Cash Flow Statement Objectives of Cash Flow State: Cash Flow Activities on Methods of Cash Flow Preparation Learning Outcomes: Atthe end of the chapter, the learners must be able to: a) recognize and explain the various activities in the cash flow statement; b) categorize the various business transactions related to activities in the cash flow statement; and ©) construct a cash flow statement. Statement of Cash Flow A cash flow statement, also known as statement of cash flows or funds flow statement, is a financial statement that shows how ‘changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis _ down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and cash out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. The cash flow statement is intended to: 1. provide information on a firms liquidity and solvency and its ability to change cash flows in future circumstances; 2. provide additional information for evaluating changes in assets, liabilities and equity; 3. waeere the comparability of different firms’ operating performance by eliminating the effects of different accounting methods; 4. indicate the amount, timing and probability of future cash flows 15 Scanned with CamScanneril Operating activities“ sales and delivery of Operating activities include the production, company’s product as well as collecting payment from its customers. This cov include purchasing raw materials, building inventory, advertising, and ship! the product. Operating cash flows include: . Receipts from the sale of goods or services . Receipts for the sale of loans, debt or equity instruments in a trading portfolio Interest received on loans . “Dividends received on equity securities Payments to suppliers for goods and services ; Payments to employees or on behalf of employees "Interest payments (alternatively, this can be reported under financing activi in IAS7, and US GAAP) i Items which are added back to [or subtracted from, as appropriate] the net income figure (which is found on the Income Statement) to arrive at cash flows from operations generally include non cash items such as: 1. Depreciation (loss of tangible asset value over time) 4 2. Deferred tax 3, Amortization (oss of intangible asset value over time) 4. Any gains or losses associated with the sale of a non-current asset b ny Bind cash flows do not belong in the operating section (unreal gains losses are also added back from the income statement), letermining cash flow from operations. the Id S Noone 4 ecause This is an indirect method of di Investing activities Examples of investing activities are 1. Purchase or sale of an asset marketable securities, etc.) 2, Loans made to suppliers or received from customers ‘ 3.: Payments related to mergers and acquisitions (assets can be land, building, equipment, Financing activities tivities include the inflow of cash from investors such as bi and shareholders, as well as the outflow of cash to shareholders as dividends as company generates income. Other activities which impact the long-term liabiliti Snd equity of the company are also listed in the financing activities section of cash flow ‘statement. __ Proceeds from issuing short-term or long-term debt 1, 2, Payments of dividends 3. Payments for repurchase of company shares 4. 5 Financing act |. Repayment of debt principal, including capital leases For non-profit organizations, receipts of donor-restricted cash that is limit to long-term purposes 16 Scanned with CamScannerItems under the financing activities section include: 1. Dividends paid 2, Sale or repurchase 6f the company’ 3. Netborrowings rany’sstock 4 Payment of dividend tax pisclosure of non-tash activities Non-cash investing and financing activiti i ; “ Ln lancing activities are disclosed in footnotes to thi sean ey Under US ine ‘Accepted Accounting Principles (Gaary, nonce fem ay be disclosed in a footnote or within the cash flow statement itself. Non-cash financing 'activities may include: bi 1, Leasing to/purchase an asset ° t 2. Converting debt to equity , 3. Exchanging Non-cash assets of liabilities for other non-cash assets or liabilities 4. Issuing shares in exchange for assets ; | Preparation methods The direct method of i t results in a more easily.” Preparing a cash flow statement e easily understood report. The indirect method is almost universally used, because FAS 95 requires a supplementary report similar to the indirect method if a. company chooses to use the direct method. f Direct method The direct method for creating a cash flow statement reports major classes of gross cash receipts and payments. Dividends 'received may be reported under operating activities or under investing activities. If taxes paid are directly linked to operating activities, they are reported under operating activities; if the taxes are directly linked to investing activities or financing activities, they are reported under investing or financing activities. The same rule is applied to interest. Sample cash flow statement using the direct method: Cash flows from (used in) operating activities Cash réceipts from customers 29,500 Cash paid to suppliers and employees (12,000) Cash generated from operations (sum) 17,500 Interest paid (2,000) 3,000) Income taxes paid Net cash flows from operating acti ies : 12,500 Cash flows from (used in) investing activities Proceeds ftom the sale of equipment 17,500 Dividends received 13,000 30,500 61,000 Net cash flows from investing activities 7 Scanned with CamScannerCash flows from (used in) financing activities” Dividends paid (25,000) ivities (25,000) Net cash flows used in financing act Net increase in cash and cash equivalents “76,500. Cash and'cash equivalents, beginning of year 10,000 Cash and cash equivalents, end of year 28,500 Indirect method The indirect method uses net ncomeasa starting point, makes adjustments for all transactions for non-cash items, then adjusts from all cash-based transactions. ‘An increase in an asset account is ‘subtracted for net income, and an increase ina liability account is added back t net income. This method converts accrual-basis net income (or loss) into cash flow yy using a series of additions and deductions. f Rules (Operating Activities) . To Find Cash Flows rom Operating Activities ic Balance Sheet and Net Income using tl For Increases in Net Inc Adj Current Assets (Non-Cash) Decrease Increase Current Liabilities For All Non-Cash “Expenses (Decreases in Fixed Assets) Increase added back to NI. Such set accounts. “Non-cash expenses must be expenses may be represented 0” the balance sheet as decreases in long term as Thus decreases in fixed assets increase NI. lowed to calculate Cash Flows from Operating The following rules can be fol arative balance sheet and the Net Activities when given only a two year comp Income figure. Cash Flows from Operating ‘Activities can be found by adjusting Net Income relative to the change in beginning and ending balances of Current ‘Assets, Current Liabilities, and sometimes Long Term Assets. When comparing the change in long-term assets over a year, the ‘accountant must be certain that these changes were caused entirely by their ‘devaluation rather than purchases or sales (i.e., they must be operating items not providing or using cash) or if they are non-operating items. 1, Decrease in non-cash current assets is added t 2. Increase in non-cash current asset is subtracted from net income. 3, Increase in current liabilities is added to net income. ‘4, Decrease in current liabilities is subtracted from net income. o net income. 