Bfm 1 Business Finance Management Introduction
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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:
•
Quiz and final exams will be closed book, closed notes and no dictionaries
Business Finance Management
Attendance/participation Quiz Final Exam
10% 30% 60%
1-1
Business Finance Management: Course outline
PPT Business Finance Management
1
1-2
Chapter 1 Business Finance Management
Basic objective of finance decisions Who is the financial manager? The Concept of Net Present Value
Business Finance Management
1-3
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.
Business Finance Management
1-4
Basic objective of business finance (cont.)
Maximizing fi Business Finance Management
1-5
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
Business Finance Management
1-6
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.
Business Finance Management
1-7
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.
Business Finance Management
1-8
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
Business Finance Management
1-9
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
Business Finance Management
1-10
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.
Business Finance Management
1-11
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
Business Finance Management
1-12
Who is the financial manager?
(2)
(1)
Financial manager
Firm's operations
(4a)
Financial markets
(4b)
(3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors
Business Finance Management
1-13
Who is the financial manager? (cont.) Chief Financial Officer
Treasurer
Comptroller
Banking relationships Cash management Obtaining financing Credit management Dividend disbursement Insurance Pensions management
Accounting Preparation of financial statements Internal auditing Payroll Custody of records Preparing budgets Taxes
Business Finance Management
1-14
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.
Business Finance Management
1-15
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)
Business Finance Management
1-16
Net present value (cont.) 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
Business Finance Management
1-17
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 = 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.
Business Finance Management
1-18
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%
Business Finance Management
1-19
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
Business Finance Management
1-20
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
Business Finance Management
1-21
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
Business Finance Management
1-22
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
Comptroller
Banking relationships Cash management Obtaining financing Credit management Dividend disbursement Insurance Pensions management
Accounting Preparation of financial statements Internal auditing Payroll Custody of records Preparing budgets Taxes
Business Finance Management
1-23
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
Business Finance Management
1-24
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
Business Finance Management
1-25
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:
•
Quiz and final exams will be closed book, closed notes and no dictionaries
Business Finance Management
Attendance/participation Quiz Final Exam
10% 30% 60%
1-1
Business Finance Management: Course outline
PPT Business Finance Management
1
1-2
Chapter 1 Business Finance Management
Basic objective of finance decisions Who is the financial manager? The Concept of Net Present Value
Business Finance Management
1-3
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.
Business Finance Management
1-4
Basic objective of business finance (cont.)
Maximizing fi Business Finance Management
1-5
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
Business Finance Management
1-6
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.
Business Finance Management
1-7
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.
Business Finance Management
1-8
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
Business Finance Management
1-9
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
Business Finance Management
1-10
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.
Business Finance Management
1-11
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
Business Finance Management
1-12
Who is the financial manager?
(2)
(1)
Financial manager
Firm's operations
(4a)
Financial markets
(4b)
(3) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors
Business Finance Management
1-13
Who is the financial manager? (cont.) Chief Financial Officer
Treasurer
Comptroller
Banking relationships Cash management Obtaining financing Credit management Dividend disbursement Insurance Pensions management
Accounting Preparation of financial statements Internal auditing Payroll Custody of records Preparing budgets Taxes
Business Finance Management
1-14
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.
Business Finance Management
1-15
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)
Business Finance Management
1-16
Net present value (cont.) 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
Business Finance Management
1-17
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 = 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.
Business Finance Management
1-18
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%
Business Finance Management
1-19
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
Business Finance Management
1-20
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
Business Finance Management
1-21
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
Business Finance Management
1-22
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
Comptroller
Banking relationships Cash management Obtaining financing Credit management Dividend disbursement Insurance Pensions management
Accounting Preparation of financial statements Internal auditing Payroll Custody of records Preparing budgets Taxes
Business Finance Management
1-23
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
Business Finance Management
1-24
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
Business Finance Management
1-25
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