 Hello everyone and welcome back to NBA 601 financial management. This is part two of our assessment review. If you haven't watched the first part, you can go back and do that. And of course, this is part of a whole video series that's covering a sailor, a sailor academies course, which of course you can find on our website, which is linked below. But I'm just going to go ahead and hand it over to Dr. Pierce. So to get us going. And if you guys have any questions as we're going along, feel free to leave them in the chat. Great. Thanks Michael. And again, welcome back everybody. This will be the last installment of our presentation series on NBA 601 financial management. As you know, we have spent the last several weeks reviewing this course. And the course is made up of these seven units. So we've covered a lot of information in detail with the whole area of basic financial management for business and the issues that are involved. We have reviewed over the past number of weeks, the learning objectives established for this course. I'm not going to go through them all in detail again. As you know, there were eight learning objectives. And the intent is that this helps us focus the material in the course to make sure we covered those things that we think were important objectives for you to have as takeaways when you take and complete the course. Now this is part two of a review of what might be a typical assessment. As in all courses, there are tests and exams, there's an assessment in the course. And last week we covered part one of the course assessment. And if you looked at that or if you recall, it was really focused on, I'll call it the ratio analysis part of financial analysis. And we spent a goodly amount of time going through and looking at various ratios that are used as measurements. There are ways to help us determine how effective we are at what we're doing. There are ways of giving us a report card on the decisions that management's making. And are the results of those decisions hopefully meeting or exceeding our expectations or what we had laid out was our expected returns for the decisions we made. So there was a lot of financial calculations. And if you follow through that and went through any of those examples, I'm sure you're developed a real appreciation for the idea of having a financial calculator, which dramatically helps in going through and doing this kind of analysis. Now we're going to wrap up this series with a review of part two of the assessment. And in part two, we're looking more at a bit of application of the financial principles and information that we covered in the course. Making sure that there's an understanding for exactly what we mean when we talk about certain key financial principles and that relate to the decision-making process. Now before I just jump in and start reviewing those questions, I'll take a moment here to see if there might be any questions from our last presentation or before I get started in reviewing the questions, if anybody has anything quick, they'd like to talk about right now. Well, as always, you can leave those questions in the chat or in the comment section below. But we don't have any questions right yet, but I'll keep my eye on it and I'll let you know. Great. And feel free to interrupt if need be. So let's get started. And what we're going to do here is I'm going to, we're going to go over a series of questions that might appear as part of an assessment for this course. These are multiple choice questions. And so the idea is we need to understand what it is that the question is looking for. And then, of course, identify what is the most appropriate answer. So let's just jump right in. And for each of these, I've kind of listed at the top, I've highlighted what either a course objective or a unit objective might be. I mean, again, there's a reason why these questions have been have been developed. And they are to support the objectives we had for the course. So in this question, we're looking at investors who have received a copy of an annual financial report. And remember that especially for publicly traded companies, the issuing of reports is a requirement. And so we get quarterly and annual reports for a publicly traded company. Annual reports are audited. That means that an outside audit firm must come in, review, conduct some audits of what the firm is doing and validate that these reports accurately represent the financial position of the firm. Now, obviously, as an investor in a company, you did assume some risk. There is risk in investments. Remember we talked earlier on the simple rule that the greater the risk, the greater the expectation of return. If I'm going to ask you to take risk, then you are going to be looking for a substantial return for taking that. Now in this case, looking at the financial report, they want to evaluate what's the firm's position on leverage. And so the shareholders will look at which statement as part of the financial package. And of course, you have four choices here. It's the income statement, statement of retained earnings, the balance sheet, or the statement of cash flows. So think a moment, select your answer, and hopefully you pick the balance sheet. Why? Because the balance sheet is a representation of all of the things that the firm owns, which are assets, and all of the things that the firm owes, and those are liabilities. So when I'm looking at liabilities, which are leverage, it's the use of outside money. If I want to know the level or the degree of leverage, I go to the balance sheet. And on the balance sheet, under liabilities, remember that we have short-term liabilities and long-term liabilities. And so we might be interested in evaluating exactly how much debt the firm is signed up for in order to continue operations. Now the second question has to deal with financial ratios, but really in determining what some of these ratios can tell us. So we know that shareholders and even potential investors want to know what's the value of the business. One method for determining value, we talked about earlier on in our reviews, was determining the future value of forecasted free cash flows. Now remember when we talk about the present value or the future value of free cash flows, we're looking at the possibility of involving a couple of factors. One of those, of course, is understanding what the free cash flow is. Now remember, as part of the budgeting process, we budget and we forecast what our expectations for free cash flow. What is the other factor that we're going to require to make a determination on that value? And so we have a number of choices here. And what we're going to be looking for is the weighted average cost of capital or the WAC. Remember