Chapter 29: Financial Panning

A. Financial Planning:A decision making process and tool that enable management and investors to assess Financial results and set targets for Financial growth of the Company.

B. Needs of Financial Planning:A. Contingency Planning

- formulate responses to inevitable surprisesB. Considering optionsC. Forcing Consistency

- firm’s growth and financing requirements should be connected

C. Financial Planning Involves Setting:- Short-Term goals and objective- Long-Term goals and objective

Then design a strategy to achieve goals.

D. Short Term Financial Planning Spans a period of (1) year or less Forecasting future sources and uses of cash Managing accounts receivable and accounts payable A standard against which subsequent performance can

be judged Makes sensible short term borrowing and lending

decisions

E. Option of Short Term FinancingBang LoansStretching Payables

F. Cash CycleA metric that expresses the length of time (in days) that it takes for a company to convert resource inputs into cash flows

This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties.

Cash Cycle (days)= average days in inventory + average collection period – average payment period

G. Strategies for reducing cash flow problems:1. Maturity Hedging2. Decrease cash cycle time3. Cash Budgeting4. Cash Reserves

Maturity Hedging - is paying for short-term costs, like inventory, with

short-term loans.

Decrease Cash Cycle Time- can be done by decrease their inventory and

receivables time periods- delay payment to supplier

Cash Budgeting- gives managers a “heads-up” about when short-term

financing may be needed.- cash budget simply records estimates of cash

receipts and payments.- starts with a sales forecast, usually by the quarter,

for the upcoming year- used to estimate of the timing of cash collections by

quarter.Cash Reserves

- Keeping cash reserves and few short-term liabilities can go a long way to help avoid financial distress.

- Higher reserve = greater liquidity- Having idle cash that is not put to work or invested

means future revenue is foregone.

H. Long Term Financial Planning concerned with funding the growth and development of

the company for three (3) to five (5) years or even longer.

obtaining debt capital from commercial banks or other financial institutions.

Helps to avoid surprises and be prepared for the unavoidable.

I. Similarities and Difference of Short Term and Long Term

Similarities:- focused on the financial health of a company- objective is to maximize the efficient use of capital - All business require capital, that is money invested

in assets, can be financed by long term or short term sources of capital

Difference:- Short-term involves short lived assets and liabilites- Short-term are easily reverable

J. Reasons why Cash Budgeting is important to Long Term Financial Planning.

Cash budgeting ensures that a company's cash position advances its overall long-term financial plan

Provides the foundation necessary to achieve the objectives.

K. Growth and External Financing

Internal growth rate maximum growth that company can achieve without external funds

“maximum growth without external funds”

Internal growth rate= retained earningnet assets

Sustainable growth rate highest growth rate the firm can maintain without increasing its financial leverage

“highest growth rate maintained without financial leverage”

Substantial growth rate=plowback rato×returnonequity

Chapter 30: Working Capital Management

A. Working CapitalShort-term, or current, assets and liabilities are collectively known as working capital.

Current Assets: Inventories Accounts Receivables Cash

Current Liabilities Accounts Payable Accrued Expense Debt due within year

B. Inventory ManagementIs the sensible balance between the benefits of holding inventory and the costs.

C. Components of Inventory Raw materials Work in process Finished goods

D. Inventory Trade-OffInvolves two (2) costs:

Carrying cost – storage cost Order cost – cost of purchase from supplier

E. Relationship of the Order Size, Order Cost, and Carrying Cost

F. Economic Order QuantityOrder size that minimizes

Total Inventory Costs.

Economic Order Quantity =2 x annual sales x cost per order

carrying cost

Example – A retailer sells 255,000 tons of coal per year. Each order that the company places involves a fixed order cost of $450, while the annual carrying cost of the inventory is estimated at $55 a ton. (a) What is the economic order quantity for this company? (b) How many orders will be made? a. Economic Order Quanitity

EOQ=√ 2×255,000×45055

=2,042.73 tons

b. Number of Order

255,0002,042.73

=124.83׿

Carrying Cost

Average Amount

of Inventory

Order Size

Order Cost

Order Size

G. Tools To Minimize Inventory1. Just-in-time2. Producing goods to order

H. Credit Management:Account Receivables

- Trade Credit- Consumer Credit

I. Term of SalesCredit, discount, and payment terms offered on a sale.

- Cash on Delivery- Cash before Delivery- Credit terms

Example - 5/10 net 30– 5 - percent discount for early payment– 10 - number of days that the discount is available– net 30 - number of days before payment is due

A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier.

