Firm objective: Firm objectives are

 Profit maximization  Maximise the value

Profit may refer to:
y y

Profit (accounting), the difference between the purchase price and the costs of bringing to market Profit (economics), has two related but distinct meanings: Normal profit and Economic profit

Accounting vs. Economic Profit

1. Accounting profit is the difference between the total revenue and the total cost, excluding the cost of the opportunity. On the contrary, economic cost is the difference between the total revenue and the total cost, including the cost of the opportunity. 2. Accounting profit can be defined as the revenue deducted from the explicit costs, and economic profits, as the revenue deducted from explicit and implicit costs. 3. When compared to economic profits, accounting profit is calculated for a certain period of time. 4. Economic profit will always be lesser when compared to accounting profits. In comparison with economic profit, the accounting profit is only given during leap years. 5. Accounting profit can be called as the revenue obtained by a firm after all t he economic costs are met. A firm can be said to have accounting profits if the revenue exceeds the accounting cost of the firm.

Limitation of accounting profit:

   

Accounting profit does not provide timely information Accounting profit ignores important no n-monetary information Accounting profit does not provide detailed analysis Accounting profit does not disclose the present value of the business

[If economic profit is taken then this problems are solved with NPV] Fisher separation theorem: A theory stating that: y y There are only two point of time; present time and future time there are no market imperfection and no capital market imperfection

The figure above describes the Fisher Separation Theorem where the line W0 -W1 represents the capital market line . Anywhere along that line shareholders may place them- selves, in terms of consumption, given the company s investment P0 and P1 in year 0 and 1 respectively. The I1 and I2 represent two distinct individual s utility curves and where along the capital market line they wish to consume (C0 for consumption in period 0 and C1 for consumption in period 1). This is possible through borrowing or lending money in the capital market. Consider a two period (for example years) interval, if an investor whishes to consume more next period the strategy is to lend money and consume less this period. I1, in figure 2 -4, is an example of an investor s utility curve that lends money today and consumes more next period. Whereas, I2, in figure 3 -2, is an example of an investor s utility curve who prefer to consume more today and less next period. Hence he or she will borrow funds against next period s income. Wherever one individual wish to end up, between W0 and W1, he or she strives to end up

As far away from the origin as possible (Copeland, et al., 2005)

Investment process: Investment process is concerned with how an investor should proceed in making decisions about what marketable securities to invest in, how extensive the investment should be and when the investment should be made. In order process we have 3 questions:

Where to invest When to invest How much invest

Steps in investment process: 1. Set investment policy: the initial step, setting investment policy, involves determining the investor s objective and the amount of his or her investable wealth. 2. Security analysis: the second step in the investment process, performing security analysis. There are many approaches to security analysis. The first classification is known as technical analysis; analysts who use this approach to security analysis are known as technical analysis. The second classification is known as fundamental analysis; those who use it are known as fundamentalists or fundamental analysis. In discussing these two approaches to security analysis, the focus at first will be on common stocks. Later whey will be discussed in terms of other types of financial assets. 3. Portfolio construction: portfolio construction involves identifying those specific assets in which to invest, as well as determining the proportions of the investor s wealth to put into each one. Here the issues of selectivity, timing and diversification need to be addressed by the investor. 4. Portfolio revision: after portfolio construction, we have revised previous three steps. 5. Portfolio performance evaluation: This step compare between expectation and real scenario of portfolio. The investment environment or climate: Securities Security market Financial intermediary

Securities Securities/financial assets/financial instruments: financial asset represent claim against the future income and asset of the person/firm/government who issued the asset. View point of owner/holder as asset View point of issuer as liability

The financial assets are the main product of financial system. Through this system is lend and borrow money. Different between Physical asset and financial asset Physical asset Financial asset 1. Tangible 1. Intangible 2. Flat, automobile, land etc we get 2. Does not provide regular service but continuous service. a future payment 3. a physical asset subject to 3. Financial asset does not subject to depreciation depreciation. 4. Less liquidity 4. Easily liquidity 5. Transportation cost high 5. Less transportation cost 6. Inflation affect less or sometime 6. Inflation affect money beneficial 7. Physical asset only convert in to cash 7. Financial asset is fungible. Different kinds of financial assets: Money: Any financial asset that is generally accepted in payment for purchases of goods and services is money. Money supply:
 . (Reserve; commercial bank to central bank deposit) The total amount of physical currencies along with central b ank accounts, which can be converted into physical currency.  (Currency + demand deposit) M0 minus the components of M0 which are held as vault cash or reserves + the amount deposited in checking or current accounts also known as demand accounts.     It refers to M1+ the majority of savings accounts, time deposits with small denominations (including CDs less than $100,000), and money market accounts. 

It refers to M2+ every other type of certificates of deposit (CDs), repurchase agreements, and Eurodollar deposits. Equities Equities represent ownership shares in a business firm.

 Common stock: Common stock is a form of ownership in a corporation. Holders of common stock, mostly, have voting rights in the election of corporate boards and the policies set forth.  Preferred stock: Preferred stock is a type of stock that has preference over common stock. That is, dividends on preferred stock are paid out before those of common stock.
Debt securities: Debt securities include such familiar instruments as bonds, notes, account payable, and savings deposits. Financial analysts usually divide debt securities into two brad classes.

