Fundamentals of Finance Notes MAF101
Topic One Three key financial decisions faced by financial managers •
Investment decision
To identify ‘profitable’ investments which maximise the wealth of the shareholders – The objective is to generate a risk adjusted return
•
!Financing decision
– The mix of funding obtained from capital markets which is the least cost and maximises shareholder wealth – The proportional holdings of $equity and $debt
•
Dividend decision – Relates to the form in which returns are passed back to (equity) shareholders. – Should companies pay high or low dividends? -What will be the impact on future growth ofh? What will be the impact on future growth of each? What will be the u8ltimate impact on shareprice (ie maximise shareholder wealth
!Real Assets !Financial Assets!
- Assets that can be put to productive use to generate a return (cash flows) e.g machinery and equipment Assets that represent a claim to a series of cash flows against an economic unit e.g shares, corporate shares Shares - A claim against a company - cash flows = dividends and sale price
!
Bonds -
!
A claim against the bond issues! Cash flows = interest and principal!
Bank Accounts! A claim against a bank! Cash flows = interest and principal!
!
Capital markets are the medium for the issue and exchange of financial assets. Capital markets can be seen as a means for exchanging current and future consumption to increased future consumption
! ! !
Owner wealth is measured by market capitalisation of securities! Taxation = assessable income less allowable deductions ! Assessable Income! Wages, salaries, dividends, fees, commissions Business income, dividend, interest, rentals Royalties and capital gains!
!
Allowable deductions! Expenses relating to your employment! Expenses related to your investments! Expense incurred when running a business!
!
Types of taxpayers:! Company! Individual! Fiduciary/ Partnership!
!
Tax Rates: Individual!
!
! ! ! ! !
Tax rates: Company! 30% flat rate! Topic 2 – Financial Maths All in financial equations sheet! Topic 3 – Risk and return Effect of risk on rates of return:! Risk! – the potential variability in future cash flows or returns can be measured by the standard deviation of the expected return! Default risk! – the possibility the borrow will not repay the debt in the future! Risk premium! – the additional return above the risk free rate expected for assuming risk! – Return% = Risk free return% + Total Risk Premium%! ! Return% = Rf% + Units of Risk * Risk Premium %! Return% = Rf% + Units of Risk * (Rm – Rf) %!
! !
Effect of inflation on rate of return! Real versus Nominal Return! • Real return is the return after taking out the effects of inflation.! • Nominal return is the return before taking out the effects of inflation.! • Thus, the nominal rate includes both the real rate and the effects of inflation!
! !
Fisher Effect
1 + i = (1 + R) (1 + inf)! i = R + inf + inf*R
where I = nominal rate of interest! R = real rate of interest! Inf= rate of inflation!
!
Example 1! What is the nominal rate of return if the real rate of return is 5.9% per annum and inflation is 3.2% per annum?!
!Answer:! ! !
! !
!
1 + i = (1 + R) (1 + inf)! 1 + i = (1 + 0.059) (1 + 0.032)! 1 + i = (1 + 0.0929)!
! Risk of a Single Asset !
1. Sensitivity analysis! • Estimation of worst case scenario and best case scenario! • Asset risk: range between BEST and WORST! • Larger range, larger risk! 2. Probability analysis! • Use historical data to find out the probability of making a positive return, for example.! • Using past performance as a “guide” for what we think the asset will do in the future!
! Calculation of risk use a historical time series! !
The standard deviation based on a historical time series of return is calculated as follows:! ! n (rt − r )2 ∑ σ k = t =1 n −1 Where:! r t! =! the observed return during interval t! ! !r =! the mean (expected) return on the security! ! n! =! the number of observations!
! ! !
! Example 1! ! Step 1 ! ! ∑r ∑r ! = r!= != (15n.9 + 275.6 + 21.1 + 25 + 18) 5 != 21.5% ! Step 2! ! ! !σ = ∑ (r − r ) = ∑ (r − 21.5) ! n −1 5 −1 ! ! (15.9 − 21.5) + (27.6 − 21.5) + (21.1 − 21.5) + (25.0 − 21.5) + 18.0 − 21.5) != ! 4 ! = 4.8% ! n
5
t
t
t =1
t =1
n
5
2
t
k
2
t
t =1
t =1
2
2
2
2
2
What do these numbers imply?! • 68% of possible outcomes lie within plus or minus one standard deviation of the mean!
