Financial markets and time value of money(3)

TimeValueofMoneyandNPVAreasinFinanceMoney,CapitalMarkets,BankingandInsuranceInvestmentsandPortfolioDecision-MakingFinancialManagementandthedecisionsaffectingbusinessfirms1Howisfinancedifferentfromaccounting?Accounting:Aninformationsystemthatgivesthefirmcontroloveritsoperationsandprovidesrecord-keeping.Finance:Utilizestheinformationtomakefinancialdecisionsthataffectafirm’sfuture.Privatewealthmanagement,butmoretraditionallycorporatefinanceTimeValueofMoneyandNPVWhataretheresponsibilitiesoffinancialmanagement?Long-terminvestmentsofthefirm.Inotherwords,whatdoesthefirmdo?Howdoesthefirmpayforitslong-terminvestments?Howdoesthefirmhandleshort-term,dailyactivitieslikecollectingfromcustomersandpayingsuppliers?2CapitalBudgetingCapitalStructureWorkingCapitalManagementTimeValueofMoneyandNPVGoalsoftheFirmGoal?Tobethebiggest(revenue),fastestgrowing(revenuegrowth),mostprofitable(ROE)?3BusinessWeekOn-LineTimeValueofMoneyandNPVQuicktest4TimeValueofMoneyandNPVBacktoourITfirms5TimeValueofMoneyandNPVThedominantobjective:maximizeexistingowner’swealthHowever,wecouldhaveaproblem-Whocontrolsthefirmonaday-to-daybasis?Managers?Shareholders?Managersarereallyagentsoftheirprincipalshareholdersandunderself-interestthereisariskofmuchconflictbetweenthetwoinlargerorganizations.Howdoesoneresolvetheprospectofagencydrivenconflicts?6TimeValueofMoneyandNPVManagingManagersManagerialcompensation–Incentivescanbeusedtoalignmanagementandstockholderinterests,e.g,performanceplans–TheincentivesneedtobestructuredcarefullytomakesurethattheyachievetheirgoalCorporatecontrol–ThethreatofatakeovermayresultinbettermanagementMonitoring–theindirectcostsofauditing1-7TimeValueofMoneyandNPVTheStructureofCEOCompensation(CEOpayof50largestfirmsduringperiods)8FrydmanandJenter,2010TimeValueofMoneyandNPVWhyOrganizationalFormMatters?LifeCashTaxOwner’sLiabilitySoleProprietorshipLifeofownerIndividualwealthIndividualratesunlimitedPartnershipDeathorsalebygeneralpartnerWealthofpartnersIncomeflowsthrutoindividualsgeneral:unlimited;limited:limited;CorporationUnlimitedAccesstoborrowingandequitymarketsCorporationmustpaytaxbeforeincomedistributedtoownerslimited9TimeValueofMoneyandNPVFinancialMarketsRaising“capital”inpublicmarkets10Thefirmissuesstocks,bondsorbothtofinanceitsoperationsTimeValueofMoneyandNPVFinancialMarketsWhatistheroleoffinancialmarketsincorporatefinance?A.WhatfinancialmarketsdoB.Moneyvs.capitalmarketsC.Primaryvs.secondarymarkets11Wanttostartabusiness?Incorporate?TimeValueofMoneyandNPVCashFlowsbetweentheFirmandtheFinancialMarkets12TimeValueofMoneyandNPVIdentificationofCashFlows(notalwayseasytoseeinaccountingdata)GriszGrainCo*IncomeStatement–GAAPRulesSales$5,000,000Costs$1,000,000Profit$4,000,000GriszGrainCo“IncomeStatement”–FinanceViewSales$0Costs$1,000,000Profit-$1,000,00013*Salesoncredit;costsincashTimeValueofMoneyandNPVWhythedifference?Whatmatters?IdentifycashflowsthatarerealandrelevantThetimingofcashflows;whenrelevantcashflowsoccurinthefutureRiskinessoffuturecashflows;wecanonlyestimatethefuture14TimeValueofMoneyandNPVTimeValueofMoneyGivenachoicewouldyouratherhave$1todayorthesame$1oneyearfromnow?Asafinancialmanagerweneedtobeabletocalculatethistrade-offbetweenmoneynowandmoneylater.Onlythencanwemakeadecisiontodayaboutaprojectwithassociatedoperatingcashinflowsandoutflowswhichareexpectedtooccurinthefuture.150CashOutflow(-)CashInflow(+)CashInflow(+)DecisionPointTimeValueofMoneyandNPVToolsofValuationFuturevalueandcompounding“FutureValue”–theamountofmoneytowhichaninvestmentwillgrowforagivenlengthoftimeatagiveninterestrate;wewilllabelthis“FV”“TimePeriod”–oneunitoftime,forexample,1-year,1-qtr,1minute;wewilllabelthis“t”1)r1(PVFV1)06.01(100$FV16Formula:Example:Save$100todayfor1yearata6%annualrate,thenPVispresentvalueandris0.06TimeValueofMoneyandNPVFutureValueovermultipleperiodsCasewherethepresentvalueisthesamebutyousavetheoriginalamountovermorethanoneperiodandinterestisreinvested(interestisearnedeachperiodontheoriginalinvestmentandinterestfrompriorperiods)LetPV=$100andr=6%,thenwecancalculatethefuturevalueacrossmorethanoneperiodBeg.YearBeg.AmountInterestEndAmount0$100$6.00$106.001$106.00$6.36$112.3617InterestismorethansimpleinterestTimeValueofMoneyandNPVInterestonInterestIllustration18TimeValueofMoneyandNPVLet’sextendourfirstequationThus,thefuturevalueof$100intwoyearsata6%annualrateiscalculatedast)r1(PVFV36.112$)06.01(100$FV219TimeValueofMoneyandNPVNewexample,sameconceptWhatwould$100beworthin30yearsifyouearned8%annuallyonyouraccount?26.006,1$)08.01(100$FV3063.737,23$)20.01(100$FV3020Howaboutyouearned20%eachyearratherthanarelativelymeasly8%?A23xchangeinvaluefora2.5xchangeininterestrates!TimeValueofMoneyandNPVWhenyoubeganyournewjobasanassistantwebdeveloperyourstartingsalarywas$40,000peryear.Supposetheinflationrateis3%peryearandyoureceiveannualcost-of-livingadjustments(so-calledCOLAs).Whatwillbetheamountofyoursalaryin40years?481,130$FV)03.01(000,40FV)r1(PVFV40t21Canyouverifywiththecalculator?PV=40000;FV=?;n=40;I=3TimeValueofMoneyand