POWER POINT ROLE OF FINANCIAL MANAGEMENT

  

THE ROLE OF FINANCIAL

MANAGEMENT

Dr. H. Mustika Lukman Arief, SE., MBA., MM.

THE ROLE OF FINANCIAL

MANAGEMENT

Dr. H. Mustika Lukman Arief, SE., MBA., MM.

• Apa itu manajemen keuangan….?

  Manajemen Keuangan meliputi semua

  aktivitas yang berhubungan dengan

  usaha mendapatkan dana yang

  dibutuhkan perusahaan serta

  mengggunakan dan/mengalokasikan

  dana tersebut secara efesien dan efektif

  guna mencapai tujuan perusahaan.

Manajemen keuangan digunakan untuk menjawab pertanyaan:

  

1. What long-term investments should

the frma engage in?

  2. How can the frm raise the money for the required investments?

  3. How much short-term cash fow does a company need to pay its bills?

  Proses manajemen keuangan for-proft organization

Dividen Laba bersih Keputusan Keputusan Keputusan Keputusan Kebijakan Kebijakan Investasi Investasi Investasi Investasi

Dividen Dividen Laba ditahan

  Alternatif investasi?

  Inv. Jangka panjang

  Penilaian investasi?

  Inv. Jangka pendek pemilihan investasi? Jangka pendek (Hutang Lanca) Jumlah kebutuhan

Keputusan Keputusan

  dana?

Pendanaan Pendanaan

  Jangka panjang

  Sumber dana?

  Modal sendiri: Struktur modal?  Laba ditahan

  Biaya modal?

The Role of The Financial Manager

   Capital Budgeting decision  decision to in tangible or intangible assets also called the investment decision

   Financing decision  raising money that the firm needs for its investments and operations

   Capital structure  the mix of long term debt and equity financing

  Untuk kebijakan fungsi tersebut, ada 3 keputusan yang perlu diambil

  1. Keputusan investasi

  2. Keputusan Pendanaan

  3. Kebijkan Dividen Masing-masing keputusan harus berorientasi pada pencapaian tujuan perusahaan Tujuan Perusahaan

Dalam pengertian mikroekonomi disebut bahwa tujuan perusahaan

adalah memaksimalkan keuntungan. Namun ditinjau dari sudut

keuangan tujuan ini mengabaikan berbagai kerumitan yang ada

dalam praktek pengambilan keputusan sehari-hari

Kelemahan Maksimalisasi Keuntungan:

  

1. Tidak mengaitkan besarnya keuntungan yang dihasilkan denga

waktu perolehannya

  2. Tidak memperhatikan masalah waktu dan ketidakpastian

  3. Mengabikan lamanya waktu pengembalian

  4. Mengabaikan beban modal yang harus dipikul pemegang saham Tujuan Perusahaan

Tujuan perusahaan adalah memaksimalkan kekayaan

pemegang saham dengan cara memaksimalkan nilai

perusahaan ‘Basic goal: Maximize stockholder value’ indikatornya

• Firm’s value yang maksimal
• Stock price yang maksimal

   Nilai perusahaan dicerminkan oleh harga pasar saham

   Mengapa harga pasar saham mencerminkan nilai perusahaan atau kekayaan pemegang saham?

  Tujuan manajemen Keuangan  mempelajari dan memahami bagaimana upaya perusahaan dalam memaksimalkan nilai

perusahaannya (Value of the frm) memalui 3

macam keputusan yaitu: keputusan investasi,

keputusan pendaaan, kebijakan dividen.

  V = f (I, F, D) _f V value of the firm (nilai perusahaan) _{f =} I = Investment Decision F = Financial Decision D = Dividen Policy Decision

  The Objektive Function Maximime the Value of the frm

  

The Objektive Function

Maximime the Value of the frm

  Basic corporation fnancial decision

  1. How do you allocate resources across competing uses?

  2. How do you raise founds to fnance the projects?

  3. How much do you reinvest back into the business and

  how much do you return to you stockholders?

Basic corporation fnancial decision

  1. How do you allocate resources across competing uses?

  2. How do you raise founds to fnance the projects?

  

3. How much do you reinvest back into the business and

how much do you return to you stockholders?

