Strategic Financial Management Lecture 1 PDF

Strategic Financial Management Lecture 1: Financial Management and Value Creation; An Overview Dr. Marc Broekema LL.M Discover theworld Discover at theworld Leiden University at Leiden University Cours...

Strategic Financial Management Lecture 1: Financial Management and Value Creation; An Overview Dr. Marc Broekema LL.M Discover theworld Discover at theworld Leiden University at Leiden University Course Topics and Schedule Date Instructor Class Chapters Topics covered Concepts in Finance and Financial Management 12 November MB 1 1,2,3 Understanding Financial Statements Part 1 Understanding Financial Statements Part 2 Baseline Knowledge Test (General Financial Knowledge + Chapters 1-3) 13 November JWK 2 Balance Sheet, P/L and Cashflow 4 The Time Value of Money 19 November MB 3 8 Valuation of Shares & Companies 7 Market Efficiency and Behavioural Finance 20 November JWK 4 11 Capital Budgeting 12 Agency Conflicts and Corporate Governance 22 November JWK 5 13 Enterprise Risk Management 18 Public and Private Financing 3 December JWK 6 19 Other Finance 10 Project Cost of Capital 4 December MB 7 15 Bankruptcy, Reorganization and Liquidation 17 December EXAM 21 January RESIT Discover theworld at Leiden University 2  Chapter 1: Concepts in Finance and Financial Management Discover theworld Discover at theworld Leiden University at Leiden University 3 Why this course? You cannot be an effective manager without a clear understanding of the principles and practices of modern finance Most of the concepts and methods underlying modern corporate finance are based on business common sense In addition to a solid understanding of fundamental principles, executives need the determination and the discipline to manage a business according to the precepts of modern finance Managers should manage their firm’s resources with the objective of increasing the firm’s value and, therefore, undertake corporate finance decisions Discover theworld at Leiden University 4 Why is corporate finance important? Discover theworld at Leiden University Corporate Finance What is Corporate Finance? Corporate finance deals with a corporation's capital structure, including its funding and management's actions to increase the company's value. Corporate finance also includes the tools and analyses utilized to prioritize and distribute financial resources. The ultimate purpose of corporate finance is to maximize the value of a business through planning and implementation of resources while balancing risk and profitability. Discover theworld at Leiden University 9 Corporate Finance: in essence Financing Decisions All issues with respect to raising capital for value creation, including all financial calculations that deal with raising capital Investment Decisions Maximizing value for the existing All issues with respect to the use of that capital for value shareholders creation, including all financial calculations that deal with the use of that capital Dividend Decisions How much cash should the firm return to its shareholders? Discover theworld at Leiden University 10  The Key Question: Will your decision create value? Discover theworld Discover at theworld Leiden University at Leiden University 11 Goals of the Corporation Shareholders desire wealth maximization: expressed through value value relates to cash Profit maximization? Maximize profits? Which year’s profits? Earning manipulation Opportunity cost of capital The minimum acceptable rate of return on capital investment is set by the investment opportunities available to investors in financial markets The Investment Trade-Off Discover theworld at Leiden University 12 The Key Question: Will Your Decision Create Value? Before going ahead with a project, its long-term financial viability needs to be checked Any proposed venture needs financing. The capital employed is usually a combination of funds supplied by: The firm’s owners, its shareholders - their cash contribution is called equity capital Those who lend money to the firm, the debt holders - their cash contribution is called debt capital Capital is not free, so the firm’s owner should consider whether the profitability before financing the venture is higher than the cost of capital If a proposal creates value, the firm can proceed with it. If not, it should abandon it