Sketches in Finance II
INTRODUCTION1
Chapter 1 NATURE of FINANCE2
1.1 Academic Discipline1
1.2 Profession1
Investment Analyst2
1.3 Other Disciplines2
1.4 Ethics and Finance2
Chapter 2 CORPORATE FINANCE 3
2.1 Objective of the Firm3
2.2 Financial Analysis3
2.3 Ratio Analysis3
2.4 Functions4
2.5 Capital Structure4
2.6 Capital Budgeting4
2.7 Net Present Value and
Discounted Cash Flow6
2.8 Internal Rate of Return (Modified)7
2.9 Dividend Policy8
2.10 Cash Flow Management9
2.11 Ancillary Responsibilities9
Chapter 3 PORTFOLIO MANAGEMENT10
3.1 Modern Portfolio Theory10
3.2 PPS through Time10
3.3 Returns through Time10
3.4 Standard Deviation of Returns10
3.5 Second Security11
3.6 Volatility of Combined Securities11
3.7 Hyperbolas11
3.8 Efficient Frontier11
3.9 Tobin’s Line11
3.10 Number of Firms12
Chapter 4 STRATEGIES13
4.1 Speculation13
4.2 Hedging13
4.3 Arbitrage13
4.4 Active Management13
4.5 Passive Management13
4.6 Efficient Mkt Hypothesis14
4.7 Capital Asset Pricing Model14
4.8 Behavioral Finance15
4.9 Fundamental Analysis15
4.10 Technical Analysis15
4.11 Black Swans & Fat Tails15
4.12 Ponzi Schemes16
Chapter 5 VALUATION17
5.1 Valuation Defined17
5.2 Gordon’s Model17
5.3 Variations17
5.4 Caveats17
5.5 Model Weaknesses18
5.6 Valuation of Bonds18
5.7 Risk on Bonds18
5.8 Continuous Compounding19
5.9 Loans19
5.10 Amortization Table19
5.11 Expected Value19
Chapter 6 DERIVATIVES20
6.1 Mutual Funds20
6.2 Index Funds20
6.3 S&P500 Index Funds 20
6.4 DJIA Index Funds20
6.5 Options21
6.6 Black-Scholes Option Pricing Model 21
6.7 Straddles &Strangles22
6.8 Hedge Funds23
6.9 Credit Default Swaps23
6.10 Collateralized Debt Obligations23
Chapter 7 FINANCIAL MODELS24
7.1 Alpha24
7.2 Beta24
7.3 Brownian Motion24
7.4 DJIA24
7.5 LIBOR24
7.6 MATLAB24
7.7 Monte Carlo Simulation24
7.8 Pi25
Chapter 8 INTERNATIONAL26
8.1 Foreign Currency Exchange26
8.2 Arbitrage26
8.3 Two Way Currency Arbitrage27
8.4 Three Way Currency Arbitrage27
8.5 Forward Contracts28
8.6 Futures28
8.7 Currency Options29
Section 9 APPENDIX29
9.1 Time Value of Money29
9.2 Correlation Coefficients30
9.3 Regression Analysis31
9.4 Z-Scores31
9.5 Normalization31
Section 10 EXERCISES32
10.1 Ratio Analysis32
10.2 NPV and IRR*33
10.3 Creating a portfolio34
10.4 Creating a hyperbola35
10.5 CAPM and beta36
10.6 Valuation of Stocks, Bonds,
and Loans 37
10.7 BSOPM38
10.8 Number of Firms39
10.9 Cross Rates, Arbitrage and
Forward Contracts40
10.10 Final Exam41
1
INTRODUCTION:
These noteswere compiled from class lectures in various financial courses.They are not intended to break new ground, to promote any particular investment philosophy, to be a complete reference,or to be the source of high entertainment. They are intended to replace the traditional textbook by touching the peaks of topics considered essential in an introductory finance course but with an economy of verbiage and economy of cost to the student.
Chapter 1 NATURE of FINANCE:
The nature of the broad discipline of finance may be regarded from slightly different perspectives: That is, one might regard finance 1) as an academic study, or 2) as a professional activity with a particular set of skills. The nature of finance is also revealed by noting 3) the relationship between finance and other academic disciplines, and finally, by noting 4) the relationship between finance and ethics.
