Introduction to the Game and
Its Environment
With a Review of the
Touchstones of Finance
Purpose
n Provide an overview of the course
n With a framework for integrating the principles of
finance into a conceptual whole.
Market Efficiency
NPV
Option
Pricing
Portfolio
Theory
Value
Additivity
This is a game
n The game has a long history, going back several
thousand years
n You will understand investing better if you think of
it as a game
F but, we must learn the rules
F the rules must be discovered by careful digging
Market Efficiency
This Game is a Fair Game
What is Finance?
n Finance is the study of the market processes which
allocate society’s savings to the most productive
uses.
n Finance is also concerned with how these market
processes influence decision makers in business
and government.
n Much of this effort involves the study of the
process of valuing securities in the marketplace
What is Finance?
n This task can be appreciated by considering the
following definition of a security given by the
Supreme Court:
F [A security is] a contract, transaction, or scheme whereby a
person invests his money in a common enterprise and is
led to expect profits solely from the efforts of the promoter
or third party.
n Key points:
F Contract, transaction, or scheme
F common enterprise
F investor expects profits solely from other peoples’ efforts
Key Features of Securities
F Common enterprise
F Profits depend on efforts of third party
n Separation of ownership from control is built into
this definition
Other Peoples’ Money—Other Peoples’ Efforts
How Does the Market Value a Company?
n a firm’s physical assets
F and the earning power derived from them
n the valuation of its human capital
F organizational capital
F structure of the incentives offered to key decision makers
n sustainable competitive advantage
What are the Value Drivers?
n Market value of physical assets
F Consider change in net worth when
new assets and liabilities are included
in the balance sheet
• When would impact on net worth
be neutral? … Negative? …
Positive?
n Option approaches continue from
here
F You may be able to stop here if
neutral or positive
n Added earning power derived
from new assets
F Value of new opportunities
F Enhanced value of human capital
• Stronger organizational capital via
enhanced flexibility
• New incentives offered to key decision
makers
F Enhanced technology
F Enhanced competitive advantage
F DCF methods focus on these earnings
F You may be able to stop here, too
Internal sources of capital
n Earnings
F decision: how much to retain and how much to pay out in
dividends
n Depreciation, and other “invisible” sources of
funds flow
F decision: how much to reinvest and how much to pay out
in dividends
n Spontaneous credit, i.e. trade credit, accruals, etc.
F decision: given the cost of such borrowing, is it better to go
elsewhere?
External sources
n Sale of real assets
F a“hot” new innovation is the securitization of assets in
such a way that they can be sold to new owners—while in
many cases leaving a substantial amount of control over
the assets in the hands of the original owner.
n Non-securitized loans
F which represent claims on the future income to be derived
from real assets held by the firm
n Sale of financial assets
F which also represent claims on the future income to be
derived from real assets held by the firm
Financial Assets
Commercial paper
Bonds
Equity
Limited partnerships and other forms of project
financing
n Government-subsidized financing
n Leases
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n
n
n
Equity
n
n
n
n
preferred stock
common stock
treasury stock
shelf registrations
Bonds
n Coupons, zeros, and strips
n Mortage bonds, equipment trust bonds, and other secured
bonds
n Debentures and subordinated debs
n Collateral trust bonds
n Convertibles, bonds with warrants, and participating bonds
n Income bonds
n Commodity-backed bonds, reserved production agreements,
and pass-throughs
n The call feature
Levels of activity in the financial markets
n Primary market
F Firms placing new securities with investors
n Secondary market
F Investors trading among themselves via organized
exchanges or over-the-counter
n Third market
F Investors trading listed securities over-the-counter
n Fourth market
F Investors trading directly among themselves without
recourse to exchanges or over-the-counter systems
How governments influence investors and
financial markets
n regulation
n taxation
n enforcement of property rights
Question for discussion: What is the effect of competition
Among governments?
What do we know about finance?
n Five paradigms
n Three separation principles
n When the financial markets are functioning
efficiently, resources are channeled to the optimal
uses.
The five paradigms
n Net Present Value Rule
n Capital Market Efficiency
n Asset Pricing Theory (includes Modern Portfolio
Theory, the CAPM, and Arbitrage Pricing Theory)
n Value Additivity Principle (VAP)
n Option Pricing Theory (OPT)
Market Efficiency
NPV
Option
Pricing
Portfolio
Theory
Value
Additivity
NPV
The three separation
principles
n Fisher’s Separation Principle
F The investment decisions of business firms are separate
from the owners’ consumption decisions.
• Managers can make the most productive use of resources
– over the long term
– without worrying about owners’ preferences concerning how
much wealth to consume now and how much to invest toward
future consumption.
• This principle is important because it says
– resource allocation decisions based on rational considerations
– do not depend upon whether the firm is controlled by a prodigal
or a miser.
What do we know about
finance? The three
separation principles
Portfolio
Theory
n Tobin’s Separation Principle
F Investment decisions are separate from investors’ preferences
concerning the risk/reward tradeoff.
• In an uncertain world, investors can choose their portfolios of
risky ventures purely on the basis of a rational evaluation of
probable outcomes.
• Choices need not depend upon the investor’s “nerve.” Given
identical expectations, a very timid person can participate in
the same investments that would be chosen by a very
aggressive investor.
F Conclusion: resource allocation decisions are based purely upon
rational considerations
What do we know about
finance? The three
separation principles
Market Efficiency
n M&M Separation Principle
F In a perfect capital market, a firm’s investment decisions
are separate from its financing decisions.
F Packaging doesn’t matter. What does matter is the
substance of the firm.
F If we think packaging matters, we need to look for a
reason why the way a thing is packaged could change its
value. Financial tricks alone can’t made a dog into a
princess, and vice versa.
What do we know about finance? What major
questions are still unresolved?
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n
n
n
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How are decisions really made?
How can we really measure NPV?
Do we really understand risk and return?
Are there important lapses in market efficiency?
Why do initial public offerings seem to be undervalued?
How are complex options valued?
Does capital structure matter?
Does dividend policy matter?
What is the value of liquidity?
Is corporate restructuring good or bad?
Finance is a dynamic and important
discipline:
n Our knowledge is rapidly increasing.
n The market processes are rapidly evolving.
F Knowledge of these market processes is crucial to practical
business executives who must make investment and
financing decisions.
n The role of institutional investors is rapidly
evolving.
n When the financial markets are functioning
efficiently, financial resources are channeled to the
optimal uses.