Download Analysis of IDC EMEA Top 10 announcement (prelim)

Association of Corporate Counsel
Pocket MBA
Finance for Non-Financial Managers
Professor Jim Nolen
Department of Finance
University of Texas at Austin
McCombs School of Business
September 19, 2013
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Agenda
1:30-2:45
Overview of the role of finance in the
organization
Operating Decisions
Measuring Performance
2:45–3:00
Break
3:00-4:15
Investing Decisions
Treasury Management
Working Capital Management
Capital Budgeting
4:15-4:30
Break
4:30-5:30
Financing Decisions
Capital Structure/Dividend Policy
Bankruptcy & restructuring
5:30-6:30
Social Networking & Happy Hour
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Learning Objectives
 To improve the participant’s financial acumen
 To gain a better understanding of finance’s role in the organization
 Making the Operating, Investing and Financing decisions of the firm
 Measuring performance and creating shareholder wealth
 Setting the financial strategies of the firm
 Setting financial policies and procedures
 Establishing financial controls
 Managing the firm’s resources
 Treasury operations, including cash management
 Tax management
 Managing the operating and capital budgeting processes
 Setting capital structure policy and proper use of leverage, including
dividend policy and stock repurchase plans
 Managing liquidity, including credit and collections
 Financial reporting and forecasting
 Working with investor relations to communicate with stakeholders
 Risk management, including hedging
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Who is the Finance Department?
 May have professional designations like Chartered Financial
Analyst (CFA), Certified Public Accountant (CPA), Certified
Management Accountant (CMA) or Certified Treasury
Professional
 Typical financial titles in firms (depending on size of firm):
 Chief Financial Officer (CFO)
 Vice-President of Finance
 Corporate Treasurer
 Chief Accounting Officer (CAO)
 Comptroller
 Cash Manager
 Credit Manager
 Risk and Insurance Manager
 Manager of International Banking
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Accounting’s Role
 The role of the accounting function is to provide
internal and external information about the past
performance to company executives and investors
 This information is communicated in the financial
statements




Balance Sheet
Statement of Shareholders’ Equity
Income Statement
Statement of Cash Flows
 Accountants are responsible for reporting,
controlling and budgeting activities.
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Finance’s Role
 The role of the finance function is to analyze
information about the past to make investment,
financing and operating decisions that improve
company performance in the future.
 Investment Decisions to maximize return and includes: make vs.
buy decisions, working capital management, treasury operations
and asset acquisitions and divestitures.
 Financing Decisions to minimize the cost of capital and includes:
debt vs. equity financing, dividend policy, and stock buybacks.
 Operating Decisions that improve efficiencies and includes:
pricing and product mix, purchasing and supply chain decisions,
controlling expenses and risk management.
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Analytical Processes
Examples:
Product Profitability
Customer Lifetime Value
Examples:
Procurement Analysis
Cash Flow Analysis
Customer
Analytics
Supply
Chain
Analytics
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Financial
Analytics
7
Examples:
Compensation Analysis
Labor Utilization Analysis
Human
Resource
Analytics
Financial Controls
 Budgeting
 In all four types of centers a budget system can
provide managers with incentives by
 Rewarding them for meeting or exceeding budget goals
 Punishing them for failing to meet budget goals
 Those goals are:
 Investment Center – Return on Investment
 Profit Center - Dollars of Net Income or Profit Margin
 Revenue Center – Dollars of Revenue, growth rate, or
market share
 Cost Center – Dollars of Cost, percent of revenues
 Agency Costs – Auditing & incentives costs for
fiduciary duty compliance
 Forecasting can be done top-down or bottom-up
 Top Down – TAM, growth rate, market share
 Bottom-up – sales by customer, territory, product then rolled-up
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Maximize Share Value
DuPont
Analysis
Growth (g)
Profitability
Operating Decisions
Customers Suppliers
Products
Pricing
Marketing Distribution
Controlling Expenses
Risk (r)
Return (ROE)
Efficiency
Leverage
Investing Decisions
Asset Mix
Terms of Trade
Liquidity, Cash Conversion Cycle
Plant Utilization, Make or Buy
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Financing Decisions
Debt-Equity Mix
Capital Structure Policy
Dividend Policy
Operating Decisions
 Measuring business performance and benchmarking
are important roles of finance to insure goals and
objectives are being achieved.
 Operating Decisions usually revolve around the Profit and
Loss statement. Finance then benchmarks these results
against budget/plan (variance analysis) and against
peers.
 Revenue – Average Selling Price (ASP), pricing, unit volume, product mix,
market share, CAGR of sales
 Cost of Sales – Outsourcing decisions, tax advantaged manufacturing locations,
supply chain management, labor productivity
 OPEX – Selling, general and administrative expense control, headcount, lease
vs. buy decisions
 Interest Expense – amount of debt, type of debt and interest rate.
 Tax Management
 Earnings Per Share - number of shares outstanding
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Corporate Counsel’s Role In Operating Decisions
 Revenue recognition through the structuring of contracts.
 Cost of sales through the negotiation and structuring of purchase
contracts and hedging contracts.
 Labor Costs through effective management of labor laws and
negotiation with collective bargaining agreements
 Selling, General and Administration costs through rent
negotiations, advertising contracts, compensation agreements
and insurance contracts
 Managing litigation in a cost effective manner
 Interest expense through negotiations on the terms and
conditions of debt instruments.
 Tax expense though management of tax liabilities and
negotiation of tax incentives
 Earnings per share through securities regulation and SEC
compliance.
 Assist in Internal Audit and External Financial Reporting
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Corporate Counsel’s Role In Investing Decisions
 Assistance in collection of accounts receivable
 Negotiation of contracts for capital expenditures and real estate
transactions
 Managing Acquisitions and Divestitures
 Monitoring Treasury Investments
 Managing IT risks and investments, including domain names and
cybersecurity
 Protecting and licensing intellectual property
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Corporate Counsel’s Role In Financing Decisions





