Financial Management models and diagrams for business presentations

Financial Management... 100 Slides Cash Finished goods inventory Receivables Raw materials inventory Powered by www.drawpack.com. All rights reserved. Key Words... Financial Market – Present Value – Perpetuity – Annuity – Compound Interest – Inflation – Bond Yield – Share Value – Free Cash Flow – IRR – Risk Valuation – Markowitz – SML – CAPM – Beta Risk – APT – Portfolio Theory – Economic Profit – Call Option – Straddle – Option Pricing Theory – Leverage Ratio – Liquidity – Du Pont – Private Equity – Volatility – Working Capital – Valuation – Value Drivers – Risk/Return – Diversification – Corporate Finance – Yield – NPV – Cash Transfer – Accounting The Dual Functions of Financial Markets The firm Investors Investors Investors cash newly issued securities cash outstanding securities The primary market The secondary market The financial markets Present Value Present Value Value today of a future cash flow. Discount Rate Interest rate used to compute present values of future cash flows. Discount Factor Present value of a $1 future payment. 1 PV = Value Present factor discount = PV C ´ DF r t = + 1 1 ( ) 1 1 1 1 r C C DF PV + = = ´ Net Present Value investment required -PV = NPV r C + + 1 C = NPV 1 0 Perpetuity Perpetuity -Financial concept in which a cash flow is theoretically received forever. PV C r = = lue present va flow cash Return rate discount flow cash Flow Cash of PV r C PV 1 = = Annuity Annuity -An asset that pays a fixed sum each year for a specified number of years. ( )       + -´ = t r r r C 1 1 1 annuity of PV Compound Interest 0 2 4 6 8 10 12 14 16 18 036912151821242730Number of Years FV of $1 10% Simple 10% Compound Inflation 1 + real inter est rate = 1 + nominal in terest rat e 1 + inflation rate Inflation -Rate at which prices as a whole are increasing. Nominal Interest Rate -Rate at which money invested grows. Real Interest Rate -Rate at which the purchasing power of an investment increases. Bond Prices and Yields 0 200 400 600 800 1000 1200 1400 1600 0 2 4 6 8 10 12 14 5 Year 9% Bond 1 Year 9% Bond Yield Price Valuing Common Stocks I Expected R eturn = = + r Div P P 1 0 -P P 1 0 0 g P Div r g r Div P + = = -= = 0 1 1 0 Rate tion Capitaliza Valuing Common Stocks II Return Measurements 0 1 P Div Yield Dividend = Share y Per Book Equit EPS Equity on Return = = ROE ROE Valuing Common Stocks III If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Perpetuity P Div r or EPS r = = 0 1 1 Assumes all earnings are paid to shareholders. FCF and PV HHHHrPVrFCFrFCFrFCFPV)1()1(...)1()1(2211++++++++=PV (free cash flows) PV (horizon value) NPV and Cash Transfers Cash Investment opportunity (real asset) Firm Shareholder Investment opportunities (financial assets) Invest Alternative: pay dividend to shareholders Shareholders invest for themselves Internal Rate of Return -2000 -1500 -1000 -500 0 500 1000 1500 2000 2500 102030405060708090100Discount rate (%) NPV (,000s) Rate of Return 1926 -1997 -60 -40 -20 0 20 40 60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 Year Percentage Return Common Stocks Long T-Bonds T-Bills Measuring Risk 0 5 10 15 Number of Securities Portfolio standard deviation Market risk Unique risk Portfolio Risk I 2 2 2 2 σ x 2 Stock 2 1 2 1 σ x 1 Stock 2 Stock 1 Stock 2 1 12 2 1 12 2 1 σ σ ρ x x σ x x = 2 1 12 2 1 12 2 1 σ σ ρ x x σ x x = The variance of a two stock portfolio is the sum of these four boxes: Portfolio Risk II Return Portfolio Expected ) r x ( ) r (x 2 2 1 1 + = Variance Portfolio ) σ σ ρ x x ( 2 σ x σ x 2 1 12 2 1 2 2 2 2 2 1 2 1 + + = Portfolio Risk III The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N 1 2 3 4 5 6 N STOCK STOCK To calculate portfolio variance add up the boxes Beta and Unique Risk beta Expected market return 10% 10% -+ +10% Expected return stock -10% s 2 m im i B s = Markowitz Portfolio Theory Price changes vs. Normal distribution # of Days (frequency) Daily % Change 0 100 200 300 400 500 600 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% Efficient Frontier I Standard deviation Expected Return (%) Risk A B Return Efficient Frontier II Standard deviation Expected Return (%) rf Lending BorrowingT S Efficient Frontier III Return Risk Low Risk High Return High Risk High Return Low Risk Low Return