Summary of Courses in Finance I-II-III. MBA2003

Summary of Finance, MBA2003 1

Summary of Coursesin Finance

(State Exam)

Mihály Ormos – Gábor Bóta


Some Words on the State Exam

18 questions in four different blocks (subjects)–Accounting (3 Theorems)–Basics of Business Economics (4 Theorems)–Corporate Finance (5 Theorems)–Macro-Finance (6 Theorems)

Only one out of eighteen should be drawn8 – 10 minutes for the answerCoherent knowledgeConversationPreparation timeThree to five different boards, with 4 membersImmediate mark as it was in the course unit exam


Accounting

1. Balance Sheet– Notation of balance sheet– The structure of the balance sheet– Contents of main groups and groups

2. Income Statement– The concept and of structure of the income statement– Total cost and turnover cost type of income statement– The contents of profit and loss categories

3. Cash-flow– The concept and of structure of the cash flow statement– Direct and indirect type of cash flow– Effect of economic events on the BS, CF and IS

(Connection between the three statements)


Business Economics & Corporate Finance

4. Markowitz’s portfolio theory– Maximization of expected utility and risk-aversion

– Diversification, diversifiable and nondiversifiable risk

– Efficient portfolio, investor decision in the Markowitz model

5. CAPM by Sharpe– Risk-free opportunity, homogeneous expectations

– Market portfolio and the capital market line

– Beta and the security market line

6. Basics of investment decisions– Owner’s value maximisation, mini-firm approach

– The opportunity cost approach, opportunity cost from the capital market, through CAPM

– Economic analyses


Accounting


Balance Sheetas the Part of the Financial Report (Statement)

Report

Analytical records

Documents (i.e. invoices)

Ledger(Continuous record of

economic events)

Balance SheetIncome StatementNotes to the Report+ Business Report

Disclosure

Ord

er o

f doc

umen

tsAudit

Stocktaking


Balance Sheettypes of financial report

Simplified annual financial report–Revenue–Average number of employees–Total Assets

Annual financial report

Consolidated annual financial report


Balance SheetConcept and Structure

Purpose: is to disclose information on the financial position of a business on a specific date.

The financial position is shown from two points:Assets are the properties and property rights of the firm

(what we have, what we hold)

Liabilities are the equity of the owners and the debts(from what we bought)

Assets = Liabilities (+ owner’s equity)

The properties are listed in a predefined order

Measurement unit: Value

Signed by a chartered accountant

Two value column (for the previous and actual year)


Balance Sheet Structure

BS, Dec. 31th of 200X LiabilitiesAssets

A. Main GroupI. Group

1. Item2. Item

II. Group1. Item2. Item3. Item

B. Main GroupI. Group

1. Item

C. Main Group I. Group

1. Item2. Item

II. Group1. Item2. Item

D. Main Group I. Group

1. Item

Totals Totals


Balance SheetMain Groups and Groups

Balance Sheet, 200X. Dec.. 31. LiabilitiesAssets

A. Fixed AssetsB. Current AssetsC. Accrued Incomes and prepaid expenses

D. Owners equityE. ProvisionsF. Liabilities (Debts)G. Passive Accruals and deferred items

Total Assets Total Liabilities


Assets Balance SheetMain Groups and Groups

The assets are classified by the duration of ownership

Fixed AssetsProperties which have been held by the firm for more than one

year.

Current AssetsThose which cannot be included in the above group.

The management should decide on the classification.

Active Accruals(Accrued incomes and prepaid expenses)

The revenues and expenditures has to be cleared to the year for which it has been occurred, in this main group the cleared revenues are increased or the expenditures are decreased.


Liabilities Balance SheetMain Groups and Groups

Shareholder’s EquityCapital which is placed at owner's disposal for permanent use.

ProvisionsProvisions are liabilities, which created in charge of the

Earnings Before Interest and Tax (EBIT) by definition, so it formulate transition between shareholder's equity and liabilities.

Liabilitiesare acknowledged debts that has to be performed in money

Passive Accruals(Deferred incomes and accrued expenses)

in this main group the cleared revenues are decreased or the expenditures are increased.


Balance SheetMain Groups and Groups

Balance Sheet, 200X. Dec.31. LiabilitiesAssetsA. Fixed Assets

I. Intangible AssetsII.Tangible AssetsIII. Invested Financial Assets

B. Current AssetsI. InventoriesII. ReceivablesIII. SecuritiesIV. Cash

C. Active accruals

D. EquityI. Subscribed CapitalII. Unpaid Subscribed CapitalIII. Capital ReserveIV. Committed ReserveV. Accumulated profit ReserveVI. Evaluation ReserveVII. Retained Earnings

E. ProvisionF. Liabilities

I. Junior DebtII. Long-term DebtIII. Short-term Debt

G. Passive Accruals

Total Assets Total Liabilities


Fixed Balance SheetAssets Main Groups and Groups

Intangible assetsTradable, non-material assets which permanently (for more than

one year) serve the firm.Constituents

Rights representing pecuniary value, Goodwill, Intellectual product,

R&D, Value of establishment or reorganisation, Revaluation upwards

Tangible assetsMaterial assets which directly or indirectly and permanently

serve the company.Constituents

Land, buildings and connecting property rights, Machinery and equipment, Other equipment, Investments, Advance payments towards investments, Revaluation upwards

Depreciation


Fixed Balance SheetAssets Main Groups and Groups

Invested financial assets (Long term investments)Investment into another entity for the sake of some kind of

cause like control or long term return.

ConstituentsProfit-sharing, Securities, Loans, Long-term bank deposits

Depletion


Current Balance SheetAssets Main Groups and Groups

InventoriesThose current assets, which can be stocked, and have

quantitative measure, likeStock (in hand),Goods,Advance payments made towards inventories,Livestock,Work in progress and semi-finished products,Finished products

ReceivablesContractual claims that acknowledged by the partner.Constituents

Accounts receivable (buyers),Draft receivables,(Unpaid issued capital),Other receivables


Current Balance SheetAssets Main Groups and Groups

SecuritiesShort term securities (maturity or its holding period is shorter

than one year)

E.g.Shares bought for sale,

Own shares, shares Other securities

Bonds and other securities bought for sale,

CashLiquid assets include:

cash, cheques and bank deposit


Owner’s Balance SheetEquity Main Groups and Groups

Subscribed CapitalPaid-in capital represents the amounts invested in the corporation by the

stockholders. This amount can be found in the statement of establishment.

Unpaid Subscribed (Issued) CapitalSome kind of receivable, just for better information this is shown here

Capital reserveCapital which is paid in above the par value by the owners.

Committed ReserveLimit for dividend pay off, formed in charge of the capital reserve or the

accumulated profit reserve

Accumulated profit reserveis the sum of the previous years’ retained earnings

Evaluation reserveis the sum of the revaluation upwards on the asset side.

Retained Earnings (Net profit)


Liabilities Balance SheetMain Groups and Groups

Junior DebtsLong-term liabilities

Long-term loansConvertible bondsDebts on issue of bondsInvestment and development creditsOther long-term creditsOther non-current liabilities

Short-term liabilitiesLiabilities with expiration less than one year, or with a less then one year

ownership. LikeShort-term loansShort-term creditsAdvance payments received from purchasersAccounts payable (suppliers)Overdraft debtsOther short term liabilities (like: Accrued salaries, Social insurance etc.)

Passive accruals


Income Statement As the Part of the Financial Report

Report

Analytical records

Documents (i.e. invoices)

Ledger(Continuous record of

economic events)

Balance SheetIncome StatementNotes to the ReportBusiness Report

Disclosure


Income Statement Concept and Structure

The income statement shows the difference of the annual revenues and expenditures.

