Finance Management

When is it comes to things that makes a business successful, what is the most important factor?

Customer satisfaction

Which part of the Value Creation Process does the financial person focus on?

Investment Decisions

Aside from investments, what other decisions does a financial manager make for a corporation?

Accessing financial capital in terms of debt and equity

What is a debt holder?

Someone who invested in the company and still needs to be paid the principle and interest by the company

What are the owners of the corporation?

The focus of the financial manager. These are the people who are the equity owners once the debt holders have been accounted for

Describe the flow in the Value Creation Process that involves financing decisions

Financial Markets (Stockholders and Bondholders) → Corporation

Describe the flow in the Value Creation Process that involves investment decisions

Corporation → Factor Market (Land, Labor, and Physical Capital)

Describe the flow in the Value Creation Process that involves dividends and interest

Corporation → Financial Markets (Stockholders and Bondholders)

Describe the flow in the Value Creation Process that involves profits

Product Market (Customers)

Describe the flow in the Value Creation Process that involves products or services

Factor Market (Land, Labor, and Physical Capital) → Product Market (Customers)

Investment decisions are also sometimes called ______

Operating decisions

What is supposed to be the outcome of making operating decisions?

To increase internal capital (resource allocation), also by acquisitions and divestitures. This in turn should also increase expected cash flows.

What happens alongside the operating decisions?

The financing decisions

What is the outcome of financing decisions?

Focusing on improving capital structure (debt and equity), as well as managing risk and the payout policies. Results in decrease cost of capital.

Which branch in the role of finance involves valuation and monitoring?

Operating decisions and performance evaluation

Which branch in the role of finance involves strategy formulation and implementation?

Financing decisions

What is the number one goal of financial management?

Maximizing shareholder wealth

What are some special qualities about shareholders?

They are residual claimants and the owners of a corporation

What payments need to happen prior to the shareholder receiving money?

* Supplier paid
* Wages to workers paid
* Interest to bondholders paid
* Taxes paid

What are firms constantly interacting with?

Financial Markets

What does IPO stand for?

Initial Public Offering

What is IPO?

It’s when investors in the market give money to the firm, then the firm gives securities to the investors.

If a company is successful, what two things can it generate profits and cashflows through?

Debt and Equity

Cashflows are returned to ____ and debt repayments to ____

Equity holders and debt holders

Aside from paying equity and debts, what third payment happens between firms and financial markets?

Tax payments to the government

Cash flows from the firm must _____ the cash flows from the financial markets

Exceed

What is capital budgeting?

The process of determining exactly which assets to invest in and how much to invest

What are the four steps, in order, of the decision making process for investments?

1. Identification
2. Evaluation
3. Selection
4. Implementation

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Describe the Identification step in Investment Projects

Finding out opportunities and generating investment proposals

What type of investments fall under the identification step?

* Required
* Replacement
* Expansion
* Diversification

Describe the evaluation step in Investment Projects

Estimating the project’s relevant cash flows and appropriate discount rate

What type of investments fall under the evaluation step?

* Expected cash-flow stream
* Discount rate

Discount rate is also sometimes known as ____

Cost of capital

Describe the selection step in investment projects

Choosing a decision making rule (accept / reject criteria)

List the types of investments that fall under the selection step

* Net present value
* Profitability index
* Internal rate of return
* Payback period

Describe the implementation step in investment projects

Establishing an audit and a follow-up procedure

List the types of investments that fall under the implementation step

* Monitor the magnitude and timing of cash flows
* Check if the project still meets the selection criterion
* Decide on a continuation or abandonment
* Review previous steps if failure rate is high

Money received in the future is _____ than money received today

less

Define opportunity cost

Rate of return sacrificed on the next best alternative

What is the formula for finding the future value FV of an investment of PV dollars today

FV = PV\*(1+r)^t

What is the present value

The amount of money you would need to invest today in order to duplicate some future dollar amount

What excel formula allows you to calculate the number of periods it will take for a future value to be achieved?

NPER

What is the formula for calculating payments of an amount with an interest rate?

PMT

What rule is usually used for forecasting the benefits and costs of an investment project?

Net Present Value (NPV)

What is the formula for Net Present Value (NPV)?

NPV= C0 + C1/(1+r) +…+ Ct/(1+r)^t

What condition needs qualifies a project to be accepted when using NPV?

If NPV > 0, the the project will increase shareholder value and should be accepted

What is an independent project?

Acceptance or rejection is independent of the acceptance or rejection of other projects

What is a mutually exclusive project?

Can accept “A” or you can accept “B” or you can reject both -- you cannot accept both

What is the payback period?

The number of periods required for the sum of the project’s expected cash flows to equal its initial cash outlay

What are some of the consequences of the payback period?

* Penalizes long-term projects
* Difficult to know who decides the period
* Ignores cashflows after the period

What is the internal rate of return?

It is the discount rate that makes the net present value of the project equal zero

What is the criteria for an acceptable project using the internal rate of return?

