Association of Corporate Counsel
Professor Jim Nolen
Department of Finance
University of Texas at Austin
McCombs School of Business
September 19, 2013
© The University of Texas at Austin 2013

1:30-2:45
2:45 –3:00
3:00-4:15
4:15-4:30
4:30-5:30
Overview of the role of finance in the organization
Operating Decisions
Measuring Performance
Break
Investing Decisions
Treasury Management
Working Capital Management
Capital Budgeting
Break
Financing Decisions
Capital Structure/Dividend Policy
Bankruptcy & restructuring
5:30-6:30 Social Networking & Happy Hour
© The University of Texas at Austin 2013 2

 To improve the participant ’ s financial acumen
 To gain a better understanding of finance ’ s role in the organization
 Making the Operating, Investing and Financing decisions of the firm

Measuring performance and creating shareholder wealth
 Setting the financial strategies of the firm

Setting financial policies and procedures
 Establishing financial controls

Managing the firm ’ s resources
 Treasury operations, including cash management
 Tax management

Managing the operating and capital budgeting processes
 Setting capital structure policy and proper use of leverage, including dividend policy and stock repurchase plans

Managing liquidity, including credit and collections
 Financial reporting and forecasting
 Working with investor relations to communicate with stakeholders
 Risk management, including hedging
© The University of Texas at Austin 2013 3

 May have professional designations like Chartered Financial
Analyst (CFA), Certified Public Accountant (CPA), Certified
Management Accountant (CMA) or Certified Treasury
Professional
 Typical financial titles in firms (depending on size of firm):
 Chief Financial Officer (CFO)
 Vice-President of Finance
 Corporate Treasurer
 Chief Accounting Officer (CAO)
 Comptroller
 Cash Manager
 Credit Manager
 Risk and Insurance Manager
 Manager of International Banking
4 © The University of Texas at Austin 2013

 The role of the accounting function is to provide internal and external information about the past performance to company executives and investors
 This information is communicated in the financial statements
 Balance Sheet
 Statement of Shareholders ’ Equity
 Income Statement
 Statement of Cash Flows
 Accountants are responsible for reporting, controlling and budgeting activities.
© The University of Texas at Austin 2013 5

 The role of the finance function is to analyze information about the past to make investment, financing and operating decisions that improve company performance in the future.
 Investment Decisions to maximize return and includes: make vs. buy decisions, working capital management, treasury operations and asset acquisitions and divestitures.
 Financing Decisions to minimize the cost of capital and includes: debt vs. equity financing, dividend policy, and stock buybacks.
 Operating Decisions that improve efficiencies and includes: pricing and product mix, purchasing and supply chain decisions, controlling expenses and risk management.
© The University of Texas at Austin 2013 6

Examples:
Product Profitability
Customer Lifetime Value
Examples:
Compensation Analysis
Labor Utilization Analysis
Examples:
Procurement Analysis
Cash Flow Analysis
Financial
Analytics
7 © The University of Texas at Austin 2013

 Budgeting
 In all four types of centers a budget system can provide managers with incentives by
 Rewarding them for meeting or exceeding budget goals
 Punishing them for failing to meet budget goals
 Those goals are:
 Investment Center – Return on Investment
 Profit Center - Dollars of Net Income or Profit Margin
 Revenue Center – Dollars of Revenue, growth rate, or market share
 Cost Center – Dollars of Cost, percent of revenues
 Agency Costs – Auditing & incentives costs for fiduciary duty compliance
 Forecasting can be done top-down or bottom-up
 Top Down – TAM, growth rate, market share
 Bottom-up – sales by customer, territory, product then rolled-up
© The University of Texas at Austin 2013
8

Maximize Share Value
DuPont
Analysis
Growth (g) Return (ROE)
Profitability Efficiency Leverage
Risk (r)
Operating Decisions
Customers Suppliers
Products Pricing
Marketing Distribution
Controlling Expenses
© The University of Texas at Austin 2013
Investing Decisions
Asset Mix Terms of Trade
Liquidity, Cash Conversion Cycle
Plant Utilization, Make or Buy
9
Financing Decisions
Debt-Equity Mix
Capital Structure Policy
Dividend Policy

 Measuring business performance and benchmarking are important roles of finance to insure goals and objectives are being achieved.
 Operating Decisions usually revolve around the Profit and
Loss statement. Finance then benchmarks these results against budget/plan (variance analysis) and against peers.
 Revenue
– Average Selling Price (ASP), pricing, unit volume, product mix, market share, CAGR of sales
 Cost of Sales – Outsourcing decisions, tax advantaged manufacturing locations, supply chain management, labor productivity

OPEX
– Selling, general and administrative expense control, headcount, lease vs. buy decisions
 Interest Expense – amount of debt, type of debt and interest rate.

