Corporate Finance I: Measuring and Promoting Value Creation

Professor Heitor Almeida and Stefan Zeume

Module 2: Financial Planning

Table of Contents
Module 2: Financial Planning .................................................................................................. 1
Lesson 1-0: Module 2 Objective and Overview ................................................................................. 2
Lesson 1-0.1: Objective and Overview................................................................................................................. 2

Lesson 1-1: Long-Term Financial Planning ......................................................................................... 9

Lesson 1-1.1: Long-Term Financial Planning ........................................................................................................ 9

Lesson 1-2: Forecasting Income Statements ................................................................................... 16

Lesson 1-2.1: Forecasting Income Statements .................................................................................................. 16

Lesson 1-3: Forecasting Cash Flow Statements ............................................................................... 25

Lesson 1-3.1: Forecasting Cash Flow Statements .............................................................................................. 25

Lesson 1-4: Forecasting Balance Sheets .......................................................................................... 35

Lesson 1-4.1: Forecasting Balance Sheets ......................................................................................................... 35

Lesson 1-5: Raising Long-Term Financing ........................................................................................ 43

Lesson 1-5.1: The Capital Structure Decision..................................................................................................... 43

Lesson 1-6: Investments in Working Capital ................................................................................... 50

Lesson 1-6.1: Investments in Working Capital ................................................................................................... 50

Lesson 1-7: Working Capital Ratios ................................................................................................. 58

Lesson 1-7.1: Working Capital Ratios................................................................................................................. 58

Lesson 1-8: Short-Term Financial Planning – Inventory ................................................................... 68

Lesson 1-8.1: Short-Term Financial Planning: Inventory ................................................................................... 68

Lesson 1-9: Seasonality and Receivables......................................................................................... 77

Lesson 1-9.1: Seasonality and Receivables ........................................................................................................ 77

Lesson 1-10: Short-Term Liabilities and Liquidity Risk ..................................................................... 86

Lesson 1-10.1: Short-Term Liabilities and Liquidity Risk .................................................................................... 86

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Lesson 1-0: Module 2 Objective and Overview

Lesson 1-0.1: Objective and Overview

In this module, we will start talking about investments. Investments are of course,
essential for companies. Companies need investments to be able to survive and to
grow. Very important topic of corporate finance is the financing of these investments.
We tend to divide investments into long-term and short-term investments.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

When we're thinking about long-term investments, we're thinking about investments
such as capital expenditures, R&D, and acquisitions. These are investments that might
take a long, long time. They may take a while to generate cash flows. We think of these
as long-term investments.

In contrast, we also have short-term investments that generate cash in the short-term
that the company must manage on a short-term basis. Think about inventory or

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

accounts payable. We are going to talk about both long-term, and short-term
investments in this course.

In this module, we are going to learn how to forecast financing needs, and how to
manage a company's liquidity. This is going to be very important. If you have long-term
investment needs and you also have short-term investment needs, you need a plan. If
you have R&D expenditures, and accounts payables, and inventory needs and all these
things, you need to know whether you have enough cash or whether you need to raise
capital. We need an investment plan. In this module, we will learn how a financial
manager can make that plan. We're going to talk about long-term financial planning,
which is the funding of long-term investments, such as capital expenditures. Then we're
going to talk about short-term financial planning, which as we're going to see, is mostly
related to working capital management. We will talk a lot about the implications of
working capital management, for cash generation in companies, and how companies
can manage their short-term financial planning.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Here is what we are not going to talk about in this module. What is coming up in later
modules. We will not discuss whether an investment should be made or not. In this
module, we will take investments as given, and talk about the financing, the funding of
these investments. In the next two modules, we will talk about whether companies
should invest or not. We will see the tools needed to make decisions about new
investments.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

In Module 3, we're going to talk about that. We're going to talk about the tools that allow
us to measure whether a new investment increases shareholder value or not. Then in
Module 4, we will look at acquisitions, and whether they increase shareholder value or
not.

What we will learn in this module, is for financial planning required to make short-term
and long-term investments. The very first thing that we will talk about, is the forecasting
of financial statements. We need to forecast financial statements to estimate the long-
term financing needs that companies have. Next, we're going to talk about working
capital management that relate to short-term investments like receivables, inventories,
and so on. We will learn that working capital management has very important
implications for cash generation in companies in the short term.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

We will learn how to calculate, and analyze working capital ratios, how to measure cash
conversion cycles, and what they mean. We will look at several examples that illustrate
the importance of working capital management for short-term cash generation in
companies. Among others, we will look at one example of inventory management, when
sales growth rates are very high.

Then we will look at another example, where seasonality in sales creates short-term

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

cash needs. Finally, we will talk about liquidity risk, and how liquidity risk relates to
short-term financial needs. Those are the topics we will be talking about in our financial
planning module.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Lesson 1-1: Long-Term Financial Planning

Lesson 1-1.1: Long-Term Financial Planning

So, let's start with long-term financial planning. We know we have a massive investment
coming up in a couple of years. Okay. The starting point, our starting point will be
financial forecasting. We will examine financial statements as we did and what you
want. But we will focus on the future, “forecasting” is our key word. We will try to figure
out what the financial statements will look like in future years.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Okay. So why should financial managers have to forecast the future financial
statements? The example we are going to cover in this lecture is mostly about financing
needs. So, we will forecast future financing needs of a company. We will learn whether
a company needs cash in the future or not. And of course, forecasting has other
important users as well. A second, very important use of forecasting is to forecast cash
flows for company valuation. In order to value a company, you have to forecast future
cash flows. So, valuation is another use of financial forecasting. A third use that is very
important in practice, is to estimate the impact of new projects and acquisitions on a
company. If a company takes on a new project or if a company acquires another
company, how is that going to affect the financial statements? We will learn some of
that when we talk about mergers and acquisitions in Module 4. Bottom line, financial
forecasting is very important in corporate finance.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

The specific example we will talk about in this module is the financing of an aggressive
expansion plan. So, we will look at a company that requires a large future capital
expenditure. For instance, that company might want to enter a new geographic market.
This company must figure out whether and when it will need to raise long term financing
to support such an expansion.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

So, the question really is willing the company generate sufficient cash internally or will
the company have to access additional funds? Will have to go to the financial markets
to raise more funds. So, these are the type of questions that we will be able to answer
to continue the theme that we started in Module One. I think it's extremely important to
try to deal with real-world financial statements as much as possible.

So as much as we can, we are going to be dealing with real-world companies for this
example, we're going to use financial statements for PepsiCo. We are going to work
with actual financial statements from PepsiCo and consider the impact of an investment
program.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Before we get started, we need to make a few specific assumptions. We will start with
the 2021 year-end financial statements, those are known already, they are reported,
they are audited, they are solid, they are solid financial statements and then we will
engage in a guessing game. We will try to guess what's going to happen in the future.
As we will learn, perhaps the most important forecast is the revenue growth forecast.
Revenue growth is going to affect everything else. For revenue growth, we're going to
have specific numbers. So, revenue growth is going to be growing at numbers that we
can take straight from Capital IQ. Those are actual forecasts made by analysts. They
thought about PepsiCo’s revenues in the next couple of years. What they are
forecasting is that there's going to be revenue growth in 2022 and 2023. The numbers
are right on the slide, 3.9%, 4%. And then we come up with an expansion plan. This is
going to be another assumption we must make. We actually don’t have this data. It's
very difficult to get the data on capital expenditure plans from oil companies. So, this is
an assumption we will make after talking to a couple of very important people at
PepsiCo. They told us, let's say that PepsiCo needs to invest $5 billion 2022, and
another eight billion in 2023. As you can see it's a very significant capital expenditure.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Next, we have a few more assumptions. Investment in networking capital is going to be

equal to, say, 12% of the increase in revenues. Let's say we use past financial
statements to come up with this number. Okay. Also, we're going to assume that Pepsi
pays 4% interest in its debt. This is taken from Pepsi's recent long-term debt issues,
which you can find on Capital IQ, for instance, or we could look at their past interest
payments on their debt. Lastly, we will keep the same dividend policy. We will assume
that PepsiCo is going to keep paying a constant fraction of net income as their dividend.
Dividend is also a use of cash, so we must forecast dividends as well.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Now the question we will try to answer is whether the company can finance this
expansion without issuing debt or equity, Does the company need to go to the bank to
get more cash? Okay, or does the company generate sufficient cash flow to finance the
expansion plan of $5 and $8 billion.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Lesson 1-2: Forecasting Income Statements

