Financial management (Financial Analysis)

Week 1

Ken Okamura
What to expect

8 weeks of lectures + 1 revision lecture

5 classes
Weeks 3,4,6,7,8
Discussion of solutions to problem sets
You must do the problem sets before class
Examination
Collections in 0th week Trinity Term
50% of Financial Management
Mainly quantitative in nature
Covers all material in course

FINANCE 2
Textbooks: Core readings
Brealey, Myers and Allen. Principles of
Corporate Finance. McGraw-Hill. 10th Ed.

Bodie, Kane and Marcus. Investments

and portfolio management. McGraw-Hill.
9th Ed.

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Other administrative details

Weblearn: All materials can be found here: lecture notes,

problem sets, solutions, and anything else

I can be contacted at
ken.okamura@sbs.ox.ac.uk

My office is W1.28, middle corridor above lecture

theatres. Office hours by appointment

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The topics we cover
Topic 1: Investment decisions and valuation

Week Topics Topics

1 Introduction to finance Fisher Model
2 Valuation techniques Common stocks
3 Fixed income
4 Capital structure
5 Market efficiency Risk and return
6 Portfolio theory
7 Capital asset pricing model
8 Forwards, options and futures

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The topics we cover
Topic 2: Financing decisions and capital structure

Week Topics Topics

1 Introduction to finance Fisher Model
2 Valuation techniques Common stocks
3 Fixed income
4 Capital structure
5 Market efficiency Risk and return
6 Portfolio theory
7 Capital asset pricing model
8 Forwards, options and futures

FINANCE 6
The topics we cover
Topic 3: Risk and return

Week Topics Topics

1 Introduction to finance Fisher Model
2 Valuation techniques Common stocks
3 Fixed income
4 Capital structure
5 Market efficiency Risk and return
6 Portfolio theory
7 Capital asset pricing model
8 Forwards, options and futures

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The topics we cover
Topic 4: Derivatives

Week Topics Topics

1 Introduction to finance Fisher Model
2 Valuation techniques Common stocks
3 Fixed income
4 Capital structure
5 Market efficiency Risk and return
6 Portfolio theory
7 Capital asset pricing model
8 Forwards, options and futures

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What is finance?

Should we invest?
How should we invest?
Who is doing the investing? (who is the “we” above)
How is the price determined? (how much should “we”
expect to receive for investing)

FINANCE 9
Financial markets

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Corporate finance

How do companies decide to invest in a project or not

Should the company buy land/factory/intellectual
property/another company
How should they fund this investment? Cash on hand,
borrowings, equity?
How should firm pay money to their investors? Capital
gains or dividends, interest etc.

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Asset pricing

How prices (and thus costs) are set for assets

How much does the company have to pay to invest in an
asset
Or, alternatively, how much do investors want to receive
to be compensated for investing in an asset

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Household finance

Household decisions on consumption vs. saving

What should the household invest in?
Bonds, bank deposits, equities, real estate
How does the household finance its purchases
Mortgages, loans, savings

FINANCE 13
Financial markets

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Accounting vs. finance

Accounting
Records, collates and reports information about a company’s
operations
Is backward looking and is generally conservative in nature
Financial accounts are based on accruals and not on cashflows,
which is the focus of finance
Accounting’s use for finance
Provides information for financial intermediaries, households
and managers themselves
Provides a basis for forecasting future cashflows
Finance
Is focused on forward-looking decisions under uncertainty

Finance begins where accounting ends…

FINANCE 15
What are financial markets?

These are where financial assets are traded

Examples:
London Stock Exchange where shares in companies are
traded
Forex markets where currencies are exchanged
Chicago Mercantile Exchange where commodity and
financial futures are traded

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Financial intermediaries

Everything from banks – who will take your deposits and

lend it out as loans to hedge funds, who will take your
money and invest it into all kinds of financial assets
Hedge funds invest in civil litigation cases, funding legal claims
Also, investment banks, fund managers, stock brokers,
insurance companies, commodity brokers, mutual funds,
pension funds, etc

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Types of financial markets / products

Foreign exchange
Equity
Derivatives
Fixed income
Commodities
Real estate
Banking

18
A typical investment banking structure

Source: Goldman Sachs

19
 What do financial markets do?

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Financial markets function I:
Resource allocation

Across time
Borrowing money: Funding expenditure now for repayment later
Saving money: Depositing in banks, investing in other assets
Across different states of the world
In boom times, equity(shares, stocks) receive higher payments
In bad times, debt holders (bonds, loans) are paid before equity
holders

FINANCE 21
Financial markets function II:
Information dissemination/Price discovery

What is the price of a loan (credit ratings, credit scores)

What is the required return from an investment in
pharmaceuticals (what does the market demand)?
How should we price that call option?
Which is the better technology?
Which company has the better manager?

