A Guide
to Profitable
Decision
Making
Hewlett-Packard’s
introduction to basic
financial concepts
every business manager
should know
“Every individual endeavors
to employ his capital so that
its produce may be of
greatest value.§ %
—Adam Smith
Wealth of Nations 1776
[) <
6
© 1974 Hewlett-Packard Company
DECISIONE=
the single most important factor
facing a manager
As a manager, your key function is to make
decisions quickly and profitably. It is a function with
which you are faced every hour of the day. And it all
affects that important goal: profitability.
What makes a
good decision-maker?
Briefly, you can become a good decision-maker—
or a better one—if you have an understanding of the
basic concepts of business finance . .. and the
ability to apply these principles to the problems
you face.
The purpose of this guide is to provide you with
a concise look at some of these concepts, together
with illustrations of their application.
Understanding these financial concepts does not
require any sophisticated mathematical knowledge
or an advanced business degree. All you need is
a little arithmetic and a knowledge of a few basic
business terms.
This guide is
about time and money
As you will soon see, there is a very direct
relationship between time and money. An
understanding of this relationship will aid you
in becoming a more effective manager.
THESE BASIC
FINANCIAL CONCEPTS
ARE VITAL TO MAKING
MORE EFFECTIVE,
MORE PROFITABLE
DECISIONS
Money value and time are inseparable. You cannot begin
to solve a financial problem without an understanding of
this irrefutable fact.
It's a fundamental error to forget that any money you
invest should bring you a return that's consistent with the
time period involved. And also, any time you make an
investment that doesn’t bring you the maximum possible
return, it is costing your company money.
Many business managers make the mistake of examining
only the total dollars involved in a financial decision and
forget that timing can be equally important. That is why
sometimes the ‘‘obvious’’ answer to a decision may end up
being the most costly.
The concepts that follow, in many cases, represent
alternative means of looking at the relationship between
time and money. But each represents an approach that can
help make you a better manager.
Interest
represents
the time value
of money
Interest, by definition, is the amount of money
paid a lender for the use of his money capital.
In practice, payment of interest is calculated
in terms of a fixed percentage of the amount
loaned for an agreed-upon period of time. This
interest rate is directly proportionate to risk, and it
fluctuates depending on the supply of and the
demand for money, as well as governmental
requirements.
The calculation of the exact amount paid for
interest may be done in one of two basic ways:
1. Simple interest, where the percentage is
figured only on the amount borrowed.
2. Compound interest, where the percentage is
figured on both the amount borrowed and on any
interest that has previously accrued.
For example, let's suppose you were to invest
$10,000 for 3 years, at 10% simple interest per
year. At the end of the 3 years, you would get back
the $10,000 plus $1,000 interest for the first year,
$1,000 interest for the second year, and $1,000 for
the third year, for a total interest of $3,000.
However if the 10%interest rate were
compounded yearly, the total interest would be
higher. For example, you would receive 10% of
$10,000—or $1,000—at the end of the first year.
The second year you would receive 10%of
$10,000 plus 10%ofthe previous interest of
$1,000, for a total of $1,100. At the end of the third
year you would receive 10% of $10,000, plus 10%
of all the previous interest, for a total of $1,210.
Thus, by compounding the interestrate annually,
you have earned $3,310 over three years . . . or
$310 more than would be earned by simple interest.
Compounding the interest rate in shorter time
periods results in even greater total interest. If
your $10,000 had been compounded monthly
using the same 10%annual rate, the three-year
total would have been $3,481.82.
The $10,000 you invested is called the PRESENT
VALUE of your capital. The amount you receive
back later is called the FUTURE VALUE. The
difference is interest (whether simple or compound)
and represents the TIME VALUE of your money
for the three year period.
INTEREST COMPARISON FOR
$10,000 INVESTED FOR 3 YEARS
At 10%simple interest per year,
the total 3-year interest is $3,000.
$10,000 Principal At 10%interest compounded annually,
the total 3-year interest grows to $3,310.
L Compounded monthly, the 3-year total
$10,000 Principal becomes $3,481.82 . . . or $481.82 more
than simple interest.
$10,000 Principal
The real value
of an income or
expense item
depends upon
when payment
actually occurs
Interestis constantly changing the value of
money. Because ofthis simple fact, the obvious
answer isn’t always the most profitable one.
