summary in finance, mba20021 summary of courses in finance (revision for the state exam) mihály...
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Summary in finance, MBA2002 1
Summary of Coursesin Finance
(Revision for the State Exam)
Mihály Ormos
Summary in finance, MBA2002 2
Business Economics & Corporate Finance
4. Markowitz’s portfolio theory–Maximization of expected utility and risk-aversion –Diversification, diversifiable and nondiversifiable risk–Efficient portfolio, investor decision in the Markowitz model
5. CAPM by Sharpe–Risk-free opportunity, homogeneous expectations–Market portfolio and the capital market line–Beta and the security market line
6. Market efficiency–Definition of perfect efficiency, and its properties–Forms of market efficiency (definitions, tests, reasons of
existence)–Perfect vs. efficient, adaptive complex systems
Summary in finance, MBA2002 3
7. Basics of investment decisions–Owner’s value maximisation, the opportunity cost approach–Opportunity cost from the capital market, through CAPM–Mini-firm approach
8. Taxation–Principles of taxation, basic types–Value Added Tax, Corporate Tax, Personal Income Tax–Consideration of taxes in corporate financial analyses
9. Dividend policy–Indicators of dividend, practices –Indifference of dividend policy in perfect and imperfect
market–Significance of indifference of dividend policy in financial
analyses, consequences
Business Economics & Corporate Finance
Summary in finance, MBA2002 4
Markowitz’s portfolio theory Maximization of expected utility, risk-aversion and rationality
Investors compare investment possibilities with different risk and return.
How do investors decide in a risky situation?
Bernoulli was the first who argued that investors decide upon the maximisation of expected value (return).
Investors’ decisions are made upon the expected utility (satisfaction) of the wealth.
So investors try to maximise the expected utility, NOT the expected value of the wealth
i iwUipUE W max)(
Summary in finance, MBA2002 5
Markowitz’s portfolio theory Maximization of expected utility, risk-aversion and rationality
The expected utility of an output is not proportionally related to expected value of the same output. The relationship can be represented by the utility function of the wealth.
Summary in finance, MBA2002 6
MU(W)
W
U(W)More money
is better...
Decreasing marginal utility of the wealth
Markowitz’s portfolio theory Maximization of expected utility, risk-aversion and rationality
Summary in finance, MBA2002 7
Portfolio theory Diversification, diversifiable and nondiversifiable risk
U5
U4
U3
U2
U1
E(r)
σ(r)
Summary in finance, MBA2002 8
Portfolio theory Diversification, diversifiable and nondiversifiable risk
By diversifying the investments (creating portfolio), the risk (variance of the return) will be decreased.
U5
U4
U3
U2
U1
E(r)
σ(r)
1
3
2
2,5
11,4
i
3,3
17,1
j
kij= 0,5
Summary in finance, MBA2002 9
Portfolio theory Diversification, diversifiable and nondiversifiable risk
U5
U4
U3
U2
U1
E(r)
σ(r)σ(r)
E(r)
Summary in finance, MBA2002 10
Portfolio theory Diversification, diversifiable and nondiversifiable risk
U5
U4
U3
U2
U1
E(r)
σ(r)σ(r)
E(r)
Summary in finance, MBA2002 11
Portfolio theory Diversification, diversifiable and nondiversifiable risk
While the diversification is free, and useful, all investors hold efficient portfolios.
U5
U4
U3
U2
U1
E(r)
σ(r)σ(r)
E(r)
A
Efficient portfolios
B
Summary in finance, MBA2002 12
Portfolio theory Diversification, diversifiable and nondiversifiable risk
In a portfolio the (total) risk of an investment can be divided into two parts:
– diversifiable (unique or non-systematic risk)
– non-diversifiable (market or systematic risk) U 5
U 4
U 3
U 2
U 1
E (r)
σ(r)σ(r)
E(r)
A
efficient portfolios
B
Summary in finance, MBA2002 13
Portfolio theory Efficient portfolio, investor decision in the Markowitz model
In the Markowitz model the portfolios held by the investors cannot be identified, so as the non-diversifiable risk .
U5
U4
U3
U2
U1
E(r)
σ(r)σ(r)
E(r)
A
Efficient portfolios
B
E(r)
C
Summary in finance, MBA2002 14
CAPM by Sharpe Risk-free opportunity, homogeneous expectations
The new assumptions and boundary conditions:• Perfect competition (microeconomic conditions)
– lot of investors with small investments–regulations and taxes have no effect on the decisions–perfect information flow–no transaction cost
• Investors–are rational, and hold Markowitz type portfolio–use the same type of analyses (together with the above conditions on
the competition gives the homogeneous expectations)
• Investment opportunities–are restricted to risky securities traded on the security market
and to risk-free lending and borrowing–the cost of risk-free lending and borrowing are the same
Summary in finance, MBA2002 15σ(r)
E(r)
U5
U4
U3
U2
U1
E(r)
σ(r)
CAPM by Sharpe Risk-free opportunity, homogeneous expectations
By introducing the two additional assumptions: risk-free assets and homogeneous expectations, CAPM solves the problem of Markowitz model.
