Finance 101

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Basic Financial Management

Importance of Financial IntelligenceSpreadsheet Financial FunctionsInvestment Risk and PortfolioStock Valuation

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Financial Intelligence

Making more money will not solve your problem if money management is your problem.

30 Year Investment Result

Annual Return $20,000 $30,0005% $1,328,777 $1,993,1656% $1,581,164 $2,371,7467% $1,889,216 $2,833,8248% $2,265,664 $3,398,496

Annual Saving

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Financial Intelligence

“Being Rich” versus “Being Wealthy”

Being Rich is about how much money you possess in a specific moment in time.

Being Wealthy is about . . .

how much money you keep

how hard it works for you

how much is left for future generations (who know what to do with it)

Being Wealthy is about exploding your Passive Income. (How long you can survive without ever having to go to work?)

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Financial Intelligence

When money works for you, every dollar is an employee. Each dollar works to bring you even more dollars while you’re asleep.

Passive Income: Interest, dividends, real estate income, royalties, residuals, annuities

The key is “What investments do you own that will bring you passive income?”

Buy assets first, luxuries last.

Ask “how can I afford it?” This stimulates your creativity.

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Income Statement

BalanceSheet

Income

Expenses (Payments)

Assets (Own) Liabilities (Debt)

Taxes, mortgage/rent, cards, car, food, fun, rent, clothes, child care, insurance, medical

Paycheck, dividends, interest,rents, royalties, profits, advances

Mortgage, car loan, credit cards, school loans

Stocks, bonds, notes,real estate, business, intellectual property

Financial Intelligence

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Income Statement

BalanceSheet

Income

Expenses

Assets

How The Wealthy Live They take the income of the poor and middle class, and buy

assets that produce more income

Liabilities

1 - 7Rich Dad’s Cash Flow Quadrant

You have a job.Someone else is the boss.Security before money.

You own a job. Loner/”boss.” Perfectionists. Small bus. Owners: Drs., restaurateurs.Independence before money.

You own a system that others operate.Coordinator. Delegator. Franchiser.Use other people's time and money.

Your money works for you.Make money with money.Other’s liabilities are your assets.

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Basic Spreadsheet Financial Functions

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Present Value Solution

A bond with a face value of $1,000 carries a coupon rate of 6.6%. The bond has 10 years till maturity and has a yield-to-maturity (YTM) of 7.6%. The bond pays coupons on a semiannual basis. What is market price?

= PV(Rate, Nper, Pmt, FV)

= PV(0.076/2,20,33,1000)=$930.83

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Future Value Solution

Peter saves 3k each month. Annual return is 8% APR compounded monthly. How much will Peter’s saving be 30 years from now. = FV(Rate, Nper, Pmt, PV)

= FV(0.08/12, 360, -3000, 0) = $4.47 M

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Payment Function

You have decided to buy a house for $312,000. You have saved enough money to make a 10% down payment, but you will need to borrow the remainder. You arrange for a 30-year mortgage (monthly payments) with a local bank at a stated rate of 6.3% APR compounded monthly. Assume that the first payment will be made one month from now

PMT(0.063/12,360,280800,0)=$1,738.08

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Interest Rate Function

Your decide to loan your little sister $2,000 so she can buy a car. You require her to pay you back over 30 months, making payments of $85.00 at the end of each month.

= RATE(Nper, Pmt, PV, FV)

interest rate per month=RATE(30,-85,2000,0,0)=1.645%

Annual rate: (1+1.645%)^12-1=21.6%

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NPER Solution

Has 1M at retirement, annual return is 8% APR compounded monthly, withdraw 8k each month, how long will the saving last.

= NPER(Rate, Pmt, PV, FV)

= NPER(0.08/12, 8000, -1000000, 0) = 270 month=23 years

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Investment Risk and Return

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What is investment risk?

Typically, investment returns are not known with certainty.

Investment risk pertains to the probability of earning a return less than that expected.

The greater the chance of a return far below the expected return, the greater the risk.

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Probability distribution

Rate ofreturn (%) 50150-20

Stock X

Stock Y

Which stock is riskier? Why?

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Standard deviation measures the stand-alone risk of an investment.

The larger the standard deviation, the higher the probability that returns will be far below the expected return.

Coefficient of variation is an alternative measure of stand-alone risk.

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Expected Return versus Risk

Expected

Security return Risk, Alta Inds. 17.4% 20.0%

Market 15.0 15.3

Am. Foam 13.8 18.8

T-bills 8.0 0.0

Repo Men

1.7 13.4

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T-bills

Coll.

MktUSR

Alta

0.0%2.0%4.0%6.0%8.0%

10.0%12.0%14.0%16.0%18.0%20.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Risk (Std. Dev.)

Re

turn

Return vs. Risk (Std. Dev.): Which investment is best?

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Portfolio Return, rp

rp is a weighted average:

rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.

rp is between rAlta and rRepo.

