This task investigates capital. Whether you are making a capital expenditure or thinking of going public with an IPO, you need to understand capital. Research Capital Watch the LinkedIn Learning cour

Look at the following four case studies and two theories that can be at least a little helpful, and you will likely answer that this is understandable but risky. We start with a personal example, because many people can relate to complex subjects more easily on a personal level. The remaining examples are taken from real corporate situations and modified to disguise the companies.

Currency Exchange Rates: A Case of Individual Investing Let's start with an example created to make a point. In May 2008, Rodney decided that rates on U.S. certificates of deposit (CDs) were too low and the time was right to invest in a bank in England. He expected to earn 4% on his money in six months (8% annually) and ended up with a loss. He discussed what went wrong with his dad.

Rodney I can't understand what went wrong. I lost money and I thought it was a sure thing. I invested $10,000 in a six-month CD on May 31, 2008, that promised a 4% return.

Dad The promised return of 4% for six months works out to be 8% per year. That was far above what CDs paid in the United States. Didn't you get the interest promised?

Rodney I don't think so. My IRA statement said that my investment earned £202.45, which is 4%. Yet my statement also said that my account was worth only $8,087.95 on December 1, 2008. If that is true, what happened to the interest? How could I have lost that much on the currency exchange?

Dad Let's take a look logically. The first thing is to create a time line that shows what you paid and what you got back. I always show cash outflow as negative and cash inflow as positive. That makes it simple to remember. When someone pays me, it is positive. When I have to pay someone else, it is negative.

 We'll put months across the top and cash flows under the line (Exhibit 7.1).

Exhibit 7.1: Time line in dollars Open table as spreadsheet Month 0 1 2 3 4 5 6 Cash flow ($10,000) $8,097.95  Your investment declined in value by 19.12% from $10,000 to $8,097.95.

Rodney Okay, now I see that I lost 19.12% on my investment. That is a lot to lose on a sure thing in just six months. What went wrong?

Dad Before I answer that, did you check the history of the exchange rates between the dollar ($) and the pound (£)? The exchange rate is the amount of currency in one country that can be purchased by one unit of currency in another country. There is a small fee built in for the bank or dealer, but we will ignore that for our purposes.

Rodney Yes, I looked on OANDA.com at www.oanda.com and found the history. Between January 1, 2007, and May 29, 2008, one U.S. dollar would buy an average of 0.50168 pounds. The range was from 0.47250 to 0.52130. When I moved my dollars to England, the bank gave me a rate of 0.50613 pounds per dollar. It seemed to be low-risk.

Dad Of course there are other sites, like www.x-rates.com. Yahoo!, Google, and MSN also have currency converters. But I usually use OandA.com, too.

First of all, most currencies' exchange rates are quoted the way you just did: the amount of foreign currency that $1 would buy. But for pounds, people usually refer to the reverse: the number of dollars that it would take to buy one pound. Looking at it that way will make you consistent with the rest of the world. On May 31, 2008, that rate was 1.97578. It would cost $1.97578 to buy £1.00. So your $10,000 should have bought you about £5,061.29.

 By December 1, the rate had changed to $1.53654 per £1.00. Your £5,061.29 before interest could be translated into dollars to get a worth of $7,776.88. You lost $2,223.12 or 22% of your initial investment just from the movement of currency. That is a 22% loss. Of course the interest that you earned lessened your loss.

Rodney I feel terrible and very foolish.

Dad If it makes you feel any better, you are not the first, nor will you be the last, to focus on the interest and lose sight of the principal. I'll tell you a story later about how the treasurer of a global company did the same and it cost the company hundreds of millions of dollars. He did not bother to do a time line. A time line is a very simple picture, but it can make a complex transaction much easier to understand. If you do it carefully, you will avoid a lot of problems.

 Now, let's use that time line and see the cash flows in British pounds (Exhibit 7.2).

Exhibit 7.2: Time line in pounds Open table as spreadsheet Month 0 1 2 3 4 5 6 Cash flow:

Investment (principal) (£5,061.29) Interest £202.45 Return of principal £5,061.29 Total £5,263.74  Now you can see the interest received in pounds. You did receive the promised 4% or £202.45. If you were in England, this would be a good return. Now let's put in the currency translation and we see that because of the change in currency exchange rates you lost $1,912.05 instead of gaining the $400 you had planned on (Exhibit 7.3).

