FNCE10002 Final: Finance Exam Key Points

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Finance Exam Key Points
Lecture 1:
- Financial systems arrange the flow of funds between surplus and deficit units
-Surplus units- suppliers of funds i.e. lenders, investors, shareholders.
-Deficit units- users of funds i.e. borrowers, credit card users, companies/issuers.
- Intermediation- indirect financing. Involves the transfer of funds between ultimate savers and
ultimate borrowers via deposit-taking institutions.
E.g. I give money to CBA who then gives money to another person.
- Direct financing: transfer of funds from ultimate savers to ultimate borrowers without an
intermediary.
E.g. BHP issues shares and raises capital from shareholders.
What is a security? A financial contract that can be traded in a financial market which specifies: a. asset
involved e.g. commodity (gold), hard asset (property), financial asset (shares). b. Quantity and unit
and c. price, date, payment and settlement terms.
Primary markets: The issue of a new financial instrument to raise funds to purchase goods, services or
assets by:
- Business- company shares or debentures.
- Governments- treasury notes or bonds.
Involving new capital raised, funds are obtained by the issuer. Direct financing raises funds in larger
amounts because the issue of securities requires a substantial effort that is only economical for large
amounts.
Secondary markets: The buying and selling of existing financial securities. A change of ownership- no new
capital is raised.
- No new funds raised and therefore no direct impact on original issuer of security
- Provides liquidity, which facilitates the restructuring of portfolios of security owners.
Secondary markets perform three main functions:
1. Provide investors with liquidity (transforming the maturity of funds)
2. Identify the price or value of the securities known as price discovery
Identify investors who are interested in securities- who could be approached to supply funds to the primary
market.
Introductory concepts:
- If an asset can be bought and sold at the same price then it is a competitive market.
-Law of one price: If equivalent investment opportunities trade simultaneously in different
competitive markets, then they must trade for the same price in both markets”. Else you can
profit from arbitrage trade and make riskless profit.
-Time value for money: a dollar received today will be different in value to that received in one
year’s time- inflation diminishes purchasing power
-Risk and return: in any period, the observed (or realised) return of an asset or security is
measured as the change in cash flows divided by the initial investment. The risk is the
uncertainty of receiving the cash flows in one year’s time. The higher the risk, the higher the
expected return. The return for a risky asset would be risk free return plus the risk premium.
Finance function:
The main goal of manager is to maximise the market value of the firm by taking on profitable investments.
- Value of the firm = Present value of future expected cash flows
- Shareholder wealth = Present value of shareholder’s future expected cash flows
Lecture 2:
Valuing Perpetuities and Annuities
- A perpetuity is an equal, periodic cash flow that goes on forever. Cash flows occur at the
end of each period.
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- A deferred perpetuity is an equal periodic cash flow that starts at some future date and
then goes on forever.
- A growth perpetuity is a perpetuity of C dollars today growing at a constant rate of g
percent per period and has the cash flow stream C(1 + g), C(1 + g)2, ... C(1 + g)n, and so on.
Note that the first cash flow is C(1 + g) not C.
Valuing Ordinary Annuities
- An ordinary annuity is a series of equal, periodic cash flows occurring at the end of each period
and lasting for n periods with n cash flows.
Valuing Deferred Ordinary Annuities
A deferred ordinary annuity is a series of equal, periodic cash flows occurring at the end of each
period where the first cash flow occurs at a future date.
Valuing Annuities Due
An annuity due is a series of equal, periodic cash flows occurring at the beginning of each period.
There are n cash flows but only n-1 periods. (First cash flow occurs at the end of period 0).
- The present value of an annuity due at at r% p.a. is equivalent to the present value of an ordinary
annuity compounded one additional period.
- The future value of an annuity due at r% p.a. is equivalent to compounding by one additional period
the future value of an ordinary annuity
Effective Annual Interest Rate (revisited)
You always use the effective interest rate per period. When the frequency of compounding per period is
one, the stated (or quoted) rate per period is also the effective rate per period.
Characteristics of debt securities
Debt instruments require the company (issuers) to repay the creditors (debt holders) both interest and
principle when they are due.
