Financial Markets and Institutions

Prof. Abhinav Sharma

Assistant Professor (Finance)
Goa Institute of Management
India

July 11, 2022

Course Outline

Session No. Topic

Session 1 Introduction to Financial Markets and Principal-agent relationship
Session 2 − 4 Time Value of Money
Session 5 − 6 Stock Valuation: Dividend discount model, Free cash flow approach.
Session 7 − 9 Portfolio Analysis
Session 10 − 12 Asset Pricing Models
Session 13 Market Efficiency
Session 14 − 16 Bond Valuation: Spot and Forward rate, duration.
Session 17 Term Structure of Interest Rates
Session 18 − 19 Foreign Exchange Markets & Exchange Rate Parity
Session 20 − 21 Forwards & Futures
Session 22 − 23 Options
Session 24 Summary, Discussion & Course Reflection
Evaluation Component

Evaluation Method Weight

Surprise Quizzes 20% Multiple Quizzes would be planned during the course
Mid-Term Exam 30% After 12 Sessions
End-Term Exam 40% End of the Term
Class Participation 10% During the entire course
Some Pointers

Avoid Coming Late to the Class

Scientific/ financial calculator might be required.

You can reach out to me directly at: abhinav@gim.ac.in

You can also reach out to Emendra at emendra@gim.ac.in

Role of Financial Manager

Shareholders (Principal)

Board of Directors

Managers (Agents) Operate the Firm

Role of Financial Manager...continued

Use of Earnings from Operations :

Paid back to Shareholders in the form of dividend or

share buyback, further invest in other financial assets.

Investment in Real projects...maximize profits.

What is the minimum rate of return a shareholder would

demand on a firm’s investments?

Opportunity cost of capital/ Hurdle rate

Is high rate of return always better?

Interplay between Shareholders and Managers

Agency Problem Type 1: Shareholders vs Managers

Asymmetric information between shareholders and

managers.
Unrelated diversification, non-profitable investments, etc.

Agency Problem Type 2: Controlling shareholders vs

Non-controlling shareholders.
Wedge between control rights vs cash flow rights.
Dual class shares, pyramidal stock ownership structure,
cross-ownership, etc.
Unrelated diversifications, diversion of loans, tunneling,
related-party transactions, etc.
Calculating Future and Present Values

What does Rs100 invested today amounts to in 2 years ?

Exercise 1
Cost of contructing a building is Rs 700, 000. Your company has cash in the bank to
finance construction. Your real estate advisor predicts that you will be able to sell the
building at Rs 800, 000 by next year.
(Assumption: The level of risk is zero such that 800, 000 is a sure thing.The return on
risk-free government securities is 7% and average return on the stock market is 12%. )

Exercise 2
Would you invest in the same project if it involves the same degree of risk as the stock
market?

Acceptance rule for Investment opportunity: Net Present

Value rule and Rate of return rule.
Calculate Net Present Value with Multiple Cash
Flows

Discounted Cash Flow Valuation.

Value of any asset is the present value of all the expected
future cash flows out of it.
Pt=n CFt
Value of Asset = t=1 (1+r )t

N is the life of an asset, CF is cash flow in period t, r is the

discount rate reflecting the riskiness of the cash flow.

Exercise 3
Cost of contructing a building is Rs 700, 000. Your company has cash in the bank to
finance construction. Your real estate advisor suggest that you can rent out the
building for 2 years at Rs 30, 000 a year, and predicts that at the end you will be able
to sell the building at Rs 840, 000.
Perpetuities and Annuities

Perpetuity: fixed cash flow each year/month/week till

perpetuity.

CashFlow C
PV = Return = r

Value of perpetuity making series of payments equal to C

C
after t years; PV = r (1+r )t

Annuities: fixed cash flow each year for a specified number of

years.

