1. Essentials of Finance in the Minor Michael Dimond

2. 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

3. 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?”

4. 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?

5. 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?

6. 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? You have 5 minutes… What did you decide?

7. 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 did it cost to get that reward? What is the percent return?

8. 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

9. 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?

10. 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%

11. 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

12. 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”

13. 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%0.05 0.75 x 0.05 = 0.0375 1.25 x 0.15 = 0.1875 8.5 x 0.60 = 5.1000 14.75 x 0.15 = 2.2125 16.25 x 0.05 = 0.8125 sum = 8.3500

14. 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?

15. Michael Dimond School of Business Administration Compounding Compounding is the growth of value resulting from some sort of return (such as interest payments) being added to the original amount. If you put $100 in the bank and receive 10% annual interest After 1 year: $100 x (1+10%) = $110 After 2 years: $110 x (1+10%) = $121 After 3 years: $121 x (1+10%) = $133.10 The three-year compounding could be rewritten like this: After 3 years: $100 x (1+10%) x (1+10%) x (1+10%) = $133.10 or $100 x (1+10%) 3 = $133.10 The general formula for compounding: PV x (1+i) n = FV where PV = Present Value, FV = Future Value, n = Number of periods, i = Interest rate

16. Michael Dimond School of Business Administration Discounting Discounting is the opposite of compounding. Instead of growing an amount by a specific rate, we are taking that expected growth out of a future total to find what the starting figure would be. Since compounding multiplies by (1+i) n, discounting will do the opposite: divide by (1+i) n. If you will need $133.10 at the end of three years, and you can receive 10% annual interest, how much would you need to deposit today? $133.10 ÷ (1+10%) 3 = $100 The general formula for discounting: FV ÷ (1+i) n = PV where PV = Present Value, FV = Future Value, n = Number of periods, i = Interest rate

17. Michael Dimond School of Business Administration Moving parts of compounding & discounting There are four “moving parts” in a compounding or discounting computation: PV (Present Value) FV (Future Value) n (Number of Periods) i (Rate of Return per Period) The general formula for compounding: PV x (1+i) n = FV The more periods something is compounded, the greater the future value is. The general formula for discounting: FV ÷ (1+i) n = PV The more periods something is discounted, the smaller the present value is.

18. Michael Dimond School of Business Administration What if compounding happens more frequently? APR means Annual Percentage Rate For example: 12% APR means 12% interest rate for the year. If interest compounds more frequently, divide that rate by the periods per year. 12 % APR compounded… Annually1 period/yr12% ÷ 1 = 12.00% interest/period Quarterly4 periods/yr12% ÷ 4 = 3.00% interest/period Monthly12 periods/yr12% ÷ 12 = 1.00% interest/period Daily360 periods/yr12% ÷ 360 = 0.03% interest/period Why do financiers use 360 days instead of 365? After 1 year, how much will $100 be at 12% APR… compounded at the end of the year?$100 x (1.1200) 1 = $112.00 compounded at the end of each quarter? $100 x (1.0300) 4 = $112.55 compounded at the end of each month ? $100 x (1.0100) 12 = $112.68 compounded at the end of each day ? $100 x (1.0003) 360 = $112.75 Remember to watch out for rounding errors: 12/360 = 0.03333…

19. Michael Dimond School of Business Administration Effective Annual Rate The Effective Annual Rate (EAR) is the APR adjusted for the value of compounding. EAR = (1+APR ÷ n) n - 1 12% APR compounded annually = (1.1200) 1 -1 = 12.00% EAR 12% APR compounded quarterly = (1.0300) 4 -1 = 12.55% EAR 12% APR compounded monthly = (1.0100) 12 -1 = 12.68% EAR 12% APR compounded daily = (1.0003) 360 -1= 12.75% EAR Sometimes this is called the APY (Annual Percent Yield)

20. Michael Dimond School of Business Administration Time vs Return: Basic TVM A dollar is worth more now than it will be at any time in the future. The concept is called the Time Value of Money (TVM). What makes money lose value over time? How long an investment takes to pay out will affect the price you would pay. If you require a 12% annual return, how much would you pay for $100 to be given to you in… 1 year? 3 years? 10 years? The further in the future a cash flow is, the less it is worth.

