SFM---CLASS 3 AND 4Management behavior and convergence between

strategy and financial analysis

Financial analysis gives leads for strategy formulation—Like breakeven point. Ratios,

growth , capacity utilization

Management convergence• Samsung Engineering Co., Ltd has created many employee and HR

oriented programmes, which have resulted in the empowerment, commitment and ownership among employees. Viney Kaushik, Chief General Manager, HR, Samsung Engineering shares, “We have a unique practice called ‘You Are CEO’, which is a management game where one employee becomes the CEO for 30 minutes and other employees discuss on a pre-decided topic to generate workable business ideas. This instills a feeling of ownership to become the CEO, which is the ultimate motto of the top management.”

Every third week of the month, this activity takes place in which a designated CEO is nominated by the team manager. The CEO and topic for discussion is decided and communicated to all participants in advance. This helps the management in understanding the thoughts and concerns of the employees, which gives them an insight in to the employees’ ideas.

• Management behavior and convergence between strategy and financial analysis—

• Correlation will be established between the strategy of core competence

• determination /SWOT/TOWS/BCG matrix/Porters model with the financial realities model with the financial realities

Value analysis—strategy perspective

• Valuation Concepts• Liquidation value ------The amount of money

that could be realized if an asset or a group of assets (firm) is sold separately from its operating organization.

• Going concern value------The amount a firm could be sold for as a continuing operating business.

• These value are seldom equal and sometimes a company is actually worth more dead than alive.

• Book Value---------------------• Asset-----the assets cost minus its accumulated

depreciation.• Firm-----TOTAL ASSETS MINUS LIABILITIES

AND PREFERRED STOCK AS LISTED ON THE BALANCE SHEET.

• Market Value-------The market price at which an asset trades.

• Intrinsic value---------The price of a security; ought to have; based on all factors bearing on valuation.

• Value Analysis---• 1. Value creation----• A. The value of a firm is the present value of the

expected cash flows from both assets in place and future growth, discounted at the cost of capital. The firm has to do either of the following for increasing value.

• *Increase the cash flows generated by existing investment.

• *Increase the expected growth rate in earning.• *Increase the length of the high growth period.• *Reduce the cost of capital that is applied to

discount the cash flows.• Stock dividends do not affect cash flows, but

they alter the perception of the firm in the mind of the investors.

• Accounting changes that do not alter the Tax implication

• does not affect the cash flows.• Value enhancement chain• Does an action create a value tradeoff, or

is it a pure value creator?—changing pricing strategy to increase margin may not work as a value addition if competitors also do the same. Changing debt equity ration alter the cost of capital.

• How quickly do actions payoff?

• ****Existing Investments• Quick Fixes------1. Divest assets / projects with

divesture value>continuing value.• 2. Terminate projects with

liquidation value>continuing value.• 3. Eliminate operating

expenses that generate no revenues and no growth.

• 4. Take advantage of Tax Law to increase cash flow.

• Odds on---------1. Reduce net working capital requirements by reducing inventory and accounts receivables or by increasing accounts payable.

• 2. Reduce capital maintenance.• 3. Reduce marginal tax rate. • Long Term-------• 1. Change pricing strategy to maximize the

product of profit margins and turn over ratio.

• 2. Move to more efficient technology for operations to reduce the expenses and improve margins.

• ****Expected Growth • Quick Fixes----eliminate new capital expenditure that is

expected to earn less than the cost of capital.• Odds on------Increase reinvestment rate or marginal

return on capital or both in firm’s existing business.• Long Term-------increase reinvestment rate or marginal

return on capital or both in new business.

• *****Length of High Growth Period-----• Quick Fixes-----If any of the firm’s products or

services can be patented and protected, do so.• Odds on-------Use economics of scale or cost

advantages to create higher return on capital.• Long Term-----.1.Build up brand name. 2.

Increase the cost of switching from product and reduce cost of switching to it.

• *****Cost of Financing• Quick fixes-----*Use swaps and derivatives to

match debt more closely to firm’s assets.

• *Recapitalize to move the firm forward its optimal debt ratio.

• Odds on-----1.Change financing type and use innovative securities to reflect the type of assets being financed.

• 2….Use the optimal financing mix to finance new investments.

• 3…..Make cost structure more flexible to reduce operating leverage.

• Long Term------Reduce the operating risk of the firm, by making products less discretionary to customers

Approaches

• 1….Income approach• 2…CAPM.• 3…Asset based approach.• 4….Market approaches---substitution.• 5----Guideline public company method----The

comparison is generally based on published data regarding the public companies stock prices and earnings , sales or revenues which is expressed as a fraction known as a mulitiple.

