F O U N D A T I O N S O F F I N A N C E N O T E S S E T
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TOPIC 1: WHAT IS FINANCE?
E(R)
ASSETS> RRoR
CAPITALThe required rate of return (RRoR) is the required amount that must be earned, while the expected rate of return is what we forecast or expect to earn. Therefore, we require a return higher than the required baseline return.
What is capital in an organisation?
• Shareholders invest their money in an organisation with the promise money returned in the future: in the form of dividends of capital gains (stock price rising).
• Creditors whom money is borrowed from requires interest to be paid (interest is a small portion of money paid regularly at a particular rate for the use of money lent), and the loan to be paid off in maturity.
• Therefore, the money raised from creditors and shareholders are known financing through capital raising.
• The capital structure: how much of the capital is financed through equity, and how much of the capital is financed through debt?
Kd = COST OF DEBT (The interest for the debt of borrowed money) +
Ke= COST OF EQUITY (Individual shareholders require a return for their investment) ß
WACC = WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital (WACC or ro ) is the benchmark required rate of return (or hurdle rate) used by the firm to evaluate its investment opportunities [this will be further explored in topic 4: capital budgeting].
• It is the discount rate used to evaluate projects of a similar risk to the firm à the WACC cannot be used to evaluate projects that alter the business or financial risks of the firm.
• WACC might change through changes in capital structure or changes in cost of debt and/or cost of equity
Flow of Funds
Flow of funds is capital that is transferred from surplus (those who have excess capital) to deficit units (to those who need to borrow money) in an economy.
• It allows for efficient flow of funds, which is important for the efficient growth of the economy as it increases investment and consumption. If the flow of funds halt, then so does our economy.
• This in turn could result in for an example, more employment.
• Without the flow of funds, the deficit units will always stay as the deficit units and won’t be able to grow.
Efficient flow of funds means that:
1. Capital is not mispriced
Mispriced means when the price paid is not appropriate. This means that the price is over or under the fair value.
• BUY PRICE > FAIR VALUE = overpriced
• SELL SOMETHING < FAIR VALUE = underpriced
Fair value is when there is no misprice, not overpriced and no underpriced.
2. Surplus and deficit units have sufficient liquidity
Liquidity is defined as where deficit units can raise the capital that they need to invest, and the surplus units have enough to meet deficit unit’s needs.
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3. Credit risk transformation and diversification
The savers risk is limited to the intermediary, but the intermediary is exposed to the credit risk of the borrower.
• Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations.
4. Economies of scale
The larger the bank are, the cheaper the intermediation becomes.
Economies of scale are the cost advantages that the enterprises obtain due to their scale of operation therefore with cost per unit output decreasing with increasing scale.
What are the financial markets? – where financial instruments are created and traded.
Primary market The primary market is where securities are created, it is also a market in which securities are offered for the first time for sale to potential investors.
It is one method of raising capital through offering investors the opportunity to contribute equity, by joining the company ownership through the purchase of shares.
• As a company grows bigger, then the additional equity is sought to finance the purchase of fixed assets and projects that add value to the shareholder (long term funding).
• Publicly listed firms issue new shares and sell them to investors in the primary market typically via an initial public offering (IPO).
Secondary market Secondary market is where financial securities are traded after creation, where currently outstanding securities are traded.
• All transactions after the initial purchase in the primary market takes place in the secondary market (E.g., once they are listed on the ASX)
• These sales do not affect the total amount of financial assets that exists in the economy, there is simply an exchange of ownership.
Public market The public market place is a central market place open to the public where buyers and sellers of meet to trade.
• This is where both individual and institutional investors can purchase securities.
Private market Private market is where buyers and sellers transact without open advertisement and inclusion of the public.
• Usually is only open to a certain group or limited to certain bigger institutions. There is NO information presented to the market.
• Securities are offered and sold directly to a limited number of Investors.
• An investment banking firm may act as a finder by bringing together potential lenders and borrowers
Money market The money market is short term financial instruments, <12 months.
• They key feature distinguishing between the money and the capital market is that maturity of the securities traded in them.
• These are generally issued by borrower with high credit ratings.
Capital market
Capital Markets is all institutions and procedures that facilitate transactions in long term instruments.
• Generally, > 12 months, maturity periods that last longer than one year.
• They are all the financial institutions that help a business raise long term capital.
• Broadly, this encompasses term loans, financial leases and corporate stocks and bonds.
Wholesale market Wholesale market is a direct and private market where large fund flow transactions between government/institutional/corporate surplus and deficit units.
Retail Retail market is primarily an intermediary market where surplus and deficit units are individuals, households and small businesses involving small transactions.
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TOPIC 3: ANNUITY FINANCIAL MATH
Growth Annuity: An annuity payment that grows over time. E.g.,CF grows bygrowth rate of g Annuity due: or called annuity in advance, iswhere equal payments for a fix period are paid orreceived at the start of each period•The (1+i) represents discounting one period back Ordinary annuity: called annuity in arrears ordeferred annuity. A fixed amount of money is paid at fixed intervals of time which cash flows occur atthe end of each period.
Perpetuity: An annuity where the cashflows continue for an indefinite period of time.
Growth perpetuity: Where the cash flows increase each period at a constant rateindefinitely. Growth annuity: An annuity payment which grows over time.
