Maf101 Fundamentals of Finance Custom for Deakin University Australia Maf101 - Fundamentals Of Finance - Revision PDF

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MAF101&–&Fundamentals&of&Finance& & Topic&1&–&Introduction&to&Finance& & What&is&Finance?& • The&art&and&science&of&managing&money& • The&study&of&management&and&use&of&financial&resources& • Finance&is&concerned&with&the&processes,&institutions,&markets&and& instruments&involved&in&the&transfer&of&money& • Acquire&>&Spend&>&Manage& & Types&of&Organisations& • Sole&Proprietorship& o A&business&owned&by&one&person&and&operated&for&his/her&own&profit& o At&risk&of&unlimited&liability&(total&wealth&can&be&taken&to&satisfy& creditors& • Partnerships& o A&business&owned&by&two&or&more&persons&and&operated&for&profit& o Owners&have&unlimited&liability& • Corporations& o An&intangible&business&entity&created&by&law&which&has&the&powers&of& an&individual& o The&owners&of&a&corporation&are&its&shareholders& o Owners&have&limited&liability&which&guarantees&they&cannot&lose&more& than&they&invest& o Taxed&at&a&flat&rate&(generally&lower&than&individual&rate)& o Subject&to&greater&government®ulations& o Limited&company&=&public&(i.e.&sold&on&the&stock&exchange)& o Proprietary&Limited&=&private&company& & The&Corporate&Objective& • Maximise&the&value&of&the&company& • Maximise&shareholder&wealth& • Make&optimal&use&of&scarce&resources&(i.e.&capital&&&labour)& & Corporate&Financial&Decisions& 1. Investment&Decision& • Evaluation&of&investment&projects& • Amount&and&type&of&assets&held& • Review&past&investments& 2. Financing&Decision& • Where&to&obtain&funds&(i.e.&public&vs&private)& • Type&of&funds&(i.e.&debt&vs&equity)& • Cost&of&funds&(i.e.&interest&rates,&cost&of&issue)& • When&to&raise&funds&and&for&how&long& 3. Dividend&Decision&

• • •

Increase/Decrease/Maintain& Availability&of&cash&to&pay÷nds& Imputation&credits&(the&need&to&pass&on&tax&credits)&

& Market&Capitalisation& • The&measure&of&owner&wealth& • The&total&market&value&of&all&the&shares&on&issue& o Number&of&shares&multiplied&by¤t&trading&price& & The&Agency&Problem& • The&likelihood&that&managers&may&place&personal&goals&ahead&of&corporate& goals& • Market&forces&&&agency&costs&act&to&prevent&or&minimise&The&Agency&Problem& o Market&forces:& §฀ Shareholder&activism&(voting&power)& §฀ Threat&of&takeover& o Agency&Costs:& §฀ Incentive&plans& §฀ Performance&plans& & & Topic&2&–&Financial&Mathematics&Pt.&1& & Time&Value&of&Money& • The&amount&received&sooner&rather&than&later&is&more&valuable& • People&are&compensated&if&they&defer&their&consumption& • People&are&charged&if&they&wish&to&consume&more&now& • Compensation/Charge&is&called&interest& & Simple&Interest& • Interest&is&earned&or&paid&on&the&basis&on&an&initial&amount& • The&result&in&the&dollar&amount&of&interest&is&the&same&for&each&period& & Nominal&Compounding&Interest& • At&the&end&of&each&compounding&period,&the&amount&of&interest&earned&or& accrued&is&calculated&and&added&to&the&balance&of&the&principal& & Effective&Interest&Rate& • The&actual&interest&rate&when&interest&is&compounded&more&frequently&than& once&per&year& & Present&Value& • Present&value&is&the&amount&applicable&to&day&that&is&equivalent&to&a&single& cash&flow&or&a&series&of&cash&flows&to&be&paid&or&received&in&the&future& • Interest&rates&quantify&the&relationship&between&present&and&future&value& &

