FINANCIAL MARKET: Place where financial assets (non-physical) are exchanged.

Surplus (they enter the market offering cash) vs. Deficit (they enter the market offering financial assets).

Bank deposit: Financial assets, they are investing your money.

Main function of financial markets:

- Increase efficiency in operations!

UNIT 1: FINANCIAL SYSTEM

1. Financial market: concept and functions

Financial market: place or mechanism where financial assets are traded and their price is determined.

- Financial Asset: Non-physical asset that gets its value from a contractual claim.
- Ex: Stocks, bonds, bank deposits, derivatives…

*Asset: a useful or valuable item of property owned by a person or company. Example: a house (physical asset)
Without the contractual claim, this stock would be just a piece of paper with no value. But the stock comes with
a contract that says that this paper corresponds to a specific part of a company’s equity, so the value of this
stock is determined by the value of the company

What determines the value / return of a Financial Asset?

Supply and demand:

- Low supply and high demand: HIGHER VALUE.
- High supply and low demand: LOWER VALUE.

Risk:
- Higher risk: Greater probability of HIGHER RETURN.
- Lower risk: Greater probability of SMALLER RETURN.

A financial market contract two kinds of economic agents:

- Surplus spending unit: Economic unit that earns more than it spends.
- Deficit spending unit: Economic unit that has spent more than it has earned over a period of time. To
raise funds to finance their deficit, they may sell debt (or equity).

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What is understood by Spending Units?

- Public sector: The part of an economy that is controlled by the state.

- Families.
- Companies.
- Foreign sector: Includes any investment directed outside the borders of a specific country. Imports and
exports.

Those who demand and supply funds will meet in the financial market.

There are two types of transactions in the financial market:

A. Indirect transactions: these transactions can only happen if there is a financial intermediary. If you
want a pension plan, you will need to deal with a bank. If you want to invest in a fund, you will need to
speak with a funds management firm, and so on.

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 - Investment fund: An investment fund is a supply of capital belonging to numerous investors used to
collectively purchase securities while each investor retains ownership and control of his own shares.
- Pension plan: contract that requires an employer to make contributions to a pool of funds set aside for a
worker's future benefit. The pool of funds is invested on the employee's behalf and generates income
that will be used for the worker’s retirement.

B. Direct transactions:
- Transactions that don’t necessarily need a financial intermediary to occur. Example: some
companies offer their workers the possibility to buy shares or corporate bonds directly from
them.
- You can buy government bonds directly from the public treasury website (we will see this later)

- In a direct transaction, there is an Exchange of direct assets (for example, shares bought directly from a
company) for funds.
- In an indirect transaction, there is an Exchange of direct assets for funds between the buyer and the
bank (for example, when a company asks for a loan to a bank, the loan is a direct asset for the bank),
but also an Exchange of indirect assets for funds between the seller and the bank (the client that puts
Money in the bankin Exchange for some returns, which would be the indirect assets).

What are the main functions of financial markets?

- Connect the economic units that supply and demand funds.

- Assign prices to financial products.
- Facilitate the liquidity of assets.
- Reduce the terms and intermediate costs.

Perfect financial market:

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 - Great amount of agents, both supplying and demanding funds.
- Lack of transaction costs.
- No restrictions when buying and selling.
- Perfect information for everybody (no insider trading).

*Great amount of agents: it means that there will be no shortage of supply and no lack of demand.
- No transaction costs/ no restrictions when buying and selling: no limits to transactions.
Perfect information: also known as “no hidden information”, means that everyone in the market has access to
information such as prices, volume offered, etc.
No one has better information than others (which could lead to insider trading)

What is a Financial System?

- A set of financial markets that exists in a country.

2. Typology of financial markets:

Financial markets can be classified depending on:

A. Asset transformation.
B. How they work.
C. Degree of formalisation.
D. Term of the assets.
E. Phase of negotiation.
F. Type of assets.

