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Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
What is Finance all about?
Finance is about three things:

raising money

allocating it

controlling return on money invested
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Spreadsheets and Finance
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Course Overview
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Financial statements (1)
Revenues and Costs (nonfinancial) (2-3)
Net Working Capital Management (4)
Time Value of Money Concept (5)
Investment Decisions (6)
Responsibility centers and managerial accounting (7)
Financial ratios (8)
Business Financing (9)
Business Modelling and Forecasting (10)
Financial Disciplines (11)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Books & Evaluation Rules
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Books:
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Brealey Richard A., Myers Stewart C.: Principles of Corporate
Finance. McGraw-Hill, New York, 1996 (or any other edition, incl.
Polish version)
Shim Jae K., Siegel Joel G.: Vest Pocket CEO. Prentice Hall, New
York, 1992 (a very good Polish edition by ABC, 1999)
Atrill Peter, McLaney Eddie: Management Accounting for
Decision Makers. Prentice Hall, Harlow, 2007.
Evaluation:
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Written, in- class, closed books Exam, with 3 out of 4 topics to
be discussed
Near to all topics will require both calculations and assessment
of a problem challenged
After class assignments not graded at all but instrumental to
succeed on the final exam
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session One Topics

General concept of financial statements
Balance sheet
Accrual vs cash flow approach
Profit and Loss (Income) Statement
Cash Flow Statement

Brealey, Myers pp.
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Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Key financial questions
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How much does the business own (at present, in the
past, in near future)?
How much has the business earned (over a given period
of time)?
How much it will earn in future?
The above indicated are key financial questions for every
person but also enterprise, institution, government.
We will discuss almost exclusively non-financial businesses
although some concepts apply to other types, too.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Balance Sheet – key notions to
remember
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Assets: properties owned (now: or under control and
with entitlement to key benefits):
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Liabilities and equity:
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Long-term (with useful life over 1 year): laptop.
Current (with useful life up to 1 year): enrolment.
Tangible: laptop.
Intangible: enrolment right.
Long-term (due later than within 1 year): Father’s loan and, by
definition, equity.
Current (due within 1 year): instalments.
A Balance Sheet: a statement of properties and
sources financing them
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Reasons why assets and liabilities
have to be recorded separately

Even if we have a dual entry approach and transactions
are not divisible their results are:
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if granted a loan to purchase a specific equipment one cannot
use the proceedings for other purpose,
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however
when transaction is closed one has to repay a loan regardless
the machine purpose and, of no specific arrangements are
made, can do whatever it wishes with the equipment.
Both relations can be discontinued separately in a
different time and circumstances.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Accruals vs cash flow
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In private life we tend to equalize revenues with cash
inflows and costs with cash outflows, sometimes
recognizing special character of investments (eg. nobody
would treat creating a bank deposit as a cost albeit
identifying it as a cash outflow).
In the least complex business activity it is a handy
approach but:
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even in such cases carries certain risk,
it would be dangerous in case of complex businesses.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Reasons why not all costs are
represented by cash outflows (1)
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Long term assets will loose their value over time and
eventually become useless (except for ground plots and
some other specific items).
The above mentioned process may be long and involve
very valuable items (f.e. a car)
Consequently we need a mechanisms to allocate
expenses incurred to acquire them over pertain time.
We say, we „depreciate” them (amortise intangible
assets, deplete natural resources)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Reasons why not all costs are
represented by cash outflows (2)
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Commercial credit.
Concurrent services (eg. electricity, employment costs).
Deferred obligations and revenues (f.e. in construction
business).
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Two financial statement addressing
the issue of results
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Income (Profit and Loss) Statement
Cash Flow Statement
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Income Statement – key notions to
remember
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Revenues: Cash inflows or other enhancements of
assets (for example acceptance of services delivered)
Costs: use of assets attributable directly or indirectly to
the revenues recognised
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cash costs.
non-cash costs (DDA)
Income (gross): revenues – costs
Income tax(es): obligatory levies on income (but not
VAT, stamp duties, etc.)
Income (net): Income (gross) – taxes
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cash Flow Statement – key notions
to remember (1)
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Operational activities :
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receipts from the sale of goods or services,
payments to suppliers for goods and services,
payments to employees or on behalf of employees,
buying Merchandise
some otherwise typically financial items if strictly connected with
operational activities (eg. interests on delayed payments for
services).
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cash Flow Statement – key notions
to remember (2)
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Financial activities:
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dividends paid (with tax if applicable),
sale or repurchase of the company's stock,
net borrowings,
interests paid & other borrowing costs (incl. certain leasing
related payments),
repayment of debt principal, including capital leases.
Investing activities:
Payments resulting from purchase or sale of a long term asset
(assets can be land, building, equipment, marketable securities,
etc.)
 Payments related to mergers and acquisition.
 (Under certain regimes) loans made to suppliers or received
from customers
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
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2
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Two Topics
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Revenues
Management accounting
Relevant costs
Cost allocation under full absorption
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Financial vs Managerial
Accounting
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Financial Accounting:
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highly regulated
independent check of
statements
accuracy oriented
backward perspective
generally external use
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Managerial
Accounting
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company dependent
no direct independent
control
speed oriented
onward perspective
generally internal use
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Financial vs Managerial Accounting
FAQ
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Financial Accounting:
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what was the A’s
equity at the date of?
What was the profit
made over a period
of?
Was the Company
solvent at the closing
date?

