1. Copyright  2005 by Thomson Learning, Inc. Chapter 3 Valuation Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received Payment Sent Cash Disbursed Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection Accounts Collection Time ==> Time ==> Accounts Disbursement Accounts Disbursement Invoice Received Payment Sent Cash Disbursed Invoice Received Payment Sent Cash Disbursed

2. Copyright  2005 by Thomson Learning, Inc. Objectives v Use cash flow timeline and discounting techniques to value future cash flows. v Explain importance for using time value of money in short-term decisions. v Apply the NPV technique to select value-enhancing proposals. v Explain how short-term decisions fit with EVA. v Apply NPV to value changes in the cash conversion period. v Recognize difficulties in selecting appropriate discount rate.

3. Copyright  2005 by Thomson Learning, Inc. Two Financial Decision-Making Approaches v Financial statement approach v Valuation approach

4. Copyright  2005 by Thomson Learning, Inc. Financial Statement Approach v Approach –compute incremental revenue and expense effects of proposal –calculate anticipated profit effect v Calculation steps –estimate unit sales and multiply by profit margin –estimate capital costs of additional required investments such as receivables, inventory, etc. –estimate additional bad-debt loss if new credit terms –calculate overall profit effect v Decision criteria –if anticipated profit is >=0, proposal would contribute profit –if anticipated profit is <0, proposal would not contribute profit

5. Copyright  2005 by Thomson Learning, Inc. Valuation Approach v Approach –accounts for timing of cash flows –accounts for present values –results in making value enhancing decisions v Four steps –determine relevant cash flows –determine timing of cash flows –determine appropriate discount rate –discount cash flows v Decision criteria –if NPV >= 0 invest –if NPV < 0 do not invest

6. Copyright  2005 by Thomson Learning, Inc. Economic Value Added v Incorporates elements from both financial statement approach and valuation approach v EVA = Operating profit(1-T) - (Cost of capital)(Capital employed) v Advantage: provides better company-wide understanding of importance of improved working capital management v Caution: can be misused if user does not take a long-term view

7. Copyright  2005 by Thomson Learning, Inc. NPV Calculations v Simple interest – 1 PV = FV x ------------------- k (1 + (------) x n) 365 v Compound interest – 1 PV = FV x -------------- k (1+ -------) n 365

8. Copyright  2005 by Thomson Learning, Inc. Basic Valuation Model........ note: i = k/365 CF o CF 1 CF 2 CF 3 CF n CF 1 CF 2 CF 3 CF n NPV = CF o + ------------- + ------------- + ------------ +.... + ------------ (1 + i x 1) (1 + i x 2) (1 + i x3) (1 + i x n)

9. Copyright  2005 by Thomson Learning, Inc. Valuation Using NPV v Solving DigiView’s financial dilemma

10. Copyright  2005 by Thomson Learning, Inc. Valuing Changes in the Cash Conversion Period v - Purchase Sale NPV CCP = --------------- + ---------------- (1 + i ) DPO (1 + i) DIH + DSO v NPV CCP-Aggregate = NPV CCP x Daily Sales / i  - Purchase Sale  NPV CCP = [ -------------- - --------------- ] ln(1 + i) (1+i) OC-CCP P (1+i) CCP O +DPO

11. Copyright  2005 by Thomson Learning, Inc. Corporate Cash Holdings and Value v Late 80’s to mid 90’s: keep cash holdings low –long-term cost of funds > return on cash –cash holdings viewed as negative debt v Late 90’s to current: bond rating agencies penalizing for too little liquidity v Current trend: reduce working capital requirements but increased cash holdings v Pinkowitz and Williams (2002): investors mark up stock value $1.26 per $1 of cash holdings

12. Copyright  2005 by Thomson Learning, Inc. Choosing the Discount Rate v Three unique problems –funds are rarely raised specifically to fund short-term type projects –short-time horizon implies short-term not long-term rate –risk should be accounted for, but may be ambiguous. v One-shot projects –if net borrower, use short-term borrowing rate –if net investor, use short-term investment rate v Multi-year projects –maybe appropriate to use cost of capital v Formulation –k adj = k rf + k avg + k 

13. Copyright  2005 by Thomson Learning, Inc. Summary v Short-term financial decisions can impact firm value by: –altering operating cash flows –changing the length of the cash conversion cycle –changing company risk posture –impacting net interest income –and by changing accuracy and timeliness of critical information. v Both financial statement approach and valuation offer insight in working-capital management decisions. v Choosing appropriate discount rate is an issue when trying to assess valuation impact.