Chapter 1

FINANCIAL
MANAGEMENT AND
VALUE CREATION:
AN OVERVIEW

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Background
 One of financial management’s most useful
guiding principles
 Managers should manage their firm’s resources with
the objective of increasing the firm’s market value
 Main objective of the course
 To present and explain the methods and tools that
help managers determine whether the firm’s current
investments are creating value
• If they are not then need to determine what remedial actions
should be taken to improve operations
• Book also shows how to determine whether a business
proposal has the potential to raise the firm’s value and how
it should be financed
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Background
 After reading this chapter, students should understand:
 The meaning of managing a business for value creation
 How to measure the value that may be created by a business
proposal, such as an investment project, a change in the firm’s
financial structure, a business acquisition, or the decision to invest in a
foreign country
 The significance of the firm’s cost of capital and how it is measured
 The function of financial markets as a source of corporate funds and
the role they play in the value-creation process
 A firm’s business cycle and how it determines the firm’s capacity to
grow
 The basic structure and the logic behind a firm’s balance sheet,
income statement and cash flow statement
 Risk, how to measure it and how it affects the firm’s cost of capital
 The terms “market value added” and “economic value added” and how
they relate to the goal of managing for value creation
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The Key Question: Will Your
Decision Create Value?
 A project is financed by either
 Shareholders—provide equity capital
 Debtholders—provide debt capital
 Firm’s owners want to increase the firm’s value
 Thus, a project’s expected return must exceed its
financing cost
 Before deciding to go ahead with a business
proposal, the manager should ask
himself/herself the Key Question:
 Will the proposal raise the firm’s market value?
• Key Question also applies to current operations
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The Importance Of Managing
For Value Creation
 The fundamental finance principle helps answer
the Key Question
 Paramount objective of management should be
the creation of value for the firm’s owners
 However, this does not mean the firm can neglect
other stakeholders, such as employers customers or
suppliers
• Results of a survey show that the firms perceived to be
highly valued with respect to management, employees and
customers were value creators
• While the lowest rated firms were value destroyers

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The Saturn Story
 Story of the Saturn
 In mid 1980s GM set up a company to build
the Saturn
• Workers were highly motivated
• Customers were extremely satisfied
• However, the Saturn project has not created value
• How long should a firm fund a project that delights
its customers, pleases its distributors, and satisfies
its employees but fails to deliver value to its
shareholders?

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The Fundamental Finance
Principle
 Key Question
 Will the decision create value for the firm’s
owners?
• Can be answered with the help of the
fundamental finance principle:
• A business proposal—such as a new investment, the
acquisition of another company, or a restructuring plan
• Will raise the firm’s value only if the present value of
the future stream of net cash benefits the proposal
is expected to generate exceeds the initial cash
outlay required to carry out the proposal

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Measuring Value Creation With
Net Present Value
 Net Present Value concept or NPV
 NPV = - Initial cash outlay + present value of
future net cash benefits
• Market value of firm should rise by
• Amount equal to project’s NPV on the day the project is
announced
 A business proposal creates value if
 Its net present value is positive
• Value is destroyed if its net present value is
negative

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Only Cash Matters
 The fundamental finance principle
 Requires that the investment as well as its
future benefits be measured in cash
• Investors have invested cash in the firm and are
only interested in cash returns
• Net profit represents an accounting measure, not
a cash one

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EXHIBIT 1.1:
Only Cash Matters to Investors.

Exhibit 1.1 is an illustration of why investors are

only interested in cash returns.

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Discount Rates
 To estimate the net present value of a
proposal
 Must first discount its future cash-flow stream
and then deduct from that present value the
initial cash outlay
• A proposal’s appropriate discount rate is the cost
of financing the proposal

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A Proposal’s Cost Of Capital
 When a project is funded with both equity
and debt
 Cost of capital is not just the cost of equity
• It is the weighted average cost of capital (WACC)
• Both shareholders and debtholders require a return
from their contribution
• Debt is measured on an aftertax basis due to
deductibility of interest expense

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EXHIBIT 1.2:
The Cost of Financing a Business Proposal Is
Its Weighted Average Cost of Capital.

