Chapter 3 Valuation Order Placed Order Received Sale

Chapter 3 Valuation Order Placed Order Received Sale Payment Sent Cash Received Accounts Collection < Inventory > < Receivable > < Float > Time ==> Accounts < Payable > Invoice Received Disbursement < Float > Payment Sent Cash Disbursed Copyright 2005 by Thomson Learning, Inc.

Objectives v Use cash flow timeline and discounting techniques to value future cash flows. v Explain importance for using time value of money in short-term decisions. v Apply the NPV technique to select value-enhancing proposals. v Explain how short-term decisions fit with EVA. v Apply NPV to value changes in the cash conversion period. v Recognize difficulties in selecting appropriate discount rate. Copyright 2005 by Thomson Learning, Inc.

Two Financial Decision-Making Approaches v Financial statement approach v Valuation approach Copyright 2005 by Thomson Learning, Inc.

Financial Statement Approach v Approach – compute incremental revenue and expense effects of proposal – calculate anticipated profit effect v Calculation steps – estimate unit sales and multiply by profit margin – estimate capital costs of additional required investments such as receivables, inventory, etc. – estimate additional bad-debt loss if new credit terms – calculate overall profit effect v Decision criteria – if anticipated profit is >=0, proposal would contribute profit – if anticipated profit is <0, proposal would not contribute profit Copyright 2005 by Thomson Learning, Inc.

Valuation Approach v Approach – accounts for timing of cash flows – accounts for present values – results in making value enhancing decisions v Four steps – determine relevant cash flows – determine timing of cash flows – determine appropriate discount rate – discount cash flows v Decision criteria – if NPV >= 0 invest – if NPV < 0 do not invest Copyright 2005 by Thomson Learning, Inc.

Economic Value Added v Incorporates elements from both financial statement approach and valuation approach v EVA = Operating profit - (Cost of capital)(Capital employed) v Advantage: provides better company-wide understanding of importance of improved working capital management v Caution: can be misused if user does not take a long-term view Copyright 2005 by Thomson Learning, Inc.

NPV Calculations v Simple interest – 1 PV = FV x ---------k (1 + (------) x n) 365 v Compound interest – 1 PV = FV x -------k (1+ -------)n 365 Copyright 2005 by Thomson Learning, Inc.

Basic Valuation Model note: i = k/365. . . . CFo NPV = CFo CF 1 CF 2 CF 3 CFn + ------------- +. . + ------(1 + i x 1) (1 + i x 2) (1 + i x 3) (1 + i x n) Copyright 2005 by Thomson Learning, Inc.

Valuation Using NPV v Solving Digi. View’s financial dilemma Copyright 2005 by Thomson Learning, Inc.

Valuing Changes in the Cash Conversion Period v - Purchase Sale NPVCCP = -------- + --------(1 + i ) DPO (1 + i) DIH + DSO v NPV CCP-Aggregate = NPVCCP x Daily Sales / i v - Purchase Sale NPVCCP = [ ------- - -------- ] ln(1 + i) (1+i)OC-CCPP (1+i)CCPO+DPO Copyright 2005 by Thomson Learning, Inc.

Corporate Cash Holdings and Value v Late 80’s to mid 90’s: keep cash holdings low – long-term cost of funds > return on cash – cash holdings viewed as negative debt v Late 90’s to current: bond rating agencies penalizing for too little liquidity v Current trend: reduce working capital requirements but increased cash holdings v Pinkowitz and Williams (2002): investors mark up stock value $1. 26 per $1 of cash holdings Copyright 2005 by Thomson Learning, Inc.

Choosing the Discount Rate v Three unique problems – funds are rarely raised specifically to fund short-term type projects – short-time horizon implies short-term not long-term rate – risk should be accounted for, but may be ambiguous. v One-shot projects – if net borrower, use short-term borrowing rate – if net investor, use short-term investment rate v Multi-year projects – maybe appropriate to use cost of capital v Formulation – kadj = krf + kavg + k Copyright 2005 by Thomson Learning, Inc.

Summary v Short-term financial decisions can impact firm value by: – – – altering operating cash flows changing the length of the cash conversion cycle changing company risk posture impacting net interest income and by changing accuracy and timeliness of critical information. v Both financial statement approach and valuation offer insight in working-capital management decisions. v Choosing appropriate discount rate is an issue when trying to assess valuation impact. Copyright 2005 by Thomson Learning, Inc.