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    FINANCIAL MANAGEMENT

    Professorial Lecturer:

    DR. EVANGELINA G. CUSTODIOVP for Administration and Finance

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    INTRODUCTION

    Organization

    (Public orPrivate)

    To earn profit;to increase the

    value, tosurvive,

    to serve orfulfill its social

    responsibility

    What shall theorganization

    produce?Goods or Services

    Wah

    Productive Resources

    (Capital)

    Non Human Resources-Tangibles-Intangibles

    Human Resources-Internal-External

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    HUMAN RESOURCES

    EMPLOYEES/ WORKERSSUPPLIERS

    BOARD OF DIRECTORS

    STOCKHOLDERS/OWNERS

    MANAGERS/SUPERVISORS

    CREDITORS

    COMPETITORS

    GOVERNMENT

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    NON HUMAN RESOURCES

    TANGIBLESINTANGIBLES

    FinancialAssets

    Real AssetsPatent

    Brand

    Goodwill

    Trademark

    Logo-

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    TO PRODUCE GOODS ORSERVICES

    Organization needs to invest in real or fixedassets or productive capital. The manager ofthe organization must make this decision. Hehas to answer these questions.

    What assets to own, or in what assets shouldthe organization invest?

    What mix of assets will best facilitate theproduction of goods or services?,

    How should the organization invest?

    THIS IS AN INVESTMENT DECISION

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    AFTER DECIDING WHAT TO INVEST . . .

    Organization needs to finance this investment

    by acquiring cash. Therefore, the managermust decide again:

    What securities to raise,

    What mix of credit best meets the objectives

    of the organization

    Where shall the organization get its fund,

    How much money or cash is needed,

    THIS IS A FINANCIAL DECISION.

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    WHAT IS FINANCIALMANAGEMENT?

    The two broad decisions (investment and financialdecisions) are the major responsibility of thefinancial manager.

    Financial management is the art and scienceof making the right investment and financialdecisions for the organization.

    The concern of Financial Management is themaintenance and creation of economic valueor wealth

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    FORMS OF BUSINESSORGANIZATIONS

    SOLE OR SINGLE PROPRIETORSHIP- a business owned and managed by a singleindividual

    PARTNERSHIP- a business owned by two or more persons

    CORPORATION

    - a legal entity that functions separateand apart from its owners betterknown as stockholders.

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    MAJOR GOALS OF FINANCIAL

    MANAGEMENT

    1. Maximization of Shareholders Wealth

    This is maximization of the market value of the existingshareholders wealth. This is translated bymaximizing the price of the existing common stocks ofa corporation. The market priceof the firms stockreflects the value of the firm as seen by its owners.Shareholders are the legal owners of the firm. This is

    a long-term goal. The objective is to have the highestmarket value of common stock. This goal recognizesrisk or uncertainty, timing of returns and considersstockholders return.

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    MAJOR GOALS OF FINANCIALMANAGEMENT

    2. Maximization of ProfitThis goal stresses the efficient use of

    capital resources within a given period of

    time. Thisis a short-term goal and itignores risk and timing of returns.

    3. Social Responsibility

    This is how the business is able toimprove the quality of life in itsenvironment and the economy.

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    TEN MAXIMS OF FINANCIALMANAGEMENT

    1. The Risk-Return TradeoffWe WontTake on Additional Risk Unless WeExpect to Be Compensated with

    Additional Return.

    - Investment alternatives have different amount ofrisk and expected returns

    - Investors demand higher returns for taking onmore risky projects.

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    The Risk-Return Relationship

    E

    x R

    p ee t

    c u

    t r

    e n

    d

    R i s k

    Expected Return for Delaying Consumption

    Expected Return for taking on Added Risk

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    2. The Time Value of Money A DollarReceived Today is Worth More Than aDollar Received in the Future

    - Money has a time value associated with it. Adollar received today is worth more than a

    dollar received a year from now. It is better toreceive money earlier than later becausemoney received today can earn interest.

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    3. Cash -- Not Profit -- is King

    - Cash flows, not accounting profits, should beused as a tool for measuring wealth or value.Cash flows are used to measure the benefitsand costs from taking on an investment.

    - Cash flows and accounting profits may notoccur together.

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    4. Incremental Cash FlowsIts Only WhatChanges That Count

    - In making business decisions, we areconcerned with the results of those decisions:

    What happens if we say yes versus whathappens if we say no?

