The Basic Principle of Financial Management

Executives would like to learn and improve their knowledge of Finance as it is an essential and exciting area in any organization It is the responsibility of every person in a managerial position in any organization to manage a firms resources intelligently and well for maximizing shareholder value
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The Importance of Financial Knowledge

The performance of business activities is evaluated in terms of money. Money is the language of business Financially intelligent managers contribute to a businesss health because they can make better decisions They can use their knowledge to help their company succeed They manage resources more prudently; use financial information more astutely, and thereby increase their companys profitability and cash flow By doing the above, they create more value for the shareholders
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The Key to a Healthy Business

When employees understand a companys objectives and work to attain them, it is easier to create an organization built on a sense of trust and a feeling of community An organization that is successful over the long haul will almost invariably be built around trust, communication, and a shared sense of purpose Financial training an increase in financial intelligence can make a big difference in this regard
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Overview of Corporate Finance

Every business decision is a corporate finance decision. Three key issues
What determines a firms value? How can managers add to a firms value? How can managers ensure that they have sufficient resources to execute value enhancement plans?
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Corporate Finance Roadmap

Maximize Value of the Firm
Investment Decisions
Project returns greater than hurdle rate

Financing Decisions
Financing that maximizes value of projects

Hurdle Rate
Function of project risk and financing employed

Returns
Measured as timeweighted, incremental cash flows

Financing Mix
Debt ratio dictates hurdle rate

Financing Type
Matching principles

Dividend Decisions
If not enough investments, return cash to owners as dividends or stock buybacks.

Factors Affecting Firm Value Maximization

Amount and timing of cash flows expected by shareholders Riskiness of the cash flows
Amount, timing and riskiness of cash flows are a function of managerial decision-making and environmental factors.

Think: Will Your Decision Create Value?

The owners of a firm (the shareholders) want the value of the firm to be enhanced Hence, before deciding to go ahead with any business proposal, the manager should ask himself/herself the Key Question:
Will the proposal raise the firms market value? This Key Question also applies to current operations

Creating Shareholder Value

The paramount objective of management should be the creation of value for the firms owners However, does this mean the firm can neglect other stakeholders, such as employees, customers or suppliers? Results of a survey by FORTUNE magazine showed that firms perceived to be highly rated with respect to management, employees and customers were value creators, while the lowest rated firms were value destroyers
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Creating Shareholder Value

According to researchers from McKinsey and Company, companies dedicated to value creation are more robust and build more economies, higher living standards, and more opportunities for individuals Their research has also indicated that American and European companies that created the most shareholder value in the past 15 years have also shown stronger employment growth McKinsey researchers found that companies that earned the highest shareholder returns also invested the most in R&D In addition, their research indicated that many corporate social responsibility initiatives help create shareholder value

The Bottom Line According to McKinsey & Company

Managers who make the effort to create long-term value for shareholders see that effort rewarded in their companies stock market performance Companies that create more lasting value for their shareholders have more financial and human capital to foster behaviors that beneficially impact other stakeholders too

The Fundamental Finance Principle

A business proposalsuch as a new investment, the acquisition of another company, or a restructuring plan will raise the firms value only if the present value of the future stream of net cash benefits the proposal is expected to generate exceeds the initial cash outlay required to carry out the proposal

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Measuring Value Creation With Net Present Value

Value creation in the case of existing operations Value creation in the case of new projects In this context, a concept known as Net Present Value or NPV is very important NPV = Present value of future cash benefits - Initial cash outlay Market value of firm should rise by an amount approximately equal to projects NPV on the day the project is announced A business proposal that is undertaken creates value if Its net present value is positive Value is destroyed if its net present value is negative 12

The Discount Rate

To estimate the net present value of a project, we must first discount its future cash-flow stream using the appropriate discount rate and then deduct from that present value, the initial cash outlay In other words, the discount rate used to evaluate the cash flows from a project should reflect the riskiness of the cash flows being evaluated
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Three Fundamental Corporate Finance Decisions

The Investment or Capital Budgeting Decision The Financing or Capital Structure Decision The Payout or Dividend Decision

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The Capital Budgeting Decision

Capital budgeting decision typically affects the firms business performance for a long period of time Example: Ford Motor Companys Edsel project

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The Capital Budgeting Decision

Decision criteria used in capital budgeting are direct applications of the fundamental finance principle

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Capital Budgeting Techniques