Negotiating and structuring debt, mortgage and equity issuances
Compliance with Security Regulations
Monitoring dividend policies
Managing risks, including continuity planning
Maintaining corporate governance and fiduciary duties
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Measuring Performance
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Financial
Statements
Market Value
How can I
improve the
firm’s ROE and
Value?
Past Performance
Return on Equity
Growth
Risk
Future Performance
Return on Equity
Growth
Risk
Filtered through:
The Economy
The Industry
The Competition
Financial
Manager
© The University of Texas at Austin 2013
DuPont
Analysis
Financial Ratios:
Key Areas of Performance Measurement
 Performance in several key areas must be considered when
evaluating a firm’s prospects for the future
 Operational analysis
 Cost Analysis, Cycle Time, Customer Satisfaction, Quality Metrics
 Resource management
 Asset Turnover, Days Sales Outstanding, Inventory Turns
 Profitability and Productivity
 Profit Margins, Sales/Employee, Sales/Sq. Ft.
 Investment returns
 ROA, ROE, ROIC
 Market indicators
 Market Share, EPS, P/E Ratio, Price/Sales
 Risk Measurements
 Liquidity, leverage, and debt service coverage
Source: Helfert, Erich A., “Techniques of Financial Analysis: A Guide to Value Creation,” 10th Edition, Irwin McGraw Hill,
Burr Ridge IL, 2000.
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Business Performance
 Managers can increase the firm’s value and it return to
shareholders: (Return on Assets and Invested Capital can also
be used)
ROE 
Net Income
Rev  Exp

Owner' s Equity Assets  Liab
 By increasing Revenue (Profitability/Growth)
 Increasing Average Selling Price (ASP) and/or Volume (Q)
 Organic growth vs. acquisition ; New Stores; New Products/Services; New
Territories
 By decreasing Expenses (Profitability)
 Decrease Avg. Unit Cost (AUC) through Supply Chain Management, Labor
Productivity, OPEX control and Scaling Fixed Costs
 By decreasing Assets (Efficiency)
 Increasing Cash Conversion Cycle and Plant Utilization
 By increasing Liabilities (Leverage/Risk – other people’s money)
 Higher returns come with higher financial risk if ROIC > Cost of Debt
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DuPont Analysis
A simple dashboard that captures three of the five value drivers of a company
(growth and risk and not fully measured).
Inc Revenue  Expenses
ROE 

OE
Assets  Liabilitie s
Inc
Inc
Sales
Assets



OE
Sales Assets
OE
Profitability
on Sales
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Asset
Turnover
(Efficiency)
18
Financial
Leverage
DuPont Analysis
Three-Factor DuPont Analysis
Return on
Assets (ROA)
Inc
ROE 
OE
Inc
Inc
Sales
Assets



