Principles of Finance

Purpose of Course  showclose

In BUS103: Financial Accounting, we learned that firms are required to keep detailed financial records so that organized reports can be distributed to managers, shareholders, and government regulators.  Principles of Finance will focus on what these managers, investors, and government agencies do with this information.  It is an introductory course to various fields of finance and is comparable in content to courses that other institutions label as “corporate finance” or “financial management.”

Finance is a broad term; you will find that both managers that compile the financial reports we discussed in financial accounting and stockbrokers working on Wall Street will claim that they work in finance.  So what exactly is finance?  Finance is the science of fund management.  It is distinct from accounting in that, whereas accounting aims at organizing and compiling past information, finance is geared towards deciding what to do with that information.

In this course, you will be exposed to a number of different sub-fields within finance.  You will learn how to determine which projects have the best potential payoff, to manage investments, and even to value stocks.  In the end, you will discover that all finance boils down to one concept: return.  In essence, finance asks: “If I give you money today, how much money will I get back in the future?”  Though the answer to this question will vary widely from case to case, by the time you finish this course, you will know how to find the answer.

You will learn how to use financial concepts such as the time value of money, pro forma financial statements, financial ratio analysis, capital budgeting analysis, capital structure, and the cost of capital.  This course will also provide an introduction to bonds and stocks.  Upon completion of this course, you will understand financial statements, cash flow, time value of money, stocks and bonds, capital budgeting, ratio analysis, and long term financing, and apply these concepts and skills in business decisions.

Course Information  showclose

Welcome to BUS202 Principles of Finance. Below, please find general information on this course and its requirements.
 
Course Designer: Claudia Araiza, PhD
 
Primary Resources: This course makes primary use of the following materials:
  • Ivo-Welch: Dr. Ivo Welch’s "Corporate Finance" (2nd edition), Online Finance Textbook
  • University of West Florida: Dr. Richard Constand’s FIN 4424 - Problems in Financial Management, Online Lectures and Assignments
  • Khan Academy: Finance, Online Lectures
  • The Wharton School at the University of Pennsylvania: Dr. Michael R. Roberts’ Finance 100: Corporate Finance, Online Assignments
Requirements for Completion: In order to complete this course, you will need to work through each unit and its assignment materials.  In addition, you must complete the assignments for each unit and subunits as indicated in the instructions.
 
Note that you will only receive an official grade on your final exam.  However, in order to adequately prepare for this exam, you will need to work through the resources and assignments for each unit.
 
In order to “pass” this course, you will need to earn a 70% or higher on the Final Exam.  Your score on the exam will be tabulated as soon as you complete it.  If you do not pass the exam, you may take it again.
 
Time Commitment: This course should take you a total of 133.5 hours to complete.  Each unit includes a “time advisory” that lists the amount of time you are expected to spend on each subunit.  These should help you plan your time accordingly.  It may be useful to take a look at these time advisories and to determine how much time you have over the next few weeks to complete each unit, and then to set goals for yourself.  For example, Unit 1 should take you 8.5 hours.  Perhaps you can sit down with your calendar and decide to complete half of subunit 1.1 (2 hours) on Monday night; the rest of subunit 1.1 (about 1.75 hours) on Tuesday night; subunit 1.2 (2 hours) on Wednesday night; etc.
 
Tips/Suggestions: It is advisable to follow these tips:
  • Complete the units and all sub-units in the order as they appear.
  • Get acquainted with Microsoft Excel before you begin this course as many of the assignments involve using Excel. You can find several tutorial sites on the web but this one is especially recommended: Florida Gulf Coast University: Technology Skills Orientation: “Excel 2000 Tutorial
  • The author of the main textbook, Dr. Ivo Welch, highly suggests that you use a robust internet browser such as Google Chrome, Mozilla Firefox, Apple Safari, Camino, Opera, or Konqueror to view the online textbook. Microsoft’s Internet Explorer is compatible with the textbook but it is better to use the latest version (version 9). You can read about other suggestions for viewing the online textbook in Dr. Ivo Welch’s information site for the textbook: “Corporate Finance (2nd edition)


Khan Academy  
This course features a number of Khan Academy™ videos. Khan Academy™ has a library of over 3,000 videos covering a range of topics (math, physics, chemistry, finance, history and more), plus over 300 practice exercises. All Khan Academy™ materials are available for free at www.khanacademy.org.

Learning Outcomes  showclose

Upon successful completion of this course, the student will be able to:
  • Explain the objectives of the financial manager and how the structure of a corporation affects financial decisions.
  • Explain how the financial manager uses and analyzes the income statement, the balance sheet statement, and the statement of cash flows to make better informed decisions.
  • Explain the concept of time value of money and how the present value calculation is related to the future value calculation.
  • Explain the rules and methods in capital budgeting when making financial decisions.
  • Explain how the financial manager makes financial investment decisions when confronted with issues of risk and uncertainty while considering different risk preferences.
  • Explain the different components of a company’s capital structure.
  • Explain the Modigliani-Miller theorem in finance.
  • Apply the WACC formula for estimating a company’s cost of capital.
  • Explain the use of the CAPM model for estimating valuations of a company’s rate of return.
  • Use Excel to prepare an analysis of a company’s financial statements and stock data.

Course Requirements  showclose

In order to take this course you must:

√    Have access to a computer.

√    Have continuous broadband Internet access.

