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FINANCE FOR EXECUTIVES

Managing for Value Creation

FINANCE FOR EXECUTIVES

Managing for Value Creation

Gabriel HawawiniGabriel Hawawini

Claude VialletClaude Viallet

Gabriel HawawiniGabriel Hawawini

Claude VialletClaude Viallet

FINANCIAL MANAGEMENT AND FINANCIAL MANAGEMENT AND VALUE CREATION: AN OVERVIEWVALUE CREATION: AN OVERVIEWFINANCIAL MANAGEMENT AND FINANCIAL MANAGEMENT AND

VALUE CREATION: AN OVERVIEWVALUE CREATION: AN OVERVIEW

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EXHIBIT 1.1: Only Cash Matters to Investors.Only Cash Matters to Investors.

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EXHIBIT 1.2: Using the Discount Rate to Estimate the NPV.Using the Discount Rate to Estimate the NPV.

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EXHIBIT 1.3: The Cost of Financing a Business Proposal The Cost of Financing a Business Proposal Is Its Weighted Average Cost of Capital.Is Its Weighted Average Cost of Capital.

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EXHIBIT 1.4: The Optimal Capital Structure Is the One that The Optimal Capital Structure Is the One that Provides the Greatest Increase in the Cash Flows Provides the Greatest Increase in the Cash Flows from Assets.from Assets.

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EXHIBIT 1.5: The Dual Functions of Financial Markets.The Dual Functions of Financial Markets.

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EXHIBIT 1.6: HLC’s Business Cycle.HLC’s Business Cycle.

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EXHIBIT 1.7: A Simplified View of the Financial Accounting Process.A Simplified View of the Financial Accounting Process.

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EXHIBIT 1.8a: HLC’s Balance Sheets on Dec. 31, 1996 & 1997.HLC’s Balance Sheets on Dec. 31, 1996 & 1997.Figures in millions of dollars

FROM HLC’s STANDARD BALANCE SHEETS:

ASSETS LIABILITIES AND OWNERS’ EQUITY

DECEMBER 31

1996

DECEMBER 31

1997

DECEMBER 311996

DECEMBER 311997

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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EXHIBIT 1.8b: HLC’s Balance Sheets on Dec. 31, 1996 & 1997.HLC’s Balance Sheets on Dec. 31, 1996 & 1997.Figures in millions of dollars

TO HLC’s MANAGERIAL BALANCE SHEETS:

INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED

DECEMBER 31

1996

DECEMBER 31

1997

DECEMBER 311996

DECEMBER 311997

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

Long-term debt

Working capitalrequirement (WCR)1 300 330 300 330

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

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EXHIBIT 1.9: HLC’s Simplified 1997 Income Statement.HLC’s Simplified 1997 Income Statement.Figures in millions of dollars

Sales $1,000

Less operating expenses ($760)

(including $60 of depreciation expenses)

Earnings before interest and tax (EBIT) $240

Less interest expenses (8% × $500) (40)

Earnings before tax (EBT) $200

Less tax expenses (50% × $200) (100)

Earnings after tax (EAT) $100

Retained earnings = $50

Dividend payment = $50

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EXHIBIT 1.10a: HLC’s 1997 Cash Flow Statement.HLC’s 1997 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 1997 Cash Flow Statement.HLC’s 1997 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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EXHIBIT 1.11: HLC Income Statement: Impact on EBIT, EBT, and HLC Income Statement: Impact on EBIT, EBT, and EAT of a 10% Drop or Rise in Sales.EAT of a 10% Drop or Rise in Sales.Figures in millions of dollars

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%

EXPECTED1 SALES DOWN 10% SALES UP 10%

1 The expected income statement is the same as the one shown in Exhibit 1.9.2 One half of total operating expenses of $760 in Exhibit 1.9.3 One half of total operating expenses of $760 in Exhibit 1.9. Note that the $60 of depreciation expenses are fixed and, hence, included in the $380 of fixed operating expenses.

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EXHIBIT 1.12: Sources of Risk that Increase Profit Volatility.Sources of Risk that Increase Profit Volatility.