Introduction: Finance Week 01

CLASS NOTES
WEEK I
READING ASSIGNMENTS
BMA Chapter 1: Finance and the Financial
Manager
Chapter 2.1: Introduction to Present Value (PV)
Alex Kane 1 IRPCOR421 Finance
Course objective and challenge
• Command of essentials of modern finance is
necessary for the management of
– Personal affairs
– Business/Corporations
– Non-profits
And for making public policy
• This course carves out these bare essentials
• Mastering those is time consuming and, at times,
difficult
• You cannot afford to postpone studying to near
exam dates
Covenants for Course Participants
• Who Will do what
• I Will end each session ON TIME
• You Will make every effort to show up ON TIME
• I Will present and post clear notes and use clear examples
• You Will ask about any item that isn’t made clear to you
• I Will respond to any question, none will be disrespected
• I Will show up to class 10 minutes early for short questions
• You Will e-mail for meeting whenever a relevant problem arises
• I Will respond and setup a meeting within 2 business days
• You Will not rest until you can solve all end-of-chapter problems and
independently construct all spreadsheets we develop
• I Will restrict the exams to similar problems
• I Will assume your intentions are always honorable
• You Will do the same and, as I, allow for cultural differences in
interpretation of behavior
• TAs Will help you as needed. Take advantage of their office hours
Efficient study of this material
• Efficient study requires
– Prior to class sessions
• read assigned text chapter(s) and class (ppt) notes
– No later than end of week
• Solve all end-of-chapter problems
• Study (by reconstructing) the Excel workbook
• Send ANY question to the First Class conference
(Finance) immediately. You’ll be answered within hours
• You must read the conference exchanges DAILY. Please
chime in with concerns/comments/responses
• Use TA sessions effectively, that is, come prepared with
questions. Passive attendance is ineffective
Grades, exams and e-mail
• Grades in this course are completely mechanical
• Exams (in class) will be in the form of
spreadsheet assignments returned at the bell
• Therefore, exams must be taken with the rest of
the class, there can be no exceptions
• Exceedingly, real-life assignment are prosecuted
in teams whose members hardly ever meet. e-
mail is a major communication channel. In this
class, e-mail communication is an important part
of learning
A note on spreadsheets
• To a large extend the course is spreadsheet based
• Spreadsheets should render “fear” of formulas and
computations obsolete. The only remaining difficulty is
conceptual
• The price, however, is the need to acquire effective use
of spreadsheets -- can be achieved only through practice
and learning essential “tricks”
• Solve all end-of-chapter problems in spreadsheets
• When asking (e-mail) questions, append your
spreadsheet and supply the cell addresses that require
clarificiation
I. The Corporation
• An independent entity defined by a nexus of contracts
(some implicit), completely separate from its owners.
Management is fraught with conflicts among parties to
the contracts. The framework is corporate governance
• The most fundamental conflict arises from the
separation of ownership (SH=shareholders) and control
(mgt)
• The charter (articles of incorporation) determines
– corporate residence, objectives and by-laws
– rules for electing the board of directors
– other governance issues, e.g., distribution of profits,
liquidation
• The SH record determines eligibility to vote (or give
proxy) for directors and receive dividends
Publicly Traded Corporations
• Corporate shares, unless otherwise designated, are
transferable, hence marketable
• A corporation is “public” if there are multiple SH and
investors can trade their shares
• At the lowest level (in the U.S.) shares are traded via
“pink sheets” held by dealers. The next step up is to
register the stock on a regional and/or national exchange
• Typical enterprise milestones
– Entrepreneur + angel financing
– Venture Capital (VC) financing
– Initial public offering (IPO) -- still a growth firm
– Maturity (one measure: the corporation pays a large share of
profits in dividends)
Separation of ownership and control
• Limited liability is what makes capitalism work. It
facilitates entrepreneurship and allows multiple owners
(investors) in a corporation. The result is separation of
ownership from control
• Ownership is limited to: investing in the corporate stock,
voting for directors/special issues in SH meetings (as
per charter), and sharing in payouts
• Control begins with the board of directors. The board,
in turn, hires management and monitors its activities
• Management (CEO and below) runs the corporation
The conflict
• Although mgt is hired by directors on behalf of
SH it obviously has its own agenda which, by
construction, conflicts with SH
• Top executives are on the board. Often mgt
controls the board more than the other way
around
• The power of mgt is fueled by the rules of
electing directors. SH activists are fighting for
universal rules that favor SH. So far these rules
are in effect in less than half of corporations, but
the number is growing
II. Assets
• An asset is an object
– on which a legal claim can be made
– is distinct from a good whose purpose is
‘immediate’ consumption, and ownership is by
possession
– the purchase of which is taken as investment
with reward in the form of future CF (cash
flow) and/or utility (=satisfaction/pleasure).