√    Have the ability/permission to install plug-ins or software (e.g., Adobe Reader or Flash).

√    Have the ability to download and save files and documents to a computer.

√    Have the ability to open Microsoft files and documents (.doc, .ppt,.xls, etc.).

√    Be competent in the English language.

√    Have read the Saylor Student Handbook.

Unit Outline show close


Expand All Resources Collapse All Resources
  • Unit 1: Introduction To Finance, Financial Statements, And Financial Analysis  

    As noted in the course introduction, finance is a broad subject and financial decisions are all around us.  Whether you work on Wall Street or in a small company, finance is vital to every business.  Therefore, understanding the fundamentals of finance is vital to your business education. This introductory unit addresses fundamental concepts of finance, stocks,  and bonds.  Also, Unit 1 exposes the importance of understanding ratios for financial statement analysis and analysis of cash flows.  The main ratios explained are: solvency (or liquidity ratios), financial ratios, profitability ratios, and market value ratios.  In addition, you will learn about financial growth, what financial factors determine growth, the importance of maintaining a sustainable growth rate, and how to use financial statement information to manage growth.  Consider this situation: You are the manager of a small retail chain and your boss has given you the task of deciding whether to invest in a second store.  You know that adding a second store means greater potential for growth.  However, you also know that adding a new store will require spending cash.  Facing this tough decision, how could you determine whether the company can “handle” such an investment?  The answer might lie in ratio analysis.  This section will explain how to use financial ratios to help you make these types of business decisions.  

    Unit 1 Time Advisory   show close
    Unit 1 Learning Outcomes   show close
  • 1.1 Introduction to Concepts in Finance  
    • Reading: Dr. Ivo Welch’s Corporate Finance (3rd Edition): “Chapter 1: Introduction” and “Chapter 7: A First Look at Investments”

      Link: Dr. Ivo Welch’s Corporate Finance (3rd Edition): “Chapter 1: Introduction” (HTML) and “Chapter 7: A First Look at Investments” (HTML)
       
      Instructions: Read Chapters 1 and 7 in the textbook as they introduce you to the main concepts and terms in finance. Chapter 1 covers the goal in finance, stocks, bonds, and the ethical dilemma of finance managers. Chapter 7 gives a historical account of the performance of stocks and bonds and also introduces you to several financial institutions such as the New York Stock Exchange. Also, make sure to answer the questions given at the end of each section in those chapters and compare your answers to the answers given at the end of Chapters 1 and 7 under the heading titled “Answers.” This reading should take you approximately 4 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • 1.2 Stock, Bonds, and Corporate Structures  
  • 1.3 Financial Statements  
  • 1.3.1 Balance Sheet Statement  

    Note: This topic is covered by the resources in subunit 1.3.  A balance sheet statement is an account of the value of assets, liabilities, and net worth of a company.  It is always considered during a point in time, such as December 31, 2011.  Assets are things that a company owns; whereas liabilities are things that a company owes.  Assets minus liabilities results in the net worth of a company.

  • 1.3.2 Income Statement  

    Note: This topic is covered by the resources in subunit 1.3.  An income statement is an account of the revenues (net sales), costs, expenses, and taxes of a company during a period of time, say from December 31, 2011 to December 31, 2012.  The goal of an income statement is to compute the net profits of a company and all the different items involved.

  • 1.3.3 Cash Flow Statement  

    Note: This topic is covered by the resources in subunit 1.3.  The cash flow statement keeps tracks of a company’s uses and sources of cash.  By cash, it does not only mean “paper money bills and coins”; it also refers to credit card (or debit card) debits and credits, payments and receipts in check or money orders, and so on.

  • 1.3.4 Accrual Basis Accounting vs. Cash Accounting  

    Note: This topic is covered by the resources in subunit 1.3.  An accountant, who is responsible for preparing financial statements, is concerned with accrual basis accounting; whereas, the financial analyst or manager is concerned with cash-basis accounting by keeping track of the real uses and sources of cash.  Make sure to know this difference.

  • 1.4 Financial Ratios  
  • 1.5 Pro Forma Financial Statements  
    • Reading: Dr. Ivo Welch’s Corporate Finance (3rd Edition): "Chapter 20: Pro Forma Financial Statements”

      Link: Dr. Ivo Welch’s Corporate Finance (3rd Edition):"Chapter 20: Pro Forma Financial Statements” (HTML)
       
      Instructions: Read Chapter 20 in the textbook in detail as it explains how to prepare “pro-forma” financial statements, which are forecasted financial statements.  Also, make sure to answer the questions given at the end of each section in Chapter 20 and compare your answers to the answers given at the end of Chapter 20 under the heading titled “Answers.”  This reading should take you approximately 6 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • 1.6 Using Excel in Applications of Financial Ratio Analysis  
  • Unit 2: Time Value Of Money: Future Value, Present Value, And Interest Rates  

    Suppose you have the option of receiving $100 dollars today vs. $200 in five years.  Which option would you choose?  How would you determine which is the better deal?  Some of us would rather have less money today vs. wait for more money tomorrow.  However, sometimes it pays to wait.  Unit 2 introduces the concept of time value of money and explains how to determine the value of money today vs. tomorrow by using finance tools to determine present and future values.  Also, Unit 2 exposes the concept of interest rates and how to apply them when multiple periods are considered.  

