Applied Corporate Finance

class #1
Value
Capital Employed
Working Capital

Paulo Soares de Pinho

Universidade Nova de Lisboa
 What drives the value of the firm?
• Present value of the future operating (unlevered) cash-flows of the firm
– Discounted at the appropriate cost of capital
• Reflective of these cash-flows systematic risk
• Present value of tax shields from debt
• Agency Costs
– And their implications on company – lenders relationship
– Corporate Governance – including management compensation
• Bankruptcy costs
• The firm’s market communications
– Management’s ability to effectively communicate; Investor relations effort; Accounting issues
• The firm’s ESG positioning
• The firm’s market positioning
– Target clientele for the firm’s shares
– Dividend policy consistent with target clientele

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 So, is future cash flow growth that drives value?
• Let us consider a company with an invested capital of 1,000 that will not grow
• The return on invested capital is 14% (11.2% after-tax)
• The cost of capital for investors is 8%; tax rate is 20%

Year: 1 2 3 4 5 Perpt
Invested Capital 1000.0 1000.0 1000.0 1000.0 1000.0
EBIT 140.0 140.0 140.0 140.0 140.0 ROIC×IC
Taxes on EBIT 28.0 28.0 28.0 28.0 28.0
NOPLAT 112.0 112.0 112.0 112.0 112.0
Investment 0.0 0.0 0.0 0.0 0.0 No growth
Cash Flow 112.0 112.0 112.0 112.0 112.0 1400.0
Present Value: 1400.0
112
0.08
• The value of this firm is 1400, which is 400 higher than invested capital
• Somehow, in spite of not growing, this company generated substantial shareholder
value

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 So, is future cash flow growth that drives value?
• Let us make this company perpetually grow at 2% per year
• The return on invested capital is 14% (11.2% after-tax)
• The cost of capital for investors is 8%; tax rate is 20%
Year: 1 2 3 4 5 Perpt
Invested Capital 1000.0 1020.0 1040.4 1061.2 1082.4 2% growth
EBIT 140.0 142.8 145.7 148.6 151.5
Taxes on EBIT 28.0 28.6 29.1 29.7 30.3
NOPLAT 112.0 114.2 116.5 118.9 121.2
Investment 20.0 20.4 20.8 21.2 21.6
Cash Flow 92.0 93.8 95.7 97.6 99.6 1692.9
Present Value: 1533.3
99.6×1.02
0.08 -0.02
• The value of this firm is now 1533, which is 133 higher than with no growth
• Growth seems to have added value to the firm, but is not the main driver of value
creation of this firm (400 still to explain)
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 Value and Growth
• The value of the previous example firm may be expressed as:
112 − 20 IC  ROIC − g  IC
V= =
0.08 − 0.02 r−g
Where IC = invested capital and ROIC is the after tax return

• Thus, in order to create value, the firm must hold:

NOPLAT investment

IC  ROIC − IC  g ROIC − g
V  IC   IC   1 ROIC  r
r−g r−g
• Thus, the condition for value creation is not growth but rather the
company’s ability to generate a ROIC that exceeds its cost of capital

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 So, but does cash flow growth generate value?
• Let us keep this company perpetually growing at 2% per year
• The return on invested capital is now lowered to 10% (8% after-tax)
• The cost of capital for investors is 8%; tax rate is 20%

Year: 1 2 3 4 5 Perpt
Invested Capital 1000.0 1020.0 1040.4 1061.2 1082.4
EBIT 100.0 102.0 104.0 106.1 108.2
Taxes on EBIT 20.0 20.4 20.8 21.2 21.6
NOPLAT 80.0 81.6 83.2 84.9 86.6
Investment 20.0 20.4 20.8 21.2 21.6
Cash Flow 60.0 61.2 62.4 63.7 64.9 1104.1
Present Value: 1000.0

• In spite of growing, this company has created no value, being worth 1,000 exactly
the initial amount of capital invested in the firm
• By generating a return on invested capital equal to investors’ cost of capital, no value
was created by this firm (ROIC = Cost of Capital)

