Investment

Analysis
Class 1:
Market Securities

Why to invest?

When current income exceeds current consumption desires,

people can do many things with their savings.
One possibility is to put the money under a mattress.
However, it is important to invest.
Defining Investment: A current commitment of $ for a period of
time in order to derive future payments.
Reasons for investing:

By investing (saving money now instead of spending it), individuals

can tradeoff present consumption for a larger future consumption.
Money is more valuable now than later. The rate of exchange between
future consumption and current consumption is the pure rate of
interest. Both peoples willingness to pay this difference for borrowed
funds and their desire to receive a surplus on their savings give rise to
an interest rate referred as the pure time value of money.

Example: If you can exchange $100 today for $104 next year,
this rate is 4% (104/100-1).

The problem of inflation, or more exactly the increase of the price of

goods and services.
This rate of increase was on average 5.0 percent a year from 1970 to
2007. It totally diminishes your purchasing power over time.

Required Rate of Return

Now that you are convinced to invest, you will earn a return
from your investment.
As we have seen previously, you want to be compensated for:
Time value of money.
Inflation, or increase of price of goods and services.
However, there is a third factor that you have consider when
investing: Risk to compensated for uncertainty.

If it is a risk free investment (usually US Treasuries are considered

risk free), then you dont have to be compensated for any risk.
However, for private equity or securities such as stocks, bonds, etc
, or actually any other financial instrument, you need to evaluate the
risk of the investment and to be compensated for the risk you take.

Then, the investor evaluates the Required Rate of Return, which

is the rate of return which compensate for the time, the rate of
inflation, and the uncertainty of the return.

What are the risks

associated with an
investment?

Business Risk

Uncertainty of income flows caused by the nature of a firms business

Sales volatility and operating leverage determine the level of business risk .
Financial Risk

Uncertainty caused by the use of debt financing .

Borrowing requires fixed payments which must be paid ahead of payments to stockholders.

The use of debt increases uncertainty of stockholder income and causes an increase in the
stocks risk premium.
Liquidity Risk

How long will it take to convert an investment into cash?

How certain is the price that will be received?

Exchange Rate Risk

Uncertainty of return is introduced by acquiring securities denominated in a currency

different from that of the investor.

Changes in exchange rates affect the investors return when converting an investment back
into the home currency.
Country Risk

Political risk is the uncertainty of returns caused by the possibility of a major change in the
political or economic environment in a country.

Individuals who invest in countries that have unstable political-economic systems must
include a country risk-premium when determining their required rate of return.

Macro Perspective

In a general perspective, finance is the science of funds management.

Financial managers have to deal with the choice of allocation of funds to
improve the wealth of the player they are dealing with.
Here are the different parties in the financial world:

Firms

Consumer
s

Government

Banking
System

Central
Bank

Structure of Production

However, there are also relationship between firms, so there is a structure of

production.
There are different firms in different industries, so they buy and sell products or
services between themselves.
We are going to represent the structure of production in a vertical way.
Lets consider a car. The way it is produced is that some firms extracted minerals
from the ground, then following that action, some other firms transformed those
minerals in useful metals or other products, then other firms build equipment from
those materials such as computers, robots, tires, brakes, etc, then other firms
such as Chrysler assemble all this equipment and fabric the car, then you have
following industries such as marketing, lawyers, and finally dealers that intervene
for us to have finally the car.
It is a simplified version in the sense that you have multiples industries all the way
one after another, from early stages to late stages, and you have loop patterns.
We are going to represent that structure of production in a simple way with the
following graph:
Stages of Production

Price

Macro Relationships

We can then represent the way finance works in the overall economic
system: it is the financial cycle.
Labor
Wages
FIRMS

HOUSEHOLDS

Consume
Consume
Save

Investment

Taxes GOVERNMEN

T
Lend

BANKING
SYSTEM FINANCIAL
MARKET

Issue Bonds

CENTRAL
BANK

Macro Relationships

Lets examine now the different parties that play a role in this system:
The firm
The households
The government
The banking system
The central bank

Financing Cycle

We can then see the overall evolution of financing of a start-up.

