Association of Corporate Counsel Pocket MBA

1. Association of Corporate CounselPocket MBA Finance for Non-Financial Managers Professor Jim Nolen Department of Finance University of Texas at Austin McCombs School of Business September 19, 2013

2. Agenda 1:30-2:45 Overview of the role of finance in the organization Operating Decisions Measuring Performance 2:45–3:00 Break 3:00-4:15 Investing Decisions Treasury Management Working Capital Management Capital Budgeting 4:15-4:30 Break 4:30-5:30 Financing Decisions Capital Structure/Dividend Policy Bankruptcy & restructuring 5:30-6:30 Social Networking & Happy Hour

3. Learning Objectives • To improve the participant’s financial acumen • To gain a better understanding of finance’s role in the organization • Making the Operating, Investing and Financing decisions of the firm • Measuring performance and creating shareholder wealth • Setting the financial strategies of the firm • Setting financial policies and procedures • Establishing financial controls • Managing the firm’s resources • Treasury operations, including cash management • Tax management • Managing the operating and capital budgeting processes • Setting capital structure policy and proper use of leverage, including dividend policy and stock repurchase plans • Managing liquidity, including credit and collections • Financial reporting and forecasting • Working with investor relations to communicate with stakeholders • Risk management, including hedging

4. Who is the Finance Department? • May have professional designations like Chartered Financial Analyst (CFA), Certified Public Accountant (CPA), Certified Management Accountant (CMA) or Certified Treasury Professional • Typical financial titles in firms (depending on size of firm): • Chief Financial Officer (CFO) • Vice-President of Finance • Corporate Treasurer • Chief Accounting Officer (CAO) • Comptroller • Cash Manager • Credit Manager • Risk and Insurance Manager • Manager of International Banking

5. Accounting’s Role • The role of the accounting function is to provide internal and external information about the past performance to company executives and investors • This information is communicated in the financial statements • Balance Sheet • Statement of Shareholders’ Equity • Income Statement • Statement of Cash Flows • Accountants are responsible for reporting, controlling and budgeting activities.

6. Finance’s Role • The role of the finance function is to analyze information about the past to make investment, financing and operating decisions that improve company performance in the future. • Investment Decisions to maximize return and includes: make vs. buy decisions, working capital management, treasury operations and asset acquisitions and divestitures. • Financing Decisions to minimize the cost of capital and includes: debt vs. equity financing, dividend policy, and stock buybacks. • Operating Decisions that improve efficiencies and includes: pricing and product mix, purchasing and supply chain decisions, controlling expenses and risk management.

7. Analytical Processes Examples: Product Profitability Customer Lifetime Value Examples: Compensation Analysis Labor Utilization Analysis Examples: Procurement Analysis Cash Flow Analysis Financial Analytics

8. Financial Controls • Budgeting • In all four types of centers a budget system can provide managers with incentives by • Rewarding them for meeting or exceeding budget goals • Punishing them for failing to meet budget goals • Those goals are: • Investment Center – Return on Investment • Profit Center - Dollars of Net Income or Profit Margin • Revenue Center – Dollars of Revenue, growth rate, or market share • Cost Center – Dollars of Cost, percent of revenues • Agency Costs – Auditing & incentives costs for fiduciary duty compliance • Forecasting can be done top-down or bottom-up • Top Down – TAM, growth rate, market share • Bottom-up – sales by customer, territory, product then rolled-up

9. Maximize Share Value DuPont Analysis Risk (r) Growth (g) Return (ROE) Profitability Efficiency Leverage Operating DecisionsCustomers SuppliersProducts Pricing Marketing Distribution Controlling Expenses Investing DecisionsAsset Mix Terms of Trade Liquidity, Cash Conversion Cycle Plant Utilization, Make or Buy Financing DecisionsDebt-Equity Mix Capital Structure Policy Dividend Policy

10. Operating Decisions • Measuring business performance and benchmarking are important roles of finance to insure goals and objectives are being achieved. • Operating Decisions usually revolve around the Profit and Loss statement. Finance then benchmarks these results against budget/plan (variance analysis) and against peers. • Revenue – Average Selling Price (ASP), pricing, unit volume, product mix, market share, CAGR of sales • Cost of Sales – Outsourcing decisions, tax advantaged manufacturing locations, supply chain management, labor productivity • OPEX – Selling, general and administrative expense control, headcount, lease vs. buy decisions • Interest Expense – amount of debt, type of debt and interest rate. • Tax Management • Earnings Per Share - number of shares outstanding

