Corporate Finance Week 1 Student Notes

Corporate Finance
Week 1
Student Notes
Chartered Professional Accountants of Canada, CPA Canada, CPA

are trademarks and/or certification marks of the Chartered Professional Accountants of Canada.
© 2020, Chartered Professional Accountants of Canada. All Rights Reserved.
2020-07-16
Table of Contents
TOPIC 1.1: INTRODUCTION ...................................................................................... 1

1.1-1 Investment (capital budgeting) ......................................................................... 2
1.1-2 Financing ......................................................................................................... 3
1.1-3 Management of daily financial activities ........................................................... 4
1.1-4 Finance perspective on the financial statements ............................................. 4
TOPIC 1.2: FINANCIAL MARKETS ............................................................................ 5
1.2-1 Primary and secondary markets ...................................................................... 5
1.2-2 Market efficiency and the efficient market hypothesis ...................................... 8
1.2-3 Ethical use of non-traditional data .................................................................. 12
TOPIC 1.3: MAJOR FINANCIAL SECURITIES ......................................................... 15
1.3-1 Short-term securities ...................................................................................... 15
1.3-2 Long-term securities (bonds and debentures)................................................ 16
1.3-3 Equity securities (preferred and common shares).......................................... 18
1.3-4 Other equity securities ................................................................................... 19
1.3-5 Advantages and disadvantages of debt versus equity securities ................... 19
TOPIC 1.4: INTEREST RATES ................................................................................. 20
1.4-1 Overview ........................................................................................................ 20
1.4-2 The short-term risk-free real interest rate ....................................................... 22
1.4-3 Expected inflation........................................................................................... 23
1.4-4 The term structure of interest rates ................................................................ 24
1.4-5 The risk premium ........................................................................................... 26
TOPIC 1.5: MATHEMATICS OF FINANCE — THE TIME VALUE OF MONEY ........ 27
1.5-1 Interest ........................................................................................................... 28
1.5-2 Annuities ........................................................................................................ 33
1.5-3 Effective annual rate of interest...................................................................... 37
WEEK 1 SUMMARY ................................................................................................. 42
SUMMARY OF FORMULAS ..................................................................................... 47
Corporate Finance Week 1 — Student Notes
WEEK 1 — STUDENT NOTES
TOPIC 1.1: INTRODUCTION
Note: This course will require extensive use of a financial calculator. If you haven’t used
one before, you should become familiar with it before working through the course
material.
Learning objectives
• Outline how finance is used in an organization and the three key functions of a
financial executive.
• Describe the types of investments made by an organization and how these are
assessed from a financial perspective using capital budgeting.
• Describe how sources of financing are assessed by a financial executive with
respect to cost of capital, capital structure, and dividend policy.
• Identify the three areas of the financial executive’s responsibility with respect to
working capital including: investment, financing, and management of daily activities.
• Explain how a financial executive uses an entity’s financial statements to make
decisions.
How an organization obtains money (or capital in the vocabulary of finance) and how
that capital is best used to benefit the organization is one way of describing finance. An
organization’s finances must be managed — this is financial management. Financial
executives are responsible for strategic planning, especially around financial decisions,
overseeing financial planning, and controlling the cash flows of the organization. To
carry out their role, financial executives must know the goal of financial management,
which is to maximize the value of the organization. Market value or market
capitalization (that is, the market-share price multiplied by the number of shares issued
and outstanding 1) measures the success of financial management. If the market value
is maximized, the wealth of the owners of the organization is maximized; the goal of
financial management is to maximize shareholder wealth.
To maximize its value, the organization must make healthy profits and, over time,
generate positive cash flows without taking on excessive risks. These profits or cash
flows will then be either paid out as dividends to the shareholders (the owners of the
firm) or reinvested in the organization for future growth in profits and dividends. This is
true regardless of whether the organization is a publicly listed company or not. Private
companies, partnerships, and sole proprietors also try to maximize the value of their
businesses in a similar way.
1
The number of shares issued refers to the total number of shares of each class issued by the corporation. The
number of shares outstanding is the number of issued shares owned by investors.
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The financial executive should be familiar with both accounting and economic concepts.
In addition to understanding how the organization operates, the financial executive
should be aware that the state of the economy can affect the results and value of the
organization.
The financial executive has three key finance functions that serve to protect the
interests of the shareholders 2: investment, financing, and management of daily
activities. More specifically, the role of corporate finance within a business organization
is to answer the following three broad questions:
1. What investments (specifically, long-term investments) should the firm make?
2. How should the firm raise the cash to make these long-term investments?
3. How should the firm manage its short-term or operating cash flows?
The first question deals with capital budgeting and non-current assets and is covered in
Weeks 3 and 4. The second question focuses on how these long-term (non-current)
investments should be funded and is covered in Week 2. The third question focuses on
how to manage net working capital (current assets and current liabilities) and is covered
in Week 5.
The topics that follow explore these functions in some detail.
1.1-1 Investment (capital budgeting)

The financial executive must carefully consider any investments that the company may
make. Investments may be internal or external. Internal investments include investing in
new fixed assets, human resources, or research and development. External
investments include the purchase of another firm or becoming involved in a joint
venture. Downsizing the organization or divesting of assets or divisions can also be
viewed as a form of investment (or disinvestment). Through the selling or closing
unprofitable divisions, the firm is redirecting the organization’s financial resources to
more profitable or higher cash flow operations.
Potential investments should be reviewed carefully, including the size and timing of the
investments, and the risk of cash flows generated by those investments. The expected
cash flows from a risky investment should be higher than the cash flows from a less
risky one as the additional return will compensate for the riskier nature of the project.
Any investment should help to increase profits and cash flows in the long term. This adds
to the market value of the organization and consequently increases shareholders’ wealth.
Methods of how to evaluate investment decisions are covered in Weeks 3 and 4.
2
Most stakeholders have an explicit or implicit contract with the firm. Shareholders have no contract; they are owners
and have a residual interest in the firm.
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1.1-2 Financing
The financial executive must seek appropriate financing before undertaking any
investment. Sources of this financing can also be categorized as internal (from retained
earnings or suspension of dividends) or external (new issues of debt or equity). These
sources are reviewed later in this week’s material.
Three important things to consider when it comes to financing are the cost of capital, the
capital structure, and dividend policy. These aspects of the financing decision are
covered in Week 2.
Cost of capital
Firms are financed primarily through shareholder equity or debt. These sources of
financing are used to calculate the overall cost of capital. The financial executive may
need additional financing and may decide to approach the shareholders, the bank, or
even a venture capitalist for funding. The executive must consider the cost of obtaining
that funding — if borrowing the money for the investment is the best option, what terms
would be acceptable? If the investment is in a new fixed asset, it may turn out that
leasing the asset is better than buying it with borrowed money.
The financial executive must be aware of all the costs associated with the chosen
financing method. This is the cost of capital.
Remember that the financial executive is always working to increase the wealth of the
shareholders. For any investment to be worthwhile, the return expected from the project
must exceed the cost of capital.
Capital structure
A firm’s capital structure refers to the mix of debt and equity in its long-term financing.
As well as raising funds, the financial executive must monitor the capital structure of the
organization. When an organization carries debt, it has to pay interest and it must pay
back the original debt according to the agreement made with the lenders. Alternatively,
for equity, dividends are paid at the discretion of the board of directors (with the
shareholders’ approval) and the firm does not need to repay the equity raised as it is a
permanent source of capital. The more debt an organization carries, the more interest it
must pay. Excessive debt commitments can, therefore, turn a profitable organization
into an unprofitable one.
When an organization’s debt increases, it becomes riskier from the point of view of both
the debt holders and the shareholders. The amount of debt on the statement of financial
position affects the value of the organization and is therefore important to consider
when the financial executive makes a financing decision.
Dividend policy
Another important issue related to the area of financing is dividends. If the organization
requires funds, one option is to omit the dividend payment to shareholders and instead
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reinvest the money in the organization, rather than taking on new borrowing or issuing
additional equity shares. Even if the financial executive does decide to pay a dividend to
the shareholders, there remains the question of how large the dividend should be.
The dividend policy of an organization is very important to both current and potential
shareholders. Shareholders have expectations about the level of current and future
dividends. These expectations are based on the firm’s prior dividend history and on
what they think the firm’s future earnings will be. If the actual dividend turns out to be
different than the expected amount, they are likely to reassess the firm’s value.
Importantly, if the dividend is less than expected, the market value of the firm’s shares
will likely be adversely affected.
1.1-3 Management of daily financial activities

The net working capital of a business is sometimes referred to as the oil that keeps the
business machine operating smoothly. Working capital describes the way a firm
manages both current assets (including inventory, accounts receivable and cash) and
current liabilities (accounts payable and accruals).
Too much investment in any current asset could result in resources being used
inefficiently as these funds are, for the most part, not generating growth. Too little
investment, on the other hand, could overstretch the resources and lead to a firm’s
downfall. For example, if a company ran out of inventory, that could lead to unfulfilled
orders, dissatisfied customers and, ultimately, lost business. The management of
working capital is explored in Week 5.
These three areas of responsibility — investment, financing, and management of daily

activities — are very broad. Each area is considered in greater depth later in the course.
As you come across these three topics, try not to lose sight of how they fit together and
help maximize the wealth of shareholders.
1.1-4 Finance perspective on the financial statements
The financial executive uses an entity’s financial statements for many of the decisions
that were briefly addressed above. Some examples include:
• Reviewing the statement of financial position to understand the assets owned by an

entity and how these have been financed. How much debt and how much equity has
been issued to fund these investments? Does the company have too much debt or
too little debt, requiring changes in its capital structure and cost of capital? Are more
investments in capital assets required, resulting in capital budget analysis?
• Reviewing the income statement to understand how an entity earns profits and the
nature of its operations. Financial forecasting is used by financial executives to
understand future implications of decisions made today, and the income statement is
often the starting point for these forecasts.
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• Reviewing the cash flow statement to understand the sources and uses of cash. As
the financial executive makes decisions based on cash inflows and outflows,
understanding how much cash is generated by an entity’s operations and how much
cash is used to reinvest is vital to making financial decisions. For example, in a
capital budget analysis, financial executives will try to assess the amount of cash
required for an initial investment and then forecast the amount and timing of cash
flows that the investment will generate in the future.
An understanding of an entity’s financial statements is critical for the financial executive.