OE
Sales Assets
OE
Profitability
on Sales
Asset Turnover
(Efficiency)
Note: The same factors affect
ROIC
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Financial
Leverage
St. Jude Medical – 12/31/11
In millions $
Income Statement
Revenue
COGS
Gross Profit
$5,612
$1,455
$4,157
R&D Exp.
SG&A (OPEX)
Depr./Amort.
Op. Inc.
$705
$1,979
$296
$1,473
GPM
OPM
74.1%
26.25%
Net Int. Exp.
($65)
Other Exp.
($31)
Taxable Inc.
$1,377
Corp. Tax
($193)
Post Tax Except. ($249)
Net Income
$826
NPM
EPS (fully diluted)
Adjusted Net Inc.
Adjusted EPS
14.7%
$2.52
$1,074
$3.28
Balance Sheet
Cash
Mkt. Sec.
Net Receivables
Inventory
Other Cur. Assets
Total Current Assets
Gross Fixed Assets
Accum Deprec.
P,P&E, net
Goodwill & Intang.
$986
$37
$1,366
$625
$375
$3,391
$2,454
($1,066)
$1,388
$4,226
Statement of
Cash Flows
Net Income
$826
+Deprec. & Amort
$296
+ Operating Exp Adj.
$110
+/- Dec/(Inc) in NWC
$56
Net Cash –
Operating Activities $1,288
Net Cash –
Investing Activities
Net Cash –
Financing Activities(1) ($465)
Total Assets
$9,005
Current Liab.
Long term Debt
Other L-T Liab
Total Liabilities
$1,062
$2,713
$ 755
$4,531
Exchange Rate
S/H Equity
$4,475
Liabilities & Equity
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$9,005
20
($337)
($8)
Net Change Cash
$486
Begin. Cash
$500
Ending Cash
$986
(1)LT Debt Issue
Debt Repaid
Issuance of Common Stk
Repurchase of Stock
Dividends
$325
( $78)
$303
($809)
($205)
DuPont Analysis
 St. Jude Medical’s Return on Equity Over Time
2006
2007
2008
2009
2010 2011
ROA
11.4%
11.3%
12.3%
12.6%
11.3% 9.5%
ROE
18.7%
18.2%
11.5%
23.7%
23.6% 18.7%
What happened in 2008 and 2011? Let’s look at the DuPont
decomposition.
What has been the effect of the stock repurchase program?
© The University of Texas at Austin 2013
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DuPont Analysis
 St. Jude Medical
FY
06
07
08
09
10
11
ROE
18.7%
18.2%
11.5%
23.7%
23.6%
18.7%
Net Profit Margin
16.6%
14.2%
8.1%
16.6%
17.6%
14.7%
Turnover
0.7
0.7
0.8
0.8
0.7
0.6
Leverage
1.7
1.82
1.77
1.93
1.96
2.0
15.5%
$34.27
7.3%
$36.78
10.3%
$42.85
Revenue Growth
13.3% 14.4%
Closing Stock Price $36.56 $40.64
© The University of Texas at Austin 2013
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8.7%
$34.48
DuPont Analysis
 St. Jude Medical vs. Its Peers – 2011
FY 2011
STJ
MDT
BSX
JNJ
ROE
18.7%
20.2%
3.9%
17.0%
Net Profit Margin (1)
13.8%
16.8%
6.1%
13.2%
Turnover
0.6
0.5
0.4
0.6
Leverage
2.0
1.9
1.9
2.0
8.7%
0.7%
-2.4%
5.6%
(1) Normalized
Rev. Growth Rate
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STJ vs. Peers – 3 Year Stock Price
S&P 500
JNJ
MDT
STJ
BSX
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Financial Strategies &
Value Creation
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Financial Goals & Strategies
 All companies have similar financial goals –
namely, to maximize shareholder wealth.
 Companies employ different strategies and
tactics to achieve this goal.
 Some work off maximizing profit margins through
differentiation or intellectual property (Software/
Pharmaceuticals)
 Some work off scale (Mass Merchandisers) lower margins
but more volume and lower selling costs. Others work off
scope by selling a broad range of offerings.
 Some work off efficient asset utilization (Airlines) –
covering fixed costs with “bottoms” in seats. Revenue
passenger seat miles.
 Some work off leverage (Financial Services) – high debt to
equity ratios in banks and insurance companies.
 Combinations are possible
© The University of Texas at Austin 2013
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Financial Strategy
 The financial goal (recognizing there are other
stakeholders) is to maximize shareholder
wealth.
 This is accomplished by investing in projects that exceed the
firm’s cost of capital (Capital Budgeting)
 Cost of capital is a function of risk and opportunity costs
 Firms can create value by using its competitive
advantage in:






Costs (power over suppliers, business model, OPEX control)
Pricing (power over customers)
Asset Utilization
Access and Cost of Capital
Growth (branding, distribution channels, marcom)
Risk Management (hedging, diversification, leverage)
© The University of Texas at Austin 2013
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DuPont Analysis
 Let’s compare some public companies in different
industries
 Let’s look at
 A Grocery Chain – Whole Foods
 A general merchandiser – Wal-Mart
 A software company – Microsoft
 A computer company – Apple
 A pharmaceutical (research) company – Merck
 A financial institution – Wells Fargo
 An insurance company – Allstate
 What would you expect the return on equity to be for each of
these companies given the risk of their industry to be able to
attract capital?
 How do you think they generate their return? Through profit
margins, asset efficiency or leverage
© The University of Texas at Austin 2013 28
DuPont Analysis
Averages – Last Five Years
ROE
Whole
Foods
11.52%
WalMart
21.9%
Microsoft
35.73%
Profit Margin
Turnover
Leverage
2.81%
2.45
1.67
3.67%
2.38
2.51
27.84%
0.59
2.39
Apple
39.24%
Wells
Merck
Fargo
15.26% 10.71%
Allstate
11.57%
23.4%
0.93
1.80
17.98% 16.62%
0.42
0.064
2.02
10.07
9.54%
0.27
4.49
Note the different financial strategies the different companies take to produce
a risk adjusted return that allows they to attract capital.
• Whole Foods and Wal-Mart works off volume and efficient asset turnover
while leveraging their suppliers, but have small profit margins.
• Microsoft, Apple and Merck have intellectual property that enables them to
have higher profit margins, but they have relatively low asset turnover
(MSFT has $76 Billion and Apple has $137 Billion in cash).
• Financial Service companies like Allstate and Wells Fargo have huge asset
bases and low turnover but work off other peoples money (leverage). Low
investment returns, catastrophic losses, bad loans have affected ROE.
© The University of Texas at Austin 2013 29
Investing Decisions
 Investing Decisions – Involves the left
side of the balance sheet.
 Treasury Management
 Working Capital Management
 Capital Budgeting
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Asset Efficiency & Utilization
Sales
Asset Turnover 
Avg. Assets
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Asset Turnover
 Return is increased when sales are increased relative to the
investment in assets.
 Fixed Assets – Higher utilization of property, plant and equipment.
Producing more sales with the same or fewer assets.
 Current Assets – Faster turnover of working capital (accounts
receivable and inventory) or a reduction in Days Sales Outstanding
(DSO) and Days Sales Inventory (DSI).
 The risk of loss of sales from capacity constraints or too
restrictive working capital polity also increases as the
company attempts to turnover the assets faster.
 We will take a closer look at the working capital as measured
by the firm’s cash conversion cycle. Poor working capital
management can create cash flow problems even in a
profitable company.
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Treasury Management
 Managing short and medium term cash flow
requirements
 Cash management and maintenance of liquidity
 Safety, liquidity and yield







