Analysisforfinancialmanagement(RobertC.

Higgins)
Summaryoftheusedchaptersinthelecture(WM0609LR)
Writtenby:JorisVanGestel

Chapter1Interpretingfinancialstatements
Accounting
Information provided by 3 annual reports:
Balance Sheet
Cash-Flow statement
Income statement

Figure1Cashflowproductioncycle

(Operating)workingcapital:movementofcashintoinventory
Investment:flowfromcashintonewfixedassets
Depreciation:thelossinvalueoffixedassetsincreaseinvalueofmerchandisemade+neededfor
growth
Solvency:abilitytohavecashtobuyfixedassetsandinventory(outflowcash)

Financial statements: Balance sheet

Thebalancesheet
Equity= assets - liabilities
current assets

current liabilities
cash

inventories

acc receivable

equipment

plant

accounts payable !

fixed assets

long-term liabilities
long-term debt

total shareholders equity

stock

retained earnings !

total assets

total liabilities + equity

Figure2exampleofabalancesheet

Financialsnapshot:1momentintime
Assetsagainsttheclaims

Liability:obligationtodeliversomethingofvalueinthefuture
Equity:differencebetweenassetsandliabilities
Liquidity:speedatwhichanitemcanbeturnedintocash
Accounting: income statement
Assetsandliabilitiesarelistedinorderofdecreasingliquidity
Current:liquidity<1year
Net sales
of Longterm:liquidity>1year
-Costs
sales
Earnings Before Interest, Taxes, Depreciation, Amortization (EBITDA)
-Depreciation, Amortization
Earnings Before Interest and Taxes (EBIT)
-Interest
Earnings before taxes (EBT)
-Taxes
Net income
-Dividends
Addition to retained earnings

Incomestatement

Differencebetween2importantbalancesheets
Change in owners equity in terms of revenues (sales) and expenses (costs) net income
(earnings,profits)
Commonlydividedinoperatingandnonoperatingsegment
Somedifferentaspectsofearnings
Accrual accounting: revenue is recognised as soon as the effort required to generate the
saleiscomplete+certainofsalelagbetweengenerationofrevenueandreceiptofcash
Depreciation:costsfor(exbuildings)arespreadovertheyearsperioddefinedbyuseful
life,salvagevalue,methodofallocationtobeemployed
o

Straightline

cos t total salvationvalue

lifetime

o Acceleratedmoredepreciationintheearlyyearsanlesslateron
Taxes: sometimes firms use different income statements for the tax and for the public
shareholders
o Taxesdifferfromtheprovisioned(higher/lower)
o Can be used to shift tax payments to later years to use the finances in the
business
Researchanddevelopment(R&D)difficulttoestimatethepayoff
o Thecosthavetobelistedasanoperatingcost(unitedstates)

SourcesandUsesstatements

Isnotthesameasincomestatementbecauseaccruals,listsonlycashflowassociatedwithsaleof
goodswithintheaccountingperiod

2balancesheetsofadifferentdateandnoteallthechangesinaccount
Segregatethechangesintogeneratedandconsumedcash
o Generate:reducingassets,increasingliabilities
o Consume:increaseassets,reduceliabilities
Cashcanalsocomefromloans(longtermdebt)ortheretentionofprofitsearnedthroughtheyear
Cashflowstatement

Differencebetween2importantbalancesheets
Providesadetailedlookatchangesinthecashbalance
Cashprovidedorconsumedby:rearrangessourcesandusesintothesethreecategories
Operating:
o Noncashcharges:amortisation,depreciation
o Changesincurrentassets,liabilities
Investing
Financing

Cashflow
Net:netincome+Noncashitems
Fromoperatingactivities:netcashflow+/changesinasstsandliabilities
Free: total cash available for distribution to owners and creditors after funding investing
activities
Discounted:sumofmoneyhavingthesamevaluereceiptanddisbursements
Allthisinfocanbefoundintheincomestatementandthebalancesheetbut
Betterunderstandingforthenonexperiencedandtheonesagainstaccrualaccounting
Moreaccurateinfoabouttaxesandsecurizations
Lightonthefirmssolvency(generating/consuming)
3

