formulas for calculating finance

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Business Finance

Table of Contents

4Chapter 1: The World of Finance

41.0Introduction

41.1.Importance of Financial Statements

51.2.Understanding Profit and Loss Accounts

61.3.Understanding Balance Sheet

9Chapter 2 : Analysis of Financial Statement

92.0Introduction

92.1.Assessing Financial Health

92.2.The Basics Financial Ratios

162.3.Trend Analysis and Industry Comparisons

18Chapter 3 : The Time Value of Money

183.0Introduction

183.1.Why Money Has Time Value

183.2.Measuring the Time Value of Money

193.3.The Present Value of a Single Amount

253.4.Working with Annuities

293.5.Special Time Value of Money Problems

31Chapter 4 : Capital Budgeting Decision Methods

314.0Introduction

314.1.The Capital Budgeting Process

324.2.Capital Budgeting Decision Methods

404.3.Capital Rationing

414.4.Risk and Capital Budgeting

42Chapter 5 : Capital Structure Basics

425.0Introduction

425.1.Breakeven Analysis and Leverage

445.2.Leverage

465.3Capital Structure Theory

47Chapter 6 : Working Capital Policy

476.0Introduction

486.1.Managing Working Capital

486.2.Why Business Accumulate Working Capital

496.3.Liquidity Versus Profitability

496.4.Establishing the Optimal Level of Current Assets

516.5.Managing Current Liabilities: Risk and Return

526.6.Three Working Capital Financing Approaches

546.7.Working Capital Financing and Financial Ratios

56Chapter 7 : Managing Cash

567.0Introduction

567.1.Cash Management Concept

577.2.Determining the Optimal Cash Balance

577.3.Forecasting Cash Needs

587.4.Managing the Cash Flowing In and Out of the Firm

Chapter 1: The World of Finance

1.0 IntroductionFinance is the process by which money is transferred among businesses, individuals and governments through the process of financing and investing. It also can be defined as the application of the principles of financial economist to an inter-related set of monetary problems.1.1. Importance of Financial StatementsFinancial statements are formal records of the financial activities of a business, person, or other entity. Financial statements provide an overview of a business or person's financial condition in both short and long term. All the relevant financial information of a business enterprise, presented in a structured manner and in a form easy to understand, is called the financial statements. There are four basic financial statements:1. Balance sheet: also referred to as statement of financial position or condition, reports on a company's assets, liabilities, and Ownership equity at a given point in time.

2. Income statement: also referred to as Profit and Loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. Profit & Loss account provide information on the operation of the enterprise. These include sale and the various expenses incurred during the processing state.

3. Statement of retained earnings: explains the changes in a company's retained earnings over the reporting period.

4. Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities

These financial statements are importance to the stakeholders of a company in order to assess the companys financial health. Financial analysis will be carried out in order to evaluate a companys performance. The assessment will be done to determine the companys past, present and anticipated future financial performance. 1.2. Understanding Profit and Loss Accounts

Profit and Loss accounts (P&L) is also known as Income Statement. A firms income statement represents a summary of the firms operating results over a period, normally for 1-year period.

IIFC Products Bhd

Income Statement for year ended Dec 31, 2009 (in RM`000)

Net Sales1,500

Cost of Goods Sold750

Gross Profits750

Operating expenses30

Depreciation Expense180

Earnings before interest and tax (EBIT)540

Interest expense40

Earnings before tax500

Taxes (40%)200

Earnings after tax (Net Income)300

Preferred stock dividend7

Earnings available to common stock holders (EACS)293

Common Stock dividends200

Addition to Retained Earnings93

Table 1.1 Income Statement of IIFC Products Bhd

The above table presents IIFC Products Bhds income statement. The 2009 statement begins with Net sales; the total RM amount of sales during the period, from which cost of goods sold, is deducted. The resulting gross profits of RM 750,000 represent the amount remaining to satisfy operating, financial and tax costs.

Operating expenses include selling expense, general and administrative expense, leasing expense and depreciation expense are deducted from gross profits to get the operating profit. Operating profit or earnings before interest and tax (EBIT) represent the profits earned from producing and selling products, without considering financial and tax costs.

Interest expense, which is the financial cost, will be subtracted from operating profits to find net profit before tax. Taxes then is calculated at the appropriate tax rates (in the example, the company has a 40% tax bracket) and deducted to determine the net profits after tax.

Any preferred stock dividend must be subtracted from net profit after tax to arrive at earnings available to common stockholders. This is the amount earned by the firm on behalf of the common stockholders during the period. The earning available to common stockholders will then be divided into two portions: common stock dividend and addition to retained earnings.1.3. Understanding Balance Sheet

Balance sheet presents a quantitative summary statement of a companys financial position at a given point in time, including assets, liabilities and shareholders equity or net worth. The first part of a balance sheet shows all the productive assets a company owns and the second part shows all the financing methods (such as liabilities and shareholders equity).

IIFC Products Bhd

Balance Sheet for year ended Dec 31, 2009

Current AssetsCurrent Liabilities

Cash108,000Account Payable178,200

Marketable Securities103,500Notes Payable4,050

Accounts Receivable124,200Accruals21,330

Inventories9,000Total Current Liabilities203,580

Total Current Assets344,700Long Term Debt202,500

Net Fixed Assets306,000Total Liabilities406,080

Total Assets650,700Shareholders' equity

Preferred Stock40,000

Common Stock64,620

Retained Earnings140,000

Total liabilities and shareholders' equity650,700

Table 1.2 Balance Sheet of IIFC Products Bhd

The above table presents IIFC Products Bhds balance sheet. The statement balances the firms assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners). The firms assets are further sub-divided into current assets (expected to be converted into cash within one year or less) and fixed asset. The same situation applies to the firms liabilities, which are divided into current liabilities (expected to be paid within one year or less) and long term liabilities.

As is customary, the assets and liabilities are listed from the most liquid to the least liquid. Liquidity depend on how easy the assets or liabilities can be converted into cash.

Current Assets

The components of current assets are cash and other assets that are consumable or convertible to cash in a relatively short time less than 1 year. It represents working capital of the firm that provides support for day-to-day operation

1. Marketable securities: very liquid short term investments, such as Treasury Bills and Certificate of deposit held by the firm. Since they are very liquid, marketable securities are viewed as a form of cash. They are also known as near cash money2. Account receivable: represent the total money owed to the firms by its customers on credit sales made to them

3. Inventories: include raw materials, work in progress (partially finished goods) and finished goods held by the firm.

Fixed Assets

Fixed assets such as equipment, lands and buildings are acquires for long-term use and cannot easily converted into cash within a short period without losing its value.

1. Net Fixed assets: represent the difference between gross fixed assets (the original cost of all long term assets owned by the firm) and accumulated depreciation (total expense recorded for the depreciation of fixed assets)Current Liabilities

Current liabilities are obligations due and payable within a period of 1 year or less

1. Account payable: amounts owed by the firm for credit purchases that they made.

2. Notes payable: outstanding short term loans

3. Accruals: amounts owed for services for which a bill may not or will not be received. For example taxes due the government and wages due employees.

Long Term Debt

Long term debt is debt due or payable beyond 1-year period

1. Long term debt: represents debt for which payment is not due in the current year. For example is bond, term loan, debentures and mortgage.Shareholders Equity

Represents ownership positions in the firm:1. Preferred stock: also called preferred shares, preference shares, or simply preferreds, is a special equity security that resembles properties of both an equity and a debt instrument and is generally considered a hybrid instrument

2. Common Stock: a form of corporate equity ownership. The common stockholders are the owners of the firm

3. Retained Earnings: the cumulative total of all earnings that have been retained and reinvested in the firm since its inception.