Financial statement analysis is covered in Week 6.
TOPIC 1.2: FINANCIAL MARKETS
Learning objectives
• Describe how primary and secondary financial markets work and the importance of
financial intermediaries and security regulators.
• Outline the four basic stages of an initial public offering.
• Outline the three types of public offerings between the firm and the investment
dealer.
• Describe market efficiency and explain the efficient market hypothesis.
• Explain why informational efficiency is important and its three forms.
• Identify issues surrounding the ethical use of data for making investment decisions.
1.2-1 Primary and secondary markets

The financial market refers to the network of players who facilitate the buying and
selling of financial assets and liabilities. Within the economy, there are three major
sectors: households, businesses, and governments. Financial markets assist the
transfer of funds between surplus economic units (lenders) and deficit economic units
(borrowers). For example, many households have more income than they wish to
currently spend, while many businesses need investment capital in excess of their
current cash flows in order to invest in new capital assets (plant and machinery).
Those with excess funds will want to buy financial securities; those who need funds will
obtain these funds from those with surplus funds by selling (issuing) financial securities.
Overall, households are the primary supplier of funds to both government and business.
Investors transfer their excess current income in exchange for a promise of future
repayment, often using intermediaries. These promises take the form of financial
securities and include short-term debt, long-term debt (bonds and loans), preferred
shares and common (ordinary) shares. These financial securities represent an
obligation or a liability for the issuer and an asset to the buyer; the sum of all financial
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securities, at any time, will be zero. In this sense, financial markets help to efficiently
allocate consumption over time.
These financial securities will vary in nature due to the type of issuer (government,
business or household) and the type of claim (debt or equity). While some transactions
are direct transactions between the lender and borrower, most involve intermediaries.
There are two types of intermediaries: financial and market.
Financial intermediaries include institutions such as commercial banks, insurance

companies, and pension funds. They pool the savings of various sectors (investors) and
then loan the pooled funds to borrowers. In this sense, they are indirect intermediaries.
In contrast, market intermediaries match lenders with borrowers without changing the
nature of the underlying financial asset. Because they arrange transfers between
lenders and borrowers without pooling the funds, these are direct intermediaries.
Examples include mortgage brokers, insurance brokers, and stockbrokers.
There are two basic stages of a financial market, the primary and secondary markets.
Primary markets involve a borrower or equity issuer, issuing new securities (bonds or
shares) in return for cash from lenders or shareholders. Secondary markets involve the
trading of previously issued securities. The secondary market is important because it
represents the mechanism through which investors can sell their investments whenever
they want to, based on their individual circumstances and research. The smooth
functioning and efficiency of secondary markets are critical for the primary markets. If
investors are unable to liquidate their investment when they want to, and do so at a fair
price, it is unlikely that they will make the investment in the first place.
Secondary markets can be further classified as exchange markets, and dealer or over-
the-counter (OTC) markets. Exchange markets have a physical location, such as the
Toronto Stock Exchange, and feature a bidding process for any listed security. Dealer
or OTC markets have no physical location and consist of a communications network of
dealers who trade with each other.
In Canada, there is no federal securities regulator; this responsibility is assigned to the

provinces. The three main regulators in Canada are the provincial securities
commissions in Ontario, Quebec, and British Columbia. The role of these provincial
regulators is to protect the public from both fraudulent and misleading financial
securities. For example, the definition of securities in the Ontario Securities Act is broad;
the provincial regulator looks at the promotion of investments, their expectation of profit,
the control over the funds advanced and the risk involved. It regulates primary market
offerings, secondary market trading, insider trading, takeover activity, and the activities
of the various players in the investment profession. Publicly traded companies must
register with a securities commission before they can offer their securities to the public.
Firms seeking to raise financing can do so either through a private placement or through
a public sale. With a private placement, the two parties negotiate the terms of the
arrangement and arrive at an agreement that suits both. With a public sale, securities
regulators oversee the sale. For a firm that already has shares listed on a stock
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exchange, the new offering is called a seasoned equity offering (SEO). For a firm that is
going public by selling shares for the first time, the offering is called an initial public
offering (IPO).
Securities regulators are concerned with the promotional activities used to sell
investments, especially those of firms that are distributing securities in the primary
market for the first time. A significant regulation affecting IPOs is that the distribution
must be accompanied by a prospectus. This long-form prospectus formally summarizes
the security and includes the costs, objectives of the investment, and risks involved. It
thoroughly discloses all of the facts that might affect the price of the security. (Firms
issuing securities through an SEO typically use a short-form prospectus, which is less
onerous.)
The four basis stages of a typical IPO are as follows.
Stage 1: Discussion with the investment dealer(s)

Any issues the dealers may have with the firm’s legal structure, bylaws, or board of
directors are discussed and resolved. This helps the new issue become more
marketable.
Stage 2: Preliminary prospectus

This may take three to five months to prepare, during which time the company consults
with the investment dealer, lawyers, and accountants. No marketing of the potential
issuance of company shares is allowed during this period, and the company covers any
expenses incurred.
Stage 3: The waiting period

The preliminary prospectus is sent to the securities regulator for approval. Meanwhile,
the investment dealer may start marketing the issue and take expressions of interest
from potential investors (usually other dealers or institutional investors). If the regulator
identifies any deficiencies, the issuer has a short period of time to fix them.
Stage 4: The distribution period

The investment dealer (or underwriter) sells the securities to the public based on the
expressions of interest during the waiting period.
There are three types of public offerings between the firm and the investment dealer:
1. Best-efforts offering: The dealer agrees to do their best to sell the shares but doesn’t
guarantee a price.
2. Firm-commitment offering: The dealer buys the shares from the issuing company at
a set price and guarantees the sale of an agreed-to number of shares. The dealer
earns the difference between the price paid to the issuer and the resale price to the
public. Here, the dealer is underwriting or guaranteeing the issue. This is also known
as a bought deal.
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3. Rights offering: This only occurs with an SEO. The new shares are offered to
existing shareholders in proportion to the number of shares they already own, often
at a discount.
In contrast with a public offering, private placements occur through what is known as the
exempt market — an unregulated market that raises money from private investors.
These securities are sold without a prospectus; instead, the issuer normally provides an
offering memorandum. The exempt market basically consists of wealthy individuals and
institutions that can hire their own experts to perform the due diligence. (With IPOs this
due diligence is accomplished with the prospectus and by involving regulators.)
Private companies can also issue securities under the exempt market without a
prospectus under the following circumstances:
• They are raising less than $3 million.
• They won’t market or promote the shares.
• They will issue the securities to less than 50 shareholders.
Finally, venture capital (VC) firms can provide financing in circumstances where a new
startup company has trouble accessing funds through more established channels.
Canada has many bright, energetic entrepreneurs whose products never get to market
because they don’t have enough money to fully develop and market their ideas. They
can’t raise bank financing because their ideas aren’t yet proven, and they can’t raise
capital in the stock market by going public because they are too small and have an
insufficient operating history. VC firms can help these entrepreneurs succeed.
A venture capitalist specializes in providing private equity capital to startup companies

with high potential. Typically, these VC firms provide cash in exchange for shares in the
company and/or options on the company’s stock. They may be actively involved in the
day-to-day management of the startup and be on the board of directors. Investments
made by VC firms are usually short-term in nature. They typically invest in the company
to see it through the startup phase and then sell their stake when the startup is
sufficiently well known to raise funds on the stock market through an IPO.
1.2-2 Market efficiency and the efficient market hypothesis

There are three general types of efficiency that are relevant when evaluating the
functioning of the capital markets. These three types are as follows:
• Operational efficiency: An operationally efficient stock market is one that carries
out its operations at as low a cost as possible. To encourage this, there must be
competition between the buyers and sellers on a particular stock exchange, and
competition between different exchanges to attract those buyers and sellers.
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• Allocational efficiency: As resources are finite, they should be allocated to where

they can be put to best use. An allocationally efficient market is one that channels
the available funds to those firms with the most promising real investment
opportunities.
• Informational (pricing) efficiency: An informationally (pricing) efficient market is
one in which the market price of a stock reflects all relevant information about the
stock. Further, the price of the stock will adjust rapidly to the release of any price
relevant new information. Thus, in an informationally efficient market, the current
share price immediately and completely reflects all current and historical information;
only new information causes the price to change.
Clearly, each of these types of efficiency represents a desirable attribute for the capital
markets, informational (pricing) efficiency is fundamental. A basic requirement for the
smooth functioning of a securities market is that all traders believe that the price at
which they trade (the market price) is in some sense “fair” or “correct.”
If, for example, shareholders thought they were almost always buying high and selling
low, then they would likely quit trading. The secondary market would then become less
active, with the potential to, at the worst, collapse. Importantly, without an active
secondary market, the primary market would likely become far less viable.
An informationally (pricing) efficient market gives shareholders the confidence to buy

long-term securities because they know that they can sell those securities to someone
else at any time (in the case of shares) or before maturity (in the case of debt securities)
if they wish. Moreover, the price at which they sell (or buy) will be a fair one.
Note, an informationally efficient market is also important to the financial executive who
uses the market value of the stock as a measure of management performance.
Undertaking corporate actions that maximize the market value of the stock is only
meaningful if that market value accurately reflects the actions of the firm’s management.
Under the efficient market hypothesis (EMH), there are three forms of informational
(pricing) efficiency. These forms differ by the type of information available, and to what
extent the price reflects each type of information:
1. Weak form: Current security prices only reflect all historical market data.
2. Semi-strong form: Current security prices reflect all publicly known and available
information, including historical stock market data.
3. Strong form: Current security prices fully reflect all information, whether public or
private.
These three forms build a hierarchy. The information set under the semi-strong form
includes that under the weak form (historical market data). Thus, for a market to be
semi-strong form efficient, it must also be weak form efficient. Similarly, the information
set under the strong form (all public and private information) included that under both
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the semi-strong and weak form. Thus, for a market to be strong form efficient, it must
also be both semi-strong and weak form efficient.
The key implication of the EMH is that no buyer or seller should be able to use a
particular form of information to their advantage. This information should already be
included in share price. For example, if a market is semi-strong form efficient, no
investor should be able to use information that is in the public domain to their
advantage.
Overall, the evidence supports the weak form and reasonably semi-strong forms of the
EMH. The evidence suggests that investors cannot use historical market data or
publicly available information to pick stocks. Stock prices already reflect these sources
of information. In the long run, stock market investors cannot beat the market and obtain
returns higher than expected. How shareholder expected returns are calculated is
discussed in Week 2.
The evidence does suggest that insider (private) information can be used to
successfully pick stocks. However, this is illegal. Insider trading occurs when an
individual buys or sells shares based on inside information — price-sensitive information
not yet made publicly available. If, for example, someone has access to privileged
inside information, they might be able to use this information to their advantage by
buying shares just before the release of good news or selling just before the publication
of bad news.
This is where the role of an active regulatory body such as the Ontario Securities
Commission becomes important. By requiring that information relevant to pricing
securities is widely disseminated, the regulator is ensuring that this information is
available to all investors and as such, no investor has an information advantage. In
addition, by enforcing insider trading laws, the regulator can seek to reduce the
likelihood of any one market participant trading with an information advantage.
However, notwithstanding the role of the regulator, there is still periodic evidence of
insider trading and hence the market is not strong form efficient.
Finally, there is also a role for financial accounting and accounting standard setting
bodies. As individual investors use financial information in their investment decisions,
security prices are driven to “properly reflect” this information. Provided that accountants
do a good job of communicating relevant and reliable information, the firm’s security
price should then be consistent with the firm’s prospects. The social benefit is that this
improves the efficient allocation of scarce capital in society. In addition, by reducing the
extent of inside information through additional disclosure requirements, investor
confidence in the fairness of the market will be enhanced. More investors are then
willing to enter the market, with a resulting improvement in market depth.
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Example 1.2a
Consider an individual investor, Raj, a dentist who has $15,000 invested in

