15.401 Finance Theory I - MITweb.mit.edu/astomper/www/univie/pof/Chapter 1.pdf1 15.401 15.401 Finance Theory I Lecture Notes Alex Stomper MIT Sloan School of Management Institute for

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15.401

15.401FinanceTheoryI15.401FinanceTheoryI

LectureNotesLectureNotes

AlexAlexStomperStomperMITSloanSchoolofManagementMITSloanSchoolofManagementInstituteforAdvancedStudies,ViennaInstituteforAdvancedStudies,Vienna

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15.401

PartAIntroductionPartAIntroduction

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Chapter 1: Introduction to Finance

Chapter 2: Present Value

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15.401

15.401FinanceTheoryI15.401FinanceTheoryI

AlexAlexStomperStomperMITSloanSchoolofManagementMITSloanSchoolofManagementInstituteforAdvancedStudies,ViennaInstituteforAdvancedStudies,Vienna

Lecture Lecture 1: Introduction and Course Overview1: Introduction and Course Overview

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15.401 Lecture1:Introductiontofinance

_ Introduction:whatis“finance”?

_ Courseoverview

_ Howtogetthemostoutofthiscourse

Readings:

_ Brealey,MyersandAllen,Chapters1–2

_ Bodie,KaneandMarkus,Chapters1-3

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AgendaAgenda

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15.401 Lecture1:Introandoverivew

Howtomakeabusinessdecision?

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MotivationMotivation

ProjectProject

0 1 2 3$10m

$15m

$5m $5m $5m

$5±em $5±em $5±em

A

B

C

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15.401

RebalancingBase TotalReturnAnnual $241,061Quarterly $62,152,362Monthly $37,634,440,695

Lecture1:Introandoverview

Statistics CRSPVWMarketReturn UST-BillReturnMean 0.95% 0.31%Volatility 5.40% 0.25%Minimum -29.01% -0.03%Maximum 38.37% 1.52%TotalReturn* $2,583 $20


January1926toDecember2007

Note:*Basedona$1.00initialinvestmentinJanuary1926.

PerfectAssetAllocation

Note:1.Ifbothstockandbondreturnsarenegative,investincash.2.Prior1941,1monthT-billreturnsareusedtoconstructannualT-billreturns.

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15.401 Lecture1:Introandoverview

-3.0%1.0%Minimump.a.Return8.3%12.6%Maximump.a.Return

20YearHoldingPeriod:-5.1%-4.1%Minimump.a.Return11.6%16.9%Maximump.a.Return

Statistics USStocks UST-Bills1YearHoldingPeriod:Maximump.a.Return 66.6% 23.7%Minimump.a.Return -38.6% -15.6%10YearHoldingPeriod:


1802-1997Realizedp.a.Returns

Source: Siegel (1998), Figure 2-1.

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_ Financeisaboutthebottomlineofbusinessactivities

_ Abusinessactivityisaprocessofacquiringanddisposingassets– Real/financial

– Tangible/intangible

_ Allbusinessactivitiesreducetotwofunctions:– Growwealth(createvalue)

– Managewealthtobestmeeteconomicneeds

_ Financially,abusinessdecisionstartswiththevaluationofassets– “Youcan’tcreateandmanagewhatyoucan’tmeasure”

_ Valuationisthecentralissueoffinance

_ Financialmarketsrevealsomeassetvalues

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Whatisfinance?Whatisfinance?

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Questionswewouldliketoanswerinthiscourse:

1. Howfinancialmarketsdetermineassetprices?

2. Howcorporationsmakefinancialdecisions?

Investments:Whatprojectstoinvestin?

Financing:Howtofinanceaproject? Designing/selling financial securities/claims (debt, stock, …)

Payout:Whattopaybacktoshareholders? Paying dividends, buyback shares, …

Riskmanagement:Whatrisktotakeortoavoidandhow?

3. Howhouseholdsmakefinancialdecisions?

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Whatisfinance?Whatisfinance?

