Corporate finance: Know your numbers 2

In Week 1 we have three main objectives. Firstly, we review the main types of decisions made when management and owners allocate capital within a business. Secondly, we will discuss why it is important to bring the shareholder perspective to these decisions. Thirdly, to introduce key terminology around the business life cycle and different types of ownership models, including venture capital, private equity and listed companies.

This week we will consider the time value of money. We will learn how to put a numerical value on the difference between money today and money at a specific time in the future. We will look at simple and compound interest, present and future value of money, annuities and perpetuities. Understanding the time value of money will help us to make investment decisions or, as corporate finance managers, decisions about whether to buy or sell an entire business or to invest in an advertising campaign. It’s an important skill and will require you to work through financial models that involve some equations and numbers. Knowledge of the time value of money will make you more confident dealing with financial transactions and better understand how the world of finance operates.

This week we will consider applying our knowledge of interest rates to some real world problems. We will learn how to estimate the value of an enterprise. We will learn about capital budgeting techniques to help us decide intelligently which projects that are available to a business should be pursued.The techniques we will learn include Net Present Value, Internal Rate of Return, Pay Back Period, and the Money Multiple Method. We will also discuss briefly the capital asset pricing model, or CAPM, which enables us to estimate the cost of capital for a business, which is the return demanded by the providers of the capital, that is, the investors.

In week 4 we extend the valuation tools developed in the course so far to evaluate a series of new business investment opportunities. We will start off by considering the value of an existing, established business. We have already seen how we can use the traditional Operating Free Cash Flow (OFCF)/Weighted Average Cost of Capital (WACC) model to estimate the Enterprise value of a business. We will now use an alternate model, the Residual Income model, for the same purpose. Once we are comfortable with the various different business valuation models, we will turn our attention to an assessment of the risk profile of the investment. We will firstly differentiate between the risks that are being allowed for in the discount rate, or “systematic risks”, and those that are specific to the project being considered, or “idiosyncratic risks”. Towards the end, we will look at tools that help assess the idiosyncratic risk of the investment.

This week, we will apply the valuation tools we have developed in the course so far to improve our existing business. We start by revisiting the NPV rule for individual project investment decisions, and then extend that to think about how individual projects impact value at the Enterprise level. We then consider a range of specific applications for our project evaluation tools, including capital rationing, asset replacement, and outsourcing decisions. After this we will turn our attention to the question of how well our existing businesses are performing. We will start by introducing a range of performance measurement tools. This will help us to develop a framework for both recognising how well we are currently performing, and selecting from a series of deliberate choices to improve that performance.

This week is all about revision. There’s not much new content. We’ll focus on applying the theories to a small example, an imaginary online business, and cover some of the more difficult techniques including annuities, perpetuities, Net Present Value, and how to turn profits into cash flows.