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Mike’s Bikes IntegratedBusiness Learning, Second Edition Finance and Performance Measurement © The McGraw−Hill Companies, 2001 Reading 7 FINANCE AND PERFORMANCE MEASUREMENT At the most general level the financial manager deals with two decision making areas: what investments should a company make; and how should it finance these. The main role of the finance function is to manage the process of funding the firm in the best possible way. The first of these involves the financial evaluation of strategies associated with existing products and new capital expenditure. The second includes decisions on capital structure and dividends. To reflect these two areas, the chapter is broken up into two main parts: evaluating strategies and investments; and financing of the firm. In each case these are concerned with finding ways of adding value to the existing business. 3 Current Profit ECONOMIC CONDITIONS COMPETITORS’ ACTIONS Demand Future Profit Supply Accounting operating decisions investment decisions Business Strategy Marketing Strategy Operations Strategy Finance Strategy Product Development Strategy Finance and Performance Measurement 1. Learning Objectives a) A Framework for Finance b) Investment Evaluation • NPV • Evaluation of projects • Weighted Average Cost of Capital (WACC) • Evaluation of shares • Risk, Return and CAPM • Evaluation of strategies • Assessing corporate takeovers c) Financing Decisions • Dividend policy • Financing by debt • Financing by equity d) Financial Measures • Increase in Shareholder Wealth ®47 • Economic Value Added (EVA ) e) The Balanced Scorecard 47 Shareholder Value Finance Logic EVA is a registered trademark of Stern, Stewart & Co Page 113 and many things outside of the control of the organization can affect success . Finance Strategy • Investment .raise or repay ($) Equity decisions .including luck. Equity. these primarily fall under two generic headings debt and equity.buy or sell ($) Assisting with evaluating strategies ($) Determining dividend policy (Cents/ Share) Debt decisions . These decisions are usually made by marketing and operations. P.Dividends.operating. Related to this is the issue of determining an appropriate level of distributions/dividends. Evaluating Projects ($) Valuing corporate takeovers . P. It is simply meant to emphasize that without a return to shareholders a capitalist system cannot operate. Wensley. 4 Finance Logic . Which of these is most important is contingent on the circumstances. 2001 Reading MIKE’S BIKES – Integrated Business Learning Online 2. and the finance function has little involvement except in assessing the funding implications of these decisions. We will consider six main financial functions listed in the table above.raise or repurchase ($) However. Marsh. It is dependent on economic conditions. and varies over time. It is difficult to define a good strategy ex ante. competitor activity and management decisions in three areas .1 THE RELATIONSHIP OF FINANCE TO STRATEGY Good strategy has been defined as the formulation and implementation of any Investment set of decisions that will lead to the long term success of the organization. One must determine how much funding is required and what is the best mix of debt and equity.. Investment decisions refer to the types of new projects and products that a firm should invest in and many people would argue that this is the area where most effort should be expended. Debt. 48 Barwise. Financing decisions determine the "best" way in which to fund the requirements of the organization and its strategy. They are not shown on the diagram above. Second Edition Finance and Performance Measurement © The McGraw−Hill Companies. Corporate Takeovers • Financing . Financing since only time will tell whether the strategy has been a success. or entire organizations. HBR. Investment Product NPV Corporate Financing Dividends Debt Equity Takeovers Operating decisions are those that result in operating profits and relate directly to the product or service Finance and Performance Measurement being produced. Sept-Oct. plant. "Must Finance and Strategy Clash”.Mike’s Bikes Integrated Business Learning. 2.Projects. Finance helps to evaluate the financial attractiveness of these. The finance function has two roles to play here. many strategies involve the decision to invest or divest of product. The first is to help other functions within the organization to evaluate their strategic investment 48 decisions . It is usually these projects that constitute the strategy of an organization.. Investment Evaluation Evaluating investments relates to the future profitability of an organization.. Page 114 . R.Detail Achieving such a return occurs through a number of levels. This type of decision will focus on identifying the projects which give the "best" possible financial return. 1989. A Framework for Finance The diagram shown assumes that the overall corporate objective is to create shareholder value. This is not to say that social objectives are not important. investment and financing. The second is in the direct valuation of corporate takeovers and divestments. While there are many unique financial instruments. 3. 