shares. Every Sunday morning, he reads through the business section of his
local newspaper. He uses a spreadsheet to graph the daily share prices from the
past week for his current investments and for any companies that he is thinking
about investing in. He makes at least one purchase or sale every month on the
strength of this analysis, phoning his instructions to his stockbroker at 9 a.m. the
following Monday morning.
If the stock market is semi-strong efficient, Raj is effectively wasting his time. Any
information contained in the Sunday newspaper would already have been
reflected in the price before he had a chance to read it. Thus, an announcement
that a company has, for example, won a new contract is probably not useful to
him because the share price will have risen as soon as the information became
public, prior to when he read it in the Sunday newspaper.
Example 1.2b
Consider Lynda, an analyst employed by a major investment institution. She is a

specialist in the oil and gas industry and regularly attends briefings organized by
the major listed companies in this industry. She has a workstation that has a 24-
hour link to the Reuters News Service on one screen and a continuous list of
major transactions and price changes on the stock exchange on another. She
has direct telephone lines to major brokers and can complete the purchase or
sale of a large quantity of stock in a matter of seconds.
Her ability to access news announcements immediately upon their release gives
Lynda the opportunity to exploit the new information before the share price
adjusts to fully reflect it. Indeed, the first investor to react to a new piece of
information will attract the attention of the rest of the market, thereby accelerating
the market’s reaction.
Lynda and others like her are key to market efficiency. Because experts who
control large amounts of capital are competing against each other, they collect
and analyze all new information as a matter of urgency. This is information that
goes beyond company press announcements. As an industry expert, she will
analyze all relevant data, including the economic indicators that might affect the
selling price of oil and gas. Experts like Lynda will, therefore, keep share prices
up to date so that they reflect all available information, consistent with the notion
of semi-strong efficiency.
In summary, informational (pricing) efficiency is critical for three key reasons:

• It encourages people to buy shares. For people to be willing to invest in shares,
the shares must be priced fairly. Otherwise, people won’t invest for fear that when
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they sell the shares, they’ll be priced inappropriately. Ultimately, a reticence to invest
can lead to a lack of funds for companies and inhibit growth.
• It facilitates financial management. Sound financial decisions can only be made if
the company’s share is correctly priced. Any implications of a decision the firm
makes need to be fully and correctly reflected in the share price.
• It helps to allocate resources. If a company performing well has under-valued
shares because the market has priced them incorrectly, the company won’t receive
an appropriate allocation of funds from investors. This will have a detrimental effect
on the overall wealth of society as a whole because the available funds will not have
been allocated to their most productive uses.
Note that prices sometimes deviate from the price implied by publicly available
information. The market doesn’t always react as expected, and human behaviour has
much to do with it. One of the newly developing fields of finance is that of Behavioural
Finance. Investors can be motivated by irrational impulses such as loss aversion or
overconfidence. Loss aversion, where investors place more emphasis on losses than on
gains, can lead investors to hold losing stocks too long to avoid recognizing a loss, and
to sell winning stocks too early for small gains to avoid losing the gained amounts.
Overconfidence leads investors to focus on information they consider important, while
ignoring other relevant information. They think their success is because of their
investing ability, and that their losses are because of factors they cannot control.
1.2-3 Ethical use of non-traditional data

As discussed above, investment analysts use a variety of sources to gain information on
a company to help with their analysis and prediction of share price movements. The
more unique the information is, the more likely it is that an analyst has an information
advantage to determine share price changes ahead of their peers. Many analysts are
now using non-traditional sources of information including social media, internet web
traffic, satellite imagery, drones, private-company data, and credit card data to gather
information on companies.
For example, consider an analyst who is covering a mining company and, using a
drone, notices that at one of the company’s mining sites is leaking waste sludge and
although the company appears to be working diligently to stop it, the waste sludge is not
being contained. This accident has not yet been publicly announced. The analyst could
take this information and short sell the shares of the company, knowing that the share
price will fall once the announcement is made to the public. Is using a drone illegal or
unethical in gathering information on this company? The analyst would have to be
knowledgeable about the regulatory requirements of using drones to gather this
information and its ethical use.
It becomes even more complicated to determine what is ethical and legal when using
private personal information gained from reviewing social media, credit card data, or
private-company data. Consider the following example. An investment analyst covers a
plastics manufacturer, Plastics M Corporation (PMC). A review of social media related
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to PMC’s CEO indicates that this individual has made four trips to Stuttgart, Germany in
the past month. The analyst also knows that a key supplier of the company operates in
Stuttgart and this supplier is currently looking to be acquired. By putting these pieces of
information together, the analyst concludes that PMC is in negotiations to purchase the
supplier. Without access to the social media, this conclusion could never have been
reached. Is it ethical to use the CEO’s personal information in this manner? Does the
CEO have a right to have his privacy protected?
From an investment analyst perspective, there are two situations where understanding
the implication of big data analysis may be relevant. The first perspective relates to the
analyst accessing and using non-traditional data to make informed investment decisions
to predict share price movements. The second perspective is looking at ethical
investing. If a company does not properly protect and manage the data it has gathered,
should analysts promote the investment in its shares?
Each of these perspectives is considered below.
1. Investment analysts using non-traditional sources of information — Factors that

should be assessed with respect to this data include:
• What is the origin of the data and how was it gathered? Consider private-
company data that a company itself has gathered and has made available to
other parties. Does this company have the right to sell this information to be used
by analysts and other parties? For example, consider the data that Facebook has
available on all its users. Does it have the right to sell this data? The analyst
would want to ensure that in gathering and selling the information, the terms and
conditions of gathering the information have not been violated. Alternatively, a
data broker may be selling the data and the analyst would want to ensure that
the data broker has legal rights to it.
• Was the data gathered originally on an anonymous basis or was it made
anonymous afterward by deleting personal information? In the second case, the
risk is higher as it has been shown that it is possible to reidentify the individual
using the right technical tools if the deletion was not made properly. If the analyst
gets access to this data where personal information is now identified, is this
violating privacy and other laws? Is it ethical to even use it?
• Is permission required from the individual to which the information relates? If
personal information is available, does the individual need to provide further
permission for its use? Are there ethical implications on using information that the
individual is unaware is available?
• In cases where information has been obtained from a website, this does not
necessarily imply that it is publicly available and can be used for any purpose.
There may be copyright and other regulatory permissions required to use the
data for the analyst’s purpose.
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• Is the data accurate and valid? The risk is that the data is not as accurate or valid
as the analyst assumes and therefore incorrect conclusions are made.
• Was the data obtained in a way that is legal under the new data security laws?
When is it appropriate to involve a lawyer to determine if the use of the data is
legal?
For the investment analyst, internal policies should be developed on using non-
traditional sources of data that cover the issues identified above.
2. Making ethical investments based on how a company manages its customer data —
With respect to the second perspective, consider the credit card company or the
social media company that provides data to third parties. What controls have these
companies implemented to ensure that the information is anonymous and remains
private? If personal information is subsequently deleted by individuals, what
happens? Does the individual have the right to assume that the information is
forgotten and is no longer available? Consider pictures posted by a university
student on a social media that a few years later they regret and delete. There should
be an obligation by the social media site to ensure that the information on this
student is no longer available in any form. Individuals should be able to know that
once deleted, the information cannot be accessed. In understanding how companies
initially capture, retain, and manage their databases of customer information, some
of the following factors should be assessed:
• What type of personal data is being gathered and are customers aware of this?
• Have customers given their permission for this information to be retained?
• Have customers given their permission for this information to be shared with
other parties?
• How is confidentiality and private information protected?
• Is access to the database protected from unauthorized internal and external
access?
• How is information deleted? Is the deletion permanent or is it possible to recover
deleted data?
• Is the company complying with all regulatory requirements including privacy
rules?
The use of big data by investment analysts (and others) is in its early stages. However,
regulatory bodies have started to scrutinize how data is being gathered, stored, and
used by other parties. As a result, there are many organizations that are working to
design regulatory requirements to ensure that the use of data is not abused. Investment
analysts will have to stay abreast of these regulatory changes to ensure that they are
not violating any laws.
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TOPIC 1.3: MAJOR FINANCIAL SECURITIES
Learning objectives
• Identify the two broad types of financial securities that an entity uses to raise funds.
• Describe different types of short-term debt securities.
• Describe types of long-term debt securities and their different features.
• Describe types of equity used and their different features.
• Describe other types of equity securities used.
• Outline the advantages and disadvantages of debt versus equity securities from the
business and investor’s perspectives.
There are two broad types of financial securities: debt and equity. Debt instruments are
legal obligations to pay back borrowed funds together with interest at specified times.
These include bank loans, bonds, treasury bills (T-bills), commercial paper, and
debentures. Equity instruments are evidence of ownership in a company and include
both common (ordinary) shares and preferred (preference) shares.
In addition to the debt / equity classification, there are two other ways in which financial
securities can be classified: by marketability and by maturity. First, in terms of
marketability, non-marketable assets (which include savings or demand bank accounts)
are those for which there is no secondary market. As such, they cannot be sold or
traded, but rather must be withdrawn at the end of the investment horizon. In contrast,
marketable securities are ones for which there is a secondary market and hence can be
purchased or sold through an active market.
Second, in terms of maturity, short-term securities are those with a maturity of less than
one year. These securities are often termed money-market securities and consist of
short-term debt instruments. Long-term securities are those with a maturity longer than
one year and include both debt and equity securities (which have no maturity date).
1.3-1 Short-term securities

Short-term securities are fixed-income securities (debt) with maturities of one year or
less. These securities are differentiated by the issuer and the form of the promised
payment. Some securities pay interest between the time of issue and maturity, while
others provide a return by being sold at a discount (below face value) and are then
redeemed at face value (zero coupon or pure-discount securities).
The most common types of short-term securities include money-market items such as
the following:
• Treasury bills (T-bills): These are promissory notes issued by the Canadian
government and have a maturity of one year or less. As T-bills are issued by the
federal government, they are viewed as virtually risk-free. The return on T-bills with a
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short maturity (such as one month) is often used as a reference point for the risk-
free rate of return.
• Commercial paper: Commercial paper is an unsecured, short-term debt instrument
issued by a company, typically to finance accounts receivable or inventory, or to
meet short-term obligations. Commercial paper typically has a maturity of between
30 and 60 days, and rarely exceeds 270 days.
• Banker’s acceptances: Banker’s acceptances are commercial paper issued by a
company but guaranteed by a bank.
These securities are traded through what is known as the money market, which is a
communications network of major dealers or traders. Buyers and sellers contact one
another to carry out transactions, and most trades are quite large. Individual investors
can participate on a smaller scale through a financial intermediary such as an online
brokerage firm and/or by purchasing units of mutual funds.
The issuers of money-market instruments are governments, corporations, banks, and

other financial intermediaries. The holders (investors) are primarily large investment
dealers and corporations. Investment dealers and banks hold government securities,
while corporations use money-market instruments to temporarily invest excess cash.
1.3-2 Long-term securities (bonds and debentures)

