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Cards In This Set
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How does return on invested capital (ROIC) affect a company's cash flow? Explain the relationship between ROIC, growth, and cash flow
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ROIC is used to generate future cash flows. Growth and ROIC are drivers of value, value beings the generation of cash flows. The amount of value created is the difference between cash inflows and outflows. The cash flow created by both drivers must be more than the cost of capital to create value. A higher ROIC will lead to lower expenditures and higher cash flows......investment rate= growth/ROIC
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If value is based on discounted cash flows, why should a company or investor analyze growth and ROIC?
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Higher ROIC will lead to less investment and higher cash flows. Discounting the smaller cash flows will lead to a smaller present value. However, one must note that a lower p/e can be deceiving with a lower ROIC. Higher growth with a low ROIC can reduce value. High ROIC and high growth leads to the most value.
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Under what circumstances does growth destroy value?
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Growth destroys value when the ROIC is low and growth is high. Faster growth can destroy capital in that instance.
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Which type of business, a software company or an electric utility, would benefit more from improving ROIC than from increasing growth? Why?
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The software company would likely benefit most by an increase in ROIC. ***However, one must remember that growth may not always return the same ROIC.
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Why does organic growth often create more value than growth from acquisitions? Describe how different types of organic growth might create different amount of value
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Organic growth frequently have the highest returns because they don't require much new capital; companies can just add new products to existing lines and distribution systems. Investments are not required all at once and can be scaled back/canceled....acquisitions require the entire transaction be made up front (this includes a premium and expected cash flows). The return is often only slightly higher than the cost of capital and value is only created by overlaps/synergies that result in revgrowth, cost reductions, or better capital allocation (ex. J&J purchasing Pfizer's consumer health business for 600M savings per yr...or J&J's purchase of neutrogena for intl exposure)....It also does not reflect the risk of failure. Acquisitions already have a working model with cash flows while organic growth may consist of failure and development costs.
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What is the conservation of value principle? Provide some examples of where it might apply
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The principle is that anything that does not increase cash flows doesn't create value. Gimmicks that redistribute value do not change value.
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Under what circumstances would changing a company's capital structure affect its value?
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Changing the capital structure can definitely influence cash flows and value. Interest payments are often deductible. Debt can also cause managers to be more diligent because they must have cash available to pay on time (thus increasing cash flow). Debt can also simply reduce cash flow...share repurchases only create value if it reduces the chance of management investing the money unwisely. When companies purchase undervalued shares, it only transfers value from those who sold to those who did not.
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What is financial engineering? When does it create value?
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It is "the design, analysis, and construction of financial contracts to meet the needs of enterprises"...aka the use of financial instruments or structures other than straight debt and equity, to manage a company's capital structure and risk profile (ex. structured debt, derivatives, securitization)...most don't create value. REIT structured income payments increase cash flows for the company since shareholders pay the taxes. CDOs through special purpose entities/vehicles do not create value (value is actually destroyed via intermediaries). Fake value was created via ratings agencies earning fees from banks.
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How would one apply the conservation of value principle to acquisitions?
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Unless the acquisition is increasing cash flows as a
result of revgrowth, cost reductions, or better capital allocation- value is not being created
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How do diversifiable and nondiversifiable risks affect a company's cost of capital?
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If a risk is diversifiable, then the company can easily eliminate the risk through diversification. When nondiversifiable, the cost of capital is higher because compensation is required for risks which cannot be eliminated.
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How should a company decide which risks to hold and which to hedge?
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Pure play companies should not hedge their main risks since it complicates the lives of their investors. One can also hedge against these volatile exposures as an investor to catch upside volatility. Shareholders can hedge this. If possible, one should hedge currency risk
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How much cash flow risk should a company take on? How should it manage risks with extreme outcomes that could potentially bankrupt the company but are very unlikely to occur?
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There is no specific amount of cash flow risk a company must take on. However, it is important that the upside potential outweighs the downside risk, whether the company can absorb the loss, and whether they can reduce the magnitude of the loss. One should not engage in any risks which have large negative spillover effects to the rest of the company.
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Investment rate (IR) =
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Growth/ROIC....the portion of NOPLAT invested back into the business
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Multiple expansion
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This is the idea that a company which acquires another with a lower or higher p/e ratio can create "value"- which is not true
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Cost of capital
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The price charged by investors for bearing the risk that the company's future cash flows may differ from what they anticipate when they make the investment.
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