Ratio Analysis

The first step in analyzing Golden State's potential is to examine its recent performance and
current financial condition. Finance professionals use a myriad of different financial ratios to
assess financial health — so many, in fact, that it helps to group them into categories. Here are
six basic categories:

 Growth
 Profitability
 Liquidity
 Leverage
 Efficiency
 Risk

Be aware that not everyone uses the same categories, and different analysts may define a given
ratio differently.

Growth

You are looking for a business with growth possibilities. More generally, investors and
managers want their businesses to produce more cash, to become more valuable. In short, they
are looking for growth. We usually measure growth as a rate of change over time in a specific
item of interest, such as sales, assets, profits, or cash flow.

One of the attractions of Golden State is the possibility of growing the business. Has it been
growing lately? How fast? How consistently? Historic growth rates may be an indicator of
future growth potential

CAGR: Compound Average Growth Rate

Profitability

Why wouldn't we always want everything included? That is, shouldn't we regard the net margin
as most comprehensive and therefore most informative? Not necessarily. By looking at
different margins, we can learn more about the reasons for good or bad performance. Simply
knowing that net margin has declined in a given year doesn't tell us why. Was it higher
production costs? Higher overhead? Interest charges?
Efficiency

Many financial ratios are intended to help assess the efficiency of a company's operations. Some
analysts call this category "Activity Ratios". For example we may want to measure how well a business
employs its plant and equipment, its inventory, its credit from suppliers, and so forth. Or we may want
to know how quickly its receivables are collected or how long some products stay in inventory before a
sale

Valuation

Balance Sheet Approach

The final item is a subtraction of the change in net working capital. This appears for much the
same reason as capital expenditures. It represents cash expenditures on those balance sheet
accounts that constitute net working capital: cash, accounts receivable, inventory, accounts
payable, accruals, and so forth. Now you can see why in an earlier chapter we rearranged
Golden State's balance sheet to put these accounts all together on the "real" side of a stylized
balance sheet.

We netted current operating liabilities against current operating assets and called the result net
working capital. In any given year, Golden State may invest in, for example, additional
inventory such as jars for the jarring line, or incremental accounts receivable for example,
extension of credit to new customers due to growth in the business. It's important to note that in
any given year, only the change in net working capital is part of free cash flow. For example,
suppose Golden State had net working capital of $60,000 at the beginning of 2007 and we
expect net working capital to be $66,300 at the end of 2007. The increase in net working capital
is $6,300 ($66,300 - $60,000) and it is this figure that should be subtracted in the calculation of
free cash flow for 2007. If the change in net working capital is negative — it fell over the year
instead of rising — then the subtraction of this negative number is, in effect, a cash inflow. Net
working capital has been liquidated.

Perhaps most surprising, Enterprise Free Cash Flows do not reflect the payment of interest.
This is so even though interest is (almost always) a cash outflow and it is generally shown
prominently in the income statement. Similarly, our free cash flow recipe shows no provision
for principal payments or dividends. None of these cash outflows is included because all of
them represent payments to suppliers of capital. The objective of our discounted cash flow
analysis at present is to estimate the value of the enterprise, which equals the present value of
the cash generated by the enterprise. We are not concerned, for now, with who exactly receives
that cash (lenders or shareholders), but merely with its value before it gets distributed to the
firm's owners. Once again it is convenient to recall the separation we made earlier between the
"real" or operating side of the firm's stylized balance sheet (this is where cash is generated) and
the "financial" side (this is where cash is distributed).

CASH CYCLE AND GROWTH

The DuPont formula expresses Return on Beginning Equity in terms of profit margin, asset turnover
and financial leverage. Let's rewrite the sustainable growth rate, with the DuPont formula. Note that
to obtain our definition of ROBE sales and beginning assets cancel. The DuPont formula shows that the
sustainable growth rate may be boosted by increasing the retention rate (cutting dividends), raising
profitability (return on sales), efficiency (asset turnover), or leverage

FINANCIAL FORECASTING
 Pro Forma Elaboration: Accounts that vary with a company's sales include (elements of the
operating cycle)
 Assets: Cash, Accounts Receivable and Inventory.
 Liabilities: Accounts Payable, Accrued Expenses.
 Income Statement: Sales, Cost of Goods Sold, SG&A (Selling, General and Administrative
Expenses)

STEP 01
STEP 02
STEP 03
Rearranging Financial Statements

FINANCIAL LEVERAGE AND RISK

But the canning business risk is still there. It's still borne by equity, only now there is less equity to
support it. So the riskiness of each unit of equity has increased. We'll call this idea the Conservation of
Business Risk and we'll use it again later. Basically, it says that when we change the capital structure of
a company we change the amount of business risk per dollar of equity, but not the total amount of
risk. All the risk of the canning business is still there — it's just on top of less equity.

In 2005 and to 2006, Golden State's EBIT fell. Had Golden State been more highly levered
during these years, its Return on Equity would actually have been lower than for the "real"
Golden State.

