TCHE302.

3
(10/30/60)

CHAPTER 1: INTRODUCTION TO FINANCE

1. Defining Finance:

Introduction: saving money for retirement: deposit to bank, mutual fund, direct stock market
management? Buy a new motorbike: saved cash, borrowed money?

Finance is the study of how people allocate scarce resources over time (Bodie and Merton)

Scarce resources: nguồn lực khan hiếm (tiền, v.v…)

You pay 5M VND to exchange a phone from the seller => an exhange/trade relation, not a
financial transaction.

You borrowed money from A to buy a motorbike, pay back money to A after a period of time =>
An exchange between You and seller; A financial transaction between A and you (money for more
money in the future).

A takes 2.3 million VND to B for 100$ in exchange => an exchange.

You borrowed money from A => A lost opportunity cost (build a shop, invest…)

Features:

 Spread out through space (from A to B) and over time (after a period of time)

A takes 2.3 million VND to B for 100$ in exchange => an exchange.

 Risk – Return trade off, with expected return/profit (+money in return), opportunity cost,
default risk (rủi ro vỡ nợ)

You borrowed money from A => A lost opportunity cost (build a shop, invest…)

 Assets used for the transactions is either cash or financial assets (tài sản tài chính).

You pay for the firm, you receive bond (Trái phiếu là một chứng nhận nghĩa vụ nợ của người phát
hành phải trả cho người sở hữu trái phiếu đối với một khoản tiền cụ thể, trong một thời gian xác
định và với một lợi tức quy định).

Real assets vs. Financial assets:

Asset: any possession that has value in an exchange.

A real asset is used to produce goods and services and thereby generate cash flow (machine, building,
equipment, land/real estate) (tài sản vật chất có giá trị nội tại nhờ tính chất và đặc điểm của chúng.
Tài sản thực bao gồm kim loại quí, hàng hóa, bất động sản, đất đai, thiết bị và tài nguyên thiên nhiên).
A financial asset is a claim against a firm, government or invididual for future expected cash slows
(Tài sản tài chính là một tài sản phi vật chất có giá trị thu được từ một yêu cầu theo hợp đồng, chẳng
hạn như tiền gửi ngân hàng, trái phiếu và phần tham gia vào vốn cổ phần của các công ty).

Financial assets:

Main properties:

 Rate of return: expected return (+money), not realized return

 Risk: credit risk, market risk
 Liquidity (thanh khoản): easy convertibility into cash with little or no loss of value

2. 5 core principles of finance:

 Time has value (MOST IMPORTANT)
 Risk requires compensation (This principle essentially states that people are generally
unwilling to accept any danger in regards to potential losses to their financial instruments,
unless they are rewarded in some way)
 Information is the basis for decisions
 Markets determine prices and allocate resources
 Stability improves welfare

3. Financial decision of households: in relation of blood, marriage… a single household.

 Consumption and saving decisions (how to allocate weath over time?)
 Investment decisions (how to grow wealth? How should they invest to get benefit?)
 Financing decisions (How to finance consumption and investment?)
 Risk management decisions (how to reduce financial uncertainties and when should increase
risk?)

Cash flow and financial decisions of households

4. Financial decisions of firms:

Business firms: entities whose primary function is to produce goods and services
 Investment decision – how to invest (capital budgeting) and in what assets?
 Financing decision – where is money from in order tp finance long-term investments?
 Working capital decision

The Capital Budgeting Process – Investment Decision

The Financing Process

Working Capital

5. The financial system:

 A Financial System is comprised of markets, intermediaries, service firms and other institutions
used to carry out the financial decisions of households, business firms, and governments

Surplus spending unit (1) Has more cash income flow than expenditure on consumption and real
investments in a period of time. The surplus is then allocated to the financial sector. Other terms
for surplus unit are saver, lender, buyer of financial assets, financial investor, supplier of loanable
funds, buyer of securities.

Deficit spending unit (1) Has more expenditures on consumption and real goods (investment) in
the real sector than income during a period of time.

Funds may flow from SSU to DSU in 3 ways:

 Directly meet
 Through market intermediaries (or markets)
 Through financial intermediaries

CHAPTER 2: RISK AND RETURN

1. Data: is the number we use to interpret reality – any observations that have been collected –
collect, describe, analyze, summerize, interpret, draw conclusions.
2. Statistic:
3. Population (tập hợp, tập thể): collection of units being studied (people, food, places, rates,
years…)
4. Sample: group of units, selected from a larger group – population. Random sampling – random
sample.
5. Parameters and statistics: numerical value of a population
An array: is a table of data

Observation 1 2 3 4 5
Data value 5 7 3 38 7
X1 X2 X3 X4 X5

Average:

Median: middle point of the data.

Measure of spread: interquartile range, standard devation, squared distance of point Xi to

Xbar (Xi – Xbar)2
Variance = 171.2 hrs2
Standard devation = √ variance = √ 171.2 = 13.08 (hrs2)
Asset:
 Return (+): mean (giá trị TB)
 Risk (-): standard deviation (độ lệch chuẩn)
What is return?

 Realized return: total gain or loss experienced on an investment over a period of time.