Discover theworld at Leiden University 13 Corporate Finance Process Financial Markets > Investments > Cash Flows > Cost of Capital Capital Budgeting ‘Investment Decision’ Cost of Capital Real (WACC) Firm Assets Capital Structure ‘Financing Decision’ NOPAT Debt Equity Adjusting for non-cash items and investments in CapEx and NWC Free Cash Flow Discover theworld at Leiden University Corporate Finance Process (2) Total Cost of Capital (WACC) Distributing Free Cash Flows The total cost of capital (WACC) reflects the risk to be run. Invested Capital Capital Employed Components of the capital structure: -Interest-bearing debt. Equity Dividend -Equity Free Cash Flow Operating Fixed Assets + Net Working Capital Providers of interest-bearing debt and equity expect (NWC) Interest their own return from their investment. Debt Repayment Cost of Capital (WACC) ROIC ROIC > WACC = value creation 𝐸𝐸 𝐷𝐷 ROIC < WACC = value destruction 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = ( × 𝑅𝑅𝑒𝑒 ) + ( × 𝑅𝑅𝑑𝑑 × 1 − 𝑇𝑇𝑐𝑐 ) 𝑉𝑉 𝐸𝐸 Discover theworld at Leiden University The Fundamental Finance Principle Discover theworld Discover at theworld Leiden University at Leiden University 16 Three themes in Corporate Finance Corporate Finance deals with three important questions: 1. Capital Budgeting: In which long-lived assets must your firm invest? 2. Capital Structure: How can your firm raise the cash for the required capital expenses? 3. Net Working Capital: How should the short-term ‘operating cash flows’ be managed? Discover theworld at Leiden University 17 (1) Capital Budgeting Decision Total Value of Assets Total Value of the Firm to Investors Current Liabilities Current Assets Long-Term Debt Fixed Assets In what long- term assets 1. Tangible should the 2. Intangible Shareholders’ firm invest? Equity Discover theworld at Leiden University 18 (1) Capital Budgeting Decision Tangible Assets Air France-KLM purchases new planes Intangible Pfizer R&D expenditures Assets Discover theworld at Leiden University 19 (2) Capital Structure Decision Total Value of Assets Total Value of the Firm to Investors Current Liabilities Current Assets Long-Term Debt How should the Fixed Assets firm raise funds 1. Tangible for the selected investments? 2. Intangible Shareholders’ Equity Discover theworld at Leiden University 20 (2) Capital Structure Decision The value of a firm is defined to be the sum of the value S of the firm’s debt and the firm’s equity. E D 40% 60% 𝑽𝑽 = 𝑫𝑫 + 𝑬𝑬 𝑽𝑽=𝑫𝑫+𝑬𝑬 V = Value of the Firm 100 = 60 + 40 D = Market Value of Debt Value of the firm E = Market Value of Equity 100 = 40 + 60 S D E If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should make the pie 40% 60% as big as possible. Discover theworld at Leiden University 21 (1+2) Capital Structure and Capital Budget Decision Capital Budgeting Real ‘Investment Decision’ Firm Assets Debt Equity Capital Structure ‘Financing Decision’ Discover theworld at Leiden University 23  (3) Net Working Capital Decision Total Value of Assets Total Value of the Firm to Investors Current Net Working Capital Liabilities Current Assets Long-Term Debt How should the Fixed Assets short-term operating cash 1. Tangible flows be managed? 2. Intangible Shareholders’ Equity Discover theworld at Leiden University 24  Applying The Fundamental Finance Principle Discover theworld Discover at theworld Leiden University at Leiden University 25 The Fundamental Finance Principle A business proposal – such as a new investment, the acquisition of another company, or a restructuring plan – will create value only if the present value of the future stream of net cash benefits the proposal is expected to generate exceeds the initial cash outlay required to carry out the proposal. Discover theworld at Leiden University 26 The Fundamental Finance Principle Measuring Value Creation With NPV The difference between a proposal’s present value and the initial cash outlay required to implement the proposal is the proposal’s net present value or NPV: Net present value = –Initial cash outlay + Present value of future net cash benefits Discover theworld at Leiden University 27 The Fundamental Finance Principle Only Cash Matters Discover theworld at Leiden University 28  Difference between Cash and (Accounting) Profit Dutch Sneakers B.V. Accounting View Income Statement year ended 31 December Sales € 1.000.000 - Costs € 900.000 Profit € 100.000 By generally accepted accounting principles (GAAP), the sale is recorded even though the customer has yet to pay. It is assumed that the customer will pay soon. However, the perspective of corporate finance is different. It focuses on cash flows: Discover theworld at Leiden University 29 Difference between Cash and (Accounting) Profit Dutch Sneakers B.V. Financial View Income Statement year ended 31 December Cash Inflow € - Cash Outflow € - 900.000 € - 900.000 Corporate finance is interested in whether cash flows are being created by the sneaker designing and selling operations of Dutch Sneakers B.V. Value creation depends on cash flows. For Dutch Sneakers, value creation depends on whether and when it actually receives €1 million. Discover theworld at Leiden University 30 Applying The Fundamental Finance Principle The Capital Budgeting Decision The capital budgeting decision, also called the capital expenditure decision, is primarily concerned with the acquisition of fixed assets, such as plant and equipment This is a major corporate decision because it typically affects the firm’s business performance for a long period of time The decision criteria used in capital budgeting, such as the NPV rule and the internal rate of return (IRR) rule, are direct applications of the fundamental finance principle Discover theworld at Leiden University 31 Applying The Fundamental Finance Principle The Capital Budgeting Decision THE NET PRESENT VALUE RULE A project should be undertaken if its NPV is positive or zero and should be rejected if its NPV is negative THE INTERNAL RATE OF RETURN RULE One of the most commonly used alternatives to the NPV rule, especially in the analysis of capital expenditures A project should be undertaken if its IRR is higher than, or equal to, its cost of capital, and should be rejected if its IRR is lower than its cost of capital Discover theworld at Leiden University 32 Applying The Fundamental Finance Principle The Capital Budgeting Decision THE NET PRESENT VALUE RULE  Net Present Value (NPV) =  Total PV of future CFs + Initial investment  𝑁𝑁𝑁𝑁𝑁𝑁 = 𝑃𝑃𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 + 𝑃𝑃𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 = 𝑃𝑃𝑃𝑃(𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 + 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖)  Estimating NPV: 1. Estimate future cash flows: How much? And when? Note that a negative cash flow 2. Estimate discount rate (outflow) is denoted as a negative number! 3. Estimate initial costs  Minimum Acceptance Criteria: Accept if NPV > 0  Ranking Criteria: Choose the highest NPV Discover theworld at Leiden University 33 Applying The Fundamental Finance Principle The Capital Budgeting Decision THE NET PRESENT VALUE RULE 𝑁𝑁𝑁𝑁𝑁𝑁 = 𝑃𝑃𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 + 𝑃𝑃𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓  Suppose an investment that promises to pay EURO 𝐶𝐶 10.000 in two years is offered for sale for EUR 9.500. 𝑃𝑃𝑉𝑉 = 𝐶𝐶 ÷ (1 + 𝑟𝑟)𝑛𝑛 = (1 + 𝑟𝑟)𝑛𝑛 Your interest rate is 5%. Should you buy?  Note that a negative cash flow (outflow) is denoted as 10.000 a negative number 𝑁𝑁𝑁𝑁𝑁𝑁 = −9.500 + 1.052 0 1 2 𝑁𝑁𝑁𝑁𝑁𝑁 = −9.500 + 9.070 𝑁𝑁𝑁𝑁𝑁𝑁 = −429,71 = < 0 = 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 -€ 9.500 € 10.000 Discover theworld at Leiden University 34 Applying The Fundamental Finance Principle The Capital Budgeting Decision THE NET PRESENT VALUE RULE  Suppose an investment that promises to pay EURO 10.000 in one year is offered for sale for EUR 9.500. Your interest rate is 5%. Should you buy? 𝑁𝑁𝑁𝑁𝑁𝑁 = 𝑃𝑃𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 + 𝑃𝑃𝑃𝑃𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 0 1 10.000 𝑁𝑁𝑁𝑁𝑁𝑁 = −9.500 + 1.051 -€ 9.500 € 10.000 𝑁𝑁𝑁𝑁𝑁𝑁 = −9.500 + 9.523,81 𝑁𝑁𝑁𝑁𝑁𝑁 = 23,81 => 0 = 𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂 Discover theworld at Leiden University 35 Applying The Fundamental Finance Principle The Capital Budgeting Decision THE INTERNAL RATE OF RETURN RULE  Internal Rate of Return (IRR)  The IRR is the discount rate that makes a project’s Net Present Value (NPV) zero.  𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 − 𝑃𝑃𝑃𝑃 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 0  Assume a simple investment project. Initially, you invest EUR 100; after year 1, you receive EUR 110. You don’t know the interest rate or your cost of capital.  