Short Term Debt Instruments Long Term Debt Instruments
Mature within the year – typically in 90 and 180
days
Typically mature after several years
Issuer has contractual obligation to make promised
payments
May or may not promise a regular interest
(coupon) payment
Lower risk than equity because you must make
promised payments
Issuer has contractual obligation to make all
promised payments
Face (or par) value is the dollar amount paid at maturity denoted as
Typically $100,000 or its multiple Usually $1,000 or its multiples
No other payments made to debtholders
(investors)
Coupon rate is the interest rate promised by the
issuer, expressed as a percentage of the face value
Interest (coupon) payment is the periodic (annual
or semi- annual) payment made to debtholders
Coupon payment (C or I) = coupon rate x Face
value
The Valuation principle
The price of a security today is the present value of all future expected cash flows discounted at the
“appropriate” required rate of return (or discount rate). Valuation principles are:
1. Market price
2. Future expected cash flows, face value and/or coupons (numerator)
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3. Yield to maturity or required rate of return (denominator)
Pricing coupon paying securities
The YTM is the rate of return earned by an investor who holds the bonds until they mature assuming that
the firm does not default on its obligations.
- The yield to maturity is the interest rate that discounts the bond’s future cash flows to equal the
market price today
- Note that the yield to maturity calculations assume that the coupons received can be reinvested at
that rate of return (otherwise, the actual yield may be more or less than the YTM)
- Price = PV(Interest payments) + PV(Face value)
Relating coupon rates to YTM
When YTM = rate; Price = Face value Bond is selling at par
When YTM < Coupon rate; Price > Face value Bond is selling at a premium
When YTM > Coupon rate; Price < Face value Bond is selling at a discount
Lecture 3:
The price of ordinary shares today is the present value of all future expected dividends discounted at the
“appropriate” required rate of return (or discount rate).
If a firm is seeking to increase share price it should:
- lower dividends and invest more
- lower its investment and increase dividends
Lowering the dividend to increase investment will raise the stock price if, and only if, the new
investments have a positive NPV (net present value).
Net present value: the difference between the present value of its benefits and the present value of its costs
NPV = PV(Benefits) - PV(Costs)
For plain vanilla preference shares the price is determined as the present value of a perpetuity of dividends
A price earnings multiple (or P/E ratio) is the ratio of the current market price to expected (or current)
earnings per share (EPS). The expected P/E ratio is defined as the amount investors are willing to pay now
for $1.00 of future expected earnings.
E.g. a P/E ratio of 10 means that investors are willing to pay a price of $10 for $1.00 of future
expected earnings.
The difference between the growth and no growth prices can be defined as the present value of growth
opportunities
What is financial leverage?
There are two main risks faced by firms:
1. Business (or operational) risk- The variability of future net cash flows attributed to the nature of the
firm’s operations or assets it holds. It is the risk faced by shareholders if the firm were financed only
by equity
2. Financial risk- The risk attributed to the use of debt as a source of financing a firm’s operations
Financial risk exists if the firm’s operations are financed using debt, that is, when there is financial
leverage. Financial leverage is measured as the debt-to-equity (D/E) or debt-to-total-assets [D/(D+E)]
ratios.
Effects of financial leverage:
- Variability of returns to shareholders also increases
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Document Summary

Financial systems arrange the flow of funds between surplus and deficit units. Surplus units- suppliers of funds i. e. lenders, investors, shareholders. Deficit units- users of funds i. e. borrowers, credit card users, companies/issuers. Involves the transfer of funds between ultimate savers and ultimate borrowers via deposit-taking institutions. I give money to cba who then gives money to another person. Direct financing: transfer of funds from ultimate savers to ultimate borrowers without an intermediary. Bhp issues shares and raises capital from shareholders. A financial contract that can be traded in a financial market which specifies: a. asset involved e. g. commodity (gold), hard asset (property), financial asset (shares). b. Quantity and unit and c. price, date, payment and settlement terms. Primary markets: the issue of a new financial instrument to raise funds to purchase goods, services or assets by: Involving new capital raised, funds are obtained by the issuer.