Time Value of Money

I am amazed how long it's taken me to finally understand the time value of money!
Today it finally clicked.

FV of 1 invested with r interest rate = (1 + r)^t where t is the number of periods.

PV of 1 paid out in the future = 1/(1+r)^t where t is the number of periods.

These both assume compound interest.

PV = FV/(1+r)^t

Balancing this equation to solve for r gives

r = (FV/PV)^(1/t) -1

FV of multiple cash flows - just take sum of each payment.

Annuity = a sequence of evenly spaced, level cash flows.
Perpetuity = payment stream lasts forever.

PV of a Perpetuity
Cash payment from perpetuity = interest rate X present value
C = r X PV
PV = C/r

Suppose some worthy person wishes to endow a chair in finance at your university. If r = 10% and aim is to provide 100K Cash payment annually, how much must be set aside today?

PV = 100K/.10 = 1 million

PV of an Annuity

Present value of t-year annuity = C[1/r - (1/(r(1+r)^t))] <- "Annunity Factor"

"Amortizing Loan " - part of the monthly  payment is used to pay interest on the loan and part is used to reducet he amount of the loan.

FV of a Annuity 
FV = PV X (1+r)^t

FV = [(1+r)^t -1]/r    (For a $1 annuity)

Effective Annual Interest Rate = not the same as APR!

1 + effective annual rate = (1 + monthly rate)^12

for example if monthly is 1%, annual is 12.68%\

If you're quoted an APR and there are m compounding periods in a year, then $1 will grow to $1 X (1+APR/m)^m  -- m is number of periods in year.

Inflation
Real future value of investment. Interest rate in real dollars.

1 + real interest rate = (1 + nominal interest rate)/(1 + inflation rate)

Useful approximation 
Real interest rate ~ nominal interest rate - inflation rate.

Healthcare back of the napkin

by Dan Roam

Healthcare Napkins All

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Finance Chapter19 - Short-Term Financial Planning

Summary of chapter  -

• show how long term financing decisions impact short term
• Components of working capital and the cash conversion cycle
• how managers forecast month by month cash requirements or surpluses
• Sources of short-term finance

Def - Total Capital Requirement. The total cost of all assets.

Figure 19-2. illustrates different long-term financing strategies

• relaxed strategy - keep permanent short term cash surplus
• restrictive strategy - firm is always in need for short-term borrowing,
• intermediate strategy - firm fluctuates between surplus that it can lend away and needing to borrow.

What is the better strategy? No clear answer, depends. Several practicabl observations

• Matching Maturities. Matching the type of financing with the type of asset. for example use long term financing (borrowing/equity) for long-lived assets like plant and machinery. Use short-term bank loans for inventory and AR.
• Permanent working capital requirements.  Working capital should be funded with long-term financing
• Consider liquidity advantages.  Certain types of firms need more liquidity than others. very predictable firms (manufacturing) need less. biotech need high in case a new drug gets approved they need large amounts of immediate cash to deploy to manufacturing.

19.2 Components of Working Capital
Current Assets

• Accounts Receivable - unfinished payments from other companies or end consumers
  
• Inventory - raw material, work in progress, finished goods awaiting sale
  
• Cash - in form of bills or bank deposits
  
• Marketable securities - "commercial paper - short-term unsecured debt sold by other firms" or "Treasury bills (T-bills) - short term debts sold by gov't"

Current Liabilities

• Accounts Payable - outstanding payments due to other companies
• short-term borrowing.

Working capital and the cash conversion cycle

Def - Net working capital = Current assets - current liabilities. Often called "working capital". For average manufacturing, this is positive. Assets are 30% greater than liabilities.

Def - Cash Conversion Cycle = (inventory period + receivables period) - accounts payable period. The amount of time between a firm's payment for materials and collection on it's sales.

Def - Inventory Period = inventory / annual COGS/365
Def - AR Period = AR / (Annual sales/365)

Def - AP Period = AP / (Annual COGS/365)


NOTE: Example 19.1 - Cash Conversion Cycle

Def  - Carrying Costs: Costs of maintaining current assets, including opportunity cost of capital.


Def - Shortage Costs: Costs incurred from shortages in current assets.


Def - Economic Value Added (EVA).


19.4 Cash Budgeting
Step1: Forecast the sources of cash
Step2: Forecast uses of cash
Step3: Calculate whether the firm is facing a shortage or surplus

Finance Chapter 18 - Long Term Financial Planning

Short term planning <12 months < long term plannning = typically 5 years "Planning Horizon" although some look out 10 yrs+.

Why build a financial plan? What do you get out of it?
- For contingency planning (aka scenario planning). a good financial plan should help you adapt as events unfold
- To Considering options.
- To force consistent

Financial Planning Models help planners explore the consequences of alternative strategies. Models range from sinple to ones that incorporate hundreds of equations.  They support the planning process by making it eaier and cheaper to construct forecast financial statements.