    Unit 2 Time Advisory   show close
    Unit 2 Learning Outcomes   show close
  • 2.1 What is Time Value of Money?  
  • 2.1.1 Definition of Time Value of Money  

    Note: This topic is covered by the resources in subunit 2.1.  The concept called the “time value of money” assumes that individuals face either an increase in prices in the economy as time passes in the form of an inflation rate, such as a 4% annual inflation rate, or an opportunity to put their savings in an investment account offering an interest rate, such as 5% per year.  Therefore, under the “time value of money” concept, you can see that $1000 that you can receive in two years from today does not have the same value as $1000 today.  In fact, it will have a lesser value today.  Likewise, if you receive $1000 today and have the opportunity to put this money in an investment account earning 5% per year, in two years you will have more than $1000.

  • 2.1.2 Rates of Return  

    Note: This topic is covered by the resources in subunit 2.1.  Of concern is the fact that a rate of return is usually expressed as a percentage (e.g., 4%) but when you need to apply it in a calculation, use it in decimal-form (e.g., 0.04 is the decimal-form of 4%, 0.10 is the decimal-form of 10%, etc).  The same applies to the numerical expressions of interest rates.

  • 2.1.3 Simple Interest vs. Compound Interest  

    Note: This topic is covered by the resources in subunit 2.1.  When you need to calculate the future value of an amount using a simple interest rate, you apply the interest rate only to the initial amount.  On the contrary, when you calculate the future value of an amount using the compound interest rate, you apply the interest rate not only to the initial amount but also to amounts of interest earned.  The compound interest rate is commonly used by banks, credit card companies, and any other financial institution.  The simple interest rate is usually applied to loans made in informal business deals, and even to loans involving family members!

  • 2.2 Future Value and Compounding  
  • 2.2.1 Definition of Future Value  

    Note: This topic is covered by the resources in subunit 2.2.  The future value of an initial amount is the future value of that amount in “n” periods into the future given that the initial amount is subject to a certain interest rate every period.

  • 2.2.2 Future Value Formula  

    Note: This topic is covered by the resources in subunit 2.2.  The future value (FV) formula when considering the same interest rate every period is as follows:

    FVn = PV x (1 + i)n 

    This formula is stating that in “n” periods from today the FV value of an initial amount today, otherwise called the present value (PV), is equal to the PV amount multiplied by (1 + i)n, where “i” is the fixed interest rate received every period expressed in decimal-form.  For example, if the interest rate is 5%, then 1+ i = 1 + 0.05 = 1.05.

  • 2.2.3 Calculating Future Value on Your Calculator  

    Note: When you use the FV formula as stated above in Subunit 2.2.2 and use a calculator to compute it, make sure to separate (1 + i)n from the PV amount by using parenthesis.  For example, to calculate the FV in 5 years of $100 under a 10% annual interest rate, in a typical calculator you will enter the amounts in the following way: 100x(1.10^5).  You will see that the final result is $161.05.  If your calculator does not allow you to raise an amount to the power of a number then you can just multiply (1+i) by itself for a total of “n” times.  For example, (1.10)5 is the same as 1.10x1.10x1.10x1.10x1.10.

  • 2.3 Present Value and Discounting  
  • 2.3.1 Definition of Present Value  

    Note: This topic is covered by the resources in subunit 2.3.  The present value of a future amount that will be received in “n” periods into the future is in today’s value.

  • 2.3.2 Present Value Formula  

    Note: This topic is covered by the resources in subunit 2.3.  The present value (PV) formula when considering the same interest rate every period is as follows:
     
    PV = FVn / (1 + i)n
     
    This formula is stating that the present value (PV) of the future value (FV) of an amount that will be received in “n” periods from today is equal to the FV amount divided by (1 + i)n, where “i” is the fixed interest rate received every period expressed in decimal-form.  For example, if the interest rate is 5%, then 1+ i = 1 + 0.05 = 1.05.

  • 2.3.3 Calculating Present Value on Your Calculator  

    When you use the PV formula as stated above in Subunit 2.3.2 and use a calculator to compute it, make sure to separate (1 + i)n from the FV amount by using parenthesis.  For example, to calculate the PV of $100 that will be received in 5 years from today under a 10% annual interest rate, in a typical calculator you will enter the amounts in the following way: 100/(1.10^5).  You will see that the final result is $62.09. If your calculator does not allow you to raise an amount to the power of a number then you can just multiply (1+i) by itself for a total of “n” times.  For example, (1.10)5 is the same as 1.10x1.10x1.10x1.10x1.10.

  • 2.4 Variable Rates of Return  
  • 2.4.1 Variable Rates of Return  

    Note: This topic is covered by the resources in subunit 2.4.  For this topic, review “Section 5.1 Working With Time-Varying Rates of Return” in the textbook.  That section shows you how to adjust the interest rate when you are given an annual interest rate but you need to consider monthly, weekly, or daily periods in the present and future value calculations.  Also, make sure to watch the Khan videos listed under subunit 2.4.

  • 2.4.2 Inflation Rate  

    Note: This topic is covered by the resources in subunit 2.4.  For this topic, review “Section 5.2 Inflation” in the textbook.  That section shows you how to adjust the interest rate in the present and future value calculations when you need to consider the role of the inflation rate in a capital budgeting decision.

