Business Concept Development (BCD)

International Program 4 (2012)

Financial Concepts

Ruttachai Seelajaroen, Ph.D.

Dept of Banking & Finance
Chulalongkorn University

27th June 2012

Topics
1. Introduction
2. Drivers of Firms Value
3. Making Investment Decisions
4. Making Financing Decisions
2

1. Introduction
1) Corporate Financial Management
2) Financial Markets
3) How Risky is the Firm?

1) Corporate Financial Management

Forms of a business organization
Sole proprietorship

General or limited partnership

Corporation
Businesses require both skill and capital, but they need
not come from the same person.

1) Corporate Financial Management

What is corporate financial management?
Finance is about the bottom line of business activities.

Financially, a business decision reduces to:

Valuation of assets
Management of assets
How could financial mangers make financial decisions to
meet the objective of the firm?

Cash flows and Financial Decision of Firms

(1) Investment

opportunities

(3)
Firms
Operations

(2)
Firm

(4)

(5)

Investors

(6)

(1) Investment decisions require cash

(2) Cash raised from investors by selling financial assets.

(3) Cash invested in real assets
(4) Cash generated from operations

(5) Cash reinvested

(6) Cash returned to investors

1) Corporate Financial Management

The ultimate goal of a business organization
Maximize profit

Maximize firms value

Maximize shareholders wealth
What should the finance department do to maximize
the firms value?
What are the questions that financial managers have to
deal with?

A Structure of a Business Organization

Board of Directors

CEO
Sales

Finance

Cash mgt
Working capital mgt
Capital budgeting
Capital structure
Financial risk mgt

Credit
Mgt

Treasurer

Inventory Capital
Mgt
Budgeting

HR

Controller

Cost
Acct

Operations
Record transactions
Manage expenditure
Internal audit
Prepare fin statements
Manage tax

Financial
Acct

Tax

A Business Cycle
Raise additional Fund

Capital budgeting
Raise fund
Fund

Retained Earnings
Payout

Profit

Assets

Asset and WC management

Risk management
Operation

Roles of Financial Management

Investment
Decisions

Financing
Decisions

Objective: To decide what to investment

Roles: Capital budgeting, Project evaluation

Objective: To obtain sufficient fund

Role: Capital structure decision, Dividend policy

Asset
Management

Objective: Efficient uses of asset in place

Role: Evaluate assets utilization, Working capital
management, Cash management

Risk
Management

Objective: Undertake acceptable level of risk

Role: Measure and manage financial risk, Determine
and execute hedging strategies

Comparison Accounting and Finance

Accounting and finance worry about different goals:

Accounting worries about control of funds and

accountability
Finance worries about decision making and creating
value
Accountants and financial managers might want to
record and report the firms performance differently.

Book value vs. Market value

Cash flows vs. Income
11

Agency Problems
Knowing the goal of the shareholders, how do we get
the managers to work toward that goal?
Agency problem refers to conflicts of interest between
the shareholders and management of a firm.
With this problem, parts of the firms value will be lost
through agency costs.
Corporate expenditures that benefits the manager.
Foregone investment opportunities or excessive
investment.
12

Agency Problems
Solutions to agency problem
Compensation plan tied to increase firm value
Control (monitoring and corporate takeovers)
Long-term relationships

13

2) Financial Markets
Corporations can raise fund from commercial banks
and/or financial markets.
In financial markets, corporations issue financial assets
and sell them to investors.
Debt securities

Common Equity
If investors view the firm as having bad prospects,
prices of securities issued by the firm will drop implying
that the firms cost of capital increases.
14

Intermediated Markets
Inter-bank Market

Saving

Loan
Bank A

Surplus
Units

Deposit Account
Principal +
Deposit Rate

Loan Contract
Bank B

Deficit
Units

Principal +
Lending Rate

In retail credit markets, commercial banks accept deposits from and make loans to individuals
and corporations. The spread between lending rate and deposit rate makes up banks profits.

