ACF213214 Finance I Finance II Lecture 1 Learning

ACF-213/214 Finance I / Finance II Lecture 1

Learning Outcome Understand the nature of risk and return in finance

Topics Covered Corporate Investment and Financing Decisions The Financial Goal of the Corporation Future Values and Present Values

Topics Covered Perpetuities and Annuities Growing Perpetuities and Annuities How Interest Is Paid and Quoted

Corporate Investment and Financing Decisions Real assets Assets used to produce goods and services. Financial assets Financial claims to the income generated by the firm’s real assets.

Corporate Investment and Financing Decisions Continued Investment decision Purchase of real assets Financing decision Sale of financial assets

Investment Decisions Capital budgeting decision Decision to invest in tangible or intangible assets Also called the investment decision called capital expenditure or CAPEX decisions

Table 1. 1 Examples of Recent Investment and Financing Decisions by Major Public Corporations

Financing Decisions Shareholders Contribute Capital are equity investors equity financing structure decision Choice between debt and equity financing Capital refers to firm’s sources of long-term financing

What Is a Corporation? Corporation A business organized as a separate legal entity owned by shareholders Types of Corporations Public companies Private corporations Limited liability corporations (LLC)

Other Forms of Business Organization Types of business organizations Sole proprietorships Partnerships Corporations Limited liability options Limited liability partnerships Limited liability companies Professional limited liability companies Limited liability: The owners of a corporation are not personally liable for its obligations.

Figure 1. 1 Flow of Cash between Financial Markets and the Firm’s Operations 1) 2) 3) 4) Cash raised by selling financial assets to investors Cash invested in the firm’s operations and used to purchase real assets Cash generated by the firm’s operations (a) Cash reinvested (b) Cash returned to investors

The Financial Goal of the Corporation Stockholders To want three things maximize current wealth To transform wealth into most desirable time pattern of consumption To manage risk characteristics of chosen consumption plan

The Financial Goal of the Corporation Continued Profit Not maximization a well-defined financial objective Which year’s profits? Shareholders will not welcome higher shortterm profits if long-term profits are damaged Company may increase future profits by cutting year’s dividend, investing freed-up cash in firm Not in shareholders’ best interest if company earns less than opportunity cost of capital

The Financial Goal of the Corporation Continued 2 Shareholders desire wealth maximization Managers have many constituencies, “stakeholders” “Agency problems” represent the conflict of interest between management and owners

Figure 1. 2 Investment Trade-Off Arrows represent possible cash flows or transfers.

The Financial Goal of the Corporation Concluded The investment trade-off Hurdle rate/cost of capital Minimum acceptable rate of return on investment Opportunity Investing cost of capital in a project eliminates other opportunities to use invested cash

Agency Problem Do managers maximize shareholder wealth or manager wealth? Managers have many constituencies, “stakeholders” Stakeholder Anyone with a financial interest in the corporation

Agency Problem Continued Agency problem Managers are agents for stockholders and are tempted to act in their own interests rather than maximizing value Agency Value cost lost from agency problems or from the cost of mitigating

Agency Problem Concluded Corporate The governance laws, regulations, institutions, and corporate practices that protect shareholders and other investors

Present Value and Future Value Amount to which an investment will grow after earning interest Present Value today of a future cash flow

Future Values Future Value of $100 = FV

Future Values Continued Example: FV What is the future value of $100 if interest is compounded annually at a rate of 7% for two years?

Figure 2. 1 Future Values with Compounding

Present Value Present value = PV

Present Value Continued Discount factor = DF = PV of $1 Discount factors can be used to compute the present value of any cash flow

Present Value Concluded The PV formula has many applications. Given any variables in the equation, you can solve for the remaining variable. Also, you can reverse the prior example.

Figure 2. 2 Present Values with Compounding

Valuing an Investment Opportunity Step 1: Forecast cash flows Cost of building = C 0 = 700, 000 Sale price in Year 1 = C 1 = 800, 000 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%

Valuing an Investment Opportunity Continued Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment

Net Present Value

Figure 2. 4 NPV Calculation

Risk and Present Value

Risk and Net Present Value

Net Present Value Rule Accept investments that have positive net present value Example Use the original example. Should we accept the project given a 10% expected return?

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?

Calculating Present Values When There Are Multiple Cash Flows For multiple periods we have the discounted cash flow (DCF) formula

Figure 2. 5 NPV Calculation

How to Value Perpetuities 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.

Shortcuts Perpetuity: Financial concept in which a cash flow is theoretically received forever.

Shortcuts Continued Perpetuity: Financial concept in which a cash flow is theoretically received forever.

Present Values Example What is the present value of $1 billion every year, for all eternity, if you estimate the perpetual discount rate to be 10%?

Present Values Continued Example continued What if the investment does not start making money for 3 years?

How to Value Annuities Annuity: An asset that pays a fixed sum each year for a specified number of years

Perpetuities & Annuities PV Annuity Factor (PVAF): The present value of $1 a year for each of t years

Figure 2. 7 Annuity

Figure 2. 8 Costing an Installment Plan

Valuing Annuities Due Annuity due: Level stream of cash flows starting immediately How does it differ from an ordinary annuity? How does the future value differ from an ordinary annuity?

Example 2. 3 Paying off a Bank Loan

Table 2. 1 Amortizing Loan Example

Future Value of an Annuity Example: Suppose you invest $429. 59 annually at the beginning of each year at 10% interest. After 50 years, how much would your investment be worth?

Future Value of an Annuity Continued Future Value of an Annuity: The future value of an asset that pays a fixed sum each year for a specified number of years.

Future Value of an Annuity Concluded Example What is the future value of $20, 000 paid at the end of each of the following 5 years, assuming your investment returns 8% per year?

Growing Perpetuities Present value of growing perpetuity g = the annual growth rate of the cash flow

Growth Perpetuity Example What is the present value of $1 billion paid at the end of every year in perpetuity, assuming a rate of return of 10% and a constant growth rate of 4%?

How Interest is Paid and Quoted Annual Percentage Rate: Interest rate that is annualized using simple interest Effective Annual Interest Rate: Interest rate that is annualized using compound interest

EAR & APR Formulas Annual Percentage Rate (APR): Effective Annual Interest Rate (EAR): *where MR = monthly interest rate

Effective Interest Rates Example: Given a monthly rate of 1%, what is the effective annual rate (EAR)? What is the annual percentage rate (APR)?