1.1 Academic Discipline: As a field of academic study, the primary focus of finance is often on the firm and the financial management of the firm because such a large proportion of the total wealth in a capitalistic economy is created within the context of the firm (i.e. the enterprise, the corporation, the business, the private sector, etc.). For this reason, introductory finance courses are variously known as financial management, corporate finance or managerial finance.
However, a secondary academic perspective is external to the firm and focuses on individuals and institutions (acting as investors) that participate in the capitalization of the firm through the purchase of equity securities (stocks) or debt instruments (bonds). As an academic study this second perspective is referred to as investing or portfolio management.
There is yet a third perspective in the academic discipline of finance that regards the activities engaged in by financial professionals who design new contracts (financial engineering), institutions that lend and borrow capital (investment banking), and others who take speculative positions based on the performance of other instruments (institutional finance). And in addition, more specialized courses, for example in international finance, financial modeling, and financial accounting, cover various niches of finance in greater detail.
1.2 Profession: As a professional activity, the practitioner needs to understand the nature of corporations, the laws (regulations, standards, protocols) governing financial activities, the mathematics of the financial instruments, the accounting standards adopted by the firm, and the economic theories that are inherent in the actual management of the firm and the management of funds that may be held external to the firm.
The particular skill set required to successfully participate in the financial profession include many of those universally found in other professions, for example the ability to work with others, the ability to communicate clearly in written and spoken discourse, and the ability to develop and practice productive work habits. However, some skill sets are more essential to finance than to some other professions, for example - the quantitative skills of mathematics and quantitative modelingand the skilled use of information technology. Below is a job description for aninvestment analyst at a large financial institution. It reflects the skills sought in the real world:
Investment Analyst (IA) [an entry-level investment/financial analyst]
Role: The Investment Analyst is responsible for participating in research and modeling work on various traditional and alternative asset classes for institutional, private bank, domestic and international retail, and high net worth businesses. The IA performs evaluation of products for inclusion in asset allocation models and develops and maintains proprietary optimization and simulation models and participates in asset allocation related projects with clients. The IA provides general support of private bank and consumer bank with respect to risk management, portfolio analytics, attribution analysis, and other general investment topics. The IA participates in marketing efforts and client meetings.
Education and Experience: MBA in finance or similarly quantitative field, and/or CFA. Five to ten years experience in portfolio management or quantitative analysis is required. Specific work in asset allocation is a plus. Quantitative background and programming skills (e.g. VBA and MATLAB) are required.
Additional qualifications:
Financial expertise: Practical understanding of financial principles and portfolio management concepts; familiarity with, risk and valuation models.
Statistical understanding: Statistical methods must be understood well enough to judge their efficacy and drawbacks in specific circumstances; must be comfortable dealing with numerical and statistical concepts.
Computer understanding: Comfortable with statistical analysis and analytic programming; familiarity with commercial analytic packages (e.g., VBA, MATLAB).
1.3 Other Disciplines: Finance has clear connections with other disciplines (e.g. law, marketing, information technology), but often the distinction between finance and economics, and between finance and accounting gets fuzzy. Finance has sometimes been considered a sub-type, a "grubby off-spring", of economics, owing to finance's pre-occupation with actually making money for the practitioner. Economics, on the other hand, tends to be more of an intellectual pursuit, seeking understanding of the cause and effect relationships among variables.
The relationship between finance and accounting is similarly fuzzy, except that accounting is the more mundane number-crunching activity that compiles the necessary statements for the higher-order financial types. [The allusion to any actual superiority of one discipline over another is purely artistic license used to illustrate a point.]
Psychology has more recently joined forces with finance as both disciplines strive to understand the markets which are an aggregate of individuals making financial choices. Within the last decade, the discipline of behavioral finance has emerged as a combination of these two disciplines. And finally, mathematics, the pure science, provides the tools for financial calculations.
