1 FINANCE FOR EXECUTIVES Managing for Value Creation FINANCE FOR EXECUTIVES Managing for Value Creation Gabriel Hawawini Claude Viallet Gabriel Hawawini Claude Viallet DIAGNOSING PROFITABILITY, RISK, AND GROWTH

2 EXHIBIT 5.1a: OS Distributors’ Balance Sheets. Figures in millions of dollars DEC. 31, 1995DEC. 31, 1996DEC. 31, 1997 ASSETS  CURRENT ASSETS $104.0$119.0$137.0 Cash 1 $6.0$12.0$8.0 Accounts receivable Inventories Prepaid expenses  NONCURRENT ASSETS Financial assets & intangibles 0.0 Property, plant, & equip. (net) Gross value 3 $90.0 $93.0 Accumulated depreciation (34.0)(39.0)(40.0) TOTAL ASSETS$160.0$170.0$190.0

3 EXHIBIT 5.1b: OS Distributors’ Balance Sheets. OS Distributors’ Balance Sheets. Figures in millions of dollars LIABILITIES AND OWNERS’ EQUITY  CURRENT LIABILITIES $54.0$66.0$75.0 Short-term debt$15.0$22.0$23.0 Owed to banks$7.0$14.0$15.0 Current portion of long-term debt 8.0 Accounts payable Accrued expenses  NONCURRENT LIABILITIES Long-term debt  Owners’ equity TOTAL LIABILITIES AND OWNERS’ EQUITY $160.0$170.0$190.0 DEC. 31, 1995DEC. 31, 1996DEC. 31, 1997

4 EXHIBIT 5.2a: OS Distributors’ Income Statements. Figures in millions of dollars % of% of % of Net sales $390.0 Sales$420.0Sales$480.0Sales There is no interest income, so net interest expenses are equal to interest expenses. Cost of goods sold($328.0)($353.0)($400.0) Gross profit % % % Selling, general, & administrative expenses(39.8)(43.7)(48.0) Depreciation expenses(5.0)(5.0)(8.0) Operating profit % % % Extraordinary items000 Earnings before interest & tax (EBIT) % % % Net interest expenses 1 (5.5)(5.0)(7.0)

5 EXHIBIT 5.2b: OS Distributors’ Income Statements. Figures in millions of dollars Earnings before tax (EBT) % % % Income tax expense(4.7)(5.3)(6.8) Earnings after tax (EAT) $7.01.8%$8.01.9%$ % Dividends$2.0$2.0$3.2 Retained earnings $5.0$6.0$7.0

6 EXHIBIT 5.3: OS Distributors’ Managerial Balance Sheets. All data from the balance sheets in Exhibit 5.1; figures in millions of dollars INVESTED CAPITAL OR NET ASSETS Cash Working capital requirement (WCR) 1 Net fixed assets $ 6.05% % % $ % TOTAL INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED DEC. 31, 1995DEC. 31, 1996DEC. 31, 1997 $ % % % $ % $ 8.06% % % $ % Short-term debt Long-term financing Long-term debt Owners’ equity $ % % $ $ % $ % % $ $ % $ % % $ $ % TOTAL CAPITAL EMPLOYED 1 WCR = (Accounts receivable + Inventories + Prepaid expenses) – (Accounts payable + Accrued expenses). These amounts are given in Exhibit 5.1.

7 EXHIBIT 5.4a: The Structure of OS Distributors’ Return on Invested Capital. Return on Invested Capital. All data from the income statements in Exhibit 5.2 and the balance sheets in Exhibit 5.3; figures in millions of dollars OPERATINGCAPITALRETURN ON YEARPROFIT MARGINTURNOVER 1 INVESTED CAPITAL 3 1 Capital turnover is the same as net asset turnover (see Note 2 below). 2 Invested capital (same as net assets) = Cash + Working capital requirement + Net fixed assets. 3 Return on invested capital (ROIC) = Return on net assets (RONA). EBITSALESEBIT SALESINVESTED CAPITAL 2 INVESTED CAPITAL ×= $17.2$390$17.2 $390$121$121 ×= $18.3$420$18.3 $420$126$126 ×= % × 3.2 = 14.2%