Tax Management
 Earnings Per Share - number of shares outstanding
© The University of Texas at Austin 2013 10

Corporate Counsel ’ s Role In Operating Decisions
 Revenue recognition through the structuring of contracts
.
 Cost of sales through the negotiation and structuring of purchase contracts and hedging contracts.
 Labor Costs through effective management of labor laws and negotiation with collective bargaining agreements
 Selling, General and Administration costs through rent negotiations, advertising contracts, compensation agreements and insurance contracts
 Managing litigation in a cost effective manner
 Interest expense through negotiations on the terms and conditions of debt instruments.
 Tax expense though management of tax liabilities and negotiation of tax incentives
 Earnings per share through securities regulation and SEC compliance.
 Assist in Internal Audit and External Financial Reporting
© The University of Texas at Austin 2013 11

Corporate Counsel ’ s Role In Investing Decisions
 Assistance in collection of accounts receivable
 Negotiation of contracts for capital expenditures and real estate transactions
 Managing Acquisitions and Divestitures
 Monitoring Treasury Investments
 Managing IT risks and investments, including domain names and cybersecurity
 Protecting and licensing intellectual property
© The University of Texas at Austin 2013 12

Corporate Counsel ’ s Role In Financing Decisions
 Negotiating and structuring debt, mortgage and equity issuances
 Compliance with Security Regulations
 Monitoring dividend policies
 Managing risks, including continuity planning
 Maintaining corporate governance and fiduciary duties
© The University of Texas at Austin 2013 13

© The University of Texas at Austin 2013 14

Financial
Statements
Past Performance
Return on Equity
Growth
Risk
Filtered through:
The Economy
The Industry
The Competition
Financial
Manager
© The University of Texas at Austin 2013
How can I improve the firm ’ s ROE and
Value?
Market Value
Future Performance
Return on Equity
Growth
Risk
DuPont
Analysis

Financial Ratios:
Key Areas of Performance Measurement
 Performance in several key areas must be considered when evaluating a firm ’ s prospects for the future
 Operational analysis

Cost Analysis, Cycle Time, Customer Satisfaction, Quality Metrics
 Resource management
 Asset Turnover, Days Sales Outstanding, Inventory Turns
 Profitability and Productivity

Profit Margins, Sales/Employee, Sales/Sq. Ft.
 Investment returns
 ROA, ROE, ROIC
 Market indicators

Market Share, EPS, P/E Ratio, Price/Sales
 Risk Measurements

Liquidity, leverage, and debt service coverage
Source: Helfert, Erich A., “ Techniques of Financial Analysis: A Guide to Value Creation, ” 10 th Edition, Irwin McGraw Hill,
Burr Ridge IL, 2000.
© The University of Texas at Austin 2013
16

 Managers can increase the firm ’ s value and it return to shareholders: (Return on Assets and Invested Capital can also be used)
ROE

Net
Owner'
Income s Equity

Rev
Assets


Exp
Liab
 By increasing Revenue (Profitability/Growth)

Increasing Average Selling Price (ASP) and/or Volume (Q)

Organic growth vs. acquisition ; New Stores; New Products/Services; New
Territories
 By decreasing Expenses (Profitability)
 Decrease Avg. Unit Cost (AUC) through Supply Chain Management, Labor
Productivity, OPEX control and Scaling Fixed Costs
 By decreasing Assets (Efficiency)
 Increasing Cash Conversion Cycle and Plant Utilization
 By increasing Liabilities (Leverage/Risk – other people ’ s money)
 Higher returns come with higher financial risk if ROIC > Cost of Debt
© The University of Texas at Austin 2013
17

A simple dashboard that captures three of the five value drivers of a company
(growth and risk and not fully measured).
ROE

Inc
OE

Revenue

Expenses
Assets

Liabilitie s
Inc

OE
Inc
Sales

Sales
Assets

Assets
OE
Profitability on Sales
© The University of Texas at Austin 2013
Asset
Turnover
(Efficiency)
18
Financial
Leverage

ROE

Inc
OE

Inc
OE
Inc
Sales

Return on
Assets (ROA)
Sales
Assets

Assets
OE
Profitability on Sales
Note: The same factors affect
ROIC
© The University of Texas at Austin 2013
Asset Turnover
(Efficiency)
19
Financial
Leverage

In millions $
Income Statement
Revenue $5,612
COGS $1,455
Gross Profit $4,157
GPM 74.1%
R&D Exp. $705
SG&A (OPEX) $1,979
Depr./Amort. $296
Op. Inc. $1,473
OPM 26.25%
Net Int. Exp. ($65)
Other Exp. ($31)
Taxable Inc. $1,377
Corp. Tax ($193)
Post Tax Except. ($249)
Net Income $826
NPM 14.7%
Balance Sheet
Cash
Mkt. Sec.
$986
$37
Net Receivables $1,366
Inventory $625
Other Cur. Assets $375
Total Current Assets $3,391
Gross Fixed Assets $2,454
Accum Deprec.
P,P&E, net
($1,066)
$1,388
Goodwill & Intang.
$4,226
Total Assets $9,005
Statement of
Cash Flows
Net Income
+Deprec. & Amort
$826
$296
+ Operating Exp Adj. $110
+/- Dec/(Inc) in NWC $56
Net Cash –
Operating Activities $1,288
Net Cash –
Investing Activities ($337)
Net Cash –
Financing Activities (1) ($465)
Current Liab.
Long term Debt
$1,062
$2,713
Exchange Rate
Net Change Cash
Other L-T Liab $ 755
Total Liabilities $4,531 Begin. Cash
($8)
$486
$500
Ending Cash $986
EPS (fully diluted) $2.52
S/H Equity $4,475
Adjusted Net Inc. $1,074
Adjusted EPS $3.28
Liabilities & Equity $9,005
(1)LT Debt Issue
Debt Repaid
Issuance of Common Stk
Repurchase of Stock
Dividends
$325
( $78)
$303
($809)
($205)
20
© The University of Texas at Austin 2013

