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Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
Chapter 1
The Role of
Managerial
Finance
© 2012 Pearson Prentice Hall. All rights reserved. 1-2
What is Finance?
• Finance:
– Most Commonly Prevailing Currency is known as Finance.
Business Finance: Any thing which can be used to Purchase Assets
and Pay off Liabilities is known as Business Finance.
Accounts Source Use
Assets - +
Equities + -
© 2012 Pearson Prentice Hall. All rights reserved. 1-3
What is Finance?
• Financial Management: can be defined as the science
and art of managing money.
• At the personal level, finance is concerned with
individuals’ decisions about how much of their earnings
they spend, how much they save, and how they invest
their savings.
• In a business context, finance involves the same types of
decisions: how firms raise money from investors, how
firms invest money in an attempt to earn a profit, and how
they decide whether to reinvest profits in the business or
distribute them back to investors.
© 2012 Pearson Prentice Hall. All rights reserved. 1-4
What is Finance?
• Finance Scope:
– Anticipation.
– Acquisition
– Allocation of Finance or Money
Financial Activities:
Balance Sheet
Assets Equates
Investing Activities Financing Activities
Rewarding Activities
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Branches of Finance
• Financial Management
– Personal Finance
– Business Finance
– Corporate Finance
– International Finance
– Investment & Portfolio Management
– Financial Statements Analysis.
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Career Opportunities in
Finance: Financial Services
• Financial Services is the area of finance concerned with
the design and delivery of advice and financial products
to individuals, businesses, and governments.
• Career opportunities include banking, personal financial
planning, investments, real estate, and insurance.
© 2012 Pearson Prentice Hall. All rights reserved. 1-7
Career Opportunities in
Finance: Managerial Finance
• Managerial finance is concerned with the duties of the
financial manager working in a business.
• Financial managers administer the financial affairs of all
types of businesses—private and public, large and small,
profit-seeking and not-for-profit.
• They perform such varied tasks as developing a financial
plan or budget, extending credit to customers, evaluating
proposed large expenditures, and raising money to fund
the firm’s operations.
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Focus on Practice
Professional Certifications in Finance:
– Chartered Financial Analyst (CFA) – Offered by the CFA
Institute, the CFA program is a graduate-level course of study
focused primarily on the investments side of finance.
– Certified Treasury Professional (CTP) – The CTP program
requires students to pass a single exam that is focused on the
knowledge and skills needed for those working in a corporate
treasury department.
– Certified Financial Planner (CFP) – To obtain CFP status,
students must pass a ten-hour exam covering a wide range of
topics related to personal financial planning.
© 2012 Pearson Prentice Hall. All rights reserved. 1-9
Focus on Practice (cont.)
Professional Certifications in Finance:
– American Academy of Financial Management (AAFM) – The
AAFM administers a host of certification programs for financial
professionals in a wide range of fields. Their certifications
include the Charter Portfolio Manager, Chartered Asset
Manager, Certified Risk Analyst, Certified Cost Accountant,
Certified Credit Analyst, and many other programs.
– Professional Certifications in Accounting – Most professionals
in the field of managerial finance need to know a great deal
about accounting to succeed in their jobs. Professional
certifications in accounting include the Certified Public Accountant
(CPA), Certified Management Accountant (CMA), Certified Internal
Auditor (CIA), and many programs.
© 2012 Pearson Prentice Hall. All rights reserved. 1-10
Legal Forms of Business
Organization
• A sole proprietorship is a business owned by one person
and operated for his or her own profit.
• A partnership is a business owned by two or more
people and operated for profit.
• A corporation is an entity created by law. Corporations
have the legal powers of an individual in that it can sue
and be sued, make and be party to contracts, and acquire
property in its own name.
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Table 1.1 Strengths and Weaknesses of the
Common Legal Forms of Business Organization
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Matter of Fact
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Figure 1.1 Corporate
Organization
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Table 1.2 Career Opportunities
in Managerial Finance
Review Questions
1–1 What is finance? Explain how this field affects all of the activities in which
businesses engage.
1–2 What is the financial services area of finance? Describe the field of managerial
finance.
1–3 Which legal form of business organization is most common? Which form is
dominant in terms of business revenues?
1–4 Describe the roles and the basic relationships among the major parties in a
corporation—stockholders, board of directors, and managers. How are corporate
owners rewarded for the risks they take?
1–5 Briefly name and describe some organizational forms other than corporations
that provide owners with limited liability.
1–6 Why is the study of managerial finance important to your professional life
regardless of the specific area of responsibility you may have within the business
firm? Why is it important to your personal life?
© 2012 Pearson Prentice Hall. All rights reserved. 1-15
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Goal of the Firm:
Maximize Shareholder Wealth
Decision rule for managers: only take actions that are
expected to increase the share price.
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Goal of the Firm:
Maximize Profit?
Profit maximization may not lead to the highest possible share price
for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later is preferred
2. Profits do not necessarily result in cash flows available to stockholders
3. Profit maximization fails to account for risk
Which Investment is Preferred?
Risk and Risk behavior
Risk The chance that actual outcomes may
differ from those expected
risk averse: Requiring compensation to
bear risk.
© 2012 Pearson Prentice Hall. All rights reserved. 1-18
© 2012 Pearson Prentice Hall. All rights reserved. 1-19
Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees, customers,
suppliers, creditors, owners, and others who have a direct
economic link to the firm.
• A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to stakeholders. The
goal is not to maximize stakeholder well-being but to
preserve it.
• Such a view is considered to be "socially responsible."
© 2012 Pearson Prentice Hall. All rights reserved. 1-20
The Role of Business Ethics
• Business ethics are the standards of conduct or moral
judgment that apply to persons engaged in commerce.
• Violations of these standards in finance involve a variety
of actions: “creative accounting,” earnings management,
misleading financial forecasts, insider trading, fraud,
excessive executive compensation, options backdating,
bribery, and kickbacks.
• Negative publicity often leads to negative impacts on a
firm
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The Role of Business Ethics:
Considering Ethics
Robert A. Cooke, a noted ethicist, suggests that the
following questions be used to assess the ethical viability of
a proposed action:
– Is the action arbitrary or capricious? Does the action unfairly
single out an individual or group?
– Does the action affect the morals, or legal rights of any
individual or group?
– Does the action conform to accepted moral standards?
– Are there alternative courses of action that are less likely to
cause actual or potential harm?
© 2012 Pearson Prentice Hall. All rights reserved. 1-22
The Role of Business Ethics:
Ethics and Share Price
Ethics programs seek to:
– reduce litigation and judgment costs
– maintain a positive corporate image
– build shareholder confidence
– gain the loyalty and respect of all stakeholders
The expected result of such programs is to positively affect
the firm’s share price.
Review Questions
1–7 What is the goal of the firm and, therefore, of all managers
and employees? Discuss how one measures achievement of
this goal.
1–8 For what three basic reasons is profit maximization
inconsistent with wealth maximization?
1–9 What is risk? Why must risk as well as return be considered
by the financial manager who is evaluating a decision
alternative or action?
1–10 Describe the role of corporate ethics policies and
guidelines, and discuss the relationship that is believed to
exist between ethics and share price.
© 2012 Pearson Prentice Hall. All rights reserved. 1-23
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Managerial Finance Function
• The size and importance of the managerial finance
function depends on the size of the firm.
• In small firms, the finance function is generally
performed by the accounting department.
• As a firm grows, the finance function typically evolves
into a separate department linked directly to the company
president or CEO through the chief financial officer
(CFO) (see Figure 1.1)
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Managerial Finance Function:
Relationship to Economics
• The field of finance is closely related to economics.
• Financial managers must understand the economic
framework and be alert to the consequences of varying
levels of economic activity and changes in economic
policy.
• They must also be able to use economic theories as
guidelines for efficient business operation.
© 2012 Pearson Prentice Hall. All rights reserved. 1-26
Managerial Finance Function:
Relationship to Economics (cont.)
• Marginal cost–benefit analysis is the economic principle
that states that financial decisions should be made and
actions taken only when the added benefits exceed the
added costs
• Marginal cost-benefit analysis can be illustrated using the
following simple example.
Example
Jamie Teng is a financial manager for Nord Department Stores, a large chain
of upscale department stores operating primarily in the western United
States. She is currently trying to decide whether to replace one of the firm’s
computer servers with a new, more sophisticated one that would both
speed processing and handle a larger volume of transactions. The new
computer would require a cash outlay of $8,000, and the old computer
could be sold to net $2,000. The total benefits from the new server
(measured in today’s dollars) would be $10,000. The benefits over a
similar time period from the old computer (measured in today’s dollars)
would be $3,000. Applying marginal cost–benefit analysis, Jamie
organizes the data as follows:
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Managerial Finance Function:
Relationship to Economics (cont.)
Nord Department Stores is applying marginal-cost benefit
analysis to decide whether to replace a computer:
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Managerial Finance Function:
Relationship to Accounting
• The firm’s finance and accounting activities are closely-
related and generally overlap.
• In small firms accountants often carry out the finance
function, and in large firms financial analysts often help
compile accounting information.
• One major difference in perspective and emphasis
between finance and accounting is that accountants
generally use the accrual method while in finance, the
focus is on cash flows.
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Managerial Finance Function:
Relationship to Accounting (cont.)
• Whether a firm earns a profit or experiences a loss, it must
have a sufficient flow of cash to meet its obligations as
they come due.
• The significance of this difference can be illustrated using
the following simple example.
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Managerial Finance Function:
Relationship to Accounting (cont.)
The Nassau Corporation experienced the following activity
last year:
Sales $100,000 (1 yacht sold, 100% still
uncollected)
Costs $ 80,000 (all paid in full under supplier
terms)
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Managerial Finance Function:
Relationship to Accounting (cont.)
Now contrast the differences in performance under the
accounting method (accrual basis) versus the financial view
(cash basis):
Income Statement Summary
Accrual basis Cash basis
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)
© 2012 Pearson Prentice Hall. All rights reserved. 1-33
Managerial Finance Function:
Relationship to Accounting (cont.)
Finance and accounting also differ with respect to decision-
making:
– Accountants devote most of their attention to the collection and
presentation of financial data.
– Financial managers evaluate the accounting statements, develop
additional data, and make decisions on the basis of their
assessment of the associated returns and risks.
© 2012 Pearson Prentice Hall. All rights reserved. 1-34
Personal Finance Example
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Figure 1.3
Financial Activities
Review Questions:
1–11 In what financial activities does a corporate treasurer
engage?
1–12 What is the primary economic principle used in
managerial finance?
1–13 What are the major differences between accounting and
finance with respect to emphasis on cash flows and decision
making?
1–14 What are the two primary activities of the financial
manager that are related to the firm’s balance sheet?
© 2012 Pearson Prentice Hall. All rights reserved. 1-36
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Governance and Agency:
Corporate Governance
• Corporate governance refers to the rules, processes, and
laws by which companies are operated, controlled, and
regulated.
• It defines the rights and responsibilities of the corporate
participants such as the shareholders, board of directors,
officers and managers, and other stakeholders, as well as
the rules and procedures for making corporate decisions.
• The structure of corporate governance was previously
described in Figure 1.1.
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Governance and Agency:
Individual versus Institutional Investors
• Individual investors are investors who own relatively small
quantities of shares so as to meet personal investment goals.
• Institutional investors are investment professionals, such as banks,
insurance companies, mutual funds, and pension funds, that are paid
to manage and hold large quantities of securities on behalf of others.
• Unlike individual investors, institutional investors often monitor and
directly influence a firm’s corporate governance by exerting pressure
on management to perform or communicating their concerns to the
firm’s board.
© 2012 Pearson Prentice Hall. All rights reserved. 1-39
Governance and Agency:
Government Regulation
• Government regulation generally shapes the corporate
governance of all firms.
• During the recent decade, corporate governance has
received increased attention due to several high-profile
corporate scandals involving abuse of corporate power
and, in some cases, alleged criminal activity by corporate
officers.
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Governance and Agency:
Government Regulation
The Sarbanes-Oxley Act of 2002:
• established an oversight board to monitor the accounting industry;
• tightened audit regulations and controls;
• toughened penalties against executives who commit corporate fraud;
• strengthened accounting disclosure requirements and ethical guidelines for
corporate officers;
• established corporate board structure and membership guidelines;
• established guidelines with regard to analyst conflicts of interest;
• mandated instant disclosure of stock sales by corporate executives;
• increased securities regulation authority and budgets for auditors and investigators.
© 2012 Pearson Prentice Hall. All rights reserved. 1-41
Governance and Agency:
The Agency Issue
• A principal-agent relationship is an arrangement in
which an agent acts on the behalf of a principal. For
example, shareholders of a company (principals) elect
management (agents) to act on their behalf.
• Agency problems arise when managers place personal
goals ahead of the goals of shareholders.
• Agency costs arise from agency problems that are borne
by shareholders and represent a loss of shareholder
wealth.
© 2012 Pearson Prentice Hall. All rights reserved. 1-42
The Agency Issue:
Management Compensation Plans
• In addition to the roles played by corporate boards,
institutional investors, and government regulations,
corporate governance can be strengthened by ensuring
that managers’ interests are aligned with those of
shareholders.
• A common approach is to structure management
compensation to correspond with firm performance.
© 2012 Pearson Prentice Hall. All rights reserved. 1-43
The Agency Issue:
Management Compensation Plans
• Incentive plans are management compensation plans that
tie management compensation to share price; one example
involves the granting of stock options.
• Performance plans tie management compensation to
measures such as EPS or growth in EPS. Performance
shares and/or cash bonuses are used as compensation
under these plans.
© 2012 Pearson Prentice Hall. All rights reserved. 1-44
Matter of Fact—Forbes.com
CEO Performance vs. Pay
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The Agency Issue: The Threat
of Takeover
• When a firm’s internal corporate governance structure is
unable to keep agency problems in check, it is likely that
rival managers will try to gain control of the firm.
• The threat of takeover by another firm, which believes it
can enhance the troubled firm’s value by restructuring its
management, operations, and financing, can provide a
strong source of external corporate governance.
Review Questions:
1–15 What is corporate governance? How has the Sarbanes-Oxley Act of
2002 affected it? Explain.
1–16 Define agency problems, and describe how they give rise to agency
costs. Explain how a firm’s corporate governance structure can help avoid
agency problems.
1–17 How can the firm structure management compensation to minimize
agency problems? What is the current view with regard to the execution of
many compensation plans?
1–18 How do market forces—both shareholder activism and the threat of
takeover—act to prevent or minimize the agency problem? What role do
institutional investors play in shareholder activism?
© 2012 Pearson Prentice Hall. All rights reserved. 1-46
Exercies
Emphasis on Cash Flows Worldwide Rugs is a rug importer located in the United States that
resells its import products to local retailers. Last year Worldwide Rugs imported $2.5 million
worth of rugs from around the world, all of which were paid for prior to shipping. On receipt of
the rugs, the importer immediately resold them to local retailers for $3 million. To allow its
retail clients time to resell the rugs, Worldwide Rugs sells to retailers on credit. Prior to the
end of its business year, Worldwide Rugs collected 85% of its outstanding accounts
receivable.
a. What is the accounting profit that Worldwide Rugs generated for the year?
b. Did Worldwide Rugs have a successful year from an accounting perspective?
c. What is the financial cash flow that Worldwide Rugs generated for the year?
d. Did Worldwide Rugs have a successful year from a financial perspective?
e. If the current pattern persists, what is your expectation for the future success of Worldwide
Rugs?
© 2012 Pearson Prentice Hall. All rights reserved. 1-47
Exercises:
Ann and Jack have been partners for several years. Their firm,
A & J Tax Preparation, has been very successful, as the pair
agree on most business-related questions. One disagreement,
however, concerns the legal form of their business. Ann has
tried for the past 2 years to get Jack to agree to incorporate.
She believes that there is no downside to incorporating and
sees only benefits. Jack strongly disagrees; he thinks that the
business should remain a partnership forever. First, take Ann’s
side, and explain the positive side to incorporating the
business. Next, take Jack’s side, and state the advantages to
remaining a partnership. Lastly, what information would you
want if you were asked to make the decision for Ann and
Jack?
© 2012 Pearson Prentice Hall. All rights reserved. 1-48
Exercises:
The end-of-year parties at Yearling, Inc., are known for their
extravagance. Management provides the best food and
entertainment to thank the employees for their hard work.
During the planning for this year’s bash, a disagreement broke
out between the treasurer’s staff and the controller’s staff. The
treasurer’s staff contended that the firm was running low on
cash and might have trouble paying its bills over the coming
months; they requested that cuts be made to the budget for
the party. The controller’s staff felt that any cuts were
unwarranted as the firm continued to be very profitable. Can
both sides be right? Explain your answer.
