financial management- module 1-6
TRANSCRIPT
FINANCIAL MANAGEMENT Module 1
COMPONENTS OF FINANCIAL MANAGEMENTFinancial Planning Master Budget Working Capital Mgt.
Operating Budget Financial Analysis Leverage Analysis Forecasting Capital Budget Cash Budget Balance Sheet
Sales Budget Prodn Budget
Current Asset Mgmt.
Break-even Analysis
Admin Budget
Short-term Sources of Capital
Selling Budget
Return Measurement
Risk Management
Time Value of Money
Valuation Approaches
Capital Sources
Cost of Capital
Capital Expenditure Budgeting
Investment Technique
Capital Allocation/ Rationing
Costs
Capital Structure Theory
Long-term FinancingLong-term Debts
Covenants Features
Concepts & Tools
Bonds Equities
Dividend Policy Distribution Stock rights
Preferred Equities Long-term Lease
IPO
Valuation Models
Acquisition Strategies
Divestment Strategies
Other Modes of Long-term Financing
Te der Offers Ti i Valuatio Hostile Takeover Ba kruptcy/ Reor a izatio Re-capitalizatio
eft-ha d i a ci
Restructuri i a cial I ovatio s Co versio BO
I ter atio al i a ce A ti-takeover Strate ies
Debt Reductio
Reor a izatio
Fi a cial Ma a e e t IPO ModelTasksResource I put Resource Process Resource Output
Objectives
Eco o y
Efficie cy
Effective ess
Outco e Be eficiary
Corporate Value Stakeholders
Financial Management Involves Resource:
PLANNING
SOURCING
ALLOCATING
CONTROLLING
UTILIZING
Fi a cial & Profit Pla
New oa s New Equities Profits
Bud eti Respo sibility Ce ters
Risk Assess e t Fi a cial Report Varia ce A alysis
I vest e t Efficie cy Eco o y Effective ess
Fir
Value Creatio
Stakeholders
Fi a cial Ma a e e t I ter ediatio ModelTHE FIRM Risk - Retur A alysis
F U N D SCreditors FINANCIA MANAGEMENT
Create Value INTERMEDIATION Fi a cial Eco o ics EVERAGING
Create Value
COST/BENEFIT A alysis Cost of Fu ds Retur
Shareholders
DIVIDENDS FIXED PAYOUTS RETURN ON EQUITY INTEREST COVER
Eco o ic Value Added
FINANCIAL MANAGEMENT OBJECTIVES Minimize Risk Maximize Returns
Firm Value Creation
Increase Stock Price
Financial Management Framework (The CAM Model)I terest
Fi a cial Resources Source
Fu ds Market Capital Market
Tar et Fi l Structure Capital Structure
Debt
Equity
Wei hted Avera e Cost of Capital
Mo ey Market
Divide d/ Ear i s
Proble s Fi a cial Health & Issues Use ProfitabilityEco o y
Economic Value AddedRetur o I vest e t
iquidityEfficie cy
ActivityEffective ess
evera e
DETERMINANTS/ASSESSMENT OF CORPORATE FINANCIAL PLANGOALSProduct Market Choices/Product Market Strate ies
Market, Operati
& Co petitive Characteristics Co pa y Sales
I vest e t required to support strate y & future sales Need for additio al fi a ce: loa s or equity issue ext 3 to 5 years
Future co petitio s a d fi a cial perfor a ce Assured access to tar et sources of fi a ce o acceptable ter s
3-5 Year Fi a cial Pla i Curre t Year Fi a cial Pla i
SOURCES OF DOWNWARD PRESSURE ON ABOVE-MARKET RETURNSNEW ENTRANTS
Entry of new firms Existi co petitors Rivalry a o fir s i the i dustry
SUPPLIERS
BUYERS
OUR FIRMThreat of substitutes
SUBSTITUTE PRODUCTS
THE FINANCIAL MARKETSLong-term Commercial Papers/Bonds
PrimaryInvestment Bankers Underwriters /Brokers Insurance Companies Banks / GFIs Savings and Mortgage Banks Pension Funds
Equities
Capital Market
Fi a cial I ovatio s
Secondary Stock Exchange Over-the-counter
Profits
Money MarketSavi s
Banks Non-Banks
EXTERNAL FACTORS AFFECTING FINANCIAL MARKETS Global issueseopolitics
I ter atio al fi a ce & tradecapital & fu d tra sfers i ter atio al trade
GoverGover
e t i terve tioe t fiscal policy
taxatio over e t spe di
Gover
e t
o etary policye
i terest forei excha i flatio
FINANCIAL MANAGEMENT POLICIES
Fi a cial Pla i Policy Capital Structure Policy Capital Bud etary Policy evera e Policy Credit Policy Cash Ma a e e t Policy
