Chapter 6. Evaluating Existing Investments and Competitive Advantages

Objective: To analyze a firm’s existing investments and to identify differential advantages that
explain excess returns on existing investments.
Key
Questions: 1. Evaluate whether the existing investments of the company generate returns that
exceed the cost of funding them.
2. If the company generates excess returns (over and above the cost of funding), tie the
returns on investments (and excess returns, if any) to the competitive advantages
possessed by the company and discuss whether threats to these competitive
advantages that might put these returns at risk.
3. If the company generates returns that are less than the cost of funding, examine
reasons for the under-performance and the best course of action on these
investments: divestiture, additional investment, continuation, or shut down.
Framework
For Analysis: 1. Analyze Exiting Investments
a. Estimate the accounting return on capital (equity) generated by your company
over the most recent year and compare to the cost of capital (equity). If your
company is in multiple businesses, try to estimate these numbers for individual
businesses.
b. Check to see if the most recent year represents an outlier, a typical year, or part of
a trend, look at the return on capital (equity) in prior years for your company and
at industry averages for these numbers.
c. If your company generates accounting returns that exceed the cost of funding,
examine how much of the difference is due to accounting choices and how much
to operating efficiency.
2. Assessing Competitive Strengths
a. If your company generates positive excess returns, examine the source of these
excess returns. Specifically, evaluate the barriers to entry that allow your
company to earn these returns and at threats to those barriers from macro-
factors (regulatory changes and shifts in economic variables), competition, and
within the company (expiring patents, for instance).
b. If your company earns close to zero excess returns, consider what types of
competitive advantages the company can work toward creating that will allow it
to earn positive excess returns in the future. If your company has negative excess
returns, evaluate the best options for the company in terms of the investments
that are causing these excess returns. You can look at the alternatives of
continuation, termination, divestiture, or restructuring, to see which one makes
the most sense

Chapter 7. Analyzing a Firm’s Current Financing Choices

Objective: Examine your firm’s current financing choices, categorizing them into debt (borrowings)
and equity, and assess the trade-off between debt and equity for your firm.
Key
Steps: 1. Examine how your firm is currently financed in both book value and market value
terms and classify the financing into debt, equity, and hybrid choices.
2. Evaluate how much your firm’s needs in recent years have come from internal equity
(retained earnings), external equity, and debt.
3. Examine in qualitative or quantitative terms the advantages and disadvantages to
your company of using debt, as opposed to equity. Based on this assessment, make a
qualitative judgment of how much debt the firm should be using.
Framework
For Analysis: 1. Current financing mix
a. Based upon the balance sheet (accounting), evaluate how much debt, equity, and
hybrid financing your company is using to fund its assets (book value).
b. Based upon market values, evaluate how much debt, equity, and hybrid financing
your company is using to fund its assets (market value).
2. Financing type
a. Examine the forms in which the company is raising equity. For a publicly traded
company, you will start with common shares, but it can be supplemented with
warrants and other equity-linked securities. For privately owned businesses, the
equity may come from venture capitalists, private equity investors, and the
owner(s) of the business.
b. Break down the debt of the firm, based upon when it comes due, what currency it
is in, and any special features associated with it (fixed versus floating rate).
c. If you have any hybrid securities (convertible bonds and preferred stock), see if
you can break down the hybrid financing into debt and equity components. If not,
consider treating it as a separate cost of financing.
3. Financing trade-off
a. Evaluate the tax benefits of debt to your company by first estimating the marginal
tax rate of the country in which it is incorporated and then following up by looking
at marginal tax rates of countries where it operates. Make a judgment on where
the company will benefit most from the tax deductibility of interest expenses and
constraints on maximizing these benefits.
b. Consider whether there is a separation of management from ownership in your
firm and the potential benefits of having more debt, as a disciplinary mechanism.
c. Based on your company’s earnings history and the business that it operates in,
evaluate the uncertainty in future earnings and the potential for default risk from
borrowing. Examine the costs (indirect bankruptcy costs) that may accrue to your business (in terms of revenues lost or higher operating expenses) from being perceived to be in financial trouble.

d. Examine whether lenders will feel secure about lending to your firm, in terms of
being able to monitor how the money is spent and whether it is being used
productively. Based on this assessment, estimate the costs and restrictions that
your firm may face, if it tries to borrow money.
e. Make a judgment on the uncertainty faced by your firm in forecasting future
investment needs and the benefits of maintaining financial flexibility (or excess
debt capacity).
f. Based on this trade-off, determine how much (if at all) your firm will benefit from
borrowing money and the financing mix that you would expect to see at the firm