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MSIN0039: Corporate Financial StrategyWeek 1: Introduction/OrientationExam: Statement Pairs Alternative AssessmentPart A: General Corporate value improvement perspective of financial officer of company including their key activities and functions Major emphasis on financing related issues (e. capita...

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MSIN0039: Corporate Financial Strategy Week 1: Introduction/Orientation! Exam: Statement Pairs Alternative Assessment! Part A: General • Corporate value improvement perspective of financial officer of company including their key activities and functions! • Major emphasis on financing related issues (e.g. capital structure, financing sources, debt capacity, CAPM, Decisions about share buy-backs, dividends)! • Internal Investment: CAPEX, Capital Funds Planning! • Externally-sourced financing: IPOs, Rights Offers, secondary financings! • Financing projection development: both from perspective of company’s own position and that of target partners-acquirees — telling the providers of debt and capital how much you need, where you adapt it and how to develop and implement a financing plan! • Dividends and buy-backs — disbursements, not value creating but can get the stock price higher! • Dealing with emergencies: bankruptcy, cash shortages, disruptive activist investors, tax/hedge, auditor relationships! Part B: Selected items from glossary • Definition, Application, Issues and Exceptions! 1. 2. 3. 4.

Acid test ratio — CA/CL without inventories in CA! Accounting Equation — A = L + E! Accounts Payable — a part of CL, short-term liabilities, credit you need to pay back! Accounts Receivable — you sell to customers as a creditor, depends on quality of borrowers because if you have poor quality borrowers, the debt will start accumulating! 5. Amortisation — writing off the worth of intangibles over a period of time e.g. patents in the pharmaceutical industry, paper transaction only! 6. Depreciation — the write off of tangible assets overtime. Accelerated depreciation reduces tax rate, writing off in the earlier years than the latter years, unlike straight line depreciation! 7. Audit letter — is a short letter good/bad? Interested in the company? The shorter, the better. Just a review of the accounts, fraud may be evident but not to be confused with a forensic diagnosis! 8. Beta —part of CAPM to determine CoE, which is used to determine one part of WACC ! 9. Bottleneck diagnosis — period of time within the inventory cycle of going from raw materials to finished goods. Smooth process is stuffed up?! 10. Buybacks — last 8 periods of every cycle, e.g. subprime, tranches, usually stock price rises! 11. Dividends — not value-creating, a distribution fo net income which has already occurred! 12. CAPM —mechanism for determining CoE, is the beta component reflective of the difference between the individual company’s shares and the risk of a diversified portfolio?! 13. CAPEX — the worth of the company is driven by profitable capital investment, different methodologies of how to value! 14. Cash — confused with funds flow statement! 15. Cash conversion cycle — how long does it take before I receive money from my customer, includes timing lag! 16. Cash flow — do NOT confuse with funds flow statement. = NOPAT + NON-CASH ITEMS. ! 17. EBITA — earnings without all the bad stuff, a joke in the financial world. It is NOT cash flow! 18. Company value — EPP and TVP DCF2S. If you’re looking at book value, the balance sheet difference between the market-adjusted worth of assets - liabilities. This is not a reliable valuation method! 19. Current Ratio — CA/CL. Paradox? You want to have something above 1:1 to make sure you have sufficient liquidity and solvency. If CA goes up, is It better? Yes, but what if CA goes up because customers aren’t paying off their debt? If assets are lower quality, then this is actually

