Increasing Shareholder Value

• Greater customer service

Revenue (higher market share,
increased gross margins).
• Greater product availability

Profitability
• Lower cost of goods sold,
transportation, warehousing,
Costs material handling and
distribution management
costs
Shareholder
value
• Lower raw materials and
finished goods inventory
Working • Shorter ‘order-to-cash’
capital cycles

Invested
capital
•Fewer physical assets (e.g.
Fixed trucks, warehouses, material
capital handling equipment)
 How managers can max shareholders’ wealth?

• Max Stock Price

– What determines stock price??
– Like any other asset, ability to generate cash flow
now and in future!!
– • Size of cash flows
• Timing of the cash flow
stream
• Riskiness of the cash flows
 Determinants of Intrinsic Value: Calculating FCF
Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

3
Modifying Accounting data to see operational efficiency

What are Free Cash Flows (FCF)?

• FCF is the amount of cash available from operations for distribution to all
investors (including stockholders and debtholders) after making the
necessary investments to support operations.
• A company’s value depends on the amount of FCF it can generate.
• After tax operating profit – the amount of new investment made in
working capital and fixed assets

• Five uses of FCF

1. Pay interest on debt.

2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable securities, investments in
other companies, etc.)
4
 Calculating Free Cash Flow in 5 Easy Steps
Step 1 Step 2

Earning before interest and taxes Operating current assets

X (1 − Tax rate) − Operating current liabilities

Net operating profit after taxes Net operating working capital

Step 3

Net operating working capital

+ Operating long-term assets

Total net operating capital

Step 5
Step 4

Net operating profit after taxes

Total net operating capital this year
− Net investment in operating capital − Total net operating capital last year

Net investment in operating capital

Free cash flow
5
Modifying Accounting data to see operational efficiency…
Lets get some terminology

NOPAT : Net Operating Profit After Tax

Firms may have identical operating performances but different net

incomes – the one with more debt would have a lower net income.
Net Income donot reflect true performance of a company’s operations,
particularly for comparisons.

A better measure: NOPAT, which is the amount of profit a company

would generate if it had no debt.

NOPAT = EBIT(1 - Tax rate)

What are operating current assets and
Operating current liabilities?
• Operating current assets are the CA needed to support
operations.
– Op CA include: cash, inventory, receivables.
– Op CA exclude: short-term investments, because these are
not a part of operations.
– As a thumb rule, if any current asset generates interest
income then its not part of operating current asset.

• Operating current liabilities are the CL resulting as a normal

part of operations.
– Op CL include: accounts payable and accruals.
– Op CL exclude: notes payable, because this is a source of
financing, not a part of operations.
– As a thumb rule, if any interest need to be paid on current
liability then its not part of Op. Current Liability 7
 Financial Statement Analysis

• Assessment of the firm’s past, present and

future financial conditions
• Find firm’s financial strengths and weaknesses
• Primary Tools:
– Financial Statements: Three primary reports
– Comparison of financial ratios to past, industry,
sector and all firms
The Statement of Cash Flows
Figure 4.3: Statement of Cash Flows

Net cash flow from operations,

after taxes and interest expenses Cash Flows From Operations

Includes divestiture and acquisition

of real assets (capital expenditures)
and disposal and purchase of + Cash Flows From Investing
financial assets. Also includes
acquisitions of other firms.

Net cash flow from the issue and

repurchase of equity, from the + Cash Flows from Financing
issue and repayment of debt and after
dividend payments

= Net Change in Cash Balance

Ties income statement, current and previous b/sheets.
 Statement of Cash Flows
• Is used to help answer questions such as:
– Is the firm generating enough cash to purchase the
additional assets required for growth?
– Is the firm generating any extra cash that can be used
to repay debt or to invest in new products?
• Such information is useful both for managers and
investors
Lets look at MiniCase from BE text Ch 2
 Income Statement
2012 2013
Sales $3,432,000 $5,834,400
COGS 2,864,000 4,980,000
Other expenses 340,000 720,000
Deprec. 18,900 116,960
Tot. op. costs 3,222,900 5,816,960
EBIT 209,100 17,440
Int. expense 62,500 176,000
Pre-tax earnings 146,600 (158,560)
Taxes (40%) 58,640 (63,424)
Net income $ 87,960 ($ 95,136)

