Introduction to MGT 470 (cs3ed) v1.0 Jun 15 1 The Six Parts of the Financial System 1. Money 2. Financial Instruments (Securities)  stocks  bonds  mortgages  insurance policies 3. Financial Markets (NYSE, NASDAQ, etc.) 4. Financial Institutions (i.e. Banks) 5. Regulatory Agencies (i.e. SEC)  regulation  supervision 6. Central banks (i.e. The U.S. Federal Reserve System)  execute monetary policy(control amount of money in circulation)  try to minimize unemployment and control inflation in order to stabilize the economy

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 2 There’s Only Two Things That Finance People Do:  Rearranging/Translating/Exchanging Cash Flows Over Time:  Exchanging a single cash flow (now) for a series of cash flows (in the future)  getting a personal loan or issuing corporate debt  entering into a mortgage  selling securities (receive lump sum in exchange for paying stock dividends & bond interest payments in the future)  Exchanging a series of cash flows (in the future) for a single cash flow (now)  retiring a loan or corporate debt  paying off a mortgage  buying securities (pay a lump sum payment in exchange for stock dividends & bond interest in the future)  Converting today’s dollars into equivalent future value  Converting future dollars into equivalent present value (in terms of “today’s” dollars)  Choosing the best/most advantageous arrangement/timing of cash flows (making financial decisions)  Speculation (exchanging a cash flow for the possibility of receiving a larger one sometime in the future)  Capital gain appreciation/growth: buying a financial asset and hoping it growths in value  Dealing in derivative securities (forwards, futures & options)  Advise people on the above What’s a Security?  Managing Risk  Identifying risk to cash flows  Assessing risk to cash flows  Mitigate risk to cash flows

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 3 Risk: Definitions:  Webster’s: a hazard; a peril; exposure to loss or injury  The chance that an outcome other than that which was expected will occur  The chance that an outcome other than that which was desired will occur (i.e. lose money)(this is the ”finance” definition)  Risk = Uncertainty of future cash flows

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 4 Primary Finance Axioms: 1. As far as the finance world is concerned, any asset (stocks, bonds, a project, a company, etc.) has positive value today (the “present value” of an asset) only if it gets more valuable in the future:  it generates future positive cash flows and/or…..  it appreciates in value over time This is because Finance is focused on the future 2. Risk affects value:  Risk Aversion: given two securities equally priced but with different degrees of risk, the rational investor would choose the one with lower risk  Valuation Implications: →all else being equal, a security whose cash flows are more certain is more valuable than a security with relatively less certain cash flows →if two securities offer the same ROR, the riskier one is priced lower if the seller of that security wants anybody to buy it (the less riskier one is priced higher)  ROR Implications: if two securities are priced the same, the riskier one must offer higher expected returns if the seller of that security wants anybody to buy it 3. The timing of cash flows matters; cash received sooner is better:  it can be utilized (invested) sooner to produce additional income  restore liquidity sooner

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 5 The Five Core Principles of Money & Banking: 1. Time Has Value (The Time Value of Money – TVM):  Time affects the value of financial assets and transactions  When money is some how invested (and not just placed under a mattress or in a safe), the amount of money grows  Although money loses value over time due to inflation, the amount of money in an account that earns a positive ROR will be greater in the future than what it is today. Why is this true?  Thus the money in the account has different values at different points in time  This is what the term “Time Value of Money” refers to  The ROR should compensate for opportunity cost, inflation and risk  the increasing amount of money over time should more than make up for the value lost due to inflation and opportunity costs 2. Risk Requires Compensation:  The Concept of Risk Aversion  Risk Aversion: given two securities equally priced but with different degrees of risk, the rational investor would choose the one with lower risk  Valuation Implications: →all else being equal, a security whose cash flows are more certain is more valuable than a security with relatively less certain cash flows →if two securities offer the same ROR, the riskier one is priced lower if the seller of that security wants anybody to buy it (the less riskier one is priced higher)  ROR Implications: if two securities are priced the same, the riskier one must offer higher expected returns if the seller of that security wants anybody to buy it

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 6 The Five Core Principles of Money & Banking: (cont.) 2. Risk Requires Compensation: (continued)  Financial professionals must deal with risk:  eliminate it  reduce or mitigate it  pay someone else to assume it (transfer the risk, i.e. insurance)  none of these strategies are costless or free  thus someone needs to be compensated for dealing with risk  investors must be paid (compensated some how) to assume risk; the greater the risk, the greater the compensation 3. Information is the Basis for Decisions:  What is the true value (fair market value, theoretical value) of an asset or transaction?  What are the associated risks? 4. Markets Determine Prices and Allocate Resources:  A market is the place (physical or virtual) where buyers & sellers meet  Markets channel resources and minimizes the cost of gathering information and making transactions  “Markets gather information from a large number of participants and aggregate it into a set of prices that signal what is valuable and what is not.  “Thus markets are a source of information.”  Markets function as auctions (ask & bid)  Supply, demand and risk establish the price  Prices establish the allocation of resources (commodities, securities, money, etc.)  The market price of a commodity does not always reflect its true value or associated risk, although very efficient markets usually achieve a close match  Well developed markets are the precondition for healthy economic growth  Even well developed and very efficient markets can break down (i.e. late ‘90s-spring 2000 and ‘07-’08)