M
All investors hold the same risky portfolio (M),independently toits preferences.This risky portfolio will be combined with risk-free assets, by its preferences.
Summary in finance, MBA2002 16
CAPM by Sharpe Market portfolio and the capital market line
While everyone hold the same risky portfolio this cannot be anything else than the Market Portfolio (M).
This will be combined with the risk-free asset, so all portfolios held by the investors will be placed on the Capital Market Line.
Capital Market Line
rf
σ(r)
E(r)
Market Portfolio
E(rM)
σ(rM)
Summary in finance, MBA2002 17
CAPM by Sharpe Market portfolio and the capital market line
After all the question is, that how a given security affects the risk of the Market Portfolio.
–Only the affect on the market portfolio has to be examined, because the risk free return does not influence the diversification or the perception of the relevant risk.
This depends on what extent the given security gains in average the deviation of the Market Portfolio.
This is shown by the slope of characteristic line.
Summary in finance, MBA2002 18
CAPM by Sharpe Beta and the security market line
rM
ri
1
βiεi
ri
rM
2222 )()()( iMii rr
αi
Summary in finance, MBA2002 19
CAPM by Sharpe Beta and the security market line
So the CAPM is fMf rrErrE )()(
E(r)
market portfolio
security market line
E(rM)
1
rf
β
riskpremium
timepremium
Summary in finance, MBA2002 20
CAPM by Sharpe Beta and the security market line
E(r)
rf
β
Summary in finance, MBA2002 21
Market efficiency Definition of perfect efficiency, and its properties
The market is perfectly efficient if all available information on securities (and everything that can be connected to the securities) is immediately and in a correct way built in to the prices.
In general this means that it is not possible that a security bought or sold on the market price can produce positive NPV.
Continuous buying and selling, and continuous information collection and “in building” with zero transaction- and information acquiring cost.
While the transactions, collection and processing information can take cost the prices will reflect all information until the marginal cost of transactions are less than the return connected to the transaction.
Summary in finance, MBA2002 22
Market efficiency Forms of market efficiency, definitions
Weak form of market efficiency:all historical price (return) information available is
immediately built in,
Semi-strong form of market efficiency: also all public (fundamental) information is immediately built
in the securities’s price,
Strong form of market efficiency:all public and non-public information is immediately built in
the prices as well.
Summary in finance, MBA2002 23
Market efficiency Forms of market efficiency, definitions
Question: whether the actual price contains all public information.
If yes, then future events are unpredictable and randomly happen.If not, then future prices can be predicted
• using historical price (return) information (weak form)
• using public fundamental information (semi- strong form)
• based on unpublic (fundamental) information (strong form)
price
presentpast future
New information, accidentiallity
Summary in finance, MBA2002 24
Market efficiency Forms of market efficiency, tests
Two types of analyses:–technical analyses
–fundamental analyses
If the technical analyses proved to be useless this verifies the weak form of market efficiency.
By the examination of the fundamental analyses the semi-strong and strong form of market efficiency can be tested.
Summary in finance, MBA2002 25
Weak Market efficiencyform Forms of market efficiency, tests
The technical analyses try to find some kind of stochastic relation between sec’s historical prices and other “things”.
Predictability testes:–Correlation tests
• auto-correlation• cross-correlation (with other sec’s, indexes, volumes)
The correlation coefficients are very small, almost random-walk.
–Runs tests
–Return patterns• January-December effect• Day of the week effect
–etc.
Summary in finance, MBA2002 26
Weak Market efficiencyform Forms of market efficiency, tests
Conclusion:The prices are unpredictable by technical analyses
in Hungary as well.
The stock prices do not have memory.
Summary in finance, MBA2002 27
Semi-strong Market efficiencyform Forms of market efficiency, tests
Testing of consultants companies and managed mutual founds past forecasts and compared them to the later reality.The results are:
– on the long run: nothing
– on the short run: nothing
– by industrial segment, region, etc.: nothing
– the managed portfolios gives the same nothing in average
There is no consistent winner.
Summary in finance, MBA2002 28
Öss
zegz
ett
átla
gos
több
leth
ozam
0
2
4
6
8
-2
-4
-6
-8
Napok a bejelentés előtt és után-20 -10 0 10 20 30 40
109
876
54
3
2
1Kum
ulál
t ab
norm
ális
hoz
am
Days before and after the events
Acc
um
ulat
ed a
bnor
mal
ret
urn
Event Market efficiencystudies Forms of market efficiency, tests
Day of publication
0 3020-10 10-20-30
Daily return
Summary in finance, MBA2002 29
Market efficiency Forms of market efficiency, reasons of existence
If the markets are proved to be efficient, than any kind of analyses are proved to be useless.
If these are useless, no one would do them,
but the markets are efficient because lot of analysts work on,
If the number of analysts decreases they would have the opportunity to gain excess profit, so the number will increases.
