Cornell University 2016 United Fresh Produce Executive Development Program

Cornell University 2016 United Fresh Produce Executive Development Program Corporate Financial Strategic Policy Decisions, Firm Valuation, and How Managers Impact Their Company s Stock Price March 7th, 2016 Copyright 2016 by Rich Curtis Rich.Curtis@cornell.edu

Corporate Financial Policy Decisions A. What Overriding Goal Should Ultimately Define the Decisions Which Managers Make? B. What Strategic Financial Policy Decisions Are Important For Firms? C. The Capital Budgeting Decision D. What Are Our Financing Alternatives? E. The Capital Structure (Debt/Equity Mix) Decision F. The Distribution Policy Decision G. Summary of Corporate Financial Policy Decisions Maximizing Shareholder Value H. What Is Value? I. The Ultimate Source of Value For Financial Assets J. Common Stock Valuation: Dividend Discount Models K. Dividend Discount Models What Defines Growth? L. The DuPont Identity M. Capital Budgeting Meets Distribution Policy N. Conclusions: How Can Managers Maximize Value For Stockholders?

A. What Overriding Goal Should Ultimately Define the Decisions Which Managers Make? Create value for the owners (the stockholders)!!!! Therefore, strategic financial policy issues should be addressed in a way that maximizes shareholder value. 3

1. Should the goal of management be to maximize the future stock price? Consider an investor who holds the stock for 10 years and then sells the stock. She anticipates a stream of future dividends and a future sale price for the stock. Which of the following cash flow patterns should that investor prefer if she discounts (present values) future cash flows at 10% per year? Time 0 1 2 3 4 5 6 7 8 9 10 Dividend $2 $2 $2 $2 $2 $2 $2 $2 $2 $2 $2 Stock Price $100 Time 0 1 2 3 4 5 6 7 8 9 10 Dividend $5 $5 $5 $5 $5 $5 $5 $5 $5 $5 $5 Stock Price $60 What could explain the higher Time 10 stock price in the first set of cash flows? Which stream should the investor prefer? NPV first stream = $50.84; NPV second stream = $53.86 4

Management s goal should be to maximize the present value of shareholder wealth. That may or may not be the same as maximizing a future stock price. It might be optimal to pay larger dividends now by reinvesting less, and accept a lower future stock price. Look to maximize the current stock price since that reflects future returns, whether those future returns are in the form of dividends or capital gains. Why might it make sense to reinvest less and pay out more now (in the form of cash dividends or share repurchases)? What kinds of firms should do this? 5

B. What Strategic Financial Policy Decisions Are Important For Firms? 1. What projects should we undertake? the Capital Budgeting Decision defines left side of Balance Sheet 2. What are our financing alternatives? see right side of Balance Sheet 3. Is there an optimal mix of debt and equity financing on the right side of the balance sheet? 4. Mergers & Acquisitions the Capital Structure Decision really, just a Capital Budgeting Decision 5. What should we do with any profits? the Distribution Policy Decision 6

Balance Sheet Assets Cash Accounts Receivable Inventories Marketable Securities Prepaid Expenses Property, Plant & Equipment Total Assets Liabilities Accounts Payable Salaries Payable Taxes Payable Loans Bonds Equity Paid-In Capital Retained Earnings Total Liabilities + Equity 7

Capital Budgeting Decision _(i.e. what assets/projects? M&A?) Market Value Balance Sheet Capital Structure Decision (i.e. how do we finance the assets? what s mix of debt & equity?) Assets Liabilities + Equity Cash Retain Pay Out (Dividends/Share Repurchases) Distribution Policy Decision (i.e. what do we do with profits?) 8

C. The Capital Budgeting Decision How Should We Decide Which Projects to Undertake? That Is, Which Projects Create Value For Our Stockholders? 1. What creates shareholder value? That is, where does value come from? 2. More specifically, what variables do we need to estimate when deciding whether a project Is good or bad? We need to estimate all the cash flows associated with the project (inflows are positive cash flows and outflows are negative cash flows), and the riskiness of those cash flows. 9

