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USC / Finance / FIN 363 / What does finance do?

What does finance do?

What does finance do?


School: University of South Carolina
Department: Finance
Course: Introduction to Finance
Professor: Ozgur ince
Term: Fall 2016
Tags: finance, fina363, final, exam, finalexam, introtofinance, and introductiontofinance
Cost: 50
Name: Finance 363 Final Exam
Description: this study guide covers everything in the course that will be on the final
Uploaded: 12/05/2016
18 Pages 20 Views 10 Unlocks


What does finance do?

History of Finance

∙ Finance: the field that deals with the study of investments

∙ Finance is a technology that enables the allocation of resources over time ∙ Emerged in Mesopotamia around 3,000 BCE

∙ Babylonia 2000 BCE

o Temples collected deposits/made loans

o Emergence of banking

∙ Code of Hammurabi – 1754 BCE

o Law 88: a merchant may collect interest of 33 and 1/3 percent on a  loan of grain and 20% interest may be charged on a loan of silver o Law 48: if a person is in debt and loses a crop because of a natural  disaster the contract shall be changed so that person will not owe the  creditor any interest for the year If you want to learn more check out What are the differences between civil and criminal cases?

o Emergence of central banking and financial regulation

What are the 2 types of markets by the maturity of securities?

∙ Ancient Greece – 4th century BCE

o Athens had population in 100,000s and had outgrown its local  agricultural capacity

o Long/risky voyages to import crops

o Wealthy citizens invested in voyages

o Emergence of partnerships

∙ Renaissance Europe- birth of modern financial system

o In 1172 Venice issued 1st government bond

o In 1300s beginning of bond market in Venice

o Honor del Bazacle- 1372

 World’s first modern corporation

o Amsterdam Bourse- 1602

 First modern stock market

What does finance do?

What are the types of risk?

We also discuss several other topics like How to identify cash inflows and outflows?

1. It reallocates capital

2. It reallocates risk

3. It reallocates economic value through time

The Financial System

∙ Purpose: to efficiently move funds from those with a surplus (suppliers) to  those with a need (users)

Financial Markets

∙ Transfer money from the suppliers to users of capital through trading of  securities

∙ Security: a transferable instrument representing rights to debt or ownership  interest

o Debt securities that represent money that is borrowed and must be  repaid or with terms that define the amount borrowed, interest rate,  and maturity date

o Equity securities (or stock or share) that represent ownership interest  held by shareholders in a corporation


 Profits from increases in the value of their ownership interest  (capital gains)

 No maturity date

∙ 2 types of markets by the maturity of securities Don't forget about the age old question of Who is armstrong williams?

o Money markets: the market for short-term securities

 Maturity ranging between overnight and 1 year

 Typically debt instruments

 Very liquid and low cost source of short-term funds

 Issued by companies, banks, and governments in need of short term financing

o Capital markets: the market for long-term securities

 Original maturity of more than a year

 Long-term bonds and equity

 Issued by companies, banks, and governments for long-term  capital needs

∙ 2 types of markets by the identity of the seller: If you want to learn more check out Who is gavrilo princip?

o Primary markets

 For securities offered for sale by the issuer for the 1st time

 Issuer (corporation or government) receives the funds

 Important source of external capital for businesses

 Intermediated by investment banks due to severe information  asymmetry problems between issuers and investors

 IPO (initial public offering): when a firm 1st offers shares to the  public and becomes a public company

 SEO (seasoned equity offering): when an already public  Don't forget about the age old question of Who is thomas hobbes?
Don't forget about the age old question of How did eratosthenes measure the size of the earth?

company sells more shares to the public to raise more capital

o Secondary markets

 For securities traded among investors after their initial sale

 Proceeds from the sale go to the selling investor, not issuer

 Provide the means for investors to tailor their investment  


 Investors may want to sell to other investors

 Efficiency: Accurate pricing of securities

 Liquidity: easy to buy/sell without affecting the price too much ∙ 2 Types of Markets by whether Trading is centralized

o Auction markets: Centralized

 All trading funnels through one location

 Trading managed by a single “specialist” for each security

 Only 1 best price for a given security at a given time

 Example: New York Stock Exchange

o Dealer Markets: Decentralized

 Trading takes place in a variety of places

 Managed by a number of dealers (“market makers”) in each  security

 Brokers’ responsibility to find the best deal

 Example: NASDAQ (National Association of Securities Dealers  Automated Quotation)