Handles foreign exchange and currency hedging
Implementation of treasury management system
Interfaces with banking platforms
Operational use of derivatives
Risk Management - Asset and liability management
Commercial Finance activities
E-banking solutions, banking arrangements &
facilities/account structures.
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Working Capital Management
 Credit administration & collection




Accounts Receivable terms
Credit and Collections
Days Sales Outstanding
Aging of Receivables
 Inventory Management
 Ordering vs. Carrying Costs
 Just-in-time, LIFO/FIFO
 Days Sales Inventory
 Accounts Payable
 Early Payment Discounts
 Days Payable Outstanding
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Cash Conversion Cycle
Accounts
Payable
Cash
Raw Materials
Inventory
Fixed
Assets
WIP
Inventory
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Accounts
Receivable
Finished Goods
Inventory
35
Efficiency – Working Capital
Days Sales
Outstanding
Days Sales
in Inventory
Days
Payables
Outstanding
DSI
DSO
DPO
Purchase
Inventory
on Account
Sell
Inventory
Pay
Payable
Collect
Receivable
Cash
Conversion Cycle
© The University of Texas at Austin 2013
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Cash Conversion Cycle =
DSO + DSI – DPO
Cash Conversion Cycle
DSO: Days Sales Outstanding
•
•
A measure of how effectively a
company is using its cash
45
+ 65 – 54 = 56
How many days, on average,
does it take for customers to pay
DSO= 45 Days
Avg Accts Receivable/Net Sales*365
DSO + DSI – DPO = CCC
DSI: Days Sales in Inventory
DPO: Days Payables Outstanding
•
•
How many days, on average,
does product sit in inventory,
waiting to be sold
DSI=65 Days
Average Inventory/COGS*365
© The University of Texas at Austin 2013
How many days, on average, does
a company wait before paying
their supplies
DPO= 54
Avg Accounts Payable/COGS*365
37
Capital Budgeting
Lawyers don’t have to be seen as sales prevention or deal killers.
Corporate Counsel needs to be included earlier in the decisionmaking process, but must change their “image” to be accepted
earlier in the process. Otherwise, they will beg for forgiveness
rather than ask for permission.
Your legal job is to mitigate risk, which can be value producing
activity. However, since there is a risk/return trade-off in business,
this is often seen as being counterproductive to people incented
by return.
© The University of Texas at Austin 2013
Common Elements of Decision-Making

Using fact-based analysis to maximize the goals and objectives of
the person or organization.





With each business decision you are involved in, you should ask:




What are the Costs (Operating, Capital & Opportunity costs)
What are the Benefits (Economic Profits/Free Cash Flow)
What are the Risks (Uncertainty/Ambiguity)
Over what Time (Time value of money)
How will this decision impact the stated goals of the organization?
What other parts of the organization will be impacted by this decision,
both negatively and positively?
Are there other options that might have better outcomes or less risk.
Where is value being created or destroyed in the firm?
© The University of Texas at Austin 2013
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Investment Decision Making
 We said that Finance role is making the investing
and financing decisions of the firm.
 Investing Decisions
 To accept a new project, the project must increase the value of
the firm. It must produce a return that exceeds the required
return (hurdle rate) based on the riskiness of the project
(always?).
 Since a firm could have more projects that produce returns that
exceed their hurdle rate, financial managers must prioritize
which investments should be chosen which produce the greatest
value to the firm.
 Thus, capital must be allocated and rationed and projects must
be ranked. This is called capital budgeting.
 Financing Decisions
 Once projects have been accepted, the financial manager must decide
how to finance the projects which produce the lowest cost of capital.
© The University of Texas at Austin 2013
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Capital Budgeting
 Time Value of Money
 Most projects require a substantial investment in CAPEX, OPEX and
working capital at the beginning of the project. The project then
generates revenues, expenses, income and cash flow over the life of
the project. However, future dollars are not worth as much as current
dollars (opportunity cost) and thus the cash flows must be adjusted
for the time value of money.
 Investment Decision –Making Tools

Financial managers have investment decision-making tools which
allow them to account for risk, return and the time value of money.
These investment decision-making tools include:
 Payback Method
 Net Present Value
 Internal Rate of Return
 Profitability Index
 and Real Options.
© The University of Texas at Austin 2013
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Capital Budgeting Issues
 Most companies have more projects than
they have capital.
 To rank projects, managers must estimate:
 Initial Investment
 CAPEX (plant and equipment) and working capital requirements
(inventory, receivables, payables)
 Ongoing Investment
 As revenues grow, the project may require additions to working capital
and additional CAPEX.
 Expected Revenues
 Expected Expenses (Cost of sales, headcount, OPEX)
 The project may have negative cash flows the first few periods which
represents OPEX investment)
 The investment horizon (usually three to five years)
 A terminal value at the end of the project
 Capital has a cost
 The future benefits and costs must be discounted at the
appropriate discount rate.
 Hurdle Rate, Opportunity Cost, Weighted Average Cost of Capital
© The University of Texas at Austin 2013
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Quantitative Tools
 How many of the value levers does the project pull?
 Growth
 Profitability
 Economic Profit – Covers Operating and Capital Costs?
 EBITDA Margin – Contribute to incremental profit?
 Asset Efficiency/Productivity/Capacity Utilization
 Leverage – Physical Assets, Capital and Human Resources
 Risk – Uncertainty – How do you mitigate.