Uniform structure, predefined earning categories.

It gives information on the profit gaining capability of the firm.

It is a report about the derivation of retained earnings.

By the law of accounting:“The profit and loss account shall contain the breakdown of the entrepreneur's balance-sheet net profit figure, that is the after-tax profit retained by the entrepreneur, the main factors influencing the development of profits and losses,...“


Income Statement Concept and Structure

Trading Revenues- Trading expenditures (costs)A/ Trading profit (EBIT)

Financial revenues- Financial expenditures .B/ Financial profitC/ Usual Entrepreneurial Profit or Loss ( A B)

Extraordinary Revenues- Extraordinary Expenditures .D/ Extraordinary profitE/ Pre-tax profit (EBT) ( C D)- Tax liability .F/ After-tax profit - Paid (approved) dividend .G/ Retained earnings (balance-sheet net profit)


Income Statement Types

In Hungary:–Total Costs profit and loss account procedure (“A”)

–Turnover costs profit and loss account procedure (“B”)

(US, UK GAAP: single step and multiple step)

The differences between the two types can be found in the derivation of the trading profit.


Income Statement Types

Total cost typeNet sales revenues

Other revenues

Capitalised value of own performance

Trading Incomes

Annual total costs

Other expenditures

Trading expenditures .

A/ Trading (Business) profit

Turnover cost typeNet sales revenues

Other revenues

Trading incomes

Costs of sales

Other expenditures

Trading expenditures .

A/ Trading (Business) profit


Net sales Income Statement

Revenues TypesThe consideration

–value of sold inventories (products, materials, good etc), and services performed,

–accepted by the partner,

–not including the VAT

– increased by the subsidies and extra charges and

–reduced by consumption tax and any reductions shall be entered as net revenues

• Net Domestic Sales Revenue• Net Export Sales Revenue

Revenues Cash inflow


Other Income Statement

Revenues TypesOther revenues are revenues not forming part of the net sales revenues which arise in the course of regular activity (business), like:

–Received compensation–Received penalty–Revenues from intangible and tangible asset sold–Utilisation of the previous year’s provisions formed


Capitalised value of Income Statementown performance Types

Two parts–Capitalised value of self-manufactured assets are

the total amount of the value of self-manufactured assets capitalised (entered among assets) in the calendar (business) year.

–Change in self-manufactured inventoriesdifference between the opening and closing self-manufactured inventory of the year.

A


Total Income StatementCosts Types

Material type expenditures–utilisation of material purchased–purchase value of goods sold–utilized services–other services–subcontractors’ work (further billed value)

Payments to personnel–wages–personnel involvement–other payments to personnel, etc.

Depreciation

A


Costs of Income StatementSales Types

That part of the total costs which can be connected to the annual revenues, so it is equal to

Total costs - Capitalised value of own performance• Direct cost of sales as

– costs of products,– materials and– goods sold– services performed accounted as direct cost– costs of trading activities that may accounted for directly

• Indirect cost of sales as– costs of sales (marketing costs)– administrative costs– other general costs (overheads)

B


Other Income StatementExpenditures Types

Other expenditures are costs and payments not connected directly or indirectly to the net sales revenues which are incurred in the course of the regular activity (business).

– Paid compensation– Paid penalty– Expenditures of (i.e. book value) of intangible and tangible

asset sold– Provisions formed– etc.


Income Statement Profit and Loss Categories

Trading Revenues- Trading expenditures (costs)A/ Trading profit (EBIT) Financial revenues- Financial expenditures .B/ Financial profitC/ Usual Entrepreneurial Profit or Loss ( A B) Extraordinary Revenues- Extraordinary Expenditures .D/ Extraordinary profitE/ Pre-tax profit (EBT) ( C D)- Tax liability .F/ After-tax profit Use of accumulated profit reserve for dividends- Paid (approved) dividend .G/ Retained earnings (balance-sheet net profit)


Financial Income StatementProfit Profit and Loss Categories

Financial profit is the difference of the revenues and expenditures of financial transactions.

Financial revenues:– interest received– interest related revenues– dividends– profit-sharing– other revenues of financial transactions

Financial expenditures– interest paid– interest related payments– write-off (depletion) of financial investments dividends– other expenditures of financial transactions


Usual Entrepreneurial Income StatementProfit or Loss Profit and Loss Categories

The sum of the trading (business) profit or loss and the financial profit or loss.

Gives information on the profit gaining capability of the firm’s normal course of activity.


Extraordinary Income StatementProfit Profit and Loss Categories

Extraordinary profit figure is the difference of the extraordinary revenues and extraordinary expenditures.

Extraordinary revenues and extraordinary expenditures are independent of the entrepreneurial activity i.e. fall outside of the entrepreneur’s normal course of business, they are directly listed in the law of accounting.


Cash-Flow Concept and Structure

The statement of cash-flows focuses on cash receipts and cash payments, so the main question to be answered is:

Did the company’s cash balance increase or decrease during the year and how?

The statement shows why cash changed over the period by reporting net cash provided or used by

–operating activities,–investing activities and–financing activities.


Cash-Flow Direct and indirect method

Direct methodinvolves listing each major class of cash receipt transactions and cash disbursement transactions for each of the three areas of activity.The operating activity transactions include cash received from customers, cash paid to merchandise or raw material suppliers, cash paid to employees for salaries or wages, and cash paid for other operating expenses etc.

Indirect methodThis method shows the net income as the first source of operating cash,derives cash flows from operating activities by explaining the CHANGE in each of the non-cash operating accounts in the balance-sheet.


Direct Cash-Flowmethod Structure

Cash-flows from operating activitiesCash received from customersCash paid to suppliersPayments for compensation of employeesOther operating expenses paidInterest paidTaxes paid .Net cash provided by operating activities

Cash-flows from investing activitiesProceeds from sale of landInvestment in plant and equipment .Net cash used for investing activities

Cash flows from financing activitiesAdditional long-term borrowingPayment of long-term debtPurchase of treasury stockPayment of dividends on common stocks .Net cash used for financing activities


Indirect Cash-Flowmethod Structure

Cash-flows from operating activitiesNet profit (income)

Depreciation expendituresIncrease in accounts receivableIncrease in inventoriesIncrease in current liabilities

Other net cash flows .Net cash provided by operating activities

Cash-flows from investing activitiesProceeds from sale of landInvestment in plant and equipment .Net cash used for investing activities

Cash flows from financing activitiesAdditional long-term borrowingPayment of long-term debtPurchase of treasury stockPayment of dividends on common stocks .Net cash used for financing activities


Law of Cash-FlowAccounting StructureCash-flows from operating activities

Pre-tax profitDepreciationDepletionForming or using provisionsProfits of selling fixed assetsChange in accounts payableChange in other short term debtsChange in passive accruals and deferred itemsChange in accounts receivableChange in current assets

(without accounts receivable and cash)Paid, payable taxPaid dividend .Net cash provided by operating activities

Cash-flows from investing activitiesProceeds from sale of land, plant and equipm.Investment in plant and equipmentReceived profit-sharing and dividend .Net cash used from investing activities

Cash flows from financial activitiesIncomes of public offeringIncomes of bond or other security offering Long-term borrowingPayment of long-term debtReceived cashStock withdrawalPayments of debtsLong term loans, bank depositsPermanently granted cashChange in claims against founding members

and in other long term liabilities .Net cash used for financing activities

Change in cash


Cash-FlowConnection between the CF, the IS, and the BS

Balance sheet vs. income statement:–Retained earnings can be found in both statements

–Change in cash cannot be seen in the profit and loss account

Cash-flowthis statement can be compiled from the data presented in the

balance-sheet and income statement

Both the balance-sheet and income statement use accrual accounting (recognises revenue when it is earned, expenses when they are incurred) while the cash-flow uses cash-flow accounting (recognises transactions when cash has been received or paid).