1 NET PRESENT VALUE (NPV) One of the main tasks of finance is evaluation of different investment alternatives.1 (1 + 0. Second Edition Finance and Performance Measurement © The McGraw−Hill Companies. 49 NPV=0 where the Discount Rate equals the Internal Rate of Return (IRR) . The best and worst case scenarios will also help ascertain how sensitive the NPV is to the uncertainty of the forecasts.Mike’s Bikes Integrated Business Learning. This requires that the expected cash flows associated with a project be adjusted by a discount factor that reflects the risk of the project relative to those normally undertaken by the firm. The risk of the project refers to whether an investor would regard this project as more risky than ones typically undertaken by the company. strategy or firm. NPV also requires a discount rate reflecting the cost of capital for the project (which in turn depends on the risk of the project). Most projects have a high capital outlay at the beginning. The method of choice is Net Present Value (NPV). The cashflows resulting from best. Projects associated with higher risk often include those more dependent on the business cycle and those with higher ratios of fixed costs to project value. the higher the 49 required discount rate. along with the estimated probability of each outcome. Using these probabilities one can arrive at an expected outcome. worst and average cases should be forecast.1) 2 = −$529 Finance and Performance Measurement 3. and then small positive net cash flows in the following periods. 2001 Reading Finance and Performance Measurement 3. This can be modified to reflect differences in the risks of the project. In Mike's Bikes it is possible to make an estimate of the NPV of a product development project by entering the costs of the project and the expected revenues and costs in the following years (up to a maximum of 10).2 EVALUATING PROJECTS The most basic way of evaluating projects is to use the measure of Net Present Value. If the project has the about the normal level of risk then the appropriate discount rate would usually be the weighted average cost of capital for the firm (see relevant section below). The current Weighted Average Cost of Capital (WACC) is applied to calculate NPV. and might highlight areas for more research. the lower the NPV. Apart from these forecast cashflows. NPV is a measure of the value added by the future income stream associated with a project.another way of selecting projects Page 115 . For these projects. 7 Example Calculation of NPV h FreeCashFlow t t t =1 (1 + DiscountRate) (and assuming h is 2) NPV = FCF0 + = −$4000 + $2000 $2000 + 1 + 0. The risk of the project does not refer to the likelihood of the project failing to meet the projected cash flows. To make the share price less volatile (and more realistic) the earnings per share figure is adjusted for expenditures that may have a long term benefit (such as product development.” ∞ Share Value = If we simplify so that dividends are assumed to grow at a constant rate and the required rate of return remains constant. The required rate of return (sometimes called the market capitalization rate) is the return that investors expect on similar shares. This is used to calculate the Required Rate of Return. Assume that this is expected to grow at 2% and the required return on equity is 15%. maintenance. RETURN AND CAPM It is an accepted principle of finance that the higher the risk associated with an investment. then the second formula can be applied.3 EVALUATION OF SHARES 10 Theoretically. Share Price := $2.rf = beta (rm .0 The Capital Asset Pricing Model says: In a competitive market. Mike’s Bikes also assumes that future earnings are reflected in a weighted average of the past earnings.60 = $20 (15% . but does give a consistent way of estimating future earnings that is representative of how some shareholders tend to view their investments.Mike’s Bikes Integrated Business Learning. Second Edition Finance and Performance Measurement © The McGraw−Hill Companies. This is to cover for situations where low dividends are paid by high-growth companies. the value of a share is the present value of all dividends that will be received from the share over its life. the higher the return expected and required from it by investors. The Capital Asset Pricing Model (CAPM) says that the required rate of return is directly RiskFree Rate (rf) Risk beta =1. The risk of the firm is determined by the risk of the industry and the extra risks associated with the firm (measured by the D/E ratio). the expected risk premium varies in direct proportion to the risk (measure by beta) Finance and Performance Measurement Page 116 . Then what is the present value of this income stream? SOLUTION But how do we calculate the required return on equity? This is determined by the risk involved and this is where the Capital Asset Pricing Model (CAPM) comes in.2%) AN EXAMPLE A simple example will help to solidify these ideas. DIVt (1+ r) t t =1 n The issue is how to estimate future dividends and the required rate of return on this company’s shares n If you assume constant dividend growth (g): Share Value 0 = DIV1 (r . While not entirely accurate. 