 St. Jude Medical ’ s Return on Equity Over Time
ROA
ROE
20 06
11.4%
18.7%
2007
11.3%
18.2%
2008
12.3%
11.5%
2009
12.6%
23.7%
2010 2011
11.3% 9.5%
23.6% 18.7%
What happened in 2008 and 2011? Let ’ s look at the DuPont decomposition.
What has been the effect of the stock repurchase program?
© The University of Texas at Austin 2013
21

 St. Jude Medical
FY
ROE
06 07 08 09 10 11
18.7% 18.2% 11.5% 23.7% 23.6% 18.7%
Net Profit Margin 16.6% 14.2%
Turnover 0.7
0.7
Leverage 1.7
1.82
8.1% 16.6% 17.6% 14.7%
0.8
0.8
0.7
0.6
1.77
1.93
1.96
2.0
Revenue Growth 13.3% 14.4% 15.5% 7.3% 10.3% 8.7%
Closing Stock Price $36.56
$40.64
$34.27
$36.78
$42.85
$34.48
© The University of Texas at Austin 2013
22


FY 2011
ROE
Net Profit Margin (1)
Turnover
Leverage
(1) Normalized
Rev. Growth Rate
STJ MDT BSX JNJ
18.7% 20.2% 3.9% 17.0%
13.8%
0.6
2.0
8.7%
16.8%
0.5
1.9
0.7%
6.1% 13.2%
0.4
0.6
1.9
2.0
-2.4% 5.6%
© The University of Texas at Austin 2013
23

MDT
S&P 500
STJ
JNJ
BSX
© The University of Texas at Austin 2013
24

© The University of Texas at Austin 2013

 All companies have similar financial goals – namely, to maximize shareholder wealth.
 Companies employ different strategies and tactics to achieve this goal.
 Some work off maximizing profit margins through differentiation or intellectual property (Software/
Pharmaceuticals)
 Some work off scale (Mass Merchandisers) lower margins but more volume and lower selling costs. Others work off scope by selling a broad range of offerings.
 Some work off efficient asset utilization (Airlines) – covering fixed costs with “ bottoms ” in seats. Revenue passenger seat miles.
 Some work off leverage (Financial Services) – high debt to equity ratios in banks and insurance companies.
 Combinations are possible
© The University of Texas at Austin 2013
26

 The financial goal (recognizing there are other stakeholders) is to maximize shareholder wealth.
 This is accomplished by investing in projects that exceed the firm ’ s cost of capital (Capital Budgeting)
 Cost of capital is a function of risk and opportunity costs
 Firms can create value by using its competitive advantage in:
 Costs (power over suppliers, business model, OPEX control)
 Pricing (power over customers)
 Asset Utilization
 Access and Cost of Capital
 Growth (branding, distribution channels, marcom)
 Risk Management (hedging, diversification, leverage)
© The University of Texas at Austin 2013
27

 Let ’ s compare some public companies in different industries
 Let ’ s look at
 A Grocery Chain – Whole Foods
 A general merchandiser – Wal-Mart
 A software company – Microsoft
 A computer company – Apple
 A pharmaceutical (research) company – Merck
 A financial institution – Wells Fargo
 An insurance company – Allstate
 What would you expect the return on equity to be for each of these companies given the risk of their industry to be able to attract capital?
 How do you think they generate their return? Through profit margins, asset efficiency or leverage
© The University of Texas at Austin 2013
28


Averages
– Last Five Years
ROE
Whole
Foods
Wal-
Mart Microsoft Apple Merck
Wells
Fargo Allstate
11.52% 21.9% 35.73% 39.24% 15.26% 10.71% 11.57%
Profit Margin
Turnover
Leverage
2.81% 3.67% 27.84% 23.4% 17.98% 16.62% 9.54%
2.45
1.67
2.38
2.51
0.59
2.39
0.93
1.80
0.42
2.02
0.064
10.07
0.27
4.49
Note the different financial strategies the different companies take to produce a risk adjusted return that allows they to attract capital.
• Whole Foods and Wal-Mart works off volume and efficient asset turnover while leveraging their suppliers, but have small profit margins.
• Microsoft, Apple and Merck have intellectual property that enables them to have higher profit margins, but they have relatively low asset turnover
(MSFT has $76 Billion and Apple has $137 Billion in cash).
• Financial Service companies like Allstate and Wells Fargo have huge asset bases and low turnover but work off other peoples money (leverage). Low investment returns, catastrophic losses, bad loans have affected ROE.
© The University of Texas at Austin 2013
29


