Presented by:
Moazam Ali Shah
ICAP KSA Chapter
24 February 2014
Bird’s eye-view:
 The Cash flow Pie- Two basic approaches for using finance
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to increase the value of the pie.
Slicing the pie.
When would the investor pay more.
Using the financial policy to increase the cash flow pie
Three sources of conflict related to financial policy
Using capital structure as a conflict management tool
The special features of “growth companies”
Financing “growth companies”
Critical importance of financial flexibility for growth
companies
Conclusion
Introduction:
 Rapid growth poses special problems for
Financial Managers. They must raise large
amounts of cash to fund this growth
 Ultimate goal of Financial Policy, whether the
firm is growing or not is to maximize the value
of shareholders’ equity.
 Let’s examine the financial tools available to
all firms to boost market value before talking
about the appropriate financial strategies for
growing firms.
2 basic approaches for using Finance to
Increase the Value of the Firm:
 Think of the firm as producing a cash flow
“pie”, which is distributable to all investors
(debt holders, stockholders and others)
 There are two basic approaches for using
finance to increase the value of the firm:
 First approach:
Considers the size the cash flow pie to be
independent of financial policy, so that the
principal role of finance is to divide the pie
into slices and distribute among the various
stakeholders.
 Second approach: focuses on ways in which financial
policy can be used to increase the size of the value pie
by affecting operating and investment decisions.
 underlying this approach is the view that a company
is a complex web of “contracts” tying together
disparate corporate stakeholders such as investors,
management, employees, customers, suppliers, and
distributors. This approach assumes that the firm’s
future operating cash flow may depend significantly
upon the perceptions and incentives of the firm’s
non-investor stakeholders. Financial policy can be
used to increase the size of the cash flow pie by
strengthening stakeholder relationships – for
example, by improving management incentives or
increasing the confidence of suppliers and
customers.
Slicing the Pie:
 The firm needs money to finance Future
Investment Projects.
 Instead of selling some of the existing assets to raise
funds, it will Sell Rights to Future Cash Flows
generated by its current and prospective projects.
 Total revenue from the sale of rights to the pie can be
increased if financial security (shares or debt) is
devised in a way that the investor is willing to pay a
higher price.
When would the investor pay
more….
 There are three circumstances in which
investors may pay more in the aggregate for
claims to the cash flow pie:
1) The securities are more liquid
2) The securities reduce transaction costs
3) The security structure reduces the
“credibility gap” between management and
potential investors that exists whenever
companies raise capital from outside sources.
Increasing Liquidity:
 There is a substantial empirical evidence that
investors are willing to accept lower returns on
more liquid assets. Other things being equal,
therefore, a firm can increase its market value by
increasing the liquidity of the claims it issues.
 Ways of increasing liquidity of claims:
a) Going public
b) Underwriting new public issues
c) Buying insurance for a bond (debt) issue
d) Listing on organized stock exchanges
Reducing Transaction Costs:
 By reducing transaction costs associated with
raising money, the firm can increase its net
proceeds
 Similarly, the use of secured debt can reduce
enforcement costs by giving a lender or lessor
clear title to the pledged or leased assets.
Bridging the Credibility Gap:
 One of the key costs associated with issuing new
securities arises from the financing problem caused by
so-called “informational symmetries” i.e. corporate
management having “inside information” about the
company’s prospects that it can use to exploit potential
investors by issuing overpriced securities.
 Recognizing managements’ ability and incentives to
exploit them by issuing overvalued securities, rational
investors will revise downward their estimates of the
company’s value as soon as management announces its
intent to issue new securities.
 Companies can overcome the credibility problem
by raising funds in accordance with what Stewart
Myers calls the financing “pecking order” i.e. use
the least riskier source first (retained earnings)
and then use progressively riskier sources such as
debt and convertibles; common stock offerings are
typically used only as a last resort.
 By using internal funds, companies avoid the
credibility problem altogether.
Using Finance to Increase the Cash
Flow Pie
 The modern corporation is an interrelated set of
contracts among a variety of stake holders:
shareholders, lenders, employees, managers,
suppliers, distributors, and customers. Although
these stake holders have a common interest in
the firm’s success, there are potentially costly
conflicts of interests. To the extent that
financial policy can reduce these conflicts, it can
enlarge the cash flow pie and thereby increase
the value of the firm.
