© The University of Texas at Austin 2013 Association of Corporate Counsel Pocket MBA Professor Jim...

© The University of Texas at Austin 2013

Association of Corporate Counsel

Pocket MBA

Professor Jim Nolen Department of Finance

University of Texas at AustinMcCombs School of Business

September 19, 2013

Finance for Non-Financial Managers


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

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

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

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.

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.

6


Analytical Processes

7

Financial Analytics

Examples:Product Profitability

Customer Lifetime Value

Examples:Compensation Analysis

Labor Utilization Analysis

Examples:Procurement AnalysisCash Flow Analysis


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

8


9

Return (ROE)Growth (g) Risk (r)

Operating DecisionsCustomers SuppliersProducts Pricing Marketing Distribution Controlling Expenses

Maximize Share Value

Efficiency LeverageProfitability

Financing DecisionsDebt-Equity Mix

Capital Structure Policy

Dividend Policy

Investing DecisionsAsset Mix Terms of Trade

Liquidity, Cash Conversion Cycle

Plant Utilization, Make or Buy

DuPont Analysis


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

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

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

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

13


Measuring Performance

14


Future PerformanceReturn on Equity

GrowthRisk

Past PerformanceReturn on Equity

GrowthRisk

Market ValueFinancial Statements

How can I improve the firm’s ROE and Value?

DuPont AnalysisFinancial

Manager

Filtered through: The Economy The Industry The Competition


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

16

Source: Helfert, Erich A., “Techniques of Financial Analysis: A Guide to Value Creation,” 10th Edition, Irwin McGraw Hill, Burr Ridge IL, 2000.


Business Performance

LiabAssets

ExpRev

Equity sOwner'

Income NetROE

17

Managers can increase the firm’s value and it return to shareholders: (Return on Assets and Invested Capital can also be used)

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


DuPont Analysis

18

sLiabilitieAssets

ExpensesRevenue

OE

IncROE

OE

Assets

Assets

Sales

Sales

Inc

OE

Inc

Profitability on Sales

FinancialLeverage

Asset Turnover

(Efficiency)

A simple dashboard that captures three of the five value drivers of a company (growth and risk and not fully measured).


DuPont AnalysisThree-Factor DuPont Analysis

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OE

IncROE

OE

Assets

Assets

Sales

Sales

Inc

OE

Inc

Profitability on Sales

Asset Turnover

(Efficiency)

FinancialLeverage

Return on Assets (ROA)

Note: The same factors affectROIC


St. Jude Medical – 12/31/11

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Income Statement

Statement of Cash Flows

Balance Sheet

Revenue $5,612 COGS $1,455

Gross Profit $4,157GPM 74.1%

R&D Exp. $705SG&A (OPEX) $1,979Depr./Amort. $296Op. Inc. $1,473

OPM 26.25%

Net Int. Exp. ($65)Other Exp. ($31)Taxable Inc. $1,377Corp. Tax ($193)Post Tax Except. ($249)Net Income $826

NPM 14.7%

EPS (fully diluted) $2.52

Adjusted Net Inc. $1,074Adjusted EPS $3.28

Net Income $826+Deprec. & Amort $296+ Operating Exp Adj . $110+/- Dec/(Inc) in NWC $56Net Cash –Operating Activities $1,288

Net Cash – Investing Activities ($337)

Net Cash – Financing Activities(1) ($465)

Exchange Rate ($8)

Net Change Cash $486

Begin. Cash $500

Ending Cash $986

(1)LT Debt Issue $325 Debt Repaid ( $78) Issuance of Common Stk $303 Repurchase of Stock ($809) Dividends ($205)

Cash $986Mkt. Sec. $37 Net Receivables $1,366Inventory $625Other Cur. Assets $375Total Current Assets $3,391

Gross Fixed Assets $2,454Accum Deprec. ($1,066)P,P&E, net $1,388Goodwill & Intang. $4,226

Total Assets $9,005

Current Liab. $1,062Long term Debt $2,713 Other L-T Liab $ 755Total Liabilities $4,531 S/H Equity $4,475

Liabilities & Equity $9,005

In millions $


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?