© 2012 Pearson Prentice Hall. All rights reserved. 1-49
Exercises:
You have been made treasurer for a day at AIMCO, Inc. AIMCO develops
technology for video conferencing. A manager of the satellite division has
asked you to authorize a capital expenditure in the amount of $10,000. The
manager states that this expenditure is necessary to continue a long-
running project designed to use satellites to allow video conferencing
anywhere on the planet. The manager admits that the satellite concept has
been surpassed by recent technological advances in telephony, but he
feels that AIMCO should continue the project. His reasoning is based on
the fact that $2.5 million has already been spent over the past 15 years on
this project. Although the project has little chance to be viable, the
manager believes it would be a shame to waste the money and time
already spent. Use marginal cost–benefit analysis to make your decision
regarding whether you should authorize the $10,000 expenditure to
continue the project.
© 2012 Pearson Prentice Hall. All rights reserved. 1-50
Exercises:
Recently, some branches of Donut Shop, Inc., have dropped the practice of
allowing employees to accept tips. Customers who once said, “Keep the
change,” now have to get used to waiting for their nickels. Management
even instituted a policy of requiring that the change be thrown out if a
customer drives off without it. As a frequent customer who gets coffee and
doughnuts for the office, you notice that the lines are longer and that more
mistakes are being made in your order. Explain why tips could be viewed
as similar to stock options and why the delays and incorrect orders could
represent a case of agency costs. If tips are gone forever, how could Donut
Shop reduce these agency costs?
© 2012 Pearson Prentice Hall. All rights reserved. 1-51
Exercises:
Liability comparisons Merideth Harper has invested $25,000
in Southwest Development Company. The firm has recently
declared bankruptcy and has $60,000 in unpaid debts.
Explain the nature of payments, if any, by Ms. Harper in each
of the following situations.
a. Southwest Development Company is a sole proprietorship
owned by Ms. Harper.
b. Southwest Development Company is a 50–50 partnership of
Ms. Harper and Christopher Black.
c. Southwest Development Company is a corporation.
© 2012 Pearson Prentice Hall. All rights reserved. 1-52
Exercises:
Accrual income versus cash flow for a period Thomas Book Sales, Inc.,
supplies textbooks to college and university bookstores. The books are
shipped with a proviso that they must be paid for within 30 days but can be
returned for a full refund credit within 90 days. In 2009, Thomas shipped
and billed book titles totaling $760,000. Collections, net of return credits,
during the year totaled $690,000. The company spent $300,000 acquiring
the books that it shipped.
a. Using accrual accounting and the preceding values, show the firm’s net
profit for the past year.
b. Using cash accounting and the preceding values, show the firm’s net cash
flow for the past year.
c. Which of these statements is more useful to the financial manager? Why?
© 2012 Pearson Prentice Hall. All rights reserved. 1-53
Exercises:
Cash flows It is typical for Jane to plan, monitor, and assess her financial
position using cash flows over a given period, typically a month. Jane has
a savings account, and her bank loans money at 6% per year while it
offers short-term investment rates of 5%. Jane’s cash flows during August
were as follows:
Clothes $1,000 Interest received $ 450 Dining out 500 Groceries 800 Salary 4,500 Auto payment 355
Utilities 280 Mortgage 1,200 Gas 222
a. Determine Jane’s total cash inflows and cash outflows.
b. Determine the net cash flow for the month of August.
c. If there is a shortage, what are a few options open to Jane?
d. If there is a surplus, what would be a prudent strategy for her to follow?
© 2012 Pearson Prentice Hall. All rights reserved. 1-54
Exercise:
Marginal cost–benefit analysis and the goal of the firm Ken Allen, capital
budgeting analyst for Bally Gears, Inc., has been asked to evaluate a proposal.
The manager of the automotive division believes that replacing the robotics used
on the heavy truck gear line will produce total benefits of $560,000 (in today’s
dollars) over the next 5 years. The existing robotics would produce benefits of
$400,000 (also in today’s dollars) over that same time period. An initial cash
investment of $220,000 would be required to install the new equipment. The
manager estimates that the existing robotics can be sold for $70,000. Show how
Ken will apply marginal cost–benefit analysis techniques to determine the following:
a. The marginal (added) benefits of the proposed new robotics.
b. The marginal (added) cost of the proposed new robotics.
c. The net benefit of the proposed new robotics.
d. What should Ken Allen recommend that the company do? Why?
e. What factors besides the costs and benefits should be considered before the final
decision is made?
© 2012 Pearson Prentice Hall. All rights reserved. 1-55
Exercises:
Identifying agency problems, costs, and resolutions Explain why each of
the following situations is an agency problem and what costs to the firm
might result from it. Suggest how the problem might be dealt with short of
firing the individual(s) involved.
a. The front desk receptionist routinely takes an extra 20 minutes of lunch
time to run personal errands.
b. Division managers are padding cost estimates so as to show short-term
efficiency gains when the costs come in lower than the estimates.
c. The firm’s chief executive officer has had secret talks with a competitor
about the possibility of a merger in which she would become the CEO of
the combined firms.
d. A branch manager lays off experienced full-time employees and staffs
customer service positions with part-time or temporary workers to lower
employment costs and raise this year’s branch profit. The manager’s
bonus is based on profitability.
© 2012 Pearson Prentice Hall. All rights reserved. 1-56
Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
Chapter 2
The Financial
Market
Environment
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Financial Institutions & Markets
Firms that require funds from external sources can obtain
them in three ways:
1. through a financial institution
2. through financial markets
3. through private placements
© 2012 Pearson Prentice Hall. All rights reserved. 2-3
Financial Institutions &
Markets: Financial Institutions
• Financial institutions are intermediaries that channel the
savings of individuals, businesses, and governments into
loans or investments.
• The key suppliers and demanders of funds are individuals,
businesses, and governments.
• In general, individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.
© 2012 Pearson Prentice Hall. All rights reserved. 2-4
Commercial Banks, Investment Banks,
and the Shadow Banking System
• Commercial banks are institutions that provide savers
with a secure place to invest their funds and that offer
loans to individual and business borrowers.
• Investment banks are institutions that assist companies
in raising capital, advise firms on major transactions such
as mergers or financial restructurings, and engage in
trading and market making activities.
© 2012 Pearson Prentice Hall. All rights reserved. 2-5
Commercial Banks, Investment Banks,
and the Shadow Banking System (cont.)
• The Glass-Steagall Act was an act of Congress in 1933
that created the federal deposit insurance program and
separated the activities of commercial and investment
banks.
– Repealed in the late 1990s.
• The shadow banking system describes a group of
institutions that engage in lending activities, much like
traditional banks, but these institutions do not accept
deposits and are therefore not subject to the same
regulations as traditional banks.
© 2012 Pearson Prentice Hall. All rights reserved. 2-6
Financial Institutions &
Markets: Financial Markets
• Financial markets are forums in which suppliers of
funds and demanders of funds can transact business
directly.
• Transactions in short term marketable securities take
place in the money market while transactions in long-term
securities take place in the capital market.
• A private placement involves the sale of a new security
directly to an investor or group of investors.
• Most firms, however, raise money through a public
offering of securities, which is the sale of either bonds or
stocks to the general public.
© 2012 Pearson Prentice Hall. All rights reserved. 2-7
Financial Institutions & Markets:
Financial Markets (cont.)
• The primary market is the financial market in which
securities are initially issued; the only market in which the
issuer is directly involved in the transaction.
• Secondary markets are financial markets in which
preowned securities (those that are not new issues) are
traded.
© 2012 Pearson Prentice Hall. All rights reserved. 2-8
Figure 2.1
Flow of Funds
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The Money Market
• The money market is created by a financial relationship
between suppliers and demanders of short-term funds.
• Most money market transactions are made in marketable
securities which are short-term debt instruments, such as
U.S. Treasury bills, commercial paper, and negotiable
certificates of deposit issued by government, business,
and financial institutions, respectively.
• Investors generally consider marketable securities to be
among the least risky investments available.
© 2012 Pearson Prentice Hall. All rights reserved. 2-10
The Money Market (cont.)
• The international equivalent of the domestic (U.S.) money
market is the Eurocurrency market.
• The Eurocurrency market is a market for short-term bank
deposits denominated in U.S. dollars or other marketable
currencies.
• The Eurocurrency market has grown rapidly mainly
because it is unregulated and because it meets the needs
of international borrowers and lenders.
© 2012 Pearson Prentice Hall. All rights reserved. 2-11
The Capital Market
• The capital market is a market that enables suppliers and
demanders of long-term funds to make transactions.
• The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity, or
ownership).
– Bonds are long-term debt instruments used by businesses and
government to raise large sums of money, generally from a
diverse group of lenders.
– Common stock are units of ownership interest or equity in a
corporation.
– Preferred stock is a special form of ownership that has features
of both a bond and common stock.
© 2012 Pearson Prentice Hall. All rights reserved. 2-12
Broker Markets and
Dealer Markets
Broker markets are securities exchanges on which the two
sides of a transaction, the buyer and seller, are brought
together to trade securities.
– Trading takes place on centralized trading floors.
– Examples include: NYSE Euronext, American Stock Exchange
© 2012 Pearson Prentice Hall. All rights reserved. 2-13
Broker Markets and
Dealer Markets (cont.)
Dealer markets are markets in which the buyer and seller
are not brought together directly but instead have their
orders executed by securities dealers that “make markets” in
the given security.
– The dealer market has no centralized trading floors. Instead, it is
made up of a large number of market makers who are linked
together via a mass-telecommunications network.
The Nasdaq market is one example (National Association of Securities
Dealers Automated Quotation System)
As compensation for executing orders, market makers make
money on the spread (bid price – ask price).
© 2012 Pearson Prentice Hall. All rights reserved. 2-14
Matter of Fact
NYSE Euronext is the World’s Largest Stock Exchange
– According to the World Federation of Exchanges, NYSE
Euronext is the largest stock market in the world, as measured
by the total market value of securities listed on that market.
– NYSE Euronext has listed securities worth more than $11.8
trillion in the U.S. and $2.9 trillion in Europe.
– Next largest is the London Stock Exchange with securities
valued at £1.7 trillion, which is equivalent to $2.8 trillion given
the exchange rate between pounds and dollars prevailing at the
end of 2009.
© 2012 Pearson Prentice Hall. All rights reserved. 2-15
International Capital Markets
• In the Eurobond market, corporations and governments
typically issue bonds denominated in dollars and sell them
to investors located outside the United States.
• The foreign bond market is a market for bonds issued by
a foreign corporation or government that is denominated
in the investor’s home currency and sold in the investor’s
home market.
• The international equity market allows corporations to
sell blocks of shares to investors in a number of different
countries simultaneously.
© 2012 Pearson Prentice Hall. All rights reserved. 2-16
The Role of Capital Markets
• From a firm’s perspective, the role of capital markets is to be a
liquid market where firms can interact with investors in order to
obtain valuable external financing resources.
• From investors’ perspectives, the role of capital markets is to be an
efficient market that allocates funds to their most productive uses.
• An efficient market allocates funds to their most productive uses
as a result of competition among wealth-maximizing investors and
determines and publicizes prices that are believed to be close to
their true value.
© 2012 Pearson Prentice Hall. All rights reserved. 2-17
The Role of Capital Markets
(cont.)
• Advocates of behavioral finance, an emerging field that
blends ideas from finance and psychology, argue that
stock prices and prices of other securities can deviate
from their true values for extended periods.
• These people point to episodes such as the huge run up
and subsequent collapse of the prices of Internet stocks in
the late 1990s, or the failure of markets to accurately
assess the risk of mortgage-backed securities in the more
recent financial crisis, as examples of the principle that
stock prices sometimes can be wildly inaccurate measures
of value.
© 2012 Pearson Prentice Hall. All rights reserved. 2-18
Focus on Ethics
The Ethics of Insider Trading
– Martha Stewart was convicted of conspiracy, obstruction, and making false
statements to federal investigators and served 5 months in jail, 5 months of
home confinement, 2 years of probation, and a $30,000 fine.
– Laws prohibiting insider trading were established in the United States in the
1930s. These laws are designed to ensure that all investors have access to
relevant information on the same terms.
– However, many market participants believe that insider trading should be
permitted.
– If efficiency is the goal of financial markets, is allowing or disallowing
insider trading more unethical?
– Does allowing insider trading create an ethical dilemma for insiders?
Review Questions
2–1 Who are the key participants in the transactions of financial institutions?
Who are net suppliers, and who are net demanders?
2–2 What role do financial markets play in our economy? What are primary
and secondary markets? What relationship exists between financial
institutions and financial markets?
2–3 What is the money market? What is the Eurocurrency market?
2–4 What is the capital market? What are the primary securities traded in it?
2–5 What are broker markets? What are dealer markets? How do they
differ?
2–6 Briefly describe the international capital markets, particularly the
Eurobond market and the international equity market.
2–7 What are efficient markets? What determines the price of an individual
security in such a market?
© 2012 Pearson Prentice Hall. All rights reserved. 2-19
Financial Crisis
20
⚫ Financial crisis broadly refers to;
⚫ disruptions in financial markets causing constraint to the flow of
credit to families and businesses and,
⚫ consequently having an adverse effect on the real economy of
goods and services.
⚫ The term is generally used to describe a situation in
which;
⚫ investors unexpectedly lose a substantial amount of their
investments, and
⚫ financial institutions suddenly lose a significant proportion of
their value.
⚫ Financial crises include, among others;
⚫ stock market crashes,
⚫ financial bubbles,
⚫ currency crises, and
⚫ sovereign defaults.
© 2012 Pearson Prentice Hall. All rights reserved. 2-21
The Financial Crisis: Financial
Institutions and Real Estate Finance
• Securitization is the process of pooling mortgages or
other types of loans and then selling claims or securities
against that pool in a secondary market.
• Mortgage-backed securities represent claims on the cash
flows generated by a pool of mortgages and can be
purchased by individual investors, pension funds, mutual
funds, or virtually any other investor.
• A primary risk associated with mortgage-back securities
is that homeowners may not be able to, or may choose not
to, repay their loans.
The Subprime Mortgage Dilemma
It is believed that every economic crisis is the product of cheap
credit; low interest rates create demand for loans that cannot be
repaid when interest rates subsequently rise.
Lower interest rates in the United States meant that mortgages
became more affordable and more in demand.
Chapra (2009) points out that in such an environment “loan
volume gained greater priority over loan quality” and ordinary
investors were enticed to live beyond their means.
As interest rates began to rise, new-home affordability and the
ability to repay existing loans have sharply plummeted.
The problem was exacerbated by the complexity of products
that have been created by intermediary players that sought to
pass the entire risk of default to the final purchasers.
22
© 2012 Pearson Prentice Hall. All rights reserved. 2-23
© 2012 Pearson Prentice Hall. All rights reserved. 2-24
© 2012 Pearson Prentice Hall. All rights reserved. 2-25
The Financial Crisis: Falling Home
Prices and Delinquent Mortgages (Figure
2.2)
© 2012 Pearson Prentice Hall. All rights reserved. 2-26
The Financial Crisis: Crisis of
Confidence in Banks (Figure 2.3)
© 2012 Pearson Prentice Hall. All rights reserved. 2-27
The Financial Crisis: Spillover
Effects and the Great Recession
• As banks came under intense financial pressure in 2008,
they tightened their lending standards and dramatically
reduced the quantity of loans they made.
• Corporations found that they could no longer raise money
in the money market, or could only do so at
extraordinarily high rates.
• As a consequence, businesses began to hoard cash and cut
back on expenditures, and economic activity contracted.
Implications of the Global Financial Crisis
A limited subprime mortgage impasse in the US real estate grew
to be the world’s biggest financial crisis since the 1930s.
Every section of the globe have been some how affected by the
crisis, as it has hit almost every sector of the world’s economy.
World economies have yet to devise prudent strategies to deal
with the crisis.
Conventional financial institutions, by and large, were the first to
feel the full impact of the crisis they had initiated.
The year 2008 was packed with unparalleled events that have
created mass uncertainty, such as:
– a sharp decline in global equity markets,
– the failure or collapse of numerous global financial institutions,
– governments of a number of industrialized countries allocating in
excess of $7 trillion for a bailout and liquidity injections to revive their
economies,
28
Review Questions
2–8 What is securitization, and how does it facilitate investment
in real estate assets?
2–9 What is a mortgage-backed security? What is the basic risk
associated with mortgage-backed securities?
2–10 How do rising home prices contribute to low mortgage
delinquencies?
2–11 Why do falling home prices create an incentive for
homeowners to default on their mortgages even if they can
afford to make the monthly payments?
2–12 Why does a crisis in the financial sector spill over into
other industries?
© 2012 Pearson Prentice Hall. All rights reserved. 2-29
© 2012 Pearson Prentice Hall. All rights reserved. 2-30
Business Taxes
• Both individuals and businesses must pay taxes on income.
• The income of sole proprietorships and partnerships is taxed as the
income of the individual owners, whereas corporate income is
subject to corporate taxes.
