Financial Management- Module 1-6

FINANCIAL MANAGEMENT Module 1

COMPONENTS OF FINANCIAL MANAGEMENTFinancial Planning Master Budget Working Capital Mgt.

Operating Budget Financial Analysis Leverage Analysis Forecasting Capital Budget Cash Budget Balance Sheet

Sales Budget Prodn Budget

Current Asset Mgmt.

Break-even Analysis

Admin Budget

Short-term Sources of Capital

Selling Budget

Return Measurement

Risk Management

Time Value of Money

Valuation Approaches

Capital Sources

Cost of Capital

Capital Expenditure Budgeting

Investment Technique

Capital Allocation/ Rationing

Costs

Capital Structure Theory

Long-term FinancingLong-term Debts

Covenants Features

Concepts & Tools

Bonds Equities

Dividend Policy Distribution Stock rights

Preferred Equities Long-term Lease

IPO

Valuation Models

Acquisition Strategies

Divestment Strategies

Other Modes of Long-term Financing

Te der Offers Ti i Valuatio Hostile Takeover Ba kruptcy/ Reor a izatio Re-capitalizatio

eft-ha d i a ci

Restructuri i a cial I ovatio s Co versio BO

I ter atio al i a ce A ti-takeover Strate ies

Debt Reductio

Reor a izatio

Fi a cial Ma a e e t IPO ModelTasksResource I put Resource Process Resource Output

Objectives

Eco o y

Efficie cy

Effective ess

Outco e Be eficiary

Corporate Value Stakeholders

Financial Management Involves Resource:

PLANNING

SOURCING

ALLOCATING

CONTROLLING

UTILIZING

Fi a cial & Profit Pla

New oa s New Equities Profits

Bud eti Respo sibility Ce ters

Risk Assess e t Fi a cial Report Varia ce A alysis

I vest e t Efficie cy Eco o y Effective ess

Fir

Value Creatio

Stakeholders

Fi a cial Ma a e e t I ter ediatio ModelTHE FIRM Risk - Retur A alysis

F U N D SCreditors FINANCIA MANAGEMENT

Create Value INTERMEDIATION Fi a cial Eco o ics EVERAGING

Create Value

COST/BENEFIT A alysis Cost of Fu ds Retur

Shareholders

DIVIDENDS FIXED PAYOUTS RETURN ON EQUITY INTEREST COVER

Eco o ic Value Added

FINANCIAL MANAGEMENT OBJECTIVES Minimize Risk Maximize Returns

Firm Value Creation

Increase Stock Price

Financial Management Framework (The CAM Model)I terest

Fi a cial Resources Source

Fu ds Market Capital Market

Tar et Fi l Structure Capital Structure

Debt

Equity

Wei hted Avera e Cost of Capital

Mo ey Market

Divide d/ Ear i s

Proble s Fi a cial Health & Issues Use ProfitabilityEco o y

Economic Value AddedRetur o I vest e t

iquidityEfficie cy

ActivityEffective ess

evera e

DETERMINANTS/ASSESSMENT OF CORPORATE FINANCIAL PLANGOALSProduct Market Choices/Product Market Strate ies

Market, Operati

& Co petitive Characteristics Co pa y Sales

I vest e t required to support strate y & future sales Need for additio al fi a ce: loa s or equity issue ext 3 to 5 years

Future co petitio s a d fi a cial perfor a ce Assured access to tar et sources of fi a ce o acceptable ter s

3-5 Year Fi a cial Pla i Curre t Year Fi a cial Pla i

SOURCES OF DOWNWARD PRESSURE ON ABOVE-MARKET RETURNSNEW ENTRANTS

Entry of new firms Existi co petitors Rivalry a o fir s i the i dustry

SUPPLIERS

BUYERS

OUR FIRMThreat of substitutes

SUBSTITUTE PRODUCTS

THE FINANCIAL MARKETSLong-term Commercial Papers/Bonds

PrimaryInvestment Bankers Underwriters /Brokers Insurance Companies Banks / GFIs Savings and Mortgage Banks Pension Funds

Equities

Capital Market

Fi a cial I ovatio s

Secondary Stock Exchange Over-the-counter

Profits

Money MarketSavi s

Banks Non-Banks

EXTERNAL FACTORS AFFECTING FINANCIAL MARKETS Global issueseopolitics

I ter atio al fi a ce & tradecapital & fu d tra sfers i ter atio al trade

GoverGover

e t i terve tioe t fiscal policy

taxatio over e t spe di

Gover

e t

o etary policye

i terest forei excha i flatio

FINANCIAL MANAGEMENT POLICIES

Fi a cial Pla i Policy Capital Structure Policy Capital Bud etary Policy evera e Policy Credit Policy Cash Ma a e e t Policy

