TMP X130F Final Study Guide

Income Statement

A financial summary of a company's operating results for a specified period of time (month, quarter, year) -Also commonly referred to as the Profit & Loss Statement, P&L, or Earnings Statement -Usually prepared monthly for management purposes -Filed with SEC quarterly/annually for public companies -Cash or accrual method of accounting •Cash (tax method) •GAAP (accrual - Matching Principle)

Vertical Analysis

- Use a single variable on a financial statement as a constant (usually Sales or total Assets) - Determine how all of the other variables relate as a percentage of the single variable - Most common for Income Statement analysis • i.e. R&D expense as a % of sales or - Can also used for Balance Sheet analysis • i.e. Accounts receivable as % of Sales or total Assets

Bonds as an Investment & Ratings

Bonds are not necessarily safe but default is not very common. Real vs. nominal returns Rating agencies rate bonds for risk. ◦ S&P, Moody's, Fitch Analysts use techniques discussed in earlier chapters, such as debt ratios and coverage ratios.

Covenants

Contractual terms to protect bondholders by impacting management decisions Examples: ◦ Lower limit on current ratio ◦ Upper limit on Debt /Equity ratio ◦ Required approval by bondholders before major acquisition or sale of assets Bondholders have no direct say in a company unless it defaults on its interest, sinking fund, or covenant obligations.

Current Asset Management

Cash Management - goal: safety of principal and liquidity while obtaining a reasonable return - in that order! Marketable Securities Management - placing excess cash in short term investment vehicles such as U.S. Treasury bills, government and corporate bonds, and stocks - most companies do not invest in stocks! Accounts Receivable Management - increasing sales by offering credit to customers Inventory Management - minimizing total inventory costs while maximizing customer satisfaction Note: Current assets are items the company usually converts into cash within 1 year

Cash Management

Cash management is the process of collecting and managing cash, as well as using it for short-term investing. It is a key component of a company's financial stability and solvency • Cash consists of: - Petty Cash and Cash on hand - Cash in bank, checking - Cash in bank, savings • Utilizing the Float: - Disbursement float - time between payment by check and the check actually clearing the bank - Collections float - time between depositing a check and the check actually clearing the bank

Operating Cash Flow - Liquidity

Cashflow from Operations is a significant measure of liquidity! Why? ➢ Liquidating assets may disrupt operations ➢ Cash flow is the superior / ideal method for generating recurrent liquidity

Financial Transaction

exchange of money or money-like instrument for another money or money-like instrument

Financing Summary Checklist

When making financing choices, keep the following in mind: 1. The ability of the company to use additional interest tax shields over the life of the debt 2. The increased probability of bankruptcy stemming from added leverage 3. The cost to the firm if bankruptcy occurs

Ratio Analysis Precautions

Deviations are symptoms - additional analysis is usually required • Ratios should be analyzed in conjunction with other data; a single ratio may be inconclusive or misleading - compare to similar firms • Financial statements being compared for analysis purposes should: - Cover the same period of time to avoid the impact of seasonality - Be developed in a consistent manner to ensure apples to apples comparison

Analyzing Activity (Conversion)

Measuring the speed with which various assets are converted into cash • Inventory turnover/Average age of inventory (DIN) • Average collection period (DSO) • Average payment period (DPO) • Asset turnover - Fixed Assets - Total Assets

Perpetuity

• An annuity that runs forever... • To find the present value of a perpetuity, divide the interest (discount) rate into 1, and multiply times the annual amount of the perpetuity

Horizontal Analysis

A determination of the % increase or decrease in an account from a base time period to successive time periods.

Bond Characteristics

Par value ($1,000 is typical in the U.S.) Coupon rate and frequency of payment - usually every 6 months Maturity date Sinking fund for periodic repayment of principal ◦ Direct payment to creditors via repurchase or retirement at par value Variable rate vs. fixed rate bonds

Simple Interest: Example

With simple interest, you don't earn interest on interest

Investment Banking

"Bake off" to assess proposals from investment bankers and choose one Winning investment bank becomes the "managing underwriter" and begins to: ◦ advise the company on security design ◦ register the issue with the SEC (30-90 days) ◦ orchestrate a "road show" ◦ assemble an underwriting syndicate who engage in book building

Steps to Creating Pro Formas

1. Examine historical data to observe patterns. 2. Forecast sales. 3. Forecast items that grow in proportion to sales. 4. Forecast other financial statement items 5. Estimate external funding required 6. Evaluate how to cover the shortfall (or use the surplus)

Capital Investment Process: Payback

1. Payback deals with the number of years that it will take a business to get back the money that it has invested in a project or asset

Company Life Cycle

1. Startup (usually with losses) 2. Rapid growth (with infusions of outside financing) and in need to lots of cash 3. Maturity (generating cash) 4. Decline (marginally profitable, with cash to search for new products, investments)

NPV

Although the inexpensive option has higher IRR and BCR, it is NPV that is the criterion that is relevant. NPV measures total value creation, not value creation per dollar invested and is the best measure to select from mutually exclusive projects. BCR and IRR are insensitive to the scale of the investment.

Too Much Growth

Growing companies often want to maximize growth. But companies must plan for the financial consequences of high growth. Without planning, companies can "grow broke". *The goal is not to have actual growth equal sustainable growth, but to understand and manage the consequences of any disparity between the two.

Future Value of a Lump Sum

▪ The future value of a lump sum amount for n periods and at i rate of return

Current Ratio - Liquidity

- Measures company's ability to meet its short-term obligations • Yields a measure of balance sheet liquidity independent of company size • Current Ratio can be compared to similar companies in the industry to judge adequacy • General Rule: Current Ratio should be 2 or higher

Risk and Return

- lenders or other investors will consider all risk factors (systematic and unsystematic) to determine whether they will lend or invest funds in a company, and at what cost More risk = More expected return (reward) key word is "expected" - does not always work out - as we are finding out now •How much more reward? -Market-determined based on tolerance for risk

Capitalization Table

-A record of all the shareholders of a company, along with their pro-rata ownership percentage at a point of time -Important during equity fundraising to show ownership of the company incorporating the new investors -Display on a fully diluted basis (assumes all options, warrants, convertible securities or instruments are exercised), assumes highest share count possible -Should include: •Shareholder name (or "New Investor") •Type of security •Number of shares •Percentage of ownership (fully diluted)

Financial Statements

-Balance Sheet -Income Statement -Cash Flow Statement -Statement of Shareholders' Equity -These add clarity and supplemental information: -Footnotes - add clarity to financial statements and supplemental material -Capitalization Table - important for start ups - shows ownership and shares, options and convertible securities outstanding

Vertical Analysis - Income Statement

-Reflects how much of a company's revenue is being consumed by each spending line item - Use 100% of Sales as the constant - Functional expense as % of Sales - We might also look at certain Balance Sheet items as a % of sales (i.e. Accounts Receivable as % of sales)

Quick (acid test) Ratio

-Similar to Current Ratio, but excludes Inventory and Prepaid Expenses - why? -Considers only the most liquid current assets • A purer and more cautious measure of Balance Sheet liquidity • A Quick Ratio of 1+ is usually considered adequate

Types of financials plans used in business

-Strategic plan - long term plan for business •Usually 3 - 5 year planning horizon but could be longer -Operating/Functional plan - supports Strategic Plan and by functional areas such as Operations, Accounting, Marketing, Human Resources, IT -Financial plan - monetary requirements to support the Operating/Functional Plans of the Company (also known as the Budget)

Ability to Borrow - Liquidity

-The ability to borrow is also an important source of liquidity! • Measure: - Unused credit lines from suppliers & banks - Positive relations with creditors - Track record - Strength of management team

Opportunity Costs

-The highest value that is surrendered when a decision to invest funds is made -No matter what we do, there are always trade-offs -Scarcity (e.g., limited resources) is the reason -Opportunity cost is a quantifiable term

Present Value of a Future Lump Sum

-The present value of a future lump sum amount for n periods at an i rate of return

Why does finance matter?