3. If we can estimate the magnitude and timing of those cash flows, how do we come up with an Accept/Reject decision? Calculate today s value (the present value) of each cash flow associated with the project and add up the individual present values. Once we have the project s present value, what s our decision rule? Accept if Net Present Value > 0. 4. How do we present value cash flows mathematically? 10

5. Problem: Perpetuity What is the present value of $1,000 received annually forever starting one year from now if the appropriate discount rate is 10%? (Try to think it through logically without using a formula. How much money would you need to invest today to give you a $1,000 cash inflow every year forever if you earned 10% per year?) $683.01 $1,000 $751.31 $1,000 Total Present Value = $1,000/.10 $826.45 $1,000 = $10,000 $909.09 $1,000 Total =?? 0 1 2 3 4 Time 11

6. Problem: Perpetual Cash Flow Stream With Growth What is the Present Value of cash flows which start at $1,000 at Time 1, but grow 6% per year forever? The discount rate is still 10%. Don t try to solve this just tell me whether the answer is less than or greater than the answer in Problem 1, and why. $813.48 $1,191.02 $844.18 $1,123.60 $876.03 $909.09 $1,000 Total =?? $1,060 Total Present Value = $1,000 / (.10-.06) = $25,000 Time 0 1 2 3 4 12

7. Problem 3: Capital Budgeting Example If the discount rate is 10% and the project s cash flows are Time Cash Flow 0 -$3,000 1 +$4,000 2 +$5,000 then what is the Time 0 Net Present Value of the project? NPV t = 0 = $3,000 + $4,000 (1.10) = + $4,769 + $5,000 (1.10) 2 Accept or Reject? What s your decision rule? 13

8. Interpretation: NPV is the value created for stockholders by the project in Time 0 dollars a. If the announcement of the project is a surprise to the market, what in theory should happen to the overall stock value (i.e. the market capitalization) b. If the announcement of the project is a surprise to the market, and if the firm has 10,000 shares of common stock outstanding, how much in theory should the stock price per share increase? 14

c. If the initial (time 0) cost increased by the NPV, the firm or individual will break even on the investment. That is, if the project s cash flows were given by: Time Cash Flow 0 -$7,769 = -$3,000 - $4,769 1 +$4,000 2 +$5,000 then with a 10% discount rate we have: NPV = $7,769 + $4,000 (1.10) + $5,000 (1.10) 2 = $0 15

d. If the NPV > 0, the investment is acceptable since it could be financed by borrowing with the loan repaid out of future cash flows. An amount equal to the NPV would be left over to contribute to profit above capital costs. t=0 t=1 t=2 CF 0 -$3,000 Loan +$3,000 -$3,300 CF 1 +$4,000 CF 2 +$5,000 $0 +$700 +$5,000 NPV 10% = +$4,769 16

9. Intuition: a. If the NPV > 0, a conventional project (i.e. with initial cash outflows followed by cash inflows) earns a return higher than the discount rate. b. For example, if the project earns 12% and the discount rate is 10%, the NPV > 0. c. The appropriate discount rate is what an asset of similar risk outside the firm would earn that is, the discount rate is the shareholders opportunity cost. d. So, if the NPV > 0, the invested capital earns more inside the firm than the stockholders could earn on that money in a project of similar risk outside the firm. e. This is exactly the scenario justifying retaining capital inside the firm (versus paying the money out to stockholders via a cash dividend or a share repurchase)!! 17

10. Discussion Question: Consider an investment with the following estimated cash flows: Time 0 -$1,000 Time 1 +$1,100 What is the % return on your money? 10% (the IRR) Should one accept the project if the appropriate discount rate is 7%? NPV t = 0 = $1,000 + $1,100 1.07 Accept! = + $28.04 18

