MF 722 Financial Management

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Product Market Strategy  Finance

3 Functions in Financial Management Planning  Performance  Assessment Valuation  How much money do we need & when? How can we measure and interpret financial performance? How is estimated performance translated into market value?

Separation of Control from Ownership Managers who setProviders of product marketfunds strategy

What Should be the Objective of Corporate Financial Decisions? We will work with: Maximizing Shareholder Value

The Importance of Cash Flow

Financial Statements and Cash Flow How can we derive cash flowing in and out of firm from Income Statement Balance Sheet Statement of Cash Flow

Cash Flow Measures Cash flow from assets (also called free cash flow): CF(A) Cash flow to creditors: CF(B) Cash flow to shareholders: CF(S) CF(A) = CF(B) + CF(S)

Cash Flow from Assets Operating Cash Flow - Capex - ΔNWC = EBIT= gross capex = increases in CA +depreciation- asset sales - increases in CL - current taxes (Note slight difference from cash flow from operations in accounting statement of cash flow – no interest subtracted from earnings here)

Cash Flow to Investors Cash Flow from Assets Cash Flow to Creditors Cash Flow to Shareholders = interest paid = dividends + debt repaid + stock repurchased - new L.T. debt issued - new stock issued

A Closer Look at Net Working Capital Let’s focus on: Inventory Accounts Receivable Accounts Payable

Illustration of Average Collection Period Each day, 1 day of sales goes on the belt (A/R) Each day, 1 day of sales falls off the belt (paid) The number of days’ sales on the belt at any one time represents average time to collect on A/R

Cash Conversion Cycle: Selected Companies Company Inv. Conv. (DSI) Ave. Coll. (DSO) Op. Cycle Pay. Def. (DPO) Cash Conv. Hewlett- Packard Boeing Wal-Mart Stores Safeway McDonald's

3 Functions in Financial Management Planning  Performance  Assessment Valuation  How much money do we need & when? How can we measure and interpret financial performance? How is estimated performance translated into market value?

Financial Forecasting How can we use facts and assumptions to construct pro forma financial statements and estimate how much cash we will need?

Steps in Financial Forecasting Choosing a model driver Making reasonable assumptions as needed Using the discipline of accounting definitions (e.g., balance sheet must balance) Making the forecast Interpreting the results Sensitivity analysis

Possible Model Drivers 1.Sales Assets are needed to support sales, so assets must keep pace with sales and increased assets must be financed 2.Financing Policy Assets (and thus sales) can only grow as fast as the company’s ability/willingness to finance them

A Simple, Sales-Driven Model Assumptions: Sales will grow by 50% (to 150) in 2007 Assets/Sales = 2.0 Costs/Sales = 0.90 Net Income/Sales (Net Profit Margin) = 0.10 Liabilities/Sales = 1.0 Plowback ratio = 0.60 How much new external funding must be provided to support the forecast 2007 sales growth? 2006 Income Statement Sales100 Costs 90 Net Income 10 Dividends 4 Ret. Earnings Balance Sheet Liabilities 100 Assets 200 Equity 100

2007 Forecasts 2007 Pro Forma Income State. Sales150 Costs135 Net Income 15 Dividends 6 Ret. Earnings Pro Forma Balance Sheet Liabilities 150 Assets 300 Equity 109 whoops! 2006 Income Statement Sales100 Costs 90 Net Income 10 Dividends 4 Ret. Earnings Balance Sheet Liabilities 100 Assets 200 Equity 100

External Funds Needed (EFN) 2007 Pro Forma Income State. Sales150 Costs135 Net Income 15 Dividends 6 Ret. Earnings Pro Forma Balance Sheet Liabilities 150 Assets 300 Equity 109 Total 300Total 259 There is a funding shortfall of 41 (A = 300, L&NW = 259) This must be made up by: 1.Issuing new equity 2.Allowing the ratio of liabilities/sales to rise 3.Some combination of (1) and (2)

EFN More Generally (Eq. 3.22, p. 70)

Sustainable Growth Rate Growth rate in sales = g (i.e., S 1 = (1+g)S 0 and ΔS = S 1 – S 0 = gS 0 At what rate can we grow without issuing new equity or allowing liabilities/sales to increase (e.g., EFN = 0)?