• Both individuals and businesses can earn two types of income—
ordinary income and capital gains income.
• Under current law, tax treatment of ordinary income and capital
gains income change frequently due frequently changing tax laws.
© 2012 Pearson Prentice Hall. All rights reserved. 2-31
Table 2.1
Corporate Tax Rate Schedule
© 2012 Pearson Prentice Hall. All rights reserved. 2-32
Business Taxes:
Ordinary Income
Ordinary income is earned through the sale of a firm’s goods
or services and is taxed at the rates depicted in Table 2.1 on
the previous slide.
Example
Weber Manufacturing Inc. has before-tax earnings of $250,000.
Tax = $22,500 + [0.39  ($250,000 – $100,000)]
Tax = $22,500 + (0.39  $150,000)
Tax = $22,500 + $58,500 = $80,750
© 2012 Pearson Prentice Hall. All rights reserved. 2-33
Business Taxation: Marginal
versus Average Tax Rates
• A firm’s marginal tax rate represents the rate at which
additional income is taxed.
• The average tax rate is the firm’s taxes divided by
taxable income.
Example
What are Webster Manufacturing’s marginal and average tax
rates?
Marginal Tax Rate = 39%
Average Tax Rate = $80,750/$250,000 = 32.3%
© 2012 Pearson Prentice Hall. All rights reserved. 2-34
Business Taxation:
Interest and Dividend Income
• For corporations only, 70% of all dividend income
received from an investment in the stock of another
corporation in which the firm has less than 20%
ownership is excluded from taxation.
• This exclusion moderates the effect of double taxation,
which occurs when after-tax corporate earnings are
distributed as cash dividends to stockholders, who then
must pay personal taxes on the dividend amount.
• Unlike dividend income, all interest income received is
fully taxed.
© 2012 Pearson Prentice Hall. All rights reserved. 2-35
Business Taxation:
Tax-Deductible Expenses
• In calculating taxes, corporations may deduct operating
expenses and interest expense but not dividends paid.
• This creates a built-in tax advantage for using debt
financing as the following example will demonstrate.
Example
Two companies, Debt Co. and No Debt Co., both
expect in the coming year to have EBIT of $200,000.
During the year, Debt Co. will have to pay $30,000 in
interest expenses. No Debt Co. has no debt and will
pay not interest expenses.
© 2012 Pearson Prentice Hall. All rights reserved. 2-36
Business Taxation:
Tax-Deductible Expenses (cont.)
© 2012 Pearson Prentice Hall. All rights reserved. 2-37
Business Taxation:
Tax-Deductible Expenses (cont.)
• As the example shows, the use of debt financing can
increase cash flow and EPS, and decrease taxes paid.
• The tax deductibility of interest and other certain
expenses reduces their actual (after-tax) cost to the
profitable firm.
• It is the non-deductibility of dividends paid that results in
double taxation under the corporate form of organization.
© 2012 Pearson Prentice Hall. All rights reserved. 2-38
Business Taxation: Capital
Gains
• A capital gain is the amount by which the sale price of an
asset exceeds the asset’s purchase price.
• For corporations, capital gains are added to ordinary
income and taxed like ordinary income at the firm’s
marginal tax rate.
Example
Ross Company has just sold for $150,000 and asset
that was purchased 2 years ago for $125,000. Because
the asset was sold for more than its initial purchase
price, there is a capital gain of $25,000 ($150,000 -
$125,000).
Review Questions
2–15 Describe the tax treatment of ordinary income and that of
capital gains. What is the difference between the average
tax rate and the marginal tax rate?
2–16 How does the tax treatment of dividend income by the
corporation moderate the effects of double taxation?
2–17 What benefit results from the tax deductibility of certain
corporate expenses?
© 2012 Pearson Prentice Hall. All rights reserved. 2-39
Self-Test Problem
Corporate taxes Montgomery Enterprises, Inc., had operating earnings of
$280,000 for the year just ended. During the year the firm sold stock that
it held in another company for $180,000, which was $30,000 above its
original purchase price of $150,000, paid 1 year earlier.
a. What is the amount, if any, of capital gains realized during the year?
b. How much total taxable income did the firm earn during the year?
c. Use the corporate tax rate schedule given in Table 2.1 to calculate the
firm’s total taxes due.
d. Calculate both the average tax rate and the marginal tax rate on the basis
of your findings.
© 2012 Pearson Prentice Hall. All rights reserved. 2-40
Warm-Up Exercises
E2–1 What does it mean to say that individuals as a group are net suppliers
of funds for financial institutions? What do you think the consequences
might be in financial markets if individuals consumed more of their
incomes and thereby reduced the supply of funds available to financial
institutions?
E2–2 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy
fashion design firm. Your firm needs $10 million to expand production.
How do you think the process of raising this money will vary if you raise it
with the help of a financial institution versus raising it directly in the
financial markets?
E2–3 For what kinds of needs do you a think firm would issue securities in
the money market versus the capital market?
© 2012 Pearson Prentice Hall. All rights reserved. 2-41
Warm-Up Exercises
E2–4 Your broker calls to offer you the investment opportunity of a lifetime,
the chance to invest in mortgage-backed securities. The broker explains
that these securities are entitled to the principal and interest payments
received from a pool of residential mortgages. List some of the questions
you would ask your broker to assess the risk of this investment
opportunity.
E2–5 Reston, Inc., has asked your corporation, Pruro, Inc., for financial
assistance. As a long-time customer of Reston, your firm has decided to
give that assistance. The question you are debating is whether Pruro
should take Reston stock with a 5% annual dividend or a promissory note
paying 5% annual interest. Assuming payment is guaranteed and the
dollar amounts for annual interest and dividend income are identical,
which option will result in greater after-tax income for the first year?
© 2012 Pearson Prentice Hall. All rights reserved. 2-42
Problems
P2–1 Corporate taxes Tantor Supply, Inc., is a small corporation acting as
the exclusive distributor of a major line of sporting goods. During 2010 the
firm earned $92,500 before taxes.
a. Calculate the firm’s tax liability using the corporate tax rate schedule given
in Table 2.1.
b. How much are Tantor Supply’s 2010 after-tax earnings?
C.What was the firm’s average tax rate, based on your findings in part a?
d. What is the firm’s marginal tax rate, based on your findings in part a?
© 2012 Pearson Prentice Hall. All rights reserved. 2-43
P2–2
Average corporate tax rates Using the corporate tax rate
schedule given in Table 2.1, perform the following:
a. Calculate the tax liability, after-tax earnings, and average tax
rates for the following levels of corporate earnings before
taxes: $10,000; $80,000; $300,000; $500,000; $1.5 million;
$10 million; and $20 million.
b. Plot the average tax rates (measured on the y axis) against
the pretax income levels (measured on the x axis). What
generalization can be made concerning the relationship
between these variables?
© 2012 Pearson Prentice Hall. All rights reserved. 2-44
P2–3
Marginal corporate tax rates Using the corporate tax rate
schedule given in Table 2.1, perform the following:
a. Find the marginal tax rate for the following levels of corporate
earnings before taxes: $15,000; $60,000; $90,000; $200,000;
$400,000; $1 million; and $20 million.
b. Plot the marginal tax rates (measured on the y axis) against
the pretax income levels (measured on the x axis). Explain
the relationship between these variables.
© 2012 Pearson Prentice Hall. All rights reserved. 2-45
P2–4
Interest versus dividend income During the year just ended, Shering
Distributors, Inc., had pretax earnings from operations of $490,000. In
addition, during the year it received $20,000 in income from interest on
bonds it held in Zig Manufacturing and received $20,000 in income from
dividends on its 5% common stock holding in Tank Industries, Inc.
Shering is in the 40% tax bracket and is eligible for a 70% dividend
exclusion on its Tank Industries stock.
a. Calculate the firm’s tax on its operating earnings only.
b. Find the tax and the after-tax amount attributable to the interest income
from Zig Manufacturing bonds.
c. Find the tax and the after-tax amount attributable to the dividend income
from the Tank Industries, Inc., common stock.
d. Compare, contrast, and discuss the after-tax amounts resulting from the
interest income and dividend income calculated in parts b and c.
e. What is the firm’s total tax liability for the year?
© 2012 Pearson Prentice Hall. All rights reserved. 2-46
P2–5
Interest versus dividend expense Michaels Corporation
expects earnings before interest and taxes to be $40,000 for
the current period. Assuming an ordinary tax rate of 40%,
compute the firm’s earnings after taxes and earnings
available for common stockholders (earnings after taxes and
preferred stock dividends, if any) under the following
conditions:
a. The firm pays $10,000 in interest.
b. The firm pays $10,000 in preferred stock dividends.
© 2012 Pearson Prentice Hall. All rights reserved. 2-47
P 2.6
Capital gains taxes Perkins Manufacturing is considering the
sale of two nondepreciable assets, X and Y. Asset X was
purchased for $2,000 and will be sold today for $2,250. Asset
Y was purchased for $30,000 and will be sold today for
$35,000. The firm is subject to a 40% tax rate on capital
gains.
a. Calculate the amount of capital gain, if any, realized on each
of the assets.
b. Calculate the tax on the sale of each asset.
© 2012 Pearson Prentice Hall. All rights reserved. 2-48
P 2.7
Capital gains taxes The following table contains purchase and sale prices
for the nondepreciable capital assets of a major corporation. The firm paid
taxes of 40% on capital gains.
a. Determine the amount of capital gain realized on each of the five assets.
b. Calculate the amount of tax paid on each of the assets.
© 2012 Pearson Prentice Hall. All rights reserved. 2-49
Copyright © 2012 Pearson Prentice Hall.
All rights reserved.
Chapter 5
Time Value of
Money
Decision Dilemma—Take a Lump Sum or
Annual Installments
❑A couple Won a Lucky Draw.
❑They had to choose between
a single lump sum $104
million, or $198 million paid out
over 25 years (or $7.92 million
per year).
❑The winning couple opted for
the lump sum.
❑Did they make the right
choice? What basis do we
make such an economic
comparison?
Opportunity Cost
Opportunity cost = Alternative use
– The opportunity cost of money is the interest rate that would be
earned by investing it.
– It is the underlying reason for the time value of money
– Any person with money today knows they can invest those funds
to be some greater amount in the future.
– Conversely, if you are promised a cash flow in the future, it’s
present value today is less than what is promised!
Choosing from Investment Alternatives
Required Rate of Return or Discount Rate
You have three choices:
1. $20,000 received today
2. $31,000 received in 5 years
3. $3,000 per year indefinitely
To make a decision, you need to know what
interest rate to use.
– This interest rate is known as your required rate of
return or discount rate.
Time Value of Money
❑Money has a time value
because it can earn more
money over time (earning
power).
❑Money has a time value
because its purchasing power
changes over time (inflation).
❑Time value of money is
measured in terms of interest
rate.
❑Interest is the cost of
money—a cost to the borrower
and an earning to the lender
The Time Value of Money
•One of the most important principle in finance
7
$1 today
Relationship
$1 future
Present Value
Future Value
Interest is the factor contributing to Time Value of Money
Simple Interest= Principal x Interest rate x time period
= Po(i)(n)
© 2012 Pearson Prentice Hall. All rights reserved. 5-8
The Role of Time Value in
Finance
• Most financial decisions involve costs & benefits that are
spread out over time.
• Time value of money allows comparison of cash flows
from different periods.
• Question: Your father has offered to give you some
money and asks that you choose one of the following two
alternatives:
– $1,000 today, or
– $1,100 one year from now.
• What do you do?
© 2012 Pearson Prentice Hall. All rights reserved. 5-9
The Role of Time Value in
Finance (cont.)
• The answer depends on what rate of interest you could
earn on any money you receive today.
• For example, if you could deposit the $1,000 today at
12% per year, you would prefer to be paid today.
• Alternatively, if you could only earn 5% on deposited
funds, you would be better off if you chose the $1,100 in
one year.
© 2012 Pearson Prentice Hall. All rights reserved. 5-10
Future Value versus Present
Value
• Suppose a firm has an opportunity to spend $15,000 today on some
investment that will produce $17,000 spread out over the next five
years as follows:
• Is this a wise investment?
• To make the right investment decision, managers need to compare
the cash flows at a single point in time.
Year Cash flow
1 $3,000
2 $5,000
3 $4,000
4 $3,000
5 $2,000
© 2012 Pearson Prentice Hall. All rights reserved. 5-11
Figure 5.1
Time Line
© 2012 Pearson Prentice Hall. All rights reserved. 5-12
Figure 5.2
Compounding and Discounting
© 2012 Pearson Prentice Hall. All rights reserved. 5-13
Computational Tools (cont.)
Electronic spreadsheets:
– Like financial calculators, electronic spreadsheets have built-in
routines that simplify time value calculations.
– The value for each variable is entered in a cell in the
spreadsheet, and the calculation is programmed using an
equation that links the individual cells.
– Changing any of the input variables automatically changes the
solution as a result of the equation linking the cells.
© 2012 Pearson Prentice Hall. All rights reserved. 5-14
Basic Patterns of Cash Flow
• The cash inflows and outflows of a firm can be described by its
general pattern.
• The three basic patterns include a single amount, an annuity, or a
mixed stream:
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Types of Interest
Formula SI = P0(i)(n)
SI: Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
Simple & Compound Interest Trends
DOLLARS
Simple Compound
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Simple Interest Future Value
Principal(Po)=$1000
Interest (i) = $10%
Time (n) = $5 Years
Interest =?
Future Value=?
17
Simple Interest Present Value
Future Value=$7500
Interest = $10%
Time = $5 Years
Interest =?
PRESENT Value=?
18
Simple Interest Present Value
Po+(Po *n*i)=7500
Po +(0.5 Po)=7500
1.5 Po =7500
Po =7500/1.5
Po =5000
Principal= 5000
Interest=Fv-Pv
Interest=7500-5000= 2500 19
© 2012 Pearson Prentice Hall. All rights reserved. 5-20
Future Value of a Single
Amount
• Future value is the value at a given future date of an
amount placed on deposit today and earning interest at a
specified rate. Found by applying compound interest over
a specified period of time.
• Compound interest is interest that is earned on a given
deposit and has become part of the principal at the end of
a specified period.
• Principal is the amount of money on which interest is
paid.
© 2012 Pearson Prentice Hall. All rights reserved. 5-21
Future Value of a Single Amount:
The Equation for Future Value
• We use the following notation for the various inputs:
– FVn = future value at the end of period n
– PV = initial principal, or present value
– r = annual rate of interest paid. (Note: On financial calculators, I is typically
used to represent this rate.)
– n = number of periods (typically years) that the money is left on deposit
• The general equation for the future value at the end of period n is
FVn = PV  (1 + r)n
FV2 = $1,000 (FVIF7%,2)
= $1,000 (1.145)
= $1,145 [Due to Rounding]
Using Future Value Tables
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
© 2012 Pearson Prentice Hall. All rights reserved. 5-23
Future Value of a Single Amount:
The Equation for Future Value
Jane Farber places $800 in a savings account paying 6% interest
compounded annually. She wants to know how much money will be in
the account at the end of five years.
This analysis can be depicted on a time line as follows:
FV5 = $800  (1 + 0.06)5 = $800  (1.33823) = $1,070.58
© 2012 Pearson Prentice Hall. All rights reserved. 5-24
Figure 5.4
Future Value Relationship
Double Your Money!!!
We will use the “Rule-of-72”.
Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?
Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
Types of Compounding Problems
There are really only four different things you can be asked
to find using this basic equation:
FVn=PV0 (1+k)n
▪ Find the initial amount of money to invest (PV0)
▪ Find the Future value (FVn)
▪ Find the rate (k)
▪ Find the time (n)
Types of Compounding Problems
Solving for the Rate (k)
Your have asked your father for a loan of $10,000 to get you started in a
business. You promise to repay him $20,000 in five years time.
What compound rate of return are you offering to pay?
This is an ex ante calculation.
FVt=PV0 (1+k)n
$20,000= $10,000 (1+r)5
2=(1+r)5
21/5=1+r
1.14869=1+r
r = 14.869%
Types of Compounding Problems
Solving for Time (n) or Holding Periods
You have $150,000 in your RRSP (Registered Retirement Savings
Plan). Assuming a rate of 8%, how long will it take to have the
plan grow to a value of $300,000?
– This is an ex ante calculation
FVt=PV0(1+k)n
$300,000= $150,000 (1+.08)n
2=(1.08)n
ln 2 =ln 1.08 × n
0.69314 = .07696 × n
t = 0.69314 / .076961041 = 9.00 years
Types of Compounding Problems
Solving for Time (n) – using logarithms
You have $150,000 in your RRSP (Registered Retirement Savings Plan).
Assuming a rate of 8%, how long will it take to have the plan grow to a
value of $300,000?
– This is an ex ante calculation.
