1. Corporate Finance for In-House Counsel
Professor Michael Smith
Questrom School of Business
Boston University

2. Session Overview
Fixed vs. variable cost in projections and decision-making
Multi-period resource allocation decisions
Ex post evaluation of investment outcomes with Economic Value Added (EVA)

3. Income Statement
Very useful for valuation (i.e., understanding the underlying economics of an entity for the purpose of assessing fair market value).
Less useful for short-term managerial planning

4. Chipotle Income Statement
2016
1,036,982
( 363,900 ) ( 286,144 )
( 74,201 )
( 166,045)
( 78,405)
( 37,434)
( 4,490)
(16,637)
(1,027,256)
9,726
( 672)
10,398
( 2,599)
7,799
2015
1,216,890
( 401,051)
( 270,076)
( 66,391)
( 134,879)
( 70,066)
( 33,145)
( 4,367)
( 2,156)
( 982,131)
234,759
( 1,518)
236,277
( 91,394)
144,883
Revenue
Restaurant operating costs
Food, beverage, packaging
Labor
Occupancy
Other operating costs
General and administrative
Depreciation and amortization
Pre-opening costs
Loss on disposal
Total operating expenses
Income from operations
Interest and other income, net
Income before income taxes
Provision for income taxes
Net income
Chipotle’s 2016 revenue is lower by 15%.
Will 2016 net income also be lower by 15%?

5. Chipotle Income Statement
2016
1,036,982
( 363,900 ) ( 286,144 )
( 74,201 )
( 166,045)
( 78,405)
( 37,434)
( 4,490)
(16,637)
(1,027,256)
9,726
( 672)
10,398
( 2,599)
7,799
2015
1,216,890
( 401,051)
( 270,076)
( 66,391)
( 134,879)
( 70,066)
( 33,145)
( 4,367)
( 2,156)
( 982,131)
234,759
( 1,518)
236,277
( 91,394)
144,883
Revenue
Restaurant operating costs
Food, beverage, packaging
Labor
Occupancy
Other operating costs
General and administrative
Depreciation and amortization
Pre-opening costs
Loss on disposal
Total operating expenses
Income from operations
Interest and other income, net
Income before income taxes
Provision for income taxes
Net income
No!
2016 net income is lower by 95% !
Why!?!?!?

6. Fixed Costs and Variable Costs
Fixed costs do not change with the level of activity
Variable costs change proportionally with the level of activity

7. Chipotle—Variable Costs
2016
1,036,982
( 363,900 ) ( 286,144 )
( 74,201 )
( 166,045)
( 78,405)
( 37,434)
( 4,490)
(16,637)
(1,027,256)
9,726
( 672)
10,398
( 2,599)
7,799
2015
1,216,890
( 401,051)
( 270,076)
( 66,391)
( 134,879)
( 70,066)
( 33,145)
( 4,367)
( 2,156)
( 982,131)
234,759
( 1,518)
236,277
( 91,394)
144,883
Revenue
Restaurant operating costs
Food, beverage, packaging
Labor
Occupancy
Other operating costs
General and administrative
Depreciation and amortization
Pre-opening costs
Loss on disposal
Total operating expenses
Income from operations
Interest and other income, net
Income before income taxes
Provision for income taxes
Net income
Revenue lower by 15%
Food, beverage and packing lower by 10%
These are likely variable costs

8. Chipotle—Fixed Costs 2016 1,036,982 ( 363,900 ) ( 286,144 ) ( 74,201 )
( 363,900 ) ( 286,144 )
( 74,201 )
( 166,045)
( 78,405)
( 37,434)
( 4,490)
(16,637)
(1,027,256)
9,726
( 672)
10,398
( 2,599)
7,799
2015
1,216,890
( 401,051)
( 270,076)
( 66,391)
( 134,879)
( 70,066)
( 33,145)
( 4,367)
( 2,156)
( 982,131)
234,759
( 1,518)
236,277
( 91,394)
144,883
Revenue
Restaurant operating costs
Food, beverage, packaging
Labor
Occupancy
Other operating costs
General and administrative
Depreciation and amortization
Pre-opening costs
Loss on disposal
Total operating expenses
Income from operations
Interest and other income, net
Income before income taxes
Provision for income taxes
Net income
Revenue lower by 15%
These costs did not decrease!
These costs are likely fixed with respect to short-term sales volume.

