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Referencenotes.pptx5-1
MBA 906 –Financial Strategy and Governance
Dr. Kashif Saleem
E-mail: [email protected]
Office: Room 4.18, 4th floor
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FINANCE
Finance : MANAGING MONEY
Trade-off between the present and future
At the personal level:
earnings
savings
investing
In a business context:
raise money
invest money
reinvest profits
distribute them back to investors.
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WHAT IS CORPORATE FINANCE?
IMAGINE that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:
What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?
Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?
How will you manage your everyday financial activities such as collecting from customers and paying suppliers?
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FINANCIAL MANAGEMENT DECISIONS
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FINANCIAL MANAGEMENT DECISIONS
CAPITAL BUDGETING - long-term investments.
The process of planning and managing a firm’s long-term investments is called capital budgeting.
In capital budgeting, the financial manager tries to identify investment opportunities
The types of investment opportunities - depend in part on the nature of the firm’s business Example: Wal-Mart, Oracle or Microsoft….
Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned:
not only with how much cash they expect to receive
but also with when they expect to receive it and how likely they are to receive it.
Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting.
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FINANCIAL MANAGEMENT DECISIONS
CAPITAL STRUCTURE
A firm’s capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations.
The financial manager has two concerns in this area.
First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm.
Second, what are the least expensive sources of funds for the firm?
Firms have a great deal of flexibility in choosing a financial structure
In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money.
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FINANCIAL MANAGEMENT DECISIONS
WORKING CAPITAL MANAGEMENT
The term working capital refers to a firm’s short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers.
Managing the firm’s working capital is a day-to-day activity
This involves a number of activities related to the firm’s receipt and disbursement of cash.
How much cash and inventory should we keep on hand?
Should we sell on credit? If so, what terms will we offer
How will we obtain any needed short-term financing? Will we purchase on credit or will we borrow in the short term and pay cash?
If we borrow in the short term, how and where should we do it?
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Examples of Recent Investment and Financing Decisions by Major Public Corporations
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Forms of Business Organization
SOLE PROPRIETORSHIP
PARTNERSHIP
GENERAL PARTNERSHIP
LIMITED PARTNERSHIP
THE CORPORATION
legal “person”
articles of incorporation
joint stock companies,
public limited companies,
limited liability companies
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The Goal of Financial Management
POSSIBLE GOALS
If we were to consider possible financial goals, we might come up with some ideas like the following:
Survive.
Avoid financial distress and bankruptcy.
Beat the competition.
Maximize sales or market share.
Minimize costs.
Maximize profits.
Maintain steady earnings growth.
Each of these possibilities presents problems as a goal for the financial manager
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THE FINANCIAL MANAGER
owners (the stockholders) are usually not directly involved in making business decisions
corporation employs managers to represent the owners’ interests and make decisions on their behalf
In a large corporation, the financial manager would be in charge of answering the three questions we raised
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The Agency Problem
in large corporations ownership can be spread over a huge number of stockholders.
This dispersion of ownership arguably means that management effectively controls the firm.
In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders’ expense?
AGENCY RELATIONSHIPS
The relationship between stockholders and management is called an agency relationship.
Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests.
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The Agency Problem
More generally, the term agency costs refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct.
An indirect agency cost is a lost opportunity
Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders.
The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.
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The Agency Problem
Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company’s management immediately begins fighting off this hostile bid.
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The Agency Problem
principal–agent problem
how corporations grapple with that problem.
Monitoring
Incentives: Making sure that managers and employees are rewarded appropriately when they add value to the firm.
Performance measurement: firms can’t reward value added unless they can measure it.
Top management, including the CFO, must try to ensure that managers and employees have the right incentives to find and invest in positive-NPV projects.
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Agency problem Solution
To solve the agency problem that arises from the conflicting interests of agents and principals, economists have considered various ways to COMPENSATE AGENTS in order to motivate them to work for the benefit of the principals
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Incentive Compensation
The amount of compensation may be less important than how it is structured.
The compensation package should encourage managers to maximize shareholder wealth.
based on input (for example, the manager’s effort) - How can outside investors observe effort? effort is not observable…
or on output (income or value added as a result of the manager’s decisions). – do results always depend just on the manager’s contribution?
link part of their executive pay to the stock-price performance - Stock options, restricted stock (stock that must be retained for several years), or performance shares (shares awarded only if the company meets an earnings or other target).
