Financial Management

1. Instructor: Dr Sam Wylie Office: Room 146 Tel: 03 9349 8185 s.wylie@mbs.edu Textbook: Hawawini and Viallet Financial Management

2. Reading for classes 1.7 & 1.8 • All of Chapter 1 of Hawawini and Viallet (HV) • Chapter 6: pages 185 to 196 & 215—218 (Appendix 6.1) of HV • To prepare for classes 2.3 & 2.4 • Review slides for Class from website • Homework and Casework • Download Problem Set 1 from the class website. Complete the questions and submit them in-class (in hard copy) • You may discuss the questions in your syndicate groups, but then each student must complete their own solution to the questions Study schedule

3. Finance in Modules 1 and 3 is concerned with two things: • Studying how managers make financial decisions to create value for shareholders (or principal beneficiaries of the organization) -- The value of different projects that the firm could invest in -- Value creation for shareholders in choosing between those projects -- The value of securities that the firm issues to finance projects -- Value creation for shareholders in choosing its capital structure • Introducing the major components of the financial system -- Financial instruments: Stocks, bonds, bank loans, options, futures, etc. -- Financial markets: Stock markets, bond markets, money market, futures markets, forex markets, etc. -- Financial intermediaries: Commercial banks, investment banks, insurance firms, investment managers -- The Central Bank and Regulators Introduction

4. Hawawini and Viallet start with the question “what is the objective of financial decision making in a firm?” • That is a natural starting point for a text on financial management. We will come directly to this crucial question in Class 1.8. • But this is a first course in finance. So, we want to start with a more general question – “what is the purpose of the financial sector of the economy?” Introduction

5. Households, firms and governments have 5 fundamental financial needs • Transfer value through time • Transfer and diversify risk • Obtain liquidity • Make payments • Obtain advice • The financial sector creates value by helping households, firms and governments to meet these basic needs Basic Financial Needs

6. Transfer value through time • Households, firms and governments each face a mismatch in time between cashflows in and cashflows out • Households -- Need to borrow early in their life cycle to buy housing and then save in mid- life for retirement • Firms -- Need to raise capital for projects early in the life-cycle of the firm, but typically generate a cash surplus as mature companies -- Need to manage fluctuations in working capital due to seasonality in revenues and costs • Governments -- Borrow to fund budget deficits during the low point of business cycles – ideally helping to stabilize the economy -- Borrow to create risk-free debt instruments in the economy Basic Financial Needs

7. Transfer or diversify risk • Households -- Transfer risks to insurance companies -- Absorb the riskiness of the cashflows of firms by buying the securities of firms (stocks and bonds) and holding them in diversified portfolios • Firms -- Sell risky securities that are claims on the cashflows of the firm -- Transfer risks through insurance contracts and through derivatives markets (options, futures, swaps markets) -- Diversify credit risk across customers and business risks across products • Governments -- Absorb macro financial risks – risks of failure of banks, failure of pension funds, etc. -- Provide social insurance to households Basic Financial Needs

8. Obtain liquidity • There are two types of liquidity -- Payments liquidity the ability of an asset to be used for immediate payment, or to soon revert to cash for immediate payment -- Asset liquidity the ability of an asset to be quickly bought or sold at near its fundamental value • Households and firms need to be able to access payments liquidity so that they can make purchases and meet obligations when they become due • Liquidity is valuable and expensive to access -- storing liquidity is expensive because cash, bank deposits and other assets that provide payment liquidity have low returns • The central bank is the ultimate source of liquidity Basic Financial Needs

9. Make payments • A payments system is the elemental component of any financial system • The payment system -- Allows secure transactions between unrelated parties -- Permits immediate discharge of liabilities -- Provides a store of value -- Provides a record of transactions • There are three types of payments systems -- Retail (Credit cards, debit cards, checks, cash) -- Wholesale (for business to business payments) -- Institutional (between major financial intermediaries Basic Financial Needs