Once we have estimated the cash flows, (CF - both
inflows and outflows) and determined the appropriate
discount rate, rt, we simply perform the calculation to
determine if the benefits exceed the costs of the project:
NPV 
n

t 0
© The University of Texas at Austin 2013
1
CFt
 rt 
43
t
Project Ideas
 How are project ideas generated?
 Large scale strategic investments tend to come from
top down.
 Merger or acquisitions. New products or territories.
 Expansion, new equipment and other capital
expenditures tend to be generated from the bottom
up.
 Each business unit or department may generate capital
projects needs or ideas.
 Projects are usually split into:
 Routine repair, replace and maintenance of existing assets
(typically a percentage of annual depreciation)
 Discretionary/expansion projects – remainder of the capital
budget.
© The University of Texas at Austin 2013
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Project Prioritization
 Projects may be prioritized first on a non-financial
basis:
 Short-term vs. long-term investment horizon – longer term projects need
more analysis.
 Strategic vs. Non-Strategic (affect a competitor, diversification of risk,
solidifies market position, builds barriers to entry, etc.)
 High financial impact vs. low financial impact ( immediate or deferred)
 Low risk (low marginal investment or costs, evolutionary) vs. high risk
project (bet the farm, revolutionary)
 Projects which can be deferred without loss of opportunity vs. projects in
which delay would cause substantial loss of opportunity.
 Synergistic vs. Non-synergistic (impact on existing operations)
 Non-financial resource constraints – technology constraints, regulatory,
engineering capacity, sales and distribution capacity, etc.)
 Market Attractiveness
 FIT with the Company’s Business Model
© The University of Texas at Austin 2013
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Market Attractiveness Factors








Market size (TAM)
Market growth rate
Market profitability
Competitive intensity/rivalry
Pricing trends
Demand variability
Opportunity to differentiate
Risk of achieving potential returns
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Fit With Model Factors
 Clear linkage between vision, strategic
initiatives, tactical plans, financial plan,
annual budgets, and operational
competency and capacity







