X100 Introduction to Business Financial Management & Planning X100 Introduction to Business Finance Financial Management & Planning Professor Kenneth EA Wendeln X100 X100 Introduction to Business

Financial Management & Planning How to manage the financial health of a company – decisions regarding the acquisition & ‘use of money’ to maximize the value of the company while achieving corporate objectives. Types of Financial Management and Planning Tools: Capital Budgeting Capital Structure Financial Ratios Used to gain insight on how a firm operates as well as its RISK and RETURN X100 Financial Management & Planning X100 Introduction to Business

The Three Steps of Financial Planning Financial Management & Planning The Three Steps of Financial Planning 1. Establish Organizational Goals & Objectives Monitor & Evaluate 2. Budget the Money needed to meet Goals & Objectives 3. Identify the Sources & Uses of Funds Profit Revenue Sales Revenue projections Expense projections for this planning period Equity Capital Money from SP or partner Common Stock Preferred Stock Dividends Debt Capital Short-term borrowing Long-term borrowing Debt repayments Use of Assets Assets acquired for use in the business Asset sales for Profit Asset sales to raise Cash X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning The Cash Flow Cycle Sales Customers Accounts Receivable Inventory Cash X100 Financial Management & Planning X100 Introduction to Business

Cash Flow for a Manufacturing Business Financial Management & Planning Cash Flow for a Manufacturing Business Expenses  Sales Revenue  Cash Received X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning Corporate Cash Needs Short-term (< 1 year) Financing Needs Day-to-day operations Payroll Inventory needs Accounts Receivable Monthly expenses Speculative production Short—term promotional needs Emergency/flexibility Long-term (> 1 year) ‘Capital Budgeting’ Business startup costs Research & new product development Long-term marketing & promotion Facilities expansion Equipment replacement Mergers and acquisitions Whether a business seeks short- or long-term financing depends on what the money will be used for X100 Financial Management & Planning X100 Introduction to Business

Financing Debt vs Equity Capital Financial Management & Planning Financing Debt vs Equity Capital Debt = Loan Repayment Principal Interest Equity = Ownership Voting Rights Dividends Reinvested ‘Retained’ Earnings X100 Financial Management & Planning X100 Introduction to Business

Differences between Debt & Equity Financing Financial Management & Planning Differences between Debt & Equity Financing Conditions Debt Financing Equity Financing Management Influence Lenders - usually none, unless special conditions have been agreed upon Common Stockholders are owners and have voting rights Repayment Debt has a maturity date. Principal must be repaid Stock has no maturity date. The company is never required to repay equity Yearly Obligation Payment of interest is a contractual obligation The firm is not legally liable to pay dividends Tax Benefits to the firm Interest payments are tax deductible by the company Dividends are paid from after tax funds & not tax deductible X100 Financial Management & Planning X100 Introduction to Business

Short-term (< 1 year) Debt Financing Methods Financial Management & Planning Short-term (< 1 year) Debt Financing Methods Type of Financing Cost Repayment Period Businesses that may use Comments Trade Credit Low, if any 30-60 days All businesses ‘Payment terms’, usually no finance charge Promissory note to suppliers Moderate < 1 year Unsecured but requires a legal document Unsecured bank loan Promissory note, line of credit, or revolving credit Commercial paper Large corporations with good credit Unsecured, available only to large firms Secured loan High Firms with questionable credit ratings Collateral - usually inventory or A/R Factoring of Accounts Receivable Highest None Firms with large number of credit customers A/R sold to factor specializing in other firms’ A/R X100 Financial Management & Planning X100 Introduction to Business

Long-term (> 1 Year) Debt Financing Methods Financial Management & Planning Long-term (> 1 Year) Debt Financing Methods Type of Financing Re-payment Period Interest Cost Businesses that may use Long-term loans Yes Usually 3 – 7 years Interest rates between 6% - 14% depending on economic conditions and company’s financial stability All firms that can meet the lender’s repayment, covenants, and collateral requirements Corporate bonds debenture registered mortgage convertible serial Usually 10 – 30 years Interest rates between 6% - 12% depending on economic conditions and financial stability of company issuing the bonds Large corporations that the investors trust Interest rate would depend on bond rating X100 Financial Management & Planning X100 Introduction to Business

Long-term Equity Financing Methods Financial Management & Planning Long-term Equity Financing Methods Type of Financing Re-payment Period Dividend Requirements Businesses that may use Common Stock No None Dividends not required Common stockholders usually have voting rights All corporations that sell stock to investors Preferred Stock Cumulative Convertible Dividends not required – but dividends must be paid to preferred stockholders before common stockholders receive any dividends Large corporations that have an established investor base of common stockholders X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning Zimmer 2006 - Balance Sheet Liabilities & Shareholders’ Equity Financial Management & Planning 2006 2005 Current liabilities Due in < 1 year Long-term Liabilities Over extended period Contributed Capital = 1942.8 Par value + paid in capital – treasury stock (2.5 + 2743.2 – 802.9) Accumulated Earnings not paid as dividends to shareholders X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning Capital Structure - Leverage Using Equity + Debt for Financing Using DEBT provides ‘LEVERAGE’ for the shareholders & increases their “Return on Owners’ Equity” BUT………using more debt (which must be repaid) increases the RISK to the lenders & shareholders X100 Financial Management & Planning X100 Introduction to Business

