Financial Management

Key Concepts and Skills

Know the basic types of financial
management decisions and the role of the
financial manager
Know the financial implications of the
different forms of business organization
Know the goal of financial management
Understand the conflicts of interest that can
arise between owners and managers
1

Goal of Financial Management

What should be the goal of a corporation?
Maximize profit ?
Minimize costs ?
Maximize market share ?
Maximize the current value per share of the
companys existing stock ?
Maximize the market value of the existing
owners equity ?

What is Financial Management?

Concerns the acquisition,

financing and management of
assets with some overall goal in
mind.

Financial Management
Decisions
Capital budgeting
What long-term investments or
projects should the business take on?

Capital structure
How should we pay for our assets?
Should we use debt or equity?

Working capital management

How do we manage the day-to-day
finances of the firm?
4

Role of the Financial Manager

Financial managers are supposed to make
financial decisions that serve SHs interests.
Firms need assets to generate income to provide
profits for the shareholders.
These assets must be paid for.
The role of the financial manager is to
determine:

What operating assets to invest in the capital

budgeting decision.
How to pay for those assets the financing
decision.

Role of the Financial Manager

Capital Budgeting Decision

Successful financial managers

purchase assets which generate cash
flows greater than the cash needed
to buy them.

Boein
g

$3 BILLION CASH FLOW

OUT
TO PURCHASE A
PRODUCTIVE ASSET WHICH
CREATES CASH FLOW IN
$8 BILLION CASH FLOW IN By
1997

757
and
767
jets

Role of the Financial Manager

Capital Budgeting Decision

Unsuccessful financial managers

purchase assets which generate cash
flows less than the cash needed to
buy them.

Walt
Disne
y

$2 Billion CASH FLOW

OUT
TO CONSTRUCT THE THEME
PARK

Disneyland
Paris

LESS THAN $1.8 BILLION ON CASH FLOW

IN
1-7

Role of the Financial Manager

1. Capital Budgeting Decision

The financial manager is concerned with:

1. The size of the future benefits which will be produced by the asset.
The bigger, the better!
2.The timing of the future benefits which will be received.
The sooner, the better!
3.The risks associated with realizing those future benefits.
The greater the certainty that they will be realized, the better!

2. Financing Decision
Once the capital budgeting decision is made, the financial manager
must determine how to pay for those assets.
The financial manager has two choices:
Purchase the assets using the firms own funds, that is, by using
internal financing.
Purchase them using external financing, that is, by raising money
from financial institutions or markets.
Semih Yildirim
3530

ADMS

1-8

Asset Management
Decisions
How do we manage existing assets
efficiently?
Financial Manager has varying
degrees of operating responsibility
over assets.
Greater emphasis on current asset
management than fixed asset
management.
9

Why Study Finance?

Marketing
Budgets, marketing research, marketing financial
products

Accounting
Dual accounting and finance function, preparation
of financial statements

Management
Strategic thinking, job performance, profitability

Personal finance
Budgeting, retirement planning, college planning,
day-to-day cash flow issues
6

Business Finance
Some important questions that are
answered using finance
What long-term investments should
the firm take on?
Where will we get the long-term
financing to pay for the investments?
How will we manage the everyday
financial activities of the firm?

1-11

The Role of The Financial Manager

(2)

(1)

Firm's
Financial

operations

Manager

Real
assets

(3)

(4a)

(4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors

Investors

Investm
ent
assets

Function of Financial Manager

1a.Raising
funds

2.Investment
s

Operations
(plant,
equipment
3.Cash
, projects)from

Financial
Manager

operational
activities 4.Reinvesting

1b.Obligatio
ns (stocks,
debt
securities)

Financial
Markets
(investor
s)

5.Dividends
or interest
payments

Finance function managing the cash flow

13

Financial decisions
Financing decision where is money going to come from
Investment decision how much to invest and in what
assets

