Financial Management PDF

9/1/2024 Financial Management Domains I. Introduction to Financial  External financing Managemen...

9/1/2024 Financial Management Domains I. Introduction to Financial  External financing Management (debt and equity financing)  Capital budgeting  Corporate governance  Risk management  Financial DR. B U E N A V E NTUR A ON TUC A II management Learning Outcomes Functions of a Financial Manager  Interacts with other  Review the nature, scope, and functions of managers to help Financial Management improve the operating  Explain the specific duties and types of performance of the firm decisions normally made by a finance  Develops information manager and provide some specific systems and processes examples to provide managers a complete and up-to-  Differentiate between debt and equity date financial picture financing decisions of the firm's  Discuss careers, jobs, and opportunities in operations and overall performance Financial Management Financial Management Defined Functions of a Financial Manager/p1  Financial  Helps decide which management (aka specific investments to “managerial finance”, pursue and identify “corporate finance”, and “business finance”) sources of funds for is a process concerned financing these with planning, investments acquiring, and utilizing  Determines which funds in order to specific funding sources increase the value of a to pursue to assist in business to its owners financing company growth plans 1  9/1/2024 Functions of a Financial Manager/p2 Examples of Financing Decisions  Takes an active role in  Determination of short-, medium-, and long- managing corporate term funds requirements governance and risk  Determination of the best capital structure management issues combination of debt and equity financing  Contributes to  Acquisition of funds through the issuance of developing and financial instruments, e.g. common stocks, maintaining the ethical preferred stocks, and bonds reputation of a firm in  Arrangement with banks, creditors, and relation to its various suppliers for working capital requirements stakeholders  Evaluation of alternative sources of financing Types of Financial Decisions Examples of Operating Decisions  Investing - involves managing the firm's  Determination of the level and amounts of cash, securities, and inventory that should be assets maintained at any given time  Financing - involves obtaining and  Determination of credit management policies and managing the financing a firm needs to procedures support its operations and investments  Determination of sources and timing of short-term financing  Operating - involves managing the firm's  Determination of the optimum means to finance working capital the purchase of raw materials and supplies requirement Examples of Investing Decisions Financial Structure Decisions/1  Evaluation and selection of capital investment  Debt - financing proposals the needs of the  Determination of fund amounts that can be firm using allocated for investment projects  Prioritization of investment alternatives borrowed capital  Determination of fixed assets to be acquired or (payment of replaced interest required  Making of buy or lease decisions but no dilution of  Evaluation of restructuring, merger, and ownership) acquisition decisions 2  9/1/2024 Financial Structure Decisions/2 Careers in Finance/p.1  Equity - financing  Managerial or the needs of the corporate finance firm through the  Government finance sale of company  Personal finance equity (no  Investments payment of interest is required  Financial but there is institutions (banks and non-banks) dilution of ownership)  International finance Finance vs. Accounting  Financial management and accounting are II. The Financial Markets separate and distinct functions but they are interrelated with each other  Accounting function is concerned with systematically recording, summarizing, and reporting information in the financial statements  Financial management function is concerned with DR. B U E N A V E NTUR A ON TUC A II using accounting information to make business decisions External Forces Influencing the Learning Outcomes Finance Function  Increased domestic  Explain the nature, purpose, and benefits of competition the financial market  Globalization of markets  Distinguish between direct finance and  Mergers, takeovers, and restructuring indirect finance  Advances in computer  Differentiate between the various sub- and information divisions of the financial market technology  Distinguish between money market and  Increasing regulatory requirements capital market instruments 3  9/1/2024 What is a Financial Market? Methods of Funds Transfer/p1  A Financial  Direct Finance – market allows lending to borrowers savers (sources of without the use of intermediaries capital) and  Private placements – borrowers (users of selling securities capital) to meet and through a private transact business offering  Brokers – act as an either directly or intermediary between through the use of buyers and sellers but an intermediary do not take title to the securities sold Functions of Financial Markets Methods of Funds Transfer/p2  Transfer funds to users of capital who use  Dealers – buy them for operational purposes and for new securities for own plant and equipment account and sells to clients  Provide sources of capital a channel where they can lend or invest their surplus funds  Investment bankers – act as investment  Facilitate economic and market efficiency “underwriter” and