CLASS NOTES WEEK I

READING ASSIGNMENTS BMA Chapter 1: Finance and the Financial Manager Chapter 2.1: Introduction to Present Value (PV)
Alex Kane 1 IRPCOR421  Finance

Course objective and challenge
• Command of essentials of modern finance is necessary for the management of
– Personal affairs – Business/Corporations – Non-profits

And for making public policy • This course carves out these bare essentials • Mastering those is time consuming and, at times, difficult • You cannot afford to postpone studying to near exam dates
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Covenants for Course Participants
• • • • • • • • • • • • • •
Alex Kane

Who I You I You I I You I You I I You TAs

Will do what Will end each session ON TIME Will make every effort to show up ON TIME Will present and post clear notes and use clear examples Will ask about any item that isn’t made clear to you Will respond to any question, none will be disrespected Will show up to class 10 minutes early for short questions Will e-mail for meeting whenever a relevant problem arises Will respond and setup a meeting within 2 business days Will not rest until you can solve all end-of-chapter problems and independently construct all spreadsheets we develop Will restrict the exams to similar problems Will assume your intentions are always honorable Will do the same and, as I, allow for cultural differences in interpretation of behavior Will help you as needed. Take advantage of their office hours
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Efficient study of this material
• Efficient study requires – Prior to class sessions • read assigned text chapter(s) and class (ppt) notes – No later than end of week • Solve all end-of-chapter problems • Study (by reconstructing) the Excel workbook • Send ANY question to the First Class conference (Finance) immediately. You’ll be answered within hours • You must read the conference exchanges DAILY. Please chime in with concerns/comments/responses • Use TA sessions effectively, that is, come prepared with questions. Passive attendance is ineffective
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Grades, exams and e-mail
• Grades in this course are completely mechanical • Exams (in class) will be in the form of spreadsheet assignments returned at the bell • Therefore, exams must be taken with the rest of the class, there can be no exceptions • Exceedingly, real-life assignment are prosecuted in teams whose members hardly ever meet. email is a major communication channel. In this class, e-mail communication is an important part of learning
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A note on spreadsheets
• To a large extend the course is spreadsheet based • Spreadsheets should render “fear” of formulas and computations obsolete. The only remaining difficulty is conceptual • The price, however, is the need to acquire effective use of spreadsheets -- can be achieved only through practice and learning essential “tricks” • Solve all end-of-chapter problems in spreadsheets • When asking (e-mail) questions, append your spreadsheet and supply the cell addresses that require clarificiation
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I. The Corporation
• An independent entity defined by a nexus of contracts (some implicit), completely separate from its owners. Management is fraught with conflicts among parties to the contracts. The framework is corporate governance • The most fundamental conflict arises from the separation of ownership (SH=shareholders) and control (mgt) • The charter (articles of incorporation) determines
– corporate residence, objectives and by-laws – rules for electing the board of directors – other governance issues, e.g., distribution of profits, liquidation

• The SH record determines eligibility to vote (or give proxy) for directors and receive dividends
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Publicly Traded Corporations
• Corporate shares, unless otherwise designated, are transferable, hence marketable • A corporation is “public” if there are multiple SH and investors can trade their shares • At the lowest level (in the U.S.) shares are traded via “pink sheets” held by dealers. The next step up is to register the stock on a regional and/or national exchange • Typical enterprise milestones
– – – –
Alex Kane

Entrepreneur + angel financing Venture Capital (VC) financing Initial public offering (IPO) -- still a growth firm Maturity (one measure: the corporation pays a large share of profits in dividends)
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Separation of ownership and control
• Limited liability is what makes capitalism work. It facilitates entrepreneurship and allows multiple owners (investors) in a corporation. The result is separation of ownership from control • Ownership is limited to: investing in the corporate stock, voting for directors/special issues in SH meetings (as per charter), and sharing in payouts • Control begins with the board of directors. The board, in turn, hires management and monitors its activities • Management (CEO and below) runs the corporation
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The conflict
• Although mgt is hired by directors on behalf of SH it obviously has its own agenda which, by construction, conflicts with SH • Top executives are on the board. Often mgt controls the board more than the other way around • The power of mgt is fueled by the rules of electing directors. SH activists are fighting for universal rules that favor SH. So far these rules are in effect in less than half of corporations, but the number is growing
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II. Assets
• An asset is an object
– on which a legal claim can be made – is distinct from a good whose purpose is ‘immediate’ consumption, and ownership is by possession – the purchase of which is taken as investment with reward in the form of future CF (cash flow) and/or utility (=satisfaction/pleasure). The flow of non-cash utility form an asset is called convenience yield
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Properties of assets
• Owned for future CF and/or convenience yield. The legal claim endows them with market value • An asset is dividend paying if CF occur during the asset’s life (plant & equip., stock). Some assets only pay off when sold (e.g., gold) or on maturity (e.g., zero-coupon bond) • Can be intangible (intellectual property) • May be expected to lose resale value over time (depreciate) due to amortization/obsolescence
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Notes
• A consumption good is defined as a good consumed within one year or less • A consumer durable (economic life longer than 1year) has an investment value = price minus imputed cost of one year’s use • Art objects convey convenience yield. Therefore, it is an ineffective investment unless the investor enjoys the yield • Cash is held for convenience yield
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III. Real and financial assets (1)
• Assets generate CF/convenience yield from either
– putting them to use, e.g., machines, intellectual property, – calling upon the issuer to pay up, e.g., bonds, stocks.

