Financial management: educational manual 9786010409095

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CHAPTER 1. Introduction. Objectives and tasks of financial management

N. Sh. Alzhanova

Financial management Educational manual

Almaty «Qazaq university» 2014

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FINANCIAL MATEMATICS

UDC 65.01(075.8) LBC 65.290-2я73 А 43 Recommended for publication by the Scientific Council of the Higher School of Economics  and  Business, Editorial and Publishing Council of the National University of Kazakhstan named after Al-Farabi and teaching and methodology section of Republican educational and methodological Council by specialty group «Social sciences, economics and business» of higher and postgraduate education at the MES at Kazakh University of Economics named after T.Ryskulov (Protocol №1 24 January 2013)

Reviewers: Doctor of economics, professor Rakhmetova R.U. Doctor of economics, professor Mukhamediyev B.M. Doctor (PhD) Tleppayev A.M.

Alzhanova N.Sh. А 43 Financial management: educational manual. – Qazaq university, 2014. – 135 p. ISBN 978-601-04-0909-5

Almaty:

The offered manual is written on the basis of a course of lectures which was read by the author for a number of years for students of economic specialties of the Kazakh national university named after al-Farabi, in it is stated bases of bases, the alphabetical principles of carrying out financial and actuarial calculations, possession with which in modern conditions is not only useful, but also it is obligatory as a starting condition of competent, operational and enterprising work of any perspective expert. The edition of this grant, in our opinion, will help students of economic specialties and the directions to seize methods and approaches for a choice of effective investment decisions, and practical orientation of a material will be reliable help in investment questions. The grant is intended also for beginners of the actuarial, insurance, auditor companies and bank workers.

UDC 65.01(075.8) LBC 65.290-2я73

ISBN 978-601-04-0909-5

© Alzhanova N.Sh., 2014 © Al-Farabi ­KazNU, 2014

CHAPTER 1. Introduction. Objectives and tasks of financial management

Contents

Introduction........................................................................................5 Chapter 1. 1.1. Chapter 2. 2.1. 2.2. 2.3. 2.4. 2.5. 2.6. Chapter 3. 3.1. Chapter 4. 4.1. Chapter 5. 5.1. Chapter 6. Chapter 7. 7.1. Chapter 8. Chapter 9.

Objectives and tasks of financial management............7 Meaning of financial management................................7 Time value of money.....................................................13 Definition of time value of money................................13 Present value basics......................................................15 Calculating the future value of an ordinary annuity...........................................................................18 Calculating the present value of an ordinary annuity...................................................19 Calculating the present value of an annuity due...........21 Interest rate....................................................................22 Risk and return. Investment returns. Benefits of diversifying overseas..................................26 Return on an investment...............................................26 Derivatives and risk management.................................30 Calculation of simple interest.......................................30 Assets valuation: key characteristics of bonds and stocks.......................................................36 Key characteristics of bonds.........................................36 Cost of capital, capital market theories. Investment projects analyses. Cost of company. Use of ratios..................................................................43 The basics of capital budgeting. Investment decisions.....................................................53 Meaning, importance & rationale of capital budgeting.......................................................53 Operating and financial leverage. Theory of capital structure............................................60 Dividends and repurchases: distributions to shareholders.........................................76

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FINANCIAL MATEMATICS

Chapter 10. Financial statements: balance sheet, cash flow and p&l reports.............................................86 Chapter 11. Working capital management: cash management, accounts payable...........................................................92 Chapter 12. Management of receivables..........................................105 Chapter 13. Inventory management..................................................113 Chapter 14. Financing of working capital........................................119 Chapter 15. Planning and budgeting of financial activities..............126

1.1. Meaning of Financial Management

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Introduction

Market economy – very thin and rather difficult mechanism. From the head, the financier, the economist, the analytics is required ability correctly to estimate possible options of financial consequences at com­mission of any transaction, at implementation of any project. For this purpose it is necessary a certain knowledge in the field of in­vestment design. At the heart of discipline – «Financial Management» one of the most dynamic directions of modern economic science – the quantita­ tive financial analysis created on a joint of financial science and mathematics. Already now it is realized a practical importance of se­rious analytical researches in the financial market and a certain lack of literature in English including on cases in point is thus felt. For the purpose of the best assimilation of a material of a grant the author sought to detail as much as possible a statement, having presented it in the form of heads, which purpose – to acquaint the reader with methodology and practice of financial and economic calculations. The purpose of development in students of skills of carrying out calculations who underlie long-term financial and investment de­ cisions is thus set. Competent implementation of the called opera­ tions is impossible without knowledge of bases of the quantitative financial analysis which methodological base is the financial mathe­matics. The textbook is calculated first of all on students of the economic specialties, according to bachelor and master programs of economics departments. For an assessment of completeness of assimilation of a training material the main part of a grant is supplied with control questions, tests and tasks with decisions, there is a section of prac­tical tasks for the independent decision with answers that does the book irreplaceable and on a practical training. The book is useful and to economists of the enterprises, banks, investment and finance com­panies who carry out development and examination of investment projects. 5

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CHAPTER 1. Introduction. Objectives and tasks of financial management

1.1. Meaning of Financial Management

Chapter

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Introduction. Objectives and tasks of financial management

   1.1. Meaning of Financial Management Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management prin­ciples to financial resources of the enterprise. Scope/Elements 1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions; 2. Financial decisions – They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby; 3. Dividend decision – The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two: a. Dividend for shareholders – Dividend and the rate of it has to be decided; b. Retained profits – Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise. 7

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CHAPTER 1. Introduction. Objectives and tasks of financial management

Objectives of Financial Management The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be: 1. To ensure regular and adequate supply of funds to the concern; 2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders; 3. To ensure optimum funds utilization. Once the funds are pro­cured, they should be utilized in the most effective way at least cost; 4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that adequate rate of return can be achieved; 5. To plan a sound capital structure – There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital. Functions of Financial Management 1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programs and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. 2. Determination of capital composition: Once the estimation has been made, the capital structure have to be decided. This involves short-term and long-term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 3. Choice of sources of funds: For additional funds to be procured, a company has many choices like: a. Issue of shares and debentures; b. Loans to be taken from banks and financial institutions; c. Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. 5. Disposal of surplus: The net profits decisions have to be made by the finance manager. This can be done in two ways: a. Dividend declaration – It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits – The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company.

1.1. Meaning of Financial Management

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6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many pur­poses like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, main­tenances of enough stock, purchase of raw materials, etc. 7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. Cost of Capital (Expected Returns): Risk-free rate of return + an equity risk premium ascribed to each corporate equity. Long term planning Exercise aimed at formulating a long-term plan, to meet future needs estimated usually by extrapolation of present or known needs. It begins with the current status and charts out a path to the projected status, and generally includes short-term (operational or tactical plans) for achieving interim goals. Long term decisions (objectives) Performance goals of an organization, intended to be achieved over a period of five years or more. Long-term objectives usually include specific improvements in the organization's competitive position, technology leadership, profitability, return on investment, employee relations and productivity, and corporate image. Short term planning The process of setting smaller, intermediate milestones to achieve within closer time frames when moving toward an important overall goal. Many business operators will engage in short term planning that typically covers time frames of less than one year in order to assist their company in moving gradually toward its longer term goals. Short term decisions (objectives) Incremental goals and benchmarks meant to aid in accomplishing the long-term objectives of an organization and which can be used to measure the effectiveness of the methods employed to accomplish the long-term objectives and the progress toward attaining those objectives. Financial control Management control (as exercised in planning, performance eva-luation, and coordination) of financial activities aimed at achieving desired return on investment. Managers use financial statements (a bud­get being the primary one), operating ratios, and other financial tools to exercise financial control. Certified Financial Manager. Career Definition. Certified Financial Managers, who may have specific titles like controller, treasurer, or finance officer, oversee the monetary affairs and transactions of organizations. They are

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CHAPTER 1. Introduction. Objectives and tasks of financial management

frequently employed by large corporations, banks, government agencies, non-profits, small business and other organizati ons. Common duties of Certified Financial Managers include monitoring cash flow, preparing income statements, balance sheets and budgets, complying with regu­latory requirements and overseeing accounting and auditing. Example of main responsibilities of financial manager in Kazakhstan: • Development of finance strategy of the company; • Development of finance policies, procedures for the company; • Provide finance analysis and planning, operation activities; • Control of accounting issues within the company; • Control and monitoring of income and payments of the company, planning activities; • Treasury activities (work with banks, issue of invoices to clients, payments to partners); • Work with contracts and tendering activities; • Budgeting (develop, coordinate, control and report to the ma­ nagement); • Insurance activities; • Prepare necessary reports (tax, statistics, audit and management reports), tax planning; • Coordinate financial guidelines, procedures and instructions with a view of improving the cost control, financial accounting and reporting; • Guiding and assisting GM in order to ensure reliable finance support and smooth business operations. Requirements: • High education in finance, MBA is advantage; • Work experience in finance (min 3-5 years); • Qualified or part-qualified ACCA, CIMA or other international accounting bodies; • Knowledge of tax, civil, bank and currency legislation of RK; • Excellent communicative skills, result-oriented, non-conflict orien­ted person; • English – intermediate level; • Experienced PC user: 1C, Microsoft Office (Word, Excel, Access, Outlook, Power Point), solid experience in working with MS Navision, SAP or other ERP applications. Financial Department Structure The Chief Financial Officer (or Financial Director) CFO or Chief financial and operating officer (CFOO) is a corporate officer primarily responsible for managing the financial risks of the corporation. This officer is also responsible for financial planning and record-keeping, as well as financial reporting to higher management. In some sectors the CFO is also responsible for analysis of data. The title is equivalent to finance director, a common title in the United Kingdom. The CFO typically reports

1.1. Meaning of Financial Management

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to the chief executive officer and to the board of directors, and may additionally sit on the board. Deputy Finance Director Deputy Finance Director is also called Finance Manager. This per­son is responsible for the preparation of the annual company budget and assisting in the preparation of the annual financial statements. Deputy Finance Director closely works with the departmental director by pro­viding financial status reports, assisting development of financial stra­tegy and managing the department team. Accountant This is the person who is in charge of processing accounts recei­vable, accounts payable, and payrolls. There can be several accountants in Finance department depending on the company's size and the scope of financial operations. Accountants assist in the preparation of financial reports, auditing documents, revision memorandum, and the monthly closing of the books. Financial Controller Samples taken from various job descriptions related to financial controller positions: The role will encompass all areas of accounting from financial accounting to forecasting and include specific project work. Working alongside the CFO and COO, the successful candidate will be required to advise on potential acquisitions and business decisions made by the company. This role is a hands role with the emphasis on providing genuine commercial direction to the MD of a fast growing niche retailer. As well as ultimate responsibility for the financial accounts preparation, you will provide regular relevant analysis and make course changing business decisions. Financial Controller, reporting to the Finance Director, to be res­ponsible for the Finance Function on a day to day basis. This is a unique opportunity to learn from a highly experienced team of professional entrepreneurs. This recent management buyout team seeks a com­ mer­cially focused accountant for production of management accounts and all commercial business issues. You will use your staff management and accountancy skills in managing a team of five and collating the numbers for the business, managing the cash-flow, and drafting the board pack commentary. The candidate will also head up the weekly finance team meeting. Further responsibilities will include payroll, VAT, cashbook. Finance Specialist Finance Specialist is in charge of monitoring the company's capital investment projects as well as the revenue analysis including sales tax and property tax analysis. This person is also accountable for keeping the general ledger, reconciling bank accounts and monitoring the company's funds. Cashier Cashier is in charge of paying and receiving money. This person can be also involved in the process of managing cash transactions

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CHAPTER 1. Introduction. Objectives and tasks of financial management

with customers. Cashier ensures that all cash money records are in line with existing cash in the cash desk. This employee reports to Accountant. Generally the Finance Department is the backbone of a company's operations and processes. It records operating transactions, analyzes them and prepares financial statements that inform top management, regulators and investors about a company's economic health. Finance employees also ensure that internal mechanisms and policies comply with regulatory standards, industry practices and human resources policies. Questions for self-control: 1. The content of Financial Management. 2. Objective, tasks and function of Financial Management. 3. The role of Financial Management positions and its importance today.

2.1. Definition of Time Value of Money

Chapter

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Time value of money  

2.1.  Definition of Time Value of Money One of the most fundamental concepts in finance is that money has a «time value». The idea that money, that is available at the present time is worth more than the same amount in the future due to its potential earning capacity.  This  core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received That is to say that money in hand today is worth more than money that is expected to be received in the future. The reason is straightforward: A dollar that you receive today can be invested such that you will have more than a dollar at some future time. This leads to the saying that we often use to summarize the concept of time value: «A dollar today is worth more than a dollar tomorrow». For instance, you have won a cash prize, and you have two payment options: to receive $10,000 now (Option A) or to receive $10,000 in three years (Option B). If you are like most people, you would choose to receive the $10,000 now. After all, three years is a long time to wait. Why would any rational person defer payment into the future when he or she could have the same amount of money now? For most of us, taking the money in the present is just plain instinctive. So at the most basic level, the  time value of money demonstrates that, all things being equal, it is better to have money now rather than later. But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn’t it? Actually, although the bill is the same, you can do much more with the money if you have it now because over time you can earn more interest on your money. Back to our example: by receiving $10,000 today, you are poised to increase the future value of your 13

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CHAPTER 2. Time value of money

money by investing and gaining interest over a period of time. For option B to receive later, you don’t have time on your side, and the payment received in three years would be your future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired over the three years. The future value for Option B, on the other hand, would only be $10,000. So how can you calculate exactly how much more Option A is worth, compared to Option B? Let’s take a look.  Future Value Basics If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the future value of your investment at the end of the first year is $10,450, which of course is calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount: Future value of investment at end of first year: = ($10,000 x 0.045) + $10,000 = $10,450 You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation: • Original equation: ($10,000 x 0.045) + $10,000 = $10,450 • Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450 • Final equation: $10,000 x (0.045 + 1) = $10,450 The manipulated equation above is simply a removal of the like-variable $10,000 (the principal amount) by dividing the entire original equation by $10,000. If the $10,450 left in your investment account at the end of the first year is left untouched and you invested it at 4.5% for another year, how much would you have? To calculate this, you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two years, you would have $10,920: Future value of investment at end of second year: = $10,450 x (1+0.045) = $10,920.25 The above calculation, then, is equivalent to the following equation: Future Value = $10,000 x (1+0.045) x (1+0.045)

amount) dividing entire original equation $10,000. Ifthethe$10,450 $10,450 in yourinvestm inves amount) bybydividing thethe entire original equation byby$10,000. If leftleftinit much would you have? To calculate this, you would would take the $10,450 $10,450 and multiply multiply ityour again by 1.0 1 much would you have? To calculate this, you take the and again by account the end first year isleft left untouched andyou youinvested investedit itat at4.5% 4.5%forforanother anotheryear, year,h account at atthe end ofofthe first year isyou untouched and (0.045 +1). At the end ofthe two years, would have$10,920: $10,920: (0.045 +1). At the end of two years, you would have muchwould wouldyou youhave? have?ToTocalculate calculatethis, this,you youwould wouldtake takethethe$10,450 $10,450and andmultiply multiplyit itagain againbyby1.0 much (0.045 +1). At the end two years, you would have $10,920: (0.045 +1). Atof end ofof two years, would have $10,920: Future value ofthe investment atend end ofyou second year: Future value investment at of second year: 2.2. Present Value Basics $10,450xx(1+0.045) (1+0.045)==$10,920.25 $10,920.25 ==$10,450 15 Future value investment end second year: Future value ofof investment at at end ofof second year: = $10,450 xabove (1+0.045) = $10,920.25 = $10,450 x above (1+0.045) = $10,920.25 The calculation, then,isisequivalent equivalenttotothe thefollowing followingequation: equation: The calculation, then, Think back to math class and the rule of exponents, which states that the multiplication of like terms is equivalent to adding their exponents. The above calculation, then, is equivalent following equation: The above calculation, then, is equivalent to to thethe following equation: FutureValue Value $10,000 (1+0.045) (1+0.045) Future == $10,000 xx(1+0.045) xx(1+0.045) In the above equation, the two like terms are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be Future Value = $10,000 x (1+0.045) xthe (1+0.045) Future Value =back $10,000 x (1+0.045) x (1+0.045) Think back math class and and the rule of of exponents, exponents, which which states states that that the the multiplication multiplication of of l Think toto math class rule represented as the following: termsisisequivalent equivalenttotoadding addingtheir theirexponents. exponents.In Inthe theabove aboveequation, equation,the thetwo twolike liketerms termsare are(1+0.045), (1+0.045), terms Think back tomath mathclass class and rule of exponents, which statesthat that themultiplication multiplicationofol Think back toisis thetherule ofequation exponents, states theexponent exponent on each equal Therefore, the equation canwhich be represented asthe the following: the on each equal toto 1.1.and Therefore, the can be represented as the following: terms equivalent adding their exponents. In the above equation, the two like terms (1+0.045 terms is is equivalent to to adding their exponents. In the above equation, the two like terms areare (1+0.045), ��� (1++0.045) Futurevalue value == $10,000 $10,000 ××(1 0.045)��� Future the exponent on each is equal to 1. Therefore, the equation can be represented as the following: the exponent on each is equal to 1. Therefore,==the equation××can be represented as the following: �� (1+ (1 $10,000 +0.045) 0.045) $10,000 ��� ��� (1 (1 Future value=== =$10,000 $10,000× × + + 0.045) Future value 0.045) $10,920.25 $10,920.25 � � (1(1 $10,000× × 0.045) = =$10,000 ++ 0.045) = =$10,920.25 We can can see see that that the the exponent exponent isis equal equal the number number of of years years for for which which the the money money isis earn ear We toto$10,920.25 the We can see that the exponent is equal to the number of years for which interest inin an an investment. investment. So, So, the the equation equation for for calculating calculating the the three-year three-year future future value value of of the the investm investm interest thethemoney is earning interest innumber an investment. So, thewhich equation We can seethat that theexponent exponent equal number years moneyis isearn ea We can see is isequal to tothethe ofofyears forforwhich thethemoney wouldlook look like this: would like this: for calculating the three-year future value of the investment would interest in an investment. So, the equation for calculating the three-year future value of the inves interest in an investment. So, the equation for calculating the three-year future value of the investm this: ����� would look like this: look like would look like this: (1++0.045) Futurevalue value == $10,000 $10,000 ××(1 0.045)����� Future � � (1++0.045) $10,000 ××(1 0.045) == $10,000 ����� ����� (1 (1 Future value= = $10,000 × + 0.045) Future value $10,000 × + 0.045) = $11,411.66 $11,411.66 � � (1(1 $10,000× × 0.045) = =$10,000 ++ 0.045) $11,411.66 = =$11,411.66

This calculation shows us that we don’t need to calculate the future value after theshows first year, then the second then the the third value year, This calculation us that don't need toyear, calculate Thisneed calculation shows usfuture that we we don't need calculate the future future value after after the the first first his calculation shows us that wecalculation don't to thewe value after thetoyou first year, then This shows that don't need toyears calculate the future value after athe first year, th and so then on.calculate Iftheus you know how many would like to years hold the second year, third year, and so on. If you know how many you would like the second year, then the third year, and so on. If you know how many years you would d year, then the third andyear, so on. youthird knowyear, howand many years you would like many holdyears a you would like to like the year, second thenIf the so in on. youfuture knowvalue how hol present amount ofan money anIf investment, the to future value ofisthat present amount of money in investment, the of that amount calculated by the present amount of value moneyofinthat an amount investment, the futurebyvalue of that amount is calculated by the mount of money in present an investment, future isfuture calculated the following amount the ofamount money in calculated an investment, thefollowing value of that amount is calculated by the follow is by the equation: equation: equation: equation:

Future Future value value Future value �� ������� Future value rate per period)������ ������ �� ������� (1 ������ �� ������� = Original Amount × + interest (1 + interest rate per period) ������ �� ������� =rate Original Amount × = Original Amount × (1 + = interest per period) Original Amount × (1 + interest rate per period) OR OR OR OR � = =� � �� (1 (1 + + �) �)� = � � (1 + �)� = � � (1 + �)�

2.2. Value Basics 2.2. Present Present 2.2. Present Value Basics2.2. Present Value Value Basics Basics 2.2.If you Present Value Basicstoday, the present value would of course be $10,000 becau $10,000 you received received $10,000 today, the present value would of course be $10,000 becau you received $10,000 today, theIf present value would of the course be $10,000 because present If you received $10,000 today, present would course be $10,000 because value is what your investment gives you now ifvalue you were toof spend it today. If $10,000 were pres to b

is what your investment gives you now if youwere weretotobespend it today. If $10,000 were to b what your investmentvalue givesisvalue you if investment you were togives spendyou it today. $10,000 received whatnow your now ifIfyou werenot to spend it today. If $10,000do were tohave be receiv in the present value the would because in aa year, year, the not present value of ofbecause the amount amount would not be beit $10,000 $10,000 because you you do not not have it it in in the present value of the amount would be $10,000 you do not have in your hand in a year, the present value of the amount would not be $10,000 because you do not have it in your ha If you received $10,000 today, the present value would of course be now, in the present. To find the present value of the $10,000 you will receive in the future, now, value in theofpresent. To find thewill present value of the $10,000 you will receive in the future, yo yo he present. To find now, the present the $10,000 you receive in the future, you need to inpretend the present. To $10,000 find the ispresent value of the $10,000 youinvestment willthat receivegives in theyou future, you need $10,000 because present value is what your that the future of an amount invested pretend that the the $10,000 is that the total total future value value of In an other amount that you you invested today. today. In In other other hat the $10,000 is the total future value of an amount you invested today. words, to pretendfind that thepresent $10,000 is theof total future value of we an amount that were you invested today.would In other words, now ifvalue you were to spend it today. If $10,000 to be received the future $10,000, to out how find the the present value of out the how future $10,000, we need need totofind find out today how much much we we would have have to to in in resent value of the future we need to find much we would have invest find the$10,000, present value of the future $10,000, we need to find out how much we would have to invest tod in a year, the present value of the amount would not be $10,000 in order to receive that $10,000 in the future. in future. order to receive that $10,000 in the future. o receive that $10,000 in the in order to receive that $10,000 in the future. you do not have itthe your hand now, in the present. Totoday, To calculate present value, or that we would have to Tobecause calculate value, or invest theinamount amount that would have to invest invest today, you you mu mu o calculate present value, or amount that wepresent wouldor have to today, youwe must subtract Tothe calculate present value, the amount that weyou would have to invest today, you must subtr find the present value of the $10,000 will receive in the future, the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the (hypothetical) accumulated interest from the discount $10,000. the To future achieve this, we can discount thetical) accumulated interest from the $10,000. To achieve this, we can the (hypothetical) accumulated interest from the $10,000. Toperiod. achieve this,value we all can an discount the futre payment amount ($10,000) by the interest rate for In you to pretend that the $10,000 isthe the total future payment amount byessence, the interest rateare fordoing the period. In essence, essence, allofyou you are are doing doing is is re amount ($10,000) by the interest rate for need the($10,000) period. allfor you rearranging payment amount ($10,000) by you theIn interest rate the period. Inis for essence, allabove youpresent are doingvalue is rearrang the future value equation above so that you may solve P. The future equati amount that invested today. In other words, to find the the future value equation above so that you may solve for P. The above future value equati value equation above so thatvalue you equation may solve for P.soThe future value can befuture value equation can the future above that above youwith may solve for equation P. The and above rewritten by the P value rewritten by replacing replacing theand P variable variable with present present value (PV) (PV) and manipulated manipulated as as follows: follows: by replacing the P variable with present value (PV) manipulated as follows: rewritten by replacing the P variable with present value (PV) and manipulated as follows: � Original e�uation� � e�uation� F� F� = = �� �� �� (1 (1 + + �) �)� Original e�uation� F� = �� Original � (1 + Original �)e�uation� F� = �� � (1 + �)� Manipulati on: Divide both sides by (1 + �)� Manipulati on: Divide both sides by Manipulati (1 + �)� on: Divide both sides by �(1 + �)�

(1 + �) � (1 + �)�

2.2. Present Value Basics 2.2. Present Value Basics 2.2. Present Basics 2.2. Present Value Basics 2.2. Value Present Value Basics 2.2. Present Value Basics 2.2. Present Value Basics received today, the present value would of course be $10,000 because present 2.2.$10,000 Present Value Basics 2.2. Present Value Basics

your investment you now if$10,000 you were towould spend it today. Ifofbe $10,000 were tobecause be received Ifgives you received today, the present value would course be $10,000 because present today, the present value ofof course $10,000 present you $10,000 today, the present value would ofcourse course be $10,000 present Ifreceived you $10,000 received $10,000 today, the present value would course beofbecause $10,000 because present ureceived received $10,000 today, the present value would be $10,000 because present CHAPTER 2. Time value of money 16 received $10,000 today, the present value would of course be $10,000 because present present value of the amount would not be $10,000 because you do not have it in your hand value is what your investment gives you now if you were to spend it today. If $10,000 were to be received your investment gives you now ifyou were totowould spend itof IfitIfbe $10,000 totobe received at investment gives you now if you were to spend it today. If $10,000 were to be received eoday, isyour what your investment gives now if you were to spend today. Ifwere $10,000 were to be received your investment gives you now ifyou you were spend ittoday. today. $10,000 were be received the present value would of course be $10,000 because present received $10,000 today, the present value course $10,000 because present our investment gives you now if you were to spend it today. If $10,000 were to be received esent. To find the present value of the $10,000 you will receive in the future, you need to in a year, the present value of the amount would not be $10,000 because you do not have it present value ofofgives the amount would not bebe $10,000 you do not have itnot your he present value of amount would not be $10,000 you not have in your year, the present value of the amount would not bebecause $10,000 because you do have ithand inhand your handin your hand value thethe amount would not $10,000 because you dodo not have itinit in your hand spresent you now if you were to spend it you today. If$10,000 $10,000 were toyou be your investment you now if were to spend it because today. Ifreceived $10,000 were to be received resent value of the amount would not be because do not have it in your hand e $10,000 is the total future value of an amount that you invested today. In other words, to now, in the present. To find the present value of the $10,000 you will receive in the future,toyou need to esent. find the present ofofnot the $10,000 you will receive in the future, need toto toneed present. find the present value of the $10,000 you receive inthe the future, you need value ofvalue the future $10,000, we need to find out how much we in theTo present. To find the present value of $10,000 you will receive in future, you resent. ToTo find the present value the $10,000 you will receive in future, you need amount would not be $10,000 because you dothe not have itwill in your hand present value of the amount would be $10,000 because you do not have itthe inyou your hand To find the present value of the $10,000 you will receive in the future, you need to ntsent. value of the future $10,000, we need to find out how much we would have to invest today pretend that the $10,000 is total future value of an amount that you invested today. end $10,000 is$10,000 total value ofthe an amount that you invested InIntoday. other words, to the the $10,000 is the total future value of an amount that invested In words, to In other would have tofuture invest today order toyou receive that $10,000 inother the that thefind isfuture the total value of amount that you invested In other to words, to $10,000 is the total future value ofreceive an amount that you invested today. other words, esent value ofthe $10,000 you will ininan the future, you need totoday. esent. To the present value of $10,000 you will receive intoday. the future, you need totowords, $10,000 is the total future value of an amount that you invested today. In other words, to eive that $10,000 infuture. the future. find present value of the future $10,000, we need to find out how much we today would have to invest today nt value of future $10,000, we need towe find out how much we would have totoinvest value of the future $10,000, we need to find out how much we would have to invest today the present value of the future $10,000, need to find out how much we would have totoday invest today ntfuture value ofthe the future $10,000, we need to find out how much we would have invest lesent value of an amount that you invested today. In other words, tohave $10,000 is the total future value of an amount that you invested today. In other words, value of the future $10,000, we need toinfind out how much we would to invest todayto culate present value, or the amount that we would have to invest today, you must subtract in order to receive that $10,000 the future. To calculate present value, or the amount that we would have to invest eive that $10,000 in the future. receive that $10,000 in the future. der tothat receive that $10,000 in how the ceive $10,000 in $10,000, the future. $10,000, to out muchtowe would havemuch to invest today have to invest today nt value ofwe theneed future we future. need find out how we would ve that $10,000 invalue, thefind future. cal) accumulated interest from the $10,000. Towould achieve this, wewould discount the future To calculate present value, orwe the amount that we have to invest today,subtract you must subtract today, you must subtract the (hypothetical) accumulated interest culate present value, or the amount that we would have to invest today, you must subtract calculate present or the amount that have to invest today, you must subtract To calculate present value, or the amount that we would have tocan invest today, you must alculate present value, or the amount that we would have to invest today, you must subtract he future. eive that $10,000 in the future. ulate present value, or the amount that we would have to invest today, you must subtract unt ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount from the $10,000. To achieve this, we can discount the future cal) accumulated interest from the $10,000. To achieve this, we can discount the future hetical) accumulated interest from $10,000. achieve this, we can discount the future hypothetical) accumulated interest from thewould $10,000. To achieve this, we can discount the future the future ical) accumulated interest from thethe $10,000. ToTo achieve this, wetoday, can discount the future or accumulated the amount that we have to invest today, you must subtract culate present value, or would the amount that we have to invest you must subtract al) interest from the $10,000. To achieve this, we can discount the future ue equation above so that you may solve for P. The above future value equation can be payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging payment amount ($10,000) by the interest rate for the period. In unt by the interest rate for the period. InIn essence, all you are doing isisrearranging mount ($10,000) by the interest rate the period. In essence, you doing is rearranging ment amount ($10,000) by the interest rate for the period. In essence, allare you are doing is rearranging unt($10,000) ($10,000) by the interest rate forfor the period. essence, allall you are doing rearranging erest from the $10,000. To achieve this, we can discount the future cal) accumulated interest from the $10,000. To achieve this, we can discount the future nt ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging essence, all you are doing is rearranging the future value equation the future value equation above so that you may solve for P. The above future value can be placing the P variable with present value (PV) and manipulated as follows: ue equation above so that you may solve for P.In above future value equation can bebebecanequation value equation above sothat that you may solve P. The future value can uture value equation above soessence, that you may solve for P. The above future value equation be lue equation above so may solve forfor P.The The above future value equation can rateabove for the period. Inyou all you are doing isabove rearranging unt ($10,000) by the interest rate for the period. essence, all you are doing isequation rearranging eyinterest equation so that you may solve for P. The above future value equation can be above so that you may solve for P. The above future value equation rewritten by replacing the P value variable with present value (PV) and manipulated placing the Pabove with present (PV) and manipulated asasfollows: replacing Psolve variable with present value (PV) and manipulated as follows: byyou replacing the Pthat variable with present value (PV) and manipulated asequation follows: as follows: eplacing thethe Pvariable variable with present value (PV) and manipulated follows: oitten that for P. The above future value equation be ue equation sowith you may for P. The above future value � placing the Pmay variable present value (PV) and manipulated ascan follows: can be rewritten by solve replacing the P variable with present value (PV) can be Original e�uation� F� = �� � (1 + �) eplacing with present value (PV) manipulated as follows: the P variable withand present value (PV) and manipulated as follows: � and manipulated as follows: �� F� � = �� Original e�uation� Original e�uation� F� ==�� �F� �)+ Original e�uation� = �=+ (1 �) Original e�uation� �� � (1 + �)� � (1 + �) Original e�uation� F�F� ���� �(1 (1 + �) � � Original e�uation� F� = �� � (1 + �) Manipulati on: Divide both sides by (1 + �) riginal e�uation� F� = �� �e�uation� (1 + �)� F� = �� � (1 + �)� Original � �both � sides Manipulati on: Divide � by (1 + �) � Manipulati on: Divide both sides by (1 + �)+ Manipulati Divide both sides by (1 �)(1 Manipulati on: Divide both sides by + �) Manipulati on:on: Divide both sides by (1 + �) � ��both sides by (1 + �) Manipulati on: Divide � �� �� = �� � (1 +��)�� Final equation: Manipulati on: Divide both sides�� by = (1(���) + �)�both Manipulati on: Divide sides by (1 +�� �) �� �� �� �� ��=�� �� = �� �� equation: Final = �� �� �� � (1 + �) �� Final equation: �� = �� �� �� � (1 + Final equation: �� = �� �� = �� � (1 + �)(1 ��) �� (���) Final equation: �� �� �� = �� � + �) � = Final equation: �� =(���) �� �� = �� � (1 + �) (���) � �� � � �� (���) Final��equation: �� = (���) �� �� �� = �� � (1 + �) �� equation: �� =Final �� �� =����=(���) � (1 �+� �) �� �� = ��B.� (1 + �) walk backwards fromequation: $10,000 offered in Option Remember; the $10,000 to be � the (���) (���) Let’s walk backwards from the $10,000 offered in Option B. Re­ mwere em­­ ree years is really the same as the future value of an investment. If today we at the Let's walk backwards from the $10,000 offered in Option B. Remember; to be walk backwards from the $10,000 offered in Option B. Remember; the $10,000 to 'swalk walk backwards from the $10,000 offered in Option B. Remember; $10,000 tobebethe Let's walk backwards from theto$10,000 offered in B. Option B. Remember; the $10,000 to $10,000 be backwards fromthe the$10,000 $10,000 offered in Option Remember; thethe $10,000 tobe ber; be received in three years is really the same asvalue alk backwards from the $10,000 offered in Option B. Remember; the $10,000 to be ,ved we would discount the payment back one year. At the two-year mark, the present of received in three years is really the same as the future value of an investment. If today we were at the ree years is really the same as the future value of an investment. If today we were at the years really the the future value aninvestment. today were at the at the three years isthefuture really the same thevalue future value ofRemember; an were investment. Ifwewe today we were hree years is is really same asas the ofof IfatIftoday were the mthree thein $10,000 offered insame Option B.future Remember; the $10,000 toIf be walk backwards from the $10,000 offered in Option B.investment. the $10,000 toat be the value of anas investment. Ifan today we the two-year ee years is really the same as the future value of an investment. today we were at the be received in one year is represented as the following: two-year mark, we would discount the payment back one year. At the two-year mark, the present value of , we would discount the payment back one year. At the two-year mark, the present ofofof ark, we would discount the payment back one year. At the two-year mark, present year mark, we would discount payment back one year. At the two-year mark, thevalue present value of we would discount the payment back one year. Atan the two-year mark, thethe present value ek, same as the future value of an investment. If today we were at the ree years isdiscount really the same asthe the future value of investment. If today we were atvalue the mark, we would discount the payment back one year. At the twowe would the payment back one year. At the two-year mark, the present value of the $10,000 to be received in one year is represented as the following: be in year ispayment asasthe following: 0o10,000 to be received in one year is represented as the following: to bediscount received in one year is represented asAtthe the following: bereceived received inone one year isrepresented represented the following: payment back one year. At two-year mark, present value mark, thethepresent value of to mark, be of received in onevalue of ,the we would the back year. the$10,000 two-year the present be received in one year year is represented asone the following: Present value of future payment of $10,000 year represented ear is represented theisis following: be received in oneas year representedasasthe thefollowing: following: at end of year two: Present value of future payment of $10,000 Present value ofoffuture payment of ofofat Present value of future payment of $10,000 at end of year two: Present value of future payment ofat$10,000 end of at end of Present value future payment of$10,000 $10,000 atend end �� Present value of future payment of $10,000 at end of (1 year two: =$10,000 × + 0.045) year two: year two: year two: year two: value of future payment of of $10,000 end of of $10,000 at end Present future at payment �� of year two:value �� �� × (1 = $9569.38 �� + 0.045) (1 (1 =$10,000 × 0.045) =$10,000 × + 0.045) (1��+��0.045) =$10,000 ×=$10,000 (1+ : =$10,000 × + 0.045) year two: =$10,000 �� × (1 + 0.045) �� ==$9569.38 = $9569.38 = $9569.38= $9569.38 0 × (1 + 0.045) $9569.38 =$10,000 × (1 + 0.045) = $9569.38 hat if today=we were at the one-year mark, $9569.38 = $9569.38 the above $9,569.38 would be considered the Note that if today we were at the one-year mark, above $9,569.38 our onewere year from now. on, at the the end ofthe the first year we would be the be the Note that if today we were at the one-year mark, the above $9,569.38 would considered the hat ifinvestment we were at one-year mark, the above $9,569.38 would be considered the te that iftoday today we at the one-year mark, the above $9,569.38 would be considered Note that ifwe today we were at theContinuing one-year mark, above $9,569.38 would be considered that iftoday were atthe the one-year mark, the above $9,569.38 would be considered the would be considered the future value of our investment one year at if today we were at the one-year mark, the above $9,569.38 would be considered the eceive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for future value our investment one year from now. Continuing on, at the end of the first year we would be our investment one year from now. Continuing on, at the end of the first year we would be e of our investment one year from now. Continuing on, at the end of the first year we would be e at value of ourweinvestment one year from now. Continuing on, at of thewould end ofbe the first we of our one year from now. Continuing on,end at $9,569.38 the end the first year we year would eour theinvestment one-year mark, the above $9,569.38 would be considered the hat if today were atnow. the one-year mark, the above considered thebewould be from Continuing on,$10,000 at the of the first year we would investment one year from now. Continuing on, at the end of the first year we would be ue of a $10,000 payment expected in two years would be the following: expecting to receive the payment of in two years. At an interest rate of 4.5%, the calculation for eceive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for octing receive the payment of $10,000 in two years. At interest rate of 4.5%, the calculation to the receive the payment ofnow. $10,000 in two years. At an interest rate of 4.5%, the calculation receive payment of $10,000 inthe two years. At anan interest rate of 4.5%, the calculation forfor for year from now. Continuing on, at end of the first year we would be our investment one year from Continuing on, at the end of the first year we would be be expecting to receive the payment of $10,000 in two years. At ceive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following: ue ofofaof expected in two years would bebe the following: a payment $10,000 expected in two years would be the following: resent value of apayment $10,000 payment expected in two years would be the following: alue a$10,000 $10,000 payment expected in4.5%, two years would the following: fevalue $10,000 in two years. At an interest rate ofthe 4.5%, the calculation for eceive the ofinterest $10,000 in in two years. At an interest of 4.5%, thevalue calculation for anpayment rate of calculation for the present of of a $10,000 payment expected two years would be year: therate following: Present value of $10,000 in one ment inpayment two yearsexpected would be following: ue ofexpected a $10,000 inthe two years in would be thewould following: a $10,000 payment expected two years be the following: Present value ofone $10,000 Present value ofof$10,000 year: Present value of $10,000 in one year: Present value ofin $10,000 in year: in one year: Present value $10,000 inone one year: Present value of $10,000 in one year: �� Present value of $10,000 in one year: (1 + 0.045) = = $10,000 ×year: Present value of $10,000 in one Present value of $10,000 in one year: �� �� �� × (1 = $10,000 $9157.30 (1 (1 ==$10,000 × 0.045) == = �� +=0.045) = = $10,000 × + (1��+��0.045) = $10,000 ×0.045) (1+ $10,000 × + 0.045) (1 = $10,000 × $9157.30 + 0.045) ��= $9157.30 �� $9157.30 $9157.30= $9157.30 = $10,000 × (1 + 0.045) = = $10,000 × (1 + 0.045) $9157.30 urse, because of the rule of exponents, we don't have to calculate the future value of the $9157.30 $9157.30 ery year counting back from the investment at third year. We could put the Of course, because of the rule of exponents, we to don't have to calculate the urse, because of the rule ofthe we don't have totothe calculate the future value ofofthe course, because ofthe the rule ofexponents, exponents, we don't have tohave calculate future value of thefuture Of because of$10,000 theexponents, rule of exponents, we don’t have to calculate Of course, because of rule of we don't calculate the future value of thevalue of the ourse, because ofcourse, rule ofexponents, we don't have calculate thethe future value the rse, because of the rule of exponents, we don't have to calculate the future value of the concisely and usethe thefuture $10,000 asfrom FV. So, here is the how you cancounting calculate today's present investment every year counting back from $10,000 investment at the third year. Wethe could put the ery year counting back from the $10,000 investment at the third year. We could put the every year counting back $10,000 investment at the third year. We could put value of the investment every year back from stment every year counting back the $10,000 investment at the third year. We very year counting back from thethe $10,000 investment the third year. We could putcould thetheput rule of exponents, we don't have to calculate thehave future value of urse, because of the rule offrom exponents, we don't toat calculate the future value of the ry year counting back from the $10,000 investment at the third year. We could put the 10,000 expected from a three-year investment earning 4.5%: equation more concisely and use the $10,000 as FV. So, here is how you can calculate today's present concisely and use the $10,000 as FV. So, here is how you can calculate today's present the $10,000 investment at the third year. We could put the equation ore concisely and use the $10,000 as FV. So, here is how you can calculate today's present tion morecounting concisely and use the $10,000 as FV. So, here is third how you can calculate today's e concisely and use the $10,000 as FV. So, here isWe how you can calculate today's present ack from the $10,000 investment at theSo, third year. could put the ery year back from the $10,000 investment atyou the year. We couldpresent put the present concisely andof use the $10,000 asinvestment FV. here is how canSo, calculate today's value the $10,000 expected from a three-year investment earning 4.5%: more concisely and use the $10,000 as FV. here is how you 10,000 expected from a three-year earning 4.5%: e $10,000 expected from a three-year investment earning 4.5%: ehe of $10,000 the $10,000 expected from three-year investment earning 4.5%: $10,000 expected from a $10,000 three-year earning 4.5%: as from FV. So, here is ahow youSo, can calculate today's present concisely and use the as investment FV. here is how you can calculate today's present 0,000 expected a three-year investment earning 4.5%: can calculate today’s present value of the $10,000 expected from a a three-year investment earning 4.5%: 10,000 expected from a three-year investment earning 4.5%: three-year investment earning 4.5%: PV of three year investment = $10,000 × (1 + 0.045)�� = $8762.97

