11/1/20151 Key Concepts In Finance Dr. Richard Michelfelder Clinical Assoc. Professor of Finance September 12, 2015 PMBA Program Boot Camp

11/1/20152 Key Topics 1) What is finance and how is it used in business and other institutions? 2) What is the connection between financial accounting and finance and how finance uses financial statements? 3) Discuss some key financial tools such as discounted cash flow, rate of return and risk, and investment decision-making. 4) Summary discussion of the application of key statistical tools for financial analysis (builds on Statistics Session). 5) Overview and summary of finance.

11/1/ ) What is finance and how is it used in business and other institutions?  Finance is a branch of economics that deals with the currency value of the real economy (currency value of real resources and assets). Real GDP (billions $): First Quarter 1947 to Third Quarter 2010

11/1/ ) What is finance and how is it used in business and other institutions?  Functions of Financial Management: acquire resources that create shareholder value by raising & investing funds. –Acquire funds: internally generate or raise capital. –Invest funds: apply funds to business/institutional endeavors that grow Cash Flow or institutional services (non-profits) proportionate risk. –Manage (not avoid!) risk  Functions similar for large mature firms, new ventures or non-business institutions.

11/1/ ) What is finance and how is it used in business and other institutions?  1 st Objective of Finance: Maximize Shareholder Value –Increase cash flow and without proportional increase in risk –Increase P s (stock price) by increasing CF t (cash flow in future year t ) with k s (discount rate and price of risk) constant, falling or rising less than proportionately:

11/1/ ) What is the connection between financial accounting and finance and how finance uses financial statements?  The practice and theory of much of finance requires statements of cash flow, income statements and balance sheets. –Some predicted, others are actual. –Cash flows from operating the business are used to do valuation of the project or business. –Therefore analyzing financials is an integral component of the investment process. –Valuations use discounted cash flow (CF) models. –CF estimation requires the use of the income statement to build the CF statement.

11/1/ ) Discuss some key financial tools such as discounted cash flow, rate of return and risk, and investment decision-making  Project or business valuation is almost always done by Discounted Cash Flow.  Key financial criteria for making an investment decision: Is the project or business worth more than cost? Value minus Cost substantially greater than 0?  The formula for discounted cash flow analysis is: Value = CF 1 /(1+r) 1 + CF 2 /(1+r) 2 + CF 3 /(1+r) CF n /(1+r) n Where: CF 1 = cash flow in period 1 CF 2 = cash flow in period 2 CF 3 = cash flow in period 3 CF n = cash flow in period n r = discount rate (also referred to as the required rate of return)

11/1/ ) Discuss some key financial tools such as discounted cash flow, rate of return and risk, and investment decision-making  Time value of money means that real assets represented by money can grow over time as they earn a rate of return.  At a ROR of 12% (long-term stock market return), a dollar invested now will be worth $1.12 after a year: Future Value = Current Value * (1+ROR) = $1 * (1.12) = $1.12  At 12% a dollar received in one year from now is currently worth = Future Value /(1+ROR) 1 = $1/(1.12) 1 = $0.89

11/1/ ) Discuss some key financial tools such as discounted cash flow, rate of return and risk, and investment decision-making  Usually a project (e.g. electric power plant) or business (e.g. consulting firm) creates cash flow over many years; therefore we discount them all to get value.  The discounted cash flow analysis of the power plant is: Value = CF 1 /(1+r) 1 + CF 2 /(1+r) 2 + CF 3 /(1+r) CF n /(1+r) n $775 million = $1.0 m /(1.128) 1 + $1.02 m/(1.128) 2 + … + $9,978 m/(1.128) 30 assuming 2% contracted growth in electric prices yearly

11/1/ ) Discuss some key financial tools such as discounted cash flow, rate of return and risk, and investment decision-making  Suppose the plant costs $400 million to build: Value minus Cost = $775 million - $400 million = $375 million DO THE DEAL! It is expected to create added equity value of $375 million in addition to returning the required 12.8%.

11/1/ ) Summary discussion of the application of key statistical tools for financial analysis (builds on Statistics Session)  But where did that 12.8% required ROR come from?  ROR that is required for the level of risk involved.  A few return / risk measures: ROR plant = Risk-free ROR + Risk Index (Market ROR - Risk-free ROR) Risk Index: how sensitive the Power Plant ROR is to the stock market ROR, referred to as beta.

11/1/ ) Summary discussion of the application of key statistical tools for financial analysis (builds on Statistics Session).128 = ( ) with a β = 1.1 given a risk free ROR of 4% and market return of 12%. 1.R

11/1/ ) Summary discussion of the application of key statistical tools for financial analysis (builds on Statistics Session) S&P 500 High Volatility Stock Expected ROR Standard Deviation Coeff. Of Variation S&P 500Power Company Expected ROR Standard Deviation Coeff. Of Variation CV Power Plant / CV S&P

11/1/ ) Summary discussion of the application of key statistical tools for financial analysis (builds on Statistics Session) See session notes for discussion of probability distributions, relative risk and return.

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11/1/ ) Summary discussion of the application of key statistical tools for financial analysis (builds on Statistics Session)  Use of correlation for portfolio diversification: The lower the correlation, the larger is the offsetting volatility to ROR relative to ROR. -1 ≤ correlation coefficient ≤ +1

11/1/ ) Summary discussion of the application of key statistical tools for financial analysis (builds on Statistics Session) Asset ROR Correlations :Stocks, Bonds, “Gold,” Solar Energy Credits Asset SREC LogSREC US Stocks (CRSP-Value Weighted Index) US Corp. Bonds Gold SREC 1.00 LogSREC 1.00 US Stocks -0.04* US Corp. Bonds ***1.00 Gold ***0.07*** 1.00

11/1/ ) Overview and summary of finance: A key few points  Finance “represents” the value of the real economy.  Need financial statements to make investment decisions using DCF.  Valuation and DCF involves ROR and risk analysis, using financial and statistical tools that we have discussed today.  Managing risk with portfolio diversification is measured by using the correlation between two assets’ ROR’s; lower correlations generate less risk relative to return.  Every organization that deals with money needs professional financial advice.

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