Finance for the Non - Financial Manager · 19/12/2019 · Finance for the Non -Financial Manager ©Temple University’s Fox School of Business Center for Executive Education –

Finance for the Non-Financial Manager

Women’s Leadership Series

Professor Sherry L. JarrellDecember 19, 2019

©Temple University’s Fox School of Business Center for Executive Education – 2019 – do not distribute.

Finance for the Non-Financial Manager


Introduction• Basic goals:

• Accounting, the language of business and finance

• Understand the role of risk in pricing or valuing assets (stocks, bonds, capital expenditures, new products, strategies, firms….) or in making personal finance decisions

• Empowerment! Do some numerical examples!


Accounting Background See class Notes/Match Industry Exercise

• Income/Statement• flow of revenues minus expenses• Earnings or Net Income or Profit ~ Cash Flows• Dividends are “0-growth Earnings! (firm vs. investor…)

• Balance Sheet• “Stock” of wealth• Cumulated

• From the past to today: Accounting• From the future to today: Finance/Economics

• Statement of Cash Flows


Match the Industry Exercise See handout

• Takeaways:• Categories of financial ratios help with different types of decisions/analysis:

• Liquidity (short term solvency)• Financial Leverage (long term solvency)• Asset utilization or turnover • Profitability• Market Value

• Financial Statement or Financial Ratio analysis is useful, but limited..• Book value• No one ratio or year of data is useful – must look at trends, a variety of

financial variables to paint a picture, then use with caution, revisit


Types of Risk – Sampling of Survey Results

• Pricing insurance too high or too low• Fraud within the client from misappropriation of assets or

misstatements of financial activity• Anything that would negatively impact our organization – can be a

costly financial impact, but could be customer or reputational impact• Not being able to make a deadline for development of an application

feature for new or existing client – could negatively impact revenue• Unhappy customers who may go to social media, BBB or regulators• Compliance with laws/regulations and ongoing safety concerns to

property and persons


Risk Survey (Continued)Example of High Risk Decision, Strategy or Development

• Acquisition of a competitor: merging employees, different business model, overall structural differences

• Losing a large client• Engaging with a large client without the resources or capabilities needed to

complete the work• Compensation Review – risk employees leaving when ask for more from them• Centralize internet sales of multiple departments• Higher risk of fraud with a larger organization• Recalls of our product• Cyber breaches• Failing to file timely report with regulators, making change to methodology

not understood by regulators, or otherwise violating some rule


Two key Sources of Risk or “Variability”

• Firm-specific (“diversifiable”): under the manager’s control

• Macroeconomic, market-wide (“undiversifiable”): beyond the manager’s control but not beyond their ability to plan for impact

Need to keep in mind your PERSPECTIVE: • Making decisions from within the firm: bringing in and managing the

assets that create the earnings, versus• Passively investing in the firm from without, earning returns driven by

the timing, level and risk of that firm’s earnings


Risk is Important! Why does it matter to finance? How do we measure its impact?

Step 1: Are we Risk Averse? To consider during break: which coin toss do you prefer?

Heads (.5) Tails (.5)Coin Toss # 1 $1000 $0

Coin Toss #2 $100,000 -$99,000


What does this “preference” say about Risk Aversion?

Returns or Payoffs:• E(payoff) Coin Toss #1: .5($1000) + .5($0) = $500• E(payoff) Coin Toss #2: .5($100,000) + .5(-$99,000) = $500

Standard Deviation or “Risk”:• σ (Coin Toss #1) = √[(.5)(1000-500)^2 + (.5)(0-500)^2 = 500• σ (Coin Toss #2)= √[(.5)(100,000-500)^2 + (.5)(-99,000-500)^2 = 99,500

“Returns per unit Risk ?” #1 = 500/500 vs. #2 = 500/99,500

Risk Aversion• prefer highest return per unit risk or lowest risk per unit return• we must be compensated to take on more risk


Are we compensated to take on more risk? Yes!


Standalone Risk versus Portfolio Risk Insurance Example

Facts:

• Term Insurance Policy on House worth $250,000.

• Annual premium of $500 (discuss!)

• Probability of No Fire: .999 Probability of Fire: .001


Return per unit Standalone Risk

Holding Period Return: • No Fire = ($0-$500)/$500 = -100%. • Fire = ($250,000 - $500)/$500 = 49,900%• Expected Return of Policy: .999 (-100%) + .001(49,900%) = -50%

Standalone Risk* = 1,580%. Return per unit of standalone risk is -50/1580!