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

Revenue Growth 13.3% 14.4% 15.5% 7.3% 10.3% 8.7%Closing Stock Price $36.56 $40.64 $34.27 $36.78 $42.85 $34.48

22


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(1) Normalized

Rev. Growth Rate 8.7% 0.7% -2.4% 5.6%

23


STJ vs. Peers – 3 Year Stock Price

24

BSX

JNJ

STJ

S&P 500

MDT


Financial Strategies & Value Creation


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

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Financial Strategy

The financial goal (recognizing there are other stakeholders) is to maximize shareholder wealth. This is accomplished by investing in projects that exceed the

firm’s cost of capital (Capital Budgeting) Cost of capital is a function of risk and opportunity costs

Firms can create value by using its competitive advantage in: Costs (power over suppliers, business model, OPEX control) Pricing (power over customers) Asset Utilization Access and Cost of Capital Growth (branding, distribution channels, marcom) Risk Management (hedging, diversification, leverage)

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

28


DuPont AnalysisAverages – Last Five Years

Whole Wal- Wells

Foods Mart Microsoft Apple Merck Fargo AllstateROE 11.52% 21.9% 35.73% 39.24% 15.26% 10.71%11.57%

Profit Margin 2.81% 3.67% 27.84% 23.4% 17.98% 16.62% 9.54%Turnover 2.45 2.38 0.59 0.93 0.42 0.064 0.27Leverage 1.67 2.51 2.39 1.80 2.02 10.07 4.49Note the different financial strategies the different companies take to producea 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.

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Investing Decisions

Investing Decisions – Involves the left side of the balance sheet.

Treasury Management Working Capital Management Capital Budgeting

30


Assets Avg.

SalesTurnover Asset

31

Asset Efficiency & Utilization


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.

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.

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

34


35

Cash Conversion Cycle

Cash

Raw MaterialsInventory

WIPInventory

Finished GoodsInventory

AccountsReceivable

FixedAssets

Accounts Payable


Efficiency – Working Capital

36

Days Sales in Inventory

Days Sales Outstanding

DSI DSO

DPO

Days Payables

Outstanding

Purchase Inventory

on AccountPay

Payable

Sell Inventory

Collect Receivable



Cash Conversion Cycle = DSO + DSI – DPO


• A measure of how effectively a company is using its cash

DSO: Days Sales Outstanding

• How many days, on average, does it take for customers to pay

DSI: Days Sales in Inventory

• How many days, on average, does product sit in inventory, waiting to be sold

DPO: Days Payables Outstanding

• How many days, on average, does a company wait before paying their supplies

37

DSO + DSI – DPO = CCCDSO + DSI – DPO = CCC

DSO= 45 DaysAvg Accts Receivable/Net Sales*365

DSO= 45 DaysAvg Accts Receivable/Net Sales*365

DSI=65 DaysAverage Inventory/COGS*365

DSI=65 DaysAverage Inventory/COGS*365

DPO= 54Avg Accounts Payable/COGS*365

DPO= 54Avg Accounts Payable/COGS*365

45 + 65 – 54 = 56


Capital Budgeting

Lawyers don’t have to be seen as sales prevention or deal killers. Corporate Counsel needs to be included earlier in the decision-making 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.


Common Elements of Decision-Making

39

Using fact-based analysis to maximize the goals and objectives of the person or organization.

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)

With each business decision you are involved in, you should ask: 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?


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.

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.

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

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:

43

t

t0 t

CFNPV

1

n

t r


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.

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

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

46


Fit With Model FactorsClear 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

47


Classifying Investment OpportunitiesBCG Graph

48

Immediate Financial Value

Str

ateg

icV

alu

e

Investing for Long-Term

Potential

Investing for Future Potential and Immediate

Returns(prioritize)

Investing forImmediate Returns

(Cash Cows)Poor Investments

(Dogs)

High

High

Low

Low

?


BCG Bubble Graph Using NPV

49

Project 1

Project 2

Project 3

Project 4

Project 5

Project 6

Project 7

Project 8

Project 9

Project 10

Project 11

Project 12

-10000

0

10000

20000

30000

40000

50000

60000

10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Net P

resen

t V

alu

e (N

PV

)

($000)

Success Certainty(Weighted combination of Scope, Schedule and Market Success Factors)

NPV vs. Success Certainty (Size of bubble corresponds to Project Resources)

High Return, Low Certainty

Low Return, High Certainty

High Certainty, High Return(Winners)

Low Certainty, Low Return(Less attractive)

Negative NPV Zone


Two parts to the problem:

Project Evaluation – Narrow the Funnel Project Evaluation – Narrow the Funnel

Front End Risks Back End Risks

• Strategy Alignment• Market & Competitive Analysis• Business Case• Product definition• Pick winners•Technology Roadmaps

Product Execution• Abort Losers• Design• Technology• Manufacturing• Product Engineering

Concept DefinitionPlanning & Scheduling

Execution &Development

ValidationRamp-UP &Phase-Over

ProductionSupport

New Project Ideas

For Target Markets

1

2

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.

51


• 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.

52

First Principle of Finance: A Dollar Today Is Worth More Than A Dollar Tomorrow


In 1626, Peter Minuit Bought Manhattan Islandfor $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)

53


Present Value and Future Value

54

Present Value

Future Value

Value In $

Years5 10

FV= $2,159

PV=$1,000

8% interest rate

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.


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

.