-Understand the underlying financial flows of your business -Data and analysis to make appropriate decisions and benchmark against others -Answer questions and meet reporting requirements from investors and lenders -Build a roadmap to execute your strategy and monitor performance

Sunk Cost

-a previous outlay that cannot be changed by any current or future decision. These costs should be ignored in an investment decision -Example: past expenditures on an R&D project should not matter on the go-forward decision. It should be based on whether the anticipated benefits exceed the remaining costs to complete

Risk

-involves the probability that the actual return on an investment will be different from the desired return -Systematic risk is associated with economic, political, and sociological changes that affect all participants on an equal basis - investors really can't diversify away as all stocks are affected •Example - fear of global pandemic decrease demand for travel, sporting events and concerts are factors of systematic risk because the effects are global. Business cycles, interest rates -Unsystematic risk is unique to individual, firm, or industry - investors can buy diversified stocks to reduce this risk •Based on management capabilities, competition within the industry, vendor reliability, and other microeconomic variables •Example - experience of management team can reduce the unsystematic risk if proven to generate profits consistently

Financial Ratios

1. Liquidity Ratios - Measure the company's ability to satisfy its short-term obligations 2. Activity (Conversion) Ratios - Measure the efficiency with which the company converts various assets into sales or cash 3. Debt/Leverage Ratios - Measure the degree of a company's indebtedness (% of the assets financed by creditors) - Measures the company's ability to service the debt 4. Profitability Ratios - Measure the company's profits in relation to sales, assets, or owner's investment (equity) - Used by potential investors/creditors to determine how much of an investment may be returned from earnings on revenues or appreciation of assets 5. Market Ratios - Used to compare companies within the same industry - Used by potential investors to determine if they should invest capital in a company

Capital Investment Process

1. Proposal Generation ◦ Includes the details of the project 2. Review & Analysis ◦ Assessment of economic viability & strategic fit 3. Decision Making / Approval ◦ Based on dollar limits / authorization levels in the organization 4. Implementation ◦ Might be in phases for larger projects 5. Follow-up ◦ Results monitored, actual vs expected results, accountability! There are three main methods that are used to evaluate a capital budgeting proposal: 1. Payback 2. Net present value (NPV) - also the Benefit / Cost Ratio (BCR) 3. Internal rate of return (IRR)

Debt: Benefits

1. The company will have increased interest tax shields, if it is profitable. 2. A share repurchase announcement will be generally warmly greeted by the market, and the firm's stock price will go up. 3. The higher debt will inject additional discipline in respect to management incentives.

Capital Investment Process: NPV Method

2. Net Present Value method of capital budgeting uses the time value of money by discounting future benefits and costs back to the present. ◦ Considers all of the future cash flows over the asset's entire economic life ◦ Applies the present-value-of-a-stream-of-payments technique for even cash flows and the present-value-of-a-future-lump-sum technique for unequal yearly cash flows ◦ Interest rate = company's cost of capital because the company must pay this cost on an annual basis to obtain the financial capital necessary to make the investment - Making the decision using NPV ◦ If NPV is positive using the WACC, the investment should be made ◦ If NPV is negative using the WACC, the investment should not be made - NPV has two primary advantages ◦ Future cash flows that will be paid and received can be discounted back to the present so that a decision on the investment can be made now ◦ Interest rates are determined by, and based on, the weighted average cost of capital that takes risk into consideration

Capital Investment Process: IRR

3. Internal Rate of Return in the actual rate of return on the investment ◦ Uses the time value of money in its calculation ◦ IRR is the interest rate that matches the present value of the cost of our investment directly against the present value of the future benefits received ◦ IRR is the interest rate that occurs when the NPV is zero. If the NPV is zero, then by definition, the present value of the costs must equal the present value of the benefits.

Sustainable Growth Rate

A company's sustainable growth rate is the maximum rate at which it can grow without depleting financial resources. The sustainable growth rate is based on the assumption that management will not sell new equity and will maintain a constant debt ratio. What limits the rate at which this company can increase sales or, more generally, its overall expansion? The limit to growth is the rate at which equity expands. New equity→New debt→More assets→More sales Therefore, g* is the ratio of the change in equity to equity at the beginning of the period.

Operating Profit Margin

A measure of operating efficiency - Tells us how much operating profit was added per dollar of sales - Ignores non-operating costs • Interest & taxes • Thus, it is independent of firm's financing structure • The higher the better Operating Income = EBIT

Net Profit Margin

A measure of overall performance - Tells us the percentage of each dollar of revenue that remain after deducting all costs • Operating and Non-Operating costs • Capitalization structure and taxes matter here! • The higher the better • Can be distorted by taxes

Seasoned Issues

A multinational firm wants to raise $200 million in new debt, using a U.S. "shelf registration." Shelf registration is a general purpose registration, good up to two years, that allows the firm to get quick approval for the use of public markets. A single underwriter often buys the entire issue. Competitive bids lower the issue costs.

Efficient Markets

A recurring issue in raising new capital is timing. Managers devote considerable time and energy into predicting future price trends in financial markets. Should managers abandon prediction and timing because markets fully reflect all available information correctly into prices? Issue is how competitive prices respond to new information How long does it take for news to impact prices? -Recent research indicates that price adjustment can occur within fractions of seconds.

Common Stock

A residual income security Shareholders are represented through a board of directors, through which they exercise control. The degree of control is variable, in terms of the fraction of share ownership required to control the board. ◦ Some companies such as Facebook, Google and Lyft have a unique structure where the founders still have significant control even where they own less than 50% of the stock

Swaps: Hedging

A swap is an agreement to pay one series of payments in return for another series of payments. Interest rate swap ◦ Trade fixed-rate payments for floating-rate payments -One party pays a fixed rate on a set amount of "notional" principal -One party pays a floating rate, often LIBOR. -Notional principal is never exchanged. -Most popular of all derivatives -Companies often get bank loans that are "floating rate" but desire fixed rate debt to better manage costs as they prefer the certainty of fixed rates Currency swap ◦ Trade liabilities denominated in different currencies -One party pays a fixed rate on a set amount of principal in one currency. -One party pays a fixed rate in another currency. Principal is exchanged at the beginning and the end. -Example of a Currency Swap. One of the most commonly used currency swaps is when companies in two different countries exchange loan amounts. They both receive the loan they want, in the currency they want, but on better terms than they could get by trying to get a loan in a foreign country on their own.

Accounts Payable Management

Accounts Payable are the debts of a business which are owed to vendors • Vendors may offer several types of discounts: - Trade discounts - amounts deducted from list prices of items when specific services are performed by the trade customer - Cash discounts - offered to credit customers to entice them to pay promptly - Quantity discounts - offered by vendors to customers who purchase items in large quantities

Common Size Financial Statements and Trend Analysis

Add insight in analyzing a company - Helps in recognizing trends over time - Can compare to other companies without scale effects What do common-size figures tell you compared to typical ratios? - For example, collection period vs. AR/Assets - For example, inventory turnover vs. Inventory/Assets What do you learn about working capital - Fraction of assets that are short-term What do you learn about COGS? - Small changes in percentages can be large relative to net income

Capital Investment (Cap-Ex)

An outlay of funds that usually provides cash returns over a period greater than 1 year Examples / motivations of Capital Investments: ◦ Expansion of operations ◦ Replacement of plant or equipment ◦ Renewal of plant or equipment ◦ Investments in Marketing or R & D projects

What To Do When Sustainable Growth Exceeds Actual Growth

Ask if the situation is temporary. -If yes, build up cash. -If no, ask if the phenomenon is industry-wide, or within the firm. -If within the firm, then a few options are available. Option 1: Ignore the Problem -Accumulated cash and slow growth attracts corporate raiders. -Why? -What do raiders believe? -Is a corporate raid bad news for shareholders? Option 2: Return Money To Shareholders -Increase dividends -Repurchase shares -Temptation is to invest in assets that reduce corporate value but increase management's empire ◦ This can quickly destroy shareholder value Option 3: Buy Growth -Buy other businesses, especially ones that need cash because they are growing rapidly. -Many M&A deals do not work out and fail - but the good ones can make a huge difference.

Impact of Taxes

Because interest is tax deductible, the return that a company's assets must generate is based on the aftertax cost of debt, (1−t) times the interest rate K_D. The amount of money a firm must earn on existing capital annually is:

Cost of Capital Formula

Because the ratio is a weighted average, the term WACC is often used for cost of capital, where WA stands for weighted-average. The after-tax cost of capital is simply the previous expression divided by total capital:

Higgins: Management Incentives

Being human, managers look out for #1 (themselves) before shareholders. Their actions increase private value for themselves at the expense of shareholder value. Aggressive debt financing can put the heat on managers, reducing the extent of this value transfer possible without risking financial distress for the firm. Low Growth Firms: -Slow growth companies have an easier time with financing decisions. -They have excess operating cash flows. -Financial flexibility is not an issue. -Market signaling is not an issue. -They can use the company's healthy operating cash flow as a magnet to borrow, and then repurchase shares.

