01 VALUE

- Finance and The Financial Manager

Topics Covered
What Is A Corporation? The Role of The Financial Manager Who Is The Financial Manager? Separation of Ownership and Management

Corporate Structure
Sole Proprietorships Unlimited Liability Personal tax on profits Partnerships

Limited Liability Corporations Corporate tax on profits + Personal tax on dividends

Role of The Financial Manager

(2) (1)

Firm's operations
(3)

Financial manager

(4a)

Financial markets

(4b)
(1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors

Role of The Financial Manager

Common Finance Terminology
Real assets Financial assets / Securities Capital markets and financial markets Investment / capital budgeting Financing

Who is The Financial Manager?

Chief Financial Officer

Treasurer

Controller

Ownership vs. Management

Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders

Present Value, the Objectives of The Firm, and Corporate Governance

Slides by Matthew Will

Topics Covered
Introduction to Present Value Foundations of the Net Present Value Rule Corporate Goals and Corporate Governance

Present and Future Value

Future Value Amount to which an investment will grow after earning interest Present Value Value today of a future cash flow.

Discount Factors and Rates

Discount Rate Interest rate used to compute present values of future cash flows.

Discount Factor Present value of a $1 future payment.

Future Values
Future Value of $100 = FV

FV = $100 (1 + r )

Future Values
FV = $100 (1 + r )
Example - FV What is the future value of $5400,000 if interest is compounded annually at a rate of 5% for one year?
t

FV = $400,000 (1 + .05) = $420,000

1

Present Value

Present Value = PV PV = discount factor C1

Present Value
Discount Factor = DF = PV of $1

DF =

1 (1+ r ) t

Discount Factors can be used to compute the present value of any cash flow.

Valuing an Office Building

Step 1: Forecast cash flows Cost of building = C0 = 400 Sale price in Year 1 = C1 = 420 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 5%, then Cost of capital = r = 5%

Valuing an Office Building

Step 3: Discount future cash flows

PV =

C1 (1+ r )

420 (1+.05)

= 400

Step 4: Go ahead if PV of payoff exceeds investment

NPV = 400 370= 30

Net Present Value

NPV = PV - required investment C1 NPV = C0 + 1+ r

Risk and Present Value

Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs

PV of C1 = $420 at 5% 420 PV = = 400 1 + .05

Risk and Present Value

PV of C1 = $420 at 12% 420 = 375 PV = 1 + .12

PV of C1 = $420 at 5% 420 PV = = 400 1 + .05

Risk and Net Present Value

NPV = PV - required investment NPV = 375,000 - 370,000 = $5,000

Rate of Return Rule

Accept investments that offer rates of return in excess of their opportunity cost of capital
Example In the project listed below, the foregone investment opportunity is 12%. Should we do the project?
profit 420,000 370,000 Return = = = .135 or 13.5% investment 370,000

Net Present Value Rule

Accept investments that have positive net present value
Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

60 NPV = -50 + = $4.55 1.10

Opportunity Cost of Capital

Example You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:

Economy Payoff

Slump

Normal

Boom

$80,000 110,000 140,000

80,000 + 110,000 + 140,000 Expected payoff = C1 = = $110,000 3

Opportunity Cost of Capital

Example - continued The stock is trading for $95.65. Next years price, given a normal economy, is forecast at $110 The stocks expected payoff leads to an expected return.
expected profit 110 95.65 Expected return = = = .15 or 15% investment 95.65

Opportunity Cost of Capital

Example - continued Discounting the expected payoff at the expected return leads to the PV of the project

110,000 PV = = $95,650 1.15

Opportunity Cost of Capital

Example - continued Notice that you come to the same conclusion if you compare the expected project return with the cost of capital.

Expected return =

expected profit 110,000 100,000 = = .10 or 10% 100,000 investment

Investment vs. Consumption

Some people prefer to consume now. Some prefer to invest now and consume later. Borrowing and lending allows us to reconcile these opposing desires which may exist within the firms shareholders.