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

56


NPV Process

57

Projectionof FCF

TerminalValue

DiscountRate

Present Value

Decision

Project free cash flow (FCF) over the planning horizon, typically 3 -10 years. Project revenues, expenses, taxes, working capital and CAPEX.

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.

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.


Net Present Value (NPV)

n

ot

n

tWACC

FCFNPV

)1(

58

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.

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

where: t is the period in which the cash flow is received.


Popular Alternatives to NPV

Payback


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).

60



61

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.

TT

221

01

CF...

1

CF

1

CFCFNPV

rrr


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?

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

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

64


Financial Leverage & Risk

.LiabAssets

Assets

Equity Avg.

Assets Avg.Leverage

65


66

Typical Life Cycle Financing


67

Financing Life Cycle

Discovery Proof-of-concept Product design Product Development Mfg. & Delivery

IdeaPre-Seed

Business PlanSeed

Mkt. ValidationStart-up/Launch

Expansion/Operating

CapitalHarvest/

Exit

Founder

Friends / Family/ Fools

Angels

Bank Loans

Guaranteed Loans -SBA

Venture Capital

Private Equity

IPO

LeasingCustomers/Suppliers

Merchant BanksMezzanine

Strategic Partners/JV

Micro Lender

Factoring

ETF


68

Cost of Funds (annual required return)

0% 5% 10% 15% 25%20% 30% 50+%……..Early

Stage VCVendors orCustomers

Banks

Asset-Based Lenders

Leasing

Factoring

Later Stage VC

MezzaninePrivate

Equity/LBO

Founder, Friends, Family & Fools


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The Equity Financing Cycle Based on Growth & Profitability

Pro

fitab

ility


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Sources Based on Purpose & Amount of Capital Needed


Financing Goals & Strategies The goal of the financing decision is to

employ capital in the correct mix of debt and equity that minimizes the average cost of capital to the firm.

Judicious use of debt will enable the firm to employ financial leverage so that the firm’s return on shareholder equity is maximized.

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Cost of Debt Debt is a cheaper source of capital than

equity but a riskier source that creates managerial inflexibility. Issuance costs are lower for debt The cost of debt is subsidized - Interest is tax

deductible and thus the after-tax cost of debt is lower. Creditors have contractual returns and higher priority

claims. As a result, they perceive less risk and thus will accept lower returns (cost) for their investment.

However, debt has fixed repayment terms and over-leverage can result in financial inflexibility and insolvency . Interest rate risk and negative leverae Renewal uncertainty

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Cost of Equity Equity capital is more expensive but

more patient and less risky source of capital. Issuance costs are higher and compliance costs

are higher. Shareholder’s are the residual claimants whose

returns are variable and thus they perceive greater risk and require higher returns (costs) for their investment.

Dividends are paid after corporate taxes and thus receive no subsidy like interest expense.

With no fixed repayment obligations, equity provides more managerial flexibility .

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Weighted Average Cost of Capital Weighted average cost of capital (WACC) is the after-tax

cost of debt and the cost of equity weighted by their market value percentage of the firm value.

The cost of debt is contractual and the rate is multiplied by one minus the tax rate to get the after tax cost of debt.

The cost of equity is an expected return to the residual claimants (shareholders) and can be estimated by the capital asset pricing model (CAPM) or dividend discount model.

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Optimal Capital Structure Where the average cost of capital is

minimized.

Where the marginal cost of new capital is equal to the marginal return on the next investment.

Where the value of the enterprise is maximized.

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Term Sheets Negotiating Items for the Bank include:

Amount of loan Interest rate, fixed or floating Maturity Loan Covenants Guarantees

Major negotiating points with the VC will be: Amount of capital needed The valuation of the business Number and composition of the Board of Directors Liquidation preferences Anti-dilution provisions Milestones Amount of Option Pool and Vesting Schedule Founder stock vesting Conversion rights, Redemption rights and Take Along rights Registration and Piggyback rights

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Leverage - Summary

The goal of capital structure and dividend policy is to minimize the cost of capital to the firm which allows the firm to invest the capital in projects that exceed the weighted average cost of capital or hurdle rate.

The weighted average cost of capital is the average cost of debt and equity in the firm, which is a function of the perceived risk of the suppliers of capital.

Are Dividends and Stock Buybacks a positive or negative signal to the market? Which is better for your bonus calculations? Can a company have a gain or loss on its purchase and sale of its own stock?

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Capital Structure Policy In general, after considering the tax effects, debt is a

cheaper but riskier source of capital than equity. If a firm thinks it can earn more than the cost of debt, then favorable financial leverage generates higher returns to shareholders but gives managers less flexibility and exposes shareholders to a higher risk of insolvency.

Dividends and share repurchases can be a good use of excess cash but remember to consider taxes.

The Company is competing with other firms for capital and must give creditors and shareholders a risk adjusted return to be able to attract capital.

