Applied Corporate Finance: Final Notes

Chapter:
1. The Objective of the Firm
The objective of the firm should:
o Maximize shareholder value
o Maximize firm value
o Maximize share price
To achieve these objectives the firm can...
o Invest in Projects
o But to raise the necessary funds to invest in these
projects, the firms management must go through
net working capital decisions
o It can raise the money for the required investments,
but how much short-term cash flow does a company
need to pay its bills?
The Balance-sheet of the model firm:
o On the left side we have the total value of assets of
the firm i.e. comprised of:
Current assets
Fixed Assets
o On the right, we have the investors claims, or
liabilities. Comprised of:
Current liabilities
LT Debt
Shareholders Equity
The decision of what projects to invest is essentially capital
budgeting decision.
o Its the process, which determines whether
investment in fixed assets, like buildings, plants etc,
are worth pursuing.
o Ideally, all businesses should pursue
projects/investments that enhance shareholder
value, however since capital is often limited,
managers must use capital budgeting processes to
determine which project is worthwhile, i.e. yields the
most return over a particular time period.
o This capital budgeting decision therefore relates to
the fixed assets side of the B/S.
The other side of the coin is how to finance these projects.
This is the capital structure decision and relates to the
liabilities side of the B/S i.e. Equity and LT Debt.
o How can the firm raise money for required
invstments?

o Issue debt or equity.

The Net Working Capital Investment Decision
o NWC= CA-CL
o How much short term cash flow does a company
need to pay its bills?
Value creation stems from smart investment decisions
(capital budgeting) and smart financing decisions (capital
structure). = Maximize firm value
In other words, Working capital is a measure of both a
companys efficiency and its short-term financial health.
If CA<CL then there may be trouble in paying back
creditors in the short-term.
WC gives investors an idea of the companys underlying
operational efficiency. Money could be tied up in
receivables/slow collection, in inventory, or the company
can be experiencing a lack of sales.
Usually compare WC historically, declining is a red flag.
Working Capital Ratio = CA/CL
o Less than 1, then they have negative working capital.
o But, a high working capital ratio is not always a good
thing.
May signal too much inventory or not investing
their cash.
Textbook on NWC:
o When +, cash available over the next 12 months is
greater than the cash that must be paid out.
o A firm can invest in NWC highlighted through
Change in NWC i.e. difference between this years
NWC and last years.
o Changes in NWC are enerally positive in a growing
firm because higher levels of NWC are necessary for
increased sales.
o Investment in NWC:
Purchasing and storing raw materials and other
inventory.
WC increases when cash is kept in a particular
project as a buffer against unexpected
expenditures or when credit sales are made,
increasing AR instead of cash.
Remember, investments in WC can be offset by
any purchases made by the company on credit.
2. Estimating Fund Requirements
Ch.2/3 Textbook Notes
Balance Sheet

o B/S is a snapshot of the firms accounting value on a

particular date.
o B/S assets on the left, SE and Liabilities on the right.
o States what the firm owns (A) and how it is financed
(L and E)
o A= SE+L
o SE=A-L SE is what the shareholders would have
remaining after the firm discharged its obligations.
o Asset side depends on nature of the business, and
how mgmt. chooses to conduct it.
o L and SE refer to financing decisions i.e. proportions
of financing for capital structure.
o CA liquid, can be converted to cash within a year
(AR, inventories, cash and equivalents, other)
o FA includes property, plant and equipment, as well as
intangibles like trademark, the value of a patent or
the value of customer recognition.
o Tradeoff exists between CA and FA
Although the more liquid a firms assets the
less likely itll experience problems meeting ST
obligations, liquid assets frequently have lower
rates of return than fixed assets.
o SE is a claim against the firms assets that is residual
and not fixed.
o Liabilities are debts associated with debt service
(contractual obligations to repay a certain amount,
plus interest at pre-specified dates)
o SE increases as retained earnings increase (leftover
earnings not paid out as dividends)
o REMEMBER bondholders get paid before
shareholders
o Assets usually measured as book value, while
liabilities/SE as market value.
o Market value is the price at which willing buyers and
sellers trade the assets.
o When book value is significantly grater than market
value, assets should be written down.
Income Statement:
o Measures performance over a specified time period.
o Income= Revenues-Expenses
o Includes several sections:
Operating section Revenues and expenses
from principal operaitons.