Managerial
Accounting
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Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
shall we buy/sell a
business segment?
shall we launch a
new product line?
shall we
increase/decrease
prices?
is our cost level still
competitive?
Financial vs Managerial Accounting
relevant costs (items)
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Financial Accounting:
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only costs incurred
matter
almost no estimates
allowed
full absorption
approach
no scenario analyses
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Managerial
Accounting
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Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
only future costs
matter (sunk
costs!!!)
estimates widely
used
marginal costs
approach
scenario analysis and
hybrids (opportunity
costs)
A concept of revenue –
definition and traps
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Revenue defined as an increase in assets or decrease in
liabilities that is caused by the provision of services or
products to customers.
Under the accrual basis of accounting, revenue is
usually recognized when goods are shipped or
services delivered to the customer. Under the cash
basis of accounting, revenue is usually recognized when
cash is received from the customer following its
receipt of goods or services.
Revenue vs cash inflow
Revenue vs price (rebates, discounts other provisions)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
A concept of cost – definition
and use
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Cost defined 1 = monetary value of economic resources
used in performing an activity
Cost defined (measured) 2 = the amount of cash or cash
equivalents paid or the fair value of the other
consideration given to acquire an asset at the time of its
acquisition (IAS 16)
Cost vs expense (very close to the second definition of a cost)
Cost vs price (quantity of payment or compensation given by one
party to another in return for goods or services)

