Business Finance Michael Dimond

Michael Dimond School of Business Administration Introduction What this class will cover How do I get an A in this class? Relevance Schedule Tools & resources

Michael Dimond School of Business Administration Doing Assigned Problems, Exams & Quizzes

Michael Dimond School of Business Administration Essential issues of financial management Purpose of business To create wealth for the owner. A business may also serve some other purpose, but if the business is not profitable these other functions will eventually fail. Jobs will be lost Benefits to society will be eliminated Improvements to the planet will stop Purpose of financial management To increase shareholder wealth. The fundamental question The fundamental question which must be asked in any business situation is, “what is this worth?”

Michael Dimond School of Business Administration Just to clear up this misconception… Should managers only take actions which increase the share price? Hey, it worked for Enron… wait, what? How about GM? Okay, how about the Mars Candy Company?

Michael Dimond School of Business Administration The goal is to increase value Managers should only take actions which increase value, not just share price. Share price should accurately reflect the value of a publicly traded company, but… What if the investors are wrong? What if the company is privately held? How do we determine value?

Michael Dimond School of Business Administration The "Magic" Machine Note: This is not a trick question, merely a framework to help you think about the subject. Consider the following scenario: You have the opportunity to buy a machine which is guaranteed to produce $100 per month for the next five years. There are no operating costs and the device will vanish at the end of that time. How much would you pay for this? What factors influence your decision?

Michael Dimond School of Business Administration Basic return: reward ÷ cost At its simplest, return is the reward you receive divided by the price you pay. For example, if you buy something for $1,000 and sell it for $1,100… How much is the reward? What was the price? What is the return?

Michael Dimond School of Business Administration Uncertainty = Risk Risk is another word for uncertainty. Things rarely happen exactly as anticipated. There is a possibility an outcome will be… Better than expected (upside risk) Worse than expected (downside risk) People in general tend to avoid significant amounts of risk Investors are risk averse

Michael Dimond School of Business Administration Risk vs Price Think again about the so-called magic machine. If the $100 monthly cash flow was not guaranteed, how would this affect the price you are willing to pay?

Michael Dimond School of Business Administration Price vs Return If we think of return as the reward divided by the price, we can see how the change in price affects the return: 100/1000 = 10% 100/900 = 11% 100/1100 = 9% What about a change in total value over time? In the previous example, you bought something for $1,000 and later sold it for $1,100. The change in value was $100 ($1,100 - $1,000) 100/1000 = 10% You can also compute the return this way: 1100/1000 – 1 = 10%

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Michael Dimond School of Business Administration Risk vs Return As risk increases, the price decreases As price decreases, return increases :. As risk increases, return increases Remember, return is the return demanded by investors, not a guaranteed result

Michael Dimond School of Business Administration Required Rate of Return Risk & Return always correlate: Investors will find a price to give them a return which compensates them for the risk they are willing to bear: the Required Rate of Return. The Required Rate of Return may have many labels. For example: Ke r s i Re E(r) WACC r d Kd “Hurdle Rate”

Michael Dimond School of Business Administration More about risk and return Risk is uncertainty. Not just success or failure, but to what extent will something be as expected? It may be necessary to consider scenarios and weigh them based on their likelihood. For example: The experts in your company predict the following results and probabilities: What is the expected rate of return? The weighted average is 8.35% ScenarioReturnProbability Very poor 0.75%0.05 Poor 1.25%0.15 Average 8.5%0.60 Good14.75%0.15 Very good16.25% x 0.05 = x 0.15 = x 0.60 = x 0.15 = x 0.05 = sum =

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Michael Dimond School of Business Administration More about risk and return Variation or volatility is another form of uncertainty. What is standard deviation? What does it represent?

Michael Dimond School of Business Administration More about risk and return How do the following assets compare to Stock X? When making a decision, which should you consider first? Risk? Return? Which has the lowest potential return? Which has the highest potential return? Which has the most uncertainty? Which has the best balance of risk and return?

Michael Dimond School of Business Administration More about risk and return How do the following assets compare to Stock X? What would be the Coefficient of Variation for each? CoV = Std Deviation ÷ Return Which has the best balance of risk and return?

Michael Dimond School of Business Administration E8-3 What is Diversification? Can all risk be diversified away?

Michael Dimond School of Business Administration Diversification in practice: portfolios & risk Assuming equal dollar amounts invested in assets X & Y…

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Michael Dimond School of Business Administration P8-2 Consider the change in value as part of the reward: – = /43300 = = 6.00% Consider the cash flow as part of the reward: 4170/43300 = = 9.63% Total reward is cash flow plus the change in market value: ( ) / = = 15.64% = = 15.64%

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Michael Dimond School of Business Administration What drives performance of an investment?

Michael Dimond School of Business Administration More risk means investors demand higher return

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Michael Dimond School of Business Administration Essential issues of corporate governance Corporation vs other types of business entities Board of directors Managers Agency cost

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Michael Dimond School of Business Administration Understanding financial statements Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity

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Michael Dimond School of Business Administration The Time Value of Money (TVM) Bring your financial calculator Bring a copy of “How do I use this financial calculator” Look on my website