Lecture 1: FNCE20001 Business Finance

Introduction to Business Finance and

Financial Mathematics I
Sturla Lyngnes Fjesme

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Subject Administration

Lecturers:

Tutor in Charge:

Dr. Sturla Fjesme (Lecture 1 - 12)

Dr. Vincent Grgoire (Lecture 13 - 24)

Robert Carey

Online tutor

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Lecture 1 12
Lecture
1

Date
Tuesday, 29 July

Topic(s)
Introduction to Business Finance
Introduction to Financial Mathematics I

Thursday, 31 July

Introduction to Financial Mathematics II

Tuesday, 5 August

Valuation of Debt Securities

Thursday, 7 August

Valuation of Equity Securities

Tuesday, 12 August

Risk and Return

Thursday, 14 August

Modern Portfolio Theory I

Tuesday, 19 August

Modern Portfolio Theory II

Thursday, 21 August

Modern Portfolio Theory III

Tuesday, 26 August

Asset Pricing Models I

10

Thursday, 28 August

Asset Pricing Models II

11

Tuesday, 2 September

Asset Pricing Models III

12

Thursday, 4 September

Capital Market Efficiency

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Lecture 13 - 24
13

Tuesday, 9 September

Capital Budgeting I

14

Thursday, 11 September

Capital Budgeting II

15

Tuesday, 16 September

Mid Semester Exam

16

Thursday, 18 September

Capital Budgeting III

17

Tuesday, 23 September

Capital Budgeting IV

18

Thursday, 25 September

Debt, Dividends and Taxes I

29 September 3 October Non-Teaching Period

19

Tuesday, 7 October

Debt, Dividends and Taxes II

20

Thursday, 9 October

Debt, Dividends and Taxes III

21

Tuesday, 14 October

Debt, Dividends and Taxes IV

22

Thursday, 16 October

Guest Presenter (TBA)

23

Tuesday, 21 October

Introduction to Derivative Securities I

24

Thursday, 23 October

Introduction to Derivative Securities II

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Subject Administration

Assessment 1 and 2: Two assignments which will count

towards 15% of your overall grade
Assessment 3: A mid semester exam which will count towards
25% of your overall grade

Date: Tuesday, 16 September

Time: During lecture time (must sit in the stream enrolled)
Venue: Wilson Hall
Exam duration: 60 minutes (no reading time)
Format: Multiple choice questions

Assessment 3: A two hour, end-of-semester final examination

which will count towards 60% of your overall grade
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Subject Administration

All lecture notes and Tutorials are available on the subjects

LMS page

Policy on calculators in examinations - see course outline

Required Textbook

Peirson, G., Brown, R., Easton, S., Howard, P. and Pinder, S.,
Business Finance, 11th or 10th ed., McGraw-Hill/Irwin (referred
to as PBEHP)

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Code of Conduct During Lectures

Be attentive to the lecturer
Do not talk
Arrive on time and stay for the full lecture
Turn off mobile phones and other electronic devices
Bring required materials to the lecture

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Dr. Sturla Fjesme

PhD Financial Economics

Master of Science in Financial Economics with Honours

BI Norwegian Business School

Bachelor of Commerce

BI Norwegian Business School. Visiting Cornell University

Bond University. Visiting Duke University

Previous Work Experience:

Deloitte
DnB NOR Bank
Royal Norwegian Air Force Seargent

Current Position:

Senior Lecturer in Finance, University of Melbourne

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Subject Objectives

Solve basic problems in financial mathematics

Discuss the basic theories underlying the pricing of risky assets
Comprehend the concepts of portfolio formation and risk
diversification
Explain the fundamentals of capital budgeting, including the
use of alternative criteria, allowing for inflation and the
treatment of risk
Analyze the issues facing managers in capital structure and
dividend policy decisions
Use the features of financial derivatives to achieve specific
financial outcomes
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1. Introduction to Business Finance

1.
2.
3.
4.
5.

Overview of the Finance discipline

Compare simple interest to compounded interest
Compute the future value of a single cash flow
Compute the present value of a single cash flow
Compute an unknown interest rate and time period

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Required Readings: Lectures 1 - 2

Lecture 1

PBEHP (10th or 11th ed.), Ch. 1 and Ch. 3 (sections 3.1 3.4.2)

Lecture 2

PBEHP (10th or 11th ed.), Ch. 3 (sections 3.4.3, 3.5 3.8)

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1.1 What is Finance?

