Download Chapter 1, Heizer/Render, 5th edition

Financial Decision Making
Dr. Haluk AYGÜNEŞ
Department of Industrial Engineering
OUTLINE
1. Decision Making Process
2. Financial Decision Making
3. Engineering Economy
4. Time Value of Money
5. Interest Rates
6. Cash Flows
7. Engineering Economy Factors
8. Evaluation and Selection of Alternatives
1-2
Decision Making
Process
1-3
Decision Making Process
1.
2.
3.
4.
5.
Understand the problem – define objectives
Collect relevant information
Define the set of feasible alternatives
Identify the criteria for decision making
Evaluate the alternatives and apply
sensitivity analysis
6. Select the “best” alternative
7. Implement the alternative and monitor
results
1-4
Decision Making Process
 Level of complexity
 Simple decision problems
 consequences are not important
 usually made intuitively
(e.g. The decision whether to walk up stairs or to take the
elevator)
 Complex decision problems
 have important consequences
 require some analysis
(e.g. Buying a new automobile, making an investment etc.)
1-5
Decision Making Process
 Level of uncertainty
 Decision making under certainty
 deterministic models
 Decision making under uncertainty
 probabilistic models
1-6
Decision Making Process
 Decision
 Allocation of resources to the activities with the
purpose of achieving an objective.
 Decision Maker
 Anyone with the authority to allocate the necesary
resources for the decision being made.
 individuals
 companies
1-7
Decision Making Process
 Alternatives
 Different ways of action among which the decision
maker makes a choice.
 Decision Criteria (Maximization / Minimization)
 Maximum utility
 Maximum profit
 Minimum cost
 Minimum time spent, ...
1-8
Financial
Decision Making
1-9
Value Chain
 Value chain: Sequence of business functions in
which usefulness is added to the products or services
of an organization.
 Value
as the usefulness of the product or service is
increased, so is its value to the customer.
1-10
Value Chain
Management accountants provide decision
support for managers in the following six
business functions (value chain)
Research &
Development
Design
Production
Management Accounting
Marketing
Distribution
1-11
Customer
Service
Value Chain
 Research & Development: process of generating
and experimenting with ideas related to new
products, services, or processes.
 Design: detailed planning and engineering of
products, services, or processes.
 Production: acquisition, coordination, and
assembly of resources to produce a product or
deliver a service.
1-12
Value Chain
 Marketing: the manner by which companies
promote and sell their products or services to
customers.
 Distribution: delivery of products or services to the
customer.
 Customer Service: after-sale support activities
provided to customers.
1-13
Key Success Factors
factors that affect the economic viability of the
organization
 Cost: … how to reduce costs?
 Quality: customers expect higher levels of quality.
 Time: meet promised delivery dates more reliably.
 Innovation: a continuing flow of innovative products
or services is a prerequisite to the ongoing success.
1-14
Role of Accounting
 Accounting: system of recording, classifying,
analyzing and reporting financial transactions.
 Types of accounting
 Cost Accounting
 Management accounting
 Financial accounting
 Cost Accounting provides information for
management accounting and financial accounting.
1-15
Role of Accounting
Management
Accounting
Financial
Accounting
Purpose
Help managers to
make decisions (to
fulfill organization’s
goal)
Communicate
organization’s financial
position to outside
parties
Users
Managers of the
organization
External users
(investors, banks,
suppliers, …)
Focus and
Future oriented
emphasis
Past oriented
1-16
Financial Statements
 Income Statement
 Prepared for a period (for a month, year, etc.)
 Shows
 Revenue (increase in capital arising from sales of products or services)
 Expenses (decrease in capital {e.g. rent expense, salary expense})
 Net income (Revenue – Expenses)
for a period of time.
 Balance Sheet
 Prepared at the end of the period (at the end of the year, etc.)
 Shows the balances of
 Assets (cash, receivables, building, equipment, …)
 Liabilities (payables {taxes, interest, …})
 Capital (Assets – Liabilities)
at the end of the reporting period.
