Principles of Finance - Key Concepts Flashcards (Video Lecture)

Overview

This is an introduction to Principles of Finance (Topic 1) by Sean Pinder, Associate Professor in the Department of Finance at the University of Melbourne.
Session aims to build a solid foundation for all future finance study; assumes no prior knowledge of finance, accounting, or economics; expects some algebra proficiency.
Emphasis on attendance: lectures are essential; Think Aloud Problem Solving (TAPS) exercises are interspersed during lectures and tied closely to past exam questions; access to TAPS materials is limited to in-lecture participation.
Full lecture recordings available this week; starting next week, recordings will pause for TAPS and only be provided to those who attend.
The course structure includes readings, a textbook, a teaching note by Ajit Lamber, and lecture notes (including instructor annotations). Lecture notes are the primary resource; textbooks are a supplementary tool.
Instructor background: research interests in corporate finance (payout decisions, value of voting rights, risk-taking and option pricing, water rights valuation).
Co-lecturer: Doctor Rinal Misra (specializes in various finance topics; involved in last five weeks of the subject).
The subject is built around a core inverted pyramid: fundamentals now, advanced topics later (investments, derivatives, machine learning, etc.).

Course Structure and Resources

Four topics in the first four weeks are examinable on the mid-semester test (details provided in upcoming weeks).
Required readings: Canvas provides access to materials; first four topics form the basis of the mid-semester assessment.
Textbook: available via library or for purchase; considered a secondary resource to lecture notes.
Lecture notes: include the instructor’s written notes and “red bits” annotations prepared for each lecture.
PASS program: Peer Assisted Study Scheme; student leaders facilitate study groups; participation highly encouraged; not a substitute for lectures.
Extracurricular offerings:
- Equity analytics with Excel (John Gauntlett): intermediate Excel skills for finance careers; limited places; links via subject website.
- EZR/R programming (Alan Horseful): intro to R for data analysis; project to get students up and running with the language; not required but beneficial for long-term skills.
Readings vs. lecture notes:
- Lecture notes are the primary resource;
- Textbook is a supplemental tool; red annotations are important for exam preparation.

What Finance Is and How It Differs from Accounting

Finance: the study of how individuals, businesses, and institutions acquire, spend, and manage financial resources (cash).
Key decision areas in finance:
- Financing decision: debt vs equity (issuing shares, borrowing from banks, issuing debt securities).
- Investment decision: which projects to fund; where to allocate cash.
- Risk management decision: how to manage cash and liquidity over time.
A unifying discipline: integrates accounting (backward-looking) with economics and econometrics to inform future, cash-flow-focused decisions.
Cash vs earnings: cash flows drive value; accounting focuses on profit (revenues minus expenses) and historical reporting.
Expected cash flows: used to forecast future cash inflows and outflows; the term “expected” reflects a probabilistic view of outcomes.
Profitability vs wealth creation: profitability (revenues − expenses) is not the sole driver of value; in finance, compensation for time, risk, and inflation is required to create wealth.
Example: if a project costs $1,000 today and returns $1,001 in one year, it is profitable, but in finance that extra $1 must compensate for the time value of money, risk, and inflation.

Listed Companies, Markets, and Agency Relationships

Listed company: a corporation whose shares are traded on a stock exchange; price movements are observable and informative for valuation.
IPO (Initial Public Offering): issuance of shares to the public; funds raised go to the company (primary market).
Primary vs secondary markets:
- Primary market: company receives cash from new shares sold (e.g., IPO, private placement).
- Secondary market: trading of existing shares between investors; no new cash flows to the company.
Example: Pinder Limited (fictional) issues shares via IPO; proceeds go to the company for growth; subsequent trading of shares (e.g., Reddit’s 2024 IPO example) occurs in the secondary market and does not provide new funds to the company.
IPO performance: first-day returns average roughly 17–20% in the US; many floats are overpriced or underpriced (IPO underpricing). You’ll learn more in Corporate Financial Decision Making.
Placements: private placements involve selling shares to a select group of institutions for rapid fundraising; can be at a discount to market price; useful for time-sensitive funding needs.
Share buybacks (on-market repurchases): primary market action where a company buys back its own shares; can signal undervaluation or return cash to shareholders; often uses cash surplus.
Liquidity: higher liquidity (more buyers and sellers) improves the attractiveness of an asset by making it easier to trade.
Key takeaway: observed share prices reflect changes in expected cash flows or changes in the market’s required return (risk, opportunity cost, inflation).
Private vs public markets: privately held firms can have shares, but trading is more difficult due to the lack of a public market; ownership can be transferred only by negotiation.