An economic evente.g. provision

IS:Cleared as other expenditure, so decreasing the pre-tax profit

BS:Increasing in provision

Decreasing in retained earnings

CF:The pre-tax profit is decreased (-)

Provisions formed (+)


7. Market efficiency– Definition of perfect efficiency, and its properties

– Forms of market efficiency (definitions, tests, reasons of existence)

– Corporate financial analyses in contrast of market pricing

8. Taxation– Principles of taxation, basic types

– Value Added Tax, Corporate Tax, Personal Income Tax

– Consideration of taxes in corporate financial analyses

9. Dividend policy– Indicators of dividend, practices

– Indifference of dividend policy in perfect and imperfect market

– Significance of indifference of dividend policy in financial analyses, consequences



10. Financing decisions– Business activity and debts in the function of leverage

– Shares in the function of leverage in equilibrium and nonequilibrium taxation

– Consequences of Miller and Modiglinai theorems on corporate financial analyses

11. Cash flow estimation– Principles of Cash flow estimation

– Consideration of the inflation, taxes and exchange rates

– Separation of expected value and risk

12. Determination of opportunity cost – Determination of opportunity cost by the CAPM

– Determination of the risk free and of the average market risk premium

– Determination of betas



Markowitz’s portfolio theory Maximization of expected utility, risk-aversion and rationality

Investors compare investment possibilities with different risk and return.

How do investors decide in a risky situation?

Bernoulli was the first who argued that investors decide upon the maximisation of expected value (return).

Investors’ decisions are made upon the expected utility (satisfaction) of the wealth.

So investors try to maximise the expected utility, NOT the expected value of the wealth

i iwUipUE W max)(



The expected utility of an output is not proportionally related to expected value of the same output. The relationship can be represented by the utility function of the wealth.


MU(W)

W

U(W)More money

is better...

Decreasing marginal utility of the wealth



Portfolio theory Diversification, diversifiable and nondiversifiable risk

U5

U4

U3

U2

U1

E(r)

σ(r)



By diversifying the investments (creating portfolio), the risk (variance of the return) will be decreased.

U5

U4

U3

U2

U1

E(r)

σ(r)

1

3

2

2,5

11,4

i

3,3

17,1

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U5

U4

U3

U2

U1

E(r)

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E(r)



U5

U4

U3

U2

U1

E(r)

σ(r)σ(r)

E(r)



While the diversification is free, and useful, all investors hold efficient portfolios.

U5

U4

U3

U2

U1

E(r)

σ(r)σ(r)

E(r)

A

Efficient portfolios

B



In a portfolio the (total) risk of an investment can be divided into two parts:

– diversifiable (unique or non-systematic risk)

– non-diversifiable (market or systematic risk) U 5

U 4

U 3

U 2

U 1

E (r)

σ(r)σ(r)

E(r)

A

efficient portfolios

B


Portfolio theory Efficient portfolio, investor decision in the Markowitz model

In the Markowitz model the portfolios held by the investors cannot be identified, so as the non-diversifiable risk .

U5

U4

U3

U2

U1

E(r)

σ(r)σ(r)

E(r)

A

Efficient portfolios

B

E(r)

C


CAPM by Sharpe Risk-free opportunity, homogeneous expectations

The new assumptions and boundary conditions:• Perfect competition (microeconomic conditions)

– lot of investors with small investments–regulations and taxes have no effect on the decisions–perfect information flow–no transaction cost

• Investors–are rational, and hold Markowitz type portfolio–use the same type of analyses (together with the above conditions on

the competition gives the homogeneous expectations)

• Investment opportunities–are restricted to risky securities traded on the security market

and to risk-free lending and borrowing–the cost of risk-free lending and borrowing are the same

Summary of Finance, MBA2003 55σ(r)

E(r)

U5

U4

U3

U2

U1

E(r)

σ(r)

CAPM by Sharpe Risk-free opportunity, homogeneous expectations

By introducing the two additional assumptions: risk-free assets and homogeneous expectations, CAPM solves the problem of Markowitz model.

M

All investors hold the same risky portfolio (M),independently toits preferences.This risky portfolio will be combined with risk-free assets, by its preferences.


CAPM by Sharpe Market portfolio and the capital market line

While everyone hold the same risky portfolio this cannot be anything else than the Market Portfolio (M).

This will be combined with the risk-free asset, so all portfolios held by the investors will be placed on the Capital Market Line.

Capital Market Line

rf

σ(r)

E(r)

Market Portfolio

E(rM)

σ(rM)


CAPM by Sharpe Market portfolio and the capital market line

After all the question is, that how a given security affects the risk of the Market Portfolio.

–Only the affect on the market portfolio has to be examined, because the risk free return does not influence the diversification or the perception of the relevant risk.

This depends on what extent the given security gains in average the deviation of the Market Portfolio.

This is shown by the slope of characteristic line.


CAPM by Sharpe Beta and the security market line

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1

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ri

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2222 )()()( iMii rr

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So the CAPM is fMf rrErrE )()(

E(r)

market portfolio

security market line

E(rM)

1

rf

β

riskpremium

timepremium



E(r)

rf

β


Basics of investment decisionsOwner’s value maximisation, the opportunity cost approachDevelopment of public limited corporations

Early capitalism• individuals and families, with unlimited liability• the owner and the manager is the same• Development of technology and mass production required

the concentration of capital

Limited liability• more owner one company• legal entity• management and ownership are separated, but• the goals are different• shares are tradable• stock exchange• agency problem

However, the management makes the decisions, as a starting point we presume, that the decisions will be made upon the theory of shareholder’s value.


Basics of investment decisionsOwner’s value maximisation, the opportunity cost approach

The goal of the owners’ is the utility maximisation, however in this special case only thy economic utility is considered.

–If this is the goal of the owner -by the shareholder’s value- this has to be goal in any business decision.

The wealth of the owner can be increased through dividend pay off or stock price increase.

Only those investment decisions suits to the value maximisation approach, which promise higher return than others.

Others means in investment decisions the capital market opportunities.

Opportunity cost is the return of other investments on the capital market with similar risk.


Basics of investment decisions Opportunity cost from the capital market, through CAPM

E(r)

rf

β

Stock prices are continuously adjusted -by the efficient capital market itself- to the expected risks and returns, so the expected returns (fitting to the risk) tends to the normal return. Only those investment decisions will be realised, which promises higher return than the normal.


E(F1)E(F2)

E(Fn)

E(FN)

F0

… …Nn21

0

βproject IRR

E(r)

piaci portfolió

értékpapír-piaci egyenes

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)(

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nn

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FENPV altrIRR

Firm

Shareholder

Project

Investmentdecision

Dividend

Tőkepiaci alternatívaCapital m.alternative

Basics of investment decisions Opportunity cost from the capital market, through CAPM


Basics of investment decisions Mini-firm approach

All investments will be implemented which is better than the similar risk capital market investment.

Better means positive NPV or IRR exceeds ralt.The opportunity cost is estimated through CAPM.The risk (so the opportunity cost) of any arbitrary

elements of the shareholder’s portfolio depend on the stochastic relationship with the market portfolio but not each other.

