FIN3004 Corporate Finance

Lecture 1
Introduction

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Learning Outcomes
 Know the basic types of financial management
decisions and
 Know the goal of financial management
 Be able to compute net present value, payback,
internal rate of return and profitability index,
and understand the advantages and
disadvantages of these approaches.
 Understand the definition of incremental cash
flows

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What Is Corporate Finance?
Corporate Finance addresses the
following three questions:
1. What long-term investments should the
firm choose?
2. How should the firm raise funds for the
selected investments?
3. How should short-term assets be managed
and financed?

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 Balance Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:
Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
The Capital Budgeting Decision

Current
Liabilities
Current
Assets Long-Term
Debt

Fixed Assets
Q1. What long-
1 Tangible term
Shareholders’
investments
2 Intangible should the firm Equity
choose?
The Capital Structure Decision

Current
Liabilities
Current
Assets Long-Term
Q2. How should Debt
the firm raise
funds for the
Fixed Assets
selected
1 Tangible investments? Shareholders’
2 Intangible Equity
Short-Term Asset Management

Current
Liabilities
Current
Net
Assets Working Long-Term
Capital Debt

Q3. How should

Fixed Assets
short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity
The Goal of Financial Management

 What is the correct goal?

 Maximize profit?
 Minimize costs?

 Maximize market share?

 Maximize shareholder wealth?

 Maximize the market value of the

existing owner’s equity?

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The Financial Manager

The Financial Manager’s primary goal

is to increase the value of the firm by:
1. Selecting value creating projects

2. Making smart financing decisions

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The Importance of Cash Flow
Firm invests Firm issues securities (A) Financial
in assets markets
(B)
Invests
Retained
in assets cash flows (F)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (E)
Equity shares

Taxes (D)

Ultimately, the firm The cash flows from

must be a cash the firm must exceed
Government
generating activity. the cash flows from
the financial markets.
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Net Present Value & Other
Investment Criteria

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The Net Present Value (NPV) Rule
 Net Present Value (NPV) =
Total PV of future CF’s + Initial Investment
 Estimating NPV:

1. Estimate future cash flows: how much? and

when?
2. Estimate discount rate
3. Estimate initial costs
 Minimum Acceptance Criteria: Accept if
NPV > 0
 Ranking Criteria: Choose the highest NPV

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Why Use Net Present Value?
 Accepting positive NPV projects
benefits shareholders.
 NPV uses cash flows
 NPV uses all the cash flows of the
project
 NPV discounts the cash flows properly

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The Payback Period Method
 How long does it take the project to
“pay back” its initial investment?
 Payback Period = number of years
to recover initial costs
 Minimum Acceptance Criteria:
 Set by management
 Ranking Criteria:
 Set by management

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The Payback Period Method
 Disadvantages:
 Ignores the time value of money
 Ignores cash flows after the payback
period
 Biased against long-term projects
 Requires an arbitrary acceptance criteria
 A project accepted based on the payback
criteria may not have a positive NPV
 Advantages:
 Easy to compute and understand
 Biased toward liquidity

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The Discounted Payback Period
 How long does it take the project to
“pay back” its initial investment, taking
the time value of money into account?
 Decision rule: Accept the project if it
pays back on a discounted basis within
the specified time.
 By the time you have discounted the
cash flows, you might as well calculate
the NPV.

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The Internal Rate of Return
 IRR: the discount rate that sets NPV to
zero
 Minimum Acceptance Criteria:
 Accept if the IRR exceeds the required
return
 Ranking Criteria:
 Select alternative with the highest IRR
 Reinvestment assumption:
 Allfuture cash flows are assumed to be
reinvested at the IRR

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 IRR: Example

Consider the following project:

$50 $100 $150

0 1 2 3
-$200
The internal rate of return for this project is 19.44%

$ 50 $ 100 $ 150
N P V  0   200   2

(1  IRR ) (1  IRR ) (1  IRR ) 3
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Calculating IRR with Spreadsheets
 You start with the same cash flows
as you did for the NPV.
 You use the IRR function:
 You first enter your range of cash flows,
beginning with the initial cash flow.
 The default format is a whole percent –

you will normally want to increase the

decimal places to at least two.

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Mutually Exclusive vs. Independent
 Mutually Exclusive Projects: only ONE of
several potential projects can be chosen,
e.g., acquiring an accounting system.
 RANK all alternatives, and select the best one.