Financialstatementandthevalueproblem

MarketvalueVsbookvalue

Acompanyisneverworthitsbookvalue
An asset purchased in 1950 can be worth less or more on this moment (land (more),
technology(less))
o Problem:valuesofthingsinthepresentaresubjective
Accountantsprefertobepreciselywrongratherthanvaguelyright
Regulators:fairvalueaccounting:someassetsandliabilitiesmustappear
attheirmarketpriceinsteadofthehistorical
Equityinvestorsbuysharesforthefutureincometheyhopetoreceiveandnotforthevalue
oftheassets
o Problem:accountantmeasureofshareholdersequityh as little relation with
futureincome
Accountantsnumberslookbackandarecostbased
Companies often have assets/liabilities that do not occur on the balance
sheet but affect the future income nonetheless (patents, trademarks, loyal
customers, lawsuits, bad/good management, technology) book value
inaccurate
Moreaccurate value =# shares value
Goodwill: buy a company for more as the book value book value in
assets,therestintheassetgoodwill

EconomicincomeVsaccountingincome

Theproblemhereliesinthedistinctionbetweenrealisedandunrealizedincome
Theaccountantonlyrecognisesrealizedgains/lossesassetsthatincreasearegainsonpaper(itcan
fluctuate)

Imputedcosts

Equity capital also has cost (investors expect a return) but these do not appear on the income
statementbecausethereisnopaperthatsayshowmuchthecompanyhastopaythiscostmustbe
estimated(imputed)

The economist would subtract these cost but an accountant does not, the difference is important
becausemanydecisionsarebasedonthenumbersintheincomestatement:wages,bonuses,etc

Chapter2.Evaluatingfinancialperformance

Returnonequity

Most popular tool to evaluate financial performance it is a measurement of efficiency

earnings

investedDOLLAR
NETincome
Isthebasicformulabutcanberedefinedas
shareholdersEQUITY

ROE =

NETincome Sales
Assets

Sales
Assets shareholdersEquity

ROE =

ROE = PROFITm argin ASSETturnover FINANCIALleverage

Profitmargin:earningsoutofeverydollarofsale

NETincome
Returnonassets ROA =

Assets
GROSSprofits
Grossmargin:
usedtofindoutthefixedandthevariablecosts
Sales

Assetturnover:salesgeneratedforeverydollarofassetsemployed

Low:assetsintensiveindustry

cos tgoodssold

Inventory ending

Inventoryturnover:

Collection period: shows the companys management of accounts receivable average time lag
betweensaleandcash

Dayssalesincash:

account recievable

creditsale day
cash + sec urities

sales day

Theoptimalratioisdifferentforeverycompanyanddependsonthenecessaryliquidity
PayablesPeriod:

accountspayable

purchasescredit day

Controlratioforliabilityperiodtoaccountspayable
FixedAssetturnover:

Sales
withnetproperty=plant,equipment
netproperty

Especiallyimportantforcompanieswithcapitalintensive(=operatingleverage)businesses(cars,etc)
Sensitivetothestateoftheeconomy


Financialleverage:amountofequityusedtofinancetheassets

Notnecessarymax:findabalancebetweenthebenefitsandcostsofdebtfinancing
Idealleveragedependsonthenatureofcompanysbusinessandtheassets
Stable/predictablecashflowhighfinancialleverage
Inversely related with ROA safe, stable, liquid investment=low returns +big borrowing
capacity

Measuresoffinancialleverage:

Debt to assets ratio:

creditors

Debttoequityratio:

liabilitiestotal
percentage of the assets book value that comes from
assetstotal
liabilitiestotal
percentagebythecreditorsforeverydollarofequity
equity shareholders

Coverageratios:usedtocalculatetheburdenofthedebtonthecashflow
(EBIT=earningsbeforeinterestandtaxes)

Timeinterest:
o

EBIT

expenseint erest

Tooliberal:assumesthecompanywillrolloverallitsobligationastheymature

Timeburdencovered:
o
o

EBIT

int erest + (repayment principal 1 taxrate)

Tooconservative:assumesthecompanytopaytheloansdowntozero
Besthighforcompanieswithhighfinancialrisksandlowwhenreadyaccesstocash

Market value leverage ratios: market value ratio are superior to book value ratio because book
valuesareoftenirrelevantandmarketvalues are based oninvestorsexpectationsaboutfuture cash
flows.
Helpful when assessing financial leverage of rapidly growing startup businesses, because lenders
willcreditcompanieswhentheybelievethattheywillbeabletoservicethedebtsbutdonthaveabad
coverageratio.

debt marketvalue
debt marketvalue
and

equity marketvalue
assetsmarketvalue

Risks:ignorerolloverrisks(paythedebtsnotbypromisingfuturecash)

