Business Finance BFM205 Session 1: Introduction

Module Introduction
Carmel de Nahlik:

Email: i.cornelius@aston.ac.uk Assessment: 2 hour closed book exam (you will be provided with a calculator, a formulae sheet and present value tables) Answer 1 question from Part A (written) (40%); Answer 1 question from Part B (numerical) (40%) ; Complete a multiple choice section (20%)

How to pass this course

In order to pass this course you will need to: Read the book chapters before you come to class and come prepared Take notes in lectures to ensure that learning is embedded Complete the tutorial exercises during the week that we look at that topic and take good and tidy notes Read around the subject in the FT and watch the news.

Module Content
1. 2. 3. 4. 5. 6. Introduction to Financial Management Valuing Shares and Debt Investment Appraisal (1): Appraisal Methods Investment Appraisal (2): Further Aspects Risk and Return The Capital Asset Pricing Model and the Cost of Capital 7. Alternative Sources of Finance 8. Debt and Dividend Policy

Session 1: Agenda

What is financial management?

The objective of the firm and agency problems The time value of money

Session 1: Objectives
At the end of this session you should be able to: explain the role of the financial manager explain the major decisions that financial managers make discuss and contrast alternative objectives of the firm discuss agency problems and potential remedies identify and describe the role of financial markets and financial intermediaries (from background reading) explain the time value of money concept calculate present and future values of streams of cash flows

Session 1 Agenda

What is financial management? The objective of the firm and agency problems The time value of money

What is Financial Management?

Finance monetary resources or funds sources and uses of funds Financial management decisions made with regard to funds: investment decisions: identifying investment opportunities and deciding how much to invest financing decisions: identifying the form and amount of financing needed to fund the organisations activities
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The Role of the Financial Manager

Three Fundamental Decisions in Financial Management
The capital budgeting decision: Which

productive assets should the firm buy?

A good capital budgeting decision is one in

which the benefits are worth more for the firm than the cost of the assets.
The financing decision: How should the firm

finance or pay for assets?

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The Role of the Financial Manager

Three Fundamental Decisions in Financial Management
Financing decisions involve trade-offs

between advantages and disadvantages of debt and equity financing.

Working capital management decisions:

How should day-to-day financial matters be managed?

The mismanagement of working capital can

cause the firm to go into bankruptcy even though the firm is profitable.
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Session 1 Agenda
What is financial management?

The objective of the firm and agency problems

The time value of money

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MPK Exhibit 1.4: Major Factors Affecting Share Prices

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The Objective of the Firm

Financial Management assumes that the firm exists to maximise shareholder wealth
How is shareholder wealth measured? Share price Total shareholder return reflects both capital gains and dividends Economic value present value of future free cash flows less value of debt
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Total Shareholder Returns: Activity

Total shareholder returns (TSR) are calculated as follows: TSR = P1 - P0 + dps P0 Where: P1 = share price at end of year P0 = share price at beginning of year dps = dividend per share in the year .

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Pearson TSR 2012

45.0p

1210.0p

1188.0p

45.0 (1188.0 1210.0) TSR 1.9% 1210.0

Pearson TSR performance benchmarked

Profit is an Unreliable Guide to Shareholder Wealth

accounting profit is a short-term measure:
shareholder wealth could be reduced by companies increasing short-term profits through cutting back on maintenance, training, marketing

accounting profit does not reflect the shareholders required rate of return:
profits could be increased by cutting dividends and investing in opportunities that deliver a poor rate of return

accounting profit is open to manipulation:

alternative accounting treatments and judgements can be applied
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The Agency Problem

Principal (Shareholders)

Agent (Managers)
Managers are employed to run the company on behalf of shareholders. The shareholders must find ways to ensure that managers are acting in their (shareholders) best interests.
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Agency Problems
For larger companies, shareholders are not likely to be the managers of the business There is a separation of ownership and control: owners (the principal) appoint managers (agents) to carry out the management of the firm on their behalf Leads to two potential agency problems:
Potential conflict of interests: shareholders and managers may have different goals Information asymmetry: shareholders do not have access to the same information that is available to managers
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Session 1 Agenda
What is financial management?

The objective of the firm and agency problems

The time value of money

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The Time Value of Money

The value of money changes through time:

This means that 1 today is worth more than 1 in the future Therefore money from different times should not be compared or added

The time value of money has 3 components:

Inflation: goods cost more in the future, so more money is required Time: the impatience to consume Risk: the return is in the future and therefore subject to a degree of variability

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Future Values
The future value of an investment earning annual compound interest:

FV = PV x (1 + r)t
Where: FV = future value r = the interest rate PV = present value t = number of years of the investment

Example: What is the future value of 100 invested for 3 years at 5%? FV = 100 x 1.05 3 = 115.76

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Present Values
The present value of a future cash value:

PV = FV x 1 / (1 + r)t
Where: FV = future value r = the interest rate PV = present value t = number of years of the investment

Example: What is the present value of 115.76 arising in 3 years time using an interest rate of 5% pa? PV = 115.76 x 1 / 1.05 3 = 100
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Present Values: Key Concepts

Present value The value today of a future cash flow. Discount factor Present value of a 1 future cash flow for a given discount rate Discount factor = 1 / (1 + r)t Discount rate The interest rate used to compute present values of future cash flows.
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Present Values: Activity

VP PLC have just made a major sale to a new customer worth 1,000,000. What is the present value of this sale if, as part of the deal you agreed that the customer could pay in: a) one year b) two years VP PLC have calculated that the appropriate discount rate is 9%.
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Present Values: Solution

a) PV = 1,000,000 x 1/(1 + 0.09)1 PV = 1,000,000 x 0.9174 = 917,400

b) PV = 1,000,000 x 1/(1 + 0.09)2 PV = 1,000,000 x 0.8417 = 841,700

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Perpetuities & Annuities

Perpetuity: A stream of annual cash flows of the same amount that continue indefinitely PVperpetuity = Cash flow Discount rate Annuity: A stream of annual cash flows of the same amount for a limited number of years
PVannuity = Cash flow x Annuity factor
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Perpetuities & Annuities: Activity

You have an received an endowment that will pay 20,000 per year: a) What is the present value of the endowment if it will continue to pay forever? b) What is the present value if the endowment is for 5 years? The appropriate discount rate is 10%.

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Perpetuities & Annuities: Solution

a) PV of perpetuity = 20,000 / 0.10 = 200,000 b) PV of annuity = 20,000 x 3.7908 = 75,816

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Perpetuities and Annuities: Further Aspects

The perpetuity and annuity valuation formulae assume the first cash flow of the series arises 1 year from now What if the first cash flow arises later? For example, returning to the previous activity, what if the first 20,000 cash flow of the perpetuity arises 2 years from now?
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Perpetuities and Annuities:Further Aspects

20k 20k 20k 20k 20k 20k 20k

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Perpetuities and Annuities: Further Aspects

200k

A perpetuity of 20k per annum with a discount rate of 10% with the first cash flow arising in 2 years time Is equivalent to a cash flow of 200k arising in 1 year. Therefore, PV = 200k x 1/1.10 = 181.8k
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Session 1: Objectives
At the end of this session you should be able to: explain the role of the financial manager explain the major decisions that financial managers make discuss and contrast alternative objectives of the firm discuss agency problems and potential remedies identify and describe the role of financial markets and financial intermediaries (background reading) explain the time value of money concept calculate present and future values of streams of cash flows

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