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Business Finance Management - Syllabus

The course will draw on material from the following easily purchased text book:

Principles of Corporate Finance, 7th Edition, by Richard A. Brealey and Stewart C. Myers, Publisher: McGraw Hill/Irwin

Corporate Finance: Theory and Practice, 2nd Edition, by Aswath Damodaran, Publisher: John Wiley and Sons

Course material includes articles from the financial press

Grading:

Attendance/participation

10%

 

Quiz

30%

Final Exam

60%

Quiz and final exams will be closed book, closed notes and no dictionaries

Business Finance Management: Course outline

PPT

1

Chapter 1 Business Finance Management

Basic objective of finance decisions

Who is the financial manager?

The Concept of Net Present Value

Basic objective of business finance

This course is about financial decisions by corporations.

Before diving into business finance, we do need to establish what basic objective we are trying to achieve when making financial decisions.

In traditional business finance, the objective in decision making is to maximize the value of the firm.

A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price.

All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.

Basic objective of business finance (cont.)

Maximizing f

Basic objective of business finance (cont.)

Why corporate financial theory focuses on maximizing stockholder wealth.

  • 1. Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).

  • 2. If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.

  • 3. The objective of stock price performance provides some very elegant theory on:

allocating resources across scarce uses (which investments to take and which ones to reject)

how to finance these investments how much to pay in dividends

Basic objective of business finance (cont.)

Is maximizing stock prices a too “narrow” an objective?

A preliminary response

Maximizing stock price is not incompatible with meeting employee needs/objectives. In particular:

Employees are often stockholders in many firms

Firms that maximize stock price generally are firms that have treated employees well.

Maximizing stock price does not mean that customers are not critical to success. In most businesses, keeping customers happy is the route to stock price maximization.

Maximizing stock price does not imply that a company has to be a social outlaw.

Basic objective of business finance (cont.)

What about bond holders? Are they at a disadvantage if a firm has an objective to maximize stock price?

In theory: there is no conflict of interests between stockholders and bondholders.

In practice: Stockholder and bondholders have different objectives. Bondholders are concerned most about safety and ensuring that they get paid their claims. Stockholders are more likely to think about upside potential.

Basic objective of business finance (cont.)

Maximizing share value versus social responsibility

In theory: There are no costs associated with the firm that cannot be traced

to the firm and charged to it.

In practice: Financial decisions can create social costs and benefits.

A social cost or benefit is a cost or benefit that accrues to society as a

whole and NOT to the firm making the decision.

environmental costs (pollution, health costs, etc )

..

quality of life costs (traffic, housing, safety, etc.)

Examples of social benefits include:

creating employment in areas with high unemployment

supporting development in poor areas

creating access to goods in areas where such access does not exist

Basic objective of corporate finance (cont.)

Social costs and benefits are difficult to quantify because ..

they might not be known at the time of the decision

they are 'person-specific' (different decision makers weight them

differently)

they can be paralyzing if carried to extreme

Basic objective of business finance (cont.)

Traditional corporate financial theory breaks down when ...

The interests/objectives of the decision makers in the firm conflict with

the interests of stockholders.

Bondholders (Lenders) are not protected against expropriation by

stockholders.

Financial markets do not operate efficiently, and stock prices do not

reflect the underlying value of the firm.

Significant social costs can be created as a by-product of stock price

maximization.

Basic objective of corporate finance (cont.)

When traditional business financial theory breaks down, the solution is to

choose a different:

mechanism for corporate governance

objective and continue to maximize stock price, but reduce the potential

for conflict and breakdown

Make managers (decision makers) and employees into stockholders

Provide information honestly and promptly to financial markets

Who is the financial manager?

(2) (1) Financial Firm's Financial (4a) manager operations markets (3) (4b) (1) Cash raised from investors
(2)
(1)
Financial
Firm's
Financial
(4a)
manager
operations
markets
(3)
(4b)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors

Who is the financial manager? (cont.)

Chief Financial Officer
Chief Financial Officer

Treasurer

Banking relationships Cash management Obtaining financing Credit management Dividend disbursement Insurance Pensions management

Comptroller

Accounting Preparation of financial statements Internal auditing Payroll Custody of records Preparing budgets Taxes

Net present value

Before starting on net present value, we need to introduce present value.

We can start with the premise that receiving $1 next year is worth less than

receiving $1 today.

There are three reasons why a dollar tomorrow is worth less than a dollar

today:

  • 1. Individuals prefer present consumption to future consumption. To induce people to give up present consumption you have to offer them more in

the future.

