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Financial Resources Management

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Title: Financial Resources Management


1
Financial Resources Management
2
Finance and Business
3
What is Finance?
  • Art and science to manage money
  • All individuals and organisations can
  • Earn money
  • Raise money
  • Spend money
  • Invest money

4
What is Finance?
  • Finance is concerned with the process of
  • Institutions
  • Markets
  • Instruments
  • involved in transfer of money among
  • Individuals
  • Businesses
  • Governments

5
Areas and Opportunities
  • Financial services
  • Design and delivery of advice and financial
    products to
  • Individuals
  • Businesses
  • Governments
  • It covers various areas
  • Banking related institutions
  • Insurance
  • Financial planning
  • Etc.

6
Areas and Opportunities
  • Managerial Finance
  • Concerned with duties of the Financial Managers
    that actively manage the financial affairs of any
    type of businesses
  • Financial and non-financial
  • Private and public
  • Large and small
  • Profit-seeking and not-for-profit
  • Today Finance Manager is actively involved in
    developing and implementing corporate strategies
    aimed at growing the firm and improving its
    competitive position

7
Legal Forms of Business Organisations
  • Sole proprietorship
  • Business owned by one person who operates for his
    or her own profit
  • Typical small business
  • Most are found in wholesale, retail, service and
    construction industries
  • Capital raised from personal resources or by
    borrowing
  • Responsible of all business decisions
  • Unlimited responsibility

8
Legal Forms of Business Organisations
  • Partnerships
  • 2 or more owners doing business together for
    profit
  • Larger than sole proprietorship
  • Typical business
  • Finance
  • Insurance
  • Real estate
  • Public accounting
  • Stock brokerage firms
  • Articles of partnership written contract
  • Generally unlimited liability all partners are
    liable for all of the debts of the partnership

9
Legal Forms of Business Organisations
  • Corporations
  • Legal entity
  • Dominant form of business organisation
  • All type of business
  • Owners are the stockholders
  • Receive dividends
  • Elect the members of the board Board of
    Directors
  • BOD hires a CEO (Chief Executive officer)

10
Legal Forms of Business Organisations
  • Chief Executive Officer
  • Responsible for
  • Managing day-to-day operations
  • Carrying out the policies established by the BOD
  • Report periodically to the Board
  • Other Limited Liability Organisations
  • Limited partnerships
  • Limited Liability Corporations
  • Limited Liability Partnerships

11
Managerial Finance Function
  • Exchange of information between finance and
    non-finance departments is crucial in any kind of
    business
  • Useful forecasts
  • Decisions
  • Organisation
  • Chief Financial Manager (CFO)
  • Firms Responsible for firms financial activities

12
Managerial Finance Function
  • Organisation
  • CFO (contd)
  • Financial planning
  • Fund raising
  • Capital expenditure decisions
  • Manage cash, credit, pension fund, foreign
    exchange
  • Linked directly to the CEO
  • Reporting to the CFO
  • Treasurer
  • Controller
  • Foreign Exchange Manager

13
Managerial Finance Function
  • Organisation
  • Treasurer
  • Handling financial activities
  • Controller
  • Also name Chief Accountant
  • Handling financial accounting activities
  • Corporate accounting
  • Tax management
  • Financial accounting
  • Cost accounting
  • Foreign Exchange Manager

14
Managerial Finance Function
  • Relationship to Economics
  • Primary economic principle
  • Marginal Cost-benefit Analysis
  • Financial decisions only made and actions taken
    only when the added benefits exceed the added
    costs.
  • Create an example

15
Managerial Finance Function
  • Relationship to accounting
  • Overlaps in activities between managerial finance
    and accounting
  • But two basic differences
  • One is to the emphasis on cash flows
  • One on decision making

16
Managerial Finance Function
  • Emphasis on Cash Flows
  • Accountants primary focus is to develop and
    report data from
  • Measuring the performance of the firm
  • Assess its financial position
  • Comply with and file reports required by
    securities regulators
  • File and pay taxes
  • Accountant prepares financial statements that
    recognise
  • Revenue at the time of sale (paid or not)
  • Expenses when they are incurred.
  • accrual basis

17
Managerial Finance Function
  • Emphasis on Cash Flows
  • Financial manager primary emphasis on cash flows
    (intake and outgo of cash).
  • Maintains the firms solvency by planning the
    cash flows necessary to satisfy its obligations
    and to acquire assets needed o achieve the firms
    goal
  • Uses this cash basis to recognise the revenues ad
    expenses only with respect to actual inflows and
    outflows of cash.
  • Whatever profit or loss, a firm must have a
    sufficient flow of cash to meet its obligations
    as they come due.

