Presented by: The Northern Trust Company Elizabeth V. Hasten,CTP

1. Windy City Summit CTP Review Chapter 13 Service Expertise Integrity Presented by: The Northern Trust Company Elizabeth V. Hasten,CTP

2. Chapter 12 Financial Decisions and Management

3. Importance of Finance and Treasury • Objectives for Treasury Professionals • Short-term – to sustain organizations operations • Long-term – to sustain organizations overall financial objectives and mission

4. Importance of Finance and Treasury Financial Objectives for Different Types of Organizations:

5. Importance of Finance and Treasury

6. Importance of Finance and Treasury • Key Capital Financial Decision • Financing Decisions • How much capital to raise outside the company? How fast will organization grow? • Capital Structure Decisions • How much short-term and long-term debt is to be used vs. equity capital? Determine mix with lowest cost with flexibility. • Asset Investment Decisions • Which projects or acquisitions to fund? How much to invest in strategic assets (compete for funding)?

7. Importance of Finance and Treasury Key Capital Financial Decisions • Dividend Decisions • How much dividends should the company pay or not pay and reinvest? Many factors: • Board of directors, in its role as the “voice” of stockholders, decides whether to pay a dividend • Decision is guided by shareholder or, in some cases, analyst expectations • May also depend on a company’s industry, stage of development, dividend payment history and/or covenants

8. Raising and Managing Long-Term Capital • Why Private Placement is preferred over Public Issuance: • Less covenants • Smaller issue size • Reduced time • Minimal reporting requirements or disclosures • IPOs require disclosure of ownership, financial statements, etc… • Lower costs • Of reporting and disclosure • Price can fluctuate due to economy, technology, government regulations or public perception of company • Control over who holds debt

9. Raising and Managing Long-Term Capital • Managing Outstanding Capital • Manage Legal and Payment Requirements • Manage Trustee Relationships • Disbursing Agent • Shareholders – dividends • Bondholders – P&I payments • Other obligations under covenants • Investor Relations • Maintain shareholder lists • Send financial statements, annual reports, other filings • Communicate with share- and bond-holders • Answer investors’ questions

10. Cost of Capital and Firm Value • Primary sources of capital are L-T debt (bonds) and equity (stock and retained earnings) • Cost of Debt: • Relevant cost is After-Tax • Pre-tax cost of bond is Yield to Maturity (YTM), or the rate of return over the bond’s remaining life based on market price when measured. TYM is converted to an after-tax rate using the following equation: • After-Tax rD = rD (1-T) After-Tax rD = After-tax cost of debt rD = Yield to maturity on newly issued debt (before tax) T = Company’s marginal income tax rate

11. Cost of Capital and Firm Value • Cost of Debt example: Marginal tax rate = 30% and a YTM = 5% on a newly issued debt. • After-Tax rD = rD (1-T) • After-Tax rD =.05 (1-0.30) = .035 = 3.5%

12. Cost of Capital and Firm Value • Primary sources of capital are L-T debt (bonds) and equity (stock and retained earnings) • Cost of Common Equity: • CAPM – Capital Asset Pricing Model (Chapter 12) • Cost that applies to equity funds that are obtained through retained earnings. • r E= r RF = (rM – r RF) β rE = Required rate of return on stockholder’s equity rRF = Expected rate of return on the Risk-Free asset (T-Bill) rM = Expected rate of return on the market portfolion (S&P 500) β = Beta value for the company’s stock

13. Cost of Capital and Firm Value Cost of Equity Capital example: Risk Free Rate (T-bill) = 4.0%, return on overall market is 10.0%, beta is 1.2. • r E= r RF = (rM – r RF) β • rE = .04 + (0.10 - 0.04)(1.2) = 0.112 or 11.2% The cost of equity capital is 11.2%, which means that the equityraised through retained earnings costs the company 11.2%, and the stockholders require a rate of return of 11.2% from the company

14. Cost of Capital and Firm Value • Weighted Average Cost of Capital (WACC) • Calculates weighted average of the costs of long-term debt and equity where the weights represent the proportion of each in long-term financing. • WACC = WDrD(1 – T) + WErE WACC = Weighted Average Cost of Capital W = % (weight) of each source of financing in relation to the sum of debt and equity financing D = Debit E= Equity (rD)(1 – T) = After-tax cost of debt rE = Cost of equity (common stock and retained earnings)

15. Cost of Capital and Firm Value WACC example: 1/3 or 33.3% of financing provide by debit and 2/3 or 66.7% provided by equity. • WACC = WDrD(1 – T) + WErE • WACC = 0.333 x 0.05 x (1 – 0.3) + (0.667 x 0.112) = 8.64% The WACC or overall cost of capital is 8.64%, which is an estimate of the market’s expected return for this company.