In the inter-bank market, commercial banks borrow and lend excess fund among themselves. The
offer rate is the interest rate that the quoting bank demand in order to make loan to another bank.
The bid rate is the interest rate that the quoting bank is willing to pay in order to borrow money
from another bank. bid rate < offer rate

Financial Markets
Business
Fund
Current
Liability
Assets
Financial Assets
Fixed
Return
Equity
Assets
Investment

Fund

Financial
Markets

Financial Assets

Investors

Return

Money market: BE, PN

Capital markets: Bonds, Equity

Secondary
Markets

A financial security is a contract representing the holders claims on the issuers assets. It is a
negotiable instrument. Financial securities are broadly categorized into debt instruments and
equities. For fees, financial institutions (FIs) help the issuer going through the process of issuing
and selling the security to investors (in primary market). FIs also help investors buying and selling
the security in secondary markets.

Primary vs. Secondary Markets

The primary market is the market that deals with the
issuance of new securities. Companies raise fund from
the primary market.
The primary market performs the crucial function of
facilitating capital formation in the economy.

The secondary market is the market for trading existing

securities. A transaction in this market represents a
transfer of ownership with no change in capital formation
in the economy.
A well functioning primary market requires liquid and
transparent secondary market. Why?
17

3) Firms Risk to Debt- and Share-Holders

Factors that affect risk of a firm
Economy-wide factors such as inflation, political risk
Industry-wide factors such as competition, substitute
products,
Firm-specific factors;
Directly related to the firms investment (i.e., asset
structure) and financing policies.
Not directly related to the firms financial policies
such as labor strike, product recall
18

Effects of Operating and Financial Leverage

A = 500 ; E = 300 & D = 200 (kD@ 20%)
E(CF)

10%

Sale

1,000

900

Variable Cost (25%)

Fixed Cost
EBIT

250
510
240

225
510
165

40
200
100
100
33%
24%

40
125
62.5
62.5
20.8%
16.5%

Interest Payment (KdD)

EBT
Tax Payment
Net Income
ROE
ROE (If all equity, E=500)

10%
10%
10%
31%
38%
38%
37%
31%

1,100
275
510
315
40
275
137.5
137.5
45.8%

+10%
+10%
+31%
+38%
+38%
+38%
+31%

Sources of Risk Affecting Profit Volatility

Economic conditions
Political & social
environments

10%

Sales
Market structure
Firms competitive
position

31%

26%

EBIT

EAT or NI

10%

Economic risk
Business risk

26%
31%

Operational risk
Financial risk

Uncertain economic, political, social and competitive environments create economic

risk, which is magnified by fixed operating expenses that produce operational risk.
Together these two risks compose business risk. Risk is further magnified by fixed
interest expenses reflecting financial risk. Business risk + Financial risk = Total risk.

2. Drivers of Firms Value

1) Measures of Profitability
2) Issues in Financial Management

21

1) Measures of Profitability
Since the objective is to maximize shareholders value,
the management often focuses on Return on Equity
(ROE).

ROE =

EAT
Eq

How operating decisions (acquisitions/sell-off of assets)

and financing decisions affect ROE?
ROE =

EAT Sales
Sales
IC

IC
Eq
22

1) Measures of Profitability
Managerial balance sheet provide a more appropriate
tool to identify the link between managerial decisions
and financial performance.
Invested capital (IC) = Net asset
= Cash + WCR + Net fixed assets
Capital employed = ST debt + LT debt + Equity capital
WCR = (Accounts receivables + Inventories + Prepaid
expenses) (Accounts payables + Accrued expenses)
23

Standard Balance Sheet

Managerial Balance Sheet

Assets

Liabilities and
Equity

Invested Capital or
Net Assets

Capital Employed

Cash

S-T debt

Cash

S-T debt

Operating
Assets
AR + Inventories
+ Prepaid
expenses

WCR
Operating Lia
AP + Accrued
expenses

L-T Financing

Net fixed
assets

L-T debt
plus
Equity

Operating assets
less
Operating lia

Net fixed
assets

L-T Financing
L-T debt
plus
Equity

1) Measures of Profitability
Economic Value Added (EVA) is a better measure of profitability.
EVA

Revenue

Operating
Charges for
Cost of

Taxes
expenses
capital used
goods sold

Net Operating Profit/Loss

after Tax (NOPLAT)
Charges for
capital used

EVA

EBIT (1 t)

