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Title: Gl


1
1
2
What is Finance all about?
  • Finance is about three things
  • raising money
  • allocating it
  • controlling return on money invested
  • Spreadsheets and Finance

3
Course Overview
  • Financial statements (1)
  • Revenues and Costs (nonfinancial) (2-3)
  • Net Working Capital Management (4)
  • Time Value of Money Concept (5)
  • Investment Decisions (6)
  • Responsibility centers and managerial accounting
    (7)
  • Financial ratios (8)
  • Business Financing (9)
  • Business Modelling and Forecasting (10)
  • Financial Disciplines (11)

4
Books Evaluation Rules
  • Books
  • Brealey Richard A., Myers Stewart C. Principles
    of Corporate Finance. McGraw-Hill, New York, 1996
    (or any other edition, incl. Polish version)
  • Shim Jae K., Siegel Joel G. Vest Pocket CEO.
    Prentice Hall, New York, 1992 (a very good Polish
    edition by ABC, 1999)
  • Atrill Peter, McLaney Eddie Management
    Accounting for Decision Makers. Prentice Hall,
    Harlow, 2007.
  • Evaluation
  • Written, in- class, closed books Exam, with 3 out
    of 4 topics to be discussed
  • Near to all topics will require both calculations
    and assessment of a problem challenged
  • After class assignments not graded at all but
    instrumental to succeed on the final exam

5
Session One Topics
  • General concept of financial statements
  • Balance sheet
  • Accrual vs cash flow approach
  • Profit and Loss (Income) Statement
  • Cash Flow Statement
  • Brealey, Myers pp.

6
Key financial questions
  • How much does the business own (at present, in
    the past, in near future)?
  • How much has the business earned (over a given
    period of time)?
  • How much it will earn in future?
  • The above indicated are key financial questions
    for every person but also enterprise,
    institution, government.
  • We will discuss almost exclusively non-financial
    businesses although some concepts apply to other
    types, too.

7
Balance Sheet key notions to remember
  • Assets properties owned (now or under control
    and with entitlement to key benefits)
  • Long-term (with useful life over 1 year) laptop.
  • Current (with useful life up to 1 year)
    enrolment.
  • Tangible laptop.
  • Intangible enrolment right.
  • Liabilities and equity
  • Long-term (due later than within 1 year)
    Fathers loan and, by definition, equity.
  • Current (due within 1 year) instalments.
  • A Balance Sheet a statement of properties and
    sources financing them

8
Reasons why assets and liabilities have to be
recorded separately
  • Even if we have a dual entry approach and
    transactions are not divisible their results are
  • if granted a loan to purchase a specific
    equipment one cannot use the proceedings for
    other purpose,
  • however
  • when transaction is closed one has to repay a
    loan regardless the machine purpose and, of no
    specific arrangements are made, can do whatever
    it wishes with the equipment.
  • Both relations can be discontinued separately in
    a different time and circumstances.

9
Accruals vs cash flow
  • In private life we tend to equalize revenues with
    cash inflows and costs with cash outflows,
    sometimes recognizing special character of
    investments (eg. nobody would treat creating a
    bank deposit as a cost albeit identifying it as
    a cash outflow).
  • In the least complex business activity it is a
    handy approach but
  • even in such cases carries certain risk,
  • it would be dangerous in case of complex
    businesses.

10
Reasons why not all costs are represented by cash
outflows (1)
  • Long term assets will loose their value over time
    and eventually become useless (except for ground
    plots and some other specific items).
  • The above mentioned process may be long and
    involve very valuable items (f.e. a car)
  • Consequently we need a mechanisms to allocate
    expenses incurred to acquire them over pertain
    time.
  • We say, we depreciate them (amortise intangible
    assets, deplete natural resources)

11
Reasons why not all costs are represented by cash
outflows (2)
  • Commercial credit.
  • Concurrent services (eg. electricity, employment
    costs).
  • Deferred obligations and revenues (f.e. in
    construction business).

12
Two financial statement addressing the issue of
results
  • Income (Profit and Loss) Statement
  • Cash Flow Statement

13
Income Statement key notions to remember
  • Revenues Cash inflows or other enhancements of
    assets (for example acceptance of services
    delivered)
  • Costs use of assets attributable directly or
    indirectly to the revenues recognised
  • cash costs.
  • non-cash costs (DDA)
  • Income (gross) revenues costs
  • Income tax(es) obligatory levies on income (but
    not VAT, stamp duties, etc.)
  • Income (net) Income (gross) taxes

14
Cash Flow Statement key notions to remember (1)
  • Operational activities
  • receipts from the sale of goods or services,
  • payments to suppliers for goods and services,
  • payments to employees or on behalf of employees,
  • buying Merchandise
  • some otherwise typically financial items if
    strictly connected with operational activities
    (eg. interests on delayed payments for services).