  The corporate fnancial toolbox Accounting stetement and ratio Present value Risk and return meodels The corporate fnancial toolbox Accounting stetement and ratio Present value Risk and return meodels

  

Aksioma-aksioma yang diperlukan

untuk memahami Manajemen

Keuangan

  Aksioma Keseimbangan risiko dan 1 pengembalian (the risk-return tradeoff Jangan menambahkan risiko kecuali mendapatkan kompensasi tambahan pendapatan Aksioma Nilai waktu uang (time value of 2 moneyf-uang yang diterima ssekarang lebih berharga dari uang yang diterima kemudian

Aksioma Yang utama adalah uang kas-bukan Lanjutan…

Aksioma 4 Tambahan Arus Kas (Increment Cash Flow) satu-satunya pertambahan nilai yang dihitung

  

Aksioma 5 Kondisi persaingan pasar-alasan kenapa sangat sulit mendapatkan

laba yang luar biasa

  Aksioma 6 Pasar modal yang efesien-pasar yang bergerak cepat dan harga yang tepat

  Aksioma 7 Masalah keagenan-manajer tidak akan bekerja bagi pemilik perusahaan jika tidak selaras dengan kepentingan mereka

  Aksioma 8 Perpajakan yang berdampak pada keputusan bisnis Aksioma 9 Tidak semua risiko sama, ada sebagian risiko yangd dapat didiversifikasi

  Aksioma 10 Melakukan sesuatu yang benar adalah perilaku yang etis, dan banyak dilema etika dalam manajemen keuangan

  What is a Corporation?  Types of Corporations

   Public Companies

   Private Corporations

   Limited Liability Corporations (LLC) Organizing a Business

 Types of Business Organizations

   Sole Proprietorships

   Partnerships

   Corporations

   Limited Liability Partnerships Organizing a Business

Sole Partnership Corporation proprietorship

  

Who owns the The manager Partners Shareholders

business? Are managers No No Usually and owners separate? What is the Unlimited Unlimited Limited owner’s liability? Are the owner & No No Yes business taxed separately?

Question

  1. Why should a company concetrate primarily on wealth maximization instead of proft maximization?

  2. What are the three types of fnancial management decisions? For each type of decision, give an example of the business transaction that would be relevant.

  3. Firms often involve themselves in projects that do

not result directly in profts: for example, IBM and

Mobil Oil frequently support public television broadcast. Do these projects contradict the goal of

maximization of shareholder wealth? Why or why

not.

Case

  

In early 2001, Doc and Lyn McGee formed the McGee Company. The company

produced a full line of cakes, and its specialties included chess cake, le,on pound cake,

and double-iced, double-chocolate cake. The couple formed the company as an outside

interest, and both continued to marketing and distribution. With good product qualty and

sound marketing plan, the company grew rapidly. In early 2006, the company was

featured in a widely distributed entrepreneurial magazine. Later that year, the company

was featured in Gourmet Desserts, sales exploded, and the company began receiving

orders from all over the world.

  

Because of the increased sales. Doc left his order job, followed shortly by lyn. The

company hired additional workers to meet demand. Unfortunately, the fast growth

experienced by the company led to cash flow and capacity problems. The company is

currently producing as many cakes a possible with the assets it owns, but demand for its

cakes is still growing. Further, the company has been approached by national

supermarket chain with an proposal to put four of its cakes in all of the chain’s stores,

and a national restaurant chain has contracted the company obout selling McGee cakes in its restaurants. The restaurant would sell the cakes without a brand name. Doc and Lyn have operated as a sole proprietorship. They have approached you to help manage direct the company’s growth.

Specifcally, they have asked you to answer the

following questions:

  

1. What are the advantages and disadvantages of

changing the company organization from a sole proprietorship to an Limited Liabilities Company (LLC)?

  2. What are the advantages and disdvantages of changing the company organization from a sole proprietorship to a corporation?