The net present value (NPV) rule
A project should be undertaken if its net present value is positive and should be rejected if its net present value is negative

The internal rate of return (IRR) rule

To use the IRR rule to determine whether a project creates value, we must compare the projects IRR to its WACC
 If IRR > WACC, project should be undertaken
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The Capital Budgeting Decision

Sources of value creation in a business proposal
Positive NPV projects and businesses are not easily discovered, but when found, they attract competitors into a market
 To keep their profits from being reduced by competition, firms create costly entry barriers
 Patents  Trademarks  Licenses, etc.
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The Capital Structure Decision

Capital structure refers to the financing mix of debt and equity used by the firm The financing choice depends on many factors, the most important of which is the nature of the business that the firm is in
 Example: Pharmaceutical, IT, and Utility companies
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The Capital Structure Decision

Importance of Capital Structure As the firm uses more and more debt, it faces the risk that it may be unable to service its debt This is called the risk of financial distress Thus, debt financing involves a tradeoff between tax benefits and financial distress risk 20

The Payout Decision

Deciding how much of earnings to return to shareholders and in what form is a key top management decision The tradeoff:  More payout means less funds available for reinvestment  This increases the dependence on external capital
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Growth and Value Creation

As discussed previously, the main objective of any business is to create value for its stakeholders Corporate Growth is an essential pre-requisite for the creation of value A firm can grow organically or through acquisitions Given the extremely competitive business environment, organic growth is usually viewed as being too slow Hence, an acquisition-driven growth strategy becomes the preferred growth option and an essential tool for value creation
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The Business Acquisition Decision

Acquisition of a business is just another investment decision This will only create value if present value of future net cash flows expected from target firm exceeds the price paid to acquire the firm
Horizontal, vertical, and conglomerate mergers Synergies Record

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The Foreign Investment Decision

Additional risks arise from overseas investments
 Currency risk Unanticipated changes in value of currency  Political risk Unexpected events

Instead of adjusting the cost of capital for the added risks, the projects future cash flows should be modified
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The Role of Financial Markets

Role of financial markets in value creation
Primary markets
Provide financing for funding growth by helping in the transmission of funds

Secondary markets
Provide efficient means for trading outstanding securities

Role of investment (merchant) bankers

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The Balance Sheet

Balance sheet provides a snapshot of the firms financial profile at a certain point in time. Structure of assets and liabilities Based on the accrual system of accounting Problem with balance sheets

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ABC Limited
Figures in millions of dollars
STANDARD BALANCE SHEET
ASSETS
DECEMBER 31 2009 DECEMBER 31 2010

LIABILITIES AND OWNERS EQUITY

DECEMBER 31 2009 DECEM8ER 31 2010

Cash Accounts receivable Inventories Net fixed assets TOTAL

$100 150 250 600 $1,100

$110 165 275 660 $1,210

Short-term borrowing Accounts payable Long-term debt Owners equity TOTAL

$200 100 300 500 $1,100

$220 110 330 550 $1,210 27

The Income Statement or P&L account

This shows the results of operations over a period of time Also based on the accrual system of accounting Net income is not a true measure of the profitability of a company

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ABCs Income Statement

Figures in millions of dollars
Sales Less operating expenses (including depreciation expenses) Earnings before interest and tax (EBIT) Less interest expenses Earnings before tax (EBT) Less tax expenses Earnings after tax (EAT) Retained earnings = $50 Dividend payment = $50
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$1,000 ($760)

$240 (40) $200 (100) $100

How Profitable Is A Firm?

Information from a firms balance sheet and income statement can be combined to analyze the firms financial performance in terms of the profitability of its equity and of its invested capital

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Some Key Issues

How to measure a firms profitability? What are the key drivers of profitability? How to analyze the structure of a firms overall profitability? How business risk and the use of debt financing affect profitability?