Remember: the minimum acceptance criteria is: Accept if NPV > 0, otherwise reject the investment (NPV < 0). 0 1 -€ 100 € 110 cash outflow cash inflow Discover theworld at Leiden University 36 Applying The Fundamental Finance Principle The Capital Budgeting Decision THE INTERNAL RATE OF RETURN RULE  For a given rate, the net present value of this project can be described as, where R is the discount rate: 110 𝑁𝑁𝑁𝑁𝑁𝑁 = −100 + 1 + 𝑅𝑅  What must the discount rate be to make the NPV of the project equal to zero? We begin by using an arbitrary discount rate of 8% (.08), which yields: 110 110 𝑁𝑁𝑁𝑁𝑁𝑁 = −100 + = −100 + = 𝟏𝟏, 𝟖𝟖𝟖𝟖 1 + 0.08 1,08  Because the NPV in this equation is positive (1,85), we now try a higher discount rate, such as 12% (.12). This yields: 110 110 𝑁𝑁𝑁𝑁𝑁𝑁 = −100 + = −100 + = − 𝟏𝟏, 𝟕𝟕𝟕𝟕 1 + 0.12 1,12 Discover theworld at Leiden University 37 Applying The Fundamental Finance Principle The Capital Budgeting Decision THE INTERNAL RATE OF RETURN RULE  Because the NPV in this equation is negative, we try lowering the discount rate to10% (.10). This yields: 110 110 𝑁𝑁𝑁𝑁𝑁𝑁 = −100 + = −100 + = 𝟎𝟎 1 + 0.10 1,10  This trial-and-error procedure tells us that the NPV of the project is zero when R equals 10%.  Thus, we say that 10% is the project’s Internal Rate of Return (IRR).  When the firm’s cost of capital is lower than 10%, accept the investment.  Note that via Excel (Goal Seek) or a financial calculator you can compute the IRR directly. Discover theworld at Leiden University 38 Applying The Fundamental Finance Principle Discount Rates The discount rate (r) is the rate at which the future cash flow must be discounted to find its present value For example: $100,000 is the discounted value at 10 percent of $110,000 to be received in one year 110,000 110,000 𝑃𝑃𝑃𝑃 = = = 100,000 (1+𝑟𝑟)𝑡𝑡 (1+0.10)1 When a project is funded with equity and debt capital, the cost of capital is the weighted average of the project’s cost of equity and its after-tax cost of debt It is the weighted average cost of capital or WACC WACC = (After-tax cost of debt x %Debt financing) + (Cost of equity x % Equity financing) Discover theworld at Leiden University 39 The Role of Financial Management The financial management’s primary goal is to increase the intrinsic value of the firm by: - Making smart financing decisions: Financing Decisions (Debt/Equity/Working Capital) - Selecting value-creating projects: Investment Decisions (Real [fixed] assets) Considering: - Maximizing the value of the existing shares - Profit maximization versus financial risks - Managing market expectations Discover theworld at Leiden University 40  Chapter 2 + 3: Understanding Financial Statements Discover theworld Discover at theworld Leiden University at Leiden University 41 Financial Statements - Financial accounting is the process of systematically collecting, organizing, and presenting financial information according to financial accounting principles, rules and standards - The main output of financial accounting is a set of financial statements - Three main financial accounting statements The balance sheet (also called the statement of financial position) The income or profit and loss (P&L) statement The statement of cash flows - Financial statements are prepared according to accounting standards (accounting principles). There are two prevailing systems of accounting standards and principles: - International Financial Reporting Standards (IFRS) - (US) Generally Accepted Accounting Principles (GAAP) Discover theworld at Leiden University Financial Statements Financial statements, such as balance sheets, income statements, and cash flow statements, are products of the financial accounting process. The Ca s h Flow Sta te m e nt Summarizes the amount of cash and cash equivalents entering and leaving a company. Discover theworld at Leiden University 43 1. The Balance Sheet Definition: Shows the value of the firm’s assets and liabilities at a particular time (from an accounting perspective), in most cases, on 31 December or 30 June. The Balance Sheet reflects a ‘snapshot’ of the company’s financial position at a point in time. The Balance Sheet, therefore, doesn’t show any movement. It balances what the company owns and what is