Week 1 – Introduction

Financial Manager
Treasurer: oversees cash management, credit management, capital expenditure and financial
planning
Accountant or controller oversees taxes, cost accounting, financial accounting, and data processing

CFO and corporate treasurer involved in cash, credit, and financial planning

Investment decisions
 Most important
 Capital budgeting is the process of planning and managing a firm’s long-term investments:
o What long term investments or projects?
o Size, timing, and risk of future cash flows
o Irreversibility, chance of failure, cash, and resource commitments
 These decisions:
o Determines nature of firm
 Guides in terms of financing
o Bad investment = failure of business

Financing decisions
 Capital structure is the mixture of debt and equity
 Determines how should we pay for our assets?
 What are the least expensive sources of funds?
o Internal
o External
 Distribute money  how?

Working capital management

 Day-to-day cashflows for operation and how we manage them
o How much cash and inventory should we keep on hand?
o What terms are we providing credit to customers (accounts receivable)
o How are we covering short-term financing needs?
 Difference between firm’s short-term assets and liabilities

Business organisations and legal forms

1. Sole proprietorships
2. Partnerships
a. General partnerships
b. Limited partnerships
3. Corporations

 Costly to change types later on

Sole proprietorships
Advantages Disadvantages
 Owned by 1 person  Limited to life of owner
 Easiest to start  Equity capital equal to owner’s
 Least regulated personal wealth
 Owner keeps all profits  Unlimited liability
 Taxed once as personal income  Difficult to sell ownership interest

E.g. Restaurants, small retailers, corner stores

Partnerships
Advantages Disadvantages
 Two or more owners  Unlimited liability for all partners for all
 More capital available debts incurred by the partnership
 Easy to start  Partnership dissolves once someone
 Income taxed once as personal dies or wishes to sell
 Difficult to transfer ownership

E.g. Lawyers, doctors, accountants, consulting

General partners
 “regular” partnership
 Run the firm on a day-to-day basis

Limited partners (“silent partners”)

 Limited liability – cannot lose more than initial investment
 No management authority and cannot legally be involved in managerial decision making

E.g. Financial investment (hedge funds)

Corporations
Advantages Disadvantages
 Corporations are their own entity (can  More complicated and costly to setup
own property – be sued) and run - high compliance fees
 Limited liability by owners  Requires constitution
 Unlimited life  Taxation of company profits – double
 Separation of ownership and taxation
management  Agency problems
 Transfer of ownership is easy
 Easier to raise capital

E.g. Large firms, multinational

Prevalence of different legal forms

  Corporations have higher revenues whereas there are more sole prop
Taxation
 Corporate tax rates are flat (Australia flat 30%, preferential rate 27.5%)
 Personal tax rates are mostly progressive (increases with income)
o Marginal tax rate applies to the last (next) dollar earned
o Tax brackets are income ranges for which the marginal rate is the same
o Average or effective tax rate is total taxes over total income

Goal of Financial Management

 Maximise the current wealth of the existing owners/shareholders
o Maximise share price

The Firm and Society (other stakeholders)

 Decisions that increase the value of the firm’s equity can benefit society
o Value creation through innovation, productivity increases
 Someone might be worse off as a consequence. If negatives outweigh positives, society as a
whole loses
o Costs imposed on outsiders or stakeholders other than owners are called
externalities

E.g. Environmental damage (fishing, oil spills), job losses

Agency relationships
 Owner hires someone else to manage business  may lead to conflict of interests

Agency problems
 Conflict of interest between principal and agent

Agency costs
 Costs to the principal from the relationship
o Direct: Losses due to differing goals
o Indirect: Costs due to monitoring the agent or creating mitigation mechanisms

Financial markets
Primary markets
 Company issues new securities to investors
 Securities entitle investors to certain cash flow or, sometimes, ownership rights in the future
 the company receives funds from investors NOW