Return on Owners’ Equity Financial Management & Planning Return on Owners’ Equity Profitability ratio that provides an overall measure of a business’s performance. Net income earned (after tax) per dollar of owners’ investment. Net Income (after taxes) Owners’ (Shareholders’) Equity Typically between 15% and 25% for profitable companies X100 Financial Management & Planning X100 Introduction to Business

Capital Structure - Leverage Low Debt to Equity Financial Management & Planning Capital Structure - Leverage Low Debt to Equity Financial leverage is the use of borrowed funds (debt) to increase return on owners’ equity. But leverage also decreases net profit. Additional Equity Only Owner’s equity $500,000 Additional equity +100,000 Total owner’s equity $600,000 No Loan 0 Total Capital $600,000 Year-end Earnings Operating profit $150,000 No interest 0 Taxes @ 40% PBT - 60,000 Net profit $ 90,000 Return on Owners Equity 15.0% ($90,000/$600,000) Additional Debt - Low Owner’s equity $500,000 Additional equity 0 Total owner’s equity $500,000 Loan (@ 10%) +100,000 Total Capital $600,000 Year-end Earnings Operating profit $150,000 Interest (@ 10%) - 10,000 Taxes @ 40% PBT - 56,000 Net profit $ 84,000 Return on Owners Equity 16.8% ($84,000/$500,000) X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning Capital Structure - Leverage Medium Debt to Equity Using financial leverage (debt) increases return on owners’ equity – but also increases the financial risk to lenders and shareholders. Additional Equity Only Owner’s equity $500,000 Additional equity +400,000 Total owner’s equity $900,000 No Loan 0 Total Capital $900,000 Year-end Earnings Operating profit $225,000 No interest 0 Taxes @ 40% PBT - 90,000 Net profit $ 135,000 Return on Owners Equity 15.0% ($135,000/$900,000) Additional Debt - Medium Owner’s equity $500,000 Additional equity 0 Total owner’s equity $500,000 Loan (@ 10%) +400,000 Total Capital $900,000 Year-end Earnings Operating profit $225,000 Interest (@ 10%) - 40,000 Taxes @ 40% PBT - 74,000 Net profit $ 111,000 Return on Owners Equity 22.2% ($111,000/$500,000) X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning Capital Structure - Leverage High Debt to Equity High financial leverage further increases financial risk to lenders & owners - may result in higher interest rates, decreasing net profit. Additional Equity Only Owner’s equity $500,000 Additional equity +700,000 Total owner’s equity $1,200,000 No Loan 0 Total Capital $1,200,000 Year-end Earnings Operating profit $300,000 No interest 0 Taxes @ 40% PBT - 120,000 Net profit $ 180,000 Return on Owners Equity 15.0% ($180,000/$1,200,000) Additional Debt - High Owner’s equity $500,000 Additional equity 0 Total owner’s equity $500,000 Loan (@ 12%) +700,000 Total Capital $1,200,000 Year-end Earnings Operating profit $300,000 Interest (@ 12%) - 84,000 Taxes @ 40% PBT - 86,400 Net profit $ 129,600 Return on Owners Equity 25.9% ($129,600/$500,000) X100 Financial Management & Planning X100 Introduction to Business

Firm’s Cost of Capital Impact of Leverage & Risk Financial Management & Planning Firm’s Cost of Capital Impact of Leverage & Risk Weighted Cost of Capital (Debt & Equity WCC) Equity investors require a return at least as great as the ‘best alternative opportunity forgone’. As ‘Leverage’ increases with more debt, the risk increases to the lenders & the shareholders, increasing the cost of both debt & equity. ‘Optimum’ Leverage & WCC Debt financing is lower risk & cost than equity, lowering the WCC. Debt as % Of Capital Low Debt Financial Leverage High Debt Source: adapted from The Real Cost of Capital X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning Key Financial Ratios Financial Management & Planning Profitability Liquidity Return on Owners’ Equity % Current Ratio # n.nn EPS – Earnings per Share $ DD.00 Acid Test or Quick Ratio # n.nn Return on Sales % Asset Turnover Accounts Receivable Turnover X (times/year) or # days Financial Leverage Total Liabilities to Equity % Inventory Turnover X (times/year) or # days X100 Financial Management & Planning X100 Introduction to Business

Financial Management & Planning X100 Financial Management & Planning X100 Introduction to Business