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Business Finance BFM205Session 1: Introduction

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Module Introduction

Carmel de Nahlik:

Email: i.cornelius@aston.ac.uk

Assessment:

2 hour closed book exam (you will be provided with a calculator,a formulae sheet and present value tables)

Answer 1 question from Part A (written) (40%);

Answer 1 question from Part B (numerical) (40%) ;

Complete a multiple choice section (20%)

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How to pass this course

In order to pass this course you will need to:Read the book chapters before you come to class and

come prepared

Take notes in lectures to ensure that learning is

embeddedComplete the tutorial exercises during the week that

we look at that topic and take good and tidy notes

Read around the subject in the FT and watch the

news.

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Module Content

1. Introduction to Financial Management

2. Valuing Shares and Debt

3. Investment Appraisal (1): Appraisal Methods

4. Investment Appraisal (2): Further Aspects5. Risk and Return

6. The Capital Asset Pricing Model and the Cost of

Capital

7. Alternative Sources of Finance8. Debt and Dividend Policy

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Session 1: Agenda

What is financial management?

The objective of the firm and agency problems

The time value of money

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Session 1: Objectives

At the end of this session you should be able to: explain the role of the financial manager explain the major decisions that financial managers

make discuss and contrast alternative objectives of the firm discuss agency problems and potential remedies identify and describe the role of financial markets and

financial intermediaries (from background reading) explain the time value of money concept calculate present and future values of streams of

cash flows

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Session 1 Agenda

What is f inancial management?

The objective of the firm and agency problems

The time value of money

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What is

Financial Management?

Finance

monetary resources or funds

sources and uses of funds

Financial management

decisions made with regard to funds:

investment decisions: identifying investment

opportunities and deciding how much to investfinancing decisions: identifying the form and amount

of financing needed to fund the organisations

activities

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Three Fundamental Decisions in Financial

Management

The capital budgeting decision: Which

productive assets should the firm buy?

A good capital budgeting decision is one in

which the benefits are worth more for the

firm than the cost of the assets.

The Role ofthe Financial

Manager

The financing decision: How should the firm

finance or pay for assets?

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Three Fundamental Decisions in Financial

Management

Financing decisions involve trade-offs

between advantages and disadvantages of

debt and equity financing.

Working capital management decisions:

How should day-to-day financial matters be

managed?

The Role of the

Financial Manager

The mismanagement of working capital can

cause the firm to go into bankruptcy even

though the firm is profitable.

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Session 1 Agenda

What is financial management?

The ob ject ive of the f i rm and agency p roblems

The time value of money

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MPK Exhibit 1.4: Major Factors Affecting Share

Prices

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The Objective

of the FirmFinancial Management assumes that the firm existsto maximise shareholder wealth

How is shareholder wealth measured?Share price

Total shareholder return

reflects both capital gains and dividends

Economic valuepresent value of future free cash flows less

value of debt

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Total Shareholder

Returns: Activity

Total shareholder returns (TSR) are calculated as

follows:

TSR = P1 - P0 + dps

P0

Where:

P1 = share price at end of year

P0 = share price at beginning of year

dps = dividend per share in the year

.

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Pearson TSR 2012

1210.0p 1188.0p

45.0p

%9.10.1210

)0.12100.1188(0.45

TSR

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Pearson TSR performance

benchmarked

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Profit is an Unreliable Guide to

Shareholder Wealth

accounting profit is a short-term measure:shareholder wealth could be reduced by companies

increasing short-term profits through cutting back on

maintenance, training, marketing

accounting profit does not reflect the shareholders

required rate of return:profits could be increased by cutting dividends and investing

in opportunities that deliver a poor rate of returnaccounting profit is open to manipulation:

alternative accounting treatments and judgements can be

applied

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The Agency Problem

Principal (Shareholders)

Agent (Managers)

Managers are employed to run the company on behalf

of shareholders. The shareholders must find ways to ensure

that managers are acting in their (shareholders) best interests.

