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B40.2302 Class #1
 BM6 chapters 1, 2, 3
 Based on slides created by Matthew Will
 Modified 9/3/2001 by Jeffrey Wurgler
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000
Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Finance and the Financial Manager
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 1
©The McGraw-Hill Companies, Inc., 2000
1- 3
Topics Covered
 What Is A Corporation?
 The Role of The Financial Manager
 Who Is The Financial Manager?
 Separation of Ownership and Management
 Financial Markets
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Corporate Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships
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Ownership = control
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Corporate Structure
Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships
Ownership = control
Limited Liability
Corporate tax on profits +
Corporations
Personal tax on dividends
Ownership =/= control
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Role of The Financial Manager
(2)
Firm's
operations
(1)
Financial
manager
Financial
markets
(1) Cash raised from investors (external finance)
(2) Cash invested in firm
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Role of The Financial Manager
(2)
(1)
Financial
manager
Firm's
operations
(4a)
Financial
markets
(4b)
(3)
(1) Cash raised from investors (external finance)
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested (internal finance)
(4b) Cash returned to investors
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Who is The Financial Manager?
Chief Financial Officer
Treasurer
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Controller
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Ownership vs. Management
Different Objectives
Different Information
Agency costs
 Managers vs.
stockholders
 Top mgmt vs. operating
mgmt
 Stockholders vs. banks
and lenders
Often exacerbates
agency costs or leads to
other costs
 Stock prices / returns
 Issues of shares and
other securities
 Dividends
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Financial Markets
Primary
Raising
and
trading
capital
Markets
OTC
Markets
Secondary
Markets
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Financial Institutions
Operating company
Obligations
Funds
Financial intermediaries
Banks
Insurance Cos.
Brokerage Firms
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Financial Institutions
Financial intermediaries
Obligations
Funds
Investors
Depositors
Policyholders
Investors
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Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Present Value and The Opportunity
Cost of Capital
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 2
©The McGraw-Hill Companies, Inc., 2000
1- 14
Topics Covered
 Present Value
 Net Present Value
 NPV Rule
 ROR Rule
 Opportunity Cost of Capital
 Managers and the Interests of Shareholders
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Present Value
Present Value
Discount Factor
Value today of a
future cash
flow.
Present value of
a $1 future
payment.
Discount Rate
Interest rate used
to compute
present values of
future cash flows.
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Present Value
Present Value = PV
PV = discount factor  C1
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Present Value
Discount Factor for one-period-ahead
cash flow = DF1 = PV of $1
DF1 
1
(1 r )
We will see how discount factors can be used to compute the
present value of any cash flow.
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Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = -350
Sale price in Year 1 = C1 = 400
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 7%, then
Cost of capital = r = 7%
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Valuing an Office Building
Step 3: Discount future cash flows
PV  DF1  C1 
C1
(1r )

400
(1.07)
 374
Step 4: Go ahead with project if PV of payoff exceeds
investment
NPV  350  374  24
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Net Present Value
NPV = PV - required investment
C1
NPV = C0 
1 r
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Risk and Present Value
 Higher-risk projects require higher discount
rates.
 Higher discount rates cause lower PVs.
PV of C1  $400 at 7%
400
PV 
 374
1  .07
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Risk and Present Value
PV of C1  $400 at 12%
400
PV 
 357
1  .12
PV of C1  $400 at 7%
400
PV 
 374
1  .07
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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
400,000  350,000
Return 