owed, including the claim of the shareholders, i.e., Equity. Assets = Liabilities + Equity The fundamental balance sheet equation: Equity = Assets − Liabilities Equity + Liabilities = Assets Liabilities (Shares + Profits) + (Borrowing + Creditors) = Assets Plant + Property + Machinery + Equity Debtors + Inventory + Cash Discover theworld at Leiden University 1. The Balance Sheet The Main Balance Sheet Items Current Assets Current Liabilities Cash & Securities Payables Receivables Short-term Debt Inventories + + = Long-term Liabilities Fixed Assets Tangible Assets + Intangible Assets Shareholders’ Equity Discover theworld at Leiden University 1. The Balance Sheet Assets are classified in decreasing order of liquidity (according to the US GAAP) Discover theworld at Leiden University 1. The Balance Sheet Current or Short-Term Assets (less than one year) CASH AND CASH EQUIVALENTS Cash Marketable securities ACCOUNTS RECEIVABLE Also called receivables, trade receivables or trade debtors INVENTORIES Raw material, work-in-process and finished goods inventories First-in, first out (FIFO), last-in, last-out (LIFO), and average cost valuation PREPAID EXPENSES Payments made by a firm for goods or services it will receive after the balance sheet date (the last day of a financial reporting period) Discover theworld at Leiden University 1. The Balance Sheet Noncurrent or Fixed Assets TANGIBLE ASSETS They are reported at their net book value, the difference between their gross value (acquisition value or historical cost) less accumulated depreciation The value of tangible assets is expected to reduce as time passes Depreciation is the systematic periodic allocation of the depreciable amount of a tangible asset over its useful life Discover theworld at Leiden University 1. The Balance Sheet Noncurrent or Fixed Assets INTANGIBLE ASSETS Patents, copyrights, trademarks, licenses, etc. Goodwill is the difference between the acquisition price of another company’s net assets and its reported net book value. Goodwill is not amortized but is subjected to annual impairment tests Intangible assets are recorded at cost Amortization is the decrease in value of an intangible asset as time passes (similar to depreciation for a tangible asset) Net fixed assets at the end of a financial reporting period = Net fixed assets at the beginning of the period + Gross value of fixed assets acquired during the period − Net book value of fixed assets sold during the period − Depreciation charges for the period Discover theworld at Leiden University 1. The Balance Sheet Liabilities are classified in increasing order of maturity (according to the US GAAP) Discover theworld at Leiden University 1. The Balance Sheet Current or Short-Term Liabilities Current or short-term liabilities have a maturity shorter than a year SHORT-TERM DEBT Notes payable Overdrafts ACCOUNTS PAYABLE Also called trade payables ACCRUED EXPENSES Discover theworld at Leiden University 1. The Balance Sheet Noncurrent liabilities Noncurrent or long-term liabilities have a maturity longer than a year LONG-TERM DEBT Long-term debt at the end of a period = Long-term debt at the beginning of the period − Portion of long-term debt due during the period + New long-term debt issued during the period PENSION LIABILITIES DEFERRED TAXES Discover theworld at Leiden University 1. The Balance Sheet The Structure of the Owner’s Equity Account The owners’ equity account represents the accumulated changes in owner’s equity since the firm’s inception Discover theworld at Leiden University 1.a. (Managerial) Balance Sheet Invested Capital + Capital Employed For managers of a firm’s operating activities, the standard balance sheet may not be the most appropriate tool for assessing their contribution to the firm’s financial performance. Consider trade payables. They are correctly recorded in the balance sheet as a liability because they represent cash owed to suppliers. Most operating managers, however, would consider trade payables an account under their full responsibility, much like trade receivables (cash owed to the firm by its customers) and inventories, both of which are recorded on the asset side of the balance sheet. It makes more managerial sense to associate trade payables with trade receivables and inventories than to combine them with other liabilities – such as