Fundamentals+of+Finance+Exam+ Revision+
Fundamentals+of+Finance+Exam+ Revision+ Chapter+One:+Financial+Management+ The+Cycle+of+Money+ Cycle&of&Money+&the&movement&of&money&from&borrowers&to&lenders.& Most%lenders%invest%their%money%in%a%financial%institution%eg.%Bank.% A%bank%is%a%financial%intermediary.%It%is%the%middle%man%between%borrowers%and%lenders.% Banks%make%money%by%charging%a%higher%interest%rate%to%borrowers%than%lenders.%
Overview+of+Finance+Areas+ There%are%four%main%areas%in%finance:% • •
• •
Corporate&finance>%financial%activities%that%supports%the%operations%of%a%corporation%or%business.% Focuses%on%any%borrowing%or%lending%of%money%in%the%corporation.% Investments>%buying%and%selling%of%assets.%Focused%on%accurate%pricing%of%assets%and%the%rules% and%regulations%that%govern%the%players.% o Real%assets>%physical%assets%such%as%property%and%buildings%or%commodities%such%as%gold,% oil%etc.% o Financial%Assets>%Intangible%assets%such%as%stocks%and%bonds.% Financial&institutions&and&markets>%Organised%financial%intermediaries%that%promote%the%cycle%of% money.%The%institutions%take%the%form%of%banks,%insurance%companies%and%foreign%exchanges.% International&Finance>%Multinational%element%to%other%finance%activities.%More%than%one%country% involved.%Different%currencies.%
Areas%are%not%mutually%exclusive.%All%connected%to%create%a%well%organised%cycle%of%money.%
Financial+Markets+ Forums%in%which%buyers%and%sellers%of%financial%assets%or%commodities%meet.%Financial%markets%can%be% classified%by:% •
•
•
•
Type%of%asset%traded% o Equity&Markets>%where%stocks%are%bought%and%sold.% o Debt&Markets+&where%bonds%are%bought%and%sold.% o Derivative&markets+&where%future%contracts%on%commodities%are%bought%and%sold.% o Foreign&Exchange&Markets+%where%currencies%are%bought%and%sold.% Maturity%of%the%assets% o Money&markets>%selling%financial%assets%that%mature%within%a%year.% o Capital&markets>%selling%financial%assets%that%mature%over%a%year.% Owner%of%the%assets% o Primary&Market+&sale%of%stock%and%the%proceeds%of%the%sale%go%to%the%company& o Secondary&Market+&reselling%the%asset%to%another%party& Method%of%sale.%
o o
Dealer&Market+&an%individual%or%firm%buying%and%selling%securities%out%of%his%own% inventory.% Auction&Market+&many%securities%are%sold%at%the%same%price.%
The+Finance+Manager+and+Financial+Management+ Chief%Financial%Officer%(CFO)%oversees%all%financial%activity.% Financial%management%can%be%broken%up%into%three%categories:% • • •
Capital&Budgeting+&the%process%of%planning,%evaluating,%comparing%and%selecting%the%long>term% operating%projects%of%the%company.% Capital&Structure+&how%the%company%is%financed;%for%public%companies,%usually%a%mix%of%bonds% and%equity%sold%to%investors%and%owners.% Working&Capital&Requirements+&the%process%of%managing%the%day>to>day%needs%of%the%company% through%current%assets%and%liabilities.%
Objective+of+the+Finance+Manager+ The%finance%manager’s%main%job%is%to%have:% •