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Corporatefinancialdecisions

(1) Cashraisedfrominvestorsbysellingfinancialassets

(2) Cashinvestedinrealassets(tangibleandintangible)

(3) Cashgeneratedbyoperations

(4) Cashreinvested

(5) Cashpaidout(mandatory:debtpayments,discretionary:dividends,etc.)

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AframeworkoffinancialanalysisAframeworkoffinancialanalysis

CorporateOperations

FinancialManager

Individualand

InstitutionalInvestors

(2) (1)

(4)

(5)(3)

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Afirm’scashflows(1)Cashraisedfrominvestorsbysellingfinancialassets(2)Cashinvestedinrealassets(tangibleandintangible)(3)Cashgeneratedbyoperations(4)Cashreinvested

(5)Cashreturnedtoinvestors(debtpayments,dividends,etc.)

Managementdecisions---managecashflow(1),(2),(4),(5)_ Investment:(2)Æ(3)(valuingrealassets)_ Financingandpayout:(1),(4),(5)(valuingfinancialassets)_ Riskmanagement:(1)and(5)(valuefinancialassets)

Objective:Createmaximumvalueforshareholders.Soundbusinessdecisionsrelyonassetvaluation.

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TaskofFinancialManagerTaskofFinancialManager

Firm'sOperations

F inancialManager

Investors{ individuals{ institutions : : :

(1)

(4)

-(5)

(2)

-(3)

)

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Eachassetisdefinedbyitscashflow(CF)

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ValuationofAssetsValuationofAssets

Fundamentalvalueofanasset=Valueofitscashflow

Invest CF0 CF3

Earn CF1 CF2 CF4 ...

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15.401

Twoimportantcharacteristicsofacashflow:

1.Time

Whichonedoyouprefer?---Timevalueofmoney


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TimeandRiskTimeandRisk

today next year

$1,000

today next year

$1,000

2.Risk

Whichonedoyouprefer?---Riskpremium

$1,000

$1,000

$0

$2,000

Timeandriskaretwokeyelementsinfinance

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Valuationofaproject:theory Afirmcanalwaysgivecashbacktoshareholders Theshareholderscan(re)investthecash. Ifthefirmretainsthecash,theshareholdersmissoutoninvestmentopportunitiesinfinancialmarkets.

Opportunitycostofcapital=theexpectedrateofreturnofferedbyequivalent(intimeandrisk)investmentsinfinancialmarkets

Marketvaluationofaproject(i.e.,itsCF):Thehigherthecostofcapital,thelowerthevalueoftheproject.

Thevalueofaprojectispositiveiftheprojectyieldsahigherexpectedreturnthanitscostofcapital.

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OpportunityCostofCapitalOpportunityCostofCapital

#

"

Ã

!CASHProject Share-

holders-

Investmentopportunities

availablein ¯nancialmarkets

-

Invest InvestDividend

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Valuationofaproject:practicalaspects

_ Weneedtodefine“equivalent”assets(cashflows)

_ Ifanassetsistradedonafinancialmarket,itspriceindicatesthevalueof“equivalent”cashflows(assets):valuationby“matching”.

_ Alternative:valuationbasedonan“equilibrium”relationshipthatmapscashflowcharacteristicsintoprices.

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OpportunityCostofCapitalOpportunityCostofCapital

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Afirmcaninvestinaprojectthatyieldsacashflowwithamarketvalueof$100Mandrequiresaninvestmentof$60M.Thefirmhascashreservesof$62M.

Thefirmhastwoowners.OwnerAhashighshort-termconsumptionneedsthatownerB.Arethetwoownersunanimouslyinfavoroftheinvestment?

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ShareholderunanimityShareholderunanimity

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Conditionss.t.allshareholdersagreethatthefirmshouldmaximizethemarketvalueofitsequity:

Shareholders’consumptiondependsonthefirm’spoliciesonlythroughtheirbudget.

Shareholderscantimetheirconsumptionbyborrowingandinvestinginfinancialmarkets.

Shareholderscanusefinancialmarketstotrade“contingent”consumption(forallrelevantcontingencies).