Effective Annual Rate=(1+ discountdiscount price )

365/extra days credit

−1

Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

EAR=(1+ 0.0595 )

365/50

−1=.454∨45.4 %

J. Credit Agreementsa. Open accountb. Sight draft – is a message to the buyer to pay

immediately since shipment is already delivered

c. Time draft—is an agreement to pay later on according to the period given in the draft

d. Trade acceptance—buyer accepts the period stated in the time draft

e. Banker’s acceptance—buyer received time or sight draft but does not have the money to pay, so buyer goes to the bank and bank accept to pay for the buyer first.

f. Irrevocable letter of credit—trade happens overseas. Buyer’s bank writes a letter to the seller’s bank. Buyer and Seller’s bank manages the transactions.

g. Conditional sale—bank owns title of ownership until buyer pays his loan.

K. Credit Analysis- Determines the likelihood a customer will pay its

bills.o Bond Ratings for large firmso Credit rating agencies, such as Dun &

Bradstreet provide reports on the credit worthiness of businesses worldwide

o Credit bureaus on customer’s credit standing

L. Credit DecisionsCredit Policy - Standards set to determine the amount and nature of credit to extend to customers.

- Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default.

- Denying credit guarantees neither profit or loss.

Based on the probability of payoff, expected profit can be expressed as:

p×PV (Rev−Cost )−(1−p )× PV (Cost )

The Break Even probability of collection is:

p=PV (Cost )PV (Rev )

M. Collection Policy Collection Policy - Procedures to collect and

monitor receivables. Aging Schedule - Classification of accounts

receivable by time outstanding. Factoring - Arrangement whereby a financial

institution buys a company's accounts receivable and collects the debt.

N. Cash Management- Responsibility to provide adequate cash to the

firm- Responsibility to ensure funds are not blocks

and remain idle

O. Objectives of Cash Managementa. Liquidityb. Marginal Benefits (interests)c. Trade off between cost of idle cash and benefits.

Ways to invest idle cash- Sweep programs

P. Way of Receiving Cash Electronicallyo Automated Clearing House

o Wire Transferare large- value payments between companies

– Fedwire– Chips

Q. Speeding Check Collection Allows the firm to gain quicker use of funds Transfer times are reduced Check clearance is fast

Concentration Banking: Decentralized system of account receivables

Lock Box System: Payments send to regional post office box

International cash Management: Multinational bank with branches in each country

Compensating balances:– Monthly fee– Minimum average balance

R. Short Term Investments Readily marketable securities (stocks and bonds) Convert the investment into cash within one (1)

year

S. Sources of Short Term Borrowings Bank loan (features)

– Commitment– Maturity– Rate of interest

Syndicated loans Loan sales and CDOs Secured loans Commercial paper Medium term notes

Chapter 20: Understanding Options

A. Terminologiesa. Derivatives - Any financial instrument that is

derived from another. (e.g.. options, warrants, futures, swaps, etc.)

b. Option - Gives the holder the right to buy or sell a security at a specified price during a specified period of time.

c. Call Option - The right to buy a security at a specified price within a specified time.

d. Put Option - The right to sell a security at a specified price within a specified time.

e. Option Premium - The price paid for the option, above the price of the underlying security.

f. Intrinsic Value - Difference between the market value of the underlying and the strike price of the given option.

g. Time Premium - Value of option above the intrinsic value

h. Exercise Price - (Striking Price) The price at which you buy or sell the security.

i. Expiration Date - The last date on which the option can be exercised.

j. American Option - Can be exercised at any time prior to and including the expiration date.

k. European Option - Can be exercised only on the expiration date.

B. Call OptionBuyer has the right to buy Seller has the obligation to buy if buyer exercises option to buy

Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You believe that XYZ stock will rise sharply in the coming weeks and so you paid $200 to purchase a single $40 XYZ call option covering 100 shares.