Profit&Maximisation+&Managers%must%maximise%the%current%stock%price%of%the%firm.%Managers% must%satisfy%owners%as%the%owners%wealth%is%the%equity%of%the%company.%For%a%publically%traded% company%it%is%the%stock%value.%% o Maximising&Current&Stock&Price+&In%order%to%increase%future%cash%flow%there%are%many% factors%to%consider.%Some%of%these%are:% ! Maintaining%a%safe%and%enjoyable%workplace.% ! Satisfy%customer%needs%by%working%closely%with%them.% ! Good%working%relationships%with%suppliers.% ! A%positive%effect%on%the%environment%and%community.%
Internal+and+External+Players+ • •
Internal%players>%managers%inside%the%company% External%players>%customers%and%suppliers.%People%who%contribute%to%the%success%of%the%company.%
Legal+forms+of+a+business+ The%legal%forms%of%a%business%are:% • • • • •
Sole&Proprietorship>%one%owner.% Partnership>%general,%limited%and%silent%partners.% Corporations>%limited%liability.% Hybrid&Corporations>%hybrid%of%partnerships%and%corporations.%A%popular%one%is%professional% corporation%(PC).%Another%Hybrid%Corporation%is%S%corporation.% Non>For+Profit&Organisations+&foundations,%charities%and%trusts.%
Agency+Model+ • • • • • •
Principals+%owners%of%a%business.% Agents>%Managers.% Principal&Agency&Problem>%due%to%the%problem%of%motivating%one%party%to%act%in%the%best%interest% of%another%party.% Agency&Theory+&the%processes%surrounding%recognition%of%the%principal>agent%problems.% Stock&Option+&the%right%to%buy%the%company%stock%at%a%preset%price%sometime%in%the%future.% Agency&Cost+&A%cost%paid%to%an%agent%acting%on%behalf%of%a%principal%for%a%service%not%rendered.%
Chapter+3:+The+Time+Value+of+Money+ Definitions+ Future&value>%value%of%money%at%a%specific%point%in%time.% • •
FV=%PV%x%(1%+%r)%n%% Future%values%grow%faster%due%to%compounding%of%interest.%
Present&value+&value%today%of%tomorrows%cash%flow.%% • • •
PV=%%%FV%%%% %%%%%%%(1+r)n% Discounting%the%future%value%back%to%present.%
Waiting&time&to&maturity+&n%is%unknown.%Logarithms%involved.% • •
n=%ln%(FV/PV)% %%%%%%%%ln(1+r)%
Finding&interest&rate+&r%is%unknown.%If%given%no%numbers%use%FV=2%and%PV=1.% • •
r=%%(FV)%1/n% %%%%%%(PV)%%%%%%%%>1%
Rule&of&72+&How%long%it%takes%to%double%money%at%a%specific%interest%rate.% •
n=%72/r%
% *some%questions%may%combine%FV%and%PV.% %
Notation+ FV=%future%value% FVIF=%future%value%interest%factor% n=%number%of%time%periods% r=%interest%rate,%growth,%discount% PV=%present%value% PVIF=%present%value%interest%factor% TVM=%time%value%of%money% %
%
Chapter+6O+Bonds+and+Bond+Valuation+ Chapter+6.1+Application+of+the+Time+Value+of+Money+Tool:+Bond+Pricing+ When%companies%or%governments%need%to%borrow%money,%they%often%sell%bonds.%A%bond&is%a%long>term% debt%instrument%by%which%a%borrower%of%funds%agrees%to%pay%back%the%principal%with%interest%on%specific% dates%in%the%future.%Bonds%are%a%promised%future%cash%flow.%Bonds%are%fixed%income%securities%because% they%pay%a%set%amount.%The%future%cash%flow%is%fixed%at%the%time%of%initial%sale%of%the%bond.%
Key+components+of+a+Bond+
1 1 −! 1 (1 + !"#)! !"#$!!"#$% = !"#!!"#$%!!! + !"#$"%!!! % (1 + !"#)! !"#
• • • • •
