Coorporate issuers Flashcards
Market factors are
shareholder engagement, shareholder activism and competition and markets
Stronger corporate governance
can have many benefits including; operational efficiency, improved control, better operating and financial performance and lower default risk and cost of debt.
A pull on liquidity is when
> disbursements are paid too quickly or trade credit availability is limited
making payments too early; reduced credit lines from suppliers due to late payments; limits of short-term lines of credit; low liquidity positions
Perquisite consumption refers to
> the level of spending that company executives are allowed to legally spend including on such things as company cars and hospitality.
Higher perquisite consumption will increase equity agency costs.
The pecking order theory suggests
> that managers will prefer to raise capital using the method which revels the least information about the internal operations of the company.
this usually means using internally generated capital first.
issue equity when they believe that it is overvalued by the market. As such investors may take the decision to issue equity as being a negative signal
Higher levels of information asymmetry between managers and investors places investors at greater risk. As such
both providers of debt capital and providers of equity capital will expect higher returns than otherwis
Freemium pricing
allows a certain level of usage or functionality of goods and services without charge
> growth strategy
Penetration pricing
is an approach which uses discounted pricing to gain market penetration
> growth strategy
An aggregator is a type of marketplace
where a company remarkets products such as the computer games under its own branding.
Limited partners cannot replace the
general partner
eu corporations pay
corporate tax + income tax
All of the profits and losses of a general partnership are
collectively shared by the general partners. If one partner is unable to pay their share of the debt, then the remaining partners remain fully liable collectively for the debt.
In a two-tier structure
the management board run the company but are supervised by the supervisory board.
the supervisory board is mainly comprised of non-executive directors whilst the management board is composed of executive directors.
A one-tier board
is comprised of both executive and non-executive directors.
responsibility of the board of directors
Ensuring the effectiveness of the company’s audit and control systems
Ensuring leadership continuity through succession planning
Income is paid to debt holders pre corporation tax but paid to equity holders post corporation tax.
It is senior management that is responsible for implementation of strategy. The Board will, however, oversee the execution of the strategy.
Use the market values if given a choice between market value and par value of debt and equity
The target structure and the optimal structure may be the same, but
> the market values are constantly varying and other factors such as the cost of issuing securities mean that this is often not the case.
companies will keep them within a range.
MM I with corporate taxes states that the
market value of a leveraged company is equal to the value of an unleveraged company plus the value of the debt tax shield.
MM II without corporate taxes states that the
cost of equity is a linear function of the company’s debt to equity ratio.
MM II with corporate taxes states that the cost of equity
is a linear function of the company’s debt-to-equity ratio with an adjustment for the tax rate.
Project NPV with real options
= NPV (based on DCF [discounted cash flow] alone) – Cost of options + Value of options. Calculate the NPV based on expected cash flows.
Sole Proprietorship (Sole trader)
- No legal identity – considered to be an extension of the owner
- Owner-operated business
- Owner retains all returns and assumes all the risk
- Profits from business taxed as personal income
- Operational simplicity and flexibility
- Financed informally through personal means
- Business growth is limited by owner’s ability to finance and personal risk appetite
- Typically, pass-through businesses (for tax)
- Business not taxed at entity level
- Profit / losses passed to sole trader who is taxed personally
- Access to capital limited by sole trader’s ability to raise finance
General Partnership
No legal identity – partnership agreement sets ownership
* Owner/Partner-operated business
* Partners share all risk and business liability
* Partners share all return, with profits taxed as personal income
* Contribution of capital and expertise by partners
* Business growth is limited by partner resourcing capabilities and risk appetite
Limited Partnership
- There must be at least one General Partner (GP) and a number of Limited
Partners (LPs) - No legal identity – partnership agreement sets ownership
- GP operates the business and has unlimited liability
- LPs have limited liability and have no control over business operations
- All partners share the returns, with profits taxed as personal income
- Contribution of capital and expertise by partners
- Business growth is limited by GP/LP financing capabilities and risk appetite and
GP competence and integrity in running the business - Typically, pass-through businesses (for tax)
- Business not taxed at entity level
- Profit / losses passed to partners who are taxed personally
- Access to capital limited by partner’s ability to raise finance
Investment fund established as a Limited Partnership
The Fund - (Limited Partnership)
Fund Manager- (GP)
Investor /client - (LP)
Corporations
- A corporation is an evolved model of a limited partnership
- Known as a limited liability company (LLC) or just limited company
- In the US a corporation and an LLC are not the same
- In a US LLC, tax is at the personal level
- In a US corporation, tax is at the personal level and corporate level
Public for-profit
Private for-profit
Nonprofit
- Separate legal identity
- Owner-operator separation allows for greater, more diverse resourcing with some risk control
- Business liability is shared across multiple, limited liability owners with claims to return and financial risk of their equity investment
- Shareholder tax disadvantage in countries with double taxation
- Dividends taxed as personal income
- Unbounded access to capital and unlimited business potential
Non profit
- Formed with a specific purpose, e.g. promoting a public
benefit or charitable mission - Have a board and can have paid employees
- No shareholders and no dividends
- Typically exempt from tax
- Any profits must be use the promote the mission
Public for-profit
- Have profit motive and specific purpose at inception
- Usually listed on a stock exchange
- In some countries (UK and Australia) having more than
50 shareholders causes the corporation to be categorized
as public whether or not it is listed on a stock exchange
Private for-profit
- Have profit motive and specific purpose at inception
- Not listed on a stock exchange
Investment fund established as a Corporation
The Fund (Corporation)
pays
Fund Manager (Separate company)
Fund Board of Directors
elected by shareholders hire fund maanger
Public companies
- Mostly, public companies have their shares listed and traded on an exchange
- Change of ownership is often quick and easy to achieve
- However, it can take some time if it involves a large order in a less liquid stock
- Each trade has the potential to move the price of the stock
- Freely traded shares, not held by insiders, strategic investors or sponsors, are
called the issuer’s “free float”
Private companies
- Private companies do not trade on exchanges
- There is no price transparency
- Trading of shares can be difficult and sometimes not allowed
- So why buy shares in a private company?