short-term borrowings and long-term debt – that are primarily the financial manager’s responsibility. Considering the concerns of operating managers and financial managers, we restructured the standard balance sheet into a new one, the managerial balance sheet. On the left side of the managerial balance sheet, three items are grouped under the heading invested capital. These are cash and cash- equivalent holdings, working capital requirement (the difference between the firm’s operating assets and its operating liabilities), and net fixed assets: Invested capital = Cash + Working capital requirement + Net fixed assets On the right side of the managerial balance sheet, two items are grouped under the heading capital employed. These are short-term debt and long-term financing, the latter consisting of long-term debt and owners’ equity (we use the terms financing, funding, and capital interchangeably): Capital employed = Short-term debt + Long-term debt + Owners’ equity Discover theworld at Leiden University 54 1.a. (Managerial) Balance Sheet Invested Capital + Capital Employed WCR = (Accounts receivable + Inventories + Prepaid expenses) – (Accounts payable + Accrued expenses) Discover theworld at Leiden University  1.a. (Managerial) Balance Sheet Deriving Operating Working Capital Fixed assets alone cannot generate sales and profits. The managerial activities required to operate these assets in order to generate sales and profit are referred to as the firm’s operating activities. These activities require investments in the form of inventories and trade receivables. What is the net investment (at the date of the balance sheet) that the firm must make to support its operating cycle? It is simply the sum of its inventories and accounts receivable less its accounts payable. If prepaid expenses are included in the firm’s operating assets and accrued expenses are included in its operating liabilities, then the firm’s net investment in its operating cycle is measured (at the date of the balance sheet) by the difference between its operating assets and operating liabilities. Operating current assets are the CA needed to support operations. - Op CA includes (cash)¹, inventory, and receivables. - Op CA excludes short-term investments, because these are not a part of operations Operating current liabilities are the CL resulting as a normal part of operations. - Op CL includes accounts payable and accruals. - Op CL excludes notes payable because this is a source of financing, not a part of operations. ¹ Only to the extent the cash is required to fund the operations. Excess cash is not part of Op WC. Discover theworld at Leiden University 56 1.a. (Managerial) Balance Sheet Deriving Operating Working Capital THE NET INVESTMENT REQUIRED TO OPERATE A FIRM’S FIXED ASSETS The net investment in operations is required to generate sales and profits from the firm’s fixed assets, and is called operating working capital or working capital requirement (WCR) Net Operating WCR = Operating CA – Operating CL Net Operating WCR (Year -1) = (48+57+2) – (40 + 4) = 63 Net Operating WCR (Year 0) = (56+72+1) – (48+4) = 77 ∆ = 14 (77-63; an investment in WCR) Discover theworld at Leiden University 57 2. The Income Statement The purpose of the income statement, also called the profit and loss (P&L) statement, is to determine the amount of net profits (or net loss) the firm has generated during the accounting period Financial statement that shows the revenues, expenses, and net income of a firm over a period of time (from an accounting perspective) It is the difference between the firm’s revenues and its expenses during that period Discover theworld at Leiden University  2. The Income or Profit and Loss Statement The operations section of the income statement reports the firm’s revenues and expenses from principal operations. The non-operating section of the income statement includes all financing costs, such as interest expense. Discover theworld at Leiden University 2. The Income Statement The income (P&L) statement records transactions that change owners’ equity during the accounting/financial reporting period Revenues are transactions increasing owners’ equity Expenses are transactions decreasing owners’ equity The fundamental income statement equation: Earnings after tax = Revenues − Expenses There are two basic principles