Introduction To Financial Management: Topic 1

Topic 1
Introduction to Financial Management
Forms of Business Organization
Balancing Shareholder Value and Society Interests
Intrinsic Values, Stock Prices, and Managerial Incentives
Important Business Trends
Conflicts Between Managers, Stockholders, and Bondholders
Financial Markets and Capital Allocation
Stock Market Efficiency
© All Rights Reserved. May not be duplicated or posted to a publicly accessible website, in whole or in part.
AC6531 Financial Management City University of Hong Kong
Finance within an organization
Board of Directors
Chief Executive Officer (CEO)
Chief Operating Officer (COO) Chief Financial Officer (CFO)
Accounting, finance, credit policy,

Marketing, manufacturing, sales,
asset acquisitions, and investor
and other operating departments

relations
Forms of business organization
• Proprietorship
• Partnership
• Corporation
Proprietorships and Partnerships
• Advantages
– Easy and inexpensive to form
– Subject to fewer regulations
– No corporate income taxes
• Disadvantages
– Unlimited liability
– Limited life
– Difficult to raise capital
Corporations
• Advantages
– Easy transfer of ownership
– Unlimited life
– Limited liability
– Easy to raise capital
• Disadvantages
– Double taxation
– Cost of setup and report filing
Class Exercise
Which of the following could explain why a business might choose to
operate as a corporation rather than as a proprietorship or a
partnership?
a. Corporations generally face fewer regulations.
b. Less of a corporation’s income is generally subject to federal taxes.
c. Corporate shareholders are exposed to unlimited liability, but his
factor is offset by the tax advantages of incorporation.
d. Corporate investors are exposed to unlimited liability.
e. Corporations generally find it easier to raise large amounts of
capital.
Balancing shareholder value and society interests
• The primary financial goal of management is

shareholder wealth maximization, which translates
to maximizing stock price.

mutts
– Value of any asset is the present value of cash flow

stream to owners.
– Most significant decisions are evaluated in terms of

their financial consequences.
– Stock prices change over time as conditions change and

as investors obtain new information about a company’s
prospects.
• Managers recognize that being socially responsible

is not inconsistent with maximizing shareholder
value.
Stock prices and intrinsic value
• In equilibrium, a stock’s price should equal its

“true” or intrinsic value.
iii
• Intrinsic value is a long-run concept.
• To the extent that investor perceptions are
incorrect, a stock’s price in the short run may
deviate from its intrinsic value.
• Ideally, managers should avoid actions that reduce
intrinsic value, even if those decisions increase the
stock price in the short run.
Determinants of intrinsic values and stock prices
Managerial Actions, the Economic Environment,
Taxes, and the Political Climate
叔⻅见上的
“True” Investor “Perceived” Investor “Perceived”

“True” Risk -Cash Flows
Cash Flows Risk
Stock’s Stock’s
Intrinsic Value Market Price
Market Equilibrium: Long1
Intrinsic Value = Stock Price 到
anniusvan
signing
10
Some important business trends
• Corporate scandals have reinforced the importance
of business ethics, and have spurred additional
regulations and corporate oversight.
• Increased globalization of business.
• The effects of ever-improving information
technology have had a profound effect on all
aspects of business finance.
• Stockholders now have more control of corporate
governance.
11
Conflicts between managers and stockholders
• Managers are naturally inclined to act in their own
best interests (which are not always the same as
the interest of stockholders).
• But the following factors affect managerial

behavior:
– Managerial compensation packages
– The threat of takeover

manor
– Direct intervention by shareholders
– The threat of firing
12
Principals and Agents
A public company is a company that sells its
stocks or bonds to the public, giving the
public a valid interest in the proper use, or
stewardship, over the company’s resources.
Managers Stockholders
Agents Principals
14
Examples of principal-agent problems
– Principal = shareholder; Agent = manager
• Manager may be lazy because manager owns less
than 100% of the company
– Principal = senior manager; Agent = company
employee
• Employee may be lazy or may steal from company
– Principal = bondholder; Agent = shareholder
• Shareholder may prefer riskier projects because

they own less than 100% of the investment fund
15

Conflicts between stockholders and bondholders

swine
earning
mnethrough

thehigher risk
• Stockholders are more likely to prefer riskier
an

bondholders
oneB projects, because they receive more of the upside if
augmentsarefixedunary

the project succeeds. By contrast, bondholders

receive fixed payments and are more interested in

limiting risk.

