Appunti corso Management di BIEM 1 parziale, Appunti di International Management

Scarica Appunti corso Management di BIEM 1 parziale e più Appunti in PDF di International Management solo su Docsity! SESSION 1 - AN INTRODUCTION TO ECONOMIC ACTIVITY MANAGEMENT A possible definition: a range of decisions associated with the acquisition, allocation and integration of resources (human, physical, financial, etc.) required to perform economic activity. Management is about people! —> economic activity: • Takes place in human societies • Is carried out through human effort • It satisfies human needs Economic activity is the production, distribution and consumption of economic goods (both physical products and services). GOALS AND NEEDS • Goals are people’s purposes and aspirations. • They drive all human activities. • Needs arise from dissatisfaction owing to the lack of something. • They are dynamic. • They are structured in a hierarchy. MASLOW’S HIERARCHY OF NEEDS It is a theory of human motivation and human action. —> why do people do certain things? What needs are they trying to fulfill? We need to fulfill the lower needs before fulfilling the higher ones. 1. Physiological needs: anything that you need to stay alive (food, water, …) 2. Safety needs: physical safety —> having a shelter, being protected + economic safety 3. Belongingness and love needs: feeling of belonging to a group that is bigger than one self 4. Esteem needs: everything that has to do with ego, status 5. Self-actualization: achieving our full potential —> spirituality, morality, creativity If a very hard economic crisis hits you, then you will focus on fulfilling the lower level needs rather than the higher ones. In management: what need is my product trying to fulfill? Economic activity is not only about CONSUMPTION but also about PRODUCTION —> we may fulfill needs by producing goods and services CONNECTING PIECES CAN ALL NEEDS BE SATISFIED WITH GOODS? Certainly goods can satisfy basic needs (food, shelter, security)… —> What about higher level needs such as “friendship”, “esteem”, “self-actualization” (realizing your potential)? Love needs: - Chips consumed with family, not only physiological need - Video-games: feel part of a group when playing Esteem needs: - Clothing (ex: luxury products) - Not say your teeth will be white but say people will look at you - Cars Self-actualization: - Self-improvement seminar SESSION 2 - WHY FIRMS EXIST? ECONOMIC ACTIVITY AND ORGANIZATIONS Organization: • A system of consciously coordinated activities of two or more people • An abstract social entity • Set pf elements and factors, personal and material resources • Directed towards a set of common goals • The product of joint efforts (organization rent) is distributed among all participants • Organizations vary across time and space, but at any point in time there is a stability of rules and models of behavior for individuals and groups (institutions) BE AN ALIEN (for a second)! (Herbert Simon, Nobel Prize in Economics 1982, from “Organizations and Markets”) Imagine an alien from Mars watching the earth with a telescope capable to see economic activity GREEN areas of economic activity INSIDE organizations RED lines connecting organizations in market exchanges BLACK dots for independent individuals => what would the alien from Mars see? No matter whether our visitor approached the United States or Russia, urban China or the EU, organizations would be the dominant feature of the landscape. A message sent back home, describing the scene, would speak of “large green areas interconnected by red lies”. It would not likely speak of “a network of red lines connecting green spots”. When our visitor came to know that the green masses were organizations and the red lines connecting them were market transactions, it might be surprised to hear the structure called a market economy. “Wouldn’t organizational economy be the more appropriate term?” It might ask. WHY DO WE HAVE SOCIAL GROUPINGS? • Better achievement of results than through individual activities (efficiency) • To fulfill the human need for sociality (social needs) 4 MAJOR SOCIAL BODIES / ORGANIZATIONS: Two important concepts: 1) Economic specialization 2) Transaction costs ECONOMIC SPECIALIZATION (https://www.youtube.com/watch?v=NI9TLDIPVcs) —> makes the production of goods more efficient Specialization makes people more productive but Adam Smith said that it is TRADE that makes them better off. Everyone should specialize in what they can do best and trade in order to obtain things the can’t make. ADVANTAGES: - if I do one thing over and over I become better at doing it and faster over time - increase productivity for cheaper (lower costs of production) 1. Learning processes —> repeating the same activity leads to: a) Developing manual dexterity b) Discovering more efficient and effective ways to perform the activity c) Creating an inventory of problems and solutions 2. Individual skills • Specialization allows to assign tasks to those people who are most skilled at them, increasing efficiency 3. Technical and managerial orientation 4. Reduction in costs pf preparing for and transitioning from phase to phase (not move from one place to another) 5. Use of specialized facilities and equipment 6. Enhances job identification and motivation • Very specialized people tend to identify with their job and enjoy a sense of the command over the work situation • Mastery contributes to self-esteem, provided that the task is difficult enough to be motivating DISADVANTAGES: 1. Costs of coordination: greater the degree of specialization, greater is the number of interfaces between workers.
 2. Costs of rigidity and specific investments: varied skills and multi-purpose facilities can be easily r-deployed to new tasks, while specialized resources are less flexible.