Exhibit 7.3: Time line in dollars and pounds Open table as spreadsheet Month 0 1 2 3 4 5 6 Cash flow:

Investment $ ($10,000.00) Exchange rate, May 31, 2008 $1.97578 per £ Investment £ (£5,061.29) £5,061.29 Interest £202.45 Principal plus interest £5,263.74 Exchange rate, December 1, 2008 $1.53654 per £ Value in $ $8,087.95 Rodney Okay, I see what happened, but how could I know that I would lose money?

Dad Unfortunately, you can't know what will happen to currency exchange rates. There are theories that seem to work some of the time, but just like investors in the stock market, even the professionals get surprised from time to time.

 Let me make the point about the time line. It is a simple device to make the complex seem easy. People who simply plug in formulas often make bad mistakes.

As an exercise, imagine the reverse situation. Assume that you were in England and decided to invest in a U.S. bank. Let's keep the initial investment the same. A 30-year-old teacher in London spends £5,061.29 to get $10,000 in U.S. dollars. He invests at only 2% interest and expects to end with $10,200. Why would he do that you may ask. One reason could be that he planned to take a Christmas vacation to Disney World and wanted to avoid any risk that his money would not cover his planned expenses.

By the way, this risk-avoidance measure can be used by almost anyone with the help of a bank. If you plan to make a purchase in another country, you can invest in anticipation of making the purchase. This avoids the risk of exchange rate movement. It also eliminates any gain from exchange rate movement. As you see, if your currency weakens, it buys less in a foreign country. If it strengthens, it buys more.

Let's assume that the vacation gets canceled and he decides to bring his investment dollars back to England. Now translate the investment to dollars at $1.53654 per £1.00. You get £6,638.29. Divide by the original investment and get 131%. That is a 31% return. In both cases, the movement in the exchange rate is the major force behind the return that the investor receives. Currency moved against you and you lost 19%. The same movement earned a 31% return for the Londoner: £6,638.29 divided by £5,061.29 = 1.31 or 131%.

Let's do our time line again, but this time from the perspective of someone in London (Exhibit 7.4).

Exhibit 7.4: Time line in pounds and dollars Open table as spreadsheet Month 0 1 2 3 4 5 6 Cash flow:

Investment £ (£5,061.29) Exchange rate, May 31, 2008 $1.97578 per £ Investment $ ($10,000.00) $10,000.00 Interest $200.00 Principal plus interest $10,200.00 Exchange rate, December 1, 2008 $1.53654 per £ Value in £ £6,638.29 Rodney Now I see what is happening. Exchange rate movement can make a big difference in the value of an investment even in a short period of time. Sometimes the rate is stable, and sometimes it moves a lot.

Dad Right! You get it. By now you are beginning to see the disadvantage and perhaps the advantage of converting currency and investing in another country. Of course, things were not always this way. Most of the major countries operated with fixed exchange rates set by the Bretton Woods Agreement concluded in 1944. This functioned well for over 40 years. (By the way, Bretton Woods is a resort town in the shadow of Mount Washington in New Hampshire.) One advantage of fixed exchange rates is that they function as one currency. You do not have to worry about exchange rates in the United States—your dollar is the same in Maine as it is in Alaska, Texas, or even New York City.

Lesson: There can be significant risk for an investment due only to the potential change of exchange rates. There are periods of little movement and periods of strong movements.

One Currency: European Union and Eurozone One reason many nations in Europe adopted the euro was to eliminate the risk and complexity of varying exchange rates. The euro avoids the need to change currency when you drive from Italy to France to Germany. It allows an investor in Ireland to invest in Austria without worrying about currency movements. You can see why this is an advantage, especially in small countries like Malta. Countries with the euro as their official currency are in the eurozone.

As a matter of fact, the following nations have adopted the euro as their official currency:

Austria Germany Malta Belgium Greece Netherlands Cyprus Ireland Portugal Finland Italy Slovenia France Luxembourg Spain Open table as spreadsheet There are a number of countries in the European Union that share open borders and free trade but have not adopted the euro. As you know, Great Britain is one.

