GEB4111 Section Three Managing Assets to Create Opportunity

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GEB4111 Section ThreeManaging Assetsto Create
Opportunity
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AssetsInventory andOperations Management
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• Objectives
• Learn how to manage short-term assets
• Determine the value of assets in your business
• Master managing fixed assets
• Understand how to capitalize investment decisions
• Recognize the advantages of renting or leasing
  capital equipment
• Understand how to manage and improve the
  operations of your business

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• Question
• Money that is owed to your business by your
  customers is called
• a) Accounts payable
• b) Accounts receivable
• c) Credit extension
• d) Lender equity

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• Managing Short-term Assets
• Accounts receivable money that is owed to your
  business by your customers
• Relatively few small businesses today provide
  credit to customers

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• Pros and cons of offering credit to your
  customers
• Providing credit usually results in higher sales
  revenue because of increased repeat business
• Reduces cost of selling
• Credit delays receipt of cash
• Must replace the missing cash
• Sooner or later a customer will not pay

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• Managing accounts receivable
• Must establish and enforce efficient and
  effective policies and procedures for extending
  credit
• Minimize the time that passes between credit sale
  and when the cash is received
• Keep number of bad accounts as low as possible

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• Using accounts receivable as a source of
  financing
• Use your receivables in two ways to quickly lay
  your hands on cash
• Pledge receivables as collateral for a commercial
  loan
• You can sell your receivables to a finance
  company in a process called factoring

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• Example
• Offering Credit to New Customers
• How do I determine if a customer is creditworthy?
  
• Three things you can do to make sure you don't
  get burned
• Check credit references
• Learn more from the major credit bureaus
• Consider products and services from DB (Dun and
  Bradstreet)

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http//www.entrepreneur.com/money/paymentsandcolle
ctions/offeringcredit/article79956.html
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• Managing Inventory
• Determine the appropriate level of inventory
• Right amount of inventory is determined by
• Cost of processing an order
• Cost of keeping merchandise in inventory
• Cost of lost sales if you run out
• Time it takes to receive inventory after its
  ordered

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Inventory Costs
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• Economic Order Quantity

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• Question
• Recording the receipt and sale of each item as
  it occurs is called
• a) Perpetual Inventory
• b) Periodic Inventory
• c) Just-In-Time Inventory
• d) Point-of-Sale Systems

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• Scheduling ordering and receipt of inventory
• Need to know when to place each order
• Deciding when to place an order
• Rate of sales
• Time required to receive new stock
• Just-in-time inventory systems
• Cost of owning and holding inventory is far
  greater than the cost of ordering inventory
• Most businesses try to acquire and keep on hand
  the minimum amount of inventory possible

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• Just-in-time inventory attempts to reduce
  inventory levels to absolute minimum
• Accepting inventory only as it is sold
• Assembling product in the absolute minimum time
  possible
• Shipping product to customer immediately upon
  completion

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• Example
• Controlling Your Inventory
• I yo-yo between having too much of my product in
  stock and not enough. How can I find a better
  system for controlling my inventory?
• Depends on how big your operation is
• Numerous inventory software programs that
  specialize in keeping track of inventory and the
  costs that go with them
• Many companies employ whats called a
  just-in-time inventory strategy, in which they
  have a solid relationship with a supplier who can
  fill inventory needs virtually as fast as youre
  filling orders

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http//www.entrepreneur.com/management/answerdesk/
article168406.html
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• Other approaches to inventory control
• Periodic inventory process of physically
  counting business assets on a set schedule
• Perpetual inventory recording the receipt and
  sale of each item as it occurs
• Provide you with instant access to accurate
  inventory
• Bar coding used to reduce cost of perpetual inv.
• UPC registered and controlled privately unique
  to each product

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• Other approaches to inventory control
• Point-of-sale systems recently become
  inexpensive enough to be used by small businesses
• May acquire complete systems, including a cash
  drawer, credit card scanner, computer, monitor,
  and software for less than 2,000

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• Value of Assets in Your Business
• Value of assets in your business far exceeds the
  value that you might realize if you were to sell
  them
• Determining the value of your operating assets
• Value of operating assets is a function of
  utility
• Utility net cash inflows the asset will produce

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• Question
• Method of estimating asset value by calculating
  the net amount that you would realize were you to
  sell the asset in an arms-length transaction
  is called
• a) Book Value
• b) Replacement Value
• c) Fair Market Value
• d) Disposal Value

