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401

15 401 Finance Theory I 15 401 Finance Theory I 15.401 Finance Theory I 15.401 Finance Theory I

Lecture Notes Lecture Notes

Haoxiang Zhu

zhuh@mit edu zhuh@mit.edu

MIT Sloan School of Management

Lecture Notes

15.401 Lecture 1: Introduction

Welcome! This is 15 401/411 Finance Theory 1 sections A/B for

Todays Class Todays Class

Welcome! This is 15.401/411 Finance Theory 1, sections A/B, for

undergraduate students and non-Sloan graduate students, as well

as Harvard/Wellesley students under cross-registration.

Practical information about the class

R l f t Rules of engagement

How to get the most out of this course

Course overview

Introduction

What is finance?

Opportunity cost of capital

Role of financial markets

Lecture Notes

No arbitrage

2

15.401 Lecture 1: Introduction

Section A: M and W 1:00pm 2:30pm E25 111

General General information information

Section A: M and W, 1:00pm-2:30pm, E25-111

Section B: M and W, 10:00am-1:30am, E51-335

Review Sections on Fridays E25 111 Review Sections on Fridays, E25-111

Section A: 10-11am; Section B: 9-10am. Ask TAs about switching.

Cl W b i Class Website:

https://stellar.mit.edu/S/course/15/sp13/15.401AB/index.html

Sl l li Sloan class policy

Arrive on time

Do not use cell phones tablet computers and laptops Do not use cell phones, tablet computers, and laptops.

Lecture Notes 3

15.401 Lecture 1: Introduction

My office hours:

Office Office Hours Hours and and TAs TAs

My office hours:

Mondays, 3:00pm-4:30 pm, E62-623

F l f t il t h h@ it d Feel free to email me at zhuh@mit.edu

Stellars Forum Stellar s Forum

Teaching assistants: Teaching assistants:

Kris Inapurapu, krisi@mit.edu

Brian Cloutier bdclout@mit edu Brian Cloutier, bdclout@mit.edu

See class website for contact info & office hours

Also answer questions on Stellars Forum

Lecture Notes

q

4

15.401 Lecture 1: Introduction

Four Parts

Course overview Course overview

Four Parts

A. Introduction

Lecture 1: Introduction to finance (framework of financial analysis)

Lecture 2: Present value (principles of asset valuation)

B. Valuation

L t 3 Fi d i iti Lecture 3: Fixed income securities

Lecture 4: Common stocks

Lecture 5: Forwards and futures

Lecture 6: Options

C. Risk

Lecture 7: Risk and return (measuring risk)

Lecture 8: Portfolio theory (managing risk)

Lecture 9: The Capital Asset Pricing Model (incorporating risk into

Lecture Notes

p g ( p g

valuation methods)

5

15.401 Lecture 1: Introduction

D Corporate Finance Applications

Course overview Course overview

D. Corporate Finance Applications

Lecture 10: Capital Budgeting (capital investment decisions)

Lecture 11: Real Options

Final Lecture: Market Efficiency (putting it all together)

Do financial markets always work well in discovering prices? Do financial markets always work well in discovering prices?

Where does money come from in financial markets?

How should finance theory be used in practice?

Lecture Notes 6

15.401 Lecture 1: Introduction

Course requirements

Course requirements Course requirements

Course requirements

Attendance and participation (5%)

7 problem sets and 2 case write ups (25%) 7 problem sets and 2 case write-ups (25%)

Midterm exam (25%) Midterm exam (25%)

Similar to problem sets in level and scope

Final exam (45%)

Similar to problem sets in level and scope

Lecture Notes 7

15.401 Lecture 1: Introduction

Learning objectives Learning objectives

What you will be able to do after taking the class:

Formulate a real-world problem as a finance problem p p

Solve the problem using the skills you learn in class

Present and defend your reasoning Present and defend your reasoning

Presenting your logic verbally or in writing shows you

have truly mastered the materialand it helps you get y p y g

partial credit in assignments/exams.

Lecture Notes 8

15.401 Lecture 1: Introduction

How to get the most out of 401 How to get the most out of 401

Some concrete suggestions Some concrete suggestions

Skim textbook chapters in advance

T k i t d i l t (l t t Take copious notes during lectures (lecture notes are

not complete)

R i h l f d i h d Review the lectures afterwards with your study group

Work on problem sets Learning by doing

Read finance/business newspapers (FT, WSJ, etc.)

Talk about what you learned with friends and family--in

a clear and cool manner.

Ask questions!!!

