Applied Corporate Finance Aug 2014. Question -1 Why are you in business as an owner (main...

Applied Corporate FinanceAug 2014

Question -1 • Why are you in business as an owner (main shareholder)?• Choose the right answer

• To provide employment• Because you love it• To keep customers happy• To keep your status• To comply with the laws of the land• To make profits• To maximise the value of the firm

• When we choose the right option, there is rarely a conflict

Question - 2• What do you see as the role of finance

The questions we grapple with• How do I know if I am making enough money for the effort I am putting

• How do I even define return – is it profits?; is it returns on capital employed?; is it IRR?

(what is IRR!)

• My land today has more value than my business! Should I just get out and sell it? Then

what happens to my business; how do I measure my convenience of getting to work

• If I did not put my money in the business, I would put in FD? Or I would put in real

estate? What is my alternate opportunity?

• How do I measure effort?

The questions we grapple with• It is a family business/ been going on for generations; why would I see anything new

now?

• The business pays my bills. How do I measure the true return? When it pays my bills, how

do I decide how much to leave and how much to take out?

• Professionals vs family managers – how does it matter? I am toiling away here - how do I

measure all that?

• I am constantly squeezed by my OEM customers and my supplier does not give credit -

isnt all that risk?

• The bank asks for 2 rupees from me for every 1 rupee they will give. For that they want

my property, my land and my peace of mind all pledged – isnt that risky?

• I don’t think my son is interested in the business. I would rather sell it – how much is it

worth?

• Is it better to be in an internet business? – they seem to be making all the money

First Principles • Invest in projects that yield a return greater than the minimum acceptable “hurdle”

rate. (Investment)

• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

• Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

• Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. (Financing)

• If there are not enough investments that earn the hurdle rate, return the cash to the owners of the firm. (Dividend)

Objective: Maximize the Value of the Firm

The Role of Finance

• Investment Decision

• Financing Decision

• Dividend Decision

MEASURING RISKIdentifying and defining Risk

First Principles • Invest in projects that yield a return greater than the minimum acceptable hurdle rate

(RISK). (Investment)

• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

• Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.




Question - 3

• How much minimum return do you want from your business?

The notion of Risk• Since financial resources are finite, there is a “hurdle” that

projects have to cross before being deemed acceptable.• This hurdle will be higher for riskier projects than for safer

projects. Higher the risk, higher the return you want

• A simple representation of the hurdle rate is as follows:• Hurdle rate = Riskless Rate + Risk Premium

• The two basic questions that every risk and return model in finance tries to answer are:• How do you measure risk?• How do you translate this risk measure into a risk premium?

The Chinese got it right

• Risk, in traditional terms, is viewed as a ‘negative’. Webster’s dictionary, for instance, defines risk as “exposing to danger or hazard”.

• The Chinese symbols for risk, reproduced above, give a much better description of risk

• The first symbol is the symbol for “danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity.

The decisions we make• Any decision that requires the use of resources (financial or

otherwise)is a project.• Broad strategic decisions• Entering new areas of business• Entering new markets• Acquiring other companies

• Tactical decisions• Management decisions• The product mix to carry• The level of inventory and credit terms• Decisions on delivering a needed service• Lease or buy a distribution system• Creating and delivering a management information system

How do you measure risk?• It is the cost of my capital invested• It is the minimum return I expect for the business risk I have

taken

• I invest equity• I borrow debt

• Risk is some average of the cost of equity and debt

Measuring cost of equity and debt• Lets ask a simple question – If I have to invest in the business,

how much should I get?• How did I arrive at the answer?• The answer is some function of what I would get for investing in

something I view as having no risk PLUS some premium for a risk I am taking• Cost of Equity= Risk Free rate + Premium

• Cost of debt is the cost of borrowing to meet the needs less the tax rate

• Cost of Capital is the average of cost of equity and debt

Cost of Equity• There is a famous CAPM Model (for those interested in

mathematics!)

• Cost of Equity = Risk free rate + β X Risk Premium

• Risk Free rate – Government bond- around 7 – 8%

• Beta – depends on your business (higher for smaller businesses with fewer customers with lower margins) – could range between 1 and 2; unless of course you are in the business of gold!