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are % per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for

2.2. Present Value Basics

17

So the present value of a future payment of $10,000 (1 is worth $8,762.97 PV of three year investment = $10,000 × + 0.045)�� �� today if interest rates are 4.5% per year. In other PV of three year investment ==$10,000 × (1 +words, 0.045)choosing $8762.97 Option B is like taking $8,762.97 now and then investing it for = $8762.97 three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers So the present value of a future payment of $10,000 is in worth todayif if interest rat you $1,237.03 ($10,000 - $8,762.97) more cash!$8,762.97 Furthermore, So the present value of a the future payment is worth $8,762.97 today interest rates 4.5% per year. In other words, choosing Option B$10,000 is like taking $8,762.97 now and ifthen investing you invest $10,000 that of you receive from Option A, your choice 4.5% year.The In other words, choosing Option BOption isislike $8,762.97 now and then investing gives you a future value that $1,411.66 ($11,411.66 -because $10,000) threeper years. equations above illustrate that Ataking is better not only it offers you itm three equations that Option A is- $8,762.97) better not only offers you moi greater thanillustrate the future value of Option B. rightyears. now The but because it above offers you $1,237.03 ($10,000 morebecause in cash!it Furthermore, right now but because it offers you $1,237.03 ($10,000 $8,762.97) more in cash! Furthermore, if invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,4 invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411 Present Value of a Future Payment ($11,411.66 - $10,000) greater than the future value of Option B. ($11,411.66 - $10,000) greater the to future value of Option B. Let’s add a little spice our investment knowledge. What if the payment Present Value of a than Future Payment in three years is more than the amount you’d today? Say Present Value of a Future Payment Let's add a little spice to our investment knowledge. What receive if the payment in three years is you could receive either $15,000 today or $18,000 in fourtoday years. Let's add a little spice to our investment knowledge. What if the payment in three years is in m than the amount you'd receive today? Say you could receive either $15,000 or $18,000 Which would you choose? The decision is now more difficult. If than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in years. Which would you choose? The decision is now more difficult. If you choose to receive $1 youchoose? choose to receive $15,000 today anddifficult. invest the entire amount, years. would The decision is now more you choose $15, todayWhich and invest theyou entire amount, you may actually end up with an If amount of cashtoinreceive four years you may actually end up with an amount of cash in four years that today the entire amount, you actually with anbut amount four years less and thaninvest $18,000. You could find themay future valueend of up $15,000, since of wecash are inalways livingth is could less than $18,000. Youvalue couldoffind the future of $15,000, less than $18,000. find theoffuture $15,000, butarevalue since we are4%. always living in present, let's findYou the present value $18,000 if interest rates currently Remember th but sincevalue we areofalways living in the present, let’s find the 4%. present present, let's find the present $18,000 if interest rates are currently Remember that equation for present value is the following: value if interest rates are currently 4%. Remember that equation for present value is of the$18,000 following: the equation for present value is the following: PV � (1 + �)�� PV � (1 + �)�� In the equation above, all we are discounting the future an investment. Usi In the equation above, all doing we areisdoing is discounting the value futureof value of In the equation above, all we are doing is discounting the future value of an investment. Using numbers above, the an present value of an $18,000 payment in four years would be calculated a investment. Using the numbers above, the present value of an numbers above, the present value of an $18,000 payment in four years would be calculated as following: $18,000 payment in four years would be calculated as the following: following: Present Value = $18,000 × (1 + 0.04)�� Present Value ==$18,000 × (1 + 0.04)�� $15,386.48 = $15,386.48 From the above calculation we now know our choice is between From the above calculation we now know our choice is between receiving $15,000 or $15,3 receiving $15,000 orknow $15,386.48 today. Of course we should the above calculation we our choice is between today.From Of course we should choose to now postpone payment for four years! receiving $15,000 or $15,386 choose to postpone payment for four years! today. Of These course calculations we should choose to postpone payment for four years! - the value of the money you demonstrate that time literally is money These calculations demonstrate that time literally is -money – theofvalue These calculations demonstrate that time literally is money value the money you h now is not the same as will be in you the future and vice versa. So, it as is the important of itthe money have now is not the same it will be to in know the how to cal now not the same it will bethat in the future and vice versa. So, itthe is important to know howthat to calcu theistime value of as money you can So, distinguish between of calculate investments offe futureso and vice versa. it is important to knowworth how to thereturns time value of money so that you can distinguish between the worth of investments that offer at different times. the time value of money so that you can distinguish between the returns at What different times. Are Annuities? worth of investments that offer you returns at different times. What AreWhat Annuities? Annuities are Are essentially series of fixed payments required from you or paid to you at a spe Annuities? Annuities are course essentially series fixed from youpayment orfrom paid you to you at a speci frequency over Annuities the of aessentially fixed of period ofpayments time. Therequired most common frequencies are y are series of fixed payments required frequency over the course of a fixed period of time. The most common payment frequencies area ye (once a year), semi-annually quarterly (four over timesthe a year) m or paid to(twice you ata ayear), specified frequency courseand of amonthly fixed (once (once a are year), (twice year), quarterly (four times a year) andare monthly There twosemi-annually basic types annuities: ordinary annuities and annuities due: periodofof time.aThe most common payment frequencies yearly (once a mon There are two basic types of annuities: ordinary and annuities due: (four (once a year),are semi-annually a year), quarterly times  Ordinary Annuity: Payments requiredannuities at (twice the end of each period. For example, straight  Ordinary Annuity: Payments are required at the end of each period. For example, straight a year) and monthly (once a month). There are two basic types of usually pay coupon payments at the end of every six months until the bond's maturity date. bo usually payDue: coupon payments atrequired the end ofthe every sixannuities months until the bond's date. of an annuities: annuities and due:period.  Annuity Payments areordinary at beginning of each Rentmaturity is an example  Annuity Due: Payments are required at the beginning of each period. Rent is an example ann • Ordinary Annuity: Payments are required at the end of each due. You are usually required to pay rent when you first move in at the beginning of theofmonth due. You are usually required to pay rent when you first move in at the beginning of the month, period. For example, straight bonds usually pay coupon payments then on the first of each month thereafter. the of every sixcalculations months until for the bond’s maturity date.and annuities du then on the first eachatmonth thereafter. Since the of present andend future value ordinary annuities Since the present calculations for value ordinary annuities annuities due slightly different, we will and first future discussvalue the present and future calculation forand ordinary annuities. slightly different, we will first discuss the present and future value calculation for ordinary annuities. 2.3. Calculating the Future Value of an Ordinary Annuity 2.3. Calculating the Future Value of an Ordinary Annuity If you know how much you can invest per period for a certain time period, the future value

18

CHAPTER 2. Time value of money

• Annuity Due: Payments are required at the beginning of each period. Rent is an example of annuity due. You are usually required to pay rent when you first move in at the beginning of the month, and then on the first of each month thereafter. Since the present and future value calculations for ordinary an­nuities and annuities due are slightly different, we will first discuss the present and future value calculation for ordinary annuities.

2.3. Calculating the Future Value of an Ordinary Annuity If you know how much you can invest per period for a certain time period, the future value of an ordinary annuity formula is useful for finding out how much you would have in the future by investing at your given interest rate. If you are making payments on a loan, the future value is useful for determining the total cost of the loan. Let’s now run through Example 1. Consider the following annuity cash flow schedule:

In order to calculate the future value of the annuity, we have to calculate the future value of each cash flow. Let’s assume that you are receiving $1,000 every year for the next five years, and you invested each payment at 5%. The following diagram shows how much you would have at the end of the five-year period:

2.4. Calculating the Present Value of an Ordinary Annuity

19

Since we have to add the future value of each payment, you may have noticed that, if you have an ordinary annuity with many cash flows, it would long time calculate all the future values and then that, if you Since we have to addtake theafuture valuetoof each payment, you may have noticed add them together. Fortunately, mathematics provides a formula ordinary annuity with many cash flows, it would take a long time to calculate all the future val Since we to add future of each have noticed if thathave serves as athe short cut value for finding thepayment, value ofasall then add them together. Fortunately, mathematics provides aaccumulated formulayou thatmay serves a short that, cut for ordinary annuity with many cash flows, it would take a long time to calculate all the future cash flows received from an ordinary annuity: the accumulated value of all cash flows received from an ordinary annuity: then add them together. Fortunately, mathematics provides a formula that serves as a short cu the accumulated value of all cash flows received from an(1ordinary + �)� −annuity: 1 � ���������� ������� = � ∗ � � (1 + �)� − 1 � ���������� ������� = � ∗ � � C = Cash flow per period C = Cash flow per period i = interest rate i = interest rate C = Cashofflow per period n = number payments n = number of payments i = interest rate n = number of payments If we If were use to theuse above for Example 1 above,1this is thethis result: wetowere the formula above formula for Example above, is the

result: � is the result: If we were to use the above formula for Example(1 1 above, + 0.05)this −1 � ���������� ������� = $1000 ∗ � (10.05 + 0.05)� − 1 = $1000 ∗ �5.53 � = $1000 ∗ � ���������� ������� 0.05 = $����. �� = $1000 ∗ �5.53� = $����. �� Note that the one cent difference between $5,525.64 and $5,525.63 is due to a rounding the first calculation. Each of the values of the first calculation must be rounded to the nearest pen Note thatthe thenumbers onecent centdifference between $5,525.64 and $5,525.63 Note one between and $5,525.63 is isduewill to aoccur. round more you have tothat round indifference a calculation the$5,525.64 more likely rounding errors due to a rounding error in the first calculation. Each of the values of the first calculation. Each of the values of the first calculation must be rounded to the nearest above formula not only provides a short-cut to finding FV of an ordinary annuity but also gives calculation rounded to the the nearest pennyrounding - the moreerrors will oc moreresult. you havethe to first round numbersmust in abecalculation more likely accurate you have to round numbers in a calculation the more likely rounding above formula not only provides a short-cut to finding FV of an ordinary annuity but also g errors will occur. So, the above formula not only provides a short-cut accurate result. 2.4.FV Calculating the Present Value an Ordinary Annuity to finding of an ordinary annuity but alsoofgives a more accurate result.

2.4. Calculating the Present Value of an Ordinary Annuity

2.4. Calculating the Present Value of an Ordinary Annuity If you would like to determine today’s value of a series of future payments, you need to use the formula that calculates the present value of an ordinary annuity. This is the formula you would use as part of a bond pricing calculation. The PV of ordinary annuity calculates the present value of the coupon payments that you will receive in the future. For Example 2, we’ll use the same annuity cash flow schedule as we did in Example 1. To obtain the total discounted value, we need to take the present value of each future payment and, as we did in Example 1, add the cash flows together.

eExample totalExample discounted value, we toannuity take the present value of as each we did in 1, add cash together. For 2, the we'll useflows theneed same cash flow schedule wefuture did in payment Exampleand, 1. Toasobtain xample 1, add the cash flows together. al discounted value, we need to take the present value of each future payment and, as we did in le 1, add the cash flows together. 20

CHAPTER 2. Time value of money

Again, calculating and adding all these values will take a considerable amount of time, especially Again, calculating and adding thesethere values take a considerable time, we expect many future payments. Asallsuch, is will a mathematical shortcutamount we canofuse forespecially PV of Again, calculating andpayments. adding allAs these values will take a considerable amountweofcan time, especially if we expect many future such, there is a mathematical shortcut use for PV of dinary annuity. Again, calculating and adding all these values will take a con­siderable we expect many future payments. As such, there is a mathematical shortcut we can use for PV ordinary annuity. amount Again, calculating and adding all these values take a1many considerable amount ofAs time, especially of − (1future + �)� payments. of time, especially if will we expect � dinary annuity. 1− + PV �)� ofwe �� ∗we� can �������� ������� xpect many futuresuch, payments. As such, there is = a � mathematical shortcut can use for PV of there is a�� mathematical shortcut use(1for � ordinary �������� ������� = � ∗1 �− (1� + �)� � annuity. �� y annuity. � �������� ������� = � ∗ � 1per − period (1 + �)�� C = Cash flow � per period� ���������� ������� � ∗flow C =i = =Cash interest rate � C = Cash per period i =flow interest rate n = number of payments i = interest rate C = CashCflow per period n = number of payments = Cash flow per period i = interest rate numberrate of payments in==PV interest The formula provides us with of the in a few easy steps. Here is the calculation of the annuity n = number payments formula provides us nwith a few easy steps. Here is the calculation of the annuity = number presentedThe in the diagram for Example 2:the PVofinpayments The formula providesfor us Example with the 2: PV in a few easy steps. Here is the calculation of the annuity represented in the diagram Thediagram formulaforprovides us2:with the PV in a few easy steps. Here is the presented in the Example �� The formula provides us with in arepresented few easy steps. Here the (1 +is0.05) 1− calculation of the the PV annuity in the diagram for calculation Example 2: of the annuity �� ���������� ������� = $1000 ∗ � 1 − (1 + 0.05) � nted in the diagram for Example 2: ���������� ������� = $1000 ∗1 �− (1 0.05 +0.05 0.05)�� � � ���������� ������� = $1000 ∗ � 0.05�� (1 1 − + 0.05) � = $1000 � ���������� ������� = $1000 ∗ ∗� �∗4.33 �4.33 � = $1000 0.05 = $1000 ∗ �4.33� = $4329.48 = $4329.48 = $1000 ∗ �4.33� = $4329.48 Calculating the Future Value of an Annuity Calculating the Future Value of=an$4329.48 Annuity Due Due Calculating the Future Value of an Annuity Due Whenthe youFuture are receiving oran paying cashDue flows for an annuity due, your Calculating Value of Annuity When you are receiving or paying cash flows for an annuity due, your cash flow schedule would cash flow schedule would appear as Whenthe youFuture are receiving oran paying cashDue flows follows: for an annuity due, your cash flow schedule would Calculating Value of Annuity pear as follows: you are receiving or paying cash flows for an annuity due, your cash flow schedule would appearWhen as follows: pear as you follows: When are receiving or paying cash flows for an annuity due, your cash flow schedule would

as follows:

2.5. Calculating the Present Value of an Annuity Due

21

Since each payment in the series isone made one period sooner, we Since each payment inseries the series is made period sooner, we need to need discount the form Since each payment in the is made one period sooner, we need to discount the fo Since each payment series is made one period sooner, we need discount formula Since each payment in in thethe is series made one period sooner, we need to to discount thethe formula o to discount the formula one period back. A slight modification period back. A slight modification to the FV-of-an-ordinary-annuity formula accounts for pa period back. A slight modification to the FV-of-an-ordinary-annuity formula accounts for period back. A slight modification to the FV-of-an-ordinary-annuity formula accounts for paym period back. A slight modification to the FV-of-an-ordinary-annuity formula accounts for paymen to the FV-of-an-ordinary-annuity formula accounts for payments occurring atbeginning the beginning of of each period. In In Example 3, illustrate let's illustrate why this modification is occurring at the beginning each period. Example 3,illustrate let's illustrate why this modification occurring beginning each period. In Example let's why this modification ne occurring at at thethe of of each period. In Example 3, 3, let's why this modification is is need occurring at the beginning of each period. In Example 3, let’s il­ when each $1,000 payment is made atbeginning the beginning ofperiod the period rather than the end (interest when each $1,000 payment is made at the beginning of the period rather than the end (interest when each $1,000 payment made at the beginning of the period rather than the end (interest rate is when each $1,000 payment is is made themodification of rather the end (interest rate israte st lustrate whyatthis is the needed when eachthan $1,000 payment 5%): 5%): 5%): 5%): is made at the beginning of the period rather than the end (interest rate is still 5%):

Notice that when payments are made at the beginning of the period, each Notice that when payments are made atbeginning the beginning the period, each amount is hfi Notice that when payments are atbeginning the beginning of the period, each amount Notice thatwhen when payments made at oftheof theperiod, period, each amount held Notice that payments areare made atmade thethe each amount is isheld amount is held for longer at the end of theofperiod. For example, if longer at the end of the period. For example, if the $1,000 was invested on January 1st rath longer at the end of the period. For example, if the $1,000 was invested on January 1st longerat atthetheend endof ofthethe period.For Forexample, example, ifthethe$1,000 $1,000 was invested January ratherthr longer if January was invested ononJanuary theperiod. $1,000 was invested on 1st rather than December 31st of 1st1strather December 31st of year, each year, the last payment before we value our investment atend the end ofyears five ye December 31st of each year, the last payment before we our investment at the end ofyears five December 31st of each year, the last payment before we value our investment end of five each year, the last payment before we value our investment at the end December 31st of each the last payment before we value ourvalue investment at at thethe of five ( December 31st) would have been made a year prior (January 1st) rather than the same day on wh December 31st) would have been made a year prior (January 1st) rather than the same day on December 31st) would have been made a year prior (January 1st) rather than the same day on which of five years (on aDecember would1st) have been than madethe a year December 31st) would have been made year prior31st) (January rather sameprior day on which it valued. valued. valued. (January 1st) rather than the same day on which it is valued. valued. The future value of annuity formula would then read: The future of formula annuity formula would then read: The future value of annuity would then read: The future value offormula annuity formula would then read: The future value of value annuity would then read: � � ��) (1 +− (1 + �) (1 + − 1− 1− 1 ��) (1 + �) 1 � �� = � ∗ ∗ �+ (1 + �) � �� = � ∗ (1 + �) � �� = � ∗ ∗ �(1 ������� ��� ������� ��� ������� ��� � �∗� (1 ��������� ��� = � ∗ � + �)∗�) � � �

Therefore, Therefore, Therefore, Therefore, Therefore,

� � �0.05) (10.05) (1 + 0.05) +− (1 + − 1− 1− 1 � (1 + 0.05) 1 (1 (1 � = $1000 ∗ ∗ �+ + 0.05) �� � = $1000 ∗ ∗0.05) + 0.05) �� � = $1000 ∗ �� ∗ �(1 ������� ��� ������� ��� ������� ��� � ∗� (1 + 0.05) ��������� ��� = $1000 ∗ � 0.05 0.05 0.05 0.05 = $1000 ∗ ∗5.53 ∗ 1.05 =∗$1000 ∗1.05 ∗ 1.05 $1000 ∗ 5.53 ∗5.53 1.05 == $1000 5.53 = $5801.91 = $5801.91 = $5801.91 = $5801.91

2.5. Calculating the Present Value of an Annuity 2.5. Calculating the Present of an Annuity Due 2.5. Calculating Present Value of Annuity DueDue 2.5. Calculating thethe Present Value ofValue anan Annuity Due

2.5. Calculating the Present Value of an Annuity Due For the present value an annuity due formula, we need to to discount the formula one For the present of an annuity due formula, we need discount the formula For the present value ofanof anannuity annuity dueformula, formula, need discount formula oneperi peo For the present value ofvalue due weweneed to to discount thetheformula one forward as the payments are held for a lesser amount of time. When calculating the present va forward as the payments are held for a lesser amount of time. When calculating the present forward as the payments are held for a lesser amount of time. When calculating the present value forward as the payments are held for a lesser amount of time. When calculating the present value, w assume that the first payment was made assume that the first payment was today.due formula, we need to discount the assume that the first payment was made today. For the present value ofmade an today. annuity assume that the first payment was made today. We could use this formula for calculating the present value of your future rent paym We could use this formula for calculating the present of your future rent pa We could use this formula for calculating present value ofyour your rentpayments payment formula one period forward asthe the payments are held for afuture lesser We could use this formula for calculating the present value ofvalue future rent specified in a lease you sign with your landlord. Let's say for Example 4 that you make your fi specified in a lease you sign with your landlord. Let's say for Example 4 that you make you amount of time. When calculating the present value, we assume specified a lease you sign with your landlord. Let's Example 4 that you make your first specified in in a lease you sign with your landlord. Let's saysay forfor Example 4 that you make your first re payment at the beginning of the month and are evaluating the present value of your five-month payment at the beginning of the month and are evaluating the present value of your five-mont that the first payment was made today. payment beginning month and evaluating present value your five-month leasl payment at at thethe beginning of of thethe month and areare evaluating thethe present value of of your five-month lease that same day. Your present value calculation would work as follows: that same day. Your present value calculation would work as follows: that same day. Your present value calculation would work follows: that same day. Your present value calculation would work as as follows:

22

CHAPTER 2. Time value of money

We could use this formula for calculating the present value of your future rent payments as specified in a lease you sign with your landlord. Let’s say for Example 4 that you make your first rent payment at the beginning of the month and are evaluating the present value of your five-month lease on that same day. Your present value calculation would work as follows:

Of course, we can use a formula shortcut to calculate the present value ofOf ancourse, annuity due: Of course, we can we use a formula shortcutshortcut to calculate the present value ofvalue an annuity due: due: can use a formula to calculate the present of an annuity ଵିሺଵା୧ሻష౤ ଵିሺଵା୧ሻష౤

PVAnnuity = C Due * ቂ= C * ቂ ቃ * (1+i) PVDue ቃ * (1+i) Annuity ୧

Therefore, Therefore, Therefore,

୧

షఱ షఱ ଵିሺଵା଴Ǥ଴ହሻ ଵିሺଵା଴Ǥ଴ହሻ



ቂ PVAnnuityPV = $1000 *ቂ DueAnnuity Due =*$1000 ଴Ǥ଴ହ = $1000*4.33*1.05 = $1000*4.33*1.05 = $4545.95 = $4545.95

ቃ *(1+0.05) ቃ *(1+0.05)

଴Ǥ଴ହ

Recall that thethat present value ofvalue an ordinary annuity annuity returnedreturned a value aofvalue $4,329.48. The present Recall the present of an ordinary of $4,329.48. The pr Recall that the present value of an ordinary annuity returned a value of value ofvalue an ordinary annuity annuity is less than that of an due because the further back weback discount a of an ordinary is less than thatannuity of an annuity due because the further we disco The present value an ordinary annuity isflow less future payment, the lower its present value:ofeach payment or cash or ordinary annuity annuity occurs one future $4,329.48. payment, the lower its present value: each payment cashinthan flow in ordinary occurs of into an annuity period further into future. period that further future. due because the further back we discount a future payment, the lower its present value: each payment or cash flow in ordinary annuity occurs one period further future. 2.6. Interest rateinto rate 2.6. Interest

InterestInterest rate riskrate is the of changes in a bond's due to changes in prevailing interest interest rates. r riskrisk is the risk of changes in aprice bond's price due to changes in prevailing ChangesChanges in short-term versus interest interest rates can affect bonds inbonds different ways, which in short-term versus long-term rates canvarious affect various in different ways, w 2.6. Interest rate long-term we'll soon discuss. we'll soon discuss. Interestrisk, ratemeanwhile, risk is the risk of changes a bond’s Credit is the risk thatin the issuer of a due bond will notwill make interest int Credit risk, meanwhile, is the risk that theprice issuer ofto achanges bond notscheduled make scheduled in prevailing interest rates. Changes in short-term versus long-term and/or principal payments. The probability of a negative credit event or default affects a bond's price – the and/or principal payments. The probability of a negative credit event or default affects a bond's price interest rates can affect various bonds in different ways, which higher the riskthe of arisk negative credit event the higher interest rate investors will demand for higher of a negative creditoccurring, event occurring, the the higher the interest rate investors will deman soon assuming that we’ll risk.that assuming risk.discuss. NominalNominal interest interest rates refer to refer referstotorefers the rate of interest prior toprior taking into account. rates to the rate of interest to inflation taking inflation into acc Depending on its application, an inflation and riskand premium must bemust added the real interest rate in order Depending on its application, an inflation risk premium betoadded to the real interest rate in to obtaintothe nominal rate. rate. obtain the nominal

2.6. Interest rate

23

Credit risk, meanwhile, is the risk that the issuer of a bond will not make scheduled interest and/or principal payments. The proba­bility of a negative credit event or default affects a bond’s price – the higher the risk of a negative credit event occurring, the higher the interest rate investors will demand for assuming that risk. Nominal interest rates refer to refers to the rate of interest prior to taking inflation into account. Depending on its application, an inflation and risk premium must be added to the real interest rate in order to obtain the nominal rate. Nominal Interest Rate = Real Interest Rate + Inflation Premium + Risk Premium In practice, the inflation premium is often assumed to be the expected inflation rate and the risk premium is ignored. Unless the economy is experiencing a deflationary period, the nominal rate  will be higher than the real rate. Compound Interest Interest that accrues on the initial principal and the accumulated interest of a principal deposit, loan or debt. Compounding of interest allows a principal amount to grow at a faster rate than simple interest, which is calculated as a percentage of only the principal amount. Annual Percentage Rate - APR The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents the actual yearly cost of funds  over the term of a loan. Loans or credit agreements can vary in terms of interest-rate structure, transaction fees, late penalties and other factors. A standardized computation such as the APR provides borrowers with a bottom-line number they can easily compare to rates charged by other potential lenders. Opportunity Cost 1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action. 2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6%-2%). Discounted Cash Flow – DCF A valuation  method used to estimate the attractiveness of an in­ vestment opportunity. Discounted cash flow (DCF) analysis uses fu­ture free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis  is higher than the current cost of the in­vestment, the opportunity may be a good one.  

your opportunity costs 4% (6% - 2%). invest in a stock and it are returns a paltry 2% over the year. In placing your money in t Discounted Cash Flow DCF the opportunity of another investment - say, a risk-free government bond yielding A valuation method estimate the attractiveness of an investment op your opportunity costs are 4%used (6%to- 2%). cash flow (DCF) analysis uses future Discounted Cash Flow - DCFfree cash flow projections and discounts them weighted cost of capital) to estimate arrive at the a present value, which is used to eva A average valuation method used to attractiveness of an investment op CHAPTER 2. Time value of money 24 investment. If theanalysis value arrived at through DCFflow analysis is higher than the current cash flow (DCF) uses future free cash projections and discounts themc the opportunity may beof a good one.to arrive at a present value, which is used to eva weighted average cost capital) Calculated as: investment. Calculated as: If the value arrived at through DCF analysis is higher than the current c the opportunity may good one. CF� CF� be a CF � DFC = � + ������ + …+ ������ Calculated as: ����� CF

CF

CF

� � � DFC + + …+ CF = =CashFlow ������ ������ ������

CF CashFlow R ==discount rate (WACC)

Lump-Sum Payment R Lump-Sum = discountPayment rate (WACC) A one-time payment forAthe total orpayment partial value of an asset. A lumpone-time for the total or partial value of an asset. A lump-sum sum payment in lieu of recurring payments that be received over a period o takenis inusually lieu oftaken recurring payments that would otherwise Lump-Sum Payment would otherwise be a period ofthe time. value a payments lump-sum paymentover is generally than the ofofall that the wo A received one-time payment forless totalThe or sum partial value of an asset. A party lump-sum lump-sumtaken payment is generally less than the sum of all payments since in thelieu party paying the lump-sum is beingbeasked to provide more of of recurring payments that payment would otherwise received over a period that the party would would otherwise since otherwise have been required to.party lump-sum payment isreceive, generally lessthe than the paying sum of the all payments that the party wou lump-sumsince payment is being asked the provide more funds upisfront Value -toTV theTerminal party paying lump-sum payment being asked to provide more fu than it otherwise would have been required to. The valuehave of an investment otherwise would been required at to.the end of a period, taking into account a spe Terminal Value The – TVformula to calculate terminal is the same as that for compound interest: Terminal Value - TV The value of an investment at the end of a period, taking into account a The value of an investment at the end of a period, taking into account a spe specified rate of interest. The formula to calculate terminal is the t The formula to calculate TV=P*(1+r) same as that for compound interest:terminal is the same as that for compound interest:

TV=P*(1+r)t Where: TV = the total amount, P = the principal amount, r = interest rate, t = period of time Market Value Added (MVA) – the difference between the market value of a firm and the capital contributed by investors. A higher MVA indicates that a company has added more value than what has been contributed to it by shareholders, while a negative MVA in­dicates that the company has destroyed value. Economic Value Added (EVA). The monetary value of an entity at the end of an time period minus the monetary value of that same entity at the beginning of that time period. Earnings per Share (EPS). Total earnings divided by the number of shares outstanding. Companies often use a weighted average of shares outstanding over the reporting term. EPS can be calculated for the previous year («trailing EPS»), for the current year («current EPS»), or for the coming year («forward EPS»). Note that last year’s EPS would be actual, while current year and forward year EPS would be estimates. Dividend per share (DPS). The amount of dividend that a stock­holder will receive for each share of stock held. It can be calculated by taking the total amount of dividends paid and dividing it by the total shares outstanding. If a company issues a $1 million dividend and has 10 million shares, the dividend per share is 10 cents ($1 million divided by 10 million shares).