»You are comparing 2 firms. One produces a unique product and has no competition. The other operates in a competitive environment, other things remaining constant , which firm should maintain higher inventory.

Bond Pricing and selection

Issuer, Security, Unsecured debt, Secured debt, Subordinated debenture---in the event of financial

distress the issuer must pay the original debenture before subordinated debenture holder.

• Revenue bond----whose interest and principal is paid from the revenue generated.

• Assessment bond ---benefits a specific group who pay an assessment to help pay principal and interest.

• Mortgages are well known securities that use land and building as collateral.

• Balloon loans may amortize the debt with each payment but repay the bulk of the principal at the end of the life of debt.

• Zero coupon bonds, Variable rate bonds, Consoles, Security based bonds, Commodity based bonds, Bearer bonds, Registered bonds,

Bond Risks

• Interest rate risk• Default risk• Convenience risk---added demand on

management time because of the bond calls ,the need to reinvest coupon payments or the difficulty in trading a bond at a reasonable price because of low marketability.

• Call risk• Reinvestment rate risk—uncertainity surrounding

the rate at which the coupon proceeds can be put back to work

• Marketable risk.

Quoted yields vary

• Securities with higher default risk must offer a higher yield.

• Securities that are less liquid must offer a higher yield.

• Taxable securities must offer a higher before tax yield than tax exempt securities.

• Securities with higher maturity offer different yield than lower maturity.

• Securities with call provision offer higher yield but with convertible clause offer a lower yeild.

Malkiels Interest Rate Theorem• Theorem -1, Bond Prices move inversely with yields.• Theorem -2,If two bonds are similar in every respect except for the

time remaining until they mature, the bond with longer life will fluctuate more as interest rate changes. long term bonds have more interest rate risk

• Theorem- 3 ,High coupon bonds have less interest rate risk. Money in hand is sure thing while present value of an anticipated future receipt is risky.

• Theoram-4,Theoarm 2 says that longer the bond has until its maturity the more its prices fluctuates. Theorem 4, tells us that when comparing 2 bonds, the relative importance of Theorem 2 diminishes.

• Theorem -5,says that capital gains from an interest rate decline exceeds ,the capital loss from an equivalent interest rate increase.11%interst goes up to 12%, the price of the bond goes down to 951 from 975, drop of 24.but when interest rate falls to 10%,the bond prices goes up to 1000, rise of 25.

Type of Returns on Bonds

• 1…Current Yield---is simply the annual coupon payment divided by the current market price of the bond.

• Yield to maturity----is the rate of return the investor would earn if he holds the bond till the date of maturity.

• Realized yield---is the rate of return investor earns on bonds if he sells the bonds before its maturity. It has 2 Components---annual coupon

• Received and appreciation ,

• Yield to call—is the return the investor earns on the callable bonds till the time bonds are called. It comprises of 2 components----annual coupon till the date of call and the call price.

• Bond Laddering----strategy is similar to buy and hold with the modification that portfolio of bond is chosen with staggered maturities, the focus is on creating a portfolio with progressive maturities so as to make available large amount of cash flows at periodic intervals. since the intention is to hold bond till maturity, the price risk is eliminated.

Nine Commandants of SFM

Assessing corporate Governance in a company

• Is this a company where there is a separation between management and ownership? If so, how responsive is management to stockholders.

• Is there a potential conflict between stockholders and lenders to the firm? If so, how it is managed?

• How does the firm interact with financial markets? How do market get information about the firm?

Contd.

• How does this firm view its social obligations and manage its image in society?

• Framework for analysis

• CEO---1. Who is the CEO, How long has he or she been CEO/

• 2.Is it a family run company , is the CEO part of the family, If not, what career path did the CEO take to get to the top( fro inside or from outside).

Contd.

• How much the CEO make last year, What form the compensation take, like salary, bonus , and option components.

• How much stock and options in the company the CEO own?

• BOD----1 Who is on the BOD, How long they have served as Directors?

• 2…How many are inside directors,• How many are connections to the firm.

Contd.

• How many directors are CEO of other firms.• Do any of the directors have large

shareholding or represent those who do.• Bondholders concern-----1.Does the firm has

any publicly traded debt.• 2..Are there bond covenants, 3.Do any of the

bonds issue by the firm comes with special protection against stockholders expropriation.

Contd.

• Financial markets concern

• How many analysts follow the firm’• How much trading volume is there in the sock.• Societal concerns---What does the firm say

about its social responsibility. Does the firm have a par ticulrily good or bad reputation as a corporate citizen, If it does, how this reputation has been earned

• If there has been a recent target of social criticism , how has it responded.