Introduction to MGT 470 (cs3ed) v1.1 Dec 15
The Six Parts of the Financial System
1. Money
2. Financial Instruments (Securities)
3. Financial Markets (NYSE, NASDAQ, etc.)
4. Financial Institutions (i.e. Banks)
5. Regulatory Agencies (i.e. SEC)
6. Central banks (i.e. The U.S. Federal Reserve System)
The role of the financial system is to facilitate production,
employment and consumption (spending). These are the
fundamental activities of any modern economy
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
Risk:
Definitions:
 Webster’s: a hazard; a peril; exposure to loss or injury
 The chance that an outcome other than that which was
expected will occur
 The chance that an outcome other than that which was desired
will occur (i.e. lose money)(this is the ”finance” definition)
 Risk = Uncertainty of future cash flows
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
Primary Finance Axioms:
1. As far as the finance world is concerned, any asset (stocks, bonds,
a project, a company, etc.) has positive value today (the “present
value” of an asset) only if it gets more valuable in the future:
it generates future positive cash flows and/or…..
it appreciates in value over time
This is because Finance is focused on the future
2. Risk affects value:
Risk Aversion: given two securities equally priced but with
different degrees of risk, the rational investor would choose the
one with lower risk
Valuation Implications:
→all else being equal, a security whose cash flows are
more certain is more valuable than a security with
relatively less certain cash flows
→if two securities offer the same ROR, the riskier one is
priced lower if the seller of that security wants anybody to
buy it (the less riskier one is priced higher)
ROR Implications: if two securities are priced the same, the
riskier one must offer higher expected returns if the seller of
that security wants anybody to buy it
3. The timing of cash flows matters; cash received sooner is better:
it can be utilized (invested) sooner to produce additional
income
restore liquidity sooner
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
The Five Core Principles of Money & Banking:
1. Time Has Value (The Time Value of Money – TVM):
Time affects the value of financial assets and transactions
When money is some how invested (and not just placed under a mattress or
in a safe), the amount of money grows
Although money loses value over time due to inflation, the amount of
money in an account that earns a positive ROR will be greater in the future
than what it is today. Why is this true?
Thus the money in the account has different values at different points in
time
This is what the term “Time Value of Money” refers to
The ROR should compensate for opportunity cost, inflation and risk
 the increasing amount of money over time should more than make up
for the value lost due to inflation and opportunity costs
2. Risk Requires Compensation:
The Concept of Risk Aversion
Risk Aversion: given two securities equally priced but with different
degrees of risk, the rational investor would choose the one with lower
risk
Valuation Implications:
→all else being equal, a security whose cash flows are more
certain is more valuable than a security with relatively less certain
cash flows
→if two securities offer the same ROR, the riskier one is priced
lower if the seller of that security wants anybody to buy it (the less
riskier one is priced higher)
ROR Implications: if two securities are priced the same, the riskier
one must offer higher expected returns if the seller of that security wants
anybody to buy it
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
The Five Core Principles of Money & Banking: (cont.)
2. Risk Requires Compensation: (continued)
Financial professionals must deal with risk:
eliminate it
reduce or mitigate it
pay someone else to assume it (transfer the risk, i.e. insurance)
none of these strategies are costless or free
thus someone needs to be compensated for dealing with risk
investors must be paid (compensated some how) to assume risk; the
greater the risk, the greater the compensation
3. Information is the Basis for Decisions:
What is the true value (fair market value, theoretical value) of an asset or
transaction?
What are the associated risks?
4. Markets Determine Prices and Allocate Resources:
A market is the place (physical or virtual) where buyers & sellers meet
Markets channel resources and minimizes the cost of gathering information
and making transactions
“Markets gather information from a large number of participants and
aggregate it into a set of prices that signal what is valuable and what is
not.
“Thus markets are a source of information.”
Markets function as auctions (ask & bid)
Supply, demand and risk establish the price
Prices establish the allocation of resources (commodities, securities, money,
etc.)
The market price of a commodity does not always reflect its true value or
associated risk, although very efficient markets usually achieve a close match
Well developed markets are the precondition for healthy economic growth
Even well developed and very efficient markets can break down (i.e. late
‘90s-spring 2000 and ‘07-’08)
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
The Five Core Principles of Money & Banking: (cont.)
5. Stability Improves Welfare:
Volatility creates risk
Reducing volatility reduces risk
Individual market participants can reduce or eliminate some of the risk on
there own How?