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Measures of Profitability
Managers adopt measures of profitability depending on their areas of responsibility
A sales manager would look at return on sales (ROS) The manager of an operating unit would choose return on assets (ROA) A chief executive would pay attention primarily to return on equity (ROE)
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Questions
These three measures of profitability raise some important questions: How are these measures related to each other ? Which one is the most comprehensive indicator of profitability? How do managerial decisions affect profitability? How does risk affect profitability?
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Return On Equity
Return on equity (ROE) is the most comprehensive indicator of profitability
Considers the operating and investing decisions as well as the financing and tax-related decisions

ROE measures the firms profitability from the perspective of the owners whose reward is the firms net profit
ROE = Earnings after tax z Owners equity
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The Impact Of Operating Decisions On Return On Equity

Operating decisions, broadly defined, involve the acquisition and disposal of fixed assets and the management of the firms operating assets (such as inventories and trade receivables) and operating liabilities (such as trade payables)
ROS (net profit per dollar of sales) and ROA (net profit per dollar of total assets) are not appropriate measures of the profitability generated by the firms operating activities because they are calculated with net profit (earnings after tax) Net profit is obtained after deducting interest expenses the outcome of a financing decision - from the firms pretax operating profit 35

The Impact of Operating Decisions on Return on Equity

ROS and ROA are thus affected by financing decisions and do not reflect only operating decisions Hence, ROS and ROA are not appropriate measures of the profitability generated by the firms operating activities
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Return on Invested Capital (ROIC)

A relevant measure of operating profitability is return on invested capital or ROIC
ROIC = EBIT z Invested Capital Invested capital = net assets Hence, ROIC = RONA Furthermore, since total invested capital is equal to total net assets, equal to total capital employed, ROIC = RONA = ROCE

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The Drivers of Operating Profitability

EBIT EBIT Sales ROIC = ! v Invested Capital Sales Invested Capital

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The Drivers of Operating Profitability

Any improvement in ROIC must be the outcome of a higher operating profit margin or a higher capital turnover

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The Drivers of Operating Profitability

A higher operating profit margin is achieved by
Increasing sales through higher prices and/or higher volume at a higher rate than operating expenses and/or Reducing operating expenses at a higher rate than sales

A higher capital turnover is achieved through a better use of the firms assets required to support the firms sales activities, for example, through a faster inventory turn, a shorter collection period for the firms receivables, or 40 fewer fixed assets per dollar of sales

The Drivers of Operating Profitability

If the key to higher operating profitability is a combination of higher operating profit margin and faster capital turnover, what are the underlying factors that would allow a firm to achieve this?

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The Drivers of Operating Profitability

High market share, superior product quality, and high capital turnover boost operating profitability, while high investments and high fixed costs depress it

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Market Share
Size and control of a larger share of the served market will generally allow a firm to enjoy relatively higher profit margins via lower cost per unit of output and stable output prices Such firms can spread their fixed costs over a larger volume, purchase inputs in bulk at a discount, and prevent market forces from putting excessive downward pressure on 43 their product prices

Perceived Product Quality

Businesses whose products and services are perceived to be of superior quality are generally more profitable than businesses whose products and services are perceived to be of inferior quality Higher profitability is achieved via relatively higher margins because businesses with superior products and services are able to avoid price competition. This allows them to protect their margins from being squeezed by competitive downward pricing Examples?
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Capital Turnover
Capital turnover has a significant influence on the profitability of a business The empirical evidence indicates that businesses with low capital turnover (businesses that require intensive investment in assets to produce sales) do not generate, on average, a high enough margin from their operating activities to compensate them for their lower capital turnover

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Capital Turnover
Why are businesses with low capital turnover usually unable to generate higher profit margins?

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Capital Turnover
Investment-intensive businesses with low capital turnover usually have relatively high fixed costs and are usually prone to price and marketing wars that weaken their margin When economic conditions become unfavorable, there is a tendency for these businesses to cut prices to maintain high rates of capacity utilization In addition, because these businesses have relatively high amounts of capital tied up in their operations, they cannot easily exit the business (they have high exit barriers) They usually try to ride the unfavorable market conditions in the hope of better future days The airline industry is a good example of such 47 behavior

The Impact of Financing Decisions on ROE

Let us consider what happens when a firm replaces some of its equity capital with an equal amount of debt The substitution of debt for equity, leaving assets unchanged, is called a leveraged recapitalization It can be carried out by using the proceeds from borrowing to buy back common stock from shareholders The repurchased shares reduce the firms equity by the same amount The higher proportion of debt financing resulting from recapitalization increases the firms financial leverage

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The Impact of Financing Decisions on ROE

A higher financial leverage affects a firms ROE in two ways First, the firms interest expenses increase and its earnings after tax (EAT) decrease. This will reduce ROE Second, owners equity decreases because debt has replaced equity. This will increase ROE Therefore, we cannot predict how financial leverage will affect ROE

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The Impact of Financing Decisions on ROE

