Coverage: Financial Planning Working Capital Options

1. Chapter 29: Financial Panning
A. Financial Planning:
A decision makingprocess and tool that enable
management and investors to assess Financial results and
set targets for Financial growth of the Company.
B. Needs of Financial Planning:
A. Contingency Planning
- formulate responses to inevitablesurprises
B. Consideringoptions
C. ForcingConsistency
- firm’s growth and financingrequirements
should be connected
C. Financial PlanningInvolves Setting:
- Short-Term goals and objective
- Long-Term goals and objective
 Then design a strategy to achieve goals.
D. Short Term Financial Planning
 Spans a period of (1) year or less
 Forecasting future sources and uses of cash
 Managing accounts receivable and accounts payable
 A standard againstwhich subsequent performance can
be judged
 Makes sensible short term borrowing and lending
decisions
E. Option of Short Term Financing
Bang Loans
Stretching Payables
F. Cash Cycle
A metric that expresses the length of time (in days) that it
takes for a company to convert resourceinputs into cash
flows
This metric looks at the amount of time needed to sell inventory, the
amount of time needed to collect receivables and the length of time
the company is afforded to pay its bills without incurring penalties.
 Cash Cycle (days)= average days in inventory + average
collection period – average payment period
G. Strategies for reducingcash flowproblems:
1. Maturity Hedging
2. Decrease cash cycletime
3. Cash Budgeting
4. Cash Reserves
Maturity Hedging
- is payingfor short-term costs,likeinventory, with
short-term loans.
Decrease Cash CycleTime
- can be done by decrease their inventory and
receivables time periods
- delay payment to supplier
Cash Budgeting
- gives managers a “heads-up” about when short-term
financingmay be needed.
- cash budget simply records estimates of cash
receipts and payments.
- starts with a sales forecast,usually by the quarter,
for the upcoming year
- used to estimate of the timing of cash collectionsby
quarter.
Cash Reserves
- Keeping cash reserves and few short-term liabilities
can go a longway to help avoid financial distress.
- Higher reserve = greater liquidity
- Havingidlecash thatis not put to work or invested
means future revenue is foregone.
H. Long Term Financial Planning
 concerned with funding the growth and development of
the company for three (3) to five (5) years or even
longer.
 obtaining debt capital from commercial banks or other
financial institutions.
 Helps to avoid surprises and beprepared for the
unavoidable.

2. I. Similarities and Differenceof Short Term and Long Term
Similarities:
- focused on the financial health of a company
- objective is to maximizethe efficient use of capital
- All business requirecapital,thatis money invested
in assets,can be financed by long term or shortterm
sources of capital
Difference:
- Short-term involves shortlived assets and liabilites
- Short-term areeasily reverable
J. Reasons why Cash Budgeting is importantto Long Term
Financial Planning.
 Cash budgeting ensures that a company's cash
position advances its overall long-termfinancial plan
 Provides the foundation necessary to achievethe
objectives.
K. Growth and External Financing
Internal growth rate
maximum growth that company can achieve without
external funds
“maximum growth without external funds”
𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 =
𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔
𝑛𝑒𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
Sustainablegrowth rate
highest growth rate the firmcan maintain without
increasingits financial leverage
“highest growth rate maintained without financial leverage”
𝑆𝑢𝑏𝑠𝑡𝑎𝑛𝑡𝑖𝑎𝑙 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 𝑝𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑜 × 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
Chapter 30: Working Capital Management
A. WorkingCapital
Short-term, or current, assets and liabilities are
collectively known as workingcapital.
Current Assets:
 Inventories
 Accounts Receivables
 Cash
Current Liabilities
 Accounts Payable
 Accrued Expense
 Debt due within year
B. Inventory Management
Is the sensiblebalancebetween the benefits of holding
inventory and the costs.
C. Components of Inventory
 Raw materials
 Work in process
 Finished goods
D. Inventory Trade-Off
Involves two (2) costs:
 Carrying cost– storage cost
 Order cost– costof purchasefrom supplier
E. Relationship of the Order Size, Order Cost, and Carrying
Cost
F. Economic Order Quantity
Order sizethat minimizes Total Inventory Costs.
 Example – A retailer sells 255,000 tons of coalper year.
Each order that the companyplacesinvolves a fixed order
cost of $450, while the annual carrying cost ofthe
inventoryis estimated at $55 a ton. (a) What is the
economic order quantityfor this company? (b) How many
orders will be made?
a. Economic Order Quanitity
𝐸𝑂𝑄 = √
2 × 255,000 × 450
55
= 2,042.73 𝑡𝑜𝑛𝑠
Economic Order Quantity =
2 x annual sales x cost per order
carrying cost
Order
Size
Order
Cost
Order
Size
Average
Amount
of
Inventory
Carrying
Cost

