MOS2310A_S23_Lecture1_Chps1_Chps2
0:01
OK.
0:04
So again, all of these are posted.
0:06
OK.
0:07
If it's easier, if you just to download and follow along that way, you can.
0:11
OK.
0:17
OK.
0:18
So chapter one is an introduction to corporate finance.
0:22
OK.
0:24
In finance, we really have three big areas of study.
0:29
OK, So we have personal finance, which deals with your own personal circumstances, right?
0:35
How do you manage your own budget?
0:37
You have what's called public finance, which basically deals with how do governments finance
themselves of government expenditures and taxation.
0:45
And then the third big bucket, the one that we're interested in, is corporate finance.
0:49
How do corporations finance themselves?
0:52
OK, so how do they, how do they pay for things?
0:55
Do they use retained earnings?
0:56
Do they try to raise equity?
0:58
Do they try to raise debt?
0:59
How do they decide?
1:00
Those are the sort of questions that we're gonna look at.
1:04
OK, OK.
1:09
I don't do every single slide, just just follow along for the ones that I emphasize.
1:14
OK.
1:15
So some important questions that are answered by using finance or the following.
1:23
What long term investments should the firm take on?
1:29
Where will we get the long term financing to pay for the investment and how will we manage the
everyday financial activities of the firm?
1:41
So here's a question for you.
1:44
What's the difference between the short run and the long run, right?
1:49
How?
1:49
How do we know that we're in the short run versus the long run?
1:52
Anybody know anyone want to guess if it's over a year?
1:59
That's a that's a good start.
2:01
That's a good rule of thumb.
2:02
Yes.
2:03
Typically that's most companies will use that as a rule of thumb.
2:07
The precise answer is it deals with what's called fixed cost versus variable cost.
2:12
OK, but there's two types of cost.
2:16
A variable cost changes with output, OK.
2:20
A fixed cost does not, for example, pretend you have some store space, OK.
2:27
And you rent that store space at the mall.
2:29
Whether you have a lot of customers come into your store or or almost no customers, your rent is the
same, OK.
2:37
That's a fixed cost.
2:39
If you have more and more customers come into the store, you probably need more sales associates
to service those customers.
2:46
That's a variable cost.
2:47
It changes with output.
2:48
OK.
2:49
So the the difference, the technical difference between the short run and the long run is that in the
short run, some costs are fixed.
2:57
OK?
2:58
In the long run, all costs are variable.
3:01
So even if you sign a lease for one year or five years, whatever the case may be, at some point that
lease is gonna be up.
3:07
OK.
3:08
But on a more practical level, the short run and the long run is often specified by the industry context.
3:15
So some industries will say one year, some will say five years.
3:18
OK, OK.
3:22
So we're interested in long term investments, OK.
3:26
So often we think of what's called CapEx where we talk about you know, land and buildings and
equipment, OK.
3:36
So those are often what we think of when we think of long term investments, what's called PPE
property, plant and equipment.
3:43
OK.
3:44
I know PPE has a different connotation with COVID Personal protective equipment.
3:50
OK.
3:52
So the people within a company that are most responsible for answering these questions are the
financial managers, OK.
4:02
And the top financial manager is usually given the designation CFO, the Chief Financial officer, OK.
4:10
Some other common roles you'll hear for employees and finance or the treasurer, they oversee the
cash management of the capital expenditures and the financial planning.
4:22
And these are very important functions.
4:25
If you don't, you know one of the things you'll learn about is there's a there's something called a
paradox.
4:30
A paradox is a puzzle.
4:32
There's what's called the paradox of growing broke.
4:36
You can have a company that looks like it's growing, but if a lot of their sales are on credit accounts
receivable and they don't manage their cash outflows properly, even though you had a company that
could have grown and might have been successful, they won't make it that far.
4:51
They'll end up in bankruptcy court.
4:54
But cash management is very important, OK, Of course Apple expenditures also very important.
5:00
If you don't invest and and keep up with the latest equipment and stay competitive, your firm and its
products may become obsolete.
5:08
OK.
5:09
And the controller, the overseas taxes, cost accounting, financial accounting and data processing.
5:17
OK, now this isn't an accounting class and I'm I'm not going to go too deep into accounting, but you
should have some rudimentary or basic understanding of accounting.
5:28
I I believe you all would have taken an accounting class in first year.
5:33
So you should be able to understand the basic financial statements, your income statement, your
balance sheets, your cash flow statement.
5:41
If you don't, you should refresh that.
5:44
OK.
5:44
So refresh that knowledge if it's something you're not entirely up to speed on.
5:50
OK, OK.
5:55
So three important decisions.
5:59
The first was the capital budget.
6:01
OK, So what long term investments or project did the business take on?
6:07
So for example, should we take on a major expansion if we're a, you know, if we're a food wholesaler,
should we invest in new refrigerated trucks?
6:17
If we're an automotive supplier, should we invest in in the latest equipment that might like say
minimize environmental damage.
6:25
So what long term investment should we take on the capital structure?
6:32
This is something we'll spend quite a bit of time on.
6:35
The capital structure is the combination of debt and equity that a firm has and we have to find that
optimal level.
6:44
So should our firm be 100% equity financed, should it be 50% equity financed, 50% debt financing,
You know what are the pros and cons of those different combinations.
6:54
So this is something we are going to study and think about and the opposite of long term is short
term and here are the day-to-day finances what we call working capital.
7:08
OK.
7:10
But how do we, how do we manage the day-to-day finances of the firm, right.
7:14
At a broad level, we don't want to have too much cash just sitting there because cash doesn't earn a
return in, in real terms in what we call inflation, ingested terms.
7:23
Cash actually has a negative return, OK.
7:27
So we don't have too much cash in there.
7:29
But at the same time, we don't want to have an insufficient amount of cash.
7:33
We don't want to be able to, you know, not meet our payroll or something, something like that.
7:37
That's not very big operational ramifications.
7:44
OK, so in Canada, as in most countries, we have 3 forms of business.
7:52
We have a sole proprietorship.
7:54
This is your classic small business.
7:56
Think, you know, a hairdresser, perhaps a small, you know, mom and pop restaurant.
8:04
You, you know, a lot of very small businesses set themselves up as sole proprietorships.
8:09
OK, partnerships.
8:12
This often happens more when you have specialists of a common field.
8:18
So you think, for example, dentists, lawyers, accountants, they often set themselves up as partnerships.
8:24
You have a general partner and then you have what's called limited partners.
8:28
It relates to the liability that they have.
8:31
I'm not gonna spend too much time on small proprietorship and partnerships because the focus of
this class is on corporations, OK?
8:40
And the big benefit of a corporation, it's it's a separate legal entity, right?
8:46
So if, for example, you're a partial owner of Flex a Apple computers, OK, we have a share of Apple
computers.
8:54
God forbid, if Apple makes a computer and it blows up and it harms somebody, you are not
personally liable for that.
9:01
OK, So there's the separation of liability from the corporation as its own legal entity and the owner as
as a person, and it's in a separate legal entity, OK.
9:12
Also, corporations have a huge ability to raise funds in a way that sole proprietorships and
partnerships can and that is corporations under certain conditions can access public capital markets,
OK.
9:26
In some countries, especially in the in the UK, instead of corporations, you may hear the phrase joint
stock company, public limited company, limited liability company.
9:40
These all mean the same thing.
9:47
OK, so again, I'm not gonna spend too much time on like I said, sole proprietorships and partnerships.
9:57
Just just in brief, the benefit of the sole proprietorship is that it's very easy to start, OK, paperwork is
incredibly minimal.
10:09
The income you get are taxes, personal income.
10:12
The disadvantage though is it's limited to the life of the owner, you can't really resell it and it has
unlimited liability.
10:23
So quick to start, but very difficult as a corporate vehicle to to expand and also to minimize risk.
10:32
OK.
10:36
Again, the partnership is relatively easy to start, OK.
10:43
But the big disadvantage is again, you have unlimited liability and it can be a very illiquid investment.
10:50
When one partner dies or wishes to sell, it can be very difficult to transfer ownership.
11:00
The one that we're most interested in is the corporation.
11:03
OK, and the corporation has limited liability.
11:08
Theoretically it has an unlimited life.
11:12
This is what's called an account In the going concern that we see the company exist indefinitely unless
there's evidence to the contrary, for example, a bankruptcy proceeding.
11:28
There's a separation of ownership and management.
11:32
For example, if you own Apple computers or some share of it, you don't manage it or it's probably
very unlikely that you do.
11:39
It's very easy to transfer ownership, OK.
11:43
And it's it's also very easy to raise capital, OK.
11:47
Now this doesn't mean for any company it's easy to raise capital, but as a category, OK.
11:53
The disadvantage we'll talk about this, the separation of ownership and management.
11:57
It's a very famous problem in finance called the principal agent problem.
12:02
OK.
12:03
And another disadvantage is that it can be inefficient from a tax standpoint because income is taxed
to the corporation and then it's taxed again when it reaches the personal level.
12:16
So whether the company gives you a dividend or buys back shares, all of those are taxable events that
trigger tax liability.
12:24
OK.
12:26
Finally, another category that's become more popular, but not not really for our purposes, but just for
your own knowledge is what's called income trust, OK.
12:43
So a business income trust, it holds the debt and the equity of an underlying business and distributes
income generated to unit holders, OK.
12:56
So again it's a separate legal entity, OK.
12:59
And it just holds the debt and equity of an underlying business and it's distributes the income to the
unit holders, OK.
13:07
The big advantage, it's not subject to corporate income tax and the income is typically taxed only in
the hands of the unit holders, OK.
13:17
It's seen as very tax efficient.
13:20
It's mostly used for estate planning and and multi generational or intergenerational wealth transfers.
13:28
Disadvantages is that the income trust are not corporations so they don't have the same advantages
as as a corporation.
13:37
You know an income trust isn't traded on, you know the New York Stock exchange can't raise capital
the same way et cetera.
13:46
Cooperatives are also an interesting category.
13:49
You may, you're probably exposed to this if you've ever used the credit union as opposed to a bank.
13:56
So kind of union.
13:57
When you when you make a deposit as a member, you're also a part owner versus the bank.
14:03
If you make a deposit, you're just a depositor.
14:05
You'd have to buy equity to have an ownership stake.
14:07
OK.
14:09
So cooperative and enterprise that's equally owned by the members, OK, Who shared the benefit of
the of the cooperation based on how much the use of the cooperative services.
14:22
OK.
14:25
And this, this what we call a social capital.
14:28
OK, so some sort of spirit of cooperation and and community service among the members.
14:35
But the disadvantage is it can be relatively inefficient.
14:39
You can imagine if you deposit $1,000,000 and someone deposits $1.00, you're both technically
members and you both still have one vote.
14:48
That's not to say the person with $1,000,000 may not get compensation through other channels.
14:54
You know, they would get probably higher dividends, maybe different type of share.
14:58
But from a government's standpoint, it's not as efficient as you know, in a typical corporation, your
$1,000,000 would get you much more shares and much more votes.
15:11
OK, now this one's very interesting.
15:16
What should be the goal of the corporation?
15:20
OK, so the goal of the corporation would be to maximize profits, to minimize costs, to maximize the
market share, to maximize the current value of the company stock.
15:32
Anyone.
15:33
Anyone want to comment?
15:34
What do you think?
15:35
What should be the goal of the corporation?
15:37
Next thing you own shares in General Motors or Apple Computers or IBM.
15:44
What would you want their goal to be?
15:47
What would you want their goal to be?
15:48
Anyone.
15:49
Don't be afraid to chime in.
15:52
I may.
15:53
I may just randomly call some names, but don't don't feel like you have to participate if you're a little
bit shy.
15:58
Actually, who we have here?
15:59
We have Abby.
16:00
We have Ying.
16:02
Carly.
16:03
Courtney.
16:04
Jen.
16:05
Julia.
16:06
Cassia.
16:07
Malik.
16:08
Ryan.
16:11
Spencer.
16:13
Don't.
16:14
Don't be shy.
16:14
What What do you think the goal of the corporation is?
16:18
I'm not sure but like market share first because you maximize market share you there's bigger chance
you can get greater profit but like still profit but like first share.
16:35
OK, OK you're you're on you're on the right track that's important.
16:39
Anyone else don't be shy.
16:41
I can't hear you speak.
16:49
Speak closer to the microphone.
16:56
No, no, I can't really hear you.
16:58
Try to.
16:58
Maybe there's something wrong with your microphone.
17:01
Profit.
17:02
The cost they they need the profit to live longer in in this industry.
17:13
If they cannot have the profit to buy the cost or or the other staff, they cannot live in a long time.
17:23
I I could just very faintly hear you.
17:25
I'm sorry.
17:26
Literally, maybe.
17:29
Maybe somebody else can try.
17:33
Don't be shy.
17:33
I think maximize profit for the shareholders or maximize return on investment for the shareholders or
the owners.
17:46
OK, that's, that's good.
17:47
That's good.
17:49
We'll take.
17:50
We'll take one more, one more try.
17:52
Who?
17:52
Who wants to try?
17:54
Maybe Ryan, maybe Samantha, maybe staff, maybe Tim.
17:59
Oh, there's a hand up.
18:00
OK, go ahead.
18:02
I think it's to be maximized profit.
18:05
I think it is important to increase market share, but I think it's main goal is to increase profit rather
than to make return on investments for investors.
18:16
OK, OK, very good.
18:18
So let me let me help you.
18:18
This is a bit of a trick question actually.
18:21
I oh, go ahead May, I don't think, just wanted to add up to my thing.
18:27
I think maybe just maximize whatever that can grow the company and then everything else is after the
company grow like shareholders get their shares and then everything gets better.
18:48
OK, that's good.
18:50
OK.
18:50
But let me, I'll, I'll just give you the answer.
18:53
So those are all very good attempts.
18:56
So it's it's a trick question.
18:57
The goal of the corporation is actually all of the above, OK.
19:02
For example, you cannot maximize profit if you do not minimize your cost, right.
19:06
Remember profit is revenue minus cost.
19:10
If you have the same revenue as another company, but they're more efficient with their cost, they're
gonna have a higher profit, right?
19:16
If you're not maximizing your profit, if you're not maximizing your market share, you can't be
maximizing your revenue, OK.
19:24
And we can summarize all of these different conditions by saying the goal of the company is to
maximize shareholder value, OK.
19:33
And the best approximation for shareholder value is the current stock price.
19:38
OK.
19:39
Now I say approximation because sometimes stock prices can can be detached from what we call
fundamentals.
19:45
Sometimes we have bubbles in the stock market and we have corrections and and whatnot.
19:50
But as a general rule, the best proxy for the for the goal of maximizing shareholder value is the current
stock price, OK.
20:01
So in short, the goal of the corporation is all of the above.
20:04
Maximize profits.
20:05
Minimize costs.
20:06
Maximize market share.
20:08
Maximize the current value of the company's stock.
20:11
OK, so.
20:16
Which is also a bit of a trick question.
20:18
Does this mean we should do anything and everything maximize owner?
20:22
Well, this one's a bit of a trick.
20:25
We have a, we have a comment here.
20:26
Go ahead, Ryan.
20:29
I just want, I just have a quick question before we move on.
20:32
Is there a difference between a shareholder and a stakeholder or is does that is that are those two
terms used interchangeably?
20:41
Sometimes, Sometimes they're used interchangeably.
20:43
But there is a difference.
20:45
A stakeholder is anyone who has an interest in in that particular outcome.
20:51
A shareholder is a is a legal owner, they have a share.
20:54
For example, a company like Toyota, Toyota Motor Company, right.
21:02
I I don't have any shares in Toyota, OK, But I like cars.
21:06
I I like, I like automobiles.
21:09
So to that extent, I'm a stakeholder in the sense that I care about.
21:13
Will Toyota push the future of automotive engineering?
21:16
Will they create some interesting products?
21:18
I'm a stakeholder because I have an interest in what happens, but I don't have any legal ownership, so
I'm not a shareholder.
21:26
OK.
21:26
So do you, do you see the difference?
21:29
Yeah.
21:29
Thank you.
21:30
Perfect.
21:31
Perfect.
21:32
I'll give you one other example.
21:35
You may have a a major company in a city who does community work.
21:40
So maybe one day a year they have all their employees come and clean up a City Park.
21:46
OK.
21:46
If I live near that City Park, I'm a stakeholder of that company to the extent they do that charitable
work because the cleaner park puts up my property value.
21:57
OK.
21:57
But I may not own any shares in the companies.
21:59
I'm not a shareholder.
22:01
OK, OK.
22:03
The second question here is a is a fun one.
22:04
It's a bit tricky.
22:06
So does this mean that we should do anything and everything to maximize owner wealth?
22:11
So we as in the corporate managers, Anyone wanna, Anyone wanna guess?
22:15
Does this mean we should do anything and everything to maximize owner wealth?
22:22
Go ahead.
22:24
No.
22:26
OK, Why?
22:26
No, the company should not only focus on maximizing their wealth, but only pay attention on some
social responsibilities.
22:39
OK, you're you're on the right track.
22:42
I'll play.
22:42
I'll play devil's advocate.
22:44
So let's pretend you're a corporate manager and I'm an owner and I say, well, wait a minute, I put my
money into this company to to make my money grow.
22:52
If I wanted to put my money into a charity, I could have donated to parity.
22:55
So I'm going to play devil's advocate.
22:59
Do you can respond or someone else can respond?
23:04
Don't, don't be shy.
23:09
Anybody want to tackle that question don't be shy.
23:13
I'm not sure like further.
23:15
I just want to say is there something wrong?
23:17
I can't hear you clear.
23:19
And then, yeah, for my answer, I think like still shouldn't like should not maximize owner's wealth like
as a priority things.
23:36
If you give out everything as a dividend, the company won't grow well.
23:42
If you grow the company first dividend is going to be lower for for sure, going to be lower, but it's
going to be a long term.
23:55
OK, Let me, let me stop you there.
23:57
So let let me stop you there.
23:58
So can can you hear me?
23:59
OK.
23:59
I think.
24:00
I think most people can hear me.
24:03
Can can you hear me OK, Someone comment if you can.
24:06
I could hear you fine.
24:07
But it's just sometimes the mic goes a little like, I don't know how to explain it.
24:13
It just defocuses or something.
24:16
Yeah.
24:16
OK Voice feels like there's interruption there.
24:21
Yeah.
24:21
But it's generally it's it's fine, OK, OK.
24:24
I don't know it might just be the Internet or or or OWL or or something to that effect.
24:30
But as long as you can mostly hear me that's that's the key point.
24:35
OK.
24:35
So to come come back to this question, does this mean we should do anything and everything to
maximize on our wealth.
24:43
So the lady who was who was answering earlier, we haven't talked about dividends yet.
24:50
What what this question really comes down to is what we call intertemporal, intertemporal means
between time periods.
24:57
So if you think of the present day in the future, for example, sometimes a company can maximize
wealth today at the expense of future wealth.
25:10
For example, maybe we cut costs too much and that leads to reliability issues or you know maybe we,
you know have some rough negotiations with the supplier and we think that we got a really good
deal.
25:28
But in fact that supplier starts looking for other clients and and maybe we we lose that supplier in the
future.
25:35
So the point is sometimes we can do things to maximize wealth today at the expense of future wealth,
OK.
25:42
So we have to be careful.
25:44
We wanna think about wealth because the company is what we call a going concern, has an unlimited
lifespan.
25:50
We want to try to think about wealth in a way that we don't have to trade off between present and
future.
25:56
OK.
25:57
So you know, the financial manager really has to try to take a long term view of of these big issues.
26:03
OK.
26:05
You know, for example, that's why most CEOs have compensation that isn't really that only a small
amount of salary, but most of it is stock options.
26:15
And in fact a lot of CEOs can't cash that stock until, you know years into the future, often often past
their tenure as CEO.
26:25
OK.
26:26
So that's the point there is you want to understand what we call intra temporal, these these trade-offs
across time, OK.
26:35
So there are three equivalent goals of financial management.
26:40
We want to maximize the shareholder wealth, we want to maximize the share price and we want to
maximize firm value.
26:48
These are all the same thing.
26:50
These are all equivalent, OK.
26:53
So for example, you cannot maximize the shareholder wealth if the share price is not at maximum, OK.
27:00
The share price won't be at a maximum unless the firm value's at a maximum, OK?
27:05
Because the share price is is really the the firm value divided by the amount of shares that you have.
27:11
OK.
27:16
This is a very famous problem in finance.
27:18
We call this the principal agent problem.
27:21
OK.
27:24
And what this is, is it's a mismatch in incentives between the principal, the principal is the owner, OK,
And the agent is someone who works for the for the principal, OK.
27:38
So for example, you know if you're the owner of a company OK, and you hire someone to work for
you, that person's interests may not completely align with their own OK.
27:51
So for example, maybe you have a like say a restaurant, right?
27:59
You know your your interest as the owner might be to have that person work at 100% their their full
productivity.
28:07
But that person as an agent, their interest may not be to work at A at full productivity.
28:12
They might say, OK, I want to do just as much work as needed so I don't get fired.
28:17
OK, that's one of the classic example, right.
28:20
There's there's much more sophisticated examples where you know, you as the owner for let's say a
major company, you know, you might expect that, you know that agent to minimize cost.
28:35
But that agent as a manager, sometimes, you know, they, they get kickbacks from, you know, not
minimizing cost by giving contracts to hurting people or certain companies and whatnot.
28:49
I'll give you one other famous example.
28:54
If you think about real estate, OK, yeah, let's say you, you put your house for sale and let's say you ask
for, you know, 500,000, OK.
29:08
And let's say the typical real estate agent, they'll get, let's say, 3% Commission.
29:12
OK.
29:13
So, you know, basically every, every $1000, you know, they would get $30.
29:24
OK.
29:25
So let's say you put your house for sale for $500,000.
29:29
OK.
29:30
And an offer comes in for $500,000.
29:35
And you think, you know what, hey, this is a this is a good offer.
29:37
It's what I wanted.
29:38
Maybe I should accept it.
29:40
But then my friend says, you know what, the house down the street sold for 500 and let's say 510,000.
29:48
OK.
29:49
And you think, you know what, maybe maybe I'll wait a couple of weeks.
29:51
You know, I I can wait, you know, for $10,000.
29:54
I can wait two weeks, 3 weeks, you know, now the real estate agent, if you get an offer that's $10,000
more, the real estate agent would just get 3% of that, right?
30:08
So you know, if we, if we think about it this way, if 1000 dollars, 10% of $1000, OK is $100 right?
30:20
And 1% OK of $1000 is $10.00, so 3% would be 30.
30:31
OK.
30:32
So if you get $10,000 more, the real estate agent only gets $300.00.
30:37
OK, now if you have to wait four weeks to get an offer of $510,000, you might think that's perfectly
fine.
30:46
I think most people would be happy to wait four weeks to get $10,000.
30:51
Most people, though, might not be happy to wait four weeks just to get an extra $300.00.
30:56
Well, the real estate agent might push you to accept the deal and say, OK, take it, take it, take it.
31:01
Whereas you know, objectively, it might be in your best interest to wait.
31:05
OK, assuming that there's a high probability that within four weeks you'd get an offer that's $10,000
higher.
31:12
So that's a classic example, as well as to where there's a mismatch between the, the principal, the
owner and somebody who works for, who works for them, the agent.
31:26
OK.
31:27
Does that make sense to everybody?
31:29
Any Any questions about that?
31:37
Any questions about that?
31:43
This is a very famous problem in finance and a lot of research goes into how do we solve this principal
agent problem?
31:50
And This is why often upper management is compensated with stock options and the goal is to try to
make them owner like they're still not entirely an owner because they're they're a combination of an
owner and employee, but they're more owner like, OK, and there's a couple other things we can try to
do to solve the principal agent problem.
32:15
Another thing is called carrots and sticks, broadly, incentives and disincentives.
32:19
Carrots are positive incentives.
32:22
Sticks are disincentives.
32:25
So, for example, you know, you reward agents for good performance.
32:29
You know, things like bonuses, promotions, whatnot, of course, disincentives, you know, things like
demotion or or lack of or or reduced budget coming to that division, et cetera.
32:46
So character sticks.
32:47
The other thing you do is you try to monitor the agents, OK, So people behave differently when they
feel that they're being monitored, OK?
32:56
So presumably they would tend to not shirk their responsibilities.
33:02
And the final one is, is what we call a threat of a takeover that if our company is not performing well,
quite possibly another company will buy us and fix the inefficiency.
33:11
And if that inefficiency is for performing, you know employees that would be, you know, a threat to
the employee for their their longevity in that area.
33:27
OK.
33:28
So we just talked about those.
33:31
This is becoming a bigger issue in today's world, what we call social, social responsibility and ethical
investing.
33:40
You know, in the old days investors paid much more attention to to their dollar return.
33:46
Now investors tend to care about other factors as well.
33:50
You know, an investor might say I can invest in, you know, a cigarette company and get a good return.
33:58
But another investor might say, you know what, I I don't for social reasons, ethical reasons, I don't
want to invest in the company that makes a product that you know is gonna cost people lung cancer.
34:09
Another example, an investor might say I I wanna know what is this company doing to care for the
environment or or helping the community.
34:17
So these are becoming bigger considerations.
34:20
OK.
34:23
And some controversial business activities, you know, things like alcohol gaming, genetic engineering,
they they may have trouble attracting investment dollars.
34:35
OK, OK, OK.
34:42
The role of financial markets in corporate finance, OK.
34:49
So loosely, you can think of a market as a group of buyers and sellers of a particular product or
service.
34:58
If you go to the grocery store and you want to buy an apple, you're part of the market for apples, OK.
35:05
The, the other part is the supplier of apples, OK.
35:09
The financial markets are those buyers and sellers of financial products, OK.
35:14
So stocks, bonds and derivatives, OK.
35:19
And financial markets play a very important role in corporate finance.
35:24
So the cash that comes into the firm often comes from financial markets.
35:31
The company sells stocks.
35:33
The company sells bonds.
35:35
So the cash comes into the company.
35:38
The company puts money back into the financial markets, OK.
35:41
So sometimes it, you know, buys back stocks, sometimes it has, it makes payments on its debt,
etcetera.
35:48
Well, the financial markets play this very important role of having money flow to and from the
company, OK.
35:57
We have what's called primary and secondary markets.
36:02
Probably the easy way to understand this is to give an analogy from automotives.
36:08
If you think about what's called the OEM, the original equipment manufacturer, so you think of like
General Motors, General Motors manufacturers, the cars.
36:17
If you buy a Cadillac, you don't buy that Cadillac directly from General Motors, you buy it from a
dealer.
36:23
So the primary market is that relationship between say the dealer and the manufacturer or the OEM.
36:31
And then the secondary market, OK, Is the relationship between the dealer and you know, you OK in
finance is the same thing When a company first releases shares, OK.
36:49
So that company may have an investment bank initially buy those shares.
36:53
That's the primary transaction.
36:55
Then those shares are sold on the public markets, that's the secondary market, OK.
37:01
Same thing with debt.
37:02
A company may initially do what's called a private placement for debt.
37:06
So, so an investment bank or a pension fund or something buys a bunch of bonds from this company
and then those bonds may be sold in secondary markets.
37:16
OK.
37:17
So primary versus secondary markets is an important distinction because sometimes one market
works better than the other.
37:24
Sometimes the primary market is very efficient and the secondary market isn't and vice versa.
37:30
OK.
37:31
So you can also, you know, look at some of the stuff on on the Internet, OK, This is a very important
picture here.
37:42
OK.
37:43
So we, we take a look at this flow chart, we look at part A, the firm issues securities, so it issues, let's
say equity, OK.
37:54
So the money comes from the financial market to the firm because it issues securities and the firm
uses that money to invest in assets, OK.
38:04
So invest in assets to generate money within the scope of its business, OK.
38:11
And then the cash from those assets has to flow.
38:14
Some of it has to flow back to the providers of capital for the people who who lent in money, the debt
holders, the people who bought ownership shares, the equity holders.
38:25
Of course, government takes some of it, right?
38:27
You have to pay your corporate tax and property tax and whatnot and you know, your GST and HSD,
right.
38:35
And some of the money gets reinvested back in the company, OK.
38:39
So when when those assets generate cash, some of it is reinvested, some of it goes to dividend and
interest payments and some of it goes to government, OK.
38:51
So this, this is a nice synopsis of how the firm interacts with the financial markets, OK.
38:58
And how the cash flows between the two.
39:01
OK.
39:02
So this is a picture you should really know quite well.
39:05
OK, OK.
39:10
Financial institutions act as intermediaries between suppliers and users of funds.
39:18
OK.
39:19
So what does that mean?
39:21
Well, if you think about a bank, a bank is intermediary, right?
39:24
There are some people who save money and and they put that money into the bank.
39:29
And there's some people who need to borrow money, you know, whether it's for personal needs,
buying a house or corporate needs, You know, business loans and whatnot.
39:37
OK, but the bank acts as that intermediary.
39:40
You can imagine, if there wasn't a bank, how inefficient it would be, right?
39:44
If you're a business and you need a loan and there isn't a bank, you'd have to somehow go to a whole
bunch of different people and and syndicate or put together a group on your own.
39:54
It'd be hugely inefficient.
39:55
Most people wouldn't know how to assess your business.
39:58
You wouldn't know how to find reliable people.
40:00
It'd be a very unwieldy system.
40:02
Right.
40:03
And and all of a society would be poorer because of it, because of a lack of investment.
40:08
So financial institutions act as intermediaries between suppliers and users of funds, OK.
40:15
And institutions earn income on the services they provide, OK.
40:21
So there's indirect finance.
40:23
So you earn interest on the spread between loans and deposits.
40:27
If I mean for example look at what the bank pays you on your deposits versus what they charge you
on your on your credit card, right.
40:35
So that's a very big spread.
40:38
Direct financing is service fees, right.
40:40
So you know you know maybe the particular account you have like have a service fee or maybe you
need a particular item from the bank, bank draft bank acceptance something like that there's service
fees.
40:59
OK.
40:59
Trends are going on in financial markets, what is called financial engineering and derivative securities.
41:07
We won't talk too much about this.
41:08
This is more advanced stuff, but this is just being creative with finance.
41:13
For example, mortgage-backed securities.
41:16
I'm not gonna go too deep into it, but if you want, it's something you can you can read about on your
own.
41:22
Generally there's been big advances in technology over time.
41:26
You know, it started with things like ATM and then online banking and and now there's, you know,
even more and more.
41:33
You know, you can do mobile banking on your phone and whatnot.
41:39
There's been deregulation.
41:41
This is especially the case of the United States.
41:44
Bank regulations have relaxed a bit over time.
41:49
Corporate governance reform, OK, Companies have been under scrutiny to to govern themselves
better.
41:58
There's been major corporate scandals over the years, you know, things like Enron, accounting, fraud,
whatnot.
42:05
But the point is there's been a lot of pressure for for companies to make sure that they have good
governance in that investors not misled.
42:13
We also have things like hedge funds.
42:15
This is example of private equity where they they sort of play by a different set of rules.
42:22
We won't go too far into that.
42:23
Now subprime markets, so basically markets where you have less than stellar participants.
42:31
So if you think about a mortgage, if you have a prime borrower for a mortgage that somebody who
has a very high credit rate in, they're not going to in a very low chance of not paying you back.
42:42
A subprime borrower is somebody who does not have such a good credit rating, but at the same time
it could be profitable for the bank to transact with such for that person.
