lecture 3 how companies work

8/11/2019 Lecture 3 How Companies Work

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Whitewater LimitedConsulting Engineers & Scientists

FINANCIAL ASPECTS OF PROJECT ENGINEERINGAND CONTRACTING

PROJECT APPRAISAL FOR BIOPROCESS

Richard Hill

HOW COMPANIES WORK


Investment and Earnings

To profit from any economic activity,you have to invest money

The return which you get variesdepending on:

Risk

Effort involved

Inflation



The greater any of these three itemsget, the higher the return

A low risk investment involving no work

and which does not suffer from inflationmight give you 1 - 3 % pa

A bank loan to a stable company will bringthe bank 6 - 7%

Credit cards (high risk and admin costs)might earn the lender around 20%


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Investment in a business earns

more, especially if the work inputincludes inventiveness andexpertise

Contracting is a high-risk businessand requires skill and experience

A 44% return on the shareholdersinvestment is not unusual


Types of Business

Suppose you decide touse your

entrepreneurial andinnovative Engineeringskills to set up abusiness

What type of business?


Types of Business

How much capital?

Where from?


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Types of Business

Sole trader

Complete controlUnlimited liability

Personal assets at risk

PartnershipShared control

Joint unlimited liability

Personal assets at risk

LLP


Types of Business

When you own your own business, you only

have to work half a day. You can do anythingyou want with the other twelve hours.

Anon


Limited Liability

Limited liability company

Most common type of business set-up

The company is treated in law as a person

Owned by shareholders

Shareholders liability is limited to his

original investment

The companys profits are paid to

shareholders as share dividend


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Shareholders

Shareholders own the company

They have no duties in terms of theday-to-day operation

Each shareholder owns a fraction of the

company proportionate to hisshareholding, with voting power inproportion


Shareholders

A company has a set of rules called theArticles of Association that define

What the company does

How it is structured and run

The company is run by a Board ofDirectors elected by the shareholders

to run the business on their behalf


Shareholders


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Shareholders

A Companys initial nominal capital is thesum of the face value of its issued shares

When first issued, shares must not be soldfor less than the nominal value, but they maybe sold at a premium

The capital raised by the initial share issue isthe called up share capital plus the sharepremium which remains constant but

Shareholders can agree to create and issuemore shares and sell them to raise capital


Shareholders

The nominal value of the share is of little realimportance

A shareholder can turn his investment backinto cash by selling his shares

If the company has done well, the priceshould be more than he paid for i t, and viceversa.

If the company goes bust, the shares areworthless, but that is the maximum which ashareholder can lose - hence LimitedLiability


Shareholders

People invest in shares in the hope ofprofiting by

getting a good dividend from profit distribution

owning shares which can be sold at a profit if thecompany does well

Shares must promise a better return thansafer investments (typically more than 5%pa)

The company may not do well - sharesalways carry some risk.


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Limited Liability Companies


Limited by guaranteeCharity or not for profit organisation

Prime beneficiary is the charity

No shareholders

Guarantors (or t rustees) have limited liabilitystatus but guarantee to pay a predeterminedsum (typically 1.00) in the event of winding upthe company




Limited by shares

Commercial operation

Prime beneficiaries are the shareholders

Private limited companies (Ltd)

Public limited companies (plc)


Private Limited Companies

Share ownership in Ltd companies iscontrolled

Articles of Association typically require ashareholder to find a buyer, agree with him a

price for the shares, and then offer theshares to the existing shareholders at thesame price

This ensures that the shares of a familycompany can be kept in the family

It also limits the ability to raise capital It is very hard to value the shares in a Ltd

company


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Public Limited Companies

A big company may choose to become a plc

It must be accepted by a stock exchange and

there are fixed rules about thatTheir shares can then be sold freely on the

open market (London Stock Exchange andAIM (Alternative Investment Market )