FINANCIAL MANAGEMENT POLICIES I ve tory Policy Divide d Policy Acquisitio Policy Risk Ma a e e t Policy I vestor Relatio s Policy Procure e t Policy
END OF MODULE 1
FINANCIAL MANAGEMENT - Module 2
FINANCIAL STATEMENT ANALYSIS - WHAT IT IS
Deter i i fi a cial data relatio ships a d correlatio Deter i i tre ds a d rowth behaviors
FINANCIAL STATEMENT ANALYSIS FOR WHAT USE IT IS Dia osiside tify proble s a d sy pto s develop solutio optio s
Predictioforecast future predict pote tial outco es
Evaluatioeasure perfor a ce
FINANCIAL STATEMENT ANALYSIS WHAT ARE THE TOOLS Structural a alysishorizo tal/ti e-series vertical co o size i dex a alysis ti e-series cross-sectio
Discri i a t a alysis
FINANCIAL STATEMENT ANALYSIS WHAT AREAS TO ANALY EAREA Profitability INTERESTED SECTORS i vestors ma a eme t creditors gover me t public Liquidity creditors i vestors ma ageme t Activity i vestors ma ageme t creditors i vestors Leverage ma ageme t creditors public i vestors Overall Measure ma ageme t public i vestors Valuation Measures ma ageme t public
FINANCIAL STATEMENT ANALYSIS WHAT ARE THESE RATIOS1. Overall Measures retur o i vestme t (ROI) retur o equity (ROE)
5. Activity Measures asset tur over capital i te sity ratio worki g capital tur over et worth tur over i ve tory tur over i ve tory stocki g period accou ts receivable tur over average collectio period
. Valuation Measures price-ear i gs ratio (P/E) market to book ratio market price per share (P/S)
3. Profitability Measures retur o sales gross profit ratio
4. Liquidity Measures curre t ratio acid test (quick) ratio
6. Leverage Measures debt to equity ratio debt to asset ratio times i terest ear ed cash flow coverage
FINANCIAL STATEMENTS ANALYSIS OBJECTIVES To determine the extent of a firms success in attaining its financial goals, namely :
To ear maximum profit To mai tai solve cy To attai stability To build up values of the firm
INDICATIONS OF MANAGERIAL EFFICIENCY IN TERMS OF PROFITABILITY
Ability to earn a reasonable return on investments for borrowed funds and owners equity Ability to control operating cost within reasonable limits No over investment in fixed assets, receivable and inventories
INDICATIONS OF SATISFACTORY SHORT-TERM SOLVENCY OR WORKING CAPITAL POSITION
Favorable credit position Satisfactory proportion of cash to the requirements of the current volume Ability to pay current debts in the regular course of business Ability to extend more credit to customers Ability to replenish inventory promptly
TESTS OF A SOUND OR HEALTHY LONG-TERM FINANCIAL POSITIONImprovement in financial position Well-balanced financial structure between borrowed funds and owners equity Effective employment of borrowed funds and owners equity Ability to declare satisfactory amount of dividends to stockholders Ability to withstand adverse business conditions Ability to engage in research and development to provide new products, method or process
MOST COMMONLY USED TECHNIQUES IN F/S ANALYSIS AND INTERPRETATION Vertical Analysis - State measuresFinancial Ratios Common-Size Statements
Horizontal Analysis Dynamic measuresComparative Statements- showing changes in absolute amounts and percentages Trend percentages
Use of Special Reports on StatementsStatements of Cash Flows Gross Profit/Net Income Variation Analysis
LIMITATION OF FINANCIAL ANALYSIS LimitationFi a cial a alysis methodology is basically u ivariate
Remedy
Combi e differe t ratios i to a mea i gful model
Example : Du Po t Model Z-score Model
EXPANDED DU PONT SYSTEM ROA/ROEMaterials Sales Ear i gs after tax
+Direct abor
Total Cost & Expe ses Sales Volume X Sales Price
:Sales
+Overhead
Retur o Sales Retur o Asset X
Total Assets
+Selli g
X Sales
: Returnon Equity
+Admi istratio Cash
:Total Worki g Capital Total Assets
Asset. Tur over
+Receivables
Total Equity
+I ve tories
+Property, Pla t & Equipme t
