02BCA4001

ECONOMICS AND FINANCIAL

MANAGEMENT
Tutorial Session:
FINAL EXAM REVISION – Dec 2016
GUIDELINE TO EXAMINATION
TWO Section A & B:
¢  Section A: Compulsory
¢  Both Calculation and Conception understanding
¢  MUST Attend ALL Parts
¢  Allocate the time smartly
¢  Don’t miss any question

¢  Section B: Answer Two out of Three

—  Both Calculation and Written
—  Calculation:
¢  Show Steps Clearly
¢  Use Time Line, if necessary
¢  Use PV & FV table; use calculator, still show STEPS
¢  Discount Factor uses/shows 3 figures after decimal
¢  BUT Answer use 2 figures after decimal
—  Written:
¢  Complete sentence with bullet points, if needed
¢  Key words got mark
EXAM REVIEW
¢  Lost marks:
—  No Step shown
—  Apply wrong formula
—  Use wrong concept
—  Don’t trial or attain all Questions (lost 5 marks or 25
marks up front)
—  Uncertain and unclear written (lost marks)
¢  Good at:
—  Tools for Capital budgeting
—  NPV and IRR, PI
—  Cash flow estimation
ECONOMICS INDEX
¢  Gross domestic product (GDP):
—  The amount of goods and services produced within a
country
—  It is a common measure of the total productivity within a
country.
—  GDP is measured by the total expenditure on final products
produced by resident producing units in a specified period.
—  The final products are either purchased by households, firms,
the government or the foreign sector
ECONOMICS INDEX
¢  The consumer price index (CPI) is a figure showing the
price level of consumer goods and services
generally purchased by (domestic)
households in a specified period relative to the price
level in the base year.
¢  Why this is important to the economics
measurement?
—  The Government use these indices as denominator to
measure other economic indictors such as:
¢  Real GNP
¢  Cost of living and hence standards of living

¢  Ensure exchange rate stability

—  Firms and traders use these indices to adjust their

profit margin especially when cost of production
changes. Trade Union use these indices in their wage
negotiation with the employers
WHAT IS CORPORATE FINANCE?
¢  Corporate finance attempts to find the answers
to the following questions:
—  What investments should the business take on?
THE INVESTMENT DECISION
—  How can finance be obtained to pay for the required
investments?
THE FINANCE DECISION
—  Should dividends be paid? If so, how much?
THE DIVIDEND DECISION
6
THE FINANCIAL MANAGER
¢ Thetask of financial manager’s is to acquire and use funds in order to
maximize the value of the firm. Some of the activities are:

¢ 1. Forecasting and planning. The financial manager must interact with
other
¢ executives as they draw up business plan that will shape the firm’s future.
¢ 2. Major investment and financing decisions. The financial manager must
help to determine the optimal sales growth rate and also help in deciding
which assets are required and how to finance those assets.
¢ 3. Coordination and control. The financial manager must interact with other
¢ executives to ensure that the firm is operated as efficiently as possible.
¢ 4. Dealing with financial markets.
¢ 5. Risk management. The financial manager is usually responsible for the
firm’s overall risk management program

7
THE INVESTMENT DECISION
¢  Involves :
—  To decision which project to take which will yield the
maximum return.
—  Need to take the risk into consideration
—  Need to consider the life span of the project.
—  To evaluate alternative project and compare various
project which will yield max profit.
—  To forecast the cash flows in advance.

8
THE FINANCE DECISION
¢  Involves:
•  To estimate the initial cost of investment
•  To explore the source of finance for the project
•  To balance the ratio between the amount of debts
and equity so as to obtain the minimum WACC.
•  The value of a firm is maximized when the WACC is
the lowest.
•  To decide on the amount of debts and equity to take.
THE DIVIDEND DECISION
¢  Involves:
•  To determine the amount of dividend to payout.
•  To determine the amount of new investment and
hence, the amount of retained earning required.
•  To ensure the dividend is consistent and maintain
as far as possible.
CASH FLOW TIMING
¢  Adollar today is worth more than a dollar at
some future date.
—  There are at least 4 reasons why a dollar today is worth more
than in a future time,
1)  Interest forgone

2)  Inflation rate

3)  Risk

4)  Personal consumption preference

¢  There is a trade-off between the size of an

investment’s cash flow and when the cash flow
is received. 11
CASH FLOW TIMING
Which is the better project?