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• Four accounting methods to value capital assets
  cont.
• Book value accounting residual that is the
  difference between the original acquisition cost
  of capital assets and the amount of depreciation
  expense that has been recognized for them
• Depreciation is not any measure of the
  consumption through use of an assets value

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• Four accounting methods to value capital assets
  cont.
• Book value
• Depreciation is based on three assumptions
• Asset has a fixed, determinable period of utility
• Asset has a fixed, determinable value that will
  exist when the depreciation process is complete
• The value of the asset will decline in a
  continuous and predictable manner

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• Four accounting methods to value capital assets
  cont.
• Disposal value method of estimating asset value
  by calculating the net amount that you would
  realize were you to sell the asset in an
  arms-length transaction

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• Four accounting methods to value capital assets
  cont.
• Replacement value value of a currently owned
  capital asset by determining the cost that would
  be incurred to replace it with an identical asset
• Fair market value an attempt to determine the
  price that the asset would bring, in its current
  location and condition

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• Determining the value of inventory
• Value that you assign to inventory sold
• Amount of profit that you recognize
• Value of your business
• Begins with knowing how much of what you are
  holding
• Assign a high value to inventory
• Increase amount deducted for COGS, which results
  in decreased sale margin

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• Property, Plant, and Equipment
• Property, plant, and equipment are likely of
  relatively minor importance to your success
• Capital assets cause you to incur costs over
  time
• Cost of acquiring the asset includes interest on
  funds borrowed and the opportunity costs of funds
  invested to acquire it include insurance on the
  asset, property taxes, and value of the space

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• Capital assets cause you to incur costs over
  time cont.
• Costs of owning an asset interest on funds
  borrowed and the opportunity costs of funds
  invested to acquire it
• Costs of operating the asset energy the asset
  consumes, maintenance, and loss of economic value
  resulting from wear and obsolescence
• Costs of disposition value of activities
  necessary to get rid of the asset include
  meeting environmental regulations, disassembly,
  advertising, commissions, shipping, insurance,
  and fees

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• Capital Budgeting Decision
• Small businesses begin to make investment
  choices
• Capital budgeting process of deciding among
  various investment opportunities to create a
  specific spending plan
• Two most commonly used financial ratios
• Payback period
• Return on investment (ROI)

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• Payback period statement of how much time must
  pass before your business receives back the same
  number of dollars in cash flow as you must pay
  out to obtain a capital asset

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• Payback period
• Two decision rules are applied
• Accept only those alternatives for which the time
  required to recoup the original investment is
  equal to or less than a maximum allowable time
  determined by management
• Accept the alternative with the shortest payback
  period among those that meet the first criterion

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• Payback period
• Primary disadvantages
• It disregards the time value of money
• It disregards all cash flows that occur after the
  payback period
• Often result in managers making suboptimal
  investment decisions

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• Rate of return on investment (ROI) measure of
  the relationship between the initial investment
  and the profits that are expected to be received
  from making the investment

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• Rate on return of investment
• Two decision rules are applied
• Accept only those alternatives for which the
  return on investment is equal to or greater than
  the businesss weighted average cost of capital
• Accept the alternative with higher ROI among
  those that meet the first criterion

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• Rate on return of investment
• Two advantages
• Easy to calculate
• It relies on accounting information with which
  business owners, lenders, and investors are
  comfortable
• Two disadvantages
• Profits are not the same as cash
• Method ignores time value of money

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• Rent or Buy
• Renting
• Provides two advantages
• Exact amount and timing of cash outflows is
  specified
• Outflows funds being paid to others by the firm
• Renting provides a fall-back position

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• Renting cont.
• Provides three disadvantages
• You do not have an ownership position
• Rental requires that you make regular, timely
  payments
• Number of dollars paid in rent usually exceeds
  the number of dollars you would spend to own the
  asset

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• Financing with leases two basic types
• Operating leases similar to renting ownership
  of the asset never passes to the lessee
• Capital leases essentially the same as buying
  the asset
• Primary disadvantage is that leasing costs more
  than would purchasing
• Leased assets are usually subject to numerous
  restrictions

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• Fractional ownership and other forms of joint
  ventures
• Little used method of reducing the costs is joint
  venturing
• Simply a formalized partnership
• Makes economic sense when each party has limited
  use of an expensive asset
• Relatively common among small businesses in
  ownership of airplanes

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Raising Capital
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Sources of Financing