Secondary markets
 Existing securities are transferred between investors
 Issuing company does not receive any more funds
 2 Types:
o Centralized auction markets like stock markets for publicly listed shares
 o Decentralized over the counter (OTC) markets for corporate debt instruments
(where dealers trade with each other and with customers for profit as part of a loose
network)

Week 1 - Time Value of Money

Time Value of Money
 forgo consumption today and invest/lend instead
 compensation for waiting
 interest rate is the price (in percent per year) you charge the borrower for delaying
consumption and waiting to get your money back
 true even in the absence of inflation or default risk

Interest rates
 transform/convert an amount of money at one point in time into money at another point in
time
 Compounding is the process of “moving” a cash flow forward through time
 Discounting is “moving” it backwards

Compound interest
 Adding interest overtime
 Next period  the whole balance
 Interest on interest

Discounting & Present Value

 Discount at rate r by dividing (1+r)

Required interest rate (rate of return)

 Rate an investment needs to grow to achieve a certain financial goal

Real vs. nominal rates of return

 Inflation is the loss of purchasing power over time
 Nominal interest rate is the rate at which nominal value grows over time
o not “richer”
 Real interest rate is the rate which your purchasing power grows or shrinks

Week 2 – Corporate debt securities & Valuing multiple cash flows

Corporate debt financing
 Short- and long-term debt financing

Long-term
 Bank loans (typically 3-15 years): very senior to other forms of financing
 Bank line of credit (revolving credit facility; “revolver”) functions a bit like a credit card:
maximum borrowing amount; flexible use (typically renewed every few years)
 Corporate bonds (often 5-10 years), issued to mostly institutional investors
 Preferred shares (often without maturity): hybrid between debt and equity
Short-term
 Discount securities (maturities of 90-365 days) based on the exact same principle: Promise
to pay back face value F in T days, borrow PV(F) today. Discount based on linear, simple
interest.
– (bank-accepted) bills of exchange
– Promissory notes
– Certificates of Deposit (issued by banks only)
 Bank overdraft (just like for your checking account)
 Accounts receivable financing by selling A/R outright or borrowing against them
 Trade Credit from a supplier (accounts payable to you

Week 3 – Equity Valuation

SHARE MARKETS
Common Equity (Ordinary Shares)
Key properties
 Ownership rights
 Right to vote at annual meetings
 Residual cash flows to whatever is left after the bills
 Limited liability: shares can only sink to $0. No obligation for extra money

Common dividend
 Some companies decide to pay out profits via dividends, no obligation
 Once declared it must be paid
 Dividends are non-tax deductible. Come out of after-tax profits

Preferred or preference shares

 Hybrid class of securities with payments (dividends)
 Rank ahead of common equity, but behind all other forms of debt in bankruptcy
 Similar to debt
o Payments are fixed
o Maturity dates and call dates
o No participation in upside of firm
o No voting rights
 Similar to equity
o Sometimes, no maturity date
o company can suspend the preferred dividends without triggering default
 All types: common dividends cannot b e paid until all owed preferred
dividend have been paid
 Cumulative shares – all missed payments need to be made up
 Non-cumulative shares – previously missed payments are “forgotten”

Financial intermediaries
 Dealers (investment bank trading desks)
o Ready to buy or sell at anytime
o Act as principals (trade on own account)
o No fiduciary duty (not your friend – trying to give you a bad price)
  Brokers (facilitate client access to market)
o Not counterparts in trading, act as agents
o Have some fiduciary duty
o Give you a good price

Bid refers to price people want to pay. Ask refers to price people want to sell.

SHARE VALUATION MODELS

How to value shares?
 Intrinsic valuation approach  estimate future cash flow, take PV, price pay today
o Dividend discount model (DDM) – constant, growing, 2-stage
o Discounting cash flow (DCF) models
o Free cash flow (FCF) analysis
 Valuation based on multiple and comparable firms
o Price to sales (P/S), enterprise value to EBITDA, price earnings (P/E)

Dividend Discount Models

Asset Pricing 101
 Value of asset should be equal to present value of all future, expected cash flows. (annuities,
loans, bonds, and shares)

The Market in equilibrium

 If market shows a price below p0  traded at a discount  more people will buy shares,
increasing demand which leads to increased price
 If market shows a price above p0  additional selling by investors to invest in other shares

The trade-offs in payout policy

 Dividend payout ratio is the share of earning that are distributed to shareholders
 In order to grow earnings, the firm must increase the payout ratio. This is at the expense of
pay more dividends, investing less which decreases earnings. OR decrease the shares
outstanding.