Beta

Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns. Beta is a key component for the capital asset pricing model (CAPM), which is used to calculate the cost of equity. Recall that the cost of capital represents the discount rate used to arrive at the present value of a company's future cash flows. All things being equal, the higher a company's beta is, the higher its cost of capital discount rate. The higher the discount rate, the lower the present value placed on the company's future cash flows. In short, beta can impact a company's share valuation. A beta coefficient is a measure of the volatility, or systematic risk, of an individual stock in comparison to the unsystematic risk of the entire market. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset using beta and expected market returns. In statistical terms, beta represents the slope of the line through a regression of data points from an individual stock's returns against those of the market. Since 1928, the risk premium has been about 6.2% as shown on the earlier slides Some risky assets are riskier than others. To customize expected return computation, we use beta. The risk premium is equal to the product of a beta and the historical excess return on common stocks. For the average stock beta = 1. A higher beta implies more risk and volatility

Stocks: Investment Performance

Between 1928 and 2016, dividend yields on large common stocks were 3.7%, and capital appreciation was 7.5%. Recent decade ➔ 2.1% and 6.4% In general, stocks are a hedge against inflation. ◦ 1973 to 1981 was an exception to the rule, when stocks returned 5.2% and inflation was 9.2%. ◦ I like to see companies that generate lots of cash and raise their dividends over time - bonds never increase their payout but many stocks increase their dividends

Bonds

Bonds are fixed-income securities. Bonds promise interest income and repayment of principal at maturity. Bonds are sold to the public in small increments, such as $1,000, and can be traded on an exchange after issue. Relative Size The U.S. bond market is twice as large as the equity market - $40 trillion vs $20 trillion ◦ But the largest issuer is the US Gov't In recent years, over 60% of business financing has come from retained earnings and cash flow from depreciation. 44% of external financing has come from corporate bonds. 10% of external financing has come from loans from banks and other financial firms. ◦ In 2016, small manufacturing firms relied on bank loans for 36% of their financing, vs. 8% for larger firms.

Capital Budget

Budgeted spending for capital investments ◦ A component of the operating / financial plan The impact of Capital Spending is reflected in the financial statements ◦ Cash outflows for capital assets are reflected in "investing activities" in the Statement of Cash Flows ◦ The value of assets purchased is reflected in the fixed assets section of the balance sheet ◦ Depreciation expense is reflected in the Income Statement and the balance sheet (accumulated depreciation)

Estimating Investment Risk

Can estimate risk in a particular investment opportunity using: ◦ Scientific or historical evidence (such as with oil and gas development) ◦ Extrapolation based on past variability and performance (such as opening a new restaurant in a chain) ◦ Subjective assessment based on knowledge of the industry

Capital Budgeting

Capital Budgeting is a method a company uses to justify the acquisition of capital goods ◦ Capital goods or a Capital investment are those items that have a useful life in excess of 1 year ◦ These long-term assets may be used by the business to generate increased cash flow by improving the efficiency or the effectiveness of the business ◦ Capital investments should only be made when the benefits to the company exceed the costs of acquiring and maintaining the assets over their useful life

Capital Plan

Capital Expenditure ("Capex") vs Operating Expense - An outlay of funds that usually provides cash returns over a period greater than 1 year - Land & buildings, machinery, equipment, factory, etc... - Technology investments - Assets that provide long-term benefit / productivity • Impacts Balance Sheet and Income Statement How? - Asset purchase is recorded on the Balance Sheet - Depreciation expense is recorded on the Income Statement over the useful life of the asset - Accumulated Depreciation is reflected on Balance Sheet

Capital Budgeting: Putting it all together

Capital budgeting is the primary technique used to evaluate long term projects To do this you need to be able to forecast the revenues costs and after-tax cash flows to arrive at the base case for financial analysis ◦ You will need to know the tax rate, deprecation, incremental working capital needs You will need to apply discounted cash flow analysis You need to be able to calculate the weighted average cost of capital from the data given and the financial statements

Futures: Different Types

Commodity Futures ◦ Wheat, corn, milk, cattle, gold, oil, etc. Currency Futures ◦ Exchange one currency for another at a predetermined exchange rate at a future date - Very common to use in multinational companies Interest Rate Futures ◦ Lock in a futures interest rate by buying or selling an interest-bearing instrument (e.g. a Treasury bond)

Sustainable Growth & Pro Forma Forecasts

Comparing actual growth and sustainable growth reveals a lot about management's financial concerns. ◦ When g>g*, focus is on getting cash for expansion ◦ When g<g*, focus is on productively spending cash Managers generally try to balance strategy, growth, and financial policy to make the disparity between g and g* manageable. However, to really understand growth management challenges, pro formas should be prepared.

Higgins: Flexibility

Credit squeezes happen. A firm might not be able to borrow to stay competitive, when it needs it most to fund an important investment opportunity. For this reason, firm managers must think about being financially flexible. Cash is king, so finance while it's possible, using equity if it's available and not too expensive. Remember that financial flexibility might argue for equity financing. Lenders are wary about lending to companies whose Debt /Equity ratio is already high, because the probability of default for these firms is higher. Keeping Debt /Equity on the low side serves as a buffer to help the firm raise new debt more easily if necessary.

Internet-Driven Finance

Crowdfunding ◦ Rewards-based crowdfunding ◦ Equity crowdfunding (aka regulation crowdfunding) ◦ "Investments" via crowdfunding are NOT investments - they are gifts to the company - you get ZERO equity but some benefits like first to buy the product ◦ New regulations do allow for some equity to be sold via crowdfunding Peer-to-peer (P2P) lending

Current Liabilities Management

Current Liabilities Management consists of maximizing the use of 'other people's money': - Short-Term Debt Management - lines of credit, short term loans, current portion of long-term debt - Accrued Liabilities Management - obligations of the company accumulated during the normal course of business such as payroll taxes, benefits, property taxes, and sales taxes - Accounts Payable Management - debts of a business owed to vendors

Securities: Types

Debt instruments offer fixed claims. Equity offers residual claims. Derivatives are a third security type. ◦ Claims to derivatives depend on the value of underlying assets. ◦ Options are an example of a derivative. Hybrids, such as convertible debt, combine both debt and equity.

Derivatives to Manage Risk

Derivative: A financial instrument whose value is derived from some other asset. Very useful for risk management when used properly ◦ Can lead to large losses if used improperly Includes forwards, futures, swaps, options, etc. 1. Derivative markets are huge, over $600 trillion in 2016. → Total value of all world equity markets ≈ $70 trillion 2. Most large companies use them (90%+ of the world's 500 largest companies). - To hedge currencies, interest rates, commodity prices, etc. to offset known risks - Can be used for speculation but rare for a company to do that 3. Misuse of derivatives can be disastrous.

DCF

Discounted cash flow analysis is the backbone of modern finance. DCF is used to evaluate cash flow streams whose costs and/or benefits extend beyond the current year. Why DCF techniques are important ◦ Many corporate activities involve costs and benefits extending over time. ◦ Adjustments for the time value of money are critical. ◦ Allow for a measurement of shareholder value creation

Inflation and Financing Strategy

During inflationary times, debts get repaid with cheaper dollars. Investors who expect inflation ask for higher interest rates to compensate them for the inflation they expect. Only if inflation is unexpected is it true that debtors gain at the expense of debt-holders. The deflation story is the reverse.

Economic Value Added

Economic value added is the difference between after-tax EBIT and the required return on capital. If economic value added is positive in a given year, the firm has earned more than the amount required to compensate debtholders and shareholders. Where Kw is the weighted average cost of capital and C is the total capital employed

Analyzing Debt (Leverage)

Financial Leverage: Measures the degree of a firm's indebtedness and the firm's ability to service the debt • Debt ratio • Times interest earned ratio

Financial Markets

Financial markets describe the distribution system by which cash-deficit entities engage in transactions with cash-surplus entities. Besides businesses, the entities in question include government agencies, universities, pension funds, endowments, individuals, commercial banks, insurance companies, etc. Money markets vs. capital markets distinguishes short-term vs. long-term contracts.

Cost of Equity

For preferred stock which pays a fixed dividend, and has a market price, use the same technique as with bonds except the dividend on preferred stocks is NOT deductible. For common stock, the issue is more difficult, because the company makes no promise about the future cash payouts to shareholders.

Hedging with Options

Forward contracts are obligations to accept delivery, if long, or to deliver, if short, at a pre-specified price. Options are rights, but not obligations, to either take delivery or to deliver, at a pre-specified (exercise) price. Call options confer the right to buy. Put options confer the right to sell.