FINANCIAL MANAGEMENT POLICIES I ve tory Policy Divide d Policy Acquisitio Policy Risk Ma a e e t Policy I vestor Relatio s Policy Procure e t Policy

END OF MODULE 1

FINANCIAL MANAGEMENT - Module 2

FINANCIAL STATEMENT ANALYSIS - WHAT IT IS

Deter i i fi a cial data relatio ships a d correlatio Deter i i tre ds a d rowth behaviors

FINANCIAL STATEMENT ANALYSIS FOR WHAT USE IT IS Dia osiside tify proble s a d sy pto s develop solutio optio s

Predictioforecast future predict pote tial outco es

Evaluatioeasure perfor a ce

FINANCIAL STATEMENT ANALYSIS WHAT ARE THE TOOLS Structural a alysishorizo tal/ti e-series vertical co o size i dex a alysis ti e-series cross-sectio

Discri i a t a alysis

FINANCIAL STATEMENT ANALYSIS WHAT AREAS TO ANALY EAREA Profitability INTERESTED SECTORS i vestors ma a eme t creditors gover me t public Liquidity creditors i vestors ma ageme t Activity i vestors ma ageme t creditors i vestors Leverage ma ageme t creditors public i vestors Overall Measure ma ageme t public i vestors Valuation Measures ma ageme t public

FINANCIAL STATEMENT ANALYSIS WHAT ARE THESE RATIOS1. Overall Measures retur o i vestme t (ROI) retur o equity (ROE)

5. Activity Measures asset tur over capital i te sity ratio worki g capital tur over et worth tur over i ve tory tur over i ve tory stocki g period accou ts receivable tur over average collectio period

. Valuation Measures price-ear i gs ratio (P/E) market to book ratio market price per share (P/S)

3. Profitability Measures retur o sales gross profit ratio

4. Liquidity Measures curre t ratio acid test (quick) ratio

6. Leverage Measures debt to equity ratio debt to asset ratio times i terest ear ed cash flow coverage

FINANCIAL STATEMENTS ANALYSIS OBJECTIVES To determine the extent of a firms success in attaining its financial goals, namely :

To ear maximum profit To mai tai solve cy To attai stability To build up values of the firm

INDICATIONS OF MANAGERIAL EFFICIENCY IN TERMS OF PROFITABILITY

Ability to earn a reasonable return on investments for borrowed funds and owners equity Ability to control operating cost within reasonable limits No over investment in fixed assets, receivable and inventories

INDICATIONS OF SATISFACTORY SHORT-TERM SOLVENCY OR WORKING CAPITAL POSITION

Favorable credit position Satisfactory proportion of cash to the requirements of the current volume Ability to pay current debts in the regular course of business Ability to extend more credit to customers Ability to replenish inventory promptly

TESTS OF A SOUND OR HEALTHY LONG-TERM FINANCIAL POSITIONImprovement in financial position Well-balanced financial structure between borrowed funds and owners equity Effective employment of borrowed funds and owners equity Ability to declare satisfactory amount of dividends to stockholders Ability to withstand adverse business conditions Ability to engage in research and development to provide new products, method or process

MOST COMMONLY USED TECHNIQUES IN F/S ANALYSIS AND INTERPRETATION Vertical Analysis - State measuresFinancial Ratios Common-Size Statements

Horizontal Analysis Dynamic measuresComparative Statements- showing changes in absolute amounts and percentages Trend percentages

Use of Special Reports on StatementsStatements of Cash Flows Gross Profit/Net Income Variation Analysis

LIMITATION OF FINANCIAL ANALYSIS LimitationFi a cial a alysis methodology is basically u ivariate

Remedy

Combi e differe t ratios i to a mea i gful model

Example : Du Po t Model Z-score Model

EXPANDED DU PONT SYSTEM ROA/ROEMaterials Sales Ear i gs after tax

+Direct abor

Total Cost & Expe ses Sales Volume X Sales Price

:Sales

+Overhead

Retur o Sales Retur o Asset X

Total Assets

+Selli g

X Sales

: Returnon Equity

+Admi istratio Cash

:Total Worki g Capital Total Assets

Asset. Tur over

+Receivables

Total Equity

+I ve tories

+Property, Pla t & Equipme t

PREDICTIVE NATURE OF FINANCIAL ANALYSIS

Regression Analysis

uses past data to predict future values of depe de t variables

Discriminant Analysis

results i a i dex that allows classificatio of a observatio i to o e of several a priori groupi gs