A bond is legal evidence of a loan obligation. The typical corporate or government bond
is a promise to return a regular, fixed-interest payment, referred to as a coupon
payment, plus a lump-sum repayment at the maturity of the bond. Some bonds are
issued with coupons that “float” with changes in a reference rate such as the inflation
rate. In this course, the focus is on fixed coupon bonds. The annual coupon or interest
payment is determined as the bond’s coupon rate multiplied by the face value of the
bond. Most bonds in North America pay this amount semi-annually, with each payment
equal to one-half of the annual coupon amount. The lump-sum repayment at maturity is
equal to the face value of the bond.
The bond contract, called the bond indenture, contains the terms or provisions of the
bond. The standard terms appearing in the indenture include the par value (face or
maturity value), coupon rate, payment dates, maturity date, and principal payment.
Often bonds also have additional features to make them more attractive to investors
(known as sweeteners) or to reduce the investor’s exposure to risk. These features may
include some or all of the following:
• Priority of payment: Some bonds (senior bonds) have priority over others (junior
bonds) in the situation that a firm cannot make all of the required debt payments.
• Collateral (security): The borrower offers the lender recourse to a particular asset
of the borrower if the borrower defaults (that is, breaks a promise contained in the
indenture). Note: An unsecured bond is called a debenture.
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• Sinking funds: The borrower promises to gradually retire the bond issue by buying
back and retiring a portion of the issue each year which can occur by purchasing
bonds on the open market.
• Retraction and extension: With a retractable bond, the holder has the option of
selling the bond back to the borrower at face value at some date prior to the bond’s
maturity. The holder will normally do so only when the market value of the bond at
that date is less than the face value. An extendible bond gives the bondholder the
option of not returning the bond to the borrower for its face value at maturity but
extending the maturity on the bond by some fixed period. The holder will do so when
the market value of the bond is higher than the face value.
• Call provision: The borrower has the option of buying the bond back from the
holder at a fixed price, at some date prior to the maturity of the bond. The borrower
may do so when the value of the bond is higher than the stated call price. As you will
see in Week 2, bond prices increase when interest rates decrease. Thus, when the
bond price is above the stated call price, the borrower may be able to issue new
bonds at a lower interest rate and use the proceeds to call the outstanding bond
issue. This may reduce the interest payments that the borrower will have to make. In
Canada, long-term corporate bonds often have a different type of call provision
called a Canada plus call (also known as a Canada call). Unlike the call provisions
just described, the Canada plus call provision does not have a specific call premium
set. Instead, the issuer must provide a call premium that compensates investors for
the difference in interest between the original bonds and the new debt issued to
replace it.
The bond market trades all long-term debt securities that are issued by corporations
and all levels of governments. As with the money market, the bond market is not a
physical location but a communication network called the OTC market. Bond dealers
quote bid prices (what they will buy a bond at) and ask prices (what they will sell a bond
at); price quotes appear daily online and in most financial newspapers. Market prices at
which bonds trade may be higher or lower than a bond’s face value; they are
determined by current interest rates in relation to the bond’s coupon rate and by the
maturity of the bond.
In Canada, the value of bonds issued by the federal and provincial governments
combined far exceeds that issued by corporations. Once issued, the bonds are held by
a variety of investors, including insurance companies, pension plans, and individual
investors.
By convention, bond quotes are expressed in terms of a $100 face value and
accompanied by a yield to maturity (YTM). This yield is the annualized rate of return the
holder of the bond would earn (in percent) if the holder bought the bond at the quoted
price and held it until maturity. The YTM assumes all coupon payments are reinvested
and earn the bond’s YTM. The yield is often broken down to units of one one-hundredth
of a percent, known as basis points; there are 100 of these basis points in 1%.
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From the investors’ perspective, the risk of investing in bonds is that the borrower may
become unable to make the coupon payments and/or the principal repayment at
maturity. For major issuers (borrowers), this risk of default is assessed by one or more
ratings services. These ratings services analyze the issuer’s ability to maintain the
required payments of interest and principal, and assign a rating. Canadian ratings
services include the Dominion Bond Rating Service (DBRS) and the Canadian Bond
Rating Service (CBRS), and international ratings services include Standard & Poor’s
(S&P) and Moody’s. DBRS bond ratings vary from the safest (AAA) to the riskiest (D).
Bonds with the lower (riskier) ratings have higher premiums included in their yield (rate
of return) to compensate for the higher default risk.
Note: Bonds are only one of many options that a firm has when it comes to arranging
long-term debt financing. Other options include mortgages, leases, and bank loans.
1.3-3 Equity securities (preferred and common shares)

By definition, equity securities are ownership interests in a firm. Where distribution of
cash to equity holders is called a dividend, it may qualify for the dividend tax credit
under the Canadian Income Tax Act. Other distributions to equity holders include share
repurchases. The two typical forms of equity are preferred and common. Preferred
shareholders are given priority over common shareholders to claim dividends. However,
common shareholders vote for the board of directors, whereas preferred shareholders
typically do not have voting rights. However, where preferred shares are participating,
they will have voting rights. Many Canadian corporations issue both common and
preferred shares.
Preferred shares have a stated dividend rate, just as bonds have a stated fixed coupon
rate. However, the preferred dividend is not a contractual obligation. The issuer can
omit payment of the preferred dividend without legal ramifications but will pay it later if
there is a cumulative provision, which is typically the case. Preferred share dividends
take priority over common share dividends in the sense that the firm cannot pay a
dividend on its common shares unless it has fully satisfied the preferred share dividend
— both current and in arrears if cumulative. This payment flexibility makes preferred
shares (rather than bonds) attractive to the borrower. However, because payments on
preferred shares are classified as dividends, they are not an allowable tax deduction to
the firm, whereas interest payments on bonds are tax-deductible. Finally, as with bonds,
ratings services such as DBRS and CBRS in Canada, and S&P and Moody’s
internationally also rate the preferred shares of many major issuers.
A firm may also pay dividends to common shareholders, typically on a quarterly basis.
Unlike preferred shares, the common share dividend is not fixed, and can vary (up or
down) at any time at the discretion of the firm’s board of directors. The common
shareholders don’t have to approve any changes to common share dividends. Common
share dividends are also not tax-deductible for the issuing company.
Equity securities are traded on both organized exchanges and OTC markets. A majority
of shares are owned by institutions such as mutual funds, exchange-traded funds
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(ETFs), pension funds, and insurance companies. Individuals participate in share

ownership either directly or through institutional investors such as mutual funds, ETFs,
and pension funds. These intermediaries may have fairly large positions in a given
firm’s shares because of their size. They are often active traders, and institutions have
become very important in terms of trading and determining market prices.
1.3-4 Other equity securities

In addition to the primary securities discussed above (bonds, preferred shares and
common shares), there are several other types or forms of security that allow the holder
(investor) to acquire common shares:
• Convertible securities: These may be either convertible debts or preferred shares
that the holder can convert into common shares of the company. These securities
will have a conversion ratio specifying the number of common shares the equity
holder will receive upon conversion. This enables investors to participate in the
capital growth of the company while having a regular stream of interest or dividend
payments. Convertible securities are a hybrid security in the sense that they have
both debt- and equity-like features.
• Warrants: A warrant is a security that entitles the holder to buy common shares of
the issuing company at a fixed exercise price until the expiry date. Warrants are
frequently attached to bonds or preferred shares as a sweetener. This makes the
underlying security more attractive to investors because of its equity potential and
allows the issuer to pay lower interest rates or dividends.
• Share rights: When additional shares are issued by a company the existing
shareholders may have the first right of refusal (pre-emptive right), which protects
their percentage ownership from being eroded (diluted). Because the number of new
shares might not correspond with the number of existing shares, some shareholders
may be left with fractional share rights, which can be traded and combined with other
rights to purchase a full share.
1.3-5 Advantages and disadvantages of debt versus equity securities

The following represents a brief summary of the key advantages (rewards) and
disadvantages (risks) of each major form of financial security.
Debt (bonds)
• Investor’s perspective: The investor (debtholder) is subject to market interest-rate
changes that will affect bond prices and to the risk that the issuer of the debt may
default, but receives the benefit of contractual cash flows and the right to seize
assets on default. Investors face lower returns than for equity investments because
of their lower risk. Debt also does not provide the investor with any control (other
than the rights specified in the bond indenture) and there is limited scope for capital
appreciation (other than through market interest-rate decreases which will increase
the market value of outstanding bonds).
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• Business’s perspective: The benefits are that the fixed (certain) cash flows
(interest) are tax-deductible, and that there is no loss of control from issuing debt.
Furthermore, the cost to the firm of debt is less than the cost to the firm of equity.
The disadvantage is that the business has to generate sufficient cash to make the
contractual payments and to repay the principal at maturity.
Equity (common shares)

• Investor’s perspective: The investor is subject to the risk of uncertain cash flows in
terms of dividends and capital appreciation, and could experience a loss in value
(when share price drops) and/ or reduced cash flow (reduced dividends). However,
the amount of value increase or capital appreciation is not limited. The investor can
also exercise control through voting and may experience leveraged returns if the
business uses debt to increase returns to the shareholders.
• Business’s perspective: The corporation benefits from not having to make any
contractual cash flows, but risks a dilution of control as new shareholders are added
to the company. Additionally, dividends are not tax-deductible for the issuing
company.
Equity (preferred shares)

