Finance and Investments/Principles of Managerial
Finance
Chapter 1: The role of managerial finance
Finance allows supply and demand.
Supply – Firms, they make sure the needs are met
Demand – Consumers, they have the needs, like food
A firm is a business organization that sells goods and/or services.
We can think of firms as entities where business owners and money holders meet.
Firms are intermediaries that bring together investors and risky investment
opportunities.
Firms are interested in investors. They allow the company to invest and grow. If you
don’t grow as a company, you will be destroyed by competition.
Firms have short-term goals (to avoid bankruptcy) and long-term goals (investments)
Goals as a firm/manager:
1. Maximize shareholder wealth.
The primary goal of managers is to maximize the wealth of the firm’s owner, meaning
shareholders or stockholders
Share price is the best index to measure stockholder wealth.
If we take into account these principles, then managers should only take action that
they expect will increase the shareholders’ wealth
Share prices can be affected by the size of the company (bigger company needs
more investments), the company’s welfare, price of assets, number of outstanding
shares (the more, the less value it has because it’s more split), but most importantly
are the beliefs and interests of the consumers.
2. Maximize stakeholder welfare
Management should focus on the maximization of stakeholder welfare instead of
shareholder wealth.
Shareholders own a part of the company; stakeholders are only affected by the
company. Stakeholders can be employees, suppliers, customers, citizens etc.
Critics of this view affirm that shareholders’ wealth maximization does not clash with
stakeholders’ welfare. More trust from consumers, less risk of boycotting or
vandalism
3. Maximize profit
Profits are commonly measured in earnings per share (EPS), which is the amount
earned during a specific period by each outstanding share of stock.
Profit maximization does not always coincide with shareholder wealth maximization.
Timing: an investment that provides small profits quickly may be preferred to one
that produces higher profits, but later.
Cash flow: Profits do not always result in cash flow. Profit is an estimate; cash flow
shows money flowing into the company
Risk: Profit maximization does not consider risk. A business that earns little but has a
low risk can be more valuable. You always need to take risk for profit.
Profit = revenues – costs. Dividends influence the profit
Managing the firm:
Managers are in charge of controlling anything that has a financial impact on or is of
financial importance to the firm.
Investment decisions:
Focuses on how companies will spend its financial resources on long-term projects
that ultimately determine whether the firms successfully creates value for the firm.
Most important decisions which determine the failure or success of the business in
the long run.
For long-term growth, advertise the investments, for a growth in stock price and
interest.
Capital building:
A technique that helps managers decide which projects create the most value for
shareholders.
In practice, this means that managers try to identify projects where the benefit
exceeds the cost, as to make a revenue off it.
This principle is the main guiding tool for investment decisions.
Financing decisions:
Financing decisions determine how companies raise the capital needed for
investment opportunities.
Therefore, it can also be called Capital Structure Decision.
Firms have 3 options:
1. Reinvest earnings;
2. Use capital from owners of the business or to external investors interested in the
ownership;
3. Request a loan to banks
This tool through which the company decides to support its investment has crucial
implications
Working capital decision:
Working capital decision refer to the management of a firm’s short-time resources.
This means tracking the cash position, making sure the firm pays its bills and receive
payments from customers on time.
This is fundamental to ensure the company has enough liquidity to meet short-term
obligations.
Guiding principles:
1. Time value of money: having money today is better than having it later.
2. Tradeoff between return and risk: investors want higher returns, must bear
higher levels of risk.
3. Cash is king: cash flow matters more than profits, since investors are paid
with cash
4. Competitive financial markets: managers need to convince investors that
their business is better than others
5. Incentives are important: whether the owner of the firm is different from the
managers, there is a principal-agent problem
Legal form and taxation:
1. Sole proprietorship:
For profit businesses, owned by one person;
Owner is also the manager;
Entrepreneurs has unlimited liability;
Income from business is passed through the owner and taxed at a personal level
2. Partnerships:
Two or more owners doing business together;
Regulated by Articles of Partnership;
In regular partnership, partners have unlimited liability;
Income from business is passed through each owner and taxed at a personal level.