 Independent Projects: accepting or

rejecting one project does not affect the
decision of the other projects.
 Must exceed a MINIMUM acceptance criteria

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Problems with IRR
 Problems for both mutually exclusive
projects and independent projects
Multiple IRRs
 Problems for mutually exclusive projects
The Scale Problem eg two projects, one
normal, another extremely small, if look
at only IRR, may choose the extremely
small one
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 Multiple IRRs
There are two IRRs for this project:

$200 $800

0 1 2 3
- $800
-
$200

IRR = 0% or 100%
Which one should we use?

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Internal Rate of Return (IRR)
 Disadvantages:
 There may be multiple IRRs
 Problems with mutually exclusive
investments
 Advantages:
 Easy to understand and communicate

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NPV versus IRR
 NPV and IRR will generally give the
same decision.
 Exceptions:
 Non-conventionalcash flows – cash flow
signs change more than once
 Multiple IRRs
 Mutually exclusive projects
 Initial investments are substantially
different

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The Profitability Index (PI)

Total PV of Future C ash Flows

PI 
Initial Investent
 Minimum Acceptance Criteria:
 Accept if PI > 1

 Ranking Criteria:
 Select alternative with highest PI

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The Profitability Index
 Disadvantages:
 Problemswith mutually exclusive
investments
 Advantages:
 Easy to understand and communicate
 Correct decision when evaluating

independent projects
 May be useful when available

investment funds are limited

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The Practice of Capital Budgeting
 The most frequently used technique
for large corporations is either IRR
or NPV.
 Varies by industry:
 Some firms use payback, others use
accounting rate of return.

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Incremental Cash Flows

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Cash Flows—Not Accounting Income

 Consider depreciation expense.

 You never write a check made out
to “depreciation.”
 Much of the work in evaluating
a project lies in taking
accounting numbers and
generating cash flows.

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Incremental Cash Flows
 Only cash flows that are incremental to
the project should be used.
 We are interested in the difference between
the cash flows of the firm with the project and
the cash flows of the firm without the project.
 Sunk costs are not relevant
 Just because “we have come this far” does not
mean that we should continue to throw good
money after bad.

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Incremental Cash Flows
 Opportunity costs do matter. Just
because a project has a positive
NPV, that does not mean that it
should also have automatic
acceptance. Specifically, if another
project with a higher NPV would
have to be passed up, then we
should not proceed.

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Incremental Cash Flows
 Side effects matter.
 Erosion is a “bad” thing. If our new
product causes existing customers
to demand less of our current
products, we need to recognize that.
 If, however, synergies result that

create increased demand of existing

products, we also need to recognize
that.

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Incremental Cash Flows
 Cash flows matter—not accounting
earnings.
 Incremental cash flows matter.
 Sunk costs do not matter.
 Opportunity costs matter.
 Side effects like cannibalism and
erosion matter.
 Taxes matter.
 Inflation matters.

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Estimating Cash Flows
 Cash Flow from Operations
 Recallthat:
OCF = EBIT – Taxes + Depreciation
 Net Capital Spending
 Do not forget salvage value (after tax, of
course).
 Changes in Net Working Capital
 Recallthat when the project winds down,
we enjoy a return of net working capital.

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Appendix

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Investments of Unequal Lives
 There are times when application of
the NPV rule can lead to the wrong
decision. Consider a factory that must
have an air cleaner that is mandated
by law. There are two choices:
 The “Cadillac cleaner” costs $4,000
today, has annual operating costs of
$100, and lasts 10 years.
 The “Cheapskate cleaner” costs $1,000
today, has annual operating costs of
$500, and lasts 5 years.

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Investments of Unequal Lives
 Assuming a 10% discount rate,
which one should we choose?

 NPV of “Cadillac cleaner” and

“Cheapskate cleaner” are –4,614.46
and –2,895.39 respectively.

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Investments of Unequal Lives
 This overlooks the fact that the
Cadillac cleaner lasts twice as long.
 When we incorporate the difference

in lives, the Cadillac cleaner is

actually cheaper (i.e., has a higher
NPV).

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 Equivalent Annual Cost (EAC)
 The EAC is the value of the level payment
annuity that has the same PV as our
original set of cash flows.

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 Equivalent Annual Cost (EAC)
 EAC for the Cadillac and Cheapskate
should be:
 –4,614.46 = PVIFA(10%,10) EAC(Cadillac)
 –2,895.39 = PVIFA(10%,5) EAC(Cheapskate)

 Thus, EAC(Cadillac) = -$750.98 and

EAC(Cheapstake) = -$763.80

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