Chapter One: The Finance Function
Two key concepts:
- Time value of money
- Relationship between risk and return: profit, dividends, interest payments
The time value of money is a fundamental concept in finance that recognizes the idea that a
sum of money has a different value today compared to its value in the future. In other words,
the value of money changes over time due to factors such as interest, inflation, and the
potential for earning a return on investment.
There are two main components of the time value of money:
1. Future value (FV)
This concept refers to the value of a sum of money at a future point in time, assuming a
certain interest rate or rate of return.
Formula:
This formula shows how an investment or sum of money grows over time.
2. Present value (PV)
Present value is the current value of a sum of money that is to be received or paid in the
future, discounted at a certain rate.
This formula helps in determining the current worth of a future sum of money.
The time value of money is crucial in various financial decisions. The concept is based on the
principle that a dollar today is worth more than a dollar in the future due to the potential to
earn a return or the impact of inflation.
1
,Risk and return
Risk-return tradeoff is a fundamental principle in finance that describes the relationship
between the level of risk associated with an investment and the potential to return or reward
that investment might yield. In essence, it suggests that the potential return on an investment
is generally correlated with the level of risk: higher potential returns usually come with higher
levels of risk, and lower-risk investments typically offer lower potential returns.
Risk refers to the possibility that actual return may be different from expected return. Risk
can be measured by standard deviation.
Investors require increasing compensation (return) for taking on increasing risk. Return on an
investment can be measured over a standard period such as 1 year.
Shareholder return is annual dividend (D1) plus share price increase (P1-P0).
Relative return in percentage terms is: 100 × [(P1 – P0) + D1]/P0.
This is called total shareholder return.
Future values: compounding
Invest £100 now at 5% interest per year:
- After 1 year: £105.00 (100 × 1.05).
- After 2 years: £110.25 (105 × 1.05).
These are future values of £100 after 1 and 2 years. Future values are found by
compounding interest forward through time.
Present values: discounting
What sum of money invested now at 5% will give £120 in 2-years’ time? This will be
£120/1.052 = £108.84. This is the present value of £120 received in 2 years, if your required
rate of return is 5%. Dividing by 1.052 to find a present value is called discounting.
A rational investor will prefer £108.84 to £100 at the current time. Discounting allows us to
compare £120 in 2-years’ time with £100 now. Note that 1/1.052 = 0.907. 0.907 is the present
value factor or discount factor of 5% over 2 years (see tables). Hence £120 × 0.907 =
£108.84.
2
,Decision-making areas
A financial manager’s tasks can be divided into three areas:
- Financing decisions
- Dividend decisions
- Investment decisions
Key point: understand the interrelationship of these three decision areas.
3
, Financial manager:
- Finance director: strategic decision-making
- Corporate treasurer: day-to-day cash management
Possible corporate objectives:
- Maximization of profit
- Maximization of sales
- Survival
- Social responsibility
- Shareholder wealth maximization
Shareholder wealth maximization (SHWM): shareholders want both dividends and capital
gains. Capital gains reflect future dividends. Current and future dividends depend on future
cash flows:
- Their magnitude or size
- Their timing
- Their associated risk
Linking NVP (net present value) to SHWM:
Net present value is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time. NPV is a financial metric used to evaluate the
profitability of an investment or project. It calculates the present value of expected future
cash flows generated by the investment, minus the initial cost of the investment. The result
represents the net value of the investment in today's dollars.
NPV is widely used in capital budgeting and investment analysis, helping businesses make
informed decisions about whether to proceed with a particular investment opportunity. It
considers the time value of money by discounting future cash flows back to their present
value, providing a comprehensive measure of the project's economic viability.
Alignment with SHWM: the goal of NPV analysis is consistent with the broader principle of
shareholder wealth maximization. SHWM posits that the primary objective of a firm should be
to maximize the wealth of its shareholders. NPV, by evaluating the net value of an investment
in present terms, supports this objective by helping identify projects that are expected to
enhance shareholder wealth.
