Portland State University Free Market Business Development Institute Financial Management 1 Management, Forecasting, and Decision Making in a Dynamic Financial

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Portland State University

Free Market Business Development Institute

Financial Management

Management, Forecasting, andManagement, Forecasting, and

Decision Making in a Decision Making in a

Dynamic Financial EnvironmentDynamic Financial Environment

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Overview: What financial management entails

Combining day-to-day cash management responsibilities with long-term planning objectivesAnalysis of past and present data for the purpose of deploying or investing the organization’s monetary and capital resources to greatest advantageManaging the firm’s cash, marketable securities, accounts receivable, inventory, equipment, and physical plantMaking decisions about how assets are financed, use of short-tern versus long-term debt, leasing, and the use of debt versus equity

Applying the disciplines of economics and accounting in the art and science of managing money…

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Overview: The financial decision-making process

Financial P lanning Decisions

Value of the Firm

Financial Decisions

Risk/Return Tradeoffs

Financial S tructure and Dividend Policy Decisions

Financial G oals of the Firm

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Financial ManagementOverview: The financial structure of an organization

Board of Directors

President

VP Sales

VP Finance

VP Mfg

Treasurer Controller

Tax DeptCost Acctg

Financial Acctg

Inventory MgrCredit Mgr

Dir Capital Budgeting

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Topics covered:

Basics of capital budgetingSales and cost forecastingTime value of money

Investment appraisalNet present value, internal rate of return

Lease/buy/rent decisionsSources of moneyInternational financeFinancing small firms and startups

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Basics of capital budgeting: sales and cost forecasting

Construction of pro forma statementsLatest financial statementsSales forecastCost accounting forecastFinancial market data

Preliminary projectionsModifications and revisionsEvaluation: are more revisions needed?Capital rationing: identification of projects to finance

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Financial ManagementTime Value of Money:

Money has different today than in the future

Reasons:Inflation/deflationOpportunity costs: the foregone investment optionsRisk factorsLess flexibility re: time preference for consumption

Financial management remedy:Cash flow is “discounted” to reflect the reduction of value

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Investment appraisal using discounted cash flows

Firms rarely have the resources to accept all good capital projects and investment opportunitiesRationing capital for investment in a project or business requires careful analysisTwo of the most common methods for ranking investments in projects are 1) net present value and 2) internal rate of return calculationsBoth methods take into consideration the time value of money

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Net present valueWeighs the investment in absolute dollars against its return in discounted cashFormula is discounted incoming cash flows minus outgoing initial cash flows:

[DISCOUNTED RETURN minus INVESTMENT]Requires assumption about the prevailing cost of money, also called a “hurdle rate”Discount rate varies for each periodTypically uses calculator function or tableInvestment or project with highest NPV is deemed most desirable

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Internal rate of returnWeighs the investment relative to the cost of money (interest rate)Solves an equation:

[INVESTMENT = FUTURE PAYMENT / (1+rate)]

Determines rate of interest that would cause the discounted (incoming) cash flows to be equal to the investment (i.e., zero difference)Typically uses calculator function or tableThe investment option or project with the highest IRR is deemed most desirable


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Internal rate of return calculation drawbacks:Assumes cash flows can be reinvested at an IRR which may not be a reasonable assumptionThere may be multiple IRRs, requiring additional calculation using NPV before decision can be made Can lead to mistaken accept/reject decisions when evaluating mutually exclusive projects when there are differences in scale, size, or differences in the time patterns of cash flow


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The main difference between NPV and IRR calculations is the interest rate used and the form of the answer (dollars versus rate) Whichever method is used, the goal should be to maximize NPV for the overall budget that is acceptedFirms using IRR therefore frequently also calculate NPV

Investment appraisal using discounted cash flows summary

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Lease/buy/rent decision criteria:

1. Cash flow: to lease or rent requires smaller payments over time versus immediate cash outlay for purchase

2. Commitment: becoming “locked in” through purchases

3. Cost: overall cost for each method, including interest, down payments, transfer costs, etc.

4. Tax consequences: purchases and leases are eligible for depreciation offsets to income; cash outlays for rentals are usually deductible expenses

5. Obsolescence risk: related to commitment; leases and rental agreements usually allow for upgrade

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Lease/buy/rent decision criteria:

While some decisions may be based on NPV comparisons between the cost of debt to purchase and the cost of leasing, a decision matrix ensures consideration of all relevant variablesMatrix scores are dependent on specific tax consequences and other situational conditionsImportant functional area perspectives include accounting and marketing

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Financial ManagementA hypothetical lease/buy/rent decision matrix showing positive and negative aspects, depending on the specifics of the item

Buy Lease Rent

Cash flow - + +

Commitment - - +

Total cost + - -

Tax impact + + +

Obsolescence – + +

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Sources of money: Equity

Advantages:Equity is “risk capital” that carries no guarantee or protection regarding the original investmentUsually has no requirement regarding payback or interest payments

Disadvantages: Represents dilution of ownership that affects entrepreneur’s claim to profits and control

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Sources of money: Equity

Sources of equity funds:

Personal funds and “sweat equity” in the form of time and laborUtilization of owner equipment and other resourcesNon-loan infusions from friends and relativesEmployee investorsCustomer “membership” fees and prepaymentsVenture capitalists and other impersonal investorsJoint venture partnerships

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Sources of money: Debt

Commercial loan from a bankLoan from friends and family Issuance and sale of bond

Advantages:Provides opportunity to develop credit historyOwnership is not diluted

Disadvantages: Collateral and/or co-signers may be requiredCost of capital may be highRestrictions may apply

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Sources of money: Trade Credit

Advantages of using suppliers as a credit source:

Often easily obtainedAmount of credit usually expands and contracts with the needs of the firmOften take the form of credit terms and cash discountsTypically does not involve a formal agreement or contractFosters supplier commitment in the success of the business

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Sources of money: Barter Arrangements

Definition and considerations:

Trade of goods and/or services

Often linked by exchange or service organizations that may charge a fee plus take a percentage of the cash valueTransactions are often taxable at cash value

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Sources of money: Retained Earnings

Definition and considerations:

The major source of financing for larger firms

Involves trade-off between payment of dividends to stockholders and investment in the firmOpportunity cost to stockholders requires careful evaluation of firm’s return on its investment of this source of financing

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International finance

Risk unique to international finance:Fluctuating exchange ratesDiffering political risks related to expropriation of assetsEconomic system differencesLegal and tax system complicationsCultural differences related to financial systemsInflation/deflation rate uncertainty

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Financing small firms and startups

Business start-ups fail largely due to inadequate fundingOwner usually is required to commit savings, mortgage assets, and borrow from friends and familyGovernment agencies often have targeted loan programs that provide funds and technical support

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Sources:

Financial, Budgeting & Cost Control (1996). Les Anderson, PhD., Portland, OR: Portland State University

Financial Management: Theory and Practice (1999). Eugene F. Brigham, Louis C. Gapenski and Michael C. Ehrhardt, Stamford, CT: The Dryden Press

Lecture notes from BA 561 Financial Management (2001). Janet Hamilton, PhD., Portland, OR: PSU

The Essentials of Financial Management (1998). Omer L. Carey, PhD and Musa M.H. Essayyad, PhD., Piscataway, NJ: Research and Education Association

Documents

Portland State University Free Market Business Development Institute Financial Management 1 Management, Forecasting, and Decision Making in a Dynamic Financial