Chapter 2 : Analysis of Financial Statement 2.0 Introduction Financial analysis is the assessment of a firms past, present and anticipated future financial performance. The analysis is made based on the firms financial statements (i.e balance sheet, income statement, statement of cash flow and statement of retained earnings). It involves looking at historical performance to estimate future performance. It allows comparison of the companys performance overt time as well as its performance in comparison with its competitor in the same industry. Financial analysis helps an individual to check whether a business is doing better this year than it was last year, or whether it is doing better or worse than other companies in the same industries.2.1. Assessing Financial HealthA companys financial health can be assessed by looking at its financial statements. The company will be considered as financially healthy when its performance outperformed other companies in the same industry and also outperformed the industrys benchmark. The need to identify a companys strengths and weaknesses is a must so that it can capitalize on this strength and take remedial and corrective actions to improve its weaknesses. The principal tool of financial analysis is financial ratios.2.2. The Basics Financial Ratios

Financial ratios are divided into five main categories; liquidity ratios, efficiency/activity ratios, leverage ratios, profitability ratios and market value ratios. To illustrate how these ratios are calculated and interpreted, we will refer to the balance sheet and income statement of IIFC Products Bhd in table 1.1 and 1.2 from previous chapter.

1. Liquidity RatiosLiquidity ratios show a firms ability to meet its short term financial obligations. In other words, they show whether the firm has the resources to pay its creditors when payments are due. The higher the ratios, the easier for the firm to meet its obligations. Among the commonly used ratios are:

a. Current Ratio

Current Assets_ Current Ratio

= Current Liabilities

= 344,700

203,580

= 1.69 timesHaving a ratio of 1.69 times means, for every RM1 of current liabilities, the firm has RM1.69 of current assets as back up. b. Quick/Acid Test Ratio

Current Assets InventoriesQuick/Acid Test Ratio

= Current Liabilities

= 344,700 9,000

203,580

= 1.65 timesThis ratio indicates whether a firm has enough current assets to cover its current liabilities without selling its inventories. Based on the above calculation, the firm still has RM1.65 for every RM1 of liabilities that they have, without having to sell its inventory.2. Efficiency/Activity RatiosThese ratios measure how effectively the firm is managing its assets in generating sales. They show the amount of sales generated for every dollar of assets investment

a. Inventory Turnover Ratio Cost of Goods Sold (COGS)Inventory Turnover Ratio= Inventories

= 750,000

9,000

= 83.33 timesThis ratio indicates how many times the inventory is sold and replaced in a year. The higher the ratio, the faster the stock is being sold, the more efficient the firm in managing its inventories. Based on the calculation above, the firm manages to sell its inventories 83.33 times per year. It shows that the company is efficient in managing its inventory.b. Average Collection Period (ACP) ____Account Receivable____Average Collection Period (ACP)= Annual Credit Sales/360 days

= ___124,200___

1,500,000/360

= 29.80 daysThis ratio indicates the number of days taken by a firm to collect its account receivable from its debtors. The shorter the days, the more effective the firm in managing its account receivable. IIFC Product Bhd takes 29.8 days to collects its debts.c. Fixed Asset Turnover

_____Sales_____Fixed Asset Turnover

= Net Fixed Assets

= 1,500,000

306,000

= 4.9 timesThis ratio measures the firms efficiency in utilizing its plant, equipment and other fixed assets in generating sales. The above calculation shows that the firm turnover its fixed assets 4.9 times a year.d. Total Asset Turnover

___Sales__Total Asset Turnover

= Total Assets

= 1,500,000

650,700

= 2.3 timesThis ratio indicates the firms efficiency in managing its assets to generate sales. The above calculation shows that the firm turnover its total assets 2.3 times a year. The higher a firms total assets turnover, the more efficiently its assets have been used.3. Leverage RatiosThe term leverage of gearing refers to the use of borrowed capital or loans. Leverage ratios measure the level of debt or borrowings in a firm. They tell us whether the company depends more on the debt financing or equity financing. They also highlight the ability of the firm to honour its medium and long term debt commitments in terms of repayment of the principal as well as the interest charges.a. Debt Ratio

_Total Debt_Debt Ratio

= Total Assets

= 446,080

650,700

= 0.6855 @ 68.55%Based on the above calculation, the firm shows that 68.55% of its assets is financed by debt, while the balance are finance by shareholders equity. This shows that the company is highly dependent on debt. Creditors and financial institutions will prefer a company with a lower debt ratio.b. Debt to Equity Ratio _Total Debt_Debt to Equity Ratio= Total Equity

= 446,080

204,620

= 2.18This ratio measures the relative funds provided by creditors as compared to owners or net worth in the firms capital structure. Ratio more than 1 means creditors provide more funds compared to owner.

c. Times Interest Earned @ Interest Coverage RatioTimes Interest Earned

= Earnings Before Interest and Tax (EBIT)

Interest Expense

= 540,000

40,000

= 13.5 timesThis ratio measures the firms ability to cover its interest charges out of its operating profits. The higher the ratio, the higher is the firms ability to fulfill interest obligations. Based on the above calculation, the firm is able to pay its interest obligations 13.5 times with the amount of operating profits that it has.

4. Profitability RatiosThese ratios measure how effectively the firm uses its assets to make profits. Profitability ratios show the profits earned for every single dollar of sales made or the profits earned for every investment in assets made.a. Gross Profit Margin (GPM) Gross ProfitGross Profit Margin (GPM)= Sales

= _750,000_

1,500,000

= 50%The above calculation shows that the firm manages to generate RM0.50 of gross profit for every RM1 of sales made. It shows the efficiency of the company in controlling its cost of goods sold.

b. Operating Profit Margin Earnings Before Interest and Tax (EBIT) Operating Profit Margin= Sales

= _540,000_

1,500,000

= 36%The above calculation shows that the firm manages to generate RM0.36 of operating profit for every RM1 of sales made

c. Net Profit Margin

Earnings Available to Common Stockholders Net Profit Margin

= Sales

= _293,000_

1,500,000

= 19.53%The above calculation shows that the firm manages to generate RM0.1953 of net profit for every RM1 of sales made

d. Return on Assets (ROA) Earnings Available to Common StockholdersReturn on Assets (ROA)= Total Assets

= _293,000_

650,700

= 45.03%This ratio also known as Return on Investments (ROI). It indicates the ability of the firm to generate profits out of the firms investments in assets. The above calculation shows that for every RM1 of total assets that the firm has, it will be able to generate RM0.4503 of profits.

e. Return on Equity (ROE) Earnings Available to Common Stockholders

Return on Equity (ROE) =

Total Equity

= _293,000_

204,620

= 143.19%ROE measures the profit earned by common stockholders from their investment in the firm. Based on the above calculation, for every RM1 of investment the shareholders made, it will be able to generate RM1.43 of return to them.5. Market Value RatiosThese ratios relate a firms stock price to its earnings and book value per share. They give the management an indication of what investors think of the firms past performance and future prospect. Market ratios are the result of the firms overall performance.Given that IIFC Products Bhds ordinary shares issued is 200,000 shares and its current market share price is RM25.

a. Earnings Per Share (EPS) Earnings Available to Common Stockholders Earnings Per Share

= Number of ordinary shares issued

= _293,000_

200,000

= RM1.465This ratio indicates the profit earned per unit of issued share. The above calculation shows that IIFC Products Bhds shareholders are getting RM1.465 for each share held in the firm

b. Dividend Per Share (DPS) _______Ordinary Dividends_______ Dividend Per Share

= Number of Ordinary Shares Issued

= _200,000_

200,000

= RM1.00This ratio indicates the total amount of dividend received by ordinary shareholders for each unit of ordinary share held. Based on the above calculation, it shows that the shareholder will receive RM1 of dividend of each share that they have.c. Dividend Payout Ratio (DPR) _Dividend Per Share_Dividend Payout Ratio

= Earnings Per Share

= _RM1.00_

RM1.465

= 0.68

Dividend payout ratio indicates the proportion of earnings that is distributed as dividends to shareholders. The above calculation shows that the firm distributes 68% of its earnings to the shareholders and retained 32% of the balance for reinvestment and other purposes.d. Price/Earnings Ratio

_Market Price Per Share_ Price/Earnings Ratio

= Earnings Per Share

= _RM25.00_

RM1.465

= 17.06 times

This ratio measures the amount that investors are willing to pay for each dollar of a firms earnings. The 17.06 shows that the investors were paying RM17.06 for each RM1 of earnings.2.3. Trend Analysis and Industry ComparisonsRatio analysis is not merely the calculation of the given ratio. A meaningful basis for comparison is needed to determine the value of the company. Two types of ratio comparisons can be made: trend analysis or also known as time series and comparative analysis or cross sectional.