Non-operating section financing costs, such

as interest expense.
Net income often expressed as per share of
commons tock, EPS.
o There are several non-cash itmes that are expenses
against revenues but do not affect cash flow directly.
Depreciation
Estimate of the cost of equipment used up in
the production process.
o Or deferred taxes, which result from differences
between accounting income and true taxable
income.
o Taxes that are not paid today will have to be paid in
the future and they represent a liability oft eh firm.
Showing up on the B/S as a deferred tax liability.
Deferred taxes however are not a cash outflow.
o SR VS LR: In the LR all costs are variable.
o Product costs total production costs incurred during
a period like direct labor, manufacturing overhead,
and raw materials on Income statement it is the
COGS. Includes both variable and fixed costs.
o Period costs are costs allocated to a time period:
selling, general, and administrative expenses. For
example, presidents salary.
Financial Cash Flow:
o In finance, the value of the firm is its ability to
generate financial cash flow.
o The cash flows coming from the firms assets, CF(A),
must equal the cash flows to the firms creditors and
equity investors.
CF(A)= CF(B)+CF(SE)
o Cash flow from operations:
CF generated from business activity (sales of
goods/services).
It reflects tax payments, but not financing,
capital spending or changes in NWC.
Defined as earnings before interest and
depreciation minus taxes.
Does not include capital spending or working
capital requirements.
Should be positive, if negative for a long time
then it may not be able to pay operating costs.
o Changes in LT assets:

Sales of long-term assets minus the acquisition

of LT assets= net change in LT assets.
Cash flow from acquiring long term assets say
$100 minus cash flow from sales of fixed assets
$(50)= Capital spending =$50
We could have arrived at the same solution by
adding the increase in property, plant and
equipment to the increase in intangible assets
in the income statement.
CFs are also used for making investments in NWC.
Operating cash flow-capital spending-additions to
NWC= Total cash flow to the firm.
Total outgoing cash flow of the firms separated into
CFs paid to shareholders and creditors.
Debt: interest plus retirement of debt minus LT debt
financing
An increase in LT debt is the net effect of new
borrowing and repayment of maturing obligations
plus interest expense.
Equity: Dividends plus repurchase of equity minus
new equity financing.
CF to shareholders = Dividends paid- Net new
equity raised
= dividends paid- (stock sold-stock
repurchased)
In determining:
Stock sold look to changes in common stock
and capital surplus accounts.
Stock repurchased changes in treasury stock.
If it goes up by $x, implies repurchase of $x
amount of stock.
Dividends paid pretty explicit.
Total CF of the firm:
Includes adjustments for capital spending and
additions to net working capital.
Frequently negative
If growing at a rapid rate, spending on
inventory and FA can be higher than CF from
sales.
Positive total CF not always a sign of financial
health.
If unprofitable and negative cash flow from
operations, a firm can make it positive by
selling assets.

o
o
o
o
o
o

o Remember, net income is not cash flow. Cash flow is

more revealing in determining economic and
financial condition.
o CF from assets also called free cash flow.
i.e. free to distribute to creditors and
shareholders
Ch. 3: Financial Planning and Growth
o The basic elements of financial planning: 1. The
investment opportunities the firm chooses to elect, 2.
The amount of debt the firm chooses to employ, and
3. The amount of cash the firm thinks is necessary
and appropriate to pay shareholders.
o Pro Forma statements: the financial plan will have a
forecast balance sheet, statement of comprehensive
income and statement of cash flows.
o The plan will describe projected capital spending, in
addition it will discuss the proposed uses of net
working capital asset requirements
o Financial requirementsshould discuss dividend
policy and debt policy.
o Economic assumptions should be made as well, in
addition to figuring out plug variables.
o % of Sales Method:
Basic idea is to separate the income statement
and balance sheet accounts into two groups:
those that vary directly with sales, and those
that do not.
In assuming that costs are a percentage of
sales is to assume that the profit margin si
constant.
For the B/S commons tock does not vary with
sales. When an item does not vary directly with
sales, we write constant
Steps:
1. Express b/s items that vary with sales
as a percentage of sales
2. Multiply the percentages determined
in step 1 by projected sales to obtain the
amount for the future period.
3. Where no percentage applies, put
previous years and assume constant.

