Finance Management Mid Term Summary

FINANCE MANAGEMENT MID TERM SUMMARY

BY CHRISTY KUSUMAATMAJA 29109009 MBA ITB CLASS OF X - 41

Financial Management Role What is finance? Finance can be describes as the art and science of managing money. Finance is concerned with the projects, institutions, markets, and instruments involved in the transfer of money among individuals, business, and governments. Finance divided into two major areas: 1. Financial Service 2. Managerial Finance Financial Service Financial Service is the area of finance concerned with the design and delivery of advice and financial products to individuals, business, and government. Managerial Finance Managerial Finance is concerned with the duties of the financial manager in the business firm, to manage the financial affairs of any type of business. The financial field covers planning, extending credits to customers, evaluating proposed large expenditures, and raising money to fund the firms operation. Economics is closely related to finance; the framework of its theory is the basis of efficient business operations, like the supply and demand analysis, profit maximizing strategies, and price theory. The needed goal is to make the added benefits exceed the added cost. We study managerial finance because business decisions are mostly measured by financial terms. In this field the emphasize is not only on ratio and accounting statement it’s about how to maintains the firm solvency by planning the cash flows necessary to satisfy its obligation and to acquire assets needed to achieve the firm’s goals. In short, the company must have a sufficient flow of cash to meet its obligation as they come due. As accountant primary function is to develop and report data for measuring the performance of the firm, assess its financial position, comply with and file reports required by securities regulators, and file and pay taxes. The financial manager places primary emphasis on cash flows, the intake and outgo of cash. Financial Statement The 4 keys of financial statement required by the SEC for reporting to share holders are; (1) the income statement; provides a financial summary of the firm’s operating results during a specified period (2) the balance sheet; is a summary statement of the firm’s financial position at a given time. Balance sheet have 2 sides that represents the asset that have been purchased to be used to increase the profit of the firm, and the other side is showing how the assets is purchased whether by investing the owners money (equity) or by borrowing funds (liabilities). Both of the side have to be balanced, the key components can be shown as Total Assets

= or

Total Liabilities + Stockholders equity

Current + Fixed Assets

=

Current Liabilities + Long-term Debt + Equity

(3) The statement of share holder’s equity; shows all the equity account transaction that occurred during the given year. The abbreviated form of the stock holders equity form is the retained earnings statement it provides a better look on the development of the stockholders investment. It shows the net profit and how much the retained earnings have changed during the year. (4) The statement of cash flows; it provides a summary of the firms operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. Financial statement is made accordingly to whom it may give interest to. The parties that have interest in the company financial ratios will be: a. Shareholders: They are concerns about the company currents and future risk and returns, which will directly effects the share price. b. Creditors: They are concerns about the short term liquidity of the company and it’s ability to make principal and interest payment towards its obligation and also to make sure that the company business is healthy. c. Management: management use ratios to control the company’s performance from period to period in order to determined the right strategy to drive the company towards profitability and growth. Financial Ratios Liquidity Ratios: Company ability to fulfill the short term obligation as they come due a. Current Ratio: a measure of liquidity calculated by the company current assets by its current liabilities. This is measuring how much assets the company has to covers its short terms debt. ( > 1 is acceptable) b. Quick Ratio: a measure of liquidity calculated by the company current assets (excluding the inventory) by its current liabilities. This is measuring how much assets the company has to covers its short terms debt, the inventory is excluded because sometimes the inventory is not easily sold and become cash cause there’s a possibility its sold on credit or the inventory turnover of the products will took sometimes to be sold. ( > 1 is acceptable) Activity Ratios: measure the speed which carious accounts are converted into sales or cash inflows or outflows. a. Inventory turnover: measure how much time the inventory need to be sold or to be cash. (have to be compared to the average industry turnover) b. Average collection period: measure the average amount of time needed to collect account receivable. (have to be compared to the average industry turnover) c. Average payment period: measure the average amount of time needed to collect account payable. (have to be compared to the average industry turnover) Debt Ratios: indicate the amount of other people’s money being used to generate profits. a. Debt Ratio: comparing the debt percentage over the total asset own by the company. (< 1 is acceptable)

