Corporate Finance Week 1 — Notes
Key points the lecturer flags and common traps.
1) How the lecturer frames “Corporate Finance”
Shareholder value vs stakeholder value (and what this class assumes)
- A shareholder is a specific stakeholder: someone who owns shares. Stakeholders can be anybody around the company affected by, or affecting, the firm.
- In this course, a “good financial decision” is the one that maximizes shareholder value (even if real CEOs may pursue broader objectives).
“Corporate finance tools are like Google Maps”
- Finance tools show the value-maximizing route.
- In reality, decision-makers might choose a different objective; that is a choice, not a math error.
- The “Google Maps” analogy is used explicitly.
2) Time Value of Money (TVM): building blocks you must use fluently
Present value of multiple cash flows (NPV as PV of a stream including negatives)
Present value (PV) of a stream of cash flows:
PV = C0 + C1/(1+r)^1 + ... + Cn/(1+r)^n
- “NPV” is often used when some cash flows are negative.
- Three interpretations of PV:
- Borrowing capacity today
- Investing today to reach future cash flows
- Competitive market price of future cash flows
Core patterns you must recognize quickly
- Perpetuity, growing perpetuity, annuity, and growing annuity formulas are in Week 1 (including the condition r > g for a growing perpetuity).
- Emphasis on pattern recognition (example: “cash flows starting next year, forever” implies perpetuity).
- If these patterns are not immediate, you are expected to refresh foundational material.
3) Investment decision rules: what to prioritize
The hierarchy: NPV first, then sometimes PI; IRR is secondary
- Primary rule: use NPV (or PI if resources are constrained).
- Lecturer quote meaning: “NPV is always your best friend.”
IRR: why it’s popular, and why it fails
When IRR “works” (conditions):
- Conventional cash flows: one negative at time 0, then positives.
- One discount rate.
- One investment decision.
Major IRR pitfalls you must know:
- Non-conventional cash flows can create delayed investment, multiple IRRs, or no real IRR solution (Excel may show #NUM). In these cases, use NPV.
- Even with conventional cash flows, IRR can mislead because of:
- Scale problem (e.g., 100% on $1 versus 50% on $1,000).
- Timing problem (rankings can flip depending on when cash flows arrive).
- Key warning: IRR is not the actual return.
MIRR
- Slides show Excel implementation.
- MIRR is a partial fix, not a full replacement for NPV.
Payback rule: why it’s used and why it’s dangerous
- Used because it is simple.
- Unreliable because it ignores:
- Time value of money
- Cash flows after payback
- Risk
- Week 1 shows a case where a high-NPV project fails a strict payback cutoff.
- Real-world critique: hard payback cutoffs can cause firms to miss large long-horizon opportunities. Often, firms can borrow to bridge timing rather than rejecting positive-value projects.
Resource constraints: Profitability Index (PI)
- In theory, firms take all positive NPV projects; in practice, constraints exist (capital, workers, engineers, factories).
- PI helps maximize total NPV under constraints; do not simply rank by NPV when constrained.
- PI is “NPV per resource consumed.” The resource can be money, engineers, warehouse space, lab space, etc.
4) Practical Excel mechanics the lecturer expects (common traps)
The biggest Excel trick for NPV
- Excel NPV() discounts from Year 1 onward.
- You must add the time 0 cash flow separately.
- IRR() is different: include the full series (including time 0) when selecting values.
Efficient spreadsheet practice (copying correctly)
- Lock the discount-rate cell using an absolute reference ($) so formulas copy correctly across projects (F4 or equivalent).
5) What the lecturer signals about how to study / perform
- You are expected to read materials before class; there is no time to read during class.
- Mini-case structure matters: multiple projects (A–D), progressively more complex, then decisions under mutual exclusivity and under a budget constraint, to show where NPV/IRR/PI diverge.
6) If you remember nothing else (Week 1 anchors)
- Course objective: maximize shareholder value (tools optimize that), but understand real-world distinctions.
- NPV is the decision anchor; IRR is intuitive but can be wrong (multiple IRRs, no IRR, scale/timing issues).
- Payback is a weak rule (ignores TVM, post-payback cash flows, risk) and can reject high-NPV long-horizon projects.
- Under constraints, PI (NPV per constrained resource) is the correct ranking tool.
- Excel NPV() trap: it discounts Year 1+; add C0 manually.