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Finance theory

Financing and investing

Traditional view Modern view

Neoclassical Neoinstitutional
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Traditional view

Pre-1950s
Finance treated as an ancillary service to production
process
Finance is not treated as a factor that alters choices of
capital structure (debt vs. equity) or whether financing
can be raised (cost of capital)
Accounting measures exist, but all elements of modern
finance do not: Modern portfolio theory, Efficient Market
Hypothesis, Asset pricing theories

FINANCE 24
Modern finance theory

Focus on rational individuals who maximise their utility

No longer “firm” centric – since the firm is just a nexus of
contracts and the people we need to focus on are the
individuals who contract via said nexus of contracts
Individual investors
Individual managers/entrepreneurs
Focus on decisions:
Should a firm invest
How should investors invest given the need to control managers
Allows for different preferences
Time preferences (some people are in a hurry)

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Neoclassical

Key assumption There exists a perfect and complete

capital market
Perfection: all individuals have equal and costless access to the
same information (market transparency). There are no
transaction costs, search costs, or other frictions when securities
are bought or sold. (Including such things as taxes)
Market completeness: Any asset (including fractions of such
assets) is tradeable
Obviously this is a model world, but it’s useful because it
focuses on the criteria for investing in a project without
the imperfections that complicate matters
Bad at explaining the existence of financial
intermediaries and unrealistic assumptions

FINANCE 26
Neoinstitutional approach

Builds on the perfect world of the neoclassical approach

and eases various assumptions
Roles of informational asymmetry, which result in
principal-agent problems, which lead to moral hazard
and adverse selection
The role of costly information to explain financial
intermediaries, which leads to transactions costs
Markets no longer complete or perfect and thus capital
structure matters and uncertainty leads to some (viable)
projects being unfunded

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Differences

Neoclassical approach is about the basic tools of

valuation (this course)
Neoinstitutional approach is about the complexities that
make assessment of investments more difficult and
corporate governance important (focus of the FHS
finance option)

FINANCE 28
 Valuation and Fisher model

FINANCE 29
Valuation

Each asset is defined by its cashflow stream

Value of the asset is the sum of the cashflows
The value of a firm is the sum of its assets
There are two key characteristics of cashflows
Time (Time value of money)
Money today is (generally) preferable to money tomorrow
Effects of inflation and flexibility
Risk (Risk premium)
Money with certainty is (generally) preferable to money with
uncertainty
People are (generally) risk averse and prefer certainty

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How to represent cashflows

Cashflow table

+
- Time

Upward cashflows = positive

Downward cashflows = negative
Left to right = time

FINANCE 31
Pharma corp: Mutually exclusive projects

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What is opportunity cost of capital?

An individual can only invest her money in a single way

(money once spent cannot be spent a second time)
A firm can invest in many projects, but sometimes they
only have resources to invest in one project
An investor must consider the other returns she can
receive
Opportunity cost of capital = the expected return offered
by an alternative, equivalent (in time and risk)
investments in financial markets

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Pharma corp: Mutually exclusive projects

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What is the value of Project A?

We know the cashflows

Now we need the opportunity cost of capital
Here we assume that the project is risk free and the
interest rate for risk free over one year is 5%
The value in today’s money of the investment in project
A is £12 million is discounted back to today’s money.
Since a £1 today is worth £1.05 in a year, we divide £12
million by £1.05 to calculate value today 12/1.05 =
£11.43 million
To calculate the value of the project we must take into
account outlays in time period zero: CF0
FINANCE 35
Project A

+£11.43m
CF1
+
-

-£10m
CF0

Net present Value = Cashflow0 + Ccashflow1

NPV = -£10m + £11.43m = +£1.43m

FINANCE 36
Pharma corp: Mutually exclusive projects

FINANCE 37
Projects B & C

Projects B and C are riskier than project A

They require a higher interest rate, Project B is 6% p.a.
and project C is 15% p.a.
Project B has a single positive cashflow in year 2, thus
we need to discount by 1.06 x 1.06 = 1.1236, whereas
project C has a cashflow in year 1, so this must be
discounted by 1.15
Project B = -£10 + £15/1.1236 = -£10 + £13.35 = £3.35
Project C = -£10 + (£30 x 50% + £0 x 50%)/1.15 = -£10
+ £13.04 = £3.04

FINANCE 38
Observations about B and C

The present value of the projects is adjusted for risk

Projects with more risk discount their future cashflows
more
The present value is the expected value of the project
discounted by the opportunity cost of capital
Which is the best project?