1.4 Ethics and Finance: In other cultures and in other times, the charging of interest was immoral and illegal. Lending money to a neighbor was considered acceptable, but charging interest on the loan was considered harvesting money from a source into which no labor was provided. Ergo, interest must have come from the Devil. Times and culture have changed to where “charging (reasonable) interest” is universally accepted as fair play, yet there are still ample opportunities to take unethical advantage of our imperfect economic system. Harry Markowitz has some thoughtful comments in "Markets and Morality" related to ethical issues in capital markets.
Chapter 2 CORPORATE FINANCE
2.1 Objective of the Firm: The discussion of finance within the corporation is best opened with the existential questions of “why does the corporation exist?” Or, put another way, “what is the objective of the firm?” Awidely accepted financial theory states that the firm exists for the benefit of the owners of the firm. The owners, or investors, put up the capital, initiated the firm’s incorporation, and are assumed to be motivated by the capitalistic desire to maximize their personal wealth through the maximization of the value of the firm as reflected in the stock price. As a consequence, owners hire agents to manage the firm in a manner that will attract new investors and create a demand for equity in the firm. Owners benefit as the demand for the stock goes up, as the price per share goes up, and the market value of their investment goes up.
2.2 Financial Analysis: Financial analysis of the firm is practiced by outside investors [outside of the firm], owners of the firm, and the management of the firm. The term "financial analysis" has different shades of meaning, but in general, the analysis regards the financial health and value of the firm from various perspectives. For example liquidity, leverage and operational efficiency are all measures of financial health, and measuring those properties may reveal financial strengths and/or weaknesses.
Financial analysis may also refer to the process of stock valuation whereby the analyst comes up with estimated price per share that the stock "should" be selling at. Benjamin Graham built a reputation on techniques to analyze the inherent value of firms. Other techniques refer to "fundamental" analysis, that regards fundamental factors such as market share, annual growth, technological advances, and ratio analysis to establish a "fair market value". "Technical Analysis", in contrast to fundamental analysis, regards quantitative and statistical patterns and trends in (primarily) the firm's stock price to forecast future stock prices.
2.3 Ratio Analysis: Ratio analysisis the classic approach to conducting corporate financial analysis. The technique has been used for over 100 years and many different ratios are commonly used. In the descriptions below, note that when “one value (A) is compared to another value (B)”, the calculation of the ratio is A divided by B. This calculation may also be framed as “A relative to B”. Some typical ratios include the following:
The Current Ratio shows the liquidity of the firm by comparing the current assets to the current liabilities. Note: the word ”current” in this context refers to the accounting definition. That is, current assets are assets that could reasonably be expected to be “convertible into cash within a year”. Current assets are usually explicitly designated as such on the balance sheet. Current liabilities refer to payments that are due within the year. A healthy firm would want a current ratio greater than 1.00, and a ratio of 2 or 3 would certainly add a margin of comfort.
The Quick Ratio, or “Acid Test”, is a more stringent measure of liquidity, in that it subtracts inventory from the current assets before doing the same comparison as with the Current Ratio (above). Inventory is not considered to be as liquid as other current assets.
Days Sales Outstanding (DSO) is a measure of the firm's ability to manage one portion of its assets - accounts receivable. Sometimes called "average collection period", it is a measure of how quickly receivables can be converted into cash. Fewer days is better than more days, and an average of a month and a half is normal for many industries. It is calculated by dividing sales into receivables to get the proportion of sales still outstanding and then multiplying the results by the number of days in a year.
Inventory Turns is another measure of the firm's asset management prowess. In this case, the skill in managing inventory is measured – having the right stuff on the shelf when needed, not having too much in stock, and moving stuff quickly. Inventory Turns represents the number of times the firm has "filled and emptied" its shelves in a year. More turns is better than fewer turns. There is a wide range of what is a normal number of turns, depending on the nature of the business. Some firms use average inventory in the calculation, others use end-of-year inventory. Some analysts divide inventory into sales, and others divide inventory into cost of goods sold. This course uses COGS/EoY inventory.
The Debt Ratio measures the proportion of debt (Total Liabilities) relative to the total capitalization (Total Assets) of the firm. Somewhat counter-intuitively, more debt is not necessarily a bad condition FOR A FIRM (debt is still something to be avoided for the individual). A firm that avoids borrowing, at the expense of foregoing profitable projects, may be losing opportunities that its competitors end up taking advantage of. Debt ratios will usually fall between 0 and 1.00. Over 1.00 is definitely a bad sign. But between 0 and .80, it's difficult to say whether a change is better or worse without further information.