Cash, Time Value, and Present/Future Value Concepts

Cash is king: cash flows drive ability to meet obligations, invest, and pay dividends; profits without cash are not immediately useful.
Time value of money (TVM): money today is worth more than the same amount in the future due to opportunity cost, inflation, and risk.
Two ways to re-express cash flows across time:
- Present value (PV): bring future cash flows back to today.
- Future value (FV): bring today’s cash flows forward to a future date.
Example: if you sell a product on 30 days’ credit, you may earn profit now, but you must wait for cash receipts to fund operations; cash availability dictates ability to meet obligations.
Key mechanism: discounting future cash flows using a rate that reflects risk, opportunity cost, and inflation to compute PV; conversely, compounding converts PV to FV.
Formulae (basic):
- Simple interest: $FV = PV imes \bigl(1 + r imes n\bigr)$
- Simple interest (alternative view): $FV = PV + PV imes r imes n = PV imes (1 + r n)$
- Present value (with simple/linear interpretation): for a single cash flow, PV =
  notated as needed; the general PV for multiple cash flows is detailed below under annuities.
- Compound interest: $FV = PV imes (1 + r)^n$
Present value and future value examples from the lecture:
- Simple interest example: invest $1{,}000 at 8% for 5 years → $FV = 1000 imes (1 + 0.08 imes 5) = 1400$
- Compound interest example: invest $1{,}000 at 8% for 5 years → $FV = 1000 imes (1 + 0.08)^5 \,=\ 1469.33$
- If a $1{,}000 loan grows to $1{,}170 in 6 years at 5% simple interest, the present value today is $900 ( PV = 900 ) because 900 + 6 imes 45 = 1170.
Short-term debt conventions: debt securities with < 12 months maturity are often priced using simple interest (non-compounded) in market practice.
Practical takeaway: the math is straightforward algebra; most of finance practice uses these TVM concepts to compare projects and assets.

Risk, Return, and the Structure of Returns

Risk-averse investors demand compensation for taking on risk; higher risk requires a higher expected return.
Risk is often measured by variability around the expected return, commonly using the standard deviation of the return distribution.
Two assets with the same expected return can differ in risk (one with higher standard deviation has higher probability of extreme outcomes, both positive and negative).
No-arbitrage intuition: in the absence of risk, one would not expect a positive return; in reality, even risk-free assets (e.g., government bonds) provide a baseline return (risk-free rate).
Risk-free rate: proxied by government bonds (e.g., Australian government bonds in this lecture); government default is historically possible but highly unlikely for developed countries.
The basic risk-return framework: the expected return on an asset equals the risk-free rate plus a risk premium that compensates for the asset’s risk: $E[R] = R_f + ext{Risk Premium}$
Observed credit spreads reflect compensation for credit risk over time; higher-rated bonds have lower spreads, while lower-rated (BBB and below) have higher risk premiums.
The level of risk premium is dynamic over time and reflects market appetite for risk; risk aversion spikes widen spreads, indicating demand for safer assets.
Core result coming later in the course: Nobel Prize–level work on asset pricing models (topic 6), linking risk, return, and prices.

The Value of the Firm and Corporate Finance Foundations

Firm value concept: the value of a firm’s assets, V, equals the value of its debt plus the value of its equity: $V = D + E$
Equity is a residual claim: equity holders get paid after debt holders and other obligations are satisfied; this residual claim makes equity riskier and thus requires higher expected returns.
Agency problems: managers may pursue value-destroying activities if their incentives are not aligned with maximizing firm value; this is a central theme in corporate finance.
The objective of management: maximize the value of the firm’s assets (and therefore equity value).
Practical implication: cash management (payments, debt service, taxes, reinvestment) determines how much cash is left for dividends; this cash-first view anchors much of the finance toolkit.