Investment vs. Consumption

income in period 1 100 A

80

60

Some investors will prefer A and others B B

40

20

20

40 60 income in period 0

80

100

Investment vs. Consumption

The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. Each invests $185,000 and returns $210,000 at the end of the year. G wants to consume now so G borrows $200,000 and repays $210,000 at the end of the year. The existence of capital markets allows G to consume now and still invest with A in the project.

Investment vs. Consumption

Dollars Next Year 210 194 A invests $185 now and consumes $210 next year
The grasshopper (G) wants to consume now. The ant (A) wants to wait. But each is happy to invest. Each invests $185,000 and returns $210,000 at the end of the year. G wants to consume now so G borrows $200,000 and repays $210,000 at the end of the year. The existence of capital markets allows G to consume now and still invest with A in the project.

G invests $185 now, borrows $200 and consumes now. Dollars Now

185

200

Managers and Shareholder Interests

Tools to Ensure Management Pays Attention to the Value of the Firm
Mangers actions are subject to the scrutiny of the board of directors. Shirkers are likely to find they are ousted by more energetic managers. Financial incentives such as stock options

Whose Company Is It?

** Survey of 378 managers from 5 countries

Japan Germany France United Kingdom United States

3 17 22 71 76 40 60 80

97 83 78 29 24

0
The Shareholders All Stakeholders

20

100

120

% of responses

Dividends vs. Jobs

** Survey of 399 managers from 5 countries. Which is more important...jobs or paying dividends?

Japan Germany France United Kingdom United States

3 40 41

97 60 59 89 89 40 60 80 100 120

11 11 0 20

Dividends Job Security

% of responses

Goals of The Corporation

Shareholders desire wealth maximization Do managers maximize shareholder wealth? Mangers have many constituencies stakeholders Agency Problems represent the conflict of interest between management and owners

Goals of The Corporation

Agency Problem Solutions 1 - Compensation plans 2 - Board of Directors 3 - Takeovers 4 - Specialist Monitoring 5 - Auditors

Agency Problems, Management Compensation, and The Measurement of Performance

Slides by Matthew Will

Topics Covered
The Capital Investment Process Decision Makers Need Good Information Incentives Residual Income and EVA Bias in Accounting Measures of Performance Measuring Economic Profitability

The Principal Agent Problem

Question: Who has the power? Answer: Managers
Managers = Employees

Shareholders = Owners

Capital Investment Decision

Strategic Planning Top Down

Capital Investments

Project Creation Bottom Up

Capital Investment Process

Capital budget Project authorization R&D Marketing Post-audits

Off Budget Expenditures

Information Technology Research and Development Marketing Training and Development

Information Problems
1. Consistent Forecasts 2. Reducing Forecast Bias 3. Getting Senior Management Needed Information 4. Eliminating Conflicts of Interest

The correct information is

Brealey, Myers & Allens Second Law The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate.

Incentives
Agency Problems in Capital Budgeting Reduced effort Perks Empire building Entrenching investment Avoiding risk

Incentive Issues
Monitoring - Reviewing the actions of managers and providing incentives to maximize shareholder value. Free Rider Problem - When owners rely on the efforts of others to monitor the company. Management Compensation - How to pay managers so as to reduce the cost and need for monitoring and to maximize shareholder value.

$ 1,000 s
0 0
Australia Canada China
Perks Benefits

50 00 00 00

10 15 20

25

00

Fance Germany India Italy Japan Mexico Netherlands Singapore Spain Sweden Switzerland United Kingdom United States

Variable Bonus

Options & Others

CEO Compensation (2003-04)

Basic Compensation

Residual Income & EVA

Techniques for overcoming errors in accounting measurements of performance. Emphasizes NPV concepts in performance evaluation over accounting standards. Looks more to long term than short term decisions. More closely tracks shareholder value than accounting measurements.

