01 Finance and the Financial Manager

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Chapter 1Principlesof

CorporateFinance

Finance and The

Financial Manager


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Topics Covered

What Is A Corporation?The Role of The Financial Manager

Who Is The Financial Manager?Separation ofOwnership and

Management


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Corporate Structure

Sole Proprietorships

Corporations

Partnerships

Limited Liability

Corporate tax on profits +

Personal tax on dividends

Unlimited Liability

Personal tax on profits


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SoleProprietorship

Partnership Corporation

Who owns the

business?

The manager Partners Shareholders

Are managersand owners

separate?

No No Usually

What is the

owners

liability?

Unlimited Unlimited Limited

Are the owner

& business

taxed

separately?

No No Yes

Organizing a Business


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Financial Market Functions

Source of funding

Investor liquidity

Risk management

Source of information


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Role of The Financial Manager

Financial manager refer to anyone responsible for a

significant investment or financing decision.

Treasureris responsible for looking after the firms cash,

raising new capital, and maintaining relationships with

banks, stockholders, and other investors who hold the firms

securities.

Controlleris one who prepares the financial statements,

managesthe firms internal accounting, and looks after its

tax obligations. The treasurers main responsibility is to obtain and manage

the firms capital, whereas the controller ensures that the

money is used efficiently.


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Financial

manager

Firm's

operations

Financial

markets

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)


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Common Finance Terminology

Real assets

Financial assets / Securities

Capital markets and financialmarkets

Investment / capital budgeting

Financing


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Who is The Financial Manager?

Chief Financial Officer

ControllerTreasurer


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Ownership vs. Management

Difference in Information

Stock prices and returns

Issues of shares and

other securities

Dividends

Financing

Different Objectives

Managers vs.

stockholders

Top mgmt vs.

operating mgmt

Stockholders vs. banks

and lenders


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CORPORATE FINANCE

TIME VALUE OF MONEY

A dollar on hand today is worth more than a

dollar to be received in the future because the dollar

on hand today can be invested to earn interest to

yield more than a dollar in the future.

The Time Value of Money mathematics quantify

the value of a dollar through time. This, of course,

depends upon the rate of return or interest ratewhich can be earned on the investment.


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TIME VALUE OF MONEY

The Time Value of Money has applications in

many areas of Corporate Finance including CapitalBudgeting, Bond Valuation, and Stock Valuation.

The Time Value of Money concepts will be

grouped into two areas: Future Value and PresentValue.

Future Value describes the process of finding what

an investment today will grow to in future. Present Value describes the process of determining

what a cash flow to be received in the future is

worth in today's dollars.


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TIME VALUE OF MONEY

Concepts

Future Value of a Single Cash Flow

Present Value of a Single Cash Flow

Cash Flow Streams

Annuities

Other Compounding Periods


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1.1 FUTURE VALUE

The Future Value of a cash flow represents the amount,at some time in the future, that an investment made

today will grow to if it is invested to earn a specific

interest rate. For example, if you were to deposit $100

today in a bank account to earn an interest rate of 10%compounded annually, this investment will grow to

$110 in one year. This can be shown as follows:


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1.1 FUTURE VALUE

At the end of two years, the initial investmentwill have grown to $121. Notice that the

investment earned $11 in interest during the

second year, whereas, it only earned $10 in

interest during the first year. Thus, in the second

year, interest was earned not only on the initial

investment of $100 but also on the $10 in

interest that was paid at the end of the first year.This occurs because the interest rate in the

example is a compound interest rate.


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1.1 FUTURE VALUE

The interest rate in the example is 10% compounded

annually. This implies that interest is paid annually.Thus the balance in the account was $110 at the end of

the first year. Thus, in the second year the account pays

10% on the initial principal of $100 and the $10 of

interest earned in the first year. Thus, the $121 balance

in the account after two years can be computed as

follows:


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1.1 FUTURE VALUE

If the money was left in the account for one more year,interest would be earned on $121, i.e., the initial

principal of $100, the $10 in interest paid at the end of

year 1, and the $11 in interest paid at the end of year 2.

Thus the balance in the account at the end of year threeis $133.10. This can be computed as follows:


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1.1 FUTURE VALUE

The Future Value of an initial investment at a giveninterest rate compounded annually at any point in the

future can be found using the following equation:

Solve Problem

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1.2 PRESENT VALUE

Present Value describes the process ofdetermining what a cash flow to be received in

the future is worth in today's dollars.

The process of finding present values is called

Discounting and the interest rate used to

calculate present values is called the discountrate.

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1.2 PRESENT VALUE

For example, the Present Value of $100 to bereceived one year from now is $90.91 if the

discount rate is 10% compounded annually.

This can be demonstrated as follows:

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1.2 PRESENT VALUE

Notice that the Future Value Equation is used

to describe the relationship between the present

value and the future value. Thus, the Present

Value of $100 to be received in two years can

be shown to be $82.64 if the discount rate is10%.

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1.2 PRESENT VALUE The following equation can be used to calculate the

Present Value of a future cash flow given the discount rateand number of years in the future that the cash flow occurs.

Solve Problem

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1.3 CASH FLOW STREAMSPRESENT VALUE

The Present Value of a Cash Flow Stream is equal to thesum of the Present Values of the individual cash flows.

To see this, consider an investment which promises to pay

$100 one year from now and $200 two years from now.

If an investor were given a choice of this investment or

two alternative investments, one promising to pay $100

one year from now and the other promising to pay $200

two years from now, clearly, he would be indifferentbetween the two choices. (Assuming that the

investments were all of equal risk, i.e., the discount rate

is the same.)

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1.3 CASH FLOW STREAMS

This is because the cash flows that the investor would

receive at each point in time in the future are the sameunder either alternative. Thus, if the discount rate is

10%, the Present Value of the investment can be found

as follows:

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The Future Value of a Cash Flow Stream is equal to the

sum of the Future Values of the individual cash flows.For example, consider an investment which promises to

pay $100 one year from now and $200 two years from

now. Given that the discount rate is 10%, the Future

Value at the end of year 2 of the investment can be found

as follows:

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As of year 2, the $100 received at the endof year 1 would have earned interest for one

year while the $200 received at the end of

year 2 would not yet have earned any

interest. Thus, the Future Value at the end

of year 2, i.e., immediately after the $200

cash flow was received, is $310.00.

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The following equation can be used to find the Future Value of a CashFlow Stream at the end of year t.

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1.4 AnnuitiesAn Annuity is a cash flow stream which adheres to a

specific pattern. Namely, an Annuity is a cash flowstream in which the cash flows are level (i.e., all of the

cash flows are equal) and the cash flows occur at a

regular interval. The annuity cash flows are called

annuity payments orsimplypayments.

Thus, the following cash flow stream is an annuity.

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1.4 Present Value of an Annuity

The Present Value of an Annuity is equal to thesum of the present values of the annuity

payments. This can be found in one step through

the use of the following equation:

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1.4 Present Value of an Annuity

Consider the annuity of $100 per year for fiveyears given in the Figure. If the discount rate

is equal to 10%, then the Present Value of the

Annuity can be found as follows:

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1.4 Future Value of an Annuity

The FV of an Annuity is calculated at the end ofthe period in which the last annuity payment

occurs. The FV of the Annuity is equal to the sum

of the future values of the individual annuity

payments at that time. This can be found in onestep through the use of the following equation:

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1.4 Future Value of an Annuity

Consider the annuity of $100 per year forfive years given in Figure. If the discount

rate is equal to 10%, then the Future Value

of this Annuity at the end of period five can

be found as follows:

01 Finance and the Financial Manager

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