ILLUSTRATION OF REGRESSION ANALYSIS

Formula

Y = a + bX

where : Y - dependent variable X - independent variable a - coefficients b - slope

CAMCOMPANY Sales Volume Data

DataDate 1 2 3 4 5 6 7 8 9 10 11 12 19x1 19x2 19x3 19x4 348 375 466 516 347 384 478 522 345 397 478 530 343 404 488 548 343 404 488 548 341 409 493 544 345 404 494 551 344 413 495 545 348 418 500 534 354 434 510 550 355 445 510 558 359 451 515 511 19x5 19x6 19x7 19x8 472 455 502 550 457 462 505 552 538 464 507 583 437 459 528 592 437 459 528 592 439 459 532 602 439 468 533 616 447 468 535 625 443 457 540 628 435 460 530 640 433 481 530 642 445 490 543 657

Tabular Values Month X 1 13 25 37 49 61 73 85 344 X Y Sales Y 348 375 466 516 473 455 502 550 3,685 = 344/8 = 3,685/8 = 43 = 461 XY X2 348 1 4,875 169 11,650 625 19,092 1,369 23,177 2,401 27,755 3,721 36,646 5,329 46,750 7,225 170,293 20,840

Regression Value XY - [(X)(7Y)] 170,293 - (43)(3,685) b = --------------------- = ---------------------------- = 1.96 7X2 - [(X)(7 X)] 20,840 - (43)(344) a = Y - (b)(X) = 461 - (1.96)(43)

= 377

Applying the linear equation, the regressed value for January 19X1 is: Y = a + bX = 377 + (1.96) (1)

= 379

ILLUSTRATION OF ALTMAN -SCORE MODEL

= .012X1 + .014X2 + .033X3 + .006 X4 + .999X5 where: X1 - WC / TA X2 - RE / TA X3 - EBIT / TA X4 - MVE / BVD X5 - S / TA

Sample Data 66 Ma ufacturi g firms Bankrupt Non-bankrupt 33 33

Tabular Values

X1 X2 X3 X4 X5esultin Values CUT-OFF

Group Means Bankrupt Non-bankrupt -6.10% 41.40% -62.60% 35.50% -31.80% 15.40% 40.10% 247.70% 1.5 times 1.9 times -0.2599 4.8863 2.675

Accuracy : 72% prediction accuracy

WHAT IS LEVERAGEAbility of the firm to

magnify returnsresulting from

effective or ineffective use of asset resourcesand

the financing thereof

WHAT ARE ITS USES

for

co trol of costs for pla i g profits for determi i g breakeve levels for a alyzi g performa ce

WHAT ARE THE TYPES OF LEVERAGE

OL+

Type of leverage i volvi g ability of firm to utilize fixed costs to e ha ce retur s Type of leverage i volvi g ability of firm to utilize borrowed fu ds to e ha ce retur s Total effect of leverage exemplified by retur o equity (ROE) or ear i gs per share (EPS)

FL=

TL

HOW IS LEVERAGE ILLUSTRATED

Total Firm Leverage

Reve ue / Sales ess: Variable Costs Co tributio ess: Fixed Costs EBIT ess: I terest Expe se EBT ess: Tax EAT Ear i gs per Share

xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx

Operative Leverage

Financial Leverage

WHAT ARE THE TYPES OF COSTS WITH RESPECT TO ASSET USE AND FINANCING

ASSETS

=

DEBTS

+

EQUITIES

OTHER OPERATING FIXED COSTS

+

FIXED COSTS

+

INTEREST COSTS

=

TOTA EVERAGE COSTS

WHAT IS THE IMPACT OF LEVERAGE ON RISK AND RETURN

Leverage MatrixH HIGH LEVERAGE H

Return RETURN Return

Risk RISK Risk

L

LOW LEVERAGE

L

WHAT ARE THE STRATEGIES TO CAPITALI E ON LEVERAGE BENEFITS

Economies of scalespread out fixed costs to higher volume of productivity

Optimality of financing mixhigher times i terest coverage

IS LEVERAGE USEFUL IN BREAK-EVEN ANALYSIS because leverage illustrates COMPONENTS OF FIRMS COST STRUCTURE

YES

VARIABLE COSTS

FIXED COSTS

WHAT ARE THE USES OF BREAK-EVEN

pla i g a d co trol For differe tial costi g For prici g For profit level pla i g For

WHAT ARE THE MATHEMATICAL FORMULATIONS OF BREAK-EVEN TFC BES = 1 - TVC TR BES BEV = UR

orTFC = UCM

END OF MODULE 2


FORECASTING TECHNIQUES

QUANTITATIVE TECHNIQUES

Historical data are available a d relatio ships of variables are expected to remai the same i the future