& Topic&2&–&Financial&Mathematics&Pt.&2& & Annuity& • A&series&of&cash&flows&of&equal&size&that&occur&at&a®ular&time&interval& extending&into&the&future& & Types&of&Annuity& • Ordinary&Annuity:&where&cash&flows&occur&at&the&end&of&each&period& • Annuity&Due:&where&the&cash&flows&occur&at&the&beginning&of&each&period& • Deferred&Annuity:&where&the&first&cash&flow&is&delayed& & Perpetuity& • A&special&ordinary&annuity&where&the&cash&flow&begins&at&the&end&of&each&time& period&and&continues&perpetually& o Eg.&Shares& & & Topic&3&–&Risk&&&Return&Pt.&1& & Risk& • The&potential&variability&of&future&cash&flows& • May&be&measured&by&the&standard&deviation&of&the&expected&return& & The&Effect&of&Inflation& • Interest&rates&are&generally&expressed&as&a&nominal&rate& • Real&rate&of&interest&represents&the&rate&after&adjusting&for&inflation& & Nominal&Interest&Rate& • The&interest&rate&paid&on&debt&securities&without&adjustment&for&loss&in& purchasing&power&(i.e.&inflation)& & Real&Interest&Rate& • The&nominal&rate&of&interest&less&any&loss&in&purchasing&power&during&the&time& of&the&investment& o Nominal&rate&minus&([)&inflation&rate& & Measure&of&Risk& • The&risk&of&a&security&is&the&extent&of&which&payoffs&are&expected&to&vary& • Standard&deviation&(SD)&(represented&by&the&Greek&letter&sigma,&σ)&is&a& measure&that&is&used&to&quantify&the&amount&of&variation&or&dispersion&of&a& set&of&data&values& & & Topic&3&–&Risk&&&Return&Pt.&2& &

Efficient&Portfolio& • A&portfolio&that&maximises&return&for&a&given&level&of&risk&or&minimises&risk&for& a&given&level&of&return& & Portfolio&Return& • The&return&of&a&portfolio&is&calculated&as&a&weighted&average&of&returns&on&the& individual&assets&from&which&it&is&formed& & Correlation& • A&statistical&measure&of&the&relationship&between&any&series&of&numbers& o Positive&Correlation&describes&two&series&that&move&in&the&same& direction& o Negative&Correlation&describes&two&series&that&move&in&the&opposite& direction& & Correlation&Coefficient& • A&measure&of&the°ree&of&correlation&between&two&numbers& o +1&=&perfectly&positive& o [1&=&perfectly&negative& & Diversification& • To&reduce&the&overall&risk,&it&is&best&to&diversify&by&combing&assets&that&have& negative&(or&low&positive)&correlation& • By&holding&a&collection&of&stocks&you&can&achieve&a&lower°ree&of&variability& in&the&combined&returns&because&the&good&performance&of&one&stock&can& offset&the&bad&performance&of&another& & Total&Risk&of&a&Portfolio& 1. Firm[specific/Company[unique&risk&>&Unsystematic&risk&=&Diversifiable&risk& 2. Market&related&risk&>&Systematic&Risk&=&Non[diversifiable&risk& & Beta&Coefficient& • A&measure&of&non[diversifiable&risk& • An&index&of&the°ree&of&movement&of&an&asset’s&returns&in&response&to&a& change&in&the&market&return& • The&Beta&Coefficient&for&the&market&is&considered&to&be&equal&to&1.0& o +1&=&moves&in&the&same&direction&as&the&market& o 0&=&unaffected&by&the&market& o [1&=&moves&in&the&opposite&direction&to&the&market& & & Topic&4&[&Investments&&&Debt&Markets& & Investments& • An&investment&is&an&asset&into&which&funds&can&be&placed&with&the& expectation&of&preserving&or&increasing&value&and&earning&a&positive&rate&of& return&