FVt=PV0 (1+k)n
$300,000= $150,000 (1+.08)n
2=(1.08)n
log 2 =log 1.08 × n
0.301029995 = 0.033423755 × n
t = 9.00 years
Types of Compounding Problems
Solving for the Future Value (FVn)
You have $650,000 in your pension plan today. Because you have retired,
you and your employer will not make any further contributions to the
plan. However, you don’t plan to take any pension payments for five
more years so the principal will continue to grow.
Assuming a rate of 8%, forecast the value of your pension plan in 5 years.
– This is an ex ante calculation.
FVt=PV0 (1+k)n
FV5= $650,000 (1+.08)5
FV5 = $650,000 × 1.469328077
FV5 = $955,063.25
Types of Compounding Problems
Finding the amount of money to invest (PV0)
You hope to save for a down payment on a home. You hope to
have $40,000 in four years time; determine the amount you
need to invest now at 6%
– This is a process known as discounting
– This is an ex ante calculation
FVn=PV0 (1+k)n
$40,000= PV0 (1.1)4
PV0 = $40,000/1.4641=$27,320.53
© 2012 Pearson Prentice Hall. All rights reserved. 5-32
Present Value of a Single
Amount
• Present value is the current dollar value of a future amount—the
amount of money that would have to be invested today at a given
interest rate over a specified period to equal the future amount.
• It is based on the idea that a dollar today is worth more than a dollar
tomorrow.
• Discounting cash flows is the process of finding present values;
the inverse of compounding interest.
• The discount rate is often also referred to as the opportunity cost,
the discount rate, the required return, or the cost of capital.
© 2012 Pearson Prentice Hall. All rights reserved. 5-33
Personal Finance Example
Paul Shorter has an opportunity to receive $300 one year
from now. If he can earn 6% on his investments, what is the
most he should pay now for this opportunity?
PV  (1 + 0.06) = $300
PV = $300/(1 + 0.06) = $283.02
© 2012 Pearson Prentice Hall. All rights reserved. 5-34
Present Value of a Single Amount:
The Equation for Present Value
The present value, PV, of some future amount, FVn,
to be received n periods from now, assuming an
interest rate (or opportunity cost) of r, is calculated
as follows:
PV2 = $1,000 (PVIF7%,2)
= $1,000 (.873)
= $873 [Due to Rounding]
Using Present Value Tables
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
© 2012 Pearson Prentice Hall. All rights reserved. 5-36
Present Value of a Single Amount:
The Equation for Future Value
Pam Valenti wishes to find the present value of $1,700 that will be
received 8 years from now. Pam’s opportunity cost is 8%.
This analysis can be depicted on a time line as follows:
PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46
© 2012 Pearson Prentice Hall. All rights reserved. 5-37
Figure 5.5
Present Value Relationship
© 2012 Pearson Prentice Hall. All rights reserved. 5-38
Annuities
An annuity is a stream of equal periodic cash flows, over a
specified time period. These cash flows can be inflows of
returns earned on investments or outflows of funds invested
to earn future returns.
– An ordinary (deferred) annuity is an annuity for which the
cash flow occurs at the end of each period
– An annuity due is an annuity for which the cash flow occurs at
the beginning of each period.
– An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound for
an additional period.
© 2012 Pearson Prentice Hall. All rights reserved. 5-39
Personal Finance Example
Fran Abrams is choosing which of two annuities to receive.
Both are 5-year $1,000 annuities; annuity A is an ordinary
annuity, and annuity B is an annuity due. Fran has listed the
cash flows for both annuities as shown in Table 5.1 on the
following slide.
Note that the amount of both annuities total $5,000.
© 2012 Pearson Prentice Hall. All rights reserved. 5-40
Table 5.1 Comparison of Ordinary Annuity and
Annuity Due Cash Flows ($1,000, 5 Years)
© 2012 Pearson Prentice Hall. All rights reserved. 5-41
Finding the Future Value of an
Ordinary Annuity
• You can calculate the future value of an ordinary annuity
that pays an annual cash flow equal to CF by using the
following equation:
• As before, in this equation r represents the interest rate
and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).
© 2012 Pearson Prentice Hall. All rights reserved. 5-42
Finding the Present Value of an
Ordinary Annuity
• You can calculate the present value of an ordinary annuity
that pays an annual cash flow equal to CF by using the
following equation:
• As before, in this equation r represents the interest rate
and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).
© 2012 Pearson Prentice Hall. All rights reserved. 5-43
Finding the Present Value of an
Ordinary Annuity (cont.)
Braden Company, a small producer of plastic toys, wants to determine the
most it should pay to purchase a particular annuity. The annuity consists of
cash flows of $700 at the end of each year for 5 years. The required return is
8%.
This analysis can be depicted on a time line as follows:
© 2012 Pearson Prentice Hall. All rights reserved. 5-44
Table 5.2 Long Method for Finding the
Present Value of an Ordinary Annuity
© 2012 Pearson Prentice Hall. All rights reserved. 5-45
Finding the Future Value of an
Annuity Due
• You can calculate the present value of an annuity due that
pays an annual cash flow equal to CF by using the
following equation:
• As before, in this equation r represents the interest rate
and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).
© 2012 Pearson Prentice Hall. All rights reserved. 5-46
Finding the Present Value of an
Annuity Due
• You can calculate the present value of an ordinary annuity
that pays an annual cash flow equal to CF by using the
following equation:
• As before, in this equation r represents the interest rate
and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).
FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07)
= $1,000 (3.215)(1.07) = $3,440
Valuation Using Table III
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07) = $2,808
Valuation Using Table IV
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
© 2012 Pearson Prentice Hall. All rights reserved. 5-49
Finding the Present Value of a
Perpetuity
• A perpetuity is an annuity with an infinite life, providing
continual annual cash flow.
• If a perpetuity pays an annual cash flow of CF, starting
one year from now, the present value of the cash flow
stream is
PV = CF ÷ r
© 2012 Pearson Prentice Hall. All rights reserved. 5-50
Personal Finance Example
Ross Clark wishes to endow a chair in finance at his alma
mater. The university indicated that it requires $200,000 per
year to support the chair, and the endowment would earn
10% per year. To determine the amount Ross must give the
university to fund the chair, we must determine the present
value of a $200,000 perpetuity discounted at 10%.
PV = $200,000 ÷ 0.10 = $2,000,000
© 2012 Pearson Prentice Hall. All rights reserved. 5-51
Future Value of a Mixed Stream
Shrell Industries, a cabinet manufacturer, expects to receive
the following mixed stream of cash flows over the next 5
years from one of its small customers.
© 2012 Pearson Prentice Hall. All rights reserved. 5-52
Future Value of a Mixed Stream
If the firm expects to earn at least 8% on its investments, how much
will it accumulate by the end of year 5 if it immediately invests these
cash flows when they are received?
This situation is depicted on the following time line.
© 2012 Pearson Prentice Hall. All rights reserved. 5-53
Present Value of a Mixed
Stream
Frey Company, a shoe manufacturer, has been offered an opportunity
to receive the following mixed stream of cash flows over the next 5
years.
© 2012 Pearson Prentice Hall. All rights reserved. 5-54
Present Value of a Mixed
Stream
If the firm must earn at least 9% on its investments, what is
the most it should pay for this opportunity?
This situation is depicted on the following time line.
© 2012 Pearson Prentice Hall. All rights reserved. 5-55
Compounding Interest More
Frequently Than Annually
• Compounding more frequently than once a year results in
a higher effective interest rate because you are earning on
interest on interest more frequently.
• As a result, the effective interest rate is greater than the
nominal (annual) interest rate.
• Furthermore, the effective rate of interest will increase the
more frequently interest is compounded.
© 2012 Pearson Prentice Hall. All rights reserved. 5-56
Table 5.3 Future Value from Investing $100 at
8% Interest Compounded Semiannually over 24
Months (2 Years)
© 2012 Pearson Prentice Hall. All rights reserved. 5-57
Table 5.4 Future Value from Investing $100 at
8% Interest Compounded Quarterly over 24
Months (2 Years)
© 2012 Pearson Prentice Hall. All rights reserved. 5-58
Table 5.5 Future Value from Investing $100 at
8% Interest Compounded Quarterly over 24
Months (2 Years)
© 2012 Pearson Prentice Hall. All rights reserved. 5-59
Compounding Interest More
Frequently Than Annually (cont.)
A general equation for compounding more frequently than annually
Recalculate the example for the Fred Moreno example assuming (1)
semiannual compounding and (2) quarterly compounding.
© 2012 Pearson Prentice Hall. All rights reserved. 5-60
Continuous Compounding
• Continuous compounding involves the compounding of
interest an infinite number of times per year at intervals of
microseconds.
• A general equation for continuous compounding
where e is the exponential function.
© 2012 Pearson Prentice Hall. All rights reserved. 5-61
Personal Finance Example
Find the value at the end of 2 years (n = 2) of Fred Moreno’s
$100 deposit (PV = $100) in an account paying 8% annual
interest (r = 0.08) compounded continuously.
FV2 (continuous compounding) = $100  e0.08  2
= $100  2.71830.16
= $100  1.1735 = $117.35
© 2012 Pearson Prentice Hall. All rights reserved. 5-62
Nominal and Effective Annual
Rates of Interest
• The nominal (stated) annual rate is the contractual annual rate of
interest charged by a lender or promised by a borrower.
• The effective (true) annual rate (EAR) is the annual rate of
interest actually paid or earned.
• In general, the effective rate > nominal rate whenever compounding
occurs more than once per year
© 2012 Pearson Prentice Hall. All rights reserved. 5-63
Personal Finance Example
Fred Moreno wishes to find the effective annual rate
associated with an 8% nominal annual rate (r = 0.08) when
interest is compounded (1) annually (m = 1); (2)
semiannually (m = 2); and (3) quarterly (m = 4).
© 2012 Pearson Prentice Hall. All rights reserved. 5-64
Special Applications of Time Value: Deposits
Needed to Accumulate a Future Sum
The following equation calculates the annual cash payment (CF) that
we’d have to save to achieve a future value (FVn):
Suppose you want to buy a house 5 years from now, and you estimate
that an initial down payment of $30,000 will be required at that time.
To accumulate the $30,000, you will wish to make equal annual end-
of-year deposits into an account paying annual interest of 6 percent.
© 2012 Pearson Prentice Hall. All rights reserved. 5-65
Special Applications of Time
Value: Loan Amortization
• Loan amortization is the determination of the equal
periodic loan payments necessary to provide a lender with
a specified interest return and to repay the loan principal
over a specified period.
• The loan amortization process involves finding the future
payments, over the term of the loan, whose present value
at the loan interest rate equals the amount of initial
principal borrowed.
• A loan amortization schedule is a schedule of equal
payments to repay a loan. It shows the allocation of each
loan payment to interest and principal.
© 2012 Pearson Prentice Hall. All rights reserved. 5-66
Special Applications of Time Value:
Loan Amortization (cont.)
• The following equation calculates the equal periodic loan payments
(CF) necessary to provide a lender with a specified interest return
and to repay the loan principal (PV) over a specified period:
• Say you borrow $6,000 at 10 percent and agree to make equal
annual end-of-year payments over 4 years. To find the size of the
payments, the lender determines the amount of a 4-year annuity
discounted at 10 percent that has a present value of $6,000.
© 2012 Pearson Prentice Hall. All rights reserved. 5-67
Table 5.6 Loan Amortization Schedule
($6,000 Principal, 10% Interest, 4-Year
Repayment Period)
© 2012 Pearson Prentice Hall. All rights reserved. 5-68
Special Applications of Time Value:
Finding Interest or Growth Rates
• It is often necessary to calculate the compound annual
interest or growth rate (that is, the annual rate of change
in values) of a series of cash flows.
• The following equation is used to find the interest rate (or
growth rate) representing the increase in value of some
investment between two time periods.
© 2012 Pearson Prentice Hall. All rights reserved. 5-69
Personal Finance Example
Ray Noble purchased an investment four years ago for
$1,250. Now it is worth $1,520. What compound annual rate
of return has Ray earned on this investment? Plugging the
appropriate values into Equation 5.20, we have:
r = ($1,520 ÷ $1,250)(1/4) – 1 = 0.0501 = 5.01% per year
© 2012 Pearson Prentice Hall. All rights reserved. 5-70
Special Applications of Time Value:
Finding an Unknown Number of Periods
• Sometimes it is necessary to calculate the number of time
periods needed to generate a given amount of cash flow
from an initial amount.
• This simplest case is when a person wishes to determine
the number of periods, n, it will take for an initial deposit,
PV, to grow to a specified future amount, FVn, given a
stated interest rate, r.
© 2012 Pearson Prentice Hall. All rights reserved. 5-71
Integrative Case: Track
Software, Inc.
Table 1: Track Software, Inc. Profit, Dividends, and
Retained Earnings, 2006–2012
© 2012 Pearson Prentice Hall. All rights reserved. 5-72
Integrative Case: Track
Software, Inc.
Table 2: Track
Software, Inc.
Income Statement
($000)for the Year
Ended December
31, 2012
© 2012 Pearson Prentice Hall. All rights reserved. 5-73
Integrative Case: Track
Software, Inc.
Table 3a: Track Software, Inc. Balance Sheet ($000)
© 2012 Pearson Prentice Hall. All rights reserved. 5-74
Integrative Case: Track
Software, Inc.
Table 3b: Track Software, Inc. Balance Sheet ($000)
© 2012 Pearson Prentice Hall. All rights reserved. 5-75
Integrative Case: Track
Software, Inc.
Table 4: Track Software, Inc. Statement of Retained
Earnings ($000) for the Year Ended December 31, 2012
© 2012 Pearson Prentice Hall. All rights reserved. 5-76
Integrative Case: Track
Software, Inc.
Table 5: Track
Software, Inc.
Profit, Dividends,
and Retained
Earnings, 2006–
2012
© 2012 Pearson Prentice Hall. All rights reserved. 5-77
Integrative Case: Track
Software, Inc.
a. Upon what financial goal does Stanley seem to be focusing? Is it
the correct goal? Why or why not?
Could a potential agency problem exist in this firm? Explain.
b. Calculate the firm’s earnings per share (EPS) for each year,
recognizing that the number of shares of common stock
outstanding has remained unchanged since the firm’s inception.
Comment on the EPS performance in view of your response in
part a.
c. Use the financial data presented to determine Track’s operating
cash flow (OCF) and free cash flow (FCF) in 2012. Evaluate your
findings in light of Track’s current cash flow difficulties.
© 2012 Pearson Prentice Hall. All rights reserved. 5-78
Integrative Case: Track
Software, Inc.
d. Analyze the firm’s financial condition in 2012 as it relates to (1)
liquidity, (2) activity, (3) debt, (4) profitability, and (5) market,
using the financial statements provided in Tables 2 and 3 and the
ratio data included in Table 5. Be sure to evaluate the firm on
both a cross-sectional and a time-series basis.
e. What recommendation would you make to Stanley regarding
hiring a new software developer? Relate your recommendation
here to your responses in part a.
© 2012 Pearson Prentice Hall. All rights reserved. 5-79
Integrative Case: Track
Software, Inc.
f. Track Software paid $5,000 in dividends in 2012. Suppose an
investor approached Stanley about buying 100% of his firm. If
this investor believed that by owning the company he could
extract $5,000 per year in cash from the company in perpetuity,
what do you think the investor would be willing to pay for the
firm if the required return on this investment is 10%?
g. Suppose that you believed that the FCF generated by Track
Software in 2012 could continue forever. You are willing to buy
the company in order to receive this perpetual stream of free cash
flow. What are you willing to pay if you require a 10% return on
your investment?
Page 1 of 2
FIN308 Introduction to Finance
Formula Sheet for Common
Assessment
Ordinary Annuity
Annuity Due
Page 2 of 2
Perpetuity
Compounding Interest More Frequently Than Annually
Continuous Compounding
𝐶𝐹 = 𝑃𝑉 × 𝑟 ÷ {1 −
1
(1 + 𝑟)𝑛
}
𝑛 =
𝑙𝑜𝑔 (
𝐹𝑉
𝑛
𝑃𝑉0
)
𝑙𝑜𝑔(1 + 𝑟)

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  • 1. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 1 The Role of Managerial Finance
  • 2. © 2012 Pearson Prentice Hall. All rights reserved. 1-2 What is Finance? • Finance: – Most Commonly Prevailing Currency is known as Finance. Business Finance: Any thing which can be used to Purchase Assets and Pay off Liabilities is known as Business Finance. Accounts Source Use Assets - + Equities + -
  • 3. © 2012 Pearson Prentice Hall. All rights reserved. 1-3 What is Finance? • Financial Management: can be defined as the science and art of managing money. • At the personal level, finance is concerned with individuals’ decisions about how much of their earnings they spend, how much they save, and how they invest their savings. • In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors.