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Applying The Fundamental
Finance Principle
 Textbook addresses the application of the
fundamental finance principle for
 Capital budgeting
 Capital structure

 Business acquisition

 Foreign investment decisions

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The Capital Budgeting Decision
 Capital budgeting decision typically affects the firm’s
business performance for a long period of time
 Decision criteria used in capital budgeting are direct
applications of the fundamental finance principle
 The net present value (NPV) rule
• A project should be undertaken if its net present value is positive
and should be rejected if its net present value is negative
 The internal rate of return (IRR) rule
• To use the IRR rule to determine whether a project creates value,
we must compare the project’s IRR to its WACC
• If IRR > WACC, project should be undertaken

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The Capital Budgeting Decision
 Sources of value creation in a business
proposal
 Positive NPV projects and businesses are
not easily discovered, but when found, they
attract competitors into a market
• To keep their profits from being reduced by
competition, firms create costly entry barriers
• Patents
• Trademarks
• Licenses, etc.

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The Capital Structure Decision
 The firm’s optimal capital structure is
 One that provides the greatest increase in the
present value of the cash flows from assets
 As the firm replaces equity with debt
 Financial distress risk ensues
• Risk firm may be unable to service its debt
 Thus, debt financing involves a tradeoff between tax
benefits and financial distress risk

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EXHIBIT 1.3:
The Optimal Capital Structure Is the One that Provides
the Greatest Increase in the Cash Flows from Assets.

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The Business Acquisition
Decision
 Acquisition of a business is just another
investment decision
 Will only create value if present value of future net
cash flows expected from target firm exceed price
paid to acquire the firm
• Pure conglomerate merger
• Business to be acquired is unrelated to firm’s current business
• Synergies
• Expected to raise sales or reduce costs beyond the sum of the
two firms’ pre-acquisition sales or costs

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The Foreign Investment
Decision
 Additional risks
 Currency risk
• Unanticipated changes in value of currency
 Political risk
• Unexpected events
 Instead of adjusting the cost of capital for
the added risks
 Project’s future cash flows are modified

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The Role Of Financial Markets
 Role of financial markets in value creation
 Primary markets
• Provide financing for funding growth
• Act as intermediaries
 Secondary markets
• Provide efficient means for trading outstanding
securities
 Role of investment (merchant) bankers

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EXHIBIT 1.4:
The Dual Functions of Financial Markets.

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The Equity Market
 Efficient equity market
 Share prices adjust instantly to new, relevant
information
• Evidence indicates that on average most well-
developed stock markets can be described as
reasonably efficient equity markets

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What Is Bad For General Motors Is Good
For Volkswagen ... And Vice Versa
 Mr. Lopez was in charge of worldwide
purchasing for General Motors
 Managed to cut  $1 billion off GM’s annual costs
• Valuable employee!
 In 1993 Volkswagen tried to hire him from GM
 However GM offered him a raise and promotion so
he stayed
• Rumors on Wall Street spread stating that he was leaving
GM for Volkswagen
• GM’s price dropped 4.4%
• VW’s price increased 1.8%
• The continuing story shows more evidence of market
reaction to news releases
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External Versus Internal
Financing
 Two ways to raise equity and debt capital are
 External financing
• Short-term
• Money market
• Long-term
• Equity market
• Bond market
 Internal equity financing
• Retained earnings
• Companies retain their profits (partially or completely)
because regular access to external equity financing is often
unavailable or is relatively expensive

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The Business Cycle
 Relationship between profit-retention and
business growth form the concept of a
"business cycle" which links a firm's:
• Debt-to-equity ratio
• Sales-to-asset ratio (also known as asset turns,
asset rotation, asset turnover)
• Net profit margin (net profit-to-sales ratio)
• Retention rate

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EXHIBIT 1.6:
HLC’s Business Cycle.

1999

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The Business Cycle
 The self-sustainable growth rate (SGR) is
defined as
 Fastest growth rate in sales that a company
can achieve by retaining a certain percent of
its profit and keeping both its operating and
financing policies unchanged
• Important indicator of business performance

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EXHIBIT 1.6:
A Simplified View of the Financial Accounting
Process.

