Management Notes > Finance (MG101) Notes

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MG101.1 FINANCE

Lecture 1: Introduction Part 1: What is Finance?

Finance is a subfield of economics (however different methodology), focusing on capital markets and how they work. Helps to evaluate uncertain cash flows and associated risk.

* Law of One Price: All assets and risk must be priced consistently so that assets with same risk yield same return

* Arbitrage: Undertaking financial transactions and obtaining a net profit without incurring any risk ---> only arises when Law of One Price does not hold

* Financial System: The set of markets and other institutions used for financial contracting and exchange of assets and risks (used when economic agents make decisions)

* Financial Decisions (Household/Firm)

- Consumption and saving decisions

- Investment decisions

- Financial decisions

- Risk management decisions

- Corporate finance and the financial manager

- Goal of financial management

- Financial markets and the corporation

- Corporate finance in actions

* Role of Financial Mangers

- Responsible for investment decisions

- Responsible for financing decisions

- Responsible for short-term financial planning

- Oversee accounting and audit function in firm

- Ensure financial welfare of firm

* 3 Types of Financial Decisions (1) Investment - Capital Budgeting

- Process of planning and managing a firm's long term investments

- Identify investment opportunities worth more to the firm than they cost to acquire

- Financial managers must be concerned not only with cash they expect to receive but always when they expect to receive it and how likely they are to receive it (2) Financing - Capital Structure

- Mixture of long-term debt (borrowing) and equity (owners' investment) maintained by a firm

- Financial managers must decided how and where to raise money - how much firms should borrow, what are the least expensive sources of funds for firms (3) Liquidity - Working Capital

- The management of a firm's short-term assets and liabilities

- Financial managers must decide how much cash and inventory should be kept on hand, whether goods should be sold on credit (and the associated conditions) and how to obtain short-term financing Goal of financial management is to maximise value of owner's equity

MG101.1 FINANCE

Lecture 1: Introduction Part 2: Financial Markets and the Corporation - The Financial System Financial decisions implemented through the financial system (both constrains and enables decision maker). Consists of the markets, intermediaries, services firm and others used to implement financial decisions of households, firms and governments through financial contracting and exchange of assets and risk.

* Financial Markets: Geography

- Some markets have defined geographic locations and trade on exchange (e.g. NYSE)

- Some financial instruments are traded OTC (e.g. between firm and bank)

- Some markets don't have central locations (e.g. currency markets, off-exchange markets ---> deals computerised or by telephone)

- Primary Markets: Securities sold to investors (first issue is IPO, second is seasoned offering), money raised goes to issuing firm

- Secondary Markets: Investors trade securities with each other, money raised goes to seller of securities

* Flow of Funds: Data that provides the consolidated picture of how money flows in the economy from net savers to net users

- Funds flow through financial system from a surplus unit to deficit unit (through financial intermediaries, through financial markets or directly)

- Units include households, firms, the government, foreign investors

- Intermediaries transfer surplus from households to businesses (e.g. banks transfer savings and use them to fund loans)

- Sometimes intermediaries themselves invest in the market ---> banks that borrow and invest in money markets can increase flexibility, reduce risks and turns profits

- Surplus funds always eventually consumed by deficit unit

- Securitisation: Banks that collect deposits/borrows from other banks, issues mortgages and then pools together mortgage contracts to construct new securities sold to institutional investors/investment banks

- Disintermediation: Sometimes surplus and deficit units contact directly due to unjustified transaction costs of using market

MG101.1 FINANCE

Lecture 2: Time Value of Money (1)

* Value of money changes over time as:

- Inflation makes tomorrow's money less valuable than today

- Money can be put in bank and receive interest

- Uncertainty of receiving tomorrow's money ---> risk

* Future Value: The amount an investment is worth after one or more periods

- Single Period: FV = PV(1+r)

- Multiple Periods: FV = PV(1+r)t

- Compounding: Process of accumulating interest on an investment over time to earn more interest

- Interest on Interest: Interest earned on reinvestment of previous interest payments

- Compound Interest: Interest earned on both initial principal and the interest reinvested from prior periods

- Simple Interest: Interest earned only on the original principal amounts invested

* Present Value: The current value of future cash flows discounted at appropriate discount rate

- PV = FVt / (1+r)t

- PV = FVt x (1+r)-t

* Discount Rate: The rate at which the investment is paying

- Single Period: r = FV/(PV - 1)

- Multiple Periods: r = t[?](FV/PV - 1

* Number of Periods

- n = [ln(FV) - ln(PV)]/ ln(1+r)

* Real and Nominal Interest Rates

- Nominal: Prices and rates expressed in terms of currency

- Real: Prices and rates expressed in terms of purchasing power

- Fisher Equation for Closed Economy: Real Rate = (Nominal - Inflation)/(1 + Inflation)

MG101.1 FINANCE

Lecture 3: Time Value of Money (2)

* Future Value with Multiple Cash Flows

- FVT = CF1(1+r)T-1 + CF2(1+r)T-2 + CF3(1+r)T-3 + CFt(1+r)T-t

* Present Value with Multiple Cash Flows

- PV0 = -CF0 + [CF1 / (1+r)] + [CF2 / (1+r)2] + [CF3 / (1+r)3] + [CFT / (1+r)T]

* Cash Flow Timing

- Implicitly assumed cash flows occur at end of each period (i.e. 31 December of relevant period)

- If occurs at beginning assume end of last period

- Unless explicitly stated otherwise always follow this assumption!!

