Financial Management Part 1

Reviewer

Chapte
r1
Finance grew out of economics and
accounting Areas of Finance:
1. Financial Mangement (Corporate Finance) focuses on decisions relating to how
much and what types of asset to acquire, how to raise the capital needed to purchase
assets, and how to run the firm so as to maximize its value.
Goals of Financial Management:
1. Stockholder wealth maximization - maximizing the price of the firms common stock.
2. Profit maximization - maximization of profits within a given period of time
Finance Manager

Controller ( Chief Accountant)

Treasurer ( Chief Financial Manager)

Finance Manager:
1. Guidance in decision
making
2. Contols asset
3. Financial analysis and
planning

4. Policy making
5. Manage risks
6. Inflows and outflows of funds

Controller ( Chief Accountant

):
1.

Financial Statements

2.

Tax Management

Treasurer ( Chief Financial

Manager )
1. Financial Analysis

2. Capital Markets markets where interest rates, along with stock and bond prices, are
determined. Also studied here are the financial institutions that supply capital to
businesses.

Financial Management Part 1

Reviewer

Chapte

3. Investments decisions concerning stocks

and bonds and include a numbe rof activities.
r1

Financial Management Part 1

Reviewer
Forms of Business Organization
1. Proprietorship unincorporated business owned by one individual
Advantages:

Disadvantages:

1. They are easily and

inexpensively formed
2. They are subject to few
government regulations
3. They are subject to lower income
taxes

1. Unlimited personal liability

2. Limited life
3. Difficulty in obtaining large sums of
capital

2. Partnership legal arrangement between two or more people who decide to do business
together.
3. Corporation legal entity created by state and is separate and distinct from its owners
and managers, having unlimited life, easy transferability of ownership and limited
liability.

S Corporation a special designation that allows small businesses that meet

qualifications to be taxed as if they were a proprietorship or a partnership rather than a
corporation.
4. Limited liability Company (LLC) a relatively new type of organization that is a hybrid
between a partnership and a corporation.
Shareholder Wealth Maximization the primary goal for managers of publicly owned
companies implies that decisions should be made to maximize the long run value of the firms
common stock.
Intrinsic Value an estimate of a stocks true value based on accurate risk and return data.
The intrinsic value can be estimated but not measured precisely.
Market Price the stock value based on perceived but possibly incorrect information as seen
by the marginal investor.
Marginal Investor an investor whose views determine the actual stock price.
Important Business Trends:
1. Increased Globalization of business developments in communications technology have
made it possible to obtain real time data .
2. Ever improving information technology improvements in IT change financial
mangement as it is practiced in the US and elsewhere
3. Corporate governance the way top managers operate and interface with stockholders.

Financial Management Part 1

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Business Ethics companys attitude and conduct toward its employees,
customers, community
and stockholders.

Chapter 2
Funds

Internal

External

from operations
from sale of asset

financial market
financial institution
private placements

Financial Markets any marketplace where buyers and sellers participate in the trade of
assets such as equities, bonds, currencies and derivatives. (brokers)
Types of Financial Market:
1. Capital Markets markets for intermediate or long term debt and corporate stocks.
1.1. Primary Markets markets in which corporations raise new capital by issuing new
securities.
1.2. Secondary Markets markets in which existing, already outstanding securities are traded
among investors.
2. Money Markets markets for short term, highly liquid debt securities.