Liquidity ratios: determinant of companys debt capacity is liquidity of its assets (maturing
mismatching=liabilitiescomeduebeforetheygenerateenoughcash),measuresofliquidityare

assetscurrent

liabilitiescurrent
assetscurrent inventory
Acidtest:

liabilitiescurrent
Currentratio:

Rathercrudemeasuresbecause:
Rollingoverobligationinvolvesnoinsolvencyrisk
Cash generated cant be used to reduce liabilities because it must be used to support
continuedoperations

ProblemsoftheROE

Timingproblem:ROElooksatthepastandoneperiodicwhenforgoodbusinessitisneededtolook
forward
ExhighstartupcostforaverygoodproductwilllettheROEfall

Risk problem: the ROE doesnt say anything about how much risk the company needed to take to
generatetheROE

Returnoninvestedcapital(ROIC):
UsedtoavoidthedistortionofleverageonROEanROA

ROIC =

EBIT (1 taxrate)

debt int erestbearing + equity

Istherateofreturnearnedonthetotalcapitalinvested

Valueproblem
The ROE is calculated on the book value of shareholders equity market value of the
equityismuchhigherneeded:highROE+unknowntootherinvestors

earning
incomenet
share
=
Earningsyield:
shareholdersequity marketvalue earning
share
o

Is no good solution because the stock price is dependent on investors

expectationhighexpectation=highstockpricelowearningyield

price

P/Eratio:
o
o
o

share
earnings
share

Price of one dollar of earningsused to normalise stock prices for different earnings
levels
Riseswithimprovedearningsandlowerswithincreasingrisks
Givesagoodimageofwhatinvestorsbelieveforthefuture

Marketpriceproblems:stockpriceasaperformancemeasure
Difficultyofspecifyinghowoperatingdecisionaffectstockprice
Managers now more about the company then external investorswhy should managers
considertheassessmentsoflessinformedinvestors
Stockpriceisalsodependentonfactorsoutofthecontrolofthecompany(ex.improving
economy)

Ratioanalysis

Strategies

Ifusedproperlycanrevealalotaboutthecompany
Noautomaticallyinsightincomplexcompaniestheyaremoreaclue
Thereisnosinglecorrectvalueforaratiodependsontheperspectiveoftheanalyst
Comparetorulesofthumb
Comparetoindustryaverages(sometimestherearegoodreasonstodiffer)
Lookatchangesintime(mostuseful)

Chapter4managinggrowth

Sustainablegrowth

Growthisnotalwaysagoodthingbecausegrowthneedsresources(financial)

Sustainable growth rate: the max rate of which a company can increase sales without depleting the
financialresources

Typicallifecycleofasuccessfulcompany
Losses:research,developing,footholdonthemarket
Rapidgrowth:growthissofastexternalinvestmentsareneeded
Maturity: decline in growth, no outside investmentgenerating more cash then can be
invested
Decline:decliningsales,marginallyprofitable

Growthphase
Thegrowthrateislimitedbythegrowthofownersequity(sustainable)

g* =
g* =

equity change
equity bop

[bop = beginning ! of ! period]

R " earnings
[R = retention ! rate]
equity bop

g* = R " ROE bop

g* = R " profit m arg in " asset turnover " assets ! to ! equity ratio

Ifacompanyincreasessalesataotherratetheng*someoftheratiosmustchange

Balancedgrowth
g* = R (assets to equity ratio ) ROA Growthdependsonreturnonassets

Whattodowhenactualgrowthexceedssustainablegrowth

Checkhowlongthiswillcontinue
Short:additionalloaningforthetransitiontomature(absorbinggeneratingfinancing)
Longterm:
o Sellnewequity:solveseverythingbutequitiesdontselleasily(illiquid,minorowner)
o Increasefinancialleverage:
o Reducedividend:
o Profitablepruning:nospreadingofresourcesovermoremarkets
o Outsource:releasesassets,increasesassetturnover
o Increaseprices:reducesgrowth
o Merge:

Productdiversification:
Lessrisksbutnotgoodfortheshareholderswhocandiversificatebybuyingdifferentstock
Spreadingofresources:followersinmanymarketslessasleadinginonemarket
8