Components of a FPM

• Inputs - The inputs to the FP consist of the firms current financial statements and its forecasts about the future.  The principal forecast is the likely growth in sales.
• The planning Model - the model calculates implications of forecasts for profits, new investment and financing.
• Outputs - the output consists of financial statements (income, balance sheets, cash flows). These are called pro formas. Can also be 'financial ratios'.

Def - percentage of sales models - Simple planning model in which sales forecasts are the driving variables and most other vars are proportional to sales.

NOTE: Financial models ensure consistency between growth assumptions (forecasts) and financing plans, but they do NOT identify the best financing plan

NOTE: Figure 18-2 has a great model spreadsheet

NOTE: Example 18.3 is a great exercise for excess capacity


While models help managers be consistent between their growth goals, investments and financing they can obscure the basic issues... Therefore it's good to have some 'rules of thumb'

Formula - Required External Financing = new investment - reinvested earnings

= (growth rate X assets) - reinvested earnings

This equation hilittes that the amount of external financing DEPENDS on the firm's projected growth.

Formula - Internal Growth Rate = maximum rate of growth without external financing

= reinvested earnings/assets

This means that a firm with a high volume of reinvested earnings relative to its assets can generate a higher growth rate without needing to raise more capital. AHA!

Formula: IGR = plowback ratio X ROE X equity/assets

= reinvested earnings/NetIncome X net Income/equity X equity /assets

This means that a firm can achieve a higher growth rate without raising capital by 

a) increasing plowback (reinvested earnings)

b) getting a higher ROE

c) keeping a low debt to asset ratio

NOTE: Example 18.4 , how to calculate internal growth rate

Def: . Sustainable Growth Rate - The highest growth rate the firm can maintain without increasing its financial leverage.

Formula: Sustainable Growth Rate = plowback ratio X ROE

= Reinvested earnings/NetIcome X NetIncome/equity

Strategy Journal Post #2

This past week we refined the project proposal for our POL with JBEI. To give a little background, JBEI has not been terribly inclined to participate in a strategic planning exercise for their organization. They see clearer value in us doing a finance project for them, but the reality of their situation is not one where a strategic plan will give them much value. They are a research driven facility with very little focus on business. That’s not to say an exercise and documentation of their strategy would not be valuable, but very likely the output of anything we delivered would not be applicable.  That said, they believe there would be greater value in such an exercise if it were paired with a different partner organization such as a VC or perhaps a company looking into extending into the cellulosic refining market.  We will be exploring this option moving forward, though at this point the team is not committing to keeping this within scope.

I feel a tinge of remorse for getting the team working with a partner where our strategic plan will not be as impactful, and I hope we can get the most learning out of the exercise. Looking back at the way the engagement was conducted, I think there are opportunities for improving, perhaps getting the faculty and administration more involved from the get go would have been advantageous.  I will be making recommendations to Erin, specifically for the cases where teams are recruiting companies who have never worked with a Presidio Team in the past.

The first few chapters of Blue Ocean Strategy have provoked a lot of reflection on the situation at my own company . I see a great need for more strategic planning to get out of the red oceans its been competing in and into the blue.  I have witnessed very incremental strategies that are shortsighted and not innovative. With our resources and talent we should be able to pioneer ahead. I hope to play a leading role in making the Maxis studio a pioneer in the Free2Play space.  While I would love to participate in this, the only question is, how do I get engaged at the right level?  Do I put together a strategy canvas this semester as an exercise and float it up the chain of command? Do I continue down the grass roots community building that I’ve started with the online discussion forums? Maybe I can use my current project as an exercise in strategy and keep it scoped down to my business unit.

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Finance Chapter 4

Def - Market Capitalization. Total market value of equity, Share price times number of shares. (Shares X Price)

Def - Market Value Added. The difference between total Market Cap and Total Shareholder's equity. How much value that a company has added to total shareholders equity. (Mkt Cap - Book Value of equity)

Def - Book Value of Equity.  Total shareholder's equity as listed in balance sheet.

Def - Market to Book Ratio. Market Value of Equite (Mkt Cap/Book Value of equity)

4.2 Measuring profitability
Def - Economic Value Added (Residual income) - (Net income - a charge for the cost of capital employed). EVA is how you measure a corps profitability. EVA is the profit after deducting all costs, including the cost of capital.. EVA is a better measure of performance than accounting profits as it includes cost of equity. EVA = Net Income - (cost of equity X equity)

Def - Return on Equity (ROE) = NetIncome/Equity: Return for shareholders.
Def - Return on Capital (ROC) = (NetIncome + interest)/(long-term debt + equity) Return to investors that includes long term debt.
Def - Return on Assets (ROA) = (NetIncome + interest)/total assets Return to investors based on total assets.

4.3 Measuring Efficiency - Always over specific time period, so look at income statement
Def - Asset Turnover = Sales/Total Assets. Shows how much sales are generated per dollar of asset
Sometimes done over averages assets over period instead. Measures how efficiently the business is using its entire asset base.

Def - Inventory Turnover = COGS/inventory. Show how efficient at clearing inventory. Good to clear inventory efficiently.  High turnover = good operations/logistics

Def - Avg days in inventory = inventory at start/daily COGS in period = XX days. higher number of days = less efficient

Def - Recievables Turnover = sales/recieveables at start of period. high number is efficient AR/credit team.

