Introduction to Business Finance
Introduction to Business Finance Key aspects of Finance : à Time Value of Money ($1 Today is worth $1 more in the future) à Diversification – aim to reduce risk due to specific investments à Arbitrage – allows to make risk free money 4 Basic Area’s of Finance Corporate Finance – (Main focus of FBF)Basic theories and ideas of finance. How does a company generate funds à Debt & Equity Capital Budgeting helps determine where to invest Investment – Assets such as shares and Bonds - Derivative securities à ‘future forward contracts’ Financial Institutions – Firm dealing in Financial Matters e.g. Banks/ insurance firms International Finance – Finance in a global context à essentially takes into account all the the above as well as others such as exchange rates. “Business Finance” – Explores: what to buy? How to buy? How will you Pay? Who Makes these decision? Goal of Financial Management: • Aim of the financial manager is to maximise shareholder wealth o Maximisation of share price § “Shareholder Wealth” = “Shareholder Value” = “Market Capitalisaition § Shareholder wealth = Share price X Number of shares • Profit maximisation is not an appropriate goal o No time frame and it can be manipulated (e.g. crude revenue) • What measure of profit? o Profit measures are dependent on accounting standards • Other goals, such as the maximisation of sales, are also not appropriate • Always focused on cash Factors in any Financial Decision - Important Dollar Amount • Dollar amount of the actual cash flow received or paid out Time • When cash flow is received or paid out à ‘Time value of money’ (TVM) Risk • Amount of uncertainty on cash flows coming in or out à investors require higher risk for higher return.
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The trade off between risk and return:
Financial Manager Responsibilities 1. Investment – what assets to buy à ‘capital budgeting decision’ The investment decision – most important decision As it: • You need to determine what assets to invest in – if incorrect, the reverse is very costly • Determines the value of long-term assets • Evaluate size, time and risk of cash flows • Select assets that create most share holder wealth 2. Finance – where to source the money à ‘Capital structure decision’ • Debt – “contractual claim” – if business goes bankrupt the lenders have first access to assets • Equity – residual claim • Trade off between return and risk à use of debt 3. Working capital decision – what decisions need to be made day-to-day à inventory, receivables, accounts payable • Managing short-term assets and liabilities à forms a part of the investment decision. Must take into account o Inventory management – what is the optimal level of inventory? o Receivables Management – should credit sales be allowed o Accounts payable management- how long should suppliers have to wait before being paid? o Cash- How much cash should a company hold? Forms of Business Sole Trader/ Proprietorship • Individual - may employ other people • Unlimited liability • Success or failure relies on the individual owner • Lasts as long as the owner is alive or sells • Raising finance usually from financial institutions • Equity component limited to sole trader’s wealth - tend to be undercapitalised • Life is limited Partnership • Similar to sole trader except several individuals All share in gains and losses Characterised by a partnership agreement If one wants to leave, partnership ends Company • Most important form • Separate legal entity • Unlimited life • Many formal and legal requirements • Limited liability for shareholders • Few companies are listed o Problems with size of firm and control
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Superior form when raising capital
Corporate Governance - Objectives of management may differ from shareholders. Brief Definition: Set of rules created by a company to ensure the company is socially and ethically responsible/ and disclose information to the public/ and managers act in the best interest of share holders. • • •
Managers may be satisfiers rather than maximisers o Management play it safe, rather than maximising the value of the firm Management are agents for the owners Introduces a potential conflict o Agency problem (Managers don’t act in the interest of all shareholders) Or, Ethical decision making
Principal and Agent Law Agency law is part of commercial law à It is a contractual relationship between a person (the agent) who is authorised to act on behalf of another (the principal) • Agent can create legal relationship with third party Creation of Agency - Expressly in writing or verbally - Implied by law à as part of a necessity, or by cohabitation, by status (such as a partnership) or working relationships • •
Not all employees are agents for the employer à Depends on the type of work carried out Sales people arranging sales Managers tend to be agents as they enter into contracts for the employer
Duties of an agent • Follow the principal’s instructions • Act personally (not delegate to another) • Exercise reasonable skill and diligence • Act in the principal’s best interest • Not to make a secret profit • Not to divulge confidential information Interactions between Firms and Financial Markets
Primary Market – transaction between business and investor • Used for a first time • Done by: Initial Public Offering (‘IPO’) or Private placements (direct sales of new shares to investors close to the firm) • Can be debt or equity Secondary Market- Financial securities that are already issued are bought and sold. • A way of transferring ownership • No addition funds are raised by the firm • Investor-to-investor trading
