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D076 Study Guide

Finance Skills for Managers (Western Governors University)

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D076 Study Guide

Unit 2
 Finance: The study of managing and allocating fund at the personal or business level.
 Accounting: The system of recording, reporting, and summarizing past financial
information and transactions.
 Capital: A financial asset that can be used by a firm or individual. Examples of capital
may be machinery or cash held by a firm.

Subspecialities in Finance:

 Business finance- an area of finance that deals with sources of funding, the capital
structure (the mixture of debt and equity used to finance a firm) of corporations, the
actions that managers take to increase the value of a firm for tis owners, and the tools
and analysis used to allocate financial resources. It is also known as managerial finance,
financial management, and organizational finance.
 Investments:
o Asset pricing- The process of valuing assets
o Current market value- what someone would pay right now for an asset
 Financial institutions- includes firms or organizations that exist to accept a wide variety
of deposits, to offer investment products to individuals and businesses, to provide loans,
or to broker financial transactions.
o Major financial institutions- central banks, consumer and commercial banks,
insurance companies, investment banks, mortgage companies, and even pension
fund management companies.
 Utility- the total satisfaction received from consuming goods and services.
 The goal of business finance is to maximize owner wealth for a privately held company
(firms that have not issues shares to the public where the ownership rights are privately
held) and to maximize shareholder wealth for a publicly held company (firms that have
issues shares to the public).
 Private equity- deal with finance within organizations and financial dealings between
businesses.

Careers in Finance

 Financial manager of firm- making financing decisions (issuance of new stock & bonds)
 Some—such as careers in corporate finance, investment banking, and private equity—
deal with finance within organizations and financial dealings between businesses.
Financial skills, though, are also needed in the analysis of assets, risk, and other
investment opportunities, such as in the fields of real estate management, insurance,
and personal financial planning.

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 Liquidity- investors can turn their financial securities into cash easily without losing
significant value.

Primary Financial Market

 Primary market- The financial market where securities (stocks and/or bonds) are first
sold.
o Syndicate- A group of intermediaries that is used to oversee the issuance of
stocks and/or bonds.
 Secondary market- The financial market where securities are traded after the initial
issuance.
o Auction market- A secondary market with a physical location and where prices
are determined by investors’ willingness to pay.
 New York Stock Exchange (NYSE)- A physical trading floor and a computer
network where stocks are bought and sold. It is the largest stock
exchange in the world.
o Dealer market- A secondary market made up of multiple dealers that hold an
inventory of securities and quote prices.
 NASDAQ- A computer network where stocks are bought and sold. It is the
second-largest stock exchange in the world. Typically, technology-related
companies will go public through this exchange.
 Money market- short-term borrowing and lending
 Capital market- long-term borrowing and lending
 U.S. Securities and Exchange Commission (SEC)- an independent federal government
agency with the responsibility to (1) protect investors, (2) maintain fair, orderly, and
efficient markets, and (3) facilitate capital formation.

Types of Indicator

 Leading- indicators that usually change before the economy as a whole changes.
o Yield curve- a graph that plots the interest rates of bonds with different maturity
dates, oftentimes U.S. Treasury bonds. When long-term bonds have a lower
interest rate than short-term bonds, you will see an inverted yield curve which
may indicate an economic downturn. A flat yield curve results when both short-
term and long-term bonds have the same interest rate, indicating that the
economy is in a transitional state.
o Stock Market Return- Often considered a leading indicator. An improving
economy, while a declining market may signal a worsening economy.

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 Lagging- change after the economy change. They indicate the changes and patterns in
the economy over time.
o Unemployment Rate
o Consumer Price Index (CPI)- measures changes in the inflation rate. Examines the
average prices of a basket of consumer good and services and the changes
associated with the cost of living.
 Coincident- collected, used, and analyzed as economic shifts happen. Provide
information about the current state of the economy.
o Gross Domestic product (GDP)- the monetary value of all the finished good an
services produced within a country’s borders in a specific time-period. Therefore,
when GDP increases, it is a sign that the economy is strong.
o Personal Income- provides some insight into overall consumer spending in an
economy and can be related to changes in overall consumption. When the
economy is doing well, personal income generally increases, which leads to an
increase in spending.