One quick way to determine the validity of a
situation regarding time and expenditure is to
examine the PRESENT VALUE. PRESENT VALUE
is a way of relating everything to the same time
frame, so that the real value of an income item or
expenditure can be determined.
For example, would you rather have $1,000
paid to you now . . or a year from now? Obviously,
it's better to have it paid to you now, so you can
invest it and earn money on it.
For the same reason, it is more profitable, in
many cases, for you to buy now and paylater.
Let's assume you can buy a piece of equipment
and pay cash and it will cost you $10,000.
Alternatively, the seller will allow you to wait 90
days and pay $10,200.
It might seem that you save $200 by paying right
away. But if your cost of capital is 1% a month
(which is not unusual) are you still better off?
The answer is no. By subtracting the 1% monthly
cost of capital from the FUTURE VALUE of $10,200
wefind that its PRESENT VALUE is only $9,900.02.
This compares to the $10,000 PRESENT VALUE
under the other alternative. So you can actually
save about a hundred dollars by waiting and paying
what seems to be more.
The important point to realize here is that when
considering alternative investment decisions, one
must examine them all at the same point in time.
This is normally done by examining costs in terms
of today’s dollars. This is known as the PRESENT
VALUE concept of analysis and requires that we
discount any future expenditures or receipts by a
stated interest rate. Discounting is simply
calculating interest in reverse. Instead of starting
with a known amount of money today and asking
whatit would be worth in the future at a given
interest, you ask how much money would | have to
have today to receive a given amount in the future.
As an example, we showed previously that
$10,000 invested today and compounded annually
at 10% would give you $13,310 at the end of three
years. If you decided instead that you wanted
$10,000 three years from now and knew you could
receive 10% compounded annually on any
investment you made today, how much would you
have to invest? The answer is found by calculating
the interest in reverse, discounting, and finding
that you should invest $7,513.15 today.
Cash flow:
the third
ingredient
Two important factors, PRESENT VALUE and
FUTURE VALUE, have been considered in
examining the time value of money. The third
important factor to consider is the CASH FLOW or
timing of PAYMENTS involved in a financial
decision. Many investments return not just one
lump-sum future payment, but instead return funds
over a period of time. This is known as CASH FLOW.
A good example ofthis can be seen when you take
out a mortgage on your home. Instead of repaying
the loan in one large sum at the end of the loan,
your bank will ask you to repayit in monthly
installments that include payment of both interest
and principal. These payments are the CASH FLOW
the bank receives in return for its investment in
your mortgage.
If the time period and interest rate remain constant,
there is a direct relationship between PRESENT
VALUE, FUTURE VALUE and CASH FLOW
PAYMENTS. To dramatize the point, let’s assume
you had 3 payment options to repay a loan with a
10% annual interest rate compounded monthly:
A) Paying $10,000 today.
B) Paying $322.67 per month for 36 months. .
atotal of $11,616.12,
C) Paying one lump-sum payment of $13,481.82
at the end of three years.
Because of the different CASH FLOWS involved,
the final payouts differ. But the PRESENT VALUE
of all three alternatives is identical—$10,000. And
the FUTURE VALUE of all three is identical—
$13,481.82.
Under alternatives A and B, you actually pay less
than this amount. But because the lender has the
benefit of your CASH FLOWS, what you pay still
has the same FUTURE VALUE as the single lump-
sum payment at the end ofthree years.
Thus one can see that given a known time period
and interestrate, once one of the three ingredients
is given—PRESENT VALUE, FUTURE VALUE, or
CASH FLOW PAYMENTS—the other two can
easily be determined. This concept gives us a
powerful tool to enable us to be able to consider
alternative investments in the same time frame.
Return on
investmentis
TT
the common
denominator
e
to evaluate
business
expenditures
Many times an investment proposal will specify two
of our three ingredients, such as PRESENT VALUE
and CASH FLOW. Now you can calculate the
interestrate, or rate of return, that equates these
two factors. This gives you a common denominator
for comparing alternative investments.
A typical example would be two real estate
investment opportunities—Project A and Project B
—each requiring an investment of $100,000 and
each ending after 5 years.
Project A would return a CASH FLOW of $27,000
per year for 5 years—a total of $135,000. Project B
would return no CASH FLOW during the first 4
years, then pay $150,000 at the end of the 5th year.
