1. 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. 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 44.048.056.0 Inventories 52.057.072.0 Prepaid expenses 2 2.0 1.0  NONCURRENT ASSETS 56.051.053.0 Financial assets & intangibles 0.0 Property, plant, & equip. (net) 56.051.053.0 Gross value 3 $90.0 $93.0 Accumulated depreciation (34.0)(39.0)(40.0) TOTAL ASSETS$160.0$170.0$190.0

3. 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 payable37.040.048.0 Accrued expenses 4 2.04.0  NONCURRENT LIABILITIES 42.034.038.0 Long-term debt 5 42.034.038.0  Owners’ equity 6 64.0 70.0 77.0 TOTAL LIABILITIES AND OWNERS’ EQUITY $160.0$170.0$190.0 DEC. 31, 1995DEC. 31, 1996DEC. 31, 1997

4. 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 1995 1996 1997 1 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 62.015.9%67.015.9%80.016.7% Selling, general, & administrative expenses(39.8)(43.7)(48.0) Depreciation expenses(5.0)(5.0)(8.0) Operating profit 17.24.4%18.34.4%24.05.0% Extraordinary items000 Earnings before interest & tax (EBIT) 17.24.4%18.34.4%24.05.0% Net interest expenses 1 (5.5)(5.0)(7.0)

5. 5 EXHIBIT 5.2b: OS Distributors’ Income Statements. Figures in millions of dollars Earnings before tax (EBT) 11.7 3.0%13.33.2%17.03.5% 1995 1996 1997 Income tax expense(4.7)(5.3)(6.8) Earnings after tax (EAT) $7.01.8%$8.01.9%$10.22.1% Dividends$2.0$2.0$3.2 Retained earnings $5.0$6.0$7.0

6. 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% 59.049% 56.046% $121.0100% TOTAL INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED DEC. 31, 1995DEC. 31, 1996DEC. 31, 1997 $ 12.010% 63.050% 51.040% $126.0100% $ 8.06% 77.056% 53.038% $138.0100% Short-term debt Long-term financing Long-term debt Owners’ equity $ 15.012% 106.088% $42.0 64.0 $121.0100% $ 22.017% 104.083% $34.0 70.0 $126.0100% $ 23.017% 115.083% $38.0 77.0 $138.0100% TOTAL CAPITAL EMPLOYED 1 WCR = (Accounts receivable + Inventories + Prepaid expenses) – (Accounts payable + Accrued expenses). These amounts are given in Exhibit 5.1.

7. 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 ×= 19954.4% × 3.2 = 14.2%

8. 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 ×= 19964.4% × 3.3 = 14.5% 19975.0% × 3.5 = 17.4%

9. 9 EXHIBIT 5.6: Comparison of Effective Tax Rates in 1990. Comparison of Effective Tax Rates in 1990. Figures in thousands of dollars PRETAXTAX-EFFECTAFTER TAXEFFECTIVE FIRMEBTEATEQUITYROERATIOROETAX RATE DEC$1,421$1,073$8,03617.7%75.5%13.4%24.5% IBM$10,203$6,020$42,83223.8%59.0%14.0%41.0% Source: Companies’ Annual Reports.

10. 10 EXHIBIT 5.7: The Drivers of Return on Equity.

11. 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%0.657.8%3.0824%0.6215% 524%0.348.2%2.8023%0.6615%

12. 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. 13 EXHIBIT 5.10: OS Distributors’ Self-Sustainable Growth Rate Compared to Growth in Sales. RETENTIONRETURN ONSELF-SUSTAINABLEGROWTH YEARRATEEQUITY GROWTH RATEIN SALES 1997 1996 7.0 10.2 = 0.69 10.2 70.0 = 14.6% 6.0 8.0 = 0.75 8.0 64.0 = 12.5% 0.69 × 14.6% = 10% 0.75 × 12.5% = 9.4% 14.3% 7.7%

14. 14 EXHIBIT 5.11: Sales Growth and Cash Condition.

15. 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. 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. 17 EXHIBIT A5.3: Relationship between Product Quality and ROIC for Businesses in Study. INFERIORSUPERIOR RELATIVEBOTTOM2ND3RD4THTOP PERCEIVED QUALITYFIFTHFIFTHFIFTHFIFTHFIFTH ROIC15%18%22%25%32%

18. 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 TURNOVER1.52.02.53.33.3 ROIC8%15%22%28%38% Operating profit margin6.4%8.2%9.8%9.8%8.6%