CASH FLOW
1|P a g e
FINANCE 1 A
FINANCE 1A WEEK 1 INTRODUCTION
The objective of managers >Should be to maximise the wealth of the shareholders • A company also has other stakeholders that rely on it, for example: – Managers: salaries, bonuses – Employees: wages – Creditors: interest & principle – Suppliers: pay for goods/services – Government: tax
FINANCIAL MANAGER: Role: Three fundamental decisions in financial management: 1. The capital budgeting decision: – Which productive assets should the firm buy? 2. The financing decision: – How should the firm finance or pay for assets? 3. Working capital management decisions: – How should day-to-day financial matters be managed? • • •
A firm generates cash flows by selling the goods and services produced by its productive assets and human capital. When the cash flows generated from the productive asset exceed the cash outflows (such as operating cash flows) the remaining cash is called residual cash flows The company can choose to pay any profit to the owners as a cash dividend, OR reinvest the cash in the business
CASH FLOW:
It is all about cash flows: • A company is unprofitable when it fails to generate sufficient cash inflows to pay operating expenses, creditors and tax. • Firms that are unprofitable over time will be forced into bankruptcy by their creditors • In bankruptcy, the company will either be reorganised, or the company’s assets will be liquidated
FINANCE 1 A
2|P a g e
Legal forms of business organization Sole Trader: • Is the simplest type of business to start and the least regulated • Keeps all the profits from the business • Doesn’t share decision making • All company income is taxed as personal income • Has unlimited liability for all business debts and other obligations of the company Partnership: • Has the same basic advantages and disadvantages as a sole trader • Has access to more capital, knowledge, experience and skills • When a transfer of ownership takes place the partnership is terminated, and a new partnership is formed • The problem of unlimited liability can be avoided in a limited partnership Company: • Is a legal entity. In a legal sense, it is a “person” distinct from its owners • The owners of a company are its shareholders • A major advantage of the company form of business is that shareholders have limited liability • Starting up is more costly compared to other forms of business • Heavily regulated by the Australian Securities and Investments Commission (ASIC) and corporate regulations (Corporations Act 2001) • Limited liability • Directors and employees could be personally liable if they commit reckless or fraudulent acts
Managing the financial function Chief Executive Officer (CEO) • Ultimate management responsibility and decision-making power in the firm • Reports directly to the board of directors, which is accountable to the company’s owners
The goal of the company What should management maximise? • Minimising risk or maximising profits without regard to the other is not a successful strategy Why not maximise profits? • Under creative accounting, a decision that increases profits under one set of accounting rules can reduce it under another • Accounting profits are not necessarily the same as cash flows • Profit maximisation does not tell us the timing cash flows are to be received • Profit maximisation ignores the uncertainty or risk associated with cash flows Maximise the value of the company’s share price • When analysts and investors determine the value of a company’s share price, they consider – The size of the expected cash flows – The timing of the cash flows – The riskiness of the cash flows. The mechanism for determining share prices is based predominately on cash-flows from correct and well executed business decisions
Many factors affect share price Short term Advertising campaign Long term Investing in new product lines
3|P a g e
FINANCE 1 A
Agency (organizational) conflicts: Ownership and control • For large companies, the ownership of the firm is spread over a number of shareholders and the company’s owners may effectively have little control over management • Management may make decisions that benefit their self-interest rather than those of the shareholders Agency relationships • An agency relationships arises whenever one party, called the principal, hires another party, called the agent • Agents have a fiduciary(trust rela) duty to shareholders to put shareholders interests above their own Do managers really want to maximize the share price? • Shareholders own the company, but managers control the money and have the opportunity to use it for their own benefit Agency Costs •
The costs of the conflict of interest between the company’s owners and its management
Aligning the interests of management and shareholders • Board of directors – represent shareholders’ interest in major decisions regarding the company An Independent Board of Directors Lack of board independence (not subject to another's authority) is a key factor in the misalignment between board members’ and shareholders’ interests • Management Compensation – a significant portion of management compensation is tied to firm performance (e.g. share price) • Managerial labour market – Companies with poor track record will have difficulty in attracting quality people • The takeover market – Corporate raiders may acquire a company at a discount due to its poor performance and replace current managers with a new manager • Control of the firm – If the interests of the manager and the firm are not aligned, then eventually the firm will underperform relative to its true potential Sarbanes-Oxley and CLERP 9 • Greater Board & Auditor Independence • Establish Internal Accounting Controls • Establish Ethics Program • Expand Audit Committee’s Oversight Powers • Enhances disclosure and accountability to shareholders
The importance of ethics in business The law is not enough • Ethicists argue that laws and market forces are not enough • Serious Consequences • Legal cost of ethical mistakes can be extremely high
Basic Sources of Funds: • • •
Make a profit by selling a product for more than it costs to produce. Borrow money – bank loans, debt issue Sell part of itself in the form of shares to investors – equity funding
FINANCE 1 A
4|P a g e
TUT WEEK 2
1. What are the two basic sources of funds for all businesses? Debt – a sum of money borrowed that is owed or due. Equity- essentially refers to the sale of an ownership interest to raise funds for business purposes. 2. Explain the difference between profitable and unprofitable companies. 3. What three major decisions are of most concern to finance managers? The capital budgeting decision: – Which productive assets should the firm buy? The financing decision: – How should the firm finance or pay for assets? Working capital management decisions: – How should day-to-day financial matters be managed?
