FINANCIAL MANAGEMENT – Module 1

COMPONENTS OF FINANCIAL MANAGEMENT

Financial Planning Master Budget Working Capital Mgt.

Sales
Operating Budget Current
Budget Asset
Mgmt.
Prod’n
Fore- Capital Budget
Financial Leverage
casting Budget
Analysis Analysis
Short-term
Cash Admin Sources of
Budget Budget Capital
Break-even
Analysis
Balance Selling
Sheet Budget
 Return Risk Time Value Valuation
Measurement Management of Money Approaches

Capital Sources Cost of Capital

Capital Expenditure Investment Capital

Budgeting Technique Allocation/ Rationing
 Costs
Capital
Long-term
Structure Covenants
Financing
Theory
Features
Long-term Debts

Concepts & Tools Bonds Dividend Policy

Distribution

Equities
Stock rights
Valuation
Preferred Equities Models
IPO

Long-term Lease
 Acquisitio Divestment Other Modes of
n Strategies Long-term Financing
Strategies

Tender Offers
Left-hand
Bankruptcy/ Re-capitalization
Financing
Timing Reorganization

Restructuring
Valuation
Financial LBO
Innovations
Hostile Takeover Conversion

International Debt Reduction

Finance

Anti-takeover Strategies Reorganization

 Financial Management
IPO Model
Resource Resource Resource
 Tasks
Input Process Output

 Objectives Economy Efficiency Effectiveness

Corporate
 Outcome
Value

 Beneficiary Stakeholders
 Financial Management Involves Resource:

PLANNING SOURCING ALLOCATING CONTROLLING UTILIZING

Financial New Loans Budgeting Risk Assessment Investment

& Profit New Equities Responsibility Financial Report Efficiency
Plan Profits Centers Variance Analysis Economy
Effectiveness

Firm Value Creation

Stakeholders
 Financial Management
Intermediation Model
THE FIRM

Risk - Return
Analysis
Create
F Value
INTERMEDIATION
U
FINANCIAL Financial Economics LEVERAGING
N MANAGEMENT

COST/BENEFIT
D Create Analysis
Value Cost of
S Funds
Return

Creditors
DIVIDENDS
FIXED PAYOUTS
Shareholders
RETURN ON EQUITY Economic
INTEREST COVER Value Added
FINANCIAL MANAGEMENT OBJECTIVES

Minimize Risk Maximize Returns

Firm Value Creation

Increase Stock Price

 Financial Management Framework
(The CAM Model)
Interest

Debt
Funds Target Weighted
Financial Fin’l Structure Capital Average Cost
Market
Resources Structure of Capital
Equity
Capital Money Dividend/
Source Market Market Earnings Economic
Problems
& Issues
Financial Health Value
Added
Use Profitability
Economy
Liquidity Return
Efficiency on
Activity Investment
Effectiveness
Leverage
 DETERMINANTS/ASSESSMENT OF
CORPORATE FINANCIAL PLAN

GOALS
nce Ba
la la nc
Ba Product Market Choices/Product Market Strategies e
Market, Operating & Competitive Characteristics

Company Sales
Investment required to support Future competitions and
strategy & future sales financial performance

Need for additional finance: loans Assured access to target sources

or equity issue next 3 to 5 years
of finance on acceptable terms
3-5 Year
Ba Financial Planning
n ce
la nc la
Ba
e Current Year
Financial Planning
 SOURCES OF DOWNWARD PRESSURE
ON ABOVE-MARKET RETURNS

NEW ENTRANTS

Entry of new firms

Existing competitors
Rivalry among firms
SUPPLIERS in the industry BUYERS
OUR FIRM

Threat of substitutes

SUBSTITUTE PRODUCTS
 THE FINANCIAL MARKETS
Long-term Primary
Commercial
Papers/Bonds  Investment Bankers
 Underwriters /Brokers
 Insurance Companies
 Banks / GFIs
 Savings and Mortgage
Equities Capital Banks
Market  Pension Funds

Financial Secondary
Innovations
 Stock Exchange
 Over-the-counter
Profits
Money Banks
Market
Savings Non-Banks
EXTERNAL FACTORS AFFECTING FINANCIAL
MARKETS
 Global issues
 geopolitics
 International finance & trade
 capital & fund transfers
 international trade
 Government intervention
 Government fiscal policy
 taxation
 government spending
 Government monetary policy
 interest
 foreign exchange
 inflation
FINANCIAL MANAGEMENT POLICIES

