Fabricio Chala, CFA, FRM

Introduction to
Finance S1
Objectives
❖  What investments to make?

❖  How to pay for the investments?

Personal

Wealth Equity (firms)

Social Welfare (Public Finances)

From a personal perspective
❖  What investments to make?

❖  New car

❖  Apartment

❖  Nice life after retirement What’s the main

❖  How to pay for the investments? objective?

❖  Cash or car loan?

❖  Buy or rent?

❖  Real assets? Pension fund?

From a firm’s perspective
❖  What investments to make?

❖  New line of products

❖  Expansion to a new geographic market

❖  New equipment What’s the main

❖  How to pay for the investments? objective?

❖  Internal funding?

❖  Debt?

❖  Equity?
From a firm’s perspective
MAXIMIZING A FIRM’S
VALUE IN THE LONG RUN

Stakeholders (shareholders, government, clients, etc.) are important

In order to achieve the main goal, Finance takes into account:

Risk Return Cash flows

 From a firm’s prespective
SHAREHOLDERS
&
BONDHOLDERS

SOCIETY
BOARD &
GOVERNMENT (CLIENTS,
MANAGEMENT
SUPPLIERS)

FINANCIAL MARKET
From a firm’s perspective
In theory…

❖  There aren’t agency problems. Managers act in the interests of their

shareholders. Interests of creditors and minority shareholders are
protected.

❖  Full transparency: timely and accurate information.

❖  There are no negative externalities.

❖  There are no circumstances that could destroy value: excessive

regulation, risk of expropriation.
Hence…
Shareholders Wealth is maximized

Creditors Interests are protected

Laws that protect companies and incentivize investments.

Government
Taxes are collected.

Financial
Information is properly and timely revealed to the market.
Market

Society No negative externalties for society

But, in reality…

❖  Managers put their interests ahead of shareholders.

❖  Shareholders may act against creditors.
❖  Government affects decisión making through regulation.
❖  Firms don’t fully revel their information to the markets.
❖  Companies generate negative externalities for society.
❖  Controling shareholders harm minority shareholders.
Therefore…
Shareholders Minority shareholders are affected.

Creditors Exposed to higher risks.

Government Laws that limit value creation. Tax evasion.

Financial Information is not fully reflected in prices. Markets can react

Market irrationally.

Society Negative externalities.

How to mitigate this?
Shareholders Offer incentives to managers. Establish a board of directors.

Creditors Include covenants in contracts.

Government Fines and surcharges to reduce tax evasion.

Financial
Credit rating companies, Research houses.
Market

Through laws, but they may have a negative impact on

Society
investment intentions.
So…
Maximize Earnings Subject to: Level of risk

Return Return volatility

❖  In an efficient market, price correctly reflects all the available

information and expectations (value of share will be maximized).
Hence, the value of the firm will be maximized, too.
Risk aversion

What do you prefer?

50% chance to win S/. 200 tomorrow

100% chance to win S/. 100 tomorrow

❖  It is implicitly assumed that investors are risk averse: They seek to

minimize risk for a given level of return.
Key takeaways

❖  Finance is all about maximizing value in the long run…

❖  …and satisfying the stakeholders‘ interests.

❖  In theory, agency problemas don’t exist, information is fully

transparent and society is not affected by negative externalities.

❖  But in reality there are many imperfections that stakeholders seek to

solve through different mechanisms.

❖  Investors are risk averse.

Key takeaways
❖  Finance takes into account:

Risk Return Cash flows

❖  So follow these three rules of thumb:

❖  More is better

❖  The less riskier, the better

❖  The sooner I get the rewards, the better

Time Value of Money

Which one is worth more: one Sol today or one tomorrow? Why?
Time Value of Money
❖  “Today, I have 1000 Soles in my wallet that I do not expect to spend
during the year. So, I decide to put this money in a 1 yr time
deposit in a bank. The bank offers to pay me a 5.0% interest rate a
year. If I decide to invest in the 1yr time deposit, how much money
will I have in one year?
Time Value of Money
❖  “Today, I have 1000 Soles in my wallet that I do not expect to spend
during the year. So, I decide to put this money in a 1 yr time
deposit in a bank. The bank offers to pay me a 5.0% interest rate a
year. If I decide to invest in the 1yr time deposit, how much money
will I have in one year?
•  Interest = 5.0% * 1000 = 50
•  Investment = 1000
•  Value of investment after 1 year: 1000 * ( 1 + 5.0% ) = 1050

1000 1050

Today 1 year
Present Future
Value Value
Negative Interest Rates?

Do they really exist?

Future Value with Simple Interest
FVN = PV(1 + r * N)
❖  Where:
❖  FVN = Future Value of Investment N periods from today

❖  PV = Present Value (Principal of the Investment)

❖  r = Stated (quoted) interest rate per period

❖  N = Number of periods

❖  IMPORTANT:

❖  Stated interest rate (r) and the number of periods (N) must be defined
in the same time units (years, months, etc.)
Simple vs. Compound Interest
❖  Simple Interest: When you only earn interest on your initial investment
(principal)

FV = PV*(1+ r*n)
❖  Compound interest: When you earn interest on the principal and on the
reinvested interest

FV = PV*(1+r)n
❖  Example:
How much money will I have in 3 years if I invest 1000 soles today…
❖  Option A: ….at a simple interest rate of 10%?
❖  Option B: … at a compound interest rate of 10%?
Time Value of Money
❖  “Today, I have 1000 Soles in my wallet that I do not expect to spend
during the year. So, I decide to put this money in a 1 yr time
deposit in a bank. The bank offers to pay me a 5.0% interest rate a
year. If I decide to invest in the 1yr time deposit, how much money
will I have in one year?
Future Value with Compound
Interest

❖  Where:
❖  FVN = Future Value of Investment N periods from today

❖  PV = Present Value (Principal of the Investment)

❖  r = Stated (quoted) interest rate per period

❖  N = Number of compounding periods

❖  IMPORTANT:

❖  Stated interest rate (r) and the number of compounding periods (N)
must be defined in the same time units (years, months, etc.)
Compounding
❖  In the previous example, we note that:
❖  I will end up with more money if I have a compound interest
(1,331) rather than a simple interest (1,300)

❖  The difference is due to the “interest on interest”

Today Year 1 Year 2 Year 3

Compounding