 Treasury Management
 Working Capital Management
 Capital Budgeting
© The University of Texas at Austin 2013
30


© The University of Texas at Austin 2013 31

 Return is increased when sales are increased relative to the investment in assets.
 Fixed Assets – Higher utilization of property, plant and equipment.
Producing more sales with the same or fewer assets.
 Current Assets – Faster turnover of working capital (accounts receivable and inventory) or a reduction in Days Sales Outstanding
(DSO) and Days Sales Inventory (DSI).
 The risk of loss of sales from capacity constraints or too restrictive working capital polity also increases as the company attempts to turnover the assets faster.
 We will take a closer look at the working capital as measured by the firm ’ s cash conversion cycle. Poor working capital management can create cash flow problems even in a profitable company.
© The University of Texas at Austin 2013 32

 Managing short and medium term cash flow requirements
 Cash management and maintenance of liquidity
 Safety, liquidity and yield
 Handles foreign exchange and currency hedging
 Implementation of treasury management system
 Interfaces with banking platforms
 Operational use of derivatives
 Risk Management - Asset and liability management
 Commercial Finance activities
 E-banking solutions, banking arrangements & facilities/account structures.
© The University of Texas at Austin 2013
33

 Credit administration & collection
 Accounts Receivable terms
 Credit and Collections
 Days Sales Outstanding
 Aging of Receivables
 Inventory Management
 Ordering vs. Carrying Costs
 Just-in-time, LIFO/FIFO
 Days Sales Inventory
 Accounts Payable
 Early Payment Discounts
 Days Payable Outstanding
© The University of Texas at Austin 2013
34

Cash Conversion Cycle
Accounts
Payable
© The University of Texas at Austin 2013
35

Days Sales in Inventory
Days
Payables
Outstanding
Purchase
Inventory on Account
DSI
DPO
Pay
Payable
DSO
Days Sales
Outstanding
Sell
Inventory
Collect
Receivable
Cash
Conversion Cycle
© The University of Texas at Austin 2013
36

Cash Conversion Cycle
• A measure of how effectively a company is using its cash
45 + 65 – 54 = 56
DSO + DSI – DPO = CCC
DSI: Days Sales in Inventory
• How many days, on average, does product sit in inventory, waiting to be sold
DSO: Days Sales Outstanding
• How many days, on average, does it take for customers to pay
DSO= 45 Days
Avg Accts Receivable/Net Sales*365
DPO: Days Payables Outstanding
• How many days, on average, does a company wait before paying their supplies
DSI=65 Days
Average Inventory/COGS*365
© The University of Texas at Austin 2013 37
DPO= 54
Avg Accounts Payable/COGS*365

Lawyers don ’ t have to be seen as sales prevention or deal killers.
Corporate Counsel needs to be included earlier in the decisionmaking process, but must change their “ image ” to be accepted earlier in the process. Otherwise, they will beg for forgiveness rather than ask for permission.
Your legal job is to mitigate risk, which can be value producing activity. However, since there is a risk/return trade-off in business, this is often seen as being counterproductive to people incented by return.
© The University of Texas at Austin 2013

 Using fact-based analysis to maximize the goals and objectives of the person or organization.




What are the Costs (Operating, Capital & Opportunity costs)
What are the Benefits (Economic Profits/Free Cash Flow)
What are the Risks (Uncertainty/Ambiguity)
Over what Time (Time value of money)
 With each business decision you are involved in, you should ask:
 How will this decision impact the stated goals of the organization?
 What other parts of the organization will be impacted by this decision, both negatively and positively?
 Are there other options that might have better outcomes or less risk.
 Where is value being created or destroyed in the firm?
© The University of Texas at Austin 2013
39

 We said that Finance role is making the investing and financing decisions of the firm.
 Investing Decisions
 To accept a new project, the project must increase the value of the firm. It must produce a return that exceeds the required return (hurdle rate) based on the riskiness of the project
(always?).
 Since a firm could have more projects that produce returns that exceed their hurdle rate, financial managers must prioritize which investments should be chosen which produce the greatest value to the firm.
 Thus, capital must be allocated and rationed and projects must be ranked. This is called capital budgeting .
 Financing Decisions
 Once projects have been accepted, the financial manager must decide how to finance the projects which produce the lowest cost of capital.
© The University of Texas at Austin 2013
40

 Time Value of Money
 Most projects require a substantial investment in CAPEX, OPEX and working capital at the beginning of the project. The project then generates revenues, expenses, income and cash flow over the life of the project. However, future dollars are not worth as much as current dollars (opportunity cost) and thus the cash flows must be adjusted for the time value of money.
 Investment Decision –Making Tools
 Financial managers have investment decision-making tools which allow them to account for risk, return and the time value of money.
These investment decision-making tools include:
 Payback Method

Net Present Value
 Internal Rate of Return
 Profitability Index
 and Real Options.
© The University of Texas at Austin 2013
41

 Most companies have more projects than they have capital.
 To rank projects, managers must estimate:
 Initial Investment

CAPEX (plant and equipment) and working capital requirements
(inventory, receivables, payables)
 Ongoing Investment

