2. COURSE 42.254 ESSENTIALS OF BUSINESS FINANCE

3. WHAT IS FINANCE?  It’s all about

4. WHAT IS FINANCE?  It’s all about

5. It’s not just about MONEY  But to money

6. Not just to Make Money  But to make money

7. Not just to make more money  But to USE

8. Historical Background  Money is one of the greatest invention in human history  At first, Money only acts as a media for trading goods  Later, people discover that they can also make use of Money to Make More Money

9. What is Finance?  Finance is a subject or branch of knowledge that teaches you how to use Money to Make More Money  It is different from Accounting because accounting only teaches you how to record the money or to save money  To some extent, it also teaches you how to make more money. But it never teaches you to use money to make money.

10. Why should you be interested in Finance?  Because you fall in love with money  Soon you will manage your own money for your future  Learn how to use others’ money to make money for yourself

11. WHAT IS BUSINESS FINANCE?  Business finance refers to the financial decision making in a corporate setting

12. Three Forms of Business Organization  Sole Proprietor – single owner with unlimited liability and limited access to capital  Partnership – partners share the unlimited liability with greater access to capital  Public Listed Company – owned by shareholders with limited liability and the greatest access to capital

13. The Goals of Business Finance  To make use of shareholders’ money to make more money for them  Primary objective is to maximize the long- term wealth of the shareholders by increasing the share price of the company  An increase in share price is achieved by earning an attractive return subject to an acceptable level of risk

14. The Agency Problem  Management (agents for the shareholders in managing the business) may be more interested in their short-term compensation, power, autonomy, etc  To align the interest of the management with the shareholders, corporation may tie executive salary to stock price of the company and/or issue stock options as bonuses.

15. What does CFO actually do?  Basically CFOs have two broad responsibilities that boil down to two simple questions  How to raise money for the company?  How to invest the money that has been raised?

16. How to raise money for a company?  For long-term purpose (> 1 year), we may issue corporate bonds, common stock and preferred stock – classes 2 & 3  For short-term purpose (< 1 year), we can raise money by managing working capital and current asset – classes 9 & 11  Either way, we need to know the cost of capital – class 4

17. How to invest the capital?  Primary objective is to get an investment return greater than the cost of capital  The greater the return, the higher the risk of the investment  Final decision or choice is a tradeoff between risk and return  Investment opportunities and selection require an understanding of capital market and capital budgeting – classes 5, 6 & 8

18. International sources of capital and inv. Opp.  Due to the globalization of our economy, we have new sources of capital coming from outside of the country  Also we are able to diversify our investments to foreign countries  As a result, we have to learn something about the international financial management – class 12

19. Are you ready to go?  Not yet.  You have to pick up some skills or tools that would help you through  First equip with the fundamental theory of finance – Time Value of Money  Then pick up basic valuation technique – discount cash flow – classes 2 & 3

20. Who wants to be a Millionaire?  According to Forbes magazine in 2003, who is the second richest man in the world?  A) Paul Allen  B) Bill Gates  C) Lawrence Ellison  D) Warren Buffett

21. Question 2  Based on the 1999 UN report, the 200 richest people in the world have money more than combined income of what percentage of poorest people in the world?  A) 30%B) 40%  C) 50%D) 60%

22. Poverty Gap is Widening  Even though you know how to make money, you are not a successful person.  It’s until you know how to share with people the money you made, you will be a true successful person with a meaningful life.  "Only a life lived for others is a life worth while." Albert Einstein

23. Question 3  Amanda was not a very smart girl but she managed to graduate from the university at age 20. Then she worked for an accounting firm and began to save $5,000 a year in a RSP for the next 10 years. After that, she got married and stopped contributing to the plan again.

24. Question 3 cont’  James was a smart boy at the same age as Amanda. He studied medicine in university and became a doctor at age 25. Then he spent 10 years in paying back his student loan. It was until age 35, he began to invest in a RSP. He kept saving $5000 a year until he retired at age 55.

25. Question 3 cont’  Assume both have invested in the same saving plan, who will have more money in the RSP when they retire at age 55?  A) Amanda  B) James  C) Both are the same  D) Cannot be determined

26. Why can the money grow?  Money can grow because interest can be earned on the money saved  It may grow by simple or compound interest arrangement  Simple interest – interest can be made on the principal only  Compound interest – interest can also be made on the interest generated by the principal

27. How does the money grow?  Assume you invest $1000 (one-time and one lump sum) at Year 0 in a saving plan that has an annual compound interest rate of 10%.  At Year 1, how much money do you have in your plan?  $1000 (1+10%) = 1100  If you keep the money growing, how much do you have at Year 2?