Cost vs investment (money committed or property acquired for
future income)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Typical costs items by origin
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Remuneration (salaries, wages, fringe benefits)
Raw materials
Energy
External services
Taxes and duties allocated to costs (real estates tax,
stamp duties but neither VAT nor excise tax
Depreciation, Depletion & Amortisation
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost absorption
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Cost of goods sold
General costs (period costs)
Logically there should be no costs left after allocation
(orphan costs) since ultimately every dollar spent has to
be covered
The problem is that share of direct costs (naturally
allocated) decreases while the one of general costs
growths rapidly and in some most advanced and
valuable businesses gets dominance
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost absorption
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Profit = Revenues – costs
Revenues (excl. bounded sales) are always direct and
objective
Costs must be fully allocated to products & services sold
Cost allocation is always to some extend subjective
According to various studies indirect costs account
between 30-42 % of the total costs (Laney, Atrill, p.
316)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Use of the full absorption
approach
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Long -term pricing
Long-term resource allocation
Financial accounting
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – types of costs
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Direct vs indirect costs
Direct vs variable costs
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raw material
wages
Indirect vs fixed costs
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office rent
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – targets
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Products (individual, group)
Business segments
Customers (individual, segments, markets)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Typical manufacturing
processes
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Job order
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order
batch
assembly
Process
process
(often with joint products issue)
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Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – job order
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Cost pools
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Overheads
For one-factory firm: typically two levels: factory shared services
+ supporting activities
For international corporations: multilayer structure
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – job order
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Cost drivers:
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Typically related to the time used
e.g. machine hours (production lines)
 e.g. employees’ working hours (services)
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A need for standardized (normative) costing: otherwise
forecasting ability non-existent
Process costing skipped as too complicated at this level
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – exercises
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
Atrill Activity 10.5
Atrill Exercise 10.6 (Homework)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – Critique of
conventional costing
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Not a tool to analyse overheads: a growing portion of
total costs
Inability to provide analytical background in responding
key strategic and operational questions:
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shall we enter a new market (say Ukraine)?
shall we keep servicing this very group of customers (say
students?)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
3
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Three Topics
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Fundaments of ABC costing
Applications of ABC costing
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – Rising share of
overheads
Netia (Telecom) Cost Structure'08 (K PLN)
19 568
Intercom settlements
Network rental and
maintenance
49 035
218 499
Commodities
233 405
Depreciation
8 781
294 225
Remunerations
Taxes and levies
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – A(ctivity)
B(ased) C(osting)
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Fundamental questions underlying ABC
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What activities are being performed?
What resources are used in these activities?
How much do these resources cost?
What really drives these costs (activity drivers)?
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
ABC vs. conventional costing –
cost drivers
Conventional costing
Number of machine
hours becomes:
ABC
Number of set ups
Number of shifts
Number of O&M
interventions
Number of working
hours per shift
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
ABC vs. conventional costing –
Example (1)
An inbound warehouse employs 12 people with the total cost (not limited
to labour cost) of 20 000 USD:
first stage cost driver = number of employees
receiving parts – requires 6 employees so cost is 10 000 USD;
second stage allocation basis is number of shipments of purchased parts
(250 per month)
receiving raw material – requires 3 employees so cost is 5 000 USD;
second stage allocation basis is number of shipments of raw materials (50
per month)
distributing material – requires 3 employees so cost is 5 000 USD;
second stage allocation basis is number of production runs (200 per
month)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
ABC vs. conventional costing –
Example (2)
Stage 2 Remove costs from activity cost pools and assign to products
using second stage cost drivers:
receiving purchased parts
10 000 USD/250 = 40 USD per shipment
receiving raw material
5 000 USD/50 = 100 USD per shipment
distributing material run
5 000 USD/200 =25 USD per run
For product A, the 100 produced require 200 purchased part shipments, 40
raw material shipments and 100 production runs. The direct labour
requirement is 2 000 hrs.
For product B, the 2 000 produced require 50 purchased part shipments,
10 raw material shipments and 100 production runs. The direct labour
requirement is 3 000 hrs.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
ABC vs. conventional costing –
Example (3)
If we use this information to compute conventional cost allocation, we see the
following results:
Warehouse (indirect) cost is 20 000 USD allocated to 5 000 hrs gives 4 USD/hr,
what translates into: for product A: 2000hr/100*4 USD = 80 USD/unit; for
product
B: 3000 hrs/2000*4USD = 6 USD/unit
If we use this information to compute the ABC cost based, we see the following
results:
A
Parts receipt
200 * 40 USD = 8 000 USD
Raw material receipt
40 * 100 USD = 4 000 USD
Distributing material
100 * 25 USD = 2 500 USD
14 500/100 = 145 USD per unit
B
Parts receipt
50 * 40 USD = 2 000 USD
Raw material receipt
10 * 100 USD = 1 000 USD
Distributing material
100 * 25 USD = 2 500 USD
5 500 USD/2000 = 2,75 USD per unit
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
ABC – sources of differences to
conventional costing
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Complexity (more operations – more costs) – an
example of newspapers attachments
Volume (large vs. small batches)
Size of products – an example of packaging line
Value of fixed assets used
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
ABC – advantages for services
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Minimal level of variable and small of direct costs
Focus on customers rather than on products
Products definition very complex, flexible and
customized
High operational gearing
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
ABC – advantages for services
This enabled managers to examine indirect cost in more detail.
For example, consider this example from an order processing department:
Using the traditional costing system, the question that managers would ask was:
Why was £74,000 spent on travel?
Using ABC, the new question is: Why was £35,000 spent on resolving problems?
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – Homework
Exercise 11-1 in Excell
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cost allocation – exercises
Buccaneers
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
4
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Four Topics
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Net Working capital
Current assets and liabilities
Balancing NWC management
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
(Net) Working Capital:
Introduction to

Revenues (accrual) not settled turn into accounts
receivables
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Supplies (of labour, raw materials) received but not
settled turn into accounts payable

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other accounts receivables are f.e. advances paid for supplies.
other accounts payable are f.e. advances received.
Raw materials, semi - products & products not sold turn
into stock.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Net Working Capital on a
balance sheet
Assets
Long term assets
Short term assets,
incl.:
Liabilities & SE
$ 10,000 Short term
liabilities, incl.:
$ 7,000 Accounts payables
Accounts receivables
$ 3,000 Overdraft
Inventory
$ 3,000 Long term
liabilities
Short term notes
$ 1,000 Shareholders’
Equity
$ 17,000
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
$ 3,000
$ 2,000
$ 1,000
$ 10,000
$ 4,000
$ 17,000
NWC ratios
Cost of Goods
Sold (COGS):
(merchandise)
$ 9,000
Accounts receivables
collection period:
3,000/20,000 *365 = 55 days
Overheards
$ 9,000

Gross profit
$ 2,000
3,000/9,000 *365 = 122 days
P & L for the 200x
Revenues
Tax (paid)

$ 20,000
$ 500
Net profit: $ 1,500
Stock conversion holding
Accounts payables
settlement period
2,000/18,000 *365 = 40 days

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Cash Conversion Cycle

Cash cycle
receivables’ collection period
+
stock holding period
payables’ settlement period
=
cash conversion period