The flow of non-cash utility form an asset is called
convenience yield
Properties of assets
• Owned for future CF and/or convenience yield.
The legal claim endows them with market value
• An asset is dividend paying if CF occur during
the asset’s life (plant & equip., stock). Some
assets only pay off when sold (e.g., gold) or on
maturity (e.g., zero-coupon bond)
• Can be intangible (intellectual property)
• May be expected to lose resale value over time
(depreciate) due to amortization/obsolescence
Notes
• A consumption good is defined as a good
consumed within one year or less
• A consumer durable (economic life longer than
1year) has an investment value = price minus
imputed cost of one year’s use
• Art objects convey convenience yield. Therefore,
it is an ineffective investment unless the investor
enjoys the yield
• Cash is held for convenience yield
III. Real and financial assets (1)
• Assets generate CF/convenience yield from either
– putting them to use, e.g., machines, intellectual
property,
– calling upon the issuer to pay up, e.g., bonds, stocks.
• Assets of the first type are called ‘real assets’.
Notice that not all are tangible (intellectual
property)
• Assets of the second type are called ‘financial
assets’
Real and financial assets (2)
• The ultimate distinction between ‘real’ and
‘financial’ assets is this
– a real asset appears only on the asset side of balance
sheets (more than one if it is owned in partnership)
– a financial asset appears on both, ‘Assets’ side of one
or more balance sheets, as well as (simultaneously
and in equal value), on the ‘Liabilities’ side of one or
more other balance sheets
• A financial asset is
– issued (‘written’) by an ‘economic agent’ -- cannot
be found in nature
– some financial assets have a limited life (e.g., bonds)
Social wealth
• The economic wealth of a society (however
defined) is the sum (aggregate) of the balance
sheets of its members
• When balance sheets are aggregated, all financial
assets add up to zero, because each appears on
both ‘assets’ and ‘liabilities’ side of these
balance sheets
• Thus, social wealth is measured by the value of
real assets -- which is why they are called ‘real’
Financial interrelations of countries
• Once we distinguish social groups (say, by country) we
must qualify the calculus of social wealth
• Suppose citizens of two countries exchange financial
assets. Then social wealth of one country (as shown in
the national accounts) will equal: real assets plus the net
value of financial assets --sum of financial assets owned
(on the ‘Assets’ side) minus those owed (on the
‘Liability’ side)
• Investment in real assets across borders is called foreign
direct investment (FDI). FDI is coveted because it is less
liquid and facilitates technology transfer. Financial
investment is liquid, hence fickle
BS of U.S. HH (Q4/2006)
Assets $ Billions
Tangible/real 26,804
Real estate 22,642
Consumer durables 3,923
Other 239
Financial 42,116
Deposits 6,670
Debt securities 3,029
Equities (direct+MF) 10,446
Non corporate equity 7,385
Other (mostly pensions) 14,586
Liabilities (mort~73%, cons credit~18%) 13,293
NW (wealth) 55,627
National Accounts (2006)
• GDP 13,244
• Personal Consumption (C) 9,269
• Gross Private Investment (I) 2,212
• Gov cons (fed=808 local=1,288) 2,096
• Gov inv (fed=118 local=312) 430
• Total Gov (G) 2,526
• Export 1,466
• Import –2,229
• Net export (X–M) –763
• GNP: add net receipt (profits) from foreigners 22
IV. Capital markets
• Set up to trade assets
• Financial markets trade financial assets
• Money markets trade financial assets of short
