* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
Download Analysis of IDC EMEA Top 10 announcement (prelim)
Survey
Document related concepts
Private equity secondary market wikipedia , lookup
Systemic risk wikipedia , lookup
Modified Dietz method wikipedia , lookup
Investment management wikipedia , lookup
Investment fund wikipedia , lookup
Early history of private equity wikipedia , lookup
Internal rate of return wikipedia , lookup
Present value wikipedia , lookup
Stock selection criterion wikipedia , lookup
Financial economics wikipedia , lookup
Business valuation wikipedia , lookup
Global saving glut wikipedia , lookup
Transcript
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 © The University of Texas at Austin 2013 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 © The University of Texas at Austin 2013 2 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 © The University of Texas at Austin 2013 3 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 © The University of Texas at Austin 2013 4 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. © The University of Texas at Austin 2013 5 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. © The University of Texas at Austin 2013 6 Analytical Processes Examples: Product Profitability Customer Lifetime Value Examples: Procurement Analysis Cash Flow Analysis Customer Analytics Supply Chain Analytics © The University of Texas at Austin 2013 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 © The University of Texas at Austin 2013 8 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 © The University of Texas at Austin 2013 9 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 © The University of Texas at Austin 2013 10 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 © The University of Texas at Austin 2013 11 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 © The University of Texas at Austin 2013 12 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 © The University of Texas at Austin 2013 13 Measuring Performance © The University of Texas at Austin 2013 14 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. © The University of Texas at Austin 2013 16 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 © The University of Texas at Austin 2013 17 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 © The University of Texas at Austin 2013 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 © The University of Texas at Austin 2013 19 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 © The University of Texas at Austin 2013 $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 21 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 22 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 © The University of Texas at Austin 2013 23 STJ vs. Peers – 3 Year Stock Price S&P 500 JNJ MDT STJ BSX © The University of Texas at Austin 2013 24 Financial Strategies & Value Creation © The University of Texas at Austin 2013 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 26 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 27 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 © The University of Texas at Austin 2013 30 Asset Efficiency & Utilization Sales Asset Turnover Avg. Assets © The University of Texas at Austin 2013 31 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. © The University of Texas at Austin 2013 32 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. © The University of Texas at Austin 2013 33 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 © The University of Texas at Austin 2013 34 Cash Conversion Cycle Accounts Payable Cash Raw Materials Inventory Fixed Assets WIP Inventory © The University of Texas at Austin 2013 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 36 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 39 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 40 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 41 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 42 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 44 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 45 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 © The University of Texas at Austin 2013 46 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 © The University of Texas at Austin 2013 47 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 © The University of Texas at Austin 2013 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) © The University of Texas at Austin 2013 49 100% 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 © The University of Texas at Austin 2013 50 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. © The University of Texas at Austin 2013 51 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. © The University of Texas at Austin 2013 52 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) © The University of Texas at Austin 2013 53 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. © The University of Texas at Austin 2013 54 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 . © The University of Texas at Austin 2013 55 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 © The University of Texas at Austin 2013 56 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. © The University of Texas at Austin 2013 57 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. © The University of Texas at Austin 2013 58 Popular Alternatives to NPV Payback Internal Rate of Return © The University of Texas at Austin 2013 59 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). © The University of Texas at Austin 2013 60 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. © The University of Texas at Austin 2013 61 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? © The University of Texas at Austin 2013 62 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 © The University of Texas at Austin 2013 63 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 © The University of Texas at Austin 2013 64 Financial Leverage & Risk Avg. Assets Assets Leverage Avg. Equity Assets Liab. © The University of Texas at Austin 2013 65 Typical Life Cycle Financing © The University of Texas at Austin 2013 66 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 © The University of Texas at Austin 2013 67 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 © The University of Texas at Austin 2013 68 50+% Early Stage VC PROFITABILITY The Equity Financing Cycle Based on Growth & Profitability © The University of Texas at Austin 2013 69 Sources Based on Purpose & Amount of Capital Needed © The University of Texas at Austin 2013 70 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. © The University of Texas at Austin 2013 71 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 © The University of Texas at Austin 2013 72 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 . © The University of Texas at Austin 2013 73 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. © The University of Texas at Austin 2013 74 of 42 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. © The University of Texas at Austin 2013 75 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: 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 © The University of Texas at Austin 2013 76 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? © The University of Texas at Austin 2013 77 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. © The University of Texas at Austin 2013 78 Bankruptcy & Restructuring © The University of Texas at Austin 2013 79 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 © The University of Texas at Austin 2013 80 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 © The University of Texas at Austin 2013 81 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 © The University of Texas at Austin 2013 82 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 © The University of Texas at Austin 2013 83 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 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 © The University of Texas at Austin 2013 85 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 86 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 © The University of Texas at Austin 2013 87 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. © The University of Texas at Austin 2013 88 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. © The University of Texas at Austin 2013 89 Contact Information Jim Nolen Texas Executive Education 512.232.6834 [email protected] © The University of Texas at Austin 2013 90