PREDICTIVE NATURE OF FINANCIAL ANALYSIS
Regression Analysis
uses past data to predict future values of depe de t variables
Discriminant Analysis
results i a i dex that allows classificatio of a observatio i to o e of several a priori groupi gs
ILLUSTRATION OF REGRESSION ANALYSIS
Formula
Y = a + bX
where : Y - dependent variable X - independent variable a - coefficients b - slope
CAMCOMPANY Sales Volume Data
DataDate 1 2 3 4 5 6 7 8 9 10 11 12 19x1 19x2 19x3 19x4 348 375 466 516 347 384 478 522 345 397 478 530 343 404 488 548 343 404 488 548 341 409 493 544 345 404 494 551 344 413 495 545 348 418 500 534 354 434 510 550 355 445 510 558 359 451 515 511 19x5 19x6 19x7 19x8 472 455 502 550 457 462 505 552 538 464 507 583 437 459 528 592 437 459 528 592 439 459 532 602 439 468 533 616 447 468 535 625 443 457 540 628 435 460 530 640 433 481 530 642 445 490 543 657
Tabular Values Month X 1 13 25 37 49 61 73 85 344 X Y Sales Y 348 375 466 516 473 455 502 550 3,685 = 344/8 = 3,685/8 = 43 = 461 XY X2 348 1 4,875 169 11,650 625 19,092 1,369 23,177 2,401 27,755 3,721 36,646 5,329 46,750 7,225 170,293 20,840
Regression Value XY - [(X)(7Y)] 170,293 - (43)(3,685) b = --------------------- = ---------------------------- = 1.96 7X2 - [(X)(7 X)] 20,840 - (43)(344) a = Y - (b)(X) = 461 - (1.96)(43)
= 377
Applying the linear equation, the regressed value for January 19X1 is: Y = a + bX = 377 + (1.96) (1)
= 379
ILLUSTRATION OF ALTMAN -SCORE MODEL
= .012X1 + .014X2 + .033X3 + .006 X4 + .999X5 where: X1 - WC / TA X2 - RE / TA X3 - EBIT / TA X4 - MVE / BVD X5 - S / TA
Sample Data 66 Ma ufacturi g firms Bankrupt Non-bankrupt 33 33
Tabular Values
X1 X2 X3 X4 X5esultin Values CUT-OFF
Group Means Bankrupt Non-bankrupt -6.10% 41.40% -62.60% 35.50% -31.80% 15.40% 40.10% 247.70% 1.5 times 1.9 times -0.2599 4.8863 2.675
Accuracy : 72% prediction accuracy
WHAT IS LEVERAGEAbility of the firm to
magnify returnsresulting from
effective or ineffective use of asset resourcesand
the financing thereof
WHAT ARE ITS USES
for
co trol of costs for pla i g profits for determi i g breakeve levels for a alyzi g performa ce
WHAT ARE THE TYPES OF LEVERAGE
OL+
Type of leverage i volvi g ability of firm to utilize fixed costs to e ha ce retur s Type of leverage i volvi g ability of firm to utilize borrowed fu ds to e ha ce retur s Total effect of leverage exemplified by retur o equity (ROE) or ear i gs per share (EPS)
FL=
TL
HOW IS LEVERAGE ILLUSTRATED
Total Firm Leverage
Reve ue / Sales ess: Variable Costs Co tributio ess: Fixed Costs EBIT ess: I terest Expe se EBT ess: Tax EAT Ear i gs per Share
xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx
Operative Leverage
Financial Leverage
WHAT ARE THE TYPES OF COSTS WITH RESPECT TO ASSET USE AND FINANCING
ASSETS
=
DEBTS
+
EQUITIES
OTHER OPERATING FIXED COSTS
+
FIXED COSTS
+
INTEREST COSTS
=
TOTA EVERAGE COSTS
WHAT IS THE IMPACT OF LEVERAGE ON RISK AND RETURN
Leverage MatrixH HIGH LEVERAGE H
Return RETURN Return
Risk RISK Risk
L
LOW LEVERAGE
L
WHAT ARE THE STRATEGIES TO CAPITALI E ON LEVERAGE BENEFITS
Economies of scalespread out fixed costs to higher volume of productivity
Optimality of financing mixhigher times i terest coverage
IS LEVERAGE USEFUL IN BREAK-EVEN ANALYSIS because leverage illustrates COMPONENTS OF FIRMS COST STRUCTURE
YES
VARIABLE COSTS
FIXED COSTS
WHAT ARE THE USES OF BREAK-EVEN
pla i g a d co trol For differe tial costi g For prici g For profit level pla i g For
WHAT ARE THE MATHEMATICAL FORMULATIONS OF BREAK-EVEN TFC BES = 1 - TVC TR BES BEV = UR
orTFC = UCM
END OF MODULE 2
FINANCIAL MANAGEMENT Module 3
FORECASTING TECHNIQUES
QUANTITATIVE TECHNIQUES
Historical data are available a d relatio ships of variables are expected to remai the same i the future
QUALITATIVE TECHNIQUES