Sales increased by over $2.4 million (up by 70%)

Costs shot up by more than sales.
Net income was negative. 12
 Balance Sheet: Assets
2012 2013
Cash $ 9,000 $ 7,282
S-T invest. 48,600 20,000
AR 351,200 632,160
Inventories 715,200 1,287,360
Total CA 1,124,000 1,946,802
Gross FA 491,000 1,202,950
Less: Depr. 146,200 263,160
Net FA 344,800 939,790
Total assets $1,468,800 $2,886,592

Net fixed assets almost tripled in size.

AR and inventory almost doubled.
Cash and short-term investments fell. 13
 Balance Sheet: Liabilities & Equity
2012 2013
Accts. payable $ 145,600 $ 324,000
Notes payable 200,000 720,000
Accruals 136,000 284,960
Total CL 481,600 1,328,960
Long-term debt 323,432 1,000,000
Common stock 460,000 460,000
Ret. earnings 203,768 97,632
Total equity 663,768 557,632
Total L&E $1,468,800 $2,886,592
CL increased as creditors and suppliers “financed” part of the expansion.
Long-term debt increased to help finance the expansion.
The company didn’t issue any stock. Retained earnings fell, due to the year’s
14
negative net income and dividend payment.
 Summary of Statement of CF
Net cash provided (used) by ops. ($ 503,936)
Net cash to acquire FA (683,350)
Net cash prov. (used) by fin. act. 1,185,568
Net change in cash (1,718)
Cash at beginning of year 9,000
Cash at end of year $ 7,282

Net CF from operations = -$503,936, because of negative net income

and increases in working capital.
The firm spent $711,950 on FA.
The firm borrowed heavily and sold some short-term investments to
meet its cash requirements.
Even after borrowing, the cash account fell by $1,718.
15
 Net Operating Profit after Taxes (NOPAT)

Firms may have identical operating performances but different

net incomes – the one with more debt would have a lower net
income. Net Income donot reflect true performance of a
company’s operations, particularly for comparisons.
A better measure: NOPAT, which is the amount of profit a
company would generate if it had no debt.
NOPAT = EBIT(1 - Tax rate)

NOPAT13 = $17,440(1 - 0.4)

= $10,464.

NOPAT12 = $125,460.

16
 What are Free Cash Flows (FCF)?
• FCF is the amount of cash available from operations for distribution
to all investors (including stockholders and debtholders) after
making the necessary investments to support operations.
• A company’s value depends on the amount of FCF it can generate.
• Five uses of FCF

1. Pay interest on debt.

2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable securities,
investments in other companies, etc.) 17
 Calculating Free Cash Flow in 5 Easy Steps
Step 1 Step 2

Earning before interest and taxes Operating current assets

X (1 − Tax rate) − Operating current liabilities

Net operating profit after taxes Net operating working capital

Step 3

Net operating working capital

+ Operating long-term assets

Total net operating capital

Step 5
Step 4

Net operating profit after taxes

Total net operating capital this year
− Net investment in operating capital − Total net operating capital last year

Net investment in operating capital

Free cash flow
18
What are operating current assets and
Operating current liabilities?
• Operating current assets are the CA needed to support
operations.
– Op CA include: cash, inventory, receivables.
– Op CA exclude: short-term investments, because these are
not a part of operations.
– As a thumb rule, if any current asset generates interest
income then its not part of operating current asset.

• Operating current liabilities are the CL resulting as a normal

part of operations.
– Op CL include: accounts payable and accruals.
– Op CL exclude: notes payable, because this is a source of
financing, not a part of operations.
– As a thumb rule, if any interest need to be paid on current
liability then its not part of Op. Current Liability 19
Net Operating Working Capital
(NOWC)

NOWC Operating Operating

= -
CA CL

NOWC13 = ($7,282 + $632,160 + $1,287,360)

- ($324,000 + $284,960)
= $1,317,842.
NOWC12 = $793,800.