18
Managerial Finance Function
  • Decision Making
  • Accountant devotes most of his attention to the
    collection and presentation of financial data
  • Financial Manager
  • Evaluate the accounting statement
  • Develop additional data
  • Make decisions on the basis of their assessment
    of the associated returns and risks
  • It does not mean that accountants never make
    decisions or that financial managers never gather
    data

19
Managerial Finance Function
  • Summary
  • Primary emphasis of accounting is on accrual
    methods
  • Primary emphasis of financial management is on
    cash flow methods
  • Technically, Financial Managers make
    recommendations with regard to decision that are
    ultimately made by the CEO and/or the BOD

20
Goal of the Firm
  • Maximise profit
  • Commonly, corporations measure profits in terms
    of earnings per share (EPS), which represent the
    amount earned during a period on behalf of each
    outstanding share of common stock
  • periods total earnings available
  • EPS
  • number of outstanding common stocks
  • As the firm can earn a return on funds it
    receives, the receipt of funds sooner rather than
    later is preferred

21
Goal of the Firm
  • Maximise profit (contd)
  • Profits do not necessarily result in cash flows
    available to the stockholders
  • Cash flows are in the form of either
  • Cash dividends paid
  • Proceeds from selling the shares for a higher
    price than initially paid
  • Greater EPS do not necessarily mean that the BOD
    will vote to increase the dividend payments
  • Profit maximisation also disregards risk return
    and risk are the key determinants of share price,
    which represents the wealth of the owner in the
    firm

22
Goal of the Firm
  • Maximise Shareholder Wealth
  • The goal of the firm is to maximise the wealth of
    the owners for whom it is being operated.
  • Financial Managers should only accept only those
    actions that are expected to increase share price
  • Return (cash flows) and Risk are the key decision
    variables in maximising owner health
  • Stockholders groups such as employees,
    customers, suppliers, creditors, owners and
    others who have a direct economic link to the
    firm

23
Goal of the Firm
  • Corporate Governance
  • System used to direct and control a corporation
  • Defines
  • The rights and responsibilities of key corporate
    participants
  • Decision-making procedures
  • Way in which the firm will set, achieve, and
    monitor its objectives
  • Potential Investors
  • Individual and institutional investors

24
Goal of the Firm
  • Ethics
  • Standards of conduct or moral judgment
  • An effective ethics program is believed to
    enhance corporate value
  • Can produce a number of positive benefits
  • Can reduce potential litigation and judgment
    costs
  • Maintain a corporate image
  • Build shareholder confidence
  • Gain loyalty, commitment and respect of the
    firms stockholders.
  • Ethical behaviour is therefore viewed as
    necessary for achieving the firms goal of owner
    wealth accumulation

25
The Financial Markets
26
Deficit vs. Surplus Entities
  • Deficit entity A person or entity that spends
    more than it currently earns and therefore must
    borrow money
  • Surplus entity - A person or entity that spends
    less than it currently earns and therefore can
    save and invest money

27
Financial Markets
  • Financial markets enable the two entities to
    achieve their objectives
  • Deficit entities (e.g., issuers) - To raise money
    in the least expensive and most efficient way
  • Surplus entities (e.g., investors) To meet
    their investment objectives as effectively as
    possible

28
Financial Markets
Deficit Entities (e.g., World Bank)
Surplus Entities (e.g., retail investors)
Deficit entities issue securities to raise money
Surplus entities buy securities as investments
29
Characteristics of Financial Markets
  • The characteristics of financial markets are
    determined by the choices made by the deficit
    entities and surplus entities in terms of timing
    and risk
  • Short term (money markets), i.e., less than one
    year
  • Longer term (capital markets), i.e., more than
    one year
  • High risk, e.g., equities, derivatives
  • Low risk, e.g., cash, bonds

30
Distinguishing Financial Markets
  • Ways of distinguishing between different
    financial markets
  • Instrument types (e.g., bond market, equities
    market, money market)
  • Relative geography (e.g., domestic, cross-border)
  • Regulatory environment (e.g., an exchange, an
    over-the-counter market)
  • Activities (e.g., primary market, secondary
    market)

31
Markets by Instrument Type
  • Convenient, not necessarily precise - Market
    players use the market(s) in which they are
    active as a point of reference
  • Type of instrument traded in a market determines
    the characteristics of the market, e.g.,
  • Equity (stock) prices are volatile and therefore
    require a high level of automation
  • Bond prices are less volatile, so bond markets
    are not as automated

32
International Market
Total Market Size, 31.12.03 7,377 bn USD
Source ISMA
33
Timing Risk
  • Due to the wide variety of objectives and needs
    of investors and issuers, the number of different
    types of financial instruments is practically
    unlimited
  • Principal criteria determining the
    characteristics of an instrument
  • Level of risk tolerated
  • Yield expectations
  • Timeframe of an investment
  • Liquidity
  • Market practice

34
Players in the Market
Issuers issue financial instruments to raise money
Issuers
Financial intermediaries provide services that
enable the market to function
Financial Intermediaries
Regulators
Regulator supervises the market and
the corresponding processes
Investors buy and sell financial instruments to
increase their wealth
Investors
35
Market Players
  • Wide variety of players with numerous variations
  • Issuers
  • Corporate
  • Public
  • Investors
  • Private
  • Institutional
  • Regulators
  • Financial Intermediaries
  • Public Financial Intermediaries
  • Private Financial Intermediaries

36
Financial Statements and Analysis
37
Four Key Financial Statements
  • Income Statement
  • Balance Sheet
  • Statement of stockholders' equity
  • Statement of Cash Flows