QUALITATIVE TECHNIQUES

Judgme tal forecast where data are ot available & key variables are expected to cha ge significantly in the future

FACTORS IN QUANTITATIVE FORECAST

TREND

SEASONALITY

CYCLE

RANDOMNESS

QUANTITATIVE TECHNIQUES DIRECT ESTIMATING METHOD Sales forecast

Mean Quota / Actual Revenue

Cost and expenses

Percent of Sales Model TIME-SERIES TECHNIQUE TREND EXP ORATION USING REGRESSION ANA YSIS

Continuation

Continuation

COMPOUND GROWTH RATE

(1 g)

n 1

Rn ! R1 or Rn R1

Where : Rn = R1(1+g)n-1 Rn = revenue for last historical period R1 = revenue for first historical period N = number of periods g = average growth rate from one period to next

g ! n

PRIOR PERIOD GROWTH RATE

QUALITATIVE TECHNIQUES Sales-Force Estimate Executive Opinion Anticipatory Surveys or Market Research Scenario Forecasts Delphi Forecast Brainstorming

FINANCIAL STRATEGIES FOR WORKING CAPITAL MANAGEMENT DEFINITION : WORKING CAPITAL CURRENT ASSET MANAGEMENT SHORT-TERM FINANCIA MANAGEMENT INVO VES IQUIDITY & SO VENCY OF FIRM

WORKING CAPITAL MEASURE CURRENT RATIO NETWORKING CAPITA

CURRENT ASSET MANAGEMENT INVOLVES DETERMINATION OF MINIMUM REQUIRED BA ANCES ADDITION OF SAFETY STOCK EVE

RISK-RETURN TRADE OFF CONSERVATIVE WORKING CAPITAL Higher ratio of current assets of sales lower return lower risk

AGRESSIVE WORKING CAPITAL lower ratio of current assets to sales unpaid bills lost sales production stoppages higher risk & return

RISK-RETURN TRADE OFF IN WORKING CAPITALLow risk

Match

Low return

CURRENT ASSETS Mismatch High risk High return PROPERTY, PLANT & EQUIPMENT

CURRENT LIABILITIES Mismatch LONG TERM CAPITAL DEBT EQUITY High risk Low risk Low return

Match

high return

WC RISK-RETURN TRADEOFF GRAPHW O R K I N G

CONSERVATIVE TOTAL WORKING CAPITAL REQUIREMENTS

C A P I T A L

AGGRESSIVE PERMANENT WORKING CAPITAL REQUIREMENTS

WORKING CAPITAL STRATEGIES AGRESSIVE STRATEGY Maintain minimum required balance Find seasonal needs by short-term financing (e.g. bank loans)

CONSERVATIVE STRATEGY Maintain highest balance Reinvest excess capital

OPTIMUM WC STRATEGY Maintain / reduce level by averaging low & high WC levels

CASH MANAGEMENT OBJECTIVES Cost of money Innovation in banking Increase in business organization complexity DEFINITION Optimization of cash as an asset GOALS Liquidity Earnings

OPERATIONAL CYCLE & OVERVIEW OF CASH MANAGERS DUTIES

Equity investment

Lines of Credit

Credit Standing

S ort-term de t Production S ipping/ Invoicing Accounts Receiva le Collections

Long-term de t

Bank relations Debt management Cash forecasting

Interest Income

Improving receivables processing Speeding collections Other receipts forecastingOt er Income

CASH

POOLInterest / Loan Payments

Maintain liquidity Short-term investing Cash forecasting Managing investments Overseeing bank accounts Reducing idle balances Slowing disbursements Cash forecasting Cash conservation

Over ead Payments

Accounts Paya le

Dividends

Payroll

APPROACHES TO CASH MANAGEMENT

Use cash as a resource Integrate with operations Market planning Credit decision Capital investment Products scheduling

Customize cash managementContinuation

Continuation

Review disbursment techniques Centralized disbursements Zero balance accounts Remote disbursements Controlled disbursements Payment through drafts Trade discounts

Invest excess funds in short-term investments Develop liquidity reserves

THE CASH CYCLEMaterials ordered Materials delivered Materials paid for Funds debited Production begins Production begins Sale of products Shipping/InvoicingAccounts receivable cycle Disbursement Float Raw Materials Inventory Accounts Payable ycle

Work in process inventory Finished product Inventory

Payment mailed received Payment deposited ash availableProcessing float Bank float