3. Corporations:
Business owned by individuals, but the legal entity is distinct from them;
Owners elect a Board of Directors, which appoint the CEO;
Stockholders have limited liability;
Income from business is passed to the owners through dividends. This means that
corporations suffer from double taxation.
Chapter 2: The Financial Market Environment
Sales are made when you lose/transfer ownership of the product.
Financial institutions serve as intermediaries by channeling the savings in the
economy into loans or investments.
Individuals: Net supplier of funds;
Firms: Net demanders of funds.
1. Commercial banks: They provide deposits/investment opportunities for capital of
savers and provide loans to businesses and borrowers. They make and provide
private money/money with a click.
2. Investment banks: they assist companies in raising capital, advise firms on major
transactions and they engage in market-making activities.
3. Shadow Banking System: Financial institutions that act like commercial banks,
but that do not accept deposits. Pension funds e.g. fake deposit cannot get it back
till the agreed-on time has passed, 10 years as an example. The time depends on
what type of investment you make. You can always add money but not add. That is a
risk of this, you cannot get your money if you ever need it.
Commercial banks are not an option; it is a must. The other banks are an addition to
that.
SBS invest in stocks or invest in companies to make money. Investment banks don’t
get money for depositors. Investment for a company or social cause.
Financial markets are forums in which suppliers and demanders meet to make
deals.
Money market where short-term trades (<1 year) happen;
Capital market where long-term trades (>1 year) happen.
When a security is issued the first time and money go directly to the issuer; we talk
about PRIMARY MARKET. Once the securities are traded between investors, we
talk about SECONDARY MARKET. Example: You buy something at the store
(primary market), later you sell it because you do not need it anymore (secondary
market).
There are 2 approaches that firms have to raise money:
1. Private placement: sale of new securities directly to investors;
2. Public offering: sale of bonds or stock.
Two types of tools are trade in Capital Markets:
1. Debt – Bonds
2. Equity – Common stock & preferred stock
Trades happen at a specific price, which is in between the bid (highest price the
buyer is willing to pay) and the ask (lowest price the seller is willing to accept) prices.
The difference between the two is called the bid/ask spread.
Common stockholders: hope to get dividend, voting right, last to get the dividend.
Preferred stockholders: no voting right and get the dividend after obligatory, but they
get the dividend before common stockholders.
Bonds are periodical and have a fixed payment, that being interest. Preferred stock is
the same, but with dividends.
Preferred stockholders can become common stockholders, but not bonds. An
investor would make this decision to increase their voting power, as an example.
Preferred stock is like a hybrid, it is in between debt and equity.
Bonds are less expensive than preferred stock and also cheaper than equity in
general.
Bid/ask spread example:
Ask 167,79
Bid: 167,85
The bid/ask spread is 167,85 – 167,79 = 0,06 euros. 167,82 is the meet
point/average.
(Amount of shares x 3 cents) + commission fee = total commission fees.
Chapter 3: Financial Statements and Ratio Analysis
The Four Key Financial Statements:
Informative financial reports constructed based on GAAPs and used for internal and
external purposes
1. Income Statement: Summary of operating results,
starting from the Gross value and arriving to the Net.
2. Balance sheet: Summary statement of the firms’ position
at given period, comparing assets against financing
instruments.
Elements are that it’s expressed in book value, ordered
based on liquidity (highest to lowest) and categorized
based on time;
Short-term: maturity < 1 year and
Long-term: maturity > 1 year
3. Statement of retained earnings: it summarizes the net
income earned during a given period and the relative
cash dividends paid, showing the change in retained
earnings between the start and the end of the period.
4. Statement of cash flow: simply, a summary of the cash
flow inside and outside the company during a given
period of time.
Using financial ratios:
Ratio Analysis involves methods of calculating and
interpreting financial ratios to analyze & monitor the firm’s
performance.
Ratio Analysis focuses more on the interpretation of the ratio
values with respect to a specific period or to peer firms.
Type of Ratio Comparisons:
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

Cross-Sectional Analysis: comparison of different units
in a specific point in time
Time-Series Analysis: evaluation of performance over
time
Combined (or Panel) Analysis: Combination of the previous two approaches.
Generally, analyzing ratios individually does not provide useful information
When comparing ratios between companies, ensure that you are using financial
statements dated at the same point in the year.