Operations

Financial
markets

Financin
g

Investmen
ts

Financial
Manager

14

Financial decisions
Capital structure and cost of
capital

Operations

Financial
markets

Financin
g

Investmen
ts

Financial
Manager

15

Objectives for financial manager

Maximizing earnings and earnings growth
Maximizing return on investments and
return on equity

16

Corporate Organization Chart

Figure 1.1

1-17

Organization of the Financial

Management Function

VP of Finance
Treasurer
Duties

Capital Budgeting
Cash Management
Credit Management
Dividend Disbursement
Fin Analysis/Planning
Pension Management
Insurance/Risk Mngmt
Tax Analysis/Planning

Controller
Duties
Cost Accounting
Cost Management
Data Processing
General Ledger
Government Reporting
Internal Control
Preparing Fin Stmts
Preparing Budgets
Preparing Forecasts

18

Who is The Financial Manager?

Chief Financial Officer (CFO)
Oversees the treasurer and controller and sets
overall financial strategy.

Treasurer
Responsible for financing, cash management, and
relationships with banks and other financial
institutions.

Controller
Responsible for budgeting, accounting, and taxes.

Financial Management
Decisions
Capital budgeting
What long-term investments or
projects should the business take on?

Capital structure
How should we pay for our assets?
Should we use debt or equity?

Working capital management

How do we manage the day-to-day
finances of the firm?
1-20

Types of Costs
Learning Objectives
Understand the importance of good project cost management
Explain basic project cost management principles, concepts, and terms
Describe how resource planning relates directly to project cost
management
Explain cost estimating using definitive, budgetary, and rough order of
magnitude (ROM) estimates
Understand the processes involved in cost budgeting and preparing a
cost estimate for project
Understand the benefits of earned value management and project
portfolio management to assist in cost control
Ex-Describe how software can assist in project cost management
21

What is Cost and Project Cost

Management?
Cost is a resource sacrificed or foregone to achieve a specific
objective, or something given up in exchange.
Costs are usually measured in monetary units, such as
Rupees/Dollars etc.
Project cost management includes the processes required to
ensure that the project is completed within an approved budget.
Ex-estimated (budget )cost of any structure for 2 yrs and final cost
at the time of possession should be less or equal to the budget cost

22

Project managers must make sure their projects are well defined,
have accurate time and costs estimates and have a realistic budget
that they were involved in approving

Project Cost Management Processes

Resource planning: determining what
resources and quantities of them should be used
Cost estimating: developing an estimate of the
costs and resources needed to complete a project
Cost budgeting: allocating the overall cost
estimate to individual work items to establish a
baseline for measuring performance
Cost control: controlling changes to the project
budget
23

Project Cost Management Summary

24

Basic Principles of Cost Management

Most members of an executive board have a
better understanding and are more
interested in financial terms:
Profits are revenues minus expenses.
Life cycle costing considers the total cost of
ownership, or development plus support costs,
for a project.
Cash flow analysis determines the estimated
annual costs and benefits for a project and the
resulting annual cash flow.
25

Life Cycle Cost for Construction Project

Management ?
Life-cycle costing (LCC) is an estimation of the monetary costs of
the funding, design, construction, operation, maintenance and
repair, component replacement, and sometimes demolition of a
building.
It may be applied to new designs or to existing structures, in the
latter case enabling residual life and value to be estimated.
life cycle costing (LCC) is an economic analysis used in the
selection of alternatives that impact both present and future costs.
A true life cycle cost analysis implies an integrated building
systems design to achieve overall efficiency of the building
operation from top to bottom, inside and out.
26

Why use LCC?

Achieving excellence in design is essential for a construction project to
deliver best value. Design is both a creative and a technical process. It
should include the following components, each of which must be addressed
appropriately:
Functional design of the facility to meet the needs of users and

operations. This should result from a detailed assessment of the needs of

the users and operations and how they may change over time, as well as
how the facility will need to be altered to meet these changing needs.
Design of the complete facility to address the environment for those

who use, enjoy, operate, maintain or are otherwise affected by it, including
aspects that impact on their health and safety. The design should address
impact on the external global environment, as well as the facilitys
aesthetic, cultural and civic values.

