Financial Goal Calculation

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					   The Finance Function, the Financial
Manager, the Goal of the Firm, and the Net
           Present Value Rule
                Econ 181

                Wadia Haddaji

               January 9, 2008
    • Topics:

      1. The finance function and the financial manager.

      2. The goal of the firm and the net present value (NPV) rule.


    • Readings:

      1. Brealey, Myers and Allen, chapter 1

      2. Brealey, Myers and Allen, section 2.3
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                                       The Finance Function

    • Broadly stated, the finance function is concerned with the flow of funds
      between the capital markets and the firm’s operations.




                                 (2)                 (1)

                     Firm's             Financial             Capital
                                                       (4a)
                    Operations          Manager               Markets

                                 (3)                (4b)




    • These flows include: (1) issues of securities to raise cash; (2) purchases of
      real assets used in the firm’s operations; (3) cash inflows generated by the
      real assets; this cash is either (4a) reinvested in the firm or (4b) returned
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      to the firm’s security holders.
                         The Finance Function (cont’d)



    • The financial manager, who serves as the intermediary between the firm’s
      operations and capital markets, is faced with two main tasks:
      1. Investment decisions or capital budgeting (allocating funds to invest-
         ments).
      2. Financing decisions (choosing what instruments to issue to raise funds).




                             Firm's                   Financial               Capital
                            Operations                Manager                 Markets



                                         Investment               Financing
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                                          Decisions               Decisions
                          The Finance Function (cont’d)

    • As we will see, these tasks tend to be closely related.

    • It is often unreasonable to make a capital budgeting decision without know-
      ing how the assets will be financed. Investment decisions interact with
      financing decisions.

    • In making these decisions, the financial manager has to deal with many
      different types of assets.
      1. Real assets:
         – tangible: machinery, factories, real estate, products, offices, etc.
         – intangible: technical expertise, trademarks, patents, reputation, etc.
      2. Financial assets:
         – stocks, bonds, bank loans, leases, etc.
4
                              Forms of Organization

    • There are different kinds of business organizations:
      1. Sole proprietorship: one-person business.
      2. Partnership: business run by two or more people.
      3. Corporation: business owned by many stockholders and run by profes-
         sional managers.

    • In this corporate finance course, our focus will be on corporations.
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                             Features of a corporation:

    • Legally distinct from its owners (i.e., legal entity ): it can borrow or lend
      money, it can sue or be sued, it pays its own taxes (but cannot vote!).

    • Stockholders have limited liability. Example: If you buy shares of Enron,
      and the firm then goes bankrupt, nobody will come and take your house and
      car away.

    • The stockholders own the firm but do not manage it. Instead, they elect a
      board of directors to represent them by hiring and overseeing professional
      managers.

    • This separation of ownership and control is a distinctive feature of cor-
      porations. An advantage of this feature is that share ownership can change
      without interfering with the operations of the business, and thus the size of
      the business is not constrained by the manager’s wealth or risk tolerance.
      However, it also implies a whole array of problems (that will not be tackled
      in this course, but in advanced corporate finance, corporate restructuring,
      etc.), e.g.,
      1. incentives: stocks, stock options,...
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      2. agency costs arising from conflicts between different constituents.
                           Who is the financial manager?



    • Anyone responsible for a significant financial decision of a company.

    • The main financial managers are usually the treasurer and, for larger com-
      panies the controller ; in the largest companies, they may report to the chief
      financial officer.

    • There are different aspects to the financial manager’s job:
      1. Understanding capital markets.
      2. Understanding value.
      3. Understanding the effects of time and uncertainty.
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                      The Objective of the Financial Manager



    • Although many claim-holders have a stake in the firm’s income, the share-
      holders are the firm’s owners, and managers should act in their best interests.

    • There are potential conflicts of interest between management and share-
      holders, and among the various claim-holder groups.

    • Also, since stockholders are the residual claimants, maximizing their stake
      will generally be consistent with maximizing everyone’s stake (ie, the whole
      pie).
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                The Objective of the Financial Manager (cont’d)



    • We will see that shareholders are made better off by any decision which
      increases the value of their stake in the firm. Therefore, managers should
      act so as to maximize the value of the shares of the firm.

    • This is a more complex objective than maximization of profits and requires
      an understanding of how financial assets are valued.

