Download MIM700 - Prof Dimond

Business Finance
Michael Dimond
Introduction
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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
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…
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?
• What did you decide?
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?
• What drove 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
• Essential Issues in Corporate Governance
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Corporation vs other types of business entities
Board of directors
Managers
Agency cost
Michael Dimond
School of Business Administration
P1-1
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%
Michael Dimond
School of Business Administration
E8-1
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
rs
i
Re
E(r)
WACC
rd
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:
Scenario
Return
Very poor
0.75%
0.05
0.75 x 0.05 = 0.0375
Poor
1.25%
0.15
1.25 x 0.15 = 0.1875
8.5%
0.60
8.5 x 0.60 = 5.1000
Good
14.75%
0.15
14.75 x 0.15 = 2.2125
Very good
16.25%
0.05
16.25 x 0.05 = 0.8125
Average
• What is the expected rate of return?
Probability
sum = 8.3500
• The weighted average is 8.35%
Michael Dimond
School of Business Administration
E8-2
Expectation
Return
4%
-4%
9%
3%
Likelihood
Probability
34%
8%
17%
41%
Product
0.0136
-0.0032
0.0153
0.0123
0.0380
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?
Expected Return
Std Deviation
Stock X
12%
5%
Stock A
12%
7%
Stock B
10%
8%
Stock C
14%
6%
• 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?
Stock X
12%
5%
Expected Return
Std Deviation
Stock A
12%
7%
Stock B
10%
8%
Stock C
14%
6%
• What would be the Coefficient of Variation for each?
• CoV = Std Deviation ÷ Return
Return
12%
12%
10%
14%
Std
Coefficient
Deviation of Variation
5%
0.4167
7%
0.5833
8%
0.8000
6%
0.4286
• Which has the best balance of risk and return?
Michael Dimond
School of Business Administration
E8-3
Expectation
Return
12%
10%
Uncertainty
Coefficient
Std Deviation of Variation
7%
0.5833
3%
0.3000
• 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…
Michael Dimond
School of Business Administration
E8-4
Expectation
Return
3.48%
9.81%
13.85%
Proportion
Weight
47%
32%
21%
100%
Product
0.0164
0.0314
0.0291
0.0768
7.68%
Michael Dimond
School of Business Administration
P8-2
• Consider the change in value as part of the reward:
• 45900 – 43300 = 2600
• 2600/43300 = 0.06005 = 6.00%
• Consider the cash flow as part of the reward:
• 4170/43300 = 0.09630 = 9.63%
• Total reward is cash flow plus the change in market value:
• (2600 + 4170) / 43300 = 0.15635 = 15.64%
• 0.06005 + 0.09630 = 0.15635 = 15.64%
Michael Dimond
School of Business Administration
P8-1
Beginning Ending
Value
Value
X
18,000
18,973
Y
51,000
51,000
Cash
Flow
1,350
5,316
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
Michael Dimond
School of Business Administration
P8-4
Michael Dimond
School of Business Administration
P8-5
Michael Dimond
School of Business Administration
Understanding financial statements
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Balance Sheet
Income Statement
Statement of Cash Flows
Statement of Shareholders’ Equity
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
Michael Dimond
School of Business Administration
P3-3
Michael Dimond
School of Business Administration
P1-2
Michael Dimond
School of Business Administration
P2-1
Michael Dimond
School of Business Administration
P2-5
Michael Dimond
School of Business Administration
P3-5
Michael Dimond
School of Business Administration
P1-4
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
Michael Dimond
School of Business Administration