1

0. Basics
IB253 Principles of Finance 1
Lecture 1
Key Readings
Hillier, Ross et al. 4.1-4.2, 9.1-9.6
Brealey et al. 2.1-2.2, 8.1
2
Introduction
IB253 Principles of Finance 1 is mainly concerned with
techniques for valuing financial assets
the same techniques will be applied in IB254
Principles of Finance 2 to value real assets used in
capital projects
Examples of financial assets include shares of stock
and bonds, and we will learn how to value both
In general, to calculate the fair value today of an
asset, we need
to forecast the cash flows (e.g. dividends on shares,
coupon payments on bonds) that the asset is
expected to pay out in the future
a mechanism for expressing those expected future
cash flows in so-called present-value terms
3
Risk
We also need to recognise that assets in the real
world are risky
this means that the size and timing of the future
cash flows are uncertain
So we also have to have some means of modelling
(and measuring) risk
Statistics provides some of the answers
best forecast of a future cash flow is the expected value
(in the sense of the mean of the distribution of possible
values) of that future cash flow
risk is measured by the variance (or equivalently its
square root, the standard deviation) of the distribution
of possible values for that future cash flow
How banks calculate compound interest provides a
clue as to how to calculate present values
run compound interest calculation in reverse gear
4
Certain vs. Uncertain
We will start by assuming a world of certainty and
learn how to discount future cash flows that are
known today with certainty back to the present day
We will then introduce risk
risk will be incorporated in our models by assuming
a number of states are possible in the future
We will assume that the payoff in each of these
possible future states is known today with certainty
what we dont know today is which of these states
will occur at that point in the future
we will also assume that we know the probabilities
that each of these states will occur
What we will need to be able to calculate, then, are
the expected (in the sense of the probability-weighted
average) future cash flow
the variance (and hence standard deviation) of possible
values for that future cash flow
5
Different Outcomes
Uncertainty about future payoff P
t+1
is modelled by
assuming that there are a number of possible states
1, 2, N next period with probabilities p
1
, p
2
, p
N
Probabilities sum to 1:
Expected future payoff E[P
t+1
] is given by:
Variance var[P
t+1
] of future payoffs:
(N)
1 t
(2)
1 t
(1)
1 t 1 t
... ] E[
+ N + 2 + 1 +
+ + + = P P P P t t t
2
1 t
(N)
1 t
2
1 t
(2)
1 t
2
1 t
(1)
1 t 1 t
] E[ ... ] E[ ] E[ ] var[
(
(

(
(

(
(

+ + N + + 2 + + 1 +
+ + + = P P P P P P P t t t
1 ...
N 2 1
= + + +
(2)
1 t+
P
(1)
1 t+
P
time t time t+1
(N)
1 t+
P
t
P
.
.
state 1
state 2
state N
p
1
p
2
p
N
.
.
6
Rates of Return
Often, it will be more convenient to work in terms of
returns rather than payoffs or cash flows
If we pay P
t
today for a share of stock, hold on to it
for one period in order to receive the dividend D
t+1
that it pays at the end of that period, and then sell
the share for P
t+1
, our rate of return R
t
equals:
There are two components to this rate of return
capital gain = (P
t+1
-P
t
)/P
t
dividend yield = D
t+1
/P
t
This method of calculating rates of return is known
as discrete compounding
Continuously-compounded rates of return are
calculated as follows (in the case of no dividends):
) (1
) (
t t 1 t 1 t
t
1 t t 1 t
t
R P D P
P
D P P
R + = +
+
=
+ +
+ +
t
e ln
t 1 t
t
1 t
t
R
P P
P
P
R = =
+
+
|
|
|
.
|

\
|
7
Example
Three equally-likely scenarios next period
recession, normal, growth
Two investment prospects
shares in car manufacturers, gold
Sample calculations:
Rate of Return R
Scenarios: Cars Gold
1. Recession -8% 20%
2. Normal 5% 3%
3. Growth 18% -20%
Expected return 5% 1%
Variance of returns 112.7%% 268.7%%
Standard deviation
[= \variance]
10.6% 16.4%
112.7%%
5%) (18% 5%) (5% 5%) 8% ( ] var[
5% (18%) (5%) 8%) ( ] E[
2 2 2
cars
cars
=
+ + =
= + + =
3
1
3
1
3
1
3
1
3
1
3
1
R
R
8
Summary
We need to be able to value assets whose future
payoffs are not known today with certainty
Two key issues
how do the future cash flows that the asset pays
impact the value of the asset today?
how do we account for the fact that these future
cash flows are not known today with certainty?
The first issue requires us to adjust the future cash
flows for the time value of money
this process of discounting future cash flows is the
reverse of compounding and requires us to know
(or estimate) the rate of return
The second issue requires us to
determine the expected value of the distribution of
possible values for each future cash flow
adjust the rate of return that we use to discount
these expected future cash flows for the level of
risk associated with those cash flows
Risk is measured by variance (or standard deviation)
of the distribution of the possible future cash flows