COURSE 42.254

ESSENTIALS OF BUSINESS FINANCE

WHAT IS FINANCE? It’s all about

WHAT IS FINANCE? It’s all about

It’s not just about MONEY But to money

Not just to Make Money But to make money

Not just to make more money

But to USE

Historical Background Money is one of the greatest invention

in human history At first, Money only acts as a media for

trading goods Later, people discover that they can

also make use of Money to Make More Money

What is Finance? Finance is a subject or branch of knowledge

that teaches you how to use Money to Make More Money

It is different from Accounting because accounting only teaches you how to record the money or to save money

To some extent, it also teaches you how to make more money. But it never teaches you to use money to make money.

Why should you be interested in Finance?

Because you fall in love with money Soon you will manage your own

money for your future Learn how to use others’ money to

make money for yourself

WHAT IS BUSINESS FINANCE?

Business finance refers to the financial decision making in a corporate setting

Three Forms of Business Organization

Sole Proprietor – single owner with unlimited liability and limited access to capital

Partnership – partners share the unlimited liability with greater access to capital

Public Listed Company – owned by shareholders with limited liability and the greatest access to capital

The Goals of Business Finance

To make use of shareholders’ money to make more money for them

Primary objective is to maximize the long-term wealth of the shareholders by increasing the share price of the company

An increase in share price is achieved by earning an attractive return subject to an acceptable level of risk

The Agency Problem Management (agents for the shareholders in

managing the business) may be more interested in their short-term compensation, power, autonomy, etc

To align the interest of the management with the shareholders, corporation may tie executive salary to stock price of the company and/or issue stock options as bonuses.

What does CFO actually do?

Basically CFOs have two broad responsibilities that boil down to two simple questions

How to raise money for the company? How to invest the money that has

been raised?

How to raise money for a company?

For long-term purpose (> 1 year), we may issue corporate bonds, common stock and preferred stock – classes 2 & 3

For short-term purpose (< 1 year), we can raise money by managing working capital and current asset – classes 9 & 11

Either way, we need to know the cost of capital – class 4

How to invest the capital?

Primary objective is to get an investment return greater than the cost of capital

The greater the return, the higher the risk of the investment

Final decision or choice is a tradeoff between risk and return

Investment opportunities and selection require an understanding of capital market and capital budgeting – classes 5, 6 & 8

International sources of capital and inv. Opp.

Due to the globalization of our economy, we have new sources of capital coming from outside of the country

Also we are able to diversify our investments to foreign countries

As a result, we have to learn something about the international financial management – class 12

Are you ready to go? Not yet. You have to pick up some skills or

tools that would help you through First equip with the fundamental theory

of finance – Time Value of Money Then pick up basic valuation technique

– discount cash flow – classes 2 & 3

Who wants to be a Millionaire?

According to Forbes magazine in 2003, who is the second richest man in the world?

A) Paul Allen B) Bill Gates C) Lawrence Ellison D) Warren Buffett

Question 2 Based on the 1999 UN report, the 200

richest people in the world have money more than combined income of what percentage of poorest people in the world?

A) 30% B) 40% C) 50% D) 60%

Poverty Gap is Widening Even though you know how to make money,

you are not a successful person. It’s until you know how to share with people

the money you made, you will be a true successful person with a meaningful life.

"Only a life lived for others is a life worth while ." Albert Einstein

Question 3 Amanda was not a very smart girl but

she managed to graduate from the university at age 20. Then she worked for an accounting firm and began to save $5,000 a year in a RSP for the next 10 years. After that, she got married and stopped contributing to the plan again.

Question 3 cont’ James was a smart boy at the same

age as Amanda. He studied medicine in university and became a doctor at age 25. Then he spent 10 years in paying back his student loan. It was until age 35, he began to invest in a RSP. He kept saving $5000 a year until he retired at age 55.

Question 3 cont’ Assume both have invested in the

same saving plan, who will have more money in the RSP when they retire at age 55?

A) Amanda B) James C) Both are the same D) Cannot be determined

Why can the money grow?

Money can grow because interest can be earned on the money saved

It may grow by simple or compound interest arrangement

Simple interest – interest can be made on the principal only

Compound interest – interest can also be made on the interest generated by the principal

How does the money grow?

Assume you invest $1000 (one-time and one lump sum) at Year 0 in a saving plan that has an annual compound interest rate of 10%.

