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Financial Management Summary/Revision Notes

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Perpetuity, annuity, interest rates, valuing stocks and bonds, dividend growth, stocks, financial distress, diversification, working capital management etc.

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  • September 22, 2022
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  • 2021/2022
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Financial Management
02/02/2022
Financial Management

Goals and Governance of the Firm
Key Terminology
Real Assets: assets used to produce goods and services
Financial Assets: financial claims to the income generated by the firm’s real assets
Investment Decision: purchase of real assets
Financing Decision: sale of financial assets
Capital Budgeting Decision: decision to invest in tangible or intangible assets (also called Investment
Decision or Capital Expenditures (CAPEX))

Role of the Financial Manager




Goals of Corporations
 To maximise their current wealth
 To transform that wealth into the most desirable time pattern of consumption either by
borrowing to spend now or investing to spend later
 To manage the risk characteristics of that consumption plan
Profit maximisation is not a well-defined financial objective because:
- A corporation may be able to increase current profits by cutting back on outlays for
maintenance or staff training, but that may add value. Shareholders will not welcome higher
short-term profits if long-term profits are damaged.
- A company may be able to increase future profits by cutting this year’s dividend and
investing the freed-up cash in the firm. Not in the shareholders’ best interest if the company
earns less than the opportunity cost of capital.

Agency Problem
Agency costs are incurred when:
- Managers do not attempt to maximise firm value and
- Shareholders incur costs to monitor the managers and constrain their actions
Managers, acting as agents for stockholders, may act in their own interests rather than maximising
value. A stakeholder is anyone with a financial interest in the firm.

,Tools to Ensure Management Pays Attention to the Value of the Firm
- Manager’s actions are subject to the scrutiny of the board of directors
- Shirkers are likely to find they are ousted by more energetic managers
- Financial incentives such as stock options

Agency Problem and Corporate Governance Solutions
1. Legal and Regulatory Requirements
2. Compensation Plans
3. Board of Directors
4. Monitoring
5. Takeovers
6. Shareholder Pressure

09/02/2022
Present Values

Terminology
Present Value is the value today of a future cash flow.
Future Value is the amount to which an investment will grow after earning interest.

Future Value
FV = C * (1 + r)^t
Where, C is the amount, r is the decimal, and t is time
What is the future value of $100 if interest is compounded annually at rate of 7% for two years?
FV = $100 * (1.07)^2 = $114.49




Present Value
PV = Discount Factor (DF) * C1
Where, DF = 1/(1 + r)^t
Discount factor can be used to compute present value of any cash flow.
PV = (1/(1.07)^2)) * 114.49 = $100




Net Present Value (NPV) = PV – Required Investment
NPV = C0 + (C1/(1+r))

, Valuing an Office Building
Step 1. Forecast Cash Flows
Cost of Building = C0 = 370,000
Sale Price in Year 1 = C1 = 420,000
Step 2. Estimate Opportunity Cost of Capital
Cost of Capital = r = 5%
Step 3. Discount Future Cash Flows
PV = 420,000/(1.05)^1 = 400,000
Step 4. Proceed is PV of Payoff Exceeds Investment
NPV = 400,000 – 370,000 = 30,000

Risk and Present Value
Higher risk projects require a higher rate of return. Higher required rates of return cause lower PVs.
PV of C1 = 420,000 at 5%
PV = 420,000/(1.05) = 400,000

PV of C1 = 420,000 at 12%
PV = 420,000/(1.12) = 375,000

NPV = 375,000 – 370,000 = $5,000

Net Present Value Rule
Accept investments that have positive net present value.
Example
Original Example. Should we accept the project given at a 10% expected return?
NPV = -370,000 + (420,000/(1.05)) = $30,000

Accept investments that offer rates of return in excess of their opportunity cost of capital.
Example
The foregone investment opportunity is 12%. Should we go the project?
Return = Profit/Investment
Return = (420,000 – 370,000)/370,000 = 0.135 = 13.5%

Multiple Cash Flows
For multiple periods we have Discounted Cash Flows (DCF) formula:
PV0  (1Cr1 )1  (1Cr2 ) 2  ....  (1Crt )t
T
NPV0 C0   (1Crt )t
t 1

Net Present Values

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