Time 0 -$1,000 Time 1 +$1,100 Should one accept the project if the appropriate discount rate is 15%? NPV t = 0 = $1,000 + $1,100 1.15 Reject! = - $43.48 What does the discount rate represent? The opportunity cost of shareholders capital. 19

Summarizing: Time 0 -$1,000 Time 1 +$1,100 NPV t = 0 = $1,000 + $1,100 1.07 Accept! = + $28.04 NPV t = 0 = $1,000 + $1,100 1.15 Reject! = - $43.48 If other projects outside the firm of similar risk return 7%, the 10% project is a good one and should be accepted. If, however, other projects outside the firm earn 15%, the 10% project is an inferior one and should be rejected. 20

11. In what sense is a potential acquisition like a potential project? How should we evaluate that acquisition? a. Accept if NPV > 0 b. NPV > 0 if Value of Acquisition as Currently Operated + Synergies > Cash + Stock + Other Assets Used to Pay For the Acquisition 21

D. What Are Our Financing Alternatives? 1. Bank Loans/Bonds, Preferred Stock, & Common Stock 2. Which has seniority? 3. What are convertibles? 4. How much financing do we need? 5. Can we anticipate short-term financing problems? a. Current Ratio = Current Assets / Current Liabilities b. Quick Ratio = Quick Assets / Current Liabilities c. Interest Coverage Ratio = EBIT / Annual Interest Expense 22

E. The Capital Structure (Debt/Equity Mix) Decision? a. Who are advantages of debt financing? (Magnifies Returns to Stockholders & Interest Expense is Tax Deductible) b. Which are disadvantages of debt financing? c. What are advantages of equity financing? d. What are disadvantages of equity financing? (Dividends, Share Repurchases, Retained Earnings are not tax deductible) e. What are after-tax costs of debt and equity? (See Table on Next Page) 23

Company Fraction Cost Fraction Cost WACC Beta of of of of Debt Debt Common Common Del Monte 9.1% 2.1% 90.9% 7.8% 7.2%.58 Alico Inc. 41.7% 1.1% 58.3% 9.9% 6.2%.86 Calavo Growers 4.3%.6% 95.7% 7.9% 7.6%.61 Limoneira Co.* 25.4% 1.5% 63.5% 9.4% 6.5%.88 Seneca Foods* 52.4%.7% 47.4% 3.4% 2.0%.43 B&G Foods 32.0% 1.7% 68.0% 5.9% 4.6%.25 Cal-Maine 1.0% 1.3% 99.0% 10.3% 10.2% 1.03 GE 45.4%.7% 54.6% 10.5% 6.0% 1.08 Hershey s 11.1% 1.0% 88.9% 7.6% 6.8%.24 Supervalu 61.0% 1.7% 39.0% 12.2% 5.8% 1.38 WalMart 22.2% 1.2% 77.8% 7.8% 6.3%.59 Whole Foods 9.7% 1.5% 90.3% 7.6% 7.0%.90 * Limoneira has 11.1% Preferred at 1.6%; Seneca has.2% Preferred at 1.3% 24

Company Beta Altria.74 AT&T.28 Cisco 1.15 Colgate-Palmolive.80 Diageo.75 Dollar Tree.53 Facebook.73 Ford 1.32 General Motors 1.66 Intel 1.03 McDonald s.58 Merck.75 Molson Coors.84 Newmont Mining.19 Nucor 1.27 Pulte Homes.97 Qualcomm 1.39 Starbucks.80 Toll Brothers 1.34 Verizon.46 WalMart.19 Wynn Resorts 1.78 25

Does firm have to earn WACC on its assets? Does every asset have to earn WACC or higher? 26

F. The Distribution Policy Decision If we have cash available, how do we decide whether to reinvest it internally, or whether to pay it out to our stockholders? If we pay it out, what are our options for the form of the payout? a. b. What is the Residual Dividend Approach? c. It s a policy whereby a firm invests in all positive NPV projects and then pays a cash dividend with any remaining cash. Is there a real-world consideration which may lead us to ignore good economic logic and pay out some cash even though we still have some unfunded positive NPV projects?? d. 27

