1. FIA Technical Workshop March 2015 Prepared by Yih Pin Tang

2. Outline  Introduction and definition  Financial management and related issues  Exercises and Discussions  Conclusion

3. What is financial management? Definition and goal: Efficient and effective management of funds to attain goals Financial goal: maximise the current (share) value of the company (wealth maximisation) Personal level Corporate level

4. Types of corporate financial decisions 3 major types : Investment Long term – capital or fixed asset Short-term - working capital and liquidity Financing Profit distribution 4

5. FINANCIAL MANAGEMENT: Major Issues Cash management (cash budget: cash collection, disbursement and balance; cash flows: matching inflows with outflows, working capital management, etc) Short-term investments (money market account/securities: CDs, commercial papers, t-bills, etc) Short-term financing (sources and costs) Short-term financial management Long-term financial management

6. FINANCIAL MANAGEMENT: Long-term and Short-term decision making Cash management (cash budget: cash collection, disbursement and balance; cash flows: matching inflows with outflows, working capital management, etc) Short-term investments (money market account/securities: CDs, commercial papers, t-bills, etc) Short-term financing (sources and costs) Short-term financial management Long-term investments (capital budgeting, NPV/APV analysis, uncertainties/“what if’s” analysis) Long-term financing (sources of funds; cost of capital) Risk management (identifying potential risk, risk analysis, hedging, insurance, diversification, etc) Long-term financial management

7. FINANCIAL MANAGEMENT: Long-term and Short-term decision making Cash management (cash budget: cash collection, disbursement and balance; cash flows: matching inflows with outflows, working capital management, etc) Short-term investments (money market account/securities: CDs, commercial papers, t-bills, etc) Short-term financing (sources and costs) Others Short-term financial management Long-term investments (capital budgeting, NPV/APV analysis, uncertainties/“what if’s” analysis) Long-term financing (sources of funds; cost of capital) Risk management (identifying potential risk, risk analysis, hedging, insurance, diversification, etc) Long-term financial management

8. FINANCIAL MANAGEMENT: Long-term and Short-term decision making Cash management (cash budget: cash collection, disbursement and balance; cash flows: matching inflows with outflows, working capital management, etc) Short-term investments (money market account/securities: CDs, commercial papers, t-bills, etc) Short-term financing (sources and costs) Others Short-term financial management Long-term investments (capital budgeting, NPV/APV analysis, uncertainties/“what if’s” analysis) Long-term financing (sources of funds; cost of capital) Risk management (identifying potential risk, risk analysis, hedging, insurance, diversification, etc) Long-term financial management

9. FINANCIAL MANAGEMENT: Long-term and Short-term decision making Cash management (cash budget: cash collection, disbursement and balance; cash flows: matching inflows with outflows, working capital management, etc) Short-term investments (money market account/securities: CDs, commercial papers, t-bills, etc) Short-term financing (sources and costs) Others Short-term financial management Long-term investments (capital budgeting, NPV/APV analysis, uncertainties/“what if’s” analysis) Long-term financing (sources of funds; cost of capital) Risk management (identifying potential risk, risk analysis, hedging, insurance, diversification, etc) Long-term financial management

10. Long-term Investments: Capital Budgeting and Investment Decisions Capital Budgeting – a decision making process for accepting or rejecting projects (for investments)

11. Capital Budgeting Techniques NPV (Net Present Value) APV (Adjusted Present Value) IRR (Internal Rate of Return) Payback method Profitability Index (1+NPV)/(initial investment)

12. Net Present Value (NPV) 12 r r

13. NPV Decision rule If the NPV of an investment is: < 0 --- the investment is generally financially unacceptable = 0 --- the investment may be regarded as marginal > 0 --- the investment is generally regarded as financially acceptable 13

14. Capital Budgeting and NPV Example Your company has an opportunity to purchase an office building. The estimated rental income (cash inflows ) this office building will generate is $16,000 per year for three years. Your company plans to sell this office building three years later at an estimated price of $450,000. The seller of this office building is currently asking for $415,000. Should you accept this project for investment? Assume that your required rate of return is 6.25%.

15. Capital Budgeting and NPV Example Your company has an opportunity to purchase an office building. The estimated rental income (cash inflows ) this office building will generate is $16,000 per year for three years. Your company plans to sell this office building three years later at an estimated price of $450,000. The seller of this office building is currently asking for $415,000. Should you accept this project for investment? Assume that your required rate of return is 6.25%. According to NPV rules, should this project be accepted? Is this the final decision?