Par&Value+&The%face%or%par%value%of%the%bond.%Stated%as%the%principal%value%of%the%bond.% Coupon&Rate+%The%interest%rate%for%the%coupons,%expressed%in%annual%terms%and%stated%on%the% bond.%It%is%the%interest%rate.% Coupon+%The%regular%interest%payment%of%the%bond.%It%is%determined%by%par%value%x%coupon%rate.% Payments%are%at%regular%intervals%known%as%annuities.% Maturity&date+%The%expiration%date%of%the%bond.%It%is%the%date%on%which%the%final%interest%is%made% as%well%as%the%par%value%being%returned.% Yield&to&Maturity&(YTM)&+%The%discount%rate%of%the%bond%or%the%return%the%bondholder%receives%on% the%bond%if%it%is%held%to%maturity.%Interest%rate%that%summarizes%the%whole%investment%value.%
Most%bonds%trade%in%a%dealership%market.%Some%examples%what%bonds%look%like%are:% • • • • • • •
Issuer+&The%company%or%country%issuing%the%bond.% Price+%The%price%as%a%percent%of%par%value.%It%is%the%price%someone%is%willing%to%pay%for%the%bond%in% today’s%market.%%%of%1000%for%corporate%banks.% Coupon&Rate+%the%annual%percentage%rate%of%each%bond.% Maturity&Rate+%the%date%when%the%principal%and%final%interest%is%paid%back.% Yield&to&Maturity+&The%final%investment%rate%you’ll%return%on%your%investment.% Current&Yield+%the%annual%coupon%payment%divided%by%the%current%price.% Rating+%A%grade%indicating%credit%quality.%From%AAA%to%CCC.%
Pricing+a+bond+in+steps+ 1. Lay%out%the%timing%and%amount%of%future%cash%flow%promised.% a. Annual%Interest%payment%=%par%value%x%coupon%rate.% b. Payment%of%the%par%value%in%the%last%year.% 2. Determine%the%appropriate%discount%rate%for%the%cash%flow.% a. It%is%the%yield%to%maturity.% 3. Find%the%PV%of%the%lump>sum%principal%and%the%annuity%stream%of%coupons.% a.
Present%value%of%coupon%stream%=%!"#!!!
!!
! (!!!)!
!
i. r=%Yield%to%Maturity.% ii. n=%No%of%years%in%the%coupon.% iii. PMT=%coupon% b. Present%value%of%this%par%value%=%!"!!!
! (!!!)!
%
%
i. FV=%Par%Value% ii. r=%YTM% 4. Add%the%present%value%of%the%lump>sum%principal%and%the%present%value%of%the%coupons.%
Overview+of+Finance+Areas+ There%are%four%main%areas%in%finance:% • •
• •
Corporate&finance>%financial%activities%that%supports%the%operations%of%a%corporation%or%business.% Focuses%on%any%borrowing%or%lending%of%money%in%the%corporation.% Investments>%buying%and%selling%of%assets.%Focused%on%accurate%pricing%of%assets%and%the%rules% and%regulations%that%govern%the%players.% o Real%assets>%physical%assets%such%as%property%and%buildings%or%commodities%such%as%gold,% oil%etc.% o Financial%Assets>%Intangible%assets%such%as%stocks%and%bonds.% Financial&institutions&and&markets>%Organised%financial%intermediaries%that%promote%the%cycle%of% money.%The%institutions%take%the%form%of%banks,%insurance%companies%and%foreign%exchanges.% International&Finance>%Multinational%element%to%other%finance%activities.%More%than%one%country% involved.%Different%currencies.%
Areas%are%not%mutually%exclusive.%All%connected%to%create%a%well%organised%cycle%of%money.%
Financial+Markets+ Forums%in%which%buyers%and%sellers%of%financial%assets%or%commodities%meet.%Financial%markets%can%be% classified%by:% •
•
•
•
