Title: GEB4111 Section Three Managing Assets to Create Opportunity
1GEB4111 Section ThreeManaging Assetsto Create
Opportunity
2AssetsInventory andOperations Management
3- Objectives
- Learn how to manage short-term assets
- Determine the value of assets in your business
- Master managing fixed assets
- Understand how to capitalize investment decisions
- Recognize the advantages of renting or leasing
capital equipment - Understand how to manage and improve the
operations of your business
16-3
4- Question
- Money that is owed to your business by your
customers is called - a) Accounts payable
- b) Accounts receivable
- c) Credit extension
- d) Lender equity
16-4
5- Managing Short-term Assets
- Accounts receivable money that is owed to your
business by your customers - Relatively few small businesses today provide
credit to customers
16-5
6- Pros and cons of offering credit to your
customers - Providing credit usually results in higher sales
revenue because of increased repeat business - Reduces cost of selling
- Credit delays receipt of cash
- Must replace the missing cash
- Sooner or later a customer will not pay
16-6
7- Managing accounts receivable
- Must establish and enforce efficient and
effective policies and procedures for extending
credit - Minimize the time that passes between credit sale
and when the cash is received - Keep number of bad accounts as low as possible
16-7
8- Using accounts receivable as a source of
financing - Use your receivables in two ways to quickly lay
your hands on cash - Pledge receivables as collateral for a commercial
loan - You can sell your receivables to a finance
company in a process called factoring
16-8
9- Example
- Offering Credit to New Customers
- How do I determine if a customer is creditworthy?
- Three things you can do to make sure you don't
get burned - Check credit references
- Learn more from the major credit bureaus
- Consider products and services from DB (Dun and
Bradstreet)
16-9
http//www.entrepreneur.com/money/paymentsandcolle
ctions/offeringcredit/article79956.html
10- Managing Inventory
- Determine the appropriate level of inventory
- Right amount of inventory is determined by
- Cost of processing an order
- Cost of keeping merchandise in inventory
- Cost of lost sales if you run out
- Time it takes to receive inventory after its
ordered
16-10
11Inventory Costs
16-11
1216-12
13- Question
- Recording the receipt and sale of each item as
it occurs is called - a) Perpetual Inventory
- b) Periodic Inventory
- c) Just-In-Time Inventory
- d) Point-of-Sale Systems
16-13
14- Scheduling ordering and receipt of inventory
- Need to know when to place each order
- Deciding when to place an order
- Rate of sales
- Time required to receive new stock
- Just-in-time inventory systems
- Cost of owning and holding inventory is far
greater than the cost of ordering inventory - Most businesses try to acquire and keep on hand
the minimum amount of inventory possible
16-14
15- Just-in-time inventory attempts to reduce
inventory levels to absolute minimum - Accepting inventory only as it is sold
- Assembling product in the absolute minimum time
possible - Shipping product to customer immediately upon
completion
16-15
16- Example
- Controlling Your Inventory
- I yo-yo between having too much of my product in
stock and not enough. How can I find a better
system for controlling my inventory? - Depends on how big your operation is
- Numerous inventory software programs that
specialize in keeping track of inventory and the
costs that go with them - Many companies employ whats called a
just-in-time inventory strategy, in which they
have a solid relationship with a supplier who can
fill inventory needs virtually as fast as youre
filling orders
16-16
http//www.entrepreneur.com/management/answerdesk/
article168406.html
17- Other approaches to inventory control
- Periodic inventory process of physically
counting business assets on a set schedule - Perpetual inventory recording the receipt and
sale of each item as it occurs - Provide you with instant access to accurate
inventory - Bar coding used to reduce cost of perpetual inv.