Conflicts between Shareholders and Bondholders

 The shareholders prefer for the company to take riskier projects and to pay more
dividends. The bondholders are more interested in strategies to increase the probability
that they will get paid back.

How To Resolve Ethical Conflicts

1. Identify and define the problem.

2. Consider alternative course of action
3. Identify what is moral, ethical, and legal of that situation.
4. Consider all stakeholders involved.
5. Consider alternative courses of action.
6. Move forward with the course of action you feel is ethical and best for the situation.

Types of Financial Institution

Type Definition

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1. Depository institution
a. Savings and loans association
2. Non-depository institution
a. Securities firm
b. Investment firm
Financial institution that accepts monetary deposits and provides loans.
Includes savings banks, commercial banks, savings and loan associations,
and credit unions. Bankrate reports that the largest banks in America were
JP Morgan Chase and Bank of America as of May 2019.1
A type of depository institution also known as a “thrift” institution that
places a significant focus on providing loans for residential mortgages and
real estate.
Financial institution that is not allowed to accept monetary deposits but
may perform functions such as lending money or acting as an intermediary
between savers and lenders. Examples include brokerage firms, investment
firms, mutual funds, and hedge funds.
Financial institution that facilitates the investment and purchase of
securities in financial markets. Common services include underwriting,
trading of securities on secondary markets, and the general sale of
securities.
Company that invests the capital of investors in financial securities.
Examples include mutual funds and investment trusts. The company may
also be involved in issuing securities. (See securities firm below).

Financial Institution Role

Central Bank Ensure that a nation’s economy remains healthy by controlling the amount
of money circulating in the economy
Banks and Credit Unions Receive deposits and extend loans to individuals and businesses
Insurance Charge premiums to invest in bonds and stocks to pay claims
Mutual Funds Offer investments and buy financial securities and instruments on behalf of
investors
Pension Funds Retirement funds contributed through companies to invest and provide
retirement
Investment Banks Offer various services such as underwriting, facilitating mergers, and trading
financial securities on behalf of large institutions and companies. Provides
individuals and firms access to financial markets.
Private Equity Receive money from institutional investors and wealthy individuals to buy
high-potential companies or troubled companies to improve and earn
returns by selling them or going public

Unit 3
 Interest rate- percentage of the principal that a lender charges a borrower for the use of
assets.
 Cost of capital- Also known as Discount rate, the cost to a firm to use an investor’s
capital

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o If the lender requires you to pay interest as stated by a required rate, the
required rate becomes the cost of borrowing to you. Since it is the cost to the
borrower to raise capital or borrow capital, we call the interest rate from the
borrower’s perspective the cost of capital.
Types of Interest

 Simple interest: Annual Interest = Principal x Interest Rate

 Total interest: Total Interest = Annual interest x t
 Compounding Interest: Total Interest = Principal x (1 + – Principal
o Example: $100 deposit, 10% annual interest, Money is kept for two years in the
account
 Interest = $100 x (1 + – 100 = $21

o By contrast, simple interest would provide the following annual interest:

 Annual Interest=$100×0.10=$10Annual Interest=$100×0.10=$10

o Since you save the money for two years, the total interest using simple
interest will be $20:

 Total Interest=$10×2=$20

Required Return
 Required rate of return- the rate of return or compensation that an investor or a lender
will accept for investments such as stocks, bons, or loans. The word compensation is
used because this is the rate that investors or lenders will be compensated for a given
level of risk associated with investments or loans.
o Also known as the hurdle rate in the context of corporate finance.
 Components of required rate of return:
o Opportunity cost- the loss of potential gain from other alternatives when one
alternative is chosen.
o Risk- possibility that the realized or actual return will differ from the expected
return.
o Inflation- the rate at which the average price level of goods and services in an
economy increases over a period of time.
Inflation

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 Inflation- the rise in the prices over time.

 Sources of inflation:
o Increased demand for goods and services
o Rising costs
o Adaptive expectations- when prices of goods and services go up, employees
expect and even demand higher wages to maintain their standard of living.
Decomposing Interest Rate
 Rate = Risk-Free Rate + Risk Premium
 Risk free rate – an indicator and opportunity cost and describes the rate of return
on an investment with no risk.
 Risk premium – the compensation for the amount of risk taken on by investors.
Nominal Rate
 Nominal rate- the rate at which invested money grows for a certain period of time.

