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RSM332H1 Study Guide - Midterm Guide: Dividend Discount Model, Canada Business Corporations Act, Profit Margin

Rotman Commerce
Course Code
Jennifer So
Study Guide

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Capital Market Theory
Lecture 1
Finance = process which individual investors
and firms allocate resources over time by
using financial assets
Financial System
Households are primary provider of
o Objective: allocate their income/savings to carious assets to maximize the utility of life-
time consumption
o Real Assets =
o Financial Assets =
o Liabilities [ex. Credit cards, car loans, mortgages]
o Net Worth = asset liabilities
Business & Gov primary user of funds
Intermediaries connection
o Financial Intermediaries [ex. banks, insurance companies, pension funds, mutual funds]
o Market Intermediaries [ex. investment dealers, brokers]
3 ways funds are moved:
o Direct transfer = saver to borrower (non-market)
Problems: Search costs [finding person to lend], Double co-incidence of wants,
Contracting costs [contract to get $ back], Default [crook? Enforce contract?],
Liquidity [want money early?], Asymmetric Information [adverse selection],
Moral Hazard [change decision after]
o Direct Intermediation = market based transaction through intermediary
o Indirect Claims through a financial intermediary = financial intermediary takes funds
from a saver and lend those funds off
Financial Intermediaries
o Take deposits and are “pooled” in the bank
o Bank takes pooled funds and lends them to household/business as loans/mortgages
o Transform original nature of savers money able to perform b/c experts at risk
assessment/financial contracting/monitoring activities
Deposit in small amounts with little risk
Loans/Mortgage: large sums, borrowed for long time, risky purpose
Insurance Companies
o Sell policies & collect premiums (based on policy type and size + admin fees)
o Invest premiums so that accumulated value in future will grow to meet anticipated
claims risk shared among all policy holders
o Allows the household, business, gov to engage in risky activities
Pension Funds/Plans
o Payments made over entire working life
o Accumulated value in pension can be used by person in retirement
o Managers collect funds to invest diverse portfolios
o Major source of capital, fueling investment in R&D, capital equipment, resource
exploration, and ultimately contribution in substantial way to growth in the economy
Mutual Funds

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o Give small investors access to diversified professionally-managed portfolios of securities
o Called Denomination b/c mutual fund makes investments available in smaller, more
affordable amounts of money
Financial Instruments
Public Debt (government) & Private Debt (household, non-financial corporations)
Contracts = connect households to production side of the economy
o Debt Instruments [ex. Commercial paper, banker acceptance, treasury bills, mortgage
loans, bonds, debentures]
o Equity Instruments [ex. Common stock, preferred stock]
Marketable Vs. Non-marketable
o Characteristics of marketable securities: can be traded between or among investors
after their original issue in public markets and before they mature or expire
o Characteristic of Non-marketable securities: cannot be traded between or among
investors, may be redeemable [ex. Saving account, term deposits, GIC, saving bonds]
Market Capitalization = total market value of a company’s equity/stock shares
Money Market Securities = short-term debt securities that are pure discount notes *ex. Banker’s
acceptances, commercial paper, treasury bills]
Capital Market Securities = long-term debt or equity securities with maturities > 1 year [ex.
Bonds, debentures, common stock, preferred stock]
Financial Markets
Primary Market = involves issue of new securities by the borrower in return for cash from
investors [ex. IPO]
Secondary Market = involves buyers and sellers of existing securities, funds flow from buyer to
seller (not capital formation occurs)
o Exchanges or Auction Markets = involved bidding process at specific location [ex. TSX]
o Dealer or Over the Counter (OTC) Markets = do not have physical location and consist of
dealers who trade directly with one another [ex. Bond Market]
o Money Markets and Bond market are global = domestic equity market
Goals of Corporation
Shareholder wealth maximization is considered most appropriate to guide officers & directors,
focuses on genuine profit, reflects into future (better than profit maximization b/c not focused
on accounting profit, not short term gain.)
Conflict arises when stakeholders have differing goals
Direct Agency Costs = arise when suboptimal decision are made by manager when the act in a
manner is the best for investors
Indirect Costs = incurred by corporation in attempt to avoid direct agency costs
Lecture 2
Time value of money (TVM) opportunity cost
o Based on idea that money today to amount tom (b/c invest)
Moving money from future to today = Discounting
Moving money from today to future = Accumulating
Interest Rate = Discount Rate = Required Rate = cost of money
Is known as the
Future Value Factor

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Compound Interest
Simple Interest = is paid or received only on the initial investment amount (only 1 time period)
o Annual interest $1000 x 0.08 = $ 80 per year
Compound Interest = interest is added to amount then new interest calculated
o Compound interest $1000 X (1.08)8 = $1469
Annuities & Perpetuities
Annuity = financial instrument that pays income in a
series of payments for the same amount over a
regular interval
o Ordinary Annuity = payment at end of the
EX. Invest $500 at end of each year
for next 4 years earn 10% each year.
Answer: (using Future Value) FV4 =
500(1.1)3 + 500(1.1)2 + 500(1.1)1 +
500 = $2320.50
o Annuity Due = payment at the beginning of
the period
Perpetuity = payments are infinite
Is known as the Discount
𝐶 is negative b/c
it represent an
Re-arranged from:
Re-arranged from:
C = PMT =
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