A FRAMEWORK OF CORPORATE FINANCE
The goal of financial management: to maximize the shareholders’ wealth.
Three questions: 1. What should the company invest (so as to earn good returns)? 2. What is the lowest cost to get money (borrow or issue equity) in order to invest? 3. How much cash needed to keep the company running?
Work Map.
Current Liabilities Current assets
Net working capital Long-term debt
Fixedassets Shareholders’ equity
Assets (investment): 1. Evaluation
Compounding & discounting
Bond valuation Stock valuation 2. Capital Budgeting Payback
Net present value
Internal rate of return 3. Return & risk
Capital market efficiency(SML) Expected returns and variance
Risks: systematic & unsystematic (Beta coefficient)
Diversification & portfolios 4. Financial Statement
Cashflow Ratio analysis Financial Planning
Liabilities & equity 1. Cost of capital
Cost of long-term debt Flotation costs Capital structure
Weighted average cost of capital(WACC) 2. Financial Leverage & capital structure
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Modigliani & Miller Proposition I & II Trade-off theory Pecking order theory 3. Raising Capital
Cash offer, rights offer, private placement Cash & stock dividends Warrants
Convertible Bonds
The dividend policy controversy Financial leasing 4. Merger & Acquisitions
Estimating gains and losses Leveraged buy-outs Boots
Working capital management (e.g. p3 )
From the balance-sheet, we can see net working capital is defined as current assets minus current liabilities. This part covers the topic of how to manage the gaps between cash inflows and outflows in order to keep the business running. 1. Operating and cash cycles 2. Cash budgeting
3. Flexible & restrictive strategies
TIME VALUE OF MONEY
BASIC PRINCIPLE:
A dollar today is worth more than a dollar tomorrow. WHY?
COMPOUNDING: FUTURE VALUE
? Borrow---$500 for one year
? Interest rate per year--- 9%
FV1 = $500 + (.09)(500) = $545
FV1 = $500 * ( 1 + .09)
FV1 = $500 ( 1 + r)
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$500 is the principal $45 is the simple interest
COMPOUNDING: MULTIPLE YEARS
? Borrow--- $500 for two years
FV1 = 500 ( 1 + r)
FV2 = FV1 ( 1 + r)
= 500 ( 1 + r)( 1 + r) = 500 ( 1 + r )2
FV2 = 500 ( 1.09)2 = 500 ( 1.1881 )
FV2 = $594.05 Principal---$500.00 Total interest---$ 94.05 Simple interest--- $45 + $45 = $90 Compound interest = $4.05 (Interest on interest) (.09)($45) = $4.05
Generally:
FVt = Principal * ( 1 + r )t
FUTURE VALUE INTEREST FACTOR = ( 1 + r )t
Notation: FVIF(r,t)
? The future value interest factor at an interest rate of r over t
periods.
DETERMINING THE FUTURE VALUE OF THE INVESTMENT OR DEBT
You run your credit card to the limit of $3,000. The interest rate is 1.75% per month. How much will you owe at the end of 12 months?
POWER OF COMPOUNDING
? About 374 years ago, Manhattan Island was sold for $24. What would be the value today
(the Future Value) if that money had been invested at a compound interest rate of 5% per year?
DISCOUNTING: PRESENT VALUE
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Present Value: value today of a future cash flow at an appropriate discount (interest) rate.
? You will receive a scholarship of $1,000 one year from now.
? 7% interest rate
The Present Value ($934.58) is today’s value of $1,000 to be received in one year’s time. Given the opportunity cost created by the 7% interest rate, a value of a future dollar has to be discounted to be comparable to a current dollar.
DISCOUNTING: MULTIPLE YEARS FVt = PV * ( 1 + r )t PV = FVt / ( 1 + r )t PV = FVt * 1/(1 + r)t
? You will receive the $1,000 scholarship in three years---what is its value today.
Generally: PV = FVt * 1/( 1 + r )t PRESENT VALUE INTEREST FACTOR = 1/( 1 + r )t
Notation: PVIF(r,t)
? The present value interest factor at a discount rate of r over t
periods.
DETERMINING THE PRESENT VALUE
You buy a type of bond called a “strip bond” with a future value of $250,000 for your retirement 35 years from now. The current interest rate (discount rate) is 7.5%. How much will you pay for the strip bond?
Overview: PV = FVt * 1/( 1 + r )t FVt = PV * ( 1 + r )t Four factors:
? Present value (PV)
? Future value (FVt)
? Discount rate (r)
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? Life of the investment (t)
Given any 3 of the factors, you can always determine the 4th.
DETERMINING THE DISCOUNT RATE
? If you give me $4,000 today, I will give you $5,000 in three years. What rate of interest will
you earn with this investment, if interest is compounded annually?
You will earn about 7.72% per year with this opportunity.
EXAMPLE: DETERMINING THE DISCOUNT RATE
You are still trying to buy the $250,000 strip bond coming due in 35 years. Your broker states that you must pay $21,000. What interest rate will you earn over the 35 years if you pay this price, if interest is compounded annually?
EXAMPLE: DETERMINING THE LIFE OF THE INVESTMENT
You have $2,000 set aside in a savings account earning ? of 1% interest per month, compounded monthly. When you have $3,000, you’re off to Mexico to lie in the sun. How many months must you wait?
MULTIPLE CASH FLOWS
? Use our basic compounding and discounting techniques to determine the present or
future value of a series of uneven payments, over a number of compounding periods.
? Understand the importance of the timing of payments.
? Calculated the present and future values of streams of cash payments, where the
payments are all the same amounts, e.g., annuities, loan payments, or perpetuities.
? Compare interest rates to determine which are the highest and which are the lowest.
? Illustrate how interest rates can be quoted in different and often deceptive ways.
FVIF(r,t) = (1 + r)t PVIF(r,t) = 1/(1 + r)t
FUTURE VALUE
The Value at 10th year from now
(i) One year at a time at a 7% discount rate
End of Year 1 Year 2 Year 3 Year 4 750 800 700 900 *1.07= 802.50 1,602.50 *1.07= 1,714.68 2,414.68 *1.07=2,583.71 3,483.71 FV4 = $3,483.71
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