15
Cash Flow Statement key notions to remember (2)
  • Financial activities
  • dividends paid (with tax if applicable),
  • sale or repurchase of the company's stock,
  • net borrowings,
  • interests paid other borrowing costs (incl.
    certain leasing related payments),
  • repayment of debt principal, including capital
    leases.
  • Investing activities
  • Payments resulting from purchase or sale of a
    long term asset (assets can be land, building,
    equipment, marketable securities, etc.)
  • Payments related to mergers and acquisition.
  • (Under certain regimes) loans made to suppliers
    or received from customers

16
Accounting statements
  • The profit and loss (PL) account (income
    statement)
  • is the financial history book
  • matches up the incomes you have earned by running
    your business with the actual running costs
    incurred in earning those income
  • refers to a certain period (usually a month,
    quarter or a year).
  • The balance sheet
  • is purely a position statement that shows how the
    business finances look at a point in time
  • adds the value of all the business possessions or
    assets and then equate this to the total finance
    invested in the business from various sources
    -these two amounts must always balance each
    other.
  • The cash flow statement
  • indicates flow of cash and cash equivalents,
    unencumbered by accounting concepts and
    conventions
  • reveals with much more clarity whether an
    organisation can meet its commitments.

17
Basic accounting rules
Boundary rules Boundary rules
Entity the organisation itself, not the owner(s)
Periodicity  a defined and regular accounting period
Going concern  assume that the organisation will exist into the foreseeable future
Quantitative only quantifiable data is recorded
   
Measurement rules  
Money measurement data must be translated into monetary terms
Historic cost data recorded at original cost
Realisation entries at the point of legal transfer of title
Matching cash received and paid, adjusted to reflect the economic reality
Dual aspect all transactions recorded to reflect the giving and receiving
Materiality rules not applied rigidly to insignificant items
   
Ethical rules Ethical rules
Prudence if there is doubt over a transaction, then the entry to understate profit should be chosen
Consistency accounting rules/policies should not be amended unless there is a fundamental change in circumstance
Objectivity personal views should be avoided
Relevance statements should give the user a true and fair view
18
Valuation
  • Fixed assets normally valued at cost less
    depreciation. Depreciation itself can only be an
    estimate, as absolute value is known only on
    disposal. Some fixed assets are revalued.
  • Stocks different conventions exist such as
    first in first out. In the case of manufactured
    stocks, fixed overheads are usually apportioned
    to stock values. This process is arbitrary.
  • Debtors debtors tend to generate a proportion
    of non-payers and so conservative accountants
    usually depress debtor values to allow for this.
  • Investments it is quite normal for one firm to
    buy shares in another and accounting convention
    requires these to be shown at cost. However, it
    is clear that these shares will fluctuate in
    value along with market conditions.
  • Goodwill when one firm takes over another, the
    value of the taken over firm, above the sum of
    its parts is called goodwill, and is shown on the
    joint or consolidated balance sheet. Many firms
    argue that goodwill must therefore exist in firms
    that have not been taken over, and should
    therefore be shown on balance sheets.
  • Brand names in modern business, firms spend
    enormous amounts to establish product credibility
    with the consumer, such that brand names have a
    worth of their own. These are not always shown on
    balance sheets, thus allowing firms worth to be
    under reported.
  • Natural resources ownership of quarries, wells,
    mines, forests and so on can be valued in any
    number of ways, representing as they do, many
    years worth of income.
  • Human assets many organisations have very few
    material assets but enormous human assets, for
    example, management consultancies. Very few firms
    show human assets on balance sheets.
    Interestingly some football clubs have just
    started to show players as assets rather than
    putting transfer fees on the profit and loss
    account.

19
2
20
Session Two Topics
  • Revenues
  • Management accounting
  • Relevant costs
  • Cost allocation under full absorption

21
Financial vs Managerial Accounting
  • Financial Accounting
  • highly regulated
  • independent check of statements
  • accuracy oriented
  • backward perspective
  • generally external use
  • Managerial Accounting
  • company dependent
  • no direct independent control
  • speed oriented
  • onward perspective
  • generally internal use

22
Financial vs Managerial AccountingFAQ
  • Managerial Accounting
  • shall we buy/sell a business segment?
  • shall we launch a new product line?
  • shall we increase/decrease prices?
  • is our cost level still competitive?
  • Financial Accounting
  • what was the As equity at the date of?
  • What was the profit made over a period of?
  • Was the Company solvent at the closing date?

23
Financial vs Managerial Accountingrelevant costs
(items)
  • Managerial Accounting
  • only future costs matter (sunk costs!!!)
  • estimates widely used
  • marginal costs approach
  • scenario analysis and hybrids (opportunity costs)
  • Financial Accounting
  • only costs incurred matter
  • almost no estimates allowed
  • full absorption approach
  • no scenario analyses

24
A concept of revenue definition and traps
  • Revenue defined as an increase in assets or
    decrease in liabilities that is caused by the
    provision of services or products to customers.
  • Under the accrual basis of accounting, revenue is
    usually recognized when goods are shipped or
    services delivered to the customer. Under the
    cash basis of accounting, revenue is usually
    recognized when cash is received from the
    customer following its receipt of goods or
    services.
  • Revenue vs cash inflow
  • Revenue vs price (rebates, discounts other
    provisions)

25
A concept of cost definition and use
  • Cost defined 1 monetary value of economic
    resources used in performing an activity
  • Cost defined (measured) 2 the amount of cash or
    cash equivalents paid or the fair value of the
    other consideration given to acquire an asset at
    the time of its acquisition (IAS 16)
  • Cost vs expense (very close to the second
    definition of a cost)
  • Cost vs price (quantity of payment or
    compensation given by one party to another in
    return for goods or services)
  • Cost vs investment (money committed or property
    acquired for future income)

26
Typical costs items by origin
  • Remuneration (salaries, wages, fringe benefits)
  • Raw materials
  • Energy
  • External services
  • Taxes and duties allocated to costs (real estates
    tax, stamp duties but neither VAT nor excise tax
  • Depreciation, Depletion Amortisation

