side of the balance sheet there are only two items there are only two ways you can fund a business you can borrow the money and generically we're going to call

it debt or you can use your own money and we're going to call it Equity what sets them apart debt gets a first claim on the cash flows basically when you make money each year the debt holders get paid first they get very little management control control of the company and if the company goes into bankruptcy they get first claim on the assets Equity gets whatever is left over and in return for settling for that residual claim Equity investors run the company so that's the financial balance sheet and it's going to be a very useful

framework for us to return to over and over to think about how Corporate Finance looks at the word so what I'd like to do now is lay out what I think are the three basic principles that govern Corporate Finance these are principles that I used to think about about running any business I'm going to call them generically the investment principle the financing principle the dividend principle let me State again what they like what they are and then we'll come back and fill in the details here's what the investment principle says when you as a business

go out and make investments in projects or assets make sure you earn a return on those Investments That exceeds some minimum acceptable hurdle rate sounds like a buzzword right so let's put some flesh on those words now the minimum acceptable hurdle rate should be higher for riskier Investments and lower for safer Investments make sense if I came to you with a really safe investment you might settle for 6% if it's much riskier you might demand 15% now we haven't defined risk and talked about how to convert into a hurdle rate yet but that's why we

have 35 sessions to come that hurdle rate should also reflect where you raise the money whether you borrow the money or used your own money so the hurdle rate should reflect the risk of what you're investing in and where you come up with the funds the return on investment should be based on cash flows as opposed to what as opposed to earnings should reflect when those cash flows come in you prefer to get those cash flows earlier rather than later and you got to figure that into the process and any side costs or side benefits

have to be built into those returns as I describe it there's no garnishing allowed in investment analysis so the investment principle says go out and find Investments that make a return greater than your minimum acceptable hurdle rate the financing principle is also very simple it says when you go out and decide how much debt and Equity to take find a mix of debt and Equity that maximizes your value as a business or minimizes your hurdle rate in other words you want the lowest hurdle rate you can and if you ask me what kind of debt

should I take my answer is going to be very simple tell me what you own if your assets are long-term assets your debt should be long-term debt if your assets throw off cash flows and Euros your debt should be Euro debt it's straightforward we choose to make it complex the dividend principle says when you go go out and look for Investments and you can't find Investments that make your hurdle rate don't push your luck if you cannot find Investments that make your hurdle rate take the cash out of the business there's no glory in growth

for the sake of growth or survival for the sake of survival and if you're a publicly traded company giving cash back to the owners takes the form of either dividends or stock BuyBacks which one you use should depend on what kind of stockholders you have and in doing all of this your investment decision your financing decision and your Dividend Decision you have a singular objective it's to maximize your value as a business this is Corporate Finance on one page what I'd like to do is use these first principles to drop some very broad themes about

corporate finance and they're pretty much what you'd expect to see here's my first one Corporate Finance is common sense because think of what I've just said if you can raise money at 8% rather than 9% please raise it at 8% and if you've raised money at 8% don't go out and take Investments that make less than 8% now part of you saying I don't need a corporate finance class to understand that and you're right there have been great business people Through the Ages who've never taken a corporate finance class who've never gone to school they

get those base principles because if you get those base principles you're going to be okay because that's really what drives a good business so the First theme that I'd like to establish is when you look at something put your common sense to use when a model gives you an answer that doesn't make sense to you you might want to take another look at that answer the second theme in corporate finance it's focused what I mean by that is you have a singular objective in corporate finance it's to maximize the value of your business so everything

you do as a business is pass through those lens so if you came to me and asked me does this make sense should I do this or this I have a way of breaking the tie because I have a singular objective there are other disciplines which might have six or seven seven objectives they might actually sound better than Corporate Finance but they don't have the focus that Corporate Finance gets because it's so centered on maximizing the value of the business that objective though can get into trouble so we'll come back and reexamine when that objective

makes sense and when it doesn't make sense here's the fourth thing to think about third thing to think about in corporate finance businesses go through life cycles just like individuals do people grow you know people are born they grow they become mature and they go into declining face companies do the same and if you tell me where your company lies on the life cycle I can pretty much tell you what Corporate Finance decisions make sense to them in this chart for instance I've contrasted two companies one is a high growth company and the other is

a mature company if you look at the high Growth Company it gets most of its value from growth assets very little from Assets in place in other words everything lies in the future the mature company gets most of its value from Assets in place the mature company is a company called ConEd it's a regulated uity the high Growth Company could be any tech company you want so you can put in a Yahoo you can put in a Google you can put in a LinkedIn whatever Growth Company comes to mind so if you think about a

