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Entrepreneurial Finance.
: Financial And Economic Concepts
Topic Objective:
At the end of this topic student would be able to:

Understand the basic concepts and importance of finance as it relates to individuals and business.

Understand the basic economic concepts of finance.

Distinguish between marginal revenue and marginal cost.

Distinguish between economic capital and financial capital.

Determine the opportunity cost of making decisions.

Identify the relationship that exists between savings, income, expenditures, and taxes.

Identify those factors that affect interest rates.

Understand the relationships that exist between supply and demand for money and prevailing

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market interest rates.

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Describe the role of the Federal Reserve and those tools used to achieve the goals of economic
growth, price stability, and full employment.

Understand the relationship that exists between risk and return on investment.

Compare systematic risk to unsystematic risk and their impact on business.

Definition/Overview:

Finance: The field of finance refers to the concepts of time, money and risk and how they are
interrelated. Banks are the main facilitators of funding through the provision of credit, although
private equity, mutual funds, hedge funds, and other organizations have become important.
Financial assets, known as investments, are financially managed with careful attention to
financial risk management to control financial risk.

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Key Points:
1. Finance
Finance is essentially any transaction where money or a money-like instrument is exchanged for
money or a money-like instrument.

2 Market
A market consists of any organized effort where buyers and sellers freely exchange goods and
services.

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Name five types of markets in which you participate: Financial, real estate, retail, wholesale,
commodities, stock markets, bond markets, money markets, and flea markets.

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3. Compare marginal revenue, marginal cost, and marginal revenue product.


Marginal revenue is the additional revenue that a firm obtains by selling one more unit. Marginal

cost is the cost of hiring one more unit of labor or the cost of producing one more unit of output.

Marginal revenue product is the additional revenue we obtain by hiring one more unit of labor.

4. Distinguish between economic and financial capital.


Economic capital resources include all items that man manufactures by combining natural and
human resources like buildings, equipment, roads, and bridges. Financial capital is a dollar value
claim on economic capital. Financial capital would include cash, deeds of trust, mortgages, loan
papers, stocks, and bonds.

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5. Value of the entrepreneur.


The entrepreneur combines natural, human, and capital resources to produce a good or service
that we value more than the individual components. Without the entrepreneur, the other
resources would not normally be combined, except for subsistence (i.e., the resources that are
just sufficient to sustain life). The entrepreneur seeks to make a profit when using his or her
ideas. When we look at overall payments, the value of the mental talents of entrepreneurs
normally exceeds the wages that are paid for labor. For example, the owner of a professional
sports team, the entrepreneur, will normally make more than any player on that team. Of course,
the more brilliant the idea and its ultimate appeal to the buyer of the good or service, the more
profit that will accrue to the entrepreneur.

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6. Opportunity cost

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An opportunity cost is the highest value that is surrendered when a decision is made; it is never

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the decision itself. It is a quantifiable term. The highest value that is surrendered when a decision
to invest funds is made.

Choices Available for Funds


Investment Opportunity
Expected Annual Return (%)

Purchase stock

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Purchase home

Purchase bonds

Place money in bank savings account

Purchase new car

-15

[Table 1 Expected Financial Returns of Investment Opportunity]

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7. What makes up gross income


Gross income is all of the money received from all sources during the year. This includes
wages, tips, interest earned on savings and bonds, income from rental property, profits to
entrepreneurs, and any other source of income an individual may have.
Income, Expenditures, and Taxes

Gross income is all of the money received from all sources during the year.

Wages

Tips

Interest earned on savings and bonds

Income from rental property

Profits to entrepreneurs

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Basic Income Calculations

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Gross income - taxes = Disposable income

For most of us, disposable income is take-home pay.

Disposable income - Fixed expenses = Discretionary income

Fixed expenses are contractual obligations like rent, utilities, insurance, and car payments.

Discretionary income is that we can spend or save.

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Federal
Income, Taxes
SS, &
Paid as
Gross Medicare a % of
Fixed
Household Income Taxes
Gross Disposable Expenses Discretionary
Name
($)
($)
Income Income ($) ($)
Income ($)

Jones

30,000 5,228

17.43% 24,773

19,673

5,100

Roberts

50,000 9,758

19.52% 40,243

32,683

7,560

23.57% 53,499

40,179

13,320

Smith

16,502

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70,000

Brown

90,000 23,432

26.04% 66,569

41,369

25,200

Meeks

110,000 28,814

26.19% 81,186

42,306

38,880

Adams

130,000 35,104

27.00% 94,896

48,096

46,800

Charles

150,000 41,394

27.60% 108,606

50,718

57,888

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Source for taxes: Department of the Treasury, Internal Revenue Service

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[Table 2 Income and Expenses of Variable Households]

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8. Progressive, regressive, and proportional taxes.

Progressive taxes take a larger percentage of your income as it increases. Regressive taxes take a

higher percentage of your income as it decreases. Proportional taxes are taxes where the

percentage paid stays the same, regardless of income. Examples include progressive income
taxes, regressive sales taxes, and proportional property taxes.

Taxes

Progressive taxes: larger percentage of tax paid as income increases.

Regressive taxes: larger percentage of tax paid as income decreases.

Proportional taxes: percentage of tax paid remains the same at all levels of income.

Example of Progressive Tax


Formula for tax percentage paid:
Income tax is progressive:

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Example of Regressive Tax

Sales tax is regressive:

Income = $20,000; savings = 0; sales tax = 5%

Sales tax paid = $20,000 x 0.05 = 1,000

Income = $60,000; savings = $10,000; sales tax = 5%

Sales tax paid = $50,000 x 0.05 = $2,500


Example of Proportional Tax

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Formula for tax percentage paid:

Medicare tax is 1.45%

Annual income $30,000

Medicare tax = $30,000 x 0.0145 = $435

Annual income $500,000

Medicare tax=$500,000 x 0.0145 = $7,250

Factors Affecting Interest Rates

The supply of money saved is primarily the total money that is placed in demand deposit

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(checking) accounts, savings accounts, and money market mutual funds.


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The demand for borrowed funds is all of the money that is demanded in our economy at a given
price.

Federal Reserve Policy

The Federal Reserve is the central bank of the United States.

Risk

Systematic Risk: Risk associated with economic, political, and sociological changes that affect
all participants on an equal basis.

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Unsystematic Risk: Risk unique to an individual, firm, or industry.

9. Law of supply
The law of supply states that as the payment or price of an item increases, ceteris paribus, we
will supply more of that item.

10. Supply Table


A supply table is a listing of the quantities of some variable, which will be supplied at various

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prices in the marketplace. The supply curve is obtained by horizontally summing the quantities
supplied by different suppliers at each price in the market.

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11. Law Of Demand

The law of demand states that if all other factors are constant, as the price for an item decreases,
people will demand more of that item, ceteris paribus.

12. Concept of a surplus of money versus a shortage of money.


When the supply of money saved exceeds the demand for money, there is a surplus of money. At
which point institutions (banks, credit unions, savings and loans, etc.) will pay less for savings,
and interest rates will begin to fall. When the demand for money exceeds the supply, there is a
shortage of money and interest rates will be bid up in the market as institutions attempt to obtain
more money.

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13. Federal Reserve (Fed)


The Fed is the central bank of the United States. The three tools for controlling the money
supply are the discount rate, the reserve requirements ratio, and federal open market operations.

14. Risk
Risk involves the probability that the actual return on an investment will be different from the
desired return. Systematic risk is risk which is associated with economic, political, and
sociological changes that affect all participants on a near-equal basis. Unsystematic risk is risk
that is unique to an individual, firm, or industry

: Financial Management And Planning

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Topic Objective:

At the end of this topic student would be able to:

Describe the five basic functions of a manager and how they relate to a business.

Distinguish between strategic plans and functional plans.

Understand the three factors that must be addressed when establishing goals.

Describe the financial goals for a for-profit organization.

Trace the three-step process that you must take when using control.

Compare and contrast the basic forms of business ownership (sole proprietor, partnership, and

corporation).

Distinguish between limited and unlimited liability.

Compare and contrast general partnership, limited partnership, and a limited liability company.

Understand the role that the franchise plays when establishing a business.

Understand the basic components of a SWOT analysis.

Know what basic factors are required to complete a business plan.

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Definition/Overview:
Managerial finance : Managerial finance, the branch of finance that concerns itself with the
managerial significance of finance techniques

Key Points:
1. Planning

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Planning is a systematic process that takes us from some current state to some future desired
state. Strategic planning establishes the overall plan for the business, whereas functional

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planning is driven by the strategic plan. If McDonalds has a strategic plan to become the
number-one family restaurant, then its functional plans would involve opening new restaurants in

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specific communities around the world, financing these restaurants, and developing marketing
plans for each area (Germany serves beer, America serves soda, England serves fish and chips,

India serves no hamburger meat, etc.).

2. Goal setting play in the planning process?


Goal setting is a precursor to establishing a plan. In order to begin planning, you need goals that
are measurable and can be reached in a specified time period.

3. Five functions of a manager


Planning, organizing, staffing, directing, and controlling.

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4. Three Steps Of Controlling


Establish a standard of measurement, measure actual performance against the standard, and take
corrective action when actual performance varies from the established standard.

5. Three forms of business ownership.


The sole proprietorship, which is a business operated by the proprietor for his or her own profit.
A partnership is an association of two or more persons who carry out a business as co-owners for
a profit. The corporation is a legal entity according to U.S. law that may accomplish all of the
tasks that can be accomplished by an individual. A limited liability company (LLC) is a hybrid

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business entity having features of both partnerships and corporations.

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6. Unlimited liability

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The owner of a business is personally liable for any debts of the business and is legally liable for
any problems that the business may have. This includes the payment of all judgments against the

business.

7 . Limited Partnership Differ From A General Partnership


A limited partnership is one in which there is one or more general partners and several limited
partners. A limited partner is basically an investor who has liability limited to the amount of the
investment in the partnership. All of the partners in a general partnership are general partners.
They are in charge of day-to-day operations and are personally liable for the partnership. General
partners have unlimited liability.

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8. Sole Proprietorship
Advantages of the corporation primarily include unlimited access to financial capital (stocks and
bonds) and limited liability for the owners (can never lose more than investment even if
corporation ceases to exist).

9. Disadvantages Of A Corporation
Disadvantages of the corporation include numerous federal and state legal requirements, double
taxation, and owners have little or no control of how the business is run on a daily basis.

