Financial Resources Management

1
Financial Resources Management
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Finance and Business
3
What is Finance?

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

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What is Finance?

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

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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.

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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

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Legal Forms of Business Organisations

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

8
Legal Forms of Business Organisations

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

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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)

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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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

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The Financial Markets
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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

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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

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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
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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

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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)

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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

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International Market
Total Market Size, 31.12.03 7,377 bn USD
Source ISMA
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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

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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
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Market Players

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

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Financial Statements and Analysis
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Four Key Financial Statements

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

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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

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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)

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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

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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

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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

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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

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Notes to the Financial Statements

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

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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

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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

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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

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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

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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

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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
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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

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Financial Ratios Liquidity Ratios

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

53
Financial Ratios Activity Ratios

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

54
Financial Ratios Activity Ratios

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

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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

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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

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Financial Ratios Debt Ratios

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

58
Financial Ratios Debt Ratios

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

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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

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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)
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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

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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

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Financial Ratios Profitability Ratios

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

64
Financial Ratios Profitability Ratios

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

65
Financial Ratios Profitability Ratios

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

66
Financial Ratios Profitability Ratios

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

67
Financial Ratios Profitability Ratios

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

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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

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Financial Ratios Profitability Ratios

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

70
Financial Ratios Market Ratios

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

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Financial Ratios Market Ratios

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

72
Financial Ratios Market Ratios

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

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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

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The Financial Planning Process
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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

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Long-Term (Strategic) Financial Plans

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

77
Short-Term (Operating) Financial Plans

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

78
Cash Planning Cash Budgets

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

79
Cash Planning Cash Budgets Sales Forecast

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

80
Cash Planning Cash Budgets Sales Forecast

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

81
Cash Planning Cash Budgets Sales Forecast

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

82
Cash Planning Cash Budgets Sales Forecast

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

83
Cash Planning Cash Budgets Preparing the Cash
Budget

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

84
Cash Planning Cash Budgets Preparing the Cash
Budget

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

85
Cash Planning Cash Budgets

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

86
Cash Planning Cash Budgets

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

87
Financial concepts
88
Time value in finance

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

89
Time value in finance

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

- 10,000
3,000
5,000
4,000
3,000
2,000
End of the year
90
Time value in finance

• Computational tools
• Time-consuming calculations often involved in
  finding future and present values
• Financial tables include various future and
  present value interest factors that simplify time
  value calculations
• Financial calculators also can be used for time
  value computations
• include numerous pre-programmed financial
  routines
• Spreadsheets have built-in routines that simplify
  value calculations

91
Time value in finance

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

92
Single Amounts

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

93
Single Amounts

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

n
n
n
94
Single Amounts

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

n
95
Single Amounts

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

n
96
Single Amounts

• Present Value of a Single Amount (contd)

FV
n
PV

97
Single Amounts

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

1
PVIF

i,n
98
Single Amounts

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

99
Annuities

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

100
Annuities

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

101
Annuities

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

102
Annuities

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

103
Mixed Streams

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

104
Compounding Interests more Frequently than
Annually

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

105
Compounding Interests more Frequently than
Annually

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

106
Special Applications of Time Value

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

107
Special Applications of Time Value

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

108
Risk and Return
109
Risk and Return Fundamentals

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

110
Types of Risks

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

111
Risk and Return Fundamentals

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

112
Risk of a Single Asset

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

113
Risk of a Single Asset

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

114
Risk of a Portfolio

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

115
Risk of a Portfolio

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

116
Risk of a Portfolio

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

117
Risk of a Portfolio

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

118
Risk of a Portfolio

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

119
Risk and Return The CAPM Model

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

120
Risk and Return The CAPM Model

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

121
Risk and Return The CAPM Model

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

122
Risk and Return The CAPM Model

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

123
Risk and Return The CAPM Model

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

124
Risk and Return The CAPM Model

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

j
m
F
F
j
F
j
m
125
Risk and Return The CAPM Model

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

m
F
126
Risk and Return The CAPM Model

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

127
Risk and Return The CAPM Model

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

128
Risk and Return The CAPM Model

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