Tolittlegrowth

Havetheproblemnotknowingwhattodowiththemoneyinefficient
Checkhowlongthiswillcontinue
Shortterm:accumulatecashforfuturegrowth
Longterm
o Ignoretheproblem:thisattractsraiders(hostilebuyers)willredeploytheresources
o Returnmoneytotheshareholders:repurchasingsharesorraisingthedividend
o Buygrowth

Growthcomesfromincreasingvolumeandrisingprices
Theinflationriseinassetsandaccountsreceivableworsensthegrowthproblems
Increasesamountofexternalfinancing
Increasedebttoequityratio

Newequityfinancing

Corporationsdontuseequityasasourcebutjustcash

WhydontUScorporationsissuemoreequity?
Noneedborrowingandretainedprofitswereenough
Expensivetoissue(510%oftheraisedamount2timesthecostfordebt)
Managersarefixatedonearningspershare(EPS)newequitylowersEPS
Companiesalmostalwaysthinkthereundervalued
Stockmarketisaunreliablefundingsource

Chapter5financialInstrumentsandmarkets

Financialsecurity:
Apieceofpaperofpaperthatinvestorsgetfromthecompanieswiththenatureoftheirclaim
onfuturecashflow
Thispapercanbetradedonfinancialmarkets.
Mustbedesignedtobeattractivetoinvestors+meetsthedemandsofthecompany

Financialinstruments

Companiesarerelativelyfreetodesigntheirownsecuritiesliketheywantonlyrealregulationis
thattheconsumerneedstogetalltheinforelevanttovaluethesecurity.

Bonds

Isafixedincomesecurityholderreceivesaspecifiedinterestandmaturity
Usuallyinsmallamounts($1000)
Largestsourceofexternalfinancing(34%)
Variables
o Parvalue:amountofmoneytheholderwillreceiveonthebondsmaturitydate
o Couponrate:%oftheparvaluetheissuerpromisestopayasannualinterestincome
o Maturitydate:companywillpaytheparvalueandstoppayinginterest
Companiestrytomaketheinitialmarketpriceofthebondsequaltoitsparvalue
Afterissuethebondsmarketpricecandiffer(differentinterestandcreditrisk)
o Interestrisesbondpricesfall
Sinkinfund:repaymentstocreditorstoreduceprincipal
o Retirebondsorrepurchasemarketsecurities
Floatingrate:interestistiedtoashortterminterestrate
Callprovisions
o Companyhastheoptiontoretirethebondearlier(mostlywithapremium)
o Delayedcall:issuercantcallbeforeaspecifiedperiod(510years)
o Ifinterestratefallsretireandresellalowerinterestrate
o Changingmarketconditionsrearrangethecapitalstructure
Covenants:specifiedintheindentureagreementtypicallysetslowerlimitforcurrentratio
and upper limit for debttoequity ratio (sometimes forbids to sell/buy major assets without
approval)company fails (default): bankruptcy or liquidation: sale of assets to meet the
claims
Rights of liquidation: distribution of the money (rights of absolute priority) government
(duetaxes),seniorcreditors,generalcreditors,subordinatedcreditors,stockandshareholders
Secured creditor (mortage, hypotheek in Dutch): loan collateralized with a specific asset
onliquidationmoneyofsaleofthisassetsgotothiscreditor
Bondsarevulnerabletoinflationinterestisthesamebutvaluedecreases
Bond rating: bonds are rated by companies with a letter grade, these grades are important
because with good grades the companies need to offer a smaller interest rate.Bad ratings
haveahighinterestbutalsohigherrisk

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Commonstock

Residualincomesecurity:
Stockholderhasaclaimonanyincomeremainingafterpaymentofaltheobligations(incl.debt
interest)
Highestbenefitswhenthecompanyprospersbutalsohighestlosswhenthingsgobad
Amountofmoneytheyreceivedependsonthedividends(choiceofthecompany)
Shareholderscontrol:theshareholdersownthecompany(intheory)whenthereisno
dominantshareholder,managementcontrolstheboard(particularlyinUSandUK)
o Managementcantignoretheshareholdersbecausethiswouldbebadperformance
lowstockpricemaybehostiletakeovers
o Securitymarketsneedstobeattractivetoraisedebtorequitycapital
anualincome = d1 + p1 p0 Withd1=dividend,p0,p1arebeginning/endofyearvalueofthe
stock

d1 d1 d0
+

p0
p0

annualreturn =

Thedifferencebetweenbondsisanadditionalpercentage(premium)fortheriskbared

Preferredstock

Isahybridsecurity:debt/equity
o Debt:fixedincome:annualdividendcouponrate
o Equity:maychoosenottopaythesedividend,notadeductableexpense,nomaturity
Havepriorityovercommonstockfordividends
o Commondontgetdividendsbeforethepreferredarefullypaid
o Cumulative:ifthedividendispassednodividenduntilfullypaidthepreferredstock
Sometimesmorecontrolinbigdecisions
Canbeseenascheapequityordebtwithataxdisadvantage