Simple vs Compound Interest and the Time Value of Money – Details

Simple interest: interest is earned only on the principal; no interest-on-interest effects.
- Example: 1000 at 8% for 5 years → $FV = 1000 imes (1 + 0.08 imes 5) = 1400$
Compound interest: interest is earned on both principal and accumulated interest; growth is non-linear over time.
- Example: 1000 at 8% for 5 years → $FV = 1000 imes (1 + 0.08)^5 \,= 1469.33$
- The difference between simple and compound grows with higher amounts and longer horizons (e.g., after 100 years, simple vs compound diverges dramatically).
Practical note: for short-term debt (< 12 months), markets often quote simple interest; for most longer-term investments, compound interest and the formula FV = PV(1 + r)^n apply.
Effective vs stated rates:
- Stated rate (per period) may be the nominal rate; the effective rate accounts for the frequency of compounding.
- Example: same nominal rate 6% annually, but with daily compounding yields a higher effective annual rate than annual compounding.
- The general conversion: given a nominal rate R per period with m subperiods per year, the effective annual rate is
  $R_E = \bigl(1 + rac{R}{m}\bigr)^m - 1.$
- Example: 6% per year compounded daily (m = 365) gives a higher effective rate than 6% compounded annually.
Effective vs stated rate intuition:
- Bank 1: 6% per year, compounding annually → lower effective return.
- Bank 2: 6% per year, compounding monthly → higher effective return due to interest-on-interest.
- Bank 3: 6% per year, compounding daily → highest effective return among the three.
Continuous time and derivatives: continuous compounding is the limiting case as the period between compounding tends to zero; relevant in advanced pricing (e.g., derivatives).
Currency of quotes: effective rates arise when the basis of quotation (per period) matches the frequency of compounding; mismatches require conversion to an effective rate for fair comparison.
Takeaway about rates: even small differences in rate or compounding frequency produce large differences over longer horizons; choice of effective rate is crucial for fair comparison.

Present Value, Future Value, and Discounting – Practical Tools

Present value and future value concepts underpin valuation across all finance decisions.
For a single cash flow: discounting and compounding are reversible operations; you can move back and forth along the timeline using rate r and number of periods n.
Examples discussed:
- If you want $10,000 in five years, with a given rate, you can compute required today investment (PV) or the future value of current investments (FV) by applying the formulas above.
- Curvature of the FV vs time graph under compound interest demonstrates the power of compounding (nonlinear growth).
Present value example: if you need $10,000 in five years and expect 6% return, the amount you must invest today is $PV = rac{FV}{(1 + r)^n} = rac{10000}{(1.06)^5} ≈ 7472$ . If expected return is 8%, $PV ≈ rac{10000}{(1.08)^5} ≈ 6805$ .
Key intuition:
- Present value declines as the number of periods increases, all else equal.
- Present value increases if the rate r falls, or if time to receipt shortens.
Multiple cash flows:
- To value a project with several cash flows, discount each cash flow back to present value at rate r and sum: for cash flows at times t = 1, 2, 3, the PV is
 $PV = rac{CF1}{(1 + r)^1} + rac{CF2}{(1 + r)^2} + rac{CF_3}{(1 + r)^3}.$
If you want to move all cash flows to a common future date, compound each cash flow forward to that date and sum.

Mutually Exclusive vs Independent Projects – Decision Rule (Introductory Topic)

Mutually exclusive projects: accepting one project precludes the acceptance of another.
Independent projects: accepting one project does not affect the acceptance of others.
Ranking: for mutually exclusive projects, you must compare the value (e.g., NPV, which requires discounting cash flows to present value) or equivalent at a common time, given a required rate of return.
Example from lecture:
- Projects A and B: cash flows are $376{,}451 in year 3 and $393{,}007.68 in year 4, respectively; required rate of return = 8.5%
- Present value of A at t = 0: $PV_A = rac{376{,}451}{(1.085)^3} ≈ 294{,}726$
- Present value of B at t = 0: $PV_B = rac{393{,}007.68}{(1.085)^4} ≈ 284{,}132$
- With these PVs, Project A is preferred.
- Alternative approach: move cash flows to year 4 (forward) and compare at that common point; A's value at t = 4 is $FVA@4 = 376{,}451 imes (1 + 0.085) ≈ 408{,}553$ (approx.) which exceeds $FVB@4 ≈ 393{,}007.68$ , reinforcing A’s preference.
Takeaway: to compare projects with cash flows at different times, bring them to a common point in time (present or future) using the required rate of return and discount/compound accordingly.

Think-Aloud Paired Problem Solving (TAPS) – Classroom Technique

Structure of a TAPS round:
- Students pair up (1-2-3 grouping via a rotation per row); each round proceeds with silent individual work for two minutes.
- A talker is selected to explain their answer and rationale to the listener, who asks probing questions to reveal underlying logic.
- No requirement for consensus; aim is to uncover reasoning and the logical underpinnings of the answer.
Example problem used in session: three reasons to prefer $100 today over $100 in one year:
- 1) Opportunity cost: today’s $100 can be invested to earn a return over the year.
- 2) Inflation/purchasing power: $100 today can buy more than $100 a year from now if inflation exists.
- 3) Risk: $100 today is inherently less risky than $100 in a year’s time.
The exercise reinforces the time value of money and the intuition behind discounting and risk premia.
Ongoing: at least 10 additional TAPS opportunities over the 12-week term; a central feature of learning in this course.