21. Michael Dimond School of Business Administration Understanding TVM problems Time Value of Money scenarios are examined with a timeline. Each tick mark on the timeline represents the end of one period. The first tick mark on the left is labeled 0 because zero periods have elapsed. It indicates the present, or the planned beginning of a project. The last tick mark indicates the end of the last period being analyzed. Payments and compounding happen at the end of each period. Consider our basic compounding example: 010123456789 0123 -100133.10 i = 10% PV = -100 i = 10% n = 3 FV = 133.10 You could use this diagram to analyze the future value or the present value

22. Michael Dimond School of Business Administration You could use this diagram to analyze the future value or the present value. Notice the cash outflow (money you invested) is shown with a minus sign. Financial calculators require this to give you the correct answer. This is called the sign convention. Understanding TVM problems 100 x (1+0.10) 3 = 133.10 :. FV = 133.10 0123 -100? i = 10% 0123 ?133.10 i = 10% 133.1 ÷ (1+0.10) 3 = 100 :. PV = -100

23. Michael Dimond School of Business Administration A TVM problem has one more “moving part” than a simple compounding or discounting problem. PV (Present Value) FV (Future Value) n (Number of Periods) i (Rate of Return per Period) PMT (Payment) There may be payments which happen between the beginning and end of the timeline. Each payment is discounted separately. The PV of the stream of cash flows is the sum of the individual PVs. Moving parts of TVM

24. Michael Dimond School of Business Administration If you require a 12% annual return, what would you pay for… …$100 to be delivered in 1 year? ($89.2857) …$100 to be delivered in 2 years? ($79.7194) …$100 to be delivered in 3 years? ($71.1780) …all of the above (i.e. $100 to be paid at the end of each of the next three years)? By adding together the present values, you find the value of all the cash flows in the stream. Discounting payments 0123 ?100 i = 12% 100 ÷ (1+0.12) 3 100 100 ÷ (1+0.12) 2 100 100 ÷ (1+0.12) 1 89.2857 79.7194 + 71.1780 240.1831

25. Michael Dimond School of Business Administration Remember the magic machine? $100 per month for 5 years. What if you require a 12% annual return? Discounting a stream of cash flows 060123456575859 ?100 i = 1% monthly (12% APR) 100 100 ÷ (1+0.01) 60 100 ÷ (1+0.01) 1 Each payment has its own present value. Adding up those PVs gives the total value of the stream of cash flows. 100 ÷ (1+0.01) 2 100 ÷ (1+0.01) 3 100 ÷ (1+0.01) 4 100 ÷ (1+0.01) 56 100 ÷ (1+0.01) 57 100 ÷ (1+0.01) 58 100 ÷ (1+0.01) 59 99.01 57.28 98.03 97.06 96.10...... 56.71 56.15 55.60 55.04

26. Michael Dimond School of Business Administration Timelines & PMTs i and n are always in the same increment. Monthly periods → monthly rate. Annual periods → annual rate. What happens to PV as n increases? As n increases, PV becomes smaller 100 ÷ 1.01 2 = 98.03 100 ÷ 1.02 60 = 55.04 Value = Sum of PVs So if you demand a 12% rate of return, the value of the machine’s monthly payments is: There is also an easier way to compute that value…

27. Michael Dimond School of Business Administration Ordinary Annuity: FV & PV A stream of cash flows where all payments are equal is called an Annuity. In an Ordinary Annuity, each payment happens at the end of the period. Your financial calculator can solve these easily and quickly. Find PV given n, i, and PMT Find FV given n, i, and PMT For the magic machine, the inputs would be: PV = ? (This is what we’re solving for) n = 60 (monthly payments) i = 12/12 (12% ÷ 12 months) PMT = 100 (per month) FV = 0 (This has no value once the final payment is delivered) Notice that these three items must always be in the same timeframe: monthly annually, daily… whatever is in the scenario

28. Michael Dimond School of Business Administration Ordinary Annuity with an additional payout What happens if there is a stream of payments, and also a lump sum being paid at the end of the timeline? Timeline… Find PV given n, i, PMT & FV

29. Michael Dimond School of Business Administration If you require a 12% annual return, what would you pay for… …$90 to be delivered in 1 year? ($80.3571) …$95 to be delivered in 2 years? ($75.7334) …$99 to be delivered in 3 years? ($70.4662) …all of the above? By adding together the present values, you find the value of all the cash flows in the stream. Discounting unequal payments 0123 ? 99 i = 12% 99 ÷ (1+0.12) 3 95 95 ÷ (1+0.12) 2 90 90 ÷ (1+0.12) 1 80.3571 75.7334 + 70.4662 226.5567

30. Michael Dimond School of Business Administration Understanding financial statements Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity We will begin Spreadsheet Assignment #1 next time