CREATING SHAREHOLDER VALUE

1. CREATING SHAREHOLDER VALUE Course 101 January 2010 John A. Boquist Edward E. Edwards Professor of Finance Indiana University Kelley School of Business

2. What distinguishes financially successful Rep/Broker firms? Shareholder value is the result of clearly defined strategies with strong financial results. An important part of any strategic plan, financial strategies must be designed for the long term health of the organization. This session involves a briefing and development of such strategies.

3. Objectives • Understand your firm’s financial performance • Understand cash flows • Be able to determine your firm’s value • Sharpen your firm’s strategic plans • Financial Planning • Value creation • Competitive barriers • Projections and budgets • Exit plans

4. Outline • Basic Financial Statements • Income Statement • Balance Sheet • Cash Flow • Tax vs. GAAP vs. Managerial Accounting • Valuation • Reasons for valuations • Methods and Models • Application

5. THE MECHANICS TODAY Balance sheet (beginning of year) Income statement Balance sheet (end of year) Assets Liabilities plus Owners’ equity Revenue less Expenses = Income Assets Liabilities plus Owners’ equity 1 ACCOUNTING CYCE (1 FISCAL YEAR )

6. The Financial Statements • How much did we earn last year? • The Income Statement • Discusses the flow of past events • How much are we worth? • The Balance Sheet • Gives a picture of the corporate financial position • How much cash flow was generated? • Statement of cash flows • Analyzes sources and uses of cash

7. Key concepts in accrual accounting • REVENUE RECOGNITION RULES • Earnings process complete • Revenue known • Amount can be estimated • Collection reasonably assured • EXPENSE RECOGNITION RULES • Match expenses to revenues • Logical, systematic allocation • Amortization over time vs. immediate write-off • IF CASH ACCOUNTING: • Revenue when “received” • Expense when “paid”

8. Statement of cash flows Opening cash balance +/- Cash flow from Operations +/- Cash flow from Investing Activities +/- Cash flow from Financing Activities = Ending cash balance

9. CASH FLOW HOW TO GO BROKE... WHILE MAKING A PROFIT As the year started, Mr. Jones of the ABC Co. was in fine shape. His company made widgets -- just what the consumer wanted. He made them for $.75 each, sold them for $1. He kept a 30-day supply in inventory, paid his bills promptly, and billed his customers 30-day net. Sales were right on target, with the sales manger predicting a steady increase. It felt like his lucky year, and it began this way: Dec. 31 CASH: $1,000 INVENTORY: $750 RECEIVABLES: $1,000 In January, he sold 1,000 widgets; shipped them at a cost of $750; collected his receivables--winding up with a tidy $250 profit and books like this: Jan. 31 CASH: $1,250 INVENTORY: $750 RECEIVABLES: $1,000 This month sales jumped, as predicted, to 1,500. With a corresponding step-up in production to maintain his 30-day inventory, he made 2,000 units at a cost of $1,500. All receivables from January sales were collected. Profit so far: $625. Now his books looked like this: Feb. 28 CASH: $750 INVENTORY: $1,125 RECEIVABLES: $1,500 March sales were even better: 2,000 units. collections: On time. Production, to adhere to his inventory policy: 2,500 units. Operating result for the month: $500 profit. Profit to date: $1,125. His books: Mar. 31 CASH: $375 INVENTORY: $1,500 RECEIVABLES: $2,000 In April, sales jumped another 500 units to 2,500--and Jones patted his sales manager on the back. his customers were paying right on time. Production was pushed to 3,000 units, and the month’s business netted him $625 for a profit to date of $1,750. He took off for Florida before he saw the accountant’s report. Apr. 30 CASH: $125 INVENTORY: $1,875 RECEIVABLES: $2,500 May saw Jones’ company really hitting astride--sales of 3,000 widgets, production of 3,500 and a five-month profit of $2,500. But, suddenly, he got a phone call from his treasurer: “Come home We need money!” His books had caught up with him: May 31 CASH: $000 INVENTORY: $2,250 RECEIVABLES: $3,000 He came home - and hollered for his banker.

10. This example indicates that even successful firms may not neglect their planning responsibilities. Too much growth can spell disaster to the undercapitalized business. A funds flow statement, prepared while Mr. Jones returns from Florida, may point out exactly what has happened. Mr. Jones has made the mistake of paying more attention to his profits than to his liquidity. A simple cash budget based on projected sales could have alerted Mr. Jones to the potential problem before it occurred. For example: Based on this cash budget, then, Mr. Jones would have made arrangements for additional capital before he left for Florida. Notice again the use for which funds flow statements and cash budgets are intended. Funds flow data is provided as a supplement to the financial statements and gives information which is not always readily available from a quick examination of the balance sheet and income statement. Its purpose, then, is in detecting trends after they occur. the cash budget, on the other hand, is a device for future planning. Its prime purpose is to point out problems resulting from too much or too little cash before they occur. Loans are seldom negotiated overnight. ABC Company may lose some profits from their shortsightedness.

11. Sources and Uses of Funds • Income • Revenue • Expense • Profit • Sources of Funds • Profitable operations • Decrease Assets • Increase Liability • Balance Sheet • Assets • Current • Fixed • Liabilities • Owners’ Equity • Uses of Funds • Losses • Increase Assets • Decrease Liabilities Depreciation Retained Earnings

12. The Cash Conversion Cycle Product Sales Inventory Conversion Period Receivables Conversion Period Resource Purchase Cash Received Operating Cycle Cash Conversion Period Payables Conversion Period Cash Outlay

13. Generalized Break-Even Chart

14. Present Value Techniques • The Time Value of Money • Compound Interest • Discount Rate ”k” - Interest Rates -Risk Factors -Opportunity Cost • Future Value Formula • Fn=P (1+k) • Present Value Formula • P= Fn/(1+k) n n

15. Present Value Shortcuts • Annuity Flows • Use of Tables • Use of Calculators • Use of PC’s

16. Valuation of Manufacturer’s Rep Business Terminal Value? $200,000 per Year Annual After-tax Cash Flows $50,000 Execute Now 5 Years 11 Years Economic Life Start-up Expand Growth Required Return = 10% $60,000 $40,000 $100,000

17. Perpetuity Models • No Growth:Value = FCF WACC • Growth:Value = WACC - Growth FCF

18. Valuation Adjustments • Value of Liabilities • Lawsuits • Pensions, etc. • Control Premium • Discount for Lack of Marketability • Prior Comparable Transactions • Multiples of Sales, Earnings, Cash Flow, Book Value • Form of Payment • Cash • Seller Financing

19. Distribution of Value Created • Use a Model of “Economic Value” • Reinvest or Distribute? • Is Value Being Added? • Recipient of Distribution • Owners • Customers • Employees • Capture Value Transferred Upon Exit From Business • Family Members • Employee • Third Party

20. Elements of Industry Structure New Entrants Industry Competitors Our Firm Suppliers Buyers Substitute Services or Products

21. Valuation References • The “Classic” for small, private business valuation: Shannon Pratt; Valuing a Business; Dow Jones-Irwin, 1988. • The “bible” for investment bankers: Copeland, Koller, and Murrin; Valuation; Second Edition; John Wiley, 1996. • The best text solely devoted to the financial management of the small firm: Walker and Pretty; Financial Management of the Small Firm; Prentice-Hall, 1986.