- UPC registered and controlled privately unique
to each product
16-17
18- Other approaches to inventory control
- Point-of-sale systems recently become
inexpensive enough to be used by small businesses - May acquire complete systems, including a cash
drawer, credit card scanner, computer, monitor,
and software for less than 2,000
16-18
19- Value of Assets in Your Business
- Value of assets in your business far exceeds the
value that you might realize if you were to sell
them - Determining the value of your operating assets
- Value of operating assets is a function of
utility - Utility net cash inflows the asset will produce
16-19
20- Question
- Method of estimating asset value by calculating
the net amount that you would realize were you to
sell the asset in an arms-length transaction
is called - a) Book Value
- b) Replacement Value
- c) Fair Market Value
- d) Disposal Value
16-20
21- Four accounting methods to value capital assets
cont. - Book value accounting residual that is the
difference between the original acquisition cost
of capital assets and the amount of depreciation
expense that has been recognized for them - Depreciation is not any measure of the
consumption through use of an assets value
16-21
22- Four accounting methods to value capital assets
cont. - Book value
- Depreciation is based on three assumptions
- Asset has a fixed, determinable period of utility
- Asset has a fixed, determinable value that will
exist when the depreciation process is complete - The value of the asset will decline in a
continuous and predictable manner
16-22
23- Four accounting methods to value capital assets
cont. - Disposal value method of estimating asset value
by calculating the net amount that you would
realize were you to sell the asset in an
arms-length transaction
16-23
24- Four accounting methods to value capital assets
cont. - Replacement value value of a currently owned
capital asset by determining the cost that would
be incurred to replace it with an identical asset - Fair market value an attempt to determine the
price that the asset would bring, in its current
location and condition
16-24
25- Determining the value of inventory
- Value that you assign to inventory sold
- Amount of profit that you recognize
- Value of your business
- Begins with knowing how much of what you are
holding - Assign a high value to inventory
- Increase amount deducted for COGS, which results
in decreased sale margin
16-25
26- Property, Plant, and Equipment
- Property, plant, and equipment are likely of
relatively minor importance to your success - Capital assets cause you to incur costs over
time - Cost of acquiring the asset includes interest on
funds borrowed and the opportunity costs of funds
invested to acquire it include insurance on the
asset, property taxes, and value of the space
16-26
27- Capital assets cause you to incur costs over
time cont. - Costs of owning an asset interest on funds
borrowed and the opportunity costs of funds
invested to acquire it - Costs of operating the asset energy the asset
consumes, maintenance, and loss of economic value
resulting from wear and obsolescence - Costs of disposition value of activities
necessary to get rid of the asset include
meeting environmental regulations, disassembly,
advertising, commissions, shipping, insurance,
and fees
16-27
28- Capital Budgeting Decision
- Small businesses begin to make investment
choices - Capital budgeting process of deciding among
various investment opportunities to create a
specific spending plan - Two most commonly used financial ratios
- Payback period
- Return on investment (ROI)
16-28
29- Payback period statement of how much time must
pass before your business receives back the same
number of dollars in cash flow as you must pay
out to obtain a capital asset
16-29
30- Payback period
- Two decision rules are applied
- Accept only those alternatives for which the time
required to recoup the original investment is
equal to or less than a maximum allowable time
determined by management - Accept the alternative with the shortest payback
period among those that meet the first criterion
16-30
31- Payback period
- Primary disadvantages
- It disregards the time value of money
- It disregards all cash flows that occur after the
payback period - Often result in managers making suboptimal
investment decisions
16-31
32- Rate of return on investment (ROI) measure of
the relationship between the initial investment
and the profits that are expected to be received
from making the investment
16-32
33- Rate on return of investment
- Two decision rules are applied
- Accept only those alternatives for which the
return on investment is equal to or greater than
the businesss weighted average cost of capital - Accept the alternative with higher ROI among
those that meet the first criterion
16-33
34- Rate on return of investment
- Two advantages
- Easy to calculate
- It relies on accounting information with which
business owners, lenders, and investors are
comfortable - Two disadvantages
- Profits are not the same as cash
- Method ignores time value of money
16-34
35- Rent or Buy
- Renting
- Provides two advantages
- Exact amount and timing of cash outflows is
specified - Outflows funds being paid to others by the firm
- Renting provides a fall-back position
16-35
36- Renting cont.