• Financing can be obtained from numerous sources,
  including
• Acquisition of Debt
• Distribution of Equity
• Earnings from Operations
• Interest from Investments
• Relationships with Customers
• Efficient use of Assets

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Sources of Financing
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Value of Capital Investment to Entrepreneurs -
1995

• Commercial Banks - 179 billion
• Venture Banks 96 Billion
• Angels - 30 Billion
• Venture Capitalists - 10 Billion
• Other - 20 Billion
• Total - 335 Billion

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Five Cs of Credit

• Capacity to repay most critical
• Capital money you personally have personally
  invested in business indication of extent of
  personal risk if business fails
• Collateral additional forms of security or
  guarantees provided to lender
• Conditions focus on the intended purpose of the
  loan
• Character general impression you make on the
  potential lender or investor

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The Entrepreneur as Collateral

• The quality of management is the top factor in
  the success of the investment
• The CEO represents about 80 of the variance in
  the outcome of the transaction
• Investors need to trust the management team

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The ABCs of Entrepreneurial Investment

• Type A Entrepreneur has experience as a
  business owner and experience in the industry
  Best Investment Choice
• Type B - Entrepreneur either has experience as a
  business owner or experience in the industry, but
  not both Average Risk Investment Choice
• Type C - Entrepreneur has no experience as a
  business owner and no experience in the industry
  High Risk Investment Choice

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Valuation
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Importance of Measuring Valuation

• Valuation is very difficult to quantify
• Valuation can never be done in a vacuum
• Valuation is always ambiguous (at best)
• Valuation is more of an art than a science
• Valuation is ultimately determined by the
  marketplace
• Valuation should be recalibrated annually

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Annual Recalibration of Value

• If you dont do it, someone else will
• Never underestimate the ability for the
  marketplace to act in its own self-interest
• The value of a business changes over time

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Pre-Money and Post-Money Valuation

• Pre-Money Valuation
• present value of a venture prior to a new money
  investment
• Post-Money Valuation
• pre-money valuation of a venture plus money
  injected by new investors
• Both the investor and the company have to agree
  on which view is correct
• At the end of an investment round, the post-money
  valuation becomes the pre-money valuation for the
  next round

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Why Value the Company?

• To determine the sale price for the company
• To determine how much equity to give up for
  partnership agreements
• To determine how much equity to give up for
  investor capital
• To know where you stand relative to competitors

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How Much Equity to give up?

• Should be based on the theoretical value of the
  company at some future point in time
• Should allow the company to retain not just
  mathematical control (51), but rather strategic
  control of future decisions
• Should be based on the need to fund for growth
  rather than funding for survival

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What is a Venture Theoretically Worth?

• Present value (PV) value today of all future
  cash flows discounted to the present at the
  investors required rate of return
• Investors pay for the future entrepreneurs pay
  for the past.
• If you dont make up the numbers, its not a
  valuation.

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Basic Mechanics Of Valuation

• Discounted cash flow (DCF)
• valuation approach involving discounting future
  cash flows for risk and delay
• Explicit forecast period
• two- to ten-year period in which the ventures
  financial statements are explicitly forecast
• Terminal (or horizon) value
• value of the venture at the end of the explicit
  forecast period
• Stepping stone year
• first year after the explicit forecast period

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Useful Terms

• Capitalization (cap) Rate
• spread between the discount rate and the growth
  rate of cash flow in terminal value period
• Reversion value
• present value of the terminal value
• Net Present Value (NPV)
• present value of a set of future flows plus the
  current undiscounted flow
• Required Cash
• amount of cash needed to cover a ventures
  day-to-day operations
• Surplus Cash
• cash remaining after required cash, all
  operating expenses, and reinvestments are made

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Key Factors Influencing Valuation

• Cash flow history and projections
• Who is doing the valuation
• Is the company private or public
• The availability of capital
• Is the investment strategic or financial
• The stage of the companys development
• The state of the economy
• The reason the company is being valued
• Tangible and intangible assets
• The state of the industry
• The quality of the Management Team
• Projected Performance

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Cash Flow Status

• The value of a company is driven by both present
  and projected future cash flow
• Value comes from positive cash flow
• The timing of when you measure cash flow can
  significantly affect valuation
• Todays cash flows are real, tomorrow s are only
  a guess
• Tomorrows cash flow projections can result in a
  higher (and not necessarily legitimate) valuation

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Who is Valuing the Company

• The Seller wants the pre-money valuation to be as
  high as possible
• The Buyer wants the pre-money valuation to be as
  low as possible
• Ultimately, the desired outcome is to give the
  investor his desired return while keeping the
  entrepreneur happy and motivated

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Is the Company Public or Private

• Two companies of similar age, operating in the
  same industry, producing the exact same products
  or services,achieving the same level of revenue,
  profits, and growth rates, will have
  significantly different values if one is publicly
  traded and the other is privately owned.
• A public company will always have a greater value
  than a private one often by 15-20

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Public vs. Private Whats the Difference?