16. Capital Budgeting and NPV Example Your company has an opportunity to purchase an office building. The estimated rental income (cash inflows ) this office building will generate is $16,000 per year for three years. Your company plans to sell this office building three years later at an estimated price of $450,000. The seller of this office building is currently asking for $415,000. Should you accept this project for investment? Assume that your required rate of return is 6.25%.

17. Capital Budgeting and NPV Example Your company has an opportunity to purchase an office building. The estimated rental income (cash inflows ) this office building will generate is $16,000 per year for three years. Your company plans to sell this office building three years later at an estimated price of $450,000. The seller of this office building is currently asking for $415,000. Should you accept this project for investment? Assume that your required rate of return is 6.25%.

18. Capital Budgeting and NPV Example Your company has an opportunity to purchase an office building. The estimated rental income (cash inflows ) this office building will generate is $16,000 per year for three years. Your company plans to sell this office building three years later at an estimated price of $450,000. The seller of this office building is currently asking for $415,000. Should you accept this project for investment? Assume that your required rate of return is 6.25%.

19. Capital Budgeting and NPV Example Your company has an opportunity to purchase an office building. The estimated rental income (cash inflows ) this office building will generate is $16,000 per year for three years. Your company plans to sell this office building three years later at an estimated price of $450,000. The seller of this office building is currently asking for $415,000. Should you accept this project for investment? Assume that your required rate of return is 6.25%. How can this analysis be improved? What are other factors to be considered?

20. Capital Budgeting and NPV Example Your company has an opportunity to purchase an office building. The estimated rental income (cash inflows ) this office building will generate is $16,000 per year for three years. Your company plans to sell this office building three years later at an estimated price of $450,000. The seller of this office building is currently asking for $415,000. Should you accept this project for investment? Assume that your required rate of return is 6.25%. How can this analysis be improved? What are the other factors to consider? Periodic maintenance costs? Taxes? Accuracy of discount rate? Other “what-if’s” questions …

21. Estimation of discount rate Discount rate Required rate of return / Opportunity Cost of Capital Cost of Capital / cost of funds

22. Uncertainty and “What if’s” Analysis

23. How To Handle Uncertainty? Sensitivity Analysis - Analysis of the effects of changes in one variable on (the NPV of) a project. Scenario Analysis - Analysis of the effects of changes in more than one variable on (the NPV of) a project. Simulation Analysis - Estimation of the probabilities of different possible outcomes and allow all variables to change at the same time. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even. 23

24. Uncertainty and Sensitivity Analysis What if the rental income changes (higher/lower) over the years? What if the estimated selling price is higher/lower? What if the required rate of return is higher/lower? Pessimistic (worst-case) NPV Expected (base-case) NPV Optimistic (best-case) NPV Higher/lower rental $________ Higher/lower selling price $________ Higher/lower discount rate Sensitivity Analysis - Analysis of the effects of changes in one variable on (the NPV of) a project.

25. Uncertainty and Scenario Analysis What if the rental income is higher and selling price is higher? What if the rental income is lower and selling price is lower? etc Pessimistic (worst-case) Scenario NPV Expected (base-case) Scenario NPV Optimistic (best-case) Scenario NPV Higher rental and selling price $________ Lower rental and selling price $________ etc Scenario Analysis - Analysis of the effects of changes in more than one variable on (the NPV of) a project.

26. NPV and Ranking of Projects If more than one investment opportunity is considered and given budget constraint, rank projects according to NPVs. Mutually exclusive projects – choose the one with highest NPV.

27. Long-term financing Sources of funds Cost of funds (cost of capital) Loan and amortisation (periodic interest payments, time period, amount of interest paid, etc)

28. Risk management Identification of potential risk Risk analysis and required rate of return Hedging Insurance Diversification Others

29. Risk and required rate of return Risk: Uncertainty (probability of happening) Volatility (variability of prices) Investors require certain rates of return (r) at given levels of risk in investments How to estimate this required rate of return? 29

30. Risk and required rate of return 30

31. Overview of CAPM where E(Ri) = Expected return on investment i r f = Risk free rate of return ß = Systematic (non-diversifiable) risk of investment i E(R m ) = Expected rate of return on market portfolio [Note: expected return, mean return and required rate of return may be used interchangeably in certain cases.] 31

32. Required rate of return / Discount rate / Cost of Capital Use E(R) of CAPM for 100% equity based company. Use WACC (Weighted Average Cost of Capital) for a company with capital structure (Debt and Equity). 32

