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Attribution Non-Commercial (BY-NC)

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Steve Montgomery

What to do when someones not telling you what to do Topics covered: Course introduction and Overview of corporate structure (1

session) Fundamentals of business strategy (2 sessions) Introduction to Marketing (2 sessions) Overview of Accounting and Finance (2 sessions) Project Valuation and ROI (2 sessions) Course review & strategy illustration (1 session)

4/5/2012

Accounting/Finance

Accounting: Two types Bookkeeping and managerial

Bookkeeping: Your companys overall financial health

Balance sheets income statements and how to read them

What incentives are you creating, and can you measure the right things?

Finance: The art and science of cash management Cash is King Treat it like its yours Time = money

End goal: Understanding your business, how you reach customers, and your firms business condition allow you to pick smart projects and sell them to management 4/5/2012

The project decision: Is this project a good use of company resources?

How can we tell? What should we measure? What are we not doing by starting this project?

Techniques for estimating Return on Investment

End goal: Understanding your business, how you reach customers, your firms business condition and the potential impact your of your work allow you to pick smart projects 4/5/2012 and sell them to management

ATH Microtechnologies Case Finance and the time value of money Present/future value problems

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ATH Microtechnologies

Founding Period: Scepters bid:

$90M initial payment $30M if new product approved by FDA $35M if independent study proved product superiority Up to $120M in cash for sales/profit goals

Growth

What are some features of this payment system? Is there anything missing here?

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Profit

Control

Did the earn out structure focus on the right performance goals? Were there adequate controls in place? What are some good metrics to measure ATHs performance by?

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Growth Phase: Autonomy granted to ATH

(why?) Goal: Get market share through new product development and marketing

Were bonuses linked to market share growth?

Growth

approved product, but European tech proved superior in test, so no second phase earn out

Profit

Control

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How did they do during the growth period? Did they achieve their strategic objectives?

9 4/5/2012

Push to profitability:

for two to Hawaii if were profitable!

Whats not to like?

Growth

incentive program this way?

Profit

Control

10

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Was ATH successful in becoming profitable? How did they do it? What effects did this have on the rest of the business?

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Refocus on Process

Issued vision

statement Restructured bonus program Launched education initiative

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How did they do? Were the issues contained at this point? Final earn out paid at this point

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Growth

Profit

Control

New Management: Declining sales Founders left the company New European tech eating at

Growth

business + other competitors entering market New spending focused on new product development and tech leadership Newest products withdrawn from market; corners cut to make deadlines

Profit

Control

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ATH Summary

People respond to incentives: You get what you measure! Consequently, measures need to be balanced: Reward one thing,

get one thing

Strategy is everything! In this case, did ATH focus on the short or the long term? Its difficult to balance short vs. long term goals, but: Design incentives that try to do both

How could that have been done here?

If one is sacrificed completely, negative consequences can appear later!

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4/5/2012

TimeIs Money

The key to understanding financing decisions is to note that the value of money decreases over time Two factors contribute:

Inflation.

It takes more dollars to buy something tomorrow that it does today Opportunity cost. By doing x instead of y, you lost out on potential revenue.

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4/5/2012

Effect Of Compounding Interest Over Time

$20.00 $18.00 $16.00 $14.00

Value j Value j 1 1 i or

10%

Value, [$]

Value j ,n Value0 1 i

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Future Value:

Future value: Example

annual interest rate: ValueYear 1 = $100(1+4%) = $104.00 ValueYear 2 = $104(1+4%) = $108.16

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CFj F0 1 i

CFj = Cash flow value at some jth compounding period j = The jth compounding period F0 = The initial investment i = The interest rate (Also called the discount rate) Note that this is the value of some single investment at some future date The factor (1+i)j is called the Future Value interest factor

Sometimes tabulated Handy to use in spreadsheets when doing discounted cash flow analysis

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Sometimes its desirable to know what the present value of a future payment will be Drives decision making: If you know what something is worth in todays dollars, is this a good investment or not? The value of money isnt static:

Inflation degrades its value Other opportunities that werent pursued should be

thought of as costs

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Revisit the equation Recast slightly:

CFj F0 1 i

Becomes

Note that the initial investment is the same as the value of that investment today, or is also the Present Value

CFj PV 1 i

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Solving for present value:

PV

1 i

CFj

Same formula, were just thinking about it differently. The factor 1/(1+i)j is called the Present Value interest factor (PVIF) Sometimes tabulated Handy to use in spreadsheets when doing discounted cash flow

analysis

23

4/5/2012

A friend of yours owes you $1,000. He cant pay you back today, but promises that he will pay you back one year from now. Suppose that inflation is 3%. What is the present value of the $1,000 payment (that happens 1 year from now)?