 3. Demotivation: simple and repetitive tasks can reduce esteem and self-fulfillment. Other examples of why the state engages in economic activity: • Incomplete markets —> there could be a firm to build a bridge, but it isn’t because it’s not the best thing for everyone • Information asymmetries —> pharmaceuticals: they tell the product is good but as a supplier (or maybe doctor) you can push a treatment that is not really needed. • Merit goods —> vaccination, primary education • Redistribution of wealth NON-PROFIT ORGANIZATIONS • Private organizations which are not allowed to distribute net earnings but instead use them to help pursue social, cultural, educational or political goals. • The aim is to satisfy the portion of demand for those goods that the State does not meet. • Very heterogeneous group of organizations in different economic areas, ex: education, health, culture, development, environment, philanthropy and religion. • Similar to “normal” companies. Why do they exist? • Mostly economic and technical reasons: private producers of public good (market failure). • Exploit regulatory advantages granted by States, es: tax breaks, preferential tariffs, flexible work. • Gather some resources at non-market conditions, and benefit from ex: voluntary work, low-interest loans, donations. ———————————————————————————————————————— QUESTIONS: Why are there so many organizations? —> Economic specialization Why do individuals who specialize in small segments of the economic activity tend to join together to form organizations? —> Efficiency / social needs Why firms internalize certain activities? —> Transaction costs Why doesn’t all economic activity take place within the framework of one large organization? —> Drawbacks of integration (coordination & information cost) Why are the various organizations outside of the family differentiated in firms, public bodies and non-profit organizations? —> Market failure, public goods, externalities, etc… SESSION 3 - STAKEHOLDER’S VS SHAREHOLDER’S VIEW OF THE FIRM Shareholders are always stakeholders in a corporation, but stakeholders are not always shareholders. A shareholder owns part of a public company through shares of stocks (hence the name), while a stakeholder has an interest in the performance of the company for reasons other than stock performance or appreciation. Stakeholders can be: Employees who would not have a jobs without the company Bondholders who own company-issued debt (and want it to live up to that obligation, obviously) Customers who may rely on the company to provide a particular good or service Suppliers and vendors who may rely on the company to provide a consistent revenue stream Although shareholders may be the largest type of stakeholders, since shareholders are affected directly by a company's performance, it has become more commonplace for additional groups to be considered stakeholders too. STOCKS = TITOLI —> STAKEHOLDER = PARTI INTERESSATE SHARES = AZIONI —> SHAREHOLDER = AZIONISTA FAMILY: • It is a different type of organization, a natural, non artificial. • Fundamental purpose: is not economic. It is to satisfy the needs of the family members. FIRMS: • Economic • Reward core stakeholders (employers, shareholders) • There are only 2 stakeholders The firm is the only organization which has as an only purpose: the economic one. Non-profits are quite similar to firms, but their fundamental purpose cannot be economic. They can make money but they then reinvest. VALEANT PHARMACEUTICALS INTERNATIONAL Canada-based pharmaceutical company with the strategy of buying up existing companies (and their drugs), rather than developing new drugs in laboratories. Usually, after buying companies, Valeant lays off their employees to achieve savings: • Medicis (acquired in 2012): had 790 employees; Valiant fired 750 • Bausch & Lomb (2013): had. 4100 employees; Valeant fired 3000 • Salix (2015): had 1000 employees; Valeant fired 400 Valeant spends only 3% of its sales on R&D, compared to 15-20% in traditional big drug companies. Valeant is also known for increasing prices aggressively whenever possible, especially after acquisitions. How are these increases possible?! I. USA system does not control drug prices. II. Many of these drugs treat rare diseases, so the sales are small and generic producers are not interested. III. This may change once the price increases, but it may take several years for a generic equivalent to be approved by the Food and Drug administration (FDA). IV. Pharmaceutical companies are often successful in promoting their branded drugs over the generic versions, sometimes by spreading doubts about the effectiveness of generics. Were the increases justified? What Valeant said: • It prices its drugs “based on clinical benefits and the value they bring to patients, physicians, payers, and society” • Patients are shielded form price increase by insurance and virtually no one is denied a drug they need. SO WHOM SHOULD A FIRM SATISFY? —> for Valeant it should satisfy only the shareholders MANAGING FOR STAKEHOLDERS PRIMARY AND SECONDARY STAKEHOLDERS Primary stakeholders: - vital to the growth and survival of the business Secondary stakeholders: - groups that can affect the primary relationships —> who is a primary or secondary stakeholder depends on the company’s overall purpose. WHAT DOES “MANAGING FOR STAKEHOLDERS” MEAN? Stakeholder theory suggests that a company that manages for shareholders as the expense of other stakeholders cannot sustain its performance. Why? • Unsatisfied primary stakeholders will withdraw their contributions, which are essential to a firm’s performance • Unsatisfied secondary stakeholders have the means to influence negatively primary stakeholders or to make life hard for companies => Managing for stakeholders means balancing and keeping an alignment among the various stakeholder interests (including those of shareholders). CENTRAL PRINCIPLES OF “MANAGING FOR STAKEHOLDERS” 1. The different interests of the various stakeholder groups go together over time; managing for stakeholders means adopting a long-term perspective. 
 2. Firms should have a purpose, a sense of what they stand for; this includes creating value for at least customers and employees. This purpose is sometimes stated in “mission statement” or in a more or less explicit “enterprise strategy”.
 - Steve Jobs’ mission statement for Apple in 1980 was: “To make a contribution to the world by making tools for the mind that advanced humankind” (no mention of shareholders!).
 3. Firms cannot put aside ethics and value questions; corporate leaders must be engaged in the conversation about how business can make society better.
 4. Managing for stakeholders is not confined in the realm of missions and abstract principles, but should be included in everyday business processes. ALTERNATIVE PROCESSES FOR DEALING WITH STAKEHOLDERS • “Do nothing” • “Public Relations approach” • executives write the company story on an issue and try to convince the public, by using communication, advertising, etc. • “Implicit negotiation”: • take the position of stakeholders into account but do not interact or explicitly negotiate with them. • “Stakeholder engagement”: • explicit negotiation with stakeholders, accepting all the complexities, ambiguities, and risks of the relationship. STAKEHOLDER MANAGEMENT AS A DIFFICULT TASK • Interests of different stakeholders may conflict with each other. • Identifying central vs peripheral stakeholders • Complex nexus of relationships - ex: damaging the environment can affect reputation, customer loyalty, employee turnover … and eventually profit IN SHORT Shareholders: owners of the firm, you provide the capital for the firm to operate Stakeholder: customer, supplier, government, community. A group that has some interest in the firm. It’s an abstract concept. Freeman and Friedman have two very contrasting opinions on the goals and responsibilities of a business. Freeman supports the Stakeholder Theory in saying that anyone who has a stake/claim in the firm has the right to be treated as a participating determining factor in the direction of a firm. They are not just a means to the end. Friedman pretty much says the opposite. He believes that businesses have no responsibility outside of those who have ownership in the company. EXAMPLES OF KEY STAKEHOLDERS Employees —> if you don’t take them serious they could strike, turnover, lower their productivity, jeopardize the quality of the product, they Amy turn to competition, … Customer —> they can stop buying your product, switch to substitutes, boycotting, bad advertisement, … Government —> major customer in the weapon industry, military industry, gas/energy, healthcare, prison Suppliers —> retail: you have to treat them well, display their product in the way they want, advertise it how they want THE LEGO / SHELL PARTNERSHIP —> Shell logo on lego cars They did this for visibility to the parents but also kids that In the future will have seen this logo since they were babies. Greenpeace (company) was pushing lego to dump shell because at the time shell was doing a lot of hole drilling in the Arctic and this was extremely polluting. Viral campaigns, petitions, that went viral => lego dropped the partnership Public opinion: secondary stakeholder —> impacted them this much DO SUSTAINABLE ENTERPRISE MODELS OUTPERFORM TRADITIONAL ONES? —> yes - Ambassadors test the things that they produce in action - Reduced packaging - Develop products to last longer and encourage costumers to repair products instead of buying new