Goodwill

Goodwill is the difference between acquisition price and the fair value of the asset acquired Example: ◦ Cash and stock paid to acquire XX company $10,000,000 ◦ Fair value of assets acquired $ 8,000,000 ◦ Goodwill $ 2,000,000 Goodwill is not amortized - rather it is reviewed at least annually for "impairment"

Risk-Adjusted Discount Rates

How do you incorporate the degree of risk into the evaluation of an investment opportunity? -Use a risk-adjusted discount rate. -A higher discount rate reduces NPV. -The alternative is to compare IRR to a risk-adjusted benchmark, where the amount the benchmark is raised to reflect the degree of risk.

Average A/R Collection Period

How long sales are sitting in accounts receivables before they are collected • Provides a measure of how effective the credit function and accounts receivable practices are being managed • Typically the lower the better • A.K.A. as DSO (Days of Sales Outstanding)

Average Age of Inventory

How many days it takes to turn inventory (how long inventory sits on the balance sheet before being sold) • Typically the lower the better • A.K.A DIN (Days in Inventory)

Preferred Stock

Hybrid security, mixing features of both debt and equity Promises annual fixed dividend = coupon rate × par value Dividend discretionary Dividend is not tax deductible, in contrast to interest payments

Convertible Bonds

Hybrid security, mixing features of both debt and equity Promises annual fixed rate of interest = coupon rate × par value Interest is always lower than a "normal" bond of similar quality Bonds convert to equity at some point in the future if the price of the stock appreciates - usually around 30% above the current price and usually 3-7 years out. Otherwise they are paid off in cash Bond holders are subordinate to other lenders and the bonds usually do not have any substantive covenants

Initial Public Offerings (IPO)

IPO can provide additional equity along with an exit route for venture investors. ◦ IPOs priced recently ◦ Pinterest - raised $1.4 billion for a valuation of around $13b ◦ Zoom - raised $337 million for a valuation of $9 billion - Zoom "zoomed up" dramatically - Zoom is profitable while UBER, Lyft and Pinterest are not IPO priced recently - Lyft ◦ Raised $2.6 billion ◦ Potentially priced too high - stock now trading well below offer price ◦ IPO in the pipeline: - WeWork - pulled for various reasons including poor governance - their business model is in trouble ◦ The "window" was open in 2019 but is closed hard now!

What to Do When Actual Growth Exceeds Sustainable Growth

If growth is temporarily too fast, just borrow and wait for it to slow down. If not, then there are a number of possible actions to take. Option 1: Sell New Equity Get cash Increase borrowing capacity Difficult to do and costly ◦ Requires a fair amount of lead time ◦ "Window" for new equity needs to be "open" ◦ If a public company - requires SEC approval and sometimes shareholder approval Option 2: Increase Leverage (i.e. take on more debt) -Raises cash -Lenders take time to evaluate the performance -Most all lenders will require collateral and financial covenants -More debt increases the risk of bankruptcy Option 3: Reduce Payout Ratio -Saves cash that can be used to build up equity -Can disappoint shareholders who respond by selling their stock, thereby driving down stock price ◦ GE had to do this last year and the stock price dropped substantially Option 4: Profitable Pruning -Raises ROE, and therefore earnings, and therefore retained earnings -Retained earnings are part of equity. -Prune by un-diversifying unrelated product lines with no synergy. ◦ Who benefits from corporate diversification, shareholders or managers? -Un-diversifying generates cash from the sale of assets and enables management to focus on the core business. Option 5: Outsourcing -Can increase asset turnover and therefore, ROA ◦ Common practice in many industries ◦ Apple outsources virtually all of its manufacturing ◦ Frees up capital but you lose some control and may add costs Option 6: Raising Prices -Increases ROE, if %-demand doesn't fall by more than the %-price increase ◦ Not always practical ◦ Market will determine the price ◦ Best to do by adding "value-added" features ◦ Apple is great at doing this ◦ Customer will pay more for these and it gives you pricing power Option 7: Merger -Find a cash cow (white knight, if threatened) with deep pockets -Often mergers are done as companies are in related fields and there are many synergies to be achieved by merging (G&A, Sales, R&D, etc.) ◦ Sawtek and TriQuint Semiconductor ◦ Cascade Microtech and FormFactor ◦ ESI and MKSI Instruments

Varying Risk

If the risk associated with the new investments differs from the existing assets, additional considerations enter. Consider the market line displayed in the next slide. Higher risk implies a higher risk-adjusted discount rate.

Shareholder Control

If there is no dominant shareholder group, management might control the board. Checks against this: ◦ Product market competition ◦ Need for external financing ◦ Market for corporate control ◦ Activist shareholders on the prowl In Europe, banks take equity positions and exercise direct control, more so than in the U.S. Japanese keiretsu and South Korean chaebol have similar effects.

Profit/Loss Plan

Important to understand Fixed vs. Variable expenses and budget accordingly - Variable expenses increase with volume - Fixed expenses are independent of volume - Cost of sales, although mostly variable and directly tied to sales, usually has some fixed components - Operating costs are usually a mix of fixed (rent, salaries) and variable (commissions, supplies, marketing) - Best method for realistic pro forma income statement is to segment company's expenses into fixed and variable and budget expenses accordingly - Understand your cost structure and use judgment!!

Rule 144a

In the past, privately placed debt was not especially liquid. SEC Rule 144a now allows for trading of privately placed debt among institutional investors. Result is two parallel markets for corporate securities, one public and the other among institutional investors ◦ - also is used for sale of common stock - both Facebook and UBER used this extensively pre-IPO

Higgins: Distress Costs

Increased debt leads to higher expected costs associated with financial distress. Bankruptcy costs → debt can turn a mild inconvenience into a major problem involving: ◦ major legal expenses, and/or ◦ the sale of company assets at fire sale prices

Leverage and Debt Financing

Increased debt lowers the initial investment required by shareholders. Increased debt amplifies the expected return. Increased debt amplifies the risk faced by shareholders. That's what financial leverage is all about. Operating leverage, featuring high fixed costs, but low variable costs, works the same way.

Fixed Asset Turnover

Indicates how efficiently fixed assets are being used to generate revenue for the company • Typically the higher the better

Total Asset Turnover

Indicates how efficiently the company uses its total assets to generate revenue for the company • Typically the higher the better

Debt to Equity Ratio

Indicates what percentage of the owner's equity is debt • Typically the lower the better

Indirect Costs

Indirect costs come in many forms: ◦ Lost profit opportunities from cutbacks to R&D ◦ Lost sales as customers bail, fearing difficulties down the line ◦ Suppliers bail out for fear that the firm won't pay its bills ◦ Competitors become more aggressive

Intangible Assets

Intangible on the balance sheet Generally come about in M&A transactions Valuations are based on values paid and from appraisals provided by third parties - e.g. intellectual property, trademarks, patents, licenses, etc. Amounts are "amortized" over expected useful life similar to depreciation of fixed asset

Taxation - Interest vs. Dividends

Interest is tax deductible for the corporation Dividends are not tax deductible Interest income to an individual is taxed at ordinary income rates - as high as 37% Federal + State Dividends (qualified dividends) are taxed to an individual at capital income rates - currently max of 20% + State tax and Medicare surcharge - net result is qualified dividends are taxed more favorably to the individual than interest income

Higgins: Tax Benefits

Interest is tax deductible. Lowering the tax bill leaves more left over for all investors, meaning the pool of shareholders and debt-holders.

Inventory Management

Inventory Management consists of minimizing total inventory costs while maximizing customer satisfaction - Goal is to have enough inventory on hand to satisfy customer demand, but keep inventory at a minimum value to free up cash • Two primary decisions must be made: - Establish the reorder quantity (the number of items to order) - Establish the reorder point (that level of inventory at which a new order will be placed) • Various methods are used to balance ordering costs against storage costs and use of "JIT"

Junk Bonds

Investment grade is "BBB" and above. Junk bonds, aka speculative or high-yield bonds, are below investment grade. Junk bond market is an alternative to bank and insurance company loans for smaller, less prominent companies. Junk bonds have been used to finance mergers and acquisitions. Also known as "high-yield" bonds

Depreciation

Is it OK to subtract depreciation from operating profit to compute profit after tax? Is physical depreciation captured by salvage value being less than the initial investment? Does including both depreciation and salvage value amount to double counting? Tax: -Depreciation is relevant for computing tax and thus is a component of a cash flow analysis. -After-tax cash flow = Operating income − Taxes -Deduct depreciation to compute tax and then add it back to find relevant cash flow ATCF (investment's after-tax cash flow). Working Capital & Spontaneous Sources: -The with-without principle indicates that changes in working capital that are the result of an investment decision are relevant to the decision. -Working capital needs typically fluctuate with sales. -Working capital investments typically have large recovery values, with associated inflows approximately as large as the outflows Sunk Costs: -The with-without principle implies that sunk costs are not part of project cash flows. -They might need to be recorded, but elsewhere. -Psychologically difficult to ignore sunk costs. -In some circumstances, it will have been unwise to adopt a project, but once undertaken, it is appropriate to continue the project. Allocated Costs: -Bearing the fair share of overhead? -With-without principle says to ignore allocated overhead because it's fixed. -The problem is that, over time, overhead might not be fixed but may indeed vary with the size of the business. Excess Capacity: -Is the use of excess capacity free? -If the excess capacity has no alternative use, then that is the case. -If using the excess capacity prevents the generation of cash flows from an alternative, then the with-without principle indicates that the foregone cash flows should be part of the analysis to reflect the opportunity cost. -Often important to link to future decisions. Financing Costs: -Financing costs refer to any dividend, interest, or principal payments associated with financing an investment. -The standard procedure is to reflect the cost of money in the discount rate and ignore financing costs in the cash flow projections.

