Saturday, October 17, 2009:
Our second case, Nike gave us a look at how DCF valuation is performed. There's a great take on the valuation process in Exhibit 2 of the Nike Inc. case (Case 13). Let me download two spreadsheet examples that I have used in the past. They are actually self-explanatory and illustrative of the process.
To further clarify the excel examples above, the resulting Equity Values from the DCF process are Post-Money values, meaning they shall have included all stock issuances from capital raising up to that point. Thus Post-Money Equity less Investments equals Pre-Money Equity. To illustrate, if Post-Money is P90 million and latest Investment is P30 million, the investor shall have a 33% share of the equity. Pre-Money Equity is thus P60 million. If pre-financing shares outstanding is say 1 million shares, the intrinsic value per share is P60.00. Dividing the investment of P30 million by P60/share will result in 500,000 shares that is issued to the investor, bringing Post-Money shares outstanding to 1.5 million shares.
The next case serves as a introduction to the capital budgeting process. Capital Budgeting as a finance subject has always held a fascinating attraction for me. For those similarly inclined, here is a primer on this fascinating subject. Enjoy!
The Teletech case provides an overview of the capital budgeting process in a company where capital is scarce and has to be rationed. The rubric "pre-financing, post-tax" is vital here. The only relevant cashflow is the free cashflow from operations. Investment decisions should never be mixed with financing decisions. A firm should first decide what investments should be made and then determine how to finance them, in that order. To reverse the order will ultimately lead to suboptimal decisions that will negatively
impact shareholder value.
Saturday, October 10, 2009:
Our first case, Kota Fibres is about liquidity and working capital. On the face of it, these are short-term problems that seem to dissipate toward the end of the year. That's why the year end statements don't seem to raise any alarm bells of long-term problems. It's when you look at the monthly statements that you see the severity of the problem.
I said that the year-end balances mask the liquidity problem during the peak selling season. The issue here is not lack of sales but the lack of liquidity and net profit margins. The higher the sales the higher the working capital needed to support that sales and the higher the short-term financing needed to fund sales. This is even without loosening credit terms; thus relaxing credit terms to 80 days will only worsen the liquidity crisis.
A closer look at the financials will reveal growing problems. While sales have been increasing, net profits had been declining. So much so that the traditional dividends will exceed profits, resulting in a lower net worth y-o-y, making the company ever more dependent on bank financing, thus increasing interest expenses even more and magnifying the portent of insolvency.
If every year its the same crises that surface but with ever greater proportions, then its time to look for long-term solutions. Where do you find those long-term solutions? Certainly not from repeating the same old remedies.
- There is certainly some good to come from raising additional long-term capital from bank or equity sources that management shall not have to scramble to repay.
- How about shaping the production schedule so that they may be able to take advantage of the economies of JIT, both at the supply and at the market end?
- How about distributing the machinery so production can be closer to the market, reducing travel and finished goods inventory time?
- How about granting better terms to customers who are willing to take non-peak delivery schedules, or vice-versa, tightening credit terms to those customers who will insist on ordering during the peak selling season.
- How about improving profitability through cost cutting and tighter controls on inventory and receivables?
- Above all, how about persuading the stockholders to putting in more capital by not expecting the outsized dividends that is draining the company of its working capital cash reserves.
For our next case, Nike, we shall examine the Nobel prize winning theory of the Capital Asset Pricing Model (CapM). With this model [Re = Rf + Beta * (Rm - Rf)], a firm is able to determine the appropriate discount rate to use in any DCF-based computation. The discount rate will have many names, opportunity cost of capital, required return on investment, hurdle rate, etc. These all have the same function, to determine the present value of future cashflows as a function of time and risk.
An important component of the CapM model is the Beta, a measure of the risk of a certain stock in relation to the market as a whole. The Beta relates the stand-alone risk of a firm (as measured by its standard deviation) to the standard deviation of the market. If the Beta is equal to 1, then the firm's risk is no more than the risk of the market and its required return or opportunty cost should be equal to market rate. If Beta exceeds 1, then the firm's risk and opportunity cost will be higher than the market's. Conversely if Beta is lower than 1, its risk and required return should be lower than market.