High Risk Low Return Security Market Line I Return Risk . rf Risk Free Return = Market Return = rm Efficient Portfolio Security Market Line II Return BETA . rf Risk Free Return = Market Return = rm Efficient Portfolio 1.0 Security Market Line III Return BETA rf 1.0 SML SML Equation = rf + B ( rm -rf ) Capital Asset Pricing Model (CAPM) 0 1 Beta Rf = 5% Rm = 13.5% Market portfolio rate Security market line Treasury bill rate Expected return R = rf + B ( rm -rf ) Beta vs. Average Risk Premium Avg Risk Premium 1966-91 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Consumption Betas vs. Market Betas Stocks (and other risky assets) Wealth = market portfolio Market risk makes wealth uncertain. Stocks (and other risky assets) Consumption Wealth Wealth is uncertain Consumption is uncertain Standard CAPM Consumption CAPM Arbitrage Pricing Theory Alternative to CAPMAlternative to CAPM Expected Risk Premium = r -rf = Bfactor1(rfactor1 -rf) + Bf2(rf2 -rf) + … Return = a + bfactor1(rfactor1) + bf2(rf2) + … Portfolio Risk Market return (%) Specific company return (%) Capital Structure & COC 0 20 0 0.2 0.8 1.2 Expected return (%) Bdebt Bassets Bequity Rdebt= 8 Rassets= 12.2 Requity= 15 Expected Returns and Betas prior to refinancing Risidual Income & EVA Residual Income or EVA = Net Dollar return after deducting the cost of capital. [ ] Investment Capital of Cost -earned Income required Income -earned Income Income Residual ´ = = = EVA Economic Profit Economic Profit = capital invested multiplied by the spread between return on investment and the cost of capital. Invested Capital ) ( Profit Economic ´ -= = r ROI EP Accounting Measurement ECONOMIC ACCOUNTING Cash flow + Cash flow + change in PV = change in book value = Cash flow -Cash flow -economic depreciation accounting depreciation Economic income Accounting income PV at start of year BV at start of year INCOME RETURN M&M Proposition r D E rD rE Risk free debt Risky debt rA WACC (traditional and M&M view) r D V rD rE rE =WACC r D V rD rE WACC r D V rD rE WACC Financial Distress Debt Value of unlevered firm PV of interest tax shields Costs of financial distress Value of levered firm Optimal amount of debt Maximum value of firm Call Option (long) Call option value given a $85 exercise price. Share Price Call option value 85 105 $20 Put Option (long) Put option value given a $85 exercise price. Share Price Put option value 80 85 $5 Call Option (short) Call option payoff (to seller) given a $85 exercise price. Share Price Call option $ payoff 85 Put Option (short) Put option payoff (to seller) given a $85 exercise price. Share Price Put option $ payoff 85 Protective Put Long stock and long put Share Price Position Value Protective Put Long Put Long Stock Straddle Long call and long put -Strategy for profiting from high volatility Share Price Position Value Straddle Black-Scholes Option Pricing Model (d1) = ln + ( r + ) t Ps S v2 2 v t 32 34 36 38 40 N(d1)= Binomial vs. Black Scholes Expanding the binomial model to allow more possible price changes 1 step 2 steps 4 steps (2 outcomes) (3 outcomes) (5 outcomes) etc. etc. Straight Bond vs. Callable Bond Value of straight bond 25 50 75 100 125 150 25 50 75 100 bond Value of Straight bond Bond Callable at 100 Exchange Rate Relationship 1 + r 1 + r foreign $ 1 + i 1 + i foreign $ f S foreign /$ foreign /$ E(s S foreign /$ foreign /$ ) equals equals equals equals Leverage Ratios I Long term debt ratio = long term debt long term debt + equity Debt equity ratio = long term debt + value of leases equity Leverage Ratios II Times interest earned = EBIT interest payments Cash coverage ratio = EBIT + depreciation interest payments Total debt ratio = total liabilities total assets Liquidity Ratios I Current ratio = current assets current liabilities Net working capital to total assets ratio = net working capital total assets Liquidity Ratios II Cash ratio = cash + marketable securities current liabilities Quick ratio = cash + marketable securities + receivables current liabilities Interval measure = cash + marketable securities + receivables average daily expenditures from operations Efficiency Ratios I Asset turnover ratio = sales average total assets NWC turnover = sales average net working capital Efficiency Ratios II Days' sales in inventory = average