2.6. Interest rate

25

Sales per share (SPS). Annual revenue of an organization divided by the average shares outstanding for that fiscal year. A ratio which measure how much each share earned per year. A high ratio indicates an active company that has successfully used its resources to produce sales. Earnings Before Interest and Taxes (EBIT). A measure of a com­pany’s earning power from ongoing operations, equal to earnings before deduction of interest payments and income taxes. EBIT ex­cludes income and expenditure from unusual, non-recurring or dis­con­ tinued activities. In the case of a company with minimal depre­ ciation and amortization activities, EBIT is watched closely by cre­ ditors, since it represents the amount of cash that such a company will be able to use to pay off creditors, also called operating profit. Earnings before taxes (EBT). An adjusted calculation of earnings, and a measure of the company’s performance, equivalent to earnings (revenue minus expenses) before the deduction of income taxes. also called profit before tax. Net income (NI). What remains after subtracting all the costs (namely, business, depreciation, interest, and taxes) from a company’s revenues. Net income is sometimes called the bottom line. also called earnings or net profit. Return on Equity (ROE). A measure of how well a company used reinvested earnings to generate additional earnings, equal to a fiscal year’s after-tax income (after preferred stock dividends but before common stock dividends) divided by book value, expressed as a percentage. It is used as a general indication of the company’s efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. investors usually look for companies with returns on equity that are high and growing. Return on Assets (ROA). A measure of a company’s profitability, equal to a fiscal year’s earnings divided by its total assets, expressed as a percentage. Return on Investment (ROI). A measure of a corporation’s pro­fitability, equal to a fiscal year’s income divided by common stock and preferred stock equity plus long-term debt. ROI measures how effectively the firm uses its capital to generate profit; the higher the ROI, the better. Questions for self-control: 1. Give the definitions of assets, liabilities, capital, income, ex­pen­­ditures? 2. Money value. 3. Effective annual rate.

26

FINANCIAL MATEMATICS

Chapter

3

Risk and return. Investment returns. benefits of diversifying overseas

3.1.  Return on an investment The earning power of assets measured as the ratio of the net income (profit less depreciation) to the average capital employed (or equity capital) in a company or project. Expressed usually as a percentage, return on investment is a measure of profitability that indicates whether or not a company is using its resources in an efficient manner. For example, if the long-term return on investment of a company is lower than its cost-of-capital, then the company will be better off by liquidating its assets and depositing the proceeds in a bank. Also called rate of return, or yield. ROI = (Annual Net Cash Flow ÷ Capital Cost) x 100% ROI must always be higher than cost of money (interest rate). Ratio on Equity Ratio measuring stockholders’ (shareholders’) profitability, expres­sed as a percentage of the firm’s net worth. ROE indicates a firm’s efficiency in applying common-stockholders’ (ordinary-shareholders’) money. ROE is expressed as a percentage and calculated as:

Return on Equity = Net Income / Shareholder’s Equity

Return on Assets Ratio measuring the operating profitability of a (non-financial) firm, 26

3.1. Return on an investment

27

expressed as a percentage of the operating assets. ROA indicates a firm’s ability to efficiently allocate and manage its resources but (unlike ‘return on equity’) ignores the firm’s liabilities. Also called return on total investment (ROTI). Formula: Return on Assets = (Operating income x 100) ÷ Operating assets. Sensitivity and Risk Analysis Many of the cash flows in the project are based on assumptions that have an element of uncertainty. The present day cash flows, such as capital cost, energy cost savings, maintenance costs, and etc. can usually be estimated fairly accurately. Even though these costs can be predicted with some certainty, it should always be remembered that they are only estimates. Cash flows in future years normally contain inflation components which are often «guess-timates» at best. The project life itself is an estimate that can vary significantly. Sensitivity analysis is an assessment of risk. Because of the un­certainty in assigning values to the analysis, it is recommended that a sensitivity analysis be carried out - particularly on projects where the feasibility is marginal. How sensitive is the project’s feasibility to changes in the input parameters? What if one or more of the factors in the analysis is not as favorable as predicted? How much would it have to vary before the project becomes unviable? What is the probability of this happening? Suppose, for example, that a feasible project is based on an energy cost saving that escalates at 10% per year, but a sensitivity analysis shows the break-even is at 9% (i.e. the project becomes unviable if the inflation of energy cost falls below 9%). There is a high degree of risk associated with this project – much greater than if the break-even value was at 2%. Many of the computer spreadsheet programs have built-in “what if” functions that make sensitivity analysis easy. If carried out ma­n ually, the sensitivity analysis can become laboriousreworking the analysis many times with various changes in the parameters. Sensitivity analysis is undertaken to identify those parameters that are both uncertain and for which the project decision, taken through the NPV or IRR, is sensitive. Switching values showing the change in a variable required for the project decision to change from ac­cep­ tance to rejection are presented for key variables and can be compa­ red with post evaluation results for similar projects. For large pro­ jects and those close to the cut-off rate, a quantitative risk analysis incorporating different ranges for key variables and the likelihood of their occurring simultaneously is recommended. Sensitivity and risk analysis should lead to improved project design, with actions mitiga­ting against major sources of uncertainty being outlined. The various micro and macro factors that are considered for the sensitivity ana­lysis are listed below.

28

CHAPTER 3. Risk and return. Investment returns. benefits of diversifying overseas

Micro factors • Operating expenses (various expenses items); • Capital structure; • Costs of debt, equity; • Changing of the forms of finance e.g. leasing; • Changing the project duration. Macro factors Macro economic variables are the variable that affects the operation of the industry of which the firm operates. They cannot be changed by the firm’s management. Macro economic variables, which affect projects, include among others: • Changes in interest rates; • Changes in the tax rates; • Changes in the accounting standards e.g. methods of calculating depreciation; • Changes in depreciation rates; • Extension of various government subsidized projects e.g. rural electrification; • General employment trends e.g. if the government changes the salary scales; • Imposition of regulations on environmental and safety issues in the industry; • Energy Price change; • Technology changes. The sensitivity analysis will bring changes in various items in the analysis of financial statements or the projects, which in turn might lead to different conclusions regarding the implementation of projects. Diversification 1. Banking: Spreading a bank’s assets (loans) over a wider as­sortment of quality borrowers, to maintain or improve earning levels while maintaining the same level of exposure. 2. Corporate strategy (Also called market diversification.): Practice under which a firm enters an industry or market different from its core business. Reasons for diversification include (1) reducing risk of relying on only one or few income sources, (2) avoiding cyclical or seasonal fluctuations by producing goods or services with different demand cycles, (3) achieving a higher growth rate, and (4) countering a competitor by invading the competitor’s core industry or market. In contrast to vertical integration, diversification does not increase a firm’s market or monopolistic power. 3. Investing: Spreading the available funds over a wider selection (portfolio) of types of investment, such as commodities, real estate, securities. Beta Coefficient Measure of the securities-market risk (‘systemic risk’), it is an indicator of the volatility of a stock (or a portfolio of stocks) relative to a benchmark, such as Standards & Poor’s 500 composite index (S&P 500), which

3.1. Return on an investment

29

is given a beta value of 1.00. Every listed stock is assigned a beta value (based on movements in its price) in ‘beta tables’ published by Standard & Poor’s and Morgan Stanley investment Corp. A betavalue of 1.0 means the stock has moved up and down roughly in step with S&P 500; a beta value of 1.25 means that the stock is expected to do 25 percent better than the S&P 500 in an up market and 25 percent worse in a down market. Conservative investors usually prefer stocks with low beta, whereas those looking for high risk-reward ratios choose high beta stocks. Questions for self-control: 1. How is market risk measured for individual securities? 2. What are the beta coefficients? 3. Deversified portfolio.

30

CHAPTER 4. Derivatives and risk management

Chapter

4

Derivatives and risk management

4.1.  Calculation of simple interest Risk is a product of the uncertainty of future events and is a part of all activity. It is a fact of life. We tend to stay away from those things that involve high risk to things we hold dear. When we cannot avoid risk, we look for ways to reduce the risk or the impact of the risk upon our lives. But even with careful planning and preparation, risks cannot be completely eliminated because they cannot all be identified beforehand. Even so, risk is essential to progress. The opportunity to succeed also carries the opportunity to fail. It is necessary to learn to balance the possible negative consequences of risk with the potential benefits of its associated opportunity. Risk may be defined as the possibility to suffer damage or loss. The possibility is characterized by three factors: 1. The probability or likelihood that loss or damage will occur; 2. The expected time of occurrence; 3. The magnitude of the negative impact that can result from its occurrence. The seriousness of a risk can be determined by multiplying the probability of the event actually occurring by the potential negative impact to the cost, schedule, or performance of the project: Risk Severity = Probability of Occurrence x Potential Nega­tive Impact Thus, risks where probability is high and potential impact is very low, or vice versa, are not considered as serious as risks where both probability and potential impact are medium to high. Project managers recognize and accept the fact that risk is inherent in any project. They also recognize that there are two ways of dealing 30

4.1. Calculation of simple interest

31

with risk. One, risk management, is proactive and carefully analyzes future project events and past projects to identify potential risks. Once risks are identified, they are dealt with by taking measures to reduce their probability or reduce the impact associated with them. The alternative to risk management is crises management. It is a reactive and resource-intensive process, with available options constrained or restricted by events. Effective risk management requires establishing and following a rigorous process. It involves the entire project team, as well as requiring help from outside experts in critical risk areas (e.g., technology, manufacturing, logistics, etc.) Because risks will be found in all areas of the project and will often be interrelated, risk management should include hardware, software, integration issues, and the human element. Process Description Various paradigms are used by different organizations to organize their risk manage management activities. While there are variations in the different paradigms, certain cha­racteristics are universally required for the program to be successful. These are listed below: • The risk management process is planned and structured; • The risk process is integrated with the acquisition process; • Developers, users, procurers, and all other stakeholders work together closely to implement the risk process; • Risk management is an ongoing process, with continual moni­ toring and reassessment; • A set of success criteria is defined for all cost, schedule, and per­formance elements of the project; • Metrics are defined and used to monitor effectiveness of risk ma­nagement strategies; • An effective test and evaluation program is planned and fol­ lowed; • All aspects of the risk management program are formally do­ cumented; • Communication and feedback are an integral part of all risk management activities. Risk management approach should be tailored to the needs of the project; it should incorporate these fundamental characteristics. Note that while planning appears as the first step, there is a feedback loop from the monitoring activity that allows planning and the other activities to be redone or controlled by actual results, providing continual updates to the risk management strategy. In essence, the process of risk management is a standard approach to problem solving: 1. Plan or define the problem solving process. 2. Define the problem. 3. Work out solutions for those problems. 4. Track the progress and success of the solutions.

32

CHAPTER 4. Derivatives and risk management

Planning Risk planning includes developing and documenting a structured, proactive, and comprehensive strategy to deal with risk. Key to this activity is the establishment of methods and procedures to do the following: • Establishing an organization to take part in the risk manage­ ment process; • Identify and analyze risks; • Develop risk-handling plans; • Monitoring or tracking risk areas; • Assigning resources to deal with risks. Assessment Risk assessment involves two primary activities, risk identifica­tion and risk analysis. Risk identification is actually begun early in the planning phase and continues throughout the life of the project. The following methods are often used to identify possible risks: • Brainstorming; • Evaluations or inputs from project stakeholders; • Periodic reviews of project data; • Questionnaires based on taxonomy, the classification of pro­ duct areas and disciplines; • Interviews based on taxonomy; • Analysis of the Work Breakdown Structure (WBS); • Analysis of historical data. When identifying a risk it is essential to do so in a clear and concise statement. It should include three components: 1. Condition – A sentence or phrase briefly describing the situa­ tion or circumstances that may have caused concern, anxiety, or uncertainty. 2. Consequence – A sentence describing the key negative outco­ mes that may result from the condition. 3. Context – Additional information about the risk to ensure others can understand its nature, especially after the passage of time. The other half of assessment is risk analysis. This is the process of examining each risk to refine the risk description, isolate the cause, quantify the probability of occurrence, and determine the nature and impact of possible effects. The result of this process is a list of risks rated and prioritized according to their probability of occurrence, severity of impact, and relationship to other risk areas. Once risks have been defined, with probability of occurrence and consequences assigned, the risk can be rated as to its severity. This facilitates prioritizing risks and deciding what level of resources to devote to the risk. Handling Risk handling is the process that identifies, evaluates, selects, and implements options for mitigating risks. Two approaches are used in handling risk. The first is to employ options that reduce the risk itself. This usually

4.1. Calculation of simple interest

33

involves a change in current conditions to lessen the pro­bability of occurrence. The second approach, often employed where risk probability is high, is to use options that reduce the negative impact to the project if the risk condition should occur. Improving jet engine maintenance and inspection procedures to reduce the risk of inflight engine failure is an example of the first approach. Providing a parachute for the pilot, to reduce loss if the risk condition should occur, is an example of the second. Monitoring Risk monitoring is the process of continually tracking risks and the effectiveness of risk handling options to ensure risk conditions do not get out of control. This is done by knowing the baseline risk management plans, understanding the risks and risk handling op­ tions, establishing meaningful metrics, and evaluating project perfor­ mance against the established metrics, plans, and expected results throughout the acquisition process. Continual monitoring also enab­ les the identification of new risks that may become apparent over time. It also discovers the interrelationships between various risks. The monitoring process provides feedback into all other activities to improve the ongoing, iterative risk management process for the current and future projects. Documentation Risk documentation is absolutely essential for the current, as well as future, projects. It consists of recording, maintaining, and reporting risk management plans, assessments, and handling information. It also includes recording the results of risk management activities, providing a knowledge base for better risk management in later stages of the project and in other projects. Documentation should include as a minimum the following information: • Risk management plans; • Project metrics to be used for risk management; • Identified risks and their descriptions; • The probability, severity of impact, and prioritization of all known risks; • Description of risk handling options selected for implementa­ tion; • Project performance assessment results, including deviations from the baseline plans; • A record of all changes to the above documentation, including newly identified risks, plan changes, etc. Financial derivatives Financial derivatives are a kind of risk management instrument. A derivative’s value depends on the price changes in some more fun­ damental underlying assets. Many forms of financial derivatives instruments exist in the fi­nancial markets. Among them, the three most fundamental financial derivatives instruments are: forward contracts, futures, and options. If the underlying assets are stocks, bonds, foreign exchange rates

34

CHAPTER 4. Derivatives and risk management

and commodities etc., then the corresponding risk management instru­ments are: stock futures (options), bond futures (options), currency futures (options) and commodity futures (options) etc. In risk management of the underlying assets using financial derivatives, the basic strategy is hedging, i.e., the trader holds two positions of equal amounts but opposite directions, one in the underlying markets, and the other in the derivatives markets, simultaneously. This risk management strategy is based on the following reasoning: it is believed that under normal circumstances, prices of underlying assets and their derivatives change roughly in the same direction with basically the same magnitude; hence losses in the underlying assets (derivatives) markets can be offset by gains in the derivatives (underlying assets) markets; therefore losses can be prevented or reduced by combining the risks due to the price changes. The subject of this activity is pricing of financial derivatives and risk management by hedging. Forward Contracts and Futures Forward contract – an agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price. A forward contract is an agreement to replace a risk with a certainty. The buyer in the contract is said to hold a long position, and the seller is said to hold a short position. The specified price in the contract is called the delivery price and the specified time is called maturity. Future same as a forward contract, an agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price. Futures have evolved from standardization of forward contracts. Futures differ from forward contracts in the following respects: a. Futures are generally traded on an exchange. b. A future contract contains standardized articles. c. The delivery price on a future contract is generally determined on an exchange, and depends on the market demands. Options Options – an agreement that the holder can buy from, or sell to, the seller of the option at a specified future time a certain amount of an underlying asset at a specified price. But the holder is under no obligation to exercise the contract. The holder of an option has the right, but not the obligation, to carry out the agreement according to the terms specified in the agreement. In an options contract, the specified price is called the exercise price or strike price, the specified date is called the expiration date, and the action to perform the buying or selling of the asset according to the option contract is called exercise. According to buying or selling an asset, options have the fol­lowing types: • call option is a contract to buy at a specified future time a certain amount of an underlying asset at a specified price; • put option is a contract to sell at a specified future time a certain amount of an underlying asset at a specified price.

4.1. Calculation of simple interest

35

According to terms on exercise in the contract, options have the following types: • European options can be exercised only on the expiration date; • American options can be exercised on or prior to the expiration date. Types of Traders There are three types of derivatives traders in the security exchange markets: 1. Hedger Hedging: to invest on both sides to avoid loss. Most producers and trading companies enter the derivatives markets to shift or reduce the price risks in the underlying asset markets to secure anticipated profits. 2. Speculator Speculation: an action characterized by willing to risk with one’s money by frequently buying and selling derivatives (futures, options) for the prospect of gaining from the frequent price changes. A speculator assumes the price risk, hoping to gain risky profits by holding certain positions (long or short). Speculators are indispensable for the existence of hedging business, and they came into markets as a necessary result of the growth of the hedging business. It is speculators who take over the price risks shifted from the hedgers, and thus become the major bearers of the risks in the derivatives markets. Speculation is an indispensable lubricant in the derivatives markets. Indeed, frequent speculative transactions make hedging strategies workable. Comparing to investing in an underlying asset, investments in its options are characterized by high profits and high risk, since an investment in options markets provides a much higher level of leverage than an investment in the spot markets. Such an investor invests only a small amount of money (to pay the premium) but can speculate on assets valued dozens of times higher than that of the invested money. 3. Arbitrageur Arbitrage: based on observations of the same kind of risky assets, taking advantage of the price differences between markets, the arbitrageur trades simultaneously at different markets to gain riskless instant profits. Arbitrage is not the same as speculation: speculation is to seek profits promised by predictions of the future prices, and is thus risky. Arbitrage is to snatch profits originated in the reality of the price differences between markets, and is therefore riskless. An opportunity for arbitrage cannot last long. Since once an opportunity for arbitrage arises, the market prices will soon reach a new balance due to actions of the arbitrageurs and the opportunity will thus disappear. Therefore, all discussions are founded on the basis that arbitrage opportunity does not exist. Questions for self-control: 1. What are the three steps of corporate risk management? 2. Describe how commodity futures markets can be used to reduce input price risk? 3. Reasons to manage risk.

36

FINANCIAL MATEMATICS

Chapter

5

Assets valuation: key characteristics of bonds and stocks

5.1.  Key Characteristics of Bonds A bond is a promissory note issued by a business or a govern-mental unit. Treasury bonds, sometimes referred to as government bonds, are issued by the Federal government and are not exposed to default risk. Corporate bonds are issued by corporations and are exposed to default risk. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and on the terms of the specific bond. Municipal bonds are issued by state and local governments. The interest earned on most municipal bonds is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state. Foreign bonds are issued by foreign governments or foreign corporations. These bonds are not only exposed to default risk, but are also exposed to an additional risk if the bonds are deno­ minated in a currency other than that of the investor’s home currency. The par value is the nominal or face value of a stock or bond. The par value of a bond generally represents the amount of money that the firm borrows and promises to repay at some future date. The par value of a bond is often $1,000, but can be $5,000 or more. The maturity date is the date when the bond’s par value is repaid to the bondholder. Maturity dates generally range from 10 to 40 years from the time of issue. A call provision may be written into a bond contract, giving the issuer the right to redeem the bonds under specific conditions prior to the normal maturity date. A bond’s coupon, or coupon payment, is the dollar amount of interest paid to each bondholder on the interest payment dates. 36

5.1. Key Characteristics of Bonds

37

The coupon is so named because bonds used to have dated coupons attached to them which investors could tear off and redeem on the interest payment dates. The coupon interest rate is the stated rate of interest on a bond. In some cases, a bond’s coupon payment may vary over time. These bonds are called floating rate bonds. Floating rate debt is popular with investors because the market value of the debt is stabilized. It is advantageous to corporations because firms can issue long-term debt without committing themselves to paying a historically high interest rate for the entire life of the loan. Zero coupon bonds pay no coupons at all, but are offered at a substantial discount below their par values and hence provide capital appreciation rather than interest income. In general, any bond originally offered at a price significantly below its par value is called an original issue discount bond (OID). Most bonds contain a call provision, which gives the issuing cor­poration the right to call the bonds for redemption. The call provision generally states that if the bonds are called, the company must pay the bondholders an amount greater than the par value, a call premium. Redeemable bonds give investors the right to sell the bonds back to the corporation at a price that is usually close to the par value. If interest rates rise, investors can redeem the bonds and reinvest at the higher rates. A sinking fund provision facilitates the orderly retirement of a bond issue. This can be achieved in one of two ways: The Company can call in for redemption (at par value) a certain percentage of bonds each year. The company may buy the required amount of bonds on the open market. Convertible bonds are securities that are convertible into shares of common stock, at a fixed price, at the option of the bondholder. Bonds issued with warrants are similar to convertibles. Warrants are options which permit the holder to buy stock for a stated price, thereby providing capitals gain if the stock price rises. Income bonds pay interest only if the interest is earned. These securities cannot bankrupt a company, but from an investor’s standpoint they are riskier than «regular» bonds. The interest rate of an indexed, or purchasing power, bond is based on an inflation index such as the consumer price index (CPI), so the interest paid rises automatically when the inflation rate rises, thus protecting the bondholders against inflation. Bond prices and interest rates are inversely related; that is, they tend to move in the opposite direction from one another. A fixed rate bond will sell at par when its coupon interest rate is equal to the going rate of interest. When the going rate of interest is above the coupon rate, a fixed-rate bond will sell at a «discount» below its par value. If current interest rates are below the coupon rate, a fixed-rate bond will sell at a «premium» above its par value. The current yield on a bond is the annual coupon payment divided by the current market price. YTM, or yield to maturity, is the rate of interest earned on a bond if it is held to maturity. Yield to call (YTC) is the rate of

38

CHAPTER 5. Assets valuation: key characteristics of bonds and stocks

interest earned on a bond if it is called. If current interest rates are well below an outstanding callable bond’s coupon rate, the YTC may be a more relevant estimate of expected return than the YTM, since the bond is likely to be called. The shorter the maturity of the bond, the greater the risk of a decrease in interest rates. The risk of a decline in income due to a drop in interest rates is called reinvestment rate risk. Interest rates fluctuate over time, and people or firms who invest in bonds are exposed to risk from changing interest rates, or interest rate risk. The longer the maturity of the bond, the greater the exposure to interest rate risk. Interest rate risk relates to the value of the bonds in a portfolio, while reinvestment rate risk relates to the income the portfolio produces. No fixed-rate bond can be considered totally riskless. Bond portfolio managers try to balance these two risks, but some risk always exists in any bond. Another important risk associated with bonds is default risk. If the issuer defaults, investors receive less than the promised return on the bond. Default risk is influenced by both the financial strength of the issuer and the terms of the bond contract, especially whether collateral has been pledged to secure the bond. The greater the default risk, the higher the bond’s yield to maturity. Corporations can influence the default risk of their bonds by changing the type of bonds they issue. Under a mortgage bond, the corporation pledges certain assets as security for the bond. All such bonds are written subject to an indenture, which is a legal document that spells out in detail the rights of both the bondholders and the corporation. A debenture is an unsecured bond, and as such, it provides no lien against specific property as security for the obligation. Debenture holders are, therefore, general creditors whose claims are protected by property not otherwise pledged. Subordinated debentures have claims on assets, in the event of bankruptcy, only after senior debt as named in the subordinated debt’s indenture has been paid off. Subordinated debentures may be subordinated to designated notes payable or to all other debt. A development bond is a tax-exempt bond sold by state and local governments whose proceeds are made available to corporations for specific uses deemed (by Congress in US) to be in the public interest. Municipalities can insure their bonds, in which an insurance company guarantees to pay the coupon and principal payments should the issuer default. This reduces the risk to investors who are willing to accept a lower coupon rate for an insured bond issue vis-a-vis an uninsured issue. Bond issues are normally assigned quality ratings by major rating agencies, such as Moody’s Investors Service and Standard & Poor’s Corporation. These ratings reflect the probability that a bond will go into default. Aaa (Moody’s) and AAA (S&P) are the highest ratings. Rating assignments are based on qualitative and quantitative factors including the firm’s debt/assets ratio, current

5.1. Key Characteristics of Bonds

39

ratio, and coverage ratios. Because a bond’s rating is an indicator of its default risk, the rating has a direct, measurable influence on the bond’s interest rate and the firm’s cost of debt capital. Junk bonds are high-risk, high-yield bonds issued to finance leveraged buyouts, mergers, or troubled companies. Most bonds are purchased by institutional investors rather than individuals, and many institutions are restricted to investment grade bonds, securities with ratings of Baa/BBB or above. Key Characteristics of Stocks: 1. Equity capital rose through sale of shares; 2. The proportional part of a company’s equity capital represented by fully paid up shares; 3. British term for (1) A fixed interest government debt security issued usually in denominations, and (2) Inventory. Stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall. In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, without any necessary notion of intrinsic value. These can be combined as «predictions of future cash flows/profits (fundamental)», together with «what will the market pay for these profits?» These can be seen as “supply and demand” sides – what underlies the supply (of stock), and what drives the (market) demand for stock? The most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposal. Stocks have two types of valuations. One is a value created using some type of cash flow, sales or fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for a particular share of stock and by how much other investors are willing to sell a stock for (in other words, by supply and demand). Both of these values change over time as investors change the way they analyze stocks and as they become more or less confident in the future of stocks. The fundamental valuation is the valuation that people use to justify stock prices. The most common example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio. This form of valuation is based on historic ratios and statistics and

40

CHAPTER 5. Assets valuation: key characteristics of bonds and stocks

aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices. The other way stocks are valued is based on supply and demand. The more people that want to buy the stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower the price will be. This form of valuation is very hard to understand or predict, and it often drives the short-term stock market trends. There are many different ways to value stocks. The key is to take each approach into account while formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other similar stocks, then the next step would be to determine the reasons. Earnings Per Share (EPS). EPS is the total net income of the company divided by the number of shares outstanding. They usually have a GAAP EPS number (which means that it is computed using all of mutually agreed upon accounting rules) and a Pro Forma EPS figure (which means that they have adjusted the income to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses). The most important thing to look for in the EPS figure is the overall quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In other words, have they consistently beaten expectations or are they constantly restating and lowering their forecasts? The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net income that excludes any one-time gains or losses and excludes any non-cash expenses like stock options or amortization of goodwill. Then divide this number by the number of fully diluted shares outstanding. Price to Earnings (P/E). Now that you have several EPS figures (historical and forecasts), you’ll be able to look at the most common valuation technique used by analysts, the price to earnings ratio, or P/E. To compute this figure, take the stock price and divide it by the annual EPS figure. For example, if the stock is trading at $10 and the EPS is $0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be sure to look at the historical and forward ratios. Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters, or for the previous year. You should also look at the historical trends of the P/E by viewing a chart of its historical P/E over the last several years. Specifically you want to find out what range the P/E has traded in so that you can determine if the current P/E is high or low versus its historical average. Forward P/Es reflect the future growth of the company into the figure. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for

5.1. Key Characteristics of Bonds

41

next calendar of fiscal year or two. P/Es change constantly. If there is a large price change in a stock you are watching, or if the earnings (EPS) estimates change, the ratio is recomputed. Growth Rate. Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company’s quarterly conference call or reading press release or other company article that discusses the company’s growth guidance. However, although companies are in the best position to forecast their own growth, they are far from accurate, and unforeseen events could cause rapid changes in the economy and in the company’s industry. And for any valuation technique, it’s important to look at a range of forecast values. For example, if the company being valued has been growing earnings between 5 and 10% each year for the last 5 years, but believes that it will grow 15-20% this year, a more conservative growth rate of 10-15% would be appropriate in valuations. Another example would be for a company that has been going through restructuring. They may have been growing earnings at 10-15% over the past several quarters / years because of cost cutting, but their sales growth could be only 0-5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore, forecasting an earnings growth closer to the 0-5% rate would be more appropriate rather than the 15-20%. Nonetheless, the growth rate method of valuations relies heavily on gut feel to make a forecast. This is why analysts often make inaccurate forecasts, and also why familiarity with a company is essential before making a forecast. Price Earnings to Growth (PEG) Ratio. This valuation technique has really become popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio, divide the Forward P/E by the expected earnings growth rate (you can also use historical P/E and historical growth rate to see where it’s traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more undervalued. The theory is based on a belief that P/E ratios should approximate the long-term growth rate of a company’s earnings. Whether or not this is true will never be proven and the theory is therefore just a rule of thumb to use in

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CHAPTER 5. Assets valuation: key characteristics of bonds and stocks

the overall valuation process. Here’s an example of how to use the PEG ratio. Say you are comparing two stocks that you are thinking about buying. Stock A is trading at a forward P/E of 15 and expected to grow at 20%. Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better purchase because it has a lower PEG ratio, or in other words, you can purchase its future earnings growth for a lower relative price than that of Stock B. Questions for self-control: 1. Give the key characteristics of Bonds and Stocks; 2. Normal and inverted yield curves; 3. Intrinsic value and market price.

Cost of Capital

Chapter

43

6

Cost of capital, Capital market theories. Investment projects analyses. Cost of company. Use of ratios

Cost of Capital Cost of Capital is the rate that must be earned in order to satisfy the required rate of return of the firm’s investors. It can also be defined as the rate of return on investments at which the price of a firm’s equity share will remain unchanged. Each type of capital used by the firm (debt, preference shares and equity) should be incorporated into the cost of capital, with the relative importance of a particular source being based on the percentage of the financing provided by each source of capital. Using of the cost a single source of capital as the hurdle rate is tempting to management, particularly when an investment is financed entirely by debt. However, doing so is a mistake in logic and can cause problems. Future Cost and Historical Cost Future cost of capital refers to the expected cost of funds to be raised to finance a project. In contrast, historical cost represents cost incurred in the past in acquiring funds. In financial decisions future cost of capital is relatively more relevant and significant. While evaluating viability of a project, the finance manager compares expected earnings from the project with expected cost of funds to finance the project. Likewise, in taking financing decisions, attempt of the finance manager is to minimize future cost of capital and not the costs already defrayed. This does not imply that historical cost is not relevant at all. 43

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CHAPTER 6. Cost of capital, Capital market theories. Investment projects analyses.

