Analysisforfinancialmanagement(RobertC.

Higgins) Summaryoftheusedchaptersinthelecture(WM0609LR) Writtenby:JorisVanGestel

Chapter1Interpretingfinancialstatements
Accounting
Information provided by 3 annual reports: Balance Sheet Cash-Flow statement Income statement

Figure1Cashflowproductioncycle

(Operating)workingcapital:movementofcashintoinventory Investment:flowfromcashintonewfixedassets Depreciation:thelossinvalueoffixedassetsincreaseinvalueofmerchandisemade+neededfor growth Solvency:abilitytohavecashtobuyfixedassetsandinventory(outflowcash)

Thebalancesheet
Equity= assets - liabilities current assets cash inventories

Financial statements: Balance sheet

current liabilities ! ! ! long-term liabilities equipment plant ! ! total shareholders equity stock ! long-term debt ! accounts payable !

acc receivable fixed assets

retained earnings !

total assets

total liabilities + equity

Figure2exampleofabalancesheet

Financialsnapshot:1momentintime Assetsagainsttheclaims Liability:obligationtodeliversomethingofvalueinthefuture Equity:differencebetweenassetsandliabilities Liquidity:speedatwhichanitemcanbeturnedintocash Accounting: income statement Assetsandliabilitiesarelistedinorderofdecreasingliquidity Current:liquidity<1year Net sales sales -Costs of Longterm:liquidity>1year
Earnings Before Interest, Taxes, Depreciation, Amortization (EBITDA) -Depreciation, Amortization Earnings Before Interest and Taxes (EBIT) -Interest Earnings before taxes (EBT) -Taxes Net income -Dividends Addition to retained earnings

Incomestatement

Differencebetween2importantbalancesheets Change in owners equity in terms of revenues (sales) and expenses (costs) net income (earnings,profits) Commonlydividedinoperatingandnonoperatingsegment Somedifferentaspectsofearnings Accrual accounting: revenue is recognised as soon as the effort required to generate the saleiscomplete+certainofsalelagbetweengenerationofrevenueandreceiptofcash Depreciation:costsfor(exbuildings)arespreadovertheyearsperioddefinedbyuseful life,salvagevalue,methodofallocationtobeemployed o Straightline

cos t total salvationvalue lifetime

o Acceleratedmoredepreciationintheearlyyearsanlesslateron Taxes: sometimes firms use different income statements for the tax and for the public shareholders o Taxesdifferfromtheprovisioned(higher/lower) o Can be used to shift tax payments to later years to use the finances in the business Researchanddevelopment(R&D)difficulttoestimatethepayoff o Thecosthavetobelistedasanoperatingcost(unitedstates)

SourcesandUsesstatements

Isnotthesameasincomestatementbecauseaccruals,listsonlycashflowassociatedwithsaleof goodswithintheaccountingperiod 2balancesheetsofadifferentdateandnoteallthechangesinaccount Segregatethechangesintogeneratedandconsumedcash o Generate:reducingassets,increasingliabilities o Consume:increaseassets,reduceliabilities Cashcanalsocomefromloans(longtermdebt)ortheretentionofprofitsearnedthroughtheyear Cashflowstatement Differencebetween2importantbalancesheets Providesadetailedlookatchangesinthecashbalance Cashprovidedorconsumedby:rearrangessourcesandusesintothesethreecategories Operating: o Noncashcharges:amortisation,depreciation o Changesincurrentassets,liabilities Investing Financing Cashflow Net:netincome+Noncashitems Fromoperatingactivities:netcashflow+/changesinasstsandliabilities Free: total cash available for distribution to owners and creditors after funding investing activities Discounted:sumofmoneyhavingthesamevaluereceiptanddisbursements Allthisinfocanbefoundintheincomestatementandthebalancesheetbut Betterunderstandingforthenonexperiencedandtheonesagainstaccrualaccounting Moreaccurateinfoabouttaxesandsecurizations Lightonthefirmssolvency(generating/consuming)
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Financialstatementandthevalueproblem