Company has no control over who owns itsshares

Shares can be bought by a competitorSize isnt everything Mars and Sir Robert

McAlpine are both still family owned


Organisation

Working together

Objective

Cooperation

Leadership


Organisation

Structure

Goal setting

Planning

Execution

Leadership/motivation

Hierarchy

Chain of command

Resourcing


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Organisation

SALE S DIR EC TO R T EC HNI CAL DIR ECTO R F INANCIAL DIRE CT OR PE RATIONS DIR EC TOR

SALES ENGINEERS ISCIPLINE ENGINEERS ACCOUNTS CONTRACT MANAGERSR&D

PROPOSALS DRAUGHTSMEN PLANNING ENGINEERSLABORATORY

COMMISSIONING PROCUREMENT

ESTIMATORS

COMPANYSECRETARY

CHAIRMAN

MANAGING DIRECTOR

One way of organising a medium sized contractor


Organisation

One way of organising a medium sized contractor

BOARD OF DIRECTORS

CEO

V-P SALES CHIEF ENGINEER CFO COO

SALES ENGINEE RS DI SCIPLIN EE NGINEE RS ACCOUNTS CONTRA CT MANAGERS

PROPOSALS DRAUGHTSMEN PLANNING ENGINEERS

COMMISSIONING PROCUREMENT

ESTIMATORS

COMPANY SECRETARY


Organisation

Strategy

Objectives

Work breakdown

MethodologySupport

Monitoring

Feedback


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Organisation

Growth of a company

Euphoric phaseGrowth phase

Financial deprivation

Maturity


Organisation

Euphoric phase

Entrepreneur(s) set up company

Creativity

Enthusiasm for product/service

Commitment to the company


Organisation

Growth phase

Product/service becomes established

Sales increase

Organisation expands

Employees lack commitment to company


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Organisation

Financial deprivation

Inadequate working capital to supportcontinued growth

Introduction of new shareholders

Loss of control of company


Organisation

Maturity

Employment of professional managers

No history with company and have nocommitment to product/service

Entrepreneurs lose control of management

Entrepreneurs become disillusioned andsell company

Company driven by profit


Organisation

Professional management

Management science?

Understanding the business


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Organisation

In fact, when I know whatis meant by mamelonand ravelin,

When I can tell at sight aMauser rifle from aJavelin

W S Gilbert

Pirates of Penzance

Henry Lytton as MajGen Stanley


Organisation

Sir John Harvey Jones

ICI

The Troubleshooter

Morgan


Organisation

And God created theOrganization and gave Itdominion over man.

Genesis 1, 30A, subparagraph VIII


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Directors

A Ltd company or PLC

is run by a Board ofDirectors elected by theshareholders at AGM

Directors may also beshareholders but that isnot necessarily the case


Directors

The Board must present its audited accountsand report to the shareholders at the AGM

If some major decision has to be made, theBoard or shareholders can convene anExtraordinary General Meeting (EGM)

At EGM the shareholders have the right (butno obligation) to vote on any resolutions putto them

The shareholders can vote to appoint or sackindividual Directors or the whole Board


Directors

The Board of Directors is controlled by theChairman of the Board although decisionsare supposed to be made by a majority voteof the directors.

Day-to-day running of the company is underthe control of the Managing Director or ChiefExecutive Officer (CEO).

Corporate governance recommendations arethat the Chairman and CEO functions shouldnot be combined.


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Directors

News Corp shareholders have re-elected the media conglomerate's

board of directors and failed toapprove a proposal to oustRupert Murdoch as chairman andCEO.

22/10/11


Directors

The Company Secretary who may or may notbe a member of the Board is responsible formaking sure that the company stays withinthe law and maintains proper record booksand accounts

There may be non-executive directors whoare usually there to represent a major financier like a merchant

bankbecause they have some special influence


Share Trading

Once a company hasbeen formed, thenominal value of theshares becomesunimportant

When buying andselling shares theshare price is afunction of supply anddemand

PLC share prices arepublished in press


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Share Trading


Bubbles


The South Sea Bubble


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1710 George Caswall and John Blunt proposed toLord Treasurer Robert Harley to convert 9.47m of

short-term war debts into equity in South Sea Co Similar debt-equity conversions had been used by

the Bank of England and the New East India Co The South Sea Co would have future profits from a

monopoly on English trade with the Spanishcolonies of South America plus the cash flow on aperpetual annuity from the government paying576,534 pa