20
Total net operating capital (also called
operating capital)
• Operating Capital= NOWC + Net fixed assets.
• Operating Capital 2013
= $1,317,842 + $939,790
= $2,257,632.
• Operating Capital 2012 = $1,138,600
(793.8k+344.8k).

21
 Free Cash Flow (FCF) for 2013

FCF = NOPAT - Net investment in operating capital

= $10,464 - ($2,257,632 - $1,138,600)
= $10,464 - $1,119,032
= -$1,108,568.

What are the uses of FCF?

How do you suppose investors reacted?
Having a negative free cash flow is problem?

22
 Uses of FCF

After-tax interest payment = $105,600

Reduction (increase) in debt = −$1,196,568
Payment of dividends = $11,000
Repurchase (Issue) stock = $0
Purch. (Sale) of ST investments = −$28,600
Total uses of FCF = −$1,108,568

23
 Return on Invested Capital (ROIC)

ROIC = NOPAT / operating capital

ROIC13 = $10,464 / $2,257,632 = 0.5%.

ROIC12 = 11.0%.

24
 The firm’s cost of capital is 10%. Did the
growth add value?
• No. The ROIC of 0.5% is less than the WACC of 10%.
Investors did not get the return they require.
• High growth usually causes negative FCF (due to
investment in capital), but that’s ok if ROIC > WACC.
• FCF <0 but ROIC > WACC : Ok for high growth firms
• FCF <0 but ROIC < WACC : Seriously wrong
• FCF > 0 and ROIC > WACC: Best for firm
• FCF > 0 and ROIC < WACC : Cause of concern

25
 Economic Value Added (EVA)
• Is an estimate of the value created by management during the year
• It differs substantially from accounting profit because no charge for the
use of equity capital is reflected in accounting profit
• In order to generate positive EVA, a firm has to do more than just
covering operating costs.
– It must also provide a return to those who have provided the firm with
capital.
• EVA takes into account the total cost of capital, which includes the cost of
equity.

EVA = EBIT (1 – Tax rate) – (Total Net Operating Capital)(WACC)

• EVA = NOPAT- (WACC)(Capital)

 What is the weighted average cost of
capital (WACC)?
• WACC is the average rate of return required by all of
the company’s investors.
• WACC is affected by:
– Capital structure (the firm’s relative use of debt and equity
as sources of financing)
– Interest rates
– Risk of the firm
– Investors’ overall attitude toward risk

27
 Economic Value Added
(WACC = 10% for both years)

EVA = NOPAT- (WACC)(Capital)

EVA13 = $10,464 - (0.1)($2,257,632)
= $10,464 - $225,763
= -$215,299.
EVA12 = $125,460 - (0.10)($1,138,600)
= $125,460 - $113,860
= $11,600.
28
 Stock Price and Other Data

2012 2013

Stock price $8.50 $6.00

# of shares 100,000 100,000

EPS $0.88 -$0.95

DPS $0.22 $0.11

29
 Market Value Added (MVA)
• MVA = Market Value of the Firm - Book Value of the Firm
• Market Value = (# shares of stock)(price per share) + Mkt Value
of debt
• Book Value = Total common equity + Value of debt
• If the market value of debt is close to the book value of debt,
then MVA is:

• MVA = Market value of equity – book value of equity

30
2013 MVA (Assume market value of debt =
book value of debt.)

• Market Value of Equity 2013:

– (100,000)($6.00) = $600,000.
• Book Value of Equity 2013:
– $557,632.
• MVA13 = $600,000 - $557,632 = $42,368.
• MVA12 = $850,000 - $663,768 = $186,232.