 Financial Planning Policy

 Capital Structure Policy
 Capital Budgetary Policy
 Leverage Policy
 Credit Policy
 Cash Management Policy
FINANCIAL MANAGEMENT POLICIES
 Inventory Policy
 Dividend Policy
 Acquisition Policy
 Risk Management Policy
 Investor Relations Policy
 Procurement Policy
END OF MODULE 1
FINANCIAL MANAGEMENT - Module 2
FINANCIAL STATEMENT ANALYSIS - WHAT IT IS

 Determining financial data

relationships and correlation

 Determining trends and

growth behaviors
 FINANCIAL STATEMENT ANALYSIS -
FOR WHAT USE IT IS
 Diagnosis
 identify problems and
symptoms
 develop solution options
 Prediction
 forecast future
 predict potential
outcomes
 Evaluation
 measure performance
FINANCIAL STATEMENT ANALYSIS -
WHAT ARE THE TOOLS

 Structural analysis
 horizontal/time-series
 vertical
 common size
 index analysis
 time-series
 cross-section
 Discriminant analysis
FINANCIAL STATEMENT ANALYSIS -
WHAT AREAS TO ANALYZE
AREA INTERESTED SECTORS
Profitability • investors • creditors
• management • government
• public
Liquidity • creditors
• investors
• management
Activity • investors
• management
• creditors • investors
Leverage • management
• creditors
• investors • public
Overall Measure • management
• public • investors
Valuation Measures • management
• public
 FINANCIAL STATEMENT ANALYSIS -
WHAT ARE THESE RATIOS
1. Overall Measures
 return on investment (ROI)
 return on equity (ROE)
2. Valuation Measures
 price-earnings ratio (P/E)
 market to book ratio
 market price per share (P/S)
3. Profitability Measures
 return on sales
 gross profit ratio
4. Liquidity Measures
 current ratio
 acid test (quick) ratio
5. Activity Measures
 asset turnover
 capital intensity ratio
 working capital turnover
 net worth turnover
 inventory turnover
 inventory stocking period
 accounts receivable turnover
 average collection period
6. Leverage Measures
 debt to equity ratio
 debt to asset ratio
 times interest earned
 cash flow coverage
FINANCIAL STATEMENTS ANALYSIS OBJECTIVES

To determine the extent of a firm’s success in

attaining its financial goals, namely :

To earn maximum profit

To maintain solvency
To attain 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
owner’s 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 POSITION
Improvement in financial position
Well-balanced financial structure
between borrowed funds and
owner’s equity
Effective employment of borrowed
funds and owner’s 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 measures”

Financial Ratios
Common-Size Statements

Horizontal Analysis – “Dynamic measures”

Comparative Statements- showing changes in absolute
amounts and percentages
Trend percentages

Use of Special Reports on Statements

Statements of Cash Flows
Gross Profit/Net Income Variation Analysis
LIMITATION OF FINANCIAL ANALYSIS

Limitation Financial analysis methodology

is basically univariate

Remedy Combine different ratios into a

meaningful model

Example : Du Pont Model

Z-score Model
 EXPANDED DU PONT SYSTEM – ROA/ROE

Materials Sales Earnings

+ - after tax Return
on
Total
Direct Labor : Assets
Total Cost & Sales
+ Expenses Sales Return
Overhead
on
+ Sales Volume X Asset X : Return
Selling on
X Sales Equity
+ Asset.
Administration Sales Price
Turn-
: Total
over
Cash
Total Working Equity
+ Capital
Total
Receivables Assets
+
+ Property, Plant
Inventories
& Equipment
PREDICTIVE NATURE OF FINANCIAL ANALYSIS

 Regression Analysis
 uses past data to predict future
values of dependent variables

 Discriminant Analysis
 results in an index that allows
classification of an observation into
one of several a priori groupings
ILLUSTRATION OF REGRESSION ANALYSIS

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

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

XY - [(X)(Y)] 170,293 - (43)(3,685)

b = --------------------- = ---------------------------- = 1.96
X2 - [(X)( 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 Z-SCORE MODEL

Z = .012X1 + .014X2 + .033X3 + .006 X4 + .999X5

where:
X1 - WC / TA
Sample Data
X2 - RE / TA
66 Manufacturing firms
X3 - EBIT / TA Bankrupt Non-bankrupt
X4 - MVE / BVD
X5 - S / TA 33 33
Tabular Values
Group Means
Bankrupt Non-bankrupt
X1 -6.10% 41.40%
X2 -62.60% 35.50%
-31.80% 15.40%
X3
40.10% 247.70%
X4 1.5 times 1.9 times
X5
Resulting -0.2599 4.8863
Values 2.675
CUT-OFF
Accuracy :
72% prediction accuracy
 WHAT IS LEVERAGE