For the example used:
55 + 122 – 40 = 137 days
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
NWC ratios calculations - tips
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Accounts receivables collection period is always
calculated against revenues. However some of short
term receivables themselves may not result from sales.
Stock holding period can be calculated either in relation
to COGS (for trading businesses) or to revenues (for
manufacturing companies)
Accounts payables are calculated in relation to cash
costs (DDD excluded)
Simplification are often used and allowed if applied
consistently.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
(Net) Working Capital

Short - term assets vs Working Capital


capital which costs (interests bearing liabilities)
liquidity approach - confusion

Exxon vs Metro (MS Excell Spreadsheet)

Net assets vs Short-term assets
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Balance Sheet basic analysis
(Net) Working Capital


Industry and business position context critical while
analysing
Exxon vs Metro (MS Excell Spreadsheet)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
5
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Five Topics
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Introducing time concept
Discounting money streams
Key problems with proper discounting
Brealey, Myers: the chapter titled: “Present Value … “
(pp. 11-56)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Time Value of Money


1 USD today does not equal 1 USD tomorrow!
FV = PV * (1+r)n where:



r represents a return
n represents number of periods (quite often years)
PV = FV/ (1+r)n
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Theoretical fundaments of relation between
time and value




Risk of a return different from the planned one (Mind you: also
bigger !!!)
Liquidity: investor converts cash, which is the most universal value
transponder into less liquid assets (Opportunity Cost of Capital),
Purchasing Power: universal (inflation, see Brealey, Myers, pp.
642-645), individual (ultimate goal in investing)
Intrinsic value of money (per se):– J.M. Keynes’ theory.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Capitalisation
FVt  CF0  (1  rt )

FVt – Future Value of a given sum
CF0 – present value of a given sum
rt – interest rate in period t (most often annual)
t – capitalisation period

Brealey, Myers pp. 11-56



Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
t
Capitalisation rate


The most common way of expressing a capitalisation rate is an
annual one, marked with r letter without index t
However quite often a real capitalisation period is different –
interests are added to a capital after each month, quarter or so.
Then the previously mentioned equitation is converted into:
FVt
r tn
 CF0  (1 
)
n
Capitalisation rate
Present Value
Capitalisation period A
Value after 1 year A
Capitalisation period B
Value after 1 year B
10%
1 000,00
12
months
1 100,00
1
month
1 104,71
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Key equations
PV 
CFn
(1  r ) n
(1)
where:
CFn
R
n
–
–
–
Year n cash flow,
discount rate.
Subsequent year
It is useful to convert a discount rate into a discount factor:
dn 
1
(1  r ) n
(2)
And then calculate Present Value as:
PV  CFn  d n
(3)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Various approaches to set an interest
(discount) rate

There is a huge variety of theories and models covering the issue. The list
below indicates a subjective selection of most commonly used ones:









Alternative capital cost
Risk-free alternative
Debt cost
WACC
Historical rate of return
Risk Adjusted Discount Rate (RADR)
Hurdle rate
Social rate of return
Discount rate quite often is presented as:
risk-free rate + risk adjustment
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Concept of risk


Financial and insurance meaning of risk
Individual attitudes towards risk:



averse,
neutral,
Seeker.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Risk – coin tossing game (1)

Game A:
Head + head = 40 % gain
 Head + tail = 10 % gain
 Tail + head = 10 % gain
 Tail + tail = 20 % lose
Expected return = 0,4*0,25+0,1*0,25+0,1*0,25-0,2*0,25 = 10%


Game B:
Head + head = 70 % gain
 Head + tail = 10 % gain
 Tail + head = 10 % gain
 Tail + tail = 50 % lose
Expected return = 0,7*0,25+0,1*0,25+0,1*0,25-0,5*0,25 = 10%

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Risk – coin tossing game (2)

Game A:
Return
Deviation
Squared
deviation
Probability
P * SD
+ 40
+ 30
900
0,25
225
+ 10
0
0
0,50
0
- 20
-30
900
0,25
225
Variance = 450 - Sq. Dev. = 21

Game B:
Return
Deviation
Squared
deviation
Probability
P * SD
+ 70
+ 60
3600
0,25
900
+ 10
0
0
0,50
0
- 50
-60
3600
0,25
900
Variance = 1800 - Sq. Dev. = 42
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Present Value as dependence on a discount
rate
Discount rate
8%
10%
Discounting Period
12%
15%
20%
Value in k USD
PV,25 yrs
747
635
549
452
346
PV,238 yrs
875
700
583
467
350
PV, infinity
875
700
583
467
350
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Homework