  • 2.4.3 U.S. Treasuries and the Yield Curve  

    Note: This topic is covered by the resources in subunit 2.4.  For this topic, review “Section 5.3 U.S. Treasuries and the Yield Curve,” “Section 5.4 Why Does the Yield Curve Usually Slope Up?,” and “Section 5.5 Corporate Insights about Time-Varying Costs of Capital” in the textbook.  Those sections expose you to the basic risk-free rate that companies consider when comparing rates of returns of their investment projects.

  • 2.5 Special Applications: Perpetuities and Annuities  
  • 2.5.1 Perpetuities  

    Note: This topic is covered by the resources in subunit 2.5.  A perpetuity is a special financial account that pays the same amount each period forever.  It is rarely used in finance today.  To calculate the present value of a perpetuity (PVP), use the following formula:
     
    PVP = A / i
     
    This formula is stating that the total present value of an amount (A) that is paid every period until infinity is equal to “A” divided by “i”, where “i” is the fixed interest rate received every period expressed in decimal-form.  For example, if the interest rate is 5%, then i =  0.05.  Due to the nature of this account, without a definite expiration date, the future value cannot be computed (or, using mathematical logic, the future value of a perpetuity is equal to infinity).

  • 2.5.2 Annuities  

    Note: This topic is covered by the resources in subunit 2.5. An annuity is a special financial account that requires the same amount payment each period up to a limited number of periods.  Annuities are common in finance.  Examples of annuities are: mortgage loans, auto loans, student loans, and retirement savings accounts.
     
    To calculate the present value of an annuity (PVA), use the following formula:
     
    PVA = (A / i) x [1- (1 + i)-n]
     
    That formula is stating that the total present value of an amount (A) that is paid every period until “n” periods into the future into an account under an interest rate (i) is equal to “A” divided by “iand then multiplied by the expression in brackets.  Notice that (1 + i)-n has the power to the negative “n.” The “i” is the fixed interest rate applied every period expressed in decimal-form.  For example, if the interest rate is 5%, then
    i =  0.05. This calculation is normally used to calculate monthly mortgage loan and student payments that are fixed for a long period of time, say 240 months. Using that formula, a loan officer solves for the monthly loan payment, the A, given a fixed monthly interest rate for a loan that will be repaid in “n” months with a beginning balance equal to the PVA.
     
    On the contrary, the future value formula of an annuity is used for calculating retirement savings accounts that are liquidated at the end of a certain future period.  To calculate the future value of an annuity (FVA), use the following formula:
     
    FVA = (A / i) x [(1 + i)n - 1]
     
    That formula is stating that the total future value of an amount (A) that is paid every period until “n” periods into the future into an account under an interest rate (i) is equal to “A” divided by “i”and then multiplied by the expression in brackets.  Notice that (1 + i)n has the power to the positive “n.”  The “i” is the fixed interest rate applied every period expressed in decimal-form.  For example, if the interest rate is 5%, then i = 0.05.  Using that formula, you will be able to know how much you will have in your retirement savings account at the end of “n” periods  when you make equal payments every period and earn a fixed interest rate every period.

  • 2.6 Using Excel in Applications of the Time Value of Money  
  • Unit 3: Capital Budgeting Techniques  

    Unit 3 shows how a financial manager makes capital investment decisions using financial tools.  It is especially the case that this unit addresses the concept of capital budgeting and how to evaluate investment projects using the net present value calculations, internal rate of return criteria, profitability index, and the payback period method.  In particular, this unit will teach you how to determine which cash flows are relevant (should be considered) when making an investment decision.  Say for instance, you have been asked to give your recommendation about buying or not buying a new building.  As the financial manager, it is your task to identify cash flows that, in some way or another, affect the value of the investment (in this case the building).  Also, this unit explains how to calculate “incremental” cash flows when evaluating a new project, which can also be considered as the difference in future cash flows under two scenarios: when a new investment project is being considered and when it is not.  Make sure to complete Unit 2 first before engaging in Unit 3 as this unit is considered the advanced portion using the financial techniques that are explained in Unit 2, such as the present and future value formulas.

    Unit 3 Time Advisory   show close
    Unit 3 Learning Outcomes   show close
  • 3.1 Capital Budgeting and Net Present Value  
    • Reading: Dr. Ivo Welch’s Corporate Finance (3rd Edition): Chapter 2: Present Value: “Section 2.6: Net Present Value” and Chapter 4: A First Encounter with Capital Budgeting Rules: “Section 4.1: Net Present Value”

      Link: Dr. Ivo Welch’s Corporate Finance (3rd Edition): Chapter 2: Present Value: “Section 2.6: Net Present Value” (HTML) and Chapter 4: A First Encounter with Capital Budgeting Rules: “Section 4.1: Net Present Value” (HTML)
       
      Instructions: Read Section 2.6 from Chapter 2 and Section 4.1 from Chapter 4 in the textbook.  Section 2.6 gives you the “net present value” (NPV) concept and shows you how to use it with several examples in finance.  Pay special attention to the “NPV capital budgeting rule,” which is another important concept in finance.  Section 4.1 revisits the concept of “net present value” that is explained in Section 2.6.  This concept is one of the tools in finance that is used for making investment decisions.  Also, make sure to answer the questions given at the end of Sections 2.6 and 4.1 and compare your answers to the answers given at the end of Chapters 2 and 4 under the heading titled “Answers.”  This resource covers the topics outlined in sub-subunits 3.1.1 to 3.1.3.  This reading should take you approximately 4 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • 3.1.1 Definition of Net Present Value  

    Note: This topic is covered by the resources in subunit 3.1.  When evaluating a project that will take place in the future, the net present value is usually applied in finance.  The net present value is the present value of all future benefits minus the present value of all future costs.

