Fundamental concepts in finance

1.- FUNCTIONS AND OBJECTIVES OF THE FINANCE

Finance emerged as a separate field of study in the early 1900s. Being its concern until the 1930s it was how to raise capital in the most economically possible way. His focus was basically on expansion problems.

After the crisis of 1929, other problems began, such as the survival of companies, banking regulations and capital markets.

Until the 1950s, Finance was a descriptive discipline, only in the last part of the 1950s did they begin to be developed with more scientific rigor with mathematical models that were applied to inventories, cash, accounts receivable and fixed assets.

Another stage was from the beginning of the 1970s when the United States abandoned the convertibility of the dollar with gold, a general float regime began, since there was no fixed relationship between the mark and the dollar or between the lira and the Frank. Emerging volatilities in the exchange rates of the different currencies.

Subsequently, the first oil shock of 1973 resulted in the change in international relative prices.

Then the volatility of interest rates and prices begin, which generates greater risks for financial decision-making.

When these risks arise, instruments and markets are born to defend their economic agents.

Given the volatility of interest rates, exchange rates, prices, competitiveness, falling profit margins, the development of communications, technology, Finance must be concerned not only with obtaining funds in the most appropriate way. economic but also of its application.

Comparative table between the traditional and modern approach to Finance:

Finance is an applied area of microeconomics but it takes elements from other disciplines such as accounting, statistics, economics, law, mathematics, sociology, among others, to develop normative theories about how to allocate resources through of time and in a context of uncertainty in order to create value.

FINANCIAL DECISIONS

Three major decisions are made in Finance:

Investment decisions: they involve the acquisition of short or long-term assets. At the beginning these decisions were evaluated individually (I buy or not such a machine) has evolved to a global analysis. This type of analysis takes into account the repercussions that the investment in question has on the rest of the company's investments is called the Investment Portfolio approach. Financing Decisions: seek to answer the question: what is the optimal combination of sources financing ?. These sources have two main origins: debts and equity. A structure of own funds and third party funds is defined, in m / e and m / n, ac / pyal / p. Dividend Decisions: It is closely linked to the financing policy.It involves seeing if shareholders are remunerated, thereby depriving the company of funds to make investments.

2.- KEY CONCEPTS IN THE FINANCIAL ANALYSIS

CASH FLOWS IN TIME VALUE TIME OF MONEY RISK ASSOCIATION BETWEEN RISK AND PROFITABILITY CONSIDER INFLATION FLOW VARIABLES AND FINANCIAL STOCK VARIABLES AS AN EXTENSION OF MICROECONOMIC THEORY

CASH FLOWS OVER TIME

These flows represent cash income and expenses, and are associated with the measurement of value creation. Being of relevant importance the moment of time in which these income and expenses occur.

THE TIME VALUE OF MONEY: If we have an amount to collect next week it is not worth to us the same as if we were to collect it within 10 months. There are three reasons for this:

Consider the profitability of the investments we can make with such money. There is a subjective preference of present consumption over future consumption. The element of risk, today is safer than tomorrow.

THE RISK: there is no certainty of the value of all the variables, so we introduced the element of uncertainty and risk into the analysis. It will always be an estimate. In the case of having a series of projects with the same estimated profitability and we fully know the field of one of them, we will very possibly invest in that because we perceive it as less risky. The risk in finance is given by the dispersion of the results around their average value (expected value). Illustrating the concept I have two projects that are expected to yield $ 2000, but project A can vary that result between losing $ 5000 and earning 5000. And on the other hand I have project B, which is expected to win $ 2000 but can lose 10,000 or win 10,000.. Project A is less risky than B.

In Finance it is assumed that the behavior of investors is of the most conservative type, they are ADVERSE TO RISK. We will find three positions of the agents against risk:

Risk takers non-riskAdverse to risk.

(Article on Life Cycle and its finances)

ASSOCIATION BETWEEN RISK AND PROFITABILITY: In financial decisions there is a game of these two elements, generalizing it can be said that the higher the risk, the higher the profitability. The essential thing is that the decision maker knows the risks and can choose. It will opt for what according to that investor considers best and this is what is known as the ATTITUDE OF INVESTORS IN THE FACE OF RISK. And so he introduces his subjective preferences against risk.