1. Trend analysisIt is also known as time series analysis, which evaluates performance of the company over time. Comparisons are made between current to past performance using ratios to assess the companys progress.

2. Cross sectional

This analysis involves the comparison of different companies financial ratios at the same point in time. Unlike trend analysis, ratios of other companies within the same industry are needed in order to analyze the performance of the company. Analysts are often interested in how well a company has performed in relation to other companies in the same industry.Chapter 3 : The Time Value of Money

3.0 IntroductionTime Value of Money (TVM) simply means a dollar received today is worth more than the same dollar received in the future. An understanding of how time value of money works is very crucial in financial management as it will enable us to further understand how stocks and bonds are valued, how to decide on the capital budgeting and many more.Given example, during your parents time when they went to school, your grandparents most likely would give them around RM0.10 as their pocket money. At school, they would be able to buy foods and drinks with that amount of money. If you give your children, the same amount of pocket money that your parents got (i.e RM0.10), would your children be able to buy foods and drinks too? I bet that they would only manage to buy a sweet.

Here we can see that, the same RM0.10, over some period of time, would value less in the future. This situation proofs the rule of thumb which says that a dollar received today is worth more than the same dollar received in the future.

3.1. Why Money Has Time ValueIn reality, we could earn interest over investment period if you make an investment. The reason is that the more time taken, the more interest you may earn. That is the trade off between time and money.In other words, the investors would be compensated for his waiting time in making their investment. This is due to the fact that investors willing to forgo their current consumption in expectation of future earnings. TVM would encourage more investment to be done since investors are aware of the benefits of their investments. 3.2. Measuring the Time Value of Money

A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today. Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date.Time Value of Money can be further subdivided into two; a) Present Values (PV)b) Future Values. (FV)There are also two situations involving TVM, which are for single cash flow and annuity.3.3. The Present Value of a Single Amount

Future Value and CompoundingCompound interest means interest is earned not only on the principal or initial investment but also on the interest earned earlier. Future value of a current amount is therefore determined by applying compound interest over a specified period of time. To simplify, future value is the value to be received in the future, given a value today. For example you invest RM1, 000 today in a unit trust account that is paying 4% interest per year for 4 years, how much money will you earn in 4 years? This is what we call as compounding.Example 1:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded annually.In order to answer this question, we have two options; formulae or present value interest factor (FVIF) table.

a. Formulae

FV = PV (1 + i )nwhere;

PV= Present Value of the future sum of money

FV= Future Value of an investment at the end of n years

i = annual discount rate

n= number of years before payment is received

To answer the question;

FV= PV (1 + i )n

= 7, 000 ( 1+0.1)4

= 10,248.70

b. Future Value Interest Factor (FVIF) table

FV= PV (FVIFI,n)

= PV (FVIF10%,4)

= 7, 000 (1.464)

= 10,248.00

Example 2:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded semi annually.

In this question, the investor will receive interest twice in a year. Do take note that the interest quoted in the question will be interest per annum. Since investors will be paid twice a year, that means the number of times interest will be paid, n, also will change. So does the interest on the investment.n = 4 years x 2 times per year

= 8

i

= 10% per annum / 2 times a year

= 5%

a. Formulae

FV= PV (1 + i )n

= 7, 000 ( 1+0.05)8

= 10,342.19

b. Future Value Interest Factor (FVIF) table

FV=PV (FVIF5%,8)

= 7, 000 (1.477)

= 10,339.00

Example 3:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded quarterly.

n = 4 years x 4 times per year

= 16

i


= 2.5%

FV= PV (1 + i )n

= 7, 000 ( 1+0.025)16

= 10,391.54

For this question, we cannot use the table since table only provide round numbers, with no decimal points. The only method that can be used is only using the formulae

Example 4:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded monthly.

FV= PV (1 + i )n

= 7, 000 ( 1+0.1/12)48

= 10,425.48

Example 5:

Find the future value of RM7, 000 to be invested for 4 years at 10% compounded daily.

FV= PV (1 + i )n

= 7, 000 ( 1+0.1/365)4x365

= 10,442.20

Present Value and Discounting

The present value is the value today of a sum of money to be received in the future. Take for example you know that in 5 years time, you will need RM50, 000 as a down payment of your dream house. By using the concept of time value of money, you could determine how much money that you need to deposit today in a fixed deposit account paying i.e 7% per year, in order for you to have RM50, 000 in 5 years. This can be referred to as discounting.Example 1:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded annually?In order to answer this question, we have two options; formulae or present value interest factor (PVIF) table.

a. Formulae

PV = __FV__

(1+i)n

where;

PV= Present Value of the future sum of money

FV= Future Value of an investment at the end of n years


n= number of years before payment is received

To answer the question;

PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.08)3= 3,969.16b. Present Value Interest Factor (PVIF) table

PV= FV (PVIFI,n)

= FV (PVIF8%,3)

= 5, 000 (0.7938)

= 3,969.00There are also situations whereby the investment made is paid interest more than once in a year. In this situation, the present value of such investment will differ than those with annual compounding.

Example 2:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded semi annually?

In this question, the investor will receive interest twice in a year. Do take note that the interest quoted in the question will be interest per annum. Since investors will be paid twice a year, that means the number of times interest will be paid, n, also will change. So does the interest on the investment.n = 3 years x 2 times per year

= 6

i


= 4%

a. Formulae

PV = __FV__

(1+i)n

= __5, 000__


PV= FV (PVIF4%,6)

= 5, 000 (0.7903)

= 3,951.50Example 3:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded quarterly?

n = 3 years x 4 times per year

= 12

i = 8% per annum / 4 times a year

= 2%

a. Formulae

PV = __FV__

(1+i)n

= __5, 000__


PV= FV (PVIF2%,12)

= 5, 000 (0.7885)

= 3,942.50Example 4:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded monthly?

PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.1/12)36

= 3,708.70For this question, we cannot use the table since table only provide round numbers, with no decimal points. The only method that can be used is only using the formulae.

Example 5:

What is the present value of RM5, 000 to be received 3 years from today if the required rate of return is 8% compounded daily?

PV = __FV__

(1+i)n

= __5, 000__

(1+ 0.1/365)3x365= 3,704.243.4. Working with Annuities

An annuity is a series of equal payments made at fixed intervals for a specific number of periods. For example, depositing RM1,000 at the end of the next five years is called a five-years annuity. Annuity is divided into two main types:1. Ordinary annuity: payments made at the end of each period (i.e payment of Astro bills)2. Annuity due: payment made at the beginning of each period (i.e rental payments)Future Value of an Ordinary Annuity

Example:

If you make a deposit of RM500 at the end of each period for five years in a bank which pays 10% interest per year, how much will you have at the end of five years?