INVESTMENT DECISION MATRIX INPUTFuture cash needs Other sources of cash Overall cash posture Degree of exposure (e.g. Investment as percent of current assets)

INPUTAcceptable Risk Acceptable Maturity Schedule

Forecasted Cash balance Capital needs Debt payment

Acceptable Liquidity

Preferred investment = high yielding instrumentsContingency cash available Volatility of cash forecast

INPUT

ACCOUNTS RECEIVABLE MANAGEMENT OBJECTIVES Cost of money Risk of bad debts Cost-free financing for customers

DEFINITION Effective conversion to liquidity position

GOALS Liquidity Risk minimization

CREDIT MANAGEMENT FUNCTION Analyzing credit risk Setting standards for deciding acceptable credit risk Specifying credit terms Deciding how to finance accounts receivable Determining who bears the credit risk Establishing collection policies & practices Avoiding sub-optimization by individual departments

CREDIT MANAGEMENT STRATEGIES OFFER PROMPT PAYMENT DISCOUNTS ENHANCE QUALITY OF ACCOUNTS BY GOOD CREDIT ANALYSIS CONTROL CREDIT LIMITS DEVELOP GOOD TERMS OF PAYMENT Use guarantees Use Drafts or bills of exchange Use commercial L / C MONITOR RECEIVABLES Days sale outstanding Aging Watching danger signals COLLECT DELINQUENT ACCOUNTS THROUGH AGENCY OR LEGAL MEANS

INVENTORY MANAGEMENT OBJECTIVES Cost of money Volatility of market Carrying cost Security Obsolescence Shipping / Lead time

DEFINITION Optimization of inventory levels & costs

GOALS Minimization of inventory levels Minimization of risks & cost

TYPES OF INVENTORIES

Raw materials

Work in process

STOCK

Finished goods

Spares & supplies

COST ASSOCIATED WITH INVENTORIES

Carrying CostStorage Insurance Taxes Cost

Ordering CostOrder-placing Setup

of capital Depreciation Obsolescence

costs Shipping Handling Discounts lost

Cost Related to Safety Stocks Loss of sales Loss of goodwill Production disruption

INVENTORY MANAGEMENT STRATEGY Develop inventory planning mechanisms Minimum / maximum levels EOQ Models Lead-time

Improve turnover Establish value analysis studies Employ ABC method Implement control reports Study JIT system

SHORT-TERM FINANCING Financing current assets Short-term credit Accounts payable Front-end arrangements

Financing by commercial banks Commercial loans Hold-out arrangements Back-to-back arrangements Bankers acceptances

Financing through accounts receivable A/R factoring A/R pledging

Financing inventories Trust receipts Vendors financing Consignment Inventory liens

END OF MODULE 3


PRINCIPLES OF INVESTMENTS

Time Value of Money

RISK

RETURN

VALUATION

UNDER WHAT CONDITIONS ARE INVESTMENT DECISIONS MADE

CONDITIONS OF CERTAINTYCONDITIONS OF UNCERTAINTY

WHAT IS RISK

DEFINITION Hazard, peril, exposure to loss or injury Potential of financial loss MARKOWITZ Variance about an asset's expected return

HOW IS TOTAL RISK DEFINED

TOTAL RISK

=

Unsystematic risk (Diversifiable, firm-specific )

+Systematic risk (Non-diversifiable, market related)

UNSYSTEMATIC A firms wizard is killed A wild cat strike A low cost competitor enters market Oil is discovered on a firms property

SYSTEMATIC Oil-producing countries institute boycott Congress votes for massive tax cut Restrictive monetary policy Precipitous rise in interest rates

WHAT ARE THE TYPES OF RISK ASSOCIATED WITH INVESTMENT DECISION

PRICE RISK

Value of an asset will decline in the future Inability to make timely principal payments & interest Adverse economic conditions Cash flow inadequacy to meet obligations

CREDIT RISK

MARKET RISK

CASH FLOW RISK

INFLATION

Decline in real return due to purchasing power riskValue change due to foreign exchange fluctuations Future investments will earn lower return Instruments are callable thus exposing investors to uncertainty & reinvestment risks Marketability of the assets

FOREX

REINVESTMENT RISK

CALL RISK

LIQUIDITY RISK

WHAT ARE THE ATTITUDES ASSOCIATED WITH RISK e ire for RISK Indifference to RISK

Aver ion to RISK

THE EFFECT OF THE IMINISHING MARGINAL UTILITY OF WEALTH

WHAT IS THE MARKOWIT TWO PARAMETER MODEL It assumes that there are only two parameters that investors consider in making decisions both for single asset or portfolio assets : The expected return The variance from expected return which measures the risk

