Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principles of Finance
 These are the underlying principles that form
the foundation for finance.
 These principles describe why and how
market participants react.
 Our attempt to explain the complicated real
world.
Prinsip Mnjm Keuangan
Minggu 2-1
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Principles are:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
The principle of Self-Interested Behavior
The principle of Two-sided transactions
The Signaling principle
The Behavioral principle
The principle of Valuable Ideas
The principle of Comparative Advantage
The Options principle
The principle of Incremental Benefits
The principle of Risk-Return trade-off
The principle of Diversification
The principle of Capital Market efficiency
The Time Value of Money principle
Prinsip Mnjm Keuangan
Minggu 2-2
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Self-Interested Behavior
“People Act in Their Own Financial Self-Interest”
 With all else equal, people choose the action
that is financially most advantageous to
themselves.
 Does not imply that making money is the
most important criterion.
 Consider charitable contributions.
Prinsip Mnjm Keuangan
Minggu 2-3
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Self-Interested Behavior
 Taking the most advantageous course of
action requires us to forego other possible
actions.
 Every action has an Opportunity Cost:
 The difference in value between the chosen
action and the next best alternative.
 For example, you give up your part-time job to
concentrate on your education.
Prinsip Mnjm Keuangan
Minggu 2-4
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Self-Interested Behavior
 Self-Interested behavior can lead to conflicts
of interest in Principal-Agent relationships.
 Agent:
 a person who acts on behalf of the principal.
 for example, the manager of a business is the
agent, and the owner is the principal.
 the manager might want to purchase an
expensive car for business use; the owner would
rather he buy an economy model, and pay off a
bank loan with the money saved.
Prinsip Mnjm Keuangan
Minggu 2-5
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Self-Interested Behavior
 The agent can take unseen actions that are
costly to the principal.
 the manager might make personal long distance
calls using the office telephone.
 This creates a Moral Hazard problem.
 The principal can reduce the severity of this
problem through more effective contract
provisions.
Prinsip Mnjm Keuangan
Minggu 2-6
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Two-Sided Transactions
“Every Financial Transaction has At Least Two Sides”
 While we act in our best interest, there is at
least one other person in this transaction
who is acting in his/her best interest.
 Underestimating the counterparty can lead to
sub-optimal decisions.
 people can suffer from hubris.
Prinsip Mnjm Keuangan
Minggu 2-7
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Two-Sided Transactions
 Most financial transactions are a zero-sum
game.
 One party gains only at the expense of another.
 Non-zero-sum transactions often result from
provisions in the tax code.
 a transaction may be structured so that both
parties pay less taxes to the government.
Prinsip Mnjm Keuangan
Minggu 2-8
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Signaling Principle
“Actions Convey Information”
 When a firm increases its dividend, it is
generally signaling a more optimistic future
for the firm.
 When actions conflict with words, pay
attention to the actions.
 The CEO announces optimistic future for the
firm, but at the same time top executives are
selling large amounts of stock they own in the
firm.
Prinsip Mnjm Keuangan
Minggu 2-9
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Signalling Principle
 If one party has information not known to
another party, there is asymmetric
information.
 Asymmetric information can lead to the
problem of adverse selection.
 For example, flip-flops, the case of the upward-
sloping demand curve.
Prinsip Mnjm Keuangan
Minggu 2-10
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Behavioral Principle
“When All Else Fails, Look at What Others
Are Doing for Guidance”
 Analyzing complex transactions can be very
difficult and/or expensive.
 In such cases, look at what others are doing.
 But be aware of the ‘blind leading the blind’!
Prinsip Mnjm Keuangan
Minggu 2-11
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Behavioral Principle
 In a competitive environment, this principle
can lead to the free-rider problem:
 The “leader” expends resources to determine the
best course of action.
 The “followers” imitate the leader and reap the
benefits without expending the resources.
Prinsip Mnjm Keuangan
Minggu 2-12
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Valuable Ideas
“Extraordinary Returns are Achievable with New Ideas”
 The value of merely imitating others is driven
out over time by competition from others
doing the same thing.
 Truly successful people / businesses have
used at least one new idea.
Prinsip Mnjm Keuangan
Minggu 2-13
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Comparative Advantage
“Expertise Can Create Value”
 This is the basis for our economic system.
 Economic efficiency results from everyone
doing what they do best.
Prinsip Mnjm Keuangan
Minggu 2-14
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Options Principle
“Options are Valuable”
 An option is the right (without the obligation)
to take some action.
