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Lecture 4

Corporate Finance Lecture 4 MF 127 Spring 2013.pdf

29 Pages

Course Code
MFIN 1127
Jerome Taillard

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Corporate Finance MF 127 Lecture 4 Jérôme Taillard Spring 2013 Outline 1. Are accounting targets compatible with maximizing shareholder value? 2. ROE – Definition – Justification of its use – Decomposition – Analysis of each component – Other ratios – Working capital management – Limitations of ROE – How to use ratios Goal of corporate finance MAXIMIZE SHAREHOLDER VALUE • For a publicly-traded company: – Equivalent to maximizing stock price • What could be potential issues associated with using the stock price to guide managers who run the business on a day-to-day basis? 1. How do operating decisions affect stock price? 2. Should managers rely on assessment of outsiders? 3. Stock price is influenced by many factors outside of management’s control • Alternatives based on accounting numbers: – ROE: Return on Equity – EVA: Economic Value Added Return on Equity: ROE • Definition: Net Income ROE = Shareholders' Equity • Measure of efficiency: – Earnings per dollar invested or equivalently; – %return on equity investment • Is shareholders’ equity = amount of dollar invested? • Careers are made on this measure – Widely used as yardstick in compensation packages Justification for use of ROE Clear positive relationship between ROE and market value of equity The higher the average ROE, the higher the market value Three determinants of ROE Net Income Net Income Sales Assets ROE = = × × Equity Sales Assets Equity Profit Asset Leverage Margin Turnover 1. Profit margin: Earnings squeezed out of each dollar of sales 2. Asset turnover: Sales generated from each dollar of assets employed 3. Financial leverage: Amount of equity used to finance the assets Assets Liabilities + EquiLiabilities Equity= Equity = Equity +1 ROE decomposition ROE Profit Margin Asset Turnover Leverage =ROA • Let’s look at each of these elements in turn… 1. Profit margin • bottom line each dollar of sales that ends up in the • It reflects: 2. PAbility to control operating costs • Differs greatly across industries – Highly dependent on products sold and business strategy • IMPORTANT: – Profit margin cannot be viewed independently of asset turnover Profit margin and other profitability ratios • Gross margin = 33.3/186.7 = 17.8% • Operating margin = 10.4/186.7 = 5.6% • Tax rate = 0.7/2.7 =25.9% • Profit margin = 2/186.7 = 1.1% 2. Asset Turnover • Measures how quickly you generate sales with your assets • Usually: Inversely related to Profit Margin! Examples: 1. Biotech 2. Retailer • Combine profit margin and turnover to get return on assets (ROA): Profit Asset ROA = × Margin Turnover Asset turnover and efficient use of assets • Is having more assets always better? – It depends on who is asking! • Debtholder vs. Shareholder conflict A. What does the banker care about? • How can assets limit the risk for a banker? B. What does the shareholder care about? • How can having more assets in place hurt shareholders? Maximizing shareholder value • Focus on generating cash Recall: Increase in (non-cash) assets = use of funds  We want to reduce the need for assets! Maximizing shareholder value • Reduce the need for long-term assets – Usually a function of industry • Need technological breakthrough for significant reduction • Fixed asset turnover = (Net PP&E / Sales) • Example? Maximizing shareholder value • Reduce the need for current assets – Manager can and should limit the use of current assets to generate sales • Also: Current liabilities can be used as a source of funds to offset the capital investments in current assets  Define control ratios (linked to operating cycle)  Working capital management Operating cycle and Cash conversion cycle (CCC) • Cash Conversion Cycle (CCC): A measure of the cash cycle • Cash Conversion Cycle (CCC) = Inventory days + Accounts Receivable days − Accounts payable days Control ratios and the operating cycle Inventory days = Inventory / [Daily average of COGS] Accounts receivable days = Accounts receivable / [Daily average Sales] Accounts payable days = Accounts payable / [Daily average of COGS] • Measures efficiency of operations in managing its cash outflows and inflows related to its operating cycle • Expressed in daysfor ease of interpretation Accounts receivable days (Collection period): • Suppose: Annual sales is $500M and Accounts receivable at year end = $50M  Daily average Sales = $500M/365 = $1.37M  Accounts receivable days = $50M/$1.37M = 36.5 days 
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