2001 Reading MIKE’S BIKES – Integrated Business Learning Online 3. branding. Share Price:= Smoothed EPS (Required Return on Equity . Use NPV to Value a Share … “the present value of all future dividends. A commonly used average for the long-term growth rate is 2%. Note that high current dividend growth rates (eg above 10%) are very unlikely to be sustained in the long-term.4 RISK.g) How is Share Price calculated in Mike’s Bikes? A key difference is that it uses smoothed EPS Finance and Performance Measurement in place of dividends. Again this is not particularly realistic. 11 Use the CAPM to Estimate the Required Rate of Return Required Rate of Return r .60 and this is all returned as dividends.Growth Rate in Perpetuity) The long-term dividend growth rate is assumed to be 2% for all firms. advertising.rf) Market Rate (rm) 3. Assume the smoothed earnings per share of a firm are $2. this makes the computation simpler and relative share prices will stay the same. supplier relations). 3. The larger and more complex the firm. and their perceptions of the quality of the firm’s management. firms need to make every effort to ensure that investors and their advisors have recent frequent clear information about the firm’s situation and plans. – Thus. Sometimes an unlevered industry beta is available.5 INVESTOR RELATIONS The value of a share is determined by more than a mathematical analysis of risks and returns. this stock will move 1. Mike's Bikes offers two ways of evaluating strategies. Sometimes the new owner is able to inject enough Page 117 . Second Edition Finance and Performance Measurement © The McGraw−Hill Companies. If the strategy is simple and essentially revolves around a product development project then there is the NPV function which requires that the player enter the likely revenue and expenses of the project for the specified time frame and the cost of capital. h NPV = FCF0 + t =1 FreeCashFlow t (1 + DiscountRate) t In Mike's Bikes there are many strategies that can be played out. There are at least two problems here already. If it moves on average less than the market then its beta is less than 1.5 then for every 1% movement in the overall market.7 VALUING CORPORATE TAKEOVERS An important part of a strategy may be to purchase another company (or to sell a subsidiary). 3. 15 3. the buying firm can add-value to its return. This includes any projects which will generate future profits any operational decisions generating current profit any acquisitions – The return on assets for the combined assets is greater than the sum of the returns on the individual assets.and this is captured in the concept of risk. which you can adjust for your firm by using the debt/equity ratio. When comparing strategies one needs to consider the true profit expected to be generated by the different strategies. adding capacity. The second relates to the fundamental uncertainty of the estimates .Mike’s Bikes Integrated Business Learning. beta measures the risk of an asset. All these strategy options must be evaluated. to introducing or deleting products in the market place. This is what Mike’s Bikes does. any divestments Same as the NPV for a project but harder to calculate. If the share is not listed (or has not been listed for long enough) then you will want to look at the betas for comparable companies in the same industry. In essence. buying or issuing stock. But how is Beta calculated? Beta measures the monthly price movements of the individual stock relative to price movements in the overall stock market. or the purchase or sale of other firms in the industry. given a certain set of assumptions for the environment and competitive actions. relative to the variablity of the "the market". the more effort is required. Hence to ensure that their shares are fairly valued.6 EVALUATING STRATEGIES NPV of a Strategy Any strategy will have a financial outcome on the organization. the players can make all the decisions that they want and then roll over to the next period to see what the effect would be in shareholder value and other measures. 2001 Reading Finance and Performance Measurement proportional to the risk as measured by “beta”. One relates to the time frame of the analysis since different strategies may be expected to have different periods over which they are effective. If the stock price on average moves at exactly the same rate as the stock market it has beta=1. If the beta of a stock is 1. For more complex strategies.5%. This could be because it will strengthen the market position of the buying company or provide it with some other advantages that would be valued higher than the purchase price. The NPV is then calculated. if more then its beta is greater than 1. It is the role of the finance function Finance and Performance Measurement to evaluate the impacts of these on shareholder value. It is also affected by how much the investment community knows and understands about the company concerned. These may be as simple as maintaining a steady path with little modification to existing decisions. Government bonds' real return is 1%. Myers. Mike's Bikes allows these dynamics to be played out. Principles of Corporate Finance. 