42:52
You know we lose some trends in in finance, OK, OK.
43:00
So that's that's chapter one in a nutshell.
43:05
Any any questions about chapter one before I move on, let's see who we have, Samantha, Sarah,
Spencer, Aiden, Carl, Courtney, Irene, Malik, Ryan Wang.
43:24
Any any questions or is that OK?
43:31
Don't don't be shy if you have questions.
43:34
OK, OK.
43:36
So let's chapter one, our plan, then let's, let's take a short break and then we'll do Chapter 2 and then
we'll call that a a day for our first session.
43:50
Just a reminder.
43:51
OK, Just a reminder, there is a list of homework questions posted for for the chapters.
43:58
So if you go to resources and Howl and you click on it, OK, I'll pull up a Word document.
44:04
Let me share my screen actually, so you can see.
44:10
OK.
44:13
OK, so you can see here the questions I've put down for each chapter.
44:18
So chapter one, you should do all of the concept review and critical thinking questions.
44:22
OK.
44:24
Chapter 2, all of those plus 814 and 16.
44:27
OK.
44:30
And I also post the the solutions.
44:34
OK, OK.
44:37
So let's take, let's take a 10 minute break.
44:39
So it's 11:04 and 11:15.
44:43
OK And now we're gonna do chapter two.
44:45
OK, so 10 minute break, come back at at 11:15.
44:49
OK.
44:51
Excuse me.
44:53
Go ahead.
44:54
Just want to ask a question.
44:56
Just like just I just read the summary slide then and then there's what ethical in fasting is.
45:04
And and I like and yeah, I'm still a bit confused on that.
45:10
OK, Ask me, ask me after the break and then I'll talk about it.
45:13
So everybody hears it.
45:14
OK.
45:16
OK.
45:16
OK.
56:51
OK.
56:51
Let's continue on.
56:53
So hopefully everybody had a little break and refreshed.
56:58
Before the break, a young lady asked me a question about ethical investing.
57:05
So let me just clarify what that is.
57:10
Think of a situation where let's say you have $100 to invest, OK?
57:15
And you have two investment opportunities, call it A or B, doesn't matter what those are for right now.
57:21
It could be a stock in a company, it could be a bond, it could be a derivative, doesn't matter.
57:27
But just to make it simple, let's let's assume it's a stock.
57:31
OK.
57:32
So you're thinking of an equity investment in two companies, Company A, Company B and you have
$100.
57:39
If you put your $100 into Company A by the end of the year, let's say you'll get $110.00, so 10%
return.
57:46
If you put your money into Company B, let's say by the end of the year, you expect to get 115 dollars,
15% return.
57:54
Looking at it strictly from an investment standpoint, Company B has the higher expected return.
58:01
So it's the it's the better investment.
58:03
OK.
58:05
That's a very simple approach.
58:07
That's that's just looking only at the total expected return.
58:11
We haven't considered anything like the level of risk or or anything like that.
58:14
But just to make it simple, we're only looking at the total return now.
58:21
Even though A has a lower expected return, it may be a better investment when we add extra
conditions.
58:28
One of those conditions could be ethical and social invested.
58:33
For example, maybe Company B is an industry that you consider to be unethical.
58:40
OK, you know maybe it makes like I said, maybe it makes cigarettes or maybe it owns casinos or
something that you may personally object to.
58:48
OK, now I think ethical invest in is what we call heterogeneous.
58:53
One person may find unethical, another person may not.
58:56
OK, there's some heterogeneity there.
59:00
The the point is ethical invest in adds A constraint or restricts the universe of possible investments.
59:09
OK.
59:11
So even though you get a lower return, a lower expected return on Company A, if you are, quote UN
quote, ethical investor, you may want to put your money in Company A.
59:23
OK.
59:24
So ethical investment is just one filter or one constraint on investment choices, OK.
59:32
Another another constraint that we'll talk more about in the future is risk.
59:36
OK.
59:37
So even though Company B may have a higher return, it may be riskier.
59:42
OK.
59:42
Maybe you have a higher chance of losing more money.
59:46
OK.
59:47
But we'll talk about risk.
59:49
Let me let me go and talk about equity later in the course.
59:52
OK.
59:54
So any any questions about chapter one before I move on?
59:59
Any other questions?
1:00:05
OK.
1:00:06
So let's move on then to Chapter 2 again with the PowerPoints, we don't do every single slide, OK.
1:00:15
Just follow along for the slides that I emphasize.
1:00:21
So here we're gonna talk about financial statements, taxes and cash flows.
1:00:25
The financial statements, I'm gonna go very quickly through because you should know this and if you
don't, you wanna just dust off your accounting text and and refresh.
1:00:35
OK.
1:00:37
So the statement of financial position, you can think of this as a snapshot.
1:00:42
OK.
1:00:42
This is a snapshot of the firm at a point in time.
1:00:45
The assets, the liabilities, assets are listed in the order of liquidity.
1:00:50
OK.
1:00:50
So how quickly can we convert them to cash without loss of value?
1:00:54
OK.
1:00:55
Of course, the very famous accounting identity assets equals liabilities plus stockholders equity.
1:01:02
OK.
1:01:05
You can see here the difference between current assets and current liabilities is what we call net
working capital.
1:01:11
OK.
1:01:12
That's also very important, OK.
1:01:18
Net working capital, it's, it's positive when the cash that will be received over the next 12 months
exceeds the cash that we paid out.
1:01:25
And as a general rule, it should be positive in a healthy firm, not a large positive but a small positive,
right a negative.
1:01:33
Networking cash flow is very problematic because you may have you may have to convert some
illiquid assets at great loss of value or you may always be on the cusp of of legal action by your
creditors on bankruptcy.
1:01:50
Liquidity is how quickly you can convert to cash, OK.
1:01:56
But obviously cash by definition is the most liquid.
1:02:01
OK, another example would be things like Treasury bills, U.S.
1:02:07
Treasury bills.
1:02:07
So the Treasury bill is a short term loan to the US government.
1:02:11
The very, very liquid security.
1:02:14
You know, the many people who want to hold it, not not people per SE, but institutions and whatnot.
1:02:21
This is just you should, you should know this an example here of a statement of financial position.
1:02:29
A value verse cost.
1:02:31
OK.
1:02:32
Well, the statement of financial position provides the book value or the historical value, OK, of the
assets, liability and equity.
1:02:42
Market value is the price at which the asset liability or equity can actually be bought or sold.
1:02:48
OK.
1:02:50
Now market value and book value tend to diverge.
1:02:55
However, for reasons of accuracy, we often use book value, OK.
1:03:00
And and the reason is, is that market value, especially for a lot of assets and liabilities can be very hard
to know with certainty.
1:03:08
You know, it's what we call thick and thin market.
1:03:10
So if you have a thick market, you have a lot of buyers and sellers and a thin market you have few.
1:03:18
It's especially problematic to value assets that are traded in thin markets.
1:03:22
OK.
1:03:25
If you're interested, I won't go too deep into this, but just for your own knowledge, there's something
called transfer pricing and this deals with intra company markets.
1:03:37
So what do I mean by that?
1:03:38
Well, if you have, let's say a coffee company, Starbucks in the US and then you have Starbucks in the
UK and Starbucks in the US sell some intellectual property to Starbucks in the UK.
1:03:51
So for example, they have a method how to how to, you know, ground their coffee beans that that
method is worth something, it's intellectual property.
1:04:00
But the only buyer, the only one they're willing to sell it to is Starbucks in the UK That's a very thin
market.
1:04:06
So estimating the price of that asset is, is very difficult, OK.
1:04:12
So market value even though it's it's the latest number until the transaction actually happens, it's very
difficult to know the market value of a lot of assets and liabilities.
1:04:23
OK.
1:04:26
And which one is more important to the decision making process?
1:04:28
Well, it depends on the context, OK.
1:04:30
It depends on what we're trying to do, OK.
1:04:35
You know if the firm's about to be liquidated then obviously market value OK.
1:04:40
If accuracy is is primal, OK.
1:04:44
If you know for example, you know the auditors have to sign off on this before it goes to the the
shareholders in the annual general meeting, then book value would be OK.
1:04:55
So of course you know companies all around the world have to report you know their financial
positions and and there has to be some consistency.
1:05:07
This is why we have accounting standards and the current standard is what we call IFRS international
financial importance standard.
1:05:15
OK, I'm not gonna go too deep into this, but that's, that's the current standard.
1:05:23
OK, So it allows companies to use the historical cost method, but it also allows revaluation.
1:05:30
OK.
1:05:31
But there's a couple of caveats.
1:05:34
The items in the asset class should be revalued simultaneously.
1:05:38
So you have to revalue all of them or none of them.
1:05:41
And revaluation should be performed with enough regularity to ensure that the carrying amount is
not materially different from the fair value.
1:05:50
OK.
1:05:51
So this should be performed regularly enough that you know your financial statements are not like a
museum, OK, but they're they're up to date, OK.
1:06:05
Statement of comprehensive income, OK.
1:06:07
It's as opposed to being a snapshot, it's like a video.
1:06:10
It captures what happened over over that 12 month period.
1:06:14
The matching principle of IFRS says we show the revenue when it accrues and match the expenses
required to generate the revenue.
1:06:26
OK.
1:06:31
So again, you would have, you would have seen these statements.
1:06:33
I'm not gonna spend time on them, OK.
1:06:37
Cedar is a very useful site, OK.
1:06:41
It's a good way to find information on companies, OK.
1:06:47
Publicly traded companies in Ontario have to register with what we call the OSC Ontario Securities.
1:06:55
OK.
1:06:55
Cash flow is one of the most important financial statements, but often overlooked, OK.
1:07:01
And it's a good way to spot a firm that could be, could be in trouble or or coming up to trouble or a
good way to spot a firm that may be underperforming.
1:07:11
OK.
1:07:11
Well, it looks at the sources of cash and the uses of cash.
1:07:15
OK.
1:07:17
I'll give you an example momentarily as to why this is critically important.
1:07:22
So we have what's called cash flow from assets.
1:07:26
So cash flow from assets has to equal the cash flow to the bondholders plus the cash flow to the
shareholders.
1:07:31
So the the cash that our assets generate have to go back to the providers of capital and the cash flow
from assets has to equal the operating cash flow minus the net capital spending.
1:07:45
So the the net, the money we spent on buying the equipment versus selling existing equipment minus
the changes in working capital.
1:07:56
So let me let me give you a little bit of context as to why this is important.
1:08:03
You know, you can have a company, let's say it has $1,000,000 cash and you have a comparable
company.
1:08:08
It also has $1,000,000 cash, OK.
1:08:11
At first glance, those companies seem comparable, right?
1:08:15
But where that cash comes from is very important.
1:08:19
Did that $1,000,000 come from cash from operations?
1:08:22
Did that $1,000,000 come from cash from, you know, from financing from a loan?
1:08:28
Did it come from cash from investment in terms of we sold some investments, right?
1:08:34
You know where that came from and how it came from is a very important piece of information, right?
1:08:42
You know, a company that has to monetize its assets, you know, in order to meet bill payments,
probably that's not as as healthy as a company that made $1,000,000 off of operations.
1:08:52
OK.
1:08:53
So you want to pay close attention to this.
1:08:56
Here's an example.
1:08:58
The operating cash flow for the income statement is earnings before interest and tax plus depreciation
minus taxes.
1:09:07
OK, is 509 dollars here and you can read the full example in the text net capital expending.
1:09:16
So we we pull this book from the balance sheet and income statement is the end in net fixed assets
minus the beginning net fixed assets plus depreciation.
1:09:25
If you remember from accounting depreciation is a non cash transaction.
1:09:29
So when we depreciate something we don't write a check, there's no national office of depreciation
we send this check to right.
1:09:36
It's just it's a non cash transaction, but you can find here the changes in net working capital, OK.
1:09:46
And we can also account for where this cash goes that we have our cash from assets, OK.
1:09:55
You have your cash flow to creditors, OK.
1:09:58
And would something just check in the, the cash flow identity which was shown in the earlier slide
here, Slide 15, OK.
1:10:09
OK.
1:10:09
So the cash identity tells me that my cash flow from assets equals my cash flow to the creditors, OK,
plus the cash flow to the shareholders.
1:10:17
So if you remember in chapter one, we have that diagram right, the financial markets give us cash, OK.
1:10:24
We use that cash to buy assets to generate more cash.
1:10:27
Some of that money has to go back to the providers of capital.
1:10:30
Right here we're simplifying it a bit We're we're, we're kind of exempting government between
earnings.
1:10:35
But broadly we're seeing that the cash from the assets has to go back to the providers of capital.
1:10:41
OK.
1:10:43
And you can you can see here some of the other identities, OK.
1:10:51
So I'm not I'm not gonna go over that.
1:10:55
All right.
1:10:56
Taxes are important the the old adage the old saying 2 guarantees of life death and taxes.
1:11:04
Right.
1:11:05
That that saying shows you how taxes have become so embedded in the human experience.
1:11:11
So we have individual versus corporate taxes.
1:11:15
In fact there are many type of taxes.
1:11:16
You know, we have taxes on international trade, we have tariffs, we have indirect taxes.
1:11:21
You know, HST, we have value added taxes, we have property taxes, right.
1:11:28
We have very long list of taxes, but a particular focus in our course is individual and corporate tax, OK.
1:11:36
Another important concept is the marginal versus the average tax rate.
1:11:41
OK.
1:11:42
So the marginal is the tax you pay on each additional dollar, OK.
1:11:48
The average tax is the tax you paid overall, OK.
1:11:55
So they appreciate the difference in, in most countries.
1:12:00
In Canada and the US, we have what's called a progressive tax system.
1:12:04
So the more you make, the more you're taxed.
1:12:06
OK, but it it goes, it's like a step function.
1:12:09
So between, you know, zero and, you know, $12,000, I believe you pay no tax between 12:00 and you
know, 30 something.
1:12:16
You pay, you know, a a certain amount of tax.
1:12:20
In fact, I'll show you the actual number.
1:12:22
Let me just pull it up here for you guys.
1:12:28
Bear with me for a second.
1:12:43
All right, let me just pull it up to show you here.
1:12:52
OK, share screen.
1:12:57
So you can see here in a country like Canada, OK, you this is the Ontario level.
1:13:03
But if we take a look at the combined, OK, so in 2021 on the right on the 1st 45,000 here, well let's just
do the Ontario one, let's probably make it easier.
1:13:21
So on the on the 1st 45,000 you're gonna pay 5%, OK, between 45 and 99.1.
1:13:30
OK, 90 to one 5011.16 and over 220.
1:13:34
Now those are those are Ontario only.
1:13:37
You also have to pay federal tax.
1:13:39
So you can see here the combined rates.
1:13:41
OK, so the the point here, you know, so let's say you have $220,000 of income.
1:13:51
If you earn one more dollar, you're gonna pay 53% of that one more dollar in tax.
1:13:56
If you have 45,000 income and you earn one more dollar, you're gonna pay only 20% of that dollar in
tax.
1:14:02
OK, So that's why the marginal and the average rates can differ.
1:14:09
OK.
1:14:10
So OK.
1:14:15
So that's where the marginal and the average rates can differ so much.
1:14:18
So the average rate is the the total amount of taxes you paid for the year divided by your total
income.
1:14:23
OK.
1:14:25
And the marginal rate is the rate you pay on that additional, any additional income.
1:14:29
And as long as the marginal rate is higher than the average rate, your average rate is going to go up.
1:14:34
OK.
1:14:38
OK.
1:14:41
Now there's different types of income, so you know the one that you'd be most familiar with would be
wages and salaries, right.
1:14:49
That's what we call ordinary income, wages and salaries.
1:14:53
Of course there's also investment income, dividends, capital gains, billing attacks differently.
1:15:00
So dividends are taxed under a sophisticated system called the the dividend gross up in tax credit
system which we're not going to get into the to the details.
1:15:10
But the point is from a tax standpoint, the different types of income are treated differently and there's
some larger policy reasons as to why that is, but it's more of a public finance question.
1:15:24
So the point for us as practitioners, corporate finance managers is to understand the differences and
and we're not so concerned about why they're different because it's sort of beyond our scope, but we
want to work with those differences.
1:15:40
So capital gain for example is when you sell an asset at a higher price than what you paid for it, OK.
1:15:47
And the tax you pay on that is, is typically at 50% your marginal rate, OK.
1:15:54
The, the taxes you pay on dividends are at A at a lower rate than what you would pay on your income
usually.
1:16:00
OK.
1:16:03
So the point is you you try to package yourself in such a way that you minimize your tax.
1:16:11
Now for a lot of people that's not always possible.
1:16:14
Most people can't really go to their company and say hey pay me with, you know, in such a way that I
got a capital gain.
1:16:21
Most people have, you know, just take wages and salaries.
1:16:23
But in terms of wealth management, if you if you deal with high net worth individuals, this really
comes into play.
1:16:30
OK, OK.
1:16:34
This is important capital cost allowance.
1:16:37
I think you would have been exposed to this in accounting.
1:16:42
So I don't want to speak too much about this, but let me let me check with you guys to make sure
you've got some exposure to this.
1:16:49
Can anybody tell me from your past accounting class, if you if you cover this, Abby, Carly, Jim, Julia,
Malik, did you cover capital cost allowance?
1:17:03
Anybody can chime in?
1:17:06
No.
1:17:07
Yeah.
1:17:07
No.
1:17:08
OK.
1:17:09
So I'll just speak about it a little bit.
1:17:12
So of course, assets lose usefulness over time.
1:17:17
This is why we depreciate them, right?
1:17:19
I mean, a computer you bought and years ago isn't going to have the same usefulness as a computer
you bought today, right?
1:17:25
Probably has minimal usefulness, maybe just a giant paperweight.
1:17:29
OK.
1:17:30
So we have to depreciate, right?
1:17:32
Because we want our financial statements to be accurate.
1:17:34
So if we don't depreciate, an investor can be misled.
1:17:37
They would say what?
1:17:37
You paid $5000 for this computer 10 years ago.
1:17:41
They're telling me it's still a $5000 asset.
1:17:43
That obviously wouldn't, you know, wouldn't work.
1:17:46
You'd be misleading the investor.
1:17:49
So the other problem is how much do we depreciate?
1:17:52
We can't just let anybody choose the amount.
1:17:54
There has to be a standardized way.
1:17:56
This is called capital cost allowance.
1:17:58
It's a standardized way to do depreciations.
1:18:02
Every asset is put into an asset class assigned by the government, in this case the CRA case the US
would be IRS and every every asset class is given a depreciation method in a rate, OK.
1:18:15
For example they might say it's straight line over you know 10 years.
1:18:20
OK, at a rate of 10% a year.
1:18:22
OK.
1:18:23
Of course the in the first year you buy the asset, OK you we we do what's called the half year rule, OK.
1:18:33
So only only half the assets cost can be used for depreciation in the first year.
1:18:38
And that's just to make it relatively simple.
1:18:39
I mean in in theory you'd have to prorate it.
1:18:43
So if for example you bought an asset and you only had one month of that year, you'd have to prorate
it, but it would become more complicated.
1:18:50
So we we simply use a broad standardized rule that for the first year of the asset we depreciate only
half the amount.
1:19:00
Now you may wonder why this is so important.
1:19:02
Well, depreciation is a is a pretty big category for most companies and it has big ramifications on the
cash flow, OK.
1:19:11
And in finance, cash is our unit of analysis, OK.
1:19:15
There's an old phrase, cash is king versus accounting.
1:19:18
Profit is our unit of analysis, OK.
1:19:21
So anything that affects cash, we're particularly interested in.
1:19:25
And depreciation is that item.
1:19:28
OK.
1:19:28
Well, you can see here for example some of the classes that affect CCA, you can see here, look at class
10 for example, this would be vans, trucks, tractors, right.
1:19:43
And this is a rate of 30%.
1:19:45
So these things depreciate pretty quickly.
1:19:49
So how do we calculate this?
1:19:50
Well, ABC Corporation purchased $100,000 worth of photocopiers in 2015.
1:19:57
Photocopiers fall under asset Class 8 will be have ACCA rate of 20%.
1:20:04
And how much CCA will be claimed in 2015 and 2016?
1:20:11
So again we bought this 2015, we used the half year rule, so 50% of 100,000 is 50,000.
1:20:20
We're gonna depreciate that 50,000 at the rate of 20%, so 10,000.
1:20:26
So at the end of the year, OK, the ending fixed asset is the 50,000 minus the 10,000 of depreciation or
40,000, OK.
1:20:38
So next year, OK, we get, we're gonna start here with with 90,000, right.
1:20:49
So we had a, we had an asset that had an original value of 100,000 and we depreciated 10,000, OK, so
that's $90,000 start.
1:21:01
We then depreciate that at 20% that's $18,000.
1:21:05
So at the end of the second year the asset has a a value on our financial statement or the statement of
financial position of $72,000, OK.
1:21:17
So that's how we apply CCA.
1:21:20
When when you work through the questions, this will this will set in, but it's a very important
calculation to do.
1:21:31
OK, yes, go ahead.
1:21:35
I have a question for the slides.
1:21:37
Yeah, since it says you only use half, shouldn't add it back at when it comes to the ending fixed assets,
yeah, you can do it that way as well.
1:21:47
That's that's fine.
1:21:48
You can either think of it as the 100,000 subtract 10,000 or you can think of the ending fixed asset
plus the beginning fixed asset 90,000.
1:21:57
Either either way will get you the same answer.
1:22:01
OK, yeah.
1:22:04
So CCA firms typically have multiple machines.
1:22:08
So you think about an office, they might not just have one photocopier.
1:22:14
You know, maybe each each floor of a major office building has a photocopier, right?
1:22:17
Maybe you have, you know, five or six.
1:22:20
So when an asset is sold, the asset class is reduced by the realized value of the asset or by its original
cost, whichever is less.
1:22:32
OK.
1:22:33
So the point is obviously CCA is not a perfectly precise tool, right?
1:22:40
The government has just assigned a rate to make financial statements comparable and more
consistent across companies.
1:22:47
But there's no, the ultimate rate that that machine is sold at is determined in negotiations between a
buyer and a seller.
1:22:55
OK.
1:22:56
So what what they're trying to say here is there's some flexibility when the asset is actually sold, OK.
1:23:02
And the means the asset class is reduced by either the realized value of the asset, So what we sold it
for or by its original cost, whichever one is less, OK.
1:23:16
So close in an asset class.
1:23:17
So when the last asset in an asset class is sold, so for example the last photocopier is sold, we have
nothing else left in that particular class.
1:23:26
We have to terminate it.
1:23:28
Now this is where it gets a little bit tricky.
1:23:31
OK, we either get what's called a terminal loss or recapture CCA.
1:23:37
Before I go to the technical details, let me just explain this at an intuitive level.
1:23:43
So if we have an asset, let's say the asset was $1000 and let's say, you know, let's let's say we think it's
gonna last 10 years and in year five, let's say the asset is now $500 on our books.
1:23:59
OK, so we've depreciated at $100 a year.
1:24:02
Now in year five, let's pretend we sell that asset and consider 2 cases.
1:24:09
Case one, we sell that asset for more than $500.00.
1:24:12
So let's say we sell it for 600.
1:24:15
OK, well, what happens then?
1:24:17
That means we depreciated that asset too much.
1:24:20
OK.
1:24:21
And if, if 'cause we sold it for more than than what we think it's real economic value is, and if we've
depreciated the asset too much, it means we didn't pay enough tax, right?
1:24:33
Because the more you depreciate something, the more you lower your profit.
1:24:36
And the lower your profit, the lower your tax.
1:24:39
OK.
1:24:41
So in that case, we have what's called a recapture in the case where let's say we sell it for less, so let's
say we sell it for 400 versus 500, it means we paid too much tax.
1:24:51
OK, so now let's add some terminology.
1:24:55
At terminal loss, the difference between the UCC, the UN depreciated capital cost and the adjusted
cost when the UCC is greater recapture CCA is the taxable difference between the adjusted cost and
the UCC when the UCC is smaller.
1:25:18
OK, so if you take a look here, here's an example.
1:25:25
Cool Drinks Corporation purchased 300,000 worth of bottling machinery in 2013.
1:25:33
Machinery falls under an asset class 43 with ACCA rate of 30%.
1:25:38
OK, in 2015, Cool Drinks sold the machinery for 150,000 and moved the production of Mexico.
1:25:46
Was there capital gain?
1:25:47
ACCA would capture a terminal loss and one of the machinery was sold for 1:20.
1:25:56
So let me take a look here.
1:25:59
You can see here in 2013, the beginning the underappreciated capital cost is 150, OK, 'cause we we
bought this machine for 300,000, but the half year rule we we use only half the amount, OK?
1:26:12
And then we're using the rate of 30%, so 30% of 150 is 45, so we get the ending UCC, OK.
1:26:21
So one O 5.
1:26:25
So we can we can add our beginning and our ending UCC to start off 2014.
1:26:31
We depreciate again by the by the rate and we follow this through.
1:26:35
And we can see at the end of 2015, the number we have on our books for the asset is 1/24, 9:50, that's
that's the UN depreciated amount, OK.
1:26:45
That's what's left.
1:26:48
So we, we, we're now assuming 2 cases, one where we sell it for 1:50 and 1:00 where we sell it for 120,
OK.
1:26:57
So if we consider the case, so if we sell for 1:50, there's no capital gain.
1:27:05
The capital gain means we would have sold it for more than the initial amount, so more than 300,000.
1:27:10
OK.
1:27:10
So there's no capital gain.
1:27:13
There is what's called the CCA recapture.
1:27:16
OK.
1:27:17
Because it means we depreciated our asset too much.
1:27:21
OK.
1:27:22
So there's ACCA recapture of 25,000 and $50, OK.
1:27:28
Versus if you saw that at 1:20, we have a terminal loss of 4950 means we didn't, we didn't depreciate it
enough.
1:27:40
OK.
1:27:41
So that's two.
1:27:43
I don't, I don't go over the summary of the quick quiz because you you're going to get plenty of
practice when you do the questions.
1:27:52
So it's very important that you work through those questions diligently.
1:27:57
This this is a tough class.
1:27:59
A lot of students find finance to be a demanding class, so.
MOS2310A_S23_Chp3_Lecture
0:09
OK, so like I said, we're going to do chapter three.
0:13
You can also download the PowerPoint and follow along that way.
0:17
Make sure you are keeping up with the homework.
0:20
So I did post a list of homework questions on OWL and the solutions are there as well.
0:26
So it's very important that you you make sure you do those.
0:30
OK, I I always tell students finance is not a spectator sport.
0:35
The way you'll master it is to practice, practice, practice.
0:38
OK, so without further ado, let me start the slideshow here.
0:54
We're gonna talk about financial statement.
0:57
Now the question I often get asked is how much accounting do you need to know and obviously this
is not an accounting class, it's a finance class, but accounting is very important.
1:08
OK.
1:10
So for finance, accounting is a key input, OK, input to production if you will, if our financial analysis.
1:17
So I'm not going to ask you to prepare financial statements, but you want to be able to deal with
financial statements from an end user standpoint, OK.
1:26
So if you're given a cash flow statement, balance sheet and income statement, you wanna be able to
look at these and understand them and and you know, be able to come up with some meaningful
analysis.
1:38
OK.
1:39
So you should be familiar with the three basic financial statements.
1:43
And this chapter is just a quick review.
1:45
It's not, it's not meant to be a comprehensive study of those financial statements.
1:50
OK.
1:51
So if you feel like you're a bit rusty on this, you should go back to your accounting notes and refresh.
1:59
OK.
2:02
OK.
2:04
So if we take a look here at the statement of financial position, which is loosely equivalent to a balance
sheet, OK, There's some technical differences, but for our purposes, they're roughly the same.
2:17
You can see here on our asset side, assets are listed in order of liquidity, OK.
2:23
And liquidity is how quickly we can convert something to cash.
2:26
By definition, cash itself is the most liquid.
2:29
OK.
2:32
On the second column, OK, you can you can see here.
2:35
So we have a change.
2:36
We have some what's called time series data.
2:38
We have our 2014 numbers and our 2015 numbers.
2:42
And in the in the, in the well the third column here you have your liabilities, OK, also listed in order of
maturity here.
2:51
OK.
2:53
And your equity, OK.
2:55
And of course, as you remember, the fundamental equation from accounting assets equals liabilities
plus owner's equity.
3:02
OK, now you should be able to recognize this.
3:07
We're going to talk about the analysis momentarily, but you should be fairly comfortable with seeing
this, recognizing the categories and being able to read such a statement.
3:21
The statement of comprehensive income, you can see here in contrast to the statement of financial
position, financial position is like a snapshot, OK, at at a point in time.
3:33
So this is more like a video over a period of time, OK.
3:39
So you can see we have our revenues here.
3:42
We have our cost of goods sold.
3:43
We have our EBIT, OK, earnings before interest and tax.
3:47
Often you see IP and DUH earnings before interest, tax, depreciation, amortization, OK, You have
interest, taxable income.
3:56
OK.
3:57
And here we have this, this?
3:59
Want to figure out how much could be put into retained earnings?
4:03
Well, it's pretty obvious when you have net income, you can do one or two things with it.
4:07
You can either keep it in the company or you can pay it out to the owners, OK.
4:14
OK.
4:15
Now we start to get into the financial analysis, OK.
4:20
And off the bat, the most important thing to remember is that the unit of analysis in finance is cash,
OK.
4:29
This is in contrast to accounting where the unit of analysis is profit, OK.
4:35
And the reason that they differ is that profit involves a lot of value judgment, OK.
4:40
Doesn't mean it's bad, doesn't mean it's, it's the wrong measure.
4:43
But for our purposes, we, we want something that's not controversial, right.
4:47
And if you think about how profit is calculated, if you, if you look back at our income statement in in
more complex cases there's a lot of value judgments that have to be made.
4:59
So for example depreciation, you know even though we use a government schedule, we can't say
exactly that this machine will lose that level of economic value.
5:11
If you look at something like IPDA, earnings before interest, tax, depreciation, amortization, you know,
interest expense can be manipulated, tax can be manipulated, depreciation, amortization, all of those
involve value judgments, OK.
5:26
Whereas if you look at cash as a measure, it's not controversial, right?
5:31
You would say to a business, look either you have $1,000,000 cash in the bank or you don't.
5:35
There's there's no two ways about it, right.
5:37
It's, it's a yes or no answer.
5:38
Whereas you might say is your profit, you know, $100,000 possibly you could probably massage that
number based on some assumptions.
5:47
So the way is that in finance, the unit of analysis is cash.
5:53
OK, OK.
5:55
So we want to pay a lot of attention to the sources and use of cash.
6:00
And even when you go into more sophisticated, you know, sophisticated utilizations of finance, for
example, valuations of companies, it's all discounted cash flow, OK.
6:10
It's all discounted cash flow models what's called free cash flow to the firm.
6:16
So cash is critically important.
6:18
OK.
6:19
So we wanna get it.
6:20
What are some sources of cash?
6:22
Well, if we sell something obviously that's gonna bring us cash, maybe not immediately maybe we
sold that item on credit, but at some point we expect to get cash if we decrease in asset account, OK.
6:38
So for example, if we, if we sell one of our assets as opposed to selling a product so that you know our
assets have decreased.
6:44
If we increase our liabilities that's effectively as if we've been given cash.
6:49
So if we buy something on credit, it's a, it's a parallel that we've been giving cash and same thing with
equity and how is cash used?