Do rational risk-averse investors hold insurance? Yes!

This ratio cannot possibly capture the investor’s actual experience!


Insurance Policy’s Portfolio Risk

Create a two-asset portfolio of the house plus the insurance policy$ Payoffs

No Fire (.999) Fire (.001)House $250,000 $0Policy $0 $250,000 (House-Policy) Portfolio $250,000 $250,000

E(Value) portfolio = .999 ($250,000) + .001 ($250,000) = $250,000! Risk? ZERO! A “perfect hedge!”No matter the probability!! How did that happen? Discuss.


Portfolio Risk Drives Market Rates of Return

• A passive investor can “costlessly diversify away firm-specific risk by holding that investment in a large portfolio.”

• All that remains is Portfolio Risk, “the risk of the security when held within a portfolio.” This drives the minimum required rate of return to the investor, the cost of capital to the firm, or the going market rate.

• The higher the remaining undiversifiable (“market”) risk for any given earnings stream, the lower its value. The investor will pay less today for a given future payoff to generate a higher compensating return.


Time Value of Money and Discounting for RiskCompounding a Single Cash Flow

• $100 in bank, one year, 10% a year: $100 (1) + $100(.10) =$100 (1.10) = $110

• $100 in the bank for two years with r1 = 10% and r2 = ?:

$100 $100(1.10) $100(1.10)(1+r2) – simplify?____________________________________________________0 1 2

r1 = 10% r2 = ?

If r2 = 10%, then $100(1.10)(1+r2) $100(1.10)(1.10)=$100(1.10)^2 = $121


Discounting is simply the Reverse of Compounding

• Discounting is finding the value today (“present value”) that will become a given future value at X% interest per period in T periods.

• How much would you pay today for $110 in a year at if

• r = 10%? PV0 (1.10) = $110 PV0 = $110/(1.10) = $100• r = 5%? PV0 (1.05) = $110 PV0 = $110/(1.05) = $104.76• r = 15%? PV0 (1.15) = $110 PV0 = $110/(1.15) = $95.65

• What pattern do you notice?


Try another example: PV as a function of time

• How much would you pay today for a $110 Savings Bond that pay 5% interest and matures in

• One year? PV0 = $110/1.05 = $104.76• Two years? PV0 = $110/(1.05)^2 = $99.77• Three years? PV0 = $110/(1.05)^3 = $95.02

• What pattern do you notice?


Present Value of Asset with Infinite Cash Flows

Present value of an infinite stream of Cash Flows (real world e.g.?)

PV0 = C1/(r-g)

If you receive $1000 a year forever (g = 0), 10% r per year, what is its value today?

Does it have infinite value? No: PV0 = $1000/.10 = $10,000.

Logic: Put $10,000 in bank at 10% interest, what do you have at end of year 1? $11,000. Take out C1 = $1000. Leave rest in bank. What is it worth at end of year 2? $11,000. Take out C2 = $1000. Leave rest in bank..goes on forever.


Present Value of Asset with Finite Cash Flows

• An annuity has a finite or countable number of cash flows.

• Can you think of real world examples?

• PV0 = C1[1/r - 1/r(1+r)^T] where T is number of Cash Flows not years!

• Derivation available upon request, but is basically the difference between the PV of a perpetuity that starts now and the PV of a perpetuity that starts later.The upfront remaining piece is the annuity!


How much do you REALLY pay for cash advance?

• Sometimes the annual rate of return is not so obvious!

• If you go into H&R block to get your $2000 tax refund 4 months in advance for a fee of 10%, what annual r have you actually paid?

• Remember the relation between “dollars today” and “dollars later:”

$1800 = $2000/(1+r-4mo) r-4mo = 11.11% Over a year, this is (1.11)(1.11)(1.11)=1.3717 or 37.17% annual interest!


Summary and Takeaways

• Better understanding of risk within a business and from the perspective of the investor

• Better idea of how risk impacts value and influences personal and corporate financial decisions

• Better understanding of what drives the value of an organization, product, asset or strategy


Finance for Non-Financial Managers by

Professor Sherry L. Jarrell

Documents

Finance for the Non - Financial Manager · 19/12/2019 · Finance for the Non -Financial Manager ©Temple University’s Fox School of Business Center for Executive Education –