• Risk Premium – the amount you want over and above the risk free rate for the risk you are taking – typically around 7%

MEASURING RETURN

Question- 4• How do you measure return?• Choose the right answer• Is it profits?• Is it return on capital employed• Is it a cash flow based measure

Time Value of money• A rupee today is more valuable than a rupee tomorrow • Inflation, uncertainty, we all prefer current consumption

• If your cost of capital is 10%, and cash flow at the end of first year is Rs 100 and second year is Rs 100, • present value = (100/1.1) + (100/(1.1^2)) = 173.55• This means you would be no better of or worse off if I gave you

either• Rs 173.55 today or Rs 100 each year for the next two years

• A finance guru will say Rs 173.55 is the present value of the cash flows

How do you define cash flows in a business?

SalesLess: Material Cost

Less: Conversion CostLess: Manpower Cost

Less: Selling and administration cost:Less depreciation

=Earnings before interest and taxes

Less Taxes (i.e. X 1-tax rate)Add Depreciation

Less: Working capital changeLess: Capital expenditure

= Free Cash flow to the firm

The value of the firm is the present value of the free cash flows the firm will earn each year discounted by the cost of capital

Summarising the investment decision

• If the present value of the free cash flows (Return) discounted at the cost of capital (risk) from the project or business • is greater than the investment you make

• Go ahead with the project• Else, reject it.

• Points to ponder• How long do I have to estimate cash flows – as long as you can –

5 or 7 or 10 years is good • What happens if the projections are wrong – Bad luck

Mistakes you can make

• If you estimate your cost of capital or risk to be too high – you may reject projects that would have otherwise been good

• If you estimate your risk to be too low, you will take a project which you should not be taking

First Principles • Invest in projects that yield a return greater than the minimum acceptable hurdle

rate. (Investment)• The hurdle rate should be higher for riskier projects and reflect the financing mix used -

owners’ funds (equity) or borrowed money (debt)• Returns on projects should be measured based on cash flows generated and the timing of

these cash flows; they should also consider both positive and negative side effects of these projects.




FINANCING DECISION

Choices in Financing• There are only two ways in which a business can raise money.• The first is debt. The essence of debt is that you promise to make

fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business.

• The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments.

• The equity can take different forms:• For very small businesses: it can be owners investing their savings• For slightly larger businesses: it can be venture capital• For publicly traded firms: it is shares

• The debt can also take different forms• For private businesses: it is usually bank loans• For publicly traded firms: it can take the form of bonds

Question 5• Which is cheaper for the business• Equity or• Bank Debt? (say 12%)

Financing decision• Principle:• Equity is more expensive than debt.

• It is your money, there is no tax benefit• It is better to do business with someone else’s money taken as a

loan!• But this does not mean you keep on taking debt – you have to

match the debt to the business risk• Remember Kingfisher Airlines?

General Principles• If your business has low variable margins (selling price less

material and conversion cost) – better of with a lower debt e.g Airlines

• If your business has very high fixed costs, take lower debt• If your business is subject to statutory risks like

pharmaceuticals, take lower debt• If your business has a high technology risk, take lower debt• If you are squeezed a lot by customers and suppliers – take

lower debt• In general, if other risks are already high, do not add to it by

taking more financial risk (also known as debt)• But debt is not a bad word – it can be a good friend

Measuring the financing mix• The simplest measure of how much debt and equity a firm is

using currently is to look at the proportion of debt in the total financing.

• This ratio is called the debt to capital ratio:

Debt to Capital Ratio = Debt / (Debt + Equity)

As you add debt, cost of capital comes down, it then increases

0% 20% 40% 60% 80% 100% 120%9.50%

10.00%

10.50%

11.00%

11.50% Cost of capital

Presence of Debt

Cost

of C

apita

l

So how much debt?• By choosing the right mix of debt, you lower your cost of

capital (risk) and therefore maximise the return you can make• Other points to ponder• Debt should be capable of being repaid by the cash flows from

the business• It should be an amount you are intuitively comfortable with• Generally (EBITDA X 2 is a good measure)

DIVIDEND DECISION

The objective function – First Principles

• Invest in projects that yield a return greater than the minimum acceptable hurdle rate. (Investment)• The hurdle rate should be higher for riskier projects and reflect the financing mix used -






Simple rule of thumb• If a company has excess cash, and few good projects (NPV>0),

returning money to owners is GOOD.• If a company does not have excess cash, and/or has several

good projects (NPV>0), returning money to stockholders is BAD.