 As an example, assume that you earn a 5% nominal investment over a year, but at
the same time, inflation increases 2%. Items you want to purchase at the end of
the period now cost you 2% more than they did when you invested.

 Mathematically, the growth rate of purchasing power is

 Growth rate in Purchasing Power =

 Using the above example with the nominal rate of 5% and the inflation of 2%, the
growth rate is calculated as follows:

 Growth rate in Purchasing Power =

 Even though you earned 5% interest, your real spending increase is only
approximately 3% (5% – 2%). Thus, your purchasing power increases by
only 3% instead of 5%.

Real Rate
 Real rate – same as the growth rate in purchasing power, even though the formula
seems different. This is call the Fisher Effect, an economic theory created by the
economist Irving Fisher.

o Real Rate = Nominal Rate – Inflation Rate

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Time Value of Money

 Time value of money- the concept that today’s dollar is worth more than a dollar in the
future.
 Compounding- finding a future value given a present value.
 Discounting- finding a present value given a future value.
Annuities
 Annuity- a stream of cash flows of an equal amount paid every consecutive period.
 Ordinary annuity- series of equal payments made at the end of consecutive periods over
a fixed length of time.
 Annuity due- paid at the beginning of consecutive periods.
 Perpetuity- a constant stream of identical cash flows that continues forever.
Return
 Return: the gain or loss on an investment over some period of time.
 Holding period return: the return that an investor gets over the entire period during
which he or she owns a financial security.
 Expected return: A hypothesized estimate of future prices or returns under different
scenarios based on expectational data.
Risk
 Standard deviation: A measure of dispersion of possible outcomes about the mean.
 Market Risk (Also known as systematic risk or nondiversifiable risk)
 Firm-specific risk (Also known as nonsystematic risk or idiosyncratic risk)
Different Types of Risk
 Interest rate risk: the probability that changes in interest rates will impact the value of a
bond. (Market risk)
 Default risk: the probability of a loss resulting from a borrower’s failure to repay a
contractual obligation. Firm-specific risk and affects both the bonds and stocks of the
firm. Firm-specific risk can be diversified.
o Firm-specific risk is the risk associated with problems that companies may face
because of lawsuits, labor problems, or management decisions, among other
factors.
 Price risk: the potential for the decline in the price of a financial security or an asset
relative to the market.
Risk Management
 Risk reduction (also known as risk mitigation): a series of techniques that help reduce
the amount of risk a person is exposed to by taking a particular action.

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o Example: “No Lifeguard on duty” or “Swim at your own risk”

 Diversification: a process of “spreading: your money over many different assets
 Correlation: the way two variables move in relation to each other.
 Risk Separation: dispersing assets geographically instead of concentrating them in one
location.
The Key Trade-Off
 Utility companies have low systematic risk because as the market moves up and down,
their level of risk will also move up and down but in a diminished way.
 Stock investments are more risky over a shorter period of time than over a longer period
of time.

 The higher the systematic risk an asset has, the higher the expected return.
 Higher-return financial securities typically have greater uncertainty in returns.
 Time diversification is the concept that riskier financial securities have lower risk in the
long term than in the short term.

Unit 4
Why Are Ratios Useful?

1. Standardization- Ratios standardize financial data to make them comparable across

firms, even those of distinctly different sizes.
2. Flexibility
3. Focus
4. Evaluation
i. Benchmarking: the process of completing a financial analysis and comparing a
firm’s performance to that of other similar firms is known as benchmarking.
Types of Ratios
Liquidity: measure a firm’s ability to meet short-term obligations without raising external capital.
While everybody is concerned about liquidity, short-term creditors such as banks and suppliers are
particularly interested. Liquidity is a measure of not only how much cash you have but also how
easily you can convert short-term assets into cash.

 Current Ratio=Current Assets/Current Liabilities

 Quick Ratio=Current Assets – Inventory/Current Liabilities
Activity: (also called efficiency ratios) measure how well the company uses its assets to generate
sales or cash—the firm’s operational efficiency and profitability.

