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Financial Resources Management

Finance and Business

What is Finance?

- Art and science to manage money
- All individuals and organisations can
- Earn money
- Raise money
- Spend money
- Invest money

What is Finance?

- Finance is concerned with the process of
- Institutions
- Markets
- Instruments
- involved in transfer of money among
- Individuals
- Businesses
- Governments

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.

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

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

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

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)

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

The Financial Markets

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

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

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

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

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)

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

International Market

Total Market Size, 31.12.03 7,377 bn USD

Source ISMA

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

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

Market Players

- Wide variety of players with numerous variations
- Issuers
- Corporate
- Public
- Investors
- Private
- Institutional
- Regulators
- Financial Intermediaries
- Public Financial Intermediaries
- Private Financial Intermediaries

Financial Statements and Analysis

Four Key Financial Statements

- Income Statement
- Balance Sheet
- Statement of stockholders' equity
- Statement of Cash Flows

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

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)

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

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

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

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

Notes to the Financial Statements

- Footnotes detailing information on
- Accounting policies
- Procedures
- Calculations
- Transactions underlying entries in the financial

statements

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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

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

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

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

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

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

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

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

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

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

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

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

The Financial Planning Process

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

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

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

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

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

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

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

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

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

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

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

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

Financial concepts

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

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

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

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

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

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

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

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

Single Amounts

- Present Value of a Single Amount (contd)

FV

n

PV

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

Single Amounts

- Comparing Present and Future value
- Present value relationship
- Discount rates
- Time periods
- Present value of the

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

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

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

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

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

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

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

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

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

Risk and Return

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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