Financial Management

Lecture 1

Lawrence Hsiao

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 Introduction
This course provides an introduction to the principles of modern finance, emphasizing
the financial aspects of managerial decisions.

• Financial managers are hired to make the financial decisions of the business for the
stockholders (firm owners).

• Goal: to maximize the wealth of the stockholders.

• Making investment decisions:

 Weigh the costs and benefits of each investment project: accept or reject?
 Example: whether to invest in the development of the first “iPhone”?

• Making financing decisions:

 Raising capital: to sell more shares of stock (equity) or borrow the money instead
(bonds and other debt)
 How does the investing public interpret a firm’s capital structure decision?

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 Introduction

Definition of Financial Management: the efficient acquisition

and allocation of financial resources to ensure that the
objectives of a firm are achieved.

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 The Goal(s) of Financial Management

A. Maximize profits, minimize costs.

B. Maintain steady earning growth

C. Reduce stock price volatility

D. …?

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 The Goal(s) of Financial Management

→ Add value for the owners!

→ Maximize the current value per share of the existing stock.

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 Terminology

*Capital structure: the proportions of the firms’

financing from debt and equity.

• The accounting equation: Assets = Liabilities + Equity.

• Assets (total value): things of value owned by a firm

• Liabilities (debt): obligations owed to others

• Equity (shareholder’s equity): the book value of a firm

(the value of a firm after all its debts have been paid)
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 Capital structure

Assets

Equity
40%
Liabilities
60%

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 The Principal-agent problem
• Shareholders (principals) hire managers (agents) to run the
company. However, do managers always act in the shareholders’
best interests?

• Example: work 1 hour a week you get $1,000; work 40 hours a week
you get $2,000.

• There are, apparently, conflicts of interests.

Source: Dilbert.com

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 Logistics
• Grading:

Midterm (10/20): (50%)

Final (12/15): (50%)

• Relative Grading System: Final grades will be assigned

based on how students perform relative to each other.

• The target distribution for A+ grades is approximately 10%-

15%

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 Logistics (continued)

• Office hour: By appointment

• No class on 9/29 (Make-up holiday as Teachers' Day)

and 10/6 (Moon Festival)

• I’ll assign some exercises as homework. We’ll go over

those problems in the following week.

• TA:
Paul (r12723057@ntu.edu.tw)
Paula (b12702097@ntu.edu.tw)

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 Textbook

• Corporate Finance: Core Principles and Applications, Stephen A. Ross,

Randolph W. Westerfield, Jeffrey F. Jaffe, Bradford D. Jordan (Main)

• Corporate Finance, Stephen A. Ross, Randolph W. Westerfield,

Jeffrey F. Jaffe, Bradford D. Jordan (Supplementary)

• Prerequisites for this course: Accounting principles

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 Big picture
• Discounted Cash Flow Valuation

• Interest Rates and Bond Valuation

• Stock Valuation

• Making Capital Investment Decisions

• Risk and Return, CAPM, Market efficiency, Portfolio theory

• Cost of Capital and Valuation

• Capital Structure with and without leverage

• Behavioral Finance

• Advanced topics
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 Registration

• Our classroom is near maximum capacity.

• On 9/4, I’ll hold a draw and send registration stickers to those who are
selected.

• If you do not receive a sticker by the end of 9/5 → you are not selected.

• Now, please come to front with your student ID card if you are
interested in taking the course.

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 Chapter 4

Discounted Cash Flow Valuation

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The Time Value of Money

• A dollar today is more valuable than a dollar in the

future.

• Interest rate (discount rate)

• In this class we assume there’s no inflation

→ nominal interest rate = real interest rate

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16
Present Value (PV) and Future Value (FV)

The value today of a payment to be received in the future.

• This measure is called the “present value.”

The value in the future of a sum invested today.

• This measure is called the “future value.”

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4.1 The One-Period Case

If you were to invest $10,000 at 5-percent interest for one year,

your investment would grow to $10,500.

• $500 interest (= $10,000 × .05)

• $10,000 principal repayment (= $10,000 × 1)
• $10,500 ($500+$10,000) is the total due.

It can be calculated as: $10,500 = $10,000 × (1.05)

The total amount due at the end of the investment is the

Future Value (FV).
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Future Value Formula

In the one-period case, the formula for FV can be written as:

FV = C0  (1+ r)

Where C0 is cash flow today (time zero), and r is the interest

rate.

