Ch01-Financial Management and Value Creation Karimova

7/27/2019 Ch01-Financial Management and Value Creation Karimova

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Chapter 1FINANCIAL MANAGEMENT AND VALUE CREATION: AN

OVERVIEW


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Definition

The performance of actions that increase theworth of goods, services or even a business.Many business operators now focus on valuecreation both in the context of creating bettervalue for customers purchasing its products and

services, as well as for shareholders in thebusiness who want to see their stake appreciatein value.


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The Key Question: Will Your DecisionCreate Value?

A project is financed by either Shareholdersprovide equity capital Debtholdersprovide debt capital

Firms owners want to increase the firms value Thus, a projects expected return must exceed its financing cost

Before deciding to go ahead with a business proposal, themanager should ask himself/herself the Key Question:

Will the proposal raise the firms market value?


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The Importance Of Managing ForValue Creation

Great companies have -satisfied shareholders, but loyalcustomers, motivated employees and reliable suppliers

Main objective of management should be the creation ofvalue for the firms owners

More value for shareholders does not mean less value foremployees, customers or suppliers

Results of a survey show that the firms perceived to be highly valuedwith respect to management, employees and customers were valuecreators

While the lowest rated firms were value destroyers


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The Saturn Story

Story of the Saturn In mid 1980s GM set up a company to build the Saturn

Workers were highly motivated

Customers were extremely satisfied However, the Saturn project has not created value

GM invested more than $6 billion to develop, manufacture and launchSaturn. Amount was so large that in order to earn return it would have tooperate existing facilities at full capacity forever, earn more than doublestandard profit margins and keep 40% of the dealers sticker price as netcash flow.


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The Fundamental Finance Principle

Key Question Will the decision create value for the firms owners? Can be answered with the help of the fundamental finance

principle:

A business proposalsuch as a new investment, the acquisition ofanother company, or a restructuring plan

Will raise the firms value only if the present value of the future stream ofnet cash benefits the proposal is expected to generate exceeds the initialcash outlay required to carry out the proposal


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Measuring Value Creation With NetPresent Value

Net Present Value concept or NPV NPV = - Initial cash outlay + present value of future net cash

benefits

Market value of firm should rise by Amount equal to projects NPV on the day the project is announced

A business proposal creates value if Its net present value is positive

Value is destroyed if its net present value is negative


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Only Cash Matters

The fundamental finance principle Requires that the investment as well as its future benefits be

measured in cash

Investors have invested cash in the firm and are only interested incash returns

Net profit represents an accounting measure, not a cash one


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EXHIBIT 1.1:Only Cash Matters to Investors.

Exhibit 1.1 is an illustration of why investors are

only interested in cash returns.


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Discount Rates

To estimate the net present value of a proposal Must first discount its future cash-flow stream and then deduct

from that present value the initial cash outlay

A proposals appropriate discount rate is the cost of financing theproposal


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A Proposals Cost Of Capital

When a project is funded with both equity and debt Cost of capital is not just the cost of equity

It is the weighted average cost of capital (WACC) Both shareholders and debtholders require a return from their

contribution

Debt is measured on an aftertax basis due to deductibility of interestexpense


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EXHIBIT 1.2:The Cost of Financing a Business Proposal Is Its

Weighted Average Cost of Capital.


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Applying The Fundamental FinancePrinciple

Financial Management addresses the application of thefundamental finance principle for

Capital budgeting

Capital structure

Business acquisition

Foreign investment decisions


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The Capital Budgeting Decision

Capital budgeting decision typically affects the firms businessperformance for a long period of time

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

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 Structure Decision

The firms optimal capital structure is One that provides the greatest increase in the present

value of the cash flows from assets

As the firm replaces equity with debt Financial distress risk ensues

Risk firm may be unable to service its debt

Thus, debt financing involves a tradeoff between taxbenefits and financial distress risk


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EXHIBIT 1.3:

The Optimal Capital Structure Is the One that Provides the

Greatest Increase in the Cash Flows from Assets.


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The Business Acquisition Decision

Acquisition of a business is just another investmentdecision Will only create value if present value of future net cash

flows expected from target firm exceed price paid toacquire the firm

Pure conglomerate merger

Business to be acquired is unrelated to firms current business Synergies

Expected to raise sales or reduce costs beyond the sum of the twofirms pre-acquisition sales or costs


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The Foreign Investment Decision

Additional risks Currency risk

Unanticipated changes in value of currency

Political risk

Unexpected events Instead of adjusting the cost of capital for the added risks

Projects future cash flows are modified


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The Role Of Financial Markets

Role of financial markets in value creation

Primary markets Provide financing for funding growth

Act as intermediaries between individuals and companies that have a cashsurplus they wish to invest

Secondary markets

Provide efficient means for trading outstanding securities Role of investment (merchant) bankers

Act as a benchmark against which they can set the price of newlyissued securities


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EXHIBIT 1.4:The Dual Functions of Financial Markets.