PV

PV

1 i

CFj

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A friend of yours owes you $1,000. He cant pay you back today, but promises that he will pay you back one year from now. Suppose you could have invested some money at 7% interest. How much would you have had to set aside this year to get $1000 next year?

PV

1 i

CFj

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4/5/2012

Suppose you invest $4,000 a year in an IRA, and that you expect the IRA to earn 5.5% on average for the next 20 years. How much will you have 20 years from now? This is a sum of future years problem: Add the future value of each of the next 20 years together:

CF20 $40001 0.055 $40001 0.055

20 19

$40001 0.055

18

26 4/5/2012

Calculations for Application #1: Personal savings Number of years of annual savings = Expected annual rate of return = Years from now 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 Amount invested 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 4000 20 5.50%

FVIF Future value 2.9178 11671.03 2.7656 11062.59 2.6215 10485.87 2.4848 9939.21 2.3553 9421.05 2.2325 8929.91 2.1161 8464.37 2.0058 8023.10 1.9012 7604.83 1.8021 7208.37 1.7081 6832.58 1.6191 6476.38 1.5347 6138.75 1.4547 5818.72 1.3788 5515.37 1.3070 5227.84 1.2388 4955.30 1.1742 4696.97 1.1130 4452.10 1.0550 4220.00 147144.30

Source: J. Karpoff, UW.

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4/5/2012

Sometimes its helpful to consider a picture:

CF1 CF2 CF3 CF4 CF5 CFn

Period 0 (Today)

Period 1

Period 2

Period 3

Period 4

Period 5

Period n

Each of these cash flows is listed in their value at that particular time period. We then use discounting (more on this in a minute) to relate them all back to today.

28 4/5/2012

Note that CFn = PV(1+k)n

k = interest rate n = number of periods

compounding period) equals the initial investment adjusted by the interest rate and number of periods)

CF0 PV 1 i CF1 PV 1 i

CF2 PV 1 i

2 n 0 2 n

CFn PV 1 i

n

CF0 CF1 CF2 ... CFn PV 1 i PV 1 i PV 1 i ... PV 1 i CFn PV 1 k Divide both sides by 1 i

n n 0 n 0 n n

CFn (Total) PV n 1 n 0 i

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4/5/2012

Considering inflation, the value of a dollar degrades over time Example: Whats the value of $1 ten years from now in todays

n

Note that theres no summation here, since theres only 1 cash flow in this case (or think of it as a series of zero cash flows)

30 4/5/2012

What if we have multiple cash flows? Example: Ichiro Suzuki signs an endorsement deal with Mizuno

paying him $2M/year for the next 4 years (payment starts 1 year from now). Whats the present value of this contract? (Assume inflation is 3%)

CFn CF0 CF3 CF1 CF2 CF4 PV n 0 1 2 3 4 1 k 1 k 1 k 1 k 1 k 1 n 0 k 0 $2,000,000 $2,000,000 $2,000,000 $2,000,000 $7.434M 0 1 2 3 4 1 3% 1 3% 1 3% 1 3% 1 3%

In other words, inflation knocks ~$565k off the value of his contract.

31 4/5/2012

CF1 *PVIF1 CF2 *PVIF2 CF3 *PVIF3 CF4 *PVIF4 CF5 *PVIF5 CFn *PVIFn

Period 0 (Today)

Period 1

Period 2

Period 3

Period 4

Period 5

Period n

To visualize what happens when we perform the discounting, multiply each CF by the PVIF of that period and see

PV, CF1 PV, CF2 PV, CF3 PV, CF4 PV, CF5

PV, CFn

Period 0 (Today)

32

Period 1

Period 2

Period 3

Period 4

Period 5

Period n

4/5/2012

PV, cont.

A good way to format this on spreadsheets is the following:

Ichiro and Spresheet-friendly formatting: Interest rate: 3% Year Payout PVIF PV, each pay: $ 0 1 2 3 4 0 $ 2,000,000 $ 2,000,000 $ 2,000,000 $ 2,000,000 * * * * * 1 0.970873786 0.942595909 0.915141659 0.888487048 $ 1,941,747.57 $ 1,885,191.82 $ 1,830,283.32 $ 1,776,974.10

What if Ichiro took this class and wanted $8M in todays dollars? How would we figure out what his payments should be?