ones Describe Patagonia’s sales and marketing function and discuss how it facilitates the company’s mission? - Spent less than 1% of its sales on marketing - Uses only 60% of the space on its catalog showcasing its products —> uses the rest to spread awareness Patagonia introduced the PRODUCT LIFE CYCLE INITIATIVE: Reduce • multifunctional products • the product line becomes smaller every year Reuse • 41,377 used Patagonia items sold via eBay’s The Common Threads Storefront • “Worn wear” program to allow customers to trade-in gently used clothes for credit • The used clothes are sold in stores’ worn wear section • Patagonia now has a partnership with Yerdle • Clothing swaps (online and in retail stores) an donation opportunities Recycle • 82 tons of worn out Patagonia clothing and gear recycled since 2005 • Patagonia pays for the shipment or collects at stores Repair • 26,078 pieces repaired in 2012-2013 • However, because of the cost it represents, Patagonia tries to minimize its provision of repairs by: - Designing more easily repaired clothes - Offering free manuals and repair kits in stores - Partnering with local tailors WHAT ARE THE BENEFITS OF PLC? • Environmental impact • Aligned with company values • Created more awareness around saving the environment • Marketing especially due to customer involvement on social media WHAT ARE THE COSTS OF PLC? • May appear gimmicky • Increased costs and introduced organizational complexity due to the increased logistics - Increase costs by $60,000 in the first year of implementation due to shipping - Need to invest in R&D (for recycling), storage and staff How successful was Patagonia in achieving its mission? • Build the best product • Cause no unnecessary harm • Use business to inspire and implement solutions to the environmental crisis SESSION 5 - OPPORTUNISM, FAIRNESS, AND COOPERATION: ASSUMPTIONS ON THE BEHAVIORS OF INDIVIDUALS AND GROUPS PART 1 => understanding how people make decisions is key TWO WAYS TO MODEL BEHAVIOR 1. Homo Oeconomicus (Léon Walras) 2. Human Being, behavioral view (Herbert Simon, Richard Cyert, James G. March) HOMO OECONOMICUS, the rational individual Autonomous, egoistical, only interested in maximizing his own wealth and income, perfectly rational. Individuals have a ranking of preferences that is complete, internally consistent and that has a maximum (ex: I prefer an apple to an orange, prefer a orange to a banana => I prefer an apple to a banana —> transitivity). Individuals have full information about all the possible outcomes from all possible choices. All information available for free. Individuals have the cognitive ability and time to calculate the optimal choice. A rational actor decision Identify the problem: • Select the investment project that provides the best return on investment - the financial benefits are uncertain • Decision criteria = $ / net profit PRELIMINARY EXPECTATIONS Problem: Finding an apartment in Milan Endogenous aspirations: • Historical: used to live in 30 m2 + parking • Social: most of your colleagues live in the inner circle of Milan Expectation: • Furnished apartment • 50 m2 • Live in the centre • With parking • Budget: 1400€ EXPLORATORY RESEARCH • Look at the website • Buy a newspaper => identify 3 few apartments that you would like EVALUATION EXPECTATIONS ADJUSTMENT Updated expectation: • Furnished apartment • 40 m2 • Live near downtown • With parking • Budget: 1400€ BACK TO EXPLORATORY RESEARCH • Go to a real estate agency => 3 new apartments that you would like 2 EVALUATION DECISION COOPERATION, ALTRUISM AND OPPORTUNISM Cooperation: • Allows people to attain results which cannot be achieved by individuals acting independently • Produces a rent shared to all participants Altruistic behavior is consistent with maximizing personal well-being (ex: to build social relationships). Opportunistic behavior results from impossibility to ascertain individual contributions and overall results. HOMO OECONOMICUS • Perfect rationality • Individual maximization of utility under given constraints • Isolation: not much room for reciprocity, trust and emotions • Likely to behave opportunistically HUMAN BEING (BEHAVIORAL VIEW) • Bounded rationality • Satisficing of well-being • Preference are shaped also on emotions, trust and reciprocity • It has social needs • Cooperative behavior - it may still be opportunistic THEORY X AND Y (Douglas McGregor) THEORY X • Dislikes to work and attempts to avoid it • No ambition, do not look for responsibility • Self-centered —> not focused on organizational goals but on its own utility • People work mostly for money THEORY Y • People are self directed to meet their work objectives • Work can help people satisfying their (high-level) need for achievement and self- respect • Committed to their objectives • People will seek responsibility SELF-FULFILLING PROPHECIES • Finance - historical values, such as acquisition can act as an anchor • Negotiation - the first offers have a strong anchoring effect when great ambiguity exists AVAILABILITY BIAS The tendency for decision makers to consider information that is easily retrievable from memory as being more likely, more relevant, and more important for a judgment. Example: • People are more likely to purchase insurance to protect themselves after a natural disaster they have just experienced than they are to purchase insurance on this type of disaster before it happens. REPRESENTATIVENESS BIAS • Insensitivity to sample size • Misconceptions of chance • Stereotyping - “look for traits the individual Amy have that correspond with previously formed stereotypes” Example: • Entrepreneurs: - compared with managers entrepreneurs are more likely to fall into the representativeness bias (generalize from limited experience) - risk to judge the probability of success based on small samples SESSION 6 - GOVERNANCE AND MANAGEMENT What is a corporate governance? CORPORATE GOVERNANCE Financial economics definition: “Deals with the way suppliers of finance assure themselves of getting a return on their investment” Relationship definition: “It is the framework by which the relationships among the management, Board of Directors, controlling shareholders, minority shareholders and other stakeholders are balanced” Stakeholder definition: “Activities of the board and its relationships with the shareholders or members, and with those managing the enterprise, as well as with the external auditors, regulators, and other legitimate stakeholders” Operational definition: “Procedures and processes according to which an organization is directed and controlled” Societal definition: “The whole set of legal, cultural and institutional arrangements that determine what public corporations arcane do, who controls them, how that control is exercised and how the risks and return from activities they undertake are allocated” SCOPE OF CORPORATE GOVERNANCE Some of the management is part of the board of directors. External auditors: will audit the documents produced by the management that will confirm that the management is following the common practices. Why do we need corporate governance? THE EVOLUTION OF FIRMS At the beginning of its existence a firm tend to have a very simple structure —> the owner was also the director and the manager. AS FIRMS GROW… Later on, several conditions change the scenario: • Company growth size • Need to seek outside capital • Need for a more professionalized management SEPARATION BETWEEN OWNERSHIP AND CONTROL The consequence is the progressive separation between ownership and control. • Efficient separation of ownership and managerial control • This separation allows shareholders to purchase stock, giving them an ownership stake and entitling them to income (residual returns) after expenses • This right implies a ‘risk’ for shareholders that expenses may exceed revenues • This risk is managed through a diversified investment portfolio • Shareholder value is thus reflected in the price of the firm’s stock
 • Shareholder specialize in risk bearing while managers specialize in decision making.
 • The separation and specialization of ownership and managerial control should produce the highest returns of the firm’s owners. So why is it hard to ensure that the manager will work in the owner’s interest? • Principal and Agent sign a contract that specifies what the manager does with the funds and how to divide the returns. • The contract should be complete, i.e. should cover all possibilities and contingencies • Most contingencies are hard to describe and to foresee (contract incompleteness) BUT THERE ARE WAYS TO ENSURE THIS THROUGH CORPORATE GOVERNANCE! MINIMIZE THE AGENCY COSTS One goal of corporate governance is to minimize agency costs, given a certain ownership structure, and a context (rules, legislation, etc.) in which the firm operates. 3 groups: 1. Monitoring
 - audits, writing compensation contracts
 - having a board of directors
 - financial statements 2. Bonding Costs
 - provide accurate information to shareholders
 - “the agent may commit to contractural obligations that limit or restrict the agent’s activity” 3. Residual Loss (whatever the amount you put in place, there will still be some losses)
 - arises form conflict of interests
 - “the actions that would promote the self-interest of the principal differ from those that would promote the self-interest of the agent, despite monitoring and bonding activities” GOVERNANCE MECHANISMS STRUCTURE - Organizational BOARD OF DIRECTORS Entity that makes the connection between the shareholders and the managers.