• Bondholders are particularly concerned about the

use of additional debt.

• Bondholders attempt to protect themselves by

including covenants in bond agreements that limit

the use of additional debt and constrain managers’

actions.

16

Class Exercise
Which of the following actions would be most likely to reduce potential
conflicts of interest between stockholders and managers?
a. Pay managers large cash salaries and give them no stock options.
ˇb. Change the corporation's formal documents to make it easier for

outside investors to acquire a controlling interest in the firm through
a hostile takeover.
c. Beef up the restrictive covenants in the firm’s debt agreements.
d. Eliminate a requirement that members of the board of directors must
hold a high percentage of their personal wealth in the firm’s stock.
e. For a firm that compensates managers with stock options, reduce the
time before options are vested, i.e., the time before options can be
exercised and the shares that are received can be sold.
17
Group Discussion
• Corporate ownership varies around the world.
Historically, individuals have owned the majority of
shares in public corporations in the United States,
United Kingdom and Hong Kong. In Germany and
Japan, however, banks, other large financial
institutions, and other companies own most of the
stock in public corporations. Do you think agency
problems are likely to be more or less severe in
Germany and Japan than in the United States,
United Kingdom and Hong Kong?
18
What is a market?
• A market is a venue where goods and services are
exchanged.
• A financial market is a place where individuals and
organizations wanting to borrow funds are brought
together with those having a surplus of funds.
19

Types of markets

• Physical assets vs. Financial assets
•he deliveredimmediately
Spot
⼀一⼀一
vs. Futures
• Money vs. Capital

• Primary vs. Secondary

• Public vs. Private

20

Financial Management
AC6531 City University of Hong Kong
Stock market transactions
• Apple Computer decides to issue additional stock
with the assistance of its investment banker. An
investor purchases some of the newly issued
shares.
– Since the company raise capital new shares of stock are

being issued, this is a primary market transaction.
• What if instead an investor buys existing shares of
Apple stock in the open market.
– Since no new shares and new capital to the company

are created, this is a secondary market transaction.
21
The capital allocation process
• In a well-functioning economy, capital flows
efficiently from those who supply capital to those
who demand it.
• Suppliers of capital: individuals and institutions

with “excess funds.” These groups are saving
money and looking for a rate of return on their
investment.
• Demanders or users of capital: individuals and
institutions who need to raise funds to finance their
investment opportunities. These groups are willing
to pay a rate of return on the capital they borrow.
22
How is capital transferred between savers and
borrowers?
• Direct transfers
• Financial intermediaries
• Investment banks
23
What is meant by stock market efficiency?
• Securities are normally in equilibrium and are
“fairly priced.”
• Investors cannot “beat the market” except through
good luck or better information.
• Efficiency continuum
Highly Highly
Inefficient Efficient
Small companies not followed by Large companies followed by many
many analysts. Not much contact analysts. Good communications
with investors. with investors.
24
Weak form EMH
etlorttnoTheory
• Can’t profit by looking at past trends. A recent
decline is no reason to think stocks will go up
(or down) in the future. Evidence supports
weak-form EMH, but “technical analysis” is still
used.
25
Semi-strong form EMH
• All publicly available information is reflected in
stock prices, so it doesn’t pay to pore over
annual reports looking for undervalued stocks.
Largely true.
26
Strong form EMH
• All information, even inside information, is
embedded in stock prices. Not true--insiders
can gain by trading on the basis of insider
information, but that’s illegal.
27
Some interesting facts
• An experiment:
– Getting $5,000 for sure
– Flipping a coin: receiving $10,000 if head and $0 if

