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Financial Management Lecture 01 Shama-e Zaheer Firm Objectives: 1.

Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners funds (equity) or borrowed money (debt) Returns on projects should be measured based on cashflows generated and the timing of these cashflows; they should also consider both positive and negative side effects of these projects. 2. Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. 3. If there are not enough investments that earn the hurdle rate, return the cash to stockholders. The form of returns - dividends or stock buybacks - will depend upon the stockholders characteristics. Overall Objective: Maximize the Value of the Firm / Shareholder Wealth The Time Value of Money Compensation required for 3 things: 1. Time: Time preference of consumption, compensated by pure rate of interest 2. Inflation: Loss of purchasing power, compensated by risk-free rate of interest (includes pure rate of interest) 3. Risk: Risks inherent in investment compensated by risk premium added to risk-free rate of interest i. Default Risk ii. Liquidity Risk iii. Maturity Risk Thus: Required Rate of Return = RFR + Risk Premium = [(1 + pure rate of interest) x (1 + expected rate of inflation) -1] + RP The required premium is set by the opportunity cost of investing in an asset of similar risk.

PV = CF/(1+r)t PV = CF/r PV = CF/(r-g) PV = (CF/r)*[1-{1/(1+r)t}] Tuff Choices Ltd.

Where, r = required rate of return, t = time period for a perpetuity for a growing perpetuity for an annuity

You are the Manager, Finance for Tuff Choices Ltd. The fully equity-financed listed company is valued at Tk.100m, given the 15% rate of return expected of shares of the same risk-class as the company. The shareholders of the company have the option of buying govt. treasury securities at a 12% rate of return. The firm is contemplating deciding on the fate of a two-acre site where the firms first factory stood ten years ago, and now the site is derelict. Recently, three studies were commissioned for Tk.50,000, Tk.100,000 and Tk.150,000 respectively to estimate the market price for the piece of land and cost of cleanup, to evaluate the potential of an office rental building construction, and to appraise the opportunities of setting up a new factory. The following three proposals were prepared. Proposal 1: Clean Up & Sell Although the current market value of the piece of land is Tk.6m, spending Tk.5m on cleanup now, will enable the firm to sell the piece of land for Tk.12m in one year. Proposal 2: Build an Office Complex Alternately, the firm can spend the Tk.5m for clean-up now, spend Tk.4m next year and Tk.10m the year after that building an office complex. 1/4th of the offices can be rented at the beginning of the 4th year, 1/2 of the offices by the 5th year and all of the offices by the 6th year (at a yearly rental income of Tk.4m per year). Finally, after one year, the office complex can be sold for Tk.40m. Proposal 3: Setup a New Factory Finally, the firm can spend Tk.5m for clean-up now, spend Tk.10m building a factory over a year. The factory will produce GreaseOut, a household cleaning product, the production, distribution, sales and marketing of which will break-even in the next year, before earning Tk.5m net income from the second year of production till infinity. Q1. How old is the Finance Manager? Q2. Which of the proposals should the firm choose?