  • 4. © 2012 Pearson Prentice Hall. All rights reserved. 1-4 What is Finance? • Finance Scope: – Anticipation. – Acquisition – Allocation of Finance or Money Financial Activities: Balance Sheet Assets Equates Investing Activities Financing Activities Rewarding Activities
  • 5. © 2012 Pearson Prentice Hall. All rights reserved. 1-5 Branches of Finance • Financial Management – Personal Finance – Business Finance – Corporate Finance – International Finance – Investment & Portfolio Management – Financial Statements Analysis.
  • 6. © 2012 Pearson Prentice Hall. All rights reserved. 1-6 Career Opportunities in Finance: Financial Services • Financial Services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and governments. • Career opportunities include banking, personal financial planning, investments, real estate, and insurance.
  • 7. © 2012 Pearson Prentice Hall. All rights reserved. 1-7 Career Opportunities in Finance: Managerial Finance • Managerial finance is concerned with the duties of the financial manager working in a business. • Financial managers administer the financial affairs of all types of businesses—private and public, large and small, profit-seeking and not-for-profit. • They perform such varied tasks as developing a financial plan or budget, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations.
  • 8. © 2012 Pearson Prentice Hall. All rights reserved. 1-8 Focus on Practice Professional Certifications in Finance: – Chartered Financial Analyst (CFA) – Offered by the CFA Institute, the CFA program is a graduate-level course of study focused primarily on the investments side of finance. – Certified Treasury Professional (CTP) – The CTP program requires students to pass a single exam that is focused on the knowledge and skills needed for those working in a corporate treasury department. – Certified Financial Planner (CFP) – To obtain CFP status, students must pass a ten-hour exam covering a wide range of topics related to personal financial planning.
  • 9. © 2012 Pearson Prentice Hall. All rights reserved. 1-9 Focus on Practice (cont.) Professional Certifications in Finance: – American Academy of Financial Management (AAFM) – The AAFM administers a host of certification programs for financial professionals in a wide range of fields. Their certifications include the Charter Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst, Certified Cost Accountant, Certified Credit Analyst, and many other programs. – Professional Certifications in Accounting – Most professionals in the field of managerial finance need to know a great deal about accounting to succeed in their jobs. Professional certifications in accounting include the Certified Public Accountant (CPA), Certified Management Accountant (CMA), Certified Internal Auditor (CIA), and many programs.
  • 10. © 2012 Pearson Prentice Hall. All rights reserved. 1-10 Legal Forms of Business Organization • A sole proprietorship is a business owned by one person and operated for his or her own profit. • A partnership is a business owned by two or more people and operated for profit. • A corporation is an entity created by law. Corporations have the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name.
  • 11. © 2012 Pearson Prentice Hall. All rights reserved. 1-11 Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization
  • 12. © 2012 Pearson Prentice Hall. All rights reserved. 1-12 Matter of Fact
  • 13. © 2012 Pearson Prentice Hall. All rights reserved. 1-13 Figure 1.1 Corporate Organization
  • 14. © 2012 Pearson Prentice Hall. All rights reserved. 1-14 Table 1.2 Career Opportunities in Managerial Finance
  • 15. Review Questions 1–1 What is finance? Explain how this field affects all of the activities in which businesses engage. 1–2 What is the financial services area of finance? Describe the field of managerial finance. 1–3 Which legal form of business organization is most common? Which form is dominant in terms of business revenues? 1–4 Describe the roles and the basic relationships among the major parties in a corporation—stockholders, board of directors, and managers. How are corporate owners rewarded for the risks they take? 1–5 Briefly name and describe some organizational forms other than corporations that provide owners with limited liability. 1–6 Why is the study of managerial finance important to your professional life regardless of the specific area of responsibility you may have within the business firm? Why is it important to your personal life? © 2012 Pearson Prentice Hall. All rights reserved. 1-15
  • 16. © 2012 Pearson Prentice Hall. All rights reserved. 1-16 Goal of the Firm: Maximize Shareholder Wealth Decision rule for managers: only take actions that are expected to increase the share price.
  • 17. © 2012 Pearson Prentice Hall. All rights reserved. 1-17 Goal of the Firm: Maximize Profit? Profit maximization may not lead to the highest possible share price for at least three reasons: 1. Timing is important—the receipt of funds sooner rather than later is preferred 2. Profits do not necessarily result in cash flows available to stockholders 3. Profit maximization fails to account for risk Which Investment is Preferred?
  • 18. Risk and Risk behavior Risk The chance that actual outcomes may differ from those expected risk averse: Requiring compensation to bear risk. © 2012 Pearson Prentice Hall. All rights reserved. 1-18
  • 19. © 2012 Pearson Prentice Hall. All rights reserved. 1-19 Goal of the Firm: What About Stakeholders? • Stakeholders are groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. • A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well-being but to preserve it. • Such a view is considered to be "socially responsible."
  • 20. © 2012 Pearson Prentice Hall. All rights reserved. 1-20 The Role of Business Ethics • Business ethics are the standards of conduct or moral judgment that apply to persons engaged in commerce. • Violations of these standards in finance involve a variety of actions: “creative accounting,” earnings management, misleading financial forecasts, insider trading, fraud, excessive executive compensation, options backdating, bribery, and kickbacks. • Negative publicity often leads to negative impacts on a firm
  • 21. © 2012 Pearson Prentice Hall. All rights reserved. 1-21 The Role of Business Ethics: Considering Ethics Robert A. Cooke, a noted ethicist, suggests that the following questions be used to assess the ethical viability of a proposed action: – Is the action arbitrary or capricious? Does the action unfairly single out an individual or group? – Does the action affect the morals, or legal rights of any individual or group? – Does the action conform to accepted moral standards? – Are there alternative courses of action that are less likely to cause actual or potential harm?
  • 22. © 2012 Pearson Prentice Hall. All rights reserved. 1-22 The Role of Business Ethics: Ethics and Share Price Ethics programs seek to: – reduce litigation and judgment costs – maintain a positive corporate image – build shareholder confidence – gain the loyalty and respect of all stakeholders The expected result of such programs is to positively affect the firm’s share price.
  • 23. Review Questions 1–7 What is the goal of the firm and, therefore, of all managers and employees? Discuss how one measures achievement of this goal. 1–8 For what three basic reasons is profit maximization inconsistent with wealth maximization? 1–9 What is risk? Why must risk as well as return be considered by the financial manager who is evaluating a decision alternative or action? 1–10 Describe the role of corporate ethics policies and guidelines, and discuss the relationship that is believed to exist between ethics and share price. © 2012 Pearson Prentice Hall. All rights reserved. 1-23
  • 24. © 2012 Pearson Prentice Hall. All rights reserved. 1-24 Managerial Finance Function • The size and importance of the managerial finance function depends on the size of the firm. • In small firms, the finance function is generally performed by the accounting department. • As a firm grows, the finance function typically evolves into a separate department linked directly to the company president or CEO through the chief financial officer (CFO) (see Figure 1.1)
  • 25. © 2012 Pearson Prentice Hall. All rights reserved. 1-25 Managerial Finance Function: Relationship to Economics • The field of finance is closely related to economics. • Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. • They must also be able to use economic theories as guidelines for efficient business operation.
  • 26. © 2012 Pearson Prentice Hall. All rights reserved. 1-26 Managerial Finance Function: Relationship to Economics (cont.) • Marginal cost–benefit analysis is the economic principle that states that financial decisions should be made and actions taken only when the added benefits exceed the added costs • Marginal cost-benefit analysis can be illustrated using the following simple example.
  • 27. Example Jamie Teng is a financial manager for Nord Department Stores, a large chain of upscale department stores operating primarily in the western United States. She is currently trying to decide whether to replace one of the firm’s computer servers with a new, more sophisticated one that would both speed processing and handle a larger volume of transactions. The new computer would require a cash outlay of $8,000, and the old computer could be sold to net $2,000. The total benefits from the new server (measured in today’s dollars) would be $10,000. The benefits over a similar time period from the old computer (measured in today’s dollars) would be $3,000. Applying marginal cost–benefit analysis, Jamie organizes the data as follows: © 2012 Pearson Prentice Hall. All rights reserved. 1-27
  • 28. © 2012 Pearson Prentice Hall. All rights reserved. 1-28 Managerial Finance Function: Relationship to Economics (cont.) Nord Department Stores is applying marginal-cost benefit analysis to decide whether to replace a computer:
  • 29. © 2012 Pearson Prentice Hall. All rights reserved. 1-29 Managerial Finance Function: Relationship to Accounting • The firm’s finance and accounting activities are closely- related and generally overlap. • In small firms accountants often carry out the finance function, and in large firms financial analysts often help compile accounting information. • One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows.
  • 30. © 2012 Pearson Prentice Hall. All rights reserved. 1-30 Managerial Finance Function: Relationship to Accounting (cont.) • Whether a firm earns a profit or experiences a loss, it must have a sufficient flow of cash to meet its obligations as they come due. • The significance of this difference can be illustrated using the following simple example.
  • 31. © 2012 Pearson Prentice Hall. All rights reserved. 1-31 Managerial Finance Function: Relationship to Accounting (cont.) The Nassau Corporation experienced the following activity last year: Sales $100,000 (1 yacht sold, 100% still uncollected) Costs $ 80,000 (all paid in full under supplier terms)
  • 32. © 2012 Pearson Prentice Hall. All rights reserved. 1-32 Managerial Finance Function: Relationship to Accounting (cont.) Now contrast the differences in performance under the accounting method (accrual basis) versus the financial view (cash basis): Income Statement Summary Accrual basis Cash basis Sales $100,000 $ 0 Less: Costs (80,000) (80,000) Net Profit/(Loss) $ 20,000 $(80,000)
  • 33. © 2012 Pearson Prentice Hall. All rights reserved. 1-33 Managerial Finance Function: Relationship to Accounting (cont.) Finance and accounting also differ with respect to decision- making: – Accountants devote most of their attention to the collection and presentation of financial data. – Financial managers evaluate the accounting statements, develop additional data, and make decisions on the basis of their assessment of the associated returns and risks.
  • 34. © 2012 Pearson Prentice Hall. All rights reserved. 1-34 Personal Finance Example
  • 35. © 2012 Pearson Prentice Hall. All rights reserved. 1-35 Figure 1.3 Financial Activities
  • 36. Review Questions: 1–11 In what financial activities does a corporate treasurer engage? 1–12 What is the primary economic principle used in managerial finance? 1–13 What are the major differences between accounting and finance with respect to emphasis on cash flows and decision making? 1–14 What are the two primary activities of the financial manager that are related to the firm’s balance sheet? © 2012 Pearson Prentice Hall. All rights reserved. 1-36
  • 37. © 2012 Pearson Prentice Hall. All rights reserved. 1-37 Governance and Agency: Corporate Governance • Corporate governance refers to the rules, processes, and laws by which companies are operated, controlled, and regulated. • It defines the rights and responsibilities of the corporate participants such as the shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and procedures for making corporate decisions. • The structure of corporate governance was previously described in Figure 1.1.
  • 38. © 2012 Pearson Prentice Hall. All rights reserved. 1-38 Governance and Agency: Individual versus Institutional Investors • Individual investors are investors who own relatively small quantities of shares so as to meet personal investment goals. • Institutional investors are investment professionals, such as banks, insurance companies, mutual funds, and pension funds, that are paid to manage and hold large quantities of securities on behalf of others. • Unlike individual investors, institutional investors often monitor and directly influence a firm’s corporate governance by exerting pressure on management to perform or communicating their concerns to the firm’s board.
  • 39. © 2012 Pearson Prentice Hall. All rights reserved. 1-39 Governance and Agency: Government Regulation • Government regulation generally shapes the corporate governance of all firms. • During the recent decade, corporate governance has received increased attention due to several high-profile corporate scandals involving abuse of corporate power and, in some cases, alleged criminal activity by corporate officers.
  • 40. © 2012 Pearson Prentice Hall. All rights reserved. 1-40 Governance and Agency: Government Regulation The Sarbanes-Oxley Act of 2002: • established an oversight board to monitor the accounting industry; • tightened audit regulations and controls; • toughened penalties against executives who commit corporate fraud; • strengthened accounting disclosure requirements and ethical guidelines for corporate officers; • established corporate board structure and membership guidelines; • established guidelines with regard to analyst conflicts of interest; • mandated instant disclosure of stock sales by corporate executives; • increased securities regulation authority and budgets for auditors and investigators.
  • 41. © 2012 Pearson Prentice Hall. All rights reserved. 1-41 Governance and Agency: The Agency Issue • A principal-agent relationship is an arrangement in which an agent acts on the behalf of a principal. For example, shareholders of a company (principals) elect management (agents) to act on their behalf. • Agency problems arise when managers place personal goals ahead of the goals of shareholders. • Agency costs arise from agency problems that are borne by shareholders and represent a loss of shareholder wealth.
  • 42. © 2012 Pearson Prentice Hall. All rights reserved. 1-42 The Agency Issue: Management Compensation Plans • In addition to the roles played by corporate boards, institutional investors, and government regulations, corporate governance can be strengthened by ensuring that managers’ interests are aligned with those of shareholders. • A common approach is to structure management compensation to correspond with firm performance.
  • 43. © 2012 Pearson Prentice Hall. All rights reserved. 1-43 The Agency Issue: Management Compensation Plans • Incentive plans are management compensation plans that tie management compensation to share price; one example involves the granting of stock options. • Performance plans tie management compensation to measures such as EPS or growth in EPS. Performance shares and/or cash bonuses are used as compensation under these plans.
  • 44. © 2012 Pearson Prentice Hall. All rights reserved. 1-44 Matter of Fact—Forbes.com CEO Performance vs. Pay
  • 45. © 2012 Pearson Prentice Hall. All rights reserved. 1-45 The Agency Issue: The Threat of Takeover • When a firm’s internal corporate governance structure is unable to keep agency problems in check, it is likely that rival managers will try to gain control of the firm. • The threat of takeover by another firm, which believes it can enhance the troubled firm’s value by restructuring its management, operations, and financing, can provide a strong source of external corporate governance.
