What is Corporate

Finance about?
Slide nr.2
Scope of this Course
Corporate finance or financial management
How are financial decisions made by corporations?
Objective: Shareholder value maximization
Two broad financial questions:
What investments should the firm make?
= spending money
Calculating cash flows
Criteria such as NPV
How should it pay for those investments?
= raising money
Equity
Debt
Capital Budgeting Decision
Financing Decision
Slide nr.3
Brealey, Myers, Marcus Fundamentals of Corporate Finance, 6
th
ed
Course Content Part 1
The Corporation and the Institutional framework (Self study)
Ch.1 (Goals and governance of the firm)
Ch.2 (Financial markets and institutions)
Ch.3 (Accounting and Finance)
Ch.4 (Measuring Corporate Performance)
Valuation of Financial Assets
Ch.5 (The Time Value of Money)
Ch.6 (Valuing Bonds)
Ch.7 (Valuing Stocks)
Ch.23 (Options)
Risk and Return
Ch.11 (Introduction to Risk, Return, and the opportunity cost of capital)
Ch.12 (Risk, Return, and Capital Budgeting)
Slide nr.4
Part 2 Activities of Financial Manager
Financing Decision and Capital Structure
Ch.14 (Introduction to Corporate Financing)
Ch.16 (Debt Policy and Capital Structure)
Financial Planning
Ch.18 (Long-term Financial Planning)
Ch.19(Short-term Financial Planning)
Capital Budgeting Decision
Ch.8 (Net Present Value and Other Investment Criteria)
Ch.9 (Using Discounted Cash-Flow Analysis to Make Investment Decisions)
Ch. 12.3 (Capital Budgeting and Project Risk)
Ch. 13 (The Weighted Average Cost of Capital)
Slide nr.5
Requirements of Corporate Finance
Effort requirements: tutorial attendance and 6 out of 8 weeks of tutorial
exercises marked sufficient
No tutorial on Friday 3rd June 2011 (compulsory day off)
Prepare tutorial exercises for first tutorial on Friday 29 April 2011
Mondays time slot of 9.00-10.45 : Q&A session
Guest lectures: attendance req. + question on final exam
Practical assignment: 30% of final grade
Midterm exam (35%) and Final exam (35%)
See Course manual, Tutorial exercises, Practical assignment guideline
and other material on WebCT
Course repeaters:
Midterm exam (40%) and Final exam (60%)
Ch. 1-4 Self study
Ch. 5: The Time Value of Money
Slide nr.7
What is the time value of money?
Do you prefer to receive EUR1,000 today or in one
year from now?
The concept of the time value of money lies upon the
premise that an investor prefers to receive a payment
of a fixed amount of money today, rather than an
equal amount in the future, all else being equal.
Slide nr.8
Topics Covered
Simple and compound interest rates
Calculating Future Values
Calculating Present Values
Perpetuities and Annuities
Slide nr.9
Future Value Simple interest
Example
Interest earned at a rate of 6% for five years on a principal
balance of EUR 100.
Interest Earned Per Year = 100 x .06 = 6
Future Value - Amount to which an investment will
grow after earning interest
Simple Interest - Interest earned only on the
original investment
Slide nr.10
Future Value Simple interest
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130
Value at the end of Year 5 = EUR 130
Example
Interest earned at a rate of 6% for five years
on a principal balance of EUR 100.
Today Future Years
1 2 3 4 5
Slide nr.11
Future Value Simple interest
Future Value of EUR 100 = FV
( ) r t FV + = 1 100
E.g. What is the future value of EUR 150 if the
annual simple interest is 8% for the next 4 years?
Solution: FV = 150 x [1+(0.08 x 4) ] = 198
Slide nr.12
Future Value Compound interest
Compound Interest - Interest earned on interest
Example
Interest earned at a rate of 6% for five years on the previous
years balance.
Interest Earned Per Year = Prior Year Balance x .06
Slide nr.13
Future Value Compound interest
Example (cont.)
0 1 2 3 4 5
Interest
earned
6.00
Value
100 106.00
Slide nr.14
Future Value Compound interest
Example (cont.)
0 1 2 3 4 5
Interest
earned
6.00 6.36
Value
100 106.00 112.36
Slide nr.15
Future Value Compound interest
Example (cont.)
0 1 2 3 4 5
Interest
earned
6.00 6.36 6.74 7.15 7.57
Value
100 106.00 112.36 119.10 126.25 133.82
Value at the end of Year 5 = EUR 133.82
Compare to EUR 130 in case of simple interest
Slide nr.16
Future Value Compound interest
Example (cont.)
1
st
year 100x1.06 =106
2
nd
year (100x1.06)x1.06 =100x1.06
2
3
rd
year
.
.
.
(100x1.06
2
)x1.06
.
.
.
=100x1.06
3
.
.
.
5
th
year