4. raising or repaying long-term debt. Dividend changes follow shifts on long-run sustainable earnings. shares in your firm). one without taxes).Mike’s Bikes Integrated Business Learning. The Lintner model suggests that a firm will have a target ratio of dividends to earnings per share. C. Miller and Modigliani showed that the amount of dividend paid has no effect on the value of the firm. Modigliani.e. McGraw-Hill. those advocating medium levels. and those advocating minimum dividends. The decision screen shown allows a team to takeover and sell other companies and to transfer capital back and forward between itself and the companies it owns.1 DETERMINING DIVIDEND POLICY 18 How do Managers decide on Dividends? (Lintner’s model) n n n n Reference: Brealey and Myers. However dividends DIV 1 .DIV 0 = adjustmen t rate x ( target rat io x EPS 1 .. 51 The slide shown indicates some empirical research as to what managers really do. but not too quickly because the management does not want to have to reduce dividends in the case that the current high earnings turn out to be short-lived. The more volatile the earnings the lower the adjustment rate will be. As earnings per share changes the dividend will begin to increase towards the target ratio. S. (In such cases it could even consider returning capital to shareholders by repurchasing shares. 50 51 Miller. In Mike's Bikes the dividend decision is given in cents you wish to pay per share.H.. 1996 Page 118 . Principles of Corporate Finance. The dividend policy may be used to stabilize the price of the firm's shares even in the context of variable earnings. Formula Each year the management team must set n the dividend level in cents per share. Managers focus more on dividend changes than on absolute levels. The Finance Decision Screen allows you to manage the cash your firm has available to it by paying dividends to your shareholders. Dividends have a direct effect on shareholder value as shareholders receive a cash return from their investment. A. McGraw Hill. and issuing or repurchasing equity (i. all else being equal. 1996 Firm’s have long-run target dividend payout ratios.) 50 In a pure economy (i. M. 34:411-433 (Oct 1961). In this model a large dividend increase can be used to signal management's view that future earnings will increase.” Journal of Business. Thus a firm should consider increasing its dividends when it does not believe that it can use the money to achieve a return greater than that required by shareholders. 4.. 2001 Reading MIKE’S BIKES – Integrated Business Learning Online capital or know-how to enable the purchased company to reach new levels of performance. The real market return shareholders can receive elsewhere is 10% per annum. As summarized in Brealey. Raising and repayment of debt and raising and repurchase of equity may be used as levers to make sure that the best cost of capital is achieved. This would again require a valuation of the true profit that would be created by the purchase and a comparison of this against the purchase price. Dividends are paid on the number of shares outstanding at the end of the previous period (as listed on your balance sheet report). R. However the fact that dividends are taxed but capital gains often not coupled with other issues muddies the waters to the extent that there are three widelyheld positions on dividend policy: those advocating high dividend levels. Financing decisions These decisions relate directly to achieving the optimal cost of capital for the organization. Managers are reluctant to make dividend changes that might have to be reversed.e. Growth and the Valuation of Shares. “Dividend Policy. Second Edition Finance and Performance Measurement © The McGraw−Hill Companies.DIV 0 ) reduce a firm's cash reserves and may prevent it from undertaking potentially Copyright 1998 Finance and Performance Measurement profitable new projects. F. if the firm has excess cash and no profitable uses for it. thereby reducing the number of shares among which the firm's future profits must be distributed. which will increase with increasing debt levels. then the largest equity issue it can make is $2m. Page 119 . Fundamental to this decision and to much of financial theory is the share price. This has been described above and is influenced by earnings per share. only issue up to 50% of the current book equity value. issues and repurchases will occur at current market prices with underwriting and merchant banking fees also being incurred. The maximum overdraft facility available is set at 25% of the book value of equity. The interest payable is negotiable (within certain limits!). If its book equity is very low. a firm can. If an organization needs more money for implementing its strategy then it can raise this by a share issue.3 RAISING/REPURCHASE OF EQUITY As an alternative to debt a firm may choose to issue shares to raise finance. then this will severely limit its ability to raise cash through equity issues. This can (depending on the regulations) dilute the ownership which makes the company more vulnerable to takeovers if results are not forthcoming. In Mike's Bikes. To prevent speculative trading. the more interest you pay. An alternative available to companies which are owned by another firm is to request debt financing from their parent. On the other hand. 