LAWRENCE C. KARLSON currently serves on the board of directors of a number of public corporations. He has broad experience investing in and building the corporate value of companies of all sizes, both public and private, through internal growth and acquisition. Since his retirement, Mr. Karlson has served on numerous boards and led various committees, including audit, finance, corporate governance, and compensation committees in these organizations. He has also provided consulting services to a wide range of companies in Europe and the United States.

Preface xiii

Acknowledgments xvii

Foreword xix

Chapter 1: Basic Concepts 1

Introduction 2

Financial Statements 2

The Income Statement 3

The Balance Sheet 10

The Cash Flow Statement 18

Required Revenue for a Given Level of Net Income 24

Case Study: Advanced Solar Systems Corporation 27

Chapter 2: The Envelope Equations 35

Introduction 36

ROCE and NiROCE 36

Net Investments 39

Investment Rate 42

Incorporating the IR and NiROCE into the Expression for Net Income 43

Incorporating IR into the Expression for Cash Flow after Investing Activities 45

NI and CFaIA—A Sequential Year-by-Year Analysis 46

NI and CFaIA—The General Model 49

Estimating Growth Rates of Cash Flow after Investing Activities and Net Income 52

Growth Rate of CFaIAg with Constant IR and NiROCE 52

Growth Rate of Net Income (NIg) 54

Net Income Growth Rate (NIg) with Constant IR and NiROCE 54

Envelope Equations Methodology for Estimating Net Income, Cash Flow after Investing Activities, and Growth Rates 56

Required Revenue Revisited 66

Growing the Net Income 71

Case Study: American Technology Corporation 71

Chapter 3: The Weighted Average Cost of Capital 81

Why Is a Company’s Weighted Average Cost of Capital Important? 82

Weighted Average Cost of Capital Defined 83

Operating and Capital Leases 84

Weighting of the Components of Capital Structure 84

Market Value of Debt and Equity 85

Impact of Taxes on the Weighted Average Cost of Capital 87

Estimating the Cost of Debt and Equity and the Capital Asset Pricing Model 88

General Equations for Estimating the WACC for a Company with One Class of Debt and Equity 90

Levered and Unlevered Betas 90

Estimating Beta for Non-Public Companies or Business Units 93

Significance and Uses of the WACC 95

Origin of the Coefficients Used in Calculating a WACC 96

Multiple Hurdle Rates 100

Introduction to Present Value 110

Case Study: Omega Corporation 115

Chapter 4: Introduction to Valuation Models 123

Introduction to Estimating Value 126

Valuation Considerations—Lessons Learned 166

Most Frequently Used Single-Stage Valuation Models 167

Multi-Stage Valuations 167

Equivalence of the Post-Forecast-Period Models 176

Impact of 1/(k − g) on the Perpetual Growth Model 180

Considerations of the Terminal Value Multiplier as Implied by the Equivalency Equations 182

