Module1 - Creating Value for Shareholders(1)

8/6/2019 Module1 - Creating Value for Shareholders(1)

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The Basic Principle of Financial

Management Executives would like to learn and improve

their knowledge of Finance as it is an

essential and exciting area in anyorganization

It is the responsibility ofeveryperson in a

managerial position in any organization tomanage a firms resources intelligently and

well formaximizing shareholder valuemaximizing shareholder value


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The Importance of Financial

Knowledge The performance of business activities is evaluated in

terms of money. Money is the language of business

Financially intelligent managers contribute to a businesss

health because they can make better decisions They can use their knowledge to help their company

succeed

They manage resources more prudently; use financialinformation more astutely, and thereby increase theircompanys profitability and cash flow

By doing the above, they create more value for themore value for theshareholdersshareholders


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The Key to a Healthy Business

When employees understand a companys

objectives and work to attain them, it is easier to

create an organization built on a sense of trust anda feeling of community

An organization that is successful over the long

haul will almost invariably be built around trust,

communication, and a shared sense of purpose Financial training an increase in financial

intelligence can make abig difference in this

regard


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Overview of

Corporate Finance Every business decision is a corporate

finance decision.

Three key issues

What determines a firms value?

How can managers add to a firms value?

How can managers ensure that they have

sufficient resources to execute value

enhancement plans?


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Corporate Finance RoadmapCorporate Finance Roadmap

Investment DecisionsProject returns greater than hurdle rate

Maximize Value of the FirmMaximize Value of the Firm

Hurdle RateFunction of

project risk andfinancing

employed

Financing DecisionsFinancing that maximizes value of projects

Financing TypeMatchingprinciples

ReturnsMeasured as time-

weighted, incrementalcash flows

Financing MixDebt ratio dictates

hurdle rate

Dividend DecisionsIf not enough investments,return cash to owners as

dividends or stock buybacks.


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Factors Affecting Firm

Value Maximization

AmountAmount and timingtiming of cash flows expected

by shareholders

RiskinessRiskiness of the cash flows

Amount, timing and riskiness of cash flows are

a function of managerial decision-making and

environmental factors.


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Think: Will Your Decision

Create Value?

The owners of a firm (the shareholders) want thevalue of the firm to be enhanced

Hence, before deciding to go ahead with anybusiness proposal, the manager should askhimself/herself the Key Question:

Will the proposal raise the firms market value?

This Key Question also applies to current operations


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Creating Shareholder Value According to researchers from McKinsey and

Company, companies dedicated to value creationare more robust and build more economies, higherliving standards, and more opportunities forindividuals

Their research has also indicated that American andEuropean companies that created the mostshareholder value in the past 15 years have alsoshown stronger employment growth

McKinsey researchers found that companies that

earned the highest shareholder returns also investedthe most in R&D

In addition, their research indicated that manycorporate social responsibility initiatives help createshareholder value


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The Fundamental Finance

PrincipleA business proposalsuch as a newinvestment, the acquisition of anothercompany, or a restructuring plan willraise the firms value only if thepresent value of the future stream of

net cash benefits the proposal isexpected to generate exceeds the initialcash outlay required to carry out theproposal


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Measuring Value Creation With

Net Present Value Value creation in the case of existing operations Value creation in the case of new projects

In this context, a concept known as Net Present Value or

NPV is very importantNPV = Present value of future cash benefits - Initial

cash outlay

Market value of firm should rise by an amount

approximately equal to projects NPV on the day the

project is announced

A business proposal that is undertaken creates value if

Its net present value is positive

Value is destroyed if its net present value is negative


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The Capital Budgeting Decision

Capital budgeting decision typically affects the

firms business performance for a long period of

timeExample: Ford Motor Companys Edsel

project


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The Capital Budgeting Decision

Decision criteria used in capital budgeting are

direct applications of the fundamental finance

principle


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The Capital Structure Decision

Capital structure refers to the financing mix

of debt and equity used by the firm The financing choice depends on many

factors, the most important of which is thenature of the business that the firm is innature of the business that the firm is in