Lesson 1-2.1: Forecasting Income Statements

In the previous lesson, we asked whether Pepsi could finance their expansion plan
internally or whether they need to go to the debt and equity markets. In order to answer
this question, we will need to do a financial forecast. The first financial statement we will
look at is the income statement. So now we will see how to forecast an income
statement. The model we are going to use is what we call the percentage of sales
model. In this model, in the percentage of sales model, all the key variables are going to
be growing at the same rate as revenues. So, everything is going to remain a constant
proportion of revenue with some exceptions, of course. There are some variables for
which we cannot use this assumption and for others we can. So, this percentage of
sales model is a very common forecasting model. Obviously, it's not the only one and it
works better in some situations than it does in others. But it's going to allow you to
illustrate what it takes to forecast a financial statement. In this case, in our case, the
income statement.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

So, this is the income statement for PepsiCo. As we said, we are going to start with
December 2021 financial statements. So, these were audited numbers that PepsiCo
reported at the end of the fiscal year in 2021. And now we will think about the future,
what's going to happen next as we're going to go forward in time? What's going to
happen to revenues, what's going to happen to costs, and so on? Ultimately, what's
going to happen to the company's profitability? That's what we are really after. And the
income statement ultimately gives us information about profits. That's what we learned
in Module 1. So, we will try to figure out future profits for PepsiCo.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Okay, so how do we use this model? Here we have our revenue forecast for 2022, as
we just talked about, we are going to use revenue growth rates from Capital IQ. In 2022,
revenues are expected to grow at 3.9%. So, PepsiCo revenues are going to increase.
They are going to increase from $79.5 billion in 2021 to $82.6 billion. You can check
that this is an increase of 3.9%.

And now the question is, what is going to be the cost of goods sold in 2022? I want you

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

to think about that for yourself. Try to solve that, okay? Try to figure out the forecast for
cost of goods sold in 2022.

Here's the answer. We start from revenues. The idea of this model is to start from the
top of the income statement. We start from revenues, then we use the same
assumption to forecast many, many other items. So really what it boils down to is that
COGS in 2022 is going to be growing at the same rate as revenues. So, notice it's 3.9%
here as before. It's really very simple. The other way to think about this is that the
company is going to keep the same cost structure. Here you have the fraction in 2021,
cost of goods sold were 37 billion, revenues were 79.5 billion. So that's a fraction. And
what's going to happen in 2022? Well, in 2022 the company is going to keep the same
fraction of cost of goods sold to revenues. So, cost of goods sold is going to increase to
38.5 billion. So that's the assumption that we will use. And of course, it's more
reasonable in some cases and it's less reasonable in other cases. But that's how you
would use a percentage of sales model.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

In practice, what we do is we go back to the income statement, you would go back here
and just write the numbers we just calculated. You will probably be doing this in a
spreadsheet, okay? It's not practical to forecast the income statement with a pencil on
paper. I mean look at all these empty columns and rows, okay? But that's literally what
you would be doing without a computer. So, we have revenue here, that's 82 billion and
573 million. And cost of goods sold here that's 38 billion 490 million. For SG& A for
selling and general admin expenses, we are going to use the same assumption. They
are going to be growing at the same rate as revenues. You can check that the answer
for SG&A in 2022 is 31 billion and 40 million. And now we come to this item, others. I
would like to talk about this for a little bit, okay? So, in every real vote financial
statement, there are going to be items that we are not so sure about. So, what about
these others? In some cases, you can do additional research. In other cases, it might
even be difficult to find out exactly what this item was back in 2021. But think about it.
We are trying to forecast future financial statements.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

The key question is, what's going to happen in the future? Is this others item a recurring
item? Is it going to grow or is it a one-off item? There are several assumptions you
could work with here. A common assumption when you have these other items is just to
assume that they are one-time items, that they are not recurring. Whatever happened in
2021, stays in 2021 and will not happen again in the future. So here we are going to
assume that they are one-time items and that they will not happen again in future years.
That means we would just write zero into the other line. And again, of course, it's an
assumption. Every time we forecast a financial statement, we are making assumptions.
The assumptions could be reasonable. And it really is the job of the financial manager
to try to come up with as good assumptions as possible.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Moving downward, our next item is interest expenses. When you think about interest
expenses, it's very clear that we should not forecast interest payments as a constant
fraction of revenues.

The amount of interest that the company pays is going to depend on how much debt the
company has, not on their revenue. So, PepsiCo in this case had 42.4 billion in debt in
2021. You can check the slide with the balance sheet that is coming up in a couple of

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

slides. So, PepsiCo had 42.4 billion in debt. That means that your interest payment is
going to be whatever interest rate you are paying times that amount of debt. So, if you
do this calculation using our assumption, then the interest expense is going to be 4%.
You can go back, refer to our slide where list all the assumptions. So, the interest
expense is 4% of total debt. That means PepsiCo is going to be paying a $1.6 billion
dollars in interest every year.

Lastly, we will assume a constant tax rate. So, the tax rate is not going to change in
future years. And really that's everything. These are all the assumptions we need to
forecast the entire income statement.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

So here are some of the numbers that we wrote down ourselves. We can do this for
every row and column for every little cell here. So here you have the interest, for
example, taxes, we are assuming a constant tax rate. And what that means is you can
forecast everything, each and every item. With other non-operating income, we are
using the same assumption we used above, which is, we set it to zero. So effectively we
are assuming that this is a one-time expense that is not going to happen again. So, this
is our forecast for PepsiCo’s future income statement.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Lesson 1-3: Forecasting Cash Flow Statements

Lesson 1-3.1: Forecasting Cash Flow Statements

We are done with our forecast of the income statement. Next, we will think about the
cash flow statement. We saw in Module 1 that the cash flow statement has three
different parts, the cash flow from operations, cash flow from investment and cash flow
from finance. And then at the end, we have the net change in cash, we already talked
about that. Here we have the 2021 cash flow statement for PepsiCo. Those are the
actual numbers that PepsiCo reported in 2021. We start with earnings and first we make
the necessary adjustments to turn earnings into cash flows from operations.
Depreciation, we are adding back depreciation because it's not a cash expense. The
company had some positive cash flow from working capital that period, so that's how
you end up with a $11.6 billion dollar cash flow from 7.6 billion in net income.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

But remember, our goal is to forecast the future. We will again, use the assumption we
made in the percentage of sales model to predict this future.

For instance, we need depreciation in 2022 and we are going to use the percentage of
sales model. We will assume that depreciation will grow at the same rate as revenues.
So, depreciation is going to be a constant fraction of revenues. That's why we have our
3.9% growth rate here. In terms of changes in net working capital, our assumption is

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

12% of the change in revenue. Remember, we said we use past financial statements to
come up with this number. And you might have learned this already or not, in any case,
we are going to be talking about this in this model when we talk about working capital.

We should think of working capital as an investment. Working capital is an investment in

the business. This investment is typically going to generate a negative cash flow.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

So, it's exactly like a capital expenditure. So, there is an additional investment in
networking capital that PepsiCo requires in 2022, and it's equal to 12% of the increase
in revenues.

