Finance Lecture 1

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					FINM7401 Lecture 1
(Week beginning 21 July)

Overview of lecture 1
Course objectives Resources Course structure Assessment Contacting staff The Objective of the Firm Time Value of Money
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Objective of the Firm Time Value of Money

Course Objectives
Financial literacy
Understand basic financial concepts Be able to apply concepts Be able to explain the relevance of concepts to current events

Resources
CD
Interactive Finance available from http://www.bigcheese.com.au or UQ bookshop NOTE: lots of practice questions, quizzes Business Finance by Peirson, Easton, Brown & Howard available from UQ bookshop Lecture notes and tutorial questions, etc.

Book:

Financial numeracy
Understand basic financial computations and when they are needed
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Blackboard

Financial Calculator-bring to class and tutorials! Student Resource Centre
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Course Structure
Lectures
One 3-hour lecture per week

Assessment
Assessment: Mid-semester exam 35%

Theory development seasoned with practical applications Prepare with CD or book when required

NOTE: I will teach first 5 lectures, then Karen or Jacquelyn will take over Tutorials
One 1-hour tutorial per week

multiple choice and short worked problems

Final Exam

65%

Tutorial times and venues on my SI-net Sign on for tutorial class
Contact Carla Cravaliat c.cravaliat@business.uq.edu.au about any sign-on problems

worked problems and some multiple choice

Prepare problems posted on blackboard

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Contacting Staff
Renée Adams – Room 39-318
Course coordinator until midsemester exam Email: r.adams@business.uq.edu.au Telephone: 3365-7285 Course coordinator after midsemester exam Telephone: 3365-4348 Email: k.benson@business.uq.edu.au Lecturer and tutor E-mail: j.humphrey@business.uq.edu.au Telephone: TBA Tutor E-mail: tabreezsp@yahoo.com Telephone: TBA Sign-on problems only E-mail: c.cravaliat@business.uq.edu.au

Tips for Success in FINM7401
Read the course outline carefully Prepare tutorial questions before the tutorial Be sure to study theory as well as practical problems The course is progressive (don’t fall behind)

Karen Benson - Room 39-322

Jacquelyn Humphrey-RoomTBA

Shams Pathan-Room TBA

Carla Cravaliat

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The Nature of Business Finance
Broad aspects of finance

The Objective of the Firm
CD Unit 1 Book, Chapter 1
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Corporate finance: the financial management of companies. Financial institutions and markets. Investments.

Focus is mainly on corporate finance, but also considers financial institutions and markets, and investments.
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Financial Decisions
Major financial decisions are:
Investment decisions — decisions that determine the asset profile of a business (amount and composition of investments). Financing decisions — how the assets are to be funded (debt and equity). Financing decisions also involve dividend decisions.

Business Structures
Sole proprietorship
Business owned by one person.

Partnership
Business owned by two or more people acting as partners.

Company
Separate legal entity formed under the Corporations Act 2001. Owned by shareholders Run by managers Limited liability

Ultimate objective of investment and financing decisions is to maximise 11 the owners’ wealth.

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Example: Deloitte
Member firm structure The partners of Deloitte member firms are the sole owners of their practices. Their member firms are organized on an individual country or regional basis, and each operates within the legal and regulatory framework of its particular jurisdiction. They are separate and independent firms that are owned and managed locally. These firms have come together to practice under a common brand, methodologies, client service standards, and other professional standards and guidelines.

Example: PriceWaterHouseCoopers
In most parts of the world, the right to practice accountancy is granted only to national firms in which locally qualified professionals have majority or full ownership. Consequently, PwC member firms are locally owned and managed. But local ownership also confers two additional strengths: a deep understanding of local markets; and the sense of individual responsibility and initiative that comes from having a stake in the practice.

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Corporations
Shareholders Board of Directors Managers Employees

Example of a corporation: BHP Billiton
BHP Billiton is a Dual Listed Company (DLC) comprising BHP Billiton Limited and BHP Billiton Plc. The two entities continue to exist as separate companies, but operate as a combined group known as BHP Billiton. BHP Billiton was created through the DLC merger of BHP Limited (now BHP Billiton Limited) and Billiton Plc (now BHP Billiton Plc), which was concluded on 29 June 2001. The headquarters of BHP Billiton Limited, and the global headquarters of the combined BHP Billiton Group, are located in Melbourne, Australia. BHP Billiton Plc is located in London, United Kingdom. Both companies have identical boards of directors and are run by a unified management team. Shareholders in each company have equivalent economic and voting rights in the BHP Billiton Group as a whole. The DLC structure maintains pre-existing primary listings on the Australian Stock Exchange (through BHP Billiton Limited) and London Stock Exchange (through BHP Billiton Plc).
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Our Focus…
…is on financial decision making by managers of public companies. But concepts also apply to
Sole proprietorship Partnerships Non-profits

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The Finance Function: Major Roles of Financial Managers
Project evaluation. Dividend and share repurchase decisions. Dividend distributions. Collection and custody of cash and payment of bills. Management of investments in current assets.

