Course Summary
MGSM835: Financial Management – Course Summary -
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Objectives o Valuation + pricing of assets o Evaluation of investment proposals / Capital Budgeting o Corporate financial policy Company Objective à Maximise shareholder wealth by making § Investment decisions § Financing decisions § Payout decisions à Know CASH, TIME, RISK à Be consistent Rate of return on securities: 𝑟=
𝑁𝑒𝑡 𝑔𝑎𝑖𝑛 𝑓𝑟𝑜𝑚 𝑎𝑠𝑠𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑟!!!"# =
𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 + 𝐷𝑖𝑣 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
Asset Valuation o Interest compounded annually
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)! o Interest compounded weekly or monthly or daily (Calculate annual effective rate)
𝐸𝑓𝑓 = 1 + !".
!
!"#. !"#$ !" !"#$"%&'(' !"#$%&' !
− 1
o Interest compounded continuously
𝐹𝑉 = 𝑃𝑉 × 𝑒 !
!"#$!!"# !"#
%$− 1 (solve with ln)
o Annuities !!! ! !! 𝐹𝑉 = 𝐴 𝐹𝑉 = 𝐴 × 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑎𝑐𝑡𝑜𝑟 ! 𝑃𝑉 = 𝐴
!"#$
!!(!!!)!! !
𝑃𝑉 = 𝐴 × 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑎𝑐𝑡𝑜𝑟
o Perpetuities (growing)
! !!!
or
!! !! !!
=
!! (!!!) !! !!
(Dividend Growth Model)
o Annuity Due (Annuity starts before the end of year 1)
𝑃𝑉 = 𝐴 + 𝐴
!! !!! !(!!!) !
o Deferred Annuity (Annuity starts later)
𝑃𝑉 =
!! !!! !! ! !!! (!!!)
!×
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Capital Budgeting
à Process of deciding on the optimum use of the scarce resources of a corporation 1. Forecast costs / benefits 2. Apply investment evaluation technique 3. Make decision Investment Evaluation Techniques o Payback à Time taken to recover initial cash outlay associated with a project. Accept project with shortest payback period. !"#$%&'$#$( !"#$ !" !"#$" !" !" 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 = 𝑌𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 + !"#! !"#$ !"#$%& !" + -
Simple to estimate and decide Not sure what the appropriate payback period should be Ignores CF beyond payback period Ignores time value for money and risk
o Average Accounting Rate of Return (AAR) à % return on invested physical capital !"#!"#$ !"#$%& 𝐴𝐴𝑅 = !"#$%&# !"#$%&$' !"#$%"& + -
Uses reported accounting numbers Ignores time value for money and risk Uses accounting numbers Does not increase shareholder wealth
o Net Present Value (NPV) à Net present value of all future CFs; increase in wealth of owner from taking on project 𝑁𝑃𝑉 = 𝑆𝑡𝑎𝑟𝑡 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 + 𝑀𝑖𝑑𝑑𝑙𝑒 𝑅𝑒𝑔𝑢𝑙𝑎𝑟 𝐶𝐹 𝐴𝑛𝑛𝑢𝑖𝑡𝑦) + 𝐸𝑛𝑑 (𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑙)
NPV > 0 à accept NPV < 0 à reject NPV = 0 à indifferent + + + + -
Clear decision rule that maximizes shareholder wealth Incorporates time value for money and risk Considers all CFs that are generated by a project Correctly ranks projects on wealth maximising criteria Difficulty in forecasting future CFs There are problems in estimating the appropriate discount rate Difficult for non-finance trained managers to fully understand what it means
o Internal Rate of Return (IRR) à Rate of return which makes NPV of project 0, implicit rate of return generated by a project taking into account time value for money, accept project if IRR > Required rate of return (IRR will generally result in same investment decision as NPV) IRR à 0 = START | MIDDLE | END = NPV x Annuity Factor à Bottom Up Approach Provides a clear decision rule that targets a hurdle rate Easily comparable to rate of return on other investments Incorporates time value of money and risk and all CFs Easier to understand Summarises project information into one number Doesn’t always choose project that maximizes shareholder wealth - Calculation is mathematically problematic without computer - Decision rule requires knowledge whether it is a financing or investing decision - If there are positive and negative CFs à may be multiple solutions - Doesn’t take into account the scale of the project, only shows rate à MIRR considers both the cost of the investment and the interest received on reinvestment à IRR has its limitations, use MIRR to question IRR! + + + + + -
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Objectives o Valuation + pricing of assets o Evaluation of investment proposals / Capital Budgeting o Corporate financial policy Company Objective à Maximise shareholder wealth by making § Investment decisions § Financing decisions § Payout decisions à Know CASH, TIME, RISK à Be consistent Rate of return on securities: 𝑟=
𝑁𝑒𝑡 𝑔𝑎𝑖𝑛 𝑓𝑟𝑜𝑚 𝑎𝑠𝑠𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑟!!!"# =
𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 + 𝐷𝑖𝑣 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
Asset Valuation o Interest compounded annually
𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)! o Interest compounded weekly or monthly or daily (Calculate annual effective rate)
𝐸𝑓𝑓 = 1 + !".