Which offers the better return on investment?
A manager without a true understanding of the
rate of return on investment might say that Project
B's return is better, because of the additional
$15,000.
However, when you figure out the actual rate of
return, Project A’s is 10.9%per year, while Project
B’sis only 8.5%per year— a 28%difference!
This is because Project A’s CASH FLOW of
$27,000 per year is very important. It means that
part of the initial investmentis being returned
every year. So, based on the amount of investment
capital remaining in the project each year,it's a
better return on investment.
Of course, not every investment with an annual
CASH FLOW is better. It depends on what the
alternatives are and what percentage of the
investment is returned each year.
10
A true
measure of loss
or gain must
consider
inflation
Inflation is virtually inevitable in our economy.
Because ofit, we must account for inflationary
trends in planning purchases, personnel
compensation, investment potential, and many
other financial decisions.
If, for example, inflation was running at a 7%
annual compounded rate, it would obviously not be
wise to take advantage of an investmentthat would
only yield a net return of 5% compounded annually.
As inflation becomes worse, investors require
higher interest returns, because they anticipate
repayment of their funds in substantially reduced
purchasing power.
It’s a hard fact to accept, but money can be
worth less every year . . . even when it is invested
and is supposedly appreciating in value.
Therefore, the rate of appreciation must exceed
the inflation rate in order to show a true gain.
11
Introducing Mr. Robert Cooper,
and how he uses these basic financial
concepts to make the right
decisions for the Cooper Company
Bob Cooper is a modern manager . . . the President of
the Cooper Company ( a fictitious firm with true-to-life
problems). As the chief executive officer of his
company, he is constantly faced with decisions that can
affect the growth and profitability of his firm.
In the short time that he has been in business, his
company has grown to annual sales of $500,000. It's
currently growing at the rate of 10%peryear. Through
careful planning and smart decision-making, Bob has
been able to generate enough pretax profit to yield him
a 15% return on his total asset base . . . the amount of
capital in the business. So he uses this figure as the
minimum acceptable return on any future investments.
Bob did not go to business school, but he is
familiar with basic financial concepts. On the
following pages, you'll have the opportunity to
experience some of the problems that Bob has had to
face, and see what decisions he made.
Put yourself in his shoes as you read along. For the
time being, don’t worry about how the answers were
worked out. Just concentrate on the solutions and their
importance.
13
€ production manager of the Cooper Company requests the
purchase of a new machine that would increase productivity and
reduce labor costs compared to the current model. The machine
costs $25,000 and would have higher maintenance costs. But due to
the labor and material savings, he estimates it would result in the
following net savings over the next four years.
Year Labor and Additional Net
Material Savings Maintenance Savings
1 $13,900 $ 800 $13,100
2 11,800 1,000 10,800
3 11,600 1,200 10,400
4 10,800 2,100 8,700
The net savings look attractive. But Bob decides to do a discounted
cash flow analysis to find its present value and see if it's really a
good investment. He uses a cost of capital of 27% (cost of money
plus the company’s acceptable rate of return) to see if the purchase
can be justified.
Solving for the present value of this cash flow yields $25,432.44.
The present cost of the machine is $25,000, so the net present value
of this investment is positive—meaning that it will cover the cost of
capital and return a little more than the 15%desired rate of return.
Therefore, the purchase is justifiable according to the company’s
profit criteria.
14
Growth over the past few years has been so good that the Cooper
Company needs to expand into another building. An adjacent
building has recently been put on the market for $100,000. Bob
decides it is priced right and meets the company’s requirements,
but he is unsure about the financing. After calling a few banks, he
finds the following options are available for 20-year, 90% mortgages:
A) 8% interest plus 4 points, with monthly payments of $752.80.
B) 8%4 %interest plus 1 point, with monthly payments of $766.86.
(One point equals 1% of the mortgage amount to be paid at the
time of loan origination.)
Bob realizes that paying points at the beginning of the mortgage
effectively raises the interest rate, because you really are borrowing
less but still make monthly payments based on the total loan
amount. Because of this, he decides to choose the loan with the
lowesttrue interest rate.
Using his pocketfinancial calculator, he finds the true annual
interest rate of option A to be 8.55%, while option B’s is 8.39%.