To answer this question, we can either use a formulae or the table

a. Formulae

FVA= PMT (1+i )n - 1 i

where:

FVA= the total future value at the end of n periods

PMT= the equal payments made for each period


n= number of payments made

FVA= 500 (1+0.1)5 1

0.1

= RM3, 052.55

b. Future Value Interest Factor Annuity (FVIFA) table

FVA= PMT (FVIFA I,n)

= 100 (FVIFA10%,5)

= 500 (6.1051)

= RM3,052.55Future Value of an Annuity Due

Example:

If you make a deposit of RM500 at the beginning of each period for five years in a bank which pays 10% interest per year, how much will you have at the end of five years?

a. Formulae

FVAD= PMT (1+i )n 1 1+i

i

where:

FVA= the total future value at the end of n periods




FVAD= 500 (1+0.1)5 1 1+0.1

0.1

= RM 3,357.81b. Future Value Interest Factor Annuity (FVIFA) table

FVA= PMT (FVIFA I,n) (1+i)

= PMT (FVIFA10%,5)(1+0.1)

= 500 (6.1051)(1+0.1)

= RM3,357.81Present Value of an Ordinary AnnuityExample:

Suppose a firm expects to receive future car loans payments of RM100 per year for the next five years from one of its customers. The first payment is due one year from today. The interest imposed on the debt is 5% per year. How much money does the customer owe to the firm?a. Formulae

PVA= PMT (1+i )n 1 i (1+i)nwhere:

PVA= the total present value of n annuity




PVA= 100 (1+0.05)5 1

0.05(1+0.05)

= RM432.94

b. Present Value Interest Factor Annuity (PVIFA) table

PVA= PMT (PVIFAi,n)

= 100 (PVIFA5%,5)

= 100 (4.3295)

= RM432.95Present Value of an Annuity DueExample:

Suppose a firm expects to receive future car loans payments of RM100 per year for the next five years from one of its customers. The first payment is due today. The interest imposed on the debt is 5% per year. How much money does the customer owe to the firm?

a. Formulae

PVAD= PMT (1+i )n 1 1+i

i (1+i)nwhere:

PVA= the total present value of n annuity




PVAD= 100 (1+0.05)5 1 1+0.05

0.05(1+0.05)

= RM454.60

b. Present Value Interest Factor Annuity (PVIFA) table

PVA= PMT (PVIFAi,n)(1+i)

= 100 (PVIFA5%,5)(1+0.05)

= 100 (4.3295)(1.05)

= RM454.603.5. Special Time Value of Money ProblemsProblem 1

Hasan currently has RM10, 000 that he can use to purchase inventory for his custom T-shirt shop. His supplier says RM10, 000 is not enough for the current shipment but that he will agree to sell a similar load of T-shirts in one year for RM10, 800 or in two years for RM11, 500. Hasan can invest his money for one year at an annual interest rate of 6% or for two years at an annual rate of 7%. Which choice can Hasan afford?

Option 1: Invest for one year @ 6%

FV= RM10,000 (1+0.06)1

= RM10,600

Hassan cannot afford to buy the T-shirt in one year time since the supplier will charge him for RM10,800

Option 2: Invest for two years @ 7%

FV= RM10,000 (1+0.7)2

= RM11,449

Hassan also cannot afford to buy the T-shirt in two years time since the supplier will charge him for RM11,500 whereas his investment could only be RM11,449.Therefore, Hassan cannot afford either one of the options given by the supplier to him.Problem 2

Kassim and Haini want to make a down payment of RM25, 000 on a condominium when they retire in three years. If they can earn 8% on their investments, how much money do they need to invest today to have enough for the down payment?

PV= __25,000__

(1+0.08)3

= RM19, 845.81

Therefore, they need to invest RM19, 845.81 today for them to be able to get RM25,000 in three years time.

Problem 3Your firm is planning to invest $25,000 per year in equal annual end-of-the-year cash flows to fund an employee retirement plan. If the investments are expected to earn 8% per year, how much will the account be worth in 20 years?

FVA= PMT (1+i )n - 1i

= 25,000 (1+0.08)20 1

0.08

= RM1, 144, 049.11Problem 4

The average annual cost of higher education at a public university is approximately $12,000 per year. If we assume those costs are lump sum beginning-of-the-year payments, and the appropriate cost of capital is 7%, what is the present value cost of four years of higher education?

PVA= Pmt (1+i )n 1 1+i

i(1+i)

= 12,000 _(1+0.07)4 1_ 1+0.07

0.07(1+0.07)

= RM43, 491.78

Chapter 4 : Capital Budgeting Decision Methods

4.0 Introduction

When the company needs to decide whether to invest in a new project, the financial manager has to focus on companys cash flow and cost involved to be used to evaluate the investments. Thus, the financial manager has to determine the relevant revenues and expenditures, that is the cash inflow and cash outflow, so that it may establish the maximum return to the company in those investments.

The purpose of this chapter is to evaluate and decide whether to purchase new equipment, the acquisition of property or acquisition of another company. Therefore the best project can give a maximum return from the companys investment.

4.1. The Capital Budgeting Process

The process of capital budgeting involves the calculation of incremental cash flows against the investment decision and thus evaluate the cost involved in the projects.

The process of capital budgeting involved four steps which is as follow :

a. Estimates the cash flows after tax from investment.

b. Consider the risk involved associated to the investment.

c. Choose the best methods to evaluate the project ; non-discounted method and discounted method.

d. Make a best decision to ensure those investments provides a positive return to the companys value. The decision is based on mutual exclusive investment and/or independent investment. Mutual exclusive investment decision refer to a decision on choosing the best project (only 1 project) which gives the positive result to the company while independent investment is refer to the decision of choosing more than 1 project as long as that project give the highest value to the company.

4.2. Capital Budgeting Decision Methods

The capital budgeting process can be determined by using 2 cash flow methods i.e.

Non-discounted cash flow and discounted cash flow method.

4.2.1 Non-discounted cash flow method

This method does not consider the time value of money in calculating and analyze the capital investment. Under this method, there are two techniques that commonly used by Financial Manager to calculate and evaluate the best investment i.e. Average Rate of Return and Payback Period.

The following is the example which will be used to calculate all the techniques.

Shasha Farzana is the Financial Manager for RIDZ Sdn Bhd. She needs to considering the potential investment for company i.e. Project A and Project B which can maximize the companys return. The below table shows the detail of each projects :

YearProject AProject B

1RM2,500RM2,500

2RM2,500RM700

3RM2,500RM3,300

Total InflowRM7,500RM6,500

Initial OutlayRM5,000RM5,000

The Accounting Rate of Return (ARR)

This method is to measures the average on profitability of proposed capital investment as the ratio of average net income after tax to the average investment.

ARR=Average Net Income After Tax

Average Investment

Where :

Average Net Income After Tax= Net Income / n

Average Investment

=(IO + SV) / 2

Where :

IO

:Initial Investment

SV

:Estimated salvage value of the investment

n

:Number of years

Illustration 1;

Refer to example above, calculate the average rate of return for both projects and decides the project to be invested when the minimum average rate of return is 80%.

ARRA=[ (2,500 + 2,500 + 2,500) / 3 years]

[ (5,000 + 0) / 2]

=(2,500 / 2,500) X 100

=100%

ARRB=[ (2,500 + 700 + 3,300) / 3 years]

[ (5,000 + 0) / 2]

=(2,167 / 2,500) X 100

=87%

As an investment criterion, the highest average rate of return is favorable as its represents a greater return on average. Therefore;

Independent project : The company should accept both projects since the rate of returns are above than the minimum average rate of return.

Mutually exclusive project : The company should adopt Project A only as it gives the highest return than Project B.