4. there is an effective limit as to how much can be raised due to the burden of high fixed interest charges. Similarly. The financial market will not allow you to raise debt beyond a debt/equity ratio of 3. and a 5% issue discount on equity raised. in a given year a firm can only repurchase shares worth up to 25% of the current book equity. the required rate of return and the expected growth rate of earnings and the economy over time.Mike’s Bikes Integrated Business Learning. or mortgages). This effectively means that the cost of repurchasing or issuing equity is 5% of the value. There is a 5% issue premium on equity repurchased. In Mike's Bikes.2 RAISING/REPAYING DEBT Except (perhaps) for retaining profits. However. the firm may choose to raise finance using debt instruments (for example. if a firm currently has book equity of $4m. The required rate of return is dependent on the risk of the firm and industry. notes. raising debt is often the easiest way to get additional funds. debentures. it may consider repurchasing some shares. 2001 Finance and Performance Measurement 4. in a given year. The lowest rate is at 8% which increases to 20% or more when the debt/equity ratio is more than 2. These costs are automatically added/deducted from the dollar figure you specify in your decision. The higher the ratio and therefore risk. Interest will be charged on these long term debts based upon the level of risk of the firm. For example. Firms which exceed this overdraft limit are placed under statutory management and must pay additional legal fees. which is determined by the debt/equity ratio. If your firm spends more money than it receives and goes into overdraft then the interest rate applied is 3% higher than what you pay on long-term debt. Second Edition Finance and Performance Measurement Reading © The McGraw−Hill Companies. 35 Total Previous Divs and Interest @ 10% $0. Total shareholder value is the shareprice change. 5. Measurement and the Balanced Scorecard 22 Is there an optimal Debt/Equity ratio? Reference: Brealey and Myers.9% 5.00 $0. Then we introduce the idea of the weighted cost of capital (WACC). shareholder value is measured quite naturally as • Share price (determined by profit and required return) • Plus any dividends/distributions (including interest on these) This table shows the calculations in more detail.00 Current Div $0. proportion of debt and equity) which minimizes the overall cost of capital.31 Change in Year 45.10 Value Created $6. The diagram shows the differing curves predicted by these two schools of thought. Modegliani and Miller (MM) argue that it does not matter.40 $0. Second Edition Finance and Performance Measurement © The McGraw−Hill Companies.89 $23.6% 65.02 $2. 2001 Reading MIKE’S BIKES – Integrated Business Learning Online In Mike’s Bikes firms pay company tax of 33% on profits and there is dividend imputation so there is no effective tax on dividends. at least in the absence of taxes. 5.20 $5. These measures which have come into fashion since the 1980's. are natural extensions of shareholder value but take explicit account of the cost of money that is used to generate income. 4.67 $1.22 $6.00 $14.Mike’s Bikes Integrated Business Learning.1 SHAREHOLDER VALUE In Mike's Bikes. McGraw Hill.e.14 Interest on Divs (PV) $0.52 $0.75 $16. Period 1 2 3 4 Share Price $13.00 $0. First we describe the Optimal D/E ratio calculation of Shareholder Value in Mike's Copyright 1998 Finance and Performance Measurement Bikes.4 DEBT OR EQUITY? IS THERE AN OPTIMAL D/E RATIO? It has been traditionally been thought that there is an optimal capital structure (i. Tax credits on losses are carried forward until the next year of profit.6% 13.02 $0.7% Shareholder Value Page 120 .20 $5.9% Cumulative Change 45.00 $0.8% 75. Principles of Corporate Finance.20 $19.61 $13.00 $15. 1996 Traditional view Modigliani and Miller (MM) – there is an optimal debt/equity ratio that minimizes the return on assets required by investors – there is no optimal debt/equity ratio rE (MM) Rates of Return rE (Traditional) In this section we look at the issue of rA (Traditional) measurement.22 $21. which leads on to Economic Value Added (EVA). To start with we consider three financial D/E measures. and introduce the rA (MM) Balanced Scorecard to reflect the movement to more complete rD measurement systems than those provided by financial measures only. plus any dividends paid and the interest on these. 000 return on 52 EVA is a registered trademark of Stern.000) which would have had an associated tax saving of about $17. since interest rates are usually explicit. This would lead to cost of equity capital of about $420. The Net Operating Profit After Tax would have been about $2. The book equity during the period may have been $2. 