MF 722 Financial Management

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Product Market Strategy Finance

3 Functions in Financial Management

• Planning

• Performance Assessment

• Valuation

• How much money do we need & when?

• How can we measure and interpret financial performance?

• How is estimated performance translated into market value?

Separation of Control from Ownership

Managers who set Providers of

product market funds

strategy

What Should be the Objective of Corporate Financial Decisions?

We will work with:

Maximizing Shareholder Value

The Importance of Cash Flow

Financial Statements and Cash Flow

How can we derive cash flowing in and out of firm from

• Income Statement• Balance Sheet• Statement of Cash

Flow

Cash Flow Measures

• Cash flow from assets (also called free cash flow): CF(A)

• Cash flow to creditors: CF(B)

• Cash flow to shareholders: CF(S)

CF(A) = CF(B) + CF(S)

Cash Flow from Assets

Operating Cash Flow - Capex - ΔNWC

= EBIT = gross capex = increases in CA+depreciation - asset sales - increases in CL- current taxes

(Note slight difference from cash flow from operations in accounting statement of cash flow – no interest subtracted from earnings here )

Cash Flow to Investors

Cash Flow from Assets

Cash Flow to Creditors Cash Flow to Shareholders

= interest paid = dividends

+ debt repaid + stock repurchased

- new L.T. debt issued - new stock issued

A Closer Look at Net Working Capital

Let’s focus on:

• Inventory

• Accounts Receivable

• Accounts Payable

THE CASH CONVERSION CYCLE

DAYS SALES IN INVENTORY DAYS SALES IN RECEIVABLES

INVENTORY/(COGS/DAY) RECEIVABLES/(SALES/DAY)

INVENTORIES SALES SUPPLIERS PAID CASH RECEIVEDPURCHASED BOOKED IN CASH FOR SALES

PAYABLES/(COGS/DAY)

DAYS SALES IN PAYABLES CASH CONVERSIONCYCLE

Illustration of Average Collection Period

• Each day, 1 day of sales goes on the belt (A/R)• Each day, 1 day of sales falls off the belt (paid)• The number of days’ sales on the belt at any one

time represents average time to collect on A/R

Cash Conversion Cycle: Selected Companies

CompanyInv. Conv.

(DSI)

Ave. Coll.

(DSO)Op. Cycle

Pay. Def.

(DPO)

Cash Conv.

Hewlett-Packard

89.8 65.1 154.9 65.9 89

Boeing 74.1 22 96.1 54.4 41.7

Wal-Mart Stores

64.4 2.8 67.2 37.4 29.8

Safeway 33.9 2.8 36.7 35.3 1.4

McDonald's 3.9 7.1 11 62.2 -51.2

3 Functions in Financial Management

• Planning

• Performance Assessment

• Valuation

• How much money do we need & when?

• How can we measure and interpret financial performance?

• How is estimated performance translated into market value?

Financial Forecasting

• How can we use facts and assumptions to construct pro forma financial statements and estimate how much cash we will need?

Steps in Financial Forecasting

• Choosing a model driver• Making reasonable assumptions as needed• Using the discipline of accounting definitions

(e.g., balance sheet must balance)• Making the forecast• Interpreting the results• Sensitivity analysis

Possible Model Drivers

1. Sales• Assets are needed to support

sales, so assets must keep pace with sales and increased assets must be financed

2. Financing Policy• Assets (and thus sales) can only

grow as fast as the company’s ability/willingness to finance them

A Simple, Sales-Driven Model

Assumptions:

• Sales will grow by 50% (to 150) in 2007

• Assets/Sales = 2.0• Costs/Sales = 0.90• Net Income/Sales (Net Profit

Margin) = 0.10• Liabilities/Sales = 1.0• Plowback ratio = 0.60

How much new external funding must be provided to support the forecast 2007 sales growth?

2006 Income StatementSales 100Costs 90Net Income 10Dividends 4Ret. Earnings 6

2006 Balance SheetLiabilities

100Assets 200

Equity 100

2007 Forecasts

2007 Pro Forma Income State.Sales 150Costs 135Net Income 15Dividends 6Ret. Earnings 9

2007 Pro Forma Balance SheetLiabilities 150

Assets 300Equity 109

whoops!

2006 Income StatementSales 100Costs 90Net Income 10Dividends 4Ret. Earnings 6

2006 Balance Sheet

Liabilities 100Assets 200

Equity 100

External Funds Needed (EFN)

2007 Pro Forma Income State.

Sales 150

Costs 135

Net Income 15

Dividends 6

Ret. Earnings 9

2007 Pro Forma Balance Sheet

Liabilities 150

Assets 300

Equity 109

Total 300 Total 259

• There is a funding shortfall of 41 (A = 300, L&NW = 259)

• This must be made up by:1. Issuing new equity

2. Allowing the ratio of liabilities/sales to rise

3. Some combination of (1) and (2)

EFN More Generally (Eq. 3.22, p. 70)

)6)(.150(10.)50(1)50(241

))((Pr

besojectedSalPMSalesSales

sLiabilitieSales

Sales

AssetsEFN

Sustainable Growth Rate

• Growth rate in sales = g (i.e., S1 = (1+g)S0 and ΔS = S1 – S0 = gS0

• At what rate can we grow without issuing new equity or allowing liabilities/sales to increase (e.g., EFN = 0)?

ROEb

ROEbgPMbPMb

sales

equityg

PMbPMbsales

liab

sales

assetsg

bSgPMgSsales

liabgS

sales

assetsEFN

1)(

).

(

)1(.

0 000