    - Incremental cash flow is the difference

    between the cash flows if the project is takenon versus what the cash flows will be if theproject is not accepted

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    5. The Curse of Competitive Markets Why

    Its Hard to Find Exceptionally ProfitableProjects

    - In competitive markets, extremely large profits

    simply cannot exist for very long. Competitionmakes it difficult to find profitable projects butwe have to invest in markets that are notperfectly competitive. Two common ways tomake market less competitive are Product

    Differentiation and Creation of CostAdvantage through economies of scale,proprietary technology and monopolisticcontrol of raw materials.

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    6. Efficient Capital Markets The Marketsare Quick and the Prices Are Right

    Efficient Market A market in which the values ofall assets and securities at any instant in timefully reflect all available public information.

    - Stock prices reflect all publicly availableinformation regarding the value of thecompany. Market prices reflect expectedcash flows available to stockholders. Pricesreflect value.

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    7. The Agency ProblemManagers WontWork for the Owners Unless Its in TheirBest Interest

    Agency problem is a problem resulting fromconflicts of interestbetween the manager(thestockholders agent) and the stockholders(principal).

    Align their interest in such a way that what is goodfor shareholders must also be good formanagers.

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    8. Taxes Bias Business Decision

    In every decision made by the financial manager,the impact of tax is considered.

    Tax plays important role in evaluating new projectsand in determining a firms financial structureor mix of debt (liabilities) and equity (ownersinvestment).

    Debt financing has cost advantage becauseinterest payments are a tax-deductiveexpense. Paying interest reduces tax.

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    9. All Risk is Not Equal Some Risk Can Be

    Diversified Away and Some Cannot

    Risk is difficult to measure. Risk is the variabilityof possible outcome. There are risks whichcan be controlled and others cannot

    Dont put all your eggs in one basket.

    Diversification can reduce risk.

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    Reducing Risk Through Diversification

    20%

    0%

    10%

    R

    E

    T

    U

    RN

    T I M E

    ASSET A

    ASSET B

    COMBINATION OFASSET A & ASSET B

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    10 MAXIMS OF FINANCIAL MANAGEMENT

    10. Ethical Behavior is Doing the Right Thing, andEthical Dilemmas Are Everywhere in Finance

    Ethics are standards of conduct or moralbehavior.

    Business ethics can be thought of as a

    companys attitude and conduct toward itsemployees, customers, community andshareholders.

    Beyond the questions of ethics is the question

    of social responsibility. Social Responsibilitymeans that a corporation has responsibilitiesto society beyond the maximization ofshareholders wealth.

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    Risk-Return Tradeoff

    Risk or uncertainty refers to the variability ofexpected returns associated with a giveninvestment.

    Let us measure risk and look at therelationships between risk and returns.

    Probabilities are used to evaluate the risk

    involved in a security.The probability of an event is defined as thechance that the event will occur.It is a

    percentage chance of a given outcome.

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    MEASURING RISK

    The Standard Deviation () is a measure of

    dispersion of the probability distribution. Itis commonly used to measure risk.

    n

    = (ri r)2pii=1

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    Steps in calculating risk

    To calculate , take the following steps:Step 1. Compute the expected rate of return

    ( r).

    nr = ripi

    i=1

    where: ri= ithpossible returnpi= probability ofith returnn = number of possiblereturn

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    Step 2. Subtract each possible return from r to

    obtain a set of deviations (ri r ).

    Step 3. Square each deviation, multiply thesquared deviation by the probability ofoccurrence for its return, and sum these

    products to obtain the variance(2):n

    2= (ri r )2pi

    i=1

    Step 4. Finally, take the square root of thevariance to obtain the standard deviation ().

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    The smaller the standard deviation, the tighter theprobability distribution and, thus, the lower therisk of the investment.

    When you compare two investment projects whichhave the same expected returns, you may usestandard deviation to measure absolute risk.

    The higher the standard deviation, the higher therisk. But when you compare two projects whichhave different expected returns, use thecoefficient of variation. The coefficient of

    variation is computed simply by dividing thestandard deviation for the project by expectedreturn or value: / r. The higher the coefficient,the more risky the project.

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    Time Value of Money

    This time value of money is another criticalconsideration in financial and investmentdecisions.

