musings of a budding social entrepeneur

Tuesday, October 20, 2009

Chapter 10 - Project Analysis

Learning objectives:
  1. appreciate the practical problems of capital budgeting in large corporations
  2. Use sensitivity, scenario and break-even analysis to see how project profitability would be affected by an error in your forecasts
  3. Understand why an overestimate of sales is more serious for projects with high operating leverage.
  4. Recognize the importance of managerial flexibility in capital budgeting
Two stages of investment evaluation
1) The capital budget: list of planned investment projects. earch year the list is generated and then assessed by senior management. senior management needs to ensure that the budgets matches teh firm's strategic plans. that the firm is concentrating efforts in areas of competitive advantage and identifying declining business that should be sold or allowed to run down.

2) project authorization: If you're on teh capital budget that doesn't mean your project is authorized. at a later stage you will need to draw up details on engineering analyses, cash-flow forecasts, PV calculations.

Monday, October 19, 2009

Chapter 9 - Usind Discounted Cash-Flow Analysis to Make Investment Decisions

Learning Objectives
  1. Identify the cash flows properly attributable toa proposed new project
  2. Calculate the cash flows of a porject from standard financial statements
  3. Understand how the company's tax bill is affected by depreciation and how this affects project value
  4. Understand how changes ni working capitral affect project cash flows.
Review:  Estimating NPV
  1. Forecase the project cash flows
  2. Estimate the opportunity cost of capital, that is, the rate of return that you shareholders could expect to earn if they invested their money in the capital market.
  3. Use the opportunity cost of capital to discount the future cash flows. The projects's present value (PV) is equal tot he sum of the discounted future cash flows.
  4. NPV measures whether the project is worth more than it costs. To calculate NPV,  you need to subtract the required investment from the present value of the future payoffs:
NPV = PV - required investement

When you discount NPV, discount CASH FLOWS, not accounting profits.
Recognize expenses when they occur, not when they show up as depreciation. 

Incremental Cash Flows
A projects present value depends on teh extra cash flows that it produces. So you need to forecast first the firms cash flows if you go ahead with thte project, then forecas the cash flows if you don't accept the project. Take the diff and you have the increamental cash flows

Incremental cash flow = cash flow with project - cash flow without project.
Example: Windows Vista

Inclue all indirect effects when forecasting cash flows.
Sometimes a new project will help the firms existing business indirectly. don't just look at the NPV in isolation.
example: adding new flight to airline service.

Dont include sunk costs. Example, lockheeds Tristar airplane. They sunk nearly $1 billion on the project and were tryign to decide on whether to .. But how do you know when somethign is fully sunk?

Include opportunity costs
Def opportunity cost - benefit of cash flow forgone as a result of an action .
Recognize the investment in working capital 
Def net working capital - current assets minus current liabilities.

Remember shut down cash flows
example: nuclear power plants, coal mines are very expensive. However, certain shutdown costs can be cash inflows, from selling of equipment, plants, inventories.

Ignore financing decisions when forecasting cash flows for NPV. Regardless of whether you finance with debt or with equity. Keep the invesmtnet decision seperate from the financing decision. first ask whether the project has positive NPV, then if it does, figure out the best financing strategy.

9.2 Calculating Cash flow
Total cash flow = Cash flows from capital invesmtents
+ cash flows from chagnes in working capital
+ operating cash flows.

Capital investments
In general, an increase in working capital is an investment adn therefore implies a negative cash flow. a decrease in working cap implies a positive cash flow. The cash flow is measured byt the change in working capital, not the lievel of working capital.

Operating Cash Flow = revenues - costs - taxes.

Dealing with depreciation when working out project's cash flows (pg 267) See three methods for operating cash flow.

Depreciation example - straight line depreciation: constat depreciateion each eyar of the asset's accounting life. for JBEI question. 
Deprecitation Tax Shield - pg 271
Straight line depreciation is one method, but Modified accelerated cost recovery system (MACRS) is another
Depreciation method that allows higher tax deductions in early years and lower deductions later

All large corporations use two sets of books, one for stockholders with straight line depreciation and one for the IRS with MACRS.  Only the tax books are relevant in capital budgeting.
9.3 - Great Example (pg  269)

Saturday, October 17, 2009

Chapter 8 - NPV and Other Investment Criteria

Learning objectives:
1) calculate NPV of an investment
2) calculate IRR of a project adn know what to look out for when using the Internal rate or return rule.
3) explain why the payback rule doesn't always make shareholders better off.
4) use the net present value rule to analyze three common problems that involve competing projects
a) when to postpone an investment expenditure
b) how to choose between projects with unequal lives
c) when to replace equipment
5) Calculate the profitability index and use it to choose between projects when funds are limited.

