Financial Theory Lecture Overview

CORPORATE FINANCIAL THEORY Lecture 1

Corporate Financial Theory Introductions Faculty Students Syllabus & Website Tests Homework (CONNECT) Supplements

Course Goals Put meanings to words Transform the complex into the simple Make HBR readable Make WSJ readable Allow you to identify BS Improve critical thinking skills

What is Finance Economics Theoretical Economics Applied Economics Financial Economics ( Finance ) Classical Economics Microeconomics Macroeconomics Capital Markets Supply Econometrics Adam Smith Investments Asset Valuation Corporate Finance Demand Monetary Policy Karl Marx Risk Financial Institutions Consumer Fiscal Policy John Keynes Management The Firm Milton Friedman

What is Finance The Role of Finance in Society Economic Level Corporate Level Individual Level Grows the economic pie Efficiently Allocating Resources which Same Principles apply to all Create value by

What is Finance We Must Grow The Economic Pie Population Unemployed 1970 = 203 mil 2007 = 301 mil Employed

What is Finance Goal of Finance Maximize the value of the firm ETHICALLY

What is Finance Accounting Accountin g Finance Statistics Economics

What is Finance Finance uses Accounting data Statistics Economic principles For purposes of Critical Thinking Analysis Decision making Statistics Finance is not Math Regurgitation Accounting Economics

Critical Thinking & Analysis Other * Identifying relevant information * Data interpretation * NOT plug and chug

How to Teach Critical Thinking DOES NOT WORK TECHNIQUES See numerous new situations Learning via different methods Non-repetitive practice Memorization Root practice Pattern matching Examples Formulas Review CONNECT

Time Value of Money Q: Which is greater? $100 today or $110 next year A: It Depends on Inflation. Example Bike Cost (today) = B0 = $100 Bike Cost (next year) = B1 = $110 B0 = B1 $100 (today) = $110 (next year) 100 =110 1.10

Time Value of Money C + = 1 r PV 0 1 ( ) Example Bike Cost (today) = B0 = $100 Bike Cost (next year) = B1 = $110 B0 = B1 $100 (today) = $110 (next year) 110 1+.10 100 =

Time Value of Money C + = 1 r PV 0 1 ( ) Modified formula for unknown time frame: C + = t r PV 0 t 1 ( )

Net Present Value Example Q:Suppose we can invest $50 today & receive $60 later today. What is our profit? A: Profit = - $50 + $60 = $10

Net Present Value Example Suppose we can invest $50 today and receive $60 in one year. Assuming 10% inflation, what is our profit? 60 + -50 = NPV = . 4 $ 55 1.10

Net Present Value C + = + NPV C t r 0 0 t 1 ( ) For multiple periods we have the Discounted Cash Flow (DCF) formula C C = + + + .... NPV C 1 r 2 r 0 0 1 2 + + 1 ( ) 1 ( )

Net Present Value Terminology C = Cash Flow t = time period r = discount rate or cost of capital Notes C is not an accounting number r is not inflation r is the cost at which you can raise capital. The cost depends on the risk.

Net Present Value Example If you can invest $50 today and get $60 in return one year from now. What is your profit? (assume you can borrow money at 12%) 60 + -50 = NPV = . 3 $ 57 1.12

Valuing an Office Building Step 1: Forecast cash flows Cost of building = C0 = 370,000 Sale price in Year 1 = C1 = 420,000 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 5%, then Cost of capital = r = 5%

Valuing an Office Building Step 3: Discount future cash flows C = = = 420 , 000 400 000 , PV 1 +r 05 . + 1 ( ) 1 ( ) Step 4: Go ahead if PV of payoff exceeds investment 000 400 , = = 370 000 , NPV , 30 000

Net Present Value NPV = PV - required investment C + +1 NPV = C 1 0 r

Risk and Present Value Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs $420,000 = PV of C at 5% 1 420,000 + = = PV 400 000 , 1 .05

Risk and Present Value $420,000 = PV of C 12% at 1 420,000 + = = PV 375 000 , 1 .12 $420,000 = PV of C at 5% 1 420,000 + = = PV 400 000 , 1 .05

Risk and Net Present Value NPV = PV - required investment NPV = 75,000 3 - 370,000 $5,000 =

Net Present Value Rule Accept ALL investments that have positive net present value Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return? 60 + -50 = NPV = . 4 $ 55 1.10