& Types&of&Investments& • Securities&and&Property&Investments& o Securities&are&investments&commonly&evidenced&by&certificates&that& represent&a&legal&claim& o Property&constitutes&investments&in&either&real&estate&or&tangible& personal&property& • Direct&and&Indirect&Investments& o With&a&direct&investment,&an&individual&acquires&a&direct&claim&on&a& security&or&property& o An&indirect&investment&provides&an&indirect&claim&(e.g.&Managed& funds)& • Debt,&Equity&and&Derivative&Securities& o An&investment&in&debt&represents&funds&loaned&in&exchange&for&the& receipt&of&interest&income&and&repayment&of&the&loan&at&a&given&future& date& o An&equity&investment&provides&an&investor&an&on[going&fractional& ownership&interest&in&a&firm& o Derivative&securities&derive&from&debt&or&equity&securities&and&are& structured&to&exhibit&characteristics&different&from&the&underlying& security& o Options&are&derivative&securities&that&allow&an&investor&to&buy/sell& another&security&or&asset&at&a&specified&price&over&a&given&time&period& • Short[term/Long[term&Investments& o Short[term&investments&typically&mature&within&one&year,&whereas& long[term&investments&have&longer&maturities& & Risk& • In&finance,&risk&refers&to&the&chance&that&the&return&from&an&investment&will& differ&from&its&expected&value& • The&broader&the&range&of&possible&values&(dispersion)&the&greater&the&risk&of& the&investment.& & Investment&Process&& • The&investment&process&brings&together&suppliers&of&funds&and&demanders&of& funds&by&means&o&financial&institutions&or&a&financial&market& & Suppliers&and&Demanders&of&Funds& • The&various&levels&of&government&require&more&funds&for&projects&and&debt& repayments&than&they&receive&in&revenues& • Businesses&are&also&net&demanders,&requiring&funds&to&cover&short&and&long& term&operating&needs& • Individuals&are&the&net&suppliers&of&fund&in&the&investment&process& o They&put&more&money&into&the&investment&process&than&they&take&out& & Types&of&Investors&

• •

Institutional&investors&are&investment&professionals&who&are&paid&to&manage& other&peoples&money& Individual&investors&manage&their&own&funds&in&order&to&meet&their&financial& goals&

& Short[Term&Investments& • Short[term&investments&usually&have&lives&of&less&than&one&year& • Used&to&warehouse&temporarily&idle&funds& • Short[term&vehicles&provide&liquidity& & Ordinary&Shares& • The&ordinary&share&is&an&equity&investment&that&represents&a&fractional& ownership&in&a&corporation& o Dividends&>&periodic&payment&made&from¤t&and&past&earnings& o Capital&Gains&>&Result&from&selling&a&share&above&the&purchase&price& & Bonds& • A&debt&obligation&of&corporations&and&governments& o Coupon&payments& o Face&value&paid&at&maturity& & Convertible&Securities& • A&fixed&income&obligation&with&a&feature&permitting&conversion&into&a& specified&number&of&shares& & Preference&Share& • Ownership&interest&in&a&company&that&pays&a&fixed&stated÷nd&which&has& precedence&over&ordinary&share÷nds& & Managed&Funds& • A&company&that&invests&in&a&large&portfolio&of&securities& • Professionally&managed&& • Offers&the&investor&the&benefits&of&diversification& & Hedge&Funds& • Similar&to&managed&funds,&but&are&open&to&a&narrower&group&of&investors&and& may&employ&high&risk&strategies& & Options& • A&derivative&security&that&provides&holders&the&right&to&buy/sell&another& security&or&property&at&a&specified&price&over&a&given&time&period& & Futures& • A&contractual&arrangement&in&which&a&seller&will&deliver&or&a&buyer&will&take& delivery&of&a&specified&commodity&at&a&given&price&by&a&certain&date& &