Times Interest Earned (TIE) indicates a firm's ability to cover its interest payments due on its bonds with its profits from operations. Said another way, TIE is the number of times the firm could pay its interest obligations with its earnings before interest and taxes (EBIT). The calculation is EBIT relative to Interest. Less than 1.00 would be a bad sign for sure, and multiples like 2, 3 and higher are healthy signs.
Profit Margin, Earnings relative to Revenues,is the percentage of the top line (sales=revenues) that flows down to the bottom line (EAC=net profit=net income) after taking out all the expenses. A firm that keeps two cents for every dollar of sales is typical, although there are certainly more profitable firms, too.
Return on Assets (ROA) Pretty self-explanatory. ROA measures the firm's bottom line profits as percentage of the total assets of the firm. Sometimes called "basic earning power", it suggests that a firm should be able to earn a (relatively) fixed percentage of every dollar invested in the firm. A 12% ROA is not unusual.
Price Earnings (P/E) Ratio is unlike the ratios above in that it is not generated solely from the income statement and balance sheets – it also requires the price per share (pps) from current market data. This ratio regards the price investors are willing to pay for a dollars worth of earnings. The earnings are usually historical, trailing twelve months (ttm), although the P/E ratio often compares current pps to estimated (future) earnings. The P/E ratio is often abbreviated to PE ratio and is sometimes called the firm's "multiple". The reciprocal of the PE is called the "earnings yield", the percentage of net earnings generated each year for a given price per share, and is perhaps a more intuitive way of understanding the relationship between pps and earnings available to common stockholders (EAC). Remember, EAC belongs to the owners of the firm – the shareholders. As of the closing bell on 17 July 2009, the average PE for the DJIA was 13. As PE is a measure of "pricey-ness" of a stock, 13 is cheap, over 20 is getting pricey.
Market to Book is similar to the PE ratio in that it relies on current pps data. In this ratio, "market" refers to the value that investors have put on the firm, the "market capitalization" or MKT CAP (as seen on Yahoo). Market cap is the total current market value of all outstanding stock, or pps times number-of-shares. Pretend you wanted to buy IBM, as in, buying the whole company. How much would it cost? That's market cap. In mkt/book, "book" is how the accountants value the company and is found on the balance sheet as "shareholders equity". Mkt/book is another measure of pricey-ness, and typical ratios run 2.0 to 4.0.
2.4 Functions: As the primary objective of the firm is to maximize stockholders wealth as reflected in the stock price, then the primary function of financial management is also to address that objective. Management accomplishes this through convincing investors that the "quality of future earnings" is strong – that is, that future earnings are both "likely" (have a high probability of coming to pass) and robust (exhibiting healthy growth through time). If management is effectively convincing, then a demand for a share of ownership in the firm will apply the upward pressure on the price, and management will have succeeded in fulfilling their objective - for the time being. The functionof a financial manager is to support the primary objective through simultaneous actions in four major areas: 1) Capital Structure, 2) Capital budgeting, 3) Dividend Policy, and 4) Cash Flow Management.
2.5 Capital Structure: Financial managers are responsible for the "capitalization of the firm", or identifying and executing sources of funding. The two major sources are stocks (selling equity) and bonds (issuing debt), with a third, and not inconsequential, source being the internally generated capitalization from earnings. This area is also referred to as "the capital structure" decision, in which the financial manager tries to anticipate the optimum mix of debt and equity (proportion of bonds to stock) to achieve the primary objective of maximizing stock price. While there are many models addressing the capital structure decision, the study by Miller [see also: Varian] raises doubts as to those models' efficacy.
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is, then, the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and issues (borrows) $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The firm's ratio of debt to total financing, 80% in this example, is sometimes referred to as the firm's leverage. In reality, capital structure may be highly complex and include multiple sources.
The Modigliani-Miller theorem, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it assumes away many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. These other real world reasons include bankruptcy costs, agency costs, taxes,information asymmetry, to name some. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm.[Adapted from: Wikipedia "capital structure"]