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10. Pitfalls Of Franchising

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You are not truly your own boss and must comply with the legal obligations to the franchiser that
you agreed to in the franchise agreement. You must provide the franchiser with a percentage of

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gross sales on a monthly basis, and are obligated to conduct business in a manner specified by
the franchiser.

11. components of a strengths, weaknesses, opportunities, and threats (SWOT) analysis.

Strengths are areas of expertise that a business has and for the individual are those things that
you do well and like doing. Weaknesses are the shortcomings of the business and for the
individual are areas that you really dislike and in which you lack expertise. Opportunities are
items that exist in the environment that provide your business with expanded sales if taken
advantage of and will help your business grow and prosper. Threats are factors that exist in the
environment that may impede the growth of your business.

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12. Major Components Of A Business Plan.


A business plan contains a description of the business which includes legal form and name, date
of formation, location, product or service, brief history, proposed future operations, financial
data, and supporting documents. The answers to these last two questions are individually
determined by each student or student team.

13. Management Functions

Planning is a systematic process that takes us from some current state to some future desired
state.

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Strategic planning involves establishing an overall plan for the business.

Functional planning is driven by strategic plans and is related to specific functional areas of a

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business such as accounting, marketing, or human resources.


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Goal setting is precursor to establishing a plan.

Goals must be measurable, achievable, and have a time frame.

Basic financial goals of a for-profit organization:

To maximize the wealth of the business owners (investors) over the life of the business

To meet interest payments on debt

To grow

Organizing is the second function of the manager and defines the structure of the business.

Who will do it?

What skills do they need?

What is the time frame that we have set in which to have it accomplished?

Where will it be accomplished?

How do we get it accomplished?

Staffing requires that the manager obtain the most capable personnel to implement the business

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plans.
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Determine job requirements.

Develop a job description.

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Directing (leading). Providing proper guidance and direction to others to accomplish the
organizations mission.

Controlling is a three-step process:

Establishing a standard of measurement

Measuring actual performance against the standard

Taking corrective action when actual performance varies from the established standard

A sole proprietorship is operated by an individual for profit.

A partnership is an association of two or more persons who carry out a business as co-owners for

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a profit.

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General partnership

Limited partnership

Limited liability company

The corporation is a legal entity according to U.S. law.

Incorporated in one of the fifty states or territories of the United States.

Public Corporation: stock is sold to the public.

Private Corporation: Stock is not sold to the public.

All corporations are formed as C corporations unless they meet the requirements of and request
Subchapter S tax status.

Subchapter S corporation: Private corporation with special tax status granted by Internal
Revenue Service (IRS)

Maximum of 100 shareholders

No double taxation

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A Limited Liability Company (LLC) is a hybrid business entity having features of both
partnerships and corporations.

Taxed as a partnership

Has limited liability for its owners

Flows through income and losses to individual owners tax returns

Franchise not an actual form of ownership. A franchise is a business in which the buyer, who is
the franchisee, purchases the right to sell the goods or services of the seller, who is the
franchiser.

Starting a Business

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Run a SWOT analysis

Strengths are the core competencies of a business. They are those factors that will make your
business succeed because you perform in these areas better than your competitor.

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Weaknesses are those areas of your company that definitely need improvement.

Opportunities are factors that exist outside of your business, but that if taken advantage of, will

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help your business to grow and prosper (e.g., low interest rates for business loans).
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Threats are factors that exist in the environment that may impede the growth of your business,

directly or indirectly (e.g., new competition).

Development of a Business Plan

Executive summary: Part of business plan that investors review to determine if they want to read
further. Two pages or fewer, the executive summary should contain:

Business strategy for success

Brief description of the market and what makes your business unique

Brief description of the product or service

Brief description of management teams qualifications

Summary of revenue and expense projections

Estimate of how much money is needed and how it will be used

General Company Description:

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Mission Statement:

Company goals

Company objectives

Business philosophy

Form or forms of business ownership

Products and services

Marketing plan

Price

Product

Promotion

Place

Operational plan

Management and organization

Personal financial statement of each owner or major stockholder

Startup expenses and capitalization

Financial plan; a 4-year projection of profit

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Appendices

Brochures, advertising materials, business cards

Industry studies

Maps and photos of location

List of equipment owned or purchased

Copies of leases or contracts

Letters of support from suppliers and future customers

Market research studies

List of assets available for a loan

Financing a Business or Raising Capital

Suppliers of funds include lenders and investors

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Lenders increase debt and include banks and any other lender

Investors increase company equity and expect a positive return on their investment:

Company owners

Angel investors provide seed money and mentoring to start-up businesses

Venture capitalist normally invests in companies with proven track record

In Section 2 of this course you will cover these topics:


Financial Statements

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Analysis Of Financial Statements

You may take as much time as you want to complete the topic coverd in section 2.
There is no time limit to finish any Section, However you must finish All Sections before
semester end date.

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If you want to continue remaining courses later, you may save the course and leave.
You can continue later as per your convenience and this course will be avalible in your
area to save and continue later

: Financial Statements

Topic Objective:

At the end of this topic student would be able to:

Understand how financial statements are used by businesses.

Understand the differences and similarities that exist between a personal cash flow statement and
a business income statement.

Distinguish between fixed and variable expenses.

Understand the changes in income statements that exist with different forms of business.

Understand the differences and similarities that exist between a personal statement of financial
position and a business balance sheet.

Analyze the components of the basic accounting equation.

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Distinguish between assets and liabilities.

Understand the relationship between fixed assets and depreciation.

Understand the significance of the statement of cash flows.

Given the basic data for a company, be able to construct a financial statement.

Understand the problems that may exist with financial statements.

Definition/Overview:
Financial statements : Financial statements (or financial reports) are formal records of a

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business' financial activities.

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Key Points:

1. Financial Statements Used By Business

They are used by the business for internal control of finance. Data from statements are used to

track the companys record, present status, and future financial direction.

2. Variable and fixed expenses.


Variable expenses are expenses that we have control over as individuals. Fixed expenses for the
individual are contractual in nature such as mortgage payments, insurance payments, and
lease payments, and we have little or no control over them. Variable expenses from the business
view are related cost of goods sold. Fixed expenses for a business are normally
considered to be operating expenses.

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3. Basic format of an income statement


The income statement has a beginning and end date, the name of the company, and provides
information from total revenues subtracting all expenditures until we arrive at net income.
Its sections include Gross Sales, Returns and Allowances, Net Sales, Cost of Goods Sold,
Operating Expenses, Operating Income, Interest Expense, Taxes (for a corporation), and Net
Income.

4. Primary Difference Between The Income Statement Of A Sole Proprietorship Or

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Partnership And The Income Statement Of A Corporation

The primary difference is that the income statement for a sole proprietorship or partnership does
not show a line for income taxes as they flow through to the owners individual tax return. The

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corporate income statement shows an entry for taxes, which are the corporate income taxes paid

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by the corporation.

5. Personal Statement Of Financial Position

It is a personal balance sheet that lists all items that are owned (assets) by the individual and all

items that are owed (liabilities) by the individual at a specific point in time (as of date). As a
result, net worth can be determined.

6. Importance Of Liquidity
Liquidity is a measure of how fast an asset can be converted to cash. If a business does not have
sufficient liquidity it will not be able to pay off short-term creditors on time. This affects
the business credit rating and ability to borrow funds.

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7. Accounting equation for the balance sheet?


Assets = Liabilities + Owners Equity

8. Difference Between A Current Asset And A Fixed Asset


A current asset is an asset that has a useful life of one year or less. A fixed asset is one that has
an expected life in excess of one year. Fixed assets may be depreciated, current assets
cannot be depreciated.

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9. Owners equity in a sole proprietorship

Owners equity in a sole proprietorship is the total value of the business that results from

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subtracting total liabilities from total assets. Owners equity in a partnership lists all of the

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individual partners equity. Owners equity in a corporation includes preferred stock at par,
common stock at par, paid in capital in excess of par value, and accumulated retained

earnings.

10. Purpose Of The Statement Of Cash Flows


The purpose is to show how cash flowed into and out of the business during the year. The reason
is that the income statement and balance sheet do not actually show cash flow during
the accounting period.

11. Components of the statement of cash flows.


The components include cash flows from operating activities, cash flows from investing
activities, and cash flows from financing activities; the result of these are the net increase

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(decrease) in cash.

12. Financial Statement (Personal Form)


Single bank loan application form which incorporates two individual financial forms:

Statement of financial position

Cash

Cash equivalents

Invested assets

Use assets

Liabilities

Net worth

Personal cash flow statement

Income

Fixed expenses

Variable expenses

Income Statement Business

Basic Format

Sales, revenues, income from doing business

Less cost of goods sold

Gross profit

Less operating expenses

Operating income

Less interest

Net income

Personal Income Statement (Cash Flow Statement)

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IncomeInclude all sources

Wages, tips, overtime

Interest on savings, stock dividends, etc.

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Fixed expenses

Contractual, must be paid

Rent, insurance, utilities, car payments, etc.

Variable expenses

You control level of expenses (food, clothing)

Balance Sheet (Statement of Financial Position)

Basic Accounting Equation

Total assets

Current assets

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Individual

Sole Proprietorship

Partnership

Corporation

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Cash, accounts receivable, inventory

Land

Building & equipment (less accumulated depreciation)

Net building & equipment

Fixed assets

Total liabilities

Current liabilities

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Accounts payable, notes payable, taxes payable

Long-term liabilities (debt)

Total equity

Preferred stock

Common stock par value

Paid-in capital in excess of par (common)

Retained earnings

Statement of Cash Flows

Statement of cash flows shows how the companys working capital flows into and out of the

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business during the year.


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Statement of cash flows includes:

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Cash flows from operating activities is the difference between all of the

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cash received by the business and all of the cash paid out by the business
in conducting its day-to-day operations.

Receipts: All cash received from sales, changes in accounts receivable,


changes in inventory.

NOTE: An increase in accounts receivable or inventory represents a

negative cash flow. A reduction in receivables or inventory is a positive


cash flow.

Payments: All payments made by the company to all accounts (suppliers,


employees, rent, utilities, etc.).

Cash Flows from Investing Activities:

Acquisition or sale of Plant Assets

Cash Flows from Financing Activities:

Proceeds from issuance or sale of stock (preferred & common), bonds. Purchase of stock or the
payment of long-term debt.

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Net increase (decrease) in cash plus the cash balance, previous year equals cash balance, current
year

: Analysis Of Financial Statements


Topic Objective:
At the end of this topic student would be able to:

Understand the purpose of financial statement analysis.