sells securities to other clients Functions of Financial Markets Diagram Methods of Funds Transfer/p3  Indirect Finance – lending to borrowers with the use of intermediaries  Examples:  Commercial banks  Credit unions  Insurance companies  Pension funds  Rural banks 4  9/1/2024 Classification of Financial Markets Components of the Capital Market  Bond market – debts instruments of any kind are traded  Stock market – common and preferred stocks of firms are traded  Mortgage market – loans on residential and commercial real estate are accomplished Classification of Financial Markets (In Terms of Maturity) Other Types Financial Markets/1  Money market –  Consumer credit market – loans on autos, debt securities with appliances, etc. are transacted maturity of less than  Auction market – independent third-party one year are traded conducts trading on behalf of buyers and sellers  Capital market –  Over-the-counter market – trading of securities (debt and unlisted securities is done equity) with maturity of one year or longer is traded Classification of Financial Markets (In Terms of Trading) Other Types of Financial Markets/2  Primary market –  Foreign currency market – foreign financial market where newly issued currencies are bought and sold securities are traded  Spot market – securities are traded for  Secondary immediate delivery and payment market – financial  Futures market – contracts where holders market through are given the right to buy something at a which existing specified price in the future financial securities are traded 5  9/1/2024 Capital Market - Fixed Income Major Classes of Financial Assets Instruments  Debt securities  Publicly Issued  Money market Instruments instruments  Treasury Bonds and Notes  Bonds  Agency Issues  Common stock  Municipal Bonds  Privately Issued  Preferred stock Instruments  Derivative  Corporate Bonds securities  Mortgage-Backed Securities Irwin/McGraw-Hill Financial Markets and Instruments Capital Market - Equity  Money Market  Common stock  Debt Instruments  Residual claim  Derivatives  Limited liability  With voting privileges  Capital Market  Preferred stock  Bonds  Fixed dividends  Equity  Priority over common  Derivatives  Without voting privileges Money Market Instruments Kinds of Stock Markets  Treasury bills  Organized stock  Certificates of deposit exchange - a place where stocks are  Commercial paper bought and sold in a  Banker’s acceptances stock exchange floor  Repurchase  Over-the-counter agreements (OTC) exchange - where securities are traded using electronic means 6  9/1/2024 Stock Market Index Learning Objectives  Stock market index is a tool to measure the  At the end of this class, you should be performance of a stock able: market  Uses:  To compute the future value of an  Describe the performance of investment made today the overall market  To compute the present value of cash to be  Compare the returns on specific investments received at some future date  Compare the performances  To compute the return on an investment of different stock markets Review Basic Definitions  Explain the nature, purpose, and benefits of  Present Value – current value of a future sum money the financial market or streams of cash flow given a specified rate of return  Future Value – value of a current asset at a future  Distinguish between direct finance and date based on an assumed rate of growth indirect finance  Interest rate – “exchange rate” between earlier  Differentiate between the various sub- money and later money divisions of the financial market  Discount rate  Cost of capital  Distinguish between money market and  Opportunity cost of capital capital market instruments  Required return Basic Definitions III. Time Value of Money  Compounding is the process whereby interest is added to a principal amount and to an interest already paid from daily to annually, the effect of which is to magnify returns to interest over time (“miracle of compounding”)  Discounting is the process of estimating the present value of a future payment or streams of cash flows that are to be received in the future DR. BUENAVENTURA ONTUCA II 7  9/1/2024 Future Values Compound Interest Example 1  Suppose you invest P1000 for one year at 5% per year. What is the future value in one year?  Interest = P1000(.05) = P50  Value in one year = principal + interest = P1000 + 50 = P1050  Future Value (FV) = P1000(1 +.05) = P1050  Suppose you leave the money in for another year. How much will you have two years from now?  FV = P1000(1.05)(1.05) = P1000(1.05)2 = P1102.50 Future Values: General Formula Compound Interest Example 2 4-47  FV = PV(1 + r)t  FV = future value  PV = present value  r = period interest rate, expressed as a decimal  t = number of periods  Future value interest factor = (1 + r)t Effects of Compounding 5% Interest Future Values – Example 1 4-48  Simple interest  Suppose you invest the P1000 from the previous  Compound interest example for 5 years. How much would you have?  Consider the previous example  FV = 1000(1.05)5 = P1276.28  FV with simple interest = 1000 + 50 + 50 =  The effect of compounding is small for a small P1100 number of periods, but increases as the number of  FV with compound interest = P1102.50 periods increases.  