Judgme tal forecast where data are ot available & key variables are expected to cha ge significantly in the future
FACTORS IN QUANTITATIVE FORECAST
TREND
SEASONALITY
CYCLE
RANDOMNESS
QUANTITATIVE TECHNIQUES DIRECT ESTIMATING METHOD Sales forecast
Mean Quota / Actual Revenue
Cost and expenses
Percent of Sales Model TIME-SERIES TECHNIQUE TREND EXP ORATION USING REGRESSION ANA YSIS
Continuation
Continuation
COMPOUND GROWTH RATE
(1 g)
n 1
Rn ! R1 or Rn R1
Where : Rn = R1(1+g)n-1 Rn = revenue for last historical period R1 = revenue for first historical period N = number of periods g = average growth rate from one period to next
g ! n
PRIOR PERIOD GROWTH RATE
QUALITATIVE TECHNIQUES Sales-Force Estimate Executive Opinion Anticipatory Surveys or Market Research Scenario Forecasts Delphi Forecast Brainstorming
FINANCIAL STRATEGIES FOR WORKING CAPITAL MANAGEMENT DEFINITION : WORKING CAPITAL CURRENT ASSET MANAGEMENT SHORT-TERM FINANCIA MANAGEMENT INVO VES IQUIDITY & SO VENCY OF FIRM
WORKING CAPITAL MEASURE CURRENT RATIO NETWORKING CAPITA
CURRENT ASSET MANAGEMENT INVOLVES DETERMINATION OF MINIMUM REQUIRED BA ANCES ADDITION OF SAFETY STOCK EVE
RISK-RETURN TRADE OFF CONSERVATIVE WORKING CAPITAL Higher ratio of current assets of sales lower return lower risk
AGRESSIVE WORKING CAPITAL lower ratio of current assets to sales unpaid bills lost sales production stoppages higher risk & return
RISK-RETURN TRADE OFF IN WORKING CAPITALLow risk
Match
Low return
CURRENT ASSETS Mismatch High risk High return PROPERTY, PLANT & EQUIPMENT
CURRENT LIABILITIES Mismatch LONG TERM CAPITAL DEBT EQUITY High risk Low risk Low return
Match
high return
WC RISK-RETURN TRADEOFF GRAPHW O R K I N G
CONSERVATIVE TOTAL WORKING CAPITAL REQUIREMENTS
C A P I T A L
AGGRESSIVE PERMANENT WORKING CAPITAL REQUIREMENTS
WORKING CAPITAL STRATEGIES AGRESSIVE STRATEGY Maintain minimum required balance Find seasonal needs by short-term financing (e.g. bank loans)
CONSERVATIVE STRATEGY Maintain highest balance Reinvest excess capital
OPTIMUM WC STRATEGY Maintain / reduce level by averaging low & high WC levels
CASH MANAGEMENT OBJECTIVES Cost of money Innovation in banking Increase in business organization complexity DEFINITION Optimization of cash as an asset GOALS Liquidity Earnings
OPERATIONAL CYCLE & OVERVIEW OF CASH MANAGERS DUTIES
Equity investment
Lines of Credit
Credit Standing
S ort-term de t Production S ipping/ Invoicing Accounts Receiva le Collections
Long-term de t
Bank relations Debt management Cash forecasting
Interest Income
Improving receivables processing Speeding collections Other receipts forecastingOt er Income
CASH
POOLInterest / Loan Payments
Maintain liquidity Short-term investing Cash forecasting Managing investments Overseeing bank accounts Reducing idle balances Slowing disbursements Cash forecasting Cash conservation
Over ead Payments
Accounts Paya le
Dividends
Payroll
APPROACHES TO CASH MANAGEMENT
Use cash as a resource Integrate with operations Market planning Credit decision Capital investment Products scheduling
Customize cash managementContinuation
Continuation
Review disbursment techniques Centralized disbursements Zero balance accounts Remote disbursements Controlled disbursements Payment through drafts Trade discounts
Invest excess funds in short-term investments Develop liquidity reserves
THE CASH CYCLEMaterials ordered Materials delivered Materials paid for Funds debited Production begins Production begins Sale of products Shipping/InvoicingAccounts receivable cycle Disbursement Float Raw Materials Inventory Accounts Payable ycle
Work in process inventory Finished product Inventory
Payment mailed received Payment deposited ash availableProcessing float Bank float
INVESTMENT DECISION MATRIX INPUTFuture cash needs Other sources of cash Overall cash posture Degree of exposure (e.g. Investment as percent of current assets)