27
Cost absorption
  • Cost of goods sold
  • General costs (period costs)
  • Logically there should be no costs left after
    allocation (orphan costs) since ultimately every
    dollar spent has to be covered
  • The problem is that share of direct costs
    (naturally allocated) decreases while the one of
    general costs growths rapidly and in some most
    advanced and valuable businesses gets dominance

28
Cost absorption
  • Profit Revenues costs
  • Revenues (excl. bounded sales) are always direct
    and objective
  • Costs must be fully allocated to products
    services sold
  • Cost allocation is always to some extend
    subjective
  • According to various studies indirect costs
    account between 30-42 of the total costs
    (Laney, Atrill, p. 316)

29
Use of the full absorption approach
  • Long -term pricing
  • Long-term resource allocation
  • Financial accounting

30
Cost allocation types of costs
  • Direct vs indirect costs
  • Direct vs variable costs
  • raw material
  • wages
  • Indirect vs fixed costs
  • office rent

31
Cost allocation targets
  • Products (individual, group)
  • Business segments
  • Customers (individual, segments, markets)

32
Typical manufacturing processes
  • Job order
  • order
  • batch
  • assembly
  • Process
  • process
  • (often with joint products issue)

33
Cost allocation job order
  • Cost pools
  • Overheads
  • For one-factory firm typically two levels
    factory shared services supporting activities
  • For international corporations multilayer
    structure

34
Cost allocation job order
  • Cost drivers
  • Typically related to the time used
  • e.g. machine hours (production lines)
  • e.g. employees working hours (services)
  • A need for standardized (normative) costing
    otherwise forecasting ability non-existent
  • Process costing skipped as too complicated at
    this level

35
Cost allocation exercises
  • Atrill Activity 10.5
  • Atrill Exercise 10.6 (Homework)

36
Cost allocation Critique of conventional costing
  • Not a tool to analyse overheads a growing
    portion of total costs
  • Inability to provide analytical background in
    responding key strategic and operational
    questions
  • shall we enter a new market (say Ukraine)?
  • shall we keep servicing this very group of
    customers (say students?)

37
3
38
Session Three Topics
  • Fundaments of ABC costing
  • Applications of ABC costing

39
Cost allocation Rising share of overheads
40
Cost allocation A(ctivity) B(ased) C(osting)
  • Fundamental questions underlying ABC
  • What activities are being performed?
  • What resources are used in these activities?
  • How much do these resources cost?
  • What really drives these costs (activity
    drivers)?

41
ABC vs. conventional costing cost drivers
Conventional costing ABC
Number of set ups
Number of machine hours becomes Number of shifts
Number of OM interventions
Number of working hours per shift

42
ABC vs. conventional costing Example (1)
An inbound warehouse employs 12 people with the
total cost (not limited to labour cost) of 20 000
USD first stage cost driver number of
employees receiving parts requires 6 employees
so cost is 10 000 USDsecond stage allocation
basis is number of shipments of purchased parts
(250 per month)receiving raw material
requires 3 employees so cost is 5 000 USDsecond
stage allocation basis is number of shipments of
raw materials (50 per month)distributing
material requires 3 employees so cost is 5 000
USDsecond stage allocation basis is number of
production runs (200 per month)
43
ABC vs. conventional costing Example (2)
Stage 2    Remove costs from activity cost pools
and assign to products using second stage cost
driversreceiving purchased parts        10 000
USD/250 40 USD per shipmentreceiving raw
material               5 000 USD/50 100 USD
per shipmentdistributing material run
            5 000 USD/200  25 USD per run For
product A, the 100 produced require 200 purchased
part shipments, 40 raw material shipments and 100
production runs. The direct labour requirement is
2 000 hrs. For product B, the 2 000 produced
require 50 purchased part shipments, 10 raw
material shipments and 100 production runs. The
direct labour requirement is 3 000 hrs.
44
ABC vs. conventional costing Example (3)
If we use this information to compute
conventional cost allocation, we see the
following results  Warehouse (indirect) cost is
20 000 USD allocated to 5 000 hrs gives 4 USD/hr,
what translates into for product A
2000hr/1004 USD 80 USD/unit for product B
3000 hrs/20004USD 6 USD/unit          
If we use this information to compute the ABC
cost based, we see the following
results           
B Parts receipt50 40 USD     2 000 USD Raw
material receipt10 100 USD 1 000
USDDistributing material   100 25 USD   2
500 USD 5 500 USD/2000 2,75 USD per unit
A Parts receipt200 40 USD   8 000 USD Raw
material receipt40 100 USD 4 000
USDDistributing material   100 25 USD   2
500 USD 14 500/100 145 USD per unit
45
ABC sources of differences to conventional
costing
  • Complexity (more operations more costs) an
    example of newspapers attachments
  • Volume (large vs. small batches)
  • Size of products an example of packaging line
  • Value of fixed assets used

46
ABC advantages for services
  • Minimal level of variable and small of direct
    costs
  • Focus on customers rather than on products
  • Products definition very complex, flexible and
    customized
  • High operational gearing

47
ABC advantages for services
This enabled managers to examine indirect cost
in more detail. For example, consider this
example from an order processing department
                                                 
                                                  
      Using the traditional costing system, the
question that managers would ask was Why was
74,000 spent on travel?Using ABC, the new
question is Why was 35,000 spent on resolving
problems?
48
Cost allocation Homework
  • Exercise 11-1 in Excell

49
Cost allocation exercises
  • Buccaneers

50
4
51
Session Four Topics
  • Net Working capital
  • Current assets and liabilities
  • Balancing NWC management

52
(Net) Working Capital Introduction to
  • Revenues (accrual) not settled turn into accounts
    receivables
  • other accounts receivables are f.e. advances paid
    for supplies.
  • Supplies (of labour, raw materials) received but
    not settled turn into accounts payable
  • other accounts payable are f.e. advances
    received.
  • Raw materials, semi - products products not
    sold turn into stock.

