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I. FINANCE - Introduction

I. FINANCE - Introduction. Professors Simon Pak and John Zdanowicz. I. FINANCE - WHAT'S IT ALL ABOUT?. MAXIMIZING PROFIT ? MAXIMIZING MONEY HOLDINGS ?. MAXIMIZING EXPECTED HAPPINESS => MAXIMIZING EXPECTED UTILITY CONSIDERING TIME AND UNCERTAINTY

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I. FINANCE - Introduction

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  1. I. FINANCE - Introduction Professors Simon Pak and John Zdanowicz

  2. I. FINANCE - WHAT'S IT ALL ABOUT? • MAXIMIZING PROFIT ? • MAXIMIZING MONEY HOLDINGS ?. • MAXIMIZING EXPECTED HAPPINESS => MAXIMIZING EXPECTED UTILITY • CONSIDERING TIME AND UNCERTAINTY MAX E(HAPPINESS) = MAX [ E(H0) + E(H1) + E(H2) + . . . + E(Hn) ] WHERE t = 0 . . . n WHAT IS n? t = -1 . . . -n PAST - SUNK COST t = 0 . . . n EXPECTED LIFE t = n+1 . . . INFINITY YOU ARE DEAD - WHO CARES n IS YOUR EXPECTED LIFE

  3. Finance Decisions and Utility • MAX E(H) => MAX E(CONSUMPTION) => MAX E(CONSUMPTION) => MAX WEALTH • WEALTH = Value Of Current Endowment + Value Of Labor Income + Value Of Claims On Assets (Investments In Firms) • FIRM VALUE = f (Investment, Financing, & Dividend Decisions)

  4. II.  EVOLUTION OF FINANCE • 1900 • EMERGED FROM ECONOMICS • INSTRUMENTS AND INSTITUTIONS • NO FINANCIAL STATEMENTS • 1920'S • NEW TECHNOLOGY AND INNOVATION • FIRMS NEEDED FUNDS • EMPHASIS ON LIQUIDITY • EMPHASIS ON RAISING EXTERNAL FUNDS • 1930'S • DEPRESSION • BANKRUPTCY AND REORGANIZATION • CONSERVATISM ‑ DEBT • GOVT. REGULATION OF THE SECURITY MARKETS • INCREASED FINANCIAL DATA

  5. II.  EVOLUTION OF FINANCE • 1940'S & Early 50’s • TRADITIONAL APPROACH • VIEW OF THE OUTSIDER ‑ INVESTOR OR CREDITOR • SECURITY ANALYSIS • NO EMPHASIS ON FIRM DECISION MAKING • MID 1950’s • VIEW OF THE INSIDER • INVESTMENT DECISIONS • CAPITAL STRUCTURE DECISIONS • DIVIDEND POLICY DECISIONS • * VALUATION THEORY • CORPORATE FINANCE <=> SECURITY ANALYSIS

  6. II.  EVOLUTION OF FINANCE • 1960'S • QUANTITATIVE ERA • MBA DEGREE ‑ PHYSICAL SCIENTISTS • COMPUTER • DATA BASES • 1970'S, 1980'S, 1990'S • THEORY ERA • COMMON THEORETICAL BASE • FINANCIAL ECONOMICS

  7. Intuitive Approach To Finance • FINANCE ‑ QUANTITATIVE VS. INTUITIVE • FINANCE IS MATHEMATICAL • DON'T NEED TO MEMORIZE EQUATIONS • NEED TO KNOW HOW TO GET THE CORRECT ANSWER • POOL ‑ PHYSICS: VELOCITY, ANGLES • MINNESOTA FATS • NEVER STUDIED PHYSICS • ACTS AS IF HE KNEW PHYSICS • LEARNED BY TRIAL AND ERROR • YOU CAN’T USE TRIAL & ERROR => BANKRUPTCY

  8. DEVELOPMENT OF FINANCE THEORY • FINANCE = ECONOMICS = SOCIAL SCIENCE • CAN'T EXPERIMENT ON HUMANS • NORMATIVE THEORY VS. POSITIVE THEORY • NORMATIVE - WHAT SHOULD BE . . . DEDUCTIVE LOGIC • POSITIVE - WHAT IS . . . INDUCTIVE LOGIC • POSITIVE IS MORE FUN . . . War Stories . . . Bad Finance • INCOME TAX WITHOLDING • CHRISTMAS CLUB • DEBIT CARDS • STUDENT LOANS • TACO BELL

