Engineering Management 452 Advanced Financial Management

1
Engineering Management 452 Advanced Financial
Management
Chapter 1 5 Review
2
Alternative Forms of Business Organization

• Sole proprietorship
• Partnership
• Corporation

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Forms of Business Organizations

• Sole Proprietorship 80 of firms, 13 of
• Partnership 10 of firms, 7 of
• Corporations 10 of firms, 80 of

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Sole Proprietorship

• Advantages
• Ease of formation
• Subject to few regulations
• No corporate income taxes
• Disadvantages
• Limited life
• Unlimited liability
• Difficult to raise capital

5
Partnership

• A partnership has roughly the same advantages and
  disadvantages as a sole proprietorship.

6
Corporation

• Advantages
• Unlimited life
• Easy transfer of ownership
• Limited liability
• Ease of raising capital
• Disadvantages
• Double taxation
• Cost of set-up and report filing

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Goals of the Corporation

• The primary goal is shareholder wealth
  maximization, which translates to maximizing
  stock price.
• Should firms behave ethically? YES!
• Do firms have any responsibilities to society at
  large? YES! Shareholders are also members of
  society.

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Factors that Affect Stock Price

• Amount of cash flows expected by shareholders
• Timing of the cash flow stream
• Risk of the cash flows

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Three Determinants of Cash Flows

• Sales
• Current level
• Short-term growth rate in sales
• Long-term sustainable growth rate in sales
• Operating expenses
• Capital expenses

10
Factors that Affect the Level and Risk of Cash
Flows

• Decisions made by financial managers
• Investment decisions (product lines, production
  processes, geographic market, use of technology,
  marketing strategy)
• Financing decisions (choice of debt policy and
  dividend policy)
• The external environment

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Financial Statements

• Balance Sheet (basis of all the others)
• organized by timing, most current first
• Income Statement (profit and loss)
• org core business functions first
• Statement of Retained Earnings
• Removes dividends from earning to retain
• Statement of Cash Flows
• Where is the cash coming from and going?

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Balance Sheet

• Assets
• Cash 15
• Securities 65
• A/R 315
• Inventory 415
• Total current 810
• Net plant eq. 870
• Total assets 1680

• Liabilities Equity
• A/P 30
• N/P 60
• Accruals 130
• Long term debt 415
• Total liability 635
• Equity 945
• Total liab. eq. 1680

These balance
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Assets

• Assets are the economic resources controlled by
  an entity that are expected to provide future
  benefits.
• Such as
• Cash, inventory, financial instruments,
• equipment, buildings, etc.

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Current Assets (less than a year)

• Cash cash and equivalents
• Securities short term investments in other
  firms, priced at cost
• Accounts receivables A/R trade credit given to
  customers, priced at cost
• Inventory raw material, sub-assemblies, work in
  progress, finished goods that will become part of
  product sold, priced at (FIFO, LIFO) cost

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Capital Assets (more than a year)

• Net Plant Equipment production equipment at
  cost less accumulated depreciation (straight
  line, accelerated)
• Goodwill premium paid for asset above its book
  value less accumulated amortization
• Prepaid expenses such as pension expense
• Customer financing term of sale that lends
  money to the customer

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Liabilities

• Liabilities are obligations of an entity to
  transfer assets or provide services to other
  entities in the future as a result of past
  transactions or events. (i.e. Resources provided
  by creditors.)
• Such as
• Loans, IOUs, wages due, taxes due, amounts owed
  to suppliers.