 Agency problem: shareholders provide the capital and managers have to report the transparency (provide documents to explain to the shareholders what they do: financial reports). GOVERNANCE VS MANAGEMENT Governance: Role is to direct the company. Protect the company’s interests and the shareholders’ assets + ensure a return on their investment. Management: Role is to run the business and execute strategy. 
 The board’s primary role is • to monitor management on behalf of the shareholders • to keep it going in the right direction • and, when it fails, to make the necessary repairs and replacements. They are there • to hire, evaluate, incentivize, and replace the top managers, • to make sure that the financial reports are appropriate and accurate, • to oversee the overall strategy and direction, • to manage risk, • and to set the tone at the top to ensure the integrity pf the company’s operations
 and employees. What it does (visual description):
 Alternative board structures I. ALL-EXECUTIVE DIRECTOR BOARD 
 Company not seen as a distinct legal entity, all board members are company “employees”.
 —> strongly discouraged to entrepreneurs
 Examples:
 - Small family firms
 - Startups
 
 II. MAJORITY EXECUTIVE DIRECTORS BOARD
 Need for additional expertise (new market, technology, …).
 More complex managerial issues.
 Capital growth.
 Executives are in majority => they have the power
 
 III. MAJORITY OF NON-EXECUTIVE DIRECTORS BOARD 
 Outside directors should have no relationship with the company. 
 => delegate the strategy formulation to the CEO —> more outsiders, the better it is in terms of having different perspectives on your business BUT at the same time it’s more difficult for those individuals to define what the strategy should be
 
 IV. INDEPENDENT DIRECTOR
 Not a recent employee.
 Has not received compensation from the company (include relatives)
 No relative is employed by the company.
 Have no close relationships with the company.
 (ex: you are the CEO of Microsoft and decide to get an independent director from Nokia, a partner)
 
 V. ALL NON-EXECUTIVE DIRECTORS BOARD
 —> rare
 All the directors are not part of the management.
 Most of them are non-profits because they are just donors, they don’t expect any return . 
 Triangle: management Circle: board of directors SESSION 7 - ENRON CASE ENRON CASE BACKGROUND: Energy market deregulation • Energy policy act of 1992: - The act opened electricity transmissions grids, which had been monopolized by utilities, to outside competitors. - “In April 1992, FERC destructed interstate pipeline operations. The move, which deregulated much of the industry, allowed companies like Enron the right to buy, sell, or trade and transport gas” Accelerated earnings • Mark to market: - Is a measure of the fair value of account that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institution’s or company’s current financial situation. - Accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value • => Permission was granted by the SEC on an “exceptional basis” and was supposed to be temporary • What are the implications for Enron of the “mark-to-market” accounting? - Virtual earnings - Very subjective profit calculation - Pressure to close more deals to maintain earnings growth - “using so-called mark-to-market accounting, Enron booked profits on trades and other transactions based on rosy assumptions about the future, exclusives said, accelerating its own earnings but leaving the company at risk if its bets failed to pay off.” Special purpose entity / vehicle • SPE/SPV: “a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objective” • “SPVs can be used to relocate the risk of a venture from the parent company to separate orphan company (the SPV) and in particular to isolate the financial risk in the event of bankruptcy or a default.” • “The SPV obtains funds to purchase the asset by way of debt financing from independent equity investors.” FAILURE IN THE GOVERNANCE SYSTEM It failed because: • It was aggressive: risk-taking / gambling • Arrogance • Ultra competitive + very high remuneration - “rank or yank” performance assessment - —> pressure to do deals • Strong beliefs in the corporate success story - “those who criticize us either don’t know or are stupid” Role of Auditors: ANDERSEN • Enron was one of Andersen biggest clients (since 1985) • Problems: - Andersen auditors and consultants occupied permanent offices at Enron - Frequent moves from Andersen to Enron - Andersen was at the same time Enron’s “independent auditor” and internal auditor, and also provided consulting services Role of Analysts • Role: “ build models to project the firms’ financial results, as well as speak with customers, suppliers, competitors, and other sources with knowledge of the industry” They generate “research report, a set of financial estimates, a price target, and a recommendation as to the stock’s expected performance”
 —> their role is to provide good information and an accurate understanding about the company, they have a lot of knowledge from different sources • May 2001: 19/22 analysts rated stock a “buy” • They trusted the cooked books —> they were asking only the CEO for information —> they had false information from the company directly • Conflict of interest: investment banks were also involved in M&A transactions and in capital market operations Role of Investment Bankers • “The evidence indicates that Enron would not have been able to engage in the event of the accounting deceptions it did, involving billions of dollars, were it not for the active participation of major financial institutions willing to go along with and even expand upon Enron’s activities” 
 —> those who were lending money to the “spd” • Conflict of interest: dual role of investors and underwriters • “Did we lend money in hopes of getting lots of other deals? Absolutely” —> an anonymous managing director at JP Morgan Chase • Benefited from high stock price —> disincentive to alert investors about the fragility of the firm Role of Consultants • Jeffrey Skilling was a former McKinsey partner —> strong relationship with Enron
 • McKinsey as strongly involved in advising Enron’s top managers
 • $10 Millions per year Role of Regulators • Hard lobbying from Enron to avoid restrictions on margin trading 
 
 => the US Commodities and Futures Trading Commission granted the exception for the trading of gas 
 • The SEC granted Enron temporary permission to use mark-to-market accounting but never re-visited its decision Role of the Board of Directors • They weren’t really independent, they were connected to politics and also to other companies —> closely link to Ken Lay (CEO of Enron)
 • There were a lot of problems inside the company and they weren’t also good at selling, they kept prices really high (high remuneration)
 • Ignored clear “red flags” and did not question unusual financial results 1990s: Aggressive growth • 120 acquisitions in 25 countries • US$8 billion of bonds issued • They spent a lot of money on publicity, marketing ecc —> they invested in football (Parmatour) which was not an intelligent investment because it needed a lot of money which the company was already lacking HOW WOULD YOU DESCRIBE THE SOCIAL AND POLITICAL CONNECTIONS OF TANZI? WHY DID THIS MATTER? The Tanzi family had many political and social connections, they had direct contact with bankers and were also involved with the Christian Democratic party (they renovated a church). They invested a lot in media (Odeon) because it was a way that helped the business grow, but the main reason why they invested so much in it was because it was a way also for the Christian Democratic Party to have a way to speak to people (because at that time there was Berlusconi who owned Mediaset to communicate with other people) The problem is that the main shareholder (Tanzi family) made decisions that were not business driven but they were driven for other reasons (football, cd party etc) PROBLEMS / REASONS FOR THE COLLAPSE: They had a very aggressive growth, uncontrolled and too fast —> problematic You need money to finance this growth • Under-capitalization • Liquidity Debt was increasing —> they got money only through debt “The origins of these problems could mainly been found in the Group’s low operating margins and in its tremendous level of debt, necessary to finance the diversification and growth strategy” Leadership: Calisto Tanzi • the pride of the entrepreneur / the “me syndrome”
 => the firm belongs to the family even if it is public 