In fact, it may serve as a guideline in predicting future costs and in evaluating the past performance of the company. Component Cost and Composite Cost A company may contemplate to raise desired amount of funds by means of different sources including debentures, preferred stock, and common stocks. These sources constitute components of funds. Each of these components of funds involves cost to the company. Cost of each component of funds is designated as component or specific cost of capital. When these component costs are combined to determine the overall cost of capital, it is regarded as composite cost of capital, combined cost of capital or weighted cost of capital, The composite cost of capital, thus, represents the average of the costs of each sources of funds employed by the company. For capital budgeting decision, composite cost of capital is relatively more relevant even though the firm may finance one proposal with only one source of funds and another proposal with another source. This is for the fact that it is the overall mix of financing over time which is materially significant in valuing firm as an ongoing overall entity. Average Cost and Marginal Cost Average cast represents the weighted average of the costs of each source of funds employed by the enterprise, the weights being the relative share of each source of funds in the capital structure. Marginal cost of capital, by contrast refers to incremental cost associated with new funds raised by the firm. Average cost is the average of the component marginal costs, while the marginal cost is the specific concept used to comprise additional cost of raising new funds. In financial decisions the marginal cost concept is most significant. Explicit Cost and Implicit Cost Cost of capital can be either explicit cost or implicit. The explicit cost of any source of capital is the discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with the present value of its incremental cash outlay. Thus, the explicit cost of capital is the internal rate of return of the cash flows of financing opportunity. A series of each flows are associated with a method of financing. At the time of acquisition of capital, cash inflow occurs followed by the subsequent cash outflows in the form, of interest payment, repayment of principal money or payment of dividends. Thus, if a company issues 10 % perpetual debentures worth $ 1,000,000, there will be cash inflow to the firm of the order of 1,000,00. This will be followed by the annual cash outflow of $ 100,000. The rate of discount, that equates the present value of cash inflows with the present value of cash outflows, would be the explicit cost of capital. The technique of determination of the explicit cost of capital is similar to the one used to ascertain IRR, with one difference, in the case of computation of the IRR, the cash outflows occur at the beginning followed by subsequent cash inflows while in the computation

Cost of Capital

45

of the IRR, the cash outflows occur at the beginning followed by subsequent cash inflows, while in the computation of explicit cost of capital, cash inflow takes place at the beginning followed by a series of cash inflow subsequently. Similarly, explicit cost of retained earnings which involve no future flows to or from the firm is minus 100%. This should not tempt one to infer that the retained earnings are cost free. As we shall discuss in the subsequent paragraphs, retained earnings do cost the firm. The cost of retained earnings is the opportunity cost of earning on investment elsewhere or in the company itself. Opportunity cost is technically termed as implicit cost of capital. It is the rate of return on other investments available to the firm or the shareholders in addition to that currently being considered. Thus, the implicit cost of capital may be defined as the rate of return associated with the best investment opportunity for the firm and its Shareholders that will be foregone if the project presently under consideration by the firm were accepted. In this connection it may be mentioned that explicit costs arise when the firm raises funds for financing the project. It is in this sense that retained earnings have implicit cost. Other forms of capital also have implicit costs once they are invested, Thus in a sense, explicit costs may also be viewed as opportunity costs. This implies that a project should be rejected if it has a negative present value when its cash flows are discounted by the explicit cost of capital. It is clear thus that the cost of capital is the rate of return a firm must earn on its investments for the market value of the firm to remain unchanged. Acceptance of projects with a rate of return below the cost of capital will decrease the value of the firm; acceptance of projects with a rate of return above the cost of capital will increase the value of the firm. The objective of the financial manager is to maximize the wealth of the firm’s owners. Using the cost of capital as a basis for accepting or rejecting investments is consistent with this goal. Capital asset pricing model (CAPM) One of the two leading capital market theories of 1960s and 1970s, it is based on the idea of risk aversion. It states (1) whatever the rate of return on an investment, it should be achieved with the lowest possible level of risk, and (2) a high-level of risk should be accompanied by a correspondingly high-level of return. CAPM (like its contemporary theory, arbitrage pricing theory or APT) works only in a market in equilibrium and makes other restrictive assumptions such as equal access to information, no information or transaction costs, and rational investors. Arbitrage pricing theory It is based on the law of one price: two identical assets cannot sell at different prices. It states that the market price (which reflects the associated risk factors) of an asset represents the value that prevents an investor from exploiting it to make a risk-free profit. Also, if the market price is more or less than this value, arbitrage by investors

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CHAPTER 6. Cost of capital, Capital market theories. Investment projects analyses.

should cancel the difference. APT (like its contemporary theory, capital asset pricing model or CAPM) works only in a market in equilibrium and makes other restrictive assumptions such as equal access to information, no information or transaction costs, and rational investors. Efficient market hypothesis Early 1990’s capital market theory, that it is impossible to earn abnormal capital gains or profit on the basis of the market information. It states that the price of a financial instrument (bond, share, etc.) reflects all the information currently available and, if the price is rumored to increase in the near future, investors or traders will buy the instrument now thus driving its price up and negating the anticipated increase. And that it is impossible to predict movement of prices with any degree of certainty because prices follow a random walk and therefore, on average, no one is likely to beat the market. The critics of this theory point out that only a few individuals are as rational as it presumes them to be, and that information gathering is expensive and tedious enough to make it unlikely to be reflected in the prices. Basis of the capital asset pricing model (CAPM), it was developed by Professor Eugene Fama (born 1939) of the University of Chicago in early 1960s, it has been superseded by the coherent market hypothesis (CMH). Coherent market hypothesis Also called coherent market model or coherent market theory. Successor to efficient market hypothesis, this capital market theory looks at a market’s progressions as complex dynamic processes similar to those explained by chaos theory. According to this model, as government policy, investor expectation, technological and financial innovation, and other such factors change over time, four types of markets emerge during different phases of economic cycle: steady state random walk, unstable transition, chaotic dynamics, or coherent cycles. It states that a stable probability distribution will show persistence over time, thus reasonable expectations of the market’s performance may be computed. Proposed by Tonis Vaga (then a consultant with the US consulting firm Booz Allen & Hamilton) in his 1991 book ‘Coherent Market Hypothesis’ and developed in his 1994 book ‘Profiting From Chaos.’ Fractal market hypothesis New capital-market theory that combines fractals and other concept from chaos theory with the traditional quantitative methods to explain and predict market behavior. FMH takes into account the daily randomness of the market and anomalies such as market crashes and stampedes. It proposes that a (1) market is stable and has sufficient liquidity when it comprises of investors with different time horizons, (2) these investors stay in their ‘preferred habitat’ (time horizon), no matter what the market information indicates, (3) the available information may not be reflected in the market prices, and (4) the market prices trend indicates the changes in

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47

expected earnings (which mirror long-term economic trends). Proposed by Edgar E. Peters, author of the 1991 book ‘Chaos and order In The Capital Markets’ and the 1994 book ‘Fractal Market Analysis: Applying Chaos Theory to Investment and Economics.’ Also called different investment horizon theory. Set of concepts aimed at building a most efficient collection (portfolio) of different types of assets, based on the observation that although investors want high returns they dislike high risk (likelihood of the deviation of an actual return from the anticipated return). It suggests that the risk of a particular investment comprising a portfolio should be assessed on the basis of how its value varies in comparison with the market value of the entire portfolio, and not in isolation. And that a diversified portfolio of investments is efficient if it yields highest possible return for a given level of risk or incurs the lowest level of risk for a given amount of return. Developed by the Nobel laureate (1990) US economist Harry Markovitz (born 1927) in the early 1950’s, it enables an investor to estimate and control the type and extent of return and the associated risk. Also called modern investment theory or portfolio theory. Investment Analysis 1. The study of how an investment is likely to perform and how suitable it is for a given investor. Investment analysis is key to any sound portfolio-management strategy. Investors not comfortable doing their own investment analysis can seek professional advice from a financial advisor.   2. An analysis of past investment decisions. An investment analysis is a look back at previous investment decisions and the thought process of making the investment decision. Key factors should include entry price, expected time horizon, and reasons for making the decision at the time. For example, in conducting an investment analysis of a mutual fund, the investor would look at factors such as how the fund has performed compared to its benchmark. The investor could also compare performed to similar funds, its expense ratio, management stability, sector weighting, style and asset allocation. Investment goals should always be considered when analyzing an investment; one size does not always fit all, and highest returns regardless of risk are not always the goal. For any beginner investor, investment analysis is essential. Looking back at past decisions and analyzing the mistakes and successes will help fine-tune strategies. Many investors don’t even document why they made an investment let alone analyze why they were wrong or right. You could make a proper decision, extraordinary events could lose you money, and if you didn’t analyze it, you would shy away from making the same decision. Investment planning The placing of funds into the proper investment vehicles based on the investor’s future goals, time horizon, and priorities. This also takes into account the safety of the investments as well as liquidity

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CHAPTER 6. Cost of capital, Capital market theories. Investment projects analyses.

and level of return. Ideally, proper investment planning will allow the investor’s funds to produce financial rewards over time. Investment planning focuses on identifying effective investment strategies ac­cording to an investor’s risk appetite and financial goals. There is a wide variety of investment options, including shares, bonds, mutual funds, bank deposits, real estate and futures and options. Through investment planning, one can identify the most appropriate portfolio mix. Investment Planning: How it Works Investment planning begins after you have taken into account your current and expected income level and have laid down your financial goals. The important aspects of investment planning are: Capital growth versus regular income: Investors aiming at long-term goals focus on capital growth. A long-term investment will allow you to tide over rough times without changing your plans. Stocks, mutual funds and real estate represent investment options for capital growth. On the other hand, if you’re investing to meet a short-term goal or to give you a regular flow of funds to complement your present salary, you should opt for income investments. These invest­ ments generate a regular flow of income in the form of dividends and interest and include fixed-income investments, such as bonds and certificates of deposit (CDs). While making a selection, you should consider the tax implications and associated risks. Risk: Every investment option represents a unique risk-return trade-off. Typically, more risky investments offer higher returns in order to make it worthwhile for investors to take on the additional risk. Investment planning should take into account an investor’s risk appetite, which dependents on your current income level, savings, lifestyle and responsibilities. Determine your investment profile: This can be done by consi­dering your risk appetite. There are mainly four types of investment profiles: • Conservative (Low Risk Tolerance): Such portfolios comprise mainly (about 70%) of income assets, such as fixed interest and cash. • Balanced (Average Risk Tolerance): This refers to portfolios with an equal emphasis on growth and income assets. • Growth (High Risk Tolerance): Such portfolios comprise mainly (up to 80%) of growth investments, such as stocks and foreign currencies. • High Growth or Aggressive (Very High Risk Tolerance): This refers to portfolios with more than 90% of the funds in growth investments. Review your investment plan regularly: This helps in fine-tuning a portfolio to suit your current financial situation and a change in risk preference. Cash flows from investing activities are those involving non­current capital assets used in the firm’s operations, such as property, plant, equipment (PP&E) and intangible assets. When a company invests

Cost of Capital

49

in new long-term capacity by acquiring either PP&E or another company, the investment is a cash outflow from investing activities. Disposals of these types of assets for cash generate inflows. Accounting standards differ somewhat as to which activities can be classified as investing. For example, under IAS, some research and development expenditures can be capitalized on the balance sheet and would thus be considered investing activities. Under U.S. GAAP, research and development costs must all be expensed immediately on the income statement and appear as ope­rating cash outflows regardless of whether the research will result in long-term benefits to the firm. The investing activities section does not necessarily provide a complete listing of all capital asset activity because only acquisitions or disposals involving cash appear here. Noncash acquisitions, such as acquisition of a building using a mortgage, are disclosed in supplemental information to the cash flow statement. Under both U.S. GAAP and IAS, a specific provision is made for these types of noncash financing and investing transactions. They are typically simultaneous, arising from an acquisition of a capital asset funded solely by incurring debt, such as the mortgage used to acquire property. Conceptually, it can be argued that a company receives cash from incurring the debt and then spends the cash on the acquisition. Nevertheless, if cash does not actually change hands, both sets of standards treat these as noncash transactions that must be disclosed separately from cash transactions. The disclosure could appear either at the end of the cash flow statement or in the notes to the statements. Another common noncash financing transaction, which is disclosed in the same manner, is the conversion of convertible debt or preferred stock into common equity. Investment risk Probability that an actual return on an investment will be lower than the investor’s expectations. All investments have some level of risk associated it due to the unpredictability of the market’s direction. Risk Management – refers to the culture, processes, and structures that are directed toward effective management of risks –including potential opportunities and threats to project objectives. Risk-Based Estimate – involves simple or complex modeling based on inferred and probabilistic relationships among cost, schedule, and events related to the project. It uses the historical data and/or cost based estimating techniques and the expert’s best judgment to develop a Base Cost or the cost of the project if the project proceeds as planned. Risk elements (opportunities or threats) are then defined and applied to the Base Cost through modeling to provide a probable range for both project cost and schedule. Risk management, as an integral part of project management, occurs on a daily basis. With pro-active risk management we look at projects

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CHAPTER 6. Cost of capital, Capital market theories. Investment projects analyses.

in a comprehensive manner and assess and document risks and uncertainty. The steps for risk management are provided below. 1) Risk Management Planning Risk Management Planning is the systematic process of deciding how to approach, plan, and execute risk management activities throughout the life of a project. It is intended to maximize the beneficial outcome of the opportunities and minimize or eliminate the consequences of adverse risk events. 2) Identify Risk Events Risk identification involves determining which risks might affect the project and documenting their characteristics. It may be a simple risk assessment organized by the project team, or an outcome of the workshop process. 3) Qualitative Risk Analysis Qualitative risk analysis assesses the impact and likelihood of the identified risks and develops prioritized lists of these risks for further analysis or direct mitigation. The team assesses each identified risk for its probability of occurrence and its impact on project objectives. Project teams may elicit assistance from subject matter experts or functional units to assess the risks in their respective fields. 4) Quantitative Risk Analysis Quantitative risk analysis is a way of numerically estimating the probability that a project will meet its cost and time objectives. Quantitative analysis is based on a simultaneous evaluation of the impacts of all identified and quantified risks. 5) Risk Response Planning Risk response strategy is the process of developing options and determining actions to enhance opportunities and reduce threats to the project’s objectives. It identifies and assigns parties to take responsibility for each risk response. This process ensures that each risk requiring a response has an «owner» . The Project Manager and the project team identify which strategy is best for each risk, and then selects specific actions to implement that strategy. 6) Risk Monitoring & Control Risk Monitoring and Control tracks identified risks, monitors residual risks, and identifies new risks − ensuring the execution of risk plans, and evaluating their effectiveness in reducing risk. Risk Monitoring and Control is an ongoing process for the life of the project. Monte Carlo method Computation intensive forecasting technique applied where sta­tistical analysis is extremely cumbersome due to the complexity of a problem (such as queuing or waiting line probabilities, or inventories involving millions of items). Used only where the problem has a chance (random) component, and is subject to unpredictable influen­ces, it simulates (models) a situation on the basis of current and past (historical) data. In the simulation process, it computes an equation (mathematical model) thousands or millions of times,

Cost of Capital

51

each time in­jec­ting random numbers to come up with a range of possibilities or outcomes of possible actions. Larger the number of computations, the greater the probability (according to the law of large numbers) of approximating the future events-provided the maximum-amount of known-data is incorporated into the model. Named after the Me­diterranean resort of Monte Carlo in Monaco (famous for its gam­bling casinos) where sophisticated betters employ scientific methods to enhance their chances to win. Tobin’s ‘Q’ theory Economics theory of investment behavior where ‘q’ represents the ratio of the market value of a firm’s existing shares (share capital) to the replacement cost of the firm’s physical assets (thus, replacement cost of the share capital). It states that if q (representing equilibrium) is greater than one (q > 1), additional investment in the firm would make sense because the profits generated would exceed the cost of firm’s assets. If q is less than one (q < 1), the firm would be better off selling its assets instead of trying to put them to use. The ideal state is where q is approximately equal to one denoting that the firm is in equilibrium. Also called general equilibrium theory or ‘q’ theory, it was proposed by the US Nobel laureate economist James Tobin (1918-). DCF model Value of the anticipated revenue stream from an investment as at today or on any given date. Because money can grow by itself (when placed in an interest earning account) a dollar received today is less valuable than a dollar received in the future. This quality (the ‘time value of money’) makes choosing among investment opportunities (requiring different sums, and having different maturity periods and rates of return) a convoluted process. Therefore, DCF techniques are applied to ‘bring-back’ (discount) the anticipated returns to a common ground their present value (PV). Two basic DCF methods are the net present value (NPV) method and the internal rate of return (IRR) method, both of which take into account the time-value of money, and are similar to the methods used in computing interest-income on bank deposits. (1) In NPV method, the anticipated total cash-inflows (returns) are multiplied with a discount-rate to bring them back to their PV. The initial investment amount and other cash-outflows (costs) are subtracted from the PV to arrive at the net PV of the investment. A positive NPV indicates a desirable investment project. (2) The IRR is that discount rate at which the PV of the anticipated total cash inflows is equal to the PV of the anticipated total cash outflows, or the rate at which NPV is zero. IRR is determined through trial-and-error calculations using a mathematical formula (included with most spreadsheet programs) or a graph. IRR higher than the minimum acceptable rate of return (called hurdle rate) indicates a desirable investment project. Discounted cash flow ana­lysis is Called also capitalization of income.

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CHAPTER 6. Cost of capital, Capital market theories. Investment projects analyses.

P/E – price/earnings ratio. The most common measure of how expensive a stock is. The P/E ratio is equal to a stock’s market capitalization divided by its after-tax earnings over a 12-month pe­riod, usually the trailing period but occasionally the current or forward period. The value is the same whether the calculation is done for the whole company or on a per-share basis. For example, the P/E ratio of company A with a share price of $10 and earnings per share of $2 is 5. The higher the P/E ratio, the more the market is willing to pay for each dollar of annual earnings. Companies with high P/E ratios are more likely to be considered «risky» investments than those with low P/E ratios, since a high P/E ratio signifies high expectations. Comparing P/E ratios is most valuable for companies within the same industry. The last year’s price/earnings ratio (P/E ratio) would be actual, while current year and forward year price/earnings ratio (P/E ratio) would be estimates, but in each case, the «P» in the equation is the current price. Companies that are not currently profitable (that is, ones which have negative earnings) don’t have a P/E ratio at all, also called earnings multiple. P/S – price to sales ratio. Regarded by some stock market analysts as a better indicator of the growth potential of a firm, because sales revenue is more difficult to fudge by creative accounting than the earnings. Formula: Share’s market price / Sales revenue per share. P/BV – price to book value ratio. A ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. A lower P/B ratio could mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong with the company. As with most ratios, be aware that  this varies  by industry. This ratio also gives some idea of whether you’re paying too much for what would be left if the company went bankrupt immediately. PEG – price to earnings growth ratio. Indicates the value stockmarket analysts and investors put on a firm’s earning expectations compared to what it had earned in the past, and is used to discover stocks that have high growth potential but are trading at a discount. A PEG ratio of 1 is considered a sign of good value. Formula: Stock’s projected PE ratio ÷ Stock’s projected EPS growth rate. Questions for self-control: 1. Monte Carlo method; 2. Capital asset pricing model; 3. What do P/E, P/S ratios diclose?

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7.1. Meaning, Importance & Rationale of Capital Budgeting

Chapter

7

The basics of capital budgeting. Investment decisions

7.1. Meaning, Importance & Rationale of Capital Budgeting A firm conducts its business in a rapidly changing and highly competitive environment. The changing environment poses both op­portunities and threats for the company. For example, change in Government policy may cause change in prices of inputs and outputs, demand and supply of products/services. Similarly, technology change may cause the production cost change. Also the cash inflows and outflows cannot be ascertained with accuracy. Therefore, evaluation of investment projects under uncertainty and risk become important. Characteristically, a capital budgeting decision involves largely irreversible commitment of resources that is generally subject to a significant degree of risk. Such decisions have far reaching effects on a company’s profitability and flexibility over the long-term, thus requiring that they be part of a carefully developed strategy that is based on reliable forecasting procedures. Capital Budgeting Capital budgeting may be defined as the decision-making process by which, firms evaluate the purchase of major fixed assets, including buildings, machinery, and equipment It also covers decisions to acquire other firms, either through the purchase of their common stock or groups of assets that can be used to conduct an ongoing business. 53

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CHAPTER 7. The basics of capital budgeting. Investment decisions

Capital budgeting scribes the firm’s formal planning process for the acquisition and investment of capital and results in a capital budget that is the firm’s formal plan for the expenditure of money to purchased assets. A capital-budgeting decision is a two-sided process: First, the analyst must evaluate a proposed project to calculate the likely or expected return from the project. This calculation generally begins with expenditure of the project’s service life and a stream of cash flowing into the firm over the life of the project. The calculation of expected, turn may be done by two methods: a) internal rate of return, or b) net present value. The second side of a capital-budgeting decision is to determine the required return from a project. We may calculate the likely return to be 12 percent but the question is whether this is good enough for the proposal to be accepted. In order to determine whether the return is adequate, the analyst must evaluate the degree of risk in the project and then must calculate the, required return for the given risk level. Two techniques may be used to perform this analysis. The weighted-average cost of capital is used when the new proposal is assumed to have the same degree of risk as the firm’s existing activities. The capital asset pricing model is used if the risk in the project is viewed as different from the firm’s current risk level. Capital budgeting is important for the future well-being of the firm; it is also a complex, conceptually difficult topic. A, we shall see later in this chapter, the optimum capital budget-the level of investment that maximizes the present value of the firm is simultaneously determined by the interaction of supply and demand forces under conditions of uncertainty. Supply forces refer to the supply of capital, the firm or its cost of capital schedule. Demand forces relate to the investment opportunities open to the firm, as measured by the stream of revenues that will result from an investment decision Uncertainty enters the decision because it is impossible to know exactly either the cost of capital or the stream of revenues that will be derived from a project. A number of factors combine to make capital budgeting perhaps the most important decision with which financial management is involved. Further, a departments Of a firm-production, marketing, and so on, are vitally affected by the capital budgeting decisions, so all executives, no matter what their primary responsibility, must be aware of how capital budgeting decisions are made. Long Term Effects First and foremost, the fact that the results continue over an extended period means that the decision maker loses some of his flexibility. He must make a commitment into the future. For example, the purchase of an asset with an economic life of ten years requires a long period of waiting before the final results of the action can be known.

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The decision maker must commit funds for this period, and, thus, he becomes a hostage of future events. Asset expansion is fundamentally related to expected future sales. A decision to buy or to construct a fixed asset that is expected to last five years involves an implicit five-year sales forecast. Indeed, the economic life of a purchased asset represents an implicit forecast for the duration of the economic life of the asset. Hence, failure to forecast accurately will result in over investment or under investment in fixed assets. An erroneous forecast of asset requirements can result in serious consequences. If the firm has invested too much in assets, it will incur unnecessarily heavy expenses. If it has not spent enough on fixed assets, two serious problems may arise. First, the firm’s equipment may not be sufficiently modern to enable it to produce competitively. Second, if it has inadequate capacity, it may lose a portion of its share of the market to rival firms. To regain lost customers typically requires heavy selling expenses, price reduction, product improvements, and so forth. Timing the Availability of Capital Assets Another problem is to phase properly the availability of capital assets in order to have them ‘come’ on stream. at the correct time. For example, the executive vice-president of a decorative tile company gave the authors an illustration of the importance of capital budgeting. His firm tried to operate near capacity most of the time. For about four years there had been intermittent spurts in the demand for its product; when these spurts occurred, the firm had to turn away orders. After a sharp increase in demand, the firm would add capacity by renting an additional building, then purchasing and installing the appropriate equipment. It would take six to eight months to have the additional capacity ready. At this point the company frequently found that there was no demand for its increased output-other firms had already expanded their operations and had taken an increased share of the market, with the result that demand for this firm had leveled off. If the firm had properly forecast demand and had planned its increase in capacity six months or one year in advance, it would have been able to maintain its market-indeed, to obtain a larger share of the market. Quality of Capital Assets Good capital budgeting will also improve the timing of asset acquisitions and the quality of assets purchased. This situation follows from the nature of capital goods and their producers. Firms do not order capital goods until they see that sales are beginning to press on capacity. Such occasions occur simultaneously for many firms. When the heavy orders come in, the producers of capital goods go from a situation of idle capacity to one where they cannot meet all the orders that have been placed. Consequently, large backlogs accumulate. Since the production of capital goods involves a relatively long work-in-process period, a year or more of waiting

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CHAPTER 7. The basics of capital budgeting. Investment decisions

may be involved before the additional capital goods are available. This factor has obvious implications for purchasing agents and plant managers. Asset expansion is fundamentally related to expected future sales. A decision to buy or to construct a fixed asset that is expected to last five years involves an implicit five year sales forecast. Indeed, the economic life of a purchased asset represents an implicit forecast for the duration of the economic life of the asset. Hence, failure to forecast accurately will result in over investment or under investment in fixed assets. An erroneous forecast of asset requirements can result in serious consequences. If the firm has invested too much in assets, it will incur unnecessarily heavy expenses. If it has not spent enough on fixed assets, two serious problems may arise. First, the firm’s equipment may not be sufficiently modern to enable it to produce competitively. Second, if it has inadequate capacity, it may lose a portion of its share of the market to rival firms. To regain lost customers typically requires heavy selling expenses, price reduction, product improvements, and so forth. Timing the Availability of Capital Assets Another problem is to phase properly the availability of capital assets in order to have them. Come ‘on stream’ at the correct time. For example, the executive vice-president of a decorative tile company gave the authors an illustration of the importance of capital budgeting. His firm tried to operate near capacity most of the time. For about four years there had been intermittent spurts in the demand for its product; when these spurts occurred, the firm had to turn away orders. After a sharp increase in demand, the firm would add capacity by renting an additional building, then purchasing and installing the appropriate equipment. It would take six to eight months to have the additional capacity ready. At this point the company frequently found that there was no demand for its increased output-other firms had already expanded their operations and had taken an increased share of the market, with the result that demand for this firm had leveled off. If the firm had properly forecast demand and had planned its increase in capacity six months or one year in advance, it would have been able to maintain it’s market-indeed, to obtain a larger share of the market. Quality of Capital Assets Good capital budgeting will also improve the timing of asset acquisitions and the quality of assets purchased. This situation follows from the nature of capital goods and their producers. Firms do not order capital goods until they see that sales are beginning to press on capacity. Such occasions occur simultaneously for many firms. When the heavy orders come in, the producers of capital goods go from a situation of idle capacity to one where they cannot meet all the orders that have been placed. Consequently, large backlogs accumulate. Since the production of capital goods involves a

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57

relatively long work-in-process period, a year or more of waiting may be involved before the additional capital goods are available. This factor has obvious implications for purchasing agents and plant managers. Raising Funds Another reason for the importance of capital budgeting is that asset expansion typically involves substantial expenditures. Before a firm spends a large amount of money, it must make the proper plans-large amounts of fund are not available automatically. A firm contemplating, major capital expenditure program may need to arrange its financing several years in advance to be sure of having the funds required for the expansion. Raising Funds another reason for the importance of capital budgeting is that asset expansion typically involves substantial expenditures before a firm spends a large amount of money, it must make the proper plans-large amounts of fund are not available automatically. A firm contemplating, major capital expenditure program may need to arrange its financing several years in advance to be sure of having the funds required for the expansion. Ability to Compete Finally, it has been said with a great deal of truth that many firms fail, not because they have too much capital equipment but because they have too little. While the conservative approach of having a small amount of capital equipment may be appropriate at times, such an approach may also be fatal if a firms competitors install modern, automated equipment that permits them to produce a better product and sell it at a lower price. The same thing also holds true for nations: If United States firms fail to modernize but those of other nations do, then the US will not be able to compete in world markets Thus, an understanding of business investment behavior and of factors that motivate firms to undertake investment programs is vital for congressional leaders and others involved in governmental policy making. Application of the Concept At the applied level, the capital budgeting process is much more complex than what it looks. Projects do not just appear, a continuing stream of good investment opportunities results from hard thinking, careful planning, and, often, large outlays for research and development Moreover, some very difficult measurement problems are involved: the sales and costs associated with particular projects must be estimated, frequently many years into the future, in the face of great uncertainty. Finally, some difficult conceptual and empirical problems arise over the methods of calculating rates of return and the cost of capital. Businessmen are required to take action, however, even in the face of the kinds of problems described; this requirement has led to the development of procedures that assist in making optimal investment decisions.

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CHAPTER 7. The basics of capital budgeting. Investment decisions

Difficulties in Capital Budgeting While capital expenditure decisions are extremely important, they also pose difficulties, which stem from three principal sources: Measurement Problems Identifying and measuring the costs and benefits of a capital expenditure proposal tends to be difficult. This is more so when a capital expenditure has a bearing on some other activities of the firm (like cutting into the sales of some existing product) or has some intangible consequences (like improving the morale of workers). Uncertainty A capital expenditure decision involves costs and benefits that extend far into future. It is impossible to predict exactly what will happen in future. Hence, there is usually a great deal of uncertainty characterizing the costs and benefits of a capital expenditure decision. Temporal Spread The costs and benefits associated with a capital expenditure decision are spread out over a long period of time, usually years for industrial projects and 20-50 years for infrastructural projects· Such a temporal spread creates some problems in estimating discount rates and establishing equivalences. For planning and control purposes, three levels of decision-ma­king have been identified: • Operating; • Administrative; • Strategic. Capital budgeting could be categorized into those three levels: Operating capital budgeting may include routine minor expen­ditures, such as on office equipment, and lower level management can easily handle it. Strategic capital budgeting involves large investments such as acquisition of new business or expansion in a new line of business. Strategic investments are unique and unstructured, and they cast a significant influence on the direction of the business. Top management therefore, generally handles such investments. Administrative capital budgeting falls in-between these two levels. It involves medium-size investments such as expenditure on expansion of existing line of business. Administrative capital budgeting decisions are semi-structured in nature, and can be handled by middle ma­nagement. Internal rate of return One of the two discounted cash flow (DCF) techniques (the other is net present value or NPV) used in comparative appraisal of investment proposals where the flow of income varies over time. IRR is the average annual return earned through the life of an investment and is computed in several ways. Depending on the method used, it can either be the effective rate of interest on a deposit or loan, or the discount rate that reduces to zero the net present value of a stream of income inflows and outflows. If the IRR is higher than the desired rate of return on investment, then the project is

7.1. Meaning, Importance & Rationale of Capital Budgeting

59

a desirable one. However, it is a mechanical method (computed usually with a spreadsheet formula) and not a consistent principle. It can give wrong or misleading answers, especially where two mutually-exclusive projects are to be appraised. Also called dollar weighted rate of return. Net Present Value The difference between the present value of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the required rate of return. For example, an investment of $1,000 today at 10 percent will yield $1,100 at the end of the year; therefore, the present value of $1,100 at the desired rate of return (10 percent) is $1,000. The amount of investment ($1,000 in this example) is deducted from this figure to arrive at net present value which here is zero ($1,000-$1,000). A zero net present value means the project repays original investment plus the required rate of return. A positive net present value means a better return, and a negative net present value means a worse return, than the return from zero net present value. It is one of the two discounted cash flow techniques (the other is internal rate of return) used in comparative appraisal of investment proposals where the flow of income varies over time. Payback Period Method Method of evaluating investment opportunities and product de­velopment projects on the basis of the time taken to recoup the investment. This period is compared to the required payback period to determine the acceptability of the investment proposal. In contrast to return on investment and net present value methods, the cash inflows occurring after the payback period are not included in this method. Formula: Payback period (in years) = Initial capital investment ÷ Annual cashflow from the investment. Questions for self-control: 1. What is the capital budgeting? 2. What is the difference between independent and mutually exclusive projects? 3. Payback Method.

60

FINANCIAL MATEMATICS

Chapter

8

Operating and financial leverage. Theory of capital structure

One of the most important of the various financial decisions is how much leverage a firm should employ. A fundamental decision made by any business is the degree to which it incurs fixed costs. A fixed cost is one that remains the same regardless of the level of operations. As sales increase, fixed costs don’t increase in the same proportion. Some fixed costs do not increase at all till a particular point. As a result, profits can rise faster during good times. On the other hand, during bad times fixed costs don’t decline, so profits fall more rapidly than sales do. The degree to which a firm locks it into fixed costs is referred to as its leverage position. The more highly leveraged a firm, the riskier it is because of the obligations related to fixed costs that must be met whether the firm is having a good year or not. At the same time, the more highly leveraged the greater the profits during good times. This presents a classic problem of making a decision where there is a trade-off between risk and return. There are two major types of leverage - financial and operating. Financial leverage is specifically the extent to which a firm gets its cash resources from borrowing (debt) as opposed to issuance of additional shares of (equity). The greater the debt compared to equity, the more highly leveraged the firm because debt legally obligates the firm to interest payments. These interest payments represent a fixed cost. Operating leverage is concerned with the extent to which a firm commits itself to high levels of fixed costs other than interest payments. A firm that rents property using cancellable leases has less leverage than a 60

Operating Leverage

61

firm that commits it to a long-term no cancellable lease does. A firm that has substantial vertical integration has created a highly leveraged situation. Consider what happens if a company vertically integrates by acquiring its raw materials’ supplier. Raw materials will now cost the company less, because it doesn’t have to buy them from an outside firm. But when times are bad, the firm will have to bear the fixed costs associated with the supplier subsidiary. Had there still been two separate companies, the big company could have simply slowed its purchases of raw materials from supplier without having to bear its fixed costs. In the cases of both financial and operating leverage, the crucial question is how much leverage is appropriate. We can’t answer that question in absolute terms, but we will help you understand the topic. This understanding should make it simpler to make appropriate choices or to understand what went into making the choices your firm has already made. Operating Leverage While decisions about financial leverage are strictly the domain of the firm’s highest levels of management, operating leverage is an issue that directly affects the line managers of the firm. The level of operating leverage a firm selects should not be made without input from the managers directly involved in the production process. For example, one of the most significant operating leverage issues is the choice of technology levels. Selection of the highest level of technology available is not always in the best interests of the business. Suppose that we are opening a chain of copy centers. Each centre will provide a full service operation. Customers can drop work off in the morning and pick it up later in the day or the week. The employees will do the actual photocopying. We are faced with the choice of renting a relatively slow copy machine, or the newest technology machine, which is considerably faster. The faster machine is also considerably more expensive to lease. It will generally be the case that newer technology has a higher fixed cost and lower variable cost than the older technology. Variable costs are those that vary directly with volume. If we double the number of copies made, we double the amount of paper, printing ink toner, and labor time needed for making the copies. One of the principle functions of new technology is to reduce the variable costs of production. It may turn out that a machine that can reduce the variable costs is more expensive to make, and thus has a higher purchase or lease price than the older generation machine. However, even if it doesn’t cost more to make, its manufacturer will charge more for the new machine than for the older machine. Intuitively, if the new machine is in some respect better than the old machine (that is, it lowers the variable cost without reducing quality), and doesn’t cost more to

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CHAPTER 8. Operating and financial leverage. Theory of capital structure

buy, then no one will buy the older machine. Thus, anytime we see two technologies being sold side by side, such as slow and fast copy machines, we can expect the faster machine to have a higher rental fee or purchase price, and therefore a higher fixed cost. Let’s assume that we could lease the slower, older technology copy machine for T1,000 per year, or a faster, newer technology copy machine for T1,500 per year. Both produce photocopies of equal quality. Both use the same quantities of paper and ink toner, but the faster machine requires less operating time. Therefore, the labor cost is much lower for the faster machine. As a result, the variable cost of copies on the slow machine is 3 tg each, while the variable cost of copies from the fast machine is only 2.5 tg each. Is the faster machine the better bet? That depends. Suppose we sell each copy for 5 tg. Then, for each copy we sell we receive 5 tg and spend extra 3 tg or 2,5 tg (depending on our choice of machine) for the variable costs. The difference between the price and the variable costs is referred to as the contribution margin. This margin represents the amount of money available to be used to pay fixed costs and provide the firm with a profit. If we use the slower machine, we receive 5 tg and spend 3 tg, leaving 2 tg to be used toward paying the rent on the copy machine. If we sell enough copies, there will be enough individual contributions of 2 tg a piece to pay the full Rs 1,000 rent and leave some receipts for a profit. So in operating leverage the decision boils down to the production levels that we have or we anticipate and on that basis we decide the amount of fixed costs that we are willing to bear. All this leads itself to breakeven analysis or cost-volume-profit analysis that you have learned earlier. Financial Leverage Let’s start our discussion of financial leverage with an example. Assume you were to buy a small building as a piece of investment property. You buy the building for $ 100,000 and pay the full amount in cash. Suppose that a year later you sell the building for $ 130,000. Your pretax profit is $ 30,000. This is a 30% pre-tax return on your original investment of $ 100,000. As an alternative to paying the full $ 100,000 cash for the investment, you might have to put $ 10,000 cash down and borrow $ 90,000 from the bank at 15% interest. This time when you sell the property for $ 1,30,000 you repay $ 90,000 to the bank, along with $ 13,500 interest. After deducting your original $ 10,000 investment, $ 16,500 is left as a pre-tax profit. This is a pre-tax return of 165% on your $ 10,000 investment. Compare the 30% we calculated earlier to this rate of return of 165%. That’s financial leverage for you! Note that we had a net profit of $ 30,000 without leverage, but only $

Operating Leverage

63

16,500 in the leveraged case. Although we earned a higher return, we had less profit. That’s because in the unleveraged case we had invested $ 100,000 of our money, but in the leveraged case we had invested only $ 10,000. If we have additional investment opportunities available to us, we could have invested our full $ 100,000, borrowed $ 900,000, and had a pre-tax profit of $ 165,000 on the same investment that yields $ 30,000 in the unleveraged situation. Financial leverage can not only increase your yield from investments, but can also allow you to consider projects that are much larger than what would be feasible without borrowing. Suppose, however, that the property were sold after one year for $ 70,000 rather than $ 130,000. On $ 100,000 unleveraged investment, the loss would be $ 30,000 before taxes. This would be a 30% loss on our original $ 100,000 investment. In the leveraged case, the loss will be magnified. We would have to repay the bank the $ 90,000 loan plus $ 13,500 of interest. These payments total to $ 103,500, which is $ 33,500 greater than the $ 70,000 proceeds from the sale. Further, we’ve lost our initial $ 10,000 investment. The total loss is $ 43,500 before taxes. On our initial investment of $ 10,000, this constitutes a loss of 435%. That’s financial leverage too! Let us put that into a table so as to see the effect of financial leverage more clearly. Original investment

Amount Borrowed

Profit/ Loss

100 000 10 000 100 000 10 000

0 90 000 0 90 000

30 000 30 000 -30 000 -30 000

Profit/ Loss as percentage of original investment 30% 1.65% -30% 4.35%

Clearly when the firm is going to accept this level of leverage it must decide if the 165% possible gain is worth the risk of a 435% loss. Whether it is or not depends on the likelihood of the increase in value versus the probability of a decline. Of course it can accept a lower level of leverage but still the interplay of debt and equity would be there and a study of its effects in both the good times and the bad times would be important. If the project really was a sure thing, leverage would certainly make sense but projects are rarely sure things. Yet, managers should try to decide how confident they are of the success of a project, and weigh that confidence against the implications for the firm if the project does indeed fail. Not all managers rate the same project as being equally likely to succeed. Some managers feel a particular project is great, while others may not think as highly of it. Further, even if all managers agreed on how likely a project were to succeed, they would not all make the same decision about financial

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CHAPTER 8. Operating and financial leverage. Theory of capital structure

leverage. Some managers and firms tend to be more averse to risk than others. There are gamblers and conservatives. Usually shareholders align themselves with a firm that they feel does things the way they want them done. A person dependent on a steady level of income from share dividends might prefer to buy the share of a firm that shuns leverage and prefers a steady, if lesser income. A person looking for large potential appreciation in share price might prefer the share of a firm that is highly leveraged. How Much Financial Leverage Is Enough In practice, the leverage decision is based on firm policy. Some firms raise almost all of their funds from issuing share to shareholders and from earnings retained in the firm. Other firms borrow as much as they possibly can and raise additional money from shareholders only when they can no longer raise any additional money by borrowing. Most firms are somewhere in the middle. In the example that we discussed above, you didn’t have to borrow $ 90,000 or nothing; you could have chosen to borrow some amount in between the two. Likewise, some firms maintain one-fourth as much debt as equity, some firms equal amounts of debt and equity, and some firms more debt than equity. The firm’s top corporate managers and the board of directors make this decision. Generally, project managers evaluating the potential of individual projects do not make the decision of issuing share or borrowing money. Debt or Equity? In making a decision regarding whether additional funds should be raised from issuing debt or equity, there are several factors to be considered. The first rule of financial leverage is that it only pays to borrow if the interest rate is less than the rate of return on the money borrowed. If your firm can borrow money and invest it at a high enough rate so that the loan can be repaid with interest and still leave some after-tax profit for your shareholders, then your shareholders have profited. They have made extra profit with no extra investment. This greatly magnifies the rate of return on the amount they invested. Why are lenders so generously allowing you to benefit at their expense? How can there be a system where a firm can increase profits to its shareholders without extra investment from them? The key is risk. The shareholders of your company don’t increase their investment, but they do increase their risk. The lender may not reap all of the possible profits from the use of his money. But the lender does earn a contractually guaranteed rate of return. The lender gets back his money plus a set amount of interest, whether we make a fortune or lose our shirts. The amount that lenders let you borrow depends largely on your available collateral. Merely desiring to be highly leveraged doesn’t guarantee that you can borrow enough to be highly leveraged. Because the lender isn’t a partner if you strike it rich, he doesn’t want to be a partner if you go bankrupt.