EVA

(ROIC WACC) Invested Capital

EBIT(1t)
ROIC =
Invested Capital

Profit Margin
Capital Efficiency

27

Economic Value Added

Profit and Loss Statement
Revenue

Value Based Management

EBIT

Costs

Taxes

NOPLAT

EVA

or EBIT(1t)

Capital
Charges

Balance Sheet

Current
Assets

Fixed
Assets

Current
Liability

Invested
Capital

Net Working
Capital

WACC

Value Drivers
Revenue

ROIC

EVA

Expenses
Asset Efficiency

Working Cap/Cash Mgt

Capital Structure

Financing Decisions

Risk Management

Credit, Liquidity, Price Risk Mgt

Expand vs. Shrink

Investment vs. Divestment

WACC

Invested
Capital
Internal vs. External

Acquisition Decisions

2) Issues in Financial Management

Although treasury department is not a profit center in a
business organization, appropriate financial
management can create value and reduce risk for the
business organization.
Apply finance theories and tools to practical financial
management.

31

2) Issues in Financial Management

Sources of financing become more opened. Financing
tools become more and more complicated.
Development in both domestic and international
financial markets can affect the value of the firm.
Centralized vs. Decentralized structure of financial
management
Outsourcing certain financial activities.

32

3. Making Investment Decisions

1) The Concept of Economic Profit
2) The Net Present Value Approach
3) The Business Acquisition Decision
4) The Foreign Investment Decision

33

1) The Concept of Economic Profit

When making an investment decision, the management
should focus on economic profit rather than accounting
profit.
Accounting Profit = Revenue Expenses
Economic Profit = Cash Inflows (Cash Outflows +
Cost of Capital)
= Present Value of Cash Inflows
Present Value of Cash Outflows
34

Comparison of Accounting and Economic Profit

Accounting Profit

Economic Profit

Time Value of Money

Not taken into

account

Taken into account

Realization of revenue
and expenses

When entering into

the transactions

When there is cash

flow

Cost of debt

Taken into account

Taken into account

Not taken into

account

Taken into account

Cost of equity

Percent of CFOs who always or almost always use a given technique

Source: Graham and Harvey (2001), The Theory and Practice of Corporate Finance: Evidence from the Field,
Journal of Financial Economics, Vol. 60(May/June) p. 187244 . [Based on the responses of 392 CFOs]

2) The Net Present Value Approach

The Net Present Value (NPV) is an approach to calculate
the value of an investment project. NPV is the different
between the present value of the projects cash inflows
and the present value of the projects cash outflows.
E ( NCF1 ) E ( NCF2 ) E ( NCF3 )
E ( NCFT )
NPV I 0

...
1
2
3
(1 k )
(1 k )
(1 k )
(1 k )T

37

2) The Net Present Value Approach

EX : The market price of a house is THB 1.05 m. An
entrepreneur expects that he can rent out the house at
THB 0.15 m./year for 3 years and sell the house at the
expected price of THB 1.1 m. The maintenance cost is
expected to be THB50,000/year. If the interest rate is
10% per year, should he make the investment?
Net Operating Cash Flows from the Project

1.05

+0.1

+0.1

3
+0.1
+1.1

38

2) The Net Present Value Approach

The intrinsic value of an asset is measured as the
present value (PV) of expected future net operating
cash flows from owning the asset.
The intrinsic value of this house to the
entrepreneur is
= 0.1/(1+.10) + 0.1/(1+.10)2 + 1.2/(1+.10)3
= 1.0742
0

+0.1

+0.1

+1.2
39

2) The Net Present Value Approach

The NPV of an asset is the difference between the
intrinsic value and the market price of the asset.
NPV

= 1.0742 1.05
= 0.0242 million or 24,200 baht

NPV is the measure of value added (or economic

profit) of an investment.
A project creates value, if its NPV 0.
Note: In practice the discount rate (k) must reflect
the projects risk.
40

2) The Net Present Value Approach

If the market price of the house = 1.0742 NPV = 0
Break-even in economic sense (make normal
profit)
If the market price of the house 1.0742 NPV 0
Make loss in economic sense
If the market price of the house 1.0742 NPV 0
Make profit in economic sense (make abnormal
profit)
41

2) The Net Present Value Approach

The time it takes to realize the full NPV amount is the
life of the project.
However, if the project is very profitable, it will attract
other entrepreneurs to join in and compete. This
implies that the actual NPV realized over the life of the
project may be less than the amount forecasted.