Example: Pharmaceutical, IT, and Utilitycompanies


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The Capital Structure Decision

Importance of Capital Structure

As the firm uses more and more debt, it facesthe risk that it may be unable to service its

debt

This is called the risk ofrisk of financial distressfinancial distress Thus, debt financing involves a tradeoff

between tax benefits and financial distress

risk


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The Business Acquisition Decision

Acquisition of a business is just anotherinvestment decision

This will only create value if presentvalue of future net cash flows expectedfrom target firm exceeds the price paid toacquire the firm

Horizontal, vertical, and conglomeratemergers

Synergies

Record


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The Role of Financial Markets Role of financial markets in value creation

Primary markets

Provide financing for funding growth by helping in

the transmission of funds

Secondary markets

Provide efficient means for trading outstanding

securities

Role of investment (merchant) bankers


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ABC LimitedFigures in millions of dollars

STANDARD BALANCE SHEET

ASSETS LIABILITIES AND OWNERS EQUITY

DECEMBER 312009

DECEMBER 312010

DECEMBER 312009

DECEM8ER 312010

Cash $100 $110 Short-term borrowing $200 $220

Accounts receivable 150 165 Accounts payable 100 110

Inventories 250 275 Long-term debt 300 330

Net fixed assets 600 660 Owners equity 500 550

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


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The Income Statement or P&L

account

This shows the results of operations over a

period of time

Also based on the accrual system of

accounting

Net income is not a true measure of the

profitability of a company


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Measures of Profitability Managers adopt measures of profitability

depending on their areas of responsibility

A sales manager would look at return on sales

(ROS)

The manager of an operating unit would choose

return on assets (ROA) A chief executive would pay attention primarily

to return on equity (ROE)


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ReturnO

n Equity Return on equity (ROE) is the most

comprehensive indicator of profitability

Considers the operating and investing decisionsas well as the financing and tax-relateddecisions

ROE measures the firms profitability from

the perspective of the owners whose rewardis the firms net profit

ROE = Earnings after tax z Owners equity


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The Impact OfOperating

DecisionsO

n ReturnO

n Equity Operating decisions, broadly defined, involve the

acquisition and disposal of fixed assets and themanagement of the firms operating assets (such

as inventories and trade receivables) and operatingliabilities (such as trade payables)

ROS (net profitper dollar of sales) and ROA (net profitper dollar of total assets) are not appropriate measuresof the profitability generated by the firms operating

activities because they are calculated with net profit(earnings after tax)

Net profit is obtained after deducting interest expenses the outcome of afinancingdecision - from the firmspretax operating profit


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The Impact ofOperating

Decisions on Return on Equity

ROS and ROA are thus affected by

financing decisions and do not reflect only

operating decisions

Hence, ROS and ROA are not appropriate

measures of the profitability generated bythe firms operating activities


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Return on Invested Capital (ROIC)

A relevant measure of operating profitability isreturn on invested capital or ROIC

ROIC = EBIT z Invested Capital

Invested capital = net assetsHence, ROIC = RONA

Furthermore, since total invested capital is equal to

total net assets, equal to total capital employed,

ROIC = RONA = ROCE


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The Drivers ofOperating

Profitability

A higher operating profit margin is achieved by

Increasing sales through higher prices and/or higher

volume at a higher rate than operating expenses

and/or Reducing operating expenses at a higher rate than

sales

A higher capital turnover is achieved through a

better use of the firms assets required tosupport the firms sales activities, for example,

through a faster inventory turn, a shorter

collection period for the firms receivables, or

fewer fixed assets per dollar of sales


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Profitability

If the key to higher operating profitability is

a combination of higher operating profit

margin and faster capital turnover, what arethe underlying factors that would allow a

firm to achieve this?


