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Summary of Introduction to Finance and Accounting, Utrecht University.Principles of Corporate Finance
Brealey, Myers and Allen
Chapter 1 – Introduction to Corporate Finance
There are three types of enterprises
1. Sole proprietorship; it is simple to establish, it is controlled by the owner and the owner is liable.
An example is a hairdresser or a cleaner.
2. Partnership; it is simple to establish, there is a shared control and a shared ownership which
means that there are more and broader skills and resources, there is limited and unlimited
liability. A law firm (Pearson, Spector, Litt) is an example.
3. Corporation; there is a separated ownership and separated control, it is easy to transfer
ownership through stockholders, the stockholders own the corporation but cannot control it, the
CEO (etc.) makes the decisions, there is a limited liability which means that shareholders cannot
be held personally responsible for the corporation’s debts. A corporation pays for its real assets
by selling claims on them and on the cash flow that they will generate. These claims are calls
financial assets or securities.
In a corporation there can be an agency problem where the shareholder is the
principal and the manager is the agent. Agency costs are incurred when:
- Managers do not attempt to maximize firm value and
- Shareholders incur costs to monitor the mangers and constrain their actions.
The financial manager makes investment (about spending
money, purchase of real assets) and financial decisions
(about getting money, sale of securities and other financial
assets). He/she stands between the firm and the outside
investors. A smart investment decision creates more value
than a smart financing decision.
Investment decisions are often referred to as capital
budgeting or capital expenditure (CapEx – look at chapter 6) decisions because most large corporations
prepare an annual capital budget listing the major projects approved for investment. Financing decisions
are less important than investment decisions
-> value comes mainly from the asset side of the balance sheet; thereby should the financing strategy be
simple.
There are tangible assets (assets that you can touch and kick) and intangible assets (assets such as
research and development, advertising and computer software. There is also a difference between real
assets (they need to be paid for) and financial assets or securities (bank loan, corporate bond).
A stockholder wants three things
1. To be as rich as possible to maximize their current wealth
2. Transform wealth into the most desirable time pattern of consumption, either by borrowing to
spend now or investing to spend later; shareholders can do this on their own – corporation
doesn’t need to do this
3. To manage risk characteristics of chosen consumption plan; shareholders can do this on their
own – corporation doesn’t need to do this
,So, the most appropriate goal for the financial manager is to maximize share (stockholder) value.
Compared to the other goals, like maximizing profits (which year’s profit -> it’s about the long term profit,
not short term), maximize market share (but make losses while doing so?), avoid bankruptcy (but what if
further losses are made?), maximizing share value is the best one because they can increase the wealth of
the stockholder. The shareholders will buy the stock for a long term, so they want to have a return on a
long period of time. But laws need to be upheld, ethics and trust matter, many shareholders care about
long term rather than short term.
Stockholders only want the corporation to keep their money if they will get more money out of it. There is
always a rate where the stockholders get more or less money. This rate is called an opportunity cost of
capital. It depends on the risk of the proposed investment project.
Chapter 2 – How to calculate present values
Time value of money; a dollar today is worth more than a dollar tomorrow, because of interest. Positive
interest rates imply money you invest today will be worth more in the future.
Future Value (FV): the amount an investment is worth after one or more periods.
V t =V 0 ( 1+ r )t - FV ( I )=I∗(1+r )t
Simple interest: Interest earned only on the original principal amount invested.
R*t
Compound Interest: Interest earned on both the initial principal and the interest reinvested from prior
periods (interest on interest).
Total interest:
( 1+r )t −1
Present Value: The current value of future cash flows discounted at the appropriate discount rate. The
present value of an investment is equal to the market price of the investment.
Ct
PV = C 0 =
( 1+ r )t
Present Value Discount Factor (DF) = PF of 1 dollar. This can be used to compute present value of any
cash flow. It measures the present value of one dollar received in year t.
1
DF =
( 1+ r )t
Discounting to present values enables you to add up multiple cash flows.
CF 1 CF 2 CF 3
PV 0= 1
+ 2
+
( 1+ r ) ( 1+r ) ( 1+r )3
Discount Rate
PV = FV x Discount Rate
Discount Rate = PV/FV
Net Present Value (NPV): it tells you if an investment is profitable. NVP > 0 means that the investment is
profitable. NVP < 0 means that is not profitable. NVP = Sum of PV’s – Investment (= cashflow today).
C1
NVP = C 0+
( 1+r )
, Rate of Return: if the return exceeds the return foregone by not investing in financial markets
(opportunity capital), you should go ahead with the
investment in a certain project. The rate of return is also
called the discount rate, hurdle rate and opportunity cost of
capital. The discount rate is the money you could have made
elsewhere. If the NPV is higher than 0, we will proceed with
the investment. If you compare the outcome of an
investment to an investment you could also have made. It is
about other opportunities in the market.
Profit
Return=
Investment
Rules of accepting an investment
1. NPV-rule; accept investments that have positive NPV
2. Rate of Return rule; accept investments that offer rates of return in excess of their opportunity
cost of capital
Perpetuities and Annuities
Annuity
An annuity is a steady cashflow (level stream of cash flows) for a certain time (a fixed period of time), it is
useful for valuing bonds. The equal-payment house mortgage or instalment credit agreement are
common examples of annuities. The expression in brackets shows the present value of 1 dollar a year for
each of t years. It is generally known as the t-year annuity factor. A level stream of payments starting
immediately is called an annuity due. It is worth (1+r) times the value of an ordinary annuity.
Present value of t-years annuity PV ( annuity ) =C ¿] (the part between brackets is the annuity factor)
C 1
Or PV ( annuity ) = ∗1−
r (1+ r)t
1
It has to be multiplied with t if the annuity doesn’t pay out in the first t periods.
(1+r )
PV∗1
FV ( annuity ) = (example 2.5, page 33)
(1+r )t
Perpetuity
A perpetuity is a steady cash flow which lasts forever and is useful for valuing shares. A perpetuity is
useful for valuing specific assets and it is a shorthand for valuing companies shares. The annual rate of
return on a perpetuity is equal to the promised annual payment divided by the present value.
C C
r= PV ( perpetuity )=
PV r
Two warnings
1. It is not the same as the formula with the present value of a single payment (1/(1+r)), but it is 1/r.
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