FINANCIAL PERSPECTIVE

FINANCE AND ENTREPRENEURS

Allocation of scarce resources within the firm

How decisions should be made? – Finance is for general managers too!

Finance cannot stand alone – to ignore human or production perspective will be as fatal as ignoring financial perspective

Effects of decisions – on shareholders and other constituencies (management, labor, suppliers, customer, government, society)

Useful to general managers and critical to entrepreneurs – Cash Risk Value

CASH

Key goal is to keep playing the game!

Cash can be consumed, traded for other assets.

Accountants match revenues with expenses, distinguish between expenditures and expenses – Managers focus on cash inflow and cash outflow

Performance Evaluation and Incentive Compensation Firm’s objective : Maximize value depending upon cash and risk Individuals act to maximize their own wealth Hence company’s incentive compensation policy is important

Taxes and Cash 4 kinds of decisions affect taxes: Legal, Investment, Financing, Accounting Try to minimize the resources siphoned off to Govt. within the constraints of the law

Cash and Growth Sales growth -> Growth in assets -> Increase of shareholder’s equity Differentiation between real growth and inflation

Pattern recognition Patterns affecting cash: cyclical, seasonal,

competitive, technological, regulatory and tax

Identifying opportunities: Using past and current data -> Predict future

Decision making: Offensive or defensive move

Not possible every time therefore responses may be delayed

Scenario Planning It is not the same as worst or best case

scenario considerations Nor it is linear extrapolation Every forecast will turn out to be wrong in

hindsight Nevertheless managers must evaluate

SITTING ON A CASH PILE

TATA motors acquires JLR cash pile of Rs. 6000 Cr and FY 07 generated free cash

of Rs. 1000 Cr March 2008 $2.3 Billion deal finalized

Cash Rich – top 3 companies

Apple - $137.1 billion

Microsoft - $68.3 billion

Google - $48.1 billion

DON’T RUN OUT OF CASH!

Forecast and plan future cash flow patterns to avoid jeopardizing the firms’ survival

Lack of cash: potential opportunities can’t be seized

Competitive or offensive moves from business rivals

TYPES OF RISK

Systematic Risk: Risk inherent to the entire market or an entire market segment. affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid

Unsystematic risk: Sometimes referred to as "specific risk". This kind of risk affects a very small number of assets. An example is news that affects a specific stock such as a sudden strike by employees. Diversification is the only way to protect yourself from unsystematic risk

TYPES OF SYSTEMATIC RISK

Interest rate risk: Arises due to variability in the interest rates from time to time. It particularly affects debt securities as they carry the fixed rate of interest

Market risk: Arises due to rise or fall in the trading price of listed shares or securities in the stock market

Purchasing power risk: Also known as inflation risk. It affects purchasing power adversely

TYPES OF UNSYSTEMATIC RISK

Business or liquidity risk: It originates from the sale and purchase of securities affected by business cycles, technological changes

Financial or credit risk: Financial risk is also known as credit risk. It arises due to change in the capital structure of the organization

Operational risk: Risks arising due to human errors. This risk will change from industry to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems

RISK & PERFORMANCE EVALUATION

How to evaluate and reward managers operating in uncertain environment?

• Measure Performance in relative sense

• Assess Performance on long term value added

HOW THE RETURNS WILL BE ACHIEVEDAbility to identify positive NPV decisions

• Delivering the right value at the right price

• Managed two crucial product inputs - labour cost advantage and the production flexibility by leveraging China

SENSITIVITY ANALYSIS

Partial Equilibrium •Determine implications of changing a variable, holding all other relative values constant

General Equilibrium

•Determine implications of changing a variable, while simultaneously allowing all other relative values to change•Understanding of fundamental relationship among variables

VALUE CREATION POTENTIAL FROM FINANCING DECISIONS

VALUE CREATION POTENTIAL FROM FINANCING DECISIONS

Debt over equityValue transfer among various ownerIts effect on incentive of various players, especially management

CONCERNS OVER DEBT?

It increase the risk to shareholders but increases expected return also

US tax laws are biased towards Debt financing

Interest is a tax deductible expense

Increasing debt means financial difficulty

Introduction of debt in capital structure means cash flow increases for owners

APPLE’S FIRST BOND 2013

Borrowed as part of a plan to return $100 billion to shareholders by the end of 2015

CONCERNS OVER DEBT?

FINANCIAL DISTRESS

Companies become vulnerable to competition

CHRYSLER IN 1980

Potential car buyers avoided Chrysler acquainted with the fact about the large debt pool.

Suppliers balked at giving credit

CONCERNS OVER DEBT?

BANKRUPTCY

LEHMAN BROTHERS 2008

$619 BILLION IN DEBT

Market reluctance to buy its bonds during 2008

VALUE TRANSFER

Size of Pie doesn’t change, but size of slices changes

Value transfer among various shareholder may vary

Variation in company strategy also changes the value transfer

EXAMPLE 1

SITUATION: Stock is overvalued

Issue of stock when stock is overvalued.

Results in a value transfer from new shareholders to old shareholders and management

They will benefit the extent of overvaluation

EXAMPLE 2

SITUATION: Management decision changes the character of cash flow stream in a way unanticipated by capital suppliers

Conservative to Risk company strategy

Supplier of debt will suffer a capital loss

The £2billion backlash: Zuckerberg sued by Facebook shareholders for 'hiding forecasts of future problems'

INCENTIVES

SITUATION 1: FIRM IS NEAR BANKRUPTCYIncentive for management is to invest in Risky projectsShareholders have a worthless claim unless the firm strikes it rich

SITUATION 2: DEBT-RIDDENManagers have strong incentive to perform well after leveraged buyouts

SITUATION 3: NATURE OF CONTRACT BETWEEN MANAGERS AND SUPPLIERSEntrepreneur expresses 51% ownershipGives 100% equity to the capital supplierWill keep the 51% on the basis of actual performanceHave strong faith in own abilities

SUMMARY

Finance is a way of thinking about cash, risk and value

It doesn’t answer the questions, but identifies the right questions

Financial perspective tells whether a decision is feasible or not

Only recurrent danger is it can easily become the excuse for inaction