Three sources of conflict related to
Financial Policy:
1. Stock holder – Manager conflict:
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Stems from the separation of ownership and control.
Managers are concerned with maximizing their own utility
Management’s tendency to consume some of the firm’s resources
in the form of various perks.
Managers have an incentive to expand the size of their firms
beyond the point at which shareholder wealth is maximized. The
problem of overexpansion is particularly severe in companies
that generate substantial amount of “free cash flow” i.e. cash flow
in excess of that required to undertake all economically sound
investments.
Maximizing share holder wealth dictates that free cash flow be
paid out to share holders. The problem is how to get managers to
return excess cash to share holders instead of investing it in
projects with negative NPVs or wasting it through inefficiencies.
2. Stock holder – Debt holder conflict:
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Debt holders have prior but fixed claims on a firm’s
assets, while stock holders have limited liability for the
firm’s debt and unlimited claims on its remaining
assets.
 In case of high leveraged firms, shareholders may pass
up projects with positive NPV that involve added
equity investment because most of the pay offs go to
the debt holders.
 The failure to invest in such projects reduces the value
of lenders’ claims on the firm as well as the total value
of the firm.
3. Non-Investor - Stake holder Conflict:
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The potential conflict between a company and its noninvestor stake holders can best be understood by
viewing stake holders as buying a set of implicit claims
from the company. For example: the manufacturer of a
car, a pump, or a refrigerator is implicitly committed to
supplying parts and service as long as that product
lasts.
 Financially healthy firms typically have a strong
incentive to honor their implicit claims, whereas, for
financially distressed firms, the long run value of a
strong reputation may be less important than
generating enough cash to make it through the next
day.
Using Capital Structure as a Conflict
Management Tool:
 Unfortunately, a financial policy designed to reduce one
source of conflict often opens the door to other conflicts.
For instance, one way to lessen the opportunity of
management to waste the firm’s free cash flow is to reduce
the scope of management discretion by issuing additional
debt. Issuing more debt, however, increases potential stock
holder – debt holder conflicts and also raises the
probability of financial distress.
 In short, any change in capital structure is likely to mitigate
some problems and aggravate others.
 It makes sense to first discuss the distinctive features of a
growth company and then to suggest how these features
affect the choice of financial policy.
The Special Features of Growth
Companies:
 The most obvious sign of a rapidly growing company is its large
appetite for cash.
 Even though profit rises along sales, cash flow is generally
negative because the investment required to finance the growth
in sales typically exceeds the current net operating cash flow.
 Therefore, the ability to locate potential sources of external
funds and to arrange them in an attractive financial package are
major factors affecting corporate growth.
 For a company to grow in value, not just in size, it must have
access to investment opportunities with positive NPVs. These
opportunities are thought of as “growth options”. Growth
options are typically the primary source of value in rapidly
expanding firms.
 Another key aspect of growth companies is that the market is likely to
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have a particularly difficult time in establishing their values.
The CREDIBILITY GAP between management and investors is likely
to be most pronounced in the case of growth companies because
management in such cases will often have far better information about
the future profitability of undeveloped products and untapped market
niches.
Investors must also cope with the problem of uncertainty about
management’s abilities and commitments.
Debt holders’ fears of being exploited are also magnified in the case of
growth companies.
Non – investor stakeholders such as customers and suppliers must
make “firm-specific investments” whose returns depend on
management’s ability to exploit growth options effectively. If the firm
fails to expand and develop new products, those parties that chose to
do business with the firm will suffer.
Financing Growth Companies:
 In an attempt to make financial choices to finance growth companies,
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the Financial Managers design financial instruments in such a way to
solve specific incentive problems and resolve potential conflicts.
Because of the LARGE CREDIBILITY GAP that faces growth
companies, investors are likely to be especially wary of new financial
instruments from such companies that promise unique risk/ return
trade-off.
Increasing LIQUIDITY and reducing TRANSACTION COSTS are
probably less useful ways to increase the value of the firm. The reason
being, that growth companies are likely to attract investors who are
more interested in LONG TERM CAPITAL APPRECIATION.
Measures designed to bridge credibility gap are likely to be particularly
valuable for growth companies.
Both investor and non-investor stakeholders will be more uncertain
about the future prospects of a growth company than about the
prospects of a more mature firm.