Audited values are to be preferred to self-assessment ones
Financial data being compared should have been constructed using the same
accounting principles.
Results can be distorted by high inflation, especially when comparing ratios over a
long time period.
Liquidity ratio:
The liquidity of a firm reflects its ability to satisfy short-term obligations as they
come due.
Trade-off: low or declining liquidity could be an early warning for financial distress. At
the same time, overinvesting in liquidity is not beneficial for the business growth.
Liquidity needed depends on different factors: firm size, access to short-term
financing sources, volatility of the business, etc.
Current Ratio: The Current Ratio measures liquidity by comparing a firm’s current
assets to its current liabilities.
Current Ratio = Current Assets / Current Liabilities
Quick (Acid-Test) Ratio: Quick ratio is similar to the current ratio, except that it
excludes inventory (generally the least liquid current asset).
Why? (i) inventory is hard to sell because it is often partially completed and (ii)
inventory is typically sold on credit.
Quick Ratio = (Current assets – inventory) / Current Liabilities.
Activity ratios:
Activity ratios measure the speed with which various assets and liabilities are
converted into sales or cash.
In other words, it measures how efficiently the firm operates
Inventory Turnover: Inventory turnover Ratio is a metric used to evaluate the
effectiveness of inventory management practices.
Inventory Turnover = Costs of goods sold / Inventory
Average age of inventory = 365 / inventory
Average Collection Period: ACP is useful in evaluating credit and collection policies
ACP = Accounts receivable / average sales per day = … days
Average sales per day = cost of goods sold / 365
Average Payment Period: APP is harder to calculate, because the Annual Purchases
are usually not published in the FSs
Ordinarily, Average purchases per day estimated as 90% of cost of good sold.
APP = Accounts payable / average purchases a day
Average purchases a day = ?? / 365
Total Asset Turnover: TAT measures the efficiency of a firm in using its assets to
generate sales
TAT = Sales / Total assets
Debt Ratios:
Debt position generally indicates how much a firm relies on funds that are not
provided by shareholders, but rather lenders.
The greater the debt, the greater is the insolvency risk, but also the potential
returns.
The more debt a firm uses in relation to its total assets, the greater is its financial
leverage.
Leverage measures: Leverage measures are of two different types: measures of the
degree of indebtedness and measures of the ability to repay debts.
Degree of indebtedness:
Debt ratio: The debt ratio measures the proportion of total assets financed by the
firm’s creditors.
Debt Ratio = Total Liabilities / Total Assets
Debt-to-Equity Ratio: The D-t-E Ratio measures the relative proportion of total
liabilities to common stock equity used to finance the firm’s assets
D-t-E Ratio = total liabilities / common stock equity
Ability to repay debts:
This ratio (also called coverage ratio) compares the income that a firm earns to the
fixed payments that it is obligated to make.
Times Interest Earned Ratio: it measures the firm’s ability to make contractual
interest payments
TIER = Earnings Before Interest and Taxes / Interest
(EBIT is the same as Operating Profits)
Fixed Payment Coverage Ratio: it measures the ability of the firm to meet all the
fixed-payment obligations
Fixed Payment Coverage Ratio = (EBIT + Lease payments) / (Interest + lease
payments) + [(Principal payments + Preferred Stock Dividends) x (1/(1-tax rate
applicable to the firm))]
Profitability Ratios:
Measures that enable analysts to evaluate a firm’s profit.
Common-size income statements:
It is a useful tool to evaluate profitability in relation to sales.
Each item is expressed as a % of sales.
Gross Profit Margin: It measures the percentage of each sale dollar remaining after
the firm has paid for its costs goods sold.
GPM = (sales – cost of goods sold) / sales
Operating Profit Margin: it measures the percentage of each sale dollar remaining
after deducting all costs and expenses other than interest taxes and preferred stock
dividends. In other words, it measures the “pure profits”.
OPM = Operating Profits / Sales
Net Profit Margin: it measures the percentage of each sales dollar remaining after all
costs and expenses, including taxes, interests and preferred stock dividends, are
deducted.