The countries in the European Union (EU) include the 15 eurozone countries and 12 other countries. This is a list of countries in the European Union:

Austria Germany Netherlands Belgium Greece Poland Bulgaria Hungary Portugal Cyprus Ireland Romania Czech Republic Italy Slovakia Denmark Latvia Slovenia Estonia Lithuania Spain Finland Luxembourg Sweden France Malta United Kingdom Open table as spreadsheet There are about 300 million people in the nations that have officially adopted the euro and 500 million in the European Union (EU). The EU is designed to allow the free flow of goods, labor, services, and transit. In practice there are still some obstacles to the complete implementation of this concept.

You might notice that Switzerland is not on either list. That country has chosen to maintain its tradition of independence and neutrality.

Rodney If there are such advantages, why don't all the countries in the EU adopt the euro?

Dad Some countries have tried. They put the prospect to a vote and the people rejected the euro. Perhaps it is national pride. Other countries have leaders who are concerned about the promises made in the various countries' versions of Social Security. Unlike the United States, the population is declining in several countries and, just as here, the system is underfunded. Also, governments have different policies about taxing, spending, military expenditures, and international conflicts.

For now, take a look at the exchange rate between the dollar and the euro at the end of the month specified (Exhibit 7.5).

Exhibit 7.5: Amount of euros (₠) purchased by one dollar ($) Open table as spreadsheet Date Exchange Rate Date Exchange Rate 12/98 0.857 6/04 0.828 6/99 0.969 12/04 0.733 12/99 0.996 6/05 0.829 6/00 1.051 12/05 0.844 12/00 1.062 6/06 0.797 6/01 1.178 12/06 0.758 12/01 1.289 6/07 0.742 6/02 1.009 12/07 0.679 12/02 0.954 6/'08 0.633 6/03 0.875 12/08 0.710 12/03 0.797 Source: FXHistory © 1997–2008 by OANDA Corporation.

This is quite a large range. In December 2001 $1,000 would buy ₠1,289. By June 2008, it would take $2,036 to purchase the same amount of euros.

Let's do the math. Divide the euro amount by the exchange rate to get the dollar amount (Exhibit 7.6).

Exhibit 7.6: Conversions between dollars and euros Open table as spreadsheet Date Dollars Exchange Rate Euros 12/01 $1,000 ₠1.289 ₠1,289 6/08 $2,036 ₠0.633 ₠1,289 Communicate with the teacher only through HomeworkMarket chat. This allows us to review the transaction if something goes wrong 12:15 hello 12:15 Not here 12:15 Chapter 11: Forecasts and Budgeting Robert F. Halsey The Concept of Budgeting Budgets serve a critical role in managing any business, from the smallest sole proprietor to the largest multinational corporation. Businesses cannot operate effectively without estimating the financial implications of their strategic plans and monitoring their progress throughout the year. During preparation, budgets require managers to make resource allocation decisions and, as a result, to reaffirm their core operating strategy by requiring each business unit to justify its part of the overall business plan. During the subsequent year, variances of actual results from expectations serve to direct management to the areas that may deserve a greater allocation of capital and those that may need adjustments to retain their viability.

A budget is a comprehensive, formal plan, expressed in quantitative terms, describing the expected operations of an organization over some future time period. As you can see, the characteristics of a budget are that it deals with a specific entity, covers a specific future time period, and is expressed in quantitative terms.

This chapter describes the essential features of a budget and includes a comprehensive example of the preparation of a monthly budget for a small business. Although the focus of the chapter is on budgeting from a business perspective, many of the principles can be applied to an individual's personal financial planning.

Previous Section Chapter 1: Understanding Financial Statements Les Livingstone What are Financial Statements? A Case Study Gail was applying for a bank loan to start her new business: Nutrimin, a retail store selling nutritional supplements, vitamins, and herbal remedies. She described her concept to Hal, a loan officer at the bank.

Hal: How much money will you need to get started?

Gail: I estimate $80,000 for the beginning inventory, plus $36,000 for store signs, shelves, fixtures, counters, and cash registers, plus $24,000 working capital to cover operating expenses for about two months. That's a total of $140,000 for the start-up.

Hal: How are you planning to finance the investment of $140,000 for the start-up?