Perform a vertical analysis of a companys financial statements by:

Comparing those accounts on the income statement as a percentage of net sales and comparing

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those accounts on the balance sheet as a percentage of total assets for a period of two or more
accounting cycles.

Determining those areas within the company that require additional monitoring and control.

Comparing the percentage change of components on a companys income statement and balance

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sheet for a period of two or more years.

Determining those areas within the company that require additional monitoring and control.

Perform ratio analysis of a company and compare those ratios to other companies within the

same industry using industry averages.

Analyze the relationships that exist between the several categories of ratios in determining the
health of a business.

Distinguish between liquidity, activity, leverage, profitability, and market ratios.

Know how to obtain financial statements and financial information from various sources.

Definition/Overview:
Financial statements : Financial statements (or financial reports) are formal records of a
business' financial activities.

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Key Points:
1. Financial statement analysis
The purpose of financial statement analysis is to generate information which can be used
internally by the business and externally by potential creditors and investors.

2. Financial Statements
Financial statements are used internally by managers to monitor the business on an ongoing

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basis. The statements can be compared to previous time periods to determine how effectively and
efficiently the companys goals are accomplished. The instructor can accept any of the financial
statement analysis ratios that managers would normally use internally as long as the student

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demonstrates an understanding of the actual use of the ratio by a business manager.

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3. Three types of financial statement analysis.

Vertical analysis is the process of using a single variable such as net sales as a constant and
determining how all other variables relate to this single variable. Horizontal analysis is the

process of determining the percentage increase or decrease in an account by comparing the base
time period to successive time periods. Ratio analysis shows the relationship between two
variables expressed as a fraction. Ratio analysis is used to determine the health of a business
especially as it compares to other firms in the same industry or similar industries.
If a company had sales of $2,587,643 in 1998 and sales of $3,213,456 in 2003, by what
percentage did sales change during this time period?

If the company had a goal of increasing sales by 25% over a five-year period, did it meet its
objectives?

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If the company in question 4 had set a goal of increasing sales by 28% during the next five
years, what should be the sales goal for 2008?

4. Five categories of business ratios


Liquidity ratios are used to measure the ability of the firm to meet its short-term creditors
claims.
Activity ratios are used to determine how well a company is managing its assets and if the assets

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being used at the optimum level.

Leverage (debt) ratios indicate how much of the companys net worth and asset commitment is
financed with debt (sources of funds obtained from creditors).

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Profitability ratios determine how well the firm is using its assets and sales revenue to generate a

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positive return for its owners.

Market ratios indicate what price investors are willing to pay for ownership in the company.

If a company computes its current ratio to be 3.56, what does this mean in terms of the companys
current assets and current liabilities? For every dollar of current liabilities or short-term creditors
claims, the company has $3.56 of current assets in order to meet these claims.
Why might a company have a high current ratio but a low quick ratio (acid test ratio)? A
company having a high current ratio may have so much inventory that it is giving an unclear
picture of its ability to meet creditors claims. This company may have so many dollars tied up in
inventory that it is over investing its own excess funds in inventory.
If a company has beginning inventory of $30,000 and ending inventory of $55,000, compute its
average inventory. If the cost of goods sold is $140,000, compute its inventory turnover and
determine how many days the average item is in stock.

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5. Fixed Asset Turnover


If fixed asset turnover falls below one, it indicates that for every dollar of fixed assets committed
by the company, it has less than one dollar of net sales generated. In order to counteract this, the
company should either increase its revenue, decrease its fixed assets, or both. In other words, the
company is not maximizing its fixed assets as much as initially intended.
If a company has $181,000 in total liabilities and $225,000 in total assets, what percentage of
total assets is being financed with the use of other peoples money?

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In other words, for every dollar of assets that the company has a right to own, it owes 80 cents to

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creditors.

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6. Gross Profit Margin

Gross Profit Margin is used to determine how much gross profit is generated by each dollar in
net sales. To calculate gross profit margin we use the following formula:

7. Operating Profit Margin


Operating Profit Margin is used to determine how much each dollar of sales generates in
operating income. The formula uses operating income which is actually the Earnings of our
company Before Interest and Taxes (EBIT) and the formula is: .

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8. Net Profit Margin


Net Profit Margin provides us with how much the firm earned on each dollar in sales after
paying all obligations including interest and taxes. The formula is: .
The distinction occurs in the numerator for all three ratios. Gross profit margin is calculated
before operating expenses, operating profit margin is calculated after operating expenses, and net
profit margin is calculated after interest and taxes are paid.

Three Methods of Analyzing Financial Statements

Vertical analysis

Horizontal analysis

Ratio analysis

Vertical Analysis

Vertical analysis is the process of using a single variable on a financial statement as a constant

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and determining how all of the other variables relate as a percentage of the single variable.

Vertical Analysis of an Income Statement

The vertical analysis of the income statement is used to determine, specifically, how much of a
companys net sales consumed by each individual entry on the income statement.

Constant is net sales. The formula is:

Horizontal Analysis

Horizontal analysis is a determination of the percentage increase or decrease in an account from

a base time period to successive time periods.


o

The basic formula is:

Vertical Analysis of a Balance Sheet

Vertical analysis of the balance sheet is always carried out by using total assets as a constant, or
100 percent, and dividing every figure on the balance sheet by total assets.

The formula is:

Ratio Analysis

Ratio analysis is used to determine the health of a business, especially as that business compares
to other firms in the same industry or similar industries.

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A ratio is nothing more than a relationship between two variables, expressed as a fraction.
Types of Business Ratios

Liquidity ratios determine how much of a firms current assets are available to meet short-term
creditors claims.

Activity ratios indicate how efficiently a business is using its assets.

Leverage (debt) ratios indicate what percentage of the business assets is financed with creditors
dollars.

Profitability ratios are used by potential investors and creditors to determine how much of an
investment will be returned from either earnings on revenues or appreciation of assets.

Market ratios are used to compare firms within the same industry. They are primarily used by

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investors to determine if they should invest capital in the company in exchange for ownership.

Liquidity Ratios

Current Ratio: The current ratio is calculated by dividing total current assets by total current

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liabilities.

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The current ratio is given by the following:

Quick, or Acid Test, Ratio: This ratio does not count the sale of the companys inventory or
prepaids. It measures the ability of the firm to meet its short-term obligations without liquidating

its inventory.
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The acid test ratio is given by the following:

Activity Ratios

Inventory turnover ratio (or, simply, inventory turnover) indicates how efficiently a firm is
moving its inventory. It basically states how many times per year the firm moves it average
inventory:

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Accounts receivable turnover ratio allows us to determine how fast our company is turning its
credit sales into cash.

Accounts receivable turnover is given by the following:

Average collection period is the average number of days that it takes the firm to collect its
accounts receivable.

Fixed asset turnover ratio indicates how efficiently fixed assets are being used to generate
revenue for a firm

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Total asset turnover ratio indicates how efficiently our firm uses its total assets to generate
revenue for the firm.

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Leverage Ratios

Debt-to-equity ratio indicates what percentage of the owners equity is debt.

Debt-to-total-assets ratio indicates what percentage of a businesss assets is owned by creditors.

Times-interest-earned ratio shows the relationship between operating income and the amount of

interest in dollars the company has to pay to its creditors on an annual basis.

Profitability Ratios

Gross profit margin ratio is used to determine how much gross profit is generated by each dollar
in net sales.

Operating profit margin ratio is used to determine how much each dollar of sales generates in
operating income.

Net profit margin ratio tells us how much a firm earned on each dollar in sales after paying all
obligations including interest and taxes.

Operating return on assets ratio is also referred to as operating return on investment and allows
us to determine how much we are actually earning on each dollar in assets prior to paying
interest and taxes.

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Net return on assets (ROA) ratio is also referred to as net return on investment and tells us how
much a firm earns on each dollar in assets after paying both interest and taxes.

Return on equity (ROE) ratio tells the stockholder, or individual owner, what each dollar of his
or her investment is generating in net income.

Return on equity (ROE) can also use the relationship between the return on assets and the
amount of debt to assets.

Market Ratios

Earnings per share ratio is nothing more than the net profit or net income of the firm, less
preferred dividends (if the company has preferred stock), divided by the number of shares of
common stock outstanding (issued).

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Price earnings ratio is a magnification of earnings per share in terms of market price of stock.

Operating cash flow per-share ratio compares the operating cash flow on the statement of cash

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flows to the number of shares of common stock outstanding

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In Section 3 of this course you will cover these topics:


Profit, Profitability, And Break-Even Analysis

Forecasting And Pro Forma Financial Statements


You may take as much time as you want to complete the topic coverd in section 3.
There is no time limit to finish any Section, However you must finish All Sections before
semester end date.
If you want to continue remaining courses later, you may save the course and leave.
You can continue later as per your convenience and this course will be avalible in your
area to save and continue later

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: Profit, Profitability, And Break-Even Analysis


Topic Objective:
At the end of this topic student would be able to:

Understand the difference between efficiency and effectiveness.

Distinguish between profit and profitability.

Compare accounting and entrepreneurial profit.

Understand the relationship of profit margin and asset turnover on the earning power of a
company.

Given the variable costs, revenue, and fixed costs of a business, determine the break-even point
and contribution margin.

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Construct and analyze a break-even chart when given variable costs, revenue, and fixed costs of
a business.

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Understand the use of leverage and its relationship to profitability and loss.

Compare and contrast the degree of operating, financial, and combined leverage and their effect

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on the profitability of a corporation.

Definition/Overview:

Efficiency And Effectiveness: Since efficiency is obtaining the highest possible return with the
minimum use of resources and effectiveness is accomplishing a specific task or goal, then one
can be effective without being efficient and vice versa.

Entrepreneurial Profit: Accounting profit is simply the bottom line of a business income
statement and is an absolute number, whereas an entrepreneurial profit uses the economic
concept of opportunity cost. It is the profit that the entrepreneur would have earned if he or she
had invested both time and money in some other enterprise.

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Earning power :Earning power is the product of two factors: net profit margin and total asset
turnover. Net profit margin is net income divided by sales, and total asset turnover is sales
divided by total assets. This product gives rise to return on assets or investment, which is net
income divided by total assets.

Key Points:
1. Efficiency and Effectiveness

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Efficiency is obtaining the highest possible return with the minimum use of resources.

Effectiveness, on the other hand, is accomplishing a specific task or reaching a goal.

