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ENGM 401

ENGM 401
Fundamentals of Engineering Finance
Fundamentals of Engineering Finance
Peter Flynn Peter Flynn
Department of Mechanical Engineering Department of Mechanical Engineering
University of l!erta University of l!erta
2
Department of Mechanical Engineering
Engineering Management Group
Course Overview
Course Overview

The big picture: learn why financial statement analysis and


investment analysis are important to engineering, and learn
to perform both.

Course outline:
How social and commercial values interact.
hat management information do financial statements contain.
How do we analy!e and choose investments"
#is$ analysis and mitigation in pro%ects.

Two big messages: don&t cheat 'including plagiarism( and


dont hold side conversations in class.
)
Department of Mechanical Engineering
Engineering Management Group
Course Overview (continued)
Course Overview (continued)

Tool building vs. thought building.

*eys to success:
+o the homewor$ to master the tools.
,ee message above.
hen writing: clear, brief and thoughtful.
Thin$ li$e a manager 'for three months only(, and see if you li$e it.

,imple math, comple- thoughts about ambiguous


situations: unli$e engineering, fu!!y logic is re.uired.
/
Department of Mechanical Engineering
Engineering Management Group
Why learn this?
Why learn this?

0ou will li$ely wor$ in a commercial enterprise whose value


is measured by the value it creates, measured in dollars.
1eople in the organi!ation are analy!ing financial data to
decide what needs to be done, hence, it affects your %ob
and career.

0ou may want to manage, or to own and manage your own


company.

0ou are li$ely to be an investor in your personal life.

2nderstanding this gives a sense of insight and power.


3
Department of Mechanical Engineering
Engineering Management Group
Your instructor : Peter Flynn
Your instructor : Peter Flynn

1rofessional engineer, spent 23 years in industry in a


variety of engineering, management and e-ecutive roles.

,erves on, and has served on, a number of 4oards of


+irectors, including 5pcor, the 4alancing 1ool of 6lberta,
and a public company trading on the T,7.

#eturned to the 2niversity of 6lberta in 8999 to rebuild the


5ngineering :anagement program.

Has opinions that will lea$ out that are no more or less valid
than those of others.
;
Department of Mechanical Engineering
Engineering Management Group
Marks
Marks

<pinion: the 2 of 6 grading system went from terrible to


worse: layers e-ceed the ability to discriminate.

<ne of many e-amples of things none of us can change,


hence:
6ssignments 2=> :ar$ed for effort, not correctness.
1ro%ect 8 8=> :ar$ed for content, no collaboration.
1ro%ect 2 8/> :ar$ed for content, no collaboration.
Two mid?terms@2A> Bon?cumulative, no final e-am.

#esulting > scaled to the 82C layers as per guidelines.


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Department of Mechanical Engineering
Engineering Management Group
What does no collaboration !ean?
What does no collaboration !ean?

Erom the time you get the ta$e home pro%ects until you turn
it in, you are on your professional, student and personal
honor not to discuss
The pro%ect
#elated homewor$ assignments
The te-t
The course concepts
with any other person, student or otherwise. Ff you can&t
meet this obligation, drop the course nowG
A
Department of Mechanical Engineering
Engineering Management Group
"ociety and #usiness
"ociety and #usiness

6ll societies are concerned with business activities.

There are vast differences in the effectiveness H productivity


of humans. The .uality of life is substantially affected by
this.
4angladesh H Chad H 4ur$ina Easo: IJ3== K+1 per capita.
2, H Canada H ,weden: I J3=,=== K+1 per capita.

,ociety hopes to impose values on business, sometimes


successfully: China and the failed industrial revolution,
Kuild restrictions, Luddites, anti?combines and anti?trust,
unions 'good and bad(, labor standards, engineering as a
profession.
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Department of Mechanical Engineering
Engineering Management Group
#usiness a$$ects society
#usiness a$$ects society

The nature of wor$ is created by both technology and


business practices. 6re we creating a new elite class and a
proletariat"

,tatus is related to wor$ and compensation: the relative pay


of the receptionist and president is a value decision that
creates social standing.

4usinesses use common environmental sin$s: all


environmental standards involve a value %udgment about
social cost and benefit, often not .uantified.
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Department of Mechanical Engineering
Engineering Management Group
Money and values (%)
Money and values (%)

:oney e-actly measures current commercial values.

:any social values cannot be measured by money.

4usiness operates in a social framewor$: ultimately society


assesses competing social and commercial values. Ft is
naMve to thin$ that this will not occur.

+emocratic processes to assess competing values are


messy, imperfect, and based on all evidence to date, better
than central planning.
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Department of Mechanical Engineering
Engineering Management Group
&e'ulation and standards
&e'ulation and standards

#egulation and standards are the $ey developed


mechanism for imposing social values on business.

Three classes of regulation:


1rotect business from business.
1rotect individuals from business.
1rotect society at large from business.

Two competing forces: streamlineHreduce for efficiency,


increase for effectiveness. History is full of imbalances in
these two forces.
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Department of Mechanical Engineering
Engineering Management Group
Pit$alls arise on either side
Pit$alls arise on either side

4usiness struggles to regulate itself: the search for the


lowest common denominator.

The professions can set standards because they have the


socially granted power to e-communicate.

N1rofessional citi!ensO distort the process. ,ierra Club has,


for some, become part of the problem.

Targets are flighty and sporadic: whatever happened to acid


rain"
8)
Department of Mechanical Engineering
Engineering Management Group
Money and values (()
Money and values (()

<ur basic assumptions about money are tied to


consumerism: we wor$ to have purchasing power, and
savings are for future purchasing power.

<verwhelmingly true today, but not typical for hunter


gatherer tribes, where:
Constant relocation limited possessions.
NealthO was derived from relationships.
The function of material possessions was to denote ran$.
8/
Department of Mechanical Engineering
Engineering Management Group
)he *ower o$ business
)he *ower o$ business
Thought provo$ing .uestion P8:

The following table summari!es the price 'current


commercial value( of fruitHvegetables and meat:

hat is the price of oil, per lb. or $g"


1rice per lb. 1rice per $g.
Fruit " vegeta!les J=.;= to J/.== J8.3= to J9.==
Meat J2.== to J82.== J/.== to J23.==
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Department of Mechanical Engineering
Engineering Management Group
Mana'ers are like doctors
Mana'ers are like doctors

6 business is li$e a comple- organism, with many systems


NrunningO at the same time.

6ll must be within acceptable boundaries to maintain health.

,ome systems are very critical in the short term, some have
a long term hori!on.

:anagement chec$s that it wor$s, and cures the NillnessesO.

:anagement wor$ is broad and high level, engineering is


narrow 'specialty( and detailed.
8;
Department of Mechanical Engineering
Engineering Management Group
+ !ana'er,s skill set (%)
+ !ana'er,s skill set (%)

Einancial analysis:
Can read financial statements and determine the appropriate action.

Einance:
Can raise money from different sources.

Company organi!ation:
*nows the ta- and liability implications of forms of organi!ation.

4usiness law:
*nows the elements of a contract and how to protect intellectual
property.
8D
Department of Mechanical Engineering
Engineering Management Group
+ !ana'er,s skill set (()
+ !ana'er,s skill set (()

:ar$eting:
Can identify a need, target the mar$et for it, understand the benefit
to the customer, and the channels to mar$et.

,elling:
6 critical subset of mar$eting: can discuss Nfeatures and benefits&,
overcome ob%ections, and Nas$ for the orderO.

Human resources:
*nows the basics of benefits, employment law, severance, and
union legislation and contracts.

1ro%ect management:
can plan and then run a one time effort on schedule and budget.
8A
Department of Mechanical Engineering
Engineering Management Group
+ !ana'er,s skill set (-)
+ !ana'er,s skill set (-)

<perations management:
Can budget and operate for steady growth with continuous
improvement, can push responsibility downwards.

1eople management:
*nows management styles and personality variations, can lead
'communicate, motivate, assess, and if needed, discipline(.

Historical and social insight:


Can place current events 'e.g. unions( in conte-t.

,trategic planning:
Can assess synergies and set broad directions.
89
Department of Mechanical Engineering
Engineering Management Group
"ociety and values: a su!!ary
"ociety and values: a su!!ary

The purpose of society is to ma-imi!e social values.


4usiness is an important contributor to a healthy society.

hat is the purpose of business: to ma-imi!e commercial


values, measured by money, within social contraints.

,ocial concerns will always be the over?arching framewor$


within which business and management ta$es place.
Engineering is the application of
science to create commercial value#
2=
Department of Mechanical Engineering
Engineering Management Group
Financial state!ents
Financial state!ents

Einancial statements are:


The ubi.uitous NdrawingsO of business.
6pply to any si!e of enterprises.
Communicate to multiple audiences.
Kive critical information to managers to guide insight and action.
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Department of Mechanical Engineering
Engineering Management Group
+ co!*any
+ co!*any

Ta$es money from others.

1erforms activities.

Tries to create value.

Tries to measure and communicate that it is


creating value.
22
Department of Mechanical Engineering
Engineering Management Group
Money co!es in two $lavors and a blend
Money co!es in two $lavors and a blend

Common shares: ownership of the company.

+ebt: a loan to the company.

1referred shares: a blend of the two.


2)
Department of Mechanical Engineering
Engineering Management Group
)he -./ Financial "tate!ents
)he -./ Financial "tate!ents

The Fncome ,tatement: how much value did we


create.

The ,tatement of #etained 5arnings: of the value we


created over the entire life of the company, how much
did we $eep within the company.

The 4alance ,heet: what do we have, and where


did the money come from to have it.

The ,tatement of Cash Elow: what did we do with


our money"
2/
Department of Mechanical Engineering
Engineering Management Group
)he e0uity investor:
)he e0uity investor:

Fs motivated by the creation of value.

Loo$s to the income statement as proof of value


creation.

Loo$s last at the balance sheetQ can the company


survive growth"

Loo$s to the statement of cash flow to see if


management has good %udgment.
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Department of Mechanical Engineering
Engineering Management Group
)he lender:
)he lender:

Fs motivated by solvency: will F get my loan


principal plus interest bac$"

+oes not share in e-traordinary value creation.

Loo$s to the balance sheet for solvency and


leverage.

Loo$s to the statement of cash flow to chec$


management %udgment.
2;
Department of Mechanical Engineering
Engineering Management Group
)he takeaway !essa'e
)he takeaway !essa'e

Einancial statements Ntal$O to managers and


convey both problems and re.uired actions.

Einancial statements Ntal$O to the people who put


money into the company. The two flavors of
money thin$ completely differently and focus on
different aspects of the statements.
2D
Department of Mechanical Engineering
Engineering Management Group
1t starts with bookkee*in'
1t starts with bookkee*in'

4oo$$eeping, then accounting, then financial statements,


then analysis and action.

4oo$$eeping:
Thousands of transactions a day, each generating a trail.
The first level of processing is to ma$e a double entry in a %ournal,
chronologically by sub%ect area.
5ntries are then transferred to ledgers that categori!e transactions
into accounts.
2A
Department of Mechanical Engineering
Engineering Management Group
)he conce*t o$ the double entry
)he conce*t o$ the double entry

6ll transactions have two sides:


F borrowed money 'F record a debt( and F got cash 'my cash position
increases by the amount of the debt(.
F spent money 'my cash position decreases( to buy a pump 'which F
record as an asset(.

4y carefully recording all transactions with a double entry,


we can chec$ values in the end by seeing if they NbalanceO.
29
Department of Mechanical Engineering
Engineering Management Group
+ccounts are s*eci$ic to a business
+ccounts are s*eci$ic to a business

or$ in progress 'F1( is an account that records the value


of all wor$ on the shop floor. #aw materials inventory is
transferred into F1, F1 is transferred to finished goods
inventory. This only makes sense if the work on the shop
floor is substantial, and the knowledge gained (at a cost) is
of management value.

Language varies between companies: a pu!!le.