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 7 The Five Core Principles of Money & Banking: (cont.) 5. Stability Improves Welfare:  Volatility creates risk  Reducing volatility reduces risk  Individual market participants can reduce or eliminate some of the risk on there own How?  Other risks can be only reduced or eliminated by financial institutions or through governmental action  Some risks cannot be eliminated, only managed (i.e. the “business cycle”)  At the macro level, a stable economy improves the welfare of everyone

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 8 Review of Some Important Basic Concepts (this stuff is not in your book) Difference Between Price and Value  The value of a financial asset is based upon expected future cash flows  this is the “theoretical value”, “fair market value (FMV)”, “true market price”, “true market value”, “intrinsic value” or “no- arbitrage price”  it is what the asset should be worth based on fundamental financial and accounting valuation principles (much more on this later)  The price (“market price” or “real market price”) of something is  what the seller wants you to pay for it  what the “real” market allows (based on Laws of Supply / Demand)  Price is usually not equal to fair market value:  “fair market value” is the value of something based on theory and does not include profit  “price” is based on market/economic forces (supply and/or demand) and usually includes profit, transaction costs, etc.  What makes the fair market value of something change?  change in expected/estimated future cash flows  change in future cash flow discount rate (more on this later)  What makes the price of something change?  the same things that make fair market value change  market forces (supply & demand) Profit  It is the difference between Market Price and Value  Profit = Market Price - Value  Profit = Sales Price – COGS (Accounting Definition)

Introduction to MGT 470 (cs3ed) v1.0 Jun 15 9 Profit (continued)  In the case of an investment: Profit = Available market price at the end of the holding period - Price paid at the beginning of the holding period (i.e. you buy a security, you hold it for a while, its price changes, you sell it) Percent (%) Profit or Rate of Profit  The percentage increase in the price (or value) of a financial asset  May involve time  Also Called:  Return  Percent Return (% Rtn)  Rate of Return (ROR)  Yield  Return on Investment (ROI)  General Equation: Profit / Investment  ROR may be thought of as rate of wealth creation Rate of Profit Examples: 1) (Spot Transaction) (Passage of time does not matter) A lawn mower manufacturing company charges $300 for a lawn mower that cost $270 to produce and ship. What is the return on this product? Return = (Sales price - COGS) / COGS = ($300 - $270) / $270 = $30 / $270 = = 11.11% = % Profit = % Rtn = ROR = Yield = ROI Profit Investment

Introduction to MGT 470 (cs3ed) v1.0 Jun Percent (%) Profit or Rate of Profit (continued) 2) (Investment Transaction) (Passage of time matters) A year ago you bought 100 shares of Intel stock for a total of $4,329. Today you sold that 100 shares for $4,489. What was your rate of return? Return = (New Price - Old Price) / Old Price = ($4,489 - $4,329) / $4,329 = $160 / $4,329 = = 3.696% The equation (New-Old)/Old is not unique to finance: Example 1: The temperature at dawn was 24 o and at 3:00 pm it was 56 o. By how much did the temperature change in percent? Answer: %  Temperature: (New-Old)/Old = (56 o – 24 o )/24 o (Note:  = change) = = 133% Check Answer: 24 o ( ) = 24 o (2.3333) = 56 o Example 2: At the beginning of 2005 the population of Albuquerque was 450,000. At the end of 2005 the population was 461,200. What was the percent change in population? %  Population = (New – Old)/Old = (461, ,000)/ 450,000 = = 2.489% Check Answer: 450,000( ) = 461,200; The general equation to find the value of some variable increased by some percent is: New = Old(1 + %  ) Profit Investment

Introduction to MGT 470 (cs3ed) v1.0 Jun Percent (%) Profit or Rate of Profit (continued) 3) (Security Spot Transaction) (Passage of time does not matter) A company intends to sell securities valued at $1, The sales price will be $1, What is the ROR? Return = (Sales Price - FMV) / FMV = ($1, $1,020.50) / $1, = $65.50 / $1, = = %  The FMV of the security is the investment: it is the amount of money (in today’s dollars) the company must promise to pay in the future to those who buy the security Profit Investment

Introduction to MGT 470 (cs3ed) v1.0 Jun Alternate Form of % Profit Equation: (New Price – Old Price) / Old Price = New Price Old Price Old Price Old Price = New Price/Old Price – 1  In Finance, we are more concerned with Rate of Return (%) than we are with Profit ($) Consider these two investment options: A) Invest $5,000 now and receive $5,500 in one year B) Invest $100,000 now and receive $108,000 in one year Find Profit: Profit A = $5,500 - $5,000 = $500 Profit B = $108,000 - $100,000 = $8,000 Find Rate of Return (ROR): ROI A = ($5,500 - $5,000) / $5,000 = 0.10 = 10% ROI B = ($108,000 - $100,000) / $100,000 = 0.08 = 8% Point:  Opt B has a higher total dollar profit but Opt A was actually more profitable because it produced more money with respect to the amount of money invested  In other words, a higher proportion of Opt A’s investment was “returned” as profit (10% as opposed to 8%)  Investments expressed as Rates of Return can be compared on the same basis and without bias. -