31
 Rationale Behind Ratio Analysis
• A firm has resources
• It converts resources into profits through
– production of goods and services
– sales of goods and services
• Ratios
– Measure relationships between resources and financial flows
– Show ways in which firm’s situation deviates from
• Its own past
• Other firms
• The industry
• All firms-
Using Financial Ratios: Interested Parties
• Ratio analysis involves methods of calculating and interpreting
financial ratios to analyze and monitor the firm’s performance.
• Current and prospective shareholders are interested in the firm’s
current and future level of risk and return, which directly affect
share price.
• Creditors are interested in the short-term liquidity of the company
and its ability to make interest and principal payments.
• Management is concerned with all aspects of the firm’s financial
situation, and it attempts to produce financial ratios that will be
considered favorable by both owners and creditors.
 Using Financial Ratios:
Types of Ratio Comparisons
• Cross-sectional analysis is the comparison of different firms’
financial ratios at the same point in time; involves comparing
the firm’s ratios to those of other firms in its industry or to
industry averages
• Benchmarking is a type of cross-sectional analysis in which
the firm’s ratio values are compared to those of a key
competitor or group of competitors that it wishes to emulate.
• Comparison to industry averages is also popular, as in the
following example.
 Different Ratios
• Profitability measures: How profitable is the company?
– Profit margin, RoE, OpProfit / OpCapital
• Activity (asset management) measures: How well does the company
employs its assets?
– NetSales/TA or NetFA; turnover ratios for each type of asset; ACP etc
• Leverage and Liquidity measures
– Long or short term; TimesInterestEarned ratio=EBIT/IntExpense; Number of days
payable=Apayable/CoGS
– CA/CL, Quick ratio
• Valuation Ratios:
• Assess market price relative to assets or earnings

• Tie up all ratios

The DuPont System – Tie the Ratios together
• Method to breakdown ROE into:
– ROA and Equity Multiplier
• ROA is further broken down as:
– Profit Margin and Asset Turnover
• Helps to identify sources of strength and
weakness in current performance
• Helps to focus attention on value drivers
 The DuPont System

ROE

ROA Equity Multiplier

Profit Margin Total Asset Turnover

ROE = Profit Margin  Total Asset Turnover  Equity Multiplier

Net Income Sales Total Assets
=  
Sales Total Assets Common Equity
Mgmt can improve RoE by improving its return on sales and / or its asset turnover and / or
by increasing its financial leverage as measured by total assets divided by owners’equity
 Cautions about Using Ratio Analysis

1. Ratios that reveal large deviations from the norm merely indicate
the possibility of a problem.
2. A single ratio does not generally provide sufficient information
from which to judge the overall performance of the firm.
3. The ratios being compared should be calculated using financial
statements dated at the same point in time during the year.
4. The financial data being compared should have been developed in
the same way.
5. Results can be distorted by inflation.
 Pros & Cons
• Benefits of these ratios
– Ease of calculation & interpretation
– Decompose to reveal sources of changes
• Downside of these ratios
– Sensitive to choice of accounting method
– Accumulation of monetary values from different periods
– Backward looking
– Fail to consider risk.

39
Identify the Industry: Operating and Competitive characteristics of a company’s industry
greatly influence its investment in the various types of assets, the riskiness of these investments
and the financial structure of its balance sheet.
Match following companies with their corresponding b/s and financial ratios for the year 2009
(1) Electric Utility (4) Automated test equipment / systems comp
(2) Japanese Automobile Manufacturer (5) Upscale apparel retailer
(3) Discount general merchandise retailer
• Electric Utility – Matches with A
– High Capital intensive industry and high profit margins
– Vlow Sales-to-Assets ratio; High NetProfit-to-Sales ratio
• Japanese Automobile Manufacturer – Matches with D
– Long collection period reflects Dealer and Low inventory
– Japanese for Just-in-time / low profit margins
• Discount General Merchandise Retailer – B
– High Sales-to-Assets ratio; Discounts business so vlow collection period; low
profit; low inventory; not much need of property/equipment so high sales-
to-net property and equipment
• Automated test equipment/systems – E
– R&D nature – cyclical -capital intensive – crisis period: together results in
low sales to assets ratio with negative profits
• Upscale Apparel Retailer –Matches with C
– Upscale – luxury apparel – retailer – high profit margins long collection
period– high interest bearing debt

• Contrast Discount general and Upscale Apparel

– Both are in retailer business – but their marketing, financing, operational
strategies are all different!
 Objectives n Tasks of J Martin

• Assess the past performance and current financial health of Tire City
• Forecast the IS and BS for next two years, planned warehouse
expansion
• Determine borrowing needs created by the Warehouse expansion
• Evaluate future financial health once the warehouse expansion is
finished
• Sensitivity analysis with respect to variation in
– inventory reductions,
– depreciation expenses,
– inflation, etc.