of accrual accounting: - Realization principle: a revenue is recorded when the transaction takes place, not when the cash is received - Matching principle: an expense associated with a revenue is recognized along with the revenue, not when paid - A consequence of accrual accounting is that a firm’s earnings after tax are different from the firm’s total net cash flows for the accounting period Discover theworld at Leiden University 2. The Income Statement Net sales, Cost of Goods Sold and Gross Profit Net sales or turnover are recorded net of any discounts and allowances for defective merchandise The cost of goods sold (COGS) or cost of sales is the cost of goods the firm has sold during the accounting period For a distribution company, COGS is the cost of items sold from inventory plus other direct costs. For a manufacturing company, COGS often includes the depreciation expense on plant and equipment. Gross profit = Net sales – COGS Discover theworld at Leiden University 2. The Income Statement SG&A Expenses, Depreciation Expense and Operating Profit Selling, general, and administrative (SG&A) expenses are expenses that relate to the sale of products and running of operations Depreciation expense represents the cost of fixed assets that is allocated to the accounting period (see ‘Balance Sheet’) Operating profit = Gross profit – SG&A expenses – Depreciation expense Discover theworld at Leiden University 2. The Income Statement Special Items and Earnings Before Interest and TAX (EBIT) Special items are unusual or infrequent transactions and include: - Extraordinary and exceptional losses and gains - Nonrecurring items - Losses and gains related to discontinued operations - Etc. Earnings before interest and tax (EBIT) EBIT = Operating profit + Gains – losses from special items EBIT plays an important role in the analysis of a firm’s profitability because it enables comparison of firm profitability with different debt policies and tax obligations Discover theworld at Leiden University 2. The Income Statement Net Interest Expense and Earnings Before Tax (EBT) Net interest expense is the difference between the interest expenses incurred by a firm from borrowing and any income it receives from financial investments during the accounting period Earnings before tax (EBT) EBT = EBIT – Net interest expense Discover theworld at Leiden University  2. The Income Statement Income Tax Expense and Earnings After Tax (EAT) The income tax expense account is a tax provision computed in accordance to accounting rules and standards applicable to a firm. It often differs from the actual tax that a firm must pay. The difference is accounted for in the deferred tax account in the balance sheet Earnings after tax (EAT) or net profit/(loss) or net income or net earnings EAT = EBT – Income tax expense Often referred as a firm’s bottom line EAT measures the net change in owners’ equity resulting from the transactions recorded in the income statement during the accounting period Positive EAT: the firm has generated a profit (“in the black”) Negative EAT: the firm has generated a loss (“in the red”) Discover theworld at Leiden University 2.a Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) EBITDA is defined as: Revenues – Expenses excluding interest, tax, depreciation and amortization EBITDA and EBIT are related as follows EBITDA = EBIT + Depreciation expense + Amortization expense EBITDA is a relevant measure of operating profit when comparing operating profitability between companies in the same industry because it is not affected by the companies’ financing decisions EBITDA is often used as a relevant measure of performance when valuing companies using earnings multiples Although EBITDA is related to value creation, it cannot be an indicator of value creation by itself Discover theworld at Leiden University 2.b. Reconciling Balance Sheets and Income Statement Owners’ equity: - Increases (decreases) when the firm generates a profit (loss) - Decreases when the firm declares a cash dividend Retained earnings = EAT – Dividends Owners’ equity also: - Increases when the firm issues new shares - Decreases when the firm repurchases its own shares In total, and over the accounting period: Net change in owners’ equity = Earnings after tax − Dividends + Amount raised by new share issuance − Amount paid for share