Corporate Financial Policy

Semester A 2012-13
City University of Hong Kong
AC4331 Week 2

Topic 2
.
1-2
Introduction to Financial Management
Free Cash Flow
Financial Planning and Forecasting
Financial Assets and Time Value of Money etc.
Bond and Stock Valuation
Cost of Capital
Cash Flow Estimation and Risk Analysis
Capital Structure and Leverage
Treasury and Valuation
Enterprise Risk Management
Dividends and Share Repurchase
Merger and Acquisitions
Working Capital Management
Extra Ref:
Financial Management, Theory and Practice, 12e Eugene and
Brigham
Understand and calculate a firms free cash
flow

Understand techniques and models for
forecasting financial statements

4
5
Company managers, investors, and outside analysts
use financial statements to conduct
Cash flow analysis
Performance (ratio) analysis


Free Cash Flow

1. What is Free Cash Flow?
2. Why is FCF an important
determinant of a firms value?
3. Calculating FCF

Ref: Eugene Ch 2 Pg 44
7
8
What are key measures of cash flow?
Profit is based on accrual accounting,
focusing on past periods.
Finance emphasizes the importance of timing.
You cant deposit net income, only cash.
Timing of cash flow matters.
Accrual accounting may obscure timing.
9
2011 2012
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
EBT 146,600 (158,560)
Taxes (40%) 58,640 (63,424)
Net income 87,960 (95,136)
10
Sales increased by over $2.4 million.
Costs shot up by more than sales.
Net income was negative.
However, the firm received a tax refund since
it paid taxes of more than $63,424 during
the past two years.
11
2011 2012
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
12
Net fixed assets almost tripled in size.
AR and inventory almost doubled.
Cash and short-term investments fell.
13
Balance of ret. earnings,
12/31/2011 203,768
Add: Net income, 2012 (95,136)
Less: Dividends paid, 2012 (11,000)
Balance of ret. earnings,
12/31/2012 97,632
14
2011 2012
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
15
CL increased as creditors and suppliers
financed part of the expansion.
Long-term debt increased to help finance the
expansion.
The company didnt issue any stock.
Retained earnings fell, due to the years
negative net income and dividend payment.
16
Operating Activities
Net Income (95,136)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP 178,400
Change in accruals 148,960
Net cash provided by ops. (503,936)
17
Investing Activities
Cash used to acquire FA (711,950)
Change in S-T invest. 28,600
Net cash provided by inv. act. (683,350)
18
Financing Activities
Change in notes payable 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash provided by fin. act. 1,185,568
19
Net cash provided by ops. (503,936)
Net cash to acquire FA (683,350)
Net cash provided 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
20
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.
21
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 companys value depends upon the amount
of FCF it can generate.
22
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.)
23
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.
24
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.
25
NOWC
12
= ($7,282 + $632,160 +
$1,287,360)
- ($324,000 + $284,960)
= $1,317,842.
NOWC
11
= $793,800.
= -
Operating
CA
Operating
CL
NOWC
26
Operating Capital= NOWC + Net fixed assets.

Operating Capital 2012 = $1,317,842 +
$939,790 = $2,257,632.

Operating Capital 2011 = $1,138,600.
27
NOPAT = EBIT(1 - Tax rate)

NOPAT
12
= $17,440(1 - 0.4)
= $10,464.

NOPAT
11
= $125,460.
28
FCF = NOPAT - Net investment in
operating capital

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

How do you suppose investors will react?
29
ROIC = NOPAT / operating capital

ROIC
12
= $10,464 / $2,257,632 = 0.5%.

ROIC
11
= 11.0%.

30
No. The ROIC of 0.5% is less than the WACC
of 10%. Investors did not get the return they
require.

Note: High growth usually causes negative
FCF (due to investment in capital), but thats
ok if ROIC > WACC. For example, Home
Depot had high growth, negative FCF, but a
high ROIC.
31
Net operating profit
after taxes (NOPAT)
= EBIT (1 T)
Operating cash
flow (OCF)
= NOPAT + Depreciation
= EBIT (1 T) + Depreciation
Free cash
flow (FCF)
= OCF AFA (ACA AAP AAccruals)
Extra Ref:
Financial Management, Theory and Practice, 12e Eugene and
Brigham
Financial Planning and Forecasting
Chapter 4
Develop a financial plan using the percentage
of sales approach
Discern how capital structure and dividend
policies affect a firms ability to grow
4.1 Forecasting Sales
4.2 Projecting the Assets and Internally
Generated Funds
4.3 Projecting Outside Funds Needed
4.4 Deciding How to Raise Funds