^

^

^

^

^ ^

^ ^

rp = wirin

i = 1

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p = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 + (10.0 - 9.6)20.40 + (12.5 - 9.6)20.20 + (15.0 - 9.6)20.10)1/2 = 3.3%.

p is much lower than:either stock (20% and 13.4%).average of Alta and Repo (16.7%).

The portfolio provides average return but much lower risk. The key here is negative correlation.

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Two-Stock Portfolios

Two stocks can be combined to form a riskless portfolio if = -1.0.

Risk is not reduced at all if the two stocks have = +1.0.

In general, stocks have 0.65, so risk is lowered but not eliminated.

Investors typically hold many stocks.

What happens when = 0?

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Portfolio

0 15

Prob.

2

1

1 35% ; portfolio 20%.Return

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Risk Relative to the Market

Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis.

The slope of the regression line, which measures relative volatility, is defined as the stock’s beta coefficient, or b.

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Calculating Beta for PQU

r PQU = 0.83r M + 0.03

R2 = 0.36-40%

-20%

0%

20%

40%

-40% -20% 0% 20% 40%

r M

r KWE

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If b = 1.0, stock has average risk.

If b > 1.0, stock is riskier than average.

If b < 1.0, stock is less risky than average.

Most stocks have betas in the range of 0.5 to 1.5.

Can a stock have a negative beta?

How is beta interpreted?

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Finding Beta Estimates on the Web

Go to www.thomsonfn.com.

Enter the ticker symbol for a “Stock Quote”, such as IBM or Dell, then click GO.

When the quote comes up, select Company Earnings, then GO.

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Use the SML to calculate eachalternative’s required return.

The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM).

SML: ri = rRF + (RPM)bi .

Assume rRF = 8%; rM = rM = 15%.

RPM = (rM - rRF) = 15% - 8% = 7%.

^

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Required Rates of Return

rAlta = 8.0% + (7%)(1.29)= 8.0% + 9.0% = 17.0%.

rM = 8.0% + (7%)(1.00) = 15.0%.

rAm. F. = 8.0% + (7%)(0.68) = 12.8%.

rT-bill = 8.0% + (7%)(0.00) = 8.0%.

rRepo = 8.0% + (7%)(-0.86) = 2.0%.

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Expected versus Required Returns

^ r r

Alta 17.4% 17.0% Undervalued

Market 15.0 15.0 Fairly valued

Am. F. 13.8 12.8 Undervalued

T-bills 8.0 8.0 Fairly valued

Repo 1.7 2.0 Overvalued

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Stocks and Their Valuation

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Dividend growth model

Using the multiples of comparable firms

Free cash flow method

Different Approaches for Valuing Common Stock

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ssss r

D

r

D

r

D

r

DP

1. . .

111ˆ

33

22

11

0

One whose dividends are expected togrow forever at a constant rate, g.

Stock Value = PV of Dividends

What is a constant growth stock?

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For a constant growth stock,

D D gD D gD D gt t

t

1 01

2 02

111

gr

D

gr

gDP

ss

100

1ˆ

If g is constant, then:

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What happens if g > rs?

If rs< g, get negative stock price, which is nonsense.

We can’t use model unless (1) g rs and (2) g is expected to be constant forever. Because g must be a long-term growth rate, it cannot be rs.

.r requires ˆs

10 g

gr

DP

s

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Assume beta = 1.2, rRF = 7%, and RPM = 5%. What is the required rate of return

on the firm’s stock?

rs = rRF + (RPM)bFirm

= 7% + (5%) (1.2)= 13%.

Use the SML to calculate rs:

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What’s the stock’s market value? D0 = 2.00, rs = 13%, g = 6%.

Constant growth model:

gr

D

gr

gDP

ss

100

1ˆ

= = $30.29.0.13 - 0.06

$2.12 $2.12

0.07

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What is the stock’s market value one year from now, P1?

D1 will have been paid, so expected dividends are D2, D3, D4 and so on. Thus,

^

D2

P1 = rs - g

= $2.2427 = $32.100.07

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The current stock price is $54.11.

The PV of dividends beyond year 3 is $46.11 (P3 discounted back to t = 0).

The percentage of stock price due to “long-term” dividends is:

Is the stock price based onshort-term growth?

^

= 85.2%.$46.11$54.11

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Why are stock prices volatile?

D1 = $2, rs = 10%, and g = 5%:P0 = D1 / (rs-g) = $2 / (0.10 - 0.05) = $40.

What if rs or g change?g g g

rs 4% 5% 6%9% 40.00 50.00 66.67

10% 33.33 40.00 50.0011% 28.57 33.33 40.00

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In equilibrium, expected returns mustequal required returns:

rs = D1/P0 + g = rs = rRF + (rM - rRF)b.^

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What’s the Efficient MarketHypothesis (EMH)?

Securities are normally in equilibrium and are “fairly priced.” One cannot “beat the market” except through good luck or inside information.