27

Why use LCC?

Detailed design of each assembly and component, whether

manufactured on-site or in a factory, and whether it is a standard product

or purpose-made or adapted for the facility.
Design of the entire construction process, addressing how each

component will be manufactured, transported and assembled to complete

the facility. Maintenance of the facility (including details of how
components can be replaced and/or repaired) should be addressed, as well
as its ultimate disposal.
Costing of projects. This should include full life-cycle costs of the

facility, as well as more immediate construction and project costs. The

quality of both design and construction has the potential to greatly reduce
life-cycle costs, including costs-in-use and eventual disposal of the built
facility

28

Cash Flow Analysis for Construction

Projects
Cash flow is simply the flow of cash through the organization
over time. In the case of businesses that are run for profit,
cash is paid out in return for the labor and materials that are
used to provide goods and services that can be sold.
The revenues received provide cash that can be used to
finance further production and sales as well as increasing the
organizations economic value.
As a manager, you need to understand how cash flows are
generated and what factors impact those flows.
The management of cash flow is one part of a larger
management responsibility known as the management of
working capital, which refers to the operating liquidity
available to an organization.

29

Cost of Work
Cost of work performed without profit
and overhead markup

Payment
Suppliers
Monthly (preferably when paid)

Labor
Weekly

Subcontractors
When paid
Withhold retention

Value, Costs, and Receipts

Value
Value of work based upon contract with the
owner (schedule of values)
Includes costs and profit and overhead
markup

Cost
Cost of work performed without P&O (Profit &
Overhead) markup

Receipts
Payments from the owner

Value, Costs, and Receipts

Cash Provided by Contractor

Difference between payments and
receipts

Determining a Projects
Cash Flow
Step 1: Prepare a cost-loaded
schedule
Step 2: Determine when costs will be
paid
Following week (e.g., labor)
End of month (e.g., some materials)
When paid, paying retention (e.g., some
materials)
When paid, holding retention (e.g.,
subcontracts)

Determining a Projects
Cash Flow
Step 3: Determine when payments
will be received from owner
When will cost be billed
When will bills be paid

Step 4: Difference in cash flows

Cash required = Payments Receipts

Maximum Cash Required

When payments are received at the
end of the month, the maximum
amount of cash required often occurs
during the month
Not at months end

CASH
CASH FLOW
FLOW STATEMENT
STATEMENT
33 sections
sections reporting
reporting cash
cash
flows
flows from
from different
different
activities
activities
i)i) Cash
Cash flows
flows from
from operating
operating
activities
activities
ii)
ii) Cash
Cash flows
flows from
from investing
investing
activities
activities
iii)Cash
iii)Cash flows
flows from
from financing
financing
activities
activities

38

i)CASH
i)CASH FLOWS:
FLOWS: Operating
Operating
Activities
Activities

Operating activities are the earningrelated activities of a company.

Most important cash flows of a business
2 methods
Direct method
Reports operating cash flows as sources, uses of cash

Indirect method
Reports operating cash by adjusting accrual net
income to cash flows

Beyond
revenue
and
expense
activities
represented in an income statement, they
include the net inflows and outflows of cash
resulting from related operating activities like
extending credit to customers, investing in
inventories, and obtaining credit from suppliers.

39

ii)CASH
ii)CASH FLOWS:
FLOWS: Investing
Investing
Activities
Activities

Cash
Cash inflows
inflows from
from investing
investing
activities
activities arise
arise from
from

Selling
Selling fixed
fixed assets,
assets, investments,
investments,
intangible
intangible assets
assets

Cash
Cash outflows
outflows from
from investing
investing
activities
activities arise
arise from
from

