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B40.2302 Class #1

B40.2302 Class #1. BM6 chapters 1, 2, 3 Based on slides created by Matthew Will Modified 9/3/2001 by Jeffrey Wurgler. Principles of Corporate Finance Brealey and Myers Sixth Edition. Finance and the Financial Manager. Slides by Matthew Will, Jeffrey Wurgler. Chapter 1.

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B40.2302 Class #1

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  1. B40.2302 Class #1 • BM6 chapters 1, 2, 3 • Based on slides created by Matthew Will • Modified 9/3/2001 by Jeffrey Wurgler

  2. Principles of Corporate Finance Brealey and Myers Sixth Edition • Finance and the Financial Manager Slides by Matthew Will, Jeffrey Wurgler Chapter 1 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

  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

  4. Corporate Structure Sole Proprietorships Unlimited Liability Personal tax on profits Ownership = control Partnerships

  5. Corporate Structure Sole Proprietorships Unlimited Liability Personal tax on profits Ownership = control Partnerships Limited Liability Corporate tax on profits + Personal tax on dividends Ownership =/= control Corporations

  6. Role of The Financial Manager (2) (1) Financial Firm's Financial manager operations markets (1) Cash raised from investors (external finance) (2) Cash invested in firm

  7. Role of The Financial Manager (2) (1) Financial Firm's Financial (4a) manager operations markets (4b) (3) (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

  8. Who is The Financial Manager? Chief Financial Officer Treasurer Controller

  9. 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 Ownership vs. Management

  10. Financial Markets Raising and trading capital Primary Markets OTC Markets Secondary Markets

  11. Financial Institutions Operating company Obligations Funds Financial intermediaries Banks Insurance Cos. Brokerage Firms

  12. Financial Institutions Financial intermediaries Obligations Funds Investors Depositors Policyholders Investors

  13. Principles of Corporate Finance Brealey and Myers Sixth Edition • Present Value and The Opportunity Cost of Capital Slides by Matthew Will, Jeffrey Wurgler Chapter 2 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

  14. Topics Covered • Present Value • Net Present Value • NPV Rule • ROR Rule • Opportunity Cost of Capital • Managers and the Interests of Shareholders

  15. Present Value Present Value Value today of a future cash flow. Discount Factor Present value of a $1 future payment. Discount Rate Interest rate used to compute present values of future cash flows.

  16. Present Value

  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.

  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%

  19. Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead with project if PV of payoff exceeds investment

  20. Net Present Value

  21. Risk and Present Value • Higher-risk projects require higher discount rates. • Higher discount rates cause lower PVs.

  22. Risk and Present Value

  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?

  24. Net Present Value Rule • Accept investments that have positive net present value. Equivalence of NPV and ROR rule:

  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):

  26. Opportunity Cost of Capital 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):

  27. Opportunity Cost of Capital Example - continued The stock’s expected payoff allows us to compute an expected return.

  28. Opportunity Cost of Capital 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.

  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).

  30. dollars in period 1 100 A n G n 80 Some investors will prefer A 60 and others G 40 20 20 40 60 80 100 dollars in period 0 Investment vs. Consumption

  31. Investment vs. Consumption 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?

  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 Dollars Later 114 107 A invests $100 now and consumes $114 next year G invests $100 now, borrows $106.54 and consumes now. Dollars Now 100 106.54

  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.

  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

  35. Principles of Corporate Finance Brealey and Myers Sixth Edition • How to Calculate Present Values Slides by Matthew Will, Jeffrey Wurgler Chapter 3 Irwin/McGraw Hill • The McGraw-Hill Companies, Inc., 2000

  36. Topics Covered • Valuing Long-Lived Assets • PV Calculation Short Cuts • Compound Interest • Interest Rates and Inflation • Example: Present Values and Bonds

  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.

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

  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?

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

  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)

  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.

  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.

  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.

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

  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.

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

  48. Annuity example Example You 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?

  49. Compound Interest

  50. Compound Interest i ii iii iv v Periods Interest Value Equiv. annually per per APR after compounded year 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

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