COURSERA

LECTURE NOTES
AN INTRODUCTION TO CORPORATE FINANCE

Franklin Allen
Wharton School
University of Pennsylvania
Fall 2013
WEEK 1
Section 1
Introduction

Copyright 2013 by Franklin Allen

An Introduction to Corporate Finance - Section 1 - Page 1

Section 1: Introduction
Supplemental Reading: BMA Chapter 1

Purpose of the Course

The purpose of the course is to give you a framework for thinking about how a firm
should make investment and financing decisions to create value for its shareholders. In order to
do this we will not only need to look at the firm but also to consider how financial markets work
and how investors in those markets should make decisions. By the end of the course you should
have a framework for thinking about business problems.

Review of Background Material

Microeconomics
You need to know about indifference curves and utility maximization subject to a budget
constraint.
If we have two commodities, apples and bananas say, we can represent a person's
preference for these commodities by indifference curves

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Apples
utility increasing

Bananas

An indifference curve is the locus of combinations of apples and bananas such that the
person is indifferent. It is assumed more is preferred to less, so moving in a northeasterly
direction utility is increasing.
We are all constrained by a budget constraint: we can't spend more than our income on
apples and bananas. It must be the case that
PA A + PB B I
where PA, PB are the prices of apples and bananas respectively, A and B are the quantities
purchased, and I is income.
This can be represented on our usual diagram.

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A
consumption bundle
must be on the line or
below

I
PA

I
PB

PB
I
B
PA
PA

If we add indifference curves to this diagram of the budget constraint we can use it to find
the combination of A and B a person will choose if he maximizes his utility.
A
utility maximizing choice

demand for
apples

demand for
bananas

In the next section we will be using these concepts a lot, so if you are at all shaky on them, you
should review them as soon as possible.

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Future Values and Present Values

One of the most important ideas in finance is present value. If you put $1 in the bank
today at 10% interest, then in a year's time youll have $1.10. This involves going forward
through time.
FV = 1 x 1.10 = $1.10
An equivalent notion is to go backwards through time and say that the present value of $1.10 in
one year's time if the interest rate is 10% is $1 now, i.e.,
PV = 1.10 = $1
1 + 0.10
In general, $C1 one year from now if the interest rate is r has
PV = C1
1+r
Suppose you put $1 in the bank today at 10% interest, then in two years time youll have
FV = $1x1.102=$1.21
Alternatively we can say that the present value of $1.21 in two years time if the interest rate is
10% is $1 now, i.e.,
PV = 1.21 = $1
(1 + 0.10)2
In general, $C2 two years from now if the interest rate is r has
PV = C2
(1 + r)2
Similarly, $Ct t years from now has
PV = Ct
(1 + r)t

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Suppose next we have a stream of cash flows C1, C2, C3, , CT. We can represent this
on a time line:
Date

C1

C2

C3

CT

Cash
Flows

The equivalent in terms of todays money of this stream of cash flows is

PV =

C1
C2
C3
CT
+
+
+ ... +
2
3
1 + r (1 + r ) (1 + r )
(1 + r )T

Summing Geometric Series: Perpetuities

Fairly soon we'll be talking a lot about PV's, and one of the things it will be useful to
know is how to sum a geometric series.
A special case of a sequence of cash flows that is of interest is when the cash flow at
every date is the same, i.e. Ct = C for every date t and this stream goes on forever. This is called a
perpetuity.
Date

Cash
Flows
(1)

PV = C + C + C + ....
1 + r (1 + r)2 (1 + r)3

Multiplying (1) by (1 + r) gives:

(2)

(1 + r)PV = C + C + C + C + ....
1 + r (1 + r)2 (1 + r)3

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Subtracting (1) from (2):
rPV = C
PV = C
r
As an example, suppose C = $20 and r = 0.10 then PV = 20/0.10 = $200.
Another way to see what is going on here is to consider the case where you put $200 in
the bank at 10% forever and receive $20 per year forever. A stream of $20 forever is therefore
equivalent to $200 today. In general, if you put PV in the bank you receive C = rPV forever so
PV = C/r.
Now that's the last time I'm going to go through the algebra of that or any other derivation
of a formula on the board. In the future I'll just refer you back to this lecture for perpetuities and
give you the general outline for other cases. However at this point you should memorize the fact
that for perpetuities you just divide by the interest rate. There will be derivations of formulas in
the appendix for Section 3 and in the solutions to Problem Set 2. If at any point you find yourself
thinking where does that formula come from you can check it out.

Statistics
We won't be using the statistics for some time and when we get to the point we do need
it, I'll review it. For those of you who want some more time to refresh your memory, I'll just list
the basic concepts you'll need to understand:
Random Variable
Probability

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Expectation
The Mean or Average
Variance
Standard deviation
Covariance
Correlation
That's the basic background knowledge you'll need. If you are at all doubtful about any of
the concepts, review them soon.