6:59
Well, if we buy something that's obviously going to deteriorate our cash and if we increase an asset
account, right.
7:07
So you know we're gaining something of value and asset.
7:10
So we have to draw down cash to get that and a decrease in the liability.
7:15
So we've paid off the debt or or we have a decrease in equity, OK.
7:18
So and that just stems from that fundamental accounting equation.
7:26
So the statement of cash flow is very important in finance and it's a statement that summarizes the
sources and uses of cash, OK.
7:37
And it changes dividends into three major categories.
7:42
Sorry, the changes are divided, not dividends.
7:44
The changes are divided into three major categories, operating activity, investment activity and
finance and activity.
7:51
And I'll give you some context as to why this is so important.
7:55
OK, imagine you have two companies, Company A and Company B and both companies have
$1,000,000 in cash.
8:03
OK, To the untrained eye, they may look comparable, right?
8:08
If we, if we simply said cash is a good enough analysis, they both have $1,000,000.
8:13
They seem equally well off, but where that $1,000,000 comes from has an important role to play.
8:22
For example, was that $1,000,000 derived from operating activities, right.
8:27
So here operating activities includes net income and changes in current accounts.
8:32
Was that $1,000,000 derived from investment activities included changes in fixed assets?
8:39
For example, we sold some of our fixed profit.
8:43
Was that $1,000,000 from financing activities?
8:47
So for example, we incurred some debt, stole some bonds or corporate notes as the case may be.
8:53
So knowing the source of that $1,000,000 is, is very important to our analysis of the company, right?
9:01
$1,000,000 that comes from operating activities sends a pretty strong signal $1,000,000 that comes
from financing activities, especially if the financing was you know very onerous, so very high interest
charges and a lot of specific covenants that doesn't bode a whole lot of confidence in our, in our
analysis of the well-being of the company.
9:24
OK.
9:25
So dividing the the cash flow into these three categories helps us a lot with our analysis.
9:31
OK.
9:33
Now you know if you had $1,000,000 cash from finance, finance activities, that's not always bad.
9:40
It could be a sign that external providers of capital have a lot of confidence in this company, especially
if they got the financing on very good terms.
9:48
OK.
9:49
So we need to think about you know, the source.
10:02
OK.
10:06
So if we take a look here, here's a a sample statement of of cash flows.
10:12
So we take a look at the cash at the beginning of the year and we take a look at those 3 categories,
right?
10:18
Our operating activity, our investment activity and our finance and activity.
10:23
And from the beginning of the year to the end of the year, OK, we have to be able to account for the
change using these 3 broad categories.
10:33
As you can see here in my operating activity, I have my net income, OK, plus depreciation.
10:41
And actually that's a question for you guys.
10:43
Why do I add depreciation?
10:44
Does anybody know actually, who do we have today?
10:47
We have Abby, we have Aiden, We have Hannah, We have Jasmine, Lauren, Ming, Ming, Sarah,
Spencer.
10:56
Anybody know why am I adding depreciation here?
11:01
Don't be shy, feel free to to chime in.
11:07
Anybody know?
11:10
Anyone want to take a guess maybe because it's not like involved in the daily operations of the
company, so you have to add it back to get rid of it.
11:25
OK, you're on the right track.
11:28
Maybe we acquire the new assets, OK.
11:31
But think about it, think about it from the standpoint of cash.
11:34
So what, what is depreciation?
11:36
Why do we depreciate something?
11:39
Is it because it's like more of like a theoretical number and it's not actually affecting the cash account?
11:45
Very good, very good.
11:46
Yeah.
11:47
So the point of depreciating something is, you know, we're trying to give as much as we can, an
honest interpretation as to where this asset is AT.
11:57
And the thickness is the asset.
11:59
Most assets lose economic usefulness over time, right.
12:04
A computer you got 10 years ago, you know, even if you paid, you know, five $10,000 for it, it's not
going to, it's not going to have that same value today, right?
12:12
It's probably not compatible with the modern programs and whatnot.
12:15
So naturally you need to depreciate, OK.
12:18
But when you depreciate, you don't actually write a check to anybody, right?
12:22
You don't.
12:22
There's no department of depreciation that you sign a check to, right?
12:26
So depreciation is a non cash transaction, right?
12:30
So it, it doesn't affect our cash position, OK.
12:35
So if we think about it, it, it does show up on our income statement though, right?
12:40
So we have to add depreciation back, OK, 'cause we, it doesn't deter from our cash position, OK.
12:47
So if we start with net income, which was from the income statement, we have to add back
depreciation, OK.
12:56
Then you can see here we have increase in other current liabilities, less increase in accounts receivable.
13:04
OK.
13:05
Remember we said if we increase our liabilities that's as if we received cash, OK.
13:11
So you can, you can see here we can get the net cash from operations.
13:16
If we go to our next category, we have our fixed asset acquisition, OK.
13:21
So this acquisition means we've we've acquired something, we've bought something and then we can
have net cash from investments.
13:28
In some cases we may sell some of our fixed assets, that's not the case in in this particular example,
but it could happen for financing we have increase in notes payable, OK.
13:39
So that brought us some money.
13:41
We have increase in in long term debt, OK.
13:44
We have a decrease here.
13:47
OK.
13:50
OK.
13:51
We have a dividends paid, OK.
13:53
So that obviously takes away cash, OK.
13:57
Decrease in this is the the common shares here and net cash from financing, OK.
14:05
You can see from a cash standpoint, our cash position is deteriorated from the beginning of the year
to the end of the year, OK, about about a 50% deduction, OK.
14:17
And there's some statistical error here due to rounding of numbers, so it won't be exact.
14:22
Now a decrease in cash does not necessarily mean it's a bad thing.
14:28
It depends on what that cash is being used for, right.
14:32
So if we've acquired some equipment that so obviously we have a very big acquisition here.
14:38
If we've acquired some equipment that will generate funds into the future, that's that's good.
14:44
OK.
14:46
You know if we for example paid off very expensive debt, that's good as well.
14:51
So we want to take a look at, you know, what are the sources and uses of our cash at this point in
time.
14:58
We're simply looking at the sources, OK, where you know the three big buckets, operating investment,
financing, OK.
15:04
And we want to get a sense of where's the cash coming from.
15:06
We can also see here some of the some of the uses of cash, the acquisition and and whatnot.
15:13
So at this stage, we're simply looking at our firm in isolation that it's by itself.
15:21
When we get to more sophisticated analysis, we'll look at time series, compare the position of the firm
over time to take a look at the trajectory, is it improving, is it deteriorating?
15:31
And we'll also compare it to similar firms, what we call a peer group comparison.
15:37
OK.
15:39
So any any questions about the cash flow, the sample cash flow I just showed, Let me any questions
about that, I'll show it again.
15:49
This is very important for finance students.
15:52
OK.
15:56
OK.
15:57
Moving on then.
16:02
OK.
16:02
So one of the things or one of the useful tools I should say is the common size statement of financial
position and this allows us to compare companies of very different sizes, OK.
16:16
So we express the accounts as a percentage of the total assets.
16:20
We can do a parallel approach to the income statement.
16:24
We express all items as a percentage of sales, OK.
16:28
And again this, this allows us to compare companies a very different size.
16:33
So if we're looking at it from the standpoint of providing our client with, you know, if we're an
investment advisor and we want to look at you know, two very different companies, we need a way to
compare them effectively, right?
16:49
So you know, you can you can imagine if you wanted to compare like say you know a Fortune 500
company with a company that's privately held and you know relatively small, It would be unfair simply
to look at the raw numbers and say, hey, this company has, you know, a billion dollars in cash and the
other company has maybe 100,000, right?
17:15
You have to look at it as a percentage and and that gives you that that commonality.
17:22
So standardized statements like you said make it easy to compare financial information and useful
comparing companies of different size within the same industry.
17:33
So for example, we may be a portfolio manager and say you know what, we want to get some
exposure to the technology sector, you know, and we might say, well you know, at at that stage we
simply want exposure to any technology company that we think is good.
17:50
It doesn't matter if it's big or small, but then we need a way to compare the big and small companies
and and that's why we have the common size statements.
18:00
OK.
18:00
Another important tool, oops.
18:07
Another important tool is what we call ratio analysis.
18:10
I'm just gonna share my screen again.
18:15
OK.
18:19
There we go.
18:23
And ratio analysis, OK, ratio analysis, this is a way to develop some quick metrics.
18:32
OK.
18:34
So to give you an example, you know from automotive, if you know if you're going to buy a car,
there's often some very quick metrics.
18:42
You know, miles per gallon, horsepower, number of seats, things like that.
18:47
If you go to buy a house, there's some quick metrics.
18:50
You look at maybe the number of bedrooms, the square feet of the house, et cetera.
18:55
Same thing in finance, when we want to do a quick assessment, say a first pass of the company,
there's some metrics we look at, OK, We call these ratios, OK.
19:07
And this gives us a very quick assessment of the company's health.
19:10
And sometimes if the ratio's outside of a normal range, then we need to do a deeper investigation,
OK.
19:16
And you can think of it as a parallel to medicine that, you know, maybe you go for your annual
checkup.
19:22
There's certain things they look at.
19:24
And if one of those metrics seems out of line, they have to do a further test perhaps.
19:29
OK.
19:32
So we have our categories of financial ratios here.
19:36
OK.
19:37
We have what we call the short term solvency ratios, the long term ratios, OK, solvency ratios, asset
management, how well are the assets being managed, the profitability and market value ratios.
19:56
So again, maybe to give you a parallel to looking at a house, you might have different categories of
ratios.
20:01
So you have some things that signal the size of the house, right?
20:04
Maybe the number of bedrooms, the number square feet.
20:06
You might have some ratios or metrics that signal the locational desirability of the house, you know,
nearness to schools, nearness to hospitals, things like that, the postal code that may tell you
something about the area what not.
20:25
OK, well, liquidity ratios, these are really important, OK.
20:30
If you take a look at the first one, the current ratio, you have your current assets divided by your
current liabilities.
20:37
Now current assets and current liabilities, these are typically, it depends on the industry, but typically
these are these are items that will be converted into cash within six months or sometimes within a
year.
20:50
OK.
20:52
The point is, is if we don't pay attention to this, especially current liabilities, we can run into trouble.
20:59
Our creditors can force us to court, and we can end up in bankruptcy proceedings.
21:02
OK, so my current ratio says I have enough current assets here to cover my current liabilities.
21:10
OK, if this is less than one, it means you're in trouble.
21:15
It means that within a short time frame, your current liabilities are gonna come due and you don't
have enough assets that you can readily convert to cash to pay them.
21:23
OK.
21:23
So that's that's very problematic.
21:26
Even the current ratio of near one is a little bit dicey, OK, 'cause it means nothing can you don't have
much room for something to go wrong.
21:34
You know, one, if your assets is not as valuable as you think it is or or something to that effect.
21:39
So this is, this is sort of a measure of how much short term breathing room do you have?
21:44
OK.
21:46
The quick ratio is very similar to the current ratio except we subtract inventory and the reason we do
that is because inventory may not always be as liquid as we think it is, may not be that easy to to sell
that inventory.
22:02
OK, maybe a recession comes along, maybe there's some kind of product recall whatever the case
may be OK, the ratio that puts us the most at ease in terms of saving off any sort of short term
liquidity problem is the cash ratio.
22:21
Simply put, do we have enough cash to cover our our upcoming bills?
22:25
OK, you know, to give you a parallel to personal finance, maybe at the end of the month you have a
bill for bills, you for, let's say you know, $1000.
22:36
A friend of yours says, OK, I'm gonna give you $1000 in two weeks, OK, I I maybe some money that
they owe you.
22:42
And you might think, OK, that's, you know, that's the current asset account receivable.
22:47
But if for whatever reason your friend isn't that reliable, you can be in trouble.
22:52
Whereas if you take a look at how much cash you have, OK, then you know you have enough cash to
cover that particular liability, OK.
22:59
And here we cash doesn't necessarily mean pure cash, it means cash equivalent things like U.S.
23:07
Treasury bills for example.
23:09
It can, it can readily be converted into cash.
23:12
OK, OK.
23:15
Long term solvency ratios, the total debt ratios, imported total assets minus total equity divided by
assets.
23:24
This is really important.
23:26
So here the firm finances about 64% of its assets with debt.
23:31
This is important because the higher this ratio is, the more, the more problematic it is.
23:37
One, to service that debt.
23:39
You're gonna have higher interest charges.
23:40
Two, to get more debt if you need it.
23:44
And three, you also have to, I mean you have to have to look at.
23:49
When we study more in finance, you'll know that there's an optimal level of debt and you compare,
you know is the firm out of optimal, optimal debt level And also take a look at its peer group
comparison.
24:03
OK.
24:04
So some debt is OK.
24:07
And the simple reason for that is debt allows us to save some taxes.
24:11
We can expense our interest payments, but too much debt can be, can be burdensome because in a
bigger and bigger portion of your incoming revenue has to go to service that debt, the interest
payments of the principal, OK.
24:25
So it can sort of to some extent strangle the operations of the company, OK.
24:32
The debt to equity ratio, again this gives you a sense of your capital structure, the sources of capital
debt and equity 1.8 times here in isolation it doesn't mean that much.
24:45
You have to take a look at how does it compare to the peer group, OK.
24:51
Equity multiplier.
24:52
You can see here this is very similar to the first one, the total assets over the total equity.
25:01
Basically how effective is that equity in in terms of being converted into assets?
25:10
The cash coverage ratio is important, OK.
25:14
The times interest earned, this is your EBIT.
25:17
So the earnings before interest and tax divided by interest, OK.
25:22
So basically how, how effective are you using that interest to generate earnings?
25:27
OK.
25:28
Your cash coverage, cash coverage is also very important.
25:32
You have to make your interest payments, OK.
25:33
And you wanna make sure you have enough cash on hand.
25:37
So basically we have you know 22 times enough cash to cover our our upcoming interest payments,
OK, OK.
25:51
So for companies that have a lot of inventory, these two metrics are very important in terms of are we
managing our inventory effectively.
26:02
So the inventory turnover is my cost of goods sold divided by my inventory.
26:09
So it basically means that within a within a period my inventory turns over 4.53 times.
26:15
Again, this number doesn't mean much in isolation.
26:17
You have to compare it to other companies in your peer group.
26:21
If for example, the average inventory turnover is, you know, double this, you then need to wonder, OK,
what's what's going on?
26:29
You know, are we not are are sales not effective?
26:32
If so, why is that?
26:34
You know, are we not placing the products properly?
26:36
Do we not have the right sales network?
26:38
It requires deeper investigation, OK.
26:42
The days of the sales are inventory is 365 divided by the inventory turnover.
26:48
So it means that on average our it takes about 81 days to move our inventory.
26:52
OK.
26:53
And again that that may be good or bad, it depends on the particular context, OK.
27:00
You know, if we're talking about very large as machinery that might not be a bad thing.
27:03
If we're talking about, you know some sort of consumer staple like a grocery store, you know you
don't want a product to know on the shelf at a grocery store for 81 days.
27:12
It's not good at all.
27:17
Receivable ratios, this is pretty straightforward.
27:20
You know, how long has it taken us back to receivables?
27:23
OK.
27:23
Obviously these numbers are good.
27:28
You know the lower the number the better you have to look at the trajectory of the company.
27:32
Is this getting shorter and how does it compare to the care group comparison?
27:40
OK.
27:40
Total asset turnover.
27:42
OK.
27:42
This is, this is a that's pretty straightforward.
27:45
I'll let you just read that on your own.
27:50
OK.
27:50
So the total asset turnover is the sales divided by your total assets, OK.
27:56
And it's a measure of asset use efficiency.
27:59
So how are are those assets translated into sales?
28:02
OK.
28:03
It's not unusual for this number to be less than one, especially for firm has a large amount of, OK,
profitability ratios are important, OK.
28:18
These are often the first things we look at as an analyst, OK.
28:23
So the profit margin, I'm sure you've heard about this, it's your net income divided by sales.
28:31
You have a lot of sales, but you know if it's very expensive to facilitate those sales, you know, we have
a lot of Labor costs, maybe a lot of shipping cost.
28:40
We wanna know what do we really get at the end of the day, how much, how much net income can
we squeeze out of this?
28:45
OK, so the profit margin here is about 10%.
28:48
OK, Now that can be good, that can be bad.
28:51
And you have to look at the peer group, You have to look at the history and we have to understand
the, the broader context.
28:56
OK.
28:58
So the important thing to understand about these metrics is that history matters and context matters.
29:04
Most of these metrics, you can't really appreciate them in isolation.
29:07
You have to look at them in in relation to other competitor firms return on assets here, OK, we have
the net income divided by total assets, basically how, how effective are our assets being used to
generate income?
29:26
So we have 9.5% and the return on equity, how effective is our equity in generated income?
29:33
OK, OK.
29:39
So moving away from financial ratios, we want to look at market market value measures.
29:45
OK.
29:45
So these are in the public markets.
29:47
You can see the stock price often fluctuates.
29:50
Let's assume that the stock price is 6098.
29:54
We have a little bit over 205,000,000 shares outstanding.
30:00
We have the market value of the long term debt, OK.
30:04
And you can find EPS is very important.
30:06
You probably have this number all the time if you follow financial markets.
30:10
So you have your earnings per share which is the net income divided by the shares outstanding.
30:16
OK.
30:17
So each year theoretically entitles you to two point $3.29.
30:23
OK.
30:26
You probably hear a lot about the PDE ratio.
30:29
OK.
30:30
The which is the per share divided by the earnings per share.
30:35
OK, so here someone's willing to pay 26 times what those earnings per share are entitled to, to buy
that share.
30:45
And you might wonder, why is that?
30:47
And the short answer Well, actually I'll ask you why would somebody pay 26.6 times to buy to buy the
share?
30:57
Well, the share entitles you the $2.29 today, but you're willing to pay, you know, almost $61.00 for it.
31:06
Why?
31:07
Why would somebody do that?
31:13
Don't be sorry.
31:14
Share increases.
31:15
You say it again if the value of the share increases.
31:22
OK, yeah, very close.
31:24
We can.
31:25
We can add to that a little bit.
31:27
Anybody wanna comment?
31:34
Don't be shy.
31:35
Anybody.
31:36
Wang, Jasmine, Jen, Noah, Spencer, Victoria.
31:44
Maybe there's a huge sorry, go ahead.
31:47
Maybe there's a huge potential for the company to grow more than it earns right now.
31:52
Per share?
31:53
Yeah, absolutely.
31:54
I mean, why would you pay $61.00 to own a share?
31:58
So the share entitles you to the earnings of the company, but right now that share's only only gonna
give you $2.29 and you're gonna pay $61.00 for it.
32:06
But the only reason you would do that is you would believe over time that it's gonna become
valuable, right?
32:13
It it's it's the same reason why you'd buy any item where the current amount is less than what you're
paying for.
32:20
It is presumably you think it's gonna appreciate, right?
32:24
Even though owning that share today entitled through the $2.29, you're thinking to yourself OK over
time this is gonna add up.
32:32
OK, this is this might entitle me to $5, might entitle me to $6.
32:36
And if I add that up over the the period I'm willing to hold it for what's called the Holden.
32:42
That presumably it would be worth significantly more than than the $2.00 to you.
32:49
So that's that's why the PDE ratio, if you go this to be financial markets, which is a third year class that
I've taught, the PDE ratio also gives you a sense of the market sentiment.
33:03
Is the market bullish?
33:04
Is it bearish?
33:05
How does the PDE ratio compare to historical levels?
33:08
OK.
33:08
And the PDE ratio can even vary a lot by stock markets, you know, the New York Stock exchange
versus the PDE Stock Exchange etcetera, OK.
33:17
The PEG ratio is the PDE ratio divided by the expected earnings growth rate.
33:24
OK.
33:25
Times 100.
33:27
OK.
33:28
So if you take a look at that, OK.
33:33
So the market to book ratio, remember book is historical, OK.
33:38
So the market value per share divided by the book value to share, you know, keep in mind that book
value, the reason we use book values for accuracy, right.
33:50
You know, market value, it may be hard to gauge the market value for some assets, OK.
33:56
Enterprise value is your EV.
33:58
So the total value divided by Impeta.
34:02
So the enterprise value is the market value of equity plus the market value of debt plus the preferred
shares plus the minority interest minus cash and cash equivalents divided by impeta.
34:16
OK.
34:17
So the enterprise value is you basically to basically own the company, to own it in, in totality, you need
to own both the equity and the debt.
34:30
OK.
34:30
And you might wonder why this is the case.
34:33
Probably in your earlier study, your more elementary study, you were told not to own the company,
you just need to own the equity, which is mostly true, but it's a bit more complicated, considered two
states of the world, a state where the company is doing very well and the equity holders are basically
running the show.
34:53
But when the company is doing poorly, for example, if they're forced into bankruptcy proceedings and
they have to negotiate with their creditors, it's the debt holders that are in control.
35:03
They're the ones who have to agree and say we're willing to take this haircut, we're willing to take this
restructuring, etcetera.
35:09
So to truly own the company, you have to have both the debt and the equity, OK.
35:13
So the enterprise value is the market value of equity.
35:16
Here we're talking about common shares plus the market value of the debt plus preferred shares
because a lot of companies don't just have one type of share, they have multiple plus any minority
interest.
35:30
So if if another company has some sort of particular stakiness, OK, minus cash and cash equivalents,
OK.
35:39
So to to truly because the reason we subtract cash and cash equivalents is we don't want to double
count, OK.
35:47
So the market value of equity, OK, market value of debt, preferred shares, minor interest that sums up
to the enterprise value divided by impeta, OK.
35:57
So this, this gives us a sense here.
36:02
Again, this doesn't mean a whole lot in isolation, but if it's if you want to compare it to the peer group,
OK.
36:12
So this gives you a sense of how how effective is your is your earnings being translated into overall
value for the for the shareholders and the providers of profitable.
36:26
OK.
36:27
So this is just the summary of what we talked about.
36:31
OK.
36:31
So let's talk about the DuPont identity.
36:37
You don't need to worry a lot about the mathematics as to how this is derived, but the analysis is
important, OK?
36:48
And here, here's the analysis.
36:50
If you have two companies that have a return on equity of 5%, OK, return on equity is simply your
total equity, OK?
36:59
They're not income divided by your total equity.
37:02
If you have two companies that have a return on equity of 5%, to the untrained eye, you may think
that they're comparable.
37:07
You might say, OK, well, you know, both of them, both of them are generated 5% on that equity, OK.
37:14
But it's not that simple.
37:17
You wanna zoom in, Think of it like a microscope.
37:20
You wanna zoom in and decompose and items that look the same, but upon closer inspection can be
very different.
37:27
OK.
37:28
So you can see here that the return on equity is actually broken down into three components, OK?
37:35
We have our profit margin, our total asset turnover and our equity multiplier.
37:41
So you can have two companies that have the same return on equity, but the source, if you go one
level deeper, can be very different.
37:52
Is it coming from the profit margin?
37:53
Is it coming from the equity multiplier?
37:55
OK, so how do we, how do we use this?
38:00
So profit margin is a measure of the firm's operating efficiency, OK.
38:08
How well does it control its cost?
38:10
OK.
38:11
Because remember, there's two components to profit.
38:14
There's revenue and there's cost.
38:16
So you know, you can be doing great on the revenue side, but if you're not careful, your cost can, you
know, run out of control.
38:25
Total asset turnover is a measure of the firm's asset use efficiency.
38:29
How well does it manage its assets?
38:36
OK.
38:37
And equity multiplier is a measure of the firm's financial leverage.
38:41
Leverage means debt.
38:43
OK.
38:45
So again, you have a company that has the same return on equity as another company, but you want
to pay attention to the source, OK.
38:53
For example, you're getting return on equity from profit margin predominantly from profit margin.
38:58
That's very good if you're getting a lot of return on equity because that equity is being amplified by a
lot of debt that could be concerning, especially if there's not a plan to manage that debt.
39:10
OK.
39:12
Again, total asset turnover is how well are we using our assets, OK.
39:21
Financial statement information, well, who uses these?
39:23
Well, obviously internal users, you know, to make plans to do performance evaluations perhaps of you
know, certain key managers and of course external users, creditors, suppliers, customers, stockholders,
OK.
39:38
So we talked about this earlier time trend in peer group.
39:40
OK.
39:44
So what are some potential problems?
39:45
Well, you have to, you have to make some important decisions here, OK.
39:53
You have to decide what ratios are the most important given the context.
39:58
If if for example, you know you're looking at investing in a company that is, you know, privately held,
relatively small, but you think they have, you know, some really great plans and they're really gonna
take off in a few years time.
40:12
You might just want to make sure they survive for that few years time.
40:15
So you might pay close attention to their liquidity ratios, right?
40:18
They can have these great plans, but if the company doesn't make it to year 3, then they may never
get to fulfill that right for firms that are diversified.
40:29
So for firms that have, you know, what we call a conglomerate that have multiple distinct divisions, it's
hard to benchmark them.
40:36
For example, GE was a good example of this.
40:39
GE, you know, 10 years ago had tons of different divisions.
40:43
You know, what do you put in a peer group comparison for your, for your GE?
40:47
It's not not the easiest thing to figure out.
40:51
You know, globalization can be problematic.
40:53
You know, do you compare firms not only in the same country but between countries?
41:00
This is less of a problem now, but a decade ago was a big issue when a lot of companies were using
US GAP versus IFRS.
41:08
These are different accounting standards and there are also different procedures.
41:14
Some use FIFO, some use LIFO, different fiscal years, some treat extraordinary events differently.
41:22
So you know you have to really when you when you say here are some ratios and here's my peer
group, you have to make sure that the peer group really is the proper peer group and that you've
addressed these issues.
41:36
So for example, you may have to make some amendments to their balance sheet, their income
statement if they treated, for example, a different fiscal year or different extraordinary events to make
sure that the the comparison truly is a proper comparison.
41:54
OK, OK, Let's Chapter 3.
41:59
Any questions about Chapter 3?
42:02
Any any questions about Chapter 3 there?
42:05
How much do we have to know about the ratios 'cause that was just a little quick.
42:11
I just don't know how, how, how far into depth should we go, right.
42:15
OK, so certainly you should, you should practice the questions in terms of knowing the ratios.
42:22
You don't need to commit them to memory.
42:24
Keep in mind that the test will be open book.
42:29
You know you can't communicate with anybody, but it is an open book test.
42:33
You may just want to keep a a sheet for yourself, the sheet that you make with the ratios, the most
important thing about the ratios is to understand why we have them.
42:43
OK, Don't fall into the trap of just memorizing ratios.
42:47
You really want to understand why do we have them.
42:50
So, So think back to the discussion as to what I talked about.
42:53
You know liquidity ratios are important to gauge or we're going to go into bankruptcy.
42:57
Solvency ratios are important to understand.
43:00
The long term viability, profitability ratio, asset turnover ratio, these are important to see.
43:06
You know how well are we utilizing the resources of the firm, OK.
43:11
So you really want to understand why we have the ratios, OK, what they're used for and what are the
limitations.
43:20
That last part is important.
43:21
What are the limitations and that's what we just talked about where you can't just apply these ratios
like a like a slapstick.
43:28
You have to make sure that you know the different peer groups that you're comparing.
43:35
It's a fair comparison.
43:37
So you have to make sure that they have roughly the same accounting treatment that you know they
don't have extraordinary events and if they do that you're gonna adjust the financial statements
accordingly.
43:48
Hopefully that the that helps.
43:50
Thank you.
43:51
No problem.
43:56
Any other questions about Chapter 3?
44:00
I just wonder that what does EBITDA means?
44:05
What's the last DA means?
44:07
Yes, OK.
44:08
So it's what's called Impida that stands for earnings before interest, tax, depreciation, amortization.
44:20
OK.
44:21
Thank you.
44:22
No problem.
44:23
So depreciation is what we use for tangible assets, OK, like a like a computer or a car.
44:31
Amortization is what we use for intangible assets like a copyright or a patent.
44:38
OK.
44:41
OK.
44:42
And in fact, I'll just tell you a bit more it to the a lot of a lot of finance practitioners really like IPDA
because it's seen as a very pure measure.
44:54
If you look for example, interest, tax, depreciation, amortization, they have a lot of value judgments
that have to be made.
45:02
So IPDA is seen as a very pure measure.
45:04
Comparing IPDA between companies of interest is very important.
45:09
OK.
45:12
Anybody else vote Chapter 3.
45:19
Could you just quickly go over why we added cash?
45:22
I mean, sorry, depreciation in the statement of cash flows, Yes.
45:27
OK.
45:28
So with with cash flow, OK, let me pull up the PowerPoint.
45:32
Actually, it's probably easier to show you that way.
45:34
Yep.
45:38
I'll go back to the beginning here for you.
45:45
OK.
45:48
If you take a look here, here, here's our net income of 471916.
45:55
It's pretty straightforward as to how we get net income.
46:00
Do you understand how we got the net income?
46:02
Any any questions about how we got the net income?
46:06
Yeah.
46:07
OK.
46:07
So net net income is clear, correct.
46:12
Yes.
46:13
OK.
46:14
So with our stimulus cash flow, we start with net income, OK.
46:20
So you can see here we're starting with our net income here in in the operating activities
subcomponent, OK.
46:26
But when we calculated our net income, we took away depreciation and depreciation is a non cash,
non cash expense, OK.
46:38
So when we presented our net income to you know, let's say the government so we can figure out the
property taxes, we're allowed to take away depreciation.
46:48
But from the standpoint of our cash flow, there's there's no reduction in our cash.
46:54
We you know when we depreciate an item, our cash doesn't go down.
46:58
Like I said, there's no National Ministry of Depreciation that we send a check to, right.
47:03
So we have to add back the depreciation because it doesn't deter from our cash.
47:10
Does that make sense?
47:12
Yes.
47:12
That clears things up.
47:13
Thank you.
47:14
No.
47:14
No problem.
47:18
Anybody else?
47:20
Anna.
47:21
Jacqueline.
47:22
Julia.
47:23
Samantha.
47:24
Spencer?
47:26
No, I'm good.
47:29
OK, very good.
47:30
So I did post the homework for Chapter 3.
47:34
Remember that finance is not a spectator sport.
47:36
OK, so so do the homework.
MOS2310A_S23_Chp4_Lecture 1
0:01
OK, let's continue on.
0:09
So we're gonna look at Chapter 4 here, which is long term financial planning.
0:15
OK, OK, so why is financial planning important?
0:32
Well, the old saying failure to plan is planning to fail probably sums it up best, OK.
0:42
So the basic elements of financial planning are as follows.
0:46
We want investment in new assets, OK, determined by the capital budgeting decision.
0:53
So here we're talking about significant assets.
0:55
It could be replaced in a fleet of trucks.
0:57
It could be actualized machinery, OK.
1:00
So investment in new assets, OK.
1:04
We call that the capital budgeting decision, OK, the degree of financial leverage, let's see how much
debt that we want our company to have.
1:16
We call this the capital structure decision and the amount of cash we're gonna pay to the shareholder.
1:25
We call that the dividend policy decision.
1:28
So we have three important decisions that we need to think about a process for capital budgeted
capital structure and dividends.
1:39
OK.
1:40
And sort of a corollary, something that follows naturally is what we call the liquidity requirement, OK.
1:49
This is determined by the net working capital decision.
1:52
This decision tends to follow naturally from the others.
1:57
OK.
1:59
So the first thing we need is our planning horizon.
