Defined Benefit (DB) vs. Defined Contribution (DC) -DB: Company puts funds into a pension fund and invests in stocks, bonds, etc. and then promised payments when retire -DC: Company put money into 401K (mutual fund) you decide what assets to buy and you withdrawal money after retire Goals of Chapter: 1. Managers should strive to make their firms more valuable 2. Value of a firm is determined by the size, timing and risk of its Free Cash Flows (FCF) a. FCF: Cash flows available for distribution to all of a firm’s investor b. Weighted average cost of capital (WACC): average rate of return require by all of the firm’s investors 3. Primary objective financial management is to maximize the intrinsic value of a firm’s stock 4. Stock values depend on timing of the cash flows’ investors expect from an investment -$1 expected sooner is worth more than $1 further in the future 5. Explain how the timing of cash flows affects assets values and rate of return 6. Time value analysis applications: retirement planning, loan payment schedules, decisions to invest in new equipment 7. Also called Discounted Cash Flow (DCF) Analysis 0
0
20
20
30
30
5%
5%
Periods
Periods
10
10
4.1 Time Lines PV=$100 PV=$100
PV=$100
Cash
Cash
FV=?
FV=?
FV= 3 years I= 5% 4.2 Future Values -A dollar today is worth more than a dollar to be received in the future -Compounding: Process of going forward from present values to future values -FVN: Future Value or ending amount in an account after N periods -CFt: Cash Flow. Can be + or – For a borrower the first cash flow is positive and the next are negative ex. CF0 = PV = the cash flow at Time 0 can be at the beginning or ends of periods -I: Interest rate earned per year. Interest is earned based on the balance at the beginning of each year. Interest is paid at the end of the year. I/YR Also can be r = rate of return. -INT: $ of interest earned during the year = beginning amount -N: Number of periods involved in the analysis -Step-by-Step Approach -Timeline can be used. Periods
Periods
0
0
2
2
30
30
40
40
5%
5%

$100
$100
$105
$105
$110.25
$110.25
$115.76
$115.76
Cash
Cash
(1+I) = (1.05)
(1+I) = (1.05)
Multiply initial amount & each succeeding beginning of year amount by this.
Multiply initial amount & each succeeding beginning of year amount by this.

PV=$100
PV=$100

-Amount at end of year 1 FV1 = PV + INT FV1 = PV + PV(I) FV1 = PV (1+I) FV1 = $100(1+.05) = $100(1.05) = $105 FV2 = -Earn more interest in 2nd year because earn $5(.05) = .25 on interest on the first year’s interest of $5 = Compounding & interest earned on interest = Compound Interest Formula:
FVN = PV(1+I)N
Formula:
FVN = PV(1+I)N
-Formula Approach FV2 = FV1(1+I) FV2 = PV(1+I)(1+I) FV2 = PV(1+I)2 FV2 = $100(1+.05) 2 = $110.25 -Financial Calculators -5 Keys N
N
I/YR
I/YR
PV
PV
PMT
PMT
FV
FV
Press value then key
Press value then key

-N = # of periods -I/YR = Interest Rate Per Year -PV = Present Value (Making a deposit so a negative outflow = negative number) -PMT = Payment – used if have a series of equal or constant payments -FV = Future Value Calculator Tips -Set to 1 payment per year -End Mode vs. Beginning Mode: KNOW -Negative sign for outflows: one transaction has to be negative: type value then +/- sign -Decimal places -Interest Rates: enter as percent (5.25) not (.025) -Spreadsheets -Create area called inputs as “references” for solving -Timelines: Each column designates a different period on it -Future Value Function (fx) symbol financial function FV Function =FV(I,N,O,PV) -“Sensitivity Analysis”: use cell reference so can swap out values -% based on how cell is formatted -Graphic View