Finance FundamentalsFundamentals of Business Workshop2006

Professor David J. Denis

What is Finance?Branch of economics

Economics allocation of scarce resources Finance resource = capital

Two fundamental questions in financial management

On what projects should funds be spent? (investment decisions)From where should the funds be obtained? (financing decisions)

Topics to be Covered A. Financial planning Projection of future cash flows Need for capitalB. Valuation How much is company worth? How much equity must be given up to raise required capital?C. Sources of funding for entrepreneurs Where do we get the required capital? On what terms?

Topic I. Financial Planning Example: How to go brokewhile making a profitWhat happened? Increased sales lead to increases in receivables and greater expenditures on inventory. Because inventory is paid for right away and must be purchased in advance of sales, there is a net drain on cash.How can this be avoided? Construct a financial plan that integrates production plans (inventory), marketing plans (e.g. sales and credit terms), financing plans.

Components of financial plan Pro-forma financial statementsIncome statementBalance SheetOutcomesCapital needsFuture cash flows

Generic Income Statement Sales- Cost of Goods Sold- Selling and Administrative Expenses- Depreciation- Interest-Research and Development Expenses= Earnings before tax (EBT)- Taxes= Net Income (NI)

Generic Balance Sheet AssetsCashAccounts ReceivableInventoryProperty, Plant, Equipment

Total Assets

Liabilities and Owners EquityAccounts payableWages payableShort-term debtLong-term debtCommon stockRetained earningsTotal Liabilities and Owners Equity

Pro-forma financial statements

Always begin with sales forecastProject expenses often a % of salesForecast changes in asset and liability accounts

Topic II. Valuation Question: How much of the companys equity will the entrepreneur have to give up in order to raise required amount of capital?Depends on the value of the stream of uncertain future cash flowsneed a technique for valuation

Three primary techniques

Discounted cash flow (DCF)Market multiplesVenture capital method

Discounted cash flow Time value of money What is the present value of $100 to be received next year? PV = CFt/(1+r)t If r = 10%, PV = 100/(1+0.1) = $90.91 What is r? Required rate of return usually 40-60% in VC situations

Market Multiples Apply valuation ratio of comparable firm to firm being valued.Examples: P-E, market value/book value, Market value/ SalesProblems:What is the appropriate multiplier?Start-ups frequently do not have positive earnings, may not yet be generating sales, and have few assets.

Venture Capital Method Effectively combines the previous two methods. Commonly used in the private equity industry. Project value at some point in the future using some sort of multiple Discount that value to the present Discount rate is more ad hoc but usually high (40-75%).

Topic III. Sources of Capital DebtEquityAngelsVenture CapitalistsStrategic partners

Two Fundamental ProblemsInformation asymmetryEntrepreneur has better information than investorMoral hazardEntrepreneur has incentive to mislead investors

Solutions Monitor/reduce asymmetryAngels typically know the entrepreneur VCs demand oversight roleDiscount the value of the companyContractual terms of financing agreement

Terms of Financing Agreement ConvertiblesStaged financingPut featuresRight of first refusal