Operating Leverage

65

Assuming that you have enough collateral to borrow as much as you might want, what factors should you consider in trying to arrive at a reasonable level of leverage? To a great degree, your desired leverage position depends on the degree to which your sales and profits fluctuate. The greater the fluctuation in sales and profits, the less leverage you can afford. If your firm is a stable, noncyclical firm that makes money in good times and bad, then use of debt will help improve the rate of return earned by your shareholders. If cyclical factors in your industry or the economy at large tend to cause your business to have both good and bad years, then debt entails a greater risk. For example, the petrochemicals industry, with its huge capital requirements has traditionally been highly leveraged. The results have been very large profits during the good years, but substantial losses during periods when petrochemical prices fall. Cyclical factors shouldn’t scare companies away from having any debt at all. The key is to accumulate no more interest and principal repayment obligations than can reasonably be met in bad times as well as good. Ultimately, considering the variability of your profit stream, a decision must be made regarding the level of extra risk you are willing to take to achieve a higher potential rate of return on shareholder investments. Impact of Financial Leverage Financial leverage acts as a lever to magnify the influence of fluctuations. Any fluctuation in earnings before interest and taxes (EBIT) is magnified on the earnings per share (EPS) by operation of leverage. The greater the degree of leverage, the wider the variation in EPS given any change in EBIT. Financial leverage is useful as long as the borrowed capital can be made to pay the company more than what it costs. Naturally it will become source of decrease in profit rates when it costs more than what it earns. To what extent debt capital should be used in order to improve earnings of the company is a major financing problem facing a finance manager. It should be remembered here that the financial leverage offers financial advantages only up to a point. Beyond that point debt financing may be detrimental to the company. For instance, as we expand the use of debt’ in our capital structure, lenders will perceive a greater financial risk for the company. For that reason, they may raise the average interest rate we pay, and place certain restrictions on the company. Furthermore, concerned equity stockholders’ may drive down the price of the stock forcing the management away from the company’s main objectives of maximizing overall value of the company in the market. Thus, before using the financial leverage as a technique of improving net earnings of the company, its impact on EPS must ca­refully weighed. Combined Leverage The operating leverage has its effects on operating risk and is measure by the percentage change in EBIT due to percentage change in

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CHAPTER 8. Operating and financial leverage. Theory of capital structure

sales. The financial leverage has its effects on financial risk and is measured by the percentage change in EPS due to percentage change in EBIT. Since both these leverages are closely concerned with ascertaining the ability to cover fixed charges (fixed-operating costs in the case of operating leverage and fixed-financial costs in the case of financial leverage), if they are combined, the result is total le­verage and the risk associated with combined leverage is known as total risk. Symbolically, DCL = DOL X DFL Where, DCL = Degree of combined leverage DOL = Degree of operating leverage DFL = Degree of financial leverage DCL = %change in EBIT / %change in Sales DCL = (Contribution / EBIT) x x (EBIT/(EBIT-1))(Contribution/(EBIT-1)) Thus, the DCL measures the percentage change in EPS due to percentage change in sales. If the degree of operating leverage of a firm is 6 and its financial leverage is 2.5, the combined leverage of this a firm would be 15(6 X 2.5). That is, 1 per cent change in sales would bring about 15 per cent change in EPS in the direction of the change in sales. The combined leverage can work in either direction. It will be favorable if sales increase and unfavorable when sales decrease because changes in sales will result in more than pro­portionate returns in the form of EPS. The usefulness of DCL lies in the fact that it indicates the effect that sales changes will have on EPS. Its potential is also great in the area of choosing financial plans for new investments. If, for example, a firm begins to invest heavily in more risky assets than usual, the operating leverage will obviously increase. If it does not change its financing policy, that is, the capital structure remains constant, there would be no change in its financial leverage. As a result, the combined leverages would increase causing an increase in its total risk. The firm, in order to keep its risk constant, may like to lower its financial leverage. This could be done if the new investments are financed with more equity than the firm has used in the past. This would lower the financial leverage and compensate for the increased operating leverage caused by investment in more risky investments. If the operating leverage has decreased due to low fixed costs, the firm can afford to have a more levered financial plan to keep the total risk constant at the same time having the same prospects of magnifying effects on EPS due to change in sales. Break-even Point (BEP). The break-even point is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has «broken even». A profit or a loss has not been made, although opportunity costs have been paid, and capital has received the risk-adjusted, expected return.

Operating Leverage

67

For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sells more, it will be a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could: • Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs); • Try to reduce variable costs (the price it pays for the tables by finding a new supplier); • Increase the selling price of their tables. Any of these would reduce the break-even point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs. The Break-Even Chart In its simplest form, the breakeven chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the «break-even point» and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity («output»). OB rep­resents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

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CHAPTER 8. Operating and financial leverage. Theory of capital structure

Break Even Analysis By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 0.6))= 589 units to break even, rather than 715.

To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal axis and the breakeven price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis. Application The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing breakeven sales as a percentage of actual sales-can give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur).

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This is very important for financial analysis. (breaking Break-even is only a supply side (i.e. costs only) produced analysis, asisit equal tells you   Break-even analysis is only a supply sideside (i.e.(i.e. costs only) asinitasthe tells you you nothing Break-even analysis isof only a supply costs analysis, it tells nothing quantity goods sold (i.e., there isonly) noanalysis, change quantity of aboutabout Limitations what sales are actually likely to be for the product at these various prices. what sales areare actually likely to be for theside product at these various prices. what sales actually likely to be for the product at these various prices.  Break-even analysis is only a supply (i.e. costs only) analysis, as it tells you nothing about in goods held in inventory atAlthough the beginning ofinthe period and the  It assumes that fixedcosts costs(FC) (FC) areconstant. constant. Although this is true in the short run, increase   It assumes thatthat fixed are this is true the run, an an increase in in It assumes fixed costs (FC) are constant. Although this is true in short the short run, an increase what sales are actually likely to be for the product at these various prices. thescale scaleofofproduction production likely cause fixed costs rise. quantityisisof goods heldfixed in inventory at the end of the period). the likely totocause costs to to rise. the Itscale of production is likely toare cause fixed costs to rise.  assumes that fixed costs (FC) constant. Although this is true in the short run, an increase in assumes• average variablecosts costsareare constantperperunit unit of output, at least in the range likely In multi-product companies, assumes the    ItItIt assumes average variable constant of output, at that least in the range of of likely assumes average variable costs are constant perit of output, at least in relative the range of likely the scale of production is likely to cause fixed costs tounit rise. quantities of sales. (i.e. linearity) proportions of costs eachareproduct sold produced quantities of of sales. (i.e.(i.e. linearity) quantities It assumes average variable constant per unitand of output, at least are in theconstant range of likely sales. linearity) assumes thatof the quantity goodsproduced equal the quantity goods sold (i.e., there    ItItassumes that the quantity ofofgoods is is equal to to the quantity of of goods sold (i.e., there is isis quantities sales. (i.e. linearity) (i.e., the sales isproduced constant). It assumes that the quantity ofmix goods produced is equal to the quantity of goods sold (i.e., there no change inthe thequantity quantity ofgoods goods held ininventory inventory atthe the beginning of the period and the no change in of held in at beginning of the period and the no It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is change in quantity leverage of goods held in inventory beginning of the period and the Degree of the operation (DOL). A period). type at of the ratio that uses a large quantity of goods held in inventory at the end of the no of change inheld the quantity of goods held in the inventory at the beginning of the period and the quantity goods in inventory at the endend of period). quantity of goods held in ainventory at the of the period). proportion of company’s fixed costs inproportions helping to summarize its multi-product companies, assumes that relative proportions each product sold quantity of goods held in inventory at the end ofthe the period).    InInIn multi-product companies, it itassumes that thethe relative of of each product sold andand multi-product companies, it assumes that relative proportions of each product sold and earnings before interest and taxes, or EBIT, as it relates to that produced are constant (i.e., the sales mix is constant).  In multi-product companies, it assumes that the relative proportions of each product sold and produced areare constant (i.e., thethe sales mixmix is constant). produced constant (i.e., sales is constant). Degree operation leverage (DOL). type of ratio that uses a large proportion a company's produced are constant (i.e.,(DOL). the sales mix isof constant). company’s operating leverage. Degree ofofof operation leverage AA type ratio that uses a large proportion of of aof company's Degree operation leverage (DOL). A type ofratio ratio that uses a large proportion a company's Degree of operation leverage (DOL). Abefore type of that uses a large proportion ofrelates company's fixedcosts costs in helping tosummarize summarize itsearnings earnings before interest and taxes, or EBIT, as itain relates to that The Degree of Operating Leverage (DOL) can be computed ato that fixed in helping to its interest and taxes, or EBIT, as it fixed costs in helping to summarize its earnings before interest and taxes, or EBIT, as it relates to that fixed costs in helping to summarize its earnings before interest and taxes, or EBIT, as it relates to that company's operating leverage. company's operating leverage. number of equivalent ways; one way it is defined as the ratio of company's operating leverage. company's operating leverage. TheDegree DegreeofofOperating OperatingLeverage Leverage(DOL) (DOL)can can computed a number equivalent ways; The bebe computed in in ainnumber of of equivalent ways; oneone the percentage change Operating Income given percentage The Degree of Operating Leverage (DOL) can be computed a anumber of equivalent ways; The Degree of Operating Leverage in (DOL) can be computed infor a number equivalent ways; one one wayititisisdefined defined asthe the ratio ofthe thepercentage percentage change in Operating Income for aofgiven percentage change way as ratio of change in Operating Income for a given percentage change way it isitdefined as as thethe ratio inOperating OperatingIncome Income a given percentage change change in of Sales: way is defined ratio ofthe thepercentage percentage change change in forfor a given percentage change Sales: ininSales: in Sales: in Sales: ���������������������������� ���������������������������� ���������������������������� ���== ���������������������������� ��� ��� = = ��� ����������������� ����������������� ����������������� �����������������

canbe also be computed as Total Contribution Margin over Operating ThisThis canalso also be computed Total Contribution Margin over Operating Income: This can computed asasTotal Contribution Margin over Operating Income: This also computed Total Contribution Margin Income: This cancan also bebe computed asasTotal Contribution Marginover overOperating Operating Income: Income:

���� �� ������������������ ������������������ ���� �� � ������������������ ������������������ � ������������������ ������������������ ���� �� � �� � �� � � ������������������ ��� = ���= = ������������������ ��� == = === �� ���������������� ������������������ � ����������� � �� � � � �� �� �� ���������������� �� ����������� � �� � ����������� = � �� ���������������� ������������������ � �� � �� � �� =������������������ ��� = ���������������� ������������������ � ����������� �� � �� � � � ��

Alternatively, as Contribution Margin Ratio over Operating Margin: Alternatively, asasContribution Margin Ratio over Operating Margin: Alternatively, Contribution Margin Ratio over Operating Margin: Alternatively, as Contribution Margin Ratio over Alternatively, as Contribution Margin Ratio over Operating Margin:

Operating Margin:

������������������������� ���������������������������� =������������������������� ��� ���== ������������������������� ����������������

���������������� ��� = ���������������� ����������������

For instance, if aifcompany has sales of 1,000,000 units, at price units, $50, unitatvariable cost of $10, For instance, a company sales of 1,000,000 price $50, For instance, ifif$10,000,000, a acompany has ofhas units, at at price $50, unit variable cost of $10, For instance, company hassales sales of1,000,000 1,000,000 price $50, unit variable cost and fixed costs of then its unit contribution isunits, $40, its Total Contribution is $40m, andof its$10, For instance, if a company has sales of 1,000,000 units, at price $50, unit variable cost of unit variable cost of $10, and fixed costs of $10,000,000, then its and costs ofof$10,000,000, then itsitsunit is is $40, itsits Total Contribution is $40m, andand its$10, andfixed fixed costsIncome $10,000,000, then unit contribution $40, Total Contribution is $40m, its Operating is $30m, so its DOL is≈contribution

and fixed costs is of $10,000,000, thenis≈ its is $40, its Total is Contribution is $40m, Operating Income sosoitsitsDOL unit contribution is unit $40,contribution its Total Contribution $40m, and its and its Operating Income is$30m, $30m, DOL is≈ Operating Income is $30m, soIncome its DOL is is≈$30m, so its DOL is Operating ���� 1 =11 ≈ 1.33 ���� ���� 1 �3�� == 1 1 ≈31≈ 1.33 ���� 1.33 �3�� �3�� =3 13 ≈ 1.33 3 �3��

This could also be computed as 80%=$40m/$50m

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CHAPTER 8. Operating and financial leverage. Theory of capital structure

Contribution Margin Ratio divided by 60%=$30m/$50m Operating Margin. It currently has Sales of $50m and Operating Income of $30m, so additional Unit Sales (say of 100,000 units) yield $5m more Sales This couldand also$4m be computed as 80%=$40m/$50m more Operating Income: a 10% increase in Sales and 13.5% increase in Operating Income. Contribution Ratio divided by 60%=$30m/$50m Margin. AssumingMargin the model, for a given level of salesOperating and profit, the DOL is It currently has Sales of $50m and Operating Income of $30m, so additional Unit Sales (say of higher the higher fixed costs are (an example): for a given level of 100,000 units) yield $5m more Sales and $4m more Operating Income: a 10% increase in Sales and sales and profit, a company with higher fixed costs has a higher 13.5% increase in Operating Income. margin, itsand Operating creases Assumingcontribution the model, for a givenand levelhence of sales profit, theIncome DOL isin­ higher the higher fixed more rapidly with Sales than a company with lower fixed costs costs are (an example): for a given level of sales and profit, a company with higher fixed costs has a (and correspondingly contribution margin). more rapidly with Sales than a higher contribution margin, and hence itslower Operating Income increases If alower company has no costs (and lower hencecontribution breaks even at zero), then company with fixed costs (andfixed correspondingly margin). its DOL equals a 10% in Sales a 10% If a company has no fixed1: costs (andincrease hence breaks evenyields at zero), thenincrease its DOL in equals 1: a 10% Income, and its contribution increase in SalesOperating yields a 10% increase in operating Operating margin Income,equals and itsitsoperating margin equals its contribution margin: margin: This could also be computed as 80%=$40m/$50m Contribution Margin Ratio divided by 60%=$30m/$50m Margin. ���������������� ���������� �Operating ������������������ It currently has Sales of $50m and Operating Income of $30m, so additional Unit Sales (say of = �����Sales and $4m more Operating ���������� 100,000 units) yield $5m more Income: a 10% increase in Sales and 13.5% increase in Operating Income. Assuming the model, for a given level of sales and profit, the DOL is higher the higher fixed DOL is example): highestfornear thelevel break-even point;a company in fact,with at higher the break-even costs are (an a given of sales andinprofit, fixed has ais undefined, DOL is highest near the break-even point; fact, at the break-even point,costs DOL point, DOL undefined, because it is infinite: an increase 10% higher contribution margin,isand hence its Operating Income increases more rapidly with of Sales than a because itcompany is infinite: an increase of 10% in sales, say, increases Operating Income for 0 to some positive with lower fixed costs (and correspondingly lowerIncome contribution margin). in sales, say, increases Operating for 0change; to somein positive number (say, $10), whichhas isnoanfixed infinite (or undefined) percentage terms of margins, its If a company costs (and hence breaks even at zero), then its DOL equals 1: a 10% (say, $10), is anSimilarly, infinite percentage innumber Sales yields a 10% increase in Operating Income,(or andaundefined) its operating equals its Operatingincrease Margin is zero, so its DOL iswhich undefined. for very small margin positive Operating Income contribution margin: in termsmay of increase margins,Operating its Operating zero,(or so9,900%) its (say, $.1), a 10% change; increase in sales IncomeMargin to $10, is a 100x increase,

is undefined. for a�very smallsmall, positive for a DOL of 990;DOL in terms of margins, Similarly, its Operating Margin is very so its Operating DOL is very large. ���������������� ���������� ������������������ =increase Income (say, to $.1), a 10% in sales may increase Operating DOL is closely related the rate of increase in the operating margin: as sales increase past the ����� ���������� to margin $10, a 100x 9,900%) increase, for a DOL 990; in and as sales break-even point,Income operating rapidly(or increases from 0% (reflected in a of high DOL), increase, asymptotically approaches the contribution margin: thus the rate of change in operating margin terms of margins, its Operating Margin is very small, so its DOL DOL is highest near the break-even point; in fact, at the break-even point, DOL is undefined, decreases, as does DOL, which asymptotically approaches 1. isthe very large. because it is infinite: an increase of 10% in sales, say, increases Operating Income for 0 to some positive number $10), which is an infinite percentage change; in termsmargin: of margins, DOL(say, is closely related to the (or rateundefined) of increase in the operating as its

Operating Margin is zero, so itspast DOLthe is undefined. Similarly, for a very small positive Operating Income Generally, sales increase break-even point, operating margin rapidly (say, $.1), a 10% increase in sales may increase Operating Income to $10, a 100x (or 9,900%) increase, from 0% (reflected a high DOL), sales increase, for a DOL increases of 990; in terms of margins, its OperatinginMargin is very small,and so itsas DOL is very large. DegreeDOL ofasymptotically Operating Leverage (EBIT costs) / EBIT, is closely related to the(DOL)= rate of increase in + theFixed operating margin: as sales increase past the approaches the contribution margin: thus the rate break-even point, operating margin rapidly increases from 0% (reflected in a high DOL), and as sales of change in operating margin decreases, as does the DOL, which increase, asymptotically approaches the contribution margin: thus the rate of change in operating margin The Degree of Financial Leverage (DFL)= EBIT / ( EBIT - Total Interest expense ); asymptotically approaches decreases, as does the DOL, which asymptotically1.approaches 1.

Generally,

Generally, Degree of Combined Leverage (DCL)= DOL * DFL Degree of Operating Leverage (DOL)= (EBIT + Fixed costs) / EBIT,

The Degree of Financial Leverage (DFL)= EBIT / ( EBIT - Total Interest

Degree of Operating Leverage (DOL)= (EBIT + Fixed costs) / EBIT, Accounting leverage expense ); has the same definition as in investments. There are several ways to define operating leverage, the most common is: (DFL)= The Degree of Financial Leverage EBIT / (DOL EBIT - * Total Interest expense ); Degree of Combined Leverage (DCL)= DFL

Accounting leverage has the same definition as in investments. Degree of Combined Leverage (DCL)=�DOL * DFL ������� ������������� ������� � ������������� There are several ways to define operating leverage, the most ������������������ = = ������� � ������������� � ���������� ���������������� common is: has the same definition as in investments. There are several Accounting leverage ways to define operating leverage, the most common is:

Financial leverage is usually defined as: ������������������ =

������� � ������������� ������� � ������������� = ���������������� ������� � ������������� � ���������� ����������������

������������������ =

Financial leverage is usually defined as:

����������

���������������� Operating leverage is an attempt to estimate ������������������ = the percentage change in operating income (earnings ���������� before interest and taxes or EBIT) for a one percent change in revenue. Financial leverage tries to estimate the percentage change in net incomeincome for a (earnings one percent change Operating leverage is an attempt to estimate the percentage change in operating in operating income. before interest and taxes or EBIT) for a one percent change in revenue.

Accounting leverage has the same definition as in investments. There are several ways to define operating leverage, the most common is: ������������������ =

������� � ������������� ������� � ������������� = Leverage Operating 71 ������� � ������������� � ���������� ����������������

Financial leverageleverage is usuallyisdefined Financial usuallyas: defined as: ������������������ =

���������������� ����������

Operating leverageleverage is an attempt to estimate change in operating income (earnings Operating is an attempt the to percentage estimate the percentage change before interest and taxes or EBIT)income for a one(earnings percent change revenue. in operating beforeininterest and taxes or EBIT) for Financial leverage to estimate percentage change in net income for a one percent change a one tries percent change the in revenue. in operating income. Financial leverage tries to estimate the percentage change in net income There are several variants of each of these definitions, and the financial statements are usually for a one percent change in operating income. adjusted beforeThere the values are computed. Moreover, there are industry-specific are several variants of each of these definitions, and the conventions financial that differ somewhat from the treatment above. statements are usually adjusted before the values are com-puted. A power of DOL and DFLthere are industry-specific conventions that differ Moreover,

somewhat from the treatment above. A power of DOL and DFL The most obvious risk of leverage is that it multiplies losses. A corporation that borrows too much money might face bankruptcy during a business downturn, while a less-levered corporation might survive. An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%. There is an important implicit assumption in that account, however, which is that the underlying levered asset is the same as the unlevered one. If a company borrows money to modernize, or add to its product line, or expand internationally, the additional diver­sification might more than offset the additional risk from leverage. Or if an investor uses a fraction of his or her portfolio to margin stock index futures and puts the rest in a money market fund, he or she might have the same volatility and expected return as an investor in an unlevered equity index fund, with a limited downside. So while adding leverage to a given asset always adds risk, it is not the case that a levered company or investment is always riskier than an unlevered one. In fact, many highly-levered hedge funds have less return volatility than unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than unlevered technology companies. Degree of Combined Leverage A type of ratio that is related to leverage and that is used for making a determination of the best combined level of operating and financial leverage for that company’s earnings per share, or EPS, if given a change in the amount of the company’s sales. (DCL)= DOL * DFL Modiglani-Miller Model Proposition that (in an efficient capital market) a firm’s cost of capital is independent of the type of capital employed. Thus, whether a firm uses debt, sale of ordinary shares (common stock), retained earnings (instead of distributing profit as dividends), or any com­ bination thereof to finance its capital needs, its market value is not affected. This concept emphasizes that what investors look for is the quality of earnings, expected rate of return, and the associated

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CHAPTER 8. Operating and financial leverage. Theory of capital structure

risks, not what is the firm’s dividend policy or how leveraged (see Leverage) it is. Therefore, the fact that firms still worry about these matters reflects the imperfection of the capital market and effect of the government’s taxation policies. Named after its Nobel laureate proposers, Italian economist Franco Modigliani (1918-) and the US economist Merton H. Miller (1923-). In other words, Miller and Modigliani Model assume that the dividends are irrelevant. Dividend irrelevance implies that the value of a firm is unaffected by the distribution of dividends and is de­termined solely by the earning power and risk of its assets. Under conditions of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of the shares, according to this model. Assumptions of MM model 1. Existence of perfect capital markets and all investors in it are rational. Information is available to all free of cost, there are no transactions costs, securities are infinitely divisible, no investor is large enough to influence the market price of securities and there are no floatation costs. 2. There are no taxes. Alternatively, there are no differences in tax rates applicable to capital gains and dividends. 3. A firm has a given investment policy which does not change. It implies that the financing of new investments out of retained earnings will not change the business risk complexion of the firm and thus there would be no change in the required rate of return. 4. Investors know for certain the future investments and profits of the firm (but this assumption has been dropped by MM later). Argument of this Model 1. By the argument of arbitrage, MM Model asserts the ir­rele­vance of dividends. Arbitrage implies the distribution of earnings to shareholders and raising an equal amount externally. The effect of dividend payment would be offset by the effect of raising additional funds. 2. MM model argues that when dividends are paid to the shareholders, the market price of the shares will decrease and thus whatever is gained by the investors as a result of increased dividends will be neutralized completely by the reduction in the market value of the shares. 3. The cost of capital is independent of leverage and the real cost of debt is the same as the real cost of equity, according to this model. 4. That investors are indifferent between dividend and retained earnings implies that the dividend decision is irrelevant. With divi­dends being irrelevant, a firm’s cost of capital would be inde­pendent of its dividend-payout ratio. 5. Arbitrage process will ensure that under conditions of uncertainty also the dividend policy would be irrelevant.

Operating Leverage

73

MM Model: Market price of the share in the beginning of the period = Present value of dividends paid at the end of the period + Market price of share at the end of the period.

P0 = 1/(1 + ke) x (D1 + P1)

Where: P0 = Prevailing market price of a share ke = cost of equity capital Dividend to be received at the end of period 1 D1 = and P1 = Market price of a share at the end of period 1. Value of the firm, nP0

=

(n + ∆ n) P1 – I + E (1 + ke)

number of shares outstanding at the beginning of the period Change in the number of shares outstanding ∆n= during the period/ additional shares issued. I = Total amount required for investment E = Earnings of the firm during the period.

Where: n

=

Limitations of MM model: 1. The assumption of perfect capital market is unrealistic. Prac­ti­ cally, there are taxes, floatation costs and transaction costs. 2. Investors cannot be indifferent between dividend and retained earnings under conditions of uncertainty. This can be proved at least with the aspects of i) near Vs distant dividends, ii) informational content of dividends, iii) preference for current income and iv) sale of stock at uncertain price. Business Risk The possibility that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit. Business risk is influenced by numerous factors, including sales volume, perunit price, input costs, competition, overall economic climate and go­vernment regulations. A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure that it can meet its financial obligations at all times. Investors in a company are exposed not only to business risk, but also to financial risk, liquidity risk, systematic risk, exchange-rate risk and country-specific risk. To calculate business risk, analysts use four simple ratios: contribution margin, operation leverage effect, financial leverage effect and total leverage effect. For more complex calculations, analysts can incorporate statistical methods.

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CHAPTER 8. Operating and financial leverage. Theory of capital structure

Financial Risk The risk that a company  will not have  adequate  cash flow to  meet financial obligations. Financial risk is the additional risk a sha­ rehol­der bears when a company uses debt in addition to equity financing. Companies that issue more debt instruments would have higher financial risk than companies financed mostly or entirely by equity. Capital Structure A mix of a company’s long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is  how a firm finances its overall operations and growth by  using different sources of funds. Debt comes in the form of bond issues or longterm notes payable, while equity  is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. A company’s proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital struc­ture they are most likely referring to a firm’s debt-to-equity ratio, which provides insight into how risky a company is. Usually a com­pany more heavily financed by debt poses  greater risk, as this firm is relatively highly levered. Optimal Capital Structure The best debt-to-equity ratio for a firm that maximizes its value. The optimal capital structure for a company is one which offers a balance between the ideal debt-to-equity range and minimizes the firm’s cost of capital. In theory, debt financing generally offers the lowest cost of capital due to its tax deductibility. However, it is rarely the optimal structure since a company’s risk generally increases as debt increases. A company’s ratio of short and long-term debt should also be considered when examining its capital structure. Capital structure is most often referred to as a firm’s debt-to-equity ratio, which provides insight into how risky a company is for potential investors. Determining an optimal capital is a chief requirement of any firm’s corporate finance department. Estimating the Optimal Capital Structure There are numerous ways in which a company’s optimal capital structure can be estimated. The most commonly used ones are: Method 1 One method of estimating a company’s optimal capital structure is utilizing the average or median capital structure of the principle companies engaged in the market approach. This approach is helpful as the appraiser is well aware about which companies are included in the analysis and the degree to which they are related to the subject company. However, this method features a limitation that fluctuations in market prices and the spread out nature of debt offerings and retirements might cause the actual capital structure of a

Operating Leverage

75

principle company to be significantly different from the target capital structure. Method 2 This method is applied if the risk of a company did not change because of the nature of its capital structure, and a company would wish as much debt as possible, as the interest payments are tax deductible and debt financing is always cheaper than equity financing. The main objective of this method is determining the debt level at which the benefits of increased debt does not overshadow the increased risks and potential costs associated with a economically distressed company.   Questions for self-control: 1. What is the operating leverage? 2. How can we use the financial leverage? 3. What can you say about Optimal capital structure?

76

CHAPTER 9. Dividends and repurchases: distributions to shareholders

Chapter

9

Dividends and repurchases: distributions to shareholders

Once a company has been formed and continues in operation, it should have earnings to retain or to distribute to the owners. This disposition of these earnings is a fundamental problem of financial management. In organizations, which are closely held, the problem is not there because the shareholders run the organization themselves and can dictate the terms. In large organizations, however, the situation is different. Here the policy concerning the distribution of earnings is normally delegated to the directors of the company by the shareholders. However, they retain the final approval authority and the dividend is paid only after final approval of the shareholders in the Annual General Meeting. Once it is approved in theAGM, the dividend cheque is sent to the shareholders within a month and is normally payable in the city of residence of the shareholder so as to expedite the payment to him. The management of an enterprise has an important financial deci-sion to decide about the disposition of income left after meeting all business expenses. Generally, of the total business profits, a portion is retained for reinvestment in the business and rest is distributed to shareholders as dividend. Organizations finance a large portion of their needs internally, that is, from retained earnings and from non-cash charges, such as depreciation, to the extent that they are covered by earnings. To the extent that the organizations are dependent on internal funds to meet their capital and other requirements, there could be a concern that the funds retained may not be used as productively as they might be elsewhere. In a small concern (especially proprietorship/ partnership) the owners are very likely to compare the return to be gained from retained earnings in the business and the return that 76

Theories of Dividends

77

they might make from some other investment of equivalent risk. Because they do not participate directly in formulating dividend policy, shareholders in large companies do not have the chance to make this direct comparison. Thus earnings that are retained in many companies have not met a «market test» and therefore we may not be sure that they should have been retained. The objective of the dividend policies should be to divert funds from the less productive operations to more productive ones. But it is very difficult for the directors and the management to accept the fate of a declining company and to allow the gradual liquidation of their company, as would be suggested by economic thought. If the ma­ nagement finds itself in a declining industry, they want to retain more funds for the business operations and pay out less so as to conserve the funds. Something that is not beneficial for the shareholders. They also try to retain more to fund other more profitable investments so the continuity of the corporation can be maintained. The important issue is to decide the portion of profit to declare for dividend payout and for retaining in business. The dividend policy decision involves two questions: 1) What fraction of earnings should be paid out, on average, over time? 2) Should the firm maintain a steady, stable dividend growth rate? Before we try and answer these questions, let us look at the theories related to dividend decisions. After that we will look at the empirical evidence of the same. Theories of Dividends Traditional Position: MM Model. Dividend Irrelevance: Miller and Modigliani. Miller and Modigliani developed the dividend irrelevance theory, which holds that a firm’s dividend policy has no effect either on the value of the firm or on its cost of capital (Do you remember the capital structure theories?). MM used the same five assumptions as they used in the debt policy: 1. There are no personal or corporate income taxes; 2. There are no share floatation or transaction costs; 3. Investors are indifferent between dollar of dividends and dollar of capital Gains; 4. The firm’s capital investment policy is independent of its dividend policy; 5. Investors and managers have the same set of information (symmetric information) regarding future investment opportunities. The above assumptions that give us MM1 actually yield a far more powerful result than just the irrelevancy of debt policy. They imply that the entire financial policy followed by the organization is irrelevant for its valuation; all that matters is the organization’s portfolio of investment projects. Hence, capital structure, dividend policy and risk management activities (among other things) are all ineffectual in altering organization’s value.

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CHAPTER 9. Dividends and repurchases: distributions to shareholders

Consider a firm that has fixed its investment policy. In each period, it is left with a net cash flow, which is simply the difference between operating income and investment costs. A straightforward corporate dividend policy would just be to pay out this net cash flow to the holders of the equity. However, consider a firm that desires to pay a dividend in excess its cash flow. In order to do this, the firm can raise funds by issuing new equity. Alternatively, the firm could borrow money, which assuming perfect capital markets is a transaction with the NPV of zero. Conversely, a firm wishing to pay a smaller dividend might spend the balance of its net cash flow on repurchasing equity. The key idea here is that a firm can choose whatever pay-out policy it desires, funding the policy through share issues/ repurchases; hence; dividend policy is irrelevant. In other words, they reasoned that the value of a firm is determined by its basic earning power and its risk class, and, therefore, that a firm’s value depends on its asset investment policy rather than on how earnings are split between dividends and retained earnings. MM demonstrated, under the light of above mentioned assumptions, which if a firm pays higher dividends, then it must sell more shares to new investors, and the value of the shares given to the new investors is exactly equal to the dividends paid out. From the individual investor’s point of view we can show that the dividend policy is irrelevant too. To do this we can use a similar argument to that employed when we said that shareholders are indifferent to capital structure changes; shareholders are indifferent to dividend policy as, through appropriate purchases or sales of shares, they can replicate any dividend policy they wish. Hence, investors will not value a firm paying a particular dividend policy different to any other firm such that firm value does not depend on dividends. The MM assumptions are not realistic, and they obviously do not hold precisely. Firms and investors do pay income taxes, firms do incur floatation costs, and investors do incur transaction costs. Further, managers often have better information than outside investors. Thus, MM’s theoretical conclusions on dividend irrelevance may not be valid under real-world conditions. Radical Models Bird-in-the-hand Theory: Gordon and Lintner Gordon and Lintner argue that the cost of equity increases as the dividend payout is reduced, because investors can be surer of re­ ceiving dividends than the capital gains that are expected to result from retained earnings. Therefore, the theory holds that the value of the firm will be maximized by a high dividend payout ratio, because investors regard actual dividends as being less risky than potential capital gains. This means that this theory is in direct contrast with MM theory of dividend irrelevance.