Financialmarkets

Financialmarkets:arethechannelsthroughwhichinvestorsprovidemoneytocompanies

Privateequityfinancing

Strategicinvestors:makesignificantequityinvestmentsinstartups
Gainaccesstopromisingnewproductsandtechnology
Outsourcingresearchanddevelopment

Venturecapitalists:wealthyindividualsorprofessionalventurecapitalcompanies(privateequity
firms)
Buyasignificantfractionofacompanyandtakeanactiveroleinthemanagement
Liquidatetheinvestmentin56years
Veryhighrisksbutalsoveryhighprofits
Unusualorganisation:privateequitypartnership
o Generalpartnerraisesapoolofmoneyfrominvestors,pensionfunds,insurance,etc
o Investandmanagesliquidatesandreturnstotheinvestors
o Firmchargespercentageoftheoriginalcapitalandaround20%oftheearnings
Addressesseveralproblemofconventionalinvestment
o Minimisedifferencesbetweenmanagementandownerscreatevaluefortheowners
o Aggressivebuyfixsellattitudemanagementhastotakedecisiveaction
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Initialpublicofferings

Initialpublicoffering(IPO):creatingapublicmarketforcommonstock
Createsliquidityforgrowthandforexistingowners
Investmentbanking:
o Proposalsofinvestmentbanks(howtosell)winner=managingunderwriter
o Roadshow:topexecutivesgoandmarkettheissueinfinancialcentres
o Sellingsyndicateandunderwritingsyndicate:shortjoiningofinvestmentbanks
Selling:eachmembersellspredefinedamountofsecurities
Underwriting:buyallthesecuritiesatafixedpriceandtrytosellthemata
higherprice

Seasonedissues

Shelfregistration:allowfrequentsecurityissuerstoavoidcumbersometraditionalregistrationby
filingageneralpurposeregistration
Readyforusewhenneeded(notimelagbetweendecisionandissue)
Highlikelihoodofbiddingbetweeninvestmentbanksissuecost1050%loweras
traditional

Internationalmarkets:wheneverthecurrencyemployedisoutsideofthecontroloftheissuing
monetaryauthorityex.DollarloantoanAmericancompanyinLondon
Minimalreportingandregulatoryrequirements,verycompetitiveprices
o Absenceofreserverequirementsoninternationalbankdeposits
o Possibilitytoissuebondsinbearerform=unregisteredowners,lowercouponratebut
sameaftertaxreturn(illegalinUStaxavoidance)

Issuecosts:coststheissueranditsshareholderincuroninitialsale
Privatelynegotiatedtransactionfeechargedbytheinvestmentbanker
Public:legal,accounting,printingfees,managingunderwriter
o Underwriter:spreadfeepersharehesoldsplitbetweensyndicateandunderwriter
Offerunderthemarketpriceeasiertoselltolessinformedoutsiders
Equityismorecostlythendebt
o 11%forIPO,7.1%forpublicsold,3.8%bonds
o Costrisewhenissuesizedecreases

Efficientmarkets

Importantinraisingnewcapitalistimingsellwhenpricesarehighpredictionsfuturepricetrends
infinancialmarkets
Market efficiency is controversial because many companies overstate the evidence supporting
efficiencyandmisrepresentitsimplications.Notblackandwhitebutshadesofgrey

Efficientmarket:isamarketinwhichthepricesadjustrapidlytonewinfoandpricesreflectfullythe
availableinfoabouttheassetstraded
Weakform:currentpricesreflectalltheinfoaboutpastprices
Semistrongform:currentpricefullyreflectallthepubliclyavailableinfo
Strongform:currentpricereflectallinfo(publicandprivate)

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Implicationsofefficiency

Publiclyavailableinfoisnothelpful
Absenceofprivatebestforecastisthecurrentprice(trend)
Withoutprivateinfoacompanycannotimprovetermstosellbytiming
Withoutprivateinfo/accepthighrisksnoearningabovemarketaveragereturn
Solutionismakinganinformationgatheringsystemorgetinsideinfo(illegal?),buyaforecastofafirm