Simple interest would have a future value of  The extra P2.50 comes from the interest of P1250, for a difference of P26.28  0.05(50) = P2.50 earned on the first interest payment 8  9/1/2024 Future Values – Example 2 Present Values – Example 1 4-49  Suppose you had a relative deposit P10 at 5.5%  Suppose you need P1,000,000 in one year for interest 200 years ago. How much would the the down payment on a new forklift for your investment be worth today? factory. If you can earn 8% annually, how much  FV = 10(1.055)200 = P447,189.84 do you need to invest today?  What is the effect of compounding?  Solution:  Simple interest = P10 + 200(10)(.055) = P210.55  PV = P1,000,000 / (1.08)1 = P925,925.93  Compounding added P446,979.29 to the value of the investment! Future Value as a General Present Values – Example 2 Growth Formula  You need to replace a machine in your plant  Suppose your company expects to increase and you estimate that you will need P1,500,000 unit sales of product X by 15% per year for in 5 years. If you feel confident that you can the next 5 years. If you currently sell 3 earn 7% per year, how much do you need to million units in one year, how many units invest today? do you expect to sell in 5 years?  Solution:  FV = 3,000,000(1.15)5 = 6,034,072 units  PV = 1,500,000 / (1.07)5 = P1,069,479.27 Present Values Present Values – Example 3  How much do I have to invest today to have a  You had invested in a real asset 10 years ago specific amount in the future? that is now worth P2 million. If the asset  FV = PV(1 + r)t earned 7% per year, how much did you invest  Rearrange to solve for PV = FV / (1 + r)t originally?  Solution:  Discounting means finding the present value of some future amount  PV = P2,000,000 / (1.07)10 = P1,016,698.58  The “value” of something means the present value unless the future value is specified 9  9/1/2024 PV – Important Relationship I The Basic PV Equation – Refresher  For a given interest rate – the longer the time  PV = FV/(1 + r)t period, the lower the present value  There are four parts to this equation  What is the present value of P500 to be received  PV, FV, r and t in 5 years? 10 years? The discount rate is 10%  If we know any three, we can solve for the  Solution: fourth  PV = 500 / (1.1)5 = P310.46 (5 years)  If you are using a financial calculator, be sure  PV = 500 / (1.1)10 = P192.77 (10 years) and remember the sign convention or you will receive an error when solving for r or t PV – Important Relationship II Formula Reviewer  For a given time period – the higher the interest rate, the smaller the present value  What is the present value of P500 received in 5 years if the interest rate is 10%? 15%?  Rate = 10%: PV = 500 / (1.10)5 = P310.46  Rate = 15%; PV = 500 / (1.15)5 = P248.58 Present Value of 1.00 Review  Future value of money and the compounding process  Present value of money and the discounting process 10  9/1/2024 Classes of Capital Expenditures IV. Capital Budgeting  Replacement investments – investments on replacement on dilapidated or obsolete facilities  Expansion investments – investments that will provide additional facilities to increase production and/or distribution capabilities DR. BUENAVENTURA ONTUCA II Learning Objectives Classes of Capital Expenditures  Explain the basic concepts and tools of  Replacement investments – investments capital budgeting on replacement on dilapidated or obsolete  Explain the methods of economic evaluation facilities  Expansion investments – investments that will provide additional facilities to increase production and/or distribution capabilities Basic Terms in Capital Budgeting Classes of Capital Expenditures  Capital expenditures – substantial outlay  Product-line or new market investments – of funds the purpose of which is to lower expenditures on new products or new markets costs and increase net income for several  Mandatory investments (or non-revenue years in the future producing projects) – expenditures needed to comply with government requirements or  Includes expenditures that tie up capital for contractual agreements ( e.g. labor contracts) long periods  Strategic investments – investments designed to  Examples: new manufacturing plant, major accomplish the overall objectives of the firm research on new products, advertising  Other investments – include office buildings, campaign parking lots, executive planes 11  9/1/2024 Capital Budgeting Defined Capital Budgeting System  Capital budgeting  Preparation and is the planning submission of budget process used for requests allocating resources  Approval of budget for major capital or  Request for fund investment appropriation expenditures to  Submission of increase the firm’s progress reports value for the benefit  Preparation and of shareowners. submission of post- approval reviews Objectives of Capital Budgeting Valuation  Setting priorities  Valuation is the  Choosing projects process of with the best yield  Eliminating estimating the duplication real worth of a  Aligning with proposed project company objectives to the firm  Keeping debt in line  Using resources efficiently Investment Methods of Economic Evaluation  Payback period  Investment is a process of allocating method funds in the expectation of some benefit  Average rate of in the future return method  Forms:  Discounted cash  Initial – amount devoted to a project until flow method it generates cash inflows from operations  Netpresent value  Later – expenditures made after the first  Internal rate of return cash inflow 12  9/1/2024 Payback Period Method Discounted Cash Flow Method  Payback period method – the  Net present value (NPV) method – difference of present value of cash inflows and cash outflows number of years required to recover  Formula: the cash investment  