So, as we did in the case of the income statement, we can go back here and start
writing down our numbers. We have the earnings of 8,965 here, that's where we get
started. We calculated these in the previous lesson, okay? Sometimes we need to

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

adjust earnings for minority shareholdings when we move from income statement to
cash flow statement, but let's ignore this for simplicity in this case. Okay, so next, we
have the depreciation that we just figured out as well, it's 3.2 billion. Then there is an
increase in net working capital of 372, that's an investment and therefore a negative
cash flow. Other than that, we are going to keep the assumption that these other
adjustments are one-time items. We will not worry about them, so we will set them to 0.
Now we can compute the cash flow from operations for PepsiCo in 2022. It should be
11.8 billion, okay? So, we are adding back depreciation, deducting the investment in
networking capital, cash flow from operations is 11.8 billion. Next, we move on to the
part of the cash flow statement where we enter our capital expenditures. Remember,
our original goal was to figure out whether the company could fund its expansion plan,
this capital expenditure, the internal funds. Okay, with internal funds. So that's where
the capital expenditures are going to be entered in the cash flow statement. So here we
assumed they are 5 billion in 2022. And as before, we again assume that others are
one-time items and 0 in 2022. So, we enter those here and our cash flow from investing
in 2022 is minus $5 billion. So now we have the cash flow from operations, and we have
the cash flow from investment. Let's think about the financial cash flows next.

One of the assumptions we use is that dividends are a constant fraction of earnings.
When dividends are a constant fraction of earnings, we can forecast dividends using
that formula, The same ratio that PepsiCo paid in 2021 is going to be paid out in 2022.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

And now I want you to think about this question. For the cash flow statement, w e need
numbers for net debt and net equity issuance. These are important numbers, and we
need to forecast them. So which values are we going to put in the cash flow statement
for that issuance and equity issuance?

And just a hint for you. The answer has to do with the question we asked to begin with,
can PepsiCo finance the expansion without new debt or equity issues? Well, you have

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Professor Heitor Almeida and Stefan Zeume

the answer right there, no new issuance. Really what this means is a big zero. That's
what we should enter. There is no new funding flowing into company from debt or equity
markets.

Alright, so we go back to the cash flow statement and we're going to put down the
dividends of 6,843. We just discussed how to calculate this and then we put down some
big zeros. Every time you see net issues of stock on that borrowing, we add zeros, and
this is not really an assumption. It really is the question we are trying to ask and answer.
You want to find out if PepsiCo can finance the expansion plan without issuing new
funds. So, we must input zero. If you had some funds coming in, then you would have to
adjust this of course. But here this is the answer zero. That's what we should do.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Okay, now we are ready to look at the entire cash flow statement. So, this is our
answer. It's on the slide right there. The numbers be plugged in, they are right there,
you will see the numbers be calculated for capital expenditure for dividends and so on.
Notice that the dividend is coming in with a negative sign. That's because dividends are
a use of cash, its cash leaving the company. And then we have all our zeros. There are
no new issues of stock, no new borrowing. There are no negative numbers, either.
Notice that in 2021 PepsiCo was repurchasing a little bit of stock and had net
borrowings. We assume that these are one of items. We eliminated them.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Okay. And now we ask whether PepsiCo generates sufficient cash to pay for its planned
investments.

So here, with all our assumptions, the total cash flow from financing is just equal to the
dividend payment. Essentially, we are assuming that PepsiCo is only paying out the
dividend and is not issuing new stock or debt or making any stock repurchase or raising
debt. Finally, we can estimate the net change in cash. So that's the amount of cash that

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Professor Heitor Almeida and Stefan Zeume

PepsiCo is going to generate in 2022. And in 2023 according to our model. If our model
is correct, PepsiCo should lose $50 million in 2022. And then here comes the Big One
in 2023 they're going to lose 2.85 billions of cash. So that's what we come up with.

Now let's try to answer our question. We have the income statement; we have the cash
flow statement and we just figured out that the company has a net change in cash of
negative 2.85 billion in 2023. The question is, does this negative number require Pepsi
to issue new debt? For example, does PepsiCo need to raise money from investors to
cover this negative change in cash or not? As you're going to learn in a second, we
actually now must go to the balance sheet. It turns out that we need to know how much
cash the company will have in order to answer our question.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Lesson 1-4: Forecasting Balance Sheets

Lesson 1-4.1: Forecasting Balance Sheets

We just discovered that we still need to think about the balance sheet. Here we go. I
know this might look scary right now. Look at all these items here. You might think it's
going to take a long time for us to go through all of them. Well, here's the good news.
For the question we are going to answer, the most important item to look at is the first
one, cash and short-term investments. It turns out we don't have to worry so much
about any of the other items. The most important item to look at is the first one, cash
and short-term investments.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

We do not have to worry about the other items at all. We mostly care about cash. What
is going to happen to cash in 2022 and in 2023? That's the key item that we are going to
look at. How do we forecast cash? It turns out to be fairly easy. It requires no
assumption. It really is just an accounting definition.

PepsiCo’s cash in 2022 should be exactly equal to the cash we ended up with in 2021
plus whatever happened in 2022. If we lost 50 million in cash in 2022, as in our

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Professor Heitor Almeida and Stefan Zeume

example, our cash is going to go down by $50 million in 2022. Then we go on one year
further into the future, 2023. What happens to cash in 2023? We start with cash in 2022
and then we just add or subtract whatever happens in 2023. We've forecasted that the
company has a large negative cash flow in 2023. In total, cash is going to go down by
approximately $2.9 billion from 2021 to 2023.

At this point, we can go back to the empty balance sheet, and we can write down the

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Professor Heitor Almeida and Stefan Zeume

numbers for cash. Cash is going down a little bit from 2021 to 2022. Then it's going to
go down substantially from 2022to 2023. These are the numbers. PepsiCo’s cash,
according to our forecast, will be 5,948 in 2022, and then 3,089 in 2023.

What about the other balance sheet items? Well, I said we don't have to worry so much
about those for now but the solution I’m going to post, the Excel spreadsheet that will be
posted for you will have everything done for you. The important thing to notice is that
the changes in the balance sheet must be consistent with the changes in the income
and the cash flow statement. That's what we did for cash. Our cash flow statement
projects that cash is going to go down by 50 million and 2.85 billion over the next two
years. The balance sheet reflects that. It's the same idea for the other balance sheet
items.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professor Heitor Almeida and Stefan Zeume

Take PP&E, for example, its property, plants, and equipment. PepsiCo has some
PP&E. If you are making capital expenditures, if you're engaging in an expansion plan,
then you PP&E is going to increase. The increase in net PP&E is going to be equal to
the capital expenditure in 2022 minus depreciation in that year. Your assets are going to
depreciate by a certain amount. That's the same thing for working capital items. We
assume that the company requires net working capital investments and receivables and
inventory. The amount of receivables and inventory that you end up with 2022 must
reflect the increase that happened during that year. This is really pretty simple, but it
does involve a lot of calculations.

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Professor Heitor Almeida and Stefan Zeume

You can do some sanity checks. For instance, in this balance sheet, PP&E is going up
substantially in 2023. That makes sense. It's due to our expansion plan. Well, take
current assets. Those reflect the drop in cash, but also the change in net working capital
and so on. As I said, I will post the solution with all the details and all the numbers for
you to check. But as I said earlier, the really important number to think about as cash.

Alright, now let's get back to our question. Can PepsiCo finance the expansion plan or

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not? Now we're actually ready to answer that question. We've done all the work, so now
it's just interpretation. Let's take a break and think about this. Given all our numbers,
can PepsiCo finance the expansion plan or not?