0ear over year analysis, critical to managers and investors,


is only possible if accounts are stable.
)=
Department of Mechanical Engineering
Engineering Management Group
#ookkee*in' illustrated
#ookkee*in' illustrated

Ta$e the following accounts:

Cash

1ayables 'owed to a supplier(

6ccrued e-penses 'typically unpaid salary(

#aw materials inventory

or$ in progress 'on the shop floor(

Einished goods inventory

#eceivables 'owed by customers(

,ales, general and administrative 'overhead(

Long term assets

5.uity 'money invested by shareholders(

+ebt
)8
Department of Mechanical Engineering
Engineering Management Group
#ookkee*in' illustrated (()
#ookkee*in' illustrated (()

hat two changes for the following transactions"

#eceiving material

1aying for it, )= days later

:oving material onto the shop floor

#ecording the cost of labor on the shop floor

#ecording the cost of a salesperson

4uying a pump

Fssuing new shares for J22 million

Fssuing a bond for J/ million

Ketting paid by a customer


$ou need to %no& this ta%es place# 't helps to
appreciate its importance# $ou do not need to
%no& ho& to do this#
)2
Department of Mechanical Engineering
Engineering Management Group
Why do we bother?
Why do we bother?

The alternative is single entry cash accounting.

:anagers and investors need to line up revenue and


e-penses to see if value is being created. Cash accounting
misses this.

6sset and liability accounts are used to time shift the


recognition of revenue and e-pense. These Ncrystalli!eO at
the defined point of sale.

This is what gives monthly and .uarterly statements


meaning.
))
Department of Mechanical Engineering
Engineering Management Group
+ccountin'
+ccountin'

Consistently rolls up the accounts into a consistent format,


the three and a half financial statements.

The labels are not consistent between companies, the


formats are more consistent.

Consolidated means all wholly owned companies are


treated as if one entity.

:ateriality governs ad%ustments and corrections: we don&t


restate for trivial errors.
)/
Department of Mechanical Engineering
Engineering Management Group
)he inco!e state!ent: value2
)he inco!e state!ent: value2

The form is revenue minus e-penses e.uals earnings H


profit H income H net income H gain.

The purpose: how much value was created. arning: there


are e-penses 'costs of doing business( that are not
reflected in current cash costs.

Hence, net income R cash flow.

Ft is a rate, hence the time period must be long enough to


ma$e sense. 1ublicly traded: three months. Fnternal: one
month. ,tupid: one wee$.
)3
Department of Mechanical Engineering
Engineering Management Group
)he $ull $or! o$ the inco!e state!ent
)he $ull $or! o$ the inco!e state!ent
Kross #evenue
:inus 6llowances
5.uals #evenue
:inus Sariable <perating Cost
5.uals Contribution :argin
:inus ,ales, Keneral and 6dministrative
5.uals <perating Fncome
1lus <ther Fncome
5.uals Bet Fncome
);
Department of Mechanical Engineering
Engineering Management Group
"o!e cautions
"o!e cautions

#evenue is aligned with its associated e-penses to cancel


timing issues.

Fncome statements are often by product or business line,


but ta- is paid by an entire company. Hence income
statements within a company are often pre ta-.

4ad debt, warranty, and returns can be treated as an


e-pense or an allowance. :aintenance can be smoothed
by an allowance. <ccasional periodic ad%ustments will align
actual with estimated.
)D
Department of Mechanical Engineering
Engineering Management Group
"o!e abuses
"o!e abuses

Hide value creation that e-ceeds e-pectations in


NreservesO, to be reversed when bad times hit:
income smoothing.

The communist variant: hide production over .uota


in the woods.

1ost 5nron, auditors are far more stringent in


reviewing the validity of reserves.
)A
Department of Mechanical Engineering
Engineering Management Group
Cost o$ 'oods sold (CO3")
Cost o$ 'oods sold (CO3")

Captures the direct 'variable( cost of ma$ing, delivering or


selling a product. The test: if one more customer buys,
what must F spendQ if one less, what do F save"

Sast differences can e-ist between products. Capital


intense products should have lower > C<K,.

:argin: what is left over after C<K,. :> T 8?C<K,>.

Consistent margin year over year is a critical business


measure 'G(.
)9
Department of Mechanical Engineering
Engineering Management Group
4ow *recise?
4ow *recise?

6 vessel fabrication shop uses a great deal of welding rod.


,hould this be traced as part of C<K,"
0es: it is a variable cost and the true measure of margin is to great it
as variable.
Bo: the effort to do the boo$$eeping, recording welding rod use by
%ob, is not %ustified by value of the information 'the welding rod cost
is not material to the accounts(.

<n balance, untrac$ed costs are often lumped into ,KU6.


/=
Department of Mechanical Engineering
Engineering Management Group
"35+: $i6ed costs
"35+: $i6ed costs

Captures the invariant costs of running a business. The


test: what do F have to spend whether one more customer
shows up or not. Clear e-amples: the company president,
interest charges on debt, office rent, the finance
department.

<ften this cannot be calculated by product line, since


overhead services are spread over many products.
'4eware of allocation, it pretends to be marginalG(

Bormally includes sales: atermetco is an e-ception.


/8
Department of Mechanical Engineering
Engineering Management Group
1s "35+ truly $i6ed?
1s "35+ truly $i6ed?

,KU6 is only fi-ed for small to medium changes in sales. Ff


sales go up tenfold, it is li$ely that more sales, finance, and
warehouse people will be re.uired.

,KU6 should grow at a rate less than revenue, otherwise it


isn&t semi?fi-ed. #ate of ,KU6 growth, and ,KU6 as a >
of sales are both $ey measures.

Long periods of good times lead to growth in ,KU6, to be


wrung out during down times. The cycle is important.
/2
Department of Mechanical Engineering
Engineering Management Group
Four key uses o$ !ar'in
Four key uses o$ !ar'in

To measure the performance of mar$eting and


manufacturing: if margin is dropping, then either

,ales is failing to raise prices to parallel increases in


costs

:anufacturing is failing to control costs

Competition is lowering their prices so you must match

To ma$e intelligent decisions about discounting.

To price products similar in nature to your current line.

To calculate the brea$even sales level.


/)
Department of Mechanical Engineering
Engineering Management Group
"a!*le discount 0uestion
"a!*le discount 0uestion

0our parents run a family restaurant. 6verage meal price is


J83, and C<K, 'the cost of the food, and an allowance of
J=.8= for the gas and power to coo$ it( is J3.

The restaurant caters to some NregularsO, including seniors


from a nearby lodge. However, wee$day business,
especially on :onday and Tuesday, is slow, and your
parents want to lure in new customers.

0ou suggest a coupon for half price off distributed in


maga!ines aimed at a young audience 'Tuesday night
movie goers(.
Does the coupon increase revenue( Margin(
Profit( )hat is the ris% in such a program(
//
Department of Mechanical Engineering
Engineering Management Group
+ second sa!*le discount 0uestion
+ second sa!*le discount 0uestion

0ou are mar$eting manager for a large chemical


intermediate company. ,ales for the last decade have been
e-clusively in Borth 6merica.

The plant is running at D;> of capacity.

The president has as$ed you to diversify sales into the


1acific #im because a competitor has announced plans to
e-pand production at the 2, Kulf Coast.

0ou chec$ C<K, for the product, which includes feedstoc$,


utilities, and an allowance for maintenance: it is D2>.
)hat *mar%et entry+ discount &ould you
authori,e &ithout a phone call to the
president( )hat pro!lems might arise(
/3
Department of Mechanical Engineering
Engineering Management Group
)he takeaway lessons
)he takeaway lessons

+iscounting up to marginal cost increases revenue, margin


and net income, but reduces margin >, provided there is
e-cess manufacturing capacity.

+iscounting a plant running at 8==> capacity reduces


revenue, margin, net income, margin >, and career
prospects.

+iscounts need to be recaptured to maintain margin >.


5liminating temporary allowances is psychologically far
easier than increasing price.
/;
Department of Mechanical Engineering
Engineering Management Group
7sin' !ar'in to set *rice
7sin' !ar'in to set *rice

0ou run a compressor s$id pac$aging business that


services shallow gas wells 'your units compress produced
gas up to pipeline pressures(.

0ou have a stable s$illed wor$force and you find things for
them to do during slow times rather than lay them off.

0our margin, based on the cost of parts and materials, has


been 8A to 89.3> for the past four years. 0ou have an
en.uiry from a customer for a new larger si!ed compressor.

0our buyer and engineer have priced all the components of


the new compressor s$id at J/D;,===.
-hould you include shop floor la!or in ./G-( )hat
do you 0uote the compressor at for the customer(
)hat pro!lem &ould occur if you sell for less(
/D
Department of Mechanical Engineering
Engineering Management Group
4ow lon' does e0ui*!ent last?
4ow lon' does e0ui*!ent last?

Thought provo$ing .uestion 2a:

How many hours per year do the following pieces of


e.uipment operate" How many hours in the total life of the
piece of e.uipment"
6 pump in an oil refinery.
6 telephone switch.
6 family automobile.
6 lawnmower.

hat is the engineering significance of this"


/A
Department of Mechanical Engineering
Engineering Management Group
Who !ade the better choice?
Who !ade the better choice?

Thought provo$ing .uestion 2b:

Two brothers inherit J8 million each. <ne buys a


2= year bond yielding 3.3>, with an interest
payment of J33,=== per year. The second brother
buys two oil well service rigs and leases them to an
oil service company for J;3,=== per year.

4rother 2 brags he was smarter. as he"


/9
Department of Mechanical Engineering
Engineering Management Group
Was value created?
Was value created?

6 Canadian wants to give her brother a %ob, so


buys a cab for J/=,===. The deal is that the
brother ta$es the cost of gas and routine
maintenance and a salary of J);,=== per year, with
the rest going to the sister.

6t the end of year 8 and year 2 the sister gets a


che.ue for J8=,===.

as value created"
3=
Department of Mechanical Engineering
Engineering Management Group
8on' ter! assets wearin' out is loss o$ value
8on' ter! assets wearin' out is loss o$ value

The income statement $eeps score over a period of time. Ff


we ignore long term assets wearing out, or lump their
purchase into one year, we don&t reflect true value creation.

+epreciation is the means by which the loss in value of long


term assets is recorded in the income statement.

The purchase of a long term asset doesn&t show up on the


income statement, only the amount of value lost in the
month, .uarter or year. <nly land and collectibles don&t
wear out.
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Department of Mechanical Engineering
Engineering Management Group
9e*reciation
9e*reciation

6ccounts for the loss of value due to property, plant


and e.uipment '11U5( wearing out, becoming
useless or becoming obsolete.

Fs not a cash cost 'G(, because the money spent for


the 11U5 was already spent.

Hence it is a non?cash charge against value: you


have the cash, you %ust don&t call it value.

Hence net income and cash are different.

+epreciation is a good pro-y for the dollars that


may need to be invested at a later date if you need
to replace the asset.
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Department of Mechanical Engineering
Engineering Management Group
4ow de*reciation works
4ow de*reciation works

:anagement %udgment sets the depreciation period.

,traight line depreciation is the most common.

+epreciation T '<riginal cost estimated salvage value(


number of years 'or months(

,alvage value is often !ero in manufacturing, but not


always.

,ince our salvage estimate is not e-actly correct, the


ad%ustment goes into Nother incomeO.
3)
Department of Mechanical Engineering
Engineering Management Group
&e*lace!ent and in$lation
&e*lace!ent and in$lation

,ome companies must always be replacing worn


out assets. <thers never need to.

Eor very long term assets, inflation in capital costs


means that replacement value far e-ceeds
depreciation. 5-amples: the original ,uncor plant,
the original TransCanada and 5nbridge pipelines,
many legacy auto manufacturing plants.
3/
Department of Mechanical Engineering
Engineering Management Group
9e*reciation a$$ects re*orted net inco!e
9e*reciation a$$ects re*orted net inco!e

Consider:

6 company has one asset, J3 million

5arnings before depreciation are J8:Hyr

Fn 2=H2= hindsight, the asset lasts 8= years

hat is the impact on reported earnings if


management pic$s a five, 8= or 2= year
depreciation period"
33
Department of Mechanical Engineering
Engineering Management Group
1$ !ana'e!ent *icks a $ive year de*reciation
1$ !ana'e!ent *icks a $ive year de*reciation
$ears
N
e
t

'
n
c
o
m
e
1

M
2
"
y
r
3
4rue life of asset 5 10 years
4rue life of asset 5 10 years
10
0
0#3
1#0
3 year depreciation
3;
Department of Mechanical Engineering
Engineering Management Group
:
:
a ten year de*reciation
a ten year de*reciation
10 year depreciation
$ears
N
e
t

'
n
c
o
m
e
1

M
2
"
y
r
3
4rue life of asset 5 10 years
4rue life of asset 5 10 years
10
0
0#3
1#0
3 year depreciation
3D
Department of Mechanical Engineering
Engineering Management Group
:
:
a twenty year de*reciation
a twenty year de*reciation
10 year depreciation
$ears
N
e
t

'
n
c
o
m
e
1

M
2
"
y
r
3
4rue life of asset 5 10 years
4rue life of asset 5 10 years
1
0
0
0#3
1#0
3 year depreciation
60 year depreciation
)rite do&n
of 26#3 M
3A
Department of Mechanical Engineering
Engineering Management Group
;ey *oints:
;ey *oints:

Total income for the ten years is the same for all three
cases.