TIME VALUE OF MONEY 1 Time Value of Money (TVM) • The financial manager makes decisions about proposals with cash flows over long periods of time • An important consideration is the timing of these cash flows o The time value of money must be recognized • It is based on the fact that a dollar today is worth more than a dollar tomorrow Variables • A dollar amount today, o present value • and an interest rate, • and a period of time, • gives a dollar amount in the future o future value TERMINOLOGY PV = present value, or principal I = interest rate, later we use ‘r’/ required rate of return/ discount rule/ cost of capital N = number of periods, later we use ‘t’ FV = future value PMT = periodic payment Simple Interest • Calculated on the original principal o Takes no account of changes in principal o Sometimes called ‘Flat rate interest’ • Used in the valuation of short-term financial instruments traded in the money market o Term is under 12 months o Bills of exchange
Future Value with Simple Interest INT = PV x i x n • i = simple interest rate per year • n = number of years FV = PV + INT • FV = future value at end of term • PV= principle value at beginning • INT = interest amount over the period FV = PV + PV x i x n = PV(1 + i + n) Present Value with simple interest • • •
The formula can be rearranged to calculate present values PV = FV / (1 + i × n) This can also be used to price short-term financial instruments
Compound Interest •
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Interest is added to the principal each period o Interest on interest o Called compounding The compounding period can be any designated length of time o yearly, half-yearly, monthly Simple interest is calculated only on the original amount
Future Value • • • •
Applying the formula many times gives FV = PV(1+i×1)×(1+i×1)×..... ×(1+i×1) which is equivalent to: FV = PV(1 + i)n where: i = the per period interest rate n = the number of compounding periods PV = the original principal
Present Value • Rearranging the future value formula gives the formula for the present value PV = FV ÷ (1 + i)n or PV = FV(1 + i)-n or PV FV (1 i) Frequency of Compounding • Interest rates are normally quotes as per annum (p.a.) • But the compounding frequency is not always annual • A nominal rate is the rate you can observe in the market
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o A nominal rates is an interest rate which compounds more than once per year. E.G 16% compounded monthly If the compounding period is not annual the rate must be qualified o 16% p.a. compounded monthly o This nominal rate is not the same as 16% return pa
Effective Annual Rates (EAR) • An effective rate is an interest rate that compounds annually • To convert a nominal rate to an effective rate • EAR=(1+i)m -1 o where o m = number of compounding periods per year o i = interest rate per period
TIME VALUE OF MONEY 2 Annuity An annuity is a number of equal cash flows occurring at equal time intervals, they are special case of multiple cash flows. • An ordinary annuity assumes all cash flows occur at the end of each period • Both the future value and the present value of an annuity can be calculated using the formulas introduced last week • In a future value calculation: First payment receives interest for two periods Second payment receives interest for only one period Third payment receives no interest Future Value of Annuity Formula: PMT - is the annuity payment n - is the number of payments i - is the per period interest rate Present Value of an Annuity • The present value is calculated at the beginning of the period • Assumes the first payment made is at the end of the first period e.g. beginning of period one = time zero Beginning of period 3 = end of period two Formula:
Perpetuity
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Is a special type of annuity - It is a perpetual annuity - That is, an annuity that continues forever The present value of annuity is PV= PMT(1-(1+i)-n) / i - As n approaches , (1 + i)-n approaches 0 Therefore PV of a perpetuity is - PV = PMT / i There is no future value
•
The trade off between risk and return:
Financial Manager Responsibilities 1. Investment – what assets to buy à ‘capital budgeting decision’ The investment decision – most important decision As it: • You need to determine what assets to invest in – if incorrect, the reverse is very costly • Determines the value of long-term assets • Evaluate size, time and risk of cash flows • Select assets that create most share holder wealth 2. Finance – where to source the money à ‘Capital structure decision’ • Debt – “contractual claim” – if business goes bankrupt the lenders have first access to assets • Equity – residual claim • Trade off between return and risk à use of debt 3. Working capital decision – what decisions need to be made day-to-day à inventory, receivables, accounts payable • Managing short-term assets and liabilities à forms a part of the investment decision. Must take into account o Inventory management – what is the optimal level of inventory? o Receivables Management – should credit sales be allowed o Accounts payable management- how long should suppliers have to wait before being paid? o Cash- How much cash should a company hold? Forms of Business Sole Trader/ Proprietorship • Individual - may employ other people • Unlimited liability • Success or failure relies on the individual owner • Lasts as long as the owner is alive or sells • Raising finance usually from financial institutions • Equity component limited to sole trader’s wealth - tend to be undercapitalised • Life is limited Partnership • Similar to sole trader except several individuals All share in gains and losses Characterised by a partnership agreement If one wants to leave, partnership ends Company • Most important form • Separate legal entity • Unlimited life • Many formal and legal requirements • Limited liability for shareholders • Few companies are listed o Problems with size of firm and control
•
Superior form when raising capital