Succeeding in the Subject – Practical Advice

A practical routine emphasized by the lecturer:
- After class, eat, then summarize notes.
- Attempt tutorial work for the next week; identify gaps in understanding.
- Revisit lecture notes and grind through the material.
- Attend consultation hours and participate in tutorials to ask questions.
There is no secret to passing; hard work, consistency, and active engagement in lectures and tutorials are essential.

Assessment, Participation, and Extra Resources

Exam Buddy (Assessment): 15% of final grade; peer-review system with four substantive tasks and one practice task.
- You must upload a PDF solution (not an image) to the Feedback Fruit portal.
- After submission, peers are anonymously assigned to review; your marks depend on whether your submission is a genuine and reasonable attempt, not on being correct.
- You do not need to get questions right; you must demonstrate a genuine attempt.
- Five tasks total: four substantive tasks plus one practice task.
- Your final mark for Exam Buddy is the average of your highest three marks among the four substantive tasks (and the highest of the three marks used for the final Exam Buddy score is used for weighting). The median score is 100% for those three tasks.
- Supportive evidence exists showing a positive relationship between engagement with Exam Buddy and final exam performance, beyond raw aptitude proxies (e.g., mid-semester test scores).
Mid-semester test:
- Covers the first four topics; scheduled for the week of Monday, September 1 (week 6).
- Attendance is tied to eligibility for the test; if you attend a different lecture than your enrollment status, ensure you take the test corresponding to your enrollment.
PASS program:
- Peer-led study groups; helps reinforce weekly material; participation is strongly encouraged.
- PASS leaders are University-paid; not a substitute for tutorials or lectures.
Extracurricular programs:
- Equity Analytics with Excel (John Gauntlett): practical Excel skills for finance; limited spots; enrollment via subject website.
- EZR (Alan Horseful): introduction to R programming for data analysis; initial exposure to handling large data sets; enrollment via subject website.
Readings and lecture notes:
- Textbook is a tool; lecture notes (including annotations) are the primary resource for exams and understanding; students should focus on lecture content first.

Summary of Key Takeaways (Core Concepts to Internalize)

Cash is king; money has a time value due to risk, opportunity cost, and inflation; accounting focuses on profits, while finance focuses on cash flows and expectations about future cash flows.
The value of a firm is determined by the present value of its expected cash flows to all claimants, summarized by V = D + E with equity being a residual, hence riskier and requiring higher returns.
Primary vs secondary markets define how cash flows reach the firm and how ownership changes hands; IPOs and placements affect the firm’s capital structure and liquidity, while secondary market trades affect liquidity and price discovery.
Present value and future value techniques are fundamental tools for evaluating investments and projects; discounting requires a rate that captures risk, opportunity cost, and inflation.
Simple vs compound interest demonstrates how compounding leads to greater wealth over time; in practice, compound interest is used for most longer-term finance calculations, while simple interest is a special-case convention for short-term debt.
The frequency of compounding matters; the effective annual rate adjusts the nominal rate to reflect compounding frequency, and continuous compounding represents the theoretical limit used in advanced pricing.
Decision rules for investment involve comparing PVs or FVs of alternative cash-flow streams; mutually exclusive projects require ranking based on these present-value or future-value distances at a given required rate of return.
The course will extend these foundations into annuities, perpetuities, and more advanced asset-pricing models in later topics.

Notable Examples and Data Points from the Lecture

IPO performance (US): average first-day returns around 17–20%; some floats are underpriced (aka IPO underpricing).
Reddit IPO (2024): closed first day around $50.44 from an IPO price of $34.
Example of a placement: a private placement with a 7% discount to a market price, executed quickly to raise cash; an example cited involved Goodman’s closing price of $35.98.
Observed credit spreads: long-run graph shows spreads between risk-free and BBB-/BBB rated bonds widening during risk-averse periods; the spread magnitude reflects risk appetite.
Risk-free proxy: Australian government bonds used as the risk-free rate in examples; government default risk is low but nonzero in principle.
Time-value decomposition: three components—risk, opportunity cost, and inflation—drive the discount rate r used in present-value calculations.

Preparation for Next Session

The next session will introduce valuing cash-flow packages (annuities and perpetuities) and lay the groundwork for subsequent asset pricing models.
Review the formulae for PV and FV, the distinction between simple and compound interest, and the effect of compounding frequency on effective rates.
Readings and lecture notes ahead of topic 2 to build a smoother transition into multi-period cash flows.
Consider participating in PASS and extracurriculars to strengthen practical financial skills (Excel, R) beyond core theory.