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Chapter 1, Heizer/Render, 5th edition

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Title: Chapter 1, Heizer/Render, 5th edition


1
Financial Decision Making
Dr. Haluk AYGÜNES Department of Industrial
Engineering
2
OUTLINE
  1. Decision Making Process
  2. Financial Decision Making
  3. Engineering Economy
  4. Time Value of Money
  5. Interest Rates
  6. Cash Flows
  7. Engineering Economy Factors
  8. Evaluation and Selection of Alternatives

3
Decision Making Process
1-3
4
Decision Making Process
  1. Understand the problem define objectives
  2. Collect relevant information
  3. Define the set of feasible alternatives
  4. Identify the criteria for decision making
  5. Evaluate the alternatives and apply sensitivity
    analysis
  6. Select the best alternative
  7. Implement the alternative and monitor results

5
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.)

6
Decision Making Process
  • Level of uncertainty
  • Decision making under certainty
  • deterministic models
  • Decision making under uncertainty
  • probabilistic models

7
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

1-7
8
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, ...

1-8
9
Financial Decision Making
1-9
10
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.

1-10
11
Value Chain
  • Management accountants provide decision support
    for managers in the following six business
    functions (value chain)

1-11
12
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.

1-12
13
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.

1-13
14
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.

1-14
15
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.

1-15
16
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
1-16
17
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.

1-17
18
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

1-18
19
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
1-19
20
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

1-20
21
Financial Decision Making
  • The three fundamental concepts

Time Value of Money
economic value of
- projects - investments - business organizations
Risk-Return Relationship
Cash Flows
1-21
22
Engineering Economy
1-22
23
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

1-23
24
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

1-24
25
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

1-25
26
Time Value of Money
1-26
27
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

1-27
28
Time Value of Money
Time
Time value of money
Interest Rates
Cash Flows
1-28
29
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.

1-29
30
Interest Rate
1-30
31
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 ()

1-31
32
Interest Rate
  • Example
  • if you borrow 2000 TL now, and
  • you will repay 2300 TL one year later
  • Interest rate ()

1-32
33
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)

1-33
34
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

1-34
35
Equivalence
  • 100 centimeters 1 meter
  • 1000 kilograms 1 ton
  • What is economic equivalence?

1-35
36
Equivalence
Different amounts of money at different times may
be equal in economic value
1-36
37
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.
1-37
38
Cash Flows
1-38
39
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

1-39
40
Cash Flows
  • Cash Flow Diagram
  • (Cash flows are shown as directed arrows )

1-40
41
Engineering Economy Factors
1-41
42
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)

1-42
43
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)

1-43
44
Basic Factors
  • F/P Factor - to find F given P
  • In general
  • F P(1i)n
  • F P(F/P,i,n)

1-44
45
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
1-45
46
Basic Factors
  • P/F Factor - to find P given F
  • In general
  • P F 1/(1i)n
  • P F(P/F,i,n)

1-46
47
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)
1-47
48
Evaluation of Alternatives
1-48
49
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)

1-49
50
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

1-50
51
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, ...

1-51
52
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

1-52
53
Financial Decision Making
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