 .14 or 14%
investment
350,000
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Net Present Value Rule
 Accept investments that have positive net
present value.
Equivalence of NPV and ROR rule:
C1  C0
ROR  r 
r
 C0
 C0 1  r   C1  0
C1
 C0 
0
1  r 
 NPV  0
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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 (with 1/3 probability each):
Economy
Payoff
Slump
Normal
Boom
$80,000 110,000 140,000
80,000  110,000  140,000
Expected payoff  C1 
 $110,000
3
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Opportunity Cost of Capital
Example - continued
A stock is trading for $95.65. Depending on the state
of the economy, the value of the stock at the end of
the year is one of three possibilities (with 1/3
probability each):
Economy
Slump
Normal
Boom
Stock Pric e
$80
110
140
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Opportunity Cost of Capital
Example - continued
The stock’s expected payoff allows us to compute an
expected return.
80  110  140
Expected payoff  C1 
 $110
3
expected profit 110  95.65
Expected return 

 .15 or 15%
investment
95.65
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Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the stock’s
expected return (our opportunity cost) leads to the
PV of the non-capital-market project.
110,000
PV 
 $95,650
1.15
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Investment vs. Consumption
 Some people prefer to consume now. Others
prefer to invest now and consume later.
 Borrowing and lending in the capital markets
allows us to reconcile these opposing desires
(which may exist within the firm’s
shareholders, for example).
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Investment vs. Consumption
dollars in period 1
100
An
80
Some investors will prefer A
and others G
60
40
Gn
20
20
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40
60
dollars in period 0
80
100
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Investment vs. Consumption
The grasshopper (G) wants to
consume now. The ant (A) wants to
wait.
Both face an investment opportunity in
the capital market: Buy a share in a
$350K building today that produces a
(riskless) $400K tomorrow. The
riskless interest rate is 7%. (The ROR
on the project is 14%.)
Who will invest? A? G? Both?
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Investment vs. Consumption
»
Dollars
Later
A invests $100 now
and consumes $114
next year
114
107
The grasshopper (G) wants to
consume now. The ant (A) wants
to wait. But each is happy to
invest. A prefers to invest 14%,
moving up the red arrow, rather
than at the 7% interest rate. G
invests and then borrows at 7%,
thereby transforming $100 into
$106.54 of immediate
consumption. Because of the
investment, G has $114 next year
to pay off the loan. The
investment’s NPV is $106.54-100
= +6.54
G invests $100 now,
borrows $106.54 and
consumes now.
100
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106.54
Dollars
Now
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A Fundamental Result
 Investors with free and equal access to
borrowing and lending markets will always
invest in positive NPV projects, no matter
what their preferred time pattern of
consumption.
 Corollary: Shareholders A and G both agree
that firm should maximize its NPV.
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Managers and Shareholder Interests
 Governance Tools to Ensure Management
Responsiveness
Subject managers to oversight and review by
specialists (directors).
 Internal competition for top level jobs that are
appointed by the board of directors.
 Financial incentives (e.g. stock options).
 Takeover pressures

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Principles of Corporate Finance
Brealey and Myers