53
Net Working Capital on a balance sheet
Assets Assets Liabilities SE Liabilities SE
Long term assets 10,000 Short term liabilities, incl. 3,000
Short term assets, incl. 7,000 Accounts payables 2,000
Accounts receivables 3,000 Overdraft 1,000
Inventory 3,000 Long term liabilities 10,000
Short term notes 1,000 Shareholders Equity 4,000
17,000 17,000 17,000 17,000
54
NWC ratios
P L for the 200x P L for the 200x
Revenues 20,000
Cost of Goods Sold (COGS) (merchandise) 9,000
Overheards 9,000
Gross profit 2,000
Tax (paid) 500
Net profit 1,500 Net profit 1,500
  • Accounts receivables collection period
  • 3,000/20,000 365 55 days
  • Stock conversion holding
  • 3,000/9,000 365 122 days
  • Accounts payables settlement period
  • 2,000/18,000 365 40 days

55
Cash Conversion Cycle
  • Cash cycle
  • receivables collection period
  • stock holding period
  • -
  • payables settlement period
  • cash conversion period
  • For the example used
  • 55 122 40 137 days

56
NWC ratios calculations - tips
  • Accounts receivables collection period is always
    calculated against revenues. However some of
    short term receivables themselves may not result
    from sales.
  • Stock holding period can be calculated either in
    relation to COGS (for trading businesses) or to
    revenues (for manufacturing companies)
  • Accounts payables are calculated in relation to
    cash costs (DDD excluded)
  • Simplification are often used and allowed if
    applied consistently.

57
(Net) Working Capital
  • Short - term assets vs Working Capital
  • capital which costs (interests bearing
    liabilities)
  • liquidity approach - confusion
  • Exxon vs Metro (MS Excell Spreadsheet)
  • Net assets vs Short-term assets

58
Balance Sheet basic analysis(Net) Working
Capital
  • Industry and business position context critical
    while analysing
  • Exxon vs Metro (MS Excell Spreadsheet)

59
5
60
Session Five Topics
  • Introducing time concept
  • Discounting money streams
  • Key problems with proper discounting
  • Brealey, Myers the chapter titled Present
    Value (pp. 11-56)

61
Time Value of Money
  • 1 USD today does not equal 1 USD tomorrow!
  • FV PV (1r)n where
  • r represents a return
  • n represents number of periods (quite often
    years)
  • PV FV/ (1r)n

62
Theoretical fundaments of relation between time
and value
  • Risk of a return different from the planned one
    (Mind you also bigger !!!)
  • Liquidity investor converts cash, which is the
    most universal value transponder into less liquid
    assets (Opportunity Cost of Capital),
  • Purchasing Power universal (inflation, see
    Brealey, Myers, pp. 642-645), individual
    (ultimate goal in investing)
  • Intrinsic value of money (per se) J.M. Keynes
    theory.

63
Capitalisation
  • FVt Future Value of a given sum
  • CF0 present value of a given sum
  • rt interest rate in period t (most often
    annual)
  • t capitalisation period
  • Brealey, Myers pp. 11-56

64
Capitalisation rate
  • The most common way of expressing a
    capitalisation rate is an annual one, marked with
    r letter without index t
  • However quite often a real capitalisation period
    is different interests are added to a capital
    after each month, quarter or so. Then the
    previously mentioned equitation is converted into

65
Key equations
66
Various approaches to set an interest (discount)
rate
  • There is a huge variety of theories and models
    covering the issue. The list below indicates a
    subjective selection of most commonly used ones
  • Alternative capital cost
  • Risk-free alternative
  • Debt cost
  • WACC
  • Historical rate of return
  • Risk Adjusted Discount Rate (RADR)
  • Hurdle rate
  • Social rate of return
  • Discount rate quite often is presented as
  • risk-free rate risk adjustment

67
Concept of risk
  • Financial and insurance meaning of risk
  • Individual attitudes towards risk
  • averse,
  • neutral,
  • Seeker.

68
Risk coin tossing game (1)
  • Game A
  • Head head 40 gain
  • Head tail 10 gain
  • Tail head 10 gain
  • Tail tail 20 lose
  • Expected return 0,40,250,10,250,10,25-0,20
    ,25 10
  • Game B
  • Head head 70 gain
  • Head tail 10 gain
  • Tail head 10 gain
  • Tail tail 50 lose
  • Expected return 0,70,250,10,250,10,25-0,50
    ,25 10

69
Risk coin tossing game (2)
  • Game A
  • Variance 450 -? Sq. Dev. 21
  • Game B
  • Variance 1800 -? Sq. Dev. 42

Return Deviation Squared deviation Probability P SD
40 30 900 0,25 225
10 0 0 0,50 0
20 -30 900 0,25 225
Return Deviation Squared deviation Probability P SD
70 60 3600 0,25 900
10 0 0 0,50 0
50 -60 3600 0,25 900
70
Present Value as dependence on a discount rate
Discount rate 8 10 12 15 20
Discounting Period Value in k USD Value in k USD Value in k USD Value in k USD Value in k USD
PV,25 yrs 747 635 549 452 346
PV,238 yrs 875 700 583 467 350
PV, infinity 875 700 583 467 350
71
Homework
  • If the PV of 150 USD to be paid in one year is
    130 USD, what is a discount rate? (Brealey,
    Myers, Chapter 2, Q 2)
  • You have come to a bank in order to make 1000 PLN
    deposit for 5 years, with 7 interest and
    half-year capitalisation (period). An financial
    advisor has stepped in with an offer of shares
    which over last 5 years period brought 40
    return. What would be your decision?