1-17
Cost, Revenue, Net Income
 Cost: a resource (material, labor, time, money, …)
sacrificed or forgone to achieve a specific objective
Cost (of a product) = Direct Cost + Indirect Cost
Direct Costs
- Direct material (e.g. paper)
- Direct Labor
PRODUCT
Example: newspaper
Indirect Costs
(rent cost for the building,
insurance cost, …)
1-18
Cost, Revenue, Net Income
 Revenue: income that a company receives from its
normal business activities, usually from the sale of
goods and services to customers
Revenue = (Selling price per product) x
(Number of products sold)
Operating Income = Total revenues – Total Costs
Net Income = Operating Income – Income Taxes
1-19
Financial Decision Making
 The framework
1. Characterizing different financial decision
problems
2. Identification and description of the alternatives
3. Determining the outcomes of the alternatives
4. Evaluation of the alternatives in relation to the
preferences of the decision-maker
1-20
Financial Decision Making
The three fundamental concepts
Time Value of
Money
economic value of
- projects
- investments
- business organizations
Cash Flows
1-21
Risk-Return
Relationship
Engineering
Economy
1-22
Engineering Economy
 Involves
 formulating,
 estimating, and
 evaluating economic outcomes.
 Engineering economy is a collection of
mathematical techniques that simplify
economic comparison
 Engineering economy is at the heart of
making decisions
1-23
Engineering Economy
 Engineers
 perform analysis
 synthesize
 come to a conclusion
as they work on projects of all sizes.
 Engineering Economy provides a framework
for modeling problems involving:
 Time
 Money
 Interest rates
1-24
Why Engineering Economy is
Important to Engineers
 Engineers “design” and create
 Designing involves economic decisions
 Engineers must be able to incorporate
economic analysis into their creative efforts
 Often engineers must select and execute from
multiple alternatives
1-25
Time Value of
Money
1-26
Time Value of Money
 Money possesses a “time value”
 The “time value” of money is the most
important concept in engineering economy
 “Time value” computations are the most
powerful tools for making financial and
business decisions
1-27
Time Value of Money
Time
Time
value of
money
Interest Rates
Cash Flows
1-28
Time Value of Money
 The four fundamental time value of money
calculations




Future Value (of a single amount)
Present Value (of a single amount)
Future Value of an Annuity (equal annual amounts)
Present Value of an Annuity (equal annual amounts)
 They provide the basis for most of the investment
and financial management calculations
 Complicated financial problems can be broken down into
parts and can be addressed with these four problems.
1-29
Interest Rate
1-30
Interest Rate
 Interest: the manifestation of the time value of money
 Rental fee that one pays to use someone else’s money
 Difference between an ending amount of money and a
beginning amount of money
 Interest rate (%) 
interest accumulate d per unit time
x100%
original amount
1-31
Interest Rate
 Example
– if you borrow 2000 TL now, and
– you will repay 2300 TL one year later
interest accumulated per unit time
 Interest rate (%) 
x100%
original amount
300

x100%
2000
 15%
1-32
Simple and Compound Interest
 Simple Interest:
 Interest = (original amount)(number of periods)(interest rate)
 Compound Interest:
 Interest earns interest on interest
 Compounds over time
 Interest = (original amount + all accrued interest) (interest rate)
1-33
Simple and Compound Interest
 Example
– Interest rate: 10% per year (i=10% or 0.10)
– You borrow 2000 TL now (P=2000)
– What will be the interest two years later? (n=2)
 Simple interest
Interest = (original amount)(number of periods)(interest rate)
=P*n*i
= 2000 * 2 * 0.10 = 400 TL
Total due = 2000 + 400 = 2400 TL
 Compound interest
Year 1 Interest = P * i = 2000 * 0.10 = 200 TL
Year 2 Interest = [P + {P * i}] * i = [2000 + 200] * 0.10 = 220 TL
Total interest = 200 + 220 = 420 TL
Total due = 2000 + 420 = 2420 TL
1-34
Equivalence
100 centimeters = 1 meter
1000 kilograms = 1 ton
 What is economic equivalence?
Time value of
money
Interest Rate
Economic equivalence
1-35
Equivalence
Different amounts of money at different times may
be equal in economic value
1-36
Equivalence
106 TL one
year from now
0
Interest rate = 6% per year
1
100 TL now
* If 100 TL is invested at the interest rate of 6% per year,
then
100 TL now is said to be equivalent to 106 TL one year from now.
* That is, if you are offered 100 TL today or 106 TL one year
from today, it would make no difference which offer you
accepted.
