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8/6/2019 Principle of Corporate Finance
1/23
Course topics
Principles of
Corporate
Finance
Seventh Edition
Richard A. Brealey
Basic concepts of Corporate Finance
Risk, portfolio selection, budgeting
Incentives of managers.
.
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Financial markets
Asset valuation
Debt structure
Risk management
Cash management
8/6/2019 Principle of Corporate Finance
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Organization
Lectures (Prof. Kirstein) Thu 1:30-3 p.m. in A-013
No regular office hours (D-003), send an email to
Tutorial (Sidi Kon) Mon 11.15-12.45, A-211
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
Book: Brealey/Myers (7th or later ed.; or any other textbook)
Homepage http://www.ww.uni-magdeburg.de/bizecon
=> teaching, Winter 2009/10, Financial Management
=> slides, book, exercises, further information
8/6/2019 Principle of Corporate Finance
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Section 1: Why Finance matters
What Is A Corporation?
The Role of The Financial Manager
Who Is The Financial Manager?
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
epara on o wners p an anagemen Financial Markets
8/6/2019 Principle of Corporate Finance
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Corporate Structure
Sole Proprietorships
Partnershi s
Unlimited Liability
Personal tax on profits
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
Corporations
Limited Liability
Corporate tax on profits +
Personal tax on dividends
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Role of The Financial Manager
Financial
manager
Firm's
operations
Financial
markets
(1)(2)
(4a)
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(3)
(4a) Cash reinvested
(4b) Cash returned to investors
(4b)
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Who is The Financial Manager?
Chief Financial Officer
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
ComptrollerTreasurer
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Ownership vs. Management
Difference in Information
Stock prices and returns
Issues of shares and
Different Objectives
Managers vs.
stockholders
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
other securities
Dividends
Financing
Top mgmt vs. operatingmgmt
Stockholders vs. banks
and lenders
8/6/2019 Principle of Corporate Finance
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Principles of
CorporateFinance
Seventh Edition
Richard A. Brealey
Chapter 2Present Value and The
Opportunity Cost of Capital
.
.
8/6/2019 Principle of Corporate Finance
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Topics Covered
Present Value
Net Present Value NPV Rule
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
u e Opportunity Cost of Capital
Managers and the Interests of Shareholders
8/6/2019 Principle of Corporate Finance
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Present Value
Present Value
Value today of a
future cash
Discount Factor
Present value of
a $1 future
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
.
Discount Rate
Interest rate used to compute
present values of future cash
flows.
.
8/6/2019 Principle of Corporate Finance
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Present Value
1factordiscount=PV C
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
1st basic principle of Financial Economics:
A $ today is more worth than a $ tomorrow
(i.e., discount factors are positive, but smaller than one)
8/6/2019 Principle of Corporate Finance
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Present Value
Discount Factor = DF = PV of $1
1DF =
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
Discount Factors can be used to compute
the present value of any cash flow.
r+
8/6/2019 Principle of Corporate Finance
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Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0
= 350
Sale price in Year 1 = C1 = 400
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
tep : st mate opportun ty cost o cap taIf equally risky assets in the capital market
yield a return of 7%, then the opportunity
cost of the investment = r = 7%
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Valuing an Office Building
Step 3: Discount future cash flows
37)07.1(400
)1(1
===++r
CPV
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
Step 4: Go ahead if PV of payoff exceeds investment
24374350 =+=NPV
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Net Present Value
r
C
+
+
1C=NPV
investmentrequired-PV=NPV
10
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
required rate of return: the rate at which NPV=0
If the ROR of an investment equals theopportunity cost of capital, then NPV=0
Hence, required ROR = oppcost of capital
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Risk and Present Value
2nd basic principle of Financial Economics:
A safe $ has a higher value than a risky one
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
. .,
with their probability AND discounted)
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Risk and Present Value
Higher risk projects require a higher rate of return
Higher required rates of return cause lower PVs
E. ., if the re uired rate of return is not 7% low
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
risk), but 12% (high risk):
374.071
400PV
7%at$400CofPV 1
=
+
=
=
8/6/2019 Principle of Corporate Finance
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Risk and Present Value
357.121
400PV
12%at$400CofPV 1
=
+
=
=
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
374.071
400PV
7%at$400CofPV 1
=
+
=
=
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Rate of Return Rule
Accept investments that offer rates of return
in excess of their opportunity cost of capital
Example
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
In the project listed below, the foregone investment
opportunity is 12%. Should we do the project?
14.3%or.143350,000
350,000400,000
investment
profitReturn =
==
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Net Present Value Rule
Accept investments that have positive net
present value
Example
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
Suppose we can invest $50 today and receive $60in one year. Should we accept the project given a
10% expected return?
55.4$1.1060+-50=NPV =
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Opportunity Cost of Capital
Example
You may invest $100,000 today. Depending on thestate of the economy, you may get one of three
possible cash payoffs (with equal probability):
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
140,000110,000$80,000Payoff
BoomNormalSlumpEconomy
000,110$3
000,140000,110000,80CpayoffExpected 1 =
++==
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Opportunity Cost of Capital
Example - continued
Alternative investment is buying stock for $95.65. Nextyears stock price is predicted as $110.
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
The stocks expected payoff leads to an expected return=> OCC or required ROR
15%or15.65.95
65.95110profitexpectedreturnExpected ===investment
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Opportunity Cost of Capital
Example - continued
Using the required ROR to discounting the expectedpayoff at the expected return leads to the PV of the
project
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
000,100$650,95$
1.15
110,000PV