Finance Fundamentals

Finance Fundamentals Fundamentals of Business Workshop 2006 Professor David J. Denis

What is Finance? • Branch of economics • Economics – allocation of scarce resources • Finance – resource = capital

Two fundamental questions in financial management • On what projects should funds be spent? (investment decisions) • From where should the funds be obtained? (financing decisions)

Topics to be Covered A. Financial planning • · Projection of future cash flows • · Need for capital • B. Valuation • · How much is company worth? • · How much equity must be given up to raise required capital? • C. Sources of funding for entrepreneurs • · Where do we get the required capital? • · On what terms?

Topic I. Financial Planning • Example: “How to go broke…while making a profit” • What happened? • Increased sales lead to increases in receivables and greater expenditures on inventory. Because inventory is paid for right away and must be purchased in advance of sales, there is a net drain on cash. • How can this be avoided? Construct a financial plan that integrates production plans (inventory), marketing plans (e.g. sales and credit terms), financing plans.

Components of financial plan • Pro-forma financial statements • Income statement • Balance Sheet • Outcomes • Capital needs • Future cash flows

Generic Income Statement Sales - Cost of Goods Sold - Selling and Administrative Expenses - Depreciation - Interest -Research and Development Expenses = Earnings before tax (EBT) - Taxes = Net Income (NI)

Assets Cash Accounts Receivable Inventory Property, Plant, Equipment Total Assets Liabilities and Owner’s Equity Accounts payable Wages payable Short-term debt Long-term debt Common stock Retained earnings Total Liabilities and Owners Equity Generic Balance Sheet

Pro-forma financial statements • Always begin with sales forecast • Project expenses – often a % of sales • Forecast changes in asset and liability accounts

Topic II. Valuation Question: How much of the company’s equity will the entrepreneur have to give up in order to raise required amount of capital? • Depends on the value of the stream of uncertain future cash flows • need a technique for valuation

Three primary techniques • Discounted cash flow (DCF) • Market multiples • Venture capital method

Discounted cash flow · Time value of money What is the present value of $100 to be received next year? PV = CFt/(1+r)t If r = 10%, PV = 100/(1+0.1) = $90.91 What is r? Required rate of return – usually 40-60% in VC situations

Market Multiples • Apply valuation ratio of comparable firm to firm being valued. • Examples: P-E, market value/book value, Market value/ Sales • Problems: • What is the appropriate multiplier? • Start-ups frequently do not have positive earnings, may not yet be generating sales, and have few assets.

Venture Capital Method • Effectively combines the previous two methods. Commonly used in the private equity industry. • · Project value at some point in the future using some sort of multiple • · Discount that value to the present • · Discount rate is more ad hoc – but usually high (40-75%).

Topic III. Sources of Capital • Debt • Equity • Angels • Venture Capitalists • Strategic partners

Two Fundamental Problems • Information asymmetry ·Entrepreneur has better information than investor • Moral hazard ·Entrepreneur has incentive to mislead investors

Solutions • Monitor/reduce asymmetry • ·Angels typically know the entrepreneur • · VCs demand oversight role • Discount the value of the company • Contractual terms of financing agreement

Terms of Financing Agreement • Convertibles • Staged financing • Put features • Right of first refusal

Finance Fundamentals