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The Equity Market

Efficient equity market Share prices adjust instantly to new, relevant information

Evidence indicates that on average most well-developed stock markets canbe described as reasonably efficient equity markets


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What Is Bad For General Motors Is Good ForVolkswagen ... And Vice Versa

Mr. Lopez was in charge of worldwide purchasing for GeneralMotors

Managed to cut $1 billion off GMs annual costs Valuable employee!

In 1993 Volkswagen tried to hire him from GM However GM offered him a raise and promotion so he stayed

Rumors on Wall Street spread stating that he was leaving GM forVolkswagen

GMs price dropped 4.4% VWs price increased 1.8%

The continuing story shows more evidence of market reaction to newsreleases


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The Business Cycle

Relationship between profit-retention and business

growth form the concept of a "business cycle" which linksa firm's:

Debt-to-equity ratio

Sales-to-asset ratio (also known as asset turns, asset rotation,asset turnover)

Net profit margin (net profit-to-sales ratio)

Retention rate


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EXHIBIT 1.6:HLCs Business Cycle.

2012


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The Business Cycle

The self-sustainable growth rate (SGR) is defined as Fastest growth rate in sales that a company can achieve by

retaining a certain percent of its profit and keeping both itsoperating and financing policies unchanged

Important indicator of business performance


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EXHIBIT 1.6:A Simplified View of the Financial Accounting

Process.


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The Balance Sheet

Balance sheet shows What a firms shareholders own (assets) What they owe (liabilities)

At a specific date

Exhibit 1.7 shows a simplified balance sheet forHologram Lighting Company (HLC)


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FROM HLCs STANDARD BALANCE SHEETS:ASSETS LIABILITIES AND OWNERS EQUITY

DECEMBER 31

2011 DECEMBER 31

2012 DECEMBER 31

2011 DECEMBER 31

2012

Cash $100 $110 Short-term borrowing $200 $220Accounts receivable 150 165 Accounts payable 100 110Inventories 250 275 Long-term debt 300 330Net fixed assets 600 660 Owners equity 500 550

TOTAL $1,100 $1,210 TOTAL $1,100 $1,210

EXHIBIT 1.7:HLCs Balance Sheets

Figures in millions of dollars


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A Variant Of The Standard Balance Sheet:

The Managerial Balance Sheet

Managerial balance sheet presents information more in line

with the traditional organization of a business Accounts receivable, accounts payable and inventories are managedtogether

Net investment required to operate firms fixed assets Accounts receivable and inventories must be financed

Financed in part through trade payables Thus, the net investment in operations is trade receivables + inventories

trade payables (AKA: working capital requirement)

Exhibit 1.8 presents HLCs managerial balance sheet


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INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYEDDECEMBER 31

2011 DECEMBER 312012 DECEMBER 312011 DECEMBER 312012

Cash $100 $110 Short-term debt $200 $220Long-term debt

Working capital

requirement (WCR)1 300 330 300 330Net fixed assets 600 660 Owners equity 500 550

TOTAL $1,000 $1,100 TOTAL $1,000 $1,1001Working capital requirement (WCR) = Accounts receivable + Inventories - Accounts payable

EXHIBIT 1.8:HLCs Managerial Balance Sheets


The upper part of Exhibit 1.8 illustrates the managerial balance sheet approach, wherethe left-hand side (invested capital or net assets) reflects capital invested in cash,operations (WCR), and fixed assets, while the right-hand side (capital employed)

represents the sources of capital used to fund the firms net assets.

This approach provides a clearer picture of the firms investments and capital than astandard balance sheet


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The Income Statement

Purpose

Provide an estimate of the change in the book value of equityover a period of time Net profit vs. net loss

Difference between revenues and expenses

EBIT can be thought of in terms of its three categories ofclaimants Debtholders (first claimants) Tax authorities (second claimants) Shareholders (residual claimants)


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Sales $1,000Less operating expenses ($760)(including depreciation expenses)

Earnings before interest and tax (EBIT) $240Less interest expenses (40)

Earnings before tax (EBT) $200Less tax expenses (100)

Earnings after tax (EAT) $100Retained earnings = $50Dividend payment = $50

EXHIBIT 1.9:HLCs 2012 Income Statement.



