Finance Notes
Lecture 1
Four Basic Areas of Finance
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Corporate finance AKA business finance
o Basic theories and ideas of finance
Investments
o Financial assets such as shares and bonds
Financial institutions
o Firms dealing in financial matters
International Finance
o Covers the above areas in a global context
What is Business finance?
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Some questions a business needs to answer:
o What equipment to buy?
o Will you use your money or someone else’s?
o When do you pay suppliers?
The answers are provided by the financial manager
o Coordinates treasury and accounting activities
Goal of Financial Management
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Aim of the financial manager is to maximize shareholder wealth
o Maximization of share price
Profit maximization is not an appropriate goal
o Not time frame
o What measure of profit?
 Profit measures are dependent on accounting standards
Other goals, such as the maximization of sales, are also not appropriate
Its all about the cash!
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Any business needs cash to survive
It is important not to confuse accounting income with cash flow
o Many non-cash items in profit
Operation cash flow and free cash flow
o Not in any financial statement
Cash from assets = Cash flow to creditors + Cash flow to shareholders
What happens if there is insufficient cash?
Factors in any financial decision
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Dollar amount
o Dollar amount of the actual cash flow received or paid out
Time
o When cash flow is received or paid out
 Time value of money (TVM)
Risk
o Amount of uncertainty
 Investors require higher returns for higher risk
The relationship between expected return and risk
Financial Manager’s responsibilities
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Investment decision
o What assets to buy?
 Capital Budgeting decision
Financing decision
o Where does the money come from?
 Capital Structure decision
Working Capital decision
o Inventory, Receivables, Accounts Payable
o Less potential for value creation
The Investment Decision
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It is the most important decision
o Incorrect decisions are costly to reverse
How to determine the value of long-term asset
Evaluate size, time, and risk of cash flows
Select assets that create most shareholder wealth
The Financing Decision
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How to finance an investment?
Determine the best mix between
o Debt (Loan funds)
 Contractual claim
o Equity (Owner’s funds)
 Residual claim
o Trade-off between return and risk
 Use of debt is called ‘gearing’ or ‘leverage’
The Working Capital Decision
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Managing short-term assets and liabilities
Forms part of the investment decision
o Inventory Management
 What is the optimal level of inventory?
o Receivables Management
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 Should credit sales be allowed?
Accounts Payable Management
 How long should suppliers have to wait before being paid?
Forms of Business
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Sold Trader/ Proprietorship
o Single owner – can employ others
o Unlimited liability
o Success or failure relies on the owner
o Lasts as long as the owner is alive or sells
o Equity component limited to sole trader’s wealth
o Easy and inexpensive to establish
o Minimal reporting requirements
Partnership
o Similar to sole trader except several individuals
o All share in gains and losses
o Characterized by a partnership agreement
o If one wants to leave, partnership ends
Company
o Most important form
o Separate legal entity
o Unlimited life
o Many formal and legal requirements
o Limited liability for shareholders
o Only a small number of companies are listed
o Superior form when raising capital
Corporate Governance
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Objectives of management may differ from shareholders
Managers may be satisfiers rather than maximizers
o Management plays it safe, rather than maximizing the value of the firm
Management are agents for the owners
Introduces a potential conflict
o Agency problem
Principal and Agent Law
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Agency law is part of commercial law
It is a contractual relationship between a person (The agent) who is authorized to act on behalf of another
(the principal)
Agent can create legal relationship with third party
Creation of agency
o Expressly in writing or verbally
o Implied by law
 As part of a necessity, or by cohabitation, by status (such as a partnership) or working
relationships
Employer-employee relationships
Not all employees are agents for the employer
This will depend on the type of work carried out
o Salespeople are agents for the employer as they are arranging sales
o Managers tend to be agents as they enter into contracts for the employer
Agents can be Special, General or Universal
Duties of an agent
o Follow the principal’s instructions
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Act personally (not delegate to another)
Exercise reasonable skill and diligence
Act in the principle’s best interest
Not to make secret profit
Not to divulge confidential information
Interaction between firms and financial markets
Primary Market
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The first sale of a security or instrument by a firm
Funds are raised by the firm and flow to it
Can be debt or equity funding
Public or private offering
Fund raising between investors and firm
Secondary Market
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Financial securities that are already issued are bought and sold
Way of transferring ownership
An example of a secondary market
o Securities exchange
Investor-to-Investor trading
No additional funds are raised by the firm
Balance Sheet
Market Values and Book Values
Income Statement
Lecture 2 (The Time Value of Money 1)
Time value of money (TVM)
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The financial manager makes decisions about proposals with cash flows over long period of time
TVM is based on the principle that a certain amount of money received today is worth more than that same
amount of money received in the future
Two important considerations:
o $100,000 received today
o $100,000 received in five years’ time
Which of the following cash flows would you prefer to receive?
o $100,000 received today
o $150,000 received in five years’ time
Example 1
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You invest $1,000 in a bank today for a period of one year
The bank will pay interest at a rate of 5% pa.