The Payback Period (PB)

The payback period method focuses on the time value of money and uses cash flow after tax, instead of net profit in evaluating an investment. This method use to measure the length of time that the company needs to consider to recover back the cost of investment. Thus, payback occurs when the total of cash inflows equal to the initial investment :

Payback period (When the cash flows are an annuity)

= IO / Average CF

Payback period (When the cash flows are mixed stream)

= (Yr 1) + [ (IO Cumulative cash inflow before Yr.) ]

Cash inflow in Yr.

Where :

Yr.:Number of years to recover the initial investment; cash flow after tax should exceed the IO

IO:Initial investment

Illustration 2 ;

Using the above example to calculate payback period and decides the best project to invest in when the targeted payback period is 3 years.

PPA= 5,000___________

(2,500 + 2,500 + 2,500) / 3 years

=2 years

PPB= (3 1) + [ (5,000 3,200) ]

3,300

=2.55 years

As an investment criterion, the shortest payback period is favorable as its represents how fast the cost could recover. Therefore;

Independent project : The company should accept both projects since the payback period is above than the targeted payback period.

Mutually exclusive project : The company should accept Project A as the company can get back the cost in 2 years time as compared to Project B.

4.2.2 Discounted cash flow methodDiscounted cash flow method considers the time value of money in the analysis. This method support the goal of the firm i.e. to maximize the shareholders wealth.

There are three common techniques in discounted cash flow ; net present value, internal rate of return and profitability index.

Net Present Value (NPV)

This technique among the common techniques and is widely used in analyzing the best investment for company. NPV is the present value of an investments annual cash flows less the initial outlay. It can be expressed as follows :

NPV (mixed stream cash flows) = [ PV1 + PV2 + + PVn ] - IO

(1 + i)1 (1 + i)1 (1 + i)n

NPV (an annuity)= PV [ 1 1 ]

(1 + i)n - IO

i

Where :

PVt =the annual cash flow in period ti

=the companys required rate of return

n

= the projects expected life

IO

=initial cost of investment

Illustration 3

If the marginal cost of capital for RIDZ Sdn Bhd is 10%, calculate the NPV for both projects.

NPVA = PV X [ 1 1 ]

(1 + i)n - IO

i

=2,500 X [ 1 1 ]

(1 + 0.10)3 - 5,000

0.10

=RM1,217.13NPVB = [ 2,500 + 700 + 3,000 ] - 5,000

(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3

=[ 2,272.73 + 578.51 + 1,365.50 ] 5,000

=4,216.73 5,000

=(RM783.27)As an investment criterion, the basic rule for NPV to accept project with NPV grater than zero. This is because the NPV indicates the firm earns a greater return than or equal to required rate of return. Therefore;

Independent project : The company should accept Project A only since the NPV is positive and more than zero and to reject Project B which having a negative NPV.

Mutually exclusive project : The company should accept Project A only since the NPV is positive and more than zero.

Profitability Index (PI)Unlike NPV, profitability index measures the ratio of present value of cash flow to the cost of investment. This index can be expressed as follows :

PI = [ PV1 + PV2 + + PVn ]

(1 + i)1 (1 + i)1 (1 + i)n

-----------------------------------------

Initial Outlay

Illustration 4

Based on above example, calculate the PI for both projects.

PIA = PV X [ 1 1 ]

(1 + i)n - IO

i

=2,500 X [ 1 1 ]

(1 + 0.10)3

0.10

-------------------------------------------

5,000

=6,217.13 / 5,000

=1.2434

PIB = [ 2,500 + 700 + 3,000 ]

(1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3

---------------------------------------------------

5,000

=[ 2,272.73 + 578.51 + 1,365.50 ]

------------------------------------------

5,000

=4,216.73 / 5,000

=0.8433The decision criterion is to accept the project if the PI is greater than or equal to 1.00 and to reject the project if the PI is less than 1.00.

Independent project : The company should accept Project A only since the PI is greater than zero and to reject Project B which is the PI is lesser than 1.00.

Mutually exclusive project : The company should accept Project A only since the PI is greater than zero.

Internal Rate of Return (IRR)

IRR is the discount rates that cause the NPV to equal zero. Therefore, IRR is when NPV is equates to zero :

IRR= [ CFATt / (1 + IRR)t ] IO

To illustrate, calculate the IRR for both projects.

Illustration 5PI (annuity)

a.Determine the PVIFAi,3 by divide the annuity with initial investment.

IO =Annuity (PVIFAi,3)

PVIFAi,3=5,000 / 2,500

=2.000

b.Refer to PVIFA table for 2.000 for period 3. Noted that 2.000 lies between 20% and 24%.

c.Do the interpolation to calculate IRRA.

PercentagePVIFAi,3

20%2.1065 2.1065

2.0000

IRR2.0000 = 0.1065 2.1065

1.9813

24%1.9813 = 0.1252

IRR=20% + (0.1065 / 0.1252) (24% - 20%)

=23.40%

PI (mixed stream of cash flow)

This method is more complexes and very tedious process. To illustrate, consider the project B to calculate IRR and decide which project to be chosen when the required rate of return in 10%.

a.Calculate the average CFAT for Project B :

Average CFATB=2,500 + 700 + 3,000

3

=2,066.67

b.Determine the simulated IRR.

IO =Average CFATB (PVIFAi,3)

PVIFAi,3=5,000 / 2,066.67

=2.4194

c.By looking at PVIFA table, 2.4194 lies between 11% and 12%.

d.It is need to adjust approximate IRR accordingly. When the cash flow is higher in the early year, therefore the estimated IRR will move upwards and vice-versa. For Project B, the cash flow is higher in the later years. Thus, 12% will be the focal point of adjustment.

e. Do the trial and error to calculate the approximate IRR and using NPV concept.

Assume i = 12%

NPVB = [ 2,500 + 700 + 3,000 ] - 5,000

(1 + 0.12)1 (1 + 0.12)2 (1 + 0.12)3

=[ 2,232.14 + 558.04 + 2,135.34 ] 5,000

=(RM74.48)

Assume i = 11%

NPVB = [ 2,500 + 700 + 3,000 ] - 5,000

(1 + 0.11)1 (1 + 0.11)2 (1 + 0.11)3

=[ 2,252.25 + 568.14 + 2,193.57 ] 5,000

=RM13.96The above calculation showed at i = 12% gives a negative value and when i = 11%, it gives a positive value. Therefore, the interpolation is needed to calculate the IRR.

PercentagePVIFAi,3

11%13.96 13.96 0

= 13.96

IRR0 13.96

(-74.48)

12%-74.48 = 88.44

IRR=11% + (13.96 / 88.44) (12% - 11%)

=11.16%As decision criterion, accept the projects with IRR higher than the required rate of return.

Independent project : The company should accept Project A and B since the IRR is greater than the required rate of return of 10%.

Mutually exclusive project : The company should accept Project A only since the IRR for Project A is higher than Project B.

Overall, the company should invest in Project A since all the techniques showed that Project A is the best in term on AAR, PP, NPV, PI and IRR.

4.3. Capital Rationing

Capital rationing is referring to placing a limit on the dollar size of the capital budget. There are three basic principles for imposing a capital-rationing constraint.

The market condition may affect on the companys decision to invest in a particular project.

The selection of manager sometimes can give a great impact in handling a new project especially less experience manager which cant contributes to increase the value of firm.

The intangible consideration for e.g. to avoid interest rate increment which may affect the investment planning.

If the company plans to impose a capital constraint on its investment project, the financial manager may select the project with highest NPV. In other words, the company should select the project which provides wealth maximization to shareholders.