72
6
73
Session Six Topics
  • Investment vs Capital Budgeting Decisions
  • I(nternal) R(ate of) Return
  • NPV
  • PI
  • Payback (discounted)
  • Brealey, Myers Chapter titled Why Net Present
    Value Leads to Better Investment Decisions
    (pp. 85-112)

74
Investment vs. Capital Budgeting Decisions
  • Investment money committed or property acquired
    for future income
  • Capital budgeting is planning capital outlays for
    purchasing new fixed assets to get additional
    profit thus it means planning investments
  • Intra-corporate investment process is usually
    much more complicated ro evaluate than financial
    investments (share, bonds) since cash flows are
    not easily defined

75
Examples of Capital Budgeting Decisions
  • Equipment selection decision.
  • Plant expansion aimed at
  • increase in sales
  • backward integration.
  • Equipment replacement decision caused by aging
    machine park.
  • New equipment purchase aimed at cost reduction.

76
Investment vs. Capital Budgeting Decisions (2)
  • A financial investment decision is usually based
    on certain one shot outlay and a clear stream of
    return.
  • Most capital budgeting decisions have to consider
    a complex influence on various items.
  • A typical equipment selection decision may be
    conditioned by
  • a cost of an equipment itself (capital
    expenditure)
  • energy consumption (operating costs)
  • personnel requirements (both quality and quantity
    operating costs)
  • service requirements (inventory of spare parts
    NWC).

77
Commonly used measures of investment efficiency
  • Payback (straight)
  • I(nternal) R(ate of) Return
  • NPV
  • PI
  • Payback (discounted)

78
Payback (period)
  • The payback period estimates the time required to
    recover the principal amount of an investment.
  • It is often defined as a length of time needed
    for an investment's net cash receipts to cover
    completely the initial outlay expended in
    acquiring the investment

79
Payback (example)
  • AB Enterprises is trying to select the best
    investment from among three alternatives. Each
    alternative involves an initial investment of
    100,000. Their cash flows follow
  • Which investment will you select using the
    payback method? Why? (Brealey, Myers)

Year A B C
1 10,000 50,000 25,000
2 20,000 40,000 25,000
3 30,000 30,000 25,000
4 40,000 - 25,000
5 50,000 - 25,000

80
Payback key issues
  • What is an investment?
  • Capital expenditure
  • Increase in NWC
  • Other
  • How one defines a pay back itself?
  • Net profit
  • Net cash flow

81
Payback - limitations
  • The payback period method ignores
  • any benefits that occur after the investment is
    repaid
  • the time value of money
  • risk-free cost of money
  • risk
  • Therefore payback period
  • is useless for ranking purposes
  • can be used only in relation to near certain
    flows

82
IRR
  • IRR vs Yield to Maturity
  • IRR algorithm
  • IRR use
  • Disadvantages of IRR

83
IRR - definitions
  •  

84
NPV and IRR
  •  

85
NPV
  •  

86
IRR vs NPV
  • IRR
  • can be calculated only if a cash flow break even
    only once which is typical for many simple
    investments
  • is directly comparable to benchmarks like
    interests on deposits
  • can be used as a ranking tool but with attention
    to various traps (see Brealey, Myers, pp. 94-101.
  • NPV
  • in practice it is calculated to get IRR
  • it can be applied to streams not to be assessed
    using IRR
  • it can not be used as a ranking tool (unless all
    investments are equal)

87
PI (Profitability Index)
  •  

88
Discounted Payback (Period)
  • The discounted payback period estimates the time
    required to recover the principal amount of an
    investment but applying discounting.
  • It is often defined as a length of time needed
    for an investment's net cash receipts to cover
    completely the initial outlay expended in
    acquiring the investment with consideration of
    time value of money concept.
  • It is quite often used as an indicator of a risk
    level

89
Homework
  • An owner of a successful retail business of a
    traditional handmade wool clothes in Krynica
    considers opening a new outlet in Warsaw. There
    are two options as far as location is concerned
    and they can be characterised as stated below in
    terms of key economic parameters. Please select
    the most efficient one using measures presented
    before. Apply 15 discount/hurdle rate when
    needed.