2:02
How long are we planning for?
2:04
So the short run is typically 12 months and the long run is typically two to five years depending on the
industry.
2:14
Now, as I said in my first lecture, this is a rule of thumb.
2:18
The exact distinction between the short run and the long run is that in the short run some costs are
fixed, whereas in the long run all costs are variable.
2:30
OK.
2:32
So aggregation, we can combine capital budgeting decisions into one big project, OK.
2:39
So we're aggregating.
2:41
We're combining, OK.
2:43
And we have to make some assumptions and some scenarios and we want them to be as realistic as
possible.
2:48
OK.
2:49
So for example, how long will our current machine last?
2:54
How much will this market grow by?
2:57
OK.
2:58
So we want to have some realistic assumptions, of course, because they're assumptions.
3:03
We also want to have scenarios, OK.
3:06
So we might have, you know, best a worse in that middle case scenario.
3:10
OK.
3:16
And just for example, those scenarios might correspond with the business cycle, you know, if we're in
a normal economic environment, a recession or maybe a boom.
3:31
So what's the role of financial planning?
3:33
Well, we want to examine the interactions.
3:37
So how how does one decision affect another?
3:40
You want to explore options.
3:42
You want to give management a systematic framework for exploring its opportunities.
3:51
You want to avoid surprises, help management identify the possible outcomes, and plan accordingly
so you know.
3:58
Of course, you can't plan for every contingency, but as much as you can, you want to.
4:04
And you want to ensure feasibility and internal consistency helps management determine if the goals
can be accomplished and if the various stated and unstated goals of the firm are consistent with one
another.
4:21
This last part, internal consistency, is important.
4:26
You know, for example, you can think of a, say, a car company.
4:32
You don't want the accounting department to have a goal that is internally inconsistent with the
engineering department, OK.
4:39
But the accounting department might say, you know, can you make this part for this amount of
money or make this car for this amount of money?
4:45
And then the during department will say, well, it's just it's not possible, you know, given certain safety
standards we need to meet and whatnot, you know, we simply can't.
4:53
So you want to have this internal consistency.
4:56
OK.
5:01
OK.
5:01
Some tools that help us.
5:03
Well, obviously a sales forecast, OK, this can be fairly elementary.
5:09
It might simply be taking a look at your sales over the past five years, looking at growth rate and just
applying that growth rate in a linear leaner way.
5:18
So it might be you realize your sales have grown by 5% a year, the forecast the next two years you
simply apply that 5% growth rate.
5:27
That's again, that's pretty elementary.
5:29
A more sophisticated look would would take a look at the underlying factors.
5:32
You might say, well you know are we the only, you know, maybe we were a duopoly, so it was our
company and another company, maybe that other company went out of business.
5:42
We're now a monopoly, you know.
5:44
So you might take a look at is the market structure changing maybe over the next few years.
5:51
There was no real substitute for our product.
5:53
Maybe in the future there might be, OK, you might take a look at the regulatory environment, maybe
some regulations might be relaxed, some might be increased.
6:02
That would be a more sophisticated sales forecast.
6:05
OK.
6:06
Do we know have to know how to calculate that or what would be giving the sale forecast number
generally in general?
6:14
Well, for the purposes of this course, you probably won't need to calculate a sales forecast.
6:19
And if you do, it would be pretty straightforward it it'd probably be just a growth rate, applying a
growth rate, you know, from past years, but more for your own professional development.
6:29
When you go to industry, you would want to, you'd wanna check your sales forecast with a more
sophisticated approach.
6:38
So you might say, OK, well, we think our sales are gonna grow 5% a year based on historical trends.
6:43
But if, for example, you know, you know one year from now there's a new competitor that's gonna
enter the industry, it would be irresponsible to simply apply the same 5% growth because there's a
structural change.
6:57
So that's not something I would test you on, but it's, it's something that you should know for yourself
just for your own professional development.
7:05
Makes sense.
7:07
Yeah.
7:07
OK.
7:08
Pro forma statements.
7:09
So these are not actual statements.
7:13
So an actual financial statement would be something that you released was audited, et cetera.
7:17
Pro forma, these are more fictitious, basically a best guess, if you will.
7:22
So what do you think future financial statements would look like?
7:25
We call these pro forma statements asset requirements.
7:30
So how much additional fixed assets will be required to meet sales projections.
7:35
So the bullet .1 and three are are linked and this is what we talked about internal consistency.
7:41
You know, if you're going to predict, let's say, five years out and you're predicting you're going to
have a 20% increase in sales, it would, it might be wishful thinking to assume that your current asset
capacity can service that you, you may have to resay.
7:55
Well, if we're gonna have a 20% increase in sales, you know, unless that most of your staff and most of
your machines are just laid idle all day, you're gonna have a problem.
8:04
You have to come up with, you know, do we need to get, you know, new machinery, you know?
8:09
And if so, do we lease or do we buy?
8:11
And these sort of questions creep up.
8:17
OK.
8:17
So some more ingredients to financial planning.
8:22
You have to come up with financial requirements.
8:24
So if if we need more assets, and this is what I was alluding to, how will we finance it?
8:29
Will we get a loan from the bank?
8:31
Will the company that sells it to us give us a loan?
8:34
Do we have enough cash on hand?
8:36
Do we want to buy, Do we want to lease?
8:38
These are the sort of questions we have to tackle and we won't tackle those now, but but later on in
the course we have what's called a plug variable.
8:48
This is important.
8:49
So it's a management decision about what type of financing will be used, OK.
8:55
And it makes the statement of financial position balance.
8:59
So basically what this tells us is once we make one decision, another decision follows naturally.
9:06
So if for example, we make a decision about, you know how much money we're going to spend, so
how much cash we're going to spend on new machinery that will lead to a decision about dividends
that we won't have that cash available to, for dividends.
9:20
OK.
9:21
So one decision sort of foretells the other economic assumptions.
9:28
So we wanna when we make our forecast, we have to be explicit, To give you an example, you can
imagine making a forecast before a recession.
9:40
So you might assume, OK, our sales are gonna grow at 5%, but then some unexpected event happens,
whether it's COVID or whether it's a global financial crisis and all of a sudden you're in a recession.
9:50
Well, then the economic assumptions you made would would be invalid, right?
9:56
Presumably your customers are going to behave differently in a recession than they would in a boom.
10:00
You know, let's say you're analyzing the restaurant industry.
10:03
If you assume that, you know, it's it's a boom.
10:07
So a lot of, a lot of commentators think that once COVID is under control, we'll have this big economic
boom, People are gonna go out and they wanna re experience life and you know, shop and go to
restaurants and whatnot.
10:19
You know, that's a different economic environment than if you're assuming that you're still gonna be
in a recession where consumers might say, you know what, maybe I will forego that purchase because
I'm very uncertain about my future and thought I don't know if I'll be in a lockdown, I don't know if
this or that.
10:35
So the economic assumptions you make are very, very important.
10:39
OK, OK, so here's an example of a historical financial statement for this company here called Gourmet
Coffee.
10:52
OK, you can see we have our assets, our debt or equity.
10:56
OK, nothing, nothing magical, very straightforward.
11:03
Here's our income statement, our revenues, our cost, our net income.
11:10
OK, now here's where it gets important.
11:13
We're now going to make some assumptions in order to predict the future.
11:18
So we're going to assume that revenues are going to grow at 15%, OK.
11:23
Now in reality, we would probably want to support that assumption with something, you know, why
do we believe revenues will grow at 15%?
11:33
Do we have, for example, a line up outside of our coffee store every day and you know some people
are just walking away because the line is too long and if we expand capacity, you know we'll be able
to service those people.
11:44
You know, you'd you'd want to have some justification for that in in the real world.
11:50
Do we believe that our competitors are growing at that speed and we're gonna be up to make some
changes and also reach that speed.
11:57
All items are tied directly to sales and the current relationships are optimal.
12:04
OK.
12:05
So basically what we're saying is that once we forecast sales, we can forecast all of the other items
because we're, we're assuming that they're directly correlated.
12:14
Consequently, all of the items will grow at 15% because we are, we're making that assumption, OK.
12:23
So you see here, our revenues have gone up from 2000 to 2300, that's that's a 15% increase, OK, 10%
of 2000 is 200, OK and 5% of 5% of 2000 is 110% + 5% is 15%, OK.
12:48
So that's 2300.
12:51
Same thing with our cost, OK, 10% of our cost is 160.
12:56
OK, Half of 160 is 8160 + 80 is 240.
13:02
So you can see here our costs have gone to 1840 and correspondingly, our net income has gone to
460 as well.
13:11
OK.
13:12
So that's a 15% increase.
13:15
OK.
13:18
Now here it gets a bit more complicated.
13:21
OK.
13:22
So let's consider 2 cases.
13:25
OK.
13:26
So case one, dividends are gonna be what we call a plug variable, OK.
13:32
So the debt and equity are going to increase at 15%.
13:37
OK.
13:38
And my my dividends, OK, so my net income here is 460, OK -90 increase in equity, OK is going to be
370.
13:53
So remember with net income I can either reinvest it, OK.
14:00
So basically increase my equity or I can pay it in dividends.
14:06
So I can see here my net income is 460, OK.
14:10
And I can see from my balance sheet, OK, we're going to assume here that everything increases 15%,
OK.
14:20
So if I look at my New Balance sheet, you can see here this is the 15% increase, right?
14:27
So this is what I was telling you here about a plug variable.
14:32
I know my net income is 460.
14:34
I know my equity went up by by $90.00.
14:38
OK, so my my dividend here is gonna be 370.
14:44
OK, so I can I can find my dividend.
14:48
It's it's what we call elementary.
14:51
I can find my dividend as an elementary decision of my other decisions, OK.
15:00
We can consider another case where I make debt my plug variable, OK.
15:06
So I can see here that no dividends are paid.
15:12
OK.
15:14
So we have 1150, OK and I have 600 + 460, OK.
15:27
So if if we go back here, OK, remember 460 is my net income, OK, and 600 is my equity, OK.
15:41
So if I go back here to my case 2, OK, my my debt, OK.
15:52
So here remember we have assets equals liabilities plus owner's equity, OK, so I can, I can rearrange
that, right.
16:02
If I want to get debt by itself, it's assets, OK.
16:07
Assets minus owner's equity, OK.
16:11
So I can I can see here it's going to be 600 + 460, OK my my old equity plus the net income, so my
debt is going to be 90.
16:24
So in order for that to happen, if my debt was 400, it's going to end at 90.
16:31
It means I repaid $310 in debt.
16:35
OK.
16:37
So once I've decided I'm not going to pay dividends, I can then figure out what the extra money is
going to be used for.
16:44
OK, You have to probably practice that to to get the hang of it.
16:52
OK.
16:55
Now another way to think about this is what we call the percentage of sales approach.
17:00
OK, some items tend to vary directly with sales while others do not.
17:08
So what this goes to is one of our earlier assumptions here that everything is going to increase 15%.
17:16
OK, now you can imagine that's not entirely true.
17:22
You know, if, for example, a restaurant decides to stay open one more hour, you know certainly their
labor costs are going to increase.
17:30
You have to pay your staff one hour of work.
17:33
But will your electricity bill increase proportionally?
17:35
Will your will you need a whole new, let's say, maybe oven equipment?
17:40
Not not necessarily.
17:43
OK, well, the point is, now we're gonna pay more attention to that.
17:50
Not all items are gonna vary directly with sales.
17:55
So if if the costs do vary directly with sales, then the profit margin is gonna be constant, OK?
18:04
And there's no guarantee that even if our sales increase, our dividends are gonna increase, OK?
18:10
Because a company doesn't have an obligation to pay dividends.
18:15
Dividends are a management decision.
18:18
So you have a company that you know companies sometimes lose money and they still pay dividends.
18:24
And typically the reason they do that is to send a signal to the investors that the loss is simply short
term and the company isn't worried about it.
18:34
I mean the company that is perpetually going to make a loss obviously won't pay dividends, but if it's
just a short term loss, they they can still pay dividends.
18:44
You know for example, some companies pride themselves on always making a dividend payment.
18:48
In fact Shell because of COVID basically for 50 years after World War 2, Shell never reduced its
dividend.
18:58
Only last year did Shell reduce its dividend.
19:01
So cut some companies really pride themselves on having a consistent dividend track record.
19:06
And when you go on to study more finance, when you look at things from the investor side.
19:12
So right now we're looking at things from the company side.
19:15
But when you look at things from the investor side, it's what we call the clientele effect Some, some
clients or some investors look for companies specifically that pay consistent dividends.
19:29
So the point is when we do our forecast dividends, there's no, there's no necessary reason as to why
dividends will change proportionally with sales.
19:44
OK, OK.
19:49
So the statement of financial position, we assume that all assets included fixed will vary directly with
sales.
20:00
The accounts payable will also normally vary directly with sales.
20:05
Unless there's a reason to believe, we're going to switch how much money we pay on credit risk, cash,
notes payable, long term debt and equity do not vary with sales in general because they depend on
the management decision about what's called the capital structure, that combination of debt and
equity, the providers of capital to the firm.
20:29
So you can imagine a firm that that's at its optimal debt ratio would not want to deviate from that
even if we're making a a sales forecast, the change in retained earnings portion of equity will come
from the dividend decision.
20:47
OK.
20:48
So we typically don't choose our retained earnings, but we do decide the dividends and then you
know as a consequence retained earnings would would be determined.
21:00
So here you can see items as a percentage of sales.
21:04
So here the cost is 60% of sales EBT, so earnings before tax is 40%, taxes are 16% and you can see
here we're making a forecast sales has increased 10% cost, OK.
21:24
But you can see here that the dividend payout rate is 50%.
21:29
OK.
21:31
So yes, you can, you can see the assumptions that we've we've made here.
21:37
OK.
21:40
So let's just wait.
21:41
Where does it say the dividend pay?
21:44
Where's the, where does it say it's 15% at the bottom?
21:47
At the bottom it's telling you the assumption 50.
21:50
OK.
21:51
So you want to state your assumptions clearly.
21:54
Yeah.
21:56
So you can see here we assume sales have grown at 10%.
21:59
So you can see 5000 goes to 5500 etcetera and the dividend payout rate is 50%, so 50% of 1320 is
660.
22:12
So that's where that comes from.
22:15
And like like you said in the previous slide, once you make your dividend decision, the rest is going to
be the addition to retain earnings just follows as the net income minus the dividends, OK.
22:29
Did you pick the random number like the 10% to assume the sales growth?
22:35
Yeah.
22:35
So this is a hypothetical example that's in the textbook.
22:39
So they would, they would just have assumed 10%.
22:43
OK.
22:43
But in in the real world, you would want to have a compelling reason as to why you believe that.
22:49
I'll give you an example.
22:50
So here we have Tasha's Toy, Emporium.
22:53
Maybe you would take a look at demographics, maybe the demographics of the area shifting.
22:58
You have a lot of young families move to the area.
23:00
You know, young families buy toys for their kids.
23:03
So you would want some reason as to why you believe that.
23:07
You know, especially if you're in a real company and you're gonna take this to the CFO, you know
you're gonna wanna have something.
23:13
You might, you might wanna say that.
23:15
I'll give you an example.
23:16
Look at COVID, you might say, you know a lot of families are are moving away from the downtown
core.
23:22
In a place like Toronto, they might be moving to the suburbs where they get more real estate.
23:27
If you're a toy store in the suburbs, you might, you might have a reason to believe your sales will go
up, OK.
23:34
But in the real world, you want some reason for that?
23:42
OK, OK.
23:46
Here we continue on.
23:47
We have our statement of financial position.
23:51
So before we looked at the income statement, now we're looking at the balance sheet and you can
see here you know cash, accounts receivable et cetera, your liabilities, OK, we we're expressing
everything here as a percentage of sales, OK.
24:09
So cash as a percentage of sales, accounts payable as a percentage of sales, et cetera.
24:18
And right and you can you can see here we assume sales are gonna grow by 10%.
24:25
So you can, you can see the the result in numbers and that's what pro forma means as as a prediction.
24:32
OK, OK, this is a bit complicated.
24:37
So pay attention to to this part in particular we call this EFN external finance needed.
24:45
OK.
24:46
Now what this means is given that we've made some assumptions, we need to figure out how much
external financing do we need in order for these assumptions to work.
24:58
So the firm needs to come up with an additional $200 in debt or equity to make the statement of
financial position balance.
25:07
OK.
25:08
So let's take a look at this.
25:10
OK, you can, you can see here that our current statement obviously balances.
25:15
So if you look at the column that says current, you can see 9509 thousand 500.
25:22
If you look at the pro forma, our total assets are 10,450 and our liabilities and owners equity is 10,250,
OK.
25:33
So obviously a balance sheet has to balance by definition.
25:37
So we need to account for this $200 discrepancy.
25:44
So if if we take a look here, we can choose a plug variable, OK, well we can borrow more short term
notes, OK.
25:54
So we what we call notes payable, we can borrow more long term.
25:59
So what we call broadly we call this long term debt or bonds.
26:04
We can sell more common shares or we can decrease the dividend payout which increases retain
earnings.
26:12
So we have to choose how we want to account for this $200.
26:23
All right.
26:23
Here's another scenario.
26:27
We're here, we have a company that's operating at less than its full capacity, OK.
26:34
So you can think for example, perhaps a restaurant where you know 80 where 20% of the time the
employees are just sort of standing around, you know, playing with their thumbs.
26:46
So we have a company that's offered at 80% capacity.
26:50
So if we're getting 5000 sales and that's 80%, it would mean 100% sales would be 6250, OK.
27:01
Look, even if we increase our sales by 10%, we're not at full capacity, OK, We're, we still have 12% to
go.
27:09
This tells me that I don't need any new assets.
27:12
I have enough assets to reach that level of predicted sales, OK.
27:18
So my pro forma total assets, OK, if we, if we take a look at my performance statement here, if you
take a look here at the performance statement, OK, I can see OK.
27:39
If I look at my fixed asset PP and E this stands for property plans and equipment and I use net PP and
E because I I may sell some fixed assets and also buy.
27:48
So I need, I need the net number here.
27:52
OK, so if I take a look at my performance statement, OK, my total assets are 10,000 and 50.
28:13
OK.
28:13
So again, 4000, if I if I look here, my current assets were 6050, my fixed assets were 4000.
28:28
But if I let everything grow as a percentage of sales, I assumed it was going to grow to 4400.
28:35
The point of the current example is I don't need it to grow to 4400, I only need 4000 because I'm not
at capacity.
28:42
OK.
28:44
So what it's telling me is that my total asset should be 10,000 and 50 rather than the number I have
here which is 10,000 and 450.
28:55
OK.
28:59
And then I have a situation where my assets don't match with my liabilities and owner equity.
29:06
So it's it's the opposite problem as opposed to having to find 200 on the the debt side, I have to find
200 on the asset side.
29:15
OK.
29:17
So I have to choose a plug variable and my choice has become I can, I can reduce some short term
debt, right?
29:24
Paying down debt is the equivalent of of gaining an asset if you will.
29:28
I can pay long term debt, I can buy back shares, I can pay more in dividends, or I can increase my cash.
29:37
OK.
29:38
So the point is when you predict sometimes because all of the items don't change by the same
percentage, you're gonna have this unbalanced amount to begin with and then you have to use a
plug variable to adjust that.
29:57
OK.
29:58
And and you, why wouldn't we just let the assets grow then the fixed assets if we have to, Well,
because because we have, we have choices.
30:07
So here we have these four choices.
30:12
So we could increase our cash account, we could pay more dividends.
30:17
It really depends on the context.
30:19
If if, for example, our shareholders have been upset that we're not paying enough dividends, we don't
want the assets to grow.
30:25
We'd rather give them dividends so that the context will matter.
30:31
But it's a process.
30:34
The point is when you forecast the, the forecast is not uniform, not everything is gonna change by the
same amount as sales.
30:43
That's that's the key point.
30:45
And as soon as things don't change by the same amount, you can have this mismatch, OK, this
unbalanced amount.
30:54
And then the third step is you have to think given this mismatch, how do you want to fix it.
31:01
So here we have 5 choices in, in the case of, you know, our assets are too little before where we had
the mismatch here where our, our debt was too little, we had the these four choices, OK.
31:21
And depending on which plug variable you choose as as I alluded to, depends on the context, you
know where you're currently at in terms of like say your shareholders, your business environment, et
cetera, OK, growth and external financing.
31:46
So at low growth levels, internal financing what we call retained earnings may exceed the required
investment in assets, OK.
31:56
Basically if our company's not growing much, we probably don't need to borrow a lot of money to get
assets.
32:04
As the growth rate increases, the internal financing will not be enough, OK.
32:10
So obviously, if our company's growing very, very fast, we probably need to buy more land, more
equipment, things like that, OK.
32:19
And we want to examine the relationship between growth and external financing and that's, that's a
useful tool.
32:29
So to help do that, we have two techniques.
32:35
One is called the internal growth rate.
32:37
And what you're wearing momentarily is what's called the sustainable growth rate.
32:42
The internal growth rate tells us how much the firm can grow assets, use and retain earnings.
32:49
OK.
32:50
So you might wonder why this is the case.
32:52
Well, sometimes it's difficult to get external financing.
32:57
You can imagine for example during the global financial crisis, a lot of small and medium businesses
had trouble getting financing because banks had just taken these big losses and they were very
diverse to making loans and whatnot.
33:11
You can imagine same thing during COVID.
33:14
You know, one of the reasons the government has to step in with grants for businesses is, you know,
banks would see it as too risky to lend.
33:22
So sometimes the firm you know may may be sort of pigeon holes and have to use only their own
internal sources of funds to grow.
33:33
You know whether that's because of some failure in the financial system or whether that's because of
they an issue with speed, maybe the loan process takes too long there.
33:44
It's an important number to know your internal growth rate.
33:48
So we can calculate it as follows.
33:50
The return on assets times R&R is the retention ratio, OK.
33:56
So you can see here the fastest this firm can grow is 6.71%.
34:04
The sustainable growth rate says how much can we grow using internally generated funds.
34:11
So the internal growth rate and issue in debt to maintain a constant debt ratio.
34:19
So assuming we're not going to change the the debt ratio, OK.
34:25
So the sustainable growth rate here is my return on equity times, my retention ratio divided by 1
minus return on equity times retention ratio.
34:36
OK.
34:37
And you can see here that the sustainable growth rate is in this context of 18%, which is very high.
34:48
Here's a question for you, which number would be higher, the sustainable growth rate or the internal
growth rate?
34:57
Nothing too hard about it.
34:59
Anybody know?
35:05
Don't be shy, Anybody know?
35:06
I'm not sure if it's sustainable plus.
35:09
Is it like there's no more share screen?
35:12
No, no, I know.
35:13
I I turned off the share screen for a moment when I asked the question.
35:17
Yeah, sustainable growth rate.
35:18
Do you know why?
35:22
Don't be shy like 1/2 guessed.
35:25
Sorry.
35:25
That's OK.
35:27
Well, think think of it this way.
35:29
The sustainable growth rate is your internal growth rate plus external financing.
35:36
So naturally your sustainable growth rate would be higher.
35:38
OK, right.
35:48
So as you can see here, the sustainable growth rate is 18% compared to the internal growth rate,
which was 6, which was about 7%, OK.
35:58
So largely the sustainable growth rate would be higher.
36:03
OK, OK.
36:13
Now, if we think of this intuitively, what are the determinants of growth?
36:18
OK, well, we're not talking numbers, we're just talking intuition.
36:27
Well, obviously a company that has a healthy profit margin is going to grow.
36:31
That's that's a good thing, right?
36:33
If your profit margin is very low, that's concerning.
36:37
It's not the end of the world, but it's concerning and total asset turnover, well, if we can use our assets
efficiently, that's good for growth.
36:47
If we have a good Financial Policy, if we have a healthy debt equity ratio, that's that's good.
36:53
We don't want to have too little debt because it means we could be missing out on opportunity, but
we don't have too much because it can be burdensome dividend policy.
37:03
Again, this is important.
37:05
We want to keep our shareholders happy, but we want to make sure that we're also reinvesting
sufficient amount into the company, right.
37:13
We don't want to pay tutorial dividends because we'll have a hard time attracting capital from
shareholders.
37:18
You know, the reason shareholders give money to our company is so that they can get more money in
turn, right?
37:25
The shareholders not doing this as a treaty, they're doing this to maximize their wealth, right.
37:30
So these are the shareholders, not people that the company management knows personally.
37:35
These are not friends and family.
37:37
If we're talking about a normal corporation, these are people who see it as a business opportunity.
37:44
So intuitively, all of these factors bode well for growth.
37:49
The stronger these factors, so the stronger your profit margin, the stronger your asset turnover, the
better your Financial Policy.
37:56
The healthier your dividend policy, intuitively, the more your firm will grow.
38:04
OK, some caveat, OK, some caveat.
38:07
So basically words of warning, it's important to remember that we are working with accounting
numbers and we have to ask ourselves an important question or important questions as we go
through the planning process.
38:21
How does our plan affect the timing and the risk of cash flows?
38:27
Does the plan point out inconsistencies in our goals?
38:31
And if we follow this plan, will we maximize owners wealth?
38:36
So let's talk about each of these.
38:41
So for example, our plan might involve us expanding into a new, a new market and that market might
be in a different country, OK.
38:50
That might make the cash flows riskier.
38:52
The cash flows may switch to being in a foreign currency.
38:56
We may have to give up, get in some cash today at the expense of getting cash into the future.
39:03
The plan may have some inconsistencies.
39:07
I gave the example of the auto company.
39:11
I'll give you a fun example about if you think about some things you hear on the news, maybe about
SpaceX and Elon Musk.
39:18
Elon Musk tends to be more overly optimistic than what his engineers can deliver.
39:23
And, you know, you always hear about this rocket that that, you know, had a failure at launch or
something like that.
39:29
And most importantly, if we follow this plan, will we maximize the owner's wealth?
39:36
That's the goal of the corporation.
39:38
OK.
39:39
It's to maximize owners wealth.
39:41
OK.
39:42
That's why the owners have put money into this.
39:46
OK, OK, so that's chapter 14.
39:50
I'm sorry, not 14.
39:51
Chapter 4.
39:53
Any questions about chapter 4?
40:02
Any questions?
40:05
Hannah Courtney, Abby, Sarah Spencer, Vincent Wang.
40:11
Yigno.
40:13
Yang, any questions?
40:16
I'm a bit confused on the retention ratio, like will we be getting those in, in exams or will we be
calculating those as well, maybe either one.
40:25
So the retention ratio is how much money goes back into the company is you calculate it, you can
calculate it from let's say a historical financial statement, taking a look at how much money was put
into dividends versus retained earnings.
40:40
You can calculate that.
40:43
But you may be you may just be given a number, you may be you may be told the retention ratio was,
you know, 30% or 40%.
40:49
OK.
40:50
But you should be prepared for either case.
40:56
And I think somebody else had a question, no, that's a similar one.
41:03
OK, OK.
41:08
Again, with Chapter 3 and Chapter 4, you really have to go through the questions you know.
41:13
Probably one of the biggest mistakes I see students make is they don't, they don't give finance the
time it deserves.
41:20
You know the the general rule of thumb for university courses, for every hour you spend in the class
you should spend, you know, two hours outside of the class.
41:29
So if a if a typical class is, you know, let's say 3 hours a week, you should spend about six hours on self
study.
41:35
And now obviously that differs by students, right?
41:37
Some students you know may may have more aptitude in the subject than another, but that gives you
a ballpark you know or rule of thumb to work with.
MOS2310A_S23_Chp5_Lecture 1
0:00
OK.
0:04
And let me see here.
0:10
OK, share screen.
0:22
OK, you should be able to see that.
0:25
If not, you can always download the PowerPoints.
0:28
They're all posted and follow along that way.
0:32
OK, so we're gonna talk about the time value of money, All right?
0:42
Now this has many important applications in finance.
0:45
But before we jump into the applications, let's talk about it from an intuitive level.
0:52
OK, so if you had the choice between getting $1000 today versus getting $1000 in 10 years from now,
most people would prefer to get the $1000 today.
1:05
And in fact everybody should prefer to get the $1000 today.
1:08
And there's there's good reasons for that, OK.
1:11
But in particular, we can boil it down to two reasons.
1:14
OK, Anybody know why would you prefer to get $1000 today versus in 10 years from now?
1:21
Any any thoughts on that?
1:24
Just like gas is like money losing its value.
1:28
Hey, you're on the right track.
1:29
Certainly there's an element of of loss of the value.
1:32
Certainly.
1:32
Yeah.
1:34
Anybody else anybody want to guess.
1:40
Hannah Courtney Ryan Wang.
1:47
OK there's it's because the value it's because the value of $1000 ten years from now will be like
nowhere near what it is today.
1:54
If you could properly like have it go up with interest and stuff.
2:00
Very close.
2:00
Yeah, very close.
2:02
So let me let me help you.
2:03
Well, there's two reasons.
2:05
The first I think most of you touched on, it's called inflation.
2:10
Inflation is the general rise in the price level in most modern economy.
2:15
As you see inflation of, you know, maybe one percent 2%.
2:18
So in general prices might rise 2%.
2:22
That doesn't mean every price rises 2%, but on average, OK, So what that means is you're purchasing
power.
2:30
What?
2:30
You're what the real goods and services your money can get.
2:33
You will deteriorate.
2:35
OK, so over time, the purchasing power for your money deteriorates.
2:40
I'm often reminded that the comic I saw, you know, this is in the 1970s.
2:46
You have this hippie with long hair and he goes into a Barber shop in in the modern age and they tell
him it's, you know, $15.00 for a haircut.
2:54
He's like what my last haircut cost $0.25, so there's that erosion of purchasing power.
3:00
So that first reason is inflation.
3:02
OK, that in most modern economies you see inflation, and in fact central banks target inflation of a
roughly 2%.
3:11
OK, you you do have more extreme cases of that where you have high inflation or even hyperinflation,
but the point still remains that money loses its purchasing power over time.
3:23
The second reason is opportunity cost.
3:26
If I give you the $1000 today, you have the ability to execute on that right away.
3:32
There's different investment strategies you can execute, right?
3:36
And if I give you the the money 10 years from now, there's that opportunity cost of the lost
investments you could have made.
3:43
OK, even if you have a strict preference to receive 10, to receive $1000 ten years from now, receiving
the $1000 today, you can strip so that you receive a guaranteed $1000 in 10 years.
3:56
There are certificates of deposits and and whatnot.
3:59
We do have a fairly complete financial market with many products and services available.
4:05
OK, so those are the 2 broad reasons, inflation and opportunity costs.
4:11
So what does this tell us?
4:12
It tells us that money in the future.
4:15
In order to compare it to money in the present, we need to somehow reduce it.
4:20
OK.
4:21
So if somebody says to you, I'll give you $1000 in 10 years from now or I'll give you $800 today, is that
a fair trade?
4:33
Is that a fair comparison?
4:34
So we need a mechanism to to compare money in the future with money today.
4:40
And you can imagine that there are many applications where you see this, right?
4:45
You know, some of you may have borrowed money to go to school.
4:48
That's that's perfectly normal.
4:50
Some people borrow money to buy a house, to buy a car.
4:53
That's also perfectly normal.
4:55
Essentially what you're doing is you're you're you're travelling through time, you're you're purchasing
power, right.
5:01
So you're saying, OK, if you give me money to buy a house today, over time I'm gonna pay you back,
you be in the bank, OK, But we need to be more precise than than that.