The answer is yes. It seems to be yes. Why is that? Because PepsiCo has about six
billion of cash in 2021. That's a cash reserve that the company has. Cash is going
down, of course. Cash is going down to 3.1 billion in 2023. But that seems like it's still a
reasonable number. PepsiCo has sufficient cash to finance the expansion plan. The
answer would be different, for example, if cash had become negative. If you figure out
that you don't have enough cash to finance the expansion, then you will need to issue
new funds. That's when the company has to plan to go to the capital markets and to
raise new financing. But in our case, the answer seems to be that PepsiCo has
sufficient cash to finance the expansion plan. Notice that I say seems to be. Everything
might be more complicated than it really seems.

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There are two issues that I want us to consider here. First, in Module 1, we talked about
liquidity and cash ratios. On the one hand, PepsiCo has sufficient cash to pay for the
capital expenditures. On the other hand, PepsiCo's cash ratio will go down. If you work
out the numbers, PepsiCo had a 23% cash ratio in 2021. Remember, the cash ratio is
cash divided by current liabilities. This cash ratio is going down from 23% in 2021 to
12% in 2023. Now, PepsiCo's financial manager, the CFO, must think about this. Is this
still a good level of liquidity to have? How's the financial manager going to answer that
question? Probably by doing even more financial forecasting. The financial manager
may have to think about other things that may happen in the future years. Is Pepsi going
to need cash elsewhere as well? Should we maybe keep a 23% cash ratio just for
security? Maybe PepsiCo will have to issue additional external finance. There's a
second issue to consider here. Let's go back to an idea we discussed in Module 1.
PepsiCo is a multinational company. Some of this cash may be trapped outside of the
US. We discussed that repatriation no longer requires large repatriation tax.
Nevertheless, there might be other costs associated with repatriating the cash reserve.
To sum up, it seems PepsiCo has a lot of cash, but in the real world, managers may
prefer to issue new equity or debt instead of using their cash reserves.

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Lesson 1-5: Raising Long-Term Financing

Lesson 1-5.1: The Capital Structure Decision

In the previous lesson, we just discussed PepsiCo’s long-term financial plan. We

discovered that PepsiCo could probably finance the expansion plan using their internal
funds. But there are reasons why the company may want to issue new long-term
financing. This is obviously a very important topic in corporate finance. If a company
decides that it does need new long-term financing, how should they do it? There are
many issues to think about here. We call this the capital structure decision. How do
companies finance themselves? What securities should they issue? To talk about all
these issues would be beyond the scope of this module. But I would just like to highlight
a few of the key issues that the company would need to consider. Just for
completeness, let's talk about a few of the issues that PepsiCo would need to consider if
the company decided to issue new external funds.

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The first issue to consider is which source of financing to use. Let's say we need three
billion of cash. There are many ways we can raise this money. We can raise the money
by issuing new stock, or we can issue the money by issuing a bond. Or we can go to the
bank and borrow the money.

There are many factors that a Chief Financial Officer would need to think about,
including taxes, liquidity, how much leverage we have and want to have. Remember, we

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talked about leverage in Module 1. We know how to measure how leverage the
company is. We have to think about market conditions, what interest rates to look at,
and many other things. Like I said in this module, we don't have time to talk about
capital structure in detail. At this point, let's just assume PepsiCo decides to issue a
bond. We considered all these things on the slide and decided to raise the money by
issuing a bond. Here's another question to think about. When should we issue the
bond? We have our financial planning model. We know that PepsiCo is going to need
the money but only in 2023. It seems that there's no need to get any new financing until
that year. You might think that it may be better for PepsiCo to just sit and wait until 2023
comes around and then issue the bond. Of course, the advantage of that is that
PepsiCo won't have to pay any interest.

The disadvantage, which may be less clear is that we are not sure what the market
conditions will be like in 2023. It's the future and we never know what's going to happen.
For example, what if we are on our way into a new financial crisis? This actually allows
me to talk a little bit about some of Heitor's research. Some of the research that he has
done with Scott Weisbenner, that is one of our other professors in this finance
specialization. In their work, they look at corporate debt during the recent financial crisis.
We had a financial crisis around the world from 2007 to 2009.

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Their paper examines what happens to companies during that time. A very interesting
finding is that companies that were forced to issue new debt at the height of the
financial crisis in 2008 made it worse than companies that were in a stronger financial
position. It's very much, like, the situation we are discussing here. PepsiCo is
considering issuing new debt today or in two years. If they wait, they might end up in a
year where market conditions are bad. They might not be able to issue debt in 2023
because banks just say no. Or they might have to pay a much higher interest rate.

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An interesting example that Hater discusses in his paper is the case of Avis and Budget.
These are two car rental companies and what happened is that before the financial
crisis, they were both independent companies. They were competitors. But Budget was
exactly in the situation that we are describing here. Budget was forced to issue debt in
2008 to refinance some long-term debt that was maturing in that year.

Avis on the other hand was in a much better financial position. If you read the news, you

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will know what happened. Avis ended up acquiring Budget following the financial crisis.
Budget was acquired by Avis partly because it was going through financial trouble and
ended up being swallowed up by a competitor.
Poor financial management, poor timing can have very extreme consequences for
companies. Going back to our PepsiCo example, it may not be a good idea to wait two
years. The takeaway so far is that PepsiCo may want to issue the debt today rather
than in 2023. But there's another challenge here. Suppose you decided that you
needed, let's say, $2.9 billion in 2023 to finance this expansion plan, should you borrow
exactly 2.9 billion? The advantage is that you minimize your interest payments. If you
borrow just what you need, you're going to be paying less interest than if you borrow
much more. But think about it. There could also be a risk that is very much related to
what we just discussed. The idea of precaution.

It might be safer to borrow more. We may be safer to borrow more than $2.9 billion
despite the additional interest. Why is that? We have this forecasting model. Our
forecasting model is telling us, yes, we will need 2.9 billion. But the forecasting model
might just be wrong. Maybe PepsiCo is going to do worse than we expected. There
might be other expenses, there might be other cash needs, so PepsiCo CFO might
have to consider borrowing more than we just calculated just for precautionary reasons.

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Here comes a question. If you are going to engage in this precautionary borrowing, if
you are going to borrow more than you need, what are you going to do with the excess
funding? What should PepsiCo do with all that cash? The answer is that you have to
hold that cash. For the excess funding to give you financial security you can't just spend
it, you have to hold that cash. Again, this allows me to talk about some of Heitor's
research where he makes exactly that point. Holding cash, in a sense, is equivalent to
precautionary borrowing. So taken together, holding precautionary cash might end up
making sense for a company that needs to take precautions against future cashflow
shocks, against future liquidity shocks.

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Lesson 1-6: Investments in Working Capital

Lesson 1-6.1: Investments in Working Capital

We just talked about long-term investments. Let's now move to short-term investments.
So, we're going to be talking about inventory, which is an investment that a company
must make in the short-term in order to sell goods. And we're going to talk about
receivables.

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And, at first, it may be strange to think about accounts receivable as an investment,

right? So, things like trade credit, consumer credit. Why is this an investment in the
business?

Let's think about that. Why does a company have receivables? The reason really is that
it may be necessary for a company to give some terms to give time for customers to pay
for their goods. So, having a receivable is a necessity of the business because it can

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increase the demand for your products. It gives better terms for customers if customers
have time to pay for whatever you're selling. That might increase demand. On the other
hand, receivables are going to tie up cash. Because you're giving customers time to pay
for their goods, it's also going to take longer for cash to come in. And cash is, of course,
going to be an important consideration.

So, how could the company reduce receivables? Of course, the first issue you might
want to consider is whether it's worth giving discounts. Companies can usually trade off
receivables for a discount, so maybe you can give discounts for customers to pay early.
But you will quickly realize that this is going to be costly. Discounts are going to reduce
revenues. There is an alternative, which is to factor receivables. Let's see how that
works.