maturity (1 year or less)
• Organization and operation of capital markets is
costly. Markets are assets owned by the
operators, e.g., NYSE (financial), Ebay (real)
V. Corporate economic objectives
• A corporation may be set up for one or more activities to
generate CF
– Non-financial: invest in real assets; use to produce (1) assets
(machines) and/or (2) goods/services
– Financial: invest in financial assets to increase value of savings
– Markets: trade real/financial assets
• In general, these activities require (or call for on grounds
of efficiency) to raise capital at the outset as well as
regularly or occasionally for ongoing investments
• The rich array of possible ways to manage this activity
calls for specialization
Financial officers
• Manage the interface of the corporation with
capital markets
– Sell securities (stocks, bonds) to raise capital
– Determine the use of net cash flows (pay out
dividends or reinvest in new assets) -- capital
budgeting
• The CFO (chief financial officer) and his staff
perform two functions
– Treasury: cash management, raising capital, capital
budgeting, banking
– Controllership: financial statements, accounting,
taxes
VI. Present Value (PV, Ch_2.1)
• Suppose a claim to $120 with a maturity date one
year from now is auctioned off.
• What is the most you should pay for the claim?
This is the present value (PV) of the claim
• Denote the future CF by C(1). Here, C(1)=120
• Observed behavior shows that a dollar today is
worth more than a dollar tomorrow: PV<C(1)
• OK, but how can we tell by how much, and how
can we determine the exact value of the claim?
Market value
• The question of PV is analogous to asking the value of a
bar of candy. People distribute on a spectrum from
those who don’t touch it to those who are addicted to it.
• Still, suppose a bar costs $1.20. Only those who value it
at $1.20 or more will buy it, others will avoid it. In any
event, $1.20 is the (market) value to use for decision
making
• Same applies to a claim on a dollar to be received one
year from now. We observe the price of a U.S. Treasury
bill that promises $10,000 a year from now. It is a safe
claim; in fact, the only safe claim to be found in the
U.S., since the U.S. government (the Treasury) owns
and operates the mint
The Discount Factor (DF) and
the ‘market rate of return’
• Suppose we observe: price of a 1-year T-bill is $9,500
• This means: The market value of a 1-year safe dollar is
9500/10,000=$0.95. We call this the discount factor (DF)
for safe dollars of 1-year maturity
• The DF implies: the required rate of return on
investment in safe dollars (r) is
C(0)*(1+r)=C(1)
1+r = C(1)/C(0) = 1/DF = 10000/9500 = 1.0526 (r=5.26%)
Equivalently: r=profit/investment=[C(1)–C(0)]/C(0)
Also: DF = 1/(1+r) = 1/1.0526 = 0.95
• 5.26% is the market rate of return on 1-year safe
investment. All safe investments must be judged against it
Can a safe investments yield less than
5.26% ??
• Can another 1-year safe asset, traded in financial
markets, yield a lower rate of return than 5.26% ?
• No! All rational investors would want to sell it and
use the proceeds to buy a safe asset that yields
5.26%, making a sure (arbitrage) profit
• Result: Only one safe rate of return (for a given
maturity) prevails in capital markets
Short Sales
• Capital markets allow sale of assets you do not own
• In a short-sale transaction you borrow the asset and sell it.
Brokers provide the service
• Some time later (the short seller decides), s/he repurchases
the asset and returns it
• As long as you haven’t returned it, you hold a short
position in the asset.