5:12
You know, finance is about precision.
5:14
So for example, if you go to the bank and they give you a 25 year mortgage, well exactly how much
more are you gonna pay them back, right.
5:21
You need, you need some degree of precision.
5:25
If you talk about a bond in finance, you know if a corporation sells a bond, if I'm a corporation and
you give me money today, so let's say I sell a bond for $1000, right?
5:36
So you give me $1000 today.
5:38
The maturity of the bond is five years.
5:41
Over those five years, I pay you something often called coupon payments or interest payments, and
then at the end of the five years, I'd pay you back $1000.
5:51
But we need to be more precise than that.
5:54
So what this chapter is about, this chapter, the next chapter is about building the mechanisms and
building the tools to be to be precise and to figure out exactly how much is that $1.00 in the future
worth the day, OK, And and what are the factors that can affect it.
6:10
So that's what we're trying to do and it's critically important because like I said in finance you have
many applications where cash flows go into the future and you need to find a way to compare it with
cash flows today or cash flows of other you know, securities that may have different maturities and
whatnot.
6:32
Let me go back to the let's start with some basic terminology so everybody understands what we're
talking about.
6:57
The first phrase you need to know is what's called present value.
7:01
OK, And if you have a timeline, present value is what the money is worth today in the present.
7:08
OK.
7:09
So a timeline is just the graph where on the horizontal axis you have different points that represent a
period in time, so today, tomorrow, one month, etcetera.
7:22
Future value is some at some point later, could be, you know, one month, one year, one decade.
7:29
It's defined by the context.
7:31
The interest rate is the exchange rate between earlier and later money.
7:38
If you want to know a fancy technical phrase, it's called the intertemporal.
7:43
Intertemporal means between time periods, intertemporal exchange discount rate, this is the actual
rate we're going to use to reduce future cash flows to the present cost of capital is what does it cost
us to get capital.
7:59
So, so debt and equity for example.
8:01
What is the cost opportunity cost of capital?
8:04
What else could we have done with our capital and the required return?
8:09
How do we come up with this required return?
8:15
So here's a simple example.
8:17
OK, you invest $1000 for one year.
8:23
At 5% per year, What is the future value in one year?
8:28
So this is fairly elementary, as you can see, pretty elementary mathematics.
8:33
So you're gonna get $50.00 in interest, 5% of 1000.
8:37
The value in one year is the principal plus the interest.
8:40
OK, so the future value.
8:43
We can also express this in a more succinct way.
8:45
Mathematically, 1.05 * 1000 is 1050 OK?
8:51
If you leave the money for in for another year, how much money will you have?
8:56
Well, you had 1000 the first year, 1050 the second year, then you add 5% on top of that.
9:03
OK, so mathematically we can express it as 1000 * 1.05 ^2.
9:09
OK, so this is very straightforward.
9:16
Of course we want to have a more general formula.
9:19
You know, we're not always going to get such a simple case, but in general, the future value is the
present value times 1 + r to the power T OK, And you can see all the terms there.
9:36
R is the period interest rate.
9:38
OK, now this is, this is really important.
9:40
This is something a lot of students make a mistake on.
9:44
There has to be what's called internal consistency.
9:48
OK, So what do I mean by that?
9:50
Well, if, for example, your interest rate is given as an annual amount and your cash flows are given
monthly, you have to convert them to be the same time reference.
10:02
So either you make your cash flows monthly and an interest rate monthly, or you make your cash
flows annually and your interest rate annually.
10:08
OK.
10:09
There has to be this internal consistency.
10:13
If you apply, you know, an interest rate quoted for a different period of time to cash flows quoted for
a different period of time, your calculation is going to be wrong.
10:23
And it's it also shows a lack of attention to detail.
10:26
OK, so pay attention to to the consistency, internal consistency of how you set up the formula.
10:35
OK, I had a question about the last slide.
10:39
Sure.
10:41
When you said like over two years yeah so the like 5% with for another year.
10:51
Why would it like, would it be OK to put 1.10 instead of doing one point O 5 twice?
10:59
Or like what's the difference with that?
11:04
What what are you what are you suggesting?
11:06
Like, what did you want to put?
11:07
So instead of doing the 5% twice, could you just add them up and do 10% instead?
11:14
So do one point.
11:15
No, no, it wouldn't be the same because here this is, this is compound interest.
11:22
So you're the interest you had on the 1st, $1000 is going to help you earn interest.
11:28
So it wouldn't you wouldn't be able to simply say 5% + 5%.
11:33
It it's it's not the same.
11:35
OK, Yeah.
11:36
So you have to do it this way.
11:37
Yeah.
11:38
OK.
11:38
Sounds good.
11:39
No problem.
11:43
OK, so again, like I mentioned here, pay attention to internal consistency.
11:51
The second thing, there's a very big assumption built into this formula.
11:56
Anybody, anybody know what it is?
11:58
Anybody want to guess?
11:59
There's a really big assumption here.
12:03
Maybe Hannah, maybe Julia, maybe Ming, Ming, Samantha.
12:09
Any guesses?
12:10
Anybody know maybe that we know all these values?
12:15
OK, that's that is an assumption.
12:18
Yes.
12:18
That's not quite the one I was thinking of.
12:20
But yes, you're you're on to something.
12:24
Is it?
12:24
How often it's compounded?
12:26
OK, you're getting close.
12:27
You're getting close.
12:30
So let me let me help you here.
12:33
R is the interest rate.
12:35
We're assuming that this interest rate is constant over the number of periods.
12:40
In reality, you can actually have different Rs, so you might have an R1 and R2, especially for long
horizon problems.
12:49
So for example, the interest rate in the 1980s isn't the same as the interest rate in the early 2000s,
right?
12:55
For for your purposes, for the purposes of class, you don't need to worry about such a case the the
cases you get will be fairly elementary in the sense that you'll have the constant interest rate.
13:06
But for your own knowledge, if you go on to further study of of finance, you know advanced finance
portfolio management, you will come across cases where you have to consider what we call
heterogeneous, so different interest rates.
13:21
But it's just something to keep in the back of your mind.
13:27
OK, well, we have two main types of interest.
13:32
We have simple interest, OK, which is only applied to the principle.
13:37
And I think this goes to the question I had about the first slide.
13:41
I don't remember who asked it, but that's roughly what it is.
13:44
And compound interest, where the interest earns interest itself, OK.
13:50
So if we consider the previous example, the future value with simple interest as 1000 + 50 + 50, so
every year we keep earning 50, OK, that would be the same as saying 1000 times the 10% * 1.10 with
compound interest, the interest itself.
14:12
So we're gonna get 5% on that $50, which is 250.
14:17
OK, you may use a financial calculator.
14:26
You don't have to.
14:30
Often in the professional world, you can use a computer program like Excel to do time value of money
calculations.
14:38
However, the financial calculator is useful when we used to have in person tests that would put a lot of
emphasis on this, but because we can't really do that, it's not something I'm gonna talk too much
about.
14:51
If you do have a financial calculator though there's many good resources.
14:57
You can pretty much just type in the the the make and model of your calculator in YouTube and then
you know, put financial calculator examples.
15:06
You know you'll come up with a lot of good examples and the specific keys you press, but I'm not
going to talk too much about it in our class.
15:14
However, if you have a financial calculator, it's to your benefit to use.
15:18
I mean, even myself, I I always keep a calculator at my desk when I'm when I'm doing my own
professional work just because I'm used to it.
15:26
So it's it's just very quick for me to punch in what I need to punch in and get the answer that I need,
whether it's a time value of money problem, whether it's you know, what we call numerical methods
or a graphical solution or whatnot.
15:38
But that's just because I'm, I'm very used to it.
15:42
Well, I I would encourage you to to use your calculator by no means required for our purposes.
15:48
OK, so this is just telling you how to how to punch it in in the calculator, what keys to use that I'm not
going to do.
15:59
Now here's an important point.
16:01
Compound interest is important, especially the longer the time period.
16:06
OK, So what you'll notice is the longer the time period under consideration, the more compound
interest is going to matter.
16:14
OK, so suppose you had a relative deposit $10 at 5.5% interest 200 years ago.
16:25
OK, so you can imagine, you know there there was an old song if you, if you guys listen to music from
the 80s, there's an old song by the police called Message in a bottle.
16:36
And you can imagine if you find some sort of scenario, but your ancestors 200 years ago had the
foresight to to think about you when they deposited $10.
16:46
That would be worth the small fortune today as you can, as you can see.
16:50
So in this hypothetical scenario, if your relative deposited $10 at 5.5% interest, how much would the
investment be worth today?
17:00
If you consistently got that 5.5% interest for the years, you can use the formula and that would be
worth, you know, effectively half $1,000,000.
17:10
OK, now if you use the calculator, N is the time period, I / y is the per.
17:19
Interest rate, the present values which you started with and the future value here is given.
17:26
Now you may wonder why does the calculator approach give you a negative versus a positive number
when you use the formula.
17:36
Any anybody know why that is?
17:39
Anybody know?
17:40
Anyone want to guess exactly the same number except one has a has a negative side.
17:49
Anybody want to guess?
17:56
Veranca Wang?
18:00
Sarah Ryan?
18:02
Noah.
18:03
Any guesses?
18:08
No.
18:09
No.
18:09
Kind of Kind of shy.
18:12
OK, I'll help you in in finance.
18:15
Negative and a positive represent cash inflows and outflows.
18:19
So if you have a positive, it's an inflow.
18:20
If you have a negative, it's an outflow.
18:22
So here's the negative because we're withdrawing from that investment, OK.
18:27
So from the standpoint of the investment itself, right.
18:31
So your ancestor set up this investment, you're now withdrawing that money.
18:35
So it's an outflow from the standpoint of the investment.
18:40
So that's what it means.
18:45
OK, another example, what is the effect of compounding?
18:50
OK, so you can see here with simple interest, OK, if if you just had a simple interest, OK, you're going
to get 120.
19:06
But the fact that your interest itself incurred interest is what is really where the bulk of your the wealth
came from.
19:15
OK, so simply, if your ancestors only put in the $10.00 for 200 years, OK, so every year you're gonna
get 5% on on the $10 and that's gonna happen 200 times.
19:30
If you get simple interest, it'd be 120.
19:32
With compounding you're gonna get the real the real bulk if it almost a half $1,000,000, right?
19:49
OK, well this is a nice graphical representation, so you can see if you put $1.00 in and as time goes by
you can see the future value, the divergent of the future value OK based on different time periods and
rates.
20:11
OK.
20:12
So you can see at the end of 10 years how how much of an impact even a a rate change from 5% to
10% has and you can see an even bigger change from 10% to 15%, OK.
20:28
And you had a bigger change from 15 to 20.
20:30
OK.
20:49
OK.
20:50
So we want to express this as a general formula.
20:54
OK.
20:56
Well, suppose your company expects to increase unit sales of widgets by 50% per year for the next
five years.
21:05
If you currently sell 3,000,000 widgets in one year, how many widgets do you expect to sell in five
years?
21:12
OK.
21:13
So you can see here this doesn't only have to be used for financial calculations, it can be used as as a
growth calculation as well.
21:21
OK.
21:22
So here we're forecasting sales, so 15% growth for the power of five.
21:29
You start with three million, you can see here that you're you're gonna expect to sell a little bit over
6,000,000 units.
21:35
OK.
21:38
OK.
21:39
That's not important.
21:40
Present value, OK, How much do I have to invest today?
21:48
Now, now we're flipping the question around, and this is an important application.
21:55
We have a particular goal in the future, OK.
21:57
So whatever that goal is, whether it's a retirement and we need a certain amount of money.
22:03
You know, maybe we know we want to retire in a few years, we want to pay off the mortgage on our
house.
22:07
How much we have to invest today to do that?
22:10
OK, so we can rearrange that formula.
22:13
So it's pretty simple mathematics.
22:16
OK, you can rearrange to get the variable of interest present value by itself.
22:22
OK, so we can now use that.
22:28
So suppose we need $10,000 in one year for the down payment on a new car.
22:34
OK.
22:35
If you can earn 7% annually, how much do you need to invest today?
22:41
So again, we're just following the formula.
22:44
10,000 is our goal.
22:45
We have our interest rate.
22:47
So I need to invest about 9300 today, OK.
22:54
And you will get proficient at this.
22:56
There's a lot of questions to practice.
22:58
OK, OK, so you want to begin saving for your daughter's college education, and you estimate that she
will need 150,000 and 17 years.
23:24
If you feel confident that you can earn 8% per year, how much do you need to invest today?
23:33
So again, it's a very simple application of our formula.
23:35
We put it on a future value or interest rate or time period, OK.
23:40
And you can see here the present value is 40,000, so you need to invest about $40,000.
23:47
OK Now you can see here we have time consistency.
23:58
You notice that the period is 17 years.
24:01
OK?
24:01
So the the N is in years and the interest rate is per year.
24:07
OK.
24:07
So we have time consistency.
24:10
Later we'll do a a question where we don't have that and you have to adjust accordingly.
24:17
OK.
24:18
Yes.
24:18
Wang, go ahead.
24:20
Sorry, I just forget is the negative inflow or outflow?
24:25
Negative is an outflow.
24:26
OK, no problem.
24:28
OK.
24:30
So here's another question.
24:31
Your parents set up a trust fund for you 10 years ago.
24:36
The trust fund is now worth about $19,000.
24:40
If the fund earned 7% per year, how much did you appear to do that?
24:44
So now we're working backwards.
24:46
OK, so you want to find the present value and it's pretty straightforward.
24:51
OK, so you can see it's 10,000.
24:56
OK, so this is fairly intuitive results for a given interest rate.
25:02
The longer the time period, the lower present value, OK.
25:10
OK.
25:10
So that's that's pretty simple.
25:12
We're not going to do that.
25:13
One.
25:14
The other result for a given time period, the higher the interest rate, the smaller the present value, OK.
25:22
If you're given a certain time horizon, 10 years, the higher the interest rate, the less you need to put in
today to get that same desired amount.
25:30
OK, OK, now this is, this is the important stuff, this equation you want to know very well.
25:40
OK, so you really want to make this equation to memory.
25:44
So PV equals FV divided by 1 + r to the power T OK, now there are four parts of this equation.
25:53
The present value, the future value, the interest rate of the time period, and if you know three out of
the four, OK.
26:02
If you know any three out of the four parts, you can find the 4th.
26:06
OK.
26:07
So you should be able to solve for any part of this equation given the other parts.
26:12
OK.
26:15
But for example, we may want to know what is the implied interest rate.
26:20
OK, so we now want to rearrange and solve this for R OK, so mathematically we can we can arrange
here.
26:28
OK, so we divide both sides by the present value.
26:32
OK, Take both sides of the power one to the T OK.
26:39
And we want to get R by itself, so we subtract 1.
26:42
OK, so here's an example.
26:49
You are looking at an investment that will pay you 1200 in five years.
26:55
If you invest $1000 today, what is the implied rate of interest?
27:02
OK, so you can see here solving for R Plugging in these numbers, the implied rate of interest is 3.7.
27:14
Now if you use the calculator again, you have to be careful about the sign.
27:19
OK, you notice that the sign on the present value is negative.
27:22
Why?
27:24
Because if you're looking at this from your perspective, you are paying the $1000, OK, so the $1000 is
a cash outflow, OK.
27:36
If you if you don't put in the negative sign, you will not get this right using the calculator.
27:41
OK, OK.
27:46
Another example, you're offered an investment that will allow you to double your money in six years.
27:53
OK.
27:54
You have 10,000 to invest.
27:58
What is the implied rate of interest?
28:02
So again, we plug it into the formula and you can see here it's 12.25%.
28:08
OK.
28:09
Notice with the calculator again, we need the negative sign for the present value.
28:15
Now let me give you an example from the real world when we talk about investments, especially
alternative investments.
28:25
So if we're not talking about a stock or a bond, but we're talking about an alternative investment.
28:29
For example, maybe your portfolio manager, you have the opportunity to invest in a mining operation
in in Africa or a seaport in South America.
28:41
You you may simply be told, you know here is what the buying is, the amount of money you have to
put in as part of the syndicate, syndicate as a group.
28:49
Here's the amount of money your firm would have to put in.
28:52
Here's what we think you'll get out in five years.
28:55
You would have to then figure out the implied interest rate, OK?
28:59
And once you know that interest rate, it allows you to compare it with other products, OK, where they
have a explicit interest rate.
29:09
It doesn't allow you a direct comparison.
29:11
You still have to consider things like different levels of risk and time frames and whatnot, but it puts
you on on track to being able to do that.
29:19
OK, OK, suppose you have a one year old son and want to provide $75,000 in seven years to once it's
college.
29:35
You currently have 5000 to invest.
29:38
What interest rate do you need to earn to reach that goal?
29:42
So you have to you have to get about a 17% interest rate.
29:45
OK.
29:46
Which unless if you were in the 19, late 1970s, early 1980s, they're trying to find a 17% return, it would
be, you know, very, very difficult.
29:57
OK, OK, now here's a different one.
30:02
We want to solve for T OK, OK, So we want to solve for T here so we can isolate T If you think back to
maybe high school mathematics, I I think you would have covered this exponents with and logarithms
and lawns.
30:36
So if you want to isolate for an exponent by itself, you need to take the lawn lawn as a mathematical
operator.
30:44
OK, And we can find what T is.
30:48
OK, so here you want to purchase a new car and you're going to pay $20,000.
30:56
You can invest at 10% per year and currently have $15,000.
31:01
How long will it take?
31:02
OK, so here you can you can solve for T OK.
31:07
And again, you just plug in the numbers and you can see it's gonna take 3.02 years.
31:14
OK, OK, that's a pretty simple example.
31:25
OK, I'm not gonna do that one.
31:27
OK, Now this is very important, not for the sake of a test, but if you're gonna become a business
professional, management consultant and certainly a financial, you know, financial analyst, financial
consultant, CFO, you know, controller, you're gonna want to know these Excel commands.
31:47
OK, I'm not gonna test you on it, but I can certainly tell you as a finance professional, I use these on a
regular basis.
31:54
OK, so in Excel, for example, the future value, the arguments of the function arguments are.
32:00
The are the parts in parentheses there.
32:06
So in order for Excel to calculate the future value, you need to tell it the rate, the amount of periods,
the payment for.
32:16
And the present value.
32:17
OK.
32:19
And there's similar arguments for different functions that you plan to find.
32:23
OK, so again, you have the future value, the present value, the rate and the number periods.
32:28
OK, So let me see if I can show you that here in Excel.
32:38
Let's see if it's going to come up here.
32:45
OK, Just bear with me here while I share my Excel screen.
32:57
OK, OK, so here, here's a question.
33:10
You have 15,000 to invest right now.
33:13
You want 25,000 to buy a car.
33:15
You earn 9% per year.
33:18
How long before you can buy the car?
33:21
OK, so you have the present value.
33:24
You have the future value.
33:26
You have the rate.
33:28
This is in percentage.
33:29
This is in decimal.
33:30
OK, so you're going to use this particular function, the N per function.
33:36
OK.
33:37
And here you're telling Excel the different parts that you need.
33:42
OK, and.
33:44
And Excel is going to solve for you and tell you that it's 5.92.
33:51
We could do the same here.
33:53
Here we have a future value question.
33:56
Here we have a present value question.
33:58
Here we have rate.
34:00
OK.
34:01
For example, you have 30,000 to invest, OK and you need 45,000 for a down payment and closing cost
on a house.
34:13
If you wanna buy the house in two years, what rate of interest do you need to earn?
34:18
OK, so again, you have your present value, the 30,000.
34:22
You have your goal, the future value.
34:25
You wanna find the number, the the rate.
34:29
OK, so you have the number periods, 2 periods.
34:32
And here you're telling Excel what to calculate.
34:36
OK, so you're saying you're saying to Excel.
34:41
Here are the different arguments.
34:43
OK, you you.
34:46
OK, so you see, you notice that G4 is a negative, OK?
34:49
Because you're gonna take out that money.
34:52
OK.
34:54
The present value is positive G3, OK.
34:57
And then G5.
35:02
G5 is the number of periods, which is 2.
35:09
OK And that's, yeah, that's pretty straightforward.
35:12
You can you can play around with that as well.
35:14
You can download the PowerPoint and double click on Excel and see these examples.
35:19
OK, so I want to explicitly ask you to use Excel on a test.
35:24
However, it's a good skill for you to have.
35:27
OK, OK, so that is chapter five.
35:38
OK, I'll just share the summary slide with you here.
35:46
OK, OK, so let's Chapter 5.
35:58
The important thing to remember about Chapter 52 items One, money in the future is worth less than
money today because of opportunity cost and inflation and the mechanics of how we calculate this
intertemporal exchange.
36:16
How we figure out the exchange between money today and money in the future is given by the
present value, future value formula.
36:25
OK, And we have 4-4 iterations of that, if you will, or four ways that the formula is represented.
36:33
OK, so we can isolate to solve for P for R, for PV, for F, OK, All right.
36:42
So that's Chapter 5.
MOS2310A_S23_Chp6_Lecture
0:00
Chapter 6
0:02
builds upon Chapter 5 naturally.
0:06
Let me share the screen here from current slide. OK,
0:12
So now what we want to do is, is use the skills we developed
0:16
in Chapter 5 and apply it to more applications in finance, OK? In particular, what we call annuities and
Perpetuities, OK. And these are very useful for things like loans like mortgages and whatnot.
0:31
So you currently have 7000 in the bank account that earns 8% interest. You think you'll be able to
deposit 4000 at the end of each of the next three years?
0:42
How much will you have in the three years?
0:46
So now this is important. You can see that this question is already different than what we talked about
in Chapter 5.
0:52
In chapter five, we simply assumed
0:56
cash inflows and outflows at the beginning and end. We didn't assume any intermediary inflows and
outflows. Now you're making these periodic deposits, right?
1:07
So here we can we can approach it this way.
1:11
Find the value
1:13
year 3 for each cash flow and add them together.
1:18
OK. So today in year zero, OK, you're going to put your $7000,
1:26
that $7.00 is going to accumulate interest at 8%, OK.
1:31
In year one you put 4000-4000 has two years to accumulate interest.
1:38
In year two you put another, 4000 has one year, and in year three the 4000 you put in doesn't have
any time to accumulate interest. OK. So the total value
1:49
of this of your cash inputs in three years, it's going to be 21,000,
1:55
803 dollars.
1:58
OK,
2:05
OK, here's another example.
2:08
Suppose you invest $500 in a mutual fund today
2:13
and $600 in one year.
2:16
If the fund pays 9% annually, how much will you have in two years?
2:23
So you can see here, OK, using the formula,
2:28
so the future value, we put $500 in, OK,
2:33
and that $500 is going to grow at 9%, OK.
2:39
And that's going to happen for two years.
2:42
The $600.00 you put in only has one year to grow, OK?
2:48
And you're going to add both together and you're going to see the future value is going to be 1248,
2:59
OK.
3:01
How much will you have in five years if you make no further deposits? OK. Well, the initial $500 you
put in OK is going to have five time periods, so five years,
3:13
alright,
3:14
growing at 9% interest.
3:17
The 600 you put in next year only has four years that incur interest,
3:24
so that's going to be 1616. OK.
3:28
The 2nd way to approach this is prior to this question. We found
3:35
what the value was after two years, so the 1248
3:40
because no more cash inflows are happening. We can treat this as a classic time value of money. So
Chapter 5,
3:49
So here you have the present value, which present value as of two years from now and it's going to
have three time periods to grow at 9%. So the future value is going to be 1616. You get the same
answer. OK,
4:06
now some of this may seem a little bit confusing, and it's important that you practice.
4:12
Like I always tell students, finance is not a spectator sport.
4:16
I've never seen anybody simply listen to the lectures and and glad to the textbook and do well in this
class.
4:21
You really have to practice, practice, practice questions. OK?
4:25
That's how you'll get that proficient at it.
4:29
Here's another example. Suppose you plan to deposit
4:33
$100 into an account in one year and 300 into the account in three years.
4:40
How much will be in the account in five years if the interest rate is 8%? OK, so again, here's the
formula. OK. So we put the $100 in,
4:54
OK,
4:56
We put it in, in one year. So the $100 isn't going to have this year to incur interest, OK. So it's only
going to have four years because it takes a year
5:07
for us to even put the $100 in, OK.
5:11
And then it took three years to put the $300
5:17
in one, right? Took three. Three years to put the $300.00 in. So there's only two years left for it to
accumulate interest. OK.
5:25
So you can see that there.
5:31
OK, this is pretty simple,
5:33
but let's show you how to use a timeline.
5:36
You are offered an investment that will pay you $200 in one year,
5:42
$400.00 the next year, 600 the year after, and 800 at the end of the following year.
5:49
You could earn 12% on a similar investment.
5:53
How much is this investment worth today?
5:56
So I'll give you a hint. The phrase you could earn 12% is very important. OK? This becomes a reference
rate or required rate of return. OK,
6:08
being able to draw a timeline is very important, especially for more complex questions.
6:14
This is a skill you want to have. In fact, there will probably be a question on your test where you will
need to draw a timeline and explain your calculations. OK,
6:28
so you can you can see here from the question.
6:34
OK.
6:37
We just omitted A0 for the numbers, but it's the same thing.
6:43
Year one, you're going to get $200.
6:47
End of year two, you're going to get 40,
6:50
etcetera, etcetera.
6:52
What we're trying to do here is we're trying to bring all of these to the present. OK,
6:57
so
6:58
$200 what we're doing here is $200.00 / 1.12, so the 12%, OK, that's the required return.
7:10
Same thing in year two, it's going to be 400 / 1.12, OK. Last year it's, sorry, it's going to be 400 / 1.12
^2, OK.
7:22
In the fourth year, it's going to be 800 / 1.12 to the power of four, OK.
7:28
And we're going to add that up.
7:31
So what this tells me is, if my required rate of return, OK is 12%, the most I should be willing to pay for
this investment
7:41
is 1432.93.
7:45
OK,
7:49
find the present value of each cash flow and add them. That's that's what we did.
7:55
So you can see here, this is the math. OK,
7:59
so these are the different. So whatever this investment is,
8:02
God,
8:04
you know, it could be equity, it could be a real asset, you know, contributing to a factory. Whatever
the case is,
8:13
this is the stream of cash flows from the asset, OK.
8:18
So yeah, one $200, you have two 400 year 3600, you have 4800 and what we want to do is again come
up with the present value, OK. So that stream of cash flows is worth 1432.93 today
8:34
when discounted at 12%. OK. And why are we using 12%? Because 12% is the required rate of return,
so the return we would get
8:44
in the financial market for an asset of similar risk, OK. And in finance, risk means standard deviation or
volatility of the outcome.
9:00
OK, I'll skip the calculator part.
9:03
OK. And again, we can use Excel to do this. OK,
9:08
I'll show you how. Let me just pull up Excel here.
9:22
Let me share my screen again.
9:28
OK.
9:30
So
9:32
consider the cash flows presented in the following table.
9:36
So year 1000, year 23000, etcetera,
9:41
you could find the present value, OK.
9:44
So this is, this is telling us the formula that we're going to use here. OK. And this is actually used in the
formula. OK,
9:53
so this is this is telling me the different parameters that I need. OK,
9:59
and you can see that the total present value you take the sum of the individual present values. OK.
10:08
And a couple of comments. OK,
10:12
so the negative sign before the present value formula makes the result positive. OK, so in general in
Excel the present the present value formula is set by default to be negative. That it's present values of
cash outflow to you.
10:33
So in this case, because this is cash coming in, you need to add a negative sign. OK?
10:39
Umm,
10:41
in Excel, add in a dollar symbol
10:44
creates what's called an absolute reference. OK, so the dollar sign around B3
10:52
makes the rate an absolute reference so that the form that may be entered once and then copied
down. If you don't do that Excel it just the that cell reference. OK.
11:05
And the formula asked for a payment between number of periods and future value,
11:10
hence the two commas together. OK,
11:17
OK.
11:21
OK. So that's how you would use Excel.
11:23
You can also easily adjust it for future value.
11:28
Yeah.
11:31
OK. Let me share my PowerPoint again,
11:39
OK.
11:46
OK,
11:48
here's another example. You were considering an investment and I'll pay you $1000 in one year,
11:55
2002 years, 3003 years.
11:59
If you want to earn 10% of your money, how much would you be willing to pay? OK, again,
12:06
here we're trying to find what you're willing to pay. So your present value, OK,
12:13
so you can see here, if you want to in 10%, you could find the present values of all those cash flows,
add them together, you get a little bit less than 5000. OK.
12:25
The calculator stuff I won't dwell upon.
12:30
OK, here's an interesting application. Your broker calls. OK, so if you don't know a broker is is an agent
that will implement your trade. So a stock broker for example, OK,
12:45
so your broker calls you and tells you that he has this great investment opportunity. If you invest 100
today, you're going to get 40 in one year, 75 in two years. And if you require a 50% rate of return on
investments of this risk,
13:01
should you take the investment? OK,
13:05
so here we could do this in Excel or by hand, they just showing you how to do it with the calculator.
But in fact, the broker is wrong. The present value of this,
13:16
given the level of risk involved, is $91.00. OK, so you're going to pay $100 for something that's really
has an equivalent present value of $91.00. So you're being overcharged.
13:29
OK,
13:33
here's more of a classic scenario.
13:38
You're offered the opportunity to put some money away for retirement.
13:42
You will receive five annual payments of 25,000 each beginning in 40 years. OK.
13:51
How much would you be willing to invest today if you desire an interest rate of 12%? OK.
14:00
So it's very helpful to start with a time diagram.
14:05
So from years 40414243 and 44, you're going to get $25,000, OK.
14:14
And again, if we look at the question, right, so you're offered the opportunity to put some money
away
14:21
and you're going to receive 5 payments of 25,000 each. You get it in 40 years, OK?
14:29
You need to figure out how much are you willing to put in today to get that. OK.
14:35
So the cash flows in years 1 to 39 are zero. You're not putting in any intermediary amounts, OK.
14:44
The cash flows in year 40 to 44 inclusive is 25,000, that's how you get the five payments, OK. Year 40,
Year 41, Year 424344. OK,
15:01
so we can use the calculator to do this or we can we can use the formula or excel but you will see here
that the present value is about $1000. So given given that 12% OK rate of return you desire,
15:17
you can you can find this present value to be 1000
15:21
and $84 OK.
15:28
So that's that's the present value of the five payments, 25,000 beginning in year 40.
15:36
OK,
15:40
OK,
15:41
we won't bother with the quick quiz because you're going to get plenty of practice in the homework.
15:47
OK, here's where this starts to get important.
15:51
In finance, we have us called an annuity and a perpetuity.
15:56
Let's start with an annuity.
15:58
And annuity is a
16:02
regular payment. So amount of money that occurs consistently for a finite amount of time, OK.
16:09
So for example, if you have a car loan and you might pay like say $500 a month for five years, that's an
annuity.
16:16
If you have a mortgage, you might pay $2000 a month for, you know, 10 years or 15 years. Whenever
you have a consistent amount of money, that's paid for a finite. So finite means countable.
16:31
You're dealing with an annuity,
16:33
and because the situation occurs so often in the world of finance,
16:38
it's important that we understand it and we can find an efficient way to calculate it. OK.
16:44
In annuities, there's two types.
16:47
If the first payment occurs at the end of the period, it's called an ordinary annuity.