Financial Institution - an establishment that focuses on dealing with financial transactions,

such as investments, loans and deposits.
Types of Financial Institution:
1. Commercial Banks are the traditional department stores of finance because they serve
a variety of savers and borrowers. (savings, deposit and loan)
2. Investment Banks traditionally help companies raise capital. They help corporations
design securities with features that are currently attractive to investors, buy these
securities from the corporation and resell them to savers. (investments)
3. Universal Banks both a commercial bank and an investment bank
Financial Services Corporation large conglomerates that combine many different
financial institutions within a single corporation. A firm that offers a wide range of
financial services, including investment banking, brokerage operations and commercial
banking. ( ex. BDO, BPI, Metrobank )

Financial Market

Suppliers of Funds

Private Placements

Demanders of Funds

Financial Institution

Stock Market where the prices of firms stocks are established.

a. Physical Location Stock Exchanges formal organizations having tangible physical
locations that conduct auction markets in designated securities.
b. Over the Counter Market a large collection of brokers and dealers, connected
electronically by telephones and computers, that provides for trading in unlisted
securities.

Chapter 3
Financial Statements convey a lot of useful information that helps corporate managers
assess the companys strengths and weaknesses and gauge the expected impact of various
proposals.
Annual Report a report issued annually by a corporation to its stockholders. It contains
basic financial statements as well as managements analysis of the firms past operations and
future prospects. The information contained in the annual report can be used to help forecast
future earnings and dividends.
Elements of Financial Statements:
1.
2.
3.
4.
5.

Statement of Financial Position / Balance Sheet

Statement of Comprehensive Income / Income Statement
Statement of Cash Flows
Statement of Changes in Equity
Notes to Financial Statements

Statement of Financial Position / Balance Sheet shows what assets the company owns
and who has claims on those assets as of a given date. The balance sheet is a snapshot of a
firm;s position at a specific point in time.

Current Assets
Cash and Cash Equivalents Accounts Receivable Inventory
Long-Term (Fixed) Assets
Net Plant and Equipment Other Long term Assets

Current Liabilities
Accrued Wages and taxes Accounts Payable
Notes Payable
Long Term Debt

Stockholders Equity
Outstanding Shares Retained Earnings

Current Assets consist of assets taht should be converted to cash

within one year Long term Assets assets expected to be used for
more than one year
Current Liabilities consist of claims that must be paid
off within a year Long term Debt included bonds that
mature in more than a year
Stockholders Equity represents the amount that stockholders paid the company when shares
were purchased and the amount of earnings the company has retained since its origination.
Retained Earnings the cumulative total of all earnings kept by the company during its life.

Total Assets = Total Liabilities + Total Equity

Net Working Capital = Current Assets Current Liabilities

Net Operating Working Capital = Current Assets (Current Liabilities

Notes Payable)

Statement of Comprehensive Income / Income Statement a report summarizing a

firms revenues, expenses and profits during a reporting period.
Revenue
Less: Cost of Goods
Sold Gross Profit
Less: Operating
Expenses EBITDA
Less: Depreciation and
Amortization EBIT /
Operating Income
Less : Interest
Expense

NIBT
Less: Income
Tax NIAT

Statement of Cash Flows - a report that shows how items that affect the balance sheet and
income statement affect the firms cash flows.
Operating Activities items that occur as part of normal ongoing operations
Net Income the first operating activity, which is the first source of cash (Indirect method, in
direct method it starts with Receipts from Customers)
Investing Activities all activities involving long
term assets Financing Activities

Statement of Stockholders Equity a statement that shows by how much a firms equity
changed during the year and why this change occured.

Ways in Analyzing Financial Statements

1. Vertical within a year
2. Horizontal with different years

Free Cash Flow the amounts of cash that could be withdrawn from a firm without harming its
ability to operate and to produce future cash flows.
FCF = [ EBIT (1-T) + Depreciation and Amortization ] (Capital Expenditures + Change in
Net Operating Working Capital)

Market Value Added (MVA) the excess of the market value of equity over its book value.
MVA = Market value of equity Book value of equity

Economic Value Added (EVA) excess of NOPAT over capital costs

EVA = EBIT (1-T) (Total investor supplied OC * After tax percentage of
cost of capital)

Progressive Tax a tax system where the tax rate is higher on higher incomes.