It is also posits the risk-aversion principle HIGH RETURN-HIGH RISK PAYOFF

HOW CAN TWO-PARAMETER MODEL BE USED FOR INVESTMENT DECISION

Deciding between single assets on a mutually exclusive basis Deciding a portfolio investment

HOW IS RISK MEASURED IN SINGLE ASSET DECISIONPROBABILTY DISTRIBUTION FOR THE RATE OF RETURN OF XYZ STOCK n 1 2 3 4 5 Rate of Return 15 10 5 0 -5 Probability Distribution 0.50 0.30 0.13 0.05 0.02 1.00

EXPECTED RETURN E (Rxyz)=P1(R1)+P2 (R2)+P3 (R3)... Substitute the values = 11% VARIANCE Var (Ri)=P1[R1-E(Ri)2+ P2[(R2-E(Ri)]2+ Substitute the values = 24% STANDARD DEVIATION

SD(R i ) ! VAR(R i )

= 4.9%

HOW IS RISK MEASURED IN A TWO-ASSET PORTFOLIOGIVEN

PROBABILITY DISTRIBUTION FOR THE RATE OF RETURN FOR STOCKS XY AND ABCN 1 2 3 4 5 Total Expected Return Variance SD Rate of Return XYZ 15 10 5 0 -5 Rate of Return ABC 8 11 6 0 -4 Probability of Distribution 0.50 0.30 0.13 0.05 0.02 1.00

11% 24 4.9

8% 9 3

Var ( R p ) Wi 2Var ( Ri ) W j2 ( R j ) 2WiW j ( Ri R j ) whereCOV (RiRj) = covariance between return for assets i &j COVA IANCE = t gr t t i r t r t rn n r ng t g t r

ILLUSTRATION

CORRELATION = covariance of two assets divided by the product of their standard deviations.

DENOTES PERFECT COMOVEMENT IN THE SAME DIRECTION (values + 1.0 ) POSITIVE CORRELATION DENOTES PERFECT COMOVEMENT IN THEOPPOSITE DIRECTION (values - 1.0 ) NE ATIVE CORRELATION

WHAT IS PORTFOLIO DIVERSIFICATION Constructing a portfolio in such a way as to reduce to portfolio risk without sacrificing return. Creating a portfolio that is less risky than its component stocks especially negative relationships Two issues : How much should be invested in each class? Which specific stocks, bonds, real estate, etc.?

WHAT ARE THE STRATEGIES RELATED TO DIVERSIFICATION NAIVE DIVERSIFICATION Simply invests in a number of stocks or assets type & hopes that the variance of the expected return on the portfolio is lowered MARKOWIT DIVERSIFICATION Concerned with degree of covariance between asset return in a portfolio Combine assets with returns that are less than perfectly positively correlated in an effort to lower portfolio risk without sacrificing return

HOW IS MARKOWIT DIVERSIFICATION ILLUSTRATED

GIVEN : Stock C Stock D Weight E(R) 10% 25% 50% SD ( R ) 30% 60% 50%

Expected Return E(Rp) = 0.50 (10%) + 0.50(25%) =17.5%

HOW IS MARKOWIT DIVERSIFICATION ILLUSTRATED VARIANCE

HOW IS MARKOWIT DIVERSIFICATION ILLUSTRATEDSubstituting into the expression for var(Rp)

Taking the square root of the variance gives

PROBLEM How would the risk change for two-asset portfolio with different correlations between the returns of the component stocks? Assume three cases cor (RC,RD) : +1.0 and 1.0

cor (RC,RD) +1.0 0.0 -1.0

E(RP) 17.5% 17.5% 17.5%

SD(RP) 45.0% 35.0% 15.0%

WHAT ARE THE IMPLICATIONS OF PORTFOLIO VARIANCE AND COVARIANCE FOR DEVELOPING EFFICIENT PORTFOLIO Portfolio risk can be low even if individual assets risks are high By combining assets with lower (preferably negative) correlations, portfolio return is maintained & portfolio risk is lowered Riskiness inherent in any single asset held in portfolio is different from riskiness of that asset held in isolation

WHAT ARE OTHER WAYS TO MINIMI E RISK

Sensitivity analysis Range determination Insurance Hedging Forward covers & contracts Derivatives management

HOW IS DIVERSIFICATION ILLUSTRATEDWe ther COMA ANY A t L ti Conditions Sunny ye r Norm l ye r R iny ye r We ther COM ANY B Dis os le um rell s Conditions Sunny ye r Norm l ye r R iny ye r We ther PORFOLIO A B ( 50/50 investment ) Conditions Sunny ye r Norm l ye r R iny ye r Ret r on Stocks A = RA 33% 12% -9% Return on Stocks B = RB -9% 12% 33% Return on Portfolio P = RP .50 (33) + .50 (-9) = 12% .50 (12) + .50 (12) = 12% .50 (-9) + .50 (33) = 12%