that the weighted average cost of capital is the cost to the firm of the money that they're using. And remember that the weighted average cost counts for both debt and equity. So based on the amount of debt and the amount of equity we're using, remember that's the capital plan, we can calculate the weighted average cost because there's a cost of debt, which is the interest payments we make, and there's a cost to the equity we use, which is the expectation of return that shareholders have. And what are we going to use this for? We're going to use this as a discount factor to determine what the present value of either a future returns on a future investment or the present value of a future stream of free cash flows. Next, we want to take a look at evaluating a firm's performance over time. Now, again, there's lots of ways to do this. We're going to focus one here, which is simply looking at what is the return of an unequity. As a shareholder, you have equity in the firm. And by the way, side question, you would find that equity where? On the balance sheet. Equity is the difference between assets and liabilities. That's what the owners, that's your value in the firm. That's what you own. Equity is being used as part of the capital plan to invest and make decisions for the firm. What kind of return are you as a shareholder getting based on the equity that's being used? And so we look at calculating the return on equity. Now the question here is an interesting one. It says that when the firm decreases the use of debt, when we use less leverage, what happens to the return on equity for shareholders? Well, the return on equity decreases. Why? Because if you're using less debt, then you're using more equity. Now, step back and just think about this for a second. When I use debt, I'm actually using other people's money to generate a return. So my return is higher because I'm using less equity. We know that there is a potential risk. The more debt you have, the higher the risk of the fault. And so the higher the cost. So we have to find the member we talked about a couple of weeks ago, the optimal plan. And the optimal plan is the one that gives us just the right amount of debt and just the right amount of equity. So as we use less debt, the return on equity for shareholders decreases. Let's think about comparing our firm's performance to other companies. We do some benchmarking. We want to do a comparative analysis. Again, if, for example, my sales are increasing year over year, you can say, wow, that's great. Your sales increased 5% a year each year for the last three years. But how good is that really if other firms in our industry, in our market silo, we're increasing 15% a year? So when we're doing comparison, we're analyzing financials. We want to analyze what we're doing and how we're performing year over year. We also want to compare that to other like firms in the industry so that we can get a sense for how well we're doing. Now one way for a firm to raise money to support some of the investments they want to make is through the sales stack. Now we're going to suppose that a company that we invested in has been in business for five years since their initial public offering, or IPO, and the IPO is when a private company for the first time goes public and offers sales of stack in the company to the public market. Now this company has made a decision to raise additional capital by offering stack. What market will they go to for this purpose? Now obviously if you look at this, what it means is that you actually have a sense for understanding that there are different markets out there for publicly traded securities. There's a bond market, there's a primary market, the New York stack exchange, the secondary market, the London exchange, lots of exchanges out there. Where will our company go to offer additional sales of stack to raise money? They're going to go to the secondary market. How do we know that? Because when they did their IPO they went to the primary market, primary being first time into the market. And by the way, for a company to make the decision to go public and to go into the primary market is a large undertaking. Having been involved in these, these are processes that can take months, years, involve investment bakers and financial analysts and attorneys. And there's a substantial investment for a firm to make that decision to sell stack and to go public. So there's a lot involved in that. Let's take a look at areas, how we would look at areas where financial performance can be improved. I mean, one thing that as a former executive I did on a regular basis is you're looking at the financials and even if there's not an issue, even if the results you're looking at are right on budget, that doesn't mean we don't constantly look and evaluate ways to improve. Because the end goal here is not only to meet the budget expectations, but we're possible to exceed those expectations. So there's no point in time when you sit back and say, okay, we're there. I'm done. I don't have to look at this anymore. We're going to constantly evaluate. We talked about the capital asset pricing model, CAPM, and it's used by firms as one way to evaluate the risk of potential investments are going to make. Remember, we need to have some sense of risk because based on the amount of risk is a direct correlation for the expectation of the returns that shareholders are going to be expected. Now, in using the CAPM model and in prior lectures, we presented the model. We showed how to calculate it. We provided some examples. We consider the market risk. Now, what is the market risk? The market risk is that risk that we associate with the overall portfolio of stocks. If you had a portfolio and you had stock in that portfolio representing all the stocks available in the market, how the market is going and the risk of that market is the market risk. So that's one of the critical components of CAPM. What's the other factor we need to know? And once we know the market risk, what we also need to know are the projected rates of return. So we have estimates. What is the projected rate of return on this project? Nobody or at least nobody who's being fiscally responsible makes an investment without having some expectation of return. So we want to know what that projected rate of return is. Let's go to recognizing other areas where financial performance can be improved. Let's consider management. And we've talked a lot about management's responsibility to all stakeholders. We talked about fiduciary responsibility. The fact that managers have a fiduciary responsibility to make decisions in the best interest of investors means that they applied reasonable reviews, done the appropriate due diligence and really