The investment decision aka "Capital budgeting" is

Any expenditure made in the hope of generating more cash later is called a capital investment project, regardless of whether the cash outlay goes to tangible or intangible assets.

Every shareholder wants to make money, therefore they want the firm to invest in every project that is worth more than it costs.

The difference between a project's value and its cost is termed the Net Present Value.(NPV)

Companies should invest in projects with positive NPV.

When companies have to make choices, they should pick the projects that have the highest NPV per dollar invested (the Profitability index)

8.1 Net Present Value

Def - Opportunity cost of capital - expected rate of return given up by investing ina  project.

Def - Net Present Value: Present Value (PV) of cash flows minus investment.
The net present value rule states that managers increase shareholder's wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive NPV.

Basic Financial Principle: a risky dollar is worth less than a safe one.

NPV = C0 + C1/(1+r) + C2/(1+r)^2 + ... CH/(1+r)^H

Calculation NPV 
1) forecast future cash flows- this is hard to do. NPV analysis is only as good as it's forecasts.

2) estimate opportunity cost of capital

Def - mutually exclusive projects: two or more projects that cannot be pursued simultaneously. When you need to choose amont mutually exclusive projects, the decision rule is simpe: Calculate the NPV of each alternative, and choose the highest positive NPV project

8.2 Payback and IRR
Def - payback period: time until cash flows recover the initial investment in teh project.

Payback is a simple mechanism for assessing profitability. Often looks at short term and small capital investments. Manager asks "What is the payback period?" "When will this be profitable?".

Def IRR - Internal Rate of Return. Discount rate at which project NPV = 0. See Figure 8-2.

Instead of doing NPV calc, companies often prefer to ask whether the project's return is higher or lower than the opportunity cost of capital (return on other investments at same risk level in the market).

1) The NPV Rule: Invest in any project that has a positive NPV when its cash flows are discounted at the opportunity cost of capital
2) Rate of Return Rule: Invest in any project offering a rate of return that is higher than the opportunity cost of capital.

More decision making criteria
Investment timing - should you buy a computer now or wait and think again next year?
The decision rule for investment timing is to choose the investment date that results in the highest net present value today. (see pg 241)

Long vs Short lived equipment - should the company save money today by installing cheaper machinery that will not last as long? Select the machine with the lowest equivalent annual annuity.

Def - equivalent annual annuity: the cash flow per period with the same present value as the cost of buying and operating a machine.

Equivalent Annual Annuity = Present value of costs/Annuity Factor

Replacing an old machine - When should existing machinery be replaced?

8.4 Capital Rationing
Def Capital Rationing - limit set on the amount of funds available for investment
Soft Rationing - limits set by management, not investors
Hard Rationing - the firm can't raise the money it needs.

Def profitability index - ratio of net present value to initial index.

If you have 5 investments all with positive NPV but limited funds, you need to select the projects that give the highest nPV per dollar of investment.

Table 8-3 has a good overview of investment decision rules

Tuesday, October 13, 2009

Chapter 7: Valuing Stocks

  1. learn how to read stock trading reports
  2. calculate the PV of a stock given forecasts of future dividends and future stock price
  3. use stock valuation formulas to infer the expected rate of return on a common stock
  4. Interpret 'priece-earnings ratios'
  5. Understand 'no free lunches' means on Wall street
 Def : Common stock - ownership shares in a publicly held corporation

LArge firms sell or issue shares of stock tot he public when they need to raise money.

Def: Primary market. Market for the sale of new securities by corporations.Fed ex and other frims sell new shares to the public only infrequentyly. These take place in the 'primary market'

Def IPO: First offering of stock to the general public.  The first time a company sells shares to the public.  Companies raise funds by selling these new shares, but the previous owners (investors, founders, employees) have to share ownership (and profits) with the new shareholders.  Current record ipo VA Linux Systems. In 1999 they shold shares at $30, but by the end of the day they had reached $239 (700% gain).

