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Lecture 1

Lecture 1. Managerial Finance FINA 6335 Ronald F. Singer. Finance. The study of resource allocation under conditions of uncertainty. Merges: Economics. Accounting. Statistics. Areas. Corporate Finance From the viewpoint of the Financial Manager Capital Budgeting Dividend Policy

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Lecture 1

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  1. Lecture 1 Managerial Finance FINA 6335 Ronald F. Singer

  2. Finance • The study of resource allocation under conditions of uncertainty. • Merges: • Economics. • Accounting. • Statistics.

  3. Areas • Corporate Finance From the viewpoint of the Financial Manager • Capital Budgeting • Dividend Policy • Capital Structure • Investments From the viewpoint of individual and institutional investors • Risk • Return • Portfolio Decisions

  4. Types of Financial Securities • Equity Capital • Common Stock • PreferredStock • Debt Capital • Bonds • Hybrid Securities • Why hold Securities?

  5. The Rewards and Risks to Security Holders • The Rewards • To Stockholders • To Bondholders • The Risks: • To Stockholders • To Bondholders

  6. The Goal of Financial Management • What should be the goal? • Possible measures of performance of financial managers • How do managers achieve their objectives? Make Decisions that

  7. Investment • The Problem How can we determine if a project will make stockholders’ better or worse off??? • What is an Investment? Current Cash Expenditures which are expected to generate cash inflows sometime in the future

  8. How to Make a Decision? Inflow Benefits vs. Costs Complications Uncertainty Future Flows

  9. Digression on Conventions of Time Cash Inflows Cash Outflows

  10. Example • For current Investment of $10,000, receive $5,000 within 1 year, $6,000 in years 3 through 5. 5000 6000 6000 6000. 0. 1 2 3 4 5 10000. • Observations: • t = 0 current time. • Everything happens at the end of a period unless specified otherwise.

  11. Using Market Prices to Determine Cash Values • Suppose a jewelry manufacturer has the opportunity to trade 10 ounces of platinum and receive 20 ounces of gold today. To compare the costs and benefits, we first need to convert them to a common unit.

  12. Using Market Prices to Determine Cash Values (cont'd) • Suppose gold can be bought and sold for a current market price of $250 per ounce. Then the 20 ounces of gold we receive has a cash value of: • (20 ounces of gold) ($250/ounce) = $5000 today

  13. Using Market Prices to Determine Cash Values (cont'd) • Similarly, if the current market price for platinum is $550 per ounce, then the 10 ounces of platinum we give up has a cash value of: • (10 ounces of platinum) ($550/ounce) = $5500

  14. Using Market Prices to Determine Cash Values (cont'd) • Therefore, the jeweler’s opportunity has a benefit of $5000 today and a cost of $5500 today. In this case, the net value of the project today is: • $5000 – $5500 = –$500 • Because it is negative, the costs exceed the benefits and the jeweler should reject the trade.

  15. Example 3.1

  16. Example 3.1 (cont'd)

  17. Example 3.2

  18. Example 3.2 (cont'd)

  19. Present Value • The present valueof receiving $1,000, one year from today? $1000 0 1 It is : What $1000 received one year from today is worth today.

  20. Present Value • Present Value is: • How much someone would lend me on that claim • How much I could sell the claim for • How much it would cost to engage in a "similar" investment • What is the Answer? • In order to answer that question we have to know what “interest rate” is assumed. • Assume that the interest rate is 25%? • Thus, you pay $200 interest to borrow $800 now

  21. The Market Rate of Interest • In this case, the initial amount is also the present value • OR

  22. 1/1+R is called the Discount Factor • Present Value = Future amount x Discount Factor • If R is 25 % Discount Factor is and PV (1,000; 25%; 1 yr) = 1 [1000] 1.25 = 0.80 [1000] = 800

  23. 3.2 Interest Rates and the Time Value of Money • Time Value of Money • Consider an investment opportunity with the following certain cash flows. • Cost: $100,000 today • Benefit: $105,000 in one year • The difference in value between money today and money in the future is due to the time value of money.

  24. The Interest Rate: An Exchange Rate Across Time • Suppose the current annual interest rate is 7%. By investing or borrowing at this rate, we can exchange $1.07 in one year for each $1 today. • Is the above investment worthwhile? • What is $105,000 worth today (i.e. its Present Value)? • It is Worth $105,000 divided by 1.07 = $98,130.84 • So is it worth giving up $100,000 to receive the equivalent of $98,130.84 today?

  25. Example 3.4 • Problem • The cost of replacing a fleet of company trucks with more energy efficient vehicles was $100 million in 2007. • The cost is estimated to rise by 8.5% in 2008. • If the interest rate were 4%, what was the cost of a delay in terms of dollars in 2007?

  26. Example 3.4 • Solution • If the project were delayed, it’s cost in 2008 would be: • $100 million × (1.085) = $108.5 million • Compare this amount to the cost of $100 million in 2007 using the interest rate of 4%: • $108.5 million ÷ 1.04 = $104.33 million in 2007 dollars. • The cost of a delay of one year would be: • $104.33 million – $100 million = $4.33 million in 2007 dollars.