Case Study: NexgenSonics and the Power of Discipline! 183

Chapter 5: ROCE and Cash Flow Analytics 195

Introduction 196

Basic Drivers of ROCE 197

Some Practical Aspects of Managing Return on Capital Employed 209

Case Study: Pharos Corporation—The Early Days 210

Chapter 6: Strategies and Best Practices for Managing ROCE and Cash Flow 225

Introduction to Maximizing Return on Capital Employed and Cash Flow 227

Basic Pricing-Driven Models 228

Value-Added Models 230

Introduction to Factors That Impact Corporate Performance 238

Depreciation and Amortization 273

Case Study: Innovative Engineering Corporation 301

Prologue 311

Chapter 7: Productivity and Operating Margin 313

Productivity 314

Incorporating Operating Margin into the Productivity Model 325

Cycle Time 337

Closing Comments on Value Added and Cost 339

Case Study: Laser Technology Inc. Develops Its Productivity Strategy 339

Chapter 8: The Expense Coverage Ratio 353

The Expense Coverage Ratio 354

Expense Coverage Ratio and EBITDA 367

Conclusion 376

Case Study: Safety Solutions Corporation 376

Chapter 9: Debt and Leverage 389

Introduction 391

Debt and Leverage 391

LIBOR and Pricing Loans 391

Debt Financing Alternatives 393

Credit Ratings 395

Relative Cost of Debt Financing 398

Impact of Debt on Return on Capital Employed and Return on Equity 399

Financial Covenants 419

Case Study: Edsson Corporation 424

Chapter 10: Understanding Financial Statements 437

Introduction 439

The Income Statement 440

The Balance Sheet 443

Some Complications 450

The Cash Flow Statement 451

Case Study: Light Technologies Inc. 460

Appendix A: Present Value Models 539

Present Value of Any Stream of Cash Flows 539

Present Value of a Cash Flow E That Takes Place at the End of Year n 540

Present Value of the Terminal Value of a Cash Flow at the End of Year n 541

Present Value of a Stream of Fixed Cash Flows E for n Years 542

Present Value of a Fixed Stream of Cash Flows in Perpetuity (n = Infinity) 544

Single-Stage Growth Models 545

Present Value of a Stream of Cash Flows That Grow at a Fixed Rate for a Finite Period 546

Present Value of a Stream of Cash Flows That Grow at a Fixed Rate in Perpetuity 550

General Equation for Present Value of Single-Stage Cash Flows That Grow at a Fixed Rate 551

Multistage Growth Models 554

Two-Stage Growth Models 555

Three-Stage Growth Models 558

Appendix B: Business Valuation Models 565

Introduction 565

Stream of Distinct Cash Flows 565

Stream of Distinct Cash Flows Followed by a Stream of Perpetual Fixed Cash Flows 566

Stream of Distinct Cash Flows Followed by a Stream of Finite Fixed Cash Flows 567

Stream of Distinct Cash Flows Followed by a Stream of Perpetual Growth Cash Flows 568

Stream of Distinct Cash Flows Followed by a Stream of Finite Growth Cash Flows 569

Stream of Distinct Cash Flows Followed by a Terminal Cash Flow 571

Initial Cash Flow Sequentially Followed by a Finite Period of Cash Flows That Grow at a Fixed Rate g_FG and a Terminal Cash Flow 572

Initial Cash Flow Sequentially Followed by a Finite Period of Cash Flows That Grow at a Fixed Rate g_FG and a Perpetual Fixed Cash Flow 573

Initial Cash Flow Sequentially Followed by a Finite Period of Cash Flows That Grow at a Fixed Rate g_FA for N_A Periods and Perpetual Cash Flows That Grow at a Fixed Rate g_PB 574

Stream of Cash Flows That Grow at a Fixed Rate g_A for N_A Periods, Followed by a Stream of Cash Flows That Grow at a Fixed Rate g_B for N_B Periods, and a Stream of Perpetual Growth Cash Flows That Grow at a Fixed Rate g_C 575

Appendix C: Growth Models 577

Introduction 577

General Compound Annual Growth Rate Model 577

General Expression for CFaIAg, the Growth Rate of CFaIA 579

General Expression for NIg, the Growth Rate of NI 580

Appendix D: General Equations for Estimating NI and CFaIA 583

Introduction 583

ROCE and NiROCE 583

The General Case for the Envelope Equations 585

Special Case: Constant Investment Rate and Net Income Return on Capital Employed 589

Special Case: Focus on Operational Cash Flows 590

Net Income and Cash Flow Growth Equations 592

Appendix E: R&D Growth and Investment Equation 593

Introduction 593

Generational Cost Factor 593

Product Life Cycle 594

Developing an Expression for the Cost of the Next Generation 595

Lifetime Revenue Factor 596

Growth Rates and Product Life Cycles That Satisfy the Requirement I_Current = I_Next 599

Appendix F: Inventory Considerations and the EOQ Model 601

Introduction 601

Components of Inventory Costs 601

Economic Order Quantity 606

Shortage Costs 607

Selected References 611

About the Author 613

Index 615

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