Principles of

Corporate
Finance
Course topics
•Basic concepts of Corporate Finance
Seventh Edition
•Risk, portfolio selection, budgeting
Richard A. Brealey
Stewart C. Myers
•Incentives of managers
•Financial markets
•Asset valuation
•Debt structure
•Risk management
. •Cash management

Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Organization

Lectures (Prof. Kirstein) Thu 1:30-3 p.m. in A-013

No regular office hours (D-003), send an email to
bizecon@rolandkirstein.de

Tutorial (Sidi Koné) Mon 11.15-12.45, A-211

Final exam in February

Book: Brealey/Myers (7th or later ed.; or any other textbook)

Homepage http://www.ww.uni-magdeburg.de/bizecon
=> teaching, Winter 2009/10, Financial Management
=> slides, book, exercises, further information

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Section 1: Why Finance matters

What Is A Corporation?

The Role of The Financial Manager

Who Is The Financial Manager?

Separation of Ownership and Management

Financial Markets

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Corporate Structure

Sole Proprietorships
Unlimited Liability
Personal tax on profits
Partnerships

Limited Liability

Corporations Corporate tax on profits +

Personal tax on dividends

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Role of The Financial Manager

(2) (1)

Firm's Financial Financial

(4a)
operations manager markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Who is The Financial Manager?

Chief Financial Officer

Treasurer Comptroller

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Ownership vs. Management

Difference in Information Different Objectives

Stock prices and returns
Managers vs.

Issues of shares and stockholders
other securities
Top mgmt vs. operating

Dividends mgmt

Financing
Stockholders vs. banks
and lenders

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
Principles of
Corporate Chapter 2
Finance
Present Value and The
Seventh Edition
Opportunity Cost of Capital
Richard A. Brealey
Stewart C. Myers

.
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Topics Covered

Present Value

Net Present Value

NPV Rule

ROR Rule

Opportunity Cost of Capital

Managers and the Interests of Shareholders

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Present Value

Present Value Discount Factor

Value today of a Present value of
future cash a $1 future
flow. payment.

Discount Rate
Interest rate used to compute
present values of future cash
flows.

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Present Value

PV = discount factor × C1

1st basic principle of Financial Economics:

A $ today is more worth than a $ tomorrow

(i.e., discount factors are positive, but smaller than one)

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Present Value

Discount Factor = DF = PV of $1

DF = 1
(1+ r )

Discount Factors can be used to compute

the present value of any cash flow.

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Valuing an Office Building

Step 1: Forecast cash flows
Cost of building = C0 = 350
Sale price in Year 1 = C1 = 400

Step 2: Estimate opportunity cost of capital

If equally risky assets in the capital market
yield a return of 7%, then the opportunity
cost of the investment = r = 7%

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Valuing an Office Building

Step 3: Discount future cash flows

PV = C1
(1+r) = 400
(1+.07) = 374
Step 4: Go ahead if PV of payoff exceeds investment

NPV = −350+ 374 = 24

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Net Present Value

NPV = PV - required investment
C1
NPV = C 0 +
1+ r

required rate of return: the rate at which NPV=0

If the ROR of an investment equals the

opportunity cost of capital, then NPV=0

Hence, required ROR = oppcost of capital

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Risk and Present Value

2nd basic principle of Financial Economics:

A safe $ has a higher value than a risky one

(i.e., future risky returns have to be weighed

with their probability AND discounted)

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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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

E.g., if the required rate of return is not 7% (low

risk), but 12% (high risk):

PV of C1 = $400 at 7%
400
PV = = 374
1 + .07
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Risk and Present Value

PV of C1 = $400 at 12%
400
PV = = 357
1 + .12
1+
PV of C1 = $400 at 7%
400
PV = = 374
1 + .07
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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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?

profit 400,000 − 350,000

Return = = = .143 or 14.3%
investment 350,000

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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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?
60
NPV = -50 + = $4.55
1.10
Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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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 three
possible cash payoffs (with equal probability):

Economy Slump Normal Boom

Payoff $80,000 110,000 140,000
80,000 + 110,000 + 140,000
Expected payoff = C1 = = $110,000
3

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Opportunity Cost of Capital

Example - continued
Alternative investment is buying stock for $95.65. Next
year’s stock price is predicted as $110.

The stocks expected payoff leads to an expected return

=> OCC or required ROR

expected profit 110 − 95.65

Expected return = = = .15 or 15%
investment 95.65

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.
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Opportunity Cost of Capital

Example - continued
Using the required ROR to discounting the expected
payoff at the expected return leads to the PV of the
project

110,000
PV = = $95,650 < $100,000
1.15

Prof. Dr. R. Kirstein, WT2009/10, Management V, Financial Management: BrealeyMyers, 7th ed.