- Potential returns can be very high since investors join when the company is new
- This also means that investment risks are high
Share issuance
- After listing, public companies may raise large amount in the capital markets by issuing additional shares to many investors
- In contrast, private companies finance much smaller amounts in the primary market with far fewer investors who have much longer holding periods
- Investors in private companies normally do this through a private placement
- Terms are outlined in a private placement memorandum
- Investment may be restricted to accredited investors, also termed eligible or professional investors
Registration and Disclosure Requirements
- Public companies are required to register with a regulatory authority and are subject to greater compliance and reporting requirements
- In the US public companies must file financial information to the SEC on a quarterly
basis through a system known as EDGAR (Electronic Data Gathering, Analysis and Retrieval) - In the Europe Union, listed companies must disclose semi-annually
- Public companies must also disclose stock transactions made by officers and directors
- Private companies are not subject to such tight regulatory oversight and do not have an obligation to report information to the public
Going Public From Private
- Initial Public Offering
- Companies must meet certain requirements required by the exchange
- They are assisted by investment banks who underwrite the issue and pass cash raised to the issuer
- Once the IPO is completed, the company is public and its share trade on the exchange
- Direct listing
- No investment bank/underwriter involvement
- No new capital is raised
- The company simply lists on the exchange and shares are sold by existing investors
- Acquisition
- A larger public company acquires a smaller company and the small company forms part of the listed company
Going Public From Private
- Special Purpose Acquisition Company (SPAC)
- A shell company (a.k.a. a ‘blank check’ company)
- Set up solely to acquire an unspecified private company in the future
- Raises capital through an IPO
- Proceeds placed in a trust account and are used for acquisition or returned back to
investors - Publicly listed and often specialize in a particular industry
- Have a shelf life, such as 18 months, to complete the deal or return the funds
- Often investors will have some indication of what company the SPAC will acquire
- Based on the backgrounds of the SPAC executives, or
- Comments such individuals have made in the media
- Once acquisition of a private company has happened, the company becomes public
Life cycle stage Start up
Revenues
Cash flow
Business risk
Financing need
Financing difficulty
Low to none
Negative
High
Proof of concept
Very high
Life cycle stage Growth
Revenues
Cash flow
Business risk
Financing need
Financing difficulty
Increasing
Increasing
Moderate
ScALE
V high to high
Life cycle stage Maturity
Revenues
Cash flow
Business risk
Financing need
Financing difficulty
Positive &
Predictable
Positive &
Predictable
Low
Business as usual
Moderate to low
Life cycle stage Decline
Revenues
Cash flow
Business risk
Financing need
Financing difficulty
Deteriorating
Deteriorating
Increasing
Shortfalls
Increasing
Shareholders
Indefinite term
Unlimited potential return
Maximum loss – initial investment
Higher investment risk
Aim is to maximise firm value
Debtholders
Defined term
Capped return
Maximum loss – initial investment
Lower investment risk
Aim is for timely repayment
Lenders
- Company has a binding contract with lenders (debtholders)
- Claims fully paid before any payments to owners (shareholders)
- Company must have the funds to make interest payments
- Legal recourse
- Interest payments are generally tax-deductible
- Cheaper source of funding for the company and less risk for investors
- If the value of the firm falls below the book value of debt,
debtholders experience losses - Potential loss is invested amount but upside is capped
Owners
- Have a residual interest after all creditors have been paid
- No legal recourse
- Dividends paid out of net income but are discretionary
- Equity is a more permanent source of capital
- Have the right to vote
- Potential loss is invested amount but unlimited upside
Bondholders
- Assess the likelihood of timely repayment of debt. As such, they:
- Assess the issuer’s cash flows and collateral/security
- Evaluate issuer creditworthiness and willingness to pay its debt
- Estimate the probability of default and the loss given default
- Downside risk increases as a company takes on more debt
- Bond investors receive priority in times of financial distress
- Can often force the company to liquidate its assets and return cash to bond
investors
Issuer perspective
Equity
Capital cost
Attractiveness
Investment risk
Investment interest
Higher
Creates dilution, may be only option when issuer cash flows
are absent or unpredictable
Lower, holders cannot force liquidation
Max (Net assets – Liabilities)
Issuer perspective
Debt
Capital cost
Attractiveness
Investment risk
Investment interest
Lower
Preferred when issuer cash flows are predictable
Higher, adds leverage
Debt repayment
Equity v Debt – Conflicts of Interest
- Potential conflicts exist between shareholders and bondholders
- Equity investors prefer management to invest in projects that have greater risk and return
- At the extreme, shareholders would like the company to increase dividend payments and share repurchases with debt proceeds
- Bondholders receive no upside from a company investing in risky projects
- Returns are capped to the par value plus coupons
- Bondholders often rely on covenants to protect them against actions by management that compromise the safety of their investment
Corporate governance practices
- The corporate governance systems adopted around the world typically reflect the influence of shareholder theory or stakeholder theory to a varying extent:
Shareholder Theory
* Most important responsibility of a company’ s managers is to maximise shareholder returns
Stakeholder Theory
* Broadens a company’s focus beyond the focus of shareholders to include customers, suppliers, employees and others that have an interest in the company
- Stakeholder theory gives more prominence to Environmental, Social and Governance considerations by making them an explicit objective for the Board of
Directors and management
Shareholders
Owners of the company entitled to the net value of the company and are the most subordinate of capital providers
* Shareholder focus is typically growth in profitability that maximizes equity value
* Have the ability to vote
* Controlling vs. Minority shareholders
Creditors
- Most commonly bondholders and banks lending money to the company
- No voting rights
- May use covenants to restrict the activities of the borrower
- Company’s ability to generate cash flows is primary source of repayment
- Creditors prefer stability in the company’s operations
- Private debtholders have greater access to company management with lower information asymmetry than public debtholders
Managers and Employees
- Compensated through salary, bonuses and equity-based compensation and therefore motivated to maximize the value of their remuneration while protecting their employment position
- Employees provide labor and skills (human capital)
Board of Directors
- Elected by shareholders to protect the shareholders’ interests, provide strategic direction, monitor and manage company performance
- Boards often have inside directors (e.g. founders) and independent directors(no material company relationship)
- One-tier board: Consist of a single board of directors containing executive and non-executive directors
- Two-tier board: Supervisory Board (mainly non-executives) overseas the Management (Executive) Board
Customers
- Customer expects a company’s product or services to satisfy their needs given the price paid and often require ongoing support from a company
- Customer satisfaction and sales revenue/profit are often highly correlated!