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If a company has, for example, $300 million in receivables that you generated because
of your business, let's say that these receivables are due in a year. The company has
two options. You can wait a year to get paid. Or you can try to get the money now. And
you can think about how the company could get the money now. You can go to a bank,
for example. And tell the bank, look, I have a receivable. I have some accounts to
receive in a year, can you give me some money now? Or a factoring company. That's
exactly what a factoring company does, is to buy receivables from companies that have
them. So, of course, that's going to have a cost, that's not going to be free. So, the bank
factoring company will pay less than 300 million. So, you're not goanna get the full 300
million. It's a little bit like a discount. Say it's 280, should the company do it? You are
goanna loses 220 million, but you are goanna get the 280 million now. That is a
question we're goanna be thinking about later in the course, when we talk about net
present value. We are going to use an example that is very similar to that.

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But for now, let's just think about the following. It's going to depend really on how bad
the company needs the cash today. You are paying a significant interest rate. Because
you are getting 280 million for a receivable of 300. If you think about how this problem
works, the company could invest the 280 million, if the company invests the 280 million
at a 7.14% interest rate, you will end up with 300 million by the end of the year, so the
implied interest rate on this deal is 7.14%. It's there as if you're borrowing money at a
7.14%, and the money in your borrowing is collateralized by the receivables that you
have. So, selling the receivable really is very similar in economic terms to borrowing
against the receivable, right?

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Let's think about inventory a little bit. Inventory, as you're going to see, is similar. We
think about raw materials, work in progress, finished goods.

Why do companies need to retain inventory? It's necessary for the business to run. So,
you might need to have the finished goods already in place to be able to sell your goods
to customers and all that. But the cost is goanna be the same as having a receivable.
Having an inventory is going to tie up cash because the company must buy the goods

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before you sell them. So, the trade-off we're going to think about is the same, so having
inventory is necessary for the business on one hand. On the other hand, it's going to tie
up cash.

And so, this is goanna be the trade off in the examples that we're going to talk about in
this seminar. Finally, we have accounts payable, which is the liability side. So, accounts
payable are exactly like accounts receivable with a reverse sign. If a company increases
accounts payable, it might seem like a bad thing. You have more liabilities to pay. But
really, what you're doing is you're freeing up cash. Increasing payables is like borrowing
money from suppliers. You're telling your suppliers, look I'm not goanna pay you now,
I'm goanna pay you later. That is going to free up cash for the company. Of course, that
might have a cost as well, similar to inventory and receivables. If you increase payables,
you might affect supply. Your customer, your suppliers, are not going to like it, they
might charge you a higher price. They might say, yes, you can do that, but we're going
to charge you a higher price for the goods. And the company must think about the
tradeoff. It's exactly the same tradeoff, but with the reverse sign. And that's why we
think of net working capital as an investment.

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So, we have receivables, inventory, and payables. Net working capital is just the sum of
these three items. Receivables plus Inventory minus Payables. So, if a company
increases net working capital, for example, increase inventory. What you're doing is,
you are tying up cash, but you are making an investment in the business. Or if you're
buying inventory, what you're doing is you're making an investment in the business. It's
a short-term investment because net working capital investments will typically generate
cash soon. So, if you increase receivables, the receivables are goanna be paid
relatively soon. Your goods will hopefully be sold. So that's why we think of net working
capital as a short-term investment.

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Lesson 1-7: Working Capital Ratios

Lesson 1-7.1: Working Capital Ratios

In the previous lesson, we talked about the main working capital items. We talked about
inventory, about payables and receivables. Let's talk about some financial ratios that
can help us analyze these working capital items for real-world companies. The first ratio
that we are going to discuss is the average collection period in days. This ratio has to do
with accounts receivable. Companies have generated accounts receivable due to the
nature of their business and this ratio will tell you how long it takes for the company to
collect its receivables. We compute this ratio by dividing the total amount of accounts
receivable in the balance sheet by the company's daily revenue.

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So let me give you an example here, suppose a company has 100 million receivables
and you have a total annual revenue of 2 billion. That means your daily revenue is 2
billion divided by 365. That's roughly 5.5 million in daily revenues. Next, we divide our
accounts receivable by that 5.5 million. The answer we get is 18 days. So, what does
that mean? It takes on average 18 days for a company to collect their receivables.

We have similar ratios for other working capital items, inventory and payables, for

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instance. Those ratios are usually based on operating costs. The definition of operating
costs that we use to calculate these ratios is the sum of cost of goods sold and selling
and general admin expenses. So COGS plus SGA and that's it, other than that the
definitions are very similar.

The average day in inventory is the total amount of inventory that a company has
divided by the daily operating costs. What does the average days in inventory ratio tell
us. That tells us how many days of inventory a company has in the balance sheet. And
then we have the payables, remember the payables are the other side of the equation.
The company might be borrowing money from suppliers and this ratio, the average
payable period tells us how many days of payables the company is carrying in the
balance sheet.

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At the end we can put all these working capital ratios together and we compute this
important ratio to talk about working capital management. We call this the cash
conversion cycle. The cash conversion cycle is equal to the collection period the days of
inventory minus the payable period. Let's make sure everybody understands this.

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So let me ask this question. What does the cash conversion cycle measure? Let's see if
you can answer that one. All right. Going back to the receivables example, it should be
intuitive.

The cash conversion cycle tells us how much time it takes for a company to generate
cash from its working capital investments. Think about it this way, suppose you're
selling a certain good, you must buy some inventory, right? The first thing a company
must do is buy inventory and hold the inventory until you finally sell the good and then
when you sell it, you might generate some receivables.

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So, the first two parts of the cash conversion cycle, they tell you how much time it takes
from buying the inventory until your customer pays. And then on the other hand, we
have payables. Payables are always the opposite side; companies are borrowing from
their suppliers. We might buy inventory but not immediately pay for it. And that shortens
the cash conversion cycle because we are essentially getting cash borrowing money
from our suppliers. So, if you calculate cash conversion cycles for real world companies,
really, you get a very useful measure of how much time it takes for a company to
generate cash from their working capital investments.

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In our assignment, we are going to calculate several cash conversion cycles for real
world companies. But let's also discuss a few examples here. We are going to use two
companies that design, manufacture and deliver aerospace and defense products. They
manufacture entire airplanes. These two companies Boeing and Airbus. What they do is
they gather all the parts needed and then they manufacture some heavy equipment. So,
what this example will show you is that the cash conversion cycles really depend on the
nature of the business.

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Here are the working capital ratios for companies. You can see that these are very
significant numbers here. So, let's look at the inventory that Boeing has for example. In
2017 Boeing was carrying 278 days of inventory in its balance sheet. That means it took
278 days, 9 months on average for Boeing to sell the goods that it had an inventory.
Then Boeing got into some trouble, right. And in 2021 that number was 474 days. There
are also some receivables and payables. In the end, if we had inventory through the
collection period and then we subtract the payables period, we get the average cash
conversion cycle for Boeing, it's 484 days on average in 2021. So that means it takes a
year and a half for Boeing to generate cash from working capital investments. From the
day that they pay for some inventory until the day that they get paid for a final product
that takes them a year and a half. Let me show you that not all of this is bad
management or trouble specific to Boeing. Airbus has a much shorter cash conversion
cycle, but it's still six months half a year. It is the nature of the business that you must
carry a very large amount of inventory. And so, you end up with a somewhat longer
cash conversion cycle.

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Of course, not all industries, not all companies are like that, we can compare these two
companies with a retailer like Walmart. The retailer will have some inventory, but a
company like Walmart takes its time to pay suppliers and really doesn't take very long to
get paid by consumers. There are some sales on credit cards that don't take as long.
So, Walmart ends up with a very short cash conversion cycle. Look at these numbers, it
only takes six days for a company like Walmart to generate cash from its working capital
investment. I can tell you this number was 12 days in 2014, in 2021 it's 6 days. Over 7
years they cut their conversion cycle in half, they cut in half the time to generate cash
from working capital investments.

