Finance Exam 2

Capital budgeting

What long-term investments should you take on (building, machinery, equipment, etc.)?

Requires financial analysis like ROI

Analyze costs/benefits of projects to make sure the future cash flow > costs to acquire

HELPS TO CREATE VALUE FOR SHAREHOLDERS

cash flow

free cash; the truest telling of a company’s financial health

time value of money

A dollar in hand today is worth more than a dollar promised at some time in the future

inflation - purchasing power goes down

future value (FV)

the amount an investment is worth after one or more periods

FV depends on interest rate and # of periods

Suppose you invest $100 in savings account that pays 10% interest per year. What’s it worth after 1 year? 2 years (assuming interest rates stay the same)?

interest rate = 10%

10% of $100 = $10

$100 + ($100 × 0.10) = $110

$110 × 0.10 = $11 interest

$110 + $11 = $121

How are projects evaluated in a business?

by determining the present value (in today’s dollars) of cash flows expected in the future

Powerball example: Which should you choose?

A. $5.5M per year over the next 20 years ($110M total)

B. $110M lump sum now

you can invest it now, it will not be worth as much in 20 years

compounding

the process of accumulating interest on an investment over time to earn more interest

interest earned only on the original principal amount invested

compound interest

compounding the interest (earning interest on interest)

What is the most likely question in corporate finance?

investment decisions

How much do I need to invest today (present value) to earn a certain amount of money in the future at a given rate?

Present value (PV)

reverse of future value

instead of compounding the money forward into the future, we discount it back to the present (calculate the PV of some future amount, using the discount rate)

How much do we invest today at 7% to have $800 in one year? (solve for PV)

PV x 1.07 = $800

$800/1.07 = $747.66

discount rate

the interest rate you use to discount a future cash flow back to the present (discount = calculate PV of a future amount)

how to solve for the number of periods using discount rate

Rule of 72

if interest rate is 12%, then 72/12 = 6 years to double your $

common loan repayment plans

making equal payments for # of years

annuity

level cash flows at the end of each period for fixed # of years

pure discount loans

simplest form

borrower receives $ today and pays single lump sum in the future

common when the loan term is short period, like T-bills

interest-only loans

borrower pays interest each period and repays the entire principal (original loan amount) at some point in the future, like corp bonds

amortized loans

lender requires the borrower to repay parts of the loan amount over time, like making regular principal/interest reductions

EAR versus APR

EAR = effective annual rate

determined based on the compounding

APR = annual percentage rate

APR equal to the interest rate per period times # of periods

if 18% APR, 0.18/12 = 0.15, or 1.5% per month

EAR is ($1 × 0.015) x 12 = $1.1956 (19.56%)

financial planning

strategic planning (long-term), annual budgets, measuring performance

capital structure/funding

Where will you get the long-term financing to pay for your investments? Will you bring in other owners or borrow money (debt)? How much should a company borrow and what is the least expensive source of funds?

working capital management

How will you manage your everyday financial activities, such as collecting from customers and paying suppliers? How much cash/inventory to keep on hand? Do we sell on credit? How to get short-term financing

financial reporting

historically reporting results, financial statements (P&L, balance sheet, cash flow statement), taxes

corporate finance responsibilities (5)

1. financial planning

2. capital structure/budgeting

3. working capital management

4. financial reporting

5. capital budgeting