Def: secondary market. Market in which previously issued securities are traded among investors.  Exchanges are really markets for secondhand stocks. (NYSE and NASDAQ are the two main ones in US)  Every day the NYSE trades 3 billion shares with market value over $100billion.

Def P/E Ratio: Ratio of stock price to earnings per share.

What determines the value of a stock?

Def: Book value: Net worth of the firm according to the balance sheet.  = Total Equity/number of shares
Example. Fed Ex Equity on 5/31/07 was $12,656 mill.  Outstanding shares were 296 mill. book value = 12,656/296 = $42.76/share

Def: Liquidation value:  Net proceeds that could be realized by selling the firm's assets and paying off its creditors.

Market price is not the same as book or liquidation value. Investors buy shares on teh basis of present and future earning power. Two key features determine the profits the firm will be able to producer
1) the earnings that can be generated by the firm's current tangible AND intangible assets
2) the opportunities that the firm has to invest in lucrative projects that will increase future earnings.

7.3 Valuing Common Stocks

a. Valuation by Comparables - common first approach. divid stock price by measures of assets or earningsa nd see how these ratios stack up against other firsms.  See table 7-5 for examples in different industries.  Look at the industry average "price to book values" or "Price to earnings ratio" and then assume then multiply your company's book value times average ratio.

"Price to book" works best for companies with lots of fixed assets.  Not so good with companies with lots of intangibles and R&D

Price and Intrinsic Value
Just as bond values are the present value of all future coupon payments + PV of final payment,
Stock value is the present value of all future dividend payments up to the time of sale + the PV of the final selling point at the time of sale.

Intrinsic Value of Stocks is the present value of future cash flows except there's no final payment.

Say for example, you want to buy stock in Blue Skies Inc and sell it in a year, what price should you pay for it?  If the predicted stock price after 1 year is P1 and the expected dividend payout is DIV1, and the discount rate for the stock's expected cash flows is r, then...
The PV of the cash flows the investor will receive is
Vo = (DIV1+P1)/(1+r)

So if you're looking to buy a stock, you need to try to guess the intrinsic value and see what the going price is Po. If Po
If Po>Vo, then don't buy.

But how do we estimate the Future price P1?

Def - Dividend Discount Model : Discounted cash flow model which states that today's stock price equals the present value of all expected future dividends

Po = PV(DIV1, DIV2, DIV3,...DIVt, ...)
= DIV1/(1+r) + DIV2/(1+r)^2 + ... + DIVt/(1+r)^t + ...

Suppose our horizon date is H

Then the stock valuation formula using the DDM is

Po = DIV1/(1+r) + DIV2 (1+r)^2 + ... + DIVH/(1+r)^H

Which is always the same regardless of time horizon.

7.4 Simplifying the Dividend Discount model (DDM)

DDM with no growth, all earnings paid out as DIVs.  This is a special case. For example, there might be a producer in an industry that is heavily regulated and has fixed limits on annual production.

Value (or price of a share) of a No-growth stock  = Po = EPS1/r
EPS = earnings per share
In other words, the stock prices is the present value of future earnings per share.

Constant Growth Dividend Discount Model, - dividend grows at constant rate.
Version of the dividend discount model in which dividends grow at a constant rate
Po = DIV1/(r-g)
r = discount rate
g = constant growth rate

Estimating Expected Rates of Return (ERR)

In competitive markets, common stocks with the same risk are expected to have the same ERR. But how do you figure ERR? It ain't easy.

Rules of thumb
1) rewrite the constant growth DDM as
r = DIV1/Po + g
r = dividend yield + growth rate
ex. Blueskies
r = $3/$75 + .08 = 12%

Rate of Return for a particular company is determined by the rate of return offered by other equally risky stocks., not by DIV or g. DIV or g affect stock price, not rate of return.

So rate of return r for a company is based on the risk, if growth changes, stock price changes with it, not necessarily the rate of return.

NonConstant Growth (variable growth?)
Many companies grow at different rates for several years before settling down. we can't use the constant growh model to estimate value. Alternative approach see page 200

7.5 Growth Stocks and Income Stocks
"Growth stocks are ones that are expected to have capital gains. Income Stocks are ones that give cash dividends." Aha!

