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Introduction to Financial Management: Concepts and Applications

In this Financial Management class, we will build on the concepts introduced in MBA 507. Led by Dr. Ken Shah, an experienced instructor with extensive industry expertise, we will delve into the complexities of investment and financing decisions and their impact on firm value. Topics will include capital budgeting, corporate finance, valuation, and sources of financing. The class will emphasize practical applications through homework, participation, and a final exam. Join us as we explore real-world financial scenarios and enhance your financial acumen.

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Introduction to Financial Management: Concepts and Applications

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  1. MBA 515 Financial Management

  2. Today’s class... • Introductions and house keeping • Review of 507 concepts

  3. My Background • NAME: Ken Shah • PhD: University of Oregon • INDUSTRY EXPERIENCE: • 4 yrs Floor Trader / Stock Broker - Bombay Stock Exchange • 3 yrs Quantitative Portfolio Management Research, Portland, Oregon

  4. Academic Experience • Taught at • University of Oregon • University of Auckland • Southern Methodist University • Courses in capital budgeting, corporate finance, investments, and money and banking

  5. Recent Research • Analyst Forecasts • Bond Returns • Capital Structure • Initial Public Offerings

  6. Please Introduce yourself... • Please fill out the student information sheet • Drop by my office! • Information sheet with photo next class

  7. Information Sheet • Attach a photo/photocopy of a photo • Tell me about yourself, if you like – present career, goals, etc. • Tell me about any anticipated absences • Any other special concerns/considerations

  8. Course Objectives • Build on MBA 507 concepts • How investment and financing decisions affect firm value • Valuation, Sources of financing, and Capital structure

  9. Course Prerequisites • Understanding of: • Financial statements • Discounting of cash flows • Spreadsheets • Rudimentary statistics • Pre-requisites: MBA 500-512

  10. Texts • Required: • Class packet at CopyMart • Lecture notes on the class web page • Optional: • Brealey & Myers, Principles of Corporate Finance • Damodaran, Investment Valuation (Advanced reading)

  11. Evaluation • Final Exam 300 • Homeworks 600 • Class Participation 100 • TOTAL 1000

  12. Grading Policy • If you attend all classes and diligently complete all required work, you would be assured of a B- grade • In order to get an A/A-, you must show work of superior quality and make a meaningful contribution to the class discussions • roughly 15% of the class

  13. Class Attendance • Mandatory • Please inform me of anticipated absences • First absence will not affect your grade • Each subsequent absence will adversely affect your grade by half grade point for each absence

  14. HW Assignments • A group of 3 students turns in one solution • Group work is required • Each member should make copies of assignment prior to turning in to facilitate discussion

  15. Review • Discounted Cash Flow/Time Value of Money • Bond Valuation • Stock Valuation • NPV • CAPM • Capital Budgeting

  16. DCF/TVM • PV and FV of a lump sum • PV and FV of Annuities • PV and FV combined • Perpetuities

  17. PV and FV of a lump sum • ‘r’ and ‘t’ must match • If t is # of months, r must be a monthly rate

  18. TVM example • How many years does it take to double your $100,000 inheritance if you can invest the money earning 11% compounded annually?Answer: 6.64 years

  19. PV of Annuity • Again: ‘r’ and ‘t’ must match • If t is # of months, r must be a monthly rate, and C is the payment per month

  20. PV of Annuity: Mortgage payments • House cost $250,000 • Mortgage Rate = 7.5% annually • Term of loan = 30 years • Payments made monthly • What are your payments? • Answer: $1748.04

  21. FV of Annuity • Again: ‘r’ and ‘t’ must match • If t is # of months, r must be a monthly rate, and C is the payment per month

  22. FV of Annuity Example • You will contribute $400 per month for the next 35 years into a retirement savings plan. If your money earns 12% interest per year, how much will you have accumulated at retirement? • Answer: $2,572,383

  23. How much must you contribute in an IRA per month to have an amount in 20 years that will provide an annual income of $200,000 per year for 10 years? Interest rate is 8% per year. • Answer: $2,278.28

  24. Perpetuity • Note: C and r measured over same interval

  25. Perpetuity Example • Preferred stock pays $1.00 dividend per quarter. The required return, r, is 10% per year. • What is the stock value? • Answer: $40.00

  26. Review: Bond Valuation • Fixed periodic coupon payments • Typically semi-annual • Principal payment at maturity • Yield to maturity (YTM) is that discount rate which makes the PV of all cash flows equal to the price

  27. Bond Price

  28. Example • $1000 par bond maturing 15 years from today has an annual coupon rate of 53/4 % paid semiannually. Required return on bond (r) is 7.5% per year compounded semiannually. • What is the value today? • Answer: $843.99 • If price is 104% of par, what is its YTM? • Answer: 5.36%

  29. Coupon Rate • Coupon Rate = Annual Coupon Payment Face Value • Coupon rate is always quoted annually • Example: 4 3/4% ATT 09 • 4 3/4% is the coupon rate

  30. Yield to Maturity (YTM) • It is the yield ‘r’ calculated when market price of bond is known • If • bond is held to maturity, AND • bond does not default, AND • bond is not called • then, • YTM is the return an investor earns on the bond • YTM is the ‘best guess’ of an investor’s expected return

  31. Current Yield • An approximation of YTMCurr. Yld. = Annual Coupon Payment Market Price • Reported for Corporate bonds in the WSJ

  32. Important to... • Distinguish between: • Yield To Maturity • Coupon Rate • Current Yield • They are not all the same!!