FINANCE 39
Shareholder unanimity

Assume Pharma has three shareholders: Grandma,

mother, daughter
Grandma is old and highly risk averse and very impatient
Mother favours a safe investment that pays off later
Daughter is myopic and does not care about risk, caring only
about cashflows
Can they agree a single project?
They should agree to the highest NPV project (B)
In a market with complete and perfect markets, the investors
can then use financial markets to sell their interest in the firm
and match their own preferences: Over time and states of the
world.

FINANCE 40
Fisher model

One period model (t0 and t1)

Certainty about the future (t1)
Individuals maximise their utility based on their
consumption (allocation)
Investment projects are independent and are divisible

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Indifference curves

Consumption in period 0 and period 1 are traded off

The indifference curve shows the trade-off between c0 and c1
that the individual is indifferent between
The slope of the indifference curve, the marginal rate of
substitution (MRS) of c1 for c0 represents how many units of
c1 an individual is willing to trade off for units of c0 at a given
utility level

FINANCE 42
Indifference curves II

MRS is always negative (e.g. you need to sacrifice units of c1

to be able to consume c0). There is a budget restriction
between the two
MRS falls in absolute value as we move from left to right
(diminishing marginal returns)
Any individual will have an array of many indifference curves
(they cannot cross)
Moving up and to the right means an indifference curve
represents a higher utility level
FINANCE 43
Investors with different preferences

The more impatient an individual the steeper her

indifference curve
The orange indifference cruves are steeper than the red
ones and thus orange values today more than tomorrow
FINANCE 44
Investors with different preferences II

Starting from point B red investor prefers D and orange

investor prefers B, for red D dominates B, but it does not
for orange
Does this lead to potential conflicts?
What if they are coinvesting in a business?

FINANCE 45
Investors with different preferences III

FINANCE 46
Fisher model

FINANCE 47
Fisher model II

FINANCE 48
Fisher model: No capital market

Each investor wants to invest in projects that are

tangential between their indifference curve (the
highest/rightest) and the investment (transformation
curve)
He/She invests in all projects with a higher return than their time
preference rate (e.g. their willingness to trade consumption
today for consumption tomorrow.)
Since time preference rates vary amongst investors, they
will disagree about the projects to undertake
The decision on the “optimal” investment programme
cannot be separate from individual consumption
preferences
FINANCE 49
Now what does a capital market look like?
c1
The sloping line is the present value line of
E(1+r) all cashflows discounted or compounded.
The slope is – (1+r) where r is the interest
β rate E is the maximum consumption in
period 0.

c0
E
If alpha represent the level of income in years 0 and 1, a shift to beta
means investing in markets to delay consumption in year 0 to year 1, a
move to gamma means borrowing money and spending in year 0
FINANCE 50
Present value line

The present value line represents all cashflow and

consumption possibilities with an equal present value
The present value line represents the set of all
investment and financing possibilities of all investors in a
perfect capital market
You need perfection in the capital market to be able to borrow
and lend at the same interest rate r and to find a counterparty at
any point on the line
Wherever you start on the present value line, you can
move along it by borrowing or investing at interest rate r
You compound the interest if you invest and move to the left and
up
You discount if you borrow and move to the right and down

FINANCE 51
Lucy and Mark

FINANCE 52
How they invest with a capital market

FINANCE 53
Fisher separation theorem

“In the presence of a perfect and complete capital market,

investment decisions can be separated from consumption
preferences (decisions)”
Thus the optimal investment programme is the same for all
individuals, because you invest in projects with a higher return
than the market and then individuals adjust using the capital
markets
Shareholder unanimity is achieved since it can be agreed that
the investments that achieve a higher return than the market
(NPV>0) should be undertaken. Maximise shareholder value
Then once shareholder value is maximised can use capital
markets to meet investor consumption preferences

FINANCE 54
Fisher model

Yes, it is a toy model. The assumptions are unrealistic

It is like an idealisation like a perfect vacuum in physics
But, by simplifying it allows us to think about key issues
and empirical generalisations
Note that these generalisations are approximations to
the real phenomena
The validity is down to the individual empirical
generalisations
As an empiricist I find models of the world invaluable for the
insights into why and what we need to test

FINANCE 55
Summary

Assets are defined by their cashflow streams, whose

value is driven by timing and risk
Present value is the cashflow discounted back to today’s
value based on the opportunity cost of capital, which
adjusts for time and risk
A firm is the sum of the value of its assets
Perfect and complete capital markets allow for a
separation of consumption and investment decisions by
shareholders, and each individual can choose to take as
much risk or allocate her wealth over time as they wish
Shareholder value maximisation emerges as the sole
objective of the firm

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