Changing the depreciation period changes when income is


reported, but in the long run it does not create value.

6n accurate depreciation period creates steady income.

Large writedowns on disposition of an asset are a sign of


overstated income.

4usinesses with steady income have high sale value.


39
Department of Mechanical Engineering
Engineering Management Group
3et de*reciation ri'ht
3et de*reciation ri'ht

Too high: depresses earnings until the boo$ value


is !ero, then earnings bounce up. Euture investors
don&t trust variable earnings.

Too low: overstates earnings until the asset is


retired, then a writedown goes in other income.
ritedowns are a sign of overstated prior earnings.

+oes it wear out or become obsolete" The shorter


period governs.
;=
Department of Mechanical Engineering
Engineering Management Group
Other !ethods $or calculatin' de*reciation
Other !ethods $or calculatin' de*reciation

,traight line is the most common and easiest to wor$ with.


+epreciation is identical in each period until the asset
reaches !ero or estimated salvage value. 4ut Nboo$ valueO
may be higher than resale value.

6lternative: sum of the years 'or months( digits: high


depreciation in the early years. 2sed for cars, +S+s.

Fncome ta- uses a compulsory and completely different


method, higher depreciation in early years. hy"
;8
Department of Mechanical Engineering
Engineering Management Group
)a6 and de*reciation
)a6 and de*reciation

Ff companies could set depreciation for ta- purposes all long


term assets would be written off in one year 'e-pensed(.

The Canadian ta- system uses a declining balance method


on a pool of assets: each asset is not trac$ed individually.

+ifferent language:
This year&s depreciation for ta- purposes is called Capital Cost
6llowance 'CC6(
The original cost is called the 6d%usted Cost 4ase
The remaining value not depreciated for ta- purposes is called
2nclaimed Capital Cost '2CC(
;2
Department of Mechanical Engineering
Engineering Management Group
Cash vs. inco!e
Cash vs. inco!e

+epreciation is a non?cash charge. 0ou have the


cash, you %ust don&t call it income 'value(.

There are other non?cash charges against income:


e-amples are writedowns, an allowance for future
reclamation, and future ta-es payable.

0ou have this cash in addition to the cash called


income, hence cash R income.
;)
Department of Mechanical Engineering
Engineering Management Group
Cash vs. inco!e (()
Cash vs. inco!e (()

The cash generated by operating a business is


operating income plus non?cash e-penses 'in this
course, depreciation only(.
CEE< T <F C depreciation
'.ash flo& from operations7

The net cash flow from operations is net income


plus non?cash e-penses.
BCE T BF C depreciation
;/
Department of Mechanical Engineering
Engineering Management Group
9istin'uishin' cash $ro! inco!e
9istin'uishin' cash $ro! inco!e

0ou borrow J) million at ;> for a three year term with e.ual
principal repayments, and combine it with your e.uity to buy
a business.

The business is essentially debt free before you buy it and


has a steady net income of JA==,=== per year.
+epreciation is J/==,=== per year and the assets are long
term, not needing replacement for ten years or more.

6re you li$ely to be able to ma$e the first payment on debt"


hat is the ris$"
;3
Department of Mechanical Engineering
Engineering Management Group
+ co!!ent on debt
+ co!!ent on debt

Fnterest payments only 'the e-pense or NrentO for borrowing


money( goes on the income statement. 1rincipal payments
do not show up thereG

Three common forms of debt repayment:

,traight line principal repayment: declining interest, and


hence declining payment.

:ortgage: constant total payment, high interest portion in


the early years, high principal repayment in later years.

4alloon principal repayment 'bond(: interest only paid


until last payment when full principal is repaid.

#are: balloon payment of all interest and principal at end of


loan.
;;
Department of Mechanical Engineering
Engineering Management Group
Princi*al re*ay!ent vs. de*reciation
Princi*al re*ay!ent vs. de*reciation

,traight line principal repayment reflects straight line


perceived loss of value in assets. This is typical for many
business assets, e.g. manufacturing e.uipment, a power
plant.

:ortgage principal repayment, very slow in the early years,


reflects the real pattern of a value of a typical house: no
drop in value for years.

4alloon payments 'e.g. bond principal( may re.uire a


sin$ing fund: money held in trust to ensure the principal is
repaid. This is then li$e straight line.
;D
Department of Mechanical Engineering
Engineering Management Group
4ow !uch breathin' roo!?
4ow !uch breathin' roo!?

hich company would you rather run"


6 4 C
#evenue J82.; J82.; J82.;
? C<K, JA.8 JA.8 JA.8
T Contribution :argin J/.3 J/.3 J/.3
? ,KU6 e-cl. +eprec. J2.3 J/.D J/.D
? +epreciation J).= J=.; J=.;
T <perating Fncome 'J8.=( 'J=.A( 'J=.A(
C <ther Fncome 'J=.3( ? J8.A
T Bet Fncome 'J8.3( 'J=.A( J8.=
;A
Department of Mechanical Engineering
Engineering Management Group
"o!e thou'hts on cash vs. inco!e
"o!e thou'hts on cash vs. inco!e

Ff income is positive, then cash flow from operations


must be positive.

Ff income is negative, then always check to see if cash


flow is healthy 'the ,tatement of Cash Elow will do this
as well(.

Consistent negative income but positive cash flow: NF&m


sorry F invested the money, but since it is sun$ F&ll run
this to get bac$ as much as F can.O
)e ma%e long term 8investment7 decisions
!ased on income and short term 8shut do&n7
decisions !ased on cash#
)e ma%e long term 8investment7 decisions
!ased on income and short term 8shut do&n7
decisions !ased on cash#
;9
Department of Mechanical Engineering
Engineering Management Group
Cash $low $ro! o*erations (CFFO)
Cash $low $ro! o*erations (CFFO)

6 business with negative CEE< is either:

6 startup, needing e.uity in%ection.

6 bas$et case.

The $ey .uestion for startups: when do I reach


breakeven"

Two brea$evens: cash 'no more in%ection( and


boo$ 'value creation(
D=
Department of Mechanical Engineering
Engineering Management Group
Mar'in and breakeven
Mar'in and breakeven

:argin is the cash left over from a sale that can


contribute to covering the fi-ed costs.

The ob%ective: build enough sales to have enough


margin to:

Eirst, reach cash brea$ even.

,econd, reach boo$ brea$ even.

Third, reach high profitability and return on investment.


.ash !rea%even9 .M 5 -G: e;cluding depreciation
<oo% !rea%even9 .M 5 -G: including depreciation
.ash !rea%even9 .M 5 -G: e;cluding depreciation
<oo% !rea%even9 .M 5 -G: including depreciation
D8
Department of Mechanical Engineering
Engineering Management Group
)he theory
)he theory
D8
2
-ales =olume
Margin
-elling and General e;cl#
depreciation
-G: incl#
depreciation
Profita!ility
<oo% !rea%even
.ash !rea%even
D2
Department of Mechanical Engineering
Engineering Management Group
1n theory
1n theory

:argin is constant with increasing sales.

,KU6 is truly Nfi-edO.


D)
Department of Mechanical Engineering
Engineering Management Group
)he $antasy case
)he $antasy case
D)
2
-ales =olume
Margin
-elling and General e;cl#
depreciation
-:G incl#
depreciation
Profita!ility
<oo% !rea%even
.ash !rea%even
D/
Department of Mechanical Engineering
Engineering Management Group
1n the $antasy case:
1n the $antasy case:

:argin increases because you can hold your price


and get lower pricing by volume discounts from
your suppliers.

,KU6 growth is minor: small increase in staff,


negligible increase in assets.

1eace brea$s out around the world.


D3
Department of Mechanical Engineering
Engineering Management Group
)he investor,s ni'ht!are
)he investor,s ni'ht!are
D3
2
-ales =olume
Margin
-elling and General e;cl#
depreciation
-:G incl#
depreciation
Profita!ility not reached
<oo% !rea%even not reached
.ash !rea%even
D;
Department of Mechanical Engineering
Engineering Management Group
1n the investor,s ni'ht!are:
1n the investor,s ni'ht!are:

,KU6 e-cluding depreciation goes up as you


discover that you need a large increase in staff and
facilities to service the higher sales.

+epreciation goes up because you need more long


term manufacturing assets.

:argin falls as you NbuyO sales by discounting


price.
DD
Department of Mechanical Engineering
Engineering Management Group
4ence:
4ence:

The smart investor in a startup company will spend


more time reviewing the sales and mar$eting plan
than the financial statements, since rosy financial
statements can be generated by overestimating
sales revenue.

4eware of the hoc$ey stic$ sales forecast: it tends


to turn into the sliding hoc$ey stic$ sales forecast.
DA
Department of Mechanical Engineering
Engineering Management Group
Calculatin' breakeven
Calculatin' breakeven

Eind a formula for variable cost 'easy(.

Eind a formula for fi-ed cost 'not easy(: start from


where fi-ed costs are today and estimate a
percentage increase that is less than the
percentage increase in sales.

2se Ngoal see$O to find brea$even sales.


D9
Department of Mechanical Engineering
Engineering Management Group
4ow do 1 reach breakeven?
4ow do 1 reach breakeven?

Cut costs.

,pend more on mar$eting 'raise costs(.

Cut price to increase sales.

Fncrease price to increase margin per sale.

Fncrease .uality 'and cost( to %ustify a higher price.

#educe .uality 'and costs( to increase sales at a


lower price but at the same margin
4here is no su!stitute for
management >udgment1 &hich often
derives from intuition#
4here is no su!stitute for
management >udgment1 &hich often
derives from intuition#
A=
Department of Mechanical Engineering
Engineering Management Group
Other inco!e
Other inco!e

6lways includes one time and unusual items, e.g.


the gain on a one time sale of a piece of property.

Fncludes writedowns or gains on disposal of assets,


since ad%usting prior periods is difficult and
e-pensive.

6bout 3=> of companies put interest on long term


debit 'as a negative entry( into other income.
A8
Department of Mechanical Engineering
Engineering Management Group
1nterest on lon' ter! debt
1nterest on lon' ter! debt

Ff included in ,KU6, then operating income is the


value the business has created as you have
financed it. Ff someone has a different mi- of debt
and e.uity, their operating income will change.

Ff included as a negative entry in <ther Fncome,


then operating income is what anyone will ma$e
from the business, independent of financing.
E<'4 8earnings !efore interest and ta;es7 is
the inherent value creation of the !usiness#
E<'4 8earnings !efore interest and ta;es7 is
the inherent value creation of the !usiness#
A2
Department of Mechanical Engineering
Engineering Management Group
<ertical and hori=ontal analysis
<ertical and hori=ontal analysis

Sertical: we normali!e e-penses to some


meaningful value. Eor retail this is always to sales
revenue, i.e. we e-press e-penses as a percent of
revenue.

Hori!ontal: trends over time.

The combination allows a powerful loo$ at a


business, and is the basis of most financial
analysis.
A)
Department of Mechanical Engineering
Engineering Management Group
>et inco!e and retained earnin's
>et inco!e and retained earnin's

Bet income is the Nall inO number.

Trac$s to the balance sheet through the ,tatement of


#etained 5arnings.

0ou can do two things with net income:

*eep the value in the business as #etained 5arnings

Kive it to ,hareholders 'owners( as a dividend.

The ,tatement of #etained 5arnings trac$s this on a


cumulative basis.
A/
Department of Mechanical Engineering
Engineering Management Group
)he "tate!ent o$ &etained ?arnin's
)he "tate!ent o$ &etained ?arnin's
Cumulative earnings, start of period
1lus: Bet Fncome for the period
Less: +ividends paid for the period
T Cumulative earnings, end of period

Bote: can be negative is a company has losses.