  33. Bond Rates and Yields • Suppose a bond currently sells for $932.90. It pays a semi-annual coupon of $35, and it matures in 10 years. It has a face value of $1000. What are its coupon rate, current yield, and yield to maturity (YTM)? 1. The coupon rate (or just “coupon”) is the annual dollar coupon expressed as a percentage of the face value: Coupon rate = $____ /$_____ = 7.00% 2. The current yield is the annual coupon divided by the current market price of the bond: Current yield = $___ _/_____ = 7.50% 3. The yield to maturity is = 7.99%

  34. Review Stock Valuation • Residual ownership • Uncertain dividends • Dividends must be estimated • Voting rights • CAPM gives us a way to estimate the required return on a stock

  35. Dividend Discount Model (DDM) • r = required rate of return on stock • ALL future dividends must be estimated • “ from here to eternity!!!” • Of little practical importance

  36. Note • Stock value is the PV of all future expected dividends • Stock value is NOT the PV of all future expected earnings or EPS • Unless a company pays out all earnings as dividends • Which implies that there is no growth

  37. Constant Growth DDM • Notice it is much simpler to estimate: • You need only THREE inputs: D1, r, g

  38. Caution • Constant growth model is simple but inappropriate model to use for many or most companies that have abnormal growth phases • Constant growth model is appropriate only for stable, mature companies like utilities • Constant growth model is often used to estimate the steady-state terminal values in a multi-stage growth model of valuing stocks

  39. Example • Kinesis Keyboard: D0 = $0.50Super growth in years 1 to 5: 55%Thereafter, constant growth of 11%r = 18%What is the current stock price? • Answer: ________

  40. Calculate dividends and terminal value 2 0 1 3 4 5 6 • Now you have all the numbers needed • Fill in the boxes • Show all the dividends and P5 on the time line +

  41. Using your calculator (HP 10B/12B) CFj CFj • Enter CF0 as: $0.0000Enter CF1 as: $0.7750 • Enter CF2 as: $1.2013 • Enter CF3 as: $1.8619 • Enter CF4 as: $2.8860 • Enter CF5 as D5 + P5: $75.4071 • Enter interest rate 11 • Hit • Answer: $ 49.68 CFj CFj CFj CFj I/YR Shift NPV

  42. Review of NPV • NPV is the dollar value added to the enterprise • it’s the amount by which the enterprise is richer! • For public companies, NPV is the increase in total market value of equity • Managers should not take negative NPV projects since it reduces the firm value

  43. NPV Formula • ‘r’ has many names: • ‘r’ is called the discount rate or • ‘r’ is called the required return or • ‘r’ is called the cost of capital

  44. Computing NPV on calculator • Use the CFj key • First entry is at time 0 • Subsequent entries are time 1, 2, 3, ... and so on • make sure the cash flows have the proper signs • Enter ‘r’ as the I/YR • Use the keys NPV

  45. Discounting Cash Flows • ALWAYS USE A DISCOUNT RATE THAT REFLECTS THE RISK OF THE CASH FLOWS THAT YOU ARE DISCOUNTING • ‘r’ in the denominator should reflect the risk of the CFt in the numerator • ‘r’ reflects the risk of the investment, not the risk of the investor!

  46. CAPM • The main contribution of CAPM is to derive an exact relation between risk and return • The main message of CAPM is that • Investors hold fully diversified (market) portfolio • Diversified portfolios have no unsystematic risk • Therefore, for individual securities, risk is measured by the contribution that security makes to the risk of the (market) portfolio, i.e., systematic risk or beta

  47. Portfolio Diversification Average annualstandard deviation (%) 49.2 Diversifiable risk 23.9 19.2 Non-diversifiable Risk Number of stocksin portfolio 1 10 20 30 40 1000

  48. CAPM Equation • [E(Rm) – Rf] = Market Risk Premium (MRP) • Rf = Risk Free rate • βi = stock beta

  49. The Security Market Line (SML) Asset expectedreturn E (Ri) = E (RM ) – Rf E (RM) Rf Assetbeta 0 M= 1.0

  50. Review of Compounding • To compound or not to compound - that is the question!! • Compounding means reinvesting the proceeds • SEC requires funds and investment managers to report returns that account for compounding

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