FINANCE NOTES – ALBERTO A MENENDEZ
Unit 1 – Chapter 1 – Goals and governance of the
firm
1.1 Investment and Financing Decisions
There are 2 major decisions finance managers make:
- A decision about which real assets a firm should acquire and how much to invest in these assets.
This decision is called the capital budgeting or the investment decision.
- A decision about how to raise the money the firm needs for its investments and operations.
This decision is called the financing decision.
The Investment Decision
The financial manager needs to place a value on the uncertain future cash inflows (benefits) generated
by capital investment projects (investments). In order to achieve this valuation, the financial manager
needs to account for:
- Amounts for the future cash flows
- Timing for the future cash flows, and
- The risk of the future cash flows
If the project’s value is greater than its required investment, the project is attractive financially.
The Financing Decision
In order to raise money for the investments and operations of the firm, the financial manager can use:
- Internally generated funds or
- External financing sources
Along with external financing, there are 2 broad categories: debt financing & equity financing.
The choice between debt and equity financing is called the Capital Structure Decision.
Real Assets: Assets used to produce goods and services. For example, machinery, factories, and patents.
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Financial Assets: Financial claims to the income generated by the firm’s real assets. Like a share of stock,
or a bank loan.
1.2 What is a corporation?
- A business (separate legal entity) owned by shareholders who are not personally liable for the
business’s liabilities (limited liability).
- Shareholders are owners, but the corporations are run by employees led by the CEO.
- Although the separation of ownership and control adds flexibility to the operation and gives
permanence to the corporation, it also creates agency problems.
- Shareholders can sell shares (ownership).
- Has a Boards of Directors elected by the shareholders.
- Must follow the rules of stock exchanges, accounting standards and securities laws.
- Taxed twice – on the company profits and also in the hands of shareholders (dividends and/or
capital gains).
- Must share information with the public.
1.3 Other Forms of Business Organization
Sole proprietorship: a business owned and operated by one individual who is personally liable for all the
firm’s obligations. No partners, no stakeholders.
Partnership: business owned by 2 or more people who are personally responsible for all of its liabilities.
Many professional businesses are organized as partnerships.
Hybrid forms: (LLP, LLC, PC) have characteristics of corporations and partnerships.
Attributes Sole Partnership Corporation
Proprietorshi
p
Who owns the One individual Partners Shareholders
business?
Are managers and No No Usually, yes
owners separate?
What is the Unlimited General- unlimited Limited
owners’ liability?
Limited - limited
Owners and No No Yes
business taxed
separately?
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1.4 Who is the Financial Manager?
- Anyone responsible for a significant corporate investment or financing decision.
- Under the Chief Financial Officer, there are usually two broad categories of job descriptions:
Treasurer - responsible for cash management, raising new capital and maintaining
relationship with banks and other investors.
Controller - responsible for preparing financial statements, managing internal
accounting and taxes.
1.5 Goals of the Corporation
- Shareholders want managers to maximize market value of the corporation.
- Increasing market value increases shareholders wealth.
- Maximizing profit does not necessarily increase overall market value.
- The objective should be to maximize the current market value.
Agency Problems?
In most large public companies, the managers are not the owners and they may not always act in the
best interests of the owners. Managers are hired as the agents of the owners. When the personal goals
of these agents create conflict in their roles in the corporation, they create Agency Problems.
Agency problems: Conflict of interest between the firm’s owners and its managers.
- Managers may over indulge in unnecessary expenses.
- They may shy away from attractive but risky projects.
- They may engage in empire building.
Managers must consider the interests of all stakeholders.
Agency Problems, Executive compensation and Corporate Governance
Agency problems can be reduced in several ways:
- Executive Compensation
- Corporate Governance
- Threat of takeovers
- Specialist monitoring
- Shareholder Pressure
Ethics and Management Objectives
- Using unethical means to increase share price will only lead to failure.
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- Crime does not pay (WorldCom, Enron, Goldman Sachs)
- The Ethics of Maximizing Value
Unwritten rules of behaviour
Reputation
1.6 Careers in Finance
Over half a million people work in financial services, and many others as financial managers. Job
opportunities are available in:
- Commercial banking
- Corporate finance
- Investment banking
- Insurance industry
Unit 2 – Chapter 5 – The time Value of Money
5.1 Future Values and Compound Interest
Interest ($) = interest rate (per year) + initial investment
Value of investment after 1 year = initial investment + interest ($)
In general, for any interest rate, “r”, the value of the investment at the end of 1 year is (1 + r) times initial
investment
Value after 1 year = initial investment * (1 + r)
Value of account after 2 years = initial investment * (1 + r)^2
Value of account after 3 years = initial investment * (1 + r)^3
This introduces the future value (FV)
Future value of initial investment = initial investment(I) * (1 + r)^t
The formula for the future value of I dollars at r% interest per period for t periods.
Interest earned on interest is called compounding or compound interest.
In the other hand, if the bank calculated interested only on your original investment, you would be paid
simple interest.
5.2 Present Values
A dollar today is worth more than a dollar tomorrow.
How much money to invest in order to produce x value at the end of the year. Financial managers refer
to this as present value (PV).
Future value is calculated by multiplying the present investment by one plus the interest rate. To
calculate the present value, we simply reverse the process and divide by (1 + r).
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Present Value = PV = future value / (1 + r)
In this context the interest rate “r” is known as the discount rate, and the present value is often called
the discounted value of the future payment. To calculate present value, we discounted the future value
at the interest “r”.
The present value formula is sometimes written differently.