10. Obtain advice • Households -- Need financial advice on investment management, retirement strategy, tax management, estate planning, etc. • Firms -- Need financial advice on: project selection; raising capital; risk management; tax management; pension fund management; liquidity management; etc. • Governments -- Have departments and other organizations for collecting data and providing financial advice – Treasury and Finance Departments, the Reserve Bank of Australia and major finance industry regulators Basic Financial Needs

11. We can understand the different parts of the financial system • Financial instruments -- Stocks, bonds, options, futures, swaps, etc. • Financial markets -- Stock markets, bond markets, futures markets, forex markets, etc. • Financial intermediaries -- Commercial banks, investment banks, insurance firms, investment managers • The Central Bank and Regulators • Payments systems in terms of the value that they add by helping to meet the basic financial needs of households, firms and governments Basic Financial Needs

12. Optimal decision making only makes sense in relation to an objective • What is the objective of financial decision makers (managers) in publically owned corporations? • To maximize shareholder value? -- What do shareholders care about? -- Is this an objective that all shareholders agree on? • What about other stakeholders in the firm? • How does the objective of managers change if the firm is “closely held?” • What are the objectives of financial managers in not-for-profit organizations? For governments? Objective in financial decision making

13. Stakeholders

14. Time value of money How much are riskfree promises of cashflows in the future worth today?

15. Example: Imagine that you are deciding whether a particular project can be funded within the firm’s capital budget. The project involves the building of a new medical equipment maintenance facility. • The up-front cost of the new facility is $1.5 mn • The facility will be used for 5 years after which it will be superceded and it will have a residual value of $200,000 • The incremental increase in firm’s cashflows from the facility will be $420,000 per year Capital budgetting example

16. Should you approve the project? • We want to compare the the present value of the cashflows to the current costs • To get the present value of the future cashflows -- Discount each of the future cashflows to the present by multiplying the cashflow by a discount factor -- Sum up the discounted cashflows to get the present value of the stream of future cashflows -- What is the discount factor? Capital budgetting example

17. How much is a dollar today worth in the future? Transferring value

18. 1 period

19. How much is a dollar today worth 2 periods from now? 2 periods

20. How much is a dollar today worth N periods from now? N periods

21. If the interest rate varies from period to period, then how much is the average yield on the investment • Example: An investment of $200 in a particular investment promises 5.1% in the first period and 14.1% in the second period Average yields

22. Average yields

23. The yield is the geometric mean of the interest rates in the two periods. It is not the arithmetic mean. • What is the arithmetic mean of the interest rates in the 2 periods? Answer: (5.1 + 14.1)/2 = 9.6% • Is the geometric mean more, or is it less, than the arithmetic mean? • The geometric mean (average yield) is less than the arithmetic mean • That is always true • Consider the example of starting with $100, then realizeing a return of 100% in the first period and then -50% in the second period. • V0 = $100; V1 = $200; V2 = $100 • Arithmetic mean of returns is [100 + (-50)]/2 = 25 • Geometric mean (average yield) = Average yields

24. Imagine an investment of $1000 in a bond fund that returns 26% in the first period and then -12% in the second period. What is the yield on the investment over the two periods? Negative returns

25. What is the average yield on an investment in a bond fund that returns: • 8.1% in the first period • -3.7% in the second period • -7.7% in the third period? 3 periods

26. Imagine a bank account that offers an annual percentage rate (APR) of interest of 10%, but half the interest is actually calculated and paid after each 6 month period rather than after 12 months. What is the difference between the APR and the equivalent annually compounded interest rate? Compounding intervals

27. What if the interest on the account (with 10% APR) were paid monthly instead of yearly? • Effective annual rate = (1+0.10/12)12-1 = 10.47% • In excel: =power(1+(0.10/12),12) - 1 • As m approaches infinity and compounding becomes continuous the yield is calculated as • Effective annual rate = (1+0.10/m)m – 1 where m, the number of = em - 1 compounding periods, is large • What if the yield were compounded continuously? • Effective annual rate = e0.10 – 1 = 10.52% In excel: =exp(0.10)-1 Compounding intervals

