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Financial Decision Making. Dr. Haluk AYGÜNEŞ Department of Industrial Engineering. OUTLINE. Decision Making Process Financial Decision Making Engineering Economy Time Value of Money Interest Rates Cash Flows Engineering Economy Factors Evaluation and Selection of Alternatives.

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slide1

Financial Decision Making

Dr. Haluk AYGÜNEŞ

Department of Industrial Engineering

outline
OUTLINE
  • Decision Making Process
  • Financial Decision Making
  • Engineering Economy
  • Time Value of Money
  • Interest Rates
  • Cash Flows
  • Engineering Economy Factors
  • Evaluation and Selection of Alternatives
slide4

Decision Making Process

  • 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
  • Select the “best” alternative
  • Implement the alternative and monitor results
decision making process
DecisionMakingProcess
  • 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.)

decision making process6
DecisionMakingProcess
  • Level of uncertainty
    • Decision making under certainty
      • deterministic models
    • Decision making under uncertainty
      • probabilistic models
decision making process7
DecisionMakingProcess

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 process8
DecisionMakingProcess

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

value chain
Value Chain

Value chain:Sequence ofbusiness functions in which usefulness is addedto the products or services of an organization.

Value

as the usefulnessof the product or service is increased, so is its valueto the customer.

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value chain11
Value Chain

Management accountants providedecision support for managers in thefollowing sixbusiness functions (valuechain)

Research &

Development

Design

Production

Management Accounting

Marketing

Distribution

Customer

Service

1-11

value chain12
Value Chain

Research & Development:process of generatingand experimenting with ideas related to newproducts, services, or processes.

Design: detailed planning andengineering of products, services, or processes.

Production: acquisition, coordination, andassembly of resources to producea product or deliver a service.

1-12

value chain13
Value Chain

Marketing:the manner by which companiespromote and sell their productsor services to customers.

Distribution: delivery of products orservices to the customer.

Customer Service: after-sale support activitiesprovided to customers.

1-13

key success factors
KeySuccessFactors

factors that affectthe economic viability of theorganization

Cost:… howtoreducecosts?

Quality: customersexpect higherlevels of quality.

Time: meetpromised delivery dates more reliably.

Innovation: a continuing flow of innovative productsor services is a prerequisite to the ongoingsuccess.

1-14

role of accounting
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

financial statements
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})

Netincome (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, 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

PRODUCT

Example: newspaper

  • Direct Costs
  • Direct material (e.g. paper)
  • Direct Labor

Indirect Costs

(rent cost for the building,

insurance cost, …)

1-18

cost revenue net income19
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
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 making21
Financial Decision Making

The three fundamental concepts

Time Value of Money

economic value of

- projects

- investments

- business organizations

Risk-Return Relationship

Cash Flows

1-21

engineering economy
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 economy24
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
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
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

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time value of money28
Time Value of Money

Time

Time value of money

Interest Rates

Cash Flows

1-28

time value of money29
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
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 (%)

1-31

interest rate32
Interest Rate
  • Example
    • – if you borrow 2000 TL now, and
    • – you will repay 2300 TL one year later
    • Interest rate (%)

1-32

simple and compound interest
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 interest34
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 1Interest = P * i = 2000 * 0.10 = 200 TL
    • Year 2Interest = [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
Equivalence

100 centimeters = 1 meter

1000 kilograms = 1 ton

  • What is economic equivalence?

Time value of money

Interest Rate

Economic equivalence

1-35

equivalence36
Equivalence

Different amounts of money at different times may be equal in economic value

1-36

equivalence37
Equivalence

106 TL one

year from now

0 1

Interest rate = 6% per year

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
Cash Flows
  • Definition of terms
    • Cash Inflows - amount of money flowing into the firm
    • Cash Outflows- amount of moneyflowing out of the firm
  • Net Cash Flow (NCF)
    • NCF =cash inflows – cash outflows
  • End of periodassumption
    • Cash flows occur at the end of a given (interest) period

1-39

cash flows40
Cash Flows

1. Draw a time line

One time period

( )

2. Show the cash flows

(+) positive flows

(-) negative flows

0 1 2 … … … n-1 n

0 1 2 … … … n-1 n

  • Cash Flow Diagram

(Cash flows are shown as directed arrows)

1-40

factors engineering economy factors
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 equalcash flows
  • n = the number of interest periods
  • i = the interest rate per time period, in percent (i%)

1-42

factors
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
Basic Factors

Fn=?

Compound forward in time

………….

n

P0

  • F/P Factor- to find F given P

In general:

F = P(1+i)n

F = P(F/P,i%,n)

1-44

basic factors45
Basic Factors

F = ?

i=10%/year

0 1 2 3

P=1,000 TL

  • Example (F/P Factor- to find F given P)
    • P= 1,000 TL;n=3;i=10%
    • What is the future value, F?

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

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basic factors46
Basic Factors

F

………….

n

Discounting back from the future

P0=?

  • P/F Factor- to find P given F

In general:

P = F [1/(1+i)n]

P = F(P/F,i%,n)

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basic factors47
Basic Factors

…………

0 1 2 3 8 9

  • 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

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
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 alternatives50
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 alternatives51
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
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