4. Compute projected retained earnings

as follows: = present retained earnings +
projected net income cash dividends.
5. Add the asset accounts to determine
projected assets, then add the liabilities
and equity accounts to determine the
total financing. Any difference is the
shortfall this equals external funds
needed. Check Formula for this.
6. Use the plug to fill EFN. New shares
can be the plug and also debt. The
choice depending on the firms optimal
capital structure.
All else equal, the higher the rate of growth in
sales or assets, the greater will be the need for
external financing.
Ideally, growth should not be a goal but a
consequence of maximizing shareholder value.
Remember change in assets= change in debt
+ change in equity.

Lecture Notes:
1. Financial Perspective of Accounting Statements:
o Assess the basis and drivers of asset value.
o Assess the contribution of managers to the firms
value.
o Estimating fund requirements financial planning.
Standard Asset information:
o Asset refers to investments.
o 3 types of assets: current assets, fixed assets and
good will. Although we can add a 4th called securities.
o The asset side by definition represents cash-out, i.e.
referring to the investment decisions of the firm.
Increasing assets entails financing those assets.
o Accounts Receivable should be considered cash out,
as it can be perceived as a loan.
o Inventories are needed to produce G and S. It is a
cash outflow and operationally related.
Liabilities and Equity Information:
o L and E refer to the financing of said assets.
o Short term financing buying credit with usually no
interest. Usually business related. Notes payable
usually.

o Long term financing can come in the form of LT debt

and Equity financing.
o An increase in retained earnings can finance the
increase in assets as well, however if not enough
other sources have to be used.
Income Statement:
o Refers to performance from al business activity.
o EBIT by definition is profit from operations. This is
reported in the operations section. It records the
revenues and expenses from principal operations.
Can give us an indication of managerial performance
in operating activity.
o EBIT= sales-COGS-Other operational expenses- dep.
o Non-operating side: Interest expense relates to the
financing, and is not an operating decision. This
section includes all financing costs.
o Operating= asset side of B/S
o Financing= liabilities side of the B/S
o Net income is the bottom line
o Say net income falls by 50% but sales grew by 12%,
where is the problem? From financing or operation or
a combination? Usually a combination of the two,
which is reflected in the net income.
Assessing Financial Performance:
o A firms cash position changes as a result of
decisions related to its operating, investment and
financing activities.
o We must find the link between the 3 activities to
analyze cash flow.
o We want to convert the financial statement read into
CFs.
Sources & Uses of Cash:
o If assets increase from year 0 to year 1, this is cash
out.
o If assets decrease it is cash in.
o If L+E decrease it is cash out.
o If L+E increase it is cash in.
o Sources = Cash inflows
Decrease in the asset account, perhaps from
liquidating assets.
Increase in the liability or equity account
(issuing new stock, or getting new debt)
o Uses = Cash outflows

Increase in the asset account (investment into

a new plant)
Decrease in liability or equity account (Retiring
debt, or share repurchases)
o An increase in AR from year 0 to year 1 is
interpreted as a use of cash, i.e. cash outflow. We
can think of it like an investment.
o Increases in inventory, net FA, and good will are as
well uses of cash which all increase the firms assets.
o Increases in AP, Notes payable, LT debt and R/E are
sources of cash.
o A decrease in asset = source of cash shown through
an increase in the cash account usually.
o SOURCES = USES Sources of Cash finance the uses
of cash.
o At this point in the overall analysis, we are still
unsure of whether things are good or bad, we still
have to go further.
Common Size F/S
o CS B/S: compute all accounts as a percent of total
assets
o CS IS: Compute all line items as a percent of sales
Ratio Analysis:
o Ratios are key to assessing the situation and need to
be compared (historically, to an average, to peers, or
a target) to extract value.
o Peer group analysis or time-trend analysis.
o With ratios we discover the links between operating,
investing and financing.
o Short term solvency or liquidity ratios:
Gauge if operating bills can be paid.
Measures the firms ability to meet short term
financial obligations.
Current ratio= Total CA/ Total CL.
Higher, the more liquidity.
If too high though, may signal excess
inventory or difficulty in collecting
receivables (through high numerator).
There might be a problem selling. If too
high it no longer becomes about liquidity
but problems with the business.
2 is a decent benchmark.
Quick Ratio: Quick Assets/Total current
liabilities

Quick Assets= Current assetsinventories.