16:54
If the payment occurs at the beginning of the period, it's called an annuity due,
16:59
and you can understand this intuitively
17:02
if you have to make a payment of $1000 a month for five months, OK.
17:09
If that payment starts at the beginning of the month, that's different than if it starts at the end of the
month. If it starts at the end of the month, it's effectively a lower payment to you, OK? Because again,
we talked about this in Chapter 5. Money in the future is worth less,
17:26
so if you have to make a payment at the end of the month at the end of the year versus at the
beginning, that payment is effectively cheaper.
17:36
Is an infinite series of equal payments OK,
17:41
cost examples, If you win the lottery and they say you know, $25,000 a year for life or something like
that, OK, well, not not for life, but a perpetuity would be. You know, if they say we'll pay 25,000 a year
to you and your ancestors continually, that would be that would be a perfect city.
18:02
Examples of perpetuities.
18:04
I talked a bit about this earlier.
18:08
This mostly comes from medieval times
18:12
where you know you had kings and Lords and whatnot, and oftentimes for the crown to finance a war,
18:20
the kings would sell a perpetuity. So in the case of the British Empire, something called a console,
where
18:30
basically the Crown would promise to pay,
18:32
you know, an infinite certain amount of money
18:36
for an infinite time horizon to, you know, perhaps some wealthy Lords that they wanted to raise funds
from, You know, trying to fund a war.
18:45
Uh, that would be the most realistic example of one. OK, this also happened too in in
18:52
in China. If you studied Chinese history in the early 1900s, there there were equivalents of this
perpetuities
19:01
that issued by the ruling dynasty at the time.
19:08
OK, so the basic formula to calculate the perpetuities as follows.
19:13
The present value for perpetuity is CC. Is the cash flow divided by RR. Is the per. Interest rate, OK.
19:23
And annuity, this is more complicated. OK. The formula for an annuity is as follows. OK. The present
value CC is the cash flow.
19:32
Parentheses you can you can just read it. R is the interest rate per. T is the time period OK? Again,
19:42
pay attention to what's called internal consistency.
19:45
So you'll see your R and your T all have to be to the same time reference. So daily, monthly, annually,
etcetera. OK,
19:58
OK.
20:00
Let's do an example here with annuities.
20:06
OK, so here's an example. After carefully going over your budget,
20:10
you have determined that you can afford to pay 632 per month once a new sports car OK,
20:16
your bank will lend you at 1% per month for 48 months.
20:21
How much can you borrow? OK,
20:24
so again, we can use our present value annuity formula, so C is 632. OK. Now remember, this is 632
per month, so this is helpful,
20:35
48 months, OK. So that's helpful as well.
20:39
And 1% per month. So you notice here everything is per month, OK. So we have that internal
consistency
20:47
we'll talk about later on, we'll talk about what do you do when that doesn't exist. It becomes more
complicated question.
20:54
So you can see here that the present value of these payments you want to make towards this car
21:01
is effectively about $24,000. OK.
21:07
OK.
21:09
What's a good time to take a break?
21:12
So let's let's take it Well, before we take a break, does anybody have any questions so far?
21:18
Any any questions so far?
21:23
OK, No. OK. So let's take a 10 minute break. So it's eleven O 9, so let's come back at 1120, OK?
21:33
Take a 10 minute break and then we'll come back and we'll continue on with Chapter 6.
35:22
OK, let's continue on. So I'm going to share my PowerPoint again.
35:33
OK.
35:35
So we were talking about annuities, right?
35:40
And remember, an annuity is a constant amount of money that occurs regularly
35:46
for a finite amount of time.
35:49
So here, here's an example.
35:52
Sweepstakes are a lottery. OK,
35:56
suppose you win the Publishers Clearing House 10 million sweepstakes.
36:02
The money is paid in equal annual installments of 333,000
36:09
over 30 years.
36:11
If the appropriate discount rate is 5%,
36:15
how much is the sweepstakes actually worth today?
36:21
So you can classic present value problem, OK, And we're using that annuity, OK,
36:28
because we have a recurrent amount of money.
36:31
So we plug it into the formula and we can see that even though it's advertised
36:37
as a $10 million sweepstakes,
36:39
it's actually effectively closer to 5 million. OK,
36:47
we can use Excel to do annuity calculations. I will show you that. In fact, I use Excel all the time to
calculate annuities.
36:57
Let me just pull up the
37:00
my excel here.
37:08
Share my screen with you
37:14
so you can see this OK
37:18
Excel is able to do this very easily. OK.
37:22
You have the rate, OK,
37:26
but what is the present value of 50,000 per year for 15 years?
37:32
So again, you have all the pieces you need,
37:36
OK.
37:37
So you have the payment amount PMT, you have the rate, you have the number of periods, OK. And
per
37:45
and you have the formula.
37:48
OK.
37:49
And again, we put the negative because Excel defaults to present value to negative, OK. It assumes
you're making a cash outflow of a payment,
37:59
when in fact this is the context of the question. Tells you
38:03
that this is a money coming to you. OK.
38:09
OK. So that's the how we can do it in Excel.
38:16
In fact, one of the projects I'm working on as a consultant right now
38:24
is for a new credit union
38:28
that a community in the GTA wants to establish. And we're building a financial model.
38:34
And you can imagine as part of that financial model, annuities are very important,
38:40
for example, trying to price a mortgage from the standpoint of the lender and whatnot. So this is the
very important tool is learning how to use annuities and how to use Excel. OK.
38:58
OK,
39:01
let me share my screen again here back to the PowerPoint.
39:07
OK,
39:12
OK,
39:14
here's another example how to find the payment.
39:17
Suppose you borrow 20,000 for a car.
39:21
You can borrow at 8% per year, compounded monthly. OK. Now see, this is important.
39:29
You see here we have 8% per year, OK. But we want to find a monthly amount, OK.
39:38
So we're divided by 12 because there's 12 months in a year.
39:43
So this is effectively a you know about 6.67% per month they're being charged.
39:51
If you take a four year loan,
39:54
what is your monthly payment. So you see we had this is where we have time inconsistency, OK, we
we have an annual interest rate but we want to find monthly payments.
40:05
So very important that we convert our annual interest rate to a monthly amount, OK.
40:12
So using the formula, OK, we have 20,000, OK, This is the present. This is the present value we want to
solve for CC. Is that regular cash, a regular payment amount? OK. And that mathematically we can
isolate for C So the monthly payment given these parameters OK would be 488.26. OK,
40:41
I won't do excel for this one, but it could be that unexcelled very easily.
40:46
Another example, you ran a little short on your February vacation. You put 1000 on your credit card.
You could only afford to make the minimum payment of $20.00 per month.
40:58
The interest rate on the credit card is 1.5% per month.
41:02
How long would you need to pay off the $1000?
41:05
So it's pretty easy. OK yeah, so 1000 is the is the present value. That's the amount we want to pay off.
41:13
We can pay $20.00 per month. That's our see here. We're trying to solve for T OK, so it would take us
93 months or we can convert that into years by dividing by 12, which will take us about 7.76 years. OK.
So if you if you just make the minimum payment, that's going to take a long time
41:38
and there's a very big assumption there that you don't charge anything else on the on the card. OK,
41:45
that's another example of solving for T which is pretty straightforward.
41:50
Um,
41:53
if you don't have access to the financial calculator.
41:56
In fact, what the financial calculator actually does is a trial and error approach, but it does it so quickly.
This is what's called numerical methods. It does it so quickly that it it's able to,
42:08
you know, effectively, instantaneously give you an answer.
42:11
But mathematically, prior to financial calculators, the way you would solve for the interest rate
42:17
in the time value of money problem
42:21
would be using approximations and formulas and then doing trial and error around the
approximation.
42:30
But that's just for your own in general knowledge. OK,
42:35
uh, OK. Example of future value. Suppose you begin to save for your retirement by depositing 2000
per year
42:43
in an RRSP. If the interest rate is 7.5%, how much would you have in 14 years?
42:49
So again, we're just using the formula, we're putting 2000, that's RC. We know the interest, We know
the time, we can find the future value.
42:57
You would effectively have about half $1,000,000. OK,
43:02
OK.
43:06
Now remember we said with annuities, there's two types.
43:10
There's ordinary annuities, OK?
43:14
There's ordinary annuities where the payment happens at the end of the time period, whatever the
particular reference time period is, a month? A year, OK, Or an annuity due, where the payment
happens right away.
43:26
You're saving for a new house and you put 10,000 per year in an account paying 8% compounded
annually. OK.
43:37
The first payment is made today. OK, emphasis on today. How much will you have at the end of three
years? OK,
43:47
so
43:48
doing a time diagram is very helpful.
43:51
You can see here in the case of an annuity due that 10,000 is effective immediately,
43:57
OK,
43:59
versus in the case of an ordinary annuity at time zero, there wouldn't be that $10,000. So we would
lose out in a period that we could incur interest, OK.
44:11
So we can use a formula here, OK. And we have a regular payment of 10,003. Three periods, three
time periods,
44:21
and we can find the future value of 35,000. OK,
44:26
OK, here's a perpetuity.
44:30
So in equities, we have common stock and preferred stock.
44:37
And theoretically companies have what's called a going concern, which means we assume that they
exist indefinitely.
44:45
And
44:47
preferred stock, especially preferred stock in major companies, tends to pay a fairly regular dividend.
44:55
So it's an approximation. It's sort of a modern day approximation to a perpetuity,
45:00
even though it's a bit of a stretch. And I say it's a bit of a stretch because
45:04
if, for example, you were to look at, you know, the 50 biggest companies in America,
45:10
you know, at the turn of the 20th century, so the early 1900s,
45:15
the vast majority of those companies don't exist today. And and if you looked at the biggest
companies at the beginning of the 21st century, so the early 2000s, in 100 years from now, they
probably won't exist, or at least not in the form you know them as.
45:29
So
45:30
it's it's a bit of a intellectual stretch to call preferred stock in perpetuity, but just for the sake of
knowledge and an easy example, we'll assume that it is.
45:44
So
45:46
the Home Bank of Canada wants to sell preferred stock at $100 per share.
45:51
A very similar issue of preferred stock already has an outstanding price of $40 per share
45:58
and offers a dividend of $1.00 every quarter.
46:01
Notice here now we have a different time reference 1/4. So 1/4 is 3 three months, OK, Because there's
four, three month period in a year,
46:12
what dividend would the Home Bank have to offer its preferred stock if its preferred stock is going to
sell? OK.
46:22
So here we can see that $40 is what a similar stock is selling at, OK.
46:30
And you can see here,
46:34
we're going to offer a $1.00 dividend every quarter. OK.
46:39
All right. And we want to solve for for R,
46:43
So we basically need to offer an interest rate here of 2.5% per quarter, OK. So
46:52
using the required return found above, we can find the dividend.
47:00
So
47:02
see, being that regular payment, in the case of preferred stock,
47:06
the regular payment would be a dividend. OK. So we can solve for C.
47:13
So there's two steps to this question. One, we need to find what would be the competitive rate of
return given the market price of similar preferred stock.
47:23
And once we find the competitive rate of return, we then have to find what that means as a dividend.
47:30
So we can find that in this case we have to offer a dividend of about $2.50 per quarter,
47:38
and this is a good example. You should, you should study this example. OK,
47:45
OK, the perpetuities discussed so far have constant payments. OK, but this is, you know, constant
payments probably aren't realistic, especially for long time periods.
48:01
Um,
48:03
a more realistic example is what we call a growing perpetuity. So these are cash flows that grow at a
constant rate, OK? So for example, maybe they grow at the rate of inflation.
48:14
We can modify the formula as follows.
48:18
Growing perpetuity is C, so C1 is is. The subscript 1 donates the time period, so the the cash in the
first period,
48:28
zero being today
48:31
our minus G, OK, so G is the growth rate, R is the interest rate.
48:38
The Hoffman Corporation is expected to pay a dividend of $3 per share next year.
48:45
Investors anticipate that the annual dividend will rise by 6% per year forever. OK. So that's our growth
48:56
and the required return is 11%. OK,
49:01
what is the price? So we just plug it into the formula, you get $60.00, OK.
49:07
We can also modify our annuity formula to get a growing annuity, OK.
49:15
Again, the difference between an annuity and the perpetuity is that the annuity has a finite amount of
periods, OK. Growing annuity is is more realistic as well,
49:29
so here's an example.
49:33
Giles has been offered a job at 50,000 a year.
49:37
He anticipates a salary will grow at 5% a year until his retirement in 40 years.
49:44
Give an interest rate of 8%. What's the present value of his lifetime salary?
49:50
So we can find this fairly easily. It's a little bit over $1,000,000. OK,
49:58
OK. So that's Chapter 6, the nutshell. OK.
50:05
Any questions or comments about Chapter 6?
50:11
Who do we have today? We have Ethan. We have Aiden, Rugee, Ryan,
50:17
Samantha Wang,
50:21
Yin Yu.
50:23
Any any questions about Chapter 6?
50:29
I just had a quick question about for like if we don't have a financial calculator and you were saying
how that's kind of the easier way to calculate things as compared to a normal calculator or a normal
calculator can do these type of questions. So you need a specific finance. Yeah. So your standard
calculator
50:49
isn't able to do high value money corrections. So like
50:54
I know that like a lot of the slides had like two different ways to do it. So we should the people with
normal calculations, we should just kind of do it in like the first examples that you were showing,
correct. So so basically there's 33 broadways. One is the formula. So the formula in that diagram like a
time value of money chart
51:14
the. So that's the 1st way you know the the formula. You want to call it the by hand method. That's
method one.
51:20
Method two would be the financial calculator, so the slides say you know these are the particular keys
you would press, and the third would be something to computer software like Excel.
51:30
OK, on a test you can use any one you like.
51:35
I'll never force you to use Excel or the financial cap there. There may be a question that says you know,
using a diagram and formula, you know show your work. So you certainly had a minimum. You need
to know how to how to use the formula, how to draw the time
51:53
at the time value of money diagram. So, you know, year zero, year 40.
51:59
So OK, so you can totally just use a normal calculator and write it like that. OK. Yes, yes, yes. I mean,
for myself because I've used the financial calculator for so long, it's, I just use it in my own work. But if
you're in it, would it would there's a bit of a learning curve. Yes. OK, That makes sense. OK, thanks. No
problem. No problem.
52:22
Anybody else?
52:29
Don't be shy if you have any questions. I know it's a lot to absorb when you practice the questions.
That's when these concepts will set in.
52:38
OK,
52:40
OK, the next item on the agenda. So as I say, I would like to give you some real world context with my
lectures.
52:48
So I've posted 2 videos. You can find them in resources Recorded lecture Lecture 3. You'll see the
videos for today.
52:57
It's about 15 minutes
52:59
and they give some context related to mortgages. So mortgages are a classic application of an
annuity,
53:06
but in the real world it's a little bit more complicated. The reality is mortgages are often reset, so
53:15
you might get a mortgage rate for five years, then it renews based on the prevailing interest rates.
53:22
So
53:23
in a lot of these questions we simply assumed certain variables. Is what's called exogenous outside of
the question.
53:30
But in reality, some of those variables we can actually explain a bit. So you might be able to figure out,
53:37
you know, for the first five years of my mortgage, that's an annuity. The next five years is also an
annuity, but I can expect the interest rate to change. OK. So watch those videos and then then I'll give
you some context on it. OK. So
53:53
it's about 15 minutes. So let's meet back at 12:00 PM That should give you enough time to watch the
videos and I'll give you some comments and then we'll wrap up for today.
1:12:58
OK, hopefully you had a chance to watch those videos.
1:13:03
It may be a bit technical for you. I don't expect you to get every single aspect of it,
1:13:08
but I do want to give some real world context on the textbook material.
1:13:14
So for example,
1:13:16
if you think about a mortgage,
1:13:19
let's say you have a 25 year mortgage.
1:13:22
That mortgage may be actually broken into five annuities. So every five years,
1:13:28
you know maybe you have you've signed on for a fixed rate. So it's it's you've just taken a mortgage,
1:13:34
you've signed on for a five year fixed rate, you can calculate what your payments will be. So for that
five year. You can calculate an annuity, OK. Then for the next five years, you can calculate another
annuity.
1:13:47
With mortgages, you can choose either fixed or variable rates. OK,
1:13:53
I'm I'm not going to explicitly test you on this, but
1:13:58
if you chose a variable rate this relates to what I talked about at the very beginning of time value of
money that in more complex real world scenarios the are variable is not fixed,
1:14:12
in fact it can actually change.
1:14:15
So instead of having one R, you would have you know R1R, 2R3 based on the respective time.
1:14:23
So in in reality when you're trying to price long dated investments or assets, you typically have a
bundle of annuities, OK. So you can think of a mortgage as a bundle of annuities based on the
renewal periods, OK.
1:14:42
And in fact,
1:14:44
if you wanted to calculate what you think the present value of your mortgage payments would be, you
would typically do scenarios so you know based on how that path of interest rates would change.
1:14:57
So you might have a scenario where the Bank of Canada raises interest rates quicker than you expect,
maybe one way where it's lower and then the base rate, OK. Or conversely, you may try to figure out
over the life of your mortgage is it better to have fixed rates or variable rates
1:15:16
and you can calculate that. Again, it's it's a present value calculation. Scenario one you calculate the
present value of your mortgage payments if you do fixed rates. Scenario two, present value. If you do
variable rates
1:15:30
and you know, you'd make some assumptions about future interest rates,
1:15:34
but ultimately the goal would be to see which scenario gives you the lowest, you know, mortgage
payments over the commitment of your mortgage.
1:15:43
So, and this doesn't just have to be for residential, in fact this is often done in commercial applications.
If you think about, you know, major commercial real estate developers.
1:15:52
So there's a lot of interesting real world applications to this.
1:15:57
So over that gives you some motivations. How useful these tools are developing are in terms of real
world application. OK,
1:16:08
um so that's a good place to stop it at for today. The homework is posted. OK so homework and the
solution manual is posted. Make sure you practice. As I always tell students, finance is not a spectator
sport
1:16:22
and typically they do well in this course. You know, the general rule for any university level course is
for every hour in class, you know you should probably do at least two hours outside of class of self
study and practice.
1:16:36
And I'm off. Sometimes students ask me what will be the average mark on the test.
1:16:41
The average can vary a little bit, but in general, the university and the department has
1:16:48
policies related to the class average by the level, of course, and this is right in the syllabus.
1:16:54
So typically for a second year course, the average is around a C plus or or maybe at most the B minus.
OK. So sometimes students ask me that question and it's sort of a redundant question because the
average is stated right in the syllabus. That's a policy of the department. OK.
1:17:12
So if no one has any questions or comments, we'll wrap up for today, but I'll just do a last check. Any
questions, comments,
1:17:21
What do we have today? We have eating. We have Courtney.
1:17:24
We have Ming Ming,
1:17:27
Ryan, Sarah F, Sarah M Go ahead ask. The contact of the video will be tasked in the exam.
1:17:39
So the the videos if I do test them, it won't be
1:17:47
it. It won't be a very hard question, it would be more of a general question. So it could be something
like it could be a short answer question
1:17:56
that would say how would annuities apply to a real world mortgage scenario. So something related to
the video and our discussion. OK,
1:18:09
Electron for us to memories in this videos. No, no more more the general lesson from the video. Yeah,
OK. Thank you. No problem.
1:18:22
I have a question. Yes, go ahead. So in this in this slide that the saving for retirement slide,
1:18:30
I don't know what it's 18, Slide 18, slide 18. Hold on, let me share it again.
1:18:38
OK, Let me just share the screen here. So we're looking at the same thing.
1:18:44
OK. The slide, Yeah. I'm just wondering how you can find the answer without the calculator. Without
the financial calculator,
1:18:51
you were offered the opportunity to put some money away for retirement. You receive five annual
payments of 25,000 each.
1:19:00
Yeah. OK. So
1:19:03
basically if you look at what they did, they they drew a diagram, OK
1:19:10
and all all you're going to do, you don't have to use the calculator, you just have to find the present
value of each cash flow. So the present value of the $25,000 in year 4041, you find each present value
1:19:25
and that would be the
1:19:28
the amount that you'd be willing to pay at a maximum. So you don't even you can just do it by hand.
1:19:35
So here, here, you know it's 12%.
1:19:39
So the present value of the 25,000 in year 40 is $25,000 divided by
1:19:46
1.12 to the power of 40 and same for the other ones. And you would take the sum of that.
1:19:54
Does that make sense? Yeah, that makes sense. Thank you.
1:20:01
Anybody else?
1:20:08
OK, well, if nobody has any questions, that's a good place to stop at for today.
1:20:14
Of course, if questions come up, you can always e-mail me and I usually get back within a day or two.
OK,
1:20:21
so have a good rest of the day, stay safe and I will see you next week.
Chps6_pt2_7_8 1
0:00
Eight.
0:01
So I'm gonna share my screen here.
0:04
I apologize if there's some background noise.
0:07
I have some yard work going on in my in my house today or outside of my house around the hedges
and whatnot.
0:15
So just bear with me, but hopefully you can you can hear it.
0:20
OK.
0:26
OK, OK.
0:31
So last time on Chapter 6, we talked about two important aspects in finance.
0:39
One's called an annuity and one's called a perpetuity.
0:42
And these are important tools because many financial applications have annuities, less so perpetuities,
but they're still so important applications.
0:51
So knowing how to work with these tools is very important.
0:55
It allows us a quick way to compute, like I said, frequent applications, things like mortgages, car
payments, et cetera, OK Perpetuities, not so much today, but they are important if for example, you're
a portfolio manager for say a family office or something to that extent.
1:14
OK, Now there's one last topic here in Chapter 6, it's called effective annual rate, OK.
1:26
And this topic is quite important because sometimes it's easy to confuse consumers, right?
1:35
But you know, there's an old phrase, if it looks like a duck, it cracks like a duck.
1:38
It's a duck, right?
1:39
If it looks like a duck, it walks like a duck.
1:41
It cracks like a duck, it is a duck.
1:44
Well, with interest rates, that's sort of the premise of effective annual rate.
1:49
Sometimes the stated rate can be a bit misleading or a bit confusing, but we have to think deeper,
especially when there's compounding involved, OK.
2:02
So with the effective annual rate, this is how we're going to approach it, OK.
2:08
So this is the actual rate paid or received after accounting for compounding that occurs during the
year.
2:17
So for example, you may have a rate of 10%, so an annual rate of 10%.
2:24
And to the untrained eye that may seem equivalent to having two semi annual rates of 5%.
2:32
But if there's compounding involved, so for example, if interest is paid upon the interest, then that's
not the effective rate.
2:40
OK.
2:42
So what effective annual rate allows us to do is if you want to compare 2 alternative investments with
different compounding periods, you need to compute the EAR for both investments and then you
compare the effective annual rates.
2:59
OK, so this is a tool to compare alternative investments with different compounding periods.
3:06
So for example, one investment has a compound period of a year, one investment has a compound
period of a year and a half, and they may have the same AP Rs, but the EA Rs would be different.
3:18
OK.
3:19
Now a common question I get is, is the EAR used and the actual contractual calculations?
3:28
The answer is no, that's the APR.
3:31
So APR is the rate that was used when you're drafting the contract, that card payment, for example,
OK, So this is the annual rate that is quoted by law, that's the APR, OK.
3:45
By definition, the APR is simply the period rate times the number of periods per year.
3:51
So for example, if it's 1% per month, you would multiply it by 12 months to get the annual rate OK.
3:59
If it's 4% semi annually, you'd multiply it by two to get the annual rate OK.
4:07
If it's 4% quarterly, you'd multiply it by three to get the annual rate OK.
4:13
So consequently, to get the period rate, we rearrange the APR equation so we can find the desired.
4:20
Whether that's a month, 1/4, semi, annually.
4:23
Whatever the case may be, we can do some mathematical rearrangement and we can find the period
rate.
4:29
OK, so the period rate is just the APR divided by the number of periods per year.
4:39
So for example, if my APR is 12% annually, I can find the monthly rate by doing my 12% divided by
the number of of that.
4:51
In the year.
4:51
So there's 12 months in a year, OK.
4:54
And that would give me my desired.
4:56
Rate, the monthly rate, OK.
5:00
Now the effective annual rate is different.
5:03
You should never divide the effective rate by the number PHP year, OK?
5:08
It will not give you the period rate.
5:11
There is a way you can convert the effective annual rate to an effective monthly rate, but it's not a
simple division.
5:18
It's a more involved calculation because of compounding.
5:21
OK, so this is pretty straightforward.
5:25
What is the APR if the monthly rate is .5%?
5:28
OK, well, that's pretty simple.
5:29
You scale up by 12.
5:31
And this is, I talked about this in the last slide.
5:34
OK, now this one's a little bit trickier.
5:37
Last example, what is the monthly rate if the APR is 12% with monthly compounding.
5:44
So you see this gets a bit trickier as soon as we introduce compound in.
5:47
It's not a simple calculation.
5:49
OK, so you can't simply divide the APR.
5:56
Can you divide the APR by two to get the semi annual rate?
6:00
No, because you have compound in.
6:03
OK.
6:06
So some important things to remember.
6:08
You always need to make sure that the interest rate of the time period match.
6:14
We talked about this last session when I talked about internal consistency, OK?
6:20
So when you're doing the annuity calculation, for example, if your cash flow is monthly, your interest
rate has to be monthly, your time period has to be monthly, the per unit of time references have to
match, OK?
6:34
You can't have an annual payment with a monthly interest rate with a semi annual time period OK.
6:42
So you have to have this internal consistency within the question.
6:49
So if you have an APR based on monthly compounding, you have to use the monthly periods for the
lump sums OK Or adjust the interest rates appropriately if you have payments other than monthly OK
so in a question the question makes not start with internal consistency.
7:09
You may have to adjust some of the variables to get the proper per unit of time reference.
7:15
OK, OK, so here's an example.
7:27
Suppose you can earn 1% per month on $1.00 invested today.
7:34
What is the APR?
7:35
OK, well that's pretty simple, right?
7:38
So you're earning 1% per month.
7:41
There's 12 months in a year, your APR is 12%.
7:45
Notice we're able to do this because there was no talk about compounding, OK, But how much are
you effectively earning?
7:54
OK, So you have, if you put your $1.00, right, and that $1.00 earns 1% and that's gonna happen 12
times, we can get the future value, OK?
8:09
So that future value is actually, you know, a little bit more than $1.12, right?
8:14
If we were to round it up, it's closer to $1.13.
8:17
So we can find what if we effectively earn, OK, well, effectively we've earned a rate of 12.68%, right,
which is higher than the APR.
8:28
That's 12%, right?
8:30
Because here we're earning interest upon that interest when we put our $1.00 in, that $1.00 is going to
grow every month and there's a little bit of interest that's also going to be accrued upon that interest,
right?
8:44
So the APR does not assume compounding.
8:47
It just simply assumes that principal amount is what's going to grow, where in fact it's both the
principal and the interest that will grow.
8:56
OK.
8:57
So the difference between 12% and 12.68% may not seem like much, but when you're dealing with
very large sums or very large or very long time periods, this can be quite a significant difference.
9:08
OK, what does effectively earn it mean?
9:13
Oh, effectively earn it.
9:14
It means what are you really getting like the effective amount, right.
9:19
So you know, if if you just think of the English word effective, right.
9:26
So if you were out, you know, let's say doing a, a very intense cardio exercise, a jog or, or, or Sprint
and your goal wasn't to exercise, you're still effectively exercise it.
9:40
So the, the end result is that you have exercised, right?
9:44
It's the same thing here.
9:46
So you're effectively earning this amount because your interest is building interest itself.
9:54
So even though the stated rate is is 12%, you're effectively getting 12.68%.
10:02
So if you go back to my example of exercise, you know, maybe you went to just do another task,
maybe you went to walk your dog, for example, but effectively you're getting exercise yourself even
though that was not the stated purpose.
10:18
Same thing here.
10:19
APR is the stated amount, but effectively you're gaining more than that rate.
10:25
OK, OK, no problem.
10:29
Suppose if you put it in another account, you earn 3% per quarter.
10:35
What is the APR?
10:37
OK.
10:38
So again, you're gonna there's this is not quoted quarterly, OK, So there's four quarters in a year, OK.
10:47
So 3 * 4 is 12%, OK.
10:52
But you need to remember if we consider compounding, that initial amount of money you put in is
gonna earn interest 2 every quarter, OK?
11:05
So you can look at this as a future value calculation.
11:09
So effectively you're not earning 12%, you're earning 12.55%.
11:14
OK.
11:16
Now we want a way to do this very direct.
11:21
We have a formula.
11:23
The EAR is one plus the APRAPR was always easy to find.
11:30
OK, APR will be stated and even if it's not stated as an annual amount, you can readily convert it.
11:37
So for example, if the stated monthly rate is, you know 2%, you multiply it by 12.
11:42
If the semi annual rate is 2%, you multiply it by two.
11:45
If the quarterly rate is 2%, you multiply it by 4.
11:49
OK, so here we have a formula and we'll we'll always know the APR.
11:55
It's very easy to find, OK, And we can plug this in and we'll get our effective annual rate.
12:02
And M is the number of times the interest is compounded.
12:06
OK, so if it's monthly, it's gonna be 12.
12:09
If it's semi annual, it's gonna be two.
12:11
OK, so here's here's where EE AR is very useful.
12:17
You're looking at two saving accounts, one pays 5.25% with daily compounding, the other pays 5.3%
with semi annual compounding.
12:30
Which account should you use?
12:34
So we can use our EAR formula, OK?
12:37
So if you look back here at the formula, this is what we're going to use, OK, because we're using daily,
there's 365 days in a year that becomes our M OK?
12:48
Remember M is the number of times interest is compounded.
12:52
So this is daily compounding.
12:54
There's 365 days, OK.
12:57
So the in the first account, the effective rate is 5.39%.
13:03
The second account, so the other account pays 5.3% with semi annual compounding, OK.
13:10
So there's only two semi annual periods in a year.
13:13
Here you can see the effective annual rate is 5.37%.
13:17
So you should choose the first account 'cause you're gonna an effectively higher interest rate.
13:23
OK, so again to go back to my everyday example of the word effective.
13:33
But then you have to take your dog out for a walk.
13:35
But this time you let your dog lead the way and your dog takes you on a on a trail that has a hill, right,
versus more of a flat surface.
13:44
OK, Well, you're effectively getting more exercise on that first route.
13:51
OK, So that's what EAR allows us to do.
13:55
EAR allows us to compare.
13:58
You have different compounding periods.
14:00
So here you have an account that has daily compounding, Then you have an account that has semi
annual compounding.
14:06
To the untrained eye, it would appear that the semi annual compounding is better.
14:10
It has a higher interest rate, but you have to take it into consideration that the first account is going to
compound more frequently, OK, 365 times versus 2 times.
14:23
And that's what EAR allows you to do, OK?
14:26
So you're able to see basically the nuts and bolts, if you will, of this interest calculation, OK, So here's
another example.
14:38
Well, continuing with the first, this is just the verification.
14:42
Suppose you invest $100 in each account.
14:46
How much would you have in each account in one year?
14:50
OK, so here we have our daily rate.
14:55
OK, so we have the rate divided by 365.
15:02
The future values is going to be the principal amount times the interest rate and that interest rate is
going to be multiplied 365 times because it happens every day.
15:12
OK, so you're gonna get $105.39.
15:16
The second account is a semi annual rate.