4. What is the general decision rule for a company considering undertaking a project? Give a real life example. 5. What are the three basic forms of business organisations? 6. Who are the owners of the company and how is their ownership separated? Shareholders -Separate legal entity Business Entity BenefitsForming a business entity such as a corporation or LLC, along with a DBA provides excellent benefits for a business owner. It allows an owner to have liability protection for their personal assets, arrange taxation of their business in a way that is most beneficial for them, and still permits them to use various names for their business endeavors. MyCorporation can help simplify the process of filing the documents for setting up corporations, LLCs, and DBAs. Call us today and let us help get your business started.
7. What is the business organisation form preferred by companies that require a large capital base, and why? 8. What are some of the drawbacks to setting profit maximization as the main goal of the company? Why not maximise profits? • Under creative accounting, a decision that increases profits under one set of accounting rules can reduce it under another • Accounting profits are not necessarily the same as cash flows • Profit maximisation does not tell us the timing cash flows are to be received • Profit maximisation ignores the uncertainty or risk associated with cash flows
9. What are the major factors affecting share price?
Short term Advertising campaign Long term Investing in new product lines
e.g. natural disasters -internal shocks e.g CEO may make an unethical decision. -Economy e.g GFC 10. What is an agency relationship and what is an agency conflict? Use an example to illustrate how such conflicts can be reduced in a company? • •
An agency relationships arises whenever one party, called the principal, hires another party, called the agent Agents have a fiduciary(trust rela) duty to shareholders to put shareholders interests above their own • The costs of the conflict of interest between the company’s owners and its management
11. What is insider trading and what ethical conflict does it present? Asymmetric information ' A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Insider trading the illegal practice of trading on the stock exchange to one's own advantage through having access to
confidential information. WEEK 2 – TIME VALUE OF MONEY – SINGLE AMOUNTS
5|P a g e
FINANCE 1 A
PV0 FVn 1 i
n
FV i n PV0
FVn PV0 1 i
n
1
n
1
FV ln n PV n 0 ln 1 i
i FVn PV0 1 m
nm
FVn PV0 ein
Time Value of Money •
• •
Money has a “time value.” – A dollar today is worth more than a dollar tomorrow as it can be invested – People prefer to consume today rather than defer(postpone) consumption This concept is essential in making financial decisions. Make sure you fully understand this material before you move on to the next topic.
Future value versus present value • Financial decisions are evaluated either on a future value basis or present value basis. • Future value (FV) measures what one or more cash flows are worth at the end of a specified period. • Present value measures what one or more cash flows that are to be received in the future will be worth today (at t=0). • Compounding is the process of earning interest over time. • Discounting is the process of converting future cash flows to their present values
Future value and compounding Single period investment • We can determine the value of an investment at the end of one period if we know the interest rate to be earned by the investment. • If you invest for one period at an interest rate of i, your investment, or principle, will grow by (1 + i) per dollar invested.
Future value of $100 at 10 per cent
FVn PV0 1 i FORMULA VERSION: • Where • FVn is the future value in period n • PV0 is the present value at period 0 • i is the compound interest rate • There is NO standard notation for this formula. n
6|P a g e
FINANCE 1 A E.G Using the variables below solve for the FV: • PV0 = 100 • i = 10% • n=5
FVn PV0 1 i
n
FV5 1001 0.10
5
Time lines • •
Translating a question into a formula is not always straightforward Best to use a time line - a graphical representation of the size and timing of the cash inflows (positive) and outflows (negative).
