Lecture'1'–'introduction''

Lecture'1'–'introduction''

! 4!Basic!Areas!of!Finance! 1. Corporate!finance! • Basic!theories!and!ideas!of!finance!!!looking!at!valuation!of!assets! • Capital!budgeting!–!what!equipment!to!buy! • Equity!or!debt!financing!! 2. Investments! • Financial!assets!such!as!shares!(unit!of!ownership!–!equity! finance)!and!bonds!(company!borrowing!money!–!debt!finance)! • Cash!flow!gives!asset!value!! 3. Financial!institutions! • E.g.!banks,!insurance!companies!funds!etc…! 4. International!Finance!! ! Goal!of!financial!management!!!maximise!shareholder!wealth! • Profit!maximization!is!not!shareholder!wealth!maximization!!!profits! depends!on!accounting!standards!! • Measured!in!terms!of!cash!flow!! ! Factors!in!any!financial!decision:! • Cash!flow! • Time!–!Time!value!of!money!(TVM)! • Risk!–!Risk!Return!Trade!Off! o To!induce!people!to!take!a!higher!risk,!they!must!have!an!incentive! (higher!return)! ! Financial!management!responsibilities!! • Investment!decision!(Capital'Budgeting)! o How!to!determine!the!value!of!long!term!assets!(ability!to!generate! cash!flows!in!longer!than!12!months)! o Evaluates!composition!of!assets!which!will!best!facilitate!the! operations!of!the!firm!! • Finance!decision!(Capital'structure)! o Mixture!of!debt!and!equity!maintained!by!a!firm!! o Debt!–!contractual!term! o Equity!–!residual!claim!(cash!generated!after!debtors!have!been! paid!! o Trade!off!between!return!and!risk!–!use!of!debt!is!called!gearing!or! leverage! • Working'capital'decision' o Managing!short!term!assets!and!liabilities!! o E.g.!Inventory!management,!when!to!allow!credit!sales?! o WC!=!Current!Assets!–!Current!Liabilities!'' ! Form!of!business! Advantages! Disadvantages! Sole' Easy!to!set!up,!owner!has! Unlimited!liability,! trader/proprietorship'' complete!control! limited!life,!

' Partnership' Company'

undercapitalized!(not! easy!access!to!capital),!! ' Owners!share!in!gains! and!losses! Separate!legal!entity,! Problem!with!size!of!firm! limited!liability,!access!to! and!control,!agency! capital,!unlimited!life! problem!(objectives! (easy!of!transferability)! different)!!!chain!of! command!

! Agency!law!is!part!of!commercial!law!!!contractual!relationship!between!a! person!(the!agent)!who!is!authorized!to!act!on!behalf!of!another!(the!principal)! • Duties!of!agent!include:! o Follow!the!principals!instructions! o Act!personally!(not!delegate!to!another)! o Exercise!reasonable!skill!and!diligence! o Act!in!principals!best!interest! o Not!to!make!a!secret!profit! o Not!divulge!(disclose)!confidential!information!! ' Agency'problem'?'A!conflict!of!interest!inherent!in!any!relationship!where!one! party!is!expected!to!act!in!another's!best!interests! • Problem!!!agent!who!is!supposed!to!make!the!decisions!that!would!best! serve!the!principal!is!naturally!motivated!by!self^interest,!and!the!agent's! own!best!interests!may!differ!from!the!principal's!best!interests! Financial!markets!facilitate!transactions!in!financial!securities!!!without! efficient!financial!markets!investment!opportunities!may!not!be!able!to!be! financed! • Primary!market!–!securities!issued!to!an!investor!for!the!first!time!!! funds!raised!by!the!firm! • Secondary!market!–!securities!that!are!already!issued!are!bought!and!sold! !!no!additional!funds!raised!by!firm!! !

Lecture'2'–'Time'Value'of'Money'1'

! Important!consideration!is!the!timing!of!these!cash!flows!–!TVM!must!be! recognised!! ! Present'Value'(PV)!–!the!current!value!of!investment!! i'–!interest!rate! n!–!number!of!periods!! PMV'–!periodic!payment!(usually!in!equal!amounts)!! Future'Value'(FV)'–!amount!an!investment!is!worth!in!the!future! ' Simple'interest'–'interest!earned!only!on!the!original!principal!amount!invested! • Used!in!valuation!of!short!term!financial!instruments!(under!12!months)! • FV'='PV(1'+ i×n)!

! Compound'interest'–!interest!earned!in!one!period!is!added!to!the!principal!to! form!a!new!principal!on!which!the!next!calculation!of!interest!is!based!!! INTEREST!ON!INTEREST!EARNED!! • FV'='PV(1'+'i)n'!'future'value'(aka'terminal'value)'increases'at'increasing'rate'the'more' frequently'interest'is'compounded'! !" • !" = ! (!!!)! '''''!'The'longer'to'wait'(higher'n'is),'the'smaller'the'PV! •

Use!PV!when!asked!to!evaluate!weather!investment!is! worth!it! Also!called!discount!cash!flow!!

• ! A!nominal'rate!is!the!rate!you!can!observe!in!the!market!!!allowance!for! inflation!! !! Effective'annual'rate'(EAR)'–!the!interest!rate!expressed!as!if!it!were! compounded!once!per!year!(rate!that!compounds!annually)!!!look!for!questions! asking!which!rate!is!higher' ' EAR'='(1'+'i)m'–'1' ! Present!value!and!interest!rate!have!an!inverse!relationship! ! Lecture'3' ! Annuity!–!number!of!equal!cash!flows!occurring!at!equal!times!!!assumes!all! cash!flows!occur!at!the!end!of!the!period! (! + !)! − ! !" = !!"# ' ! ' ! − (! + !)!! !" = !!"# ' ! ' Perpetuity'–!type!of!annuity!that!continues!forever!(infinite!number!of! payments)! • Future!value!cannot!be!determined! ! !"# !" = ! ' ! !

Lecture'4'–'Debt'and'Valuation'' ! DEBT' Contractual!claim! Commits!firm!to!interest!and!principal! repayments!! No!voting!power! Interest!payment!!!business!expense! which!is!tax!deductible! Unpaid!debt!is!liability!of!the!firm!!!

EQUITY' Residual!claim! No!commitments!! Voting!power! No!interest!payment!! !