BUSI 1045 Business Finance
THEORY
1. Liquidation paying claimants order:
a. Tax
b. Employee wages
c. Secured creditors
d. Unsecured creditors
e. Preference shareholders
f. Ordinary shareholders
2. Profit maximisation fails in identifying:
- Uncertainty of return
- Timing of cash flow
3. Difference between profit maximisation and maximising shareholder’s wealth:
Profit maximization typically is defined as a more static concept than shareholder
wealth maximization. The profit maximization objective from economic theory does not
normally consider the time dimension or the risk dimension in the measurement of
profits. In contrast, the shareholder wealth maximization objective provides a
convenient framework for evaluating both the timing and the risks associated with
various investment and financing strategies.
Shareholder wealth is defined as the present value of the expected future returns to the
owners (that is, shareholders) of the firm. These returns can take the form of periodic
dividend payments and/or proceeds from the sale of the shares. Shareholder wealth is
measured by the market value (that is, the price that the share trades in the
marketplace) of the firm's ordinary shares.
The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is
a function of all the future returns to the shareholders. Hence, in making decisions that
maximize shareholder wealth, management must consider the long-run impact on the
firm and not simply on short-run effects. For e.g., a firm could increase short-run
earnings and dividends by eliminating all research and development expenditures.
However, this decision would reduce long-run earnings and dividends, and hence
shareholder wealth, because the firm would be unable to develop new products to
produce and sell.
The maximizing of shareholder’s wealth is a more appropriate objective for corporation
because it takes into account three major factors that determine the market value of a
firm's shares: (1) the amount of the cash flows expected to be generated for the benefit
of shareholders; (2) the timing of these cash flows; and (3) the risk of the cash flows.
,4. Importance of time value money:
The time value of money refers to the belief that, all other things equal, the earlier that
a dollar of cash flow is received the better.
Time value is important to valuation because cash flows are often received at different
times and in order to validly aggregate their contribution to value, we need to
appropriately down weight cash flows, the more distant in time that they occur.
Time value is related to the rate of return by inducing expected returns to be a positive
value, thereby providing compensation for deferring consumption (the time value of
money). The time value of money principally expresses how an investor will choose
between cash flows that occur in different time periods. In this example, the investor
has a choice between 2 certain cash flows being £100 now and £100 in a year’s time.
Assuming a positive rate of interest, an investor will prefer £100 now as this money can
be invested at the rate of interest to accumulate to more than £100 in one year’s time.
5. Agency problem:
- Shareholders vs managers conflict of interest
- Shareholders don’t want to carry out projects with risks
- Solution: tie manager’s salary to share value
6. Investment appraisal techniques:
- Non-Discounted Cash Flow method: (ignores time value money)
o Payback
o Accounting Rate of Return
- Discounted Cash Flows
o Net Present Value
o Internal Rate of Return
7. Capital Budgeting:
o Analysis of potential additions to fixed assets, using NPV along with IRR
o Independent vs Mutually exclusive
▪ Ind: have the resources to do both projects at the same time
▪ Mutual: Can’t do the same time
8. NPV: PV of cash inflow – PV of cash outflow
- Accept project if NPV is positive – the project is expected to add value to the firm –
increasing wealth of owners
9. IRR: rate of return of the project, etc put $100 get $110, IRR=10%
- IRR is required to make NPV zero.
, 10.Payback Period:
- The length of time before the cumulated cash flows = initial investment
- Acceptable if actual payback period is ≤ initial figure
- Drawbacks:
o Ignores time value money
o Requires arbitrary cut off point
o Ignores cashflow after cut-off
o Biased against long-term projects
11.AROR: compares the average of profit after tax with average size of the investment
- Accept if AROR is > minimum acceptable AROR
12.Capital Rationing
- Hard & Soft
o Hard: “external” factors, issues with raising funds in external market, lead to
shortage of capital to finance new projects – limit cost of capital
o Soft: “internal” factors, caused by internal policies, company may impose
certain limit to funds available for investment
o Divisible Projects: single period capital rationing, use profitability index (PI)
13.Cash Flows – Relevance:
- “Will the cash flow occur ONLY if we accept the project?”
