Introduction to Finance

1
Introduction

See the syllabus on virtual campus> netsyllabus for detail

This course introduces the theory and practices of the financial system and the
basic principles of finance.
It explains the decision-making process in finance by introducing the time
value of money and its applications, the main decision criteria return and
risk, and the objectives a decision maker has to consider in financial
management.
Next, the course explains the foundations of finance by explaining the role
of diversification in the risk-return relationship and the price of risk. A
basic introduction to options will conclude this course for a better
understanding of the concept of risk and introducing the bases of hedging
strategies.
The third part introduces the functions of the financial system, and its
segmentation/fragmentation with the roles of intermediaries and direct
finance. The student will learn the basic architecture and functioning of
contemporary financial markets. After which, the course focuses on
financing instruments (bonds and stocks), their characteristics and
valuation principles.

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Course content

PRELIMINARY READING(S) ADDITIONAL READING(S)

SESSION TOPIC
AND ASSIGNMENTS AND ASSIGNMENTS
Profit, return and the (Ref 2) Chapter 6
1 (Ref 1) Chapter 16,17
time value of money See Video 1
Risks and the Law of
2 (Ref 1) Chapter 18 (Ref 2) Chapter 7
one price
(Ref 1) Chapter 23
3 Equity financing Assignment 1 (individual): (Crossknowledge) (Ref 2) Chapter 15
Validation of online module: What is a share?
Managing risk:
4 diversification and the (Ref 1) Chapter s 18,19
price of risk

5 Case study GroupWork (5 students) in class

Financial management:
6 (Ref 1) Chapter 1 See Video 2
the big picture
(Ref 1) Chapter 21
7 Debt financing Assignment 2 (individual): (Crossknowledge) (Ref 2) Chapter 14
Validation of online module: What is a bond?

8 Financial environment (Ref 1) Chapter 15

Assignment 3 (individual): (Crossknowledge)

9 Synthesis - Case study
Validation of online module: What is an option?

10 Final examination

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Textbook

(Ref 1) Vernimmen Pierre. (2011) Corporate finance: theory and practice, 3rd
edition. John Wiley & Sons. (Cyberlibris; ISBN: 9781119975588).

This book is also available in french:

P. Vernimmen (2010) Finance d'entreprise, 8me dition par Pascal Quiry et
Yann Le Fur, Dalloz

A website is also available for a french/english glossary and definitions,

formulas
www.vernimmen.net (French version)
www.vernimmen.com (English version)

(Ref 2) Schim Jaek. (2007). Schaums outline of financial management, 3rd

edition. McGraw Hill. (Cyberlibris; ISBN: 9780071481281).

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 Evaluation

Assignments :
Validation of online modules.
Exams:
The final exam is an individual written exam.
A list of the main formulas is given but the student needs a calculator.

A calculator is required for most of sessions!

EVALUATION OF STUDENT PERFORMANCE

Assignment 1 Assignment 2 Assignment 3 Group work Final examination

5% 5% 5% 20% 65%
Session 5
Session 3 Session 7 Session 9 Session 10
Groups of 5 students
Validation of Validation of Validation of Stock and Portfolio No document allowed
online module online module online module Analysis Calculator allowed

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Access to online modules

As soon as possible, students have to connect to

Virtual Campus > Crossknowledge (via Moodle)

Enter your Login and Password in the Moodles page.

Then, click-on the Cross plateform and check if you are registered as a student
for this course (contact the HUB if theres any problem).

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Evaluation criteria

Relevant data and calculations: 40%

Understanding of key concepts and evidence of relevant analysis: 60%

Below requirements Meets requirements Exceeds

requirements
Understands the data
Does not understand and Understands the
Relevant data and the data and the formula to use formula and the
calculations formula to use but fails to find the data to use and finds
right solution the right solution

Does not understand

Understands and Understands and
Understanding of key concepts nor the masters of the key masters all the key
key concepts and interaction between
evidence of relevant the concepts or does concepts and of the concepts and all the
analysis interaction between interactions
not understand the
them between them
question

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 Introduction to Finance

Profit, Return, and the time value of money

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Outline (NO COMPUTER, IPAD, SMARTPHONE, etc.)

