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Accounting Finance and Control (AFC)

Introduction
Michela Arnaboldi
michela.arnaboldi@polimi.it
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Assumption and Agenda
Enterprise value and its management is the
backbone of this course.
Today an introductory frame is provided:
Scope of the course
What is enterprise value
How to manage enterprise value
Why to manage enterprise value
AFC program
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Scope
Disciplinary scope
Accounting = the measurement, processing and
communication of financial information about economic
entities. Accounting measures the results of an organizations
economic activities and conveys this information to a variety
of users including investors, creditors, management, and
regulators
(corporate) Finance = the sources of funding and the capital
structure of corporations and the actions that managers take
to increase the value of the firm to the shareholders
Control (in management) = setting standards, measuring
actual performance and taking corrective action
(source Wikipedia)
Focus on profit enterprises
WHAT IS ENTERPRISE VALUE
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Profit Enterprises
Enterprise can be seen as an input-output system
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Which is the goal of a profit enteprise?
Enteprise goal
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Companies try to maximize their our output with their inputs
To translate this goal, money is taken as reference measure
(homogeneous measure):
Investments (I): assets that a company is going to use for more
than 1 year
Cash flows (CF): refer to cash exchanges related to transactions
that have an impact on the short-term
Net Cash Flow (NCF) = CF - I
Enterprise
Project &
Activities
Investments (I)
Cash Flows (CF)
Enteprise goal: infinite lifecycle
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Assuming we focus only on 1 year (Year 0)
Enterprise value (V) = NCF(0) = CF (0) I(0)
Yet, companies are supposed to have an infinite lifecycle
Problem in summing NCFs: the value of money changes
overtime
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Time-value of money:
Compounding and discounting
The future projection of cash flows is generalized with
the compounding formula, where:
r
f
is the risk-free rate
n is a generic year
FV stands for future value.
PV (0) =
FV(n)
(1+r
f
)
n
FV(n) = V(0)*(1+r
f
)
n
To solve the opposite problem, to calculate the present
value of future NCF, we use the discounting formula
PV = Present Value
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Present Value in risk-free condition
The discounting formula allows to sum expected cash
flows over different years.
Using the risk-free rate and considering an infinite
horizon, the present value of different NCFs is:
NCP
1
1+
]
1
NCP
2
1+
]
2
NCP
3
1+
]
3
+ +
NCP
N
1+
]
N
NCP
t
1+
]
t
+
t=0
[present value in risk-free conditions]
Two problems
1. Enterprises need to be financed
To invest (I)
And then to generate cash (CF)
2. Enterprises operate in risk conditions;
investors want to be remunerated for risk
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Enterprise: shareholders
Enterprise
Project &
Activities
Investments (I)
Cash Flows (CF)
Shareholders
Equity Capital
Dividends
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Equity Present Value
For Shareholders (Equity investors), risk is compensated
by a risk premium included in the denominator
The discounting factor becomes (k
E
) and PV is
addressed as Equity Present Value (E)
NCF is here substituted by the term Free Cash Flow to
Equity (FCFE), to clarify that here we are assuming that
cash flows pertain to shareholders
PCPL(t)
1+k
E
t
+
t=0
[Equity present value]
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Enterprise: debtholders
Enterprise
Project &
Acitivities
Investments (I)
Cash Flows (CF)
Shareholders
Equity Capital
Dividends
Debtholders
Debt Capital
Interests
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Enteprise Value
Enterprises are also financed by Debt capital (D)
In this case:
Cash flows pertain to both equity and debt holders and called Free
Cash Flow to Firm (FCFF)
Discounting rate is the Weighted Average Cost of Capital (WACC)
WACC(t) =

+E
k

1 -t
c
+
E
+E
k
L
k
D
= average interest rate
t
c
= tax rate
PCPP(t)
1+wACC
t
+
t=0
[Enterprise present value]
This complete vision allows formulating Enterprise Value
HOW MANAGING ENTERPRISE VALUE
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Enterprise Value and Environmental
Complexity
Enterprise value is the reference goal for enterprises
At the conceptual level this is the indicator to maximise,
but:
Increasing pressures for enterprise sustainable corporate
behaviour more performance factors (triple bottom line)
Trade-off between completeness and timeliness
Misalignment with managers responsibility
Interconnection between enterprise and global risks Risk
appetite
Higher complexity and uncertainty
Economic
Enterprise
Value
Shareholders Banks
Governement
Citizen
Clients
Employees
Rating
agencies
Enlarging theperformancetoolkit
NetCashFlow
Revenue Cost
OWC EBITDA
Performancedrivers
Time
Quality
Productivity
Flexibility
Environment&society
Resourcedrivers
Image
Technology
HumanResource
FixedAssets
Receivable Payable Inventory
EnterpriseValue
Value
based
proxies
TerminalValue Costofcapital
Risk
Value
measures
KeyRiskindicators
CashFlows InvestedCapital
AccountingBased indicators
Valued Based indicators
ValueDrivers
Directmeasurement
Value
based
proxies
Indirectmeasurement
WHY MANAGING ENTERPRISE VALUE
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Why? A multi-stakeholder perspective (1)
Building Enterprise value, we encountered two main
stakeholders, who are also investors:
Shareholders
Debtholders
To manage value, a more complete set of actors must be
considered:
External, including individuals and entities who have direct or
indirect interests:
Shareholder
debt holders
financial analysts
other societal actors more broadly.