C C
PV of Annuity till t years = r − r (1+r )t
Exercises on Perpetuity and Annuity

Exercise 4
You go to XYZ auto to buy a car. XYZ auto offers an installment
option on a new car with installment equal to Rs3.59 lakhs a year,
paid at the end of each of the next five years. What is the car
really costing you?
Exercises on Perpetuity and Annuity...Continued

Exercise 5
Suppose you take a 4 year loan of Rs1000 from a bank. The bank
requires you to pay the loan in equal installments in the next 4
years. Calculate your installment amount to be paid each year.
Also prepare a loan amortization schedule.
Valuing Annuities Due

A level of stream of payments starting immediately.

Value of ordinary annuity ×(1 + r )

Exercise 6
Suppose you want to buy a Mercedes. You estimate that as you
work, you can save Rs 500, 000 a year from your income and earn a
return of 8% on these savings. How much will you be able to
spend after 5 years.
Growing Perpetuities and Annuities

CashFlow C1
PV of an Perpetual = Return−Growth = r −g .

C (1+g )t
PV of an annuity = r −g × (1 − (1+r )t ).
Semi-Annually, Monthly and Continuous
compounding

C1
PV of asset compounded ’m’ times a year = (1+ mr )m .

In case of continuous compounding, as m approaches

infinity...(1 + mr )m = (exp)r = (2.718)r .

C 1
PV of annuity continuously compounded = r × (1 − (e)rt ).
Exercise 7
After you have retired, you plan to spend Rs 2, 00, 000 a year for 20
years. The annually compounded interest rate is 10%. How much
you save by the time you retire to support this spending plan?
How to Analyze a Proposed Investment

Step 1: Forecast the cash flows generated by the project over

its economic life.

Step 2: Determine the appropriate opportunity cost of

capital (r), depending on the risk of the project.

Step 3: Use ’r’ to discount future cash flows and sum them
up to get the present value of the project.

Step 4: Calculate the NPV of the project.

Internal Rate of Return

Discount rate at which the NPV equals to zero.

2000 4000
NPV = −4000 + 1+IRR + (1+IRR)2
= 0.

Accept project if the opportunity cost of capital is less

than the IRR.

Discount rate > IRR... Negative NPV

Discount rate < IRR... Positive NPV

Which project you would choose?

Cash Flows (in Thousands)

Project C0 C1 C 2 C 3 NPV @ 8%
A -9.0 2.9 4 5.4 1.4
B -9000 2560 3540 4530 1.4
Compare projects based on their IRR

Cash Flows (in Thousands)

Project C0 C 1 C 2 C 3 NPV @ 8% IRR (%)
A -9.0 2.9 4 5.4 1.4 15.58
B -9000 2560 3540 4530 1.4 8.01
Would you choose this project?

Cash Flows

C0 C1 C2
+5000 +4000 -11000

IRR of this project is 13% and opportunity cost of capital is

10%.

Will you accept this project?

Choosing Project with Capital Rationing

Cash Flows (millions)

Project C0 C1 C 2 NPV @ 10%
A -10 +30 21 21
B -5 +5 16 16
C -5 +5 12 12

Firm is limited to spending a maximum of 10 Million.

Which project you would choose?

Profitability Index

Net Present Value

Profitability Index = Investment

In millions
Project Investment NPV Profitability Index
A 10 21 2.1
B 5 16 3.2
C 5 12 2.4
Would you choose this project?

Cash Flows

C0 C1 C2
-100 +200 -75

Compute IRR if the opportunity cost of capital is 20%.

Will you accept this project?

Which project would you choose?

Cash Flows (Thousands)

Project C 0 C1 C 2 IRR
A -400 +250 300 23
B -200 +140 +179 36

Opportunity cost of capital is 9%

Which project you would choose?

Monthly and Continuous Compounding

Exercise 8
After you have retired, you plan to spend Rs 2, 00, 000 a year for
20 years. The annual compounded interest rate is 10%. How much
you save by the time you retire to support this spending plan if,

If you spent Rs 2,00,000 spread evenly over each of the 12

months in a year, i.e. monthly compounding.

If you spent Rs 2,00,000 spread evenly over the entire year,

i.e. continuous compounding.
References

References I

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