Revenue

Strategic Alliances
Acquisition/Mergers
Seed Capital
Venture Capital

IPO
Secondary Market

Time

Market

Private Equity

Public

Sole Proprietor

A sole proprietor company is owned and run by only one person.

They are obviously small firms, but they are numerous.
In the US, sole proprietorship represented 71% of the businesses in 2007 but
generated only 5% of the revenues.
Characteristics:
They are easy to set up
There is no separation between the owner and the firm; there cannot be
other investors with ownership.
The owner has unlimited personal liability, so they are responsible for the
debt of the firm. It limits the desire to be the sole owner in the sense that as
soon as debt becomes too big, owners dont want to be personally liable.
The life of the firm is limited to the life of the owner.
Business: it is the kind of small business that relies relationships developed
through reputation. It is the case of small law firms, medical practice,
accounting firms, small entrepreneurs, etc
They are financed with the money of the owner, and/or money that the owner
borrowed from other people or banks.

Partnership

A partnership, contrary to sole proprietorship, is owned by more than one

owner.
Characteristics:
All partners are liable, so there are all responsible for the debt of the firm.
It reduces the risk for each individual partner because there are a few of
them, but there are still personally responsible.
However, the firm can create a limited partnership:
The general partners are personally liable for the debt of the firm
The limited partners have limited liability in the sense that they are
liable only for their investment.
The partnership is terminated in the case of death or withdrawal of any
single partner.
To prevent liquidation in case of death or withdrawal, partners can have an
agreement that provides alternative solutions such as buyout of a decease
or withdrawn partner.
Business: as for sole proprietorship, partnership is the kind of small business
that relies relationships developed through reputation. It is the case of small
law firms, medical practice, accounting firms, small entrepreneurs, etc

Limited Liability
Companies

A limited liability company (LLC) is a partnership but all partners have

only limited liability.
It means that they are personally responsible for their investment, not for
the all debt of the firm.
This form of organization appeared in the US relatively late, while it is
common in Europe for a long time.
The first state to pass a statue allowing the creation of an LLC was
Wyoming in 1977.

Financing of
Partnerships and LLCs

As with the sole proprietorship, those firms can finance themselves in the sense
that:

partners provide money , so invest into the firm

they can borrow money from others or banks.

There is always another distinct way:
Money from enterprises specialized in financing start-up:
It starts usually with seed funding: it is used for low scale operations that
are considered to be in preliminary stages of evolution: a product or service
is in an early development.
Investments are usually low and really risky.
Then, at the next stage, when the product or service shows more promising
results, venture capital firms start to finance those kind of firms.
They are specialized in providing money for growth starting company with
high risk.
In exchange for the risk, venture capital firms get significant control over
company decisions, and get a significant portion of the companys
ownership.
Venture capital firms are part of a larger sort of firms: private equity firms.

Corporations

A corporation distinguishes itself from the previous form of organization by being

a legal entity on itself and separated from the owners.
Characteristics:
It has then as many legal powers that people have.
In that sense it can enter into contracts, acquire assets, and incur obligations.
It is the solely responsible for its own obligations. Then, owners, employees,
contractors and any other entity in contact with the firm are not liable.
The property of a corporation is private and entitle to protection under the US
Constitution.
A corporation must be legally formed in the sense that the state in which the
firm is incorporated must provide its consent for the formation of that
corporation.
It is then more costly to set up than a sole proprietorship.
The ownership of the firm is divided into shares, or known as stocks.
The collection of those outstanding shares is called the equity of the
corporation.
An owner of a share is a shareholder, or stockholder, or equity holder.
There is no limit on the number of shareholders.
There is no limitation on who can own a stock.

Corporate Taxes

There are some implication on taxes for corporate entities.