33. Weighted Average Cost of Capital (WACC): V = total value of company = Debt + Equity D = debt ($) E = equity ($) T = tax rate r = rate

34. Online calculator for CAPM: EXAMPLE Expected return on the capital asset (E(R i )) _____% Risk free rate of interest (R f )_____% Expected return of the market (E(R m )) _____% Beta for capital asset (β i )_____ http://www.miniwebtool.com/capm- calculator/?n1=&n2=3&n3=10&n4=0.95

35. Online calculator for CAPM: EXAMPLE Expected return on the capital asset (E(R i )) 9.65% Risk free rate of interest (R f )3% Expected return of the market (E(R m )) 10% Beta for capital asset (β i )0.95 http://www.miniwebtool.com/capm- calculator/?n1=&n2=3&n3=10&n4=0.95

36. APPLICATION EXERCISE: Project Analysis, Evaluation and Scenario Analysis

37. APPLICATION EXERCISE: Project Analysis, Evaluation and Scenario Analysis A small health-food business will cost $80,000 to open. Assuming annual sales of $400,000, variable costs of 40% of sales, annual fixed costs of $50,000, 10-year straight-line depreciation on the initial outlay horizon (no inflation or salvage value is assumed) and a tax rate of 20%, calculate the NPV of the project over a 10- year period with a 12% cost of capital. Is this a profitable investment according to the NPV rules? To conduct scenario analysis, what are the “what-if’s” questions to ask? [Note: Cost of capital, required rate of return and discount rate are used interchangeably in many cases.]

38. APPLICATION EXERCISE: Project Analysis, Evaluation and Scenario Analysis A small health-food business will cost $80,000 to open. Assuming annual sales of $400,000, variable costs of 40% of sales, annual fixed costs of $50,000, 10-year straight-line depreciation on the initial outlay horizon (no inflation or salvage value is assumed) and a tax rate of 20%, calculate the NPV of the project over a 10- year with a 12% cost of capital. Is this a profitable investment? Conduct a scenario analysis for (i) optimistic (best-case) and (ii) pessimistic (worst-case) cases, allowing the initial investment outlay, sales and fixed costs to vary by plus/minus 10% from the original estimates. Under each scenario, also allow the variable costs to change accordingly. Is this a profitable investment under each scenario? Overall, should this project be accepted for investment?

39. Tax rate0.2 Base Case OPTIMISTIC PESSIMISTIC t=0 Sales VC FC DEPR Gross Income TAX 20% NI CF r (disc rate)0.12 n (years)10 PV NPV

40. Time Value of Money and Annuity formulae Present Value of Annuity: or Where C=periodic cash flow r= discount rate t= time period

41. Tax rate0.2 Base Case OPTIMISTIC PESSIMISTIC t=0 $ 80,000.00 Sales $ 400,000.00 VC $ 160,000.00 FC $ 50,000.00 DEPR $ 8,000.00 Gross Income $ 182,000.00 TAX 20% $ 36,400.00 NI $ 145,600.00 CF $ 153,600.00 r (disc rate)0.12 n (years)10 PV NPV

42. Base-case present value

43. Tax rate0.2 Base Case OPTIMISTIC PESSIMISTIC t=0 $ 80,000.00 Sales $ 400,000.00 VC $ 160,000.00 FC $ 50,000.00 DEPR $ 8,000.00 Gross Income $ 182,000.00 TAX 20% $ 36,400.00 NI $ 145,600.00 CF $ 153,600.00 r (disc rate)0.12 n (years)10 PV$867,874.26 NPV$787,874.26

44. Tax rate0.2 Base Case OPTIMISTIC PESSIMISTIC t=0 $ 80,000.00 $ 72,000.00 Sales $ 400,000.00 $ 440,000.00 VC $ 160,000.00 $ 176,000.00 FC $ 50,000.00 $ 45,000.00 DEPR $ 8,000.00 $ 7,200.00 Gross Income $ 182,000.00 $ 211,800.00 TAX 20% $ 36,400.00 $ 42,360.00 NI $ 145,600.00 $ 169,440.00 CF $ 153,600.00 $ 176,640.00 r (disc rate)0.12 n (years)10 PV$867,874.26 $998,055.40 NPV$787,874.26 $926,055.40