38
Four Key Financial Statements
  • Income Statement
  • Provides a financial summary of the firms
    operating results during a specified period
  • Most common income statements covering a 1-year
    period ending at a specified date
  • Monthly income statement are prepared for the
    management
  • Quarterly statements must be made available o the
    stockholders of publicly owned corporations

39
Four Key Financial Statements
  • Income Statement (contd)
  • It describes
  • Sales revenue
  • Costs of goods sold
  • Gross profit
  • Operating expenses
  • Operating profits
  • Earnings before interest and taxes
  • Net profits before taxes
  • Net profits after taxes
  • Earnings available for common stockholders
  • Earnings per share (EPS)
  • Dividend per share (DPS)

40
Four Key Financial Statements
  • Balance Sheet
  • Summary statement of the firms financial
    position at a given point in time
  • Balances the firms assets against its financing,
    either debt or equity
  • Distinction between short-term and long-term
    assets and liabilities
  • Short-term assets or current assets are expected
    to be converted into cash within one year
  • Short-term liabilities or current liabilities are
    expected to be paid within one year or less
  • All other assets and liabilities, along with
    stockholders equity (assumed to have an infinite
    life), are considered long term

41
Four Key Financial Statements
  • Balance Sheet (contd)
  • Long-term debts debts for which payment is not
    due in the current year
  • Paid-in capital in excess of par the amount of
    proceeds in excess of the par value received from
    the original sale of common stock
  • Retained earnings cumulative total of all
    earnings, net of dividends, that have been
    retained and reinvested in the firm since its
    inception

42
Four Key Financial Statements
  • Statement of Retained Earnings reconciles the
    net income earned during a given year, and any
    cash dividends paid, with the change in retained
    earnings between the start and the end of that
    year. Abbreviated form of the Statement of
    Stockholders Equity
  • Statement of stockholders equity shows all
    equity account transactions that occurred during
    a given year

43
Four Key Financial Statements
  • Statement of Cash Flows provides a summary of
    the firms
  • Operating
  • Investment
  • Financing
  • Cash flows and reconciles them with changes in
    its cash and marketable securities during the
    period

44
Notes to the Financial Statements
  • Footnotes detailing information on
  • Accounting policies
  • Procedures
  • Calculations
  • Transactions underlying entries in the financial
    statements

45
Financial Ratios
  • The Ratio Analysis involves methods of
    calculating and interpreting financial ratios to
    analyse and monitor the firms performance
  • The management should be the most interested
    party of all. Managers not only have to worry
    about the financial situation of the firm, but
    they are also critically interested in what the
    other parties think about the firm

46
Financial Ratios
  • Types of Ratio Comparisons
  • Ratio analysis is not the calculation of a given
    ratio, but the interpretation of the ratio value
  • Cross sectional analysis
  • Comparison of different firms financial ratios
    at the same point in time
  • Involves comparing the firms ratios to those of
    other firms in its industry or to industry average

47
Financial Ratios
  • Types of Ratio Comparisons (contd)
  • Benchmarking is a type of cross-sectional
    analysis in which the firms ratio values are
    compared to those of a key competitor or group of
    competitors that it wishes to emulate
  • Time series analysis Evaluation of the firms
    financial performance over time using financial
    ratio analysis
  • Comparison of current and past performance
    enables analysts to assess the firms progress
  • Any significant year-to-year changes may be
    symptomatic of a major problem

48
Financial Ratios
  • Types of Ratio Comparisons (contd)
  • Combined analysis combines cross-sectional and
    time-series analysis.
  • Combined view makes it possible to assess
  • The trend in the behaviour of the ratio
  • And the trend for the industry
  • Any significant year-to-year changes may be
    symptomatic of a major problem

49
Financial Ratios
  • Cautions
  • Large deviations can indicate symptoms of a
    problem, but additional analysis the causes
  • A single ratio doesnt generally provide
    sufficient information to judge the overall
    performance of the firm. Set of ratio has to be
    used
  • We must take care of the seasonality
  • Use audited financial statements
  • Same accounting treatments
  • Take into account inflation

50
Financial Ratios
  • Types of financial ratios 5 basic categories
  • Liquidity
  • Activity
  • Debt
  • Profitability
  • Market ratios

Primarily measure risks
Primarily measure return
Primarily measure both risks and return
51
Financial Ratios Liquidity Ratios
  • Liquidity Ratios
  • A firms ability to satisfy its short-term
    obligations as they come due
  • Current Ratio
  • One of the most cited financial ratios
  • A measure of liquidity calculated by dividing the
    firms current assets by its current liabilities
  • Current assets
  • Current liabilities

52
Financial Ratios Liquidity Ratios
  • Quick (Acid-test) Ratio
  • A measure of liquidity calculated by dividing the
    firms current assets minus inventory by its
    current liabilities
  • Generally the low liquidity of an inventory
    results from
  • Many types of inventory cannot be easily sold
    because they are partially completed items,
    special purpose items
  • Inventory is typically sold on credit meaning it
    becomes an account receivable before being
    converted into cash