MarketvalueVsbookvalue Acompanyisneverworthitsbookvalue An asset purchased in 1950 can be worth less or more on this moment (land (more), technology(less)) o Problem:valuesofthingsinthepresentaresubjective Accountantsprefertobepreciselywrongratherthanvaguelyright Regulators:fairvalueaccounting:someassetsandliabilitiesmustappear attheirmarketpriceinsteadofthehistorical Equityinvestorsbuysharesforthefutureincometheyhopetoreceiveandnotforthevalue oftheassets o Problem:accountantmeasureofshareholdersequityh as little relation with futureincome Accountantsnumberslookbackandarecostbased Companies often have assets/liabilities that do not occur on the balance sheet but affect the future income nonetheless (patents, trademarks, loyal customers, lawsuits, bad/good management, technology) book value inaccurate Moreaccurate value =# shares value Goodwill: buy a company for more as the book value book value in assets,therestintheassetgoodwill EconomicincomeVsaccountingincome Theproblemhereliesinthedistinctionbetweenrealisedandunrealizedincome Theaccountantonlyrecognisesrealizedgains/lossesassetsthatincreasearegainsonpaper(itcan fluctuate) Imputedcosts Equity capital also has cost (investors expect a return) but these do not appear on the income statementbecausethereisnopaperthatsayshowmuchthecompanyhastopaythiscostmustbe estimated(imputed) The economist would subtract these cost but an accountant does not, the difference is important becausemanydecisionsarebasedonthenumbersintheincomestatement:wages,bonuses,etc

Chapter2.Evaluatingfinancialperformance

Returnonequity

Most popular tool to evaluate financial performance it is a measurement of efficiency

earnings investedDOLLAR
NETincome Isthebasicformulabutcanberedefinedas shareholdersEQUITY

ROE =

ROE =

NETincome Sales Assets Sales Assets shareholdersEquity

ROE = PROFITm argin ASSETturnover FINANCIALleverage Profitmargin:earningsoutofeverydollarofsale NETincome Returnonassets ROA = Assets GROSSprofits Grossmargin: usedtofindoutthefixedandthevariablecosts Sales Assetturnover:salesgeneratedforeverydollarofassetsemployed
Low:assetsintensiveindustry Inventoryturnover:

cos tgoodssold Inventory ending

Collection period: shows the companys management of accounts receivable average time lag betweensaleandcash Dayssalesincash:

account recievable creditsale day cash + sec urities sales day

accountspayable purchasescredit day

Theoptimalratioisdifferentforeverycompanyanddependsonthenecessaryliquidity PayablesPeriod:

Controlratioforliabilityperiodtoaccountspayable FixedAssetturnover:

Sales withnetproperty=plant,equipment netproperty

Especiallyimportantforcompanieswithcapitalintensive(=operatingleverage)businesses(cars,etc) Sensitivetothestateoftheeconomy
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 Financialleverage:amountofequityusedtofinancetheassets
Notnecessarymax:findabalancebetweenthebenefitsandcostsofdebtfinancing Idealleveragedependsonthenatureofcompanysbusinessandtheassets Stable/predictablecashflowhighfinancialleverage Inversely related with ROA safe, stable, liquid investment=low returns +big borrowing capacity

Measuresoffinancialleverage: Debt to assets ratio: creditors Debttoequityratio:

liabilitiestotal percentage of the assets book value that comes from assetstotal liabilitiestotal percentagebythecreditorsforeverydollarofequity equity shareholders

Coverageratios:usedtocalculatetheburdenofthedebtonthecashflow (EBIT=earningsbeforeinterestandtaxes) Timeinterest: o

Tooliberal:assumesthecompanywillrolloverallitsobligationastheymature

EBIT expenseint erest

Timeburdencovered: o o

EBIT int erest + (repayment principal 1 taxrate)

Tooconservative:assumesthecompanytopaytheloansdowntozero Besthighforcompanieswithhighfinancialrisksandlowwhenreadyaccesstocash

Market value leverage ratios: market value ratio are superior to book value ratio because book valuesareoftenirrelevantandmarketvalues are based oninvestorsexpectationsaboutfuture cash flows. Helpful when assessing financial leverage of rapidly growing startup businesses, because lenders willcreditcompanieswhentheybelievethattheywillbeabletoservicethedebtsbutdonthaveabad coverageratio.