Paulo Soares de Pinho Applied Corporate Finance 6

 Can growth destroy value ?
• Let us keep this company perpetually growing at 2% per year
• The return on invested capital is now lowered to 8% (6.4% after-tax)
• The cost of capital for investors is 8%; tax rate is 20%
Year: 1 2 3 4 5 Perpt
Invested Capital 1000.0 1020.0 1040.4 1061.2 1082.4
EBIT 80.0 81.6 83.2 84.9 86.6
Taxes on EBIT 16.0 16.3 16.6 17.0 17.3
NOPLAT 64.0 65.3 66.6 67.9 69.3
Investment 20.0 20.4 20.8 21.2 21.6
Cash Flow 44.0 44.9 45.8 46.7 47.6 809.7
Present Value: 733.3
• This company is destroying value (733 < 1,000) by generating a return (ROIC) lower
than the investors’ cost of capital (6.4% < 8%)
• Growth in this case only contributes to value destruction: the more capital invested
at this rate the more value will be destroyed

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 Value and growth
EV Company's growth rate
1533,3 0% 1% 2% 3% 4% 5% 6%
4% 500,0 428,6 333,3 200,0 0,0 -333,3 -1000,0
Growth
Company's after-tax Return on Invested Capital

5% 625,0 571,4 500,0 400,0 250,0 0,0 -500,0

6% 750,0 714,3 666,7 600,0 500,0 333,3 0,0 destroys
7% 875,0 857,1 833,3 800,0 750,0 666,7 500,0 value
8% 1000,0 1000,0 1000,0 1000,0 1000,0 1000,0 1000,0
9% 1125,0 1142,9 1166,7 1200,0 1250,0 1333,3 1500,0
10% 1250,0 1285,7 1333,3 1400,0 1500,0 1666,7 2000,0
11% 1375,0 1428,6 1500,0 1600,0 1750,0 2000,0 2500,0
12% 1500,0 1571,4 1666,7 1800,0 2000,0 2333,3 3000,0
13% 1625,0 1714,3 1833,3 2000,0 2250,0 2666,7 3500,0
14% 1750,0 1857,1 2000,0 2200,0 2500,0 3000,0 4000,0 Growth
15% 1875,0 2000,0 2166,7 2400,0 2750,0 3333,3 4500,0 creates
16% 2000,0 2142,9 2333,3 2600,0 3000,0 3666,7 5000,0 value
17% 2125,0 2285,7 2500,0 2800,0 3250,0 4000,0 5500,0
18% 2250,0 2428,6 2666,7 3000,0 3500,0 4333,3 6000,0
19% 2375,0 2571,4 2833,3 3200,0 3750,0 4666,7 6500,0
20% 2500,0 2714,3 3000,0 3400,0 4000,0 5000,0 7000,0

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 The four cornerstones of value
• Companies create value by investing on their business capital raised from investors
in order to generate future cash-flows that produce rates of return exceeding the
cost of capital
– Value is thus a combination of today’s ROIC (versus the cost of capital) and it’s
ability to grow
• Shareholder value can only be created by increasing expected future cash-flows;
future cash flows that are not expected to change will not change today’s value
• The company’s stock market valuation changes as a direct result of changes in
investors’ expectations (prices react to new information only)
• Value of a business depends on who is managing it since different “owners” have
different ability to manage it as well as may pursue different strategies

Paulo Soares de Pinho Applied Corporate Finance 9

 Working Capital

Paulo Soares de Pinho Applied Corporate Finance 10

 Working Capital
• In Accounting, Net Working Capital (NWC) is defined as the difference
between Current Assets and Current Liabilities
• In other words, it represents the amount of current assets that was
financed by long-term funds

Fixed Assets Equity

N
W LT
Current Assets C Liabilities
Current Liabilities

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 NWC requirements and the Operating Cycle

• The firms’ operating cycle generates a corresponding cash-cycle who

determines how much working capital is required to finance the firm’s
operations
purchase sale collection

inventory receivables $

30 60 120

payables
$ NWCR
payment

Cash conversion cycle (days)

NWCR = Inventories + Receivables - Payables (+ other)

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 Rethinking the balance Sheet

Financial Assets Operating Liabilities

(Cash & Marketable Securities)
(Payables + Accruals)

Operating Assets
Financial Liabilities
(Receivables + Inventories + Accruals)
(Bank Loans, Bonds, etc)

Fixed Assets
Shareholders’ Equity

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 Reorganised balance Sheet

Net Working Capital Requirements

Net Debt
Operating Asets minus Operating
Liabilities Financial Debt minus Financial Assets

Fixed Assets
Shareholders’ Equity

Capital Employed = FA + NWCR = Net Debt + Equity

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 How does capital employed relate with company’s value?