This adds to 'or subtracts from( shareholder e.uity.


A3
Department of Mechanical Engineering
Engineering Management Group
1t will 'et !ore co!*licated
1t will 'et !ore co!*licated

6fter 5nron accounting standards have aimed at identifying


and reporting all possible changes in value including events
far into an uncertain future.

5-ample: you loc$ in a wholesale power price at ;.3 cents


per $h for a five year term. Ff the mar$et price drops to 3
cents, you report a deemed NlossO on future power
purchases as if you had spent the funds this year. Ff a
borrower&s credit rating drops, you decrease the value of the
asset.

The result is lumpy reported income not reflecting cash, and


more emphasis on the ,tatement of Cash Elow.
A;
Department of Mechanical Engineering
Engineering Management Group
Cookin' the inco!e state!ent
Cookin' the inco!e state!ent

Fncrease the depreciation period.

Capitali!e e-penses and amorti!e over years


'orldcom(.

#eport revenue based on uncertain future events


as if it is reali!ed today '5nron, Bortel(.

Trade inflated services, and report as income


'many +otcom startups(.
AD
Department of Mechanical Engineering
Engineering Management Group
)he balance sheet
)he balance sheet

Tells us, at a specific point in time 'hence not a rate


function( how much we have and where the money came
from to ac.uire it.

e use owners& money 'e.uity( and other people&s money


'liabilities( to ac.uire assets, hence 'if assets are recorded
at cost(: assets 5 lia!ilities ? e0uity

Historically, assets were recorded at original cost minus


depreciation and writedowns.

The pro-imate cause of business failure is on the balance


sheet.
AA
Department of Mechanical Engineering
Engineering Management Group
)he $or! o$ the balance sheet
)he $or! o$ the balance sheet
ssets9 @ia!ilities9
.urrent9 .urrent9
Cash ,hort Term Credit Line
#eceivables 6ccounts 1ayable
,hort Term Botes 6ccrued 5-penses
Fnventory Ta-es 1ayable
1repaid 5-penses Curr. 1ort. <f L?T +ebt
Long Term: Land, 4ldgs, U 5.uip @ong 4erm: Long Term +ebt
less 6ccum +epreciation #epayable Krants
Long Term Fnvestments -hareholderAs E0uity9
Capital ,hares
Koodwill and Fntangible 6ssets #etained 5arnings
A9
Department of Mechanical Engineering
Engineering Management Group
"hort ter! credit line: $our covenants
"hort ter! credit line: $our covenants

The company must file monthly financial statements with


the ban$.

The owners 'directors( will not declare a dividend without


the consent of the ban$.

The company will maintain wor$ing capital in e-cess of a


set value.

The company will maintain the wor$ing capital ratio in


e-cess of a set value.
9=
Department of Mechanical Engineering
Engineering Management Group
;ey conce*ts
;ey conce*ts
8. e want and need debt, but it thin$s differently than e.uity:
forget the upside, focus on solvency. +ebt is not patientG
2. 6ssets e.ual liabilities plus e.uity. The right side is a
historical record of where money came from, those funds
no longer e-ist since they were used to get the assets.
). Companies float on cash or a short term credit line
'negative cash(. This is how we balance.
98
Department of Mechanical Engineering
Engineering Management Group
;ey conce*ts (()
;ey conce*ts (()
/. Li.uidity decreases as we move down assets. N+ue dateO of
the liability lengthens as we move down liabilities.
3. NCurrentO means less than one year. This year&s principal
repayment on long term debt is current.
;. Long term lenders are typically secured by a charge 'lien(
on assets. ,hort term lenders don&t rely on long term
assets, they are already ta$en. Hence, the relay on wor$ing
capital, current assets 'C6( minus current liabilities 'CL(,
and wor$ing capital ratio, C6HCL.
92
Department of Mechanical Engineering
Engineering Management Group
;ey conce*ts (-)
;ey conce*ts (-)
D. ,hort term lenders 'typically ban$s( are shrewd in setting
covenants on C: how sellable is the inventory, how
collectible are the receivables"
A. The need for wor$ing capital increases with sales level,
since receivables and inventory are usually larger in value
than payables. Krowth can $ill unless its financial impacts
are recogni!ed.
9. 6 shortage of wor$ing capital is the leading cause of
business failure. rong actions are common when C is
the problem.
9)
Department of Mechanical Engineering
Engineering Management Group
)he $atal @% !illion sale
)he $atal @% !illion sale

Fmagine a startup Nmagic bo-O business 'chip plus software


in a bo-( with the following characteristics:

6 Nrich uncleO gave you J3==$ to see what you could do.

0ou and some friends spent two years and J/==$ doing
the software.

0our losses to date from two years of prototyping are


J93$.

0our sales strategy is a C: of 3=>.

:aterial is 9=> of C<K,, contract labor is 8=>.

0ou are selling J23$Hmonth to larger companies, who are


testing the product. 0ou are at brea$ even.

<ne company gives you an order for J8 millionG


9/
Department of Mechanical Engineering
Engineering Management Group
)he $atal @% !illion sale (()
)he $atal @% !illion sale (()

Can you harvest the benefit" Thin$ li$e a ban$er, and also
thin$ li$e a manager.

The se.uence:

0ou order the material 'terms net )=( at time !ero 'receipt of
order(.

0ou receive the material at month end.

0ou pay for the material on time.

0ou hire the labor force in month two to finish the product.
They ship the product at the start of month three, terms net
)=. 5arnings are boo$ed at this time.

0our large customer ta$es ;= days to pay, due to testing of


the first shipment.

hat else could management have done"


93
Department of Mechanical Engineering
Engineering Management Group
)he takeaway !essa'e
)he takeaway !essa'e

Companies need two $inds of management: operational


and financial.

<perational management buys, ma$es and sells thing, with


competitive costs and full paying customers.

Einancial management gets the money that operational


management needs to do this. ,ince debt has legal powers,
the financing must be in a manner that ensures that all
creditors are secure.
9;
Department of Mechanical Engineering
Engineering Management Group
"o!e thou'hts on wealth
"o!e thou'hts on wealth

Fn mar$et regulated agricultural and industrial societies


wealth is held primarily by individuals, not society at large.

5ven where society owns a resource 'e.g. the oil sands(,


the development is done by private parties who ta$e the ris$
and the reward in e-cess of the Neconomic rentO.

:ost with wealth wish to preserve and grow it, but wealth
and entrepreneurial spirit often don&t align.

5.uity investment and debt are ways to grow wealthQ


realigning wealth to entrepreneurial activity is critical to
economic growth.
9D
Department of Mechanical Engineering
Engineering Management Group
?0uity vs. debt
?0uity vs. debt

5.uity is direct ownership in a company: the


investor faces the full ris$ and gets the full reward.

+ebt ran$s ahead of 'gets paid in full before( any


benefit to investors, and has the power to foreclose
to 'hopefully( ensure recovery of principal.

Lenders trade lower return for lower ris$. +ebt is


the primary mechanism to reduce ris$.
9A
Department of Mechanical Engineering
Engineering Management Group
Why debt instead o$ e0uity?
Why debt instead o$ e0uity?

+ebt doesn&t convey ownership, the sole control is by


covenants. 5nbridge is D=> debt )=> e.uity, but all
the directors are elected by the shareholders, not the
lenders.

+ebt doesn&t get the Nblue s$yO potential: its returns are
fi-ed and low.

+ebt is cheap: the borrower believes that the return on


assets will e-ceed the cost of the debt, and the e-cess
return will belong to the borrower.
99
Department of Mechanical Engineering
Engineering Management Group
)hus:
)hus:

4orrowing can be thought of as Npartitioning ris$ and


returnO.

The lender accepts an e-pectation of lower return for lower


ris$.

The borrower has higher ris$ 'since failure to pay the debt
means the business goes into receivership(, and an
e-pectation of higher return if the business succeeds.
4he ris% avoided !y the lender goes to the investor#
4his *levers+ the investorAs return 8gro&th in &ealth71
!oth up and do&n# %ey financial management
decision9 ho& much de!t(
4he ris% avoided !y the lender goes to the investor#
4his *levers+ the investorAs return 8gro&th in &ealth71
!oth up and do&n# %ey financial management
decision9 ho& much de!t(
8==
Department of Mechanical Engineering
Engineering Management Group
8evera'e
8evera'e

Leverage measures the relative amounts of debt vs. e.uity


in a company.

Leverage 'debt( ratio T total liabilities


total assets

Loo$ at three companies with the same operating


management, and hence same operating income e-cluding
interest on long term debt, but three different levels of
leverage.
8=8
Department of Mechanical Engineering
Engineering Management Group
4ow levera'e works
4ow levera'e works
Earning
po&er of
the
investment
.ost of
De!t

30B @everage in Good 4imes


Ceturn
De!t E0uity
4he earning po&er of the de!t portion in e;cess of the cost of de!t
is transferred to e0uity and increases the return on e0uity#
Ceturn on
E0uity
8=2
Department of Mechanical Engineering
Engineering Management Group
4ow levera'e works (()
4ow levera'e works (()
Earning
po&er of
the
investment
.ost of De!t

D0B @everage in Good 4imes


Ceturn
De!t E0uity
More earning po&er of the de!t portion in e;cess of the cost of de!t
is transferred to less e0uity and increases the return on e0uity#
Ceturn on
E0uity
8=)
Department of Mechanical Engineering
Engineering Management Group
4ow levera'e works (-)
4ow levera'e works (-)
Earning
po&er of
the
investment
.ost of De!t

30B @everage in <ad 4imes


Ceturn
De!t E0uity
4he earning po&er of the de!t portion is higher than the earning
po&er of the pro>ectE the e0uity return is reduced to cover the de!t#
Ceturn on
E0uity
8=/
Department of Mechanical Engineering
Engineering Management Group
4ow levera'e works (A)
4ow levera'e works (A)
Earning
po&er of
the
investment
.ost of De!t

D0B @everage in <ad 4imes


Ceturn
De!t
E0uity
-o much cash must !e transferred to service de!t that the return on
e0uity is !elo& ,eroE interest and principal canAt !e covered#
Ceturn on
E0uity
8=3
Department of Mechanical Engineering
Engineering Management Group
)he takeaway !essa'e
)he takeaway !essa'e

Leverage ratio, also called the debt ratio, is a $ey


financial management decision.

High leverage gives a company a better return in good


times and more ris$ of insolvency in bad times.

#is$ arises from the nature of the business and differs


between companies. 1ipelines and regulated power
companies have lower ris$ than car manufacturers.
The choice of level of leverage partly reflects the
nature of the business.
8=;
Department of Mechanical Engineering
Engineering Management Group
Pre$erred shares: a hybrid
Pre$erred shares: a hybrid

Ket a fi-ed dividend from after ta- profits.

#an$ behind debt 'debt would have to be paid in full before


a preferred share dividend could be paid(, but are paid
before any dividend can be paid to common shareholders,
hence NpreferredO relative to common shares.

+on&t have the power to go to court, force foreclosure, and


get a receiver appointed if the dividend isn&t paid.
4he lender1 focused on ran%ing first1 security of
payment and the sole a!ility to force
foreclosure1 sees preferred shares as e0uity#
4he lender1 focused on ran%ing first1 security of
payment and the sole a!ility to force
foreclosure1 sees preferred shares as e0uity#
8=D
Department of Mechanical Engineering
Engineering Management Group
Pre$erred shares as seen by e0uity
Pre$erred shares as seen by e0uity

+on&t get to vote, e.g. for directors.

Ket no upside if the company does e-tremely well, since


the dividend is a pre?specified amount, and hence dont
affect the leverage of the common shareholder.

Typically can be redeemed at the choice of the company.


4he common shareholder1 focused on the
gro&th in company value1 sees preferred
shares as a form of de!t#
4he common shareholder1 focused on the
gro&th in company value1 sees preferred
shares as a form of de!t#
8=A
Department of Mechanical Engineering
Engineering Management Group
)y*ical $eatures o$ *re$erred shares
)y*ical $eatures o$ *re$erred shares

#edeemable: means that the company can buy bac$


the shares at the issue price at any time.

Cumulative: any missed dividend accumulates, i.e. is


still due to the holder of the preferred share, and past
due dividends must be paid before any dividend to
common shareholders.