18 Scanned with CamScannerExpenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that hav. on cash flows in the period), ve ees 6. Revenues with no cash inflows aré subtracted from net income, 7. Non-operating losses are added back to net income. Non-operating gains are subtracted from net income. ' ‘The intricacies of this procedure might bé seen as: Net Cash Flows from Operating Activities = Net Income + Rule Items Hlustration: Consider a hotel company that has a net income of P1,000,000 this yeat, and § its Accounts Receivable (A/R) increased by P250,000 since the beginning of the = year _ Uf the balances of all other current assets, long-term assets and current liabilities did not change over the year, the cash flows could be determined by the rules above as 1,000,000 - 250,000 = Cash Flows from Operating Activities = P750,000. The logic is that, if the hotel company made P1,000,000 that year (net income), and they are using the accrual accounting system (not cash based) then any income they generated that year which has not yet been paid for in cash should be subtracted from the net income figure in order to find cash flows from operating activities. The increase in A/R meant that P250,000 of sales occurred on credit and has not yet been paid for in cash. In the case of finding Cash Flows when there is a change ina fixed asset account, say the Buildings and Equipment account decreases, the change is subtracted from Net Income. The reasoning behind this is that because Net Incomeis calculated by: Net Income = Revenue — Cost of Sale — Depreciation Expense — Other Expenses The Net Income figure will be decreased by the building’s depreciation that year. This depreciation is not associated with an exchange of cash; therefore, the depreciation is added back into net income to remove the non-cash activity. Rules (Financing Activities) Finding the Cash Flows from financing activities is much more intuitive and reeds little explanation. Generally, the things to account for are financing activities: 1, Include as outflows, reductions of long term notes payable (as would represent" the cash repayment of debt on the balance sheet) 2. Oras inflows, the issuance of new notes payable Include as outflows, all dividends paid by the entity to outside parties Or as inflows, dividend payments received from outside parties 19 Scanned with CamScanner5. Include / clude as outflows, the purchase of notes stocks of bonds - 6. Of Ir as i ve ih : tas inflows, thé receipt of payments on such financing vehicles. In the case'of more advanced accounting situations, such as when dealing, yt subsidiaries, the accountant must ~ i 2 Exclude intra-company dividend payments. Exclude intra-company bond interest. i | Mustration: Cash Flow of DME Hotel Company. DME Hotel Company Cash Fiow Statement (all numbers in millions p) Period ending i 03/31/2010 ) Net income 21,538 Operating activities, cash flows provided by oF used in: ' ‘Depreciation and amortization 3,790 Adjustments to net income 4617 Decrease (increase) in accounts receivable el reat ee Increase (decrease) in liabilities (A/P, taxes payable)” 131,622 Decrease (increase) in inventories al eapaiie st Increase (decrease) in other operating activities!” 473,057) Net cash flow from operating activities i 13 Investing activities, eash flows provided by or used i Capital expenditures pe a. (4 035) Investments : (201,777) Other cash flows from investing activities = 1,606 Net cash flows from investing act 1(204,206) Financing activities, cash flows provided by or used i : Dividends paid ih i (9,826) Sale (repurchase) of stock fe ey (5,827) Increase (decrease) in debt SOG 101122 ‘ Other cash flows from financing activities = 5), 120,461 Net cash flows from financinig activities 206,430 Effect of exchange rate changes st 645 | 2,882 Net increase (decrease) in cash'and cash equivalents, 20 03/31/2009 24,589 2,592 621 17,236 19,822 (33,061) 31,799 (3,724) (71,710) 17,009 (98,425) (9,188) (12,090) 26,651 27,910 33,283 (1,840) 4,817 03/31/2008 17,046 2,747 2,910 37,856 (62,963) (2,404) 0011) (75,649) (971) (79,231) (8,375) 133 21,204 70,349 83,311 21 2,407 Scanned with CamScanner —. Forecasting Forecasting Financial statement analysis, as discussed in the previous chapter, helps individuals understand the 5 performance of the firm. Likewise, it gives an idea on what will become of the firm in the future, Needless to say, firms analyze the past to determine the furure. Management has always been coupled with a forward-looking decision in mind. Knowing the future practically operates under conditions of uncertainty. Views are developed through the analysis of the firm, Forecasting is a projection of future sales, revenues, earnings, costs, and other possible variables that are helpful in the firm's operations (Brigham & Houston, 2011). Forecasting is the starting point of business planning, making it as one of the most important functions to be applied to business. The primary objective of forecasting is to reduce the risk or uncertainty that the firm will face in making a decision. Before a firm starts with the production, it has to determine its sales forecast. With the available figures on hand, a strate, Blt Objects At the end of the chapter, students are expected to be able to: + define the tern forecasting; +. identify the different uses of forecasting; + determine why forecasting isan essential tool in financial planning; * differentiate the various tools of forecasting; and + apply the tools and techniques of forecasting. oer) gic plan is laid our by the top management with the alternative courses of action, Production plan, inventory plan, and variable and factory overhead plan are also put in place to avoid possible miscalculations that may result in unnecessary losses. Users of Forecast Forecast, with its wide array of application, is used by people within and outside the company for various Feasons, Some of the users of forecast and their purposes are listed below: 1. Top Management — makes use of the forecast as a tool for long-range planning, particularly in providing a basis for performance targets, implementing long-range strategic objectives, and making _capital budgeting decisions. 2, Production Manager ~ utilizes the forecast to determine the amount of raw materials that will be needed in the production, the budget, schedule of production activities, inventory levels to maintain 80 as not to disrupt the production, labor hours, and the schedule of shipments. Scanned with CamScanner| roanctat stannceasent tnt oOo Ss 3, Purchasing Manager — uses the forecast to ascertain the volume or bulk of materials ¢hay be purchased fora particular period. This avoids overstocking of understocking of inven, Muy is, much sales should be ies for the prodiicts, "in, ‘Marketing Manager ~ makes use of the forecast to estimate hi 4. particular period, and ro plan promotional and advertising act needed by the firm. The fi nae 5, Finance Manager — uses the forecast to anticipate the funding needs : manager must establish the firm's cash inflows and oueflows, and indicare the exact momen, the firm will need additional funding, aS he human resource needed in ach, "idivional people £0 suppory 4.'%ng he Fant Human Resource Manager — utilizes the forecast co supply th 6. the firm's objectives. He or she must specify when to hire a¢ ‘operations. Kote et i lees in a schi 7. Colleges and Universities ~ makes use of forecast to identify possible enr0 00 yea, figures on hand help determine the revenues to be obtained from the tuition fees, the Facet hired, the planning of room assignments, and building of facilities. Forecasting Approaches | forecasting: qualitative and quantitative (Shim et al, 2006), In general, there are two approaches to forecasts incorporate factors such as the decision, maker's intuition, emotion, personal experiences, and value system. In practice, the combination op both qualitative and quantitative methods is usually the most effective. The qualitative approach je useful in formulating shore-term forecasts. It also supplements the projections made using any of the qualitative methods. 