3.4m in “profit” being earned by the company on $3. where the required return on the capital is about $0. ) 29 Economic Value Add EVA is a registered trademark of Stern.Cost of Debt (eg interest costs adjusted for tax) .3m capital ($0. Economic Value Add Finance and Performance Measurement AN EXAMPLE Consider the sample EVA report to the right. Second Edition Finance and Performance Measurement © The McGraw−Hill Companies.000. Roughly speaking. Assuming that this interest cost is a fair reflection of what the company could expect to pay in interest the $33. The CAPM makes it clear that projects of above average risk should have above average required rates of return applied to them. Stewart & Co Improves on profit measures by deducting the implicit cost of the equity used to generate the profits.45m ($30. Of this about $50. Cost of debt The interest cost of debt (adjusted for tax) is usually a reasonable approximation for this.2 WEIGHTED AVERAGE COST OF CAPITAL (WACC) The weighted average cost of capital for a project or firm depends on whether it is financed by debt or equity or both. WACC = rA = ç D æE ö × rD ÷ + ç × rE ÷ èV V Note that it is reasonably straight forward to estimate the cost of debt. Each of these will have a different cost associated with it and the WACC forms a weighted average of these to get the true cost of capital.000 would have been interest cost (eg 10% on $500.000 can be taken as the cost of debt capital.000. So the net effective interest cost to the company is about $33. we have $2. Clearly WAAC is an average.Mike’s Bikes Integrated Business Learning. To summarize.8m equity). and may not be the appropriate rate to use for evaluating a project proposal if the risk of the project differs from the average risk of the firm.37m. The cost of capital is made up of the cost of debt (eg interest adjusted for tax) and cost of equity (required return on equity). Stewart & Co Page 121 . III n Roughly speaking: Operating Profit . 2001 Reading Finance and Performance Measurement 5.Cost of Equity (implicit required rate of return on equity) The return on equity expected by shareholders (covered in an earlier section).3 ECONOMIC VALUE ADDED (EVA Economic Value Add (EVA) improves on conventional profit measures by deducting the cost of capital.5m debt and $2. Bennett Stewart. as shown (assuming no taxes).000. The cost of equity (rE) is not so easily observed.8m with a required rate of return of 15%. “operating profit less the cost of all the capital employed to produce the earnings” 2. ®52 5. it is calculated from 1. Cost of equity (EVA®) G. Operating Profit excluding interest costs. and the weights (D/V and E/V) should be based on maket values of D and E.000 net effective interest and $420. Mike’s Bikes Integrated Business Learning.Product innovations • Internal .e. 53 See for example: Kaplan. The long-term overall plan is to double sales and production volumes to 30. Norton.S. 5.4m less $0. These measures can also be linked to rewards. “Putting the Balanced Scorecard to Work”.P. remove the protection from the relevant worksheet(s) by choosing Protection\ Unprotect Sheet from the Tools menu. The Balanced Scorecard supplements financial measures with measures of innovation and learning. D. Norton. customer satisfaction and internal performance. Value add 6.. ACCOUNT. It links these upwards to the strategic intent and vision of the company. “Using the Balanced Scorecard as a Strategic Management System”. Note that this level of earned value is very high compared to most real-life examples. 1993. Efficiency • Financial – Revenue. R. Kaplan. Reorders • Innovation . Norton.S. Sept-Oct. Jan-Feb. Second Edition Finance and Performance Measurement © The McGraw−Hill Companies. 2001 Reading MIKE’S BIKES – Integrated Business Learning Online equity). HBR. HBR. R. 1992. A popular methodology for bringing together such measures is the Balanced Scorecard methodology developed by Kaplan 53 and Norton .. through critical success factors (i.S.XLS and FINANCE.. 1996 Page 122 .. while still earning a good profit.XLS. “The Balanced Scorecard .Measures that Drive Performance”. those few aspects of a business that must succeed for the business to succeed) as well as downwards to sub units and to individuals.Delivery time. Unless otherwise advised assume a cost of capital of 11% for all the following questions.P.000 units. Assume also that someone in the firm has put together this spreadsheet model of the SoloMike bike industry. So the value earned by the company above that which would be expected is $1. This allows you to use data tables and add graphs to the sheet. D.XLS found in the directory where you installed SoloMike (usually C:\MikeBike\SoloMike). Copy these workbooks to another directory to use for this assignment. For the purposes of this assignment assume that your firm has decided to “consistently produce a bike that is considered the best value for the Adventurer segment” and the management team is assessing ways of implementing financial areas of this strategy.1 QUANTITATIVE QUESTIONS BASED ON SOLOMIKE The following questions deal with information contained in the workbooks DEVELOP. Kaplan. HBR.4 THE BALANCED SCORECARD Financial measures are just one part of the picture and tend to look more at the past than the future.. 32 Balanced Scorecard Vision/Strategic Intent Critical Success Factors Goals/Measures Rewards Customer Financial Internal Innovation Sub-unit Personal Finance and Performance Measurement Examples of some typical Balanced Scorecard measures would be: • Customer – Satisfaction. Before starting each question. D.. Profit.45m). R. reducing unit costs and being able to lower prices.P. They must be supplemented by other measures for a better indication of future profits. Questions to Assist Learning 6. Jan-Feb.95m ($2. Work out what level of sales volume this corresponds to. b) [Basic] An alternative valuation method is to assume that Real Cool holds the investment in perpetuity. Investment Evaluation . 