1referred shares have more ris$ than debt but much


less than common shares. +ividends in Canada get
favorable ta- treatment. 4oth are figured into the
dividend rate.
8=9
Department of Mechanical Engineering
Engineering Management Group
Why issue *re$erred shares?
Why issue *re$erred shares?

Credit rating agencies assess the .uality and ris$


associated with debt 'bonds(. The most critical factor in
rating a company&s debt is Ntimes interest earnedO, 54FT H
interest payments. The second most critical factor is debt
'leverage( ratio.

The cost of debt 'the re.uired interest rate to get


someone to buy the bond( is directly related to the credit
rating.

1referred shares are used by companies to have a


redeemable form of money that preserves a debt rating
and avoids issuing common shares in a down mar$et.
88=
Department of Mechanical Engineering
Engineering Management Group
Cookin' the balance sheet
Cookin' the balance sheet

Have debt or its e.uivalent that is in fact


guaranteed by the company but that is somehow
treated as being the responsibility of another party
'5nron(.

Bote that some product purchase agreements in


the 89A=&s did this, with full disclosure.
888
Department of Mechanical Engineering
Engineering Management Group
1t will 'et !ore co!*licated
1t will 'et !ore co!*licated

FE#, 'Fnternational Einancial #eporting ,tandards( is being


adopted by Canada for E0 2=88.

Companies will have the option to revalue assets on an


annual basis based on fair mar$et value. :any will choose
not to.

6n increase or decrease in assets 'left side( will be reflected


by a change in shareholder e.uity 'right side(, but will not
show up in the income statement 'G(.

1ersonal opinion: this is dangerous 'e.g. 5nron(.


882
Department of Mechanical Engineering
Engineering Management Group
+t this *oint:
+t this *oint:

e $now the assets and liabilities of a company at


a point in time.

e $now the value the company created over a


period of time.

e don&t have a clear easy to read picture of what


it did with it&s cash.
88)
Department of Mechanical Engineering
Engineering Management Group
3oodco and #adco
3oodco and #adco

Have the same starting balance sheet: they own the same
assets and got the money from the same sources.

Have the same income statement this year: their


operational management 'and profit( is identical.

Have the same dividend 'and hence the same retained


earnings(.

:a$e the same decision on purchase of assets.


4he companies are in different shape at the
end of this year# )hy(
4he companies are in different shape at the
end of this year# )hy(
88/
Department of Mechanical Engineering
Engineering Management Group
)rackin' the $low o$ cash
)rackin' the $low o$ cash

e $now that:

6n increase in an asset re.uires 'uses( cash: my assets


go up because F spent money to buy things.

6 decrease in an asset is a source of cash: if F sell


something F own, F get cash.

6n increase in a liability is a source of cash: if F ta$e out


a loan F get cash.

6 decrease in a liability is a use of cash: if F pay bac$ a


loan F used money.

+epreciation 'a negative entry on the asset side( only


increases, and is a source of cash.
883
Department of Mechanical Engineering
Engineering Management Group
"te* %: sources and uses o$ cash
"te* %: sources and uses o$ cash

Two successive balance sheets are compared.

Eor each entry: is it a net source of cash, or a net


use"

1ositive values only.

,ources T uses.
88;
Department of Mechanical Engineering
Engineering Management Group
"te* (: the "tate!ent o$ Cash Flow
"te* (: the "tate!ent o$ Cash Flow

6ll net cash activities from the Fncome ,tatement,


,tatement of #etained 5arnings and 4alance ,heet are
captured in a standard format.

The convention: source of cash is positive, use of cash is


negative.

,tandard categories:

<perating activities

Fnvesting activities

Einancing activities

The balancing entry is change in net cash, where net cash is


cash the short term credit line.
88D
Department of Mechanical Engineering
Engineering Management Group
)he $or! o$ the "CF
)he $or! o$ the "CF
<perating 6ctivities
Bet income
+epreciation
Change in non?cash wor$ing capital
Fnvesting 6ctivities
6c.uisition of Bew 6ssets
+isposal of 6ssets
Einancing 6ctivities
+ividends
Bew debt or e.uity
#edemption of debt or e.uity
5.uals Change in Bet Cash 'Cash ? ,T credit line(
Chec$: Change in Bet Cash during period
88A
Department of Mechanical Engineering
Engineering Management Group
What do we look $or on the "CF?
What do we look $or on the "CF?

1ositive income" 1ositive cash flow from operations" Fs


income steady"

Fnvestment relative to depreciation:


:uch larger: growing company.
I ,ame: stable.
,maller: blowdown of assets.

+ividend" How large compared to income"

Loc$ing in or paying bac$ long term debt"

Fssuing or buying bac$ shares"

Fs the change in non?cash wor$ing capital out of line"


889
Department of Mechanical Engineering
Engineering Management Group
Match the invest!ent to the investor
Match the invest!ent to the investor

+ividends are more important to an older investor, an irritant


to the small portfolio of a young investor.

High capital investment almost always means high retained


earnings and a low dividend payout ratio.

6 focus on growth will have more appeal to a young investor


'NF don&t buy green bananasO(.

5arnings variability re.uires a tolerance of ris$ because it is


often reflected in the share price 'pHe ratio(.
82=
Department of Mechanical Engineering
Engineering Management Group
O*erational vs. $inancial !ana'e!ent
O*erational vs. $inancial !ana'e!ent

6ll businesses re.uire that management address two $ey


areas:

<perational health: buy, ma$e and sell things with competive


costs, at a price that creates value.

Einancial health: raise money in a way that can sustain the


business, service all debt, and reward investors.

The Fncome ,tatement is the primary source of evidence of


operational health. The 4alance ,heet is the primary source
of evidence of financial health.

The ,tatement of Cash Elow lin$s these two.


828
Department of Mechanical Engineering
Engineering Management Group
4ow is !ana'e!ent *er$or!in'?
4ow is !ana'e!ent *er$or!in'?

Fs our credit rating good with suppliers"

Fs our inventory e-cessive"

6re we collecting our receivables in a timely way"

6re we ma$ing good use of our assets"

Can we finance a growth opportunity by debt"

Fs our stoc$ fairly priced"


822
Department of Mechanical Engineering
Engineering Management Group
&atios
&atios

,tandard tests recogni!ed by almost all analysts.

Fndicative of some underlying value that is important.

2seful in following year over year changes in one


company.

2seful in comparing companies within a given industry.

Bot useful in comparing companies in very different


industries: e.g. a capital intensive integrated steel
company and a grocery chain.

5-tensively by lenders 'including suppliers deciding on


whether to give credit( and by financial analysts.
82)
Department of Mechanical Engineering
Engineering Management Group
Five classes o$ ratios
Five classes o$ ratios
1. i!uidity "atios: will the company stay solvent in the short
term" Eor a short term lender or a supplier, Nwill F get my
money bac$O"
#. $ctivity or $sset %anagement "atios: is management
ma$ing good use of the company&s assets"
&. everage or 'ebt %anagement "atios: will the business
be able to service the debt it has underta$en, paying both
interest and principal"
(. )rofitability "atios: is the company earning enough on the
assets H e.uity given to the business.
*. %arket +alue "atios: for publicly traded companies, how
does the stoc$ value compare to earnings and the boo$
value of assets.
82/
Department of Mechanical Engineering
Engineering Management Group
8i0uidity ratios
8i0uidity ratios

The Current #atio:

Ere.uently a covenant for short term lending.

,hort term lenders will fre.uently specify a current ratio and


a level of wor$ing capital.

6 high current ratio gives assurance that even in a crisis


short term debt will be repaid.
.urrent Catio 5 .urrent ssets " .urrent @ia!ilities
.urrent Catio 5 .urrent ssets " .urrent @ia!ilities
823
Department of Mechanical Engineering
Engineering Management Group
8i0uidity ratios (()
8i0uidity ratios (()

The Vuic$ #atio or N6cid TestO:

Ff greater than 8, then the short term lender can be repaid


from receivables. This is a very comfortable position for a
lender.

5liminates the need to worry about the .uality or


obsolescence of inventory. 'Fn a crisis, inventory rarely sells
at boo$ value.(
Fuic% Catio 5 8.urrent ssets minus
'nventory7 " .urrent @ia!ilities
Fuic% Catio 5 8.urrent ssets minus
'nventory7 " .urrent @ia!ilities
82;
Department of Mechanical Engineering
Engineering Management Group
+ctivity or asset !ana'e!ent ratios
+ctivity or asset !ana'e!ent ratios

Fnventory Turnover:

:easures how many times inventory Nturns overO in a year.


Bot a true NturnoverO, since finished goods are carried in
inventory at C<K,.

Fnventory often increases during a downturn, this is an


opportunity for good management.

,tale inventory will reduce the turnoverQ management can


reduce by writing off useless inventory. 'ont let bad
inventory accumulate,
'nventory 4urnover 5 nnual -ales " 'nventory
'nventory 4urnover 5 nnual -ales " 'nventory
82D
Department of Mechanical Engineering
Engineering Management Group
+ctivity or asset !ana'e!ent ratios (()
+ctivity or asset !ana'e!ent ratios (()

+ays ,ales <utstanding:

#eceivables are more often .uoted in NdaysO rather than


dollars.

Kood management can have a ma%or impact.

,tale receivables will be detected and acted upon in any


well run company, by screening for C)=, C;= and C9=. +on&t
ship to deadbeatsG

Lenders don&t count C9= day receivables as a current asset,


hence not considered in wor$ing capital calculation.

2ncollected receivable end up as Nbad debtO.


Days -ales /utstanding 5 Ceceiva!les " 8nnual
-ales " GH0 or GH37
Days -ales /utstanding 5 Ceceiva!les " 8nnual
-ales " GH0 or GH37
82A
Department of Mechanical Engineering
Engineering Management Group
+ctivity or asset !ana'e!ent ratios (-)
+ctivity or asset !ana'e!ent ratios (-)

Ei-ed 6ssets Turnover:

:ost useful within an industry.

Can be distorted by inflation andHor new vs. old assets 'due


to depreciation(. 5.g. the Nbig threeO automa$ers would have
a higher turnover 'lower boo$ value of assets( than a new
entrant to Borth 6merica, e.g. Honda.
Fi;ed ssets 4urnover 5 nnual -ales " Fi;ed ssets
Fi;ed ssets 4urnover 5 nnual -ales " Fi;ed ssets
829
Department of Mechanical Engineering
Engineering Management Group
+ctivity or asset !ana'e!ent ratios (A)
+ctivity or asset !ana'e!ent ratios (A)

Total 6ssets Turnover:

,ame issues as Ei-ed 6sset Turnover: of some use within


an industry if the asset ac.uisition time profile is
comparable. <f no use between industries.
4otal ssets 4urnover 5 nnual -ales " 4otal ssets
4otal ssets 4urnover 5 nnual -ales " 4otal ssets
8)=
Department of Mechanical Engineering
Engineering Management Group
8evera'e or debt !ana'e!ent ratios
8evera'e or debt !ana'e!ent ratios

+ebt #atio:

Fncludes all current liabilities, not %ust ban$ debt.

This ratio is sometimes mista$enly called the debt to e.uity


ratioQ both are used. Chec$ to see what is being .uoted.

This is the test of the NleverageO of a company, meaning the


relative level of debt it carries.
De!t Catio 5 4otal @ia!ilities " 4otal ssets
De!t Catio 5 4otal @ia!ilities " 4otal ssets
8)8
Department of Mechanical Engineering
Engineering Management Group
8evera'e or debt !ana'e!ent ratios (()
8evera'e or debt !ana'e!ent ratios (()

Times Fnterest 5arned:

:easures the ability of a company to service its debt 'pay


the interest(.

This is the most important ratio for setting a credit rating.

54FT '5arnings 4efore Fnterest and Ta-es( is a $ey financial


measure. Ta-es are e-cluded because as a firm&s earnings
drop, so do its ta-es 'no ta-es are payable at brea$ even(,
hence interest is paid before ta-es.
4imes 'nterest Earned 5 Earnings <efore
'nterest and 4a;es 8E<'47 " 'nterest Payments
4imes 'nterest Earned 5 Earnings <efore
'nterest and 4a;es 8E<'47 " 'nterest Payments
8)2
Department of Mechanical Engineering
Engineering Management Group
8evera'e or debt !ana'e!ent ratios (-)
8evera'e or debt !ana'e!ent ratios (-)

Ei-ed Charge Coverage:

,imilar to NTimes Fnterest 5arnedO, e-cept that other fi-ed


charges are included.

