Business Finance Final Exam Notes

Business Finance Revision Lecture Notes

Introduction

• Last lecture, approximately 30 minutes.
• Lecturer going on holiday to Japan and Taiwan.
• Final grades will be adjusted by Dr. Daniel.
• Review lecture focuses on structure and key information for the final exam.

Chapter 1: Basic Ideas of Business Finance and Financial Statements

• No calculations, except for parts specifically asked to remember.
• Key theory: Agency Theory
  • Agency Relationship -> Agency Conflict -> Agency Costs
  • Methods to mitigate agency conflict.
• Major differences between organization structures:
  • Sole Trader
  • Partnership
  • Company
• Goal of Financial Management: Maximize shareholder's value.
  • Maximize value, not profit; understand why.

Chapters 2-5: Time Value of Money

• Foundation for all finance theories.
• Focus on calculations.

Chapter 2: Time Value of Money

• Understand different types of cash flows:
  • Perpetuity
  • Ordinary Annuity
  • Annuity Due
• Questions will be mini-cases related to real-world scenarios (e.g., mortgages, retirement investments).

Chapter 3: Interest Rates

• Effective Annual Rate (EAR) vs. Annual Percentage Rate (APR)
  • Deep understanding of key differences.

Chapter 4: Bond Valuation

• Based on time value of money.
• Key Method: Discounting future cash flows.
• Common Mistake: Using the wrong discount rate.
• Use Yield to Maturity (YTM) as the discount rate.
  • YTM also called market yield.
  • YTM represents the return investors require in the market.
• Scenario where YTM equals Coupon Rate: Bond is trading at par (market price equals face value).

Chapter 5: Equity Valuation

• Based on time value of money.
• Estimating the equity's future value.
• Cash flows considered are dividends.
• Dividend payment patterns:
  • Constant dividend (perpetuity).
  • Constant growth rate (constant growth dividend discount model).
  • Irregular dividend payments followed by constant growth.
• Constant Growth Dividend Discount Model Formula:
  • P0 = \frac{D1}{r - g}
  • Where:
    • P_0 = Price at time zero.
    • D_1 = Dividend at time one.
    • r = Required rate of return.
    • g = Constant growth rate.

Topic 6: Risk and Return

• Purely calculation-based.
• Calculate historical return for individual investments.
• Two methods for expected return.
• Expected Return Calculation (Method, not Formula)
  • Involves scenarios with probabilities (e.g., 30% chance of 10% growth).
• Risk measurement: Standard deviation (σ) or variance (\sigma^2).

Topic 7: Portfolio Risk and Return

• Portfolio: More than one asset.
• Calculate portfolio's return using weighted average method.
• Calculate portfolio's risk using a long formula (provided on formula sheet).
• Total Risk separated into:
  • Individual Risk
  • Systematic Risk
• Market only compensates shareholders for systematic risk.
• Capital Asset Pricing Model (CAPM) helps to identify systematic risk (formula provided).
• Beta: Measure of systematic risk.

Topics 8-10: Capital Budgeting

• Focus on project evaluation.

Topic 8: Basic Methods for Project Evaluation

• Four major methods:

  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)
  • Payback Period
  • Profitability Index (PI) - another version of NPV.

• Advantages and disadvantages of each method.

• NPV is the most reliable method.

• Situations where NPV and IRR provide conflicting results.

• IRR is problematic under two scenarios:

  1. Non-conventional cash flows (sign changes in future cash flows).
  2. Differences in project scale and cash flow timing (mutually exclusive projects).

Topic 9: Estimating Cash Flows for Capital Budgeting

• Estimate future cash flows for the project.
• Discount using appropriate discount rate.
• NPV = Sum of discounted cash flows - Initial cost.
• Estimate initial cost, operating cash flow (for 5-10 years), and terminal value.
• Initial Cost: Easiest to estimate.
• Operating Cash Flow: Requires memorization of a mini profit statement.
• Tax depreciation.
• Three major cash flows: initial, operating, and terminal.
• Terminal Cash Flows: Selling assets at the end of the project.
• Tax consequences of selling assets depends on the comparison of selling proceeds to book value.
  • Selling Price > Book Value -> Income Tax.
  • Selling Price < Book Value -> Tax Credits/Savings (Cash inflow).

Topic 10: Weighted Average Cost of Capital (WACC)

• Calculate WACC as the appropriate discount rate for capital budgeting.
• WACC formula (provided, but understanding is key).
• Calculate cost of each capital component (equity, debt, preference shares).
• Two methods to calculate cost of common shares:
  1. CAPM
  2. Constant growth dividend discount model.
• Cost of Debt: Yield to maturity (YTM).
• Weight: Percentage of capital from each element (equity, debt, preference share).
• Use market value, not book value, to calculate weights.

Final Exam Information

• Duration: 2.5 hours (160 minutes).
• Closed book exam.
• Calculators: Any calculator without WiFi, GPS, or stored value function.
• No exam hurdle rate (overall 50% required to pass).
• Formula sheet will be provided.
• Use blue or black pen (not erasable).
• Answer Booklet: All answers, including multiple-choice, must be written in the answer booklet.

Exam Structure

• Section A: 10 multiple choice questions (2 marks each, 20 marks total).

• Section B: 6 short answer based questions.

  • 5 calculation-based.
  • 1 theory-based.

• Question 1: (34 marks)

  • Two linked parts 17 marks each.
  • Part 1: WACC calculation in multiple guided steps.
  • Part 2: Estimate operating cash flow and use WACC to calculate NPV, IRR, or payback period.

• Question 2: Return and Risk (historical or expected).

• Question 3: Equity Evaluation.

• Question 4: Theory.

• Question 5: Gift for Students Who Study Hard.