Financial management: Lecture 2 Financial markets and review of some concepts Some important concepts

Financial management: Lecture 2 Today’s agenda Some administrative issues Understand financial markets and their functions Understand the concept of the cost of capital and the time value of money Learn how to compare: Cash flows or payments you get today Cash flows or payments you get in the future

Financial management: Lecture 2 Course materials I have posted all the materials on my website: I am sorry that I don’t post things on I- learn

Financial management: Lecture 2 Financial Manager Firm's operations Investors (1) Investors buy shares with cash (1) (2)Cash is invested (2) (3) Operations generates cash (3) (4a) Cash reinvested (4a) (4b) Cash returned to investors (4b) Financial markets and investors Real assets (timberland) (stockholders save and invest in closely held firm.)

Financial management: Lecture 2 Financial markets A financial market Securities are issued and traded The classification of the financial market By seasoning of claim Primary market Secondary market By nature of market Debt market Equity market

Financial management: Lecture 2 Financial markets (continue) By maturity of claim Money market Capital market

Financial management: Lecture 2 The functions of financial markets 1. Conducting exchange 2. Providing liquidity 3. Pooling money to fund large corporations 4. Transferring money across time and distance 5. Risk management (hedge, diversify) 6. Providing information 7. Providing efficient allocation of money

Financial management: Lecture 2 Conducting exchange What does it mean ? Examples

Financial management: Lecture 2 Providing liquidity What does this mean? Examples

Financial management: Lecture 2 Pooling money to fund large corporation investments What does this mean? Examples

Financial management: Lecture 2 Transferring money across time and distance What does this mean? Examples

Financial management: Lecture 2 Risk management What does this mean? Examples

Financial management: Lecture 2 Providing information What does this mean? Examples

Financial management: Lecture 2 Providing efficient allocation of money What does this mean? Examples

Financial management: Lecture 2 The cost of capital The cost of capital is a very important concept in capital budgeting. It links investment opportunities in financial markets and investment opportunities in real assets markets.

Financial management: Lecture 2 What is the cost of capital? Cash Investment opportunity (real asset) FirmShareholder Investment opportunities (financial assets) InvestAlternative: pay dividend to shareholders Shareholders invest for themselves

Financial management: Lecture 2 Financial choices Which would you rather receive today? TRL 1,000,000,000 ( one billion Turkish lira ) USD 850 ( U.S. dollars ) Both payments are absolutely guaranteed. What do we do?

Financial management: Lecture 2 Financial choices We need to compare “apples to apples” - this means we need to get the TRL:USD exchange rate From we can see: USD 1 = TRL 1,505,274 Therefore TRL 1bn = USD 664

Financial management: Lecture 2 Financial choices with time Which would you rather receive? $1000 today $1200 in one year Both payments have no risk, that is, there is 100% probability that you will be paid there is 0% probability that you won’t be paid

Financial management: Lecture 2 Financial choices with time (2) Why is it hard to compare ? $1000 today $1200 in one year This is not an “apples to apples” comparison. They have different units $100 today is different from $100 in one year Why? A cash flow is time-dated money It has a money unit such as USD or TRL It has a date indicating when to receive money

Financial management: Lecture 2 Present value In order to have an “apple to apple” comparison, we convert future payments to the present values this is like converting money in TRL to money in USD Certainly, we can also convert the present value to the future value to compare payments we get today with payments we get in the future. Although these two ways are theoretically the same, but the present value way is more important and has more applications, as to be shown in stock and bond valuations.

Financial management: Lecture 2 Present value (2) The formula for converting future cash flows or payments: = present value at time zero = cash flow in the future (in year i) = discount rate for the cash flow in year i

Financial management: Lecture 2 Example 1 What is the present value of $100 received in one year (next year) if the discount rate is 7%? Step 1: draw the cash flow diagram Step 2: think ! PV $100 Step 3: PV=100/(1.07) 1 = Year one $100 PV=?

Financial management: Lecture 2 Example 2 What is the present value of $100 received in year 5 if the discount rate is 7%? Step 1: draw the cash flow diagram Step 2: think ! PV $ 100 Step 3: PV=100/(1.07) 5 = Year 5 $100 PV=?

Financial management: Lecture 2 Example 3 What is the present value of $100 received in year 20 if the discount rate is 7%? Step 1: draw the cash flow diagram Step 2: think ! PV $ 100 Step 3: PV=100/(1.07) 20 = Year 20 $100 PV=?

Financial management: Lecture 2 Present value of multiple cash flows For a cash flow received in year one and a cash flow received in year two, different discount rates must be used. The present value of these two cash flows is the sum of the present value of each cash flow, since two present value have the same unit: time zero USD.

Financial management: Lecture 2 Example 4 John is given the following set of cash flows and discount rates. What is the PV? Step 1: draw the cash flow diagram Step 2: think ! PV $200 Step 3: PV=100/(1.1) /(1.09) 2 = Year one $100 PV=? $100 Year two

Financial management: Lecture 2 Example 5 John is given the following set of cash flows and discount rates. What is the PV? Step 1: draw the cash flow diagram Step 2: think ! PV $350 Step 3: PV=100/(1.1) /(1.09) /(1.07) 3 = Yr 1 $100 PV=? $50 Yr 3Yr 2 $200

Financial management: Lecture 2 Projects A “project” is a term that is used to describe the following activity : spend some money today receive cash flows in the future A stylized way to draw project cash flows is as follows: Initial investment (negative cash flows) Expected cash flows in year one (probably positive) Expected cash flows in year two (probably positive)

Financial management: Lecture 2 Examples of projects An entrepreneur starts a company: initial investment is negative cash outflow. future net revenue is cash inflow. An investor buys a share of IBM stock cost is cash outflow; dividends are future cash inflows. A lottery ticket: investment cost: cash outflow of $1 jackpot: cash inflow of $20,000,000 (with some very small probability…) Thus projects can range from real investments, to financial investments, to gambles (the lottery ticket).

Financial management: Lecture 2 Firms or companies A firm or company can be regarded as a set of projects. capital budgeting is about choosing the best projects in real asset investments. How do we know one project is worth taking?

Financial management: Lecture 2 Net present value A net present value (NPV) is the sum of the initial investment (usually made at time zero) and the PV of expected future cash flows.

Financial management: Lecture 2 NPV rule If NPV > 0, the manager should go ahead to take the project; otherwise, the manager should not.

Financial management: Lecture 2 Example 6 Given the data for project A, what is the NPV? Step1: draw the cash flow graph Step 2: think! NPV 10 Step 3: NPV=-50+50/(1.075)+10/(1.08) 2 = Yr 0 Yr 1Yr 2 $10$50 -$50