CONSIDER INFLATION: Economic processes are sometimes affected by inflationary processes. Which must be considered in the analysis for the final decision. For example. Sales prices, input prices, tariffs, etc. they are not the same at time 1 of a project as at time 13 of the project. We must be consistent in using the rate to deflate a flow, if the values to be deflated consider inflation we must use nominal rates (which include inflation). On the other hand, if the values are expressed in constant currency, one must work with a real rate (also eliminating the inflationary effect in the rate).

FLOW VARIABLES AND STOCK VARIABLES:

The Flow variables are those that are measured over a period of time, they are the variables of the Income Statement

Typical case earnings. The variables of stock are those that are measured in an instant of time, they are those found in the ESP. By. Eg investment and debts.

FINANCE AS AN EXTENSION OF MICROECONOMIC THEORY:

The optimum in terms of economic theory occurs when marginal revenue equals marginal cost. In Finance, the assumptions on which this statement is based are being raised.

On the basis of these elements, FINANCE would be the area of knowledge that emerges as an extension of microeconomic theory, which, managing flow and stock variables, seeks the optimal use of financial resources in terms of creating value.

3.- PILLARS OF FINANCIAL DECISIONS

Financial decisions are based on 6 basic conceptual pillars, which are:

I) NPV Net Present Value: It is the fundamental analysis to decide whether or not an investment contributes wealth to a company.

II) Portfolio Theory: We find authors such as Tobin 1958, and Markowitz 1959. Financial decisions are made under conditions of uncertainty, there are risks and expected returns on investments. There is an association between risk and return, the higher the risk, the greater the return. What is the best decision? Depending on the investor's subjective risk preferences, there is no single best decision. This theory shows investment in the context of the company not in isolation, but in conjunction with other investments. Quantitative risk subrogatives are created, the measure is the dispersion of the returns of an asset with respect to the mean.

Markowitz introduces the concept of diversifying risk. The best Portfolio for a certain level of return is the one that minimizes the risk for that level of return

III) Required Rate of Return: In 1963 Sharp takes up the Portfolio theory and seeks to quantify the opportunity cost in what he calls TRR, (it was what the investor failed to obtain in the best alternative investment we had of those resources). He defined it as K = Rf + p where Rf is the risk-free rate and p the plus for risk (called the premium).

The TRR will be the minimum rate at which I accept or not an investment in a certain risk band.

IV) Agency Theory: The company is conceived as a set of formal and informal contracts between the different parties involved with it.

These involved are:

the owners, owners, administrators, creditors, personal government, the environment in which the company operates.

For example. The company annually donates a figure for a school. The school will look for it to be bigger and the owners want to lower their expenses. There are two involved with different objectives, generating a conflict and its resolution may imply restrictions in the creation of value.

One of the relevant contracts is the relationship between owners and managers.

An administrator is someone that the employer hires to fulfill the functions that he will not perform.

The problem arises when managers have different motivations than employers.

An author named Donaldson indicates that there are three types of motivations for administrators:

the survival of the company independence in decision-making self-sufficiency self-management, not depending on third-party financing.

The objective of the administrators is going to be the maximization of the value of the company and not of the owners. For example: it may happen that you grow at the cost of borrowing and your own funds decrease because the funds were not generated to pay the loans. In this situation it was aimed at growth and does not create value for the owners of the company.

Other authors Jensen and Meckling are those who give the name to this theory as "THEORY OF THE AGENCY". They define administrators as agents of owners.

When unshared goals appear between owners and managers, conflicts are generated that are called Agency Problems.