Future Cash Flows

Year Project A Project B
1 $0 $20 000
2 $10 000 $10 000
3 $20 000 $0
12
Total $30 000 $30 000
CASH FLOW RISK
¢  The role of the financial manager is to deal with the
uncertainty associated with investment decisions.

¢  Assessing the risk associated with the size and timing of

expected future cash flows is critical to investment decisions.

¢  Risk is associated with the variability of expected income or

income streams.

¢  Important concept that we always hold, the higher the risk, the
higher the return will be or the lower the risk, the lower the return
will be. So risk and return have direct relationship

¢  Risk can be eliminated or reduced through ‘Diversification’ on

project investment or through synergy for non-mutually exclusive
projects 13
CASH FLOW RISK
Future Cash Flows

Pessimistic Expected Optimistic

Project 1 $100 000 $300 000 $500 000

Project 2 $200 000 $400 000 $600 000

¢  In risk situation, we can assumed the situation will be at the

worst scenario, or as predicted or the outcome may be at the
best situation. So in different situation, we will calculate all
the outcomes using few finance calculation methods. And
from the results, we can predicted what will happened if we
have bad or even good investment. So it is very useful to
make good judgment on the investment we selected as it will
affect the company’s future profit. 14
TIME VALUE TERMINOLOGY
—  “What have you understood about “Time Value of Money”

0 1 2 3 4

PV FV
—  Future value (FV) is the amount an investment is worth after one or more periods.

—  Present value (PV) is the current value of one or more future cash flows from an
investment.

•  The number of time periods between the present value and the future value is
represented by ‘t’.

•  The rate of interest for discounting or compounding is called ‘r’.

•  All time value questions involve four values: PV, FV, r and t. Given three of them, it
is always possible to calculate the fourth.
15
BASIC EQUATIONS

Eq. 1.1 : Future Value of a

Lump Sum

Eq. 1.2 : Present Value of a

Lump Sum
FUTURE VALUE OF MULTIPLE CASH FLOWS

Future value calculated by compounding forward one period

at a time0 1 2 3 4 5
Time
(years)
$0 $ 0 $2200 $4620 $7282 $10 210.20
0 2000 2000 2000 2000 2000.00
x 1.1 x 1.1 x 1.1 x 1.1 x 1.1
$0 $2000 $4200 $6620 $9282 $12 210.20

Future value calculated by compounding each cash flow separately

0 1 2 3 4 5
Time
(years)

$2000 $2000 $2000 $2000 $2000.0

x 1.1
2200.0
x 1.12
2420.0
x 1.13
2662.0
x 1.14
2928.2

Total future value $12 210.20

Figures — Calculation of FV for Multiple Cash Flow Stream

17
PRESENT VALUE OF MULTIPLE CASH FLOWS
Present value
0 1 2 3 4 5 calculated by
discounting each
$1000 $1000 $1000 $1000 $1000 Time cash flow
x 1/1.06 (years) separately
$ 943.40
x 1/1.062
890.00
x 1/1.063
839.62
x 1/1.064
792.09
x 1/1.065
747.26

$4212.37 Total present value

r = 6%
Present value
0 1 2 3 4 5 calculated by
discounting back
$4212.37 $3465.11 $2673.01 $1833.40 $ 943.40 $ 0.00 Time one period at a time
0.00 1000.00 1000.00 1000.00 1000.00 1000.00 (years)
$4212.37 $4465.11 $3673.01 $2833.40 $1943.40 $1000.00

Total present value = $4212.37

r = 6%

Figures — Calculation of PV for Multiple Cash Flow Stream

18
 ANNUITIES
¢ Anannuity is a series of equal cash flows (paid or received), separated by equal intervals of
time. Hence $5 a month for a year is an annuity. A stream of monthly payments that alternates
between $5 and $10 is not an annuity, nor is a steam of $5 payments that skips an occasional
month. Examples of annuities are monthly car payments, or the fixed annual payment over 20
years from a lottery. Annuities are fairly common in business and can be valued using the simple
present value and future value techniques that we have already covered.
¢ 

¢ Suppose your parents offer to help you pay for college, and give you a choice between a gift of
$10,000 today or $3,500 at the end of each of the next three years. If you can earn 5% annual
interest on your money which option would you prefer? If we make the assumption that you will
pass this class and stay in school, solving this problem rather straight forward. The first step
involves calculating the present value of the three $3,500 cash flows. The second step involves
selecting the greater of 1) the sum of these three present values, or 2) the single payment of
$10,000.