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The Balance Sheet
 Balance sheet shows
 What a firm’s shareholders own (assets)
 What they owe (liabilities)
• At a specific date
 Exhibit 1.7 shows a simplified balance sheet for
Hologram Lighting Company (HLC)

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 EXHIBIT 1.7:
HLC’s Balance Sheets
Figures in millions of dollars

FROM HLC’s STANDARD BALANCE SHEETS:

ASSETS LIABILITIES AND OWNERS’ EQUITY
DECEMBER 31 DECEMBER 31 DECEMBER 31 DECEMBER 31
1999 2000 1999 2000

Cash $100 $110 Short-term borrowing $200 $220

Accounts receivable 150 165 Accounts payable 100 110
Inventories 250 275 Long-term debt 300 330
Net fixed assets 600 660 Owners’ equity 500 550

TOTAL $1,100 $1,210 TOTAL $1,100 $1,210

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A Variant Of The Standard Balance
Sheet: The Managerial Balance Sheet
 Managerial balance sheet presents information more in
line with the traditional organization of a business
 Accounts receivable, accounts payable and inventories are
managed together
 Net investment required to operate firm’s fixed assets
 Accounts receivable and inventories must be financed
• Financed in part through trade payables
• Thus, the net investment in operations is trade receivables +
inventories – trade payables (AKA: working capital requirement)

 Exhibit 1.8 presents HLC’s managerial balance sheet

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 EXHIBIT 1.8:
HLC’s Managerial Balance Sheets
Figures in millions of dollars

INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED

DECEMBER 31 DECEMBER 31 DECEMBER 31 DECEMBER 31
1999 2000 1999 2000

Cash $100 $110 Short-term debt $200 $220

Working capital
requirement (WCR)1 300 330 Long-term debt 300 330
Net fixed assets 600 660 Owners’ equity 500 550
TOTAL $1,000 $1,100 TOTAL $1,000 $1,100

1 Working capital requirement (WCR) = Accounts receivable + Inventories - Accounts payable

The upper part of Exhibit 1.8 illustrates the managerial balance sheet approach, where
the left-hand side (invested capital or net assets) reflects capital invested in cash,
operations (WCR), and fixed assets, while the right-hand side (capital employed)
represents the sources of capital used to fund the firm’s net assets. This approach
provides a clearer picture of the firm’s investments and capital than a standard balance
sheet (see Chapter 3 for further discussion).

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The Income Statement
 Purpose
 Provide an estimate of the change in the book value
of equity over a period of time
• Net profit vs. net loss
• Difference between revenues and expenses
 EBIT can be thought of in terms of its three
categories of claimants
 Debtholders (first claimants)
 Tax authorities (second claimants)
 Shareholders (residual claimants)

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EXHIBIT 1.9:
HLC’s 2000 Income Statement.
Figures in millions of dollars

Sales $1,000
Less operating expenses ($760)
(including depreciation expenses)

Earnings before interest and tax (EBIT) $240

Less interest expenses (40)

Earnings before tax (EBT) $200

Less tax expenses (100)

Earnings after tax (EAT) $100

Retained earnings = $50
Dividend payment = $50

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How Profitable Is A Firm?
 Information from a firm’s balance sheet
and income statement can be combined
 To analyze the firm’s financial performance in
terms of the profitability of its equity and of its
invested capital

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The Profitability Of Equity
Capital
 A firm’s profitability to its shareholders is
measured by the owners’ return on
investment
 Known as return on equity (ROE)
Earnings aftertax (EAT)
ROE =
Owners' Equity

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The Profitability Of Invested
Capital
 To measure the profitability of HLC’s total
capital (provided by both shareholders
and debt-holders)
 Must use the firm’s aftertax operating profit
• The resulting ratio is the firm’s return on invested
capital (ROIC)
• Which is the same as return on net assets (RONA) or
return on capital employed (ROCE)
Aftertax operating profit
ROIC =
Invested capital

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How Much Cash Does A Firm
Generate?
 Expected cash flows are a key factor in
deciding
 Whether a project will create or destroy value
• Thus, it is essential to measure cash flows generated by a
firm’s activities on a continuous basis
 A firm’s EBIT or EAT does not represent cash
 Need to know how much cash is behind EBIT and
EAT
• Start by examining balance sheet