2012 2013E
Cash and equivalents $ 20 $ 25
Accounts receivable 240 300
Inventories 240 300
Total current assets $ 500 $ 625
Net fixed assets 500 625
Total assets $1,000 $1,250
4-36
2012 2013E
Accts payable & accrued liab. $ 100 $ 125
Notes payable 100 190
Total current liabilities 200 315
Long-term debt 100 190
Common stock 500 500
Retained earnings 200 245
Total liabilities & equity $1,000 $1,250
4-37
2012 2013E
Sales $2,000.0 $2,500.0
Less: Variable costs 1,200.0 1,500.0
Fixed costs 700.0 875.0
EBIT $ 100.0 $ 125.0
Interest 16.0 16.0
EBT $ 84.0 $ 109.0
Taxes (40%) 33.6 43.6
Net income $ 50.4 $ 65.40
Dividends (30% of NI) $15.12 $19.62
Addition to retained earnings $35.28 $45.78
4-38
2012 2013E Ind Avg Comment
Basic earning power 10.00% 10.00% 20.00% Poor
Profit margin 2.52% 2.62% 4.00% Poor
Return on equity 7.20% 8.77% 15.60% Poor
Days sales outstanding 43.8 days 43.8 days 32.0 days Poor
Inventory turnover 8.33x 8.33x 11.00x Poor
Fixed assets turnover 4.00x 4.00x 5.00x Poor
Total assets turnover 2.00x 2.00x 2.50x Poor
Debt/assets 30.00% 40.40% 36.00% OK
Times interest earned 6.25x 7.81x 9.40x Poor
Current ratio 2.50x 1.99x 3.00x Poor
Payout ratio 30.00% 30.00% 30.00% OK
4-39
Financial Models

Projection of Future Plans
Short Term or Long Term
Results in Pro-Forma Statements
Influenced by:
Investment in new assets capital budgeting
decisions
Degree of financial leverage capital structure
decisions
Cash paid to shareholders dividend policy
decisions
Liquidity requirements net working capital
decisions
Sales Forecast cash flows depend directly on the
level or estimated growth rate of sales
Pro Forma Statements Presenting the plan as
projected financial statements (pro forma) allows
for consistency and ease of interpretation
Asset Requirements additional assets required to
meet sales projections
Financial Requirements financing needed to pay
for the required assets
Plug Variable depends on type of financing to be
used (makes the balance sheet balance)
Some items vary directly with sales, others
do not.
Income Statement
Costs may vary directly with sales - if this is the
case, then the profit margin is constant
Depreciation and interest expense may not vary
directly with sales if this is the case, then the
profit margin is not constant
Dividends are a management decision and
generally do not vary directly with sales this
affects additions to retained earnings
Balance Sheet
Initially assume all assets, including fixed, vary
directly with sales.
Accounts payable also normally vary directly with
sales.
Notes payable, long-term debt, and equity
generally do not vary with sales because they
depend on management decisions about capital
structure.
The change in the retained earnings portion of
equity will come from the dividend decision.
External Financing Needed (EFN)
The difference between the forecasted increase in
assets and the forecasted increase in liabilities and
equity.
Operating at full capacity in 2012.
Each type of asset grows proportionally
with sales.
Payables and accruals grow proportionally
with sales.
2013 profit margin (2.52%) and payout
(30%) will be maintained.
Sales are expected to increase by $500
million. (%AS = 25%)
4-44
Spontaneous Liabilities: Accounts Payables +
Accrued Liabilities
PM = Profit Margin
D = payout ratio

AFN = (A
0
*/S
0
)AS (L
0
*/S
0
)AS M(S
1
)(RR)
= ($1,000/$2,000)($500)
($100/$2,000)($500)
0.0252($2,500)(0.7)
= $180.9 million

4-45
) 1 ( Sales) Projected ( Sales
Sales
Liab Spon
Sales
Sales
Assets
d PM A
|
.
|

\
|
4-46
Consultation with some key managers has
yielded the following revisions:
Firm expects customers to pay quicker next year,
thus reducing DSO to 34 days without affecting
sales.
A new facility will boost the firms net fixed assets
to $700 million.
New inventory system to increase the firms
inventory turnover to 10x, without affecting sales.
4-47
These changes will lead to adjustments in the
firms assets and will have no effect on the
firms liabilities and equity section of the
balance sheet or its income statement.
2012 2013F
Cash and equivalents $ 20 $ 67
Accounts receivable 240 233
Inventories 240 250
Total current assets $ 500 $ 550
Net fixed assets 500 700
Total assets $1,000 $1,250
4-48
2012 2013F Ind Avg Comment
Basic earning power 10.00% 10.00% 20.00% Poor
Profit margin 2.52% 2.62% 4.00% Poor
Return on equity 7.20% 8.77% 15.60% Poor
Days sales outstanding 43.8 days 34.0 days 32.0 days OK
Inventory turnover 8.33x 10.00x 11.00x OK
Fixed assets turnover 4.00x 3.57x 5.00x Poor
Total assets turnover 2.00x 2.00x 2.50x Poor
Debt/assets 30.00% 40.40% 36.00% OK
Times interest earned 6.25x 7.81x 9.40x Poor
Current ratio 2.50x 1.98x 3.00x Poor
Payout ratio 30.00% 30.00% 30.00% OK
4-49
4-50
$1,125
625 $ 125 $ $625
(NFA) Assets Fixed Net (NWC) Capital g Net Workin Capital
2013
=
+ =
+ =
900 $ 2012 Capit al =
225 $
900 $ $1,125 capital in investment Net
=
=
FCF = EBIT(1 T) Net investment in capital
= $125(0.6) $225
= $75 $225
= -$150
4-51
The maximum amount of sales that can be
supported by the 2012 level of assets is:

4-52
$2,353 5 $2,000/0.8
capacity of % sales/ Actual sales Capacity
= =
=
2013 forecast sales exceed the capacity
sales, so new fixed assets are required to
support 2013 sales.
Sales wouldnt change but assets would be
lower, so turnovers would improve.
Less new debt, hence lower interest and
higher profits
EPS, ROE, debt ratio, and TIE would improve.
4-53
Higher dividend payout ratio?
Increase AFN: Less retained earnings.
Higher profit margin?
Decrease AFN: Higher profits, more retained
earnings.
Higher capital intensity ratio?
Increase AFN: Need more assets for given sales.
Pay suppliers in 60 days, rather than 30
days?
Decrease AFN: Trade creditors supply more capital
(i.e., L
0
*/S
0
increases).
4-54
External Financing Needed (EFN) can also
be calculated as:
) 1 ( Sales) Projected ( Sales
Sales
Liab Spon
Sales
Sales
Assets
d PM A
|
.
|

\
|
The first term measures the increase in assets, which is
based on the capital intensity ratio.
The second and third terms capture the increase in
liabilities and equity, respectively.
External Financing and Growth

At low growth levels, internal financing
(retained earnings) may exceed the required
investment in assets.
As the growth rate increases, the internal
financing will not be enough, and the firm will
have to go to the capital markets for
financing.
Examining the relationship between growth
and external financing required is a useful
tool in financial planning.
The internal growth rate is the maximum growth
rate using retained earnings as the only source of
financing (Without raising external capital)
In other words, the IGR is the maximum growth
rate with no EFN of any kind.
Using the information from the Hoffman Co.

b ROA - 1
b ROA
Rate Growth Internal

=
= plowback rate * return on equity *
equity/net assets
= retained earnings/net income * net
income/equity * equity/net assets

If a company wishes to grow faster, it would
need to (1) plow back more earnings, (2) earn
a higher return on equity (ROE), (3) have a
lower debt-equity ratio
The sustainable growth rate tells us how
much the firm can grow by using internally
generated funds and issuing debt to maintain
a constant debt ratio (not increasing financial
leverage)
= plowback ratio * return on equity
= Retained earnings/net income * return on
equity (debt-equity ratio remains unchanged)
b ROE - 1
b ROE
Rate Growth e Sustainabl

=
Profit margin operating efficiency
Total asset turnover asset use efficiency
Financial leverage choice of optimal debt
ratio
Dividend policy choice of how much to pay
to shareholders versus reinvesting in the
firm
Some Caveats


Financial planning models do not indicate
which financial polices are the best.
Models do not contain finance in them
Models are simplifications of reality, and the
world can change in unexpected ways.
Without some sort of plan, the firm may find
itself adrift in a sea of change without a
rudder for guidance.
Standardize financial statements for
comparison purposes
Compute and interpret important financial
ratios including the famous DuPont Identity
Financial Statements Analysis

Must develop a good working knowledge of
financial statements
Making financial statements useful for users
is one finance role
In order to make meaningful comparisons
of companies of different size financial
professionals use two key techniques:
Common-Size Statements
Financial Ratios
Common-Size Balance Sheets
Compute all accounts as a percent of total assets
Common-Size Income Statements
Compute all line items as a percent of sales
Standardized statements make it easier to compare
financial information, particularly as the company
grows.
They are also useful for comparing companies of
different sizes, particularly within the same
industry.
Practice Hint: You may have round percentages in
Common-Size Statements

Ratio Analysis

Ratios compliment common size analysis and allow
for deeper comparison through time or between
dissimilar companies
Not always computed precisely the same; document
your approach
As we look at each ratio, ask yourself:
How is the ratio computed?
What is the ratio trying to measure and why?
What is the unit of measurement?
What does the value indicate?
How can we improve the companys ratio?
67
Liquidity Ratios
Current Ratio
Quick Ratio
Turnover Ratios
Collection/Payment Period
Debt-to-Equity Ratio
Times Interest Earned Ratio
Profit Margin
Return on Assets
P/E Ratio
Market-to-Book Ratio
Activity Ratios
Debt Ratios
Profitability Ratios
Market Ratios
Short-term solvency or liquidity ratios
Asset management or turnover ratios
Long-term solvency or financial leverage
ratios
Profitability ratios
Market value ratios