A corporation is a legal entity, so it is subject to taxation, and after the
firm gave back some profits to the owner, or shareholder through the form
of dividend, then those shareholder are subject to taxes again: it is double
taxation.
However, we distinguish two kind of corporation in that regard:
S corporations are firms that are exempt of double taxation.
Firms profit are not subject of taxes, but are directly considered to be
owned by shareholders, and those are of course taxes, even if they
didnt receive any dividends.
This is possible only for corporations with less than 100 shareholders.
C corporation are firm that have more than 100 shareholders, then
then shareholders are subject to double taxation.

Financing or Raising
Money

A firm wants to engage into projects but it needs to raise money to be able
to invest into those.
They are three ways to raise capital:
Stocks
Preferred stocks
Bonds

Stocks

Bonds

Preferred Stocks

Financing or Raising
Money

Firms that want to issue stocks, preferred stocks or bonds dont do it by

themselves.
They use investment banks to do the work for them.
They value the firm
They organize the advertisement of the selling of the securities
They organize the selling of securities on secondary markets such as
the stock market or bond market.
If it is the first time the firm issues stock, this operation is called an
IPO, or initial public offering.
The investment banker could:
Either buy all the stocks, it is the primary market, and sell them
on the secondary market: so it guarantees that all the stocks will
be bought at the agreed price: it is a firm commitment contract
Or sell as much as possible the stocks: it is the best effort
contract.
The company becomes then public: the stocks are sold on exchange
markets or what we call over-the-counter and can be traded.

Financing or Raising
Money

We can see that there are two steps when a firm issues stock:
First, there is an initial transaction.
The firm issues shares and sell them to investors through investment
bankers.
It is the primary market.
Then, after that first step, those shares are sold again in the
secondary market, in which is exchange over and over.
Activities include also:
Mergers and acquisitions
Research
Money management

Financial Markets

We can also make a distinction between the type of securities that are
traded depending on the maturity of the securities.
If the maturity of the security is less than one year, then it is in the
money market.
It includes mainly debt securities such as Treasury bills, commercial
papers, bankers acceptances, etc
The other securities are in the capital market.
It includes notes, bonds, equities, etc

Raising Money for the

Firm

We can then represent the way finance works in the overall economic system:
it is the financial cycle.

FIRMS

HOUSEHOLDS

Consume
Money
Security
Invest
Save
Investment
Bank

Market

GOVERNMEN
T

Lend
Stock
market

CENTRAL
BANK

Brokers
Primary Bond
Market market

Secondary

Bank

Corporate Finance

Financial managers have to deal with the following situation:

They will have to deal mainly with selecting projects to invest in, make
decisions about the capital structure and dividend policy, and how to
finance the firm.
They will have also to manage short term cash needs.
Investors

Stockholders

Government

Bondholders
Taxes

Earnings
Dividend Policy

Projects
Financing-Capital Structure

Capital Budgeting

Managers

Futures/Swaps/Options
Risk Management

Goals of Managers

As we saw, there is a separation between the firms and the owners.

The shareholders own the firm, but managers are the ones who manage the firm
and make decisions.
There may be here a conflict of interest: managers may be tempted to engage
into projects or make decisions that benefit them but not the shareholder.
The problem is that managers know better about the firms than the
shareholders in the sense that the latter have less information or precise
knowledge of what is going on.
This is the agency problem.
However, it must be clear that the primary goal of managers is to maximize the
wealth of the shareholders.
Here are the main task of the financial managers:
To choose projects
To choose finance or raise money and establish capital structure
To manage risks
To set up dividend policy
To manage short-term cash needs

Choosing Projects or
Capital Budgeting

The first task of the firm is to select projects: it is capital budgeting.

Firms requires to engage in new project or make sure that current
projects continue, so they need to develop new products, build factories,
create distribution centers, install information technology, expand to new
markets, and acquire other companies.
However, firms have to decide whether or not they should embark into
specific projects.
It is the role of the financial managers to help to estimate the cost and
benefits of different projects.
They have to make sure that money is used in the best interest of the
shareholders.

Capital Structure

When choosing the quantity of stocks, preferred stocks, and bonds to

raise money, financial managers have to make sure that they behave in
the best interest of the shareholders.
Indeed, there have to optimize the proportion of stocks, preferred stocks
and bonds to obtain the maximum value for the price of the stock: it is
what we call capital structure.

