201 Lecture 01

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1.1

Lecture 1: FNCE20001 Business Finance

Introduction to Business Finance andFinancial Mathematics I

Sturla Lyngnes Fjesme

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Lecturers:

Dr. Sturla Fjesme (Lecture 1 - 12)

Dr. Vincent Grégoire (Lecture 13 - 24)

Tutor in Charge:

Robert Carey

Online tutor

Subject Administration

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Lecture 1 – 12

Lecture Date

Topic(s)

1 Tuesday, 29 July Introduction to Business Finance

Introduction to Financial Mathematics I

2 Thursday, 31 July Introduction to Financial Mathematics II

3 Tuesday, 5 August Valuation of Debt Securities

4 Thursday, 7 August Valuation of Equity Securities

5 Tuesday, 12 August Risk and Return

6 Thursday, 14 August Modern Portfolio Theory I

7 Tuesday, 19 August Modern Portfolio Theory II

8 Thursday, 21 August Modern Portfolio Theory III

9 Tuesday, 26 August Asset Pricing Models I

10 Thursday, 28 August Asset Pricing Models II

11 Tuesday, 2 September Asset Pricing Models III

12 Thursday, 4 September Capital Market Efficiency

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Lecture 13 - 24

13 Tuesday, 9 September Capital Budgeting I

14 Thursday, 11 September Capital Budgeting II

15 Tuesday, 16 September Mid Semester Exam

16 Thursday, 18 September Capital Budgeting III

17 Tuesday, 23 September Capital Budgeting IV18 Thursday, 25 September Debt, Dividends and Taxes I

29 September – 3 October Non-Teaching Period

19 Tuesday, 7 October Debt, Dividends and Taxes II

20 Thursday, 9 October Debt, Dividends and Taxes III21 Tuesday, 14 October Debt, Dividends and Taxes IV

22 Thursday, 16 October Guest Presenter (TBA)

23 Tuesday, 21 October Introduction to Derivative Securities I

24 Thursday, 23 October Introduction to Derivative Securities II

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Assessment 1 and 2: Two assignments which will count

towards 15% of your overall grade

Assessment 3: A mid semester exam which will count towards

25% of your overall grade

Date: Tuesday, 16 September

Time: During lecture time (must sit in the stream enrolled)

Venue: Wilson Hall

Exam duration: 60 minutes (no reading time)

Format: Multiple choice questions

Assessment 3: A two hour, end-of-semester final examination

which will count towards 60% of your overall grade


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All lecture notes and Tutorials are available on the subject’s

LMS page

Policy on calculators in examinations - see course outline

Required Textbook

Peirson, G., Brown, R., Easton, S., Howard, P. and Pinder, S.,

Business Finance, 11th

or 10th

ed., McGraw-Hill/Irwin (referredto as PBEHP)

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Code of Conduct During Lectures

Be attentive to the lecturer

Do not talk

Arrive on time and stay for the full lecture

Turn off mobile phones and other electronic devices

Bring required materials to the lecture

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Dr. Sturla Fjesme

PhD Financial Economics BI Norwegian Business School. Visiting Cornell University

Master of Science in Financial Economics with Honours BI Norwegian Business School

Bachelor of Commerce Bond University. Visiting Duke University

Previous Work Experience:

Deloitte

DnB NOR Bank

Royal Norwegian Air Force – Seargent

Current Position:

Senior Lecturer in Finance, University of Melbourne

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Subject Objectives

Solve basic problems in financial mathematics

Discuss the basic theories underlying the pricing of risky assets

Comprehend the concepts of portfolio formation and risk

diversification

Explain the fundamentals of capital budgeting, including the

use of alternative criteria, allowing for inflation and the

treatment of risk

Analyze the issues facing managers in capital structure and

dividend policy decisions

Use the features of financial derivatives to achieve specific

financial outcomes

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1. Introduction to Business Finance

1. Overview of the Finance discipline

2. Compare simple interest to compounded interest

3. Compute the future value of a single cash flow

4. Compute the present value of a single cash flow

5. Compute an unknown interest rate and time period

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Required Readings: Lectures 1 - 2

Lecture 1

PBEHP (10th or 11th ed.), Ch. 1 and Ch. 3 (sections 3.1 – 3.4.2)

Lecture 2

PBEHP (10th or 11th ed.), Ch. 3 (sections 3.4.3, 3.5 – 3.8)

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1.1 What is Finance?