Illustration 7

Company ABC has a budget constraint of RM4 million and there are four projects available. The table below is the information for each of proposed projects :

ProjectInitial Outlay (RM)NPV (RM)

AA2.0 million0.8 million

BB1.0 million0.4 million

CC1.2 million0.6 million

DD1.8 million0.9 million

From the above table, it shows that Project DD and AA have the highest initial outlay of RM1.8 million and RM2.0 million respectively, making a total of RM 2 million and has the remaining balance of RM 2 million. If the projects are not detachable, then no project will be accepted and considering project AA and DD will yield a total NPV of RM 1.7 million. The following table is the possible combinations which can fulfill the budget constraint.

CombinationProjectInitial Outlay (RM)NPV (RM)

1AA2.0 million0.8 million

BB1.0 million0.4 million

3.0 million1.2 million

2BB1.0 million0.4 million

CC1.2 million0.6 million



3AA2.0 million0.8 million



From the above combination result, it shows that combination 2 gives the highest NPV within the capital constraint.

4.4. Risk and Capital Budgeting

Risk is referring to the degree of uncertainty or variation from the expected income from investment.

Chapter 5 : Capital Structure Basics

5.0 Introduction

Capital structure is the mix or combination of firms permanent long term financing including firms debt, preferred stock and common stock.

Different companies may imply different optimal structure. The objectives of capital structure are as follows :

Investment decision

Financing decision

Dividend policy decision

These decisions have to be well-planned in order to maximize the shareholders wealth.5.1. Breakeven Analysis and Leverage

Breakeven analysis is focus on the relationship between sales volume and profitability, which has a direct relationship to the firms total cost structure.

Break Even point

Also known as a cost-volume analysis which is finding the level of sales where operating profit or net income before interest and tax equals to zero that is the total revenues equal to total cost. EBIT is;

EBIT=Q (P V) FC

Where ;

Q

:Sales quantity (in unit)

P

:Price per unit

V

:Variable cost per unit

FC:Fixed cost

Break even analysis can be used in profit planning.

BE (in unit)=(FC + Profit) / (P V)

BE (in RM)=(FC + Profit) / 1 - (V / P)

Sales Break Even

It involves the same formula except the sales break even uses contribution margin (CM). The sales break even can be calculated as follows :

CM=1 Variable cost ratio

=1 (V / P)

Cash Break Even (CBE)

It concern with the sales level in order to meet operating cash requirement. This is because cash receipts and expenditure do not correspond directly with the sales and expenses as per income statement. In CBE, non-cash expenses such as depreciation are not included as it will overstate the CBE. The CBE can be computed as follows;

CBE (in unit)=(FC depreciation) / (P V)

CBE (in RM)=(FC depreciation) / [ 1 - (V / P)

Break Even Margin

This technique is used to calculate the margin of safety when the level of sales is known. This relates to the firms current sales level to break even point and thus it will measures the risk on how much the sales can be decline before meet the break even point which result in negative operating earnings. Break even margin (BEM) can be computed using the following formula :

BEM

=S0 BE (in RM) / S05.2. Leverage

Leverage implies the usage of fixed costs in a business to firms earnings. The leverage is included the operating leverage and financial leverage.

Operating leverage is the fixed operating costs which is appear in the firms income statement and the financial leverage relates to the financial sources which carry fixed financing charges that the company willing to bear in order to maximize their returns on shareholders wealth. The combination between operating leverage and financial leverage known as the total leverage.

5.2.1Operating Leverage

It represents the firms fixed operating cost. Fixed cost is not vary to the change in sales or operation. Example of such cost includes insurance, cost of management, overhead cost and depreciation cost.Refer to the following example of the amount of leverage used in Syarikat Mama, Mimi and Mumu.

Illustration 1

CompanySyarikat MamaSyarikat MimiSyarikat Mumu

Sales (RM)5,5009,7505,000

Operating cost :

Fixed cost (RM)1,0007,0003,500

Variable cost (RM) 3,5001,5001,000

Operating profit1,0001,250500

Fixed cost0.220.820.78

The above illustration, it shows that Syarikat Mimi has the highest percentage of fixed cost of 0.82. This is requires a large amount of sales in this company as compared to Syarikat Mama and Mumu in recovering the total costs and thus able to make a highest profit.

Assume that the sales of this three companies increased by 50%, the following table shows the effect :


Sales (RM)8,25014,6257,500

Operating cost :

Fixed cost (RM)1,0007,0003,500

Variable cost (RM) 5,2502,2501,500

Operating profit2,0005,3751,200

Assume the sales and variable cost increased by 50% but the fixed cost remain unchanged. The result is as follows :


Sales before the change (RM)1,0001,250500

Sales after the change (RM)2,0005,3752,500

Changes (RM) 1,0004,1252,000

Changes (number of times)1,000 / 1,000

= 14,125 1,250

= 3.32,000 / 500

= 4

Syarikat Mumu is the most sensitive with the change in sales and the profit has increased by 4 times.

Degree of Operating Leverage (DOL)

DOL is the percentage change in a firms operating profit due to the change in sales volume.

The formula to calculate DOL is as follows :

DOL

=Percentage change in operating profit

Percentage change in sales

Based on the example above, the DOL for each of companies are as follows :

CompanyChange in sales (%)Change in profit (%)DOL

Syarikat Mama501002

Syarikat Mimi503306.6

Syarikat Mumu504008

5.2.2Financial LeverageIt involves the use of fixed cost financing that a company acquires by choice. Financial leverage concerns the effect of financing decision on the owners return and relationship between firms operating profit and earning per share.

Degree of Financial Leverage (DFL)

DFL is defined as the percentage of change in EPS as the result from percentage change in EBIT. The level of financial leverage can be determined by applying the following formula :

DFL

= Percentage change in EPS____or

Percentage change in operating profit

DFL

=

EBIT______________

EBIT 1 Preferred dividend / (1 Tax)5.3Capital Structure Theory

This capital structure theory assumes that there is an optimal capital structure, whereby when a company increases the amount of debt in capital structure, the weighted average cost of capital (WACC) will be reduced. The WACC will increase when the company has more debt. This is due to the required return by investors will increase and thus reduced the debt fund.The theory has a few assumptions: No tax will be charge to business entity.

There are 2 types of finance availability; ordinary equity share and perpetual debt financing.

No transaction costs

All the distributable earnings are paid as a dividend.

Business risk is constant

Earnings and dividend remain fixed.

Chapter 6 : Working Capital Policy

6.0 Introduction

Working capital is a financial metric which represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.6.1. Managing Working Capital

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Working capital management includes;1. Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.

2. Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow.

3. Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa).

4. Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

6.2. Why Business Accumulate Working Capital

The accumulation of capital refers simply to the gathering of objects of value; the increase in wealth; or the creation of wealth. Capital can be generally defined as assets invested with the expectation that their value will increase, usually because there is the expectation of profit, rent, interest, royalties, capital gain or some other kind of return. Accumulations of capital refer to a net addition to existing wealth, or to a redistribution of wealth. If more wealth is produced than there was before, a society becomes richer; the total stock of wealth increases.6.3. Liquidity Versus Profitability

A firm can increase its investment in working capital by increasing its investment in current assets. This in turn increases the firms liquidity. A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations. Investments in current assets are expected to ensure delivery of goods or services to the ultimate customers. A proper management of the same could result in the desired impact on either profitability or liquidity.

Liquidity is a precondition to ensure that firms are able to meet its short-term obligations. The 'liquidity position' in a company is measured based on the 'current ratio' and the 'quick ratio'. The current ratio establishes the relationship between current assets and current liabilities. Normally, a high current ratio is considered to be an indicator of the firm's ability to promptly meet its short term liabilities. The quick ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is liquid if it can be converted into cash immediately or reasonably soon without a loss of value.