repurchase Discover theworld at Leiden University 2.b. Reconciling Balance Sheets and Income Statement Net change in owners’ equity = Earnings after tax − Dividends + Amount raised by new share issuance − Amount paid for share repurchase Discover theworld at Leiden University 2.b. Reconciling Balance Sheets and Income Statement Discover theworld at Leiden University 3. The Statement of Cash Flows Definition - Financial statement that shows the firm’s cash receipts and cash payments over a period of time - The statement of cash flows tells you how and why the firm’s cash position has changed during a particular period of time. - It tells you which of the firm’s decisions have generated cash and which have consumed cash. Discover theworld at Leiden University 3. The Statement of Cash Flows Profits vs. Cash Flows Differences - “Profits” subtract depreciation (a non-cash expense) - “Profits” ignore cash expenditures on new capital (the expense is capitalized) - “Profits” record income and expenses at the time of sales, not when the cash exchanges actually occur - “Profits” do not consider changes in working capital Discover theworld at Leiden University 3. The Statement of Cash Flows Discover theworld at Leiden University 3. The Statement of Cash Flows Indirect Method NET CASH FLOW FROM OPERATING ACTIVITIES Net operating cash flow from operating activities = EAT + Depreciation expense – ∆WCR NET CASH FLOW FROM INVESTING ACTIVITIES Data regarding capital expenditures and acquisition of fixed assets are available in the firm’s financial statements The data must be consistent with the following relationship Net fixed assetsend = Net fixed assetsbeginning + Fixed assets acquisitions − Depreciation expense − Fixed assets sales NET CASH FLOW FROM FINANCING ACTIVITIES Data not available in balance sheets and income statements can be found in the notes to the firm’s financial statements in its annual report Discover theworld at Leiden University 3. Reconciling Statement of Cash Flows and Balance Sheet Discover theworld at Leiden University 3.a. Free Cash Flow Free cash flow is a measure of the cash flow available to those who finance the firm’s activity (lenders and shareholders) Free cash flow is a key input to value investment projects and businesses Since free cash flow is cash flow available to all the suppliers of capital, it is not affected by the firm’s capital structure decision. As a result, Free cash flow = Net cash flow from operating activitiesall equity finance + Net cash flow from investing activities Using equation: Net cash flow from operating activities = EAT + Depreciation expense - ∆WCR, it can be shown that Free cash flow = EBIT( 1 – Tc) + Depreciation expense – ∆WCR – Net cash flow from investing activities (or net capital expenditure) Discover theworld at Leiden University 3.a. Free Cash Flow Free Cash Flow (FCF) - Cash available for distribution to investors after the firm pays for new investments or additions to working capital FCF = Net Income + interest + depreciation - additions to net working capital - capital expenditures Discover theworld at Leiden University 3.b. How Profitable is the Firm? The Profitability of Equity Capital and Invested Capital The return on shareholder’s equity investment is equal to EAT divided by owner’s equity. This is called return on equity (ROE): EAT ROE = Owner′ s equity To measure the after-tax operating profit, we need a measure of earnings before payments are made, but after tax. Dividing the after-tax operating profit by the amount of capital that was used to generate that profit gives a measure of the firm’s return on invested capital (ROIC): After−tax operating profit ROIC = Invested capital ROIC is the same as return on capital employed (ROCE) because invested capital is equal to capital employed Discover theworld at Leiden University 78 3.b. How Risky is the Firm? Sales fluctuate because of uncertain environments; these fluctuations are then transmitted to EBIT. This is the business risk Business risk is magnified by the presence of fixed-interest expenses that create a financial risk Discover theworld at Leiden University 79 3.b. Did the firm create any value? ROIC > WACC (firm’s cost of capital) = value creation in a year ROIC < WACC (firm’s cost of capital) = value destruction in a year Discover theworld at Leiden University 80