mature company versus a Growth Company here's the contrast when it comes to corporate finance and you can state it in terms of those first principles we talked about a growth company has its entire value coming from its investment decisions so everything runs on making those decisions well you'll have a lot of decisions to make it should basically try to fund those decisions primarily with equity and here's why if you're a Growth Company most of your value lies in the future if you borrow money today making those interest payments you might not be able to do

because you don't have the cash flows coming through today so if you're a Growth Company here's what I'd expect to see on your balance sheet mostly Equity very little or no debt and if you ask me how much you can afford to return to your stockholders if you're truly a Growth Company my answer is going to be either not very much or nothing at all because if you're a Growth Company everything you make is probably going back into the business to create future growth in contrast think about a mature company it's got most of its

Investments and assets in place it doesn't have very many growth opportunities so when it makes money it doesn't have much to reinvest in so it can afford to pay out a lot more in dividends it can also afford to borrow a lot more money so one very simple template that you can use for corporate finance is to think of where your company falls in the life cycle and if you can tell me where it falls in the life cycle you can probably also tell me what kind of decisions you'd expected to make in terms of

Investments financing and dividends now let let me look go on move on to the fourth theme that I hope to establish I think Corporate Finance is universal I think in fact the title for this course is a bit of a misnomer cuz when you see the word corporate you're probably thinking that much of what we're going to talk about is only for publicly traded corporations nothing could be further from the truth the principles we're going to lay out matter just as much for private businesses as public companies small companies as well as large companies Emerging

Market companies as much as developed Market companies so rather than parse different companies we're going to look at what they share in common Corporate Finance principles really are unchangeable across continents across Ross markets and across types of businesses and here's my final theme once in a while you will run into someone who says the corporate finance principles don't matter to them and usually that someone should be better informed they they perhaps have the right education they've gone to the right Schools they're working at the right places and they think because of those reasons they can

violate first principles and get away with them I have some bad news for them if you violate first principles it's not a question of whether you're going to pay price it's when and perhaps you won't pay the price your clients might pay the price so if there's a common theme that's going to run through everything we're going to do in the next 35 sessions it's establishing first principles because I firmly believe that if you violate first principles it's going to be incredibly costly so with that set up let me let me lay out how this

class is going to approach Corporate Finance I describe this class as an applied corporate finance class what I mean by that is I'm not going to talk about theories and models and equations and metrics standing alone I'm going to apply them to real companies in fact these are the six companies I'm going to use to establish Corporate Finance principles the first company of course is Disney why did I pick Disney because everybody knows what Disney does large US entertainment company I'm going to take Disney through every aspect of corporate finance the second company I'm going

to use to establish Corporate Finance principles is a company called Val V is a Brazilian Mining Company why did I P Val to get as different from Disney as I could Service Company commodity company develop Market company Emerging Market company it'll allow us to look at what they share in common and what they might do differently the third company I'm going to use to illustrate principles is a company called Tata Motors it's part of a of a a family group in India called the Tata group I'm going to use it both to talk about the

special travails that manufacturing companies face as well as what it means to be part of a much larger family group whose interest might actually be different from the interest of the company the fourth company I'm going to use is a company called ba Buu is a Chinese search engine in fact it is the dominant search engine in China I want to use it to talk about Chinese companies because they front and center in terms of economic growth now what they share in common with the rest of the world and how Corporate governance can be an

issue with Chinese companies the fifth company I'm going to use is deutche Bank why because I want to talk about a regulated Financial Service company and the constraints that are put on you in terms of corporate finance decisions the final business I'm going to use is really not a company it's a small independently owned private bookstore in New York City that I've changed the name on and I'm going to call bookscape I'm going to use book bookscape to illustrate how the owner of a small Private Business faces exactly the same decisions that a large publicly

traded company faces and in fact the consequences for making those decisions badly are much greater when you're the owner of a small private business so small to large private to public develop to Emerging Markets these six companies will be my lab experiments that run through these 35 sessions so here's the road map for what's coming we just finished the first session we have 35 more sessions to go in the next two sessions I will revisit that objective in corporate finance maximizing the value of the business talk about what's good about it and when it can

get into trouble in the next sequence of sessions we're going to look at the investment principle and that's going to take us almost halfway through the class laying out first how we come up with hurdle rates and then talking about how that plays out in measuring returns then we'll move on to the financing principle and that'll take us about a third of the class looking at the right mix of debt and equity for a company and tools for coming up with that mix and then finding out what the right kind of debt for your company

is and we'll close by looking at the dividend principle at the end of the class we'll pull all these principles together and talk about how they play out in the value of a company I hope you'll come along with me for the ride cuz it's going to be a lot of fun thank you