© 2009 South-Western, a division of Cengage Learning 1 Chapter 9: FINANCE Using Funds To Maximize Value

© 2009 South-Western, a division of Cengage Learning 2 LOOKING AHEAD How does maximizing financial value relate to social responsibility? How do financial managers use key ratios? How do financial managers use cash budgets? Why is working capital management important? How do financial managers evaluate capital budgeting proposals? How do financial managers determine the firm’s capital structure?

© 2009 South-Western, a division of Cengage Learning 3 WHAT MOTIVATES FINANCIAL DECISIONS What types of assets do we need to achieve goals? How do we get the funds we need? Evaluate financial performance Plan financial resources Manage working capital Evaluate investment opportunities Determine appropriate strategy

© 2009 South-Western, a division of Cengage Learning 4 % EVALUATING PERFORMANCE: WHERE DO WE STAND? Financial ratios provide insight into financial strengths and weaknesses Use financial data from balance sheet and income statement Companies can compare their ratios with other businesses

© 2009 South-Western, a division of Cengage Learning 5 KEY FINANCIAL RATIOS RATIOTYPE HOW IT IS COMPUTED CurrentLiquidity: ability to pay short-term liabilities. Current Assets Current Liabilities Inventory Turnover Asset Management: how firm is using assets to generate revenue. Cost of Good Sold Average Inventory Debt-to-equityLeverage: extent to which a firm relies on debt. Total Debt Total Owner’s Equity

© 2009 South-Western, a division of Cengage Learning 6 KEY FINANCIAL RATIOS RATIOTYPE HOW IT IS COMPUTED Debt-to- assets Leverage: measures the extent to which a relies on debt Total Debt Total Assets Return on equity Profitability: compares the amount of profit compared to resources invested Net Income – Preferred Div Avg Common Stock Equity Return on assets Profitability: compares the amount of profit compared to resources invested Net Income Average Total Assets Earnings per share Profitability: compares the amount of profit compared to resources invested Net Income – Pref Dividends Avg # of Shares Out

© 2009 South-Western, a division of Cengage Learning 7 BASIC PLANNING TOOLS Pro Forma Income Statement – forecasts the sales, expenses and net income Pro Forma Balance Sheet – forecasts the types and amounts of assets a firm will need to carry out plans. Cash Budget – detailed projection of cash flows to determine when cash shortages and surpluses will occur.

© 2009 South-Western, a division of Cengage Learning 8 CASH BUDGET

© 2009 South-Western, a division of Cengage Learning 9 FINANCIAL PLANNING: PROVIDING A ROAD MAP FOR THE FUTURE What assets must be obtained? How much additional financing is needed? How much can the firm generate Internally? Externally? When will external financing be required?

© 2009 South-Western, a division of Cengage Learning 10 MANAGING WORKING CAPITAL: CURRENT EVENTS Net Working Capital: –Difference between current assets and liabilities Working capital must be managed –Appropriate level of current assets –Current liabilities needed to finance activities

© 2009 South-Western, a division of Cengage Learning 11 SAMPLE BALANCE SHEET

© 2009 South-Western, a division of Cengage Learning 12 MANAGING CASH Need cash to pay bills Cash does not earn returns

© 2009 South-Western, a division of Cengage Learning 13 CASH EQUIVALENTS Commercial Paper –Short-term unsecured promissory note (IOUs). –Issued by major corporations with excellent credit rating –Sold at a discount; price plus interest is paid when the paper comes due T-bills –Short-term IOUs issued by the U.S. government. –T-Bills normal mature in 4, 13, or 26 weeks –Sold at a discount; face value is paid at maturity –Good market for T-Bills since they are backed by the government Money Market Mutual Funds –Pooled funds to purchase a portfolio of short-term, liquid securities –Affordable way for small investors to get into the market

© 2009 South-Western, a division of Cengage Learning 14 MANAGING ACCOUNTS RECEIVABLE Set Credit Terms Establish Credit Standards Design Appropriate Collection Policy Accounts Receivable - Money which is owed to a company by a customer for products and services provided on credit.

© 2009 South-Western, a division of Cengage Learning 15 SHORT-TERM FINANCING Spontaneous Financing –Trade Credit Short-Term Bank Loans –Line of Credit –Revolving Credit Factoring Commercial Paper

© 2009 South-Western, a division of Cengage Learning 16 BORROWING MONEY “ “ “If you want to know the value of money, go and try to borrow some.” - Benjamin Franklin

© 2009 South-Western, a division of Cengage Learning 17 CAPITAL BUDGETING: IN IT FOR THE LONG HAUL Replace machines and equipment New machines and equipment Build a new factory, warehouse or office Introduce a new product line Capital Budgeting – a systematic evaluation of a firm’s major long-run capital investment opportunities.

© 2009 South-Western, a division of Cengage Learning 18 COMPARING CASH FLOWS THAT OCCUR AT DIFFERENT TIMES Managers must evaluate costs and benefits of investment that occur over a period of many years. Time Value of Money – a dollar received today is worth more than a dollar received in the future. Compounding – earning interest in the current period on interest from previous periods.

© 2009 South-Western, a division of Cengage Learning 19 SOURCES OF LONG-TERM CAPITAL: LOANERS VS. OWNERS Capital Structure – the mix of equity and debt financing a firm uses for financing needs. Debt Financing – creditors. Equity Financing – owners.

© 2009 South-Western, a division of Cengage Learning 20 SAMPLE BALANCE SHEET

© 2009 South-Western, a division of Cengage Learning 21 SOURCES OF DEBT FINANCING Long-term loans Issuing notes or bonds

© 2009 South-Western, a division of Cengage Learning 22 SOURCES OF EQUITY FINANCING Direct contributions by owners –Owners directly contribute resources to unincorporated businesses –Corporations raise equity capital by issuing stock Retained earnings

Equity vs. Debt Equity doesn’t require payments Debt has tax advantages Equity gives up ownership control Debt had interest © 2009 South-Western, a division of Cengage Learning 23