NPV = [Cash flow/(1 + i)t] – Initial investment on a project  Formula: Where:  Payback period = i – discount rate cost/annual cash t – number of time periods inflow Average Rate of Return Method Risk and Uncertainty  Average rate of Risk and uncertainty both refer to return (ARR) variations of actual values from expected method – ratio of values average cash inflow to the capital outlay The variation attributed to risk is caused by chance  Formula:  ARR = average cash The variation attributed to uncertainty is inflow/capital outlay caused by estimating errors Discounted Cash Flow Method Sensitivity Analysis The formula for finding the present Sensitivity analysis is technique used to value of an expected cash inflow: examine the change in cash inflows as a result of changes concerning a project or PV = A/(1 + R)n proposal  Where: Example: what would the impact on A = expected cash inflow   R = desired rate of return returns be if plant capacity is operating at  n = number of years the cash inflow is expected 100%, at 75%, or at 50? 13  9/1/2024 V. Financial Statement Financial Ratio Analysis 2- 82 Analysis  Financial ratio analysis involves using financial ratios to analyze financial statements  Different parties will focus on certain types of financial ratios depending on their needs  Ratios may vary from DR. BUENAVENTURA ONTUCA II one industry to another Learning Outcomes Categories of Financial Ratios  Identify and explain the different financial  Liquidity ratios ratios used to evaluate short-term financial  Asset management position (liquidity ratios), asset liquidity and ratios management efficiency (activity ratios), long- term financial position (debt ratios),  Debt management profitability and return to investors ratios (profitability ratios), and valuation (market  Profitability ratios ratios)  Market ratios  Discuss the limitations of financial statement analysis Financial Statement Analysis Liquidity Ratios 2- 81  Financial statement  Liquidity ratios analysis is “the measure a firm’s process of extracting ability to satisfy its information from financial statements short-term to better understand obligations as they a company’s current come due and future  Liquidity ratios are performance and good indicators of financial condition” cash flow problems (E. Cabrera, 2015) 14  9/1/2024 Types of Liquidity Ratios Types of Activity Ratios  Current ratio – measures a firm’s ability  Inventory turnover – number of times a to pay short-term obligations (due within 1 firm turned over its inventory during a given year) year  Formula: current assets/current liabilities  Formula: cost of goods sold/average merchandise inventory  Quick (acid-test) ratio – measures a firm’s ability to pay its short-term  Average collection period – amount of obligations with its most liquid assets time needed to collect accounts receivable  Formula: current assets - inventory/current  Formula: accounts receivable/average sales liabilities per day Types of Liquidity Ratios Types of Activity Ratios 2- 86  Fixed asset turnover – indicates how well a firm is using its fixed assets to generate sales  Formula= sales/net fixed assets  Total asset turnover – indicates how well a firm is using its total assets to generate sales  Formula: sales/total assets Activity Ratios  Activity ratios (also known as Types of Activity Ratios efficiency ratios) measure the speed with which a firm is able to convert various accounts into sales or cash  These financial ratios are used to assess how efficiently a firm manages its assets (especially inventory) in order to generate revenues and cash 15  9/1/2024 Debt Ratios 2- 94  Debt ratios measure the extent to which a firm uses money from creditors rather than shareholders to finance its operations  These ratios are used to assess a firm’s long-term indebtedness and its ability to meet the fixed payment associated with debt  Generally, the more debt a firm uses in relation to its total assets, the greater its financial leverage Types of Debt Ratios Profitability Ratios 2- 95  Debt ratio – indicates the proportion of a firm’s  Profitability ratios measure a firm’s assets that are financed with debt (financial leverage) profitability and returns to investors  Formula: = total liabilities/total assets  Debt-to-equity ratio – indicates the degree to  Profitability ratios are the most closely which a firm is financing its operations with debt watched and widely quoted financial ratios rather than its own resources  Many firms link employee bonuses to these  Formula: long-term debt/stockholders’ equity ratios  Times interest earned ratio - measures a firm’s ability to pay interest on debt with current income  Formula: net income before interest and taxes/interest expense Types of Debt Ratios Types of Profitability Ratios 2- 93  Gross profit margin - shows how much gross profit a firm makes as a % of sales  Formula: gross profit/sales  Operating profit margin – shows how much operating profit a firm makes as a % of sales  Formula: operating profit/net sales  Net profit margin – shows how much net profit a firm makes as a % of sales  Formula: net profit/net sales 16  9/1/2024 Types of Debt Ratios Market Ratios 2- 97  Market ratios are financial metrics used to evaluate whether the current share price of a publicly traded firm is overpriced or underpriced  These ratios provide insight into how investors think the firm is performing  High P/E ratios could indicate a firm’s stock is overvalued (investors expecting high