The Finance Function: Major Roles of Financial Managers (cont.)
Assessing the viability of growth through acquisitions. Planning the future development of the business. Interest rate and exchange rate risk management. Development and implementation of financial policies.

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A Company’s Financial Objective
In order to study the behaviour of financial managers and understand their decisions, we need to understand the objective of their decision making. Possible objectives
Maximise manager salaries Maximise market share Best possible reputation Maximise sales Maximise profit Maximise share price Maximise shareholder wealth

Why shareholder wealth?

The maximisation of market value of a company’s shares is the overriding objective. We are able to rationalise theories and important results in finance by appealing to this ultimate objective of financial decision makers.

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BHP Billiton Charter
We Are BHP Billiton, A Leading Global Resources Company Our purpose is to create long-term value through the discovery, development and conversion of natural resources, and the provision of innovative customer and marketfocused solutions. To prosper and achieve real growth, we must: Actively manage and build our portfolio of high quality assets and services. Continue the drive towards a high performance organisation in which every individual accepts responsibility and is rewarded for results. Earn the trust of employees, customers, suppliers, communities and shareholders by being forthright in our communications and consistently delivering on commitments. We value: ….. We are successful in creating value when: Our shareholders are realising a superior return on their investment. Our customers and suppliers are benefiting from our business relationships. The communities in which we operate value our citizenship. Every employee starts each day with a sense of purpose and ends each day with a sense of accomplishment. Chip Goodyear Chief Executive Officer October 2004

Evidence of agency problems
Founder CEO of Occidental Petroleum, Armand Hammer, entered the hospital
Share price rose from $28 to $31 Gain to shareholders ~$300 million<actual gain since expected due to age Information that visit was routine → stock price fell by $2
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Who is this guy?
Bernie Ebbers, 63 The former CEO of WorldCom, found guilty in March 2005 of running the largest corporate fraud ever Sentenced to 25 years to life WorldCom crashed and burned in July 2002 under the weight of an $11 billion accounting fraud, which Ebbers maintains was the handiwork of CFO Scott Sullivan, who kept him in the dark.

Financial Times, May 2006: Rio Tinto litigation move blocked by SHAREHOLDERS
Institutional investors in Rio Tinto, the UK and Australianbased mining company, have scuppered a move by the group that would have protected it from litigation in countries where it is not domiciled. The proposal...was not put to the corresponding meeting of the dual-listed company in Melbourne yesterday after proxy votes indicated it would be soundly defeated. Rio Tinto was asking shareholders to approve an "exclusive jurisdiction" amendment to its articles of association, which would have stipulated that any suit, action or dispute between Rio, or its directors or former directors, and a shareholder could only be brought in the courts of Victoria, or before the courts in England and Wales. The move is believed to have been opposed by some US institutional shareholders, who were concerned at losing their rights to litigation in US courts. The company has never faced shareholder litigation in the US, but class actions by shareholders in that country reached USDollars 7.5bn in 2005.
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Maximising Shareholder Wealth
What is shareholder wealth?
Current net asset value? What someone would pay today to receive all future cash flows from assets? What the shares sell for on the share market?

Example: Investment Decision
You are the Chief Financial Officer (CFO) at a Japanese company that manufactures TVs The company plans to expand business by exporting to the United States Is this plan aligned with the interests of shareholders? Will it maximise shareholder wealth? How do you make this Investment Decision?

How is shareholder wealth maximised?
Maximise current value of future cash flows

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Making Investment Decisions
Market Research:
How many units will we sell? How much can we charge for the product?

Time Value of Money
CD Unit 2, 1-4 Book chapter 3, 3.1-3.3.1

Economics:
What will happen to interest rates? Will individuals demand a premium to invest in risky projects?

Accounting:
What depreciation method will we use? How will we account for inventories?

Operations Management:
What will it cost us to produce the product? Are there synergies with other production runs?

Cash Flows from New Project

Required Return for New Project

Strategy:
If we charge too much will a competitor enter the market? Should we make a low price guarantee?