- Provides three disadvantages
- You do not have an ownership position
- Rental requires that you make regular, timely
payments - Number of dollars paid in rent usually exceeds
the number of dollars you would spend to own the
asset
16-36
37- Financing with leases two basic types
- Operating leases similar to renting ownership
of the asset never passes to the lessee - Capital leases essentially the same as buying
the asset - Primary disadvantage is that leasing costs more
than would purchasing - Leased assets are usually subject to numerous
restrictions
16-37
38- Fractional ownership and other forms of joint
ventures - Little used method of reducing the costs is joint
venturing - Simply a formalized partnership
- Makes economic sense when each party has limited
use of an expensive asset - Relatively common among small businesses in
ownership of airplanes
16-38
39Raising Capital
40Sources of Financing
- Financing can be obtained from numerous sources,
including - Acquisition of Debt
- Distribution of Equity
- Earnings from Operations
- Interest from Investments
- Relationships with Customers
- Efficient use of Assets
41Sources of Financing
42Value of Capital Investment to Entrepreneurs -
1995
- Commercial Banks - 179 billion
- Venture Banks 96 Billion
- Angels - 30 Billion
- Venture Capitalists - 10 Billion
- Other - 20 Billion
- Total - 335 Billion
43Five Cs of Credit
- Capacity to repay most critical
- Capital money you personally have personally
invested in business indication of extent of
personal risk if business fails - Collateral additional forms of security or
guarantees provided to lender - Conditions focus on the intended purpose of the
loan - Character general impression you make on the
potential lender or investor
44The Entrepreneur as Collateral
- The quality of management is the top factor in
the success of the investment - The CEO represents about 80 of the variance in
the outcome of the transaction - Investors need to trust the management team
45The ABCs of Entrepreneurial Investment
- Type A Entrepreneur has experience as a
business owner and experience in the industry
Best Investment Choice - Type B - Entrepreneur either has experience as a
business owner or experience in the industry, but
not both Average Risk Investment Choice - Type C - Entrepreneur has no experience as a
business owner and no experience in the industry
High Risk Investment Choice
46Valuation
47Importance of Measuring Valuation
- Valuation is very difficult to quantify
- Valuation can never be done in a vacuum
- Valuation is always ambiguous (at best)
- Valuation is more of an art than a science
- Valuation is ultimately determined by the
marketplace - Valuation should be recalibrated annually
48Annual Recalibration of Value
- If you dont do it, someone else will
- Never underestimate the ability for the
marketplace to act in its own self-interest - The value of a business changes over time
49Pre-Money and Post-Money Valuation
- Pre-Money Valuation
- present value of a venture prior to a new money
investment - Post-Money Valuation
- pre-money valuation of a venture plus money
injected by new investors - Both the investor and the company have to agree
on which view is correct - At the end of an investment round, the post-money
valuation becomes the pre-money valuation for the
next round
50Why Value the Company?
- To determine the sale price for the company
- To determine how much equity to give up for
partnership agreements - To determine how much equity to give up for
investor capital - To know where you stand relative to competitors
51How Much Equity to give up?
- Should be based on the theoretical value of the
company at some future point in time - Should allow the company to retain not just
mathematical control (51), but rather strategic
control of future decisions - Should be based on the need to fund for growth
rather than funding for survival
52What is a Venture Theoretically Worth?
- Present value (PV) value today of all future
cash flows discounted to the present at the
investors required rate of return - Investors pay for the future entrepreneurs pay
for the past. - If you dont make up the numbers, its not a
valuation.
53Basic Mechanics Of Valuation
- Discounted cash flow (DCF)
- valuation approach involving discounting future
cash flows for risk and delay - Explicit forecast period
- two- to ten-year period in which the ventures
financial statements are explicitly forecast - Terminal (or horizon) value
- value of the venture at the end of the explicit
forecast period - Stepping stone year
- first year after the explicit forecast period
54Useful Terms
- Capitalization (cap) Rate
- spread between the discount rate and the growth
rate of cash flow in terminal value period - Reversion value
- present value of the terminal value
- Net Present Value (NPV)
- present value of a set of future flows plus the
current undiscounted flow - Required Cash
- amount of cash needed to cover a ventures
day-to-day operations - Surplus Cash
- cash remaining after required cash, all
operating expenses, and reinvestments are made
55Key Factors Influencing Valuation
- Cash flow history and projections
- Who is doing the valuation
- Is the company private or public
- The availability of capital
- Is the investment strategic or financial
- The stage of the companys development
- The state of the economy
- The reason the company is being valued
- Tangible and intangible assets
- The state of the industry
- The quality of the Management Team
- Projected Performance
56Cash Flow Status
- The value of a company is driven by both present
and projected future cash flow - Value comes from positive cash flow
- The timing of when you measure cash flow can
significantly affect valuation - Todays cash flows are real, tomorrow s are only
a guess - Tomorrows cash flow projections can result in a
higher (and not necessarily legitimate) valuation
57Who is Valuing the Company
- The Seller wants the pre-money valuation to be as
high as possible - The Buyer wants the pre-money valuation to be as
low as possible - Ultimately, the desired outcome is to give the
investor his desired return while keeping the
entrepreneur happy and motivated
58Is the Company Public or Private
- Two companies of similar age, operating in the
same industry, producing the exact same products
or services,achieving the same level of revenue,
profits, and growth rates, will have
significantly different values if one is publicly
traded and the other is privately owned. - A public company will always have a greater value
than a private one often by 15-20
59Public vs. Private Whats the Difference?
