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Principles of Corporate Finance
Brealey and Myers
Sixth Edition

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Finance and the Financial Manager

Chapter 1

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Topics Covered
w What Is A Corporation? w The Role of The Financial Manager w Who Is The Financial Manager? w Separation of Ownership and Management w Financial Markets

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Corporate Structure
Sole Proprietorships Unlimited Liability Personal tax on profitsPartnerships

Limited Liability Corporations Corporate tax on profits + Personal tax on dividends

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Role of The Financial Manager
(2) (1)

Firm's operations
(3)

Financial manager

(4a)

Financial markets

(4b)
(1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors

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Who is TheFinancial Manager?
Chief Financial Officer

Treasurer

Comptroller

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Ownership vs. Management
Difference in Information w Stock prices and returns w Issues of shares and other securities w Dividends w Financing Different Objectives w Managers vs. stockholders w Top mgmt vs. operating mgmt w Stockholders vs. banks and lenders

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Financial Markets
Money

Primary Markets SecondaryMarkets

OTC Markets

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Financial Institutions
Company

Obligations

Funds

Intermediaries
Banks Insurance Cos. Brokerage Firms

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Financial Institutions
Intermediaries

Obligations

Funds

Investors
Depositors Policyholders Investors

Principles of Corporate Finance
Brealey and Myers
Sixth Edition

u

Present Value and The Opportunity Cost of Capital

Chapter 211

Topics Covered
w Present Value w Net Present Value w NPV Rule w ROR Rule w Opportunity Cost of Capital w Managers and the Interests of Shareholders

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Present Value
Present Value Value today of a future cash flow. Discount Rate Interest rate used to compute present values of future cash flows. Discount Factor Present value of a $1 future payment.

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Present ValuePresent Value = PV PV = discount factor × C1

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Present Value
Discount Factor = DF = PV of $1

DF =

1 t (1+ r )

Discount Factors can be used to compute the present value of any cash flow.

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Valuing an Office Building
Step 1: Forecast cash flows Cost of building = C0 = 350 Sale price in Year 1 = C1 = 400 Step 2: Estimate opportunity cost of capital If equally risky investmentsin the capital market offer a return of 7%, then Cost of capital = r = 7%

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Valuing an Office Building
Step 3: Discount future cash flows

PV =

C1 (1+r)

=

400 (1+.07)

= 374

Step 4: Go ahead if PV of payoff exceeds investment

NPV = −350+ 374= 24

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Net Present Value
NPV = PV - required investment C1 NPV = C0 + 1+ r

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Risk and Present Value
w Higher riskprojects require a higher rate of return. w Higher required rates of return cause lower PVs.

PV of C1 = $400 at 7% 400 PV = = 374 1 + .07

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Risk and Present Value
PV of C1 = $400 at 12% 400 PV = = 357 1 + .12 PV of C1 = $400 at 7% 400 PV = = 374 1 + .07

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Rate of Return Rule
w Accept investments that offer rates of return in excess of their opportunity cost of capital.Example In the project listed below, the foregone investment opportunity is 12%. Should we do the project?
profit 400,000 − 350,000 Return = = = .14 or 14% investment 350,000

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Net Present Value Rule
w Accept investments that have positive net present value.
Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

60NPV = -50 + = $4.55 1.10

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Opportunity Cost of Capital
Example You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs:

Economy Payoff

Slump

Normal

Boom

$80,000 110,000 140,000

80,000 + 100,000 + 140,000 Expected payoff = C1 = = $110,000 3

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Opportunity Cost of Capital
Example - continued The stock is...