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15.401FinanceTheoryI
LectureNotes
AlexStomper
MITSloanSchoolofManagement InstituteforAdvancedStudies,Vienna

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PartAIntroduction
Chapter 1: Introduction to Finance Chapter 2: Present Value

15.401

15.401FinanceTheoryI
AlexStomper
MITSloanSchoolofManagement InstituteforAdvancedStudies,Vienna

Lecture 1: Introduction and Course Overview

Agenda

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Lecture1:Introductiontofinance

_ Introduction:whatisfinance? _ Courseoverview _ Howtogetthemostoutofthiscourse

Readings: _ Brealey,MyersandAllen,Chapters12 _ Bodie,KaneandMarkus,Chapters1-3

Motivation

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Lecture1:Introandoverivew

Howtomakeabusinessdecision?

Project
$15m A 0 $10m B $5m $5m $5m 1 2 3

$5em $5em $5em

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Motivation

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Lecture1:Introandoverview

January1926toDecember2007 Statistics Mean Volatility Minimum Maximum TotalReturn* CRSPVWMarketReturn 0.95% 5.40% -29.01% 38.37% $2,583 UST-BillReturn 0.31% 0.25% -0.03% 1.52% $20

Note:*Basedona$1.00initialinvestmentinJanuary1926.

PerfectAssetAllocation RebalancingBase TotalReturn Annual $241,061 Quarterly $62,152,362 Monthly $37,634,440,695

Note:1.Ifbothstockandbondreturnsarenegative,investincash.
2.Prior1941,1monthT-billreturnsareusedtoconstructannualT-billreturns.

Motivation

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Lecture1:Introandoverview

1802-1997Realizedp.a.Returns Statistics 1YearHoldingPeriod: Maximump.a.Return Minimump.a.Return 10YearHoldingPeriod: Maximump.a.Return Minimump.a.Return 20YearHoldingPeriod: Maximump.a.Return Minimump.a.Return Source: Siegel (1998), Figure 2-1. USStocks 66.6% -38.6% 16.9% -4.1% 12.6% 1.0% UST-Bills 23.7% -15.6% 11.6% -5.1% 8.3% -3.0%

Whatisfinance?

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Lecture1:Introandoverview

_ Financeisaboutthebottomlineofbusinessactivities _ Abusinessactivityisaprocessofacquiringanddisposingassets
Real/financial Tangible/intangible

_ Allbusinessactivitiesreducetotwofunctions:
Growwealth(createvalue) Managewealthtobestmeeteconomicneeds

_ Financially,abusinessdecisionstartswiththevaluationofassets
Youcantcreateandmanagewhatyoucantmeasure

_ Valuationisthecentralissueoffinance _ Financialmarketsrevealsomeassetvalues

Whatisfinance?

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Lecture1:Introandoverview

Questionswewouldliketoanswerinthiscourse: 1. Howfinancialmarketsdetermineassetprices? 2. Howcorporationsmakefinancialdecisions?

Investments:Whatprojectstoinvestin? Financing:Howtofinanceaproject? Designing/selling financial securities/claims (debt, stock, ) Payout:Whattopaybacktoshareholders? Paying dividends, buyback shares, Riskmanagement:Whatrisktotakeortoavoidandhow?

3. Howhouseholdsmakefinancialdecisions?

Aframeworkoffinancialanalysis Corporatefinancialdecisions
(2)

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Lecture1:Introandoverview

(1)

Corporate Operations
(3)

Financial Manager

Individual and (4) Institutional Investors

(5)

(1) Cashraisedfrominvestorsbysellingfinancialassets (2) Cashinvestedinrealassets(tangibleandintangible) (3) Cashgeneratedbyoperations (4) Cashreinvested (5) Cashpaidout(mandatory:debtpayments,discretionary:dividends,etc.)
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TaskofFinancialManager

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Lecture1:Introandoverview

Afirmscashflows (1) Cashraisedfrominvestorsbysellingfinancialassets (2) Cashinvestedinrealassets(tangibleandintangible) (3) Cashgeneratedbyoperations (4) Cashreinvested (5) Cashreturnedtoinvestors(debtpayments,dividends,etc.) Managementdecisions---managecashflow(1),(2),(4),(5) _ Investment:(2)(3)(valuingrealassets) _ Financingandpayout:(1),(4),(5)(valuingfinancialassets) _ Riskmanagement:(1)and(5)(valuefinancialassets) Objective:Createmaximumvalueforshareholders. Soundbusinessdecisionsrelyonassetvaluation.
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ValuationofAssets

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Lecture1:Introandoverview

Eachassetisdefinedbyitscashflow(CF)
Invest CF0 CF3

Earn CF1 CF2

CF4 ...