 “Tanzi’s lawyer said that his client did not think he was doing anything out of the ordinary when he shifted hundreds of millions of Euros from Parmalat’s accounts to his other firms” Changes in the environment • Mani pulite (clean hands) —> • Privatization of the banks —> harder to find business approvals HOW WERE THE PROBLEMS HIDDEN? Corporate governance - the board They were independent directors but just 2 of them had a small power so there were conflicts of interest. Only 2 independent directors with low positions —> Tanzi wanted the power all to himself Role of Auditors: - “since 1985-1986, [Grant Thornton SPA] was fully aware of all the legal and illegal activities of the Group” - 1998: Parmalat has to rotate its auditors —> Deloitte - Parmalat established a new Cayman-based subsidiary to which the Group would transfer all of the balance sheet anomalies - Grant Thornton remains the auditor for the certification of the financial statements of those subsidiaries (representing 49% of the holding’s assets) - Deloitte & Touche would audit only the consolidated accounts and up to 51% of the Group assets Role of the banks (international): - Connection between Parmalat and Italian banks —> got approved businesses that shouldn’t have been approved - Documents were forged, cooking the books - International banks? - Parmalat was an attractive, an “institution” in Italian industry - Local bankers considered Parmalat as a good client - Use of multiple banks - Herd behavior (no centralized power) - Less due diligence - Self-interest —> “like bees to a honey pot” - Individuals bought Parmalat’s debt The “usual mechanism” • Hiding existing debt off balance sheet - “Parmalat issued debt to its own subsidiaries in order to cover their losses or it issued debt to shell companies that transferred those funds to the Tanzi family companies.” • Manipulating financial statements - “The group’s turnover was estimated to be 25% lower than what was declared […] and its operating margin was about 81% lower” SUMMARY • CEO’s inability of distinguishing between the interests of the family and the company • Failures in business strategy • Danger of rapid expansion through debt-funded acquisitions • Failure in corporate governance mechanism: • Board of director • Auditors • Inadequate impartiality of banking relationships Enron vs Parmalat: Type of firm (ownership): - E: public company —> problem of greed - P: public company, family owned the majority of the shares —> "me syndrome”, entrepreneur believes that the company belongs only to him (also greed) Business: - E: - P: Key actors: - E: role of the banks, conflict of interest - P: Accounting practices: - E: mark to market —> had to seem stronger, book that showed a lot of - P: forged documents, needed to hide their debt - => both had to find a way to seem more wealthy Corporate culture: - E: failure of the board of directors, of the —> no rotation - P: rotation Agency problem: FUNCTIONAL AREAS 1. Institutional structure design: creation, basic configuration, transformation & termination of an organization.
 2. Operations: set of activities through which firms carry out their economic production of goods and services. (buy raw materials, assemble them …)
 3. Organization: designing the organizational structure, assigning tasks and responsibilities, managing personnel.
 4. Information: gathering, processing, and disseminating data and information to internal decision makers and external stakeholders. INSTITUTIONAL STRUCTURE DESIGN These processes determine the overall design by which the firm is created and how it evolves. This is where decisions are made as to: • Founding the organization • Defining or changing its legal status • Designing governing bodies • Defining shareholder structure • Mergers, acquisitions, break-ups • Partnerships and alliances • Liquidating the organization CORE OPERATIONS They refer to the extensive set of activities by which the firm actually carries out economic production. R&D Establish products features and production methods • Fundamental research • Es: xerox and kodak invested in the ?? —> became leaders in the photocopy and scanner business —> worked even in the beginning of production, not only the selling of printers • Technology / competition watch • Evaluation of customers needs • New product development • Problem solving with existing products & upgrades • Quality check Purchasing Buying long-term equipment/facilities, raw materials, services • Recognition of needs • Forecast and Plan Requirements • Supplier Identification / Evaluation / Selection • Analyzing quotations and bids • Placing orders • Spend Analysis • Contract Management (contract with supplier) • Supplier Relationship Management POSITIVE: “good contract development and management could improve profitability by the equivalent of massive 9% of annual revenue” NEGATIVE: “based on the company’s own investigation and independent scientific analysis of the issues by three consulting bodies, the overheating was caused by separate problems in batteries sourced form two different suppliers.” Manufacturing • Processing and assembling raw materials and parts • Planning, quality control, maintenance • Technical skills (+ economics) “New survey of auto industry manufacturing executives shows stopped production costs an average of $22,000 per minute. Manufacturers say they need better machine maintenance” Sales and marketing • Selling the firm’s product while optimizing economic profitability • Understand customers, competitors’ offering, define sales policies (4/5 P), advertising and communication campaign • Sales and marketing skills + technical skills Logistics • Transport, store and move raw materials, semi-finished or finished products • Multidisciplinary skills CORE OPERATIONS - TRANSVERSAL PROCESS New product development: • Technology idea (R&D) • Contact with suppliers / availability (Purchasing) • Feasibility / Prototyping / Production (Manufacturing) • Customer’s need (S&M) Processing customer orders: • Purchase raw materials (Purchasing) • Production / Quality control (Manufacturing) • Take orders (S&M) • Plan production and shipping (Logistics) INFORMATION • Provide data and information to firm’s decision makers, and firm’s stakeholders who need information to decide if/how to establish and grow their relationship with the firm.
 • Extreme variety and complexity of recipients, purposes, rules, and technologies involved.
 • A central component of a firm’s information system is given by financial statements, which measure a firm’s performance. SESSION 10 - ORGANIZATIONAL DESIGN ORGANIZATIONAL DESIGN Definition: Organizational design is a formal, guided process for integrating people, structure, process and culture of an organization. It is used to match the form of the organization as closely as possible to the purpose(s) the organization seeks to achieve. Through the design process, organizations act to improve the probability that the collective efforts of members will be successful. WHY DO FIRMS NEED AN ORGANIZATION? 1. Divide labor among members 
 - allocating tasks, authority and accountability 2. Coordinate units
 - fostering exchange and circulation of information 3. Ensure cooperation
 - aligning goals and controlling their pursuit ORGANIZATIONAL STRUCTURE Definition: “Refers to the division of labor and the patterns of coordination, communication, workflow and formal power that direct organizational activities.” “It formally dictates what activities receive the most attention, as well as financial, power, and information resources.” It includes the organizational chart but “it also relates to job design, information flow, work standards and rules, team dynamics, and power relationships.” 2 fundamental processes: 1. Division of labor 2. Coordination DIVISION OF LABOR - DISTRIBUTING TASKS —> we divide labor to be more efficient
 Horizontal division (comes from specialization)
 Increases work efficiency:
 - cycles are shorter 
 - it doesn’t take time to switch from one task to another
 - lower training cost (train them only to do one task and not several)
 - easier match (between skills / preferences and the different kind of job)
 Vertical division: as the organization grows you may decide to have some individuals that don’t produce directly but they are managers —> their role is to facilitate the coordination within a certain group COORDINATION - may have some issues: Misalignment: people have different goals/incentives due to misunderstanding
 - misaligned goals demotivate
 - misaligned goals signal unnecessary difficulty 
 - salespeople will find the resources to achieve goals, at a cost
 Duplication: different parts of the organization do the same thing
 - it’s inefficient, costly and can lead to doing the same thing with different interpretations 
 Mistiming: problem of timing
 waste of time and money SOLUTIONS: INFORMAL COMMUNICATION: • Sharing information & Information communication • Common mental methods: shared, organized understanding and mental representation of knowledge about key elements of the team’s relevant environment —> BUT it may be dangerous! (Satellite crashed into Mars: there were two pieces of electronics trying to communicate and the number that was communicated was interpreted in newtons while the other part defined it in pounds of force) FORMALIZATION • Standardizing behavior through rules, procedures, training, etc.