Brand Relevancy
Core Competencies
Market share and “managed” growth
Customer loyalty and switching costs
Competitive pricing and cost advantage
Control & influence over hospital and quality of care
Leverage System - Ability to leverage distribution, supply chain,
capacity and company networks
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Classifying Investment Opportunities
BCG Graph
?
High
Strategic
Value
Investing for
Long-Term
Potential
Investing for Future Potential
and Immediate Returns
(prioritize)
Investing for
Immediate Returns
(Cash Cows)
Poor Investments
(Dogs)
Low
Low
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Immediate
Financial Value
48
High
BCG Bubble Graph Using NPV
NPV vs. Success Certainty
(Size of bubble corresponds to Project Resources)
60000
High Return, Low Certainty
High Certainty, High Return
(Winners)
Project 2
50000
Net Present Value (NPV)
($000)
40000
Project 12
Project 4
30000
20000
Project 3
Project 7
Project 9
10000
Project 1
Low Return, High Certainty
Project 10
Low Certainty, Low Return
(Less attractive)
Project 11
Project 8
0
Project 5
10%
20%
30%
40%
50%
60%
Project 6 Negative NPV
70%
80%
90%
Zone
-10000
Success Certainty
(Weighted combination of Scope, Schedule and Market Success Factors)
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100%
Project Evaluation – Narrow the Funnel
Two parts to the problem:
Concept
Definition
Planning &
Scheduling
Execution &
Development
Validation
Ramp-UP &
Phase-Over
Production
Support
New Project Ideas
1
For Target Markets
Front End Risks
Back End Risks
Product Execution
• Abort Losers
• Design
• Technology
• Manufacturing
• Product Engineering
• Strategy Alignment
• Market & Competitive
Analysis
• Business Case
• Product definition
• Pick winners
•Technology Roadmaps
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Time Value of Money
 Managers invest money today in assets which will generate
cash flows in the future.
 A basic problem faced by financial managers when
evaluating new investments is estimating the value of the
future cash flows (variability = risk).
 Average Selling Price (ASP), units sold, cost of good sold,
operating expenses, R&D, Capital Expenditures (CAPEX),
depreciation, working capital all must be estimated and then
discounted at a rate commensurate with the risk.
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First Principle of Finance: A Dollar Today
Is Worth More Than A Dollar Tomorrow
• If you invest a dollar today you will earn interest
during the year so that you will have more than a
dollar in the future.
• The trade-off between current dollars and future
dollars is determined by the rate of return that
you can earn on money during the year. This is
what we refer to as the interest rate or opportunity
cost.
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In 1626, Peter Minuit Bought Manhattan Island
for $24 from the Indians
 You might suspect that the Indians got a
bad deal, but ...
 If the Indians had invested the money at
10% per year, the value today of the $24 in
1626 would be.
= ($24)(1.1)385 = ($2.07)x1017 = $207,000 trillion
This is enough money to buy all of the world’s
financial assets! ($198 Trillion per McKinsey)
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Present Value and Future Value
Value In $
8% interest rate
FV= $2,159
Present Value
PV=$1,000
Future Value
5
10
Years
Thus, $1,000 invested today at 8% will be worth $2,159 in 10 years. If
someone promised to pay you $2,159 ten years from now, the present
value would be $1,000 today assuming you require an 8% return.
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Safe vs. Risky Dollars
 Second Basic Principal of Finance: A safe
dollar is worth more than a risky dollar.
 If future cash flows are not certain:
 Use expected future cash flows (apply probabilities)
and
 Use a higher discount rate that reflects the expected
rate of return on other investments of comparable risk
.
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Time Value of Money
 Future Value is greater with:
 Larger interest rate
 Longer time period
 Present Value is greater with:
 a smaller interest rate
 a shorter time period
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NPV Process
Projection
of FCF
Project free cash flow (FCF) over the planning horizon, typically
3 -10 years. Project revenues, expenses, taxes, working capital
and CAPEX.
Terminal
Value
Calculate the terminal value (if any) at the end of the forecast
period by taking the non-depreciated value of the fixed assets
(net book value of the fixed assets) plus add back the net
working capital at the end of the project.
Discount
Rate
Present
Value
Decision
Find the company’s hurdle rate. This discount rate for the time
value of money should be based on the riskiness of the cash
flows (opportunity cost). If similar in risk to other company
projects, the company’s weighted average cost of capital
(WACC) can be used by proportionately weighting the after-tax
cost of debt and equity.
Determine the current value by discount each year’s projected
FCF as well as the terminal value with the discount rate to get
the present value of the future FCF.
If the NPV is > $0, the project is acceptable and if the NPV is < $0
then the project is rejected. If the project returns a $0 NPV, then
you have found the IRR of the project which is equal to the hurdle
rate.
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Net Present Value (NPV)
The Net Present Value of a project
equals the present value of the
project’s annual cash inflows and
outflows (Free Cash Flows)
discounted by the firm’s weighted
average cost of capital, WACC.
n
NPV  
t o
The free cash flows from a
project are calculated as
follows:
Net Revenue
- COGS & Operating Expenses
Earnings Before Interest, Taxes,
Dep & Amort (EBITDA)
- Depreciation and Amortization
Operating Income. (EBIT or Op Inc)
x (1 - Average Tax Rate)
Net Operating Profit After Tax (NOPAT)
+ Depreciation and Amortization
- Capital Expenditures
- Additions to Working Capital
Free Cash Flows
FCFn
(1  WACC )
t
where:
t is the period in which the
cash flow is received.
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Popular Alternatives to NPV
 Payback
 Internal Rate of Return
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The Payback Period
 The payback period is the length of time it
takes to recover the initial investment.
 Over the payback period, the cumulative
cash flows generated by an project are
equal to the original investment outlay.
 Accept an investment if its expected
payback period is less than some
predetermined cutoff value (e.g., 2 years).
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Internal Rate of Return
CF1
CF2
CFT
NPV  CF0 

 ... 
2
1  r  1  r 
1  r T
The IRR is the discount rate, r, for which the NPV = 0.
It is the average rate of return earned during the project.
IRR assumes you get your investment back plus earn a
rate of return that produces an NPV of $0.
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Capital Budgeting Summary
 Capital Budgeting allows us to pursue the goal of
maximizing shareholder wealth by taking future
costs and benefits, discounting them to the current
point in time and comparing the project to other
opportunities the company may have to invest.
 Different projects can have different risks and these
risk factors can be modeled into the analysis by
adjusting the expected cash flows or by varying the
discount rate.
 If a project is accepted and the projections are
realized exactly, then the market value of the
company should increase by the NPV of the project.
 Would a company ever accept a negative NPV
project?
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Practical Applications of Capital Budgeting
 Building new plants or acquiring new capital
equipment
 Lease vs. Buy Decision
 Outsoursing vs. In-house production
 Make or Buy Decision
 Mergers and Acquisition
 New Store openings
 New product introduction, rollout
 Selling to customers on credit
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Financing Decisions
 Financing Decisions – Involves the
right side of the balance sheet




Amount and type of Debt
Amount and type of Equity
Dividend Policy
Stock Repurchases
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Financial Leverage & Risk
Avg. Assets
Assets
Leverage 

