Individual Assignment on Intermediate Financial Management

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Individual Assignment on Course of

Intermediate Financial Management
Prepared by ID No

Feyissa Taye MGMTPGW/011/13

Submitted to: Dr. Ermias M. (PHD)

Woliso, Ethiopia
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Chapter review
Chapter review Assignment on “CORPORATE VALUATION-FINANCIAL PLANNING
AND VALUE BASED MANAGEMENT”.
1.Financial planning is an important aspect of the firm’s operations because it provides road maps
for guiding, coordinating, and controlling the firm’s actions to achieve its objectives. Two key
aspects of the financial planning process are cash planning and profit planning. Cash planning
involves preparation of the firm’s cash budget. Profit planning involves preparation of pro forma
statements. Both the cash budget and the pro forma statements are useful for internal financial

planning. They also are routinely required by existing and prospective lenders. The financial
planning process begins with long-term, or strategic, financial plans. These plans, in turn, guide
the formulation of short-term, or operating, plans and budgets. Generally, the short-term plans and
budgets implement the firm’s long-term strategic objectives.

THE SALES FORECAST

The key input to the short-term financial planning process is the firm’s sales forecast. This
prediction of the firm’s sales over a given period is ordinarily prepared by the marketing
department. On the basis of the sales forecast, the financial manager estimates the monthly cash
flows that will result from projected sales and from outlays related to production, inventory, and
sales. The manager also determines the level of fixed assets required and the amount of financing,
if any, needed to support the forecast level of sales and production. In practice, obtaining good
data is the most difficult aspect of forecasting. The sales forecast may be based on an analysis of
external data, internal data, or a combination of the two.

An external forecast is based on the relationships observed between the firm’s sales and certain
key external economic indicators such as the gross domestic product (GDP), new housing starts,
consumer confidence, and disposable personal income. Forecasts containing these indicators are
readily available.
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Internal forecasts are based on a consensus of sales forecasts through the firm’s own sales
channels. Typically, the firm’s salespeople in the field are asked to estimate how many units of
each type of product they expect to sell in the coming year. These forecasts are collected and
totaled by the sales manager, who may adjust the figures using knowledge of specific markets or
of the salesperson’s forecasting ability. Finally, adjustments may be made for additional internal
factors, such as production capabilities. Firms generally use a combination of external and internal
forecast data to make the final sales forecast. The internal data provide insight into sales
expectations, and the external data provide a means of adjusting these expectations to take into
account general economic factors. The nature of the firm’s product also often affects the mix and
types of forecasting methods used.

The Financial Plan

The financial planning process has five steps:
1. Project financial statements to analyze the effects of the operating plan on projected
profits and financial ratios.
2. Determine the funds needed to support the 5-year plan.
3. Forecast the funds to be generated internally and identify those to be obtained from
external sources, subject to any constraints due to borrowing covenants, such as restrictions
on the debt ratio, the current ratio, and the coverage ratios.
4. Establish a performance-based management compensation system that rewards
employees for creating shareholder wealth.
5. Monitor operations after implementing the plan, identify the cause of any deviations,
and take corrective actions.

Sales forecasts help you set goals

Having a solid sale forecast also provides a picture of your performance and performance
milestones for potential investors. Like you, they want to be sure you have established goals and
a firm trajectory for your business laid out. The more detailed, organized, and up-to-date your
forecast is, the better you explain the position of your business to third parties and even employees.

Why Accurate Sales Forecasting Matters

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❖ A sales forecast helps every business make better business decisions. It helps in overall
business planning, budgeting, and risk management.
❖ Sales forecasting allows companies to efficiently allocate resources for future growth and
manage its cash flow.
❖ Sales forecasts help sales teams achieve their goals by identifying early warning signals in their
sales pipeline and course-correct before it’s too late
❖ Sales forecasting also helps businesses to estimate their costs and revenue accurately based on
which they are able to predict their short-term and long-term performance.