b. Time interest earned ratio: measure the company ability to make contractual interest payments. c. Fixed payment Coverage Ratio: measure the company ability to make contractual principal payments of fixed payments obligation. Profitability Ratios: this measurement enable analyst to evaluate the company’s profits with respects to a given level of sales, a certain level of assets, and the owner’s investments. a. Gross Profit Margin: measure the percentage of each sales dollar remaining after the firm has paid for its goods.

b. Operating Profit Margin: measure the percentage of each dollar remaining after all costs and expenses other than interest, taxes and preferred stock dividend are deducted

c. Net Profit Margin: measure the percentage of each dollar remaining after all costs and expenses including interest, taxes and preferred stock dividend are deducted

d. Earning per Shares

e. Return on Total Assets (ROA): often called Return Of Investment and also known as DuPont Formula

f. Return on Total Equity (ROE): also known as Modified DuPont Formula

Market Ratio: market ratios measure investor response to owning a company's stock and also the cost of issuing stock. a. Price/Earning Ratio: assess the owner’s appraisal of share value

b. Market/Book Ratio: assess how investors view firms’s performance

Financial Mathematic Financial value and decision can be assessed by using either future value or present value technique. Future value technique typical measure cash flow at the ends

starts of a project life. A Time Line can be used to depict the cash flows associated with a given investment. A time value in finance is based on believes that a dollar today is a worth more than a dollar that will be received at the same future date. Basic Patterns of Cash Flow: a. Single Amount: A lump-sum amount either currently held or expected at some future date. • Future value of single amount : the value at a given future date of a present amount placed on deposit today and earning interest at a specified rate. • Present Value of Single Amount: the current dollar value of a future amount-the amount of money that would be invested today at a given interest rate over a specified period to equal the future amount. b. Annuities: A level periodic stream of cash flow over a specified time period. • Ordinary Annuities: o Future values: This is used to calculate the future value of an ordinary annuity at a specified interest rate over a given period of time. o Present values: The multiplier used to calculate the present value of an ordinary annuity at a specified discount rate over given period of time c. Mixed Streams: Two basic types of cash flow streams: the annuity and the mixed stream Annuity is a pattern of equal periodic cash flows. Mixed is a streams o unequal periodic cash flows that reflect no particular pattern Interest Interest is often compounded more frequently intervals: Semiannual: compounding of interest involves 2 compounding periods within the years. Quarterly: compounding of interest involves 4 compounding periods within the years. Annual Percentage Rate (APR): The nominal annual rate of interest, found by multiplying the periodic rate by multiplying the periodic rate by the number of period in one years, that must be disclosed t consumer on the credit cards and loans as are result of “Truth in lending laws” Annual Percentage Yield (APY): The effective annual rate of interest that must b disclosed to consumers by banks on their savings product as a result of “truth in savings laws” Spesial applications of time value 1. Determining deposits needed to accumulate a future sum the equations : FVAn = PMT X (FVIFAi,n) FVAn = the future value of n-years ordinary annuity

PMT = The annual deposits (FVIFAi,n) = the appropriate 2. Loan Amortization the determination of equal periodic loan payments necessary to provide a lender with a specified interest return and to repay the loan principal over a specified period. PVAn = PMT X (PVIFAi,n) 3. Finding interest or Growth Rates its often necessary to calculate the compound annual interest or growth rate of series cash flows. In doing this , we can use either future value or present value interest factors. Capital Budgeting Capital Budgeting is the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth. CAPITAL BUDGETING CASHFLOW 1. Capital budgeting decision process Capital budgeting is the process of evaluating and selecting long-term investment that are consistent with the firm’s goal of maximizing owner wealth. Firms typically make a variety of long-term investments, but the most common for the manufacturing firm is in fixed asset, which include property, land and equipment. These assets, often referred to as earning asset, generally provide the basis for the firm earning and value. Motives for capital expenditure A capital expenditure is an outlay of funds by the firm that is expected to production benefits over a period of time greater than 1 year. An operating expenditure is an outlay resulting in benefits received within 1 year. The basic motives for capital expenditure are to expand operations, replace or renew fixed assets, or to obtain some other, less tangible benefit over a long period. Step in process The capital budgeting process include five distinct steps: proposal generation, review and analysis, decision making, implementation and follow-up. Basic Terminology Capital expenditure proposal may be independent or mutually exclusive project. Independent project are those whose cash flows are unrelated or independent of one another, the acceptance of one does not eliminate the others form further consideration. Mutually exclusive project are those that have the same function and

