Chapter 1 - Fundamental Financial Management Concepts (Student's Copy)

MODULE I
FUNDAMENTAL FINANCIAL
MANAGEMENT CONCEPTS
 I. Opening Prayer
 II. Announcements
 III. Overview of the topic
 IV. Discussion and Recitation
FUNDAMENTAL FINANCIAL MANAGEMENT CONCEPTS
Learning Objectives :
After studying this module, you should be able to:
1) Explain the role of corporate finance in business
2) Identify the essentials of corporate finance functions
3) Differentiate maximizing profit vs maximizing wealth
4) Define risk and return
5) Understand the concept of Time Value of Money
Lesson I : 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 profitability.
 By taking actions that generate more benefits versus the costs, the firms will generate
wealth for their investors.
Lesson 2 : Corporate Finance Functions
The main functions of corporate finance which will be thoroughly discussed for the entire
semester are the following:
1. External Financing - Raising capital to support the company’s operations
and investment programs, from either shareholders (equity) or creditors
(debt).
2. Capital Budgeting - 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.
3. Financial Management- Managing the firm’s internal cash flows, and its mix
of 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
4. 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 company-wide structures and incentives that influence managers to
behave ethically and make decisions that benefits shareholders.
5. 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.
Lesson 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 earnings reflect past performance, rather than current or future performance.
Lesson 4 : Define Risk and Return
 Risk is defined in financial terms 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 terms, 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 may be represented in terms of price change or
percentage change.
Lesson 4 : Define Risk and Return
 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.
Lesson 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 costs 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 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 the 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 is the 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?
Aunt Bee, a big-time saver, has decided to open a savings account with a 5% interest rate
compounded 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.
Present Value of a Lump Sum
 The present value (PV) is the current value 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 rate, 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 finding present value:
Present Value of a Lump Sum
Donna's parents think she's a pretty smart girl, especially after she shows 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 save today to have a specific amount at some point in the future.
So, if Dad needs the Php20,000 in 10 years and can invest what he has for five percent, let's find out how much he
needs to invest today.
Future Value of Cash Flow Streams (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 rate, the greater the annuity's future value
The formula in finding future value (annuity) :
Future Value of Cash Flow Streams (Annuity)
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. The expected future value of this payment stream
using the above formula is as follows:
Present Value of Cash Flow Streams (Annuity)
 The present value of an annuity refers to how much money would be needed today to
fund a series of future annuity payments. Because of the time value of money, a sum of
money received today is worth more than the same sum at a future date.
The formula in finding present value (annuity) :

Present Value of Cash Flow Streams (Annuity)
Assume a person has the opportunity to receive an ordinary annuity that pays P50,000 per
year for the next 25 years, with a 8% discount rate, or take a P650,000 lump-sum payment.
Which is the better option? Using the above formula, the present value of the annuity is
Given this information, the annuity is worth P116,265 less

on a time-adjusted basis, so the person would come out
ahead by choosing the lump-sum payment over the
annuity.
Annuity due is an annuity whose payment is
due immediately at the beginning of each
period.
Annuity due – beginning of year

Ordinary annuity – end of year
Assessment :
Assessment :

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MODULE I

The formula in finding present value (annuity) :

Given this information, the annuity is worth P116,265 less

Annuity due – beginning of year

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