Forecasting Models

Judgmental models - are qualitative, and essentially use estimates based on expert opinion (surveys of customers, market research, etc.). Time Series models - are quantitative and use historical records that to predict future sales. Assumes the past is predictive of the future. Causal models - use cause and effect, and are externally based because they take into account variables in the general economy that affect the revenues of the company. All models attempt to predict the future.

Private Placement

Large corporations can avoid registering with the SEC by placing debt privately with one or more institutional investors. The private placement market might be half the size of the public market, excluding bank loans. Attractive option if public investors not especially receptive for reasons of complexity or familiarity

International Markets

Large corporations use foreign financial markets because they want the contract to be in a foreign currency; they can get better terms than in the U.S. Foreign markets often impose fees and restrictions on foreign investors. International markets allow the currency specified in the transaction to be outside the control of issuing country's monetary authority.

Liquidity - Analysis

Liquidity = the company's ability to meet short term obligations as they become due • Current ratio • Quick (acid test) ratio • Operating cash flow • Ability to borrow

Long-Term Financial Plan

Long-Term Financial Plan = aka the "Strategic" Financial Plan - Usually a component of an integrated strategic plan - Planned financial activities over the next 2 to 5 years - Typically less detailed, at a higher level (pro-forma F/S) The longer the time horizon, the higher the uncertainty

Market Ratio: Earnings Per Share (available to common shareholders)

Measures Net Income or Profit per share • Of great interest to current & prospective shareholders • The higher the better

Return on Assets (ROA) (a.k.a. Return on Investment or Asset Turnover)

Measures managements effectiveness in selecting profitable investments • How does the return on investment (ROA) compare to the firms cost of capital? - If it's not higher... we've made a bad investment • Useful to outsiders to determine if the firm is a good investment relative to other alternatives • The higher the better

Gross Profit Margin (a.k.a. Gross Margin)

Measures the % of each sales dollar remaining after the company has paid for the goods / services it sells • The higher the better Often used as a measure of MFG efficiency - Many variables to consider • Pricing • Sales volume vs. fixed costs • Sales product mix • Manufacturing (MFG) Cost

Financial Leverage - Assets to Equity

Measures the amount of equity used to finance the assets of the company - How effective is management in leveraging the owners' investment? - Tells investors what each dollar of his / her investment is used to acquire assets • The higher the better to increase ROE - But too much leverage in never good

Debt (to Assets) Ratio

Measures the proportion of total assets financed by the company's creditors • The higher the ratio, the greater amount of other people's money being used to generate profits • ... and the more financial leverage... • Typically the lower the better

Return on Invested Capital

Measures the return earned on all capital invested regardless of the type - eliminates the distortion of leverage present in ROE and ROA - Tells investors the earnings power irrespective of financing strategy • The higher the better

Ballparking

Most executives have a rough sense of how stocks have performed relative to bonds over time. They know that stocks have outperformed government bonds by about 6.2 percentage points over time, which allows for a rough calculation of what discount rate to use for a project with average risk.

Statistical Models

Moving average model - actual sales are best predictor of future sales Mean Absolute deviation - measures forecast error Exponential smoothing - uses a smoothing constant to adjust the forecast Linear regression - least squares based on the assumption that you have a dependent and independent variable

Share Repurchases

Much of the trend over time can be attributed to the increasing popularity of share repurchases. - Repurchases can help manage EPS. ◦ Reduces share count ◦ Offsets dilution from equity awards to employees - Repurchases are viewed as more flexible than dividend payments. ◦ Forever reduces share count ◦ Once dividends are started it's hard to stop and expectation is to increase payout over time

Performance Assessments - Cash Flow & Net Income

Net income includes estimates, allocations, and approximations. Cash flow from operations is actual cash. Low or negative cash flow does not necessarily imply poor performance - but is a key indicator. Cash flow statements can record items such as AR and employee stock options differently from net income.

Net Present Value (NPV)

Net present value is the present value of the future expected cash flows minus the initial investment. NPV measures the amount of value creation. Decision Rule: Accept projects with NPV>0, reject projects with NPV<0.

IPO Risks

Offer price set hours before stock goes public ◦ Deal is not done until it's done Company bears price risk during the registration process ◦ Also costs are high and some are fixed even if the deal does not go through - legal, accounting, printing, etc. Syndicate bears risk associated with unsold shares, which they cannot sell above the offer price ◦ In reality the deal does not happen if all of the shares are not fully committed at pricing

Why Don't US Companies Issue More Equity

Other sources generated sufficient cash Equity is expensive to issue ◦ Perhaps 5% to 10% of amount raised ◦ Higher percentage for smaller companies Fear of diluting EPS in the short run Concern that their stock is undervalued in the market Window is closed - was that way for an extended period 2008 - 2012. It is closed now!

PRAT

P = profit margin = Net Income / Sales - the higher the better R = retention rate = the percentage of earnings that are retained. For example if you earn $1000 but pay out a dividend of 40% your retention rate is 60% A = Asset turnover = Sales / Assets - the higher the better T = "Total leverage" = Assets to Equity ratio = total assets / total equity, also known as financial leverage. For this equation this is measured at the beg of the period PAT are the "levers of performance" P*A*T = ROE

Cumulative Preferred

Preferred shareholders have higher priority than common shareholders. Common shareholders receive no dividend until preferred shareholders are paid in full, including past arrears. Control features of preferred stock vary from required approval to no voice at all unless dividend payments are in arrears.

Value and Investment Horizon

Private equity partnerships induce managers to work for them, creating value over the long run without having to manage to short-run fluctuations. The horizon is normally longer than a VC fund, but not so long, thus managers are under pressure to create a cash exit event for private equity investors.

Venture Capitalists

Professional venture capital companies, who make high risk investments in entrepreneurial businesses capable of rapid growth and high investment returns ◦ Investors in VC funds are wealthy individuals and institutions like State Pension Funds Big stakes, active role in management, investment horizon of 5-6 years (5-10x) View many proposals and are highly selective

Average Payment Period

Refers to how long a vendor invoice sits before being paid • Typically the higher the better • A.K.A DPO (Days of Purchases Outstanding) • Challenges: - Not easily calculated - Must determine a number for purchases, which is not separately reported on the F/S - Most people use COGS as a proxy for purchases

Accounts Receivable Turnover

Refers to how many times per year the accounts receivable balance is fully collected • Typically the higher the better

Inventory Turnover

Refers to how many times per year the inventory balance is fully sold off • Typically the higher the better

Adjusted Earnings - Non-GAAP reporting

Reported by over 70% of companies in the S&P 500 Common adjustments ◦ Restructuring charges ◦ Litigation expenses ◦ Acquisitions GAAP - generally accepted accounting principles SEC regulates use of non-GAAP earnings ◦ Must include reasons for non-GAAP and a reconciliation Some companies reports its financial results on both a GAAP (required by law) and non-GAAP (allowed with reconciliations - subject to SEC guidance) ◦ Non-GAAP measures assist investors to better understand the impact of one-time events and certain non-cash charges ◦ Examples included non-cash stock compensation, large restructuring costs, major changes in tax laws, acquisition related costs, settlement of a large law-suit.