therefore compete with one another. The acceptance of one eliminates from further consideration all other projects that have similar function. The typically, firms have only limited funds for capital investment and must ration them among projects. Two basic capital budgeting approaches are the accept-reject approach and the ranking approach. Conventional cash flow patterns consist of an initial outflow followed by series of inflow, any other pattern is nonconventional. 2. Relevant Cash Flow Include three basic components: (1) an initial investment (2) operating cash inflow (3) terminal cash flow. For replacement decision, these flows are the difference between the cash flows of the new asset and the old asset. When estimating relevant cash flows, ignore sunk costs and include opportunity cost as cash outflows. The International capital budgeting differs from the domestic version because (1) cash outflows and inflows occur in a foreign currency (2) foreign investments entail potentially significant political risk, can be minimize by planning.

3. Finding initial investment The initial investment is the initial outflow required, taking into account installed cost of the new asset, the after tax proceeds from the sale of the old asset, and any change in net working capital. The initial investment is reduced by finding the after-tax proceeds from sale of the old asset. The book value of an asset is used to determine the taxes as a result of its sale. Either of two form of taxable income-gain or a loss-can results from sale of an asset, depending on whether the asset is sold for (1) more than book value, (2) book value (3) less than book value. The change in the net working capital is the difference between the change in the current asset and the change in the current liabilities expected to accompany a given capital expenditure.

4. Finding operating cash Inflows The operating cash inflows are the incremental after-tax cash inflow to expect to result from the project. The income statement format involve adding depreciation back to net operating profit after taxes and gives the operating cash inflows, which are the same as operating cash flow, associated with the propose and the present project. The relevant incremental inflow for a replacement project is the difference between the operating cash inflow of the proposed project and those of the present project.

5. Finding the Terminal Cash Flow The terminal cash flows represents the after tax flow that is expected from liquidation of project. It is calculated for replacement project by finding the difference between the after tax proceeds from sale of the new and old asset at termination and adjusting this difference for any change in net working capital. Sale price and depreciation data are use to find the taxes and the after tax sale proceed on the new and old assets. The change in the net working capital typically represents the reversion of any initial net working capital investment.

6. Summarizing the relevant cash flow The initial investment, operating cash inflow and terminal cash flow together represent a project relevant cash flow. This can be viewed as the incremental after tax cash flow attributable to the proposed project.

CAPITAL BUDGETING TECHNIQUES

Capital budgeting techniques are the tools used to assess project acceptability and ranking. Applied to each project relevant cash flows, they indicate which capital expenditures are consistent with the firm goal of maximizing owner’s health.

1. Payback Period Payback period is the amount of time required for the firm to cover its initial investment, as calculated from the cash inflow. Shorter payback period are preferred.

2. Net Present Value NPV measure the amount of value created by given project, positive NPV are acceptable. The rate at which cash flow are discounted in calculating NPV called discount rate. This represent the minimum return that must be earned on a project to leave the firm market value unchanged.

3. Internal Rate of Return Internal Rate of Return (IRR) compound annual rate that company will earn by investing in a project in excess of the firm cost of capital, the firm should enhance its market value and the wealth of its owner.