Finance is the study of how individuals, businesses and

institutions acquire, spend and manage financial resources

Major areas of finance

Investment analysis and management

Corporate finance

Capital markets and financial institutions

International finance

Personal finance

Real estate finance

This subject provides an introduction to Investment Analysis

and Corporate Finance

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This Subject

Investment analysis is mainly concerned with where and how to

invest

Valuation of stocks, bonds and derivatives

Portfolio diversification

Asset pricing and market efficiency These topics (except derivatives) are covered in the first half of

this subject

Corporate finance is mainly concerned with the decisions of

managers Capital budgeting - what investments to make

Capital structure - how to finance these investments

Dividend policy - what to payout to shareholders

These topics (including derivatives) are covered in the second

half of this subject

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Career Opportunities in Finance

Career opportunities in several capacities

Financial management

Financial intermediaries

Securities markets

Government entities

Not-for-profit organizations

Personal financial planning

High demand for qualified finance specialists Finance specialists need a good working knowledge of other

disciplines as well

Economics, Accounting, Statistics, Mathematics, Marketing, …

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The Finance Function

The main goal of managers is to maximize the market value of

the firm

Value of the firm = Present value of future expected cash flows

This maximizes the wealth of shareholders

Shareholder wealth = Present value of shareholder’s future

expected cash flows

Do managers always maximize firm value?

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The Market Value of a Firm

Firm value is the present value of future expected cash flows

E (CF t ) = Expected cash flows received at the end of period t

n = Number of periods over which cash flows are received

r = Rate of return required by investors

( )

( )=1

=1

n

t

t

t

E CF Firm Value

r +∑

Main factors to consider when valuing a firm…

Magnitude of expected cash flows - E(CF t) Timing of cash flows - n

Risk of expected cash flows - r

Efficiency of capital markets

This is the main focus of Lectures 1 – 12

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Simple interest

The value of a cash flow is calculated without including anyaccrued interest to the principal

Example: If you invest $1,000 at 8% p.a. earning simple

interest for 5 years what amount will you have in your accountat the end of that time period?

Interest earned in each of the five years = 1000 × 0.08 = $80

Interest earned over five years = (1000 × 0.08) × 5 = $400

Future value at the end of year 5 = 1000 + 400 = $1,400

Future value at the end of year 5 = 1000(1 + 5 × 0.08) = $1,400

Future value using simple interest, F n = P0(1 + n × r )

Present value using simple interest, P0 = F n / (1 + n × r )

1.2 Simple Versus Compounded Interest

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Simple Versus Compounded Interest

Compound interest

Interest accrued is added to the principal and reinvested

The (future) value of a cash flow is calculated based on the

principal and interest accrued

Example: If you invest $1,000 at 8% p.a. earning compounded

interest for 5 years what amount will you have in your account

at the end of that time period?

Future value at the end of year 1 = 1000(1.08) = $1,080.00

Future value at the end of year 2 = 1080(1.08) = $1,166.40

Future value at the end of year 5 = 1000(1.08)5 = $1,469.33

Note that the difference of $69.33 (= 1469.33 – 1400.00) is due

to the compounding of interest (“interest on interest”)

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Simple Versus Compounded Interest

End of year Simple interest

Compounded

interest Difference

1 $1,080.00 $1,080.00 $0.00

2 $1,160.00 $1,166.40 $6.40

3 $1,240.00 $1,259.71 $19.71

4 $1,320.00 $1,360.49 $40.49

5 $1,400.00 $1,469.33 $69.33

20 $2,600.00 $4,660.96 $2,060.96

50 $5,000.00 $46,901.61 $41,901.61

100 $9,000.00 $2,199,761.26 $2,190,761.26

So what’s the big deal?

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The future value at r % p.a. of P0 today is the dollar value to

which it grows at the end of time period n

F n = P0(1 + r )n

P0

F n = P0(1 + r )n

0 n

Cash flows occur at the end of the period

1.3 Future Value of a Single Cash Flow

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Example: You decide to invest $1,000 for different time

periods. What is the future value of this $1,000 in 5, 20 and

100 years at an interest rate of (a) 6% and (b) 8%?