Liquidity& • An&asset&is&liquid&if&it&can&be&converted&into&cash&easily&and&quickly,&with&little& to&no&loss&in&value& & Bond&Appeal& • Bonds&are&appealing&to&investors&because&they&provide&a&generous&amount&of& current&income&and&they&can&generate&large&capital&gains& • Bonds&make&an&attractive&investment&outlet&because&of&their&versatility& & Bonds&&&Risk& • Interest&Rate&Risk& o This&affects&the&market&as&a&whole&and&therefore&translates&into& market&risk& o When&market&interest&rates&rise,&bond&prices&fall&and&vice&versa& • Purchase&Power&Risk& o This&is&the&risk&caused&by&inflation& o When&inflation&heats&up,&bond&yields&lag&behind& • Liquidity&Risk&& o This&is&the&risk&that&a&bond&will&be&difficult&to&sell&if&an&investor&choses& to&do&so& • Business/Financial&Risk& o This&refers&to&the&risk&that&the&issuer&will&default&on&interest&and/or& principal&payment& • Call&Risk& o This&refers&o&the&risk&that&a&bond&will&be&retired&before&its&maturity& & Call&Features& 1. Freely&Callable:&Issuer&can&permanently&retire&a&bond&any&time& 2. Non[Callable:&Issuer&is&prohibited&from&retiring&the&bond& 3. Deferred&Callable:&Bond&cannot&be&called&until&after&a&certain&amount& of&time& & Premium&Bond& • Sells&for&more&than&its&par&value& • Occurs&when&market&interest&rates&drop&below&coupon&rate& & Discount&Bond& • Sells&for&less&than&par&value& • Occurs&when&market&rates&rise&above&the&coupon&rate& & Bond&Equivalent&Yield&(BEY)& • BEY&is&an&annual&percentage&rate&that&would&be&earned&on&a&short&term& security&sold&at&a&discount& & & Topic&5&–&Investments&and&Equity&Markets&

& What&is&a&Share?& • An&ordinary&share&is&an&equity&investment&which&represents&fractional& ownership&in&a&corporation& • As&residual&owners&of&a&corporation,&ordinary&shareholders&are&entitled&to& dividend&income& & Advantages& • The&major&advantage&of&share&ownership&is&the&returns&it&offers& • There&is&no&limit&to&a&share’s&capital&gain&potential& • Provides®ular¤t&income&in&the&form&of÷nds& • Highly&liquid&and&easily&transferable& • Transaction&costs&are&relatively&low& • Market&Information&is&readily&available& & Disadvantages& • The&risky&nature&of&ordinary&shares&is&the&most&significant&disadvantage& • No&return&is&guaranteed& • Prices&are&subject&to&wide&swings& • Valuation&is&difficult& & Stock&Split& • A&stock&slit&occurs&when&a&firm&announces&its&intention&to&increase&the& number&of&shares&outstanding&by&exchanging&a&specified&number&of&new& shares&for&each&outstanding&share& • Executed&with&a&view&of&lowering&unit&price,&in&turn&enhancing&trading&appeal& & Stock&Spin[Off& • Involves&conversion&of&one&of&a&firm’s&subsidiaries&to&a&stand[alone&company& by&distribution&of&shares&in&that&new&company&to&existing&shareholders& & Dividend&Reinvestment&Plan& • Firms&with÷nd&reinvestment&plans&allow&shareholders&to&automatically& reinvest&their÷nds&into&additional&shares& • Provides&a&convenient&and&inexpensive&way&to&accumulate&capital& & Divided&Valuation&Model&(DVM)& • The&value&of&an&asset&is&the&present&value&of&all&future&cash&flow&benefits&& 1. Zero&Grow&Model& 2. Constant&Growth&Model& 3. Variable&Growth&Model& & & Topic&6&–&Financial&Markets&&&Institutions& & Financial&Markets&

• •

Financial&markets&refers&to&a&complex&of&institutions&and&procedures&that& facilitate&a&transfer&of&funds& The&main&role&of&financial&institutions&is&to&facilitate&the&transfer&of&funds& between&net&suppliers&and&net&demanders&of&funds&