 • Increases as firms get older, larger, regulated.
 • Problems with formalization
 - less organizational flexibility 
 - discourages organizational learning/creativity
 - increases job dissatisfaction and work stress
 - rules/procedures become focus of attention DEPARTMENTALIZATION • Specifies how employees and their activities are grouped together.
 • Strategic decision:
 - establishes the chain of command: interdependencies, resource sharing, supervision
 - focuses people around common mental models 
 - coordination through informal communication within department Let’s step back a bit… • What different types of organizations exist? • How do they differ? • What are their pros and cons? MECHANISTIC VS ORGANIC STRUCTURES FLATLAND: Elements of organizational structure Mechanistic vs. organic structures Welcome to Flatland Hierarchy is great for maintaining predictability and repeatability. It simplifies planning and makes it easier to control a large group of people from the top down, which is why military organizations rely on it so heavily. But when you're an entertainment company that's spent the last decade going out of its way to recruit the most intelligent, innovative, talented people on Earth, telling them to sit at a desk and do what they're told obliterates 99 percent of their value. We want innovators, and that means maintaining an environment where they'Il flourish. That's why Valve is flat. It's our shorthand way of saying that we don't have any management, and nobody “reports to” anybody else. We do have a founder/president, but even he isn't your manager. This company is yours to steer—toward opportunities and away from risks. You have the power to green-light projects. You have the power to ship products. A at structure removes every organizational barrier. Elements of organizational structure Mechanistic vs. organic structures Welcome to Flatland A flat structure removes every organizational barrier between your work and the customer enjoying that work. Every company will tell you that “the customer is boss,” but here that statement has weight. There's no red tape stopping you from figuring out for yourself what our customers want, and then giving it to them. If you’re thinking to yourself, “Wow, that sounds like a lot of responsibility” you’re right. And that's why hiring is the single most important thing you will ever do at Valve (see “Hiring,” on page 43). Any time you interview a potential hire, you need to ask yourself not only if they're talented or collaborative but also if they're capable of literally running this company, because they will be. SESSION 11 - ORGANIZATIONAL DESIGN (2) TYPES OF ORGANIZATIONAL STRUCTURE FUNCTIONAL FORM • Organizes employees around specific knowledge or other resources (e.g. marketing, production) Typically used when… • Small organizations, single-business firms • Simple product lines (focus on efficiency) • Stable markets and products DIVISIONAL STRUCTURE • Organizes employees around outputs, clients, or geographic areas ORGANIZATIONAL SYSTEMS They provide rules, procedures, mechanisms of communication, decision making and control that allow companies to solve the problems of achieving both coordination and cooperation. Information system Financial planning and control Human resource management Organizational culture well aligned with the structure —> structure and culture go together (ex rooms for meetings made in a specific way) CASE STUDY: PROCTER AND GAMBLE P&G HISTORY: 1837-1948 The origins • 1837: Procter (candlemaker) and Gamble (soap-maker) formed a partnership in Cincinnati • Strong local competition • 1850: investment in large factory • P&G is awarded several contracts to supply swap and candles to the Union armies An innovative company • 1879: Ivory soap (symbol of purity) • 1882: National advertisement campaign • 1887: Ivorydale • 1887: Profit-sharing program • R&D lab • Diversification: cooking oils, detergent, paper products, pharmaceutical products, etc… • 1919: a market research department is created to study … • 1933: the name soap Opera came from this company Organization • 1920s: Competitive environment between brands • 1943: Creation of the first product category division (drug-products department) • Level of centralization? • Decentralized consumer-focused decisions • But with centralized functions: R&D and manufacturing 1955: Product Division (US) —> not very efficient because this kind of structure doesn’t allow synergies between divisions because everyone tries to maximize their own department —> it has a large portfolio, therefore it facilitates the aim to create high quality products in a competitive industry —> risk of competition between departments and duplication —> this helped to diversify, broaden their audience, flood the market and grow faster 1956: Geographic Division (Europe) —> country manager handles the core operations —> Europe decided to organize themselves like this because, for example, German customers have different taste than Italian customers so it made more sense (vs USA product division) Europe “alternative” organization: This is an alternative view that Europe could have adopted but they decided not to. You believe that customers from different states are different —> you decide to kinda replicate the US model so for each country you will have a representative for marketing, manufacturing, ecc… —> brand managers are aware that there are preferences between the countries => Instead of having a country manager you have a product at the top (= US) and then there are local representatives for any kind of core function that will customize the product for their country P&G did not opt for this division because: - People try to make their products sell more in those countries with the best market and best economies —> we have to realize that in Europe there are also small countries which have small markets => if you were a brand manager you would start going to Germany, France, Italy not to Slovenia => there would be no P&G products in small countries and there would be a lot competing in the big countries With the other structure the country manager objective is to maximize the profit of P&G products overall —> so yes there may not be products sold in Slovenia but at the time the goal of the company was not having their products distributed everywhere, the goal was to flood the market with their products So this alternative structure would not have worked ORGANIZATION 2005: Decided to have this even more progressive structure in 2005 Product and regions on top of the organizations and functions go under the product Someone in Germany in charge of selling the product and someone making sure that the firm rolls out the different products Possible misalignment between sales and marketing functions: sales wants a higher price, while marketing wants to market at a lower price to incentivize consumers to buy If GM Germany and GM Ariel have a disagreement —> CEO decides to let the two decide, if not they would be fired —> this did not work —> organized meetings between the two —> job rotations: moved from one part of the organization to the other —> understood better the global goals and not the ones of their section —> very decentralized organization SESSION 12 - UNDERSTANDING THE FINANCIAL STATEMENTS WHAT IS ACCOUNTING? • The language of business.
 • The “system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results”.
 • “The process of identifying, measuring and communicating economic information to permit informed judgments and decisions by users of the information”.
