Financial Management - 1

Sat, May 16, 2020 7-minute read

Overview of Financial Management

Philosophy: it is more import to know the basics well and be able to apply them to new situations than it is to know everything there is to know.

Learning Jargons:

We will learn more about financial mode of thinking

Think in Examples

What is finance?

Finance deals with the allocation problem resources to create value.
allocation problem = investments = acquisiton of assets
Assets = a stream of Cash flows = Projects

Real vs Fianancial assets real assets have its own productive capacity Financial assets have claims over real assets

Corporate Finance and Investments

Investment decisions require valuation.

The flip side of investing is financing

Valuation

What is value

We use a narrow and specific definition of value. The magnitude of present and future net monetary benefits as a consequence of the allocation decisions

$!(intrinsic)Value = \frac{E(CF_1}{1 + E(r)} + \frac{E(CF_2)}{(1 + E(r))^2} + …$!

Finance cannot estimate philosophical or moral value.

Valuation is forward looking.

value depends on net cash flow

Why do we need valuation?

Capital budgeting

Should you take a particular project?
What is this project worth?

Investments

Where should you put your dollors?
How should an investor choose an investment portofolio?

Financing (Capital Structure)

to undertaking project, should you borrow money sell a share to partners or finance it yourself?
Should firms finance projects ordisperse funds?

These problems are interconnected and related. Thus we need valuation for solutions.

Background Displines

To answer these questions, Finance is a hybrid of Economics, statistics, accounting.

Law of One price Many financial valuation is realtive to alternatives The "Law of One Price" Same thing should cost the same A natural extension: Similar things should cost similarly

Project

A project is anything that generates a series of cash flows. A repair shop, an investor purchases a certificate of deposit from a bank for 10,000. The bacnk will repay 12000 in two years

Projects can range from true physical investments to pure monetary investments. to pure gambles.

whatever the source of the flows, finance concerns with cash flow in and of themselves.

Bonds and Stocks

Two particularly common projects: Stocks and Bonds. From the perspective of finance and valuation, these two kinds of claims are primarily sets of cash flow streams that is paid to the holders of these claims.

Bonds usually promise given fixed payments at given fixed points in time.

Stocks get what is left over after the bonds have been paid off. Stock is sometimes called equity or levered equity.

Debt and equity are often called financial securities

Bonds A bond is a contractual obligation by a borrower to pay certian anmotns of cash in the future to a lender. Fixed payments in the future. Special kind of loan

A Firm

A Firm is a clooection of projects, fianced by claims, that generate cash inflows and outflows.

Revenues in excess of expenses go either into new investments or back to the firm’s claimants.

Claimants can be debt and equity holders. Other claimants can be suppliers who sold product on credit, or governments who demand taxes.

Corporate Accounting Identities By definition, the sum of the value of all claims is the value of the firm.

$!Firm = Debt + Other liabilites + Equity = All Future Payouts$!

If you own all claims, you own the firm!

Firm value = value of all claims.

IF YOU OWN THE PROJECT, you own all net earnings of the project.

Moving flows across time.

The time distribution of future inflows or outflows can be shifted neutrally in a perfect market, properly accounted for.

Whether the cash flows (or earnings) grow or shrink, or whether dividends are zero today or zero next year... etc.. are all irrelevent. You can easily reduce cash flows today in order to jack them up tommorow (i.e. reinvesting them at rate r). You can easily increase dividends today at the expense of dividends tomorrow.

Time Value of Money

Can you add rates of return and interest rates? When we have two rates of return, do we simply add?

If the bank posts an 8% interest rate and you invest 100, how much money will you have at the end of the year?

The answer might not be 108!

Perfect Market

For the next few chapters, we pretend we live in a perfect market

No difference in opinion
- Uncertainty is Ok, but everyone thinks the same thing
No texes -> no governement interference
NO transaction costs
NO big sellers/ buyers

Why do we have this assumption?

Wrong logic in the simplest world, that must be wrong in the real world too!