Sixth Edition
How to Calculate Present Values
Slides by
Matthew Will,
Jeffrey Wurgler
Irwin/McGraw Hill
Chapter 3
©The McGraw-Hill Companies, Inc., 2000
1- 36
Topics Covered
 Valuing Long-Lived Assets
 PV Calculation Short Cuts
 Compound Interest
 Interest Rates and Inflation
 Example: Present Values and Bonds
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Present Values
 For a one-period-ahead cash flow
C1
PV  DF1  C1 
1  r1
 But discount factors can be used to compute
the present value of any cash flow.
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Present Values
Ct
PV  DFt  Ct 
t
1  rt 
 Replacing “1” with “t” allows the formula
to be used for cash flows that exist at any
point in time.
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Present Values
Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on
your money in each of the next two years, how much
should you set aside today in order to make the payment
due in two years?
PV 
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3000
(1.08) 2
 $2,572.02
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Present Values
 PVs can be added up to value a package of
cash flows across many periods.
PV 
C1
 (1 r )2  ...
C2
(1 r1 )
1
2
  (1 r )t
Ct
t
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t
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Present Values
 There are some limits on the relationship between r1
and r2. It is not arbitrary.
 Suppose one dollar is received a year from now and
another two years from now. Suppose r1 = 20% and
r2 = 7%. Then the current value of each dollar is:
DF1 
1.00
(1.20)1
 .83
DF2 
1.00
2
(1.07 )
 .87
 (Unless o.w. noted we will assume r1= r2= rt= r)
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Present Values
Example
Assume that the cash flows
from the construction and sale
of an office building are as
below. Given a 7% opportunity
cost of capital, create a present
value worksheet and calculate
the net present value.
Year 0
Year 1
Year 2
 150,000  100,000  300,000
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Present Values
Example - continued
Assume that the cash flows from the construction and sale of an office
building are as below. Given a 7% opportunity cost of capital, create a
present value worksheet and calculate the net present value.
Period
0
1
2
Discount
Factor
1. 0
Cash
Present
Flow
 150,000
Value
 150,000
 .935  100,000  93,500
1
 .873  300,000  261,900
1.07 2
1
1.07
NPV 
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$18,400
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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.
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Short Cuts
Perpetuity - A constant cash flow is received
forever, starting at the end of the first period.
C
PV 
r
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Short Cuts
Growing perpetuity - A cash flow growing at rate g is
received forever. The first cash flow, arriving at the
end of the first period, is C1.
C1
PV 
rg
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Short Cuts
Annuity – A constant cash flow that arrives only for t
periods. The first cash flow arrives at end of first
period.
1
1 
PV of annuity  C   
t
 r r 1  r  
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Annuity example
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?
 1

1
Lease Cost  300  

48 
 .005 .0051  .005 
 $12,774.10
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18
16
14
12
10
8
6
4
2
0
10% Simple
30
27
24
21
18
15
12
9
6
10% Compound
3
0
FV of $1
Compound Interest
Number of Years
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Compound Interest
i
ii
Periods Interest
per
per
year
period
iii
APR
(i x ii)
iv
Value
after
one year
v
Equiv. annually
compounded
interest rate
1
6%
6%
1.06
2
3
6
1.032
= 1.0609
6.090
4
1.5
6
1.0154 = 1.06136
6.136
12
.5
6
1.00512 = 1.06168
6.168
365
.0164
6
1.000164365 = 1.06183
6.183
Inf.
Small
6
e.06 = 1.06184
6.184
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6.000%
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Inflation
Inflation - Rate at which prices as a whole are
increasing.
Nominal Interest Rate - Rate at which money
invested grows.
Real Interest Rate - Rate at which the real
purchasing power of an investment grows.
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Inflation
1+nominal interest rate
1  real interest rate =
1+inflation rate
The formula above is exact. Here’s an approximation:
real interest rate
 nominal interest rate - inflation rate
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Inflation
Example
If the nominal interest rate on one year govt. bonds
is 5.9% and the inflation rate is 3.3%, what is the
real interest rate?
1+.059
1  real interestrate = 1+.033
Savings
= 1.025
Bond
 real interestrate = .025or 2.5%
Approx.  .059 - .033 = .026or 2.6%
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Discount nominal cash with nominal rate,
real cash with real rate
 NPV rule gives same answer whether
discounting nominal cash by nominal rate or
real cash by real rate.
 Just don’t mix them up!
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Valuing a Bond
Example
If today is October 2001, what is the value of the following
bond?
 An IBM Bond pays $115 end of every September for 5
years. In September 2006 it pays an additional $1000 and
retires.
 The bond is rated AAA (WSJ AAA YTM is 7.5%).
Cash Flows
Sept 02 03 04 05 06
115 115 115 115 1,115
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Valuing a Bond
Example continued
115
115
115
115
1,115
PV 




2
3
4
5
1.075 1.075 1.075 1.075 1.075
 $1,161.84
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Bond Prices and Yields (YTM)
1600
1400
Price
1200
1000
800
600
400
200
0
0
2
4
5 Year 9% Bond
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6
8
10
12
14
YTM
1 Year 9% Bond
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