© the mcgraw-hill companies, inc., 2000 irwin/mcgraw hill 1- 1 b40.2302 class #1 bm6 chapters 1,...
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©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
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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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
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Corporate Structure
Sole Proprietorships
Partnerships
Unlimited Liability
Personal tax on profits
Ownership = control
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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
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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)
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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)
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Who is The Financial Manager?
Chief Financial OfficerChief Financial Officer
ControllerTreasurer
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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
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Financial Markets
Primary
Markets
Secondary
Markets
OTC
Markets
Raising and
trading capital
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Financial Institutions
Operating company
Financial intermediaries
Banks
Insurance Cos.
Brokerage Firms
ObligationsFunds
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Financial Institutions
Financial intermediaries
Investors
Depositors
Policyholders
Investors
ObligationsFunds
Present Value and The Opportunity Cost of Capital
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler Chapter 2
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1- 14
Topics Covered
Present Value Net Present Value NPV Rule ROR Rule Opportunity Cost of Capital Managers and the Interests of Shareholders
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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.
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Present Value
1factordiscount =PV
PV=ValuePresent
C
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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
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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
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%
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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
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Net Present Value
r
C
1C=NPV
investment required-PV=NPV
10
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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
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Risk and Present Value
374.071
400PV
7%at $400 C of PV 1
357.121
400PV
12%at $400 C of PV 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
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
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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
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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
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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):
140110$80eStock Pric
BoomNormalSlumpEconomy
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Opportunity Cost of Capital
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
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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.
650,95$1.15
110,000PV
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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).
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Investment vs. Consumption
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
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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?
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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.
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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.
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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
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will, Jeffrey Wurgler
Chapter 3
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Topics Covered
Valuing Long-Lived Assets PV Calculation Short Cuts Compound Interest Interest Rates and Inflation Example: Present Values and Bonds
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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
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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
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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
( . )$2, .
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Present Values
PVs can be added up to value a package of cash flows across many periods.
tr
C
r
C
r
C
tt
t
PV
)1(
)1()1(...2
2
21
1
1
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Present Values
There are some limits on the relationship between r1 and r2. It is not arbitrary. Suppose one dollar is received a year from now and another two years from now. Suppose r1 = 20% and r2 =
7%. Then the current value of each dollar is:
(Unless o.w. noted we will assume r1= r2= rt= r)
87.
83.
2
1
)07.1(00.1
2
)20.1(00.1
1
DF
DF
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Present Values
Example
Assume that the cash flows from the construction and sale of an office building are as below. Given a 7% opportunity cost of capital, create a present value worksheet and calculate the net present value.
000,300000,100000,150
2Year 1Year 0Year
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Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office building are as below. Given a 7% opportunity cost of capital, create a present value worksheet and calculate the net present value.
400,18$
900,261000,300873.2
500,93000,100935.1
000,150000,1500.10Value
Present
Flow
Cash
Factor
DiscountPeriod
207.11
07.11
NPV
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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.
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Short Cuts
Perpetuity - A constant cash flow is received forever, starting at the end of the first period.
r
CPV
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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
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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
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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
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Compound Interest
02468
1012141618
Number of Years
FV
of
$1
10% Simple
10% Compound
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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
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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.
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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
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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
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NPV rule gives same answer whether discounting nominal cash by nominal rate or real cash by real rate.
Just don’t mix them up!
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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 $1000 and retires. The bond is rated AAA (WSJ AAA YTM is 7.5%).
Cash Flows
Sept 0203 04 05 06
115 115 115 115 1,115
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Valuing a Bond
Example continued
84.161,1$
075.1
115,1
075.1
115
075.1
115
075.1
115
075.1
1155432
PV
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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