LIMITATIONS OF DIVIDEND DISCOUNT MODELS

Limitations of the DDM
 Applicability
o Firms that do not pay any dividend cannot be valued this way
o Firms with volatile dividends cannot be valued this way as assumptions are pointless
 Any model cannot be better than its inputs:
o The GiGo principle applies: “Garbage in, garbage out”
o Growth rates are uncertain – especially further into the future
o Discount rates are subject to volatility
 Bad behaviour when g is close to r
o Stock price explodes
SHARE VALUTION USING MULTIPLES
Valuation based on multiples/comparables
Step 1: Find a number of peers (comparable companies with similar characteristics)
 Industry, growth rate, size

Step 2: Collect data on several valuation metrics (ratios of firm to measure firms cash flow)
 Price/earnings, price/shares, ev/EBITDA
 Price/book

Step 3: Apply peer valuation metrics to target

 Compute average metrics of peer group and apply that ratio to target firm

Common Valuation Metrics

 Price-earnings (P/E) Ratio
o Share price divided by earnings per share (EPS)
o Based on trailing or forward earnings
 Price/Sales Ratio
o Market capitalisation (share price x #shares) divided by total revenue
 EV/EBITDA
o Enterprise value over “earnings before everything”
o EV = Market Cap PLUS total debt MINUS cash
 Price/Book
o Market cap divided by book value of equity

Enhanced valuation metrics

 PEG Ratio
o P/E Ratio divided by the earnings growth rate (averaged over 5 years)
o Could be expected or historical
o < 0.5 is attractive, >2 is unattractive
o Concept of GARP = “growth at a reasonable price”
o Balance expensiveness with growth prospects
o Both growth as well as value stocks could look cheap

Limitations of Multiples
 No clear guidance about how to adjust for differences in future growth, risk, or differences in
accounting policies
 Young companies have no history of earnings/dividends, there is a lack of suitable metrics
 Different valuation metrics provide different answers
 Information regarding the value of a firm relative to other firms in the comparison set
o Using multiples will not help us determi9ne entire industry is overvalued

Week 4 – Investment Decision Making

The capital budgeting process
  Concern with the generation, evaluation and selection of investment proposals, the
management of capital expenditures during the implementation as well as control and audit
functions later on
1. Identity and forecast relevant cash flows
2. Establish investment decision rules
3. Apply investment decision rules to select the best project

A framework for projects

 Independent project does not affect another project’s cash flow.
o Accepting/rejecting one does not affect the decision to accept/reject another
 Interdependence among projects can take several forms
o Budget constraints mean that there is limited capital for all projects at once.
Projects need to ranked and chosen to maximise overall wealth creation
o Mutually exclusive projects – accepting one requires the rejection of all others, e.g.
due to the indivisibility or exclusive use or resources

NET PRESENT VALUE

 NPV is the sum of the present value of all cash flows that arise from the project over time

Net Present Value Decision Rule

 NPV measures the $ value that is “added today” by investing in the project
 Accept projects with NPV > 0
 Reject projects with NPV < 0
 Choose the highest NPV

Which discount rate to use?

1. Most common: When a firm considered a new project, it often uses a firm-wide cost of
capital. You will often hear the word hurdle rate.
2. More correct: The discount rate should adequately reflect the risk involved in executing the
project on a stand-alone basis, regardless of the cost of capital of the firm. It could be
inferred by looking at opportunities with similar risk.