  • 3.1.2 NPV Capital Budgeting Rule  

    Note: This topic is covered by the resources in subunit 3.1.  When deciding whether or not to invest in a new business project, such as a store expansion, the net present value (NPV) rule in capital budgeting is to accept that project only if the NPV of the project is greater than or equal to $0. I n addition, when choosing between projects, the NPV rule is to accept that project with the highest NPV.

  • 3.1.3 NPV Formula  

    Note: This topic is covered by the resources in subunit 3.1.  The net present value (NPV) formula is stated as follows:
     
    NPV = present value of all benefits – present value of all costs
     
    The details of that formula can be explained using a cash flow amount represented by Ct in period “t” for each benefit and each cost.  For example, when a project has an initial upfront cost in period 0, the present value of that cash flow is C0.  Suppose for example that you are evaluating the NPV of an investment project that costs C0, which is paid in the beginning, and provides benefits for the next three years represented by cash flows C1, C2, and C3.  The NPV of this project with an interest rate of “i” is computed as follows:
     
    NPV = [C1/(1+i)] + [C2/(1+i)2] + [C3/(1+i)3] - C0

  • 3.2 Internal Rate of Return  
  • 3.2.1 Definition of Internal Rate of Return  

    Note: This topic is covered by the resources in subunit 3.2.  When evaluating a project that will take place in the future, the return of that project is computed and then compared to alternative returns.  Recall that a return in the language of finance is expressed as a percentage, which is technically called a rate of return.  The internal rate of return (IRR) is the return of project when its NPV is set to $0.  

  • 3.2.2 IRR Capital Budgeting Rule  

    Note: This topic is covered by the resources in subunit 3.2.  When deciding whether or not to invest in a new business project, such as a store expansion, the internal rate of return (IRR) rule in capital budgeting is to accept that project only if its IRR is greater than the average cost of capital in the economy, industry, or in a company.  For example, if you have a project with an IRR of 10% but interest rates on business loans are 20%, then it seems that you will lose money if your company is taking out loans from a bank with a 20% interest rate in order to buy new machinery or expand operations that will return 10%.  In addition, when choosing between projects, the IRR rule is to accept that project with the highest IRR.

  • 3.2.3 IRR Formula  

    Note: This topic is covered by the resources in subunit 3.2.  Using the example in sub-subunit 3.1.3, the IRR of a three-year project with an initial cost of C0 is computed as follows:
     
    $0 = [C1/(1+IRR)] + [C2/(1+IRR)2] + [C3/(1+IRR)3] - C0
     
    In the formula above you might be wondering how you can solve for the IRR as the algebraic mechanics look cumbersome.  With special computer software, and even with Microsoft Excel, you can solve for the IRR.  Look at Exhibit 4.2 in Chapter 4 of the textbook on page 66 for a demonstration in Excel.

  • 3.3 Profitability Index  
    • Reading: Dr. Ivo Welch’s Corporate Finance (3rd Edition): Chapter 4: A First Encounter with Capital Budgeting Rules: “Section 4.3: The Profitability Index”

      Link: Dr. Ivo Welch’s Corporate Finance (3rd Edition): Chapter 4: A First Encounter with Capital Budgeting Rules: “Section 4.3: The Profitability Index” (HTML)
       
      Instructions: Read Section 4.3 from Chapter 4 in the textbook.  That section highlights another important capital budgeting concept in finance that is used for making investment decisions when the scale of projects differs.  The profitability index rule applies well when projects that differ in size need to be compared.  Also, make sure to answer the questions given at the end Section 4.3 and compare your answers to the answers given at the end of Chapter 4 under the heading titled “Answers.”  This resource covers the topics outlined in sub-subunits 3.3.1 to 3.3.3.  This reading should take you approximately 2 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • 3.3.1 Definition of Profitability Index  

    Note: This topic is covered by the resources in subunit 3.3.  When comparing the net present value (NPV) of different projects that vary in size, the profitability index (PI) of each project can be computed.  The PI is computed by taking the present value of the benefits divided by the present value of the costs.  The PI is, therefore, a relative measure for comparing projects that differ in scale.  For example, if a small project has an NPV of $4 million and a large project has an NPV of $200 million, using the NPV rule you are most likely to choose the large project.  The problem is that the large project required a larger investment.  However, if you find that the small project has a PI of 5.00 and the large project has a PI of 2.00, your best option under this criterion is to choose the small project as it gives you more relative net benefits than the large project.

  • 3.3.2 PI Capital Budgeting Rule  

    Note: This topic is covered by the resources in subunit 3.3.  When choosing between projects that vary in scale, the PI rule is to accept that project with the highest PI.

