finance notes mar 12

Lecture Overview

• The lecture series introduces key finance principles that are vital for understanding investment and corporate finance decisions.

Lecture 1 - The Valuation Principle

• Cost-Benefit Analysis: Decisions that yield benefits exceeding costs enhance firm value.

• Competitive Markets: Goods are traded at uniform prices, which define their market value. Higher benefits than costs increase market value.

• Valuation Principle: The market price determines the value of an asset or commodity.

• Time Value of Money: Acknowledges that money's value diminishes over time; interest rates are used to quantify this.

Lecture 2 - Interest Rates and Cash Flows

• Interest Rate (r): Rate for borrowing or lending money over time.

• Interest Rate Factor (1+r): Translates money's present value to its future value.

• Discount Factor: Present value of future cash flows.

• Future Value (FV): Value of cash flow when moved forward in time.

• Present Value (PV): Current value of future cash flows.

• NPV Decision Rule: Assess projects based on the difference between present value of benefits and costs. A positive NPV indicates the firm’s value increases.

• Financial Market Role: Allocating resources effectively based on risk-return profiles.

• Law of One Price: Similar cash flows in competitive markets must be priced identically.

Lecture 3 - Time Value of Money

• Compounding: Accruing interest on previously earned interest leads to greater returns.

• Comparison of Cash Flows: Only cash flows at identical periods can be combined or compared.

• Annuities: Regular cash flows at fixed intervals; can be calculated for FV and PV purposes.

• Perpetuity vs Annuitization: Understanding the differences in cash flow frequency and longevity.

Lecture 4 - Bonds

• Bond Basics: A financial instrument for raising funds; characterized by maturities, coupon payments, face value, and yield to maturity (YTM).

• Zero Coupon Bonds: Bonds without periodic interest, returning only face value at maturity.

• Bond Valuation: Pricing principles based on present values of cash flows, influencing investment returns.

• Risk in Bond Valuation: Interest rate and credit risks significantly impact value and yield.

Lecture 5 - Stocks

• Common vs Preferred Stocks: Rights associated with ownership, dividend preferences, and capital gains.

• Valuation Models: Using dividends and earnings for assessing stock prices (e.g., Discounted Cash Flow Model).

• Dividend Yield and Growth: Calculating expected returns from stock ownership.

Lecture 6 - Investment Decision Rules

• Capital Budgeting: Evaluating investments that create value and calculating NPV and IRR for decision making.

• Payback Period: Minimum time needed to recover an investment; highlights issues such as ignoring time value and risk.

• Internal Rate of Return (IRR): Rate where NPV equals zero; highlights project-specific discounting approaches.

• Profitability Index (PI): Ratio to analyze project viability relative to initial investment.

Lecture 7 - Income Statement and Free Cash Flow

• Income Statement Analysis: Relationships between revenues, costs, EBIT, and net income—relevance for financial performance tracking.

• Free Cash Flow (FCF): Important calculation for assessing project contribution to firm value.

Lecture 8 - Risk and Return

• Understanding Risk Types: Differentiating systematic (market) risk from unsystematic (firm-specific) risk.

• Portfolio Diversification: Strategies to mitigate risk exposure through varied asset allocation.

• Expected Returns vs Variability: Importance of historical performance and realized returns in financial forecasting.

Lecture 9 - Systematic Risk & Equity Risk Premium

• Risk Premium Dynamics: Relation between expected return and systematic risk; applies to security investment and portfolio management preferences.