  9. Methodology To Develop Finance Theory - Physical Science 1. Make Assumptions About Man - Rational And Economic A. Comparability - people can compare and rank choices A (PREFERRED TO) B A (P) B B (PREFERRED TO) A B (P) A A (INDIFFERENT TO ) B A (I) B B. Transitivity - people are logically consistent IF A(P)B AND B(P)C . . . THEREFORE . . . A(P)C OR IF A(I)B AND B(I)C . . . THEREFORE . . . A(I)C

  10. U Decreasing Marginal Utility U Constant Marginal Utility Increasing Marginal Utility U2 U U1 Wealth W1 W W2 Wealth Wealth Assumptions - continued C. NON-SATURATION MORE IS PREFERRED TO LESS TOO MUCH OF A GOOD THING IS GREAT MORE WEALTH => MORE CONSUMPTION => MORE HAPPINESS d(U)/d(C)>0 and d(C)/d(W)>0 U D. DIMINISHING MARGINAL UTILITY HAPPINESS INCREASES AT A DECREASING RATE RESULTS IN RISK AVERSION

  11. Scientific Approach To Theory 1. MAKE ASSUMPTIONS ABOUT MAN: Rational And Economic 2. REMOVE REAL WORLD CONSTRAINTS No Taxes, No Transactions Costs, Divisibility Of Securities 3. DEDUCE CONCLUSIONS - BASED ON LOGIC Constant Over Time 4. ADD BACK REAL WORLD CONSTRAINTS 5. EMPLOY THE MODEL MAKES FINANCE MORE LIKE A PHYSICAL SCIENCE ALLOWS REAL WORLD CONSTRAINTS TO CHANGE

  12. Max Happiness - Max Wealth - For Whom? • CONSUMER • EMPLOYEE • CREDITOR • GOVERNMENT • SOCIETY • MANAGEMENT • OWNER => SHAREHOLDER • THE GOLDEN RULE OF FINANCE • THOSE WHO HAVE THE GOLD MAKE THE RULES • MAXIMIZE SHAREHOLDER WEALTH

  13. II. Focus Of Finance ‑ Return On Capital • CAPITALISM ‑ RETURN ON INVESTMENT • WHY DO CAPITALISTS DESERVE A RETURN ON CAPITAL • KARL MARX ARGUED THAT THEY WERE EXPLOITING THE WORKERS • AUSTRIAN ECONOMISTS REFUTED HIS ARGUMENTS

  14. A. Time Value Of Money (Delayed Consumption) • INCOME = CONSUMPTION + SAVINGS (INVESTMENT) • INCOME => FIXED • THEREFORE TO INCREASE INVESTMENT MUST DECREASE CONSUMPTION • INDIVIDUALS PREFER CURRENT CONSUMPTION • THEREFORE DEMAND COMPENSATION FOR DELAYING CONSUMPTION • EXAMPLE: PORSCHE • $ 100,000 DELAY FOR 1 YEAR ‑ NO • BUT PAY $110,000 IN 1 YEAR ‑ YES *** INTEREST RATE CREATED = 10 %

  15. CAPITAL MARKETS • INTEREST RATES SET BY SUPPLY AND DEMAND • INTEREST RATE = COMPENSATION FOR DELAYED CONSUMPTION = PAYMENT FOR CURRENT CONSUMPTION CANNOT BE TOO MUCH BORROWING => AN EQUAL AMOUNT OF LENDING MUST EXIST • CAPITAL MARKETS:  • NEEDED FOR ECONOMIC DEVELOPMENT • NEED TO TRADE OVER TIME

  16. Capital Market Examples • EXAMPLES:  • MORTGAGE, CREDIT CARD, AUTO LOANS, EDUCATION LOANS, • PENSIONS, SAVINGS ACCOUNTS, LIFE INSURANCE • DIRECT SECURITIES: STOCK, BONDS, PRIVATE MORTGAGE • INDIRECT SECURITIES: PENSION FUND, INSURANCE, MUTUAL FUND, SAVINGS ACCOUNT => FINANCIAL INTERMEDIARIES i = Pure Interest Rate ‑ Treasury Securities => Time Value

  17. B. RISK PREMIUM • Individuals Demand Compensation For Bearing Risk • RISK PREMIUM = q • GREATER RISK ==> LARGER RISK PREMIUM q • LOWER RISK ==> SMALLER RISK PREMIUM q • NO RISK ==> NO RISK PREMIUM q

  18. Expected Return (Benefit) E(R)* q i i Risk* Risk C. Total Return On Capital (Investment) • ROI = Compensation For Delayed Consumption + Risk Premium • ROI = i + q

  19. Risk vs. Benefit Examples • Examples Of Risk Vs. Benefits *** Natural Event ‑ No Law ** • Investment ‑ T Bills ==> Futures (Illegal) • Job Safety ‑ Clerk Typist ==> Red Adaire (OSHA ?) • Product Warranties ‑ As Is ==> Lifetime (Lemon Law ?) • Auto Insurance ‑ Safe Drivers ==> Bad Drivers (Risk Pool ?) • Consumer Credit ‑ Low Risk ==> High Risk (Usury Laws ?)