Avg. Equity Assets  Liab.
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Typical Life Cycle Financing
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Financing Life Cycle
Discovery
Idea
Proof-of-concept
Pre-Seed
Business Plan
Product design
Product Development Mfg. & Delivery
Seed
Mkt. Validation
Start-up/
Launch
Expansion/
Operating
Capital
Harvest/
Exit
Private Equity
Founder
Micro Lender
Friends / Family/ Fools
Guaranteed Loans -SBA
Angels
IPO
Factoring
Venture Capital
Customers/Suppliers
Bank Loans
Leasing
Merchant Banks
Mezzanine
ETF
Strategic Partners/JV
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Cost of Funds (annual required return)
0%
10%
5%
15%
20%
25%
Vendors or
Customers
30%
……..
Later
Stage VC
Founder, Friends,
Family & Fools
Banks
Factoring
Mezzanine
Private
Equity/LBO
AssetBased
Lenders
Leasing
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50+%
Early
Stage VC
PROFITABILITY
The Equity Financing Cycle Based on Growth & Profitability
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Sources Based on Purpose & Amount of Capital Needed
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Financing Goals & Strategies
 The goal of the financing decision is to
employ capital in the correct mix of
debt and equity that minimizes the
average cost of capital to the firm.
 Judicious use of debt will enable the
firm to employ financial leverage so
that the firm’s return on shareholder
equity is maximized.
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Cost of Debt
 Debt is a cheaper source of capital than
equity but a riskier source that creates
managerial inflexibility.
 Issuance costs are lower for debt
 The cost of debt is subsidized - Interest is tax
deductible and thus the after-tax cost of debt is lower.
 Creditors have contractual returns and higher priority
claims. As a result, they perceive less risk and thus
will accept lower returns (cost) for their investment.
 However, debt has fixed repayment terms and overleverage can result in financial inflexibility and
insolvency .
 Interest rate risk and negative leverae
 Renewal uncertainty
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Cost of Equity
 Equity capital is more expensive but
more patient and less risky source of
capital.
 Issuance costs are higher and compliance costs
are higher.
 Shareholder’s are the residual claimants whose
returns are variable and thus they perceive
greater risk and require higher returns (costs) for
their investment.
 Dividends are paid after corporate taxes and thus
receive no subsidy like interest expense.
 With no fixed repayment obligations, equity
provides more managerial flexibility .
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Weighted Average Cost of Capital
 Weighted average cost of capital (WACC) is the
after-tax cost of debt and the cost of equity
weighted by their market value percentage of the
firm value.
 The cost of debt is contractual and the rate is
multiplied by one minus the tax rate to get the after
tax cost of debt.
 The cost of equity is an expected return to the
residual claimants (shareholders) and can be
estimated by the capital asset pricing model
(CAPM) or dividend discount model.
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Optimal Capital Structure
 Where the average cost of capital is
minimized.
 Where the marginal cost of new capital
is equal to the marginal return on the
next investment.
 Where the value of the enterprise is
maximized.
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Term Sheets
 Negotiating Items for the Bank include:





Amount of loan
Interest rate, fixed or floating
Maturity
Loan Covenants
Guarantees
 Major negotiating points with the VC will be:

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

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




Amount of capital needed
The valuation of the business
Number and composition of the Board of Directors
Liquidation preferences
Anti-dilution provisions
Milestones
Amount of Option Pool and Vesting Schedule
Founder stock vesting
Conversion rights, Redemption rights and Take Along rights
Registration and Piggyback rights
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Leverage - Summary
 The goal of capital structure and dividend policy is to
minimize the cost of capital to the firm which allows
the firm to invest the capital in projects that exceed the
weighted average cost of capital or hurdle rate.
 The weighted average cost of capital is the average
cost of debt and equity in the firm, which is a function
of the perceived risk of the suppliers of capital.
 Are Dividends and Stock Buybacks a positive or
negative signal to the market? Which is better for your
bonus calculations? Can a company have a gain or
loss on its purchase and sale of its own stock?
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Capital Structure Policy
 In general, after considering the tax effects, debt is a
cheaper but riskier source of capital than equity. If a
firm thinks it can earn more than the cost of debt, then
favorable financial leverage generates higher returns
to shareholders but gives managers less flexibility
and exposes shareholders to a higher risk of
insolvency.
 Dividends and share repurchases can be a good use
of excess cash but remember to consider taxes.
 The Company is competing with other firms for capital
and must give creditors and shareholders a risk
adjusted return to be able to attract capital.
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Bankruptcy & Restructuring
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20 Largest Public Company Bankruptcy Filings 1980 – Present
Present Company
Bankruptcy Date
Lehman Brothers Holdings Inc.
09/15/08
Washington Mutual, Inc.
09/26/08
WorldCom, Inc.
07/21/02
General Motors Corporation
06/01/09
CIT Group
11/01/09
Enron Corp.
12/02/01
Conseco, Inc.
12/17/02
MF Global Holdings
10/31/11
Chrysler LLC
04/30/09
Thornburg Mortgage, Inc.
05/01/09
Pacific Gas and Electric Company 04/06/01
Texaco, Inc.
04/12/87
Financial Corp. of America
09/09/88
Refco Inc.
10/17/05
IndyMac Bancorp, Inc.
07/31/08
Global Crossing, Ltd.
01/28/02
Bank of New England Corp.
01/07/91
General Growth Properties, Inc. 04/16/09
Lyondell Chemical Company
01/06/09
Calpine Corporation
12/20/05
New Century Financial Corporation 04/02/07
Colonial BancGroup, Inc., The
08/25/09
Description
Assets
Investment Bank
$691,063
Savings & Loan Holding Co.
327,913
Telecommunications
103,914
Manufactures & Sells Cars
91,047
Financial Services
80,448
Energy Trading, Natural Gas
65,503
Financial Services Holding Co.
61,392
Financial Services
40,541
Manufactures & Sells Cars
39,300
Residential Mortgage Company 36,521
Electricity & Natural Gas
36,152
Petroleum & Petrochemicals
34,940
Financial Services
33,864
Brokerage Services
33,333
Bank Holding Company
32,734
Global Telecommunications Carrier 30,185
Interstate Bank Holding Company 29,773
Real Estate Investment Company 29,557
Global Manufacturer of Chemicals 27,392
Integrated Power Company
27,216
Real Estate Investment Trust
26,147
Bank Holding Company
25,816
Source: Bankruptcydata.com
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Debt Restructuring Options
 Modify & Extend the terms
 Lower interest rate
 Longer maturity (balloon?)
 Stand still agreement (defer payments to back
end of the note)
 Renegotiate covenants