Chapter 4
Ratios help us evaluate financial statements.
Liquidity Ratios firms ability to pay off debts that are maturing within a year. Ratios that
show the relationship of a firms cash and other current assets to its current liabilities.
1. Current Ratio it indicates the extent to which current liabilities are covered by those
assets expected to be converted to cash in the near future.
Current Ratio = Current Assets / Current
Liabilities
2. Quick Ratio measures the firms ability to pay off short-term obligations without
relying on the sale of inventories. ( inventory least liquid )
Quick Ratio = Current Assets - Inventories /
Current Liabilities

Asset Management Ratios - measure how effectively the firm is managing its assets.
1. Inventory Turnover Ratio shows how many times the inventory is turned over during the
year.
ITO = Sales /
Inventories
2. Days Sales Outstanding indicates the average length of time the firm must wait after
making a sale before it receives cash.
DSO = Receivables / (Sales /
365 )
3. Fixed Asset Turnover Ratio measures how effectively the firm uses its plants and equipment.
FATO = Sales / Net Fixed
Assets
4. Total Asset Turnover Ratio measures the turnover of all the firms assets
TATO = Sales / Total
Assets
Debt Management Ratios set of ratios that measure how effectively a firm manages
its debt.
1. Debt Ratio measures the percentage of funds provided by creditors.
DR = Total Debt / Total
Assets

2. Times-Interest-Earned ratio measure of the firms ability to meet its annual interest
payments.
TIER = EBIT / Interest
Expense

3. Debt- Equity Ratio

D-E Ratio = Total Debt / Total

Equity

4. Debt Service Coverage Ratio

DSCR = EBITDA / (Loan Repayments +
Interest Paid)
Profitability Ratios show the combined effects of liquidity, asset management and debt on
operating results.
1. Operating Margin measures operating income per sales. ( Margin maximizing sales )
OM = EBIT / Sales
2. Profit Margin measures the net income per sales.
PM = Net Income /
Sales

3. Return on Total Assets

ROTA = Net Income / Total

Assets
4. Basic Earning Power Ratio indicates the ability of the firms assets to generate operating
BEP = EBIT / Total
Assets

income.

5. Return on Common Equity measures the rate of return on common stockholders

ROE = Net Income / Total
Equity

investment.
6. Return on Invested Capital

ROIC = EBIT (1-T) / (Debt +

Equity)

Market Value Ratios relate the firms stock price to its earnings and book value per
share.
1. Price / Earnings Ratio shows how much investors are willing to pay per peso of reported
profits.
P/E = Price per Share / Earnings per Share
EPS = NIAT / Outstanding Shares
2. Market / Book Ratio indication of how investors regard the company
Book Value = Common Equity / Outstanding Shares
M/B Ratio = Market Price / Book Value

DuPont Equation a formula that shows that the rate of return on equity can be found as the
product of profit margin, total assets turnover, and the equity multiplier. It shows the
relationships among asset management, debt management and profitability ratios. Helps
identify ways to improve performance
ROE = ROA * Equity Multiplier
= Profit Margin * Total Asset Turnover * Equity Multiplier
= (Net Income / Sales) * ( Sales / Total Assets) * ( Total Assets /
Total Equity)

Using Financial Ratios to Assess Performance

1. Comparison to Industry Average
2. Benchmarking the process of comparing a particular company with a set of benchmark
companies.
3. Trend Analysis an analysis of a firms financial ratios over time, used to estimate the
likelihood of improvements or deterioration in its financial condition.

Chapter 5
Time Value analysis has many applications, including planning for retirement, valuing stocks
and bonds, setting up loan payment schedules, and making corporate decisions regarding
investing in new plant and equipment.
Time line important tool used in time value analysis, it is a graphical representation used to
show the timing of cash flows.
Future Value - the amount to which a cash flow or series of cash flows will grow over a
given period of time when compounded at a given interest rate.
Present Value the value today of a future cash flow or series of cash flows.
Compounding the arithmetic process of determining the final value of a cash flow or
series of cash flow when compound interest is applied.
Discounting the process of finding the present value of a cash flow or a series of cash flows,
reverse of compounding
Compound Interest occurs when interest is earned on prior periods interest.
Simple Interest occurs when interest is not earned on the interest.
Annuity a series of equal payments at fixed intervals for a specified number of periods.

