CORPORATE FINANCE SHORT VERSIONShort term debt are loans and
other obligations that must be repaid within 1 year Long term debt
is debt that does not have not to be repaid within 1 year Capital
budgeting or capital expenditure is process of making and managing
expenditures on long lived assets Net working capital is defined as
current assets minus current liabilities NWC = current assets
current liabilitiesCreditors are persons or institutions that buy
debt from the firm Stakeholders are the holders of equity
shares.Value of the firm: V = B+ S (B - the value of the debt, S -
the value of the equity)The Financial ManagerFinance activity is
associated with a top officer of the firm, such as a vice president
and chief financial officer. (CFO)The treasurer is responsible for
handling cash flows, making capital expenditures decisions and
making financial plans. The controller handles the accounting
function, includes taxes, cost and financial accounting and
information systems.The most important job of a financial manager
is to create value from the firms capital budgeting, financing and
liquidity activities.The Corporate Firm - The firm is a way of
organizing the economic activity of many individuals, and there are
many reasons why so much economic activity is carried out by firms
and not by individuals. The most of large firms are corporations
rather than any of the other legal forms that firms can assume. A
basic problem of the firm is how to raise cash.The Sole
Proprietorship - This is a business owned by one person. More
information! Two basic types of securities to investors: debt and
equity securities. The financial markets are composed of the money
markets and the capital markets. The financial markets can be
classified as the primary and the secondary markets.Time Value of
Money
The time value of money(TVM) serves as the foundation for all
other notions in finance. It impacts corporate finance, consumer
finance and government finance. Time value of money results from
the concept of interest.Time Value of Money (TVM) is an important
concept in corporate finance. It can be used to compare investment
alternatives and to solve problems involving loans, mortgages,
leases, savings, and annuities. TVM is based on the concept that a
KM that you have today is worth more than the promise or
expectation that you will receive a KM in the future. Money that
you hold today is worth more because you can invest it and earn
interest. A key concept of TVM is that a single sum of money or a
series of equal, evenlyspaced payments or receipts promised in the
future can be converted to an equivalent value today.Compounding
the process of finding the future value (FV) of a cash flow or a
series of cash flows. The compounded amount, or future value, is
equal to the beginning amount plus the interest earned.Discounting
the process of finding the present value (PV) of a future cash flow
or a series of cash flows;One of the most important tools in time
value analysis is the time line. Time line is used to help
visualize what is happening in a particular problem and then to
help set up the problem for solution.You can calculate the fifth
value if you are given any four of: Interest Rate (i) the cost
stated as a percent of the amount borrowed per period of time,
usually one year.Number of time periods (n) Periods are
evenlyspaced intervals of time. Payments a series of equal,
evenlyspaced cash flows.Future Value (FV) the value at some future
time of a present amount of money, or a series of payments,
evaluated at a given interest rate.Present Value (PV) the current
value of a future amount of money, or a series of payments,
evaluated at a given interest rate
Simple VS Compound Interest Simple interest is calculated only
on the beginning (original) principal. Accumulated interest from
previous periods is not used in calculations for the following
periods.Compound interest is calculated each period on the original
principal and all interest accumulated during past periods. The
interest earned in each periodis added to the principal of the
previous period to become the principal for the next period.
An annuity is a series of equal payments or receipts that occur
at evenly spaced intervals. The most common payment frequencies are
annually (once a year), semi-annually (twice a year), quarterly
(four times a year) and monthly (once a month). There are two basic
types of annuities: When the payments appear at the end of each
time period, the annuity is said to be an ordinary annuity. When
the payments appear at the beginning of each time period, the
annuity is said to be an annuity due.These annuities are
characterized by recurring, identical, cash payment amounts
(payments, receipts, deposits, withdrawals, rents) at the end or
beginning of each equal period.
In order to calculate the present value or future value of an
annuity, payments (PMT) must: be the same amount each period occur
at evenly spaced intervals occur exactly at the beginning or end of
each period be all inflows or all outflows (payments or receipts)
represent the payment during one compounding (or discounting)
period
The Future Value of an Ordinary Annuity (FVoa) is the value that
a stream of expected or promised future payments will grow to after
a given number of periods at a specific compounded interest. The
Future Value of an Ordinary Annuity could be solved by calculating
the future value of each individual payment in the series using the
future value formula and then summing the results.
The Future Value of an Annuity Due (FVad) is identical to an
ordinary annuity except that each payment occurs at the beginning
of a period rather than at the end. Since each payment occurs one
period earlier, we can calculate the present value of an ordinary
annuity and then multiply the result by (1 + i).
Since table 3 is built for ordinary annuities, we need to make
one simple adjustment to theformula to allow for the extra
compounding period.
FVad = FVoa (1+i)The Present Value of an Ordinary Annuity (PVoa)
is the value of a stream of expected or promised future payments
that have been discounted to a single equivalent value today. The
Present Value of an Ordinary Annuity could be solved by calculating
the present value of each payment in the series using the present
value formula and then summing the results.
The Present Value of an Annuity Due is identical to an ordinary
annuity except that each payment occurs at the beginning of a
period rather than at the end.