Location (PLN) Cost/ month Monthly turnover Mark up Days in stock Days payable Initial investment
Premium 10 000 50 000 50 30 60 90 000
Subarbian 6 000 35 000 30 45 60 30 000
90
7
91
Session Seven Topics
  • Responsibility Centers
  • Fundamental Income Statement analysis
  • Budgeting and control tools and processes
  • Other performance measurement concepts

92
Responsibility centres
  • Cost centres
  • cost only
  • Revenue centres
  • revenues (usually combined with some costs)
  • Profit centres
  • revenues and costs but no capital expenditures
  • Investment centres
  • all three rev., costs, and CAPEX
  • measured by ROI, NPV, EVA(Residual Income)

93
CVP analysis
  • Cost structures - variability
  • fixed costs
  • variable costs
  • other types
  • semi variable
  • stepped costs

94
B(reak) E(ven) P(oint) analysis
  • BEP formula
  • BEP as a measure of companies risk exposure
  • Variable costing (USA) vs. marginal costing (UK)

95
BEP concept
Company B, likely metal industry, mining
Company A, likely FMCG retail
96
Contribution concept
  • Contribution Revenues - Variable costs
  • Contribution ways of presenting
  • Value/unit or per tone
  • of sales revenues

97
BEP and pricing decisions
  • Full absorption vs variable costing
  • Pressure on price
  • Allocation of fixed costs
  • Opportunity costs limited resources issue
    fixed costs as representation of limited resources

98
Pricing most widely used methods
  • Cost method
  • Mark-up vs Margin

99
Variance analysis in the control process
  • Volume and price variance
  • Budgeted amount
  • budgeted price budgeted quantity
  • Actual amount
  • actual price actual quantity
  • Variances tree
  • Atrill Example 13.1

100
Variance analysis in the control process
practical issues
  • Huge number of calculations
  • 1500 products 3-4 major costs componentstime
    frame
  • Delay in time actual data available when
    decisions are taken
  • Dynamic environment
  • Benchmarking issue

101
Value creation measures
  • ROCE
  • Return Net profit
  • Capital Employed Equity Debt Net Working
    Capital Fixed Assets
  • EVA (RI)
  • EVA Net profit - Capital Charge
  • Capital Charge CE cost of capital

102
Investment measures
  • Hurdle rate as a cut-off point
  • Shell to find 4 billions USD as lazy assets -
    underperforming with ROCE less than 13-15
    (FT.com., 22 December 2003)

103
Budgeting and Control
  • Budget as the key tool in any controlling process
  • Budget vs plan
  • Levels of budgeting
  • strategic
  • operational
  • managerial

104
Budgeting - purpose general remarks
  • Resource allocation
  • Congruence with strategy
  • Master budget vs. operating budgets
  • Monetary budgeting vs budgeting in natural units

105
Budgeting - typical structure
  • Revenues
  • Variable costs
  • Fixed costs
  • OPEX
  • Other Investment costs
  • Capital Expenditures (CAPEX)

106
Balance Scorecard as a non-financial performance
measure
  • Customer Perspective
  • Business Processes Perspective
  • Organisational learning (Development) Perspective
  • Financial Perspective (RI)

107
Budgeting - typical processes
  • Top -down (authoritarian)
  • Bottom up
  • participation
  • consultation
  • Role of K(ey) P(erformance) I(ndicators)

108
Budgeting KPI of Netia
109
8
110
Session Eight Topics
  • Introducing ratio analysis
  • Short-term solvency (liquidity)
  • Long-term solvency
  • Working Capital Ratios (see Session Four)
  • Financial efficiency
  • Using ratio analysis
  • Brealey, Myers Chapter Analyzing Financial
    Performance (pp. 765 -773)

111
Liquidity ratios
  • Current ratio
  • current assets/current liabilities
  • mind you in this case (as oppose to NWC) a short
    term debt is included
  • Quick ratio (ACID - test)
  • Cash short term securities receivables/
    current liabilities
  • mind you sometimes it is said that the only
    difference lays in not including inventories in
    many cases its true but often misleading

112
Solvency ratios
  • Gearing (debt/equity) ratio
  • Debt, including leases /equity
  • mind you various authors exclude short-term debt
    (Brealey, Myers including) in US practice it is
    reasonable but in many cases short term debt is
    very important
  • Interests coverage
  • EBIT (Earnings Before Interest and Taxes)/
    interests other debt related costs
  • mind you banks charge provisions and other which
    are not disclosed as interests but other
    financial costs on the otehr side financial
    costs may include net results on currency rates

113
Financial Efficiency Ratios
  • Gross Margin
  • EBIT (if possible before overheads)/revenues
  • mind you sometimes quite difficult to be
    established directly from PL
  • Return on assets
  • EBIT/ total assets
  • Return on equity
  • Net profit/ equity

114
Financial efficiency
  • The second DuPont formula
  • ROE Net profit/Equity (average)
  • ROA (EBIT Tax)/Total Assets (average)
  • Therefore
  • ROEROA(Total assets/equity)

115
DuPont Formula
116
Comprehensive Financial Ratio Analyses
Ratios
Sources
117
9
118
Session Nine Topics
  • Business financing overview
  • Debt financing financial markets
  • Debt financing banks
  • Equity
  • Other sources of financing

119
Balance Sheet basic analysisSources of finance
  • Structuring criteria
  • duration
  • form of remuneration
  • providing entity
  • legal form
  • Long term vs short term

120
Balance Sheet basic analysisSources of finance
  • Remuneration
  • (Accounts) payables ---gt cost included in
    price/cost of the original item
  • Loans (and overdrafts, receivables discounting),
    debentures (bonds), leases
  • --- gt interests
  • Equity ----gt profit (dividends growth)

121
Balance Sheet basic analysisSources of finance
  • Providing entity
  • Shareholders
  • stock
  • preferred stock
  • subordinated loans
  • Financial institutions (mainly banks)
  • loans
  • overdraft
  • trade receivables discounting
  • Special category Bonds