Therefore to resolve them Agency Costs are incurred, they are grouped into three types:

Monitor costs: it is the personnel that the owner incorporates to control what is done. For example. Audits Incentive costs: higher remuneration based on value creation. Opportunity costs: these are the costs for decisions not taken.

v) Efficient Markets: (Samuelson) a market is efficient if it reflects the available information in its price, so prices tend to equalize. If we all had the information available, it would be difficult to do business, the financial markets are becoming more efficient by having more and more information available. The more efficient a market, the more difficult it is to create value.

vi) Options: 1973 Black -Schools, is considered the element of contingency. An option is a contract by which I acquire the right to buy or sell a certain asset at a predetermined price and date. (It will be observed in detail in the part of the international finance program).

Based on these 6 elements, financial decisions will be made to obtain greater value for the company.1

4.- WHAT IS THE OBJECTIVE OF THE FINANCE?

Intuitively, it is winning or creating value for the owners of the company.

A first approach: MAXIMIZE PROFITS

It has three criticisms:

The definition of profit is fuzzy, being refers to profit on vtas, on capital, ac / pol / p, before or after taxes It does not consider the time value of money: $ 1 at moment 0 is not the same as at moment 13 Nor does it consider the risk implicit in the decision, the uncertainty. Investing in a food factory is not the same as investing in a high-tech one.

These criticisms generate a second and new definition of the objective of finance which is the maximization of value creation.

In principle, there are two ways to measure value creation:

the Net Present Value (NPV) the EVA or VAE Economic added value

The solutions to the previous criticisms are:

The first criticism of the definition of the previous objective, the NPV will measure the creation of value through cash flows (financial income and expenses) The second criticism arises when working with the time value of money, since they are updated the cash flows to bring them all at the same time, the usual is year 0 (for convenience to have closer benchmarks).

The difference between the Initial investment (F0) and the updated amount of flows is the creation of value.

The third criticism is raised by introducing the rate K, which is the required rate of return on the investment. It is the value of money over time but includes a risk plus. Said rate K = Rf + p where Rf is the risk-free rate and p the plus for risk. As a convention, an investment in American government bonds is considered to be without risk, since the American government is not supposed to stop paying those bonds.

The other criterion for measuring value creation is the EVA (Economic Value Added). If you think about a financial year of a company, you could have made decisions that started before the start of the year and generate value in it and there is also decision-making in this year that can create value in this or the next year..

When comparing the financial statements, the following observations are obtained:

It does not consider the time value of money, since in the income statement on sales I add up those made in every month assigning the same value to $ 1 in February as in November. It also does not consider the cost of own funds, the cost of Debts are seen in the interest paid. Own funds are distributed through dividends and at no point does the cost of financing appear.

This criterion is seen in detail in part VII of the program.

In 1947 SIMON states that talking about maximization implied that the human being knows all the options but has a BOUNDARY RATIONALITY because he does not know all of them, therefore he does not take the best option.

It does not maximize but SATISFY. Therefore, when choosing the best option that YOU KNOW is not to maximize but SATISFY.

IN 1976 a third approach to define the objective of finance is THE THEORY OF AGENCY

(See previous development in Pillars of Financial Decisions).

The objective continues to be the creation of value for the owners BUT subject to restrictions that the company has derived from its contracts with the different groups related to it.

5.- VALUE CREATION

The goal of finance is value creation. For which there are two ways to measure said creation:

VPNVAE (previously discussed)

For individual investment decisions the VPN is used, but for the overall performance of the Company the VAE is used.

Today, value is created on the balance sheet side of assets, in the last years of the 1960s value was created on the financing side. Since the rates were lower than inflation, a loan was invested in merchandise that accompanied inflation in a certain way and the loan was paid alone.