A. Asset transformation:
- With transformation.
- Without transformation.

- Some markets/ financial intermediaries transform the assets that they are trading with.
- Ex. of an asset transformation: Creating a loan from a deposit (banking activity).

B. How they work:

- Direct research: Government bonds.
- Broker: Etoro.
- Dealer: Ameriprise.

Broker vs. Dealer:

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 Broker Dealer

Executes the trade on behalf of others Trades on their own behalf

Buy and sell securities for their clients Buy and sell securities on their own account

Charges a commission Charges a markup or markdown

*When dealing with securities, dealers make all decisions in respect of purchases. On the other hand, a broker
will only make purchases as per the client’s wishes.
When talking about their experience, a broker has only a little experience in the field compared to dealers.
DEALER: As a normal trading company. The money they get is from their own operations.

C. Degree of formalisation:
- Organised: Typical markets, big ones (NASDAQ, IBEX)
- Over-the-counter (OTC): Informal market. They don’t follow rules. One agent contacts another agent and
makes some deals, agreements.

ORGANISED OTC

Regulated and centralised market, where

Decentralised dealer market, where
trading of stocks takes place between
Definition brokers and dealers transact directly via
buyers and sellers in a safe, transparent
computer networks and phone.
and systematic manner.

Used by Well established companies Small companies

Physical Location Yes No

Trading hours Exchange hours 24×7

Transparency Comparatively high Low

D. Term of the assets:

- SPOT CONTRACT: (Normal operations, most simple operation)
● Involves the purchase or sale of a commodity, security or currency for immediate delivery and
payment.
● The spot price is the current price of the asset.

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 - FORWARD CONTRACT: (Specialised transaction, it’s been negotiated but maybe the buyer won’t need
it right now.)
● Customized contract between 2 parties to buy or sell an asset at a specified price on a future
date.
● The forward price is set before the transaction happens. It might be very different from the
current price of the asset (spot price) when the transaction happens.

Example of Spot contract:

A supermarket want immediate delivery of 100.000 litres of orange juice:

- They pay the spot price to the seller (immediately) 1€ per litre = 100.000€.
- 1€ per litre is the current market price for a litre of orange juice.
- They receive the orange juice shortly after their payment.

Example of Forward contract:

A supermarket wants to order 100.000 litres of orange juice for the summer season, which is 6 months away:
- The supermarket entered into a forward contract with their supplier, to buy 100.000 litres of orange
juice at a forward price of 1,5€ in six months.
- In 6 months, the spot price of a litre of orange juice has 3 possibilities:
● It is exactly 1,5€: no one loses or earns money.
● It is lower than 1,5€. For example, 1€: the supermarket pays 50.000€ more to the supplier (the
supermarket loses 50.000€).
● It is higher than 1,5€. For example, 2€: the supermarket pays 50.000€ less to the supplier
(supplier loses 50.000€)

E. Phase of negotiation:
- PRIMARY MARKET:
● Securities directly purchased from the issuer. In this case, the exchanged financial assets are
newly created, being transferred for the first time.
● Example: Initial Public Offering (IPO) is an offering of the primary market where a private
company decides to sell stocks to the public for the first time.

- SECONDARY MARKET: (Most of them)

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 ● Investors trade securities among themselves and the company with the security being traded
usually does not participate in the transaction. Post-issue transactions are made for the first
time (securities resale market).
● Placing shares in the primary market means increasing the share capital of a company. In
contrast, shares in the secondary market are already existing securities in the company that do
not involve an increase in share capital.
● Examples: New York Stock Exchange (NYSE), London stock exchange or Nasdaq.

F. Type of assets:

- MONETARY MARKET: (Very exclusive, only big entities)

● Wholesale markets where short-term financial assets are traded. Its participants are large
institutions and specialized financial intermediaries.
● Ex: Interbank market
- Market where banks lend money to each other at a certain price and interest.