tail.
– Losing $5,000 for sure
– Flipping a coin: losing $10,000 if head and $0 if tail.
• A large majority of people (e.g., 90%) believe that
they have above-average driving ability.
28
Topic 2
Time Value of Money
Future Value
Present Value
Annuities
Rates of Return
Amortization BAT
we
© All Rights Reserved. May not be duplicated or posted to a publicly accessible website, in whole or in part.
Time lines
0 1 2 3
I%
CF0 CF1 CF2 CF3
• Show the timing of cash flows.
• Tick marks occur at the end of periods, so Time 0 is
today; Time 1 is the end of the first period (year,
month, etc.) or the beginning of the second period.
Drawing time lines
$100 lump sum due in 2 years
0 1 2
I%
100
3-year $100 ordinary annuity
0 1 2 3
I%
100 100 100
Drawing time lines
Uneven cash flow stream
0 1 2 3
I%
-50 100 75 50
What is the future value (FV) of an initial $100 after 3
years, if I/YR = 10%?
• Finding the FV of a cash flow or series of cash flows
is called compounding.
• FV can be solved by using the step-by-step, financial
calculator, and spreadsheet methods.
0 1 2 3
10%
100 FV = ?
Solving for FV:
The step-by-step and formula methods
• After 1 year:
FV1 = PV(1 + I) = $100(1.10) = $110.00
• After 2 years:
FV2 = PV(1 + I)2 = $100(1.10)2 = $121.00
• After 3 years:
FV3 = PV(1 + I)3 = $100(1.10)3 = $133.10
• After N years (general case):
FVN = PV(1 + I)N
Solving for FV:
Calculator method
• Solves the general FV equation.
• Requires 4 inputs into calculator, and will solve for
the fifth. (Set to P/YR = 1 and END mode.)
INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10
What is the present value (PV) of $100 due in
3 years, if I/YR = 10%?
• Finding the PV of a cash flow or series of cash flows
is called discounting (the reverse of compounding).
• The PV shows the value of cash flows in terms of
today’s purchasing power.
0 1 2 3
10%
PV = ? 100
Solving for PV:
Formula method
• Solve the general FV equation for PV:
PV = FVN /(1 + I)N
PV = FV3 /(1 + I)3
= $100/(1.10)3
= $75.13
Solving for PV:
Calculator method
• Solves the general FV equation for PV.
• Exactly like solving for FV, except we have different
input information and are solving for a different
variable.
INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13
10
Solving for I: What annual interest rate would cause
$100 to grow to $125.97 in 3 years?
• Solves the general FV equation for I/YR.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 3 -100 0 125.97
N I/YR PV PMT FV
OUTPUT 8
11
Solving for N: If sales grow at 20% per year, how long
before sales double?
• Solves the general FV equation for N.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8
12
Ordinary Annuity versus Annuity Due
Ordinary Annuity期末
0 1 2 3
I%
PMT PMT PMT
期初
Annuity Due
0 1 2 3
I%
PMT PMT PMT
13
Solving for FV:
3-year ordinary annuity of $100 at 10%
• $100 payments occur at the end of each period, but
there is no PV.
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT 14
Solving for FV of ordinary annuity:
Formula method
• FV of Ordinary Annuity:
FV = PMT(1+I)N-1 + PMT(1+I)N-2 + … + PMT(1+I)0 - (1)
• Multiply both side by (1+I)
(1+I)FV = PMT(1+I)N + PMT(1+I)N-1 + … + PMT(1+I)1 - (2)
• (2) – (1)
IxFV = PMT(1+I)N - PMT(1+I)0
FV = PMT{[(1+I)N – 1]/I}
P吓芈些 īuin
15
Solving for FV:
100
FV (1 0.10)3 1 331
0.10
16
Solving for PV:
• $100 payments still occur at the end of each period,
but now there is no FV.
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT
17
Solving for PV of ordinary annuity:
Formula method
• PV of Ordinary Annuity:
PV = PMT/(1+I)1 + PMT/(1+I)2 + … + PMT/(1+I)N - (1)
• Multiply both sides by (1+I)
(1+I)PV = PMT + PMT/(1+I)1 + … + PMT/(1+I)N-1 - (2)
• (2) – (1)
IxPV = PMT – PMT/(1+I)N
PV = PMT{[1 – 1/(1+I)N ]/I}
1 兴 1笇 Hiǐhjf
恐
18
Solving for PV:
100 1
PV 1 3
248.69
0.10 1 0.10
19
annuity 附
funny for FV:

Solving
3-year annuity due of $100 at 10%

221 𠜎
n_n_ • Now, $100 payments occur at the beginning of each
period.
mdtzndtlozndt
FVAdue= FVAord(1 + I) = $331(1.10) = $364.10
回 • Alternatively, set calculator to “BEGIN” mode and solve
for the FV of the annuity:
BEGIN
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 364.10
20
Solving for PV:
3-year annuity due of $100 at 10%
• Again, $100 payments occur at the beginning of each

period.
PVAdue = PVAord(1 + I) = $248.69(1.10) = $273.55
• Alternatively, set calculator to “BEGIN” mode and solve
for the PV of the annuity:
BEGIN
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55
21
What is the present value of a 5-year $100 ordinary
annuity at 10%?
• Be sure your financial calculator is set back to END
mode and solve for PV:
– N = 5, I/YR = 10, PMT = -100, FV = 0.
– PV = $379.08.
22
What if it were a 10-year annuity? A 25-year
annuity?
• 10-year annuity
– N = 10, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$614.46.
• 25-year annuity
– N = 25, I/YR = 10, PMT = -100, FV = 0; solve for PV =
$907.70.
23
Solving for PV of perpetuity:
Formula method
• Perpetuity: An annuity that lasts forever
• PV of Perpetuity :
PV = PMT/(1+I)1 + PMT/(1+I)2 + PMT/(1+I)3 + … - (1)
• Multiply both sides by (1+I)
(1+I)PV = PMT + PMT/(1+I)1 + PMT/(1+I)2 + … - (2)
• (2) – (1)
IxPV = PMT
PV = PMT/I
1 1- 忘
N 华川
㗊等 1亩
灬 24
What is the PV of a perpetuity that pays $100 per
year at 10%?
PV = PMT/I = $100/0.1 = $1,000
25
The power of compound interest
A 20-year-old student wants to save $3 a day for her
retirement. Every day she places $3 in a drawer. At the
end of the year, she invests the accumulated savings
($1,095) in a brokerage account with an expected
annual return of 12%.
How much money will she have when she is 65 years
old?
26
Solving for FV: If she begins saving today, how much
will she have when she is 65?
• If she sticks to her plan, she will have $1,487,261.89
when she is 65.
INPUTS 45 0 -1095
12
N I/YR PV PMT FV
OUTPUT 1,487,262
27
Solving for FV: If you don’t start saving until you are 40
years old, how much will you have at 65?
• If a 40-year-old investor begins saving today, and
sticks to the plan, he or she will have $146,000.59
at age 65. This is $1.3 million less than if starting at
age 20.
• Lesson: It pays to start saving early.
INPUTS 25 12 0 -1095
N I/YR PV PMT FV
OUTPUT 146,001
28
Solving for PMT: How much must the 40-year old
deposit annually to catch the 20-year old?
• To find the required annual contribution, enter the
number of years until retirement and the final goal
of $1,487,261.89, and solve for PMT.
INPUTS 25 12 0 1487262
N I/YR PV PMT FV
OUTPUT -11,154.42
29
What is the PV of this uneven cash flow stream?
Compute 四 byBAE 4
回 0 1 2 3
cow 10%
cow 100 300 300 -50
Fai 90.91
247.93
盥
1 ⽌止 225.39
凹⼗十四
-34.15
530.08 = PV
30
Solving for PV:
Uneven cash flow stream
• Input cash flows in the calculator’s “CFLO” register:
– CF0 = 0
– CF1 = 100
– CF2 = 300
– CF3 = 300
– CF4 = -50
• Enter I/YR = 10, press NPV button to get NPV =
$530.087. (Here NPV = PV.)
31
Recap
Future value of lump sum after N years:
FVN = PV(1 + I)N
Present value of lump sum due in N years:
PV = FVN /(1 + I)N
Future value of ordinary annuity:
PMT N
FV 1 I 1
Present value of ordinary annuity:
PMT 1
PV 1 N
I 1 I
32
Recap
PMT N
FV 1 I 1 (1 I )
I
PMT 1
PV 1 N
(1 I )
I 1 I