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Equity

• Common stock initial investment in our firm by
  investors, at cost
• Retained earnings R/E accumulation of profits
  generated that are not distributed to the
  stockholders through dividends
• Preferred stock less risky form of equity,
  hybrid between equity and debt (not common)
• Net worth common stock retained earnings, or
  total assets total liabilities preferred stock

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Basic Accounting Equations

• Equity Assets - Liabilities
• Liabilities Assets - Equity

T-account
Assets
Liabilities Equity Liab. Equity
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Inventory accounting

• Purchased 4 identical items at 10, 20, 30 40
• Sold two of them

cost inventory
LIFO 70 30 FIFO 30 70 AVE 50 50
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Depreciation

• If equipment cost 1000 and supports production
  for 4 years

Method year1 yr2 yr3 yr4 Expense 1000 0 0 0 S
traight line 250 250 250 250 DDB
500 250 125 62.5 SYD 400 300 200 100
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Income Statement (PL)

• Net sales 3000
• Operating costs (2716)
• Earnings before int. taxes 284
• less interest (88)
• Earnings before taxes 196
• less taxes (78)
• Net income (profit after tax) 118
• less dividends (62)
• Addition to retained earnings 56

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Income (Revenue)

• Revenues are increases in equity resulting from
  the exchange of goods, services, or other
  activities involving the entitys central
  operation.
• Such as
• Sales revenue, service income, rent income

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Expenses

• Expenses are decreases in equity resulting from
  the process of earning revenues.
• Such as
• Cost of goods sold, cost of services rendered,
  salary expenses, training expense

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Statement of Cash Flows

• Excellent assessment tool that looks at more than
  just profit.
• Look for the largest numbers and let them tell
  you the story of what is happening.
• Critical for high growth and smaller businesses.
• Breaks down business by activities

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Statement of Cash Flows

• An increase in a current asset decreases cash
• An increase in a current liability increases cash

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Market Value Added (MVA)

• Shareholder wealth is maximized by maximizing the
  difference between the market value of the firms
  stock and the amount of equity capital that was
  supplied by shareholders
• MVA Market value of stock Equity capital
  supplied by the shareholdersor
• MVA (Shares outstanding)(Stock price) Total
  common equity

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Economic Value Added (EVA)

• Economic Value Added (EVA) focuses on managerial
  effectiveness of a company
• EVA Net operating profit after taxes- After-tax
  dollar cost of capital used to support operations

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Ratio Analysis

• A ratio is simply one number divided by another.
  Not all ratios are relevant for all industries.
  Must understand what the ratio is telling us to
  determine its usefulness.
• What is the unit of measurement? What might a
  high or low value be telling us? How can this
  number be improved?
• Generally categorized as Liquidity, Asset
  management, Debt Management, Profitability, and
  Market Value ratios.

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Examples of Liquidity Ratios and Asset Management
Ratios

• Current ratio Current assets / Current
  liabilities
• Quick ratio (Current assets Inventory) /
  Current liabilities
• Cash Ratio Cash / Current Liabilities
• Inventory Turnover Ratio Sales / Inventories
• Days Sales Outstanding Receivables / Average
  Sales per day
• Average Collection Period
• Fixed Asset Turnover ratio Sales / Net Fixed
  Assets
• Total Asset Turnover ratio Sales / Total Assets

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Debt Management and Profitability

• Debt ratio (Total Debt) / Total assets
• Times Interest Earned EBIT / Interest charges
• Fixed Charge Coverage Ratio (EBIT Lease
  Payments) / (Interest charges Lease Payments
  Sinking Fund Payments / (1 Tax Rate)
• Profit margin Net Income available to CS /
  Sales
• Basic Earning Power EBIT / Total Assets
• Return on Assets Net Income available to CS /
  Total Assets
• Return on Common Equity Net Income available to
  CS / Common Equity

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Profitability Ratios

• Profit margin Net Income available to CS /
  Sales
• Basic Earning Power EBIT / Total Assets
• Return on Assets Net Income available to CS /
  Total Assets
• Return on Common Equity Net Income available to
  CS / Common Equity

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Market Value Ratios

• Earnings per Share Net Income / Shares
  Outstanding
• PE ratio Price per Share / Earnings per share
• Market to Book ratio Market value per share /
  Book value per share
• Book value per share is common equity divided by
  the number of shares outstanding
• Du Pont equation gives you ROA Profit Margin
  Total Asset Turnover, The extended Du Pont give
  you ROE Profit Margin Total Asset Turnover
  Equity Multiplier
• Trend Analysis, Comparative Ratios, Benchmarking