2.The combined effect of all the changes in credit policy is a projected corresponding changes on
the projected balance sheet -the higher sales would necessitate somewhat larger cash balances,
inventories, and, depending on the capacity situation, perhaps more fixed assets. Accounts
receivable would, of course, also increase. Because these asset increases would have to be
financed, certain liabilities and/or equity would have to be increased. higher sales must be
supported by additional assets, (2) some of the asset increases will be financed by spontaneous
increases in accounts payable and accruals, and by retained earnings, but (3) any shortfall must be
financed from external sources, using some combination of debt, preferred stock, and common
stock. Assuming that a company qualifies, many believe that listing is beneficial to the company
and to its shareholders. Listed companies receive a certain amount of free advertising and publicity,
and their status as listed companies may enhance their prestige and reputation, which often leads
to higher sales. Investors respond favorably to increased information, increased liquidity, and the
confidence that the quoted price is not being manipulated. Higher sales require more labor, and
higher sales normally result in higher taxable income and thus taxes. Therefore, accrued wages
and taxes both increase as sales increase. Also, in response to increasing sales, the firm’s accruals
increase as wages and taxes rise because of greater labor requirements and the increased taxes on
the firm’s increased earnings. There is normally no explicit cost attached to either of these current
liabilities, although they do have certain implicit costs. In addition, both are forms of unsecured
short-term financing, short-term financing obtained without pledging specific assets as collateral.
The firm should take advantage of these “interest-free” sources of unsecured short-term financing
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whenever possible .i.e. Accounts payable are the major source of unsecured short-term financing
for business firms.

Dividends are not the only means by which firms can distribute cash to shareholders. Firms can
also conduct share repurchases, in which they typically buy back some of their outstanding
common stock through purchases in the open market. In addition to increasing its dividend payout,
If we generalize the lessons about payout policy, we may expect the following to be true:

1. Rapidly growing firms generally do not pay out cash to shareholders.

2. Slowing growth, positive cash flow generation, and favorable tax conditions can prompt firms
to initiate cash payouts to investors. The ownership base of the company can also be an important
factor in the decision to distribute cash.

3. Cash payouts can be made through dividends or share repurchases. Many companies use both
methods. In some years, more cash is paid out via dividends, but sometimes share repurchases are
larger than dividend payments.

4. When business conditions are weak, firms are more willing to reduce share buybacks than to
cut dividends. One type of dividend policy involves use of a constant payout ratio. The dividend
payout ratio indicates the percentage of each dollar earned that the firm distributes to the owners
in the form of cash. It is calculated by dividing the firm’s cash dividend per share by its earnings
per share. With a constant-payout-ratio dividend policy, the firm establishes that a certain
percentage of earnings is paid to owners in each dividend period.

The problem with this policy is that if the firm’s earnings drop or if a loss occurs in a given period,
the dividends may be low or even nonexistent. Because dividends are often considered an indicator
of the firm’s future condition and status, the firm’s stock price may be adversely affected.

GROSS PROFIT MARGIN

The gross profit margin measures the percentage of each sales dollar remaining after the firm has
paid for its goods. The higher the gross profit margin, the better (that is, the lower the relative cost
of merchandise sold). The gross profit margin is calculated as
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Gross profit margin = Sales - Cost of goods sold

Sales

OPERATING PROFIT MARGIN

The operating profit margin measures the percentage of each sales dollar remaining after all
costs and expenses other than interest, taxes, and preferred stock dividends are deducted. It
represents the “pure profits” earned on each sales dollar. Operating profits are “pure” because they
measure only the profits earned.

NET PROFIT MARGIN

The net profit margin measures the percentage of each sales dollar remaining after all costs and
expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher
the firm’s net profit margin, the better. The net profit margin is calculated as

Net profit margin= Net Income available for common stockholders

Sales

Average payables period (APP) evaluates how quickly the firm pays off its suppliers and is
calculated by dividing accounts payable by average daily operating cost to find the number of
days’ costs that have not yet been paid. Average daily cost of goods sold can also be used in the
denominator.

APP =Average payables period= Payables

Annual operating cost/365

or

Average COGS per day

Annual COGS/365

3.Overview of Corporate Valuation

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The corporate valuation model can be used to calculate the total value of a company by finding
the value of operations plus the value of nonoperating assets. corporate valuation model, which
is the present value of expected future free cash flows, discounted at the weighted average cost of
capital. In a sense, the corporate valuation model is the culmination of all the material covered thus
far, because it pulls together financial statements, cash flows, financial projections, time value of
money, risk, and the cost of capital. Finally, the decisions companies make regarding the above
inputs into the corporate valuation model often depend on each company’s corporate governance,
which is the set of laws, rules, and procedures that influence its operations and the decisions made
by its managers. This chapter addresses all of these topics, beginning with corporate valuation.

As stated earlier, managers should evaluate the effects of alternative strategies on their firms’
values. This really means forecasting financial statements under alternative strategies, finding the
present value of each strategy’s cash flow stream, and then choosing the strategy that provides the
maximum value. However, that model is often unsuitable for managerial purposes. For example,
suppose a start-up company is formed to develop and market a new product. Its managers will
focus on product development, marketing, and raising capital. They will probably be thinking
about the sale of the company to a larger firm. For the managers of such a start-up, the decision to
initiate dividend payments in the foreseeable future will be totally off the radar screen. Thus, the
dividend growth model is not useful for valuing most start-up companies. Fortunately, the
corporate valuation model does not depend on dividends, and it can be applied to divisions and
subunits as well as to the entire firm.