Buying
Buying fixed
fixed assets,
assets, investments,
investments,
intangible
intangible assets
assets
40

iii)CASH
iii)CASH FLOWS:
FLOWS: Financing
Financing
Activities
Activities

Financing
Financing activities
activities are
are means
means of
of
contributing,
contributing, withdrawing
withdrawing and
and servicing
servicing
funds
funds to
to support
support business
business activities.
activities.
Cash
Cash inflows
inflows from
from financing
financing activities
activities arise
arise from
from
Issuing
Issuing debt
debt (Debtis
(Debtis an
an amount
amount owed
owed for
for funds
funds
borrowed),
borrowed), equity
equity securities
securities

Cash
Cash outflows
outflows from
from financing
financing activities
activities arise
arise
from
from

(Re)Paying
(Re)Paying dividends,
dividends, debt,
debt, purchasing
purchasing treasury
treasury
stock
stock
41

EXERCISE
EXERCISE
Identify cash flow from operating
activity.

1.
2.
3.
4.
5.
6.

Purchased patents
Purchased buildings
Purchased treasury stock
Sold equipment
Net income
Issued preferred stock

7.
8.
9.

Redeemed bonds
Paid cash dividends
Sold long-term
investment
10. Issued common stock
11. Issued bonds

Click
button
to skip
this
exercis
e

Press Enter or click left mouse button

for answer.
42

EXERCISE
EXERCISE 13-3b
13-3b
Identify cash flow from investing
activity.

1.
2.
3.
4.
5.
6.

Purchased patents
Purchased buildings
Purchased treasury stock
Sold equipment
Net income
Issued preferred stock

7.
8.
9.

Redeemed bonds
Paid cash dividends
Sold long-term
investment
10. Issued common stock
11. Issued bonds

Click
button
to skip
this
exercis
e

Press Enter or click left mouse button

for answer.
43

EXERCISE
EXERCISE 13-3c
13-3c
Identify cash flow from financing
activity.

1.
2.
3.
4.
5.
6.

Purchased patents
Purchased buildings
Purchased treasury stock
Sold equipment
Net income
Issued preferred stock

7.
8.
9.

Redeemed bonds
Paid cash dividends
Sold long-term
investment
10. Issued common stock
11. Issued bonds

Click
button
to skip
this
exercis
e

Press Enter or click left mouse button

for answer.
44

Basic Principles of Cost Management

Cost Estimating
Project managers must take cost estimates
seriously if they want to complete projects
within budget constraints.
Its important to know the types of cost
estimates, how to prepare cost estimates, and
typical problems associated with organization
cost estimates.
45

Basic Principles of Cost Management

Cash flow analysis determines the estimated annual costs and benefits for a
project and the resulting annual cash flow
Too many projects with high cash flow needs in the same year may not be able to
be supported which will impact profitability
Tangible costs or benefits are those costs or benefits that an organization can
easily measure in Dollars/Rupees
A task that was allocated Rs 150,000 but actually costs Rs 100,000 would have
a tangible benefit of Rs 50,000 if the assets allocated are used for other projects
Intangible costs or benefits are costs or benefits that are difficult to measure in
monetary terms
Costs resources used to research related areas of a project but not billed to the
project
Benefits goodwill, prestige, general statements of improved productivity not
easily translated in dollars
46

Basic Principles of Cost Management

Direct costs are costs that can be directly related to producing the products
and services of the project

Ex- These include labour cost, material cost and equipment cost etc
Indirect costs are costs that are not directly related to the products or services
of the project, but are indirectly related to performing the project

Ex- administrative and establishment charges and

(i) Overhead Loss - overhead, supervision, expenditure on a central
store organization, loss of revenue,
(ii) Outage Loss - lost profit (due to inability to meet demand), penalty
(due to delay) etc
Sunk cost is money that has been spent in the past; when deciding what
projects to invest in or continue, you should not include sunk costs
To continue funding a failed project because a great deal of money has already been
spent on it is not a valid way to decide on which projects to fund
Sunk costs should be forgotten