• Public companies are required to disclose all
  details regarding the companys financial
  condition providing potential investors with
  more information. Private companies do not have
  to disclose anything that they dont want to
  disclose.
• Investors in public companies have a ready market
  to by and sell shares of stock. Private companies
  can only sell to sophisticated investors.

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Availability of Capital

• 80 of bank loans are for less than 1 million
• 80 of all private placements were for 10 to
  100 million
• 80 of all bond offerings were for 100 to 500
  million.

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Availability of Capital

• Bank loans were usually for less than a year.
  Term loans (50) privately placed were for seven
  to fifteen years. 70 of bonds were over ten
  years to maturity.
• With small loans, collateral is very important.
  As the size of the loan increases, and the
  information problems decrease, collateral
  becomes less important. Then Cash Flow takes
  over.

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Strategic or Financial Buyer

• Strategic Buyers Corporations that are
  acquiring companies to add to their core
  competencies have historically valued companies
  at higher prices than Financial buyers
• Financial buyers entrepreneurs with financial
  backing from LBOs, and other private sources
  are willing to pay more because they are
  interested more in a long term rate-of-return,
  than on a strategic fit

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Speculation

• Speculative buyers are looking for all of their
  value from future projected performance of the
  company, based on the companys perceived ability
  to ride the crest of the next great wave in the
  industry
• All one has to do to understand the risk
  associated with speculative buying is to look at
  the current state of the mortgage market.

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Stage of Company Development

• The earlier the stage of a company, the lower its
  value
• High risk of failure
• Lack of cash flow
• Lack of customers
• Capital comes (or should come) mostly from
  personal sources, family, friends, and fools
• Equity funding puts all of the leverage on the
  side of the investors, and the founder loses
  control

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State of the Economy

• Economic conditions, both domestic and
  international, can dramatically affect the
  valuation of a company
• The economy affects the availability of capital,
  which in turn affects the value of companies
• A strong economy translates into an increase in
  investor capital, which raises potential value
• A weak economy translates into a reduction in
  investor capital, which reduces potential value

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Other Valuation Issues

• Reason for selling
• Tangible and intangible assets
• Type of industry
• Quality of management Team

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Cash Flow Valuation Options

• Multiple of Cash Flow
• Historically 3-10x EBITA
• Higher for high growth industries
• Higher for strong management
• Lower for low growth industries
• Lower for riskier ventures
• Multiple of Free Cash Flow
• More conservative approach
• Common for manufacturing companies
• Free cash Flow EBITA - CapEx
• Multiple of Sales
• Even more conservative, since sales growth cant
  be accurately predicted
• Historically 1.5-2x revenues

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Cash Flow Valuation Options (Cont.)

• P/E method
• Compares company to similar publicly traded
  companies
• Multiple of Gross Margin
• Most conservative approach, since margins are not
  entirely under the companys control
• Historically, never higher than 2x Gross Margin

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The Art and Craft of Valuation

• The entrepreneurs world of finance is very
  different from corporate finance of public
  companies.
• The private capital world of entrepreneurial
  finance is more volatile, more imperfect, and
  less accessible than capital markets.
• The sources of capital are different.
• The companies are much younger and the
  environment more rapidly changing.
• Cash is king, and liquidity and timing are
  everything.
• The determination of a companys value is
  elusive.

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What Is a Company Worth?

• It all dependsthe market for private companies
  is very imperfect.
• Determinants of Value.
• The criteria and methods used to value companies
  traded publicly have severe limitations.
• The ingredients to the entrepreneurial valuation
  are cash, time, and risk.
• Long-Term Value Creation versus Quarterly
  Earnings.
• An entrepreneurs core mission is to build the
  best company possible.
• Building long-term value is more important than
  maximizing quarterly earnings.

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What Is a Company Worth?