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a deterioration of the company. If CL are reduced, CR is improving but you may have just sacked half your company which isn’t good for the company?! 20. Debt Inflection Point —after tax cost of equity is 2-2.5x more expensive than the after tax cost of debt. WACC — more debt in this will mean it goes down but more debt means more instability! 21. Defined benefit — guaranteed payout per month regardless of market and bond yields, now changed to DC! 22. Defined contribution — you only have to pay x amount per period! 23. Discounting — the basis at which we look at the future, time value of money, value = FCF = CF - period investment, into the future. FCF in the future are worth less so we need to calculate the adjustment, dependent on WACC! 24. EPS — shares outstanding = shares authorised minus treasury shares, not profit, changes in net income are only 0.46 correlated with changes in stock price, cash flow correlated is 0.92! 25. Economic Profit — refers to excess by which company has returns above and beyond of the industry! 26. Expected Economic Return (EER) — how to predict FCF and future outcomes? But, instead, you can assign probabilities to different scenarios — a base line, optimistic and going wrong scenario! 27. Gordon formula — (continuous value formula) stage 2 of DCF2S. Numerator has FCF, denominator is WACC - future growth expectation for FCF. Companies just dependent on this come up with wildly inaccurate valuations! 28. DCF2S — 1. Explicit projection period (EPP) — budget projection for 4-7 years. 2. Gordon formula! 29. Incremental value effect (IVE) — single rule of financial metrics. What generates the biggest value? One has a NPV of 120bn, the other 100bn, you do it with the higher NPV. But what if only one project — it has to have a higher return than the WACC. If it exceeds WACC and higher than other opportunity costs, then go ahead. This metric supersedes any other metric ! 30. IPO — ways to get your equity, largest single way of equity raising, up to 30% of a company’s overall capital comes from an IPO issue! 31. Optimal capital structure — 12 different methods for coming up with a mix of debt to equity. 2 schemes in particular: pecking order and static trade-off! 32. WACC — the higher, the lower the value of the company, ceteris paribus, due to the time value of money! 33. WACD — weighted average cost of capital! 34. WACE — weighted average cost of equity! Week 1 Formative Assessment 1. Two hundred basis points equals? ! C: 2% — one percentage point corresponds to one hundred basis points! 2. The phrase and conception “retained earnings” appear where? ! E: None of the above — retained earnings = accumulated net income, which is a sub-account of owners’ equity on the balance sheet. Cash is a current asset so it cannot be B: as part of “cash” in the statement of financial condition. It’s not directly part of cash.! 3. The term “debtors” refers to the following. ! B: Accounts receivable! 4. What is the difference between straight line vs accelerated depreciation? ! B: SL is based on equal amounts per year, ACC skews more depreciation period charges to earlier periods of that asset’s functional/economic life. OR C: SL is compiled for book purposes, ACC for tax purposes. Book/reporting purposes, management want to show the highest net asset balance (original cost basis minus accumulated depreciation), thus a (lower) equal amount per reporting period. Tax purposes, accelerated methods are acceptable in earlier years of that tangible asset’s life, reflecting fast obsolescence, other considerations.! 5. Which of the words or phrases or acronyms below comes closest to capturing the essence of the nature of “time value of money”? !

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B: NPV — stands for Net Present Value, effectively the inverse of DCF. Monies received in the future are deemed to be worth less than same amounts received today, because of effect of WACC/opportunity cost. By discounting future FCF using WACC, the result is NPV. As long as NPV is greater than 0, it is acceptable acquisition on a straight-line basis.! 6. What best explains the difference between bookkeeping and funds flow statement? ! C: 1st is to do with cash inflows versus outflows, 2nd is one of the firm’s 3 integrated financial statement. Funds flows statement is one of the firms’ 3 core (accrual accounting basis) financial statements. Today called that by many/most today in part to avoid any confusion with Best Practice Modern Corporate Finance’s two KEY metrics: Cash Flow & Free Funds Flow (CF minus period investment). Bookkeeping is primitive T-ledger record of monies received and dispensed: in that manner, it developed on a simple cash accounting basis.! 7. In an accounting sense, what does the word “goodwill” mean? ! E: None of the above. It reflects the difference (in a narrow accounting sense only) between the recorded book ‘value’ of an intangible asset vs the price basis paid. Most frequently arises in acquisitions, where closure almost always dictates a bid price 15+% in excess of that reflected by the target company’s (acquiree) share price. To do with amortisation, not a decision factor.! 8. What’s the difference between a firm’s Income Statement (profit and loss statement) and the same corporation’s Balance sheet (Statement of financial condition/position)? ! E: None of the above.These are two of the three accrual accounting-basis (‘book’) fundamental financial periodic reports. The other is Funds Flow Statement. Balance Sheet provides a snapshot view of the company’s equity position, accomplished by subtracting debt from assets. Simple liquidity indications (e.g., Working Capital Ratio, CA/CL may also be determined via this report. Income Statement is identified Net Income after adjustments from revenue for all costs ‘above and below’ the gross profit line. NI is a first step towards today’s standard financial metrics: CF and FCF.! 9. What are “capital expenditures”/CAPEX? ! B: Company outlays for depreciable, tangible assets, usually for the purpose of growth or efficiencies, as reflected in part of the company's Plant & Equipment asset category.The company’s investment in its own future, presuming that operations are profitable, argument arises this is the priority for funding. BUT first, one must make certain that those projects are profitable. And, that under real-world conditions of limited funds, the most deserving (that is, those with the highest risk-adjusted return) projects & investments are financed internally by the corporation.! 10. Explain the difference between company gross profits and net income. ! A: The 1st is Revenues minus Cost of Goods Manufactured or Sold. The 2nd starts with Gross Profits, and then the following are deducted: general and administrative costs, depreciation, other operating expenses, net financing interest costs, and taxes. This is a quick check as to whether (or not) the student fully understands key differences between the two main parts of the Income Statement. Gross Profit (and related gross margin) merely adjust revenue for costs directly involved in the provision of that firm’s goods or services. To get from that point to gross profit, all other costs must also be subtracted, as well as actual taxes paid.! 11. To what extent doest he accounting “matching principal” refer? ! D: It means that for purposes of revenue and expense timing in financial reports, a critical consideration is consistency of timing of costs with the same period that related turnover (sales) is recognised, with deferrals accruals applied to deal with differences. The principle of matching is part of accrual accounting norms & rules. In AA, (GAAP & IFRS-qualifying, revenues are recorded as when they are deemed to occur, which is not necessarily the same as when those transactions chronologically occur. “Matching” means that any expenses corresponding to that AA-basis revenue is also recorded and recognised on the identical basis. ! 12. A longer audit letter - rather than a shorter one - is better from the company’s perspective because… !