Ordinary Annuity an annuity whose payments occur at the end of

each period. Annuity due an annuity whose payments occur at the
beginning of each period. Perpetuity a stream of equal payments at
fixed intervals expected to continue forever. Amortized Loan a loan
that is repaid in equal payments over its life.

Financial Management Part 1

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Formulas:

Annuity Due:
(1+)1

FV = PV

FV = R (1+i) (

(1+i) PV =
FV (1+i)
log

1 (1+)

-n

PV = R (1+i) (

N=log (1
+)

I =
1

Perpetuity:

PV =

Ordinary
Annuity:

Amortization:

(1+)1

FV =
R(
PV =
R(

A = annual

1 (1+)

payment
principal

P=
r=
rate

Chapter 10
When calculating the WACC, our concern is with capital that must be provided by investors
interest bearing debt, preferred stock, and common equity.
Target Capital Structure the mix of debt, preferred stock and common equity the firm plans to
raise to fund its future projects.
Capital Components one of the types of capital used by firms to raise funds. (debt,
preferred stocks and common equity)
Weighted Average Cost of Capital a weighted average of the component costs of debt,
preferred stock and common equity.
WACC = WdRd + WpRp + WeRe + WrRr
Cost of Debt ( Rd )
The after tax cost of debt should be used to calculate the weighted average cost of capital
because interest is tax deductible.

Rd = rd (1-T)

Financial Management Part 1

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rd = cost of debt before tax

rd = Rf + DM
Rf = risk free rate

DM = Debt Margin

rd =

I=

V = net proceeds of

interest M = par

bonds n = life of

value of bonds

bonds

Formulas:
Rd = rd (1-T)
DM (1-T)

Rd = Rf +

Rd = + (1-T)

Cost of Preferred Stock ( Rp ) the rate of return investors require on the firms preferred
stock.
Rp = Dp / Po
Dp = preferred dividends per share
Po = net proceeds of P/S (Selling price Flotation cost)
Cost of Equity ( Re )
R =
e

()

D1 = dividends per
share P = net
proceeds
g = growth rate
If g = 0%, Zero Growth Model
If g is constant, Constant Growth Model

Arbitrage Percentage
Method Re = Rf + 1Rf

+ 2Rf + ... nRf Rf =

risk free rate
= beta coefficient

Capital Asset Pricing

Model ( CAPM ) Re = Rf +
( Rm - Rf)
Rm = market return
= beta
coefficient Rf =
risk free rate
Although the CAPM appears to produce an accurate, precise estimate of R e, several potential
problems may exist.
1. If the firms stockholders are not well diversified, they may be concerned with stand
alone risk rather than just market risk.
2. Even if the CAPM theory is valid, it is hard to obtain accurate estimates of the required inputs
because
a. there is controversy abouth whether to use long term or short term treasury bills for Rf
b. it is hard to estimate the beta that investors expect the company to have in the future
c. it is difficult to estimate the proper risk premium.

Cost of Retained earnings ( Rr )

Rr = Re
Basis of Weight:
1. Target Values
2. Historical Values ( Book Value and Market Value)
Factors that Affect the WACC
1. Factors the firm cannot control
a. interest rate in the economy if the interest rates in economy rise, the cost of debt
increases because the firm must pay bondholders more when it borrows.
b. general level of stock prices if stock prices in general decline, its cost of equity will rise.
c. tax rates
2. Factors the firm can control
a. by changing its capital structure if a firm changes its target capital structure, the
weighs used to calculate the WACC will change.
b. by changing its dividend payout ratio the higher the dividend payout ratio, the
smaller the addition to retained earnings, the higher the cost of equity, and
therefore the higher WACC
c. by altering its capital budgeting decision rules