FINM 7401
Value of New Project
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Fundamental Concepts
finance, the funds that flow between parties either now or in the future as a consequence of a financial contract.
Rate of return — relates cash inflows to cash outflows. Cash flows — fundamental to

Fundamental Concepts (cont.)
Interest rate — special case of rate of

return (used when the financial agreement is in the form of debt).

Time value of money
Money received now can be invested to earn additional cash (interest). Relates to opportunity cost of giving up money or resources for a period of time — either forgone investments or consumption, whatever the next best alternative is.
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C − C0 r= 1 C0

where: C1 = cash inflow at time 1 C0 = cash inflow at time 0

r = rate of return per period
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Time Value of money
We will cover four key concepts
Future Value Present Value

Which Would You Rather Have?
$100 Today $100 Next Year

Single Cashflow

Future value of a single cash flow Future value of an annuity

Present value of a single cash flow Present value of an annuity

Why?

Annuity

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Present Value
How much would you be willing to pay today to be guaranteed $110 in one year?
$105? $100? $95?

Present & Future Values
If you invest $100 today and are promised $110 in one years time
$100 is the present value (PV) $110 is the future value (FV)

Amount depends on ‘opportunity cost’
the value of the best alternative investment you have forgone
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There is a precise mathematical relationship between present and future values The study of Financial Management requires a sound understanding of that relationship and the ability to perform related calculations
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Future Value of a Single Cash Flow
If I deposit $100 with a bank that pays a fixed rate of interest (10%) per annum, how much will I have in one years time?
=$100(1.10) =$110

Future Value of a Single Cash Flow
$121 = $100(1 + 0.1) 2 FVn = PV (1 + r )
n

How much will I have in two years time?
=$100(1.10)(1.10) =$100(1.10)2 =$121

PV = present value FVn = future value in n periods r = interest rate (opportunity cost) Interest is compounded

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Future Value
Suppose you receive $1000 and decide to save it until you retire If the interest rate is 10%, how much will you have in 40 years (with annual compounding).

Present Value

FV n = PV (1 + r )

n

PV =

FV n = PV (1 + r )

n

(1 + r )
= 100 1.10

FV n

n

FV n = 1000 (1 + 0.1)

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If the interest rate is 10%, what is the present value of $100 to be received in one year?

PV =

100

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(1 + .10 )

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Present Value – example
You wish to have $100000 for your child’s university education in 18 years. How much do you need to invest today if the interest rate is 6%p.a.

Adding single cash flows
How much would you pay for the right to receive $300 every 3 months for the next year? Assume your opportunity cost is 1% per month.
$300 $300 $300 $300

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Adding single cash flows

Compound Interest
Interest is earned on principal and interest

= 291.1770 + 282.6136 + 274.3019 + 266.2348 = $1,114.33

Year 1 2 3 4

$ $ $ $

Begin 1,000.00 1,050.00 1,102.50 1,157.63

Interest $ 50.00 $ 52.50 $ 55.13 $ 57.88

$ $ $ $

End 1,050.00 1,102.50 1,157.63 1,215.51

$300

$300

$300

$300

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FV n = PV (1 + r )n
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FV 4 = 1000(1.05)4 = 1215.51
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Future Values with compound interest
Future Value

Simple Interest
Interest is earned on principal only
Year 1 2 3 4 Begin 1,000.00 1,050.00 1,100.00 1,150.00 Interest $ 50.00 $ 50.00 $ 50.00 $ 50.00 End 1,050.00 1,100.00 1,150.00 1,200.00

Present Value

$ $ $ $

$ $ $ $

Time, e.g. years
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Simple Interest
Interest is earned on principal only FV = PV (1 + ( r × n ) )
n

Future Values with simple interest
Future Value

What is the future value of a $1000 investment earning 5% p.a. simple interest for 4 years?
FV = 1000 (1 + (.05 × 4 ) )
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Present Value

Time, e.g. years
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Nominal Interest Rate
Most interest rates are quoted as annual nominal rates
6% p.a. compounded monthly

Summary So Far
Future Value
Single Cashflow

Convert to rate per compounding period (periodic rate)
Divide annual rate by number of compounding periods per year 0.5% per month

Present Value
n

FVn = PV (1 + r )

PV =

(1 + r )

FVn

n

Annuity

rper =

rann m

.005 =

.06 12
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Objective of the firm Future Value and Present Value of single cash flow Interest rates – compounding, simple, nominal.

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What is an Annuity?
An annuity is a series of regular equal cashflows:
$1,000 per month for 360 months, $5,000 per year for 20 years, Saving $200 each fortnight out of your pay packet.