Investment decision
To identify ‘profitable’ investments which maximise the wealth of the shareholders – The objective is to generate a risk adjusted return
•
!Financing decision
– The mix of funding obtained from capital markets which is the least cost and maximises shareholder wealth – The proportional holdings of $equity and $debt
•
Dividend decision – Relates to the form in which returns are passed back to (equity) shareholders. – Should companies pay high or low dividends? -What will be the impact on future growth ofh? What will be the impact on future growth of each? What will be the u8ltimate impact on shareprice (ie maximise shareholder wealth
!Real Assets !Financial Assets!
- Assets that can be put to productive use to generate a return (cash flows) e.g machinery and equipment Assets that represent a claim to a series of cash flows against an economic unit e.g shares, corporate shares Shares - A claim against a company - cash flows = dividends and sale price
!
Bonds -
!
A claim against the bond issues! Cash flows = interest and principal!
Bank Accounts! A claim against a bank! Cash flows = interest and principal!
!
Capital markets are the medium for the issue and exchange of financial assets. Capital markets can be seen as a means for exchanging current and future consumption to increased future consumption
! ! !
Owner wealth is measured by market capitalisation of securities! Taxation = assessable income less allowable deductions ! Assessable Income! Wages, salaries, dividends, fees, commissions Business income, dividend, interest, rentals Royalties and capital gains!
!
Allowable deductions! Expenses relating to your employment! Expenses related to your investments! Expense incurred when running a business!
!
Types of taxpayers:! Company! Individual! Fiduciary/ Partnership!
!
Tax Rates: Individual!
!
! ! ! ! !
Tax rates: Company! 30% flat rate! Topic 2 – Financial Maths All in financial equations sheet! Topic 3 – Risk and return Effect of risk on rates of return:! Risk! – the potential variability in future cash flows or returns can be measured by the standard deviation of the expected return! Default risk! – the possibility the borrow will not repay the debt in the future! Risk premium! – the additional return above the risk free rate expected for assuming risk! – Return% = Risk free return% + Total Risk Premium%! ! Return% = Rf% + Units of Risk * Risk Premium %! Return% = Rf% + Units of Risk * (Rm – Rf) %!
! !
Effect of inflation on rate of return! Real versus Nominal Return! • Real return is the return after taking out the effects of inflation.! • Nominal return is the return before taking out the effects of inflation.! • Thus, the nominal rate includes both the real rate and the effects of inflation!
! !
Fisher Effect
1 + i = (1 + R) (1 + inf)! i = R + inf + inf*R
where I = nominal rate of interest! R = real rate of interest! Inf= rate of inflation!
!
Example 1! What is the nominal rate of return if the real rate of return is 5.9% per annum and inflation is 3.2% per annum?!
!Answer:! ! !
! !
!
1 + i = (1 + R) (1 + inf)! 1 + i = (1 + 0.059) (1 + 0.032)! 1 + i = (1 + 0.0929)!
! Risk of a Single Asset !
1. Sensitivity analysis! • Estimation of worst case scenario and best case scenario! • Asset risk: range between BEST and WORST! • Larger range, larger risk! 2. Probability analysis! • Use historical data to find out the probability of making a positive return, for example.! • Using past performance as a “guide” for what we think the asset will do in the future!
! Calculation of risk use a historical time series! !
The standard deviation based on a historical time series of return is calculated as follows:! ! n (rt − r )2 ∑ σ k = t =1 n −1 Where:! r t! =! the observed return during interval t! ! !r =! the mean (expected) return on the security! ! n! =! the number of observations!
! ! !
! Example 1! ! Step 1 ! ! ∑r ∑r ! = r!= != (15n.9 + 275.6 + 21.1 + 25 + 18) 5 != 21.5% ! Step 2! ! ! !σ = ∑ (r − r ) = ∑ (r − 21.5) ! n −1 5 −1 ! ! (15.9 − 21.5) + (27.6 − 21.5) + (21.1 − 21.5) + (25.0 − 21.5) + 18.0 − 21.5) != ! 4 ! = 4.8% ! n
5
t
t
t =1
t =1
n
5
2
t
k
2
t
t =1
t =1
2
2
2
2
2
What do these numbers imply?! • 68% of possible outcomes lie within plus or minus one standard deviation of the mean!
