remenLecture 1

 Finance has three main elements: Investment decision, Financing decision, and
Liquidity. The investment decision is about choosing the best projects for the
company or the projects that maximize the value of the firm and value for
shareholders. The tool we use to choose the best projects are called Capital
Budgeting. Next, the financing decision is linked to the investment decision, and it is
about choosing the source of financing for the chosen projects/investments. Do we
borrow money for the project? Do we use retained earnings for the project? Do we
issue shares for the project? And those are all linked to the capital structure, which is
about the firm’s debt and equity. Finally, Liquidity ensures that the firm has enough
cash and inventory in order to deal with the short-term financial planning.
 The balance sheet model of the firm is a statement of financial position or the
snapshot of a firm’s financial position at a specific point in time. It contains the firm’s
total value of assets and the firm’s total liabilities and shareholder’s equity, which
helps us calculate the net working capital. The balance sheet helps us look at the
firm’s capital budget, capital structure, and net working capital.
 The capital structure has to do with a mix of debt and equity. By debt, we mean what
the company owes to either the creditors, bondholders, or/and debtholders. Equity
is about the issue of shares or the process by which a company raises money by
selling ownership stakes in the form of shares of stock to investors.
 Value of firm = Value of Bonds + Value of Shares. It is more expensive issuing shares
rather than issuing debt because debtholders take on a much smaller risk and
therefore require less in return. Debtholders take on a smaller risk because if the
company were to go bankrupt, the first to get paid would be the debtholders and
the last would be the owner’s of the company or shareholders. This is why also
shareholders expect a lot more in return.

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 The role of the financial manager is that they are responsible for the investment
decision, financing decision, short-term financial planning, overseeing accounting
and audit function in the firm, and ensuring the financial welfare of the firm.
 The goal of the financial manager is for the company to survive, avoid financial
distress and bankruptcy, beat the competition, maximise sales or market share,
minimise costs, maximise profits, maintain steady earning growth, social
responsibility THE GOAL OF FINANCIAL MANAGEMENT IS TO MAXIMISE THE
SHARE PRICE OF THE COMPANY
 Financial Markets: Money Markets: are the markets for debt securities that will pay
off in the short term (usually less than one year). Capital Markets: are the markets
for long term debt (with a maturity of over one year) and for equity shares
 Financial Markets can be classified further as Primary and Secondary markets. In
primary markets, securities are sold to investors. Money that is raised goes to the
firm, which is linked to the first share issue being the Initial Public Offering. Second
share issue is called a Seasoned Offering. In secondary markets, investors trade
securities with each other. Money that is raised goes to seller of securities and that is
how share prices are determined.
  Stock exchanges: New York Stock Exchange, London Stock Exchange, EURONEXT,
Shanghai Stock Exchange, Tokyo Stock Exchange

Lecture 2

 Why is time value of money important? It is important not only because of the
implications time has on investment decision which is simply based on the principle:
A pound today is worth more than a pound tomorrow. But also when exploring
capital budgeting and investment appraisal techniques: So time value of money is an
important element we need to take into account when choosing which project
would increase the value of the firm.
 Compounding periods: sometimes interest is charged more frequently than once per
year. Semi annually (2 times a year), Quarterly (4 times a year), Monthly (12 times a
year), Weekly (52 times a year), Daily (365 times a year) or continuously (perpetuity).
 The stated annual interest rate is the annual interest rate without consideration of
compounding. The effective annual interest rate is the annual interest rate with
consideration of compounding. It is if compound interest accumulates over a year.
 The annual percentage rate: many loans have front or back end fees relating to
management costs, administration, etc. In the EU, all loans must state the effective
interest rate that includes all costs, not just the interest payments. This is known as
the Annual Percentage Rate (APR). It is the cost to you of borrowing money and the
fees that you have to pay to get the loan.
 Continuous compounding is when interest is compounded every infinitesimal
instant.
 Perpetuity: is a constant stream of cash flows that never ends. Important points
about the formula is the numerator, the discount rate and growth rate, and the
timing assumption
 Annuity: is a level stream of cash flows that last for a fixed number of periods.
Annuity factor is a factor that can be used to calculate the present value of a series
of annuities. Tricky issues of annuity formula is delayed annuity, annuity due,
infrequent annuity, and equating the PV of two annuities.

 Capital Investment appraisal:

-Capital budgeting: the decision-making process for accepting or rejecting projects
remember $1 today is worth more than $1 tomorrow.

 The NPV or Net Present Value method of investment appraisal uses discounted cash
flows to evaluate capital investment projects. It compares the present value of all
cash flows with the present value of all cash outflows. IS the value of all future cash
flows over the entire life of an investment, discounted to the present.
 NPV Investment Rule: AcceptNPV is GREATER than ZERO
RejectNPV is LOWER than ZERO
  Strengths of NPV: Uses Cash flowscash flows are better than earnings. Uses all
cash flowsOther approaches ignore cash flows beyond a certain date. Discounts
Cash FlowsFully incorporates the Time Value of Money.
 Weaknesses of NPV  The NPV method makes certain unrealistic assumptions. The
project cash flows may be difficult to estimate (but applies to all methods). Accepting
all projects with positive NPV only possible in a perfect capital market. Cost of capital
may be difficult to find. Cost of capital may change over project life, rather than
being constant.

 Payback Period Method of project appraisal calculates the length time required for
the stream of cash inflows from the project to equal the original outlay.
 Payback Period Rule: AcceptPayback Period is LESS than benchmark
RejectPayback Period is GREATER than benchmark

 Strengths of Payback Period  Very small scale investments, Firms with severe
capital rationing, Exceptionally simple to understand.
 Weaknesses of Payback Period  Timing of Cash flows, Payments after the payback
period, arbitrary standard for the payback period(what is the benchmark here?)