Therefore, the lower cost mortgage is option B, even though its
stated interest rate is higher.
15
The Cooper Company needs a new photocopier and the one that
best suits its needs costs $10,000. Bob knows leasing has
really grown in the last few years as an alternate way of
financing equipment, and he wonders if it might be the better
option in this case.
Checking into this, he finds he can lease the photocopier for
5 years at $210 per month. If he buys the machine he will
require a 5-year loan, which would be at a 12% interest rate
with monthly payments of $222.44.
Bob realizes that the true cost of each alternative is affected
by taxes. If the machine is leased, the full lease payment can
be treated as an expense. If it's purchased, the machine’s
depreciation and the interest on the loan are considered
expenses for tax purposes.
With this in mind, Bob calculates the net cash cost of each
alternative with the following results:
16
PURCHASE
(Assume the machine has a 5 year useful life and no salvage
value. Use sum-of-the-years’-digits depreciation and a monthly
loan payment of $222.44.)
Year Net Cash Cost*
1 $ 533
2 948
3 1,375
4 1,815
5 2,270
Total Net Cash Cost $6,941
LEASE
(Assume monthly payments of $210.00.)
Year Net Cash Cost*
1 $1,310
2 1,310
3 1,310
4 1,310
5 1,310
Total Net Cash Cost $6,550
*Net Cash Cost equals total payments minus the tax savings of 48%.
Looking at total cost, leasing appears to be less. But, purchase
costs less the first few years. Bob knows he can make a 15%
return on every dollar he puts in the business; the sooner he
can reinvest money, the sooner he earns 15%. Therefore, he
decides to consider the timing of the costs, discounting the
cash flows at 15% to find the present value of the alternatives.
Doing this he discovers leasing has a present value cost of
$4,391, while purchasing has a present value cost of $4,251.
Since these are both expense items, the lowest present value
is the most desirable. So, in this case, purchase is the least
costly alternative.
17
4 Bob’s production manager is recommending a 25%
raise for George, who is one of his professional
employees. Bob feels this is totally out of line. But
his manager reminds Bob that George is very sharp,
a hard worker, and highly regarded by his co-workers.
Bob admits it would be a real company loss if George
should become dissatisfied and look elsewhere.
The manager thinks inflation has eliminated any
increase in real buying power for George and feels
it is time to adequately compensate him for past
discrepencies. Bob agrees thata 10%per year
increase in real buying power is an excellent reward
for an outstanding job and decides to apply this to
George’s salary history for the past 3 years and
relate it to inflation.
George’s salary history is as follows:
Current $14,700
2 years ago $13,000
3 years ago $12,000
In the same period, inflation has been 6% per year.
Considering these facts, Bob calculates what
George's salary should be if he had experienced a
10% per year increase in buying power in addition
to the increase necessary to keep up with inflation.
The result is an astounding $18,731, which would be
a 27% increase over his current level. In light of the
circumstances, Bob concedes that the 25%
increase is advisable.
S
Terms on most of the company’s accounts payable are
2/30, net/90. There is sufficient cash to pay them in 30
days and take the discount. However, Bob’s bookkeeper
suggests it might be better to buy short-term notes with
a 90-day term and 10% interest. This alternative
sounds attractive.
But Bob knowsthat the real value of expense items
depend on when payment actually occurs. In this case,
passing up the 2%discount means that the company is,
in effect, paying a 2% finance charge to retain its money
for an additional 60 days.
So he uses his pocketfinancial calculator to figure out
the annual percentage rate of delaying payments for 60
days—and it comes out 12.4%.
Since the short term notes only yield 10%), obviously
the company is better off to pay its accounts payable
within 30 days and take advantage of the discount.
19
One of Bob Cooper’s friends, who is a Realtor, presents him
with two personal investment alternatives. Each requires an
initial investment of $20,000 and will be sold at the end of
“ 5 years. Based on studying the income and expenses for the
next 5 years and considering his tax bracket, Bob determines
the net cash flows he will receive for each investment:
Property A Property B
Year Cash Flow Year Cash Flow
1 $ 3,600 1 $ 200
2 3,620 2 420
3 3,510 3 610
4 2,970 4 870
5 19,300 5 32,900
Total Cash Flow $33,000 Total Cash Flow $35,000
Although Property B has a larger total cash flow, Bob is not
sure that the larger total compensates for the difference in
timing of the cash flows. Therefore, he decides to find the
rate of return for each investment. Using his pocket financial
calculator, he finds that property A returns 14%, while
Property B only returns 12%. So the larger total cash flow
really does not have the best return on investment.