Relative performance - industry Equity compensation
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Management Compensation
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Management Compensation
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Incentive Compensation: stock-price performance
CEOs might sacrifice increasing dividends in favor of using the cash to try to increase the stock price
CEOs have a tendency to pick a higher risk business strategy
CEOs may try to time stock price movements to match the time horizons of their own stock options
Disney CEO Michael Eisner —Stock options create the possibility that only short-term value will be created, not long-term value
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Disney CEO Michael Eisner
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Example: Xerox Corporation
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Management Compensation
“excessive” pay - big handouts to departing executives - left behind troubled and underperforming companies
Robert Nardelli (Home Depot) $210 million severance pay
Henry McKinnell (Pfizer) $200 million
Merrill Lynch: The second largest Wall Street bonus of 2008 – the year that the financial system melted down — was the $39.4 million paid out to Thomas Montag.
Lehman Brothers: CEO Richard Fuld was paid $484 million in salary (2000-2007)
Bear Stearns: CEO James Cayne was paid $163 million from 2003 to 2007
Countrywide Financial: Angelo Mozilo collected $471 million from 2002 to 2007
Bankers whose decisions contributed to the financial crisis were among the highest paid employees on Wall Street.
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Financial Markets and the Corporation
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Financial Markets and the Corporation
PRIMARY VERSUS SECONDARY MARKETS
The term primary market refers to the original sale of securities by governments and corporations.
The secondary markets are those in which these securities are bought and sold after the original sale.
Primary Markets:
public offering , private placement
Secondary Markets:
Dealer markets, Auction markets
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Introduction to Valuation: The Time Value
of Money
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Basic Definitions
Present Value – earlier money on a time line
Future Value – later money on a time line
Interest rate – “exchange rate” between earlier money and later money
Discount rate
Cost of capital
Opportunity cost of capital
Required return or required rate of return
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PV and FV
Finance uses “compounding” as the verb for going into the future and “discounting” as the verb to bring funds into the present.
Today
1
2
3
4
5
FV
PV
Today
1
2
3
4
5
FV
PV
Compounding
Discounting
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Future Values: General Formula
FV = PV(1 + r)t
FV = future value
PV = present value
r = period interest rate, expressed as
a decimal
t = number of periods
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Future Values
Today
1 Year
2 Years
$1,000
$1,050
?
Suppose you invest $1,000 for one year at 5% per year.
What is the future value in one year?
Interest = 1,000(.05) = 50
Value in one year = principal + interest = 1,000 + 50 = 1,050
Future Value (FV) = 1,000(1 + .05) = $1,050
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Future Values
Suppose you leave the money in for another year.
How much will you have two years from now?
FV = 1,000(1.05)(1.05)
= 1,000(1.05)2 = $1,102.50
Today
1 Year
2 Years
$1,000
$1,050
$1,102.60
?
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Effects of Compounding
Simple interest
Compound interest
Consider the previous example:
FV with simple interest = 1,000 + 50 + 50 = $1,100
FV with compound interest = $1,102.50
The extra $2.50 comes from the interest of .05(50) = $2.50 earned on the first interest payment or “interest on interest”
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Future Values – Example 2
Suppose you invest the $1,000 from the previous example for 5 years.
How much would you have at time 5?
Today
1
2
3
4
5
$1,000
?
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Future Values – Example 2
Suppose you invest the $1,000 from the previous example for 5 years.
How much would you have at time 5?
Today
1
2
3
4
5
$1,000
?
$1,276.28
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Future Values – Example 2
The effect of compounding is small for a small number of periods, but increases as the number of periods increases.
(Simple interest would have a future value of $1,250, for a difference of $26.28.)
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Future Values-Example 3
Suppose you had a relative deposit $10 at 5.5% 200 years ago.
How much will you have today?
FV = 10(1.055)200
= 10 (44,718.9839) = $447,189.84
200 years ago
Today
$10
$447,189.84
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Future Value as a General Growth Formula
Suppose your company expects to increase unit sales of widgets by 15% per year for the next 5 years. If you sell 3 million widgets in the current year, how many widgets do you expect to sell in the fifth year?
FV = 6,034,072 units
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Multiple Cash Flows Future Value 1
Suppose you have $1,000 now in a savings account that is earning 6%. You want to add $500 one year from now and $700 two years from now.
How much will you have two years from now in your savings account (soon after you make your $700 deposit)?
