© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 1 B40.2302 Class #1 BM6 chapters 1, 2, 3 Based on slides created by Matthew Will Modified

©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill

1- 1

B40.2302 Class #1

BM6 chapters 1, 2, 3 Based on slides created by Matthew Will Modified 9/3/2001 by Jeffrey Wurgler

Finance and the Financial Manager

Principles of Corporate FinanceBrealey and Myers Sixth Edition

Slides by

Matthew Will, Jeffrey Wurgler

Chapter 1



1- 3

Topics Covered

What Is A Corporation? The Role of The Financial Manager Who Is The Financial Manager? Separation of Ownership and Management Financial Markets


1- 4

Corporate Structure

Sole Proprietorships

Partnerships

Unlimited Liability

Personal tax on profits

Ownership = control


1- 5

Corporate Structure

Sole Proprietorships

Corporations

Partnerships

Unlimited Liability

Personal tax on profits

Ownership = control

Limited Liability

Corporate tax on profits +

Personal tax on dividends

Ownership =/= control


1- 6

Role of The Financial Manager

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors (external finance)

(2) Cash invested in firm

(1)(2)


1- 7

Role of The Financial Manager

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors (external finance)

(2) Cash invested in firm

(3) Cash generated by operations(4a) Cash reinvested (internal finance)

(4b) Cash returned to investors

(1)(2)

(3)

(4a)

(4b)


1- 8

Who is The Financial Manager?

Chief Financial OfficerChief Financial Officer

ControllerTreasurer


1- 9

Ownership vs. Management

Different Information

Often exacerbates agency costs or leads to other costs

Stock prices / returns Issues of shares and

other securities Dividends

Different Objectives

Agency costs Managers vs.

stockholders Top mgmt vs. operating

mgmt Stockholders vs. banks

and lenders


1- 10

Financial Markets

Primary

Markets

Secondary

Markets

OTC

Markets

Raising and

trading capital


1- 11

Financial Institutions

Operating company

Financial intermediaries

Banks

Insurance Cos.

Brokerage Firms

ObligationsFunds


1- 12

Financial Institutions

Financial intermediaries

Investors

Depositors

Policyholders

Investors

ObligationsFunds

Present Value and The Opportunity Cost of Capital


Slides by

Matthew Will, Jeffrey Wurgler Chapter 2



1- 14

Topics Covered

Present Value Net Present Value NPV Rule ROR Rule Opportunity Cost of Capital Managers and the Interests of Shareholders


1- 15

Present Value

Present Value

Value today of a future cash

flow.

Discount Rate

Interest rate used to compute

present values of future cash flows.

Discount Factor

Present value of a $1 future payment.


1- 16

Present Value

1factordiscount =PV

PV=ValuePresent

C


1- 17

Present Value

Discount Factor for one-period-ahead cash flow = DF1 = PV of $1

We will see how discount factors can be used to compute the present value of any cash flow.

)1(1

1 rDF


1- 18

Valuing an Office Building

Step 1: Forecast cash flows

Cost of building = C0 = -350

Sale price in Year 1 = C1 = 400

Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market

offer a return of 7%, then

Cost of capital = r = 7%


1- 19

Valuing an Office Building

Step 3: Discount future cash flows

Step 4: Go ahead with project if PV of payoff exceeds investment

374)07.1(400

)1(111 r

CCDFPV

24374350 NPV


1- 20

Net Present Value

r

C

1C=NPV

investment required-PV=NPV

10


1- 21

Risk and Present Value

Higher-risk projects require higher discount rates.

Higher discount rates cause lower PVs.

374.071

400PV

7%at $400 C of PV 1


1- 22

Risk and Present Value

374.071

400PV

7%at $400 C of PV 1

357.121

400PV

12%at $400 C of PV 1


1- 23

Rate of Return Rule

Accept investments that offer rates of return in excess of their opportunity cost of capital.