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Present Value formula

In the one-period case, the formula for PV can be written as:

C1
PV =
1+ r

Where C1 is cash flow at Date 1, and r is the appropriate

interest rate.

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Example: Present Value
Suppose you were promised $10,000 due in one year when
the annual interest rate is 5%.

Your investment would be worth $9,523.81 in today’s dollars.

$10, 000
$9,523.81 =
1.05

Note that $10,000 = $9,523.81 × (1.05).

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Net Present Value

The Net Present Value (NPV) of an investment:

NPV = PV –Cost

the present value of the expected cash flows, less the cost of
the investment today.

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Net Present Value: Example

Suppose an investment that promises to pay $10,000 in one

year is offered for sale for $9,500. Your interest rate is 5%.

Accept the investment?

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Net Present Value Formula

In the one-period case, the formula for NPV can be written as:

NPV = –Cost + PV

NPV= –9,500+10,000/1.05 >0

The present value of the cash inflow is greater than the cost.

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Net Present Value

If we had not undertaken the positive NPV project considered

on the last slide, and instead invested our $9,500 elsewhere
at 5 percent.

Our FV would be less than the $10,000 the investment

promised, and we would be worse off in FV terms:

$9,500 × (1.05) = $9,975 < $10,000

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4.2 The Multiperiod Case

The previous examples considered only one period of time.

We’d like to compute PV & FV for multiple periods of time.

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Compound Interest

Suppose an investor has $1,000 to invest at an interest rate

of 9%.

In one year, she will have earned $90.

Now suppose that the investor reinvests both the original

$1,000 capital AND $90 earnings for another year at 9%.

In one year she will have earned $98.10.

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Compound Interest

• The effect of earnings interest on both the original principal

plus the accumulated interest is known as compound
interest.

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Multiperiod Future Value

The general formula for the future value of an investment

over many periods can be written as:

FV = C0  (1+ r)T

Where C0 is cash flow at date 0, r is the appropriate interest

rate, and T is the number of periods over which the cash is
invested.

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Example: Multiperiod Future Value

Suppose you save $1.10 in a bank for five years. The annual
interest rate is 40%.

What is the amount of your investment in five years?

FV = C0  (1+ r) T

$5.92 = $1.10  (1.40)5

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Future Value and Compounding illustrated

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Example: Multiperiod Present Value and Discounting

How much would an investor have to set aside today in order

to have $20,000 five years from now if the current rate is
15%?

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Solve for Any Variable

Examples thus far have offered the time and interest rate and
solved for PV or FV.

Keep in mind that there are four variables:

• PV
• FV
• T
• R
𝑃𝑉 ∗ (1 + 𝑅)𝑇 = 𝐹𝑉
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Example: Solving for Time

If we deposit $5,000 today in an account paying 10%, how

long does it take to grow to $10,000?

$10,000 = $5,000  (1.10)T

$10,000
(1.10) =
T
=2
$5,000

ln(1.10)T = ln(2)
ln(2) 0.6931
T= = = 7.27 years
ln(1.10) 0.0953
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Example: Solving for Required Rate of Return

Assume the total cost of a college education will be $50,000

when your child enters college in 12 years. You have $5,000
to invest today. What rate of interest must you earn on your
investment to cover the cost of your child’s education?

FV = C0  (1+ r)T $50,000 = $5,000  (1+ r)12

$50,000
(1+ r) =
12
= 10 (1+ r) = 10 1 12
$5,000

r = 101 12 −1 = 1.2115−1 = .2115

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Multiple Cash Flows

Consider an investment that pays $200 one year from now,

with cash flows increasing by $200 per year through year 4.
If the interest rate is 12%, what is the present value of this
stream of cash flows?

If the issuer offers this investment for $1,500, should you

purchase it?

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Example: Multiple Cash Flows

Present Value < Cost → Do Not Purchase

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Computing FV with Multiple Compounding Periods

Compounding an investment m times a year for a total of T

years results in a future value of

mT
 r
FV = C0  1+ 
 m

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Compounding Periods

For example, if you invest $50 for 3 years at 12%

compounded semi-annually, your investment will grow to:

23
 .12 
FV = $50   1 +  = $50  (1.06) 6 = $70.93
 2 

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Effective Annual Rates of Interest

What is the effective annual rate of interest on that investment?

