Foundations of finance

Real Assets

Used to produce goods and services → generate net income to the economy.

• can be tangible - real estate

• or intangible - patents

Tangible Assets

Physical assets such as machinery, cash, and equipment.

Intangible Assets

Non-physical assets like brand recognition and negotiation ability of employees; hard to measure.

Financial Assets

Define allocation of income or wealth among investors → indirectly contribute to the productive capacity of the economy.

• like stocks, bonds, deposits

Household wealth

Real assets + Financial assets

Corporate Bond

A loan that can be sold second-hand on financial markets.

Securities

Tradable financial assets, including shares of stock and options.

Efficient Financial System

Provides options for savers to mitigate risks, allows diversification, and facilitates risk sharing (through asset transformation).

Risk Shifting

Typically achieved through fair-priced mechanisms such as insurance contracts. Reducing risk causes increases in price - tradeoff for reduced uncertainity

Role of Financial Markets

Channel funds from savers to borrowers, allocate resources to productive uses, help price discovery, and provide diversification and liquidity.

Financial Intermediaries

Facilitate flow of funds between suppliers and demanders of capital, such as banks by lowering costs through EOS, search costs risk sharing and diversification.

Transaction Costs

Time, money, and effort spent making a deal.

Economies of Scale

Using one standardized contract for many customers to reduce transaction costs.

Search Costs

Costs incurred when depositors hunt for borrowers and borrowers pitch to lenders.

Maturity Transformation

Turning short-term deposits into long-term loans.

Risk Transformation

Pooling many deposits allows better diversification and lowers individual risk.

Investment Decisions

The purchase of real assets.

Capital Expenditure (CAPEX)

Buying tangible assets.

Financing Decisions

The sale of financial assets.

Capital Structure

The choice between debt (lenders) and equity financing (shareholders).

Debt

Raising money from lenders, borrowing and paying with interest.

Interest on Debt

Often tax-deductible for the company.

Equity Financing

Issuing new shares of stock or buying new assets.

Debt Financing

Paying lenders back the principal and interest on borrowing

Debt covenants

contactual obligations in debt agreements

• affirmitive - active condititons to maintain / adhere to

• restrictive - retrict borrowers from engaging in activities that can jeapordise lender’s interest

Debentures

Loans that have been secured on some/all assets of the company.

• Mortgage (fixed charge) - specific and identifiable secured assets of the company e.g. land and buildings

• Floating charge - company can change the secured assets in normal course of business e.g. inventory and receivables

Shareholders

Residual claimants entitled to residual claim on company's earnings and assets after all debt is paid off.

Dividends

Payments to shareholders that are not tax-deductible and can be suspended in tough times.

Investment Decisions vs Financing Decisions

The real value of a company stems from its investment decisions rather than how it pays for it.

Information Asymmetry

One party in a transaction has more information than the other.

Adverse Selection

Riskier borrowers ("lemons") are more eager to borrow; safer borrowers ("peaches") drop out.

Credit Crunch

Can lead to a market full of high-risk borrowers.

Moral Hazard

Borrowers (or managers) may take on riskier actions once they have the loan or investment.

Diversification

By investing in a variety of assets, losses in one can be offset by gains in another.

Corporation

legal entity (person) owned by shareholders that can make contracts, run a business, borrow & lend money, sue or be sued and pay taxes.

Limited Liability

shareholders cannot be held personally responsible for corporation's debts.

Financial Manager

The financial manager stands between the firm and outside investors, helping to manage the firm's operations and make good investment decisions.

Financial Goal of the Corporation

Every investor wants the financial manager to increase shareholder wealth.

Profit Maximization

is not a well-defined financial objective for at least two reasons: which year's profits and risk consideration.

Maximising Shareholder Value

Each shareholder wants to be as rich as possible and manage timing and risk of consumption plan.

Secondary Financial Markets

serve a key social purpose by enabling shareholder autonomy and simplifying managers' goals.

Short-terminism

managers might reduce R&D, cut wages etc, to cut costs and make short term profit.

Myopic Stock Markets

undervalue long-term investments unfairly punishing companies.

Long-term Shares

giving managers long-term shares incentivizes them to maximize long-term value.

Neglecting Stakeholders

cut costs, raise prices leading to overworked workers and unhappy customers.

Stakeholder Satisfaction

Critical to long term profits.

Opportunity Cost of Capital

The minimum acceptable return rate based on market investment alternatives.

Hurdle Rate

Depends entirely on external factors (rates of return shareholders can get elsewhere).

