FINANCE FOR EXECUTIVES Managing for Value Creation

FINANCE FOR EXECUTIVES Managing for Value Creation Gabriel Hawawini Claude Viallet FINANCIAL MANAGEMENT AND VALUE CREATION: AN OVERVIEW

EXHIBIT 1.1: Only Cash Matters to Investors.

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

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

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

EXHIBIT 1.5: The Dual Functions of Financial Markets.

EXHIBIT 1.6: HLC’s Business Cycle.

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

EXHIBIT 1.8a: HLC’s Balance Sheets on Dec. 31, 1996 & 1997.Figures in millions of dollars FROM HLC’s STANDARD BALANCE SHEETS: ASSETS LIABILITIES AND OWNERS’ EQUITY DECEMBER 31 1996 DECEMBER 311997 DECEMBER 311996 DECEMBER 311997 Cash $100 $110 Short-term borrowing $200 $220 Accounts receivable 150 165 Accounts payable 100 110 Inventories 250 275 Long-term debt 300 330 Net fixed assets 600 660 Owners’ equity 500 550 TOTAL $1,100 $1,210 TOTAL $1,100 $1,210

EXHIBIT 1.8b: HLC’s Balance Sheets on Dec. 31, 1996 & 1997.Figures in millions of dollars TO HLC’s MANAGERIAL BALANCE SHEETS: INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED DECEMBER 31 1996 DECEMBER 311997 DECEMBER 311996 DECEMBER 311997 Cash $100 $110 Short-term borrowing $200 $220 Working capitalrequirement (WCR)1 300 330 300 330 Long-term debt Net fixed assets 600 660 Owners’ equity 500 550 TOTAL $1,000 $1,100 TOTAL $1,000 $1,100 1Working capital requirement (WCR) = Accounts receivable + Inventories - Accounts payable

EXHIBIT 1.9: HLC’s Simplified 1997 Income Statement.Figures in millions of dollars Sales $1,000 Less operating expenses ($760) (including $60 of depreciation expenses) Earnings before interest and tax $240 (EBIT) Less interest expenses (8% × $500) (40) Earnings before tax (EBT) $200 Less tax expenses (50% × $200) (100) Earnings after tax (EAT) $100 Retained earnings = $50 Dividend payment = $50

EXHIBIT 1.10a: HLC’s 1997 Cash Flow Statement.Figures in millions of dollars CASH FLOW FROM OPERATING ACTIVITIES Sales $1,000 Less operating expenses (which include depreciation expenses) (760) Less tax expenses (100) Plus depreciation expenses 60 Less cash used to finance the growth of WCR (30) A. NET OPERATING CASH FLOW $170 CASH FLOW FROM INVESTING ACTIVITIES Capital expenditures (120) (120) B. NET CASH FLOW FROM INVESTING ACTIVITIES

D. TOTAL NET CASH FLOW (A + B + C) 10 E. CASH HELD AT THE BEGINNING OF THE YEAR $100 F. CASH HELD AT THE END OF THE YEAR (E + D) $110 EXHIBIT 1.10b: HLC’s 1997 Cash Flow Statement.Figures in millions of dollars CASH FLOWS FROM FINANCING ACTIVITIES New borrowing 50 Interest payments (40) Dividend payments (50) (40) C. NET CASH FLOW FROM FINANCING ACTIVITIES

EXHIBIT 1.11: HLC Income Statement: Impact on EBIT, EBT, and EAT of a 10% Drop or Rise in Sales. Figures in millions of dollars SALES DOWN 10% SALES UP 10% EXPECTED1 Sales $1,000 $900 –10% $1,100 +10% Less variable operating expenses2 (380 ) (342 ) –10% (418 ) +10% Less fixed operating expenses3 (380 ) (380 ) same (380 ) same EBIT (earnings before interest & tax) $240 $178 –26% $302 +26% Less fixed interest expenses (40 ) (40 ) same (40 ) same EBT (earnings before tax) $200 $138 –31% $262 +31% Less variable tax expenses (50%) (100 ) (69 ) –31% (131 ) +31% EAT (earnings after tax) $100 $69 –31% $131 +31% 1 The expected income statement is the same as the one shown in Exhibit 1.9. 2 One half of total operating expenses of $760 in Exhibit 1.9. 3 One half of total operating expenses of $760 in Exhibit 1.9. Note that the $60 of depreciation expenses are fixed and, hence, included in the $380 of fixed operating expenses.

EXHIBIT 1.12: Sources of Risk that Increase Profit Volatility.

FINANCE FOR EXECUTIVES Managing for Value Creation