Forwardcontracts,optionsandthemanagementofcorporaterisks

Forwardsandoptionsareaclassofsecurities:derivatives:valuedependsonunderlyingassets
Usedtocontrolrisksofvolatileexchangerates,interestsratesandcommodityprices
Mustbeverycarefulcanloosealotofmoneyto

Forwardmarkets

Forwardmarket:thepriceissettodaybutexchangehappensonafuturedate(exreservingaroom)
Speculating:ex.Sellingeuroswhentheeurohasahighvaluethenwaitawhileandbuythemagain
whenpriceislower

ThiscanresultsontransactionswitheurostoaUScompanysotheycansellthesameamountin
eurosfordollarssotheeffectofafallishedgedforafuturedropoftheeuro(forwardmarkethedge)
isconvenienttoputintherightnumberinaccountsreceivable

Options:asecurityentitlingtheholdertoeitherbuyorselltheassetatapredefinedprice/time
Putoption:righttosellatapredefinedprice
Calloption:righttobuyatapredefinedprice
Premium:amountyoupayfortheoption
Maturitydate:dateoptionexpires
Canbeusedtohedgetheeffectsoftheexchangeratebybuyingputoptions

Limitationsofhedging
Assetcreatingtheriskmusttradeinfinancialmarkets
Amountandtimingoftheforeigncashneedstobeknownwithreasonablecertainty
o Thisisaproblemwhenitisanoperatingcashflow
Hedgeanunknownamount

13

Chapter6thefinancingdecision

Financingdecision
Decidehowmuchcapitalisrequired:estimatesalesgrowth,assetsneeded,availablemoney
Instrumenttobesoldrisk,inabilitytosell,excessivecostsifwrongchoicewasmade
Focusshouldbeonsupportingthebusinessstrategy(acquiring/deployingassets)
Takeintoaccounttheeffectonthefutureabilitytoraisemoney

Financialleverage

Financialleverage:deviceincreasesownersexpectedreturnatthecostofgreaterrisk
Increasethedebtfinancinginterestexpenses
Waytovarythewaytheyfinancedebtequityratio
Debtreducesvariablecosts+increasesfixedcostsafterbreakevenincomewillrisemore

ROE = ROIC + ( ROIC i')

Debt int eres

Equity bookvalue Withiaftertaxinterestrate

o ROICisthereturnacompanyearnsbeforethefinancialleverage
o Improvesfinancialperformancewhenbusinessisgoingwellandviceversa
Examplep203210

Bondfinancing:lowertaxbillinteresttaxshield
Commonstock:higherearningsaftertax
Tomakeadecisionarangeofearningsneedtobemade(plotEBITEPS)

Howmuchtoborrow

Purposeshouldbetoincreasetheshareholdersvalue
Increasevaluetheshareholdersattachtotheoperatingcashflow(absolutebyM&M)
Increasethelevelofcashflow

IrrelevancebyFrancoModiglianiandMertonMiller(M&M)
Whencashflowisconstanttheamountofdebthasnoeffectonthevaluenoconcernin
valuemaximizing
Increasedriskpreciselyoffsetstheincreasedreturn
Physicalassetsproducevaluenoincreaseincashflowproducednoincreasedvalue
Concl:financialchoiceshouldbetheonethatmaximizesthecashflow

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5factormodeltochangethecashflow
Taxbenefits:debtfinancingincreasesthetaxbenefitincreasescashflow
Distresscosts:variouscostsacompanyincurswhenithastomuchdebtcapital
o Bankruptcy: P (banktruptcy ) cos ts ,bankruptcydoesntnecessarilymeanliquidation
buttheriskisveryhighanddependsontheresalevalueofsomeassets
o Indirectcosts:increaseasthechanceofbankruptcyrisesandcanreinforcethechance
ofbankruptcy
Internal:conservecashbycuttingR&D,marketing(lostprofitopportunities)
External:costumersareconcerned+higherfinancingcostbyworriedinvestors
+concurrentwouldtrytokillyoubymakingapricewar
o Conflictsofinterest:variouspartiesinthecompanyworryaboutthemselvesowners
havenothingtoloosebutcreditorsdo
Flexibility:ifthedebtcapacityisreachedfurtherfinancingneedstobedonebyequitywhichis
notalwaysreliableorevenpossibleremainingunderthedebtcapacityisbettertobeableto
handlefutureextracosts
Marketsignalling:studieshaveshownthattotalstockpricesdeclinewith30%ofthenew
issuedequityandviceversa(permanent)marketsignalling:sailofextraequitysignals
investorsthatmanagementisconcernedforthefuturefirmstryfirsttointernallyfinanceto
avoidunnecessarysignalling
Managementincentives:(aansporing):debtcanbeaverystrongincentive,management
doesntdoesitsbesttheycouldlosetherebusiness(jobs)