Profit, Return, and the time value of money:

1-The return
2-The capitalization process
3-The discounted process
4-The present value
5-The net present value

Vernimmen Pierre. (2011) Corporate finance: theory and practice, 3rd edition.
John Wiley & Sons. (Cyberlibris; ISBN: 9781119975588): chap. 16,17

Schim Jaek. (2007). Schaums outline of financial management, 3rd edition.

McGraw Hill. (Cyberlibris; ISBN: 9780071481281): chap. 6

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1-The return: Income statement

Profit (or loss): a residual To renew Creditors (bank,

Government
fixed assets bondholders, etc.)
income for the firms owners
since the revenue (sales) is Depreciation Interest Taxes
shared among the firms
Costs Sales
stakeholders Providers
Employees Firm Customers

Income Statement Net Income

Sales 2000
Owners of the firm
(stockholders)
- Costs 1400
= EBITDA 600 EBITDA: Earning Before Interest,
Tax, Depreciation, Amortization
- Depreciation 100
= EBIT 500 Economic Income EBIT: Earning Before Interest
- Interest 100 and Tax

= Taxable Income 400

- Taxes 200
= Net Income 200

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1-The return: Earning

Which firm is the most attractive for investors (stockholders)?

In which firm would you like to invest?

Firm A B C D
Net Income 20 20 200 200

Earnings are not the right criterion to compare firms.

It depends on how much you have to invest to earn this profit!

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 1-The return: Balance sheet

The amount invested by stockholders is available on the balance sheet.

How the firm is financed is presented on the right-hand side of the balance
sheet.
Balance sheet (French version)
ASSETS RESOURCES (LIABILITIES)
Owners
Net fixed assets Equity (stockholders)
Intangible fixed assets
Long term Creditors
Tangible fixed assets Long term (financial) debt (banks, bondholders)
Current assets
Inventory
Accounts receivable Current liabilities
Providers, employees,
Marketable securities Accounts payable (non financial debt) Government, etc.
Short term creditors
Cash Payable notes (short term financial debt) (banks, money market investors)

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1-The return: Return On Equity (ROE)

The return represents in percentage the earning in comparison with the amount
invested.
Return for firms owners (stockholders):
Net Incomeend of year
ROE =
Equity beginning of year

Now, which firm is really the most attractive for investors?

In which firm would you like to invest?
Is your decision the same as the one based on profit only?

Firm A B C D
Net Income 20 20 200 200
Equity 100 1,000 1,000 10,000
Return On Equity (ROE) 20% 2% 20% 2%

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1-The return: Time value of money

Why do you want to earn money on your investment?

There is a natural preference for the present time.
It leads money to have a time value.

What do you prefer?

a) 100 today or 100 in one year?
b) 100 today or 90 in one year?
c) 100 today or 105 in one year?
d) 100 today or 110 in one year?
e) 100 today or 120 in one year?

Other choice? In other words, what is the return you expect?

Investing now means accepting to change your cash available now into a
future cash flow?
Is this expected return the same for everyone? Everytime?

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2-The capitalization process: Future value of investment

We assume that you expect to earn a 10% return on your 1-year investment:
To hold 100 now is equivalent to hold 10% more in one year.

The value of your investment in the future or the future/final/capitalized value

of investment (or wealth) is :
100 (1 + 10 %) = 110
C 0 (1 + r ) = C 1
C0 : the amount initially invested (today, at time 0)
r : the return on your investment over 1 year
C1 : the future value of your investment (your final wealth in 1 year)

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2-The capitalization process: Generalized formula

Generalized 1-period formula: future value 1 period after:

Ct (1 + r ) = Ct +1

Ct : initial amount of money invested (at time t)

r : the return over a 1-year period (between t and t+1), the capitalization
rate, the rate of return
Ct+1 : the future value (final wealth) 1 year after your investment (at t+1)

What will be the future value of your investment after 3 years with an annual
rate of return r (%) ? C = C (1 + r )
3 2

= [C1 (1 + r )] (1 + r )
= [[C0 (1 + r )] (1 + r )] (1 + r )
= C0 (1 + r ) 3

Generalized t-period formula: future value:

Ct = C0 (1 + r )t

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2-The capitalization process:

Problem 1.1: If you deposit $200 in one year. $300 in two years, and $400 in
three years, how much will you have in three years? How much of this is
interest? Assume a 6 percent interest rate throughout.
How much will you have in five years if you don't add additional amounts?