- Public companies are required to disclose all
details regarding the companys financial
condition providing potential investors with
more information. Private companies do not have
to disclose anything that they dont want to
disclose. - Investors in public companies have a ready market
to by and sell shares of stock. Private companies
can only sell to sophisticated investors.
60Availability of Capital
- 80 of bank loans are for less than 1 million
- 80 of all private placements were for 10 to
100 million - 80 of all bond offerings were for 100 to 500
million.
61Availability of Capital
- Bank loans were usually for less than a year.
Term loans (50) privately placed were for seven
to fifteen years. 70 of bonds were over ten
years to maturity. - With small loans, collateral is very important.
As the size of the loan increases, and the
information problems decrease, collateral
becomes less important. Then Cash Flow takes
over.
62Strategic or Financial Buyer
- Strategic Buyers Corporations that are
acquiring companies to add to their core
competencies have historically valued companies
at higher prices than Financial buyers - Financial buyers entrepreneurs with financial
backing from LBOs, and other private sources
are willing to pay more because they are
interested more in a long term rate-of-return,
than on a strategic fit
63Speculation
- Speculative buyers are looking for all of their
value from future projected performance of the
company, based on the companys perceived ability
to ride the crest of the next great wave in the
industry - All one has to do to understand the risk
associated with speculative buying is to look at
the current state of the mortgage market.
64Stage of Company Development
- The earlier the stage of a company, the lower its
value - High risk of failure
- Lack of cash flow
- Lack of customers
- Capital comes (or should come) mostly from
personal sources, family, friends, and fools - Equity funding puts all of the leverage on the
side of the investors, and the founder loses
control
65State of the Economy
- Economic conditions, both domestic and
international, can dramatically affect the
valuation of a company - The economy affects the availability of capital,
which in turn affects the value of companies - A strong economy translates into an increase in
investor capital, which raises potential value - A weak economy translates into a reduction in
investor capital, which reduces potential value
66Other Valuation Issues
- Reason for selling
- Tangible and intangible assets
- Type of industry
- Quality of management Team
67Cash Flow Valuation Options
- Multiple of Cash Flow
- Historically 3-10x EBITA
- Higher for high growth industries
- Higher for strong management
- Lower for low growth industries
- Lower for riskier ventures
- Multiple of Free Cash Flow
- More conservative approach
- Common for manufacturing companies
- Free cash Flow EBITA - CapEx
- Multiple of Sales
- Even more conservative, since sales growth cant
be accurately predicted - Historically 1.5-2x revenues
68Cash Flow Valuation Options (Cont.)
- P/E method
- Compares company to similar publicly traded
companies - Multiple of Gross Margin
- Most conservative approach, since margins are not
entirely under the companys control - Historically, never higher than 2x Gross Margin
69The Art and Craft of Valuation
- The entrepreneurs world of finance is very
different from corporate finance of public
companies. - The private capital world of entrepreneurial
finance is more volatile, more imperfect, and
less accessible than capital markets. - The sources of capital are different.
- The companies are much younger and the
environment more rapidly changing. - Cash is king, and liquidity and timing are
everything. - The determination of a companys value is
elusive.
70What Is a Company Worth?
- It all dependsthe market for private companies
is very imperfect. - Determinants of Value.
- The criteria and methods used to value companies
traded publicly have severe limitations. - The ingredients to the entrepreneurial valuation
are cash, time, and risk. - Long-Term Value Creation versus Quarterly
Earnings. - An entrepreneurs core mission is to build the
best company possible. - Building long-term value is more important than
maximizing quarterly earnings.
