B40'2302 Class

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B40.2302 Class 1

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

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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

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Corporate Structure
Sole Proprietorships
Unlimited Liability Personal tax on
profits Ownership control
Partnerships
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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
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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
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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
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Who is The Financial Manager?
Chief Financial Officer
Controller
Treasurer
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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
Raising and trading capital
Primary Markets
OTC Markets
Secondary Markets
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Financial Institutions
Operating company
Obligations
Funds
Financial intermediaries Banks Insurance
Cos. Brokerage Firms
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Financial Institutions
Financial intermediaries
Obligations
Funds
Investors Depositors Policyholders Investors
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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

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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.
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Present Value
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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.
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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

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Net Present Value
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Risk and Present Value

• Higher-risk projects require higher discount
  rates.
• Higher discount rates cause lower PVs.

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Risk and Present Value
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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?
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Net Present Value Rule

• Accept investments that have positive net present
  value.

Equivalence of NPV and ROR rule
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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)

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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)

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Opportunity Cost of Capital

• Example - continued
• The stocks expected payoff allows us to compute
  an expected return.

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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.

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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 firms shareholders,
  for example).

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Investment vs. Consumption
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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
  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
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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

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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

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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.

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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.

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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?
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Present Values

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

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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)

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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.
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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.
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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.

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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.

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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.

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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?
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Compound Interest
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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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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
The formula above is exact. Heres an
approximation
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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
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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!

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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

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