• Why short sell? A belief that the asset is overpriced, and
investing the proceeds from the short sale in fairly priced
assets (or better yet in underpriced assets), will yield a
profit.
• Short sale facilitate holding down prices below irrational
levels. Institutional constraints/cost limit this activity
Investments that yield more: the rate of
return to a successful entrepreneur
• Suppose the price of silkworms today is $1/dozen
• An entrepreneur can grow a dozen worms over a
year for only $0.94 (inclusive of all costs)
• The profit per dozen is: 1– 0.94 = $0.06
• The 1-year rate of return is:
Profit/investment = 0.06/0.94 = 0.0638 (6.38%)
• In principle, this is possible. Is this likely?
Return to enterprises
• The example of silk worms cannot be taken as safe. How
can the entrepreneur be sure the price will remain at
$1/dozen in one year? So this is a risky investment
• However, suppose the entrepreneur is Japanese, and the
Japanese government guarantees the price.
• That investment would now be a steal (from the taxpayers,
because the guarantee is valuable and can actually be
priced!)
• The raison d’etre (reason for existence) of enterprises is to
try and beat the market return. Success is likely with risky
investments as we shall see, never with safe investments
(net of subsidies)
The significance of the market rate of
return and other names for it
• The market rate of return is the benchmark for
any and all investments. There is a market rate
for any degree of risk
• The rate on safe investments (T-bills) is a factor
in the benchmarks for risky investments
• That ‘market rate’ has equivalent names:
– the opportunity cost of capital
– the required rate of return
– the hurdle rate
– ‘The’ discount rate
The PV quantified
• The PV is related to the future CF by the discount
rate (or, equivalently, the DF)
PV = C(1)/(1+r) = C(1)/1.0526 = DF*C(1) = 0.95*C(1)
• Thus, the value of the 1-year claim on $120 is
120/(1+r) = 120/1.0526 = DF*120 = 0.95*120 = $114
• We make decisions about such claims based on
their market value ($114) which we derive from the
market DF (0.95), or discount rate (5.26%),
observed from T-bills
PV and uncertainty
• Suppose the silk-worm grower faces uncertainty
about the price of silkworms
• A scenario analysis yields the following table
State of the world: Good Likely Poor
Probability 0.3 0.5 0.2
Price per dozen ($) 1.3 1.0 0.8
• Expected price = sumproduct(prob,price)=$1.05
• Expected profit per dozen: 1.05–0.94 = $0.11
• Expected rate of return: 0.11 /0.94 = 11.70%
The business of silkworms (hypothetical)
• Suppose the way it works is that an investment
of I = $940,000 will produce a one-time crop of
1 million dozens of worms.
• What we called ‘price’ is really the revenue
minus selling cost per dozen
• Thus, at year end, E(CF) = C1 = $1,050,000
• We know that PV(C1) = 1,050,000/(1+r)
• But what should we use for r?
• The question is really, what is the ‘required rate’
= ‘market rate’ = opportunity cost of capital ?
The rate of return on risky investment
• As we shall see, we can quantify the level of risk
carried by owners of various securities traded on
capital markets, as well as the expected rate of
return on these assets
• In sum, we observe a market expected rate of
return for any level of risk
• We can estimate the level of risk involved in a
project not yet traded
• We use the market rate that applies to the level of
the project’s risk to discount expected future CF
• The project PV is the sum of thus discounted CF
VII. Net Present Value (NPV)
• The most fundamental concept in finance
• NPV = – I + PV(CF)
• For the silkworm business:
• Suppose the risk-free rate is: 5.26% (as before)
• The risk premium for silkworms is 4.54%
• The required rate is: 5.26+4.54 = 10%
• NPV = – 940,000 + 1,050,000/1.1 = $14,545
• Notice: The expected rate of return is actually
R=110,000/940,000 = 11.70%.
• The difference between R (also called internal rate of
return) and the required rate, generates the positive NPV

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