  • 46. Review Questions: 1–15 What is corporate governance? How has the Sarbanes-Oxley Act of 2002 affected it? Explain. 1–16 Define agency problems, and describe how they give rise to agency costs. Explain how a firm’s corporate governance structure can help avoid agency problems. 1–17 How can the firm structure management compensation to minimize agency problems? What is the current view with regard to the execution of many compensation plans? 1–18 How do market forces—both shareholder activism and the threat of takeover—act to prevent or minimize the agency problem? What role do institutional investors play in shareholder activism? © 2012 Pearson Prentice Hall. All rights reserved. 1-46
  • 47. Exercies Emphasis on Cash Flows Worldwide Rugs is a rug importer located in the United States that resells its import products to local retailers. Last year Worldwide Rugs imported $2.5 million worth of rugs from around the world, all of which were paid for prior to shipping. On receipt of the rugs, the importer immediately resold them to local retailers for $3 million. To allow its retail clients time to resell the rugs, Worldwide Rugs sells to retailers on credit. Prior to the end of its business year, Worldwide Rugs collected 85% of its outstanding accounts receivable. a. What is the accounting profit that Worldwide Rugs generated for the year? b. Did Worldwide Rugs have a successful year from an accounting perspective? c. What is the financial cash flow that Worldwide Rugs generated for the year? d. Did Worldwide Rugs have a successful year from a financial perspective? e. If the current pattern persists, what is your expectation for the future success of Worldwide Rugs? © 2012 Pearson Prentice Hall. All rights reserved. 1-47
  • 48. Exercises: Ann and Jack have been partners for several years. Their firm, A & J Tax Preparation, has been very successful, as the pair agree on most business-related questions. One disagreement, however, concerns the legal form of their business. Ann has tried for the past 2 years to get Jack to agree to incorporate. She believes that there is no downside to incorporating and sees only benefits. Jack strongly disagrees; he thinks that the business should remain a partnership forever. First, take Ann’s side, and explain the positive side to incorporating the business. Next, take Jack’s side, and state the advantages to remaining a partnership. Lastly, what information would you want if you were asked to make the decision for Ann and Jack? © 2012 Pearson Prentice Hall. All rights reserved. 1-48
  • 49. Exercises: The end-of-year parties at Yearling, Inc., are known for their extravagance. Management provides the best food and entertainment to thank the employees for their hard work. During the planning for this year’s bash, a disagreement broke out between the treasurer’s staff and the controller’s staff. The treasurer’s staff contended that the firm was running low on cash and might have trouble paying its bills over the coming months; they requested that cuts be made to the budget for the party. The controller’s staff felt that any cuts were unwarranted as the firm continued to be very profitable. Can both sides be right? Explain your answer. © 2012 Pearson Prentice Hall. All rights reserved. 1-49
  • 50. Exercises: You have been made treasurer for a day at AIMCO, Inc. AIMCO develops technology for video conferencing. A manager of the satellite division has asked you to authorize a capital expenditure in the amount of $10,000. The manager states that this expenditure is necessary to continue a long- running project designed to use satellites to allow video conferencing anywhere on the planet. The manager admits that the satellite concept has been surpassed by recent technological advances in telephony, but he feels that AIMCO should continue the project. His reasoning is based on the fact that $2.5 million has already been spent over the past 15 years on this project. Although the project has little chance to be viable, the manager believes it would be a shame to waste the money and time already spent. Use marginal cost–benefit analysis to make your decision regarding whether you should authorize the $10,000 expenditure to continue the project. © 2012 Pearson Prentice Hall. All rights reserved. 1-50
  • 51. Exercises: Recently, some branches of Donut Shop, Inc., have dropped the practice of allowing employees to accept tips. Customers who once said, “Keep the change,” now have to get used to waiting for their nickels. Management even instituted a policy of requiring that the change be thrown out if a customer drives off without it. As a frequent customer who gets coffee and doughnuts for the office, you notice that the lines are longer and that more mistakes are being made in your order. Explain why tips could be viewed as similar to stock options and why the delays and incorrect orders could represent a case of agency costs. If tips are gone forever, how could Donut Shop reduce these agency costs? © 2012 Pearson Prentice Hall. All rights reserved. 1-51
  • 52. Exercises: Liability comparisons Merideth Harper has invested $25,000 in Southwest Development Company. The firm has recently declared bankruptcy and has $60,000 in unpaid debts. Explain the nature of payments, if any, by Ms. Harper in each of the following situations. a. Southwest Development Company is a sole proprietorship owned by Ms. Harper. b. Southwest Development Company is a 50–50 partnership of Ms. Harper and Christopher Black. c. Southwest Development Company is a corporation. © 2012 Pearson Prentice Hall. All rights reserved. 1-52
  • 53. Exercises: Accrual income versus cash flow for a period Thomas Book Sales, Inc., supplies textbooks to college and university bookstores. The books are shipped with a proviso that they must be paid for within 30 days but can be returned for a full refund credit within 90 days. In 2009, Thomas shipped and billed book titles totaling $760,000. Collections, net of return credits, during the year totaled $690,000. The company spent $300,000 acquiring the books that it shipped. a. Using accrual accounting and the preceding values, show the firm’s net profit for the past year. b. Using cash accounting and the preceding values, show the firm’s net cash flow for the past year. c. Which of these statements is more useful to the financial manager? Why? © 2012 Pearson Prentice Hall. All rights reserved. 1-53
  • 54. Exercises: Cash flows It is typical for Jane to plan, monitor, and assess her financial position using cash flows over a given period, typically a month. Jane has a savings account, and her bank loans money at 6% per year while it offers short-term investment rates of 5%. Jane’s cash flows during August were as follows: Clothes $1,000 Interest received $ 450 Dining out 500 Groceries 800 Salary 4,500 Auto payment 355 Utilities 280 Mortgage 1,200 Gas 222 a. Determine Jane’s total cash inflows and cash outflows. b. Determine the net cash flow for the month of August. c. If there is a shortage, what are a few options open to Jane? d. If there is a surplus, what would be a prudent strategy for her to follow? © 2012 Pearson Prentice Hall. All rights reserved. 1-54
  • 55. Exercise: Marginal cost–benefit analysis and the goal of the firm Ken Allen, capital budgeting analyst for Bally Gears, Inc., has been asked to evaluate a proposal. The manager of the automotive division believes that replacing the robotics used on the heavy truck gear line will produce total benefits of $560,000 (in today’s dollars) over the next 5 years. The existing robotics would produce benefits of $400,000 (also in today’s dollars) over that same time period. An initial cash investment of $220,000 would be required to install the new equipment. The manager estimates that the existing robotics can be sold for $70,000. Show how Ken will apply marginal cost–benefit analysis techniques to determine the following: a. The marginal (added) benefits of the proposed new robotics. b. The marginal (added) cost of the proposed new robotics. c. The net benefit of the proposed new robotics. d. What should Ken Allen recommend that the company do? Why? e. What factors besides the costs and benefits should be considered before the final decision is made? © 2012 Pearson Prentice Hall. All rights reserved. 1-55
  • 56. Exercises: Identifying agency problems, costs, and resolutions Explain why each of the following situations is an agency problem and what costs to the firm might result from it. Suggest how the problem might be dealt with short of firing the individual(s) involved. a. The front desk receptionist routinely takes an extra 20 minutes of lunch time to run personal errands. b. Division managers are padding cost estimates so as to show short-term efficiency gains when the costs come in lower than the estimates. c. The firm’s chief executive officer has had secret talks with a competitor about the possibility of a merger in which she would become the CEO of the combined firms. d. A branch manager lays off experienced full-time employees and staffs customer service positions with part-time or temporary workers to lower employment costs and raise this year’s branch profit. The manager’s bonus is based on profitability. © 2012 Pearson Prentice Hall. All rights reserved. 1-56
  • 57. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 2 The Financial Market Environment
  • 58. © 2012 Pearson Prentice Hall. All rights reserved. 2-2 Financial Institutions & Markets Firms that require funds from external sources can obtain them in three ways: 1. through a financial institution 2. through financial markets 3. through private placements
  • 59. © 2012 Pearson Prentice Hall. All rights reserved. 2-3 Financial Institutions & Markets: Financial Institutions • Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. • The key suppliers and demanders of funds are individuals, businesses, and governments. • In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds.
  • 60. © 2012 Pearson Prentice Hall. All rights reserved. 2-4 Commercial Banks, Investment Banks, and the Shadow Banking System • Commercial banks are institutions that provide savers with a secure place to invest their funds and that offer loans to individual and business borrowers. • Investment banks are institutions that assist companies in raising capital, advise firms on major transactions such as mergers or financial restructurings, and engage in trading and market making activities.
  • 61. © 2012 Pearson Prentice Hall. All rights reserved. 2-5 Commercial Banks, Investment Banks, and the Shadow Banking System (cont.) • The Glass-Steagall Act was an act of Congress in 1933 that created the federal deposit insurance program and separated the activities of commercial and investment banks. – Repealed in the late 1990s. • The shadow banking system describes a group of institutions that engage in lending activities, much like traditional banks, but these institutions do not accept deposits and are therefore not subject to the same regulations as traditional banks.
  • 62. © 2012 Pearson Prentice Hall. All rights reserved. 2-6 Financial Institutions & Markets: Financial Markets • Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. • Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market. • A private placement involves the sale of a new security directly to an investor or group of investors. • Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public.
  • 63. © 2012 Pearson Prentice Hall. All rights reserved. 2-7 Financial Institutions & Markets: Financial Markets (cont.) • The primary market is the financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction. • Secondary markets are financial markets in which preowned securities (those that are not new issues) are traded.
  • 64. © 2012 Pearson Prentice Hall. All rights reserved. 2-8 Figure 2.1 Flow of Funds
  • 65. © 2012 Pearson Prentice Hall. All rights reserved. 2-9 The Money Market • The money market is created by a financial relationship between suppliers and demanders of short-term funds. • Most money market transactions are made in marketable securities which are short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions, respectively. • Investors generally consider marketable securities to be among the least risky investments available.
  • 66. © 2012 Pearson Prentice Hall. All rights reserved. 2-10 The Money Market (cont.) • The international equivalent of the domestic (U.S.) money market is the Eurocurrency market. • The Eurocurrency market is a market for short-term bank deposits denominated in U.S. dollars or other marketable currencies. • The Eurocurrency market has grown rapidly mainly because it is unregulated and because it meets the needs of international borrowers and lenders.
  • 67. © 2012 Pearson Prentice Hall. All rights reserved. 2-11 The Capital Market • The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. • The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity, or ownership). – Bonds are long-term debt instruments used by businesses and government to raise large sums of money, generally from a diverse group of lenders. – Common stock are units of ownership interest or equity in a corporation. – Preferred stock is a special form of ownership that has features of both a bond and common stock.
  • 68. © 2012 Pearson Prentice Hall. All rights reserved. 2-12 Broker Markets and Dealer Markets Broker markets are securities exchanges on which the two sides of a transaction, the buyer and seller, are brought together to trade securities. – Trading takes place on centralized trading floors. – Examples include: NYSE Euronext, American Stock Exchange
  • 69. © 2012 Pearson Prentice Hall. All rights reserved. 2-13 Broker Markets and Dealer Markets (cont.) Dealer markets are markets in which the buyer and seller are not brought together directly but instead have their orders executed by securities dealers that “make markets” in the given security. – The dealer market has no centralized trading floors. Instead, it is made up of a large number of market makers who are linked together via a mass-telecommunications network. The Nasdaq market is one example (National Association of Securities Dealers Automated Quotation System) As compensation for executing orders, market makers make money on the spread (bid price – ask price).
  • 70. © 2012 Pearson Prentice Hall. All rights reserved. 2-14 Matter of Fact NYSE Euronext is the World’s Largest Stock Exchange – According to the World Federation of Exchanges, NYSE Euronext is the largest stock market in the world, as measured by the total market value of securities listed on that market. – NYSE Euronext has listed securities worth more than $11.8 trillion in the U.S. and $2.9 trillion in Europe. – Next largest is the London Stock Exchange with securities valued at £1.7 trillion, which is equivalent to $2.8 trillion given the exchange rate between pounds and dollars prevailing at the end of 2009.
  • 71. © 2012 Pearson Prentice Hall. All rights reserved. 2-15 International Capital Markets • In the Eurobond market, corporations and governments typically issue bonds denominated in dollars and sell them to investors located outside the United States. • The foreign bond market is a market for bonds issued by a foreign corporation or government that is denominated in the investor’s home currency and sold in the investor’s home market. • The international equity market allows corporations to sell blocks of shares to investors in a number of different countries simultaneously.
  • 72. © 2012 Pearson Prentice Hall. All rights reserved. 2-16 The Role of Capital Markets • From a firm’s perspective, the role of capital markets is to be a liquid market where firms can interact with investors in order to obtain valuable external financing resources. • From investors’ perspectives, the role of capital markets is to be an efficient market that allocates funds to their most productive uses. • An efficient market allocates funds to their most productive uses as a result of competition among wealth-maximizing investors and determines and publicizes prices that are believed to be close to their true value.
  • 73. © 2012 Pearson Prentice Hall. All rights reserved. 2-17 The Role of Capital Markets (cont.) • Advocates of behavioral finance, an emerging field that blends ideas from finance and psychology, argue that stock prices and prices of other securities can deviate from their true values for extended periods. • These people point to episodes such as the huge run up and subsequent collapse of the prices of Internet stocks in the late 1990s, or the failure of markets to accurately assess the risk of mortgage-backed securities in the more recent financial crisis, as examples of the principle that stock prices sometimes can be wildly inaccurate measures of value.
  • 74. © 2012 Pearson Prentice Hall. All rights reserved. 2-18 Focus on Ethics The Ethics of Insider Trading – Martha Stewart was convicted of conspiracy, obstruction, and making false statements to federal investigators and served 5 months in jail, 5 months of home confinement, 2 years of probation, and a $30,000 fine. – Laws prohibiting insider trading were established in the United States in the 1930s. These laws are designed to ensure that all investors have access to relevant information on the same terms. – However, many market participants believe that insider trading should be permitted. – If efficiency is the goal of financial markets, is allowing or disallowing insider trading more unethical? – Does allowing insider trading create an ethical dilemma for insiders?
  • 75. Review Questions 2–1 Who are the key participants in the transactions of financial institutions? Who are net suppliers, and who are net demanders? 2–2 What role do financial markets play in our economy? What are primary and secondary markets? What relationship exists between financial institutions and financial markets? 2–3 What is the money market? What is the Eurocurrency market? 2–4 What is the capital market? What are the primary securities traded in it? 2–5 What are broker markets? What are dealer markets? How do they differ? 2–6 Briefly describe the international capital markets, particularly the Eurobond market and the international equity market. 2–7 What are efficient markets? What determines the price of an individual security in such a market? © 2012 Pearson Prentice Hall. All rights reserved. 2-19
  • 76. Financial Crisis 20 ⚫ Financial crisis broadly refers to; ⚫ disruptions in financial markets causing constraint to the flow of credit to families and businesses and, ⚫ consequently having an adverse effect on the real economy of goods and services. ⚫ The term is generally used to describe a situation in which; ⚫ investors unexpectedly lose a substantial amount of their investments, and ⚫ financial institutions suddenly lose a significant proportion of their value. ⚫ Financial crises include, among others; ⚫ stock market crashes, ⚫ financial bubbles, ⚫ currency crises, and ⚫ sovereign defaults.
  • 77. © 2012 Pearson Prentice Hall. All rights reserved. 2-21 The Financial Crisis: Financial Institutions and Real Estate Finance • Securitization is the process of pooling mortgages or other types of loans and then selling claims or securities against that pool in a secondary market. • Mortgage-backed securities represent claims on the cash flows generated by a pool of mortgages and can be purchased by individual investors, pension funds, mutual funds, or virtually any other investor. • A primary risk associated with mortgage-back securities is that homeowners may not be able to, or may choose not to, repay their loans.
  • 78. The Subprime Mortgage Dilemma It is believed that every economic crisis is the product of cheap credit; low interest rates create demand for loans that cannot be repaid when interest rates subsequently rise. Lower interest rates in the United States meant that mortgages became more affordable and more in demand. Chapra (2009) points out that in such an environment “loan volume gained greater priority over loan quality” and ordinary investors were enticed to live beyond their means. As interest rates began to rise, new-home affordability and the ability to repay existing loans have sharply plummeted. The problem was exacerbated by the complexity of products that have been created by intermediary players that sought to pass the entire risk of default to the final purchasers. 22
  • 79. © 2012 Pearson Prentice Hall. All rights reserved. 2-23
  • 80. © 2012 Pearson Prentice Hall. All rights reserved. 2-24
  • 81. © 2012 Pearson Prentice Hall. All rights reserved. 2-25 The Financial Crisis: Falling Home Prices and Delinquent Mortgages (Figure 2.2)
  • 82. © 2012 Pearson Prentice Hall. All rights reserved. 2-26 The Financial Crisis: Crisis of Confidence in Banks (Figure 2.3)
  • 83. © 2012 Pearson Prentice Hall. All rights reserved. 2-27 The Financial Crisis: Spillover Effects and the Great Recession • As banks came under intense financial pressure in 2008, they tightened their lending standards and dramatically reduced the quantity of loans they made. • Corporations found that they could no longer raise money in the money market, or could only do so at extraordinarily high rates. • As a consequence, businesses began to hoard cash and cut back on expenditures, and economic activity contracted.
  • 84. Implications of the Global Financial Crisis A limited subprime mortgage impasse in the US real estate grew to be the world’s biggest financial crisis since the 1930s. Every section of the globe have been some how affected by the crisis, as it has hit almost every sector of the world’s economy. World economies have yet to devise prudent strategies to deal with the crisis. Conventional financial institutions, by and large, were the first to feel the full impact of the crisis they had initiated. The year 2008 was packed with unparalleled events that have created mass uncertainty, such as: – a sharp decline in global equity markets, – the failure or collapse of numerous global financial institutions, – governments of a number of industrialized countries allocating in excess of $7 trillion for a bailout and liquidity injections to revive their economies, 28
  • 85. Review Questions 2–8 What is securitization, and how does it facilitate investment in real estate assets? 2–9 What is a mortgage-backed security? What is the basic risk associated with mortgage-backed securities? 2–10 How do rising home prices contribute to low mortgage delinquencies? 2–11 Why do falling home prices create an incentive for homeowners to default on their mortgages even if they can afford to make the monthly payments? 2–12 Why does a crisis in the financial sector spill over into other industries? © 2012 Pearson Prentice Hall. All rights reserved. 2-29
  • 86. © 2012 Pearson Prentice Hall. All rights reserved. 2-30 Business Taxes • Both individuals and businesses must pay taxes on income. • The income of sole proprietorships and partnerships is taxed as the income of the individual owners, whereas corporate income is subject to corporate taxes. • Both individuals and businesses can earn two types of income— ordinary income and capital gains income. • Under current law, tax treatment of ordinary income and capital gains income change frequently due frequently changing tax laws.