NPM = Earnings Available for Common Stockholders / Sales
Earnings per Share: Hardly comparable between companies due to the different
number of common shares outstanding.
EPS = EACS / number of shares of common stock outstanding
Return on Total Assets: sometimes called Return on Investment (ROI), measures the
overall effectiveness of management in generating profits with its assets.
ROA = EACS / Total Assets
Return on Equity: the ROE is similar to ROA, except this one focusses on the
earnings generated by the equity invested in the firm, rather than the assets invested.
ROE = EACS / Common Stock Equity
Assets = (Liabilities + Equity)
This means that as long as the firm has at least some liabilities: A > E
The more it borrows, the bigger the gap between ROA and ROE will be
1. If positive earnings available for common stockholder, ROE > ROA
2. If there are no positive earnings available for common stockholders, ROE < ROA
Market ratios:
Market Ratios relate the firm’s market value, as measured by its current share price
to certain accounting values.
These ratios give insights into how investors believe the firm is doing.
Price/Earnings Ratio: P/E ratio measures the amount of money investors are willing
to pay for each dollar of a firm’s earnings. One relevant factor affection P/E ratios is
the growth rate that investors believe a firm will achieve.
P/E ratio = Market Price Share of Common Stock / Earnings per Share
Market/Book Ratio: The M/B Ratio provides an assessment of how investors view the
firm’s performance.
M/B ratio compares the market price of the firm’s common stock (i.e. value
investors are willing to pay) to the book value of common stock (i.e. value shown
on the balance sheet).
Book Value per Share of Common Stock = Common Stock Equity / Numbers of
shares of common stock outstanding
Market/Book Ratio = Market price per share of common stock / Book value per share
of common stock
DuPont System Analysis:
Dupont System analysis is used to dissect and assess its financial condition.
Dupont Formula: the DuPont system first brings together the net profit margins
(measures of sales’ profitability) with its total asset turnover (indicated firm’s
efficiency in exploiting its assets)
ROA = Net Profit Margin x Total Asset Turnover
This analysis shows that the company can choose its desired ROA in two ways:
- Through strong net profit margins
- Turning over its assets rapidly
Modified DuPont Formula: this formula relates the firm’s ROA to its ROE. The key
ratio linking the two is the Financial Leverage Multiplier (FLM), which is also called
Equity Multiplier.
FLM = Total Assets / Common Stock Equity.
Chapter 4: Long- & Short-Term Financial Planning
Financial Planning Process:
Financial planning allows the company to draw up a strategy through which it can
achieve the objective of creating value for shareholders.
Two aspects of the financial planning process are:
1. Cash planning: preparation for the firm’s cash budget  needs sales forecast
2. Profit planning: preparation of pro-forma statement, projecting futures figures for
the future.
Long-Term Financial Plan: This plan describes the strategy for how the company will
compete in the market and relative impact of such strategy over period ranging from
2 to 10 years.
2 main objectives of the Long-Term Financial plan:
1. Build/create value for the shareholders
2. Whether the firm needs to raise additional external capital or whether it generates
efficient cash flow.
The plan specifies the magnitude, timing and return of major investments.
This helps managers in forecasting funds availability and cash requirements,
meaning:
1. Investment decisions.
2. Financing decisions.
Short-Term Financial Plan: This plan describes short-term financial and operating
decisions and their relative impact over periods ranging from 1 to 2 years.
Notice that the attention remains on cash position and profits perspectives.
Key inputs: sales forecast and various forms of operating and financial data
Key outputs: operating budgets, the cash budget and pro forma financial statements
Measuring the firm’s cash flow:
Estimating cash flow is central to the valuation process of an investment.
We refer to cash flow as an inflow and/or outflow of money inside and outside the
company.
Depreciation:
Accounting principle that consider the cost of an asset as spreadable over its lifetime.
This means that the cost of an asset is not accounted entirely in the year of the
purchase of the same.
To calculate the depreciation of an asset we use the Modified Accelerated Cost
Recovery System (MACRS).
- The depreciable value of an assets is its full cost, installation cost included
- The depreciable life of an assets can be of six recovery years (3, 5, 7, 10, 15 and 20
years)
- The Half-Year convention assumes that the firm buys the assets in the middle of the
year.