• Assets of the first type are called ‘real assets’. Notice that not all are tangible (intellectual property) • Assets of the second type are called ‘financial assets’
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Real and financial assets (2)
• The ultimate distinction between ‘real’ and ‘financial’ assets is this
– a real asset appears only on the asset side of balance sheets (more than one if it is owned in partnership) – a financial asset appears on both, ‘Assets’ side of one or more balance sheets, as well as (simultaneously and in equal value), on the ‘Liabilities’ side of one or more other balance sheets

• A financial asset is
– issued (‘written’) by an ‘economic agent’ -- cannot be found in nature – some financial assets have a limited life (e.g., bonds)
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Social wealth
• The economic wealth of a society (however defined) is the sum (aggregate) of the balance sheets of its members • When balance sheets are aggregated, all financial assets add up to zero, because each appears on both ‘assets’ and ‘liabilities’ side of these balance sheets • Thus, social wealth is measured by the value of real assets -- which is why they are called ‘real’
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Financial interrelations of countries
• Once we distinguish social groups (say, by country) we must qualify the calculus of social wealth • Suppose citizens of two countries exchange financial assets. Then social wealth of one country (as shown in the national accounts) will equal: real assets plus the net value of financial assets --sum of financial assets owned (on the ‘Assets’ side) minus those owed (on the ‘Liability’ side) • Investment in real assets across borders is called foreign direct investment (FDI). FDI is coveted because it is less liquid and facilitates technology transfer. Financial investment is liquid, hence fickle
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BS of U.S. HH (Q4/2006)
Assets $ Billions Tangible/real 26,804 Real estate 22,642 Consumer durables 3,923 Other 239 Financial 42,116 Deposits 6,670 Debt securities 3,029 Equities (direct+MF) 10,446 Non corporate equity 7,385 Other (mostly pensions) 14,586 Liabilities (mort~73%, cons credit~18%) 13,293 NW (wealth) 55,627
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National Accounts (2006)
• GDP 13,244 • Personal Consumption (C) 9,269 • Gross Private Investment (I) 2,212 • Gov cons (fed=808 local=1,288) 2,096 • Gov inv (fed=118 local=312) 430 • Total Gov (G) 2,526 • Export 1,466 • Import –2,229 • Net export (X–M) –763 • GNP: add net receipt (profits) from foreigners 22
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IV. Capital markets
• Set up to trade assets • Financial markets trade financial assets • Money markets trade financial assets of short maturity (1 year or less) • Organization and operation of capital markets is costly. Markets are assets owned by the operators, e.g., NYSE (financial), Ebay (real)

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V. Corporate economic objectives
• A corporation may be set up for one or more activities to generate CF
– Non-financial: invest in real assets; use to produce (1) assets (machines) and/or (2) goods/services – Financial: invest in financial assets to increase value of savings – Markets: trade real/financial assets

• In general, these activities require (or call for on grounds of efficiency) to raise capital at the outset as well as regularly or occasionally for ongoing investments • The rich array of possible ways to manage this activity calls for specialization
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Financial officers
• Manage the interface of the corporation with capital markets
– Sell securities (stocks, bonds) to raise capital – Determine the use of net cash flows (pay out dividends or reinvest in new assets) -- capital budgeting

• The CFO (chief financial officer) and his staff perform two functions
– Treasury: cash management, raising capital, capital budgeting, banking – Controllership: financial statements, accounting, taxes
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VI. Present Value (PV, Ch_2.1)
• Suppose a claim to $120 with a maturity date one year from now is auctioned off. • What is the most you should pay for the claim? This is the present value (PV) of the claim • Denote the future CF by C(1). Here, C(1)=120 • Observed behavior shows that a dollar today is worth more than a dollar tomorrow: PV<C(1) • OK, but how can we tell by how much, and how can we determine the exact value of the claim?
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Market value
• The question of PV is analogous to asking the value of a bar of candy. People distribute on a spectrum from those who don’t touch it to those who are addicted to it. • Still, suppose a bar costs $1.20. Only those who value it at $1.20 or more will buy it, others will avoid it. In any event, $1.20 is the (market) value to use for decision making • Same applies to a claim on a dollar to be received one year from now. We observe the price of a U.S. Treasury bill that promises $10,000 a year from now. It is a safe claim; in fact, the only safe claim to be found in the U.S., since the U.S. government (the Treasury) owns and operates the mint
Alex Kane 24 IRPCOR421  Finance