    Finding the Future Values CompoundingA dollar received today is worth more than

    a dollar to be received tomorrow because

    of the interest it can earn from putting it ina savings account or placing it in aninvestment account. Compoundinginterest means that interest earns interest.

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    Time line:

    P at time o 1 2 3 F at time n

    P F1 F2 F3 Fn

    Let us define: Fn= future value or the amount of money at theend of yearn

    P = principali = annual interest raten = number of years

    Then,

    F1 = the amount of money at the end of year 1

    = principal and interest= P + i P t= P(1+i)

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    F2= the amount of money at the end of year 2

    = F1(1+i)= P(1+i) (1+i)= P(1+i)2

    The future value of an investmentcompounded annually at rate iforn years

    isFn= P(1+i)

    n

    If (1+i)n = FVIFi,n

    then Fn = P(FVIFi,n)where FVIFi,n is the future value interest factor

    for $1. Table of Compound Interest of $1

    Example: You place $100 in a savings

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    Example: You place $100 in a savingsaccount earning 8% interest compoundedannually. How much money will you have

    in the account the end of 4 years?

    Fn= P(1+i)n = P(FVIFi,n)

    F4= $100(1+.08)4 = $100(FVIF8%,4)

    F4= $100(1.03605) = $136.05

    At the end of 4 years, at 8% interest rate,your $100 today will be $136.05.

    Fi di P V l Di i

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    Finding Present Value Discounting

    Present values is the present worth of futuresums of money. The process ofcalculating present values or discounting,is actually the opposite of compounding or

    finding the future value. In connection withpresent value calculations, the interestrate iis called discount rate.

    Lets recall this formula of compounding

    Fn= P(1+i); from this we can derive P

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    Therefore,

    Fn 1

    P= =

    Fn(1 + i)n (1 + i)n

    if 1/(1+i)n = PVIFi,n

    then P = Fn(PVIFi,n)

    where PVIFi,n

    represents the present valueinterest factor for $1.

    Example: You are given an opportunity to receive

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    Example: You are given an opportunity to receive$10,000 six years from now. If you can earn10% on your investments, what is the most youshould pay for this opportunity. To answer this

    question, you must compute the present value of$10,000 to be received 6 years from now at a10% rate of discount. F6is $10,000, i is 10%,which is 0.1, and n is 6 years. PVIF10%,6 is

    0.5645.

    $10,000 1

    P= = $10,000(1 + .1)6 (1 + .1)6

    = $10,000 (0.5645) = $5,645

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    This means that at 10% interest on yourinvestment, you could be indifferent to thechoice between $5,645 now or $10,000

    six years from now since the amounts aretime equivalent. In other words, youcould invest $5,645 today at 10% and

    have $10,000 in 6 years.

    If series of payments or receipts of a fixed

    amount for a specified number of periodsare expected, future value and presentvalue can be calculated using the formulafor an annuity.

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    Annuity is a series of payments or receipts of afixed amount for a specified number of periods

    For future value of an annuity:

    Fn= A (FVIFAi,n)For present value of an annuity:

    Pn= A (PVIFAi,n)Where A = the amount of an annuity

    FVIFAi,n represents the future value interest factorfor an n-year annuity compounded at ipercent.

    PVIFAi,n represents the appropriate value for thepresent value interest factor for a $1 annuitydiscounted at ipercent forn years.

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    Example: Future value of an annuity

    You wish to know the sum of money youwill have in your savings account at theend of 6 years by depositing $100 at the

    end of each year for the next 6 years. Theannual interest rate is 8%. The FVIFA8,6is 7.336. Therefore,

    F6 = $100 (7.336) = $733.60

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    Example: Future value of an annuity

    You wish to know the sum of money you

    will have in your savings account at theend of 6 years by depositing $100 at theend of each year for the next 6 years. The

    annual interest rate is 8%. The FVIFA8%,6is 7.336. Therefore,

    F6 = $100 (7.336) = $733.60

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    Example: Present value of an annuity

    Your father will retire at age 65 andexpects to live to age 75. At the rate of10%, calculate the amount your fathermust have available at age 65 in order toreceive $10,000 annually from retirementuntil death. A=$10,000, i= 10%,PVIFA10,10) = 6.1446

    Pn = A(PVIFAi,n) = $10,000 (6.1446)

    = $61,446

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    Capital Budgeting

    Capital Budgeting is the process of makinglong-term planning decisions forinvestments.