Benefit from Capital Employed CAPITAL EMPLOYED Cost of Capital Employed

Net Debt
Future Cash Flows Capital Cost of debt (RD)
Employed RWACC
Operating Income (FA+NWCR) Equity Cost of Equity (RE)

• EV is thus the present value of the future operating cash flows generated by the firm’s operating
assets (FA+NWCR) discounted at the appropriate wacc; this is why EV = Net Debt + Equity
• Annually, the firm’s operating income (after taxes) must be sufficient to pay for the cost of funding
the company’s operating assets
• Value is only generated, on a yearly basis, if the return generated by these assets is higther than the
cost of funding them

Paulo Soares de Pinho Applied Corporate Finance 15

 EV and CE

CAPITAL EMPLOYED ENTERPRISE VALUE

Net Debt Net Debt

Capital
Employed

(FA+NWCR) Equity EV Equity

(book value)
(market
value)
Value created (cumulative NPV)

EV is the present value of the future cash flows generated

by the firm’s investment in capital employed

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 Return on Capital Employed (ROCE / ROIC)
• Also sometimes designated as return on invested capital (ROIC) measures the return
generated by the firm’s operating assets:
Operating Profit net of taxes
ROCE =
Capital Employed
• We may also compute ROCE* after tax = NOPLAT / CE
• In order to continuously being adding value, companies must generated a ROCE that
exceeds their cost of capital:
• ROCE* (after tax) > RWACC
• The annual contribution to value creation is designated EVA (Economic Value
Added), which is measured as follows:
• EVA = Operating Profit Net of Taxes* – Capital Employed × RWACC
(*) Frequently designated as NOPLAT (net operating profits less adjusted taxes)

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Working Capital and Financial Policy

18
 How much (net) Working Capital?

First, let’s disaggregate Net Debt by maturity:

Net Treasury Funding

Net Working Capital Requirements
Short Term Financial Debt minus
Financial Assets
Operating Asets minus Operating w
Liabilities C Long Term Debt

Fixed Assets
Shareholders’ Equity

Long-Term Funding

Working capital is the amount of current assets that is financed by long-term funds and
works as a financing safety net against fluctuations of NWCR and difficulties with short
term funding
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 Seasonal Company – Conservative Approach

A B Long Term Funding

Surplus
Capital Employed

Surplus
Surplus
(FA+NWCR)

Net Working Capital

Fixed Assets

time

Company employs too high volume of long term funds

Most of the time uses very expensive funds (LT debt + equity) to fund short term treasury applications
(deposits, securities) => negative margin
Extremely low (re)financing risk

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 Equilibrium

A B

Fixed Assets Fixed Assets

Long Term Long Term

Funding NWCR Funding
NWCR
Treasury
Surplus

Paulo Soares de Pinho Applied Corporate Finance 21

 Seasonal company – moderate risk
C

Capital Employed

ST Debt
ST Debt
(FA+NWCR)

ST Debt
D Long Term Funding
Net Working Capital

Fixed Assets

time
Company uses long term funding to finance permanent needs (only)
All seasonal NWCR are funded by short term debt; Permanently dependent upon renewal of short term
funding requirements
Moderate financing risk

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 Equilibrium

C D

Fixed Assets Long Term Fixed Assets

Long Term
Funding Funding
NWCR
NWCR Short Term
Funding

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 Seasonal company – high risk
E

Capital Employed
(FA+NWCR)

ST Debt
ST Debt

ST Debt
F
Fixed Assets
Negative Net Working Capital

Long Term Funding

time

Company with insufficient long term funds to support permanent capital requirements, leading to
negative net working capital; Excessively reliant on short-term funding
High refinancing risk

Paulo Soares de Pinho Applied Corporate Finance 24

 Equilibrium

E F
Long Term Long Term
Fixed Assets Funding Fixed Assets Funding

Short Term
Funding
Short Term NWCR
NWCR Funding

Negative Net Working Capital

With this policy the company permanently relies on short-term funding being extremely subject to
refinancing risk
Some of the company’s permanent needs are financed with short term funds

Paulo Soares de Pinho Applied Corporate Finance 25

 Seasonal company – balanced policy
G

ST Debt
ST Debt
Capital Employed
(FA+NWCR)