The corporate valuation model shows how corporate decisions affect shareholders. However,
corporate decisions are made by managers, not shareholders, and maximizing shareholder wealth
is not the same as individual managers maximizing their own “satisfaction.” Thus, a key aspect is
making sure that managers focus on the goal of shareholder wealth maximization. The laws, rules,
and procedures that influence a company’s operations and motivate its managers fall under the
general heading of corporate governance.

Finally, the decisions companies make regarding the above inputs into the corporate valuation
model often depend on each company’s corporate governance, which is the set of laws, rules, and
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procedures that influence its operations and the decisions made by its managers. This chapter
addresses all of these topics, beginning with corporate valuation.

The Corporate Valuation Model

Corporate assets are of two types: operating and nonoperating. Operating assets, in turn, take two
forms: assets-in-place and growth options. Assets-in-place include tangible assets such as land,
buildings, machines, and inventory, plus intangible assets such as patents, customer lists,
reputation, and general know-how. Growth options are opportunities to expand that arise from the
firm’s current operating knowledge, experience, and other resources. The assets-in-place provide
an expected stream of cash flows, and so do the growth options.

Most companies also own some nonoperating assets, which come in two forms. The first is a
marketable securities portfolio over and above the cash needed to operate the business.

Comparing the Corporate Valuation and Dividend Growth Models

Because the corporate valuation and dividend growth models give the same answer, does it matter
which model you choose? In general, it does. For example, if you were a financial analyst
estimating the value of a mature company whose dividends are expected to grow steadily in the
future, it would probably be more efficient to use the dividend growth model. Here you would
only need to estimate the growth rate in dividends, not the entire set of pro forma financial
statements.

However, if a company is paying a dividend but is still in the high-growth stage of its life cycle,
you would need to project the future financial statements before you could make a reasonable
estimate of future dividends. Then, because you would have already estimated future financial
statements, it would be a toss-up as to whether the corporate valuation model or the dividend
growth model would be easier to apply Actually, even if a company is paying steady dividends,
much can be learned from the corporate valuation model; hence many analysts today use it for all
types of valuations. The process of projecting the future financial statements can reveal quite a bit
about the company’s operations and financing needs, and can provide insights into actions that
might be taken to increase the company’s value.
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Two widely used DCF methods are (1) the corporate valuation method and (2) the
equity residual method, which is also called the free cash flow to equity method.

4.Value-based management- projected statements used to estimate the effects of different plans
on stock price. In general, activist investors with large blocks in companies have been good for all
shareholders. They have searched for firms with poor profitability and then replaced management
with new teams that are well-versed in value-based management techniques, thereby improving
profitability. Not surprisingly, stock prices usually rise when the news comes out that a well-
known activist investor has taken a major position in an underperforming company.

An agency conflict refers to a conflict between principals and agents. For example, managers, as
agents, may pay themselves excessive salaries, obtain unreasonably large stock options, and the
like, at the expense of the principals, the shareholders.

Conflicts between Shareholders and Creditors

Creditors have a claim on the firm’s earnings stream, and they have a claim on its assets in the
event of bankruptcy. However, shareholders have control (through the managers) of decisions that
affect the firm’s riskiness. Therefore, creditors allocate decision-making authority to someone else,
creating a potential agency conflict. Creditors lend funds at rates based on the firm’s perceived
risk at the time the credit is extended, which in turn is based on (1) the risk of the firm’s existing
assets, (2) expectations concerning the risk of future asset additions, (3) the existing capital
structure, and (4) expectations concerning future capital structure changes. These are the primary
determinants of the risk of the firm’s cash flows, hence the safety of its debt. A similar situation
can occur if a company borrows and then issues additional debt, using the proceeds to repurchase
some of its outstanding stock, thus increasing its financial leverage. If things go well, the
shareholders will gain from the increased leverage. However, the value of the debt will probably
decrease, because now there will be a larger amount of debt backed by the same amount of assets.
In both the asset switch and the increased leverage situations, shareholders have the potential for
gaining, but such gains are made at the expense of creditors.

