BFM 1 Business Finance Management Introduction

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 1-1


Business Finance Management: Course outline

1 BFM Introduction2 NPV and Valuing Securities3 NPV and Investment Decisions4 Risk and Return, Cost of Capital

Mid-term Exam Chapters 1-45 Efficient Markets6 Overview of Financing7 Dividend policy8 Optimal Capital Structure9 Investment and Financing Decisions

10 Ratio Analysis

SubjectPPT

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.

1-4Business Finance Management

Basic objective of business finance (cont.)

1-5

Maximizing firm value

Maximizing equity value

Assets Liabilities

- Residual claim on cash flows- Significant role in mgmt supervision

- Fixed claims on cash flows- Little or no role in management

- Existing investments- Generate cashflows today- Includes fixed assets and working capital

Growth assets

Expected value created by future investments

Assets in place Debt

Equity

Business Finance Management


• 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



• 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.



• 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.



• 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



• 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?

1-13

Financial

managerFirm's

operations

Financial

markets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)


Who is the financial manager? (cont.)

1-14

Chief Financial Officer

TreasurerBanking relationshipsCash managementObtaining financingCredit managementDividend disbursementInsurancePensions management

ComptrollerAccountingPreparation of financial statementsInternal auditingPayrollCustody of recordsPreparing budgetsTaxes


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.

• P1 or the value in one year would be P X (1+r)

• We can inverse the equation and say that P = P1 / (1 + r)

• P is the same as saying the value of P1 today or its Present Value is

PV = P1 / (1 + r)



PV = P1 / (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?

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



• 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 = C0 + C1/(1+r)

• C0 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



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



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.

1-23

TreasurerBanking relationshipsCash managementObtaining financingCredit managementDividend disbursementInsurancePensions management

ComptrollerAccountingPreparation of financial statementsInternal auditingPayrollCustody of recordsPreparing budgetsTaxes



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



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


Documents

BFM 1 Business Finance Management Introduction