Type%of%asset%traded% o Equity&Markets>%where%stocks%are%bought%and%sold.% o Debt&Markets+&where%bonds%are%bought%and%sold.% o Derivative&markets+&where%future%contracts%on%commodities%are%bought%and%sold.% o Foreign&Exchange&Markets+%where%currencies%are%bought%and%sold.% Maturity%of%the%assets% o Money&markets>%selling%financial%assets%that%mature%within%a%year.% o Capital&markets>%selling%financial%assets%that%mature%over%a%year.% Owner%of%the%assets% o Primary&Market+&sale%of%stock%and%the%proceeds%of%the%sale%go%to%the%company& o Secondary&Market+&reselling%the%asset%to%another%party& Method%of%sale.%
o o
Dealer&Market+&an%individual%or%firm%buying%and%selling%securities%out%of%his%own% inventory.% Auction&Market+&many%securities%are%sold%at%the%same%price.%
The+Finance+Manager+and+Financial+Management+ Chief%Financial%Officer%(CFO)%oversees%all%financial%activity.% Financial%management%can%be%broken%up%into%three%categories:% • • •
Capital&Budgeting+&the%process%of%planning,%evaluating,%comparing%and%selecting%the%long>term% operating%projects%of%the%company.% Capital&Structure+&how%the%company%is%financed;%for%public%companies,%usually%a%mix%of%bonds% and%equity%sold%to%investors%and%owners.% Working&Capital&Requirements+&the%process%of%managing%the%day>to>day%needs%of%the%company% through%current%assets%and%liabilities.%
Objective+of+the+Finance+Manager+ The%finance%manager’s%main%job%is%to%have:% •
Profit&Maximisation+&Managers%must%maximise%the%current%stock%price%of%the%firm.%Managers% must%satisfy%owners%as%the%owners%wealth%is%the%equity%of%the%company.%For%a%publically%traded% company%it%is%the%stock%value.%% o Maximising&Current&Stock&Price+&In%order%to%increase%future%cash%flow%there%are%many% factors%to%consider.%Some%of%these%are:% ! Maintaining%a%safe%and%enjoyable%workplace.% ! Satisfy%customer%needs%by%working%closely%with%them.% ! Good%working%relationships%with%suppliers.% ! A%positive%effect%on%the%environment%and%community.%
Internal+and+External+Players+ • •
Internal%players>%managers%inside%the%company% External%players>%customers%and%suppliers.%People%who%contribute%to%the%success%of%the%company.%
Legal+forms+of+a+business+ The%legal%forms%of%a%business%are:% • • • • •
Sole&Proprietorship>%one%owner.% Partnership>%general,%limited%and%silent%partners.% Corporations>%limited%liability.% Hybrid&Corporations>%hybrid%of%partnerships%and%corporations.%A%popular%one%is%professional% corporation%(PC).%Another%Hybrid%Corporation%is%S%corporation.% Non>For+Profit&Organisations+&foundations,%charities%and%trusts.%
Agency+Model+ • • • • • •
Principals+%owners%of%a%business.% Agents>%Managers.% Principal&Agency&Problem>%due%to%the%problem%of%motivating%one%party%to%act%in%the%best%interest% of%another%party.% Agency&Theory+&the%processes%surrounding%recognition%of%the%principal>agent%problems.% Stock&Option+&the%right%to%buy%the%company%stock%at%a%preset%price%sometime%in%the%future.% Agency&Cost+&A%cost%paid%to%an%agent%acting%on%behalf%of%a%principal%for%a%service%not%rendered.%
Chapter+3:+The+Time+Value+of+Money+ Definitions+ Future&value>%value%of%money%at%a%specific%point%in%time.% • •
FV=%PV%x%(1%+%r)%n%% Future%values%grow%faster%due%to%compounding%of%interest.%
Present&value+&value%today%of%tomorrows%cash%flow.%% • • •
PV=%%%FV%%%% %%%%%%%(1+r)n% Discounting%the%future%value%back%to%present.%
Waiting&time&to&maturity+&n%is%unknown.%Logarithms%involved.% • •