    • Need to understand
      1. the time value of money (each cash flow comes with a time stamp);
      2. the effect of uncertainty (the cash flows are stochastic);
      3. the effect of (corporate and personal) taxes;
      4. the interaction of financial and strategic concerns.
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                      The Incentives of the Financial Manager



     • Several institutional arrangements exist to ensure that managers will indeed
       follow this value-maximization objective:

     • Compensation packages often include stock options or restricted stock.

     • Managers who increase shareholder wealth will find that they can move on
       to better jobs and higher salaries.

     • Managers of companies with depressed stock values may find their companies
       taken over by another firm. After the takeover, they may be fired.

     • Shareholders vote for the board of directors, which then appoints the top
       managers of the firm.
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     • Voting shares priced at a 3-4% premium over non-voting shares.
           The Incentives of the Financial Manager (cont’d)



     • Legal rules and stockholder litigation also keep boards account-
       able (take Corporate Restructuring for more on this).


     • Monitoring by institutional shareholders.


     • Mutual funds are not good at monitoring management.


     • Pension and hedge funds are probably better candidates.
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                                   Motivation



     • Suppose you are at a GM shareholders’ meeting. Three shareholders in
       particular are quite vocal about what the firm should do.

     • An old man wants money right now: he wants GM to invest in sports cars
       which would yield a quick profit.

     • A little child’s trust fund representative wants money a long way in the
       future: he wants GM to invest in developing electric cars.

     • A mother concerned about her child’s education wants money at some spe-
       cific time in the future (say 10 years): she wants GM to build small cars
       because experts forecast a sharp rise in oil price during this time.

     • What do you think GM’s managers should do?
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                                 Mr. Rossi’s Problem



     • Rossi has inherited $1M . He grew up in Italy and completely detests work.
       He therefore plans to use his inheritance to finance himself for the rest of
       his life.

     • for simplicity, we will divide his life into two periods, youth and old age.

     • We are going to assume that the current interest rate available in capital
       markets (for borrowing or lending) is 20%, so that for every dollar Mr. Rossi
       saves in his youth, he gets $1.20 in old age.
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                     How the Capital Market Helps Smoothing Consumption
     • Once the possibility of borrowing/lending is taken into account, here are some of the
       possibilities available to Mr. Rossi:
        1. He could go on a fantastic trip around the world, spend the whole $1M and then live
           in poverty in his old age.
        2. He could spend $0.5M in his youth, put $0.5M in the bank, and have $0.6M in his old
           age.
        3. He could spend nothing in his youth and take an even fancier $1.2M trip in his old age.
     • More generally, the capital markets allow him to choose any combination in the following
       figure:

                                                   1.2M
                                  $ spent in old age




                                                                     Slope = -(1+r) = -1.2
                                                       .6M
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                                                                   .5 M                1M
                                                             $ spent in youth
                    The Effect of Real Investment Opportunities



     • In spite of the fact that borrowing/lending gives him some choice as to
       how to allocate his money, Mr. Rossi feels he could do even better by also
       considering real investment opportunities.

     • He therefore fancies himself as an entrepreneur and sits down to work out
       what investments he can make.

     • Mr. Rossi is a wine lover. He reckons that a small vineyard that has just
       come on the market will cost him $50, 000 and will yield $200, 000 for his
       old age. This is the best project he can think of.

     • Mr. Rossi is also a gourmet. The next best project he can think of is to run
       a restaurant. This will cost $100, 000 now and give $140, 000 inm his old
       age.
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                                               The Effect of Real Investment Opportunities Cont’d

     • We can represent these and the other projects Mr. Rossi can think of through the following
       curve:

                   $ spent in old age




                                        .34M                              Vineyard+Restaurant

                                        .2M                                  Vineyard



                                                                      .85M .95M 1M
                                                   $ spent in youth


     • Notice that Mr. Rossi’s set of real investment opportunities is concave. This is because
       Mr. Rossi will undertake the projects that are most profitable before undertaking others.
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                                                                                                   200
     • For example, the rates of return for the first two projects are: for vineyard                50
                                                                                                         − 1 = 300%
       and for restaurant 140 − 1 = 40%.
                          100
                      Should Mr. Rossi Invest in the Vineyard?

     • Suppose Mr. Rossi invests in the vineyard. This means he is left with
       1. $1M − $0.05M = $0.95M now;
       2. $0.20M later.

     • Instead of simply consuming these amounts, Mr. Rossi could use borrowing
       and lending to achieve other consumption patterns:

     • Suppose he invests the whole $0.95M . This will generate $0.95M ∗ (1.2) =
       $1.14M later, so he is left with
       1. $0 now (since the whole $1M was invested);
       2. $1.14M + $0.2M = $1.34M later.