33 4/5/2012

Back to Ichiro

What if Ichiro wanted $8M in today's dollars? Interest rate 3% Year 0 1 2 3 4 TOTAL New payout $ $ $ $ $ 2,060,000 2,121,800 2,185,454 2,251,018 8,618,272 PVIF 1 0.970874 0.942596 0.915142 0.888487 PV $ $ 2,000,000.00 $ 2,000,000.00 $ 2,000,000.00 $ 2,000,000.00 $ 8,000,000.00 Total PV $ 618,272 Difference

Notice the power of inflation to get $8M in todays dollars, he needs to be paid $618k more over the course of 4 years Why do the payments get bigger further out in time?

34 4/5/2012

A Bond Example

You want to invest in something, yet youre leery of the stock market. How about buying bonds? A bond is a promissory note from an entity obligating the payee to pay out interest over the life of the bond, and refund the principal at some later date

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4/5/2012

Bonds are present value problems: You get the interest (Called coupon payments) + the amount of the bond (Called the face value) back when the bond expires Bonds are issued in lots of $1000 (Face) with some pre-determined interest rate (Coupon)

Lets buy a bond and figure out how much our investment is worth

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4/5/2012

Suppose you want to buy a bond for $1000 face value and a coupon rate of 10% The market interest rate is 12% (The market expects to earn a 12% return on this bond).

compounding periods

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First, how much is each interest payment?

Next step is to find the present value of each of the interest payments, then add those up:

CFn CF0 CF3 CF1 CF2 CF4 1 k n 1 k 0 1 k 1 1 k 2 1 k 3 1 k 4 n 0 0 $100 $100 $100 $100 $565.02 0 1 2 3 4 1 12% 1 12% 1 12% 1 12% 1 12% PV

n

Next, find the present value of $1000 at a rate of 12% in 10 years ($321.97) The sum is the price of the bond: $287.48 + $565.02 = $887.

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Bond Example Interest rate Compounding Period 0 1 2 3 4 5 6 7 8 9 10 12.00% Interest Payment $0.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 $100.00 Principal 0 0 0 0 0 0 0 0 0 0 1000 PVIF 1 0.892857143 0.797193878 0.711780248 0.635518078 0.567426856 0.506631121 0.452349215 0.403883228 0.360610025 0.321973237 CF $0.00 $89.29 $79.72 $71.18 $63.55 $56.74 $50.66 $45.23 $40.39 $36.06 $354.17

5.650223028

$887.00 Total

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Bonds, cont.

When a bond is first issued, you can pay the face value and realize payments at the coupon rate

like stocks! This affects the math Also, theres the matter of getting in on a bond at the beginning of its term or somewhere in the middle

40 4/5/2012

Emerson Electric: 5% coupon, semi-annual $1000 face ~10 payments remaining of (5%)($1000)/2 = $25. Whats the price of this bond?

41 4/5/2012

The markets expected rate of return is called the Yield To Maturity (2.456% in this case) So the interest rate to use is (2.456/2)%:

Bond Example Interest rate Compounding Period 0 1 2 3 4 5 6 7 8 9 10 1.228% Interest Payment $0.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00 $25.00

Principal 0 0 0 0 0 0 0 0 0 0 $1,000

PVIF 1 0.987868969 0.9758851 0.964046608 0.952351728 0.94079872 0.929385862 0.918111453 0.906973815 0.895971287 0.885102232

CF $0.00 $24.70 $24.40 $24.10 $23.81 $23.52 $23.23 $22.95 $22.67 $22.40 $907.23 $1,119.01 Total

42 4/5/2012

You being a hot commodity thanks to some class you took at UW has landed you a new job. Upon leaving your old company, you have the option to take your retirement plan savings as either:

Lump sum of $50,000 now 18 monthly payments of $3,000 (for a total of $54k)

In either case, you can invest your money at 6%/year (0.5%/month)

43 4/5/2012

With the monthly payments, at this interest rate you came our ahead by $1,518.30. What would change this situation?

New Job Example Interest rate Compounding Period 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 0.500% Monthly Payment $0.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 $3,000.00 PVIF 1 0.995024876 0.990074503 0.985148759 0.980247522 0.975370668 0.970518078 0.96568963 0.960885204 0.95610468 0.951347941 0.946614866 0.94190534 0.937219243 0.932556461 0.927916877 0.923300375 0.918706841 0.91413616 CF $0.00 $2,985.07 $2,970.22 $2,955.45 $2,940.74 $2,926.11 $2,911.55 $2,897.07 $2,882.66 $2,868.31 $2,854.04 $2,839.84 $2,825.72 $2,811.66 $2,797.67 $2,783.75 $2,769.90 $2,756.12 $2,742.41 $51,518.30 Total

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PV/FV techniques are useful for a variety of different calculations

Theyre also useful for evaluating projects. The only thing we do differently is change the discount rate and the cash flows

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4/5/2012

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