Future Value of an Annuity
Example: starting one year from today, deposit $500 into bank account. Do same thing every year for six years.
If r = 6% pa, how much is in the bank account after six years?

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Regular Cashflows
$500 $500 $500 $500 $500 $500

Future Value of an Annuity
0 1 A 2 A ... ... n A

0

1

2

3 Years

4

5

6

The future value of an annuity is

FV = 500(1.06) 5 + 500(1.06) 4 + 500(1.06) 3 + 500(1.06) 2 + 500(1.06)1 + 500 = $3,487.66
Assuming r = 6%
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⎡ (1 + r ) n − 1 ⎤ FVn = A ⎢ ⎥ r ⎣ ⎦
note: this formula gives a value at the time of the last cashflow
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Where does this come from?
See text p. 2-39 or book for different derivation
FV n = A + A (1 + r ) + A (1 + r ) 2 + ... + A (1 + r ) n − 1

Using the Formula
Using our previous example: starting one year from today, deposit $500 into bank account. Do same thing every year for six years.
If r = 6% pa, how much is in the bank account after six years?

Geometric series:
1 + x + x 2 + ... + x m = x m +1 − 1 x −1

⎡ (1.06)6 − 1 ⎤ FV = 500 ⎢ ⎥ ⎣ 0.06 ⎦ = 3487.66
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Present Value of an Annuity
$500 $500 $500 $500 $500 $500

Present Value of an Annuity
⎡1 − (1 + r )−n per PV = A ⎢ ⎢ r per ⎣ ⎤ ⎥ ⎥ ⎦

0

1

2

3 years

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5

6

PV =

500 500 500 500 500 500 + + + + + 2 3 4 5 6 1.06 (1.06 ) (1.06 ) (1.06 ) (1.06 ) (1.06 )

⎡1 − (1 + .06 )−6 ⎤ ⎥ = 500 × 4.9173 PV = 500 ⎢ .06 ⎢ ⎥ ⎣ ⎦ = 2458.66

An annuity – equal, regular payments
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Where does this come from?
Easy way to think about it:
PV =

Matching Cash Flows With Formulas

(1 + r )

FVn

1.
n

Annuity formula gives PV one period before first payment Annuity formula gives FV at same time as last payment

2.

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Matching Cash Flows With Formulas
What is the future value of the following series of cash flows?

Matching Cash Flows With Formulas
$200 $200 $75 $75 $75 $75

$75

$75

$75

$75

0
0 1 2 3 Quarters 4 5 6

1

2

3 Quarters

4

5

6

r = 8% p.a.
⎛ (1.02 )4 − 1 ⎞ ⎟ FV 4 = 75 ⎜ ⎜ ⎟ .02 ⎝ ⎠
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⎛ (1.02 )4 − 1 ⎞ 2 ⎟ (1.02 ) + 200 FV 6 = 75 ⎜ ⎜ ⎟ .02 ⎝ ⎠

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Summary So Far
We have covered the four basic concepts we need:
Future Value Present Value

Next Week
Issues with respect to compounding periods Effective interest rates Deferred annuities Perpetuities Application to mortgages

Single Cashflow

Fn = P (1 + r )

n

P =

(1 + r )

Fn

n

Annuity

n ⎡ (1 + r ) − 1⎤ FVn = A ⎢ ⎥ r ⎣ ⎦

−n ⎡1 − (1 + r ) ⎤ PV = A ⎢ ⎥ r ⎦ ⎣

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Additional Exercises
1. You have just received a letter from your favourite aunt. She advises that she has written you into her will. On her passing, you will receive an inheritance of $50,000. While this seems great, you are aware of the time value of money, and your aunt is in good health for her age. Assuming an average interest rate of 8% per annum, what is the inheritance worth in today's dollars if your aunt lives another 5 years? If she lives another 15 years?

Additional Exercises
2. You will receive a payment of $10,000 two years from now and another payment of $10,000 four years from now. If the discount rate is 8% pa, what is the present value of these two payments?

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Additional Exercises
3. It is 1 July, 2003. On 1 July, 2001 you received an inheritance of $1000 which you deposited into a savings account earning 6% p.a. compounded monthly. You need a savings plan in order to cover a $20000 deposit on a house on 1 July 2004 and an overseas holiday leaving 1 July 2006, which will cost $8000. How much will you need to save on a monthly basis to do this - you plan to start saving next month. You expect to maintain the 6% p.a. compounded monthly rate. You may round to whole dollars.
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Description: Finance - Master of Commerce- The University of Queensland Australia