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Profitability

High market share, superior product

quality, and high capital turnover boost

operating profitability, while highinvestments and high fixed costs depress

it


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Market Share

Size and control of a larger share of the

served market will generally allow a firm to

enjoy relatively higher profit margins via

lower cost per unit of output and stable

output prices

Such firms can spread their fixed costs over

a larger volume, purchase inputs in bulk at adiscount, and prevent market forces from

putting excessive downward pressure on

their product prices


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Perceived Product Quality

Businesses whose products and services areperceived to be of superior quality are generallymore profitable than businesses whose products

and services are perceived to be of inferior quality Higher profitability is achieved via relatively

higher margins because businesses with superiorproducts and services are able to avoid price

competition. This allows them to protect theirmargins from being squeezed by competitivedownward pricing

Examples?


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Capital Turnover

Capital turnover has a significant influence on the

profitability of a business

The empirical evidence indicates that businesseswith low capital turnover (businesses that require

intensive investment in assets to produce sales) do

not generate, on average, a high enough margin

from their operating activities to compensate themfor their lower capital turnover


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Capital Turnover Why are businesses with low capital

turnover usually unable to generate higher

profit margins?


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Capital Turnover

Investment-intensive businesses with low capitalturnover usually have relatively high fixed costsand are usually prone to price and marketing warsthat weaken their margin

When economic conditions become unfavorable,

there is a tendency for these businesses to cutprices to maintain high rates of capacity utilization

In addition, because these businesses haverelatively high amounts of capital tied up in theiroperations, they cannot easily exit the business

(they have high exit barriers) They usually try to ride the unfavorable market

conditions in the hope of better future days

The airline industry is a good example of such

behavior


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Taxation and ROE

The third determinant of a firms ROE is its

effective tax rate


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Taxation and ROE

EBT 1 - effectivetax rateEATTaxeffect ratio= EBT EBT

1 effectivetax rate

!

!


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The Structure Of A Firms

Profitability ROE is the product of five ratios

Operating profit margin

Capital turnover

Financial cost ratio

Financial structure ratio

Tax effect ratio

EBT I st c it l

E

EBIT l s EATE

l s I st c it BIT w rs' equity EBTlv vvv

ture the im ct ofthe

firmsi esti g and

operating decisions

Reflect the impact of thefinancial policy on the

firms overall profitability.Their product is calledthe financial leverage

multiplier


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How Much Cash Does A Firm

Generate?

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

Cash flow is a critical measure of a companys financial health

A firms EBIT or EAT does not represent cash

flow Net Cash Flow = EAT + Depreciation &Amortization


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The Cash Flow Statement

Summarizes a firms cash transactions

It breaks them down into three main

corporate activitiesOperations

Investments

Financing


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Cash From or Used in Financing

Activities Financingrefers to borrowing and paying back

loans

If a company receives a loan, the proceeds show up inthis category

It also includes transactions between a companyand its shareholders

If a company pays off the principal on a loan, buys

back its own stock, or pays a dividend to itsshareholders, such expenditure of cash would appear inthis category


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ABCs Statement of Cash Flows

Figures in millions of dollars

CASH FLOW FROM OPERATING ACTIVITIES

Sales $1,000

Less operating expenses(which include depreciation expenses) (760)

Less tax expenses (100)

Plus depreciation expenses 60

Less cash used to finance the growth of WCR (30)

A. NET OPERATING CAS

H FLOW $170CASH FLOW FROM INVESTING ACTIVITIES

Capital expenditures (120)

B. NET CASH FLOW FROM INVESTING ACTIVITIES (120)


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ABCs Statement of Cash Flows

Figures in millions of dollars

CASH FLOWS FROM FINANCING ACTIVITIES

New borrowing 50

Interest payments (40)

Dividend payments (50)

C. NET CASH FLOW FROM FINANCING ACTIVITIES (40)

D. TOTAL NET CASH FLOW (A + B + C) 10

E. CASH HELD AT THE BEGINNING OF THE YEAR $100

F. CASH HELD AT THE END OF THE YEAR (E + D) $110


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What is Free Cash Flow (FCF)?

FCF is the amount of cash available from

operations for distribution to all investors

(including stockholders and debt holders)after making the necessary investments to

support operations.