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2 . Profit versus Profitability

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Profit is an absolute number that is earned on an investment.

Accounting profit, for a business, is typically shown at the bottom of an income statement as net

income.

Entrepreneurial profit is the amount that is earned above and beyond what the entrepreneur
would have earned if he or she had chosen to invest time and money in some other enterprise.

Profitability can be measured in a business by using a ratio that is obtained by dividing net profit
by total assets. Profitability, therefore, is our Return on Investment (assets).

3. Earning Power

The earning power of a company can be defined as the product of two factors:

The companys ability to generate income on the amount of revenue it receives, which is also
known as net profit margin; and

Its ability to maximize sales revenue from proper asset employment, also known as total asset
turnover.

Earning Power Formulas

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Earning power is equal to net profit margin multiplied by total asset turnover which is equal to
return on investment (total assets).

4. Break-Even Analysis

Break-even analysis is a process of determining how many units of production must be sold, or
how much revenue must be obtained, before we begin to earn a profit.

For break-even quantity:

Where VC is variable cost expressed as a percentage of sales (revenue).

For retail firm: VC percentage =(Cost of Goods Sold)/(Net Sales)

For manufacturing firm: VC percentage = (Variable cost of a unit)/(Selling price)

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Contribution margin is the amount of profit that will be made by a company on each unit that is
sold above and beyond the break-even quantity.

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Contribution margin is also the amount the company will lose for each unit of production by
which it falls short of the break-even point.

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5. Profit and Break-Even

Desired profit with break-even analysis in quantity to produce.

VC is variable cost per unit

Desired profit with break-even analysis in dollars.

VC is a percentage of sales dollar (e.g., cost of goods sold as a percent).

6. Leverage

Leverage uses those items that have a fixed cost to magnify the return to a company. Fixed costs
can be related to company operations or related to the cost of financing.

Interest expenses paid on the amount of debt incurred is the fixed cost of financing.

A firm is heavily financially leveraged if the fixed costs of financing are high.

Degree of operating leverage (DOL) is the percentage change in operating income divided by the
percentage change in sales.

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Degree of financial leverage (DFL) is the percentage change in earnings per share divided by the
percentage change in operating income.

Degree of combined leverage (DCL) is the percentage change in earnings per share divided by
the percentage change in sales.

7. Bankruptcy

Bankruptcy for a business occurs when the liabilities of the firm exceed the assets and the
business does not have sufficient cash flow to make payments to creditors. There are essentially
three types of bankruptcy

Bankruptcy occurs when a business seeks court protection while it develops a reorganization

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plan.

Bankruptcy is reserved for individuals and sole proprietorships and is similar to, but much

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simpler than.

Bankruptcy requires liquidation of all assets of the business, and payment to the creditors.

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8. Bankruptcy Abuse, Prevention, and Consumer Protection Act.

Signed into law by President Bush on April 20, 2005.

Took effect October 17, 2005.

Makes it much more difficult for individuals and business to declare Chapter 7 bankruptcy.

Establishes a means test to determine if an individual filing Chapter 7 is abusing the system.

Imposes federal guidelines for using the homestead exemption

: Forecasting And Pro Forma Financial Statements


Topic Objective:
At the end of this topic student would be able to:

Understand the basic steps used in selecting a forecasting model.

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Know how to evaluate a forecasting model.

Given a business situation, choose the proper forecasting model.

Calculate a forecast using time series data.

Explain the role that the Mean Absolute Deviation (MAD) plays in selecting a forecasting
model.

Understand the relationship among a businesss revenue base, sales forecast, assets, and need for
financing.

Construct pro forma financial statements from available data on a proposed or existing business.

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Definition/Overview:

Forecasting : Forecasting is the process of estimation in unknown situations. Prediction is a

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similar, but more general term. Both can refer to estimation of time series, cross-sectional or

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longitudinal data. Usage can differ between areas of application: for example in hydrology, the
terms "forecast" and "forecasting" are sometimes reserved for estimates of values at certain
specific future times, while the term "prediction" is used for more general estimates, such as the

number of times floods will occur over a long period. Risk and uncertainty are central to

forecasting and prediction.

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Key Points:

1. Forecasting
A forecast is a quantifiable estimate of future demand.

Forecasting in business is the process of estimating the future demand for our products and
services.

Forecasting for the financial manager also requires estimates of future interest rates.

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2. Forecasting Process

Determine the type of model to be used.

Determine the forecast horizon.

Select one or more forecasting models.

Evaluate the models.

Apply the chosen model.

Monitor and control the model.

3 Determine the Type of Model to be Used

Who will be using the forecast and what information do they require?

How relevant is historical data, and what is its availability?

How accurate does the forecast have to be?

What is the time period of the forecast?

How much time do we have to develop the forecast?

What is the cost or benefit (value) of this forecast to our company?

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4. Determine the Forecast Horizon

Inverse relationship between forecast accuracy and time horizon.

The longer the time horizon the more inaccurate the forecast will be.

Time horizon should be at least as long as time period of strategic plan.

Product life cycles influence length of forecasts.

Technological product sales would have a short forecast.

Milk sales would have a long forecast.

Select One or More Forecasting Models

5. Evaluate the Models

Compare the accuracy of forecasting models by use of Mean Absolute Deviation (MAD)

Remember the model assists the forecaster, it does not make the decision.

Changing market and economic conditions require us to constantly evaluate our forecasting
models.

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6. Apply the Chosen Model

Application in business is used to determine future requirement.


Application of the model and specific units of measurement used depends on the area of the
business that uses the model:

Marketing wants demand of product.

Production requires units.

Finance requires dollars.

Personnel requires human resources.

7. Monitor and Control the Model

Model should allow us to develop controls in a three-step process:

Determine standard for measuring progress toward forecast.

Measure actual performance against this standard.

Take corrective action.

When the forecasting model no longer allows the manager to do this, then a new forecasting

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model must be developed.

8. Types of Forecasting Models

Judgmental models, which use qualitative methods

Time series models, which use quantitative methods

Causal models, which use cause-and-effect methods

9. Judgmental Models

Judgmental models are qualitative and essentially use estimates based on expert opinion.

Survey of Sales Forces: most appropriate for manufacturing and wholesale firms.

Surveys of Customers: applicable to all firms. Customers express preference for new or modified
products.

Historical Analogy most appropriate for firms that have several outlets. Introduction of new
product which has characteristics similar to previous products.

Market Research can include surveys, tests, and observations. Results are statistically
extrapolated to develop forecasts of demand for products.

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Delphi Method uses a panel of experts to obtain a consensus of opinion. Used primarily for
unique new products or processes for which no previous data exist.

10. Time Series Models

Time series forecasting models normally use historical records that are readily available within
the firm or industry to predict future sales.

For this reason they are often referred to as internal or intrinsic models.

Assumption in time series forecasting is that past sales are a fairly accurate predictor of future
sales.

Moving average model

Weighted moving average model

Exponential smoothing model

Linear regression model

References for mathematics in forecasting:

A = Actual observation of the variable to be forecast.

F = Forecast of the variable.

References for mathematics in forecasting (continued):

t = current time period. Time periods can be a measure of any time period (e.g., hour, day,

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month, year, decade, etc.). If time periods are measured in months and the current month is

April, then t = April.


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t-1 = one time period in the past. If time is being measured in months and t is April then one
time period in the past is March.

t-2 = two time periods in the past, etc. If time is being measured in months and t is April then
two time periods in the past is February.

t+1 = one time period in the future. If time is being measured in months and t is April then one
time period in the future is May.

t+2 = two time periods in the future. If time is being measured in months and t is April then two
time periods in the future is June.

References for mathematics in forecasting (continued):

D = the difference between two numbers. For example DAF would be actual observation of
variable minus forecast.

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S= Sum of several numbers, normally in a column.

n = the number of observations used in a calculation. The n for months in a year equal 12 and n
for years in a decade is 10.

11. Moving Average Model

Moving average model assumes that actual sales for some recent previous time periods are the
best predictor of future sales.

It assumes that each time period taken in succession has an equal influence on the prediction of
future sales.

12. Mean Absolute Deviation

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Mean absolute deviation (MAD) is a tool used to measure the forecasting error of a model.

MAD is simple to calculate and provides us with a method of determining which weights, or

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alpha, to choose for our model and which model is most appropriate for predicting sales.
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Absolute deviation is the absolute difference between forecasted sales and actual sales.

The absolute value of any number is positive and is represented mathematically by vertical lines

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drawn on either side of the number or formula.

Mean absolute deviation (MAD) is the measure of the overall forecast error.
MAD represents the average difference between our forecast and actual sales data.

13. Weighted Moving Average Model

Weighted moving average model assumes that the closest time period is a more accurate
predictor of future sales than previous time periods.

Previous time periods do have some influence on future sales.

Forecaster will assign weights to the time periods based on his or her judgment.

The sum of the weights normally equal one.

If the forecaster does not want to use a sum of one, then we sum the weights and use this sum as
the denominator in our equation.

The value of each weight is based on how much of an influence the forecaster believes the
corresponding time period has on overall sales.

The formula for this method, using three months, is as follows:

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14. Exponential Smoothing Model

Exponential smoothing model uses a smoothing constant, alpha (a), as an adjustment in


determining the forecast.

A smoothing constant is a value assigned by the forecaster to adjust the forecast based on the
forecasters assumption of the relationship between sales in one time period and sales in the next
time period.

Alpha can have any value between 0 and 1; however, alpha is normally 0.1, 0.2, or 0.3.

The higher the value of alpha, the greater the emphasis given to sales for the current time period.

With exponential smoothing we must begin with an assumed rather than an actual forecast.

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15. Linear Regression Model

Linear regression uses a statistical method known as least squared regression.

Four areas of variation:

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Seasonal variation is caused by the predictable shopping habits of our

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customers.

Trend variation is variation caused by growth or decline in demand for

our product or service over time.

Cyclical variation is caused by general economic factors that affect our

industry.

Noise is random variation in our data that is not explained by the

preceding factors.

Linear regression is used to determine two factors:

The slope of the regression line

The intercept of the regression line

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16. Causal Models

Causal models are also known as external or exogenous models.

Causal models take into account variables in the general economy that affect the revenue
obtained by a company.

Causal models can be simple or very complex.

Most of them require multiple regression analysis, which is normally beyond the scope of a small
business manager.

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17. Practical Sales Forecasting for Startup Businesses

Steps to take for a sales forecast:

Listing what you know:

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Expertise, experience, knowledge of charges and fees.