1. Qualitative (or judgmental) forecasts. These The qualitative forecasting methods are as follows: a. Expert opinions b. Delphi method cc. Sales force polling d. Consumer market surveys ¢. PERT-derived forecasts Expert Opinion Under this method, the views of the managers or a group with a high level of expertise, often in combination with statistical models, are synthesized to generate a consensual forecast. A leading business magazine, for instance, gathers a certain number of well-known practitioners who usually meet as a group or as a jury of executive opinion predicting economic trends. : This forecasting method is simple and easy to implement. The opinions of experts become the basis of forecasting. No statistical tools are employed. At times, this method of forecasting is used in conjunction with a quantitative method, The disadvantage of this method is the presence of bias. Since the experts are in the same field or group, their mentality or way of thinking is homogeneous. When chere is a dissenting or differing opinion, group pressure comes into play. The presence of a strong group leader also becomes problematic. This strong leader exerts undue influence over the members who almost always arrive at # ‘unanimous deci Scanned with CamScannerMethod hod, si ‘, eopenr ry indigent eeee opinion, is also done by a group of experts. The difference is {ufe OF RTOUP Consensus ene Mesionnaite about their forecast of Future events, In this Se ot toal As mentioned, individuals he fi ized. The advantage of this method is that tt ie useful for long-range Saves eal te ale ee y the grouy by he grow or by Np. On the other hand, this method has been elted for ies cipants in the Delphi method are th ‘The parcicipants in the Delpt od are the decisis dent makers usually consist of experts who make the acual fy stants, and respondents, Deserings distributing, and collecting the questionainn and anchag a asp Heridon- rosie its The respondents area group of people, often from different places weet the survey {risgroup pores Inputs to the decision-makers before the See eee hers, stall a forecast is made. CO | rerecasung gales Force Polling Oftentimes, the sales force is used by companies to arrive at their sales forecast. The sales people, direct contact with the consumers, envision the condition of the future market. In this approach, gery sales person estimates the sales in his or her region. These forecasts are then reviewed to ensure thae theyare realistic. Then they are combined at the district and national levels to arrive ata general forecast. ‘The advantages of this method of forecasting are the following: itis. simple and practical; the responsibility fdrwing up the forecast lies with the people who will actually work for the forecasted value; it uses the ira feedback given by the sales force; and the information can easily be determined by segments, products, regions, or individuals. Consumer Market Survey Firms, at times, conduct their own customer or potential customer surveys to accumulate information regarding fucure purchasing plans. Surveys are conducted through telephone inquiries, questionnaires, and imervews. Surveys can help not only in preparing a forecast but also in improving product design, fornew products, and determining consumer behavior. eat | 2. Quantitative forecasts use a variety of mathematical models that rely on historical data and/or | causal variables to forecast demand. The two types of quantitative forecasting are: a. Time series forecasting ’ *| i, Naive model ii, Moving average iii, Weighted moving average iv, Exponential smoothing v. Trend projections b. Associative or causal models Regression analysis ek Scanned with CamScannerTime Series Forecasting ; me series forecasting assumes tha che Furure isa Function of che past. Thus historical data ae, vo pees the frure using sequences with equal periods. ‘The sequence may be dally, eck mt pred Innually, of any equal periods the firm may think of If che yeatly sales oF 4 ettain roduc, aware ered, the past year's cales willbe used in making the forecasts. I frm it forecasting mon pins Fen past monthly dara are used. Forecasting time-series data implies that Future values are pred. u sa yng past values. Other variables no mater how significant, are ignored. Decomposition of a Time Series Forecast sng a time series means breaking down past data into components and then projecting Analyzing a time seri 1g. down p: So camponents and hen Pg Forward. A time series typically has four components: trend, seasonality, cycle 1. Trend is the gradual upward or downward movement of the data over time- Changes population, age distribution, or cultural views may account for movement in enc: income, Seasonality isa data pattern that repeats itself after a period of days, weeks» months, or quarter, There are six common seasonality patterns: Week Day 7 Month Week 4-442 Month Day 28-31 Year Quarter 4 Year Month 12 Year Week 52 3, Cycle is a pattern of the data that occurs every several years. Ic is usually associated with the “business cycle and is very important in short-term business analysis and planning. A business cycle is difficult to predict because of armed conflicts, political upheavals, economic development, and social changes in the global scene. Random variations are “blips” in the data caused by chance and unusual situations. They follow no discernible pattern, so they cannot be predicted. Naive Model The simplest way to forecasts to assume that the demand in the next period will be equal to the demand in the most recent period. The naive model is considered as the benchmark model. Other models which cannot beat it should be disregarded. ‘The common advantages of using the naive model are as follows: Ie is cheap to develop. L 2. Iedoes not require any software or machine. 3. Storing of data is simple because all one has to do is to keep the previous records. : : Its very easy to operate because it does not require or use complex mathematical applications. Scanned with CamScanneris common disadvantages are as follows: » 1, edocs noc attempt to explain casual relationships with the forecasted vr 2. drastic change inthe variable For Forecasting isnot camrnce variable. ing the symbol Y',, as the forecasted value f . sin et : apelin this ‘period, then “fOr the next period and the symbol Y,as the observed Example: Consider the following sales data of XYZ. Corporation for 201 : forecast the sales for the month of Jantaty 201 * 2019. The corporation would like v0 013 2 Month Monthly Sales of Produce January P4150 February 4,250 | March 3,950 April 4,230 i | ‘May P4,050 | June 3,950 July 4,175 | August : 4,785 | September 4,875 October 5,250 November 5,550 December P5,750 Answer: Y= ¥,=P5,750 Ifthe actual sales for January 2014 was P6,250 and the sales for February 2014 is forecasted, the answer would be: Ya =Y,= P6,250 The naive model is very simple and easy to apply. Proper keeping of records is what matters most in making this kind of forecast. However, the accuracy of this application could not be ascertained since only the previous data was used as the forecasted value for the coming period. Moving Average The moving average is the simplest among the time series models, In this model, the number of period 1, in which a series of averages will be created and computed, should be decided, The manager-in-charge should determine the most appropriate number of periods that would result in the smallest forecasting error. Inusing this model, the averages are immediately updated as new information becomes available, The most ‘ecent observations are used to calculate the average to obtain the forecast for the next period. All data in the sample are weighted equally. Scanned with CamScanner | sorecsina co =S| BD | rmsncia acre ivan TI mi of the moving average are: ‘on advantages of the moving average the com 1. Tris simple 0 use- 5 eis easy to understand. ‘Thecammon disadvantages ofthe moving average ae as fllows: e 1 eros numerous records and data > eisinconvenient to update the records and data needed to conduct a forecase ‘The following formula is used in finding the moving average of order , MA(n) for pag tH, MA,,= [D,+D, Where: = the number of observations used in the calculation, The forecast for time period t1 is the Forecast forall future time periods. However, ehg revised when new data becomes available. fore Example: The table sles of Tableu Company are shown in the middle column of the table three-monch moving average appears on the right lon 4 Month Actual Sales 3-Month Moving Average January 2 February March 3 Ae April 15412415 = 14.00 3 May 21 18+15+12 = 15.00 3 25 214+18+15 = 18.00 D July 28 25 +21 +18 2 28+25+21 = 2467 3 32428425 = 28.33 Eo October 20 30+32+28 = 30.00 J 18 20+30+32 = 2733 3 June 21.33 August 32 September 30 November December 16 18+20+30 = 22.67 3 Scanned with CamScannerThus i ca be seen that the foreat for December 122,67 "To se coingJanuany the October, November and Decent Sah ar feeast= 20+ 18 + 16)/3 = 18, and the sum is di id for sales in the ided by 3: January ena detectable tend or patter is presen, we ‘ makes the forecasting techni vo can be used to place m: eee '8 technique mote res ised to place more emphasis on recent MS ive to change because the more recent weight is somewhat arbit Be ine them. Therefore, deciding which weight era a bee Tn ena oe jum of the weights should always equal to one. Foe example if the latest wey erty tobe the forecast might reflect a large unusual change bel | derermi z '¢ demand or sales pattern too quickly. 