If the PV of 150 USD to be paid in one year is 130 USD,
what is a discount rate? (Brealey, Myers, Chapter 2, Q
2)
You have come to a bank in order to make 1000 PLN
deposit for 5 years, with 7% interest and half-year
capitalisation (period). An financial advisor has stepped
in with an offer of shares which over last 5 years period
brought 40 % return. What would be your decision?
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
6
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Six Topics






Investment vs Capital Budgeting Decisions
I(nternal) R(ate of) Return
NPV
PI
Payback (discounted)
Brealey, Myers: Chapter titled “Why Net Present Value
Leads to Better Investment Decisions …” (pp. 85-112)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Investment vs. Capital
Budgeting Decisions



Investment = money committed or property
acquired for future income
Capital budgeting is planning capital outlays for
purchasing new fixed assets to get additional
profit thus it means planning investments
Intra-corporate investment process is usually
much more complicated ro evaluate than
financial investments (share, bonds) since cash
flows are not easily defined
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Examples of Capital Budgeting
Decisions


Equipment selection decision.
Plant expansion aimed at:




increase in sales;
backward integration.
Equipment replacement decision caused by
aging machine park.
New equipment purchase aimed at cost
reduction.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Commonly used measures of
investment efficiency





Payback (straight)
I(nternal) R(ate of) Return
NPV
PI
Payback (discounted)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Payback (period)


The payback period estimates the time required
to recover the principal amount of an
investment.
It is often defined as a length of time needed for
an investment's net cash receipts to cover
completely the initial outlay expended in
acquiring the investment
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Payback (example)

A&B Enterprises is trying to select the best investment from among
three alternatives. Each alternative involves an initial investment of
$100,000. Their cash flows follow:
Year
A
B
C
1
$ 10,000
$ 50,000
$ 25,000
2
$ 20,000
$ 40,000
$ 25,000
3
$ 30,000
$ 30,000
$ 25,000
4
$ 40,000
-
$ 25,000
5
$ 50,000
-
$ 25,000
Which investment will you select using the payback method? Why?
(Brealey, Myers)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Payback – key issues

What is an investment?




Capital expenditure
Increase in NWC
Other
How one defines a pay back itself?


Net profit
Net cash flow
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Payback - limitations

The payback period method ignores:


any benefits that occur after the investment is repaid
the time value of money
risk-free cost of money
 risk


Therefore payback period:
is useless for ranking purposes
 can be used only in relation to near certain flows

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
IRR




IRR vs Yield to Maturity
IRR algorithm
IRR use
Disadvantages of IRR
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
IRR - definitions

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
NPV and IRR

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
NPV

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
IRR vs NPV

IRR:




can be calculated only if a cash flow break even only once –
which is typical for many simple investments;
is directly comparable to benchmarks like interests on deposits;
can be used as a ranking tool but with attention to various traps
(see Brealey, Myers, pp. 94-101.
NPV



in practice it is calculated to get IRR;
it can be applied to streams not to be assessed using IRR;
it can not be used as a ranking tool (unless all investments are
equal)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
PI (Profitability Index)

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Discounted Payback (Period)



The discounted payback period estimates the time
required to recover the principal amount of an
investment but applying discounting.
It is often defined as a length of time needed for an
investment's net cash receipts to cover completely the
initial outlay expended in acquiring the investment with
consideration of time value of money concept.
It is quite often used as an indicator of a risk level
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Homework

An owner of a successful retail business of a traditional handmade
wool clothes in Krynica considers opening a new outlet in Warsaw.
There are two options as far as location is concerned and they can
be characterised as stated below in terms of key economic
parameters. Please select the most efficient one using measures
presented before. Apply 15 % discount/hurdle rate when needed.
Location
(PLN)
Cost/
month
Monthly
turnover
Mark up
Days in
stock
Days
payable
Initial
investm
ent
Premium
10 000
50 000
50 %
30
60
90 000
6 000
35 000
30 %
45
60
30 000
Subarbian
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
7
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Seven Topics




Responsibility Centers
Fundamental Income Statement analysis
Budgeting and control tools and processes
Other performance measurement concepts
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Responsibility centres

Cost centres
cost only
Revenue centres
 revenues (usually combined with some costs)
Profit centres
 revenues and costs but no capital expenditures




Investment centres


all three: rev., costs, and CAPEX
measured by ROI, NPV, EVA(Residual Income)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
CVP analysis

Cost structures - variability:



fixed costs
variable costs
other types:
semi variable
 stepped costs

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
B(reak) E(ven) P(oint) analysis