In this chapter, we go further and also assume that there is no UNCERTAINTY, and assume equal rate of return.

C, CF = cash amount

$$C_t$$ = instant cash amount at time t

$$r_1, r_t, …$$ := rate of return

If the investment is a loan, the rate of return is usually called an interest rate.

If you invest $$CF_0$$ today, and in the future you recieve $$CF_1$$,

Net return : $$CF_1 - CF_0$$

rate of return : $$\frac{CF_1 - CF_0}{CF_0}$$

When we say "return", we usually mean "rate of return"

rate of return = $$r = \frac{CF_1 - CF_0}{CF_0} = \frac{CF_1}{CF_0} - 1$$

When there are dividends (or coupon or rent) paid at the end of the period, we have: $!r = \frac{CF_1 + D_1 - CF_0}{CF_0}$!

The dividend yield is $$D_1 / CF_0$$

If the rate of return is positive, can the percent price change be negative?

Q1: If you invest in the project that cost $$100$$, and the price chagned to $$95$$, but there are $$10$$ dividends, that makes rate of return positive,

$$r = \frac{95 + 10 - 100}{100} = 0.05$$, but perecent price change ( = Capital Gain) is negative, because:

$$ppc = \frac{95 - 100}{100} = -0.05$$

Q2: If you invest $ 5 and will receive $ 8 in 10 years, what is yout holding rate of return?

$!\frac{8 - 5}{5}$!

Q3: Can a rate of return be negative?

Obviously, yes.

Q4: Can an interest rate be negative?

YES! When bank has surplus, the put their cash in Central bank, but if the centeral bank wants more cash in the economy, then they will charge negative interest rate!

Q5: What is the interest rate today?

–> the question is vague. Who is the burrower, what is the length of maturity? what is the credit worthiness of the burrower? etc etc...

Q6: Compare 10%, 5%, Can we say 10% is 100% more than 5%? or 10% is 5% more than 5%?

a point : 1%.

5% is 5% point more than 5%.

a bases point : 1%/100 –> 10% is 500 bps more than 5%.

Q7: If you ivest $ 55,000 at an interest rate of 350 basis point above the 5% interst rate, what will you receive at the end of the period?

5% + 3.5 % = 8.5 %

55,000 ( 1 + 8.5 %) = 59,675 Future value

Q8: If you have $ 5m and you earn a rate of return of 250%, how much will you have?

$ 5 ( 1 + 2.5) = $ 17.50

Q9: What is the formula for the FV (Future value) of money? How does it relate to the rate of return formula?

$!C_1 = C_0 ( 1 + r)$! $!FV = PV ( 1 + r)$!

$!\frac{FV}{PV} - 1 = r$!

If you have $ and you earn a rate of return of 20% in the first year and a rate of return of 20% the following year, how much money will you have?

$! \$ 5\xrightarrow{} \$ 5 ( 1 + 0.2 ) \xrightarrow{} \$ 5 ( 1 + 0.2)^2 $!

This is called "Compound interest rate"

Q10: If your first year rate of return in 20%, and next year is 50%, is your rate of return 70%?

–> no! it is (1 + 0.2)(1 + 0.5) - 1 = 0.8 !

Q11: What is the compounding formula to get $$r_{0,x}$$?

$!1 + r_{0,x} = (1 + r_1)(1 + r_2) \dots (1 + r_x)$!

For small $$x$$, we have the following approximation:

$!(1 + x)^n ~ 1 + nx$!

Q12: If the annual interest rate is 14%, what is the daily rate?

$! (1 + r)^{365} = 1.14$! $!r = 0.14/365 = 0.0359%$!

Q13: Is compounding more like "adding" or "averaging"? its more like adding.

Warning : Convention and Jargon

Sometimes, it is obvious that people mean, sometimes interest rates are intentionally obscure in order to deceive you.

Q14: A bank quotes you 8% interest per year, what will you end up with 100$ investment?

The question is vague. we need compunding frequency information:

if daily : $$(1 + 8/365)^{365} = 1 + 0.0833 \neq 0.08$$...