So, if the CAPM is used than the risk of any single entity -as well as the risk of any project- individually with respect to the market portfolio will be examined, i.e. independently from its corporate environment.

The single projects will be considered as “mini-firms”.


Basics of investment decisions Economic analyses

The main steps of a corporate financial analyses are–Determination of opportunity costs (identification of the return

of the similar risk capital market investment possibility) –Determination of future cash-flows (this is the sum of economic

effects of the project) –Economic analyses (comparison between the profitability of the

project and the alternative investment possibility)• NPV, IRR, PI, AE


Basics of investment decisions Economic analyses Net present value

Net Present Value is the sum of discounted cash-flows of a given project by the opportunity cost.

So in this way the economic value of a project can be compared to other investment possibility with the same risk. The result of NPV calculation shows the value increase above the capital market opportunity.

Therefore, all projects have to be implemented with NPV>0.

nn

n 0 alt

E(F )NPV 0

(1 r )


Basics of investment decisions Economic analyses Internal rate of return

Internal Rate of Return is defined as the rate of discount which makes the NPV=0.

IRR is the average return of the project which has to be compared to the opportunity cost.

So the IRR rule is to accept an investment project if the opportunity cost of capital is less then the IRR.

Pitfalls of IRR:–It shows the average return of the project i.e. the increase of

unit equity in unit time–Lending or borrowing–Multiple rates of return–Mutually exclusive projects–Short- and long term interest rates may differ


Basics of investment decisions Economic analyses Profit Index and Annual Equivalent

Profit index is the quotient of the Net Present Value and the investment cost of the project:

0

NPVPI

F

It is used in case of limited capital, for mutually exclusive projects.


Basics of investment decisions Economic analyses Profit Index and Annual Equivalent

Annual equivalent can be used to compare mutually exclusive and repeating projects with different life time.

In this case the future cash-flows of the project converted to annuity and these annuities will be compared (NPV of the normal cash flows has to give the same result as the NPV of the annuity)


Market efficiency Definition of perfect efficiency, and its properties

The market is perfectly efficient if all available information on securities (and everything that can be connected to the securities) is immediately and in a correct way built in to the prices.

In general this means that it is not possible that a security bought or sold on the market price can produce positive NPV.

Continuous buying and selling, and continuous information collection and “in building” with zero transaction- and information acquiring cost.

While the transactions, collection and processing information can take cost the prices will reflect all information until the marginal cost of transactions are less than the return connected to the transaction.


Market efficiency Forms of market efficiency, definitions

Weak form of market efficiency:all historical price (return) information available is

immediately built in,

Semi-strong form of market efficiency: also all public (fundamental) information is immediately built

in the securities’s price,

Strong form of market efficiency:all public and non-public information is immediately built in

the prices as well.


Market efficiency Forms of market efficiency, definitions

Question: whether the actual price contains all public information.

If yes, then future events are unpredictable and randomly happen.If not, then future prices can be predicted

• using historical price (return) information (weak form)

• using public fundamental information (semi- strong form)

• based on unpublic (fundamental) information (strong form)

price

presentpast future

New information, accidentiallity


Market efficiency Forms of market efficiency, tests

Two types of analyses:–technical analyses

–fundamental analyses

If the technical analyses proved to be useless this verifies the weak form of market efficiency.

By the examination of the fundamental analyses the semi-strong and strong form of market efficiency can be tested.


Weak Market efficiencyform Forms of market efficiency, tests

The technical analyses try to find some kind of stochastic relation between sec’s historical prices and other “things”.

Predictability testes:–Correlation tests

• auto-correlation• cross-correlation (with other sec’s, indexes, volumes)

The correlation coefficients are very small, almost random-walk.

–Runs tests

–Return patterns• January-December effect• Day of the week effect

–etc.


Weak Market efficiencyform Forms of market efficiency, tests

Conclusion:The prices are unpredictable by technical analyses

in Hungary as well.

The stock prices do not have memory.


Semi-strong Market efficiencyform Forms of market efficiency, tests

Testing of consultants companies and managed mutual founds past forecasts and compared them to the later reality.The results are:

– on the long run: nothing

– on the short run: nothing

– by industrial segment, region, etc.: nothing

– the managed portfolios gives the same nothing in average

There is no consistent winner.


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Event Market efficiencystudies Forms of market efficiency, tests

Day of publication

0 3020-10 10-20-30

Daily return


Market efficiency Reasons of existence

If the markets are proved to be efficient, than any kind of analyses are proved to be useless.

If these are useless, no one would do them,

but the markets are efficient because lot of analysts work on,

If the number of analysts decreases they would have the opportunity to gain excess profit, so the number will increases.

Corporate financial analyses in contrast of market pricing:

–If not only the normal profit can be gained on the capital markets, than the CAPM would give nothing to compare.


TaxationPrinciples of taxation, basic types

Two basic principles of taxation:–Principle of benefit

The value of contribution “to the common” is fair if it is proportional to the received benefit form the “common”.

–Principle of solvencyDetermining the value contribution, the income and the financial

position should be considered

Two basic types of taxation was settled:–Indirect types

These do not consider the personal conditions, these are connected to the consumption and to the turnover (e.g. VAT)

–Direct types• These are strictly connected to the individual conditions (like income, or

profit) of the person or corporation (e.g. PIT, or CT)


TaxationValue Added Tax, Corporate Tax, Personal Income Tax

Connected to almost all products and services.In this case the authority does not have any connection to the taxing individuals, because the supplier pays after all transaction, actually the purchaser pays the tax but the price contains it.

If the purchased good or service will be used for business activity the tax payable can be reduced with the shifted tax, so only the added value will be charged by this tax.

The general degree of VAT in Hungary is 25%.Advantages:

– if a wide black market exists, than from the income side it is difficult to collect the tax

– strengthening the documentation of transactions– the consumer does not sense, “hidden tax”

Disadvantages:– higher administrative task– intellectual crimes (negative tax)– not proportional contribution (with higher income, the less amount will be

used for consumption)



The tax base is coming form the accounting pre-tax profit.

This accounting pre-tax profit has to be modified according to the differences between the law of accounting and taxation.

From the corrected positive pre-tax profit 18% corporate tax has to be paid.



In case of private domestic individuals the sum of all income (money or payments in kind) forms the tax base

There are two types of income tax–aggregated income

• tax brackets (higher income – higher tax rate)

–separated income• revenue on capital investment: 20% tax rate (the interest is 0%, price

earnings 20%, dividend tax 20%, etc.)


TaxationConsideration of taxes in corporate financial analyses

VAT: net amounts are used in the calculations (the company actually just an intermediary)

Other taxes, which are not connected to the accounting profit e.g. consumption tax are considered in the cash flow as simple costs (cash outflow)

Corporate tax and personal income tax:These types reduce the shareholder’s value, the main difference is the

level on which they act.The two tax types are summarized in the so called effective tax rate

teff=1-(1-tc)(1-tp)

As a basic principle in determination of the expected cash-flows and opportunity cost, that the same taxation should be considered.

If the opportunity cost were determined after all tax liability, than the cash flows should be calculated on the same way.


Dividend policyIndicators of dividend, practices

Dividend yield ratio– (dividend/price, Div/P)

Dividend payout ratio– dividend/income

Practices– Positive correlation can be found between the annual income and the

dividend,

– but there is a time lag between the two parameters.

– Never decrease the dividend!• what if the firm will not be able to pay that much next year …

– This is why the volatility of the dividends is much less than that of the incomes.