Long Term Funding

Surplus
Surplus
Net Working Capital
H Fixed Assets

time

Company sets us working capital to alternate periods on negative and positive treasury. At the bottom
of the NWCR cycle, long term-funding is excessive for NWCR needs and the company has zero ST
bank borrowings. At the top of the NWCR cycle the company partially finances temporary NWCR with
ST debt

Paulo Soares de Pinho Applied Corporate Finance 26

 Equilibrium

G H

Fixed Assets Fixed Assets

Long Term Long Term
Funding Funding
NWCR
NWCR
Treasury Surplus

Short Term Funding

With this policy the company agrees with its banks to use flexible short term bank borrowings such
as credit lines that allow it to borrow up to a certain maximum amount, to withdraw money or repay
debt as needed, paying interest only on the outstanding balance plus a fee.

Paulo Soares de Pinho Applied Corporate Finance 27

 Growth
Capital Employed
(FA+NWCR)

ST Debt
ST Debt

Surplus
time
Maintaining the original financial policy requires the firm to make long term funds to grow in line with the capital
employed in fixed assets and NWCR
That may imply dividend limitations, raising new long term loans and even new equity (in order to keep the ability to
raise new debt and maintain overall financing risk)

Paulo Soares de Pinho Applied Corporate Finance 28

 Otherwise...
Capital Employed
(FA+NWCR)

ST Debt
ST Debt Negative Net Working Capital
Working Capital

surplus

time

If long term funds do not accompany the evolution of long-term capital employed, then working capital declines
by the time until becoming negative. The company’s financial ratios deteriorate (leverage and liquidity) making it
more difficult and expensive to raise new short term debt. One day, the company’s ability to borrow stops and a
liquidity crisis may become inevitable.

Paulo Soares de Pinho Applied Corporate Finance 29

 Case-study
Dell’s Working Capital

Paulo Soares de Pinho Applied Corporate Finance 30

 Main issues
1. Is Dell’s working capital management a source of competitive
advantage?
2. How did Dell fund its 1996 growth?
3. What is the firm’s ROCE?
4. What would have happened if the company kept its 1993 cash
conversion cycle?
5. May the firm sustain a 50% growth for 1997?

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 Competitive advantage
• Dell’s inventory management has substantial advantages over competitors’:
– Quicker to respond to shifts in demand; lower storage costs
– Quicker to adapt to new technologies
– Lower risk of obsolescency of finished goods (lower write-offs)
– Reduced levels of capital employed (and corresponding funding and cost of funds)
• Dell vs Compaq in late 1995
– If Dell had the same inventory management as Compaq, the increase in capital
employed would be:
• (73 - 32) × 2,737 / 360 = $312 million (48% of Dell’s equity!)

Dell’s COGS

Compaq’s DSI Dell’s DSI

Paulo Soares de Pinho Applied Corporate Finance 32

 Balance Sheet
Year Ended
January 28, January 29, January 30,
1996 1995 1994
Current Assets:
Cash 55 43 3
Short Term Investments 591 484 334
Accounts Receivables, net 726 538 411
Inventories 429 293 220
Other 156 112 80
Total Current Assets 1 957 1 470 1 048
Property, Plant & Equipment, net 179 117 87
Other 12 7 5
Total Assets 2 148 1 594 1 140

Current Liabilities:
Accounts Payable 466 403 NA
Accrued and Other Liabilities 473 349 NA
Total Current Liabilities 939 752 538
Long Term Debt 113 113 100
Other Liabilities 123 77 31
Total Liabilities 1 175 942 669
Stockholders’ Equity:
Preferred Stocka 6 120 NA
a
Common Stock 430 242 NA
Retained Earnings 570 311 NA
Other (33) (21) NA
Total Stockholders’ Equity 973 652 471
2 148 1 594 1 140

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 Year Ended
January 28, January 29, January 30,
1996 1995 1994
Net Working Capital Requirements
Accounts Receivables, net 726 538 411
Inventories 429 293 220
Other 156 112 80
(A) Total Current Operating Assets 1 311 943 711
minus
Accounts Payable 466 403 NA
Accrued and Other Liabilities 473 349 NA
(B) Total Current Operating Liabilities 939 752 538

(C) = (A) - (B) Total Net Workig Capital Requirements 372 191 173

Property, Plant & Equipment, net 179 117 87

Other 12 7 5
(D) Total Fixed Assets 191 124 92

(C) + (D) Total Capital Employed 563 315 265

Net Treasury
Cash 55 43 3
Short Term Investments 591 484 334
(E) Total Net Treasury -646 -527 -337