33

AC6531 Financial Management

City University of Hong Kong
Class Exercise 1
Find the present value of the following annuities. The
first payment in these annuities is made at the end of
Year 1.
a. $400 per year for 10 years at 10%.
b. $200 per year for 5 years at 5%.
c. $400 per year for 5 years at 0%.
d. Now rework parts a, b, and c assuming that
payments are made at the beginning of each year.
Utr
34
Class Exercise 2
What is the present value of a perpetuity of $100 per year
if the appropriate discount rate is 7%? If interest rates in
general were to double and the appropriate discount rate
rose to 14%, what would happen to the present value of
the perpetuity?
35
Will the FV of a lump sum be larger or smaller if
compounded more often, holding the stated I% constant?
复利利下利利滚利利 compoundedmoreoften FUisbigger
• LARGER, as the more frequent compounding
occurs, interest is earned on interest more often.
0 1 2 3
10%
100 133.10
Annually: FV3 = $100(1.10)3 = $133.10
0 1 2 3
0 1 2 3 4 5 6
5%
100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01
36
Classification of interest rates
• Nominal rate (INOM): also called the quoted or
stated rate. An annual rate that ignores
compounding effects.
– INOM is stated in contracts. Periods must also be
given, e.g. 8% quarterly or 8% daily interest.
• Periodic rate (I ):期间利利平13胜输⼊入

amount
PER
值 charged
of interest
each period, e.g. monthly or quarterly.
– IPER = INOM/M, where M is the number of

_
compounding periods per year. M = 4 for quarterly
and M = 12 for monthly compounding.
⼯工和iodicrates Inning
年年
计息次致
37

Classification of interest rates

•1 Effective (or equivalent) annual rate (EAR = EFF%):

补充

APR EAR 𠱃

the annual rate of interest actually being earned,

considering compounding.

– EFF% for 10% semiannual interest

EFF% = (1 + INOM/M)M – 1

= (1 + 0.10/2)2 – 1 = 10.25%

– Should be indifferent between receiving 10.25%

annual interest and receiving 10% interest,

compounded semiannually.

38

Why is it important to consider effective rates
of return?
• Investments with different compounding intervals
provide different effective returns.
• To compare investments with different
compounding intervals, you must look at their
effective returns (EFF% or EAR).
39
Why is it important to consider effective rates
of return?
• See how the effective return varies between
investments with the same nominal rate, but
different compounding intervals.
EARANNUAL 10.00%
EARSEMIANNUALLY 10.25%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%
40
When is each rate used?
• INOM: Written into contracts, quoted by banks and
brokers. Not used in calculations or shown on time
lines.
• IPER: Used in calculations and shown on time lines.

If M = 1, INOM = IPER = EAR.
• EAR: Used to compare returns on investments with
different payment frequencies per year. Used in
calculations when annuity payments don’t match
compounding periods.
41
What is the FV of $100 after 3 years under 10%
semiannual compounding? Quarterly compounding?
M N
I
FVN PV 1 NOM
2 3
0.10
FV3S $100 1
2
FV3S $100(1.05)6 $134.01
FV3Q $100(1.025)12 $134.49
42
Can the effective rate ever be equal to the nominal
rate?
• Yes, but only if annual compounding is used, i.e., if
M = 1.
• If M > 1, EFF% will always be greater than the
nominal rate.
43
What’s the FV of a 3-year $100 annuity, if the quoted
interest rate is 10%, compounded semiannually?
• Payments occur annually, but compounding occurs
every 6 months.
• Cannot use normal annuity valuation techniques.
0 1 2 3 4 5 6
5%
100 100 100
44
Method 1:
Compound each cash flow
0 1 2 3 4 5 6
5%
100 100 100
110.25
121.55
331.80
FV3 = $100(1.05)4 + $100(1.05)2 + $100
FV3 = $331.80
45
Method 2:
Financial calculator
• Find the EAR and treat as an annuity.
• EAR = (1 + 0.10/2)2 – 1 = 10.25%.
INPUTS 3 10.25 0 -100
N I/YR PV PMT FV
OUTPUT 331.80
46
Find the PV of this 3-year ordinary annuity
• Could solve by discounting each cash flow, or…
• Use the EAR and treat as an annuity to solve for PV.
INPUTS 3 10.25 100 0
N I/YR PV PMT FV
OUTPUT -247.59
47
Loan amortization
分期BA
到
• Amortization tables are widely used for home
mortgages, auto loans, business loans, retirement
plans, etc.
• Financial calculators and spreadsheets are great for