At Year 1, how much money do you have in your plan?

$1000 (1+10%) = 1100 If you keep the money growing, how much

do you have at Year 2?

How does the money grow?

$1100 (1+10%) = 1210 Since $1100 = 1000(1+10%) We can express Year 2 figure as: $1000(1+10%)(1+10%) = 1210 If you keep it on, how much do you

have at Year 3? $1210 (1+10%) = 1331

How does the money grow?

Since $1210 = $1100 (1+10%), we can express the Year 3 calculation as:

$1100 (1+10%)(1+10%) = 1331 Since $1100 = 1000 (1+10%) in the

previous slide, we can express the Year 3 figure further as:

1000 (1+10%)(1+10%)(1+10%)=1331

How does the money grow?

Year 0 = $1000 Year 1 = $1000(1+10%) Year 2 = $1000(1+10%)(1+10%) Year 3 = $1000(1+10%)(1+10%)(1+10%)

Scientific Expression I

Year 0 = $1000 (1+10%)^0

Year 1 = $1000 (1+10%)^1

Year 2 = $1000 (1+10%)^2

Year 3 = $1000 (1+10%)^3

………………………….

Year n = $1000 (1+10%)^n

Scientific Expression II

If we call Year 0 figure as Present Value (PV), Year n figure as Future Value (FV) and interest rate as(i), then

FV = PV ( 1+i )^nPut in table form

FV = PV*FVIF

How does an annuity grow?

Instead of investing $1000 at Year 0 and let the money grow, annuity means that we are going to invest $1000 at the end of each year for three years (a series of equal payments for a number of years)

Unlike the previous example, we invest our first $1000 at Year 1 (not Year 0) and let it grow for 2 periods

How does an annuity grow?

We then invest another $1000 at Year 2 and let it grow for 1 period

Finally, we invest the last $1000 at Year 3

Without letting our final deposit grow, we calculate the total amount we have at Year 3

How does an annuity grow?

Year 1 deposit turns into: $1000 (1+10%)^2 =1210 Year 2 deposit turns into: $1000 (1+10%)^1 = 1100 Year 3 deposit turns into: $1000 x 1 = 1000 Total 3310

How does an annuity grow?

Year 3 total amount: $1000{(1+10%)^2+(1+10%)^1+1} Put it in formula form FVa = $1000{(1+10%)^2+(1+10%)^1+1} (1+10%)FVa =

$1000{(1+10%)^3+(1+10%)^2+(1+10%)} (1+10%)FVa – FVa = $1000{(1+10%)^3 –1} FVa = $1000{(1+10%)^3 –1}/10%

How does an annuity grow?

FVa for 3 years = $1000{(1+10%)^3 – 1}/10% = 3310 General formula FV a=A{(1+i )^n – 1}/ i FV a = Future value of an annuity (A)

How does an annuity grow?

Put it in a table form FV a = A x FVIFA FVIFA = FV interest factor of annuity

How does an annuity in advance grow?

If we want to invest money at the beginning of each period, the future value of an annuity in advance will simply be:

FV a= (1+i ) x A{(1+i )^n – 1}/ i FV a = (1+ i ) x A x FVIFA

Answer for Question 3 Assume Amanda invest $5000 at the end of

each year for 10 years At the end of the 10 years (age 30), the

amount she has: FV a = $5000{(1+10%)^10 – 1}/ 10% = $79687 This amount will grow for another 25 years

FV = $79687 (1+10%)^25 = $863385

Answer for Question 3 At age 35, James started to invest

$5000 at the end of each year for 20 years. At age 55, he will have:

FV a = $5000{(1+10%)^20 – 1}/ 10% = $286375

How to become a millionaire

FV a = $5000{(1+10%)^n – 1}/ 10% = $1000000 Solve the above equation n = 31.94 say 32 years That is, you start to save $5000 a

year. 32 years later, you will be a millionaire

50-Year Rate of Return Canada T-bills 4.8% Gov. bonds 5.8% Corp. bonds 7.2% Common stock

11.4%

United States T-bills 3.8% Gov. bonds 6.2% Corp. bonds 6.2% Common stock

12.4% S&P 500 13.6%

What have you learnt? How to calculate the future value of a

lump sum investment or saving How to calculate the future value of a

series of equal payments at uniform intervals for a number of periods

How to become a millionaire To share with people with what you

have