- Yes – Incremental; No – It’ll happen anyway; Part of it – include that part
- Relevant:
o Opportunity cost
o Purchase Costs
o Set-up Costs
o Proceeds from Disposals
o Capital Allowance
o Taxation
o Changes in Working Capital
THEORY
1. Liquidation paying claimants order:
a. Tax
b. Employee wages
c. Secured creditors
d. Unsecured creditors
e. Preference shareholders
f. Ordinary shareholders
2. Profit maximisation fails in identifying:
- Uncertainty of return
- Timing of cash flow
3. Difference between profit maximisation and maximising shareholder’s wealth:
Profit maximization typically is defined as a more static concept than shareholder
wealth maximization. The profit maximization objective from economic theory does not
normally consider the time dimension or the risk dimension in the measurement of
profits. In contrast, the shareholder wealth maximization objective provides a
convenient framework for evaluating both the timing and the risks associated with
various investment and financing strategies.
Shareholder wealth is defined as the present value of the expected future returns to the
owners (that is, shareholders) of the firm. These returns can take the form of periodic
dividend payments and/or proceeds from the sale of the shares. Shareholder wealth is
measured by the market value (that is, the price that the share trades in the
marketplace) of the firm's ordinary shares.
The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is
a function of all the future returns to the shareholders. Hence, in making decisions that
maximize shareholder wealth, management must consider the long-run impact on the
firm and not simply on short-run effects. For e.g., a firm could increase short-run
earnings and dividends by eliminating all research and development expenditures.
However, this decision would reduce long-run earnings and dividends, and hence
shareholder wealth, because the firm would be unable to develop new products to
produce and sell.
The maximizing of shareholder’s wealth is a more appropriate objective for corporation
because it takes into account three major factors that determine the market value of a
firm's shares: (1) the amount of the cash flows expected to be generated for the benefit
of shareholders; (2) the timing of these cash flows; and (3) the risk of the cash flows.
,4. Importance of time value money:
The time value of money refers to the belief that, all other things equal, the earlier that
a dollar of cash flow is received the better.
Time value is important to valuation because cash flows are often received at different
times and in order to validly aggregate their contribution to value, we need to
appropriately down weight cash flows, the more distant in time that they occur.
Time value is related to the rate of return by inducing expected returns to be a positive
value, thereby providing compensation for deferring consumption (the time value of
money). The time value of money principally expresses how an investor will choose
between cash flows that occur in different time periods. In this example, the investor
has a choice between 2 certain cash flows being £100 now and £100 in a year’s time.
Assuming a positive rate of interest, an investor will prefer £100 now as this money can
be invested at the rate of interest to accumulate to more than £100 in one year’s time.
5. Agency problem:
- Shareholders vs managers conflict of interest
- Shareholders don’t want to carry out projects with risks
- Solution: tie manager’s salary to share value
6. Investment appraisal techniques:
- Non-Discounted Cash Flow method: (ignores time value money)
o Payback
o Accounting Rate of Return
- Discounted Cash Flows
o Net Present Value
o Internal Rate of Return
7. Capital Budgeting:
o Analysis of potential additions to fixed assets, using NPV along with IRR
o Independent vs Mutually exclusive
▪ Ind: have the resources to do both projects at the same time
▪ Mutual: Can’t do the same time
8. NPV: PV of cash inflow – PV of cash outflow
- Accept project if NPV is positive – the project is expected to add value to the firm –
increasing wealth of owners
9. IRR: rate of return of the project, etc put $100 get $110, IRR=10%
- IRR is required to make NPV zero.
, 10.Payback Period:
- The length of time before the cumulated cash flows = initial investment
- Acceptable if actual payback period is ≤ initial figure
- Drawbacks:
o Ignores time value money
o Requires arbitrary cut off point
o Ignores cashflow after cut-off
o Biased against long-term projects
11.AROR: compares the average of profit after tax with average size of the investment
- Accept if AROR is > minimum acceptable AROR
12.Capital Rationing
- Hard & Soft
o Hard: “external” factors, issues with raising funds in external market, lead to
shortage of capital to finance new projects – limit cost of capital
o Soft: “internal” factors, caused by internal policies, company may impose
certain limit to funds available for investment
o Divisible Projects: single period capital rationing, use profitability index (PI)
13.Cash Flows – Relevance:
- “Will the cash flow occur ONLY if we accept the project?”
- Yes – Incremental; No – It’ll happen anyway; Part of it – include that part
- Relevant:
o Opportunity cost
o Purchase Costs
o Set-up Costs
o Proceeds from Disposals
o Capital Allowance
o Taxation
o Changes in Working Capital