As revenues grow, the project may require additions to working capital and additional CAPEX.
 Expected Revenues
 Expected Expenses (Cost of sales, headcount, OPEX)

The project may have negative cash flows the first few periods which represents OPEX investment)
 The investment horizon (usually three to five years)
 A terminal value at the end of the project
 Capital has a cost
 The future benefits and costs must be discounted at the appropriate discount rate.
 Hurdle Rate, Opportunity Cost, Weighted Average Cost of Capital
© The University of Texas at Austin 2013
42

 How many of the value levers does the project pull?
 Growth
 Profitability

Economic Profit
– Covers Operating and Capital Costs?
 EBITDA Margin – Contribute to incremental profit?
 Asset Efficiency/Productivity/Capacity Utilization
 Leverage – Physical Assets, Capital and Human Resources
 Risk – Uncertainty – How do you mitigate.

Once we have estimated the cash flows, (CF - both inflows and outflows) and determined the appropriate discount rate, r t
, we simply perform the calculation to determine if the benefits exceed the costs of the project:
NPV
 t n 

0

1
CF t
 r t
 t
© The University of Texas at Austin 2013
43

 How are project ideas generated?
 Large scale strategic investments tend to come from top down.
 Merger or acquisitions. New products or territories.
 Expansion, new equipment and other capital expenditures tend to be generated from the bottom up.
 Each business unit or department may generate capital projects needs or ideas.
 Projects are usually split into:
 Routine repair, replace and maintenance of existing assets
(typically a percentage of annual depreciation)
 Discretionary/expansion projects – remainder of the capital budget.
© The University of Texas at Austin 2013
44

 Projects may be prioritized first on a non-financial basis:
 Short-term vs. long-term investment horizon – longer term projects need more analysis.
 Strategic vs. Non-Strategic (affect a competitor, diversification of risk, solidifies market position, builds barriers to entry, etc.)
 High financial impact vs. low financial impact ( immediate or deferred)
 Low risk (low marginal investment or costs, evolutionary) vs. high risk project (bet the farm, revolutionary)
 Projects which can be deferred without loss of opportunity vs. projects in which delay would cause substantial loss of opportunity.
 Synergistic vs. Non-synergistic (impact on existing operations)
 Non-financial resource constraints – technology constraints, regulatory, engineering capacity, sales and distribution capacity, etc.)
 Market Attractiveness
 FIT with the Company ’ s Business Model
© The University of Texas at Austin 2013
45

 Market size (TAM)
 Market growth rate
 Market profitability
 Competitive intensity/rivalry
 Pricing trends
 Demand variability
 Opportunity to differentiate
 Risk of achieving potential returns
© The University of Texas at Austin 2013
46

 Clear linkage between vision, strategic initiatives, tactical plans, financial plan, annual budgets, and operational competency and capacity
 Brand Relevancy
 Core Competencies
 Market share and “ managed ” growth
 Customer loyalty and switching costs
 Competitive pricing and cost advantage
 Control & influence over hospital and quality of care
 Leverage System - Ability to leverage distribution, supply chain, capacity and company networks
© The University of Texas at Austin 2013
47

High
?
Investing for
Long-Term
Potential
Investing for Future Potential and Immediate Returns
(prioritize)
Low
Low
Poor Investments
(Dogs)
Immediate
Financial Value
Investing for
Immediate Returns
(Cash Cows)
High
© The University of Texas at Austin 2013
48

NPV vs. Success Certainty
(Size of bubble corresponds to Project Resources)
60000
High Return, Low Certainty
50000
Project 2
High Certainty, High Return
(Winners)
40000
30000
Project 4
Project 12
20000
Project 7
Project 9
Project 3
Low Return, High Certainty
10000
Project 1
Low Certainty, Low Return
(Less attractive)
0
10% 20% 30%
-10000
Project 10
Project 8
40% 50% 60%
Project 6
Negative NPV Zone
70%
Project 5
80%
Project 11
90%
Success Certainty
(Weighted combination of Scope, Schedule and Market Success Factors)
100%
© The University of Texas at Austin 2013
49

Project Evaluation – Narrow the Funnel
Two parts to the problem:
Concept Definition
Planning &
Scheduling
Execution &
Development
Validation
Ramp-UP &
Phase-Over
Production
Support
New Project Ideas
For Target Markets
Front End Risks
•
Strategy Alignment
• Market & Competitive
Analysis
• Business Case
• Product definition
• Pick winners
• Technology Roadmaps
© The University of Texas at Austin 2013
50
Back End Risks
Product Execution
• Abort Losers
• Design
• Technology
• Manufacturing
• Product Engineering

 Managers invest money today in assets which will generate cash flows in the future.
 A basic problem faced by financial managers when evaluating new investments is estimating the value of the future cash flows (variability = risk).
 Average Selling Price (ASP), units sold, cost of good sold, operating expenses, R&D, Capital Expenditures (CAPEX), depreciation, working capital all must be estimated and then discounted at a rate commensurate with the risk.
© The University of Texas at Austin 2013
51

