MBAM 614 Finance
Spring 2004
• MBAM614
Class 1 - 1
• MBAM614
Class 1 - 2
1
• MBAM614
Class 1 - 3
Course Outline
Text is Ross, Stephen A., R. W. Westerfield, and J. Jaffe, “Corporate Finance,” 6th Edition, Irwin/McGrawHill, 1999 3 Exams: 50%, 35% and 15%
- best grade counts for 50% - next best grade is 35% - last grade counts 15% - you MUST write all 3 exams
Exam Dates:
Sat, February 7, 1 – 3 pm Sat, March 13, 1 – 3 pm Sat, April 10, 1 – 3 pm
• MBAM614
Class 1 - 4
2
Learning Objectives
Introduce Corporate Finance Review Financial Statements Introduce Common Size Statements and Ratio Analysis
• MBAM614
Class 1 - 5
What is the Goal of Financial Management?
Many different possible goals: Survive, Min. Costs, Max. Revenues, Increase Market Share, etc. Financial Manager manages for the owners (Shareholders) Shareholders want to Make Money! Good Financial Management Increases Shareholder Wealth
• MBAM614 Class 1 - 6
3
What are the Primary Decisions That a Financial Manager Makes?
Investment Decisions
Current Assets Net Working Capital
Financing Decisions
Current Liabilities
Fixed Assets: 1. Tangible 2. Intangible
Long Term Debt Shareholders’ Equity Total Value of the Firm to Investors
Class 1 - 7
Total Value of Assets
• MBAM614
John Labatt Limited Balance Sheet - 1991
Investment Decisions
Cash Accounts Rec. Inventories Prep. Exp.
Financing Decisions
$ 519 MM $ 27 MM
$300 MM Trade Credit $409 MM Taxes Payable $444 MM $ 81 MM NWC = $688 MM Bonds
$1,055 MM
Fixed Assets Other
$1,257 MM $ 647 MM
Shareholders’ Equity
$1,537 MM
Total Value of Assets
• MBAM614
Total Book Value of the Firm to Investors
Class 1 - 8
4
What are the Basic Concerns?
What Long Term Investment Strategy Should the Firm Undertake? – Business Strategy or Capital Budgeting Decision How Can Cash be Raised for the Required Investment? – Financial Strategy or Capital Structure Decision How Much Short-term Cash Flow Does a Company Need to Pay Its Bills? – Working Capital Management Decisions
• MBAM614
Class 1 - 9
How Much Money do the Projects Make?
Revenues
-
Expenses
=
Income
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Class 1 - 10
5
John Labatt Limited Income Statement - 1991
Net Sales Costs of Sales Depreciation EBIT Interest Earnings Before Tax Net Tax NET INCOME
• MBAM614
$4,700 MM 4,350 MM 150 MM 200 MM 41 MM 159 MM 50 MM 109 MM
Class 1 - 11
Why Do Liabilities (Stocks & Bonds) Have Value?
Claims on the Money or Cash Flows Generated by the Assets (based on accounting identity: Assets = Liabilities + Equity)
Free Cash Flows From Assets
(after re-investment)
=
Net Cash Flows to Bondholders
(first claim)
+
Net Cash Flows to Shareholders
(residual claim)
Cash Generated > Cash Consumed Value Created for Shareholders
• MBAM614
Class 1 - 12
6
What Are Free Cash Flows From Assets?
