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01 VALUE
- Finance and The
Financial Manager
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Topics Covered
What Is A Corporation?
The Role of The Financial ManagerWho Is The Financial Manager?
Separation of Ownership and Management
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Corporate Structure
Sole Proprietorships
Corporations
Partnerships
Limited Liability
Corporate tax on profits +
Personal tax on dividends
Unlimited LiabilityPersonal tax on profits
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Role of The Financial Manager
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors
(1)
(2) Cash invested in firm
(2)
(3) Cash generated by operations
(3)
(4a) Cash reinvested
(4a)
(4b) Cash returned to investors
(4b)
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Role of The Financial Manager
Common Finance Terminology
Real assets Financial assets / Securities
Capital markets and financial
markets Investment / capital budgeting
Financing
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Who is The Financial Manager?
Chief Financial Officer
ControllerTreasurer
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Present Value,
the Objectives of The Firm,
andCorporate Governance Slides by
Matthew Will
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Topics Covered
Introduction to Present Value
Foundations of the Net Present Value
Rule
Corporate Goals and Corporate
Governance
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Present and Future Value
Present Value
Value today of
a future cashflow.
Future Value
Amount to which aninvestment will grow
after earning interest
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Discount Factors and Rates
Discount Rate
Interest rate usedto compute
present values of
future cash flows. Discount Factor
Present value of
a $1 futurepayment.
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Future Values
Future Value of $100 = FV
FV rt
= +$100 ( )1
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Future Values
FV r t= +$100 ( )1
Example - FV
What is the future value of $5400,000 if interest iscompounded annually at a rate of 5% for one year?
000,420$)05.1(000,400$ 1 =+=FV
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Present Value
1factordiscount=PV
PV=ValuePresent
C
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Present Value
Discount Factor = DF = PV of $1
Discount Factors can be used to compute the present value of
any cash flow.
DFr
t=
+
1
1( )
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Valuing an Office Building
Step 1: Forecast cash flows
Cost of building = C0 = 400
Sale price in Year 1 = C1 = 420
Step 2: Estimate opportunity cost of capital
If equally risky investments in the capital market
offer a return of 5%, then
Cost of capital = r = 5%
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Valuing an Office Building
Step 3: Discount future cash flows
Step 4: Go ahead if PV of payoff exceeds investment
400)05.1(420
)1(1
===++r
CPV
30370400 ==NPV
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Net Present Value
r
C
+
+
1
C=NPV
investmentrequired-PV=NPV
10
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Risk and Present Value
Higher risk projects require a higher rate of
return
Higher required rates of return cause lower
PVs
400.051
420PV
5%at$420CofPV 1
=
+
=
=
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Risk and Present Value
400.051
420PV
5%at$420CofPV 1
=
+
=
=
375.121
420PV
12%at$420CofPV 1
=
+
=
=
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Risk and Net Present Value
$5,000
370,000-75,0003=NPV
investmentrequired-PV=NPV
=
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Rate of Return Rule
Accept investments that offer rates of return
in excess of their opportunity cost of capital
Example
In the project listed below, the foregone investment
opportunity is 12%. Should we do the project?
13.5%or.135370,000
370,000420,000
investment
profitReturn =
==
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Net Present Value Rule
Accept investments that have positive net
present value
Example
Suppose we can invest $50 today and receive$60 in one year. Should we accept the project
given a 10% expected return?
55.4$1.10
60+-50=NPV =
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Opportunity Cost of Capital
Example
You may invest $100,000 today. Depending on the
state of the economy, you may get one of threepossible cash payoffs:
140,000110,000$80,000Payoff
BoomNormalSlumpEconomy
000,110$3
000,140000,110000,80CpayoffExpected 1 =
++==
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Opportunity Cost of Capital
Example - continued
The stock is trading for $95.65. Next years price,
given a normal economy, is forecast at $110
The stocks expected payoff leads to an expectedreturn.
15%or15.65.95
65.95110profitexpected
returnExpected =
==
investment
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Opportunity Cost of Capital
Example - continued
Discounting the expected payoff at the expected
return leads to the PV of the project
650,95$1.15
110,000
PV ==
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Opportunity Cost of Capital
Example - continued
Notice that you come to the same conclusion if you
compare the expected project return with the costof capital.
10%or10.
000,100
000,100000,110profitexpectedreturnExpected =
==
investment
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Investment vs. Consumption
Some people prefer to consume now. Some
prefer to invest now and consume later.Borrowing and lending allows us to
reconcile these opposing desires which mayexist within the firms shareholders.