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B: It isn’t: shorter letters signal few problems or issues of concern. The auditor’s letter is found in the back of the annual report. Generally speaking, the briefer the better” one simple statement about accounting practices reviewed being in accordance with GAAP (or IFRS) principles. A second short statement implying that company appears to be a going concern. WHY? NOT A FORENSIC AUDIT. Longer letters bring well-deserved suspicions that something(s) is/are amiss.! 13. “Accounting Equation” refers to ! D: A = L + E! Acclimation Series 1. Integrated Financial statements — 2, 3, 6, 7, 8, 10, 13 • We call cash-flow statements, “fund-flows statements” to not confuse it with CF!

• FF statement — where did we get the money from and where did it go out, sources: new equity/ debt, outflows: buybacks, dividends?! Net Income — achieved as a result of income, net revenues - COGS, goes into retained earnings, and because of the matching principal, it goes into cash generally! Plant and Equipment — additional purchase will affect amortisation and depreciation and goes into CAPEX, allowing expansion and creating new products! SG&A — Selling General and Administrative costs! • All statements interact with each other as shown below!

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2. Capital, Break-even, best practice pricing — 1, 9 • Capital, not finance, as the corporation’s ‘life blood’! • Dual identity! • Capital = debt and equity! • Capital = assets (but the term typically refers to long-term assets)! • Liquidity (capital) necessary to pay salaries and suppliers, other requirements! • Insufficient capital = NO BUSINESS — providers of capital may be inclined to reallocate capital if returns to capital disappoint e.g. Softbank’s Disinvestment from WeWork in 2019, failed IPO, could not get equity despite cutting their price by 85%, did not have enough capital to continue, Softbank decided not to — audit letter saying you’re probably going out of business, must recast the asset values on the balance sheet for liquidation level! Breakeven analysis —! • Look at variable costs first as some of the fixed costs can be semivariable! • Breakeven point is exactly where your revenue covers your total costs + any amount more, matching it is an indifference point! Minimal pricing — pricing and losing money on a price basis if you’re pricing below this level!

PRICING I: FIXED v VARIABLE COSTS, BREAK-EVEN (B/E), MINIMUM PRICE RULE Minimum Pricing ‘rule’: Cover variable costs, make some contribution to fixed Break-Even volume

REVENUE

Deficit

£/ Unit

Excess TOTAL COSTS

Variable Costs (decreases w/ volume) Low

!

Production or Sales Unit Volume (quantity)

Assumption: constant unit pricing

Relative to pricing:! • Highly inelastic demand — not many substitutes, boost pricing! • Elastic demand — able to defer a purchase if the price goes up! • Acquisitions — raise prices by 5%? Depends on the demand, are you reducing your volume and not getting any real value?! • Henderson model (LEFT GRAPH) — there are different strategies for how you position yourself overtime. In advancing maturity stage, change basic profit and pricing strategy!