It determines the firms ability to pay off
current liabilities without relying on asset
liquidation.
H thinks its useless.
Days of purchase in AP= AP/Daily purchases.
Daily purchases = (Cost of goods sold +
inventory increase) / 365
Tells us how many days it takes the
company to pay back its payable.
The higher the better because theres no
interest incurred from utilizing this time.
However, if too high supplier
relationships may be damaged.
o Turnover Ratios:
Measure how effectively the firms assets are
being managed by comparing investment in
assets with sales performance.
Total asset turnover= total operating revenues/
average total assets
Higher the better.
If low, the firm is not using its assets up
to its capacity and must either increase
sales or sell (reduce) some assets. May
indicate a need to change policy, say
from bad marketing or assets have been
over-invested in.
No real benchmark here, should look to
averages and trends.
Receivables Turnover= total operating
revenues/ average receivables
The higher the better
Average collection period = Days in period (i.e.
365)/ receivables turnover.
= Average receivables/daily operating
revenues
The lower the better
Daily Operating Revenues= Total operating
revenues/365
These ratios reflect the films sales
performance against the firms credit policy.
If the firm has a liberal credit policy, the
amount of AR will be higher.

The firm must find the right policy depending

on the nature of the business. Some
businesses require liberal AR and some need to
collect faster.
Inventory Turnover= COGS/Avg. Inventory
Measures how quickly inventory is
produced and sold
The higher the better.
Days in inventory= days in period
(i.e.365)/inventory turnover
The lower the better.
A high ratio could indicate a high level of
unsold finished goods or longer
production process.
Context is important here.
o Financial Leverage Ratios:
Measure the extent to which a firm relies on
debt financing.
Too much debt can lead to a greater probability
of default.
However, debt does provide a tax shield for
firms. i.e. interest on debt is tax-deductible.
Debt Ratio = Total debt/Total assets
The lower the better
Debt-to-Equity Ratio= Total debt/Total Equity
The lower the better
Equity Multiplier= total assets/total equity
=Total assets/(total assets- total debt)
Higher the equity multiplier, the more
assets are financed by debt. So, the
lower the better.
All 3 above assess the debt-level of the firm.
Interest coverage ratio = EBIT/Interest expense
EBIT=Income
Interest coverage = EBITDA/Interest expense
EBITDA=Cash
Higher the better for both.
ICR directly connected to the firms ability to
pay interest. Is it generating enough profit to
meet obligations?
It looks at the firms debt capacities.
Fixed charge covered by income= (EBIT +
Lease Expense)/(Interest + Lease Expense)

EBIT + lease expense gives you

operating profit.
Fixed charge covered by CF is the same as
above except with EBITDA
o Profitability Ratios:
The extent to which a firm is profitable
Are you making money from the business?
Net Profit Margin= Net income/ total operating
revenue.
Reflects the ability to produce an item at
a lowest cost or to sell at the highest
price.
It reflects the firms cost structure.
If increasing, indicates a worsening cost
structure.
If falling, better cost structure.
Return on Assets (ROA)= Net income/Average
total assets
Reflects managerial performance.
The higher the better.
ROE= Net income/Average SE
Reflects the net benefit to owners.
The higher the better.
o Dupont System:
ROA=Net income/average total assets
ROA= Net income/ total operating
revenue * total operating
revenue/average total assets
o ROA = Profit Margin * Asset
Turnover
Profit margin max sales at lowest costs
Asset turnover Max sales with the last
amount of capital.
ROE= Net income/average SE
ROE= net income/total operating
revenue * total operating
revenue/average total assets * average
total assets/average shareholders equity
o ROE = profit margin* asset
turnover* equity multiplier.
o Equity multiplier representing
leverage.
o Market Value Ratios:

Reflects the markets assessment of the

performance of the firm.
P-E Ratio: Market price per share / current
annual earnings / share.
PE ratio shows how much investors are
willing to pay $1 of earnings per share
(independent of the size of the firm)
The higher the better as investors are
willing to pay more for $1 of earnings per
share
It also reflects investors views of the
growth potential of the firm.
However, high growth not necessarily
beneficial.
Market-to-book ratio= Market price per share/
book value per share
Compares the market value of the firms
investments to their cost
If less than one, it is an indication that
the firm has not been successful in
creating value for its shareholders.
Ratio mainly used in extreme cases such
as times of financial distress.
Financial ratios are linked to one another
Profitableliquidlow debt high
turnover higher share price.
Measures of profitability do not take risk
of timing or cash flows into account
o Growth Policy:
Assess a firms capacity to finance its expected
growth in sales.
External Funds Needed (EFN)
Reflects how to forecast short term
financing needs
The normal reason for asset increase is
due to sales increase. An asset increase
represents a cash outflow.
Therefore, asset growth must be
supported by financial capital.
EFN comes from the sale of debt and/or
Equity.
1. Take the most recent income
statement

2. Take each account as x% of sales (if

sales goes up by x%, so do these
accounts) and remember to only do it
with those accounts you expect to
increase as a proportion of sales
(represents changes in operations) and
note these % can change depending on
what you expect
3. Assume a growth rate in sales.
The retained profit goes to retained
earnings account and becomes your
internal equity financing (cheaper
compared to issuing stocks)
4. Next do the same thing but with the
balance sheet. If you dont agree with %
of sales for an account, adjust, keep
constant or put N.A.
Note that: interest expenses, dividend
payout, common stock, ST notes, LT debt
do reflect sales. For net plant..e.tc
assume linear increase.
Then use the EFN Formula:
o EFN=Change in TA- Change in APChange in RE
o = TA*g-AP*g-RE*g
o EFN = f(g) it is a function of the
growth rate. Increasing g means
increasing the external funds
needed
o Growing very fast implies higher
financing costs (1-to-1)
o The firm can be in 3 scenarios:
1. Assets can be growing
faster than financing (R/E and
AP) so implies need for EFN.
2. Assets are not growing fast
enough hoarding cash and
not exploiting potential with
cash surplus.
3. Break even growth rate, a
rate that can be sustained
without EFN. So financed with
AP and R/E only
o Sustainable Growth Rate:

The growth rate of equity or assets that could

be sustained under the following assumptions:
Constant future ROE
Constant retention rate of NI
The firm does not raise new equity from
sale of stock
o Only equity growth is from
retention of net income
Constant ratio equal to an assumed D/E
ratio
No change in operating decision same
profit margin
SGR should be used as a benchmark
Assumptions imply capital structure is
unchanged constant debt-equity ratio
SGR represents financial stability and what the
business can support based on its capacities.
SGR= ROE(on starting equity)* (RE/NI)
Expected return of
shareholders*Retention Ratio
If no profit is retained, RE=0, then
SGR=0
A business can afford to grow at SGR%
An equilibrium growth rate with all assets, debt
and sales growing at this sustainable growth.
No need for external financing and no extra
cost.
Net profit remains the same however.
For a firm, should they grow faster than SGR or
slower than SGR or the same?
It depends on the objectives of the firm
and the context.
However, if growing below SGR then a
surplus of cash should be expected, as
you are not exploiting potential.
Recommendation therefore is to exploit it
through increased sales. If youre not
growing at potential you are not
maximizing value per share. May be a
problem with the marketing department
here, increase g by employing aggressive
marketing strategy.
If growing faster than g, the firm is
growing beyond capacity. This can be

good or bad. You just need external

financing to do so. So, is the firm willing
to and can the firm afford to raise capital
through equity or debt?
If you dont have the skills or can raise
the capital? The firm should go back to
growing at potential.
All depends on whats feasible and what not.
As well as knowing the business inside and out.