28. Consider an investment of $4,000 that is paid an APR of 12.6% and is continuously compounded at that rate for 3 years. How much does the investment grow to in 3 years? • Answer: V3 = 4,000 e(0.126)(3) = $5,837.45 =4000*exp(0.126*3) • Consider an investment of $1,000 that realizes an APR of -12%, continuously compounded for 18 months. How much does the investment shrink to in 18 months? • Answer: Vt = 1,000 e(-0.12)(1.5) = $835.27 =1000*exp(-0.12*1.5) Compounding intervals

29. So far we have discussed transferring value into the future -- how much will a dollar today be worth in the future? • But what we really need to know is – how much is cash that will be received in the future worth today? • We will consider the following problems: • Single period discounting • Discount factor • Multiple period discounting • Present value of a stream of future cashflows • Present value of a perpetuity • Present value of an annuity • Present value of a growing perpetuity • What happens to these present values when the discount factors change? Transferring value

30. If you were offered an investment that is certain to pay $1 one year from today. Then what would you be willing to pay for it? • Recall from economics that willingness-to-pay (WTP) depends upon your best alternative. You will not pay more than your best alternative investment that will also deliver $1 with certainty in one year. • If risk-free bank accounts pay 5% per annum then how much would you have to deposit with the bank today to have $1 in one year? • Your best alternative to $1 in the future is to invest 1/(1+r) today, so you will not pay more than 1/(1+r) for a claim on $1 in one year • 1/(1+r) is the one period discount factor DF1 Single period discounting

31. If the risk-free interest rate is 5% then a promise of $1 with certainty in one year is worth 1/(1.05) = $0.9524 today • The present value of $1 in one period is 1/1+r Single period discounting

32. The same logic of discounting future cashflows applies to longer periods Multi-period discounting

33. Example: What is the present value PV of riskfree cashflows of $100 after 1 year, $200 after 2 years, $300 after 3 years if the risk free interest rate for these periods is 7%? PV example

34. Example: Consider the same example a different way. Imagine that we invested $513.04 today at an interest rate of 7% and we withdrew $100 after one period, $200 after 2 periods and $300 after 3 periods, then how much would be left? PV example

35. Net Present Value (NPV)

36. Example: What is the net present value (NPV) of an investment in new managerial accounting software. The software costs $250,000 but is expected to deliver improvements to firm cashflow of $70,000 per year for five years. Assume that the opportunity cost of capital for these types of low risk projects in the firm is 9%.

37. Example: In the previous example the NPV was positive. The project adds $22,275.59 of value to firm for its shareholders. Now repeat the calculation with a cost of capital of 12.5% • The NPV is no longer positive with the higher cost of capital – the project will destroy value and should be rejected

38. Reading for sessions 2.3 & 2.4 • You should have read HV Chapter 1 and HV Chapter 6 pp 185-196, 215-218 by this point • To prepare for classes 2.7 & 2.8 • Read HV Chapter 6 pp 196-209 • Read HV Chapter 8 all pages • Review slides for class from website Class 2 Debt Markets

39. Major financial choices of the firm can be seen in its balance sheet Major financial decisions

40. Chief Financial Officer

41. In this course (and Corporate Finance) we are mostly concerned with the functions of the Treasury Department, and especially: • Capital budgetting The process of determining which of the projects that have been proposed by divisions of the firm should proceed. Ideally, every positive NPV project should proceed, however, firms are usually capital constrained and the approved projects must fit within a budget • Capital structure Deciding what type of securities should be sold to investors to maximize the value of the cashflows generated by the firm. For instance, the CFO might decide that the firm would be more valuable to shareholders if it had more leverage. The CFO might then issue debt to generate cash and then use all the cash to buy back shares of the firm – hence increasing leverage in the firm for the remaining shareholders Chief Financial Officer