Internal, which refers to managers operating at different levels of
the enterprise.
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Enterprise
Organizational units
FinancialAnalysts
Shareholders
Other
Stakeholders
Bondholders
Managers
Internal
accountability
External
Accountability&
Corportate
Governance
Banks
Why?Amultistakeholderperspective(2)
Adapted from Damodaran, 2011
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Shareholders
Shareholders are the main investors in risk capital for
enterprises and aim to increase the company equity
value
Yet, traditional corporate finance takes stock price
maximization as reference objective, because:
Stock prices are observable and are updated constantly to reflect
new information coming out about the firm
Assuming that investors are rational and markets efficient, stock
prices will reflect the effect in the long run of enterprise decisions.
Shareholder (and other external actors) can test impact on stock
price of investments decision (evidence)
E u =
PCPL(t)
1+k
E
t
+
t=0
Is stock price maximization aligned with Enterprise Value creation?
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Debtholders (1)
The debtholders of a company could be divided into:
banks (or financial institutions) and bondholders
Financial institutions support company, granting loans,
which vary in terms of:
amount granted,
maturity
interest rate
the type of the amortization schedule
other features e.g. prepayments
The main characteristic of a loan is its seniority, which
determines the priority of its reimbursement in case of
bankruptcy
Debtholder has to objective to ensure its loan with the
highest seniority, in order to be more confident of its
repayment
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Debtholders (2)
A bond is a security which requires the issuer to pay
specified interests (coupons) and make principal
payments to the holders (bondholders) at maturity or
even on specified dates.
Bondholders do not increase their cash if projects
succeed, but have costs if they fail
Tend to view the risk in investments much more negatively than
shareholders
Difference in scale:
Small-scale creditors are more interested in the features of the
corporate bond such as the amount and the frequency of the
coupon and its maturity rather than in the company running
Large-scale creditors are more similar to financial institutions
Financial Analysts
A financial analyst is a professional who is responsible
for investigating companies that belong to the same
industry, the same country, or the same market (Equity
research)
They provide report to be released on the stock
exchange
The central information of the report is the stock target
price and a rating (e.g., buy, neutral/hold, or sell)
The first report about a company is called Initial
Coverage, the following reports are is called a Company
Update
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http://www.borsaitaliana.it/borsa/azioni/documenti/societa-quotate/studi-e-ricerche.html
http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/tools-and-services/company-
profile/company-profile.html
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Source: borsa Italiana
Other Stakeholders
Further to Equity and Debt holders there are other
more indirect stakeholders:
Customers
suppliers
Local community
State
Local Authorities
International organizations
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Stakeholders and External Accountability
There are two central instruments that companies uses to
account externally:
Disclosure
Financial Statements - mandatory
Other report (e.g. sustainability reports); these are not mandatory
but they should be:
Complete with reference to international or national
standards;
Stable across time; changes in reporting initiatives have to
be justified.
Transparent and understandable for readers.
Corporate Governance Code is a regulatory framework
regarding how companies are governed.
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External Accountability - Eni
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Internal Accountability
Internal accountability refers to the use of indicators to
guide management.
We introduce the concept of Performance Measurement
System (PMS), which is a system intended to guide the
decisions and behavior of managers by providing
performance and risk indicators.
PMS has two main intertwined functions:
Decision making
Motivation
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Note: in practice different labels are used to refer to the indicator system: management control
system, performance management system, management accounting systems.
