Skills for managers., Summaries of Managerial Economics

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M. Stettner,

Skills for managers

D076 Study Guide Unit 2

• Finance: The study of managing and allocating fund at the personal or business level.
• Accounting: The system of recording, reporting, and summarizing past financial information and transactions.
• Capital: A financial asset that can be used by a firm or individual. Examples of capital may be machinery or cash held by a firm. Subspecialities in Finance: - Business finance- an area of finance that deals with sources of funding, the capital structure (the mixture of debt and equity used to finance a firm) of corporations, the actions that managers take to increase the value of a firm for tis owners, and the tools and analysis used to allocate financial resources. It is also known as managerial finance, financial management, and organizational finance. - Investments: o Asset pricing- The process of valuing assets o Current market value- what someone would pay right now for an asset - Financial institutions- includes firms or organizations that exist to accept a wide variety of deposits, to offer investment products to individuals and businesses, to provide loans, or to broker financial transactions. o Major financial institutions- central banks, consumer and commercial banks, insurance companies, investment banks, mortgage companies, and even pension fund management companies.
• Utility- the total satisfaction received from consuming goods and services.
• The goal of business finance is to maximize owner wealth for a privately held company (firms that have not issues shares to the public where the ownership rights are privately held) and to maximize shareholder wealth for a publicly held company (firms that have issues shares to the public).
• Private equity- deal with finance within organizations and financial dealings between businesses. Careers in Finance
• Financial manager of firm- making financing decisions (issuance of new stock & bonds) - Some—such as careers in corporate finance, investment banking, and private equity— deal with finance within organizations and financial dealings between businesses. Financial skills, though, are also needed in the analysis of assets, risk, and other investment opportunities, such as in the fields of real estate management, insurance, and personal financial planning.

Type Definition

- Lagging- change after the economy change. They indicate the changes and patterns in the economy over time. o Unemployment Rate o Consumer Price Index (CPI)- measures changes in the inflation rate. Examines the average prices of a basket of consumer good and services and the changes associated with the cost of living. - Coincident- collected, used, and analyzed as economic shifts happen. Provide information about the current state of the economy. o Gross Domestic product (GDP)- the monetary value of all the finished good an services produced within a country’s borders in a specific time-period. Therefore, when GDP increases, it is a sign that the economy is strong. o Personal Income- provides some insight into overall consumer spending in an economy and can be related to changes in overall consumption. When the economy is doing well, personal income generally increases, which leads to an increase in spending. Conflicts between Shareholders and Bondholders

• The shareholders prefer for the company to take riskier projects and to pay more dividends. The bondholders are more interested in strategies to increase the probability that they will get paid back. How To Resolve Ethical Conflicts 1. Identify and define the problem. 2. Consider alternative course of action 3. Identify what is moral, ethical, and legal of that situation. 4. Consider all stakeholders involved. 5. Consider alternative courses of action. 6. Move forward with the course of action you feel is ethical and best for the situation. Types of Financial Institution

1. Depository institution Financial institution that accepts monetary deposits and provides loans. Includes savings banks, commercial banks, savings and loan associations, and credit unions. Bankrate reports that the largest banks in America were JP Morgan Chase and Bank of America as of May 2019. a. Savings and loans association A type of depository institution also known as a “thrift” institution that places a significant focus on providing loans for residential mortgages and real estate. 2. Non-depository institution Financial institution that is not allowed to accept monetary deposits but may perform functions such as lending money or acting as an intermediary between savers and lenders. Examples include brokerage firms, investment firms, mutual funds, and hedge funds. a. Securities firm Financial institution that facilitates the investment and purchase of securities in financial markets. Common services include underwriting, trading of securities on secondary markets, and the general sale of securities. b. Investment firm Company that invests the capital of investors in financial securities. Examples include mutual funds and investment trusts. The company may also be involved in issuing securities. (See securities firm below). Financial Institution Role Central Bank Ensure that a nation’s economy remains healthy by controlling the amount of money circulating in the economy Banks and Credit Unions Receive deposits and extend loans to individuals and businesses Insurance Charge premiums to invest in bonds and stocks to pay claims Mutual Funds Offer investments and buy financial securities and instruments on behalf of investors Pension Funds Retirement funds contributed through companies to invest and provide retirement Investment Banks Offer various services such as underwriting, facilitating mergers, and trading financial securities on behalf of large institutions and companies. Provides individuals and firms access to financial markets. Private Equity Receive money from institutional investors and wealthy individuals to buy high-potential companies or troubled companies to improve and earn returns by selling them or going public Unit 3