Previous revenue and cost information based on experience.

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specific publications.
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Research similar companies via EDGAR competing company annual reports, or industry-

List three types of expenses:

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Startup

Fixed

Variable

Develop a revenue forecast

18. Forecast of Revenue for a Startup Pro Forma Financial Statements

A pro forma financial statement is a projected statement based on the forecast.

The three basic pro forma statements are:

Pro forma income statement

Pro forma cash budget

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Pro forma balance sheet

19. Pro Forma Balance Sheet Using Percentage of Sales

Percentage of sales method is based on the fact that assets and liabilities historically vary with
sales.

Thus any increase in sales will cause a subsequent buildup in both assets and liabilities.

Both profit margins and dividend (owner) payout ratios determine the amount of internal
financing that can be applied to support increased asset buildup.

20. Monitoring and Controlling the Business

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Monitoring in finance is normally accomplished by use of budgets and pro forma financial
statements.

Most small businesses require only two budgets for monitoring and controlling purposes, the

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capital budget and the cash budget.

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Controlling process requires three steps:

Establishing a standard

Comparing actual performance to the standard

Taking corrective action if necessary

Instructions

In Section 4 of this course you will cover these topics:


Working Capital Management
Time Value Of Money Part I: Future And Present Value Of Lump Sums
You may take as much time as you want to complete the topic coverd in section 4.
There is no time limit to finish any Section, However you must finish All Sections before
semester end date.
If you want to continue remaining courses later, you may save the course and leave.
You can continue later as per your convenience and this course will be avalible in your
area to save and continue later

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: Working Capital Management


Topic Objective:
At the end of this topic student would be able to:

Understand the general concept of working capital management.

Describe the asset categories that are included in working capital management.

Determine the methods of managing disbursement and collection of cash to increase business
profitability.

N
I
.
E

Understand how a business balances extending credit and its ability to manage increased
accounts receivable.

Explain how accounts receivable are analyzed.

Understand the role that proper inventory management plays in the profitability of a business

V
S

S
.B

enterprise.

Understand how a businesss current liabilities are managed.

Understand the relationship of accrued liabilities management and obligations to federal and
local government agencies.

Understand the relationship of trade and cash discounts to the minimization of accounts payable.

W
Definition/Overview:

Working capital : Working capital, also known as net working capital, is a financial metric
which represents operating liquidity available to a business. Along with fixed assets such as plant
and equipment, working capital is considered a part of operating capital. It is calculated as
current assets minus current liabilities. If current assets are less than current liabilities, an entity
has a working capital deficiency, also called a working capital deficit.

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Key Points:
1. Working Capital

Working capital consists of the current assets and the current liabilities of a business.

Current assets are gross working capital.

Cash, marketable securities, accounts receivable, and inventory

Net working capital is the difference between a businesss total current assets and its total
current liabilities.

2. Working Capital Management

N
I
.
E

Working capital management is our ability to effectively and efficiently control current assets
and current liabilities in a manner that will provide our firm with maximum return on its assets

V
S

and will minimize payments for its liabilities.

S
.B

3. Current Asset Management

Cash management

Marketable securities management

Accounts receivable management

Inventory management

4. Cash Management

The goal of cash management is to obtain the highest return possible on cash. Cash consists of:

Petty cash

Cash on hand

Cash in bank, checking

Cash in bank, savings

Float

The disbursement float is the time that elapses between payment by check and the checks
actually clearing the bank, at which point funds are removed from our checking account.

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Collections float is the amount of time that elapses between your depositing a debtors check in
your account and the checks clearing, at which point the funds are actually placed in your
account.

Float (continued)

Managing collection float:

A lockbox is a post office box that is opened by an agent of the bank,


and checks received there are immediately deposited in our account.

Electronic funds transfer is accomplished when funds are immediately


transferred from one bank account to another via computer.

N
I
.
E

5. Marketable Securities Management

Marketable securities normally are those investment vehicles that include U.S. treasury bills,

V
S

government and corporate bonds, and stocks.

Excess cash should be placed in the above vehicles because they increase in value more than

S
.B

cash itself.

6. Accounts Receivable Management

The goal of accounts receivable management is to increase sales by offering credit to customers.

Options to offering credit include:

The business issuing its own credit card or line of credit.

Factoringselling accounts receivable to another firm at a discount off of

the original sales price.

The 3 Cs of credit:

A customers character is favorable if that customer has paid his or her bills on time in the past
and has favorable credit references from other creditors.

Capacity to pay refers to whether the customer has enough cash flow or disposable income to
pay back a loan or pay off a bill.

Collateral is the ability to satisfy a debt or pay a creditor by selling assets for cash.

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Credit terms are the requirements that our business establishes for payment of a loan (the use of
credit by a customer).

To speed up collections, cash discounts are often offered to a business customer. An example
would be 2/10 net 30. If the customer pays the bill within 10 days of the invoice a 2 percent
discount is given. Otherwise the entire net is due 20 days later or at the 30th day.

Analyzing accounts receivable:

Accounts receivable turnover:

Aging of accounts receivable is accomplished by determining the amounts of accounts


receivable, the various lengths of time for which these accounts have been due, and the
percentage of accounts that falls within each time frame.

N
I
.
E

7. Inventory Management

The overall goal of inventory management is to minimize total inventory costs while maximizing

V
S

customer satisfaction.

Two primary decisions must be made:

Establish the reorder quantity (the number of items to order)

Establish the reorder point (that level of inventory at which a new order will be placed).

EOQ and Quantity Discounts

If the business is large or uses items in quantity, then quantity discounts may override the EOQ

S
.B

formula. We will determine this by use of both the EOQ formula previously given and the total
cost formula which is:
o

Determining EOQ with quantity discounts requires the following procedures:

Compute EOQ for each discounted price.

If the computed EOQ falls within the discounted quantity area, then
order the EOQ.

If the EOQ does not fall within the discounted quantity area, then
compute total inventory costs.

Order the minimum quantity that provides the lowest overall total
inventory costs.

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Reorder Point Calculations

The reorder point (ROP) has three factors that are used in determining the quantity of an item
that exists when we actually place an order:

Lead-time (L) is the time that lapses from order placement to order
receipt.

Daily demand (d) is the quantity of a product that is used per day.

Safety Stock (ss) the quantity of stock you keep for variations in
demand.

Just-in-time (JIT) is an inventory system where orders are delivered to satisfy daily, and in some

N
I
.
E

cases hourly, demand. It is primarily used in manufacturing.


o

If daily demand can be accurately predicted

If vendor delivery reliability is outstanding

If vendors will deliver on an hourly or daily basis, then JIT inventory can be used

Types of inventories

V
S

S
.B

Raw materials are the items that a company uses in producing its final product.

Work-in-process inventories are made up of those items that are being produced.

Finished goods inventories are made up of those items that are actually sold by the business.

Maintenance, repair, and operating (MRO) inventories are made up of those items that are used
by the firm in normal operations, but are not manufactured or sold by the firm.

ABC inventory analysis is based on the 80-20 rule or Paretos Law


A items: 5 to 10 percent of the inventory items (i.e., individual stock numbers or stock keeping
units) that make up approximately 75 percent of total costs

B items: 10 to 15 percent of the inventory stock numbers that make up 10 to 15 percent of the
total costs

C items: The remaining 75 to 80 percent of the stock numbers account for only 10 to 15 percent
of total costs (C items)

Determining ABC items in inventory:

Take the total quantity purchased and multiply it by the unit cost to determine total cost for the
item (Table 7-3).

Take the inventory items and list them in descending order, based on total cost (Table 7-4).

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Compute the percentage of total cost that each inventory item consumes.

8. Current Liabilities Management

Current liabilities management consists of minimizing our obligations and payments for shortterm debt, accrued liabilities, and accounts payable. It consists of:

Short-term debt management

Accrued liabilities management

Accounts payable management

Short-term debt management

Short-term debt consists of business obligations that will be paid within the current accounting
period. They consist of the following:

Current payments on long-term debt

Bank lines of credit

Notes payable

Accounts payable

Short-term loan for one year or less

N
I
.
E

V
S

S
.B

Lines of credit:

A line of credit is similar to a credit card.

With it, we obtain a credit limit, but we are not obligated to make

payments unless we actually borrow the money.

A line of credit is normally obtained from our primary bank.

A line of credit is used when our cash outflow exceeds our cash inflow.

9. Accrued Liabilities Management

Accrued liabilities are those obligations of the firm that are accumulated during the normal
course of business and are primarily payroll taxes and benefits, property taxes, and sales taxes.

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10. Accounts Payable Management

Accounts payable are the debts of a business which are owed to vendors. Vendors offer several
types of discounts. They are:

Trade discounts

Cash discounts

Quantity discounts

Trade discounts are amounts deducted from list prices of items when specific services are
performed by the trade customer.

Trade discounts may be expressed as a single amount, such as 30 percent, or in a series, such as
30/20/10.

N
I
.
E

Calculation of trade discounts:

Calculation of trade discounts can be accomplished by moving backward from the list price.

Calculation of trade discounts (continued)

The net cost rate factor is the actual percentage of the list price paid after taking all successive

V
S

S
.B

trade discounts50.4 percent in this case.


o

One minus the net cost rate factor is the single equivalent discount.

Calculation of trade discounts (continued)

A second simpler way of determining the net cost rate factor and the invoice price is to multiply

the complements of the trade discounts as shown below:

Calculation of trade discounts (continued)


The invoice price (the price that you actually pay the vendor) can be simply calculated by the
following formula:

Cash discounts are offered to credit customers to entice them to pay promptly.

The seller views a cash discount as a sales discount.

The customer views it as a purchase discount.

The terms of a cash discount play an important role in determining how the invoice will be paid.

Cash discounts will normally appear on an invoice in terms such as 2/10 n30.

This means that the customer may deduct 2 percent off of the invoice price if he or she pays
within 10 days.

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If the customer does not pay within 10 days, he has the use of 98% of the money owed for the
next 20 days.

If the customer pays within 30 days, the net, or total amount, of the invoice is due.

If he or she pays after 30 days, the credit agreement with the seller normally stipulates that a
monthly interest charge be added to the unpaid balance.

Calculations used in cash discounts:

A $10,000 invoice with terms of 2/10 n30

Option 1: Pay off the $10,000 with a payment of $9,800 within 10 days of the invoice date.

This is computed by multiplying the invoice price by 1 minus the


discount (1 - 0.02 = 0.98, and $10,000 x 0.98 = $9,800).