thought through the process. Now we talked about the primary roles of management. And we said that there were three primary responsibilities. The third responsibility is we have planning, we have evaluating, and what's the third responsibility of management? And if you go back in some of our presentations, you'll see that we had a discussion describing each of these responsibilities, each of these roles. And the third role is that of controlling. All right, so when you think about it, management has a responsibility to plan, which means that you are thinking ahead. You're preparing the business plan. You're working on strategies. You're forecasting revenue. You're creating goals and objectives for the firm. That's the planning role of management. Then there's the evaluating. You're making decisions. Opportunity should I pursue. What about staffing? The day-to-day activities, they keep you busy. Oh, go ahead. No problem. I think when we were talking about evaluating, which is making decisions for the firm. And remember, making decisions was that whole process of considering costs of capital, expected returns, what's the benefit to the firm? You might be involved in things like determining appropriate employee training. Employee training today is almost something that has to be considered an ongoing process within the business, managing the day-to-day activities. So that's the second role of management. And that third role is that of controlling. And by controlling, we mean that you're actually looking at what you're doing versus what you said you would do. All right, so in its simplest form, you're comparing actual results with budgeted results. Are you on target? Are you meeting the goals that were established at the beginning of the year? Or in my way of thinking about it, controlling is simply the fact that one of the things you must do as the manager executive of the firm is keep the train on the track. If you see that we're getting off the track, if we're veering away from our planned and budgeted expectations, you've got some things to do. You need to understand, first of all, that there is an issue. Then you need to understand why that issue exists. The third thing you have to do is make plans, make some decisions on what will you do to correct it. And you're not done then. The fourth thing is to go back and review it and make sure that it's working. So planning, evaluating, and controlling three basic roles of management. And at this point, I'll stop again just to see if in fact anybody's posted any questions. Michael. OK. I've not seen any questions in the chat as of right now, but always a great time to remind people that if you do have any questions, feel free to leave them over in the chat, and we'll get to them. And with that, we will continue. So our next question is going to be talking about looking at the value of investments. And so one of the things we talked about was calculating the net present value of a project. And if you recall, when we calculate net present value, you can have a couple of different results. It can be negative. It can be positive. It can be zero. Which of the following applies when we're looking at making a reasonable decision here on an investment? And the answer here is that if the NPV is negative, what does that mean? It means that the investment's not going to cover the initial investment we made, the project, the return on the project's not going to cover the investment. And the returns are going to be less than what we call and what we determine was our required rate of return. That's what a negative on that present value means. Remember, if the net present value is zero, it means that the return will be less than the required rate of return. And if it's zero, it means that it can capture the investment and the return, but it's not creating additional value for shareholders. So net present value very much applied in terms of making investments that have future paybacks, making it trying to make a determination on whether or not to proceed with the investment. And remember, we said in the review that whenever the net present value is positive, assuming funds are available, the firm should make the investment. We touch base on the fact that risk has directly correlated to returns. And Pearsall's rule of finance is the greater the risk, the greater the return that I want for taking that risk. Now, managing the capital plan, which is a combination of debt and equity is important. One way that the firm can raise needed capital is by issuing bonds, companies issue bonds. Investors purchase these bonds, and typically they will get interest payments. And what else? Why would you consider buying a corporate bond? The answer here is B, that investors also receive the principal at maturity. Remember that in a bond, let's assume that we purchase a bond, a $50,000 bond. It's five years maturity, and it pays an interest rate of 5% a year. As the bond holder, each year you're going to receive that 5% interest check. In year five, you're going to receive the interest check and your principal back to $50,000. So you're investing that principal for a period of time to get to earn a certain amount of interest. Companies can do this, and it can be an effective way to raise additional capital. Many times, these bonds can be secured. A secured bond means that the company actually has put aside materials that will secure the amount of money that the bonds are committed for. Remember that bonds for the investor is an investment opportunity for the business. You're writing an IOU. You're taking money now with a promise to pay it back with interest in the future. Calculating the risk of an investment. Now in today's day, for sure, we recognize that the market is global and it is dynamic. In my own experience, I spent many years as an executive and a firm that was in fact a global manufacturing company. We had operations in some 30 countries around the world. Now there are risks that we face day to day in our own home markets. We know what a lot of those risks are. There's economic conditions and country-specific rules, regulations, and tariffs that apply when we go outside our border. So lots of potential risks. What's another risk that you can encounter when you're in fact talking about extending your presence into the global marketplace? And that risk unique to the global marketplace is the risk of currency translations. Remember that in the currency market, if you've traveled outside your country, you've gone to another country, you've exchanged your domestic currency for the currency in that other country. There's an exchange rate. And if you do this on a regular basis, I, for example, traveled globally, probably 300,000 miles a year. So I was in