 Depending on circumstances, the
optionholder may decide to:
 take the action (exercise the option) or
 forego the action (let the option expire).
Prinsip Mnjm Keuangan
Minggu 2-15
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Options Principle
 Explicit Option Contracts:
 Call Option:
 Gives the optionholder the right to buy the
specified asset at a strike (pre-specified)
price (within a specified time period).
 Put Option:
 Gives the optionholder the right to sell the
specified asset at the strike price (within a
specified time period).
Prinsip Mnjm Keuangan
Minggu 2-16
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Options Principle
 Hidden or Embedded Options:
 These options may be a part of another contract.
 Example:
 Bankruptcy laws provide debtors legal
protection from creditors - the limited liability
provision.
 Debtors have the option to not fully repay the
debt IF they declare bankruptcy.
Prinsip Mnjm Keuangan
Minggu 2-17
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Incremental Benefits
“Financial Decisions are Based on
Incremental Benefits”
 Incremental costs and benefits are those that
occur with a particular action, over and
above those that occur without this course of
action.
 Sunk costs (costs that have already been
incurred) are irrelevant to financial decision
making.
Prinsip Mnjm Keuangan
Minggu 2-18
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Principle of Incremental Benefits
Advertising
Budget
$1.0 million
$1.5 million
Status
Current
Proposed
Total Annual
Sales
$12.0 million
$12.6 million
Should you implement the new
advertising plan?
Prinsip Mnjm Keuangan
Minggu 2-19
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Principle of Incremental Benefits
Advertising
Budget
$1.0 million
$1.5 million
Status
Current
Proposed
Total Annual
Sales
$12.0 million
$12.6 million
Incremental cost of proposed advertising
budget = $0.5 million.
Incremental annual sales = $0.6 million
So, YES! Sales increase more than the cost.
Prinsip Mnjm Keuangan
Minggu 2-20
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Risk-Return Trade-Off
“There is a trade-off between Risk and Return”
 To have a chance to earn higher returns, you
must be willing to take more risk.
 High risk brings with it a greater chance of a
really good outcome as well as a greater
chance of a really bad outcome.
Prinsip Mnjm Keuangan
Minggu 2-21
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Risk Aversion
 When all else is equal, people prefer higher
returns and lower risk.
 People will choose the high risk alternative
only if they expect to earn a sufficiently high
return.
 Individuals would accept a lower return in
exchange for lower risk.
Prinsip Mnjm Keuangan
Minggu 2-22
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Application of Risk-Averse Behavior (2)
 Example:
 Which of the following games would you play?
A:
B:
C:
Roll 7 or 11
and win $50
Roll 7
and win $100
Roll 11
and win $150
 Game A or B?
 Game B or C?
 Game A or C?
Prinsip Mnjm Keuangan
Minggu 2-23
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Application of Risk-Averse Behavior
Consider the following Alternatives:
Choice
Expected Return
Risk Units
A
10%
20
B
10%
25
C
16%
25
 Comparing A & B, which would you choose?
 Comparing B & C, which would you choose?
 Comparing A & C, which would you choose?
Prinsip Mnjm Keuangan
Minggu 2-24
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Diversification
“Diversification is Beneficial”
 “Don’t put all your eggs in the same basket!”
 Spreading your investments (diversifying)
can reduce risk without a significant
decrease in return.
 A prudent investor will not invest her entire
wealth in a single asset (for example, one
firm).
Prinsip Mnjm Keuangan
Minggu 2-25
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Capital Market Efficiency
“The Capital Markets Reflect All Information Quickly”
 Capital markets are markets in which
financial securities, such as stocks and
bonds are bought and sold (traded).
 Examples of capital markets include
organized exchanges such as the New York
Stock Exchange.
Prinsip Mnjm Keuangan
Minggu 2-26
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Principle of Capital Market Efficiency
 Market prices of financial assets that are
traded regularly in the capital markets
 reflect all available information and
 adjust quickly to new information.
 New information is information that was not
previously known for certain. Note that
information may be thought possible,
expected, or even anticipated.
 Trading by astute investors in response to new
information causes prices to change quickly.
Prinsip Mnjm Keuangan
Minggu 2-27
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
Stock Price Response to New Information
Suppose an oil company unexpectedly
discovers a massive oil field. How would this
affect the stock prices of:
 That oil company?
 Other oil companies?
 Companies that use oil as a raw material?
 Banks that have loaned money to
Venezuela?
