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Financial Decision Making

Dr. Haluk AYGÜNES Department of Industrial

Engineering

OUTLINE

- Decision Making Process
- Financial Decision Making
- Engineering Economy
- Time Value of Money
- Interest Rates
- Cash Flows
- Engineering Economy Factors
- Evaluation and Selection of Alternatives

Decision Making Process

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Decision Making Process

- Understand the problem define objectives
- Collect relevant information
- Define the set of feasible alternatives
- Identify the criteria for decision making
- Evaluate the alternatives and apply sensitivity

analysis - Select the best alternative
- Implement the alternative and monitor results

Decision Making Process

- Level of complexity
- Simple decision problems
- consequences are not important
- usually made intuitively
- (e.g. The decision whether to walk up stairs or

to take the elevator) - Complex decision problems
- have important consequences
- require some analysis
- (e.g. Buying a new automobile, making an

investment etc.)

Decision Making Process

- Level of uncertainty
- Decision making under certainty
- deterministic models
- Decision making under uncertainty
- probabilistic models

Decision Making Process

- Decision
- Allocation of resources to the activities with

the purpose of achieving an objective. - Decision Maker
- Anyone with the authority to allocate the

necesary resources for the decision being made. - individuals
- companies

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Decision Making Process

- Alternatives
- Different ways of action among which the decision

maker makes a choice. - Decision Criteria (Maximization / Minimization)
- Maximum utility
- Maximum profit
- Minimum cost
- Minimum time spent, ...

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Financial Decision Making

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Value Chain

- Value chain Sequence of business functions in

which usefulness is added to the products or

services of an organization. - Value
- as the usefulness of the product or service is

increased, so is its value to the customer.

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Value Chain

- Management accountants provide decision support

for managers in the following six business

functions (value chain)

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Value Chain

- Research Development process of generating and

experimenting with ideas related to new products,

services, or processes. - Design detailed planning and engineering of

products, services, or processes. - Production acquisition, coordination, and

assembly of resources to produce a product or

deliver a service.

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Value Chain

- Marketing the manner by which companies promote

and sell their products or services to customers. - Distribution delivery of products or services to

the customer. - Customer Service after-sale support activities

provided to customers.

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Key Success Factors

- factors that affect the economic viability of the

organization - Cost how to reduce costs?
- Quality customers expect higher levels of

quality. - Time meet promised delivery dates more reliably.
- Innovation a continuing flow of innovative

products or services is a prerequisite to the

ongoing success.

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Role of Accounting

- Accounting system of recording, classifying,

analyzing and reporting financial transactions. - Types of accounting
- Cost Accounting
- Management accounting
- Financial accounting
- Cost Accounting provides information for

management accounting and financial accounting.

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Role of Accounting

Management Accounting Financial Accounting

Purpose Help managers to make decisions (to fulfill organizations goal) Communicate organizations financial position to outside parties

Users Managers of the organization External users (investors, banks, suppliers, )

Focus and emphasis Future oriented Past oriented

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Financial Statements

- Income Statement
- Prepared for a period (for a month, year, etc.)
- Shows
- Revenue (increase in capital arising from sales

of products or services) - Expenses (decrease in capital e.g. rent expense,

salary expense) - Net income (Revenue Expenses)
- for a period of time.
- Balance Sheet
- Prepared at the end of the period (at the end of

the year, etc.) - Shows the balances of
- Assets (cash, receivables, building, equipment,

) - Liabilities (payables taxes, interest, )
- Capital (Assets Liabilities)
- at the end of the reporting period.

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Cost, Revenue, Net Income

- Cost a resource (material, labor, time, money,

) sacrificed or forgone to achieve a specific

objective - Cost (of a product) Direct Cost Indirect

Cost

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Cost, Revenue, Net Income

- Revenue income that a company receives from its

normal business activities, usually from the sale

of goods and services to customers

Revenue (Selling price per product) x

(Number of products sold)

Operating Income Total revenues Total Costs

Net Income Operating Income Income Taxes

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Financial Decision Making

- The framework
- 1. Characterizing different financial decision

problems - 2. Identification and description of the

alternatives - 3. Determining the outcomes of the alternatives
- 4. Evaluation of the alternatives in relation to

the preferences of the decision-maker

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Financial Decision Making

- The three fundamental concepts

Time Value of Money

economic value of

- projects - investments - business organizations

Risk-Return Relationship

Cash Flows

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Engineering Economy

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Engineering Economy

- Involves
- formulating,
- estimating, and
- evaluating economic outcomes.
- Engineering economy is a collection of

mathematical techniques that simplify economic

comparison - Engineering economy is at the heart of making

decisions

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Engineering Economy

- Engineers
- perform analysis
- synthesize
- come to a conclusion
- as they work on projects of all sizes.
- Engineering Economy provides a framework for

modeling problems involving - Time
- Money
- Interest rates

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Why Engineering Economy is Important to Engineers

- Engineers design and create
- Designing involves economic decisions
- Engineers must be able to incorporate economic

analysis into their creative efforts - Often engineers must select and execute from

multiple alternatives

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Time Value of Money

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Time Value of Money

- Money possesses a time value
- The time value of money is the most important

concept in engineering economy - Time value computations are the most powerful

tools for making financial and business decisions

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Time Value of Money

Time

Time value of money

Interest Rates

Cash Flows

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Time Value of Money

- The four fundamental time value of money

calculations - Future Value (of a single amount)
- Present Value (of a single amount)
- Future Value of an Annuity (equal annual

amounts) - Present Value of an Annuity (equal annual

amounts) - They provide the basis for most of the investment

and financial management calculations - Complicated financial problems can be broken down

into parts and can be addressed with these four

problems.