71What Is a Company Worth?
- Psychological Factors Determining Value.
- At market peaks, price/earnings have exceeded 20
times earnings. - During the dot.com bubble from 1999 to early
2000, valuations were more extreme. - Behind this is a psychological wave, a
combination of euphoric enthusiasm exacerbated by
greed and fear of missing the run up.
72What Is a Company Worth?
- A Theoretical Perspective Establishing
Boundaries and Ranges Rather Than Calculating
Number. - There are at least a dozen different ways of
determining the value of a private company. - It can be a mistake to approach valuation in
hopes of arriving at a single number. - It is more realistic to set a range of values
within which the buyer and the seller need to
negotiate.
73What Is a Company Worth?
- Investors Required Rate of Return (IRR).
- Various investors will require a different rate
of return (ROR) for investments in different
stages of development. - Factors underlying the required ROR include
premium for systemic risk, illiquidity, and value
added. - Investors Required Share of Ownership.
- The rate of return required by the investor
determines the investors required share of the
ownership. - Text Exhibit 14.2 illustrates this calculation.
- By changing any of the key variables, the results
will change accordingly.
74The Theory of Company Pricing
- The capital market food chain depicts the
evolution of a company from its idea stage
through an initial public offering (IPO.) - The appetite of the various sources of capital
vary by company size, stage, and amount of money
invested. - Entrepreneurs who understand the food chain are
better prepared to target fund-raising strategies.
75The Reality of Company Pricing
- The venture capital industry has exploded in the
past 25 years. - Current market conditions, deal flow, and
relative bargaining power influence the actual
deal. - The dot.com implosion led to much lower values
for private companies.
76The Reality of Company Pricing
- Improved Valuations by 2005.
- Both the number of deals and average investment
per deal were slowly increasing by 2005. - Valuations were rising and the punishing
cramdown rounds with severe preferential returns
had become the exception rather than the norm.
77Valuation Methods
- The Venture Capital Method.
- is appropriate for investments in a company with
negative cash flows at the time of the
investment, but which anticipates significant
earnings in a number of years. - Venture capitalists are the most likely investors
to participate in this type of investment. - The steps involved are
- Estimate the companys net income in a number of
years. - Determine the appropriate price-to-earnings
ratio, or P/E ratio. - Calculate the projected terminal value by
multiplying net income and the P/E ratio. - The terminal value can then be discounted to find
the present value of the investment. - To determine the investors required percentage
of ownership, the initial investment is divided
by the estimated present value. - Finally, the number of shares and the share price
must be calculated.
78Valuation Methods
- The Fundamental Method is simply the present
value of the future earnings stream. - Discounted Cash Flow.
- In a simple discounted cash flow method, three
periods are defined - Years 1-5.
- Years 6-10.
- Year 11 to infinity.
- The necessary operating assumptions are initial
sales, growth rates, EBITA/sales, and (net fixed
assets operating working capital)/sales. - The discount rate can be applied to the weighted
average cost of capital (WACC.) - Then the value for free cash flow (Years 1-10) is
added to the terminal value.
79Valuation Methods
- Other Rule-of-Thumb Valuation Methods.
- Other valuation methods are based on similar,
most recent transactions of similar firms. - Venture capitalists know the activity in the
current marketplace for private capital. - These methods are used most often to value an
existing company rather than a startup.
80Staged Capital Commitments
- Venture capitalists rarely invest all the
external capital that a company will require. - Instead, they invest in companies at distinct
stages in their development. - By staging capital, the venture capitalists
preserve the right to abandon a project whose
prospects look dim.
81Staged Capital Commitments
- Staging the capital also provides incentives to
the entrepreneurial team. - To encourage managers to conserve capital,
venture capital firms apply strong sanctions if
capital is misused. - Increased capital requirements invariably dilute
managements equity share. - The staged investment process enables venture
capital firms to shut down operations. - The threat by investors to abandon a venture is a
key incentive for entrepreneurs.
82Staged Capital Commitments
- Venture capitalists can also discipline wayward
managers by firing or demoting them. - The stock purchase agreement then becomes
important. - Noncompete clauses can impose strong penalties on
those who leave. - Entrepreneurs understand that if they meet those
goals, they will end up owning a significantly
larger share of the company than if they insisted
on receiving all the capital up front.