20
7
To handleits intercity deliveries the Cooper Company has just
purchased a new $8,000 van. The van is estimated to have a
useful life of 5 years with a salvage value of $800. Knowing
that the depreciation method used affects taxes, Bob decides
to compare the three depreciation methods—straight line,
double declining balance, and sum-of-the-years’-digits—to see
which method leads to the most tax savings. Assuming a 48%
tax rate he calculates the following yearly tax savings.*
Double Sum-of-the-
Year Straight Line Declining Balance Years’-Digits
1 $ 691 $1,536 $1,152
2 691 921 921
3 691 553 691
4 691 332 461
5 691 113 230
Total Tax Savings $3,455 $3,455 $3,455
*Tax Savings equal 48% of annual depreciation amount.
Even though the total savings are the same, the yearly amounts
are different. Being aware of the time value of money, Bob uses
a present value approach to determine which method really
has the most savings.
Discounting the cash flows at the company’s 15% desired rate
of return yields the following present values:
Straightline $2,316.34
Double declining balance $2,641.67
Sum-of-the-years’-digits $2,530.42
Since the highest present value indicates the greatest savings,
this readily shows that Bob should use double declining balance
to maximize his tax savings and minimize costs.
21
8
The Cooper Company is just closing its books after completing
a very good year. Bob decides a bonus would be in order for
the vice president, who is the number two man in the company,
and who has done an outstanding job this year.
He can’t decide whether to give him $5,000 now or give him
$480 a month for the next 12 months. He consults his
accountant, and learns that both options have the same tax
implications, because the bonus amount can be charged off as
an expense for the current year.
Bob knows that the monthly bonus plan would cost $5,760
instead of $5,000. But it would have the advantage of providing
extra working capital in the months ahead. By discounting the
monthly payments at 27% (cost of capital plus desired rate of
return), he finds that their present value is $4,999.09.
Because the net present values under the two alternatives
are so similar Bob decides to use the monthly bonus plan. He is
thus able to pay a bigger bonus at very nominal additional cost
to the company.
22
Sound decision-making...
like other things in life,
IS easy when you know how
Although Bob Cooper is imaginary, business problems similar to his occur
every day in the real world. And they can be solved just as quickly, easily
and, above all, accurately by using some ofthe basic financial concepts
shown in this booklet.
Attempting to make business decisions without using these concepts
can be very costly. As you have just seen in many of the problems, the
"apparently obvious” solution is not always the best one. Until recently
there was a “good excuse” for not applying these financial concepts—
the necessary mathematical calculations were difficult to do. Or time-
consuming. Or both.
But today, any decision-maker—with or without financial training—can
use a pre-programmed business calculator to readily obtain the answers.
Itisn’t even necessary to know the mathematical formulas involved. All you
need do is enter the variables and press the keys! Or have your bookkeeper
or assistant use the calculator to work the problems for you.
Should you buy a pre-programmed financial calculator to help you make
decisions? Probably yes, because you may very well make or save far more
than its cost the veryfirst time you use it. And this, according to one of the
basic concepts, would be a very nice return on investment!
23
Hewlett-Packard offers a complete selection
of problem-solving tools to aid in decision-
making — from business pocket
calculators to computers
Hewlett-Packard Company is one of the world’s major designers
and manufacturers of electronic tools for people who measure,
compute and analyze.
For business people, Hewlett-Packard offers a wide selection
of pocket-sized and desktop calculators, in addition to mini-
computers and complete data systems. The company has a
reputation for introducing innovative products with unique
features and benefits.
HP's pocket calculators for business use have put real
decision-making power at an executive’s fingertips. Because of
their low cost and portability, every modern manager can quickly
get the answers he or she needs.
These pocket calculators are pre-programmed with all the
necessary equations and interest tables for solving virtually any
problem involving the relationship between time and money.
Calculations that would take considerable time and effort on a
non-programmed calculator are easily handled with a few
keystrokes that initiate all the calculations for you.
Hewlett-Packard makes decision-making easier, by
providing the tools a decision-maker needs.
24
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