WACC: Steps to Calculate

Review balance sheet and determine current long-term capital structure Obtain current market values or debt and equity and the risk-free rate debt Obtain the current market cost of debt and tax rate for the company Obtain the number of shares outstanding to compute market value of equity Calculate the proportion of debt and equity Obtain Beta for the company and the market risk premium for common stocks Calculate cost of debt and cost of equity using the equations Cost of debt: 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 𝐾_𝐷 Cost of equity: K_E = cost of risk free debt + (company beta X market risk premium for common stocks) Apply the cost of debt to the % of debt capital and add to that the cost of equity to the % of equity capital and the result is the WACC

Call Provisions

Right to retire bonds prior to maturity Call price is typically a modest premium above par Delayed call prevents retirement before some date Call provisions help companies: ◦ take advantage of declines in interest rates and ◦ rearrange capital structure Investors require a premium for call provisions.

Rights in Liquidation

Rights of absolute priority ◦ Government in respect to taxes past due ◦ Senior creditors ◦ General creditors including employees ◦ Subordinated creditors ◦ Preferred shareholders ◦ Common shareholders

Secured Creditors

Secured credit involves collateral. In liquidation, proceeds from the sale of collateral only go to the secured creditor, up to the amount of the secured credit. Any residual goes into the pot shared by the pool of investors. If the sale of collateral is insufficient, the secured creditor becomes a general creditor for the balance.

Calculate Beta: Process

See Figure 8.4. Obtain the actual stock prices over time of time Compute the daily changes as well as the daily changes in the market overall Plot the data points Run a regression analysis and plot the line Measure the slope of the line relative to the market return line Calculate the slope of the line and that is your Beta

Estimating Investment Risk: Three Techniques

Sensitivity analysis (to changes in a single parameter) Scenario analysis (optimistic, pessimistic, and most likely forecast) Simulation (computer-generated multiple scenarios) The chief value of these techniques is to help the analyst think systematically about the economic determinants.

Market Timing

Shelf registrations provide managers with ability to time issues of new equity. "Universal" shelf registrations provide flexibility in respect to choice of debt or equity, and public announcement of intentions.

Capitial Rationing

Situation: The decision maker has a fixed investment budget that is not to be exceeded. Task is to rank the opportunities according to their investment merit. Capital rationing can alter the ranking of alternative independent investments.

Mutually Exclusive Alternatives

Situation: there is more than one way to accomplish an objective, and the investment problem is to select the best alternative. When investments are independent, all three approaches—NPV, IRR, BCR—will generate the same investment decision. With mutually exclusive investments, this is no longer true.

Preferred Stock Perspectives

Some managers view preferred as cheap equity, because the dividends are fixed even when earnings grow. However, they are normally taxed at 15% vs. 20% for other qualified dividends Other managers view preferred as debt with a tax disadvantage. Preferred stock is not widely used. ◦ About 16% of S&P 500 companies ◦ Usually by banks, insurance companies and utilities ◦ Common in venture financing but it is "convertible preferred" and goes away once the company is either sold of goes public

Cash - Sources and Uses

Sources: -decreases in assets -increases in liabilities and equity Uses: -increases in assets -decreases in liabilities and equity

Startup Financing

Startup: too risky for bank lending and too small to attract the attention of investors in public markets Funding options include: ◦ loans against stable cash flows such as accounts receivable ◦ personal savings ◦ friends and family ◦ "angel" investors ◦ venture capitalists ◦ strategic investors (large firms who provide seed money but with potential acquisition on their minds)

Private Equity

Structured as limited partnerships with a specified duration such as 10 years The general partner is the private equity firm, which raises a pool of money from limited partners, such as institutional investors, wealthy individuals and insurance companies. Limited partners have limited liability. Typical fee structure is "2 and 20", the sum of a management fee and carried interest. ◦ Carried interest in NOT interest in the traditional sense; rather it is the General Partner's share of "or interest in" the of the profits of the fund

Benefit-Cost Ratio

The BCR is also known as the profitability index. The BCR of the container pier project is: 49.75/40 = 1.24 Decision Rule: Accept projects with BCR>1, reject projects with BCR<1.

Monte Carlo Simulation Models

The Monte Carlo Simulation is a tool for risk assessment that aids us in evaluating the possible outcomes of a decision and quantify the impact of uncertain variables on our models. The method allows analysts to gauge the inherent risk in decision-making and quantitative analysis. • Enables you to look at thousands for outcomes plotted as probability distributions • In theory, it is quite easy to perform the Monte Carlo Simulation. The way the method works is by following these steps: 1. Assign a random value to the variable, for which we cannot calculate the probabilities; 2. Calculate the model with this random value for the assumption; 3. Record the result; 4. Change the random value for the variable; 5. Recalculate and re-iterate for hundreds, or even thousands of times; 6. Average out the result • During each iteration of the simulation, we select random values from the distribution population of each variable. • The result of the Monte Carlo Simulation is a probability distribution, or an array of sorts, of all possible outcomes from our model. It provides a more comprehensive outlook on what may happen and how likely it is to happen.

Cash Conversion Cycle (CCC)

The average length of time between when cash goes out the door and when it comes back in CCC= Days inventory outstanding + Collection period - Payables period Measures the time it takes to convert cash • DSO = days sales outstanding aka Collection Cycle (365 / AR turnover) - AR turnover = sales / average Accounts Rec. • Days in inventory (365 / inv turnover) - Inv turnover = COGS / average inventory • Days payable (AP / annual purchases)*365 • Add DSO + Days in Inventory less Days Payable (e.g. 65 + 90 - 45 = 110) • The lower the better

Cost of Capital

The before-tax cost of capital is a weighted average of the return required by creditors and the return required by owners. The weights are the relative liabilities of the two groups, the debt-to-capital and equity-to-capital ratios. How do you find the appropriate risk-adjusted discount rate for a specific investment? Do you just add an estimate like 7% to the risk-free rate? Use the cost of capital, which is the minimum rate of return the company must earn on its existing assets to meet the expectations of its capital providers. The cost of capital can serve as the discount rate for a project of average risk.

Cost of Capital in Investment Appraisal

The cost of capital is the return investors require that the company earn on its existing assets. What about new investments? Must they earn the cost of capital? Only if the new investments feature the same risk as the risk associated with existing assets.

Equivalent Annual Cost

The equivalent annual cost is an annuity payment that has the same present value as the actual cash flows on an investment. Example: What annual lease payment would have to be charged to recover the cost of the $40 million container pier (assume a life of 12 years and a $4 million residual value at the end of 12 years) at 10% discount rate.

Expected Returns

The expected return on a risky asset is the sum of: ◦ the risk-free rate ◦ the inflation premium ◦ the risk premium The sum of the first two terms is the interest rate on a government bond.

Market Value vs. Book Value

The financial statements are a mix of historical amounts and mark-to-market amounts. Book values are historical. Market values are forward-looking. Intangible assets not appearing in the financial statements include patents, brand reputation, superior technology, human capital of workforce, etc.

Capital Budgeting

The future of a company lies in the investments it makes today. Weigh the cost of an outlay today vs. expected future benefits

Internal Rate of Return (IRR)

The internal rate of return (IRR) is "the discount rate" that makes the PV of a stream of cash flows equal to zero. Loosely speaking, the IRR can be regarded as the rate of return associated with the cash flows. Decision Rule: Accept projects with IRR>K, reject projects with IRR<K. (K=cost of capital)

Levers of Growth

The levers of growth here are PRAT. g* is the only growth rate consistent with these ratios. If a company grows at a rate g > g*, then one of the four levers must increase. If a fast-growing company can't increase profit margin, retention ratio, or asset turnover, it will end up increasing leverage.

Market Ratio: Price / Earnings Ratio

The multiple attached to the earnings of a public company • A measure of market respect, reputation/credibility of management, company performance, industry trends • Investors place a higher value on growth - Companies with high growth characteristics sell at higher "multiples" of current earnings than slow growth (Facebook vs. Ford)

Payback Period

The payback period is the amount of time the company must wait before recouping its original investment. Problems: The payback period ignores cash flows after payback, and also ignores the time value of money. ◦ The payback period is sometimes useful as a rough guide to project risk and is almost always part of the decision process. Yet it is almost always a consideration

Cost of Capital

The rate of return required by suppliers of capital (lenders, investors, etc.) to attract funds to the company ◦ Debt financing (interest) ◦ Equity financing (return on investment) ◦ Expected return on investment drives valuation / share price, and related dilution It is the minimum rate of return a project must earn on its investment to increase the company's value ◦ In concept, investments with a rate of return above the cost of capital will increase company value ◦ In concept, investments with a rate of return below the cost of capital will decrease company value -if the projected Return on Investment ("ROI") is higher, then we do it! -if projected ROI is lower, we would not proceed

Short-Term Financial Plan

The short-term "operating" financial plan always begin with a Sales plan • From the Sales plan, production plans are developed that consider material (inventory) requirements - Quantities, lead times, cost, etc. • From the production plan, direct labor, factory overhead, factory capacity, and operating expense are estimated - Fixed asset investments are included in the Capital Plan • From this info, the Profit/Loss Plan, Capital Plan, and Cash Plan can be prepared • Then pro-forma financial statements are developed with those plans

Computing the Cost of Equity

The value of KE is based on an estimate of beta, the government bond rate (risk free rate), and the market risk premium. This equation is part of the capital asset pricing model (CAPM) where i = risk free rate, B = beta for the company, R = historical excess return of stocks over bonds

Risk Defined

There are two aspects to investment risk: 1. Dispersion 2. Correlation Figure 8.2 illustrates dispersion. Dispersion risk is often known as an investment's total risk.