4 weighted Moving Average Avweighted moving average (WMA) is more powerful and economical compared with eos i ipared with moving average. Irswidely used where repeated forecasts requite the application of methods like sum-oF the digits sad trend q adjsiment methods. WMA may be expressed mathematically az WMA,,, = EW,D, Where: W, = weight assigned in a particular period D, = demand for the period Buample: Tableu Company (see previous example) decides to forecast table sales by assigning the past 3 months with the following weight: Weight Applied Period = ae a 0.20 Three months ago “ 030 ‘Two months ago ae 050 Last month nee 1.00 Sum of weights Forecast this month = (0.20 x sales 3 months ago) + (0.30 x sales 2 months ago) + (0.50 x sales last month) The results of this weighted average forecast are as follows: Three-month weighted Month Actual sales moving average January 15 February 12 " March 15 i April 18 (15 x 0,20) + (12 x 0.03) + (15 x 0.50) = 14.10 May 21 (12 x 0,20) + (15 x 0.03) + (18 x 0.50) = 15.90 June 25 (15 x 0,20) + (18 x 0.63) + (21 x 0.50) = 18. July 28 (18 x 0,20) + (21 x 0,03) + (25 x 0.50) = 22.40 Scanned with CamScannerTIMANCIAL MANAGEMENT | Port 100 “Aagui 32 (21 x 0.20) + (25 x 0.03) + (28 x 0.50) = 25; ea 30 (25 x 0.20) + (28 0.03) + (32 x 0.50) = 29.40 September October 20 (28 x 0.20) + 2 x 0.03) + (30 x 0.50) = 30.29 November 18 (32 « 0.20) + G0 x 0.03) + (20 x 0.50) = 25,49 December 16 (30 x 0.20) + (20 x 0.03) + (18 x 0.50) =-21.99 By observing the results ofthe weighted moving average, giving heavier weight ro the mos rece rather than. nder ob, AE mo, rovides a more accurate projection 1 provides 3 mit forecasted value for the month of December using the moving average is 22 67 For instance, using the weighted moving average, ing or weighted moving averages provides stable estimates by effectively, the demand pattern. Moving averages, however, present three Problems, ting as the period under observation increases. Scanned with CamScanner Using cither movi ‘out any sudden sh less sensitive to real changes Lie It requites extensive records of past data. 3, Iedoes not pick up trends very well. Exponential Smoothing This method uses the weighted moving average technique where more weight is given to the daca. tis supporced by che belief thatthe future is more dependent on che recent past than on the ge past. Exponential smoothing is a popular technique that does not involve voluminous records to forecay and is easy to use and effective for short-run forecasting. The method is known to be useful on tango historical data with no seasonal fluctuations. One disadvantage of the method, however, is that ir saa chat changes in the mean of the time seties is slow, making the model underestimate the data when there is sudden fluctuation. Exponential smoothing is a continuous adjustment process. The alpha & ize the error and has a value of 0 to 1. The ois adjusted until the minimized mea parameter to mii squared error (MSE) is solved. If the difference between the actual value and the forecasted valu. positive, it means thar the forecasted value is slow in reacting to the changes in sales increase and a higher @ must be assigned. On the other hand, if the difference between the actual value and forecasted value a negative, a lower 0. must be assigned. A higher ot means that a greater weight is given to the most re data and less weight to the distant past. The formula for exponential smoothing i Y',,,=@Y,+ (1-0) ¥) of, inwords, Y',, = 0Y,,+ (1-0) Vy used as the smoo exponentially smoothed average to be used as the forecast Where: aie Y,, = most recent actual data Y’,, = most recent smoothed forecast @& = smoothing constant The formula for MSE is: n MSE= > ol‘Where i= the number of observations "used to determing 5 he initial forecast peample: “The following are data on sales. iod (Actual sales (¥.) . ‘Time peri (0003) Time period) Actual sales (¥,) i # 1 P100 iz (eons) i > te Z P20 i 124 é 3 108 9 i. — 4 6 10 124 10 5 120 n ns 6 no 12, 116 The initial forecast is necessary forthe exponential smoothing process. The frst smoothed forecast. © pbeosed an be =) |, First actual observations 2. Anaverage of the actual data for afew periods : Forillustrative purposes, afive-period average is used as the initial forecastY',withasmoothingconstant (4-070. : oe] Yor MH +¥+¥ +X +) i = (110 +114 + 108+ 116+ 120) LOH 114 + 108 + 116 + 120) 5: 113.60 ee Note that Y,= 110. Then Y’, is computed as follows: Y,= @Y,+(1-a)¥, = (0.70) (110) + (1 - 0.70) (113.60) = 77.0 + 34.08 = 111.08 Y, = @Y,+(1-a)¥, = (0.70) (120) + (1 - 0.70) (111.08) 84.00 + 33.32 = 117.32and aY,+ (1-0) Y', (0.70) (124) + (1 = 0.70) (117.32) = 86.80 + 35.20 = 122.00 i i i fY’,, Y',, and Y’,,. The table below shor edure is followed in computing for the values of Y',, Y',, and Y'. : a uaa Paorescn che actual sales and the predicted sales using the exponential smoothing method ‘TimePeriod Actual Sales Predicted Sales —_Difference Difference © @) ¥, ¥e-¥, ,-¥) 1 10 2 4 3 108 4 6 120 é 10 113.60 (3.60) 12.96 7 120 111.08 8.92 7957 8 124 117.32 6.68 44.62 9 m2 122.00 (10.00) 100.00 10 124 115.00 9.00 81.00 . n 18 121.30 (3.30) 10.89 12 “116 118.99 (2.99) 8.94 337.98 ‘The formula presented in exponential smoothing is expected to give either positive or negative rests berween the actual sales and the predicted sales. Since the objective is to bring the differences or errot® zero, the forecaster may use a higher or lower smoothing constant (ct) to adjust the prediction co larg fluctuations in the data series. MsE= 5 yyy “ Based on the example, the value of i is 5. Therefore, MSE is computed as: = 337.98 12-5 48.28 The idea isto select the o that minimizes the MSE which is the average sum of the variations betwe™ the historical sales data and the forecast values for the corresponding periods, Scanned with CamScannerTimePeriod Actual Sales Predicted —_Differen ® ie) Sales (¥" = Diberaoes 1 u10 Co eae 0-7) 2 4 3 108 a 4 6 3 5 120 g § ay 113.60 (8.60) a 7 120 44 856 8 124 116.58 742 10 9 2 121.03 (0.03) 10 124 115.61 839 n ng 120.64 2.64) 12 16 119.06 G06) The example with 0 = 0.70. shows an MSE of 48.28 as compared with ot = 0.60 with an MSE of 4.22. Ic simply means that using a smoothing constant of 0.60 gives the forecaster a better prediction decause of a smaller error. It is worth noting that trying different values for the 0: is necessary bef ‘hosing the best ot that will arrive with the least MSE. on Tend Projection Trend projection technique fits a trend line toa series of historical data points and then projects the line into the future for medium-to-long range forecasts. The problem with this kind of technique isthaticonly visualizes the relationship ofthe given variables. Through this visualized relationship, a best fitting line is drawn through the observed data, Hence, doing a visual inspection suggests Several trend lines that produce errors or vertical distances from the observed values co the plorted tend line, However, ushag the least squares method allows the user co find a line of best fit which willkeep the errors to's inimum, This approach results ina straight line chat minis the leviations between the observed values and the predicted values. The deviations or errors are the ‘ettical distances beeween the observed values and the predicted values. Scanned with CamScannerwu = OE tua Bz *q : _____ FEIMWHOY 94 YI punos sf g adojs ay.y * gosr821 AUP 209 q pu jo sanjea ayn puy on posn 9q tivo aeyn suornenbo podojaazp. npn oun (eum ‘ose syya ut) a]qetzeA auspusdspur == x («uy Bury UdAI e aoy {uy duryo jo axes oy 10) aut] woyssaSo1. 242 yo adojs = = q adooiniuy speek = (21qeuea auspusdap oy payyes) . oroypoud aq o1 ajquysea ayp jo anyea pamndwos — = 5 aroy my poyed aur, sion Jo uonerad anjea paarasqg——>. YJ 3Saq JO aUTT (sanyea 4) aiqetea yuapuadap Jo saiqeuen, xq+e=K ‘uonenbs Surmoyjoy axp ypta possoidxo 2q ue> ouyy ayp “painduiod aq wes adojs pue adaouaiurk ayp J] “(euy aup Jo opBue axp) adoys su pue (xe-4 ayp sidzor01 Jo Suiza) ut poquosap st our sozenbs aseay y- ‘yoryes 2e ay3r9y atp) adoozomr “Sunn up sauasaidax rou] ou (x) [qeirea 1uapuadsput *P ‘Mou ang “{ 9q [IPS |]! P22se29105 9q 02 SoIquIZeA aUapuadap Sy J “sIsu ‘UorssoiBo1 seaUT] se Yons ‘s]apouLl (fENseD J0) DANEDOSSY s|apoyy anjjeloossy ul Scanned with CamScannerWhere: b = slope of the regression line EZ = summation sign . x = known values of the independent variable y= known values of the dependent variable % = average of the value of the x’s F¥ = average of the value of y's g = number of data points or observations i Example: - Nodel Construction Company renovates old homes in Quezon City. Over time, thecompany [J has found that its peso volume of renovation work is dependent on the Quezon City area payroll. The following table lists Nodel’s revenues and the amount of money earned by wage earners in Quezon City during the past six years. Nodel’s Sales Local Payroll Nodel’s Sales Local Payroll (P000,000), y (P.000,000,000), x (P000,000), y (000,000,000), x 2.0 1; 20 2 3.0 3 2.0 1 25 4 35 7 Nodel management wants to establish a mathematical relationship wo help predict sales. Firs, it needs to determine whether there is a straight-line (Linea) relationship between the area payroll and sales, so itplots the known data on a scatter diagram. a4 38}. 