Ability of the firm to

magnify returns
resulting from

effective or ineffective
use of asset resources
and

the financing thereof

WHAT ARE ITS USES

 for control of costs

 for planning profits
 for determining break-
even levels
 for analyzing
performance
WHAT ARE THE TYPES OF LEVERAGE

OL Type of leverage involving ability

of firm to utilize fixed costs to
enhance returns
+
Type of leverage involving ability
FL of firm to utilize borrowed funds to
enhance returns
= Total effect of leverage exemplified
by return on equity (ROE) or
TL earnings per share (EPS)
 HOW IS LEVERAGE ILLUSTRATED

Revenue / Sales xxx

Less: Variable Costs xxx Operative
Contribution xxx Leverage
Total Less: Fixed Costs xxx
Firm EBIT xxx
Leverage Less: Interest Expense xxx
EBT xxx Financial
Less: Tax xxx Leverage
EAT xxx
Earnings per Share xxx
WHAT ARE THE TYPES OF COSTS WITH RESPECT
TO ASSET USE AND FINANCING

ASSETS = DEBTS + EQUITIES

OTHER TOTAL
FIXED INTEREST
OPERATING + COSTS + COSTS = LEVERAGE
FIXED COSTS COSTS
 WHAT IS THE IMPACT OF LEVERAGE
ON RISK AND RETURN

Leverage Matrix

H HIGH LEVERAGE H

Return Risk
RETURN RISK
Return Risk

L LOW LEVERAGE L
WHAT ARE THE STRATEGIES TO CAPITALIZE
ON LEVERAGE BENEFITS

Economies of scale
 spread out fixed costs to higher
volume of productivity
Optimality of financing mix
 higher times interest coverage
 IS LEVERAGE USEFUL IN
BREAK-EVEN ANALYSIS

because leverage illustrates

COMPONENTS OF FIRM’S
YES COST STRUCTURE

VARIABLE COSTS FIXED COSTS

WHAT ARE THE USES OF BREAK-EVEN

 For planning and control

 For differential costing
 For pricing
 For profit level planning
WHAT ARE THE MATHEMATICAL
FORMULATIONS OF BREAK-EVEN

TFC
BES =
1 - TVC
TR
BES
BEV =
UR
or
TFC
=
UCM
END OF MODULE 2
FINANCIAL MANAGEMENT – Module 3
 FORECASTING TECHNIQUES
 QUANTITATIVE
TECHNIQUES
• Historical data are available and
relationships of variables are
expected to remain the same in
the future

 QUALITATIVE TECHNIQUES

• Judgmental forecast where data

are not available & key variables
are expected to change
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 EXPLORATION USING

REGRESSION ANALYSIS

Continuation
 Continuation

 COMPOUND GROWTH RATE

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

 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 FINANCIAL MANAGEMENT
• INVOLVES LIQUIDITY & SOLVENCY OF FIRM

 WORKING CAPITAL MEASURE

• CURRENT RATIO
• NETWORKING CAPITAL

 CURRENT ASSET MANAGEMENT INVOLVES

• DETERMINATION OF MINIMUM REQUIRED BALANCES
• ADDITION OF SAFETY STOCK LEVEL
 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 CAPITAL

Low risk
Match Low return

CURRENT CURRENT
ASSETS LIABILITIES
Mismatch Mismatch
High risk Low risk
LONG TERM CAPITAL
High return PROPERTY, PLANT &
DEBT Low return
EQUIPMENT
EQUITY

High risk
Match high return
 WC RISK-RETURN TRADEOFF GRAPH

W
O
R
K CONSERVATIVE
I TOTAL WORKING
N CAPITAL REQUIREMENTS
G

C AGGRESSIVE
A PERMANENT WORKING
P CAPITAL REQUIREMENTS
I
T
A
L
 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
MANAGER’S DUTIES
 Equity Credit
investment Standing
Lines of •Bank relations
Credit •Debt management
•Cash forecasting
Long-term
Short-term debt
debt