  • 87. © 2012 Pearson Prentice Hall. All rights reserved. 2-31 Table 2.1 Corporate Tax Rate Schedule
  • 88. © 2012 Pearson Prentice Hall. All rights reserved. 2-32 Business Taxes: Ordinary Income Ordinary income is earned through the sale of a firm’s goods or services and is taxed at the rates depicted in Table 2.1 on the previous slide. Example Weber Manufacturing Inc. has before-tax earnings of $250,000. Tax = $22,500 + [0.39  ($250,000 – $100,000)] Tax = $22,500 + (0.39  $150,000) Tax = $22,500 + $58,500 = $80,750
  • 89. © 2012 Pearson Prentice Hall. All rights reserved. 2-33 Business Taxation: Marginal versus Average Tax Rates • A firm’s marginal tax rate represents the rate at which additional income is taxed. • The average tax rate is the firm’s taxes divided by taxable income. Example What are Webster Manufacturing’s marginal and average tax rates? Marginal Tax Rate = 39% Average Tax Rate = $80,750/$250,000 = 32.3%
  • 90. © 2012 Pearson Prentice Hall. All rights reserved. 2-34 Business Taxation: Interest and Dividend Income • For corporations only, 70% of all dividend income received from an investment in the stock of another corporation in which the firm has less than 20% ownership is excluded from taxation. • This exclusion moderates the effect of double taxation, which occurs when after-tax corporate earnings are distributed as cash dividends to stockholders, who then must pay personal taxes on the dividend amount. • Unlike dividend income, all interest income received is fully taxed.
  • 91. © 2012 Pearson Prentice Hall. All rights reserved. 2-35 Business Taxation: Tax-Deductible Expenses • In calculating taxes, corporations may deduct operating expenses and interest expense but not dividends paid. • This creates a built-in tax advantage for using debt financing as the following example will demonstrate. Example Two companies, Debt Co. and No Debt Co., both expect in the coming year to have EBIT of $200,000. During the year, Debt Co. will have to pay $30,000 in interest expenses. No Debt Co. has no debt and will pay not interest expenses.
  • 92. © 2012 Pearson Prentice Hall. All rights reserved. 2-36 Business Taxation: Tax-Deductible Expenses (cont.)
  • 93. © 2012 Pearson Prentice Hall. All rights reserved. 2-37 Business Taxation: Tax-Deductible Expenses (cont.) • As the example shows, the use of debt financing can increase cash flow and EPS, and decrease taxes paid. • The tax deductibility of interest and other certain expenses reduces their actual (after-tax) cost to the profitable firm. • It is the non-deductibility of dividends paid that results in double taxation under the corporate form of organization.
  • 94. © 2012 Pearson Prentice Hall. All rights reserved. 2-38 Business Taxation: Capital Gains • A capital gain is the amount by which the sale price of an asset exceeds the asset’s purchase price. • For corporations, capital gains are added to ordinary income and taxed like ordinary income at the firm’s marginal tax rate. Example Ross Company has just sold for $150,000 and asset that was purchased 2 years ago for $125,000. Because the asset was sold for more than its initial purchase price, there is a capital gain of $25,000 ($150,000 - $125,000).
  • 95. Review Questions 2–15 Describe the tax treatment of ordinary income and that of capital gains. What is the difference between the average tax rate and the marginal tax rate? 2–16 How does the tax treatment of dividend income by the corporation moderate the effects of double taxation? 2–17 What benefit results from the tax deductibility of certain corporate expenses? © 2012 Pearson Prentice Hall. All rights reserved. 2-39
  • 96. Self-Test Problem Corporate taxes Montgomery Enterprises, Inc., had operating earnings of $280,000 for the year just ended. During the year the firm sold stock that it held in another company for $180,000, which was $30,000 above its original purchase price of $150,000, paid 1 year earlier. a. What is the amount, if any, of capital gains realized during the year? b. How much total taxable income did the firm earn during the year? c. Use the corporate tax rate schedule given in Table 2.1 to calculate the firm’s total taxes due. d. Calculate both the average tax rate and the marginal tax rate on the basis of your findings. © 2012 Pearson Prentice Hall. All rights reserved. 2-40
  • 97. Warm-Up Exercises E2–1 What does it mean to say that individuals as a group are net suppliers of funds for financial institutions? What do you think the consequences might be in financial markets if individuals consumed more of their incomes and thereby reduced the supply of funds available to financial institutions? E2–2 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy fashion design firm. Your firm needs $10 million to expand production. How do you think the process of raising this money will vary if you raise it with the help of a financial institution versus raising it directly in the financial markets? E2–3 For what kinds of needs do you a think firm would issue securities in the money market versus the capital market? © 2012 Pearson Prentice Hall. All rights reserved. 2-41
  • 98. Warm-Up Exercises E2–4 Your broker calls to offer you the investment opportunity of a lifetime, the chance to invest in mortgage-backed securities. The broker explains that these securities are entitled to the principal and interest payments received from a pool of residential mortgages. List some of the questions you would ask your broker to assess the risk of this investment opportunity. E2–5 Reston, Inc., has asked your corporation, Pruro, Inc., for financial assistance. As a long-time customer of Reston, your firm has decided to give that assistance. The question you are debating is whether Pruro should take Reston stock with a 5% annual dividend or a promissory note paying 5% annual interest. Assuming payment is guaranteed and the dollar amounts for annual interest and dividend income are identical, which option will result in greater after-tax income for the first year? © 2012 Pearson Prentice Hall. All rights reserved. 2-42
  • 99. Problems P2–1 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusive distributor of a major line of sporting goods. During 2010 the firm earned $92,500 before taxes. a. Calculate the firm’s tax liability using the corporate tax rate schedule given in Table 2.1. b. How much are Tantor Supply’s 2010 after-tax earnings? C.What was the firm’s average tax rate, based on your findings in part a? d. What is the firm’s marginal tax rate, based on your findings in part a? © 2012 Pearson Prentice Hall. All rights reserved. 2-43
  • 100. P2–2 Average corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following: a. Calculate the tax liability, after-tax earnings, and average tax rates for the following levels of corporate earnings before taxes: $10,000; $80,000; $300,000; $500,000; $1.5 million; $10 million; and $20 million. b. Plot the average tax rates (measured on the y axis) against the pretax income levels (measured on the x axis). What generalization can be made concerning the relationship between these variables? © 2012 Pearson Prentice Hall. All rights reserved. 2-44
  • 101. P2–3 Marginal corporate tax rates Using the corporate tax rate schedule given in Table 2.1, perform the following: a. Find the marginal tax rate for the following levels of corporate earnings before taxes: $15,000; $60,000; $90,000; $200,000; $400,000; $1 million; and $20 million. b. Plot the marginal tax rates (measured on the y axis) against the pretax income levels (measured on the x axis). Explain the relationship between these variables. © 2012 Pearson Prentice Hall. All rights reserved. 2-45
  • 102. P2–4 Interest versus dividend income During the year just ended, Shering Distributors, Inc., had pretax earnings from operations of $490,000. In addition, during the year it received $20,000 in income from interest on bonds it held in Zig Manufacturing and received $20,000 in income from dividends on its 5% common stock holding in Tank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70% dividend exclusion on its Tank Industries stock. a. Calculate the firm’s tax on its operating earnings only. b. Find the tax and the after-tax amount attributable to the interest income from Zig Manufacturing bonds. c. Find the tax and the after-tax amount attributable to the dividend income from the Tank Industries, Inc., common stock. d. Compare, contrast, and discuss the after-tax amounts resulting from the interest income and dividend income calculated in parts b and c. e. What is the firm’s total tax liability for the year? © 2012 Pearson Prentice Hall. All rights reserved. 2-46
  • 103. P2–5 Interest versus dividend expense Michaels Corporation expects earnings before interest and taxes to be $40,000 for the current period. Assuming an ordinary tax rate of 40%, compute the firm’s earnings after taxes and earnings available for common stockholders (earnings after taxes and preferred stock dividends, if any) under the following conditions: a. The firm pays $10,000 in interest. b. The firm pays $10,000 in preferred stock dividends. © 2012 Pearson Prentice Hall. All rights reserved. 2-47
  • 104. P 2.6 Capital gains taxes Perkins Manufacturing is considering the sale of two nondepreciable assets, X and Y. Asset X was purchased for $2,000 and will be sold today for $2,250. Asset Y was purchased for $30,000 and will be sold today for $35,000. The firm is subject to a 40% tax rate on capital gains. a. Calculate the amount of capital gain, if any, realized on each of the assets. b. Calculate the tax on the sale of each asset. © 2012 Pearson Prentice Hall. All rights reserved. 2-48
  • 105. P 2.7 Capital gains taxes The following table contains purchase and sale prices for the nondepreciable capital assets of a major corporation. The firm paid taxes of 40% on capital gains. a. Determine the amount of capital gain realized on each of the five assets. b. Calculate the amount of tax paid on each of the assets. © 2012 Pearson Prentice Hall. All rights reserved. 2-49
  • 106. Copyright © 2012 Pearson Prentice Hall. All rights reserved. Chapter 5 Time Value of Money
  • 107. Decision Dilemma—Take a Lump Sum or Annual Installments ❑A couple Won a Lucky Draw. ❑They had to choose between a single lump sum $104 million, or $198 million paid out over 25 years (or $7.92 million per year). ❑The winning couple opted for the lump sum. ❑Did they make the right choice? What basis do we make such an economic comparison?
  • 108. Opportunity Cost Opportunity cost = Alternative use – The opportunity cost of money is the interest rate that would be earned by investing it. – It is the underlying reason for the time value of money – Any person with money today knows they can invest those funds to be some greater amount in the future. – Conversely, if you are promised a cash flow in the future, it’s present value today is less than what is promised!
  • 109. Choosing from Investment Alternatives Required Rate of Return or Discount Rate You have three choices: 1. $20,000 received today 2. $31,000 received in 5 years 3. $3,000 per year indefinitely To make a decision, you need to know what interest rate to use. – This interest rate is known as your required rate of return or discount rate.
  • 110.
  • 111. Time Value of Money ❑Money has a time value because it can earn more money over time (earning power). ❑Money has a time value because its purchasing power changes over time (inflation). ❑Time value of money is measured in terms of interest rate. ❑Interest is the cost of money—a cost to the borrower and an earning to the lender
  • 112. The Time Value of Money •One of the most important principle in finance 7 $1 today Relationship $1 future Present Value Future Value Interest is the factor contributing to Time Value of Money Simple Interest= Principal x Interest rate x time period = Po(i)(n)
  • 113. © 2012 Pearson Prentice Hall. All rights reserved. 5-8 The Role of Time Value in Finance • Most financial decisions involve costs & benefits that are spread out over time. • Time value of money allows comparison of cash flows from different periods. • Question: Your father has offered to give you some money and asks that you choose one of the following two alternatives: – $1,000 today, or – $1,100 one year from now. • What do you do?
  • 114. © 2012 Pearson Prentice Hall. All rights reserved. 5-9 The Role of Time Value in Finance (cont.) • The answer depends on what rate of interest you could earn on any money you receive today. • For example, if you could deposit the $1,000 today at 12% per year, you would prefer to be paid today. • Alternatively, if you could only earn 5% on deposited funds, you would be better off if you chose the $1,100 in one year.
  • 115. © 2012 Pearson Prentice Hall. All rights reserved. 5-10 Future Value versus Present Value • Suppose a firm has an opportunity to spend $15,000 today on some investment that will produce $17,000 spread out over the next five years as follows: • Is this a wise investment? • To make the right investment decision, managers need to compare the cash flows at a single point in time. Year Cash flow 1 $3,000 2 $5,000 3 $4,000 4 $3,000 5 $2,000
  • 116. © 2012 Pearson Prentice Hall. All rights reserved. 5-11 Figure 5.1 Time Line
  • 117. © 2012 Pearson Prentice Hall. All rights reserved. 5-12 Figure 5.2 Compounding and Discounting
  • 118. © 2012 Pearson Prentice Hall. All rights reserved. 5-13 Computational Tools (cont.) Electronic spreadsheets: – Like financial calculators, electronic spreadsheets have built-in routines that simplify time value calculations. – The value for each variable is entered in a cell in the spreadsheet, and the calculation is programmed using an equation that links the individual cells. – Changing any of the input variables automatically changes the solution as a result of the equation linking the cells.
  • 119. © 2012 Pearson Prentice Hall. All rights reserved. 5-14 Basic Patterns of Cash Flow • The cash inflows and outflows of a firm can be described by its general pattern. • The three basic patterns include a single amount, an annuity, or a mixed stream:
  • 120. Compound Interest Interest paid (earned) on any previous interest earned, as well as on the principal borrowed (lent). Simple Interest Interest paid (earned) on only the original amount, or principal, borrowed (lent). Types of Interest
  • 121. Formula SI = P0(i)(n) SI: Simple Interest P0: Deposit today (t=0) i: Interest Rate per Period n: Number of Time Periods Simple & Compound Interest Trends DOLLARS Simple Compound 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
  • 122. Simple Interest Future Value Principal(Po)=$1000 Interest (i) = $10% Time (n) = $5 Years Interest =? Future Value=? 17
  • 123. Simple Interest Present Value Future Value=$7500 Interest = $10% Time = $5 Years Interest =? PRESENT Value=? 18
  • 124. Simple Interest Present Value Po+(Po *n*i)=7500 Po +(0.5 Po)=7500 1.5 Po =7500 Po =7500/1.5 Po =5000 Principal= 5000 Interest=Fv-Pv Interest=7500-5000= 2500 19
  • 125. © 2012 Pearson Prentice Hall. All rights reserved. 5-20 Future Value of a Single Amount • Future value is the value at a given future date of an amount placed on deposit today and earning interest at a specified rate. Found by applying compound interest over a specified period of time. • Compound interest is interest that is earned on a given deposit and has become part of the principal at the end of a specified period. • Principal is the amount of money on which interest is paid.
  • 126. © 2012 Pearson Prentice Hall. All rights reserved. 5-21 Future Value of a Single Amount: The Equation for Future Value • We use the following notation for the various inputs: – FVn = future value at the end of period n – PV = initial principal, or present value – r = annual rate of interest paid. (Note: On financial calculators, I is typically used to represent this rate.) – n = number of periods (typically years) that the money is left on deposit • The general equation for the future value at the end of period n is FVn = PV  (1 + r)n
  • 127. FV2 = $1,000 (FVIF7%,2) = $1,000 (1.145) = $1,145 [Due to Rounding] Using Future Value Tables Period 6% 7% 8% 1 1.060 1.070 1.080 2 1.124 1.145 1.166 3 1.191 1.225 1.260 4 1.262 1.311 1.360 5 1.338 1.403 1.469
  • 128. © 2012 Pearson Prentice Hall. All rights reserved. 5-23 Future Value of a Single Amount: The Equation for Future Value Jane Farber places $800 in a savings account paying 6% interest compounded annually. She wants to know how much money will be in the account at the end of five years. This analysis can be depicted on a time line as follows: FV5 = $800  (1 + 0.06)5 = $800  (1.33823) = $1,070.58
  • 129. © 2012 Pearson Prentice Hall. All rights reserved. 5-24 Figure 5.4 Future Value Relationship
  • 130. Double Your Money!!! We will use the “Rule-of-72”. Quick! How long does it take to double $5,000 at a compound rate of 12% per year (approx.)? Approx. Years to Double = 72 / i% 72 / 12% = 6 Years [Actual Time is 6.12 Years]
  • 131. Types of Compounding Problems There are really only four different things you can be asked to find using this basic equation: FVn=PV0 (1+k)n ▪ Find the initial amount of money to invest (PV0) ▪ Find the Future value (FVn) ▪ Find the rate (k) ▪ Find the time (n)
  • 132. Types of Compounding Problems Solving for the Rate (k) Your have asked your father for a loan of $10,000 to get you started in a business. You promise to repay him $20,000 in five years time. What compound rate of return are you offering to pay? This is an ex ante calculation. FVt=PV0 (1+k)n $20,000= $10,000 (1+r)5 2=(1+r)5 21/5=1+r 1.14869=1+r r = 14.869%
  • 133. Types of Compounding Problems Solving for Time (n) or Holding Periods You have $150,000 in your RRSP (Registered Retirement Savings Plan). Assuming a rate of 8%, how long will it take to have the plan grow to a value of $300,000? – This is an ex ante calculation FVt=PV0(1+k)n $300,000= $150,000 (1+.08)n 2=(1.08)n ln 2 =ln 1.08 × n 0.69314 = .07696 × n t = 0.69314 / .076961041 = 9.00 years
  • 134. Types of Compounding Problems Solving for Time (n) – using logarithms You have $150,000 in your RRSP (Registered Retirement Savings Plan). Assuming a rate of 8%, how long will it take to have the plan grow to a value of $300,000? – This is an ex ante calculation. FVt=PV0 (1+k)n $300,000= $150,000 (1+.08)n 2=(1.08)n log 2 =log 1.08 × n 0.301029995 = 0.033423755 × n t = 9.00 years
  • 135. Types of Compounding Problems Solving for the Future Value (FVn) You have $650,000 in your pension plan today. Because you have retired, you and your employer will not make any further contributions to the plan. However, you don’t plan to take any pension payments for five more years so the principal will continue to grow. Assuming a rate of 8%, forecast the value of your pension plan in 5 years. – This is an ex ante calculation. FVt=PV0 (1+k)n FV5= $650,000 (1+.08)5 FV5 = $650,000 × 1.469328077 FV5 = $955,063.25
  • 136. Types of Compounding Problems Finding the amount of money to invest (PV0) You hope to save for a down payment on a home. You hope to have $40,000 in four years time; determine the amount you need to invest now at 6% – This is a process known as discounting – This is an ex ante calculation FVn=PV0 (1+k)n $40,000= PV0 (1.1)4 PV0 = $40,000/1.4641=$27,320.53
  • 137. © 2012 Pearson Prentice Hall. All rights reserved. 5-32 Present Value of a Single Amount • Present value is the current dollar value of a future amount—the amount of money that would have to be invested today at a given interest rate over a specified period to equal the future amount. • It is based on the idea that a dollar today is worth more than a dollar tomorrow. • Discounting cash flows is the process of finding present values; the inverse of compounding interest. • The discount rate is often also referred to as the opportunity cost, the discount rate, the required return, or the cost of capital.