Assets used in Day-to-Day Operations to Generate Cash Flows: Cash Flow From Operations less Must Maintain Old Assets and Invest in New Assets to Continue Operations: Net Capital Investment less As Sales Grow, Need Additional Inventories, Accounts Receivables, etc. (CA) and Will Produce/Consume More so Will Increase Accounts Payable, etc. (CL): Additions to Net Working Capital
• MBAM614 Class 1 - 13
Cash Flows From Operations
Cash Revenues Generated From Operations less Cash Expenses Incurred Due to Operations (not including non-cash expenses)
Cash Flow From Operations
=
EBIT
+
Depreciation
-
Taxes
• MBAM614
Class 1 - 14
7
John Labatt Limited Cash Flow from Operations - 1991
Net Sales Costs of Sales Depreciation EBIT Interest Earnings Before Tax Net Tax NET INCOME Cash Flow = from Ops EBIT Depreciation + 200 150 $4,700 MM 4,350 MM 150 MM 200 MM 41 MM 159 MM 50 MM 109 MM Taxes = $300 MM 50
-
• MBAM614
Class 1 - 15
Net Capital Investments
Cash Spent on Capital Assets less Cash Received From Sale of Capital Assets Year-end Beginning New Assets = + - Depreciation Net Assets Net Assets Assets Sold
Net Capital Investments
Net Capital Investments
=
Year-end + Depreciation Net Assets
-
Beginning Net Assets
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Class 1 - 16
8
John Labatt Limited Net Capital Investment
Cash Accounts Rec. Inventories Prep. Exp. Fixed Assets 1991 $ 300 $ 409 $ 444 $ 81 $1,904 1990 300 418 397 69 1,762 Trade Credit Taxes Payable Bonds Share Equity Retained Earn. 1991 $ 519 $ 27 $1,055 $ 608 $ 929 1990 473 84 892 595 902
Year-end Depreciation Net Assets + 150 (I/S) 1,904
-
Beginning Net Assets 1,762
=
Net Capital Investments $292 MM
• MBAM614
Class 1 - 17
Additions to Net Working Capital
Ending Net Working Capital (CA-CL) less Beginning Net Working Capital (also CA - CL) Net Working Capital Current Assets Current Liabilities
=
-
Increases Usually to Support Increases in Fixed Assets Decreases Usually Due to Reductions in Fixed Assets
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Class 1 - 18
9
John Labatt Limited Additions to Net Working Capital
Cash Accounts Rec. Inventories Prep. Exp. Fixed Assets 1991 $ 300 $ 409 $ 444 $ 81 $1,904 1990 300 418 397 69 1,762 Trade Credit Taxes Payable Bonds Share Equity Retained Earn. Current Liabilities (473+84) Current Liabilities (519+27) 1991 $ 519 $ 27 $1,055 $ 608 $ 929 1990 473 84 892 595 902 NWC $627 MM NWC $688 MM
Current Assets (300+418+397+69) Current Assets (300+409+444+81)
-
=
-
=
Additions to = NWC
• MBAM614
Ending NWC 688
Beginning NWC = $61 MM 627
Class 1 - 19
John Labatt Limited Free Cash Flows From Assets
Free Cash Flows From Assets
=
Cash Flows Net Capital - Investment from Operations
-
Additions to NWC
-$53 MM
$300 MM
$292 MM
$61 MM
Labatt Spent More Cash on New Assets in 1991 Than Their Assets Generated Where did the CASH Come From?
• MBAM614 Class 1 - 20
10
Free Cash Flows From Assets Revisited
Free Cash Flows From Assets
=
Net Cash Flows to Bondholders
+
Net Cash Flows to Shareholders
Cash Flows Belong to the Suppliers of Funds (A = L + E) If More Cash is Spent on Assets Than They Generate, Suppliers of Funds Must Have Invested More Cash Labatt Must Have Issued More Bonds and/or More Stock
• MBAM614
Class 1 - 21
What Are Net Cash Flows To Bondholders?
Cash Flows to Bondholders (Interest Payments) less Cash Flows from Bondholders (Net New Borrowings)
Year-end Bonds = Beginning Bonds + New Bonds Bonds Repaid
Net New Bonds
Net Cash Flows to Bondholders
=
Interest Payments
-
Year-end Bonds
+
Beginning Bonds
- Net New Bonds
• MBAM614 Class 1 - 22
11
John Labatt Limited Net Cash Flows To Bondholders
Cash Accounts Rec. Inventories Prep. Exp. Fixed Assets 1991 $ 300 $ 409 $ 444 $ 81 $1,904 1990 300 418 397 69 1,762 Trade Credit Taxes Payable Bonds Share Equity Retained Earn. 1991 $ 519 $ 27 $1,055 $ 608 $ 929 1990 473 84 892 595 902
Interest Payments 41 (I/S)
-
Net New Bonds 1,055 - 892 = 163
=
Net Cash Flow to Bondholders - $122 MM
• MBAM614
Class 1 - 23
What Are Net Cash Flows To Shareholders?