     • Alternatively, suppose he borrows the present value of $0.2M , that is $0.2M/1.2 =
       $0.167M. Of course this loan needs to be reimbursed with interest later,
       i.e., $0.167M × 1.2 = $0.2M will have to be paid later. So Mr. Rossi is left
       with
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       1. $0.95M + $0.167M = $1.117M now;
       2. $0.2M − $0.2M = $0 later.
                 Should Mr. Rossi Invest in the Vineyard? (cont’d)

     • In fact, by borrowing or lending the appropriate amounts, Mr. Rossi could
       achieve any consumption on the following (continuous) line.

     • the consumption plans below (0.95M, 0.2M) are achieved by borrowing, and
       the consumption plans above (0.95M, 0.2M) are achieved by lending.

     • Mr. Rossi is better off by investing in the vineyard.

     • For example, if he chose to consume everything today, he could consume
       $1.117M now. In other words, his current wealth is increased by $1.117M −
       $1M = $0.117M.

     • Notice that this increase in wealth corresponds exactly to the project’s net
       present value (i.e., the present value minus the initial cost):

       1. N P VVineyard = $0.2M − $0.05M = $0.117M.
                            1.2
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                        Should Mr. Rossi Invest in the Vineyard? (cont’d)


                                             1.34M

                                                 1.2M




                                $ spent in old age
                                                     .2M                                 Vineyard



                                                                                      .95M 1M 1.117M
                                                           $ spent in youth           increase in wealth

                                                             total wealth = $1.117M



     • The net present value (NPV) is introduced/defined here for the first time.
        1. First, calculate the present value (PV) of future cash flows (here, there is only one
           future cash flow).
        2. Then subtract the initial cost.
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        3. The result is the net present value.
                                        Should Mr. Rossi Invest in the Vineyard? (cont’d)



     • More generally, Mr. Rossi can consume more both in his young and old age.



                    1.34M

                        1.2M
       $ spent in old age




                            .2M                         Vineyard



                                                     .95M 1M 1.117M
                                  $ spent in youth



     • For every consumption plan that Mr. Rossi had access to before, he now
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       can consume more now and later.
                             Should Mr. Rossi Invest in the Restaurant?

     • Similarly, if Mr. Rossi also invests in the restaurant, in addition to investing in the vineyard,
       he will be left with
        1. $1M − $0.05M − $0.1M = $0.85M now;
        2. $0.20M + $0.14M = $0.34M later.

     • As before, instead of simply consuming these amounts, Mr. Rossi could use borrowing and
       lending to achieve other consumption patterns:

     • Suppose he invests the whole $0.85M. This will generate $0.85M ∗ (1.2) = $1.02M later,
       so he is left with
        1. $0 now (since the whole $1M was invested);
        2. $1.02M + $0.34M = $1.36M later.

     • Alternatively, suppose Mr. Rossi borrows the present value of $0.34M , that is $0.34M/1.2 =
       $0.283M. Of course this loan needs to be reimbursed with interest later, i.e., $0.283M ×
       1.2 = $0.34M will have to be paid later. So he is left with
        1. $0.85M + $0.283M = $1.133M now;
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        2. $0.34M − $0.34M = $0 later.
                                                 Should Mr. Rossi Invest in the Restaurant? (cont’d)

     • In fact, by borrowing or lending the appropriate amounts, Mr. Rossi could achieve any
       consumption on the following (continuous) line.


                            1.36M
                            1.34M
                             1.2M
       $ spent in old age




                            .34M                          Vineyard+Restaurant
                                                              Vineyard



                                                       .85M 1M 1.117M 1.133M
                                    $ spent in youth


     • Mr. Rossi is better off by investing in both the vineyard and the restaurant, than just the
       vineyard.
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     • For example, if he chose to consume everything today, he could consume $1.133M now.
       In other words, his current wealth is increased by $1.133M − $1.117M = $0.016M.
                                      Should Mr. Rossi Invest in the Restaurant? (cont’d)

     • Again, this increase in wealth corresponds exactly to the project’s net present
       value (i.e., the present value minus the initial cost):

            1. N P VRestaurant = $0.14M − $0.1M = $0.016M.
                                   1.2


                            1.36M
                            1.34M
                             1.2M
       $ spent in old age




                            .34M                                Vineyard+Restaurant
                                                                    Vineyard



                                                           .85M 1M 1.117M 1.133M
                                    $ spent in youth

                                       total wealth = $1.133M
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                                      Should Mr. Rossi Invest in the Restaurant? (cont’d)

     • More generally, the line representing his possible consumption combinations
       is pushed farther out, i.e., he can consume more in both periods.