  27. Future Value versus Present Value • We compared the cost of replacing the fleet today with the Present Value of replacing it in the future. • Alternatively we could find the Future Value of replacing it today, compared with the value of replacing it in the future. • Thus, the Future Value of replacing it today is: $100 million times (1.04) = $104 million • Comparing that with the actual cost of replacing it one year in the future gives a benefit of • The benefit in future value terms is thus: $108.5 million - $104 million or $4.5 million Note that in present value terms the present value of $4.5 million is: $4.5 million divided by 1.04 or $4.33 million!!!

  28. Figure 3.1 Converting Between Dollars Today and Gold, Euros, or Dollars in the Future

  29. 3.3 Present Value and the NPV Decision Rule • The net present value (NPV) of a project or investment is the difference between the present value of its benefits and the present value of its costs. • Net Present Value

  30. The NPV Decision Rule (cont'd) • Accepting or Rejecting a Project • Accept those projects with positive NPV because accepting them is equivalent to receiving their NPV in cash today. • Reject those projects with negative NPV because accepting them would reduce the wealth of investors.

  31. Example 3.5

  32. Example 3.5 (cont'd)

  33. Choosing Among Projects

  34. Choosing Among Projects (cont'd) • All three projects have positive NPV, and we would accept all three if possible. • If we must choose only one project, Project B has the highest NPV and therefore is the best choice.

  35. NPV and Individual Preferences • Although Project B has the highest NPV, what if we do not want to spend the $20 for the cash outlay? Would Project A be a better choice? Should this affect our choice of projects? • NO! As long as we are able to borrow and lend at the risk-free interest rate, Project B is superior whatever our preferences regarding the timing of the cash flows.

  36. NPV and Individual Preferences (cont'd)

  37. NPV and Individual Preferences (cont'd) • Regardless of our preferences for cash today versus cash in the future, we should always maximize NPV first. We can then borrow or lend to shift cash flows through time and find our most preferred pattern of cash flows.

  38. Wealth • Wealth is the present value of all Current and Future income. • Suppose that an individual has $1,000 in his/her pocket and has a claim on $1,000 one year from now. What is his wealth if the interest rate is 20%? $1,000 in his/her pocket is worth $1,000. $1,000 one year from now is worth $833.33 = 1,000/(1 +R) = 1000/(1.20)  Therefore, his/her Wealth is $1,833.33. • You have to convert all future income to Present Values before you can add them up

  39. Market Opportunity Line • The Market Opportunity Line shows how an individual can exchange current for future consumption. 2250 2200 1625 1000 375 500 1000 1833 • Possible Alternatives

  40. Wealth and the NPV of a Project • Now suppose the investor has the opportunity to invest in only one of the three projects: Project A 2320 2292 2200 1625 1000 375 500 1000 1833 1910 1933

  41. Wealth and the NPV of a Project • Now suppose the investor has the opportunity to invest in only one of the three projects: Project B 2320 2292 2200 1625 1000 375 500 1000 1833 1910 1933

  42. Market Opportunity Line • Notice that this individual's wealth is indicated by the horizontal intercept. • The Wealth is the maximum an individual can consume today by borrowing against all of his/her future income

  43. Market Opportunity Line • The slope of the market opportunity line is: - (1 + R) • Slope = Rise/Run = (Principal + Interest) - Principal = -( 1 + Interest ) Principal = -(1 + R) • If you give up $500 now, you can get: 500 X (1 + R) = 500(1.20) = $600 more next year. • If you want to get $800 more now, you must give up: 800 X (1.20) or $960 next year

  44. Bottom Line 1.Wealth is the PRESENT VALUE of income stream 2. All individuals are unambiguously better off when their wealth increases. 3. The net present value of an investment project is the amount investors' wealth would increase (decrease) if the project were undertaken.

  45. Lecture 2 Managerial Finance FINA 6335 Ronald F. Singer

  46. 3.4 Arbitrage and the Law of One Price • Arbitrage • The practice of buying and selling equivalent goods in different markets to take advantage of a price difference. An arbitrage opportunity occurs when it is possible to make a profit without taking any risk or making any investment. • Normal Market • A competitive market in which there are no arbitrage opportunities.

  47. 3.4 Arbitrage and the Law of One Price (cont'd) • Law of One Price • If equivalent investment opportunities trade simultaneously in different competitive markets, then they must trade for the same price in both markets.

  48. 3.5 No-Arbitrage and Security Prices • Valuing a Security • Assume a security promises a risk-free payment of $1000 in one year. If the risk-free interest rate is 5%, what can we conclude about the price of this bond in a normal market? • Price(Bond) = $952.38

  49. 3.5 No-Arbitrage and Security Prices (cont'd) • Valuing a Security (cont’d) • What if the price of the bond is not $952.38? • Assume the price is $940. • The opportunity for arbitrage will force the price of the bond to rise until it is equal to $952.38.

  50. 3.5 No-Arbitrage and Security Prices (cont'd) • Valuing a Security (cont’d) • What if the price of the bond is not $952.38? • Assume the price is $960. • The opportunity for arbitrage will force the price of the bond to fall until it is equal to $952.38.

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