Gail: I can put in $100,000 from my savings, and I'd like to borrow the remaining $40,000 from the bank.

Hal: Suppose the bank lends you $40,000 on a one-year note, at 15% interest, secured by a lien on the inventory. Let's put together projected financial statements from the figures you gave me. Your beginning balance sheet would look like what you see on the computer screen:

Open table as spreadsheet Nutrimin Projected Balance Sheet as of January 1, 20XX Assets Liabilities and Equity Cash $24,000 Bank loan $40,000 Inventory 80,000 Current assets 104,000 Current liabilities 40,000 Fixed assets:

Equity:

Equipment 36,000 Owner capital 100,000 Total assets $140,000 Liabilities and equity $140,000 The left side shows Nutrimin's investment in assets. It classifies the assets into "current" (which means turning into cash in a year or less) and "noncurrent" (not turning into cash within a year). The right side shows how the assets are to be financed: partly by the bank loan and partly by your equity as the owner.

Gail: Now I see why it's called a "balance sheet." The money invested in assets must equal the financing available—it's like two sides of the same coin. Also, I see why the assets and liabilities are classified as "current" and "noncurrent"—the bank wants to see if the assets turning into cash in a year or less will provide enough cash to repay the one-year bank loan. Well, in a year there should be cash of $104,000. That's enough cash to pay off more than twice the $40,000 amount of the loan. I guess that guarantees approval of my loan!

Hal: We're not quite there yet. We need some more information. First, tell me: How much do you expect your operating expenses will be?

Gail: For year 1, I estimate as follows:

Store rent $36,000 Phone and utilities 14,400 Assistants' salaries 40,000 Interest on the loan 6,000 (15% on $40,000) Total $96,400 Open table as spreadsheet Hal: We also have to consider depreciation on the store equipment. It probably has a useful life of 10 years. So each year it depreciates 10% of its cost of $36,000. That is $3,600 a year for depreciation. So operating expenses must be increased by $3,600 a year from $96,400 to $100,000. Now, moving on, how much do you think your sales will be this year?

Gail: I'm confident that sales will be $720,000 or even a little better. The wholesale cost of the items sold will be $480,000, giving a markup of $240,000—which is 33⅓% on the projected sales of $720,000.

Hal: Excellent! Let's organize this information into a projected income statement. We start with the sales, and then deduct the cost of the items sold to arrive at the gross profit. From the gross profit we deduct your operating expenses, giving us the income before taxes. Finally we deduct the income tax expense in order to get the famous "bottom line," which is the net income. Here is the projected income statement shown on my computer screen:

Open table as spreadsheet Nutrimin Projected Income Statement for the Year Ending December 31, 20XX Sales $720,000 Less cost of goods sold 480,000 Gross profit 240,000 Less expenses Salaries $40,000 Rent 36,000 Phone and utilities 14,400 Depreciation 3,600 Interest 6,000 100,000 Income before taxes 140,000 Income tax expense (40%) 56,000 Net income $84,000 Gail, this looks very good for your first year in a new business. Many business start-ups find it difficult to earn income in their first year. They do well just to limit their losses and stay in business. Of course, I'll need to carefully review all your sales and expense projections with you, in order to make sure that they are realistic. But first, do you have any questions about the projected income statement?

Gail: I understand the general idea. But what does "gross profit" mean?

Hal: It's the usual accounting term for sales less the amount that your suppliers charged you for the goods that you sold to your customers. In other words, it represents your markup from the wholesale cost you paid for goods to the price for which you sold those goods to your customers. It is called "gross profit" because your operating expenses have to be deducted from it. In accounting, the word gross means "before deductions." For example, "gross sales" means sales before deducting goods returned by customers. Sales after deducting goods returned by customers are referred to as "net sales." In accounting, the word net means "after deductions." So, "gross profit" means income before deducting operating expenses. By the same token, "net income" means income after deducting operating expenses and income taxes. Now, moving along, we are ready to figure out your projected balance sheet at the end of your first year in business. But first, I need to ask you: How much cash do you plan to draw out of the business as your compensation?

Gail: My present job pays $76,000 a year. I'd like to keep the same standard of compensation in my new business this coming year.