Cash Flows to Shareholders (Dividends) less Cash Flows from Shareholders (Net New Stock Issues)
Year-end R/E
=
Beginning R/E
+
Net Income
-
Dividends Paid
Net Cash Flows to Shareholders
=
Beginning R/E
+
Net Income Dividends
-
Year-end R/E
-
Year-end Stock
+
Beginning Stock
- Net New Stock Issues
Class 1 - 24
• MBAM614
12
John Labatt Limited Net Cash Flows To Shareholders
Cash Accounts Rec. Inventories Prep. Exp. Fixed Assets 1991 $ 300 $ 409 $ 444 $ 81 $1,904 1990 300 418 397 69 1,762 Trade Credit Taxes Payable Bonds Share Equity Retained Earn. 1991 $ 519 $ 27 $1,055 $ 608 $ 929 1990 473 84 892 595 902
Dividends Paid 902+109-929 = 82
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Net New Stock 608-595 = 13
=
Net Cash Flow to Stockholders $69 MM
Class 1 - 25
Free Cash Flows
Free Cash Flows From Assets
Operations New Assets New NWC 300 (292) ( 61)
=
Net Cash Flows to Bondholders
Interest New Bonds 41 (163)
+
Net Cash Flows to Shareholders
Dividends New Stock 82 (13)
- $53 MM
- $122 MM
$69 MM
• MBAM614
Class 1 - 26
13
Standardized Financial Statements
How Can We Compare Firms of Different Sizes? How Can We Compare a Firm’s Performance Over Time if it is Changing in Size? Must Standardize Financial Statements Common Size Statements – Express B/S as Percentage of Total Assets – Express I/S as Percentage of Total Sales
• MBAM614
Class 1 - 27
John Labatt Limited Common Size Balance Sheet
1991 $ 300 $ 409 $ 444 $ 81 $1,904 CS 9.6% 13.0% 14.1% 2.6% 60.7% 1991 $ 519 $ 27 $1,055 $ 608 $ 929 CS 16.5% 0.9% 33.6% 19.4% 29.6%
Cash Accounts Rec. Inventories Prep. Exp. Fixed Assets
Trade Credit Taxes Payable Bonds Share Equity Retained Earn.
Total Assets
$3,138
Total Liab & Equity: $3,138
Common Size Cash = $300 / $3,138 = 9.6%
• MBAM614
Class 1 - 28
14
John Labatt Limited Common Size Income Statement
1991 $4,700 MM 4,350 MM 150 MM 200 MM 41 MM 159 MM 50 MM 109 MM CS 100.0% 92.6% 3.2% 4.3% 0.9% 4.4% 10.6% 2.3%
Net Sales Costs of Sales Depreciation EBIT Interest Earnings Before Tax Net Tax NET INCOME
Common Size EBIT = $200 / $4,700 = 4.3%
• MBAM614
Class 1 - 29
Basic Tools to Assist in Assessing Financial Health?
Liquidity Ratios: To Assess a Firm’s Ability to Pay Its Short-term Firm’ Short(Maturing) Obligations Financial Capacity (Leverage and Coverage) Ratios: To Assess a Firm’s Ability to Meet Its Financial Firm’ Obligations and To Raise Additional Funds in Good Times and Bad Profitability Ratios: To Assess the Overall Managerial Efficiency of a Firm Activity Ratios: To Assess How Efficiently a Firm is Employing Its Resources
• MBAM614 Class 1 - 30
15
Basic Tool to Assist in Assessing Financial Health?
Ratios: Liquidity: Current = CA / CL Acid Test = (CA - Illiquid Assets) / CL Financial Capacity: Coverage = EBIT / Interest Leverage = Debt / Equity Profitability: Return on Net Assets = NIAT / NA Return on Equity = NIAT / Equity Activity: Collection Period (Days) = AR/(Sales/365) Inventory Turnover = Sales / Inventory Accounts Pay. (Days) =AP/(Purchases/365)
Ad Hoc, No Theoretical Definitions
• MBAM614 Class 1 - 31
Putting Financial Ratios in Perspective
Level: Trend: Comparison: Relative to Some Standard Over Time Against the Industry Leader Against Our Own Best Past Performance
• MBAM614
Class 1 - 32
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Key Points
1. Goal of Financial Manager is Increase Shareholder Wealth 2. Principal Financial Decisions are: Capital Budgeting (Business Strategy); Capital Structure (Financial Strategy); and Working Capital Management 3. FCF to Assets = NCF to Bondholders + NCF to Shareholders (based on TA = TL + E) 4. Compare Across Time or Firms With Common Size Statements 5. Ratio Analysis Looks at: Levels, Trends, Comparison
• MBAM614 Class 1 - 33
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