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 Account receivable turnover (AR turnover): Ratios help to identify how quickly these
accounts receivable turn over during a given year.
o AR Turnover= Credit Sales/Account Recievable
 Average Collection Period (ACP): An activity ratio found by the number of days in a year
(365) divided by AR turnover.
o Average Collection Period= 365/AR Turnover
o Inventory Turnover= COGS/Inventory
o Total Asset Turnover= Sales/Total assets
o Fixed asset turnover= Sales/Fixed Assets
 Operating income return on investment (OIROI)
o OIROI= Operating Income/Total Assets

Leverage: (also called financing ratios or solvency ratios) consider how the firm is financed.
 Debt Ratio= Total Liabilities/Total Assets
 Debt-to-Equity Ratio= Total Liabilities/Total Owners’ Equity
 Times ineptest earned (TIE)= EBIT/Interest Expense
Probability: can be based on either sales or asset investment. They are commonly used to directly
judge how profitable the company is and how well management is doing as they strive to maximize
owner wealth. Examine the cost efficiency of a firm’s production.

 Return on assets (ROA)= Net Income/Total Assets

 Return on equity (ROE)= Net Income/Owners’ Equity
 Gross Margin= Gross Profit/Sales
 Operating Margin= EBIT/Sales
o Comparing the profitability of firms with different capital structures
 Net Margin= Net Income/Sales
o Percentage of sales that will become net income, which is the amount
remaining for the equity holders.
Market: are used to evaluate the current share price of a public firm’s stock
 Market-to-Book Ratio= Market Value of Equity/Book Value of Equity
o Ratio less than 1 is considered a value stock
 Price-to-Earnings= Price per Share/Earnings per Share

o If ratio is above 1, then the stock is undervalued. If it is less than 1, the stock
is considered overvalued.

DuPont Framework
 ROE = ROA x Leverage Multiplier

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 A positive net profit margin that is higher than the industry’s indicates that the firm has
a strong performance in its operations and ability to convert sales into profits for
shareholders.

Unit 5
 Cash budgets: A forecast of future events. Usually prepared for a shorter time horizon—
generally between one month and one year. Used to estimate whether a company had
sufficient amount of cash for regular operations.
Three Major Uses of Cash Budgeting
1. Future Financing Needs
2. Corrective Action
3. Performance Evaluation
Key Principles for Effective Budgeting
1. Know Yourself
2. Understand the Key Areas of Savings, Income, and Expenses
3. Develop Savings, Income, and Expense Strategies
4. Keep Records
5. Use a Method That Meets Your Needs and Objectives
6. Eliminate Consumer Debt and Minimize Long-Term Debt
Creating a cash budget
1. Determine cash receipts
2. Estimate cash disbursements
3. Create the cash budget
Application to Personal Finance
1. Understand your goals
2. Track your savings, income, and expenses
3. Develop a cash budget (plan_
4. Implement your plan
5. Compare the cash budget to your actual spending and make necessary changes
Item in a Cash Budget
1. Cash Receipts: include cash sales and the collected portion of accounts receivable for
businesses and include salary or wages for individuals.
2. Cash Disbursements: may be for suppliers of materials, interest, taxes, and so on for
businesses. For individuals, cash disbursements come from day-to-day expenditures
such as groceries, gas, and insurance.

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3. Borrowing
Key Forecasts
1. Profit forecasting: the projection of future earnings after all the projected costs are
subtracted from the projected sales. The earnings change with changes in production or
service costs, depreciation policies, and taxes. It may be necessary for a company to
conduct a thorough study and estimation of both economic and non-economic variables
that affect its sales volume as well as costs to operate the business that affect profits in
the future.
2. Balance sheet forecasting: typically done in conjunction with projecting income
statements. Given an understanding of the sales growth and a project forecast, a
financial manager can construct a pro forma balance sheet to understand how sources
and uses of finances change in a company. Balance sheet forecasting helps management
understand the future implications of the company’s financing strategies.
 Budgeting is concerned with where management ideally wants to take the company, and
forecasting is concerned with whether the company is heading in the right direction.