47

Time Value of Money

1.U
1.Understand
nderstandwhat
whatisismeant
meantby
by"the
"thetime
timevalue
valueofofmoney."
money."
2.Understand
2.Understandthe
therelationship
relationshipbetween
betweenpresent
presentand
andfuture
futurevalue.
value.
3.Describe
3.Describehow
howthe
theinterest
interestrate
ratecan
canbe
beused
usedtotoadjust
adjustthe
thevalue
valueofofcash
cash
flows
flowsboth
bothforward
forwardand
andbackward
backwardtotoaasingle
singlepoint
pointinintime.
time.
4.Calculate
4.Calculateboth
boththe
thefuture
futureand
andpresent
presentvalue
valueof:
of:(a)
(a)an
anamount
amountinvested
invested
today;
today;(b)
(b)aastream
streamofofequal
equalcash
cashflows
flows(an
(anannuity);
annuity);and
and(c)
(c)aastream
stream
ofofmixed
mixedcash
cashflows.
flows.
5.Distinguish
5.Distinguishbetween
betweenan
anordinary
ordinaryannuity
annuityand
andan
anannuity
annuitydue.
due.
6.Use
6.Useinterest
interestfactor
factortables
tablesand
andunderstand
understandhow
howthey
theyprovide
provideaashortcut
shortcut
totocalculating
calculatingpresent
presentand
andfuture
futurevalues.
values.
7.Use
7.Useinterest
interestfactor
factortables
tablestotofind
findan
anunknown
unknowninterest
interestrate
rateororgrowth
growth
rate
ratewhen
whenthe
thenumber
numberofoftime
timeperiods
periodsand
andfuture
futureand
andpresent
presentvalues
values
are
areknown.
known.
8.Build
8.Buildan
anamortization
amortizationschedule
schedulefor
foran
aninstallment-style
installment-styleloan.
loan.

48

The Time Value of Money

The Interest Rate

Simple Interest
Future Value and Present Value
Compound Interest
Effective Annual Yield
Inflation

Interest
If we borrow an amount of money today, we will
repay a larger amount later. The increase in value
is known as interest. The money gains value
over time.
The amount of a loan or a deposit is called the
principal. The interest is usually computed as a
percent of the principal. This percent is called the
rate of interest (or the interest rate, or
simply the rate).
The rate of interest is assumed to be an annual
rate unless otherwise stated.

Interest
Simple Interest
Interest calculated only on principal is called simple
interest. or
Interest paid (earned) on only the original amount, or
principal, borrowed (lent).
Compound Interest
Interest calculated on principal plus any previously
earned interest is called compound interest. or
Interest paid (earned) on any previous interest earned, as
well as on the principal borrowed (lent).

Simple Interest
If P = principal amount,
r = annual interest rate,
t = time (in years),
then the simple interest I is given by
I = Prt
Ex-Find the simple interest paid to borrow Rs
4800 for 6 months at 7%.
Solution
I = Prt = Rs 4800(0.07)(6/12) = Rs 168
6 months is 6/12 of a year.

Future and Present Value

In the last example, the borrower would have to repay Rs
4800 + Rs 168 = Rs 4968.
The total amount repaid is called the maturity value (or
the value) of the loan. We will refer to it as the future
value, or future amount.
The original principal, denoted P, can also be thought of as
present value.
If a principal P is borrowed at simple interest for t years at
an annual interest rate of r, then the future value of the
loan, denoted A, is given by
A = P(1 + rt)

Example: Future Value for Simple Interest

Ex - Find the future value of $460 in 8 months, if
the annual interest rate is 12%.
Solution

8
A P 1 rt $460 1 .12 $496.80.
12

Example: Present Value for Simple Interest

Ex - If you can earn 6% interest, what lump sum
must be deposited now so that its value will be
$3500 after 9 months ?
Solution

A P 1 rt

9
3500 P 1 .06
12

$3500
P
$3349.28
1.045

Compound Interest
Interest paid on principal plus interest is called
compound interest. After a certain period, the
interest earned so far is credited (added) to the
account, and the sum (principal plus interest)
then earns interest during the next period.
Interest can be credited to an account at time
intervals other than 1 year.
For example, it can be done semiannually,
quarterly, monthly, or daily.
This time interval is called the compounding
period (or the period).

