Principle of Corporate Finance

8/6/2019 Principle of Corporate Finance

1/23

Course topics

Principles of

Corporate

Finance

Seventh Edition

Richard A. Brealey

Basic concepts of Corporate Finance

Risk, portfolio selection, budgeting

Incentives of managers.

.

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

Financial markets

Asset valuation

Debt structure

Risk management

Cash management


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Organization

Lectures (Prof. Kirstein) Thu 1:30-3 p.m. in A-013

No regular office hours (D-003), send an email to

[email protected]

Tutorial (Sidi Kon) Mon 11.15-12.45, A-211

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.

Book: Brealey/Myers (7th or later ed.; or any other textbook)

Homepage http://www.ww.uni-magdeburg.de/bizecon

=> teaching, Winter 2009/10, Financial Management

=> slides, book, exercises, further information


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Section 1: Why Finance matters

What Is A Corporation?

The Role of The Financial Manager

Who Is The Financial Manager?


epara on o wners p an anagemen Financial Markets


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Corporate Structure

Sole Proprietorships

Partnershi s

Unlimited Liability

Personal tax on profits


Corporations

Limited Liability

Corporate tax on profits +

Personal tax on dividends


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Role of The Financial Manager

Financial

manager

Firm's

operations

Financial

markets

(1)(2)

(4a)


(1) Cash raised from investors

(2) Cash invested in firm

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4b) Cash returned to investors

(4b)


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Who is The Financial Manager?

Chief Financial Officer


ComptrollerTreasurer


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Ownership vs. Management

Difference in Information

Stock prices and returns

Issues of shares and

Different Objectives

Managers vs.

stockholders


other securities

Dividends

Financing

Top mgmt vs. operatingmgmt

Stockholders vs. banks

and lenders


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Principles of

CorporateFinance

Seventh Edition

Richard A. Brealey

Chapter 2Present Value and The

Opportunity Cost of Capital

.

.


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Topics Covered

Present Value

Net Present Value NPV Rule


u e Opportunity Cost of Capital

Managers and the Interests of Shareholders


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Present Value

Present Value

Value today of a

future cash

Discount Factor

Present value of

a $1 future


.

Discount Rate

Interest rate used to compute

present values of future cash

flows.

.


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Present Value

1factordiscount=PV C


1st basic principle of Financial Economics:

A $ today is more worth than a $ tomorrow

(i.e., discount factors are positive, but smaller than one)


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Present Value

Discount Factor = DF = PV of $1

1DF =


Discount Factors can be used to compute

the present value of any cash flow.

r+


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Valuing an Office Building

Step 1: Forecast cash flows

Cost of building = C0

= 350

Sale price in Year 1 = C1 = 400


tep : st mate opportun ty cost o cap taIf equally risky assets in the capital market

yield a return of 7%, then the opportunity

cost of the investment = r = 7%


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Valuing an Office Building

Step 3: Discount future cash flows

37)07.1(400

)1(1

===++r

CPV


Step 4: Go ahead if PV of payoff exceeds investment

24374350 =+=NPV


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Net Present Value

r

C

+

+

1C=NPV

investmentrequired-PV=NPV

10


required rate of return: the rate at which NPV=0

If the ROR of an investment equals theopportunity cost of capital, then NPV=0

Hence, required ROR = oppcost of capital


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Risk and Present Value

2nd basic principle of Financial Economics:

A safe $ has a higher value than a risky one


. .,

with their probability AND discounted)


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Higher risk projects require a higher rate of return

Higher required rates of return cause lower PVs

E. ., if the re uired rate of return is not 7% low


risk), but 12% (high risk):

374.071

400PV

7%at$400CofPV 1

=

+

=

=


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357.121

400PV

12%at$400CofPV 1

=

+

=

=


374.071

400PV

7%at$400CofPV 1

=

+

=

=


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Rate of Return Rule

Accept investments that offer rates of return

in excess of their opportunity cost of capital

Example


In the project listed below, the foregone investment

opportunity is 12%. Should we do the project?

14.3%or.143350,000

350,000400,000

investment

profitReturn =

==


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Net Present Value Rule

Accept investments that have positive net

present value

Example


Suppose we can invest $50 today and receive $60in one year. Should we accept the project given a

10% expected return?

55.4$1.1060+-50=NPV =


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Example

You may invest $100,000 today. Depending on thestate of the economy, you may get one of three

possible cash payoffs (with equal probability):


140,000110,000$80,000Payoff

BoomNormalSlumpEconomy

000,110$3

000,140000,110000,80CpayoffExpected 1 =

++==


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Example - continued

Alternative investment is buying stock for $95.65. Nextyears stock price is predicted as $110.


The stocks expected payoff leads to an expected return=> OCC or required ROR

15%or15.65.95

65.95110profitexpectedreturnExpected ===investment


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Example - continued

Using the required ROR to discounting the expectedpayoff at the expected return leads to the PV of the

project


000,100$650,95$

1.15

110,000PV

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Principle of Corporate Finance