The Percent of Sales Method

1) Project sales revenues and expenses

2) Forecast change in spontaneous balance sheet accounts
3) Deal with discretionary accounts
4) Estimate fixed asset account
5) Calculate retained earnings (RE)
a) Payout ratio: The percent of net income distributed to the shareholders
b) Plowback ratio (retention ratio): The percent of net income retained in the firm
6) Determine total financing need (projected total assets)
7) Calculate DFN
a) DFN=Projected Total Assets−Projected Total Liabilities−Projected Owner’s Equity

The Sustainable Growth Rate

 The SGR is the growth rate at which a firm can grow without issuing new equity.
 The components of SGR are profitability, asset use efficiency, capital structure,
and dividend policy.
 Controlling the variable that changes the SGR will decrease the DFN.
Ways to Reduce DFN

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1) Slow Sales Growth

2) Examine Capacity Constraints
a) Fixed assets
3) Lower Dividend Payout
4) Increase Net Margin
If DFN is negative, the firm will have enough financing to fund projected sales.

Unit 6
NPV (Net Present Value): A method used when only 1 project can be chosen and investment
costs are not widely different.

Advantages Disadvantages
1. Considers time value of money 1. Requires calculation of appropriate
2. Calculates value added to the firm cost of capital
3. Considers risk and required return 2. Is not useful to compare projects of
varying sizes

 NPV is the sum of expected discounted future cash flows of a project.

 The highest NPV will bring the most value to the company.
 NPV tells you how much value would be added to a firm by doing a particular project.
 Advantages of NPV are that it considers all cash flows, takes the time value of money into
account, and considers the risk of the project.
 Disadvantages of the NPV are that it may not always consider the whole picture when it is
used to compare two different-sized or mutually exclusive projects and that it is difficult to
estimate the cost of capital of a project.
Internal Rate of Return
 Internal rate of return (IRR): Rate of return that a firm earns on its capital projects.
 IRR makes the NPV of the project equal to zero.

Advantages Disadvantages
1. Easy to interpret
1. is not a good indicator of the
2. Considers time value of money
3. Does not require use of required amount of value created,
rate of return 2. ignores mutually exclusive
projects,

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3. assumes reinvestment at the

IRR rate,
4. cannot be used to compare
projects with different
durations, and
5. requires conventional cash
flows.

Profitability Index
The PI is the ratio of discounted benefits to discounted costs.

Advantages Disadvantages
1. Considers the time value of 1. requires calculation of cost of
money capital and
2. Takes into account the risk of 2. is not useful for mutually
future cash flows through the exclusive projects.
cost of capital
3. Includes all future cash flows
4. Indicates whether an investment
will create value for the company

Bonds
 Premium bond: Bond is selling above its par value
 Par bond: the bond’s price is exactly equal to its face value
 Discount bond: Bond is selling below its par value

Advantages Disadvantages
1. Interest payments are tax deductible 4. Requires repayment
2. Does not dilute ownership 5. Increases firm’s debt and equity ratio
3. Lowest risk and rate
 Par or face value (aka maturity value)- the amount the investor will be paid when the
bond matures.
 Coupon rate (aka stated interest rate)- the amount of interest received each year

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 Maturity- the length of time until the bond expires (becomes due)
 Yield to maturity (YTM)- rate of return earned by an investor if the bond is purchased at
market rate today and held to maturity.
Stocks

Advantages Disadvantages
1. Never has to be repaid 3. Dividends are not tax deductible
2. Not required to pay dividends on 4. Dilutes ownership
common stock 5. Higher risk and rate

Financial Security Valuation and Capital Investment Evaluation

 Capital budgeting: process of evaluating and planning for purchases of long-term assets
 Incrimental Cash flows: Cash clows, whether in or out of the firm, that are created as a
result of our accepting the project. They include any additional revenue, expenses, taxes,
or other costs. The net incremental cash flow is the sum of all additional cash flows, or in
other words, incremental cash in minus incremental cash out

Common Stock Preferred Stock

Equity, ownership in the firm Equity, ownership in the firm
Typically has voting rights Set, preferred dividend payments
Residual claim upon the assets of the firm Most payments are cumulative
No set dividends; some firms may not pay Preferred liquidation status over common stock
dividends at all to common shareholders
Potential for return from increased value of stock Return to investor provided from dividends paid
share and any dividends paid and increase in value of stock share

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