53
Financial Ratios Activity Ratios
  • Activity ratios
  • Measure the speed with which various accounts are
    converted into sales or cash-inflows or outflows
  • Inventory Turnover
  • Measures the activity, or liquidity, of a firms
    inventory
  • Costs of goods sold
  • Inventory

54
Financial Ratios Activity Ratios
  • Inventory Turnover (contd)
  • Average age of inventory is the average number of
    days sales in inventory
  • Average Collection Period
  • Average amount of time needed to collect accounts
    receivable
  • Accounts receivable
  • Average sales per day
  • or
  • Accounts receivable
  • Annual sales / 365

55
Financial Ratios Activity Ratios
  • Average Payment Period
  • Average amounts of time needed to pay accounts
    payable
  • Accounts payable
  • Average purchases per day
  • or
  • Accounts payable
  • Annual purchases / 365
  • Difficult to find annual purchases, value not
    available in published annual statement
  • Ordinarily estimated as a percentage of cost of
    goods sold

56
Financial Ratios Activity Ratios
  • Total Asset Turnover
  • Indicates the efficiency with which the firm uses
    its assets to generate sales
  • Sales
  • Total assets
  • The higher the cost of the new assets, the larger
    the denominator and thus the smaller the ratio.
    Therefore, due to inflation and use of historical
    costs, firms with newer assets will tend to have
    lower turnover than those with older assets

57
Financial Ratios Debt Ratios
  • Debt Ratios
  • The Debt position of a firm indicates the amount
    of others people money being used to generate
    profit
  • The more debt a firm uses in relation to its
    total assets, the greater its financial Leverage
  • Financial Leverage is the magnification of risk
    and return introduced through the use of
    fixed-cost financing such as debt and preferred
    stock
  • The more fixed-cost debt a firm uses, the greater
    will be its expected risk and return

58
Financial Ratios Debt Ratios
  • Debt Ratio
  • Measures the proportion of total assets financed
    by the firms creditors
  • Total Liabilities
  • Total Assets
  • The higher the ratio, the greater the amount of
    others people money being used to generate
    profit
  • The higher the ratio, the greater the firms
    degree of indebtedness and the more financial
    leverage it has

59
Financial Ratios Debt Ratios
  • Time Interest Earned Ratio
  • Measures the firms ability to make contractual
    interest payments sometimes called the interest
    coverage ratio
  • The higher the ratio, the better able the firm to
    fulfil its interest obligations
  • Earnings before interest and taxes
  • Interest
  • The figure for earnings before interest and taxes
    is the same as that for operating profits in the
    income statement

60
Financial Ratios Debt Ratios
  • Fixed-Payment Coverage Ratio
  • Measures the firms ability to meet all
    fixed-payment obligations such as
  • Loan interest and principal
  • Lease payments
  • Preferred stocks dividends
  • Where T is the corporate tax applicable to the
    firms income
  • 1/(1-T) is included to adjust the after-tax
    principal and preferred stock dividend payment
    back to the before-tax equivalent that is
    consistent with the before tax values of all
    other terms

Earnings before interest and taxes lease
payments Interest Lease payments (Principal
payments Preferred stock dividends) x
1/(1-T)
61
Financial Ratios Profitability Ratios
  • To evaluate the firms profit with respect to
  • Given level of sales
  • Certain level of assets
  • The owners investment
  • Owners, creditors and management pay close
    attention to boosting profits because of the
    great importance place on earnings in the
    marketplace

62
Financial Ratios Profitability Ratios
  • Use of Common-Size Income Statement
  • An income statement in which each item is
    expressed as a percentage of sales
  • Specially useful in comparing performances across
    the years
  • Frequently cited Profitability Ratios
  • Gross Profit Margin
  • Operating Profit Margin
  • Net Profit Margin

63
Financial Ratios Profitability Ratios
  • Gross profit Margin
  • Measures the percentage of each sales dollar
    remaining after the firm has paid for its goods
  • The higher the gross profit margin, the better
  • Sales Cost of goods sold Gross Profit
    Sales Sales


64
Financial Ratios Profitability Ratios
  • Operating Profit Margin
  • Measures the percentage of each sales dollar
    remaining after all costs and expenses other than
    interest, taxes, and preferred stock dividends
    are deducted the pure profits earned on each
    sales dollar
  • A high ratio is preferred
  • Operating profits
  • Sales

65
Financial Ratios Profitability Ratios
  • Net Profit Margin
  • Measures the percentage of each sales dollar
    remaining after costs and expenses, including
    interest, taxes and preferred stock dividends,
    have been deducted
  • The higher the ratio, the better
  • Earnings available for common stockholders
  • Sales
  • The NPM is sometimes defined as net profits after
    taxes divided by sales

66
Financial Ratios Profitability Ratios
  • Earning Per Share (EPS)
  • EPS represents the dollar amount earned on behalf
    of each outstanding share of common stock not
    the amount of earnings actually distributed to
    shareholders
  • Earnings available for common stockholders
  • Number of shares of common stock outstanding

67
Financial Ratios Profitability Ratios
  • Return on Total Assets (ROA)
  • ROA measures the overall effectiveness of
    management in generating profits with its
    available assets also called Return on
    Investments (ROI)
  • Some firms use this measure as a simple decision
    technique for evaluating proposed fixed-asset
    investments
  • Earnings available for common stockholders
  • Total assets

