Types of Firms
Focus is on the listed companies
Also have sole proprietorship, partnership/limited partnership, proprietary limited company,
limited liability company
Corporation is a legal entity separate from owners
Ownership represents owning shares, offered via initial public offering (IPO)
Direct control by an elected board of directors, CFO handles financial concerns
Market Value Maximization
Shareholders are the main stakeholder focused on by managers
3 Important Concepts:
1. Time value of money and interest rates
2. Riskless arbitrage and the law of one price (idea of an item trading at the same price
in any market)
3. The role of information and capital market efficiency (market prices reflect all relevant
information available)
Google mistake with Bard lost $100 billion, market reacts very swiftly
Time Value of Money and Interest Rates
Examining costs and benefits of cash flows
Valuation principle states that if the value of benefits exceed the value of costs, decision will
increase the company’s value
Riskfree interest rate measures the rate of exchange over time, borrowing exchanges future
money for money today
Always need to take time value of money into account
Simple Versus Compounded Interest
Simple interest is the value of a cash flow without any earned interest to the amount you
invest e.g. $1,000 investment with 8% interest over 5 years is 10001.085 = $1,400 total
FV=PV((1+n)*r)
Compounded interest is used more commonly
Compounded Interest: Amount accrued is added back to the principal and reinvested,
referred to as interest on interest
For the same scenario = $1,469.33
FV=PV(1+r)^n
FV and PV of Single Cash Flow
FV at r% of a PV is the dollar value at the end of time period n
PV at r% of a FV at the end of time n is the amount which invested today would grow to FV
in n
1/(1+r) is referred to as the one-year discount factor
PV=FV/(1+r)^n <- INCREDIBLY IMPORTANT
Factors Influencing PV and FV
Time period (n):
FV increases as n increases
PV decreases as n increases
Interest rate (r):
FV increases as r increases
PV decreases as r increases
Method of computing interest:
FV increases as compounding frequency increases
PV decreases as compounding frequency increases
Four Rules
1. Can only compare or combine cash flows at the same point in time
2. Move cash flows forwards in time must have compounding
3. Moving cash flows back must have discounting
4. Interest rate used to compound or discount must match periodicity of cash flows
PV and FV of a Series of Cash Flows
Valued using the value additivity principle: The present (future) value of a series of cash
flows is equal to the sum of the present (future) values of each cash flow
Net present value of an investment resulting in a series of cash flows is PV of benefits minus
PV of costs
Decision: Accept investment if NPV is positive
Internal rate of return is when investment and interest rates produce the same return
Key Concepts
Managers aim to maximize firm’s share by taking profitable investments
Simple interest doesn’t include accrued, compound interest does
PV and FV of a cash flow
Interest rate and computing interest method
NPV of a project = PV (inflows) - PV (outflows)
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