inventory cost of goods sold /365 Inventory turnover ratio = cost of goods sold average inventory Average collection period = average receivables average daily sales Profitability Ratios I Return on assets = EBIT -tax average total assets Net profit margin = EBIT -tax sales Return on equity = earnings available for common stock average equity Profitability Ratios II Plowback ratio = earnings -dividends earnings = 1 -payout ratio Payout ratio = dividends earnings Growth in equity from plowback = earnings -dividends earnings Market Value Ratios I PE Ratio = stock price earnings per share Forecasted PE ratio = P 0 aveEPS 1 r -g = Div EPS x 1 1 1 Dividend yield dividend per share stock price = Market Value Ratios II Price per share = = Div r -g P 0 1 Tobins Q = market value of assets estimated replcement cost Market to book ratio = stock price book value per share Du Pont System I ROA = sales assets x EBIT -taxes sales asset turnover profit margin Du Pont System II ROE = assets equity x sales assets x EBIT -taxes sales x EBIT -taxes -interest EBIT -taxes leverage ratio asset turnover profit margin debt burden Firm‘s Cumulative Capital Requirement Strategy A: A permanent cash surplus Strategy B: Short-term lender for part of year and borrower for remainder Strategy C: A permanent short-term borrower A B C Year 2 Year 1 Dollars Cumulative capital requirement Time Working Capital Simple Cycle of operations Cash Finished goods inventory Receivables Raw materials inventory Inventories & Cash Balances I Total order costs Order size Total costs Carrying costs Optimal order size Inventories & Cash Balances II Weeks 0 Value of bills sold = Q = 2 x annual cash disbursement x cost per sale interest rate 25 12.5 Cash balance ($000) Average inventory 1 2 3 4 5 Private Equity Partnership Investment Phase Payout Phase General Partner put up 1% of capital General Partner get carried interest in 20% of profits Limited partners put in 99% of capital Limited partners get investment back, then 80% of profits Investment in diversified portfolio of companies Sale or IPO of companies Partnership Partnership Company 1 Company 2 Company N Mgmt fees Increase in the Cash Flows from Assets Assets Cash flows form assets Debtholders They have fixed claims on these cash flows Shareholders They have residual claims on these cash flows so that the larger the cash flows, the more value created A Simplified View of the Financial Accounting Process The firm The rest of the world Financial accounting process The balance sheet Records assets and liabilities at the date of the balance sheet. Their difference is the book value of equity at that date. The income statement Records revenues and expenses over a period of time. Their difference, which represents an increase or a decrease in the book value of equity, is the profit or loss for the period. Financial transactions Sources of Risk That Increase Profit Volatility SALES Earnings before interest and taxes Earnings after taxes • Economic conditions • Political & social environment • Market structure • Firm‘s competitive position Less variable and fixed expenses Less fixed interest expenses and variable tax expenses + 10% -10% + 26% -26% + 31% -31% ECONOMIC RISK OPERATIONAL RISK BUSINESS RISK FINANCIAL RISK The Link Between the Balance Sheets and the Income Statement Assets $170 Liabilities $100 Owner‘s equity $70 Revenues $480 Expenses $469.8 Net Profit $10.2 Assets $190 Liabilities $113 Owner‘s equity $77 Retained earnings $7 Dividends $3.2 Balance Sheet December 31, 2002 Income Statement Year 2002 Balance Sheet December 31, 2001 The Managerial Balance Sheet Versus the Standard Balance Sheet The Standard Balance Sheet Total assets Liabilities and owner‘s equity Cash Operating assets Accounts receivable plus Inventories plus Prepaid expenses Net fixed assets Short-term debt Long-term financing Long-term debt plus Owner‘s equity Operating liabilities Accounts payable plus Accrued expenses The Managerial Balance Sheet Invested capital or net assets Capital employed Cash Net fixed assets Short-term debt Long-term financing Long-term debt plus Owner‘s equity Working capital requirement (WCR) Operating assets less Operating liabilities The Firm‘s Operating Cycle and Its Impact on the Firm‘s Balance Sheet Cash Sales Procurement