N
I
.
E

Or by taking the invoice price times the discount and subtracting it from
the invoice price ($10,000 x 0.02 = $200, and $10,000 - $200 = $9,800).

V
S

A $10,000 invoice with terms of 2/10 n30

Option 2: Pay the invoice price of $10,000 on the 30th day after the invoice date. If this option is

S
.B

chosen, he will pay the equivalent of 36.7 percent annual interest because of his delaying
payment. The logic is shown on the following page.
o

$200 is the cost paid on $9,800 for 20 days, or an interest rate of 2.04 percent ([$200 $9,800] x
100).

This will result in an effective annual interest rate of 36.7 percent (2.04 x [360 20days]).

The effective annual interest rate is obtained by multiplying the time period interest rate by the

number of time periods in an accounting year (360 20).

11. Accounts Payable Management

Quantity discounts are offered by vendors to increase their own cash flow when they offer
discounts to customers who purchase items in large quantities.

Cumulative discounts are normally discounts that are offered on total purchases of an item
during the vendors fiscal year

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: Time Value Of Money Part I: Future And Present Value Of Lump Sums
Topic Objective:
At the end of this topic student would be able to:

Explain the relationship between the time value of money and inflation.

Distinguish between effective rate and stated rate.

Calculate the future value lump sum and present value lump sum factors that are used to solve
time value of money problems.

Compare bank discount and simple interest.

Calculate the internal rate of return with respect to the present value of a lump sum and future
value of a lump sum.

N
I
.
E

Integrate the present value of a lump sum and the future value of a lump sum to solve real-life
financial problems.

V
S

Use financial tables to solve time value of money problems.

Use financial calculators to solve time value of money problems.

S
.B

Definition/Overview:

Time Value Of Money And Inflation: Money has an opportunity cost which corresponds to the
time value of money. There is always a lost opportunity when a choice is made on how to spend
or invest money. Mathematically, the time value of money is the loss of purchasing power that
occurs over time as a result of inflation.

Inflation: Inflation is an increase in average prices over time.

Simple Interest : simple interest is the interest earned or paid on the principal and added to the
principal to get the maturity value.

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Compound interest : Compound interest is interest earned on both the principal and interest
previously earned.

Bank Discount: The bank discount is an amount of interest that is deducted from the amount
you wish to borrow in order to get the proceeds.

Stated Rate Of Interest : The stated rate of interest is the annual rate of interest that is quoted

N
I
.
E

by the lender.

V
S

Effective Rate: The effective rate is the actual annual interest rate after compounding is taken
into consideration.

S
.B

Internal Rate Of Return (IRR): The internal rate of return is the actual rate of return that takes

into consideration the time value of money.

W
Key Points:
1. Simple Interest

Simple interest is the amount of interest earned on the principal amount stated.

Principal amount stated is the base amount that we borrow or save.

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2. Federal Treasury Bills

There are situations in which the entrepreneur can actually perform the function of a bank.

What better source of investing than to lend the government of the United States money for a
short period of time?

The government issues discounted treasury bills in denominations of $10,000 for three months,
six months, and one year.

3. Effective Rate

The stated or quoted rate is the rate of interest that is listed, normally on an annual basis, and it

N
I
.
E

disregards compounding.

The effective annual rate is the actual rate that is paid by the borrower or earned by the investor
after compounding is taken into consideration.

S
.B

compounds monthly.

V
S

Example: A bank quotes 8 percent annual rate. The bank wants monthly payments, so it

You save $10,000 at 5 percent interest for 10 years compounded annually. What is the future
value of this investment after 10 years?

4. Present Value of a Lump Sum (Examples)

How much do you have to deposit in an account today that will have a value of $10,000,000 in 7
years if annual interest is 6% compounded annually? Note: If tables are used rather than a
calculator, the answer will be $6,651,000.

Present Value of a Stream of Unequal Payments

An athlete is offered a $20 million contract over 5 years with a $4 million signing bonus. The
contract consists of $2 million for year 1, $3 million for year 2, $3 million for year 3, $3 million
for year 4, and $5 million for year 5. What is the present value of the $20 million contract if
money can earn 5 percent annual interest?

Internal Rate of Return

Internal Rate of Return (IRR) is the actual rate of return that equates a dollar invested now with a
dollar received in the future.

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Rule of 72

We can also find an approximation of the amount of time that it takes a present sum of money to
double by dividing the number 72 by the interest rate earned on an investment. This procedure is
known as the rule of 72. Example: How long will it take $1,000 to double if it can be invested at
12%?

We can also find the interest required if we know how long it takes an investment to double

N
I
.
E

In Section 5 of this course you will cover these topics:


Time Value Of Money Part Ii: Annuities

V
S

Capital Budgeting
Personal Finance

S
.B

You may take as much time as you want to complete the topic coverd in section 5.
There is no time limit to finish any Section, However you must finish All Sections before
semester end date.

If you want to continue remaining courses later, you may save the course and leave.
You can continue later as per your convenience and this course will be avalible in your
area to save and continue later

: Time Value Of Money Part Ii: Annuities


Topic Objective:
At the end of this topic student would be able to:

Explain the differences between an ordinary annuity and an annuity due.

Calculate the future value and present value annuity factors that are used to solve time value of
money problems.

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Integrate several of the methods provided in time value of money to solve real-life financial
problems.

Use a financial calculator to solve time value of money problems.

Present spreadsheet applications of the mathematics of finance.

Use financial tables to solve time value of money problems.

Calculate future and present value amounts by solving problems involving annuities and lump
sums.

Definition/Overview:

N
I
.
E

Present value of an annuity: The present value of an annuity is the present value of a stream of
payments that one will receive over a period of time (it would be the lump sum equivalent of the

V
S

retirement amount that people have in a retirement account such as an IRA or 401k, when they

S
.B

begin retirement). Its a form of distribution of retirement or other income such as a mortgage
payment.

Future value: The future value is the amount of money that results from accumulating equal
payments over a period of time until retirement or some other event occurs.

Ordinary Annuity: An ordinary annuity is a stream of payments paid or received at the end of
the compounding period and an annuity due is a stream of payments paid or received at the
beginning of the compounding period.
They calculate it as an ordinary annuity (end-of-month payment). However, the payment is
collected in the beginning of the month.

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Future lump sums and streams of equal and unequal payments: When one pays or receives
unequal amounts over a period of time, the amount accumulated must be based on a lump sum
calculation. When one pays or receives equal payments over a period, the amount accumulated is
calculated as an annuity. For example, if one funds a retirement account with unequal annual
payments, the total amount in the account at some future date must be calculated as sum of a
series of unequal payments. If one funds a retirement account with equal payments the total
amount of the account is calculated as an ordinary annuity or an annuity due. Therefore, if one
uses both methods of funding a retirement account, then the total amount in the account will be
calculated using both future values of lump sums and future values of annuities.

N
I
.
E

Key Points:
1. Future Value of an Ordinary Annuity

V
S

S
.B

The Future Value of an Ordinary Annuity (FVoa) is the value that a stream of expected or
promised future payments will grow to after a given number of periods at a specific compounded

interest.

The Future Value of an Ordinary Annuity could be solved by calculating the future value of each

individual payment in the series using the future value formula and then summing the results. A
more direct formula is:

FVoa = PMT [((1 + i)n - 1) / i]


Where:
FVoa = Future Value of an Ordinary Annuity
PMT = Amount of each payment
i = Interest Rate Per Period
n = Number of Periods

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2. Future Value of an Annuity Due


The Future Value of an Annuity Due is identical to an ordinary annuity except that each
payment occurs at the beginning of a period rather than at the end. Since each payment occurs
one period earlier, we can calculate the present value of an ordinary annuity and then multiply
the result by (1 + i).

N
I
.
E

FVad = FVoa (1+i)


Where:

V
S

FVad = Future Value of an Annuity Due

S
.B

FVoa = Future Value of an Ordinary Annuity


i = Interest Rate Per Period

3. Present Value of an Ordinary Annuity


The Present Value of an Ordinary Annuity (PVoa) is the value of a stream of expected or
promised future payments that have been discounted to a single equivalent value today. It is
extremely useful for comparing two separate cash flows that differ in some way.
PV-oa can also be thought of as the amount you must invest today at a specific interest rate so
that when you withdraw an equal amount each period, the original principal and all accumulated
interest will be completely exhausted at the end of the annuity.

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The Present Value of an Ordinary Annuity could be solved by calculating the present value of
each payment in the series using the present value formula and then summing the results. A more
direct formula is:
PVoa = PMT [(1 - (1 / (1 + i)n)) / i]
Where:
PVoa = Present Value of an Ordinary Annuity
PMT = Amount of each payment
i = Discount Rate Per Period

N
I
.
E

n = Number of Periods

V
S

4. Present Value of an Annuity Due

S
.B

The Present Value of an Annuity Due is identical to an ordinary annuity except that each
payment occurs at the beginning of a period rather than at the end. Since each payment occurs

one period earlier, we can calculate the present value of an ordinary annuity and then multiply

the result by (1 + i).

Where:

PVad = PVoa (1+i)

PV-ad = Present Value of an Annuity Due


PV-oa = Present Value of an Ordinary Annuity
i = Discount Rate Per Period

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5. Amortization
Amortization is the distribution of a single lump-sum cash flow into many smaller cash flow
installments, as determined by an amortization schedule. Unlike other repayment models, each
repayment installment consists of both principal and interest. Amortization is chiefly used in loan
repayments (a common example being a mortgage loan) and in sinking funds. Payments are
divided into equal amounts for the duration of the loan, making it the simplest repayment model.
A greater amount of the payment is applied to interest at the beginning of the amortization
schedule, while more money is applied to principal at the end.

N
I
.
E

6. Combining Lump Sums and Annuities

V
S

You open a 401k with $300 per month and increase the monthly payments by $200 each year

S
.B

until you have the maximum $1,250 monthly payment ($15,000 per year). The 401k is in mutual
funds that average 11%. You are currently 26 and plan to retire at 67

: Capital Budgeting

Topic Objective:

At the end of this topic student would be able to:

Understand the purpose and need for capital budgeting.

Explain the impact that government regulations may have on a companys capital budgeting
decision.

List and explain the steps required in making a capital budgeting decision.

Distinguish between startup costs, working capital commitment costs, and tax factor costs and
the role each plays in the capital budgeting decision.

Compare the relationship between increased efficiency benefits and tax factor benefits and
understand their effect on a companys cash flow.

