1 Intro TimeValueOfMoney

Course Objectives

Bridging engineering and business is the point of the course.

learning the language of business (enhance communication)

strategic contribution: prepare students to contribute to high-level decision-making processes and potentially assume leadership roles within their orgs

entrepreneurial finance skills: provide foundational knowledge for those interested in starting their own businesses

introduction to quantitative finance: introduce the field of QF

About Jean-Paul Tenant

Enrollment Status

What are we going to learn?

we are going to learn a lot about what MBAs learn about accounting and finance fundamentals

the nice thing about finance is that it's like physics where nothing changes

corporate finance and accounting is going to give you quickly everything you need to know to understand financial statements

what questions do i need to ask based on what this balance sheet looks like?

This section really covers what an MBA does in a semester of finance, and we are doing it in 4 weeks, and then the financial accounting happens in 2 weeks.

The last section is on investments and asset management and is also in 2 weeks.

we need all of that before we can have any intelligent conversation about venture capital and any intelligent conversation about QF. So we will focus on derivative securities

those are all financial concepts that we will focus on.

Hw is released on thursdays, due the following wed at 11:59 pm - self graded - working in groups is allowed and encouraged

Pre class reading

reading will be assigned in bcourses along with several short questions,
readings are typically short
will be discussed at the beginning of class
topics may or may not pertain to current lecture
class participation is 15% of grade

Systems

Read it in the syllabus

both the midterm and the final will be in the CBTF

attendance is highly recommended unless you are sick.

Lectures are recorded but not released unless you ask for one without

USE OF AI IS HIGHLY ENCOURAGED AND ALLOWED (fact-check as necessary)

no electronics will be allowed during exams

Context: typical MBA program

Year 1:

accounting
finance
marketing (not in EE156)
economics
organizational behavior
data analysis
management communication

Year 2:

strategy
advance finance/investments
operations management (not in EE156)
leadership and organizational design
entrepreneurship and innovation
ethics and CSR (not in EE156)
Capstone/experimental projects (not in EE156)

Should you get an MBA?

Should you hire an MBA?

what is the dollar cost of an MBA at a top tier school?

tuition + fees = $160,000

that's not the economic cost

Opportunity cost: the value of the next best alternative that is forfeited when making a choice

opportunity cost: 2 years of salary, career advancement, etc

what is an MFE (masters in financial engineering)

there is one at haas that is really good.

typical MFE program

core foundation

prob and stochastic processes
financial economics
derivatives futures, options, swaps
quants methods and statistics for finance,
numerical methods, and computer sims
programming for financial modeling

quick 5 min break

The value of money

A dollar today is worth more than a dollar tomorrow

Is this always true?

It is always true!

If you have the dollar earlier, you have the option to use it now, but if you get it tomorrow you have to wait

It gives you the option to invest earlier

we prefer liquidity

uncertainty (what if you don't get the dollar)

Would a deflationary environment change our conclusion?

Time value of money: future value

suppose a bank offers a risk free return of $r = 7\%$ per year on a fixed term (illiquid) 2 year deposit

$100 \to 107 \to 114.49$

# fixed term deposit: 100 at 7% for 2 years
principal = 100
r = 7%
# after 1 year
principal * (1 + r) =>
# after 2 years
principal * (1 + r)^2 =>

$\text{future value} = \text{present value} \times (1 + r)^t$

the future value of 100 is 114.49 in 2 years

we divide by 2 years so the principal is 100 interest is 14.49

this is an example of annual compounding

the rate of return is the APR (annual percentage rate). APR is both a legal and financial concept: for example, hidden fees are required by law to be embedded into the APR.

Rule of 72:

$\text{years to double your money} = 72/\text{APR}$

time value of money - present value

suppose some bank offers risk free return of 7% per year. how much would one need to invest today, to produce 114.49 by the end of 2 years!

$\text{present value} = PV = \text{Cashflow}_t/(1 + r)^t$

where cashflow is what you want to achieve

if you want to discount in the present, it's hard to summate over weird times, so we bring everything to the present to calculate.

a long term investor sees no preference between 100 today and 114.49 in 2 years.

we say the present value of 114.49 in 2 years is 100 in this case $r$ is referred to as the discount rate

to evaluate a sequence of cash flows, determine the PV of each, then add.

each point in time has an associated discount factor (DF). in this example

#=: DF_2 = 1/(1.07)^2

Time value of money: PV of multiple cash flows!

if you have 8000 today and 12000 in 2 years with $r = 0.1$

then what would it look like?

#=: 8000 + 12000/(1.1)^2

etc.

what if the first 8000 is broken up into 4000 now and 4000 in 6 months?

r = 0.1
# 4000 now, 4000 in 6 months (t = 0.5), 12000 in 2 years
4000 + 4000 / (1 + r)^0.5 + 12000 / (1 + r)^2 =>

NET PRESENT VALUE

adding all cashflows including the initial investment is the net present value

if NPV is positive, do the project, if NPV is neg then don't do the project.

A safe dollar is worth more than a risky dollar.

investors will demand a higher expected rate of return in order to compensate for the added risk. The difference between the risk free rate (100% guaranteed payment) and the demanded rate is known as the risk premium.

the US has never defaulted on its commitments: Argentina, etc, have defaulted on these debts.

choose a discount rate that equates to the market rate for investments of similar risk. This rate is referred to as the opportunity cost of capital (OCC)

Risk and net present value

an alternative method for assessing the value of a project is to calculate its rate of return.

$\text{return} = \text{profit}/\text{investment}$

the rate of return should be compared to the OCC

we now have two equivalent ways to assess whether or not to pursue based on the NPV

NPV

$PV = C_1/(1+r) + C_2/(1+r) \ldots$

above is the discounted cash flow formula and is the basis for one of the common methods for valuing companies.

DCF analysis is one of 3-4 primary ways analysts try to value a company.

the cash flow at 0 time is the NPV

Perpetuities

note that there is no payment at time zero.

imagine you get a consistent cash flow forever until perpetuity, and it's like an infinite series.

the first payment is at time 1

what is the present value of a series of fixed payments, with term $r$

$PV = C/r$

related question: suppose you are this very wealthy person and you want to set up an endowment that generates $\$C$ per year. the endowment is to be invested in a single asset that provides a fixed annual return rate of $r$. how much money must be placed in the endowment.