Hal: Let's see how that works out after we've completed the projected balance sheet at the end of year 1. Here it is on my computer screen:

Open table as spreadsheet Nutrimin Projected Balance Sheet as of December 31, 20XX Assets Liabilities and Equity Cash $35,600 Bank loan $40,000 Inventory 80,000 Current assets 115,600 Current liabilities 40,000 Fixed assets:

Equity:

Equipment $36,000 Capital: Jan. 1 100,000 Less depreciation 3,600 Add net income 84,000 Net equipment $32,400 32,400 Less drawings (76,000) Capital: Dec. 31 108,000 Total assets $148,000 Liabilities and equity $148,000 Gail, let's go over this balance sheet together. It has changed, compared to the balance sheet as of January 1. On the "Liabilities and Equity" side of the balance sheet, the net income of $84,000 has increased capital to $184,000 (because earning income adds to the owner's capital), and deducting drawings of $76,000 has reduced capital to $108,000 (because drawings take capital out of the business). On the "Assets" side, notice that the equipment now has a year of depreciation deducted, which writes it down from the original $36,000 to a net (there's that word "net" again) $32,400 after depreciation. The equipment had an expected useful life of 10 years, now reduced to a remaining life of nine years. Last, but not least, notice that the cash has increased by only $11,600 from $24,000 at the beginning of the year to $35,600 at year-end. This leads to a problem: The bank loan of $40,000 is due for repayment on December 31. But there is only $35,600 of cash available on December 31. How can the loan be paid off when there is not enough cash to do so?

Gail: I see the problem. But I think it's bigger than just paying off the loan. The business will also need to keep about $25,000 cash on hand to cover two months' operating expenses and income taxes. So, with $40,000 to repay the loan, plus $25,000 for operating expenses, the cash requirements add up to $65,000. But there is only $35,600 cash on hand. This leaves a cash shortage of almost $30,000 ($65,000 less $35,600). Do you think that will force me to cut down my drawings by $30,000, from $76,000 to $46,000? Here I am, opening my own business, and it looks as if I have to go back to what I was earning five years ago!

Hal: That's one way to do it. But here's another way that you might like better. After your suppliers get to know you, and do business with you for a few months, you can ask them to open credit accounts for Nutrimin. If you get the customary 30-day credit terms, then your suppliers will be financing one month's inventory. That amounts to one-twelfth of your $480,000 annual cost of goods sold, or $40,000. This $40,000 will more than cover the cash shortage of $30,000.

Gail: That's a perfect solution! Now, can we see how the balance sheet would look in this case?

Hal: Sure. When you pay off the bank loan, it vanishes from the balance sheet. It is replaced by accounts payable of $40,000. Then the balance sheet looks like this:

Open table as spreadsheet Nutrimin Projected Balance Sheet as of December 31, 20XX Assets Liabilities and Equity Cash $35,600 Accounts payable $40,000 Inventory 80,000 Current assets 115,600 Current liabilities 40,000 Fixed assets:

Equity:

Equipment $36,000 Capital: Jan. 1 100,000 Less depreciation 3,600 Add net income 84,000 Net equipment $32,400 32,400 Less drawings (76,000) Capital: Dec. 31 108,000 Total assets $148,000 Liabilities and equity $148,000 Now the cash position looks a lot better. But it hasn't been entirely solved: there is still a gap between the accounts payable of $40,000 and the cash of $35,600. So, you will need to cut your drawings by about $5,000 in year 1. But that's still much better than the cut of $30,000 that had seemed necessary before. In year 2, the bank loan will be gone, so the interest expense of $6,000 will be saved. Then you can use $5,000 of this savings to restore your drawings back up to $76,000 again.

Gail: That's good news. I'm beginning to see how useful projected financial statements are for business planning. Can we look at the revised projected balance sheet now?

Hal: Of course. Here it is:

Open table as spreadsheet Nutrimin Projected Balance Sheet as of December 31, 20XX Assets Liabilities and Equity Cash $40,600 Accounts payable $40,000 Inventory 80,000 Current assets 120,600 Current liabilities 40,000 Fixed assets:

Equity:

Equipment $36,000 Capital: Jan. 1 100,000 Less depreciation 3,600 Add net income 84,000 Net equipment $32,400 32,400 Less drawings (71,000) Capital: Dec. 31 113,000 Total assets $153,000 Liabilities and equity $153,000 As we see, cash is increased by $5,000 to $40,600—which is sufficient to pay the accounts payable of $40,000. Drawings are decreased by $5,000 to $71,000, which provided the $5,000 increase in cash.