Present Value of an Annuity Future Value of an Annuity 19

PERPETUITIES
¢  The future value of a perpetuity cannot be calculated as the
cash flows are infinite.

¢  The present value of a perpetuity is calculated as follows:

C
PV =
r

20
 CAPITAL STRUCTURE
¢  A firm’s capital structure is the specific mix of debt
and equity used to finance the firm’s operations.
¢  Decisions need to be made on both the financing
mix and how and where to raise the money.

¢ Decision on capital structure is very important. The finance manager

must find one point where this point will give good capital structure to
the company and will not be a burden to them . For example, if the
company use all equity means at the end of the year, the company
may find it is a burden to pay dividend to all its shareholders. But if, the
company use to much debt in other word, the company is burden with
the obligation to pay interest. If the company mix the debt and equity,
what will be the best combination of percentage? Debt-50% or Equity
50%. Or perhaps debt-60% and equity-40% debt. So it is up to the
manager to decide and different company may have different
percentage of financing mix. 21
WORKING CAPITAL MANAGEMENT
Ø  How much cash and inventory should be kept on hand?
Ø  Should credit terms be extended? If so, what are the
conditions?
Ø  How is short-term financing acquired?

¢  Working capital comprises short term net assets: stock,

debtors, and cash, less creditors.

¢  Working capital management is the management of all aspects

of both current assets and current liabilities, so as to minimize
the risk of insolvency while maximizing return on assets.

22
 SIMPLE AND COMPOUND INTEREST
¢  Understanding Interest: SIMPLE Interest

— 
 SIMPLE AND COMPOUND INTEREST

¢  Understanding Interest: COMPOUND

Interest

The first method divides the nominal rate by number of compounding

periods in a year (c) and pays this interest rate for each of the periods.
SIMPLE AND COMPOUND INTEREST

Understanding Interest: COMPOUND Interest

The second method divides the nominal interest rate by 365 days per year
and multiplies the resultant by the number of days in the billing period. This
conversion method uses the following formula for the periodic interest rate:
COMPARING INTEREST RATE

¢  Yield or Annual Percentage Yield (APY) or

effective annual rate (EAR)
¢  To compare interest rates with different compounding
periods, the interest rates must be converted to a common
compounding period. The common compounding period
used is one year and the equivalent interest rate is known
as the yield (i.), which is also referred to as the annual
percentage yield or APY.
 COMPARING RATES

¢  The nominal interest rate (NIR) is the interest rate

expressed in terms of the interest payment made each
period.
¢  The effective annual interest rate (EAR) is the interest
rate expressed as if it was compounded once per year.
¢  When interest is compounded more frequently than
annually, the EAR will be greater than the NIR.

27
INTEREST AND LOAN
¢  Loans typically consist of a fixed amount of money, known
as the principal, which is borrowed at the beginning of the
loan and is paid back with interest at some point in the
future or over a period of time by making periodic payments.

¢  Short-term loans are loans with a term of one year or less.

¢  Long-term loans are loans with a term of more than a year.