Risks:ignorerolloverrisks(paythedebtsnotbypromisingfuturecash) Liquidity ratios: determinant of companys debt capacity is liquidity of its assets (maturing mismatching=liabilitiescomeduebeforetheygenerateenoughcash),measuresofliquidityare

debt marketvalue debt marketvalue and equity marketvalue assetsmarketvalue

Rathercrudemeasuresbecause: Rollingoverobligationinvolvesnoinsolvencyrisk Cash generated cant be used to reduce liabilities because it must be used to support continuedoperations

assetscurrent liabilitiescurrent assetscurrent inventory Acidtest: liabilitiescurrent

Currentratio:

ProblemsoftheROE
Timingproblem:ROElooksatthepastandoneperiodicwhenforgoodbusinessitisneededtolook forward ExhighstartupcostforaverygoodproductwilllettheROEfall Risk problem: the ROE doesnt say anything about how much risk the company needed to take to generatetheROE Returnoninvestedcapital(ROIC): UsedtoavoidthedistortionofleverageonROEanROA

ROIC =

EBIT (1 taxrate) debt int erestbearing + equity

Istherateofreturnearnedonthetotalcapitalinvested Valueproblem The ROE is calculated on the book value of shareholders equity market value of the equityismuchhigherneeded:highROE+unknowntootherinvestors

earning incomenet share = Earningsyield: shareholdersequity marketvalue earning share

o

Is no good solution because the stock price is dependent on investors expectationhighexpectation=highstockpricelowearningyield

P/Eratio: o o o

Price of one dollar of earningsused to normalise stock prices for different earnings levels Riseswithimprovedearningsandlowerswithincreasingrisks Givesagoodimageofwhatinvestorsbelieveforthefuture

share earnings share

price

Marketpriceproblems:stockpriceasaperformancemeasure Difficultyofspecifyinghowoperatingdecisionaffectstockprice Managers now more about the company then external investorswhy should managers considertheassessmentsoflessinformedinvestors Stockpriceisalsodependentonfactorsoutofthecontrolofthecompany(ex.improving economy)

Ratioanalysis
Strategies Ifusedproperlycanrevealalotaboutthecompany Noautomaticallyinsightincomplexcompaniestheyaremoreaclue Thereisnosinglecorrectvalueforaratiodependsontheperspectiveoftheanalyst Comparetorulesofthumb Comparetoindustryaverages(sometimestherearegoodreasonstodiffer) Lookatchangesintime(mostuseful)

Chapter4managinggrowth

Sustainablegrowth

Growthisnotalwaysagoodthingbecausegrowthneedsresources(financial) Sustainable growth rate: the max rate of which a company can increase sales without depleting the financialresources Typicallifecycleofasuccessfulcompany Losses:research,developing,footholdonthemarket Rapidgrowth:growthissofastexternalinvestmentsareneeded Maturity: decline in growth, no outside investmentgenerating more cash then can be invested Decline:decliningsales,marginallyprofitable Growthphase Thegrowthrateislimitedbythegrowthofownersequity(sustainable)

g* = g* =

equity change equity bop

[bop = beginning ! of ! period]

R " earnings [R = retention ! rate] equity bop

g* = R " ROE bop g* = R " profit m arg in " asset turnover " assets ! to ! equity ratio
Ifacompanyincreasessalesataotherratetheng*someoftheratiosmustchange Balancedgrowth g* = R (assets to equity ratio ) ROA Growthdependsonreturnonassets

Whattodowhenactualgrowthexceedssustainablegrowth
Checkhowlongthiswillcontinue Short:additionalloaningforthetransitiontomature(absorbinggeneratingfinancing) Longterm: o Sellnewequity:solveseverythingbutequitiesdontselleasily(illiquid,minorowner) o Increasefinancialleverage: o Reducedividend: o Profitablepruning:nospreadingofresourcesovermoremarkets o Outsource:releasesassets,increasesassetturnover o Increaseprices:reducesgrowth o Merge: Productdiversification: Lessrisksbutnotgoodfortheshareholderswhocandiversificatebybuyingdifferentstock Spreadingofresources:followersinmanymarketslessasleadinginonemarket
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Tolittlegrowth