Fundamentalvalueofanasset=Valueofitscashflow

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TimeandRisk

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Lecture1:Introandoverview

Twoimportantcharacteristicsofacashflow: 1.Time
$1,000 today next year today $1,000 next year

Whichonedoyouprefer?---Timevalueofmoney 2.Risk
$1,000 $1,000 $0 $2,000

Whichonedoyouprefer?---Riskpremium Timeandriskaretwokeyelementsinfinance
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OpportunityCostofCapital Valuationofaproject:theory

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Lecture1:Introandoverview

Afirmcanalwaysgivecashbacktoshareholders Theshareholderscan(re)investthecash. Ifthefirmretainsthecash,theshareholdersmissouton investmentopportunitiesinfinancialmarkets. Opportunitycostofcapital=theexpectedrateofreturnofferedby equivalent(intimeandrisk)investmentsinfinancialmarkets Marketvaluationofaproject(i.e.,itsCF):

Thehigherthecostofcapital,thelowerthevalueoftheproject. Thevalueofaprojectispositiveiftheprojectyieldsahigherexpected returnthanitscostofcapital.
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OpportunityCostofCapital

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Lecture1:Introandoverview

Valuationofaproject:practicalaspects _ Weneedtodefineequivalentassets(cashflows) _ Ifanassetsistradedonafinancialmarket,itspriceindicatesthe valueofequivalentcashflows(assets):valuationbymatching. _ Alternative:valuationbasedonanequilibriumrelationshipthat mapscashflowcharacteristicsintoprices.

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Shareholderunanimity

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Lecture1:Introandoverview

Afirmcaninvestinaprojectthatyieldsacashflowwithamarket valueof$100Mandrequiresaninvestmentof$60M.Thefirm hascashreservesof$62M.

Thefirmhastwoowners.OwnerAhashighshort-termconsumption needsthatownerB.Arethetwoownersunanimouslyinfavorof theinvestment?

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Shareholderunanimity

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Lecture1:Introandoverview

Conditionss.t.allshareholdersagreethatthefirmshouldmaximize themarketvalueofitsequity: Shareholdersconsumptiondependsonthefirmspoliciesonly throughtheirbudget. Shareholderscantimetheirconsumptionby borrowingandinvestinginfinancialmarkets. Shareholderscanusefinancialmarketstotradecontingent consumption(forallrelevantcontingencies). Perfectcompetitioninfinancialmarkets,andallshareholders havesimilaraccesstoallfinancialmarkets.

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FinancialMarkets

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Lecture1:Introandoverview

Households

Labor Markets

Financial Markets & Intermediaries

Product Markets

Nonfinancial Firms

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FinancialMarkets

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Lecture1:Introandoverview

_ Financialmarkets-wherefinancialassetsaretraded
Moneymarkets:Short-termdebtsecurities
Short-term government, bank and corporate debt (T-bills, CDs, CPs, )

Capitalmarkets:Long-termsecurities
Government and corporate bonds, asset-backed securities, Stocks,

Derivatives:Securitieswithpayoffstiedtootherprices
Forwards and futures, options,

_ FinancialIntermediaries-Ownmostlyfinancialassets
Banks, insurance companies, S&Ls, Mutual funds, hedge funds, private equity,

_ Nonfinancialfirms-Ownmostlyrealassets _ Households-Ownbothrealandfinancialassets.
LectureNotes 2008JiangWang 19

FunctionsofFinancialMarkets 1. Allocatingresources _ Acrosstime

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Lecture1:Introandoverview

Example.Borrowmoneytobuyahome _ Acrossdifferentstatesoftheeconomy

Example.Investinstocks/bonds 2. Communicatinginformation/pricediscovery _ Marketpricesreflectavailableinformation

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Courseoverview FourParts A. Introduction

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Lecture1:Introandoverview

Lecture1:Introductiontofinance Lecture2:Presentvalue(principlesofassetvaluation)

B. Valuation
Lecture3:Fixedincomesecurities Lecture4:Commonstocks Lecture5:Forwardsandfutures Lecture6:Options

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Courseoverview C.Risk

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Lecture1:Introandoverview

Lecture7:Riskandreturn(measuringrisk) Lecture8:Portfoliotheory(managingrisk) Lecture9:TheCapitalAssetPricingModel(incorporatingriskinto valuationmethods)

D.CorporateFinanceApplications
Lecture10:CapitalBudgeting(capitalinvestmentdecisions)

FinalLecture:MarketEfficiency(puttingitalltogether)
Dofinancialmarketsalwaysworkwellindiscoveringprices? Wheredoesmoneycomefrominfinancialmarkets? Howshouldfinancetheorybeusedinpractice?
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Courseoverview Courserequirements
_ _ _ _ _

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Lecture1:Introandoverview

Lecturesandreadings(attendanceandparticipation)

AcidRaincasestudywrite-up
Midtermexam Finalexam Problemsets(optional) Facultyshould Cometoclassontimeandbewellprepared Provideclearandtime-appropriateexpositionofmaterial Manageclassdiscussionseffectively Cometoclassontimeandbewellprepared Contributetoclassdiscussions Refrainfromnon-classactivities(email,newspapers,etc.)
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ImplicitContract
_

Studentsshould

Howtogetthemostoutof401 Theoryvs.Practice
_ _ _

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Introandoverview

Mostofthiscoursewillbedevotedtotheory Whataboutpractice? Theoriginsoftheoryiscommonelementsdeducedfrompractice!

Somehelpfulsuggestions
_ _ _ _ _ Doreadingsaheadoftime(skimtextbookchaptersinadvance) Takecopiousnotesduringlectures(lecturenotesarenotcomplete) Reviewthelecturesafterwardswithyourstudygroup Workonproblemsets---Financeisnotaspectatorsport Askquestions!!!

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Summary

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Lecture1:Introandoverview

Evaluatingabusinessboilsdowntovaluationassets Anassetisdefinedbyitscashflow(CF) TwoimportantcharacteristicsofaCF:timeandrisk Valueofassets(CFs)aredeterminedbyfinancialmarkets Costofcapital Therolesoffinancialmarkets

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