Financial Management
Five functions
- Financing: Raising capital
- Capital budgeting: Selecting the best projects
- Financial management: Managing the firm’s internal cash flows and capital structure
- Corporate governance: Developing an ownership and corporate governance system
- Risk management: Managing the firm’s exposure to all types of risk
Ultimate goal of management: maximization of value for its owners, the stockholders
Time Value of Money
Valuation of bonds
Discount: Stated rate < Market rate
Par: Stated rate = Market rate
Premium: Stated rate > Market rate
Interest Rates
Determination of interest rates
Nominal interest rates = 1 + 2 + 3 + 4 + 5
1. time preferences for consumption
2. inflation
3. default risk
4. liquidity risk
5. maturity risk
Effective annual rate
EAR = (1 + r/m)m – 1 where r = stated interest rate, m = compounding frequency
Portfolio Theory
Risk and Return: trade-off
Investor type: Risk averse, Risk neutral, Risk seeking
Certainty Equivalent: An amount that would be accepted in lieu of a chance at a possible higher, but uncertain, amount
Portfolio effect = Diversification effect
Eliminate (diversify away) unsystematic risk
Unsystematic risk: Diversifiable, Unique, Firm specific risk
Systematic risk: Non-diversifiable, market risk (eg. Inflation)
Expected returns of a portfolio are simply the weighed-average of the expected returns of the assets making up the portfolio
Efficient frontier: Graph representing a set of portfolio that maximize expected return at each level of portfolio risk
CAPM (Capital Asset Pricing Model)
E(Ri) = Rf + (E(RM) – Rf)βi
Where Rf = risk-free of interest (US Treasury bond rate), RM = expected market rate of interest
Capital Budgeting
Capital budgeting models
Payback: evaluates investments on the length of time until recapture of the investment
Limitations – ignores total project profitability and time value of money
Accounting Rate of Return (ARR)
ARR = Annual net income / Average (or initial) investment
Advantages – simple and intuitive, used to evaluate management
Limitations – results are affected by the depreciation method, no adjustment for project risk, no adjustment for the time value of money
Net Present Value: discounted cash flow method, most widely accepted method
NPV = Present value of future cash flows – Required investment
Advantages – easily understood, adjusts for the time value of money, considers the total profitability of the project, straightforward method of controlling for the risk, provides a direct estimate of the change in shareholder wealth
Internal Rate of Return (IRR): determined by setting the investment today equal to the discounted value of future cash flows
If NPV > 0, then IRR > Discounted rate
Limitations – may be no unique internal rate of return, limitations when evaluating mutually exclusive investments