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How Profitable Is A Firm?

Information from a firms balance sheet and incomestatement can be combined

To analyze the firms financial performance in terms of theprofitability of its equity and of its invested capital


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The Profitability Of Equity Capital

A firms profitability to its shareholders is measured bythe owners return on investment

Known as return on equity (ROE)

Earnings aftertax (EAT)ROE =

Owners' Equity


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The Profitability Of Invested Capital

To measure the profitability of HLCs total capital(provided by both shareholders and debt-holders)

Must use the firms aftertax operating profit The resulting ratio is the firms return on invested capital (ROIC)

Which is the same as return on net assets (RONA) or return on capitalemployed (ROCE)

Aftertax operating profitROIC =

Invested capital


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How Much Cash Does A FirmGenerate?

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 afirms activities on a continuous basis

A firms EBIT or EAT does not represent cash Need to know how much cash is behind EBIT and EAT Start by examining balance sheet


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Sources And Uses Of Cash

Sources of cash Operationscustomers pay invoices Investingfirm sells assets Financingfirm borrows or issues new shares

Uses of cash

Operationspay its suppliers Investingcapital expenditures Financinginterest and dividend payments


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The Cash Flow Statement

Summarizes a firms cash transactions Breaks them down into three main corporate activities

Operations

Investments Financing


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CASH FLOW FROM OPERATING ACTIVITIESSales $1,000Less operating expenses(which include depreciation expenses) (760)Less tax expenses (100)Plus depreciation expenses 60Less cash used to finance the growth of WCR (30)

A. NET OPERATING CASH FLOW$170

CASH FLOW FROM INVESTING ACTIVITIES

Capital expenditures (120)B. NET CASH FLOW FROM INVESTING ACTIVITIES (120)

EXHIBIT 1.10a:HLCs 2012 Cash Flow Statement.



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CASH FLOWS FROM FINANCING ACTIVITIESNew borrowing 50Interest payments (40)Dividend payments (50)

C. NET CASH FLOW FROM FINANCING ACTIVITIES (40)D. TOTAL NET CASH FLOW (A + B + C) 10E. CASH HELD AT THE BEGINNING OF THE YEAR $100F. CASH HELD AT THE END OF THE YEAR (E + D) $110

EXHIBIT 1.10b:HLCs 2012 Cash Flow Statement.



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How Risky Is A Firm?

Firms sales may fluctuate

Because of the uncertain economic, political, social, and competitive environments inwhich it operates

Creates economic risk, which is magnified by fixed operating expenses that produceoperational risk

Together these two risks compose business risk 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 uncertaintysurrounding sales translates into operating profits that are more risky than sales

Because of fixed interest expenses, risk increases further, and as a result, net profitsare even more risky than operating profits

EXHIBIT 1 11:


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EXHIBIT 1.11:HLC Income Statement: Impact on EBIT, EBT, and

EAT of a 10% Drop or Rise in Sales.Figures in millions of dollars

Exhibit 1.11 provides a numerical illustration of the rise in the

level of risk from sales to the bottom line.

EXPECTED1 SALES DOWN 10% SALES UP 10%

1 The expected income statement is the same as the one shown in Exhibit 1.8.2 One half of total operating expenses of $760 in Exhibit 1.8.3 One half of total operating expenses of $760 in Exhibit 1.8. Note that the $60 of depreciationexpenses are fixed and, hence, included in the $380 of fixed operating expenses.

Sales $1,000 $900 10% $1,100 +10%

Less variable operating expenses2

(380) (342) 10% (418) +10%

Less fixed operating expenses3

(380) (380) same (380) same

EBIT (earnings before interest & tax) $240 $178 26% $302 +26%

Less fixed interest expenses (40) (40) same (40) same

EBT (earnings before tax) $200 $138 31% $262 +31%

Less variable tax expenses (50%) (100) (69) 31% (131) +31%

EAT (earnings after tax) $100 $69 31% $131 +31%


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EXHIBIT 1.12:Sources of Risk that Increase Profit Volatility.

Exhibit 1.12 summarizes different types of risksand the numbers pertinent to the HLC example.


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Is Value Created?

According to the fundamental finance principle

A firm is creating value if the NPV of all its investments (calledmarket value added or MVA) is positive A firms MVA is positive if the market expects the firm to generate

positive economic value added, or EVA, in the future

A firms EVA is equal to the aftertax operating profit(sometimes referred to as net operating profit after taxes orNOPAT) generated by the firms net assets

Less the dollar cost of the capital employed to finance these assets 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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Thank You for attention!

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Ch01-Financial Management and Value Creation Karimova