• Interest rate- percentage of the principal that a lender charges a borrower for the use of assets.
• Cost of capital- Also known as Discount rate, the cost to a firm to use an investor’s capital

▪ As an example, assume that you earn a 5% nominal investment over a year, but at the same time, inflation increases 2%. Items you want to purchase at the end of the period now cost you 2% more than they did when you invested. ▪ Mathematically, the growth rate of purchasing power is

▪ Growth rate in Purchasing Power =

▪ Using the above example with the nominal rate of 5% and the inflation of 2%, the growth rate is calculated as follows:

▪ Growth rate in Purchasing Power =

▪ Even though you earned 5% interest, your real spending increase is only approximately 3% (5% – 2%). Thus, your purchasing power increases by only 3% instead of 5%. ▪ Inflation- the rise in the prices over time. ▪ Sources of inflation: o Increased demand for goods and services o Rising costs o Adaptive expectations- when prices of goods and services go up, employees expect and even demand higher wages to maintain their standard of living. Decomposing Interest Rate ▪ Rate = Risk-Free Rate + Risk Premium ▪ Risk free rate – an indicator and opportunity cost and describes the rate of return on an investment with no risk. ▪ Risk premium – the compensation for the amount of risk taken on by investors. Nominal Rate ▪ Nominal rate- the rate at which invested money grows for a certain period of time. Real Rate ▪ Real rate – same as the growth rate in purchasing power, even though the formula seems different. This is call the Fisher Effect, an economic theory created by the economist Irving Fisher.

o Real Rate = Nominal Rate – Inflation Rate

Time Value of Money ▪ Time value of money- the concept that today’s dollar is worth more than a dollar in the future. ▪ Compounding- finding a future value given a present value. ▪ Discounting- finding a present value given a future value. Annuities ▪ Annuity- a stream of cash flows of an equal amount paid every consecutive period. ▪ Ordinary annuity- series of equal payments made at the end of consecutive periods over a fixed length of time. ▪ Annuity due- paid at the beginning of consecutive periods. ▪ Perpetuity- a constant stream of identical cash flows that continues forever. Return

• Return: the gain or loss on an investment over some period of time.
• Holding period return: the return that an investor gets over the entire period during which he or she owns a financial security.
• Expected return: A hypothesized estimate of future prices or returns under different scenarios based on expectational data. Risk
• Standard deviation: A measure of dispersion of possible outcomes about the mean.
• Market Risk (Also known as systematic risk or nondiversifiable risk)
• Firm-specific risk (Also known as nonsystematic risk or idiosyncratic risk) Different Types of Risk
• Interest rate risk: the probability that changes in interest rates will impact the value of a bond. (Market risk)
• Default risk: the probability of a loss resulting from a borrower’s failure to repay a contractual obligation. Firm-specific risk and affects both the bonds and stocks of the firm. Firm-specific risk can be diversified. o Firm-specific risk is the risk associated with problems that companies may face because of lawsuits, labor problems, or management decisions, among other factors.
• Price risk: the potential for the decline in the price of a financial security or an asset relative to the market. Risk Management
• Risk reduction (also known as risk mitigation): a series of techniques that help reduce the amount of risk a person is exposed to by taking a particular action.

o If ratio is above 1, then the stock is undervalued. If it is less than 1, the stock is considered overvalued.

• Account receivable turnover (AR turnover): Ratios help to identify how quickly these accounts receivable turn over during a given year. o AR Turnover= Credit Sales/Account Recievable
• Average Collection Period (ACP): An activity ratio found by the number of days in a year (365) divided by AR turnover. o Average Collection Period= 365/AR Turnover o Inventory Turnover= COGS/Inventory o Total Asset Turnover= Sales/Total assets o Fixed asset turnover= Sales/Fixed Assets
• Operating income return on investment (OIROI) o OIROI= Operating Income/Total Assets Leverage: (also called financing ratios or solvency ratios ) consider how the firm is financed.
• Debt Ratio= Total Liabilities/Total Assets
• Debt-to-Equity Ratio= Total Liabilities/Total Owners’ Equity
• Times ineptest earned (TIE)= EBIT/Interest Expense Probability: can be based on either sales or asset investment. They are commonly used to directly judge how profitable the company is and how well management is doing as they strive to maximize owner wealth. Examine the cost efficiency of a firm’s production.
• Return on assets (ROA)= Net Income/Total Assets
• Return on equity (ROE)= Net Income/Owners’ Equity
• Gross Margin= Gross Profit/Sales
• Operating Margin= EBIT/Sales o Comparing the profitability of firms with different capital structures
• Net Margin= Net Income/Sales o Percentage of sales that will become net income, which is the amount remaining for the equity holders. Market: are used to evaluate the current share price of a public firm’s stock
• Market-to-Book Ratio= Market Value of Equity/Book Value of Equity o Ratio less than 1 is considered a value stock
• Price-to-Earnings= Price per Share/Earnings per Share DuPont Framework
• ROE = ROA x Leverage Multiplier