¢  Short-term loans may allow that both the principal and

interest may be paid off at the maturity of the loan or the
loan may require that the interest be paid at regular
intervals with the principal being paid at the end of the loan.
¢  Long-term loans usually require periodic payments covering
both interest and principal, thus reducing the principal over
time.
INTEREST AND LOAN
¢  Payment on Long-Term Loans

¢  A = P[i(1 + i)n]
[(1 + i)n – 1]
where
A = Monthly payment (excludes taxes and
insurance)
P = Principal
i = Periodic interest rate for one month (r/12)
n = Duration of loan in months
INTEREST AND LOAN
INTEREST AND LOAN
¢  Effective Annual Interest Rate with Closing
Costs

¢  Closing costs increase effective annual interest rate

¢  Step 1: Determine payment (P)

¢  Step 2: Determine closing costs

¢  Step 3: Solve the following equation for i :

A = (P – Closing Costs)[i (1 + i)n]

[(1 + i)n – 1]
CAPITAL BUDGETING
What is Capital Budgeting:
•  At every point in a firm’s lifetime, there are many projects up for
consideration. Capital budgeting is the process of analyzing these
many projects and deciding which projects to take up and which ones
to ignore.

Procedure for Capital Budgeting

•  Estimate cash flows
•  From the whole firm’s point of view.

•  Assess the risk of cash flows

•  Determine discount rate r for project (i.e., cost of capital for the
project, which is not necessarily the same as the cost of capital for
the firm).

•  Make capital budgeting decisions (two types):

•  Accept/Reject
•  Rank alternatives
CAPITAL BUDGETING
¢  TOOLS for Capital Budgeting

Ø  Payback period: most commonly used

Ø  Accounting rate of return (ARR): focuses on project’s

impact on accounting profits

Ø  Net present value (NPV): best technique theoretically

Ø  Internal rate of return (IRR): widely used with strong

intuitive appeal

Ø  Profitability index (PI): considers budget constraint

 THE NET PRESENT VALUE (NPV) RULE
Net Present Value (NPV) = Total PV of future CFs - Initial
Investment
Inputs required for estimating NPV:
1. Estimate future cash flows: size and timing
2. Estimate discount rate
3. Estimate initial costs

CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N
 INTERNAL RATE OF RETURN (IRR)
•  The discount rate that equates
the present value of the future
cash flows with the initial cost.
•  Generally found by trial and
error.
•  A project is accepted if its IRR is
> the required rate of return.
•  The IRR on an investment is the
required return that results in a
zero NPV when it is used as the
discount rate.
Minimum Acceptance Criteria:
§ Accept if the IRR exceeds the
discount rate.
Ranking Criteria:
§ Select alternative with the highest
IRR (Questionable criteria).
Disadvantages:
§ IRR may not exist or there may be
multiple IRR
§ Problems with mutually exclusive
investments

Advantages:
§ Easy to communicate

If IRR > discount rate (WACC), then the project’s rate of return is greater
than its opportunity cost. Thus, shareholders earn an abnormal return.

Example:
Discount rate (WACC) = 10%, IRR = 15%. 35
Shareholders get 5% abnormal returns.
EXAMPLE—IRR
Initial investment = –$200
Year Cash flow
1 $ 50
2 100
3 150

n Find the IRR such that NPV = 0

50 100 150
0 = –200 + + +
(1+IRR)1 (1+IRR)2 (1+IRR)3
50 100 150
200 = + +
(1+IRR)1 (1+IRR)2 (1+IRR)3

CF1 CF2 CFN

NPV = + + ··· + − Initial cost
(1 + r )1 (1 + r)2 (1 + r)N
36
 PAYBACK PERIOD
•  The amount of time required for an investment to generate cash
flows to recover its initial cost.
•  Estimate the cash flows.
•  Accumulate the future cash flows until they equal the initial
investment.
•  The length of time for this to happen is the payback period.
•  An investment is acceptable if its calculated payback is less than
some prescribed number of years.
 DISCOUNTED PAYBACK PERIOD
•  The length of time required for an investment’s discounted cash
flows to equal its initial cost.
•  Takes into account the time value of money.
•  More difficult to calculate.
•  An investment is acceptable if its discounted payback is less than
some prescribed number of years.
ADVANTAGES AND DISADVANTAGES OF
DISCOUNTED PAYBACK