Dividend Policy

When profits become positive, then the ways the company can distribute it
are:
Pay interest expenses
Pay down the principal on debt
Pay dividends
Repurchase stocks
Buy non operating assets such as Treasury Bills or other marketable
securities.
It would reduce the risk of financial distress in case of an economic
downturn.
It could also provide funding with no flotation cost and no signaling
effects.
However, there may be an agency cost: managers might be tempted to
spend the money on perks or high-priced acquisition.
The objective for the financial manager is to find the optimal policy in
terms of redistribution to optimize the value of the stock.

Short-term Cash
Management

Another objective of financial managers is to deal with short-term

management of cash.
As we will see later, the firm has to make sure that even if they have
multiple years plans, they can have enough cash on the short term to
continue the functioning of the firm.
It is made through what we call the management of working capital, or
current assets minus current liabilities.

Management of Risk

By investing in projects, a firm is subject to some risk.

Indeed, most of the time, the projects have inputs and outputs that can
have their prices affected significantly by changes in commodity prices or
currencies fluctuations. As a consequence, the firm has to find a way to
protect itself and hedge the risk
It is mainly made through the use of derivatives:
Forward and futures
Swaps
options

Households

Households provide labor to and receive wages from firms.

From the wages they receive, household can use money in two ways:
They consume
They save
We include in saving the amount of money they deposit at banks, but we may also
consider the amount of money they invest directly in different financial
instruments.
As an investor, they may put their money in:
Stocks
Bonds
Commodities,
Currencies
Real Estate
Art
Private equity
Funds such as mutual funds, hedge funds, etc
The study of finance for household is called personal finance, and includes the choice of
investment considering the needs, the financial situation, and objectives of the
household.

Household

We can then represent the way finance works in the overall economic system:
it is the financial cycle.

Wages
FIRMS

HOUSEHOLDS

Consume
Money
Security
Invest
Save
Investment
Bank

Market

GOVERNMEN
T

Lend
Stock
market

CENTRAL
BANK

Brokers
Primary Bond
Market market

Secondary

Bank

Financial Markets

As we can see on the graph previously designed, the banking system and
more generally financial markets play a role of intermediary between
household and government in one hand and firms in the other hand.
Financial markets are markets in which assets are exchanged, and in
developed countries, they are structured and organized.
We start with the depositary institutions: they accept deposits.
Commercial banks
Savings and loans (S&L)
Savings banks
Credit unions
They are highly regulated.
Banks use those deposit and lend to firms for investing in projects.

Depositary Institutions

We can then represent the way finance works in the overall economic
system: it is the financial cycle.

FIRMS

HOUSEHOLDS

Consume
Money
Security
Invest
Save
Investment
Bank

Lend

GOVERNMEN
T
Lend
Stock
market

CENTRAL
BANK

Brokers
Bond
market

Depositary
Institutions

Intermediaries

We have also non-depository institutions:

Insurance companies
Pension funds
Investment companies such as mutual funds, close-end funds, unit
trust.
This part is investment analysis and also portfolio management.
However, there are other type of firms that also play a role of
intermediary, such as:
Hedge funds
Private equity firms
Asset management firms
Etc..

Intermediary Institutions

We can then represent the way finance works in the overall economic
system: it is the financial cycle.

Wages
FIRMS

HOUSEHOLDS

Consume
Money
Security
Invest
Save
Investment
Bank

Lend

Intermediaries

GOVERNMEN
T

Lend
Stock
market

CENTRAL
BANK

Brokers
Bond
market

Derivatives
Others

Depositary
Institutions

Government

The government has regulatory activities and also consumes by engaging

in projects.
To get funded, then it can:
Use taxes
Raise money through debt.
It issues what we call Treasuries:
Treasury bills (maturity less than 1 year)
Treasury notes (maturity more than 1 year and less than 10 years)
Treasury bonds (maturities more than 10 years)
This part is public finance.
It is the study of the role of government. It assesses the government
revenue and cost.

