Fin 120

3 Main Tasks of Financial Managers

1. Investment decisions (Capital budgeting)

2. Financing decisions

3. Manage short-term cash needs (Working capital management)

Short Term

= working capital management

How should a company pay for its investments?

• Debt → borrow money

• Equity → money from owners/shareholders

What is corporate finance?

How does a company get money, use money, and manage money?

Sole proprietorship

Important characteristics:

• One person owns/runs it

• No separation between owner and firm

• Limited life

• Profits taxed as personal income

• Unlimited personal liability

• Cheapest/easiest to form

Partnership

Two or more owners

General partners:

• All have unlimited liability

• Income is taxed as personal income

• Partners personal reputation is the basis for the firm

Limited partnership. There are two types:

General partner
→ Unlimited liability

Limited partner
→ Liability limited to their investment
→ Cannot manage/control the firm

LLC = Limited Liability Company

Think of it as a combination/hybrid.

• All owners have limited liability

• Taxation similar to partnerships

• No general partner

• Combines characteristics of partnerships and corporations (avoids double taxation)

Corporation

A separate legal entity from its owners.

Owners = shareholders/stockholders

Ownership = shares of stock

Advantages of Corporations

• Limited liability

• Easier transfer of ownership

• Indefinite/perpetual life

• Easier to raise funds

Disadvantages of Corporations

*Double taxation

The corporation pays taxes on its income.

Then shareholders can pay taxes on dividends they receive.

Goal of Financial Management

Maximize the value of shareholders’ equity

AKA maximize the current stock price.

Possible goals:

• Avoid bankruptcy

• Maximize sales

• Maximize stock price

• Minimize costs

• Maximize profit

Stakeholders

A stakeholder is anyone who has an interest or is affected by the firm.

Examples:

• Employees

• Suppliers

• Customers

• Society

• Environment

Risk

= uncertainty associated with earning the expected return.

How do we measure risk?

Variance and standard deviation

Higher standard deviation

= higher risk

Stockholder/shareholder

→ Owns part of the company.

Higher risk

→ higher required return

Because investors need compensation for taking on more risk.

Risk Premium

Extra return for taking risk.

The basic formula:

Risky Return - Risk - Free Return

For a normal distribution:

Within 1 standard deviation

68%

Within 2 standard deviations

95.44%

Within 3 standard deviations

99.7%

68 → 95.44 → 99.7

Return

= what you gain or lose from an investment.

How can agency problems be reduced?

1. Compensation

Tie CEO compensation to company performance.

2. Corporate takeover threat

Agency costs

= costs caused by agency problems.

How much will I have later?

=FV()

How much is it worth (today)?

=PV()

How long will it take?

How many years until I have enough money?

=NPER()

What interest rate?

=RATE

How much is each payment?

How much do I pay?

= PMT ()

NPER

Number of periods

If the problem doesn’t mention regular deposits/payments, then:

PMT = 0

“There are no additional payments being made.”

Negative PV:

Excel treats money you pay/invest as negative and money you receive as positive.

Average return

EX:

=AVERAGE(B2:B7)

Variance

Population Variance:

=VAR.P(B2:B7)

sample variance:

=VAR.S(B2:B7)

Standard deviation

=STDEV.P(B2:B7)

=STDEV.S(B2:B7)

APR → EAR (effective annual rate)

=EFFECT(12%,12)

=EFFECT(APR,m)

M= number of compounding periods per year

Monthly compounding

M = 12

Daily compounding

M = 365

Interest rate formula

Example:

$45,100 becomes $71,287 in 11 years:

=RATE(11,0,-45100,71287)

=RATE(nper,pmt,pv,fv)

Future value formula

=FV(rate,nper,pmt,pv)

If there are no additional payments: 0

=FV(6.5%,4,0,-800)

Present value formula

=PV(rate,nper,pmt,fv)

Example: $999 in 4 years at 6.5%:

=PV(6.5%,4,0,-999)

Future → Today = PV

Present Value of MULTIPLE future cash flows

Cash Flow	Years	PV Calc.
$1,325	3	$1,081.59	=A72/(1.07^3)
$475	4	$362.38	=A73/(1.07^4)
$620	7	$386.10	=A74/(1.07^7)
Total		$1,830.07	=SUM(C72:C74)

Multiple future amounts → calculate each PV → add them.

Interest rate= 1+7%=1.07

Present value perpetuity problem

Perpetuity = payments forever.

$1,350 per year in perpetuity, starting one year from today, at 6%. What’s the PV?

= 1350 / 0.06 = $22500

Perpetuity / Annuity (Repeating payments)

First payment is 7 years from now.

Use ^6 years on excel

=(B1 / (B2 - B3)) / (1 + B2)^6

1 comes from the math rule used to calculate interest. Represents 100% of your original money plus the interest rate. Multiplying by 1 + 6.50%(which is 1.065) grows the whole amount forward by one year.