Perfectcompetitioninfinancialmarkets,andallshareholdershavesimilar“access”toallfinancialmarkets.

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ShareholderunanimityShareholderunanimity

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FinancialMarketsFinancialMarkets

FinancialMarkets

&Intermediaries

Households

Nonfinancial Firms

ProductMarkets

LaborMarkets

LectureNotes ©2008JiangWang

15.401

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_ Financialmarkets-wherefinancialassetsaretraded– Moneymarkets:Short-termdebtsecurities

– Short-term government, bank and corporate debt (T-bills, CDs, CPs, …)

– Capitalmarkets:Long-termsecurities– Government and corporate bonds, asset-backed securities, …– Stocks, …

– Derivatives:Securitieswithpayoffstiedtootherprices– Forwards and futures, options, …

_ FinancialIntermediaries-Ownmostlyfinancialassets– Banks, insurance companies, S&Ls, …– Mutual funds, hedge funds, private equity, …

_ Nonfinancialfirms-Ownmostlyrealassets

_ Households-Ownbothrealandfinancialassets.

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FinancialMarketsFinancialMarkets

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1. Allocatingresources

_ Acrosstime

Example.Borrowmoneytobuyahome

_ Acrossdifferentstatesoftheeconomy

Example.Investinstocks/bonds

2. Communicatinginformation/pricediscovery

_ Marketpricesreflectavailableinformation

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FunctionsofFinancialMarketsFunctionsofFinancialMarkets

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FourParts

A. Introduction Lecture1:Introductiontofinance

Lecture2:Presentvalue(principlesofassetvaluation)

B. Valuation Lecture3:Fixedincomesecurities

Lecture4:Commonstocks

Lecture5:Forwardsandfutures

Lecture6:Options

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CourseoverviewCourseoverview

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C.Risk Lecture7:Riskandreturn(measuringrisk)

Lecture8:Portfoliotheory(managingrisk)

Lecture9:TheCapitalAssetPricingModel(incorporatingriskintovaluationmethods)

D.CorporateFinanceApplications Lecture10:CapitalBudgeting(capitalinvestmentdecisions)

FinalLecture:MarketEfficiency(puttingitalltogether) Dofinancialmarketsalwaysworkwellindiscoveringprices?

Wheredoesmoneycomefrominfinancialmarkets?

Howshouldfinancetheorybeusedinpractice?

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Courserequirements_ Lecturesandreadings(attendanceandparticipation)_ AcidRaincasestudywrite-up_ Midtermexam_ Finalexam_ Problemsets(optional)

ImplicitContract_ Facultyshould

– Cometoclassontimeandbewellprepared– Provideclearandtime-appropriateexpositionofmaterial– Manageclassdiscussionseffectively

_ Studentsshould– Cometoclassontimeandbewellprepared– Contributetoclassdiscussions– Refrainfromnon-classactivities(email,newspapers,etc.)

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15.401 IntroandoverviewHowtogetthemostoutof401Howtogetthemostoutof401

Theoryvs.Practice_ Mostofthiscoursewillbedevotedtotheory_ Whataboutpractice?_ Theoriginsoftheoryiscommonelementsdeducedfrompractice!

Somehelpfulsuggestions

_ Doreadingsaheadoftime(skimtextbookchaptersinadvance)

_ Takecopiousnotesduringlectures(lecturenotesarenotcomplete)

_ Reviewthelecturesafterwardswithyourstudygroup

_ Workonproblemsets---“Financeisnotaspectatorsport”

_ Askquestions!!!

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Evaluatingabusinessboilsdowntovaluationassets

Anassetisdefinedbyitscashflow(CF)

TwoimportantcharacteristicsofaCF:timeandrisk

Valueofassets(CFs)aredeterminedbyfinancialmarkets

Costofcapital

Therolesoffinancialmarkets

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SummarySummary

15.401 Finance Theory I - MITweb.mit.edu/astomper/www/univie/pof/Chapter 1.pdf1 15.401 15.401 Finance Theory I Lecture Notes Alex Stomper MIT Sloan School of Management Institute for

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