Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

ECO562-Financial Economics
Semester: Summer 2021

Dr. Zulfiqar Hyder

Institute of Business Administration, Karachi

June 10, 2021

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Introduction:What is Financial Economics?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Introduction:What is Financial Economics?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Introduction:What is Financial?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Introduction:How does it work?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Real assets vs Financial assets

Real assets: Assets used to produce goods and services.

Financial assets: Financial claims to the income generated by

the firms real assets.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Corporate Investment and Financing Decisions

Investment decision : Purchase of real assets

Financing decision: Sale of financial assets

Capital structure: Choice between debt and equity financing

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Corporate Investment and Financing Decisions

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Dramatis Personae of Financial Economics

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Corporate Investment and Financing Decisions

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Flow of cash between financial markets and the firms

operations

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

The Investment Trade-off

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Fundamental Challenges of Finance

All Business Activities Reduce To Two Functions:

1 Valuation of assets (real/financial, tangible/intangible)

You cannot manage what you cannot measure.

Valuation is the starting point for management.

2 Management of assets (acquiring/selling)

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Fundamental Challenges of Finance (conti. . . )

Valuation of Assets
1 How are financial assets valued?
2 How should financial assets be valued?
3 How do financial markets determine asset values?
4 How well do financial markets work?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Fundamental Challenges of Finance (conti. . . )

Management of Assets
1 How much should I save/spend?
2 What should I buy/sell?
3 When should I buy/sell?
4 How should I finance the transaction?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

The Framework of Financial Analysis

Accounting: The language of finance

Financial Statements
1 Balance sheet: snapshot of financial status quo (stock, not
equity)
2 Income statement: rate of change of the status quo (flow)

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

The Framework of Financial Analysis(conti. . . )

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

The Framework of Financial Analysis(conti. . . )

Two Other Factors That Make Finance Challenging: Time

and Risk
Time
1 Cash flows now are different from cash flows later
2 Time flows in only one direction (as far as we know)
3 How should we model temporal differences?
Risk
1 Under perfect certainty, finance theory is complete
2 Risk creates significant challenges
3 How should we model the unknown?

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

The Framework of Financial Analysis(conti. . . )

To Address These Two Issues:

Use historical data

Use mathematics (probability and statistics)Cash flows now

are different from cash flows later

Challenges can easily overwhelm current mathematical abilities

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Six Fundamental Principles of Finance

P1: There Is No Such Thing As A Free Lunch

P2: Other Things Equal, Individuals:

1 Prefer more money to less (non-satiation)
2 Prefer money now to later (impatience)
3 Prefer to avoid risk (risk aversion)
P3: All Agents Act To Further Their Own Self-Interest

P4: Financial Market Prices Shift to Equalize Supply and

Demand

P5: Financial Markets Are Highly Adaptive and Competitive

P6: Risk-Sharing and Frictions Are Central to Financial

Innovation
Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021
Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

The Consumption-Investment Problem

Indifference curve is locus of all (C1, C2) points giving the
same utility level

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Individual Wealth Constraint

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Individual’s Constrained Utility-Maximization Choice

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Numerical Example

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Effects of Capital Market Imperfections

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021

Introduction Financial Analysis Fundamental Principles of Finance Financing Under Certainty

Practical Importance of Consumption-Investment Theory

Household Saving Decisions: Deposits, Pension Fund,

insurance, Mutual funds, Equities, etc. are primary source of
capital.

Main source of funds to finance firms investment activities.

A Criterion for managers of firms.

The best that management of corporations can do for their

owners is to maximize the PV of their ownerships interests in
that corporations.

Dr. Zulfiqar Hyder ECO562-Financial Economics Semester: Summer 2021