 • “Accounting is an information science used to collect, classify, and manipulate financial data for organizations and individuals. Accounting is instrumental within organizations as means of determining financial stability. Accountants are responsible for determining an organization’s overall wealth, profitability, and liquidity. Without accounting, organizations would have no basis or foundation upon which daily and long-term decisions could be made.” Goal of the Accounting & Management Unit at HBS: • Communicate with external investors to ensure that their firms’ securities are fairly priced and that they are able to access capital. • Measure and evaluate their firms’ economic performance. • Improve resource allocation and strategy implementation within their firms. • Build accountability for performance through effective external and internal governance. TYPES OF ACTIVITIES: Operating activities: • involve transactions that enter into the determination of net income and are primarily activities that comprise the day-to-day business functions of a company.
 Investing activities: • activities associated with the acquisition and disposal of long-term assets, such as equipment.
 Financial activities: • activities related to obtaining or repaying capital to be used in the business. DIFFERENT TYPES OF ACCOUNTING OUTPUT OF THE ACCOUNTING CYCLE Tesla vs apple - assets: what the firm owns —> apple:? Tesla: 8 billion - Apple: Shareholders equity: 1/2 of the capital —> founded through equity - Tesla: shareholders equity: 1/7 of the capital —> firm founded mainly through debt - Apple: growing slowly - Tesla: growing aggressively INCOME STATEMENT • “Information on the financial results of company’s business activities over a period of time”. • Also called Statement of operations and Profit and loss (P&L) statement • Information available:
 - revenue generated during the period
 - costs it incurred in connection with generating that revenue (COGS, operating expenses, etc…)
 - net income Net sales: Tesla: parenthesis: negative number —> not profitable but growing fast —> investors believe in the future Apple: profitable STATEMENT OF CASH FLOW • Shows the cash inflows (receipts) and cash outflows (payments) of an entity during a period of time. • “helps creditors, investors, and other statements users evaluate the company’s liquidity, solvency, and financial flexibility” (International Financial Statement Analysis, CFA Institute) • Classifies all company cash flows into:
 - operating activities cash flows
 - investing activities cash flows
 - financing activities cash flows SESSION 13 - THE BALANCE SHEET THE BALANCE SHEET • It is “an instant snapshot of the assets used by the company and of the funds that are revealed to those assets”. • It is a static document relating to one point in time. • We therefore take repeated ‘snapshots’ at fixed intervals … to see how the assets and funds change with the passage of time. ASSETS Resources owned or controlled by the firm that are expected to yield economic benefit for the firm and that are the results of past transaction. Is it an asset? Machinery: yes Customer loyalty: no Lottery: no Tomato sauce: yes Workforce: no —> the firm does not own people 2 types of assets: FIXED ASSETS: not expected to be converted into cash within 12 months
 Divided in: • Net fixed assets: long-lasting physical items needed for the operations of the firm (property, plants and equipment: PPE) - impairment: sudden and unexpected loss of value (technological redundancy, coning laws change) —> something you did not forecast
 • Investments: long-term holdings of shares in other companies, when they are nit consolidates (shares lower than 50%). Valuation based on original cost but it can be updated to reflect current market value.
 • Intangibles: assets that do not have a physical presence but have a value for firm’s activities. 
 Ex: - Patents: is the granting a property right by a sovereign authority to an inventor. This grant provides the inventor exclusive rights to the patented process, design, or invention for a designated period in exchange for a comprehensive disclosure of the invention. - Goodwill: the value of intangibles in another company that the focal one has acquired, as reflected in at the price it paid (reflected only in the consolidated). CURRENT ASSETS: are expected to be covered into cash within 12 months.
 Divided in: • Inventories: goods, raw materials and work in process held for purpose of resale (ex: ingredients for a food manufacturer)
 • Accounts receivable: amount due from customers within a year (trade credit) 
 • Cash and equivalent: liquidity means available to the firm (ex: cash, short term loans, cheques)
 • Miscellaneous: covers any short-term assets not included elsewhere (ex: advances to employees, pre-paid expenses) Fixed or current asset? —> depends on your business Asset: computer Retail store: current —> will shortly sell it Engineering office: fixed —> will use it for a long time PC manufacturer: current—> will shortly sell it NET WORTH = owners’ funds —> $15,000 WORKING CAPITAL = current assets - current liabilities —> $13,000 CAPITAL EMPLOYED = owners’ funds + long-term loans —> $25,000 SOLVENCY • Making profits takes time - firms may need to borrow. • Debt generates financial changes§
 - payment of the borrowed amount (principal) plus periodic interest
 - … increases corporate risk (asynchrony between cash flow generation and financial charges) => Solvency (or cash equilibrium) is about being able to meet debt positions as they fall due. PROFITABILITY • Production and market transactions generate revenues and costs • Profitability is about the ability to compensate all production factors with positive components of income • Profitability measures will relate to income to inputs used in the production process SESSION 14 - THE INCOME STATEMENT IMPORTANT TERMS PROFIT AND LOSS STATEMENT Costs are incurred when goods are consumed, not when they are purchased or paid for. The profit and loss account is not concerned with cash flow! REVENUES
 Revenues mainly refer to the monetary value of a company’s sales of goods and services to its customers.
 Even though a company’s “bottom line” (its net income) gets most of the attention from investors, the “top line” is where the revenue or income process begins. Revenues grow by: • Increasing volumes, • Raising prices, or • Improving product mix (selling more high-priced items rather than low-priced ones). REVENUE IS NOT PROFIT!! OPERATING COSTS
 What are they? • For a manufacturer, they are the expenses incurred for raw materials, labor and manufacturing overhead used in the production of its goods. • For retailers, they are essentially the purchase cost of merchandise bought for resale. • For service firms, they are the cost f producing services. Typical items: • “purchase of materials” (or “materials”) • “administration costs” (or “administration”, or “administration overhead”) • “labor costs” (or “labor”) • “sales and marketing expenses” EBITDA
 Stands for: Earnings Before Interests, Taxes, Depreciation, and Amortization
 Important because: • Some subsequent items in the P & L account do not correspond to cash flow in the period (ex: depreciation and amortization). • EBITDA is largely free from effects of previous investment decisions, capital structure and distortions that can arise from accounting policies. • The EBITDA margin is an ineffective indicator of financial performance for companies with high levels of debt or for companies that consistently purchase expensive equipment for their operations. DEPRECIATIONS
 What are they? • Way to deal with the cost of a long term asset that is used over several years • Depreciation indicates how much of an asset’s value has been used up • “Cash spent on the purchase of assets is not a cost, but the corresponding depreciation over the following years is” => for tax purposes, businesses can deduct the cost of the tangible assets they purchase as businesses expenses To compute the depreciations you need: • The cost of the good • Useful economic life (you asses how many years you will use this tool) REVENUES - OPERATING COSTS = EBITDA NET INCOME 
 What is it?
 This is the bottom line, which is the most commonly used indicator of the company's profitability.
 
 If expenses exceed income, this account caption well read as a net loss. DIVIDENDS
 What are they?