- Tend to be less concerned with, and affected by, a company’s financial performance
Governments
- Seek to protect the interests of the general public and ensure the well-being of their nations’ economies
- Companies have a significant impact on an economy’s output, employment and social welfare
- Regulators have an interest that applicable laws are adhered to
- Major source of tax revenue to a government
Suppliers
Primary interest in being paid in a timely manner
* Suppliers often seek to build long-term transparent and fair relationships with the companies for the benefit of both parties
* Concerned with the company’s cash flows generating abilities to meet its obligations
Introduction to Environmental, Social, and Governance Issues
- Environmental and social issues were treated as negative externalities (costs which are not borne by the company or investors) – ESG aims to internalise these costs
- The concept of considering the environmental, social and governance factors in the investment process
- The inclusion of governance factors in investment analysis has been in place for some time but the practice of considering environmental and social issues has
evolved more slowly - ESG factors were once regarded as intangible or qualitative information but this has moved on to become tangible and decision-useful information due to increased corporate disclosures and refinements in the identification and analysis of ESG factors
Environmental issues
Climate change and carbon emissions
Air and water pollution
Biodiversity
Deforestation
Energy efficiency
Waste management
Water scarcity
Social issues
Customer satisfaction and product responsibility
Data security and privacy
Gender and diversity
Occupational health & safety
Treatment of workers
Community relations & charitable activities
Human rights
Labor standards
Governance issues
Board composition (independence & diversity)
Audit committee structure
Bribery and corruption
Executive compensation
Shareholder rights
Lobbying & political contributions
Whistleblowing schemes
Three catalysts for ESG Growth
- Increased material impact of ESG factors
- Environmental disasters
- Social controversies
- Governance deficiencies
- The interest of younger clients in the environmental and social impact of
investments has grown - Government stakeholder’s prioritization of climate change and social policies
Environmental Factors
- Environmental factors that are material in investment analysis include: Natural resource management, pollution prevention, water conservation, energy efficiency
and reduced emissions - Climate change risk can be identified as:
- Physical risk: Such as the risk of extreme weather damage to assets (commonly insurable or diversifiable)
- Transition risk: Risks associated with the change to a low carbon economy (may result in stranded assets e.g. oil reserves no longer economically viable)
- Adverse material environmental effects can result from factors such as reputational damage, legal claims, regulatory fines or environmental clean-up
costs
Social Factors
- Social factors relate to the impact of an organisation’s actions on:
- Employees e.g. employee turnover, health and safety, diversity
- Human capital
- Customers e.g. data privacy
- Communities e.g. community relations
- Managing social risk can reduce organisational costs, for example by increasing employee productivity, reducing litigation actions and reducing reputational damage
Governance Factors
- Governance factors include issues such as:
- Company ownership and voting
- Board composition and skills
- Executive remuneration
- Board level management of long term risk and sustainability
Assessment of how ESG-related risks and opportunities impact a company’s cash flows
- Identify material ESG effects and quantify them in financial terms
- Major, long term ESG effects will usually have greatest effect on equity
- Fixed income investors are mainly impacted by adverse ESG events which affect the ability to make interest and principal payments
- The maturity of an adverse ESG event is important e.g. consider the long-term risk that a fossil fuel reserve becomes a stranded asset - mainly affecting longer term debt vs shorter term debt
Economic Balance Sheet
includes nonfinancial claims and obligations such as human
capital and customer
Examples of principal (shareholder)-agent relationships and potential conflicts
Shareholder vs. Manager/director
* Managers are expected to act in the best interests of the shareholders by maximising shareholder value.
* Managers/directors may seek to maximize their personal benefits, empire build (if remuneration is linked to business size), become entrenched (act to preserve their job), or self-dealing (exploiting firm resources for personal gain)
* Risk tolerances may differ: The shareholder may have a higher risk tolerance as the investment in the company may be diversified across their other investments.
* Information asymmetry: Managers will have access to more information.
* Conflict can arise if directors favour certain influential shareholders.
Controlling vs. minority shareholders
- In a straight vote (one vote for each share) the controlling shareholders yield more power than that of minority shareholders in board election. As a result, minority shareholders will have less representation on the board.
- Decisions made by controlling shareholders, or their board
representatives, during corporate action such as takeovers can often be at the expense of the minority shareholders’ wealth. - Equity structures that have multiple class shares can create divergence between ownership and control right e.g. through the creation of non-voting shares, or dual-class shares some carrying a greater numbers of votes and often held by company founders.
Managers vs. board
- Board of directors rely on the management to operate the company
- If limited information is provided to the board, it hinders the board’s monitoring role
- Typically pronounced for non-executives who may not be involved in the day-to-day operations of the company
Shareholder vs. creditors
- Shareholders typically seek growth in profitability to chase residual returns and are therefore likely to prefer riskier projects with a higher potential return but with higher leverage
- However, creditors are typically focused on pre-determined return of debt obligations and may favour stable perform and and lower-risk activities
- The distribution of excess dividends to shareholders may impair the ability to pay interest and principal to the creditors
Stakeholder Management
- Involves identifying, prioritising, and understanding the interests of stakeholder groups in order to manage the company’s relationship with these groups
- Companies typically seek to balance the interests of their stakeholders in order to limit conflicts
Corporate Governance and Stakeholder
Management Framework
- Defines rights, responsibilities, and powers of each
stakeholder group
Legal Infrastructure
* Defines rights established by law and ease of legal recourse following a breach
Contractual Infrastructure
* Contractual arrangements in place with stakeholders
Organisational Infrastructure
- Internal systems, governance procedures adopted to mange stakeholder relationships
Governmental Infrastructure
* Regulation imposed on companies
Corporate Reporting and Transparency
- Corporate reporting provides external stakeholders with information about company performance and position. They enable investors to:
- Assess company, director and management performance
- Make valuation and investment decisions
- Vote in an informed way
- Ensure compliance with legal debt contracts
- Corporate reporting is considered very important and mandated by legal, regulatory and quasi-regulatory methods
- Examples: annual reports, proxy statements, company disclosures, investor relation resources, investor meetings
- Most jurisdictions and stock exchanges require independent third-party auditing of listed public companies
- Private companies make less disclosures, often in non-standardised forms which are often not audited
- Annual General Meetings (AGM)
– held within a certain time-period following
the end of a fiscal year. The main purposes include:
- Presenting the annual audited accounts, dividends and director/auditor compensation (and possibly to gain approval)
- Overview of company performance and activities
- Approval of equity-based compensation plans and “say on pay” binding compensation plan votes
- Election of directors
- Appointment of external auditors
- Extraordinary General Meeting (EGM)
can be called throughout the year by the company or the shareholders. Called when significant resolutions requiring
shareholder approval are proposed:
- Amendments to the company’s bylaws or rights attached to shares
- Mergers and acquisitions, takeovers & sale of significant corporate assets or businesses
- Special elections of board members (generally after shareholder proposal)
- Capital increases
- Voluntary liquidation of firm
Nomination Committee
- Identifies candidates qualified to serve as directors and recommends their nomination for election by the shareholders
- Establishes the nomination policies and procedures
- Defines the definition for an independent director
Risk committee
- Determines the risk policy, profile and appetite of the company
- Overseas the enterprise risk management plans of the company
- Supervises the risk management functions of the company
Investment Committee
- Reviews material investment opportunities proposed by the management
e.g. large projects, acquisition and expansion projects - Will often challenge management assumptions that underlie investment prospects
Audit committee
- Oversees the audit and control systems, monitors the financial reporting process and application of accounting policies
- Ensures the integrity of the financial statements, supervises the internal audit and ensures its independence and competence
- Appoints an independent external auditor and proposes the auditors remuneration
Governance committee
Primary role is to ensure that a good corporate governance practices are adopted e.g. via a code of ethics and conflicts of interest policy
* Reviews the policies adopted and make sure they adhere to legal requirements
* May be responsible for overseeing an annual evaluation of the board
Remuneration or Compensation Committee
Develops and proposes remuneration policies for the directors and key executives
* May handle the contracts of managers and directors along with any performance criteria
* May implement human resource policies for the company when remuneration is involved e.g. employee benefit plans
Shareholder Activism
- Strategies by investors to make the company behave in a desired way
- The primary motivation for shareholder activism is to rapidly increase shareholder value
- Some shareholder activism is driven by social, political or environmental considerations
- Hedge funds often engage in shareholder activism and face few restrictions
- Regulated entities including mutual funds may face restrictions to shareholder activism activities
Shareholder Litigation
- Shareholders might undertake litigation or lawsuits
- Shareholder derivative lawsuits are legal proceedings against board of directors, management and/or controlling shareholder by a shareholder considered to be acting on behalf of a company instead of directors who are considered to have failed in their actions
- Some countries may restrict shareholder legal
Corporate Takeovers
- Proxy contest / proxy fight describes a group seeking a controlling position on a company’s board and aims to convince shareholders to vote for this group
- Tender offers invite shareholders to sell their stake directly to a group seeking control
- Hostile takeovers aim to takeover a company without the consent of management
- A poison pill is an example of an antitakeover measure allowing the company to issue new shares at a discount or free to existing shareholders which will dilute
Creditor Mechanisms
- Bond indentures are legal contracts identifying the structure of a bond and the rights of bondholders
- Creditor committees may be established, often for unsecured bondholders, to represent bondholders during bankruptcy, restructuring or liquidation
- An ad hoc committee may be formed by a group of bondholders to approach the company with potential bond restructuring options
Corporate governance and stakeholder management risks and benefits
Operational
Risks:
Weak control systems
Ineffective decision making
Benefits:
Operational efficiency
Improved operating and financial performance
Legal, regulatory& reputational
Risks:
Legal, regulatory, and reputational risks
Benefits:
Effective mitigation of risks
Financial
Risks:
Default and bankruptcy risks
Benefits:
Lower default risk and cost of debt
Studies suggest that strong corporate governance practices by companies can:
- Increase the likelihood of credit rating agency upgrades to investment grade
- Reduce exposure to legal, regulatory and reputational risks
- Reduce the risk of lawsuits from violations of stakeholder’s legal rights
- Provide stronger market performance during a crisis for listed companies with
financial expertise - Be considered an important firm valuation factor associated to board diversity
and independence
if interest expense is not tax deductible, as a company’s marginal tax rate increases, the company’s WACC:
there should be no adjustment to the before-tax cost of debt, and WACC = wdrd + wprp + were.
Thus, all else being equal, a change in the marginal tax rate would have no impact on the company’s WACC.
cash flow of operations:
Cash from customers
Plus: Interest and dividends received on financial investments
Minus: Cash paid to employees and suppliers
Minus: Taxes paid to governments
Minus: Interest to lenders
Cash flow from operations
Cash flow from operations
Minus: Investments in long-term assets
Free cash flow
Primary sources of liquidity are the sources of the most easily accessible cash for a company. These include:
Cash and marketable securities on hand
Cash or easily sellable securities
Borrowings
Cash from banks, bondholders or trade credit from suppliers – this creates an obligation to settle with the lender
Cash flow from the business
Cash flow through the business may take time to generate, but it can be an important source of liquidity for profitable companies
Sources of liquidity
* Secondary sources:
- Likely to affect the normal operations of the firm, i.e., likely to affect the
company’s financial and operating positions - Suspending or reducing dividend payments
- Delaying or reducing capital expenditure
- Issuance of equity
- Renegotiating debt contracts to relieve pressure from high interest payments
or principal repayments - Renegotiating contracts with customers and suppliers
- Liquidating company assets, which depends on the capacity to turn into
cash without substantial loss in value - Filing for bankruptcy protection and reorganization
Short-term assets and liabilities
Days payable outstanding (DPO)
Time that accounts payable are outstanding on balance sheet
Days of inventory on hand (DOH)
Time that inventory is outstanding on balance sheet
Days sales outstanding (DSO)
Time that accounts receivable are outstanding on balance sheet
Cash conversion cycle =
DOH + DSO – DPO
Reduce DOH by:
- discontinuing products with low demand
- negotiating just in time agreements with suppliers
- forecasting customer demand
Reduce DSO by:
- offering prompt payment discounts
- late fees
- tighter credit standards
- upfront deposits
- 3rd party collection agencies
Increase DPO by:
- Negotiating longer terms with suppliers
Effective interest rate (EAR) of a supplier
EAR = ( 1+ Discount % / 100% - Discount %) ^(( Days in year / (payment period - discount period) )- 1
1/10 net 30 means that credit terms offered are:
A 1% discount for the goods / services supplied if payment is made within 10 days of a 30 day payment agreement
This means that if a company decides to pay on day 30, they effectively borrow at 1% for 30 – 10 = 20 days by forsaking the 1% discount
Net working capital
current assets (excluding cash & marketable securities)
- current liabilities (excluding short-term & current debt)
Higher liquidity to lower liquidity
Cash - Accrued payroll
Short-term investments - Accounts payable
Accounts receivable - Lease payment
Lower liquidity Inventory - Short-term debt
Drags and pulls on liquidity