Summary in finance, MBA2002 30
Basics of investment decisionsOwner’s value maximisation, the opportunity cost approachDevelopment of public limited corporations
Early capitalism• individuals and families, with unlimited liability• the owner and the manager is the same• Development of technology and mass production required
the concentration of capital
Limited liability• more owner one company• legal entity• management and ownership are separated, but• the goals are different• shares are tradable• stock exchange• agency problem
However, the management makes the decisions, as a starting point we presume, that the decisions will be made upon the theory of shareholder’s value.
Summary in finance, MBA2002 31
Basics of investment decisionsOwner’s value maximisation, the opportunity cost approach
The goal of the owners’ is the maximisation value, that is the maximisation of the value of the corporation.
–If this is the goal of the owner -by the shareholder’s value- this will be goal in any business decision.
The wealth of the owner can be increased through dividend pay off or stock price increase.
Only those investment decisions suits to the value maximisation approach, which promise higher return than others.
Others means in investment decisions the opportunity cost.
Opportunity cost is the return of other investments on the capital market with similar risk.
Summary in finance, MBA2002 32
Basics of investment decisions Opportunity cost from the capital market, through CAPM
E(r)
rf
β
Stock prices are continuously adjusted -by the efficient capital market itself- to the expected risks and returns, so the expected returns (fitting to the risk) tends to the normal return. Only those investment decisions will be realised, which promises higher return than the normal.
Summary in finance, MBA2002 33
E(F1)E(F2)
E(Fn)
E(FN)
F0
… …Nn21
0
βproject IRR
E(r)
piaci portfolió
értékpapír-piaci egyenes
E(rM)
1
rf
β
ralt
0)1(
)(
0
nn
alt
n
r
FENPV altrIRR
Firm
Shareholder
Project
Investmentdecision
Dividend
Tőkepiaci alternatívaCapital m.alternative
Basics of investment decisions Opportunity cost from the capital market, through CAPM
Summary in finance, MBA2002 34
Basics of investment decisions Mini-firm approach
All investments will be implemented which is better than the similar risk capital market investment.
Better means positive NPV or IRR exceeds ralt.The opportunity cost is estimated through CAPM.The risk (so the opportunity cost) of any arbitrary
elements of the shareholder’s portfolio depend on the stochastic relationship with the market portfolio but not each other.
So, if the CAPM is used than the risk of any single entity -as well as the risk of any project- individually with respect to the market portfolio will be examined, i.e. independently from its corporate environment.
The single projects will be considered as “mini-firms”.
Summary in finance, MBA2002 35
TaxationPrinciples of taxation, basic types
Two basic principles of taxation:–Principle of benefit
The value of contribution “to the common” is fair if it is proportional to the received benefit form the “common”.
–Principle of solvencyDetermining the value contribution, the income and the financial
position should be considered
Two basic types of taxation was settled:–Indirect types
These do not consider the personal conditions, these are connected to the consumption and to the turnover (e.g. VAT)
–Direct types• These are strictly connected to the individual conditions (like income, or
profit) of the person or corporation (e.g. PIT, or CT)
Summary in finance, MBA2002 36
TaxationValue Added Tax, Corporate Tax, Personal Income Tax
Connected to almost all products and services.In this case the authority does not have any connection to the taxing individuals, because the supplier pays after all transaction, actually the purchaser pays the tax but the price contains it.
If the purchased good or service will be used for business activity the tax payable can be reduced with the shifted tax, so only the added value will be charged by this tax.
The general degree of VAT in Hungary is 25%.Advantages:
– if a wide black market exists, than from the income side it is difficult to collect the tax
– strengthening the documentation of transactions– the consumer does not sense, “hidden tax”
Disadvantages:– higher administrative task– intellectual crimes (negative tax)– not proportional contribution (with higher income, the less amount will be
used for consumption)
Summary in finance, MBA2002 37
TaxationValue Added Tax, Corporate Tax, Personal Income Tax
The tax base is coming form the accounting pre-tax profit.
This accounting pre-tax profit has to be modified according to the differences between the law of accounting and taxation.
From the corrected positive pre-tax profit 18% corporate tax has to be paid.
Summary in finance, MBA2002 38
TaxationValue Added Tax, Corporate Tax, Personal Income Tax
In case of private domestic individuals the sum of all income (money or payments in kind) forms the tax base
There are two types of income tax–aggregated income
• tax brackets (higher income – higher tax rate)
–separated income• revenue on capital investment: 20% tax rate (the interest is 0%, price
earnings 20%, dividend tax 20%, etc.)
Summary in finance, MBA2002 39
TaxationConsideration of taxes in corporate financial analyses
VAT: net amounts are used in the calculations (the company actually just an intermediary)
Other taxes, which are not connected to the accounting profit e.g. consumption tax are considered in the cash flow as simple costs (cash outflow)
Corporate tax and personal income tax:These types reduce the shareholder’s value, the main difference is
the level on which they act.The two tax types are summarized in the so called effective tax rate
teff=1-(1-tc)(1-tp)
As a basic principle in determination of the expected cash-flows and opportunity cost, that the same taxation should be considered.
If the opportunity cost were determined after all tax liability, than the cash flows should be calculated on the same way.