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2-The capitalization process: Future values

Example 1.1: How to make a decision by comparing future (final/capitalized)

values?
What would be your choice between a, b and c if you have the opportunity
to invest at a 15% rate of return per year?

a) To hold 90 now

b) To hold 113 in 2 years

c) To hold 127 in 3 years

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3-The discounted process: The present value of investment

Discounting is the reversal of capitalization:

The process of capitalization refers to the determination of the future value
of your investment (Ct), when you know the initial amount of your
investment (C0) and the periodical rate of return (r).
The discounting process is the determination of the present value of your
investment (C0) when you know the future value of your investment (Ct)
and the periodical rate of return (r).

The question is how much to invest now, in order to hold a final wealth Ct in t
periods if you expect a return r (%) for each period?
You would like to hold 110 in 1 year, expecting to earn a 10% return on
your initial investment, how much to invest now (C0)?

C 0 (1 + r ) = C 1
C 0 (1 + 10 %) = 110
110
C0 =
(1 + 10 %)
C0 = 100
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3-The discounted process: Generalized formula

Generalized 1-period formula: discounted value or present value

Ct +1
Ct =
(1 + r )
What is the initial investment with an annual rate of return r (%) over 3 years?
C2
C0 = 1 = 1 + r
C
1+ r 1+ r
C3
= 1+ r 2
C2
=
(1 + r ) 2
(1 + r )
C3
=
(1 + r )3
Generalized t-periods formula: discounted value or present value
Ct
C0 =
(1 + r )t
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3-The discounted process: Present values

Example 1.2: How to make a decision by comparing present values?

What would be your choice between a, b and c if you have the opportunity
to invest at a 15% rate of return per year?

a) To hold 90 now

b) To hold 113 in 2 years

c) To hold 127 in 3 years

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4-The present value: Cash-flows

Example 1.3: These are the expected cash-flows for two investment projects.
year 1 2 3 4
Project A 10 10 10 110
Project B 10 15 18 120
How much to invest now if you expect to earn a 10% return each year (in
average)?
In order to solve this problem, just consider each project as a set of several
investments. For example, for project A, you would like to estimate how much
to invest now to earn:
10 in 1 year, so

10 in 2 years, so

10 in 3 years, so

110 in 4 years, so

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4-The present value: Generalized formula

Generalized formula: present or discounted value of t future cash-flows

CF1 CF2 CF3 CFt
C0 = + + + ...
(1 + r )1 (1 + r ) 2 (1 + r )3 (1 + r ) t

How much to invest in project A and B if you expect to earn a 10% annual
return?
year 1 2 3 4
Project A 10 10 10 110
Project B 10 15 18 120
For project A, the calculation was:
10 10 10 110
C0 = + + + = 100
(1 + 10%) (1 + 10%) (1 + 10%) (1 + 10%)
1 2 3 4

For project B, the calculation is:

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4-The present value: Constant growth rate

The present value of all future cash-flows when cash-flows grow at a constant
rate (g) for T periods is :
T 1
CF1 (1 + g )1 CF1 (1 + g )T 1 CFT CF1 1 + g 1 1+ g
C0 = + + ... + = 1 + + ... +
(1 + r )1
(1 + r ) 2
(1 + r ) T
(1 + r ) 1 + r
1
1 + r
144444244444 3
sum of the first T terms of a geometric series

1 + g T 1 + g T
1 1 1 + g T
C0 =
CF1
1 + r = CF
1 + r = CF1 1 + r
1
1
(1 + r )1 1 1 + g 1 + r 1 + r 1 g 1 + r 1 + r 1 g 1 + r
1 + r 1+ r

This formula gives the amount based on constant growth:

CF1 1 + g
t

C0 = 1
r g 1 + r

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4-The present value: Growth rates and periods

The present value of all future cash-flows :

When cash-flows grow at a constant rate (g) for T periods is:
CF1 1 + g T
C0 = 1
rg 1 + r
When cash-flows are constant (g=0 so CF1==CF15=) for T periods is:

CF1 1
T

C0 = 1
r 1 + r
When cash-flows grow at a constant rate (g) forever is:
CF1
C0 =
rg
When cash-flows are constant indefinitely (g=0 so CF1==CF15=) is:
CF1
C0 =
r
In other cases is:
CF1 CF2 CF3 CFt
C0 = + + + ...
(1 + r )1 (1 + r ) 2 (1 + r ) 3 (1 + r ) t
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5-The net present value: Value created or destroyed

How to measure the value created (destroyed) by your investment projects?