  3. Ulimately, what action would you recommend the company undertake? Why ?

  Financial Statement Analysis Financial Statement Analysis

Financial analysis can be defned as the

process of assessing the fnancial condition of a frm Basic Fianancial Statements 

  Balanced Sheet 

  The Income Statement

The Balance Sheet

  Defnition

fnancial statements that show the

value of the frms’s assets and liabilities at a particular point in time (from an accounting perspective)

US Corporation Balance Sheet

  U.S. CORPORATION 2004 and 2005 Balance Sheets (S in Millions)

  Assets Liabilities and Owners’ Equity 2004 2005 2004 2005 Current assets current liabilities

  

Cash $ 104 $ 160 ccounts payable $ 232 $ 266

Accoumts receivable 455 988 notes payable 196 123

Inventory 553 555 total $ 428 $ 389

Total $1.112 $1.403 Fixed assets Net plant and Long-term debt $ 408 $ 454 Equipment $1,644 $1,709 Owners’ equity Common stock and

Paid-in surplus 600 640

Retained earnigs 1,320 1,629

Total $1,920

  $2,269 Total liabilities and Total assets $2,756 $3,112 owners’ equty $2,756 $3,112

The Income Statement

  Defnition Financial statement that shows the revenues, expenses, and net income of a frm over a period of time (from an accounting perspektive) US Corporation Income Statement U.S. CORPORATION 2005 Income Statement

  (S in Millions)

  Net sales $1,509 Cost of goods sold 750 Depreciation 65 Earnings before interest and taxes $ 694 Interest paid 70 Taxable income $ 624 Taxes 212 Net income $ 412 Diviends $ 103 Addition to retained earnings 309

Why Evaluate Financial Statements?

• Internal uses
• Performance evaluation-compensation and comparison between divisions
• Planning for the future-guide in estimating future cash fows
• External uses
• Creditors - Suppliers - Custolers - Stockholders

Financial Ratio

• The principal analytical tool of the fnancial analyst is the fnancial ratio

• • Financial ratios help us identify some

  of the fnancial strengths and weaknesses of a company
• The ratios give us a way of making

  meaningful comparisons of a frm’s

  fnancial data at dinerent points in

Categori of Financial Ratios

• • Short-term solvency or liquidity ratios

• Long-term solvency or fnancial leverage ratios

• • Asset management or turnever ratios

• Proftability ratios
• Market value ratios

  Liquidity Ratios Current ratio = current assets current liabilities Quick ratio = current assets - inventorie s

Current liabilitie s

  Cash ratio = cash + marketable securities Current Long-term solvency or fnancial leverage ratios Total debt ratio = total liabilities total assets

  Debt/equity ratio = Total debt equity Equity multiplier = Total Assets equity

  Long term debt ratio = long term debt long term debt+equty

  Times interest earned = EBIT Interest

Asset management or turnover ratios

  Receivable turnover ratio = Sales Receivable Day’s sales in receivable = 365

Receivables turnover

Inventory turnover ratio = cost of goods sold Inventory Day’s sales in inventory = inventory Cost of goods sold/365

Asset management or turnover ratios

  Fixed asset turnover ratio = Sales

Net fxed assets

Total asset turn over= Sales Total assets NWC Turnover = Sales/NCW Net working capital (NCW) = CA - CL

Proftability ratios

  Net proft margin = net income Sales

Return on asset (ROA) = net Income

Total Return on equity = net income Total equity

Market value ratios

• PE Ratio = Price per share/Earnings per share

• • Market-to-book ratio = market value

  per sgare/book value per share

  Sample Balance Sheet

  Numbers in millions

  2008 2007 2008 2007

  Cash 696

  58 A/P 307 303

  A/R 956

  992 N/P 26 119

  Inventori 604

  625 Other CL 1,662 1,352 Total CL 1,995 1,775

  Total CA 2,256

  1,675 LT Debt 843 1,091 Sample Income Statement Numbers in millions, except EPS & DPS

  

Revenues

5,000

Ost of Goods Sold

2,006

Expenses

1,740

Depreciation

116

EBIT

1,138

Interest Expense

  

Taxes

Liquidity Ratios

  1. Current Ratio = CA/CL

  1. Current Ratio = CA/CL

• 2256/1995= 1.13 times
• 2256/1995= 1.13 times

  

2. Quick Ratio = (CA-Inventory)/CL

  

2. Quick Ratio = (CA-Inventory)/CL

• (2256-604)/1995 = 83 times
• (2256-604)/1995 = 83 times

  3. Cash Ratio = Cash/CL

  3. Cash Ratio = Cash/CL

• 696/1995 = 35 times
• 696/1995 = 35 times

  