Net Present Value Rule Accept ALL investments that have positive net present value Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 25% expected return? 60 + -50 = NPV = . 2 $ 00 1.25

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? profit 420,000 370,000 = = = Return 13.5% or .135 investment 370,000

Additivity Principle Good Company Bad Company Project NPV Project NPV A $ 12 mil A $ 12 mil B $ 28 mil B $ 28 mil C $ 5 mil C - $ 5 mil Total Value . . $ 45 mil Total Value . $ 35 mil Project NPV Stop negative NPV Project A $ 12 mil B $ 28 mil C (discontinue) 0 Total Value . $ 40 mil

Short Cuts Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tools allow us to cut through the calculations quickly.

Short Cuts C Perpetuity 0= 1 PV r C = 1 PV Constant Growth Perpetuity 0 r g 1 1 = PV C 0 1 Annuity + t r 1 ( ) r r

Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever. cash flow = PV of Cash Flow discount rate C = 1 PV 0 r

Present Values Example What is the present value of $1.2 billion every year, for all eternity, if you estimate the perpetual discount rate to be 8%?? = = $1.2 bil billion 15 $ PV . 0 08

Present Values Example Tiburon Autos offers you easy payments of $5,000 per year, at the end of each year for 5 years. If interest rates are 7%, per year, what is the cost of the car? 5,000 5,000 5,000 5,000 5,000 Year Present Value at year 0 0 1 2 3 4 5 = , 5 000 . 1 / 07 , 4 673 ( ( ( ( . 1 ) ) ) ) 2 = , 5 000 / . 1 07 , 4 367 3 = , 5 000 / . 1 07 , 4 081 4 = , 5 000 / . 1 07 , 3 814 5 = , 5 000 / 07 , 3 565 = Total NPV 20,501

Short Cuts Annuity - An asset that pays a fixed sum each year for a specified number of years. 1 1 = PV of annuity C ) ( t + r 1 r r

Annuity Short Cut Example You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

Annuity Short Cut Example - continued You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease? 1 1 + = Lease Cost 300 ( ) 48 005 . 005 . 1 005 . = 12 $ 774 , 10 . Cost

Annuity Short Cut Example The state lottery advertises a jackpot prize of $295.7 million, paid in 25 installments over 25 years of $11.828 million per year, at the end of each year. If interest rates are 5.9% what is the true value of the lottery prize? 1 1 + = Lottery Value 11 828 . ( ) 25 059 . 059 . 1 059 . = 152 $ 600 , 000 , Value

Constant Growth Perpetuity C = 1 PV 0 r g g = the annual growth rate of the cash flow

Constant Growth Perpetuity NOTE: This formula can be used to value a perpetuity at any point in time. C = +1 t PV t C r g = 1 PV 0 r g

Constant Growth Perpetuity Example What is the present value of $1 billion paid at the end of every year in perpetuity, assuming a rate of return of 10% and a constant growth rate of 4%? 1 = PV 0 10 . 04 . = 16 $ 667 . billion

Opportunity Cost of Capital How much return do you EXPECT to earn on your money?

Opportunity Cost of Capital Example You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs: Economy Slump Normal Boom Payoff $80,000 110,000 140,000 + + 80 000 , 110 000 , 140 000 , C = = = Expected payoff 110 $ 000 , 1 3

Opportunity Cost of Capital Example - continued The stock is trading for $95.65. Next year s price, given a normal economy, is forecast at $110 The stocks expected payoff leads to an expected return. expected investment profit 110 95 65 . = = = Expected return 15 . or 15% 95 65 .

Opportunity Cost of Capital Example - continued Discounting the expected payoff at the expected return leads to the PV of the project 110,000 = = PV 95 $ 650 , 1.15 NPV requires the subtraction of the initial investment = = NPV 95 650 , 100 000 , $ , 4 350

Internal Rate of Return Rule Example - continued Accept the project only if the expected return exceeds the opportunity cost of capital expected investment profit 110 000 , 100 000 , = = = Expected return 10 . or 10% 100 000 ,

Internal Rate of Return IRR is related to Opportunity Cost of Capital Pay Attention to Math

Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment? , 2 + 000 IRR , 4 + 000 IRR = , 4 + + = 000 0 NPV 1 2 1 ( ) 1 ( ) = 28 08 . % IRR