Example

In the project listed below, the foregone investment opportunity is 12%. Should we do the project?

14%or .14350,000

350,000400,000

investment

profitReturn


1- 24

Net Present Value Rule

Accept investments that have positive net present value.

Equivalence of NPV and ROR rule:

0

01

01

10

10

0

01

NPV

r

CC

CrC

rC

CCrROR


1- 25

Opportunity Cost of Capital

Example

You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs (with 1/3 probability each):

140,000110,000$80,000Payoff

BoomNormalSlumpEconomy

000,110$3

000,140000,110000,80C payoff Expected 1


1- 26


Example - continued

A stock is trading for $95.65. Depending on the state of the economy, the value of the stock at the end of the year is one of three possibilities (with 1/3 probability each):

140110$80eStock Pric

BoomNormalSlumpEconomy


1- 27


Example - continued

The stock’s expected payoff allows us to compute an expected return.

15%or 15.65.95

65.95110

investment

profit expectedreturn Expected

110$3

14011080C payoff Expected 1


1- 28


Example - continued

Discounting the expected payoff at the stock’s expected return (our opportunity cost) leads to the PV of the non-capital-market project.

650,95$1.15

110,000PV


1- 29

Investment vs. Consumption

Some people prefer to consume now. Others prefer to invest now and consume later.

Borrowing and lending in the capital markets

allows us to reconcile these opposing desires (which may exist within the firm’s shareholders, for example).


1- 30


A

G

100

80

60

40

20

40 60 80 100dollars in period 0

dollars in period 1

Some investors will prefer A

and others G


1- 31


The grasshopper (G) wants to consume now. The ant (A) wants to wait.

Both face an investment opportunity in the capital market: Buy a share in a $350K building today that produces a (riskless) $400K tomorrow. The riskless interest rate is 7%. (The ROR on the project is 14%.)

Who will invest? A? G? Both?


1- 32

Investment vs. Consumption» The grasshopper (G) wants to

consume now. The ant (A) wants to wait. But each is happy to invest. A prefers to invest 14%, moving up the red arrow, rather than at the 7% interest rate. G invests and then borrows at 7%, thereby transforming $100 into $106.54 of immediate consumption. Because of the investment, G has $114 next year to pay off the loan. The investment’s NPV is $106.54-100 = +6.54

100 106.54 Dollars Now

Dollars Later

114

107

A invests $100 now and consumes $114 next year

G invests $100 now, borrows $106.54 and consumes now.


1- 33

A Fundamental Result

Investors with free and equal access to borrowing and lending markets will always invest in positive NPV projects, no matter what their preferred time pattern of consumption.

Corollary: Shareholders A and G both agree that firm should maximize its NPV.


1- 34

Managers and Shareholder Interests

Governance Tools to Ensure Management Responsiveness

Subject managers to oversight and review by specialists (directors).

Internal competition for top level jobs that are appointed by the board of directors.

Financial incentives (e.g. stock options). Takeover pressures

How to Calculate Present Values


Slides by

Matthew Will, Jeffrey Wurgler

Chapter 3



1- 36

Topics Covered

Valuing Long-Lived Assets PV Calculation Short Cuts Compound Interest Interest Rates and Inflation Example: Present Values and Bonds


1- 37

Present Values

For a one-period-ahead cash flow

But discount factors can be used to compute the present value of any cash flow.

1

111 1 r

CCDFPV


1- 38

Present Values

Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time.

tt

ttt

r

CCDFPV

1


1- 39

Present Values

Example

You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money in each of the next two years, how much should you set aside today in order to make the payment due in two years?

PV 30001 08 2 572 02

( . )$2, .


1- 40

Present Values

PVs can be added up to value a package of cash flows across many periods.

tr

C

r

C

r

C

tt

t

PV

)1(

)1()1(...2

2

21

1

1


1- 41

Present Values

There are some limits on the relationship between r1 and r2. It is not arbitrary. Suppose one dollar is received a year from now and another two years from now. Suppose r1 = 20% and r2 =

7%. Then the current value of each dollar is:

(Unless o.w. noted we will assume r1= r2= rt= r)

87.