The PV calculation is useful in a variety of situations
including: valuing a series of retirement payments; calculating the
lump sum value of lottery winnings; establishing the purchase price
of property sold for instalment payments; determining the value of
periodic payments under an insurance contract or a structured
settlement; pricing a coupon bearing bondRisk and ReturnPrinciples
for Risk analysis:1. All financial assets are expected to produce
cash flows, and the risk of an asset is judged in terms of the risk
of its cash flows.2. The risk of an asset can be considered in two
ways: (1) on a stand-alone basis, where the assets cash flows are
analyzed by themselves, or (2) in a portfolio context, where the
cash flows from a number of assets are combined and then the
consolidated cash flows are analyzed.3. In a portfolio context, an
assets risk can be divided into two components: (a) diversifiable
risk, which can be diversified away and thus is of little concern
to diversified investors, and (b) market risk, which reflects the
risk of a general stock market decline and which cannot be
eliminated by diversification, does concern investors. Only market
risk is relevant -diversifiable risk is irrelevant to rational
investors because it can be eliminated.4. An asset with a high
degree of relevant (market) risk must provide a relatively high
expected rate of return to attract investors. Investors in general
are averse to risk, so they will not buy risky assets unless those
assets have high expected returns.5. Our focus is on financial
assets such as stocks and bonds, but the concepts discussed here
also apply to physical assets such as computers, trucks, or even
whole plants.
Investment Return Investment returns measure the financial
results of an investment. Return refers to the gain or loss on an
investment. It is generally stated as a percent of the original
investment, and annualized. Returns may be expected or historical.
Returns can be expressed in: Absolute terms Percentage termsThe
concept of return provides investors with a convenient way of
expressing the financial performance of an investment.One way of
expressing an investment return is in absolute terms. The absolute
return is simply the total KM received from the investment less the
amount invested:Absolute return =Amount received-Amount
invested
Although expressing returns in absolute amount is easy, two
problems arise:a) To make a meaningful judgment about the return,
you need to know the scale (size) of the investment; a KM10 return
on a KM10 investment is a good return (assuming the investment is
held for one year), but a KM10 return on a KM1,000 investment would
be a poor return.b) You also need to know the timing of the return;
a KM10 return on a KM10 investment is a very good return if it
occurs after one year, but the same absolute return after 20 years
would not be very good.The solution to the scale and timing
problems is to express investment results as rates of return, or
percentage returns.
Risk Risk refers to the chance that some unfavorable event will
occur. It is defined as uncertainty of outcomes. In a financial
sense, we are uncertain of the outcome of any investment.An assets
risk can be analyzed in two ways:a) on a stand-alone basis, where
the asset is considered in isolation, andb) on a portfolio basis,
where the asset is held as one of a number of assets in a
portfolio.Thus, an assets stand-alone risk is the risk an investor
would face if held only this one asset. Obviously, most assets are
held in portfolios, but it is necessary to understand stand-alone
risk in order to understand risk in a portfolio context.Probability
Distributions An events probability is defined as the chance that
the event will occur. If all possible events, or outcomes, are
listed, and if a probability is assigned to each event, the listing
is called a probability distribution. Probabilities can also be
assigned to the possible outcomes (or returns) from an
investment.If you buy a bond, you expect to receive interest on the
bond plus a return of your original investment, and those payments
will provide you with a rate of return on your investment. The
higher the probability of default, the riskier the bond, and the
higher the risk, the higher the required rate of return. The
possible outcomes from this investment are:a) that the issuer will
make the required payments orb) that the issuer will default on the
payments.If you invest in a stock instead of buying a bond, you
will again expect to earn a return on your money. A stocks return
will come from dividends plus capital gains.Expected Rate of
ReturnIf we multiply each possible outcome by its probability of
occurrence and then sum these products, we have a weighted average
of outcomes. The weights are the probabilities, and the weighted
average is the expected rate of return.The expected return on an
investment is the mean value of its probability distribution of
returns. The expected rate of return calculation can be expressed
as an equation:
Here Ri is the ith possible outcome, Pi is the probability of
the ith outcome, and n is the number of possible outcomes. Thus, is
a weighted average of the possible outcomes (the Ri values).The
tighter, or more peaked, the probability distribution, the more
likely it is that the actual outcome will be close to the expected
value, and, consequently, the less likely it is that the actual
return will end up far below the expected return. Thus, the tighter
the probability distribution, the lower the risk assigned to a
stock.Measuring Stand-Alone Risk: The Standard DeviationA common
definition is stated in terms of probability distributions: The
tighter the probability distribution of expected future returns,
the smaller the risk of a given investment. Formally, uncertainty
is measured by variability.Risk in statistics and financial
economics is measured by standard deviation, which measures the
variability of the return. Thus, the standard deviation is
essentially a weighted average of the deviations from the expected
value, and it provides an idea of how far above or below the
expected value the actual value is likely to be.The smaller the
standard deviation, the tighter the probability distribution, and,
accordingly, the lower the riskiness of the stock. Standard
deviation is an absolute measure of stand-alone risk.
Using Historical Data to Measure RiskIf only sample returns data
over some past period are available (historical data), the mean and
standard deviation of returns can be estimated using these
formulas:
Measuring Stand-Alone Risk: The Coefficient of VariationIf a
choice has to be made between two investments that have the same
expected returns but different standard deviations, most people
would choose the one with the lower standard deviation and,
therefore, the lower risk.Similarly, given a choice between two
investments with the same risk (standard deviation) but different
expected returns, investors would generally prefer the investment
with the higher expected return.How do we choose between two
investments if one has the higher expected return but the other the
lower standard deviation? To help answer this question, we often
use another measure of risk, the coefficient of variation (CV),
which is the standard deviation divided by the expected return:The
coefficient of variation shows the risk per unit of return, and it
provides a more meaningful basis for comparison when the expected
returns on two alternatives are not the same. Coefficient of
variation is an alternative measure of stand-alone risk.
Investor attitude toward risk can be: Risk aversion assumes
investors dislike risk and require higher rates of return to
encourage them to hold riskier securities.Risk premium the
difference between the return on a risky asset and less risky
asset, which serves as compensation for investors to hold riskier
securities.8