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.
2.

On what projects should funds be spent?

(investment decisions)
From where should the funds be obtained?
(financing decisions)

Topics to be Covered
A. Financial planning

Projection of future cash flows

Need for capital

B. Valuation

1.

How much is company worth?

How much equity must be given up to raise required capital?

C. Sources of funding for entrepreneurs

2.

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 = CFt/(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
o

What is the appropriate multiplier?

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

Debt
Equity

1.
2.

Angels
Venture Capitalists
Strategic partners

Two Fundamental Problems

1.

2.

Information asymmetry
Entrepreneur has better information than investor

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