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Tax Preference Theory: Litzenberger and Ramaswamy If a firm retains its earnings then the share gains in value in the market which results in capital gains for the shareholder. If the company pays out dividend the share value does not increase but the shareholder gains cash. In case of getting dividends the shareholder has effectively paid only 10% tax while in the case of capital gains he would be in the 20% tax bracket. This means that he would prefer to get dividends rather than get capital gains but if the capital gains are disproportionate he would prefer capital gains rather than dividends. The tax preference theory holds that the value of the firm will be maximized by a low dividend payout, because investors pay lower effective taxes on capital gains than on dividends internationally. In India the situation is different and the shareholder would prefer dividends rather than capital gains. The above analysis suggests that there is a preference for current dividends – that, in fact, there is a direct relationship between the dividend policy of a firm and market value. The argument goes on the lines that investors are generally risk averse and therefore attach less risk to current as opposed to future dividends or capital gains. In the words of John E. Kirshmann «Of two stocks with identical earnings, records and prospects but the one paying a larger dividend than the other, the former will undoubtedly command a higher price merely because shareholder’s prefer present to future values. Myopic vision plays a part in the price-making process. Stock­holders often act upon the principle that a bird in hand is work two in the bush and for this reason are willing to pay a premium for the stock with the higher dividend rate, just as they discount the one with the lower dividend rate». Benjamin Graham and David L. Todd, authors of the well-known security valuation book ‘Security Analysis’ also say that «The typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself. No instances are on record in which the withholding of dividends for the sake of future profits has been hailed with such enthusiasm as to advance the price of the stock. The direct opposite has invariably been true. Given two com­panies in the same general position and with the same earnings po­wer, the one paying the larger dividend will always sell at the higher prices». These observations are supported by the share valuation models that have been developed using the dividend payouts. Walter’s model (which is actually an adaptation of the Gordon’s model) are given below. Walter’s Model Walter’s model is one of the earliest dividend models is adapted from the Gordon’s model for valuation of an equity share. Gordon’s model gives us the cost of internally generated common equity

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P=D1 / (K-r*b), Here, b is the percentage of earnings retained, r is the expected rate of profitability from the retained earnings. It follows from the formula that if the earnings retained gives you a higher return than the cost of capital, you would get a positive return and the share price would go up and otherwise the share price would come down because of the higher earnings retained. Walter’s formula highlights the return on retained earnings relative to the average market rate of return on investment (market capi­ talization rate) as the critical determinant of dividend policy. A high rate of return on retained earnings indicates a low payout ratio, whereas a low rate relative to the market average indicates the desirability of a high payout ratio to increase the price of the equity shares. Therefore to increase the share valuation a company may go in for a higher payout in the form of a dividend. But this reduces the growth rate of the dividends (keeping all other things constant) bringing it back to square one. Also a high dividend policy may force the firm to go to the capital markets more often. In practice, most firms try to follow a policy of paying a steadily increasing dividend. This policy provides investors with stable, dependable income, and if the signaling theory is correct, it also gives investors information about management’s expectations for earnings growth. Most firms use the residual dividend model to set a long run target payout ratio which permits the firm to satisfy its equity requirements with retained earnings. Factors Affecting Dividend Policies Fund Requirements: Generally, the firms that have substantial investment opportunities and consequently considerable funding needs to keep their payout ratio rather low to conserve resources for growth. On the other hand, firms which have rather limited investment avenues usually pursue a more generous payout policy. Bond indentures: Debt contracts often restrict dividend payments to earnings generated after the loan was granted. Also, debt contracts frequently stipulate that no dividends can be paid unless the current ratio, the interest coverage ratio, and other safety ratios exceed stated minimum values. Preference share restrictions: Typically, equity dividends cannot be paid if the company has omitted (not paid) dividend on its preference shares. The preference dividends arrears must be paid before equity dividends can be resumed. Availability of cash: Cash dividends can only be paid with cash. Thus, a shortage of cash in the bank can restrict dividend payments. However, unused borrowing capacity can offset this factor. Control: If the management is concerned about maintaining control, it may be reluctant to sell new shares; hence it may retain more earnings than it otherwise would. This factor is especially important for small, closely held firms.

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Differences in the cost of External equity and Retained Ear­nings: Cost of external equity is obviously more than the cost of retained earnings due to the floatation costs of raising the former. Therefore, if the company has some expansion plans which involves capital expenditure it is very likely that it would prefer a low dividend payout ratio. Signaling: As we have noted earlier, managers can and do use dividends to signal the firm’s situation. For example, if management thinks that investors do not fully understand how well the firm is doing, and how good its prospects are, it may increase the dividend by more than that was anticipated in an effort to boost the stock price. Shareholder Preference: When equity shareholders have greater interest in current dividend vis-a-vis capital gains, the firm may be inclined to follow a liberal dividend payout policy. While the preference of equity shareholders has some influence over the dividend policy of the firm, the dividend policy may have a greater impact on the kind of shareholders who are attracted towards it. Each firm is likely to draw itself a «clientele» which finds its payout policy attractive. As mentioned above certain formal and casual empirical obser­vations point in the opposite direction. Perhaps the most famous set of results on actual dividend policy was compiled and presented by John Lintner. Lintner interviewed the management of a sample of US corporations in order to determine what lay behind their dividend-setting decisions. His research led to the four following stylised facts: • Managers seem to have a target dividend pay-out level; • This pay-out level is determined as a proportion of long run (i.e. sutainable) earnings of the firm; • Managers are more concerned with changes in dividends rather than the actual level of dividends; • Managers prefer not to make dividend changes that might need to be reversed (e.g. cutting dividends after having raised them in the previous period). As the second fact implies, it is not current but long-run earnings that matter in setting dividends such that dividends can be seen to be smoothed relative to earnings. There are three basic types of dividend policies that are used by the companies. They are: 1. Stable dividends; 2. Target Payout Ratio; 3. Regular and extra dividends. 1. Stable dividends: A company following this type of a policy maintains a constant dividend rate irrespective of the actual earnings level and the company tries to maintain it even when during the recession the earnings go down below the actual dividends pay, trying to signal to the investor that this is a temporary phase and earnings will be back up when the economy revives.

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Companies expect that the investors will place a premium on the shares of a company which pays stable dividends and only increases its dividend payment when it believes that increase can be maintained. A stable dividend policy irrespective of fluctuating earnings also is beneficial because many institutions take decisions based on the actual payout by the companies. Signalling effect of this type has already been mentioned above. This is the most favoured type of dividend policies adopted by the companies the world over. 2. Target Payout Ratio: Although there is a reason to believe that stable dividends have a positive effect on a company’s share price, many firms set a bench-mark target payout ratio (or range). They only deviate from this target to achieve relatively stable dividends or stable and occasionally increasing ones. Lintner contents that companies seek to maintain a target dividend payout ratio over the long run, but only with a lag. For example, a company may decide that it will pay around 40 percent of its earnings as dividends and only increase it when this ratio falls to 30 per cent of the earnings that the company is reasonably sure of. This is especially applicable in case of companies with stable earnings and earnings growth for only they can sustain a target payout ratio in the long run. 3. Regular and extra dividends: Especially when a company earns above average earnings because of any reason but which is nonrecurring in nature, it proposes a extra dividend over and above the regular dividend it pays. This extra earnings could be due to divestment of a plant or business operations and the company has no possible utilization of the same. In line with the recommendations that investors like to receive the money back from the company rather than the company utilizing that money in non-business activities, the companies usually return the money back to the shareholders. This labeling of extra dividends or one-time dividends is given to help the investors appreciate the fact that extra dividends are non-recurring in nature and this is the only year this is being paid. There are other ways of returning cash to shareholders and one of the biggest ones is gaining ground in India recently. This is share buyback. Stock Dividends and Stock Splits An integral part of dividend policy of a firm is the use of bonus shares and stock splits. Both involve issuing new shares on a pro rata basis to the current shareholders while the firm’s assets, its earnings, the risk being assumed and the investors percentage ownership in the company remain unchanged. The only definite result from either a bonus share or share split is the increase in the number of shares outstanding. The share split is similar to bonus issue from the economic point of view though there are some differences from the accounting point of view. In the equity portion of the firm, a bonus issue reduces the retained earnings and correspondingly increases paid-up equity and share premium, if any, whereas stock/share split has no such

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effect. The economic effect of both is to increase the number of equity shares outstanding. As pointed out earlier, no major economic benefit results from bonus shares and share splits. Yes, certain advantages are associated with them. In the first place, the issue of bonus shares / share splits would have the effect of bringing the market price of shares within more popular range as a result of larger number of shares outstanding. The larger number of outstanding shares will also promote more active trading in the shares due to availability of floating stock. Yet another advantage might relate to the informational content of bonus/split announcement. The announcement is perceived as favorable news by the investors in that with growing earnings, the company has bright prospects and the investors can reasonably look for increase in future dividends. Moreover, it enables the conservation of corporate cash. If the bonus share is an effort to conserve cash for profitable investment op­ portunities, the share prices will tend to rise and the shareholders benefit. However, if the move to conserve cash relates to financial difficulties within the firm, the market price will most likely react adversely. Finally, bonus / split announcements improve the prospect of raising additional funds particularly through the issue of convertible debentures. Repurchase of Stock As an alternative to paying cash dividends, a company may distribute income to its shareholders by repurchasing its own shares. Assuming that the repurchase does not adversely affect the firm’s earnings, the earnings per share on the remaining shares will increase, resulting in a higher market price per share, which means that the capital gains will have been substituted for dividends. A repurchase that is part of capital restructuring is different from a regular repurchase mentioned above. In a capital restructuring repurchase plan asset sales and issuance of debt are used to bring in additional capital and then this capital is distributed to shareholders through a major, one-time share repurchase. Advantages of Share Repurchases: 1. Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management’s belief that the firm’s shares are undervalued; 2. The shareholders have a choice to sell or not to sell in share repurchase situation. So those who prefer capital appreciation can get the same and those who prefer cash can sell the shares; 3. Repurchase can help reduce the supply of shares in the market, thereby increasing the value of the share; 4. Management dislikes increasing cash dividend as it sends positive signals about future profitability and if the company cannot maintain the same in the future it may result in a sharp fall in the share price. Therefore, if the earnings increase is

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only temporary then the management may prefer to make the distribution in the form of a share repurchase; 5. It can help in drastically changing the capital structure of the company, which is otherwise very difficult. There are certain disadvantages too: 1. The shareholder may benefit more from cash dividends than share repurchase if the market discounts the earnings more than a given level; 2. The selling shareholder may lose because of the share repurchase plan as he would get the long term benefit of share repurchase; 3. The company may pay too high a price for share repurchase, resulting in a reduction in value for existing shareholders. All this means that share repurchases on a systematic, dependable basis is probably not a good idea. However, it can be given careful consideration if the market is not discounting the share in a proper manner and the company has extra cash that it can utilise for the same. Repurchases can be especially valuable to a firm that wants to make a large shift in its capital structure within a short period of time. Procedural Aspects The important events and dates in the dividend payment pro­cedure are: 1. Board Resolution: The dividend decision is the prerogative of the board of directors. Hence, the board of directors should in a formal meeting resolve to pay the dividend. 2. Shareholder Approval: The resolution of the board of di­rectors to pay the dividend has to be approved by the shareholders in the annual general meeting. However, their approval is not required in the case of declaration of interim dividend. Further, it should be noted that the shareholders in the annual general meeting have neither the power to declare the dividends (if the Board of Directors do not recommend it) nor to increase the amount or dividend. However, they can reduce the amount of the proposed dividend. 3. Record Date: The dividend is payable to shareholders whose names appear in the register of members as on the record date. 4. Dividend Payment: Once a dividend declaration has been made, dividend warrant must be posted within 30 days. Within a period of 7 days, after the expiry of 30 days, unpaid dividends must be transferred to a special account opened with a scheduled bank. In case the company fails to transfer the unpaid dividend to the ‘unpaid dividend account’ within 37 days of the declaration of dividend, an interest of 12 per cent per annum on the unpaid amount is to be paid by the company. The interest so accruing is to be paid to the shareholders in the proportion of the dividend amount remaining unpaid to them. The dividend will be paid to the registered shareholder or to his order or to his banker or in case a share warrant has been issued to

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the bearer of such a share warrant. In the case of joint-holders, the dividends should be paid to the first joint holder. Further, as per the notification issued by the Department of Com­pany Affairs, the payment of dividend to the shareholders involving the fraction of 50 paise and above be rounded off to the rupee and the fraction of less than 50 paise may be ignored. In the case of dematerialized shares (i.e., the shares held in electronic form), the corporate firms are required to collect the list of members holdings shares in the depository and pay them the dividend. 5. Unpaid dividend: If the money transferred to the ‘unpaid dividend account’ in the scheduled bank remains unpaid / unclaimed for a period of 7 years from the date of such transfer, the company is required to transfer the same to the ‘Investor, Education and Pro­ tection Fund’ established for the purpose. Dividend Policies in Practice Generous Dividend and Bonus Policy. Firms which follow this policy reward shareholders generously by stepping up total dividend payment over time. Typically, these firms maintain the dividend rate at a certain level (15 to 25 per cent) and issue bonus shares when the reserves position and earnings potential permit. Such firms naturally have a strong share holder orientation. More or Less Fixed Dividend Policy. Some firms have a target dividend rate which is usually in the range 10 per cent to 20 per cent which they consider as a reasonable compensation to equity share­holders. Such firms normally do not issue bonus shares frequently, may be once in few years, the dividend rate may be raised slightly to provide somewhat higher compensation to equity shareholders to match the higher returns from other forms of investment. Erratic Dividend Policy. Firms which follow this dividend policy seem to be indifferent to the welfare of equity shareholders. Dividends are paid erratically whenever the management believes that it will not strain its resources. Questions for self-control: 1. Three dividend policies. 2. Comparison of dividends and repurchases. 3. Stock splits.

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CHAPTER 10. Financial statements: balance sheet, cash flow and p&l reports

Chapter

10

Financial statements: balance sheet, cash flow and p&l reports

The Balance Sheet The balance sheet is an accountant’s snapshot of the firm’s ac­ counting value on a particular date, as though the firm stood momentarily still. The balance sheet has two sides: On the left are the assets and on the right are the liabilities and stockholders’ equity. The balance sheet states what the firm owns and how it is financed. The accounting definition that underlies the balance sheet and describes the balance is Assets = Liabilities + Stockholders’ equity We have put three-line equality in the balance equation to indicate that it must always hold, by definition. In fact, the stockholders’ equity is defined to be the difference between the assets and the liabilities of the firm. In principle, equity is what the stockholders would have remaining after the firm discharged its obligations. The assets in the balance sheet are listed in order by the length of time it normally would take an ongoing firm to convert them to cash. The asset side depends on the nature of the business and how ma­nagement chooses to conduct it. Management must make decisions about cash versus marketable securities, credit versus cash sales, whether to make or buy commodities, whether to lease or purchase items, the types of business in which to engage, and so on. The liabilities and the stockholders’ equity are listed in the order in which they would typically be paid over time. 86

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The liabilities and stockholders’ equity side reflects the types and proportions of financing, which depend on management’s choice of capital structure, as between debt and equity and between current debt and long-term debt. When analyzing a balance sheet, the financial manager should be aware of three concerns: accounting liquidity, debt versus equity, and value versus cost. Accounting Liquidity Accounting liquidity refers to the ease and quickness with which assets can be converted to cash. Current assets are the most liquid and include cash and those assets that will be turned into cash within a year from the date of the balance sheet. Accounts receivable are amounts not yet collected from customers for goods or services sold to them (after adjustment for potential bad debts). Inventory is composed of raw materials to be used in production, work in process, and finished goods. Fixed assets are the least liquid kind of assets. Tangible fixed assets include property, plant, and equipment. These assets do not convert to cash from normal business activity, and they are not usually used to pay expenses such as payroll. Some fixed assets are not tangible. Intangible assets have no phy­sical existence but can be very valuable. Examples of intangible as­sets are the value of a trademark or the value of a patent. The more liquid a firm’s assets, the less likely the firm is to experience prob­lems meeting short-term obligations. Thus, the probability that a firm will avoid financial distress can be linked to the firm’s liquidity. Unfortunately, liquid assets frequently have lower rates of return than fixed assets; for example, cash generates no investment income. To the extent a firm invests in liquid assets, it sacrifices an op­portunity to invest in more profitable investment vehicles. Debt versus Equity Liabilities are obligations of the firm that require a payout of cash within a stipulated time period. Many liabilities involve contractual obligations to repay a stated amount and interest over a period. Thus, liabilities are debts and are frequently associated with nominally fixed cash burdens, called debt service that put the firm in default of a contract if they are not paid. Stockholders’ equity is a claim against the firm’s assets that is residual and not fixed. In general terms, when the firm borrows, it gives the bondholders first claim on the firm’s cash flow. 1 Bondholders can sue the firm if the firm defaults on its bond contracts. This may lead the firm to declare it bankrupt. Stockholders’ equity is the residual difference between assets and liabilities. This is the stockholders’ share in the firm stated in accounting terms. The ac­ counting value of stockholders’ equity increases when retained earnings are added. This occurs when the firm retains part of its earnings instead of paying them out as dividends.

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Value versus Cost The accounting value of a firm’s assets is frequently referred to as the carrying value or the book value of the assets. Under generally accepted accounting principles (GAAP), audited financial statements of firms in the United States carry the assets at cost. Thus the terms carrying value and book value are unfortunate. They specifically say «value», when in fact the accounting numbers are based on cost. This misleads many readers of financial statements to think that the firm’s assets are recorded at true market values. Market value is the price at which willing buyers and sellers would trade the assets. It would be only a coincidence if accounting value and market value were the same. In fact, management’s job is to create value for the firm that exceeds its cost. Many people use the balance sheet, but the information each may wish to extract is not the same. A banker may look at a balance sheet for evidence of accounting liquidity and working capital. A supplier may also note the size of accounts payable and therefore the general promptness of payments. Many users of financial statements, in­cluding managers and investors, want to know the value of the firm, not its cost. This information is not found on the balance sheet. In fact, many of the true resources of the firm do not appear on the balance sheet: good management, proprietary assets, favorable eco­no­­mic conditions, and soon. Henceforth, whenever we speak of the value of an asset or the value of the firm, we will normally mean its market value. So, for example, when we say the goal of the financial manager is to increase the value of the stock, we mean the market value of the stock. The Income Statement The income statement measures performance over a specific period of time, say, a year. The accounting definition of income is: Revenue – Expenses = Income If the balance sheet is like a snapshot, the income statement is like a video recording of what the people did between two snapshots. The income statement usually includes several sections. The operations section reports the firm’s revenues and expenses from principal operations. One number of particular importances is earnings before interest and taxes (EBIT), which summarizes earnings before taxes and financing costs. Among other things, the nonoperating section of the income statement includes all financing costs, such as interest expense. Usually a second section reports as a separate item the amount of taxes levied on income. The last item on the income statement is the bottom line, or net income. Net income is frequently expressed per share of common stock, that is, earnings per share. When analyzing an income statement, the financial manager should keep in mind GAAP (IFRS), noncash items, time, and costs.

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Financial standards Revenue is recognized on an income statement when the earnings process is virtually completed and an exchange of goods or services has occurred. Therefore, the unrealized appreciation from owning property will not be recognized as income. This provides a device for smoothing income by selling appreciated property at convenient times. For example, if the firm owns a tree farm that has doubled in value, then, in a year when its earnings from other businesses are down, it can raise overall earnings by selling some trees. The matching principle of GAAP dictates that revenues be matched with expenses. Thus, income is reported when it is earned, or accrued, even though no cash flow has necessarily occurred (for example, when goods are sold for credit, sales and profits are reported). Guidelines and rules set by the International Accounting Standards Board (IASB) that companies and organizations can follow when compiling financial statements. The creation of international standards allows investors, organizations and governments to compare the IFRS-sup­ported financial statements with greater ease. Over 100 countries currently require or permit companies to comply with IFRS stan­dards. The International Financial Reporting Standards were pre­viously called the International Accounting Standards (IAS). Organi­zations in the United States are required to use the Generally Ac­cepted Accounting Principles (GAAP). A major difference between US GAAP and IFRS is the fact that three fundamentally different concepts of capital and capital maintenance are authorized in IFRS while US GAAP only authorize two capital and capital maintenance concepts during low inflation and deflation: (1) physical capital maintenance and (2) financial capital maintenance in nominal mone­ tary units (traditional Historical Cost Accounting) as stated in Par 45 to 48 in the FASB Conceptual Statement Nº 5. US GAAP does not recognize the third concept of capital and capital maintenance during low inflation and deflation, namely, financial capital main­ tenance in units of constant purchasing power as authorized in IFRS in the Framework, Par 104 (a) in 1989. Noncash Items The economic value of assets is intimately connected to their future incremental cash flows. However, cash flow does not appear on an income statement. There are several noncash items that are expenses against revenues, but that do not affect cash flow. The most important of these is depreciation. Depreciation reflects the accountant’s estimate of the cost of equipment used up in the production process. For example, suppose an asset with a five year life and no resale value is purchased for $1,000. According to accountants, the $1,000 cost must be expensed over the useful life of the asset. If straightline depreciation is used, there will be five equal installments and $200 of depreciation expense will be incurred each year. From a finance perspective, the cost of the asset is the actual negative cash

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flow incurred when the asset is acquired (that is, $1,000, not the accountant’s smoothed $200-peryear depreciation expense). Another noncash expense is deferred taxes. Deferred taxes result from differences between accounting income and true taxable income. However, the theory is that if taxable income is less than accounting income in the current year, it will be more than accounting income later on. Consequently, the taxes that are not paid today will have to be paid in the future, and they represent a liability of the firm. This shows up on the balance sheet as deferred tax liability. From the cash flow perspective, though, deferred tax is not a cash outflow. In practice, the difference between cash flows and accounting income can be quite dramatic, so it is important to understand the difference. For example, Sirius XM Radio reported a net loss of about $413 million for the third quarter of 2009. That sounds bad, but Sirius XM also reported a positive cash flow of $116 million from operating activities for the same quarter! Time and Costs It is often useful to think of all of future time as having two distinct parts, the short run and the long run. The short run is that period of time in which certain equipment, resources, and com­mitments of the firm are fixed; but the time is long enough for the firm to vary its output by using more labor and raw materials. The short run is not a precise period of time that will be the same for all industries. However, all firms making decisions in the short run have some fixed costs, that is, costs that will not change because of fixed commitments. In real business activity, examples of fixed costs are bond interest, overhead, and property taxes. Costs that are not fixed are variable. Variable costs change as the output of the firm changes; some examples are raw materials and wages for laborers on the production line. In the long run, all costs are variable. Financial accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs. Product costs are the total production costs incurred during period − raw materials, direct labor, and manufacturing overhead − and are reported on the income statement as cost of goods sold. Both variable and fixed costs are included in product costs. Period costs are costs that are allocated to a time period; they are called selling, general, and administrative expenses. One period cost would be the company president’s salary. Net Working Capital Net working capital is current assets minus current liabilities. Net working capital is positive when current assets are greater than cur­rent liabilities. This means the cash that will become available over the next 12 months will be greater than the cash that must be paid out. In addition to investing in fixed assets (i.e., capital spending), a firm can invest in net working capital. This is called the change in net

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working capital. The change in net working capital is usually positive in a growing firm. Financial Cash Flow Perhaps the most important item that can be extracted from financial statements is the actual cash flow of the firm. There is an official accounting statement called the statement of cash flows. The first point we should mention is that cash flow is not the same as net working capital. For example, increasing inventory requires using cash. Because both inventories and cash are current assets, this does not affect net working capital. In this case, an increase in a particular net working capital account, such as inventory, is associated with decreasing cash flow. Just as we established that the value of a firm’s assets is always equal to the value of the liabilities and the value of the equity, the cash flows received from the firm’s assets (that is, its operating activities), CF( A ), must equal the cash flows to the firm’s creditors, CF( B ), and equity investors, CF( S ): CF(A) = CF(B) + CF(S) The first step in determining cash flows of the firm is to figure out the cash flow from operations. As can be seen in Table, operating cash flow is the cash flow generated by business activities, including sales of goods and services. Operating cash flow reflects tax payments, but not financing, capital spending, or changes in net working capital. Items Earnings before interest and taxes Depreciation Current taxes Operating cash flow

IN $ MILLIONS $ 219 $ 90 $ -71 $ 238

Another important component of cash flow involves changes in fixed assets. Questions for self-control: 1. Which items are included into assets and liabilities? 2. The results of financial activities. 3. Capital gain or loss.

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CHAPTER 11. Working capital management: Cash management, accounts payable

Chapter

11

Working capital management: Cash management, accounts payable

Concept Working capital could be defined as the portion of assets used in current operations. The movement of funds from working capital to income and profits and back to working capital is one of the most important characteristics of business. This cyclical operation is concerned with utilization of funds with the hope that they will return with an additional amount called Income. If the operations of a company are to run smoothly, a proper relationship between fixed capital and current capital has to be maintained. Sufficient liquidity is important and must be achieved and maintained to provide the funds to pay off obligations as they arise or mature. The adequacy of cash and other current assets together with their efficient handling, virtually determine the survival or demise of the company. A businessman should be able to judge the accurate requirement of working capital and should be quick enough to raise the required funds to finance the working capital needs. Working capital is often classified as Gross Working Capital and Net Working Capital. The former refers to the total of all Current Assets and the latter refers to the difference between Current Assets and Current Liabilities. The maintenance of a sound Working Capital position is an important function of the Finance Department of the organization. With the magnitude of business rising with globalization, the quantum of working capital to be managed is on the increase. No wonder, working capital management is talked about more today than ever before. 92

Concept

93

Long-term investment decisions (capital budgeting) and long-term financing decisions are characterized by the facts that they (a) generally involve large amounts of money, and (b) are relatively infrequent occurrences. Decisions that come under the heading short-term finance are equally important, because, while typical decisions often don’t involve as much money, decisions are much more frequent. This is suggested in the results of a recent survey of CFOs.

Financial Planning Working Capital Mgmt Capital Budgeting Long-Term Financing Total 100%

Ranked Greatest Importance 59% 27% 9% 5% 100%

Average Time Allocated 35% 32% 19% 14% 100%

In defining short term finance, we focus on the cash flows connected with the operations of a company. Because the cash inflows and cash outflows are not synchronized, a company needs a temporary parking place for cash, which we can call a liquidity portfolio. This liquidity portfolio may consist of cash and marketable securities. Since cash flows for a company are uncertain, both in amount and timing, the amount of cash in temporary storage may not be adequate for all time periods. Thus, it is necessary to provide some backup liquidity for periods when the normal store of liquidity is insufficient. Also there is a need to move cash from one point to another within a company. We need to have internal cash flows to connect these various inflows, outflows and sources of liquidity. The cash system of a company is the mechanism that provides the linkage between cash flows. The financial manager of the company has the responsibility, at least in part, to develop and maintain the policies and procedures necessary to achieve an efficient flow of cash for the company’s operations. Short term financial management thus encompasses decisions about activities that affect cash inflows, cash outflows, liquidity, backup liquidity, and internal cash flows. Many decisions of a company have a short term financial management aspect. For example, the decision to sell a bond issue in order to raise funds to finance an expansion in plant and equipment is clearly a long term decision. However, the decision on how to invest the proceeds from the bond issue until they are needed to pay for the construction is a short term financial decision. The use of a 1-year time horizon to separate short term and long term decisions is arbitrary and, in some cases, ambiguous. To refine the definition of short term finance, it is helpful to examine the differences and interrelationships between the decisions that are classified as short term finance and those that are considered long term finance.

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Decisions usually classified as long term are difficult to reverse and essentially determine the basic nature of the business and how it will be carried out. Short term financial policies take the results of these decisions as a starting point and concentrate on how they can be efficiently and economically carried out. We can think of short term decisions as being more operational. Once implemented they are easier to change. Importance of Working Capital Management Working capital management includes a number of aspects that make it an important topic for study, and we will now consider some of them. Surveys indicate that the largest portion of a financial manager’s time is devoted to the day-by-day internal operation of the firm; this may be appropriately subsumed under the heading «working capital management». Since so much time is spent on working capital decisions, it is appropriate that the subject be covered carefully in managerial finance courses. Characteristically, current assets represent more than half the total assets of a business firm. Because they represent a large investment and because this investment tends to be relatively volatile, current assets are worthy of the financial manager’s careful attention. Working capital management is particularly important for small firms. A small firm may minimize its investment in fixed assets by renting or leasing plant and equipment, but there is no way it can avoid an investment in cash, receivables, and inventories. Therefore, current assets are particularly significant for the financial manager of a small firm. Further, because a small firm has relatively limited access to the long – term capital markets, it must necessarily rely heavily on trade credit by increasing current liabilities. Relationship between Sales, Growth and current Assets The relationship between sales growth and the need to finance current assets is close and direct. For example, if the firm’s average collection period is 40 days and if its credit sales are 1,000 a day it will have an investment of 40,000 in accounts receivable. If sales rise to 2,000 a day. the investment in accounts receivable will rise to 80,000. Sales increases produce similar immediate needs for additional inventories and, perhaps, for cash balances. All such needs must be financed, and since they arise so quickly, it is im­ perative that the financial manager keep himself aware of develop­ ments in the working capital segment of the firm. Of course, con­ tinued sales increases will require additional long- term assets, while must also be financed. However, fixed asset investments, while criti­cally important to the firm in a strategic, long .run sense do not gene­rally have the same urgency as do current asset investment. Original Concept of Working Capital The term «working capital» originated at a time when most Indus­tries were closely related to agriculture. Processors would buy crops

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in the fall, process them, sell the finished product, and end up just before the next harvest with relatively low inventories. Bank loans with maximum maturities of one year were used to finance both the purchase and the processing costs, and these loans were retired with the proceeds from the sale of the finished products. Longer term versus Short-term Debt The larger the percentage of funds obtained from long-term sources, the more conservative the firm’s working capital policy. The reason for this, of course, is that during times of stress the firm may not able to renew its short-term debt. This begin so, why firms ever use short-term. Concepts of Working Capital There are two concepts of working capital-gross and net: 1) Gross working capital refers to the firm’s investment in cur­rent assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory); 2) Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets. The two concepts of working capital- gross and net – are not exclusive, rather they have equal significance from the management viewpoint The gross working capital concept focuses attention on two aspects of current assets management; (a) How to optimise in­vestment in current assets? (b) How should current be financed? The consideration of the level of investment in current assets should avoid two dangers points- excessive and inadequate investment in current assets. Investment in current assets should be just adequate, not more not less, to the needs of the business firm. Excessive investment in current assets should be avoided because it impairs the firm’s profitability, as idle investment earns nothing. On the other hand, inadequate amount of working capital can threaten solvency of the firm because of its inability to meet its current obligation. It should be realized that the working capital needs of the firm may be fluctuating with changing business activity. This may cause excess or shortage of working capital frequently. The mana­gement should be prompt to initiate an action and correct imbalances. Another aspect of the gross working capital points to the need of arranging founds to finance current assets. Whenever a need of working capital funds arises due to the increasing level of business activity, or for any others reason, financing arrangement should be made quickly. Similarly, if suddenly, some surplus funds arise

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they should be allowed to remain idle, but should be invested in short-term securities. Thus the financial manager should have knowledge of the sources of working capital funds as well as investment avenues where idle funds may be temporarily invested. Net working capital is a qualitative concept. It indicates the liquidity position of firm and suggests the extent to which working capital needs may be financed by permanent sources of funds. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for maturing obligations within the ordinary operating cycle of a business. In order to protect their interests, short-term creditors always like a company to maintain current assets at a higher level than current liabilities. It is a conventional rule to maintain the level of current assets twice the level of current liabilities. However, the quality of current assets should be considered in determining the level of current assets vis.a-vis. current liabilities. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe and unsound. A negative working capital means a negative liquidity, and may prove to be harmful for the company’s reputation. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management improve and correct the imbalances in the liquidity position of the firm. Net working capital concept also covers the question of judicious mix of long-term and short-term funds for financing current assets. For every firm, there is a minimum amount of net working capital which is permanent. Therefore, a portion of the working capital should be financed with the permanent sources of funds such as equity share capital, debentures, long-term debt, preference share capital or retained earnings. Management must, therefore, decide the extent to which current assets should be financed with equity capital and/or borrowed capital. In summary, it may be emphasized that both gross and net concepts of working capital are equally important for the efficient management of working capital. There is no precise way to deter­mine the exact amount of gross or net working capital for any firm. The data and problems of each company should be analyzed to determine the amount of working capital. There is no specific rule as to how current assets should be financed. It is not feasible in practice to finance current assets by short-term source only. Keeping in view the constraints of the individual company, a judicious mix of long and short-term finances should be invested in current assets. Since current assets involve cost of funds, they should be put to productive use. The finance mix for working capital is as follows: Current Assets (in descending order of liquidity): 1. Cash 2. Bank Balance

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3. Short term investments 4. Trade Debtors 5. Inventory 1) Finished Goods; 2) Work in process 3) Raw materials 4) Stores & Spares 6. Pre-payments (Insurance, advances etc.) Current Liabilities: 1. Trade Creditors 2. Bank Overdraft or Cash Credit 3. Short Term Borrowings 4. Provision for taxes 5. Provision for dividends In addition to the working parameters peculiar to a company that determine the quantum of required working capital, the following factors are also equally important: 1. Profit levels: A company earning huge amounts of profits can add to the working capital pool a larger quantum of funds. Such companies should, however, guard against the temptation of expanding beyond necessity and tying up the funds in unproductive capital expenditure or allow unnecessary increase in overheads. Generally it is seen that companies with high profit levels become lax in management of funds and usually mismanage by blocking funds excessively in stocks or debtors; 2. Tax Levels and Planning: Income Tax laws provide for payment of advanced tax in installments. Excise and sales tax are payable at time of dispatch of goods from the factory premises and the point of sales respectively. Any working capital management must make adequate and timely provision for the same as all of them involve cash outlays; 3. Dividend Policies and Retained Earnings: Dividend policy and retained earnings are directly related. There has to be a proper balance between the need to preserve cash resources and the obligation to satisfy shareholder expectations. Sometimes reserves are sacrificed for consistent dividends. Dividends once declared become a short time liability which has to be paid for in cash and this impact should be recognized in the working capital budget. On the other hand, it would be of little satisfaction to the general body of the shareholders to enjoy a liberal dividend at the expense of sloughing back the same for the growth of the company. Reserves in the form of retained earnings is a very important source of augmenting working capital; 4. Depreciation Policy: The extent to which depreciation provision is made during the course of making the financial statements has a direct bearing on the dividend policy and retained earnings. This so because a higher quantum of depreciation would leave lesser profits resulting in reduced retained earnings and dividends.