INPUTAcceptable Risk Acceptable Maturity Schedule
Forecasted Cash balance Capital needs Debt payment
Acceptable Liquidity
Preferred investment = high yielding instrumentsContingency cash available Volatility of cash forecast
INPUT
ACCOUNTS RECEIVABLE MANAGEMENT OBJECTIVES Cost of money Risk of bad debts Cost-free financing for customers
DEFINITION Effective conversion to liquidity position
GOALS Liquidity Risk minimization
CREDIT MANAGEMENT FUNCTION Analyzing credit risk Setting standards for deciding acceptable credit risk Specifying credit terms Deciding how to finance accounts receivable Determining who bears the credit risk Establishing collection policies & practices Avoiding sub-optimization by individual departments
CREDIT MANAGEMENT STRATEGIES OFFER PROMPT PAYMENT DISCOUNTS ENHANCE QUALITY OF ACCOUNTS BY GOOD CREDIT ANALYSIS CONTROL CREDIT LIMITS DEVELOP GOOD TERMS OF PAYMENT Use guarantees Use Drafts or bills of exchange Use commercial L / C MONITOR RECEIVABLES Days sale outstanding Aging Watching danger signals COLLECT DELINQUENT ACCOUNTS THROUGH AGENCY OR LEGAL MEANS
INVENTORY MANAGEMENT OBJECTIVES Cost of money Volatility of market Carrying cost Security Obsolescence Shipping / Lead time
DEFINITION Optimization of inventory levels & costs
GOALS Minimization of inventory levels Minimization of risks & cost
TYPES OF INVENTORIES
Raw materials
Work in process
STOCK
Finished goods
Spares & supplies
COST ASSOCIATED WITH INVENTORIES
Carrying CostStorage Insurance Taxes Cost
Ordering CostOrder-placing Setup
of capital Depreciation Obsolescence
costs Shipping Handling Discounts lost
Cost Related to Safety Stocks Loss of sales Loss of goodwill Production disruption
INVENTORY MANAGEMENT STRATEGY Develop inventory planning mechanisms Minimum / maximum levels EOQ Models Lead-time
Improve turnover Establish value analysis studies Employ ABC method Implement control reports Study JIT system
SHORT-TERM FINANCING Financing current assets Short-term credit Accounts payable Front-end arrangements
Financing by commercial banks Commercial loans Hold-out arrangements Back-to-back arrangements Bankers acceptances
Financing through accounts receivable A/R factoring A/R pledging
Financing inventories Trust receipts Vendors financing Consignment Inventory liens
END OF MODULE 3
FINANCIAL MANAGEMENT Module 4
PRINCIPLES OF INVESTMENTS
Time Value of Money
RISK
RETURN
VALUATION
UNDER WHAT CONDITIONS ARE INVESTMENT DECISIONS MADE
CONDITIONS OF CERTAINTYCONDITIONS OF UNCERTAINTY
WHAT IS RISK
DEFINITION Hazard, peril, exposure to loss or injury Potential of financial loss MARKOWITZ Variance about an asset's expected return
HOW IS TOTAL RISK DEFINED
TOTAL RISK
=
Unsystematic risk (Diversifiable, firm-specific )
+Systematic risk (Non-diversifiable, market related)
UNSYSTEMATIC A firms wizard is killed A wild cat strike A low cost competitor enters market Oil is discovered on a firms property
SYSTEMATIC Oil-producing countries institute boycott Congress votes for massive tax cut Restrictive monetary policy Precipitous rise in interest rates
WHAT ARE THE TYPES OF RISK ASSOCIATED WITH INVESTMENT DECISION
PRICE RISK
Value of an asset will decline in the future Inability to make timely principal payments & interest Adverse economic conditions Cash flow inadequacy to meet obligations
CREDIT RISK
MARKET RISK
CASH FLOW RISK
INFLATION
Decline in real return due to purchasing power riskValue change due to foreign exchange fluctuations Future investments will earn lower return Instruments are callable thus exposing investors to uncertainty & reinvestment risks Marketability of the assets
FOREX
REINVESTMENT RISK
CALL RISK
LIQUIDITY RISK
WHAT ARE THE ATTITUDES ASSOCIATED WITH RISK e ire for RISK Indifference to RISK
Aver ion to RISK