5-amples of other fi-ed charges include lease and sin$ing


fund payments.

+ifficult to calculate from public information, more often


used by financial analysts.
Fi;ed .harge .overage 5 Earnings <efore
'nterest1 /ther Fi;ed .harges and 4a;es " 'nterest
and /ther Fi;ed .harge Payments
Fi;ed .harge .overage 5 Earnings <efore
'nterest1 /ther Fi;ed .harges and 4a;es " 'nterest
and /ther Fi;ed .harge Payments
8))
Department of Mechanical Engineering
Engineering Management Group
Pro$itability ratios
Pro$itability ratios

1rofit :argin on ,ales:

6 powerful tool for comparison within an industry. Leads to


the .uestion: Nhy does a competitor ma$e moreHless than
we do per sales dollar"O

:eaningless between industries.

+ifferent analysts have different numeratorsQ alternatives


are 54FT and Nnet income available to the shareholderO
54FT e-tracts the impact of financing, BF6T, includes all
impacts of management.
Profit Margin on -ales 5 Net or /perating
'ncome " -ales
Profit Margin on -ales 5 Net or /perating
'ncome " -ales
8)/
Department of Mechanical Engineering
Engineering Management Group
Pro$itability ratios (()
Pro$itability ratios (()

#eturn on Total 6ssets:

6 very powerful tool for comparing companies in the same


industry: NHow much money do you ma$e per unit of assets
that you manage"O

Can be used within a company, by product line, on an


N54FTO basis, to as$ how well our product lines use our
shareholders& capital.
Ceturn on 4otal ssets 5 Net or /perating
'ncome " 4otal ssets
Ceturn on 4otal ssets 5 Net or /perating
'ncome " 4otal ssets
8)3
Department of Mechanical Engineering
Engineering Management Group
Pro$itability ratios (-)
Pro$itability ratios (-)

#eturn on 5.uity:

Eor the owners of a company, this is the ultimate test: NHow


much return am F ma$ing on my investment in this
company"O

2nli$e #eturn on 6ssets, "eturn on -!uity is highly


influenced by financing, and can be leveraged up in good
times and down in bad times.

Eor large companies with preferred and common shares,


the impact of preferred shares is usually e-tracted, to give
return on common shareholder e.uity.
Ceturn on E0uity 5 Net 'ncome "
-hareholder E0uity
Ceturn on E0uity 5 Net 'ncome "
-hareholder E0uity
8);
Department of Mechanical Engineering
Engineering Management Group
Market value ratios
Market value ratios

1rice to 5arnings '1H5( #atio:

5arnings are Ntrailing twelve monthO 'TT:(.

+oes not derive from financial statements alone, but


incorporates a li.uid public mar$et value of the company.

The most widely .uoted ratio for publicly traded shares.

6 wide range 'from / to over 8==( for companies with


positive earnings reflects shareholders e-pectations of future
earnings and the emotional competition between greed and
fear.
Price to Earnings Catio 5 Price per -hare "
Earning per -hare
Price to Earnings Catio 5 Price per -hare "
Earning per -hare
8)D
Department of Mechanical Engineering
Engineering Management Group
Market value ratios (()
Market value ratios (()

:ar$et to 4oo$ #atio:

6 company&s Nboo$ valueO of e.uity is related to the


ac.uisition cost of assets less depreciation.

Less useful when inflation has been high relative to initial


asset value.

Fn a low inflation environment, a low ratio when depreciation


is added bac$ in can indicate when companies are below
replacement value.

Can help to identify bargains in the stoc$ mar$et as mass


psychology swings past an e.uilibrium value.
Mar%et to <oo% Catio 5 Mar%et Price per -hare "
8-hareholder E0uity " Num!er of -hares7
Mar%et to <oo% Catio 5 Mar%et Price per -hare "
8-hareholder E0uity " Num!er of -hares7
8)A
Department of Mechanical Engineering
Engineering Management Group
1nvest!ent analysis: so!e bi' conce*ts
1nvest!ent analysis: so!e bi' conce*ts

:oney has a time value: we have an inherent


sense of this.

:uch of engineering is either designing and


building stuff, using money today, to earn future
dollars, or running stuff other engineers designed
and built.

e need to be able to relate the value of future


dollars to present dollars to decide whether to
invest.
8)9
Department of Mechanical Engineering
Engineering Management Group
Why does !oney have a ti!e value?
Why does !oney have a ti!e value?

Cash is:

Li.uid: doesn&t need to be converted to anything before it is


used.

6vailable: can be used at once.

#elatively safe: 'inflation and government stability are the ris$


factors(.

,torable.

e rent out the use of our money at a price that offsets the
loss of those four factors.

:oney is sub%ect to supply and demand forces, li$e any


other commodity.
8/=
Department of Mechanical Engineering
Engineering Management Group
What ti!e value $or the source and receiver
What ti!e value $or the source and receiver

The time value is specific to each investment, and reflects:

Fnflation

The general supply and demand for money

#is$

Li.uidity of the investment

Eor the lender H investor, the time value of money must


e-ceed anticipated inflation and offset the other factors.

4orrowers must believe they can create money at a rate


higher than the cost.
8/8
Department of Mechanical Engineering
Engineering Management Group
9iscountin' !oney
9iscountin' !oney

6 dollar in your hand today is worth more than one in the


future because you have the choice of investing today&s
dollar for a return.

6 future dollar is worth less than a dollar today because you


could invest less than a dollar today to get the same value.

+iscounted cash flow '+CE( puts all dollars on a Nlevel


playing fieldO.
'n investment analysis the terms interest1
discount rate and return on investment have
identical meanings#
'n investment analysis the terms interest1
discount rate and return on investment have
identical meanings#
8/2
Department of Mechanical Engineering
Engineering Management Group
)he key $or!ula
)he key $or!ula

The present value of a future dollar is given by


1 T WWEWW
'8 C i(
n

,o E T 1 X '8 C i(
n

here E T future value, 1 T present value, i T interest H


discount H return rate during the period, and n T the number of
periods.

Convention: money is reali!ed at the end of the period,


which is true for loans and Nclose enoughO for pro%ects.
8/)
Department of Mechanical Engineering
Engineering Management Group
With which we
With which we

Calculate the net present value (.)+) of a stream of future


dollars.

Calculate the stream of future dollars needed to pay bac$ a


present sum of money, including blending capital and
operating costs to set machine charge out rates.

Calculate the return rate at which a near term outflow of


dollars is e-actly offset by a later inflow of dollars 'the
classic investment pattern(: this is called the internal rate of
return (I"") or return on investment ("/I).

e can also calculate paybac$ period, simple or


discounted: how long does it ta$e to get our money bac$"
Fn practice, we don&t discount in this calculation.
8//
Department of Mechanical Engineering
Engineering Management Group
"o!e sa!*le *roble!s
"o!e sa!*le *roble!s

Fnsulation can save J3=,=== a year for 2= years on a


building. How much does it ma$e sense to spend if the time
value of money is 9>" 8A>"

hat is the payment on a J)==,=== mortgage at /.3>"

6 machine cost J8.2 million, is e-pected to last 8= years,


has an estimated A== billable hours per year, and has an
operating cost per billable hour of J288. hat should you
charge customers for an hour of machine time"

4uilding a waste wood steam plant at a cost of J8D million,


J3 million in the first year and J82million in the second, will
save you J2 million per year for an estimated 2= years. Fs
this a good investment"
8/3
Department of Mechanical Engineering
Engineering Management Group
=
8=====
2=====
)=====
/=====
3=====
;=====
D=====
A=====
9=====
8======
= 8 2 ) / 3 ; D A 9 8= 88 82 8) 8/ 83 8; 8D 8A 89 2=
'nterest Cate1 B
P
r
e
s
e
n
t

)
o
r
t
h
+ takeaway lesson
+ takeaway lesson
6 high time value of money means we are not willing to spend as
much to achieve the same savings. The value of ten e.ual annual
payments of J8==,===:
8/;
Department of Mechanical Engineering
Engineering Management Group
Fiscal *olicy and econo!ic activity
Fiscal *olicy and econo!ic activity

High interest rates ma$e capital more e-pensive: debt is


more costly, and e.uity investors want the e-pectation of
yet a higher return.

Heavy government borrowing and a loose money policy


aggravate inflation and raise the time value of money.

Capital investment shrin$s at such times, since the future is


worth less. This damages the prosperity of a nation.
'nterest rates are headline ne&s !ecause they affect
investment1 and hence productivity and >o!s#
'nterest rates are headline ne&s !ecause they affect
investment1 and hence productivity and >o!s#
8/D
Department of Mechanical Engineering
Engineering Management Group
What is the ri'ht value o$ i?
What is the ri'ht value o$ i?

The broad factors:


Keneral interest rate 'which is set by both inflation and the supply
and demand for money(.
,pecific funds availability: if F have surplus cash, F might accept a
lower i.
#is$.
Li.uidity.
6lternative investment opportunities.

e have escalating standards for investment hurdles:


,mall decisions in design: use paybac$.
,mall to medium revamp pro%ects: use :6## 'hurdle rate of return(.
Large pro%ects: a thoughtful detailed analysis of B1S, F## and
paybac$.
8/A
Department of Mechanical Engineering
Engineering Management Group
)he historical value o$ interest rates
)he historical value o$ interest rates
8/9
Department of Mechanical Engineering
Engineering Management Group
1n$lation: !oney *urchases less
1n$lation: !oney *urchases less
83=
Department of Mechanical Engineering
Engineering Management Group

&eal interest: no!inal interest !inus in$lation


&eal interest: no!inal interest !inus in$lation
838
Department of Mechanical Engineering
Engineering Management Group
Federal debt: one source o$ de!and
Federal debt: one source o$ de!and
832
Department of Mechanical Engineering
Engineering Management Group
8o'ical discount $actors $or calculatin' >P<
8o'ical discount $actors $or calculatin' >P<

:6## 'minimum acceptable rate of return(, the company&s


pre?defined hurdle rate of return for pro%ect investment.

6CC, the weighted average cost of capital: the deemed


cost to the company of raising a blend of debt and e.uity.

8=> and 83>, because we have five fingers.


)ith the e;ception of mandated investment that
has no revenue1 e#g# environmental protection1 'CC
8also called C/'7 is much more fre0uently used in
ma%ing investment decisions#
)ith the e;ception of mandated investment that
has no revenue1 e#g# environmental protection1 'CC
8also called C/'7 is much more fre0uently used in
ma%ing investment decisions#
83)
Department of Mechanical Engineering
Engineering Management Group
W+CC: wei'hted avera'e cost o$ ca*ital
W+CC: wei'hted avera'e cost o$ ca*ital

Sirtually all large publicly traded companies have a blend of


financing:
,hort term debt

Long term debt


1referred shares 'dividend is paid from after ta- net income(
5.uity 'the mar$et has an e-pectation of long term gain from
dividends and capital gains(

6CC ta$es a weighted average of the cost of each source


of funds, included e-pected return on capital which is
related to historical volatility of the stoc$ 'beta(.

6CC becomes the theoretical minimum hurdle rate for a


pro%ect with !ero ris$. 6 ris$ premium can be applied that is
pro%ect specific.
83/
Department of Mechanical Engineering
Engineering Management Group
)he takeaway !essa'e
)he takeaway !essa'e

6 great deal of %udgment and often intuition is often


involved in defining an appropriate value of i. Ft is
pro%ect specific, reflecting perceived pro%ect ris$. Ft
also reflects inflation, the general supply and
demand for money in the economy, and the
specific funds availability in the company.
4here is no su!stitute for
management >udgment#
4here is no su!stitute for
management >udgment#
833
Department of Mechanical Engineering
Engineering Management Group
What is the ri'ht value o$ n?
What is the ri'ht value o$ n?

:atch the payment schedule, e.g. monthly for a mortgage.

Compounding period for a loan can be less than annual:


interest is .uoted on an NannualO basis but compounding
can increase the effective rate. +isclosure is now re.uired.