setting up amortization tables.
EXAMPLE: Construct an amortization schedule for a
$1,000, 10% annual rate loan with 3 equal
payments.
48
Step 1:
Find the required annual payment
• All input information is already given, just
remember that the FV = 0 because the reason for
amortizing the loan and making payments is to
retire the loan.
INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11
49
Step 2:
Find the interest paid in year 1
• The borrower will owe interest upon the initial
balance at the end of the first year. Interest to be
paid in the first year can be found by multiplying
the beginning balance by the interest rate.
INTt = Beg balt(I)
INT1 = $1,000(0.10) = $100
50
Step 3:
Find the principal repaid in year 1
• If a payment of $402.11 was made at the end of the
first year and $100 was paid toward interest, the
remaining value must represent the amount of
principal repaid.
PRIN = PMT – INT
= $402.11 – $100 = $302.11
51
Step 4:
Find the ending balance after year 1
• To find the balance at the end of the period,
subtract the amount paid toward principal from the
beginning balance.
END BAL = BEG BAL – PRIN
= $1,000 – $302.11
= $697.89
52
Constructing an amortization table:
Repeat steps 1-4 until the end of loan
YEAR BEG BAL PMT INT PRIN END BAL
1 $1,000 $ 402 $100 $ 302 $698
2 698 402 70 332 366
3 366 402 36 366 0
TOTAL – $1,206 $206 $1,000 –
• Interest paid declines with each payment as the
balance declines.
53
Illustrating an amortized payment:
Where does the money go?
402.11
Interest
302.11
Principal Payments
0 1 2 3
• Constant payments
• Declining interest payments
• Declining balance
54
Class Exercise 3
While Mary Corens was a student at the University
of Tennessee, she borrowed $12,000 in student
loans at an annual rate of 9%. If Mary repays
$1,500 per year, how long, to the nearest year, will
it take her to repay the loan?
55
Class Exercise 4
IAMORTET
btmtvg
a. Set up an amortization schedule for a $25,000 loan to be
repaid in equal installments at the end of each of the next 5
years. The interest rate is 10%.
b. How large must each annual payment be if the loan is for
$50,000? Assume that the interest rate remains at 10% and the
loan is paid off over 5 years.
c. How large must each payment be if the loan is for $50,000, the
interest rate is 10%, and the loan is paid off in equal
installments at the end of each of the next 10 years? This loan
is for the same amount as the loan in part b, but the payments
are spread out over twice as many periods. Why are these
payments not half as large as the payments on the loan in part

b?
56

CITY UNIVERSITY OF HONG KONG
DEPARTMENT OF ACCOUNTANCY
Time Value of Money – Suggested Solutions
Question 1
a. With a financial calculator, simply enter the known values and then press the key for
the unknown. Enter: N = 10, I/YR = 10, PMT = -400, and FV = 0. PV = $2,457.83.
b. With a financial calculator, enter: N = 5, I/YR = 5, PMT = -200, and FV = 0. PV =

$865.90.
c. With a financial calculator, enter: N = 5, I/YR = 0, PMT = -400, and FV = 0. PV =