Production

Shipping/ Interest Income

•Improving receivables
Invoicing
processing
•Speeding collections
Accounts •Other receipts
Receivable
forecasting
Collections Other Income •Maintain liquidity
•Short-term investing
•Cash forecasting
CASH POOL •Managing investments
•Overseeing bank accounts
•Reducing idle balances

Interest / •Slowing disbursements

Overhead Accounts Dividends Payroll Loan •Cash forecasting
Payments Payable Payments
•Cash conservation
 APPROACHES TO CASH MANAGEMENT

 Use cash as a resource

 Integrate with operations

• Market planning
• Credit decision
• Capital investment
• Products scheduling

 Customize cash management

Continuation
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 CYCLE
Materials ordered

Materials delivered
Accounts Payable Cycle
Materials paid for

Funds debited Disbursement Float

Production begins Raw Materials Inventory

Production begins Work in process inventory

Sale of products Finished product Inventory

Shipping/Invoicing
Accounts receivable cycle
Payment mailed received

Payment deposited Processing float

Cash available Bank float

 INVESTMENT DECISION MATRIX

INPUT
•Future cash needs INPUT
•Other sources of cash
•Forecasted
•Overall cash posture
Acceptable •Cash balance
•Degree of exposure
Acceptable Maturity •Capital needs
(e.g. Investment as Risk Schedule •Debt payment
percent of current
assets)
Acceptable
Liquidity

Preferred investment
= high yielding instruments
•Contingency 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
• Day’s sale outstanding
• Aging
• Watching danger signals

 COLLECT DELINQUENT ACCOUNTS THROUGH AGENCY OR LEGAL MEAN

 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

Cost Related to
Carrying Cost Ordering Cost
Safety Stocks
•Storage •Order-placing •Loss of sales
•Insurance •Setup costs •Loss of goodwill
•Taxes •Shipping •Production
•Costof capital •Handling disruption
•Depreciation •Discounts lost
•Obsolescence
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
• Banker’s acceptances
 Financing through accounts receivable
• A/R factoring
• A/R pledging
 Financing inventories
• Trust receipts
• Vendors financing
• Consignment
• Inventory liens
END OF MODULE 3
FINANCIAL MANAGEMENT – Module 4
PRINCIPLES OF INVESTMENTS

Time Value of Money

RISK

RETURN

VALUATION
UNDER WHAT CONDITIONS ARE INVESTMENT
DECISIONS MADE

CONDITIONS OF CERTAINTY
CONDITIONS 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  SYSTEMATIC
• A firm’s wizard is killed • Oil-producing countries

• A wild cat strike institute boycott

• A low cost competitor • Congress votes for

enters market massive tax cut

• Oil is discovered on a • Restrictive monetary

firms property 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

CREDIT RISK  Inability to make timely

principal payments &
interest
MARKET RISK  Adverse economic
conditions

CASH FLOW RISK  Cash flow inadequacy to

meet obligations
 INFLATION  Decline in real return due to
purchasing power risk
FOREX  Value change due to
foreign exchange
fluctuations
REINVESTMENT  Future investments will earn
RISK lower return

CALL RISK  Instruments are callable thus

exposing investors to
uncertainty & reinvestment risks

LIQUIDITY RISK  Marketability of the assets

 WHAT ARE THE ATTITUDES
ASSOCIATED WITH RISK

Desire for RISK Indifference to RISK

Aversion to RISK

THE EFFECT OF THE DIMINISHING

MARGINAL UTILITY OF WEALTH
 WHAT IS THE MARKOWITZ 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

ItItisisalso
alsoposits
positsthe
therisk-aversion
risk-aversionprinciple
principle
HIGH
HIGHRETURN-HIGH
RETURN-HIGHRISK RISKPAYOFF
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 DECISION
PROBABILTY DISTRIBUTION FOR THE RATE OF RETURN OF XYZ STOCK

n Rate of Return Probability Distribution

1 15 0.50
2 10 0.30
3 5 0.13
4 0 0.05
5 -5 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%
4.9%
 HOW IS RISK MEASURED IN A
TWO-ASSET PORTFOLIO

GIVEN
PROBABILITY DISTRIBUTION FOR THE RATE
OF RETURN FOR STOCKS XYZ AND ABC
N Rate of Return Rate of Return Probability of
XYZ ABC Distribution
1 15 8 0.50
2 10 11 0.30
3 5 6 0.13
4 0 0 0.05
5 -5 -4 0.02
Total 1.00
Expected
Return 11% 8%
Variance 24 9
SD 4.9 3
 Var ( R p )  Wi 2Var ( Ri )  W j2 ( R j )  2WiW j ( Ri R j )
where
COV (RiRj) = covariance between return for assets i &j