Government

We can then represent the way finance works in the overall economic
system: it is the financial cycle.
Taxes
Wages
FIRMS

HOUSEHOLDS

Consume
Money
Security
Invest
Save
Investment
Bank

Lend

Intermediaries

GOVERNMEN
T

Lend
Stock
market

CENTRAL
BANK

Brokers
Bond
market

Derivatives
Others

Depositary
Institutions

Central Bank

In the US, the central bank was created in 1913 to manage the banking
system.
It supervises banks and was created to deal with specific issues:
The original idea was to manage the supply of currency by expanding
or contracting it with changes in the quantity of currency demanded.
This role was to prevent a panic when a lot of depositors were rushing
to banks at the same time and the bank was not able to provide the
corresponding cash.
It plays a role of last resort when panic is installed and severe crisis
affect the good functioning of the banking system.
It establishes the monetary policy with the objective to stabilize the
economy and prevent disruptive and aggravated business cycles.
The goal is to achieve full employment and stability of prices.
It plays a huge role because it establishes interest rates, plays a role of
last resort to avoid crisis and so intervene in some operations that will
described later and affect banks, so the whole economy.

Central Bank

There are 3 ways a central bank can intervene into the economy:
The central bank can buy or sell treasury bonds through what is called open
market operations.
If it buys treasury bonds, it increases the amount of money into the financial
system, so it lowers the federal fund rate which is the rate at which borrow
and lend to each others, and it supposes to stimulate the economy.
If it sells treasury bonds, it retracts the amount of money into the financial
system, so it increases the federal fund rate, and it supposes to slow down the
economy.
The central bank can change the discount rate, which is the rate at which the
central bank lends money to banks.
By increasing the discount rate, it diminishes the capability for banks to lend
and vice versa.
The central bank can change the level of reserve required in banks.
By increasing the level of reserve, it diminishes the capability for banks to
lend, and vice versa.
This part is monetary policy.
Of course, we shouldnt forget also the role it plays when exercising the role of last
resort.

Central Bank

We can then represent the way finance works in the overall economic
system: it is the financial cycle.

Wages
FIRMS

HOUSEHOLDS

Consume
Money
Security
Invest
Save
Investment
Bank

Lend

Intermediaries

GOVERNMEN
T

Lend
Stock
market

CENTRAL
BANK

Brokers
Bond
market

Derivatives
Others

Depositary
Institutions

Central Bank

There are three ways central banks can influence the economy. It is done
through manipulation of interest rate.
Open Market
Operation

Bond
Market

Central Bank

Discount Rate

Bank

Bank

Reserve

Bank
Fed Fund Rate

Bank

Bank

Level

Foreign Investment

To have a complete picture of how different markets may move, it is

essential to evaluate the level of foreign investment and the motive of
foreigners to invest or not into the country.
Investment could come in two forms:
Private foreign investors
Sovereign Wealth Funds: they are state own investment funds.
They are vehicules that allow foreign states to invest in real assets
and financial assets such as bonds, stocks, real estate, derivatives,
etc and even in private equity firms or hedge funds.
Their money, for examples US dollars may come from:
commodity export (such as for Norway, Saoudi Arabia)
Trade surplus (such as China)

Central Bank

We can then represent the way finance works in the overall economic
system: it is the financial cycle.

Foreign Investment

Wages
FIRMS

HOUSEHOLDS

Consume
Money
Security
Invest
Save
Investment
Bank

Lend

Intermediaries

GOVERNMEN
T

Lend
Stock
market

CENTRAL
BANK

Brokers
Bond
market

Derivatives
Others

Depositary
Institutions

Reference

Principle of Corporate Finance Berk, DeMarzo, and Hartford, Custom

Edition, Pearson
Chapter 1
Essentials of Investment Bodie, Kane, Marcus, McGraw Hill, 9th Edition
Chapter 1,2,3,4
Fundamentals of Corporate Finance 7th Edition, Brealey, Myers and
Marcus
Chapter 1
Financial Management Theory & Practice Brigham and Ehrhardt
Chapter 1