COURSERA

LECTURE NOTES AN INTRODUCTION TO CORPORATE FINANCE

Franklin Allen Wharton School University of Pennsylvania Fall 2013 WEEK 1 Section 1 Introduction

Copyright 2013 by Franklin Allen

An Introduction to Corporate Finance - Section 1 - Page 1 Section 1: Introduction Supplemental Reading: BMA Chapter 1

Purpose of the Course The purpose of the course is to give you a framework for thinking about how a firm should make investment and financing decisions to create value for its shareholders. In order to do this we will not only need to look at the firm but also to consider how financial markets work and how investors in those markets should make decisions. By the end of the course you should have a framework for thinking about business problems.

Review of Background Material Microeconomics You need to know about indifference curves and utility maximization subject to a budget constraint. If we have two commodities, apples and bananas say, we can represent a person's preference for these commodities by indifference curves

An Introduction to Corporate Finance - Section 1 - Page 2

Apples utility increasing

Bananas

An indifference curve is the locus of combinations of apples and bananas such that the person is indifferent. It is assumed more is preferred to less, so moving in a northeasterly direction utility is increasing. We are all constrained by a budget constraint: we can't spend more than our income on apples and bananas. It must be the case that PA A + PB B I where PA, PB are the prices of apples and bananas respectively, A and B are the quantities purchased, and I is income. This can be represented on our usual diagram.

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A consumption bundle must be on the line or below

I PA

PB I B PA PA

I PB

If we add indifference curves to this diagram of the budget constraint we can use it to find the combination of A and B a person will choose if he maximizes his utility. A utility maximizing choice

demand for apples

demand for bananas

In the next section we will be using these concepts a lot, so if you are at all shaky on them, you should review them as soon as possible.

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Future Values and Present Values One of the most important ideas in finance is present value. If you put $1 in the bank today at 10% interest, then in a year's time youll have $1.10. This involves going forward through time. FV = 1 x 1.10 = $1.10 An equivalent notion is to go backwards through time and say that the present value of $1.10 in one year's time if the interest rate is 10% is $1 now, i.e., PV = 1.10 = $1 1 + 0.10 In general, $C1 one year from now if the interest rate is r has PV = C1 1+r Suppose you put $1 in the bank today at 10% interest, then in two years time youll have FV = $1x1.102=$1.21 Alternatively we can say that the present value of $1.21 in two years time if the interest rate is 10% is $1 now, i.e., PV = 1.21 = $1 (1 + 0.10)2 In general, $C2 two years from now if the interest rate is r has PV = C2 (1 + r)2 Similarly, $Ct t years from now has PV = Ct (1 + r)t

An Introduction to Corporate Finance - Section 1 - Page 5 Suppose next we have a stream of cash flows C1, C2, C3, , CT. We can represent this on a time line: Date 0 | Cash Flows 1 | C1 2 | C2 3 | C3 T | CT

The equivalent in terms of todays money of this stream of cash flows is

C1 C2 C3 CT + + + ... + 2 3 1 + r (1 + r ) (1 + r ) (1 + r )T

PV =

Summing Geometric Series: Perpetuities Fairly soon we'll be talking a lot about PV's, and one of the things it will be useful to know is how to sum a geometric series. A special case of a sequence of cash flows that is of interest is when the cash flow at every date is the same, i.e. Ct = C for every date t and this stream goes on forever. This is called a perpetuity. Date 0 | Cash Flows (1) 1 | C 2 | C 3 | C

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

Multiplying (1) by (1 + r) gives: (2) (1 + r)PV = C + C + C + C + .... 1 + r (1 + r)2 (1 + r)3

An Introduction to Corporate Finance - Section 1 - Page 6 Subtracting (1) from (2): rPV = C PV = C r As an example, suppose C = $20 and r = 0.10 then PV = 20/0.10 = $200. Another way to see what is going on here is to consider the case where you put $200 in the bank at 10% forever and receive $20 per year forever. A stream of $20 forever is therefore equivalent to $200 today. In general, if you put PV in the bank you receive C = rPV forever so PV = C/r. Now that's the last time I'm going to go through the algebra of that or any other derivation of a formula on the board. In the future I'll just refer you back to this lecture for perpetuities and give you the general outline for other cases. However at this point you should memorize the fact that for perpetuities you just divide by the interest rate. There will be derivations of formulas in the appendix for Section 3 and in the solutions to Problem Set 2. If at any point you find yourself thinking where does that formula come from you can check it out.

Statistics We won't be using the statistics for some time and when we get to the point we do need it, I'll review it. For those of you who want some more time to refresh your memory, I'll just list the basic concepts you'll need to understand: Random Variable Probability

An Introduction to Corporate Finance - Section 1 - Page 7 Expectation The Mean or Average Variance Standard deviation Covariance Correlation That's the basic background knowledge you'll need. If you are at all doubtful about any of the concepts, review them soon.