Corporate Governance - Objectives of management may differ from shareholders. Brief Definition: Set of rules created by a company to ensure the company is socially and ethically responsible/ and disclose information to the public/ and managers act in the best interest of share holders. • • •
Managers may be satisfiers rather than maximisers o Management play it safe, rather than maximising the value of the firm Management are agents for the owners Introduces a potential conflict o Agency problem (Managers don’t act in the interest of all shareholders) Or, Ethical decision making
Principal and Agent Law Agency law is part of commercial law à It is a contractual relationship between a person (the agent) who is authorised to act on behalf of another (the principal) • Agent can create legal relationship with third party Creation of Agency - Expressly in writing or verbally - Implied by law à as part of a necessity, or by cohabitation, by status (such as a partnership) or working relationships • •
Not all employees are agents for the employer à Depends on the type of work carried out Sales people arranging sales Managers tend to be agents as they enter into contracts for the employer
Duties of an agent • Follow the principal’s instructions • Act personally (not delegate to another) • Exercise reasonable skill and diligence • Act in the principal’s best interest • Not to make a secret profit • Not to divulge confidential information Interactions between Firms and Financial Markets
Primary Market – transaction between business and investor • Used for a first time • Done by: Initial Public Offering (‘IPO’) or Private placements (direct sales of new shares to investors close to the firm) • Can be debt or equity Secondary Market- Financial securities that are already issued are bought and sold. • A way of transferring ownership • No addition funds are raised by the firm • Investor-to-investor trading
TIME VALUE OF MONEY 1 Time Value of Money (TVM) • The financial manager makes decisions about proposals with cash flows over long periods of time • An important consideration is the timing of these cash flows o The time value of money must be recognized • It is based on the fact that a dollar today is worth more than a dollar tomorrow Variables • A dollar amount today, o present value • and an interest rate, • and a period of time, • gives a dollar amount in the future o future value TERMINOLOGY PV = present value, or principal I = interest rate, later we use ‘r’/ required rate of return/ discount rule/ cost of capital N = number of periods, later we use ‘t’ FV = future value PMT = periodic payment Simple Interest • Calculated on the original principal o Takes no account of changes in principal o Sometimes called ‘Flat rate interest’ • Used in the valuation of short-term financial instruments traded in the money market o Term is under 12 months o Bills of exchange
Future Value with Simple Interest INT = PV x i x n • i = simple interest rate per year • n = number of years FV = PV + INT • FV = future value at end of term • PV= principle value at beginning • INT = interest amount over the period FV = PV + PV x i x n = PV(1 + i + n) Present Value with simple interest • • •
The formula can be rearranged to calculate present values PV = FV / (1 + i × n) This can also be used to price short-term financial instruments
Compound Interest •
• •
Interest is added to the principal each period o Interest on interest o Called compounding The compounding period can be any designated length of time o yearly, half-yearly, monthly Simple interest is calculated only on the original amount
Future Value • • • •
Applying the formula many times gives FV = PV(1+i×1)×(1+i×1)×..... ×(1+i×1) which is equivalent to: FV = PV(1 + i)n where: i = the per period interest rate n = the number of compounding periods PV = the original principal
Present Value • Rearranging the future value formula gives the formula for the present value PV = FV ÷ (1 + i)n or PV = FV(1 + i)-n or PV FV (1 i) Frequency of Compounding • Interest rates are normally quotes as per annum (p.a.) • But the compounding frequency is not always annual • A nominal rate is the rate you can observe in the market
•
o A nominal rates is an interest rate which compounds more than once per year. E.G 16% compounded monthly If the compounding period is not annual the rate must be qualified o 16% p.a. compounded monthly o This nominal rate is not the same as 16% return pa
Effective Annual Rates (EAR) • An effective rate is an interest rate that compounds annually • To convert a nominal rate to an effective rate • EAR=(1+i)m -1 o where o m = number of compounding periods per year o i = interest rate per period
TIME VALUE OF MONEY 2 Annuity An annuity is a number of equal cash flows occurring at equal time intervals, they are special case of multiple cash flows. • An ordinary annuity assumes all cash flows occur at the end of each period • Both the future value and the present value of an annuity can be calculated using the formulas introduced last week • In a future value calculation: First payment receives interest for two periods Second payment receives interest for only one period Third payment receives no interest Future Value of Annuity Formula: PMT - is the annuity payment n - is the number of payments i - is the per period interest rate Present Value of an Annuity • The present value is calculated at the beginning of the period • Assumes the first payment made is at the end of the first period e.g. beginning of period one = time zero Beginning of period 3 = end of period two Formula:
Perpetuity
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•
•
•
Is a special type of annuity - It is a perpetual annuity - That is, an annuity that continues forever The present value of annuity is PV= PMT(1-(1+i)-n) / i - As n approaches , (1 + i)-n approaches 0 Therefore PV of a perpetuity is - PV = PMT / i There is no future value