– The practices can be connected to the PVGO of the company

Huge differences can be found in the practices of the firms


Dividend policyIndicators of dividend, practices

0

50

100

150

200

250

300

350

400

0% 0-1% 1-2% 2-3% 3-4% 4-5% 5-6% 6-7% >7%

Dividend yield

Nu

mb

eroff

irm

s

0

50

100

150

200

250

300

350

400

0% 0-1% 1-2% 2-3% 3-4% 4-5% 5-6% 6-7% >7%

Dividend yield

Nu

mb

eroff

irm

s

050

100150200250300350400450

Dividend payout ratio

Nu

mb

eroff

irm

s

050

100150200250300350400450

Dividend payout ratio

Nu

mb

eroff

irm

s

0

10

20

30

40

50

6019

60

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Div

iden

d($

) EarningsDividend

0

10

20

30

40

50

6019

60

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

Div

iden

d($

) EarningsDividend


Dividend policyIndifference of dividend policy in a perfect market

The suppositions (circumstances)the firm has settled on its investment program (i.e. it is already worked out

that how much of this program can be financed by borrowing, and the plan meets other funds requirements)

perfect market (fair issuing price, zero transaction cost, equal tax rates – dividend and price earnings)

What happens if the dividend wanted to be increased without changing the investment and borrowing policy?

The only solution is to print some new shares and sell them.

Miller and Modigliani states that the dividend policy has no affect to the value of the firm in the above circumstances.

Investment and borrowing policy is determined so to increase the value of dividend new shares have to be offered so one part of the company become the property of the new owners.



It is indifferent for the old owners how they get money by dividend or by selling some of their stocks.

Before dividendT

otal

val

ue

of f

irm

After dividend

New stocks

moneyprice

decrease



Shares

Firm

Cash

Cash

New stockholders

Old stockholders

New stockholders

Old stockholders

No dividend no stock issue

Dividend financed by stock issue

Cash Shares


Dividend policyIndifference of dividend policy in an imperfect market

Arguments usually presents some kind of market imperfection (tax differences, transaction cost, information, etc.)

Reasons to pay higher dividend–There is a conservative group which believes that an increase

in dividend payout increases firm value

–In lack of information the high dividend is a good sign

–The paid dividend is certain while the price increase is uncertain

Reasons to pay lower dividend–High transaction cost of issuing

–Higher taxation of divined incomes


Dividend policyIndifference of dividend policy in an imperfect market

Even in case of slight market imperfections the indifference can be defended.

Empirically it can be proven that a supply-demand equilibrium is created between investors’ preferences to dividend and corporations’ dividend policies.

If there exists a better dividend policy, all company would use that,

however many kind of policies can be found in the market.


E(F1)E(F2)

E(Fn)

E(FN)

F0

… …Nn21

0

βproject IRR

E(r)

piaci portfolió


E(rM)

1

rf

β

ralt

0)1(

)(

0

nn

alt

n

r

FENPV altrIRR

Firm

Shareholder

Project

Investmentdecision

Dividend


Dividend policySignificance of indifference of dividend policy in financial analyses

If the indifference of dividend policy is assumed, then the project analyses can be derived through the cash flow steams of a pure equity financed mini-firm, so the shareholder’s cash flows resulted from dividend pay offs can be neglected.

Nevertheless the cash flow streams can be assumed as dividends.

By the above hypothesis (which is already proved) the corporate financial analyses are highly simplified, because the mini-firm approach can be used.


Financing decisions Effects of capital structure in perfect market without taxesNine different factors should be investigated:

– Value, Expected return and Risk of the– Firm (business activity), Equity, Debt

The Firm (business activity)The value of the firm is equal to the sum of the value of equity and the

value of debt V=E+D (the capital structure can be characterized as the financial leverage of the firm which is shown by the D/E ratio)

The expected return of the firm [E(rV)] and the risk of the firm [βV] are given by the projects of the firm

Therefore the value, the expected return and the risk of the firm is independent from the capital structure of the company, so from the D/E ratio


Financing decisions Business activity and debts in the function of leverage

The capital structure can only have a slight affect on the value of the business activity.These effects can be gained by the financial difficulties produced by the increasing leverage.

– Efficiency of the projects decreases• buyers, sellers, employees become cautious (decr. revenues, incr. costs)

– Business decisions are not made on the value maximization• only short return investments are implemented

– Danger of bankruptcy– Increasing cost of control (managers vs. owners)– Effect of information

The above losses are mainly connected to the owners so the value of the business activity is decreasing due tothe decreasing return of the projects while the risk is constant.

βV

β

D/E10

E(rV)

E(r)

D/E10

V

E(F1)

E(F2)

E(Fn)

E(Fn+1)

E(F3)

cE pE cD pD

V E D T

E D T T T T

E(F1) E(F2) E(F3)

E(F1)

E(F2)

E(Fn)

E(Fn+1)

E(F3)

cE pEE T T

cD pED T T

E(F1)

E(F2)

E(Fn)

E(Fn+1)

E(F3)E

pETE(TpE1)

E(TpE2)E(TpE3) E(TpEn)

E(TpEn+1)

E(F1) E(F2) E(F3)

E(TpD1) E(TpD2) E(TpD3)

D

pDTE(F1) E(F2) E(F3)

pDD T

cDT

E(TcD1) E(TcD2) E(TcD3)

E(Fn)E(F3)

E(F1)

E(F2) E(Fn+1)

cET

E(TcE1)E(TcE2)

E(TcE3) E(TcEn)E(TcEn+1)

pEE T


Financing decisions Business activity and debts in the function of leverage

Assuming an efficient financial (debt) market – The price of the debts (credits and bonds) are adjusted to their

risk– The risk of the debts (βD) in a low leveraged situation is 0,

because the equity covers the debts, thereforethe required return of the debts (rD) is equal to the risk free return.

– After a certain leverage the risk and therefore the required return of the debts begin to increase,because the probability of debt trapping is increased.

rM

rD

E(rV)

rDf

D/E

E(r)

10

rD

βV

Risk-freedebts

Riskydets

Risk-freedebts

Riskydetbt

β

D/E10

βD


Financing decisions Shares in the function of leverage in equilibrium and nonequilibrium taxation

If the taxation is equal on the owner and debtor side:


β

D/E10

βD

Risk-freedebts

Riskybedts

βE

βV



E(r)

D/E10

E(rV)

Kockázat-mentes hitel

Kockázatos hitel

E(rD)

rDf

E(rE)



D/E10

P

V

D

E

T




The value of taxes connected to the debt side are usually lower than the equity side:

Until this point the lower leveraged seemed to be better

–the costs of financial difficulties (bankruptcy) decreased the equity side

If the taxation of the debt side is advantageous (lower) this makes an opposite effects

–the excess return remain in the pocket of the owners


D/E10

P

V

D

E

T



β

D/E10

βD

Risk-freedebts

Riskydebts

βE

βV

βE

βT



E(r)

D/E10

E(rV)

Risk-freedebts

Riskydebts

E(rD)

rDf

E(rE)E(rE)

E(rT)



E(r)

E(rV)rD

rDf

D/E10Kockázat-

mentes hitelKockázatos

hitel

rf


An additional affect gained by taxation differences of debts (e.g. revenues from government securities)



Summarizing the 5 effects– Increasing leverage increases the possibility of bankruptcy, therefore

the return of the business activity decreases with constant risk so the value of the firm decreases while the value of the debts is constant the value and return loss is connected to the owners, ie. to the equity.