First Principle of Finance: A Dollar Today
Is Worth More Than A Dollar Tomorrow
If you invest a dollar today you will earn interest during the year so that you will have more than a dollar in the future.
The trade-off between current dollars and future dollars is determined by the rate of return that you can earn on money during the year. This is what we refer to as the interest rate or opportunity cost .
© The University of Texas at Austin 2013
52

In 1626, Peter Minuit Bought Manhattan Island for $24 from the Indians
 You might suspect that the Indians got a bad deal, but ...
 If the Indians had invested the money at
10% per year, the value today of the $24 in
1626 would be.
= ($24)(1.1) 385 = ($2.07)x10 17 = $207,000 trillion
This is enough money to buy all of the world ’ s financial assets! ($198 Trillion per McKinsey)
© The University of Texas at Austin 2013
53

Value In $
8% interest rate
FV= $2,159
Present Value
PV=$1,000 Future Value
5 10
Years
Thus, $1,000 invested today at 8% will be worth $2,159 in 10 years. If someone promised to pay you $2,159 ten years from now, the present value would be $1,000 today assuming you require an 8% return.
© The University of Texas at Austin 2013
54

Safe vs. Risky Dollars
 Second Basic Principal of Finance: A safe dollar is worth more than a risky dollar.
 If future cash flows are not certain:
 Use expected future cash flows (apply probabilities) and
 Use a higher discount rate that reflects the expected rate of return on other investments of comparable risk
.
© The University of Texas at Austin 2013
55


 Larger interest rate
 Longer time period

 a smaller interest rate
 a shorter time period
© The University of Texas at Austin 2013
56

Projection of FCF
Terminal
Value
Discount
Rate
Present
Value
Project free cash flow (FCF) over the planning horizon, typically
3 -10 years. Project revenues, expenses, taxes, working capital and CAPEX.
Calculate the terminal value (if any) at the end of the forecast period by taking the non-depreciated value of the fixed assets
(net book value of the fixed assets) plus add back the net working capital at the end of the project.
Find the company ’ s hurdle rate. This discount rate for the time value of money should be based on the riskiness of the cash flows (opportunity cost). If similar in risk to other company projects, the company ’ s weighted average cost of capital
(WACC) can be used by proportionately weighting the after-tax cost of debt and equity.
Determine the current value by discount each year ’ s projected
FCF as well as the terminal value with the discount rate to get the present value of the future FCF.
Decision
If the NPV is > $0, the project is acceptable and if the NPV is < $0 then the project is rejected. If the project returns a $0 NPV, then you have found the IRR of the project which is equal to the hurdle rate.
© The University of Texas at Austin 2013
57

The Net Present Value of a project equals the present value of the project ’ s annual cash inflows and outflows (Free Cash Flows) discounted by the firm ’ s weighted average cost of capital, WACC.
NPV
 t n 
 o
FCF n
( 1

WACC ) t where: t is the period in which the cash flow is received.
The free cash flows from a project are calculated as follows:
Net Revenue
- COGS & Operating Expenses
Earnings Before Interest, Taxes,
Dep & Amort (EBITDA)
- Depreciation and Amortization
Operating Income. (EBIT or Op Inc) x (1 - Average Tax Rate)
Net Operating Profit After Tax (NOPAT)
+ Depreciation and Amortization
- Capital Expenditures
- Additions to Working Capital
Free Cash Flows
© The University of Texas at Austin 2013
58

 Payback
 Internal Rate of Return
© The University of Texas at Austin 2013
59

 The payback period is the length of time it takes to recover the initial investment.
 Over the payback period, the cumulative cash flows generated by an project are equal to the original investment outlay.
 Accept an investment if its expected payback period is less than some predetermined cutoff value (e.g., 2 years).
© The University of Texas at Austin 2013
60

NPV

CF
0

CF
1
CF
2

1
 r
 
1
 r

2

...

CF
T

1
 r

T
The IRR is the discount rate, r , for which the NPV = 0.
It is the average rate of return earned during the project.
IRR assumes you get your investment back plus earn a rate of return that produces an NPV of $0.
© The University of Texas at Austin 2013
61

 Capital Budgeting allows us to pursue the goal of maximizing shareholder wealth by taking future costs and benefits, discounting them to the current point in time and comparing the project to other opportunities the company may have to invest.
 Different projects can have different risks and these risk factors can be modeled into the analysis by adjusting the expected cash flows or by varying the discount rate.
 If a project is accepted and the projections are realized exactly, then the market value of the company should increase by the NPV of the project.
 Would a company ever accept a negative NPV project?
© The University of Texas at Austin 2013
62

 Building new plants or acquiring new capital equipment
 Lease vs. Buy Decision
 Outsoursing vs. In-house production
 Make or Buy Decision
 Mergers and Acquisition
 New Store openings
 New product introduction, rollout
 Selling to customers on credit
© The University of Texas at Austin 2013
63


 Amount and type of Debt
 Amount and type of Equity
 Dividend Policy
 Stock Repurchases
© The University of Texas at Austin 2013
64