28. How does the money grow?  $1100 (1+10%) = 1210  Since $1100 = 1000(1+10%)  We can express Year 2 figure as:  $1000(1+10%)(1+10%) = 1210  If you keep it on, how much do you have at Year 3?  $1210 (1+10%) = 1331

29. How does the money grow?  Since $1210 = $1100 (1+10%), we can express the Year 3 calculation as:  $1100 (1+10%)(1+10%) = 1331  Since $1100 = 1000 (1+10%) in the previous slide, we can express the Year 3 figure further as:  1000 (1+10%)(1+10%)(1+10%)=1331

30. How does the money grow?  Year 0 = $1000  Year 1 = $1000(1+10%)  Year 2 = $1000(1+10%)(1+10%)  Year 3 = $1000(1+10%)(1+10%)(1+10%)

31. Scientific Expression I Year 0 = $1000 (1+10%)^0 Year 1 = $1000 (1+10%)^1 Year 2 = $1000 (1+10%)^2 Year 3 = $1000 (1+10%)^3 …………………………. Year n = $1000 (1+10%)^n

32. Scientific Expression II If we call Year 0 figure as Present Value (PV), Year n figure as Future Value (FV) and interest rate as(i), then FV = PV ( 1+i )^n Put in table form FV = PV*FVIF

33. How does an annuity grow?  Instead of investing $1000 at Year 0 and let the money grow, annuity means that we are going to invest $1000 at the end of each year for three years (a series of equal payments for a number of years)  Unlike the previous example, we invest our first $1000 at Year 1 (not Year 0) and let it grow for 2 periods

34. How does an annuity grow?  We then invest another $1000 at Year 2 and let it grow for 1 period  Finally, we invest the last $1000 at Year 3  Without letting our final deposit grow, we calculate the total amount we have at Year 3

35. How does an annuity grow?  Year 1 deposit turns into:  $1000 (1+10%)^2 =1210  Year 2 deposit turns into:  $1000 (1+10%)^1 = 1100  Year 3 deposit turns into:  $1000 x 1 = 1000  Total 3310

36. How does an annuity grow?  Year 3 total amount:  $1000{(1+10%)^2+(1+10%)^1+1}  Put it in formula form  FVa = $1000{(1+10%)^2+(1+10%)^1+1}  (1+10%)FVa = $1000{(1+10%)^3+(1+10%)^2+(1+10%)}  (1+10%)FVa – FVa = $1000{(1+10%)^3 –1}  FVa = $1000{(1+10%)^3 –1}/10%

37. How does an annuity grow?  FVa for 3 years =  $1000{(1+10%)^3 – 1}/10% = 3310  General formula  FV a=A{(1+i )^n – 1}/ i  FV a = Future value of an annuity (A)

38. How does an annuity grow?  Put it in a table form  FV a = A x FVIFA  FVIFA = FV interest factor of annuity

39. How does an annuity in advance grow?  If we want to invest money at the beginning of each period, the future value of an annuity in advance will simply be:  FV a= (1+i ) x A{(1+i )^n – 1}/ i  FV a = (1+ i ) x A x FVIFA

40. Answer for Question 3  Assume Amanda invest $5000 at the end of each year for 10 years  At the end of the 10 years (age 30), the amount she has:  FV a = $5000{(1+10%)^10 – 1}/ 10%  = $79687  This amount will grow for another 25 years FV = $79687 (1+10%)^25  = $863385

41. Answer for Question 3  At age 35, James started to invest $5000 at the end of each year for 20 years. At age 55, he will have:  FV a = $5000{(1+10%)^20 – 1}/ 10%  = $286375

42. How to become a millionaire  FV a = $5000{(1+10%)^n – 1}/ 10%  = $1000000  Solve the above equation  n = 31.94 say 32 years  That is, you start to save $5000 a year.  32 years later, you will be a millionaire

43. 50-Year Rate of Return  Canada  T-bills 4.8%  Gov. bonds 5.8%  Corp. bonds 7.2%  Common stock 11.4%  United States  T-bills 3.8%  Gov. bonds 6.2%  Corp. bonds 6.2%  Common stock 12.4%  S&P 500 13.6%

44. What have you learnt?  How to calculate the future value of a lump sum investment or saving  How to calculate the future value of a series of equal payments at uniform intervals for a number of periods  How to become a millionaire  To share with people with what you have