Introduction to Business Finance

Introduction to Business Finance

Part 1.1 What is Corporate Finance?

  • Definition of Corporate Finance:
    Corporate finance involves the management of the financial resources available to a business. It includes:

    • Acquiring, managing and financing the business's resources or assets which can be either:

    • Tangible (e.g., inventory, plant & equipment)

    • Intangible (e.g., research and development, intellectual property (IP) and patents)

  • Key questions addressed by corporate finance:

    • What long-term investments should the firm undertake?

    • Where will we obtain the long-term financing to pay for the investments?

    • How do we manage the day-to-day financial activities of the firm?

Financial Managers

  • Role of Financial Managers: Financial managers strive to answer questions relevant to the financial health of the firm. Their responsibilities include:

    • Capital Budgeting: Determining what long-term investments or projects the business should take on.

    • Capital Structure: Decisions on how to pay for assets, whether through debt or equity.

    • Working Capital Management: Managing the day-to-day finances of the firm.

Basic Corporate Finance Functions

  • Key Functions:

    • Capital Budgeting

    • Capital Structure Decisions

    • Working Capital Management

    • Risk Management

    • Corporate Governance

Financial Institutions

  • Definition:

    • Entities that specialize in financial matters, facilitating finance in various forms through:

    • Banks

    • Insurance Companies

    • Brokerage Firms

    • Investment Banks

Forms of Business Organization

Major Forms of Business Structures

  1. Sole Proprietorship (Sole Trader)

    • Business owned by a single individual.

  2. Partnership

    • Owned by two or more persons with shared profits and losses.

  3. Limited Partnership

    • Contains:

    • General Partners: Responsible for management and debts.

    • Limited Partners: Typically investors who have limited liability.

  4. Corporations

    • A legal entity that is distinct from its owners.

Sole Proprietorship

  • Advantages:

    • Easiest to start and least regulated.

    • Single owner retains all profits.

    • Income is taxed only once as personal income.

  • Disadvantages:

    • Business is limited to the life of the owner.

    • Equity capital is limited to the owner's personal wealth.

    • Unlimited liability.

    • Difficult to sell ownership interest.

Partnership

  • Advantages:

    • Brought by two or more owners, leading to more capital availability.

    • Relatively easy to start.

    • Income is taxed once as personal income.

  • Disadvantages:

    • Unlimited liability for all partners.

    • The partnership is dissolved if one partner dies or leaves.

    • Challenging to transfer ownership.

Corporation

  • Advantages:

    • Limited liability protection for shareholders.

    • Unlimited life span of the entity.

    • Clear separation between ownership and management.

    • Easier to raise capital compared to sole proprietorships and partnerships.

    • Ownership transfer is straightforward, especially in public corporations.

  • Disadvantages:

    • Separation of ownership can lead to inefficient management.

    • Taxation of corporate profits can be burdensome.

Ownership of Public Corporations

  • Ownership Representation:

    • Represented by shares of stock.

    • Owners are termed:

    • Shareholders

    • Stockholders

    • Equity Holders

  • Equity Calculation:

    • The sum of all ownership values constitutes equity.

    • Unlimited number of shareholders leads to potentially significant funding through stock sales.

    • Owners possess voting rights and are entitled to dividends.

The Stock Market

  • Function:

    • Provides liquidity to shareholders.

    • Liquidity: The ability to sell (or buy) an asset close to its market price.

  • Types of Companies:

    • Public Companies: Stock traded publicly on stock exchanges.

    • Private Companies: Stock traded privately, not on public exchanges.

Primary and Secondary Stock Markets

  • Primary Market:

    • Corporations issue new shares of stock to investors.

  • Secondary Market:

    • Shares trade between investors after the initial sale in the primary market.

Agency Theory

Goals of Financial Management

  • Core Responsibilities:

    • Capital budgeting

    • Financing investments

    • Working capital management

  • Corporate Goals:

    • Maximize profit?

    • Minimize costs?

    • Maximize market value of existing owners’ equity?

Agency Relationship

  • Definition:

    • An agency relationship exists when a principal hires an agent to act on their behalf.

    • Example: Shareholders (principals) hire managers (agents) to operate the company.

Agency Problem

  • Potential Conflicts:

    • Differences in interests between principal and agent can lead to the agency problem, where managers may not act in the best interests of shareholders.

    • Agency Costs: When managers hesitate or fail to invest in valuable opportunities available to the firm.

Management Incentives

  • Do managers align with shareholder interests?

    • Strong Board of Directors: Oversight can mitigate agency problems.

    • Managerial Compensation: Incentives need to be strategically structured to align interests.

    • Market for Corporate Control: The threat of takeover can provide a check on management.

    • Monitoring Measures: Regulatory protection and independent audits can ensure alignment.

Time Value of Money

Cash Flows

  • Types of Cash Flow Streams:

    • Perpetuities

    • Annuities (Ordinary Annuity, Annuity Due, Deferred Annuity)

    • Growing Cash Flows

Perpetuities

  • Definition:
    A perpetuity is a constant cash flow that continues indefinitely.

  • Characteristics:

    • The first cash flow occurs at the end of the first period.

Example: Endowing a Perpetuity

  • Problem: Wanting to fund an annual graduation party for $30,000 forever with an investment returning 8% annually.

  • Solution: To provide $30,000 each year, a donation of $375,000 is required today.

Annuities

  • Definition:
    An annuity is a series of equal cash flows received at regular intervals over a specified time.