- Factors influencing a company’s liquidity position
- Drags on liquidity
- When receipts lag creating pressure due to decreased availability of funds
- Uncollected receivables
- Obsolete inventory
- Tight credit conditions in economy
- Pulls on liquidity
- When disbursements are paid too quickly or trade credit availability is limited
- Making payments too early
- Reduced credit lines from suppliers due to late payments
- Limits of short-term lines of credit
- Low liquidity positions
Quick ratio =
Cash + Short-term marketable securities + Receivables / Current liabilities
Quick ratio > 1 means firm can meet short-term obligations
without liquidating inventory
Cash ratio =
Cash + Short-term marketable securities / Current liabilities
Cash ratio > 1 means firm can meet all short-term obligations without liquidating inventory or collecting receivables
Relations between working capital, liquidity and short-term funding needs
- Companies need funding to meet day-to-day obligations
- Pay suppliers and employees
- Make lease payments
- Continue as a going concern
- Companies have to strike a balance between
- Holding too many current assets that don’t generally provide a return, and
- Managing the risk of not having sufficient current assets and causing damage to
day-to-day operations - Working capital requirements are often a function of the firm’s business model
- Shops often hold lots of inventory and, therefore, require a large amount of working
capital - Technology businesses typically have lower working capital needs
- Companies usually determine their working capital needs by identifying their
optimal levels of inventory, receivables and payables as a function of sales - They have to consider
- The ‘right’ amount of inventory to carry to manage the risk of obsolescence but also
avoid inventory shortfalls - How much credit to offer – management might believe that a more accommodative policy will lead to higher sales
- Once working capital requirements are known the company must identify the mix of short- and long-term financing to acquire necessary current assets whilst still
providing sufficient financial flexibility in times of stress - Companies adopt different approaches to working capital management
- Conservative: holding large positions in current assets relative to sales
- Aggressive: holding smaller positions in current assets relative to sales
- Moderate: holding positions in current assets relative to sales somewhere between the
two above
Relations between working capital, liquidity and short-term funding needs
- A company can reduce its working capital by using just-in-time inventory management
- A company that generates high levels of sales with minimal asset levels can provide strong returns to shareholders
Funding approach
Conservative
Current asset level
Financing required
Financing cost
Financial flexibility
Financial risk
Equity return
Higher
Higher
Higher
Higher
Lower
Lower
Funding approach
Moderate
Current asset level
Financing required
Financing cost
Financial flexibility
Financial risk
Equity return
Moderate
Moderate
Moderate
Moderate
Moderate
Moderate
Funding approach
Aggressive
Current asset level
Financing required
Financing cost
Financial flexibility
Financial risk
Equity return
Lower
Lower
Lower
Lower
Higher
Higher
Major objectives of a short-term borrowing strategy
- Ensuring that sufficient capacity exists to handle peak cash needs
- Maintaining sufficient sources of credit to be able to fund ongoing cash needs
- Ensuring that rates obtained are cost-effective and do not substantially exceed
market averages - In addition, several factors will influence a company’s short-term borrowing
strategies - Size and credit-worthiness
- Legal and regulatory considerations
- Sufficient access
- Flexibility of borrowing options
- Borrowing strategies can be passive or active
Depreciation and Amortization
- Capital investments
- A life of one year or longer
- Generally seen on balance sheet as a long-term asset on a net basis
- In income statement, a non-cash charge is made as depreciation or amortization expense (the full value of asset is not expensed in one go)
- The book value less the cumulative depreciation or amortization gives net basis
- Capital investments (both tangible and intangible) give an insight into the quality of management decisions and the ways that the company creates value
Capital Allocation
Business Maintenance
Going concern (Maintenance)
* Replacing assets at end of lifespan
* Match funding – funding to match the lifespan term of new asset
* Analysts often estimate annual maintenance capital expenditure as amount of reported depreciation & amortisation
Regulatory/Compliance
* Required to meet rules & standards
* Will often increase expense without increased revenue
* Rules & standards may be barriers to industry entry for new entrants
Capital allocation
Business growth
Expansion of business
* May introduce execution risks such as sourcing additional inputs, unforeseen bottlenecks, or budgetary failures
* Usually needed to expand operations to new products / services or new markets / regions
New Business Lines & Other
Projects
* Investment in activity unrelated to existing business
* Usually, the riskiest capital investments
Capital Allocation
Basic principles of capital budgeting
* Decisions are based on cash flows
* Timing of cash flows is crucial
* Cash flows are based on opportunity costs
- Cash flows with the investment, compared to cash flows without the investment, i.e. incremental cash flows
* Cash flows are after tax
* Financing costs are ignored
- Cost of interest is accounted for in the discount rate
* Use cash flows, not net income
Capital Allocation
Steps in the process
Step 1 Idea Generation (considered the most important aspect)
Step 2 Investment Analysis
Step 3 Capital Allocation Planning and Prioritization
Step 4 Monitor and Post-Audit Review
Net present value (NPV)
Present value of future after-tax cash flows
* NPV > 0, accept the project
* NPV < 0, reject the project
* NPV = 0, could accept the project but not much room
for error
* Positive NPV increases shareholder value
Internal rate of
return (IRR)
Discount rate where NPV = 0
* If IRR > hurdle rate, accept project
* If IRR < hurdle rate, reject project
Corporate usage of capital allocation methods
* Return on Invested Capital (ROIC)
- Is a measure of the profitability of a company relative to the capital invested by shareholders and bond investors
𝐑𝐎𝐈𝐂 = 𝐍𝐞𝐭 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱 / 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐛𝐨𝐨𝐤 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐜𝐚𝐩𝐢𝐭𝐚𝐥
- The ROIC is an aggregated measure whereas NPV and IRR measure individual projects
- The ROIC is often compared with the cost of capital used in the NPV calculation
- If the ROIC is higher than the cost of capital, the company is increasing the firm’s value for investors
- The NPV criterion is the criterion most directly related to stock prices
- Limitations of ROIC
- ROIC is an accounting measure, while NPV and IRR are cash based
- ROIC is backward looking and can be volatile
- ROIC is an aggregated figure which can fail to highlight specific areas of profit
Important concepts
- Cash flows after tax
- Capital allocation decisions should be made on an after-tax basis
- Incremental cash flows
- Cash flows arising with a decision minus cash flows that would have flowed without that decision
- Sunk costs are costs that have already been incurred and should be ignored
- Decisions should be based on current and future cash flows
- Timings of cash flows
- Cash flow timings can change the calculation of NPV and IRR
- Sunk costs
- A cost that has already been incurred
- Decisions should be based on current and future cash flows
Capital Allocation – cognitive errors
- Internal forecasting errors
- Management forecasting errors can be hard for analysts to identify
- Ignoring costs of internal forecasting
- Internal cash flows from operations are the main source of cashflow
- Internal cashflows should be assessed using the appropriate risk adjusted rates of return
- Inflation affects a company’s capital allocation in a number of ways
- Is the investment analysis done in real or nominal terms?