1. Examples of Dividend Payout Ratios Company Dividend Payout Ratio Alphabet 0% American Electric Power 60% Apple 22% ATT 80% Del Monte 43% Exxon Mobil 75% Facebook 0% General Mills 71% Hershey 96% Kellogg 115% McDonald s 72% Mondelez 14% Qualcomm 62% Starbucks 42% Target 47% WalMart 42% WhiteWave 0% As an investor, all else equal, do I prefer to see higher or lower dividend payout ratios? 28

2. How does the market react to a dividend cut? Devon Energy: Fell 4.4% on 2-17-16 after announcing quarterly dividend cut from $.24/share to $.06/share on a day the Dow, S&P 500, and Nasdaq Composite were up 1.59%, 1.65%, and 2.21%, respectively. Devon fell 5.5% after hours when it announced plans for a 55 million-share public offering, and said it expects to grant underwriters an option to buy an additional 8.25 million shares. 29

G. Summary of Corporate Financial Policy Decisions Maximizing Shareholder Value The value of a firm equals the value of the cash flows thrown off by the firm s assets. How can we maximize cash flows generated for investors? 1. Choose Good Projects a. Accept if Net Present Value > 0 2. Finance Projects (i.e. assets) Appropriately a. Does modest amounts of debt financing give us a way to create value for stockholders? 3. Return Capital to Shareholders If All Positive NPV Projects are Funded And Firm Still Has Excess Cash a. But perhaps alter the strategy if it would result in a dividend cut (which the market would likely punish) 30

Let s Talk About Valuing the Common Stock 31

H. What Is Value? 1. Warren Buffett: Price is what you pay, value is what you get. 2. Valuation of financial assets, especially shares of common stock, is tricky and imprecise a science based on numbers, but perhaps a bit of an art also. 3. Reasonable people can disagree. 4. Just because something goes down in price doesn t mean it was overvalued, and just because something goes up in price doesn t mean it was undervalued. 32

There are at least 2 ways we could estimate the value of all the firm s common stock (i.e. its Market Capitalization or Market Cap ) Balance Sheet Liabilities Assets Preferred Stock Common Stock 1. Value the common stock directly, or 2. Value the firm s total sources of financing and subtract the value of liabilities and preferred stock 33

Then divide the estimated market capitalization by the number of common shares to get the price per share: Common Stock Price Per Share ($) = Market Capitalization # of Shares of Common Outstanding Is the market cap arbitrary? Is the share count arbitrary? 34

I. The Ultimate Source of Value For Financial Assets Question: What is the ultimate source of value for financial assets? Answer: The future cash flows which are estimated to go to the owner of the asset. But to get today s worth (i.e. present value) of the asset, those future cash flows have to be discounted back to get today s worth (i.e. present value) at a rate which reflects the riskiness of those cash flows. 35

Valuation of Assets: Asset Cash Flows Discount Rate Bonds Interest & Principal Cost of Debt Common Cash Flows to Cost of Stock Common Stockholders (Common) Equity Firm Cash Flows to Weighted Average the Firm (All Investors) Cost of Capital (WACC) Capital Project s Cash Flows Discount Rate Budgeting Appropriate To The Project Risk of the Project Commercial Project s Cash Flows Discount Rate Real Estate Appropriate To The Risk of the Project 36

J. Common Stock Valuation -- Dividend Discount Models P 0 = Dividend at Time 1 Dividend at Time 2 Dividend at Time 3 + + (1+Cost of Equity) 1 (1+Cost of Equity) 2 (1+Cost of Equity) 3 +... Stockholders Expected or Required Return If the dividends grow at a constant rate g (e.g. 4%) after Time 1, then the above formula becomes: Today's Stock Price = Dividend Over Next 12 Months Cost of Equity - Growth Rate This is called the Gordon Growth Model and is based on the assumption that the cash flows grow at a constant rate after Time 1. To use this formula, the cost of equity must be greater than the long-term annual growth rate of the dividends. 37