In summary, the primary effect of leverage is to amplify, from the perspective of the
shareholders, the ups and downs of the business. The good times feel better and the bad times
feel worse than if the company had no debt.
Let's compare Golden State's original 2007 income statement with the more highly levered
hypothetical income statement we recently examined. Golden State paid interest expense of
$8,700 in 2007. Assuming a tax rate of 36 percent, Golden State's interest tax shield was
$8,700x.36=$3,100. In other words, had Golden State been entirely financed with equity in
2007, its tax bill would have been $3,100 higher. The total portion of Golden State's EBIT that
actually accrues to investors, rather than to the government, is $8,700+$37,600=$46,300.

Now let's look at Golden State's pro forma 2007 income statement, assuming it had issued
twice as much debt. The tax shield doubles, to $6,300, which equals $17,400x.36. Because the
tax shield is higher, so is the portion of EBIT that winds up with investors. Even though net
income is lower (it's now only $32,000, compared to $37,600), total income paid to investors
(that is, creditors and shareholders) is higher. It is now $49,400 compared to $46,300.

In summary, when we relax the assumption of no taxes, capital structure may matter because it
affects how much of a firm's EBIT is paid to the government in taxes and is therefore not
available to investors

We will discuss present value computations in detail in the next section. For now it suffices to
say that the present value of a perpetual stream of $1 payments is simply $1 divided by the
interest rate. So if the interest rate is 5%, the present value of receiving $1 every year forever is
$1/0.05 = $20. Therefore the present value of a perpetual stream of interest tax shields equals
the amount of the tax shield received every year divided by the interest rate.
Now note that the interest tax shield is the amount of debt, D, times the interest rate, r, times
the tax rate, t, or Drt. The present value of a perpetual stream of tax shields is then Drt/r, which
simplifies to Dt. This expression oversimplifies the real world, for reasons we'll mention below,
but it is an elegant, simple formula and a common rule of thumb.

ALTERNATIVE MODELS OF CAPITAL STRUCTURE: STATIC TRADEOFF MODEL

Suppose a jewelry store owner is concerned about the possibility of a robbery. In deciding how
best to protect the store and how much to spend on protection, the owner considers the cost of a
robbery. This has two components. First is the likelihood of a robbery, and second is the value
of the stolen jewels if a robbery actually occurs. The store owner can take different steps to
manage each part of the exposure. For example, she could hire a watchman or improve the
store's alarm system to reduce the likelihood of a robbery. To reduce the cost of a robbery,
given that it has occurred, she could remove all cash and the most valuable jewels each night
before closing.

A company can think of managing the present value of the cost of financial distress in the same
ways as the jewelry store owner thinks about robberies. Some policies, such as selecting the
debt ratio, are intended to affect the likelihood of distress. Others, such as selecting the
particular lenders and the covenants may be ways to manage the costs of distress in the event
that it actually occurs.
Consider what happens to the market value of the firm as we increase the amount of debt in its
capital structure. First, suppose that the M&M conditions hold. In that case, the value of a
levered firm is the same as the value of an unlevered firm. Graphically, we have a horizontal
line, because leverage does not affect value. Next, if we allow for taxes, the value of the
levered firm rises in a straight line. This is because the present value of tax shields is, for a
simple perpetuity, D times t. So we have a line sloping upward with slope equal to the tax rate.
Finally, when we consider costs of financial distress, we get a curve that begins on the vertical
axis, slopes upward at a rate less than t, and finally turns over and begins to slope downward.
Where this curve reaches its highest point corresponds to the optimal amount of debt according
to the static tradeoff model. The Static Tradeoff Model gives a unique interior optimum.
That is, according to the model, the optimal capital structure for most firms is neither
100% equity nor 100% debt. In this simple model the optimum occurs at the point where
the marginal benefit of interest tax shields equals the marginal cost of financial distress.

ALTERNATIVE MODELS OF CAPITAL STRUCTURE: PECKING ORDER

ALTERNATIVE MODELS OF CAPITAL STRUCTURE: AGENCY COSTS

For example, a firm that has fallen into financial distress after years of mismanagement has to
repay a $100,000 loan next year, but its assets currently are worth only $80,000. If the situation
doesn't improve, management (acting for the shareholders) will default and the creditor will
obtain $80,000.

Now management is presented with an opportunity to invest $50,000 with a payoff of either
$120,000 or $0 with probabilities of 20% and 80%, respectively. This is certainly a bad
investment, with an expected value of negative $26,000 = ($120,000*.2)+(0*0.8)-$50,000.
However, given that the company is facing bankruptcy next year, it doesn't look so bad from a
shareholder's perspective. If the project succeeds, creditors are paid their loan of $100,000, and
the firm retains ($80,000-$50,000)+$20,000=$50,000. If the project fails the shareholders are
left with nothing, and the creditors received the residual, that is, $80,000-$50,000=$30,000.

Something interesting has happened. This bad gamble actually looks good to the shareholders!
Their expected payoff is $10,000 and a chance to save the business, compared to $0 without the
investment. Not surprisingly, for the creditor this is clearly a bad deal, with an expected value
of only $44,000 if the investment is undertaken. In overall terms of maximizing enterprise
value the investment is a loser. Management and the shareholders are only willing to take the
gamble because they are gambling with the creditor's money.