and out of 20 some countries a year. And so tracking the currency transactions can be a tad cumbersome given the fact that these rates change on a daily basis. There is a market for currency. And one way to protect against this particular risk, if the company's large enough, is we actually invested in the currency futures market, where we would take out options on what the value of a foreign currency would be 60, 90 days down the road. I mean, imagine this. You are selling equipment from your company to a customer in another country. You negotiate, you settle a price, and you close the deal. Well, that price perhaps reflected what the value of each currency was today. It's gonna take you six months to build and ship the equipment. What will that currency be worth then? And so there's a risk on either side of that transaction. One party, the other is going to do better and the other side is going to do worse. And so recognizing that risk and finding ways to mitigate the risk is a responsibility of management. Now, when looking at certain investment opportunities, and we talked a lot about how one of the things businesses must do, if you're going to sustain where you are and hopefully grow, is you're gonna have to be making investments. And one of the things we look at is using the risk free rate and the market risk premium and determining what that project and that present value is. How do we do that? Remember that we were taking a future forecast with a lot of money and we were discounting it back to determine what its present value is. And so that discount needs to know what the market risk premium and the risk free rate are. Now, we know what the risk free rate is. Here in the US, the risk free rate is a US Treasury bill or a Treasury bond. Why is it risk free? Because it's guaranteed and backed by the United States government. So there's little to no risk of default. At least I hope not. The other thing is with that, because it's risk free, what do you suppose the interest rate is? It's very small. Why? There's not a lot of risk. So we want to know what the market risk premium is. So there's a difference between the risk free rate and that premium that the market is. So what is the market risk premium? Well, it's the difference between what that risk free rate is and what the expected returns in the market are. So for example, I'll say that the current interest rate on a Treasury bill is 3%. That's a low rate. If I look at the overall market, I say, well, the market is returning 10%. I wish. But suppose the market was returning 10%. So what's the market risk premium? It's going to be the difference between the risk free rate and the market rate. So the premium is a 7%. That's the differential between the 3% risk free and the 10% what the market's doing. That's the premium that you're going to need to entice an investor to invest in the stock. Now, we talked a lot about returns and the capital plan and putting together the capital budget. And we know that we're looking to achieve the optimal capital structure. Management has a responsibility to meet the expectations of investors in their return or to exceed that expectation. So given the information here on four different capital plans with different amounts of debt, different amounts of equity, the earnings per share, what is the earnings per share on a share of stock and what the current stock price is, what's the optimal capital structure for this firm? Now you're going to be surprised at the answer to this or maybe not. It's the one that has the highest stock price. Why is that? Because that's what's returning the maximum return to your shareholders. That's creating the most value. So in fact, if you've developed a capital structure that is being reflected in the market in higher stock prices then you're doing a good job for your investors or at least if I was your investor I think you were doing a good job. Now, how about applying some value creation methodologies to business decisions? One method of doing that is let's think again about stock price is we'll consider the book value of the firm versus its market value. Now we talked about this in last week's presentation and the book value of the company is what? We go to the balance sheet. The book value of the firm is the shareholders equity. Right? That's the book. And the book says if I take all the assets and liquidate them, turn them in the cash, pay off all the debts, what's left? That's the actual book value of the firm. That's the check you would write to shareholders and say, here, this is yours. Not to be confused with market value. Now market value is when the market out there looks at your business, how do they value what you're doing? And so we wanna know what happens if the book value is less than the market value. Book value is what? That means the market value is greater. And what that means is the market's looking at your business and they're saying, you know what? I think you're going in the right direction. I like what you're doing. It looks to me like there is going to be a continued path to growth. There's going to be a continued creation of value to shareholders. So we're valuing the stock of your company higher than what the book value is. Now that's typically a good thing. It's even better if, in fact, you can meet those expectations as you go forward into the future. And obviously the return is what happens if the market values your business at less than book value. And that's an indication that they see some issues here, some real problems that are gonna require some attention. Now with that, we've done a reasonable review of the kinds of questions you might see in part two of your assessment. We've spent 10 weeks together. I certainly appreciate the time of you folks that took to review this and to make any comments or ask any questions. I have enjoyed sharing this with you. I hope you've gotten the idea that I really do love finance and I like talking about it. But more importantly, I hope this information is something that you can actually use and you've benefited from. Remember that the MBA six to one, this is one course, financial management in our master's program offered by Sailor Academy and you can certainly find out more about that. Having said that, thanks again for participating and good luck everybody. Michael. All right, well, let me just echo what you said about thanking everyone for joining us and let me just say thank you for taking us through this. It's been great. I'm not seeing any questions in the chat right now so I think we'll probably just call it but then thank you everyone for joining us throughout and good luck on your furthering education in the world of finance. Thank you everybody and thank you Michael. Bye.