11. Corporate Counsel’s Role In Operating Decisions • Revenue recognition through the structuring of contracts. • Cost of sales through the negotiation and structuring of purchase contracts and hedging contracts. • Labor Costs through effective management of labor laws and negotiation with collective bargaining agreements • Selling, General and Administration costs through rent negotiations, advertising contracts, compensation agreements and insurance contracts • Managing litigation in a cost effective manner • Interest expense through negotiations on the terms and conditions of debt instruments. • Tax expense though management of tax liabilities and negotiation of tax incentives • Earnings per share through securities regulation and SEC compliance. • Assist in Internal Audit and External Financial Reporting

12. Corporate Counsel’s Role In Investing Decisions • Assistance in collection of accounts receivable • Negotiation of contracts for capital expenditures and real estate transactions • Managing Acquisitions and Divestitures • Monitoring Treasury Investments • Managing IT risks and investments, including domain names and cybersecurity • Protecting and licensing intellectual property

13. Corporate Counsel’s Role In Financing Decisions • Negotiating and structuring debt, mortgage and equity issuances • Compliance with Security Regulations • Monitoring dividend policies • Managing risks, including continuity planning • Maintaining corporate governance and fiduciary duties

14. Measuring Performance

15. Market Value Financial Statements How can I improvethe firm’s ROE and Value? Past PerformanceReturn on EquityGrowthRisk Future PerformanceReturn on EquityGrowthRisk Filtered through: The Economy The Industry The Competition DuPont Analysis Financial Manager

16. Financial Ratios:Key Areas of Performance Measurement Source: Helfert, Erich A., “Techniques of Financial Analysis: A Guide to Value Creation,” 10th Edition, Irwin McGraw Hill, Burr Ridge IL, 2000. • Performance in several key areas must be considered when evaluating a firm’s prospects for the future • Operational analysis • Cost Analysis, Cycle Time, Customer Satisfaction, Quality Metrics • Resource management • Asset Turnover, Days Sales Outstanding, Inventory Turns • Profitability and Productivity • Profit Margins, Sales/Employee, Sales/Sq. Ft. • Investment returns • ROA, ROE, ROIC • Market indicators • Market Share, EPS, P/E Ratio, Price/Sales • Risk Measurements • Liquidity, leverage, and debt service coverage

17. Managers can increase the firm’s value and it return to shareholders: (Return on Assets and Invested Capital can also be used) By increasing Revenue(Profitability/Growth) Increasing Average Selling Price (ASP) and/or Volume (Q) Organic growth vs. acquisition ; New Stores; New Products/Services; New Territories By decreasing Expenses (Profitability) Decrease Avg. Unit Cost (AUC) through Supply Chain Management, Labor Productivity, OPEX control and Scaling Fixed Costs By decreasing Assets (Efficiency) Increasing Cash Conversion Cycle and Plant Utilization By increasing Liabilities (Leverage/Risk – other people’s money) Higher returns come with higher financial risk if ROIC > Cost of Debt Business Performance

18. DuPont Analysis A simple dashboard that captures three of the five value drivers of a company (growth and risk and not fully measured). Profitability on Sales Asset Turnover(Efficiency) FinancialLeverage

19. DuPont Analysis Return on Assets (ROA) Profitability on Sales Asset Turnover (Efficiency) FinancialLeverage Note: The same factors affect ROIC Three-Factor DuPont Analysis

20. St. Jude Medical – 12/31/11 In millions $ Balance Sheet Cash $986 Mkt. Sec. $37 Net Receivables $1,366 Inventory $625 Other Cur. Assets $375 Total Current Assets $3,391 Gross Fixed Assets $2,454 Accum Deprec. ($1,066) P,P&E, net $1,388 Goodwill & Intang. $4,226 Total Assets $9,005 Current Liab. $1,062 Long term Debt $2,713 Other L-T Liab $ 755 Total Liabilities $4,531 S/H Equity $4,475 Liabilities & Equity $9,005 Income Statement Statement of Cash Flows Revenue $5,612 COGS $1,455 Gross Profit $4,157 GPM 74.1% R&D Exp. $705 SG&A (OPEX) $1,979 Depr./Amort. $296 Op. Inc. $1,473 OPM 26.25% Net Int. Exp. ($65) Other Exp. ($31) Taxable Inc. $1,377 Corp. Tax ($193) Post Tax Except. ($249) Net Income $826 NPM 14.7% EPS (fully diluted) $2.52 Adjusted Net Inc. $1,074 Adjusted EPS $3.28 • Net Income $826 • +Deprec. & Amort $296 • + Operating Exp Adj . $110 • +/- Dec/(Inc) in NWC $56 • Net Cash – • Operating Activities $1,288 • Net Cash – • Investing Activities ($337) • Net Cash – • Financing Activities(1) ($465) • Exchange Rate ($8) • Net Change Cash $486 • Begin. Cash $500 • Ending Cash $986 • LT Debt Issue $325 • Debt Repaid ( $78) • Issuance of Common Stk $303 • Repurchase of Stock ($809) • Dividends ($205)

