15.401 finance theory i - mitweb.mit.edu/astomper/www/univie/pof/chapter 1.pdf1 15.401 15.401...
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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
MotivationMotivation
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:
MotivationMotivation
1802-1997Realizedp.a.Returns
Source: Siegel (1998), Figure 2-1.
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15.401 Lecture1:Introandoverview
_ 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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15.401 Lecture1:Introandoverview
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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15.401 Lecture1:Introandoverview
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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15.401 Lecture1:Introandoverview
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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15.401 Lecture1:Introandoverview
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
Lecture1:Introandoverview
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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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15.401 Lecture1:Introandoverview
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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15.401 Lecture1:Introandoverview
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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15.401 Lecture1:Introandoverview
Afirmcaninvestinaprojectthatyieldsacashflowwithamarketvalueof$100Mandrequiresaninvestmentof$60M.Thefirmhascashreservesof$62M.
Thefirmhastwoowners.OwnerAhashighshort-termconsumptionneedsthatownerB.Arethetwoownersunanimouslyinfavoroftheinvestment?
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ShareholderunanimityShareholderunanimity
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15.401 Lecture1:Introandoverview
Conditionss.t.allshareholdersagreethatthefirmshouldmaximizethemarketvalueofitsequity:
Shareholders’consumptiondependsonthefirm’spoliciesonlythroughtheirbudget.
Shareholderscantimetheirconsumptionbyborrowingandinvestinginfinancialmarkets.
Shareholderscanusefinancialmarketstotrade“contingent”consumption(forallrelevantcontingencies).
Perfectcompetitioninfinancialmarkets,andallshareholdershavesimilar“access”toallfinancialmarkets.
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ShareholderunanimityShareholderunanimity
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15.401 Lecture1:Introandoverview
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FinancialMarketsFinancialMarkets
FinancialMarkets
&Intermediaries
Households
Nonfinancial Firms
ProductMarkets
LaborMarkets
LectureNotes ©2008JiangWang
15.401
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Lecture1:Introandoverview
_ 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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15.401 Lecture1:Introandoverview
1. Allocatingresources
_ Acrosstime
Example.Borrowmoneytobuyahome
_ Acrossdifferentstatesoftheeconomy
Example.Investinstocks/bonds
2. Communicatinginformation/pricediscovery
_ Marketpricesreflectavailableinformation
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FunctionsofFinancialMarketsFunctionsofFinancialMarkets
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15.401 Lecture1:Introandoverview
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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15.401 Lecture1:Introandoverview
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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CourseoverviewCourseoverview
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15.401 Lecture1:Introandoverview
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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CourseoverviewCourseoverview
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15.401 IntroandoverviewHowtogetthemostoutof401Howtogetthemostoutof401
Theoryvs.Practice_ Mostofthiscoursewillbedevotedtotheory_ Whataboutpractice?_ Theoriginsoftheoryiscommonelementsdeducedfrompractice!
Somehelpfulsuggestions
_ Doreadingsaheadoftime(skimtextbookchaptersinadvance)
_ Takecopiousnotesduringlectures(lecturenotesarenotcomplete)
_ Reviewthelecturesafterwardswithyourstudygroup
_ Workonproblemsets---“Financeisnotaspectatorsport”
_ Askquestions!!!