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So, what we learned is that the cash conversion cycle really depends on the nature of
the business. Because Boeing and Airbus have this need to hold large inventory and
because it takes them time to sell planes and to get paid, they are going to end up with
a very long cash conversion cycle. The financial manager of these companies Boeing
and Airbus must consider that cash conversion cycle, they have to know that it tends to
take long and that's where we're going next. We will think about how working capital
needs like inventory and other working capital needs generate specific needs for short
term financial planning.

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Lesson 1-8: Short-Term Financial Planning – Inventory

Lesson 1-8.1: Short-Term Financial Planning: Inventory

So, let's start talking about short-term financial planning, okay. The general theme of
these examples that we're going to talk about is that working capital management,
which as we just learned is an investment of the, in the business, is going to determine
cash generation and liquidity management needs for a company, okay. So, this is going
to become clear as we go through these three examples. The first one is going to be an
example of inventory management in a high growth environment, okay. Then we're
going to talk about seasonality. And the third example is going to be about managing
liquidity risk arising from accounts payable, okay. So, let's start with inventory
management.

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The specifics, so we are going to have some numbers now to give a specific example.
So, the situation we have is a company that on average has to purchase inventory 90
days ahead of the time when the goods are actually sold, okay. The sales are going to
be 300 million a year and they're going to grow at 10% per quarter, okay. All sales are
cash for simplicity. We're not going to have any receivables, okay, and we're going to
have a profit margin of 8%. And if you're wondering, where did I get those numbers
from, we can show that these figures closely match the current situation at Power
Solutions International, okay. The distributor that we just talked about when we
discussed the working capital ratios, what they have is a situation where they have a
very high, you know, huge growth – 10% a quarter is a huge growth rate, okay,
combined with a very long cash conversion cycle, okay.

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So just to show you this, these are the basic financial numbers for PSI, okay. You can
see in this table that the company is growing at a very high growth rate, right. So, the
growth rate of revenues here is 33% expected growth rate for 2014. Was 46% at that
time, right. The company has about an 8% profit margin, okay. So, in terms of, and the
revenue, even the amounts match, right, because it's about $300 million in annual
revenue, 350 expected in 2014, okay. These are the numbers, right.

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It's a simplification of PSI's problem, but it is, it's going to give a very similar answer to
what I, what's happening in that company, okay. So here we have a snapshot of a year
in a company like PSI, okay. We have the sales, we have the costs, and we have
inventory. So, let's look at this example here. We have, right, annual sales are 300
million, right, so you start the quarter with $75 million in sales, okay, and then your sales
are going to be growing at 10% per quarter, right. So that's why sales are going to 82.5,
then they go to 90.8, then they go to 99.8, okay. So those are your sales. You have an
8% profit margin, right, so you profit is 8% of sales. And your inventory has to be in
place 90 days beforehand, right. What this means essentially, it's one-fourth of the year,
okay. So, what this means is that your inventory has to be in place at the beginning of
the quarter, right. So, to be able to sell the goods at the end of the quarter, a company
like PSI must have the goods already in place at the beginning of the quarter, okay. So
that's what is in this model here. In the beginning of quarter one, the company has to
buy 69 million, which then you sell, right. This number goes here. That becomes your
cost when you sell the good, okay. So, you can check that PSI's profitable, right. You're
making a profit, which is 8% of sales by assumption, okay. And then at the end of
quarter one, right, what PSI needs to do is to buy the inventory for the next quarter,
right. The beginning, they are going to begin the second quarter with $75.9 million in
inventory. Where is that number coming from? That number is the cost of the goods that
they are going to sell at the end of the second quarter, right. So that's the situation in
this company. Every quarter, if you look at this model here, right, every quarter, at the
beginning of the quarter, they must have the amount of goods in inventory ready to sell
for the end of the quarter, okay.

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So that's the situation, right. So think about this. That is a very interesting example,
right? When you start thinking about cash flows, okay. So here's the model. I hope, you
know, and I hope everything is clear now where the numbers come from. So now let's
think about the following question. What is the cash flow, right? At the end of each
quarter, if we had to figure out how much cash is coming into a company like PSI, what
would be the answer? What is the, how much cash are the, are they generating?

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And the answer, it might seem very surprising, but the answer is that PSI's generating
negative cash flow, okay. Remember, you know, the assumption, this company has a
very high growth rate, right. This company has a very high growth rate. Sales are
growing. It's a profitable company, okay, but cash flow is negative. If you want to see
why, you know, you just have to think about what's happening here, right. So at the end
of Quarter 1, you're selling 75, but you have to buy the goods that you're going to sell
next quarter, right. Because your growth rate is so high, right, the amount of inventory
that PSI has to buy every, you know, every quarter end is actually larger than the
amount that you're selling in that period, right. So your cash flow, for example, in
Quarter One, would be 75 minus 75.9, which is minus 0.9, okay. And this happens
every quarter. Quarter 1, Quarter 2, Quarter 3, Quarter 4, right. It's a negative cash flow
plus you can see that the cash flow is growing. It's increasingly negative, right. That's
very interesting I think, okay.

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So think about this. PSI is a profitable company that's growing very fast, you know. If I, if
you had heard that before you took this course, you might have thought, "Yeah, this is a
great company, right," and yes, it may well turn out to be a great company, but right now
it's generating negative cash flow, okay, because your investment in inventory is always
larger than the amount that you're selling, okay. So your cash flow is always negative.

And if you look at the cash flow statement for the company, that's exactly what you

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see. So the company's profitable, you're generating a positive profit, okay, but the
amount of, your investment in inventory, which is highlighted here, you know, for
example, for the year of 2014 was minus $29 million, which is significantly higher than
the profit that you're generating, okay. When we get to the bottom of the cash flow
statement, of course, there are other items here. It's not just inventory. When we get to
bottom of the cash flow statement, what you see is that PSI is generating a negative
cash flow, okay. So you're profitable, but you're generating a negative cash flow, right.

This is a situation where a company seems to be generating negative cash flow forever,
right, and ask yourself, if a company generates negative cash flow forever, what should
be the stock price, right? Let's go back to model one and think about what determines a
stock price. The stock price is a discounted sum of future cash flows, right. If all future
cash flows are negative, the company is worthless. Zero, okay.The company should be
liquidated. It's not generating any profit, right. In economic, in cash flow, okay. So, this is
an extreme situation where you have a company with a very high growth rate, but, you
know, working capital needs that are making the company cash negative. The company
is not generating any cash flow, right. And of course, PSI is not bankrupt, right. PSI is a
valuable company. Why is this the case? It has to be that PSI is going to become cash
positive going forward, right. The company has to become cash positive going forward
one way or the other, right.
One possibility is that there's going to be a natural slowdown in sales growth, okay. The
40% growth rate that we had in our model is not reasonable. I mean, it's what's
happening right now. It's unlikely to go, to keep, the company isn't likely to keep growing

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at that rate, so if sales growth is low, then this problem is going to change. It's one of the
examples that we have in our assignment for you guys to go and try to show that, okay.
So, there's going to be an exercise where you show that, okay. In addition, the company
might consider changing working capital management, right. Perhaps what PSI needs is
improved inventory management, right. Maybe you're keeping too much inventory. You
have to move towards the situation where you have more adjusting time inventory and
try to generate cash quicker, okay. Another possible solution is trying to increase your
profit margin, right. We can also show in the example that if a company has a higher
profit margin, you're going to be generating positive cash flow, okay. So, the bottom line
is that for, you know, PSI is definitely expected to become cash positive going forward
for some of these reasons. Possibly the most important one is that sales growth is not
going to keep as high as it is right now.