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Interest Rates

• Result of supply and demand
• Fluctuate over time
• Impact of inflation
• Impact of risk
• Default risk of issuer
• Liquidity risk of market
• Maturity risk of economy

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Interest rate model

• K k IP DRP LP MRP
• K quoted or nominal rate
• k risk free rate with zero inflation
• IP inflation premium
• DRP default risk premium
• LP liquidity premium
• MRP maturity risk premium

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Determinants of Interest Rates

• Nominal Rate (k) - usually what is quoted is
  composed of
• Real Risk Free Rate (k) interest rate that
  would exist on a riskless security if no
  inflation were expected. Dependent on the rate of
  return borrows expect to earn on productive
  assets and lenders preference for current and
  future consumption.
• Inflation Premium (IP) average expected
  inflation rate over the life of the security.
  Compensation for the eroding purchasing power of
  the dollar.
• Default Risk Premium (DRP) Compensation for the
  chance a borrower may default on the loan.
• Liquidity Premium (LP) Compensation for a
  security that cannot be quickly converted into
  cash at close to fair market value
• Maturity Premium (MP) Compensation for interest
  rate risk

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Estimating the Components of Interest Rates

• Expected Inflation Risk Premium
• Matching historical rate over comparable time
  periods (Expectations for future inflation are
  somewhat correlated with rates experienced in the
  recent past)
• Real Risk Free Rate
• Risk Free Rate (Government Security) minus the
  expected inflation risk premium
• Default Risk Premium
• Difference between risk free and comparable
  security with risk.

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Some Examples of Factors that affect interest
rates

• Federal Deficit
• If the government spends more than it takes in,
  the deficit must be covered by either borrowing
  or by printing money.
• If the government wants to borrow more, the
  demand causes interest rates to rise.
• If it prints more money, increased expectations
  of higher inflation will raise interest rates.
• Foreign Trade Balance
• If the US imports more than it exports, the
  deficit must be financed, most likely with debt,
  which will increase demand for funds, resulting
  in higher interest rates.

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Factors Influencing Interest Rates

• Federal Reserve Policy
• Increasing growth in the money supply initially
  lowers interest rates (however, it may also lead
  to an increase in the expected interest rate,
  which in turn could push interest rates up). The
  reverse is true if the Fed tightens the money
  supply.
• The Fed sets the Discount Rate (the interest rate
  the Fed charges on loans to banks) and controls
  the Federal Funds Rate (The rate at which banks
  borrow reserves from each other)
• Level of Business Activity During a recession,
  the demand for money and the rate of inflation
  tend to fall.

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Interest Yield Curves
Interest rates
k
Inverted
Normal
Time
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Why are interest rates important?

• Affect stock prices
• Change interest expense
• affects economic activity
• affects competitive investment opportunities
• Affect business decisions
• Choosing short or long term investments
• Timing for investments and ventures

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How Interest rates can affect you

• You have 5,000 to put down on a car and can
  afford to pay 500 a month for 60 months.
• How much can you afford to pay if the interest
  charged is 6 a year compounded monthly?
• Answer 30,862.78 (Limited Edition)
• Principal 30,862.78 Interest 4,137.22
• How much can you afford to pay if the interest
  charged is 12 a year compounded monthly?
• Answer 27,477.52 (Cloth Interior)
• Principal 27,477.52 Interest 7522.48

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How Interest rates can affect you

• You have 20,000 to put down on a beach house and
  can afford to pay 1500 a month for 30 years.
• How much can you afford to pay if the interest
  charged is 8 a year compounded monthly?
• Answer 224,425.24 (Ocean Front)
• Principal 224,425.24 Interest 335,574.76
• How much can you afford to pay if the interest
  charged is 12 a year compounded monthly?
• Answer 165,827.50 (Bay Side)
• Principal 165,827.50 Interest 394,172.50