5 Finance and Financial Management 2

Course:
Theory of Finance
and Money
Dang Anh Tuan,

PhD.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

What is finance?
1-2
Meaning of finance (Longman Concise
Dictionary of Business English)
1-3
Financial management
• Personal Finance
• Corporate finance
• Public finance
• Multinational Finance
1-4
Understanding finance, money
and markets
• Finance in business:
– Finance is a key factor in the success of any
business.
– Businesses need finance to:
• start up
• operate
• expand.
– The size of a business and the nature of its
ownership determine the finance options
available.
1-5
Business structures and finance
• The owners of a business usually choose the
structure that will help management to
maximise the value of the business entity.
• Important considerations are:
– size
– taxation
– legal liability
– ability to raise cash for finance.
1-6
• Sole traders:
– Owned by one person, typically consisting of the
trader and a handful of employees.
– Simplest type of business to start and it is the
least regulated.
– Keep all the profits from the business and do not
have to share decision‐making authority.
– But, have unlimited liability for all the business's
debts and other obligations.
1-7
• Partnerships:
– Two or more owners legally managing a business.
– A formal partnership agreement is recommended.
– Have access to more capital, and the pooling of
knowledge, experience and skills.
– But, disputes can occur over profit sharing,
administration and business development.
– Limited liability: consists of general (unlimited)
and limited partners.
1-8
• Companies:
– An independent legal entity able to do business in
its own right.
– The owners of a company are its shareholders.
• Shareholders have limited liability.
– Public companies can list on the stock exchange
1-9
The financial goals of a business
• For business owners, it is important to
determine the appropriate goal for financial
management decisions.
• What should management maximise?
– Depending on preferences and tolerance for risk,
any goals can be set for the business.
• Why not maximise profits?
1-10
• Why not maximise profits?
– Goal for financial decision‐making is profit
maximisation.
– Potential problems:
• Hard to define ‘profit’.
• Must consider the timing of cash flows.
– The time value of money is one of the most important
concepts in finance.
• Ignores the uncertainty of cash flows.
1-11
• Maximise the value of the company’s
shares:
– Asset value is determined by the future cash
flows.
– When determining the value of a company’s
shares, the below should be considered:
1. the size of the expected cash flows
2. the timing of the cash flows
3. the riskiness of the cash flows.
– An appropriate goal is to maximise the current
value of the company’s shares.
1-12
• Can management decisions affect share
prices?
– It is affected by a number of factors and
management can control only some of them.
• Direct and indirect impacts.
• Long term and short term impacts.
• Internal and external factors.
1-13
• Can management decisions affect
share prices?
– Major factors that affect share prices:
1-14
The financial manager
• The financial manager:
– Responsible for making decisions that are in the
best interests of the business’s owners.
– Should make decisions that maximise the value
of the owners’ shares - helps maximise the
owners’ wealth.
1-15
• The financial manager:
– Stakeholders:
• Someone other than an owner who has a claim on the
cash flows of the company.
– Managers, creditors, employees, suppliers and the
government.
• May have interests that differ from those of the owners.
1-16
• Cash flows between the company and
its stakeholders and owners:
1-17
• Three fundamental decisions in financial
management:
1. Capital budgeting decisions:
• Identifying the productive assets the company should
buy.
2. Financing decisions:
• Determining how the company should finance or pay for
assets.
1-18
• Three fundamental decisions in financial
management:
3. Working capital management decisions:
• Determining how day‐to‐day financial matters should be.
1-19
• How the financial manager’s decisions
affect the balance sheet:
1-20
Managing the financial function
• Simplified company organisation

