introtofinance.pdf - A First Course in Finance Preview A First Course in Finance 2003 2004 by Ivo Welch All rights reserved Cartoons are copyright and

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Unformatted text preview: A First Course in Finance Preview, June 25, 2004 A First Course in Finance © 2003, 2004 by Ivo Welch. All rights reserved. Cartoons are copyright and courtesy of Mike Baldwin. See . ISBN: no number yet. Library of Congress: no number yet. Book Website: . Typesetting System: pdflatex. Cover Font Y&Y Lucida Casual 15, 36, 43pt. Main Body Font Y&Y Lucida 11pt. Other Fonts Y&Y Lucida variations See Most graphics were created in R, open-source and free: . The referenced spreadsheets are Excel and OpenOffice (free). Printed: June 25, 2004. Warning: This book is in development. It is not error-free. A First Course in Finance Preview, June 25, 2004 Ivo Welch Professor of Finance and Economics Yale University There are a large number of individuals who have helped me with this book. They will eventually be thanked here. Until then, some random collection: Rick Antle. Donna Battista. Randolph Beatty. Wolfgang Bühler. Kangbin Chua. Diego Garcia. Stan Garstka. Mary-Clare McEwing. Roger Ibbotson. Matthew Spiegel. Julie Yufe. Many victim students using earlier error-ridden drafts. Warning: This book is in development. It is not error-free. Dedicated to my parents, Arthur and Charlotte. i last file change: Jun 14, 2004 (14:56h) ii iii To the Student Finance and Prerequisites Finance is such an important part of modern life that almost everyone can benefit from understanding it better. What you may find surprising is that the financial problems facing PepsiCo or Microsoft are not really different from those facing an average investor, small business owner, entrepreneur, or family. On the most basic level, these problems are about how to allocate money. The choices are many: money can be borrowed or saved; money can be invested into projects, undertaken with partners or with the aid of a lender; projects can be avoided altogether if they do not appear valuable enough. Finance is about how best to decide among these alternatives—and this textbook will explain how. To do so, it has to cover a lot of theory, but trust me: when properly defanged, the theory is not difficult. Finance as a subject of study. What do you need to to understand this book? You do not need any specific background in finance. You do need to be thoroughly comfortable with arithmetic and generally comfortable with algebra. You do need mathematical aptitude, but no knowledge of advanced mathematical constructs, such as calculus. (Knowledge of statistics would be helpful, but I will explain the relevant concepts when the need arises.) You should own a $20 scientific calculator, but not (necessarily) a financial calculator. You should learn how to operate a spreadsheet (such as Excel in Microsoft’s office or the OpenCalc spreadsheet in the excellent and free OpenOffice at ). The financial world is moving rapidly away from financial calculators and toward computer spreadsheets. Because I have tried hard to keep the book self-contained and to explain everything from first principles, you do not need to go hunting for details in statistics, economics, or accounting textbooks. (This is not to say that you do not need to take courses in these disciplines: they have way more to offer than just background knowledge for a finance textbook.) This book and the subject itself are tough, but they are not forbidding, even to an average student. The main prerequisite is mathematical aptitude, but not mathematical sophistication. One word of caution: the biggest problem for a novice of any field, but especially of finance, is jargon: the specialized terminology known only to the initiated. Worse, in finance, much jargon is ambiguous. Different people may use different terms for the same thing, and the same term may mean different things to different people. You have been warned! This book attempts to point out such ambiguous usage. Luckily, the bark of jargon is usually worse than its bite. It is only a temporary barrier to entry into the splendid field of finance. Jargon can trip up the reader. Struggling with the Learning Process in a Business School If you are taking finance in a business school, chances are that you find yourself in a classroom with considerable heterogeneity in student preparation. Unlike almost any other core course in business schools, as many as half the students regularly come from a background in which their prime function is finance-related. Usually, this work experience will not have left such students with solid enough knowledge to skip the finance core course, but it will have left them with the knowledge to help them better integrate the new information—which leaves them with a considerable headstart when it comes to test performance relative to students who come from non-quantitative and non-financial backgrounds. In universal core courses, it is thus inevitable that many It is impossible to time a finance course in a business school core, so that both the well-prepared finance nerds and novices will be happy from the start. iv students find the tempo too fast and many other students find the tempo too slow. The world is not fair—and neither is the grade competition in such a course. But there is no way around it: although the most important goal of a finance course must be to see that all students are solidly prepared for interviews with companies—many interviewers ask students to apply the very concepts taught in this introductory course—it makes it difficult for previously unprepared students to keep up. In its combination of unequal preparation, often splitting a class into two equal students clienteles, and in its need to cover “unskippable” material, finance is unique among core business disciplines. There are no easy shortcuts in the curriculum. Advice to the “non-quants.” At times, students without quantitative and financial preparation inevitably feel overwhelmed by their class experience. If you are one of these students, let me advise patience, practice, and reflection: it will all eventually fall into place, kemosabe, and you can do well in the end. Some of my best and brightest students felt frustrated during the course, but they kept at it, studied and learned twice as hard, and ended up at the top of their class. Struggling and anxiety along the way are necessary, maybe even desirable, and in the end unavoidable. The Book This book is concise, focusing on the essence of arguments. This textbook is concise. Its intent is to communicate the essential material in a straightforward (and thus compact), but also conversational (and thus more interactive) and accessible fashion. There are already many finance textbooks with well over a thousand pages. Much of the content of these textbooks is interesting and useful but not essential to an understanding of finance. (I personally find some of this extra content distracting.) The layout of the book. The book is organized into four parts: the Basics, Valuation, Investments, and Financing. Major sections within chapters end with questions that ask you to review the points just made with examples or questions similar to those just covered. You should not proceed beyond a section without completing these questions (and in “closed book” format)! Many, but not all, questions are easy and/or straightforward replications of problems that you will have just encountered in the chapter. Others are more challenging. Each chapter ends with answers to these review questions. Do not move on until you have mastered the material. This is an annotation. There are “annotations” on the left side of most paragraphs throughout the text. Suggestion: use the remaining white space in the margin to scribble your own notes, preferably in pencil so that you can revise them. These are other notices. Especially important concepts that you should memorize are in red boxes: Important: This is an important point to remember. Interesting, related points that either interrupt the flow of an argument, or that are not absolutely necessary are called “Side Notes: v Side Note: This is an interesting side note. More detailed points are called “Nerd Notes”: Nerd Note: If you are really interested, here is a curious fact or a derivation. Both side notes and nerd notes can be safely omitted from reading without compromising understanding. Sometimes, an appendix contains further advanced material. A final warning: I have a strange sense of humor. For example, do not be turned off by the term “nerd notes.” They could also have been called “technical notes”—but this would have been dry and boring. Sense of Humor This book cannot do it all. It is important for you to keep up with current financial developments. Frequent reading of the financial section of a major newspaper (such as the New York Times [N.Y.T.]), the Wall Street Journal [W.S.J.], or the Financial Times [F.T.] can help, as can regular consumption of good business magazines, such as The Economist or Business Week. (See the website at for more useful resource links.) Although this is not a book on “how to read and understand the newspaper,” you should be able to understand most of the contents of the financial pages after consuming this textbook. Advice: Follow current coverage of financial topics elsewhere! Enjoy! Ivo Welch, Yale University, 2004. PS: And if you would like to learn more about my take on business and finance education today, feel free to read the epilogue (Chapter A). vi A Quick Adoption Checklist For Instructors This checklist will not apply after AFCIF is published (with full supplementary materials) by AddisonWesley-Pearson. The recommended checklist for this book (AFCIF) while in beta test mode: ✓ Read this prologue and one or two sample chapters to determine whether you like the AFCIF approach. • Do not select the introduction chapter (Chapter 1), because it is not representative. If you cannot make up your mind as to which chapter to sample, you might try the chapters on taxes, inflation, and default in rates of return (Chapter 4) or in NPV (Chapter 6); the chapter on financial statements (Chapter 9) and pro formas (Chapter 10). (The following are not yet edited: you could also glance at the chapter on statistics for investments in the survey book, followed by its CAPM chapter; or you could read the chapter on valuation with corporate taxes [APV vs. WACC] in Chapter 22).) Finally, although not representative, either, you might enjoy reading the epilogue. • If you do like the AFCIF approach, then please continue. If you do not like AFCIF (or the chapters you read), please email [email protected] why you did not like it. I promise I will not shoot the messenger: I want to learn how to improve. ✓ You can continue to assign whatever other finance textbook you were planning to use, but now please add AFCIF. • AFCIF is a full-service textbook for an introductory finance course. However, this does not mean that it cannot also work as a complement to your previous textbook. The fact that it is so different from the competition means that you and your students can benefit from a test, in which you assign both books for one year. Relative to relying on only your old textbook, AFCIF will not increase, but decrease your student confusion and workload. See how well AFCIF works! (Take the Pepsi challenge!) I hope that the majority of your students (and you) will prefer reading AFCIF rather than your old textbook. • I believe it should also be a relatively simple matter for you to plug AFCIF into your current class: The chapters are short and easy to map to your curriculum. Having the old textbook is also your insurance against using a novel textbook. It will also make students less critical of the remaining shortcomings in AFCIF, such as the limited number of exercises (and their occasionally erroneous solutions). Perhaps most importantly, AFCIF does not yet have full supplementary materials. It will, but until then, the older textbook may help. • For now, the printing cost for AFCIF adds only around $20 to student cost, so affordability should not be a concern. I cannot see how you can go wrong if you try out AFCIF in this manner. ✓ You can receive permission to post AFCIF on your class website. (The website must be secured to allow only university-internal distribution). ✓ Ask your copy center to print and bind the version on your website. (If need be, I can send you nicely bound copies at $50/book. Your copy center can probably do it for $20/book.) • Although versions on the AFCIF website at will be better than the version you download, it is good for you and your students to have one definitive reference version. ✓ If you are using AFCIF and you are looking for lecture notes, feel free to “steal” and adapt my lecture notes (linked at ) to your liking. (Please avoid the homeworks for now. Like some of the Q&A in AFCIF, the homeworks are not solid.) ✓ At the end of the course, please ask your students which textbook they found more helpful. Please email your conclusions and impressions to [email protected] Any suggestions for improvement are of course also very welcome. vii To The Instructor: Differences and Innovations The main concepts of finance are found in all textbooks, and this textbook is no exception. Thus, most—though not all—of the concepts and subjects in A First