Time Value of Money

Money today is worth more than the same amount tomorrow.

Inflation

Prices rise, so money buys less in the future.

Impatience

Preference for current consumption; people want to be compensated for waiting.

Risk

There's a chance you won't get repaid.

Required Return

Often equals risk-free rate plus risk premium.

Agency Costs

The principal-agent problem.

Rate of Return

Calculated from the cash inflows and outflows generated by the investment project.

Investment Project Cash Flows

Include all inflows and outflows resulting from the investment, calculated after taxes.

Present Value (PV)

The value of the asset right now.

Compound Interest

Getting interest on the money gained through interest in the previous year.

Future Value Formula

Future Value = present value * (1+r)^t.

Present Value Calculation

PV = C_t / (1+r)^t, where Ct is the cash flow and r is the discount rate.

Discount Factor

Discount Factor = 1 / (1+r)^t.

Net Present Value (NPV)

NPV = PV - initial investment.

Valuing an Investment Opportunity

Example of constructing an office block with costs and expected returns.

Opportunity Cost of Capital Example

7% return from US treasuries used to evaluate investment.

Return Calculation

Return = profit / investment.

Discounted Cash Flow (DCF)

PV = sum of cash flows discounted by (1+r)^t.

NPV with Multiple Cash Flows

NPVs are expressed in current dollars and can be added up.

Initial Cash Flow in NPV

NPV = C_0 + PV.

Attractiveness of Investment

Present value required to make the project as attractive as the alternative investment.

Opportunity Cost of Capital

The return you would expect from the next best, equally risky alternative investment.

Perpetuity

An investment that pays the same cash flow every year in perpetuity, starting one period from now.

Return on Perpetuity

The annual rate of return on a perpetuity is equal to the promised annual payment divided by Present Value: Return=C/PV.

PV of Perpetuity

The present value of a perpetuity given the discount rate r and cash payment C is PV=C/r.

Perpetuity Due

A perpetuity that starts immediately.

PV of Perpetuity Due

PV=C+(C/r)=C/r(1+r).

Annuity

An asset that pays a fixed sum each year for a specified number of years.

PV of t-year Annuity

PV of t-year annuity=C[(1/r)-(1/(r(1+r)^t)).

Annuity Factor

The expression inside the brackets in the annuity formula, representing the present value of $1 a year for each of t years.

Annuity Due

A level stream of payments starting immediately.

Mortgage Payments Calculation

For a $250,000 house mortgage with a 12% interest rate, the annual mortgage payment is $250,000/30-year annuity factor.

PV of Growing Perpetuity

PV of growing perpetuity is calculated as PV=C1/(r-g).

PV of Growing Annuity

PV=23.18*(1/(0.034-0.05))[1-((1.05)^t)/((1+0.34)^t)].

Interest Payment Frequency

In U.S. and Britain, government bonds pay interest semiannually, meaning 10% annually is 5% every 6 months.

Annual Percentage Rate (APR)

How much interest is paid over the course of the year, ignoring how often it's paid and ignoring compounding.

Effective Annual Rate (EAR)

APR but includes compounding; for example, 5% semiannually equals 10.25% compounded annually.

Continuous Compounding

Present value of $1 received at the end of year t when the continuously compounded rate is r is PV=$1/e^(rt).

Continuous Payments

Pretending that money can be dispensed in a continuous stream, simplifying calculations and approximating the PV of frequent payments.

Bond

A security that obligates the issuer to make specified payments to the bondholder.

Face value

Payment at the maturity of the bond.

Coupon

The interest payments made to the bondholder.

Coupon rate

Annual interest payment, as a percentage of face value.

Bond pricing

The price an investor is willing to pay for a bond depends on the present value of the cash flows expected to be received by holding the bond.

Cash flows from bonds

Coupon payments + par value.

Bond Value

Present Value of coupons + Present Value of par value discounted at the required rate of return.

Bond Price

Bond Price = ∑(Coupon / (1 + r)ⁿ) + (Par Value / (1 + r)ᵀ), where T is the maturity date and r is the required interest rate (yield to maturity)

Settlement

Date when the bond is purchased (1st October 2023).

Rate

Security's annual coupon payment (e.g., 0.0425 since 4.25% coupon rate).

yld

Security's annual yield (e.g., 0.0015 since 0.15% interest rate).

Redemption

Security's redemption value per 100 face value. Face value is 100.

Frequency

Number of coupon payments per year. 1 since annual coupon payment.