Managerial Goals

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Managerial Goals
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Goal of Financial Management

• Profitability
• Risk
• Liquidity
• Taken together, these elements determine the
  well-being of the firm
• Decisions on investments, financing, growth
  rates, and capital structure are evaluated
  according to these criteria

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Goal Identification

• Increase Profitability
• Reduce Risk
• Provide Liquidity

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Profitability

• Profit difference between value of goods and
  services produced by the firm and the cost of
  resources used in production
• Perfectly competitive markets MAX profit
• MVP MIC
• MR MC

5
Effects of Time

• Want to grow profit over time
• May mean sacrificing profit now for future profit
• Measure profit over time
• Static measure not adequate
• Present Value summing annual projected cash
  flows and appropriately discounted for time

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Risk

• CANNOT IGNORE RISK
• Risk attitudes
• Risk Averse
• Risk Neutral (normal profit MAX)
• Risk Preferring

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Risk Aversion

• Risk aversion does not mean you will not take
  risks
• Does mean that you must be compensated for taking
  risks and the required compensation must increase
  as the risk increases
• Risk aversion levels influenced by wealth,
  experience,etc.

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Risk Premium

• Risk Premium increase in required returns to be
  indifferent between a investments with different
  risk levels
• Ex U.S. government bond (low risk) and beef cow
  enterprise

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Risk Dominance

• Trade-off between risk and expected profit
• Plot investments risk with risk on horizontal
  axis, profit on vertical axis

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Risk Dominance
J
H
Profit
G
D
F
E
A
B
I
C
Risk
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Risk Profit Curve

• Investments with higher expected profits also
  have higher risk
• Increase in risk is faster than increase in
  profits
• Investment with MAX expected profit is at the top
  if the dominating set (investment J)
• Profit MAX investments is most risky of the
  dominating investments
• The dominating set becomes large with many
  investments Risk profit curve
• Optimal investment cannot be determined without
  knowing risk-return preferences (level of risk
  aversion)

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Risk Measures

• Risk is due to unanticipated changes
  (variability)
• Ex Investor considering beef cow and hog
  investment
• 1st forecast rates of return and probabilities
  of returns under several states of nature
  optimistic, most likely, and pessimistic

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Probability Distribution for two Investments
Beef Cattle Hogs ____ Forecast Profit
Rate Probability Profit Rate Profitability_ Opt
imistic 0.15 0.30 0.21 0.10 Most
Likely 0.12 0.40 0.15
0.60 Pessimistic 0.09 0.30 0.08 0.30
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Calculate statistical measures

• Expected Value (EV)
• Standard Deviation (s)
• Coefficient of Variation (CV)

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Expected Value

• Expected Value mean weighted average of the
  profit rates for the projected outcomes with the
  probabilities used as weights
• E(V) SiPiVi
• Where EV is expected value
• S is the summation sign
• Pi is the probability of forecast I
• Vi is the profit projected for each forecast

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Expected Value

• E(V) beef cattle
• (0.30)(0.15) (0.40)(0.12) (0.30)(0.09)
• 0.12 or 12
• E(V) hogs
• (0.10)(0.21) (0.60)(0.15) (0.30)(0.08)
• 0.135 or 13.5
• E(V) hogs is larger, meaning the expected
  profitability is higher for the hog investment

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Standard Deviation

• Standard Deviation statistical measure of the
  amount of dispersion or variation of the
  projected outcomes about the expected value
• Measure of risk (variability)
• s Si (Pi)( Vi V)2
• 1st find the difference between the E(V) and the
  projected outcome
• 2nd square the difference
• 3rd multiply each squared difference by its
  probability
• 4th add up these products
• 5th take square root

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Standard Deviation

• Beef cattle
• s ((.30)(0.15-0.12)2 (0.40)(0.12-0.12) 2
  (0.30)(0.09-0.12) 2)½
• 0.023 or 2.3
• Hogs
• s ((.10)(0.21-0.135)2 (0.60)(0.15-0.135) 2
  (0.30)(0.08-0.135) 2)½
• 0.04 or 4.0

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Standard Deviation

• Hogs have the higher standard deviation, thus the
  larger risk
• Hogs are more profitable and more risky
• HOW DO WE COMPARE THE INVESTMENTS THEN?
• COEFFICIENT OF VARIATION

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Coefficient of Variation

• Coefficient of Variation (CV) provides a
  relative measure of the amount of risk to the
  amount of expected return
• CV s / E(V)
• CV beef cattle 2.3 / 12 0.192
• CV hogs 4.0 / 13.5 0.296
• CV of hogs is larger, thus it is a more risky
  venture relative to the expected returns
• The investor will make their decision based on
  risk preferences

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Estimating Probabilities

• Subjective probabilities are used when data is
  not available
• Ex odds on athletic event
• Objective probabilities are used when data is
  available
• Ex to forecast your grade in here, you could
  look at grades from similar classes you took from
  same professor, your major, background, interest
  in the course, study habits

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Liquidity

• Liquidity refers to the ability to generate cash
  in order to meet cash demands as they occur and
  to provide for both anticipated and unanticipated
  events
• Occurrence of risk is one need for liquidity
• Liquidity can be generated by holding highly
  liquid, salable assets, or having the capacity to
  borrow funds quickly

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Life Cycle of the Firm

• Introduction
• Wealth and liquidity low risk high family
  assistance important lease assets
• Growth
• Fully utilize management gain economic security
  competitive in industry
• Consolidation
• Stronger financial position continued growth
• Transfer
• Let other assume control of decisions attention
  to stable retirement funds management
  continuity production efficiency transferring
  funds to heirs cost efficiently

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Statistical Relationship for Normal Variables
Statistical Relationship for Normal Variables
E(V)
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Statistical Relationship for Normal Variables
68
95
E(V)
E(V)-2s
E(V)-s
E(V)s
E(V)2s
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Example

• State of Nature Profit Probability E(V)
• Optimistic 400 .2 80
• Most Likely 100 .6 60
• Pessimistic -400 .2 -80
• 60
• s (.2(400-60)2 .6(100-60)2 .2(-400-60)2 )½
• 258

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Example

• 68 chance profit
• 60258318
• 60-258-198
• 95 chance profit
• 602(258)576
• 60-2(258)-456