- CAPITAL MARKET: (Anyone can engage)

● The one that market agents go to both to finance themselves in the medium and long term
(over 18 months) and to make investments. When trading longer-term assets than in the money
market, it incorporates a higher risk.
● Includes:
- Fixed income market.
- Equity market: Stock market.
- Derivatives market (They are subjected to another asset).

- COMMODITIES MARKET.
- FOREX MARKET. (Currencies)
- INSURANCE MARKET. (Insurances)
- CRYPTOCURRENCY MARKET.

3. Characteristics of financial markets:

A. TRANSPARENCY:
- The extent to which investors have access to required financial information about a company
such as price levels or audited financial reports.

B. FREEDOM:

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 - The extent to which the prices are determined by the open market and by consumers. In a free
market the laws and forces of supply and demand are free from any intervention by a
government or by other authority.
- How can we be measured?
● How prices are exclusively determined.
● WALES : Very big economic agents, they can sensitively change the prices of the
market. This happens frequently.

C. DEPTH:
- Market’s ability to sustain(=absorb) relatively large market orders without impacting the price
of the security.
- Ex: If a stock is extremely liquid and has a large number of buyers and sellers, purchasing a
bulk of shares typically will not result in noticeable stock price movements.

D. EFFICIENCY:
- Degree to which market prices reflect all available, relevant information.
- If markets are efficient, then all information is already incorporated into prices and so there is
no way to “beat” the market because there are no under- or overvalued securities available.

4. Global trends in financial markets:

- IMPACT OF NEW TECHNOLOGIES:

● Ex: service-based investing, robo investing, digital-based crowdfunding.

- SECURITISATION: (Process of asset transformation)

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 ● Process of taking an illiquid asset or group of assets and through financial engineering,
transforming it (or them) into a security (tradable financial asset).
● Ex: “Securitisation food chain.

- DEREGULATION:
● Process of removing or reducing state regulations in the financial market.

- POPULARITY:
● Investing popularity has increased exponentially during the last few years.
● Ex: Chinese retail investors.

- GLOBALISATION:
● Pros: Access to new markets all over the world.
● Cons: Increased contagion susceptibility between global markets.
● Ex: Brexit.

5. Financial management: aims:

Overall aim: Maximise corporate value.

Specific aims: Maximise corporate value for shareholders:

- A better situation of the company implies that it can obtain debt to finance its investments.
- Occasionally, there might be conflicts of interest between managers and shareholders.

1. INVESTMENT DECISIONS: Decide which investments to make.

2. FINANCING DECISIONS: Obtain funds and determine the optimal proportion of them.
3. DIVIDENDS DECISIONS: Generate returns for shareholders.
4. GROWTH STRATEGIES: Create value.

UNIT 2: STATIC AND DYNAMIC INVESTMENT SELECTION METHODS

Real investment vs. Financial Investment:

1. REAL INVESTMENT:
- Money invested in tangible and productive assets such as the company’s production plant or
machinery.
2. FINANCIAL INVESTMENT:

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 - Purchase of an asset or item with the hope that it will generate financial income (such as
dividends), or that its value will increase in the future, so that it can be sold at a higher price.

The investment decision process:

The investment decision process involves 3 basic steps:

1. Generating investment proposals.

2. Reviewing, analyzing and selecting from the proposals that have been granted.
3. Implementing and monitoring the investment proposals that have been selected.

MANAGERS SHOULD SEPARATE INVESTMENT AND FINANCING DECISIONS.

Elements in the investment decision process:

1. The initial investment required (or initial outlay) to start the project.
- To get the initial idea until the launch of the company.

2. The duration of the investment, in terms of deadlines.

3. The collections and payments from the project.

- The net cash flows are obtained by the difference between the inputs and the outputs of the
project life.

Initial investment:

- Amount of funds that the company or the entrepreneur needs to start their project.
- Includes the cost of:
● Necessary assets to start the business.
● Other various concepts necessary to implement the project.
- Initial outlay = Initial investment in fixed assets + cash needed to start operations.
- Considered as a net outflow in time 0:
● Calculated as the updated sum of all initial payments.

