Module 1 – Financial Management - Basic Areas of Finance - Corporate finance (san mig., unilever, coca-cola, pepsi) Investments (col financial, investment banking) Financial Institutions (banks) International finance Investments - Work with financial assets such as stocks and bonds Value of financial assets, risk versus return, and asset allocation Why is there a reason to invest in stocks? Consider risk involved. High risk high return - Job opportunities o Stockbroker or financial advisor o Portfolio manager o Security analyst Financial Institutions - - Companies that specialize in financial matter o Banks – commercial and investment, credit unions, saving and loans. o Insurance companies o Brokerage firms Job opportunities International Finance (working at IMF) - This is an are of specialization within each of the areas discussed so far. It may allow you to work in the other countries or at leas travel on a regular basis. ADB – work in other countries - - International finance mandated by IMF, NO TAX, exempted from withholding tax. Need to be familiar with exchange rates and political risk. Need to understand the customs of the other countries; speaking a foreign language fluently is also helpful. Why study Finance? Proper management of cash and prepare for future obligations. - - - - Marketing o Budgets, marketing research, marketing financial products Accounting o Dual accounting and finance function, preparation of financial of financial statements Management o Strategic thinking, job performance, profitability Personal finance o Budgeting, retirement planning, college planning day-to-day cash flow issues Business Finance - Some important questions that are answered using finance. o What long-term investments should the firm take on? o Where will we get the longterm financing to pay for the investments? o How will we manage the everyday financial activities of the firm? Financial Manager - Financial Managers try to answer some, or all, of these questions. The top financial within a firm is usually the Chief Financial Officer (CFO) o Treasurer – oversees cash management, credit management, capital expenditures, and financial planning. o Controller – oversees taxes, cost accounting, financial accounting, and data processing. - - - - Capital Budgeting o What long-term investments or projects should the business take on? Capital Structure to have proper funding and management. Identify sources of funds. To balance equity and debt. o How should we pay for our assets? o Should we use debt or equity? Working Capital Management o How do we manage the day-to day finances of the firm? Forms of Business Organization Three major forms in the Philippines Disadvantages Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest Partnership - - Financial Management Decisions - Least regulated Single Owner keeps all of the profits Taxed once as personal income - Advantages Two or more owners More capital available Relatively easy to start Income taxed once as personal income Disadvantages Unlimited liability o General liability o Limited Partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer onwership Corporation - - Advantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital Disadvantages Separation of ownership and management (agency problem) Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate, while dividends paid are not tax deductible) Sole proprietorship - Advantages Easiest to start Goal of Financial Management - - What should be the goal of a corporation? o Maximize profit? o Minimize costs? o Maximize market share? o Maximize the current value of the company’s stock? Does this mean we should do anything and everything to maximize owner wealth? Do transaction or should have profit with honor/ ethical. Sarbanes-Oxely Act response to financial scandals - - - The Sarbanes-Oxely Act of 2002 is a federal law that established sweeping auditing and financial regulations for public companies. Lawmakers created the legislation to help protect shareholders, employees and the public from accounting errors and fraudulent financial practices. Other key provisions under SOX include: o Mandated disclosure of transactions and relationships that are off-balance sheet hat could impact financial status; o Near-ubiquitous prohibition of personal loans from a corporation to executives; o Establishment for tampering or destroying documents in events of investigations or court action; and o Requirements for attorneys who represent public companies before the SEC to report security violations to the CEO. Managing Managers - - - Managerial compensation o Incentives can be used to align management and stockholder interest. o The incentives need to be structured carefully to make sure that they achieve their goal. Corporate control o The threat of a takeover mar result in better management Other stakeholders Financial Management in a nutshell - - What is the cost and benefit of operating, investing and financial management decisions? Cashflow statement What are the risks and returns associated with these management decisions? In any business there is a risk involved. Proper utilization of funds. Module 2 – Financial Markets Definitions of Financial Markets - - Venue for financial exchange between suppliers of capital and users of capital. Users may be suppliers and suppliers may be users of capital. Price discovery mechanism Reduces cost of information and research. Structures - Capital Market – where long-term capital funds in debt and equity are transacted. - Money Market – Where short-term capital is obtained. - Specific