 Example: Suppose the growth option is to invest in the
development of new software package for word
processing……
 All else being equal, therefore, the high costs of financial
distress together with the costs associated with resolving
the conflicts of interest between shareholders and debt
holders, reduce the optimal amount of debt in a growth
firm’s capital structure. By contrast, established firms
operating in stable markets can afford more debt since
their competitive stance will be less compromised by the
restrictions and delays associated with high financial
leverage.
The Role of Bank Loans in Financing
Growth Companies:
 A banking relationship may solve many of the problems
associated with public debt.
 The advantages of a banking relationship to a growing
company stems from the personal nature of the
relationship between borrower and lender.
 Banks play the role of delegated monitors who check on
the behavior of the firm’s managers.
 When a firm is unable to make interest payments on time
or when its financial statements indicate problems, the
banker’s first response is to examine the firm’s conditions
more closely. On the contrary, if the banker finds that the
firm’s prospects are promising, he can reschedule the firm’s
payments, waive a covenant, or even increase the loan.
 The loan approval process by the bank conveys two
pieces of positive information about the
borrowing firm to outside investors:
1) The bank believes the firm is sound, and
2) The bank will supervise corporate management
to ensure that it behaves properly
However, despite the advantages of bank debt,
banks cannot supply all the financing required
by growth companies.
The Role of Venture Capital in
Financing Growth Companies:
In the case of start-ups, whose assets are comprised primarily of
growth options, bank loans are virtually unobtainable.
Venture capital has evolved as a solution to these problems.
In effect, venture capitalists provide private equity. But in
return, they demand a much closer relationship, more control,
and a significantly higher expected rate of return.
Venture capitalists also typically demand a financial structure
that shifts a great deal of risk onto company management.
The financial structure also motivates management to work
harder and thereby increases the probability that a favorable
outcome will occur.
 To further limit their downside risk, venture
capitalists also rarely give a start-up company all
money it needs at once. Typically there are several
stages of financing. At each stage, the venture
capitalist will give the firm enough money to get to
the next product or market development
milestone. The use of this staged capital
commitment can be seen as a mean of
overcoming the “credibility gap” that confronts
all growth companies in raising capital.
Critical Importance of Financial Flexibility
for Growth Companies:
 Availability of substantial financial resources also signal
the competitors, actual and potential, that the firm will not
be an easy target.
 A firm that is highly leveraged, with no excess lines of
credit or cash reserves, a competitor can move into the
firm’s market and gain market share with less fear of
retaliation. In order to retaliate – by cutting prices or by
increasing advertising expenditures, the firm will need
more money. Because it has no spare cash and can’t raise
additional debt at reasonable price, it will have to go to the
equity market. But we have already seen that firm’s issuing
new equity face a credibility gap.
 Thus, firms with valuable growth options should place a
high priority on financial flexibility.
 In an attempt to preserve financial flexibility, corporate
managers have a strong preference to fund new
investment with the least risky sources available i.e.
retained earnings and then debt capital and in the last,
common stock. By adhering to this PECKING ORDER
and overcoming one problem, however, management
may well be creating another. The reason: a firm that
issues debt today thereby increases the probability that it
“must” raise equity tomorrow – perhaps on a very
unfavorable terms.
Financing Growth Firms –
Conclusion:
 For a rapidly expanding company, the primary role of finance should be
to PRESERVE THE GROWTH OPTIONS that are its principal source
of value.
 One way to improve the financing trade-off is to develop a close
working relationship with the providers of funds. This means that a
BANKING RELATIONSHIP or some other source of “PRIVATE DEBT”
may be particularly important for those growth companies with enough
tangible assets to support moderate amount of debt.
 In the case of start ups, VENTURE CAPITAL, most likely will be the
principal source. In such cases, the credibility problem is partly
resolved by the close relationship between management and the
provider of funds that allows for the exchange of information on a
confidential basis.
 Moreover, these funding sources can negotiate financing
terms which offer management considerable financial and
operating flexibility.
 Finally, a growing company cannot make financial policy
without considering its non-investor stakeholders. If
customers, suppliers and distributors feel that the firm is
so financially weak that it longevity is in question, they will
not make the investment required to develop a relationship
with the firm.
 For this reason, a growing firm must demonstrate that it
has financial flexibility and strength.
 All this analysis points to one avoidable conclusion: a
growth company needs a good deal of equity upfront; debt
is to be used with care and moderation.
Thank You!