Long Term Debt 113 113 100

Other Liabilities 123 77 31
(F) Total Long Term Liabilities 236 190 131

(G) Total Stockholders’ Equity 973 652 471

(H) = (F) + (G) Total Long Term Funds 1 209 842 602

(I) = (E) + (H) Total Capital Employed 563 315 265

(H) - (D) Working Capital 1 018 718 510

Paulo Soares de Pinho Applied Corporate Finance 34

 What if 1993 ratios persisted?
Year Ended
January 28,
January 29,
January 30,
1996 1995 1994 Ratio
Net Working Capital Requirements
Accounts Receivables, net 765 502 415 52
Inventories 552 357 319 47
Other 156 112 80
(A) Total Current Operating Assets 1 473 971 814
minus
Accounts Payable 599 388 NA 51
Accrued and Other Liabilities 473 349 NA
(B) Total Current Operating Liabilities 939 752 538

(C) = (A) - (B) Total Net Workig Capital Requirements 534 219 276

Property, Plant & Equipment, net 179 117 87

Other 12 7 5
(D) Total Fixed Assets 191 124 92

(C) + (D) Total Capital Employed 725 343 368

Actual Capital Employed 563 315

Difference: 162 28

ROCE 42.3%

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 ROCE
Fiscal Year 1996 1995 1994
Sales $5 296 $3 475 $2 873
Cost of Sales 4 229 2 737 2 440
Gross Margin 1 067 738 433
Operating Expenses 690 489 472
Operating Income 377 249 (39)
Taxes on Operating Income @ 40% 151 100 -16
NOPLAT 226 149 -23

Capital Employed (eoy) 563 315 265

Capital Employed (avg) 439 290

ROCE (after tax) 51,5% 51,5%

Paulo Soares de Pinho Applied Corporate Finance 36

 Financing growth
Financing of Dell's Growing Capital Employed 1996 1995

Change in Capital employed

Change in Net Working Capital 181 18
Change in Fixed Assets 67 32
(A) Increase in Capital Employed 248 50

Increase in Net Debt

Change in Short Term Liabilities
Change in Long Term Liabilities 46 59
Change in Liquidity -119 -190
(B) Increase in Net Debt -73 -131

(C) Increase in Equity 321 181

(A) = (B) + (C) Increase in Capital Employed 248 50

Paulo Soares de Pinho Applied Corporate Finance 37

 How was growth financed
• The company was able to keep NWCR under control, by keeping the
cash conversion cycle around 40 days for most of 1996; this implied
$181 million on NWCR for that year
• The company was able to finance the $248 million increase of capital
employed via increase in equity ($321m), mostly via retained earnings
and partially via issuance of common stock (conversion of preferred
stock at a favorable price)
• The surplus, combined in an increase in long term liabilities of $46m,
resulted in an increase in liquidity investments of $119m

Paulo Soares de Pinho Applied Corporate Finance 38

 Financing 1997
Fiscal Year 1997 1996
Sales $7 944 $5 296
Cost of Sales 6 344 4 229
Gross Margin 1 601 1 067
Operating Expenses 1035 690
Operating Income 566 377
Financing & Other Income 0 6
Income Taxes 215 111
Net Profit 351 272

Paulo Soares de Pinho Applied Corporate Finance 39

 Financing 1997
1997 1996 1996 % of sales
Net Working Capital Requirements
Accounts Receivables, net 1089 726 13,7%
Inventories 644 429 8,1%
Other 234 156 2,9%
(A) Total Current Operating Assets 1 967 1 311 24,8%
minus
Accounts Payable 699 466 8,8%
Accrued and Other Liabilities 710 473 8,9%
(B) Total Current Operating Liabilities 1409 939 17,7%

(C) = (A) - (B) Total Net Workig Capital Requirements 558 372 7,0%

Property, Plant & Equipment, net 269 179 3,4%

Other 18 12 0,2%
(D) Total Fixed Assets 287 191 3,6%

(C) + (D) Total Capital Employed 845 563 10,6%

Increase in Capital Employed 282

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 Financial Equilibrium in 1997

Financial Equilibrium 1997

Capital Employed 845
Fixed Assets 287
Net Working Capital Requirements 558

Equity 1324

Net Debt -479

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