Lecture 1 Managerial Finance FINA 6335 Ronald F. Singer

1-2 Finance The study of resource allocation under conditions of uncertainty. Merges: –Economics. –Accounting. –Statistics.

1-3 Areas Corporate Finance From the viewpoint of the Financial Manager –Capital Budgeting –Dividend Policy –Capital Structure Investments From the viewpoint of individual and institutional investors –Risk –Return –Portfolio Decisions

1-4 Types of Financial Securities Equity Capital –Common Stock –Preferred Stock Debt Capital –Bonds Hybrid Securities –Why hold Securities?

1-5 The Rewards and Risks to Security Holders The Rewards –To Stockholders –To Bondholders The Risks: –To Stockholders –To Bondholders

1-6 The Goal of Financial Management What should be the goal? Possible measures of performance of financial managers How do managers achieve their objectives? Make Decisions that

1-7 Cash Flow The cash flows of a company are the total dollar amount of funds available for the firm use Steps to determine cash flows –1 –2 Example: - Revenues less cost of production depreciation - Profit before Taxes less Income Taxes (34%) - Net Income Cash Flow = Net Income + Non-Cash Expenses Note that Net Income and Cash Flow are not the same! Cash Flow is the basic unit of how the firm is doing What is Cash Flow?

1-8 Investment The Problem How can we determine if a project will make stockholders’ better Or worse off??? What is an Investment? Current Cash Expenditures which are expected to generate cash inflows sometime in the future

1-9 How to Make a Decision? Inflow Benefits vs. Costs Complications Uncertainty Future Flows

1-10 Digression on Conventions of Time Cash Inflows Cash Outflows

1-11 Example For current Investment of $10,000, receive $5,000 within 1 year, $6,000 in years 3 through Observations: 1.t = 0 current time. 2.Everything happens at the end of a period unless specified otherwise.

1-12 Present Value The present value of receiving $1,000, one year from today? $ It is : What $1000 received one year from today is worth today.

1-13 Present Value Present Value is: –How much someone would lend me on that claim –How much I could sell the claim for –How much it would cost to engage in a "similar" investment What is the Answer? –In order to answer that question we have to know what “interest rate” is assumed. –Assume that the interest rate is 25%? –Thus, you pay $200 interest to borrow $800 now

1-14 The Market Rate of Interest In this case, the initial amount is also the present value OR

1-15 1/1+R is called the Discount Factor Present Value = Future amount x Discount Factor If R is 25 % Discount Factor is and PV (1,000; 25%; 1 yr) = 1 [1000] 1.25 = 0.80 [1000] = 800

1-16 Wealth Wealth is the present value of all Current and Future income. Suppose that an individual has $1,000 in his/her pocket and has a claim on $1,000 one year from now. What is his wealth if the interest rate is 25%? $1,000 in his pocket is worth $1,000. $1,000 one year from now is worth $800 = 1,000/(1 +R) = 1000/(1.25) Therefore, his Wealth is $1,800. You have to convert all future income to Present Values before you can add them up

1-17 Market Opportunity Line The Market Opportunity Line shows how an individual can exchange current for future consumption Possible Alternatives Endowment1000Now1000Next Year How?500“1625“ How?Zero“2250“ Wealth1800“Zero“ 1500“?“

1-18 Market Opportunity Line Notice that this individual's wealth is indicated by the horizontal intercept. The Wealth is the maximum an individual can consume today by borrowing against all of his/her future income

1-19 Market Opportunity Line The slope of the market opportunity line is: - (1 + R) Slope = Rise/Run = (Principal + Interest) - Principal = -( 1 + Interest ) Principal = -(1 + R) If you give up $500 now, you can get: 500 X (1 + R) = 500(1.25) = $625 more next year. If you want to get $800 more now, you must give up: 800 X (1.25) or $1,000 next year

1-20 Production/Investment Future consumption If you invest $500 you get $800 more next year. Rate of return on investment = = 0.60 (or 60%)

1-21 What is the wealth of this individual after he makes the investment Wealth = Current + Future x Discount Income Income Factor = x 1 / 1.25 = $1940 If this individual desires, he can alter the time pattern of his income by borrowing/lending

1-22 If he wants to consume $1,000 now instead of $500, Borrow $500 after making the $500 investment Next year, pay back principal plus interest: 500 X (1.25) = 625 He will have left 1, = 1,175 $1000 Now And $1175 Next Year or, 500 " And $1800 " " or, Zero " And $2425 " " or, 1940 " And Zero " " Consequently, regardless of his time preference for consumption, this individual is better off after the investment. He is better off, because he's wealthier?

1-23 Bottom Line 1. Wealth is the PRESENT VALUE of income stream 2. All individuals are unambiguously better off when their wealth increases. 3. The net present value of an investment project is the amount investors' wealth would increase (decrease) if the project were undertaken.

1-24 Problem of the Day Find the Wealth of an individual who will earn $500,000 over the current year and who has $2,000,000 equity in assets (such as a home, a car, cash, etc.). Assume the interest rate is 8% Find the wealth of the same individual who also can invest up to $200,000 in a machine which will produce widgets. The rate of return for this investment is 17%.

1-25 Problem of the Day Determine the Net Income and cash flow arising from the following: Total Revenue$300,000 Cost of Goods Sold $50,000 Depreciation $60,000 The corporate tax rate is 34% of before tax income.