Conflicts between Inside Owner/Managers and Outside Owners

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If a company’s owner also runs the company, the owner/manager will presumably operate it so as
to maximize his or her own welfare. This welfare obviously includes the increased wealth due to
increasing the value of the company, but it also includes perquisites (or “perks”) such as more
leisure time, luxurious offices, executive assistants, expense accounts, limousines, corporate jets,
and generous retirement plans. However, if the owner/manager incorporates the business and then
sells some of the shares to outsiders, a potential conflict of interest immediately arises This agency
problem causes outsiders to pay less for a share of the company and require a higher rate of return

Conflicts between Managers and Shareholders

Shareholders want companies to hire managers who are able and willing to take legal and ethical
actions to maximize intrinsic stock prices. This obviously requires managers with technical
competence, but it also requires managers who are willing to put forth the extra effort necessary
to identify and implement value-adding activities. However, managers are people, and people have
both personal and corporate goals. Logically, therefore, managers can be expected to act in their
own self-interests, and if their self-interests are not aligned with those of shareholders, then
corporate value will not be maximized.

5.Board of directors Group elected by the firm’s stockholders and typically responsible for
approving strategic goals and plans, setting general policy, guiding corporate affairs, and
approving major expenditures

Monitoring and Discipline by the Board of Directors

Shareholders are a corporation’s owners and they elect the board of directors to act as agents on
their behalf. In Canada and the United States, it is the board’s duty to monitor senior managers and
discipline them, either by removal or by a reduction in compensation, if the managers do not act
in the interests of shareholders. This is not necessarily the case in other countries.

The Election Process

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The board of directors has a nominating committee. These directors choose the candidates for the
open director positions, and the ballot for a board position usually lists only one candidate.
Although outside candidates can run a “write-in” campaign, only those candidates named by the
board’s nominating committee are on the ballot. Board members typically want to retain their
positions, and they are grateful to whoever helped get them on the board. Thus, the nominating
process often results in a board that is favorably disposed to the CEO.

Voting Procedures

Voting Procedures also affect the ability of outsiders to gain positions on the board. For example,
boards can be elected by either cumulative or noncumulative voting. Under cumulative voting,
each shareholder is given a number of votes equal to his or her shares times the number of board
seats up for election.

Board Make-up

Many board members are “insiders,” that is, people who hold managerial positions within the
company, such as the CFO. Because insiders report to the CEO, it may be difficult for them to
oppose the CEO at a board meeting. The compensation of board members has an impact on the
board’s effectiveness. When board members have extraordinarily high compensation, the CEO
also tends to have extremely high compensation

Managerial Behaviour and Shareholder Wealth

There are six ways in which a manager’s behaviour might harm a firm’s intrinsic value.

1. Managers might not expend the time and effort required to maximize firm value. Rather than
focusing on corporate tasks, they might spend too much time on external activities, such as serving
on boards of other companies, or on nonproductive activities, such as golf, gourmet meals, and
travel.

2. Managers might use corporate resources on activities that benefit themselves rather than
shareholders. For example, they might spend company money on perquisites such as lavish offices,
memberships at country clubs, museum-quality art for corporate apartments, large personal staffs,
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and corporate jets. Because these perks are not actually cash payments to the managers, they are
called nonpecuniary benefits.

3. Managers might avoid making difficult but value-enhancing decisions that harm friends in the
company. For example, a manager might not close a plant or terminate a project if the manager
has personal relationships with those who are adversely affected by such decisions, even if
termination is the economically sound action.

4. Managers might take on too much risk or they might not take on enough risk. For example, a
company might have the opportunity to undertake a risky project with a positive NPV. If the
project turns out badly, then the manager’s reputation will be harmed and the manager might even
be fired. Thus, a manager might choose to avoid risky projects even if they are desirable from a
shareholder’s point of view. On the other hand, a manager might take on projects with too much
risk. Consider a project that is not living up to expectations. A manager might be tempted to invest
even more money in the project rather than admit that the project is a failure. Or a manager might
be willing to take on a second project with a negative NPV if it has even a slight chance of a very

positive outcome, because hitting a home run with this second project might cover up the first
project’s poor performance. In other words, the manager might throw good money after bad.

5. If a company is generating positive free cash flow (FCF), a manager might “stockpile” it in the
form of marketable securities instead of returning FCF to investors. This potentially harms
investors because it prevents them from allocating these funds to other companies with good
growth opportunities. Even worse, positive FCF often tempts a manager into paying too much for
the acquisition of another company. In fact, most mergers and acquisitions end up as break-even
deals, at best, for the acquiring company because the premiums paid for the targets are often very
large.