Def payout ratio - Fraction of earnings paid out as dividents
Def Plowback ratio - fraction of earnings retained by the firm
Def Sustainable Growth Rate : steady rate at which firm can grow; 

g = return on equity X plowback ratio

The total value of stock is equal to the value of it's assets in place (tangible/intangible) plus the present value of its growth opportunities (PVGO)

Def Present value of Growth opportunities (PVGO). Net present value of a firm's future investments.

Price to Earnings (P/E) ratio is an indicator of prospects. High P/E means that investors think that the company has good growth potential. however, if earnings are trending down, P/E will increase. Not necessarily a good sign.

7.6 No such thing as free lunches
Difference between technical analysts, and fundamental analysts. one look at numbers, the other look at trends in market/govt/society.

Chapter 6 - Valuing Bonds

Def - Bond: a security that obligates the issuer to make specified payments to the bondholder

Def - Face Value: payment at the maturity of the bond. Also called the 'principal' or 'par value'

Def - coupn: The interest payments paid to the bondholder.

Terminology "The 5s of 2011" is the 5% coupon bonds maturing in 2011.

Calculating the present value of a bond.

PV = PV(Coupons issued over time) + PV(Face value of the bond)
= (coupon X annuity factor) + (FV X Discount factor)
=  Coupon [1/r - 1/r(1+r)^t] + FV x (1/r^t)

6.3 yield to maturity

Def current yield = annual coupon payments divided by bond price - thiis not really good for anythign besides telling you how much you'll get this year.

Def yield to maturity = interest rate for which the PV of teh bond's payments equals the price

Def Rate of return = Total income per period per dollar invested

Def Default (or credit) risk: The risk that a bond issuer may default on its bonds. This is relevant to corporate bond issuers, not so much national governments

Def default premium: the additional yield on a bond that investors require for bearing credit risk.

Def Investment grade: Bonds are rated by Moody's or S&P's. from Triple A: Aaa, Aa, A.Baa...
Bonds rated Baa and above are Investment grade (according to Moody's). BBB and above are investmetn grade for S&P (as opposed to Junk  Bonds) see table 6.2 for ratings


Sunday, September 20, 2009

Time Value of Money

I am amazed how long it's taken me to finally understand the time value of money!
Today it finally clicked.

FV of 1 invested with r interest rate = (1 + r)^t where t is the number of periods.

PV of 1 paid out in the future = 1/(1+r)^t where t is the number of periods.

These both assume compound interest.

PV = FV/(1+r)^t

Balancing this equation to solve for r gives

r = (FV/PV)^(1/t) -1

FV of multiple cash flows - just take sum of each payment.

Annuity = a sequence of evenly spaced, level cash flows.
Perpetuity = payment stream lasts forever.

PV of a Perpetuity
Cash payment from perpetuity = interest rate X present value
C = r X PV
PV = C/r

Suppose some worthy person wishes to endow a chair in finance at your university. If r = 10% and aim is to provide 100K Cash payment annually, how much must be set aside today?

PV = 100K/.10 = 1 million

PV of an Annuity

Present value of t-year annuity = C[1/r - (1/(r(1+r)^t))] <- "Annunity Factor"

"Amortizing Loan " - part of the monthly  payment is used to pay interest on the loan and part is used to reducet he amount of the loan.

FV of a Annuity 
FV = PV X (1+r)^t

FV = [(1+r)^t -1]/r    (For a $1 annuity)

Effective Annual Interest Rate = not the same as APR!

1 + effective annual rate = (1 + monthly rate)^12

for example if monthly is 1%, annual is 12.68%\

If you're quoted an APR and there are m compounding periods in a year, then $1 will grow to $1 X (1+APR/m)^m  -- m is number of periods in year.

Real future value of investment. Interest rate in real dollars.

1 + real interest rate = (1 + nominal interest rate)/(1 + inflation rate)

Useful approximation 
Real interest rate ~ nominal interest rate - inflation rate.