4
Two key concepts:
- Time value of money
- Relationship between risk and return: profit, dividends, interest payments
The time value of money is a fundamental concept in finance that recognizes the idea that a
sum of money has a different value today compared to its value in the future. In other words,
the value of money changes over time due to factors such as interest, inflation, and the
potential for earning a return on investment.
There are two main components of the time value of money:
1. Future value (FV)
This concept refers to the value of a sum of money at a future point in time, assuming a
certain interest rate or rate of return.
Formula:
This formula shows how an investment or sum of money grows over time.
2. Present value (PV)
Present value is the current value of a sum of money that is to be received or paid in the
future, discounted at a certain rate.
This formula helps in determining the current worth of a future sum of money.
The time value of money is crucial in various financial decisions. The concept is based on the
principle that a dollar today is worth more than a dollar in the future due to the potential to
earn a return or the impact of inflation.
1
,Risk and return
Risk-return tradeoff is a fundamental principle in finance that describes the relationship
between the level of risk associated with an investment and the potential to return or reward
that investment might yield. In essence, it suggests that the potential return on an investment
is generally correlated with the level of risk: higher potential returns usually come with higher
levels of risk, and lower-risk investments typically offer lower potential returns.
Risk refers to the possibility that actual return may be different from expected return. Risk
can be measured by standard deviation.
Investors require increasing compensation (return) for taking on increasing risk. Return on an
investment can be measured over a standard period such as 1 year.
Shareholder return is annual dividend (D1) plus share price increase (P1-P0).
Relative return in percentage terms is: 100 × [(P1 – P0) + D1]/P0.
This is called total shareholder return.
Future values: compounding
Invest £100 now at 5% interest per year:
- After 1 year: £105.00 (100 × 1.05).
- After 2 years: £110.25 (105 × 1.05).
These are future values of £100 after 1 and 2 years. Future values are found by
compounding interest forward through time.
Present values: discounting
What sum of money invested now at 5% will give £120 in 2-years’ time? This will be
£120/1.052 = £108.84. This is the present value of £120 received in 2 years, if your required
rate of return is 5%. Dividing by 1.052 to find a present value is called discounting.
A rational investor will prefer £108.84 to £100 at the current time. Discounting allows us to
compare £120 in 2-years’ time with £100 now. Note that 1/1.052 = 0.907. 0.907 is the present
value factor or discount factor of 5% over 2 years (see tables). Hence £120 × 0.907 =
£108.84.
2
,Decision-making areas
A financial manager’s tasks can be divided into three areas:
- Financing decisions
- Dividend decisions
- Investment decisions
Key point: understand the interrelationship of these three decision areas.
3
, Financial manager:
- Finance director: strategic decision-making
- Corporate treasurer: day-to-day cash management
Possible corporate objectives:
- Maximization of profit
- Maximization of sales
- Survival
- Social responsibility
- Shareholder wealth maximization
Shareholder wealth maximization (SHWM): shareholders want both dividends and capital
gains. Capital gains reflect future dividends. Current and future dividends depend on future
cash flows:
- Their magnitude or size
- Their timing
- Their associated risk
Linking NVP (net present value) to SHWM:
Net present value is the difference between the present value of cash inflows and the present
value of cash outflows over a period of time. NPV is a financial metric used to evaluate the
profitability of an investment or project. It calculates the present value of expected future
cash flows generated by the investment, minus the initial cost of the investment. The result
represents the net value of the investment in today's dollars.
NPV is widely used in capital budgeting and investment analysis, helping businesses make
informed decisions about whether to proceed with a particular investment opportunity. It
considers the time value of money by discounting future cash flows back to their present
value, providing a comprehensive measure of the project's economic viability.
Alignment with SHWM: the goal of NPV analysis is consistent with the broader principle of
shareholder wealth maximization. SHWM posits that the primary objective of a firm should be
to maximize the wealth of its shareholders. NPV, by evaluating the net value of an investment
in present terms, supports this objective by helping identify projects that are expected to
enhance shareholder wealth.
4
