FINANCIAL PERSPECTIVE
FINANCE AND ENTREPRENEURS
Allocation of scarce resources within the firm
How decisions should be made? – Finance is for general managers too!
Finance cannot stand alone – to ignore human or production perspective will be as fatal as ignoring financial perspective
Effects of decisions – on shareholders and other constituencies (management, labor, suppliers, customer, government, society)
Useful to general managers and critical to entrepreneurs – Cash Risk Value
CASH
Key goal is to keep playing the game!
Cash can be consumed, traded for other assets.
Accountants match revenues with expenses, distinguish between expenditures and expenses – Managers focus on cash inflow and cash outflow
Performance Evaluation and Incentive Compensation Firm’s objective : Maximize value depending upon cash and risk Individuals act to maximize their own wealth Hence company’s incentive compensation policy is important
Taxes and Cash 4 kinds of decisions affect taxes: Legal, Investment, Financing, Accounting Try to minimize the resources siphoned off to Govt. within the constraints of the law
Cash and Growth Sales growth -> Growth in assets -> Increase of shareholder’s equity Differentiation between real growth and inflation
Pattern recognition Patterns affecting cash: cyclical, seasonal,
competitive, technological, regulatory and tax
Identifying opportunities: Using past and current data -> Predict future
Decision making: Offensive or defensive move
Not possible every time therefore responses may be delayed
Scenario Planning It is not the same as worst or best case
scenario considerations Nor it is linear extrapolation Every forecast will turn out to be wrong in
hindsight Nevertheless managers must evaluate
SITTING ON A CASH PILE
TATA motors acquires JLR cash pile of Rs. 6000 Cr and FY 07 generated free cash
of Rs. 1000 Cr March 2008 $2.3 Billion deal finalized
Cash Rich – top 3 companies
Apple - $137.1 billion
Microsoft - $68.3 billion
Google - $48.1 billion
DON’T RUN OUT OF CASH!
Forecast and plan future cash flow patterns to avoid jeopardizing the firms’ survival
Lack of cash: potential opportunities can’t be seized
Competitive or offensive moves from business rivals
TYPES OF RISK
Systematic Risk: Risk inherent to the entire market or an entire market segment. affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid
Unsystematic risk: Sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk
TYPES OF SYSTEMATIC RISK
Interest rate risk: Arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest
Market risk: Arises due to rise or fall in the trading price of listed shares or securities in the stock market
Purchasing power risk: Also known as inflation risk. It affects purchasing power adversely
TYPES OF UNSYSTEMATIC RISK
Business or liquidity risk: It originates from the sale and purchase of securities affected by business cycles, technological changes
Financial or credit risk: Financial risk is also known as credit risk. It arises due to change in the capital structure of the organization
Operational risk: Risks arising due to human errors. This risk will change from industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems
RISK & PERFORMANCE EVALUATION
How to evaluate and reward managers operating in uncertain environment?
• Measure Performance in relative sense
• Assess Performance on long term value added
HOW THE RETURNS WILL BE ACHIEVEDAbility to identify positive NPV decisions
• Delivering the right value at the right price
• Managed two crucial product inputs - labour cost advantage and the production flexibility by leveraging China
SENSITIVITY ANALYSIS
Partial Equilibrium •Determine implications of changing a variable, holding all other relative values constant
General Equilibrium
•Determine implications of changing a variable, while simultaneously allowing all other relative values to change•Understanding of fundamental relationship among variables
VALUE CREATION POTENTIAL FROM FINANCING DECISIONS
VALUE CREATION POTENTIAL FROM FINANCING DECISIONS
Debt over equityValue transfer among various ownerIts effect on incentive of various players, especially management
CONCERNS OVER DEBT?
It increase the risk to shareholders but increases expected return also
US tax laws are biased towards Debt financing
Interest is a tax deductible expense
Increasing debt means financial difficulty
Introduction of debt in capital structure means cash flow increases for owners
APPLE’S FIRST BOND 2013
Borrowed as part of a plan to return $100 billion to shareholders by the end of 2015
CONCERNS OVER DEBT?
FINANCIAL DISTRESS
Companies become vulnerable to competition
CHRYSLER IN 1980
Potential car buyers avoided Chrysler acquainted with the fact about the large debt pool.
Suppliers balked at giving credit
CONCERNS OVER DEBT?
BANKRUPTCY
LEHMAN BROTHERS 2008
$619 BILLION IN DEBT
Market reluctance to buy its bonds during 2008
VALUE TRANSFER
Size of Pie doesn’t change, but size of slices changes
Value transfer among various shareholder may vary
Variation in company strategy also changes the value transfer
EXAMPLE 1
SITUATION: Stock is overvalued
Issue of stock when stock is overvalued.
Results in a value transfer from new shareholders to old shareholders and management
They will benefit the extent of overvaluation
EXAMPLE 2
SITUATION: Management decision changes the character of cash flow stream in a way unanticipated by capital suppliers
Conservative to Risk company strategy
Supplier of debt will suffer a capital loss
The £2billion backlash: Zuckerberg sued by Facebook shareholders for 'hiding forecasts of future problems'
INCENTIVES
SITUATION 1: FIRM IS NEAR BANKRUPTCYIncentive for management is to invest in Risky projectsShareholders have a worthless claim unless the firm strikes it rich
SITUATION 2: DEBT-RIDDENManagers have strong incentive to perform well after leveraged buyouts
SITUATION 3: NATURE OF CONTRACT BETWEEN MANAGERS AND SUPPLIERSEntrepreneur expresses 51% ownershipGives 100% equity to the capital supplierWill keep the 51% on the basis of actual performanceHave strong faith in own abilities
SUMMARY
Finance is a way of thinking about cash, risk and value
It doesn’t answer the questions, but identifies the right questions
Financial perspective tells whether a decision is feasible or not
Only recurrent danger is it can easily become the excuse for inaction