Finance is the study of how individuals, businesses and

institutions acquire, spend and manage financial resources
Major areas of finance

Investment analysis and management

Corporate finance
Capital markets and financial institutions
International finance
Personal finance
Real estate finance

This subject provides an introduction to Investment Analysis

and Corporate Finance
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This Subject

Investment analysis is mainly concerned with where and how to

invest
Valuation of stocks, bonds and derivatives
Portfolio diversification
Asset pricing and market efficiency
These topics (except derivatives) are covered in the first half of
this subject
Corporate finance is mainly concerned with the decisions of
managers
Capital budgeting - what investments to make
Capital structure - how to finance these investments
Dividend policy - what to payout to shareholders
These topics (including derivatives) are covered in the second
half of this subject
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Career Opportunities in Finance

Career opportunities in several capacities

Financial management
Financial intermediaries
Securities markets
Government entities
Not-for-profit organizations
Personal financial planning

High demand for qualified finance specialists

Finance specialists need a good working knowledge of other

disciplines as well
Economics, Accounting, Statistics, Mathematics, Marketing,
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The Finance Function

The main goal of managers is to maximize the market value of

the firm

This maximizes the wealth of shareholders

Value of the firm = Present value of future expected cash flows

Shareholder wealth = Present value of shareholders future
expected cash flows

Do managers always maximize firm value?

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The Market Value of a Firm

Firm value is the present value of future expected cash flows

n

Firm Value =

t =1

(1 + r )

E(CFt ) = Expected cash flows received at the end of period t

n = Number of periods over which cash flows are received
r = Rate of return required by investors

Main factors to consider when valuing a firm

E ( CFt )

Magnitude of expected cash flows - E(CFt)

Timing of cash flows - n
Risk of expected cash flows - r
Efficiency of capital markets

This is the main focus of Lectures 1 12

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1.2 Simple Versus Compounded Interest

Simple interest

Example: If you invest $1,000 at 8% p.a. earning simple

interest for 5 years what amount will you have in your account
at the end of that time period?

The value of a cash flow is calculated without including any

accrued interest to the principal

Interest earned in each of the five years = 1000 0.08 = $80

Interest earned over five years = (1000 0.08) 5 = $400
Future value at the end of year 5 = 1000 + 400 = $1,400
Future value at the end of year 5 = 1000(1 + 5 0.08) = $1,400

Future value using simple interest, Fn = P0(1 + n r)

Present value using simple interest, P0 = Fn/(1 + n r)
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Simple Versus Compounded Interest

Compound interest

Interest accrued is added to the principal and reinvested

The (future) value of a cash flow is calculated based on the
principal and interest accrued

Example: If you invest $1,000 at 8% p.a. earning compounded

interest for 5 years what amount will you have in your account
at the end of that time period?

Future value at the end of year 1 = 1000(1.08) = $1,080.00

Future value at the end of year 2 = 1080(1.08) = $1,166.40
Future value at the end of year 5 = 1000(1.08)5 = $1,469.33
Note that the difference of $69.33 (= 1469.33 1400.00) is due
to the compounding of interest (interest on interest)
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Simple Versus Compounded Interest

So whats the big deal?
Simple interest

Compounded
interest

Difference

$1,080.00

$1,080.00

$0.00

$1,160.00

$1,166.40

$6.40

$1,240.00

$1,259.71

$19.71

$1,320.00

$1,360.49

$40.49

$1,400.00

$1,469.33

$69.33

20

$2,600.00

$4,660.96

$2,060.96

50

$5,000.00

$46,901.61

$41,901.61

100

$9,000.00

$2,199,761.26

$2,190,761.26

End of year

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1.3 Future Value of a Single Cash Flow

The future value at r% p.a. of P0 today is the dollar value to

which it grows at the end of time period n
Fn = P0(1 + r)n
Fn = P0(1 + r)n

P0
Cash flows occur at the end of the period

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Future Value of a Single Cash Flow

Example: You decide to invest $1,000 for different time

periods. What is the future value of this $1,000 in 5, 20 and
100 years at an interest rate of (a) 6% and (b) 8%?
At r = 6% p.a.