:ore fre.uent compounding has a diminishing return:


6nnual: 9.====>
,emi?annual 9.2=23
Vuarterly 9.)=A)
:onthly 9.)A=D
+aily 9./8;2
Continual 9./8D/
'n practice all pro>ect investment decisions are !ased
on one n per year9 the accuracy of assumptions on
cash flo& donAt &arrant more precision#
'n practice all pro>ect investment decisions are !ased
on one n per year9 the accuracy of assumptions on
cash flo& donAt &arrant more precision#
83;
Department of Mechanical Engineering
Engineering Management Group
4ow to calculate a real rate
4ow to calculate a real rate

2se more n&s, interest T annual rate H 'n&s per year(

5-ample: compound 9> monthly on J8==.


Period 'nterest <alance
8 =.D3 J 8==.D3 J
2 =.D; J 8=8.38 J
) =.D; J 8=2.2D J
/ =.DD J 8=).=) J
3 =.DD J 8=).A8 J
; =.DA J 8=/.39 J
D =.DA J 8=3.)D J
A =.D9 J 8=;.8; J
9 =.A= J 8=;.9; J
8= =.A= J 8=D.D; J
88 =.A8 J 8=A.3D J
82 =.A8 J 8=9.)A=D J
'f you !orro& a small amount1 it usually isnIt a
!ig issue# 'f you lend !illions1 it is#
'f you !orro& a small amount1 it usually isnIt a
!ig issue# 'f you lend !illions1 it is#
83D
Department of Mechanical Engineering
Engineering Management Group
1nvest!ent analysisB ste* %: cash $low
1nvest!ent analysisB ste* %: cash $low

6ll investment analysis starts with the calculation of


incremental cash flow, both outflows and inflows.

0ear over year for construction and operationQ startup profile


is critical, late spending much less so.

Fncremental cost onlyG +eemed e-penses for accounting


calculations, e.g. depreciation or allocation of overhead, are
not included. The F## factors in recovery of capital.
'n reality1 cash flo& forecasts are influenced !y
internal politics and are far less accurate than the
techni0ues of analy,ing them# Cecord all
assumptions and chec% for internal consistency#
'n reality1 cash flo& forecasts are influenced !y
internal politics and are far less accurate than the
techni0ues of analy,ing them# Cecord all
assumptions and chec% for internal consistency#
83A
Department of Mechanical Engineering
Engineering Management Group
1nternal consistency: an e6a!*le
1nternal consistency: an e6a!*le

Consider power generation in 6lberta. There are many


sources:
Coal
Batural gas combined cycle
Hydro
ind 'but limited by necessity due to unreliability(
4iomass 'but limited by resource(

,ince there is not enough hydro, wind and biomass


capacity to meet future needs, long term power price must
be related to the cost of coal or gas based power, otherwise
new investment in these would not occur.
.onsistency in all long term assumptions1 e#g#
inflation and relative pricing1 is critical#
.onsistency in all long term assumptions1 e#g#
inflation and relative pricing1 is critical#
839
Department of Mechanical Engineering
Engineering Management Group
"te* (: Calculatin' a$ter ta6 cash $low
"te* (: Calculatin' a$ter ta6 cash $low

Ta- has its own rate of depreciation, called CC6.


2ndepreciated value is called 2CC.

:ost CC6 is declining balance.

Half year rule: use one half of otherwise allowable CC6 in


year 8.

6vailable for use rule: not until production unless the


facility is defined as a ma%or pro%ect.
4a; is highly comple; and is undergoing significant
changes in rates1 dropping to J63B# n engineer
should %no& enough to estimate in the preliminary
analysis and get help in the final investment analysis#
4a; is highly comple; and is undergoing significant
changes in rates1 dropping to J63B# n engineer
should %no& enough to estimate in the preliminary
analysis and get help in the final investment analysis#
8;=
Department of Mechanical Engineering
Engineering Management Group
Calculatin' ta6 de*reciation (CC+)
Calculatin' ta6 de*reciation (CC+)

:a$e a pool of Navailable for useO assets.

6pply the declining balance.

6pply the half year rule for assets in their first year: reduce
the CC6 by one half.

,ubtract this from the 2CC: the balance is the 2CC for the
ne-t year.

+educt total CC6 for all classes from ta-able income.

,pecial rules for the sale of an asset. Fn practice, this is so


late and so small that it can be neglected.
8;8
Department of Mechanical Engineering
Engineering Management Group
Calculatin' CC+
Calculatin' CC+
0ear Class > 2CC CC6 Half
0ear"
CC6 Bew
2CC
8 A 2= J;= J82.= 0es J;.= J3/.=
8 8= )= JD= J28.= 0es J8=.3 J39.3
8 /) )= J;== J8A= 0es J9= J38=
.ontinue this year !y year through the entire
D.F analysis#
.ontinue this year !y year through the entire
D.F analysis#
8;2
Department of Mechanical Engineering
Engineering Management Group
Calculatin' )a6
Calculatin' )a6

#evenue e-pense T ta-able income, but recogni!ed


e-penses do not include depreciation since ta- will specify
its own version of depreciation 'CC6(.

,ome other e-penses are not recogni!ed by CC#6: this are


minor and Npolitically correctO: e.g. a portion of meal and
entertainment e-pense. Eor investment analysis, this can
be ignored.

+educt CC6 up to the limit of ta-able income from all


sources 'not %ust the pro%ectG(, then apply ta- rate and
calculate ta-.
pplying .. against all company ta;a!le
income can create a !etter return for an already
ta;a!le company compared to a start up#
pplying .. against all company ta;a!le
income can create a !etter return for an already
ta;a!le company compared to a start up#
8;)
Department of Mechanical Engineering
Engineering Management Group
)he *olitically incorrect e6*ense
)he *olitically incorrect e6*ense
8;/
Department of Mechanical Engineering
Engineering Management Group
1$ *roCect ta6able inco!e e6ceeds CC+
1$ *roCect ta6able inco!e e6ceeds CC+
0ear
1re ta-
Fncome CC6
Ta-able
Fncome
Ta-
1ayable
6fter Ta-
Fncome
8 J89=.= J8=;.3 J A).3 J )2.2 J83D.A
2 J89=.= J8A8.D J A./ J ).2 J8A;.A
) J89=.= J82A.2 J ;8./ J 2).9 J8;;.8
/ J89=.= J 9=.; J 99.)/ J )A./ J838.;
3 J89=.= J ;/.8 J823.9 J /A.; J8/8./
8;3
Department of Mechanical Engineering
Engineering Management Group
1$ CC+ e6ceeds *roCect ta6able inco!e
1$ CC+ e6ceeds *roCect ta6able inco!e
0ear
1re ta-
Fncome CC6
Ta-able
Fncome
Ta-
1ayable
6fter Ta-
Fncome
8 J8==.= J8=;.3 J ?;.3 J ?2.3 J8=2.3
2 J8==.= J8A8.D J ?A8.D J ?)8.; J8)8.;
) J89=.= J82A.2 J ;8./ J 2).9 J8;;.8
/ J89=.= J 9=.; J 99.)/ J )A./ J838.;
3 J89=.= J ;/.8 J823.9 J /A.; J8/8./
'nclude negative ta; as a source of positive cash
flo& only if ta;es are !eing paid !y the parent
company1 other&ise defer the ..#
'nclude negative ta; as a source of positive cash
flo& only if ta;es are !eing paid !y the parent
company1 other&ise defer the ..#
8;;
Department of Mechanical Engineering
Engineering Management Group
When the cash $low is done
When the cash $low is done

Calculate F##.

Calculate B1S at benchmar$ values of i.

Calculate paybac$ 'years from startup(.

Calculate sensitivitiesQ how do changes in capital cost,


interest rate, completion time, fuel or feedstoc$ costs
affect F##" hat is the F## most sensitive to"

6ssess strategic fit and future opportunities.

6ssess ris$ and the potential to mitigate.


1# For pro>ects &ith high uncertainty1 use pay!ac%1 only
!ecause longer term data is so uncertain 8e#g# soft&are7#
6# For re0uired pro>ects &ith little or no revenue1 select
!ased on minimum NP=#
G# void small *dead ends+ in ne& areas#
1# For pro>ects &ith high uncertainty1 use pay!ac%1 only
!ecause longer term data is so uncertain 8e#g# soft&are7#
6# For re0uired pro>ects &ith little or no revenue1 select
!ased on minimum NP=#
G# void small *dead ends+ in ne& areas#
8;D
Department of Mechanical Engineering
Engineering Management Group
&e0uired invest!ent with no revenue
&e0uired invest!ent with no revenue

5-ample, environmental cleanup: how do F choose between


a high capital low operating cost case and a low capital high
operating cost case"

e can&t use F##: there is no revenue.

1ic$ the pro%ect that has the highest 'least negative( B1S.

B1S at 6CC would give the present value cost at the


company&s net cost of money. B1S at :6## might reflect
the ris$ that the capital investment won&t wor$.
8;A
Department of Mechanical Engineering
Engineering Management Group
1ncre!ental 1&&
1ncre!ental 1&&

,ophisticated thin$ing is re.uired when pic$ing between two


or more suitable alternatives, e.g. ways to primarily upgrade
bitumen.

+evelop a cash flow forecast and calculate F## for each


alternative.

,tarting with the lowest 'base( and second lowest cost


alternatives, calculate the incremental cash flow and F##.

Chose, based on incremental analysis. The winner is the


new base case. 1roceed stepwise with further alternatives.
8;9
Department of Mechanical Engineering
Engineering Management Group
1ncre!ental 1&& (()
1ncre!ental 1&& (()
Ff F##
alternative
Y F##
base
and you have the capital, choose the
alternative.
Ff F##
alternative
Z F##
base
but F##
incremental
Y :6## and you have
the capital, choose the alternative because even though the
overall F## is lower the e-tra funds are earning more than
:6##. hat else would you do with your funds"
Ff F##
alternative
Z F##
base
but F##
incremental
Y :6## and you don&t
have much capital, choose the base case.
Ff F##
alternative
Z F##
base
and F##
incremental
Z :6##, choose the
base case: the e-tra investment doesn&t meet your hurdle
rate of return.
8D=
Department of Mechanical Engineering
Engineering Management Group
1ncre!ental 1&& (-)
1ncre!ental 1&& (-)

Ff the ris$ of obsolescence is high, factor in


paybac$ as well as F## Y :6##.

Ff the F##s are close, pic$ the shortest


paybac$ for a pro%ect giving a return greater
than :6##.
8D8
Department of Mechanical Engineering
Engineering Management Group
"o!e *it$alls in invest!ent analysis
"o!e *it$alls in invest!ent analysis

Can not handle base business capital investment to $eep


the e-isting business running. hat does one ta$e as the
incremental income" Ff the whole plant output, the analysis
is meaningless.

The math is far more sophisticated than the forecasts,


which often evolve under political influence andHor %udgment
from a senior person.

6 deceptive confidence can ensue that mas$s the


uncertainty of the forecasts. F## analysis wor$s best for
relative investment decisions, is less precise for absolute
return.
8D2
Department of Mechanical Engineering
Engineering Management Group
&isk and its !iti'ation
&isk and its !iti'ation

,ensitivity analysis helps us identify the important areas of


ris$.

Three fundamental ways of dealing with ris$:

0ontingency: plug in a cost allowance to cover what you don&t


$now, standard practice in engineering and construction
pro%ects. Ft is a Nshoc$ absorberO.

"eturn: the higher the perceived ris$, the higher the hurdle
rate. Ff fully e-posed to mar$et price ris$, e-pect a higher
return.

%itigation: identify the ris$ you can&t accept and develop a


plan to buy your way out of that ris$.
Most larger pro>ects &ill have a com!ination of all
three# Most smaller pro>ects &ill rely on
contingency alone#
Most larger pro>ects &ill have a com!ination of all
three# Most smaller pro>ects &ill rely on
contingency alone#
8D)
Department of Mechanical Engineering
Engineering Management Group
Contin'ency
Contin'ency

,hrin$s as pro%ect definition increases.

<ften triggered by NclassO of estimate: factored, ma%or


e.uipment, all e.uipment and hours, post e.uipment
purchase.

1ro%ect NdrawsO from contingency, monitoring it is a ma%or


pro%ect control tool.

Vuantification of contingency is an area of active


research.

:onte Carlo simulation suffers from gigoQ inputs are highly


%udgmental and final output is often %igged to fit prior
e-pectations.
8D/
Department of Mechanical Engineering
Engineering Management Group
&eturn
&eturn

e automatically e-pect higher return for higher ris$.

,ome firms .uantify this and tie it to specific business


targets.