Say you were proven right and the price of XYZ stock rallies to $50 on option expiration date. With underlying stock price at $50, if you were to exercise your call option, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000. Since you had paid $200 to purchase the call option, your net profit for the entire trade is therefore $800.

However, if you were wrong in your assessment and the stock price had instead dived to $30, your call option will expire worthless and your total loss will be the $200 that you paid to purchase the option.

C. Put OptionSeller has the right to sell

Buyer is obligated to buy if seller exercises option to sell

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don't own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

Call OptionBuyer Seller

Expectation MP MPLoss Limited to OP Unlimited

Profit Unlimited Limited to OP

Put OptionBuyer Seller

Expectation MP MPLoss Limited to OP Limited to Stock Price

Profit Limited to Stock Price Limited to OP

D. Moneyness

A term describing the relationship between the strike price of an option and the current trading price of its underlying security

At the money In the Money Out the Money(breakeven) (to exercise) (not to exercise)

EP = MP EP < MP: call optionEP > MP: put option

EP < MP: put optionEP > MP: call option

IN THE MONEY In-the-money options are generally more expensive

as their premiums consist of significant intrinsic value.

Has an intrinsic valueThe Intrinsic value is a difference between the strike price and the underlying price. It can be only positive

Intrinsic value for the CALL Option = Underlying Price – Strike Price

Intrinsic value for the PUT Option = Strike Price – Underlying Price

OUT THE MONEY Out-of-the-money options have zero intrinsic value Out-of-the-money options are cheaper as they

possess greater likelihood of expiring worthless.

AT THE MONEY Has no intrinsic value

E. Financial Alchemy with Options

EP

MP

MP

Put Option

Call Option

looks at how options can be used to modify the risk characteristics of a portfolio.

1. Protective Put- A risk-management strategy that investors

can use to guard against the loss of unrealized gains. The put option acts like an insurance policy.

Advantages of Protective Puts...o Allows you to hold on to your stocks and

participate in the upside potential while at the same time insuring against any losses

o The cost to buy the insurance is relatively cheap considering how much money you are protecting

Disadvantages of Protective Puts...o Cost of the Put option eats into your profito The option has a limited lifespan (it expires)

and has to keep being renewed (buying another option)

2. Straddle - Involves purchasing both put and call option- Both options has the same EP and expiration

date- Straddle is useful in a high volatile market

since it allows you to choose which ever option would benefit you the most

F. Six (6) Factors Affecting Option Premium

1. Underlying Price (MP)2. Strike Price (EP) 3. Time until expiration4. Volatility5. Interest Rate6. Dividends

Underlying Price- most influential factor on an option premium

- MP: call prices increase and put prices decrease- MP: call prices decrease and put prices increase.

Strike Price- determines if the option has any intrinsic value- More in the money = OP- More out the money = OP

Expected Volatility- Volatility is the degree to which price moves,

regardless of direction. - DEGREE OF PRICE MOVEMENT- Historical volatility refers to the actual price

changes that have been observed over a specified time period.

o historical volatility is used to determine possible volatility in the future.

- Implied volatility is a forecast of future volatility and acts as an indicator of the current market sentiment.

- Volatility = OP Time until expiration

- The longer an option has time until expiration, the greater the chance that it will end up in-the-money, or profitable. (because of time money value)

- ‘Time Decay’ is the ratio of the change in an option's price to the decrease in time to expiration. (Also known as "theta" and "time-value decay")

o As an option approaches its expiry date without being in the money, its time value declines because the probability of that option being

profitable (in the money) is reduced.

Interest Rates

can sell share for….

can buy share for….

PutOption

MP:40

MP:60

EP:52

100 shared @50

CallOption

- also have small, but measurable, effects on option prices.

- interest rates: call premiums will increase and put premiums will decrease.

o because of the costs associated with owning the underlying; the purchase will incur either interest expense (if the money is borrowed) or lost interest income (if existing funds are used to purchase the shares). In either case, the buyer will have interest costs.

Dividends- underlying stock's price typically drops by the

amount of any cash dividend.- underlying's dividend: call prices will decrease and

put prices will increase- underlying's dividend: call prices will increase and

put prices will decrease.