42

2) The Net Present Value Approach

What should the company do to be able to create value
(NPV 0) in the long run.
The firm must create barrier to entry and create its
comparative advantage, such that it is hard for
potential competitors to join in and compete.
Examples of barrier to entry are ownership of
patents, technologies and brands, protections from
the law, economies of scale, economies of scope.

43

Cash Flows Estimation

Estimate the required capital
Investment in fixed assets

Investment in working capital or working capital

requirement (WCR)
Cash in hand

44

Net Operating Cash Flows

Sale Revenue
Less Cost of Good Sold
Depreciation
Earnings before Interest and Tax
Less Tax (30%)
Earnings After Tax
Plus Depreciation
Less Increase in working capital
Capital expenditure
Cash flows from operating

CGS
DEP

REV

EBIT
(EBITt)

EBIT(1t)
DEP
(WCR1WCR0)
CAPEX

EBIT(1t)+DEPWCRCAPEX

Sensitivity Analysis
NPV is calculated from estimated cash flows and cost of
capital
There is risk that realized cash flows and other factors
will be different from expectation.
To get the feeling of what would happen to NPV if the
realization is different from expectation, one should
perform a sensitivity analysis to see how NPV changes
when important assumptions are changed.
Changes in sales volume
Changes in production costs
46

Other Aspects of Project Feasibility

Marketing feasibility
PEST Analysis to analyze affect on the project from
external factors over which the firm has no control.
Five Force Model to analyze the competitive level in
the industry.

SWOT Analysis to analyze the companys weakness

and strength
Operational feasibility

47

Other Project Evaluation Methods

Pay back period (PB) is the time it takes for the project
to break-even
Decision to invest: PB Acceptable period
Internal rate of return (IRR) is the discount rate that
make the projects NPB to be zero.

Decision to invest: IRR Cost of capital

48

3) The Business Acquisition Decision

An acquisition of a company is just another type of
investment, albeit a large one.
There are three types of merger.
Vertical mergers
Horizontal mergers

Conglomerate mergers
The key to merger is synergy.

49

4) Foreign Investment Decision

Foreign investments may offer something that domestic
investments could not, for example, access to
resources, technology and markets.
Additional risk must be considered when making foreing
investment decisions.
Currency risk
Political risk

50

4. Making Financing Decision

1) External Financing Needed
2) Sources of Fund
3) Debt vs. Equity
4) Banks vs. Financial Markets

51

1) External Financing Needed

In long-term financial planning, finance managers must
evaluate and forecast the need for external financing.
Internal finance is from retained earnings and does not
subject the firm to market scrutiny.
External finance refers to selling newly issued securities.
The external financing needed (EFN) depends on
Investment in new assets
Retained earnings (which depends on profitability of
existing operation and dividend payouts)
Level of liquidity required
52

Expansion in Operation Requires More Fund

Liabilities and
Equity

Assets

New assets
supporting
increased sales

New
liability
New equity

1) External Financing Needed

Choices
Equity vs. Debt
Equity: Internal vs. External
Debt: Bank Loan vs. Corporate Bonds
Debt: Long-Term vs. Short-Term Financing
Reduce operations that are non-core business
Outsourcing
Increase profit margin

54

2) Sources of Fund
Differences among funds from different sources.
Cost of capital

Financial risk
Liquidity risk
Interest rate risk
Currency risk
Reliability of the source of fund

Conditions/Restrictions on uses of fund

55

2) Sources of Fund
Financing decisions
What is the optimal combination between debt and
equity?
What is the optimal combination between long-term
and short-term debt?