Other risks can be only reduced or eliminated by financial institutions or
through governmental action
Some risks cannot be eliminated, only managed (i.e. the “business cycle”)
At the macro level, a stable economy improves the welfare of everyone
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
Review of Some Important Basic Concepts (this stuff is not in your
book)
Difference Between Price and Value
The value of a financial asset is based upon expected future cash
flows
 this is the “theoretical value”, “fair market value (FMV)”,
“true market price”, “true market value”, “intrinsic value” or “noarbitrage price”
 it is what the asset should be worth based on fundamental
financial and accounting valuation principles (much more on this
later)
The price (“market price” or “real market price”) of something is
 what the seller wants you to pay for it
 what the “real” market allows (based on Laws of Supply /
Demand)
Price is usually not equal to fair market value:
 “fair market value” is the value of something based on theory
and does not include profit
 “price” is based on market/economic forces (supply and/or
demand) and usually includes profit, transaction costs, etc.
What makes the fair market value of something change?
 change in expected/estimated future cash flows
 change in future cash flow discount rate (more on this later)
What makes the price of something change?
 the same things that make fair market value change
 market forces (supply & demand)
Profit
It is the difference between Market Price and Value
Profit = Market Price - Value
Profit = Sales Price – COGS (Accounting Definition)
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
Profit (continued)
In the case of an investment:
Profit = Available market price at the end of the holding period
- Price paid at the beginning of the holding period
(i.e. you buy a security, you hold it for a while, its price changes,
you sell it)
Percent (%) Profit or Rate of Profit
The percentage increase in the price (or value) of a financial asset
May involve time
Also Called:
 Return
 Percent Return (% Rtn)
 Rate of Return (ROR)
 Yield
 Return on Investment (ROI)
General Equation: Profit / Investment
ROR may be thought of as rate of wealth creation
Rate of Profit Examples:
1) (Spot Transaction) (Passage of time does not matter) A lawn
mower manufacturing company charges $300 for a lawn mower that
cost $270 to produce and ship. What is the return on this product?
Profit
Return = (Sales price - COGS) / COGS
Investment
= ($300 - $270) / $270
= $30 / $270
= 0.1111 = 11.11% = % Profit = % Rtn = ROR = Yield = ROI
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
Percent (%) Profit or Rate of Profit (continued)
2) (Investment Transaction) (Passage of time matters) A year ago you
bought 100 shares of Intel stock for a total of $4,329. Today you sold
that 100 shares for $4,489. What was your rate of return?
Profit
Return = (New Price - Old Price) / Old Price
= ($4,489 - $4,329) / $4,329
= $160 / $4,329
= 0.03696 = 3.696%
Investment
The equation (New-Old)/Old is not unique to finance:
Example 1: The temperature at dawn was 24o and at 3:00 pm it was
56o. By how much did the temperature change in percent?
Answer: %D Temperature: (New-Old)/Old = (56o – 24o)/24o
(Note: D = change)
= 1.3333 = 133%
Check Answer: 24o(1 + 1.3333) = 24o(2.3333) = 56o
Example 2: At the beginning of 2005 the population of Albuquerque
was 450,000. At the end of 2005 the population was 461,200. What
was the percent change in population?
%D Population = (New – Old)/Old = (461,200 - 450,000)/ 450,000
= 0.02489 = 2.489%
Check Answer: 450,000(1 + 0.02489) = 461,200; The general
equation to find the value of some variable increased by some percent
is: New = Old(1 + %D)
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
Percent (%) Profit or Rate of Profit (continued)
3) (Security Spot Transaction) (Passage of time does not matter) A
company intends to sell securities valued at $1,020.50. The sales
price will be $1,086.00. What is the ROR?
Profit
Investment
Return = (Sales Price - FMV) / FMV
= ($1,086.00 - $1,020.50) / $1,020.50
= $65.50 / $1,020.50
= 0.064184 = 6.4184%
The FMV of the security is the investment: it is the amount of
money (in today’s dollars) the company must promise to pay in the
future to those who buy the security
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Introduction to MGT 470 (cs3ed) v1.0 Jun 15
Alternate Form of % Profit Equation:
(New Price – Old Price) / Old Price =
New Price Old Price
Old Price Old Price
= New Price/Old Price – 1
In Finance, we are more concerned with Rate of Return (%) than
we are with Profit ($)
Consider these two investment options:
A) Invest $5,000 now and receive $5,500 in one year
B) Invest $100,000 now and receive $108,000 in one year
Find Profit:
ProfitA = $5,500 - $5,000 = $500
ProfitB = $108,000 - $100,000 = $8,000
Find Rate of Return (ROR):
ROIA = ($5,500 - $5,000) / $5,000 = 0.10 = 10%
ROIB = ($108,000 - $100,000) / $100,000 = 0.08 = 8%
Point:
Opt B has a higher total dollar profit but Opt A was actually more
profitable because it produced more money with respect to the
amount of money invested
In other words, a higher proportion of Opt A’s investment was
“returned” as profit (10% as opposed to 8%)
Investments expressed as Rates of Return can be compared on the
same basis and without bias.
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