– By the leverage increase the risk end the return is increased of the equity but these increases are in equilibrium so the value of the equity does not change

– The advantageous debt side taxation creates a tax-shield and this excess return is connected to the owners of the firm, while the risk is unchanged therefore this creates a value surplus of the equity

– Rearranging the debts and the equity through tax-shield the leverage decreases, which has no affect the value

– The non-tax investment opportunities on the debt market increases the required return on the corporate debts, so the increasing leverage decreases the expected return and the value of the equity.


βVβ

E(r)

E(rV)

rfrD

rE

Financing decisions Effect of leverage in the CAPM


βVβ

E(r)

E(rV)

rfrD

rE

Financing decisions Effect of leverage with increasing financial difficulties in the CAPM


βVβ

E(r)

E(rV)

rfrD

rE

Financing decisions Effect of leverage with taxation in the CAPM


βVβ

E(r)

E(rV)

rfrD

rE

Financing decisions Effect of leverage with preferred debts in the CAPM


βVβ

E(r)

E(rV)

rfrD

rE

Financing decisions All effects together in the CAPM


Financing Effects of capital structure in perfect market

ConclusionThe changing D/E ratio has no effect on the value of the firm, the

equity and the debt (MM. I.)

The expected return of the equity is proportionally increasing with the D/E ratio.The rate of increase in the beginning is linear, then due to the increasing required rate of debt return (rD) the increase slows down. (MM. II.)

This is why the pure equity financed “mini-firm” approach is adequate in corporate financial analyses.


Financing Pure equity financed mini-firm approach

E(F1)E(F2)

E(Fn)

E(FN)

F0

… …Nn21

0

βproject IRR

E(r)

piaci portfolió


E(rM)

1

rf

β

ralt

0)1(

)(

0

nn

alt

n

r

FENPV altrIRR

Firm

Shareholder

Project

Investmentdecision

Dividend



Cash flow estimation Principles of Cash flow estimation

What is the aim of determination of cash flows?– Corporate financial analyses are based on the future cash

flows created by the project.– These cash flows will be examined through the analyses

Relevant cash flows – Incremental cash flows should be considered– All incidental effects have to be considered (with or without)– Opportunity cost has to be taken into consideration– Sunk Cost– Careful separation of overheads– Working capital needs


Cash flow estimation Consideration of inflation

Using nominal values.All cash flows are considered on current price, so the estimated

price changes tendencies – of e.g. material costs, payments to personnel, selling price – are calculated. Of course the opportunity cost should be considered in the same way.

Using real values.Unchanging, actual prices are considered, but in this case the

opportunity cost should be estimated on the same way.


Cash flow estimation Consideration of taxation and currencies

Most taxes are taken into account as costs, i.e. they are considered as indirect or general expenditures for which the base is the net profit.

General rule that is in the estimation of cash flows and in the estimation of opportunity cost the same calculation procedure should be used.

However the opportunity cost is estimated on an after all taxes base, the cash flow streams should be done in a similar manner.

Any currency can be used for cash flow estimation (international financial equilibrium)


Cash flow estimation Separation of expected value and risk

In case of cash flow streams only the expected value has to be found, while the risk is built into the opportunity cost of the project.


Determination of opportunity cost Determination of opportunity cost by the CAPM

The opportunity cost gives the reference return in economic analyses.

To determine this reference return the CAPM can be used.

Why the CAPM?

The project’s expected return have to exceed this to be worthy for the owner to accomplish the investment.

CAPM by SharpeBeta and the security market line

E(r)

rf

β


Determination of opportunity cost Determination of the parameters of the market portfolio

In the determination of the opportunity cost we have to start from the CAPM.

–There exists risk-free asset–There is a premium accompanied to risk taking–The required, expected and average returns are equal

averagehistoricalfMaveragehistorical

fMf

premiumriskf

risktimealt

)r(rβ

rrEβr

rEr

rrrEr

fr

))((

)(

)(

0)1(0

nn

alt

n

r

FNPVF0

F1

F2

Fn Fn+1


By definition the return of the risk free asset (time premium) is the return of any real asset with zero standard deviation. (There is no asset like this…)

In the estimation the return of that financial asset should be considered, which certainly pays back the claim with its interest. There is only one issuer which can guarantee that this will happen and this is the government.

Therefore some kind of government security should be considered.

The risk of inflation can be eliminated in two ways:– inflation indexed government security–modifying with the estimated inflation rate

If the return of government security is changing in time, the return of zero-coupon bonds, or the return of security with similar maturity to the project life time.

Determination of opportunity cost Determination of opportunity cost by the CAPM

rf


Determination of opportunity cost Determination of the parameters of the market portfolio

By definition the return of the market portfolio can be given by the expected return of that portfolio which represents the capitalization weighted average return of all securities traded in the world.

This can be approximated with the global portfolios e.g. MSCI world index

However it would be rational to hold the global portfolio (MSCI), there are many factors against this rational behavior.

The security market returns gives information of the expected return of leveraged business activities therefore it has to be unlevered by MM II.

rM


We are always interested in the opportunity cost of projects, (but the risk of a specific project and the risk of a specific stock (company) is not necessarily equal) nevertheless capital market information is available only on stocks.

For starting point we can choose the beta of the given company if the project is similar to the function of the firm, otherwise industrial averages can be used.

Determination of opportunity cost Determination of betas


13. Market for Goods– Consumption, investment, government purchases, equilibrium in the

market for goods in the long run

– Measures of the value of economic activity

– Say’s law, the neutrality of money

14. Economic Growth– Steady state

– The golden rule level of capital

– Population growth and technological progress

15. Basics of fiscal policy and monetary policy– Stabilization options according to the Keynesian cross

– Money demand and money supply

– Instruments of monetary policy

Macroeconomics


16. Monetary equilibrium – Monetary equilibrium in the long run

– Types of unemployment, the Phillips curve

– Measurement of inflation, the social costs of inflation, sacrifice ratio

17. IS-LM model– IS-curve

– LM-curve

– Macroeconomic policy responses for external shocks

18. Macroeconomic Policy– Active – passive

– Conducted by rule – discretion

– The four most important lessons and the four most important unresolved questions of macroeconomics

Macroeconomics


Market for Goods Consumption, investment, government purchases

Closed economy–households, firms, government

Consumption–Households divide their disposable income between

consumption and saving.–Income after the payment of all taxes is disposable income.–We assume that the level of consumption depends directly on

the level of disposable income. The higher the disposable income, the greater the consumption is.

–Consumption function:

–Marginal propensity to consume (MPC)• the amount by which the consumption changes when disposable

income changes by one dollar.

)( TYCC


)(rII


Investment–Investment goods are purchased by firms but households

spend their income indirectly through firms–The motivation behind investment is to increase future

income and future consumption–The quantity of investment goods demanded depends on the

real interest rate, which measures the cost of the funds used to finance investment.

• Profitability of investments depend on the real interest rate• Net Present Value

–Investment functionR

eal i

nte

rest

rat

e, r

Investment, I

Investment function, I=I(r)R

eal i

nte

rest

rat

e, r

Investment, I

Rea

l in

tere

st r

ate,

r

Investment, I

Investment function, I=I(r)Investment function, I=I(r)



Government purchases–Transfer payments to households are not included.

• Transfer payments are not made in exchange for some of the economy’s output, or rather do affect the demand for goods only indirectly.

• Disposable income (Y-T) includes both the negative impact of taxes and the positive impact of transfer payments.

–Motivated by political reasons–Government purchases and taxes are exogenous variables

–We assume a balanced budget (G=T)

,G G T T


Market for Goods Equilibrium in the market for goods in the long run

Factors of production and the production function determine the quantity of output supplied to the economy

National income accounts identity

Summarizing our discussion about the market for goods

Real interest rate (r) is the only variable not determined, so it must adjust to ensure that the demand for goods equals the supply. Real interest rate is the factor responsible for the equilibrium.