Gail: Thanks. That makes sense. I really appreciate everything you've taught me about financial statements.

Hal: I'm happy to help. But there is one more financial statement to discuss. A full set of financial statements consists of more than the balance sheet and the income statement. It also includes a cash flow statement. Here is the projected cash flow statement:

Open table as spreadsheet Nutrimin Projected Cash Flow Statement for the Year Ending December 31, 20XX Sources of Cash From operations:

Net income $84,000 Add depreciation 3,600 Add increase in current liabilities 40,000 Total cash from operations (a) $127,600 From financing:

Drawings $(71,000) Negative cash Bank loan repaid (40,000) Negative cash Net cash from financing (b) (111,000) Negative cash Total sources of cash (a + b) $16,600 ($127,600 cash from operations less $111,000 negative cash from financing) Uses of Cash Total uses of cash 0 Total sources less total uses of cash $16,600 Net cash increase Add cash at beginning of year 24,000 Cash at end of year $40,600 Gail, do you have any questions about this cash flow statement?

Gail: Actually, it makes sense to me. I realize that there are only two sources that a business can tap in order to generate cash: internal (by earning income) and external (by obtaining cash from outside sources, such as bank loans). In our case the internal sources of cash are represented by the "Cash from Operations" section of the cash flow statement, and the external sources are represented by the "Cash from Financing" section of the cash flow statement. It happens that the "Cash from Financing" is negative, because no additional outside financing is received for the year 20XX, but cash payments are incurred for drawings and for repayment of the bank loan. I also understand that there are no "Uses of Cash" because no extra equipment was acquired. In addition, I can see that the total sources of cash less the total uses of cash must equal the net cash increase, which in turn is the cash at the end of the year less the cash at the beginning of the year. But I am puzzled by the "Cash from Operations" section of the cash flow statement. I can understand that earning income produces cash. However, why do we add back depreciation to the net income in order to calculate cash from operations?

Hal: This can be confusing, so let me try to explain as clearly as I can. Certainly net income increases cash, but first an adjustment has to be made in order to convert net income to a cash basis. Depreciation was deducted as an expense in figuring net income. So adding back depreciation to net income just reverses the charge for depreciation expense. We back it out because depreciation is not a cash outflow. Remember that depreciation represents just one year's use of the equipment. The cash outflow for purchasing the equipment was incurred back when the equipment was first acquired, and amounted to $36,000. The equipment cost of $36,000 is spread out over the 10-year life of the equipment at the rate of $3,600 per year, which we call depreciation expense. So, it would be double counting to recognize the $36,000 cash outflow for the equipment when it was originally acquired, and then to recognize it again a second time when it shows up as depreciation expense. We do not write a check to pay for depreciation each year, because it is not a cash outflow.

Gail: Thanks. Now I understand that depreciation is not a cash outflow. But I don't see why we also added back the increase in current liabilities to the net income in order to calculate cash from operations. Can you explain that to me?

Hal: Of course. The increase in current liabilities is caused by an increase in accounts payable. Accounts payable is amounts owed to our suppliers for our purchases of goods for resale in our business. Purchasing goods for resale from our suppliers on credit is not a cash outflow. The cash outflow occurs only when the goods are actually paid for by writing out checks to our suppliers. That is why we added back the increase in current liabilities to the net income in order to calculate cash from operations. In the future, the increase in current liabilities will, in fact, be paid in cash. But that will take place in the future, and is not a cash outflow in this year. Going back to the cash flow statement, notice that it ties in neatly with our balance sheet amount for cash. It shows how the cash at the beginning of the year plus the net cash increase equals the cash at the end of the year.

Gail: Now I get it. Am I right that you are going to review my projections and then I'll hear from you about my loan application?

Hal: Yes, I'll be back to you in a few days. By the way, would you like a printout of the projected financial statements to take with you?

Gail: Yes, please. I really appreciate your putting them together and explaining them to me. I picked up some financial skills that will be very useful to me as an aspiring entrepreneur.

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