AFM 271 Blake Phillips

Topic 1: Overview of the Financial System

- Financial Markets
- Financial Intermediaries
- Risk Components
- Unifying principles of finance
Financial Markets
- Channel funds from savers with surplus fund to spenders with fund shortages
- Allows savers to grow income, and allows those who lack capital to expand through growth
- Functions of financial markets
1. Aggregate and centralize buyers and sellers of financial assets to facilitate price
formation (important because a segmented market limits competition, may result in
multiple prices, fails to aggregate capital for large transactions, and limits investor
choices)
2. Provides a mechanism for investors to sell a financial asset (liquidity provision is
important; assets with low liquidity demand a price premium)
3. Reduction of search and information costs of transacting in financial assets to reduce
information asymmetries
4. Create small denomination or aggregated instruments (i.e. shares in a company)

Financial Intermediaries
- Roles of financial intermediaries
1. Liquidity Provision and Economies of Scale
2. Mitigation of Adverse Selection Costs
3. Mitigation of Moral Hazard
- Types of financial intermediaries
1. Depository institutions (banks, credit unions)
2. Contractual savings institutions (insurance companies, pension funds)
3. Investment intermediaries (finance companies, mutual funds)
Financial System Regulation
- Oversees disclosure on information and insider trading
- Ensures soundness of financial intermediaries
o Restriction on entry, disclosure, restriction on assets, and deposit insurance
- Control monetary policy
Risk Components
Risk made of 2 components: Time and Uncertainty
- Time:

Inflation and deferred consumption (can be estimated by examining government bonds/

other risk-free investments)
Uncertainty:
o Payoff uncertainty

Unifying Principles of Finance

- Assumptions of Perfect financial market
o Broad range of financial assets traded
o Enforceable contracts
o Ability for participants to freely enter and exit market
o No constraints on trading *(contingent)
st
1. 1 principle : Markets are arbitrage free
o Requires no initial investment, yields non-negative payoff
nd
2. 2 principle: Each investor has a preference sequence expressed by expected utility
3. 3rd principle: Each investor seeks to optimize his total utility
4. 4th principle: Market equilibrium determines prices in terms of fundamentals

Topic 2: Overview of Security Types

- Interest Bearing
- Equity
- Derivatives

Interest-Bearing Securities
- Debt instruments represent a loan between the investor and the firm
- Fixed term, at conclusion investment is repaid
- Interest payments are tax deductible for the firm
- Does not infer ownership of the firm (has little or no impact on control of the company)
- Debt holders typically paid before equity holders in the event of bankruptcy
- Money Market
o Short term: <1 year
o Ex. US Government Treasury Bills
o Extremely liquid and easily traded at market value
o No fixed payments and sold at a discount when issued by the firm or government
- Fixed Income
o Fixed interest payments
o Ex. Government of Canada Bonds, corporate bonds
o Coupon rate, coupon frequency, face value and maturity set upon issuance and are fixed
for the lifetime of the bond
2

o
o

After initial offering, bonds can be traded on a secondary market

Value affected by holding maturity and liquidity constant

Equity Securities
- No fixed terms, valid for the firms lifespan
- Dividends are main form of payments, but not required
- Dividend not tax deductible, made form post-tax operating profits
- Represents ownership of the firm and infers control to its holder
- Value based on expected profitability (cash flows) of the firm
- Common Stock
o Ownership in firm, has voting and shareholder rights
o Entitled to dividend profits after preferred stockholders (dividends not mandatory)
- Preferred Stock
o Fixed rate of dividend pay, usually paid before distribution to common stockholders (but
after debt holders)
o Dividend typically fixed at some point in time
o In the event of bankruptcy, preferred stock typically have a face value that is paid before
any distribution to common shareholders
- Too much debt financing causes liquidity ratios to suffer
o Trade-off between giving up firm ownership and the requirement to pay back
investors
Derivative Securities
- The value of the security is derived from an existing primary asset rather than issued by the firm
- A claim either on the asset or access to a specified price for an asset in the future
- Needed to offset some of the portfolio risks, and to reduce or eliminate downside exposure
- Futures Security
o A binding agreement (obligation) to buy/sell an asset in the future, at a price set today
o Forward contract specifies features and quantity of the asset, date/time/place, and
price buyer will pay at time of delivery
- Option Security
o Call: gives the owner the right but not the obligation to buy an asset at a predetermined
price during a predetermined time period
o Put: gives the owner the right but not the obligation to sell an asset at a predetermined
price during a predetermined time period
o Options require upfront payment to offset default risk
o Trading occurs on organized exchanges

Topic 3: Time Value of Money and Bond Valuation

- Value today of a series of payments to be received in the future is NOT equal to the sum of
those payments
o Deferred consumption risk, inflation risk, default risk
o A dollar today is worth more than a dollar promised in the future
- Calculate the PV of cash flows adjusts payments to reflect the above risks
- Allows for comparability between Present CFs and Future CFs, in turn able to compare different
projects and profits/costs
3

