Finance Week 10

Question 1

Methodology for the pricing of assets is based on __ and the absence of __

Answer 1

“LAW OF ONE PRICE” - all assets and risk must be priced consistently, so that assets with the same risk yield the same return

ARBITRAGE - undertaking financial transactions and obtaining a net profit w/o incurring any risk (due to misplacing of assets)

Question 2

Goal of financial management

Answer 2

Traditionally, main goal is to MAXIMISE value of owner’s EQUITY. But this is challenged and no longer acceptable today.

Other STAKEHOLDERS’ needs - employees, customers, suppliers
Non-financial criteria - ESG criteria

Question 3

Financial system

Answer 3

Consists of the…
financial INSTRUMENTS,
fin. MARKETS, &
fin. INSTITUTIONS (firms whose primary biz is to provide financial services & fin. products)…
that are used to implement the financial decisions of households, biz firms & governments through financial CONTRACTING and EXCHANGE of assets and risks

• both constrains and enables the decision maker
• it is the “oil in the wheels”, the plumbing of an economy (= seen as the enabler of the economy rather than centre of everything)

Question 4

5 principles at the core of the financial system of capitalist market economies

Answer 4

1. Time has value in market economies
   - time has an opportunity cost. compensating the bank for the opportunity cost of time that they can’t use the money
2. Risk requires compensation
   - the higher the risk you undertake, the higher the return
   - financial decisions are taken today to account for future, which means uncertainty, which means risk
3. Information at the core of decisions
   - prices capture financial info about counterparties
4. Markets determine prices and allocate resources
   - markets need to be fair, regulated by governments. Regulation is extremely important.
5. Stability improves welfare
   - financial stability is a public good (nonrivalrous and non-excludable)
   - enables economic growth

Question 5

Flow of funds

Answer 5

The set of data that shows all the financial flows that occur in the economy from the NET SAVERS to the NET USERS

Funds flow via fin. intermediaries (eg. surplus units deposit $$ into banks & banks give loans to deficit units) & financial markets (firms can issue shares in the market and households buy stocks); or directly w/o intermediary

• • securitisation (intermediary collects loans then create new fin. instruments that are sold to other fin. institutions; then create new markets)
• disintermediation

Question 6

Annuity vs Perpetuity

Answer 6

Annuity - A level stream of cash flows (= CONSTANT) for a FIXED PERIOD of time

Perpetuity - A level stream of cash flows FOREVER

Question 7

Nominal vs Real interest rates (+ formula)

Answer 7

Nominal: aka QUOTED interest rate. The interest rate expressed in terms of the interest payment made each period
- denominated in units of a particular currency
So, if I invest £100 in this bond I will have an additional £6.81 after one year, which means that I have £6.81 extra to spend at the end of the year.
- does not tell me how many more goods I could buy next year as a consequence of having invested in the bond, because it depends on how much goods prices have increased in the same period

Real: the rate that has been adjusted for inflation to reflect the change in “purchasing power”
- denominated in units of some commodity/basket of goods and services
So, if I invest £100 in this bond, the real return is £4, which means that I can purchase £4 worth of goods more than I could the year before
Formula:
rr =(r - i)/(1 + i) from
1 + rr = (1 + r)/(1 + i)

*r = nominal interest rate

Question 8

Nominal interest rate vs Effective annual percentage rate (EAR) (+ formula)

Answer 8

Nominal: aka QUOTED interest rate. The interest rate expressed in terms of the interest payment made each period

EAR: The interest rate that you effectively end up paying per year, taking into account the compounding period
EAR = (1 + (Quoted rate / m))^m -1

Question 9

Compounding vs Simple interest

Answer 9

Accumulating interest on principal + interest (exponential growth)
vs
Accumulating interest on principal only

Question 10

PV for an annuity

PV for a perpetuity

Answer 10

1. PV = C * annuity factor, A

2. PV = C/r

Question 11

Even if a project generates positive cash flows forever, why might it have the lowest NPV?

Answer 11

B/c future, far-away cash flows, once discounted, count for very little

Question 12

Formula to calculate FV using PV & constant rate

Answer 12

FV = PV (1+r)^n