34 289 eee eee 2p a) 154 qe ee of thousands of Php) 085 Te er oe of} tt tt tt Oa Be eer Nodet's sales (In hundreds ‘Area payroll (In hundreds of millions of Php) is a sli iti ionship berween the & from the six data points that there is a slight positive relationship : pea ona (pays and the dependent variable (sales), As payroll increases, Nodel’s sales tend to be higher. ‘A mathematical equation may be derived by using the least squares regression approach. Scanned with CamScannerFINANCIAL MANAGEMENT | Part 106 a Sales (y) Payroll (x) x xy 2.0 1.0 1.0 2.0 3.0 - 3.0 9.0 9.0 25 4.0 16.0 10.0 2.0 2.0 40 4.0 2.0 1.0 1.0 2.0 58 10, 49.0 245 Lx? 80.0 y = b = Lxy=nxy = 51.5 - (6)(3)(2.5) = 0.25 Lx? - nx 80 = (6)(3?) y - bx = 2.5 - (0.25)(3) = 1.75 The estimated regression equation, therefore, is: Y =1.75+0.25x or’ Sales ='1.75 + 0.25 (payroll) Ifthe local chamber of commerce predicts that the Quezon City area payroll will be P600 millions ~ year, the sales of Nodel may be estimated with the regression equation: Sales (in hundred thousands of Php) = 1.75 + 0.25(6) ay | = 175 +150 = 3.25 Standard Error of the Estimate 5 in The forecast of P325,000 for Nodel's sales in the example is called a point estimate of y. The P™ estimate is really the mean, or expected value, of a distribution or possible values of sales. | : st ‘To measure the accuracy of the regression estimates, the standard error of the estimates, SPs ey solved. This computation is called the standard deviation of the regression: it measures the error dependent variable, y, to the regression line, rather than to the mean. gx = De [39.5 - 1.75(15.0) ~ 0.25(51.5) 6-2 = (0.09375 = 0.306 (in hundred thousands of Php) ‘Thus, the standard error of the estimate is P30,600 in sales. Scanned with CamScannercorrelation Coefficients for Regression Lines ‘The regression equstion is One way of expressing the iacure of the reladionship berween two variables. {shows how one variable relates to the values and changes in another vaca : Another way to evaluate the relationship between two variables is to compute the coefficient of coreation. This measure expresses the degree or Strengths of the linear relationship. Usually identified as the coefficient of correlation can be any number between +1 and 1 ‘To compute for r, the same data needed earlier will be used to calculate a and b for the regression line. ‘The rather lengthy equation for r is: r xy x: \ (SP Ib yy) To compute for the coefficient of correlation for the data shown, calculate for y2. The equation is then applied for r: Pe S| Forecasting ar] an additional column is needed to y x x xy 2.0 10 1.0 2.0 3.0 3.0 9.0 9.0 25 4.0 16.0 10.0 2.0 2.0 4.0 4.0 2.0 1.0 1.0 2.0 “20 490. 245, Dx - 18. Ex? = 80.0 Yay = 515 (6) (51.5) - (18) (15.0) {© (80) - (18)?][(6) (39.5) = (15.0)] = 309 - 270 = 39 \(156)(12) 1,872 eeao9 = 0.901 43.3 This 7 of 0.901 a bea si .901 appears to be a si ‘Wo variables, = icant correlation and helps confirm the relationship between the Although the coefficient of correlation is the most commonly used measure to describe the relationship “ween two variables, another measure exists. It is called the coefficient of determination. It is simply the _ SBA of the coefficient of correlation namely, r2, The value of r? will always be a positive number in the on of 0s +? < 1. The coefficient of determination is the percent of variation in the deperd-aeiaee (? thats explained by the regression equation, In Nodel’s case, the value of ris 0.81, indicating thae the toal variations is explained by the regression equation. x wd Scanned with CamScannermodule 5 & chapter’5 Time Value of Money Overiew - Time Value of Money Concepts Futw? Value of Money. Presat Value of Money Riskind Return Concept Leating Outcomes ‘Atte end of the chapter, the learners must be able to: a) describe the concept of the time value of money; }) compute and calculate the future and’ present value of money; and ¢) discuss the concept of risk and return. Ovrview on Time Value of Money (TVM) Time value of money is the concept that the value of a peso to be received in fuure is less than the value of a peso on hand today. One reason is that money recived today can be invested thus generating more money. Another reason is, tht when a person opts to receive a sum of money in future rather than today, he isfectively lending the money and there are risks involved in lending such as deault tisk and inflation. Time value of money principle also applies when comparing the worth of money to be received in future and the worth of money to be received in further fuure. In other words, TVM principle says that the value of given sum of money tobe received on a particular date is more than same sum of money to be received ona later date. Few of the basic terms used in time value of money calculations are: 1. Present Value When a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect the time value of money, the resulting value is called present value, " 87 Scanned with CamScannerge 2. Future Value : Bitar value is amount that is obtained by enhancing the value of a Present | payment or a series of payments at the given rate of interest to reflect the time value of money. : 3.. Interest Interest is charge against use of money paid by the borrowe, der it ir to the lerder in addition to the actual money lent. : i Interest is the cost of borrowing money, where the borrower pays a fee to the owner for using the owner's money. The interest is typically expressed as a percentage and can be either simple oF compounded. Simple interest is Only based on the principal amount of a loan, while compound interest is based 0" the principal amount and the accumulated interest. i For example, a student obtains a simple interest loan to pay one year of her college tuition, which costs P18,000, and the annual interest rate on her loan is 6%. She repaid her loan over three years and the amount of simple interest she paid was P3240, or P18,000°0.06*3. The total amount she repaid was P21,240, or P18,000+ P3,240. E Conversely, compound interest, is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods minus one. As opposed to simple interest, compound interest accrues on the principal amount and the accumulated interest of previous periods. suppose another student obtains a compound interest loan to pay one year of his college tuition, which costs P20,000, and the annual interest rate on his Ioan is 8%. Unlike the simple interest, the compound interest accrues on both the principal and the accumulated interest. He repaid his loan over four years and the amount of compound interest he paid was P7,209.77, or P20,000*((1+0.08)"4 — 1) and the total amount he repaid was P27,209.77, or P20,000+ P7,209.77. For example, P4000 is deposited into a bank account and the annual interest rate is 8%. How much is the interest after 4 years? Use the following simple interest formula: For example, T=pxrxt where p is the principal or money deposited ris the rate of interest tis time 88 Scanned with CamScannerBi weset: - qapxrxt 1 .1000% 8% * 4 1.4000 0.08 4 _P 1280 i oF My i the original terest is the interest earned not only pn He Te : wever, coumpound int inci Put also on all interes prey 2am the interest earned is a teinvited t for the situation above, 1 we use compound interest comted as follows: aterest at the erid of the first year: = 4000x:0.08 x 1 1=P320 Your new principal p interest at the end of the second year: T= 4320x 0.08 x 1 2 1=P345.6 Your new principal is now 4320 + 345. Interest at the end of the third year: I= 4665.6x 0.08 x 1 1=P373,25 Your new principal is now 4665.6 + 373.25 = 503! Interest at the end of the fourth year: | 1 = 5038.848 x 0.08 x 1 I= P403.10 1 f Your new principal is now 