  • Types of Annuities:

    • Ordinary Annuity: Payments occur at the end of each period.

    • Annuity Due: Payments at the beginning of each period.

    • Deferred Annuity: Payments start at a future date.

Present Value of an Annuity

  • Present value calculations assume that the first payment takes place one period from today.

Future Value of an Annuity

  • To calculate the future value at some point in time, you need to compound the present value:
    FV(extannuity)=PVimes(1+r)nFV( ext{annuity}) = PV imes (1+r)^n

Growing Cash Flows

  • Growing Annuities:
    A growing annuity consists of cash flows that increase at a constant rate.

Time Value of Money

  • Concept: The difference in value between money received today versus in the future, impacted by:

    • Inflation

    • Opportunity cost

  • A dollar today is worth more than a dollar in the future due to these factors.

Cash Flows Timeline

  • Definition: A timeline helps visualize the timing of cash flows related to financial problems.

Solving for Variables

  • Context: Present/Future values may be used to solve for rates, cash flow amounts, or durations.

Example: Loan Payment Calculation

  • Problem: A firm buys a warehouse for $100,000 with an interest rate of 8% over 30 years, financing $80,000 after a 20% down payment.

Loan Payment Formula

  • C=racPimesr1−(1+r)−NC = rac{P imes r}{1 - (1 + r)^{-N}}

  • Calculation yields annual payments of C=7106.19C = 7106.19.

Interest Rate Computation

  • Example with an investment: $1,000 today vs. $2,000 in six years, necessitating solving for the interest rate via:
    PV=FVimes(1+r)−nPV = FV imes (1 + r)^{-n}

Valuing Cash Flows Rules

  1. Values must occur at the same point in time to be compared.

  2. Future values require compounding: FV=PVimes(1+r)nFV = PV imes (1 + r)^{n}

  3. Present values require discounting: PV=racFV(1+r)nPV = rac{FV}{(1+r)^{n}}

Cash Flow Valuation Examples

Future Value Calculation

  • Example: Saving $1,000 today, followed by $1,000 at the end of the next two years with a 10% interest rate.

  • Future Value combining separately calculated amounts will yield the total.

Present Value Calculation Example

  • Loan repayment scenario over four years to repay $5,000 and three payments of $8,000 with a 6% interest rate calculated as the present value:
    PV=rac50001.06+rac80001.062+rac80001.063+rac80001.064PV = rac{5000}{1.06} + rac{8000}{1.06^2} + rac{8000}{1.06^3} + rac{8000}{1.06^4} yields PV=24890.65PV = 24890.65.

Interest Rates

Interest Rate Mechanics

  • Definition: Interest rates signify the cost of using money.

Effective Annual Rate (EAR)

  • Definition: Total interest earned at the end of one year.

  • Example: An investment of $100 grows to:

    • After 6 months = $102.47

    • After 1 year = $105.00

    • After 2 years = $110.25

Adjusting Discount Rates

  • Necessary to align discount rates with cash flow periods using:
    extEquivalentn−periodDiscountRate=(1+r)n−1ext{Equivalent n-period Discount Rate} = (1 + r)^{n} - 1

Monthly Cash Flow Valuation Example

  • Saving to accumulate $100,000 in 10 years requires determining the equivalent monthly discount rate and solving via the future value of an annuity formula.

  • Solution indicates a monthly savings requirement of 615.47615.47.

Annual Percentage Rates (APR)

  • Definition: Reflects the amount of interest earned in a year without compounding effects.

  • Cannot be straightforwardly used as a discount rate.

  • Annual Percentage Rate is the quoted interest amount per compounding period.

Converting APR to EAR

  • Calculating EAR based on APR considers the rate per month derived using the formula:
    extEAR=(1+extAPR)n−1ext{EAR} = (1 + ext{APR})^{n} - 1

Example: Cost Comparison of Buying vs. Leasing a System

  • Evaluate whether purchasing a phone system for $150,000 or leasing for $4,000 monthly for 48 months is more beneficial, requiring present value computation using monthly discount rates.

Analyzing Loan Payments

  • Employ present value of annuity formula to determine monthly repayments for a car loan ($30,000 at 6.75% apr over 60 months), resulting in monthly payments of 590.08590.08.

Determinants of Interest Rates

Overview

  • Interest rates are dictated by market forces influenced by the relative supply and demand for funds.

Components of Interest Rate (r)

  • r=extrealrisk−freeinterestrate+extinflationpremium+extriskpremiumr = ext{real risk-free interest rate} + ext{inflation premium} + ext{risk premium}

Real vs. Nominal Rates

  • Nominal Interest Rate: Effective growth rate of money before inflation.

  • Real Interest Rate: Growth rate of purchasing power adjusted for inflation.

Fisher Equation

  • The relationship among nominal, real rates, and inflation is expressed as:
    (1+r)=(1+rreal)(1+rinflation)(1 + r) = (1 + r_{real})(1 + r_{inflation})

  • To find the real interest rate from nominal rates:
    rreal=rac(1+r)(1+extinflation)−1r_{real} = rac{(1+r)}{(1+ ext{inflation})} - 1

Real Interest Rate Calculation Example

  • Given data for 2005 and 2016, calculate real interest rates:

    • 2005: Government bond rates at 5.1% and inflation at 2.7%, resulting in a real interest rate of:
      r_{real} = 2.34 ext{%}

    • 2016: Bond rates at 1.7% with inflation at 1.3%, yielding r_{real} = 0.39 ext{%} .