So where are the agency costs? They could take several forms. The creditors will have to spend
something somewhere to avoid this outcome. They will spend resources when they lend the
money to make sure they have good contracts. Then they will spend money to monitor the
situation, so they know when to intervene. When things start going bad, they will spend money
on attorneys and take legal steps to prevent the firm from wasting more money. In this sense,
high leverage has agency costs associated with it. There are theories that examine tradeoffs
between, for example agency costs of too much debt versus too little debt. They are fascinating,
but can be difficult to apply in practice.
ALTERNATIVE MODELS OF CAPITAL STRUCTURE: PRODUCT MARKET MODELS

ALTERNATIVE MODELS OF CAPITAL STRUCTURE: CONTROL AND GOVERNANCE

ISSUES
Time Value of Money
PERPETUITY
RISK AND RETURN
In business projects, one frequently encounters cash flow distributions that are skewed with
long right "tails". The skewed distribution is reflecting possibilities for high upsides and limited
downsides — an attractive characteristic. But because the distribution is not symmetric, the
mean and the mode will differ — that is, the expected outcome (mean) is higher than the most
likely outcome (mode).
Suppose you and a business school classmate have a great idea to start a company and you need some
capital. Fortunately you have a kind and wealthy grandmother who agrees to lend you $1 million,
interest-free. Her only condition is that you repay the $1 million in 5 years. What is your cost of
capital?v
Now consider a portfolio invested 50% in each. Can you plot this portfolio on the graph? You might
have guessed that a point halfway on the line between A and B represents the 50-50 portfolio, but it
doesn't. Combining A and B gives the investor the benefit of diversification. Portfolios that combine A
and B actually lie on a curve connecting A and B, not a straight line.
The degree of benefit from diversification depends on the correlation between A and B. The
lower the correlation between A and B, the lower the volatility of a portfolio comprised of A
and B. You would expect that if A and B are perfectly correlated, there is no diversification: the
two move together. When the correlation is less than 1, the volatility is reduced until you reach
the minimum possible correlation of -1. When correlation is -1, A and B are perfectly
negatively correlated and the volatility of one asset completely offsets that of the other, they are
held in equal proportion!
Because it is a public company, the data required to calculate costs of debt and equity for
Smucker is readily available from public sources. The rates of return are seen here.

The discount rate for debt, denoted by k equals the risk free rate plus the debt risk premium.
d

The discount rate for equity, denoted by k equals the risk free rate plus the equity risk
e

premium. We can locate these rates on the familiar risk-and-return graph we used previously.

By applying the weights of debt and equity in the capital structure to costs of debt and equity,
we obtain a rate appropriate for the company as a whole — that is, for Smucker's operations. In
other words, a weighted average of Smucker's debt and equity risk premia must equal the risk
premium of the fruit-preserving business.
VALUATION
In an earlier chapter, we addressed this question directly, by preparing pro forma financial
statements, first for 2008 and subsequently for 2009-2013. These were based on plans for
growing the business by utilizing currently idle capacity and developing new products aimed at
gourmet or health-food niches that could be sold at higher prices. These and other operating
plans, including increased sales and overhead costs, were built into the pro formas we prepared.

At the time we prepared these pro formas for Golden State, we were interested in funding
requirements — we wanted to know how much external funding would be required to carry out
growth plans we had in mind. The same pro forma financial statements can now help us figure
out how much Golden State is worth if operated according to these plans

One way to check reasonableness is to look at trends over time in revenue, EBIT, and so forth
to identify unreasonable trends or unusual ups and downs. Such checking will reveal, for
example, a large negative free cash flow figure for 2009. Can you discover the cause of it?

Another good check is to compare key parameters such as growth rates and profit margins to
objective benchmarks. In the case of Golden State, we have some information about other
companies operating in the same business, and we have the ratio analyses we performed on
Golden State's own historical financial statements. Both may be used as benchmarks to check
the reasonableness of the Golden State Free Cash Flow projections.
TERMINAL VALUE

No caso acima, a taxa de crescimento foi aplicada diretamente sobre o Cash Flow…

Abaixo, a taxa de crescimento para projeção mostra conclusões diferentes..., quando da

normalização...
Let EBIT(1-t) grow by 3% from 2013 to 2014, in other words, from $105,800 to $108,900.
Likewise, let's take the ending 2013 values for net working capital and net fixed assets and
grow each by 3%. Let us apply a normalized depreciation of $35,000 a year. The implied
increase in net working capital is $7,700 and, in net fixed assets, $48,300. The resulting
normalized free cash flow for 2014 is $88,000. The resulting terminal value using the
perpetuity formula is $1.54 million, more than 50% greater than the previous estimate! What
causes such a dramatic difference? The 2013 free cash flow projection on which we based the
first estimate included relatively heavy expenditures on net working capital and net fixed assets
— greater spending than may in fact be required to sustain growth of only 3% in perpetuity.
The normalized cash flow calculation was an attempt to reflect the likelihood of reduced
spending, in line with the projected perpetual growth rate. If Golden State could hold down
spending in this fashion, free cash flow would rise and so would the terminal value of the firm.
SENSITIVITY
Veja planilha SENSIBILITY