A profit ratio indicates how effectively management can make profits from sales. It also indicates how much a company has to hold up a downturn, discourage competition and make mistakes. Potential investors are interested in dividends and appreciation in market price of stock, so they focus on profitability ratios. Managers, on the other hand, are interested in measuring the operating performance in terms of profitability. Hence, a low profit margin would suggest ineffective management and investors would be hesitant to invest in the company. Further discussion on the liquidity concept and profitability had been discussed in the earlier chapter.6.4. Establishing the Optimal Level of Current Assets

Management of current assets consists of the management of inventory, accounts receivable, cash and marketable securities

1. Inventory ManagementEffective management of inventory depends on the size of investment. When inventory is managed well, the costs of inventory will be at a minimum. The Economic Order Quantity (EOQ) model will determine the optimal order size for an inventory item and therefore helps to minimize the inventory costs.

EOQ=

Where:

S= usage in units per year

O= order cost per order

H= holding cost per unit per period

Other system of inventory also may be used such as the ABC Approach, Materials Requirement Planning (MRP) Approach and Just-In-Time (JIT) Approach.

2. Account Receivable Management

Account receivable must be closely monitored as it represents a large portion of current assets. It starts with the process of credit Selection whereby the customers will be evaluated using the 5Cs of credit before any credit sales is granted. The 5Cs are:

Character: reliability in payments

Capital: the customers debt to equity ratio

Conditions: Economic and industry conditions

Collateral: Assets available to secure the debts

Capacity: cash flow available to pay debts

Once credit sales is granted, customers shall be given a credit term which will specify the possible discount for early repayment. For example a credit term of 2/10 net 30 means that a customer shall be given a 2% discount if they are able to settle their debt within 10 days, and the debt should be paid off within 30 days of sales.

If the customers default in payment, there will be steps in collecting the ccount receivable. Firstly, customer shall be given a reminder such as sending a duplicate invoice or courteous letter. If the debt is still failed to be collected, second step will be taken which the company shall make follow up sending e mail, making phone calls or pay a visit to the debtor. Last step the company can take in collecting their debt is by taking drastic action such as collection by attorney of employ a collection agency on their behalf.

3. Cash Management4. Marketable Securities6.5. Managing Current Liabilities: Risk and Return

Liquidity is a firm's ability to meet its short-term debts, and cash is the most liquid asset, because it can be spent immediately. Non-cash current assets, mainly receivables and inventory, are less liquid because it may take time to turn them into cash. For example, ratios measuring receivables collection periods and inventory turnover rates, estimate how long it is taking to convert receivables and inventory into cash. In general the more current assets a firm holds the greater its liquidity (measured by the current ratio). If liquidity is, or becomes, very important managers may decide to hold proportionately more cash and/or marketable securities (measured by the quick ratio) than non-cash assets, receivables and inventory.

There is always a trade-off in holding high levels of cash assets because they earn very little return. In general, managers can only reduce the risk of becoming less liquid by reducing the overall return on current assets, and on total assets (the ROA measure).

Another factor affecting net working capital is the firm's use of current versus long-term debt. Again, this poses the risk-return trade-off. All else being constant, the more that managers rely on short-term debt or current liabilities to finance investment in assets the lower will be the firm's liquidity. Think about this!

However, using current liabilities costs less (in interest) than long-term debt and is a flexible means of funding fluctuating needs for assets.

The major disadvantage of short-term debt is that it must be repaid or 'rolled over' more often, and any deterioration in the firm's overall financial condition may be made worse if the firm can't refinance the short-term debt. So liquidity and longer-term solvency are linked.

Another risk is linked to the interest rates. Every time funding arrangements are renewed the interest rates will also be reviewed. Any change in the lender's perception of the firm's riskiness will lead to higher interest being charged. So short-term interest rates are likely to change more often than interest on long-term loans.

Where possible cash should be held in interest bearing accounts and drawn on only when actually needed to pay accounts, otherwise there is an unnecessary opportunity cost in terms of lost interest.

The following reading explains the management function of cash and marketable securities. Note the formula for calculating optimum cash withdrawal amounts. You don't need to learn the formula! Make brief notes of the main points.

The risk and cost factors are inversely related, in that if a company goes for a low risk source of finance, it is related to a high cost source of finance and vice versa.

Assuming a normal yield curve (the term structure of interest rate) where the interest rate curve is upward sloping, a short-term loan will be cheaper than a long-term source of finance. This means that based on cost, a company may rather choose to use short-term source of finance than a long-term source of finance.

Based on risk, short-term source of finance (e.g. bank overdraft) is assumed tobe more risky than a long-term source of finance (e.g. long-term bank loans).Bank overdraft can technically be withdrawn on demand, at short notice, even if acompany use short-term loan, upon maturity, it may not be renewed or it may berenewed on unfavourable terms, unlike long-term loan where a company meetingits loan interest payment and the terms of the loan, will not have to worry aboutits withdrawal or it not being renewed as may be the case with the short-termsource of finance.

In summary:

Source of finance

Cost

Risk

Short-termLow

High

Long-term

High

Low

6.6. Three Working Capital Financing Approaches

To discuss the three different working capital financing approach, it is important to make distinction between permanent current assets and fluctuating working capital.

Permanent current assets are often the minimum current assets held by companies at any given time. Example of which may include minimum inventoryheld by a company at any given time for precautionary purpose, others mayinclude the minimum trade receivable that are almost always outstanding,another permanent current asset could be the minimum cash balance thatcompany always wish to hold for precautionary and speculative purpose. Even though these minimum current assets a still recorded as current assets, it exhibits characteristics similar to that of non-current assets.

Fluctuating current assets are therefore the current assets that are used continuously by the company in its operating activities, such that before itreaches the minimum it takes action to replenish such current assets, such asinventory, cash etc. with fluctuating current assets, just as it is being used, it isalways replenished by the company anytime such assets reaches re-order levels,or return points etc, to avoid such assets going out of stocks.

There are 3 approaches in working capital :

1. Aggressive approach to financing working capital

The aggressive method is where a company predominantly finance all itsfluctuating current assets and most of its permanent current assets using short-term source of finance and it is only a small proportion of its permanent currentassets that is financed using long-term source of finance.

A company that uses more short-term source of finance and less long-termsource of finance will incur less cost but with a corresponding high risk. This hasthe effect of increasing its profitability but with a potential risk of facing liquidityproblem should such short-term source of finance be withdrawn or renewed onunfavourable terms.

2. Conservative approach to financing working capital

The other extreme method of financing working capital is where a company decides to use mainly long-term source of finance and very little short-term source of finance to finance its working capital. This option means that the companys finance is going to be relatively high cost (that is sacrificing low cost finance) but low risk; this will make the companys profit to be low but does not run the risk of being faced with liquidity problem as a result of withdrawal of its source of finance.

The conservative method is where a company predominantly finance all itspermanent current assets and most of its fluctuation current assets using long-term source of finance and it is only a small proportion of its fluctuating currentassets that is financed using short-term source of finance.

3. Moderate approach to financing working capital

Between the two extreme approaches to financing working capital is themoderate (or the matching or balancing) approach. This approach makesdistinction between fluctuating current assets and permanent current assetswith the suggestion that to finance working capital; short-term source of financeshould be used to finance fluctuating current assets, whiles long-term source offinance should be used to finance permanent current assets. This matches thesource of finance with the character of the current assets.6.7. Working Capital Financing and Financial Ratios

Working capital financing is essential to any growing business. It helps keep the business current and competitive in the market. If the company has the commercial real estate or equipment that produces an income for the business, it can obtain working capital financing that can help pay down credit lines or accounts payable, freeing up money for growth opportunities. Before attempting to obtain this type of loan make sure that the company has established good business credit scores. These credit scores will make a big difference when the lending institution is determining whether to give your business the money that it needs to succeed. Working capital financing can range anywhere from RM100,000 to RM2,000,000 and more. The loan terms can range anywhere from 15 to 25 years. These loans typically are paid back in installments with no large lump-sum payments required. This is also known as a fully amortizing loan. Once acquired working capital financing can be used for acquiring real estate, expanding a current facility, building a new office, purchasing new equipment, operating expenses, or to buy out a current owner or shareholder.