 Expected return: is the average return that an investment is expected to produce overtime.

What is risk? (volatility)

Is the variability of return associated with a given asset.

Is the difference btw actual return & expected return.

Unequal probability:

Probability changes to 0.4 and 0.6.

Measuring risk:

Variance (phương sai): average of the squared differences from the mean.
Probability changes to 0.4 and 0.6. E(R) = 10% and 13%.
Risk – return trade off

“Risk-return trade off relation always exists in Finance”

Return measured by μ, let us know the central value of observations.
Risk measured by σ, let us know how deviate observations are from the central value.
Risk appetite (needs, ability, willingness)

People can be risk averse, risk neutral, or risk loving:

A risk averse investor will generally take a guaranteed outcome even if it has a lower expected payout
than a gamble.
A risk neutral investor is indifferent to risk when making an investment decision (only considers the
expected return of each investment, and ignores the potential downside risk).
A risk lover will choose a higher risk option with an expectation of receiving higher return.

 Postively related
 Inversely related
 Uncorrelated

Covariance (hiệp phương sai): >0 = postively related

<0 = inversely related

=0 = uncorrelated
P= 0: uncorrelated
Definition of investment portfolio:

A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents.

Portfolio weights:
Portfolio’s expected return:

Portfolio’s variance:
For a portfolio:

Combining assets that have a low correlation with each other helps to reduce the overall risk of the
portfolio

CHAPTER 3: TIME VALUE OF MONEY.

2.3. The freqency of compunding – nominal and effective interest rate:

A Nominal Interest Rate is an interest rate that does not include any consideration of
compounding.
Also called Annual Percentage Rate (APR).
Example: 8% annually, 8% quarterly (APR)

Effective Annual Rate (EAR) is an annual rate of interest when compounding occurs more often than
once a year.

APR m
EAR = (1+ ) – 1 – m: number of compound in a year.
m
EAR is corresponding to APR but compund only once a year.

7% annually – 7% EAR

6.5 % 4
6% quarterly – EAR = EAR = (1+ ) – 1 = 6.66%
4

The frequency of compounding:

EAR = eAPR – 1

Where “APR” is the nominal rate of interest compounded continuously.

This is the max. interest rate for any value of “APR” compounded continuously.

CHAPTER 4: TIME VALUE OF MONEY APPLICATIONS

1. Annuity:

Annuity – present value of an Annuity, future value of annuity

Perpetuities – present value of level perpetity, present value of growing perpetuity

An annuity is any collection of equal payments made at regular time intervals such as monthly,
quarterly, or annually over a finite period of time.

Example: Monthly credit card payments, ultility bills (not an annuity)

Assumptions of regular annuity

- The first cash flow will occur exactly one period from now
- All subsequent cash flows are separated by exactly oneperiod
- All periods are of equal length
- The term structure of interest is flat
- All cash flows have the same (nominal) value

A 1
PV = (1 - n)
i (1+i)
Amortized loans (vay trả góp)

Future value of an Annuity

A sum of money to which an annuity’s payments and interest accumulate in the end is called the
annuity’s future value.

FV annuity formula: payment

Sinking funds: are annuities for which the amount of the payment (A) is determined by the FV
desired.

2. Perpetuities

A perpetuities is an annuity that continues forever or has no maturity. For example, a dividend stream
on a share of preferred stock. There are 2 basic types of perpetuities:

 Growing perpetuity in which cash flows at a constant rate, g, from period to period.
 Level perpetuity in which the payments are constant rate from period to period.

Present value of a level perpetuity:

Present value of a growing perpetuity:

PROJECT APPRAISAL RULES

1. Payback period:

Payback Period = number of years

to recover initial costs
Computation
Estimate the cash flows
Subtract the future cash flows
from the initial cost until the
initial investment has been
recovered
Decision Rule – Accept if the
payback period is less than some
preset limit
Advantages and Disadvantages

Advantages: easy to understand, adjusts for uncertainty of later cash flows.

Disavantages: ignore the time value of money, ignore cash flows beyond the cutoff date.
Net present value (NPV)

Net Present Value - Present value of cash flows minus initial investments.
Opportunity Cost of Capital - Expected rate of return given up by investing in a project.

NPV = PV (Ct) – required investment

1. Estimate the expected future CFs.

2. Estimate the required return for the project of this risk level.
3. Find the PV of the future CFs and subtract the initial investment.

Terminology
Ct = Cash Flow at time t
t = time period of the investment
r = “opportunity cost of capital”

The Cash Flow could be positive or negative at any time period.

INTERNAL RATE OF RETURN

IRR – discount rate at which NPV=0

IRR – Decision Rule

 Minimum Acceptance Criteria:

Accept project if the Required rate of return < IRR
 Ranking Criteria:
Select alternative with the highest IRR

Disadvantages: IRR may not exist, or there may be multiple IRRs; Scale problem.
Advantages: Easy to understand and communicate.

NPV VERSUS IRR

NPV and IRR will generally give the same decision.

Exceptions:
Non-conventional cash flows – cash flow signs change more than once.
Mutually exclusive projects