Following Examples all Based on Tables 3.1 & 3.4
69
Current
ratio
=
Current assets
Current liabilities
Quick
ratio
=
Current assets Inventory
Current liabilities
70
Inventory
turnover
=
Cost of goods sold
Inventory
Average
collection
period
=
Accounts receivable
Average daily sales
Average
payment
period
=
Accounts payable
Average daily purchases
71
Fixed asset
turnover
=
Sales
Net fixed assets
Total asset
turnover
=
Sales
Total assets
73
Debt ratio =
Total liabilities
Total assets
Equity
multiplier
=
Total assets
Common stock equity
Debt-to-equity
ratio
=
Long-term debt
Stockholders equity
74
Times
interest
earned
=
EBIT
Interest expense
75
Gross profit
margin
=
Gross profit
Sales
Operating
profit
margin
=
Operating profit
Sales
Net profit
margin
=
Earnings available for
common shareholders
Sales
76
Earnings per
share (EPS)
=
Earnings available for common stockholders
Number of common shares outstanding
Return on total
assets (ROA)
=
Earnings available for common stockholders
Total assets
Return on
common equity
(ROE)
=
Earnings available for common stockholders
Common stock equity
Current Ratio = CA / CL
Quick Ratio = (CA Inventory) / CL
Cash Ratio = Cash / CL

Total Debt Ratio = (TA TE) / TA
Debt/Equity = TD / TE
Equity Multiplier = TA / TE = 1 + D/E
Times Interest Earned = EBIT / Interest

Cash Coverage = (EBIT + Depreciation +
Amortization) / Interest
Inventory Turnover = Cost of Goods Sold /
Inventory
Days Sales in Inventory = 365 / Inventory
Turnover

Receivables Turnover = Sales / Accounts
Receivable
Days Sales in Receivables = 365 /
Receivables Turnover

Total Asset Turnover = Sales / Total Assets
Profit Margin = Net Income / Sales
Return on Assets (ROA) = Net Income /
Total Assets
Return on Equity (ROE) = Net Income / Total
Equity
EBITDA Margin = EBITDA / Sales
Market Capitalization = $Market value per share x
no. of shares = $million
PE Ratio = Price per share / Earnings per share
Market-to-book ratio = market value per share /
book value per share
Enterprise Value (EV) = Market capitalization +
Market value of interest bearing debt cash
EV Multiple = EV / EBITDA
Ratios are not very helpful by themselves: they
need to be compared to something
Time-Trend Analysis
Used to see how the firms performance is
changing through time
Peer Group Analysis
Compare to similar companies or within
industries
Go to www.reuters.com/finance/stocks
Use the ratios link to get comparative ratios for many
companies
The DuPont Identity

Popularized by the DuPont Corporation
A more sophisticated method of evaluating
return
Illustrates the interaction between profit,
assets and leverage
Holds that ROE is actually a function of 3
measures:
Operating Efficiency (Profit Margin)
Asset Use Efficiency (Total Asset Turnover)
Financial Leverage (Equity Multiplier)
87
ROA = Net profit
margin

Total asset
turnover
ROE = ROA A/E
ROE =
Net profit
margin

Total asset
turnover
A/E
ROE = NI / TE
Multiply by 1 and then rearrange:
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1 again and then rearrange:
ROE = (NI / TA) (TA / TE) (Sales / Sales)
ROE = (NI / Sales) (Sales / TA) (TA / TE)
ROE = PM * TAT * EM
ROE = PM * TAT * EM
Profit margin is a measure of the firms operating
efficiency how well it controls costs.
Total asset turnover is a measure of the firms
asset use efficiency how well it manages its
assets.
Equity multiplier is a measure of the firms
financial leverage.
There is no underlying theory, so there is no
way to know which ratios are most relevant.
Benchmarking is difficult for diversified
firms.
Globalization and international competition
makes comparison more difficult because of
differences in accounting regulations.
Firms use varying accounting procedures.
Firms have different fiscal years.
Extraordinary, or one-time, events
How do you standardize balance sheets
and income statements?
Why is standardization useful?
What are the major categories of financial
ratios?
How do you compute the ratios within
each category?
What are some of the problems
associated with financial statement
analysis?
What is the purpose of financial planning?
What are the major decision areas
involved in developing a plan?
What is the percentage of sales approach?
What is the internal growth rate?
What is the sustainable growth rate?
What are the major determinants of
growth?