Classifications - Debt/bond market (domestic and foreign Long-term Equities market Long-term Future market derivatives Forward market derivatives Options market derivatives Major Players in the Financial Market - - Institutional players and investors Investment bankers and underwriters (third party) why we need underwriters, to process their stock. Banks, insurance companies they lend money with interest. Fund managers The Financial Markets and Products Environmental Factors – political/regulatory, economic, social, technological, environment Industry Factors – rivalry among firms, threat of new entrants, threat of substitutes, bargaining power of the buyers, and bargaining power of the suppliers. Porter’s five forces External Factors affecting financial markets - Global Issues o Geopolitics - International finance & trade o Capital & fund transfers o International trade - Government intervention o Government fiscal policy Taxation Government spending o Government monetary policy Interest Foreign exchange Inflation Capital Market – Long term commercial papers/bonds. - Equities - Financial Innovations Primary - Investment Bankers - Underwriters /Brokers - Insurance Companies - Banks /GFIs - Savings and Mortgage Banks - Pension Funds Secondary - Stock Exchange - Over-the-counter Money Market – Profits - Savings o Banks o Non-banks Determinants of Market Conditions Impact of Factors on Financial Market - Risks Returns and cash flows Liquidity ability of the company to pay Cost of financing - Access to financing Types of financial products Price and valuation Financial Management Intermediation Model Financial Management IPO Model Financial Management Objectives Minimize Risk Firm Value Creation Why is there IPO (initial public offering)? Issue the company in public. To raise capital, more funding for expansion. Financial Management Involves Resource: Maximize Return Increase Stock Price Financial Management Framework (The CAM Model) Firm value creation – Stakeholders - Planning – Financial & profit plan Sourcing – New loans, new equities, profits Allocating – Budgeting, responsibility, centers Controlling – Risk assessment, Financial Report, Variance Analysis Investing – investment timing, risks/ returns, price/ value. Corporate Value - Tangibles and Intangibles o Assets + Earning PH 1.0B o Market Value 2.0B o Intangible Ph 1.0B Intangible assets no physical form, like copyrights. As part of a corporate value. Components of Goodwill (through merger and acquisition) - Brand Equity Future earning potential Market dominance Location Track record Organizational capital Human/intellectual capital Module 3 – Risk and Return a company’s return on its financial investment. The Capital Budgeting Evaluation Process Many companies follow a carefully prescribed process in capital budgeting. The process usually includes the following steps: 1. Project proposals are requested from departments, plants, and authorized personnel. 2. Proposals are screened by a capital budget committee. 3. Officers determine which projects are worthy of funding. 4. Board of directors approves capital budget. Module 4 – Capital Budgeting Cashflow Information - Capital Budgeting Capital Budgeting Evaluation Process o o Cash Flow Information Illustrative Data Cash Payback - - Net Present Value Method o o o o o Equal Cash Flows Unequal Cash Flows Choosing a Discount Rate Simplifying Assumptions Comprehensive Example Cash Budgeting – The process of making capital expenditure decisions. - Involves choosing among various capital projects to find one’s that will maximize Most capital budgeting decision methods employ cashflow numbers rather than accrual accounting revenues and expenses. Revenues and expenses often differ significantly from cash inflow and outflows. Although accrual accounting has its advantages over cash-basis accounting, for purposes of capital budgeting, estimated cash inflows and outflows are preferred as inputs into capital budgeting decision tools. Capital Budgeting Considerations The capital budgeting decision, under any technique, depends in part on a variety of consideration: - The availability of funds - The relationships among proposed projects. The company’s decision- making approach. Cash Payback – identifies the time period required to recover the cost of the capital investment from the annual cash inflow produced by the investment. - - - The cash payback technique may be useful as initial screening tool. It may also be the most critical factor in the capital budgeting decision for a company that desires a fast turn around of its investment. It is easy to compute and understand. However, it should not normally be the only basis for a capital budgeting decision because it ignores the profitability of the project. It also ignores the time value for money. Appendix C reviews the time value of money concepts upon which these methods are based. (all of the PV factors in the following examples come from Appendix C.) Net Present Value Method - Return on investment. Cash Payback: Advantages and Disadvantages - - - - - Under the net present value (NPV) method, cash inflows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is referred to as the net present value. The interest rate to be used in discounting the future cash flows is the required minimum rate of return. A proposal is acceptable when the NPV is zero or positive. The higher the NPV, the more attractive are investment. Discounted Cash Flow Techniques - - - - Capital Budgeting techniques that take into account both the time value of money and the estimated