Financial Intermediaries

∙ Suppliers and users of capital usually transact through a variety of “financial  intermediaries”

∙ Mutual Funds: buy a large number of publicly traded stocks and bonds on  behalf of their investors

∙ Hedge Funds: invest in any kind of investment to maximize returns ∙ Pension Funds: manage retirement savings

∙ Endowments: manage funds donated to the university to support the  university’s budget

∙ Venture capital funds: buy stock of private high-tech start-up entrepreneurial  firms

∙ Private equity funds: purchase a whole company using large amounts of debt


∙ Finance isn’t all good or bad

∙ Good

o Engine of economic growth and innovation by allocating society’s  savings into their most efficient use

o Democratizes entrepreneurship and investing

o Reduces household economic risk

∙ Bad

o Excessive debt

o Market bubbles resulting in financial crises and crashes

o Financial fraud, Ponzi schemes, etc

Formulas to know:

Simple interest = PV x i

Future value with compounded interest: FVn = PV0 x FVIFi,n where FVIFi,n = (1+i)n  FVn = PV0 x (1+i)n 

Total interest earned (or owed): Interest = FVn – PV0

Solving for the interest rate: i = [FVn / PV0]1/n – 1

Solving for the number of years: n = ln(FVn/PV0) / ln(1+i)

FV with non-annual compounding: FVn=PV0 x [1+ (i/m)]nxm 

Effective interest rate: EIR = [1 + (i/m)]m – 1

Present value of a single sum: PV0 = FVn x PVIFi,n where PVIFi,n = 1/(1+i)n  PV0 =  FVn / (1+i)n 

PV with non-annual compounding: PV0=FVn/[1+(i/m)]nxm


Capital Budgeting

∙ Firms must allocate limited funds in a way that maximizes firm value ∙ Process of deciding which investments and projects a firm should acquire in  pursuit of that goal


∙ Good investments increase firm value, bad investments destroy value Techniques for Analyzing Projects




Decision Criteria

Payback Period

Number of years  required to  

recapture initial  investment

initial investment

annual cash flow


Net Present Value

Present value of all cash flows

PV (cashinflows)−PV

Accept if greater ( cashoutflows) than or equal to 0

Profitability Index

The ratio of the  present value of  the cash inflows to outflows

PV (inflows)

PV ( outflows)

Accept if greater  than or equal to 1

Internal Rate of  Return

The interest rate  that sets the  

present value of  the cash inflows  equal to the  

present value of  the outflows

Calculator or  


Accept if greater  than or equal to  cost of capital

Modified Internal  Rate of Return

The interest rate  that sets the  

present values of  the outflows equal  to the future  

values of the  

inflows, computed  at the firm’s cost  of capital

Calculator or  


Accept if greater  than or equal to  cost of capital

The appropriate Discount Rate

∙ Risk-free rate: we need to be compensated for inflation

∙ Risk premium: risk-averse people require extra compensation for taking on  risk

∙ Discount rates increase (and present value decreases with)

o Higher expected inflation

o Greater risk

o Greater risk aversion

The Risk-Return Relationship

∙ Investors estimate an asset’s risk, based on the uncertainty of future cash  flows

∙ Use the appropriate discount rate to establish a price that compensates for  holding an asset with that level of risk


∙ Higher risk  higher required returns  higher discount rate  lower price  today  greater expected return

∙ Too low a discount rate  valuation too high  returns too low ∙ Too high a discount rate  valuation too low  you turn down or miss out on  too many profitable opportunities