  • 2. When there is monetary inflation, the value of currency decreases over time. The greater the inflation, the greater the difference in value between a dollar today and a dollar tomorrow.

  • 3. If there is any uncertainty (risk) associated with the cash flow in the

future, the less that cash flow will be valued.

Net present value (cont.)

If receiving $1 next year is worth less than receiving $1 today, how much

less is it?

We will use the present value equation to arrive to a solution.

Suppose you could invest P at an interest rate r.

P 1 or the value in one year would be P X (1+r)

We can inverse the equation and say that P = P 1 / (1 + r)

P is the same as saying the value of P 1 today or its Present Value is

PV = P 1 / (1 + r)

Net present value (cont.)

PV = P 1 / (1 + r)

Where 1 / (1+r) = Discount Factor

We can also say that r = the rate of return demanded by investors for

receiving funds in the future.

The rate of return is also called the discount rate, the hurdle rate, or the

opportunity cost of capital.

Example. Suppose it will cost $350,000 to construct an office building which

can be sold for $400,000 next year if the discount rate is 7%

What is the present value of the building?

Net present value (cont.) PV = P / (1 + r) • Where 1 / (1+r)

PV = $400,000 / (1 + .07) = $373,832

Net present value (cont.)

The building sold for $400,000 in 1 year is worth $373,832 today.

But the building required an investment of $350,000.

We can say that the Net Present Value or NPV of the investment is :

NPV = -$350,000 + $373,832 = $23,832

The NPV formula is:

NPV = C 0 + C 1 /(1+r)

C 0 is the cash flow in year 0 or now and is often a negative number because we need to invest.

Because the NPV > 0, we will invest in the building construction and selling.

We will investigate how to analyze “r” in a future lesson. For the moment, it is the return that investors require for a certain type of investment.

NPV vs. Rate of Return

We decided that the construction of the building was a good idea because it

had an NPV > 0 or in other words the present value of its selling price in

one year is greater than the construction costs today.

We can also calculate the return on the capital invested (also stated as the

return on investment.)

Return = profit / investment = (400,000 – 350,000)/350,000 = 14%

Suppose that if we didn’t invest in the building and we invested in the stock

market. An average return in the stock market is about 12% (We will study

this too later in the course.)

We could say that the 12% is the opportunity cost of capital.

Deciding between the two alternatives, we would choose the building

because of its return of 14%

NPV vs. Rate of Return (cont.)

Here then we have two equivalent rules for capital investment:

  • 1. Net Present Value Rule. Accept investments that have positive net present

values

  • 2. Rate of Return Rule. Accept investments that offer rates of return above

their opportunity cost of capital

Questions and problems

  • 1. What basic objective do we recommend for finance decisions?

In most cases we will want to maximize shareholder value or share price.

  • 1. Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).

  • 2. If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.

  • 3. The objective of stock price performance provides some very elegant

theory on:

allocating resources across scarce uses (which investments to

take and which ones to reject)

how to finance these investments

how much to pay in dividends

Questions and problems

  • 2. What do we do when maximizing share price does not seem the best objective?

Choose a different mechanism for corporate governance

Choose a different objective by focus. Yes, maximize stock price, but

reduce the potential for conflict and breakdown

Make managers (decision makers) and employees into stockholders

Provide information honestly and promptly to financial markets

Questions and problems

  • 3. The financial manager handles the two functions of treasury and comptroller. In a large company they would be divided into two departments. Describe the two functions.

Treasurer

Banking relationships Cash management Obtaining financing Credit management Dividend disbursement Insurance Pensions management

Comptroller

Accounting Preparation of financial statements Internal auditing Payroll Custody of records Preparing budgets Taxes

Questions and problems

  • 4. A merchant pays $100,000 for a load of grain and is certain that it can be

resold at the end of 1 year for $132,000.

  • a. What is the return on his investment?

  • b. If the return were less than the interest rate, does the investment have a positive or negative NPV?

  • c. If the interest rate is 10% was is the present value of the investment?

  • d. What is the net present value?

  • a. Return = profit/investment = ($132,000 - $100,000) / $100,000 = 32%

  • b. Negative

  • c. PV = $132,000 / 1.10 = $120,000

  • d. NPV = -$100,000 + $120,000 = $20,000

Questions and problems

  • 4. What is the NPV rule? And the rate of return rule?

    • a. Net Present Value Rule. Accept investments that have positive net present values

    • b. Rate of Return Rule. Accept investments that offer rates of return above their opportunity cost of capital