Time horizon:

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 - Time from the first project payment until the last investment return that is generated.
- It is necessary to limit the period examined in order to perform the calculations.

1. INVESTMENT DECISIONS: STATIC METHODS

An investment decision should:

- Account for the time value of money.
- Account for risk.
- Focus on cash flows.
- Rank competing projects appropriately.
- Lead to investment decisions that maximize shareholders’ wealth.

Ex: Global Wireless:

- Global Wireless is a worldwide provider of wireless telephone devices.

- Global Wireless is contemplating a major expansion of its wireless network into 2 different regions:
● Western Europe expansion.
● A smaller investment in the Southeast U.S. (to establish a toehold)

- Initial investment in RED (Negative numbers).

- Other number = Returns, positive.

A. PAYBACK PERIOD: (We evaluate how fast is a project in returning the money)

The payback period is the amount of time required for the firm to recover its initial investment.
- If the project’s payback period is less than the maximum acceptable payback period, accept the project.
- If the project payback period is greater than the maximum acceptable payback period, reject the
project.
MANAGEMENT DETERMINES MAXIMUM ACCEPTABLE PAYBACK PERIOD.

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Payback period method: Pros and Cons

Advantages:
- Easy to calculate.
- Easy to understand.
- Focuses on cash flow.

Disadvantages:
- Does not account properly for the time value of money.
- Does not account properly for risk.

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 - Cutoff period is arbitrary.
- Does not lead to value-maximizing decisions.

B. CASH FLOW PROFITABILITY METHOD: (The money we get and the money we put in the project)

The cash profitability method consists in calculating the cash flow per euro invested.

- If the project’s cash flow profitability is bigger than 1, we accept the project.
- The bigger cash flow profitability, the better.

Cash Flow profitability method: Pros and Cons

Advantages:

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 - Easy to calculate.
- Easy to understand.
- Focuses on cash flow.

Disadvantages:
- Does not account properly for the time value of money.
- Does not account properly for risk.

C. AVERAGE ANNUAL CASH FLOW PROFITABILITY METHOD:

In this case, we calculate the average annual cash flow per euro invested:

- The bigger cash flow profitability, the better.

*This is telling us that on average every year we are recovering half of the initial investment (0,508).

Average annual cash flow profitability method: Pros and Cons

Advantages:
- Easy to calculate and understand.
- Annual basis.
- Focuses on cash flow.

Disadvantages:
- Does not account properly for the time value of money.
- Does not account properly for risk.

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2. INVESTMENT DECISIONS: DYNAMIC METHODS

Discounted payback method:

- Represents the amount of time that it takes (in years) for the initial cost of a project to equal to
discounted value of expected cash flows.
- Discounted payback accounts for time value:
● Applies discount rate to cash flows during payback period.
● But still ignores cash flows after the required payback period.

Discounted payback method: Pros and Cons

Advantages:
- Easy to calculate.
- Easy to understand.
- Focuses on cash flow.
- Take into account the time value of money and risk.

Disadvantages:
- Cutoff period is arbitrary.
- Does not lead to value-maximizing decisions.

Net Present Value:

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Net Present Value: Pros and Cons

NPV is the “gold standard” of investment decision rules.

Advantages:
- Focuses on cash flows, not accounting earnings.
- Makes appropriate adjustments for the time value of money.
- Can properly account for risk differences between projects.

Disadvantages:
- Lacks the intuitive appeal of payback.

Internal rate of return:

Excel: TIR

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 Reminder:
Hurdle rate: Represents the minimum required
return.
IRR: Discount rate that gives us NPV=0

Internal rate of return: Pros and Cons

Advantages:
- Properly adjust the time value of money.
- Uses cash flows rather than earnings.
- Accounts for all cash flows.
- Project IRR is a number with intuitive appeal.

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Disadvantages:
- “Mathematical problems”: Multiple IRRs, no real solutions.
- Scale problem.
- Timing problem.