∙ Different labels for discount rate

o Bonds – bond yield

o Stocks – investors’ required return

o Capital budgeting – hurdle rate or firm’s cost of capital

Holding Period Return

∙HPRi=ending price−beginning price+dividends

beginning price

∙ HPR = capital gains + dividend yield

Multi-period returns

∙HPRtotal=(1+HPR1) (1+HPR2)…(1+HPRn )−1

∙ HPRtotal=(adjusted ending value

adjusted beginnning value)-1 

Average Returns

∙ Arithmetic Average Return: average return ignoring compounding


nk1+k 2+…+k n 




∙ Geometric (compound) average return: Average return incorporating  compounding

o(HPRtotal+1)1/ n−1


o (ending value 

beginning value )


Computing Expected Returns

∙ Expected returns: Investors’ evaluation of the probable yield of an investment ∙ Historical Analysis: Expected return = arithmetic average return observed in  the past

oE( k )=(k1+k2+…+k n)/ n

∙ Scenario Analysis: expected return = weighted average of possible future  outcomes

oExpected Return=E (k )=Pr 1k1+Pr2k2+…+Pr nkn


Computing Standard Deviation

∙standard deviation=√∑i=1n(ki−E (k ))2∗Pri 

∙ Historical analysis

n−1∑i=1n(ki−E (k ))2 

o standard deviation=√1 

o Computing the standard deviation using historical analysis is  equivalent to conducting a scenario analysis with each historical data  point treated as a potential future outcome with a probability of 1/(n-1)

Computing the Expected Return for a Portfolio of Assets

∙ Portfolio is a collection of assets


total amount invested

∙expected return on portfolio=E ( k p)=w1 E( k1)+w2 E( k2)+…+wnE ( kn )

Evaluating Risk of a Portfolio of Assets

∙ Portfolio returns=weighted sum of individual asset returns

∙ If one asset is moving up while the other is moving down, these two assets  will at least partially offset each other

∙ Measuring how closely assets are correlated becomes important in  constructing a portfolio


∙ The act of giving something variety

Portfolio Risk

∙ We need to know

o Risk of the component stocks

o Weights of the component stocks

o Degree to which they move together

∙ Correlation

o A relationship between observations, in which the movement over time of one item is related to the movement of another


∙ Measures the degree to which assets’ returns share common risks ∙ The correlation coefficient varies between -1 (perfectly negative correlation)  and +1 (perfectly positive correlation)


oPX ,Y=σX ,Y 


Volatility of a portfolio with two assets

∙ Portfolio return is the weighted average of the returns of component  securities

ok p=wk1+(1−w) k 2 

∙ Portfolio standard deviation is typically not the weighted average standard  deviations of component securities

o σp=√w2σ12+(1−w)2σ22+2w(1−w)ρ1,2σ1σ2 

Volatility and Returns

∙ Portfolio volatility is lower than individual assets’ volatilities ∙ Strong positive relation between portfolio volatility and returns ∙ Weak/no relation between individual volatility and returns

Types of Risk

∙ Diversifiable risk

o Risk that can be eliminated through diversification

o Caused by events that affect 1 or few firms

o Also called unsystematic or firm-specific risk

∙ Non-diversifiable risk

o Risk that cannot be eliminated through diversification

o Caused by events that affect all assets to some extent

o Measured by beta

o Also called market risk or systematic risk

 Total risk=non-diversifiable risk + diversifiable risk

o Diversification is “free”

 Investors should not expect to earn higher returns for bearing  diversifiable risk they can diversify away

 The only way to get higher returns is by bearing non

diversifiable risk

 Risk-averse investors’ optimal portfolios will be fully diversified o Reflects vulnerability to events that affect aggregate outcomes  Recession

o Good way to evaluate an asset’s systematic risk is to measure its  movements with the broad stock market (market portfolio)

 Beta


∙ Graph the asset’s returns against the returns on the market portfolio ∙ Slope of the line of best fit (characteristic line) is the asset’s beta


k i, k M 



Cov ¿ βi=¿

oβi=ρi , M σi 


∙ Many points don’t fall on the characteristic line due to the asset’s  diversifiable risk

∙ Properties

∙ Captures the change in an asset’s return for each 1% change in the market  return