.
© The University of Texas at Austin 2013 65

Typical Life Cycle Financing
© The University of Texas at Austin 2013
66

Financing Life Cycle
Discovery Proof-of-concept Product design Product Development Mfg. & Delivery
Idea
Pre-Seed
Business Plan
Seed
Mkt. Validation
Start-up/
Launch
Expansion/
Operating
Capital
Harvest/
Exit
Founder
Friends / Family/ Fools
Angels
ETF
Private Equity
Micro Lender
Guaranteed Loans -SBA
Factoring
IPO
Venture Capital
Customers/Suppliers
Bank Loans
Leasing
Merchant Banks
Mezzanine
Strategic Partners/JV
© The University of Texas at Austin 2013
67

Cost of Funds (annual required return)
0% 5% 10% 15% 20% 25% 30%
50+%
Vendors or
Customers
Founder, Friends,
Family & Fools
Banks
Asset-
Based
Lenders
Leasing
Mezzanine
Later
Stage VC
Factoring
Private
Equity/LBO
Early
Stage VC
© The University of Texas at Austin 2013
68

The Equity Financing Cycle Based on Growth & Profitability
© The University of Texas at Austin 2013
69

Sources Based on Purpose & Amount of Capital Needed
© The University of Texas at Austin 2013
70



© The University of Texas at Austin 2013
71

 Debt is a cheaper source of capital than equity but a riskier source that creates managerial inflexibility.
 Issuance costs are lower for debt
 The cost of debt is subsidized - Interest is tax deductible and thus the after-tax cost of debt is lower.
 Creditors have contractual returns and higher priority claims. As a result, they perceive less risk and thus will accept lower returns (cost) for their investment.
 However, debt has fixed repayment terms and overleverage can result in financial inflexibility and insolvency .
 Interest rate risk and negative leverae
 Renewal uncertainty
© The University of Texas at Austin 2013
72


 Issuance costs are higher and compliance costs are higher.

Shareholder ’ s are the residual claimants whose returns are variable and thus they perceive greater risk and require higher returns (costs) for their investment.
 Dividends are paid after corporate taxes and thus receive no subsidy like interest expense.
 With no fixed repayment obligations, equity provides more managerial flexibility .
© The University of Texas at Austin 2013
73

 Weighted average cost of capital (WACC) is the after-tax cost of debt and the cost of equity weighted by their market value percentage of the firm value.
 The cost of debt is contractual and the rate is multiplied by one minus the tax rate to get the after tax cost of debt.
 The cost of equity is an expected return to the residual claimants (shareholders) and can be estimated by the capital asset pricing model
(CAPM) or dividend discount model.
74 of 42
© The University of Texas at Austin 2013




© The University of Texas at Austin 2013
75

 Negotiating Items for the Bank include:
 Amount of loan
 Interest rate, fixed or floating
 Maturity
 Loan Covenants
 Guarantees
 Major negotiating points with the VC will be:
 Amount of capital needed
 The valuation of the business
 Number and composition of the Board of Directors
 Liquidation preferences
 Anti-dilution provisions
 Milestones
 Amount of Option Pool and Vesting Schedule
 Founder stock vesting
 Conversion rights, Redemption rights and Take Along rights
 Registration and Piggyback rights
© The University of Texas at Austin 2013
76

 The goal of capital structure and dividend policy is to minimize the cost of capital to the firm which allows the firm to invest the capital in projects that exceed the weighted average cost of capital or hurdle rate.
 The weighted average cost of capital is the average cost of debt and equity in the firm, which is a function of the perceived risk of the suppliers of capital.
 Are Dividends and Stock Buybacks a positive or negative signal to the market? Which is better for your bonus calculations? Can a company have a gain or loss on its purchase and sale of its own stock?
© The University of Texas at Austin 2013 77

 In general, after considering the tax effects, debt is a cheaper but riskier source of capital than equity. If a firm thinks it can earn more than the cost of debt, then favorable financial leverage generates higher returns to shareholders but gives managers less flexibility and exposes shareholders to a higher risk of insolvency.
 Dividends and share repurchases can be a good use of excess cash but remember to consider taxes.
 The Company is competing with other firms for capital and must give creditors and shareholders a risk adjusted return to be able to attract capital.
© The University of Texas at Austin 2013
78

