Ch01-Financial Management and Value Creation Karimova
Transcript of 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
Figures in millions of dollars
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.
Figures in millions of dollars
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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.
Figures in millions of dollars
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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.
Figures in millions of dollars
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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!