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B40'2302 Class

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Based on s created by Matthew Will. Modified 9/3/2001 by Jeffrey Wurgler ... The grasshopper (G) wants to consume now. The ant (A) wants to wait. ... – PowerPoint PPT presentation

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Title: 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

2
Principles of Corporate Finance Brealey and Myers
Sixth Edition
  • Finance and the Financial Manager
  • Slides by
  • Matthew Will, Jeffrey Wurgler

Chapter 1
  • The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
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
(1)
(2)
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
(1)
(2)
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
Controller
Treasurer
9
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

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
  • The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
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 stocks expected payoff allows us to compute
    an expected return.

28
Opportunity Cost of Capital
  • Example - continued
  • Discounting the expected payoff at the stocks
    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 firms shareholders,
    for example).

30
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
    investments 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
  • The McGraw-Hill Companies, Inc., 2000

Irwin/McGraw Hill
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
51
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.

52
Inflation
The formula above is exact. Heres an
approximation
53
Inflation
  • Example
  • 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?

Savings Bond
54
Discount nominal cash with nominal rate, real
cash with real rate
  • NPV rule gives same answer whether discounting
    nominal cash by nominal rate or real cash by real
    rate.
  • Just dont mix them up!

55
Valuing a Bond
  • Example
  • 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 02 03 04 05 06
  • 115 115 115 115 1,115

56
Valuing a Bond
Example continued
57
Bond Prices and Yields (YTM)
Price
YTM
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