© The University of Texas at Austin 2013
79

20 Largest Public Company Bankruptcy Filings 1980 – Present
Present Company Bankruptcy Date Description
Lehman Brothers Holdings Inc. 09/15/08 Investment Bank
Washington Mutual, Inc.
WorldCom, Inc.
09/26/08
07/21/02
Savings & Loan Holding Co.
Telecommunications
General Motors Corporation
CIT Group
Enron Corp.
Conseco, Inc.
MF Global Holdings
06/01/09
11/01/09
Manufactures & Sells Cars
Financial Services
Assets
$691,063
327,913
103,914
91,047
80,448
12/02/01 Energy Trading, Natural Gas 65,503
12/17/02 Financial Services Holding Co. 61,392
10/31/11 Financial Services 40,541
Chrysler LLC
Thornburg Mortgage, Inc.
04/30/09 Manufactures & Sells Cars 39,300
05/01/09 Residential Mortgage Company 36,521
Pacific Gas and Electric Company 04/06/01 Electricity & Natural Gas
Texaco, Inc. 04/12/87 Petroleum & Petrochemicals
36,152
34,940
Financial Corp. of America
Refco Inc.
IndyMac Bancorp, Inc.
Global Crossing, Ltd.
Bank of New England Corp.
09/09/88
10/17/05
07/31/08
Financial Services
Brokerage Services
Bank Holding Company
33,864
33,333
32,734
01/28/02 Global Telecommunications Carrier 30,185
01/07/91 Interstate Bank Holding Company 29,773
General Growth Properties, Inc. 04/16/09 Real Estate Investment Company 29,557
Lyondell Chemical Company 01/06/09 Global Manufacturer of Chemicals 27,392
Calpine Corporation 12/20/05 Integrated Power Company
New Century Financial Corporation 04/02/07 Real Estate Investment Trust
27,216
26,147
Colonial BancGroup, Inc., The 08/25/09 Bank Holding Company 25,816
Source: Bankruptcydata.com
© The University of Texas at Austin 2013
80


 Lower interest rate
 Longer maturity (balloon?)
 Stand still agreement (defer payments to back end of the note)
 Renegotiate covenants




© The University of Texas at Austin 2013
81

Bankruptcy may be voluntary or involuntary
Venue- Federal court in state of incorporation, principal location of the business or assets located more than 180 days. May also look at proximity of creditors and debtor to the court .
Managers and Creditors compare two values:
• Firm liquidated value
• Firm's value as a going concern
If a firm's
• Liquidation value > going concern value
Chapter 7
• Liquidation value < going concern value
Chapter 11
© The University of Texas at Austin 2013
82

© The University of Texas at Austin 2013 83

Main objective is to rehabilitate.
1. Filing of Petition
2. Order of Relief
3. Automatic Stay of Proceedings
4. Reorganization Plan
Exclusivity Period (120 days)
Debtor in possession (DIP)
Creditor Committees
Alternative Plans
5. Approval of Plan
6. Confirmation of Plan
Total cram down
7. Plan enacted
Debtor may convert to Chapter 7 if no trustee has been appointed and the Court can convert if determined to be in the best interest of the creditors and the estate.
© The University of Texas at Austin 2013 84

 Administration of the estate
 Claims against the estate
 Counterclaims by the estate
 Orders regarding obtaining credit or to turn over property to the estate
 Proceedings to determine preferences
 Motions to terminate or recover preferences
 Proceedings to determine fraudulent conveyances
 Dischargeability of particular debts
 Determination of property liens
 Confirmation of plans
 Orders approving sale of property
 Proceedings affecting liquidation of property
© The University of Texas at Austin 2013
85

1. Debtor-in-Possession (DIP) loans
2. Certain obligations incurred after filing for Chapter 11
3. Unsecured claims for employee compensation
4. Unsecured claims from employee benefit plans
5. Secured creditors
6. Senior creditors
7. Unsecured creditors (other than senior creditors)
8. Subordinated debt claims
9. Equity holders.
© The University of Texas at Austin 2013 86

© The University of Texas at Austin 2013 87

 Cram-down – Under certain circumstances, the bankruptcy court may "cram down" a plan over the objection of creditors. In order to confirm a Chapter 11 plan over the objection of a secured creditor, a holder of a secured claim must receive the entire value of the property securing the claim or the entire value of the claim, whichever is smaller. Unsecured creditors must either accept the Chapter 11 plan or the owners of the business must not receive any property under the plan on account of their pre-bankruptcy interest in the farming operation. Finally, a plan cannot be confirmed if the plan does not pay each claim holder as much as he would have received under a Chapter
7 liquidation unless those who receive less accept the plan.
 Objections to Plan – Creditors may object to the confirmation of the debtor's plan in a Chapter 11 case. Such objections will usually challenge whether the debtor has met the technical requirements of Chapter 11. However, creditors may also challenge the debtor's valuation of their collateral and the feasibility of the debtor's plan. As a result, it is usually necessary for the debtor to obtain expert testimony concerning the current value of machinery, equipment, livestock, and crops. In addition, it will be necessary for the debtor to provide his creditors with detailed financial projections which will assist the bankruptcy court in determining that the business may be successfully restructured.
© The University of Texas at Austin 2013
88

 Competing Plans – As previously mentioned, only the debtor may submit a plan of reorganization within 120 days of the initiation of the bankruptcy case. Any interested party may file a plan thereafter. A plan, including a plan proposed by a creditor, may provide for the liquidation of some or all of the debtor's nonexempt assets. Such a liquidating plan may be proposed and approved by the court.
 Confirmation – Confirmation of a plan under Chapter 11 acts as a discharge of all debts, filed or not, excluding those specified as not dischargeable elsewhere in the bankruptcy code. Upon confirmation of a plan, the debtor receives back all his property free and clear of all liens and encumbrances unless such liens are preserved by the plan. Both the debtor and the creditors are bound by the terms of the confirmed plan.
© The University of Texas at Austin 2013
89

Jim Nolen
Texas Executive Education
512.232.6834
James.Nolen@mccombs.utexas.edu
© The University of Texas at Austin 2013
90