F5 = 1000 (1.06)5 = $1,338.23

F20 = 1000 (1.06)20 = $3,207.14
F100 = 1000 (1.06)100 = $339,302.08

At r = 8% p.a.

F5 = 1000 (1.08)5 = $1,469.33

F20 = 1000 (1.08)20 = $4,660.96
F100 = 1000 (1.08)100 = $2,199,761.26
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Future Value of a Single Cash Flow

Future Value of $1000 over Different T ime Periods at Different Interest Rates
$8,000
$7,000

10%

Future Value

$6,000
$5,000

8%

$4,000
$3,000

6%

$2,000

4%

$1,000
0

10

12

14

16

18

20

End of Year

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1.4 Present Value of a Single Cash Flow

The present value (P0) at r% p.a. of Fn at the end of time n is

the amount which invested today would grow to Fn in time n
P0 = Fn/(1 + r)n, or
P0 = Fn(1 + r)-n
F
n

P0 = Fn/(1 + r)n
Cash flows occur at the end of the period

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Present Value of a Single Cash Flow

Example: If you needed $10,000 in (a) five years and (b)

twenty years how much would you need to save and invest
today if the interest rates were (a) 6% and (b) 8%?
The present value today of $10,000 in five years

At 6% p.a.: P0 = 10000/(1.06)5 = $7,472.58

At 8% p.a.: P0 = 10000/(1.08)5 = $6,805.83

The present value today of $10,000 in twenty years

At 6% p.a.: P0 = 10000/(1.06)20 = $3,118.05

At 8% p.a.: P0 = 10000/(1.08)20 = $2,145.48

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Present Value of a Single Cash Flow

Present Value of $10000 over Different Time Periods at Different Interest Rates

Present Value

$10,000
$9,000
$8,000
$7,000
$6,000
$5,000

4%

$4,000
$3,000

6%
8%
10%

$2,000
$1,000
$0
0

10

12

14

16

18

20

$10,000 Received at the End of Year

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Factors Influencing Present and Future Values

The present and future values of a cash flow depend on the

following factors
The time period, n

The interest rate, r

Future value increases as n increases

Present value decreases as n increases
Future value increases as r increases
Present value decreases as r increases

The method of computing interest (examined in lecture 2)

Future value increases as the compounding interval increases

Present value decreases as the compounding interval increases
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1.5 Unknown Interest Rate or Time Period

Example: You invest $10,000 for a five year period. What

interest rate do you need to earn for the funds to double in that
time period? If you invest $10,000 at an interest rate of 10%
p.a. how long will it take for these funds to triple in value?
In the first case we have an unknown interest rate, r

P0 = $10,000, F5 = $20,000, n = 5

10000(1 + r)5 = 20000

So, (1 + r)5 = 20000/10000 = 2
r = 21/5 1 = 14.9%

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Unknown Interest Rate or Time Period

In the second case we have an unknown time period, n

P0 = $10,000, Fn = $30,000, r = 10%

10000(1.10)n = 30000
So, (1.10)n = 30000/10000 = 3.00
Taking natural logs we have
n ln(1.10) = ln(3.00)
So, n = 1.0986/0.0953 = 11.5 years

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Key Concepts

Managers should aim to maximize the value of the firm by

taking on profitable investments. This results in maximum
shareholder wealth
Money has time value because of compounded interest
In simple interest, the value of a cash flow is calculated
without including any accrued interest to the principal
In compounded interest, the value of a cash flow is calculated
based on the principal and interest accrued
The present and future values of a cash flow depend on the
time period, the interest rate, and the method of computing
interest

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Formula Sheet

Future value of a single cash flow using simple interest

Present value of a single cash flow using simple interest

P0 = Fn/(1 + n r)

Future value of a single cash flow

Fn = P0(1 + n r)

Fn = P0(1 + r)n

Present value of a single cash flow

P0 = Fn/(1 + r)n
P0 = Fn(1 + r)-n

(Note: The formula sheets on the mid semester and final exams will
contain all the formulas covered in lectures but without the descriptions)
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