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Investment vs. Consumption
A
B
100
80
60
40
20
40 60 80 100income in period 0
income in period 1
Some investors will prefer A
and others B
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Investment vs. Consumption
The grasshopper (G) wants to
consume now. The ant (A) wants to
wait. But each is happy to invest.Each invests $185,000 and returns
$210,000 at the end of the year. G
wants to consume now so G borrows$200,000 and repays $210,000 at the
end of the year. The existence of
capital markets allows G to consumenow and still invest with A in the
project.
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Investment vs. Consumption
The grasshopper (G) wants to consume
now. The ant (A) wants to wait. But
each is happy to invest. Each invests
$185,000 and returns $210,000 at the end
of the year. G wants to consume now soG borrows $200,000 and repays
$210,000 at the end of the year. The
existence of capital markets allows G to
consume now and still invest with A inthe project.
185 200Dollars
Now
Dollars
Next Year
210
194
A invests $185 now
and consumes $210
next year
G invests $185 now,
borrows $200 and
consumes now.
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Managers and Shareholder Interests
Tools to Ensure Management Pays
Attention to the Value of the Firm
Mangers 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
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Whose Company Is It?
24
29
78
83
97
76
71
22
17
3
0 20 40 60 80 100 120
UnitedStates
UnitedKingdom
France
Germany
Japan
% of responsesThe Shareholders
All Stakeholders
** Survey of 378 managers from 5 countries
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Dividends vs. Jobs
11
11
59
60
97
89
89
41
40
3
0 20 40 60 80 100 120
UnitedStates
UnitedKingdom
France
Germany
Japan
% of responsesDividends
Job Security
** Survey of 399 managers from 5 countries. Which is more important...jobs orpaying dividends?
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Goals of The Corporation
Shareholders desire wealth
maximization
Do managers maximize shareholder
wealth?
Mangers have many constituenciesstakeholders
Agency Problems represent theconflict of interest between
management and owners
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Goals of The Corporation
Agency Problem Solutions
1 - Compensation plans
2 - Board of Directors
3 - Takeovers
4 - Specialist Monitoring5 - Auditors
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Agency Problems,Management
Compensation, and
The Measurement
of PerformanceSlides by
Matthew Will
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Topics Covered
The Capital Investment Process
Decision Makers Need Good Information
Incentives
Residual Income and EVA
Bias in Accounting Measures of
Performance
Measuring Economic Profitability
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The Principal Agent Problem
Shareholders = Owners
Managers = Employees
Question: Who has
the power?
Answer: Managers
i l i i
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Capital Investment Decision
Project Creation
Bottom Up
Strategic Planning
Top Down
Capital Investments
i l
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Capital Investment Process
Capital budget
Project authorization
R&D
Marketing
Post-audits
Off B d E di
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Off Budget Expenditures
Information Technology
Research and DevelopmentMarketing
Training and Development
I f i P bl
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Information Problems
1. Consistent Forecasts
2. Reducing Forecast Bias
3. Getting Senior Management
Needed Information
4. Eliminating Conflicts of
InterestThe correct
information
is
l & All S d
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Brealey, Myers & Allens Second Law
The proportion of proposedThe proportion of proposed
projects having a positive NPVprojects having a positive NPVat the official corporate hurdleat the official corporate hurdle
rate is independent of therate is independent of thehurdle rate.hurdle rate.
I i
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Incentives
Reduced effort
Perks
Empire building
Entrenching investment
Avoiding risk
Agency Problems in Capital Budgeting
I ti I
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Incentive Issues
Monitoring - Reviewing the actions of managers
and providing incentives to maximize shareholder
value.
Free Rider Problem - When owners rely on the
efforts of others to monitor the company.
Management Compensation - How to paymanagers so as to reduce the cost and need for
monitoring and to maximize shareholder value.
CEO C ti (2003 04)
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CEO Compensation (2003-04)
0
500
1000
1500
2000
2500
$1,000s
Australia
Canada
China
Fance
Germany
India
Italy
Japan
Mexico
Netherlands
Singapore
Spain
Sweden
Switzerland
U
nitedKingdom
UnitedStates
Benefits
Perks
Options & OthersVariable Bonus
Basic Compensation
R id l I & EVA
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Residual Income & EVA
Techniques for overcoming errors in accountingmeasurements of performance.
Emphasizes NPV concepts in performanceevaluation over accounting standards.
Looks more to long term than short termdecisions.
More closely tracks shareholder value thanaccounting measurements.