45. Tax rate0.2 Base Case OPTIMISTIC PESSIMISTIC t=0 $ 80,000.00 $ 72,000.00 $ 88,000.00 Sales $ 400,000.00 $ 440,000.00 $ 360,000.00 VC $ 160,000.00 $ 176,000.00 $ 144,000.00 FC $ 50,000.00 $ 45,000.00 $ 55,000.00 DEPR $ 8,000.00 $ 7,200.00 $ 8,800.00 Gross Income $ 182,000.00 $ 211,800.00 $ 152,200.00 TAX 20% $ 36,400.00 $ 42,360.00 $ 30,440.00 NI $ 145,600.00 $ 169,440.00 $ 121,760.00 CF $ 153,600.00 $ 176,640.00 $ 130,560.00 r (disc rate)0.12 n (years)10 PV$867,874.26 $998,055.40 $737,693.12 NPV$787,874.26 $926,055.40 $649,693.12

46. What is the probability of each state happening? Pessimistic (worst-case) Scenario NPV Expected (base-case) Scenario NPV Optimistic (best-case) Scenario NPV $649,693.12$787,874.26$926,055.40

47. NPV Analysis: Other considerations  Allowing estimates to change from period to period Example:

48. NPV Analysis: Other considerations  Allowing estimates to change from period to period Example: Sales may change due to changes in demand, inflation rates, etc. Costs may change due to changes in size/capacity, inflation, etc.

49. APPLICATION EXERCISE: Leasing versus Buying

50. Exercise: Buy or Lease? Your small business needs to buy a van. You face the option of leasing it for $800 per month for ten years or buying it for $80,000 cash on the day of purchase. If you buy the van, the general servicing expense will be $600 per year, but you can sell the van for $30,000 cash 10 years later. The discount rate is 11% for both cases. Should you buy or lease? Briefly explain your decision. 50

51. Exercise: Buy or Lease? Your small business needs to buy a van. You face the option of leasing it for $800 per month for ten years or buying it for $80,000 cash on the day of purchase. If you buy the van, the general servicing expense will be $600 per year, but you can sell the van for $30,000 cash 10 years later. The discount rate is 11% for both cases. Should you buy or lease? Briefly explain your decision. 51

52. Exercise: Buy or Lease? Your small business needs to buy a van. You face the option of leasing it for $800 per month for ten years or buying it for $80,000 cash on the day of purchase. If you buy the van, the general servicing expense will be $600 per year, but you can sell the van for $30,000 cash 10 years later. The discount rate is 11% for both cases. Should you buy or lease? Briefly explain your decision. 52

53. Exercise: Buy or Lease? Your small business needs to buy a van. You face the option of leasing it for $800 per month for ten years or buying it for $80,000 cash on the day of purchase. If you buy the van, the general servicing expense will be $600 per year, but you can sell the van for $30,000 cash 10 years later. The discount rate is 11% for both cases. Should you buy or lease? Briefly explain your decision. 53 Monthly discount rate = 0.11/12 = 0.0091667 Total periods = months * years = 12 * 10 120 Which option is preferred? Why?

54. Exercise: Buy or Lease? Your small business needs to buy a van. You face the option of leasing it for $800 per month for ten years or buying it for $80,000 cash on the day of purchase. If you buy the van, the general servicing expense will be $600 per year, but you can sell the van for $30,000 cash 10 years later. The discount rate is 11% for both cases. Should you buy or lease? Briefly explain your decision. 54 Monthly discount rate = 0.11/12 = 0.0091667 Total periods = months * years = 12 * 10 120 Which option is preferred? Why?

55. APPLICATIONS OF FINANCIAL TECHNIQUES Lease or buy? Financing: cost of capital and loan amortisation Online financial calculators Auto Credit card Debt management Mortgage Insurance Investment Savings Small business Others http://www.bankrate.com/calculators.aspx

56. Conclusion Various applications of Cash flows and Time Value of Money concept and techniques – personal and corporate levels Many other Financial Management topics Example: o Dividends and Payout Policy o Financial statements and financial planning o Hedging and Derivative Securities o International Financial Management Mergers and Acquisitions Risk, Return and Capital Market Stock and Bond Valuations

57. Use of Online Calculator Net Present Value (NPV) Calculator http://www.calculatorsoup.com/calculators/financial/ net-present-value-calculator.php http://www.calculatorsoup.com/calculators/financial/ net-present-value-calculator.php

58. Online calculators Copyright© 2006 John Wiley & Sons, Inc. 58 Examples: https://www.easycalculation.com/mortgage/re quired-rate-return.php http://money.cnn.com/calculator/pf/home- rate-of-return/ http://www.moneychimp.com/calculator/comp ound_interest_calculator.htm Many others…

59. THANK YOU!

61. Time Value of Money and Annuity formulae Present Value of Annuity: or Future Value of Annuity: or