    Some methods of evaluating investmentprojects are:

    Payback period

    Net Present ValueInternal Rate of Return

    Profitability Index (benefit/cost ratio)

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    Payback period. The payback period measures the lengthof time required to recover the amount of initialinvestment. It is computer by dividing the initialinvestment by the cash inflows through increased

    revenues or cost savings.Example: Assume: Cost of Investment $18,000

    Annual cash savings $3,000Then, the payback period (PBP) is:

    Initial Investment Cost $18,000PBP = =Increased Revenues or Lost Savings

    $3,000

    PBP = 6 years

    Decision Rule: Choose the project with the shorterpayback period. The shorter the payback period, theless risky the project, and the greater the liquidity.

    Net Present Val e (NPV) is the e cess of the present al e

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    Net Present Value (NPV) is the excess of the present value(PV) of cash inflows generated by the project over theamount of the initial investment ( I ):

    NPV = PV I

    The present value of future cash flows is just discounting.

    Decision Rule: If NPV is positive, accept the project.Otherwise, reject it.

    Example: Consider the following investment:Initial Investment $12,950

    Estimated life 10 yearsAnnual cash inflows $ 3,000Required Rate of Return 12%

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    PV = Annual cash inflows (PVIFAi,n)

    PV = $3,000(PVIFA 12,10)

    = $3,000 (5.6502)= $16,950

    NPV = PV - I

    NPV = $16,950 - $12,950

    = $4,000

    Since the NPV of the investment is positive,the investment should be accepted.

    I t l R t f R t (IRR) i d fi d t

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    Internal Rate of Return (IRR) is defined atthe rate of interest that equates InitialInvestment (I) with the Present Value

    (PV) of future cash inflows. In otherwords, at IRR,

    I = PV or NPV = 0

    Decision Rule: Accept the project if the

    IRR exceeds the required rated of return(RRR) or the cost of capital. Otherwise,reject it.

    Using the same data:

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    Using the same data:

    I = $12,950, PV = $3,000(PVIFA?,10)

    I = PV

    2,950 = $3,000 (PVIFA?,10)

    $12,950/$3,000 = (PVIFA?,10)

    (PVIFA?,10) = 4.317

    4.317 stands somewhere between 18% and20% in the 10-year line of PVIFA table. Byinterpolation, IRR is 19.17%.

    Since IRR of 19.17% is greater than the costof capital of 12%, accept the investment.

    f ( f /C )

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    Profitability Index (Benefit/Cost Ratio) is theratio of the total PV of future cash inflows

    to the initial investment, that is, PV/I.If the profitability index is greater than 1,

    then accept the project.

    This is used as a means of ranking projectsin descending order of attractiveness.

    Using the same data:

    PV/I = $16,950/$12,950 = 1.31Since the project generates $1.31 foreach dollar invested, accept the project.

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    Financial Decisions

    1. Short-term financingfinancing that will be

    repaid in 1 year or less. It may be used tomeet seasonal and temporaryfluctuations in acompanys funds positions as well as to meetpermanent needs of the business. It may be

    used to provide extra net working capital,finance current assets, or provide interim(temporary) financing for a long-term project.Examples: trade credit, bank loans, bankers

    acceptance, finance company loans,commercial papers, receivable financing andinventory financing

    2 L t d bt fi i fi i th t

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    2. Long-term debt financing financing thatwill be repaid in more than one year.Sources of long-term debt financing

    include mortgages (notes payable thathave as collateral real assets) and bonds(certificate indicating that a company has

    borrowed a given sum of money that itagrees to repay it a future date).

    3. Equity financing is financing throughissuance of preferred and commonstocks.

    I h i h f fi i h f

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    In choosing the type of financing, the cost ofcapital is a critical consideration.

    Cost of capital is defined as the rate of returnthat is necessary to maintain the market value ofthe firm (price of the firms stock).

    The cost of capital is computed as a weightedaverage of the various capital components,which are debt, preferred stock, common stockand retained earnings (right-hand side of thebalance sheet).

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    Always remember the techniques inchoosing the right investment. The

    investment must earn a return more thanits cost, and be guided by the ten maximsof financial management in making

    financial and investment decisions.

    SALAMAT PO