BEP formula
Fixed cos ts
BEP  Volume 
Sales / unit  Variable cos ts / unit


BEP as a measure of companies’ risk exposure
Variable costing (USA) vs. marginal costing (UK)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
BEP concept
Company B, likely: metal
industry, mining
120 000
100 000
80 000
60 000
120 000
40 000
100 000
20 000
80 000
-20 000
60 000
2 000
1 500
1 000
500
-40 000
40 000
-60 000
20 000
Sales revenues
Total costs
EBIT
2 000
1 500
1 000
500
-20 000
Sales revenues
Total costs
EBIT
Company A, likely: FMCG
retail
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Contribution concept


Contribution = Revenues - Variable costs
Contribution – ways of presenting:


Value/unit or per tone
% of sales revenues
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
BEP and pricing decisions




Full absorption vs variable costing
Pressure on price
Allocation of fixed costs
Opportunity costs – limited resources issue – fixed costs
as representation of limited resources
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Pricing – most widely used
methods


Cost + method
Mark-up vs Margin
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Variance analysis in the control
process

Volume and price variance
Budgeted amount =
budgeted price * budgeted quantity
 Actual amount =
actual price * actual quantity



Variances’ tree
Atrill Example 13.1
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Variance analysis in the control
process – practical issues

Huge number of calculations:




1500 products* 3-4 major costs
components*time frame
Delay in time – actual data available when
decisions are taken
Dynamic environment
Benchmarking issue
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Value creation measures

ROCE



Return = Net profit
Capital Employed = Equity + Debt = Net Working Capital +
Fixed Assets
EVA (RI)


EVA = Net profit - Capital Charge
Capital Charge = CE * cost of capital
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Investment measures


Hurdle rate as a cut-off point
Shell to find 4 billions USD as ‘lazy assets’ underperforming with ROCE less than 13-15%
(FT.com., 22 December 2003)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Budgeting and Control



Budget as the key tool in any controlling process
Budget vs plan
Levels of budgeting:



strategic
operational
managerial
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Budgeting - purpose + general
remarks




Resource allocation
Congruence with strategy
Master budget vs. operating budgets
Monetary budgeting vs budgeting in natural units
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Budgeting - typical structure

Revenues
Variable costs
 Fixed costs
= OPEX



Other Investment costs
Capital Expenditures (CAPEX)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Balance Scorecard as a nonfinancial performance measure




Customer Perspective
Business Processes Perspective
Organisational learning (Development)
Perspective
Financial Perspective (RI)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Budgeting - typical processes

Top -down (authoritarian)

Bottom up



participation
consultation
Role of K(ey) P(erformance) I(ndicators)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Budgeting – KPI of Netia
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
8
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Eight Topics







Introducing ratio analysis
Short-term solvency (liquidity)
Long-term solvency
Working Capital Ratios (see Session Four)
Financial efficiency
Using ratio analysis
Brealey, Myers: Chapter “Analyzing Financial
Performance” (pp. 765 -773)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Liquidity ratios

Current ratio:

current assets/current liabilities
mind you: in this case (as oppose to NWC) a short
term debt is included
Quick ratio (ACID - test)



Cash + short term securities + receivables/ current liabilities:

mind you: sometimes it is said that the only
difference lays in not including inventories – in
many cases it’s true but often misleading
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Solvency ratios

Gearing (debt/equity) ratio:

Debt, including leases /equity
mind you: various authors exclude short-term debt
(Brealey, Myers including) – in US practice it is
reasonable but in many cases short term debt is
very important
Interests coverage



EBIT (Earnings Before Interest and Taxes)/ interests & other
debt related costs:

mind you: banks charge provisions and other
which are not disclosed as interests but other
financial costs – on the otehr side financial costs
may include net results on currency rates
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Financial Efficiency Ratios

Gross Margin:

EBIT (if possible before overheads)/revenues
mind you: sometimes quite difficult to be
established directly from P&L
Return on assets




EBIT/ total assets
Return on equity

Net profit/ equity
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Financial efficiency



The second DuPont formula
ROE = Net profit/Equity (average)
ROA = (EBIT – Tax)/Total Assets (average)
Therefore:
ROE=ROA*(Total assets/equity)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
DuPont Formula
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Comprehensive Financial Ratio
Analyses
Ratios:
Sources:
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
9
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Nine Topics





Business financing overview
Debt financing – financial markets
Debt financing – banks
Equity
Other sources of financing
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Balance Sheet basic analysis
Sources of finance

Structuring criteria:





duration
form of remuneration
providing entity
legal form
Long term vs short term
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Balance Sheet basic analysis
Sources of finance

Remuneration:



(Accounts) payables ---> cost included in price/cost of the
original item
Loans (and overdrafts, receivables discounting), debentures
(bonds), leases
--- > interests
Equity ----> profit (dividends + growth)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Balance Sheet basic analysis
Sources of finance

Providing entity:

Shareholders
stock
 preferred stock
 subordinated loans


Financial institutions (mainly banks)
loans
 overdraft
 trade receivables discounting


Special category: Bonds
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Financial markets
Bonds, especially quoted on regulated financial markets:





Accessible for renowned companies or investors
Issued with different maturities (short-term are named notes)
Usually very liquid
Common in US and UK but gaining importance elsewhere
Other forms:



Private placement
Preferred stock
Financial markets usually do not seek high interests but
insist on security (exception: junk bonds)


Brealey, Myers pp. 640-62
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Maturity & Yield to Maturity


Maturity is a period for which a loan (or other form of financing is
granted)
Yield to maturity is nothing else but a rate of interest paid (price,
cost) for obtaining a financing
PVt
CFn

tn
(1  y )
Z- Bond value at maturity
Present Value
Time to maturity (years)
Yield
100,00
92,00
1
8,7%
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Z – bond:
a zero coupon
bond = does
not pay interest
Yield to Maturity with interest paying bonds

When an interest (coupon) is to be paid the yield has to be
calculated as both coupons and a principal are actually equal to
zero-coupon bonds – different payments
Principal
1st Coupon
2nd Coupon
CF
Yield (1st method)
Yield (2nd method)
2010-01-01 2010-06-30 2010-12-31
100
100
5
5
100
5
105
10,25%
10,25% /*
* -The second method is valid on the following two conditions: (1)
purchasing price = principal (2) all coupons are equal
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Banks
Asset based financing:



Leasing (based on fixed assets)
Factoring (based on receivables)
Other forms:



Credit notes
Loans
Banks usually do not seek high interests but try to
reinforce sales of other services


Brealey, Myers pp. 640-62
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Equity




Financing provided by owners (although owners may
also use debt financing but always additionally):
Residual value of all assets remaining after satisfying all
liabilities (including debt paid back to owners)
The most risky and volatile form of financing
Essential for business existence
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Equity vs Debt Financing (1)
Miller-Modigliani Preposition I:



A firm cannot change it’s value through changing a financial
structure thus investment decision have to be taken disregarding
financing methods
There are no taxes & financial markets are perfect
Miller-Modigliani Preposition II:





Expected yield on shares rises as share of debt-financing
increase
Tax credit favours debt
Increasing debt drives risk up
Brealey, Myers pp. 450-457
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Equity vs Debt Financing (2)
Scenario
0
Debt
Equity
1
1 000
1 000
2
1 000
1 000
0
1 000
1 000
EBIT
300
(Earnings Before Interests & Taxes)
Interests rate
10%
Interests
100
-
600
75
10%
100
-
10%
100
Gross Profit
500
Tax rate
Tax
Net profit
Return
200
-
20%
40
160
16%
-
20%
100
400
40%
20%
-
-
25
-2%
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
2
2 000
2 000
300
600
10%
25
-
1
2 000
75
10%
10%
-
-
300
600
75
20%
120
-
20%
15
480
60
20%
60
240
12%
-
24%
3%
Homework
Calculate:
a) yield to maturity on 7 percent, 8-year bond selling at
74,5;
b) price of 7 percent, 9-year bond yielding 10 percent;
c) price of 8 percent, 12-year bond yielding 14 percent;
(Brealey, Myers, Chapter 23, Q 4, use either Table 23-1 or
a spreadsheet)

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
10
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Session Ten Topics




Creating a Financial Model
Forecasting
Interpretations and application of financial modelling
Brealey, Myers: Chapter “Approaches to Financial
Planning” (pp. 794 -809)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Fundaments of Financial
Planning





There is nothing like precise financial planning. If your
actuals match exactly the financial plan it means only
that one column in excel has been mistakenly copied.
Any financial plan in fact reflects authors’ understanding
of the business in consideration but helps substantially
to deepen it.
Consistency is more important that results obtained.
Financial planning shall not start with numbers but end
with them.
All three statements has to be completed: P&L, BS and
CF.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Basis of financial modelling



Existing businesses usually start from past statements.
New businesses typically start with crunching revenues.
Good planners start with goods/services volumes
expressed as KPIs:


Say, in case of a restaurant one should start rather with number
of lunches and dinners served than with sales value.
Some key assumptions have to be defined upfront and
followed consistently:
 primary currency,
 inflation,
 time frame and structure.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Creating a Financial Model (1)


There are many financial models available on shelf. They
offer many useful functions form consistently check up
to very advanced iconography. It is nothing wrong with
using them however they will not understand the
business instead of managers.
My advice: first develop the model yourself from scratch.



this will check your business understanding,
allows you to focus on important issues (many models are in
practice full of “zeros” since aiming at wide audience they have
to incorporate many rarely used items,
will really help you run a business.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Creating a Financial Model (2)