Someone offers you to invest 105 in project A and 105 in project B: what
to do? (Remember that you expect a 10% rate of return)

1 euro today is not equivalent to 1 euro in the future!

You must compare the present value (or future value) of each alternative.

Project A:
Would you accept to invest 105 now while the future cash-flows for this
project are equivalent to 100 (present value)?
The result is: - 105 + 100 = -5
Value is destroyed for project A, what is your decision for A?

Project B:
Would you accept to invest 105 now while the future cash-flows for this
project are equivalent to 116.97 (present value)?
The result is: - 105 + 116.97 = +11.97
Value is created for project B , what is your decision for B?
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5-The net present value:

Problem 1.2: You are offered an investment that will pay you $300 in one year,
$500 the next year, $700 the next year, and $900 at the end of the next year.
You can earn 11 percent on very similar investments. What is the most you
should pay for this one?
What will you do if they ask you for $1 820? Explain.
If you can always earn 11 percent, what is the future value of the cash flows in
year 4?

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5-The net present value: Generalized formula

Generalized formula: Net Present Value (NPV)

CF1 CF2 CF3 CFt
NPV = CF0 + + + + ...
(1 + r )1 (1 + r ) 2 (1 + r ) 3 (1 + r )t
With CF0, the amount of money you have the opportunity to invest in
order to earn a stream of cash-flows in the future (CF1, , CFt)

Decision rule:
NPV 0 => you accept to invest in order to create value by investing (you
pay less than the present value of your future cash-flows)
NPV < 0 => you don't want to invest in order to avoid to destroy value
(you pay more than the present value of your future cash-flows)

And if NPV = 0? What to think and what to do?

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5-The net present value: The present value of an investment

The maximum amount to invest in order to earn the expected return.

A FAIR price:
the maximum price to pay to buy the right to earn the future cash-flows
the minimum price at which a seller would like to sell the right to earn
those future cash-flows

A market value (a fair estimate of market price).

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5-The net present value: Internal Rate of Return (IRR)

The IRR is the return offered by the project when you invest CF0 in order to
earn CF1, , CFt in the future.
In other words, the IRR is the value of r when NPV = 0:

CF1 CF2 CF3 CFt

CF0 + + + + ... =0
(1 + IRR)1 (1 + IRR) 2 (1 + IRR)3 (1 + IRR) t

Why do you lose money by investing 105 in project A while you earn money on
project B?

The (Internal) Rate of return on A is less than the 10% return expected.
IRR project A = 8.47%

The (Internal) Rate of return on B is more than the 10% return expected.
IRR project B = 13.52%

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5-The net present value:

Problem 1.3: Shortly after graduation, you receive an inheritance that you use
to purchase a small bed-and-breakfast inn as an investment. Your plan is to sell
the inn after five years. You estimate that expenses will total $5,000 during year
1, $7,000 during year 2, $6,000 during year 3, $3,000 during year 4, and
$2,000 during year 5, the final year of your ownership.
Because you have some of your inheritance left over after purchasing the inn,
you want to set aside a sum today from which you can make annual
withdrawals to meet these expenses when they come due. Suppose you invest
the sum in a bank account that pays 8 percent interest.
What is the amount of money you need to put in the account to meet these
expenses?

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6-Conclusion: Key Terms

Profit or loss statement Balance Sheet (Create) Return on Equity (ROE) (Equation)
Income Statement (Create) Net Fixed Assets Capitalization process
Sales Intangible fixed assets Future (final or capitalized) value of
Costs Tangible fixed assets an investment (wealth) (Equation)
EBITDA Current assets Discounting process
Depreciation Inventory Present value of an investment
EBIT Accounts receivable (Formula)
Interest Marketable securities Net present value (Formula)
Taxable income Cash Fair price
Taxes Equity (E) Market value
Net Income Long term debt (D) Internal Rate of Return (IRR)
Creditors Current liabilities (Formula)
Bondholders Accounts payable
Stockholders Payable notes
Providers

Create: It is necessary to be able to create it.

Formula: It will be included in the formula sheet given at the exam.
Equation: It is necessary to know it since it will not be included in the formula
sheet given at the exam.
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