Today
1 Year
2 Years
$1,000
$500
$700
?
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Multiple Cash Flows Future Value 1
Simply look at each payment separately and compute the FV of each as we did in the earlier session.
Today
1 Year
2 Years
$1,000
$ 500
$ 700
$1,124
$ 530
Now just add them up
because they are all
adjusted to be in “year 3” value
$2,354
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Multiple Cash Flows Future Value 1C
Let’s add one more twist to the problem:
What would be the value at year 5 if we made no further deposits into our savings account?
Today
1
2
3
4
5
$1,000
?
500
700
40
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Multiple Cash Flows Future Value 1C
We could do this two different ways:
2. Bring each of the three original dollars to year 5 and add them all up.
Today
1
2
3
4
5
$2,803
$1,000
?
500
700
$1,338
$ 631
$ 833
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Present Values
If we can go forward in time to the future (FV), then why can’t we go backward in time to the present (PV)?
We can!
As a matter of fact, finance uses the process of moving future funds back into the present when we value financial instruments like bonds, preferred stock, and common stock. We also use it to evaluate investing in projects.
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Present Values
If we can go forward in time to the future (FV), then why can’t we go backward in time to the present (PV)?
We can! All we need to do is refocus our concept of moving money through time.
Today
1
2
3
4
5
FV
PV
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Present Values
When we talk about “discounting”, we mean finding the present value of some future amount.
When we talk about the “value” of something, we are talking about the present value unless we specifically indicate that we want the future value.
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Present Values
How much do I have to invest today to have some amount in the future?
FV = PV(1 + r)t
Rearrange to solve for PV:
PV = FV / (1 + r)t
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Present Value: One Period Example
Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually, how much do you need to invest today?
PV = 10,000 / (1.07)1 = $9,345.79
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Present Values-Example 1
Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually.
PV = 10,000 / (1.07)1
= $9,345.79
$9,345.79
$10,000
?
Today
1
i = 7%
How much do you need to invest today?
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Present Values – Example 2
Your Dad want to begin saving for your college education and he estimate that you will need $150,000 in 17 years. If he feel confident that he can earn 8% per year, how much he need to invest today?
N = 17; i = 8;
FV = 150,000
PV = FV /(1+i)^17 = ?
$40,540.34
$150,000
?
Today
17
i = 8%
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Multiple Cash Flows Present Value
To compute the present value of multiple cash flows, we again just bring the payments into the present value – one year at a time.
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Multiple Cash Flows Present Value - 1
Consider receiving the following cash flows:
Year 1 CF = $200
Year 2 CF = $400
Year 3 CF = $600
Year 4 CF = $800
If the discount rate is 12%, what would this cash flow be worth today?
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Multiple Cash Flows Present Value -1
Find the PV of each cash flow and just add them up!
PV1 = 178.57
PV2 = 318.88
PV3 = 427.07
PV4 = 508.41
Total PV = 178.57 + 318.88 + 427.07 + 508.41 = $1,432.93
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Multiple Cash Flows Present Value - 2
You are considering an investment that will pay you $1,000 in one year, $2,000 in two years and $3,000 in three years. If you want to earn 10% on your money, how much would you be willing to pay?
PV (CF1) = 909.09
PV (CF2) = 1,652.89
PV (CF3) = 2,253.94
PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.93
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Discount Rate
Often we will want to know what the implied interest rate is on an investment
Rearrange the basic PV equation and solve for r:
FV = PV(1 + r)t
r = (FV / PV)1/t – 1
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Discount Rate – Example 1
You are looking at an investment that will pay $1,200 in 5 years if you invest $1,000 today. What is the implied rate of interest?
r = (1,200 / 1,000)1/5 – 1 = .03714 = 3.714%
Calculator note – the sign convention matters (for the PV)!
N = 5
PV = 1,000 (you pay 1,000 today)
FV = 1,200 (you receive 1,200 in 5 years)
R = 3.714%
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Discount Rate – Example 2
Suppose you are offered an investment that will allow you to double your money in 6 years. You have $10,000 to invest. What is the implied rate of interest?
N = 6
PV = 10,000
FV = 20,000
R= 12.25%
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Discount Rate – Example 3
Suppose you have a 1-year old son and you want to provide $75,000 in 17 years towards his college education. You currently have $5,000 to invest. What interest rate must you earn to have the $75,000 when you need it?