4. Comparing NPV and IRR Techniques NPV assumes reinvestment of intermediate cash inflows at the more conservative cost of capital, IRR assumes reinvestment at the project’s IRR. From the theoretical view NPV preferred over IRR because NPV assumes the more conservative reinvestment. In practice view IRR more commonly used because it is consistent with the general preference of businesspeople for rates of return, and corporated financial analysis can identify and resolve problem with the IRR before decision makers use it.

Risk and Refinement in Capital Budgeting The cash flow associated with capital budgeting project typically has different level of risk. Thus is important to incorporated risk consideration in capital budgeting? Various behavioral approaches can use to know the level of risk.

Behavioral Approaches for dealing with risk Risk in capital budgeting is the degree of variability of cash flow, which conventional capital budgeting project stems almost entirely in cash inflows. Finding the breakeven cash inflow and estimating the probability that it will be realized make up one behavioral approach for assessing capital budgeting risk. Scenario analysis is another behavioral approach for capturing the variability of cash inflow and NPV’s. Simulation is statistically based approaches that result in a probability distribution of project return.

Risk-Adjusted Discount Rate (RADRs) RADR is the rate of return that must be earned on a given project to compensate the firm’s owners adequately-that is, to maintained or improve the firm’s share price. The higher the risk of a project, the higher the RADR and therefore the lower the net present value for a given stream of cash inflow.

The RADR closely linked to CAPM, but because real corporate asset are generally not trade in an efficient market, the CAPM cannot be applied directly to the capital budgeting.

Annualized Net Present value (ANPV) approach ANPV approach convert the NPV of each unequal-lived project into an equivalent annual amount, the ANPV approach is the efficient method of comparing ongoing, mutually exclusive projects that have unequal usable lives. ANPV can be calculated using a financial calculator, a spreadsheet or financial tables. The project with the highest ANPV is the best.

Credit Analyst You're probably already familiar with the concept of "credit," the idea that if you build up a reputation for paying bills and debts on time, you'll be better able to borrow money in the future. Your credit is one of the most important aspects of your personal finances. Credit is important because it enables you to borrow money when you need it. In addition, the better your creditworthiness, the more cheaply you'll be able to borrow money, whether for a car, education, home, or some other large expense. On the other hand, if you are not a good credit risk, you may not be able to borrow when you need to, or you might be able to borrow but only at a very high interest rate. Your creditworthiness may also be important when you are looking for certain types of insurance, and when you apply for certain types of jobs. Credit is used primarily in order to obtain loans. Loans can be an excellent way to fund large purchases and business initiatives, but managing debt can be a complicated process. Lets face it: it can take just a few months to get into financial trouble and years to get out. Although debt is sometimes useful, there is a difference between good debt and bad debt. In banking, loan channeling credit analysis is based not only on financial terms but also qualitative terms. On the finpancial terms what important is: 1. Spreadsheet ratio, current ratio, liquidity ratio, solvability ratio, etc. 2. Cash flow generation, return on equity and investment. 3. Debt service ratio, repayment capability, etc. On the qualitative side there is 1. Characteristic refers to the personality of the key person and management, the responsiveness, responsibility, etc. 2. Collateral refers to assets of the company or the person in order to guarantee the credit facility given 3. Capability refers to the management/key person ability to run the business and expand it. 4. Capacity refers to the company production/operation limit, do they have the capacity to meet the market demand or do they have the capacity to take the company to a higher and better level.

5. Condition refers to the macro economics condition, whether the economics is in a investment situation, the GDP, the market demand, etc. The two most important characteristic are how you borrow the money and what you do with it. A mortgage is usually good debt, since you probably couldn’t afford the house otherwise, the interest rate is relatively low, and the interest is usually taxdeductible. Borrowing to pay for an education is usually a good debt, because it’s an investment in future earnings. Carrying a balance on your credit card at high rate of interest is bad debt, especially if the money was used to buy luxury items or things you didn’t really need. Even though debt is a part of life, the key to prevent it from becoming destructive knows its benefits and risks.