MScFI: Best Practice:

1. Present value concept:

a. In Finance, we see the world from the perspective of Cash flows
b. We frequently assume no arbitrage
c. We try to determine the value of those cashflows under different circumstances
(time, risk, states of the economy) -> We adjust the value of of cash flows (discount
rate).
d. PV = CF/(1+r)
2. PV of a perpetuity:
a. Perpetuity: a stream of cash flows until infinity
b. PV of perpetuity = CF/r
i. CF= future (expected) constant CF
3. Features of concepts:
a. Concepts/theories/models help us understand complex phenomena in the real
world
i. Link monetary policy to overall stock market development
ii. Prediction of future stock market reaction following interest rate changes.
b. The concept is not a comprehensive/detailed model for reality
i. Interest rate is not the only influence

Conclusion:

- Concepts are highly simplified representation of reality that allow us to have an intuition
about relations in the world and make predictions.
- All concepts are likely to be wrong
- Learning about concepts requires reflecting about it and seeing it from a different angle.
Accounting-Finance refresher
Two questions get asked in Finance:

- How do we acquire Asset

- How do we

Balance sheet

- Assets: economic resources that are owned by the business and are expected to generate
value.
o Cash
o Account receivables
o Inventory
o Properties, plants and equipment
o Land
o Building

- Liabilities: debts that represent negative future cash flows for the company.
- Owners’ Equity: => Debt
o Stock:
o Retained earnings
o Companies with negative equity is bad

Cash flow statement

- Cash flow from Operations (Revenues, costs, etc.)

- Cash flow from Investments (fixed assets)
- Cash flow from Financing (right side of the Balance sheet -> capital structure of a company)
- Cash flow can be minus and means that the company is expanding.

Limitation of Ratio analysis:

- Picking an industry benchmark can sometimes be difficult

- Published peer group or industry averages are not always representative of the firm being
analyzed.
- An industry average is not necessarily a desirable target or norm
- Accounting practices differ widely among firms
 - Many firms experience seasonal changes in their operations.
- Financial ratios offer only clues. We need to analyze the numbers in order to fully
understand the ratios.
- The results of financial analysis are dependent on the quality of the financial statements.

Time value of money:

Present value of an annuity:

- Annuity: a level stream of regular payments that lasts for a fixed number of periods.

NPV and Investment rules

- 2 questions asked in Finance:
o In which Assets should we invest
 o How should we finance these Assets.
 We want to invest in assets in such a way that profit is maximized.
- Accept the project if the NPV is positive.

Alternative method to NPV is Internal Rate of Return (IRR)

Internal Rate of Return (IRR): provides a single number summarizing the merits of a project. The
number doesn’t depend on the interest rate in the capital market -> the number is internal or
intrinsic to the project and only depend on the cash flows of the project.

- Trial and error the discount rate to make NPV=0

Profitability index:

Capital Asset Pricing Model

Where does the initial cash outlay -CF0 from?

Weighted Average Cost of Capital (WACC)

WACC is used as discount rate

- The firm pays Rb for debt, Rs for equity financing.
- IN order to calculate WACC we need CAPM to calculate the cost of capital.
- Blue part is CAPM -> CAPM is used to evaluate the cost of capital Rs.

- Investors use CAPM to calculate the required return, which is also the cost of capital for the
firm.
- Beta: tells us how much the stock move together or against the market. Market risk of a
given security: the tendency to move with the general market.
 Evaluate a project:
- Start with CAPM to calculate the Cost of equity Rs, in order to calculate WACC, which then
be used as a discount rate for the NPV model.
Investments
Basic theory: CAPM (Capital Asset Pricing Model)

Assumptions:

- All assets fairly priced

- Borrowing and lending at the same rate
- No transaction costs or other frictions
- Investors only care about expected returns and dislike risk (measured by variance of returns)

CAPM predicts 2 fund separation:

- Investors only invest in market portfolio and risk-free asset -> by using index fund and bank
account.
- Possible to take short or levered positions (e.g invest with borrowed money)
-> Impossible to consistently outperform.

How to do/balance this?

- Invest in Broad index funds
- Invest in passive mutual funds:
o Can only trade once a day at NAV (Net Asset Value)
o No transaction costs for getting in or out (depends on share class)
o Any transaction costs for remaining fund participants
- Exchange-traded funds (ETFs):
o Trade like regular stock (all the time)
o Qualified parties can arbitrage difference between ETF price and Net Asset Value
away. (Arbitrage: to simultaneously buy and sell securities in different markets to
take advantage of differing price for the same asset)
o Typically trades close to NAV.

CAPM doesn’t do well empirically as a tool: Risk vs. mispricing

 - Evidence of being able to systematically generate extra return based on e.g. firm size, recent
performance, liquidity, or book-to-market. => Value stock: stock has higher book value to
price.
- Are stocks mispriced or are these higher returns compensation for risk? => Hard to answer
o No consensus
o Risk is most consistent with traditional finance theory
o At least part of it is due to mispricing.
o Zero alpha: not overperforming nor underperforming.

The zoo of factors:

- Factor: A factor is an intermediary agent that provides cash or financing to companies by

purchasing their accounts receivables. A factor is essentially a funding source that agrees to
pay the company the value of an invoice less a discount for commission and fees.
- Fake factors: purposefully engineer data and methodology to get certain results.
- Arbitrageurs restore market efficiency after discovery.
- Some factors may measure the same thing.