Residual Income & EVA

Quayle City Subduction Plant ($mil)
Income Sales COGS 550 275 200 taxes @ 35% Net Income 70 $130 Assets Net W.C. 80 Property, plant and equipment 1170 less depr. Net Invest.. Other assets Total Assets 360 810 110 $1,000

Selling, G&A 75

Residual Income & EVA

Quayle City Subduction Plant ($mil)

130 ROI = = .13 1,000

Given COC = 10%

NetROI = 13% 10% = 3%

Residual Income & EVA

Residual Income or EVA = Net Dollar return after deducting the cost of capital

EVA = Residual Income = Income Earned - income required = Income Earned - [Cost of Capital Investment]

EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

Residual Income & EVA

Quayle City Subduction Plant ($mil)

Given COC = 10%

EVA = Residual Income = 130 (.10 1,000) = +$30 million

Economic Profit
Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital.

EP = Economic Profit = ( ROI r ) Capital Invested

EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

Economic Profit
Quayle City Subduction Plant ($mil)
Example at 10% COC continued.

EP = ( ROI r ) Capital Invested = (.13 - .10) 1,000 = $30 million

EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.

Message of EVA
+ Managers are motivated to only invest in projects that earn more than they cost. + EVA makes cost of capital visible to managers. + Leads to a reduction in assets employed. - EVA does not measure present value - Rewards quick paybacks and ignores time value of money

EVA of US firms - 2003

($ in millions)

Wal-Mart Stores Johnson & Johnson Microsoft Merck Coca Cola Intel Corp. Dow Chemical Boeing Delta Airlines Viacom IBM

Econimic Value Added (EVA) 4,525 4,459 4,027 3,347 2,729 (57) (1,503) (1,974) (2,288) (5,508) (7,505)

Capital Invested 79,177 51,508 24,677 40,941 20,503 31,216 44,158 50,046 27,238 96,515 108,926

Return on Capital 12.30% 17.6 29.8 16.9 20.1 15.6 3.6 2.2 -0.9 3.5 4.6

Cost of Capital 6.60% 8.9 13.5 8.7 6.7 15.8 7 6.1 7.5 9.2 11.5

Accounting Measurements
cash receipts + change in price Rate of return = beginning price C1 + ( P1 P0 ) = P0

Economic income = cash flow + change in present value

C1 + ( PV1 PV0 ) Rate of return = PV0

Accounting Measurements
ECONOMIC INCOME Cash flow + change in PV = Cash flow economic depreciation RETURN Economic income PV at start of year Accounting income BV at start of year ACCOUNTING Cash flow + change in book value = Cash flow accounting depreciation

Nodhead Book Income & ROI

Year 3 250 667

Cash flow Book value at start of year, straight-line depreciation Book value at end of year, straight-line depreciation Book depreciation Book income Book ROI Forecasted EVA (5-.1 *2)

1 100 1000

2 200 833

4 298 500

5 298 333

6 298 167

-0.67 -167

167 -67 0.04 -50

167 33 0.124 17

167 83 0.262 81

167 131 0.393 98

167 131 0.784 115

Nodhead Store Forecasts

Year 1 Cash flow PV, at start of year, 10 percent discount rate PV, at end of year, 10 percent discount rate Economic depreciation Economic income Rate of return Forecasted EVA (5-.1*2) 2 3 4 5 6

1000

1000

901

741

517

271

0 100 0.1 0

100 100 0.1 0

160 90 0.1 0

224 74 0.1 0

246 52 0.1 0

271 27 0.1 0

Nodhead Peer Book ROI

1 Book Income for store 1 2 3 4 5 6 Total book income Book value for store 1 2 3 4 5 6 Total book value Book ROI for all stores EVA for all stores 2 Year 3 4 5 6 -67 33 -67 83 33 -67 131 83 33 -67 131 131 83 33 -67 311 131 131 131 83 33 -67 442

-67

-34

49

180

1000

833 1000

667 833 1000

500 667 833 1000

333 500 667 833 1000 3333

1000

1833

2500

3000

167 333 500 667 833 1000 3500

-0.067 -167

-0.019 -217

0.02 -201

0.06 -120

0.093 -22

0.126 92

Nodhead Growth v. Return

Rate of Return (%) 12 11 10 9 8 7 Book rate of return Economic rate of return

10

15

20

25

Rate of Growth (%)