n=%ln%(FV/PV)% %%%%%%%%ln(1+r)%
Finding&interest&rate+&r%is%unknown.%If%given%no%numbers%use%FV=2%and%PV=1.% • •
r=%%(FV)%1/n% %%%%%%(PV)%%%%%%%%>1%
Rule&of&72+&How%long%it%takes%to%double%money%at%a%specific%interest%rate.% •
n=%72/r%
% *some%questions%may%combine%FV%and%PV.% %
Notation+ FV=%future%value% FVIF=%future%value%interest%factor% n=%number%of%time%periods% r=%interest%rate,%growth,%discount% PV=%present%value% PVIF=%present%value%interest%factor% TVM=%time%value%of%money% %
%
Chapter+6O+Bonds+and+Bond+Valuation+ Chapter+6.1+Application+of+the+Time+Value+of+Money+Tool:+Bond+Pricing+ When%companies%or%governments%need%to%borrow%money,%they%often%sell%bonds.%A%bond&is%a%long>term% debt%instrument%by%which%a%borrower%of%funds%agrees%to%pay%back%the%principal%with%interest%on%specific% dates%in%the%future.%Bonds%are%a%promised%future%cash%flow.%Bonds%are%fixed%income%securities%because% they%pay%a%set%amount.%The%future%cash%flow%is%fixed%at%the%time%of%initial%sale%of%the%bond.%
Key+components+of+a+Bond+
1 1 −! 1 (1 + !"#)! !"#$!!"#$% = !"#!!"#$%!!! + !"#$"%!!! % (1 + !"#)! !"#
• • • • •
Par&Value+&The%face%or%par%value%of%the%bond.%Stated%as%the%principal%value%of%the%bond.% Coupon&Rate+%The%interest%rate%for%the%coupons,%expressed%in%annual%terms%and%stated%on%the% bond.%It%is%the%interest%rate.% Coupon+%The%regular%interest%payment%of%the%bond.%It%is%determined%by%par%value%x%coupon%rate.% Payments%are%at%regular%intervals%known%as%annuities.% Maturity&date+%The%expiration%date%of%the%bond.%It%is%the%date%on%which%the%final%interest%is%made% as%well%as%the%par%value%being%returned.% Yield&to&Maturity&(YTM)&+%The%discount%rate%of%the%bond%or%the%return%the%bondholder%receives%on% the%bond%if%it%is%held%to%maturity.%Interest%rate%that%summarizes%the%whole%investment%value.%
Most%bonds%trade%in%a%dealership%market.%Some%examples%what%bonds%look%like%are:% • • • • • • •
Issuer+&The%company%or%country%issuing%the%bond.% Price+%The%price%as%a%percent%of%par%value.%It%is%the%price%someone%is%willing%to%pay%for%the%bond%in% today’s%market.%%%of%1000%for%corporate%banks.% Coupon&Rate+%the%annual%percentage%rate%of%each%bond.% Maturity&Rate+%the%date%when%the%principal%and%final%interest%is%paid%back.% Yield&to&Maturity+&The%final%investment%rate%you’ll%return%on%your%investment.% Current&Yield+%the%annual%coupon%payment%divided%by%the%current%price.% Rating+%A%grade%indicating%credit%quality.%From%AAA%to%CCC.%
Pricing+a+bond+in+steps+ 1. Lay%out%the%timing%and%amount%of%future%cash%flow%promised.% a. Annual%Interest%payment%=%par%value%x%coupon%rate.% b. Payment%of%the%par%value%in%the%last%year.% 2. Determine%the%appropriate%discount%rate%for%the%cash%flow.% a. It%is%the%yield%to%maturity.% 3. Find%the%PV%of%the%lump>sum%principal%and%the%annuity%stream%of%coupons.% a.
Present%value%of%coupon%stream%=%!"#!!!
!!
! (!!!)!
!
i. r=%Yield%to%Maturity.% ii. n=%No%of%years%in%the%coupon.% iii. PMT=%coupon% b. Present%value%of%this%par%value%=%!"!!!
! (!!!)!
%
%
i. FV=%Par%Value% ii. r=%YTM% 4. Add%the%present%value%of%the%lump>sum%principal%and%the%present%value%of%the%coupons.%
