Intro to Finance

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Introduction: Why Finance?- The study of value â€“ what human after, money is just the tool- Value creation â€“ time and uncertainty; Time â€“ implication in assessing value- Everything can be valued through this framework- Itâ€™s a way of thinking and a set of tools that reflect this way of thinking (Way of thinking + Tools = Art + Science)- Most applicable decision-making system -> transparent and value base decision makingSyllabus1. Time Value of Money: Understanding how to value benefits/costs occurring over time (No uncertainty)2. Decision criteria: Understanding how to make value-enhancing decisions3. Bonds and Stocks: the 2 key ways of financing any idea4. Uncertainty and risk: the role and measurement of risk in assessing valueEconomics the mother-discipline of finance. Mathematics and statistics â€“ calculate risk and uncertainty Accounting â€“ language Â of business, limited Economics: a collection of assumptions about human behavior and Â in the hope that human behavior matches what the predictions or the assumptions are. ASSUMPTIONS:Competitive market: similar to democracy, â€śinequality of incomeâ€ť â€ślack of ability to participateâ€ť â€śconcentration of power in few businessesâ€ť can take away competitive markets. When one value something, one needs to know how similar things are valued. Frictions small relative to power of most good ideas; market is strong enough for value proposition larger than fictions. More competition -> less frictionCapital can flow relatively easily -> great ideas get adopted quicklyTime Value of Money (TVM)The Essence of Decision MakingVirtually every decision involves time and uncertaintyVery important to understand the impact of just the passage of time on a decisionWe will first assume no uncertainty to internalize the time value of moneyPV = Present Value ($)FV = Future Value ($)Both are measured in dollar, a measurement of valueN = # of Periods (#) # = day/month/year etc passage of time makes decision making difficultR= interest rate (%) > 0 (assumption): change over time (Theory of Interest by Irving Fisher 1930)Simple Future Value (FM)Time Lines: all issues/problems can be put on a time line. [pic 1]The Main Insight: A dollar today is worth more than a dollar tomorrow. Money cannot be compared across time -> unless time has no valueEvery value creating decision that one makes should force self to look into the future. Future Value (FV)Â = Initial Payment Â (P)+ Accumulated Interest (P*r)FV = P + r*P = (1+r)*P; 1+r = Future Value Factor; r*P = Accumulated Interest

FV = P*(1+r)^n after n period of timeMost answers to finance question is COMPOUNDINGSuppose you invest $500 in bank at interest rate of 7%, how much will you have after 10 years?FV = 500*(1+0.07)^10 = 983.58ECCEL=FV(rate, nper, pmt, [pv], [type]) â€“ rate = interest rate; nper = period; pmt = payment; pv = present value=FV(.07,10,0)Compounding interactions of the interest rate and timeWhat are the FV of investing $100 at 10% vs 5% for 100 years? (Risk usually largely affects interest rate): Bond ~ 5%; Shares ~ 10%FV(0.05,100,0,100) = -$13,150.13; FV(0.1,100,0,100)= -$1,378,061.23If there is no compounding: 100 years of 5% interest on principle will = $500 onlyFV(0.06,2012-1626,0,24) = -$140,693,888,847.341.9 Simple Present ValueWhat is the present value of receiving $110 one year from if the interest rate is 10%?To work out the present value to achieve the future value[pic 2]Suppose you will inherit $121,000 2 years from now and the interest rate r = 10%, what is the value today to you?PV = 121,000/(1+0.1)^2=100,000 EXCEL: =PV(rate,nper,pmt,[fv],[tpe)2.1 Recap Week 1PV —â†’1—â†’2 FV TIMELINE; FV = PV(1+r)^n; PV = FV/(1+r)^n2.2FV of Annuity: ConceptMultiple Payments: Annuities = a collection of payments to be periodically receive d over a specified period of timeVery rare occasion, one will only see one input and one output overtimeEg: Regula deposit into a saving account, monthly home mortage payments etcA special case of multiple payments: annuities (C for cashflow or PMTÂ for Payment) Annuity pays C (cashflow) 3 times; none at year 0Fv of an Annuity: FormulaFV = C(1+r)^2+C(1+r)+C = C{(1+r0^2 + (1+r) + 1]FV = c{(1+r)^n-1 + â€¦.+ 1}- n-1 because there is no payment on year 0What will be the value of your portfolio at retirement if you deposit $10000 every year in a pension fund. You plan to retire in 40 years and expect to earn 8% on your portfolio. EXCEL: =fv(rate, nper, pmt, [pv], [type]) = FV(0.08,40,10000) = 2,590,565.19If there was no interest rate = total will be 40*10000 = 400,000Interest rate is determined by the investor, higher risk = higher interest/higher volatility Suppose you want to guarantee yourself $500,000 when you retire 25 years from now. How much must you invest each year, starting at the end of this year, if the interest rate is 8%?EXCEL: =PMT(0.08,25,0,500000) = $6840If interest rate is 0, total will only be 6840*25; the effect of compounding is again seen2.5 PV of AnnuityPV = C/(1+r) + C/(1+r)^2 + C/(1+r)^3; C can be replaced by PMT= C{1/(1+r) + 1/(1+r)^2 + 1/(1+r)^3]; n =3How much money do you need in the bank today so that you can spend 10,000 every year for the next 25 years, starting end of this year. Suppose r = 5%.