Important to note that only values at the same point in time can be compared or combined,
moving a cash flow forward in time means compounding, and moving a cash flow backward in
time means discounting
When solving questions involving time value of money, it may be helpful to start with a timeline,
then determine the interest rate and determine appropriate formula to use before completing
the calculations

PV = Present Value
FV = Future Value
C = Cash Flow
r = interest rate
T = number of years
M = number of periods
n = total number of periods (n = m x T)

PV

C
(1 r ) n

FV C (1 r ) n

Stream of cash flows must be discounted one by one unless:

o Cash flow are the same in all periods (annuity and perpetuity)
o Cash flows increase at a constant rate (growing Annuity and growing perpetuity)

Perpetuity: asset pays fixed sum each period in perpetuity

Annuity: pays fixed sum each period for T periods
Growing Perpetuity: pays increasing sum each period in perpetuity
Growing Annuity: pays increasing sum each period for T periods

C
1
1

r 1 r T

T
C1 1 g
1
T
r g 1 r

At the most basic level, quoted interest has two components:

o Interest Rate
o Frequency which interest is applied (compounding frequency)
4

After-tax interest rate for investors: r(1 ), where is the effective tax rate

Annual Percentage Rate (APR) = Interest rate reported on an annual basis; is distorted and does
not allow you to directly calculate the amount of interest you would actually pay per year
(leaves out compounding frequency)
o Need to adjust by using the APR conversion formula to get the Effective Interest Rate
b

APR
EXR 1
1
m

Where:
EXR can be EAR, ESR, EQR, EMR, EWR etc.,
m = compounding frequency (ex. compounded monthly, m = 12)
b = number of m units in X (ex. To find ESR, b = 6 if compounded monthly)
Ex. APR = 8%, compounded monthly, what is the ESR?
6

0.08
ESR 1
1
12

Ex. You purchased a $42,000 car that was financed with a down payment of $12,000 and a $30,000 bank
loan at interest rate of 5% compounded annually. The car loan is to be amortized over 5 years with
payments made at the end of each month. The first payment will be one month from today. Calculate
(a) the monthly payment on the car loan, and (b) the interest and principal portion of the 20th payment.
(a) Monthly interest rate:
(

Number of periods/payments:

Monthly interest payment:

(

(b) The balance owning after the 19th payment is:

(

The interest portion of the 20th payment is:

The principal portion of the 20th payment is:

Ex. You have income today of $25,000. You plan to work for 20 more years. All future income will be
received at the end of the year. Your income will grow by 7% per year until year 10. Over years 11 20,
it will grow by 4% per year. Assume discount rate is 6%. Find (a) present value of all your income, and (b)
Suppose that you want to spend some amount today and at the end of each of the next 20 years. Your
spending will increase by 3% per year, and you also want to have $150,000 left after 20 years. How
much can you spend today?
(a)
(

)[

)(

)[

(b) Let C denote the amount spent today.

(

)[

Note that since $30,580.80 is greater than the current income of $25,000, you will have to borrow for
the first few years before your income catches up.
Ex. Suppose you plan on saving for retirement starting a year from now for 15 years, and deposits
$8,000 at the end of every year to your bank. You plan on retiring 15 years after your last year of
savings, and wish to withdraw an equal amount at beginning of each year (i.e. at the start of year 31) for
the following 30 years. How much will your annual withdrawal be? Interest rate is 8% before retirement
and 7% after retirement.
FV of savings 15 years from now:

FV of savings above 30 years from now:

Using the equation for PV of annuity:

](

Topic 4: Investment Decision Rules

- Net Present Value
- Payback Rule
- Profitability Index
- Internal Rate of Return
NPV
T

CFt
t
t 1 1 RRR
NPV 0 TAKE
NPV C0

Measures difference between PV(benefits) and PV(costs)

Net present value of all discounted cash flows
If positive, accept the project regardless of preference for cash today versus cash in the future
o Can borrow or lend to create preferred pattern of cash flows
Take the project with the highest NPV if must choose one project over others
Advantages: considers all cash flows, and discount them to incorporate time value of money
Disadvantages: requires forecasting of future cash flows, and can be difficult to estimate
discount rate

Payback Rule
-

Time required for the investor to recover initial investment

Payback rule:
o for independent projects, accept if payback under pre-specified threshold
o for mutually exclusive projects, accept projects with shortest payback under the prespecified threshold
It is simple and may be important for firms with liquidity problems and in need of funds,
however, it ignores the time value of money and risk differences between projects. Payback rule
does not look at cash flows after reaching the threshold, and the threshold is arbitrarily set

Discounted Payback Rule

- Same as Payback rule but discount for each cash flow period
- Discounted payback rule: for independent projects, accept if discounted payback under a prespecified threshold
- For mutually exclusive projects, accept the project with the shortest discounted payback under
the threshold
- If investment can never be recovered through DP, NPV of project is negative
- Advantages: simple, useful for firms with liquidity problems, and takes into account the timing
of cash flows
- Disadvantages: arbitrary payback threshold, ignores cash flows after the threshold, does not
consider risk differences between projects, and can be difficult to estimate discount rate
Profitability Index (PI):