Havetheproblemnotknowingwhattodowiththemoneyinefficient Checkhowlongthiswillcontinue Shortterm:accumulatecashforfuturegrowth Longterm o Ignoretheproblem:thisattractsraiders(hostilebuyers)willredeploytheresources o Returnmoneytotheshareholders:repurchasingsharesorraisingthedividend o Buygrowth Growthcomesfromincreasingvolumeandrisingprices Theinflationriseinassetsandaccountsreceivableworsensthegrowthproblems Increasesamountofexternalfinancing Increasedebttoequityratio

Newequityfinancing

Corporationsdontuseequityasasourcebutjustcash WhydontUScorporationsissuemoreequity? Noneedborrowingandretainedprofitswereenough Expensivetoissue(510%oftheraisedamount2timesthecostfordebt) Managersarefixatedonearningspershare(EPS)newequitylowersEPS Companiesalmostalwaysthinkthereundervalued Stockmarketisaunreliablefundingsource

Chapter5financialInstrumentsandmarkets

Financialsecurity: Apieceofpaperofpaperthatinvestorsgetfromthecompanieswiththenatureoftheirclaim onfuturecashflow Thispapercanbetradedonfinancialmarkets. Mustbedesignedtobeattractivetoinvestors+meetsthedemandsofthecompany

Financialinstruments

Companiesarerelativelyfreetodesigntheirownsecuritiesliketheywantonlyrealregulationis thattheconsumerneedstogetalltheinforelevanttovaluethesecurity.

Bonds
Isafixedincomesecurityholderreceivesaspecifiedinterestandmaturity Usuallyinsmallamounts($1000) Largestsourceofexternalfinancing(34%) Variables o Parvalue:amountofmoneytheholderwillreceiveonthebondsmaturitydate o Couponrate:%oftheparvaluetheissuerpromisestopayasannualinterestincome o Maturitydate:companywillpaytheparvalueandstoppayinginterest Companiestrytomaketheinitialmarketpriceofthebondsequaltoitsparvalue Afterissuethebondsmarketpricecandiffer(differentinterestandcreditrisk) o Interestrisesbondpricesfall Sinkinfund:repaymentstocreditorstoreduceprincipal o Retirebondsorrepurchasemarketsecurities Floatingrate:interestistiedtoashortterminterestrate Callprovisions o Companyhastheoptiontoretirethebondearlier(mostlywithapremium) o Delayedcall:issuercantcallbeforeaspecifiedperiod(510years) o Ifinterestratefallsretireandresellalowerinterestrate o Changingmarketconditionsrearrangethecapitalstructure Covenants:specifiedintheindentureagreementtypicallysetslowerlimitforcurrentratio and upper limit for debttoequity ratio (sometimes forbids to sell/buy major assets without approval)company fails (default): bankruptcy or liquidation: sale of assets to meet the claims Rights of liquidation: distribution of the money (rights of absolute priority) government (duetaxes),seniorcreditors,generalcreditors,subordinatedcreditors,stockandshareholders Secured creditor (mortage, hypotheek in Dutch): loan collateralized with a specific asset onliquidationmoneyofsaleofthisassetsgotothiscreditor Bondsarevulnerabletoinflationinterestisthesamebutvaluedecreases Bond rating: bonds are rated by companies with a letter grade, these grades are important because with good grades the companies need to offer a smaller interest rate.Bad ratings haveahighinterestbutalsohigherrisk

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 Commonstock
Residualincomesecurity: Stockholderhasaclaimonanyincomeremainingafterpaymentofaltheobligations(incl.debt interest) Highestbenefitswhenthecompanyprospersbutalsohighestlosswhenthingsgobad Amountofmoneytheyreceivedependsonthedividends(choiceofthecompany) Shareholderscontrol:theshareholdersownthecompany(intheory)whenthereisno dominantshareholder,managementcontrolstheboard(particularlyinUSandUK) o Managementcantignoretheshareholdersbecausethiswouldbebadperformance lowstockpricemaybehostiletakeovers o Securitymarketsneedstobeattractivetoraisedebtorequitycapital anualincome = d1 + p1 p0 Withd1=dividend,p0,p1arebeginning/endofyearvalueofthe stock

annualreturn =

d1 d1 d0 + p0 p0

Thedifferencebetweenbondsisanadditionalpercentage(premium)fortheriskbared

Preferredstock
Isahybridsecurity:debt/equity o Debt:fixedincome:annualdividendcouponrate o Equity:maychoosenottopaythesedividend,notadeductableexpense,nomaturity Havepriorityovercommonstockfordividends o Commondontgetdividendsbeforethepreferredarefullypaid o Cumulative:ifthedividendispassednodividenduntilfullypaidthepreferredstock Sometimesmorecontrolinbigdecisions Canbeseenascheapequityordebtwithataxdisadvantage