15:20
OK, so this is look here at the feature value.
15:27
We have the principal amount of 100 times the rate.
15:31
OK times that rate is gonna happen twice the compound twice.
15:37
So we can write that to the power two.
15:40
OK, so 100 and 5:37.
15:44
So this is what we call first principles where we're simply finding the end result, the future value
without using the EAR formula.
15:54
So this is a verification of what we saw here using the formula.
15:59
OK, OK, what if you want to go in reverse?
16:09
OK, so going forward was taking an APR and finding an EAR.
16:18
But what if it's the other way around?
16:19
What if you have an EAR and you want to know the APR?
16:24
OK, if you have an effective rate, how can you compute the APR?
16:31
OK, so rearrange the EAR equation and you will get the following.
16:45
So suppose you want to earn an effective rate of 12% and you're looking at an account that
compounds on a monthly basis.
16:54
OK, what APR must they pay?
16:57
All right, So here you're going in reverse.
16:59
You know the effective rate that you want to earn, and you know that this account is going to
compound on a monthly basis.
17:05
So what APR must the bank offer you?
17:08
OK, so we're just going to plug it into the formula.
17:11
OK, So we know our EAR is 12% OK and we know it's monthly.
17:20
OK, so there's here it's 1 / m OK.
17:25
So the API they must pay is 11.39%.
17:30
Now notice the EAR OK is less than the APR and that's a logical check.
17:37
You would you would expect it to be less than that.
17:40
OK, you would expect it to be less than that, and that's because you need a less of an EAR to get the
same APR because the EAR has intermittent compounding.
17:52
OK, here's another example.
17:58
Suppose you want to buy a new computer and the stores won't allow you to make monthly payments.
18:04
The entire system costs 3500.
18:08
The loan.
18:08
Is for two years and the interest rate is 16.9% with monthly compounding.
18:16
What is your monthly payment?
18:18
OK, so we can find the monthly rate here.
18:23
OK, so this is just from the question.
18:28
So 16.9% as a decimal divided by 12, OK.
18:33
And you can find the number of months.
18:37
So this is over two years, right?
18:40
So there's 12 months in a year over 2 * 2.
18:43
So it's 24 months.
18:46
We can put this into our formula, OK?
18:51
OK.
18:52
So we're just, we're just plugging in the numbers that we want, OK?
18:56
And we can see here that the payment is gonna be 17288, OK?
19:03
So this is just plugging it into the formula, OK?
19:05
So just from the information we have here, OK, OK, OK, that's not too important.
19:23
OK, We'll do one last example then.
19:25
Suppose you deposit $50.00 a month into an account that has an APR of nine percent based on
monthly compounding, how much will you have the account in 35 years?
19:37
OK, so again, we can we can find the monthly rate, we have the number of months, OK, We could find
the future value if that's some, OK, OK, Another example, you need 15,000 in three years for a new car.
19:58
If you deposit money into an account that pays an APR 5.5% based on daily compounding, how much
would you need to deposit?
20:06
OK.
20:07
So you can find the daily rate, you know the number of days over a three-year.
20:13
And you just plug it into the equation for future value, OK?
20:20
OK.
20:21
Now this is a very important application of APR and EAR mortgages, OK.
20:27
So by law in Canada, financial institutions quote mortgage rates with semi annual compounding.
20:36
OK, but most people pay their mortgages monthly.
20:41
You'd be hard pressed to find somebody who you know makes a semi annual month mortgage
payment OK.
20:47
Or some people pay their semi monthly OK 24 months or biweekly 26 payments.
20:56
You need to remember to convert the interest rate before calculating the mortgage payment OK.
21:04
If you don't, you'll come up with the wrong payment.
21:07
So here's an example.
21:08
Theodore is applying to his friendly neighbourhood bank for a mortgage of 200,000.
21:14
The bank is quoting 6%.
21:17
He would like to have a 25 year amortization.
21:20
So the period over which he pays off the loan and wants to make the payments monthly.
21:26
What will Theodore's payments be?
21:30
Well, we have to calculate the effective rate, OK.
21:36
So again, this is just information from the question, right?
21:40
So 6%, OK.
21:43
And by law the bank quotes this semiannually, OK.
21:46
So there's there's two of these periods in a year, OK.
21:50
So we can find that the EAR OK is a little bit higher, 6.09%, OK.
21:56
Now naturally it's higher because this is from the perspective of the payer, OK, From the perspective
of of the person receiving, it's going to be you, you would need a lower amount, OK.
22:10
But from the from the perspective of the payer, it's actually higher because your, your interest is being
charged interest.
22:19
So we can plug this in.
22:20
The effective monthly rate OK is as follows.
22:26
Once you have the EAR, you're then going to convert it to an effective monthly rate, OK, using the
following formula.
22:34
And the effective monthly rate is .4939%.
22:40
Once you have the monthly rate, OK, you can calculate the monthly payment.
22:47
All right, so 200,000.
22:51
So, so now we have your classic annuity set up here, OK?
22:55
So we have 200,000 OK And we're trying to solve for C, which is the the payment amount, OK.
23:04
So you can see here that his monthly payment is going to be 1002 seven 9.61 OK.
23:18
Now this is an interesting case.
23:21
It's the case of continuous compounding.
23:25
Sometimes investments or loans are calculated based on continuous compounding, OK, represented
by E to the power Q.
23:35
He's a special mathematical function.
23:38
You probably would have studied it in high school when you did the exponential and, and logarithms
and lines.
23:43
OK, So this is what we call continuous compounding.
23:50
What is the effective annual rate of 7% compounded continuously?
23:57
OK, so you can see here we're just plugging this into the formula above where Q is 7%.
24:04
So as a decimal it's point O 7.
24:08
And you can see here that the effective annual rate is 7.25%, OK?
24:15
So if you had continuous compounding, if you had an investment that was continuously compounded
at 3%, it's as if you were receiving 7.25% simple interest a year.
24:26
OK, That's that's what it means.
24:30
We won't worry about the quick quiz.
24:31
You'll get plenty of practice in the homework.
24:33
OK, Sure.
24:36
A discount loan isn't too important.
24:39
OK, this is a good example here.
24:46
So consider a 50,010 year loan at 8% interest.
24:52
OK, so 50,010 year loan at 8% interest.
24:56
The loan agreement requires the firm to pay 5000 principal each year plus interest for that year, OK?
25:05
And we wanna click on the Excel icon to see the amortization table.
25:09
So let me pull this up here for you and share my excel, OK?
25:22
I'm just gonna share my Excel file.
25:25
OK, share screen, here we go Oh, you can see here, this is quite useful.
25:40
We can we can do what's called an amortization table.
25:43
So this is the year, this is the beginning balance, this how much interest you're going to pay this how
much principal is going to be paid.
25:50
So this amortization table is designed so that you have a consistent payment amount.
25:56
And you can see here that at the end of the 10 years, your ending balance is going to be zero, OK.
26:06
You see amortization tables for often for any significant assets, you know, major equipment or
consumer loans and whatnot.
26:16
Let me show you another example here.
26:23
OK, so the the example I showed you is the amortization loan with a fixed principal payment.
26:32
OK.
26:39
OK.
26:43
Let me share my screen again, OK.
26:54
So we went over this example here, OK.
26:58
So this is an amortized loan with a fixed principal payment, OK?
27:03
So the amount of principal you pay is always consistent and often consumers like this, OK?
27:11
It's just the proportion of your payment that goes to interest changes over time, OK, OK, so here's an
amortized loan with fixed payment and here's here's an example.
27:26
OK, so each payment covers the interest expense plus reduces the principal.
27:33
OK.
27:33
If you want to consider a four year loan with annual payments, the interest rate is 8% and the principal
amount is 5000.
27:43
What will be the annual payment?
27:51
So here N is 4, that's your time period.
27:55
You have four years.
27:57
Your interest per year is 8%.
28:00
OK, 5000 is the present value.
28:06
OK.
28:07
And you want to calculate the payment amount.
28:08
So this is how you would do it using the financial calculator.
28:15
I'll share the Excel screen here.
28:23
OK, so you can see here.
28:27
OK, here this is your beginning balance.
28:32
OK, your your total payment.
28:34
So what's interesting here is you can see the amount that's paid in interest.
28:38
OK.
28:39
So your total payment is consistent, but the amount that's paid in interest becomes less and less and
the percentage of the total payment that goes to the principal increases, OK.
28:52
And that's typically how most of these loans are structured.
28:56
Consumers want a fixed payment.
28:58
For example, when you graduate, if you have student loans to pay, you'll have a fixed monthly
payment, but the amount that goes to pay interest will get smaller and smaller and smaller over time
versus the amount that goes to pay principal, OK.
29:14
And that's, that's by design.
29:16
OK, I know EAR and APR can be a bit confusing.
29:24
It's often one of the topics that students find challenging.
29:27
But if you practice it will it will set in.
29:32
Just keep in mind that there's a difference between the stated amount and the effective amount.
29:37
OK.
29:38
And if you want, you can think back to to my example I gave of exercise, right, that there may be a
stated purpose, but the effective result is different, right?
29:54
So that's what EAR is about is it helps you compare loans with different interest rates and different
maturities.
30:03
And you may have a stated interest rate for a year, another loan that has a stated interest rate for a
semi annual.
30:09
And you want a way to compare them.
30:12
So what EAR, what EAR does it?
30:14
It levels the playing field and you figure out what are you effectively paying or in the case of the
lender, what are you effectively getting, OK, what's your EAR does it?
30:22
It's a way to compare so-called apples and oranges, OK?
30:28
So that's the purpose of EAR.
30:29
It allows us to have a complete understanding of the financial products in front of us and compare
them on a common footing.
30:38
OK, that requires quite a bit of practice.
30:44
OK, On an unrelated note, I did design your first Test, which will be next Friday and I'll send a, I'll send
an announcement about it towards the end of the week.
30:57
But just to figure out if we talk about it before we go to Chapter 7, the test has two concept questions.
31:06
So a concept question is, you know, one to two paragraph answer two concept questions worth 5
marks.
31:15
1 short answer question problem solving question.
31:19
You'll need to use Microsoft Excel for it.
31:23
You could do it by hand, but it'd be very tedious and very ineffective.
31:28
1 short answer question, sorry, not short answer, but problem solving question worth 10 Marks, and
then one essay question worth 15 marks.
31:38
OK, so to repeat, there's two concept questions, each requires one to two paragraphs.
31:44
Each is worth 5 marks, one problem solving question worth 10 marks, and an essay question worth 15
marks.
31:52
And I'll send that all out in an e-mail.
31:54
But just off the top of my head, I know some people like to know that information early on.
32:03
So that's the end of chapter 6.
32:04
I'm gonna switch to Chapter 7.
32:10
Any questions about EAR or APR before we jump to Chapter 7?
32:20
No, no questions.
32:22
OK, let me share my screen for Chapter 7 then.
32:28
OK.
32:34
OK.
32:35
Chapter seven.
32:35
Yeah.
32:41
OK.
32:43
So now we're gonna talk about interest rates and bond valuations.
32:47
OK.
32:47
So just to do a quick refresh, a bond is a type of financial instrument, OK, A type of security.
32:56
So security is a claim on cash flows, right?
33:00
But if you own a security, you have some claim on cash flows of the entity, the entity that issued that
security.
33:07
That security could be a stock, it could be a bond, it could be a derivative.
33:11
But for right now, we're focused on a bond, OK?
33:14
So if I'm a company and if I sell a bond and you buy that bond, that means you're giving me money
today.
33:23
I'm promising to give you more money in the future, OK.
33:27
And there's different ways bonds can be structured.
33:31
Sometimes a bond can be structured to have coupon payments.
33:35
So I give you periodic payments and then I give you a principal amount.
33:40
Other times a bond can be structured to be what's called a a discount bond.
33:44
So there's no coupon payments.
33:46
You simply pay me today and I send you more money in the future.
33:50
So that's what this chapter's gonna focus on is, is bond valuation.
33:55
Now think of it this way.
33:58
You would think of it intuitively before we even really start the chapter.
34:03
If I'm a company and I sell you a 10 year bond, OK, so there's over 10 years, I promise to pay you, you
know, coupon payments like say once a year and then the principal payment at the end of 10 years.
34:14
It's pretty easy for you to calculate, you know, what's called an implied interest rate.
34:19
You can take a look at the coupon rates and whatnot.
34:23
But by lending me money for those ten years, you've effectively locked your money in at that
prevailing interest rate, OK.
34:31
And there's an opportunity cost to you as interest rates change.
34:37
And of course, as interest rates change, that affects how desirable the bond is to hold.
34:42
OK, so for example, let's say you've lent me money for a 10 year bond and and the effective interest
rate might be 5%.
34:54
If the financial environment changes such that it's now easy to get a return of, let's say, 6%, well, then
the bond you hold for me is less desirable, right?
35:07
Conversely, the financial environment changes so that interest rates go down.
35:12
Maybe now the prevailing rates are 3%.
35:16
The bond you hold for me is seen as relatively more valuable.
35:21
The intuition, you know, this is kind of not the bolts of the chapter.
35:30
So first you need to understand bonds and you need to understand the terminology.
35:37
OK.
35:38
The 1st is what's called the face value or the par value of the bond.
35:42
That's the stated amount.
35:45
The 2nd is the coupon rate.
35:47
This is as a percentage, a percentage of the face value that's gonna be paid to you.
35:52
The third, well the 4th there is the coupon payment.
35:56
This is the actual payment amount in the frequency.
35:59
So for example, semi annual annual maturity date, when, when is this, you know, legal commitment
over OK and the yield or the yield to maturity now in fixed income.
36:14
So a bond is what's called fixed income.
36:17
And and the reason we call a bond fixed income is because in contrast to a stock, right, you see how
stock prices change often what you get from a bond is fixed.
36:28
The most you ever get from a bond is the coupon payments plus the principal.
36:33
So it's called fixed income.
36:35
In fixed income, we use the phrase yield, OK, Yield means the same thing as interest, but it's specific to
fixed income, OK.
36:45
So there's what's called the holding period yield.
36:48
So for example, if you hold that bond for some subset of its maturity versus the yield to maturity, if
you were to hold the bond until it's maturity, what would you get in terms of your return, OK, Easy to
price a bond in terms of what we call first principles.
37:11
And in finance, the fundamental value of any asset is always the present value of the cash flows, OK?
37:21
So here the bond value is the present value of those coupon payments, OK?
37:28
So for example, if over 10 years you received 10 coupon payments, right, the coupon payments you
received earlier are more desirable from a present value standpoint, from a time value of money
standpoint.
37:39
So the bond value is the present value of the coupon payments plus the present value of the the face
amount or the par value, OK.
37:50
We can treat those coupon payments as an annuity, right?
37:53
So remember, an annuity is a regular payment that's paid for a finite amount of time.
37:59
So if I pay you $1000 a year in coupon payments for 10 years, that's an annuity.
38:06
So we can calculate that very easily, OK.
38:09
And the present value is the final payment, OK?
38:13
As interest rates increase, the present value is decrease and money in the future is worthless, OK, And
vice versa.
38:23
So as interest rates increase, bond prices decrease.
38:27
And you can see that here by decomposing the bond into a combination of coupons and principal
payments.
38:34
OK.
38:37
All right.
38:38
So the pretty, pretty standard calculation here, consider a bond with a coupon rate of 10% and
coupons paid annually.
38:47
The par value is $1000 and the bond has five years to maturity.
38:56
The yield to maturity is 11%.
39:00
OK, What is the value of the bond?
39:02
Well, it's going to be the present value of the annuity.
39:05
So this bond pays me right.
39:11
OK, so it's going to be let's see here.
39:15
So the coupon rate is 10%.
39:17
So 10% of 1000 is 100.
39:20
So that's that's where $100 comes from.
39:22
OK.
39:22
That's your periodic payment, OK.
39:26
And that's gonna happen.
39:30
So this bond has five years to maturity, OK?
39:33
So we're gonna get 5 payments of that $100, OK.
39:38
And we're gonna use here the present value of an annuity.
39:42
So this is that's the first part here before the + That's just an annuity formula, OK.
39:50
And the respective interest rate is what's called the yield to maturity, OK?
39:55
So if I hold this bond to maturity, it's it's as if I had an interest rate of 11% on this investment.
40:00
OK.
40:04
So I can then calculate this and I can see here that the bond price should be $963.04.
40:14
So basically if I'm offering this bond.
40:17
Someone should pay me $963.04 today.
40:21
That would be the fair value.
40:24
OK, OK, OK Suppose you're looking at a bond that has a 10% annual coupon and a face value of
$1000.
40:42
There are 20 years to maturity.
40:45
The yield to maturity is 8%.
40:47
What's the price of this bond?
40:49
Again, just like the first question, the first example we did, except the numbers are a little bit different.
40:56
You just plug them into the formula and you can see here that the bond price is 1196.
41:07
Now this here is actually really interesting.
41:12
You notice here that the bond price is higher than the face value, OK, in contrast to the previous
example where the bond price was lower than the face value.
41:22
And there's gonna be a useful rule of thumb you're gonna learn that relates to the the coupon rate
versus the yield to maturity, OK?
41:35
So this is a graphical relationship between the price and the yield to maturity.
41:41
So the higher the yield to maturity, the lower the price, OK?
41:50
And like I said, here's a quick rule of thumb.
41:53
If the yield to maturity is greater than the coupon rate, so as we saw in the last example, then the
power value is going to be greater than the bond price, OK?
42:05
And if the yield to maturity is less than the coupon rate, then the power value is going to be less than
the bond price, OK?
42:14
So we call this a premium bond versus the previous case where we call it a discount bond.
42:22
OK, OK, Now we can express this with a very succinct equation.
42:35
So the bond value is equal to C, OK.
42:40
So C is that coupon payment, R is the interest rate, OK T is the amount, the time period, OK.
42:50
Of course, these are internally consistent.
42:52
So R if if R is, you know, monthly, then T is gonna be monthly.
42:58
OK.
42:59
And then finally you have your face value or your par value paid at the end.
43:04
OK.
43:07
OK, so let's do an example here.
43:15
So most bonds in Canada make coupon payments semi annually.
43:20
OK, So suppose you have an 8% semi annual pay bond with a face value of 1000 that matures in seven
years.
43:31
If the yield is 10%, what is the price of this bond?
43:35
OK, So the bondholder receives a payment of $40 every six months, OK, so a total of 80 per year, OK,
OK.
43:49
And the market automatically assumes that the yield is compounded semi annually, OK, So this is just
stated information.
43:57
So you have an 8% semi annual pay bond, OK.
44:03
So 8% of 1000 is 80, it's gonna be paid semi annually.
44:07
That's gonna be $40, OK.
44:11
You're gonna have fourteen of those semi annual periods in seven years, OK.
44:18
So we can plug this into our bond price formula that we just covered, OK.
44:24
So 40 is our coupon payment, OK.
44:28
The interest rate as it told us in the in the question, OK.
44:34
So the the yield or the interest rate is 10%, OK.
44:38
But remember this is an annual amount and the and everything else is semi annual.
44:43
So we have to convert this to semi annual as well.
44:45
So we're going to divide by 2, OK?
44:52
So we're going to have 5%, OK.
44:54
And we're going to have fourteen of those semi annual interest periods.
45:01
OK, well, the bond price is gonna be 9 O1.
45:05
OK, This is what we call a discount bond.
45:07
It's it's selling at a discount to the par value.
45:10
OK.
45:14
And right.
45:15
OK.
45:16
If you wanted to use a calculator, that's how you could use it.
45:19
One of the ways you can think about yield to maturity.
45:25
If you've ever watched, you know, bread or something bake in the oven, how it rises, you can think of
it similar to that with a bond.
45:35
The yield to maturity is that is that increase between the price you pay and and the fixed income value
of the bond that that rise, if you will.
45:46
OK.
45:47
So if you want to sort of a graphical analogy, OK, So what are some of the risk?
45:57
OK.
46:07
So interest rate risk, so it arises from fluctuating interest rates.
46:13
OK, so two things determine how sensitive a bond will be to interest rate risk, OK, the first is the time
to maturity.
46:26
So all other things being equal, the longer the time to maturity, the greater the interest rate risk.
46:34
So if you think about this logically, if you've bought a bond that has 30 years to maturity, it's much
more likely that interest rates will change between now and 30 years into the future than if you
bought a bond that has three months to maturity, OK?
46:49
So you're exposing yourself to more risk just based on the maturity of the bond.
46:55
The second point is the coupon rate, OK?
46:59
The lower the coupon rate, the greater than straight risk.
47:03
Remember that the coupon is that periodic payment.
47:06
So the higher the coupon rate, the more of the the more of the value of the bond that's going to be
paid to you periodically and sooner rather than waiting until the end to receive the face value, OK?
47:19
So these two factors intuitively are what affect the interest rate risk of the bond, OK?
47:26
So you can see here in this the diagram, our 30 year bond is is far more sensitive as you can see from
its slope than the one year bond to changes in interest rates, OK?
47:43
And, and again, that's because of those two factors that we talked about, the maturity and and the
coupon rate, OK Yield to maturity is the rate implied by the current bond price, OK Finding the yield to
maturity requires trial and error if you do not have a financial calculator and it's similar to the process
for finding R with an annuity, OK.
48:19
So this is really why the financial calculator became so valuable.
48:23
You know, prior to things like Microsoft Excel and whatnot, it was just very easy to calculate the yield
to maturity.
48:30
So if you're on a fixed income trading desk, you know, this was, you know, financial calculator in the
1970s, nineteen 80s was very useful.
48:38
Now with the advent of Excel, we have functions that we just type in that will calculate it for us.
48:44
But the yield to maturity, mathematically, it's something called numerical methods and it requires trial
and error.
48:50
OK.
48:54
OK.
48:57
So again, what yield to maturity tells us is if I hold that bond to maturity, given the current bond price,
what's my return?
49:06
OK, So here if you have a bond with a 10% annual coupon rate, 15 years to maturity and a par value of
1000, the current price is 928, $928.09.
49:26
Will the yield be more or less than 10%?
49:30
OK, so we can if we plug this into our calculator, we can find that it's gonna be 11.
49:34
Again, you can find this in Excel very easily.
49:37
So I'm not I'm not gonna spend time on it.
49:40
OK, suppose you have a bond with a 10% coupon rate and semi annual coupons has a face value of
1000, 20 years to maturity and is selling for 1197 and 93 cents.
49:57
OK, so you can see here that the yield to maturity.
50:01
OK, Well first thing is your calculator is gonna give you a semi annual amount, so you have to multiply
it by two, OK, And it's gonna give you a semi annual amount because the information you're giving it
is is in semi annual.
50:17
OK.
50:18
So the coupon payments are semi annual, OK?
50:23
And there's gonna be 40 of those semi annual periods in 20 years, OK?
50:28
So the results will be consistent with that information.
50:31
So then you have to multiply it by two to come up with an annual amount, OK?
50:37
So in terms of bonds, the most important thing for you to know is this equation, OK?
50:45
And so finding the yield on a bond, it's in this equation here.
50:48
OK, so if you didn't have a financial calculator, here's how you would find the yield on a bond.
51:03
So if you're given the bond value, the coupon, the times maturity and the face value.
51:09
So basically all the information except for R, is it possible to find the discount rate?
51:16
OK, well, the way you would do it is you would try different rates until the calculated bond price
equals the given the given price, OK.
51:26
And if you remember that increase in the rate is going to decrease the bond value, right?
51:34
So if for example, think of this as a left hand side and the right hand side of the equation, OK, So the
right hand side is is the part is the long part and the left hand side is just the the market price, OK.
51:48
So if you notice that the right hand side is too high, you wanna decrease it.
51:53
So then you would try a different, a higher number for R than your previous guess.
51:59
OK.
52:00
And that's effectively what the calculator does.
52:02
But it doesn't so quickly you wouldn't, you wouldn't realize it.
52:08
OK, some useful theorems, OK.
52:12
Wands of a similar risk and maturity will be priced to yield about the same return regardless of the
coupon rate.
52:22
And if you think about this logically, just the students of finance, this should make sense to you.
52:28
There's something called arbitrage, right?
52:30
Arbitrage is a riskless profit, which shouldn't happen in finance, right?
52:35
We know that risk and reward are matched.
52:38
So an example of arbitrage is, you know, let's say you buy something from me for, for like say $100
and right away you turn around and sell it to someone in your household for $150.00.
52:51
You know, assuming that there was no risk to you, you shouldn't have made a profit.
52:55
That's that's what finance would tell us.
52:57
OK, so if you have a bond of similar risk, OK, so risk here could be, for example, what we call
counterparty risk, the risk of the other person doesn't pay you.
53:09
So the issuer of the bond.
53:11
So you have a bond of similar risk and maturity.
53:14
They should be priced to yield about the same return, OK, regardless of the coupon rate, OK.
53:23
So what this is telling us is the biggest determinant of the bond pricing is the risk and the maturity,
OK.
53:32
If you know the price of 1 bond, you can estimate its yield to maturity and use that to find the price of
the second bond, OK.
53:42
So again, the bond should be priced similarly.
53:45
This is a useful concept that can be transferred to value and assets other than bonds, OK.
53:51
And the concept is called arbitrage price in theory that the financial instrument should be priced so
that there's not an arbitrage opportunity, OK.
54:03
You can just imagine if this wasn't the case.
54:06
So you have two bonds that have similar risk.
54:08
Let's say they're both AAA bonds.
54:10
So there's almost no risk and they're both 10 year maturity and one is priced twice as high as the
other, right?
54:18
Well, right away you can, you can find an arbitrage opportunity, right?
54:22
So the whole phrase, buy low and sell high, right?
54:26
Well, you would buy the lower one, wait until the market realizes, hey, these should be priced the
same and then sell at a higher price.
54:34
OK, OK, good.
54:46
In today's world, this is more important the Excel functions.
54:52
So there's some specific formulas that you can use to find the bonds and relevant information on a
spreadsheet.
54:59
So the first is the price function, OK.
55:02
The 2nd is the yield function, OK.
55:05
And the settlement in the maturity needs to be actual dates, OK?
55:11
So the settlement is the date you enter into the deal.
55:14
Maturity is when it expires and and you need an actual date for it to work in Excel, OK.
55:23
So I'll show you an example here.
55:24
I'll just pull up Excel momentarily.
55:31
OK, let me share my screen here.
55:43
OK, so here this is using the Excel functions and, and you can also look at this directly from the
PowerPoint.
55:53
So you're looking at a bond that's 25 years to maturity.
55:56
The coupon rate is 9%, it's paid semi annually.
56:00
The yield to maturity is 8%.
56:02
OK, That's the current price.
56:05
But right away you can see that the coupon rate is higher than the yield to maturity.
56:09
So the bond rate priced higher than par as as a first approximation.
56:15
Also, if it's not stated in the question, the default value for the par value is always 1000, OK?
56:24
You can find your rate, you can find the number of periods, you can find the future value, the payment
amount, the price, OK.
56:41
And here again, we can look at the actual formula, OK?
56:51
So you can see here the formula.
56:55
Well, we can look at a couple of things here, OK?
56:57
This is this is if we go to the bond price tab OK, so here we have the actual settlement date.
57:04
OK, so you can see this is Excel would need this information, OK?
57:09
And you can see here you tell Excel the formula that you want, OK?
57:19
OK, so we'd actually just remove this part here so it actually calculates.
57:28
So here we can have Excel actually calculate it for us.
57:31
So turn out correct, OK, that shouldn't be there, that's why OK.
57:38
But the point is you can you can see here using the actual formula.
57:45
Oops, go back, there we go.
57:50
You can see here using the actual formula price, it would it would give us the price of the bond, OK?
57:56
So that's what it would that would that's what it would tell us, OK.
58:02
And you can see here using the form that yield, OK, given this information, it would give us the yield
to maturity, OK.
58:12
And this is just the time value of money part OK?
58:18
So you can see here, so you can see here with the Excel workbook, that's how we would how we'd
calculate the bond.
58:34
OK, let's return to the PowerPoint.
58:42
So back to the PowerPoint here, OK?
58:50
So let's talk about the differences between debt and equity, OK?
58:56
So remember that debt is not an ownership interest, OK?
59:03
So the bond holders, if you have a bond from let's say Apple Computers or IBM or General Motors,
you don't have a voting, right, OK.
59:13
From the standpoint of the issuer, OK, debt is considered a cost of doing business, OK?
59:21
So that that is tax deductible.
59:24
In fact, in the business world you may hear the word leverage.
59:27
Leverage and debt are interchangeable, OK.
59:32
And sometimes you hear about a company being over leveraged and under leveraged and effectively
what they're getting at is, is the following.
59:41
There's a benefit to having debt in that it reduces your taxes, OK.
59:47
But if you have too much debt, you're seen as risky and you have to pay higher interest.
59:55
So you're trying to balance two things.
59:57
On one hand, you wanna save taxes, but on the other hand, you don't wanna have such a
burdensome interest payment that it's difficult on your cash flows, OK?
1:00:07
So there's an optimal level of debt and it it tries to balance those two factors, OK.
1:00:16
In terms of debt versus equity, there's also another benefit.
1:00:21
If a company goes bankrupt, bondholders have a higher claim than equity holders.
1:00:30
So it's in terms of a security, it's less risky in that regards.
1:00:38
OK.
1:00:39
And finally, excess debt can lead to financial distress and even bankruptcy.
1:00:48
OK, so there's sort of a sort of a joke in finance that an all equity company can never go bankrupt, OK,
because there's there's no claims that you have to pay.
1:01:04
So if your company is entirely equity financed, for example, you don't have to make dividend
payments to your shareholders, right?
1:01:13
Dividends are at the discretion of the board of directors.
1:01:16
They don't have to be paid.
1:01:18
But if you miss your payments to your debt holders, they can force you into bankruptcy, right?
1:01:25
So if you have too much debt, it becomes difficult to make those payments, then you end up in the
bankruptcy process.
1:01:33
To give you an example that relates to our contemporary business environment, if you think about
COVID, one of the interesting financial plays has been to invest in companies that have strong cash
flows.
1:01:50
And the reason is, is that if you have strong cash flows, you could at least make the required debt
payments, right?
1:01:59
Whereas if you don't have strong cash flows, you know, even if it's a promising business, you may
never get to execute on those promising business plans you have because the debt holders force you
into bankruptcy and then the company ceases to exist.
1:02:14
OK, so these are some important differences.
1:02:19
In fact, I remember listening to a financial analysis at the beginning of COVID where one of the
commentators was talking about how his basically how his investment division was now making sure
that the companies they had would be able to service their debt payments as as the primary concern.
1:02:42
Because at that point in time when COVID first happened, there wasn't a whole lot of news about
some of the, you know, government assistance programs and whatnot that was still in the works.
1:02:51
So they wanted to make sure that on their own, these companies could, could manage that.
1:02:56
OK, so these are some important differences between debt and equity, right?
1:03:01
And if you go on to study corporate finance further, you will learn more about the optimal debt level
for a company.
1:03:10
But broadly, like I said, it's based on those two factors.
1:03:13
One, you want to save taxes, but two, you don't want to constrain your cash flows to such an extent
with interest payment.
1:03:21
OK, OK.
1:03:24
Continuing on equity, so we're going to talk about this in the next chapter.
1:03:29
Equity.
1:03:30
So stock is an ownership interest.
1:03:34
So unlike a bond, but where the benefit is fixed, so the maximum benefit you can get is coupon
payments plus principal with equity.