chart:
1-21
Ethics in business
• The term ethics describes a society’s ideas
about what actions are right and wrong.
• Ethical values are not moral absolutes and
they can and do vary across societies.
• But, we would all probably prefer to live in a
world where people behave ethically.
1-22
Ethics in business
• Are business ethics different from
everyday ethics?
– Some refer to business ethics as the same as the
‘ethics of the poker game’.
– Normally, investors only learn the hard way about
companies that have been behaving unethically.
• For example, Storm Financial Limited or Opes Prime
Stockbroking Limited.
– But, regardless, ethics do matter in business.
1-23
Ethics in business
• Types of ethical conflicts in business:
– Most problems involve three related areas:
• Agency obligations:
– To act honestly with respect to financial transactions.
• Conflicts of interest.
• Information asymmetry:
– When one party has information that is unavailable to the
other parties.
1-24
Ethics in business
• The importance of an ethical business
culture:
– The business culture has a powerful influence on
the way people behave and the way they make
decisions.
– An unethical business culture can lead to adverse
consequences — not only to the management
and investors, but also to the general public.
1-25
Risk and Rates of Return
 Stand-alone risk
 Portfolio risk
 Risk & return: CAPM / SML
5-26
Investment returns
The rate of return on an investment can be

calculated as follows:
(Amount received – Amount invested)
________________________
Return =
Amount invested
For example, if $1,000 is invested and $1,100

is returned after one year, the rate of return
for this investment is:
($1,100 - $1,000) / $1,000 = 10%. 1-27
What is investment risk?
• Two types of investment risk

– Stand-alone risk
– Portfolio risk
• Investment risk is related to the
probability of earning a low or negative
actual return.
• The greater the chance of lower than
expected or negative returns, the
riskier the investment.
1-28
Probability distributions
• A listing of all possible outcomes, and

the probability of each occurrence.
• Can be shown graphically.
Firm X
Firm Y
Rate of
-70 0 15 100 Return (%)
Expected Rate of Return

1-29
Returns,
1926 – 2001
Average
Standard
Return
Deviation
Small-company stocks 17.3%
33.2%
Large-company stocks 12.7
20.2
L-T corporate bonds 6.1 8.6
L-T government bonds 5.7 9.4
U.S. Treasury bills 3.9 3.2 1-30
Investment alternatives
Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%
Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%
Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%
Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%
Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%
1-31
Why is the T-bill return
independent of the economy?
Do T-bills promise a
completely risk-free return?
T-bills will return the promised 8%, regardless of

the economy.
No, T-bills do not provide a risk-free return, as they
are still exposed to inflation. Although, very little
unexpected inflation is likely to occur over such a
short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the word.
1-32
How do the returns of HT
and Coll. behave in relation
to the market?
• HT – Moves with the economy, and has a
positive correlation. This is typical.
• Coll. – Is countercyclical with the economy,
and has a negative correlation. This is
unusual.
1-33
Return: Calculating the
expected return for each
alternative
^
k  expected rate of return
^ n
k   k i Pi
i1
^
k HT  (-22.%) (0.1)  (-2%) (0.2)
 (20%) (0.4)  (35%) (0.2)
 (50%) (0.1)  17.4%
1-34
Summary of expected
returns for all
alternatives
Exp return
HT 17.4%
Market 15.0%
USR 13.8%
T-bill 8.0%
Coll. 1.7%
HT has the highest expected return, and

appears to be the best investment
alternative, but is it really? Have we failed
to account for risk?
1-35
Risk: Calculating the
standard deviation for each
alternative
  Standard deviation
  Variance  2
n
  (k  k̂ ) P
i1
i
2
i
1-36
Standard deviation calculation
n ^
  i1
(k i  k ) 2 Pi
1
(8.0 - 8.0) (0.1)  (8.0 - 8.0) (0.2)
2 2
 2
 T bills   (8.0 - 8.0)2 (0.4)  (8.0 - 8.0)2 (0.2) 


2
 (8.0 - 8.0) (0.1) 
 T bills  0.0%  Coll  13.4%

 HT  20.0%  USR  18.8%
 M  15.3%
1-37
Comparing standard
deviations
Prob.
T - bill
USR
HT
0 8 13.8 17.4 Rate of Return (%)