20012003 are $1. a) [Basic] Many people base their share price estimates solely on the current profit and earnings per share figures. Assume that additional costs for 1999 are $1. The Net Present Value found in the previous question is very impressive (about $11m!). find the value of MountainTop Cycles.Share Valuation The team is considering the likely effect of the long-term strategy on share price.5m (product development. If the required return on equity for MountainTop is 11%. Calculate the Net Present Value of this investment. Investment Evaluation .) Assume that Real Cool purchases all shares for MountainTop Cycles for a final cost of $24m at the beginning of 1999 and that MountainTop pays a dividend at the beginning of each of 1999-2003: $1m in 1999 and growing by 2% for each year following. They look at the performance of the company in the past and adjust for investments made. a) [Basic] Assume that the existing margin is (15. 2000 are $2. Calculate the net present value of this investment between 1999 and 2003.especially when the firm is investing for future profits. Calculate the additional gross margin for 2000-2003 if the sales of the cheaper product are 30. Finally. 2001 Finance and Performance Measurement 1. This question uses the COMPANY SHAREHOLDINGS sheet in the FINANCE workbook.5m. Share Valuation and Company takeover Your management team is considering taking over MountainTop Cycles. Consider the Net Present Value table found at the base of the worksheet in workbook DEVELOP. (Use the table presented at the bottom of the COMPANY SHAREHOLDINGS sheet. the team decides to investigate the benefits of this investment further. the NPV of any investment should always be zero. what is the source of the large NPV figure found in (a)? What would you expect to happen over time? 3. b) [Advanced] Sensitivity Analysis on NPV. The question is whether the current minimum realistic bid of about $24m represents a good purchase or not. How would these people value the shares after Real Cool Cycles posted a lower profit in 1999? (This is essentially how the Mike’s Bikes logic works). How would these people value the shares after Real Cool Cycles posted a lower profit in 1999? b) [Basic] Others realize that short-term blips will occur .NPV. extra depreciation and training). Imagine the sales volumes are 20% less than predicted. Investment Evaluation . Second Edition Finance and Performance Measurement Reading © The McGraw−Hill Companies. How would these people value the shares after Real Cool Cycles posted a lower profit in 1999? Page 123 . Assume that that MountainTop pays a dividend of $1m at the start of 1999 and each year thereafter growing by 2% per annum.NPV and Product Development Given the importance of the prime cost reduction product development project to the overall strategy (see the Product Development section of the manual).25m per year.Mike’s Bikes Integrated Business Learning. However. c) [Basic] Based on these analyses. extra depreciation).000 at $700 and unit prime cost is $225. would you recommend taking over MountainTop Cycles (assuming that you had sufficient cash)? 2. at the beginning of 2004 Real Cool sells all its shares receiving $30m. c) [Integrating] Given that in a perfect market. Then use Goal Seek to find the level of extra margin at which the NPV falls to zero. a) [Basic] As a first cut on determining the value of MountainTop the team considers the classic dividend-based method of valuation where the value of an investment is the present value of the sum of the future dividends.000*($850-$300)) $8. c) [Basic] Still others analyze the company’s strategy and decide whether they think that the strategy will produce good returns in the long-run. there is some uncertainty in the demand forecast. Find the NPV in this case (assume all costs constant).7m (incl quality systems. Implement this dividend policy on the Planning Ahead sheet. 6.000 shares? Enter a dividend pay out of 40% of $2m in cell C19. Find the dividend paid out in 1999 if the Profit After Tax was $2m in 1998. Finance .Dividend policy It would be good to find a consistent dividend policy which will work for the proposed strategy. Create a graph of these figures. copy this formula across cells D79 to G79.EVA The accountant mentions that EVA has become a fashionable measure of company performance. 