Depending on the provisions of these shares, the risks and rewards would fall between
those of common shares and debt. For example, convertible or participating preferred
shares would have some of the advantages of common shares for investors while
offering regular dividend payments (a characteristic of debt).
TOPIC 1.4: INTEREST RATES
Learning objectives
• Outline the major four factors that affect interest rates.
• Outline the factors that impact the short-term risk-free real interest rate.
• Explain how expected inflation affects interest rates and calculate the real rate or
nominal rate using the Fisher equation.
• Describe the term structure of interest rates and calculate the rates on investments
using the expectations theory.
• Describe the risk premium and the sources of risk that impact it.
1.4-1 Overview
Interest rates represent the amount that will be earned on a dollar invested (loaned), or
must be paid on a dollar borrowed, expressed in percentage terms. In this sense, the
interest rate is the cost associated with the borrowing and lending of funds and is one
component of the cost of capital.
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As with any other free-market price, interest rates are determined by the forces of
supply and demand; here the supply of, and demand for, money. The major factors that
determine interest rates are as follows:
• the short-term real risk-free return
• expected inflation (nominal as opposed to real interest rates)
• investor and borrower time preferences (the term structure)
• default risk premium reflecting the credit risk of the borrower
The following figure illustrates the influence that these factors have on interest rates for
debt securities with the same default risk, but different maturities:
As revealed through this figure, the interest rate on the 10-year bond for an issuer that
has default risk can be thought of as developing through the following four-step process:
Step 1: Current investment opportunities (the demand for money) determine the real
interest rate (no inflation) on short-term, risk-free financial investments.
Step 2: Next the relationship between time to maturity and interest rates is considered.
That is, the analysis is expanded to include intermediate- and long-term, risk-
free debt securities (those with a longer maturity). Borrowers are often willing to
pay higher interest rates to secure financing for a longer time period and
lenders often require higher interest rates to lock into longer investments, so
that the term structure tends to be more positively sloped than it otherwise
would be, due to these “liquidity premiums.”
Step 3: Expected inflation over different times to maturity is taken into account, shifting
interest rates up when there is positive expected inflation. These are the
“nominal” or observed interest rates. The term structure of interest rates refers
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to this relationship between nominal interest rates and time to maturity for
securities that are default risk-free.
Step 4: The default risk of an individual security would then be accounted for by adding
a premium to the time-adjusted rate to further increase the interest rate.
The following topics discuss each of the four factors in detail.
1.4-2 The short-term risk-free real interest rate
Short-term refers to a maturity of one year or less. Risk-free means that there is no
uncertainty about whether all promised future payments will be made. Government
treasury bills and bonds are examples of risk-free investments. The real interest rate
excludes the effect of inflation.
This component represents the underlying price of money at which the demand for
loanable funds is equal to the supply of loanable funds. The demand for funds arises
largely from firms that want to make capital investments and from government. The
supply of funds arises largely from households and financial intermediaries. Thus, the
factors that are the primary determinants of the short-term, risk-free, real interest rate
are then consumer consumption preferences, firms’ current investment opportunities
(including government borrowing to finance public projects), money supply management
by central banks and tax laws.
A change in any or all of these factors would affect the short-term, risk-free, real interest
rate. To illustrate with reference to the supply and demand curve presented in the figure
below:
• Shifts in consumption preferences. Suppose all savers suddenly wanted to
consume more today and consequently save less. The supply curve would then shift
up and to the left, and the equilibrium interest rate would rise.
• Shifts in firms’ investment opportunities. Suppose firms’ new technological
opportunities suddenly evaporated, so that their new potential investment projects
had lower rates of return. The demand curve would then shift down and to the left,
and the equilibrium interest rate would fall.
• Changes in tax laws. Changes in tax laws will alter investors’ after-tax income
and/or corporations’ after-tax investment returns, and thereby impact consumption
preferences and investment opportunities.
If through these types of changes, more funds are desired than are available, the cost of
the funds (that is, the interest rate) will rise to the point where some borrowers are no
longer interested. Likewise, if there are more funds available than required, the interest
rate will decrease until some lenders are no longer willing to lend. Ultimately, as
illustrated by the figure below, the point at which supply equals demand will be the
short-term risk-free real interest rate (k*).
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1.4-3 Expected inflation

By investing, investors are trading current consumption for future consumption. As a
result, they also want to protect themselves against a loss in purchasing power. This is
usually measured by the consumer price index. Also, because investors earn their
returns in the future, they require compensation for expected future inflation and not for
current or past inflation. Thus, it is expected inflation that is embedded in interest rates.
Interest rates that embed expected inflation are referred to as nominal interest rates
whereas those that do not are referred to real interest rates. The relationship between
the nominal interest rate and the real interest rate can be expressed through the Fisher
equation:
Nominal rate = (1 + Real rate) × (1 + Expected inflation rate) – 1
When interest rates are quoted, they are considered nominal rates. The short-term risk-
free nominal interest rate is typically identified as the rate on short-term federal
government debt (government bonds or treasury bills (T-bills) with a maturity of less
than one year).
Example 1.4a
If the short-term government treasury bill rate is 6% and the expected rate of
inflation is 3%, what is the real rate of interest?
Solution to Example 1.4a
Rearranging the Fisher equation,
Real rate = (1 + Nominal rate) ÷ (1 + Expected inflation rate) – 1

= 1.06 ÷ 1.03 – 1 = 0.0291
Thus, the real interest rate is 2.91%.
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Note that the Fisher equation is often approximated by using the following formula:
Nominal rate ≈ Real rate + Expected inflation rate
If the approximation formula is applied in Example 1.4a, the real rate would be
approximately 3%.
Finally, as noted, interest rates include expected inflation. Actual inflation may, however,
turn out to be higher or lower than anticipated; this creates “winners” and “losers” in
lending agreements:
• If actual inflation exceeds expected inflation, then the borrower “wins;” the lender is
paid back in dollars that are worth less than the lender expected.
• If actual inflation is less than expected inflation, then the lender “wins;” the lender is
paid back in dollars that are more valuable than anticipated.
As a consequence, uncertainty about future inflation can make both potential lenders
and borrowers reluctant to enter into loan agreements. This can inhibit lending and
borrowing. Importantly, because inflation is harder to predict over more distant time
spans, the impact is likely to be greater on loans with longer maturities.
1.4-4 The term structure of interest rates

The term structure (or yield curve) is the relationship between the annual interest rate,
or YTM, and the term to maturity. As portrayed in the figure in Topic 1.4-1, the shape of
the yield curve is typically upward sloping — annual rates are higher on securities that
have a longer term to maturity. When the yield curve assumes this shape, it indicates
that investors require additional compensation for committing to longer term
investments as compared to shorter term ones.
To provide context, the current annual YTM on Government of Canada marketable

bonds across different terms to maturity as at April 12, 2018, are as follows: 3
Term to maturity Average yield

1-3 years 1.88%
4-5 years 2.08%
6-10 years 2.22%
> 10 years 2.36%
Thus, the yield curve represented by these annual yields (interest rates) on risk-free
Government of Canada marketable bonds is indeed upward sloping.
Although the typical shape of the yield curve is upward sloping because rates tend to be
higher for long-term investments than for short-term investments, there is no reason that
3
https://www.bankofcanada.ca/rates/interest-rates/canadian-bonds/
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it will always assume this shape. In fact, over time there have also been periods when it
has been downward sloping, although this occurs much less frequently.
One theory frequently advanced to explain the shape of the yield curve is referred to as
the expectations theory. The expectations theory proposes that the shape of the yield
curve reflects investors’ expectations about future interest rates. Under this theory, the
annual rate of return on a security with a maturity of n years is equal to the geometric
average of the returns expected from holding a series of securities with one-year
maturities over the same n years. Interest rates implied by the expectations theory are
then reflected in the following formula:
(1 + kn)n = (1 + r1)(1 + r2) … (1 + rn)
where
kn = the average annual return that an investor earns over a period of n years
rn = expected interest rate for a one-year loan during year n
The expectations theory is illustrated in the following two examples.
Example 1.4b
Assume that the YTM on government bonds with a maturity of one year is 10%.
Given expectations about future economic activity, investors believe that the
YTM on one-year government bonds will be 11.5% next year.
If you decide to invest in government bonds with a two-year maturity today,

based on the expectations theory, what should the annualized rate for these
bonds be today?
Solution to Example 1.4b
Under the expectations theory,
(1 + kn)n = (1 + r1)(1 + r2) = (1.10)(1.115) = 1.2265
kn = (1.2265)1/2 – 1 = 0.1075
Thus, based on the expectations theory, the annualized rate of return offered by
the two-year bond will be 10.75%.
Example 1.4c
The YTM on government bonds with a maturity of one year is 10%. As investors
currently believe that interest rates are relatively high, they believe that they will
fall over the next several years. As a result, the expected interest rates on one-
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year government bonds are 8% next year (year 2) and 6% the following year
(year 3).
Based on the expectations theory, what should the current annualized yields
offered by government bonds with two-year and three-year maturities be?
Solution to Example 1.4c
Given r1 = 0.10
r2 = 0.08
r3 = 0.06
(1 + k2)2 = (1 + r1)(1 + r2) = (1.10)(1.08) = 1.188 k2 = (1.188)1/2 – 1 = 0.0900
(1 + k3)3 = (1.10)(1.08)(1.06) = 1.25928 k3 = (1.25928)1/3 – 1 = 0.0799
Thus, based on the expectations theory, the annualized rate of return offered by
the two-year and three-year maturity bonds will be 9.00% and 7.99%,
respectively.
Note: The yield curve depicted in Example 1.4b is upward sloping whereas the yield
depicted in Example 1.4c is downward sloping. Thus, as can be inferred from these two
examples, under the expectations theory, the shape of the yield curve is dependent
upon expectations about whether future one-year interest rates will be higher or lower
than the current one-year interest rate.
1.4-5 The risk premium

Given that investors are risk averse, they will demand a higher rate of return to invest in
risky securities. There are additional components of the risk premium compensating the
investor for any additional risk beyond the risk-free rate for debt. As expected, this risk
premium will be larger for securities with greater risk than those with less risk.
In addition to maturity impacts on interest rates as described by the term structure of

interest rates, sources of risk include the following:
• Default risk is the risk that the borrower may not be able to make the required
payments.
• Liquidity risk refers to the fact that some investments may not be readily sold
because there is not an active market for their sale.
• Issue-specific features refer to special characteristics of the investment that may
make it more or less attractive to an investor.
As presented in the Topic 1.4-2, one way in which data on bond yields can be viewed in
from the perspective of the yield curve. In general terms, the yield curve portrays the
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relationship between yield (interest rate) and term to maturity, holding risk constant
(above, it was developed in terms of risk-free government bonds).
A second perspective is the relationship between yield and risk, holding maturity
constant. Here, as argued, the yield on riskier securities should be higher because they
should attract a larger risk premium.
The following schedule presents the average yield for bonds with maturities between
three and five years for selected issuers as at April 12, 2018, and their rating (risk
category) from the DBRS:
Issuer DBRS Bond Rating YTM

