Finance for managers 35 PM

1
Finance for managers ( 3-5 PM)

• Financing a business
• Stages in the life of a business and sources of
  financing.
• How do we go about deciding what type of
  financing to use?
• Effect of the financing source used.
• Residual risk of the equity
• Beta of the firm and required return
• Cost of the capital

2
Stages in the life of a business

• Initial / Startup Phase
• Entrepreneur, family and friends. (management
  and ownership same or close to same)
• Early phase
• Angel investor (money and contacts / expertise)
• Venture Capital (funds expertise)
• Going Public
• Initial Public Offering (more regulatory
  oversight)
• Seasoned issues (Secondary Market)
• Organized in the order of High to Low Risk
  Availability of information (public private)
  liquidity (exit possibilities)

3
Why use each type of Financing?

• Why use Equity?
• Relatively greater flexibility (cant be forced
  into bankruptcy)
• Signaling Issues Willingness to share ownership
  and what that conveys.
• Why use Debt?
• Does NOT dilute Ownership
• Tax deductible (subsidy) so lower cost
• If profitable enough (can benefit from leverage
  effects)
• Signals willingness to submit yourself to
  external scrutiny unwilling to share ownership.
• Effect of the capital structure?

4
Effect of the financing source used

• Effect of the financing source used. Debt
  Impacts
• Residual risk of the equity
• Beta of the firm and required return
• Cost of the capital
• May induce adverse selection effects and
  bankruptcy costs.

5
WACC

• What is it?
• Definition
• Computation mechanics of the component costs.
• Weighted Average of different sources of capital.
• Market weights are key.
• Target capital structure and its importance.

6
Capital Structure

• Adding debt to an all equity firm (increases
  risk)
• ( Draw Graph )
• --------------------
• Can we use a firm wide cost of capital? Not
  really, because it might adversely impact
  selection of projects. (Draw Diagram)

7
How do we decide Capital Budget?

• Role of Investment Opportunity Set
• Marginal Cost of Capital.
• (Draw Diagram)

8
Other related issues

• Role of Debt Capacity.
• Strategic resource and impacts the risk of the
  firm as well as the cost of funds raised.
• Effect of being part of a firm
• Project benefits from access to all the assets of
  the firm and from the reduction of variability
  (total risk sigma)
• What determines Debt Capacity
• Among other things, quality of the assets and
  ability to survive bankruptcy with value (fixed
  v/s intangible assets)

9
EVA

• What is EVA?
• Value creation entails generating after-tax cash
  returns (Return on Invested Capital ROIC) above
  the cost of capital invested in business. ROIC
  is measured as NOPAT / Invested Capital
• EVA (ROIC WACC) Invested Capital

10
EVA characteristics of measure

• What are the advantages and disadvantages of
  using EVA as a measure of company performance?
• EVA attempts to approx. cash profits and cash
  invested, so a better measure of performance than
  accounting based measures like ROI, ROE etc.
• Greater informational clarity insight into
  factors that drive value creation cash flows
  risk
• Can quantify value created or destroyed gauge
  magnitude of returns (ROIC-WACC spread)
• Can provide yearly account of value created /
  destroyed.
• Finally, may be used as a valuation tool (Market
  value can be seen as invested capital plus PV of
  future EVAs)

11
What are the key drivers of EVA?

• Returns on Invested Capital
• Risk. Where does EVA account for this?
• Through WACC market determined required return
  to generate the capital needed for the business)
• Insight The market (investors) not managers set
  the cost of capital for a firm.
• Value creation projects that return more (less)
  than cost of capital generate (destroy) value.

12
small EVA video after next session!
13
EVA Video

• Management Concept in Action
• Economic Value Added
• What are some of the key points made in the video?

14
EVA Video

• Application of Valuation principles
• Highlight the role/s limitations of
• Accounting information
• Stock Market Feedback on Performance
• Cash v/s Accounting Profits and the behavioral
  implications of the measurement metrics
• Further Readings / links on the website for
  follow up before next month sessions.