How much will you have in the bank at the end of one year?
Three known variables:
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Dollar amount invested today (present value)
 $1,000
o Interest rate paid by the bank
 5%
o The period the money is invested for
 1 year
o One unknown variable:
 The dollar amount at the end of the period (future value)
 $?
Step 1: Calculate the interest
o 1000 *5% or (0.05) = 50
Step 2: Add the interest to the original investment
o $1000 + $50 = $1,050
Terminology
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Time Value of Money has its own language:
o PV = present value or principle
o i = interest rate, later we use ‘r’
o n = number of periods, later we use ‘t’
o FV = future value
o PMT = periodic payment (next week)
This week, we learn about applications that require three variables to then determine a fourth
Timeline
Simple Interest
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Calculated on the original present value
o Takes no account of changes in principle
o Sometimes called flat rate interest
Used in the valuation of short-term financial instruments traded in the money market
o Term is under 12 months
o Bills of exchange
Future value with simple interest
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Step 1: INT = PV *I *N
o i = simple interest rate per year
o n = number of years
Step 2: FV = PV + INT
o FV = future value at the end of term
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o PV = principal value at beginning
o INT = interest rate amount over the time period
FV = PV + (PV * i * n)
Simplified: FV = PV (1 + i * n)
Example 2
Compound interest
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Interest is added to the principal each period
o Interest on interest
o Called compounding
The compounding period can be any designated length of time
o Yearly, Half yearly, monthly
Simple interest is calculated only on the original amount
Future value
Example 3
Example 4
Present Value
Example 5
Frequency of Compounding
Example 6
Example 7
Example 8
Lecture 3 (The Time Value of Money 2)
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Understand the principles of annuities and perpetuities
Be able to calculate
o The future value of an annuity
o The present value of an annuity and perpetuity
o An annuity payment
Annuity
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Annuities are a special case of multiple cash flows
An annuity is a number of equal cash flows occurring at equal time intervals
An ordinary annuity assumes all cash flows occur at the end of each period
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Both the future value and the present value of an annuity can be calculated using the formulas introduced
last week
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In the above future value calculation:
o First payment receives interest for two periods
o Second payment receives interest for only one period
o Third payment receives no interest
Example 1
Future value of an annuity
Example 1 (solution)
Example 2
Example 3
Present value of annuity
Example 4
Example 5
Example 6
Example 7
Perpetuity
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A perpetuity is a special type of annuity with an infinite number of payments
o It is a perpetual annuity
The present value of a perpetuity is:
o PV = PMT / i
There is no future value
Example 8
Example 9
Lecture 4 (The Time Value of Money 3)
Saving
Examples of saving
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Retirement planning (super)
Saving for an expense in the future
Investments
Example 1
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You are required to analyze the investment potential of a forestry plantation.
The cost to invest is $6,000 in 2019.
Projected returns from this investment are
o $3,000 in 2022 and
o $7,500 in 2027
The interest rate is 15%.
Is it worth investing in this project?
Example 2
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Bert and Beryl want to establish a fund that will pay $10,000 to each of their two grandchildren, Peter, and
Mary, when they turn 21.
Mary turns 21 in ten years’ time and Peter turns 21 in twelve-and-a-half years’ time.
If the fund’s interest rate is 8% pa. compounded half-yearly, what amount should Bert and Beryl deposit
today?
Example 3
Examples 4
Effective annual Rates (EAR)
Example 5
The “Rule of 72”
Borrowing
Examples of Borrowing
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Loans
Mortgages
Example 6
Example 7
Amortization Schedule
Lecture 5 (Debt)
What is debt?
Distinguishing Features of debt?
Why lenders protect against loss
Short Term Debt
Bills of Exchange
Legal Definition of a bill
Features of a Bill
Long Term Debt
Features of a Bond
Valuation of Debt
Valuing Bills
Example 1
Example 2
Bond Valuation
Question
Example 3
Example 4
Example 5
Bond values and yields
Yield to maturity
Example 6
Example 7