122
Financial markets
  • Bonds, especially quoted on regulated financial
    markets
  • Accessible for renowned companies or investors
  • Issued with different maturities (short-term are
    named notes)
  • Usually very liquid
  • Common in US and UK but gaining importance
    elsewhere
  • Other forms
  • Private placement
  • Preferred stock
  • Financial markets usually do not seek high
    interests but insist on security (exception junk
    bonds)
  • Brealey, Myers pp. 640-62

123
Maturity Yield to Maturity
  • Maturity is a period for which a loan (or other
    form of financing is granted)
  • Yield to maturity is nothing else but a rate of
    interest paid (price, cost) for obtaining a
    financing

Z bond a zero coupon bond does not pay
interest
124
Yield to Maturity with interest paying bonds
  • When an interest (coupon) is to be paid the yield
    has to be calculated as both coupons and a
    principal are actually equal to zero-coupon bonds
    different payments

-The second method is valid on the following
two conditions (1) purchasing price principal
(2) all coupons are equal
125
Banks
  • Asset based financing
  • Leasing (based on fixed assets)
  • Factoring (based on receivables)
  • Other forms
  • Credit notes
  • Loans
  • Banks usually do not seek high interests but try
    to reinforce sales of other services
  • Brealey, Myers pp. 640-62

126
Equity
  • Financing provided by owners (although owners may
    also use debt financing but always additionally)
  • Residual value of all assets remaining after
    satisfying all liabilities (including debt paid
    back to owners)
  • The most risky and volatile form of financing
  • Essential for business existence

127
Venture capital (1)
  • Relatively new and most famous source of capital.
  • Born around 1980 and attracted 4,5 billion USD
    capital by 1984 (data based on disclosures of 600
    companies) and reached 30,8 billion solely in the
    USA in 2007 (Szablewski, ed. Captal Flows )
  • There are various types of venture capital
    companies, founded by individuals, investment
    banks, MNCs and governments but also charities.
  • They diffuse along many dimensions of interest as
    size, industry, geographical regions, recipients
    social status and so on.
  • They share two common denominators appetite for
    risk and medium term (3-5 yrs.) investment
    horizon.
  • Owen Robert R., Garner Daniel R., Bunder Dennis
    S. The Arthur Young Guide to Financing for
    Growth. Wiley, 1986, p. 71-85

128
Venture capital (2)
  • VCs are usually not interested in investing less
    than 250 k USD and more than 10 millions USD in a
    project
  • Venture capital providers seek to take over
    control of certain areas of the business (usually
    finance but sometimes HR, supplier relationship
    and so on).
  • Venture capital providers do not care to whom
    they ultimately sell their stake in the business.
  • Quite often the only option for founders after
    the VC exit is to quit as well.
  • Owen Robert R., Garner Daniel R., Bunder Dennis
    S. The Arthur Young Guide to Financing for
    Growth. Wiley, 1986, p. 71-85

129
Equity vs Debt Financing (1)
  • Miller-Modigliani Preposition I
  • A firm cannot change its value through changing
    a financial structure thus investment decision
    have to be taken disregarding financing methods
  • There are no taxes financial markets are
    perfect
  • Miller-Modigliani Preposition II
  • Expected yield on shares rises as share of
    debt-financing increase
  • Tax credit favours debt
  • Increasing debt drives risk up
  • Brealey, Myers pp. 450-457

130
Equity vs Debt Financing (2)
131
Homework
  • Calculate
  • yield to maturity on 7 percent, 8-year bond
    selling at 74,5
  • price of 7 percent, 9-year bond yielding 10
    percent
  • price of 8 percent, 12-year bond yielding 14
    percent
  • (Brealey, Myers, Chapter 23, Q 4, use either
    Table 23-1 or a spreadsheet)

132
10
133
Session Ten Topics
  • Creating a Financial Model
  • Forecasting
  • Interpretations and application of financial
    modelling
  • Brealey, Myers Chapter Approaches to Financial
    Planning (pp. 794 -809)

134
Fundaments of Financial Planning
  • There is nothing like precise financial planning.
    If your actuals match exactly the financial plan
    it means only that one column in excel has been
    mistakenly copied.
  • Any financial plan in fact reflects authors
    understanding of the business in consideration
    but helps substantially to deepen it.
  • Consistency is more important that results
    obtained.
  • Financial planning shall not start with numbers
    but end with them.
  • All three statements has to be completed PL, BS
    and CF.

135
Basis of financial modelling
  • Existing businesses usually start from past
    statements.
  • New businesses typically start with crunching
    revenues.
  • Good planners start with goods/services volumes
    expressed as KPIs
  • Say, in case of a restaurant one should start
    rather with number of lunches and dinners served
    than with sales value.
  • Some key assumptions have to be defined upfront
    and followed consistently
  • primary currency,
  • inflation,
  • time frame and structure.

136
Creating a Financial Model (1)
  • There are many financial models available on
    shelf. They offer many useful functions form
    consistently check up to very advanced
    iconography. It is nothing wrong with using them
    however they will not understand the business
    instead of managers.
  • My advice first develop the model yourself from
    scratch.
  • this will check your business understanding,
  • allows you to focus on important issues (many
    models are in practice full of zeros since
    aiming at wide audience they have to incorporate
    many rarely used items,
  • will really help you run a business.