The debt conversion was a success



Commercial trade depended on peace

Under 1713 Treaty of Utrecht England gained:

monopoly of slave trade to the Spanish W Indies

the right to sail one ship annually for commerce

No trading voyage to South America until 1717and made little profit

By 1718 Britain was at war with Spain

Short-term prospects were poor but thecompany argued that its longer-term futurewould be extremely profitable (jam tomorrow)



In January 1720 the British governmentdebt was 50 million pounds

The government was running intodifficulties servicing its debt

Debt conversion would make highinterest, difficult to trade debt, into lowinterest, easily traded shares

All parties could gain


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The South Sea Company won a competitivebid against the Bank of England but had to:

raise its offer of a lump-sum payment to thegovernment from 3m to over 7.5m

Pay out 1.3m in bribes

To finance the debt acquisition, the companyissued more shares

South Sea share prices started at about 120per 100 share in January 1720 (thatsabout 14,000 at 2009 value)



The country became obsessed with shares

IPO (initial public offer) schemes To buy the Irish Bogs

To manufacture a gun to fire square cannon balls

"For carrying-on an undertaking of greatadvantage but no-one to know what it is"(Unbelievably 2000 was invested in this one!)

Stocks increased in all these 'dodgy'schemes

Huge fortunes were made - and lost andsuicides became a daily occurrence



South Sea shareprices reached 950pounds in July 1720

Then the bubble

burstShares collapsed

from about 775 onAugust 31 to about290 on October 1


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Share Trading

STOCK EXCHANGE RATIOS

Profit after taxEarnings per share =

Number of shares

Profit after taxDividend Yield =

Share Capital

Share PriceP/E Ratio =

Earnings per share


Share Trading

The earnings per share is not what theshareholder receives as dividend

because the company will plough backa part of its earnings to increase itscapital


Share Trading

In most plcs the ratio of the share priceto the companys earnings per share(P/E) is around 12-14 (equivalent to a

return of 7-8%)If the P/E falls below 12 the market

thinks the company is not doing well sothe price has fallen

If the P/E increase above 14 the marketthinks the share is overpriced


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Share Trading

P/E ratio 2000-2010 based onFTSE All-share Index


Share Trading

P/E ratio 1860-2007 based onStandard & Poors 500 Index


Share Trading

Why buy shares?

Existing shareholders can sell their shares easily

The company may issue more shares to raisecapital offered first to existing shareholders

Shares in plcs often give a poor return purely interms of dividend

Investors buy shares if they think there is aprospect of improved future trading, with largerdividends and/or the possibility of selling theshares at a profit


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Share Trading

Short selling

Trader borrows sharesTrader sells shares

Trader waits for share price to fall

Trader buys shares back

Trader returns shares to lender

Trader pays lender for loan

Trader keeps profit


Share Trading

Margaret Thatcher

Milton Friedman


Share Price

The Directors decide what to do with profits

Paying a large dividend

makes shares attractive

share price rises in the short termmay leave the company under-capitalised

Ploughing profits back into the company

adds to its wealth

value of the shares will rise in the long term


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Share Price

The average tenure of Managing

Directorships in big UK plcs is about 3years

Most Directors of plcs get somepayment in shares so a high shareprice is to his advantage


Share Price

The stock marketis posh gambling

So is insurance

So is investment

banking

The difference isthat bookiesnever lose!


Private vs Public

Very occasionally the shares of a plc get into thehands of one or a few owners with a sufficiently largemajority to entitle them to decide to convert it backinto a private limited company

In a private limited company the Board, their friendsand families usually own most of the shares, so theyare working for themselves

The share price is unknown quantity

If the company performs well the directors benefitdirectly by larger salaries or dividends so theyconcentrate on improving its performance


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Summary

The Limited Liability Company is themost convenient form for most tradingventures

It starts by setting up its Articles ofAssociation and selling shares

If its big enough it can apply to a StockExchange to become a public limitedcompany (plc), which makes its sharesavailable to the public.


Summary

Investors buy shares in the expectationof getting a better return than from

some safer kind of investment, but takethe risk that the company might fail.

The share price is important to a plc,but a private company doesnt reallyhave one

lecture 3 how companies work

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