growth rates in the future)  Low P/E ratios could indicate a firm’s stock is undervalued (investors expecting low growth rates in the future) Types of Profitability Ratios Types of Market Ratios  Earnings per share – company’s net profit  Price/earnings (P/E) ratio – relates a company’s divided by total shares it has outstanding current share price to its earnings per share  Formula: net income/average number of shares of  Formula: market price per share of common common stock outstanding stock/earnings per share  Return on total assets – measures how  Price/book ratio (P/B) ratio – relates a efficiently a firm uses its assets to generate profits company’s current share price to its book value per  Formula: net income/average total assets share  Return on common equity – measures a firm’s  Formula: market price per share of common profitability and how efficiently it generates those stock/book value per share of common stock profits **Book value per share = stockholders’  Formula: net income/average shareholders’ equity equity/average no. of shares of common stock outstanding Types of Debt Ratios Types of Market Ratios 2- 2- 99 102 17  9/1/2024 VI. Working Capital Types of Market Ratios 2- 103 Management Dr. Buenaventura Ontuca II Source: Business Finance, 2nd ed. - R. Medina, Ph Limitations of Financial Statement Analysis Learning Objectives  Information derived is only an indication of  Explain the concept of working capital and actual business performance (not absolute) its various elements  Lack of consistency and variation in  List some ways in which a firm can manage accounting data results in faulty analysis its working capital  Limitation of particular tools or techniques  Identify some means in which a firm can used in the analysis increase its cash on hand  Management has tendency to influence the outcome of the analysis  Distinguish between the different methods of inventory Review Basic Concepts of Working Capital  Identify and explain the different financial  Working capital is part of the capital of ratios used to evaluate short-term financial the company which is continually position (liquidity ratios), asset liquidity and management efficiency (activity ratios), long- circulating term financial position (debt ratios), and  Types: profitability and return to investors  Gross working capital – total amount of the (profitability ratios), and valuation (market firm’s current assets ratios)  Working capital – total amount of current  Discuss the limitations of financial statement analysis assets minus current liabilities 18  9/1/2024 Gross Working Capital Liquidity Management  Cash in the firm’s safe  Cash sales  Checks to be cashed  Balances in bank  Collections of accounts accounts receivables  Marketable securities  Sale of assets  Notes and accounts receivable  Additional  Supplies contribution from  Inventories owners  Prepaid expenses  Advances from  Deferred items customers Need for Working Capital Cash Management  Replenishment of  Cash inventory management is  Provision for the proper operating expenses collection, handling and usage of cash  Support for credit to ensure company sales stability and  Provision of a solvency safety margin Management of Working Capital Effective Cash Management  Working capital must be adequate to cover  Use money mobilization techniques to all current financial requirements reduce operating requirements for cash  Working capital structure must be liquid  Increase accuracy and reliability of cash enough to meet current obligations as they flow forecasting fall due  Carefully define the liquidity reserve needs  Working capital must be conserved of the firm through proper allocation and use  Develop alternative sources of liquidity  Working capital must be used to achieve  Seek more productive uses of surplus the profit objectives of the firm funds 19  9/1/2024 Accounts Receivable Management Sources of Credit Information  Accounts receivable  Personal interviews – purchases made by customers but not yet  References paid for  Objectives:  Credit bureaus  Determine the cost and  Credit-reporting profitability of credit sales agencies  Estimate cash flows from accounts  Banks receivables  Direct and control activities involved in extending credit to customers Elements of the Cost of Credit Inventory Management  Inventory  Cost of bad debts management involves activities related to  Cost of invested keeping track of how funds many of the purchased items needed to produce  Administrative and a product or service are related costs available, where each item is, and who has the responsibility for each item  Key points:  Profitability – inventory level at a given level of sales and profit  Liquidity – inventory turnover Functions of the Credit Department Forms of Inventory  Gather and organize the  Raw materials information necessary for decisions on granting  Work-in-process credit to particular customers  Finished goods  Ensure that efforts are made to collect receivables when they become due  Determine and carry out activities needed to collect accounts of customers who cannot or do not intend to pay 20  9/1/2024 Inventory Management Methods  ABC method  Economic order quantity (EOQ) method  Safety stock  Anticipation stock Review  Explain the concept of working capital and its various elements  List some ways in which a firm can manage its working capital  Identify some means in which a firm can increase its cash on hand  Distinguish between the different methods of inventory 21