Example: Mystery Stock: If D 1 = $.92 = 4($.23), k e =.105, and g =.0797 (somewhat arbitrary, BUT is analysts 5-year earnings growth estimate), then P o = D 1 k e -g = $.92.105 -.0797 = $36.36 General Electric (GE) closed at $28.28 on February 9 th, 2016. 38

K. Dividend Discount Models What Defines Growth? In the context of dividend discount models, the present value of the estimated future dividends is our estimate of the current stock price. What causes the stock price to change, and are any of those variables potentially under the control of management? 1. The current dividend 2. The growth rate of the dividends, and 3. The riskiness of the dividend and levels of interest rates 39

If the Discount Rate is greater than the Growth Rate, then we saw that: Current Stock Price = Dividends Over Next 12 Months Discount Rate - Growth Rate of Annual Dividends = (Earnings Over Next 12 Months) (1 - Reinvestment Rate) Discount Rate - Growth Rate of Annual Dividends Risk & Interest Rates Reinvestment Rate x Return on Equity (ROE) Net Margin x Asset Turnover x Financial Leverage If you invest in all positive NPV projects, (i.e. projects having a Return on Equity greater than the Discount Rate ), you should in theory maximize your stockholders wealth!! 40

Note that organic growth is given by: Earnings Growth Rate = Reinvestment Rate x Return on Equity What s the intuition? Time 0 1 2 3 4 Reinvested Equity (50%) - $10 $11 $12.10 $13.31 Invested Equity $100 $110 $121 $133.10 $146.41 Return on Equity (20%).20.20.20.20.20 Earnings $20 $22 $24.20 $26.62 $29.282 We see that the growth rate of earnings (.10 or 10% per year) equals the reinvestment rate (.5) times the return on those equity investments (.20).

1. Return on Equity = Net Income Book Value of Equity Beginning of Year Example: If E = Net Income = $10 Million and Equity Book Value = $60 Million, ROE = $10 M/$60 M =.1667 or 16.67% It s a measure of how well management is utilizing the capital that stockholders have put into the firm. 42

L. The DuPont Identity Return on Assets Return on Equity = Net Income S/H's Equity = Net Income Sales x Sales Assets x Assets S/H's Equity Beginning of Year Net Margin Asset Turnover Financial Leverage Does this expression suggest some strategic alternatives? Can you name companies which are high on any of the 3 measures? What are the red flags? 43

Return on Assets Return on Equity = Net Income S/H's Equity = Net Income Sales x Sales Assets x Assets S/H's Equity Beginning of Year Net Margin Asset Turnover Financial Leverage 1-31-15: WalMart.2010 = $16.363 B $485.651 B x $485.651 B $203.706B x $203.706 B $81.394 B =.03369 x 2.38408 x 2.5027 9-27-15: Whole Foods.1422 = $.536 B $15.389 B x $15.389 B $5.741 B x $5.741 B $3.769 B =.03483 x 2.68054 x 1.52322 44

Net Asset Company Year Margin x Turnover x Leverage = ROE Walmart 2015 3.4% 2.38 2.50 20.10% 2014 3.4% 2.33 2.69 21.01% 2013 3.6% 2.31 2.66 22.27% 2012 3.5% 2.31 2.71 22.01% 2011 3.9% 2.34 2.64 23.91% Whole Foods 2015 3.5% 2.68 1.52 14.22% 2014 4.1% 2.47 1.51 15.19% 2013 4.3% 2.33 1.43 14.21% 2012 4.0% 2.21 1.39 12.24% 2011 3.4% 2.35 1.43 11.45% Hershey 2015 7.0% 1.38 5.36 51.40% 2014 11.4% 1.32 3.86 58.20% 2013 11.5% 1.33 3.34 51.12% 2012 10.0% 1.40 4.59 63.75% 2011 10.3% 1.38 5.14 73.36%