• Psychological Factors Determining Value.
• At market peaks, price/earnings have exceeded 20
  times earnings.
• During the dot.com bubble from 1999 to early
  2000, valuations were more extreme.
• Behind this is a psychological wave, a
  combination of euphoric enthusiasm exacerbated by
  greed and fear of missing the run up.

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What Is a Company Worth?

• A Theoretical Perspective Establishing
  Boundaries and Ranges Rather Than Calculating
  Number.
• There are at least a dozen different ways of
  determining the value of a private company.
• It can be a mistake to approach valuation in
  hopes of arriving at a single number.
• It is more realistic to set a range of values
  within which the buyer and the seller need to
  negotiate.

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What Is a Company Worth?

• Investors Required Rate of Return (IRR).
• Various investors will require a different rate
  of return (ROR) for investments in different
  stages of development.
• Factors underlying the required ROR include
  premium for systemic risk, illiquidity, and value
  added.
• Investors Required Share of Ownership.
• The rate of return required by the investor
  determines the investors required share of the
  ownership.
• Text Exhibit 14.2 illustrates this calculation.
• By changing any of the key variables, the results
  will change accordingly.

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The Theory of Company Pricing

• The capital market food chain depicts the
  evolution of a company from its idea stage
  through an initial public offering (IPO.)
• The appetite of the various sources of capital
  vary by company size, stage, and amount of money
  invested.
• Entrepreneurs who understand the food chain are
  better prepared to target fund-raising strategies.

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The Reality of Company Pricing

• The venture capital industry has exploded in the
  past 25 years.
• Current market conditions, deal flow, and
  relative bargaining power influence the actual
  deal.
• The dot.com implosion led to much lower values
  for private companies.

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The Reality of Company Pricing

• Improved Valuations by 2005.
• Both the number of deals and average investment
  per deal were slowly increasing by 2005.
• Valuations were rising and the punishing
  cramdown rounds with severe preferential returns
  had become the exception rather than the norm.

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Valuation Methods

• The Venture Capital Method.
• is appropriate for investments in a company with
  negative cash flows at the time of the
  investment, but which anticipates significant
  earnings in a number of years.
• Venture capitalists are the most likely investors
  to participate in this type of investment.
• The steps involved are
• Estimate the companys net income in a number of
  years.
• Determine the appropriate price-to-earnings
  ratio, or P/E ratio.
• Calculate the projected terminal value by
  multiplying net income and the P/E ratio.
• The terminal value can then be discounted to find
  the present value of the investment.
• To determine the investors required percentage
  of ownership, the initial investment is divided
  by the estimated present value.
• Finally, the number of shares and the share price
  must be calculated.

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Valuation Methods

• The Fundamental Method is simply the present
  value of the future earnings stream.
• Discounted Cash Flow.
• In a simple discounted cash flow method, three
  periods are defined
• Years 1-5.
• Years 6-10.
• Year 11 to infinity.
• The necessary operating assumptions are initial
  sales, growth rates, EBITA/sales, and (net fixed
  assets operating working capital)/sales.
• The discount rate can be applied to the weighted
  average cost of capital (WACC.)
• Then the value for free cash flow (Years 1-10) is
  added to the terminal value.

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Valuation Methods

• Other Rule-of-Thumb Valuation Methods.
• Other valuation methods are based on similar,
  most recent transactions of similar firms.
• Venture capitalists know the activity in the
  current marketplace for private capital.
• These methods are used most often to value an
  existing company rather than a startup.

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Staged Capital Commitments

• Venture capitalists rarely invest all the
  external capital that a company will require.
• Instead, they invest in companies at distinct
  stages in their development.
• By staging capital, the venture capitalists
  preserve the right to abandon a project whose
  prospects look dim.

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Staged Capital Commitments

• Staging the capital also provides incentives to
  the entrepreneurial team.
• To encourage managers to conserve capital,
  venture capital firms apply strong sanctions if
  capital is misused.
• Increased capital requirements invariably dilute
  managements equity share.
• The staged investment process enables venture
  capital firms to shut down operations.
• The threat by investors to abandon a venture is a
  key incentive for entrepreneurs.

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Staged Capital Commitments

• Venture capitalists can also discipline wayward
  managers by firing or demoting them.
• The stock purchase agreement then becomes
  important.
• Noncompete clauses can impose strong penalties on
  those who leave.
• Entrepreneurs understand that if they meet those
  goals, they will end up owning a significantly
  larger share of the company than if they insisted
  on receiving all the capital up front.