AFC14 Arnaboldi01 Intro

8/10/2019 AFC14 Arnaboldi01 Intro

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Accounting Finance and Control (AFC)

Introduction

Michela Arnaboldi

[email protected]


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Assumption and Agenda

Enterprise value and its management is the

backbone of this course. Today an introductory frame is provided:

Scope of the course

What is enterprise value How to manage enterprise value

Why to manage enterprise value

AFC program


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Scope

Disciplinary scope

Accounting = the measurement, processing and

communication of financial information about economic

entities. Accounting measures the results of an organizationseconomic activities and conveys this information to a variety

of users including investors, creditors, management, and

regulators

(corporate) Finance = the sources of funding and the capitalstructure of corporations and the actions that managers take

to increase the value of the firm to the shareholders

Control (in management) = setting standards, measuring

actual performance and taking corrective action(source Wikipedia)

Focus on profit enterprises


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WHAT IS ENTERPRISE VALUE

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Profit Enterprises

Enterprise can be seen as an input-output system

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Which is the goal of a profit enteprise?


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Enteprise goal

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Companies try to maximize their our output with their inputs

To translate this goal, money is taken as reference measure

(homogeneous measure): Investments (I): assets that a company is going to use for more

than 1 year

Cash flows (CF): refer to cash exchanges related to transactions

that have an impact on the short-term Net Cash Flow (NCF) = CF - I

EnterpriseProject &

Activities

Investments (I)

Cash Flows (CF)


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Enteprise goal: infinite lifecycle

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Assuming we focus only on 1 year (Year 0)

Enterprise value (V) = NCF(0) = CF (0) I(0)

Yet, companies are supposed to have an infinite lifecycle

Problem in summing NCFs: the value of money changes

overtime


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Time-value of money:

Compounding and discounting

The future projection of cash flows is generalized with

the compounding formula, where:

rf is the risk-free rate

n is a generic year

FV stands for future value.

PV (0) =FV(n)

(1+rf)n

FV(n) = V(0)*(1+rf)n

To solve the opposite problem, to calculate the present

value of future NCF, we use the discounting formula

PV = Present Value


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Present Value in risk-free condition

The discounting formula allows to sum expected cash

flows over different years.

Using the risk-free rate and considering an infinite

horizon, the present value of different NCFs is:

+ +

[present value in risk-free conditions]


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Two problems

1. Enterprises need to be financed To invest (I)

And then to generate cash (CF)

2. Enterprises operate in risk conditions;investors want to be remunerated for risk

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Enterprise: shareholders

EnterpriseProject &

Activities

Investments (I)

Cash Flows (CF)

ShareholdersEquity Capital

Dividends


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Equity Present Value

For Shareholders (Equity investors), risk is compensated

by a risk premium included in the denominator

The discounting factor becomes (kE) and PV is

addressed as Equity Present Value (E)

NCF is here substituted by the term Free Cash Flow to

Equity (FCFE), to clarify that here we are assuming that

cash flows pertain to shareholders

[Equity present value]


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Enterprise: debtholders

EnterpriseProject &

Acitivities

Investments (I)

Cash Flows (CF)

ShareholdersEquity Capital

Dividends

Debtholders

Debt Capital

Interests


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Enteprise Value

Enterprises are also financed by Debt capital (D)

In this case:

Cash flows pertain to both equity and debt holders and called Free

Cash Flow to Firm (FCFF) Discounting rate is the Weighted Average Cost of Capital (WACC)

WACCt

1

kD = average interest rate

tc

= tax rate

[Enterprise present value]

This complete vision allows formulating Enterprise Value


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HOW MANAGING ENTERPRISE VALUE

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Enterprise Value and Environmental

Complexity

Enterprise value is the reference goal for enterprises

At the conceptual level this is the indicator to maximise,

but:

Increasing pressures for enterprise sustainable corporate

behaviour more performance factors (triple bottom line)

Trade-off between completeness and timeliness Misalignment with managers responsibility

Interconnection between enterprise and global risks Risk

appetite

Higher complexity and uncertainty


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Economic

Enterprise

Value

ShareholdersBanks

Governement

Citizen

Clients

Employees

Rating

agencies

Enlarging theperformancetoolkit


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NetCashFlow

Revenue Cost

OWCEBITDA

Performancedrivers

Time

Quality

Productivity

Flexibility Environment &society

Resourcedrivers

Image

Technology

HumanResource

FixedAssets

Receivable Payable Inventory

EnterpriseValue

Value

based

proxies

TerminalValueCostofcapitalRisk

Value

measures

KeyRiskindicators

Cash

Flows Invested

Capital

AccountingBased indicators

Valued Based indicators

ValueDrivers

Direct

measurement

Value

based

proxies

Indirectmeasurement


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WHY MANAGING ENTERPRISE VALUE

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Why? A multi-stakeholder perspective (1)

Building Enterprise value, we encountered two main

stakeholders, who are also investors:

Shareholders

Debtholders

To manage value, a more complete set of actors must be

considered:

External, including individuals and entities who have direct orindirect interests:

Shareholder

debt holders

financial analysts

other societal actors more broadly.

Internal, which refers to managers operating at different levels of

the enterprise.