Sunday, September 13, 2009

Healthcare back of the napkin

by Dan Roam

Finance Chapter19 - Short-Term Financial Planning

Summary of chapter  -
  • show how long term financing decisions impact short term
  • Components of working capital and the cash conversion cycle
  • how managers forecast month by month cash requirements or surpluses
  • Sources of short-term finance
Def - Total Capital Requirement. The total cost of all assets.

Figure 19-2. illustrates different long-term financing strategies
  • relaxed strategy - keep permanent short term cash surplus
  • restrictive strategy - firm is always in need for short-term borrowing,
  • intermediate strategy - firm fluctuates between surplus that it can lend away and needing to borrow.
What is the better strategy? No clear answer, depends. Several practicabl observations
  • Matching Maturities. Matching the type of financing with the type of asset. for example use long term financing (borrowing/equity) for long-lived assets like plant and machinery. Use short-term bank loans for inventory and AR.
  • Permanent working capital requirements.  Working capital should be funded with long-term financing
  • Consider liquidity advantages.  Certain types of firms need more liquidity than others. very predictable firms (manufacturing) need less. biotech need high in case a new drug gets approved they need large amounts of immediate cash to deploy to manufacturing.
19.2 Components of Working Capital
Current Assets
  • Accounts Receivable - unfinished payments from other companies or end consumers
  • Inventory - raw material, work in progress, finished goods awaiting sale
  • Cash - in form of bills or bank deposits
  • Marketable securities - "commercial paper - short-term unsecured debt sold by other firms" or "Treasury bills (T-bills) - short term debts sold by gov't"
Current Liabilities
  • Accounts Payable - outstanding payments due to other companies
  • short-term borrowing.
Working capital and the cash conversion cycle

Def - Net working capital = Current assets - current liabilities. Often called "working capital". For average manufacturing, this is positive. Assets are 30% greater than liabilities.

Def - Cash Conversion Cycle = (inventory period + receivables period) - accounts payable period. The amount of time between a firm's payment for materials and collection on it's sales.

Def - Inventory Period = inventory / annual COGS/365
Def - AR Period = AR / (Annual sales/365)

Def - AP Period = AP / (Annual COGS/365)

NOTE: Example 19.1 - Cash Conversion Cycle

Def  - Carrying Costs: Costs of maintaining current assets, including opportunity cost of capital.

Def - Shortage Costs: Costs incurred from shortages in current assets.

Def - Economic Value Added (EVA).

19.4 Cash Budgeting
Step1: Forecast the sources of cash
Step2: Forecast uses of cash
Step3: Calculate whether the firm is facing a shortage or surplus

Saturday, September 12, 2009

Finance Chapter 18 - Long Term Financial Planning

Short term planning <12 months < long term plannning = typically 5 years "Planning Horizon" although some look out 10 yrs+.

Why build a financial plan? What do you get out of it?
- For contingency planning (aka scenario planning). a good financial plan should help you adapt as events unfold
- To Considering options.
- To force consistent

Financial Planning Models help planners explore the consequences of alternative strategies. Models range from sinple to ones that incorporate hundreds of equations.  They support the planning process by making it eaier and cheaper to construct forecast financial statements.

Components of a FPM
  • Inputs - The inputs to the FP consist of the firms current financial statements and its forecasts about the future.  The principal forecast is the likely growth in sales.
  • The planning Model - the model calculates implications of forecasts for profits, new investment and financing.
  • Outputs - the output consists of financial statements (income, balance sheets, cash flows). These are called pro formas. Can also be 'financial ratios'.
Def - percentage of sales models - Simple planning model in which sales forecasts are the driving variables and most other vars are proportional to sales.

NOTE: Financial models ensure consistency between growth assumptions (forecasts) and financing plans, but they do NOT identify the best financing plan

NOTE: Figure 18-2 has a great model spreadsheet

NOTE: Example 18.3 is a great exercise for excess capacity

While models help managers be consistent between their growth goals, investments and financing they can obscure the basic issues... Therefore it's good to have some 'rules of thumb'

Formula - Required External Financing = new investment - reinvested earnings
= (growth rate X assets) - reinvested earnings
This equation hilittes that the amount of external financing DEPENDS on the firm's projected growth.
Formula - Internal Growth Rate = maximum rate of growth without external financing
= reinvested earnings/assets