2001 MIKE’S BIKES – Integrated Business Learning Online 4. Investment valuation .000. and with operations and finance strategies.4m) b) [Advanced] The accountant suggests a slightly more conservative approach of adjusting the previous period’s dividend up or down trending towards a long-term target pay out ratio of 40%.000.1m. This should include pro-formas (forecasted) for the following. What is the dividend per share if there are 2. (2-3pages).000.000.) a) Statement of Financial Performance (Profit and Loss) b) Statement of Financial Position (Balance Sheet) c) Statement of Cash Flows . Enter sales of 30. Construct a draft finance plan for the Mike’s Bikes environment for the next 2 years.7m. It essentially attempts to compare the firm’s earnings with the cost of the capital invested in the firm. and weighted cost of capital as percentages. set cells D19 to G19 to be 40% of the previous year's after tax profit. WACC The accountant mentions that it might be worth investigating different capital structures to see if the cost of capital can be reduced. Assume a dividend paid out in 1999 of $800. capital charge and total cost of capital for a range of debt/equity ratios from 0.000.66m. copy this formula across cells E27 to G27. Roughly what debt/equity ratio corresponds to the minimal cost of capital? Now add the effective cost of debt. a) [Basic] The marketing manager suggests that a certain proportion of the previous period’s earnings be paid out as a dividend each period. $350. with the overall strategy. $2.25. a) [Basic] Use the table provided to calculate the interest charge.000. the management team decides to aim for a debt/equity ratio of about 1. See if you can implement this policy using the raise (repay) LT debt and dividend decisions on the Planning Ahead sheet. b) [Advanced] Why does the EVA fall in 2002 and 2003 even though the profit is rising? What finance decisions could be taken to increase the EVA? 5.8m.Mike’s Bikes Integrated Business Learning. and an adjustment factor of 0. a) Open the PLANNING AHEAD sheet of the ACCOUNT. Set up the PLANNING AHEAD sheet as described in the question e).000.XLS workbook. Consider the capital structure table outlined on the INTEREST sheet of the FINANCE workbook. and enter the following figures. General expenses (cells C55-G55) as $3m. Integrating Finance . What is the dividend in 2003? What is the Retained Earnings at the close of 2003? (Ans: $1. What is the rough minimum weighted average cost of capital? b) [Integrating] Based on the analysis in the previous question.Optimal Capital Structure (Debt/Equity Position). $250.including sources and uses of funds The statement of cash flows should include a description of major investments and critical areas of funding. Change cell C79 to =C48-C78. Page 124 .000 units in cells D22 to G22. What is the dividend in 2003? What would the target dividend for 2003 be? What is the Retained Earnings at the close of 2003? 6.2 to 2.2 QUALITATIVE QUESTIONS (APPLICABLE TO SOLOMIKE OR NETMIKE) 1. equity. (Make sure that you think about consistency among themselves. Next change cells D27 to =D22*400. $500. both the cost of debt and the implied cost of equity being the rate of return required by shareholders.0. Graph these also. Second Edition Finance and Performance Measurement Reading © The McGraw−Hill Companies. He suggests that 40% might be a good proportion. They also want to minimize unused cash by maintaining only about $1m in cash above what it is required to pay tax in the following period. To maintain consistency with the remainder of the sheet go to Depreciation (row 78) in the cashflow section and enter the following approximate depreciation figures (into cells C50-G50) $650. $2. $27. $3. $400.5m. $3. what is the relationship between WAAC and the overall firm value? d) Will you have a dividend policy in Mike’s Bikes? What is this? 7..e. Evaluating Strategies a) Describe a way for evaluating a strategy? b) What are the most difficult parts of doing this in practice? 6. c) Choosing the underwriters. Modifications for NetMike The main difference is that the firm takeovers become more complex when there are 5 firms instead of 2. R. McGraw-Hill.Mike’s Bikes Integrated Business Learning. Debt Policy a) How does the cost of debt alter as the level of debt in the capital structure increase? b) What practically determines the amount of debt that a firm such as Real Cool Cycles should hold? c) How does the desired debt/equity ratio come into this decision? 8. 3. Brealey. b) The advertising that would be carried out. Page 125 . Project Evaluation a) What are the key issues that determine the attractiveness of a new project for a company. 8. b) How will WACC vary with project. Takeovers If you are attempting to purchase other organizations. Second Edition Finance and Performance Measurement Reading © The McGraw−Hill Companies. Equity Issues a) How does the cost of equity alter as the level of debt in the capital structure increase? b) When would a company such as Real Cool Cycles decide to issue equity? c) When should it decide to repurchase equity? 7. 1996. Principles of Corporate Finance.. 2001 Finance and Performance Measurement 2. and Myers. company and industry? 4. References 1. how will you determine which one to purchase (or sell)? 5.A. Construct a draft plan for a share float for the Mike’s Bikes environment (2-3pages). This should describe the process that would be followed including: a) Evaluating the number and price of the shares. Dividend Policy a) What are the key determinants of a dividend policy b) How should this be reflected in the main characteristics of a firm’s dividend policy? c) Does it appear as though there is an optimal capital structure for our firm? What are the major determinants of this? Why is this an important issue (i. C. S.