THE EFFECT OF THE IMINISHING MARGINAL UTILITY OF WEALTH
WHAT IS THE MARKOWIT TWO PARAMETER MODEL It assumes that there are only two parameters that investors consider in making decisions both for single asset or portfolio assets : The expected return The variance from expected return which measures the risk
It is also posits the risk-aversion principle HIGH RETURN-HIGH RISK PAYOFF
HOW CAN TWO-PARAMETER MODEL BE USED FOR INVESTMENT DECISION
Deciding between single assets on a mutually exclusive basis Deciding a portfolio investment
HOW IS RISK MEASURED IN SINGLE ASSET DECISIONPROBABILTY DISTRIBUTION FOR THE RATE OF RETURN OF XYZ STOCK n 1 2 3 4 5 Rate of Return 15 10 5 0 -5 Probability Distribution 0.50 0.30 0.13 0.05 0.02 1.00
EXPECTED RETURN E (Rxyz)=P1(R1)+P2 (R2)+P3 (R3)... Substitute the values = 11% VARIANCE Var (Ri)=P1[R1-E(Ri)2+ P2[(R2-E(Ri)]2+ Substitute the values = 24% STANDARD DEVIATION
SD(R i ) ! VAR(R i )
= 4.9%
HOW IS RISK MEASURED IN A TWO-ASSET PORTFOLIOGIVEN
PROBABILITY DISTRIBUTION FOR THE RATE OF RETURN FOR STOCKS XY AND ABCN 1 2 3 4 5 Total Expected Return Variance SD Rate of Return XYZ 15 10 5 0 -5 Rate of Return ABC 8 11 6 0 -4 Probability of Distribution 0.50 0.30 0.13 0.05 0.02 1.00
11% 24 4.9
8% 9 3
Var ( R p ) Wi 2Var ( Ri ) W j2 ( R j ) 2WiW j ( Ri R j ) whereCOV (RiRj) = covariance between return for assets i &j COVA IANCE = t gr t t i r t r t rn n r ng t g t r
ILLUSTRATION
CORRELATION = covariance of two assets divided by the product of their standard deviations.
DENOTES PERFECT COMOVEMENT IN THE SAME DIRECTION (values + 1.0 ) POSITIVE CORRELATION DENOTES PERFECT COMOVEMENT IN THEOPPOSITE DIRECTION (values - 1.0 ) NE ATIVE CORRELATION
WHAT IS PORTFOLIO DIVERSIFICATION Constructing a portfolio in such a way as to reduce to portfolio risk without sacrificing return. Creating a portfolio that is less risky than its component stocks especially negative relationships Two issues : How much should be invested in each class? Which specific stocks, bonds, real estate, etc.?
WHAT ARE THE STRATEGIES RELATED TO DIVERSIFICATION NAIVE DIVERSIFICATION Simply invests in a number of stocks or assets type & hopes that the variance of the expected return on the portfolio is lowered MARKOWIT DIVERSIFICATION Concerned with degree of covariance between asset return in a portfolio Combine assets with returns that are less than perfectly positively correlated in an effort to lower portfolio risk without sacrificing return
HOW IS MARKOWIT DIVERSIFICATION ILLUSTRATED
GIVEN : Stock C Stock D Weight E(R) 10% 25% 50% SD ( R ) 30% 60% 50%
Expected Return E(Rp) = 0.50 (10%) + 0.50(25%) =17.5%
HOW IS MARKOWIT DIVERSIFICATION ILLUSTRATED VARIANCE
HOW IS MARKOWIT DIVERSIFICATION ILLUSTRATEDSubstituting into the expression for var(Rp)
Taking the square root of the variance gives
PROBLEM How would the risk change for two-asset portfolio with different correlations between the returns of the component stocks? Assume three cases cor (RC,RD) : +1.0 and 1.0
cor (RC,RD) +1.0 0.0 -1.0
E(RP) 17.5% 17.5% 17.5%
SD(RP) 45.0% 35.0% 15.0%
WHAT ARE THE IMPLICATIONS OF PORTFOLIO VARIANCE AND COVARIANCE FOR DEVELOPING EFFICIENT PORTFOLIO Portfolio risk can be low even if individual assets risks are high By combining assets with lower (preferably negative) correlations, portfolio return is maintained & portfolio risk is lowered Riskiness inherent in any single asset held in portfolio is different from riskiness of that asset held in isolation
WHAT ARE OTHER WAYS TO MINIMI E RISK
Sensitivity analysis Range determination Insurance Hedging Forward covers & contracts Derivatives management