Prinsip Mnjm Keuangan
Minggu 2-28
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Capital Market Efficiency
For capital markets to be “informationally” efficient,
they must be “operationally” efficient as well.
 trading convenience
 large number of participants
 low cost of trading
 rapid execution of trades
Prinsip Mnjm Keuangan
Minggu 2-29
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Capital Market Efficiency
If capital markets are efficient, then
 The price of an asset is the same
everywhere in the market.
 The “law of one price” holds.
 equivalent securities must sell at the
same price.
 Arbitrage opportunities cannot exist.
 Arbitrage allows you to earn riskless
profits without any capital commitments.
Prinsip Mnjm Keuangan
Minggu 2-30
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
The Time-Value-of-Money Principle
“Money has Time Value”
 A dollar today is worth more than a dollar
tomorrow.
 The time value of money derives from the
opportunity to earn interest on the money.
Prinsip Mnjm Keuangan
Minggu 2-31
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
The Time-Value-of-Money Principle
The jackpot in your state’s lotto is $20 million, to
be paid out in 20 equal annual installments of
$1 million each.
 Is the jackpot really worth $20 million to
the winner?
NO! At a 6% interest rate, the
jackpot is actually only worth:
$11,469,921.22
Prinsip Mnjm Keuangan
Minggu 2-32
Tatang A Gumanti-FE-UNEJ
Mnjmn Keuangan -FE-UNEJ
A Simple Example of the Time Value of Money
Suppose you deposit $1,000 today in a bank
account that pays 10% interest per year.
 How much will you have one year from
today?
 How much will you have two years from
today?
Prinsip Mnjm Keuangan
Minggu 2-33
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
A Simple Example
 Represent the initial deposit of $1,000 as PV
(Present Value).
 Represent the interest rate paid by the bank
as r (r = 10% or 0.10).
 The Future Value one year from now (FV1)
is:
FV1 = PV + r(PV) = PV(1+r)
= 1,000 + .10*1000
= 1,000 + 100 = $1,100
Prinsip Mnjm Keuangan
Minggu 2-34
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
A Simple Example
 FV1 = PV + r(PV) = PV(1+r)
 During the second year, the entire balance of
$1,100 will earn interest at the rate of 10%
per year.
 The interest earned in the second year will
be $1,100(10%) = $110.
 Thus, the Future Value at the end of year 2
(FV2) is $1,100 + $110 = $1,210.
Prinsip Mnjm Keuangan
Minggu 2-35
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
A Simple Example
 Note that the interest earned in the second
year is $110.
 This $110 represents $100 earned on the
original deposit of $1,000 and $10 earned on
the $100 interest earned in the first year.
 Earning interest on interest already earned is
called compounding.
 FV2 = FV1(1 + r) = [PV(1 + r)][1 + r]
So:
Prinsip Mnjm Keuangan
FV2 = PV(1 + r)2
Minggu 2-36
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Time-Value-of-Money
Value of
Investment today
 FVn = PV(1 + r)n
Value of
Investment at
time n in future
Number of
Time Periods
Interest
Rate
 PV = FVn/(1 + r)n
Prinsip Mnjm Keuangan
Minggu 2-37
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Net Present Value (NPV)
NPV = Present value of expected future cash flows
- Cost
 NPV measures the value created by a financial
decision.
 Positive NPV increases wealth.
 A zero NPV decision earns the “fair” rate of
return.
 A positive NPV decision earns more than the
fair rate of return.
Prinsip Mnjm Keuangan
Minggu 2-38
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Required Rate of Return
 The required rate of return is the return that
exactly reflects the risk of the expected
future cash flows.
 It is the return a person requires from an
investment before being willing to make the
investment.
 It is determined by market conditions.
 It reflects the opportunity cost of the
investment.
Prinsip Mnjm Keuangan
Minggu 2-39
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Expected Rate of Return
 It is the return that an investor expects to
earn from the investment.
For conventional investments:
 If it is equal to the required rate of return, the
investment has a zero NPV.
 If it is greater than the required rate of return,
the investment has a positive NPV.
 If it is less than the required rate of return,
the investment has a negative NPV.
Prinsip Mnjm Keuangan
Minggu 2-40
Mnjmn Keuangan -FE-UNEJ
Tatang A Gumanti-FE-UNEJ
Realized Rate of Return
 It is the return actually earned on the
investment during a given time period.
 It can only be observed after the fact.
 It is disconnected from the expected (and
required) rate of return by the risk of the cash
flows.
Prinsip Mnjm Keuangan
Minggu 2-41