Deed in lieu of foreclosure (short sale)
Haircut – discount the note for payoff
Debt for Equity swap
Debt Sandwich – new capital
sandwiched between existing debt
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Resolving Financial Distress
Bankruptcy may be voluntary or involuntary
Venue- Federal court in state of incorporation,
principal location of the business or assets located
more than 180 days. May also look at proximity of
creditors and debtor to the court .
Managers and Creditors compare two values:
• Firm liquidated value
• Firm's value as a going concern
If a firm's
• Liquidation value > going concern value
Chapter 7
• Liquidation value < going concern value
Chapter 11
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Chapter 7 Bankruptcy
Liquidation Proceeding
1. Filing of Petition
2. Order of Relief
3. Automatic Stay of Proceedings
4. Interim Trustee Appointed
5. Assets Liquidated
6. Proceeds Distributed to creditors
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Chapter 11 Bankruptcy
Main objective is to rehabilitate.
1. Filing of Petition
2. Order of Relief
3. Automatic Stay of Proceedings
4. Reorganization Plan
Exclusivity Period (120 days)
Debtor in possession (DIP)
Creditor Committees
Alternative Plans
5. Approval of Plan
6. Confirmation of Plan
Total cram down
7. Plan enacted
Debtor may convert to Chapter 7 if no trustee has been
appointed and the Court can convert if determined to
be in the best interest of the creditors
and the estate.
84
© The University of Texas at Austin 2013
Core Proceedings


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








Administration of the estate
Claims against the estate
Counterclaims by the estate
Orders regarding obtaining credit or to turn over
property to the estate
Proceedings to determine preferences
Motions to terminate or recover preferences
Proceedings to determine fraudulent conveyances
Dischargeability of particular debts
Determination of property liens
Confirmation of plans
Orders approving sale of property
Proceedings affecting liquidation of property
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Absolute Priority Rule
The absolute priority rule:
1. Debtor-in-Possession (DIP) loans
2. Certain obligations incurred after filing for Chapter 11
3. Unsecured claims for employee compensation
4. Unsecured claims from employee benefit plans
5. Secured creditors
6. Senior creditors
7. Unsecured creditors (other than senior creditors)
8. Subordinated debt claims
9. Equity holders.
© The University of Texas at Austin 2013
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Bankruptcy as a Strategic Device
Most bankruptcies are voluntary.
Bankruptcy can be used to:
• increase firm's borrowing (DIP Financing)
• get around uncooperative creditors
• reject collective bargaining agreements
• reject obligations to suppliers
• avoid litigation
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Cram-downs and Objections


Cram-down – Under certain circumstances, the bankruptcy court may "cram
down" a plan over the objection of creditors. In order to confirm a Chapter 11
plan over the objection of a secured creditor, a holder of a secured claim
must receive the entire value of the property securing the claim or the entire
value of the claim, whichever is smaller. Unsecured creditors must either
accept the Chapter 11 plan or the owners of the business must not receive
any property under the plan on account of their pre-bankruptcy interest in the
farming operation. Finally, a plan cannot be confirmed if the plan does not
pay each claim holder as much as he would have received under a Chapter
7 liquidation unless those who receive less accept the plan.
Objections to Plan – Creditors may object to the confirmation of the debtor's
plan in a Chapter 11 case. Such objections will usually challenge whether the
debtor has met the technical requirements of Chapter 11. However, creditors
may also challenge the debtor's valuation of their collateral and the feasibility
of the debtor's plan. As a result, it is usually necessary for the debtor to
obtain expert testimony concerning the current value of machinery,
equipment, livestock, and crops. In addition, it will be necessary for the
debtor to provide his creditors with detailed financial projections which will
assist the bankruptcy court in determining that the business may be
successfully restructured.
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Competing Plans & Confirmation
 Competing Plans – As previously mentioned, only the debtor
may submit a plan of reorganization within 120 days of the
initiation of the bankruptcy case. Any interested party may file
a plan thereafter. A plan, including a plan proposed by a
creditor, may provide for the liquidation of some or all of the
debtor's nonexempt assets. Such a liquidating plan may be
proposed and approved by the court.
 Confirmation – Confirmation of a plan under Chapter 11 acts
as a discharge of all debts, filed or not, excluding those
specified as not dischargeable elsewhere in the bankruptcy
code. Upon confirmation of a plan, the debtor receives back
all his property free and clear of all liens and encumbrances
unless such liens are preserved by the plan. Both the debtor
and the creditors are bound by the terms of the confirmed
plan.
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Contact Information
Jim Nolen
Texas Executive Education
512.232.6834
[email protected]
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