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Importance of Free Cash Flow

(FCF) A companys value ultimately dependsA companys value ultimately depends

upon the amount of FCF it can generateupon the amount of FCF it can generate

It is a key indicator of a companys

financial health, along with profitability and

shareholders equity

Its a final link in the triad, and you need allthree to assess a companys financial health


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How to Calculate Free Cash Flow?

Get the companys cash flow statement

Subtract the amount invested in capital equipment

The balance is free cash flow Free cash flow is simply the cash generated by

operating the business minus the money investedto keep it running

Remember: Free cash flow is simply the cashgenerated by operating the business minus themoney invested to keep it running


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Free Cash Flow (FCF)

FCF = NOPAT - Net investment in

operating capital

FCF is the amount of cash flow available for

distribution to investors after paying

expenses and taxes and making the

necessary investments in working capital


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Risk and Value Creation

While we have discussed various ways of

creating value for shareholders, we must

recognize the fact that there are certainextraneous factors that could impinge on

value creation

Hence, it is essential to discuss the variousfacets of risk faced by a firm


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Business Risk

Uncertainty of income flows caused by the

nature of a firms business

Sales volatility and operating leverage determinethe level of business risk

What are some examples of industries where

firms face a high level of business risk?


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Financial Risk

Uncertainty caused by the use of debt financing

Borrowing requires fixed payments which must

be paid ahead of payments to stockholders The use of debt, or financial leverage places the

firms business risk more on its stockholders

Thus, the use of debt increases uncertainty ofstockholder income


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Risk

If a firm has a high level of fixed operatingcosts, its operating income (EBIT) will be verysensitive to fluctuations in sales

Hence, it would beprudent for such a firm not totake on a lot of debt as this would add financial

risk to the firms existing business risk andincrease the overall risk exposure of the firm

The owners of a levered firm face bothbusinessriskand financial riskwhereas the owners of anunlevered firm face only business risk

The levered firm is riskier than the unlevered oneand its risk increases with rising levels ofborrowing


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Liquidity Risk

Uncertainty is introduced by the secondary

market for an investment.

How long will it take to convert an investmentinto cash?

How certain is the price that will be received?


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Exchange Rate Risk

Uncertainty of return is introduced by

acquiring securities denominated in a

currency different from that of the investor.

Changes in exchange rates affect the

investors return when converting an

investment back into the home currency.


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Is Value Created?

Acceptance of positive NPV projects will

result in positive MVA

Concept of MVA

Concept of EVA


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Is Value Created?

MVA = Total Market Value Total Capital

MVA = (Market Value of Stock + Market

Value of Debt) Total Capital

The total market value of a company is the

sum of the market values of common

equity, debt, and preferred stock

The total amount of investor-supplied

capital is the sum of equity, debt, and

preferred stock


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Is Value Created?

A firms EVA is equal to the after-tax operatingprofit (sometimes referred to as net operatingprofit after taxes orNOPAT) generated by thefirms net assets less the dollar cost of the capitalemployed to finance these assets

EVA = NOPAT- (WACC) (Capital)

Where WACC is weighted average cost of capital

An alternative way of expressing EVA suggeststhat EVA will be positive (negative) if the firmsreturn on invested capital is higher (lower) thanthe cost of that capital measured by its WACC


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Is Value Created?

EVA = (Operating Capital) (ROIC-WACC)

As this equation shows, a firm adds value-that is, has a positive EVA if its ROIC is

greater than its WACC

If WACC exceeds ROIC, then newinvestments in operating capital will reduce

the firms value Thus, EVA represents the residual income

that remains after the cost ofallcapital,including equity capital, has been deducted


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REVIEW

In this discussion, we addressed

Importance of value creation

Three fundamental corporate finance decisions The business acquisition decision

The foreign investment decision

Key financial statements An integrated approach to profitability analysis

Facets of risk

Concepts of MVA and EVA


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Documents

Module1 - Creating Value for Shareholders(1)