Eailure rate increases with higher ris$ H return. Senture


capital firms operate at the far end of the spectrum and
e-pect /=> returns and a high drop out rate.
8D3
Department of Mechanical Engineering
Engineering Management Group
1denti$ication and !iti'ation
1denti$ication and !iti'ation

*ey .uestions:

hat are the ris$ elements.

ho can ta$e these"

hat is the price"

5-ample: doing a pro%ect in a foreign country and


being paid in the local currency. Ff in 2,, 5urope,
6ustralia or [apan, forward sales mechanisms are
easy. Ff in \aire or 2!be$istan, currency hedging
mechanisms are non?e-istent and a national
government, orld 4an$ or other aid body is the
most li$ely acceptor of ris$.
8D;
Department of Mechanical Engineering
Engineering Management Group
&isk ele!entsB ?PC
&isk ele!entsB ?PC
Cis% Mitigation
1olitical CF+6, 4 or 6+4 guarantee.
4an$ruptcy Completion 'performance( bond or guarantee by
more credit worthy party.
1ro%ect
Cancellation
1repayment, funds in trust, guarantee.
+elayed
,tart
:a$e national government a guarantor in the event
of change of regulation.
Eoreign
e-change
<wn currency as basis, hedge or guarantee.
Eoreign
ta-es
:a$e national government a guarantor in the event
of change of regulation.
8DD
Department of Mechanical Engineering
Engineering Management Group
&isk ele!entsB ?PC (()
&isk ele!entsB ?PC (()
Cis% Mitigation
Contract Fnternational arbitrator or court, guarantee by
national government.
Batural
+isaster
Fnsurance.
Loss +uring
Transport
Fnsurance 'loss of item or business interruption""(.
,tri$e H
Loc$out
6 pro%ect specific Nno stri$e H no loc$outO agreement.
Technical
Elaw
Eormali!ed review, periodic constructability reviews.
F1
Fnfringement
5-ternal or internal review, third party supplier
indemnification.
8DA
Department of Mechanical Engineering
Engineering Management Group
&isk ele!entsB o*eratin' co!*anies
&isk ele!entsB o*eratin' co!*anies
Cis% Mitigation
Eeedstoc$ H
2tilities 1rice
Long term contract, hedging, re?opener clause in all
contracts, vertical integration.
1roduct 1rice
+rop
1re?sold long term contracts 'ensure enforceability(.
Change in
#egulations
#eview li$elihood of affecting some vs. all, develop
industry based lobby, understand life cycle.
Change in
Ta-ation
#eview li$elihood of affecting some vs. all, develop
industry based lobby.
8D9
Department of Mechanical Engineering
Engineering Management Group
+sset vs. share sale
+sset vs. share sale

6 company can be effectively purchased in two manners:

4uy the shares. Ff an individual purchase, the company is


unchanged e-cept for ownership. Ff a company
purchase, the bought company is folded into the new
company, which assumes all the obligations.

4uy the assets. The company that sells the assets still
e-ists, but its only asset is cash, which is disperses to its
shareholders as a repayment of capital and a dividend.
4hese t&o methods have very different ris% and
ta; implications# @egal and ta; advice is needed#
4hese t&o methods have very different ris% and
ta; implications# @egal and ta; advice is needed#
8A=
Department of Mechanical Engineering
Engineering Management Group
+sset vs. share sale (()
+sset vs. share sale (()

,hare sale:

Transfers company liabilities, 2CC as per the company&s


boo$s, ta1 losses (if similar business).

4uyer has goodwill from any e-cess of purchase price over


boo$.

,eller pays capital gain on sale of shares.

6sset sale:

,eller $eeps company and its liabilities, any recapture of


CC6 is treated as income and sub%ect to ta-.

4uyer recreates CC6 at purchase price or fair mar$et valueQ


if arm&s length, purchase price is usually deemed to be fair
mar$et value.
8A8
Department of Mechanical Engineering
Engineering Management Group
What drives value $or sale o$ a co!*any?
What drives value $or sale o$ a co!*any?

Li$e any other investment, the prime driver is pro%ection of


future cash flow.

54FT is the most common financial number used to forecast


cash flow from a Ngoing concernO.

2sing 54FT assumes that future capital replacement can be


ade.uately covered by depreciation during the paybac$
period.

54FT+ can more accurately forecast cash flow in


speciali!ed cases where reinvestment is not needed in the
paybac$ period.
Multiples of E<'4 or E<'4D are commonly cited in
the sale of privately held companies#
Multiples of E<'4 or E<'4D are commonly cited in
the sale of privately held companies#
8A2
Department of Mechanical Engineering
Engineering Management Group
<aluation is co!*le6
<aluation is co!*le6

The method depends on the case.


<uyer is
pu!lic
<uyer is
pu!lic
<uyer is
private
<uyer is
private
Esta!lished
Esta!lished
-tartup
-tartup
Good " -teady
Earnings
Good " -teady
Earnings
No " Erratic
Earnings
No " Erratic
Earnings
E;tension of
technology or
mar%et
E;tension of
technology or
mar%et
<rea%through
<rea%through
E<'41 Kigher
Multiple
E<'41 Kigher
Multiple
E<'41 @o&er
Multiple
E<'41 @o&er
Multiple
=alue Celated to
ssets 8'f
Future Profit7
=alue Celated to
ssets 8'f
Future Profit7
Ceplacement
=alue of ssets
? *head start+
Ceplacement
=alue of ssets
? *head start+
*<lue -%y+
*<lue -%y+
8A)
Department of Mechanical Engineering
Engineering Management Group
?6*ected $uture earnin's drive valuation
?6*ected $uture earnin's drive valuation

The mar$et focus is on the future earning power of a


business, not on its shareholder e.uity or value of fi-ed
assets.

4usinesses that have no cash flow from operations are


worth brea$up value if there is no prospect of earnings, or
replacement value if purchase at a lower cost will generate
earnings.
Firm Fi;ed
ssets
-hareholder
E0uity
nnual
Earnings
Mar%et
.ap
Eord J2/.; K J?;.3 K J2.D K J/=.= K
:icrosoft JD.3 K J)9.3 K J8/.; K J22; K
8A/
Department of Mechanical Engineering
Engineering Management Group
Other $actors in valuation
Other $actors in valuation

Low Nbarriers to entryO reduce the multiple that a business


can command.

#eplacement value ma$es more sense when cash flow is


not consistent and often !ero.

54FT needs to be ad%usted for management bonuses in


small Canadian businesses. Leave fair salary in
e-penses, add bac$ the rest.

,trategic buyers outbid financial buyers because they can


build on some synergy. Eind one if you are sellingG

Kood records build valueG

1ublicly traded companies have far higher multiples and


special considerations. ,pecial advice is needed.

4rea$up value is a special 'and painful( case.


8A3
Department of Mechanical Engineering
Engineering Management Group
<aluation o$ a *ublicly traded stock
<aluation o$ a *ublicly traded stock

There is no set ruleQ if there were, all who $new it would


be richG

The regulator ta$es pains to achieve:

Li.uidity

6ccessibility

Eairness

<ur NsystemO depends on this.

,trict rules for a prospectus: full, plain and true.

Limits on insider trading, ma%or events re.uire notice


and often suspension of trading.
8A;
Department of Mechanical Engineering
Engineering Management Group
Chan'es in stock or bond value
Chan'es in stock or bond value

Ff a stoc$ or bond increases in value, the issuer


does not see that increase, only the NownerO.

The theory is that managers wor$ for the owners.


The reality is comple- and shifts over time.

The mar$et value of bonds is driven by interest rate


changes. Ealling interest increases the value of
bonds.

,toc$ values are changed by interest rates


'because interest investments compete(,
profitability, and growth prospects.
8AD
Department of Mechanical Engineering
Engineering Management Group
1nvest!ent styles
1nvest!ent styles

Conservative: focus on yield 'cash transfers to owner,


hence bonds and high dividend stoc$s(.

Salue: loo$ for low 1H5 and steady 'usually low( growth
in income.

Krowth: loo$ for evidence of high growth rates.

,peculative: loo$ for the ne-t new thing or invest for


changes in commodity value.
8AA
Department of Mechanical Engineering
Engineering Management Group
&unnin' a business
&unnin' a business

,ales:
,hare is a bigger signal than absolute sales level. ,low growth
plus loss of share spells trouble.

:argin:
:argins fall as a business matures and competitors focus on price
to buildHhold share.
N1ass it onO is crucial to holding margin.

,KU6:
The natural tendency in good times is to get soft. Too much or too
little softness spells trouble.

Fntegrating the three:


<ne can build revenue by margin 'higher price lower share(, by
price 'lower margin higher share(, and by promotion 'higher
salesHshare, higher cost(. There is no free lunch, the answer is
usually intuitive.
8A9
Department of Mechanical Engineering
Engineering Management Group
&unnin' a business (()
&unnin' a business (()

#eceivables:
Collect them by nagging N%ust the right amountO.

Fnventory:
+o you need so much '%ust in time("
ill your supplier own it"
Fs e-press shipping a cheaperHbetter alternative"
6void the big hit, write down stale inventory in small doses.

1ayables
Tap this for special needs 'Nthe big saleO(.
4e fair, not foolish.

,hort Term Credit Line


Cash 'as measured by or$ing Capital( is breath.
89=
Department of Mechanical Engineering
Engineering Management Group
)ra'edy o$ the co!!ons
)ra'edy o$ the co!!ons

6 common gra!ing area shared by many has the following


productive capacity.
No# Produc# No# Produc#
D 28== 8) 233=
A 22== 8/ 2/3=
9 2)== 83 2)23
8= 2/== 8; 22==
88 2/D3 8D 2=3=
82 2323 8A 89==
'f L farmers share the common and each have
one sheep1 ho& many sheep &ill gra,e the
common ne;t year(
'f L farmers share the common and each have
one sheep1 ho& many sheep &ill gra,e the
common ne;t year(
898
Department of Mechanical Engineering
Engineering Management Group
Cyclical *ricin': nickel
Cyclical *ricin': nickel
Fluctuation in Nic%el Price
=.==
3.==
8=.==
83.==
2=.==
$ear
D
e
c
e
m
!
e
r

N
i
c
%
e
l

P
i
r
c
e
1

U
-
2
"
l
!
6ctual
Fn Constant 8999J
Salues
892
Department of Mechanical Engineering
Engineering Management Group
Cyclical *ricin': a!!onia
Cyclical *ricin': a!!onia
Fluctuation in mmonia Price
=
3=
8==
83=
2==
23=
)==
)3=
8
9
A
=
8
9
A
2
8
9
A
/
8
9
A
;
8
9
A
A
8
9
9
=
8
9
9
2
8
9
9
/
8
9
9
;
8
9
9
A
$ear

v
e
r
a
g
e

n
n
u
a
l

m
m
o
n
i
a

P
r
i
c
e
1

U
-
2
"
t
o
n
6ctual
Fn Constant 8999J
Salues
89)
Department of Mechanical Engineering
Engineering Management Group
Why does cyclical *ricin' occur?
Why does cyclical *ricin' occur?

The allegory of the tragedy of the commons provides a


model for cyclical pricing in commodity businesses:

6ll producers see the same opportunity at the same time.

6ll invest as if they are the only investor.

<vercapacity depresses the mar$et.

The e-pected mar$et price must return to a level that


generates profitability for a new investor before the cycle
begins again.

6ffects industries with an undifferentiated product, high


capital cost and long construction time. Fs deregulated
power a candidate"
89/
Department of Mechanical Engineering
Engineering Management Group

The math is simple. hat is hard is

+etecting the right information from financial statements and


from people.

2nderstanding the right thing to do.

:ost business situations are ambiguous: there is no clear


correct answer. This is a setting for intuition, the right hand
side of the brain, and fealty.

:easurement is a powerful tool of change.


Meep an open mind1 e;pect mista%es and
learn from them1 listen to all !ut follo& your
o&n intuition#
Meep an open mind1 e;pect mista%es and
learn from them1 listen to all !ut follo& your
o&n intuition#
893
Department of Mechanical Engineering
Engineering Management Group
)hou'ht *rovokin' 0uestion (-)
)hou'ht *rovokin' 0uestion (-)

6 female red fiddler crab lays 8=


3
eggs per molt,
and will molt on average 3 to 8= times in a normal
life e-pectancy.

<n average, how many of the eggs will


successfully hatch and grow to be reproductive
adult red fiddler crabs"