Principles of Corporate Finance

1
Why finance matters
Your lovin' gives me a thrillBut your lovin'
don't pay my bill.Now gimme money THAT'S WHAT I
WANT
Money don't get everything it's true.What it
don't get I can't use.So gimme money THAT'S WHAT
I WANT (Strong)
2
Two financial decisions
INVESTMENT OR CAPITAL
FINANCING BUDGETING WHAT
TO HOW TO
INVEST PAY FOR
IN
IT SUCCESS IS JUDGED IN TERMS
OF VALUE
3
Flow of cash between capital marketsand firm's
operations
(1)
(2)
Financial
Firm's
Capital
(4a)
manager
operations
markets
(4b)
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
4
The capital investment trade-off
The firm can always give cash back to the
shareholders
Invest Invest PROJECT CASH
STOCKHOLDER The opportunity cost of capital is
the expected rate of return offered by equivalent
investments in the capital markets.
Pay dividend
Investment opportunities available in capital
markets
5
The firm's objectives

• To maximize profits?
• - To act in an ethical manner?
• - To increase market share?
• - To maximize shareholder wealth?
• To maximize managers wealth?
• What are agency problems?
• Interests of managers shareholders can be
  aligned by
• - compensation plans
• - appointment review by board of
  directors and auditors

6
Net Present Value ObjectiveThe broad argument

• n Shareholders want
• to be as rich as possible (wealth)
• to choose when they consume (time)
• to choose the risk of their consumption plan
  (risk)
• n Capital markets allow them to shift
• time and risk of consumption
• n The role of the manager is to increase
  their wealth (Invest in positive NPV projects)

7
Present and Future Value
Future Value Amount to which an investment will
grow after earning interest
Present Value Value today of a future cash flow.
8
Discount Factors and Rates
Discount Rate Interest rate used to compute
present values of future cash flows.
Discount Factor Present value of a 1 future
payment.
9
Calculating returns
Profit 400
- 350 Return
Investment 350
14.3 TWO RULES 1. Invest
in positive-NPV projects 2. Invest in
projects offering return in excess of
opportunity cost of capital
10
Opportunity cost of capital - examples
Invest 1,000 now Receive certain 1,300 after 1
year Assume investors can obtain 15 safe
return. DECISION 1. Invest because 30 project
return exceeds 15 opportunity cost. 2.
Invest because present value of 1,300 next
year exceeds 1,000 now. PRESENT 1300
1130 VALUE 1.15 NET PRESENT
1130 - 1000 130 VALUE FIRM VALUE INCREASES
BY 130
11
One-period project, return uncertain
Invest 1,000 now. Receive uncertain cash flow
of 1300 after 1 year. Investors can buy
equally risky securities with 35 forecasted
return. DECISION 1. Dont invest because 30
project return is less than 35 opportunity
cost. 2. Dont invest because present value of
forecasted return falls short of
1,000. PRESENT 1300 963 VALUE
1.35 NET PRESENT 963 - 1000
-37 VALUE FIRM VALUE WOULD FALL BY 37