The IRR needs to be greater than the cost of capital

What is the profitability index?

It is the present value of an investment’s future cash flows divided by its initial cost

What is another name for the profitability index?

Benefit / cost ratio

How do you calculate the profitability index?

(CF + NPV) / CF

What is the criteria for accepting the profitability index?

PI > 0 means you accept the project

What are some of the issues with IRR?

* Multiple IRRs can exist
* Scale issue
* Timing issue

What happens to cause multiple IRRs?

There is more than one change of sign of the cashflows (positive to negative and negative to positive)

What is the crossover rate?

NPVa = NPVb

What two evaluation methods will generally give the same decision?

NPV and IRR

Why would NPV and IRR not produce the same outcomes?

1. Non-conventional cashflows (flow signs change more than once)
2. Mutually exclusive projects


1. Initial investments are substantially different
2. Timing of cash flows is substantially different

What is the most popular capital budgeting method?

IRR and NPV

What is the difference between discounted and undiscounted payback periods?

Undiscounted means that the payments shown already are adjusted to incorporate the time value of money, whereas discounted means you need to make that adjustment

If you want to determine the amount of capital expenditures a company made during the previous year, you should find the company’s most current ____ and look under the caption ________

cash flow statement; cash flow investments

When combining investment IRR, the combined IRR will be _____ the two individual IRRs

between

Conventional cash flows must be ______ for the NPV and IRR methods to be consistent in accept / reject decisions

independent

What are the two principle for recording relevant cash flows:?

1. Record cash flows when the money actually moves
2. Cash flows that are different in both scenarios (accepting or rejecting an investment) are relevant to the decision, and those that are the same are irrelevant

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Define Sunk Costs

Something you’ve already spent -- not relevant for decision making

Define test marketing costs

These are the marketing research expenses expended

Define erosion costs

Taking away costs from an existing location -- Cash flow transferred to a new project from sales and customer of other products of the firm

Define Opportunity Costs

Lost revenues from alternative uses of the asset

What kind of an expense is depreciation?

Non-cash

How do you calculate the after-tax cash flow (ATCF)?

ATCF = (revenue - costs - depreciation)(1- tax) + depreciation

What is working capital?

Changes in the current assets that are the result of the investment decision -- this is relevant to the decisions

What is working capital considered (directionally) at the start and end of a project?

Start: cash outflows

End: cash inflows

What are the three groups to consider when making cash flow estimates?

* Price, volume
* Variable costs
* Fixed costs
* Capital expenditure
* Working capital

What are the factors to consider with Price, Volume?

* Competition from existing products
* Competition from technological advances
* Values to customer

What are the factors to consider with variable costs?

Labor, material, energy

What are the factors to consider with fixed costs?

Marketing (sales, advertising), information technology, accounting management

What are the factors to consider with capital expenditure?

Property, plant and equipment

What are the factors to consider with working capital?

Inventory, accounts payable, accounts receivable

What does the operating margin consist of?

Revenues (price, volume) and costs (variable and fixed)

What does the operating cash flow consist of?

The operating margin and taxes

What does the capital requirement consist of?

Capital expenditure, working capital (accounts receivable/payable, inventory)

What does the free cash flow consist of?

Operating cash flow and capital requirement

What does the cost of capital consist of?

Cost of debt and cost of equity

What does the net present value (NPV) consist of?

Free cash flow and cost of capital

The goal of the company is to ______ free cash flow and _______ cost of capital

maximize; minimize

What is a nominal return?

The percentage change in the amount of money you have

What is the real return?

The percentage change in the amount of stuff you actually buy

What is the Fisher Effect?

1 + Nominal = (1+Real) \* (1+Inflation)

Describe the two methods you can use to account inflation and estimation of cashflows

1. Express cash flows in real terms and discount them at the real interest rate
2. Convert real cash flows to nominal cash flows by allowing them to grow at rate of inflation and discount them at the nominal rate

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Cost of capital is expressed in ______ terms

Nominal

Depreciation is expressed in ______ terms

Nominal

When is it important to account for inflation/

When dealing with long horizons and high inflationary times

How can you do sensitivity analysis?

Ask what if questions:

* Target Market Share
* Cost overrun
* Inflation
* Competition
* Discount rate
* Valuable options

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What are the steps?

1. Identify each key variable and the probability distribution associated with it


1. Base case
2. Revenues
3. Growth
4. Operating Margin
5. Working Capital
2. Draw one outcome for each variable
3. Estimate PV and IRR
4. Repeat steps 2 and 3 many times (\~5000)
5. Use the distribution of NPV to answer the following questions:


1. What is the likelihood that this will be a bad project?
2. What is the worst case and best case scenarios?
3. Can you try to build linkages in the simulations?

What is the most preferred technique for capital investment analysis?

Net Present Value (NPV)

Capital budgeting must be done on an _____ basis

Incremental

In regards to capital budgeting, what costs are ignored and what costs are considered?

Sunk costs are ignored; opportunity costs and side effects are considered