Chapter 14
Target capital structures often change over time, such changes affect the risk and cost of each
type of capital, and all this can change the WACC. Moreover, a change in WACC will affect capital
budgeting decisions and ultimately the stock price
Capital refers to investor-supplied funds debt, preferred stock, common stock and retained
earnings.
Capital Structure the percentage of each type of investor-supplied capital
Optimal Capital Structure mix of debt, preferred stock and common equity that maximizes
the stocks intrinsic value.

Firms actual capital structures changes over time, and for two quite different reasons:
1. Deliberate Actions if a firm is not currently at its target, it may deliberately raise new
money in a manner that moves the actual structure toward the target.
2. Market Actions the firm could incur high profits or losses that lead to significant
changes in book value equity as shown to its balance sheet and to a decline in its stock
price.

Risk on stand alone basis where an assets cash flows are analyzed by themselves
Risk in a portfolio context where cash flows from a number of assets are combined and
consolidated cash flows are analyzed.
a. Diversifiable Risk which can be diversified away and hence is of little concern to
most investors
b. Market Risk which is measured by the beta coefficient and reflects broad
market movements that cannot be eliminated by diversification and therefore is
of concern to investors.
Two Dimensions of Risk:
1. Business Risk riskiness of the firms assets if no debt is used.
2. Financial Risk which is the additional risk placed on the common stockholders as a result of
using debt.

Business Risk - is the single most important determinant of capital structure, and it represents
the amount of risk that is inherent in the firms operation even it uses no debt financing. A
commonly used measure of business risk is the standard deviation of the firms return on
invested capital, or ROIC.

ROIC = EBIT (1-T) / (Debt + Equity)

ROIC measures the after-tax return that the company provides for all of its investors. Since ROIC
does not vary with changes in capital structure, the standard deviation of ROIC measures the
underlying risk of the firm before considering the effects of the debt financing, thereby
providing a good measure of business risk.
The more the uncertainty there is about future EBIT and thus ROIC, the greater the business risk.

Factors that Affect Business Risk:

1. Competition - less competition lowers business risk
2. Demand Variability the more stable the demand for a firms products, other things held
constant, the lower its business risk
3. Sales price Variability firms whose products are sold in volatile markets are exposed to
more business risk than firms whose output prices are stable, other things held constant.
4. Input Cost Variability firms whose input costs are uncertain have higher business risks.
5. Product obsolescence the faster its products become obsolete, the greater the business risk.
6. Foreign risk exposure firms that generate a high percentage of their earnings overseas
are subject to earnings declines due to exchange rate fluctuations.
7. Regulatory risk and legal exposure
8. The extent to which cost are fixed: operating leverage if a high percentage of its costs
are fixed and thus do not decline when demand falls, this increases the firms business
risk.
The higher a firms fixed costs, the higher its business risk.
Operating Leverage - the extent to which fixed costs are used in a firms operations. When a
high percentage of total costs are fixed, the firm is said to have a high degree of operating
leverage. A high degree of operating leverage, other factors held constant, implies that a
relatively small change in sales results in a large change in ROIC.
Operating Breakeven the output quantity at which EBIT = 0
QBE = F / ( P V )
F = fixed

V = variable cost per

operating cost P

unit QBE = break-even

= sales price per

quantity

unit

Financial Risk is the additional risk placed on the common stockholders as a result of the
decision to finance with debt. if a firm uses debt, this concentrates the business risk on common
stockholders. Changes in the use of debt would cause changes in EPS as well as changes in risk.
Financial Leverage the extent to which fixed income securities are used in a firms capital
structure.
Optimal Capital Structure the optimal capital structure is the one that maximizes the price
of the firms stock and this generally calls for a Debt/Capital ratio that is lower than the one that
maximizes expected EPS.
Increasing the debt ratio increases the risk that bondholders face and thus the cost of debt.
more debt also raises the risk borne by stockholders, which raises the cost of equity.