42. Financial planning The process of estimating and managing tthe growth of assets and liabilities of the firm and planning capital expenditure, the raising of capital, return of capital to investors, and working capital levels, to ensure that the firm has the necessary cash on hand at all times • Raising capital The process of selling claims on the cashflows of the firm to investors – those claims are bank loans, corporate bonds, equity etc. • Financial risk management Deciding which financial risks should be retained in the firm and which risks should be transferred out of the firm to investors who can bear the risk at lower cost. For instance, the CFOs of Qantas and VirginBlue must decide whether to hedge the risk that the price of oil will go up, because fuel costs represent 20% of their total costs. Qantas has a policy of hedging fuel risk through the futures market (fixing the price for future delivery) and VirginBlue has a policy of not hedging – retaining the risk of a fuel price rise within the firm Chief Financial Officer

43. Shareholders control the firm (if corporate governance is effective) • They vote for the board and the board appoints the CEO and the senior management team • Why is it that shareholders control the firm, rather than other stakeholders controlling the firm? • Because shareholders are the residual claimants. All other claims on the revenues of the firm are met before the shareholders’ claim (cash in the form of dividends and stock buy-backs) • The residual claimants would probably get nothing if another stakeholder, with an earlier claim on cashflow, controlled the firm Shareholders control of the firm

44. What do shareholders want the CFO to maximize? • Generally, shareholders all agree that they want the share price maximized • What do shareholders do to ensure that the management of the firm acts in the interest of shareholders? • This the same as asking how is corporate governance effected in the firm • Shareholders align the incentives of management with that of shareholders by giving management stock options that become valuable if the stock price rises • Shareholders also replace CEOs that are not focused on creating shareholder value (increasing the share price) Objective of financial management

45. Determining whether a project adds value • To calculate NPV (project’s addition to shareholder’s wealth) we need to: • Estimate the future cashflows (C1, C2, C3, …) • Determine how much future cashflows are worth today

46. Determining present value of future cashflows • Ct is the present value compounded for t periods • PVt is the future value (Ct) discounted for t periods • But what value of r should we use? That is, what discount rate?

47. NPV = PV – C0 = Present value of cashflows - current investment = (Future cashflows adjusted for the return that investors could have received in other projects of the same risk) - investment = Total revenues – total costs (including costs of capital) • Note that the returns promised to the providers of debt capital are fixed (bank debt and corporated bonds are fixed income investments) • So, the surplus from the project (the NPV) flows through to the residual claimants -- shareholders Net Present Value

48. If the management of the firm can create a project that has a positive net present value then they have created value for the shareholders A project creates value if the revenue generated by the project exceeds the costs of all the inputs to the project, including the capital supplied by investors. Future revenues are estimated and after subtracting cash costs of: labour; payment to vendors and other costs of goods sold; and general selling expenses, we have the operating cashflows from the project each period. These cashflows are destined for the investors in the project (banks, bondholders, shareholders) and the tax office. The process of reducing the future cashflows by the appropriate discount factor effectively removes from the cashflows the compensation that the providers of capital expect to receive if they had invested their capital elsewhere (the opportunity cost of capital). What remains after deducting ALL costs from revenues, including the opportunity cost of capital, is the NPV of the project. This NPV accrues to the residual claimants of the firm – shareholders. Net Present Value (NPV)

49. In Class 3 (session 2.7 and 2.8) we will consider the practicalities of estimating the cashflows in of a project • The choice of an appropriate discount rate for the projects cashflows will be addressed over several classes in Module 3. For now we will assume that the cashflows we are considering are risk-free, or we will simply state the discount rate without consideration of its origin • So, for project evaluation we need to discuss the estimation of cashflows and choice of appropriate discount rates. However, we already have the tools that we need to start valuing financial investments that promise future cashflows Delaying consideration of risk

50. Debt Markets What type of securities are used to raise debt capital, and how are those securities valued?