=100x1.06
5
Slide nr.17
Future Value Compound interest
Future Value of EUR 100 = FV
t
r FV ) 1 ( 100 + =
07 . 204 ) 08 . 1 ( 150
4
= + = FV
E.g. What is the future value of EUR 150 if
interest is compounded annually at a rate of 8%
for 4 years?
Slide nr.18
0
1000
2000
3000
4000
5000
6000
7000
0 2 4 6 8
1
0
1
2
1
4
1
6
1
8
2
0
2
2
2
4
2
6
2
8
3
0
Number of Years
F
V

o
f

$
1
0
0 0%
5%
10%
15%
Future Values with Compounding
Interest Rates
Future Value with Compounding
Extensions to Basic Model
Slide nr.20
Extension 1
Suppose the investment period does not correspond
with a calendar year
E.g. What is the FV of EUR 100,000 invested at a
compound interest of 5% over a period of 7 years
and 3 months
Solution: express in fractions of years
t = 7.25
Answer: 100,000 (1.05)
7.25
= 142,437 EUR
Slide nr.21
Extension 2
Suppose you deposit 1,000 in a bank account that
pays 5% per year
At the end of the year you have 1,000(1.05) or 1,050
on your account
Suppose now that instead the bank makes semi-
annual payments at 5% per year or equivalently 2.5%
semi-annually.
Slide nr.22
Extension 2 (cont.)
After six months, youll have 1,025
On this amount, youll earn another six months
interest
After one year, youll have 1,050.625, or
FV = (1,000 x 1.025) x 1.025 = 1025 x 1.025
= 1,000 x (1+ (0.05/2) )
2
= 1,050.625
Slide nr.23
Extension 2 (cont.)
Problem of interest payments on a semi-annual,
quarterly, monthly, weekly or daily basis instead of an
annual basis
If you get paid interest at an annual rate 5% m times
per year, your account balance at the end of the year will
be:
m
m
Value Future
|
.
|

\
|
+ =
05 . 0
1 000 , 1
Slide nr.24
Extension 2 (cont.)
E.g. What is the FV of EUR 1,000 invested for 6 years
at an interest rate of 5% per year compounded on a
semi-annual basis?
n m
m
m j
FV

|
.
|

\
|
+ =
) (
1 1000 $
With j(m) = annual interest rate, compounded m times
per year = 5%; j(m)/m = 2.5%;
n = 6 and m = 2
Answer: 100 x (1.025)
12
= 134.49 EUR
Slide nr.25
Extension 2 (cont.)
What is the equivalent annually compounded interest
rate, i (effective annual interest rate)?
j(m): annual percentage rate (APR) compounded m
times per year
j(m)/m: periodical interest rate
Example: 1 + i = (1 + monthly interest rate)
12
m
m
m j
i
|
.
|

\
|
+ = +
) (
1 1
i = 6.5%
Slide nr.26
Impact of frequency of interest payment
Frequency m FV Effective annual
interest rate
Yearly 1 1050.00 5.000%
Semi-annual 2 1050.63 5.063%
Quarterly 4 1050.95 5.095%
Monthly 12 1051.16 5.116%
Weekly 52 1051.25 5.125%
Daily 365 1051.27 5.127%
Investment of EUR 1,000 during 1 year at 5%
Slide nr.27
Extension 3
Frequency m FV
Yearly 1 1050.00
Semi-annual 2 1050.63
Quarterly 4 1050.95
Monthly 12 1051.16
Weekly 52 1051.25
Daily 365 1051.27
Continuous 1051.27
Slide nr.28
Extension 3 (cont.)
Continuous interest rate (r
c
)
E.g. Assuming a continuous interest rate of 5%, an
amount of 1,000 EUR will increase
after 1 year to 1,000 e
0.05x1
or 1,051.27 EUR
after 5 years to 1,000 e
0.05x5
or 1284.03 EUR
c
r
m
m
e
m
m j
=
|
.
|