Long-term Solvency ratios

• Total Debt Ratio = (TA – TE)/ TA
• (5394 – 2556)/5394=52.61%
• Debt/Equity = TD/TE
• (5394-2556)/2556= 1.11 times
• Equity Multiplier = TA/TE = 1+D/E
• 1=1.11= 2.11
• Long-term debt ratio = LTD/(LTD=TE)
• 843/(843=2556)= 24.80%
• Times Interest Earned= EBIT/Interest
• 1138/7= 162.57 times
Asset management or turnover ratios

Computing Receivables ratios

• Receivables Turnover= Sales/Accounts= Receivable - 5000/956= 5. 23 times

• • Days’ Sales in receivables = 365/

  Receivales Turnover - 365/5.23= 70 days

  Asset management or turnover ratios Computing Inventory ratios

• • Inventory Turnover = Cost of Goods

  Sold/Inventory
• 2006/301= 6.66 times
• Days’ Sales in Inventory = 365/Inventory Turnover - 365/6.66 = 55 days

  Asset management or turnover ratios Computing Inventory ratios

• Total Asset Turnover= sales/Total Assets - 5000/5394= 93
• it is not unusual for TAT <1, especially if

  a frm has a large amount of fxed assets

• NWC Turnover = Sales/NWC
• 5000/(2256-1995)= 19.16 times
• Fixed Asset Turnover= Sales/NFA
• 5000/3138= 1.59 times
Proftability Measures

• • Proft Margin= Net Income/Sales

• 689/5000= 13.78%
>Return on Assets (ROA) = Net Income/Total Assets - 689/5394 = 12.77%
• Return on Equity (REO) = Net Income/Total Equty - 689/2556= 26.96%

  Computing Market Value Measures

• Market Price = $ 87.65 per share
• Shares outstanding = 190.9 million

• • PER ratio = Price per share/Earnings

  per share
• 87.65/3.61 = 24.28 times

• • Market-to-book ratio = market value

  per share/book value per share

• - 87.65/ (2556/190.9) = 6.56 times

Harley-Davidson, Inc. Ratio Analysis

  Current ratio 1.13 1,5 Acid-test ratio

  83 1,06 Cash ratio

  35

  50

  2. Financial leverage ratio Total Debt ratio 52.61% 48% Debt/Equity ratio

  1.11

  98 Equity multiplier

  2.11

  2.01 Long term debt ratio 24.80% 20.04% Time interest earned 162.57 154.46

  3. Turnover ratio Total assets turnover

  93

  1.2 Account receivable

  5.23

  8.11 turnover

  6.66

  7.05 Inventory turnover

  1.59

  1.66 Fixed assets turnover

  4. Proftability ratios Net proft margin 13.78% 14.04% Using the DuPont Identity ROE = PM * TAT * EM ROE = Net Income/sales x sales/assets x assets/Equity

• Proft margin is a measure of the frm’s operating efciensy
• how well does it control costs
• total asset turnover is a measure of the frm’s asset use efciency-how well does it manage its assets

• - Equity multiplier nis a meausre of the frm’s fnancial leverage

Expanded Dupont Analysis- Aeropostale data

• • Balance Sheet Data • income Statement Data

  - cash= 138,356 - Sales= 734,868
• inventory= 61,807 - COGS+ 505,152
• other CA = 12,284 - SG&A = 141,520
• fxed assets = 94, 601 - interest = (760)
• equity = 185, 640 - taxes = 34, 702
• Computations • Computations - TA = 307,048 - NI= 54,254
• TAT = 2. 393 - PM= 7,383%
• EM = 1.654 - ROA= 17.668%
• ROE= 29.223%
Aeropostale Expanded DuPont Chart Aeropostale Expanded DuPont Chart ROE = 29.22%

  11,654

  17,668

  PM= TAT=2,393 7,383%

  Sales=734, TA=307,04 Sales=734, 868

  8 NI=54,254 868 Current Assets=

  Sales= TC=734,86 Fixed 212,447

  680,614

  8 Assets=94601 Inventor Cash= COGS= 505,

  SG&A= y= 138,356

  152 141,520 61,807 Other

  Interest= Taxes= ROE = net income x sales x assets sales assets equty = 54,254 x 734, 868 x 307, 048 734,868 307,048 185, 640 = 07383 x 2.3933 x 1.6540 = 29.2%