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Enterprise

Organizational units

FinancialAnalysts

Shareholders

Other

Stakeholders

Bondholders

Managers

Internal

accountability

External

Accountability&

Corportate

Governance

Banks

Why?Amultistakeholderperspective(2)

Adapted from Damodaran, 2011


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Shareholders

Shareholders are the main investors in risk capital forenterprises and aim to increase the company equityvalue

Yet, traditional corporate finance takes stock price

maximization as reference objective, because: Stock prices are observable and are updated constantly to reflect

new information coming out about the firm

Assuming that investors are rational and markets efficient, stock

prices will reflect the effect in the long run of enterprise decisions. Shareholder (and other external actors) can test impact on stock

price of investments decision (evidence)

E 0

Is stock price maximization aligned with Enterprise Value creation?


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Debtholders (1)

The debtholders of a company could be divided into:banks (or financial institutions) and bondholders

Financial institutions support company, granting loans,

which vary in terms of: amount granted,

maturity

interest rate

the type of the amortization schedule other features e.g. prepayments

The main characteristic of a loan is its seniority, whichdetermines the priority of its reimbursement in case of

bankruptcy Debtholder has to objective to ensure its loan with the

highest seniority, in order to be more confident of itsrepayment


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Debtholders (2)

A bond is a security which requires the issuer to payspecified interests (coupons) and make principalpayments to the holders (bondholders) at maturity or

even on specified dates. Bondholders do not increase their cash if projects

succeed, but have costs if they fail

Tend to view the risk in investments much more negatively than

shareholders

Difference in scale: Small-scale creditors are more interested in the features of the

corporate bond such as the amount and the frequency of the

coupon and its maturity rather than in the company running Large-scale creditors are more similar to financial institutions


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Financial Analysts

A financial analyst is a professional who is responsible

for investigating companies that belong to the same

industry, the same country, or the same market (Equityresearch)

They provide report to be released on the stock

exchange

The central information of the report is the stock target

price and a rating (e.g., buy, neutral/hold, or sell)

The first report about a company is called Initial

Coverage, the following reports are is called a CompanyUpdate

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http://www.borsaitaliana.it/borsa/azioni/documenti/societa-quotate/studi-e-ricerche.html

http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/tools-and-services/company-

profile/company-profile.html


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Source: borsa Italiana


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Other Stakeholders

Further to Equity and Debt holders there are other

more indirect stakeholders:

Customers

suppliers

Local community

State Local Authorities

International organizations

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Stakeholders and External Accountability

There are two central instruments that companies uses to

account externally:

Disclosure Financial Statements - mandatory

Other report (e.g. sustainability reports); these are not mandatory

but they should be:

Complete with reference to international or nationalstandards;

Stable across time; changes in reporting initiatives have to

be justified.

Transparent and understandable for readers.

Corporate Governance Code is a regulatory framework

regarding how companies are governed.

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External Accountability - Eni

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Internal Accountability

Internal accountability refers to the use of indicators to

guide management.

We introduce the concept of Performance MeasurementSystem (PMS), which is a system intended to guide the

decisions and behavior of managers by providing

performance and risk indicators.

PMS has two main intertwined functions:

Decision making

Motivation

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Note: in practice different labels are used to refer to the indicator system: management control

system, performance management system, management accounting systems.


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Internal accountabili ty: decision making

The set of decisions that PMS supports is large: Operational

Management

Strategic

The decision making cycle can be divided in four

phases: Definition of goals and actions Measurement of results

Analysis, formalisation and communication of actual results

Identifying corrective actions


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1. Supporting decisions: Planning

This first phase aims at defining a plan of action,

considering: Objectives

Resources

Risks

PMSs provide information which are based on models and

assumptions: Price (Historical, Predicted)

Product costs (Material, Labour, Other costs)

Defining the plan needs itself a model:

Customer profitability: Operating Margin (Price costs)

Operating margin + insolvency probability

During the planning phase we set a target

1 S ti d i i


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1. Supporting decisions:

Measurement of Results

After (or during) actions we want to know the results

Measurement would be useless if:

Variables was known exactly since the planning phase Our models were perfect

Actual results differs from predicted data: External variables (e.g sales, material prices)

Internal variables (e.g. productivity)

MCSs provide information on:

Results

Update on risks

1 Supporting decisions:


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1. Supporting decisions:

Variance Analysis and feed-back actions

When results differ from forecasts we need to analyse

Variances:

Variances in external variables

Variances in internal variables

The quality of the models is essential

The final step after the analysis of variances are

corrective actions, where it is important to highlight:

Level of influence External/internal


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Individual

results

Enterprise

Objectives

Ability

Knowledge

Skills

Effort

Reward

ActionTheories

Organizationalrole

andcontext

Performance

Choice Theories

2.InternalAccountability:Motivation

2 Motivation


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2. Motivation

Increasing Efforts and Equity theory

Equity theory helps in translating the relation betweenindividual results and the social interactions

According to this theory individuals provide input (effort,experience,) in relation to the output benefits.

The situation is balanced when the ratio - output/input - issimilar among individuals doing similar activities

A perception of difference leads individuals to modify theratio

Output/Input = k

Underestimation

Reduce efforts

Overestimation

Increase expectations

K i>K i

Documents

AFC14 Arnaboldi01 Intro