\
|
+

) (
1 lim
Slide nr.29
Extension 3 (cont.)
Suppose the yearly effective interest rate is 10%.
Question: what is the continuous interest rate?
Solution:
t r t
c
e i

= + ) 1 (
c
r i t = + = ) 1 ln( 1
If i = 10%, then r
c
= ln (1.10) = 9.53%
Slide nr.30
Calculating present values
You just bought a new computer for EUR 3,000. You
have to pay this amount only after two years. If you can
earn 8% on your money, how much money should you set
aside today in order to make the payment when due in
two years?
( )
572 , 2 $
08 . 1
3000
2
= = PV
(1 )
(1 )
t
t
FV
FV PV r PV
r
= + =
+
Slide nr.31
Present Values
Discount Factor (DF) = PV of EUR 1
DF
r
t
=
+
1
1 ( )
Tables: see Appendix Table A-2
DF(8%,2y) = 0.8573
PV = 3,000 x DF = 3,000 x 0.8573 = 2,572
Slide nr.32
Example 1
Your auto dealer gives you the choice to pay $15,500
cash now, or make three payments: $8,000 now and
$4,000 at the end of each of the following two years. If
your cost of money is 8%, which one would you prefer?
$15,133.06 PV Total
36 . 429 , 3
70 . 703 , 3
8,000.00
2
1
) 08 . 1 (
000 , 4
2
) 08 . 1 (
000 , 4
1
payment Immediate
=
= =
= =
+
+
PV
PV
Slide nr.33
PV of Multiple Cash Flows
PVs can be added together to evaluate multiple cash
flows.
PV
C
r
C
r
= + +
+ +
1
1
2
2
1 1 ( ) ( )
....
Slide nr.34
Perpetuities & Annuities
Annuity = stream of fixed cash flows (equally spaced)
for a limited period of time.
If the payment stream lasts forever it is called a
perpetuity.
Slide nr.35
Perpetuities
PV of Perpetuity Formula
with:
C = fixed cash payment
r = discount rate
r
C
PV =
Slide nr.36
Extension 4
Suppose that the cash flow grows yearly at a
constant rate g:
with:
C
1
= cash payment in year 1
r = discount rate
g = growth rate
g r
C
PV

=
1
Slide nr.37
Annuities
PV of Annuity Formula
with:
C = fixed cash payment
r = interest rate
t = Number of years cash payment is received
| |
PV C
r
r r
t
=
+
1 1
1 ( )
Slide nr.38
Perpetuity A
(start year 1)
Perpetuity B
(start year t+1)
Annuity
(year 1 to t)
1 2 t t+1
( ) ( )
(

+
=
+
=
=
t t
r r
r
C
r
r
C
r
C
B Perp PV A Perp PV Ann PV
1
1 1
1
1
) . ( ) . ( ) (
Annuities
Slide nr.39
Appendix Table A-3:
Present value of AF(10%, 3y) = 2.4869
PV (Ann)= 100,000 x 2.4869 or 248,690
Annuity Factor (AF) = the present value of EUR 1 a
year for each of t years.
Annuities
( )
(

+
=
t
r r
r
AF
1
1 1
Slide nr.40
Example 2
You are purchasing a car. You are scheduled to
make 3 annual installments of EUR 4,000 per year.
Given a rate of interest of 10%, what is the price you
are paying for the car (i.e. what is the PV)?
41 . 947 , 9 = PV
( )
(

=
3
10 . 1 10 . 0
1
10 . 0
1
000 , 4 PV
Slide nr.41
Future Value of an Annuity
FV of annuity of EUR 1 a year = PV of annuity x (1+r)
t
1 1 (1 ) 1
(1 )
(1 )
t
t
t
r
FV r
r r r r
( +
= + =
(
+

Slide nr.42
Example 3
You plan to save $4,000 every year for 20 years and
then retire. Given a 10% rate of interest, what will be the
FV of your retirement account?
20
1 1
0.10
0.10(1 0.10)
4, 000
$34, 054.25
PV
PV
+
(
=

=
Slide nr.43
Real interest rate vs nominal interest rate
Inflation = an overall general rise in prices
Inflation is measured using price indexes, such as
consumer price index CPI
The real interest rate = (1 + nominal interest rate)/(1+
inflation rate)