16. Cost of Capital and Firm Value • Firm Value • Economic value added (EVA) emphasizes a rate of return on assets that exceeds the cost of capital to create shareholder value. Assume that $50,000,000 of capital is employed, the company generated an operating profit of $6,800,000, and WACC is 8.64%. • EVA = EBIT (1 – Tax Rate) – (WACC)(Long-Term Debt + Equity) • = $6,800,000(1 – 0.30) – (.0864)($50,000,000) • = $4,760,000 - $4,320,000 = $440,000 Positive EVA will cause share price to increase .

17. Debt Financing and Management • Costs of Borrowing • Interest expense • Credit enhancements (guarantees or letters of credit) • Rating agency fees • Legal fees • Commitment and facility fees • Broker/Dealer fees • Monitoring, negotiating (soft $ cost), and maintaining loan covenants

18. Debt Financing and Management

19. Debt Financing and Management • Base Rates • Economic conditions and yield curves (Ch 11) impact base rates • LIBOR – London Interbank Offer Rate • Fed Funds (Federal Reserve) Rate • Prime Rate • Short- vs. Long-Term Borrowing • Risks of Short-Term Borrowing • Fluctuation of rates – companies use derivatives to reduce risk (Long-Term Borrowing uses fixed rates) • Availability of funds – may not always be available from lenders – mitigated by using multi-year lines of credit

20. Debt Financing and Management • Advantages of Short-Term Borrowing: • Ease of access: • No Fed reserve requirements < 365 days • Less-restrictive covenants • Flexibility for future borrowing • Ability to finance seasonal credit needs efficiently • Can be obtained from spontaneous sources: • A/P • Accrued expenses

21. Debt Financing and Management • Disadvantages of Short-Term Borrowing: • Continuing need to roll over financing • Lender may not renew: • Changes in financial variables in the firm • Changes in general economic conditions • Clean-up periods on lines of credit • Downsides to secured borrowing: • Asset monitoring • Asset key ratios • Limited to percentage of asset value

22. Debt Financing and Management • Loan Agreements and Covenants • Impose restrictions (covenants) or obligations on management, which have an impact on decision making • Restrictions could include: • Ability to sell certain assets • Right of an organization to issue additional bonds • Use of second or junior mortgages • Key ratios that limit flexibility in financial decision making • Payment of dividends

23. Debt Financing and Management • Credit Rating Agencies • National Recognized Statistical Rating Organizations (NRSRO) ratings are not investment recommendations but an assessment of the potential downside loss. • Generally have access to firm’s internal information (widely accepted). • Dodd-Frank Act rating agency changes: • Rating agencies must provide greater disclosure of rating models and methodologies. • Subject to greater liability. • SEC given two years to eliminate conflicts of interest between rating agencies and the organizations they regulate. • Classes: • Issuer – Issuer’s overall capacity to meet financial obligations • Issue-Specific – Consider the specific terms of the issue

24. Debt Financing and Management • Ratings Process – quantitative and qualitative analysis • Reviews of Ratings – usually once per year • Credit Rating Scales • Scales used for bonds recognized by SEC • Short-Term credit uses different system since Long-Term debt has more variables that affect ratings • Long-Term Bond Credit Ratings (page 491) • Short-Term Credit Ratings (page 492)

25. Lease Financing and Management • Capital Asset Acquisition process: • Acquisition - capital budget decision already made prior to leasing decision • Finance - borrowing or leasing • Why Companies Lease - • Lessor receives lease payments from lessee; both get a tax benefit • Direct substitute for debt • Good for when there is a high uncertainty for future demand or for items outside firm’s area of expertise

26. Lease Financing and Management • Types of Leases • Sale and leaseback • Give company cash infusion • For companies that cannot take advantage of depreciation tax benefits • Operating or service leases • Lessor maintains, retains asset at end • Often OBSA • Shorter duration than life of asset • Capital Asset Acquisition process: • Acquisition - capital budget decision already made prior to leasing decision • Finance - borrowing or leasing

27. Lease Financing and Management • Capital or financial leases • Alternative to borrowing funds and purchasing asset • Residual value is estimated value at end of lease (lessee maintains asset and pays taxes and insurance) • Double-net lease (triple-net in real estate) • ASC Codificaiton Topic 840-10-15: restate company’s balance sheet (leased asset as fixed asset, lease payments as liability • Leases meeting any one of the following four conditions must be classified as a capital lease: • The length of the lease is at least 75% of the estimated useful life of the asset. • There is a transfer of ownership to the lessee at the end of the lease. • The lease agreement contains a provision that allows the lessee to purchase the asset per a bargain purchase option during or at the end of the lease’s life. • The present value of the discounted lease payments at the beginning of the lease term exceeds 90% of the asset’s fair market value.