END OF MODULE 4


WHAT IS TIME VALUE

Used to denote the relationship of value with time Used to measure return and risk expectations of investment decisions

WHAT ARE THE TIME VALUE DIMENSIONS

The present value formula : FV PVIFkn = ----------( 1+k )n n FV

PVIFAkn = 7 ----------t=1 ( 1+k )t n

The future value formula : FVIFkn = PV( 1+k )n

FVIFAkn = 7 PV ( 1+k )n-1 t=1

ILLUSTRATION

PRESENT VALUE FORMULA

Present Value Interest Factor (PVIF) Period 8% 10% Mixed Stream Annuity Mixed Stream Annuity 1 2 3 4 5 .926 .857 .794 .735 .681 .926 1.783 2.577 3.312 3.993 .909 .827 .751 .663 .621 .909 1.736 2.487 3.170 3.791

ILLUSTRATION

FUTURE VALUE FORMULA

Present Value Interest Factor (PVIF) Period 8% 10% Mixed Stream Annuity Mixed Stream Annuity 1 2 3 4 5 1.080 1.166 1.260 1.360 1.469 1.000 2.080 3.246 4.506 5.887 1.100 1.210 1.331 1.464 1.611 1.000 2.100 3.310 4.641 6.105

WHAT ARE THE SPECIAL USES OF TIME VALUE

Accumulating

a future

sum of money Estimating installment payments Determining growth rate or interest rate

COST OF BONDS

KB

(Par-NP) / n = RF + ----------------(Par+NP) / 2

1-taxrate

where: KB RF Par NP n

- cost of bond - risk-free coupon rate - unit denomination - net proceeds - maturity

ILLUSTRATION

KB

(Par-NP) / n = RF + ----------------(Par+NP) / 2

1-taxrate

KB

(P10,000 - P9,000) / 3 = 15% + ------------------------------(P10,000 + P9,000) / 2 = (15% + 3.5% ) (65%)

1-35%

= 12.025%

COST OF BANK LOANS / COMMERCIAL PAPERS( P - NP ) / n ----------------( P + NP ) / 2

KL/CP = RF + Premium

1-taxrate

where: K L/CP - cost of loan or commercial paper RF - riskfree coupon rate Premium - add-on cost over benchmark P - principal NP - net proceeds n - maturity

ILLUSTRATION (P-NP) / n KL/CP = RF + Premium + ----------------(P+NP) / 2

1 - taxrate

(P50,000 - P48,000) / 3 KL/CP = 18% + 1.5%+ ------------------------------(P50,000 + P48,000) / 2 = (18% + 1.5% + 1.4%) (65%)

1-35%

= 13.585%

COST OF PREFERRED STOCK

KPS

Par Value x Dividend Rate = --------------------------------------NP

Illustration P10,000 x 20% = -------------------------P12,000

KPS

= 16.666%

COST OF COMMON STOCK AND RETAINED EARNINGSA. ero-growth Model where: KCS - cost of common stock D D - zero-growth dividend KCS = ----------P - market price P or NP NP - net proceeds B. Constant Growth Model D where: g - growth rate KCS = ------------ + g P or NP C. CAPM Model where: RF - risf-free rate F - beta KCS = RF + [ F(Mr - RF)] Mr - market return

ILLUSTRATION A. ero-growth Model P2.00 KCS = ----------= 16.666% P12.00 B. Constant Growth Model P2.00 KCS = ------------ + 5% P12.000 C. CAPM Model

= 21.666%

KCS = 20% + [ 0.5 ( 30 - 20 )] = 20% + 5%

= 25%

WHAT IS COST OF CAPITAL User point of view amount paid to suppliers of capital for the privilege of using their funds

Investor point of view return generated and obtained from the users of capital

Business point of view cost of doing business from using capital return generated for employing capital

WHAT IS WEIGHTED AVERAGE COST OF CAPITALThe summation of capital costs based on financing mix/component proportions The formula is :

C1 C2 C3 WACC = ---- (K1) + ---- (K2) + ---- (K3) + . . . TC TC TC

where: WACC - weighted average cost of capital TC - total capital C - component capital K - cost of component capital