3. b. Number of Order
255,000
2,042.73
= 124.83 𝑡𝑖𝑚𝑒𝑠
G. Tools To MinimizeInventory
1. Just-in-time
2. Producinggoods to order
H. Credit Management:
Account Receivables
- Trade Credit
- Consumer Credit
I. Term of Sales
Credit, discount,and payment terms offered on a sale.
- Cash on Delivery
- Cash before Delivery
- Credit terms
 Example - 5/10 net 30
– 5 - percent discount for earlypayment
– 10 - number of days that the discount is available
– net 30 - number of days before payment is due
A firmthat buys on creditis in effect borrowing from its
supplier. It saves cash today but will have to pay later.
This,of course, is an implicit loan from the supplier.
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒
= (1
+
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑟𝑖𝑐𝑒
)
365 𝑒𝑥𝑡𝑟𝑎 𝑑𝑎𝑦𝑠 𝑐𝑟𝑒𝑑𝑖𝑡⁄
− 1
 Example - On a $100 sale, with terms 5/10 net 60,
what is the impliedinterest rate on the credit given?
𝐸𝐴𝑅 = (1 +
0.05
95
)
365 50⁄
− 1 = .454 𝑜𝑟 45.4%
J. Credit Agreements
a. Open account
b. Sight draft – is a message to the buyer to pay
immediately sinceshipment is already
delivered
c. Time draft—is an agreement to pay later on
accordingto the period given in the draft
d. Trade acceptance—buyer accepts the period
stated in the time draft
e. Banker’s acceptance—buyer received time
or sightdraftbut does not have the money
to pay,so buyer goes to the bank and bank
accept to pay for the buyer first.
f. Irrevocableletter of credit—trade happens
overseas.Buyer’s bank writes a letter to the
seller’s bank. Buyer and Seller’s bank
manages the transactions.
g. Conditional sale—bank owns title of
ownership until buyer pays his loan.
K. Credit Analysis
- Determines the likelihood a customer will pay
its bills.
o Bond Ratings for largefirms
o Credit rating agencies, such as Dun &
Bradstreet provide reports on the
creditworthiness of businesses
worldwide
o Credit bureaus on customer’s credit
standing
L. Credit Decisions
Credit Policy - Standards set to determine the amount
and nature of creditto extend to customers.
- Extending creditgives you the probability of
making a profit, not the guarantee. There is still
a chance of default.
- Denying credit guarantees neither profitor loss.
Based on the probability of payoff, expected profit
can be expressed as:
𝑝 × 𝑃𝑉( 𝑅𝑒𝑣 − 𝐶𝑜𝑠𝑡) − (1 − 𝑝) × 𝑃𝑉( 𝐶𝑜𝑠𝑡)
The Break Even probability of collection is:
𝑝 =
𝑃𝑉( 𝐶𝑜𝑠𝑡)
𝑃𝑉( 𝑅𝑒𝑣)
M. Collection Policy
 Collection Policy - Procedures to collectand
monitor receivables.
 Aging Schedule - Classification of accounts
receivableby time outstanding.
 Factoring - Arrangement whereby a financial
institution buys a company's accounts receivable
and collects the debt.
N. Cash Management
- Responsibility to provideadequate cash to the
firm
- Responsibility to ensure funds are not blocks
and remain idle
O. Objectives of Cash Management
a. Liquidity
b. Marginal Benefits (interests)
c. Trade off between cost of idlecash and benefits.
Ways to investidlecash
- Sweep programs