PI

PV
I0

Where I = initial investment

-

Accept project if PI > 1 (which is equivalent to NPV > 0)

Can be used to rank projects when there is capital rationing (resources limited)
Advantage: reflects time value of money and considers all cash flows
Disadvantages: can be difficult to estimate discount rate (as with NPV) and scaling issues

Internal Rate of Return (IRR)

-

IRR is the discount rate that makes the NPV of a project equal to zero
keep project if IRR >= to cost of capital
Will give the correct assessment if all the negative cash flows precede the positive cash flows
(i.e. investing activity) (when positive cash flows precede negative cash flows, NPV is an
increasing function of the discount rate, so the higher the discount rate the higher the NPV)
In other cases, such as with unconventional cash flows or multiple IRRs, the IRR will disagree
with the NPV and be incorrect
No IRR if project NPV is positive for all values of the discount rate (always positive cash flows)
Advantages: better than alternatives like payback, is more intuitive, coincides with NPV method
for simpler results, and provides a single number that summarizes the projects profitability
Disadvantages: cannot be used to evaluate mutually exclusive projects that differ in scale or
timing, there may be multiple IRRs or no IRRs, assumes a flat term structure, and the same rule
cannot be applied to both investing and financing activities
T

CFt
0
t

IRR
t 1

NPV C0

Ex. [T/F] A project acceptable under the discounted payback rule would also be acceptable under the
profitability index rule.
If the project is acceptable under the discounted payback rule, its cash flows before the threshold covers
the initial investment cost. However, as it ignores future cash flows after the cut-off date. A project
acceptable under the profitability index rule is one where the sum of all discounted future cash flows
exceeds the initial cost of investment. These two will lead to the same result as long as there are no
large negative cash flows after the cut-off period for discounted payback rule.
Ex. Assume opportunity cost of capital is 10%, and a threshold of 2 years. Will the following project be
taken under the discounted payback rule?
Year 0
-$5,000

Year 1
$2,000

Year 2
$2,000

Year 3
$4,000

Year 2
$1,652.89

Year 3
$3,005.26

The discounted cash flows are:

Year 0
-$5,000

Year 1
$1,818.18

The discounted payback period is:

Alternatively, we can see that the cumulative cash flow after 2 years is still negative (-5,000 + 1,818.18 +
1,652.89 = -$1,528.93), which also means that discounted payback period is longer than the threshold.
Therefore, the project will not be taken.

Topic 5: Capital Budgeting

1. Estimate expected future incremental cash flows (sales or cost reduction) which will result from
the project
2. Determine incremental costs
Fixed costs
Variable costs which are typically assumed to be a function of sales
Opportunity costs
Initial capital outlay
3. Using estimated incremental sales and costs estimate EBIT and Net Income
4. Calculate changes in net working capital attributable to the project
5. Calculate CCA tax shield attributable to project
6. Calculate project NPV
-

Net working capital

o the capital tied up in ongoing operations
o Includes cash, inventory, receivables and payables.
o Increasing the need for cash on hand, inventory or receivables increases NWC
CCA tax shield

PV

C1
rg

C1 I 0 d TC
g d

PV

I 0 d TC
rd

To adjust for the HALF YEAR RULE

I d TC 1 0.5 r
PV 0

d
1

For SALE OF ASSETS

I d TC 1 0.5 r
PV 0

r d 1 r
1

T
1 r

RST d TC

rd

Example:
McCain Manufacturing is considering the acquisition of a new machine that will replace their old
machines. The new machine costs $700,000 and can be sold at the end of its expected 4 year
operating life for $200,000. The new machine takes up more space so McCain Manufacturing will need
to move some supplies into a storage room that would otherwise be sublet for $10,000 per year.
The old machine was bought 5 years ago for $800,000 and can be sold for $200,000 today or $100,000
in 4 years. McCain Manufacturing paid $10,000 for a study which indicates that the new machine will
reduce costs by $170,000 annually and net working capital will be reduced by $100,000 when the new
machine is installed. Both machines have a CCA rate of 30%. McCain Manufacturing has a tax rate of
40% and uses 12% cost of capital to evaluate projects of this nature.

Calculate the NPV of this project.

T=0
Cash Flow (1)
Tax
After Tax CF
Investment
dNWC
Total Cash Flow
PV of CF
Total PV CF
PV CCA TS (2)
NPV

-500,000
100,000
-400,000
-400,000
-108,414.46
117,046.42
8,631.96

Year 1
160,000
64,000
96,000

Year 2
160,000
64,000
96,000

Year 3
160,000
64,000
96,000

96,000
85,714.29

96,000
76,530.91

96,000
68,330.90

Year 4
160,000
64,000
96,000
100,000
-100,000
96,000
61,009.74

(1) Manufacturing Costs Opportunity Cost

= 170,000 10,000
(2) CCA Tax Shield Calculation

I d TC 1 0.5 r 1
PV 0

T
r d 1 r 1 r

RST d TC

1
500,000 .30 .40 1 0.5 .12

T
.12 .30

1 .12 1 .12
117,046.42

100,000 .30 .40

.
12

.
30

10