9. Financial Planning Example
Last year Mary’s Cleaners cleaned 1,500 houses. Variable costs were 50/cleaning. Fixed costs were 35,000. Price was 100/cleaning.
Profit = Quantity x (Price – VC/unit) – Fixed Costs
Profit = 1, x (100 – ) – , = 40,000
Mary’s Cleaners is considering one of three alternatives:
Status quo
Cut price by 10, increase marketing by 4,000. Estimate volume will increase by 33%
Increase price by 10. Upgrade to premium cleaning products, extra 5 in variable cost. Estimate volume will decrease by 20%.

10. Financial Planning Example
Status Quo
150,000
(75,000)
(35,000)
40,000
1,500
100 50
Cut Price
180,000
(100,000)
(39,000)
41,000
2,000 90 50
Raise Price
132,000
(66,000)
(35,000)
31,000
1,200
110 55
Revenue
Total variable cost
Fixed cost
Profit
Sales volume
Price/unit
Variable cost/unit

11. Financial Modeling
Financial modeling excels at eliminating alternatives
“Raise price” is unambiguously dominated
When two alternatives are close, other decision strategies are necessary.

12. Multi-Period Resource Allocation
Also known as “capital budgeting”
How do organizations quantify resource allocation decisions?

13. Steps in Capital Budgeting
Establish general investment guidelines
i.e, decision rules--criteria necessary to gain approval
Identify the cash flows of the project
Compute the performance measures required by the decision rule in place.
Evaluate the project according to the decision rule.

14. Decision Rules Most commonly used decision rules: Payback period
Net present value
Implied rate of return (a.k.a. internal rate of return)

15. Decision Rule: Payback Period
The payback period is the time until the firm recoups the initial investment.
“Finance the project if the payback period is less than X years”

16. Decision Rule: Net Present Value (NPV)
Time value of money: having $1 today is better than having $1 in the future because the $1 earns interest.
Present value is a mathematical method for summarizing a sequence of future cash flows in a single cash flow denominated in current dollars.
The net present value of an investment is the present value of the investment less the investment’s cost.
“Finance the project if the NPV is greater than 0.”

17. Implied Rate of Return (IRR)
Some investments have an explicit rate of return
Example: US government debt.
Most investments do not have an explicit rate of return, but the expected pattern of cash flows implies a rate of return.
“Invest in the project if the implied rate of return exceeds X%”

18. Capital Budgeting Example
A firm is considering buying software that will streamline its billing process and allow it to save on personnel costs.
The software costs $22,000. There will also be first-year implementation costs of $7,000.
The cash flow cost savings over the life of the software (10 years) will be $4,500/year for the first five years and $5,000/year after that.

19. Capital Budgeting Example
Payback period:
Total outlay is $29,000. It takes 6.3 years to realize $29,000th of savings
Make investment if required payback period is less than 6.3 years.
Present value (assume discount rate of 7%)
Total cash savings: 5 x $4, x $5,000 = 47,500.
But future dollars are worth less.
Present value of cash savings is $33,068.
Net present value is $33,068 – $29,000 = $4,068
Make investment because greater than 0
The IRR (implied rate of return) is 9.86%.
It is as though the firm had invested $29,000 at a rate of 9.86%
Make investment if IRR hurdle rate is lower than 9.86%

20. Economic Value Added (EVA)
Capital budgeting is forward-looking, planning for what hasn’t happened yet.
EVA is backward-looking, a way to evaluate what has already happened.
EVA adjusts accounting profit to include the opportunity cost of capital.
Owners could have invested their money elsewhere and earned a return.
Firm does not add value unless it returns more to the owners than they could have received elsewhere.

21. Economic Value Added (EVA)
Capital budgeting is forward-looking, planning for what hasn’t happened yet.
EVA is backward-looking, a way to evaluate what has already happened.
EVA adjusts accounting profit to include the opportunity cost of capital.
Owners could have invested their money elsewhere and earned a return.
Firm does not add value unless it returns more to the owners than they could have received elsewhere.

22. EVA Example EVA adjusts accounting profit for a charge for capital
EVA = Earnings – invested capital x cost of capital
Whole Foods
Adjusted earnings
Invested Capital
Average working capital
Average property and equipment 2,308
Average other assets 1,066
Average other liabilities ( 524)
Average invested capital 3,736

23. Main Takeaways
Fixed and variable cost and their role in managerial decision-making
Conceptual frameworks for resource allocation
Economic Value Added