- If considering nominal cash flows then use a nominal discount rate
- If considering real cash flows then use a real discount rate
- Inflation reduces the value of the depreciation tax savings, effectively increasing its real taxes
- The effect of expected inflation is captured in the discount rate
- If inflation is higher than expected, the profitability of the investment is lower than expected
- Inflation does not affect all revenues and costs in the same way
- A company’s after-tax cash flows will be better or worse depending on how sales outputs or cash inputs are affected
Capital Allocation – behavioural biases
- Intertia
- Studies suggest that management tend to anchor capital investment decisions to prior year budget amounts
- If year on year investment by segment or business lie is static analyst might ask if the capital could have a better alternative use
- Basing investment decisions on accounting measures
- Management incentives may be to increase accounting values such as EPS or ROE, and capital investments might decrease these over the short term
- Analysts can look at financial compensation and spending relative to historical / peers
- Pet project bias
- Favoured projects may be selected with insufficient capital allocation analysis
- Not considering investment / scenario alternatives
- Some companies may fail to consider alternative capital allocation opportunities
Investment Decision Criteria
Ranking conflicts between NPV and IRR
* Single, independent, conventional project
- No conflict between NPV and IRR
* Mutually exclusive projects
- May be a conflict
- Caused by different cash flow patterns
* Conflict
- Use NPV, because of reinvestment assumption
* More realistic to assume cash flows are reinvested at cost of capital (the NPV assumption),
rather than IRR (the IRR assumption)
Multiple IRR problem
* Projects that have a positive NPV at all discount rates will have no IRR
* Non-conventional projects
- Might have multiple IRRs
Real options
* Real options are options that allow companies to make decisions in the future that alter the value of capital investment decisions made today
* That is, you can delay a decision until later if that decision is contingent on future economic events or information (wait and see)
* A combination of optimal current and future decisions is what will maximize company value
Investment Decision Criteria
Types of real options
* Timing options – make a decision in the future based on up-to-date information
such as the success of another project
* Sizing options
- An abandonment option allows a company to abandon a project after investing if the
financial results are disappointing
- A growth option or expansion option allows a company to make further investments if
financial results are strong
* A flexibility option arises from operational flexibility
- If demand exceeds capacity then companies can benefit from increasing prices (a pricesetting option) if an increase in production levels is not possible
- If demand varies from what was forecast then a company might have a productionflexibility option
* Fundamental options – perhaps the whole investment is an option
- The value of investing in an oil refinery is contingent on the price of oil
* High oil prices leads to investment
* Low oil prices means no investment
Approaches to real option analysis
- Use DCF analysis without considering options
- If NPV is positive without considering real options (which would only add value) then make the investment
- Consider
- the Project NPV = NPV (based on DCF alone) – cost of options + value of options
- Use decision trees
- Decision trees can capture the essence of many sequential decision-making problems for companies
- Use option pricing models
Cost of Capital
Definition
Definition
* Rate of return that suppliers of capital require as compensation for their contribution of capital
* Opportunity cost of funds for suppliers of capital
- Bondholders and owners
Sources of capital
* Equity, debt and hybrid instruments such as preferred shares
* Each source has a cost or required rate of return
- Component cost of capital
Cost of capital
* Used in evaluation of investment projects
- Dealing with a marginal cost of capital
- Cost to raise additional funds for potential investment project
Weighted average cost of capital (WACC)
- Also referred to as marginal cost of capital (MCC)
- Required rate of return investors demand for average risk investment
of a company - Method of calculation
- Calculate marginal cost of each source and calculate a weighted average of costs
WACC = wdrd (1 - t) + were
- wd and we are the weights used for debt and equity (either market value proportions or target weights)
- rd, and re are the cost of debt and the cost of equity respectively
- rd, (1 – t) gives the after tax cost of debt for jurisdictions where interest expenses are tax deductible
Weights of the weighted average
- Ideally use proportion of each source of capital to be used in project or company
- Target capital structure
- Capital structure company is striving to obtain
- Use if we can assume company raises capital consistent with this target
- How to estimate target capital structure
- Use firm’s current structure
- Using market-based values
- Firm’s target structure can be inferred from past actions and management comments
- A weighted average of comparable firms’ capital structures could also be used
Valuation of individual projects
- Cost of capital should reflect riskiness of future cash flows of project, product, or division
- Average risk project
- Use WACC
- Not average risk
- Need downward (less risky) or upward (more risky) adjustment
Factors Affecting Capital Structure
Internal
Business model characteristics
Cash flow and profitability
Asset types and ownership
Company life cycle stage
External
Market conditions/Business cycle
Regulatory constraints
Industry/Peer firm leverage
Factors Affecting Capital Structure – Internal Factors
Business model characteristics
Revenue, earnings, and cash flow sensitivity
Business model characteristics
* Key factors that differ across business models include
- Revenue, earnings, and cash flow sensitivity
- Asset type
- Asset ownership
- Revenue, earnings, and cash flow sensitivity
- Mobile phone companies have stable revenue streams due to the subscription nature of their businesses – this is a positive for supporting debt
- Automobile companies have more irregular revenue streams due to them being more affected by the macroeconomic environment
- Companies in industries with stable cash flows, greater profitability, more liquid assets can support more debt and tend to have higher debt levels and lower borrowing costs
- Lower operating leverage where:
- Operating leverage = Fixed costs/Total costs
- means more ability to service debt since earnings are less volatile
- Asset ownership can be viewed as good or bad
- Ownership means collateral to borrow against
- Non-ownership companies such as Uber (described as “capital-light”) have less operating
leverage which generally means less volatile earnings but don’t have collateral to borrow against
Factors Affecting Capital Structure – External Factors
Market conditions/business cycle
Market conditions/business cycle
* Financing decisions are often opportunistic and helps explain why capital structures often deviate from the target levels
- For example, it might be a good time to issue debt if market interest rates are low
* The possible meeting of a criteria to ensure inclusion in an index might be a reason to issue debt or equity
* At higher levels of debt a company’s incremental cost of debt can rise steeply
* Macro-economic and country-specific factors are reflected in the benchmark rate and in the overall levels of credit spread
- Borrowing costs are lower when interest rates and inflation rates are low as well as during expansionary stages of the business and credit cycle
- Countries with stronger banking systems, stronger currencies and more developed capital markets generally offer lower borrowing costs
* When a company has debt and equity options management should choose the mix of debt and equity that minimizes the weighted average cost of capital
Factors Affecting Capital Structure – External Factors
Regulatory constraints
Industry factors
- The capital structure of some companies might be regulated by governments or other regulators
- Financial institutions must generally maintain certain levels of solvency or capital adequacy as defined by regulators
- Utility companies are overseen by local governments who often influence capital structures through rules and regulations relating to setting prices/rates
Industry factors
* Companies within the same industry often have similar capital structures
* This is possibly because companies in the same industry will likely have similar asset types and business model characteristics
Start-up
Capital structure
Availability
Costs
Typical cases
Typical % of capital structure
- Typically companies start life as consumers of capital but as they mature cash flows turn from negative to positive
Debt capital/leverage
Very limited
High
N/A
Close to 0%
Growth
Capital structure
Availability
Costs
Typical cases
Typical % of capital structure
Debt capital/leverage
Limited/Improving
Medium
Secured
0% - 20%
Mature
Capital structure
Availability
Costs
Typical cases
Typical % of capital structure
High
Low
unsecured
20%+
Factors affecting the costs of debt and equity
Top-down factors
- Factors including industry conditions and financial market conditions affect the cost of capital
Issuer specific factors
* Factors associated with the risk and return profile of an issuer will affect its
required rate of return, including its:
- Sales risks
- Revenue stability i.e. operating leverage = fixed costs / total costs
- Financial leverage and interest coverage
- Collateral / type of assets owned
Operating leverage
Operating leverage =
Fixed costs / total costs