∙ The market’s beta is 1

∙ The risk free asset’s beta is 0

Addition of borrowing to portfolio

∙ Buying on margin

o Borrowing to buy more assets than you can afford with your own  money

o Typically from a broker

Treynor Index

∙ Slope of the portfolio-possibility line can be used as a performance metric for  evaluating risky investments

∙ “How much risk premium (excess return) am I earning for the amount of risk I am bearing?”

o Treynor Index=E (k i)−kF 


∙ Market equilibrium: the treynor indexes of all assets are equal ∙ Market Treynor Index=E ( k M)−kF 

o Market risk premium




(¿ M ¿)−k F 


E(¿¿ i)=k F+βi∗¿ ¿

∙ Implies a linear relation between expected return and β for all capital assets ∙ If markets are efficient, meaning that all assets are correctly priced, the 2 are  the same and the asset is on the SML


∙ If an asset is mispriced

o Expected return > CAPM required return  asset is above the SML  buy the asset until expected return falls

o Expected return < CAPM required return  asset is below the SML  sell (or short-sell) the asset until expected return goes up

Introduction to bonds and interest rates

∙ Bond: a type of debt security issued in connection with a borrowing  arrangement

∙ Similar to a loan except:

o Loan: the lender typically holds loan until maturity

 Often 1 lender or a small group of lenders participate in a loan o Bond: the lender can sell the bond to other investors before maturity  Often a large number of bondholders participate in a bond  


∙ Typical coupon bond: issuer (borrower) makes semi-annual interest payments (coupon) to the bondholder for the life of the bond plus a lump-sum payment  (par value or face value) at maturity

o Zero coupon bonds: no interest payment until maturity

Debt Markets

∙ Money markets

o Market for bonds with short maturities

 1 year or less

o Very liquid, relatively safe debt instruments

o US Treasury bills

o Commercial paper

∙ Bond markets

o Market for debt instruments with long maturity

 More than 1 year

o Coupon or zero-coupon

o US treasury notes and bonds

Zero-Coupon Bonds

∙ Promises holder a fixed sum of money (face value or par value of the bond) at a fixed date in the future (bond maturity)

∙ Typically sell at a discount to their face value

∙ Return



Price )


o Yield to maturity or yield

∙ Yield curve: term structure graphed against respective maturities o Expectations theory:

 Long term spot rates reflect market’s expectations about future  short term rates

o Liquidity preference:


 Issuers prefer to borrow for long maturities, investors prefer to  lend for short maturities

∙ Lower rates in the short term, higher rates in the long  


o Normal yield curve: upward sloping with maturity

 steep yield curve implies higher expected short term rates in the future

 this is a positive signal since higher future rates indicate  

increasing productivity of capital

 Steep yield curves have historically preceded economic upturns o Flat yield curve: spot rates don’t vary much with maturity

 Flat curve despite liquidity preference

 Implies declining short term rates in the future

∙ Negative signal

 Signals economic slowdown

o Inverted yield curve: downward sloping

 Significantly lower rates in the future

∙ Very negative signal

 12-18 months before recession


(1+k n)n 

Coupon Bond

∙ Debt instrument which pays periodic interest payments to the holder and  pays the final lump sum (face value) at maturity

∙ Convertible bond

o A corporate bond which allows the holder the right to convert the bond into a fixed number of shares in the company

∙ Callable bond

o The issuer has the right to force early redemption of the bond o When called the holder must return the bond in exchange for the FV of  the bond and possibly a premium