PROCESS OVERALL: • Identify the variables – PV, FV, N and i • Draw a timeline • Take a guess (Use logic) • Apply the formula and check your answer E.G •
Your wealthy aunt passed away, and one of the assets she left to you was a savings account that was set up by you greatgrandfather 100 years ago. The account had a single deposit of $500 and paid 5% interest every year. How much have you inherited?
FVn PV0 1 i
n
FV100 5001.05
100
FV100 $65,751
Future value of $1 for different periods and interest rates •
How would your answer change if: – The present value was $1000?
or –
Number of years was 200?
–
Interest rate was 10%?
Or
Solving for an unknown:
7|P a g e
FINANCE 1 A
FVn n FVn 1 i n 1 i
PresentValue :
PV0
Future Value :
FVn PV0 1 i
Interest rate :
in
Number of periods :
n
FVn 1 PV0
FV ln n PV n 0 ln 1 i
E.G •
If I want to have $2,000 saved at the end of 4 years how much should I invest today if the interest rate is 6%
FIND INTEREST RATE: • I borrowed $1,000 from my parents agreed to pay back $1,200 at the end of 2 years. What annual interest rate have I agreed to?
FIND TIME PERIOD: • How many years would it take me to double my money if I invested $100 at 12%?
Compound frequency What is the future value of $100 invested for 1 year at 12% p.a. compounded annually?
•
What is the future value of $100 invested for 1 year at 12% p.a. compounded monthly? • Rate: 12%/12 = 1% every month • Periods: n x 12 = 12
8|P a g e
FINANCE 1 A
The more frequently the interest payments are compounded, the larger the future value of $1 for a given time period.
What is the future value of $100 invested for 2 years at 12% p.a. compounded: Semi-annually Quarterly daily
• •
When compounding interval is so fine, until at the extreme, it is compounded continuously m will approach infinity (∞)
put in calculator compounded to 100,000 times per year. Find the FV of $10,000, 5%p.a. over 5 years at different compounding periods Compounding period
Future Value
Interest earned
Yearly
$12 762.82
$2762.82
Quarterly
$12 820.37
$2820.37
Daily
$12 840.03
$2840.03
Continuous
$12 840.25
$2840.25
•
Compound growth occurs when the initial value of a number increases or decreases each period by the factor (1 + growth rate)
•
Examples include population growth, earnings growth
FINANCE 1 A
FINANCE 1A WEEK 1 INTRODUCTION
The objective of managers >Should be to maximise the wealth of the shareholders • A company also has other stakeholders that rely on it, for example: – Managers: salaries, bonuses – Employees: wages – Creditors: interest & principle – Suppliers: pay for goods/services – Government: tax
FINANCIAL MANAGER: Role: Three fundamental decisions in financial management: 1. The capital budgeting decision: – Which productive assets should the firm buy? 2. The financing decision: – How should the firm finance or pay for assets? 3. Working capital management decisions: – How should day-to-day financial matters be managed? • • •
A firm generates cash flows by selling the goods and services produced by its productive assets and human capital. When the cash flows generated from the productive asset exceed the cash outflows (such as operating cash flows) the remaining cash is called residual cash flows The company can choose to pay any profit to the owners as a cash dividend, OR reinvest the cash in the business
CASH FLOW:
It is all about cash flows: • A company is unprofitable when it fails to generate sufficient cash inflows to pay operating expenses, creditors and tax. • Firms that are unprofitable over time will be forced into bankruptcy by their creditors • In bankruptcy, the company will either be reorganised, or the company’s assets will be liquidated
FINANCE 1 A
2|P a g e
Legal forms of business organization Sole Trader: • Is the simplest type of business to start and the least regulated • Keeps all the profits from the business • Doesn’t share decision making • All company income is taxed as personal income • Has unlimited liability for all business debts and other obligations of the company Partnership: • Has the same basic advantages and disadvantages as a sole trader • Has access to more capital, knowledge, experience and skills • When a transfer of ownership takes place the partnership is terminated, and a new partnership is formed • The problem of unlimited liability can be avoided in a limited partnership Company: • Is a legal entity. In a legal sense, it is a “person” distinct from its owners • The owners of a company are its shareholders • A major advantage of the company form of business is that shareholders have limited liability • Starting up is more costly compared to other forms of business • Heavily regulated by the Australian Securities and Investments Commission (ASIC) and corporate regulations (Corporations Act 2001) • Limited liability • Directors and employees could be personally liable if they commit reckless or fraudulent acts
Managing the financial function Chief Executive Officer (CEO) • Ultimate management responsibility and decision-making power in the firm • Reports directly to the board of directors, which is accountable to the company’s owners