Production Impact on the balance sheet: • Raw materials inventory • Work in progress inventory • Finished goods inventory Impact on the balance sheet: • Accounts payable • Raw material inventory Payments for nonoperating activities Impact on the balance sheet: • Accounts receivable • Finished goods inventory Sources of Cash Inflow and Cash Outflow Investing activities • Sale of fixed assets • Sale of long-term financial assets • Collection of interest and dividend income • Collection of loans mad Financial activities • Issuance of stocks and bonds • Long-term borrowings • Short-term borrowings Operating activities • Sale of goods and services Investing activities • Capital expenditures and acquisitions • Long-term financial investments Financial activities • Repurchase of stocks and bonds • Repayment of long-term debt • Repayment of short-term debt • Interest payment • Dividend payment Operating activities • Purchase of supplies • Selling, general, and administrative expenses • Tax expense CASH Net cash flow from operating activities $11.2 New cash flow from investing activities ($10) New cash flow from financing activities ($5.2) Sources of cash inflow Sources of cash outflow $2 $12 $18.2 $13 $472 $460.8 The Drivers of Return on Equity Return on equity ROE = Earnings after tax Owner‘s equity Financial leverage multiplier Tax effects Return on invested capital ROIC = Earnings before interest and tax Invested capital Operating profit margin Earnings before interest and tax Sales Capital turnover Sales Invested capital Financial structure ratio Invested capital Owner‘s equity Financial cost ratio Earnings before tax Earnings before interest and tax Tax effect ratio Earnings after tax Earnings before tax Sales Operating costs Invested capital Owner‘s equity Cost of debt Tax rate Cash Working Capital requirement Fixed assets The Financial System Intermediation via institutional investors Insurance companies, pension funds, Investment funds & venture capitalists F I R M S S U P P L I E R S OF F U N D S Intermediation via banks and other lending institutions The equity market (Trading in shares of common stocks) The corporate market (Trading in corporate bonds) The money market (Trading in money market instruments) Insurance policies Retirement plans Shares in funds PRIVATE PLACEMENT CASH CASH CASH CASH BONDS Commercial paper SHARES CASH CASH CASH BONDS Commercial paper SHARES CASH CASH DEBT OWED TO BANKS BANK DEPOSITS CASH Bank certificates of deposit (CD) CASH CASH CASH SHARES BONDS Money Market Instruments Alternative Equity Valuation Models Equity value Present value of debt Levered asset value Firm‘s earnings, cash flows, or book value Corresponding market multiple Firm‘s earnings, cash flows, or book value Corresponding market multiple Discounted cash flow model Adjusted present value model Future expected dividends Cost of equity equals less the discounted at the multiplied by the discounted at the Cash flows from assets Unlevered cost of equity discounted at the Tax savings Cost of debt discounted at the Unlevered asset value Present value of tax savings Market multiples model Dividend valuation model The Drivers of Value Creation Operating margin = EBIT Sales Capital turnover = Sales Invested capital Tax effect = (1 – Taxe rate) Aftertax cost of debt Estimated cost of equity Economic, political, and social environments Market structure Competitive advantages and core competencies EBIT Invested capital (pretax ROIC) Expected after tax ROIC Return spread (ROIC – WACC) Percent of debt financing Percent of equity financing Weighted average cost of capital WACC Sustainability of growth Market Value Added (MVA) If the present value of the future stream of expected return spreads is positive, MVA is positive and the higher the growth, the more value created. If the present value of the future stream of expected return spreads is negative, MVA is negative and the higher the growth, the more value destroyed. EBIT = Earnings before interest and taxes (operating profit before tax); Invested capital = Cash + Working capital requirement + net fixed assets; WACC = (%Debt)(After tax cost of debt) + (%Equity)(Cost of equity). Capital-Budgeting Simulation Step 1: Develop probability distributions for key factors. Step 2: Randomly select values from these