• As we study the fgure, we quickly see that improvement in the ROE can common in one or more of four ways:

  1. Increase sales without a disproportionate increase in cost and expenses

  3. Increase the sales relative to the asset base, either by

increasing sales or by reducing the amounts invesred in

company assets. From our earlier exammination of Harley- Davidson, we learned that the frm had excessive account

receivables and fxed assets. Thus management need to

reduce these assets to the lowest in the return on which

would in turn result in an increase in the return on assets and then the return on equity

  4. Increase the use of debt relative to equity, but only to the extent tha it does not unduly jeopardize the frm’s fnancial position.

Limitations of ratio analysis

  1. It is sometimes dincult to identify the industry category to which a frm belongs when the frm enganges in multiple line of business

  2. Published industry averages are only approximations and provide the user with general guidelines rather than scientifcally determoned averages of the ratios of all or even a representative sample of the frms within an industry

  3. Accounting practice diner widely among frms and can lead to dinerences in computed ratio

  4. An industry average may not provide a desirable target ratio or norm

Case

  Chris was recently hired by S&S Air, Inc., to assist the

company with its fnancial planning and to evaluate the

company’s performance. Chris graduated from college fve

years ago with a fnance degree. He has been employed in

the fnance departement of a fortune 500 company since

then.

  S&S Air was founded 10 years ago by friends Mark Sexton

and Todd Story. The company has manufactured and light

airplanes this period, and the company’s products have

received high reviews for safety and reliability. The company

has a niche market in that it sells primarily to individuals

who own and fy their own airplanes. The company has two

models; the birdie, which sells for $53,000, and the Eagle, Although the company manufactures aircraft, its operations are dinerent from commercial aircraft companies S&S Air builds aircraft to oredr. By using prefabricated parts, the company can complete the manufacture of an airplane in only fve weeks. The

company also receives a deposit on each order, as well

as another partial payment before the order is

complete. In contras, a commersial air plane may take

one and one-half to two years to manufacture once the

order is placed Mark and Todd have provide the following fnancial statements. Chris has gathered the industry ratios for the light airplane manufacturing industry.

Sample Income Statement

  Revenues $21,785,300 Cost of of Goods Sold 15,874,700 Expenses 2,762,500 Depreciation 976,200 EBIT 2,171,900 Interest Expense

Sample Balance Sheet

  2006 Cash

  $315,000 2006 A/R

  506,000 A/P Inventory

  740,800 $635,000 N/P

  Total CA $1,561,800 1,450,000 11,516,000

  Net FA Total CL

  Total 13,077,800 2,085,000

  Assets LT Debt 3,800,000 Light Airplane Industri ratios Lower Median Upper

  1 Current ratio

  0.50

  1.43

  1.89

  2 Quick ratio

  0.21

  0.38

  0.62

  3 Cash ratio

  0.08

  0.21

  0.39

  4 Total Assets turnover

  0.68

  0.85

  1.38

  5 Inventory turnover

  4.89

  6.85

  10.89

  6 Receivables turnover

  6.27

  9.82

  14.11

  7 Total debt

  0.44

  0.52

  0.61

  8 Debt-Equity ratio

  0.79

  1.08

  1.56

  9 Equity multiplier

  1.79

  2.08

  2.56

  10 Time interest earned

  5.18

  8.06

  9.83

  11 Proft margin 4.05% 6.98% 9.87%

  12 Return on assets 6.05% 10.53% 13.21%

Question

  1. Using the fnancial statements provided for S&S Air, calculate each of the ratios listed in the table for the light aircraft industry.

  2. Compare the performance of S&S Air to the industry, for each ratio, comment on why it might be viewed as positive or negative relative to the industry. How do you think S&S Air’s ratio would compare to industry average?

TIME VALUE OF MONEY

• Future Value-Taking an amout and

  fnding its value at sometime in the

  future

• • Present Value-Taking an anmout from

  sometime in the future and fnding its value today.

Future Values

  Future Value – Amount to which an invenstement will grow after earning interest Compound Interest – Interest earned on interest.

  Simple Interest – Intrest earned only on the original investment.