21. DuPont Analysis St. Jude Medical’s Return on Equity Over Time 2006 2007 2008 2009 2010 2011 ROA 11.4% 11.3% 12.3% 12.6% 11.3% 9.5% ROE 18.7% 18.2% 11.5% 23.7% 23.6% 18.7% What happened in 2008 and 2011? Let’s look at the DuPont decomposition. What has been the effect of the stock repurchase program?

22. DuPont Analysis St. Jude Medical FY 06 07 08 09 10 11 ROE 18.7% 18.2% 11.5% 23.7% 23.6% 18.7% Net Profit Margin 16.6% 14.2% 8.1% 16.6% 17.6% 14.7% Turnover 0.7 0.7 0.8 0.8 0.7 0.6 Leverage 1.7 1.82 1.77 1.93 1.96 2.0 Revenue Growth 13.3% 14.4% 15.5%7.3% 10.3% 8.7% Closing Stock Price $36.56 $40.64 $34.27 $36.78 $42.85 $34.48

23. DuPont Analysis St. Jude Medical vs. Its Peers – 2011 FY 2011 STJ MDT BSX JNJ ROE 18.7% 20.2% 3.9% 17.0% Net Profit Margin (1) 13.8% 16.8%6.1% 13.2% Turnover 0.6 0.5 0.4 0.6 Leverage 2.0 1.9 1.9 2.0 (1) Normalized Rev. Growth Rate 8.7%0.7%-2.4% 5.6%

24. STJ vs. Peers – 3 Year Stock Price S&P 500 JNJ MDT STJ BSX

25. Financial Strategies & Value Creation

26. Financial Goals & Strategies • All companies have similar financial goals – namely, to maximize shareholder wealth. • Companies employ different strategies and tactics to achieve this goal. • Some work off maximizing profit margins through differentiation or intellectual property (Software/ Pharmaceuticals) • Some work off scale (Mass Merchandisers) lower margins but more volume and lower selling costs. Others work off scope by selling a broad range of offerings. • Some work off efficient asset utilization (Airlines) – covering fixed costs with “bottoms” in seats. Revenue passenger seat miles. • Some work off leverage (Financial Services) – high debt to equity ratios in banks and insurance companies. • Combinations are possible

27. Financial Strategy • The financial goal (recognizing there are other stakeholders) is to maximize shareholder wealth. • This is accomplished by investing in projects that exceed the firm’s cost of capital (Capital Budgeting) • Cost of capital is a function of risk and opportunity costs • Firms can create value by using its competitive advantage in: • Costs (power over suppliers, business model, OPEX control) • Pricing (power over customers) • Asset Utilization • Access and Cost of Capital • Growth (branding, distribution channels, marcom) • Risk Management (hedging, diversification, leverage)

28. DuPont Analysis • Let’s compare some public companies in different industries • Let’s look at • A Grocery Chain – Whole Foods • A general merchandiser – Wal-Mart • A software company – Microsoft • A computer company – Apple • A pharmaceutical (research) company – Merck • A financial institution – Wells Fargo • An insurance company – Allstate • What would you expect the return on equity to be for each of these companies given the risk of their industry to be able to attract capital? • How do you think they generate their return? Through profit margins, asset efficiency or leverage

29. DuPont Analysis • Averages – Last Five YearsWhole Wal- Wells Foods Mart Microsoft Apple Merck Fargo Allstate ROE 11.52% 21.9% 35.73% 39.24% 15.26% 10.71% 11.57% Profit Margin 2.81%3.67% 27.84%23.4% 17.98% 16.62% 9.54% Turnover 2.45 2.38 0.590.93 0.42 0.0640.27Leverage 1.67 2.51 2.39 1.80 2.02 10.074.49 • Note the different financial strategies the different companies take to produce • a risk adjusted return that allows they to attract capital. • Whole Foods and Wal-Mart works off volume and efficient asset turnover while leveraging their suppliers, but have small profit margins. • Microsoft, Apple and Merck have intellectual property that enables them to • have higher profit margins, but they have relatively low asset turnover (MSFT has $76 Billion and Apple has $137 Billion in cash). • Financial Service companies like Allstate and Wells Fargo have huge asset bases and low turnover but work off other peoples money (leverage). Low investment returns, catastrophic losses, bad loans have affected ROE.