1-37
Cash Flows
1-38
Cash Flows
 Definition of terms
 Cash Inflows - amount of money flowing into the firm
 Cash Outflows - amount of money flowing out of the
firm
 Net Cash Flow (NCF)
 NCF = cash inflows – cash outflows
 End of period assumption
 Cash flows occur at the end of a given (interest) period
1-39
Cash Flows
 Cash Flow Diagram
(Cash flows are shown as directed arrows )
1. Draw a time line
0
1
2
… … …
n-1
n
One time period
2. Show the cash flows
0
1
2
(
(+) positive flows
… … …
1-40
(-) negative flows
n-1
n
)
Engineering
Economy Factors
1-41
Factors
(Engineering Economy Factors)
 Reflect how time and interest rate affect money
 Help in determining economic equivalence of various cash
flow patterns
Notation
 P = present amount of money at time t = 0
(t represents time)
 F = future amount of money at a time later than t = 0
 A = a series of equal cash flows
 n = the number of interest periods
 i = the interest rate per time period, in percent (i%)
1-42
Factors
 Standard Notation
(X/Y, i, n)
X : unknown (what is sought)
Y : known (what is given)
i : interest rate
n : number of periods
 Determining factors (three methods)
 Formulas
 Interest tables
 Computer (Excel)
1-43
Basic Factors
 F/P Factor - to find F given P
Fn=?
………….
n
Compound forward in time
P0
In general:
F = P(1+i)n
F = P(F/P,i%,n)
1-44
Basic Factors
 Example (F/P Factor - to find F given P)
 P= 1,000 TL; n=3; i=10%
 What is the future value, F?
0
1
2
F=?
3
i=10%/year
P= 1,000 TL
Using formula;
F3 = P(1+i)n = 1,000(1+0.10)3 = 1,000(1.331) = 1,331 TL
Reading factor value from interest table;
F3 = P(F/P,i,n) = 1,000(F/P,10%, 3) = 1,000(1.3310) = 1,331 TL
1-45
Basic Factors
 P/F Factor - to find P given F
………….
F
n
Discounting back from the future
P0=?
In general:
P = F [1/(1+i)n]
P = F(P/F,i%,n)
1-46
Basic Factors
 Example (P/F Factor - to find P given F)
 Assume F = 100,000 TL 9 years from now
 What is the present worth of this amount now if i =15%?
F9 = 100,000 TL
i = 15%/yr
0
1
2
3
…………
8
9
P= ?
Using formula;
P=F[1/(1+i)n] = 100,000[1/(1.15)9] = 100,000(0.2843) = 28,430 TL
Reading factor value from interest table;
P=F(P/F,i,n) = 100,000(P/F,15%, 9) = 100,000(0.2843) = 28,430 TL
(100,000 TL 9 years from now  28,430 TL now, at 15% / year)
1-47
Evaluation of
Alternatives
1-48
Evaluation of Alternatives
 Evaluation / Comparison Criteria
 Economic criteria
 Noneconomic factors
 Types of Alternatives
 Mutually Exclusive Alternatives
• Only one alternative can be selected
 Independent Alternatives
• More than one alternative can be selected
(depending on budget limitations)
1-49
Evaluation of Alternatives
 Economic Criteria
 Profit (select higher profits)
 Cost (select lower costs)
 Rate of return (compare with others)
 “Benefit / Cost” Ratio (select if B/C ≥ 1.0)
 Noneconomic Factors
 For example; when buying/renting an apartment
 Number of rooms
 Design, ease of use
 Location and environment
 Closeness to public facilities (schools, hospitals, ...)
 Ease of transportation
1-50
Evaluation of Alternatives
Which evaluation criteria do you use for selecting
the best restaurant?
Economic Criteria
 Select cheapest one
 Noneconomic criteria
Select
 nearest,
 quickest,
 tastiest,
 most scenic, ...
1-51
Summary
 Engineering Economy – application of economic factors
and criteria to evaluate alternatives
 Applies the time value of money
- Interest rate
- Cash flows
- Time
 Application of economic equivalence
 Cash flow estimation
 Modeling – cash flow diagrams
1-52
Financial Decision Making