Multiple Internal Rate of Return:

No real solution:

The Scale problem:

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Why the conflict?
- The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project.
- Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the
much larger Western Europe investment is more attractive.

*Imagine that you have 2 projects:

- Project 1: You invest 1 million and you get 10 million.
- Project 2: You invest 1 euro and you get 10 euro.
Both projects have the same IRR, because it is a percentage and it does not take into account the scale of the
project
Which project would you select?
If you have 1 million, it’s better that you invest it in Project 1.

Conflicts between NPV and IRR:

- The product development proposal generates a higher NPV, whereas the mkt campaign proposal offers a
higher IRR (scale problem).
Profitability Index:

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Excel: VNA (discount rate; CF)/ - (initial investment)

Weighted Average Profitability Index:

UNIT 3: INVESTMENT PROJECT ANALYSIS AND ASSESSMENT

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What we understand by investment:

Any increase in a company’s assets:

- ASSETS = Need of Funds for Operations (NFO) + Fixed Assets (FA).
- Thus, Investment = any increase in NFO or FA.
- Investments always involve an outlay of cash, which we call a cash flow (CF).

What are FA?

Fixed Assets (FA):

- Assets which are purchased for long-term use and are not likely to be converted quickly into cash, such
as land, buildings and equipment.

What are NFOs?

Need of Funds for Operations (NFOs):

- Funds required to finance a company’s operations.
- “Use of Funds”, they are assets.

When a company is operating, their money may be invested in:

- Receivables: Sales made on credit basis. Usually the company’s sales don¡t get paid immediately.
- Inventory: For future sales.

These two items require financing. But the company’s operations will help financing part of these current assets,
since they also have:
- Payables: Purchases made on credit basis. Usually the company’s purchases don’t get paid
immediately either.
NFO = RECEIVABLES + INVENTORY - PAYABLES
Main difference between NFO and FAs:

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 - Fixed assets require strategic decisions by top management.
- NFOs come directly from the company’s daily operations: they can be changed by middle management.

EX: A sales agent who decides to give a customer better terms may increase the NFO.

Investment projects are undertaken for various reasons:

- Necessity: Legal obligations, major repairs, etc.
- Cost reduction: More efficient machinery purchase, process improvement, etc.
- Sales expansion: Increase in productive activity.
- Strategy: Innovation for business survival, competition, etc.

- In most cases, it is because the company expects to obtain a return.

An investment project includes the following essential elements:

- The investment’s cash flows in NFO and FA.
- Cash flows resulting from project income.
- The returns and risks (%) of the project’s cash flows.
- The return that we require from the project (%) and other criteria for deciding whether to go ahead
with it.

Estimating project Cash Flows:

Free Cash Flow (FCF):

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 - Cash flow related to the company’s Operating activities (excluding the firm’s Financing activities):
1. Company generates cash (through its Sales).
2. This cash is used to pay the company’s operating expenses (employees, bills) and capital
expenditures (new machine, new building).
3. The cash that is left over will go to:
- Lenders: (Ex: paying interests to Banks)
- Owners: (Ex: shareholders dividends)

Free Cash Flow: Cash that is left BEFORE being distributed to Lenders and/or Owners.
- FCF is the cash a company produces through its operations, less the cost of expenditure on assets.
- In other words, free cash flow or FCF is the cash left over after a company pays for its operating
expenses (OPEX) and capital expenditures (CAPEX).

FCF = EBIT * (1-t) + Depreciation - CAPEX - Increase in Working Capital

t = Tax rate (%)

DEPRECIATION:
- Accounting method that allows a company to write off (cancel) an asset’s value over time, but it is
considered a non-cash transaction.

CAPEX:
- Funds used by a company to acquire, upgrade and maintain physical assets such as property, industrial
buildings or equipment.
- Often used to undertake new projects or investments by the firm.
WORKING CAPITAL = CA - CL:
- Difference between a company’s current assets, like cash, accounts receivable (customers’ unpaid bills)
and inventories of raw materials and finished goods, and its current liabilities, like accounts payable.

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