Lecture Notes 9

15.401

Part A Introduction

Ch t 1 I t d ti t Fi Chapter1:IntroductiontoFinance

Chapter 2:PresentValue

Lecture Notes

15.401

15 401 Finance Theory I 15 401 Finance Theory I 15.401 Finance Theory I 15.401 Finance Theory I

Haoxiang Zhu

MIT Sloan School of Management

Lecture 1: Introduction

Lecture Notes

15.401 Lecture 1: Introduction

Opportunity cost of capital

Key Concepts Key Concepts

Opportunity cost of capital

Role of financial markets

No arbitrage g

Readings:

Brealey, Myers and Allen, Chapter 1

Lecture Notes

12

15.401 Lecture 1: Introduction

Motivation Motivation

Statistics Market Return T-Bill Return

Mean (Arithmetic) 0.91% 0.33%

January 1926 to December 2009 (Monthly)

Mean (Arithmetic) 0.91% 0.33%

Volatility 5.45% 0.29%

Minimum -29.01% -0.93%

Maximum 38 37% 2 13% Maximum 38.37% 2.13%

Total Return* $2,097 $27

Note: *Based on a $1.00 initial investment in January 1926. Market return from CRSP, value-weighted returns, including dividends,

NYSE/AMEX/NASDAQ.

Lecture Notes 13

15.401 Lecture 1: Introduction

Motivation Motivation

Statistics Market Return T-Bill Return

Mean (Arithmetic) 0.91% 0.33%

January 1926 to December 2009 (Monthly)

Mean (Arithmetic) 0.91% 0.33%

Volatility 5.45% 0.29%

Minimum -29.01% -0.93%

Maximum 38 37% 2 13% Maximum 38.37% 2.13%

Total Return* $2,097 $27

Note: *Based on a $1.00 initial investment in January 1926. Market return from CRSP, value-weighted returns, including dividends,

NYSE/AMEX/NASDAQ.

Rebalancing Base Total Return

Annual $253,062

Perfect Asset Allocation

Quarterly $78,989,897

Monthly $71,835,987,263

Note: If stock returns are negative invest in T-Bill

Lecture Notes

Note: If stock returns are negative, invest in T-Bill.

14

15.401 Lecture 1: Introduction

Motivation Motivation

Hibernia Networks Project Express connects NY and London by cable beneath Atlantic HiberniaNetworks ProjectExpress connectsNYandLondonbycablebeneathAtlantic.

Itcosts$300mandcutroundtripdatatraveltimefrom64.8msto59.6ms,saving5.2ms.

Lecture Notes

Source: BloombergBusinessweek,March2012

15.401 Lecture 1: Introduction

Finance is about the bottom line of business activities

What is finance ? What is finance ?

Finance is about the bottom line of business activities

A business activity is a process of acquiring and disposing assets

Real/financial

Tangible/intangible

Financially, a business decision starts with the valuation of assets

Y t t d h t t You cant create and manage what you cant measure

Valuation is the central issue of finance

Value is an objective measure --- determined by financial markets Value is an objective measure determined by financial markets

Lecture Notes 16

15.401 Lecture 1: Introduction

Questions we would like to answer in this course:

What is finance ? What is finance ?

Questions we would like to answer in this course:

1. How to value assets?

2 How do corporations make financial decisions? 2. How do corporations make financial decisions?

Investments: What projects to invest in?

Financing: How to finance a project?

Sellingfinancialassets/securities/claims(debt,stocks,)

Payout: What to pay back to shareholders?

Paying dividends, buyback shares, Payingdividends,buybackshares,

Risk management: What risk to take or to avoid and how?

3. How do households make financial decisions?

Lecture Notes 17

15.401 Lecture 1: Introduction

Financial markets at the center of universe

Financial markets Financial markets

Financial markets at the center of universe

Households

Financial

Markets

&

I t di i

Product

Markets

Labor

Markets

Intermediaries

NonfinancialFirms

Lecture Notes 18

15.401

Lecture 1: Introduction

Financial markets - where financial assets are traded

Financial markets Financial markets

Financial markets - where financial assets are traded

Equity markets

Commonstocks,preferredstocks,etc.

Debt markets

Governmentbonds,corporatebonds,municipalbonds

Mortgagebackedsecurities,assetbackedsecurities

Derivatives markets: Payoffs derived from other securities or derivatives

Forwards,futures,options,swaps,etc.