N = 17; PV = 5,000; FV = 75,000
R = 17.27%
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Finding the Number of Periods
Start with the basic equation and solve for t (remember your logs)
FV = PV(1 + r)t
t = ln(FV / PV) / ln(1 + r)
You can use the financial keys on the calculator as well; just remember the sign convention.
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Number of Periods: Example 1
You want to purchase a new car, and you are willing to pay $20,000. If you can invest at 10% per year and you currently have $15,000, how long will it be before you have enough money to pay cash for the car?
R = 10%; PV = 15,000; FV = 20,000
N = 3.02 years
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Number of Periods: Example 2
Suppose you want to buy a new house. You currently have $15,000, and you figure you need to have a 10% down payment plus an additional 5% of the loan amount for closing costs. Assume the type of house you want will cost about $150,000 and you can earn 7.5% per year. How long will it be before you have enough money for the down payment and closing costs?
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Number of Periods: Example 2 (Continued)
How much do you need to have in the future?
Down payment = .1(150,000) = 15,000
Closing costs = .05(150,000 – 15,000) = 6,750
FV=Total needed = 15,000 + 6,750 = 21,750
Compute the number of periods
PV = 15,000; FV = 21,750; R = 7.5%
N = 5.14 years
Using the formula
t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years
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Annuities and Perpetuities Definitions
Annuity – finite series of equal payments that occur at regular intervals
If the first payment occurs at the end of the period, it is called an ordinary annuity
If the first payment occurs at the beginning of the period, it is called an annuity due
Most problems are ordinary annuities
Perpetuity – infinite series of equal payments
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Annuities and Perpetuities Basic Formulas
Perpetuity: PV = C / r
Annuity:
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Annuity: Saving for a Car
After carefully going over your budget, you have determined you can afford to pay $632 per month towards a new sports car. You call up your local bank and find out that the going rate is 1% per month for 48 months. How much can you borrow?
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Annuity: Saving for a Car
You borrow money TODAY so you need to compute the present value.
Formula:
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Annuity: Buying a House
You are ready to buy a house, and you have $20,000 for a down payment and closing costs. Closing costs are estimated to be 4% of the loan value. You have an annual salary of $36,000, and the bank is willing to allow your monthly mortgage payment to be equal to 28% of your monthly income.
The interest rate on the loan is 6% per year with monthly compounding (.5% per month) for a 30-year fixed rate loan.
How much money will the bank loan you?
How much can you offer for the house?
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Annuity: Buying a House - Continued
Bank loan
Monthly income = 36,000 / 12 = 3,000
Maximum payment = .28(3,000) = 840
30*12 = 360 N
r = 0.5
C = 840/ month
PV = $140,105
Total Price
Closing costs = .04(140,105) = 5,604
Down payment = 20,000 – 5,604 = 14,396
Total Price = 140,105 + 14,396 = $154,501
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Finding the Payment
Suppose you want to borrow $20,000 for a new car. You can borrow at 8% per year, compounded monthly
(8/12 = .66667% per month).
If you take a 4-year loan, what is your monthly payment?
20,000 = C[1 – 1 / 1.006666748] / .0066667
C = 488.26
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Future Values for Annuities
Suppose you begin saving for your retirement by depositing $2,000 per year in a fund. If the interest rate is 7.5%, how much will you have in 40 years?
FV = $454,513.04
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Annuity Due
You are saving for a new house and you need 20% down to get a loan. You put $10,000 per year in an account paying 8%. The first payment is made today.
How much will you have at the end of 3 years
(you make a total of three $10,000 payments)?
FV = $35,061.12
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Perpetuity Example
Suppose the Fellini Company wants to sell preferred stock at $100 per share. A similar issue of preferred stock already outstanding has a price of $40 per share and offers a dividend of $1 every quarter.
What dividend will Fellini have to offer if the preferred stock is going to sell?
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Perpetuity
Perpetuity formula: PV = C / r
Current required return:
40 = 1 / r
r = .025 or 2.5% per quarter
Dividend for new preferred:
100 = C / .025
C = 2.50 per quarter
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Growing Annuity
A growing stream of cash flows with a fixed maturity
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Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000 per year for 40 years and increase the annual payment by three-percent each year.
What is the present value at retirement if the discount rate is 10 percent?
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Growing Perpetuity
A growing stream of cash flows that lasts forever
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Growing Perpetuity Example
The expected dividend next year is $1.30, and dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this promised dividend stream?
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