• Remember what Infosys ex CFOs are saying now? Wonder why they didn’t say this when they were in their jobs!

MAXIMISING VALUE

Maximising value• To summarise• Take projects that return more than your risk• Lower your risk by mixing appropriate amount of debt with

equity• Do not take cash out of the business if the business is capable of

returning more than what you can otherwise do with the cash….if you had better uses of cash, don’t be in the business anyway!

Simple measures for a running business

• Asset turnover ratio = Sales / Assets; Assets = fixed Assets + working capital

• EBIT margins (Earnings before interest and taxes / Sales)

• Return on capital employed (ROCE)

• (Sales/Assets) X (EBIT/ Sales) = ROCE

• Higher the ROCE, the better of you are

VALUATION

So how much is the business worth?• To calculate this• Take Free cash flows to the firm• Do the projections for 5 years• Apply a perpetuity in the 5th year

• To calculate perpetuity – take the last year cash flow (CF)• Take (CF/(Cost of capital - Growth rate))

• Calculate the present value of all these cash flows

• Subtract Debt

• The balance is your equity value

P/L statementYear 1 Year 2 Year 3 Year 4 Year 5

Sales 100.0 110.0 121.0 133.1 146.4 Material Cost 65.0 71.5 78.7 86.5 95.2 Power etc 4.0 4.4 4.8 5.3 5.9 Labor Cost 10.0 11.0 12.1 13.3 14.6 Selling Expenses 5.0 5.3 5.5 5.8 6.1 Admin Exp 3.0 3.2 3.3 3.5 3.6 Earnings before interest and tax and Depreciation (EBITDA) 13.0 14.7 16.6 18.7 21.0 Depreciation 1.6 1.6 1.6 1.7 1.7 Earnings before Interest and Tax (EBIT) 11.4 13.1 15.0 17.0 19.3 Interest 1.0 0.8 0.6 0.4 0.2 Profit Before Tax 10.4 12.3 14.4 16.6 19.1 Tax 3.4 4.1 4.7 5.5 6.3 Profit after Tax (PAT) 7.0 8.2 9.6 11.1 12.8

Balance sheetBalance sheetLiabilities Opening Year 1 Year 2 Year 3 Year 4 Year 5Equity 10.0 10.0 10.0 10.0 10.0 10.0 Reserves 20.0 27.0 35.2 44.8 56.0 68.8 Debt 10.0 8.0 6.0 4.0 2.0 - Total 40.0 45.0 51.2 58.8 68.0 78.8

AssetsFixed Assets 20.0 20.0 20.4 20.8 21.2 21.5 Add Capex 2.0 2.0 2.0 2.0 2.0 Less Depreciation 1.6 1.6 1.6 1.7 1.7 Closing Fixed Assets 20.0 20.4 20.8 21.2 21.5 21.8

Working Capital 20.0 22.0 24.0 26.2 28.6 31.3

Cash and Bank 2.6 6.4 11.5 17.8 25.7 Total 40.0 45.0 51.2 58.8 68.0 78.8

Cash FlowCash Flow Year 1 Year 2 Year 3 Year 4 Year 5

EBIT 11.40 13.10 14.96 17.03 19.33 Less Taxes -3.43 -4.06 -4.74 -5.49 -6.31 Add Depreciation 1.60 1.60 1.63 1.66 1.69 Less change in working capital -2.00 -2.00 -2.20 -2.42 -2.66 Less Capital Expenditure -2.00 -2.00 -2.00 -2.00 -2.00 Free Cash Flow to the Firm 5.57 6.64 7.65 8.78 10.05 Less Interest Payments -1.00 -0.80 -0.60 -0.40 -0.20 Less debt repayment -2.00 -2.00 -2.00 -2.00 -2.00 Free cash flow available to equity 2.57 3.84 5.05 6.38 7.85

ValuationValuationCost of capital 10%

Year 1 Year 2 Year 3 Year 4 Year 5Free Cash Flow to the Firm 5.57 6.64 7.65 8.78 10.05 Present Value 5.06 5.49 5.75 6.00 6.24 Sum of Present Value 28.54 Perpetuity growth Rate 3%Perpetuity Value 147.84 Total Value 176.38 Less Debt 10.00 Equity Value 166.38

CHEERS and GOOD LUCK

Applied Corporate Finance Aug 2014. Question -1 Why are you in business as an owner (main...

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