HOW IS DIVERSIFICATION ILLUSTRATEDWe ther COMA ANY A t L ti Conditions Sunny ye r Norm l ye r R iny ye r We ther COM ANY B Dis os le um rell s Conditions Sunny ye r Norm l ye r R iny ye r We ther PORFOLIO A B ( 50/50 investment ) Conditions Sunny ye r Norm l ye r R iny ye r Ret r on Stocks A = RA 33% 12% -9% Return on Stocks B = RB -9% 12% 33% Return on Portfolio P = RP .50 (33) + .50 (-9) = 12% .50 (12) + .50 (12) = 12% .50 (-9) + .50 (33) = 12%
END OF MODULE 4
FINANCIAL MANAGEMENT Module 5
WHAT IS TIME VALUE
Used to denote the relationship of value with time Used to measure return and risk expectations of investment decisions
WHAT ARE THE TIME VALUE DIMENSIONS
The present value formula : FV PVIFkn = ----------( 1+k )n n FV
PVIFAkn = 7 ----------t=1 ( 1+k )t n
The future value formula : FVIFkn = PV( 1+k )n
FVIFAkn = 7 PV ( 1+k )n-1 t=1
ILLUSTRATION
PRESENT VALUE FORMULA
Present Value Interest Factor (PVIF) Period 8% 10% Mixed Stream Annuity Mixed Stream Annuity 1 2 3 4 5 .926 .857 .794 .735 .681 .926 1.783 2.577 3.312 3.993 .909 .827 .751 .663 .621 .909 1.736 2.487 3.170 3.791
ILLUSTRATION
FUTURE VALUE FORMULA
Present Value Interest Factor (PVIF) Period 8% 10% Mixed Stream Annuity Mixed Stream Annuity 1 2 3 4 5 1.080 1.166 1.260 1.360 1.469 1.000 2.080 3.246 4.506 5.887 1.100 1.210 1.331 1.464 1.611 1.000 2.100 3.310 4.641 6.105
WHAT ARE THE SPECIAL USES OF TIME VALUE
Accumulating
a future
sum of money Estimating installment payments Determining growth rate or interest rate
COST OF BONDS
KB
(Par-NP) / n = RF + ----------------(Par+NP) / 2
1-taxrate
where: KB RF Par NP n
- cost of bond - risk-free coupon rate - unit denomination - net proceeds - maturity
ILLUSTRATION
KB
(Par-NP) / n = RF + ----------------(Par+NP) / 2
1-taxrate
KB
(P10,000 - P9,000) / 3 = 15% + ------------------------------(P10,000 + P9,000) / 2 = (15% + 3.5% ) (65%)
1-35%
= 12.025%
COST OF BANK LOANS / COMMERCIAL PAPERS( P - NP ) / n ----------------( P + NP ) / 2
KL/CP = RF + Premium
1-taxrate
where: K L/CP - cost of loan or commercial paper RF - riskfree coupon rate Premium - add-on cost over benchmark P - principal NP - net proceeds n - maturity
ILLUSTRATION (P-NP) / n KL/CP = RF + Premium + ----------------(P+NP) / 2
1 - taxrate
(P50,000 - P48,000) / 3 KL/CP = 18% + 1.5%+ ------------------------------(P50,000 + P48,000) / 2 = (18% + 1.5% + 1.4%) (65%)
1-35%
= 13.585%
COST OF PREFERRED STOCK
KPS
Par Value x Dividend Rate = --------------------------------------NP
Illustration P10,000 x 20% = -------------------------P12,000
KPS
= 16.666%
COST OF COMMON STOCK AND RETAINED EARNINGSA. ero-growth Model where: KCS - cost of common stock D D - zero-growth dividend KCS = ----------P - market price P or NP NP - net proceeds B. Constant Growth Model D where: g - growth rate KCS = ------------ + g P or NP C. CAPM Model where: RF - risf-free rate F - beta KCS = RF + [ F(Mr - RF)] Mr - market return
ILLUSTRATION A. ero-growth Model P2.00 KCS = ----------= 16.666% P12.00 B. Constant Growth Model P2.00 KCS = ------------ + 5% P12.000 C. CAPM Model
= 21.666%
KCS = 20% + [ 0.5 ( 30 - 20 )] = 20% + 5%
= 25%
WHAT IS COST OF CAPITAL User point of view amount paid to suppliers of capital for the privilege of using their funds
Investor point of view return generated and obtained from the users of capital
Business point of view cost of doing business from using capital return generated for employing capital
WHAT IS WEIGHTED AVERAGE COST OF CAPITALThe summation of capital costs based on financing mix/component proportions The formula is :
C1 C2 C3 WACC = ---- (K1) + ---- (K2) + ---- (K3) + . . . TC TC TC
where: WACC - weighted average cost of capital TC - total capital C - component capital K - cost of component capital
ILLUSTRATION
Bonds Loans Preferred Common Retained Earnings Capital
30% 20% 10% 30% 10% 100%
x x x x x
12.025 13.585 16.666 25.000 25.000
= 3.607% = 2.717% = 1.666% = 7.500% = 2.500%
WACC = 17.990%
END OF MODULE 5
FINANCIAL MANAGEMENT Module 6
CORPORATE PLANNING TIME HORI ON