Active managers:

- Using active managers is the most appealing option for small investors.
- Active managers, on average, don’t perform so well.
- At best, they make zero alpha on average before cost.
- Negative alpha after costs.
- Active managers cost significantly higher than for passive funds (ETFs)
- Is it because managers have no skills? (Berk and Green, 2002)
o Managers have skill and can attract volume.
o They are motivated to increase volume since they are compensated by % of Asset
Under Management (AUM)
o Harder to implement good ideas at scale:
 They attract volume, but the bigger the volume, the lower the return can be
in the long run as they keep buying up all assets in the market.
 When they keep buying or doing certain things, the market picks up on that
-> the more Active managers need to buy, the higher the price; the more
AM need to sell, the lower the price.
o In equilibrium all managers display close to 0 alpha (perform very average)
 But the most skilled AM manage large portfolio -> Market for fund is
efficient.

Passive options to harvest risk premia:

- Many of the pricing anomalies have factor structure:

o Prices of Firms with similar characteristics move together -> Adds to the
interpretation of risk premia rather than mispricing itself
- Harvesting risk premia by investing in funds following “style indices”
o ETF tracking value index, small firm index, etc.
o Relatively cheap.
o Passive funds: lower cost than active, higher cost than ETF; become more popular
because of scrutiny around costs for investments.
Roles and issue with funds:

- Funds also plays a role in corporate engagement: e.g. ESG issues. Active funds have more
independent research.
- Funds care about track record:
o Tournament behavior: if you’re a top performance, you get a lot of AUM. If you are a
poor performer, you also get the same => funds take a lot of risks.
- Some funds only pretend to be active: Closet style funds
o Still charge a large fee like active funds.
- Front-running of passive funds
o Front-running: trading stock or any other financial asset by a broker who has inside
knowledge of a future transaction that is about to affect its price substantially
Corporate Finance
Finance is about the allocation of assets.

- Assets -> Investment decisions

- Liabilities and Equity -> Financing decision.
- Cash flows are more important in evaluating a project.

Sustainability = Transition:

- In transition environment, can’t extrapolate Cash flow due to changing conditions.

- Valuation is useless when Sustainability factors are not integrated and assuming business as
usual.

Sustainability can be a risk but also opportunity:

- ESG ratings are often poor.

- Transition are transforming industries -> opportunities
- The real risk is not being prepared for transition (Kodak)

Big sustainability transition:

- Climate – energy transition

- Raw material – circular economy: redesign and recycle products
- Biodiversity – healthy food and regenerative agriculture
- Labor practices – social transition

Transition and value:

EAT= expected exposure at transition

Expected transition losses = Transition in sector (full to no transition) x Value of the company x
probability of transition x (1-adaptability of the company)

E.g. the car industry has transitioned fully into electric cars -> bj=1

- Adaptability or transition preparedness is a key factor for company valuation.

- Good management + early mover => easy to improve adaptability

- Bad management + late mover => Far more expensive to improve adaptability.

CSR and M&A:

- How to acquire transition capabilities? => Make or buy.

- M&As are potential vehicles to buy sustainability/transition capabilities.
- CSR is positively linked to bid premiums (M&As bids premium for CSR)
o Environmental component is more valued in domestic deals
o Social component is more valued in cross-border deals.
Banking
Banks create value on BOTH sides of the balance sheets.

- Asset side:
o Loans to firms and businesses
o Monitoring and screening borrowers to overcome asymmetric info problem
- Liability side:
o Create liquid, money like assets
o Deposits (= bank account) are safe and liquid assets used as money
o Supported by electronic payment system
- Banks transform long term, illiquid and risky asset to short term, liquid (money like)
liabilities.

- Banks engage in asset transformation:

o Maturity transformation (long term to short term)
o Liquidity transformation (illiquid to liquid)
o Risk transformation (risky to safe)
- Diamond and Dybvig (1983):
o Banks should grow like apple tree (make long term investments, loans)
o Consumers hold demandable claim on bank that is used as money (imagine you go
to AH and pay by card -> putting a claim on the bank account)
- liquidation of illiquid asset.
- Overcome liquidity risk:
o Increase interest on deposits
o Consumers who need money (liquidity) can sell demandable claims to other
consumers who can wait.
- Risks in business model of banks:
o Banks transform long term, illiquid and risky asset to short term, liquid (money
like) liabilities.
o But doing so expose banks to credit risk and liquidity risk
 Credit risk: Assets incur losses
 Liquidity risk: Short term liabilities (deposits from clients) are withdrawn
and force
- Nash equilibrium: if no player can do better by unilaterally changing his or her strategy =>
outcome can either be both good or both bad.
- To avoid bank runs (when clients all withdraw deposits with the bank):
o Banks can borrow from each other in the interbank markets, or from the central
bank => central banks act as lender of last resort.
o Deposit insurance
 o Capital regulation (mor bank equity)
- Distinguish illiquid from insolvent banks:
o Central bank should lend:
 Quickly and freely
 At a high interest rate
 Against good collateral
 Goal: Ensure the central bank lends to illiquid but solvent bank.
- Promising deposit insurance eliminates run-equilibrium (the worse case Nash equilibrium)
o No runs in equilibrium => Deposit insurance does not have to pay anything
o Credible announcement of insurance is good enough.

Conclusion:

- Many of the worst financial crises were triggered or accelerated by banks overstretching this
business model (asset transformation)
- We have developed many institution to mitigate these risks.