8 EXHIBIT 5.4b: The Structure of OS Distributors’ Return on Invested Capital. Return on Invested Capital. All data from the income statements in Exhibit 5.2 and the balance sheets in Exhibit 5.3; figures in millions of dollars OPERATINGCAPITALRETURN ON YEARPROFIT MARGINTURNOVER 1 INVESTED CAPITAL 3 EBITSALESEBIT SALESINVESTED CAPITAL 2 INVESTED CAPITAL ×= $24$480$24 $480$138$138 ×= % × 3.3 = 14.5% % × 3.5 = 17.4%

9 EXHIBIT 5.6: Comparison of Effective Tax Rates in Comparison of Effective Tax Rates in Figures in thousands of dollars PRETAXTAX-EFFECTAFTER TAXEFFECTIVE FIRMEBTEATEQUITYROERATIOROETAX RATE DEC$1,421$1,073$8, %75.5%13.4%24.5% IBM$10,203$6,020$42, %59.0%14.0%41.0% Source: Companies’ Annual Reports.

10 EXHIBIT 5.7: The Drivers of Return on Equity.

11 EXHIBIT 5.8: The Structure of Return on Equity for Five Firms in Different Sectors (December 1995). 1 OperatingReturn onFinancialPretaxReturn ProfitCapitalInvestedLeverageReturn onTaxon Company 2 Margin 3 Turnover 4 Capital 5 Multiplier 6 Equity 7 Effect 8 Equity 9 (1)(2)(3) = (1) × (2)(4)(5) = (3) × (4)(6)(7) = (5) × (6) 1 Compiled by the authors with accounting data from Compustat. 2 See text for names of companies. 3 Operating profit margin = Earnings before interest and tax/Sales. 4 Capital turnover = Sales/Invested capital, where invested capital = Cash + Working capital requirement + Net fixed assets. 5 Return on invested capital = Earnings before interest and tax/Invested capital. 6 Financial leverage multiplier = Pretax return on equity/Return on invested capital. 7 Pretax return on equity = Earnings before tax/Owners’ equity. 8 Tax effect = Earnings after tax/Earnings before tax = (1 – effective tax rate). 9 Return on equity = Earnings after tax/Owners’ equity. 126%1.7044%1.8280%0.6955% 230%0.9027%1.2634%0.7024% 35.6%3.2418%1.6730%0.6319% 412% %3.0824%0.6215% 524% %2.8023%0.6615%

12 EXHIBIT 5.9: Effect of Financing on Profitability for Different Levels of EBIT. EBITROICROEROICROE ALTERNATIVEPROFITABILITY OFPROFITABILITY OF LEVELS OF PRETAXTHE FIRM WITH 100%THE FIRM WITH 50% OPERATING PROFITEQUITY FINANCINGEQUITY FINANCING $14 million14%14%14%18% $10 million10%10%10%10% $8 million8%8%8%6%

13 EXHIBIT 5.10: OS Distributors’ Self-Sustainable Growth Rate Compared to Growth in Sales. RETENTIONRETURN ONSELF-SUSTAINABLEGROWTH YEARRATEEQUITY GROWTH RATEIN SALES = = 14.6% = = 12.5% 0.69 × 14.6% = 10% 0.75 × 12.5% = 9.4% 14.3% 7.7%

14 EXHIBIT 5.11: Sales Growth and Cash Condition.

15 EXHIBIT A5.1: Distribution of ROIC for 3,000 Businesses in Study. Businesses in Study. Percentage of businesses that fall in ROIC range 0%10%20%30%40%Above ROICNegativeto 10%to 20%to 30%to 40%to 50%50% Percent16%16%21%17%11%7%12%

16 EXHIBIT A5.2: Relationship between Market Share and ROIC for Businesses in Study. MARKET SHAREUP TO 8%8% TO 15%15% TO 24%24% TO 38%ABOVE 38% ROIC10%17%21%26%38%

17 EXHIBIT A5.3: Relationship between Product Quality and ROIC for Businesses in Study. INFERIORSUPERIOR RELATIVEBOTTOM2ND3RD4THTOP PERCEIVED QUALITYFIFTHFIFTHFIFTHFIFTHFIFTH ROIC15%18%22%25%32%

18 EXHIBIT A5.4: Relationship between Capital Turnover and Both ROIC and Operating Profit Margin for Businesses in Study. CAPITALBELOW1.5 to2.0 to2.5 toABOVE TURNOVER ROIC8%15%22%28%38% Operating profit margin6.4%8.2%9.8%9.8%8.6%