This means that a firm with a high volume of reinvested earnings relative to its assets can generate a higher growth rate without needing to raise more capital. AHA!
Formula: IGR = plowback ratio X ROE X equity/assets
= reinvested earnings/NetIncome X net Income/equity X equity /assets
This means that a firm can achieve a higher growth rate without raising capital by 
a) increasing plowback (reinvested earnings)
b) getting a higher ROE
c) keeping a low debt to asset ratio
NOTE: Example 18.4 , how to calculate internal growth rate
Def: . Sustainable Growth Rate - The highest growth rate the firm can maintain without increasing its financial leverage.
Formula: Sustainable Growth Rate = plowback ratio X ROE
= Reinvested earnings/NetIcome X NetIncome/equity

Strategy Journal Post #2

This past week we refined the project proposal for our POL with JBEI. To give a little background, JBEI has not been terribly inclined to participate in a strategic planning exercise for their organization. They see clearer value in us doing a finance project for them, but the reality of their situation is not one where a strategic plan will give them much value. They are a research driven facility with very little focus on business. That’s not to say an exercise and documentation of their strategy would not be valuable, but very likely the output of anything we delivered would not be applicable.  That said, they believe there would be greater value in such an exercise if it were paired with a different partner organization such as a VC or perhaps a company looking into extending into the cellulosic refining market.  We will be exploring this option moving forward, though at this point the team is not committing to keeping this within scope.

I feel a tinge of remorse for getting the team working with a partner where our strategic plan will not be as impactful, and I hope we can get the most learning out of the exercise. Looking back at the way the engagement was conducted, I think there are opportunities for improving, perhaps getting the faculty and administration more involved from the get go would have been advantageous.  I will be making recommendations to Erin, specifically for the cases where teams are recruiting companies who have never worked with a Presidio Team in the past.

The first few chapters of Blue Ocean Strategy have provoked a lot of reflection on the situation at my own company . I see a great need for more strategic planning to get out of the red oceans its been competing in and into the blue.  I have witnessed very incremental strategies that are shortsighted and not innovative. With our resources and talent we should be able to pioneer ahead. I hope to play a leading role in making the Maxis studio a pioneer in the Free2Play space.  While I would love to participate in this, the only question is, how do I get engaged at the right level?  Do I put together a strategy canvas this semester as an exercise and float it up the chain of command? Do I continue down the grass roots community building that I’ve started with the online discussion forums? Maybe I can use my current project as an exercise in strategy and keep it scoped down to my business unit.

Thursday, September 10, 2009

Obama on Health Care

Friday, September 04, 2009

Finance Chapter 4

Def - Market Capitalization. Total market value of equity, Share price times number of shares. (Shares X Price)

Def - Market Value Added. The difference between total Market Cap and Total Shareholder's equity. How much value that a company has added to total shareholders equity. (Mkt Cap - Book Value of equity)

Def - Book Value of Equity.  Total shareholder's equity as listed in balance sheet.

Def - Market to Book Ratio. Market Value of Equite (Mkt Cap/Book Value of equity)

4.2 Measuring profitability
Def - Economic Value Added (Residual income) - (Net income - a charge for the cost of capital employed). EVA is how you measure a corps profitability. EVA is the profit after deducting all costs, including the cost of capital.. EVA is a better measure of performance than accounting profits as it includes cost of equity. EVA = Net Income - (cost of equity X equity)

Def - Return on Equity (ROE) = NetIncome/Equity: Return for shareholders.
Def - Return on Capital (ROC) = (NetIncome + interest)/(long-term debt + equity) Return to investors that includes long term debt.
Def - Return on Assets (ROA) = (NetIncome + interest)/total assets Return to investors based on total assets.

4.3 Measuring Efficiency - Always over specific time period, so look at income statement
Def - Asset Turnover = Sales/Total Assets. Shows how much sales are generated per dollar of asset
Sometimes done over averages assets over period instead. Measures how efficiently the business is using its entire asset base.

Def - Inventory Turnover = COGS/inventory. Show how efficient at clearing inventory. Good to clear inventory efficiently.  High turnover = good operations/logistics

Def - Avg days in inventory = inventory at start/daily COGS in period = XX days. higher number of days = less efficient

Def - Recievables Turnover = sales/recieveables at start of period. high number is efficient AR/credit team.

