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    Value-based financial management: Towards a Systematic Process for Financial Decision - Making
    Value-based financial management: Towards a Systematic Process for Financial Decision - Making
    Value-based financial management: Towards a Systematic Process for Financial Decision - Making
    Ebook236 pages2 hours

    Value-based financial management: Towards a Systematic Process for Financial Decision - Making

    By Maximiliano González Ferrero, Alexander Guzmán Vásquez and María Andrea Trujillo Dávila

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    About this ebook

    This book poses the question: Can a private company be managed using the same criteria as a publicly traded company, basing its decisions on the same financial tools? The answer is yes, and the main objective here is to describe a basic dynamic valuation model through which senior managements can determine the "market" value of a company at any moment. In other words, although these companies remain private, the management model proposed in the book makes their decision-making process as rigorous and professional as if they were listed companies, by using appropriate financial tools that serve as the main support in the decision-making process. The model also encourages the use of different risk management tools to analyze some of the variables that affect value, so that after establishing the allowed movement ranges (risk map), hedging or mitigation mechanisms can be implemented. The objectives outlined in this book are relevant for management practice since they seek to promote a systematic, orderly, documented, and value-oriented decision-making process.
    LanguageEnglish
    PublisherCESA
    Release dateOct 15, 2021
    ISBN9789588988573
    Value-based financial management: Towards a Systematic Process for Financial Decision - Making

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      Book preview

      Value-based financial management - Maximiliano González Ferrero

      Chapter 1

      What Is a Good Financial Decision?

      For this study, a good financial decision is the one that follows a systematic and organized process of analysis. It should be noted that one thing is a good decision and another one is the result. The decision-making process can be monitored, while the result cannot. In this context, the quality of decisions is independent of their results. A good result without a systematic and orderly process of analysis has not been the product of a good decision, it was only luck!

      Figure 1 outlines the most complete decision-making process possible. However, it should be clarified that companies constantly make three types of decisions: operating, financing, and investment. The first type is related to liquidity managment necessary for the company’s operations, as well as to revenues and expenses that are reflected in the operating profit. Investment decisions refer to the purchase or sale of long-term operating and non-operating assets, including an analysis of the return generated by this investment. Finally, financing decisions refer to the long-term capital or financing structure of the company, along with an assessment of the cost associated with each financing source.

      Figure 1. Process of Making a Good Financial Decision

      Regardless of its type, every decision requires a certain modeling process. The most complete process involves the projection of cash flows, their discount with the opportunity cost, and sensitivity analyses associated with the stochastic behavior of the projected cash flows.

      A financial review of historical information allows obtaining parameters to construct an assumptions table based on which financial statements are projected, especially the income statement or p&l, the balance sheet or balance sheet, and the statement of cash flow. Based on this information, the free cash flow (FCF) is constructed and then discounted using the weighted average cost of capital (WACC) to calculate the NPV (and other ratios) of the decision. This would be the base case. The risks are then examined to carry out sensitivity, break-even, and scenario analyses, as well as a Monte Carlo simulation. Completing this whole process provides the necessary basis to make a good financial decision.

      Before describing the process, it is necessary to answer the following question: What is a good financial decision? As already explained, a good financial decision is the one that follows a systematic process that seeks to add value as its ultimate goal. What does it mean to add value? It means to increase the long-term wealth (possibilities of consumption) of the shareholders or owners of a company, which can be measured through the concept of net present value (NPV). ¹

      There are three important concepts included in this definition. The first one is that the present value of the FCF produced by an asset, based on which the decision is made (e.g., company, project), is wealth. In other words, a decision always implies a present event (e.g., investing in an asset) with an effect that will be observed in the future. Therefore, it is necessary to estimate the present value of the FCF that will occur in the future, and to do this, the decision maker must be clear about its opportunity cost. For a company, this opportunity cost is the WACC, that is, the cost of financing an asset. Then, the FCF is discounted using the company’s (or decision maker’s) WACC.

      To understand this more clearly, let us suppose that a company is studying the possibility of investing a certain amount of money in an investment project. This amount can be invested in any other project of similar risk. Therefore, for the decision to make sense, the expected return must be higher than the opportunity cost. This opportunity cost is precisely the WACC. However, in practice, most entrepreneurs—and even managers of small and medium-sized firms—are unaware of the opportunity cost of the company. In other words, they do not know their company’s WACC. This implies that decisions are made without knowing with certainty the cost associated with obtaining financial resources. To make a good financial decision, it is essential to have at least an approximate idea of the company’s WACC, estimating the cost of financing with financial creditors, and the cost of financing with shareholders, that is, the opportunity cost of those who contribute to the firm’s capital. An entire chapter is devoted to this calculation later.

      The second concept is market value. The main difference between accounting and finance is that the former generally works with historical values, while the latter uses market values. It is necessary to clarify that records in the accounting books seek to reflect the financial reality of the company, which implies properly evaluating its assets. For example, under the International Financial Reporting Standards (IFRS or NIIF as known in Spanish), assets are revalued to reflect a value closer to its market value. Similarly, the impairment of assets such as inventories and accounts receivable are adjusted, so that they reflect their true market value. However, from a financial point of view, assets are worth their ability to generate future cash flows, which may mean a higher value than the market would pay if the company was being liquidated. Thus, it is always possible that there is a difference between the estimated asset value, from the financial point of view, and the book or accounting value.

      In the case of a publicly traded company, the market value reflects the present value of future cash flows expected by shareholders. Therefore, the market value of a share is a break-even value that arises when the demand price is equated to the supply price. Thus, if the share price of a publicly traded company is below its true valuation (undervalued), many investors would be interested in acquiring it, pushing its price up; on the contrary, if the price is higher than expected by the market (overvalued), investors would be incentivized to sell, pushing the price down. An example of how this notion of market value generates financial statements that are very different from accounting statements is examined later.

      The third concept is related to the meaning of NPV itself. It measures the amount of value being generated (npv > 0) or destroyed (npv < 0). The NPV can be understood in colloquial terms as the amount of wealth generated by a project or an investment. To explain this, let us consider the following example: an investment of $1,000 generates a FCF of $1,500 within two years. If the WACC is 12%, is this a good project? To answer this, the NPV is calculated first:

      According to the result, it is a good project because it generates a positive NPV equal to $196; nevertheless, the following question arises: if $196 represent a real increase in wealth today, then, in principle, could consumption capacity increase today? Can those $196 be spent today if necessary? The answer is yes, recognizing the existence of financial markets. Let us suppose that you want to spend this money today, but you will receive the FCF in two years; then you can go to the financial market and borrow the money needed. Additionally, let us assume that the financial market agrees with you about the risk-return ratio of the project and lends you at

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