The Discount Factor (DF) and the ‘market rate of return’
• Suppose we observe: price of a 1-year T-bill is $9,500 • This means: The market value of a 1-year safe dollar is 9500/10,000=$0.95. We call this the discount factor (DF) for safe dollars of 1-year maturity • The DF implies: the required rate of return on investment in safe dollars (r) is
C(0)*(1+r)=C(1) 1+r = C(1)/C(0) = 1/DF = 10000/9500 = 1.0526 (r=5.26%) Equivalently: r=profit/investment=[C(1)–C(0)]/C(0) Also: DF = 1/(1+r) = 1/1.0526 = 0.95

• 5.26% is the market rate of return on 1-year safe investment. All safe investments must be judged against it
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Can a safe investments yield less than 5.26% ??
• Can another 1-year safe asset, traded in financial markets, yield a lower rate of return than 5.26% ? • No! All rational investors would want to sell it and use the proceeds to buy a safe asset that yields 5.26%, making a sure (arbitrage) profit • Result: Only one safe rate of return (for a given maturity) prevails in capital markets

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Short Sales
• Capital markets allow sale of assets you do not own • In a short-sale transaction you borrow the asset and sell it. Brokers provide the service • Some time later (the short seller decides), s/he repurchases the asset and returns it • As long as you haven’t returned it, you hold a short position in the asset. • Why short sell? A belief that the asset is overpriced, and investing the proceeds from the short sale in fairly priced assets (or better yet in underpriced assets), will yield a profit. • Short sale facilitate holding down prices below irrational levels. Institutional constraints/cost limit this activity
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Investments that yield more: the rate of return to a successful entrepreneur
• Suppose the price of silkworms today is $1/dozen • An entrepreneur can grow a dozen worms over a year for only $0.94 (inclusive of all costs) • The profit per dozen is: 1– 0.94 = $0.06 • The 1-year rate of return is:
Profit/investment = 0.06/0.94 = 0.0638 (6.38%)

• In principle, this is possible. Is this likely?
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Return to enterprises
• The example of silk worms cannot be taken as safe. How can the entrepreneur be sure the price will remain at $1/dozen in one year? So this is a risky investment • However, suppose the entrepreneur is Japanese, and the Japanese government guarantees the price. • That investment would now be a steal (from the taxpayers, because the guarantee is valuable and can actually be priced!) • The raison d’etre (reason for existence) of enterprises is to try and beat the market return. Success is likely with risky investments as we shall see, never with safe investments (net of subsidies)
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The significance of the market rate of return and other names for it
• The market rate of return is the benchmark for any and all investments. There is a market rate for any degree of risk • The rate on safe investments (T-bills) is a factor in the benchmarks for risky investments • That ‘market rate’ has equivalent names:
– – – –
Alex Kane

the opportunity cost of capital the required rate of return the hurdle rate ‘The’ discount rate
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The PV quantified
• The PV is related to the future CF by the discount rate (or, equivalently, the DF)
PV = C(1)/(1+r) = C(1)/1.0526 = DF*C(1) = 0.95*C(1)

• Thus, the value of the 1-year claim on $120 is
120/(1+r) = 120/1.0526 = DF*120 = 0.95*120 = $114

• We make decisions about such claims based on their market value ($114) which we derive from the market DF (0.95), or discount rate (5.26%), observed from T-bills
Alex Kane 31 IRPCOR421  Finance

PV and uncertainty
• Suppose the silk-worm grower faces uncertainty about the price of silkworms • A scenario analysis yields the following table State of the world: Good Likely Poor Probability 0.3 0.5 0.2 Price per dozen ($) 1.3 1.0 0.8 • Expected price = sumproduct(prob,price)=$1.05 • Expected profit per dozen: 1.05–0.94 = $0.11 • Expected rate of return: 0.11 /0.94 = 11.70%
Alex Kane 32 IRPCOR421  Finance

The business of silkworms (hypothetical)
• Suppose the way it works is that an investment of I = $940,000 will produce a one-time crop of 1 million dozens of worms. • What we called ‘price’ is really the revenue minus selling cost per dozen • Thus, at year end, E(CF) = C1 = $1,050,000 • We know that PV(C1) = 1,050,000/(1+r) • But what should we use for r? • The question is really, what is the ‘required rate’ = ‘market rate’ = opportunity cost of capital ?
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The rate of return on risky investment
• As we shall see, we can quantify the level of risk carried by owners of various securities traded on capital markets, as well as the expected rate of return on these assets • In sum, we observe a market expected rate of return for any level of risk • We can estimate the level of risk involved in a project not yet traded • We use the market rate that applies to the level of the project’s risk to discount expected future CF • The project PV is the sum of thus discounted CF
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VII. Net Present Value (NPV)
• • • • • • • • The most fundamental concept in finance NPV = – I + PV(CF) For the silkworm business: Suppose the risk-free rate is: 5.26% (as before) The risk premium for silkworms is 4.54% The required rate is: 5.26+4.54 = 10% NPV = – 940,000 + 1,050,000/1.1 = $14,545 Notice: The expected rate of return is actually R=110,000/940,000 = 11.70%. • The difference between R (also called internal rate of return) and the required rate, generates the positive NPV
Alex Kane 35 IRPCOR421  Finance

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