28. Lease Financing and Management • Estimated Residual Value • Sale and leaseback • Lessor has primary claim on an asset’s residual value. • Residual value is built in to most lease arrangements, and potentially high residual value can lower lease payments. • Residual value may impact a lease’s tax status and requirements for listing as an Off-Balance Sheet Arrangement (OBSA) • Assumed residual value is important because the lease may require payment of the difference between this amount and actual residual value (e.g., tied to mileage or general condition of a vehicle) • Tax Considerations for U.S. Corporations • Lease vs. Borrow-and-Buy • Based on comparing the costs of leasing with the costs of borrowing to buy the asset • Net present value of cash flows for each alternative

29. Equity Financing and Management • IPO • Advantages • Diversification and increased liquidity • Establishing the value of a closely held company • Spin off a subsidiary • Disadvantages • SEC disclosure • Loss of managerial flexibility • Surrender of some control • Other factors: • Smaller company stocks may not be especially liquid. • Small market/infrequent trading leads to undervalued stock. • Increased reporting and disclosure (debt rating).

30. Equity Financing and Management • The Decision to List Stock • Advantages • Primary advantage: increased marketability of stock. • Increased public exposure causes higher sales. • Increased level of disclosure may lower WACC on a company’s common stock and bonds, increasing the firm’s market value. • Disadvantages • Additional requirements keep some companies in OTC market. • OTC liquidity has increased since 1990s (e.g., NASDAQ). • Some smaller companies voluntarily delist rather than comply with disclosure requirements of SOX. • Delisting – may still be traded on the OTC market • Exchanges – requirements for various exchanges

31. Equity Financing and Management • Shareholder Rights • Control of Company • Cumulative Voting - # of votes per share as open posts on board • Proxy • Assigning another individual, trough a proxy, the right to vote at the annual meeting • Staggered Election of Directors • Makes it difficult to take over the entire board • Preemptive Right • Existing shareholders have first right to purchase shares of any new stock issue on a pro-rata basis based on the number of shares owned

32. Equity Financing and Management • Financing Mergers and Acquisitions • Merger • Two companies combine and one ceases to exist • Consensual • Acquisition • One company buys majority voting shares of another • Friendly – stock transfer or asset purchase • Bidding company informs board of intent • If rejected, bidder may take case directly to shareholders • Hostile – lack of due diligence • Direct tender to shareholders (usually a premium) • Proxy fight • Creeping tender offer

33. Equity Financing and Management • Stock Transfer • Exchange of stock of companies • May pay cash to shareholders of acquired firm • Acquiring firm owns other’s assets and assumes liabilities • Asset Purchase • Acquiring firm may buy some or all of the assets • May selectively assume liabilities • Cash Payment • Cash from either company • Sale of assets • Issuance of bonds – investment or junk • LBO – Leveraged Buy Out • Small group of investors purchases a firm using large amounts of debt; results in a high debt (i.e., leverage) ratio.

34. Other Topics in Financial Decisions • Tax Strategies • International businesses need global tax strategy to avoid unfavorable tax consequences, such as: • Double taxes • Balancing home country and foreign tax considerations • Working in countries without an international tax treaty network • Widespread and complex international transfer pricing rules: • Strict arm’s length • Understand both home country and foreign transfer rules • Deemed dividends • Solid tax strategy requires understanding firm’s: • Business and financial position • International operating strategy • Intended areas of operation outside the U.S.

35. Other Topics in Financial Decisions • Impact of a Financial and Credit Crisis • Impact on Financial Institutions • Crisis creates liquidity problems due to asset/ liability mismatch (long-term assets financed with short-term funds). • Governments provide liquidity infusion. • Systemic risks. • Tightening of Credit Markets • FIs revalue portfolios → FIs reinforce capital base, tighten lending standards, reduce lending → corporate ratings decline → non-bank, short-term lending markets reduced. • Increased Awareness of Financial Risk • FIs revalue portfolios → FIs reinforce capital base, tighten lending standards, reduce lending → corporate ratings decline → non-bank, short-term lending markets reduced. • Market Analysis and Research Tools