Financial Management
What is Financial Management?
Financial management is helping corporate investment decision making. The main question at hand being, how do you allocate the internal capital for future growth. It looks at investment alternatives, estimates a project’s estimated cash flow, evaluates stock and firm values, measures risk and expected return, ect.
Some questions financial management considers: What should a company do moving forward? Where they should open up? Where should they shut down? Who they should hire?
Their goal is is maximize shareholder wealth. When shareholder’s are happy, everyone is happy.
What makes a company successful?
1) Taking care of customers on a repeated basis.
2) Create cash flow, continuous employment, decrease cost of capital, managing debt properly
Capital Budgeting
Capital Budgeting is the process of determining how much to invest and what to invest in.
You have to 1) Identify: find opportunities and generate investment proposals 2) Evaluate: estimate the projects cash flows and discount rate (cost of capital) 3) Selection: Choosing criterion for acceptance and rejection. Often Net Present Value, Payback Period, and Rate of Return. 4) Implementation: Monitor your decisions, does it make sense to continue?, establishing an audit and a follow up procedure.
Time Value of Money
Money coming you to the future is worth less compared to receiving it today.
You always have to include the interest, and maybe even opportunities cost.
Future Value
$Future Value = Present Value \cdot (1+i)^n$
Excel even has a Future Value function (FV).
Present Value
How much money would $1,500 in 5 years be today?
\[Present Value = Future Value \cdot (1+i)^{-n}\]This also has a function in Excel as well, PV.
Payment
How much money a year would you need in order to match present value over time.
\[Anual Payments = \frac{r\cdot PV}{1-(1+r)^{-t}}\]Use the PMT function in Excel.
Net Present Value (NPV)
Net present value is a way to evaluate long-term investments. It is seen as the greatest way to quantify a project.
Add all your cash flows.
\[NPV = C_0 + \frac{C_1}{1+IRR} + \frac{C_2}{1+IRR^2 }+ \frac{C_3}{1+IRR^3} + ...\]Often the first few cash flows are negative (you have to invest).
If NPV > 0, accept the project. If NPV < 0, reject the project.
In Excel, the NPV(C’s)+Original.
Crossover Rate: $NPV_A=NPV_B$
Gross Profit - Depreciation = Profits Before Tax
Profits Before Tax - (Tax Rate * Profits Before Tax) = Profits After Tax
After Tax Cash Flow = Profits After Tax + Depreciation
After Tax Cash Flows \(ATCF=(Revenue - Costs - Depreciation)\cdot (1 - Tax) + Depreciation\)
Internal Rate of Return (IRR)
IRR is the discount rate or interest rate that is the minimum return that would make the NPV of 0.
As long as the IRR is higher than the capital percentage cost. But choose the largest if mutually exclusive.
Activities like mining where end of project have a big cash requirement, you can have two IRR’s because the NPV is concave.
Also, would you want 100% of $1 or 50% of $1,000. The answer: 50%! But IRR suggests differently.
IRR and NPV usually give the same answer, unless non-conventional cash flows (sign changes more than once) and mutually exclusive projects.
Use IRR function in Excel.
Combined IRR
Payback Period
The payback period is how long it’ll take to cover the initial investments.
Penalizes long-term projects that take awhile to get off the ground.
\[PaybackPeriod=OriginalCost/CashInflows\]Discounts future cash flows and recognizes the time value of money.
Probability Index (Benefit Cost Ratio)
Highest PI is good, but bigger than 1 is profitable.
\[PI = \frac{CF_o+NPV}{CF_0}\]Cash Flows
Cash flows are recorded when the money actually moves, not when the accountant using accrual concepts says they occur.
Sunk Costs are not relevant for present decisions. You’ve already spent it and won’t affect the project.
Test Marketing Costs are expenses expended. Money to investigate a project.
Erosion Costs are cash flowed from sales/existing customers from other projects to a new project
Opportunity Costs are lost revenues from alternative use of the assets.
Depreciation is a non-cash expense.
Working Capital is the amount you spend on things like initial inventory, so it is cash outflow at the beginning but can turn back into cash inflow on the way back.
Inflation
Inflation can be very large, especially in international business where inflation isn’t as stable as it might be in the United States. It’s also important for large inflation or longer time horizons.
Nominal Rate of Return
Nominal rate is the percentage change in the amount of money you have.
Cost of capital is expressed in nominal terms.
Real Return
Real return is the percentage change in the amount of stuff you can actually buy.
Relationship
The relationship is often called The Fisher Effect and is demonstrated by
\(1+R=(1+r) \cdot (1+h)\) where R is the nominal return. r is the real return, and h is the inflation rate.
We can also say that approximately:
\[R=r+h\]Simulations
If you don’t know the numbers, run a simulation! You can have your variables follow distributions and repeat it thousands of times.
Stock Evaluation
Stock ownership is pretty much cash flows from dividends and capital gains.
Zero Growth Model
The dividends remain the same forever. This is pretty much the preferred stock. The future value of all future dividends. Given by $P_0=\frac{Div}{R}$ where R is equity model.
Constant Growth Model
The dividends will grow at a constant rate, g. Simplifies to $P_0=\frac{Div_1}{R-g}$. This can be shown as $R = \frac{Div_1 - P_0 \cdot g}{P_0}$
Differential Growth Model
Dividends will vary for awhile and
R
R is the discount rate and can be broken into two parts: dividend yield, growth rate (in dividends)
Independent Projects
Independent projects are those that acceptance/rejection decision are made independently of other projects. Each one can be decided by their own merits.
Mutually Exclusive
You can’t accept both projects. It is one or the other.
Cost of Capital
Cost of capital is the rate of return the corporation must earn on its invested capital in order to compensate for the time value of money and risk. The break even rate!
$WACC=CostOfDebt \cdot (1-TaxRate) \cdot (\frac{Debt}{Debt+Equity}) + CostOfEquity \cdot (\frac{Equity}{Debt+equity})$
Interest rate on debt is deductible. This means the government incentivizes debt.
The Cost of Debt
Rate of interest the firm would pay on a new bond. It is build upon the US Treasury bond and Default Risk. Treasury bonds are seen risk free and hence the lowest rate.
Sandard and Poors and Moody’s give bond ratings based on a company’s ability to repay debt.
Cost of Debt = 10 year Treasury Note + Bond Premium (basis points)
Risk
You can never make risk go away, it decays exponentially. The market risk will always stay. The more stocks you have, the least risky the investment is.
Market risk is anything with tax cuts or interest rates or changes in fiscal policy. It can be measured by Beta. The SP500 beta is 1. The beta of the Treasury Bonds is 0. Total Portfolio Risk? Average Beta x Market Standard Deviation. A company with a beta of 0.5 will be half as volatile as the overall market. A portfolio with a beta of 2 will be twice as volatile as the overall stock market.
Individual risk could be a CEO stepping down, bad press, ect.
Capital Asset Pricing Model (CAPM)
Cost of Equity = US Treasury Rate + Market Risk Premium x Beta
Market Risk Premium is the average differences in the rate of return on stocks and long-term US Treasury Bonds.
Market Capable, The Debt Value, and Beta to compute Cost of Capital
Firm Valuation
Firm Value = Equity + Debt
Projects have finite life. Firms have unlimited life time.
Discounted Cash Flow Method
CF = EBIT * (1-T) + DEPR - CAPEX - Delta(NWC)