Ways to Create Value:

Create a new product: By being the first to exploit it, significant income is obtained, which results in increasing the value of the Company since it is the updated value of its cash flows). For example. Laptop, Palm, etc. Create barriers to discovery: in the case of patents, for a certain time it is impossible for another to manufacture that product. Classic example Polaroid instant photo machines for 15 years could not manufacture a similar product.Variations of existing products: VAN trucks Krysler created the mini vanIncrease the competitiveness of a product based on technology: The case of engines with higher performance. Everything that turns for example to formula 1, are tests and then it is analyzed what can be put on the market. Cell phones with mailing, camera and web..Create product differentiation: this is the case of Coca Cola and Quilmes beer. The first imposes the slogan "Always Coca Cola", the second unites patriotic sentiment to its design and propaganda. Reorganizing the Company: One of the important cases was Motorola (US company) that was organized as a Japanese company. Taking the Japanese principles: 1) just in time: the use of fair inventories does not exist the concept of safety stock 2) administration by consensus 3) the position is remunerated according to its performance Dividing the Company: IBM symbol of quality of its equipment but progress is so fast that the market no longer sees quality as an added value. So IBM split up crafting small PCs with propaganda "for the same price buy an IBM." Generating the need:The Italian lens industry generated the idea that the lens is just another item of clothing (no longer just for the sun or prescription). It convinced the market that captured it, and has obtained significant income, improving the design: for example, the Chinese industry (being less rough and of poor quality) or the Peugeot (being more streamlined). Other forms: mergers, acquisitions, equity investments.

6.- THE FINANCIAL MANAGER

It is the one that must seek to create value like the rest of the employees, through allocating resources in such a way that the assets produce greater cash flows than their costs.

Read Pascale's book page 17 3rd Edition

7.- FINANCIAL MARKETS

The field of study of finance will open in two areas:

how to allocate and displace resources over time and in a context of uncertainty the roles of economic organizations in facilitating this allocation of resources. (Individuals, companies, financial intermediaries and the capital market).

Where does the Company get its funds from?

The Company has as its source of funds the financial markets through shares or obligations. And allocate funds for the payment of dividends and interest. You can also get funds by withholding profits.

MARKET CLASSIFICATION

In the factor market we have the factors of production. Financial assets that are also called financial instruments are managed in the financial markets. Asset is any possession that has a value in an exchange.

(1) Assets can be either tangible or intangible. Tangibles are those whose value depends on their physical characteristics. The latter depend on the rights that it generates on a future cash flow.

Financial assets are intangible assets. For example:

Bonds: according to the right to collect interest and recover the principal.

A loan is a right to interest and principal. The shares a right on the future profits that the company distributes or in case of liquidation the net value of the asset after paying all the debts.

These assets or financial instruments are the way in which the transfer of funds from surplus to deficit units takes place.

WHAT ECONOMIC FUNCTIONS DO FINANCIAL MARKETS PLAY?

They are 5:

1. They transfer funds from surplus to deficit units: A surplus unit is one in which savings exceed your investment needs in physical assets. Savings = Current income current expenses. A deficit unit is the other way around.

Among the first in general are companies and the state, and within the second are families.

The markets facilitate the interconnection of the units. This becomes important as savings go from surplus to deficit units, allowing them to invest and grow.

The development of these markets allows capital formation and are of great importance for economic growth.

2. Risk Transfer or Risk Distribution: When the company captures funds through debt, the lender only shares the credit risk. On the other hand, when obtaining funds from the partners, the business risk is assumed. There is redistribution of risk to the extent that capital is contributed to the company and not through debt.

3. Mechanism for pricing: these instruments, when traded in a market, generate supply and demand, so it is possible that these instruments have a price.

4. They allow to provide liquidity for these financial assets: it is possible for the holder of a financial asset to go to the market and sell it to another person, this is called the facility to exit the instrument.

5. Facilitates the reduction of transaction costs: if a deficit unit must find another surplus on its own, the cost is greater than going to the market.

CLASSIFICATION OF FINANCIAL MARKETS

For the type of right:

Stock market: they are in which property or residual rights are managed: for example shares. The shareholder has something left to the extent that there are profits and that they are distributed, or when the remainder is settled after paying the debts. They are generally called variable income instruments. Debt securities market: they are in which credit or debt rights are traded: they are all debts since they give a right to be paid the capital and a certain interest. They are fixed income instruments.

For the moment of transaction:

Primary: it is when the issuer and the investor intervene. It is in the only market that the issuer receives the Secondary funds: they are already the subsequent transactions that the investor makes with that instrument. Their importance is that they facilitate the liquidity of the asset and determine the price of the instrument.