∙ Foreign bond

o Bonds issued by an entity in a foreign country and in that country’s  currency

∙ Floating rate bonds

o Coupon rate fluctuates with some benchmark rate

∙ Coupon bond cash flows

o Coupon rate

 The annual dollar value of the coupons divided by the FV of the  bond

 Annual coupon amount = coupon rate x face value

 Each coupon amount = coupon rate x face value / number of  coupons per year

∙ Coupon bond price



Yield to Maturity

(1+k t)t+FV (1+k n)n 

∙ What return will the bond holder earn if she holds the bond until maturity? ∙ Single rate which discounts the bond’s cash flows such that PV=Pbond ∙ Common rate for all maturities

n Ct 


(1+k d)t+FV (1+k d)n 

∙Pbond=C∗PVIFAn ,k d+FV (1+k d)n 


o PVIFAn ,k d=

(1+kd)n k d 

Non-annual Coupon Bonds

∙Pbond=C/m∗PVIFAn∗m, k d/m+FV (1+k d/m)m∗n 



∙ Pbond=

kd/m+FV (1+k d/ m)m∗n 

Coupon Bond Price Properties

∙ Par value bond: bond price=FV

o Coupon rate = YTM

o All bonds trade at par right before they mature

∙ Discount bond: bond price < FV

o YTM > coupon rate

o Discount bonds’ price goes up to FV as bond approaches maturity ∙ Premium bond: Bond price > FV

o YTM < coupon rate

o Bonds price goes down to FV as bond approaches maturity

Bond Price Changes over Time

∙ HPR = (End price-Beg Price + Earnings paid)/ Beg Price

o Earnings paid = coupon payments

∙ If YTM stays the same, we earn the YTM despite selling early ∙ If YTM goes up before we sell the ending price is lower

∙ If YTM goes down before we sell the price is higher


Bond Duration

∙ Macaulay Duration

o Weighted average maturity of cash flows n




( 1+k d)t+n∗FV


(1+k d)n 


o Useful to estimate bond price sensitivity to yield changes

o Used to ensure that the firm’s assets and liabilities have similar  duration and similar interest rate risk

∙ Modified Duration

o Bond price sensitivity to yield changes


(1+k d)

o∆ Price=(−1)∗Price∗∆ kd∗ModD

Stock Valuation & Market Efficiency Definitions

∙ Equity

o Ownership interest in an entity

o Equity value goes up if the entity becomes more valuable, vice versa ∙ Stock

o A company can raise equity capital by selling a portion of its ownership to investors by issuing stock

∙ Share

o A company’s stock is divided into shares

Two Types of Equity Securities vs. Debt





DEBT Coupons  (guaranteed)

Highest Finite maturity No


Dividends  (typically  guaranteed)

Middle Perpetual  (typically)



Dividends (not guaranteed)

Lowest Perpetual Yes

Valuation of Preferred Stock

∙ Simple preferred stock that pays fixed dividends in perpetuity oPPreferred=Dk


Valuation of Common Stock

∙ DCF valuation

o Based on the idea that every asset has an intrinsic value driven by its  fundamentals (cash flows)

o Discount forecasted dividends using firm’s cost of equity

o Discount forecasted FCFE using cost of equity

o Discount forecasted FCFF using firm’s cost of capital, then subtract the  value of debt and preferred stock




∙ Relative valuation

o Based on how the market prices similar assets

Generalized Dividend Valuation

∙ Based on the idea that stock price is the present value of all future dividend  payments

∞ Dt 


(1+k )t 

∙ Constant Growth Model

o Based on the assumption that dividends grow at a constant rate  forever

o P0=D0∗(1+g)



og=(D0 D−n)

1/ n


Free Cash Flow Valuation

∙ Ideal cash flow measure: FCFE

∙ FCFE = Net Income + Cash-flow adjustments



(1+k )2 …

Valuation Multiples

∙ When CF projections are unreliable, we need an alternative methodrelative  valuation

∙ Price-to-Earnings Ratio



o P0=EPS1 



Efficient Market Hypothesis

∙ Efficient market

o Market where securities are priced fairly at all times and new info is  rapidly reflected in the price

o “Fair” price: reflecting firms’ intrinsic value without systematic bias o Many competitive, informed investors

o Investors with the same goal of locating securities offering the highest  risk-adjusted returns

o Investors that are reacting rapidly and accurately to new information ∙ Inefficient market

o Price adjustments are slow

o Price movements are unpredictable based on past information o Similar securities have different prices

