Econ134a-Financial Management

Finance is the Interaction of TIME, MONEY

and UNCERTAINTY
Course Outline
Understand how to compare amounts of
money being generated in different
moments in time.
Identify the cash flow patterns of the two
most important types of securities (Stocks
and Bonds)
How to reconstruct the pattern of cash
flows from a specific project or firm (a
portfolio of projects)
Course Outline
Learn a model that quantifies how risky
those cash flows are and how it affects the
value of those cash flows.
Connect with the financing decisions of a
firm (issuing Bonds and Stocks)
How the financing choices affect the cash
flows and riskiness of the Stocks and
Bonds
Course Outline
What the course will NOT teach
Investment strategies for Stock and Bond
portfolios
Pricing derivative securities (Options, Futures)
and convertible securities
Risk hedging strategies using securities and
derivatives.
Financial Manager
Function
Intermediary Between the Firms Operations and
Capital Markets
Objective
Maximize the Value of the Shareholder
Sometimes incompatible with his own private
interests: AGENCY PROBLEMS
Institutional Arrangements
Incentives in Contracts
Financial Manager
Decisions
1. Capital Budgeting Decisions
Which Projects to Invest?
How much Money allocate to Specific Assets?
2. Financing Decisions
How should the Money to Finance the Investments
be raised?
The Capital Budgeting Decision will be
discussed in the first part of the course
The Financing Decision and how it affects the
Value of the Corporation will be discussed in
the second part of the course
Financing Decisions
Two sources of Capital to the Corporation
Issue Debt (Bonds)
Issue Ownership of the Corporation (Stock)
Important Distinction!
Bondholders need to be paid first and only the
residual goes to the Stockholders
Critical Assumptions
Perfect Markets: Investors can freely trade any
securities. They do not pay any transaction
costs and do not affect the price of the
security
Efficient Markets: The Price of a Security will
reflect All the Available Information
Complete Markets: Any pattern of payoffs can
be obtained by an Individual Asset or a
Combination of Assets.
Time Value of Money
Time Value of Money
Is Money received Today worth more or less
than the same received in the Future?
Usually MORE
Why?
Time Value of Money
We could invest the money received today in a
riskless asset and have more in the future.
Example:
The 6-month Treasury Bill has a return of
1.56%. If $1,000 are invested in it, after 6
months you end up with $1,015.6.
Time Value of Money
The conclusion is that $1,000 today are more
valuable than $1,000 six months from now.
Time Value of Money
George Washington received a salary of
$25,000 in 1789
George Bush receives a salary of $400,000 to
go with a $50,000 expense account.
Who was better paid?
Time Value of Money
If we use the CPI Index, $25,000 in 1789 is the
same as $550,000 today.
If we use the GDP per-capita measure,
$25,000 in 1789 is the same as $23,000,000
today.
Future Value and Compounding
If you invest C
0
today, earn a interest rate of r,
how much do you have after one year?
C
1
= C
0
x(1+r)
C
1
is the FUTURE VALUE in one year of C
0
today
Future Value and Compounding
If you invest C
0
today, earn a interest rate of r,
how much do you have after two years?
After one year
C
1
= C
0
x(1+r)
In the second year
C
2
= C
1
x(1+r)=C
0
x(1+r)x(1+r)=C
0
x(1+r)
2
C
2
is the FUTURE VALUE in two years of C
0
today
What is Compounding?
It Means that the interest you receive during
the time of your investment is RE-INVESTED
and will itself earn interest in the next periods
You are earning interest over past interest!
General Rule
If you invest C
0
today, earn a interest rate of r,
how much do you have after n years?
C
n
= C
0
x(1+r)
n
C
n
is the FUTURE VALUE in n years of C
0
today
Is Compounding Important?
If you invest C
0
today, earn a interest rate of r,
how much do you have after n years if you do
NOT re-invest the yearly interest?
C
n
= C
0
x(1+nxr)
Is this difference important?
Is Compounding Important?
You invest $1,000 and earn 10% every year.
How much do you have after 20 years if.
You re-invest the interest?
$1,000x(1+0.1)
20
= $6,727.5
If you do not re-invest the interest?
$1,000x(1+20x0.1)=$3,000
Present Value and Discounting
Answers the question: How much do I need to
invest today to get C
T
, T years in the Future, if the
investment earns r% every year?
C
T
= C
0
x(1+r)
T
Which means that
C
0
is the PRESENT VALUE of obtaining the payoff
C
T
, in T years
T
T
r
C
C
) 1 (
0
+
=
Relation between Compounding and
Discounting
Are just the opposite operations
Compounding allows you to move forward in
Time
Discounting allows you to move back in Time
Relation between the Present Value
and Future Value
Suppose you have a series of Cash Flows at
different points in the Future.
Suppose the rate of interest to be earned in
those Cash Flows is r% a year
Suppose that the Present Value of those Cash
Flows is PV
The Future Value in year T of those same Cash
flows is FV and FV=PVx(1+r)
T
Illustration:
Cash Flows
Now: CF1=100
Next Year: CF2=130
Two Years from now: CF3=150
Three Years from now: CF4=180
Interest Rate: 10% year
Present Value
Present Value of Cash Flows
PV(CF
0
)=100
PV(CF
1
)=130/(1+0.1)=118.18
PV(CF
2
)=150/(1+0.1)
2
=123.97
PV(CF
3
)=180/(1+0.1)
3
=135.24
The Present Values will add to 477.39
Future Value
Future Value Three Years from Now
FV(CF
0
)=100x(1+0.1)
3
=133.1
FV(CF
1
)=130x(1+0.1)
2
=157.3
FV(CF
2
)=150x(1+0.1)
1
=165.0
FV(CF
3
)=100
The Future Values add to 635.4
What is the Future Value, three years from
now, of the Present Values we calculated?
FV(477.39)=477.39x(1+0.1)
3
=635.4
Its the same!
Conclusion
Present Value and Future Value are similar
operations, only taking different directions in
time.
Once you calculate the Present Value of a Cash
Flow, if you want the Future Value of the same
Cash Flow at some point in time, you only
need to Compound that value up to the
moment you want.
Perpetuities
Is a perpetual stream of Cash Flows. All the
Cash Flows will be equal and occur with the
same periodicity. The first starts one period
from now.
What is the Present Value of this stream of
Cash Flows (if the interest rate is r%)?
Year 0 1 2 3 N N+1
Cash C C C C C
Perpetuities
Imagine the Perpetuity is the Result of making
a deposit of V today and C is the interest you
earn from it. Since r is the interest rate we
have that
C=Vxr
Therefore V=C/r, where V is the Present Value
of the Perpetuity
Perpetuities
Or, we can simply add the Present Values of
the Cash Flows
This is a Geometric Series of rate 1/(1+r). The
sum of such series is C/r
Year 0 1 2 3 N N+1
Cash C C C C C
PV of Cash C/(1+r) C/(1+r)
2
C/(1+r)
3
C/(1+r)
N
C/(1+r)
N+1
Annuities
Is a stream of Cash Flows. They are all equal
and occur with constant periodicity. The first
Cash Flows occurs one period from now and
the last will occur T periods from now.
What is the Present Value of this stream of
Cash Flows?
Year 0 1 2 3 T T+1
Cash C C C C 0
Annuities
You can see an Annuity has the difference
between two Perpetuities. The first starting
one period from now and the next starting
T+1 periods from now.
Year 0 1 2 T T+1 T+2
Perpetuity 1 C C C C C
Perpetuity 2 0 0 0 -C -C
Annuity C C C 0 0
Annuities
The Present Value of the Annuity will be the
Present Value of the First Perpetuity minus the
Present Value of the Second Perpetuity.
PV(Perpetuity 1)=C/r
PV(Perpetuity 2)=(C/r)/(1+r)
T
Annuities
So,
( )
( )
(

