03mtreview

03mtreview - Introduction to Finance Asset Valuation...

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Introduction to Finance Asset Valuation Arbitrage Pricing Assets having same payoﬀs must have same prices Fixed-Income securities, Common Stocks, Forwards, Futures etc. Equilibrium Pricing Determinants of fundamentals Expectation of cash ﬂows, investor preferences, discount rate etc. Market Function of Financial Market Allocate resources Communicate information Role of Manager Maximize current market value of the ﬁrm Household Optimze investments based on preferences. 1

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Present Value Components Expected Cash Flow Discount Rates * Compounding (1 + r EAR ) = (1 + APR k ) k * Nominal versus Real (1 + r real )(1 + inﬂation) = (1 + r nominal ) Investment Rule Take project: NPV > 0 Present Value Formula PV = X t CF t (1 + r t ) t Future Value FV t = PV 0 (1 + r t ) t Special equations perpetuity perpetuity with growth annuity annuity with growth Consistency Match characteristics of cash ﬂows and discount rates Risk, Real, Nominal, Currency, tax etc. Remember to discount everything to the same point of time, and also note if inﬂation aﬀect your results! 2
Fixed-Income Securities Spot rates, r t Term Structure Forward rates (1 + r t ) t = (1 + r s ) s (1 + f s,t ) t - s Bond Price B = T X t =1 C t (1 + r t ) t + P (1 + r T ) T Yield-to-maturity, y B = T X t =1 C t (1 + y ) t + P (1 + y ) T Duration D = 1 B X CF t × t (1 + y ) t Modiﬁed Duration MD = D 1 + y or MD = - 1 B d B d y Convexity CX = 1 2 1 B d 2 B dy 2 Price Approximation Δ B B ≈ - MD × y ) + CX × y ) 2 + ··· Hedging V P = V A + V B MD P = V A V P MD A + V B V P MD B Inﬂation Risk Default Risk Default Premium Risk Premium 3

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General Pricing Formula P 0 = X t =1 E 0 (D t ) (1 + r t ) t + lim T →∞ E 0 (P T ) (1 + r ) T constant growth multiple stage growth Terminology Earnings per share (EPS) Payout ratio ( p ) Plowback ratio ( b ) b = 1 - p Dividends per share (DPS) DPS = (1 - b ) · EPS Return on Equity (ROE) Growth rate ( g ) g = ROE · b Book Value Dividend Yield
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03mtreview - Introduction to Finance Asset Valuation...

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