68
Financial Ratios Profitability Ratios
  • Return on Common Equity (ROE)
  • ROE measures the return earned on the common
    stockholders investment in the firm
  • Some firms use this measure as a simple decision
    technique for evaluating proposed fixed-asset
    investments
  • Earnings available for common stockholders
  • Common stock equity

69
Financial Ratios Profitability Ratios
  • Return on Expenses (ROX)
  • ROX measures the return earned in comparison to
    the expenses
  • It shows how much dollar in expenses is necessary
    to generate one dollar of return
  • The lower the ratio is, the better
  • Earnings
  • Expenses

70
Financial Ratios Market Ratios
  • Markets Ratios
  • Relate a firms market value as measured by its
    current share price, to certain accounting values
  • Give insight into how well investors in the
    marketplace feel the firm is doing in terms of
    risk and return

71
Financial Ratios Market Ratios
  • Price / Earnings Ratio (P/E Ratio)
  • Measures the amount that investors are willing to
    pay for each dollar of a firms earnings
  • The higher the ratio, the greater the investor
    confidence
  • Market price per share of common stock
  • Earnings per shares

72
Financial Ratios Market Ratios
  • Market / Book Ratio (M/B Ratio)
  • Prides an assessment of how investors view the
    firms performance.
  • Firms expected to earn high returns relative to
    their risk typically sell at higher M/B multiples
  • We need first to find the book value per share of
    common stock
  • Common stock equity
  • Number of shares of common stock outstanding

73
Financial Ratios Market Ratios
  • Market / Book Ratio (M/B Ratio) (contd)
  • The Market Book ration is
  • Market price per share of common stock
  • Book value per share of common stock
  • The stocks of a firm that are expected to perform
    well
  • Improve profits
  • Increase market share
  • Launch successful products
  • Sell at a higher M/B ratios than the stocks of
    firms with less attractive outlook
  • Firms expected to earn high returns relative to
    their risk typically sell at higher MB multiples

74
The Financial Planning Process
75
Financial Planning
  • Planning starts with long-term or strategic,
    financial plans that in turns guide the
    formulation of short-term, or operating, plans
    and budget
  • Two key aspects
  • Cash planning
  • Preparation of cash budget
  • Profit planning
  • Preparation of pro-format statements
  • Both are important
  • for internal financial planning
  • For routinely existing and prospective lenders

76
Long-Term (Strategic) Financial Plans
  • Strategic Financial Plans lay out
  • Companys financial actions
  • The anticipated impact on those actions over
    periods ranging from 2 to 10 years
  • Preparation of the annual budget is an important
    part of the plannings process that involves all
    managers
  • It represents a tedious but important management
    activity
  • Together with production and marketing plans,
    guides the firm towards strategic goals

77
Short-Term (Operating) Financial Plans
  • Operating Financial Plans specifies
  • Short-term financial actions
  • The anticipated impact on those actions
  • More often over 1- to 2-year period
  • Key inputs include
  • Cash budget
  • Pro forma financial statements

78
Cash Planning Cash Budgets
  • Cash budget specifies inflows and outflows of
    cash that is used to estimate its short-term cash
    requirements
  • Typically to cover a 1-year period, divided into
    small intervals
  • Often presented on a monthly basis as many firms
    and seasonal and uncertain cash flows
  • Firms with stable patterns of cash flows use
    quarterly or annual time intervals

79
Cash Planning Cash Budgets Sales Forecast
  • Prediction of the firms sales over a given
    period
  • Based on external and/or internal data
  • Used as key input to the short-term financial
    planning process
  • The manager estimates monthly cash flows
    resulting from
  • Projected sales
  • Outlays related to production, inventory and sales

80
Cash Planning Cash Budgets Sales Forecast
  • The manager also determines
  • The level of fixed assets required
  • The amount of financing (if any) needed to
    support the forecast level of sales and
    production
  • In practice, obtaining good data is the most
    difficult aspect of forecasting
  • Sales forecast may be based on analysis of
  • External data
  • Internal data
  • Or a combination of the two

81
Cash Planning Cash Budgets Sales Forecast
  • External forecast
  • Sales forecast based
  • On relationships observed between the firms
    sales
  • Certain key external economic indicators, such
    as
  • GDP
  • New housing starts
  • Consumer confidence
  • Disposable personal income
  • Internal Forecast
  • Sales forecasts are based on a build up or
    consensus, of sales forecasts through the firms
    own sales channels

82
Cash Planning Cash Budgets Sales Forecast
  • Internal Forecast (contd)
  • The firm need to spend a great deal of time and
    effort to make the sales forecasts as precise as
    possible
  • An after-the-fact analysis of the prior years
    forecast can help the firm to determine which
    approach or combination of approaches will give
    it the most accurate forecasts
  • Firms generally use a combination of the two
  • Internal data provide insight into sales
    expectations
  • External data provide a means of adjusting these
    expectations to take into account general
    economic factors