83.

2

1

)07.1(00.1

2

)20.1(00.1

1

DF

DF


1- 42

Present Values

Example

Assume that the cash flows from the construction and sale of an office building are as below. Given a 7% opportunity cost of capital, create a present value worksheet and calculate the net present value.

000,300000,100000,150

2Year 1Year 0Year


1- 43

Present Values

Example - continued

Assume that the cash flows from the construction and sale of an office building are as below. Given a 7% opportunity cost of capital, create a present value worksheet and calculate the net present value.

400,18$

900,261000,300873.2

500,93000,100935.1

000,150000,1500.10Value

Present

Flow

Cash

Factor

DiscountPeriod

207.11

07.11

NPV


1- 44

Short Cuts

Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tools allow us to cut through the calculations quickly.


1- 45

Short Cuts

Perpetuity - A constant cash flow is received forever, starting at the end of the first period.

r

CPV


1- 46

Short Cuts

Growing perpetuity - A cash flow growing at rate g is received forever. The first cash flow, arriving at the end of the first period, is C1.

gr

CPV

1


1- 47

Short Cuts

Annuity – A constant cash flow that arrives only for t periods. The first cash flow arrives at end of first period.

trrrC

1

11annuity of PV


1- 48

Annuity example

ExampleYou agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

10.774,12$

005.1005.

1

005.

1300Cost Lease 48


1- 49

Compound Interest

02468

1012141618

Number of Years

FV

of

$1

10% Simple

10% Compound


1- 50

Compound Interest

i ii iii iv vPeriods Interest Value Equiv. annuallyper per APR after compoundedyear period (i x ii) one year interest rate

1 6% 6% 1.06 6.000%

2 3 6 1.032 = 1.0609 6.090

4 1.5 6 1.0154 = 1.06136 6.136

12 .5 6 1.00512 = 1.06168 6.168

365 .0164 6 1.000164365 = 1.06183 6.183

Inf. Small 6 e.06 = 1.06184 6.184


1- 51

Inflation

Inflation - Rate at which prices as a whole are increasing.

Nominal Interest Rate - Rate at which money invested grows.

Real Interest Rate - Rate at which the real purchasing power of an investment grows.


1- 52

Inflation

1 real interest rate = 1+nominal interest rate1+inflation rate

The formula above is exact. Here’s an approximation:

rate inflation-rateinterest nominal

rateinterest real


1- 53

InflationExample

If the nominal interest rate on one year govt. bonds is 5.9% and the inflation rate is 3.3%, what is the real interest rate?

2.6%or .026=.033-.059Approx.

2.5%or .025 = rateinterest real

1.025 =

=rateinterest real1 .033+1.059+1

Savings

Bond


1- 54 Discount nominal cash with nominal rate, real cash with real rate

NPV rule gives same answer whether discounting nominal cash by nominal rate or real cash by real rate.

Just don’t mix them up!


1- 55

Valuing a BondExample

If today is October 2001, what is the value of the following bond? An IBM Bond pays $115 end of every September for 5 years. In September

2006 it pays an additional $1000 and retires. The bond is rated AAA (WSJ AAA YTM is 7.5%).

Cash Flows

Sept 0203 04 05 06

115 115 115 115 1,115


1- 56

Valuing a Bond

Example continued

84.161,1$

075.1

115,1

075.1

115

075.1

115

075.1

115

075.1

1155432

PV


1- 57

Bond Prices and Yields (YTM)

0

200

400

600

800

1000

1200

1400

1600

0 2 4 6 8 10 12 14

5 Year 9% Bond 1 Year 9% Bond

YTM

Pri

ce

Documents

© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 1- 1 B40.2302 Class #1 BM6 chapters 1, 2, 3 Based on slides created by Matthew Will Modified