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The quantum of depreciation can be made to vary by choosing different methods to provide for the use of assets. As provisions for depreciation are actually only book entries and represent no cash flow at that time, they will have no bearing on working capital except to the extent they may hold back distribution of dividends; 5. Expansion/Diversification Plans: Addition of fixed assets to produce new products, resorting to multiple shifts, or marginally adding to the plant and machinery are some of the common known ways to expand or diversify. Either of them represent an increase in production which calls for a higher quantum of spending of current assets, e.g., you buy more raw materials when you produce more and so on. In such situations, it is unwise to strain the internal resources for avoiding external funding; 6. Price level changes in raw material and finished goods: Inflation has got a direct bearing on the working capital. It depends to a large extent on the company’s ability to readjust its own prices to cover the increase in the cost. In case the product or service requires government approval or is administered as far as the price is concerned, inflation may have a very significant bearing on the working capital needs. Inflation could be either recessive or ex­pensive. During recessive inflation the companies are unable to sell more products due to lack of demand which results in the reduction of production. Inventories pile up and fixed expenses need a drastic reduction; 7. Operating Efficiency of the company: Operating efficiency of a company plays a major role in working capital management. An efficient company will have a shorter manufacturing period, long credit terms available from suppliers and minimal customers credit outstanding. If this is achieved then the quantum of working capital required will be naturally reduced. The Working Capital Cycle The Working Capital Cycle (or operating cycle) is the length of time between a companies’ paying for material entering into stock and receiving the inflow of cash from sales. The movements in the cycle are different for different types of companies and are dependent on the nature of the company. The operating cycle is the time period from inventory purchase until the receipt of cash. (Sometimes the operating cycle does not include the time from placement of the order until the arrival of stock.) The cash cycle is the time period from when cash is paid out, to when cash is received. Cash Management A thorough understanding of why and how a firm holds cash requires an accurate conception of how cash flows into and through the enterprise. Figure depicts the process of cash generation and disposition in a typical manufacturing setting. The arrows in the Jingle show the flow is, whether the cash balance is being increased or decreased.

Concept

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The firm experiences irregular increases in its cash holdings from several external sources. Funds can be obtained in the financial markets from the sale of securities, such as bonds, preference shous and equity shares or through debt contracts with lenders such as commercial banks. These irregular cash inflows do not occur on a daily basis. They tend to be episodic, in that the financing arrangements that give rise to them are effected at wide intervals. The reason is that external financing contracts usually involve huge sums of money stemming from a major need identified by the company’s management, and these needs do not occur every day. For example, a new product might be in the process of launched, or a plant expansion might be required to provide added productive capacity. In most organizations the financial officer responsible for cash management also controls the transactions that affect the firm’s investment in marketable, securities. As excess cash becomes tem­porarily available, marketable securities will be purchased. When cash is in short supply, a portion of the marketable securities port­folio will be liquidated. Whereas the irregular cash inflows are from external sources, the other main sources of cash to the firm arise from internal operations and occur on a more regular basis. Over long periods the largest receipts will come from accounts receivable collections and to a lesser extent from direct cash sales of finished goods. Many manufacturing concerns also generate cash on a regular basis through the liquidation of scrap or obsolete inventory. In the automobile industry large and costly machines called chip cruisers grind waste metal fine scrap that brings considerable re­venue to the major producers. At various times fixed assets may also be sold, thereby generating some cash inflow. This is not a large source of funds except in unusual situations where, for instance, a complete plant renovation may be taking place. Apart from the investment of excess cash in near-cash assets, the cash balance will experience reductions for three key reasons. First, on an irregular basis withdrawals will be made to (1) pay cash dividends on preferred and common shares, (2) meet interest requirements on debt, (3) repay the principal borrowed from creditors, (4) buy the firm’s own shares in the financial markets for use in executive compensation plans or as an alternative to paying a cash dividend, and (5) pay tax. Again, by an ‘irregular basis’ we mean items not occurring on a daily or highly frequent schedule. Second, the company’s capital expenditure program will designate that fixed assets be acquired at various intervals. Third, inventories will be purchased on a rather regular basis to ensure a steady flow of finished goods off the production line. Note that the investment in fixed assets with the inventory account does involve depreciation. This indicates that a portion of the cost of fixed assets in charged against the product coming of the assembly fine.

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This cost is subsequently recovered through the sale finished goods inventory, as the product selling price will be set by management to cover all of the costs of production, including depreciation. The variety of influences we have mentioned that constantly affect the cash balance held by the firm can be synthesized in terms of the classic motives for holding cash, as identified in the literature of economic theory. Motives for Holding Cash In a classic economic treatise John Maynard Keynes segmented the firm’s or any economic units demand for cash into three categories: (1) the transactions motive, (2) the precautionary motive, and (3) the speculative motive. Transactions Motive Balances held for transactions purposes allow the firm to dispense with cash needs that arise in the ordinary course of doing business. Transactions balances would be used to meet the irregular outflows as well as the planned acquisition of fixed assets and inventories. The relative amount of transactions cash held with is significantly affected by the industry in which the firm operates. If revenues can be forecast to fall within a tight range of outcomes, then the ratio of cash and near cash to total assets will be less for the firm than if the prospective cash inflows might be expected to very over a wide range. In this regard, it is well known that utility concerns can forecast cash receipts quite accurately, owing demand for their services arising from their quasi-monopoly status. This enables them to stagger their billings throughout the month and to time to coincide with their planned expenditures. Inflows and outflows of cash are thereby synchronized. Thus, we would expect the cash holdings of utility firms relative to sales or assets to be less than those associated with a major retail chain that sells groceries. The concern experiences a large number of transactions each day, almost all of which involve an exchange of cash. Cash Management Objectives A companywide cash management must be concerned with minimizing the firm’s risk of insolvency. In the context of cash management the term insolvency is used to describe the situation where the firm is unable its maturing liabilities on time in case the company is technically insolvent in that it lacks the necessary liquidity to make prompt payment on its current debt obligations. This problem could be met quite easily by carrying large cash balances to pay the bills that come due. Production, after all, would soon come to halt should payments for raw material purchases be continually late or omitted entirely. The firm’s suppliers would cut off further shipments. In fact, the fear of irritating a key supplier by being past due on the payment of a trade payable does cause some financial managers to invest in too much liquidity.

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The management of the company’s cash position, though, is one of those major problem areas where you are criticized if you don’t and criticized if you do. True, the production process will eventually be halted should too little cash be available to pay bills. If excessive cash balances are carried, however, the value of the enterprise in the financial marketplace will be suppressed of the large cost of Income forgone. The explicit return earned on idle cash balances is zero. The financial manager must strike an acceptable balance between holding too much cash and too little cash. This is the focal point of the risk-return tradeoff. A large cash investment minimizes the chances of insolvency but penalizes company profitability. A small cash investment frees excess balances for investment in both marketable securities and longer-lived assets; this enhances company profitability and thereby the value of the firm’s common shares but increases the chances of running out of cash. Objectives The risk-return tradeoff can be reduced to two prime objectives for the firm’s management system: 1. Enough cash must be on hand to dispense effectively with the disbursal needs that arise in the course of doing business; 2. The firm’s investment in idle cash balances must be reduced to a minimum. Evaluation of these operational objective, and a conscious attempt on the part of management to meet them, gives rise to the needs for some typical cash management decisions. Cash Forecasting One objective of cash management is clearly to ensure that the business does not run short of cash. There must always be enough cash available to meet liabilities as they fall due. Equally the business should not have much more cash than what it requires. The financial manager must be alert for opportunities to make use of any cash temporarily in excess of current needs. To ensure that these aims are met, it is necessary to know in advance as accurately as possible when cash shortages or cash surpluses are likely to occur, so that action can be planned to deal with these eventualities. Cash management depends on cash forecasting. The most convenient type of cash forecast for this purpose is the receipts and payment forecast, because it built up in the same form as that used for recording actual transactions in the books of account. A typical form of receipts and payment forecast is illustrated below, and it covers a period of three months with monthly rests. The first item, collection of debts, is derived from two sources: • The outstanding debtors list at the commencement of the forecast period. Such lists should be under continuous review as part of the company’s credit control procedure, and it should be possible to enter the expected collections under the various future months;

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• Estimates of sales invoicing over the next three months. The

invoice estimates will be converted into collection estimates using the company’s normal credit period, with adjustments for any major items to which special credit terms apply, or where delays may be anticipated. The collaboration of the sales department is needed in developing these forecasts. Other cash receipts may include cash sales (probably extrapolated from past experience), interest receivable at known due dates, and dividends receivable so far as these can be forecast. A major item of cash outflow will be payments to suppliers. It will be convenient for control if all items that are dealt with through the purchase ledger are grouped together, though various managers will be involved in forecasting transactions of different types. Basically the purchase manager must be required to prepare a forecast of purchase orders due to be placed month by month.

The Cash Budget When a cash forecast shows unsatisfactory cash balance throughout, it will probably be necessary to consider ways of obtaining additional capital. But as cash shortages are forecast only as shortterm features within a general satisfactory trend, each item in the forecast should be scrutinized for possible modification to either: a) timing: or b) amount. The possibility of changes in amount should be dealt with first, because an improvement in total collectibles or a reduction in total payables is of greater benefit to the business than the mere shifting of an item from one time period to another. In relation to sales income, forecast sales quantities and prices could be reviewed, but care must be taken that this leads to a new figure which is genuinely expected to occur, and is not just a change from a moderate to an optimistic forecast. Because of the variety of possibilities (and often their relatively small amounts), miscellaneous receivables may have been ignored by and it is possible that in total they could have a significant effect on the cash position. Three particular examples are: • Sales of scrap, possibly after sorting and cleaning; • Disposals of underutilized fixed assets; • Sales of surplus stock. In each case the potential sales proceeds have to be compared with the opportunity cost of relinquishing the assets. In attempting to reduce the amount of proposed expenditure a good starting point is to classify the various items between those that are essential to current operations and those that are discretionary. Discretionary expenses may include such items as subscriptions and donations, books and publications, advertising and publicity. Such expenditure can be reduced without causing short-term damage to the business. There is nothing like shortage of cash (real or

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induced) to get every manager reviewing the effectiveness of his expenditure (though there must be strong central co-ordination to ensure that short-term savings do not lead to longer-term losses): • Ensuring that responsibilities have been allocated for rigorous progress action on over-due or disputed customer accounts, and that the cash forecast incorporates the collection of such items at target dates; • Scheduling the essential payments in such a way that the cash balance is preserved with the least impairment of good relations with the creditors. Once we have the cash back, we have to manage it too till the time it is utilized in paying for the purchases and other expenses. The primary purpose of cash in business is to make possible those transactions necessary to set up the business and run it day by day. Before discussing the control of cash, therefore, it is helpful to look at the various transactions in respect of which cash will be received or disbursed. We shall refer to this several times, but for our immediate purpose the important features are as follows: • The total cash available in hand or in the bank at any time is represented by the large box left-centre of the diagram; • The cash balance with which the business was first established will have been obtained by an injection of capital as shown in the top left-hand corner of the chart; • During the course of the normal trading, manufacturing or service operations of the business, cash will be paid out for the purchase of goods, materials and supplies, for wages and salaries, and for various other expenses such as travelling, postage, insurance and so on; • The marketable items or services emerging from this expenditure will be sold to customers who will pay for them and thus reinstate the cash balance; • If this cycle of events happened instantaneously, then so far as operating transactions were concerned there would never be any shortage of cash. Accruals Short-term liabilities (such as interest, taxes, utility charges, wa­ges) which continually occur during an accounting period but are not supported by an invoice or a written demand for payment. When preparing financial statements for that accounting period, such liabilities are estimated on the basis of experience (based on previous payments). Similar increases in the assets of the firm (which may also continually occur) is not taken into account in order to comply with accrual basis accounting rules. Accounts payable Accounts payable is a file or account sub-ledger that records amounts that a company owes to suppliers, but has not paid yet (a form of debt), sometimes referred as trade payables. When an invoice is received, it is added to the file, and then removed when it is

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paid. Thus, the A/P is a form of credit that suppliers offer to their customers by allowing them to pay for a product or service after it has already been received. Expense administration is usually closely related to accounts payable, and sometimes those functions are performed by the same employee. The expense administrator verifies employees’ expense reports, confirming that receipts exist to support airline, ground tran­sport, meals and entertainment, telephone, hotel, and other expenses. This documentation is necessary for tax purposes and to prevent reimbursement of inappropriate or erroneous expenses. Airline expenses are, perhaps, the most prone to fraud because of the high cost of air travel and the confusing nature of airline-related documentation, which can consist of an array of reservations, receipts, and actual tickets. A variety of checks against abuse are usually present to prevent embezzlement by accounts payable personnel. Segregation of duties is a common control. Nearly all companies have a junior employee process and print a check and a senior employee review and sign the check. Often, the accounting software will limit each employee to performing only the functions assigned to them, so that there is no way anyone employee – even the controller – can singlehandedly make a payment. Some companies also separate the functions of adding new vendors and entering vouchers. This makes it impossible for an employee to add himself as a vendor and then cut a check to himself without colluding with another employee. This file is referred to as the master vendor file. It is the repository of all significant information about the company’s suppliers. It is the reference point for accounts payable when it comes to paying invoices. In addition, most companies require a second signature on checks whose amount exceeds a specified threshold. In accounts payable, a simple mistake can cause a large over­payment. A common example involves duplicate invoices. An invoice may be temporarily misplaced or still in the approval status when the vendors calls to inquire into its payment status. After the A/P staff member looks it up and finds it has not been paid, the vendor sends a duplicate invoice; meanwhile the original invoice shows up and gets paid. Then the duplicate invoice arrives and inadvertently gets paid as well, perhaps under a slightly different invoice number. Questions for self-control: 1. Importance of Working Capital Management; 2. The Cash Budget; 3. Net working capital.

Deciding the Credit Period

Chapter

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12

Management of receivables

If we are getting trade credit to fund our needs, we also have to extend trade credit to our customers. A company grants trade credit to protect its sales from the competitors and to attract the potential customers to buy its products at favorable terms. Extending trade credit creates receivables or book debts which the company expects to collect in the near future. The book debts or receivables’ arising out of trade credit has three characteristics: 1. It involves an element of risk: This should be carefully analyzed. Cash sales are riskless, but not the credit sales as the cash are yet to be received. 2. It is based on economic value: To the buyer, the economic value in goods or services passes immediately at the time of sale, while the seller expects an equivalent amount of value to be received later on. 3. It implies futurity: The cash payment for the goods or services received by the buyer will be made by him in a future period. The customers from whom receivables or book debts are due are called «debtors» and represent the company’s claim or asset. Three ways of management control in connection with credit policy: (a) Debtors expressed in relationship to sales – either as a percentage or as a number of weeks sales. This provides an overall confirmation that the business is effective in carrying out its own credit policy. With a seasonal business, however, these calculations could be misleading.Another disadvantage of averages is that they may conceal the fact that some long-overdue debts are being compensated by quicker collections from other customers. For management control there is no substitute for a complete listing of debtor accounts, analyzed by age, compiled every month. (b) Bad debts as a percentage of sales value, or reported otherwise in detail. 105

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(c) Credit control costs. This means that credit control involves three types of action: 1. Deciding the normal credit period to be allowed; 2. Establishing credit limits for individual customers; 3. Implementing the system (that is to say, ensuring that credit limits and the credit period are not exceeded). 1. Deciding the Credit Period: If a business is offering a unique product or service, or one for which demand exceeds supply, there may be no need to offer credit terms at all. In other cases the starting point in deciding credit policy is a review of the credit terms offered by competitors, and from this basis the credit terms of the particular business will be developed. Other factors that affect the length of the credit period are the following: − Buyer’s inventory and operating cycle − Perish ability and collateral value − Consumer demand − Cost, profitability and standardization − Credit risk − The size of the account − Competition − Customer type. Long credit period may be offered to the customers if this will enable the business to capture a larger share of the available market, or the break into a new market. The initial effect of granting long credit periods may be adverse because of the extra costs involved but profits from increased volumes should more than offset the losses. If it does not there is no use in extending longer credit periods. Even otherwise it is necessary to look to the longer term where, among other possibilities, selling prices may be increased because smaller competitors have been eliminated in the ‘credit war’. Shorter credit may be imposed if demand is inelastic, so that the quantity sold will not be affected simply by changes in credit terms. Influence of Credit Policy Credit policy will directly influence sales, investment levels, bad-debt losses, and collection costs. Sales: Sales vary directly with the extent to which credit terms are liberalized. The demand for a firm’s product is greatly influenced by the ease with which the products can be purchased on credit. Sales will be at their lowest level if they are strictly for cash. Those who want to buy on credit will patronize other manufacturers who extend credit. Sales will start increasing as credit terms are liberalized. Sales will be at their maximum level when the firm does not screen buyers for credit worthiness. Rather, credit is extended to all who want to buy the firm’s products. Investment Levels: Sales on credit result in accounts receivable. As discussed above, sales are directly related to the liberality of credit terms. As credit terms are liberalized, sales increase and to service

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this increased level of sales properly, the firm needs to increase its investments in cash and inventories. Finally, if sales increase suf­ ficiently, the firm may have to increase its productive capacity. As credit terms are made more liberal, the firm’s investment in cash accounts receivable, inventories, and perhaps physical equipment increases in a complimentary fashion. Bad-Debt Losses: Without credit sales the firm will not incur any baddebt losses. With a very conservative credit policy, bed-debt losses will be nonexistent or minimal. As credit terms are liberalized, the firm begins to give credit to marginally less-creditworthy clients. The liberalization of credit terms result in increases in bad-debt losses. Collection Costs: Collection costs are the clerical and admi­nistrative costs associated with granting credit and managing ac­counts receivable. When credit is not granted, collection costs are minimal. As credit terms liberalized, the firm’s volume of accounts receivable increases. The clerical and administrative costs of invoi­ cing, collecting, and book keeping also increase as credit terms are liberalized. A second type of collection cost is the one related to ef­forts to collect on delinquent accounts. As credit terms are libe­ ralized, delinquent accounts increase and the costs of efforts to collect on these accounts also increases. Credit Terms As discussed previously, credit policy has a direct influence on sales, investment levels, bad-debt losses, and collection costs. From a managerial view-point and looking strictly at the relationship between credit policy and sales, one could conclude that a very liberal credit policy is highly desirable. However, the relationship between credit policy and investment levels, bad-debt losses, and collection costs implies that a very conservative credit policy is desirable. An appropriate credit policy balances profits from in­ creased sales due to more liberal credit terms with increased costs due to increased investments, bad-debt losses, and collection costs. The ideal credit policy allows for the liberalization of credit terms to the point where the marginal revenues from a new category of credit accounts is exactly equal to the marginal costs of selling and servicing accounts. In practice it is not feasible to establish the ideal credit policy. However, firms do consider alternative credit terms to see what influence they have on profits. Our focus here will be to look at certain specific credit terms and see how they might affect profits and what guidelines a firm could use to enhance its profitability. The three specific components of credit terms are credit period, credit discount, and discount period. Credit Period: The credit terms are specified on the invoices sent out by firms. A typical credit term may state: 2/10, net 30. The first number «2» is the credit discount and indicates that a 2 per cent

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discount may be taken if the invoice is paid within the number of days specified by the second term, or 10 days. The second term «10» is the discount period and indicates the number of days during which the credit discount can be taken. The last number «30» indicates the credit period. The credit period specifies the number of days that a firm can take to pay the invoice without being considered to be delinquent. With terms of 2/10, net 30 the credit period is 30 days and the full amount of the invoice is due within 30 days. One way to liberalize credit terms is to increase the credit period. Conversely, credit terms can be tightened by shortening the credit period. Mitsui Corporation is currently selling on credit terms of 2/10, net 30. All sales are for credit. Fifty per cent of its clients take the 2 per cent discount and pay on the tenth day. The other 50 per cent, who do not take the discount, on the average pay after 30 days. The sales volume between discount takers and non-discount takers is evenly divided. The company’s management is considering two alternative credit plans: plan A would change the credit terms 2/10, net 45; plan B would extend the credit period even further, making the terms 2/10, net 60. Plan A is expected to increase sales by 5 per cent from current levels, whereas plan B would increase sales by 7 per cent. Mitsui’s margins on sales before credit-related costs and taxes are 20 per cent. Investments in accounts receivable carry a 12 per cent before tax cost. In trying to decide whether to keep the present credit plan or switch to either of plans A or B, management recognizes that an occasional result of extending the credit period will be that more customers will take the discount. However, they feel that with the present plans there will be no change in the rupee volume of sales on which the discount is taken. That is, all incremental sales will be paid for after the 10-day discount period. In addition, management feels that 1 per cent of all incremental sales under plan A and 2 per cent under plan B will prove to be uncollectible. No additional credit costs will be involved in clerical or administrative functions. Which credit period policy appears to be the most desirable? The variables to be considered in deciding between the present credit terms and plans A and B are profits on increased sales, increases in accounts receivables, increases in the cost of financing the additional receivables, and increased in bad-debt losses. Discount Period: The analysis of changing discount periods is very similar to the analysis for changing credit discounts. As the discount period is increased, the opportunity cost of not taking a discount increases. Therefore, it becomes more attractive for a credit buyer to take the discount. However, as the discount period is extended the existing discount takers take advantage of the liberalized credit terms and delay making their payments until the end of the new discount period. Whether extending the discount period is desirable is dependent on whether total receivables increase or decrease.

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Collection Policy When an account becomes delinquent, a firm can resort to a series of actions to try to collect on the account. These actions include writing a letter, calling on the phone, calling in person, using a collection agency, and legal action. The particular collection procedures followed have a direct impact on bad-debt losses and the average collection period. The firm has an obvious interest in reducing both bad-debt losses and the average collection period, which lower total receivables and average collection period, which lower total receivables and investment in receivables. In general, the more the firm spends on collection, the lower its delinquency costs (bad-debt losses) and the cost of maintaining excess receivables. However, the marginal productivity of collection expenditures decline as the firm expends more and more. The discussion on collection policy has assumed that sales are independent of collection policy. Most firms recognize that instituting a very aggressive collection policy may be very irritating for some customers who are frequently slow in paying. An aggressive collection policy may therefore adversely affect sales. A second result of an aggressive collection policy may be to force more customers to prefer taking the discounts. These two factors need to be recognized before a firm implements a collection policy that equates marginal collection expenditures with marginal reductions in delinquency costs. Establishing Credit Limits The fact that the business has a credit policy does not mean that credit terms will be granted to every customer. It is not always easy to decide whether a particular customer is ‘credit worthy’ in the sense that he has both the ability and the inclination to pay at the due date. Many companies require cash with order from new customers until their creditworthiness have been established. Five Cs of Credit that a bank looks at are the ones that you should also look at while granting credit: Character: Willingness to pay back the credit; Capacity: Ability to pay back; Capital: Financial reserves including cash; Collateral: What assets could be pledged or are pledged to others that hinder payments; Conditions: Relevant economic conditions. That means that in assessing the creditworthiness of a customer two things are absolutely necessary: (a) Facts about his business, in particular whether it is profitable, whether it is generating or has access to sufficient cash to meet its liabilities, and whether it has suitable assets available to cover the claims of unsecured creditors in the event of winding up. In brief, it is necessary to analyze the accounts of the business. It is helpful also if the customer will supplement these with the sort of information they do not give; e.g., the

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current order book, any plans for future development, and the condition and market value of the assets owned by his business. (b) Opinions about the business and the people running it, formed from either personal contacts (director level, or at any reliable and knowledgeable level) or obtained from third parties such as business associates, mutual acquaintances or employees changing jobs. There are other sources from which we can have information about the company as well as the industry that it is operating in: (a) Reports from the relevant trade protection association, if one exist; (b) Trade references from other companies with which the cus­ tomer does business; (c) Bank references - these may not give a lot of information but they tend to use a series of standardized replies, and experience of these will indicate the relative credit grading of the customer in question; (d) Reports published in trade journals or the financial press dealing either with the customer company or with the type of bu­siness in which it is engaged. In assessing the creditworthiness of overseas customers, reports from bankers are an important source of information. It is also necessary to weigh up the risks of the customer being prevented from paying either through political or exchange control restrictions. On all these matters the Export Credits Guarantee Department can usually give guidance. If the customer’s creditworthiness appears to be established, the next stage is to decide the amount of credit to be given. Theoretically there are three possible ways of doing this: (a) The income or cash flow method, which requires knowledge of the amounts of cash becoming available to the customer, and how he proposes spending them, thus indicating his ability to pay the suppliers invoices – this method is possible between a bank manager and his client seeking an overdraft or loan, but seldom in business life; (b) The capital structure method, under which the value of uncharged assets in the customer’s last balance sheet is established, and the credit limit will be a percentage of this value. This is a necessary calculation when the proposed value of future transactions will involve a major increase in the customer’s total indebtedness, but it is not an indicator of liquidity, and is not particularly relevant to small transactions in the ordinary course of trade; (c) The requirement method, which is almost always used in practice. If the customer is creditworthy then we should be able to rely on him to pay any amounts arising from the ordinary course of business. The amount of credit granted, therefore, is based on the value of business which the customer expects to place with the supplier each month. The forecast monthly

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sales to the customer are multiplied by a number of months. Credit laid down as company policy to give that customer’s credit limit. For customers of international repute it may be decided that no limitation of credit is necessary, but the financial difficulties faced by several major companies in recent years must be a warning against the automatic granting of unlimited credit. Vetting Incoming Orders The amount appearing on the customer’s ledger account at any time will, of course, result from invoicing the orders he has placed, so that if the value of orders in any period were to exceed the original forecast this might not become apparent until after invoicing. At that time the outstanding balance on the ledger would suddenly be found to be in excess of the agreed limit. To safeguard against this possibility an order register may be kept for each customer, showing the value of orders placed for delivery in particular months. Each incoming order will then be checked against the register to confirm that it will not cause the credit limit to be exceeded. This could be a cumbersome procedure, and normally it would only be used in respect of: (a) New customers, whose compliance with credit limits has not been established; (b) Customers who had consistently failed to adhere to their credit limits in the past. (It might be better in such cases to withdraw credit facilities completely). All incoming orders should be checked to ensure that are placed on the customer’s official order form and authorized by somebody purporting to have the power to place that type of order. Compute­ rization has made this task very easy. Debt Collection There must be no slackness in pursuing the collection of debts. In most business purely formal reminders are ineffective, and therefore a waste of money, when an account has passed its due date there should be early personal contact with the customer either by telephone or a salesman’s visit or by a letter addressed to a named person in the customer company. If necessary, there may be a follow up at the higher level of authority. And this should be followed by a threat to cut off supplies. The value of legal action against debtors needs to be assessed. When this stage is reached, the likelihood of the customer’s paying is sharply reduced, and additional legal costs may never be recouped. On the other hand, the action may deter potential future defaulters. From the point of view of the salesman every customer is va­luable. From the financial director’s standpoint the marginal contri­bution from goods sold to a late payer will be more profitable without sales to that particular customer. Overdue debts should be the subject of formal discussion between the sales and financial managers. The reasons for delayed payment

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should be noted, and decisions should be minute on the action to be taken in each case and the people responsible for taking it. Although the salesman’s job is not complete until his customer has paid the money due, it is often advantageous for the more rigorous collection procedures to be handled by finance staff, leaving the salesman free to exercise his persuasive influence with the cus­ tomer’s buying department. Questions for self-control: 1. Deciding the Credit Period. 2. Collection Policy. 3. Establishing Credit Limits.

Economic Order Quantity (EOQ)

Chapter

113

13

Inventory management

The financial decisions relating to stockholding have certain special features, but looking first at saleable stocks (finished goods) we can postulate that the object of holding stocks is to increase sales, and that the object of increasing sales is to increase profit. Stock Service Levels In deciding on an inventory policy it is necessary to define the level of service to be offered to the customer, in the sense of the percentage of order which can be satisfied immediately from stock. This will depend on the nature of the business. In some cases the company may be the monopoly supplier of certain goods, or may offer particular advantages of quality, re­putation, reliability or after-sales services. Where such distinguishing features exist, it is possible that the customers will be prepared to endure occasional delays in meeting their requirements, and it would not be necessary to hold sufficient stocks to ensure immediate delivery. In other cases quick delivery may be an essential feature of success in achieving sales. This would be the case, for example, if there was strong competition for a limited market, or if the failure to supply a spare part for installed equipment would cause significant loss to the customer while the equipment was out of use. When the required level of service has been defined, the next problem is to decide how much stock is needed to meet that requirement. This will be the minimum holding, and not the average holding which will be influenced by the stockholding costs. Inventory Management Techniques Economic Order Quantity (EOQ) The economic order quantity is defined as a point where the total costs of restocking and carrying costs are the lowest. EOQ is usually calculated by a formula based on differential calculus. 113

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Though we will not derive the formula we need to understand it’s working. EOQ =√ (2xFCx S)/ (IxP) There are three assumptions that we make in the EOQ model: 1. Sales can be forecasted perfectly, 2. Sales are evenly distributed throughout the year, and 3. Orders are received as soon as they are placed. This set of assumptions mean is pretty restrictive and we will relax these assumptions slowly. Before we relax these assumptions there are two important things to note about the EOQ: 1. Although a mathematically precise EOQ can be calculated, in practice there is likely to be a range of order quantities within which total costs remain at a low level. The choice of order quantity within this low-cost range may not significantly affect the overall financial plan. 2. The key factor in the calculations is usually the cost of capital (interest on stockholdings). In times of high interest rates this is likely to outweigh all the other variables. The inventory holding costs will go up very steeply, and one’s conclusion will be that stockholdings should be kept to the lowest figure possible having regard to any practical difficulties in obtaining frequent replacement supplies. Optimum Order Quantity (OOQ) The last comment above is a reminder that suppliers do not like handling small orders. The purchase price per unit, therefore, may vary with the size of the purchase order, and this will require a mo­dification to our EOQ calculation. The supplier might, for example, impose a ‘minimum order value’ so that for quantities below this limit the cost per unit would, in effect, be higher than normal. This would either impose a lower cut-off limit on the size of order placed, or would introduce an upward curve at the lower end of the holding cost line on the EOQ chart, since insurance and interest charges per unit would be relatively high until the small order limit was reached. For larger orders, on the contrary, there might be quantity discounts, and these would cause one or more downward steps at those points on the holding cost line where they began to operate. This possibility can result in minimum total cost which differs from the position of the EOQ as originally calculated. This point is sometimes distinguished as the ‘optimum order quantity’. Safety Margins in Stockholding So far we have assumed that a company will he placing purchase orders at regular intervals of time for a fixed quantity (the economic or optimal order quantity) of any particular item. The possibility of doing this depends on demand remaining constant from period to period and on supplies being available as and when required.

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115

Sales demand, however, could show fluctuations around the normal level, so that in a period of high demand the available stock could be used up before fresh supplies are due. Similarly, in some periods deliveries from suppliers could be delayed so that even the normal sales demand could not be satisfied. Against both these contingencies, it is necessary to hold a safety margin of stock. If it were necessary to hold a safety margin sufficiently large to cover the simultaneous occurrence of a peak in demand and a delay in supplies, then the minimum stockholding would form the greater part of the total stockholding. Very little can be done to correct for random delays in supply, but it may be possible to anticipate changes in the trend of demand and to modify the purchasing procedure to meet them in one of the following ways: • to order in economic order quantities but at varying time intervals according to the rate of demand currently being experienced, or an­ticipated in the near future – this is known as the fixed order quantity or re-order level system (for reasons which will be explained below); • to order at regular intervals but in varying quantities determined by the current rate of demand - this is the fixed interval, or periodic review system. Modified Ordering Systems The re-order level system involves deciding a level of stockhol­ding at which new purchase orders shall be placed. This will be decided in relation to the normal rate of issues during the normal purchasing lead time. The quantity to be ordered is constant, and an order for that quantity will be placed whenever stock falls to the predetermined order level. The system thus responds quickly to va­ riations in demand though there is a danger that in doing so it may reflect purely short term or random fluctuations in sales. The operations of re-order level system include the use of: a maximum stock level. This would correspond to the normal peak holding under stable conditions. If the stockholding exceeds the peak level this provides a warning that demand has been running below the rate expected when the EOQ was fixed. The stock controller should then review the correctness of his standard purchase order quantity A minimum stock level which, as suggested above, is probably the amount of the safety margin. The minimum stock level provides a warning of a potential out-of-stock position. When a stockholding falls to that level the stock controller will review his outstanding purchase orders and their due dates, and also the current trend of demand, and can then decide whether additional emergency procurement is necessary. Under the periodic review system purchase orders are placed at fixed intervals of time but the quantity ordered can be modified to meet the rate of demand indicated by current experience. This gives an opportunity for analyzing the trend of demand, and various

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techniques such as ‘exponential smoothing’ can be used in forecasting this trend. The system does not respond rapidly to immediate needs, and it may therefore necessitatea larger safety margin than the re-order level system. It is, in fact, a common experience that the re-order level system gives slightly lower average stock levels, and it is sometimes thought to be the cheaper system to operate because reordering is triggered automatically at the re-order levels, however, requires reviewing in the light of changes in the rate of demand. Any system can appear cheap in the short run if it is operated in a slovenly manner. Infrequent and Seasonal Demand In most inventories it will be necessary to carry items which are slow moving in the sense that units of demand are separated by significant intervals of time. These items may have high individual value but because they are demanded infrequently they will probably contribute only a small percentage of the total annual value of sales. The normal distribution of stockholdings would show that about 20% of the line items carried would contribute 80% of the total annual usage, though this relationship will vary between different types of business. It may be decided not to hold stocks of some slow-moving items, but to procure them as and when they are required. If a stock is needed however the amount held will probably be limited to the quantity most likely to be next demanded, the occurrence of the demand being the signal for further procurement action. The quantity held may, however, be increased if the purchase price per unit is sufficiently lower for large quantities so as to offset any increase in holding costs for a larger stock holding. This could occur for example when the supplier imposed a minimum order value. There should be a regular review of slow-moving items to identify stocks which have become technically obsolete or for which the demand has diminished to the point where stock holding is no longer justified. In some businesses (for example, ladies fashion wear), it is necessary to place orders for the full seasonal requirement well in advance of the demand occurring, with a high probability that repeat orders will not be obtainable. In such instances the purchase and sale of each batch will be a separate project or venture dependent heavily on accurate forecasting of demand quantities and selling prices. In this case, the evaluation procedure applicable to stock holding for continuous demand will not apply. Of a similar nature will be decisions like the following: • to purchase goods in bulk in advance of demand arising in order to protect the business against anticipated price rises or shortages of supply; • to purchase commodities forward at a fixed price for future delivery;

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117

• to combine forward purchase options with forward sales

options, so as to limit losses arising from price changes (including changes in currency exchange rates); • to purchase foreign currency forward against specific overseas purchases, so as to minimize the effect of changes in exchange rates. These are financial decisions quite separate from the routine problems of inventory control, and would be evaluated as investment projects. The Total Inventory The techniques described in the foregoing paragraphs all relate to single line items of stock; the assumption has been made that if each item is held at its own economic level then the overall holding of stock will be correctly balanced. This would be true provided that two conditions were satisfied: 1) that there was enough space available to hold all the stocks required; 2) That enough money could be found to finance them. Neither condition is likely to be fulfilled in practice, so some form of mathematical programme might be used to constrain the ideal unit quantities within the limiting factors. There are, however, a number of simple pragmatic approaches to inventory reduction, and these include: • modifying the service level offered, either generally or in rela­ tion to selected items; • letting the company’s suppliers act as stockholders (possibly by placing bulk orders with schedules of call-off dates linked to sales demand); • discontinuing those items which are the least profitable having regard to their marginal contribution and relevant fixed costs per unit of the limiting factor. Raw Material Stocks and Work-In-Progress So far, in considering inventory control we have been discussing saleable stocks, but the same principles apply to stocks of raw materials. The main difference is that demand for raw materials is not direct from the outside customers but indirect through the production plans of the factory using the raw materials. In considering the scheduling of production the ‘Economic Batch Quantity’ (EBQ) corresponds to the EOQ for purchased items. Ma­nufacture in small batches will be more costly than in larger batches because there will be greater repetition of planning and progress actions and of the setting up and breaking-down of machine tooling, and also because there will be less opportunity for an efficient momentum of work to be established. However, these batch pro­cessing costs (like procurement costs of stocks) will change inversely to the holding costs of the work-in-progress (floor space, insurance, interest on capital, etc.). A big problem with work-in-progress is that work passes in sequence through a series of operations. What is an economic batch for

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lathe work may not be economic for drilling, milling or assembly operations. Applying EBQ calculation to one operation in isolation can cause bottlenecks in the flow or production – creating excessive holdings of partly-completed work because it could be produced cheaply in a large batch, even though there will be no demand for that work for some time ahead. A similar problem is that of keeping skilled work people steadily occupied, since their wages are basically fixed in relation to time, even though outside customer demand may be seasonal or erratic. Because these problems are concerned with the uneven timing of cash flows they are best solved by the use of discounted cash flow techniques. If, however, there is a capability of a rate of production which is in excess of a steady rate of demand (internal or external) then the problem is to decide what is the economic length of a production run, the facilities then being switched to other work until the next run is required. As the number of items could be very large in case of raw materials it is necessary to find ways to selectively pay attention to those items that represent the highest value. A categorization method known as ABC analysis is used for the same purpose. The idea behind ABC analysis is that attention is focused on the highest value items that are usually small in number categorized as A-category items and the lowest value items are categorized as C and are ordered in more quantities so that less attention is required there. Questions for self-control: 1. Inventory Management Techniques. 2. Raw Material Stocks. 3. ABC analysis.