Financialmarkets
Financialmarkets:arethechannelsthroughwhichinvestorsprovidemoneytocompanies

Privateequityfinancing

Strategicinvestors:makesignificantequityinvestmentsinstartups Gainaccesstopromisingnewproductsandtechnology Outsourcingresearchanddevelopment Venturecapitalists:wealthyindividualsorprofessionalventurecapitalcompanies(privateequity firms) Buyasignificantfractionofacompanyandtakeanactiveroleinthemanagement Liquidatetheinvestmentin56years Veryhighrisksbutalsoveryhighprofits Unusualorganisation:privateequitypartnership o Generalpartnerraisesapoolofmoneyfrominvestors,pensionfunds,insurance,etc o Investandmanagesliquidatesandreturnstotheinvestors o Firmchargespercentageoftheoriginalcapitalandaround20%oftheearnings Addressesseveralproblemofconventionalinvestment o Minimisedifferencesbetweenmanagementandownerscreatevaluefortheowners o Aggressivebuyfixsellattitudemanagementhastotakedecisiveaction
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 Initialpublicofferings
Initialpublicoffering(IPO):creatingapublicmarketforcommonstock Createsliquidityforgrowthandforexistingowners Investmentbanking: o Proposalsofinvestmentbanks(howtosell)winner=managingunderwriter o Roadshow:topexecutivesgoandmarkettheissueinfinancialcentres o Sellingsyndicateandunderwritingsyndicate:shortjoiningofinvestmentbanks Selling:eachmembersellspredefinedamountofsecurities Underwriting:buyallthesecuritiesatafixedpriceandtrytosellthemata higherprice

Seasonedissues
Shelfregistration:allowfrequentsecurityissuerstoavoidcumbersometraditionalregistrationby filingageneralpurposeregistration Readyforusewhenneeded(notimelagbetweendecisionandissue) Highlikelihoodofbiddingbetweeninvestmentbanksissuecost1050%loweras traditional Internationalmarkets:wheneverthecurrencyemployedisoutsideofthecontroloftheissuing monetaryauthorityex.DollarloantoanAmericancompanyinLondon Minimalreportingandregulatoryrequirements,verycompetitiveprices o Absenceofreserverequirementsoninternationalbankdeposits o Possibilitytoissuebondsinbearerform=unregisteredowners,lowercouponratebut sameaftertaxreturn(illegalinUStaxavoidance) Issuecosts:coststheissueranditsshareholderincuroninitialsale Privatelynegotiatedtransactionfeechargedbytheinvestmentbanker Public:legal,accounting,printingfees,managingunderwriter o Underwriter:spreadfeepersharehesoldsplitbetweensyndicateandunderwriter Offerunderthemarketpriceeasiertoselltolessinformedoutsiders Equityismorecostlythendebt o 11%forIPO,7.1%forpublicsold,3.8%bonds o Costrisewhenissuesizedecreases

Efficientmarkets
Importantinraisingnewcapitalistimingsellwhenpricesarehighpredictionsfuturepricetrends infinancialmarkets Market efficiency is controversial because many companies overstate the evidence supporting efficiencyandmisrepresentitsimplications.Notblackandwhitebutshadesofgrey Efficientmarket:isamarketinwhichthepricesadjustrapidlytonewinfoandpricesreflectfullythe availableinfoabouttheassetstraded Weakform:currentpricesreflectalltheinfoaboutpastprices Semistrongform:currentpricefullyreflectallthepubliclyavailableinfo Strongform:currentpricereflectallinfo(publicandprivate)

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 Implicationsofefficiency
Publiclyavailableinfoisnothelpful Absenceofprivatebestforecastisthecurrentprice(trend) Withoutprivateinfoacompanycannotimprovetermstosellbytiming Withoutprivateinfo/accepthighrisksnoearningabovemarketaveragereturn Solutionismakinganinformationgatheringsystemorgetinsideinfo(illegal?),buyaforecastofafirm