R id l I & EVA
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Residual Income & EVA
Income
Sales 550
COGS 275
Selling, G&A 75
200
taxes @ 35% 70
Net Income $130
Assets
Net W.C. 80
Property, plant and
equipment 1170
less depr. 360
Net Invest.. 810
Other assets 110
Total Assets $1,000
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
R id l I & EVA
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Residual Income & EVA
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
13.000,1
130==ROI
Given COC = 10%
%3%10%13 ==NetROI
R id l I & EVA
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Residual Income & EVA
Residual Income or EVA = Net Dollar return
after deducting the cost of capital
EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
[ ]InvestmentCapitalofCost-EarnedIncome
requiredincome-EarnedIncomeIncomeResidual
=
=
=EVA
R id l I & EVA
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Residual Income & EVA
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
Given COC = 10%
million03$
)000,110(.130IncomeResidual
+=
=
=EVA
E i P fit
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Economic Profit
Economic Profit= capital invested
multiplied by the spread between return on
investment and the cost of capital.
EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
InvestedCapital)(
ProfitEconomic
=
=
rROI
EP
E i P fit
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Economic Profit
EVA is copyrighted by Stern-Stewart Consulting Firm and used with permission.
Quayle City Subduction Plant ($mil)Quayle City Subduction Plant ($mil)
Example at 10% COC continued.
million$30
1,000.10)-.13(InvestedCapital)(
=
=
=
rROIEP
Message of EVA
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Message of EVA
+ Managers are motivated to only invest in
projects that earn more than they cost.
+ EVA makes cost of capital visible tomanagers.
+ Leads to a reduction in assets employed.- EVA does not measure present value
- Rewards quick paybacks and ignores timevalue of money
EVA of US firms 2003
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EVA of US firms - 2003
($ in millions)
Econimic Value Added
(EVA)
Capital
Invested
Return on
Capital
Cost of
CapitalWal-Mart Stores 4,525 79,177 12.30% 6.60%
Johnson & Johnson 4,459 51,508 17.6 8.9
Microsoft 4,027 24,677 29.8 13.5
Merck 3,347 40,941 16.9 8.7
Coca Cola 2,729 20,503 20.1 6.7
Intel Corp. (57) 31,216 15.6 15.8
Dow Chemical (1,503) 44,158 3.6 7
Boeing (1,974) 50,046 2.2 6.1
Delta Airlines (2,288) 27,238 -0.9 7.5Viacom (5,508) 96,515 3.5 9.2
IBM (7,505) 108,926 4.6 11.5
Accounting Measurements
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Accounting Measurements
0
011 )(
pricebeginning
priceinchangereceiptscashreturnofRate
PPPC +=
+=
Economic income = cash flow + change in present value
0
011 )(returnofRatePV
PVPVC +=
Accounting Measurements
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Accounting Measurements
ECONOMIC ACCOUNTING
Cash flow + Cash flow +change in PV = change in book value =
Cash flow - Cash flow -
economic depreciation accounting depreciation
Economic income Accounting income
PV at start of year BV at start of year
INCOME
RETURN
Nodhead Book Income & ROI
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Nodhead Book Income & ROI
1 2 3 4 5 6Cash flow 100 200 250 298 298 298
Book value at start of year,
straight-line depreciation 1000 833 667 500 333 167
Book value at endof year,
straight-line depreciationBook depreciation 167 167 167 167 167
Book income -67 33 83 131 131
Book ROI -0.67 0.04 0.124 0.262 0.393 0.784
Forecasted EVA (5-.1 *2) -167 -50 17 81 98 115
Year
Nodhead Store Forecasts
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Nodhead Store Forecasts
1 2 3 4 5 6
Cash flow
PV, atstart of year, 10 percent
discount rate 1000 1000 901 741 517 271
PV, at endof year, 10 percent
discount rate
Economic depreciation 0 100 160 224 246 271
Economic income 100 100 90 74 52 27
Rate of return 0.1 0.1 0.1 0.1 0.1 0.1
Forecasted EVA (5-.1*2) 0 0 0 0 0 0
Year
Nodhead Peer Book ROI
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Nodhead Peer Book ROI
1 2 3 4 5 6
Book Income for store
1 -67 33 83 131 131 131
2 -67 33 83 131 131
3 -67 33 83 1314 -67 33 83
5 -67 33
6 -67Total book income -67 -34 49 180 311 442
Book value for store1 1000 833 667 500 333 167
2 1000 833 667 500 333
3 1000 833 667 500
4 1000 833 667
5 1000 833
6 1000Total book value 1000 1833 2500 3000 3333 3500
Book ROI for all
stores -0.067 -0.019 0.02 0.06 0.093 0.126
EVA for all stores -167 -217 -201 -120 -22 92
Year
Nodhead Growth v Return
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Nodhead Growth v. Return
Rate of Return
(%)
Rate of Growth
(%)
Economic rate of return
Book rate of return
12
11
10
9
8
7
5 10 15 20 25