Trade Finance

Chapter

119

14

Financing of working capital

Trade Finance The absence of an adequate trade finance infrastructure is, in effect, equivalent to a barrier to trade. Limited access to financing, high costs, and lack of insurance or guarantees are likely to hinder the trade and export potential of an economy, and particularly that of small and medium sized enterprises. Traders require working capital (i.e., short-term financing) to support their trading activities. Exporters will usually require financing to process or manufacture products for the export market before receiving payment. Such financing is known as pre-shipping finance. Conversely, importers will need a line of credit to buy goods overseas and sell them in the domestic market before paying for imports. In most cases, foreign buyers expect to pay only when goods arrive, or later still if possible, but certainly not in advance. They prefer an open account, or at least a delayed payment arrangement. Being able to offer attractive payments term to buyers is often crucial in getting a contract and requires access to financing for exporters. Therefore, governments whose economic growth strategy involves trade development should provide assistance and support in terms of export financing and development of an efficient financial infra­structure. There are many types of financial tools and packages designed to facilitate the financing of trade transactions, mainly three types: • Trade Financing Instruments; • Export Credit Insurances; • Export Credit Guarantees. 1. Trade Financing Instruments The main types of trade financing instruments are as follows: a) Documentary Credit This is the most common form of the commercial letter of credit. The issuing 119

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bank will make payment, either immediately or at a prescribed date, upon the presentation of stipulated documents. These documents will include shipping and insurance documents, and com­mercial invoices. The documentary credit arrangement offers an inter­ nationally used method of attaining a commercially acceptable un­ dertaking by providing for payment to be made against presentation of documentation representing the goods, making possible the transfer of title to those goods. A letter of credit is a precise document whereby the importer’s bank extends credit to the importer and assumes res­ pon­sibility in paying the exporter. A common problem faced in emerging economies is that many banks have inadequate capital and foreign exchange, making their ability to back the documentary credits questionable. Exporters may require guarantees from their own local banks as an additional source of security, but this may generate significant additional costs as the banks may be reluctant to assume the risks. Allowing internationally reputable banks to operate in the country and offer documentary credit is one way to effectively solve this problem. b) Countertrade As mentioned above, most emerging economies face the problem of limited foreign exchange holdings. One way to overcome this constraint is to promote and encourage countertrade. Today’s modern counter trade appears in so many forms that it is difficult to devise a definition. It generally encom­ passes the idea of subjecting the agreement to purchase goods or services to an undertaking by the supplier to take on a compensating obligation. The seller is required to accept goods or other instruments of trade in partial or whole payment for its products. Some of the forms of counter trade include: c) Factoring This involves the sale at a discount of accounts receivable or other debt assets on a daily, weekly or monthly basis in exchange for immediate cash. The debt assets are sold by the exporter at a dis­ count to a factoring house, which will assume all commercial and political risks of the account receivable. In the absence of private sector players, governments can facilitate the establishment of a state-owned factor; or a joint venture set-up with several banks and trading enterprises. This is financing for the period prior to the shipment of goods, to support pre-export activities like wages and overhead costs. It is especially needed when inputs for production must be imported. It also provides additional working capital for the exporter. Pre-shipment financing is especially important to smaller en­terprises because the international sales cycle is usually longer than the domestic sales cycle. Pre-shipment financing can take in the form of short-term loans, overdrafts and cash credits. e) Post-Shipping Financing

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121

Financing for the period following shipment. The ability to be competitive often depends on the trader’s credit term offered to buyers. Postshipment financing ensures adequate liquidity until the purchaser receives the products and the exporter receives payment. Postshipment financing is usually short-term. f ) Buyer’s Credit A financial arrangement whereby a financial institution in the exporting country extends a loan directly or indirectly to a foreign buyer to finance the purchase of goods and services from the exporting country. This arrangement enables the buyer to make payments due to the supplier under the contract. g) Supplier’s Credit A financing arrangement under which an exporter extends credit to the buyer in the importing country to finance the buyer’s purchases. 2. Export Credit Insurance In addition to financing issues, traders are also subject to risks, which can be either commercial or political. Commercial risk arises from factors like the non-acceptance of goods by buyer, the failure of buyer to pay debt, and the failure of foreign banks to honour documentary credits. Political risk arises from factors like war, riots and civil commotion, blockage of foreign exchange transfers and currency devaluation. Export credit insurance involves insuring exporters against such risks. It is commonly used in Europe, and increasing in importance in the United States as well as in developing markets. The types of export credit insurance used vary from country to country and depends on traders’ perceived needs. The most com­monly used are as follows: • Short-term Export Credit Insurance – covers periods not more than 180 days. Protection includes pre-shipment and postshipment risks, the former covering the period between the awarding of con­tract until shipment. Protection can also be covered against com­mercial and political risks. • Medium and Long-term Export Credit Insurance – issued for credits extending longer periods, medium-term (up to three years) or longer. Protection provided for financing exports of capital goods and services. • Investment Insurance – insurance offered to exporters investing in foreign countries. • Exchange Rate Insurance – covers losses as a result of fluctua­ tions in exchange rates between exporters’ and importers’ national currencies over a pe­riod of time. The benefits of export credit insurance include: • Ability of exporters to offer buyers competitive payment terms; • Protection against risks and financial costs of non-payment; • Access to working capital; • Protection against losses from foreign exchange fluctuations;

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• Reduction of need for tangible security when borrowing from banks. Export credit insurance mitigates the financial impact of the risk. There are specialized financial institutions available that offer in­surance cover, with premiums dependent on the risk of the export markets and export products. 3. Export Credit Guarantees Export credit guarantees are instruments to safeguard export-financing banks from losses that may occur from providing funds to exporters. While export credit insurance protects exporters, gua­ rantees protect banks offering the loans. They do not involve the actual provision of funds, but the exporters’ access to financing is facilitated. The export credit guarantee is issued by a financial institution, or a government agency, set up to promote exports. Such guarantee allows exporters to secure pre-shipment financing or post-shipment financing from a banking institution more easily. Even in situations where trade financing is commercially available, companies without sufficient track records may not be looked upon favourably by banks. Therefore, the provision of financial guarantees to the banking system for purveying export credit is an important element in helping local companies go into exporting. The agency providing this service has to carefully assess the risk associated in supporting the exporter as well as the buyer. 4. The Role of Governments in Trade Financing The role of government in trade financing is crucial in emerging economies. In the presence of underdeveloped financial and money markets, traders have restricted access to financing. Governments can either play a direct role like direct provision of trade finance or credit guarantees; or indirectly by facilitating the formation of trade financing enterprises. Governments could also extend assistance in seeking cheaper credit by offering or supporting the following: • Central Bank refinancing schemes; • Specialized financing institutes like Export-Import Banks or Factoring Houses; • Export credit insurance agencies; • Assistance from the Trade Promotion Organisation; and • Collaboration with Enterprise Development Corporations (EDC) or State Trading Enterprises (STE). a) Central Bank Refinancing Schemes Under this type of schemes, the Central Bank will rediscount the commercial bills of exporters at preferential rates. This will provide the cheap post-shipment financing necessary for exporters to quickly turn around funds for further export business. Here, the government is subsidizing the cost of funds that ex­porters have to pay if they rediscount their bills with commercial banks. In a similar scheme, government could also offer factoring ser­vices at subsidized rates.

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b) Export-Import Bank (EXIM Bank) The Export-Import Bank (EXIM Bank) specifically caters to the needs of exporters and importers and those of investors in foreign markets. It offers various services, including long-term direct loans to foreign buyers for loans and equipment sales of sufficient sizes. Several countries, including developed nations, have EXIM banks. For example, the United States EXIM Bank was created in 1934 and established under its present law in 1945. Its primary role is to aid in financing US exports, and for medium-term (181 days to 5 years) transactions, it co-operates with US commercial banks by providing export credit guarantees. In setting up the EXIM Bank, the US recognized that job creation is a consequence of exports. Its main customers are SMEs in the United States. c) Export Credit Insurance Agencies Export credit insurance agencies act as bridges between banks and exporters. In emerging economies where the financial sector is yet to be developed, governments often take over the role of the export credit insurance agent. Governments traditionally assume this role because they are deemed to be the only institutions in a position to bear political risks. Several countries in Asia and Africa have such an organization. However, the viability of such an organization depend on the volume of business and income from insurance premium. In that context, credit insurance policies vary according to the type of exports. For example, short term policies on the sale of raw materials on 180 days terms are covered up to 95 per cent for commercial risk and 100 per cent for political risk. Such trades are considered relatively secure. Nonetheless, it is good practice to get the exporter to bear a certain portion of the risk. d) Support from Trade Promotion Organisations (TPOs) As explained earlier, banks are often reluctant to lend to exporters because of their lack of knowledge about the creditworthiness of the traders, and as a result may raise interest to compensate for the risks taken. TPOs are in a position to know the strengths and weaknesses of the individual trading houses and exporters, and could share information with financial institutions to facilitate access to financial services. TPOs are the government agencies that are most directly involved with the trading community, often supporting promising trading and exporting enterprises. The support and assistance given by the TPOs could act as a signal to banks as to which companies are creditworthy companies. In addition, TPOs could establish network of financial institutions, identify their credit requirement, and match trading en­terprises and financial institutions based on these requirements. e) Export Development Corporation and State Owned Enterprises In most emerging economies, there are a few key conglomerates with a diverse range of products, substantial export capacity and sustainable

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financial resources. They could be private sector export development corporations (EDCs) or state-owned enterprises (SOEs). Governments could harness these enterprises as mechanisms to assist other local firms, especially SMEs, to export their products or import goods. Unlike the SMEs, the EDCs and the SOEs have the financial resources and trade expertise needed to participate in trading activities. Smaller exporters could sell their products to the EDCs and SOEs and receive payment earlier than if they exported directly by themselves. Small importers could also purchase goods from the EDCs and SOEs, which have the financial strength to bulk purchase from abroad. A line of credit A line of credit is any credit source extended to company by a bank or other financial institution. A line of credit may take several forms, such as overdraft protection, demand loan, special purpose, export packing credit, term loan, discounting, purchase of com­mercial bills, traditional revolving credit card account, etc. It is effectively a bank account that can readily be tapped at the bor­rower’s discretion. Interest is paid only on money actually withdrawn, although the borrower may be required to pay an unused line fee, often an annualized percentage fee on the money not withdrawn. Lines of credit can be secured by collateral or unsecured. Lines of credit are often extended by banks, financial institutions and other licensed consumer lenders to creditworthy customers (though certain special purpose lines of credit may not have credit­ worthiness requirements) to address short liquidity problems or to increase a value of working capital; such a line of credit is often called a personal line of credit. The term is also used to mean the credit limit of a customer, that is, the maximum amount of credit a customer is allowed. Traditionally, industrial borrowers enjoyed a relatively easy access to bank finance for meeting their working capital needs. But it depends on firm’s deposits, credit history, market share and other factors. Further, the cash credit arrangement, the principal device through which such finance has been provided, is quite advantageous from the point of view of borrowers. Ready availability of finance in a fairly convenient form led to, in the opinion of many informed observers, over borrowing by industry and deprivation of other sectors. Banks practice regulation schemes by requirements and norms for inventory and receivables. The corporate should be discouraged from accumulating too much of stocks of current assets and should move towards very lean inventories and receivable levels. There are varied norms of the maximum levels of Raw Material, Stock-in-process and Finished Goods which a corporate operating in an industry should be allowed to accumulate. These levels were termed as inventory and receivable norms. Depending on the size of credit required, the funding of these current assets (working capital needs)

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of the corporate could be met by one of the following methods (as widespread in the Eastern Asia): First Method of Lending Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings. This approach was considered suitable only for very small borrowers. Second Method of Lending: Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the buildup of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. Raw materials: 2.75 months’ consumption Stocks in process: ½ month’s cost of production Finished goods: 2 months’ cost of sales Receivables: 1.25 months’ sales For determining the maximum permissible bank finance (MPBF), the methods suggested were: Method I: 0.75 (CA - CL) Method II: 0.75 CA – CL Method III: 0.75 (CA - CCA) – CL Here CA stands for CURRENT ASSETS corresponding to the suggested norms or past levels if lower, CL represents CURRENT LIABILITIES excluding bank lending and CCA stands for the ‘Core Current Assets’, i.e., permanent current assets. Questions for self-control: 1. What do you know about trade financing instruments? 2. Factoring; 3. Export Credit Guarantees.

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CHAPTER 15. Planning and budgeting of financial activities

Chapter

15

Planning and budgeting of financial activities

Financial Planning One factor that has hampered the development of financial planning as a discipline and as a profession is the fact that there has been very little agreement among advisors as to what exactly financial planning is. Indeed, it sometimes seems that there are as many definitions of financial planning as there are people who believe they are engaged in financial planning. This debate, which continues among financial advisors even now, it is not merely an exercise in semantics. It becomes intensely practical when questions are raised about such issues as who shall regulate those advisors engaged in financial planning, who shall set standards for the financial planning profession, what sort of education should these advisors have, or which advisors may hold themselves out to the public as practicing financial planning. Financial Planning Is a Process Despite this ongoing controversy among advisors, financial planning can be defined conceptually as a process that accomplishes both of the following: • ascertaining the client’s financial goals; • providing a plan (not necessarily written) for achieving the client’s goals. Whether used by advisors or self-planning individuals, the financial planning process has six steps: (1) establish financial goals, (2) gather relevant data, (3) analyze the data, (4) develop a plan for achieving goals, (5) implement the plan, and (6) monitor the plan. (Many advisors will reverse steps 1 and 2. The Certified Financial Planner Board of Standards essentially combines steps 1 and 2 126

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into step 2 and adds a new step 1 establishing and defining the relationship with the client. Six Steps of Financial Planning 1. Establish financial goals. 2. Gather relevant data. 3. Analyze the data. 4. Develop a plan for achieving goals. 5. Implement the plan. 6. Monitor the plan.

For advisors, this process for helping clients achieve their financial goals can be applied to the full range of client goals on a comprehensive basis. The process can also be applied on a narrower basis to only a subset of those goals or even to only a single financial goal of a client. It is not the range of client goals addressed that determines whether an advisor is engaged in financial planning. Rather, it is the process used by the advisor in addressing client goals that is the determining factor. The following pages present a brief discussion of the six steps in the financial planning process. Step 1: Establish Financial Goals Few people begin a vacation without having a specific destination in mind. In contrast, millions of people make significant financial decisions without having a specific financial destination. Goal setting is critical to creating a successful financial plan, but few people actually set clearly defined goals. By leading the client through the goal-setting exercise, the financial advisor not only helps establish reasonable, achievable goals, but also sets the tone for the entire financial planning process. Clients typically express concern about such topics as retirement income, education funding, premature death, disability, taxation, qualified plan distribution, and a myriad of others. Sometimes clients enumerate specific, prioritized goals, but they are more likely to present a vague list of worries that suggest anxiety and frustration rather than direction. The advisor’s responsibility is to help the client transform these feelings into goals. Advisors should question clients to learn what they are trying to accomplish. Usually the response is couched in general terms, such as «Well, we want to have a comfortable standard of living when we retire». At first glance this seems to be a reasonable goal, but a closer evaluation reveals that this goal is far too vague. When do they want to retire? What is meant by “comfortable»? Do they want to consider inflation? Do they want to retire on «interest only» or draw down their accumulated portfolio over their expected lives? Skillful questioning may reveal a more precise goal, such as «We want to retire in 20 years with an after-tax income of $60,000 per year in current dollars, and we want the income to continue as long as we live without depleting the principal». Helping the client quantify goals is among the most valuable services a financial advisor can provide.

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Another important service of the advisor is goal prioritization. Clients usually mention competing goals, such as saving for retirement and saving for education. Advisors help clients rank these competing goals. Step 2: Gather Relevant Data Because there are many client concerns that a financial advisor may need to address, the advisor will have to gather considerable information from the client. Defining the client’s current situation, determining what the client’s desired future situation is and when it is to be achieved, and establishing what the client is willing and able to do in order to get there require information. This information must be accurate, complete, up-todate, relevant to the client’s goals, and well organized. Otherwise, financial plans based on the information will be deficient-perhaps erroneous, inappropriate, inconsistent with the client’s other goals, or dangerous to the client’s financial well-being. After a client expresses goals, objectives, and concerns, the advisor gathers all the information about the client that is relevant to the problem(s) to be solved and/or to the type of plan to be prepared. The more complex the client’s situation and the more varied the number of his or her goals, the greater the information-gathering task. Two broad types of information will need to be gathered: objective and subjective. A few examples of objective (factual) information that might be needed from the client include a list of securities holdings, inventory of assets and liabilities, a description of the present arrangement for distribution of the client’s (and spouse’s) assets at death, a list of annual income and expenditures, and a summary of present insurance coverages. Of at least equal importance is the subjective information about the client. The financial advisor often will need to gather information about the hopes, fears, values, preferences, attitudes, and nonfinancial goals of the client (and spouse). One piece of information worthy of special attention is the client’s financial risk tolerance. Advisors must determine the client’s (and spouse’s) attitude toward risk before making recommendations, preferably through use of a scientific, third-party evaluation. Such information offers the additional benefit of helping avoid (or at least defend) lawsuits from a dissatisfied client. Before the financial advisor begins the information-gathering process, he or she should give certain information to the client. First, the client should be made aware that he or she will have to invest time, perhaps a significant amount of time, in the information-gathering stage of financial planning. Even though part of the financial advisor’s responsibility is to avoid consuming the client’s time unnecessarily, this commitment of time by the client is essential. The magnitude of the needed time commitment will depend on the scope and complexity of the client’s needs and circumstances, but the proper development of even a narrowly focused and fairly uncomplicated plan requires information that only the client can furnish. Second, the client should be made aware that he or she probably will have to provide the advisor with some information that is highly

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confidential, perhaps even sensitive or painful, for the client to reveal. Again, the scope and complexity of the client’s needs will inf­luence this matter. The creation of even rather straightforward plans, however, may require clients to disclose such things as their income and spending patterns, their attitudes toward other family members, or their opinions as to the extent of their own financial respon­sibilities to others. Another prerequisite for the effective gathering of client information is a systematic approach to the task. Although there are many possible ways to systematize the gathering of information, one way that has been found useful by many financial advisors is to use a structured fact-finder form. Some fact finders are only a few pages long and ask for basic information, while others are thick booklets that seek very detailed data on each asset and amount. Most fact finders are designed for specific financial planning software to simplify data entry. For many client situations, a formal fact finder elicits considerably more in­ formation than needed. The sections that should be completed depend on the particular areas of concern to be addressed in each client’s financial plan. Obviously, information gathering is far more than asking the client a series of questions or filling out a form. Certainly that is required, but usually information gathering also requires examination and analysis of documents-such as wills, tax returns, employee benefit plan coverage, and insurance policies-supplied by the client or the client’s other financial advisors. It also requires advising, counseling, and listening during face-to-face meetings with the client and spouse. These skills are especially important because the advisor needs to help the client and spouse identify and articulate clearly what they really want to accomplish and what risks they are willing to take in order to do so. Step 3: Analyze the Data Once the relevant information about the client has been gathered, organized, and checked for accuracy, consistency, and completeness, the financial advisor’s next task is to analyze the client’s present financial condition. The objective here is to determine where the client is now in relationship to the goals that were established by the client in step one. This analysis may reveal certain strengths in the client’s present position relative to those goals. For example, the client may be living well within his or her means, and thus resources are available with which to meet some wealth accumulation goals within a reasonable time period. Maybe the client has a liberal set of health insurance coverages through his or her employer, thereby adequately covering the risks associated with serious disability. Perhaps the client’s will has been reviewed recently by his or her attorney and brought up-to-date to reflect the client’s desired estate plan. More than likely, however, the financial advisor’s analysis of the client’s present financial position will disclose a number of weaknesses or

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conditions that are hindering achievement of the client’s goals. For example, the client may be paying unnecessarily high federal income taxes or using debt unwisely. The client’s portfolio of investments may be inconsistent with his or her financial risk tolerance. Maybe the client’s business interest is not being used efficiently to achieve his or her personal insurance protection goals, or important losscausing possibilities have been overlooked, such as the client’s exposure to huge lawsuits arising out of the possible negligent use of an automobile by someone other than the client. One conclusion from the advisor’s analysis may be that the client cannot attain the goals established in step one. For example, the client’s resources and investment returns may preclude reaching a specified retirement income goal. In this case, the advisor helps the client to lower the goal or shows what changes the client must make to achieve the goal. Postponing retirement, saving more money, seeking higher returns, and deciding to deplete principal during retirement are four ways to help achieve the goal. Presented with alternatives, the client can restate the original goal by either lowering it or revising restrictive criteria to make it achievable. Step 4: Develop a Plan for Achieving Goals After the information about the client has been analyzed and, if necessary, the goals to be achieved have been refined, the advisor’s next job is to devise a realistic financial plan for bringing the client from his or her present financial position to the attainment of those goals. Since no two clients are alike, a well-drawn financial plan must be tailored to the individual, with all the advisor’s recommended strategies designed for each particular client’s needs, abilities, and goals. The plan must be the client’s plan, not the advisor’s plan. It is unlikely that any individual advisor can maintain an up-to-date familiarity with all the strategies that might be appropriate for his or her clients. Based on his or her education and professional specialization, the advisor is likely to rely on a limited number of «tried and true» strategies for treating the most frequently encountered planning problems. When additional expertise is needed, the advisor should always consult with a specialist in the field in question to help him or her design the client’s overall plan. Also there is usually more than one way for a client’s financial goals to be achieved. When this is the case, the advisor should present alternative strategies for the client to consider and should explain the advantages and disadvantages of each strategy. Strategies that will help achieve multiple goals should be highlighted. The financial plan that is developed should be specific. It should detail who is to do what, when, and with what resources. Implicit in plan development is the importance of obtaining client approval. It follows that the plan must not only be reasonable; it must also be acceptable to the client. Usually interaction between advisor and client continues during plan development, providing constant

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feedback to increase the likelihood that the client will approve the plan. Normally, the report describing the plan should be in writing. Since the objective of the financial planning report is to communicate, its format should be such that the client can easily understand and evaluate what is being proposed. Some financial advisors take pride in the length of their reports, although lengthy reports are often made up primarily of standardized or «boilerplate» passages. In general, the simpler the report, the easier it will be for the client to understand and adopt. Careful use of graphs, diagrams, and other visual aids in the report can also help in this regard. After the plan has been presented and reviewed with the client, the moment of truth arrives. At this time the advisor must ask the client to approve the plan (or some variation thereof). As part of this request, the advisor must ask the client to allocate money for the plan’s implementation. While there are those who frown at the mere mention of selling in connection with financial planning-financial planning does involve selling. Even financial advisors who are compensated entirely on a fee-for-service basis must sell the client on the need to work with the advisor to develop and implement a plan. Step 5: Implement the Plan The mere giving of financial advice, no matter how solid the foundation on which it is based, does not constitute financial planning. A financial plan is useful to the client only if it is put into action. Therefore, part of the advisor’s responsibility is to see that plan implementation is carried out properly according to the schedule agreed upon with the client. Financial plans that are of limited scope and limited complexity may be implemented for the client entirely by the advisor. For other plans, however, additional specialized professional expertise will be needed. For example, such legal instruments as wills and trust documents may have to be drawn up, insurance policies may have to be purchased, or investment securities may have to be acquired. Part of the advisor’s responsibility is to motivate and assist the client in completing each of the steps necessary for full plan implementation. Step 6: Monitor the Plan The relationship between the financial advisor and the client should be an ongoing one. Therefore, the sixth and final step in the financial planning process is to monitor the client’s plan. Normally the advisor meets with the client at least once each year to review the plan, or more frequently if changing circumstances warrant it. The first part of this review process should involve measuring the performance of the implementation vehicles. Second, updates should be obtained concerning changes in the client’s personal and financial situation. Third, changes that have occurred in the economic, tax, or financial environment should be reviewed with the client. If this periodic review of the plan indicates satisfactory performance in light of the client’s current goals and circumstances, no action

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needs to be taken. However, if performance is not acceptable or if there is a significant change in the client’s personal or financial circumstances or goals or in the economic, tax, or financial environment, the advisor and client should revise the plan to fit the new situation. This revision process should follow the same six steps used to develop the original plan, though the time and effort needed will probably be less than in the original process. Strategic business plan Internal document that (1) outlines an organization’s overall di­rection, philosophy, and purpose, (2) examines its current status in terms of its strengths, weakness, opportunities, and threats, (3) sets longterm objectives, and (4) formulates short-term tactics to reach them. Financial operating plan A business or financial road map that identifies revenues and expenses. This type of plan tracks where money comes from and where it goes in a business operation. It defines specific goals such as budgeting, costs associated with operations, and sales projections. A financial operating plan uses historic and recent performance to predict expected outcomes in the near future. The plan must be updated periodically to adjust for changing circumstances. Budgeting Process of expressing quantified resource requirements (amount of capital, amount of material, number of people) into time-phased goals and milestones. Budget is a financial plan that sets forth the resources necessary to meet a set of goals, (departmental, college, campus) for a certain period of time. The budget records, in monetary terms, realistic goals for programs, staffing, and operations. The revenue portion of the budget identifies the means for financing the plan, and the expense portion of the budget estimates the cost of the plan. Typically, the time period covered by the budget is a fiscal year. When working with capital construction projects or sponsored projects, the time period covered by the budget spans the duration of the project rather than the fiscal year. Incremental Budgeting The incremental budgeting process begins with last year’s continuing budget figures as the base budget. These numbers are then adjusted to reflect inflation, growth, changing conditions and other information gathered from financial forecasts for the upcoming fiscal year. The advantage to using the incremental method of budgeting is that the work is greatly simplified, since this approach starts with a budget that is already in place. The disadvantage to incremental budgeting is that the inefficiencies and inadequacies of the prior year’s budget are automatically built into the budget for the upcoming fiscal year. Zero-Base Budgeting Zero-Base budgeting (ZBB) employs a «bottom-up» approach. This method starts with a base budget of zero and calculates the costs of

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running each program from scratch. On an annual basis, each cost associated with running a program must be justified before it can be included in the budget. The advantage of the ZBB method resides in the extensive review it gives each program. While the ZBB approach can uncover operating inefficiencies and identify weaker programs, it also can highlight those programs that are most vital to the organization. The effort and time requirements of ZBB are its principal disadvantages. Questions for self-control: 1. How do the planning processes organized? 2. Why do the companies plan their financial activities? 3. What is the budgetary control?

134

Recommended literature

Recommended literature

1.

Akulov, V.B. Financialmanagement: textbook / V.B. Akulov. – M.: Flinta, MPSU, 2010. – 264 p. 2. Arkhipov, А.P. Financial management in insurance: textbook / А.P. Arkhipov. – М.: FiS, INFRA-М, 2010. – 320 p. 3. Basovsky, L.Е. Financialmanagement: textbook L.Е. Basovsky. – М.: NISINFRA-М, 2013. – 240 p. 4. Basovsky, L.Е. Financialmanagement: textbook: Study guide / L.Е. Basovsky. – М.: ISRIOR, INFRA-М, 2011. – 88 p. 5. Bakhramov, Y.М. Financial Management: textbook for universities. Standard of third generation / Y.М. Bakhramov, V.V. Glukhov. – St.-Petersburg: Piter, 2011. – 496 p. 6. Brusov, P.N. Financial Management. Mathematical Foundations. Shortterm­financialpolicies: study guide / P.N. Brusov, T.V. Philatov. – M.: KnoRuss, 2013. – 304 p. 7. Varlamova, Т.P. Financial Management: study guide / Т.P. Varlamova, М.А. Var­la­mova. – М.: Dashkov&К, 2012. – 304 p. 8. Gavrilova, А.N. Financial Management: study guide / А.N. Gavrilova, Е.Ph. Sisoyeva, А.I. Barabanov. – М.: KnoRuss, 2013. – 432 p. 9. Ginsburg, М.Y. Financial Management in the enterprises of oil and gas industry: study guide / М.Y. Ginsburg, L.N. Krasnova, R.R. Sadikova. – М.: NISINFRA-M, 2013. – 287 p. 10. Yermasova, N.B. Financial Management: study guide / N.B. Yermasova, S.V. Yermasov. – М.: URight, IDUright, 2010. – 621 p. 11. Kandrashina, Е.А. Fiancial Management: textbook / Е.А. Kan­drashina. – М.: Dashkov&К, 2013. – 220 p. 12. Kovalev, V.V. Financial Management questions and answers: study guide / V.V. Kovalev, V.V. Kovalev. – М.: Prospect, 2013. – 304 p. 13. Kovalev, V.V. FinancialManagement: theory and practice / V.V. Kovalev. – М.: Prospect, 2013. – 1104 p. 14. Kokin, А.S. Financial Management: study guide for students / А.S. Kokin, V.N. Yasnev. – М.: Unity-DANA, 2013. – 511 p. 15. Samilyn, А.I. Financial Management: textbook / А.I. Samilyn. – М.: NISINFRA-М, 2013. – 413 p. 16. Higgins,R. Financial Management: money management and in­vestment / R. Higgins; trans. fromenglish. А.N. Svirid. – М.: Williams, 2013. – 464 p.

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Educational issue

Alzhanova Nurzhan Sharipovna FINANCIAL MANAGEMENT Educational manual Computer page makeup: K. Umirbekova Cover designer: K. Umirbekova _www.maths.york.ac.uk

IB No 7564

Signed for publishing 13.10.14. Format 60x84 1/16. Off set paper. Digital printing. Volume 11,25 printer’s sheet. Edition: 50. Order No 1981. Publishing house “Qazaq university” Al-Farabi Kazakh National University KazNU, 71 Al-Farabi, 050040, Almaty Printed in the printing offi ce of the “Kazakh Universitety” publishing house

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Новые книги издательского дома «Қазақ университеті» Дуламбаева Р.Т. Государственная политика повышения конкурентоспособности национальной экономики. – 2014. – 276 с. ISBN 978-601-04-0491-5 Монография посвящена исследованию проблем разработки государственной политики повышения конкурентоспособности национальной экономики в условиях неустойчивости глобальных процессов. Рассмотрены различные теоретические подходы к определению понятий конкуренции и национальной конкурентоспособности в современных условиях, определены основные направления реализации концепции конкурентного развития страны в базовых сферах экономики РК, в частности, редкометальной отрасли, топливно-энергетическом, агропромышленном комплексах. Книга предназначена для научных работников, преподавателей, студентов, магистрантов и докторантов высших учебных заведений, специализирующихся в области экономики, а так же может быть полезной для всех, кто интересуется проблемами экономической теории и разработки мероприятий экономической политики. Альжанова Н.Ш. Финансовая математика: учебное пособие. – 2013. – 106 с. ISBN 978-601-04-0140-2 В учебном пособии наглядно изложены теоретические, методические и практические основы применения наиболее распространенных методов финансовых вычислений. Работа построена в соответствии университетской учебной программой по финансовой математике. Принципиальные теоретические положения иллюстрируются примерами решения типовых задач. Особое внимание уделено возможностям самостоятельной работы, с этой целью приведены примеры решения задач, имеется раздел практических заданий для самостоятельного решения с ответами. Рекомендуется в качестве учебного пособия для студентов и преподавателей экономических вузов и факультетов. Пособие предназначено также для актуарных, страховых, аудиторских компаний и банковских работников. V.D. Ly, A.V. Hamzaeva General course of finance: educational manual / translation in English: A.V. Hamzaeva. – Almaty: Kazakh University, 2014. – 314 p. ISBN 978-601-04-0269-0 This book is the basic textbook at the rate «Finance», in which current trends found reflection in a financial system: roles of financial policy and financial mechanism finance of the state entities, modern taxation system, budget system, etc. In the book important provisions of the financial theory, value of anti-recessionary financial policy and the financial mechanism of its implementation are opened, value and a role of finance of the state entities reveal. It is intended for students, undergraduates, doctoral candidates and teachers of higher education institutions, listeners of system of advanced training and retraining of personnel, financial officers and government employees. По вопросам приобретения обращаться в отдел продаж издательского дома «Қазақ университеті». Контактные тел.: 8 (727) 377-34-11, 328-56-51. E-mail: [email protected], cайт: www.read.kz, www.magkaznu.com