Y C I G

YLKFY ),(

( ) ( )Y C Y T I r G


I, S

r

I=I(r)

Equilibrium interest rate

S

S

Market for Goods Equilibrium in the market for goods in the long run


Market for Goods Measures of the value of economic activity

• Gross domestic product measures both the income of everyone in the economy and the total expenditure on the economy’s output of goods and services.

Nominal and real GDPGDP is the sum of four categories of expenditure: C+I+G±NX

• Gross national product measures the total income earned by residents of the nation.

GNP=GDP±factor payment from and to abroad• Net national product = GNP – depreciation• National income = NNP – indirect taxes• Personal income

The amount of income that households receive• Disposable personal income

The amount households have available to spend after satisfying their tax obligations to the government.


Market for Goods Say’s law, the neutrality of money

• Say’s law–If saving above consumption is transformed totally into

investment (interest rate mechanism) and prices and wages (and interest rates) are flexible

–Then all produced goods can be sold, there is no unemployment

Supply always creates its demand, wages and interest rates are always ample to facilitate the selling of all goods.

• Say’s law spectacularly failed in 1930s.– For long term it is an approximately correct model.– In the long run prices are flexible, in the short run prices are sticky


Market for Goods Say’s law, the neutrality of money

We can model the economy – in the long run – without the existence of money.

This is called classical dichotomyReal variables and nominal variables can be separated.

The money supply does not effect real variables, money is neutral.

Consequently the output (standard of living) is not affected by any monetary factors.


Economic Growth Steady State

Solow growth modelThe accumulation of capital

–Determined by the supply and demand for goods

Ou

tpu

t p

er w

ork

er, y

Capital per worker, k

c

i

s f(k)

f(k)

MPK

1

y

( )y f k

y c i i sy


Economic Growth Steady State

Capital stock is a key determinant of the economy’s output, is influenced by investment and depreciation

s f(k)

f(k)

δk

There is a single capital stock at which investment equals depreciation: steady-state level of capital

It represents the long-run equilibrium of the economy

k1 k2k*

i*=δk*

δk1

δk2

k

y

s1 f(k)

k1*

s2 f(k)

k2*


Economic Growth The Golden Rule Level of Capital

We assume that policymakers can set the economy’s saving rate at any level.– What steady state should the policymakers choose?– The goal is to maximize the well-being of society which is described by the highest level of consumption.

Steady state consumption:Increase in steady state capital has two opposing effects

• more output • more output must be used to replace capital that is wearing out

Where is the optimum?There is only one level of stock that maximizes consumption.

s f(k)

f(k)

δk

k

y

k1 k2k*

i*=δk*δk1

δk2

kopt*

sopt f(k)iopt*

copt*

MPK δ

* ( *) *c f k δk

Golden Rule level of capital


Economic Growth The Golden Rule Level of Capital

Economy will not move to the Golden Rule level of capital, there is only one saving rate that produces it.Supposing that the economy has reached a steady state other than the Golden Rule, policymakers face two different problems:

1. The economy begins at a steady state with more capital than it would have in the Golden Rule steady state.The rate of saving should be reduced, and consumption should be increased in order to reduce the capital stock.

2. The economy begins with less capital than in the Golden Rule steady state.The saving rate must be raised. This causes an immediate fall in consumption and a rise in investment.

Output, y

Timet0

Consumption, c

Investment, i

Output, y

Timet0

Consumption, c

Investment, i

“Generation problem”


Economic Growth Population growth and technological progress

The basic Solow model shows that capital accumulation, by itself, cannot explain sustained economic growth.The economy eventually approaches a steady state.

We add population growth to the model.We assume that the population and the labor force grow at a constant rate: nThe growth in the number of workers causes capital per worker and output per worker to fall

Population growth has the same affect as depreciation

Δ ( )k i δ n k

Δ ( ) ( )k s f k δ n k



k

k (δ+n1)

k1*

f(k)

s f(k)

y

k2*

k(δ+n2)



As the efficiency of labor rises, the output per worker increases Technological progress can lead to sustained growth.

k (δ+n)

f(k)

s f(k)

k

y

k*

g

g


Basics of fiscal policy and monetary policy Stabilization options according to the Keynesian cross

Keynesian crossPlanned expenditure

The amount households, firms, and the government would like to spend on goods and services.

Pla

nned

exp

endi

ture

, E

Income, output, Y

GICE

MPC

1$

G

I



Economy equilibrium:Actual Expenditure = Planned Expenditure

EY

E

Income, output, Y

GICE

45º

EY

Equilibrium income



The adjustment to equilibrium in the Keynesian crossIf the economy is not in equilibrium, firms will experience unplanned changes in inventories, and this induces them to change production levels. Changes in production in turn influence total income and expenditure moving the economy toward equilibrium.

Unplanned inventory accumulation

Unplanned drop in inventory45º

E

Income, output, Y

GICE

EY

Equilibrium income



• Government purchases• Decrease in taxes

E

Income, output, Y

45º

EY

1. An increase in government

purchases, or a tax cut shifts planned

expenditure upward…

G

Y 2. …which increases equilibrium income.

MPC TBoth increase in G and decrease in T have a multiplied effect on income


Basics of fiscal policy and monetary policy Money demand and money supply

Money demandMoney means liquidity not wealth.Quantity equation:

Assuming constant velocity, money demand is affected by:• Output• Price level• Nominal interest rate

Opportunity cost of holding cash

YPV

M 1

Money × Velocity = Price × Output

YPVM



The money supply includes currency in the hands of the public and deposits at banks that households can use on demand for transactions.

If banks hold 100 percent of deposits in reserve, the banking system does not affect the supply of money.If banks keep only a fraction of their deposits in reserve (reserve deposit ratio, rr), and lend the remaining amount. If the borrower deposits his money in another bank, the bank keeps rr percent in reserve, and loans the remaining amount…

Fractional-reserve banking creates money, although it does not create wealth.



Determinants of money supply:– The monetary base (B) is the total number of dollars held by the public as currency (C) and the banks as reserves (R).

• Directly controlled by the central bank.– The reserve-deposit ratio (rr) is the fraction of deposits that banks hold in reserve.

• Determined by business policies of banks and bank regulating laws.– The currency-deposit ratio (cr) is the amount of currency (C) people hold as a fraction of their holdings of demand deposits (D).

• Reflects the preferences of households regarding the form of money they want to hold.We can examine how central bank policy and the choices of banks and households influence the money supply. BmB

rrcr

crM

1


Basics of fiscal policy and monetary policy Instruments of monetary policy

Monetary policy is the control over money supply.The central bank controls the money supply indirectly by altering either the monetary base or the reserve-deposit ratio.The central bank has at its disposal three instruments of monetary policy:

– Open-market operations– Operations in the foreign-exchange market– Minimum reserve requirements


Monetary equilibrium Monetary equilibrium in the long run

Equilibrium in the market for goods in the long runClassical dichotomy:

Real and nominal variables can be separatedMoney is neutral

Money supply only influences inflation in the long run.

(In the short run prices are sticky, therefore changes in the money supply can influence the level of output, and the standard of living.)


Monetary equilibrium Types of unemployment, the Phillips curve

UnemploymentThe natural rate of unemployment is the average rate around which the economy fluctuates.Frictional unemployment is caused by the time it takes workers to search for a job.

Some frictional unemployment is inevitable in a changing economy.Unemployment insurance inadvertently increase it.