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Lesson 1-9: Seasonality and Receivables

Lesson 1-9.1: Seasonality and Receivables

Our second example is about seasonality, okay. So, for, for many companies in the, in
the real world, the common situation is that sales tend to be higher in the fourth quarter,
right. But on the other hand, you know expenses are not necessarily seasonal.
Expenses can come at any time of the year, okay. So that's going to generate
seasonality in cash flows which, when you couple that with accounts receivable, that is
going to generate a need for short term financial planning. Okay, so this is what we're
going to characterize here using a simple numerical example.

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Okay. Here you have an example of a situation where sales are seasonal, you can
check that sales start slow and then they pick up in the fourth quarter, okay. Let's say
that the company starts the fourth quarter with receivables equal to 15, okay. So, what
this means is that the company's going to collect this 15, let's say $15 million this
quarter, and then you're going to collect some cash from the sales this period, let's say
that your collection, the percentage of sales that you collect this period is 80%, okay.
So, you sell 87.5 you collect 80% this period, okay. And in addition to that you collect
the existing receivables, okay. So, you had 15, so your total collection is 85 million this
period, right. And now what we're going to think about is you know, what happens in the
future quarters. So, let's go here.

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Okay. Right, so think about this. We have, you have degenerated 70, right, I mean you
have sold 87.5 in the first quarter, collected 70 this quarter, so what happens to the
rest? It becomes an account receivable, right. The 17.5 becomes a receivable that then
you're going to collect next quarter, right. So, this is a little bit like our inventory example
that there is the timing of collection of cash, okay. So, the 17.5 gets collected next
quarter, right. So that is going to be your accounts receivable from, from last period,
okay. In addition to that you have the sales from this period, okay. So, you're going to
collect in the second quarter you collect 80% of that. If you do the calculation, you're
going to get 62.8, okay. So, your total collection in the second quarter is 8.3, 80.3, okay.
And then you know, the model goes on same way as we did for the first quarter, you're
going to generate some receivables in the second quarter and so on and so forth, okay.

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So here you have the answer, okay. Here you have the answer with the numbers that
we plugged in, and in fact all the numbers for the fourth quarter, okay. So, you collect
80.3 in the second quarter, 108.5 in the third quarter, and then you collect 128 in the
fourth quarter, okay. So, you can see that cash collection becomes seasonal as well,
right. Because your sales are seasonal, you're going to collect more cash in the first
quarter, sorry, in the fourth quarter than in the first quarter, okay.

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Let's think about expenses now, right. So, you have the collection here that we just
computed, okay. Let's say that there is one more source of cash, just for the sake of the
example, it comes in the third quarter so it's 12.5 million for you know, any reason there
is another inflow of cash, so it goes to 121 in the third quarter. And now there are the
users of cash, right. So, you must make payments on accounts payable, have to pay
your labor expenses, and an important one, let's say that there is a capital expenditure
that the company has to pay for in the first quarter, okay. The timing of the capital
expenditure doesn't have to coincide with the, doesn't have to coincide with the timing of
sales so it's plausible that it must come, that it's going to up early in the year, okay.
What this means is that you're going to have a high usage of cash in the first quarter,
okay. If you sum all these sources, you're going to get 131.5 million, okay. Which then
means that the company is generating a negative cash flow of minus 46.5 in the first
quarter, you generate minus 15 in the second, 26 in the third, and then 35 in the fourth
quarter, okay. So, the pattern is a seasonality pattern where you generate negative
cash flow in the first two quarters and then positive in the last two, okay.

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So, suppose that the company has some cash, okay, in the balance sheet. So, you
have five million dollars in cash, but you have no excess cash. So, this five million is the
minimal amount that you think you should have for precautionary reasons, this is
something we discussed already in this model, companies may need to keep a certain
amount of cash, okay. Let's say that this is your minimal operating balance, right. And
we compute it in our example the sources minus users, right, so the amount of cash that
the company is generating, right. So, the question is how much the company needs to
borrow at the end of each quarter, right. So, try to think about that yourself.

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Okay, and here is the answer, right. So, since you cannot use your cash, it says that
you have no cash, right. This is your minimum borrowing, minimum operating balance
so the situation is just as if the company didn't have any cash in the balance sheet,
okay. So, what you're going to have to do is you're going to have to borrow at the, at the
end of the, of the first quarter you're going to have to get the 46.5 million from
somewhere. Notice that here we are taking the cash into account, right. So, we're doing
what we did in the past. For example, for the long term but in this short-term model, but
we are already taking that cash into account, so really the company does need to get
46.5 from somewhere, okay. In addition to this you know, in the second quarter you
generate an additional negative cash flow. So now you have to borrow 16, 15 million
dollars more, okay. So, by the end of Quarter Two the company needs to borrow 61.5
million, okay. And this is a short-term financial need. Why? Because, as we did, as we
discussed, the company is going to generate cash in the third and the fourth quarter so
when you get to the end, right, when you get to the fourth quarter the company can
essentially repay everything, okay. So, you can, if you borrow 61.5 by the end of
Quarter Two, when you get to the end of the year your cumulative financial requirement
has gone down to zero. This means that the cash flows you generate in Quarter 3 and
four are sufficient to pay for the amount that you had to raise, okay.

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So, the question is now is how the company can do this, right. You have a short-term
financial need, right. You have to get some cash in the beginning of the year and then
repay it at the end of the year. What are the options that, that this company has, okay.

The first option is to make a short-term loan, right. It doesn't have to be a long-term loan
because you can repay it within the year. But you might have to raise some money,
okay. So, one option is to open a credit line with a bank. In the next example we're

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going to talk more about credit lines, which is a very important corporate finance
instrument. Here you could use a credit line as well. Just have a credit line open with a
bank saying that you could borrow for example 65 million dollars from the bank. And
then if the company has a cash you need in the first two quarters you could raise that
cash and then repay it at the end of the year, okay. Another option is to increase your
cash balance, right. You can always use your existing cash to manage the financial
need, but this company doesn't have enough cash. So, if you're going, if you're going to
use cash balances to manage these liquidity needs, you're going to have to raise more
from long, from long term financial sources, right. So maybe you must issue a bond or
issue equity, or perhaps the company can save cash from operations, okay. And finally,
the third option that the company has is to change operations, right. If you are having
difficulty managing your liquidity using just financial variables what you can do is to
change your operations, for example delaying the capital expenditure, right. If you can
delay the captain expenditure from the first quarter to the fourth quarter, that will be
sufficient for you to manage your cash need, okay. Or try to extend accounts payable,
right. You can try to get financing from suppliers. And finally, one option that the
company could contemplate is to sell receivables, right. Is to either sell the receivables
to a factory forum, or maybe borrow money from a bank using receivables as collateral,
okay. Changing operations of course is an option that companies should generally
avoid, right. For example, delaying the capital expenditure might be costly for the
company, right. If you need to make the investment now, delaying it to the end of the
year may not be the best option. So, in general what we recommend is that if you can
use a financial you know, like a loan or a credit line to manage this short-term liquidity
need, it might, it will generally be more desirable than changing operations, you know,
for example going to your suppliers and asking them to extend accounts payable, that's
going to be a costly option for the business. Raising a short-term loan is generally going
to be a lower cost option.

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Lesson 1-10: Short-Term Liabilities and Liquidity Risk

Lesson 1-10.1: Short-Term Liabilities and Liquidity Risk

Let's go back to artists, which is one of the companies where we're using as an example
here in our course, in Module One. In Module One, we calculated the liquidity ratios for
Altice in December 2021. And our conclusion was that also had less liquidity than the
comparable company we're looking at, which was Dish. So here are the calculations,
right? The current ratio, the quick ratio and the and the cash ratio that we calculated
there. The liquidity ratios were discussed in Module One. Right.