1:03:44
In theory, your return is unlimited.
1:03:47
In in theory, there's no constraint on the upper limit of the stock price.
1:03:51
OK.
1:03:53
Of course there's some, you know, practical and realistic constraints, but theoretically there's there's
no constraint with equity.
1:04:02
You tend to have what we call common stock and preferred stock, but we're just gonna focus on
common stock and common shareholders can vote for the board of directors and other issues.
1:04:12
OK.
1:04:18
Dividends are not considered the cost of doing business and are not tax deductible.
1:04:26
Well, dividends are paid from after tax income and like I said, dividends are not a liability to the firm.
1:04:32
Shareholders can't sue the firm or take the management to court if they don't pay dividends.
1:04:37
That's by right their discretion.
1:04:40
And as I said, the old joke is that an all equity firm can never go bankrupt.
1:04:47
Now naturally you wouldn't want to be an all equity firm.
1:04:50
You wouldn't.
1:04:51
You wouldn't be acting in the shareholders best interest because you're effectively making cost higher
than they have to be.
1:04:58
One of those cost is taxes.
1:05:00
OK All right, So the bond indenture is a contract between the company and the bondholder and it
includes the basic terms of the bond, the total amount of bonds issued.
1:05:16
So maybe a company wants to raise, let's say $10 million, they issue ten $1 million bonds, OK Or
alternatively $110,000 bonds.
1:05:25
OK Oh, sorry, I know that'd be 1010 thousand dollar bonds if you wanted to raise 10 million.
1:05:35
A description of property used as security.
1:05:38
So sometimes the bonds are linked to a particular asset.
1:05:42
This happens a lot in really big industrial companies.
1:05:45
You know, they may have a bond for a particular asset, you know, like a tunnel boring machine or
something like that.
1:05:53
There's something called a sinking fund provision.
1:05:55
This is a a fund that the company maintains to buy back bonds before the maturity.
1:06:02
It's something they do to give confidence to the buyers of the bonds not to worry so much about, you
know, default risk.
1:06:13
Finally, there's a call provision.
1:06:15
A call provision allows the issuer of the bond to call the bond back early.
1:06:22
OK.
1:06:23
But for example, if I if I issued a bond with a 10 year maturity, a call provision might allow me in year
five to call that bond back early.
1:06:31
Now why would I want to do that?
1:06:33
Well, the reason I would want to do that is if I think I'm going into an environment of decline in
interest rates, then I could call my bond back early so I stop the payments on it and reissue another
bond.
1:06:47
But that bond would be issued at a lower interest rate because that's the prevailing environment.
1:06:54
Finally, there's something called protected covenants.
1:06:57
So, for example, if you're buying a bond from a company that seems very risky, you may insist upon
what's called predicted covenants.
1:07:06
One of them might be constraints on the company's cash flow.
1:07:10
So they, you know, executive composition, sorry, executive comp compensation or for example, you
make sure that the company can't pay, you know, really big shareholder dividends right now or
something like that.
1:07:25
And it's just to protect the holders of the bond to make sure that they, you know, minimize the chance
that they won't get paid.
1:07:33
OK, OK.
1:07:39
In terms of classifying bonds, this is important.
1:07:44
We have what's called a registered versus bearer form.
1:07:50
A registered bond is they have the information about you, the bond holder.
1:07:55
So if I'm a company and you buy a bond for me and it's registered, I have your information so you
know your name, the bank account, information to deposit the payments, etcetera.
1:08:07
Bearer form is the opposite.
1:08:09
Bearer form is I would Simply put in a notice saying if you hold a bond with this particular serial
number, you know, please show it and and you will get your payment.
1:08:22
Now you might wonder why there's a difference.
1:08:25
Well, the effective reason why there's a difference relates to taxes, but there's some more, how should
I say more legitimate reason.
1:08:38
So let me give you a bit of a backgrounder.
1:08:42
With the registered bond, it's easier to trace the money.
1:08:45
So it's easier to say you received the coupon payment, that's an interest payment, it's going to be
taxes, interest, etcetera.
1:08:52
Bearer form.
1:08:54
There's not that explicit link between the bond issuer and the bond holder.
1:08:59
So it's, this is not a legitimate reason, but it's it's easier to avoid taxes and most bonds today are
registered bonds.
1:09:09
So avoiding taxes.
1:09:11
So tax, tax avoidance is legal.
1:09:15
Tax evasion is illegal.
1:09:17
OK.
1:09:19
So if you use bare forms for tax evasion, that's obviously illegal.
1:09:24
A more legitimate reason why you'd want to use a bare form of a bond is if you think about things like
joint ventures and you know, to conceal company secrets that you may not want to show that your
company's funding the joint venture until it reaches a certain stage.
1:09:40
OK, that would be a more legitimate reason.
1:09:44
Bonds can have particular securities, so for example, collateral, you know, mortgages, etcetera.
1:09:54
Some terminology, debentures are unsecured debt with the maturity of 10 years or more.
1:10:00
Notes are unsecured debt with the maturity less than 10 years.
1:10:08
So both debentures are notes and are unsecured, but they differ in terms of the maturity, OK, we
talked about a thinking fund already, OK, this is not too important, you know, protective covenants we
already talked about, call provision we talked about, OK, you can read about the sub cases in the
textbook.
1:10:33
In terms of bond characteristics, the con rate depends on the risk characteristics of the bond when
issued, which bot will have the higher coupon all else equaled.
1:10:47
OK, well, we can think about this.
1:10:52
It's not too difficult.
1:10:55
So if everything else is equal except that they different secure debt versus debenture, the debenture
would have to have a higher coupon to compensate the risk, OK.
1:11:06
A subordinated debenture versus a senior debt, this relates to in the case of bankruptcy, priority for
payment.
1:11:14
So a senior debt is ranked higher than a subordinated debt, OK.
1:11:19
But for example, in the bankruptcy process, let's let's say I'm a company and I go bankrupt.
1:11:27
In the bankruptcy process, the order of payments as is followed, the first thing that has to be paid is
the court and the legal fees, OK?
1:11:35
Then the second thing is unpaid employee wages and salaries.
1:11:42
Then the third thing is unpaid taxes.
1:11:45
And the 4th, then it gets the the debt holders.
1:11:49
But even within the the debt holding category, you have subcategories, so senior debt, subordinated
debt, etcetera.
1:11:54
OK.
1:11:55
And then you get to equity and whatnot.
1:11:57
So basically the less desirable the bond, the higher the coupon payments.
1:12:03
All things being equal, it helps what it comes down to how do you rate bonds?
1:12:10
Well, we have rating agencies, OK?
1:12:12
So these are agencies that specialize in determining the issuer's ability to pay and they use a simple
scale, OK.
1:12:21
So in Canada, the big rating agency is DBRS, but you also have in the US Moody's and Standard and
Poor's and whatnot.
1:12:31
This is pretty straightforward.
1:12:32
You know, typically something denoted by an A is good.
1:12:36
C and DS are not good, OK, We have what's called stripped or zero coupon bonds, OK, So these are
bonds that make no coupon payments, OK.
1:12:49
Or in the case of stripped, the this is an example of financial engineering.
1:12:55
The coupon payments from the bond are detached from the face value and they're packaged as
separate financial instruments.
1:13:05
OK.
1:13:05
Floating rate bonds are actually quite interesting as opposed to the coupon rate being fixed.
1:13:11
So for example, 10 percent, 10% of part value.
1:13:17
So part value is 1000 and the coupon rate is 10%.
1:13:21
Well, then it's gonna be 100.
1:13:23
In contrast, you can have a floating rate.
1:13:27
So for example, you know, there's a particular index reference rate, it could be Libor, it could be
something like that, and the coupon rate would change as a result of that reference rate.
1:13:38
I'll tell you an interesting historical example.
1:13:41
In the 1980s, Chile wanted a lot of copper.
1:13:48
And this is actually very interesting because if you think about the, the cycle for that commodity, you
know, something like copper, you need a lot of investment up front to extract it.
1:14:04
And you know, copper is, is important for production.
1:14:08
So, you know, as world economies are in a boom.
1:14:12
You're in the, in the bull phase of the cycle, but when there's a recession, you're in the bear phase.
1:14:19
So Chile, this is actually very interesting.
1:14:22
They had issued these sovereign debts.
1:14:25
So bonds, but sovereign debt, it means it's issued by the government, but they had issued these
bonds that were linked to the world price of copper, OK.
1:14:33
But basically when the world price of copper was high, the periodic payments you got on these
government bonds went up.
1:14:41
OK.
1:14:42
So that's a, that's a very interesting historical example for you.
1:14:48
Other types of bonds, you don't really need to know about these.
1:14:52
They're very interesting.
1:14:52
But catastrophe bonds, these are used by insurance companies.
1:14:58
Convertible bonds are interesting.
1:15:00
These are bonds that can be converted to equity.
1:15:03
Often these are done in companies that are very high risk.
1:15:08
So, you know, these are companies that really need some cash flows and they have, they may have a
business proposition that, you know, it's, it's skeptical, but if it works, it's gonna be a big money
maker.
1:15:22
So at that point in time, you wouldn't want to be a bondholder, you want to be an equity holder.
1:15:26
So being a bondholder protects you because if things go South, you have more protection than the
equity holders.
1:15:33
But if things turn out really well, you don't want to be a bondholder, you want to be an equity holder.
1:15:37
OK, So that's the key there.
1:15:44
Bond market here, what's called over the counter transactions.
1:15:48
Well, you know, for example, there's a New York Stock Exchange, Toronto Stock Exchange.
1:15:52
There isn't an equivalent to that for bonds.
1:15:56
Even if you go on to something like your online banking and you have an investment platform, it's not
that the bonds are traded on organized markets, it's that the banks keep an inventory if the, you
know, the the more readily available than the ones that would interest consumers.
1:16:15
But theoretically bonds are sold over the counter.
1:16:17
So the bond dealers and the banks that connect with each other and they negotiate, OK.
1:16:24
The exception is Treasury securities, which are sold through an auction system by the US Treasury
Department.
1:16:31
OK, inflation.
1:16:35
Inflation, as you know, is the rise in the price level.
1:16:39
So the real interest rate is net of inflation, OK?
1:16:43
So this isn't too, too important.
1:16:47
The key here is that with interest rates, we can approximate them as r = r + H So the nominal interest
rate is the real interest rate plus the inflation rate.
1:17:00
OK.
1:17:04
OK, term structure of interest rate.
1:17:09
I'm not going to ask you about term structure of interest rate.
1:17:12
I'll just talk about it briefly for your own knowledge.
1:17:15
OK.
1:17:15
So the term structure is the relationship between the time to maturity and the yields, all else equal.
1:17:24
OK.
1:17:26
So the yield curve is typically what we call normal.
1:17:31
A normal year curve is upward sloping.
1:17:33
Basically the longer the time to maturity, the higher the yield you should get.
1:17:38
And what we're trying to do is we're trying to decompose this into three parts.
1:17:42
So we're saying that there's the real rate that's your your net of inflation rate, then you add an
inflation premium.
1:17:51
So obviously the longer the time to maturity, the more inflation premium you need and the longer the
time to maturity, the more interest rate premium you need.
1:18:00
So we're really trying to explain the differences in the the high yields that you see on longer maturity
versus the lower yields on short maturity.
1:18:12
And these three factors are what explain it.
1:18:16
OK.
1:18:16
Occasionally you got a downward sloping yield curve, but that's sort of a rare event.
1:18:21
So we're not going to spend too much time on that, OK, OK.
1:18:25
So that's Bonds.
1:18:29
Any questions about in Chapter 7?
1:18:38
Any questions about Chapter 7?
1:18:43
Aiden, Hannah, Jackie, Rebecca, Yao, Yinyu.
1:18:53
No.
1:18:54
Does it make sense?
1:18:55
Chapter 7 made sense, Sarah.
1:19:01
Little Jenna.
1:19:07
No, no questions.
1:19:11
You guys can still hear me, correct?
1:19:14
Making sure.
1:19:17
Yeah.
1:19:18
OK, Perfect.
1:19:19
Perfect.
1:19:21
OK, well, let's take a short break.
1:19:22
It was 11/28, so let's come back.
1:19:26
Let's say 11:40 and then we'll do chapter 8.
1:19:31
OK, so take a 12 minute break and then we'll come back.
1:33:02
OK, let's continue on.
1:33:07
I'm gonna share my screen here for Chapter 8.
1:33:11
OK, so now we're gonna talk about another very common security, which are stocks.
1:33:20
OK, so stocks and bonds make up the the bulk of the securities you're gonna come across and
finance.
1:33:27
The three main asset classes are equity, fixed income, so bonds and you know primarily bonds, but
also notes and whatnot.
1:33:37
And then the third category is derivatives.
1:33:40
We're not too concerned with derivatives in our course, but we're definitely concerned with stocks.
1:33:49
OK.
1:33:51
So we first want to introduce some important terminology.
1:33:57
The first is a common stock, OK?
1:34:01
So within equities, we have two broad categories, common stock and preferred stock.
1:34:07
They differ mainly in their priorities to receive dividends.
1:34:10
So these are periodic payments to equity holders and also on the sort of issues they can vote on.
1:34:17
Typically preferred stocks aren't used as voting stocks.
1:34:21
They're seen as more for higher priorities for dividends.
1:34:25
OK.
1:34:26
Now, of course this is just a generic template.
1:34:29
The actual division of equity would be specified in what's called the articles of incorporation.
1:34:36
So the legal document that creates the firm, the birth certificate of the firm, if you will.
1:34:42
OK And you can have different shares, so for example, Class A shares, Class B shares, et cetera.
1:34:50
And they may have different, you know, voting rights and whatnot, but the set up is you have
common stocks and preferred stocks.
1:34:58
OK, So we'll talk about that.
1:35:02
So if you buy a share of stocks, there's two ways you can actually receive cash, OK?
1:35:08
So the company can pay a dividend or you can sell your shares.
1:35:12
Either the company may buy it back, or you can sell your shares to another investor in the
marketplace.
1:35:21
Unlike a bond or like any other asset in finance, the fundamental value of any asset is the present
discount value off the cash flows.
1:35:30
So the same way how we price the bond is the present value of the coupon payments plus the par
value.
1:35:35
OK, It's going to be the same principle for stock.
1:35:39
It's the present value of the future cash flows.
1:35:42
OK, well, here's a simple example.
1:35:46
Suppose you're thinking of purchasing a stock of the company called More Oil.
1:35:50
You're expected to pay a $2.00 dividend in one year, and then you believe you can sell the stock for
$14.00 if you require a return of 20%.
1:36:00
OK, for an investment of this risk, what is the maximum you'd be willing to pay?
1:36:06
So we want to compute the present value of those cash flows.
1:36:13
So we're going to get 14 + 2.
1:36:15
So in a year from now, we're going to get the dividend plus the sale price.
1:36:19
And we need a return of 20%.
1:36:21
So that's our discount rate.
1:36:23
So it means you should pay 1333 for the stock today, OK.
1:36:31
Or conversely, you can think of it, what future value if you put in $13.33 today, demarcated by the
negative sign to to imply a cash outflow.
1:36:47
OK, now what if you decide to hold the stock for two years?
1:36:51
So in addition to the $2.00 dividend in one year, you expect a dividend of $2.10, so a 5% increase in
two years and a stock price of 1470 at the end of year 2.
1:37:05
How much would you be willing to pay now, so again we can calculate the present value pretty
straightforward.
1:37:12
Again, you'd be willing to pay $13.33, OK, OK.
1:37:25
Finally, three period example, OK, So in addition to the dividends at the year, at the end of year one
and two, you expect to receive another dividend, OK, at the end of year 3 and an increase in the stock
price to 15435.
1:37:44
Now how much would you be willing to pay?
1:37:45
And again, it works out that the math when you crunch the numbers turns out to be 1333, OK?
1:37:57
So let's develop a, a, a more general model so we could price any stock, OK?
1:38:06
OK, so you can continue to push back the dates when you would sell the stock, OK?
1:38:12
You would find that the price of the stock is really just the present value of all expected future
dividends.
1:38:19
OK, well, how can we estimate all future dividend payments?
1:38:24
OK, well, so let me actually go back to this last point, because this is sort of where theory diverges
from practice.
1:38:32
In theory, future demands are known with certainty.
1:38:36
So the examples we gave in two years, you'll get $2.00 and whatnot.
1:38:41
In reality, that's far from clear estimated in the future cash flows is, is very difficult.
1:38:48
And, and in in in practice, this is done by, you know, certain investment banks.
1:38:52
They have what's called debts, quote UN quote.
1:38:55
So you know, you have, for example, your fixed income debts, but then even with inequities, you'd
have debts that specialize in certain things.
1:39:02
So you'd have a debt, for example, that would specialize in commodities, or you'd have a desk that
would specialize in tech companies and whatnot.
1:39:12
So but for our purposes, we're gonna estimate dividends based on three broad categories.
1:39:19
The case for the dividend is constant, OK?
1:39:22
So the firm always pays a constant dividend.
1:39:27
The case where the dividend grows at a constant rate, OK.
1:39:31
And finally, a case of what's called super normal dividends.
1:39:33
So the dividend grows at an increase in rate, then slows down and then reaches sort of plateaus at a
constant rate.
1:39:41
Now these three buckets or three cases if you will, are not that unrealistic.
1:39:46
There have been companies that have paid consistent dividends for a long time.
1:39:50
A good example is Royal Dutch Shell.
1:39:52
A previous good example was GE prior to some of its hardships.
1:39:57
OK.
1:39:58
But these categories aren't that unrealistic and it really helps us develop conceptually our our equity
pricing model and supernormal growth.
1:40:10
This this does happen.
1:40:13
It's a bit more complicated in practice.
1:40:18
It it, it depends on the type of investors the firm wants to get and also what else the firm could do
with its dividends.
1:40:25
But these three buckets will largely help us with equity prices.
1:40:32
At regular intervals forever, this is simply a perpetuity, OK amount that's paid, you know, basically into,
you know, Infinity if you will, or add infinite as they say and do the proper terminology.
1:40:51
This is a perpetuity.
1:40:52
So it's the payment amount divided by the required return.
1:40:57
Now this is quite rare.
1:40:59
You don't really get a stock that pays the same amount forever, mostly because, you know, that came
in amount to become less desirable due to things like inflation.
1:41:14
This one is much more common.
1:41:17
OK, so this is the dividend that grows at a constant percentage per.
1:41:23
OK, so with a little algebra, the price of the stock is gonna be the dividend next period, which is the
dividend this.
1:41:32
Times the growth rate divided by R which is the required return less the growth rate.
1:41:40
OK, suppose Big D Inc just pay the dividend of $0.50.
1:41:50
It is expected to increase its dividend by 2% per year.
1:41:56
If the market requires a return of 15% on assets of this risk, how much should the stock be selling for?
1:42:05
OK.
1:42:07
OK.
1:42:08
So this is fairly straightforward, OK?
1:42:12
We're just gonna plug in into the formula, OK.
1:42:16
So the dividend next period, the required return and the growth rate.
1:42:20
So you can see the stocks you sell for 392, OK, Another example, TD Pirates is expected to pay $2.00
dividend in one year.
1:42:30
Dividends expected to grow at 5% per year and the required return is 20%.
1:42:35
What is the price?
1:42:40
So in this case, there's a question here, why isn't the $2.00 in the numerator multiplied by 1.05?
1:42:48
Because it's already telling us that this is the dividend next year in contrast to the previous example,
this was the dividend this year and we needed to find the next year amount in order to use the
formula, OK?
1:43:04
So you can see here this is relates to the stock price, OK, And the growth rate, OK.
1:43:14
And this is the stock price of sensitivity to the required return.
1:43:18
So obviously the the higher the required return.
1:43:20
So the higher the discount rate here, the lower the present value.
1:43:29
OK, so here's another example.
1:43:36
The Gordon Growth Company is expected to pay a dividend of $4.00 next period, and the dividends
are expected to grow at 6% per year.
1:43:49
The required return is 16%.
1:43:55
So what's the current stock price?
1:43:56
Again, we plug this into the formula, we can save $40, OK, And we already have the dividend next
year, so we can skip the multiply by 1 + G OK?
1:44:09
Now here's what gets a bit trickier.
1:44:10
What's the price expected to be in the year 4?
1:44:14
OK.
1:44:17
Well it'll the price in year four, OK.
1:44:20
It's going to be all of the future dividends after year four, OK, so the dividend year five onward, OK.
1:44:29
What is the implied return given the change in price during the four year.
1:44:38
OK, so we can find the implied return.
1:44:43
So what's the implied return given the change in price during the four year.
1:44:48
So we have fifty 50s or $50.50 is the price in.
1:44:54
Four.
1:44:55
OK.
1:44:57
And you can see here, you wanna find, you wanna do this mathematically that if you start with $40
one plus the return or the interest, OK to the power of four.
1:45:09
So you can see mathematically this is equivalent to 6%, OK, Well, the price grows at the same rate as
the dividend, OK?
1:45:20
So that's a fortunate coincidence there.
1:45:23
So if you look back at the key, the key parts here, OK.
1:45:27
So basically today you're paying $40.00 for the stock, OK.
1:45:34
In four years you can calculate what you're going to sell the stock at, so $50.50.
1:45:39
And you want to define what the implied return is.
1:45:42
Now here's a hint, hint, hint, big hint for you guys for your test.
1:45:47
You want to study the Gordon growth example.
1:45:50
OK, that's my hint to you.
1:45:56
Hopefully everybody heard that and hasn't nobody fell asleep.
1:46:01
The what?
1:46:01
Growth, Sorry, the Gordon growth example, this example that we're working on, that's a hint for your
test.
1:46:10
OK, Another example, suppose a firm is expected to increase dividends by 20% in one year and by
15% in two years.
1:46:22
After that, dividends will increase at a rate of 5% per year indefinitely.
1:46:26
If the last dividend was $1.00 and the required return is 20%, what is the price of the stock?
1:46:34
OK.
1:46:35
So remember we have to find the present value of all expected future dividends, right?
1:46:40
Because by having to share that company, that's what you're entitled to is those future dividends.
1:46:47
OK, OK, So now this one is a bit more piece meal.
1:46:54
And in fact, this is also another hint, this example is also very relevant for your test as well.
1:46:59
Hint, hint.
1:47:00
So the Gordon Growth example and this example, so we have to do this in a piece meal approach
because we have different growth rates, OK?
1:47:11
So we know in the first year it's growing at 20%, the next year the dividend's growing at 15%, the third
year it's growing at 5%.
1:47:17
So we can find those individual dividends, OK, in year three, if you look at the information we're given,
yeah, after that, the dividends increase at a rate of 5% indefinitely, OK.
1:47:35
But after year three, we can use our our growing perpetuity formula, which is exactly what we've done
here, OK.
1:47:45
So we, we know that the price in year 2 is going to be all the future dividends, OK.
1:47:52
And we know that we can find the dividend next year.
1:47:58
So we have that information.
1:48:00
So it's 1.499 and and year three onwards the stock grows at a constant rate.
1:48:09
So we're using our growing perpetuity formula, OK.
1:48:13
So we have our required return, the 20% required return less the 5% growth rate, OK.
1:48:24
So the price today is going to be the present value of those future cash flows.
1:48:30
So it's gonna be the dividend next period, OK.
1:48:33
So the present value of the dividend next period, that's 1.20 / 1.2 plus the present value of the
dividend in year 2 plus the price in year two.
1:48:45
And the price of year 2 reflects all of the future dividends, OK.
1:48:50
And because both the 1.38 and the 9.66 happened in year 2, we need to discount, OK, they're, they're
both two years into the future.
1:49:02
So we discount by 1.2 ^2.
1:49:05
So the price of the stock today is 8 point $8.67.
1:49:13
So my hint for your test is the Gordon growth example and this supra, what's called Supra normal
growth example are very relevant, OK?
1:49:26
We won't worry about the quick quiz.
1:49:27
We've got plenty of practice on the homework, OK, using the constant, OK, DGM, OK to find R, OK.
1:49:41
So here, this is if the dividends are growing at a constant amount, OK, We know that the price today
equals the dividend next period divided by r -, G here we wanna rearrange this.
1:49:56
So we wanna, we wanna rearrange for R.
1:50:00
And this shows me that the components of the required return are the following, the dividend next
period, the price today and the growth rate.
1:50:09
OK.
1:50:12
So here suppose a firm stock is selling for $10.50.
1:50:17
They just paid a $1.00 dividend, and dividends are expected to grow at 5% per year.
1:50:24
What is the required return?
1:50:31
OK, well, you can see this is pretty straightforward.
1:50:34
We're just plugging it into the formula we just derived.
1:50:37
OK.
1:50:38
So we have the dividend amount, we have the growth rate, we have the current price.
1:50:45
So you can find that the required return is 15%.
1:50:49
The dividend yield is simply the dividend divided by the current price, OK.
1:50:55
So it's gonna be 10%.
1:50:58
And what is the capital gains yield?
1:51:01
Well, there's two sources of of gain, OK?
1:51:05
One is from the dividend, the other is from the capital gain.
1:51:09
Which capital gain is the price appreciation, OK.
1:51:13
If my total return is 15% and if 10% came from dividends, then capital gains have to make up the
other 5%, OK?
1:51:24
So this this example, the supernormal growth example and the Gordon growth example are very
important for your test.
1:51:33
And that's my big hint for those listening live and also for those who will listen to the recording, OK?
1:51:44
So in summary, we can break our stock valuation to three cases.
1:51:49
OK, let me just give a little bit of context about how this is done in the real world.
1:51:59
So a book I'd recommend if you're really interested in this topic is called the Random walk down Wall
Street.
1:52:06
You can, you can just type it into Google and you'll you'll find it pretty easily or Amazon.
1:52:10
It's called the random walk down Wall Street.
1:52:14
And basically what I tell my students in more advanced finance courses, you know, whether it's
financial markets or something more specialized like a portfolio management, you know, broadly you
can think of stock pricing as A2 tiered approach.
1:52:33
The first tier is the fundamental value.
1:52:35
So the present discount value of those cash flows, the dividends, or in the case that you know, a
definitive time that you're gonna sell the stock, the present discount value of the dividends plus the
capital gain.
1:52:52
So that's, that's the first tier.
1:52:53
The first tier is fundamental.
1:52:56
But if you go on to study the stock market, there's a lot of behavioral aspects.
1:52:59
There's a, there's a big field of study called behavioral finance.
1:53:03
So we notice things like momentums and bubbles in the stock market.
1:53:07
So the place of stock in, in the real world, you take a look at the fundamentals, but you also need to
understand what's going on with the behavioral aspect of the market.
1:53:16
So for example, are we in a bull market where prices are rising and you know, investor sentiment is
high and whatnot or are we in a bear market?
1:53:26
Sometimes even stocks is good fundamentals get clobbered in the bear market.
1:53:36
So the, the point is in in the real world, the price stocks, you really have to have an appreciation on
behavioral finance.
1:53:49
This is pretty straightforward as far as common stock features go.
1:53:54
You can, you know, this is stuff you can read in the textbooks.
1:53:57
I'm not gonna spend too much time on it, but shareholders do have rights.
1:54:03
And this is all part of us called corporate governance.
1:54:07
So you, you would receive dividends in proportion to the shares you own.
1:54:14
So for example, you get half the shares in the company, you get half of the declared dividends, OK.
1:54:20
If the company is liquidated by the time it gets to the equity holder, you would share proportionally in
the remaining assets based on the share proportion you have.
1:54:30
What's called preemptive right is when a company decides to have what's called a seasoned offering.
1:54:34
So when they they issue more stocks to the public, existing shareholders get first chance to buy those
stocks so that their ownership share is not diluted various classes of stocks.
1:54:49
So some stocks have unequal voting rights.
1:54:53
So to give you an example, if you think about Ford Motor Company, the stocks that are sold to the
general public are different than the stocks that are held by the Ford family right in terms of their
voting rights and and level of control.
1:55:05
Another famous example is is the Chinese giant e-commerce company Alibaba.
1:55:14
The stocks held by the founders and the and the and you know, the early employees are different than
the stocks that are sold to the general public in terms of their voting rights and control of the firm.
1:55:27
OK dividend characteristics.
1:55:29
The most important thing to know is that dividends are paid after tax.
1:55:33
OK, dividends are not what I would call an explicit liability, but they they aren't the sun extent of an
implicit liability.
1:55:41
Shareholders do get frustrated and they don't receive dividend payments, OK?
1:55:48
Dividend payments are not considered a business expense and are not tax deductible, OK, So
dividends received by corporate shareholders are not taxed.
1:56:01
This prevents double taxation of dividends, OK.
1:56:05
So basically a, a dividend received from 1 Canadian company to another is not taxed.
1:56:12
It's only tax when it goes from the corporate to the personal level.
1:56:16
OK.
1:56:21
And there's in terms of how dividends are taxed on the personal level, bit beyond our scope.
1:56:27
But if the the tax by what's called the gross up factor and then a dividend tax credit, I'm not going to
go too deep into that.
1:56:35
It's something you can read about if you're really interested.
1:56:39
The big difference with preferred stocks is that preferred stocks have priority on dividends.
1:56:46
So again, when you, you know, when you go to the grocery store and there's different types of fruits
or different types of cereal, it's because people have different preferences.
1:56:55
Same thing with investors.
1:56:58
Investors have different preferences, right?
1:57:00
So even in the broad category of, you know, fixed income equities, derivatives, if you know you want
equities, you you then have the choice between common and preferred.
1:57:12
And some investors want a preferred stock.
1:57:14
They prefer that steady cash flow versus the more uncertain cash flow from a common stock, even
though they have more voting rights.
1:57:22
OK.
1:57:23
So most preferred stocks have what's called a stated dividend.
1:57:28
So it doesn't mean the firm has to pay it, but they have to pay it before they pay common stocks.
1:57:34
And the preferred stocks are what's cumulative.
1:57:37
So even if there is a dividend that's missed, they have to pay that before they can pay any common
dividends.
1:57:43
OK.
1:57:44
So basically this type of equity is geared for those who value consistent cash flow more than say stock
appreciation.
1:57:53
So, so for the capital gain aspect, which would be more desirable to common stockholders, Stock
market quotations are published in the newspaper and also available online.
1:58:09
Usually there's 15 minute delays unless if you're connected directly to the Stock Exchange.
1:58:13
So if you're a, a broker in Canada, the main Stock Exchange is the TSX.
1:58:19
OK, OK, this is just some information for you guys.
1:58:27
You need to know about corporate voting.
1:58:28
So I won't I won't cover that.
1:58:32
So the key point to remember about stocks and bonds is if fundamental value is the present discount
value by cash flows.
1:58:40
OK.
1:58:41
And when you pack up some questions this fall, this will set in OK.
1:58:46
And later this week I'll send out an overview of your test.
1:58:51
But like I said, I gave you a hint in today's lecture.
1:58:53
OK, that pertains to the problem solving question.
1:59:02
What else?
1:59:03
Well, in terms of hints, the essay question pertains the time value of money very loosely and the
concept questions pertain to some of the earlier concepts in in the course.
1:59:17
So from the early, early chapters.
1:59:19
OK, OK, that's a good place to stop it at for today.
1:59:26
Does anyone have any questions about what we talked about?
1:59:30
Will there be like a practice test or something?
1:59:33
No, no practice test.
1:59:34
The best way to prepare is to do the homework questions.
1:59:39
Homework questions plus review the major concepts from the chapters.