  • 3.3.3 PI Formula  

    Note: This topic is covered by the resources in subunit 3.3.  The profitability index (PI) formula is stated as follows:
     
    PI = present value of all benefits / present value of all costs
     
    The details of that formula can be explained using a cash flow amount represented by Ct in period “t” for each benefit and each cost. For example, when a project has an initial upfront cost in period 0, the present value of that cash flow is C0.  Suppose for example that you are evaluating the PI of an investment project that costs C0, which is paid in the beginning, and provides benefits for the next three years represented by cash flows C1, C2, and C3.  The PI of this project with an interest rate of “i” is computed as follows:
     
    PI = { [C1/(1+i)] + [C2/(1+i)2] + [C3/(1+i)3] } / C0

  • 3.4 Payback Period Method  
  • 3.4.1 Definition of Payback Period Method  

    Note: This topic is covered by the resources in subunit 3.4.  The payback period (PP) method is a simple way for comparing the feasibility between projects.  It is a measure that tells you how long a project takes to recover its initial investment.  

  • 3.4.2 PP Capital Budgeting Rule  

    Note: This topic is covered by the resources in subunit 3.4.  When choosing between projects, the PP rule is to accept that project with the shortest PP.  For example, if project A takes 5 years to recover its initial investment but project B takes 1 year, then under this method it is best to choose project B.  The PP method, as you can see, is very simple and may lead to erroneous decisions because it does not tell you anything about the size of the returns.  Will you change your mind knowing that project A is a 7-year project that will give you a $50 million profit compared to project B that is a 2-year project that will only give you a $1 million profit?

  • 3.4.3 PP Formula  

    Note: This topic is covered by the resources in subunit 3.4.  The payback period (PP) method is computed by counting the time (in years, months, or days) that it takes for a project to recoup its initial investment.  For example, suppose that a 3-year project that costs $100,000 will give you benefits of $50,000 in the first year, $100,000 in the second year, and $150,000 in the third year.  The PP for this project is 1.5 years as it will take 1 year and 6 months to recover the entire $100,000.  Notice that the net profit of this project is $200,000!

  • 3.5 Evaluating Projects Incrementally  
  • 3.5.1 Initial Investment  

    Note: This topic is covered by the resources in subunit 3.5.  When a replacement project is being considered, the initial investment is composed of the cost of the new project plus any installation or cleaning costs minus the after-tax cash flow from selling the current project.

  • 3.5.2 MACRS Depreciation Method  

    Note: This topic is covered by the resources in subunit 3.5.  The MACRS depreciation schedule is used to estimate the current value of a physical asset, such as a computer, at any moment of time of this asset’s life.  That value is called the “book value.”

  • 3.5.3 Incremental Operating Cash Flows  

    Note: This topic is covered by the resources in subunit 3.5.  When a replacement project is being considered, the incremental operating cash flows need to be computed every period starting with period 1 as follows:
     

    incremental C1 = C1 from the new project – C1 from the current project

  • 3.5.4 Terminal Cash Flow  

    Note: This topic is covered by the resources in subunit 3.5.  When a replacement project is being considered, the terminal cash flow is the cash flow that will be generated in the last period of the project.  This is an important concept when machines with a long life are intended to be used for short periods until the end of a project.  After the project is over, a long-lasting machine could either be sold to a buyer in the market at the given market price or sold as scrap for a lower amount than its remaining book value.

  • 3.6 Using Excel in Applications of Capital Budgeting Decisions  
  • Unit 4: Risk And Return  

    Unit 4 provides an explanation of the relationship between risk and return.  Every investment decision carries a certain amount of risk.  Therefore, the role of the financial manager is to understand how to calculate the “riskiness” of an investment so that he or she can make sound financial and business decisions.  For example, you are the financial manager for a large corporation and your boss has asked you to choose between two investment proposals.  Investment A is a textile plant in a remote part of a third world country.  This plant has the capacity to generate $50 million dollars in yearly profits.  Investment B is a textile plant located in the United States, near a small Virginia Town with a rich textile industry tradition.  However, investment B’s capacity for profits is only $30 million (due to higher startup and operating costs).  You are the financial manager.  Which option do you chose?  While investment A has the capacity to yield significantly higher profits, there is a great deal of risk that must be taken into consideration.  Investment B has a much lower profit capacity, but the risk is also much lower.  This relationship between risk and return is explained in this unit. Specifically, you will learn how to compute the level of risk by calculating expected values and the standard deviation.  Also, you will learn about handling risk in a portfolio with different investments and how to measure the expected performance of a stock investment when it is being affected by the overall performance of a stock market.

    Unit 4 Time Advisory   show close
    Unit 4 Learning Outcomes   show close
  • 4.1 Statistical Concepts in Finance: Probabilities, Expected Value, Standard Deviation, and Risk-Return Tradeoff  
  • 4.1.1 Expected Value  

    Note: This topic is covered by the resources in subunit 4.1. The expected value is simply an average but with probabilities attached. For example, suppose that you have these three possible investment outcomes with their respective probabilities of occurring:

    Investment Outcome Probability
    Profit $100,000 0.30
    Profit$50,000 0.40
    No profit and no loss 0.30
     
    Notice that the sum of these probabilities needs to add up to 1.00 (or 100%).  To compute your “average” profits, you need to consider their probabilities.  This average is normally called the “expected value” in statistics.  Using this example, the expected value is computed as follows: (100,000x0.30) + (50,000x0.40) + (0x0.30) = 30,000 + 20,000 + 0 = 50,000.  Therefore, you expect to receive $50,000 from this investment project.  In general, the expected value formula is:
     
    Expected Value = (outcome A x probability of A) + (outcome B x probability of B) + ... + (outcome of Z x probability of Z)
     
    where the sum of the probabilities add up to 1.00.