30. Investing Decisions • Investing Decisions – Involves the left side of the balance sheet. • Treasury Management • Working Capital Management • Capital Budgeting

31. Asset Efficiency & Utilization

32. Asset Turnover • Return is increased when sales are increased relative to the investment in assets. • Fixed Assets – Higher utilization of property, plant and equipment. Producing more sales with the same or fewer assets. • Current Assets – Faster turnover of working capital (accounts receivable and inventory) or a reduction in Days Sales Outstanding (DSO) and Days Sales Inventory (DSI). • The risk of loss of sales from capacity constraints or too restrictive working capital polity also increases as the company attempts to turnover the assets faster. • We will take a closer look at the working capital as measured by the firm’s cash conversion cycle. Poor working capital management can create cash flow problems even in a profitable company.

33. Treasury Management • Managing short and medium term cash flow requirements • Cash management and maintenance of liquidity • Safety, liquidity and yield • Handles foreign exchange and currency hedging • Implementation of treasury management system • Interfaces with banking platforms • Operational use of derivatives • Risk Management - Asset and liability management • Commercial Finance activities • E-banking solutions, banking arrangements & facilities/account structures.

34. Working Capital Management • Credit administration & collection • Accounts Receivable terms • Credit and Collections • Days Sales Outstanding • Aging of Receivables • Inventory Management • Ordering vs. Carrying Costs • Just-in-time, LIFO/FIFO • Days Sales Inventory • Accounts Payable • Early Payment Discounts • Days Payable Outstanding

35. Cash Conversion Cycle Accounts Payable Cash Raw Materials Inventory Accounts Receivable Fixed Assets WIP Inventory Finished Goods Inventory

36. Efficiency – Working Capital Days Sales Outstanding Days Sales in Inventory Days Payables Outstanding DSI DSO DPO Purchase Inventory on Account Sell Inventory Collect Receivable Pay Payable Cash Conversion Cycle

37. Cash Conversion Cycle = DSO + DSI – DPO Cash Conversion Cycle • A measure of how effectively a company is using its cash DSO: Days Sales Outstanding • How many days, on average, does it take for customers to pay DSI: Days Sales in Inventory • How many days, on average, does product sit in inventory, waiting to be sold DPO: Days Payables Outstanding • How many days, on average, does a company wait before paying their supplies 45 + 65 – 54 = 56 DSO= 45 Days Avg Accts Receivable/Net Sales*365 DSO + DSI – DPO = CCC DSI=65 Days Average Inventory/COGS*365 DPO= 54 Avg Accounts Payable/COGS*365

38. Capital Budgeting Lawyers don’t have to be seen as sales prevention or deal killers. Corporate Counsel needs to be included earlier in the decision-making process, but must change their “image” to be accepted earlier in the process. Otherwise, they will beg for forgiveness rather than ask for permission. Your legal job is to mitigate risk, which can be value producing activity. However, since there is a risk/return trade-off in business, this is often seen as being counterproductive to people incented by return.

39. Using fact-based analysis to maximize the goals and objectives of the person or organization. What are the Costs (Operating, Capital & Opportunity costs) What are the Benefits (Economic Profits/Free Cash Flow) What are the Risks(Uncertainty/Ambiguity) Over what Time (Time value of money) With each business decision you are involved in, you should ask: How will this decision impact the stated goals of the organization? What other parts of the organization will be impacted by this decision, both negatively and positively? Are there other options that might have better outcomes or less risk. Where is value being created or destroyed in the firm? Common Elements of Decision-Making

40. Investment Decision Making • We said that Finance role is making the investing and financing decisions of the firm. • Investing Decisions • To accept a new project, the project must increase the value of the firm. It must produce a return that exceeds the required return (hurdle rate) based on the riskiness of the project (always?). • Since a firm could have more projects that produce returns that exceed their hurdle rate, financial managers must prioritize which investments should be chosen which produce the greatest value to the firm. • Thus, capital must be allocated and rationed and projects must be ranked. This is called capital budgeting. • Financing Decisions • Once projects have been accepted, the financial manager must decide how to finance the projects which produce the lowest cost of capital.