ILLUSTRATION

Bonds Loans Preferred Common Retained Earnings Capital

30% 20% 10% 30% 10% 100%

x x x x x

12.025 13.585 16.666 25.000 25.000

= 3.607% = 2.717% = 1.666% = 7.500% = 2.500%

WACC = 17.990%

END OF MODULE 5


CORPORATE PLANNING TIME HORI ON

1. Strategic Planning

2. Long-ter

Planning

3. Short-ter

Planning

BUDGETING Process of developing financial plans Process of translating plans in quantitative terms

BUDGETS

Plans, programs, and targets expressed in financial terms planning tool and score card

TYPES OF BUDGETSOperating Budgets

Sales Production Materials Purchases Direct Labor Overhead Selling General & Administration

Financial Resources Budgets Cash Financial Position

Master Budgets Zero-based Budgets Capital Expenditure Budgets

BUDGETING FLOWCHARTSales Budget Production Budget Budgeted Materials Cost Long-Range Sales Outlook Gen. & Admin. Expenses Budget Capital Expenditure Budget

Selling Expenses Budget Budgeted Labor Cost

Factory Overhead Budget

Cash Budget Financial Budget

USES OF BUDGET

For planning & control For decision-making For establishing

standards of performance For effectiveness & efficiency measures For programming For investments decision For direction-setting

PROBLEMS WITH BUDGET Unrealistic forecast Unreliable forecasting tools Behavioral dimensions Lack of coordination Lack of commitment Communication problem Lack of management

interest & support Static Lack of effective measurements

APPROACH TO EFFECTIVE BUDGETING

TOP DOWN

BOTTOM UP

Involves top management direction & support Coordinated effort Consensus attained

PARTICIPANTS IN BUDGETINGENTITY

ACTIVITY Sets direction establishes parameters composes committee Approves budget Coordinates activities Issues specific guidelines Collates & reviews

Top Management

Budget Committee

Develops unit budgets within Responsibility Centers Reviews and collates

CAPITAL BUDGETINGUnder Uncertainty

PROCESS

DECISIONS

TECHNIQUESUnder Certainty

WHAT IS CAPITAL BUDGETING

Process of planning expenditures with returns that extend beyond one year Conducted under conditions of certainty or uncertainty

WHY PLAN CAPITAL EXPENDITURES Huge amount of outlay Long gestation period Risky Availability of financing Unpredictability of returns Unpredictability of cashflow Decision choices Rationing/allocation of capital Conditions of certainty vs. certainty

UNDER WHAT FRAMEWORK SHOULD CAPITAL BUDGETING BE INTEGRATED

Integrated with:

STRATEGIC PLANNING FRAMEWORK

WHAT ARE THE CATEGORIES OF CAPITAL BUDGETING DECISIONS Project size Effect on business risk Cost reduction & revenue increase Replacements Expansion Growth Mandatory/intangible investments Degree of independence Administrative aspects

WHAT ARE THE EVALUATION CRITERIA FOR RANKING CAPITAL BUDGETS

Cash payback (CP) Discounted cashpayback (DCP) Accounting rate of return (ARR) Net present value (NPV) Internal rate of return (IRR) Profitability index (PI)

WHAT ARE THE GENERAL PRINCIPLES IN ARRIVING AT OPTIMAL CAPITAL BUDGETING DECISIONS Consider all cash flows Discount cash lows at appropriate marketdetermined cost of capital Select projects that maximizes shareholders wealth Allow managers to consider each project independently from all others (known as value additivity principle)

WHAT ARE THE APPROACHES TO CAPITAL BUDGETING UNDER UNCERTAINTY

Sensitivity Analysis Monte Carlo Simulation Decision Tree CAPM

HOW IS DECISION TREE ANALYSIS ILLUSTRATED

Build big plant at P5.0 M

Demand PV of Less Action Cond. Prob CV Initial (1) (2) (3) (4) Cost H M L 50 P8.8 M P5.0 M 30 P3.5 M P5.0 M 20 P1.4 M P5.0 M Expected NPV H M L

Possible Probable NPV NPV (4)-(5) (3)x(6) P3.8 M P1.900 M (P1.5 M) (P0.450 M) (P3.6 M) (P0.720 M) P0.730 M

1

Decision

2Build small plant at P2.0 M

50 P2.6 M P2.0 M P0.6 M P0.300 M 30 P2.4 M P2.0 M P0.4 M P0.120 M 20 P1.4 M P2.0 M (P0.6 M) (P0.120 M) Expected NPV P0.300 M

VALUATION APPROACHES How are assets valued/priced

Present Value Method Capitalization Method Book Value Method Net Asset Value Method Price-Earnings Method Dirty Asset Value Method

END OF MODULE 6

Documents

Financial Management- Module 1-6