+
=
(

+
=
T
T
r
r
C
r
r
C
r
C
Annuity PV
1
1
1
1
1
) (
T
r
A =
Annuities
What is the Future Value of an Annuity?
It is the Future Value of the Cash Flows of the
Annuity at time T (the end of the Annuity)
FV(Annuity)=PV(Annuity)x(1+r)
T
FV(Annuity)=(C/r)x[(1+r)
T
-1]
Application: Value of a Tax Deferred
Savings plan for Retirement
Suppose you are 29 years old. You will invest
$2,000 every year in an IRA until you retire 35
years from now. The IRA gives an interest of
10% a year.
You plan to enjoy your retirement benefits in
the form of a 20 year Annuity.
How much will you receive every year in your
retirement?
Application
First Step: I need to know how much money I
have in my savings account once I retire.
What do I know:
The yearly payments will be an Annuity. The Annuity
will be 35 years long.
The balance of the account on retirement will be the
Future Value of that Annuity.
The investment in IRA are tax-free.
Interest rate is 10%
Application
FV(Annuity)=($2,000/0.1)[(1.1)
35
-1]
= $542,049
On Retirement the IRA account will have
$542,049.
Application
Step 2: I need to know how I can make those
$542,049 into 20 equal yearly payments.
What do I know:
This means creating an Annuity of 20 Cash Flows.
$542,049 will be the Present Value of those 20
payments.
The interest rate is still 10%
Application
(
(

|
.
|

\
|
+
=
20
1 . 0 1
1
1
1 . 0
049 , 542 $
X
663 , 63 $ = X
Application
Step 3: How much will receive every year?
What do I know?
The payments are no longer tax-free.
The tax rate is 30%
Payments = $63,663x(1-30%)=$44,568