Def - Avg collection period = receivables at start of yr/avg daily sales = XX days. higher number of days = less efficient credit team.

4.4 Measuring Return on Assets (Du Pont)
Def - Profit Margin = NetIncome/Sales
Def - Operating Profit Margin = (NetIncome + interest)/sales. This is better measure of operating as it isolates performance from interest. Debt/Financing decisions are not included. 

Dupont System
Def - ROA = (NetIncome + interest)/assets = Sales/assets x (NetIncome + interest)/sales
Def - ROA = Asset Turnover x operation profit margin

The Dupont Formula implies strategy. For example, a company with high asset turnover, but slim margin is probably in mass market retail. As opposed to one with low asset turnover and high margin (specialty/luxury retail).
Fast Food Chains - high turnover (due to nature of food inventory) with low margin

4.5 Measuring Financial Leverage
When a firm borrows money, it promises to make a series of intereste payments and then to replay the amount it's borrowed. If profits rise, the debtholders(lenders) continue to recieve only the fixed interest payments and gains return to shareholders. If profits fall, shareholders bear most of the pain. If times are really hard, the firm may not be able to repay it's debts is forced into bankruptcy and shareholders lose most or all of their investment.

Financial Leverage is a measure of how reliant a firm is on debt to finance it's operations.
Leverage ratios measure how much leverage a firm has taken on.

Debt Ratios
Def - Long-term Debt Ratio =  long-term debt/(long-term debt + equity) [14% for Pepsi)
Def - Long-term Debt Equity Ratio = long-term debt/equity [17% for Pepsi]

Pepsi is not leveraged all that much.
For a highly leveraged company the ratios are higher.
Typically for manufacturing companyies, LTDR is about 30%.
Firms can buyout other firms through leveraged buyouts (see ch 21)

Note short-term debt is ignored in these ratios

Def - Total debt ratio = total liabilities/total assets. [Pepsi is 49%]

Times Interest Earned Ratio
Def - Times Intereste Earned Ratio: the extent to which interest obligations are covered by earnings. If it's high, then more earnings are being used to pay off interest.  Better to have low.

Def - Times Interest Earned Ration = Earnings Before Interest and Taxes (EBIT)/interest payments
Pepsi's is 30.2 because they are conservatively financed

Cash Coverage Ratio
Def - Cash Coverage Ratio is like Times Interest Earned, but keeps depreciation in the equation
Def - Cash Coverage Ratio = EBIT + depreciation/interest payments

Dupont formula in 4 parts
ROE = NetIncome/Equity
= leverage ratio X asset turnover X operating profit margin X Debt burden
= Assets/Equity X sales/assets X (NetIncome + interest)/sales X netIncome/(NetIncome + interest)

4.6 Measuring Liquidity
Def - liquidity: access to cash or assets that can be turned into cash on short notice

while generally liquidity is seen as a good thing, too high levels indicate sloppy use of capital.

Def - Net Working Capital to Total Assets Ratio = NetWorkingCapital/Total Assets [PEpsi's is 8%]
Def - Current ratio = CurrentAssets/CurrentLiabilities
Def - Quick (Acid-Test) Ratio = cast+marketable securities+receivables/current liabilities [This doesn't count inventory]
Def - Cash Ratio = cash+marketable securities/current liabilities [this is the companies most liquid assets]

4.7 Calculating Sustainable Growth
Def - Sustainable Rate of Growth: steady rate at which a firm can grow without changing leverage.

NOTE: Table 4-7 is very good reference!!


Finance Basics

Managerial Finance Chapters 1,2,3
Financial management at the highest level is all about making good finance related decisions.
It can be broken down to two main types of decisions:
- Investment decisions: what projects to spend money on. what capital investments to allocate funds to and how much to invest in each project.
- Financing decisions: how to raise capital for that a company needs for its investments. There are two ways to finance, via equity or debt.  In equity financing the company asks investors to put up cash for future profits. In debt financing the company gets a loan. The choice between this two is called the "capital structure" decision.

Def: Cost of capital -  minimum acceptable rate of return on capital investment.  The rates of return on investments outside the corp set the minimum return for investment projects inside. [If you get a higher return on the outside, why invest inside?] The cost of capital for corp investment is set by the rates of return on investment opps in financial markets. That is why financial managers talk about the 'opportunity cost' of capital.  When shareholders invest in the corp, they lose the opportunity to invest that case in financial markets where returns could be better.