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Agency Problems

For larger companies, shareholders are not likely to

be the managers of the business

There is a separation of ownership and control:

owners (the principal) appoint managers (agents)to carry out the management of the firm on their

behalf

Leads to two potential agency problems:Potential conflict of interests: shareholders and managers

may have different goals

Information asymmetry: shareholders do not have access

to the same information that is available to managers

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Session 1 Agenda

What is financial management?

The objective of the firm and agency problems

The time value of money

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The Time Value of Money

The value of money changes through time:This means that 1 today is worth more than 1 in the future

Therefore money from different times should not be compared oradded

The time value of money has 3 components:Inflation: goods cost more in the future, so more money is required

Time: the impatience to consumeRisk: the return is in the future and therefore subject to a degree

of variability

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Future Values

The future value of an investment earning annual compound interest:

FV = PV x (1 + r)t

Where:

FV = future value PV = present value

r = the interest rate t = number of years of the investment

Example:What is the future value of 100 invested for 3 years at 5%?

FV = 100 x 1.05 3 = 115.76

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Present Values

The present value of a future cash value:

PV = FV x 1 / (1 + r)t

Where:

FV = future value PV = present value

r = the interest rate t = number of years of the investment

Example:What is the present value of 115.76 arising in 3 years time using

an interest rate of 5% pa?

PV = 115.76 x 1 / 1.05 3 = 100

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Present Values:

Key Concepts

Present value

The value today of a future cash flow.

Discount factorPresent value of a 1 future cash flow for a given

discount rate

Discount factor = 1 / (1 + r)t

Discount rate

The interest rate used to compute present values

of future cash flows.

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Present Values: Activity

VP PLC have just made a major sale to a newcustomer worth 1,000,000.

What is the present value of this sale if, as part of the

deal you agreed that the customer could pay in:a) one yearb) two years

VP PLC have calculated that the appropriate

discount rate is 9%.

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Present Values: Solution

a) PV = 1,000,000 x 1/(1 + 0.09)1

PV = 1,000,000 x 0.9174 = 917,400

b) PV = 1,000,000 x 1/(1 + 0.09)2

PV = 1,000,000 x 0.8417 = 841,700

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Perpetuities & Annuities

Perpetuity:

A stream of annual cash flows of the same amount that

continue indefinitely

PVperpetuity = Cash flow

Discount rate

Annuity:

A stream of annual cash flows of the same amount fora limited number of years

PVannuity = Cash flow x Annuity factor

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Perpetuities & Annuities: ActivityYou have an received an endowment that will pay

20,000 per year:

a) What is the present value of the endowment ifit will continue to pay forever?

b) What is the present value if the endowment is

for 5 years?

The appropriate discount rate is 10%.

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Perpetuities & Annuities: Solution

a) PV of perpetuity

= 20,000 / 0.10 = 200,000

b) PV of annuity

= 20,000 x 3.7908

= 75,816

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The perpetuity and annuity valuation formulae

assume the first cash flow of the series arises 1 yearfrom now

What if the first cash flow arises later?

For example, returning to the previous activity, what

if the first 20,000 cash flow of the perpetuity arises

2 years from now?

Perpetuities and Annuities:

Further Aspects

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Perpetuities and

Annuities:Further Aspects

0 1 2 3 4 5 6 7 8

20k 20k 20k 20k 20k 20k 20k

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Perpetuities and Annuities:

Further Aspects

0 1 2 3 4 5 6 7 8

200k

A perpetuity of 20k per annum with a discount rate of 10% with the first

cash flow arising in 2 years time Is equivalent to a cash flow of 200k arising

in 1 year. Therefore, PV = 200k x 1/1.10 = 181.8k

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Session 1: Objectives

At the end of this session you should be able to: explain the role of the financial manager explain the major decisions that financial managers

make discuss and contrast alternative objectives of the firm discuss agency problems and potential remedies identify and describe the role of financial markets and

financial intermediaries (background reading) explain the time value of money concept calculate present and future values of streams of

cash flows