Future Values

  Example – Simple Interest Interest earned at a rate of 6% for fve years on a principal balance of $100 Today Future Years

  

1 2 3 4

  5 Interest earned Value 100 6 6 6 6 6 106 112 118 124 130 Future Values Example – Compound Interest

Interest earned at a rate of 6% for fve years on the

previous year’s balance Today Future Years

  

1 2 3 4 5

Interest earned 100 6 6.36 6.74 7.15 7.57

  Value 106 112.36 119.10 126.25 133.82 Value at the end of year 5 =$133.82

  Future Values Example-FV

  1. What is the future value of$100 if interest is compounded annually at a rate 6% for fve years? FV = $100 x (1+.06)

  5 = $133.82

  

2. What is the future value of $100 invested for fve

years at a nominal interest rate 12%, compounded continuosly?

  FV = $100x(1+r)

  t

  

Compounding Periods

Compounding an investment m times a years for

T years provides for future value of wealth: FV = C o for example, if you $50 for years at 12%

compounded semi-annually, your investment will

grow to

  6 FV

  = =$70.93

  

Enective Interest Rates

ren= (1+r/m)

  m- 1 Ren= (1+0,12/2)2- 1 = 12,36% Continuous Compounding :

  ren = e

  m- 1

  Ren = (2,71828)

  0,12- 1 = 12,75%

Dampak dari periode pemajemukan yang berbeda atas nilai masa depan $1.000, diinvestasikan dengan tingkat bunga nominal 8%

  Jumlah Periode Pemajemukan

  Future value pada akhir 1 th Tingkat bunga tahunan efektif

  $1.000 Tahunan $1.080,00 8,00% $1.000 Semi tahunan $1.081,60 8,16% $1.000 4 bulanan $1.082,43 8,24% $1.000 Bulanan $1.083,00 8,30% $1.000 Harian $1.083,28 8,32% $1.000 Berkelanjutan $1.083,29 8,33% How Long is the wait?

If we deposit $5,000 today in an account paying 10% how long

does it take to grow to $10,000?

  T T

  (1+r) FV = C x $10,000=$5,000x(1.10) o

  T = (1.10) $10,000 = 2

   $5,000 T =

  1.10) ln( ln 2

  What Rate Is Enough? Assume the total cost of a college education will be

$50,000 when your child enters college in 12 years. You

have $50,000 to invest today. What rate of interest must

you earn on your investment to cover the cost of your child’s education ? About 21.15%

  T

  12 FV = C x (1+r) $50,000=$5,000 x (1.r) o

  12 1/12

  (1.r) =$50,000=10 (1+r)10 $5,000 1/12 r =10 = 1 = 1.2115 = 1 = 2115 What is the future value three years hence of $1.000

invested in an account with a stated annual interest rate of

8% a.

  Compounded annually b. Compounded semiannually c. Compounded monthly d. Why does the future value increase as the Compounding period shortens

Present Values

  Present Value Value today of a future cash fow.

  Discount factor Present value of a $1 future payment.

  

Discount Rate

Interest rate used

to compute prent

values of future

  (APPLICATIONS) The PV formula has many application, you can

   solve for the remaining variable.

  PV = FV x 1 t

  (1+r)

What is the present value of $ 100 to be received in 3 years if the appropriate interest rate 1s 10%, 15%, and 20%

  

3

PV = $100 x 1/(1,1) = $75,13

  3 PV = $100 x 1/(1,15) = $65,75

  3 PV = $100 x 1/(1,20) = $57,87

  PV of Multiple cash Flows

  Example your auto dealer gives you the choice to pay $15,500 cash now, or make three payments: $8,000 now and $4,000 at the end of the flowwing two years. If your cost of money is 8% wich do you prefer?

  Immediate payment 8,000.00 PV = 4,000 = 3,703.70

  1

  1 (1+.08) PV 4,000 = 3,429.36

  2=

  2 (1+.8) Total PV = $15,133.06

Example you are selling your house. The Smith have offered you $115.000

  they will pay you immediately. The Joneses have offered you $150.000, but the cannot pay you until theree years from today.

  The interest rate is 10 percent. Which offer should you choose?

you have the opportunity to make invesment that cost $900.000. if

you make the investment now, you will receive $120.000 and

three years from today, respectively. The appropriate discount rate

for this invesment is 12%. Should you make invesment?