distributions. Step 3: Combine these factors and determine a net present value. Step 4: Continue to repeat this process until a clear portrait of the results is obtained. Step 5: Evaluate the resultant probability distribution. Probability Value range Market size Selling price Fixed costs Market growth rate Investment required Residual value of investment Share of market Operating costs Useful life of facilities Probability Net present value Cash Flow Diagram Supplies and materials purchased using trade credit Saleable product (inventory) Credit sales (accounts receivable) Suppliers Stockholders Creditors Government Payments for credit purchases Cash dividends Proceeds from sale or issuance of stock Proceeds from sale or issuance of notes and bonds Interest and principal Payment of taxes Bad debts Collections from credit sales Cash sales Cash Payment for fixed asset purchases Payment for wages and salaries Payment for heat and power Aggressive Financing Strategy: Permanent Reliance on Short-Term Financing DOLLAR AMOUNT TIME Permanent plus spontaneous financing Temporary (short-term) financing Fixed assets Current assets Permanent dependence on short-term financing Permanent current assets Cash and Marketable Securities Management Cash balance Marketable securities Receivables Inventory Fixed assets Irregular outflows Dividends Interest Principal on debt Share repurchase Taxes Purchase Labor and material Credit sales Depreciation Sale Cash sales Collections Purchase Sale Out Irregular cash inflows Bond sales Other debt contracts Preferred stock sales Common stock sales In Three Ways to Transfer Financial Capital in the Economy The business firm (a savings deficit unit) The business firm (a savings deficit unit) The business firm (a savings deficit unit) Marketable securities Marketable securities Savers (savings surplus units) Savers (savings surplus units) Savers (savings surplus units) Funds (dollars of savings) Firm‘s securities (stocks, bonds) Securities Funds Securities Funds Intermediary‘s securities Funds Firm‘s securities Funds (1) Direct transfer of funds (2) Indirect transfer using the investment banker (3) Indirect transfer using the financial intermediary Key Metrics Required for Different Company Situations Growth of net income Multiyear DCF of economic profit Net income, return on sales ROIC-WACC, economic profit (one year) Operating value drivers Low High High Low Capital intensity (need for balance sheet focus) • Working capital • Property, plant, and equipment Need for long-term view • High probability of significant change of -Technology -Regulation -Competition • Long life of investments • Complexity of business portfolio Various Levels of Value Driver Identification Generic Business-unit specific Operating value drivers Examples • Customer mix • Sales force productivity (expense: revenue) • Fixed cost/allocations • Capacity management • Operational yield Examples • Percent accounts revolving • Dollars per visit • Unit revenues • Billable hours to total payroll hours • Percent capacity utilized • Cost per delivery • Accounts receivable terms & timing • Accounts payable terms & timing ROIC Margin Invested capital Margin Invested capital Margin Invested capital LEVEL 2 LEVEL 3 LEVEL 1 Customer Servicing – Human Expense Flowchart Total CS-human expense Service Delivery Center expense Overhead expense Headquaters expense Regional center expenses Area staff center expense Allocated G&A Number of SDCs Cost per SDC Personal cost Station cost Supervisory cost Overhead cost Number of people Cost per person Number of stations per SDC Equipment cost per station Equipment, maintenance experse per station Other equipment expense Salary expense Number of supervisors Building operating expense Building maintanance expense Call volume Percent occupancy Average work time per call Hourly rate Benefits Annual salary Benefits Span of control Number of employees Utilities Other Number of employees Equipment Materials Other % time on board % time in training % time on breaks % time on vacation % time paid Absence/other Six Conditions for Excellent Value-Based Management 1 2 3 4 5 Performance Driven Value-based Managed bottom up as well as top down Low cost Strong self-reinforcement process Two-way communications Highest level Good Medium