5038,85 + 403.10 = 5441.95 Total interest earned = 5441.95 — 4000 = 1441.95 The difference in money betwéen compound interest and simple interest i 1441.96 - 1280 = 161.96 Ps ple interest i K As you can see, compound interest yields better result, so you make mor oney. i Therefore, before investing your money, you should doubl rl 5 | local bank if compound interest will be hen # le check with yoi esiamned previously: In other words; o ca to the original amount and the money is the interest will be er day is now 4000 + 320 = 4320 6 = 4665.6 8.85 Scanned with CamScannerApplication of Time Value of Money Principle There are many 4 ‘ inciple. For empl zn \Y applications of time value of money principle. For e@™mple, Ie can use it to pe i the worth of cash flows seni at different Mes in é Mae. to find the present worth of a series of payments to be received pericdically a A ture, to find the required amount of current investment that must be made at aired interest rate to generate a required future cash flow, etc. Money 1258s its ya ue over a period of time and there are several reasons why money lose* value Ver time. Most obviously, there is inflation which reduces the buying Poe Of money. But quite often, the cost of receiving money in the future rather than now Will be Sreater than just the loss in its real value on account of inflation. The oppot™nity cost of not having the money right now also includes the loss of additional itcome that you could have earned simply by having received the cash earlier. Moreover, receiving money in the future rather than now may involve Some risk and uncertainty regarding its recovery. For these reasons, future cash flows are worth less than the present cash flows. Time value of money concept attempts to incorporate the above considerations into financial decisions by facilitating an objective evaluation of cash flows from different time periods by converting them into present value or future value equivalents. This ensures the comparison of ‘like with like’. The present or future value of cash flows is calculated using a discount rate (also known as cost of capital, WACC and required rate of return) that is determined on the basis of several factors such as: 1. Rate of inflation Higher the rate of inflation, higher the return that investors would require on their investment. Higher the interest rates on deposits and debt securities, greater the loss ‘of interest income on future cash inflows causing investors to demand.a higher return on investment. s Greater the risk associated with future cash flows of an investment, higher the rate of return required by an investors to compensate for the additional risk. 2. Interest Rates 3. Risk Premium Consider a simple example of a financial decision below that illustrates the use of time value of money. Example: Suppose that you have earned a cash bonus for an outstanding performance at your job during the last year. Your pleased boss gives you two options to choose from: 1. Option A: Receive P10,000 bonus now 2. Option B: Receive P10,800 bonus after one year 90 Scanned with CamScannerFurther Nformation which you may consider in your decision: 1. Infition rate is 5% per annum. 2, Ingest rate on bank deposits is 12% per annum. Which tion would you choose? Soluti" hough in absolute terms, Option B offers the higher amount of bonus, io A gives i ivi tio You the choice of receiving bonus one year earlier than Option B. This ct be beneficial for the following reasons: 1, 7 Stat with, you can buy more with P10,000 now than with P10,800 in one y2t's time due to the 5% inflation. 2. scondly, if you receive the bonus now, you could invest the cash in a bank eposit and eam a safe annual return of 12%. In contrast, you stand to lose this wterest income if you choose Option B. 3. hirdly, future is uncertain. In worst case scenario, the company you work or could become bankrupt during the next year which would significantly ‘educe your chances of receiving any bonus. The probability of this happening night be remote, but there would be a slim chance nonetheless. The above considerations must be incorporated into the decision analysis by facoting them into a discount rate which will then be used to calculate the future valies and present values as illustrated below. Disount Rates As the interest rate on bank deposits is higher than the rate of inflation, we shuld setthe discount rate at 12% for our analysis because it represents the highest opportunity cost for receiving the bonus in one year’s time rather than today. For this example, we may assume that the risk of not getting the bonus after ore year (e.g. due to the company becoming bankrupt) is minimal and is therefore ignored. If such a risk is considered significant, we would have to increase the dicount rate to reflect that risk, Using the 12% discount rate, we could either calculate future value or present value of the two options to assess which option is better in financial terms. Both are included here for completeness sake although they shall lead to the same conclusion. Fulure Values The future value of Option A will be the amount of bonus plus the interest income of 12% which could be earned for one year. a1 Scanned with CamScannerOption A Bonus P10,000 Interest Tneorte P 1,200 (P10,000 x 12%) Future Value P11,200after 1 year —_(P10,000 + P1,200) Option B Bonus 10,800 Interest eae 9 Income Future Value P 10,800 after 1 year * No interest income shall accrue on P10,800 as it shall be received after one year Based on the future values, Option A is preferable as it has the. highest future value. Present Values The present value of Option B will be the amount required today that shall equal to P10,800 in one year’s time after having accrued an interest income of 12%. Option A Bonus P10,000 Interest Income 10."* 4 ud se 1 Present Value 10,000 ($10,000 x 1.0) | *No need to discount as P10,000 is already stated in its present value terms. Option B | Bonus P10,800 Interest Income 0.8928 (1+ [1 +0.12]) | Present Value 9,642" (P10,800 x 0.8928) | “The present value.of P9,642 represents the amount of cash that, if invested in a bank deposit @ 12% p.a., shall equal to P10,800 in one year. This can be confirmed as follows: P9,642 x 1.12 = P10,800 Based on the present values, Option A is preferable as it has the highest present value. . Note Both present and future value analysis lead to the same conclusion (i.e, Option A is preferable over Option B). This is because both methods are a mirror image of the other. 92 Scanned with CamScannerormay wonder why thedliference between the two future values (ie. P400) sree Present values (F358) is not the same, The difference 8 i oi ree reaag ok other cash flows (Le. future value is calculated one yeat ahead (present value) The ciferene canbe reconciled bY calculating either the future E358), P858x1.12 = PAOO) or the present valt® of PA00 (i.e. P Using’@bleS to Solve Future Value Problems smpound j fui i vate interest tables have been calculated by figuring out the ne that ti8 table td time periods and interest rates (see appendix), You will a To we the table ce izes the factors for various interest rates for various YP numét Of years. They go down the left-hand column to locate the casio is locted. Note ‘en go out along the top row until the appropriate ino 3% fe there are three pages containing interest rates 1% through 19%. - pany to find the future value of P100 at 5% compound interest baie evears on the table, then go out to 5% interest. At the intersection of thes valusa factor of 1.2763 appears. Multiplying this factor times the beginning value Of 00.00 results in Past oe camctly oka ras caleuated using, the COMPOLES Inteest Formula previously. Note, however, that there may P® slight differences betveen using the formula and tables due to rounding err An example shows how simple it is to use the tables to calculate future ampunts. You deposit P2,000 today at 6% interest. How much will you have in five years? Using Tables to Solve Future Vatue of Annuity Problems ‘An annuity ig an ‘equal, annual series of cash flows.’Annuities may be equal amual deposits, equal annual withdrawals, equal annual payments, or equal amual receipts. The key is equal, annual cash flows. ‘When cash flows occur at the end of the year, this makes them an ordinary annuity. If the cash flows were at the beginning of the year, they would be an annuity due, Annuities due will be covered later. Annuities