Def - Avg collection period = receivables at start of yr/avg daily sales = XX days. higher number of days = less efficient credit team.

4.4 Measuring Return on Assets (Du Pont)
Def - Profit Margin = NetIncome/Sales
Def - Operating Profit Margin = (NetIncome + interest)/sales. This is better measure of operating as it isolates performance from interest. Debt/Financing decisions are not included. 

Dupont System
Def - ROA = (NetIncome + interest)/assets = Sales/assets x (NetIncome + interest)/sales
Def - ROA = Asset Turnover x operation profit margin

The Dupont Formula implies strategy. For example, a company with high asset turnover, but slim margin is probably in mass market retail. As opposed to one with low asset turnover and high margin (specialty/luxury retail).
Fast Food Chains - high turnover (due to nature of food inventory) with low margin

4.5 Measuring Financial Leverage
When a firm borrows money, it promises to make a series of intereste payments and then to replay the amount it's borrowed. If profits rise, the debtholders(lenders) continue to recieve only the fixed interest payments and gains return to shareholders. If profits fall, shareholders bear most of the pain. If times are really hard, the firm may not be able to repay it's debts is forced into bankruptcy and shareholders lose most or all of their investment.

Financial Leverage is a measure of how reliant a firm is on debt to finance it's operations.
Leverage ratios measure how much leverage a firm has taken on.

Debt Ratios
Def - Long-term Debt Ratio =  long-term debt/(long-term debt + equity) [14% for Pepsi)
Def - Long-term Debt Equity Ratio = long-term debt/equity [17% for Pepsi]

Pepsi is not leveraged all that much.
For a highly leveraged company the ratios are higher.
Typically for manufacturing companyies, LTDR is about 30%.
Firms can buyout other firms through leveraged buyouts (see ch 21)

Note short-term debt is ignored in these ratios

Def - Total debt ratio = total liabilities/total assets. [Pepsi is 49%]

Times Interest Earned Ratio
Def - Times Intereste Earned Ratio: the extent to which interest obligations are covered by earnings. If it's high, then more earnings are being used to pay off interest.  Better to have low.


Def - Times Interest Earned Ration = Earnings Before Interest and Taxes (EBIT)/interest payments
Pepsi's is 30.2 because they are conservatively financed

Cash Coverage Ratio
Def - Cash Coverage Ratio is like Times Interest Earned, but keeps depreciation in the equation
Def - Cash Coverage Ratio = EBIT + depreciation/interest payments

Dupont formula in 4 parts
ROE = NetIncome/Equity
= leverage ratio X asset turnover X operating profit margin X Debt burden
= Assets/Equity X sales/assets X (NetIncome + interest)/sales X netIncome/(NetIncome + interest)

4.6 Measuring Liquidity
Def - liquidity: access to cash or assets that can be turned into cash on short notice

while generally liquidity is seen as a good thing, too high levels indicate sloppy use of capital.

Def - Net Working Capital to Total Assets Ratio = NetWorkingCapital/Total Assets [PEpsi's is 8%]
Def - Current ratio = CurrentAssets/CurrentLiabilities
Def - Quick (Acid-Test) Ratio = cast+marketable securities+receivables/current liabilities [This doesn't count inventory]
Def - Cash Ratio = cash+marketable securities/current liabilities [this is the companies most liquid assets]

4.7 Calculating Sustainable Growth
Def - Sustainable Rate of Growth: steady rate at which a firm can grow without changing leverage.

NOTE: Table 4-7 is very good reference!!

Finance Basics

Managerial Finance Chapters 1,2,3

Financial management at the highest level is all about making good finance related decisions.

It can be broken down to two main types of decisions:

- Investment decisions: what projects to spend money on. what capital investments to allocate funds to and how much to invest in each project.

- Financing decisions: how to raise capital for that a company needs for its investments. There are two ways to finance, via equity or debt.  In equity financing the company asks investors to put up cash for future profits. In debt financing the company gets a loan. The choice between this two is called the "capital structure" decision.

Def: Cost of capital -  minimum acceptable rate of return on capital investment.  The rates of return on investments outside the corp set the minimum return for investment projects inside. [If you get a higher return on the outside, why invest inside?] The cost of capital for corp investment is set by the rates of return on investment opps in financial markets. That is why financial managers talk about the 'opportunity cost' of capital.  When shareholders invest in the corp, they lose the opportunity to invest that case in financial markets where returns could be better.

Important distinction for Financial Reports.
They show book value of assets, not real market value. Book value is original cost - depreciation.

Why I'm staying home today

Why I'm staying home today

Financial Management first takes

At highest level FM decisions are about how to get your company financed or what to invest in.
From the financing perspective, do you want to issue new stock for shareholders to buy? Do you want to issue bonds? Do you want to sell a portion of your company to another company? Do you want to take a bank loan? With each of these options careful consideration must be made.

From investing, what is the ROI on the investment? Is the future value of this investment greater than the cost to invest now? This is where NPV comes into play.