The McGraw-Hill Companies, Inc.

, 2000 Irwin/McGraw Hill

1- 1
B40.2302 Class #1
BM6 chapters 1, 2, 3
Based on slides created by Matthew Will
Modified 9/3/2001 by Jeffrey Wurgler
Finance and the Financial Manager
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 1
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
1- 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
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
1- 4
Corporate Structure
Sole Proprietorships
Partnerships
Unlimited Liability
Personal tax on profits
Ownership = control
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
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Corporate Structure
Sole Proprietorships
Corporations
Partnerships
Unlimited Liability
Personal tax on profits
Ownership = control
Limited Liability
Corporate tax on profits +
Personal tax on dividends
Ownership =/= control
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1- 6
Role of The Financial Manager
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors (external finance)
(2) Cash invested in firm
(1) (2)
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1- 7
Role of The Financial Manager
Financial
manager
Firm's
operations
Financial
markets
(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
(1) (2)
(3)
(4a)
(4b)
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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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1- 10
Financial Markets
Primary
Markets
Secondary
Markets
OTC
Markets
Raising
and
trading
capital
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1- 11
Financial Institutions
Operating company
Financial intermediaries
Banks
Insurance Cos.
Brokerage Firms
Obligations
Funds
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1- 12
Financial Institutions
Financial intermediaries
Investors
Depositors
Policyholders
Investors
Obligations
Funds
Present Value and The Opportunity
Cost of Capital
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 2
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
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1- 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 Rate
Interest rate used
to compute
present values of
future cash flows.
Discount Factor
Present value of
a $1 future
payment.
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Present Value
1
factor discount = PV
PV = Value Present
C
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Present Value
Discount Factor for one-period-ahead
cash flow = DF
1
= PV of $1




We will see how discount factors can be used to compute the
present value of any cash flow.
) 1 (
1
1
r
DF
+
=
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Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C
0
= -350
Sale price in Year 1 = C
1
= 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

374
) 07 . 1 (
400
) 1 ( 1 1
1
= = = =
+ +r
C
C DF PV
24 374 350 = + = NPV
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Net Present Value
r
C
+
+
1
C = NPV
investment required - PV = NPV
1
0
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Risk and Present Value
Higher-risk projects require higher discount
rates.
Higher discount rates cause lower PVs.
374
.07 1
400
PV
7% at $400 C of PV
1
=
+
=
=
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Risk and Present Value
374
.07 1
400
PV
7% at $400 C of PV
1
=
+
=
=
357
.12 1
400
PV
12% at $400 C of PV
1
=
+
=
=
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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?
14% or .14
350,000
350,000 400,000
investment
profit
Return =

= =
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Net Present Value Rule
Accept investments that have positive net
present value.
Equivalence of NPV and ROR rule:

( )
( )
0
0
1
0 1
1
0
1 0
0
0 1
>
>
+
+
> + +
>

+
>
NPV
r
C
C
C r C
r
C
C C
r ROR
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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):
140,000 110,000 $80,000 Payoff
Boom Normal Slump Economy
000 , 110 $
3
000 , 140 000 , 110 000 , 80
C payoff Expected
1
=
+ +
= =
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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):
140 110 $80 e Stock Pric
Boom Normal Slump Economy
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Opportunity Cost of Capital
Example - continued
The stocks expected payoff allows us to compute an
expected return.
15% or 15 .
65 . 95
65 . 95 110
investment
profit expected
return Expected
110 $
3
140 110 80
C payoff Expected
1
=

= =
=
+ +
= =
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
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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.
650 , 95 $
1.15
110,000
PV = =
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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
A n

G n
100
80
60
40
20
20 40 60 80 100
dollars in period 0
dollars in period 1
Some investors will prefer A
and others G
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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?

The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
1- 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
100 106.54
Dollars
Now
Dollars
Later

114
107
A invests $100 now
and consumes $114
next year
G invests $100 now,
borrows $106.54 and
consumes now.
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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
How to Calculate Present Values
Principles of Corporate Finance
Brealey and Myers Sixth Edition
Slides by
Matthew Will,
Jeffrey Wurgler
Chapter 3
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill
1- 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.
1
1
1 1
1 r
C
C DF PV
+
= =
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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.
( )
t
t
t
t t
r
C
C DF PV
+
= =
1
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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?
PV = =
3000
1 08
2
572 02
( . )
$2, .
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Present Values
PVs can be added up to value a package of
cash flows across many periods.

+
+ +
=
+ + =
t
r
C
r
C
r
C
t
t
t
PV
) 1 (
) 1 ( ) 1 (
...
2
2
2
1
1
1
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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)
87 .
83 .
2
1
) 07 . 1 (
00 . 1
2
) 20 . 1 (
00 . 1
1
= =
= =
+
+
DF
DF
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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.
000 , 300 000 , 100 000 , 150
2 Year 1 Year 0 Year
+
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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.
( )
400 , 18 $
900 , 261 000 , 300 873 . 2
500 , 93 000 , 100 935 . 1
000 , 150 000 , 150 0 . 1 0
Value
Present
Flow
Cash
Factor
Discount
Period
2
07 . 1
1
07 . 1
1
=
+ + =
=

NPV
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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.
r
C
PV =
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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 C
1
.
g r
C
PV

=
1
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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.
( )
(

+
=
t
r r
r
C
1
1 1
annuity of PV
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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?
( )
10 . 774 , 12 $
005 . 1 005 .
1
005 .
1
300 Cost Lease
48
=
(

+
=
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Compound Interest
0
2
4
6
8
10
12
14
16
18
0 3 6 9
1
2
1
5
1
8
2
1
2
4
2
7
3
0
Number of Years
F
V

o
f

$
1
10% Simple
10% Compound
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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 1.03
2
= 1.0609 6.090

4 1.5 6 1.015
4
= 1.06136 6.136

12 .5 6 1.005
12
= 1.06168 6.168

365 .0164 6 1.000164
365
= 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
1 + real interest rate =
1+nominal interest rate
1+inflation rate
The formula above is exact. Heres an approximation:
rate inflation - rate interest nominal
rate interest real
~
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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?
2.6% or .026 = .033 - .059 Approx.
2.5% or .025 = rat e int erest real
1.025 =
= rat e int erest real 1
.033 + 1
.059 + 1
~
==>
+
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

( ) ( ) ( ) ( )
84 . 161 , 1 $
075 . 1
115 , 1
075 . 1
115
075 . 1
115
075 . 1
115
075 . 1
115
5 4 3 2
=
+ + + + = PV
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Bond Prices and Yields (YTM)
0
200
400
600
800
1000
1200
1400
1600
0 2 4 6 8 10 12 14
5 Year 9% Bond 1 Year 9% Bond
YTM
P
r
i
c
e