4. P. Way of ReceivingCash Electronically
o Automated ClearingHouse
o WireTransfer
are large- valuepayments between companies
– Fedwire
– Chips
Q. Speeding Check Collection
 Allows the firmto gain quicker useof funds
 Transfer times are reduced
 Check clearanceis fast
 Concentration Banking: Decentralizedsystem
of account receivables
 Lock Box System:Payments sendto regional
post office box
 International cash Management: Multinational
bank withbranches ineachcountry
 Compensating balances:
– Monthlyfee
– Minimum average balance
R. Short Term Investments
 Readily marketablesecurities (stocks and bonds)
 Convert the investment into cash within one (1)
year
S. Sources of Short Term Borrowings
 Bank loan (features)
– Commitment
– Maturity
– Rate of interest
 Syndicated loans
 Loan sales and CDOs
 Secured loans
 Commercial paper
 Medium term notes
Chapter 20: Understanding Options
A. Terminologies
a. Derivatives - Any financial instrumentthat is
derived from another. (e.g.. options,warrants,
futures, swaps,etc.)
b. Option - Gives the holder the rightto buy or sell
a security at a specified priceduringa specified
period of time.
c. Call Option - The rightto buy a security at a
specified pricewithin a specified time.
d. Put Option - The rightto sell a security ata
specified pricewithin a specified time.
e. Option Premium - The pricepaid for the option,
above the priceof the underlyingsecurity.
f. Intrinsic Value - Difference between the market
valueof the underlying and the strikepriceof
the given option.
g. Time Premium - Value of option above the
intrinsicvalue
h. Exercise Price - (StrikingPrice) The priceat
which you buy or sell the security.
i. Expiration Date - The lastdate on which the
option can be exercised.
j. American Option - Can be exercised at any time
prior to and including the expiration date.
k. European Option - Can be exercised only on the
expiration date.
B. Call Option
Buyer has the right to buy
Seller has the obligation to buy if buyer
exercises option to buy
 Suppose the stock ofXYZ company is tradingat $40. A
call optioncontract witha strike price of $40 expiring
in a month's time is being pricedat $2. You believe
that XYZ stock willrise sharplyin the coming weeks
and soyou paid $200 to purchase a single$40 XYZ call
optioncovering100 shares.
 Sayyou were provenright andthe price of XYZ stock
rallies to $50 on optionexpirationdate. With
underlying stockprice at $50, if you were to exercise
your call option, you invoke your right to buy100
shares ofXYZ stock at $40 eachandcansell them
immediatelyin the openmarket for $50 a share. This
gives you a profit of$10 per share. As eachcalloption
contract covers 100 shares, the total amount you will
receive from the exercise is $1000. Since you hadpaid
$200 to purchase the call option, your net profit for
the entire trade is therefore $800.
 However, if you were wrong inyour assessment and
the stock price had insteaddived to $30, your call
optionwill expire worthless andyour total loss willbe
the $200 that you paid to purchase the option.