work as follows: 1. Annuity = Equal Annual Series of Cash Flows 2. Assume annual deposits of P100 deposited at end of year earning 5% interest for three years. Year 1: P100, deposited at end of year = P100 Year 2: P100 x .05 = 5.00 + P100 + P100 P205 Year 3 205 x .05 = P10.25 + P205 + P100 = 315.25 93 Scanned with CamScannerAgain, there are tables for working with annuities (see appendix). Basically, this table works the same way as the previous table. Look up the appropriate number of periods, locate the appropriate interest, take the factor found and multiply it by the amount of the annuity. For instance, on the three-year, 5% interest annuity of P100 per year. Going down three years, out to 5%, the factor of 3.152 is found. Multiply that by the annuity of P100 yields a future value of P315.20. Another example of calculating the future|value of an annuity is illustrated. You deposit P300 each year for 15 years at 6%: How much will you have at the end of that time? Using Tables to Solve Present Value Problems Present value is simply the reciprocal of compound interest. Another way to ‘ink of present value is to adopt a stance out on the time line in the future and look back toward time 0 to see what was the beginning amount. Present Value Present Value = P,=P. / (141)> TYM ‘able 3 shows Present Value Factors. Notice that they are all less than one. Therefore, when multiplying a future value by these factors, the future vatue is discounted down to present value. The table is used in much the same way as the previously discusseq time To find the present value of a future amount, locate the appropriate number of years and the appropriate interest rate, factor and multiply it times the future value. An example illustrates the process, How much would you to have P15,000 in ‘i inteneat is 7%? have to deposit now 8 years if take the resulting Using Tables 0 Solve Preseny Value of an Annuity Problems” To find the present value of Annuity Factors. Find the appropri, te factor and multiply it times the the annuity to find the present yas ofthe annuity, an ‘An example illustrates the an annuity, use TVM Table 4: Present Value of ‘Ount of Process. Find the present value of a 4-year, p3,000 per year annuity at 6%, 94 Scanned with CamScannerNet Present Value Analysis An’ capital investment involves an initial cash outflow to pay for it, followed by cashinflows in the form of revenue, or a decline in existing cash flows that are causedby expense reductions. We can lay out this information in a spreadsheet to show #l expected cash flows over the viseful life of an investment, and then apply a discunt rate that reduces the cash flows to what they would be worth at the preser' date. This calculation is known as net present value analysis. ___Ntpresent value is the traditional approach to evaluating capital proposals, since t is based on a’ single factor — cash flows — that can be used to judge any propéal arriving from anywhere in a company. Net fesent Value Example \BC International is planning to acquire an asset that it expects will yield posiive cash flows for the next five years. Its cost of capital is 10%, which it uses as tle discount rate to construct the net present value of the project. The following, tabl shows the calculation: Year Cash Flow, 10% Discount Factor Present Value 0 -P500,000, 1.0000 -P500,000 1 +130,000 0.9091 +118,183 2 +130,000. 0.8265 +107,445 3 +130,000, 0.7513 +97,669 4 +130,000 0.6830 +88,790 5 +130,000 0.6209 $80,717 Net Present Value =$2,196 The net present value of the proposed project is negative at the 10% discount rate, so ABC should not invest in the project. The Discount Rate In the “10% Discount Factor” column, the factor becomes smaller for periods further in the future, because the discounted value of cash flows is reduced as they progress further from the present day. The discount factor is widely available in progres’ g, or can be derived from the following formula: Present value of @ = (5 Discount ra ihe number of period: a Periods of future cash flow discounting To use the formula for an example, if we forecast the receipt of $100,000 in one Year andl are using @ discount rate of 10 percent, then the calculation 95 Scanned with CamScannerPresent value = $90,909 Contents of a Net Present Value Analysis 1 A net present value calculation that truly reflects the reality of cash flows will likely be more complex than the one shown in the preceding ‘example. It is best to break down the analysis into a number of sub-categories, so that you can S& exactly when cash flows are occurring and with what activities they are associated. Here are the more common contents of a net present value analysis: 1. Asset purchases. All of the expenditures associated with the purchase, delivery, installation, and testing of the asset being purchased. 2. Asset-linked expenses. Any ongoing expenses, such.as warranty agreements, property taxes, and maintenance, that are associated with the asset. 3. Contribution margin. Any incremental cash flows resulting from sales that can be attributed to the project. 4. Depreciation effect. The asset will be depreciated, and this depreciation shelters a portion of any net income from income taxes, s0 note the income tax reduction caused by depreciation. 5. Expense reductions. Any incremental expense reductions caused by the project, such as automation that eliminates direct labor hours. Tax credits. If an asset purchase triggers a tax credit (such as for a purchase of energy-reduction equipment), then note the credit. 7, Taxes. Any income tax payments associated with net income expected to be derived from the asset. a 2 Working capital changes. Any net changes in inventory, accounts receivable, or accounts payable associated with the asset Also, when the asset is eventually sold off, this may trigger a reversal of the initial working capital changes. By itemizing the preceding factors in a net present Value analysis, you can more easily review and revise individual line items. Cautions when using Net Present Value Net present value does not consider the presence of a constraint in the system, of generating cash flow, which could restrict the total amount of cash actuall Gesrated. The result can be an estimated net present Value that cannot be teallzed. , _ ‘Apositive net present value means a better return, and a negative net present Yalue means a worse return, than the return from zero net present value. It is one of the two discounted cash flow techniques (the other is internal rate of return) used in comparative appraisal of investment proposals where the flow of income varies over time. 96 Scanned with CamScanner aacDefinitio! of ‘Risk Return Trade Off’ Higter risk is associated with greater probability of higher return and lower tisk wit\ a greater probability of smaller return. This trade off which an investor faces beween risk and return while considering investment decisions is called the risk retin trade off, ___ Foexample, Rohan faces a risk return trade off while making his decision to invest.{f he deposits all his money in a saving bank account, he will earn a low returni., the interest-rate paid by the bank, but all his money will be insured up toan mount of P 1 MILLION PESO. fi _bwever, if he invests in equities, he faces the risk of losing a major part of his capite along with a chance to get a much higher return than compared to a saving depot in a bank. The world of investing can be a cold, chaotic, and confusing, place The fisk Return Trade-off Deciding what amount of risk you can take while remaining comfortable with yow investments is very important. In the investing world, the dictionary definition of risk is the chance that an investment’s actual return will be different than expected. Technically, this is me:sured in statistics by standard deviation. Practically, risk means you have the posibility of losing some or even all of your original investment. Low risks are associated with low potential returns. High risks are associated wih Kigh potential returns. The risk retum trade-off is an effort to achieve a Dalance between the desire for the lowest possible risk and the highest possible reurn, The risk return trade-off theory is aptly demonstrated graphically in the Chit below. A higher standard deviation means a higher risk and, therefore, a higher possible return. Risk/Return Trade-off a High Risk, High Potential Return i Standard Deviation (or Risk) 97 Scanned with CamScannerA common misconception is that higher risk equals greater return. ie risk return trade-off tells us that the higher risk gives us the possibility of higher returns. There are no\guarantees. Just as risk means higher potential returns, it also means higher potential losses. On the lower end of the risk scale is a measure called the risk-free Tate of return. It is represented by the return on 10 year Government Securities because their chance of default (ie. not being able to repay principal and interest) is next to nothing. This risk free rate is used as a reference for equity markets whereas the Overnight repo rate is used as a reference for debt markets, If the risk-free rate is ‘currently 6 per cent, this means, with virtually no risk, we can earn 6 per cent per year on our money. ‘The common question arises: who wants 6 per cent when index funds average 13 per cent per year over the long run (last five years)? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 13 per cent every year, but rather -5, per cent one year, 25 per cent the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government: security. We call this additional return, the risk premium, which in this case is 7 per cent (13 per cent - 6 per cent). How do you know what risk level is most appropriate for you? This isn’t an easy question to answer. Risk tolerance differs froth person to person. It depends on goals, income, personal situation, etc, Hence, an individual investor needs to arrive at his own individual risk return trad. le-off based on his investment objectives, his lifestage and his risk appetite. 98 Scanned with CamScanner aChapter VI Cost of Capital Cost of Capital, defined Weighted Average Cost of Capital Cost of Borrowin, Cost of Debt Cost of Equity Learting Outcomes At the end of the chapter, the learner must be able to: a) tecognize the meaning of cost of capital; b) explain and discuss the cost of borrowing, debt and equity; and ¢) illustrate cost of capital through the use of weighted average cost of capital and capital asset pricing models. Cost of Capital, defined Financing activity would include borrowing money or taking loans from a financial institution. The said sources of funds would carry some cost in order to acquire it from the lender and the said cost is known as the “cost of capital”. Simply stated, cost of capital is the cost incurred in order to raise needed fund for business operations. The said cést is also referred to as financing cost (interest rate) thecompany pays when securing a loan. Business firms normally define their own “cost of capital” in one of two ways: Firstly, “cost of capital” simply refers to the financing cost that needs to be paid when borrowing funds, either by securing a loan or by selling bonds, or equity financing, and this comes in the form of an annual interest rate, such as 5%, 0r 10%, Secondly, if it refers to investment decision making, cost of capital may be referred to as the rate of return that can be earned on such investment, 145 Scanned with CamScannerpital (WACC) ‘apital is the arithmetic average (mean) pital f each capital source by the proportion of total rage cost of capital” usually appears 35 an Weighted Average Cost of Ca Weighted Average Cost of C cost that weighs the contribution funding it provides. “Weighted ave annual percentage- : Calculating WACC is a matter of summing the capital cost components, multiplying each by its appropriate weight. For example, in simplest terms WACC = (Proportion of total funding that is equity funding ) x (Cost of equity) + (Proportion of total funding that is debt funding) x (Cost of Debt) x (1 - Corporate tax rate) a firm has determined its, cost of each source of capital and To illustrate, & optimal capital structure, which is composed of the following sources and target market value proportions: Target cc £ Capital Market After Tax ee x Source of Capital Proportions | Cost (ATC) “a'tc) (TMP) Long term debt 40% 6% 2.40% Preferred Stock 10% 11% 1.10% ‘Common Stock 50% 15% |. 7.50% Total 100% 11.00% It will be noted based on the above illustration that WACCis simply computed by multiplying the total market proportion to the after tax cost. Thus, the WACC for the given example is 11%. Cost of Borrowing Cost of borrowing refers to the total amount a debtor pays to secure a Joan and use funds, including financing costs, account maintenance, loan origination, and other loan-related expenses. When a debtor repays a loan over time, the following equation holds: syry? Total payments = Repaypentt loan principal + cost of borrowing i | Cost of borrowin, i de, for instance, interest orrowing may include, q Payments, and (in si cases) cH Grigiation fees, loan account maintenance fees, borrower oom fees, and still other fee ‘example, consider a loan wi Hl Properties: ae 4 an with 'the following; 146 Scanned with CamScannertoc iy gh: | Atinual interest rate: | Amortization time: the Such a loan calls for 120 monthly payments of P1,110.21. They Of 120 x borrower Who makes all payments on schedule ends up repaying 2 ination, P600 $1,11021, or P133,295, The borrower will also pay P200 for loan FEENEY Te ct in account maintenance fees (120 x P5), and P250 in borrower insvr of borrowing, therefore, calculates as: | Cost of borrowing caleula : oe : P133,225.20.00, (100,000.00), 33,225.20, 200.00) | | Total repayments: : 3 | Less principal re | | Account “600.00 intenan : 250.00 | -P34,255.20, Cost of Debt ta fe bt is the overall average rate an organization pays on all its be eno these typically consist ofbonds and bankloans,"Cost of debt” usually obligations. coearege an anal percentage with a marginal income tax rate of 30% and a before-tax cost of 5 aio otto tax cost of debt is as follows: ebt of 6%, 147 —_——— —— Scanned with CamScanner“Alter-tax cost of debt = Before tax cost of debt) x (1 ~ Marginal tax rate) pet Stas strates et aHeD LS ginal ta 1 = (0.08) x (0.70) : = 6.042 or 4.20% ‘As with “cost of capital,” “cost of debt” tends to be higher for companies With lower credit ratings — companies that the bond market considers riskier Of More speculative. Whereas “cost of capital” is the rate the company must paY NOW to raise more funds, cost of debt is the cost the company is paying to carry all debt it has acquired. ‘ Cost of debt becomes a concern for stockholders, bondholders, and potential investors for “high-leverage” companies (i.¢., companies where debt financing is large relative to owners equity). High leverage is riskier-and less profitable ina weak economy when the company’s ability to service a massive debt load may be questionable. The cost of debt may also weigh in management decisions regarding asset acquisitions or other investments bought with borrowed funds. The additional cost of debt in such cases reduces the value of investment tools such as: return on investment (ROJ) or internal rate of return (IRR). Cost of Equity (COE) Cost of equity (COE) is part of a company’s “capital structure.” COE measures the returns demanded by stock market investors who will bear the risks of ownership. COE usually appears as an annual percentage. One approach to calculating cost of equity refers to equity appreciation and dividend growth. : y stock) gro a eal lividend arket value. of Cost of equity = (Next { (Current mi For example, consider a stock whose current market value is P8.00, paying an annual dividend of P0.20 per share. If those conditions held for the next year, the investor's return would be simply 0.20/8.00, or 2.5%. When the investor requires a return of, say 5%, one or two terms of the above equation must change: , 1. If the stock price appreciates 0.20 to 8.20, the investor would experience a 5% return: (0.20 dividend + 0.20 stock appreciation) /(8.00 current value of stock). 2. When, instead, the company doubles the dividend (dividend growth) to 0.40, while the stock price remains at 8.00, the investor also experiences a 5% return. 148 Scanned with CamScannerCalculating Cost of Equity From the Capital Asset Pricing Model (CAPM) | [Bots e uy : ing usually In the CAPM, beta is a measure of the stock's historic eo On alerts price changes compared to changes in the market as a Wh0le. 72 "1," oo ative beta the stock tends to rise or fall independently from the MPT" tends to fall mears the stock tends to rise when the market falls, and OS OS OG fan with while the market rises. 'A positive beta means the stock the market, 14 Scanned with CamScanner