Forwardcontracts,optionsandthemanagementofcorporaterisks
Forwardsandoptionsareaclassofsecurities:derivatives:valuedependsonunderlyingassets Usedtocontrolrisksofvolatileexchangerates,interestsratesandcommodityprices Mustbeverycarefulcanloosealotofmoneyto

Forwardmarkets
Forwardmarket:thepriceissettodaybutexchangehappensonafuturedate(exreservingaroom) Speculating:ex.Sellingeuroswhentheeurohasahighvaluethenwaitawhileandbuythemagain whenpriceislower ThiscanresultsontransactionswitheurostoaUScompanysotheycansellthesameamountin eurosfordollarssotheeffectofafallishedgedforafuturedropoftheeuro(forwardmarkethedge) isconvenienttoputintherightnumberinaccountsreceivable Options:asecurityentitlingtheholdertoeitherbuyorselltheassetatapredefinedprice/time Putoption:righttosellatapredefinedprice Calloption:righttobuyatapredefinedprice Premium:amountyoupayfortheoption Maturitydate:dateoptionexpires Canbeusedtohedgetheeffectsoftheexchangeratebybuyingputoptions Limitationsofhedging Assetcreatingtheriskmusttradeinfinancialmarkets Amountandtimingoftheforeigncashneedstobeknownwithreasonablecertainty o Thisisaproblemwhenitisanoperatingcashflow Hedgeanunknownamount

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Chapter6thefinancingdecision
Financingdecision Decidehowmuchcapitalisrequired:estimatesalesgrowth,assetsneeded,availablemoney Instrumenttobesoldrisk,inabilitytosell,excessivecostsifwrongchoicewasmade Focusshouldbeonsupportingthebusinessstrategy(acquiring/deployingassets) Takeintoaccounttheeffectonthefutureabilitytoraisemoney

Financialleverage
Financialleverage:deviceincreasesownersexpectedreturnatthecostofgreaterrisk Increasethedebtfinancinginterestexpenses Waytovarythewaytheyfinancedebtequityratio Debtreducesvariablecosts+increasesfixedcostsafterbreakevenincomewillrisemore

ROE = ROIC + ( ROIC i')

Debt int eres

Equity bookvalue Withiaftertaxinterestrate

Bondfinancing:lowertaxbillinteresttaxshield Commonstock:higherearningsaftertax Tomakeadecisionarangeofearningsneedtobemade(plotEBITEPS)

o ROICisthereturnacompanyearnsbeforethefinancialleverage o Improvesfinancialperformancewhenbusinessisgoingwellandviceversa Examplep203210

Howmuchtoborrow
Purposeshouldbetoincreasetheshareholdersvalue Increasevaluetheshareholdersattachtotheoperatingcashflow(absolutebyM&M) Increasethelevelofcashflow IrrelevancebyFrancoModiglianiandMertonMiller(M&M) Whencashflowisconstanttheamountofdebthasnoeffectonthevaluenoconcernin valuemaximizing Increasedriskpreciselyoffsetstheincreasedreturn Physicalassetsproducevaluenoincreaseincashflowproducednoincreasedvalue Concl:financialchoiceshouldbetheonethatmaximizesthecashflow