1. Strategic Planning
2. Long-ter
Planning
3. Short-ter
Planning
BUDGETING Process of developing financial plans Process of translating plans in quantitative terms
BUDGETS
Plans, programs, and targets expressed in financial terms planning tool and score card
TYPES OF BUDGETSOperating Budgets
Sales Production Materials Purchases Direct Labor Overhead Selling General & Administration
Financial Resources Budgets Cash Financial Position
Master Budgets Zero-based Budgets Capital Expenditure Budgets
BUDGETING FLOWCHARTSales Budget Production Budget Budgeted Materials Cost Long-Range Sales Outlook Gen. & Admin. Expenses Budget Capital Expenditure Budget
Selling Expenses Budget Budgeted Labor Cost
Factory Overhead Budget
Cash Budget Financial Budget
USES OF BUDGET
For planning & control For decision-making For establishing
standards of performance For effectiveness & efficiency measures For programming For investments decision For direction-setting
PROBLEMS WITH BUDGET Unrealistic forecast Unreliable forecasting tools Behavioral dimensions Lack of coordination Lack of commitment Communication problem Lack of management
interest & support Static Lack of effective measurements
APPROACH TO EFFECTIVE BUDGETING
TOP DOWN
BOTTOM UP
Involves top management direction & support Coordinated effort Consensus attained
PARTICIPANTS IN BUDGETINGENTITY
ACTIVITY Sets direction establishes parameters composes committee Approves budget Coordinates activities Issues specific guidelines Collates & reviews
Top Management
Budget Committee
Develops unit budgets within Responsibility Centers Reviews and collates
CAPITAL BUDGETINGUnder Uncertainty
PROCESS
DECISIONS
TECHNIQUESUnder Certainty
WHAT IS CAPITAL BUDGETING
Process of planning expenditures with returns that extend beyond one year Conducted under conditions of certainty or uncertainty
WHY PLAN CAPITAL EXPENDITURES Huge amount of outlay Long gestation period Risky Availability of financing Unpredictability of returns Unpredictability of cashflow Decision choices Rationing/allocation of capital Conditions of certainty vs. certainty
UNDER WHAT FRAMEWORK SHOULD CAPITAL BUDGETING BE INTEGRATED
Integrated with:
STRATEGIC PLANNING FRAMEWORK
WHAT ARE THE CATEGORIES OF CAPITAL BUDGETING DECISIONS Project size Effect on business risk Cost reduction & revenue increase Replacements Expansion Growth Mandatory/intangible investments Degree of independence Administrative aspects
WHAT ARE THE EVALUATION CRITERIA FOR RANKING CAPITAL BUDGETS
Cash payback (CP) Discounted cashpayback (DCP) Accounting rate of return (ARR) Net present value (NPV) Internal rate of return (IRR) Profitability index (PI)
WHAT ARE THE GENERAL PRINCIPLES IN ARRIVING AT OPTIMAL CAPITAL BUDGETING DECISIONS Consider all cash flows Discount cash lows at appropriate marketdetermined cost of capital Select projects that maximizes shareholders wealth Allow managers to consider each project independently from all others (known as value additivity principle)
WHAT ARE THE APPROACHES TO CAPITAL BUDGETING UNDER UNCERTAINTY
Sensitivity Analysis Monte Carlo Simulation Decision Tree CAPM
HOW IS DECISION TREE ANALYSIS ILLUSTRATED
Build big plant at P5.0 M
Demand PV of Less Action Cond. Prob CV Initial (1) (2) (3) (4) Cost H M L 50 P8.8 M P5.0 M 30 P3.5 M P5.0 M 20 P1.4 M P5.0 M Expected NPV H M L
Possible Probable NPV NPV (4)-(5) (3)x(6) P3.8 M P1.900 M (P1.5 M) (P0.450 M) (P3.6 M) (P0.720 M) P0.730 M
1
Decision
2Build small plant at P2.0 M
50 P2.6 M P2.0 M P0.6 M P0.300 M 30 P2.4 M P2.0 M P0.4 M P0.120 M 20 P1.4 M P2.0 M (P0.6 M) (P0.120 M) Expected NPV P0.300 M
VALUATION APPROACHES How are assets valued/priced
Present Value Method Capitalization Method Book Value Method Net Asset Value Method Price-Earnings Method Dirty Asset Value Method
END OF MODULE 6