Net Asset Company Year Margin Turnover Leverage ROE WhiteWave 2015 4.4%.91 3.49 13.91% 2014 4.1% 1.04 3.08 13.02% 2013 3.9% 1.11 2.37 10.30% Del Monte 2015 1.5% 1.56 1.52 3.65% 2014 3.6% 1.47 1.53 8.15% 2013 -.9% 1.42 1.51-2.01% Microsoft 2015 13.0%.53 2.20 15.23% 2014 25.4%.50 1.92 24.59% 2013 28.1%.55 1.80 27.69% Coach 2015 9.6%.90 1.87 16.16% 2014 16.3% 1.31 1.51 32.28% 2013 20.4% 1.44 1.47 42.94% 46

M. Capital Budgeting Meets Distribution Policy Are Increasing Dividends Unambiguously Good? Or Is Growth? Current Stock Price = (Earnings Over Next 12 Months) (1 - Reinvestment Rate) Discount Rate - Growth Rate of Annual Cash Flows Can we automatically manufacture a stock price increase by reinvesting less and paying out more of our earnings to common stockholders via cash dividends and share repurchases (i.e. share buybacks)? Or is there a potential downside to increasing our dividend? Is there a potential downside to reinvesting internally for growth??? What is the tradeoff?? 47

Current Stock Price = (Earnings Over Next 12 Months) (1 - Reinvestment Rate) Discount Rate - Growth Rate of Annual Cash Flows Reinvestment Rate x Return on Equity (ROE) Net Margin x Asset Turnover x Financial Leverage Answer: Reinvesting less and increasing the dividend may or may not increase our stock price! The higher dividend will tend to push up the stock price, but less reinvestment may reduce growth (assuming we have good projects) and reduced growth tends to lower the stock price. But. If you invest in all positive NPV projects, (i.e. projects having a Return on Equity greater than the Discount Rate ), you should in theory maximize your stockholders wealth!!!! 48

N. Conclusions: How Can Managers Maximize Value For Stockholders? 1. Undertake Positive NPV Projects!!!! Use Risk-Adjusted Discount Rates! Same Thing 2. Invest Internally Only If You Can Earn A Return On Capital Greater Than The Project s Risk-Adjusted Cost of That Capital!! Otherwise Pay Cash Dividends or Repurchase Shares! 3. Utilize Modest Amounts of Debt to Take Advantage of Tax-Deductibility of Interest Expense IF You Have Enough Stable Cash Flows to Service the Debt 4. Align Management s Interests With Stockholders a. Give Management Stock Options (but not too many!!) b. Tie Bonuses & Promotions at Least Partially To a Budgeted Economic Value Added (EVA): EVA = (Return on Capital - Cost of Capital) x Capital Employed

So let s revisit our balance sheet and the strategic corporate financial policy decisions which will maximize the present value of shareholders wealth. 50

Capital Budgeting Decision _(i.e. what assets/projects? M&A?) Market Value Balance Sheet Capital Structure Decision (i.e. how do we finance the assets? what s mix of debt & equity?) Assets Liabilities + Equity Cash Retain Pay Out (Dividends/Share Repurchases) Distribution Policy Decision (i.e. what do we do with profits?) 51

And let s finally connect managers actions (which impact net margins and asset turnover) and managers choices (about the amount of debt) to strategic corporate financial policy decisions (i.e. capital budgeting, distribution policy, and capital structure) and eventually to their impact on the current stock price 52

Capital Budgeting Decision + Capital Structure Decision Capital Budgeting Decision + Distribution Policy Decision Current Stock Price = (Earnings Over Next 12 Months) (1 - Reinvestment Rate) Discount Rate - Growth Rate of Annual Cash Flows Capital Budgeting Decision (Asset Risk) + Levels of Interest Rates Reinvestment Rate x Capital Budgeting Decision + Distribution Policy Decision Return on Equity (ROE) Net Margin x Asset Turnover x Financial Leverage Capital Budgeting Decision + Distribution Policy Decision Capital Structure Decision 53

The End