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Understand payback, net present value, profitability index, internal rate of return, and accounting
rate of return as techniques of capital budgeting.

Definition/Overview:
Capital budgeting: Capital budgeting (or investment appraisal) is the planning process used to
determine whether a firm's long term investments such as new machinery, replacement
machinery, new plants, new products, and research development projects are worth pursuing.

N
I
.
E

Key Points:

V
S

S
.B

1. Capital Budgeting

Capital budgeting is the method we use to justify the acquisition of capital goods (those items
that have a useful life in excess of one year).

Assumptions:

Long-term assets generate increased cash flow by improving efficiency and effectiveness.

Rates of return on investments and current inflation rate will remain the same.

2. Factors Affecting Capital Budgeting

Changes in government regulations

Research and development

Changes in business strategy

3. Steps in Capital Budgeting

Formulate a proposal

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Evaluate the data

Make a decision

Follow up

Take corrective action

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4. Formulating a Proposal

Costs in capital budgeting

Startup costs

Working capital commitment cost

Tax factor costs

N
I
.
E

5. Benefits in capital budgeting

Increased efficiency

Reducing taxable income

Tax factor benefits

Depreciation

V
S

S
.B

6. Evaluating the Data-techniques of Capital Budgeting

There are six methods that are used to evaluate the capital budgeting proposal.

Payback

Net present value (NPV)

Profitability index (PI)

Internal rate of return (IRR)

Accounting rate of return (ARR, also known as an average rate of return)

Lowest total cost (LTC)

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7. Payback

Payback deals with the number of years that it will take a business to get back the money that it
has invested in a project or asset.

8 Net Present Value, or NPV

The net present value method of capital budgeting uses the time value of money by discounting
future benefits and costs back to the present.

It applies the present-value-of-a-stream-of-payments technique for even cash flows and the
present-value-of-a-future-lump-sum technique for unequal yearly cash flows.

N
I
.
E

The calculations are made using an interest rate that matches our cost of capital for the

investment. This rate is used because the company must pay this cost on an annual basis to
obtain the financial capital necessary to make the investment.

V
S

There are two interest rates that we must consider:

The interest rate charged by the supplier of funds, or the lender

The interest rate that the borrower could receive by investing in some other enterprise (the latter
is the borrowers opportunity cost)

S
.B

There are three components that determine the lenders interest rate:

The real rate of return (the return that will be received after factoring out inflation)

The inflation premium (the expected average inflation rate for the term of the investment)

investment)

The risk premium (the rate added to the interest rate to take into account the risk of the

Weighted average cost of capital (WACC) is obtained by multiplying the cost of debt (rate that
the lender charges) by its proportion of total funds raised, and multiplying the cost of equity
(opportunity cost to the owner) by its proportion of total funds raised.

Making the decision using NPV:

If NPV is positive using the WACC, the investment should be made.

If NPV is negative using the WACC, the investment should not be made.

NPV has two primary advantages:

Future cash flows that will be paid and received can be discounted back to the present so that a
decision on the investment can be made now.

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Interest rates are determined by and based on the weighted average cost of capital that takes
risk into consideration.

9. Profitability Index, or PI

The profitability index is the ratio of the present value of the benefits to the present value of the
costs. The formula for PI is:

10. Internal Rate of Return, or IRR

The internal rate of return is the actual rate of return of an investment and uses the time value of

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money in its calculation. The IRR is the interest rate that matches the present value of the cost of
our investment directly with the present value of the future benefits received.

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The future benefits can be in the form of a stream of payments over a period of time or a lump
sum (salvage value) received.

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The IRR is the interest rate that occurs when the NPV is zero. If the NPV is zero, then by
definition, the present value of the costs must equal the present value of the benefits.

The IRR is an interest rate that corresponds to a present value annuity factor that is found by
dividing the present value of the cost by the periods cash flow.

11. Accounting Rate of Return, or ARR

The accounting rate of return is the average annual income from a project divided by the average
cost of the project.

12. Lowest Total Cost

The lowest total cost (LTC) method of capital budgeting is similar to the net present value (NPV)
method because it uses the time value of money by discounting future costs and benefits back to
the present.

The method used to determine the lowest present value of total cost is as follows:

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Include all costs associated with two or more competing investments.

Calculate the present value of these costs. Add the present value of any benefits (salvage value)
that may be obtained on the investment.

Select the investment with the lowest overall total cost.

13. Making the Decision

The methods previously discussed are often used in making a capital budgeting decision.
However, two other scenarios exist.

Mutually Exclusive: Some investments are mutually exclusive because one is chosen and the
others are automatically sacrificed or excluded.

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Capital Rationing: Capital rationing is a constraint placed on the amount of funds that can be
invested in a given time period.

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14. Following Up

Following up consists of monitoring and controlling our cash flows.

A post-audit requires the owner or manager to establish procedures that will determine how well

the outcome of the decision correlates with the proposal.

Controlling, as we have said before, is a three-step process:

(1) establish standards for measuring the project, (2) measure actual performance against the

standards established, and (3) take corrective action if required


: Personal Finance
Topic Objective:
At the end of this topic student would be able to:

Understand the overall nature of risk as it pertains to both individuals and businesses.

Distinguish between speculative and pure risk.

Identify the programs employed by individuals and businesses in managing risk.

Understand the role that insurance plays in the transfer of risk.

Understand the role of capital accumulation in achieving the financial success.

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Analyze and determine which investment vehicles to select in order to efficiently accumulate and
preserve capital.

Understand the importance of retirement planning.

Definition/Overview:
Speculative risk : Speculative risk that in which there is a possible gain or loss. This type of risk
is uninsurable. Pure risk involves only the chance of loss and this type of risk is insurable. The
instructor might have students list items that would fall under each of the above categories.

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Whole-life insurance: Whole-life insurance allocates part of the premium to building equity or

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cash value that can be used upon retirement or borrowed against in case of an emergency. The

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remainder of the premium buys insurance. Term insurance allocates 100 percent of the premium
to the purchase of insurance. Therefore, premiums for term insurance are less expensive than
those for whole-life.

Coupon Rate: The coupon rate is the rate of interest of the bond that the issuer agrees to pay the

lender on an annual basis and for a stipulated length of time. The amount of dollars and cents is
calculated by multiplying the rate by $1,000. The current market interest rate is the prevailing
interest rate in the marketplace that everyone is currently receiving. The coupon rate and current
market rate can be the same if the price of the bond is $1,000, or they can vary considerably. As
a result, prices of bonds that were previously issued adjust accordingly.

No-load funds : No-load funds do not charge commissions on the amount invested. They may
however have a sales charge when you sell the investment. Load mutual funds charge a
commission when the fund is initially purchased. They do not charge a commission on the sale
of the fund.

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Short-term investment strategies : Short-term investment strategies are those that are designed
to get a return on investment during time periods that are normally one year or less.

Long-term investment strategies : Long-term investment strategies include selecting


investments based on individual goals that are established for some time in the future.

Contribution- And A Benefit-Oriented Retirement Plan: A contribution-oriented retirement

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plan provides benefits to the retiree based on the account balance that has accumulated during
the working life of the pensioner. A benefit-oriented plan provides a defined benefit to the
retiree at retirement, which is generally a percentage of the compensation paid to the employee

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during the last several years of employment and the total term of employment.

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Life insurance: Life insurance on key personnel in the business is used so that adequate

financial capital will be available to continue the business when one of the key people dies.

Trusts may also be used to insure the protection of assets upon the death or disability of the
business owner.

Key Points:
1. Risk

Risk is the uncertainty of future outcomes.


Speculative risk is that in which there is a possible gain or loss.

Uninsurable

Pure risk involves only a chance of loss or experiencing a theft or fire.

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Insurable

2. Risk Criteria for an Insurable Loss

Potential losses must be reasonably predictable.

The loss must be accidental.

The loss should be beyond the control of the insured.

The loss should not be catastrophic to the insurance company.

3. Identification of Risk Exposure

Marketing risk

Credit risk

Loss of service due to death or disability of the owner

Business interruption risk

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4. Management of Risk

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Risk management involves performing the management planning function in a manner that will
reduce uncertainty. Methods include:

Risk reduction

Risk avoidance

Risk transfer

Risk assumption

Risk reduction includes programs that reduce risk. Examples are:

Sprinkler systems

Giving up smoking

Investing in government securities

Risk avoidance is avoiding any hazard which exposes the business to risk. An example is:

Cash-only sales policy

Risk transfer is transferring risk to another party, usually a factor or insurance company.

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Risk assumption occurs when you believe that the loss you might incur is less than the cost of
risk avoidance or risk transfer.

5. Types of Insurance

Life insurance is a method of transferring risk from the insured to the insurance company. Two
basic types are:

Term insurance assumes that you pay the premium for pure life insurance.

Permanent, or whole-life insurance allocates part of the premium to building equity or cash value
that can be used upon retirement or borrowed against in case of an emergency.

Permanent and whole-life insurance variations:

Universal Life Insurance is a policy where purchasers set the premium and the death benefit

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themselves.
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Variable life insurance allows the individual to buy insurance and at the same time make choices

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among investment options.


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Health insurance is purchased to alleviate the cost of an illness or other health problem.

Disability insurance is purchased to replace lost income when an employee is unable to do the

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job due to a physical or mental handicap.


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Long-term care insurance provides for all of the assistance one needs if one has a chronic illness
or disability for an extended period of time.

Liability insurance is used to transfer the risk of property damage and personal injury that might

result from your business operation or individual actions.

6. Financial Planning Goals

To achieve the financial success in life, we must:

Establish goals that are realistic and obtainable

Begin with the acquisition stage of capital accumulation

Preserve capital by investing in vehicles that provide us a return greater than the inflation rate

Consider individual tolerance for risk

Distribute capital through retirement income or estate transfer

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7. Investments

Investment vehicles are the specific financial instruments that we use to generate growth and
income.

Cash equivalents

Certificates of deposit

Bonds

Stock

Mutual funds

Real estate

Precious metals

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Collectibles

Cash equivalents are liquid assets that are invested in savings accounts or brokerage money

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market accounts.
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Money market consists of:

Treasuries

Bankers acceptances

Certificates of deposit

Repurchase agreements

Certificates of deposit, or CDs, are promissory notes whereby a bank promises to pay the
purchaser the principal amount plus interest after a stipulated period of time.

Bonds are contractual agreements that are made between a borrower and a lender of financial
capital.