INTERNAL RATE OF RETURN

IRR decision rules
 Standard cash flows
o Accept the project if IRR > required rate of return
o Reject the project if IRR < required rate of return
 Bad idea to use the IRR
o Rely on the IRR for projects with non-standard cash flows
o Rely on IRR to choose the best among multiple projects
Is the IRR rules a good decision rule?
Pros
 IRR and NPV rules give the same
answer
 IRR intuitively appealing, easy to
communicate
 IRR provides a margin of error: If IRR is
high, we don’t need to know the
required rate exactly
Cons
 Non-standard cash flows make the IRR
rule unusable
 IRR may not correctly rank competing
projects
 Focuses on return and cannot capture
differences in scale of project

ALTERNATIVE MEASURES
Payback Period
 Look slide for example

Limitations of the Payback Period

 Not very scientific: ignores time value of value/cost of capital
 Does not consider cash flows after the payback period is reached
 Does not consider scalability or returns
 How to choose the cut-off time
 Tilts towards early payback, liquidity

Profitability Index (PI)

 Profitability index or benefit-cost ratio and is simply the ratio of the PV of future cash flows
relative to upfront costs

Limitations of PI
 Closely related to NPV, but …
o PI ignores scale: smaller, lower ranked project can still increase NPV
o Projects can lumpy so that all possible combinations have to be tried
o In case of multiple resource constraints, this 1D ranking breaks down

Equivalent Annual Annuity

 The level of annual cash flow that has the same present value as the cash flows of a project
over the same horizon

Comparison of NPV, IRR and EAA

 NPV measures a total benefit ⇒ favours a large scale, long-lasting investment (metal toaster)
 IRR favours high average returns relative to the initial cost and favours a cheap purchase
with high returns relative to cost, even if those returns only occur for a short period of time
 Neither measure considers an average $ benefit per year
 Neither measure is able to incorporate the cost from frequently having to replace the
investment
  EAA has these characteristics by assuming that you will repeatedly invest in the same project
again after the last one ends. On an amortized per-year basis, the “Plastic Plus” toaster is
best

EAA analysis
 Required life
 Replacement cost

Week 5 – Cash Flows

INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS
Statement of financial position (Balance Sheet)
 Important insights:
o Shareholder equity = Assets – Liabilities
 Residual value = whatever is left over
o Leverage ratio = Debt / Equity
 Leverage amplifies gains and losses
 High ratio sign of risk or even financial distress

Net working capital

 Net working capital = current assets – current liabilities
 Converts into cash minus what needs to be paid out within 12 months
 NWC > 0 typically seen as a measure of financial health  positive good
 NWC >> 0 can be sign of problems  exceeds a lot = bad
o Unsold inventories or overdue A/R  write downs
o Too much cash, not used efficiently for investments, financed by LT liabilities
 NWC < 0 means that there is a short-term need for additional financing  liquidity problems
 Optimal “choice” of NWC represents a trade-off between efficiency and financial risk

Book vs. Market value

 Most accounting standards require assets to be held at historical cost (minus depreciation)
 Market value = what is something worth today to an arm’s length buyer
 Book values can be far removed from market values
o Assets rise in value over time
o Volatile market price
o If paid a lot more than book value, record difference under goodwill
o Asset write-downs bring values closer to market value
 Market to Book ratio gives idea of difference

Statement of Profit or Loss (Income Statement) – what happened in a year

 Summary of a firm’s financial performance over some period
 Profit = Revenue MINUS Cost
 Variations of Profit / Income
o EBITDA (Earnings before interest, taxes, depreciation, and amortisation)
o EBIT
o Net Profit
 Use of net profit:
 o Payouts
o Retained earnings

Principles for income statements

 Accounting standards:
o Recognition principle: recognise revenue and cost when it accrues (when sale is
made not when cash is received)
o Matching principle: attribute the cost of producing revenue in the same period
 COGS is sales not production
 Costs
o Fixed vs. Variable
o Accountants (COGS and period costs (salaries)