Government of Canada AAA 2.08%
Province of Alberta AA 2.82%
Loblaw Companies Ltd BBB 4.05%
Bombardier Inc. B 5.72%
As expected, as the DBRS rating declines, the average yield across the issuer’s mid-
term bonds increases. Specifically, the AAA-rated Government of Canada mid-term
bonds have a YTM (2.08%) that is lower than the mid-term bonds with similar maturity
dates of AA-rated Province of Alberta (2.82%) which in turn have a lower yield than the
BBB-rated Loblaw Companies mid-term bonds (4.05%), and finally the B-rated
Bombardier mid-term bonds (5.72%). While the terms to maturities of the various mid-
term bonds are identical across issuers, the message is relatively clear — higher risk
requires a higher yield reflecting a greater risk premium.
TOPIC 1.5: MATHEMATICS OF FINANCE — THE TIME VALUE OF MONEY
Learning objectives
• Calculate the present value and future value of a single amount or a stream of cash
flows.
• Calculate the present value and future value of an annuity.
• Calculate the effective annual interest rate for a stream of cash flows.
The operating, financing, and investing decisions that the financial executive makes
involve a series of cash flows, with many of these cash flows occurring in the future. As
a result, the financial executive is faced with two basic challenges. The first is that these
cash flows almost always occur at different points in time. The second is that there is
uncertainty associated with future cash flows. Thus, when making decisions, the
financial executive has to compare cash flows with different timings. In addition, the
future cash flows on which the decisions are based are only estimates. The challenge
for the executive is to incorporate both the timing and the uncertainty of these future
cash flows into their analysis.
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The following discussion illustrates how both the timing of the cash flows and their
uncertainty can be incorporated into the analysis through the use of mathematical
formulas.
1.5-1 Interest
Interest is the money that a borrower pays to a lender to borrow the lender’s money for
a certain period of time. The money borrowed or loaned is called the principal. The rate
of interest is the amount charged for the use of the principal. Rates of interest are
usually expressed as a percentage.
Simple interest
When interest is paid only on the principal and not on any interest that accrues
subsequently, the interest is called simple interest. The total amount of simple interest
paid or earned (I) can be determined using the following formula:
I = PV × i × n
where
PV = the principal amount borrowed or invested today (also referred to as Present

Value)
n = the number of periods
i = the interest rate
The future value (FV) of the investment (or loan), which is the sum of the principal and
interest, can then expressed as follows:
FV = PV + (PV × i × n) = PV (1 + i × n)
Example 1.5a
a) If you deposit $100 in a savings account that pays simple interest at an

annual rate of 3%, what will the balance of your account be at the end of
three years?
b) If you borrow $1,000 from your bank at an annual simple interest rate of 12%
and do not make any payments, how much will you owe at the end of five
years?
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Solution to Example 1.5a
a) Timeline showing cash deposited
Time - Year
0 1 2 3
$100 ???
FV = 100 (1 + 0.03 × 3) = $109
b) FV = 1,000 (1 + 0.12 × 5) = $1,600
Compound interest
With simple interest, the interest is not reinvested; interest is earned only on the original
principal. A more common situation is when interest is paid or accrued on the principal
plus the accumulated interest. This is called compound interest.
Consider the situation in part a) of Example 1.5a, but assume that the interest of 3% is
compound interest. This is how the account balance would increase:
Year 1 $100 + 3% interest = 100 × 1.03 = $103
Year 2 $103 + 3% interest = 103 × 1.03 = $106.09
Year 3 $106.09 + 3% interest = 106.09 × 1.03 = $109.27
With compound interest, the FV is expressed using the following formula:

FV = PV (1 + i)n
If the interest in part a) of Example 1.5a was compound interest:

FV = 100 (1 + 0.03)3 = $109.27
If the interest in part b) of Example 1.5a was compound interest:

FV = 1,000 (1 + 0.12)5 = $1,762.34
Clearly based on these examples, the FV can be quite different depending on whether
you use compound interest or simple interest. This difference is much smaller over a
short period of time but increases rapidly as the time frame increases. This is the power
of compound interest.
The formulas above can also be rearranged in order to determine the amount needed
today — the present value (PV) — based on the amount to be received or paid in the
future. Specifically, inverting the formula for FV with compound interest provides the
formula for calculation of the PV.
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FV -n
FV = PV (1 + i)n ⇒ PV = = FV (1+i)
(1 + i)n
Note: PV and FV problems can be solved using two different methods:

1. The formulas provided above
2. A financial calculator
Example 1.5b
In five years’ time, John needs to have $15,000 to finance his daughter’s first
year of university education. Assuming that he can earn 8% interest compounded
annually, how much will he need to invest today to have the $15,000 available in
five years, ignoring taxes?
Solution to Example 1.5b
Timeline showing the amount of cash wanted at the end of five years:
Time - Year
0 1 2 3 4 5
??? $15,000
PV = FV (1 + i)–n = 15,000 (1 + 0.08)–5 = $10,208.75
Using the financial calculator:

N = 5 years
I/Y = 8% return per year
FV = $15,000
PMT = 0
CPT PV = –$10,208.75
Tip: When you use a financial calculator, results shown are often negative. This
is because it calculates the PV or FV by setting the sum of PV and FV as zero.
Or, think of it this way – based on the above example, you need to invest
(meaning cash flows out) $10,208.75 to get (cash flow in) of $15,000 in 5 years.
Thus the $15,000 is a positive amount and the $10,208.75 is a negative amount.
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Example 1.5c
You’ve just received an inheritance of $10,000. Your 10th wedding anniversary is

in five years, and you’d like to plan a special vacation with your spouse. How
much would you have at the end of five years, assuming that you could invest the
inheritance at 7% return compounded annually?
Solution to Example 1.5c
FV = PV (1 + i)n = 10,000 (1 + 0.07)5 = $14,025.52

N = 5 years
PV = –$10,000
PMT = 0
CPT FV = $14,025.52
Depending on which number is entered positively, the other will be negative.

Enter cash outflows as negatives. In the current example, the initial investment
(PV) is a cash outflow and should be entered as –$10,000. The final balance, a
cash inflow, will then be positive. It is important to note the point of view outlined
in a given question when using your financial calculator. An investor would
assess the interest from a bond, for example, as a cash inflow but the bond
issuer would see that same amount as a cash outflow.
The same principles can be applied to determine the PV or FV of a series of cash

flows that occur at different points in time as illustrated in the following example:
Example 1.5d
You expect to receive a series of gifts from your aunt at the end of each of the
next three years: $200 in one year, $250 in two years, and $300 in three years.
You intend to deposit each gift into a savings account that pays 6% interest
compounded annually.
a) How much will you have in the account at the end of the three years?
b) What is the PV of this series of gifts?
c) What do these two figures tell you, and how do they relate to each
other?
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Solution to Example 1.5d
This represents three separate lump sums, each of which will earn a return for a
different period of time.
Timeline showing the cash payments received each year:
Time - Year
0 1 2 3
$200 $250 $300
a) FV = 200 (1 + 0.06)2 + 250 (1 + 0.06) + 300 = $789.72
b) PV = 200 (1 + 0.06)–1 + 250 (1 + 0.06)–2 + 300 (1 + 0.06)–3 = $663.06
c) The FV figure is the balance in the account at the end of the three
years after receiving the third payment.
The PV is the equivalent amount required in the account today to

generate the same final balance that you would have in the account if
you receive and deposit the gifts as indicated.
If you deposit $663.06 into a savings account paying 6% interest
compounded annually for three years, the ending balance will be
$789.72, the FV amount calculated in part a):
FV = 663.06 (1 + 0.06)3 = $789.72
Alternatively, if you require a balance of $789.72 at the end of three

years, you would need to deposit the PV amount calculated in b)
($663.06) today:
PV = 789.72 (1 + 0.06)–3 = $663.06
More broadly, if you can deposit the cash flows in an account that pays 6%
interest compounded annually, you would be indifferent between the following
three alternatives:
1. Receiving a lump sum of $663.06 today
2. Receiving the series of payments specified above over the three-year
period
3. Receiving a lump sum of $789.72 at the end of three years
The reason that you would be indifferent between these three alternatives is that
no matter which you receive, you can always create the other two.
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First, if you receive the lump sum of $663.06 today, as indicated by the FV
calculation above, you can deposit it and have a balance of $789.72 in three
years. Equally, if you need $663.06 today and know that you will receive $789.72
in three years, you can borrow the $663.06 today and then exactly repay the loan
with the $789.72 that you will receive in three years. Thus, assuming that you
can invest and borrow at a rate of 6% interest compounded annually, you will be
indifferent between receiving the lump sum of $663.06 today or receiving the
lump sum of $789.72 in three years. Given one, you can create the other.
Second, if you receive the lump sum of $663.06 today and deposit it into the
savings account paying 6% interest compounded annually, as illustrated by the
following schedule, you can recreate the series of payments by making a series
of withdrawals from the account in the required amounts.
Beginning Interest Ending

Year balance @ 6% Payment balance
1 663.06 39.78 –200 502.84
2 502.84 30.17 –250 283.01
3 283.01 16.99 –300 0.00
(May not add due to rounding.)
As this example illustrates, there is a natural relationship between the PV and FV

of the same series of cash flows, and the series of cash flows themselves, where
the relationship is defined through the interest rate. Thus, be calculating PV
today, or FV for a specific point in the future, the financial executive is able to
directly compare cash flows that occur at different points in time and thereby
make decisions on a common basis.
Importantly, as discussed in the previous topic, one component or determinant of the

interest rate is the risk premium. Thus, not only does the interest rate allow the financial
executive to directly compare cash flows that occur at different points in time, equally it
also incorporates the riskiness or uncertainty associated with estimated future cash
flows into the analysis.
The process of calculating the PV of cash flows received or paid at future dates is
known as discounting, and the rate (i) is known as the discount rate.
1.5-2 Annuities
When the series of cash flows are for the same amount (A) and they occur at a
regular interval, this is known as an annuity. An annuity where the payments
occur at the end of each period is called an ordinary annuity, whereas an annuity
paid at the beginning of the period is called an annuity due.
Note: Unless otherwise stated, assume that the cash flows occur at the end of
the period (ordinary annuity).
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As with the series of lump-sum payments illustrated in Example 1.5d above, the
PV can be calculated by discounting the value of each payment (A) back to the
present day and then totalling them as follows:
PV = A (1 + i)–1 + A (1 + i)–2 + … + A (1 + i)–n
where
A = periodic amount of the annuity
n = number of periods
i = rate of return
Alternatively, given the specific pattern to the cash flows, the PV of the annuity
(ordinary annuity) can be calculated directly and more simply using the following
formula:
1 − (1 + i)−n
PV = A � �
i
The FV of the annuity can also be calculated directly using the following formula:
(1 + i)n − 1
FV = A � �
i
Finally, these formulas can be rearranged to determine the required annuity payment
(A) if the interest rate and either the PV or the FV is given.
Example 1.5e
Tony expects to receive $5,000 per year from an investment for four years. What
is the PV of the investment if investments of this type currently yield a rate of
return of 5% compounded annually?
Solution to Example 1.5e
𝟏𝟏 − (𝟏𝟏 + 𝒊𝒊)−𝒏𝒏 𝟏𝟏 − (𝟏𝟏 + 𝟎𝟎. 𝟎𝟎𝟎𝟎)−𝟒𝟒