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Interest Rate

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Interest Rate

- Interest the manifestation of the time value of

money - Rental fee that one pays to use someone elses

money - Difference between an ending amount of money and

a beginning amount of money - Interest rate ()

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Interest Rate

- Example
- if you borrow 2000 TL now, and
- you will repay 2300 TL one year later
- Interest rate ()

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Simple and Compound Interest

- Simple Interest
- Interest (original amount)(number of

periods)(interest rate) - Compound Interest
- Interest earns interest on interest
- Compounds over time
- Interest (original amount all accrued

interest) (interest rate)

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Simple and Compound Interest

- Example
- Interest rate 10 per year (i10 or 0.10)
- You borrow 2000 TL now (P2000)
- What will be the interest two years later?

(n2) - Simple interest
- Interest (original amount)(number of

periods)(interest rate) - P n i
- 2000 2 0.10 400 TL
- Total due 2000 400 2400 TL
- Compound interest
- Year 1 Interest P i 2000 0.10 200 TL
- Year 2 Interest P P i i 2000

200 0.10 220 TL - Total interest 200 220 420 TL
- Total due 2000 420 2420 TL

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Equivalence

- 100 centimeters 1 meter
- 1000 kilograms 1 ton
- What is economic equivalence?

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Equivalence

Different amounts of money at different times may

be equal in economic value

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Equivalence

If 100 TL is invested at the interest rate of

6 per year, then 100 TL now is said to be

equivalent to 106 TL one year from now.

That is, if you are offered 100 TL today or 106

TL one year from today, it would make no

difference which offer you accepted.

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Cash Flows

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Cash Flows

- Definition of terms
- Cash Inflows - amount of money flowing into the

firm - Cash Outflows - amount of money flowing out of

the firm - Net Cash Flow (NCF)
- NCF cash inflows cash outflows
- End of period assumption
- Cash flows occur at the end of a given (interest)

period

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Cash Flows

- Cash Flow Diagram
- (Cash flows are shown as directed arrows )

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Engineering Economy Factors

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Factors (Engineering Economy Factors)

- Reflect how time and interest rate affect money
- Help in determining economic equivalence of

various cash flow patterns - Notation
- P present amount of money at time t 0
- (t represents time)
- F future amount of money at a time later than

t 0 - A a series of equal cash flows
- n the number of interest periods
- i the interest rate per time period, in

percent (i)

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Factors

- Standard Notation
- (X/Y, i, n)
- X unknown (what is sought)
- Y known (what is given)
- i interest rate
- n number of periods
- Determining factors (three methods)
- Formulas
- Interest tables
- Computer (Excel)

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Basic Factors

- F/P Factor - to find F given P

- In general
- F P(1i)n
- F P(F/P,i,n)

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Basic Factors

- Example (F/P Factor - to find F given P)
- P 1,000 TL n3 i10
- What is the future value, F?

Using formula F3 P(1i)n 1,000(10.10)3

1,000(1.331) 1,331 TL Reading factor value from

interest table F3 P(F/P,i,n) 1,000(F/P,10,

3) 1,000(1.3310) 1,331 TL

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Basic Factors

- P/F Factor - to find P given F

- In general
- P F 1/(1i)n
- P F(P/F,i,n)

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Basic Factors

- Example (P/F Factor - to find P given F)
- Assume F 100,000 TL 9 years from now
- What is the present worth of this amount now if

i 15?

F9 100,000 TL

i 15/yr

P ?

Using formula PF1/(1i)n 100,0001/(1.15)9

100,000(0.2843) 28,430 TL Reading factor

value from interest table PF(P/F,i,n)

100,000(P/F,15, 9) 100,000(0.2843) 28,430 TL

(100,000 TL 9 years from now ? 28,430 TL now, at

15 / year)

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Evaluation of Alternatives

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Evaluation of Alternatives

- Evaluation / Comparison Criteria
- Economic criteria
- Noneconomic factors
- Types of Alternatives
- Mutually Exclusive Alternatives
- Only one alternative can be selected
- Independent Alternatives
- More than one alternative can be selected

(depending on budget limitations)

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Evaluation of Alternatives

- Economic Criteria
- Profit (select higher profits)
- Cost (select lower costs)
- Rate of return (compare with others)
- Benefit / Cost Ratio (select if B/C 1.0)
- Noneconomic Factors
- For example when buying/renting an apartment
- Number of rooms
- Design, ease of use
- Location and environment
- Closeness to public facilities (schools,

hospitals, ...) - Ease of transportation

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Evaluation of Alternatives

- Which evaluation criteria do you use for

selecting the best restaurant? - Economic Criteria
- Select cheapest one
- Noneconomic criteria
- Select
- nearest,
- quickest,
- tastiest,
- most scenic, ...

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Summary

- Engineering Economy application of economic

factors and criteria to evaluate alternatives - Applies the time value of money
- Interest rate
- Cash flows
- Time
- Application of economic equivalence
- Cash flow estimation
- Modeling cash flow diagrams

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Financial Decision Making