Future Value for Compound Interest

If P dollars are deposited at an annual
interest rate of r, compounded m times per
year, and the money is left on deposit for a
total of n periods, then the future value,
A (the final amount on deposit), is given by

r
A P 1 .
m

Example: Future Value for Compound Interest

Ex- Find the future value of $8560 at 4%
compounded quarterly for 8 years.
Solution
P = $8560, r = 4% = .04, m = 4. Over 8 years
8m = 8(4) = 32.

r
.04

A P 1 $8560 1
m

n=

32

$11,769.49.

Example: Present Value for Compound Interest

Ex-What amount must be deposited today, at 5%
compounded monthly, so that it will be $18,000 in 20
years?

Solution

.05
$18000 P 1
12

$18000
.05
1
12

240

240

$6635.60

Effective Annual Yield

Savings institutions often give two quantities
when advertising the rates. The first, the actual
annualized interest rate, is the nominal rate
(the stated rate).
The second quantity is the equivalent rate that
would produce the same final amount, or
future value, at the end of 1 year if the interest
being paid were simple rather than compound.
This is called the effective rate, or the
effective annual yield.

Effective Annual Yield

A nominal interest rate of r, compounded
m times per year, is equivalent to an
effective annual yield of

r
Y 1
m

1.

Ex - What is the effective annual yield of an

account paying a nominal rate of 4.2%,
compounded monthly?
Solution

.042
Y 1

12

12

1 .0428 4.28%

Inflation
Inflation is defined as a sustained increase in the
general level of prices for goods and services. It is
measured as an annual percentage increase. or
In terms of the equivalent number of goods or
services that a given amount of money will buy, it
is normally more today than it will be later. In
this sense, the money loses value over time. This
periodic increase in the cost of living is called
inflation.
Unlike
account
values
under
interest
compounding, which make sudden jumps at
certain points, price levels tend to fluctuate
gradually over time.
It is appropriate, for
inflationary estimates, to use a formula for
continuous compounding.

Inflation
Unlike
account
values
under
interest
compounding, which make sudden jumps at
certain points, price levels tend to fluctuate
gradually over time.
It is appropriate, for
inflationary estimates, to use a formula for
continuous compounding.
Inflation in an economy usually is expressed as a
monthly or annual rate of price increases,
estimated by government agencies in a systematic
way.
63

Future Value for Continuous

Compounding
If an initial deposit of P dollars earns
continuously compounded interest
at an annual rate r for a period of t
years, then the future value, A is
given by
rt

A Pe .

Example:
Suppose that a cup of your favorite
coffee is $1.25. If the inflation rate
persists at 2% over time, find the
approximate cost of the coffee in 25
years.

Solution
rt

A Pe $2.25e

(.02)(25)

The coffee will cost about $3.71.

$3.71

Inflation Proportion
For a consumer product or service
subject to average inflation,

Price in year A CPI in year A

Price in year B CPI in year B

Example: Inflation
If your mother paid $3,000 in tuition in 1980 at the same college
that you will be attending and paying $9,300 in 2005, compare
the schools tuition increase to inflation over that same period of
time.

Solution
Let x represent what we expect the tuition to be in 2005 if it had
increased at the average rate since 1980.

Price in year 2005 CPI in year 2005

Price in year 1980 CPI in year 1980

Example: Inflation
Solution (continued)

x
195.3

$3000 82.4

x $7110.44.

Now compare with the actual 2005 tuition.

$9300
1.30
$7128.64
Tuition at the school increased approximately 30% more than the
average CPI-U rate.

Rule of 70
An estimation of the years to double, which is the number of
years it takes for the general level of prices to double for a given
annual rate of inflation, is given by

70
years to double
.
annual inflation rate

Example:
Estimate the number of years to double for an annual inflation
rate of 2.1%

Solution
70
Years to double
33.33
2.1
With an inflation rate of 2.1%, prices would double in about 34
years.