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So, always good to recap what we learned. Don't forget, we're going to use it again
here, you know, for another application. Okay. So, we talked about the fact that the
liquidity ratios were low in this module. We're talking about financial planning. So, what
we're going to try to do is to think about whether this is a problem. Right? And then try to
if it is a problem, try to think about how the company can address that. Okay. Before
that, let me point out to you that we actually need to look at other data. The fact that the
company has a low liquidity ratio doesn't mean necessarily that, that the company has a
liquidity problem. And that is because of cash flow. Right. It may be the case that the
company can finance expenses using profits. Right. What the liquidity ratios tell you is
how much liquidity is in the balance sheet, but essentially in very simple terms, the
company could be generating liquidity from the annual operation. Right? So, if the
company has is a lot that has a lot of profits, then you may not need to worry about
liquidity and we all in in the class, we all, we also talked about the cash flow statement
of these companies.

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I showed you the example already. Here is the cash flow statement of Altice again,
right? So the company is in fact generating a lot of cash from operations.

But as we discussed it before, the company is also investing a lot. Okay, so you have
solid operating cash flows about 2.5 billion. In fact, what I did here is I got some
projections as well, instead of just looking at the historical data. I also obtained the cash
flow from operations that is projected for 2022 according to capital IQ. However, the

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company is also investing a lot Capital IQ has a projection of close to $2 billion in capital
expenditures referring to 2022. Capital expenditures are important. Right? So, the
company may not want to cut these capital expenditures if they are planned. If the
investors expect the company to make these investments.

So, the question is, right, is the company going to be able to pay liabilities that are doing
2022, while maintaining investment, of course, if you could cut your investment to zero,
then you have a lot of cash.

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But once you factor in the $2 billion in investment, then you really only have $500 million
of extra cash. And that is assuming that everything works as planned, right? If the cash
flow goes down, then that's another situation. Okay, so you have cash flow minus
Capex, that's 500 million. You have current assets are 790 million. And then here you
have cash and current liabilities.

So, this is a situation that is becoming interesting right? Because the current assets

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don't seem to be sufficient right to finance to allow the company to pay the current
liabilities even if you take the excess cash flow into account. Right? As I said before, if
the company could cut Capex to zero, fine, but that's probably not what the company
should try to do. Okay. Before we do anything it is important to go to the details of the
current liabilities. You should be able to find that from a good database like capital IQ, or
other similar. Okay. Here what I've done is I've got the data for December 2021 for
Altice. The company has had a total of $2.7 billion in total current liabilities. And here
you have the breakdown a significant parties accounts payable. So, these are
essentially bills that are due to suppliers, accrued expenses very similar. Okay, you can
think of this as these are essentially accounts payable as well and then you have
financing expenses, you have current portion of long-term debt. So that means there is
a debt that is maturing during 2021. It's $811 million. You have leases. Okay and you
have some other stuff. But essentially the bulk of what the company has is accounts
payable debt and lease payments.

So, let's think about this. Right? So, what's the problem then? What's going to happen?
The company has to pay this liability it’s doing in 2022. The cash flow is not going to be
sufficient. So, the company is not generating enough profits, right? And you have
current assets that that can be used to finance this current to pay the current liabilities,
for example cash, but the cash is not enough either. For example, the company has
$812 million dollars of debt that is coming through. Okay, what is going to happen? So,
think about that for a second. What could happen to the company? And the answer is
that the, maybe nothing bad will happen. Right.

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The first, the default action for the company should be to try to refinance the debt. So,
what do I mean, the company must pay this liability? Right, so this is a liability that is
coming due, but the company may be able to borrow more. Right?

So, you generate a new liability from your creditors. So, if this is a bank for example,
right? You can pay the bank loan, but then you can raise a new bank loan and the bank
loan can be similar to the liability that you're paying. And what this will mean is that

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there is no net cash outflow. If you look at cash flow statements for the real-world
companies, this is going to be a very common situation. You will see the company
repaying that in a certain year and then issuing that of about the same value. So that
refinancing is very common. And that may be an explanation for why, you know, Altice
can have such a low liquidity ratio while having relatively low excess cash flow because
the company is expecting to refinance liability. Okay.

But there is a risk and that's what we call liquidity risk. The risk is that the creditors may
of course not agree to extend new financing. For example, it may be that the company
is in a crisis. The bank turns more negative about the prospects of the company. The
company cannot raise financing from other sources. So, in that case, the company will
face a liquidity crisis. Right? If you, if you don't have cash and you must pay liabilities,
then you're going to have to try to work it out. Right? So, for example, then in that case,
the company may have to cut capital expenditure, but investors were already expecting
that. So that's probably not going to end up well, you know, the stock price is going to
go down and the company may actually become financially distressed later in the, in the
course, we're going to talk more about financial distress, but this is a situation that may
actually generate financial distress.

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Okay, so how do companies manage this liquidity risk in the real world? In the case of
Altice, how is the company managing this risk? Is the company just taking a chance?
Right. Is the company just assuming that, that is going to be refinanced? And the
answer is no. And I'm going to show you the data, but there is a broad point here which
is related to credit lines, right? So, companies, actually, you can use bank credit lines to
manage this liquidity risk. And the trick here is that the credit line terms are negotiated
ahead of the time when the loan is actually needed. So, when the company goes to the
bank should try to issue the new loan right of $800 million. The bank, the bank can say
no, as we talked about the company's liquidity crisis. But if the company has an
outstanding credit line, then the company is more likely that the company is going to be
able to draw on the credit line because the terms are negotiated ahead of the time. So,
in a sense, the bank has already agreed to provide that loan when the company needs
it. So, in corporate finance, we think of credit lines almost as a substitute for cash. A bit
more details on bank credit lines, we're going to talk more about credit lines later in the
course as well. When we go into the details of that structure, as I mentioned before, the
interest rate and the credit limit are pre-negotiated. Right? So, it's important that you
have both the limit and the interest rate because the bank could say sure you can
borrow $800 million but you're going to have to pay 30% a year so that the company
may not be able to afford. Okay, the interest rate is typically set as a spread, right? So,
if the baseline interest rate in the economy is changing, then interest rates are going to
change as well, but the spread is fixed, right? So, you know, it's not going to go to 30%
unless there is a huge rise, is a huge increase in inflation, right? It's unlikely that that the
interest rate is going to go completely out of reach. So, the companies when they rely

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on the lines, they can typically borrow at reasonable interest rates. Even if there is a
problem in the economy. In exchange, the company pays a commitment fee to the
bank. So of course, it's not free, right? You have an option to borrow and this option to
borrow is going to cost money. Typically, it's 0.1% to 0.3% a year. So, for example, if
the company has a credit line of $100 million then you're paying 10 to 30 million dollars
a year. Just to keep the credit line open. It's like an insurance contract. Think of this as
insurance, right? For example, if you have life insurance, you're paying an annual
premium, right? And if something goes wrong and you die before, before you expect
then you're going to, your family is going to get a payment, here's the same thing or car
insurance, right?

And it turns out that all this does have a credit line. So that is the answer of the puzzle.
That's why the financial management here is not crazy, right? It seems that the
company is taking a chance. But when we go into the details of the of the debt structure,
you see that the company has at the end of 2021 the company has a non-drawn credit
line of $1.6 billion. It's here in the, this is in the debt summary data in capital IQ. You see
that the company does have, it has available credit basically that you can use if there is
a problem, if there is a liquidity crisis.

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Okay, it’s even higher in March of 2022, it went up a bit between December and March
and the idea you can think of this as a corporate credit card. Altice has the right to use
this line if the need arises, there are some conditions, and later on in the course, we're
going to talk more about this. But that's essentially how you can think of credit lines, and
that's why credit lines are very important to manage liquidity risk in the real world.

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