  • 4.1.2 Standard Deviation  

    Note: This topic is covered by the resources in subunit 4.1.  The standard deviation does not have an intuitive meaning, but it is a measure of risk in finance.  When you are facing an investment project with several possible outcomes and you know their respective probabilities, you learned from sub-subunit 4.1.1 that you can compute the expected value of an investment project.  But when you also need to know the level of risk, you can compute the standard deviation as follows:
     
                Standard Deviation = square root of 
                                                     (outcome A – expected value)x  probability of A
                                                    + (outcome B – expected value)x probability of B
                                                    + ... 
                                                    + (outcome Z – expected value)x probability of Z
     
    where the sum of the probabilities add up to 1.00.

  • 4.1.3 Risk-Return Tradeoff  

    Note: This topic is covered by the resources in subunit 4.1.  In finance, an investor will take on more risk only if the return is higher, or vice versa.  This is what we call in finance the “risk-return tradeoff.

  • 4.2 Uncertainty in Capital Budgeting  
  • 4.3 Risk and Reward in a Portfolio  
  • 4.4 Risk Diversification in a Portfolio  
  • 4.5 Risk of Stock Investments and Market Betas  
  • 4.6 Using Excel in Applications of Risk  
  • Unit 5: Corporate Capital Structure, Cost Of Capital, And Taxes  

    Does it matter whether a company’s assets are being financed with 50% from a bank loan and 50% from investors’ money?  Does that form of capital structure, where 50% of assets comes from debt and 50% from equity, influence how a company succeeds in business?  This unit addresses these questions by focusing on the theory of capital structure.  Specifically, Unit 5 explains the concept of capital structure and introduces you to the most common formula used when comparing a company’s return to the cost of capital: The weighted average cost of capital (WACC).  Also, Unit 5 exposes the concept of how tax policy affects a company’s true cost of capital.  

    Unit 5 Time Advisory   show close
    Unit 5 Learning Outcomes   show close
  • 5.1 Capital Structure Finance Theory: Modigliani-Miller  
  • 5.1.1 Maximization of Firm Value  

    Note: This topic is covered by the resources in subunit 5.1.  The goal of managers in a corporation is to maximize firm value.  This means that managers need to make business decisions that improve the efficiency and competitiveness of a firm.

  • 5.1.2 Modigliani-Miller Theorem  

    Note: This topic is covered by the resources in subunit 5.1.  According to the Modigliani-Miller theorem in finance: Firm value is independent of the capital structure of a firm.  This means that how a firm is financed, for example 80% equity and 20% debt vs. 50% equity and 50% debt, has no effect on the value of the firm.

  • 5.2 Cost of Capital and Capital Structure: WACC  
  • 5.2.1 Cost of Capital  

    Note: This topic is covered by the resources in subunit 5.2.  The cost of capital usually refers to: The interest rate on a loan (cost of debt), the interest rate placed on a corporate bond (cost of debt), and the return demanded by shareholders (cost of equity).

  • 5.2.2 Weighted Average Cost of Capital (WACC) Formula  

    Note: This topic is covered by the resources in subunit 5.2.  Suppose that a company has total financing where 20% comes from bonds, 50% from a loan, and 30% from shareholders’ equity.  The bonds pay a 10% interest rate, the loan has a 5% interest rate, and shareholders require an 8% return. Under this scenario, this company’s WACC is:
     
    WACC = (.20x10) + (.50x5) (.30x8) = 6.9%
     
    This means that on average this company has a cost of capital of 6.9%. In general, the WACC formula is:
     
    WACC = (percentage of total financing from A source x interest rate of A)
    + (percentage of total financing from B source x interest rate of B)
    + ... + (percentage of total financing from Z source x interest rate of Z)
     
    where percentage of total financing from A + percentage of total financing from B+ ... + percentage of total financing from Z = 1.00.

  • 5.3 Taxes and Capital Structure  
    • Reading: Dr. Ivo Welch’s Corporate Finance (3rd Edition): "Chapter 17: Taxes and Capital Structure”

      Link: Dr. Ivo Welch’s Corporate Finance (3rd Edition): "Chapter 17: Taxes and Capital Structure” (HTML)
       
      Instructions: Read Chapter 17 in the textbook.  Sections 17.1, 17.2, and 17.3 show you how to adjust the WACC formula when we consider a realistic issue concerning loans: Interest payments on loans are tax-deductible.   Follow the examples given in Sections 17.4 through 17.8 about PepsiCo’s case and the U.S. tax system.  Also, make sure to answer the questions given at the end of each section from Chapter 17 and compare your answers to the answers given at the end of Chapter 17 under the heading titled “Answers.”  This resource covers the topics outlined in sub-subunits 5.3.1 and 5.3.2.  This reading should take you approximately 6 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • 5.3.1 Cost of Debt and Taxes  

    Note: This topic is covered by the resources in subunit 5.3.  According to the U.S. tax system and GAAP rules, interest payments on loans are deductible from operating profits.  This means, as a company takes out a loan to finance an asset (e.g., to buy a new machine), the company will be able to deduct the interest payments and thus pay less taxes on profits.  Essentially, this makes the cost of the loan be less than the interest rate.  The cost of the loan is:

    cost of loan = interest rate x (1 – tax rate)
     
    where the interest rate and tax rate are expressed in decimal form (e.g., .10 for 10%, 0.05 for 5%, etc).