Financial firms - Own mostly financial assets Financial firms Own mostly financial assets

Banks,brokerdealers

Mutualfunds,pensionfunds,insurancecompanies,hedgefunds,sovereignwealth

Nonfinancial firms Own mostly real assets Nonfinancial firms - Own mostly real assets

Households - Own both real and financial assets

Lecture Notes 19

15.401 Lecture 1: Introduction

Financial decisions

A framework of financial analysis A framework of financial analysis

Financial decisions

(2)

(1)

Corporate

Operations

Financial

Manager

Individual

and

Institutional

Investors

(4)

Investors

(5) (3)

(1) Cash raised from investors by selling financial assets

(2) Cash invested in real assets (tangible and intangible)

(3) Cash generated by operations

(4) Cash reinvested

(5) Cash returned to investors (debt payments dividends etc )

Lecture Notes

(5) Cash returned to investors (debt payments, dividends, etc.)

20

15.401 Lecture 1: Introduction Task of financial Task of financial m manager anager

Corporate

Financial

Individual

and

(2)

(1)

(4)

Corporate

Operations

Financial

Manager

and

Institutional

Investors

(4)

(5) (3)

Management decisions --- manage cash flow (1), (2), (3), (4), (5)

Investment: (2) & (3) (valuing real assets)

Financing and payout: (1), (4), (5) (valuing financial assets)

Objective: Create maximum value for shareholders

Sound business decisions rely on how to value of assets.

Lecture Notes 21

15.401

Lecture 1: Introduction

Valuation of a project

Opportunity cost of capital Opportunity cost of capital

Valuation of a project

A firm can always give cash back to shareholders

A shareholder can invest in financial markets

Project

CASH Shareholders

Investment

Opportunities

availablein

Financial

Markets

Invest Dividend Invest

Opportunity cost of capital is the expected rate of return offered by

equivalent (in time and risk) investments in financial markets

Market valuation of the project (i.e., its cash flows):

Good if it offers a return higher than its cost of capital

B d if it i ld t l th it t f it l

Lecture Notes

Bad if it yields a return lower than its cost of capital

22

15.401 Lecture 1: Introduction

Valuation of assets Valuation of assets

Time 0 1 2 .

Cash Out CF

0

CashIn CF

1

CF

2

.

1 2

NetCashFlows CF

0

CF

1

CF

2

.

Value of an asset = Value of its cash flow

Lecture Notes 23

15.401

Two important characteristics of a cash flow:

Lecture 1: Introduction

Time and risk Time and risk

Two important characteristics of a cash flow:

1. Time

$1,000 $1,000

Which one do you prefer? --- Time value of money

today nextyear today nextyear

2. Risk

$1,000 $2,000 $1,000

$1,000

$2,000

$0

Which one do you prefer? --- Risk premium

Time and risk are two key elements in finance

Lecture Notes 24

y

15.401

Lecture 1: Introduction

PPrinciples of finance rinciples of finance

1. Investorsprefermoretoless

FinanceisBasedonSimpleAxioms:

p

A:$100now,or

B:$200now

2 Investors are risk averse 2. Investorsareriskaverse

A:$100now,or

B:$200nowwith50%chance,nothingotherwise

3. Moneypaidinthefutureisworthlessthanthesameamounttoday

A:$100now,or

B:$100inayear

4. Financialmarketsarecompetitive;noarbitrage

Anarbitrageisatradingstrategythathasapositiveprofitatnorisk.

Lecture Notes 25

15.401

Lecture 1: Introduction

No Arbitrage No Arbitrage

R t P l & C 10% if i 20% if

DIY:Exampleofanarbitrageopportunity:

ReturnParasol&Co:10%ifrain,+20%ifsun

ReturnUmbrella&Co:+20%ifrain,10%ifsun

Youcanlendandborrowat4%interestrate

Howcanyoumakeasure profitwithzeroinitialcash

outlay?

Lecture Notes 26

15.401

Lecture 1: Introduction

3 Nobel 3 Nobel--Prize Prize--Winning Insights Winning Insights

Harry Markowitz (1990): Optimal portfolio selection Dont put all your eggs in HarryMarkowitz(1990):Optimalportfolioselection. Don tputallyoureggsin

onebasket.

WilliamSharpe(1990):CapitalAssetPricingModel.Inequilibrium,riskierassets

havehigherreturns

RobertBobMerton,MyronScholes (1997):Noarbitrageandpricingof

derivatives (options)

Lecture Notes 27

derivatives(options)

15.401 Lecture 1: Introduction

Summary Summary

Evaluating a business boils down to valuation of assets

An asset is defined by its cash flow (CF)

Two important characteristics of a CF: time and risk Two important characteristics of a CF: time and risk

Value of assets (CFs) are determined by financial markets

Opportunity cost of capital Opportunity cost of capital

Financial markets

No arbitrage

Lecture Notes 28

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