All types of businesses are eligible for working capital financing. Service businesses, manufacturers, distributors, retail stores, professionals, restaurants, and gas stations can all benefit from these types of loans. Meanwhile, financial ratios are useful to the company as indicator to the firms performance and financial situation. Most ratios can be calculated by the given financial statements. Financial ratios can be used to analyze trends and to be compared with other firms in the same industry. In the some cases, financial ratios can predict future bankruptcy.The following types of ratios commonly used :

Liquidity ratios

Activity ratios

Leverage ratios

Profitability ratios

Market ratios

Further discussion on financial ratios in Chapter 2 : Analyze of Financial Statement.

Chapter 7 : Managing Cash

7.0 Introduction

In United States banking, cash management, or treasury management, is a marketing term for certain services offered primarily to larger business customers. It may be used to describe all bank accounts (such as checking accounts) provided to businesses of a certain size, but it is more often used to describe specific services such as cash concentration, zero balance accounting, and automated clearing house facilities. Sometimes, private banking customers are given cash management services.

7.1. Cash Management ConceptCash is defined as coins and currency plus demand deposit account that available to meet individuals need and is use in a daily transaction.

Management of cash refer to the liquidity of a firm and thus can minimize the risk of solvency in a company. A company can become insolvent when they unable to meet its maturing liabilities due to lack of necessary liquidity to make prompt payment on its current debts.

The firm has to hold cash a a few reasons :

1. Transaction : The amount of cash that the company needs can support day-to-day operations. The firm must have enough cash in hand which they can make its daily purchases of materials and pay its liabilities.2. Precautionary : The company holds cash for a general function of predictability of a firms cash inflow and outflow. The more unpredictable the cash the greater needs for precautionary balance of cash.3. Speculation : To take advantage of any bargain that may arise.4. Compensating balance : To compensate for services that they perform. 7.2. Determining the Optimal Cash BalanceOne of the important aspects in cash management is knowing the optimal cash balance. The financial managers task is to maintain the cash balance (including the bank balance) at a proper level. The company requires cash for transaction purpose in making payment of day to day routine expenses like wages payment, payment of creditors and etc.

There is always a gap between cash inflow and cash outflow, where the firm has always to maintain a certain cash balance in a company. But the firm has to maintain a cash balance which is neither too small nor too high. If the firm maintains too small a balance, it may find it difficult to make payment of day-to-day expenses and it runs out of cash.

When the cash balance has increased, it makes transaction in marketable securities become reduces and thus transaction costs will reduce too.

7.3. Forecasting Cash Needs

Most of us are familiar with at least one firm that has encountered serious financial difficulties, or even faced bankruptcy, while earning a continuously larger income over time. One factor many of these firms have in common is their failure to adequately budget future operating expenses and to forecast future needs.

A cash forecast also serves as a control mechanism if projected figures are compared with actual figures. If your company planned on a RM150,000 cash inflow for June but received only RM80,000, the discrepancy will be clearly visible if you have a cash budget--though the budget won't tell you the reasons for a problem. Maybe you weren't getting enough product to one of your markets, or your customers might have stretched their payables. But no matter what causes you find for the problems, a cash forecast will help you keep your fingers on your company's pulse.

One method of preparing a cash forecast requires financial information from several prior years and takes four basic steps:

1. Estimate sales for the forecast period, a year in this instance

2. Break down the annual sales figure into monthly units to reflect any seasonal factors.

3. Construct pro forma income statements from the monthly sales figures.

4. Translate the income statement information into a cash forecast.

This kind of cash projection, with monthly performance reviews and revisions, is the first step to sound cash management. From here, owners can go on to properly time loans and repayments, assess the impact of borrowings and investments, and fine tune the company's cash needs for continued growth.

7.4. Managing the Cash Flowing In and Out of the Firm

Cash flow refers to the differences between the number of dollars that came in and the number of dollar that went out. The cash flow cycle shows how the actual net cash flows into and out of the firm during a specified period. It concerns only with the actual movement of the cash and as such expenses on depreciation and sales on credit do not constitute as cash flows.

There are three main activities that explain the cash inflow and cash outflow of a business, that is :

1.Generating cash flows from day to day business operations. It is important to know how much cash is being generated in the normal cause of operating a business on a daily basis, beginning with purchasing inventories on credit, selling on credit, paying for the inventories and finally collecting on the sales made on credit.

2.Investing in fixed assets and other long term investment. When a company purchases or sells fixed assets like equipment and buildings, there can be significant cash inflows and outflows.

3.Financing the business. Cash inflow and outflows occur from borrowing or repaying debt, paying dividends and from issuing stock (equity) or repurchase stock from shareholders.

7.4.1Preparing the Statement of Cash Flow

A "Cash Flow Statement" shows the sources and uses of cash and is typically divided into three components:

Operating Cash Flow. Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It comes from sales of the product or service of your business, and because it is generated internally, it is under your control. The companys income statement will be converted from accrual basis to cash basis. There are two steps involved :

Add depreciation to net income since depreciation is non-cash expenses

Subtract any uncollected sales and cash payment from inventories.

Investing Cash Flow. Investing cash flow is generated internally from non-operating activities. This includes investments in plant and equipment or other fixed assets, nonrecurring gains or losses, or other sources and uses of cash outside of normal operations. When a company purchase fixed assets, such as plant and equipment, this expenditures are shown as an increase in gross fixed assets (not the increase in the net fixed assets) in the balance sheet.

Financing Cash Flow. Financing cash flow is the cash to and from external sources, such as lenders, investors and shareholders. A new loan, the repayment of a loan, the issuance of stock, and the payment of dividend are some of the activities that would be included in this section of the cash flow statement. Financing a business involves (1) paying dividend to the owners, (2) increase or decrease in short term and long term debts, (3) selling shares of stock or repurchase stock.

Refer to example below on how to prepare Statement of Cash Flow when the Balance Sheet and Income Statement are given to you.

Balance Sheet as of 31st Dec 2008 and 31st Dec 2009

31/12/2008 (RM000)31/12/2009 (RM000)

Cash200150

Ac Receivable450425

Inventory550625

Total Current Assets1,2001,200

Plant and Equipment2,2002,600

Less : Accumulated Depreciation1,0001,200

Net Plant and Equipment1,2001,400

Total Assets2,4002,600

Account payable200150

Notes payable 0150

Total Current Liabilities200300

Bond600600

Common stock300300

Paid-in capital600600

Retained Earnings700800

Total owners equity1,6001,700

Total liabilities and owners equity2,4002,600

Income Statement for the Year Ended 31st Dec 2009

RM000

Sales1,450

Cost of Goods Sold850

Gross Profit600

Operating Expenses40

Depreciation200

Net Income360

Less : Interest Expenses300

EBT120

Less : Taxes Expenses180

Dividend80

Additional Retained Earnings100

Statement of Cash Flow For the Year Ended 31st Dec 2009

RM000RM000

Net Income180

Plus : Depreciation200

Account Receivable25

Inventory(75)

Account Payable(50)

Net Cash Flow from Operating Activities280

Plant and Equipment(400)

Net Cash Flow form Investment Activities(400)

Dividend (80)

Notes Payable150

Net Cash Flow from Financing Activities70

Net Cash Flow(50)

Plus : Beginning Cash200

Ending Cash Balance150

BUSINESS FINANCE

Shaliza/PBFPage 1Shaliza/PBFPage 31

formulas for calculating finance

Documents

companys financial

financial activities

financial health

basic financial statements

basics financial ratios

capital rationing

capital policy

capital budgeting process