¢  Advantages ¢  Disadvantages

- Includes time value of -  May reject positive NPV

money investments
- Easy to understand -  Arbitrary determination of
- Does not accept negative acceptable payback period
estimated NPV -  Ignores cash flows beyond
investments the cutoff date
- Biased towards liquidity -  Biased against long-term
and new products
39
THE AVERAGE ACCOUNTING RETURN RULE
Average Net Income
AAR =
Average Book Value of Investment
¢  AAR is another attractive but fatally flawed approach.
¢  Ranking Criteria and Minimum Acceptance Criteria are set by
management.
¢  focuses on project’s impact on accounting profits
¢  Decision Rule for Accounting Rate of Return
—  Accept the project if project ARR > Firm’s benchmark ARR
—  Reject the project if project ARR < Firm’s benchmark ARR

¢  Disadvantages:
—  Ignores the time value of money
—  Uses an arbitrary benchmark cutoff rate
—  Based on profits and book values, not cash flows and market values
¢  Advantages:
—  The accounting information is usually available
—  Easy to calculate
 THE PROFITABILITY INDEX (PI) RULE
Total PV of Future Cash Flows
PI =
Initial Investent
¢  Minimum Acceptance Disadvantages:
Criteria:
—  Accept if PI > 1 § Problems with mutually exclusive
¢  Ranking Criteria: investments
—  Select alternative with
highest PI Advantages:
§ May be useful when available
investment funds are limited
§ Easy to understand and communicate
§ Correct decision when evaluating
independent projects
CASH FLOW ESTIMATION

•  Sunk costs do not matter. (refer lecture note)

•  Opportunity costs matter. (refer lecture note)
•  Side effects like cannibalism or erosion
matter, but there are exceptional cases.
(refer lecture note)
•  Financing expenses do not matter.
•  Taxes matter. (refer lecture note)
•  Inflation matters (e.g Fisher Equation)
CASH FLOW ESTIMATION
¢  Cash Flows—Not Accounting Earnings
Ø  Use accounting numbers to generate cash flows.
FCF = EBIT
+ Depreciation
- Taxes
- Additions to NWC
- Capital Expenditures
Ø  Cash Flows from Operations
Operating Cash Flow (OCF)
= EBIT – Taxes + Depreciation
= Sales – COGS – Taxes
= (Sales – COGS)(1-T) + T*Depreciation
¢  Minus Capital Expenditure
¢  Minus Changes in Net Working Capital (NWC)
INFLATION AND CAPITAL BUDGETING
¢  Inflation affects the cash flows from a project.
—  Effect on revenues
—  Effect on expenses

¢  Inflation also affects the cost of capital.

—  The higher the expected inflation, the higher the
return required by investors.

¢  Thus, the
effects of inflation must be properly
incorporated in the NPV analysis.
INFLATION AND CAPITAL BUDGETING
¢  Consider the relationship between interest rates and inflation, often
referred to as the Fisher relationship:
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)
(1 + rn) = (1 + rr) (1 + h)
rn = rr + h + hrr

¢  For low rates of inflation, this is often approximated as

Real Rate ≅ Nominal Rate – Inflation Rate
rn ≅ rr + h
¢  where
rr = cost of capital in real terms
rn = cost of capital in nominal terms
h = expected annual inflation rate
CAPITAL RATIONING (INTERNAL)
¢  Internal:
—  Capital rationing occurs when a company chooses not to fund
all positive NPV projects.

—  The company typically sets an upper limit on the total amount

of capital expenditures that it will make in the upcoming year.

¢  Reason:
—  Companies want to avoid the direct costs (i.e., flotation costs)
and the indirect costs of issuing new capital.

—  Companies don’t have enough managerial, marketing, or

engineering staff to implement all positive NPV projects.

—  Companies believe that the project’s managers forecast

unreasonably high cash flow estimates, so companies “filter”
out the worst projects by limiting the total amount of projects
that can be accepted
CAPITAL RATIONING (EXTERNAL)
¢  External:
—  Mostly, the company has to consider the external
factors on determining to accept or reject the
project disregard the NPV is positive
—  For some reasons , financial companies and bank
may not be able to supply enough new finance for all
profitable projects
¢  Reason:
—  If the company has good profit records, then finance
company will not permanently deny the company
the required finance.
—  The firm may be expanding too fast and seen as been
too risky or unsteady by finance company to provide
the required finance
—  Finance company may refuse to provide additional
capital if they consider to have exceed their
perceived safe limit.
 GOOD LUCK
TO YOUR EXAMINATION