There is a financial cost effect that reduces ROE (more interest expenses) and a simultaneous financial structure effect that increases ROE (less equity capital) The net effect depends on the strength of the former relative to the latter) If the financial cost effect is weaker than the financial structure effect, higher financial leverage will increase the firms ROE If it is stronger, higher financial leverage will 50 decrease the firms ROE

The Impact of Financing Decisions on ROE

Financial cost ratio (FCR) measures the financial cost effect
FCR = EBT z EBIT

Financial structure ratio (FSR) or equity multiplier measures the financial structure effect
FSR = Invested capital z Owners equity
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Taxation and ROE

The third determinant of a firms ROE is its effective tax rate

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Taxation and ROE

EAT EBT1 - effective tax rate Tax effect ratio = ! EBT EBT ! 1 effective tax rate

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The Structure Of A Firms Profitability

ROE is the product of five ratios
     Operating profit margin Capital turnover Financial cost ratio Financial structure ratio Tax effect ratio
E EBIT v l s I l s EBT I st c it l EAT v v v st c it l EBIT w rs' equity EBT
Reflect the impact of the financial policy on the firms overall profitability. Their product is called the financial leverage multiplier 54

ture the im ct of the firms i esti g and operating decisions

How Much Cash Does A Firm Generate?

Expected cash flows are a key factor in deciding whether a project will create or destroy value
Thus, it is essential to measure cash flows generated by a firms activities on a continuous basis Cash flow is a critical measure of a companys financial health

A firms EBIT or EAT does not represent cash flow

Net Cash Flow = EAT + Depreciation &Amortization

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The Cash Flow Statement

Summarizes a firms cash transactions It breaks them down into three main corporate activities
Operations Investments Financing

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Cash From or Used in Operating Activities

This includes all the cash flow, in and out, that is related to the actual operations of the business It includes the cash customers send in when they pay their bills It includes the cash the company pays out in salaries, to vendors, etc.
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Cash From or Used in Investing Activities

This includes cash spent on capital investments that is, purchase of assets It includes the cash paid out when the company buys a truck or a machine It also includes the cash received from the sale of a truck, a machine, or any other asset

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Cash From or Used in Financing Activities

Financing refers to borrowing and paying back loans
If a company receives a loan, the proceeds show up in this category

It also includes transactions between a company and its shareholders

If a company pays off the principal on a loan, buys back its own stock, or pays a dividend to its shareholders, such expenditure of cash would appear in this category
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ABCs Statement of Cash Flows

Figures in millions of dollars
CASH FLOW FROM OPERATING ACTIVITIES Sales Less operating expenses (which include depreciation expenses) Less tax expenses Plus depreciation expenses Less cash used to finance the growth of WCR
A. NET OPERATING CASH FLOW

$1,000 (760) (100) 60 (30) $170 (120) (120)

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CASH FLOW FROM INVESTING ACTIVITIES Capital expenditures B. NET CASH FLOW FROM INVESTING ACTIVITIES

ABCs Statement of Cash Flows

Figures in millions of dollars
CASH FLOWS FROM FINANCING ACTIVITIES New borrowing Interest payments Dividend payments C. NET CASH FLOW FROM FINANCING ACTIVITIES D. TOTAL NET CASH FLOW (A + B + C) E. CASH HELD AT THE BEGINNING OF THE YEAR F. CASH HELD AT THE END OF THE YEAR (E + D) 50 (40) (50) (40) 10 $100 $110

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What is Free Cash Flow (FCF)?

FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debt holders) after making the necessary investments to support operations.

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Importance of Free Cash Flow (FCF)

A companys value ultimately depends upon the amount of FCF it can generate It is a key indicator of a companys financial health, along with profitability and shareholders equity Its a final link in the triad, and you need all three to assess a companys financial health
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How to Calculate Free Cash Flow?

Get the companys cash flow statement Subtract the amount invested in capital equipment The balance is free cash flow Free cash flow is simply the cash generated by operating the business minus the money invested to keep it running Remember: Free cash flow is simply the cash generated by operating the business minus the money invested to keep it running
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What are Operating Current Assets?

Operating current assets (Op CA) are the current assets needed to support operations. Op CA include: cash, inventory, receivables. Op CA exclude: short-term investments, because these are not a part of operations.

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What are Operating Current Liabilities?

