Finance: Balancing Risk and Return

1. Finance: Balancing Risk and Return

2. Chapter 15Finance: Balancing Risk and Return Appreciate the crucial relationship between risk and return and the way this affects all business finance decisions. Understand the issues involved in short-term capital management and methods that managers can use to increase the rate of return on capital. Understand the issues involved in long-term capital management and financial tool like net present value and breakeven analysis that help managers decide where to invest. Describe four different methods companies can use to finance capital investments. Differentiate the roles of debt and equity securities in financial decision making.

3. Chapter 15Finance: Balancing Risk and Return The Role of Finance A company’s business model is its plan of action for using assets to create cash flow and profit Finance – the activities required to decide how to invest a company’s capital so it generates additional cash, profit and capital in the future and to increase profitability

4. Chapter 15Finance: Balancing Risk and Return Risk versus Return Capital - funds used to purchase assets (productive resources) Return – difference between an investment amount today and when I initially invested it I invested $100 one year ago Today that investment is worth $120 My return is $20 Rate of return – the return divided by the investment $20 / $100 = .20 (20%)

5. Chapter 15Finance: Balancing Risk and Return Risk versus Return Investing capital in a particular asset requires a return to the investor – otherwise the person could put their money in a bank account Riskier investments Must generate a higher rate of return to the investor (known as a risk premium) As a reward for the higher risk of investing capital Evaluate the role of Finance and relate to capital in the Winning Advice video

6. Chapter 15Finance: Balancing Risk and Return Business Finance Increasing the rate of return on a company’s capital Increases the value of the investment And increases the market value of stockholder’s equity Ensures the methods used to borrow, invest, spend and lend its capital lead to a rate of return that maximizes the present market value of its stock

7. Chapter 15Finance: Balancing Risk and Return The Cycle of Profit Assets – generate cash flow and profit Profit – increased profits and cash and cash flows raises value of stockholder equity Stockholder Equity – higher equity provides a company with more capital to find new growth opportunities Capital – provides funds to purchase assets Do you see the circular flow?

8. Chapter 15Finance: Balancing Risk and Return

9. Chapter 15Finance: Balancing Risk and Return Four Ways to Use Capital Borrowing Lending Spending Investing Evaluate the role of Finance and balancing risk and return in Starting Your Business

10. Chapter 15Finance: Balancing Risk and Return Return on Invested Capital - ROIC Capital investment and budgeting involves development of a financial plan and budget to manage and invest capital to purchase assets that will lead to the highest ROIC

11. Chapter 15Finance: Balancing Risk and Return Managing the Short-Term Operating Cycle The way and/or time the capital is locked up in an asset affects risk and return Short term capital management decisions involve resources that will be sold within a one year period Ex: inventory, raw materials, etc. Evaluate capital alternatives and relate to balancing risk and return in the short term

12. Chapter 15Finance: Balancing Risk and Return Managing the Short-Term Operating Cycle

13. Chapter 15Finance: Balancing Risk and Return Managing the Short-Term Operating Cycle Working capital The cash or funds available to pay for operating activities – like payroll, electricity, insurance, etc. WC = current assets minus current liabilities Key financial decisions find ways to shorten the cycle or reduce amount of working capital tied up in operations

14. Chapter 15Finance: Balancing Risk and Return Managing the Long-Term Operating Cycle Long term capital budgeting decisions involve choices about how to invest capital for extended periods of time Always made in the context of uncertainty and risk Need to estimate value of a proposed investment Net present value analysis –> income over time - costs Break-even analysis –> total revenues = total costs

15. Chapter 15Finance: Balancing Risk and Return Managing the Long-Term Operating Cycle NPV –> sum of income over time – total costs Break-even The number of units we have to produce / sell Where total revenues = total costs

16. Chapter 15Finance: Balancing Risk and Return Capital Budget Break-even analysis contains the cost and revenue assumptions that determine the project’s rate of return and aids in building a capital budget A set of rules for allocating funds to the different functions to achieve a predetermined rate of return on an investment

17. Chapter 15Finance: Balancing Risk and Return Brand Manager Responsible for a product and maximization of its profitability over time - makes both long and short term financial decisions for the life of that product Long term decisions include increasing revenues and reducing costs Short term decisions include better inventory and distribution management methods to increase cash flow and reduce costs

18. Chapter 15Finance: Balancing Risk and Return Return on Invested Capital - ROIC The goal of all these financial decisions is to increase ROIC and stockholder’s equity In not only investment decisions – but also in financing decisions Financing investments Short term – from current assets (cash, inventory, etc) Long term – from fixed assets (property, equity, etc.) Capital financing develops a plan to obtain capital to finance investments at the lowest possible cost

19. Chapter 15Finance: Balancing Risk and Return Short Term Financing Methods Cash reserves Secured loan Unsecured loans

20. Chapter 15Finance: Balancing Risk and Return Long Term Financing Methods Spending retained earnings Issuing debt securities Selling equity securities Outsourcing production to another company (or country)

21. Chapter 15Finance: Balancing Risk and Return Methods of Obtaining New Capital Issue new debt securities Issue new stock securities Outsource production to avoid need to raise capital Use internally generated funds

22. Chapter 15Finance: Balancing Risk and Return Key Terms Leverage – the ability to use borrowed capital that has the potential to receive high rates of return Capital structure refers to the portions of debt versus equity capital within the company Debt securities – pledge to repay the liability (e.g., bonds) Equity securities – purchasing ownership in company (e.g., stock)

23. Chapter 15Finance: Balancing Risk and Return Stocks Four main types of stock Blue chip stocks Growth stocks Income stocks Speculative stocks Value stocks Price to earnings ratio (PE) Ratio of the closing price to the annual earnings per share (EPS)