 Discounted Payback Period: due to some of the disadvantages of the Payback Period
method a variant called the Discounted Payback Period method was established.
Under this approach, the cash flows are first discounted and then try to find how
long it takes for the discounted cash flows to equal the initial investment.

 Discounted Project Rule: Accept  Discounted Payback Period is LESS than

benchmark
Reject  Discounted Payback Period is GREATER than
benchmark.

 Strengths of Discounted Payback Period  Simple and Uses time value of money.
 Weaknesses of Discounted Payback Period  Ignores cash flows beyond benchmark
and arbitrary benchmark.

Lecture 3

 This lecture is about the Average Accounting Return (AAR), Internal Rate of Return
(IRR), Profitability Index (PI) and Capital Rationing
  The Average Accounting Return Method (AAR) is the average project earnings after
taxes and depreciation, divided by the average book value of the investment during
its life.
 AAR is an attractive but flawed approach to financial decision making.
 In spite of its flaws, AAR is worth examining because it is used frequently in the real
world.
 The average accounting return method RULE: Accept  Average accounting return is
GREATER than target return
Reject  Average accounting return is LESS than the Target Return.

 Example of Average Accounting Return STEPS

1. Determine average net income
2. Determine average investment
3. Determine average accounting return

 Strengths of the Average Accounting Return: Simple return based measure

 Weaknesses of the Average Accounting Return: Does not use cash flows, does not
use time value of money, and arbitrary target rate.

 The Internal Rate of Return (IRR): The IRR is the discount rate, which, when applied
to the future cash flows of a project, will produce a NPV of zero.
-Also involves discounting future cash flows
-It represents the yield from an investment opportunity. Or the compound annual
return an investor expect to earn over the life of an investment.

 Represents the average percentage return on the investment, taking account of the
fact that cash may be flowing in and out of the project at various points in time.

 The rule of the Internal Rate of Return: Accept  Internal rate of return is GREATER
than discount rate
Reject Internal rate of return is LESS than
discount rate

 General Rules for IRR and NPV:

1st Cash flow negative; remaining cash flows positive:

-Number of IRRs: 1
-Accept if IRR > R; Reject if IRR < R
-Accept if NPV > 0; Reject if NPV < 0
1st Cash flow Positive; remaining cash flows negative:
-Number of IRRs: 1
-Accept if IRR < R; Reject if IRR > R
-Accept if NPV > 0; Reject if NPV < 0

Mixture of Positive and Negative Cash Flows:

-Number of IRRs: usually more than 1
-No valid IRR
-Accept if NPV > 0; Reject if NPV < 0

Some important Definitions

 Independent Project: an independent project is one whose acceptance or rejection

is independent of the acceptance or rejection of other projects
 Mutually Exclusive Projects: With mutually exclusive projects, you can accept A or
you can accept B or you can reject both of them, but you cannot accept both of
them.

IRR Problems Specific to Mutually Exclusive Projects

1. Scale of Cash Flows  IRR ignores Scale. When scale is an issue, calculate the
incremental cash flows and IRR from them.
2. Timing of Cash Flows  IRR also ignores the timing of cash flows.

To avoid issues such as timing and scale, use incremental NPV or incremental IRR.

 Profitability Index investment appraisal approach is a measure of the attractiveness

of a project or investment. Ratio of discounted cash inflow to the discounted cash
outflow. Benefit to cost ratio.
 Profitability Index Investment appraisal RULE: Accept  Profitability Index is
GREATER than 1
Reject  Profitability Index is LESS than 1.

Profitability Index: Capital Rationing

 Capital rationing occurs when there is not enough cash to invest in all positive NPV
projects
 Under Capital rationing, you cannot rank projects according to NPV
 Should use Profitability Index or Incremental NPV.
Lecture 4

 Capital budgeting is placed on an incremental basis

A summary:

-Cash flows – matter

-Sunk costs – do not matter
-incremental cash flows – matter
-opportunity costs – matter
-side effects like cannibalism and erosion – matter
-taxes – matter
* we want incremental after-tax cash flows
-Inflation – matters.

 Cash flows are not accounting income

-For example:
capital expenditures versus depreciation expenses
Evaluating a project involves converting accounting numbers into cash flows

 Sunk Costs: is a cash flow that has already occurred and the RULE is to IGNORE ALL
sunk costs. They are not relevant and cannot be changed and are the same whether
the project is accepted or rejected. Do not throw good money after bad
 Opportunity costs do MATTER. Even if project has a positive NPV, it should not have
automatic acceptance. If another project with a higher NPV would have to be passed
up, then we should not proceed.
 Opportunity Costs are lost revenues that you forego as a result of making the
proposed investment. RULE: incorporate opportunity costs into your analysis

 Cash flows  Side effects matter

-Erosion and cannibalism are both bad things. A new product might cause existing
customers to demand less of current products (for example an ice cream company
introducing a new flavour)
-On the other hand, synergies (The interaction of two or more organizations or
agencies) can create increased demand for existing products.
Incremental Cash Flows and Allocated Costs

 Some costs are divided over all the projects

-For example overheads or expense of firm that is not directly related to producing a
good or service.

 Only take them into account in evaluating a project if they are increased by the
specific project.

Interest Expense
-Later in your studies you will deal with the impact that the amount of debt that a firm has
in its capital structure has on a firm value. For now, assume that the firm’s level of debt (and
interest expense) is independent of the project.

Types of bonds:

Callable bonds allow the issuer to repurchase the bond at a specified call price before the
maturity date (call provision)
Primary principle:
Value of financial securities = PV of expected future cash flows
Negative relationship between bonds and yield. If inflation increases bonds decrease
because interest rates go up as well.
Bond prices and market interest rates move in opposite directions.