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Internal accountability: decision making
The set of decisions that PMS supports is large:
Operational
Management
Strategic
The decision making cycle can be divided in four
phases:
Definition of goals and actions
Measurement of results
Analysis, formalisation and communication of actual results
Identifying corrective actions
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1. Supporting decisions: Planning
This first phase aims at defining a plan of action,
considering:
Objectives
Resources
Risks
PMSs provide information which are based on models and
assumptions:
Price (Historical, Predicted)
Product costs (Material, Labour, Other costs)
Defining the plan needs itself a model:
Customer profitability:
Operating Margin (Price costs)
Operating margin + insolvency probability
During the planning phase we set a target
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1. Supporting decisions:
Measurement of Results
After (or during) actions we want to know the results
Measurement would be useless if:
Variables was known exactly since the planning phase
Our models were perfect
Actual results differs from predicted data:
External variables (e.g sales, material prices)
Internal variables (e.g. productivity)
MCSs provide information on:
Results
Update on risks
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1. Supporting decisions:
Variance Analysis and feed-back actions
When results differ from forecasts we need to analyse
Variances:
Variances in external variables
Variances in internal variables
The quality of the models is essential
The final step after the analysis of variances are
corrective actions, where it is important to highlight:
Level of influence
External/internal
Individual
results
Enterprise
Objectives
Ability
Knowledge
Skills
Effort
Reward
ActionTheories
Organizationalrole
andcontext
Performance
Choice Theories
2.InternalAccountability:Motivation
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2. Motivation
Increasing Efforts and Equity theory
Equity theory helps in translating the relation between
individual results and the social interactions
According to this theory individuals provide input (effort,
experience,) in relation to the output benefits.
The situation is balanced when the ratio - output/input - is
similar among individuals doing similar activities
A perception of difference leads individuals to modify the
ratio
Output/Input =k
Underestimation
Reduce efforts
Overestimation
Increase expectations
K
i
>
K
i
<
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2. Motivation
Orienting efforts: two theories
The efforts put into activities are not enough for
achieving organisational results; efforts need to be in
the right direction
There are two theories which help in evidencing the
role of PMS
Expectancy theory
Goals setting theory
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2. Motivation
Expectancy theory
According to this theory individuals are rational
They act for maximising their results with equally
efforts
There are two elements considered in this relation:
Reward
Effort
Expectation = Reward/Effort
Expectation = Reward/Performance * Performance/Effort
PMS needs to be
Complete
PMS needs to consider
individuals Specific Responsibilities
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2. Motivation
Goal setting theory
Individuals decide to which objective addressing their effort
on the basis of their importance for them (as individuals)
Individuals increase their motivation when:
Well defined goals are set
Goals are stimulating and they can hardly be reached
Goals can be reached
In complex setting, targets can be complemented with
minimum threshold (lower value)
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Requirements of PMS
Goals
Requirements
Internal Accountability External
accountability
(Disclosure) 1. Decision
making
2. Motivation
Measurability X X X
Specific responsibilities X
Completeness X X X
Timeliness X X
Long term oriented X
Stability across time X
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System to Control Measurement
of actual results
Variance analysis
Feed-back
Objective
Resources
Budgeting
Risk Analysis and mitigation
Reporting
Risk and Performance
Measurement
Risks
Action
PMS: the operational system
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Program
Introduction (today)
Consolidated Financial statements
Value Based indicators
Accounting-Based Measures
Value Drivers
Scorecards
Budgeting and Risk Management
The role of management accounting information in decision
making
Performance Management of Organizational Units
Forms and Techniques for Financing
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References
Main text book
Arnaboldi, A. Azzone, G. and Giorgino, M. (2014) Performance
Measurement and Management for Engineers Elsevier.
Further material
Anthony R. and Govindarajan V. (2006) Management Control
Systems McGraw-Hill Higher Education.
Gavin Lawrie and Ian Cobbold Development of the 3rd Generation
Balanced Scorecard 2GC Active Management
Kaplan R.S. and Norton D.P. (1993). Putting the Balanced
Scorecard to Work, Harvard Business Review.
Simons, R. (1995) Control in an age of empowerment. Harvard
Business Review (March-April): 80-88.
Course website available at: http://beep.metid.polimi.it
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Teachers
Prof. Michela Arnaboldi: michela.arnaboldi@polimi.it
Assisted by:
Dr. Antonio Conte: antonio1.conte@polimi.it
Dr. Yulia Sidorova: yulia.sidorova@polimi.it
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Exam
The exam is articulated in three parts:
Written test (20% of the final grade)
Group work (20% of the final grade)
Oral (60% of the final grade)
Passing all three tests is compulsory to pass the exam.
IMPORTANT
The oral can be taken maximum 3 times during the
Academic Year (AY).
The group work and the written test will be valid for the
entire AY in which are passed.
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Self Assessment
1. Which is the objective function and the goal of a profit company
2. What is Enterprise value?
3. Which is the difference between Enterprise Value and Equity Value
4. What is WACC
5. Why do companies use the discounting formula? And the compounding formula?
6. Which is the difference between external and internal accountability?
7. Have diverse stakeholder different goals? Which are they?
8. Which the role of financial analysts?
9. What is an equity research?
10. What is a PMS? Would you be able to explain its functioning to a person not used to
business and finance?
11. How PMS support decision making?
12. How PMS support motivation?
13. Can you explain the equity theory?
14. Can you explain the expectancy theory?
15. Which are the requirements for a PMS?
16. Which requirements are most important for external and internal accountability?
17. Can you outline the PMSs operational system?