Introductory Lecture: The
Touchstones of Finance
• Purpose: Provide a framework for
integrating the principles of finance into a
conceptual whole
Introductory Lecture: The Touchstones of
Finance
• Purpose: Provide a framework for integrating
the principles of finance into a conceptual
whole
Market Efficiency
NPV
Option
Pricing
Portfolio
Theory
Value
Additivity
What is Finance?
• Finance is the study of the market processes that
allocate society’s savings to the most productive
uses.
• Finance is also concerned with how these market
processes influence decision makers in business
and government.
• Much of this effort involves studying how security
values are established in the marketplace
What is Finance?
• The dimensions of this task can be appreciated through the
following definition of a security given by the Supreme
Court:
[A security is] a contract, transaction, or scheme whereby a person
invests his money in a common enterprise and is led to expect
profits solely from the efforts of the promoter or third party.
• Key points:
– Contract, transaction, or scheme
– common enterprise
– investor expects profits solely from other peoples’ efforts
Other Peoples’ Money—Other Peoples’ Efforts
How Does the Market Value a Company?
• A firm’s physical assets
– and the earning power derived from them
• The valuation of its human capital
– organizational capital
– structure of the incentives offered to key
decision makers
• Sustainable competitive advantage
What are the Value Drivers?
• Market value of physical
assets
– Consider change in net worth
when new assets and liabilities
are included in the balance sheet
• When would impact on net
worth be neutral? … Negative?
… Positive?
– You may be able to stop here if
neutral or positive
• Added earning power
derived from new assets
– DCF methods focus on these earnings
– You may be able to stop here, too
• Option approaches continue
from here
– Value of new opportunities
– Enhanced value of human capital
• Stronger organizational capital
via enhanced flexibility
• New incentives offered to key
decision makers
– Enhanced technology
– Enhanced competitive advantage
Finance is a dynamic and important discipline:
• Our knowledge is rapidly increasing.
• The market processes are rapidly evolving.
– Knowledge of these market processes is crucial to practical
business executives who must make investment and financing
decisions.
• The role of institutional investors is rapidly evolving.
• When the financial markets are functioning efficiently,
financial resources are channeled to the optimal uses.
What do we know about finance? The five
paradigms (building blocks of finance)
• Capital Market Efficiency
• Net Present Value Rule
• Asset Pricing Theory (includes Modern Portfolio Theory,
the CAPM, and Arbitrage Pricing Theory)
• Value Additivity Principle (VAP)
• Option Pricing Theory (OPT)
Market Efficiency
NPV
Option
Pricing
Portfolio
Theory
Value
Additivity
NPV
What do we know about
finance? The three separation
principles
• Fisher’s Separation Principle
– The investment decisions of business firms are separate from the
owners’ consumption decisions.
• Managers can make the most productive use of resources
– over the long term
– without worrying about owners’ preferences concerning how much
wealth to consume now and how much to invest toward future
consumption.
• This principle is important because it says
– resource allocation decisions based on rational considerations
– do not depend upon whether the firm is controlled by a prodigal or a
miser.
What do we know about
finance? The three separation
principles
Portfolio
Theory
• Tobin’s Separation Principle
– Investment decisions are separate from investors’ preferences concerning
the risk/reward tradeoff.
• In an uncertain world, investors can choose their portfolios of risky
ventures purely on the basis of a rational evaluation of probable
outcomes.
• Choices need not depend upon the investor’s “nerve.” Given identical
expectations, a very timid person can participate in the same
investments that would be chosen by a very aggressive investor.
– Conclusion: resource allocation decisions are based purely upon rational
considerations
What do we know about
finance? The three
separation principles
Market Efficiency
• M&M Separation Principle
– In a perfect capital market, a firm’s investment decisions are
separate from its financing decisions.
– Packaging doesn’t matter. What does matter is the substance of
the firm.
– If we think packaging matters, we need to look for a reason why
the way a thing is packaged could change its value. Financial
tricks alone can’t made a dog into a princess, and vice versa.
What do we know about finance? What major
questions are still unresolved?
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How are decisions really made?
How can we really measure NPV?
Do we really understand risk and return?
Are there important lapses in market efficiency?
Why do initial public offerings seem to be undervalued?
How are complex options valued?
Does capital structure matter?
Does dividend policy matter?
What is the value of liquidity?
Is corporate restructuring good or bad?