The goal of the company What should management maximise? • Minimising risk or maximising profits without regard to the other is not a successful strategy Why not maximise profits? • Under creative accounting, a decision that increases profits under one set of accounting rules can reduce it under another • Accounting profits are not necessarily the same as cash flows • Profit maximisation does not tell us the timing cash flows are to be received • Profit maximisation ignores the uncertainty or risk associated with cash flows Maximise the value of the company’s share price • When analysts and investors determine the value of a company’s share price, they consider – The size of the expected cash flows – The timing of the cash flows – The riskiness of the cash flows. The mechanism for determining share prices is based predominately on cash-flows from correct and well executed business decisions
Many factors affect share price Short term Advertising campaign Long term Investing in new product lines
3|P a g e
FINANCE 1 A
Agency (organizational) conflicts: Ownership and control • For large companies, the ownership of the firm is spread over a number of shareholders and the company’s owners may effectively have little control over management • Management may make decisions that benefit their self-interest rather than those of the shareholders Agency relationships • An agency relationships arises whenever one party, called the principal, hires another party, called the agent • Agents have a fiduciary(trust rela) duty to shareholders to put shareholders interests above their own Do managers really want to maximize the share price? • Shareholders own the company, but managers control the money and have the opportunity to use it for their own benefit Agency Costs •
The costs of the conflict of interest between the company’s owners and its management
Aligning the interests of management and shareholders • Board of directors – represent shareholders’ interest in major decisions regarding the company An Independent Board of Directors Lack of board independence (not subject to another's authority) is a key factor in the misalignment between board members’ and shareholders’ interests • Management Compensation – a significant portion of management compensation is tied to firm performance (e.g. share price) • Managerial labour market – Companies with poor track record will have difficulty in attracting quality people • The takeover market – Corporate raiders may acquire a company at a discount due to its poor performance and replace current managers with a new manager • Control of the firm – If the interests of the manager and the firm are not aligned, then eventually the firm will underperform relative to its true potential Sarbanes-Oxley and CLERP 9 • Greater Board & Auditor Independence • Establish Internal Accounting Controls • Establish Ethics Program • Expand Audit Committee’s Oversight Powers • Enhances disclosure and accountability to shareholders
The importance of ethics in business The law is not enough • Ethicists argue that laws and market forces are not enough • Serious Consequences • Legal cost of ethical mistakes can be extremely high
Basic Sources of Funds: • • •
Make a profit by selling a product for more than it costs to produce. Borrow money – bank loans, debt issue Sell part of itself in the form of shares to investors – equity funding
FINANCE 1 A
4|P a g e
TUT WEEK 2
1. What are the two basic sources of funds for all businesses? Debt – a sum of money borrowed that is owed or due. Equity- essentially refers to the sale of an ownership interest to raise funds for business purposes. 2. Explain the difference between profitable and unprofitable companies. 3. What three major decisions are of most concern to finance managers? The capital budgeting decision: – Which productive assets should the firm buy? The financing decision: – How should the firm finance or pay for assets? Working capital management decisions: – How should day-to-day financial matters be managed?
4. What is the general decision rule for a company considering undertaking a project? Give a real life example. 5. What are the three basic forms of business organisations? 6. Who are the owners of the company and how is their ownership separated? Shareholders -Separate legal entity Business Entity BenefitsForming a business entity such as a corporation or LLC, along with a DBA provides excellent benefits for a business owner. It allows an owner to have liability protection for their personal assets, arrange taxation of their business in a way that is most beneficial for them, and still permits them to use various names for their business endeavors. MyCorporation can help simplify the process of filing the documents for setting up corporations, LLCs, and DBAs. Call us today and let us help get your business started.
7. What is the business organisation form preferred by companies that require a large capital base, and why? 8. What are some of the drawbacks to setting profit maximization as the main goal of the company? Why not maximise profits? • Under creative accounting, a decision that increases profits under one set of accounting rules can reduce it under another • Accounting profits are not necessarily the same as cash flows • Profit maximisation does not tell us the timing cash flows are to be received • Profit maximisation ignores the uncertainty or risk associated with cash flows