This involves trading-off between cost of capital and risk

(financial distress and liquidity risk)

56

Debt-to-Equity Ratio of US Firms

Debt-to-Equity Ratio from Various Countries

Debt-to-Asset Ration of Various Industries

Percent of CFOs identifying factor as important or very important

Source: Graham and Harvey (2001), The Theory and Practice of Corporate Finance: Evidence from the Field,
Journal of Financial Economics, Vol. 60(May/June) p. 187244 . [Based on the responses of 392 CFOs]

Percent of CFOs identifying factor as important or very important

Source: Graham and Harvey (2001), The Theory and Practice of Corporate Finance: Evidence from the Field,
Journal of Financial Economics, Vol. 60(May/June) p. 187244 . [Based on the responses of 392 CFOs]

Survey evidence whether firms have target capital structure

Source: Graham and Harvey (2001), The Theory and Practice of Corporate Finance: Evidence from the Field,
Journal of Financial Economics, Vol. 60(May/June) p. 187244 . [Based on the responses of 392 CFOs]

Debt vs. Equity

Debt

Equity

Cost of capital

Lower

Higher

Floatation costs

Lower

Higher

Yes

No

More leverage

Less lverage

No

Increase financial risk

Restricted by loan
agreements

No restriction

Help reduce agency

problems

Subject to agency
problems

No effect

Yes

Yes, due to limited

term to maturity

No

Tax shield
Effect on capital structure
Effect on financial risk
Flexibility on how to use
fund

Agency problem
Effect of ownership
structure
Liquidity risk

Financing Choices across the life cycle

Reven ues
$ Reven ues/
Earnings

Earnings

Time

External funding
needs

High, but
constrained by
infrast ruct ure

High, relative
t o firm value.

Moderat e, relat ive

t o firm value.

Declining, as a
percent of firm
value

Intern al finan cing

Negat ive or
low

Negat ive or
low

Low, relat ive to

funding needs

High, relative t o
fundin g needs

More than funding needs

External
Financing

Owners Equit y
Bank Debt

Venture Capit al
Common St ock

Common st ock
Warrant s
Convert ibles

Debt

Retire debt
Repurchase st ock

Growt h st age

St age 1
St art-up

St age 2
Rapid Expansion

St age 4
Mat ure Growt h

St age 5
Decline

Financing
Transitions

Accessing private equit y Inital Public offering

St age 3
High Growt h

Seasoned equity issue

Bond issues

Low, as project s dry

up.

Factors in Target Debt Ratio

Industry Norms

Taxes
Since interest is tax deductible, highly profitable firms
should use more debt (i.e., greater tax benefit).
Types of Assets
The costs of financial distress depend on the types of
assets the firm has.
Uncertainty of Operating Income
Even without debt, firms with uncertain operating
income have a high probability of experiencing financial
distress.

Factors in Target Debt Ratio

Growth Opportunity
Firms with high growth opportunity may choose to keep
more retained earnings and rely less on debt.
Pecking Order and Financial Slack
Theory stating that firms prefer to issue debt rather
than equity if internal financing is insufficient.
Floatation Costs
Managerial Risk Aversion
Managerial Opportunistic Behavior

Approaches to Raise Fund

Equity Financing

Retained earnings vs. Issue new equity

Issuance of new equity: Right Issues vs. Seasoned Equity
Offering

Debt Financing
Long-term vs. Short-term Debt
Bank Loan vs. Corporate Bonds

Corporate Bonds: Private vs. Public Placement

Long-Term vs. Short-Term Debt

Cost of capital
Effect on financial risk

Short-term Debt

Long-term Debt

Lower

Higher

Higher liquidity
risk

Lower liquidity risk

68

Matching Duration between Assets and Financing

In-between

Current Assets

S-Term Financing

Fixed Assets

L-Term Financing

Conservative

Current Assets

Fixed Assets

S-Term Financing

L-Term Financing

Aggressive

Current Assets

Fixed Assets

S-Term Financing

L-Term Financing69

Banks vs. Financial Markets

Banks

Bonds

Cost of Capital

Higher

Lower for good

rating

Floatation costs

Lower

Higher

Renegotiation (i.e.,
Refinance)

Easier

Harder

Confidentiality

More

Less

Creditors have
economies of scale

Creditors do not
have economies of
scale

Monitoring

70

Sources of Fund of Thai Businesses

16,000
14,000

Billion Baht

12,000
10,000
8,000
6,000
4,000
2,000
2536 2537 2538 2539 2540 2541 2542 2543 2544 2545 2546 2547 2548 2549 2550 2551 2552 2553

SET Market Capitalization

Outstanding Domestic Debt Securities

Finanical Institution Loans

Source : Bank of Thailand