With a free cashflow projection, we can then discount the cashflows to present value using the appropriate discount rate (R). Then we derive a terminal value (TV) using the R and a perpetuity growth rate (g). [TV = terminal fcf * (1 + g)/ (R - g)], which we likewise discount to present value. The sum of the discounted cashflows and terminal value equals the intrinsic value of the enterprise. Assuming this is also the equity value, we can then easily determine the intrinsic value per share by dividing the computed equity value by the fully-diluted shares outstanding.
You will notice I skipped the chapters which deals with debt securities and bonds. As I emphasized in Session 1, the pinnacle objective of financial management is to maximize the value of the shareholder. The shareholder alone (i.e. equity) bears the market risk (non-diversifiable risk) of the firm. Lenders exposure to a firm, on the other hand, are normally fully secured. Hence our emphasis on shareholder value.
Saturday, September 15, 2009:
I wish to welcome you all to the wonderful (to some) or horrifying (to others) world of Financial Management. There are financial implications to virtually all business decisions, and so it is vital for any MBA student to be concerned with financial management, regardless of his or her major.
At our opening session, we discussed what financial management is all about. Firstly, its about decision-making, on what investments to make and how to finance those investments. The pinnacle aim of financial management is to increase the value of the shareholder.
The myriad tasks of financial management range from making decisions regarding plant expansions to choosing what types of securities to issue when financing expansion. Financial managers also have the responsibility for deciding credit terms under which customers may buy, how much inventory the firm should carry, how much cash to keep on hand, whether to acquire other firms (merger analysis), and how much of the firm's earnings to plow back into the business or pay out as dividends.
The overview of topics to be covered in our course, as enumerated in the syllabus, listed 21 topics. The list does not include all the topics contained in our text, as it has been necessary to skip some topics in order to fit the course into a 12-session (excluding exams) schedule.
At the start, I mentioned that my preferred pedagogical approach is the Case Method, primarily because that's the method I learned when I was myself in grad school at AIM.
Over a year ago, I enjoyed a thoroughly stimulating seminar on the Case Method conducted by Dr. Willis Emmons III of Georgetown U. The seminar debunked some of my firmly held views on effective case method teaching. The most treasured practice that a teacher has to lay aside in order to be an effective case method teacher is the summation towards the end of the class. If the class discussion of a case proceeded with the minimum intervention by the teacher, then there would have been no need for a summation at the end. The students themselves would have distilled the essential principles of the case through the stimulus of the class discussion.
As a primer to the case method, I have found this article very useful. As well Bruner's notes on the case method is highly enlightening.
Nevertheless, for a finance class, the mathematics part is unavoidable. On this matter, doing the end of chapter problems is absolutely necessary. You may have questions about how to do those problems. When such questions arise, you and the other students in the class are expected to discover the answers yourselves. My job is to guide you in that discovery and I will help with the problems, but will not do all of them for you. If you begin to feel overwhelmed by the material, tell me. I am here to help and will try to address your concerns both during class and in private discussions.
Beginning with the 3rd session, we will discuss the assigned case in class. Each case may contain study guide questions. For most of the class period, we will consider these questions and the material in the case. Cases should typically be discussed in groups prior to the relevant class session, and every student must come prepared to open a discussion. The give-and-take in class discussion forms an important component of learning. Accordingly, 25% of the course grade is based on class participation. Quantity and quality both count, the latter more than the former.
Class members are expected to organize themselves into groups of 4 students each. Every group shall be submitting a written analysis of case (wac) report to be turned in before the end of every class. Since I shall be averaging only the best 6 case reports of each group, a group has the option of not submitting some case reports. Case reports constitute another 30% of the weight of the final grade.
Finally, there will be a midterm and a final exam, constituting 20% and 25% weights, respectively.
Today, we introduced you to the very important financial concept of Time Value of Money. This concept is expressed in the well known Discounted Cash Flow Method or DCFM. The DCFM undergirds every topic to be taken up in this course. As mentioned in class, here are some "time value" exercises for everyone to play with.
May I also encourage my students to take advantage of the class egroup forums to discuss topics that may not have been covered sufficiently during class. Or to raise questions or issues or even objections to my commentaries in this web journal. So once again, I welcome you to an exciting or disquieting journey into the world of financial management.