83
Cash Planning Cash Budgets Preparing the Cash
Budget
  • Cash receipts
  • Include all firms inflow of cash during a given
    financial period
  • Most common components are
  • Cash sales
  • Collections of accounts receivable
  • Other cash receipts
  • Cash Disbursements
  • All outlays of cash by the firm during a given
    financial period

84
Cash Planning Cash Budgets Preparing the Cash
Budget
  • Cash Disbursements (contd)
  • The most common cash disbursements are
  • Cash purchases
  • Payment of accounts payable
  • Rent (or lease) payments
  • Wages and salaries
  • Tax payments
  • Fixed-asset outlays
  • Interest payments
  • Cash dividend payments
  • Principal payments (loans)
  • Repurchase or retirements of stock

85
Cash Planning Cash Budgets
  • Some definitions
  • Net cash flow mathematical difference between
    the firms cash receipts and its cash
    disbursements in each period
  • Ending cash the sum of the firms beginning cash
    and its net cash flow for the period
  • Required total financing amount of funds needed
    by the firm if the ending cash for the period is
    less than the desired minimum cash balance
    typically represented by notes payable

86
Cash Planning Cash Budgets
  • Some definitions (contd)
  • Excess cash balance the (excess) amount
    available for investment by the firm if the
    periods ending cash is greater than the desired
    minimum cash balance assumed to be invested in
    marketable securities

87
Financial concepts
88
Time value in finance
  • Time value of money is one of the most important
    concepts in finance.
  • Money that the firm has is more valuable than
    money inthefuture as money can be invested and
    earn positive earnings

89
Time value in finance
  • Future Value versus Present value
  • The time line is a horizontal line on which time
    zero appears at the leftmost end and future
    periods are marked from left to right. It can be
    sued to depict investment cash flows

- 10,000
3,000
5,000
4,000
3,000
2,000
End of the year
90
Time value in finance
  • Computational tools
  • Time-consuming calculations often involved in
    finding future and present values
  • Financial tables include various future and
    present value interest factors that simplify time
    value calculations
  • Financial calculators also can be used for time
    value computations
  • include numerous pre-programmed financial
    routines
  • Spreadsheets have built-in routines that simplify
    value calculations

91
Time value in finance
  • Basic patterns of Cash Flow
  • Single amount
  • A lump-sum amount either currently held or
    expected at some future date
  • Annuity
  • Level periodic stream of cash flow. (For our
    purposes well work with annual cash flows)
  • Mixed stream
  • Stream of cash that is not an annuity
  • Unequal periodic cash flows that reflect no
    particular pattern

92
Single Amounts
  • Future Value of a Single Amount
  • The future value is the value at a given time in
    the future of a present amount
  • placed on deposit today and
  • Earning interest at a specified rate
  • Found by applying compound interest over a period
    of time
  • Compound interest
  • Interest that is earned on a given deposit and
    has become part of the principal at the end of
    the specified period
  • Principal
  • The amount of money on which interest is paid

93
Single Amounts
  • Future Value of a Single Amount (contd)
  • FV PV x (1i)
  • FV Future value at the end of the period n
  • PV Initial principal, or present value
  • i annual rate of interest paid
  • n number of periods that the money is left
    on deposit

n
n
n
94
Single Amounts
  • Future Value of a Single Amount (contd)
  • Using computational tools
  • Future value interest factor
  • The multiplier used to calculate at a specifies
    interest rate, the future value of a present
    amount as of a given time
  • FV PV x (FVIF )

n
95
Single Amounts
  • Present Value of a Single Amount
  • The current value of a future amount
  • The amount of money that would have to be
    invested today at a given interest rate over a
    specified period to equal the future amount
  • The concept of future value often refers to
    discounting cash flows
  • Discounting cash flows
  • Process of finding present values
  • Inverse of compounding interest

n
96
Single Amounts
  • Present Value of a Single Amount (contd)

FV
n
PV

97
Single Amounts
  • Present Value of a Single Amount (contd)
  • Present value interest factor
  • The multiplier used to calculate, at a specified
    discount rate, the present value of an amount to
    be received in a future period

1
PVIF

i,n
98
Single Amounts
  • Comparing Present and Future value
  • Present value relationship
  • Discount rates
  • Time periods
  • Present value of the

99
Annuities
  • Annuity
  • A stream of equal periodic cash flows, over a
    specified time period
  • These cash flows can be
  • Inflows of returns earned on investments
  • Outflows of funds invested to earn future returns
  • Ordinary annuity
  • An annuity for which the cash flow occurs at the
    end of each period
  • Annuity due
  • An annuity for which the cash flow occurs at the
    beginning of each period

100
Annuities
  • Future Value of an Ordinary Annuity
  • What we will receive at the end of a specified
    period
  • EX 1,000end-of-year deposit earning 7, at the
    end of 5 years
  • Year 1 1,000 1,311
  • Year 2 1,000 1,225
  • Year 3 1,000 1,145
  • Year 4 1,000 1,070
  • Year 5 1,000 1,000
  • TOTAL 5,751

101
Annuities
  • Present Value of an Ordinary Annuity
  • The cash flows are discounted at an interest rate
    over the specifies period
  • EX 700 end of-year cash flows, discounted at 8
    over 5 years
  • Year 1 700 648.2
  • Year 2 700 599.9
  • Year 3 700 555.8
  • Year 4 700 514.5
  • Year 5 700 476.7
  • TOTAL 2,795.10

