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Finance

Chapter 1 Notes

6/22/15

Definition of Finance
The cycle of Money
Overview of Finance areas
Classification of financial markets
Financial management
Goal of Financial management
Three key factors determining stock price
* Definition of Finance
1
...

- It is about making decisions regarding what assets to buy/ sell and when to buy/ sell
* The Cycle of Money
Borrower - receives $500 x 1% lender( investor ) = $5
Money goes from lender to borrower and then from borrower to lender
...

In a real world, most lenders are not in direct contact with their borrower
...

The bank is called a financial intermediary, a institution that acts as a middleman between
borrowers and lenders
...
Bank’s income comes from interest margin, the
difference between the interest rate the bank pays to lenders and the interest rate the bank
charges borrowers
...

2
...

4
...
Corporate Finance - It is a set of financial activities that support the operations of a
corporation and its use of money, including borrowing funds to finance projects
...
Investments - are the activities of buying and selling assets
...
Financial institutions - are organized intermediaries to promote the cycle of money
includes commercial
...

Commercial - TDBank, Bank of America, Wells Fargo
Investment - JP Morgan, Goldman Sachs, Merril Lynch
4
...

2
...

4
...
We classify financial markets by the type of asset that are bought and sold in the
market
...
Equity markets where stocks are traded
2
...
Derivative markets where futures and options are traded
4
...
We classify financial markets by the maturity of the assets
Maturity means the length of time the borrower has to pay back the borrowed money
...
Money market (Short-term), where investors trade financial assets that will mature within 1
year
...
Capital Market (Long-term), where investors trade financial assets that will mature over
(longer than) 1 year
3
...

1
...
When a firm offers stock for sale
for the first time, and the investors buy stock from the firm which issues the stock
...
Secondary market- Investors buy asset from other buyers

4
...


1
...
The dealer makes money by buying at a lower price and selling at a
higher price
...
Auction market or broker market - The broker or auctioneer helps investors find assets buyer
which bid the highest price and sell the asset to them
...

* Financial Management
Involves 3 main functions
1
...
Capital structure
3
...
Capital budgeting - the process of planning, evaluating, comparing and selecting the long
term operating projects of the company
...
Capital structure - The means by which a company finance its projects or activities
...

3
...
It
answers how do the firm manage its day to day business? (short term )
* Goal of Financial Management
1
...
The goal of financial management is to maximize the stock price of the public traded firm
...

2
...

4
...

Bank returns principal ($100) + interest earned ($100 x
...
05)

FV - PV x 1 + R)^N

Year 2

105 x
...
05 ^2

The interest rate is 5% per year
the deposit is $15,000
how much money do you have after 18 years

R = interest rate N = #of time period

FV = PV x (1 + R)^N
15000 X (1 + 5%) ^ 18

36099

Original deposit is 15000 ( which is present value, PV), the annual interest rate is 5% (which is
r) over the next 18 years ( which is n)
...
Formula : FV = PV x (1 + r)^n = 15000 ( 1 +
...
05^18
$36099
(1 + r) ^ n = future value interest factor ( FVIF )

2
...
05 PV = -15000 PMT = 0 CPT ( compute) then Fv ( future value)
Make present value negative when using the financial calculator, then future value will be
positive
...
The spreadsheet ( Excel )
Click on Fx key to insert a function
FV: Future Value
Rate: interest Rate = 0
...
05,18,0,-15000)

4
...
FVIF Look on the table and then multiply by present
value

present value and discounting
present value is the value today of futures cash flow
the single period scenario
how much do you have to save today at 5 % annual interest rate to have $1000 one year from
now? in essence how much $1000 one year from now is worth today at 5% annual interest
rate?
year 0 ———— Year 1
PV?

$1000 = FV

FV - PV ( 1 + r) ^2
PV = FV x 1 / (1+ r)^ n
= 1000 x 1 / ( 1+
...
95238 = 952
...
Formula method
PV = FV x 1 / ( 1 + R) ^ N
500 (1/(1
...
4564
= $228
...
financial calculator method
N = 20, I / Y = 4 , PMT = 0 , FV = 500 , CPT > PV ?

3
...
04), 20, 0 , 500 )
4
...
One equation and four variables
FV = PV x ( 1 + r) ^ N
4 variables - FV, PV, r, n
r = ( FV / PV ) ^ 1/ n - 1

If you deposit $250 in the bank today, and in 5 years you will get back $400, what is the interest
rate
( 400/ 250 ) ^ ( 1 /5) - 1 =
...
856%
financial calculator
n = 5, PV = -250 , FV = 400 , PMT = 0 CPT > I/Y?
n = ln ( fv / pv )
/ ln ( 1 + r )
y = b ^ x > logb ( y ) = x
???
you deposit 500 ( PV ) today, the interest rate is 3
...
5%) = ln ( 2 ) / ln ( 1
...
069315/ 0
...
15 years

financial calculator
i /y = 3
...
5 percent
...
5 )
format

spreadsheet - > nper

spreadsheet / formula uses decimal

rate - 0
...
035,0,-500,1000)

Rule of 72
To determine how long it exactly takes your money ( or saving ) to double at a certain interest
rate, we use 1 as present value and 2 as future value
...


N = 9
...
2 years

another use of rule of 72 is to calculate what interest rate you will need to double your money
over a certain time period
...

n = how many years to grow
You save $2000 today, save $3000 at the end of the first year, save $4000 at the end of the
second year and save $5000 at the end of the third year
...
25
FV of cash flow at T 1 = 3000 x ( 1 + 5%) ^ 2 = 3307
...
3 + 3307
...
75
Present value of multiple uneven payment streams
You receive $2000 today and will receive $3000 at the end of first year, $4000 at the end of the
second year and $5000 at the end of the 3rd year
...
05) = 2857
...
1025 =
PV of cash flow at T3 = 5000 x 1 / ( 1 + 5%) = 5000x ( 1 / 1
...
14 + T2 + T3
Future Value of an annuity stream
You decide to save $1000 at the end of every year for next 5 years
...

We can calculate the future value of each cash flow, and sum up all the future values
...
06^4
t2 = 1000 x 1
...
06^2
t4 = 1000 x 1
...

We call this type of annuity ( which has payment occurring at the end of each period) an
ordinary annuity
If we label the equal amount of cash flow every period as PMT, The future value of an ordinary
annuity is
FV = PMT x

( 1 + r) ^ n - 1
——————r

= $1000 x ( 1 + 6%)^ 5 - 1
———————
6%
FV = 5637

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