U. S. Treasury bonds

T-bills

T-notes

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Federal bonds

General revenue bonds

General obligation bonds

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Municipal bonds

Corporate bonds

U. S. Treasury bonds

T-bills (or treasury bills) are risk-free investments that mature in less than one year, typically in
three or six months.

T-notes are bonds that mature in 10 years or less, typically 10 years, 5 years and 2 years.

Federal bonds mature in periods that are greater than 10 years and range up to 30 years.

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Municipal bonds are issued by a government agency other than the federal government.

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income from the project to pay the bondholder.


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General obligation bonds are used to build projects that do not normally generate revenue such
as public schools and roads.

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General revenue bonds are issued to build specific projects for the municipality that will use the

Corporate bonds are issued by a public corporation that wants to borrow money to invest in

assets that will help it earn revenue.


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Secured debt refers to the fact that the corporation pledges specific assets to guarantee the bonds.

When the bond is not backed by secured debt, it is referred to as a debenture.

Debenture bondholders have a claim on the remaining assets of a


company.

Bond terminology:
Par value (face value or principal value) of the bond.

Denomination of $1,000, paid to the bondholder at maturity (the due


date of the bond).

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Coupon rate (quoted rate or stated rate) is the rate of interest that the issuer agrees to pay to the
lender on an annual basis.

Current market interest rate the prevailing rate in the market on the date we decide to sell the
bond.

Bond terminology (continued):

Premium: Bonds that are sold at a value above par ($1,000)

Discount: Bonds that are sold at a value below par ($1,000)

Junk bond (high-income yielding): A corporate bond having a rating of B or less (this bond by
definition is a high-risk investment)

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Bond valuation:

Using current interest rates, find the present value of the bonds interest payments paid over the

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remaining life of the bond.

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Using current interest rates, find the present value of the $1,000 maturity value (par) of the bond.

Add the two together to get the price of the bond.

Common stock is issued by public or private corporations to raise the financial capital.

Owners of corporation

Votes for the board of directors

May or may not pay a dividend

Stock terminology:

Par value is an arbitrary dollar amount that is used for accounting purposes to determine the

number of shares of stock that have been sold by the corporation.


o

The book value of the stock is the total stockholders equity that is carried on the corporate
balance sheet. Contains three factors:

Stock at par

Additional paid-in capital

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Retained earnings

Stock terminology

Book value per share:

Market value is the price at which the owners of current shares are buying and selling the stock
at the time that a share is actually traded.

Factors affecting market value of a share of stock:

Supply and demand for shares

Actual earnings and anticipation of earnings

Book value of stock and number of shares outstanding

General economic conditions

Preferred stock is issued by a corporation to raise the financial capital but it occupies an

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intermediate position between common stock and bonds.

Quasi-owners of corporation

No voting rights

Guaranteed a specific return on investment if a corporation pays a dividend

Types of preferred stock:

Cumulative preferred stock has the following important feature:

When the corporation decides to pay a dividend, the preferred stockholder will
receive back dividends, or dividends in arrears.

Convertible preferred stock is preferred stock that may be exchanged for


shares of common stock.

Callable preferred stock is preferred stock that can be called back by the
company at some specified price.

Dividend is a payment made by the corporation to each shareholder of a class of stock.

Dividends are paid on a per-share basis.

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Preferred stock dividends are paid first, the remainder is paid to common shareholders.

Dividends are calculated as follows:

Company has 1 million shares of common and 10,000 shares of $100, 7% preferred stock, and
declares a $1 million dollar dividend.

Mutual funds are companies that are involved in collecting the funds of investors and using these
funds to purchase large blocks of stocks, bonds, or other investment vehicles.

Each fund is established with a specific goal and risk objective.

Types of mutual funds:

Growth funds invest primarily in common stock of publicly held corporations and have capital

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appreciation as their objective.


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Income funds specialize in corporate and government bonds.

Growth and income funds, or balanced funds, invest in both stocks and bonds.

A mutual fund family is an investment group that may have mutual fund portfolios in all of the

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preceding categories.

No-load funds do not charge commissions on the amount invested.

Load funds charge a commission on the initial investment, but have no

sales charges when you sell the shares.


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Global and international funds are funds that invest in stocks and bonds of companies primarily
outside of the United States.

Money market funds primarily invest in short-term, highly liquid investments such as CDs,
short-term government treasuries, commercial paper, repurchase agreements, and bankers
acceptances.

Real estate is an investment in land and buildings.

Owner-occupied residential real estate is any kind of building in which


people live.

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It is limited by law to your primary residence and one additional vacation home.

Non-owneroccupied residential real estate is property that can be


leased by the owner to the tenant for the purpose of generating income.

Property may be in the form of houses, apartments, motels, or hotels.

Real estate:
Commercial real estate is both land and improved property that is used by the owner to generate
income.

Examples are commercial office buildings, shopping centers, factories,


and warehouses.

Real estate investment trusts (REITs) provide the investor with the opportunity to participate in

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the commercial and nonresidential real estate market.

A REIT is a pooling of individual investor funds, much like a mutual

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fund.

Precious metals fall into the area of commodity trading.

They are primarily gold, silver, and platinum.

Considered to be hedges against inflation.

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Collectibles are items that become valuable or appreciate with time because of their scarcity.

Examples include coins, paintings, sculptures, antiques, stamps, and even baseball cards and
comic books.

Short-Term Investment Strategies include:

Buying stock on margin

Selling short

Option trading

Long-Term Investment Strategies include:

Buy and hold

Dollar cost averaging

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8. Pension Planning

Pension planning consists of making plans to guarantee a system of conserving the future
income for the time when you choose to retire or are forced into retirement due to circumstances
beyond your control.

Three main sources of retirement income

Social Security

Employee Sponsored Retirement Plans

Personal savings

Contribution-oriented plans provide benefits to the retiree based on the account balance that has
been accumulated during the working life of the pensioner.

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9. Pension Planning (continued)


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Types of retirement plans:

Benefit-oriented plans provide a defined benefit to the retiree at retirement, which is generally a
percentage of the compensation paid to the employee during the last several years of

employment and the total term of employment. An example would be military retirement pay.
o

Combined plans are retirement plans designed by individuals or employers.

Deferment of salaries into a retirement plan

Employer contributions into a retirement plan

Individual retirement accounts, or IRAs, are plans that allow us to contribute current annual
income into retirement accounts.

Deductible IRAs

Non-deductible IRAs

Roth IRAs

Educational IRAs

Deductible IRAs are those in which you can contribute pretax dollars up to an amount specified
by current law.

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Nondeductible IRAs allow you to contribute the same amounts as do deductible IRAs, but the
contribution is after-tax dollars.

For both of the above, returns accumulate tax-free until withdrawn.

Roth IRAs will allow you to contribute up to $5,000 of after-tax dollars by 2008 as shown in
Table 11-2.

If the funds are held in the account for at least five years, there are no
taxes due.

Your original contributions can be withdrawn tax-free at any time.

Can roll a current IRA into a Roth IRA provided you pay tax on current

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IRA.

Can withdraw $10,000 tax-free and penalty-free to purchase first home if

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IRA is more than 5 years old.

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Simplified Employee Pension (SEP) Plans are pension plans that are funded by employers.

Employer-established

All employees must agree

Common for self-employed

Contributions can be up to the lesser of $42,000 or 25 percent of the participants compensation.

SIMPLE plan. SIMPLE (Savings Incentive Match Plan for Employees) is a pension plan

established by an employer who has fewer than 100 employees.

Tax-sheltered annuities (TSAs 403b plans) are plans that allow employees of not-for-profit
organizations (churches, public schools, charitable organizations, etc.) to establish a retirement
fund that is purchased and approved by the employer.

Keogh plans are for self-employed individuals in sole proprietorships, partnerships, and LLCs.

Contribute up to the lesser of 100% of earned income or $42,000 for 2005.

Maximum deductible contribution is up to 25% of compensation.

Define both contribution and benefit amounts derived from the account.

$165,000 limit on annual retirement benefit.

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Profit-sharing plans are established by employers who have determined that a portion of each
dollar in profit will be allocated to the employees of the company.

Annual contributions to these plans vary drastically because profits fluctuate due to economic,
industry, and specific company health.

Never stand alone but are incorporated into other types of retirement plans.

401k plans are retirement plans established to accept employee contributions.

Based on salary reduction

Employer may match a portion of employee contribution on some basis

Allows for pretax contributions up to $15,000 per year. $20,000 for individuals 50 and above.

Cannot favor highly compensated employees

SIMPLE 401k is a modification of the 401k plan

Limited to firms with fewer than 100 employees

Employee contribution limited to $15,000 per year, $20,000 if age 50 or older.

Employer can contribute up to 3% of workers compensation

Plan has to be the only plan the business offers

Employers are spared from discrimination testing

Roth 401k plan.

Must be established by an employer.

Grows tax-free.

Uses after-tax money.

Max contribution is $15,000 in 2006 and $20,000 if age 50 or older.

All funds passed on the beneficiaries tax-free.

Money purchase plans are defined contribution plans that are established by the employer to

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contribute a fixed percentage of payroll into a retirement fund for the employees.
o

Maximum contribution is 25% of payroll

Employer does not contribute

Employee must contribute even if company makes no profit

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Stock bonus plans are similar to profit-sharing plans, except that the employer contributes shares
of stock, rather than money, into the retirement account.

Employer gets a deduction for the value of the stock.

Contribution is pre-tax dollars.

10. Retirement Strategies

Establish a goal, or minimum, income level that you desire when you retire.

Do not wait until you believe you can afford to start a retirement account.

Plan for capital preservation and continued growth.

Invest in instruments that provide you with a degree of risk that is comfortable to you.

Try to invest the maximum amount, but never less than the amount that the employer uses to
calculate profit-sharing or matching contributions.

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Estate planning a method of planning for use, conservation, and transfer of wealth as efficiently

as possible.
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Wills are written documents that provide direction to others as to how you want your wishes
carried out after death.

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Consider opening a Roth IRA even if you have an employer-sponsored plan.

11. Estate Planning

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Probate is a legal court process that addresses and focuses in on the will and the probate estate.
Trusts are legal arrangements that actually divide legal and beneficial interests among two or
more people.

When a trust is set up during the life of the trustor, it is referred to as a


living trust.

When a trust is established at death, it is referred to as a testamentary


trust.

A revocable trust is one in which the trustor has the right to cancel the
trust during his or her lifetime.

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An irrevocable trust is one that is unalterable during a persons lifetime

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