COVARIANCE = degree to which the return on

two assets vary or change together

ILLUSTRATION

Cov
Cov((RRXYZ , ,RRABC ))00.(.(15
15%%11
11%)(88%
%)( % 88%)
%)
XYZ ABC
00.30
.30(10
(10%%11
11%)(
%)(11
11%%88))....
....
88.9.9

CORRELATION = covariance of two assets divided by

the product of their standard
deviations.
 COV(R
COV(R iRRj ))
COR(RiRj) 
COR(RiRj) 
i j
SD(R
SD(Ri )(SD(R
)(SD(Rj )) i j
8.9
 8.9
(4.9)(3)
(4.9)(3)
0.60
0.60
DENOTES PERFECT COMOVEMENT IN THE SAME DIRECTION (values + 1.0 )

POSITIVE CORRELATION

DENOTES PERFECT COMOVEMENT IN THEOPPOSITE DIRECTION (values - 1.0 )

NEGATIVE 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

 MARKOWITZ 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 MARKOWITZ DIVERSIFICATION
ILLUSTRATED

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

Expected Return
E(Rp) = 0.50 (10%) + 0.50(25%) =17.5%
 HOW IS MARKOWITZ DIVERSIFICATION
ILLUSTRATED
 VARIANCE
Var(R  2
var(R
2 )  W 2
2
var(RDD) )2W
Var(Rp p )  WCC var(RCC )  WDDvar(R
) W 2WCCW
WDDcov(R
cov(RCC,R
,RDD) )
(0.50)
(0.50) (30%)  (0.50) (60%)22(0.50)(0.
2
(30%)
2
2
2 (0.50) (60%)
2
2
2
2(0.50)(0.50)cov(R
50)cov(RC ,R
,RD ) )
C D
cov(R
cov(RC ,R
, D ))
R
Cor(R , R ) 
Cor(RCC ,RDD ) SD(R )SD(RD )
C
SD(RCC )SD(RDD )
socov(R
socov(RC ,R
C,RD ) )SD(R
D SD(RC )SD(R
C)SD(RD )cor(R
D)cor(RC ,R
,RD ) )
C D
Since
Since
SD(RC ) )30%
SD(R
C 30%
and
and
SD(RD ) )60%
SD(R
D 60%
then
then
cov(R
C,RD ) )(30%)(60%)
cov(RC ,R D (30%)(60%)cor(R
cor(RC ,R
,RD ) )
C D
 HOW IS MARKOWITZ DIVERSIFICATION
ILLUSTRATED

Substituting into the expression for var(Rp)

Var ( Rp p )  (0.50) (30%)  (0.50) (60%) 222(0

 
2 2 2 2
Var ( R ) ( 0.50) (
2 30%) 2 ( 0.50) (
2 60%) (0.50
.50)()(00.50
.50)cor
)cor( (RRCC, ,RRDD) )

Taking the square root of the variance gives

SD( Rp p )  (0.50) (30%)  (0.50) (60%) 222(0

 
2 2 2 2
SD ( R ) ( 0.50) (
2 30%) 2 ( 0.50) (
2 60%) (0.50
.50)()(00.50
.50)()(60
60%)
%)oo
oo

 00.1125
.1125((00.09
.09))cor
cor((RRCC, ,RRDD))
 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) E(RP) SD(RP)

+1.0 17.5% 45.0%
0.0 17.5% 35.0%
-1.0 17.5% 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 MINIMIZE RISK

 Sensitivity analysis
 Range determination
 Insurance
 Hedging
 Forward covers
& contracts
 Derivatives
management
 HOW IS DIVERSIFICATION ILLUSTRATED

Weather Return on Stocks

Conditions A = RA
COMAPANY A Sunny year 33%
Suntan Lotion Normal year 12%
Rainy year -9%

Weather Return on Stocks

Conditions B = RB
COMPANY B
Sunny year -9%
Disposable umbrellas
Normal year 12%
Rainy year 33%
Weather Return on Portfolio
Conditions P = RP
PORFOLIO A & B
Sunny year .50 (33) + .50 (-9) = 12%
( 50/50 investment )
Normal year .50 (12) + .50 (12) = 12%
END OF MODULE 4
FINANCIAL MANAGEMENT – Module 5
 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 n FV
PVIFkn = ----------- PVIFAkn =-----------
( 1+k )n t=1 ( 1+k )t
The future value formula :
n
FVIFkn = PV( 1+k )n FVIFAkn = 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 .926 .926 .909 .909