Instead of dividing the future payment by (1 + r) ^t, we could just easily multiply by 1/ (1 + r) ^t
PV = future value * 1/ (1 + r) ^t
The expression 1/ (1 + r) ^t is called the discount factor or the present value interest factor PVIF (r, t). It
measures the present value of $1 to be received in t years from today at a discount rate of r%.
Future value is calculated by multiplying the present investment by one plus the interest rate. Future
value is calculated by multiplying the present investment by one plus the interest rate.
Finding interest rate
The Rule of 72 states that the time it will take for an investment to double in value quals approximately
72/r where r is expressed as a percentage.
72 / r = t
Finding the investment period
5.3 Multiple Cash Flows
When there are many payments, you’ll hear businesspeople refer to a stream of cash flows.
To find the value at some future date of a stream of cash flows, calculate what each cash flow will be
worth at that future date, and then add up these future values.
Future Value of Multiple Cash Flows
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You deposit $1,200 in your bank account today; $1,400 one year later; and $1,000 two years from today.
If your bank offers you an 8% interest rate on your account, how much money will you have in the
account three years from today?
Present Value of Multiple Cash Flows
Your auto dealer gives you the choice to pay $15,500 cash now, or make three payments: $8,000 now
and $4,000 at the end of the following two years. If your cost of money is 8%, Which is the better deal?
Only cash flows that occur at the same time can be compared. Since option 1 occurs today, we can
convert option 2 to today as well and compare. We do this by finding the PV of each cash flow under
option 2 and adding them together.
Compare the present value of the two options at present:
Option 1: $15,500 Option 2: $15,133
Option 2 is the better choice for the buyer as the PV is less. That means, option 1 is the better choice for
the (dealer).
5.4 Level Cash Flows: Perpetuities and Annuities
Annuities: Equally spaced, and level stream of cash flows is called an annuity. (annuities are for a finite
period). Example: Loan payments for automobile, home mortgage, etc.
Perpetuities: Stream of level cash payments that never ends (infinite period).
How to value Perpetuities?
Cash payment from perpetuity = interest rate * present value, C = r * PV
PV of perpetuity = C / r = cash payment / interest rate
The present value of a stream of future cash flows is the amount you would have to invest today to
generate that stream.
There are also delayed perpetuities.
PV of delayed perpetuity =
Cash Payment
t (as delayed periods)
r∗(1+r )
How to Value Annuities?
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There are 2 ways to value an annuity (a limited number of cash flows).
The slow way is to value each cash flow separately and add up the present values.
The quick way is to take advantage of the following explanation.
Row 1. Immediate perpetuity. Stream of $1 cash payment after year 1. We have already seen that this
perpetuity has present value of 1/r
Row 2. Delayed perpetuity. Stream of $1 cash payments starting in year 4. In year 3, the investment will
be an ordinary perpetuity with payments staring in 1 year, therefore, it will be worth 1/r in year 3. To find
the value today we simply multiply this by the 3-year discount factor.
Row 3. Three-year annuity. Cash payment of $1 a year for 3 years. Row 2 & 3 provide exactly same cash
payment as the investment in row 1. Therefore, the value of this annuity must be equal to row 1
perpetuity minus the value of the delayed perpetuity in row 2.
The general formula for the value of an annuity that pays C dollars a year for each of t years is:
The expression in square brackets shows the present value of a t-year annuity of $1 a year. Generally
known as the t-year annuity factor and can be written as PVA(r, t).
“Amortizing” means that part of the monthly payment is used to pay interest on the loan and part is
used to reduce the amount of the loan.
Annuities due
A level stream of payments starting immediately is known as an annuity due.
In general, the present value of an annuity due if t payments of $1 per period is the same as 1 plus the
present value of an ordinary annuity providing the remaining t-1 payments.
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Future Value of an Annuity
We calculated the future value of the annuity by first calculating the present value and then multiplying
by (1 + r) ^t.
Future value of annuity due
Cash flows growing at a constant rate – Variations on perpetuities and annuities
The perpetuity and annuity formulas make valuing streams of equal cash flows easy. Unfortunately,
many streams of cash flows are not equal. If, however, the cash flow stream grows at a constant rate:
- C is the payment to occur at the end of the first period
- R is the discount rate
- G is the growth rate of the payments
If the growth is zero, the formula becomes the familiar perpetuity formula, C/r. A perpetual stream of
cash flows growing at a constant rate is sometimes called a growing perpetuity.
Another formula, this time if the cash flow grows at a constant rate for a limited or finite time.
- C is the payment to occur at the end of the first period
- R is the discount rate
- G is the growth rate of the payments
- T is the number of payments
A finite stream of cash flows growing at a constant rate is sometimes referred to as a growing annuity.
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We can also calculate the future value of a stream of cash flows that grow at the constant rate for a
limited or finite period.
5.5 Inflation and the time value of money
When a bank offers to pay 6% on a savings account, it promises to pay interest of $60 for every $1,000
you deposit. The bank fixes the number of dollars that it pays, but it doesn’t provide any assurance of
how much those dollars will buy. If the value of your investment increases by 6%, while the prices of
goods and services increase by 10%, you actually lose ground in terms of the goods you can buy.
Real Versus Nominal cash flows
Prices of goods and services continually change. And overall rise in prices is known as inflation.
Economists track the general level of prices using several different price indexes. The best known of
these is the consumer price index, or CPI. This measures the number of dollars that it takes to buy a
specified basket of goods and services, which is supposed to represent the typical family’s purchases.
Economists sometime talk about current or nominal dollars versus constant or real dollars. Current or
nominal dollars refer to the actual number of dollars of the day; constant or real dollars refer to the
amount of purchasing power.