 Negotiable: negotiable which can easily be transferred from holder as marketable security.  Nonnegotiable: nonnegotiable which cannot legally be transferred to another party.
Derivatives: Derivatives are among the newest kinds of financial instruments that are closely linked to financial assets. Example: future contracts, options and swaps.

Securities market or financial market Three types of markets at work within the global economic system: (1) factor markets (2) product markets and (3) financial markets Financial market A financial market is the system or economy relating to the management of money and assets. It refers to buying, selling, trading, investing, and all other aspects of the money market. Financial markets are segmented into money markets and capital markets. 1. Money market instruments (they are called cash equivalents, or just cash for short) include short-term, marketable, liquid, low-risk debt securities.

2. Capital markets include longer-term and riskier securities. We subdivide the capital market into four segments: longer-term bond markets, equity markets, and the derivative markets for options and futures.

 Primary market: the primary market is for the trading of new securities.  Secondary market: the secondary market deals in securities previously issued.
Money market versus capital market

 The money market is designed for the making short-term loans where individuals and institutions with temporary surpluses of funds meet borrowers who have temporary cash shortages. On the other hand, the capital market is designed to finance long -term investments.  Matures within one year or less is considered to be a money market instrument. Financial instruments traded in the capital market have original maturities of more than one year.  The money market instruments are T-bill, Certificates of deposit (CD), Commercial deposit (CP), Eurodollars, Repos. The capital market instruments are treasury notes and bonds, international bonds (Euro bond, foreign Bond), corpor ate equities, term loans.

The efficient markets Hypothesis The efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". Different forms of the EMH 1. Weak EMH. This states all past market prices and data are fully reflected in the price of securities and stocks. However, some information about events shaping the company may not be fully reflected in price. In other words, technical analysis of prices is of no use. 2. Semi strong EMH. This states form asserts that all publicly available information is fully reflected in securities prices. In other words, fundamental analysis is of no use. 3. Strong Form of EMH asserts that all information is fully reflected in securities prices. In other words, even insider information is of no use. The reason of inefficiency of our capital market  Lack of investors education  Demand and supply huge inequality  Market captivity to some influencial persons  Price manipulation  Political unrest Valuation of Securities

The value of an asset is the price that a willing and able buyer pays to a willing and able seller. There are several types of value, of which we are concerned with three:

 Book Value - The asset s historical cost less its accumulated depreciation  Market Value - The price of an asset as determined in a competitive marketplace  Intrinsic Value - The present value of the expected future cash flows discounted at the decision maker s required rate of return
Estimated value = market value = fairly priced Estimated value <Market value = over priced Estimated value >Market value = under price Key Input: Key inputs to the valuation process include:

Cash Flows (returns), Timing, and Required Return (r isk).

Greater risk can be incorporated into an analysis by using a higher required return or discount rate.

Asset class: 1. Valuation of fixed income securities (Bond valuation) 2. Valuation of variable income securities (Stock Valuation)

Valuation of fixed income securities (Bond valuation) There are two types of cash flows that are provided b a bond investments:

Periodic interest payments (usually every six months, but any frequency is possible) Repayyment of the face value (also called the principal amount, which is usually $1,000) at maturity

The following timeline illustrates a typical bond s cash flows:

There are several terms with which you must be familiar to solve bond valuation problems: Coupon R t - This is the stated rate of interest on the bond. It is fixed for the life of the bond. Also, this rate time the face value determines the annual inter payment amount. est Valu - This is the principal amount (nominally, the amount that was borrowed). This is the amount that will be repaid at maturity atu it Dat - This is the date after which the bond no longer exists. It is also the date on which the loan is repaid and the last interest payment is made Example: Assume that you are interested in purchasing a bond with 5 years to maturity and a 10% coupon rate. If your re uired return is 12%, what is the highest price that you would be willing to pay?
      

y y y y y

n B0 ! I v  M v t n t! (  kd ) (  kd ) B0 = value of the bond at time zero I = annual interest paid in dollars n = number of years to maturity M = par value in dollars Kd= re uired rate of return on a bond


Th b si

qu tion fo th

lu of bond:

We c use the principle of v lue additivity to find the value of this stream of cash flows Note that the interest payments are an annuity and that th face value is a lump e sum Therefore the value of the bond is simply the present value of the annuity -type cash flow and the lump sum: 1  1 1  k d N FV VB ! Pmt N  kd 1   kd

1  1 1  0.12 5  1,000 ! 927.90 VB ! 100   0.12 5 0.12 1 Some Notes About Bond Valuation The value of a bond depends on several factors such as time to maturity, coupon rate, and required return We can note several facts about the relationship between bond prices and these variables (ceteris paribus):

Higher required returns lead to lower bond prices, and vice -versa Higher coupon rates lead to higher bond prices, and vice versa Longer terms to maturity lead to lower bond prices, and vice -versa

Bond Valuation Behavior

 The required return on a bond may differ from the coupon rate because of either:
Economic conditions have changed, causing a shift in the cost of funds; or The firm s risk profile has changed.

 When required rate is greater than coupon, then the bond will sell at a discount.  When required rate is less than coupon, then the bond will sell at a premium