For Delivery term:

Cash market is also called cash and settlement is almost immediate, maximum 72 hours. For example. Selling dollars in an exchange Derivatives market: instruments are futures, fowards and options.

By Expiration term:

Money or money market: instruments with less than one year maturity Capital market: more than one year (it is a convention)

By type of organization:

Auction markets: it is where the buyers and sellers are in the same venue. Eg Stock Exchanges Over the counter (OTC) markets are those where there is no central location, operators are dispersed and are contacted through trading systems (in general, intermediaries sell and buy their stocks). Intermediary markets: we have direct financing (by bonds, stocks and bonds) and with indirect financing that banks intermediate between market units.

THE PARTICIPANTS OF THE FINANCIAL MARKET

Families: in theory they are the bidders Public and private companies National and regional governments Multilateral financial organizations Credit WB; IDB

FINANCIAL INTERMEDIATION

Intermediaries have a substantial role in financial markets, which due to the scale in which they are managed, reduce transaction costs and the problems generated by what we call Adverse Selection and Moral Hazard.

In the case of Adverse Selection, it can be when, for example, a bank charges more interest to a bad payer and there are other bad payers who are still willing to pay that rate, so the Bank is attracting what it does not want.

Regarding moral damage, it occurs when a market to protect one agent causes damage to another. The typical case in Uruguay is the Refinancing laws eg. of the BHU.

The current intermediation is based on the same principles as when it began at the time of the discovery of America.

Principle 1. That of deposits: it was observed that if a deposit was obtained for an amount, it was not necessary to have its entirety prompt in case it was withdrawn. So part of them began to be lent. So the portion that must be kept depends on the banks and the country, but ranges from 2 to 10%. Principle 2. Pool of funds: with deposits, a pool of funds is made that is lent at different prices (interest rates)

A bank is more or less solvent depending on the relationship between capital and its loans.

The bank handles 4 variables:

your asset: are the loans that you have granted and collect interest on your liability: they are the deposits and you pay interest. His assets are small but he must give confidence that it is enough to not go bankrupt. Overhead: financial costs and general expenses

This changes given the requirement of market players who say if I have less risk, I will not charge the same. As the Banks did not react quickly to this point, the new financial intermediation was developed, consisting of:

Pension funds Investment funds: many savers accumulate millionaire capital figures. Insurance companies Capital markets: in Uruguay National Development Commission loans to companies.

The risk is borne by the investor, so new elements such as risk rating agencies are born to protect it.

For example. When Uruguay had a country risk of 200 basis points, it means that I have 2% more than the rate on US bonds. See Pearls article »Country risk”.

CLASSIFICATION OF FINANCIAL INTERMEDIARIES

Deposit-taking institutions: such as commercial banks, financial cooperatives, loan savings associations, and credit unions (cooperatives based on unions that obtain their funds from their associates). Contractual savings institutions: receive deposits not by the depositor's will but by Contract. Life insurance companies, or general lines, pension funds (AFAPS). Intermediary investment institutions. Basically they are mutual funds and they are called Investment Funds. (They join a set of savers and generate capital which they invest). We also have financial companies that sell shares and bonds obtaining funds and lend them.

INTEGRATION OF FINANCIAL MARKETS

Examples:

Domestic: a Uruguayan deposits in a plaza bank and this lends to a Uruguayan companyExternal: carry out an import and get money from abroadEuro-markets or offshore market. The case of an Argentine who deposits his money in Uruguay and invests it abroad. Its reference rate is the libor (London Interbank Offered rate), the rate at which banks generally lend their money.

Eurocurrencies are the currencies of the countries deposited in other Europeans. For example. Euro-dollars are dollars deposited in London and thus with Eurofranks, Euro marks, etc.

In general, the control of the Banks is carried out by government entities, there are two ways to do it:

central banks or bank superintendencies do so.

In Germany the superintendency is separate, in Uruguay it is part of the central bank.