102
Annuities
  • Future Value of an Annuity Due
  • Occurs at the start of the period
  • Present Value of an Annuity Due
  • Each annuity cash flow due is discounted back one
    less year than for an ordinary annuity
  • Present Value of a Perpetuity
  • Perpetuity is an annuity with an infinite life,
    providing continual annual cash flow

103
Mixed Streams
  • Future Value of a Mixed Stream
  • Straightforward we determine the future value of
    each cash flow at the specified future date and
    then add the individual future values to find the
    total future value
  • Present Value of a Mixed Stream
  • We determine the present value of each amount and
    then add the individual present values together
    to find the total present value

104
Compounding Interests more Frequently than
Annually
  • Semi-annual compounding
  • Compounding of interest over two periods within
    one year
  • Quarterly compounding
  • Compounding of interest over four periods within
    the year
  • Continuous compounding
  • Compounding of interest an infinite number of
    times per year at interval of micro-seconds

105
Compounding Interests more Frequently than
Annually
  • Nominal and Effective Annual Rate of Interest
  • Nominal (stated) annual rate contractual rate of
    interest charged by a lender or promised by a
    borrower
  • Effective (true) annual rate (EAR) the annual
    interest actually paid or earned
  • i the nominal annual rate
  • m the compounding frequency

106
Special Applications of Time Value
  • Determining Deposits Needed to Accumulate a
    Future Sum
  • Closely related to finding the future value of an
    annuity
  • Loan Amortisation
  • Determination of the equal periodic loan payments
    necessary to provide a lender with a specified
    interest return and to repay the loan principal
    over a specified period
  • The loan amortisation schedule a schedule of
    equal payments to repay a loan. It shows the
    allocation of each loan payment to interest and
    principal

107
Special Applications of Time Value
  • Finding Interest or Growth rates
  • Rate of growth rate in
  • Sales
  • Earnings
  • Etc.
  • We can use either future or present value
    interest factors
  • Finding an Unknown Number of Periods
  • Sometimes necessary to calculate the number of
    time periods needed to generate a given amount of
    cash flow from an initial amount

108
Risk and Return
109
Risk and Return Fundamentals
  • A portfolio is a collection, or group, of assets
  • Risk Defined
  • Chance of financial loss or more formally, the
    variability of returns associated with a given
    asset
  • Return Defined
  • Total gain or loss experienced on a investment
    over a given period of time
  • Calculated by dividing the assets cash
    distributions during the period, plus change in
    value, by its beginning-of-period investment
    value

110
Types of Risks
  • Risks you can measure
  • Market Risk
  • Liquidity Risk
  • Credit Risk
  • Solvency Risk
  • Risks you can estimate
  • Operational Risk
  • Legal Risk
  • Risks you cannot measure
  • Business/event risk
  • Systemic risk
  • Political Risk

111
Risk and Return Fundamentals
  • Risk Preferences
  • Risk-indifferent
  • the attitude toward risk in which no change in
    return would be required for an increase in risk
  • Risk-averse
  • An increase in return is required for an increase
    in risk
  • Risk-seeking
  • Decreased return would be accepted for an
    increase in risk
  • Most of the managers are risk-averse for a given
    increase in risk, the require an additional
    increase in return

112
Risk of a Single Asset
  • Risk Assessment
  • Sensitivity analysis
  • Approach for assessing risk that uses several
    possible-return estimates to obtain a sense of
    the variability among outcomes
  • Range
  • A measure of an assets risk, which is found by
    subtracting the pessimistic (worst) outcome from
    the optimistic (best) outcome
  • Decreased return would be accepted for an
    increase in risk
  • Probability
  • The chance that a given outcome will occur
  • A probability distribution is a model that
    relates probabilities to the associated outcomes

113
Risk of a Single Asset
  • Risk Measurement
  • Standard deviation
  • Most common statistical indicator of an assets
    risk it measures the dispersion around the
    expected value
  • The expected value of a return is the most likely
    return of a given asset
  • The normal probability distribution is a
    symmetrical distribution whose shape resembles a
    bell-shaped curve
  • Coefficient of variation
  • A measure of relative dispersion that is useful
    in comparing the risks of assets with differing
    expected returns
  • The higher the coefficient of variation, the
    greater the risk and therefore the higher the
    expected return

114
Risk of a Portfolio
  • The financial managers goal is to create an
    efficient portfolio
  • Maximising return at a given level of risk
  • Or
  • Minimising risk for a given level of return
  • Portfolio Return and standard Deviation
  • The return of a portfolio is a weighted average
    of the returns of the individual assets from
    which it is formed

115
Risk of a Portfolio
  • Portfolio Return and standard Deviation (contd)
  • The correlation
  • Statistical measure of the relationship between
    two series of numbers representing data of any
    kind
  • Positively correlated describes the series that
    move in the same direction
  • Negatively correlated describes two series that
    move in opposite directions