137
Creating a Financial Model (2)
  • Use plain Excell Sheet (or similar software)
  • In case of continuing business follow the
    sequence the coming period P L, BS and then CF
    while completed go to next periods.
  • In case of start ups start with the forecast of
    the first full capacity year (PL and BS only),
    then make previous years PLs and BSs and finally
    close CFs.
  • Define revenues in volume terms using KPIs.
  • Remember VAT issue.
  • Use ABC costing widely wisely.

138
VAT issue
  • In principle VAT, Value Added Tax, is imposed on
    final consumers. All other entities paying VAT in
    procurement of goods and services can deduct the
    amount paid from VAT imposed on their customers.
    In ideal world enterprises shall not be bothered
    with it.
  • Based on this principle ISAB requests VAT
    exclusion from PL.
  • Technically VAT works like a sales tax but with a
    profoundly complicated calculation process.
    Enterprises are ultimately responsible and
    financially liable for its collection and
    payment to a proper tax office.
  • Therefore if you grant all customers 30 days
    payment period with flat sales instead of 30 days
    ARCP expect longer (36 days if 20 VAT is
    applied). The same rule refers to APSP.

139
Financial Models in Big Corporations
  • Complexity issue
  • no of responsibility centers can exceed 1 000
    easily,
  • no of currencies involved can reach 100 with no
    dominant one (say USD, EUR and Chinese Remnibi
    could weight substantially enough not to allow
    for simplifications),
  • no of business lines can exceed 1,000 with more
    than 5 really important ones,
  • no of substantially different accounting
    regulations might be applied on local level
    forcing numerous translations and corrections.
  • MNCs usually develop their own financial planning
    models (often with support of service providers)
    and stick to them for long times.

140
Forecasting
  • Forecasting is in fact not a part of Finance. One
    applies model/methodologies relevant for
    forecasting areas.
  • Focus on a few key items, crucial for the
    business, typically
  • 1-2 shaping revenues
  • variable costs per unit
  • 1-2 shaping fixed costs.
  • and elaborate on them extensively and carefully.
  • Use benchmarks or official sources or seek for
    external solutions in other areas say, ask tax
    expert to calculate taxes.

141
11
142
Finance vs Accounting
  • Financial Accounting
  • historically the first to described and
    normalized officially
  • oriented towards stakeholders not directly
    involved into operations
  • primary data source for all mentioned below.
  • Tax Accounting
  • driven by state regulations
  • strictly regulated.
  • Managerial Accounting
  • oriented towards managers and other people
    directly involved into operations
  • based on certain standards but not regulated.
  • Corporate Finance
  • Banking Financial Markets
  • Insurance

143
Exercise
  • An owner of a successful retail business of a
    traditional handmade wool clothes in Krynica
    considers buying the house he runs his business
    in. The landlord expects an offer around 500,000
    PLN. At present the monthly rent is 1,000 PLN and
    does not include any maintenance. On the upper
    floor there is an apartment rented for 800
    PLN/month net. Since there is a high risk of
    cancellation of rent in case a third party buys
    in the owner identified another location to be
    rented for 800 PLN, though slightly less
    attractive.

Location (PLN) Cost/ Month (excl. rent) Monthly turnover Mark up Days in stock Days payable Initial investment
Present 4 000 30 000 30 15 60 0
New 3 500 25 000 30 15 60 20 000
144
Additional exercises (1)
  • You have been offered 2 years bonds zero coupon,
    100 GBP nominal value, for 91 GBP
  • Now a bank pays you 4,5 on a semi-annual
    deposit. What is your decision?

145
Additional exercises (2)
  • You have considered investing up to 2 million PLN
    somewhere (your bank offers you 6 per annum)
  • Since You owned a plot nearby the city centre one
    obvious idea was to construct an office building.
  • A property agent contacted has a client willing
    to pay 2,5 millions for the building desired
    providing it becomes available in 2 years.
  • The agent also pointed out that he would be
    willing to buy this plot onto his own account for
    400 thousands PLN
  • The agent provision is 4
  • Your colleague, running a construction company
    offered to construct this building on a turn-key
    basis for 1 500 thousands,
  • and expects his consideration in three equal
    instalments (500 thousands each)

146
Additional exercises (3)
Comapany X has budgeted the following for the coming month Comapany X has budgeted the following for the coming month Comapany X has budgeted the following for the coming month Comapany X has budgeted the following for the coming month Comapany X has budgeted the following for the coming month Comapany X has budgeted the following for the coming month

Production Production
Product A 5000 units
Product B 15000 units

Direct material Direct material

Product A 25 GBP/unit
Product B 5 GBP/unit

Direct labour Direct labour

Product A 4 hrs/unit
Product B 2 hrs/unit

rate 10 GBP/unit

Overheads Overheads Total no of activities Product A B
Total 750 000

Machine set-ups Machine set-ups 115 000 GBP 5 000 3 000 2 000
Quality inspections Quality inspections 320 000 GBP 8 000 5 000 3 000
Production orders Production orders 90 000 GBP 900 300 600
Machine hours worked Machine hours worked 175 000 GBP 25 000 5 000 20 000
Material receipts Material receipts 50 000 GBP 5 2 3

Prepare conventional based and ABC based cost forecast for product A and B Prepare conventional based and ABC based cost forecast for product A and B Prepare conventional based and ABC based cost forecast for product A and B Prepare conventional based and ABC based cost forecast for product A and B Prepare conventional based and ABC based cost forecast for product A and B Prepare conventional based and ABC based cost forecast for product A and B
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