Course in Finance overlap with more traditional finance textbooks. This text’s content is evolutionary, not revolutionary. But I do believe that it represents a dramatic departure from traditional finance textbooks in terms of its presentation. Here is my view of how this book differs from what is currently out there: This book is intentionally different. Conversational Tone The tone is conversational, which (I hope) makes the subject more accessible. Conversational Tone. Numerical Example Based I learn best by numerical example, and firmly believe that students do, too. Whenever I want to understand an idea, I try to construct numerical examples for myself (the simpler, the better). I do not particularly care for long algebra or complex formulas, precise though they may be. I do not much like many diagrams with long textual descriptions, either—I often find them too vague, and I am never sure whether I have really grasped the whole mechanism by which the concept works. Therefore, I wanted to write a textbook that relies on numerical examples as its primary tutorial method. The method of instruction is “step-by-step numerical examples.” This approach necessitates a rearrangement of the tutorial textbook progression. Most conventional finance textbooks start with a bird’s eye view and then work their way down. The fundamental difference of this book is that it starts with a worm’s eye view and works its way up. In caricature form, the format of other textbooks is “institutional background, hand-waving, formulas, figures, recipé application.” The format of this textbook is the posing of a critical question like “what would it be worth?,” which is then explained in numerical step-by-step examples from first principles. Right under the numerical computations are the corresponding formulas. In my opinion, this structure clarifies the meaning of these formulas, and is better than either a textual exposition or an algebraic exposition. I believe that the immediate duality of numerics with formulas ultimately helps students understand the material on a higher level and with more ease. (Of course, this book also provides some overviews, and ordinary textbooks also provide some numerical examples.) This “forward development” approach also goes well with a book that has a conversational, more interactive flavor. Brevity Sometimes, less is more. This book is intentionally concise, even though it goes into a lot more theoretical detail than other books! Institutional descriptions are short; only concepts and models are explained in great detail. My view is that when students are exposed to too much material, they won’t read it, they won’t remember it, and they won’t know what is really important and what is not. Ten years after our students graduate, they should still solidly remember the fundamental ideas and be able to look up the details when they need them. Aside, many institutional details will have changed—it is the concepts that will last longer. Brevity is important. The book focus is on explanations, not institutions. viii Self-contained means students can backtrack. Self-Contained for Clarity Finance is a subject that every smart student can comprehend, regardless of background. The real problem is that many students come into class without much prerequisite knowledge, which we, the instructors, often erroneously believe they have. It is easy to mistake such “lost students” as “dumb students,” especially if there is no reference source where lost students can quickly fill in the missing parts. In this book, I try to make each topic’s development as self-contained as possible. I try to explain everything from first principles, but in a way that every student can find interesting. For example, even though the necessary statistical background is integrated in the book for the statistics novice, the statistics-savvy student also should find value in reading it. This is because it is different in our finance context than when it is taught for its own sake in a statistics course. Because this book tries to be as self-contained as possible, students who have failed to understand a particular lecture or topic (or who simply miss class) can now be referred back to read a self-contained chapter. My experience is that having a textbook that relates closely to the curriculum significantly reduces the need to back up and re-lecture on topics when enough students have become confused. My experience tells me that this reduces the planned time necessary to cover topics by about 10%. Less Chapter Reordering. Closer Correspondence with the Curriculum I believe that most finance core courses follow a curriculum that is much closer in spirit to this book—and more logical— than it is to the order in traditional finance textbooks. In the places where this book covers novel material (see below), I hope that you will find that it has merit— and if you do, that covering the topic is much easier with this book than with another book. Every finance course must begin with some basic institutional information, some statistics (at least, expected values), and a thorough description of what returns are, how they are computed, and what they mean. Thereafter, capital budgeting can be taught before asset pricing, or vice versa. This book accommodates either approach by keeping these parts self-contained.   Investor Choice  Basics Computing Returns    @ R @    Project Choice   Asset Pricing @  R @   Financing Choice Capital Structure, WACC   [email protected]  @  R @ @@  Capital Budgeting  Web Chapters Supplementary   The advantage of teaching asset pricing first is that it is the more logical flow: when capital budgeting begins, students already know where the r in the NPV formula comes from. However, asset pricing relies on statistical concepts such as variance and covariance. If the finance course is taught in a first semester, contemporaneously with the statistics course, it may be better to delay covering asset pricing until the statistics course has explained some of the relevant concepts. ix The capital structure part is recommended to come last: its ideas will be easier for students if they already understand NPV, payoff diagrams, and the fact that riskier securities command higher expected rates of returns. Side Note: I have wrestled with good names for the three areas. I started with Investments (asset pricing), Valuation (capital budgeting), and Financing (capital structure); but on reflection, I now believe that all traditional designations are ambiguous. This fellow points out when a discussion references material from chapters that have not been covered yet. This happens rarely, and the necessary ...
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