& Flow&of&Funds& 1. Direct&>&firms&seeking&cash&sell&securities&directly&to&investors& 2. Indirect&(Banks)&>&banks&collect&savings&and&provide&funds&by&way&of&loans& to&other&individuals&and&businesses& 3. Indirect&(Other)&>&similar&to&banks;&however,&acquired&funds&are&used&to& invest&in&direct&securities& & OTC/Exchange[Traded&Transactions& • OTC&transactions&are&negotiated&between&two&parties&and&the&price&is¬& available&to&the&public& • Exchange[traded&transactions&involve&the&exchange&acting&as&a&clearing&house& & Foreign&Exchange&Market& • Provides&a&mechanism&for&the&transfer&of&purchasing&power&from&one& currency&to&another& o Spot&transactions& o Forward&transactions& & Primary/Secondary&Markets& • Primary&refers&to&when&securities&are&traded&for&the&first&time& • Secondary&represents&transactions&in¤tly&issued&securities& & Money&Markets/Capital&Markets& • Money&markets&=&short&term&debt&instruments& • Capital&markets&=&long&term&financial&instruments& & Public&Offering/Private&Placement& • Public&>&both&individuals&and&institutional&investors&have&the&opportunity&to& purchase&securities& • Private&>&securities&offered&and&sold&to&a&select&few&& o Often&to¤t&major&investors&in&the&corporation& & Commercial&Banks/Non[Bank&Deposit[Taking&Institutions& • Unlike&commercial&banks,&non[bank&authorised&deposit[taking&institutions&are& unlisted¬[for[profit&organisations&owned&by&their&members& • Profits&generated&are&used&to&improve&services& & Investment&Banks& • Specialised&financial&intermediaries&that&help&companies&and&governments& raise&money& • Provide&advisory&services&

•

Major&source&of&revenue&is&fees&for&financial&services&rendered&

& Insurance&Companies& • Contractual&savings&institutions& • Pool&of&premiums&collected&are&invested& & Superannuation&Funds& • Retirement&funds& • Pool&of&contributions&are&invested& & Investment&Companies& • Pool&the&savings&of&individuals&and&invest&the&money&purely&for&investment& purposes&in&securities&by&other&companies& o Mutual&Funds&(Managed&Funds)& §฀ Shares&in&mutual&funds&grant&ownership&claim&to&a&portion&of& the&portfolio& o Hedge&Funds& §฀ Similar&to&mutual&funds&but&more®ulated&and&risky& o Private&Equity&Funds& §฀ Invest&in&companies¬&traded&on&private&capital&markets& • Venture&Capital&=&start[ups& • Leveraged&Buyout&Funds& & Regulatory&Bodies& • RBA&(Reserve&Bank&of&Australia)& o Responsible&for&systematic&stability& • ASIC&(Australian&Securities&and&Investments&Commission)& o Responsible&for&consumer&protection&and&market&integrity& • APRA&(Australian&Prudential&Regulatory&Authority)& o Responsible&for&prudent®ulation&of&financial&institutions& & Objectives&of&Regulations& 1. Systematic&Stability& 2. Depositor&Protection& 3. Social&Objectives& & & &Topic&7&–&Personal&Finance& & Financial&Planning& • Financial&planning&is&concerned&with&investments,&insurance,&taxation&and& estate&planning& • Financial&planning&is&a&process&of&constructing&a&documented&financial&plan& for&an&individual’s&set&of&personal&financial&goals& & Financial&Planning&Process&(6&Steps)&

1. Gather&Financial&Information&(data)& • Current&financial&situation& • Tolerance&to&risk& • Future&goals&and&objectives& 2. Identify&Goals& • Analyse&information&gathered&to&determine&goals& 3. Identify&Financial&Issues& • Address&discrepancy&between¤t&assets&and&future&goals& 4. Prepare&&&Present&Financial&Plan& • Create/present&financial&plan&document&outlining¤t&position,& goals,&and&recommended&strategies&and&investments& 5. Implement&Recommendations& 6. Review&and&Revise& & Fact&Finding& • Personal&details& • Employment&arrangements& • Income&details& • Expense&details& • Goals&&&Objectives& • Assets&&&Liabilities& • Superannuation&details& • Entitles& • Insurance& • Estate&Planning& • Attitude&to&risk&and&return& & Statement&of&Advice&(SOA)& 1. Scope&of&advice& 2. Executive&summary& 3. Existing&position& 4. Goals&&&objectives& 5. Investor&Risk&Profile& 6. Strategic&recommendations& 7. Investment&recommendations& 8. Revised&position& 9. Services& 10. Fees&and&interests& 11. Disclaimer& 12. Appendices&...