- Companies with higher operating leverage have higher change in cash flow and profitability for a given change in revenue
Interest coverage
Interest coverage =
Profit before interest / interest expense
- Interest coverage measures a firm’s ability to make interest payments from core profits
Unique situations
* There are important exceptions to what we have so far discussed
- Capital intensive businesses with marketable assets
- Some businesses, (e.g., real estate, utilities, shipping, airlines, etc.) use high levels of leverage throughout their lives
- This is because their underlying asset can be bought and sold fairly easily, tend to retain their value and can, therefore, support substantial debt secured by those assets
- Cyclical industries
- Businesses in cyclical industries tend to have less debt than those in non-cyclical industries due to the variability of cash flows during the economic cycle
- ‘Capital-light’ businesses
- Software-based technology businesses have minimal fixed investments or working capital needs
- They tend to have little debt and often substantial net cash
- Don’t tend to pay dividends or repurchase shares
- Rapidly growing share price can cause the market value of equity to dwarf the value of any debt that has been raised
Modigliani – Miller Assumptions
- Homogeneous expectations
- Perfect capital markets
* No taxes
* No brokerage costs
* No bankruptcy costs
* Everyone has the same information - All investors borrow and lend at the same risk-free rate
- No agency costs, i.e., managers always aim to maximize shareholder wealth
- Financing and investment decisions are independent of each other
Modigliani and Miller’s Proposition I: No Tax
- Capital structure irrelevance theory
- Theory suggests that there is, under certain assumptions, no optimal capital structure
- The value of the firm is not affected by how it is financed
- This assumes that the weighted average cost of capital remains unchanged
*equity holders demand a higher return as leverage increases in order to offset increased risk
Modigliani and Miller’s Proposition II: No Tax
- Still a variation of capital structure irrelevance theory
- States that the cost of equity is a linear function of the company’s debt to equity
ratio
RE = R0 + (R0 – RD)D/E - Financial leverage changes risk (due to earnings variability), so with greater
financial leverage equity holders will require higher returns - However the overall WACC will not be affected
- Therefore total firm value is still not affected by capital structure
- Equity value is affected by capital structure
- Theory suggests that there is no optimal capital structure
- Value of the firm is driven by assets, not by how it is financed
Modigliani and Miller’s Proposition I: With Taxes
- In most countries interest is tax deductible
- After tax cost of debt = Before-tax cost of debt x (1 – marginal tax rate)
- Given
VL = Value of a leveraged company
VU = Value of an unleveraged company (all-equity company)
- t = marginal tax rate
- D = Value of debt
VL = VU + tD
Note: tD is referred to as the debt tax shield
Modigliani and Miller’s Proposition II: With Taxes
Modigliani and Miller’s Proposition II: With Taxes
* If the value of a company increases as it uses more debt then the weighted average cost of capital must decrease as it uses more debt
* Given
- V = Value of company
- D = Value of debt, RD = cost of debt
- E = Value of equity, RE = cost of equity
- t = marginal tax rate
Rwacc = (D/V) RD(1-t) + (E/V) RE
If R0 represents the cost of equity for an all-equity company then the cost of equity for the same company with debt is
RE = R0 + (R0 – RD)(1 – t)D/E
Modigliani-Miller Propositions
Summary
Proposition 1
Without taxes
VL = VU
Proposition 2
Without taxes
RE = R0 + (R0 – RD)D/E
Proposition 1
Without taxes
VL = VU + tD
Proposition 2
Without taxes
RE = R0 + (R0 – RD)(1-t)D/E
Financial distress and bankruptcy costs
- Increased debt increases the risk of bankruptcy
- Bankruptcy brings explicit costs (legal and administrative fees) and implicit costs (foregone investment opportunities, reputational risk, impaired ability to conduct
business) - Implicit costs are incurred even before actual bankruptcy as fear of bankruptcy rises (lost customers, creditors, suppliers and valuable employees etc.)
- Agency costs of debt refers to costs incurred due to conflict between management and shareholders
- Companies with safe tangible assets (airlines, shipping companies, etc.) are likely to have less bankruptcy cost than those without such assets
- Good corporate governance and/or lower debt levels can reduce the probability of financial distress and bankruptcy
Optimal and Target Capital Structure
Target capital structure
Target capital structure
The debt to equity ratio the firm attempts to maintain over time
Optimal capital structure
The theoretical point at which the value of the company is maximised
Optimal and Target Capital Structure
Static trade-off theory of capital structure
- Managers need to determine optimal level of leverage by balancing the benefits of low cost tax-deductible debt against:
- Cost of financial distress or bankruptcy
- Debt agency costs
- Debt structuring and issuance fees, etc.
- The formula below only considers the tax shield and cost of financial distress
VL = Vu + tD - PV (Costs of financial distress)
Where:
*VL = Value of levered firm
*Vu = Value of unlevered firm - t = tax rate
- D = Value of debt
In practice the optimal and target capital structures should be within a range
- Difficult to say that weighting of debt should be exactly 35% but it might be possible to say that it should be between 30% and 40%
- Market value v Book Value
- Optimal capital structure is calculated using market values but target capital structure often uses book values
- Target capital structure
- Capital structure company is striving to obtain
- Use if we can assume company raises capital consistent with this target
- How to estimate target capital structure
- Use firm’s current structure
- Using market-based values
- Firm’s target structure can be inferred from past actions and management comments
- A weighted average of comparable firms’ capital structures could also be used
Factors Affecting Capital Structure Decisions
Agency costs
Refers to the incremental costs associated with public companies being run by nonowners
* Conflicts arise between management and investors
* Perquisite consumption refers to items authorized by executives that have a cost for investors such as subsidized dining, chauffeurs, corporate jet fleet
* Managers with a small stake in the company will be less worried about such costs because it is not them bearing the cost
* Better corporate governance means lower agency costs since managers’ interests will be better aligned with those of shareholders
* The greater the leverage, the lower the agency costs since management have to be more careful with what they do with cash since they have to service the debt (free cash flow hypothesis)
* This is particularly important in emerging markets where there is a tendency to overinvest
Factors Affecting Capital Structure Decisions
Costs of asymmetric information
- M&M assumed that everyone, management and investors had the same information about the company
- In reality there is information asymmetry, with management knowing far more than investors
- The more complex a firm’s business the greater the asymmetry
- Investors require compensation for this asymmetry in the form of greater returns
- Financing decisions made by management are often taken by investors as clues to the firm’s internal health
- Consequently firms often choose to finance projects internally so as not to give these signals to investors
‒ pecking order theory
Pecking order theory
* Internal financing (contains least information content)
* Debt
* Equity (contains most information content)
Factors Affecting Capital Structure Decisions
Comparing the theories
> MM without taxes : Capital structure does not matter
MM with taxes: 100% debt is optimal
Static trade-off: Optimal capital structure is where WACC is minimized
Pecking order: Managers disposed to using least visible financing (retained earnings) first, then debt, then equity (most visible)
A firm’s channels
- A firm’s channel strategy refers to where the firm is selling and how it reaches its customers, i.e. selling then delivering
Function
* Selling/display
* Handling inquiries
* Order processing
* Physical distribution
* After-sale service
Assets
Warehouses
* Retail stores
* Sales force
* E-commerce website
Firm
Retailers
* Wholesalers
* Agents
* Franchisees
Firm business model
- Intermediaries may work as agents
- Earning commission rather than taking ownership, e.g. Sotheby’s
- Drop shipping – enables an online marketer to have goods delivered directly from manufacturer to end customer without ever seeing the goods
- Omnichannel strategy – both physical and digital channels are used
- Click and collect – customer orders online but picks up from a store, or
- Select an item from a store but have it delivered
- Use of a digital channel creates cybersecurity and access risks
- Having a physical location might create substantially greater financial risk
Pricing: How Much
- Does the firm price at a premium, parity or discount relative to competitors
- How is the firm’s pricing justified in the business model
- Commodity producers (with little differentiation) are usually price takers
- Companies with high differentiation can charge premium prices (price setters)
- An analyst should ask if the firm requires access to specific capital, labor or inputs to maintain this differentiation
- A discounting strategy might be used to build scale
- ‘Total cost of ownership’ is often used to attract buyers
- The running costs of an electric vehicle mighty be attractive and enable Tesla to sell their cars as a premium product whilst still offering lower costs overall
What is a Business Model?