Thefinancingdecisionandgrowth

Rapidgrowth
Maintainconservativeleverageratiowithunusedborrowingcapacity
Modestdividendpayoutsinternalfinancingofgrowth
Cash,marketablesecurityasbufferliquidityinvestmentexceedsinternalsources
Externalfinancingdebtonlyuntilleverageratiothreatensflexibility
Sellequityratherthenrestrictaccesstofinancialmarketsreducegrowthonlywhenno
alternative

Lowgrowth

Easyfinancialdecisionsbecauseonlyproblemishowtogetridoftheexcesscashcreatevaluefor
theownersbyaggressivedebtfinancinguseproceedstorepurchaseshares
Increasedtaxshield(reducetaxes)
Positivemarketsignal(
Highfinancialleverageincreasesthemanagementincentive

Selectingamaturitystructure

Minimumriskmaturitystructureoccurswhenthematurityofliabilitiesequalsthatofthe
assetscashgeneratedbyoperationsovertheyearsshouldbesufficienttorepayexistingliability
Maturityislessthentheassetsriskofrefinancing:maturingliabilitieshavetobepaidwith
newlyraisedcapital.
Maturitylongerthentheassets:extramarginofsafety+excesscash

Cantalwaysusetheperfectmaturity
Unacceptableterms
Reduceborrowingcosts
Debthasanadvantagewithinflationonlywheninflationisunexpectedelseitiscompensatedforin
theinterest
15

Chapter7discountedcashflowtechniques

Companyfuturedependsontheinvestmentsoftoday
Keyaspectiscapitalbudgeting:processoffinancialevaluationofinvestmentproposals

Discountedcashflowtechniques:relevantwheneveracompanycontemplatesanactionentailingcosts
orbenefitsthatextendbeyondthecurrentyear
Valuingstocksandbonds,divisions,companies
Choosingcompetingproducttechnologies
Etc

Figuresofmerit

Financialevaluation
Estimateofrelevantcashflows
Figureofmeritoftheinvestment:numbersummarizinganinvestmenteconomicworth
Comparefigureofmerittoanacceptancecriterion:standardofcomparison

Figuresofmerit
Paybackperiod:timetorecouptheinitialinvestment
o Problem:insensitivetotheperiodafterthat
Accountingrateofreturn
o

average cash inf low annual

cashoutflow total

o Problem:insensitivetotimingofcashflow

Timevalueofmoney
Adollartodayisworthmorethenadollarinayear
Inflation:reducesthepurchasepowerofonedollarinthefuture
Uncertaintyofreceiptriseswhenreceiptdateisfurtherinthefuture
Opportunitycost:returnonecouldearnonthenextbestalternativecashreceivedinthe
futurecouldalreadybeusedininvestmentsifreceivedtoday

Becauseofthisnocashflowsoccurringatdifferentdatescanbejustaddedupbeforeadjustedby
Compounding:processofdeterminingthefuturevalueofapresentsum

Discounting:processoffindingthepresentvalueofafuturesum

Presentcashisequivalenttofuturecash

Netpresentvalue(NPV)

1$

(1$ + 1$ discountrate ) period

NPV = cash inf low present,value cashoutflow present,value

Importanttocalculateifaninvestmentwilladdvaluetoyourcompanyinthefuture

Benefitcostratio(BCR):profitabilityindex

BCR =

cash inf low present,value

Higherthen1isgood
cashoutflow present,value

Internalrateofreturn(IRR)
MostpopularformofmeritandcloselyrelatedtoNPVisthediscountrateatwhichheNPVis0
16

Determiningtherelevantcashflows

Relevantcashflow

Cashflowprinciple:recordinvestmentcashflowswhenthemoneyactuallymovesnotwhen
theaccountantsaytheyoccur
Withwithoutprinciple:image2worlds,theonewiththeinvestmentmadeandonewithoutall
cashflowsthataredifferentintheseworldsarerelevant

17