Unlevered beta the firms beta coefficient if it has no debt.

bU = bL / [1 + ( 1- T )(D/E) ]
bU = unlevered
beta bL = firms
current beta

Business risk is an important determinant of the optimal capital structure.

Formulas:
1.

Contribution Margin

3.

Degree of Total Leverage (DTL)

DTL = DOL * DFL

CM =

2. Break-even
Point
BEPsales =

DOL = %

where: %
EBIT =

BEPUnits =

DFL =

DFL =

Chapter 16
Working Capital current assets are often called working capital because these assets turn
over
Net Working Capital defined as the current assets minus current liabilities
Net Operating Working Capital represents the working capital that is used for operating
purposes.

Current Asset Investment Policies:

1. Relaxed Investment Policy relatively large amounts of cash, marketable securities,
and inventories are carried and a liberal credit policy results in a high level of receivables,
results in low turnover, which in turns lowers ROE.
2. Restricted Investment Policy holdings of cash, marketable securities,
inventories and receivables are constrained. Results in high ROE.
3. Moderate Investment Policy an investment policy that is between the relaxed and
restricted policies.

Current Asset Financing Policies: the way permanent and temporary current assets are
financed
1. Maturity Matching or Self-Liquidating Approach a financing policy that matches
the maturities of assets and liabilities. this is a moderate policy.
2. Aggressive Approach
3. Conservative Approach
Cash Conversion Cycle - the length of time funds are tied up in working capital, or the length
of time between paying for working capital and collecting cash from the sale of the working
capital.
1. Inventory Conversion Period the average time required to convert raw materials into
finished goods and then to sell them.

2. Average Collection Period the average length of time required to convert the firms
receivables into cash, that is, to collect cash following a sale.
3. Payables Deferral Period the average length of time between the purchase of materials
and labor and payment of cash for them.
Cash Conversion Cycle = Inventory Conversion Period + Average Collection
Period Payables Deferral Period

Inventory Conversion Period =

Average Collection
Period =

Payables Deferral Period =

/

Cash Budget a table that shows cash receipts, disbursements and balances over some period.
The monthly cash budget begins with a sales forecast for each month and a projection of
when actual collections will occur. Then there is a forecast of materials purchases, followed by
forecasted payments for materials, labor, leases, new equipment, taxes and other expenses.

Chapter 17
Stages in Planning
1.
2.
3.
4.
5.
6.

Strategic Planning
Tactical Planning
Execution Planning
Financial Planning
Implementation
Review / Evaluation

Strategic Planning
1.
2.
3.
4.
5.

Mission Statement a condensed version of a firms strategic plan

Corporate Scope defines a firms lines of business and geographic areas of operation
Statement of Corporate Objectives set forth specific goals to guide management
Corporate Strategies broad approaches developed for achieving a firms goals
Operating Plan provides management detailed implementation guidance, based on the
corporate strategy, to help meet the corporate objectives.

6. Financial Plan the document that includes assumptions, projected financial statements
and projected ratios and ties the entire planning process together.

Financial Management Part 1

Reviewer
Sales Forecast the financial plans generally begins
with a sales forecast. Financial Planning
1.
2.
3.
4.

Sales Budget
Production Budget
Operating Expense Budget
Projected Financial Statements ( Income Statement, Balance Sheet, Cash Flows )

Additional Funds Needed the amount of external capital ( interest bearing debt and preferred
and common stock ) that will be necessary to acquire the required assets.
Formulas:
AFN
=

S - S MS1 ( 1 Payout )

Economic Order Quantity

S = used units

O = ordering cost

C = carrying cost

Reordering Point = ( Lead time * Daily Sale ) + Safety Stock