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Bankruptcy & Restructuring

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Present Company Bankruptcy Date Description Assets Lehman Brothers Holdings Inc. 09/15/08 Investment Bank $691,063 Washington Mutual, Inc. 09/26/08 Savings & Loan Holding Co. 327,913 WorldCom, Inc. 07/21/02 Telecommunications 103,914 General Motors Corporation 06/01/09 Manufactures & Sells Cars 91,047CIT Group 11/01/09 Financial Services 80,448Enron Corp. 12/02/01 Energy Trading, Natural Gas 65,503 Conseco, Inc. 12/17/02 Financial Services Holding Co. 61,392 MF Global Holdings 10/31/11 Financial Services 40,541Chrysler LLC 04/30/09 Manufactures & Sells Cars 39,300 Thornburg Mortgage, Inc. 05/01/09 Residential Mortgage Company 36,521 Pacific Gas and Electric Company 04/06/01 Electricity & Natural Gas 36,152

Texaco, Inc. 04/12/87 Petroleum & Petrochemicals 34,940 Financial Corp. of America 09/09/88 Financial Services 33,864 Refco Inc. 10/17/05 Brokerage Services 33,333 IndyMac Bancorp, Inc. 07/31/08 Bank Holding Company 32,734 Global Crossing, Ltd. 01/28/02 Global Telecommunications Carrier 30,185 Bank of New England Corp. 01/07/91 Interstate Bank Holding Company 29,773 General Growth Properties, Inc. 04/16/09 Real Estate Investment Company 29,557 Lyondell Chemical Company 01/06/09 Global Manufacturer of Chemicals 27,392

Calpine Corporation 12/20/05 Integrated Power Company 27,216 New Century Financial Corporation 04/02/07 Real Estate Investment Trust 26,147

Colonial BancGroup, Inc., The 08/25/09 Bank Holding Company 25,816

20 Largest Public Company Bankruptcy Filings 1980 – Present

Source: Bankruptcydata.com80


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 debt81


Resolving Financial Distress

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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 valueChapter 11


Chapter 7 Bankruptcy

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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


Chapter 11 Bankruptcy

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Main objective is to rehabilitate.1. Filing of Petition2. Order of Relief 3. Automatic Stay of Proceedings4. Reorganization Plan

Exclusivity Period (120 days)Debtor in possession (DIP)Creditor Committees

Alternative Plans5. Approval of Plan6. Confirmation of Plan

Total cram down7. 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.


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

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Absolute Priority Rule

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The absolute priority rule:

1. Debtor-in-Possession (DIP) loans2. Certain obligations incurred after filing for Chapter 113. Unsecured claims for employee compensation4. Unsecured claims from employee benefit plans5. Secured creditors6. Senior creditors7. Unsecured creditors (other than senior creditors)8. Subordinated debt claims9. Equity holders.


Bankruptcy as a Strategic Device

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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


Cram-downs and Objections Cram-down – Under certain circumstances, the bankruptcy court may "cram

down" a plan over the objection of creditors. In order to confirm a Chapter 11 plan over the objection of a secured creditor, a holder of a secured claim must receive the entire value of the property securing the claim or the entire value of the claim, whichever is smaller. Unsecured creditors must either accept the Chapter 11 plan or the owners of the business must not receive any property under the plan on account of their pre-bankruptcy interest in the farming operation. Finally, a plan cannot be confirmed if the plan does not pay each claim holder as much as he would have received under a Chapter 7 liquidation unless those who receive less accept the plan.

Objections to Plan – Creditors may object to the confirmation of the debtor's plan in a Chapter 11 case. Such objections will usually challenge whether the debtor has met the technical requirements of Chapter 11. However, creditors may also challenge the debtor's valuation of their collateral and the feasibility of the debtor's plan. As a result, it is usually necessary for the debtor to obtain expert testimony concerning the current value of machinery, equipment, livestock, and crops. In addition, it will be necessary for the debtor to provide his creditors with detailed financial projections which will assist the bankruptcy court in determining that the business may be successfully restructured.

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Competing Plans & Confirmation Competing Plans – As previously mentioned, only the debtor

may submit a plan of reorganization within 120 days of the initiation of the bankruptcy case. Any interested party may file a plan thereafter. A plan, including a plan proposed by a creditor, may provide for the liquidation of some or all of the debtor's nonexempt assets. Such a liquidating plan may be proposed and approved by the court.

Confirmation – Confirmation of a plan under Chapter 11 acts as a discharge of all debts, filed or not, excluding those specified as not dischargeable elsewhere in the bankruptcy code. Upon confirmation of a plan, the debtor receives back all his property free and clear of all liens and encumbrances unless such liens are preserved by the plan. Both the debtor and the creditors are bound by the terms of the confirmed plan.

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Contact Information

Jim Nolen

Texas Executive Education

512.232.6834

[email protected]

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