Multiple Hurdle Rates

Three possible ways to adjust hurdle rates for differing investment risks (Be aware that multiple hurdle rate techniques involve arbitrary elements): 1. For large projects, identify an industry in which the contemplated investment is of average risk and estimate the WACC for this industry. →Try to find "pure plays," if possible. 2. In a multi-division company, calculate a separate cost of capital for each division. -Otherwise, the company runs the risk of accepting projects that are too risky and rejecting projects that are too safe. -Try to use primary division competitors, with pure plays, if possible. 3. Use risk buckets for different project types and assign projects to buckets. -Examples of buckets, ranked from low risk to high risk, are: ◦ replacement or repair ◦ cost reduction ◦ expansion ◦ new product

Total Risk

Total risk = Systematic risk + Unsystematic risk Systematic risk reflects exposure to economy-wide events that cannot be eliminated through diversification. Unsystematic risk reflects exposure to specific events, such as fires or lawsuits, that can be eliminated through diversification.

Equivalence

Two cash flow streams with the same present value can be transformed into each other.

Determining the Relevant Cash Flows

Two principles: ◦Cash flow principle: time stamp cash flows, recording them when they actually occur. ◦With-without principle: record only cash flow differences that occur because an investment is made as opposed to not made.

Cost of Capital and Stock Price

What happens when a firm earns more than its cost of capital? -Owners capture the entire excess. -If the situation persists, investors will bid up the price of the firm's stock until the excess disappears. -A similar statement applies if the excess is negative. -The cost of capital is the return that "keeps the firm's stock price constant."

Maturity Structure Selection

What is the right maturity for debt? The minimum risk maturity structure is to match the maturity of the liabilities against the maturity of the operating income from the firm's assets. This makes the liabilities self-liquidating. If the debt matures too soon, there is refinancing risk. If the debt matures too late, the company must manage the cash until maturity

% EBIT Can Fall

When a coverage ratio drops below 1.0, the company is in danger of not being able to make its payments from operating cash flows. Ask by what % can EBIT fall before a ratio drops to 1.0 The larger the % EBIT can drop, the less risk the company faces. Consider how debt financing impacts % that EBIT can fall.

Higgins: Market Signaling

When companies announce that they intend to raise new equity, their stock prices drop. Equity investors do not like dilution. Announcements about new debt have a much more neutral impact. Announcements about stock repurchases often result in a stock price increase. Does issuing new equity lower EPS? -It can, if earnings stay the same but the number of shares goes up. -But why would earnings stay the same if the money raised from the new stock issue was put to good use? Pecking Order: -Managers might respond to these issues with a "pecking order" rule. -They fund new projects with existing cash, before turning to external sources. -If they fund externally, they fund first with debt. -They use equity only as a last resort.

Short and Long Positions

When you are "long" you own the asset in question or expect to receive it in the future. ◦ You are long if you own a stock or commodity or currency. I own Apple shares so I am "long" in my position with respect to Apple ◦ You are long if you expect to receive it in the future. - My company receives euros for an accounts receivable that will get paid in 30 days so you are long euros in 30 days When you are "short" you do not own and expect to have to buy the asset in question in the future ◦ If you need to buy something that you do not have now you are "short" that item. I need euros to pay a loan but I don't have any euros ◦ If you sell something that you do not own you are "short" that item. I sold Apple short as I expect the value to decline

Capital Investment Planning

Which capital investments should be planned? - Do they support the business in meeting plan objectives - Do they offer a return > cost of capital • Planned investments should be carefully considered: - Investments are not easily reversed, eliminates other options - Need to understand financial & strategic impact on the company • Quantifying cost/benefit is the key to good capital budgeting

Working Capital Management

Working capital refers to the net current asset of a business used in its day-to-day trading operations • It consists of the current assets and the current liabilities of a business. • Current assets are gross working capital • Net working capital = Current assets - Current liabilities. Working capital management is our ability to: - effectively and efficiently control current assets and current liabilities - in a manner that will provide our firm with maximum return on its assets, and - will minimize payments for its liabilities Proper management of working capital can improve the overall health of the company by increasing current assets and optimizing current liabilities - Cash is cash - Accounts receivable only becomes cash if the customer pays us - Inventory is only an asset if it can be turned into cash - Current liabilities must be recognized and cash available to pay them when due

Forward Markets

You can buy spot today for immediate delivery. ◦ "Spot" prices means the price today You can contract today at a predetermined price for future delivery. ◦ This is the "forward" price You can use forward markets to offset risks or to speculate by betting on the future spot price, using today's known forward price.

Financial Intelligence

understanding how financial success is measured, and understanding how you can impact the financial performance of the company

Accounts Receivable Management

• Accounts Receivable Management consists of increasing sales by offering credit to customers • Options to offering credit include: - The business issuing its own credit card or line of credit • Must develop credit policy, which includes a credit evaluation and credit terms • 5 C's of credit used in determining credit worthiness - character, capacity, capital, collateral, and conditions - Factoring-selling accounts receivable to another firm at a discount off of the original sales price • e.g., Credit cards - allow us to receive cash quicker for a fee, rather than establish credit with the Customer ourselves and risk not collecting

Accrued Liabilities Management

• Accrued liabilities are those obligations of the company that are accumulated during the normal course of business • Includes payroll taxes and benefits, property taxes, and sales taxes - owed primarily to governmental authorities (e.g., IRS and other tax agencies) • Need to set aside money for these liabilities to avoid penalties and interest (and possibly impounding of bank accounts)

Pro Forma Issues: Interest Expense

• Circular reasoning - Interest this year is based on debt this year. - But interest this year feeds into earnings this year, and therefore into balance sheet retained earnings. - Debt this year, needs to be determined by the gap between assets and liabilities in the balance sheet. • Can try a decent plug, such as basing the interest on the prior year debt • Can iterate, because the two need to be determined simultaneously (spreadsheets can handle this).

Compound Interest

• Compound interest is the interest that is earned or charged on both the principal amount and on the accrued interest that has been previously earned or charged. • Albert Einstein - "Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it. Compound interest is the most powerful force in the universe." - What is your bank balance on a $1,000 deposit earning 4% per year after three years?

Pro Forma Financial Statements

• Estimated or Forecasted Financial Statements - Pro forma Income Statement , Pro forma Balance Sheet, Pro forma Statement of Cash Flows • Can be utilized for "top-down" forecasting and higher-level financial planning as well as bottoms up - Long or Short-Term (1 to 5 years) - Interim forecasts of operating/financial plans • Common approaches and inputs - Financial Statements from the preceding year - The sales plan/forecast for the plan year - Key assumptions about various business factors - % of sales method - Judgmental method (most typical for smaller ventures)

Pro Forma Issues: Seasonality

• External financing needed is only computed on the date of the balance sheet. • What about points of time in between? • Do a series of these, quarterly, monthly, etc.

Future Value

• Future Value (FV) - The cash paid / received at a given future date - Future Value is determined by compounding at a specific interest rate

Analyzing Profitability

• Gross profit margin • Operating profit margin • Net profit margin • Return on assets • Return on equity • Earnings per share - Market Ratio • Price / Earnings (PE) ratio - Market Ratio

Financial Planning: The Certainty of Uncertainty

• How do we prepare a financial plan in a situation of uncertainty? - Sensitivity analysis! - Multiple forecasts based on several potential scenarios (e.g., worst, likely, best cases) • Range of financial outcomes - Cash is always a key concern - Determine capital needs for "worst case" scenario - Assess the availability and risk of alternatives • Spending alternatives • Investment alternatives • Financing alternatives

Why Are Lenders So Conservative

• If expected loan returns are low, lenders cannot accept high risk. • Look at the lending margin (spread) between paying depositors and what the loan pays. • So getting a high ROE requires high financial leverage (like 10-to-1). • Complete default by just a few borrowers can erase a bank's earnings. • The aggressive lenders have long since gone bankrupt. Leverage was 30 to 1 for some banks before the financial crisis of 2008 - insane!