• A positive net profit margin that is higher than the industry’s indicates that the firm has a strong performance in its operations and ability to convert sales into profits for shareholders. Unit 5
• Cash budgets: A forecast of future events. Usually prepared for a shorter time horizon— generally between one month and one year. Used to estimate whether a company had sufficient amount of cash for regular operations. Three Major Uses of Cash Budgeting

1. Future Financing Needs
2. Corrective Action
3. Performance Evaluation Key Principles for Effective Budgeting
4. Know Yourself
5. Understand the Key Areas of Savings, Income, and Expenses
6. Develop Savings, Income, and Expense Strategies
7. Keep Records
8. Use a Method That Meets Your Needs and Objectives
9. Eliminate Consumer Debt and Minimize Long-Term Debt Creating a cash budget
10. Determine cash receipts
11. Estimate cash disbursements
12. Create the cash budget Application to Personal Finance
13. Understand your goals
14. Track your savings, income, and expenses
15. Develop a cash budget (plan_
16. Implement your plan
17. Compare the cash budget to your actual spending and make necessary changes Item in a Cash Budget
18. Cash Receipts: include cash sales and the collected portion of accounts receivable for businesses and include salary or wages for individuals.
19. Cash Disbursements: may be for suppliers of materials, interest, taxes, and so on for businesses. For individuals, cash disbursements come from day-to-day expenditures such as groceries, gas, and insurance.

• NPV is the sum of expected discounted future cash flows of a project.
• The highest NPV will bring the most value to the company.
• NPV tells you how much value would be added to a firm by doing a particular project.
• Advantages of NPV are that it considers all cash flows, takes the time value of money into account, and considers the risk of the project.
• Disadvantages of the NPV are that it may not always consider the whole picture when it is used to compare two different-sized or mutually exclusive projects and that it is difficult to estimate the cost of capital of a project. If DFN is negative, the firm will have enough financing to fund projected sales. Unit 6 NPV (Net Present Value): A method used when only 1 project can be chosen and investment costs are not widely different. Advantages Disadvantages 1. Considers time value of money 2. Calculates value added to the firm 3. Considers risk and required return 1. Requires calculation of appropriate cost of capital 2. Is not useful to compare projects of varying sizes Internal Rate of Return
  • Internal rate of return (IRR): Rate of return that a firm earns on its capital projects.
  • IRR makes the NPV of the project equal to zero. Advantages Disadvantages 1. Easy to interpret 2. Considers time value of money 3. Does not require use of required rate of return 1. is not a good indicator of the amount of value created, 2. ignores mutually exclusive projects,

1. Slow Sales Growth
2. Examine Capacity Constraints a) Fixed assets
3. Lower Dividend Payout
4. Increase Net Margin

Profitability Index The PI is the ratio of discounted benefits to discounted costs. Advantages Disadvantages

1. Considers the time value of money
2. Takes into account the risk of future cash flows through the cost of capital
3. Includes all future cash flows
4. Indicates whether an investment will create value for the company 1. requires calculation of cost of capital and 2. is not useful for mutually exclusive projects. Advantages Disadvantages
5. Interest payments are tax deductible
6. Does not dilute ownership
7. Lowest risk and rate
8. Requires repayment
9. Increases firm’s debt and equity ratio - Par or face value (aka maturity value)- the amount the investor will be paid when the bond matures. - Coupon rate (aka stated interest rate)- the amount of interest received each year Bonds

• Premium bond: Bond is selling above its par value
• Par bond: the bond’s price is exactly equal to its face value
• Discount bond: Bond is selling below its par value

3. assumes reinvestment at the IRR rate,
4. cannot be used to compare projects with different durations, and
5. requires conventional cash flows.