Developing the Statement of Cash Flow:
Cash flow can be summarized into three categories:
1. From Operating activities: directly related to sales and production of a firm’s
product
2. From Investment Activities: related to purchase and sale of both fixed assets
and equity investments in other firms.
3. From Financing activities: it results from debt and equity financing
transactions.
Changes in the balance sheet reflect inflows and outflows.
Interpreting the Statement:
A useful way to evaluate cash flow is to split its analysis based on the classification
given previously.
Operating Cash Flow: First calculate the Net Operating Profits After Taxes
NOPAT = EBIT x (1-t)
Then NOPAT into OCF
OCF = NOPAT + Depreciation
Free cash flow: FCF represents the cash available to investors after the firms has
met all operating costs and paid for the net investments in fixed and current assets.
Net Fixed Asset Investment = Change in Net Fixed Assets + Depreciation
Net Current Asset Investments = Change in Net Current Assets - Change in (Account
payable + accruals)
Now we can calculate Free Cash Flow
FCF = OCF – NFAI – NCAI
Cash budget:
With the cash budget a firm plans its own flow of cash.
A key input is the Sales Forecast, which considers inflows and outflows related to
production, inventory and sales.
There are two ways to deal with sale forecast:
1. External Forecast: top-down approach
2. Internal Forecast: bottom-up approach
Preparing the Cash Budget:
Total Cash Receipts: all cash inflow
during a specific period
Total Cash Disbursements: all cash
outflows during a given period
Net Cash Flow: difference between
inflows and outflows
Ending Cash: Net cash + cash owned at
the beginning of the period
Required Total Financing: Amount of funds needed if ending cash is less than the
desired minimum cash balance
Excess Cash balance: the excess cash available for investments.
Evaluating the Cash Budget:
By the analysis of the cash budget, you should be able to expect eventual cash
surpluses or shortages.
Your cash forecasts should be flexible enough to face uncertainty of the estimation
in the same forecast:
1. Conservative Analysis
2. Simulation Analysis
Profit planning: Pro Forma Statements:
Of great interest to shareholders, creditors and management, since it summarizes the
firm’s overall financial position.
Two ingredients are needed: previous year’s financial statement and sales
forecast for the coming year.
Pro Forma Income Statement:
Percent-of-sales method:
Use % sales of previous year to forecast projected income statement items.
Underlying assumption: all costs are variable.
Possible adjustments: divide costs into fixed and variable.
Pro Forma Balance Sheet:
A balance sheet represents a summary of the firm’s assets and liabilities for a given
period.
Two approaches:
1. Percentage-of-sales
2. Judgmental: percentage of sales + external financing required (what is needed to
bring the statement into balance)
Chapter 5: Time Value of
Money
Time Value
It is better to receive
money sooner than later.
This creates a tradeoff
when actions that require
outflow of cash today may
produce cash inflows later
in the future.
There are two ways to
pose the problem:
1. What is the future value of €x? Use the compounding approach.
2. What is the present value of future €y? Use the discounting approach.
Single amount
A lump sum amount currently held or expected in the future
Future Value:
What is the future value of an investment
made today?
Compound interest:
Compound interest is an interest paid
on an investment’s original value
(principal value) and on the interest that has been accumulated over previous
periods.
Simple interest:
A simple interest is earned only on an
investment’s original principle.
The higher the interest rate is and the longer
the period of the investment is, the bigger the
difference in the Future Value of an investment
with a compounding interest will be.
Future Value with a compounding interest >
Future with a simple interest
Present value:
What is the present value of a future cash flow? Or what Is the
amount that I need to invest today to obtain a specific value in the
future?
The process of finding the Present value of an investment consists
of discounting the cash flow of the same,
assuming a specific discount rate.
Annuity:
A period stream of cash flow.
Ordinary Annuity:
The cash flow occurs at the end of each
period.
Annuity Due:
The cash flow occurs at the
beginning of each period.
Perpetuity:
Annuity with infinite life
Annuity that grows at a steady rate.
A periodical stream of unequal cash flow. The solution here is to calculate individually
the future or present value of each cash flow. Then sum the values up to obtain the
total value.