  20. Shareholder Wealth Maximization • Alternative Argument To Justify Shareholder Wealth Maximization • Most direct securities owned by financial institutions • The ‘little guy’ invests through financial institutions • ‘Buy a piece of the rock’ • FIRM • A nexus of contracts • The firm is individuals who contract with each other • Business - a fiction • Can’t tax business - can only tax people

  21. D. RISK ANALYSIS • NEW DECISIONS:  • PEOPLE TEND TO FOCUS ON RETURN OR BENEFITS • MUST ALSO LOOK AT RISK ==> DEVIATIONS FROM EXPECTED • WORST CASE <======> BEST CASE & HOW WOULD I FEEL • HISTORICAL ANALYSIS:  • MEASURING PERFORMANCE ‑ YOU AND YOUR BOSS • STATEMENT: I BOUGHT IBM OR I BOUGHT HALOID ! • CORRECT RESPONSE: HOW MUCH RISK DID YOU TAKE ?

  22. EXAMPLE: Risk Analysis • INDIVIDUAL A & B GIVEN $1,000 TO INVEST FOR ONE YEAR • A RETURNS WITH $ 10,000 • B RETURNS WITH $ 00,000 • WHO SHOULD YOU HIRE AND FIRE ? BUT BOTH PLAYED THE SAME GAME:  • PICK A NUMBER FROM 2 TO 12 • BET $1000 • ROLL THE DICE • WINNING NUMBER PAYS $ 10,000

  23. EXAMPLE: Risk Analysis - continuted • A BET ON 12 1/36 X $10,000 = $ 278.00 35/36 X $00,000 = $0,000.00 EXPECTED RETURN = $ 278.00 • B BET ON 7 6/36 X $10,000 = $1,667.00 30/36 X $00,000 = $0,000.00 EXPECTED RETURN = $1,667.00 • DICE ROLLED ===> 12 ROLLED ===> A WINS, B LOSES • NOW, WHO WOULD YOU HIRE & FIRE If you hired A, hire all former lottery winners to manage $

  24. EXAMPLE: Risk Analysis - continuted *** LEARN TO BET ON 7'S *** LIFE IS A CRAP SHOOT *** • RISK SHIFTING: **** LIFE IS RISKY **** • CAN'T ELIMINATE ALL RISK • CAN SHIFT RISK ==> MUST COMPENSATE THOSE WHO ASSUME RISK • INSURANCE, PRODUCT WARRANTIES, ETC. • Eliminating Risk • Proper Diversification • 2 + 2 = 3

  25. Expected Return (Benefit) E(R) A i Risk E. ROLE OF FINANCE • Can't tell you what choice to make • Your choice depends on your attitude toward risk and return * Can Teach You How to Make Rational Choice ! * Can Teach You How to Bet on 7's ! * Can Teach You How to Behave Like Minnesota Fats ! • Simon Pak & John Zdanowicz 2000

  26. F. FINANCE VS. ACCOUNTING • ACCOUNTING ‑ RECORD KEEPING • FINANCIAL ACCOUNTING ‑ EXTERNAL ‑ SHAREHOLDERS & CREDITORS • MANAGERIAL (COST) ACCOUNTING ‑ INTERNAL ‑ MANAGEMENT • TAX ACCOUNTING ‑ EXTERNAL ‑ IRS • " REAL ACCOUNTING " ‑ IN THE DESK ‑ THE TRUTH • FINANCE ‑ DECISION MAKING • HOW YOUR DECISIONS IMPACT SHAREHOLDER WEALTH !

  27. G. Overview Of The Firm ‑ Financial Statements • STOCK VS. FLOW Balance Sheet ==> + Income Statement ==> Balance Sheet (1/1/1998) (1/1/1998 TO 12/31/1998) (12/31/1998) • BALANCE SHEET • STOCK • FIRM AT A POINT IN TIME • INCOME STATEMENT • FLOW • WHAT HAPPENED TO THE FIRM OVER TIME • EXAMPLE: FILM OF YOUR TRIP • 1'st Frame ‑ Where You Started ===> 1'st Balance Sheet • Last Frame ‑ Where You Ended ===> Last Balance Sheet • All Other Frames ‑ How You Got There ===> Income Statement

  28. THE FIRM

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