41. Capital Budgeting • Time Value of Money • Most projects require a substantial investment in CAPEX, OPEX and working capital at the beginning of the project. The project then generates revenues, expenses, income and cash flow over the life of the project. However, future dollars are not worth as much as current dollars (opportunity cost) and thus the cash flows must be adjusted for the time value of money. • Investment Decision –Making Tools • Financial managers have investment decision-making tools which allow them to account for risk, return and the time value of money. These investment decision-making tools include: • Payback Method • Net Present Value • Internal Rate of Return • Profitability Index • and Real Options.

42. Capital Budgeting Issues • Most companies have more projects than they have capital. • To rank projects, managers must estimate: • Initial Investment • CAPEX (plant and equipment) and working capital requirements (inventory, receivables, payables) • Ongoing Investment • As revenues grow, the project may require additions to working capital and additional CAPEX. • Expected Revenues • Expected Expenses (Cost of sales, headcount, OPEX) • The project may have negative cash flows the first few periods which represents OPEX investment) • The investment horizon (usually three to five years) • A terminal value at the end of the project • Capital has a cost • The future benefits and costs must be discounted at the appropriate discount rate. • Hurdle Rate, Opportunity Cost, Weighted Average Cost of Capital

43. Quantitative Tools • How many of the value levers does the project pull? • Growth • Profitability • Economic Profit – Covers Operating and Capital Costs? • EBITDA Margin – Contribute to incremental profit? • Asset Efficiency/Productivity/Capacity Utilization • Leverage – Physical Assets, Capital and Human Resources • Risk – Uncertainty – How do you mitigate. • Once we have estimated the cash flows, (CF - both inflows and outflows) and determined the appropriate discount rate, rt, we simply perform the calculation to determine if the benefits exceed the costs of the project:

44. Project Ideas • How are project ideas generated? • Large scale strategic investments tend to come from top down. • Merger or acquisitions. New products or territories. • Expansion, new equipment and other capital expenditures tend to be generated from the bottom up. • Each business unit or department may generate capital projects needs or ideas. • Projects are usually split into: • Routine repair, replace and maintenance of existing assets (typically a percentage of annual depreciation) • Discretionary/expansion projects – remainder of the capital budget.

45. Project Prioritization • Projects may be prioritized first on a non-financial basis: • Short-term vs. long-term investment horizon – longer term projects need more analysis. • Strategic vs. Non-Strategic (affect a competitor, diversification of risk, solidifies market position, builds barriers to entry, etc.) • High financial impact vs. low financial impact ( immediate or deferred) • Low risk (low marginal investment or costs, evolutionary) vs. high risk project (bet the farm, revolutionary) • Projects which can be deferred without loss of opportunity vs. projects in which delay would cause substantial loss of opportunity. • Synergistic vs. Non-synergistic (impact on existing operations) • Non-financial resource constraints – technology constraints, regulatory, engineering capacity, sales and distribution capacity, etc.) • Market Attractiveness • FIT with the Company’s Business Model

46. Market Attractiveness Factors Market size (TAM) Market growth rate Market profitability Competitive intensity/rivalry Pricing trends Demand variability Opportunity to differentiate Risk of achieving potential returns

47. Fit With Model Factors • Clear linkage between vision, strategic initiatives, tactical plans, financial plan, annual budgets, and operational competency and capacity • Brand Relevancy • Core Competencies • Market share and “managed” growth • Customer loyalty and switching costs • Competitive pricing and cost advantage • Control & influence over hospital and quality of care • Leverage System - Ability to leverage distribution, supply chain, capacity and company networks

48. Classifying Investment OpportunitiesBCG Graph ? High Investing for Long-Term Potential Investing for Future Potential and Immediate Returns (prioritize) Strategic Value Investing for Immediate Returns (Cash Cows) Poor Investments (Dogs) Low Low Immediate Financial Value High

49. BCG Bubble Graph Using NPV

50. Concept Definition Planning & Scheduling Execution & Development Validation Ramp-UP & Phase-Over Production Support Project Evaluation – Narrow the Funnel Two parts to the problem: New Project Ideas For Target Markets 1 2 Front End Risks Back End Risks • Strategy Alignment • Market & Competitive Analysis • Business Case • Product definition • Pick winners • Technology Roadmaps • Product Execution • Abort Losers • Design • Technology • Manufacturing • Product Engineering