∙ Implications

o Keep trading to a minimum

 Lower trading commissions

 Lower taxes

 Lower likelihood of making a mistake

Weighted Average Cost of Capital

∙ Firms can issue debt (bank loan, bonds) or stock (preferred, common) ∙ Cost of capital is the required return of the investors’ providing that capital ∙ WACC

o Captures the average cost of funds for firm’s projects

o Computed as weighted average cost of debt and stock financing, using the long-term target weights from the balance sheet

After-tax Cost of Debt

∙ Interest on debt is a tax deductible expense for firms

∙ After-tax cost of debt = (1-T)kd

Cost of Preferred Stock

∙k p=Dp/ Ppreferred 

Cost of Common Stock

∙ Often the most expensive source of financing due to increased risks faced by  outside investors

∙ Cost of equity comes from having to sell ownership interest at a relatively low price

∙ Three methods to find cost of equity


o CAPM:  

(¿¿ i)=k F+β[E ( k M )−kF] ke=E ¿

 Challenging to forecast the expected market risk premium


o Constant growth model: k e=D1 


 Works for firms paying steadily growing dividends

o Premium over Bond Yield: k e=k d+θ

 Usually for firms with bonds outstanding

Computing the WACC

∙ WACC=wdk d(1−T )+wpk p+weke 

∙ Total firm value: V = D + P + E

FCFF Valuation

∙ Very similar to D and FCFE valuation except

o FCFF is the cash flow measure

o WACC is the discount rate

o Measures entire firm value, so the market value of debt must be  subtracted at the end



(1+WACC)2 …−MV of Debt−MV of Preferred


Chapter 3 (TVM)

∙ Future and present values of sums and mixed streams

∙ Solving for the interest rate

∙ Solving for the number of periods

∙ Non-annual compounding and the Effective interest rate (EIR)

Chapter 4 (Annuities and Loans)

∙ Future and present values of annuities

∙ Present value of perpetuities

∙ Solving for payment (PMT)

∙ Solving for the number of payments

∙ Imbedded annuities

∙ Balloon and amortized loans

Chapter 9 (Capital budgeting)

∙ Payback period

∙ Net present value

∙ Profitability index

∙ Modified internal rate of return (MIRR)

Chapter 5 (Risk and return)

∙ Holding period return (HPR), capital gains yield, dividend yield ∙ Multi-period HPR, arithmetic and compound average returns ∙ Expected return of a single asset (Historical and scenario analysis) ∙ Standard deviation of returns of a single asset (Historical and scenario  analysis)

∙ Portfolio weights and portfolio returns

Chapter 6 (Portfolio theory)

∙ Portfolio standard deviation

∙ Correlation coefficient

∙ Estimating beta

∙ Treynor index and the capital asset pricing model (CAPM) ∙ Portfolio beta

∙ Buying on margin

Chapter 7 (Interest rates and bonds)

∙ Zero coupon bond pricing

o Find yield given price

o Find price given yield

∙ Coupon bond pricing

o Find price given the term structure

o Find price given the yield-to-maturity

o Find price for coupon bond with non-annual coupons

∙ HPR of bond holdings

∙ Bond duration


o Macaulay Duration (MacD)

o Estimate the change in bond price given MacD

Chapter 8 (Stock valuation and market efficiency) ∙ Valuation of preferred stock

∙ Stock valuation using DCF methods

o Methods: One-period, constant-growth, non-constant growth o Cash flows: Dividends and free cash flow to equity (FCFE) ∙ Valuation multiples and relative valuation

Chapter 11 (Cost of capital)

∙ Computing the weighted average cost of capital (WACC) ∙ Stock valuation using FCFF discounting

Typical numerical question distribution in past final exams ∙ Chapters 3 and 4 (TVM): 2 questions

∙ Chapter 9 (Capital budgeting): 2 questions

∙ Chapter 5 (Risk & Return): 4 questions

∙ Chapter 6 (Portfolio theory): 4 questions

∙ Chapter 7 (Bond valuation): 4 questions

∙ Chapter 8 (Stock valuation): 4 questions

∙ Chapter 11 (Cost of capital): 2 questions

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