.12 23
FV = $50 (1+ ) = $50 (1.06) 6 = $70.93
2

The Effective Annual Rate (EAR) of interest in this

example is the annual rate that would give us the same
end-of-investment wealth after 3 years:

$50  (1+ EAR) 3 = $70.93

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Example 1: Effective Annual Rates of Interest

FV = $50  (1+ EAR) 3 = $70.93

$70.93
(1+ EAR) = 3
$50
13
 $70.93 
EAR =   −1 = .1236
 $50 

So, investing at 12.36% compounded annually is the same as investing at

12% compounded semi-annually.

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Example 2: Effective Annual Rates of Interest

Find the Effective Annual Rate (EAR) of an 18% loan that is

compounded monthly.

What we have is a loan with a monthly interest rate of 1.5%.

This is equivalent to a loan with an annual interest rate of

19.56%.
m
 r   .18 
12

1+  = 1+  = (1.015)12 = 1.1956

 m  12 

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Computing FV with Multiple Compounding Periods

Compounding an investment m times a year for T years

provides for the future value of wealth:

mT
 r
FV = C0  1+ 
 m

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44
Continuous Compounding

The general formula for the future value of an investment compounded

continuously over many periods can be written as:

FV = C0  e rt

Where C0 is cash flow at date 0, r is the stated annual interest rate, T is

the number of years, and e is a constant that is approximately equal to
2.718.

• Proof (take-home exercise)

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Simplifications: Four classes of cash flow streams

• Perpetuity

• Growing Perpetuity

• Annuity

• Growing Annuity

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Perpetuity
A constant stream of cash flows that lasts forever.

C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3

C
PV =
r
Example: Perpetuity

What is the value of a British consol that promises to pay £15

every year forever?

The interest rate is 10%.

PV= 15/0.1 = 150

Growing Perpetuity

A growing stream of cash flows that lasts forever.

C C  (1 + g ) C  (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

C
PV =
r−g
Example: Growing Perpetuity

The expected dividend next year is $1.30, and dividends are

expected to grow at 5% forever.

If the discount rate is 10%, what is the value of this promised

dividend stream?

$1.30
PV = = $26.00
.10 − .05
Expected v.s. current
Annuity

A constant stream of cash flows with a fixed maturity.

C C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r )t

C 1 
PV = 1 −
r  (1 + r )t 
Example 1: Annuity

If you can afford a $400 monthly car payment, how much car
can you afford if interest rates are 7% on 36–month loans?

$400  1 
PV = 1− 36 
= $12,954.59
.07 /12  (1 + .07 12) 
Example 2: annuity

What is the present value of a four–year annuity of $100 per

year that makes its first payment two years from today if the
discount rate is 9%?
4
$100 $100 $100 $100 $100
PV1 =  t
= 1
+ 2
+ 3
+ 4
= $323.97
t =1 1.09 1.09 1.09 1.09 1.09

$327.97
PV = 1.09 = $297.22
0
Growing Annuity

A growing stream of cash flows with a fixed maturity.

C C  (1 + g ) C  (1 + g )t −1
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r )t

C   (1 + g )  
t

PV = 1 −   
r − g   (1 + r )  
Example: Growing Annuity

A retirement plan offers to pay $20,000 per year for 40 years

and increase the annual payment by three–percent each year.
What is the present value at retirement if the discount rate is
10 percent?

$20,000   1.03  
40

PV = 1 −    = $265,121.57
.10 − .03   1.10  
Application 1: Pure Discount Loans

If a T-bill promises to repay $10,000 in 12 months and the

market interest rate is 7 percent, how much will the bill sell
for in the market?

• PV = 10,000 / 1.07 = 9,345.79 = the price of this T-bill

• What if the price is lower/higher than $9,345.79?

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Application 2: Loans with interests

Consider a 5-year loan with a 7% interest rate. The principal amount is

$10,000. Interest is paid annually.

• What would the stream of cash flows be?

• Years 1 to 4: Interest payments of .07(10,000) = 700

• Year 5: Interest + principal = 10,700

What is the price of this loan? We need a discount rate, r.

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What Is a Firm Worth?

Conceptually, a firm should be worth the present value of the

firm’s future cash flows.

The tricky part is determining the size, timing and risk of

those cash flows.

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