Intro to Finance

1. Introduction: Why Finance?

- The study of value – what human after, money is just the tool

- Value creation – time and uncertainty; Time – implication in assessing value

- Everything can be valued through this framework

- It’s a way of thinking and a set of tools that reflect this way of thinking (Way of thinking + Tools = Art + Science)

- Most applicable decision-making system -> transparent and value base decision making

Syllabus

1. Time Value of Money: Understanding how to value benefits/costs occurring over time (No uncertainty)

2. Decision criteria: Understanding how to make value-enhancing decisions

3. Bonds and Stocks: the 2 key ways of financing any idea

4. Uncertainty and risk: the role and measurement of risk in assessing value

• Economics the mother-discipline of finance.
• Mathematics and statistics – calculate risk and uncertainty
• Accounting – language  of business, limited

Economics: a collection of assumptions about human behavior and  in the hope that human behavior matches what the predictions or the assumptions are.

ASSUMPTIONS:

• Competitive market: similar to democracy, “inequality of income” “lack of ability to participate” “concentration of power in few businesses” can take away competitive markets. When one value something, one needs to know how similar things are valued.
• Frictions small relative to power of most good ideas; market is strong enough for value proposition larger than fictions.
• More competition -> less friction
• Capital can flow relatively easily -> great ideas get adopted quickly

1. Time Value of Money (TVM)

The Essence of Decision Making

• Virtually every decision involves time and uncertainty
• Very important to understand the impact of just the passage of time on a decision
• We will first assume no uncertainty to internalize the time value of money

PV = Present Value ($)

FV = Future Value ($)

Both are measured in dollar, a measurement of value

N = # of Periods (#) # = day/month/year etc passage of time makes decision making difficult

R= interest rate (%) > 0 (assumption): change over time (Theory of Interest by Irving Fisher 1930)

1. Simple Future Value (FM)

Time Lines: all issues/problems can be put on a time line

. [pic 1]

The Main Insight: A dollar today is worth more than a dollar tomorrow.

Money cannot be compared across time -> unless time has no value

Every value creating decision that one makes should force self to look into the future.

Future Value (FV) = Initial Payment  (P)+ Accumulated Interest (P*r)

FV = P + r*P = (1+r)*P; 1+r = Future Value Factor; r*P = Accumulated Interest

FV = P*(1+r)^n after n period of time

Most answers to finance question is COMPOUNDING

Suppose you invest $500 in bank at interest rate of 7%, how much will you have after 10 years?

FV = 500*(1+0.07)^10 = 983.58

ECCEL

=FV(rate, nper, pmt, [pv], [type]) – rate = interest rate; nper = period; pmt = payment; pv = present value

=FV(.07,10,0)

Compounding interactions of the interest rate and time

What are the FV of investing $100 at 10% vs 5% for 100 years? (Risk usually largely affects interest rate): Bond ~ 5%; Shares ~ 10%

FV(0.05,100,0,100) = -$13,150.13; FV(0.1,100,0,100)= -$1,378,061.23

If there is no compounding: 100 years of 5% interest on principle will = $500 only

FV(0.06,2012-1626,0,24) = -$140,693,888,847.34

1.9 Simple Present Value

What is the present value of receiving $110 one year from if the interest rate is 10%?

• To work out the present value to achieve the future value
• [pic 2]

Suppose you will inherit $121,000 2 years from now and the interest rate r = 10%, what is the value today to you?

PV = 121,000/(1+0.1)^2=100,000 EXCEL: =PV(rate,nper,pmt,[fv],[tpe)

2.1 Recap Week 1

PV ---→1---→2 FV TIMELINE; FV = PV(1+r)^n; PV = FV/(1+r)^n

2.2FV of Annuity: Concept

Multiple Payments: Annuities = a collection of payments to be periodically receive d over a specified period of time

Very rare occasion, one will only see one input and one output overtime

Eg: Regula deposit into a saving account, monthly home mortage payments etc

A special case of multiple payments: annuities (C for cashflow or PMT for Payment)

Annuity pays C (cashflow) 3 times; none at year 0

Fv of an Annuity: Formula

FV = C(1+r)^2+C(1+r)+C = C{(1+r0^2 + (1+r) + 1]

FV = c{(1+r)^n-1 + ….+ 1}

- n-1 because there is no payment on year 0

What will be the value of your portfolio at retirement if you deposit $10000 every year in a pension fund. You plan to retire in 40 years and expect to earn 8% on your portfolio.

EXCEL: =fv(rate, nper, pmt, [pv], [type]) = FV(0.08,40,10000) = 2,590,565.19

If there was no interest rate = total will be 40*10000 = 400,000

Interest rate is determined by the investor, higher risk = higher interest/higher volatility

Suppose you want to guarantee yourself $500,000 when you retire 25 years from now. How much must you invest each year, starting at the end of this year, if the interest rate is 8%?

EXCEL: =PMT(0.08,25,0,500000) = $6840

If interest rate is 0, total will only be 6840*25; the effect of compounding is again seen

2.5 PV of Annuity

PV = C/(1+r) + C/(1+r)^2 + C/(1+r)^3; C can be replaced by PMT

= C{1/(1+r) + 1/(1+r)^2 + 1/(1+r)^3]; n =3

How much money do you need in the bank today so that you can spend 10,000 every year for the next 25 years, starting end of this year. Suppose r = 5%.