Pricing and Revenue Models
- Pricing approaches are typically value or cost based
- Value-based pricing tries to set prices based on value received by customers, e.g. Tesla
- Cost-based sets prices based on costs incurred
- “Price discrimination” is an economics term that is used when firms charge
different prices to different customers - Tiered pricing charges different prices based on volume bought
- Dynamic pricing charge different prices at different times, e.g. holidays, cinema tickets
- Value-based pricing sets prices based on value received by customers
- Auction/reverse auction models establish prices through bidding
- Pricing for multiple products
- Bundling is combining products/services so customers buy them at the same time
- Razors-and-blades pricing combines a low price on a piece of equipment, e.g. a printer,
and a high price on repeat-purchase consumables, e.g. ink cartridges - Add-on pricing – an example is the extras that can be added to a car
Pricing for Rapid Growth
- Penetration pricing is an example of discount pricing when a firm willingly sacrifices margins to build scale and market share
- Freemium pricing allows customers a certain level of usage or functionality at no charge, e.g. a game
- You get access to a basic version of the game whereby the manufacturer is trying to tempt you to buy the upgraded version
- Hidden revenue business models provide services at no charge and generate revenues elsewhere
- E.g. in the media sector where we have free content but paid advertising
Alternatives to Ownership
- Recurring revenue/subscription pricing enables customers to rent a product or service for as long as they need/want it
- Fractionalization creates value by selling an asset in smaller units, e.g. vacation property time shares
- Leasing allows a firm the use of an asset without actually owning it, e.g. vehicles
- Licensing typically gives a firm access to intangible assets, e.g. films, songs, in return for a payment
- Franchising is a more comprehensive form of licensing
- The franchisor gives the franchisee the right to sell or distribute its products or service and receive marketing and other support
Value Proposition (“Who + What + Where + How Much”)
- A firm’s value proposition refers to the product or service attributes valued by a firm’s target customer that lead those customers to prefer a firm’s offering over its competitors, given relative pricing
- Although value propositions vary greatly they relate to:
- The product itself, e.g. features
- Service and support
- The sales process
- Pricing relative to competitors
Business Organization, Capabilities: (“How”)
- What assets and capabilities does the firm need to execute its business model
- E.g. skilled personnel, technology, etc.
- Will these be owned/insourced or rented/outsourced
- If renting or buying from other firms, the supplier relationships can become key elements of its strategy and a potential risk
Value Chain
- The ‘how’ aspect of a business model is also referred to as the value chain
- The systems and processes within a firm that create value for its customers
- A value chain includes only those functions performed by a single firm and should not be confused with a supply chain (involves processes within and outside of a
firm) - Value chain analysis involves:
- Identifying the specific activities carried out by a firm
- Estimating the value added and costs associated with each activity, and
- Identifying opportunities for competitive advantage
- A firm’s four primary ‘support’ activities are; procurement, human resources, technology development, and firm infrastructure
Goods-producing v Service businesses
- In goods-producing sectors, it is common to classify firms on how they fit into the supply chain
- Manufacturers, wholesalers, retailers, and various suppliers of raw materials, components, equipment, and services
- Service businesses are more diverse
- Some target consumers (B2C), some target other businesses (B2B)
- Some involve physical products, e.g. importing, but most do not
- In the Financial Services sector, as an example, some act as ‘universal’ banks offering many services whilst others specialize
Business Model Innovation
- Digital technology has created many new businesses such as
- Software, content, digital advertising, internet-based communities and marketplaces
- Whilst these businesses are not necessarily new (think traditional advertising) they have changed these services and how they are delivered
- Digital technology has transformed the ‘where’ and ‘how’
- Location matters less
- Outsourcing is easier
- Digital marketing makes it easier and cheaper to reach specific groups
- Network effects (see later) have become more powerful and accessible
Business Model Variations
- There are still many business model variations such as:
- Private label or ‘contract’ manufacturers that produce goods to be marketed by others
- Licensing agreements - a firm produces a product using someone else’s brand name in return for a royalty
- Value added resellers – distribute a product but also handle complex aspects of installation, customization, service, or support, e.g. air conditioning systems
- Franchise models – retailers have a tightly defined and exclusive relationship with a parent company
- E-commerce business models
- Affiliate marketing generates commission revenue for sales generated on other firm’s websites (leads, clicks, or actual sales)
- Marketplace businesses creates networks of buyers and sellers without taking ownership of the goods during the process, e.g. eBay
- Aggregators are similar to marketplaces except that they re-market products and services
under its own brand, e.g. Spotify
Network Effects and Platform Business Models
- Network effects refer to the increase in value of a network to its users as more users join
- Many internet-based businesses are built on network effects
- Social media, ride-sharing services
- Platform businesses are based on a network and value is created by the network
- e.g. Airbnb, Facebook, Uber
- Crowdsourcing businesses enable users to contribute directly to a product, service, or online content
- Online gambling, open source software, Wikipedia, Tripadvisor
- Hybrid business models combine platform and traditional ‘linear’ business models
- E.g. Amazon’s core business has traditional elements (goods distribution) as well as platform elements (online marketing and advertising)
A simple way of transforming a debt-to-equity ratio (D/E) into a weight—that is, D/(D + E)
D/E by 1 + D/E