  

You are given three invesment alternatives to

anlyze. The cach fows from these three invesments

are follows:

  END OF A B C YEAR 1 $5,000 $1,000 $10,000 2 $5,000 $3,000 $10,000 3 $5,000 $5,000 $10,000 4 -$15,000 $10,000 $10,000 5 $15,000 $10,000 -$40,000

Perpetuities & Annuities

  

Annuity = Equally spaced level stream

of cash fows for a limited period of time.

  Perpetuity = A stream of level cash payments that never ends.

  Annuities FV of Annuity Formula

  FVAN = C X (1 +

  t

  r) - 1 r C = cash payment r = interest rate

t = Number of years cash payment is received Annuities Example – future Value of annual payments You plan to save $4,000 every year for 20 years and then retire. Given a 10% rate of interest, what will be the FV of your retirement account?

  20 FVAN = 4.000 x (1 + 0,10) - 1 0,10 FVAN = $229,100 Annuities PV of Annuity Formula PVAN = C x (1 –

  t

  1/(1+r) r C = cash payment r = interest rate

t = Number of years cash payment is received Annuities Example – Annuities you are purchasing a car. Your are scheduled to make 3 annual instllments of $4,000 per year. Given a rate

of interest of 10%, what is the price you are paying

for the car (i.e. what is the PV)

  3 PVAN = 4.00 x 1- 1/

(1+0,1)

   0,1 PVAN = $9.947,41

  Annuity: Example Your insurance agent oners to sell you an annuity. It will pay you $400 per for fve years. Your requred rate of return is 7%. How much will you be willing to pay? 0 1 2 3 4 5 6

  ….. ……… …..…. ...……. ……… ...… 400 400 400 400 400 PV = = $1,640.08

  Annuity: Example

Your insurance agent offers to sell you an annuity. It will pay you $400

per for five years beginning of each years. Your requred rate of return is

7%. How much will you be willing to pay?

  0 1 2 3 4 5 6

  …... ……….. ….……. ….……. ...…….. …… 400 400 400 400 400 t

  PAVN = C x (1 – 1/(1+r) x (1 + r) r PV = = = $1,724.85

  

Your company is considering leasing $120.000

piece of equipment for the next 10 years. The

annual lease payments of $15.000 are due

beginning of each year. The buy the equipment

for $25.000 at the end of the leasing period.

  

Should your company accept the lease offer if appropriate discount rate is 8 percent a year? Perpetuities

PV of Perpetuity Formula

  PV = c r c = cash payment r = interest rate

Perpetuities & Annuities

  Example – Annuities

in order to create an endowment, which pays $100,000

per year, forever, how much money must be set aside today in the rate of interest is 10% ? PV = 100,000= $1,000,000

  10 The market interest rate is 15 percent. What is the price of a consol bond that pays $120 annually ? Perpetuities & Annuities Example –continued if the first perpetuity payment will not be received until three years from today, how

much money needs to be set aside today?

  PV = 1,000,000 = $751,315

  3

  (1+.10)

Inflation

  

Inflation – Rate at which prices as a whole are

increasing.

  Nominal Interest Rate – Rate at which money inveted grows.

  Real Interest Rate – Rate at which the purchasing power of an investment increases.

  Inflation 1 + real interest rate = 1+nominal interest rate 1+inflation rate Approximation formula

Real int. rate = nominal int. rate – inflation rate

  Questions and Problem

  1. Ellen, a sophmore mechanical engineering student, receives a call from an insurance agent, who believes that Ellen is an older woman ready to retire from teaching. He talks to her about several annuities that she could buy that would guarantee her an annual fixed income. The annuities are as fllows:

  Annuity Initial payment into Amount of money Duration of Annuity annuity (At t=0) received year (Years) A $50,000 $8,500

  12 B $60,000 $7,000

  25 C $70,000 $8,000

  20 If Ellen could earn 12 percent on her money by placing it in savings account, should she place it instead in any of the annuities? Which ones, if any? Why ?

Questions and Problem

  2. You are triying to plan for retirement in 10 years and currently you have $150,000 in savings account and $250,000 in stock. In addition, you plan to add to your savings by depositing $8,000 per year in your saving account at the end of each of the next five years and then $10,000 per year at the end of each year for the final five years until retirement.