Structural unemployment results from wage rigidity and job rationing.The real wage is stuck above the equilibrium level, and the supply of labor exceeds the demand.Causes of wage rigidity:

– Minimum-wage laws– Unions and collective bargaining– Efficiency wages



The Phillips curve shows the tradeoff between inflation and unemployment.Short-run Phillips curve

Infl

atio

n, r

inf

Unemployment

Policymakers can choose between inflation and unemployment

• Nominal wage rigidity– Inflation makes real wages flexible– Money illusion

• If policymakers try to reduce unemployment, then increasing labor demand raises wages, which leads to higher price level

In the short-run classical dichotomy fails.



In the long-run the expected rise of price level is built into wage increases. This increases the price level again, which increases the wages, while unemployment stay constant.

Inflation is built into the expectations.The long-run Phillips curve becomes a

vertical linePolicymakers can choose between inflation

rates, but unemployment can not be controlled by choosing the inflation rate

rinf

U

rinf2

rinf1

U1U3U2


Monetary equilibrium Measurement of inflation

Inflation is the overall increase in pricesMeasurement of inflation

–Consumer Price IndexMeasures changes in the cost of living through the changes of the price of a basket of goods and services purchased by a typical consumer.

–GDP deflatorThe ratio of nominal GDP and real GDP


Monetary equilibrium The social costs of inflation

Inflation does not make people poorer. Accumulation of capital and technological progress lead to higher consumption.

Problems result from inflation:– Unproductive activities because of the inflation– Destroys the information function of the price system, which leads to inefficiencies in the allocation of resources.– The costs of expected inflation

• shoe-leather costs• menu costs• the cost of relative price variability• tax distortions• inconvenience of making inflation corrections

– Unexpected inflation arbitrarily redistributes wealth among individuals. The more variable the inflation is, the greater the uncertainty both debtors and creditors face.


Monetary equilibrium Sacrifice ratio

As the Phillips curve shows the price paid for lowering inflation is the appearance of a period of high unemployment (and reduced output).Sacrifice ratio is the percentage of a year’s nominal GDP that must be forgone to reduce inflation by 1 percentage point.

Typical estimate is about 5 percent: for every percentage point that inflation is to fall, 5 percent of one year’s GDP must be sacrificed.

The price paid for lowering inflation is also influenced by people’s expectations: – Theory of adaptive expectations:

Expected inflation depends on recently observed inflation.– Theory of rational expectations

A credible announcement of a change in the fiscal or the monetary policy might be able to influence expectations directly, and reduce inflation without causing a recession.


The IS-LM modelThe IS curve

• The IS-LM model is a general theory of the aggregate demand for goods and services.–The IS curve can be derived from the Keynesian cross.

• The Keynesian cross shows how the spending plans determine the economy’s income, but it makes the simplifying assumption that the level of planned investment is fixed.• As we discussed earlier, planned investment depends on the interest rate. (Investment function)

–The IS curve shows the negative relationship between the interest rate and income.• A higher interest rate lowers planned investment, and this in turn lowers national income.

–Changes in fiscal policy that raise the demand for goods shift the IS curve to the right.


Inte

rest

rat

e, r

……Income, output, Y

…E

xpen

ditu

re, E

...... Income, output, Y45º

EY

Investment, I

Inte

rest

rat

e, r

Y

4. …and lowers income.

I3. …which shifts

planned expenditure downward…

5. The IS curve summarizes these

changes.

IS2. lowers planned investment

1. An increase in the interest

rate…

The IS curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for goods.


Y2. …which raises

income...

3. …and shifts IS curve to the right.

IS2

….E

xpen

ditu

re, E

………Income, output, Y45º

EY

Investment, I

Inte

rest

rat

e, r

Inte

rest

rat

e, r

……...Income, output, Y

IS1

G

1. Higher G or lower T shifts

planned expenditure upward…

Expansionary fiscal policy which does not change the level of interest rate shifts the IS curve outward.

–increase in G –tax cut

MPCT


The IS-LM modelThe LM curve

• The LM curve plots the relationship between the level of income and the interest rate. • Theory of liquidity preference posits that the interest rate adjusts to balance the supply and demand for money.• The level of income also affects the demand for money.

–Greater income implies greater money demand, and this in turn raises the interest rate.• Expansionary monetary policy shifts the LM curve downward.


Inte

rest

rat

e, r

……..Income, output, YMoney balances, M

Inte

rest

rat

e, r

The LM curve shows the interest rate that equilibrates the money market for a given supply of money.

1. An increase in income raises

money demand…

2. …increasing the interest rate

3. The LM curve summarizes these

changes in the money market equilibrium.

LM

Money demand

Money supply

Equilibrium interest rate



A decrease in the interest rate for a given output shifts the LM curve downward. The central bank increases the money supply.

Inte

rest

rat

e, r

……..Income, output, Y

LM2

3. … and shifting the LM curve downward.

LM1


Money balances, M

Inte

rest

rat

e, r

1. The central bank raises the money supply…

2. …reducing the interest rate


The IS-LM modelMacroeconomic policy responses for external shocks

• Because the IS-LM model shows how national income is determined in the short run, we can use the model to examine how various economic disturbances affect income.–Shocks to the IS curve are exogenous changes in the demand for goods.

• Changes in demand can arise from investors’ optimism and pessimism.• Changes in the demand for consumer goods.

–Shocks to the LM curve arise from exogenous changes in the demand for money.Shocks can cause economic fluctuations by shifting the IS curve or the LM curve, but these fluctuations are not inevitable. Policymakers can try to use the tools of monetary and fiscal policy to offset exogenous shocks.


Macroeconomic PolicyActive – passive

Why do some critics want the government to refrain from using monetary and fiscal policy for economic stabilization?The effects of economic policy are not immediate.

– Inside lag is the time between a shock to the economy and the policy action responding to that shock. –Outside lag is the time between a policy action and its influence on the economy.Fiscal policy has long inside lag, monetary policy has substantial outside lag.

Automatic stabilizers are policies that stimulate or depress the economy when necessary without any deliberate policy change.– The system of income taxes– Unemployment insurance

Difficulties associated with active policy– Economic forecasting is difficult.– People’s expectations are not predictable– History does not settle the debate over stabilization policy


Macroeconomic PolicyConducted by rule – discretion

• Policy is conducted by rule if policymakers announce in advance how policy will respond to various situations and commit themselves to following through on this announcement.• Policy is conducted by discretion if policymakers are free to size up events as they occur and choose whatever policy seems appropriate at the time.

– Distrust in (incompetent and opportunistic) politicians is against discretionary policy.– If we can trust policymakers, discretionary policy is better, because it is more flexible.– The time inconsistency of discretionary policy

– Rules for monetary policy


Macroeconomic PolicyThe four most important lessons of macroeconomics

In the long run, a country’s capacity to produce goods and services determines the standard of living of its citizens.In the short run, aggregate demand influences the amount of goods and services that a country produces.In the long run, the rate of money growth determines the rate of inflation, but it does not affect the rate of unemployment.In the short run, policymakers who control monetary and fiscal policy face a tradeoff between inflation and unemployment.


Macroeconomic PolicyThe four most important unresolved questions

How should policymakers try to raise the economy’s natural rate of output?Should policymakers try to stabilize the economy? How costly is inflation, and how costly is it to reduce inflation? How big a problem is government debt?

Summary of Courses in Finance I-II-III. MBA2003

Economy & Finance

financial assets

groups balance sheet

current assets

xliabilities assets

balance sheet concept

balance sheet structure

nonmaterial assets

financial report statement