$2,000.00, or simply, 5x$400 = $2,000.
d. PV of annuity due = PV of ordinary annuity x (1 + i)
(1) PV = $2,457.83 x 1.10 = $2,703.61.
(2) PV = $865.90 x 1.05 = $909.20.
(3) PV = $2,000.00 x 1.00 = $2,000.00.
Question 2
PV = $100/0.07 = $1,428.57. PV = $100/0.14 = $714.29.
When the interest rate is doubled, the PV of the perpetuity is halved.
Question 3
With a calculator, enter I = 9%, PV = 12000, PMT = -1500, and FV = 0. Press N to get N =
14.77 15 years. Therefore, it will take approximately 15 years to pay back the loan.
Question 4
a. With a financial calculator, enter N = 5, I = 10%, PV = -25000, and FV = 0, and then

press the PMT key to get PMT = $6,594.94.
Repayment Remaining
Year Payment Interest of Principal Balance
1 $ 6,594.94 $2,500.00 $4,094.94 $20,905.06
2 6,594.94 2,090.51 4,504.43 16,400.63
3 6,594.94 1,640.06 4,954.88 11,445.75
4 6,594.94 1,144.58 5,450.36 5,995.39
5 6,594.93* 599.54 5,995.39 0
$32,974.69 $7,974.69 $25,000.00
*The last payment must be smaller to force the ending balance to zero.
b. Here the loan size is doubled, so the payments also double in size to $13,189.87.
c. The annual payment on a $50,000, 10-year loan at 10 percent interest would be

$8,137.27. Because the payments are spread out over a longer time period, more
interest must be paid on the loan, which raises the amount of each payment. The total
interest paid on the 10-year loan is $31,372.70 versus interest of $15,949.35 on the
5-year loan.

Introduction To Financial Management: Topic 1

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Introduction To Financial Management: Topic 1

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Topic 1

Introduction to Financial Management

Forms of Business Organization

Balancing Shareholder Value and Society Interests

Intrinsic Values, Stock Prices, and Managerial Incentives

Important Business Trends

Conflicts Between Managers, Stockholders, and Bondholders

Financial Markets and Capital Allocation

Stock Market Efficiency

AC6531 Financial Management City University of Hong Kong

Finance within an organization

Chief Executive Officer (CEO)

Chief Operating Officer (COO) Chief Financial Officer (CFO)

Accounting, finance, credit policy,

and other operating departments

AC6531 Financial Management City University of Hong Kong

Forms of business organization

AC6531 Financial Management City University of Hong Kong

Proprietorships and Partnerships

– Easy and inexpensive to form

– Subject to fewer regulations

– No corporate income taxes

– Difficult to raise capital

AC6531 Financial Management City University of Hong Kong

– Easy transfer of ownership

– Easy to raise capital

– Cost of setup and report filing

AC6531 Financial Management City University of Hong Kong

Which of the following could explain why a business might choose to

operate as a corporation rather than as a proprietorship or a

a. Corporations generally face fewer regulations.

b. Less of a corporation’s income is generally subject to federal taxes.

c. Corporate shareholders are exposed to unlimited liability, but his

factor is offset by the tax advantages of incorporation.

d. Corporate investors are exposed to unlimited liability.

e. Corporations generally find it easier to raise large amounts of

AC6531 Financial Management City University of Hong Kong

Balancing shareholder value and society interests

• The primary financial goal of management is

to maximizing stock price.

– Value of any asset is the present value of cash flow

– Most significant decisions are evaluated in terms of

– Stock prices change over time as conditions change and

• Managers recognize that being socially responsible

AC6531 Financial Management City University of Hong Kong

Stock prices and intrinsic value

• In equilibrium, a stock’s price should equal its

• Intrinsic value is a long-run concept.

• To the extent that investor perceptions are

incorrect, a stock’s price in the short run may

deviate from its intrinsic value.

• Ideally, managers should avoid actions that reduce

intrinsic value, even if those decisions increase the

stock price in the short run.

AC6531 Financial Management City University of Hong Kong

Determinants of intrinsic values and stock prices

Managerial Actions, the Economic Environment,

Taxes, and the Political Climate

“True” Investor “Perceived” Investor “Perceived”

Cash Flows Risk

Intrinsic Value Market Price

Market Equilibrium: Long1

Intrinsic Value = Stock Price 到