Interest Coverage Ratio a.k.a. Times Interest Earned

• Measures the company's ability to make its contractual interest payments • Shows the relationship between operating income and the amount of interest the company has to pay to its creditors on an annual basis • Typically the higher the better • Operating income = EBIT - Earnings before interest and taxes

Return on Equity

• Measures the return earned on the stockholder's investment in the company - How effective is management in leveraging the owners' investment? - Tells investors what each dollar of his/ her investment is generating in net income • The higher the better

Mixed Streams

• Mixed Stream Annuities - To find the PV of a mixed stream of cash flows: ➢Find the present value of each stream and add them together - To find the FV of a mixed stream of cash flows: ➢Find the future value of each stream and add them together

Annuities: Types

• Ordinary Annuity - Cash flow occurs at the end of the period • Example - car or mortgage payment • Annuity Due - Cash flow occurs at the beginning of the period • Example - rent • Perpetuity - An annuity that runs forever... • If not stated, we assume we are dealing with an ordinary annuity

Pro Forma Income Statement Preparation

• Percent of Sales Method - Starts with the sales plan/forecast - always - Expresses COGS, operating expenses, and profit as a percent of projected sales - Pro Forma based on previous year's % or a new % target - Assumes majority of costs are variable • Increases/decreases are in proportion to sales • Understates profits when sales are increasing • Overstates profits when sales are decreasing Fixed vs. variable expenses - Variable expenses increase with volume - Fixed expenses are independent of volume - Most businesses have a mix - Thus strict application of percent-of-sales method may not yield a reasonable forecast!! - Best method for realistic pro forma income statement is to segment company's expenses into fixed and variable and budget expenses accordingly - Judgment !!

Present Value

• Present Value (PV) - The value today of cash paid / received in the future - Present Value is determined by discounting at a specific interest rate

Profit vs Profitability

• Profit is the absolute number that is earned - Income statement - From an investment • Profitability is measured by using a ratio - Income statement: profit divided by sales - Investment: net profit divided by total assets - Profitability, therefore, is our Return on Asset (ROA)

Patterns of Cash Flow

• Single Amount - A lump sum expected to be received in the future • Annuity - A level, periodic stream of cash flow • Mixed Stream - A stream of unequal cash flows that follow no pattern

Time Value of Money (TVM)

• The Basics: - Simple interest vs. compound interest - Present Value (PV) deals with how much something is worth today given a set of assumptions about the future - Future Value (FV) calculations deal with how much money you will have in the future given a set of assumptions - Compounding (FV) vs. Discounting (PV) - Real world example: Capital budgeting When we're talking about receiving money, sooner is almost always better than later! When we're talking about paying money, the opposite holds true!

Cash Plan

• The Company's planned cash inflows & outflows - Cash inflows from projected sales - Cash adjustments to account for forecasted growth in current assets - Cash outflows related to production, overhead and operating expenses - Cash adjustments for changes in working capital (accounts receivable, inventory, accounts payable) that will impact cash vs net income - Cash outflows related to capital investment projects - The goal is to estimate cash requirements or cash surplus over the planning period • Usually one year (by quarter) for operating plan, longer for strategic plan The Cash Plan determines financing needs!

Future Value of an Annuity Due

• The future value of a stream of payments for n periods at an i rate of return when the money is invested at the beginning of each compounding period

Future Value of an Ordinary Annuity

• The future value of a stream of payments for n periods at an i rate of return when the money is invested at the end of each compounding period

Present Value of an Ordinary Annuity

• The present value of a stream of payments for n periods at an i rate of return

Present Value of an Annuity Due

• The present value of a stream of payments that are received at the beginning of each time period

Rule of 72

• This is a quick way to determine the approximate interest rate or years it take to double your money • Example - you are earning 10% • Take 72 and divide by 10 and it is 7.2 • Assume now you are earning 5% - Take 72 and divide by 5 and it is 14.4 • Now assume you want to double your money in 8 years - take 72 / 8 = 9 which is the interest rate needed to double in 8 years

Vertical Analysis - Balance Sheet

• Use Total Assets as a constant (100%), and divide balance sheet items by Total Assets

Cash Flows - Statement

•A reconciliation of beginning and ending cash positions for a specified period of time (month, quarter, year) •Net cash flow can vary significantly from net income due to timing of AR collections, AP payments and other non cash items (depreciation) •Shows how the company's working capital flows into and out of the business during the year: -Operations (day to day business) -Investing (long term investments) -Financing (raising capital $$$) •Cash flows from operating activities -The difference between all of the cash received by the business and all of the cash paid out by the business in conducting its day-to-day operations -Signified by changes in working capital accounts: Accounts Receivable, Accounts Payable, Inventory •Cash receipts from credit sales •Cash payments to all accounts - suppliers, employees, rent, utilities, etc. •NOTE: An increase in accounts receivable or inventory represents a negative cash flow. A reduction in receivables or inventory is a positive cash flow. •Cash flows from investing activities: -Acquisition (or sale) of plant assets •Cash flows from financing activities: -Proceeds from issuance or sale of stock (preferred or common), bonds -Purchase of stock or the payment of long-term debt •Net increase (decrease) in cash plus the cash balance of previous year equals cash balance of current year

General Ledger

•Also known as the "books" of the company •A General Ledger (GL) contains all the accounts for recording transactions relating to a company's assets, liabilities, owners' equity, revenue, and expenses •All company financial transactions are entered into the GL with debits and credits (double sided entry) •For example, if salaries of $1,000 are paid, you would book an entry to reduce cash (credit to cash) and record salaries expense (debit to salaries expense): Dr. Salaries Expense $1,000 Cr. Cash $1,000 •The Chart of Accounts is the listing of accounts in the General Ledger (e.g., Cash, Accounts Receivable, Fixed Assets, Accounts Payable, Shareholders' Equity, etc.) •The GL is the basis for all Financial Statements

Ethics

•Business ethics = right or wrong behavior in the business world •Examples of unethical behavior: -Dishonesty and manipulation -Misrepresentation of financial statements -Negative environmental impact; theft and fraud - insider trading -Harassment of any kind - cannot be tolerated •Ethical violations attract negative publicity -Can drive down a firm's value (share price) -Difficult to recover from a bad reputation •Positive ethical actions: -Improve image; Increase shareholder confidence -Reduce legal risk / cost

Why are financial statements prepared?

•Financial statements (F/S) are produced for external and internal reporting - to enable you to understand and manage the business •Public companies must provide audited F/S: -SEC reporting 10K (annual report) 10Q quarterly -Subject to strict SEC / FASB / PCOAB standards •Private companies produce F/S for: -Internal shareholders (Board, managers, employees) -Lender(s) or investor(s) usually have requirements -Subject to FASB / AICPA standards •Public agencies and non-profits have their own requirements

Cash is King

•Owner Earnings -Measure of ability to generate cash over a period of time -What an owner can take out of a business -Allows for capital investment to maintain a healthy business (long-term view) •Cash is a reality check, and what pays the bills

Who uses financial statements?

•Public companies (i.e., listed on the stock exchange) must provide audited financials -SEC governs -Usually in the form of an Annual Report known as the 10K •Private companies also produce them for: -Internal shareholders (Board, managers, employees) -Lender(s) or investor(s) usually have requirements -May or may not be in an Annual Report format -Guidelines generally not regulated •Public agencies and non-profits have their own requirements -Can vary significantly •Objective: Keep stakeholders "in the know"

Stockholder's Equity - Statement

•Summarizes equity accounts transactions occurring over a given period of time -Month, quarter, year -Issuance of Stock (par value + paid in capital) •Retained Earnings -Net Income adds to retained earnings -Dividends Paid reduces retained earnings

Balance Sheet

•The Balance Sheet is a snapshot of the company's financial condition at a given point in time (end of month, end of quarter, end of year) •Also referred to as the Statement of Financial Position •The Balance Sheet is made up of Assets, Liabilities, and Equity -Assets are what the company owns -Liabilities are what the company owes to others -Equity is the owners' investment balance Assets = Liabilities + Equity

Simple Interest

▪ Simple interest is the amount of interest earned on the principal amount stated ▪ Principal amount stated is the base amount that we borrow or save

Weighted Average Cost of Capital (WACC)

➢(1−t)KD is the after-tax yield on the company's bonds (or on other bonds of similar risk and maturity). ➢D is the market value of the company's interest-bearing debt (book value is usually substituted). ➢KE is the cost of equity using the CAPM. ➢E is the market value of the company's equity.