if you produce too much of a product
or a product that no one wants to buy, you still must pay for materials, labor, and storage.
if you produce too little of a product
you will lose sales and possibly market share.
three general forecasting approaches
experience, probability, correlation
experience
Managers who have been in the business for a long time have developed a sense for the patterns in sales, expenses, consumer demand factors, etc.
probability
Past history often tells us a lot about what will happen in the future.
Managers can use this information to estimate the future.
correlation
Correlation is a measure of the relative movement of two variables relative to each other.
Example: If interest rates go up, a real estate agent knows that home sales will tend to fall (because the higher cost of financing makes it harder for buyers to qu
The Finance Department
(does sales forecasting)
marketing (sales estimate)
top management (policy, strategy)
production (capacity, schedules)
accounting (fin statements, depreciation, taxes)
trend line
a line on a graph indicating a statistical trend
depreciation
Any decrease or loss in value caused by age, wear, or market conditions
sales growth can...
create needs
such as needing more assists (more technology for upgrading)
current assets
Assets that can normally be converted to cash within one year (Cash, accounts receivables, and merchandise inventory).
fixed assets
assets such as equipment, buildings, and land
Pro Forma Financial Statements
forecasts of the firm's future financial statements based on a certain set of assumptions about sales trends and the relationships between sales and various financial variables, and between other financial statement variables relative to each other.
balancing problem
If outside financing is required, the new debt or equity may affect your original projections of the amount of the addition to retained earnings (due to increased interest or dividends on the income statement).
retained earnings
An amount earned by a corporation and not yet distributed to stockholders.
Producing Pro Formas - Summary
-Determine sales growth.
-Calculate projected net income.
-Project assets needed to support the new sales level.
-Project increases in spontaneous asset and liability accounts.
-Project addition to retained earnings.
-Determine the difference between proj
expected return
is the mean of the probability distribution of possible returns.
standard deviation
future returns are uncertain, the measure of this uncertainty is SD
risk
is the potential for unexpected events to occur.
If two financial alternatives are similar except for their degree of risk
most people will choose the less risky alternative because they are risk averse i.e. they don't like risk.
risk averse investors
will require higher expected rates of return as compensation for taking on higher levels of risk.
firm specific risk
-Risk due to factors within the firm
-Example: Stock price will most likely fall if major government contract is lost unexpectedly.
-Diversification can effectively eliminate firm specific (un-systematic) risk
market related risk
-Risk due to overall market conditions
-Example: Stock price is likely to rise if overall stock market doing well
-Diversification does not reduce market related (systemic) risk
market risk
the risk of the overall market, so we need to measure the sensitivity of the individual company's stock returns to the variability of returns of the market.
Beta
Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
Beta > 1
High Market Risk Company
Stock return will be more affected by the market than average
The Capital Asset Pricing Model
measures required rate of return for investments, given the degree of market risk measured by beta.
types of risk
business, finical, portfolio
business risk
-Source is Sales Volatility
-Operating Leverage magnifies effect of Sales Volatility
volatility
Indicates how much and how quickly the value of an investment, market, or market sector changes.
financial risk
Financial Leverage magnifies effect of Sales Volatility
portfolio risk
-Total risk of portfolio
-Correlation Coefficient affects diversification effectiveness
time value of money
Money grows over time when it earns interest.
Therefore, money that is to be received at some time in the future is worth less than the same dollar amount to be received today.
Similarly, a debt of a given amount to be paid in the future is less burdensom
present value of lump sum
Value today of an amount to be received or paid in the future.
annuity
is a series of equal cash flows spaced evenly over time.
-For example, you pay your landlord an annuity since your rent is the same amount, paid on the same day of the month for the entire year.
ordinary annuity
The cash payments occur at the END of each time period.
annuity due
The cash payments occur at the BEGINNING of each time period.
amortized loans
-A loan that is paid off in equal amounts that include principal as well as interest.
-Solving for loan payments.
-Solving for interest and principal paid.
principal paid
the original amount
perpetuities
a series of equal payments at equal time intervals (an annuity) that will be received into infinity.
continuous compounding
The process of earning interest on top of interest. The interest is earned constantly, and immediately begins earning interest on itself.
Compounding frequency
is infinitely large
compounding period
is infinitely small