!
!"#. !"#$ !" !"#$"%&'(' !"#$%&' !
− 1
o Interest compounded continuously
𝐹𝑉 = 𝑃𝑉 × 𝑒 !
!"#$!!"# !"#
%$− 1 (solve with ln)
o Annuities !!! ! !! 𝐹𝑉 = 𝐴 𝐹𝑉 = 𝐴 × 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑎𝑐𝑡𝑜𝑟 ! 𝑃𝑉 = 𝐴
!"#$
!!(!!!)!! !
𝑃𝑉 = 𝐴 × 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑎𝑐𝑡𝑜𝑟
o Perpetuities (growing)
! !!!
or
!! !! !!
=
!! (!!!) !! !!
(Dividend Growth Model)
o Annuity Due (Annuity starts before the end of year 1)
𝑃𝑉 = 𝐴 + 𝐴
!! !!! !(!!!) !
o Deferred Annuity (Annuity starts later)
𝑃𝑉 =
!! !!! !! ! !!! (!!!)
!×
-
Capital Budgeting
à Process of deciding on the optimum use of the scarce resources of a corporation 1. Forecast costs / benefits 2. Apply investment evaluation technique 3. Make decision Investment Evaluation Techniques o Payback à Time taken to recover initial cash outlay associated with a project. Accept project with shortest payback period. !"#$%&'$#$( !"#$ !" !"#$" !" !" 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 = 𝑌𝑟 𝑏𝑒𝑓𝑜𝑟𝑒 𝑓𝑢𝑙𝑙 𝑟𝑒𝑐𝑜𝑣𝑒𝑟𝑦 + !"#! !"#$ !"#$%& !" + -
Simple to estimate and decide Not sure what the appropriate payback period should be Ignores CF beyond payback period Ignores time value for money and risk
o Average Accounting Rate of Return (AAR) à % return on invested physical capital !"#!"#$ !"#$%& 𝐴𝐴𝑅 = !"#$%&# !"#$%&$' !"#$%"& + -
Uses reported accounting numbers Ignores time value for money and risk Uses accounting numbers Does not increase shareholder wealth
o Net Present Value (NPV) à Net present value of all future CFs; increase in wealth of owner from taking on project 𝑁𝑃𝑉 = 𝑆𝑡𝑎𝑟𝑡 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡 + 𝑀𝑖𝑑𝑑𝑙𝑒 𝑅𝑒𝑔𝑢𝑙𝑎𝑟 𝐶𝐹 𝐴𝑛𝑛𝑢𝑖𝑡𝑦) + 𝐸𝑛𝑑 (𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑙)
NPV > 0 à accept NPV < 0 à reject NPV = 0 à indifferent + + + + -
Clear decision rule that maximizes shareholder wealth Incorporates time value for money and risk Considers all CFs that are generated by a project Correctly ranks projects on wealth maximising criteria Difficulty in forecasting future CFs There are problems in estimating the appropriate discount rate Difficult for non-finance trained managers to fully understand what it means
o Internal Rate of Return (IRR) à Rate of return which makes NPV of project 0, implicit rate of return generated by a project taking into account time value for money, accept project if IRR > Required rate of return (IRR will generally result in same investment decision as NPV) IRR à 0 = START | MIDDLE | END = NPV x Annuity Factor à Bottom Up Approach Provides a clear decision rule that targets a hurdle rate Easily comparable to rate of return on other investments Incorporates time value of money and risk and all CFs Easier to understand Summarises project information into one number Doesn’t always choose project that maximizes shareholder wealth - Calculation is mathematically problematic without computer - Decision rule requires knowledge whether it is a financing or investing decision - If there are positive and negative CFs à may be multiple solutions - Doesn’t take into account the scale of the project, only shows rate à MIRR considers both the cost of the investment and the interest received on reinvestment à IRR has its limitations, use MIRR to question IRR! + + + + + -