Sup par Lowest Simple Entity Valuation of a Single-Business Company Operating value Equity value Debt value 70 90 100 130 140 150 160 Operating free cash flow 20 36 43 69 74 80 85 50 54 57 61 66 70 75 Cash flow to debtholders Cash flow to equity owners Entity Valuation of a Multibusiness Company 700 400 300 200 150 1,500 1,100 250 100 300 Market value: • Of debt • Of preferred stock Corporate overhead Total value before subtracting corporate overhead Total company value Common equity value Unit A Unit B Unit C Unit D Excess marketable securities 1,750 Steps in Valuation (1) Analyze historical performance (2) Forecast performance (3) Estimate cost of capital (4) Estimate continuing value (5) Calculate and interpret results • Calculate NOPLAT and invested capital • Calculate value drivers • Develop an integrated historical perspective • Analyze financial health • Understand strategic position • Develop performance scenarios • Forecast individual line items • Check overall forecast for reasonableness • Develop target market value weights • Estimate cost of noequity financing • Estimate cost of equity financing • Select appropriate technique • Select forecast horizon • Estimate the parameters • Discount continuing value to present • Calculate and test results • Interpret results within decision context Business System Analysis Product Design and Development Procurement Manufacturing Marketing Sales and Distribution Issues • Product attributes • Quality • Time to market • Proprietary technology • Access to sources • Costs • Outsourcing • Costs • Cycle time • Quality • Pricing • Advertising/promotion • Packaging • Brands • Sales effectiveness • Costs • Channels • Transportation Structure-Conduct-Performance Model External Shocks STRUCTURE CONDUCT PERFORMANCE Industry Producers Feedback Feedback Cooperation vs. Rivalry Rates of Return Implied by Alternative Continuing-Value Formulas Forecast period Continuing-value period WACC Time CV = NOPLAT WACC CV = NOPLAT WACC -g Average ROIC Convergence formula Aggressive formula Impact of Continuing-Value Assumptions $3,000 $2,000 $1,000 0 10% 20 18 16 14 12 CONTINUING VALUE ($) RETURN ON NET NEW INVESTED CAPITAL g = 8% g = 6% g = 4% g = 2% g = 0% Relative Positions of Selected Industries Along Continuing-Value Parameters Not economic Not economic Entertainment Sporting goods Soft drinks Information processing Most firms Tobacco Steel Defense > Inflation = Inflation < Inflation < WACC = WACC > WACC Declining Growing EARNINGS GROWTH RETURN ON NEW CAPITAL CONSUMPTION Factors affecting returns Low Entry costs High Many Substitutes Few Short Life cycle Long High Price elasticity Low A Forecast Period that Will Result in a Poor Valuation of a Cyclical Business NOPLAT Date of valuation End of forecast period TIME Risk/Return Trade-Offs of Hedging Programs Beta unchanged B Beta decreased Total risk Rf E (Return) A Rf E (Return) B A Beta unchanged Beta decreased Beta (undiversifiable risk) Framework for Evaluating the Value of an Acquisition Stand-alone value of acquiror (pre-merger) Stand-alone value of target (without any takeover premium) Value of synergies Transaction costs Combined value Value of next best alternative Value of target to acquiror Price paid including premium Net value gained from acquisition Patent Valuation: DCF Method Overview Value (NPV) of technology/project/product NPV = Estimation of present value of a business using discounted cash flows Max Protection Factor = Empirical factor indicating maximal impact of patents on NPV Patent Protection Factor = Measure of the quality of the patent protection Maximal value of technology = NPV x Max Protection Factor Value of patents = NPV x Pfmax x PPF Patent Valuation: Maximal Protection Factor 30% 5% Empirical curve Technology under R&D Mature Technology Maximal Protection Factor Age of Technology Patent-Value = Maximal-Protection-Factor x Patent-Protection-Factor x NPVtec Pval = Pmax x PPF x NPVtec Acquisition of Real Options Big bets Alliance leverage Entry stakes Risk pooling Internal External Low High SOURCE OF OPTIONS LEVEL OF INVESTMENT (OPTION PRICE) Drawpack Diagrams Drawpack.com offers premium Business Diagrams for students and professionals around the globe for their personal use. 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