 Dividends are the part of earnings that shareholders get in cash.
 
 Firms may decide to pay lots of dividends (e.g. AT&T) or very few dividends (e.g. Apple) RETAINED EARNINGS
 What are they?
 The part of net earnings are not paid out as dividends, but retained by the company to be reinvested in its core business or to pay debt.
 
 Often firms retain earnings to invest where they can create growth opportunities, such as buying new machinery or spending the money on more research and development.
 
 Retained earnings are important for high-growth firms!!! EBT - TAXES = NET INCOME NET INCOME - DIVIDEND = RETAINED EARNINGS SESSION 15 - THE INCOME STATEMENT (2) EARNINGS PER SHARE (EPS) • “Common shareholder comes last in the queue for participating in profit” • “the profit used in the calculation [of the earnings per share] is the figure after all other claimants have been satisfied”
 - after interests 
 - after tax It is a measure of a company profit. It is the profit earned by shareholders for every share held. As you see, EPS is not comparable across companies because it depends on how many shares a company issued. But growth in EPS in a company is an important measure of progress. PRICE TO EARNINGS RATIO (P/E) It expresses how many years of EPS are needed to buy the share / how much investors are willing to pay per dollar of earnings. P/E is comparable across companies and is an indicator of the opinion of investors are about the potential growth in the profits of the company (high P/E implies high expected growth). In practice, the P/E of companies varies with: • Industries (higher in high-growth industries, lower in mature or declining industries) • Countries (higher in high-growth countries, lower in low-growth countries) • Periods of time (higher in “bull” periods of the stock market, lower in “bear” periods of the stock market) MARKET TO BOOK RATIO It is that the amount that the shareholders own after the company’s liabilities have been paid off. = Assets - Long-term loans - Current liabilities If > 1, the firm has goodwill. A higher market to book ratio implies an expectation of earnings growth, or that intangible and other assets in the balance sheet are undervalued. If < 1, the firm has badwill. A low or negative market to book ratio implies an expectation of low future earnings or even losses, or that the assets of the company are overvalued. SESSION 16 - MEASURING PERFORMANCE FINANCIAL RATIOS • Provide targets and standards for management • Show connections between different parts of the business • Support managerial decision-making PROFITABILITY RATIOS => Measure the capacity to preserve the income equilibrium in the future. They use important values in the financial statements. • From the income statement: Operating income (EBIT), Income before tax (EBT), Net income (EAT) • From the balance sheet: Total assets (TA), Capital employed (CE), Net Worth (NW) Among the different possible ratio combinations, ROTA (or “ROA”) and ROE are the most important. Comparison shall be meaningful!! Example Retail firms have high revenue during the Christmas season: - Comparing the profit margin of the 4th quarter within the 1st quarter do not give a clear picture of the profitability - To judge of the profitability appropriately, the profit margin of the 4th quarter should be compared with the profit margin of the 4th quarter of the previous year 1. ROTA: RETURN ON TOTAL ASSETS How to interpret? • Rate of return earned by the total assets • This ratio measures how well management uses all the assets to generate an opening surplus
 - key tool is directing management’s day-to-day activities.
 - it provides a benchmark against which all operations can be measured. Comparisons should be made with companies in the same industry. When ROTA is higher than industry average, a company is said to have a competitive advantage. In absolute terms, you should receive a ROTA of at least 8-12% if you wanted to get a decent ROE (which measures of the final profitability for investors, after considering interest and taxes). Problems/Limitations: • Firm deal with several products, not just one
 - hard to disentangle specific contributions from average components
 • Depends heavily on asset valuations in the Balance Sheet
 - age of plants, depreciation etc. play an important role THE COMPONENTS OF ROTA As a simple figure it simply provides a target. To be useful in decision-making, it must first be broken down into its component parts. 2. ROS: RETURN ON SALES 3. ASSET TURNOVER • It should be high enough to compensate shareholders for the specific risk of investing in the company. Riskier companies should earn higher ROE to convince shareholders to invest. • 12-15% is considered an adequate ROE of most companies • ROE is usually higher than ROTA. ROE depends on: - ROA - The financial structure of the company • A good ROE drives an increase in the share price, helps firms raising new funds from shareholders and in general supports a firm’s growth. Decomposing ROE To understand how profitability can be affected by financial leverage, it must first be broke down into its component parts FINANCIAL STRENGTH RATIOS => Measure the reliance of the firm on long-term risk capital FINANCIAL STRENGTH (FS) It is the firm’s ability to met interest and principal payments in the long-run. Financial strength is linked to the structure of capital, i.e. risk capital (equity) vs. loan capital (bank and other debt). This is a very important area of corporate finance, because decisions on the structure of capital have huge impact on riskiness of firm and profitability of the firm for shareholders. 1. INTEREST COVERAGE RATIO • It indicates how many times a firm’s operating income exceeds interest expenses —> the higher the better • 3 factors determine the value of this ratio: 1. The operating profit of the firm 2. The total amount borrowed 3. The effective rate of interest • Low values (lower than 1.5) are worrying because they indicate that the firm may encounter difficulties in paying interest • When the interest coverage ratio is lower than 1, the firms usually has an economic loss THE STRUCTURE OF CAPITAL It is the composition of debt (current liabilities + long-term liabilities) and equity (owners’ funds). What are the financial charges generated by debt? Interest Payment of the principal (either by a single lump sum payment at the end of the loan period, or by periodic installments) The problem with debt is that payments are certain, while the cash flows of the companies are uncertain, because of ups and downs of business. So, as a general rule, the lower the amount of debt, the safer the balance sheet of a firm (financial strength). High risk means a high likelihood for the firm of going out of business • If the firm is unable to meet debt payment —> default • A court may impose supervision on how to handle a default —> bankruptcy (i.e. legal procedure to use a firms’ assets to pay creditors) But then why do companies use debt? Equity is much safer for the firm because it does not have to pay dividends if earnings are low (or negative); moreover, the firms does not have to pay equity back. The reason why firms use debt is cheaper than equity. 1. Banks and other lenders accept interest rates that are lower than expected returns for equity (lenders have precedence over shareholders during bankruptcy, which makes loans less risky than equity) 2. Interest is deducted from taxable income (dividends or capital gains for shareholders are not), so it reduces corporate taxes 2. DEBT TO EQUITY RATIO Meaning: if higher than 1, then Debt > Equity Usually values between 1 and 2 are considered safe. Above 2, the Debt-to-Equity ratio may indicate excessive risk, although high values are common in capital intensive industries that need much capital and have to use debt. In this class we consider the following definition of debt: Total debt = long term liabilities + current liabilities 3. COST OF DEBT = TOTAL INTEREST / DEBT Cost of debt = interest (on P&L) / total debt DEBT RATIO Remember that Debt + Equity = Total Assets The Debt ratio indicates the part of Assets that is financed by Debt Standards: based on those of the Debt-to-equity ratio (ex a debt-to-equity of 1 translates in a debt ratio of 0.5)