Finance Chapter 1, 4, 5 study notes

Chapter 1

Introduction to Corporate Finance

Value creation – purpose of a firm is to create value for the owner; depends on cash flows

Most important principles of finance is that individuals prefer to receive cash flows earlier rather than later

Balance Sheet Model of the Firm

Assets are on the left side Forms of finance are on the right side
Current assets have short lives (inventory) Liabilities – debt of equity shares
Fixed assets last a long time (building) Short term debt = < 1 year
Tangible fixed assets (machinery and equipment) Long term debt => 1 year
Intangible fixed assets (patents and trademarks cell-content
Total Value of Assets Total Value of the Firm to Investors

Capital budgeting – process of making and managing expenditures on long-lived assets
• Capital structure – proportions of the firm’s financing from current and long-term debt and equity Creditors buy debt from the firm
• Shareholders buy equity shares

Net working capital – current assets minus current liabilities

Treasurer is responsible for handling cash flows, managing capital expenditure decisions, and making financial plans.
Controller handles the accounting function, which include taxes, cost and financial accounting, and information systems.

The Corporate Firm

Sole proprietorship – business owned by one person

Partnership – any two or more people to form
• General partnership – all partners agree to provide some fraction of the work and cash to share the profit and losses
• Limited partnership – liabilities are limited to the amount of cash each has contributed

Main advantage to a sole proprietorship or partnership is the cost of getting started
• Unlimited liability
• Limited life of the enterprise
• Difficulty of transferring ownership
• Difficulty in raising cash

Corporation – a citizen of its state of incorporation (can’t vote)
• Limited liability
• Ease of ownership transfer
• Unlimited life
• Enhanced ability to raise cash

Limited liability company (LLC) – operate and taxed like a partnership, but retain limited liability for owners

The goal of financial management is to maximize the market value of the existing owner’s equity

The Agency Problem and Control of the Corporation

Agency relationship - the relationship between stockholders and management. Financial managers are to act in the best interest of the stockholders by taking actions that increase the value of the firm.
Agency problem – conflict of interest between the principal and the agent
• Agency cost – the cost of the conflict of interest between stockholders and management
Direct agency cost
 Corporate expenditure that benefits management but costs the stockholders
 Expense that arises from the need to monitor management actions
Managers generally act in the stockholder’s interest for 2 main reasons
• Managerial compensation is tied to financial performance (stock options) The more the stock is worth, the more valuable the option
• Better manager performance leads to promotions
Unhappy stockholders can replace existing management through a proxy fight
• Proxy – the authority to vote someone else’s stock

Stakeholders – someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm.

Financial Markets

Money markets – market for debt securities that will pay off in the short term
• Dealers buy and sell money market instruments for their own inventory and at their own risk
Capital markets – the markets for long term debt and equity shares

Primary market is used when governments and corporations initially sell securities
• Public offering – the underwriting syndicate buys the new securities from the firm for the syndicate’s own account and resells them at a higher price. Must be registered with the US Securities and Exchange Commission (SEC)
• Private placement – Privately placed debt and equity are sold on the basis of private negotiations to large financial institutions, such as insurance companies, mutual funds, and other investors. Not registered with the SEC
Secondary market transaction involves one owner or creditor selling to another
• Dealer markets (over-the-counter or OTC) – trading in stocks and long term debt takes place over the counter/electronically
• Auction markets – exchange has a physical location. Dealer does most of the buying and selling (matching those who wish to sell with those who wish to buy)

Sarbanes-Oxley Act in 2002 (Sarbox or SOX) – intended to protect investors from corporate abuse.

Chapter 4

Discounted Cash Flow Valuation

Considering the time value of money

Valuation: The One-Period Case
Future value or compound value – the value of a sum after investing over one or more periods

Present Value of Investment:

PV=C1 / 1 + r

Present value analysis and future value analysis must always lead to the same decision
Net present value – the present value of future cash flows minus the present value of the cost of the investment

Net Present Value of Investment:

NPV = - Cost + PV

The Multiperiod Case

Compounding – process of leaving the money in the financial market and lending it for another year
Simple interest – interest is not reinvested
Compound interest – each interest payment is reinvested

Future Value of an Investment:

FV = C0 x (1 + r)T

Discounting – the process of calculating the present value of a future cash flow
Present value factor – the factor used to calculate the present value of a future cash flow

Present Value of Investment (multiperiod case):

PV = Ct / (1 + r)^t

Compounding Periods

Stated annual interest rate (annual percentage rate or APR) – annual interest rate without consideration of compounding
Effective annual rate (EAR) or the effective annual yield (EAY) – annual rate of return

Effective Annual Rate:

EAR (1 + r / m)^m - 1

Distinction between Stated Annual Interest Rate and Effective Annual Rate

SAIR becomes meaningful only if the compounding interval is given

EAR is meaningful without a compounding interval

Future Value with Compounding:

FV = C0 (1 + r / m)^m x t

Continuous compounding – compounding semiannually, quarterly, monthly, daily, hourly, each minute…

C0 x e^r x t

Semiannual compounding gives rise to both a smoother curve and a higher ending value than does annual compounding
Continuous compounding has both the smoothest curve and the highest ending value of all


Four classes of cash flow streams simplifying formulas:

Perpetuity – constant stream of cash flows without end

Formula for Present Value of Perpetuity:

PV = C / r

• The value of the perpetuity rises with a drop in the interest rate.
• Conversely, the value of the perpetuity falls with a rise in the interest rate

Growing perpetuity – the rise in cash flow will continue indefinitely

Formula for Present Value of Growing Perpetuity:

PV = C / r - g

3 important points concerning the growing perpetuity formula:
• The numerator: the numerator is the cash flow one period hence, not at date 0
• The discount rate and the growth rate: the discount rate r must be greater than the growth rate g for the growing perpetuity formula to work
• The timing assumption: assumes the cash flows are received and disbursed at regular and discrete points in time.

Annuity – a level of stream of regular payments that lasts for a fixed number of periods

Formula for Present Value of Annuity:

PV = C ( [1 - (1 / (1 + r)^t)] / r)

Annuity factor – the term used to compute the present value of the stream of level payments, C, for T years

Formula for the Future Value of an Annuity:

FV = C ( [(1 + r)^t – 1 / r] )

Growing Annuity – a finite number of growing cash flows

Formula of Present Value of Growing Annuity:

PV = C [ (1 – (1 + g / 1 + r)^t ) / r- g]

Chapter 5

How to Value Bonds and Stocks
Bond – a certificate showing that a borrower owes a specified sum

How to Value Bonds

Pure discount bond (zero coupon bonds) – simplest kind of bond that promises a single payment at a fixed future date
Maturity date – the date when the issuer of the bond makes the last payment
Payment at maturity is termed the bond’s face or par value

Value of a Pure Discount Bond:

PV = F / (1 + r)^t

Level Coupon Bonds
Coupons – cash payments at regular times in between and at maturity

Value of a Level Coupon Bond:

PV = C x ATR + F / (1 + r)^t

Consols – bonds that never stop paying a coupon and have no maturity date

ie. Preferred stock – stock that is issued by corporations that provides the holder a fixed dividend in perpetuity

Value of Consols:

PV = C / R

Bond Concepts

At face value, if the coupon rate is equal to the marketwide interest rate
At a discount, if the coupon rate is below the marketwide interest rate
At a premium, if the coupon rate is above the marketwide interest rate

Yield to Maturity (bond’s yield) – the discount rate that equates the price of the bond with the discounted value of the coupon and face value
Corporate bond deals are now required to report trade information through Transactions Report and Compliance Engine (TRACE)

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