Jessica Wachter Notes for Finance 604
Topic I: Introduction
This course is about: Corporate Finance
We ask two questions:
1. What projects should a corporation undertake? (investment)
2. How should a corporation obtain the $ it needs to undertake them? (financing)
That there are general principals that tell us how to make these decisions is one of the
most remarkable facts in economics.
We start by examining investment decisions for a firm – say, Boeing Corp:
•Boeing has to decide what kinds of planes to design and build. Does it new
equipment? More employees?
•Where will it get money? Typically from financial markets. But then it faces a
decision. Should it issue bonds (which require fixed payments – interest), or stock?
⇒These are the kind of decisions the firm needs to make. If these are made correctly,
value will be created. If these are made incorrectly, value will, typically, be destroyed.
So, we want to know what we can do to make these decisions correctly. With this in mind,
let’s consider the outline:
1. Net present value (NPV) rule: what is it and why it works
2. Specifics of calculating present value
3. Using present value to value bonds (fixed income).
4. Using present value to value equities. This is a precursor to valuing the corporation.
5. The relation between NPV rule, and a competing measure, the internal rate of return.
6. Putting NPV into practice: depreciation, inflation, decision to replace
7. We take a break from CFO thinking and start to think like investors in financial
markets. First: what are definitions of risk and return?
8. Then: given the universe of stocks, bonds and mutual funds, how do you think about
forming a portfolio?
Even for CFOs who don’t manage their own money, this exercise is very important.
Why? Because it is necessary to understand how investors in markets make decisions,
in order to use the markets as a source of financing
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Jessica Wachter Notes for Finance 604
9. This will lead to a way to adapt NPV analysis for situations involving risk
10. Market efficiency also should be interesting to CFOs and investors in financial
markets, and it has been a hotly debated area in recent years. The question market
efficiency deals with is how quickly markets incorporate information. Can when make
money by trading on publicly available information?
11. The next topics use this material on risk as background to look specifically at the
question of debt versus equity. Can value be improved with this choice? Sometimes.
In this section, we consider the investment decisions as fixed
12. Finally, we integrate the financing with the investing decision. This is where tools
such as adjusted present value and weighted average cost of capital come into play
13. Options is a special topic at the end. Many kinds of financial decisions can be
thought of in terms of pricing an option. Here, our aim is to present foundational
material that will prepare you for finance electives.
(a) Present Value Concepts
Before defining the NPV rule, we need several present value concepts:
Future Value
Assume you deposit $1000 in a bank account that pays 10% interest:
•The value of the deposit in 1 year:
FV = Principal + Interest
= $1000 + $1000(0.10)
= $1100.
•In general, suppose ris the interest rate:
= $1000 + $1000r
= $1000(1 + r).
⇒The future value of your investment at the interest rate ris $1000(1 + r)
Definition The future value of C0at interest rate rin 1 year is:
FV = C0(1 + r).
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Jessica Wachter Notes for Finance 604
Note: We are moving the cash flow forwards in time.
Present value
Suppose you need $1000 in one year. What do you need to put aside today? Note that
$1000 is now the future value:
$1000 = PV ×(1 + r)
Rearranging:
PV = $1000
1 + r
when r= 10%, PV = $1000/(1.10) = $909.09. $909.09 is the present value of $1000, at
10%. Note that we are bringing the $1000 backward in time.
Definition Suppose you will have a cash flow of C1in one year. The present value of C1
at interest rate ris:
PV = C1
1 + r.
