Finance Fundamentals

Fundamentals of Business Workshop

2006

Professor David J. Denis
What is Finance?
Branch of economics

Economics allocation of scarce resources

Finance resource = capital

Two fundamental questions in
financial management

1. On what projects should funds be spent?
(investment decisions)
2. From where should the funds be obtained?
(financing decisions)

Topics to be Covered
A. Financial planning
Projection of future cash flows
Need for capital
1. B. Valuation
How much is company worth?
How much equity must be given up to raise required capital?
2. C. Sources of funding for entrepreneurs
Where do we get the required capital?
On what terms?

Topic I. Financial Planning
Example: How to go brokewhile making a profit
What happened?
Increased sales lead to increases in receivables and greater
expenditures on inventory. Because inventory is paid for right
away and must be purchased in advance of sales, there is a net
drain on cash.
How can this be avoided? Construct a financial plan that
integrates production plans (inventory), marketing plans (e.g.
sales and credit terms), financing plans.
Components of financial plan
Pro-forma financial statements
Income statement
Balance Sheet
Outcomes
Capital needs
Future cash flows

Generic Income Statement
Sales
- Cost of Goods Sold
- Selling and Administrative Expenses
- Depreciation
- Interest
-Research and Development Expenses
= Earnings before tax (EBT)
- Taxes
= Net Income (NI)

Generic Balance Sheet
Assets
Cash
Accounts Receivable
Inventory
Property, Plant, Equipment


Total Assets

Liabilities and Owners Equity
Accounts payable
Wages payable
Short-term debt
Long-term debt
Common stock
Retained earnings
Total Liabilities and Owners
Equity




Pro-forma financial statements

Always begin with sales forecast
Project expenses often a % of sales
Forecast changes in asset and liability accounts

Topic II. Valuation
Question: How much of the companys equity will
the entrepreneur have to give up in order to
raise required amount of capital?

Depends on the value of the stream of uncertain
future cash flows
need a technique for valuation

Three primary techniques

Discounted cash flow (DCF)
Market multiples
Venture capital method

Discounted cash flow
Time value of money
What is the present value of $100 to be received next
year?
PV = CF
t
/(1+r)
t
If r = 10%,
PV = 100/(1+0.1) = $90.91

What is r? Required rate of return usually 40-60%
in VC situations

Market Multiples
Apply valuation ratio of comparable firm to firm being
valued.
Examples: P-E, market value/book value, Market value/
Sales
Problems:
o What is the appropriate multiplier?
o Start-ups frequently do not have positive earnings, may not yet
be generating sales, and have few assets.

Venture Capital Method
Effectively combines the previous two methods.
Commonly used in the private equity industry.
Project value at some point in the future using some sort of
multiple
Discount that value to the present
Discount rate is more ad hoc but usually high (40-75%).

Topic III. Sources of Capital
1. Debt
2. Equity
Angels
Venture Capitalists
Strategic partners

Two Fundamental Problems

1. Information asymmetry
Entrepreneur has better information than investor

2. Moral hazard
Entrepreneur has incentive to mislead investors

Solutions
Monitor/reduce asymmetry
Angels typically know the entrepreneur
VCs demand oversight role
Discount the value of the company
Contractual terms of financing agreement

Terms of Financing Agreement
Convertibles
Staged financing
Put features
Right of first refusal