  

a. Assumsing your savings account returns 8 percent compounded

annually and your investment in stocks will return 12 percent compounded annually, how much will you have at the end of 10 years? (ignore taxes) b. if you expect to live 20 years after you retire, and at a retirement you deposit all of your savings in a bank account paying 11 percent, how

much can you withdraw each year after retirement (20 equal

withdrawls beginning one year after you retire) to end up with zero- balance at death?

  CAPITAL

BUDGETING What Is Capital Budgeting 

  Capital budgeting involves the decision making

process with respect to investment in fixed assets;

specifically, it involves measuring the incremental

cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project’s costs

   Capital budgeting is decision process that managers

use to identify those projects that add to the firm’s

value, and as such it is perhaps the most important

task faced by financial managers and their staffs.

   First, a firm’s capital budgeting decisions

define its strategic direction, because moves

into new products, services, or markets must

be preceded by capital expenditures.

   Second, the results of capital budgeting decisions continue for many years

   Thied, poor capital budgeting can have serious finacial consequences.

Projects Classifcations

  1. Replacement – Worn out equipment

  2. Replacement – Reduce costs

  

3. Expansian of existing produkcts or markets

  4. Expansion into new products or markets

  5. Safety/environmental projects

  6. Recearch and Developments

  7. Other

   Independent Projects: if the cash flows of one are unaffected by the acceptance of the other.

  Acceptance or rejection of project depends upon merits of project compared to decision criteria.

  

Mutualli Exclusive Prjocts: if the cash flows of

  one can be adversely impacted by the acceptance of the other.

  The acceptance of one project excludes the possibility of accepting the other(s)

  

An Example of Mutally Exclusive

Projects BRIDGE vs BOAT to get products across a river

Some Alternative Invesment Rules

• Payback Period • Discounted Payback • Net Present Value (NPV)
• Proftability Index • Internal Rate of Return

  • Modifed internal rate of Return

  (MIRR)

  Payback Period

• How long does it take to get the initial cost back in a nominal sense?
• Computation

   Estimate the cash flows

   Subtract the future cash flows from the initial cost

until the initial investment has been recovered

• Decision Rule - Accept if the

  payback period is less than some

  

Net Cash Flows for Projects

S and L Project S : 0 1 2 3 4

• 1,000500 400 300 100 Project L : 0 1 2 3 4
• 1,000100 300 400 600

  Payback S = 2 + $100/$300= 2.33 years Payback L= 3 + $200/$600 = 3.33 years

Advantages and Disadvantages of Payback

   Easy ro undersand ignore the time value of   money

   Advantages Disadvantages

• adjusts for uncertainly of requres an arbitrary cuton
• later

  point cash fows Biased towards liquidity Ignores cash fows beyond   the cuton date

  Biased againt long-term  projects, such as recearch and development, and new projects

  back on a discounted basis within the specified time

  Discounted Payback Period

• • Compute the present value of each cash flow

  and then determinane how long it takes to Payback on a discounted basis
• Compare to a specified required period

• • Decision Rule – Accept the project if it pays

  

Projects S and L: Discounted Payback

Period Project S : 0 1 2 3 4

• 1,000 500 400 300 100

  Disc. NCF (at 10%) -1,000 455 331 225 68 Project L : 0 1 2 3 4

• 1,000 100 300 400 600

  Disc. NCF (at 10%) -1,000 91248 301 410

  Payback S = 2 + $100/$300= 2.33 years Payback L= 3 + $200/$400 = 3.33 years Net Present Value Net Present Value – Present value of cash fows minus initial invesments Opportunity Cost of Capital –

  Expected rate of return given up by investing in a project

• C + C +….+ C = -C + C NPV= -C

  o o

  (1+r) (1+r) (1+r) T

  (1+r) The Net Present Value Method :

  Net Present

  Value Equal to or greater than zero

  Accept the inevestment Reject the investment

  Less than zero

Minimum Acceptance Criteria: Accept if NPV > O

Net Present Value (NPV)

  NPV = -1,000 + 500 400 300 100 _{1 2 3 4}

  (1+0,10) (1+0,10) (1+0,10) (1+0,10) =78.82 Cash Flows 1 2 3 4