2 .857 1.783 .827 1.736
3 .794 2.577 .751 2.487
4 .735 3.312 .663 3.170
5 .681 3.993 .621 3.791
ILLUSTRATION

FUTURE VALUE FORMULA

Present Value Interest Factor (PVIF)

Period 8% 10%
Mixed Stream Annuity Mixed Stream Annuity

1 1.080 1.000 1.100 1.000

2 1.166 2.080 1.210 2.100
3 1.260 3.246 1.331 3.310
4 1.360 4.506 1.464 4.641
5 1.469 5.887 1.611 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

(Par-NP) / n
KB = RF + ----------------- 1-taxrate
(Par+NP) / 2

where:
KB - cost of bond
RF - risk-free coupon rate
Par - unit denomination
NP - net proceeds
n - maturity
ILLUSTRATION

(Par-NP) / n
KB = RF + ----------------- 1-taxrate
(Par+NP) / 2

(P10,000 - P9,000) / 3
KB = 15% + ------------------------------- 1-35%
(P10,000 + P9,000) / 2

= (15% + 3.5% ) (65%)

= 12.025%
COST OF BANK LOANS / COMMERCIAL PAPERS

( P - NP ) / n
KL/CP = RF + Premium ----------------- 1-taxrate
( P + NP ) / 2

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 + ----------------- 1 - taxrate
(P+NP) / 2

(P50,000 - P48,000) / 3
KL/CP = 18% + 1.5%+ ------------------------------- 1-35%
(P50,000 + P48,000) / 2

= (18% + 1.5% + 1.4%) (65%)

= 13.585%
 COST OF PREFERRED STOCK

Par Value x Dividend Rate

KPS = ---------------------------------------
NP
Illustration

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

= 16.666%
 COST OF COMMON STOCK AND
RETAINED EARNINGS

A. Zero-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
KCS = RF + [ (Mr - RF)]  - beta
Mr - market return
 ILLUSTRATION

A. Zero-growth Model
P2.00
KCS = ----------- = 16.666%
P12.00
B. Constant Growth Model
P2.00
KCS = ------------ + 5% = 21.666%
P12.000
C. CAPM Model
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 CAPITAL
 The 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 30% x 12.025 = 3.607%

Loans 20% x 13.585 = 2.717%
Preferred 10% x 16.666 = 1.666%
Common 30% x 25.000 = 7.500%
Retained Earnings 10% x 25.000 = 2.500%

Capital 100% WACC = 17.990%

END OF MODULE 5
FINANCIAL MANAGEMENT – Module 6
CORPORATE PLANNING TIME HORIZON

1. Strategic Planning

2. Long-term Planning

3. Short-term 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 BUDGETS
Operating 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 FLOWCHART

Sales Budget Long-Range Sales Outlook

Production Selling Expenses Gen. & Admin.

Budget Budget Expenses Budget

Budgeted Budgeted Factory Capital

Materials Labor Overhead Expenditure
Cost Cost Budget 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 BUDGETING
ENTITY ACTIVITY
 Sets direction
 establishes parameters
Top Management  composes committee
 Approves budget

 Coordinates activities
Budget Committee  Issues specific guidelines
 Collates & reviews

Develops unit budgets within


Responsibility Centers  Reviews and collates
 CAPITAL BUDGETING

Under Uncertainty
PROCESS

DECISIONS

TECHNIQUES
Under 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 cash
payback (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 market-
determined cost of capital
 Select projects that maximizes shareholder’s
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

Demand PV of Less Possible Probable

Action Cond. Prob CV Initial NPV NPV
(1) (2) (3) (4) Cost (4)-(5) (3)x(6)
Build big
plant at H 50 P8.8 M P5.0 M P3.8 M P1.900 M
P5.0 M M 30 P3.5 M P5.0 M (P1.5 M) (P0.450 M)
1
L 20 P1.4 M P5.0 M (P3.6 M) (P0.720 M)
Expected NPV P0.730 M
Decision
H 50 P2.6 M P2.0 M P0.6 M P0.300 M
2 M 30 P2.4 M P2.0 M P0.4 M P0.120 M
L 20 P1.4 M P2.0 M (P0.6 M) (P0.120 M)
Build small
Expected NPV P0.300 M
plant at
P2.0 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