1-38
Comments on standard
deviation as a measure of
risk
• Standard deviation (σi) measures total, or
stand-alone, risk.
• The larger σi is, the lower the probability
that actual returns will be closer to
expected returns.
• Larger σi is associated with a wider
probability distribution of returns.
• Difficult to compare standard deviations,
because return has not been accounted
for.
1-39
Comparing risk and return
Security Expected Risk, σ

return
T-bills 8.0% 0.0%
HT 17.4% 20.0%
Coll* 1.7% 13.4%
USR* 13.8% 18.8%
Market 15.0% 15.3%
* Seem out of place.
1-40
Coefficient of Variation (CV)
A standardized measure of dispersion

about the expected value, that shows
the risk per unit of return.
Std dev 
CV   ^
Mean k
1-41
Risk rankings,
by coefficient of variation
CV
T-bill 0.000
HT 1.149
Coll. 7.882
USR 1.362
Market 1.020
Collections has the highest degree of risk per unit of
return.
HT, despite having the highest standard deviation of
returns, has a relatively average CV.
1-42
Illustrating the CV as a
measure of relative risk
Prob.
A B
0 Rate of Return (%)
σA = σB , but A is riskier because of a larger

probability of losses. In other words, the
same amount of risk (as measured by σ) for
less returns. 1-43
Investor attitude towards risk
• Risk aversion – assumes investors

dislike risk and require higher rates of
return to encourage them to hold
riskier securities.
• Risk premium – the difference
between the return on a risky asset
and less risky asset, which serves as
compensation for investors to hold
riskier securities.
1-44
Portfolio construction:
Risk and return
Assume a two-stock portfolio is created with

$50,000 invested in both HT and Collections.
Expected return of a portfolio is a

weighted average of each of the
component assets of the portfolio.
Standard deviation is a little more tricky
and requires that a new probability
distribution for the portfolio returns be
devised.
1-45
Calculating portfolio
expected return
^
k p is a weighted average :
^ n ^
k p   wi k i
i1
^
k p  0.5 (17.4%)  0.5 (1.7%)  9.6%
1-46
An alternative method for
determining portfolio expected
return
Economy Prob. HT Coll Port.

Recession 0.1 -22.0% 28.0% 3.0%
Below avg 0.2 -2.0% 14.7% 6.4%
Average 0.4 20.0% 0.0% 10.0%
Above avg 0.2 35.0% -10.0% 12.5%
Boom 0.1 50.0% -20.0% 15.0%
^
k p  0.10 (3.0%)  0.20 (6.4%)  0.40 (10.0%)
 0.20 (12.5%)  0.10 (15.0%)  9.6%
1-47
Calculating portfolio
standard deviation and CV
1
 0.10 (3.0 - 9.6) 2
 2
 0.20 (6.4 - 9.6)2 

 
 p   0.40 (10.0 - 9.6)2   3.3%
 0.20 (12.5 - 9.6)2 
 2

  0.10 (15.0 - 9.6) 
3.3%
CVp   0.34
9.6%
1-48
Comments on portfolio
risk measures
• σp = 3.3% is much lower than the σi of

either stock (σHT = 20.0%; σColl. =
13.4%).
• σp = 3.3% is lower than the weighted
average of HT and Coll.’s σ (16.7%).
• \ Portfolio provides average return of
component stocks, but lower than
average risk.
• Why? Negative correlation between
stocks. 1-49
General comments about risk
• Most stocks are positively correlated

with the market (ρk,m  0.65).
• σ  35% for an average stock.
• Combining stocks in a portfolio
generally lowers risk.
1-50
Returns distribution for two
perfectly negatively correlated
stocks (ρ = -1.0)
Stock W Stock M Portfolio WM

25 25 25
15 15 15
0 0 0
-10 -10 -10
1-51
Returns distribution for two
perfectly positively correlated
stocks (ρ = 1.0)
Stock M Stock M’ Portfolio MM’