     • Therefore, Mr. Rossi should invest in the restaurant: this is true no matter
       what his preferences are, as long as he prefers more to less.



                            1.36M
                            1.34M
                             1.2M
       $ spent in old age




                            .34M                          Vineyard+Restaurant
                                                              Vineyard
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                                                       .85M 1M 1.117M 1.133M
                                    $ spent in youth
                        How Much Should Mr. Rossi Invest in Real Assets?

     • Clearly, Mr. Rossi should keep investing for as long as he can keep pushing
       out the line representing his consumption possibilities, i.e., for as long as he
       can find investments having a positive net present value.

     • Again, this is true independently of his preferences for consumption today
       versus consumption in the future.
       payoff of real
        Investment




                             1M-I *   1M
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            How Much Should Mr. Rossi Invest in Real Assets? (Cont’d)

     • From this picture, we can see that the following rule are equivalent:
       1. undertake all positive-NPV projects;
       2. invest in all projects with a return greater than r (IRR > discount rate);
       3. the last dollar invested in real investments returns r (the marginal return
          in real investments is r).
       4. This makes intuitive sense too: why would you invest in capital markets
          at a rate r if you can beat that using real investments?
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            How Much Should Mr. Rossi Invest in Real Assets? (cont’d)

     • Notice that by investing I ∗, Mr. Rossi would be investing up to the point at
       which the slope of the investment opportunity line just equals (minus) 1 + r.

     • The slope of the investment opportunity line tells you how many more dollars
       tomorrow you can have for an additional dollar of investment today, and thus
       equals (minus) 1 plus the rate of return of the marginal investment.

     • Therefore, we can also say that Mr. Rossi should invest for as long as he
       can find investments whose rates of return are above the interest rate.

     • In short, Mr. Rossi started with $1 million, invested some of it (I ∗) in real
       investment opportunities.

     • These real investments(projects) increased his current wealth by their net
       present value.
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                        How Much Should Mr. Rossi Invest in Real Assets? (cont’d)

     • We can think of Mr. Rossi’s assets as Mr. Rossi’s firm. The value of his
       firm is simply his total wealth, that is, the sum of
         1. the value of the firm’s initial assets ($1 million in cash), and
         2. the net present value of all the firm’s projects.
       payoff of real
        Investment




                                                    1M-I *        1M
                               PV of real investment
                              Cost of real investment
                              NPV of real investment

                         total wealth (total value of Mr. Rossi's firm)
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                                                           Solution to Mr. Rossi’s Problem

     • Now that Mr. Rossi has decided how much to invest in real investment
       opportunities, he can choose how much to borrow/lend.

     • This will depend on his preferences for consumption in youth versus con-
       sumption in old age, as represented by the shape of his indifference curves.




                     Preferences 1: lender
                     (ex: child's trust fund)



        return on
       investment
        in capital
         markets


         repay                                         Preferences 2: borrower
          loan                                              (ex: old man)




                                        1M-I *        1M
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                         amount lent
                                            amount
                                           borrowed
                       Implications for the Financial Manager



     • When facing investment decisions managers should accept investments with
       positive NPV. By doing so, they will be maximizing shareholders’ wealth.

     • The above criterion has nothing to do with the individual’s preferences for
       the timing (and risk) of their consumption pattern. Once their wealth is
       maximized, individual shareholders can use the capital market to achieve
       the profile of consumption they like the most.

     • It is because of this independence of the optimal investment decision from
       individual preferences that different shareholders can cooperate in the same
       firm and delegate the operation of that firm to a professional manager.
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                              Back to GM’s Problem



     • Although GM’s three investors claim to disagree, they should actually all
       want the same thing: maximization of their wealth, or, equivalently, the
       acceptance of all positive NPV projects.

     • They can allocate their maximized wealth through time using capital markets
       to borrow or lend. This will be done if the cash flows coming from the firm
       do not have the timing that the shareholders desire/prefer.

     • This is one of the advantages of the corporate form – all owners share the
       same preferences for corporate policy, so we can state a simple objective
       that the managers should follow.
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