total cash flows from an investment are called discounted cash flow techniques. They are generally recognized as the most informative and best conceptual approaches to making capital budgeting decisions. The primary capital budgeting method that uses discounted cash flow techniques is called net present value. A second method, to be discussed later, is the interest rate of return. Equal Annual Cash Flows Example - Stewart’s annual cash inflows are $24,000. If we assume this amount is uniform over the asset’s useful life, the present value of its annual cash flows can be computed as shown: - The proposed capital expenditure is acceptable at the 12% required rate of return because the NPV is positive. PV at 12% Discount factor for annuity of $1 For 10 periods 5.65022 Present value of cash flows: $24,000 x 5.65022 $135,605 - Therefore, the analysis of the proposal by the NPV method is: 12% Present value of cash flows: $135,605 Capital investment 130,000 Net Present Value $ 5,605 - Why cashflow to be consider in capital budgeting? - To know the movement of the investment - Involves a large amount of investment. The proposed capital expenditure is acceptable at the 12% required rate of return because the NPV is positive. Unequal Cash Flows Example - When annual cash flows are unequal, it is not possible to use annuity tables to calculate their PV. Instead tables showing the PV of a single amount must be applied to each annual cash flow. Why time value of money? - Because in terms of the NPV, the value of money is different from the money in the future. Cash payback period - Payback period must be lower than the useful life of the asset. Accept. Net Present Value - Is considered as the time value of money. NPV= Present Value of Cashflow – Net Investment - If the NPV is zero or positive accept the proposal. Whichever is higher. Profitability Index D - One relatively simple method of comparing alternative projects that takes into account both the size of the original investment and the discounted cash flows is the profitability index. The profitability index is computed with the following formula: Profitability Index = Present Value of Cashflow / Initial Investment - Therefore, the analysis of the proposal by the NPV method is: 12% Present Value of cash flows: $144,367 Capital investment 130,000 Net Present Value $ 14,367 Profitability Index Example - A company must choose between two mutually exclusive projects. Each project has a 10-year life and a 12% discount rate can be assumed. Data related to the two projects is as shown: *written on paper* - - As shown both projects have positive NPVs. Project B’s NPV is higher, but that project also requires more than two times the initial investments that Project A does. Which mutually exclusive projects should the company accept? Internal Rate of Return Factor = Capital Investment / Net annual Cash Inflow $249,000 / $45,000 = 5.5333 Step 2: Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Internal Rate of Return Method - - The internal rate of return method results in finding the interest yield of the potential investment. The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows (i.e., a NPV of zero). - Determining the internal rate of return involves three steps: (These steps assume that annual cash flows are equal; an alternative method of computing the internal rate of return must be used when cash flows are unequal.) - Tampa Company will be used as an example. Tampa Company is considering a new project with an 8year estimated life, an initial cost of $249,000, and a net annual cash inflow of $45,000. Step 1: Compute the internal rate of return factor using the following formula: Step 3: Compare the internal rate of return to management’s required rate of return. Decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, reject the project when the internal rate of return is less that the required rate. This decision rule is shown graphically on the next slide. Comparing Discounted Cash Flow Methods - - A comparison of the two discounted cash flow methods (net present value and internal rate of return) is presented below. When used properly, either method will provide management with relevant quantitative data for making capital budget decisions. Annual Rate of Return: Advantage & Disadvantages - Annual Rate of Return The annual rate of return technique is based on accrual accounting data. It indicates the profitability of a capital expenditure. - Annual Rate of Return = Expected Annual Net Income / Average Investment (beginning + ending /2) - - Cash payback, NPV, IRR and PI used cash flow. Annual rate of return use accrual accounting. - - The annual rate of return is compared to management’s required minimum rate of return for investments of similar risk. The project is acceptable under this method if the annual rate of return is greater than the required rate of return. Average Investment = Original Investment + Investment at end of useful life /2 - The investment at the end of the useful life is equal to the asset’s salvage value. For Reno, average investment is $65,000 [($130,000+ $0)/2] The expected annual rate of return for Reno’s investment is therefore 20% computed as follows: $ 13,000 / $65,000 = 20% - Accept when the ARR is higher than cost of capital. The principal advantages of this method are the simplicity of its calculation and management’s familiarity with the accounting terms it uses. A major limitation is that it does not consider the time value of money. Also, this method relies on accrual accounting numbers instead of actual cash flows.