Use plain Excell Sheet (or similar software)
In case of continuing business follow the sequence: the
coming period P & L, BS and then CF – while completed
go to next periods.
In case of start ups start with the forecast of the first full
capacity year (P&L and BS only), then make previous
years P&Ls and BSs and finally close CFs.
Define revenues in volume terms using KPIs.
Remember VAT issue.
Use ABC costing widely & wisely.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
VAT issue




In principle VAT, Value Added Tax, is imposed on final
consumers. All other entities paying VAT in procurement of goods
and services can deduct the amount paid from VAT imposed on
their customers. In ideal world enterprises shall not be bothered
with it.
Based on this principle ISAB requests VAT exclusion from P&L.
Technically VAT works like a sales tax but with a profoundly
complicated calculation process. Enterprises are ultimately
responsible and financially liable for it’s collection and payment to a
proper tax office.
Therefore if you grant all customers 30 days payment period with
flat sales instead of 30 days ARCP expect longer (36 days if 20 %
VAT is applied). The same rule refers to APSP.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Financial Models in Big
Corporations

Complexity issue:





no of responsibility centers can exceed 1 000 easily,
no of currencies involved can reach 100 with no dominant one
(say USD, EUR and Chinese Remnibi could weight substantially
enough not to allow for simplifications),
no of business lines can exceed 1,000 with more than 5 really
important ones,
no of substantially different accounting regulations might be
applied on local level forcing numerous translations and
corrections.
MNCs usually develop their own financial planning
models (often with support of service providers) and
stick to them for long times.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Forecasting


Forecasting is in fact not a part of Finance. One applies
model/methodologies relevant for forecasting areas.
Focus on a few key items, crucial for the business,
typically:




1-2 shaping revenues;
variable costs per unit;
1-2 shaping fixed costs.
and elaborate on them extensively and carefully.
Use benchmarks or official sources or seek for external
solutions in other areas: say, ask tax expert to calculate
taxes.
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
11
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Finance vs Accounting

Financial Accounting




Tax Accounting






driven by state regulations;
strictly regulated.
Managerial Accounting


historically the first to described and normalized officially;
oriented towards stakeholders not directly involved into operations;
primary data source for all mentioned below.
oriented towards managers and other people directly involved into operations;
based on certain standards but not regulated.
Corporate Finance
Banking & Financial Markets
Insurance
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Exercise

An owner of a successful retail business of a traditional handmade
wool clothes in Krynica considers buying the house he runs his
business in. The landlord expects an offer around 500,000 PLN. At
present the monthly rent is 1,000 PLN and does not include any
maintenance. On the upper floor there is an apartment rented for
800 PLN/month net. Since there is a high risk of cancellation of rent
in case a third party buys in the owner identified another location to
be rented for 800 PLN, though slightly less attractive.
Location
(PLN)
Cost/
Month
(excl.
rent)
Monthly
turnover
Mark up
Days in
stock
Days
payable
Present
4 000
30 000
30 %
15
60
0
New
3 500
25 000
30 %
15
60
20 000
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Initial
investm
ent
Additional exercises (1)


You have been offered 2 years bonds: zero coupon, 100
GBP nominal value, for 91 GBP
Now a bank pays you 4,5 % on a semi-annual deposit.
What is your decision?
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Additional exercises (2)







You have considered investing up to 2 million PLN somewhere (your
bank offers you 6 % per annum)
Since You owned a plot nearby the city centre one obvious idea was
to construct an office building.
A property agent contacted has a client willing to pay 2,5 millions
for the building desired providing it becomes available in 2 years.
The agent also pointed out that he would be willing to buy this plot
onto his own account for 400 thousands PLN
The agent provision is 4 %
Your colleague, running a construction company offered to
construct this building on a turn-key basis for 1 500 thousands,
and expects his consideration in three equal instalments (500
thousands each)
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego
Additional exercises (3)
Comapany X has budgeted the following for the coming month:
Production
Product A
Product B
5000 units
15000 units
Direct material
Product A
Product B
25 GBP/unit
5 GBP/unit
Product A
Product B
4 hrs/unit
2 hrs/unit
Direct labour
rate
10 GBP/unit
Overheads
Total no of activities
Product
A
B
Total
750 000
Machine set-ups
Quality inspections
Production orders
115 000
320 000
90 000
GBP
GBP
GBP
5 000
8 000
900
3 000
5 000
300
2 000
3 000
600
Machine hours worked
Material receipts
175 000
50 000
GBP
GBP
25 000
5
5 000
2
20 000
3
Prepare conventional based and ABC based cost forecast for product A and B
Robert Uberman, Financial Management, KA im Frycza Modrzewskiego