9. What are the major factors affecting share price?
Short term Advertising campaign Long term Investing in new product lines
e.g. natural disasters -internal shocks e.g CEO may make an unethical decision. -Economy e.g GFC 10. What is an agency relationship and what is an agency conflict? Use an example to illustrate how such conflicts can be reduced in a company? • •
An agency relationships arises whenever one party, called the principal, hires another party, called the agent Agents have a fiduciary(trust rela) duty to shareholders to put shareholders interests above their own • The costs of the conflict of interest between the company’s owners and its management
11. What is insider trading and what ethical conflict does it present? Asymmetric information ' A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Insider trading the illegal practice of trading on the stock exchange to one's own advantage through having access to
confidential information. WEEK 2 – TIME VALUE OF MONEY – SINGLE AMOUNTS
5|P a g e
FINANCE 1 A
PV0 FVn 1 i
n
FV i n PV0
FVn PV0 1 i
n
1
n
1
FV ln n PV n 0 ln 1 i
i FVn PV0 1 m
nm
FVn PV0 ein
Time Value of Money •
• •
Money has a “time value.” – A dollar today is worth more than a dollar tomorrow as it can be invested – People prefer to consume today rather than defer(postpone) consumption This concept is essential in making financial decisions. Make sure you fully understand this material before you move on to the next topic.
Future value versus present value • Financial decisions are evaluated either on a future value basis or present value basis. • Future value (FV) measures what one or more cash flows are worth at the end of a specified period. • Present value measures what one or more cash flows that are to be received in the future will be worth today (at t=0). • Compounding is the process of earning interest over time. • Discounting is the process of converting future cash flows to their present values
Future value and compounding Single period investment • We can determine the value of an investment at the end of one period if we know the interest rate to be earned by the investment. • If you invest for one period at an interest rate of i, your investment, or principle, will grow by (1 + i) per dollar invested.
Future value of $100 at 10 per cent
FVn PV0 1 i FORMULA VERSION: • Where • FVn is the future value in period n • PV0 is the present value at period 0 • i is the compound interest rate • There is NO standard notation for this formula. n
6|P a g e
FINANCE 1 A E.G Using the variables below solve for the FV: • PV0 = 100 • i = 10% • n=5
FVn PV0 1 i
n
FV5 1001 0.10
5
Time lines • •
Translating a question into a formula is not always straightforward Best to use a time line - a graphical representation of the size and timing of the cash inflows (positive) and outflows (negative).
PROCESS OVERALL: • Identify the variables – PV, FV, N and i • Draw a timeline • Take a guess (Use logic) • Apply the formula and check your answer E.G •
Your wealthy aunt passed away, and one of the assets she left to you was a savings account that was set up by you greatgrandfather 100 years ago. The account had a single deposit of $500 and paid 5% interest every year. How much have you inherited?
FVn PV0 1 i
n
FV100 5001.05
100
FV100 $65,751
Future value of $1 for different periods and interest rates •
How would your answer change if: – The present value was $1000?
or –
Number of years was 200?
–
Interest rate was 10%?
Or
Solving for an unknown:
7|P a g e
FINANCE 1 A
FVn n FVn 1 i n 1 i
PresentValue :
PV0
Future Value :
FVn PV0 1 i
Interest rate :
in
Number of periods :
n
FVn 1 PV0
FV ln n PV n 0 ln 1 i
E.G •
If I want to have $2,000 saved at the end of 4 years how much should I invest today if the interest rate is 6%
FIND INTEREST RATE: • I borrowed $1,000 from my parents agreed to pay back $1,200 at the end of 2 years. What annual interest rate have I agreed to?
FIND TIME PERIOD: • How many years would it take me to double my money if I invested $100 at 12%?
Compound frequency What is the future value of $100 invested for 1 year at 12% p.a. compounded annually?
•
What is the future value of $100 invested for 1 year at 12% p.a. compounded monthly? • Rate: 12%/12 = 1% every month • Periods: n x 12 = 12
8|P a g e
FINANCE 1 A
The more frequently the interest payments are compounded, the larger the future value of $1 for a given time period.
What is the future value of $100 invested for 2 years at 12% p.a. compounded: Semi-annually Quarterly daily
• •
When compounding interval is so fine, until at the extreme, it is compounded continuously m will approach infinity (∞)
put in calculator compounded to 100,000 times per year. Find the FV of $10,000, 5%p.a. over 5 years at different compounding periods Compounding period
Future Value
Interest earned
Yearly
$12 762.82
$2762.82
Quarterly
$12 820.37
$2820.37
Daily
$12 840.03
$2840.03
Continuous
$12 840.25
$2840.25
•
Compound growth occurs when the initial value of a number increases or decreases each period by the factor (1 + growth rate)
•
Examples include population growth, earnings growth