25 25 25
15 15 15
0 0 0
-10 -10 -10
1-52
Creating a portfolio:
Beginning with one stock and
adding randomly selected stocks
to portfolio
• σp decreases as stocks added, because

they would not be perfectly correlated
with the existing portfolio.
• Expected return of the portfolio would
remain relatively constant.
• Eventually the diversification benefits of
adding more stocks dissipates (after
about 10 stocks), and for large stock
portfolios, σp tends to converge to 
20%. 1-53
Illustrating diversification
effects of a stock portfolio
sp (%)
Company-Specific Risk
35
Stand-Alone Risk, sp
20
Market Risk
0
10 20 30 40 2,000+
# Stocks in Portfolio
1-54
Breaking down sources of risk
Stand-alone risk = Market risk + Firm-specific

risk
• Market risk – portion of a security’s stand-

alone risk that cannot be eliminated
through diversification. Measured by
beta.
• Firm-specific risk – portion of a security’s
stand-alone risk that can be eliminated
through proper diversification. 1-55
Failure to diversify
• If an investor chooses to hold a one-stock

portfolio (exposed to more risk than a
diversified investor), would the investor
be compensated for the risk they bear?
– NO!
– Stand-alone risk is not important to a
well-diversified investor.
– Rational, risk-averse investors are
concerned with σp, which is based upon
market risk.
– There can be only one price (the market
return) for a given security.
– No compensation should be earned for 1-56
Capital Asset Pricing
Model (CAPM)
• Model based upon concept that a stock’s

required rate of return is equal to the
risk-free rate of return plus a risk
premium that reflects the riskiness of
the stock after diversification.
• Primary conclusion: The relevant
riskiness of a stock is its contribution to
the riskiness of a well-diversified
portfolio.
1-57
Beta
• Measures a stock’s market risk, and shows a
stock’s volatility relative to the market.
• Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
1-58
Calculating betas
• Run a regression of past returns of a security
against past returns on the market.
• The slope of the regression line (sometimes
called the security’s characteristic line) is
defined as the beta coefficient for the
security.
1-59
Illustrating the
calculation of beta
_
ki
. Year kM ki
20
15
. 1
2
15%
-5
18%
-10
10 3 12 16
5
_
-5 0 5 10 15 20
kM
-5 Regression line:
. -10
^
ki = -2.59 + 1.44 ^
kM
1-60
Comments on beta
• If beta = 1.0, the security is just as risky as
the average stock.
• If beta > 1.0, the security is riskier than
average.
• If beta < 1.0, the security is less risky than
average.
• Most stocks have betas in the range of 0.5 to
1.5.
1-61
Can the beta of a security
be negative?
• Yes, if the correlation between Stock

i and the market is negative (i.e., ρi,m
< 0).
• If the correlation is negative, the
regression line would slope
downward, and the beta would be
negative.
• However, a negative beta is highly
unlikely.
1-62
Beta coefficients for
HT, Coll, and T-Bills
_
ki HT: β = 1.30
40
20
T-bills: β = 0
_
-20 0 20 40 kM
Coll: β = -0.87
-20
1-63
Comparing expected
return and beta
coefficients
Security Exp. Ret. Beta
HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-Bills 8.0 0.00
Coll. 1.7 -0.87
Riskier securities have higher returns, so

the rank order is OK.
1-64
(SML):
Calculating required rates of
return
SML: ki = kRF + (kM – kRF) βi
• Assume kRF = 8% and kM = 15%.

• The market (or equity) risk premium is RPM
= kM – kRF = 15% – 8% = 7%.
1-65
What is the market risk
premium?
• Additional return over the risk-free

rate needed to compensate investors
for assuming an average amount of
risk.
• Its size depends on the perceived risk
of the stock market and investors’
degree of risk aversion.
• Varies from year to year, but most
estimates suggest that it ranges
between 4% and 8% per year.
1-66
Calculating required rates of
return
• kHT = 8.0% + (15.0% - 8.0%)(1.30)

= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
• kM = 8.0% + (7.0%)(1.00) =
15.00%
• kUSR = 8.0% + (7.0%)(0.89) =
14.23%
• kT-bill = 8.0% + (7.0%)(0.00) =
8.00% 1-67
Expected vs. Required returns
^
k k
^
HT 17.4% 17.1% Undervalued (k  k)
^
Market 15.0 15.0 Fairly val ued (k  k)
^
USR 13.8 14.2 Overvalued (k  k)
^
T - bills 8.0 8.0 Fairly val ued (k  k)
^
Coll. 1.7 1.9 Overvalued (k  k)
1-68
Illustrating the
Security Market Line
SML: ki = 8% + (15% – 8%) βi

ki (%)
SML
HT
.. .
kM = 15
kRF = 8 . T-bills USR
-1
. 0 1 2
Risk, βi
Coll.
1-69
An example:
Equally-weighted two-stock
portfolio
• Create a portfolio with 50% invested in HT
and 50% invested in Collections.
• The beta of a portfolio is the weighted
average of each of the stock’s betas.
βP = wHT βHT + wColl βColl

βP = 0.5 (1.30) + 0.5 (-0.87)
βP = 0.215
1-70
Calculating portfolio required
returns
• The required return of a portfolio is the

weighted average of each of the stock’s
required returns.
kP = wHT kHT + wColl kColl
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%
• Or, using the portfolio’s beta, CAPM can be

used to solve for expected return.
kP = kRF + (kM – kRF) βP
kP = 8.0% + (15.0% – 8.0%) (0.215)
1-71
Factors that change the SML
• What if investors raise inflation
expectations by 3%, what would happen
to the SML?
ki (%)
D I = 3% SML2
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5
1-72
Factors that change the SML
• What if investors’ risk aversion
increased, causing the market risk
premium to increase by 3%, what
would happen to the SML?
ki (%)
D RP = 3%
SML2
M
18 SML1
15
11
8
Risk, βi
0 0.5
1.0 1.5 1-73
Verifying the CAPM empirically
• The CAPM has not been verified completely.
• Statistical tests have problems that make
verification almost impossible.
• Some argue that there are additional risk
factors, other than the market risk premium,
that must be considered.
1-74
More thoughts on the CAPM
• Investors seem to be concerned with both
market risk and total risk. Therefore, the
SML may not produce a correct estimate of
ki .
ki = kRF + (kM – kRF) βi + ???
• CAPM/SML concepts are based upon
expectations, but betas are calculated using
historical data. A company’s historical data
may not reflect investors’ expectations about
future riskiness.
1-75

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Course:

Dang Anh Tuan,

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

• Simplified company organisation

The rate of return on an investment can be

For example, if $1,000 is invested and $1,100

• Two types of investment risk

• A listing of all possible outcomes, and

Expected Rate of Return

Economy Prob. T-Bill HT Coll USR MP

Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

T-bills will return the promised 8%, regardless of

HT has the highest expected return, and

 T bills   (8.0 - 8.0)2 (0.4)  (8.0 - 8.0)2 (0.2) 

 T bills  0.0%  Coll  13.4%

0 8 13.8 17.4 Rate of Return (%)

Security Expected Risk, σ

A standardized measure of dispersion

0 Rate of Return (%)

σA = σB , but A is riskier because of a larger

• Risk aversion – assumes investors

Assume a two-stock portfolio is created with

Expected return of a portfolio is a

Economy Prob. HT Coll Port.

 0.20 (6.4 - 9.6)2 

• σp = 3.3% is much lower than the σi of

• Most stocks are positively correlated

Stock W Stock M Portfolio WM

-10 -10 -10

Stock M Stock M’ Portfolio MM’

-10 -10 -10

• σp decreases as stocks added, because

Stand-alone risk = Market risk + Firm-specific

• Market risk – portion of a security’s stand-

• If an investor chooses to hold a one-stock

• Model based upon concept that a stock’s

• Yes, if the correlation between Stock

Riskier securities have higher returns, so

SML: ki = kRF + (kM – kRF) βi

• Assume kRF = 8% and kM = 15%.

• Additional return over the risk-free

• kHT = 8.0% + (15.0% - 8.0%)(1.30)

SML: ki = 8% + (15% – 8%) βi

kRF = 8 . T-bills USR

βP = wHT βHT + wColl βColl

• The required return of a portfolio is the

• Or, using the portfolio’s beta, CAPM can be

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