  • 138. © 2012 Pearson Prentice Hall. All rights reserved. 5-33 Personal Finance Example Paul Shorter has an opportunity to receive $300 one year from now. If he can earn 6% on his investments, what is the most he should pay now for this opportunity? PV  (1 + 0.06) = $300 PV = $300/(1 + 0.06) = $283.02
  • 139. © 2012 Pearson Prentice Hall. All rights reserved. 5-34 Present Value of a Single Amount: The Equation for Present Value The present value, PV, of some future amount, FVn, to be received n periods from now, assuming an interest rate (or opportunity cost) of r, is calculated as follows:
  • 140. PV2 = $1,000 (PVIF7%,2) = $1,000 (.873) = $873 [Due to Rounding] Using Present Value Tables Period 6% 7% 8% 1 .943 .935 .926 2 .890 .873 .857 3 .840 .816 .794 4 .792 .763 .735 5 .747 .713 .681
  • 141. © 2012 Pearson Prentice Hall. All rights reserved. 5-36 Present Value of a Single Amount: The Equation for Future Value Pam Valenti wishes to find the present value of $1,700 that will be received 8 years from now. Pam’s opportunity cost is 8%. This analysis can be depicted on a time line as follows: PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46
  • 142. © 2012 Pearson Prentice Hall. All rights reserved. 5-37 Figure 5.5 Present Value Relationship
  • 143. © 2012 Pearson Prentice Hall. All rights reserved. 5-38 Annuities An annuity is a stream of equal periodic cash flows, over a specified time period. These cash flows can be inflows of returns earned on investments or outflows of funds invested to earn future returns. – An ordinary (deferred) annuity is an annuity for which the cash flow occurs at the end of each period – An annuity due is an annuity for which the cash flow occurs at the beginning of each period. – An annuity due will always be greater than an otherwise equivalent ordinary annuity because interest will compound for an additional period.
  • 144. © 2012 Pearson Prentice Hall. All rights reserved. 5-39 Personal Finance Example Fran Abrams is choosing which of two annuities to receive. Both are 5-year $1,000 annuities; annuity A is an ordinary annuity, and annuity B is an annuity due. Fran has listed the cash flows for both annuities as shown in Table 5.1 on the following slide. Note that the amount of both annuities total $5,000.
  • 145. © 2012 Pearson Prentice Hall. All rights reserved. 5-40 Table 5.1 Comparison of Ordinary Annuity and Annuity Due Cash Flows ($1,000, 5 Years)
  • 146. © 2012 Pearson Prentice Hall. All rights reserved. 5-41 Finding the Future Value of an Ordinary Annuity • You can calculate the future value of an ordinary annuity that pays an annual cash flow equal to CF by using the following equation: • As before, in this equation r represents the interest rate and n represents the number of payments in the annuity (or equivalently, the number of years over which the annuity is spread).
  • 147. © 2012 Pearson Prentice Hall. All rights reserved. 5-42 Finding the Present Value of an Ordinary Annuity • You can calculate the present value of an ordinary annuity that pays an annual cash flow equal to CF by using the following equation: • As before, in this equation r represents the interest rate and n represents the number of payments in the annuity (or equivalently, the number of years over which the annuity is spread).
  • 148. © 2012 Pearson Prentice Hall. All rights reserved. 5-43 Finding the Present Value of an Ordinary Annuity (cont.) Braden Company, a small producer of plastic toys, wants to determine the most it should pay to purchase a particular annuity. The annuity consists of cash flows of $700 at the end of each year for 5 years. The required return is 8%. This analysis can be depicted on a time line as follows:
  • 149. © 2012 Pearson Prentice Hall. All rights reserved. 5-44 Table 5.2 Long Method for Finding the Present Value of an Ordinary Annuity
  • 150. © 2012 Pearson Prentice Hall. All rights reserved. 5-45 Finding the Future Value of an Annuity Due • You can calculate the present value of an annuity due that pays an annual cash flow equal to CF by using the following equation: • As before, in this equation r represents the interest rate and n represents the number of payments in the annuity (or equivalently, the number of years over which the annuity is spread).
  • 151. © 2012 Pearson Prentice Hall. All rights reserved. 5-46 Finding the Present Value of an Annuity Due • You can calculate the present value of an ordinary annuity that pays an annual cash flow equal to CF by using the following equation: • As before, in this equation r represents the interest rate and n represents the number of payments in the annuity (or equivalently, the number of years over which the annuity is spread).
  • 152. FVADn = R (FVIFAi%,n)(1+i) FVAD3 = $1,000 (FVIFA7%,3)(1.07) = $1,000 (3.215)(1.07) = $3,440 Valuation Using Table III Period 6% 7% 8% 1 1.000 1.000 1.000 2 2.060 2.070 2.080 3 3.184 3.215 3.246 4 4.375 4.440 4.506 5 5.637 5.751 5.867
  • 153. PVADn = R (PVIFAi%,n)(1+i) PVAD3 = $1,000 (PVIFA7%,3)(1.07) = $1,000 (2.624)(1.07) = $2,808 Valuation Using Table IV Period 6% 7% 8% 1 0.943 0.935 0.926 2 1.833 1.808 1.783 3 2.673 2.624 2.577 4 3.465 3.387 3.312 5 4.212 4.100 3.993
  • 154. © 2012 Pearson Prentice Hall. All rights reserved. 5-49 Finding the Present Value of a Perpetuity • A perpetuity is an annuity with an infinite life, providing continual annual cash flow. • If a perpetuity pays an annual cash flow of CF, starting one year from now, the present value of the cash flow stream is PV = CF ÷ r
  • 155. © 2012 Pearson Prentice Hall. All rights reserved. 5-50 Personal Finance Example Ross Clark wishes to endow a chair in finance at his alma mater. The university indicated that it requires $200,000 per year to support the chair, and the endowment would earn 10% per year. To determine the amount Ross must give the university to fund the chair, we must determine the present value of a $200,000 perpetuity discounted at 10%. PV = $200,000 ÷ 0.10 = $2,000,000
  • 156. © 2012 Pearson Prentice Hall. All rights reserved. 5-51 Future Value of a Mixed Stream Shrell Industries, a cabinet manufacturer, expects to receive the following mixed stream of cash flows over the next 5 years from one of its small customers.
  • 157. © 2012 Pearson Prentice Hall. All rights reserved. 5-52 Future Value of a Mixed Stream If the firm expects to earn at least 8% on its investments, how much will it accumulate by the end of year 5 if it immediately invests these cash flows when they are received? This situation is depicted on the following time line.
  • 158. © 2012 Pearson Prentice Hall. All rights reserved. 5-53 Present Value of a Mixed Stream Frey Company, a shoe manufacturer, has been offered an opportunity to receive the following mixed stream of cash flows over the next 5 years.
  • 159. © 2012 Pearson Prentice Hall. All rights reserved. 5-54 Present Value of a Mixed Stream If the firm must earn at least 9% on its investments, what is the most it should pay for this opportunity? This situation is depicted on the following time line.
  • 160. © 2012 Pearson Prentice Hall. All rights reserved. 5-55 Compounding Interest More Frequently Than Annually • Compounding more frequently than once a year results in a higher effective interest rate because you are earning on interest on interest more frequently. • As a result, the effective interest rate is greater than the nominal (annual) interest rate. • Furthermore, the effective rate of interest will increase the more frequently interest is compounded.
  • 161. © 2012 Pearson Prentice Hall. All rights reserved. 5-56 Table 5.3 Future Value from Investing $100 at 8% Interest Compounded Semiannually over 24 Months (2 Years)
  • 162. © 2012 Pearson Prentice Hall. All rights reserved. 5-57 Table 5.4 Future Value from Investing $100 at 8% Interest Compounded Quarterly over 24 Months (2 Years)
  • 163. © 2012 Pearson Prentice Hall. All rights reserved. 5-58 Table 5.5 Future Value from Investing $100 at 8% Interest Compounded Quarterly over 24 Months (2 Years)
  • 164. © 2012 Pearson Prentice Hall. All rights reserved. 5-59 Compounding Interest More Frequently Than Annually (cont.) A general equation for compounding more frequently than annually Recalculate the example for the Fred Moreno example assuming (1) semiannual compounding and (2) quarterly compounding.
  • 165. © 2012 Pearson Prentice Hall. All rights reserved. 5-60 Continuous Compounding • Continuous compounding involves the compounding of interest an infinite number of times per year at intervals of microseconds. • A general equation for continuous compounding where e is the exponential function.
  • 166. © 2012 Pearson Prentice Hall. All rights reserved. 5-61 Personal Finance Example Find the value at the end of 2 years (n = 2) of Fred Moreno’s $100 deposit (PV = $100) in an account paying 8% annual interest (r = 0.08) compounded continuously. FV2 (continuous compounding) = $100  e0.08  2 = $100  2.71830.16 = $100  1.1735 = $117.35
  • 167. © 2012 Pearson Prentice Hall. All rights reserved. 5-62 Nominal and Effective Annual Rates of Interest • The nominal (stated) annual rate is the contractual annual rate of interest charged by a lender or promised by a borrower. • The effective (true) annual rate (EAR) is the annual rate of interest actually paid or earned. • In general, the effective rate > nominal rate whenever compounding occurs more than once per year
  • 168. © 2012 Pearson Prentice Hall. All rights reserved. 5-63 Personal Finance Example Fred Moreno wishes to find the effective annual rate associated with an 8% nominal annual rate (r = 0.08) when interest is compounded (1) annually (m = 1); (2) semiannually (m = 2); and (3) quarterly (m = 4).
  • 169. © 2012 Pearson Prentice Hall. All rights reserved. 5-64 Special Applications of Time Value: Deposits Needed to Accumulate a Future Sum The following equation calculates the annual cash payment (CF) that we’d have to save to achieve a future value (FVn): Suppose you want to buy a house 5 years from now, and you estimate that an initial down payment of $30,000 will be required at that time. To accumulate the $30,000, you will wish to make equal annual end- of-year deposits into an account paying annual interest of 6 percent.
  • 170. © 2012 Pearson Prentice Hall. All rights reserved. 5-65 Special Applications of Time Value: Loan Amortization • Loan amortization is the determination of the equal periodic loan payments necessary to provide a lender with a specified interest return and to repay the loan principal over a specified period. • The loan amortization process involves finding the future payments, over the term of the loan, whose present value at the loan interest rate equals the amount of initial principal borrowed. • A loan amortization schedule is a schedule of equal payments to repay a loan. It shows the allocation of each loan payment to interest and principal.
  • 171. © 2012 Pearson Prentice Hall. All rights reserved. 5-66 Special Applications of Time Value: Loan Amortization (cont.) • The following equation calculates the equal periodic loan payments (CF) necessary to provide a lender with a specified interest return and to repay the loan principal (PV) over a specified period: • Say you borrow $6,000 at 10 percent and agree to make equal annual end-of-year payments over 4 years. To find the size of the payments, the lender determines the amount of a 4-year annuity discounted at 10 percent that has a present value of $6,000.
  • 172. © 2012 Pearson Prentice Hall. All rights reserved. 5-67 Table 5.6 Loan Amortization Schedule ($6,000 Principal, 10% Interest, 4-Year Repayment Period)
  • 173. © 2012 Pearson Prentice Hall. All rights reserved. 5-68 Special Applications of Time Value: Finding Interest or Growth Rates • It is often necessary to calculate the compound annual interest or growth rate (that is, the annual rate of change in values) of a series of cash flows. • The following equation is used to find the interest rate (or growth rate) representing the increase in value of some investment between two time periods.
  • 174. © 2012 Pearson Prentice Hall. All rights reserved. 5-69 Personal Finance Example Ray Noble purchased an investment four years ago for $1,250. Now it is worth $1,520. What compound annual rate of return has Ray earned on this investment? Plugging the appropriate values into Equation 5.20, we have: r = ($1,520 ÷ $1,250)(1/4) – 1 = 0.0501 = 5.01% per year
  • 175. © 2012 Pearson Prentice Hall. All rights reserved. 5-70 Special Applications of Time Value: Finding an Unknown Number of Periods • Sometimes it is necessary to calculate the number of time periods needed to generate a given amount of cash flow from an initial amount. • This simplest case is when a person wishes to determine the number of periods, n, it will take for an initial deposit, PV, to grow to a specified future amount, FVn, given a stated interest rate, r.
  • 176. © 2012 Pearson Prentice Hall. All rights reserved. 5-71 Integrative Case: Track Software, Inc. Table 1: Track Software, Inc. Profit, Dividends, and Retained Earnings, 2006–2012
  • 177. © 2012 Pearson Prentice Hall. All rights reserved. 5-72 Integrative Case: Track Software, Inc. Table 2: Track Software, Inc. Income Statement ($000)for the Year Ended December 31, 2012
  • 178. © 2012 Pearson Prentice Hall. All rights reserved. 5-73 Integrative Case: Track Software, Inc. Table 3a: Track Software, Inc. Balance Sheet ($000)
  • 179. © 2012 Pearson Prentice Hall. All rights reserved. 5-74 Integrative Case: Track Software, Inc. Table 3b: Track Software, Inc. Balance Sheet ($000)
  • 180. © 2012 Pearson Prentice Hall. All rights reserved. 5-75 Integrative Case: Track Software, Inc. Table 4: Track Software, Inc. Statement of Retained Earnings ($000) for the Year Ended December 31, 2012
  • 181. © 2012 Pearson Prentice Hall. All rights reserved. 5-76 Integrative Case: Track Software, Inc. Table 5: Track Software, Inc. Profit, Dividends, and Retained Earnings, 2006– 2012
  • 182. © 2012 Pearson Prentice Hall. All rights reserved. 5-77 Integrative Case: Track Software, Inc. a. Upon what financial goal does Stanley seem to be focusing? Is it the correct goal? Why or why not? Could a potential agency problem exist in this firm? Explain. b. Calculate the firm’s earnings per share (EPS) for each year, recognizing that the number of shares of common stock outstanding has remained unchanged since the firm’s inception. Comment on the EPS performance in view of your response in part a. c. Use the financial data presented to determine Track’s operating cash flow (OCF) and free cash flow (FCF) in 2012. Evaluate your findings in light of Track’s current cash flow difficulties.
  • 183. © 2012 Pearson Prentice Hall. All rights reserved. 5-78 Integrative Case: Track Software, Inc. d. Analyze the firm’s financial condition in 2012 as it relates to (1) liquidity, (2) activity, (3) debt, (4) profitability, and (5) market, using the financial statements provided in Tables 2 and 3 and the ratio data included in Table 5. Be sure to evaluate the firm on both a cross-sectional and a time-series basis. e. What recommendation would you make to Stanley regarding hiring a new software developer? Relate your recommendation here to your responses in part a.
  • 184. © 2012 Pearson Prentice Hall. All rights reserved. 5-79 Integrative Case: Track Software, Inc. f. Track Software paid $5,000 in dividends in 2012. Suppose an investor approached Stanley about buying 100% of his firm. If this investor believed that by owning the company he could extract $5,000 per year in cash from the company in perpetuity, what do you think the investor would be willing to pay for the firm if the required return on this investment is 10%? g. Suppose that you believed that the FCF generated by Track Software in 2012 could continue forever. You are willing to buy the company in order to receive this perpetual stream of free cash flow. What are you willing to pay if you require a 10% return on your investment?
  • 185. Page 1 of 2 FIN308 Introduction to Finance Formula Sheet for Common Assessment Ordinary Annuity Annuity Due
  • 186. Page 2 of 2 Perpetuity Compounding Interest More Frequently Than Annually Continuous Compounding 𝐶𝐹 = 𝑃𝑉 × 𝑟 ÷ {1 − 1 (1 + 𝑟)𝑛 } 𝑛 = 𝑙𝑜𝑔 ( 𝐹𝑉 𝑛 𝑃𝑉0 ) 𝑙𝑜𝑔(1 + 𝑟)