Lecture 1: Introduction

Question 1

What is the motivation of Finance?

Answer 1

to make business decisions to create wealth

Question 2

What is finance?

Answer 2

a tool for valuing business activity for the purpose of making an economic decision with the intention to grow wealth or manage wealth to meet economic needs

Question 3

3 questions we will address in this course

Answer 3

1. How to value assets?
2. How corporations make financial decisions?
3. How households make financial decisions?

Question 4

How will this course answer these 3 questions?

Answer 4

by developing a unified analytical framework and a set of basic principles of modern finance

Question 5

A financial framework for analysis:

Answer 5

1. Balance sheet
2. Income Statement
3. Balance sheet evolution
4. financial decisions

Question 6

Corporate Balance Sheet

Answer 6

Assets = Liabilities

Assets consist of cash, capital, and intangibles

Liabilities consist of debt and equity

Question 7

Income Statement

Answer 7

Source of Funds = Use of Funds

NI + change in Debt + change in Equity = I + C + Div + T

change in debt: funds raised from new debt issue

change in equity: fund raise from new equity issue

C = coupon payment

Div = dividend payment

T = tax payment

Question 8

Balance sheet evolution

Answer 8

Assets: Cash + (Capital + I) + Intangible

Liabilities: (Debt + Change in Debt) + (Equity + Change in Equity)

Question 9

Corporate Financial Decisions

Answer 9

1) Cash raised from investors by selling financial assets (chg D + chg E)
2) Cash invested in real assets (tangible and intangible) (I)
3) Cash generated by operations (after tax) (NI - T)
4) Cash returned to investors (debt payments, dividends, etc) (C + Div)
5) Cash reinvested (NI - T - C - Div)

Question 10

Corporate Mangement Decisions

Answer 10

Objective: Create maximum value for shareholders.
Sound business decisions rely on ability to value assets

real investment vs financing and payout

manage cash flow: 1, 2, 4, 5

Real investment/capital budgeting: 2, 3 – valuing real assets

Financing and payout: 1, 4, 5 – valuing financial assets

Risk Management: 1, 4 – valuing financial contracts

Question 11

Household financial decisions

Answer 11

1) Cash fraise from financial institutions or holdings of financial assets
2) Cash invested in real assets (tangible and intangible)
3) Cash generated by labor supply and real assets
4) Cash returned to financial institutions or invested in financial assets
5) Cash consumed and reinvested

Question 12

Household financial decisions

Answer 12

Objective: maximize lifetime happiness/welfare or utility

manage cash flow: 1, 2, 4, 5

Real investment: 2, 3 – valuing real assets

Consumption/saving/investment: 1, 4, 5 – valuing financial. assets

Risk Management: 1, 4 – valuing financial contracts

Question 13

Valuation of Assets

Answer 13

each asset is defined by its cash flow

Value of an Asset = Value of its Cash Flow

Question 14

Two important characteristics of cash flow

Answer 14

Time and Risk

Timing of cash flow matters. How much the timing matters is what we refer to as Time Value of Money. A dollar today is worth more than a dollar a year from now since you could earn positive interest rate or put the money to use in a way that would make it more valuable than a dollar tomorrow

Risk or uncertainty of a cash flow matters for its valuation. How much it matters is what is referred to as the risk premium

Question 15

Valuing an asset

Answer 15

PV = FV / (1 + r)

or

FV = PV(1 + r)

Question 16

principle of no free lunch

Answer 16

an efficient market should eliminate free lunches.

BUT, for it to be eliminated… somebody has to be eating the free lunches in the first place… and if its the same players offering liquidity and then competing in the same marketplace, this is an unfair advantage!

Question 17

What is arbitrage?

Answer 17

an arbitrage (free lunch) is a set of trades in the financial market such that it:

+ non-positive initial cash flow/investment
+ yields non-negative future payoffs
+ at least one of the inequalities is strict

Example of Arbitrage opportunity:

Citi’s 12-month lending rate is 1% per year and Chase is selling a 12-month Certificate of Deposit at an interest rate of 1.125%.

1) Borrow $100 Million for Citi
2) Buy $100 Million worth of 12-month CD from Chase
Result: in 1 year, you will owe Citi $101 Million AND you will receive $101.125 Million from Chase. Thus, you will net $125,000 without ever spending a dollar.

Question 18

Basic problems in finance, which finance tries to solve.

Answer 18

1. How to value assets accurately and appropriately?

2. How to maximize wealth and utilize it to best meet economic needs

Question 19

Unifying Principles of Finance

Answer 19

1. There’s no free lunch in the financial market
2. Other things equal, individuals/agents:
   prefer more money to less