5. C. Put Option
Seller has the rightto sell
Buyer is obligated to buy if seller exercises
option to sell
 Suppose the stock ofXYZ company is tradingat $40. A
put optioncontract witha strike price of$40 expiring
in a month's time is being pricedat $2. You strongly
believe that XYZ stock will dropsharplyinthe coming
weeks after their earnings report. So youpaid$200 to
purchase a single $40 XYZ put optioncovering 100
shares.
 Price of XYZ stock plungesto $30 after the company
reportedweak earnings andloweredits earnings
guidance for the next quarter. Withthis crashinthe
underlying stockprice, your put buying strategywill
result in a profit of $800.
 you invoke your right to sell 100 shares of XYZ stock
at $40 each. Althoughyou don't ownanyshare of XYZ
companyat this time, you caneasilygo to the open
market to buy100 shares at only$30 a share andsell
them immediatelyfor $40 per share. This gives you a
profit of $10 per share. Since eachput option
contract covers 100 shares, the total amount you will
receive from the exercise is $1000. As you hadpaid
$200 to purchase thisput option, your net profit for
the entire trade is $800.
Call Option
Buyer Seller
Expectation MP MP
Loss Limited to OP Unlimited
Profit Unlimited Limited to OP
Put Option
Buyer Seller
Expectation MP MP
Loss Limited to OP Limited to Stock Price
Profit Limited to Stock Price Limited to OP
D. Moneyness
A term describingthe relationship between
the strikepriceof an option and the current trading
priceof its underlyingsecurity
At the money In the Money Out the Money
(breakeven) (to exercise) (not to exercise)
EP = MP EP < MP: call option
EP > MP: put option
EP < MP: put option
EP > MP: call option
IN THE MONEY
 In-the-money options are generally more expensive
as their premiums consistof significant intrinsic
value.
 Has an intrinsic value
The Intrinsic value is a difference between the strikeprice
and the underlyingprice.It can be only positive
 Intrinsicvaluefor the CALL Option =
UnderlyingPrice– Strike Price
 Intrinsic valuefor the PUT Option =
Strike Price– UnderlyingPrice
OUT THE MONEY
 Out-of-the-money options have zero intrinsic value
 Out-of-the-money options are cheaper as they
possess greater likelihood of expiringworthless.
AT THE MONEY
 Has no intrinsicvalue
Long Short
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
EP
MP
MP
Put Option
Call Option

6. E. Financial Alchemy with Options
 looks athow options can be used to modify the risk
characteristicsof a portfolio.
1. Protective Put
- A risk-management strategy that investors
can use to guard againstthe loss of
unrealized gains.The put option acts likean
insurancepolicy.
Advantages of Protective Puts...
o Allows you to hold on to your stocks and
participatein the upsidepotential whileat
the same time insuringagainstany losses
o The cost to buy the insuranceis relatively
cheap consideringhowmuch money you
are protecting
Disadvantages of Protective Puts...
o Cost of the Put option eats into your profit
o The option has a limited lifespan (itexpires)
and has to keep being renewed (buying
another option)
2. Straddle
- Involves purchasingboth put and call option
- Both options has the same EP and expiration
date
- Straddleis useful in a high volatilemarket
sinceitallows you to choose which ever
option would benefit you the most
F. Six (6) Factors Affecting Option Premium
1. UnderlyingPrice(MP)
2. Strike Price(EP)
3. Time until expiration
4. Volatility
5. Interest Rate
6. Dividends
UnderlyingPrice
- most influential factor on an option premium
- MP: call prices increaseand put prices decrease
- MP: call prices decreaseand put prices increase.
Strike Price
- determines if the option has any intrinsicvalue
- More in the money = OP
- More out the money = OP
Expected Volatility
- Volatility is thedegree to which pricemoves,
regardless of direction.
- DEGREE OF PRICE MOVEMENT
- Historical volatility refers to the actual price
changes that have been observed over a specified
time period.
o historical volatility is used to determine
possiblevolatility in the future.
- Implied volatility is a forecastof future volatility
and acts as an indicator of the current market
sentiment.
- Volatility = OP
Time until expiration
- The longer an option has time until expiration,the
greater the chancethat itwill end up in-the-money,
or profitable.(becauseof time money value)
- ‘Time Decay’ is the ratio of the change in an
option's priceto the decrease in time to expiration.
(Also known as "theta" and "time-value decay")
o As an option approaches its expirydate without
being in the money, its time value declines
because the probabilityof that optionbeing
profitable (inthe money) is reduced.
Call
Option
100 shared
@50 EP:5
2
MP:60
MP:40
Put
Option
can buy share for….
can sell share for….

7. Interest Rates
- also havesmall,butmeasurable,effects on option
prices.
-  interest rates: call premiums will increaseand put
premiums will decrease.
o because of the costs associatedwith owning
the underlying;the purchase will incur either
interest expense (if the moneyis borrowed)or
lost interest income (if existingfunds are used
to purchase the shares). Ineithercase, the
buyer will have interest costs.
Dividends
- underlyingstock's pricetypically drops by the
amount of any cash dividend.
- underlying's dividend:call prices will decreaseand
put prices will increase
- underlying's dividend:call prices will increaseand
put prices will decrease.