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Sources And Uses Of Cash
 Sources of cash
 Operations—customers pay invoices
 Investing—firm sells assets
 Financing—firm borrows or issues new shares
 Uses of cash
 Operations—pay its suppliers
 Investing—capital expenditures
 Financing—interest and dividend payments

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The Cash Flow Statement
 Summarizes a firm’s cash transactions
 Breaks them down into three main corporate
activities
• Operations
• Investments
• Financing

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EXHIBIT 1.10a:
HLC’s 2000 Cash Flow Statement.
Figures in millions of dollars

CASH FLOW FROM OPERATING ACTIVITIES

Sales $1,000
Less operating expenses
(which include depreciation expenses) (760)
Less tax expenses (100)
Plus depreciation expenses 60
Less cash used to finance the growth of WCR (30)
A. NET OPERATING CASH FLOW $170
CASH FLOW FROM INVESTING ACTIVITIES
Capital expenditures (120)
B. NET CASH FLOW FROM INVESTING ACTIVITIES (120)

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EXHIBIT 1.10b:
HLC’s 2000 Cash Flow Statement.
Figures in millions of dollars

CASH FLOWS FROM FINANCING ACTIVITIES

New borrowing 50
Interest payments (40)
Dividend payments (50)
C. NET CASH FLOW FROM FINANCING ACTIVITIES (40)

D. TOTAL NET CASH FLOW (A + B + C) 10

E. CASH HELD AT THE BEGINNING OF THE YEAR $100

F. CASH HELD AT THE END OF THE YEAR (E + D) $110

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How Risky Is A Firm?
 Firm’s sales may fluctuate
 Because of the uncertain economic, political, social, and competitive
environments in which it operates
• Creates economic risk, which is magnified by fixed operating expenses that
produce operational risk
 Together these two risks compose business risk
 Further magnified by fixed interest expenses reflecting financial risk
• Business risk and financial risk together constitute the firm’s total risk
 Since some of the firm’s operating expenses are fixed, the
uncertainty surrounding sales translates into operating profits that
are more risky than sales
 Because of fixed interest expenses, risk increases further, and as a
result, net profits are even more risky than operating profits

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 EXHIBIT 1.11:
HLC Income Statement: Impact on EBIT, EBT,
and EAT of a 10% Drop or Rise in Sales.
Figures in millions of dollars

1
EXPECTED SALES DOWN 10% SALES UP 10%
Sales $1,000 $900 –10% $1,100 +10%
Less variable operating expenses2 (380) (342) –10% (418) +10%
Less fixed operating expenses3 (380) (380) same (380) same
EBIT (earnings before interest & tax) $240 $178 –26% $302 +26%
Less fixed interest expenses (40) (40) same (40) same
EBT (earnings before tax) $200 $138 –31% $262 +31%
Less variable tax expenses (50%) (100) (69) –31% (131) +31%
EAT (earnings after tax) $100 $69 –31% $131 +31%
1
The expected income statement is the same as the one shown in Exhibit 1.8.
2
One half of total operating expenses of $760 in Exhibit 1.8.
3
One half of total operating expenses of $760 in Exhibit 1.8. Note that the $60 of depreciation
expenses are fixed and, hence, included in the $380 of fixed operating expenses.
Exhibit 1.11 provides a numerical illustration of the rise in the
level of risk from sales to the bottom line.
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EXHIBIT 1.12:
Sources of Risk that Increase Profit Volatility.

Exhibit 1.12 summarizes different types of risks

and the numbers pertinent to the HLC example.
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Is Value Created?
 According to the fundamental finance principle
 A firm is creating value if the NPV of all its investments (called
market value added or MVA) is positive
• A firm’s MVA is positive if the market expects the firm to generate
positive economic value added, or EVA, in the future
 A firm’s EVA is equal to the aftertax operating profit
(sometimes referred to as net operating profit after
taxes or NOPAT) generated by the firm’s net assets
 Less the dollar cost of the capital employed to finance these
assets
• An alternative way of expressing EVA suggests that EVA will be
positive (negative) if the firm’s return on invested capital is higher
(lower) than the cost of that capital measured by its WACC

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