Operating current liabilities (Op CL) are the current liabilities resulting as a normal part of operations Op CL include: accounts payable and accruals. Op CL exclude: notes payable, because this is a source of financing, not a part of operations.
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Net Operating Working Capital (NOWC)

NOWC = Operating CA Operating CL

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Total net operating capital (also called operating capital)

Operating Capital= NOWC + Net fixed assets.

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Net Operating Profit after Taxes (NOPAT)

NOPAT = EBIT(1 - Tax rate)

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Free Cash Flow (FCF)

FCF = NOPAT - Net investment in operating capital FCF is the amount of cash flow available for distribution to investors after paying expenses and taxes and making the necessary investments in working capital

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Risk and Value Creation

While we have discussed various ways of creating value for shareholders, we must recognize the fact that there are certain extraneous factors that could impinge on value creation Hence, it is essential to discuss the various facets of risk faced by a firm
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Riskiness of a Firm
Let us now drill down deeper into the different types of risk

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Facets of Fundamental Risk

Business risk Financial risk Liquidity risk Exchange rate risk Country risk

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Business Risk
Uncertainty of income flows caused by the nature of a firms business Sales volatility and operating leverage determine the level of business risk What are some examples of industries where firms face a high level of business risk?

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Financial Risk
Uncertainty caused by the use of debt financing Borrowing requires fixed payments which must be paid ahead of payments to stockholders The use of debt, or financial leverage places the firms business risk more on its stockholders Thus, the use of debt increases uncertainty of stockholder income
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Riskiness of a Firm
Firms sales may fluctuate because of the uncertain economic, political, social, and competitive environments in which it operates
This creates economic risk, which is magnified by fixed operating expenses that produce operational risk

Together these two risks compose business risk. This is further magnified by fixed interest expenses reflecting financial risk
Business risk and financial risk together constitute the firms total risk

Since some of the firms operating expenses are fixed, the uncertainty surrounding sales translates into operating profits that are more risky than sales
Because of fixed interest expenses, risk increases further, and as a result, net profits are even more risky 76 than operating profits

Risk
If a firm has a high level of fixed operating costs, its operating income (EBIT) will be very sensitive to fluctuations in sales Hence, it would be prudent for such a firm not to take on a lot of debt as this would add financial risk to the firms existing business risk and increase the overall risk exposure of the firm The owners of a levered firm face both business risk and financial risk whereas the owners of an unlevered firm face only business risk The levered firm is riskier than the unlevered one and its risk increases with rising levels of borrowing
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Liquidity Risk
Uncertainty is introduced by the secondary market for an investment. How long will it take to convert an investment into cash? How certain is the price that will be received?

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Exchange Rate Risk

Uncertainty of return is introduced by acquiring securities denominated in a currency different from that of the investor. Changes in exchange rates affect the investors return when converting an investment back into the home currency.
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Country Risk
Political risk is the uncertainty of returns caused by the possibility of a major change in the political or economic environment in a country. Individuals who invest in countries that have unstable political-economic systems must include a country risk-premium when determining their required rate of return
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Is Value Created?
Acceptance of positive NPV projects will result in positive MVA Concept of MVA Concept of EVA

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Is Value Created?
MVA = Total Market Value Total Capital MVA = (Market Value of Stock + Market Value of Debt) Total Capital The total market value of a company is the sum of the market values of common equity, debt, and preferred stock The total amount of investor-supplied capital is the sum of equity, debt, and preferred stock
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Is Value Created?
A firms EVA is equal to the after-tax operating profit (sometimes referred to as net operating profit after taxes or NOPAT) generated by the firms net assets less the dollar cost of the capital employed to finance these assets EVA = NOPAT- (WACC) (Capital) Where WACC is weighted average cost of capital An alternative way of expressing EVA suggests that EVA will be positive (negative) if the firms return on invested capital is higher (lower) than the cost of that capital measured by its WACC
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Is Value Created?
EVA = (Operating Capital) (ROIC-WACC) As this equation shows, a firm adds valuethat is, has a positive EVA if its ROIC is greater than its WACC If WACC exceeds ROIC, then new investments in operating capital will reduce the firms value Thus, EVA represents the residual income that remains after the cost of all capital, including equity capital, has been deducted 84

REVIEW
In this discussion, we addressed Importance of value creation Three fundamental corporate finance decisions The business acquisition decision The foreign investment decision Key financial statements An integrated approach to profitability analysis Facets of risk Concepts of MVA and EVA

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Module 2
Time Value of Money

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