Lecture 3: Flashcards
(18 cards)
What are the different goals of a firm?
- Size Maximisation
- Customer satisfaction
- Customer maximisation
- Sales maximisation
- Profits maximisation
- Dividend growth maximisation
What is the goal of corporate finance?
To maximise shareholders wealth
- Can be achieved by taking decisions that lead to a maximisation of the market price of the company shares
How can firms maximise wealth?
- Allocate their scarce resources to their most productive use
- This way, the firms automatically respond to the needs of all stakeholders including the shareholders
What is Net Present Value (NPV)?
Used to calculate the current value of a future stream of payments from a company (How much a company will make after a certain period of time after investment)
What is discount rates in NPV?
It is the rate at which an investor trades off future cash for present cash.
Higher discount rate decreases the present value of future cash flows which results in a lower NPV
Lower discount rate = Increases present value which raises the NPV
What criterion should finance managers use when making decisions so that they lead to maximisation of shareholder’s wealth?
Under certain conditions, using the net present value (NPV) rule maximises the share price and hence maximises shareholder’s wealth
What is the decision rule for NPV?
Accept the project is NPV > 0
Reject the project if NPV < 0
What is Fisher’s Separation Theorum?
- If capital markets for borrowing and lending are well-functioning, companies can make their investment decision independently of individual shareholders’ consumption decisions and by using the NPV Rule
What is the condistion for Fisher’s separation Theorum?
That capital markets are perfect
What are characteristics of A PCM (Perfect Capital Market)?
- No transactions costs or other frictions to accessing capital markets by both firms and investors
- Markets are competitive in the sense that access is free and equal and no participants have the power to influence prices
- All participants have the same info about prices and security / firm characteristics
- No distorting taxes
In a PCM, why is maximising share prices better off?
Because shareholders can sell or buy shares and other securities
Or they can borrow and lend to get their desired consumption
What happens when capital markets are imperfect?
When borrowing rates are much larger than saving rates:
Impatient investors who want to borrow and consume more than their income will want firm to use a higher discount rate when calculating NPC
Patient investors who want to save for the future will want the firm to use a low discount rate when calculating the NPV
How do perfect capital markets solve the previous dilemma?
- Both investors want the firm to accept positive NPV projects because it increases their wealth
- Impatient investors caan borrow money from the market to sell shares to finance their consumption
- Patient investors can lend money or buy more shares to invest for future consumption
- Finance manager can then focus on just one goal to find and implement a positive NPV project
What does Fisher’s Separation Theorum assume in a PCM?
That the firm’s optimal investment decision depends solely on estimated cash flowes from investment and market interest rates.
Completely independent of shareholder’s various preferences for current vs future consumption
Implies that Firms should accept positive NPVs
How to calculate NPV?
(Cashflow / (discount rate +1)) - initial investment
What increases when NPV is positive?
The firm’s equity capital will increase when NPV is positive
What are the issues with NPV?
- Too black and white, now or never kind of standpoint when actually firms and managers have more choice
- Managers could choose to delay a project instead
- NPV ignores investment options like slowing down project, expediting it, out-sourcing it, stopping it, expanding it etc
- Hasn’t incuded the opportunity costs of loft opportunities or the benefits of opportunities gained
Why would a manager choose to delay a project?
- Expecting a fall in interest rates
- Expected cash flows might increase
- New regulation affecting the project expected etc
