FUNDAMENTAL FINANCIAL MANAGEMENT CONCEPTS

1. Role of Corporate Finance

 Corporate Finance deals with the capital structure of a corporation, including its funding and
the actions that management takes to increase the value of the company. Corporate
Finance also includes the tools and analysis utilized to prioritize and distribute financial
resources.
 The ultimate purpose of corporate finance is to maximize the wealth or value of a business
through planning and implementation of resources, while balancing risk and probability.
 By taking actions that generate more benefits versus the costs, the firms will generate
wealth for their investors.

2. Corporate Finance Functions

 The main functions of corporate finance which will be thoroughly discussed for the entire
semester are the following:
A. External Financing – Raising capital to support the company’s operations and
investment programs, from either shareholder (equity) or creditor (debt).
B. Capital Sourcing – Selecting the best projects in which to invest the resources of the
firm, based on each project’s perceived risk and expected return. Select investments in
which the marginal benefits exceed the marginal costs.
C. Financial Management – Managing the firm’s internal cash flows, and its mix debt and
equity financing, to maximize the value of the debt and equity claims on firms, and to
ensure that companies can pay off their obligations when they become due. It also
involves obtaining seasonal financing, managing inventories, paying suppliers, collecting
from customers, and investing surplus cash.
D. Corporate Governance – The idea of a “nexus of stakeholders” is becoming increasingly
recognized, thus the corporation must be concerned with all its users of financial
statements. Developing ownership and corporate governance structures for companies
is deemed necessary to ensure that managers behave ethically and make decisions that
benefit shareholders as well as the stakeholders.
E. Risk Management – Any business is exposed to RISK such as change in prices due to
market, technology advancement, political environment, possible disaster brought by
climate change among others. This function will manage the firm’s exposure to all types
of risk (insurable and non-insurable) in order to maintain optimum risk-return trade-offs
and thereby maximize shareholder value.

3. Maximize Wealth or Maximize Profit

 The Corporate Financial Manager’s goals are to maximize wealth because shareholders are
overwhelmingly concerned with cash flow, not accounting numbers, even though there is a
high positive correlation between cash flow and net income.
 Shareholders believe that maximizing profit ignores the timing of the profits, cash flows, and
risk while earning reflect past performance, rather than current or future performance.
4. Define Risk and Return
 Risk is defined in financial term as the chance that an outcome or investment’s actual
gains will differ from an expected outcome or return. Risk includes the possibility of
losing some or all of an original investment.
 Return, also known as a financial return, in its simplest term, is the money made or lost
on an investment over some period of time. A return is the change in price of an asset,
investment, or project over time, which mat be represented in terms of price change or
percentage change.
 It is said that “the higher the risk, the higher the return”, but it’s important to keep in
mind that a higher risk doesn’t automatically equate with higher returns. The risk-return
trade-off only indicates that higher risk investments have the possibility of higher
returns, but there are no guarantees.

5. Time Value of Money

 “Time is Money” especially in Business. Thus, business would always consider the cash
flows of any investment together with its time frame plus the interest (risk) associated
with such cash flows. It is said that a peso received today is worth more than a peso
received in the future.
 Financial managers compare the marginal benefits and marginal cost of investment
projects and these projects usually have a long-term horizon: timing of benefits and cost
matters.
 Time Value of Money is a very important “tool” as it introduces valuation methods that
we will use heavily in later modules.

Future Value of a Lump Sum

 Future Value (FV) is the value of a current asset at a future date based on an
assumed rate of growth. The future value (FV) is important to investors and financial
planners as they use it to estimate how much an investment made today will be
worth it in the future. Knowing the future value enables investors to make sound
investment decisions based on their anticipated needs. However, external economic
factors, such as inflation, can adversely affect their future value of the asset by
eroding its value.
 The future value (FV) of a present amount can be computed by adding compound
interest over a specified period of time. Compound interest is the amount by which
the principal grows each period. Principal amount on which interest is paid.

Consider a simple example. What is the future value of a P200 savings account paying
8% interest compounded annually after three years?

FV = PV(1 + i)n
FV Future Value
PV Present Value
I Periodic interest rate
 n Total number of compound periods

Year Principal + Interest P x (1 + %) Value at the end of year

1 P200 + 8% * P200 P200 * (1 + 8%) P216
2 P216 + 8% * P216 P216 * (1 + 8%) P233.28
3 P233.28 + 8% * 233.28 * (1 + 8%) P251.94
P233.28

Aunt Bee, a big-time saver, has decided to open a savings account with a 5% interest rate
compound annually. She wants to know how much her account will be worth in 10 years after she
makes this one-time deposit of Php1,000.

FV = P1,000 (1+5%)10

FV = P1,000 (1.05)10

FV = 1,000 (1.62889)

FV = 1,628.89

Using the formula, which assumes the savings account pays a consistent 5% interest rate, Aunt
Bee will have Php1,628.89 at the end of 10 years.

Present Value of a Lump Sum

 The Present Value (PV) is the current of a future sum of money or stream of cash flows
given a specified rate of return. Future cash flows are discounted at the discount rate,
and the higher the discount, the lower the present value of the future cash flows.
Determining the appropriate discount rate is the key to properly valuing future cash
flows, whether they be earnings or obligations
 The formula in the finding the Present Value:

FV
PV =
¿¿
PV Present Value
FV Future Value
r Periodic interest rate
n Total number of compounding periods

Donna’s parents think she’s pretty smart girl, especially after she knows her dad these cool
formulas. Dad knows he will need money in a few years to pay for Donna’s college. He’s wondering
how much he can invest today in some CDs that would be worth Php 20,000 or so in 10 years when
he’ll need it. Donna shows him a formula for present value, or how much you need to have today
to have a specific amount at some point in the future.
 P20,000
PV =
¿¿

P20,000
PV =
1.6298

PV =P 12,278
Her dad needs to invest P12,278

Future Value of Cash Flow Steams (Annuity)

 The future value of an annuity is the value of a group of recurring payments at a

certain date in the future, assuming a particular rate of return, or discount rate. The
higher the discount, the greater the annuity’s future value.
 The formula in finding the future value (annuity):

F V =PMT x ¿ ¿

PMT Amount each annuity payment

FV Future Value of annuity stream
r Periodic interest rate
n Total number of periods in which payment will be made

Assume someone decides to invest P125,000 per year for the next five years in an
annuity they expect to compound at 8% per year.

FV =P 125,000 x ¿ ¿
FV =733,3525.12