Fixed Costs (constant w/ volume)

High

CFS MSIN0039 ACCLIMATION SERIES

PRICING II: ELASTICITY, PRODUCT LIFE CYCLE PRICING C = HIGHLY High

A

INELASTIC Reduction in demand is LESS than corresponding increase in price

High

Low

Y

Z1 Marketforced Exit

B = HIGHLY ELASTIC Reduction in demand is GREATER than corresponding increase in price

Unit Pr

Advancing Infancy & Late Early Adolescence Maturity Adolescence to Early Maturity

TP ‘Excess Profits’ Unit Pr

X ‘Share Build’

45o Low

Z2 Liquidity Concerns Prevail

Low

High

Unit Quantity (Demand)

time

Low

A= Perfectly ELASTIC (exactly proportional changes in price and demand)

Price-Demand Elasticity

TP= ‘Target Price / unit” under product midlife cycle expected scale efficiencies, demand, sustainable positioning

PLC Pricing

CFS MSIN0039 ACCLIMATION SERIES

3. Financing sources vs risk, order in liquidation — 8, 13 • Debt vs equity strategy, optimal capital structure! SOME FORMS OF COMPANY FINANCING: RISK v COST CONTINUUM • Long-term debt is lower cost to company, a first in priority for liquidation! Lowest • Some forms of equity may overlap and have Cost to Company lower costs than some individual forms of Owed to Government Senior Debt, Bonds long-term debt but there are also a few forms of equity that are lower cost with higher Junior Debt priority in liquidation! Debentures • An inverse relationship — the lower the cost of Units (D+E) the security, the higher you are in terms of priority in liquidation! Preferred shares Highest Cost

Common equity

Short-Term Debt (CL) First Priority in Liquidation

LTD

EQ (Last)

• After-tax cost of equity is 2-2.5x the cost of debt — hence high cost, but last to be paid in the case of any restructuring, they are the buffer!

SHORT TERM v LONG TERM FINANCING SHORT TERM

LONG(ER)TERM

Trade Related

Growth Related

Purpose

Liquidity, Solvency

Ongoing Capital Adequacy

Examples

Creditors (Acct. Pay) Deferred Taxes Current Portion LTD

Bank Loans (LTD) Bonds / Gilts (LTD) Equity

Sources

Vendors’ Advances Deferrals

Financial Institution Negotiations Securities Issuance

Only long-term debt is part of the permanent base of capital of the company. Short-term debt means you have to pay it back within the reporting period — this can include: the near-term portion of long-term debt which is the need to provide enough capital to keep the company going or even trade payables.! • Term loan — more than a year! • Seasonal loan — less than a physical year !

INTERNAL v EXTERNAL FINANCING INTERNAL

EXTERNAL

Company itself- HOW? Recurring trade partners

External Market, via investment or commercial bankers

Examples

Retained Earnings Proceeds from Disposals Intra-company Transfers Commercial Paper

Share offers Bonds (gilts) placements

Control No Negotiations No Apparent Cost

Amounts

Advantages

Provider(s)

Disadvantages

Opportunity Cost New Stakeholders Amount, Timing Regulatory & Bureaucracy Loss of Contingency Not Available to Small Firms CFS MSIN0039 ACCLIMATION SERIES Costs Alienating Key Suppliers

Internal — generate within the company, see operations as the company itself as the financing source, because there’s a lot of waste in companies. E.g. afraid not to show a large cash balance, but they may show a minimal cash balance but have a standby loan, especially if they are a highly creditworthy company. By leaning out and reducing the amount of assets you require, you reduce your financing requirements, which may be said as a source of financing. You can control it but it’s usually not enough, there’s only a certain amount you can cut. ! External — from underwriters, issuing debt and equity, do not confuse with external investment such as acquisition!

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4. Best Practice financial strategic management metrics — 5, 9, 10 Incremental value effect — does value increase or decrease as a result with value being measured singularly, by whether DCF2S worth, increases or decreases as a result of that decision?!

FINANCIAL INSTITUTIONS especially tend to be subject to Financial Community‘ Evaluation by ROI’ (CFROI)

HOW? One (but not the only) way involves leverage: Company Achieving a Higher Return With Effective Gearing (CFS Wk 3)

R E T U R N %

B

A

L E V E R A G E %* ”Bank Metrics” Feb. 25, 2010, FT Lex

CFS MSIN0039 ACCLIMATION SERIES

* LTD/ (LTD+E)– NOT LTD/E

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• Financial institutions tend to have an expectation that they will have a return on equity (ROI) of 10% or greater! • Morgan had a low ratio but improves overtime, dependent on the firm’s strategy! • Look at return on assets before looking at ROI because looking just at ROI would provide you with the instinct to just gross up the balance sheet, meaning to add debt reg...