Managerial Finance

1
Lecture 1

• Managerial Finance
• FINA 6335
• Ronald F. Singer

2
Finance

• The study of resource allocation under conditions
  of uncertainty.
• Merges
• Economics.
• Accounting.
• Statistics.

3
Areas

• Corporate Finance
• From the viewpoint of the Financial Manager
• Capital Budgeting
• Dividend Policy
• Capital Structure
• Investments
• From the viewpoint of individual and
  institutional investors
• Risk
• Return
• Portfolio Decisions

4
Types of Financial Securities

• Equity Capital
• Common Stock
• Preferred Stock
• Debt Capital
• Bonds
• Hybrid Securities
• Why hold Securities?

5
The Rewards and Risks to Security Holders

• The Rewards
• To Stockholders
• To Bondholders
• The Risks
• To Stockholders
• To Bondholders

6
The Goal of Financial Management

• What should be the goal?
• Possible measures of performance of financial
  managers
• How do managers achieve their objectives?
• Make Decisions that

7
Cash Flow

• The cash flows of a company are the total dollar
  amount of funds available for the firm use
• Steps to determine cash flows
• 1
• 2
• Example
• - Revenues less cost of
  production
• 
  depreciation
• - Profit before Taxes less Income Taxes
  (34)
• - Net Income
• Cash Flow Net Income Non-Cash Expenses
• Note that Net Income and Cash Flow are not
  the same!
• Cash Flow is the basic unit of how the firm
  is doing
• What is Cash Flow?

8
Investment

• The Problem
• How can we determine if a project will make
  stockholders better Or worse off???
• What is an Investment?
• Current Cash Expenditures which are expected to
  generate cash inflows sometime in the future

9
How to Make a Decision?

• Inflow
• Benefits vs.
  Costs
• Complications
• Uncertainty Future Flows

10
Digression on Conventions of Time
Cash Inflows
Cash Outflows
11
Example

• For current Investment of 10,000, receive 5,000
  within 1 year, 6,000 in years 3 through 5.
• 5000
  6000 6000 6000.
• 0.
• 1 2
  3 4 5
• 10000.
• Observations
• t 0 current time.
• Everything happens at the end of a period unless
  specified otherwise.

12
Present Value

• The present value of receiving 1,000, one year
  from today?
• 1000
• 0 1
• It is What 1000 received one year
  from today is worth today.

13
Present Value

• Present Value is
• How much someone would lend me on that claim
• How much I could sell the claim for
• How much it would cost to engage in a "similar"
  investment
• What is the Answer?
• In order to answer that question we have to know
  what interest rate is assumed.
• Assume that the interest rate is 25?
• Thus, you pay 200 interest to borrow 800 now

14
The Market Rate of Interest

• In this case, the initial amount is also the
  present value
• OR

15

• 1/1R is called the Discount Factor
• Present Value Future amount x Discount Factor
• If R is 25 Discount Factor is
• and PV (1,000 25 1 yr)
• 1 1000
• 1.25
• 0.80 1000
• 800

16
Wealth

• Wealth is the present value of all Current and
  Future income.
• Suppose that an individual has 1,000 in his/her
  pocket and has a claim on 1,000 one year from
  now. What is his wealth if the interest rate is
  25?
• 1,000 in his pocket is worth 1,000.
• 1,000 one year from now is worth
• 800 1,000/(1 R)
• 1000/(1.25) 
• Therefore, his Wealth is 1,800.
• You have to convert all future income to Present
  Values before you can add them up

17
Market Opportunity Line

• The Market Opportunity Line shows how an
  individual can exchange current for future
  consumption.
• 2250
• 1625
• 1000
• 375
• 500 1000 1800

• Possible Alternatives

Endowment 1000 Now 1000 Next Year
How? 500 1625
How? Zero 2250
Wealth 1800 Zero
1500 ?
18
Market Opportunity Line

• Notice that this individual's wealth is indicated
  by the horizontal intercept.
• The Wealth is the maximum an individual can
  consume today by borrowing against all of his/her
  future income

19
Market Opportunity Line

• The slope of the market opportunity line is
• - (1 R)
• Slope Rise/Run
• (Principal Interest)
• - Principal
• -( 1 Interest )
• Principal
• -(1 R)
• If you give up 500 now, you can get
• 500 X (1 R) 500(1.25) 625 more
  next year.
• If you want to get 800 more now, you must give
  up
• 800 X (1.25) or 1,000 next year

20
Production/Investment

• Future consumption
• 2250
• 1800
• 1625
• 1000
• 375
• 500 1000
  1800

• If you invest 500 you get 800 more next year.
• Rate of return on investment 800 - 500
• 
  500
  0.60
  (or 60)

21

• What is the wealth of this individual after
  he makes the investment
• Wealth Current Future x Discount
• Income Income
  Factor
• 500 1800
  x 1 / 1.25
• 1940
• If this individual desires, he can alter the time
  pattern of his income by borrowing/lending
•  

22

• If he wants to consume 1,000 now instead of
  500,
• Borrow 500 after making the 500 investment
• Next year, pay back principal plus interest
• 500 X (1.25) 625
• He will have left 1,800 - 625 1,175
• 1000 Now And
  1175 Next Year
• or, 500 " And 1800 " "
• or, Zero " And 2425 " "
• or, 1940 " And Zero " "
• Consequently, regardless of his time preference
  for consumption, this individual is better off
  after the investment.
• He is better off, because he's wealthier?

23
Bottom Line

• 1. Wealth is the PRESENT VALUE of income stream
• 2. All individuals are unambiguously better off
  when their wealth increases.
• 3. The net present value of an investment
  project is the amount investors' wealth would
  increase (decrease) if the project were
  undertaken.

24
Problem of the Day

• Find the Wealth of an individual who will earn
  500,000 over the current year and who has
  2,000,000 equity in assets (such as a home, a
  car, cash, etc.). Assume the interest rate is 8
• Find the wealth of the same individual who also
  can invest up to 200,000 in a machine which will
  produce widgets. The rate of return for this
  investment is 17.

25
Problem of the Day

• Determine the Net Income and cash flow arising
  from the following
• Total Revenue 300,000
• Cost of Goods Sold 50,000
• Depreciation 60,000
• The corporate tax rate is 34 of before tax
  income.