116
Risk of a Portfolio
  • Portfolio Return and standard Deviation (contd)
  • The correlation (contd)
  • The correlation coefficient measures the degree
    of correlation between two series
  • Perfectly positively correlated 1
  • Perfectly negatively correlated -1
  • Uncorrelated two series that lack any
    interaction and therefore have a coefficient
    correlation close to 0

117
Risk of a Portfolio
  • Portfolio Return and standard Deviation (contd)
  • The correlation, Diversification, Risk and
    Return
  • The lower the correlation between assets returns,
    the greater the potential diversification of risk
  • International Diversification
  • Returns form international diversification
  • Over long periods, the returns from
    internationally diversified portfolios tend to be
    superior to those of purely domestic ones

118
Risk of a Portfolio
  • Portfolio Return and standard Deviation (contd)
  • International Diversification (contd)
  • Risks of international diversification
  • The most important is the political risk
  • This risk arises from the possibility that a host
    government will take actions harmful to foreign
    investors or that political turmoil in a country
    will endanger investments there

119
Risk and Return The CAPM Model
  • The most important aspect of risk is the overall
    risk of the firm viewed by the investors in the
    marketplace
  • Overall risk affects investment opportunities and
    owners wealth
  • The CAPM model basic theory that links risk and
    return for all assets

120
Risk and Return The CAPM Model
  • Types of risk
  • Total risk
  • Combination of a security non-diversifiable risk
    and diversifiable risk
  • Diversifiable risk
  • Portion of an assets risk that is attributable
    to firm specific, random causes
  • Can be eliminated through diversification
  • Also called unsystematic risk

121
Risk and Return The CAPM Model
  • Types of risk (contd)
  • Non-diversifiable risk
  • Relevant portion of asses risk that is
    attributable to market factors that affect all
    firms
  • Cannot be eliminated through diversification
  • Also called systematic risk

122
Risk and Return The CAPM Model
  • The Model CAPM
  • Links non-diversifiable risk and return for all
    assets
  • The Beta coefficient
  • Relative measure of non-diversifiable risk
  • Index of the degree of movement of an assets
    return in response to a change in the market
    return
  • The market return is the return on the market
    portfolio of all traded securities
  • Published betas are calculated using historical
    data
  • When investors used beta for decision making,
    they should recognise that past performance
    relative to the market average may not accurately
    predict future performance

123
Risk and Return The CAPM Model
  • The Beta coefficient (contd)
  • The beta coefficient for the market is considered
    as equal to 1.0
  • All other betas are viewed in relation to this
    value
  • May be positive or negative but positive betas
    are the norm
  • The return of a stock that is half responsive as
    the market (b.5) is expected to change by ½
    for each 1change in the return of the market
    portfolio
  • Portfolio beta can easily be estimated by using
    the betas of individuals assets it includes

124
Risk and Return The CAPM Model
  • The Equation
  • Using the beta coefficient to measure
    non-diversifiable risk, the CAPM is
  • k R b x (k R )
  • Where
  • k required return on asset j
  • R risk-free rate of return, commonly measured
    by the return on a US T-Bill
  • b beta coefficient or index of
    non-diversifiable risk for asset j
  • k market return return on the market portfolio
    of assets

j
m
F
F
j
F
j
m
125
Risk and Return The CAPM Model
  • The Equation (contd)
  • Risk-free rate of return is the required return
    on a risk free asset (US TBill)
  • The CAPM can be divided into two parts
  • Risk-free rate of return
  • Risk premium
  • The (k - R ) portion of risk premium is also
    called market risk
  • Historical risk premiums
  • Using the historical data for selected security
    investment, we can calculate the risks premiums
    for each investment category
  • subtracting the historical US T-Bill average
    return form the historical average return for a
    given investment

m
F
126
Risk and Return The CAPM Model
  • The Graph The Security Market Line (SML)
  • SML is the depiction of the CAPM as a graph that
    reflects the required return in the marketplace
    for each level of non-diversifiable risk (beta)
  • The SML will be a straight line
  • It reflects the required return in the
    marketplace for each level of non-diversifiable
    risk.
  • In the graph, risk is measure by beta, b, is
    plotted on the x axis and required returns, k,
    are plotted on the y axis
  • ThetheSML is not stable overtime and shifts in
    the security market line can result in a change
    in required return two major faces inflationary
    expectations and risk aversion

127
Risk and Return The CAPM Model
  • Changes in Inflationary expectations
  • These changes affect the risk-free rate of return
  • As the risk-free rate is a basic component of all
    rates of return, any change in RF will be
    reflected in all required rates of return
  • Changes in inflationary expectations result in
    parallel shifts in the SL in direct response to
    the magnitude and direction of the change

128
Risk and Return The CAPM Model
  • Comments on the CAPM
  • CAPM was developed to explain the behaviour of
    security prices and provide a mechanism whereby
    investors cold asses the impact of a proposed
    security investment on their portfolios overall
    risk and return
  • Based on an efficient market
  • Efficient market has the following
    characteristics
  • Many small investors, all havingthesame
    information and expectations
  • No restrictions on investment
  • No taxes
  • No transaction costs
  • Rational investors who vie securities similarly
    and are risk-averse, preferring higher returns
    and lo
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