* Valuing Level Cash Flows: Annuities and Perpetuities

- Annuities: A level stream of cash flows for a fixed period of time

- Perpetuity: A level stream of cash flows forever

[?]1

1 [?]

- Annuity PV:C [?] -

t [?] , C = constant value per period for t periods with interest r r(1+

r)

[?]

[?]

rate r

1 [?]

[?]1

- Annuity Factor: [?] -

t [?]

[?] r r(1+ r) [?]

- C = Annuity PV/ Annuity Factor

- Finding Number of Payments (t) (1) Find present value factor (Total Payment/Monthly Payments x Interest Rate) (2) Equate present value factor to 1/(1+r)t (3) t = ln(1/present value factor)/ ln(1+r)

[?] (1+ r)t 1 [?]

- [?]

- Future Value of Annuities = C [?]

r[?]

[?] r

- PV for Perpetuity: C/r

[?] [?] 1+ g [?] t [?]

[?] 1- [?][?]

[?] [?]

1+ r [?] [?]

- Growing Annuity PV: C [?]

[?] r-g [?]

[?]

[?]

[?]

[?]

- Growing Perpetuity PV:

C r-g

* Comparing Rates

- Nominal Interest Rate: The interest rate expressed in terms of the interest payment made it period

- Real Interest Rate: Purchasing power rate

rr = (r-i)/(1+i) where rr = real interest rate, r = nominal rate, i = rate of inflation

- Effective Annual Percentage Rate (EAR): Interest rate expressed as if it were compounded once per year

EAR = [1+(Quoted rate/m)]m - 1

- Annual Percentage Rate (APR): Yearly interest rate with yearly compounding includes total cost of borrowing ---> all costs not just interest payments

PV = C0 + SCi /(1+APR)i ---> use excel to solve

MG101.1 FINANCE

Lecture 4: Financial Decisions of Firm - Capital Budgeting (1) Investment Decision's Criteria

* Involves using discounted cash flow analysis to make decisions such as whether to enter new line of business, start producing a new product, invest in equipment to reduce costs

* Objective of firm to maximise shareholder's equity however other approaches consider other shareholders 1) Net Present Value: Difference between PV of future cash inflows and outflows

- NPV0 = -CF0 + [CF1 / (1+r)] + [CF2 / (1+r)2] + [CFT / (1+r)T]

- NPV Investment Rule: Accept project if NPV > 0, reject if NPV < 0, indifferent if NPV

= 0; if multiple projects accept one with highest NPV

- Discount rate considered opportunity cost of capital ---> require investment project to produce potential rate of return earned by investing in other project with similar risk

Uses all cash flows

Discounts cash flows ---> full incorporate time value of money

Represents additional value to shareholders 2) Internal Rate of Return: Discount rate in NPV formula that make the NPV = 0

- 0 = -CF0 + [CF1 / (1+IRR)] + [CF2 / (1+IRR)2] + [CFT / (1+IRR)T] not required to calculate in exam although may need to recall formula

- IRR Decision Rule: Compare IRR to discount rate (i.e. opportunity cost of capital); accept if IRR > discount rate, reject if IRR < discount rate

- If NPV is 0 at IRR, NPV is +ve for any discount rate < IRR

Closely related to NPV ---> often leads to identical decision

Easy to understand and communicate

- However non-conventional cash flows can lead to multiple rates of return (more than one rate at which the discount rate will make the investment 0) ---> maximum number equal to number of times cash flow changes signs

- Does not consider timing of each cash flow (as sum of discount cash flows forced to add up to 0)

- Misleading when evaluating projects that are mutually exclusive ---> may be discount rates where Investment A's NPV > Investment B's NPV while other discount rates result in the opposite (i.e. crossover point between investments)

- Does not consider scale of project 3) Payback Rule: Amount of time required for investment to generate cash flows sufficient to recover initial costs ---> project life resulting in NPV = 0

- Payback Decision Rule: Accept if payback period is less than benchmark, reject if payback period is greater than benchmark

- Add cash flows until they equal 0, if does not reach 0 at an exact year find the difference needed/cash flow of subsequent year to find an estimate of the number of additions months required

Easy to understand

Adjusts for uncertainty of later cash flows

Biased towards liquidity

- Ignores time value of money

- Requires arbitrary cut-off point

- Ignores cash flows beyond cut-off date

- Biased against long-term projects such as R&D and new projects

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