  • 5.3.2 WACC and Taxes  

    Note: This topic is covered by the resources in subunit 5.3.  Suppose that a company has total financing where 20% comes from bonds, 50% from a loan, and 30% from shareholders’ equity.  The bonds pay a 10% interest rate, the loan has a 5% interest rate, and shareholders require an 8% return.  Also, consider that the interest loan payments are tax-deductible and the corporate tax rate is 40%.  Under this scenario, this company’s WACC is:
     
    WACC = (.20x10) + (.50x5)(1-.40) + (.30x8) = 5.9%
     
    This means that on average this company has a cost of capital of 5.9%.  In general, the WACC formula is:
     
    WACC = (percentage of total financing from debt source x interest rate of debt)(1 – tax rate)
    + (percentage of total financing from B source x interest rate of B)
    + ... + (percentage of total financing from Z source x interest rate of Z)
     
    where percentage of total financing from A + percentage of total financing from B+ ... + percentage of total financing from Z = 1.00.

  • 5.4 WACC Exercises  
  • Unit 6: Application: The Capm Model  

    Unit 6 gives you an application in finance that puts what you have learned from the previous units about cost of capital, net present value, and risk into one widely used model: The CAPM model. The CAPM model is used to compute a company’s costs of capital that can be used in net present value calculations.  It has been used in court cases for estimating a company’s stock value as with the case of the breakup of AT&T in 1984 that resulted in seven companies.  Also, the CAPM model is used in computing stock valuation.  This unit will show how the financial manager uses this financial tool to value stock and to determine which stocks are the better options for investors, based on their rates of returns and how they compare to the overall stock market return.

    Unit 6 Time Advisory   show close
    Unit 6 Learning Outcomes   show close
  • 6.1 Calculating the Cost of Capital using CAPM  
    • Reading: Dr. Ivo Welch’s Corporate Finance (3rd Edition): "Chapter 9: The Capital Asset Pricing Model”

      Link: Dr. Ivo Welch’s Corporate Finance (3rd Edition): "Chapter 9: The Capital Asset Pricing Model” (HTML)
       
      Instructions: Read Chapter 9 in the textbook.  This chapter explains a commonly used model for computing the return of a company using stock prices: The CAPM model.  Specifically, the CAPM model is used to compute a company’s costs of capital value that can be used in the net present value calculations.  It has been used in court cases for estimating a company’s stock value.  Also, make sure to answer the questions given at the end of each section in Chapter 9 and compare your answers to the answers given at the end of the chapter under the heading titled “Answers.”  This resource covers the topics outlined in sub-subunits 6.1.1 and 6.1.2.  This reading should take you approximately 8 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

    • Reading: University of Illinois at Urbana Champaign: Department of Finance’s Financial Markets FIN 300: “Equity Project”

      Link: University of Illinois at Urbana Champaign: Department of Finance’s Financial Markets FIN 300: “Equity Project” (HTML)
       
      Instructions: Access that webpage and follow the example given on how to apply the CAPM model in Excel with the use of current stock data.  Make sure to follow the instructions given in detail for using the advanced statistical features in Excel.  This resource covers the topics outlined in sub-subunits 6.1.1 and 6.1.2.  This resource should take you approximately 4 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • 6.1.1 Definition of the CAPM Model  

    Note: This topic is covered by the resources in subunit 6.1.  The CAPM model is used to calculate a company’s cost of capital using stock data.  It considers the riskiness of a stock compared to the overall return in the stock market.  Specifically, it provides an expected rate of return of a company, which can be used as part of the interest rate value in a net present value (NPV) calculation.

  • 6.1.2 CAPM Formula  

    Note: This topic is covered by the resources in subunit 6.1. The CAPM formula is as follows:

    Expected Return of Stock A =

    Risk-free return + (Expected Stock Market Return – Risk-free return)xBeta of A

    where all the returns are known from actual data but the beta value is computed using a sophisticated statistical model called “regression analysis.”  Using historical stock data, a regression model estimates the value of a company’s beta.  Once the value of beta is known, we can estimate the expected rate of return of a stock.  For example: Suppose that a risk-free asset (such as a U.S. government bond) pays 1% as interest, the stock market return is 10% on average, and a company’s beta is 2.  Then the expected return of that company’s stock will be: 1 + (10-1)x2 = 1 + 18 = 19%.

  • 6.2 CAPM Exercises  
    • Activity: The Wharton School at the University of Pennsylvania: Dr. Michael R. Roberts’ Finance 100: Corporate Finance: “Topic 4: Asset Pricing Models”

      Link: The Wharton School at the University of Pennsylvania: Dr. Michael R. Roberts’ Finance 100: Corporate Finance: “Topic 4: Asset Pricing Models” (PDF and Excel)
       
      Instructions: In Dr. Roberts’ webpage titled “Topic 4: Asset Pricing Models,” scroll down to the section titled “Downloadable Files” and access the three problem set files with these titles: “Problem Set (PDF File),” “Problem Set Solutions (Excel File),” and “Alternative Problem Set Solutions (PDF File).”  Make sure to solve the problems on your own and then take a look at the solutions.  Please ignore the problems relating to standard deviations, and focus on the typical CAPM problems.  These assignments should take you approximately 6 hours to complete.
       
      Terms of Use: Please respect the copyright and terms of use displayed on the webpage above.

  • Final Exam