In the new financial intermediation, the risk is passed to the market, generating greater transparency and a change of information in the market. Capital markets operate with what are called risk rating agencies.

The most important company is Standard & Poors, followed by Moody´s.

One scale is as follows:

AAA has countries like the US and Germany, few companies. It continues to drop to BBB where if we go down another level we lose the INVESTING DEGREE.

Until early 2002, the only Latin American countries with investment grade were Chile and Uruguay.

When a company has a certain rating, it is necessary to see which is the country in which it is located, and the lowest is taken.

(Read article from the pearls "Country Risk")

FINANCIAL ASSETS OR INSTRUMENTS

In the money market we find:

Treasury bills, which can be in m / n and m / e being short-term. Negotiable certificates of banks: they are a transferable debt instrument that banks sell to their clients. Commercial papers: they are debt instruments issued by companies Important or banks Bank acceptances: promises to pay on a certain date issued by a company and guaranteed by a bank. Repurchase agreements: very short-term loans that are guaranteed by treasury bills. Federal funds: are overnight loans between banks, of the funds that they maintain in the Central Bank. Eurodollars: they are the American dollars deposited in banks outside the USA.

In capital markets, instruments mature beyond the year.

Shares: rights against the profits or assets of a saHipotecas: loans to buy assets and with a real right on them.Obligations and bonds of companies: they are long-term instruments rated by specialized firms, pay interest twice a year and amortize as stated in the document. Government bonds: are issued by national governments, sometimes municipal, and their maturity is several years. Loans from banks and companies.

8.- FINANCIAL MARKETS AND NET PRESENT VALUE

The financial market is in equilibrium when the total demand for loans by the claimants equals the total supply of funds by the lenders. The interest rate defined at this point is called the Equilibrium Interest Rate.

CONSUMPTION ELECTIONS

They provide the conceptual basis for continuing with the analysis of net present value operations.

Class example:

A person has current income in the current year of 10,000, and the following year of 12,000. This person decides to consume 10,000 this year, that is, he consumes what he enters.

Then it may happen that it consumes part of its 10,000 and saves it for the following year. And we can go to extremes that consume nothing this year and the entire amount of the two years in the next. Or that it consumes both years in the first year.

Suppose the interest rate were 10%

Case one: 12,000 + 10,000 * (1 + 0.1) = 23,000 Consumes every year 2

Case two: 10000 + 12000 / (1 + 0.1) = 20 909 Consume all year 1

The price of the change in current consumption for future consumption is given by the interest rate, it is the concept that will be handled later as the Required Rate of Return.

Financial markets exist due to the wishes of economic agents to postpone or advance their consumption.

Why is the current consumer preference over the other?

The subjective preference to present consumption versus the enjoyment of future consumption. There are investment opportunities that can be accepted and realized if you have the money before. There is a prize for uncertainty, I prefer $ 100,000 today sure that the same in a year. The inflationary element plays its role.

VALUATION

The most important valuation types are:

Book valuation: Asset Liability, is the book value by which an asset is registered according to generally accepted accounting standards. Valuation of the going concern or fair value: it is used when there is going to be a merger. The value of a company is taken based on its current activities and given the possibility of generating wealth. It is the updated value of its cash flows by the company's TRR. Market value: it is the value of the company in the market, for example on the Stock Market. (Number of shares * share price). If no dividends are distributed, the shareholders sell so that demand increases and therefore the price decreases.Multiples of the price-earnings ratio:it is the substitute when the company is not publicly traded it is the amount that investors would pay for each peso of profit.

VALUATION OF THE BONDS

Zero Coupon or Pure Discount Bonds:

They are the bonds that do not have coupons to cut, but their interest is implicit in the bond issue itself.

Eg Class: final value U $ S 100,000 and it is 25 years at the rate of 9%.

It means that a zero coupon bond of 100,000 at 9% per year over 25 years, is purchased today for 11,597.

The VPN of the bond would be

VPN = PV Initial Price

Bonds with coupons, are those that have a sheet indicating that the bond is worth a certain amount and has semi-annual interest. And all the coupons indicate the expiration date.