6.Corporate Governance

Corporate governance refers to the rules, processes, and laws by which companies are operated,
controlled, and regulated. It defines the rights and responsibilities of the corporate participants
such as the shareholders, board of directors, officers and managers, and other stakeholders as well
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as the rules and procedures for making corporate decisions. A well-defined corporate governance
structure is intended to benefit all corporate stakeholders by ensuring that the firm is run in a lawful
and ethical fashion, in accordance with best practices, and subject to all corporate regulations. A
firm’s corporate governance is influenced by both internal factors such as the shareholders, board
of directors, and officers as well as external forces such as clients, creditors, suppliers, competitors,
and government regulations. The corporate organization. In particular, the stockholders elect a
board of directors, who in turn hire officers or managers to operate the firm in a manner consistent
with the goals, plans, and policies established and monitored by the board on behalf of the
shareholders.

Agency conflicts can decrease the value of stock owned by outside shareholders. Corporate
governance can mitigate this loss in value. Corporate governance can be defined as the laws, rules,
and procedures that influence a company’s operations and the decisions made by its managers. At
the risk of oversimplification, most corporate governance provisions come in two forms, sticks
and carrots. The primary stick is the threat of removal, either as a decision by the board of directors
or as the result of a hostile takeover. If a firm’s managers are maximizing the value of the resources
entrusted to them, they need not fear the loss of their jobs.

On the other hand, if managers are not maximizing value, they should be removed by their own
boards of directors, by dissident shareholders, or by other companies seeking to profit by installing
a better management team. The main carrot is compensation. Managers have greater incentives to
maximize intrinsic stock value if their compensation is linked to their firm’s performance rather
than being strictly in the form of salary.

Almost all corporate governance provisions affect either the threat of removal or compensation.
Some provisions are internal to a firm and are under its control. These internal provisions and
features can be divided into five areas: (1) monitoring and discipline by the board of directors; (2)
charter provisions and bylaws that affect the likelihood of hostile takeovers; (3) compensation
plans; (4) capital structure choices; and (5) accounting control systems.

In addition to the corporate governance provisions that are under a firm’s control, there are also
environmental factors outside a firm’s control, such as the regulatory environment, block
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ownership patterns, competition in the product markets, the media, and litigation. Our discussion
begins with the internal provisions.

Individual versus Institutional Investors

To better understand the role that shareholders play in shaping a firm’s corporate governance, it is
helpful to differentiate between the two broad classes of owners: individuals and institutions.
Generally, individual investors own relatively few shares and as a result do not typically have
sufficient means to influence a firm’s corporate governance. To influence the firm, individual
investors often find it necessary to act as a group by voting collectively on corporate matters. The
most important corporate matter individual investors vote on is the election of the firm’s board of
directors. The corporate board’s first responsibility is to the shareholders. The board not only sets
policies that specify ethical practices and provide for the protection of stakeholder interests, but it
also monitors managerial decision making on behalf of investors.

Although they also benefit from the presence of the board of directors, institutional investors have
advantages over individual investors when it comes to influencing the corporate governance of a
firm. Institutional investors are investment professionals that are paid to manage and hold large
quantities of securities on behalf of individuals, businesses, and governments. Institutional
investors include banks, insurance companies, mutual funds, and pension funds. Unlike individual

investors, institutional investors often monitor and directly influence a firm’s corporate
governance by exerting pressure on management to perform or communicating their concerns to
the firm’s board. These large investors can also threaten to exercise their voting rights or liquidate
their holdings if the board does not respond positively to their concerns. Because individual and
institutional investors share the same goal, individual investors benefit from the shareholder
activism of institutional investors.

Government Regulation

Unlike the effect that clients, creditors, suppliers, or competitors can have on a particular firm’s
corporate governance, government regulation generally shapes the corporate governance of all
firms. During the past decade, corporate governance has received increased attention due to several
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high-profile corporate scandals involving abuse of corporate power and, in some cases, alleged
criminal activity by corporate officers. The misdeeds derived from two main types of issues:

➢ false disclosures in financial reporting and other material information releases and
➢ undisclosed conflicts of interest between corporations and their analysts, auditors, and
attorneys and between corporate directors, officers, and shareholders. Asserting that an
integral part of an effective corporate governance regime is provisions for civil or criminal
prosecution of individuals who conduct unethical or illegal acts in the name of the firm.

References

1. Eugene F. Brigham, Michael C. Ehrhardt, Jerome Gessaroli, Richard R. Nason

“Financial Management Theory & Practice”, 3rd Edition,
2. Lawrence J. Gitman, Chad J. Zutter “Principles of Managerial Finance” 7th Edition.