Important distinction for Financial Reports.
They show book value of assets, not real market value. Book value is original cost - depreciation.


Why I'm staying home today

Why I'm staying home today

Tuesday, September 01, 2009

Financial Management first takes

At highest level FM decisions are about how to get your company financed or what to invest in.
From the financing perspective, do you want to issue new stock for shareholders to buy? Do you want to issue bonds? Do you want to sell a portion of your company to another company? Do you want to take a bank loan? With each of these options careful consideration must be made.

From investing, what is the ROI on the investment? Is the future value of this investment greater than the cost to invest now? This is where NPV comes into play.

Monday, August 31, 2009

Strategy Journal Post #1

Strategy formulation is a thoughtful process, often philosophical. Questions of Management vs. Leadership vs. Strategy arise. Keep a weekly journal (10 total) in which you pose a question you‘ve had about strategy and write several paragraphs exploring the question

In the context of our POL project with http://www.jbei.org, the initial challenge is scope scope scope. We need to identify a decision that jbei is trying to make and develop a strategy plan for determining the answer.

This weekend, strategy was defined by our faculty and a series of panelists. It's one of those amorphous concepts that many define in the context of their own environments and experiences. For some strategy is a process, for others it's an exploration, for others a decision.

I feel my first question to answer is, what is my interpretation of strategy? What does it mean to me? From there, I can apply my definition to the POL. From what I understand, strategy is a process through which decisions are made. To DO strategy is to engage in the process of making decisions. A strategic plan does the following

1) Defines a specific business question to ask, the answer of which supports decisive action.
2) Lays out the framework for decision making around a particular question.
3) Clarifies all inputs (data points and assumptions)
4) Concludes with an answer or set of recommendations for how to proceed given the inputs to the framework

The result of engaging through the process in steps 1-4 is a decision that improves or maintains the integrity and performance of the business.

Gerald Harris defined it as "Decisions which lead to structural or process changes in an organization designed to support further growth or maintain the current positive performance of the organization."

Does my definition gel with Gerald's? Close but not exactly. My definition is a process that leads to a decision. Though the by-product of DOING strategy, could be considered a "Set of decisions which...". Let's look at another definition from Teddy's slides. "Strategy is a creative endeavor"... "decisions about resource allocation, especially time/effort/attention". Again, strategy is decisions.
Jay's scenario planning is one way to engage in the process of making decisions.

Ok, let's bring it back to JBEI. What's the first thing to do in the strategic planning process?

1) Define the question whose answer supports decisive action:
Questions related to resource allocation around certain research activities
Should JBEI model bio ethanol or something else?
Should JBEI cut spending on research of a certain technology?
Should JBEI refocus spending on certain feedstocks?
Should JBEI increase investment in X?
Should JBEI decrease investment in X?
Should JBEI divert funds to biodiesel research?

Questions related to resource allocation around certain financing options:
Should JBEI recommend financing of biorefineries through government bonds?
Should JBEI recommend financing of biorefineries through equity?
Are these really applicable to strategy?

Questions related to onsite discussion:
Should JBEI encourage farmers to switch to growing different feedstocks?

Rebranding blog

I'm re-entering the blogosphere with a reflective journal around my fall semester classes at the Presidio. Taking and strategic management this semester with Jay Ogilvy and Teddy Zmhral and finance with Steven Crane.

Stay tuned.

Thursday, February 05, 2009


"No problem can be solved from the same level of consciousness that created it. We must learn to see the world anew.”"

“There are only two ways to live your life. One is as though nothing is a miracle. The other is as though everything is a miracle.”
– Albert Einstein


Be patient … and try to love the questions themselves. Live the questions now. Perhaps you will then gradually, without noticing it, live along some distant day into the answer.
– Rainer Maria Rilke

Wednesday, August 29, 2007

tonight i'm showing jennifer my blog

she wants to start blogging because she wants to be cool like me.

Monday, May 07, 2007

wellington arch

wellington arch, originally uploaded by sfxian.

just got off the undrgrnd

- Taken at 12:41 PM on May 05, 2007 - cameraphone upload by ShoZu