Accounting and Finance Notes
Accounting and Finance Notes
Chapter 1
Chapter 2
Lecture 1
Chapter 3
Chapter 1
Real assets - physical assets that have an intrinsic value
Ex. factories, machines - tangible assets;
patents, brands - intangible assets
Financial assets - assets with value from a contract and with claimed ownership
Ex. bank loan, bond
Securities - trandable financial assets; A security is a financial instrument, typically any
financial asset that can be traded
Investment decision = purchase of real asset; how the funds of a firm are to be invested into
different assets, so that the firm is able to earn highest possible return for the investors; include
outflow of cash
Financial decision = sale of financial asset; decisions that managers take with regard to the
finances of a company; include inflow of cash
Capital expenditure (budgeting) - money invested by a company to acquire or upgrade fixed,
physical, non-consumable assets; invest in tangible things
Corporation - legal entity that is owned by its shareholders
Closely held company - private company
Limited liability partnership (LLP) - partnership with a limited amount; each partner is not
responsible or liable for another partner's misconduct or negligence.
Externalities - cost or benefit caused by a producer that is not financially incurred or received by
that producer. An externality can be both positive or negative and can stem from either the
production or consumption of a good or service
Opportunity cost of capital - incremental return on investment that a business foregoes when it
elects to use funds for an internal project rather than investing cash in a marketable security
Hurdle rate - minimum rate of return possible; the minimum rate of return required on a project or
investment. Hurdle rates give companies insight into whether they should pursue a specific project.
Riskier projects generally have a higher hurdle rate, while those with lower rates come with lower
risk.
Agency problem - conflict between the investors and the manager
Agency costs - shareholders want to check the manager and the costs; internal company expense,
which comes from the actions of an agent acting on behalf of a principal
Error of omission - error in which a transaction is not at all recorded in the books, either completely
or partially
Error of commission - error in which the transaction is incorrectly recorded in the books
Limited liability - the condition by which shareholders are legally responsible for the debts of a
company only to the extent of the nominal value of their shares; legal structure of organizations that
limits the extent of an economic loss to assets invested in the organization and that keeps the
personal assets of investors and owners off-limits.
Chapter 2
Have 100$ with a compound rate of 7% -> 100x1.07=107$
-> For 1 year, compound interest is 7$
REVERSE
-> What is the present value of 114.49 investment in order to have them in 2 years?
PV = 114.49 / (1+r)^2 = 114.49 / 1.07^2 = 100
r as interest rate
t
The expression 1/(1 + r) is called the discount factor. It measures the present value
of one dollar received at the end of year t. For example, with an interest rate of 7% the two-year
discount factor is
DF2 = 1 / ( 1.07 )2 = 0.8734
Investors are willing to pay $0.8734 today for delivery of $1 at the end of two years. If each
dollar received in year 2 is worth $0.8734 today, then the present value of your payment of
$114.49 in year 2 must be
Present value = DF 2 ×C 2 = 0.8734×114.49 =$100
Net Present Value = PV - investment ; PV = 74,100; investment = 70,000 => NPV = 4100
Ex. opportunity cost of capital 7%, investment 700,000$, sell in 1 year for 800,000$
C(0) -> cash flow - year => C(0) = -700,000 = investment; C(1) = 800,000
=>PV = C(1) / (1+r)^1 = 800,000 / 1.07 = 747,664 NPV = C(0) + PV = -700k + 747k = 47k
Rate of Return = profit / investment => 100k / 700k = 0,143 = 14.3%
Net Present Value Rule - accept investments that have positive net present
values
Rate of Return Rule - accept investments that offer rates of return in excess of their
opportunity costa of capital
Discount Cash Flow (DCF)
Perpetuity - an investment that pays off the same cash flow same year starting a year later; a
bond or other security with no fixed maturity date
Present value of perpetuity = C / r ; C is the cash payment, r is the discount rate
Perpetuity due - perpetuity that starts immediately
Delayed Perpetuity
Annuity - an asset that pays fixed money each year for a specific amount of years
Annuity due - it is (1+r) times normal annuity
Loan amortization - how you repay the loan over time
Amortization of loan = total year-end payment - year-end interest balance
(loan with amortization) Annual mortgage payment = whole sum taken / t-year annuity factor
Annual Percentage Rate (APR) - tells how much interest is paid over the course of the year, ignoring
how often is paid
Effective Annual Rate (EAR) - equally annual compound
Growing Perpetuities
Growing Annuities
Continuous Compounding
Lecture 1
DCF Setting For Shares
● Estimate the expected level of future cash flows (Ct)
○ Starting point: simply take expected dividends
● Determine the appropriate discount rate r
○ The expected level of return that is acceptable by the investor
○ If r=8%, the investor requires to make 8% per invested $ per year
○ Market figures for r are risk-dependent! (CAPM will make this concrete)
PV(stock) = PV(expected future benefits)
PV(expected dividends)
Interpretation: Investor makes an annual return r indeed if he/she pays P0 and gets back the
(expected) dividends
Check:
● Amount DIV1 back in one year; willing to pay for it: DIV1 / (1+r)
● Amount DIV2 back in 2 years; willing to pay for it: DIV2 / (1+r)2
Now sum over all years, and conclude that investor is willing to pay P0
Assume dividends are constant, for all t: DIVt = DIV1
By the perpetuity formula, then P0 = DIV1 / r
This is
Now, assume dividends ARE NOT constant, there is a fixed growth rate g: DIVt = DIVt-1 x (1+g)
This yields:
Second Formula
First term: hypothetical price under a no-growth policy
● As if EPS is the same every year
● And as if this is paid out entirely as a dividend
Second term: PV of Growth Opportunities
● The value of the share not captured by the previous term
● Growth stock: stock with relatively high PVGO
Corresponding decomposition in terms of rates:
r = EPS / P0 + r PVGO / P0
EPS / P0=> operating performance ; r PVGO / P0 => (anticipated) investment performance
CAPM
The market risk premium is approximately 7%
β measures the scale of risk in an asset - intuitively
β of a share X not proportional to the risk of a share X in isolation
β measures the contribution of share X to the ‘market portfolio’
Technically: regression coefficient, not a standard deviation
Chapter 3
Bond - if you own a bond, you are entitled to a fixed set of cash payoffs. Every year until the
bond matures, you collect regular interest payments