Cash vs. non-cash items

 Non-cash items affect income but not actual cash flow (depreciation, write downs)
 Measures of “actual cash flow”:
o Operating cash flow = cash generated by operating activities
o Free cash flow = cash available to shareholders to either reinvest or payout
o No complete agreements on definition
o Statement of cash flows is different – separate net change in cash due to operating,
investing, and financing activities

Discrepancy between Earnings and Cash Flow

Accounting-based earnings
 All sales (including credit)
 Includes COGS but not produced
 Deduct depreciation but ignores CAPEX
Cash Flows
 Includes only cash sales and costs
 Deducts increase in inventory
 Includes CAPEX but ignores
depreciation

PROJECT CASH FLOWS

Relevant Cash Flows in a Project
 Consider any and all cash flows as a consequence of accepting the project
o These cash flows are called incremental cash flows  don’t need to model cash
flows of the cash flows of existing firm
 Common items:
o Sunk costs: accrued / committed in past  NO!
o Opportunity costs: lost options / alternative uses  YES!
o Side effects: benefits / costs to other operations as a consequence of the project
(cannibalisation of sales)  YES!
o Changes in NWC: e.g. higher inventory  YES!
o Additional financing costs NO! – not part of investment decision
o Taxes are real cash flows YES!

Pro Forma Financial Statements  projection over years

 Derived under assumptions and hypothetical conditions for the future
  Has focus on income statement and cash flow projections
 Incremental cash flows (FCF): what is left to the capital providers of the projects after all bills
are paid (WC and CAPEX)

Cash Flow Types & Timing

Figure 9.1

Are these incremental cash flows?

 Refer to week 5 slides

Changes in NWC
 Cash – is additional cash required to sustain turnover?
 A/R – is it going up as a consequence of project?
 A/P – “^”
 Inventory – is additional inventory being held

Depreciation
 Prime cost (straight line) deprecation
o D = (initial cost – salvage) / number of years
o To zero for tax purposes
 Diminishing value depreciation
o Multiply percentage by the written down value at the beginning of year
o In final year, full dep. Is 0
 What type of assets can be depreciated over X years and Y rates – ATO

Net capital spending

 New purchases of fixed assets MINUS proceeds from sale of fixed assets
o What you buy minus what you sell
 Period 0 – buy stuff

E.g. New machinery for project, major repairs, replacing old machine which is sold and tax
implications

After-tax salvage
 If salvage is different to book value, there is a tax effect

Evaluating NPV estimates

 If there is a positive NPV, need to consider:
o Scenario analysis
 “what if?” optimistic and pessimistic scenario
o Sensitivity analysis
 How sensitive is NPV to changes in ONE variable – more sensitive means
greater risk
o Consider sources of net value add:
 Why should this project create value?
  Degree of competition

Disadvantages of scenario/sensitivity analysis

1. No indication of project expected return is sufficient to compensate for risk
2. Measure only stand-alone risk – not most relevant risk in capital budgeting
Making a decision
 Analysis paralysis
 Make a decision at one point
 Majority of scenarios may have positive NPV – accept project
 If crucial variable leads to negative NPV with small changes in estimate, forgo project

Week 7

Week 8 – Capital Structure

Measuring capital structure
 Capital structure is the composition of the funding of the firm – distribution of sources
funding firm
o Leverage = use of debt in capital structure
o Debt to equity ratio
o Debt to asset ratio
 Capital restructuring = changing the amount of leverage without changing the firm’s assets
o Increase leverage by issuing debt and repurchasing outstanding shares
o Decrease by issuing new shares and retiring outstanding shares
o Manipulate debt

Equity vs. Debt

 Reasons for equity:
o Cheap in short-term as there are no required payouts
o Expensive in the long-term for shareholders
 Dilution of issuing additional shares lead to EPS decreasing
 Reasons for debt:
o Use other people’s money to be able to control more assets
o Other than fixed payments, no additional participation in upside of firm (cheap)
o Amplification of good economic outcomes  good earnings
 Downsides of debt:
o Amplification of bad economic outcomes
o Adds financial risk
o Chance of bankruptcy and loss of ownership

Unlevered (pure equity) vs Levered firms (has debt)