At r = 6% p.a.

F 5 = 1000 × (1.06)5 = $1,338.23

F 20 = 1000 × (1.06)20 = $3,207.14

F 100 = 1000 × (1.06)100 = $339,302.08

At r = 8% p.a.

F 5 = 1000 × (1.08)5 = $1,469.33

F 20 = 1000 × (1.08)20 = $4,660.96

F 100 = 1000 × (1.08)100 = $2,199,761.26

Future Value of a Single Cash Flow

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Future Value of a Single Cash Flow

Future Value of $1000 over Different Time Periods at Different Interest Rates

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

0 2 4 6 8 10 12 14 16 18 20

End of Year

F u t u r e V a l u e

4%

6%

8%

10%

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The present value (P0) at r % p.a. of F n at the end of time n is

the amount which invested today would grow to F n in time n

P0 = F n/(1 + r )n, or

P0 = F

n(1 + r )-n

P0 = F n/(1 + r )n

F n

0 n

Cash flows occur at the end of the period

1.4 Present Value of a Single Cash Flow

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Example: If you needed $10,000 in (a) five years and (b)

twenty years how much would you need to save and invest

today if the interest rates were (a) 6% and (b) 8%?

The present value today of $10,000 in five years

At 6% p.a.: P0 = 10000/(1.06)5 = $7,472.58

At 8% p.a.: P0 = 10000/(1.08)5 = $6,805.83

The present value today of $10,000 in twenty years

At 6% p.a.: P0

= 10000/(1.06)20 = $3,118.05

At 8% p.a.: P0 = 10000/(1.08)20 = $2,145.48

Present Value of a Single Cash Flow

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Present Value of a Single Cash Flow

Present Value of $10000 over Different Time Periods at Different Interest Rates

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

$10,000

0 2 4 6 8 10 12 14 16 18 20

$10,000 Received at the End of Year

P r e s e n t V a l u e

10%8%

6%

4%

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Factors Influencing Present and Future Values

The present and future values of a cash flow depend on the

following factors…

The time period, n

Future value increases as n increases

Present value decreases as n increases

The interest rate, r

Future value increases as r increases

Present value decreases as r increases

The method of computing interest (examined in lecture 2)

Future value increases as the compounding interval increases

Present value decreases as the compounding interval increases

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1.5 Unknown Interest Rate or Time Period

Example: You invest $10,000 for a five year period. What

interest rate do you need to earn for the funds to double in that

time period? If you invest $10,000 at an interest rate of 10%

p.a. how long will it take for these funds to triple in value?

In the first case we have an unknown interest rate, r

P0 = $10,000, F 5 = $20,000, n = 5

10000(1 + r )5 = 20000

So, (1 + r )5 = 20000/10000 = 2

r = 21/5 – 1 = 14.9%

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Unknown Interest Rate or Time Period

In the second case we have an unknown time period, n

P0 = $10,000, F n = $30,000, r = 10%

10000(1.10)n = 30000

So, (1.10)n

= 30000/10000 = 3.00 Taking natural logs we have…

n × ln(1.10) = ln(3.00)

So, n = 1.0986/0.0953 = 11.5 years

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Key Concepts

Managers should aim to maximize the value of the firm by

taking on profitable investments. This results in maximum

shareholder wealth

Money has time value because of compounded interest

In simple interest, the value of a cash flow is calculatedwithout including any accrued interest to the principal

In compounded interest, the value of a cash flow is calculated based on the principal and interest accrued

The present and future values of a cash flow depend on thetime period, the interest rate, and the method of computing

interest

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Formula Sheet

Future value of a single cash flow using simple interest

F n = P0(1 + n × r )

Present value of a single cash flow using simple interest

P0 = F

n / (1 + n × r )

Future value of a single cash flow

F n = P0(1 + r )n

Present value of a single cash flow

P0 = F n/(1 + r )n

P0 = F n(1 + r )-n

( Note: The formula sheets on the mid semester and final exams willcontain all the formulas covered in lectures but without the descriptions)

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201 Lecture 01

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