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5factormodeltochangethecashflow Taxbenefits:debtfinancingincreasesthetaxbenefitincreasescashflow Distresscosts:variouscostsacompanyincurswhenithastomuchdebtcapital o Bankruptcy: P (banktruptcy ) cos ts ,bankruptcydoesntnecessarilymeanliquidation buttheriskisveryhighanddependsontheresalevalueofsomeassets o Indirectcosts:increaseasthechanceofbankruptcyrisesandcanreinforcethechance ofbankruptcy Internal:conservecashbycuttingR&D,marketing(lostprofitopportunities) External:costumersareconcerned+higherfinancingcostbyworriedinvestors +concurrentwouldtrytokillyoubymakingapricewar o Conflictsofinterest:variouspartiesinthecompanyworryaboutthemselvesowners havenothingtoloosebutcreditorsdo Flexibility:ifthedebtcapacityisreachedfurtherfinancingneedstobedonebyequitywhichis notalwaysreliableorevenpossibleremainingunderthedebtcapacityisbettertobeableto handlefutureextracosts Marketsignalling:studieshaveshownthattotalstockpricesdeclinewith30%ofthenew issuedequityandviceversa(permanent)marketsignalling:sailofextraequitysignals investorsthatmanagementisconcernedforthefuturefirmstryfirsttointernallyfinanceto avoidunnecessarysignalling Managementincentives:(aansporing):debtcanbeaverystrongincentive,management doesntdoesitsbesttheycouldlosetherebusiness(jobs) Thefinancingdecisionandgrowth Rapidgrowth Maintainconservativeleverageratiowithunusedborrowingcapacity Modestdividendpayoutsinternalfinancingofgrowth Cash,marketablesecurityasbufferliquidityinvestmentexceedsinternalsources Externalfinancingdebtonlyuntilleverageratiothreatensflexibility Sellequityratherthenrestrictaccesstofinancialmarketsreducegrowthonlywhenno alternative Lowgrowth Easyfinancialdecisionsbecauseonlyproblemishowtogetridoftheexcesscashcreatevaluefor theownersbyaggressivedebtfinancinguseproceedstorepurchaseshares Increasedtaxshield(reducetaxes) Positivemarketsignal( Highfinancialleverageincreasesthemanagementincentive

Selectingamaturitystructure
Minimumriskmaturitystructureoccurswhenthematurityofliabilitiesequalsthatofthe assetscashgeneratedbyoperationsovertheyearsshouldbesufficienttorepayexistingliability Maturityislessthentheassetsriskofrefinancing:maturingliabilitieshavetobepaidwith newlyraisedcapital. Maturitylongerthentheassets:extramarginofsafety+excesscash Cantalwaysusetheperfectmaturity Unacceptableterms Reduceborrowingcosts Debthasanadvantagewithinflationonlywheninflationisunexpectedelseitiscompensatedforin theinterest
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Chapter7discountedcashflowtechniques
Companyfuturedependsontheinvestmentsoftoday Keyaspectiscapitalbudgeting:processoffinancialevaluationofinvestmentproposals Discountedcashflowtechniques:relevantwheneveracompanycontemplatesanactionentailingcosts orbenefitsthatextendbeyondthecurrentyear Valuingstocksandbonds,divisions,companies Choosingcompetingproducttechnologies Etc

Figuresofmerit
Financialevaluation Estimateofrelevantcashflows Figureofmeritoftheinvestment:numbersummarizinganinvestmenteconomicworth Comparefigureofmerittoanacceptancecriterion:standardofcomparison Figuresofmerit Paybackperiod:timetorecouptheinitialinvestment o Problem:insensitivetotheperiodafterthat Accountingrateofreturn o

o Problem:insensitivetotimingofcashflow Timevalueofmoney Adollartodayisworthmorethenadollarinayear Inflation:reducesthepurchasepowerofonedollarinthefuture Uncertaintyofreceiptriseswhenreceiptdateisfurtherinthefuture Opportunitycost:returnonecouldearnonthenextbestalternativecashreceivedinthe futurecouldalreadybeusedininvestmentsifreceivedtoday Becauseofthisnocashflowsoccurringatdifferentdatescanbejustaddedupbeforeadjustedby Compounding:processofdeterminingthefuturevalueofapresentsum Discounting:processoffindingthepresentvalueofafuturesum

average cash inf low annual cashoutflow total

Presentcashisequivalenttofuturecash Netpresentvalue(NPV)

(1$ + 1$ discountrate ) period

1$

NPV = cash inf low present,value cashoutflow present,value

Importanttocalculateifaninvestmentwilladdvaluetoyourcompanyinthefuture Benefitcostratio(BCR):profitabilityindex

BCR =

cash inf low present,value Higherthen1isgood cashoutflow present,value

Internalrateofreturn(IRR) MostpopularformofmeritandcloselyrelatedtoNPVisthediscountrateatwhichheNPVis0
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Determiningtherelevantcashflows
Relevantcashflow
Cashflowprinciple:recordinvestmentcashflowswhenthemoneyactuallymovesnotwhen theaccountantsaytheyoccur Withwithoutprinciple:image2worlds,theonewiththeinvestmentmadeandonewithoutall cashflowsthataredifferentintheseworldsarerelevant

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