𝑷𝑷𝑷𝑷 = 𝑨𝑨 � � = 𝟓𝟓, 𝟎𝟎𝟎𝟎𝟎𝟎 � � = $𝟏𝟏𝟏𝟏, 𝟕𝟕𝟕𝟕𝟕𝟕. 𝟕𝟕𝟕𝟕
𝒊𝒊 𝟎𝟎. 𝟎𝟎𝟎𝟎

N = 4 years
PMT = $5,000 (the PMT is the annuity)
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FV = 0
CPT PV = –$17,729.75
Example 1.5f
A savings product from an insurance company guarantees a return of 10%

compounded annually if you invest $3,000 per year for seven years. What will the
value of the investment be in seven years if you make all of the required
investments?
Solution to Example 1.5f
Timeline showing annual investments of cash per year:
Time - Year
0 1 2 3 4 5 6 7
$3,000 $3,000 $3,000 $3,000 $3,000 $3,000 $3,000
(1 + i)n − 1 (1 + 0.10)7 − 1
FV = A � � = 3,000 � � = $28,461.51
i 0.10

N = 7 years
PMT = –$3,000
PV = 0
CPT FV = $28,461.51
Example 1.5g
Helene has invested $10,000 in a fund that will pay her an annuity at the end of
each of the next five years. If the interest rate offered by the fund is 12%
compounded annually, what is the amount of the annual annuity that Helene
should receive?
Solution to Example 1.5g
1 − (1 + i)−n
Because PV = A � �, then
i
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A = PV ÷ {[1 – (1 + i)–n] ÷ i}
A = PV ÷ { [1 – (1 + i)–n] ÷ i}
A = 10,000 ÷ { [1 − (1 + 0.12)−5] ÷ 0.12} = $2,774.10

N = 5 years
PV = –$10,000
FV = 0
CPT PMT = $2,774.10
Helene should receive an annual payment of $2,774.10 at the end of each

of the next five years from her investment of $10,000.
Example 1.5h
Your child will go to school in six years’ time. If school fees in six years’
time are estimated at $9,000 per year, calculate how much you will have
to invest annually at 10% per annum to pay the first year’s fees.
Solution to Example 1.5h
(𝟏𝟏 + 𝐢𝐢)𝐧𝐧 − 𝟏𝟏
Because FV = A � �, then
𝐢𝐢
A = FV ÷ {[(1 + i)n – 1] ÷ i}
A = FV ÷ { [(1 + i)n – 1]÷ i}
A = $9,000 ÷ { [(1 + 0.10)6 – 1] ÷ 0.10} = $1,166.47

N = 6 years
PV = 0
FV = $9,000
CPT PMT = –$1,166.47
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You must invest $1,166.47 at the end of each year for six years to
accumulate the $9,000 required to meet the first year’s fees of
$9,000.
In the special case when the series of payments continues indefinitely, the series is
called a perpetuity. An example of a perpetuity is the dividends on preferred shares
because the shares don’t have a maturity date. With a perpetuity, the present-value
formula can be further simplified:
A
PV =
i
Finally, as mentioned at the start of this topic, it is assumed that the annuity is an
ordinary annuity — payments are made or received at the end of each period.
Alternatively, for an annuity due, where payments are received or made at the
beginning of each period, each payment is available one period earlier. Thus, the
present and future values of an annuity due can be determined by simply multiplying the
PV and FV formulas for an ordinary annuity by (1 + i). If you are using a financial
calculator, set the mode to [BGN].
1.5-3 Effective annual rate of interest

In the examples so far, interest has compounded annually. Often, however, interest is
charged or paid more frequently. For example, for a savings account, the bank may
calculate and pay interest monthly rather than annually. Similarly, bonds typically pay
interest semi-annually.
Interest rates are almost always quoted as annual rates (that is, rates without any
adjustments such as compounding) compounded at a different interval. The quoted
rates are known as the nominal or stated interest rates. If interest is calculated more
frequently than once a year, the actual or effective annual interest rate will be higher
than the nominal or stated interest rate.
To convert a nominal or stated annual interest rate to the effective rate for the
compounding period, simply divide the annual rate by the number of compounding
periods (i divided by n) and raise this figure to the power indicated by the number of
compounding periods (n). Below, there are two methods demonstrated to calculate the
effective annual interest rate — the formula method and the calculator method.
1. Use the following formula:

i
Effective annual rate = (1 + )n − 1
n
2. Use the “ICONV” function on the calculator.
Some key definitions:

NOM is the nominal interest rate, which is measured per annum.
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C/Y is the number of compounding periods per year (that is, for semi-annual
compounding C/Y is 2 and for quarterly compounding C/Y is 4).
EFF is the effective annual interest rate.
To access the ICONV function:

1. Press the “2nd” key and then press “2”. You will notice that “ICONV” is above the “2”
key, showing that the “ICONV” function can be accessed in the 2nd functions.
2. You will see “NOM=” displayed on the screen. Here, enter the nominal interest rate
per annum and then press the “ENTER” key.
3. Use the down-arrow keys (press the down-arrow key twice) to navigate to where the
screen now displays “C/Y=”. Enter the number of compounding periods per annum
and then press the “ENTER” key.
4. Use the up-arrow key (press the up-arrow key once only) to navigate to where the
screen displays “EFF=” and then press “CPT”.
5. The screen should then display the effective annual interest rate computed based on
the inputs made.
6. The actual keystrokes are detailed below for the first example to calculate the
effective annual interest rate.
Example 1.5i
You have just deposited $100 into a savings account at your bank that pays a
nominal interest rate of 6% per year. You intend to leave the money in the
account for five years. Calculate the effective annual interest rate that you will
earn, and your final balance at the end of five years under each of the following
scenarios:
a) Interest is compounded semi-annually (twice a year).
b) Interest is compounded quarterly (four times per year).
c) Interest is compounded monthly (12 times per year).
Solution to Example 1.5i
a) With interest compounded semi-annually, the semi-annual interest rate is 6%

÷ 2 = 3%.
i. Using the formula method, the effective annual interest rate is 6.09%:
i
(1 + )n − 1 = 1.032 – 1 = 0.0609
n
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ii. Using the calculator method, the effective annual interest rate is
determined to be 6.09% using the following inputs:
NOM = 6; C/Y = 2; CPT EFF = 6.09
The next steps are as follows:

Step 1: To enter “NOM” as “6” and “C/Y” as “2”
Press the “2nd” key and then press “2”. “ICONV” is above the “2” key.
Once “NOM=” is displayed on the screen, press “6” and “ENTER”.
Press the down-arrow key twice to where the screen displays “C/Y=” and
then press “2” and “ENTER”.
Step 2: To compute EFF
Press the up-arrow key once to where the screen displays “EFF=” and
then press “CPT”.
The screen now displays “EFF = 6.09”.
For the five-year investment period, there will be 2 × 5 = 10 semi-annual

compounding periods. The balance at the end of the five years will be
$134.39:
Ending balance = 100 × 1.0310 = $134.39
b) With interest compounded quarterly, the quarterly interest rate is 1.5%.
i. Using the formula method, the effective annual interest rate is 6.14%:
Effective annual interest rate = 1.0154 – 1 = 0.0614
determined to be 6.14% using the following inputs (and steps outlined
above):
NOM = 6; C/Y = 4; CPT EFF = 6.14
Ending balance = 100 × 1.01520 = $134.69
c) With interest compounded monthly, the monthly interest rate is 0.5%.
i. Using the formula method, the effective annual interest rate is then 6.17%:
Effective annual interest rate = 1.00512 – 1 = 0.0617
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determined to be 6.17% using the following inputs (and steps outlined
above):
NOM = 6; C/Y = 12; CPT EFF = 6.17
Ending balance = 100 × 1.00560 = $134.89
Thus, as illustrated, the effective annual rate of interest increases when interest is
compounded more frequently (with a shorter compounding period).
Example 1.5j
You have been trying to sell your car and have received two offers. The first offer
is for $10,500 cash today. The second offer is for $250 to be paid semi-monthly
for two years. You can earn a stated annual interest rate on these payments of
6% compounded semi-monthly. Which is the better offer?
Solution to Example 1.5j
The second offer is for 48 semi-monthly payments of $250 with an effective

monthly interest rate of 0.5% or 0.25% semi-monthly. The PV of this annuity is
$11,294.67.
𝟏𝟏 − (𝟏𝟏 + 𝟎𝟎.𝟎𝟎𝟎𝟎𝟎𝟎𝟎𝟎)−𝟒𝟒𝟒𝟒
𝑷𝑷𝑷𝑷 = 𝟐𝟐𝟐𝟐𝟐𝟐 � � = $𝟏𝟏𝟏𝟏, 𝟐𝟐𝟐𝟐𝟐𝟐. 𝟔𝟔𝟔𝟔
𝟎𝟎.𝟎𝟎𝟎𝟎𝟎𝟎𝟎𝟎

N = 48 semi-monthly periods
I/Y = 0.25% semi-monthly
PMT = –$250
CPT PV = $11,294.67
The series of monthly payments is a better offer because their PV of

$11,294.67 exceeds the cash payment of $10,500 today. Note that the
non-payment by the buyer is reflected in the discount rate, while cash
today has no risk attached.
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Example 1.5k
You have decided to lease a new car. The lease contract calls for payments of
$300 per month at the beginning of each month for 60 months (five years). What
is the PV of the lease payments that you will make if the stated annual interest
rate is 6%, compounded monthly?
Solution to Example 1.5k
The lease contract will involve 60 payments, with the first payment made at the
start of the lease followed by 59 equal payments at the beginning of each month,
to cover the 60-month lease period. The effective interest rate is 0.5% per month
(6% ÷ 12 = 0.5%). (Note that this is an annuity due, where you pay at the
beginning of each month.)
The timeline below shows that the first payment is made at Time 0, and then at
the beginning of each month (rather than at the end of each month).
Time — Month
0 1 2 3 4 5 ….......... 59 60
$300 $300 $300 $300 $300 $300 $300 $300
1 − (1 + i)−n
PV = A � � × (1 + i)
i
1 − (1.005)−60
= 300 � � × (1.005)
0.005
= $15,595.26
Using the financial calculator, set to [BGN] mode:

N = 60 months
I/Y = 0.5% per month
PMT = –$300
CPT PV = $15,595.26
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WEEK 1 SUMMARY
The following is a list of the competencies from the CPA Competency Map that pertain
to this week’s subject matter identified by their number in the map. For more information
on the CPA Competency Map, see the CPA Canada website
(https://www.cpacanada.ca/en/become-a-cpa/pathways-to-becoming-a-cpa/national-
education-resources/the-cpa-competency-map).
Competencies:
5.1.2 Develops or evaluates financial proposals and financing plans
5.1.3 Assesses reporting systems, data quality, and the analytical models used to
support financial analysis and decision-making
5.2.2 Evaluates the entity’s investment portfolio
5.2.3 Evaluates sources of financing
Topic 1.1: Introduction
• A financial executive has three key functions:

o raising capital to finance long-term investments
o investing this capital to increase shareholders’ wealth
o managing net working capital (current assets and current liabilities), including the
company’s cash flows
• Many of the decisions made by the financial executives involve cash flows received
or paid today or at some time in the future. The financial executive uses financial
statements to assist with decisions.
Topic 1.2: Financial markets
• Primary markets involve a borrower issuing new securities for cash received directly
from the lenders or investors.
• Secondary markets are where the trading of these securities occurs, with investors
buying from and selling to each other and providing investors with an opportunity to
liquidate investments as desired.
• These secondary markets can be as follows:
o OTC markets
o exchange markets
o dealer markets
In Canada, these markets are regulated by the provinces to ensure that fraudulent or
misleading securities are not sold in the secondary markets.
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• A firm wishing to go public must follow the IPO process, which consists of four
stages.
o Investment dealers are hired to assist with all stages of this process:
 discussion with investment dealer
 preliminary prospectus
 the waiting period
 the distribution period
• Private placement is an alternative to the public market and may occur through the
exempt market, which is not regulated.
• Venture capitalists are another source of financing for startup companies that cannot
raise funds through the traditional channels.
• Venture capitalists will generally provide cash in return for shares and/or options in
the company.
• The investment is usually for a short period of time, after which the venture
capitalists will sell their shares, often as part of an IPO.
• There are three types of market efficiency:

o operational
o allocational
o informational (or pricing):
 weak
 semi-strong
 strong
• It is important that a market has informational efficiency to encourage investments,
facilitate financial decisions, and appropriately allocate resources.
• Research indicates that the market in general will meet the requirements of a weak
and semi-strong informationally efficient market.
• There are many ethical issues surrounding how data is used to make investment
decisions.
Topic 1.3: Major financial securities
Debt
• Investors receive interest payments and principal; but the value of the bond will vary
depending on prevailing interest rates, and there is the risk that the issuer may
default on its payments.
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• The cost of debt is lower than the cost of equity because debt is less risky than
equity to the investor.
• Debtholders have no ownership in the company and usually no potential capital
appreciation (unless interest rates in the market change).
• The issuer is committed to paying the fixed amount of interest and principal when
due.
• Interest is tax-deductible.
• There is no loss of ownership in the company when bonds are issued.
Types of debt securities
• Short-term securities:
o These are fixed income with maturities of less than one year.
o Examples include T-bills, commercial paper, and banker’s acceptances.
• Long-term bonds and debentures:
o A bond is a legal obligation.
o Bonds generally promise to pay interest and principal.
o A bond indenture (the bond contract) will outline coupon rates, maturity, face
value, and any special features.
o Other additional features may include priority of payment, collateral, sinking
funds, retraction, extension, and call provisions.
o Bonds quotes are in terms of a $100 face value.
o The yield to maturity is the annualized return that an investor receives if the bond
is purchased today and held to maturity.
o Credit rating agencies grade the risk of default by the issuer impacting the market
yield; that is, the higher the default risk is, the higher will be the current market
yield.
Equity
• The investor has uncertain risk for future dividends and capital appreciation.
• The investor also has ownership and voting control.
• If debt is issued, the equity investor can leverage the debt to realize higher returns.
• From the business perspective, there are no obligatory payments required.
• Percentage ownership is diluted when equity is issued.
• Dividends are not tax-deductible.
44 / 49
Types of equity securities
• Preferred shares:
o These have a stated dividend rate but a dividend is not a contractual obligation
and is only paid when declared by the board.
o Dividends can be cumulative or non-cumulative.
o Dividends are not tax-deductible.
o Preferred shares may also be rated by credit rating agencies.
o They will rank ahead of common shareholders for both the payment of dividends
and on dissolution.
• Common shares:
o Dividends are not fixed and are only paid at the discretion of the board.
o Dividends are not tax-deductible.
Other types of equity securities
• Convertible securities:
o Convertible bonds or convertible preferred shares are bonds or preferred shares
that may be converted into common shares.
o The conversion ratio specifies the number of shares that would be issued on
conversion.
o The investor will receive interest on the bonds or the preferred share dividends
prior to conversion.
• Warrants:
o These give the holder the right to buy common shares of the company at a
specified price for a specified period.
o They can be attached to bonds to make the investment more attractive to reduce
the coupon rate required to be paid on the bond.
• Share rights:
o Rights are issued to existing shareholders, giving them the first right of refusal to
buy additional shares in a new share offering. This allows existing shareholders
to maintain their existing proportionate ownership if they so wish. If not, the rights
can be sold.
45 / 49
Topic 1.4: Interest rates
• Interest rates are the costs associated with borrowing. They reflect four components:
o the prevailing risk-free rate
o expected inflation
o term structure for different maturities
o risk premiums for:
 the borrower’s default risk
 liquidity risk related to being able to sell the investment
 any risks related to special features of the debt
• You should be familiar with and able to calculate the Fisher equation for nominal and
real rates.
Topic 1.5: Mathematics of finance — The time value of money
• Any analysis has to compensate for the cash flows occurring at different times and
for their uncertainty.
o The time value of money concepts are vital to incorporate into these calculations.
o Time value of money concepts are mathematical formulas that allow for a
comparison of cash flows today with uncertain cash flows in the future.
o The discount rate (interest rate) used in the calculations allow the financial
executive to directly compare cash flows that occur at different points in time and
includes a risk premium that incorporates the riskiness or uncertainty associated
with estimated future cash flows into the analysis.
• You should be familiar with the formulas for the following and be able to calculate
using a financial calculator:
o simple interest
o compound interest
o annuities and annuities due
O effective annual interest rates
• the discount rate used in the calculations allows the financial executive to directly
compare cash flows that occur at different points in time and also incorporates the
riskiness or uncertainty associated with estimated future cash flows into the analysis
46 / 49
SUMMARY OF FORMULAS
PV, FV, and annuities may be calculated more efficiently using a financial calculator.
You are encouraged to learn how to use the calculator rather than going through these
formulas.
Simple interest
I = PV × i × n
where
I = simple interest
PV = present value (the initial principal)
i = interest rate
Future value with simple interest
FV = PV + (PV × i × n) = PV (1 + i × n)
where
FV = future value
PV = present value (the initial principal)
i = interest rate
Future value with compound interest
FV = PV (1 + i)n
where
FV = future value
PV = present value (the initial amount)
i = interest rate for the period
Present value with compound interest
FV –n
PV = = FV (1 + i)
(1 + i)n
where
PV = present value
FV = future value (amount due at the end of n periods)
i = interest rate
47 / 49
Effective annual rate

i n
Effective annual rate = �1 + � − 1
n
where
i = nominal or stated annual interest rate
n = the number of compounding periods per year
Present value of an ordinary annuity
1 – (1 + i)–n
PV = A � �
i
where
PV = present value
A = annuity
i = rate of return
Annuity received from a fixed amount
A = PV × {i ÷ [1 – (1 + i)–n]}
where
A = annuity
i = rate of return
PV = investment (or present value)
Future value of an ordinary annuity
(1 + i)n − 1
FV = A � �
i
where
FV = future value
A = annuity
i = rate of return
48 / 49
Amount of money to be set aside annually to achieve a specific value after n

years
A = FV × {i ÷ [(1 + i)n – 1]}
where
A = annuity (amount to be set aside annually)
FV = future value
i = rate of return
Present value of perpetuity
A
PV =
i
where
PV = present value
A = annuity
i = rate of return
Expectations theory of interest rates:
(1 + kn)n = (1 + r1)(1 + r2) … (1 + rn)
where
kn = the average annualized return that an investor earns over a period of n years
rn = expected interest rate for a one-year loan during year n
Fisher equation
Nominal rate = (1 + Real rate) × (1 + Expected inflation rate) – 1
Real interest rate
Real interest rate = (1 + Nominal rate) ÷ (1 + Expected inflation rate) – 1
49 / 49

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Corporate Finance

Chartered Professional Accountants of Canada, CPA Canada, CPA

TOPIC 1.1: INTRODUCTION ...................................................................................... 1

WEEK 1 — STUDENT NOTES

TOPIC 1.1: INTRODUCTION

The topics that follow explore these functions in some detail.

1.1-1 Investment (capital budgeting)

1.1-3 Management of daily financial activities

These three areas of responsibility — investment, financing, and management of daily

1.1-4 Finance perspective on the financial statements

• Reviewing the statement of financial position to understand the assets owned by an

An understanding of an entity’s financial statements is critical for the financial executive.

TOPIC 1.2: FINANCIAL MARKETS

1.2-1 Primary and secondary markets

Financial intermediaries include institutions such as commercial banks, insurance

In Canada, there is no federal securities regulator; this responsibility is assigned to the

The four basis stages of a typical IPO are as follows.

Stage 1: Discussion with the investment dealer(s)

Stage 2: Preliminary prospectus

Stage 3: The waiting period

Stage 4: The distribution period

A venture capitalist specializes in providing private equity capital to startup companies

1.2-2 Market efficiency and the efficient market hypothesis

• Allocational efficiency: As resources are finite, they should be allocated to where

An informationally (pricing) efficient market gives shareholders the confidence to buy

Consider an individual investor, Raj, a dentist who has $15,000 invested in

Consider Lynda, an analyst employed by a major investment institution. She is a

In summary, informational (pricing) efficiency is critical for three key reasons:

1.2-3 Ethical use of non-traditional data

Each of these perspectives is considered below.

1. Investment analysts using non-traditional sources of information — Factors that

TOPIC 1.3: MAJOR FINANCIAL SECURITIES

1.3-1 Short-term securities

The issuers of money-market instruments are governments, corporations, banks, and

1.3-2 Long-term securities (bonds and debentures)

1.3-3 Equity securities (preferred and common shares)

(ETFs), pension funds, and insurance companies. Individuals participate in share

1.3-4 Other equity securities

1.3-5 Advantages and disadvantages of debt versus equity securities

Equity (common shares)

Equity (preferred shares)

TOPIC 1.4: INTEREST RATES

The following topics discuss each of the four factors in detail.

1.4-2 The short-term risk-free real interest rate

1.4-3 Expected inflation

Nominal rate = (1 + Real rate) × (1 + Expected inflation rate) – 1

Solution to Example 1.4a

Rearranging the Fisher equation,

Real rate = (1 + Nominal rate) ÷ (1 + Expected inflation rate) – 1

Thus, the real interest rate is 2.91%.

1.4-4 The term structure of interest rates

To provide context, the current annual YTM on Government of Canada marketable

Term to maturity Average yield

(1 + kn)n = (1 + r1)(1 + r2) … (1 + rn)

The expectations theory is illustrated in the following two examples.

If you decide to invest in government bonds with a two-year maturity today,

Solution to Example 1.4b

Under the expectations theory,

(1 + kn)n = (1 + r1)(1 + r2) = (1.10)(1.115) = 1.2265

Solution to Example 1.4c

(1 + k2)2 = (1 + r1)(1 + r2) = (1.10)(1.08) = 1.188 k2 = (1.188)1/2 – 1 = 0.0900

(1 + k3)3 = (1.10)(1.08)(1.06) = 1.25928 k3 = (1.25928)1/3 – 1 = 0.0799

1.4-5 The risk premium