JGU Zettelkasten

MIT 15.401 Finance theory 1

4 min read

MIT Finance theory 1

Intro

Fundamental challenges of finance

All business activities reduce to two functions:

  • Valuation of assets (real/financial, tangible/intangible)
  • Management of assets (acquiring, selling)

Business decisions involve valuation and management:

  • you cannot manage what you cannot measure
  • Valuation is the starting point for management
  • Once value is established, management is relatively easy to do.

Objective + valuation ⇒ Decision

Framework of financial analysis

Accounting

  • Language of finance
  • Stock vs flow (bathtub water level vs faucet flow)

Balance sheet and income statement

  • Balance sheet: the snapshot of finance status quo (stock)
  • Income statement: rate of change of the status quo (flow)

Corporate financial decisions

  1. Cash raised from investors (selling financial assets)
  2. Cash invested in real assets (tangible and intangible)
  3. Cash generated by operations
  4. Cash reinvested
  5. Cash returned to investors (debt payments, dividends etc)

Management

Different management levels care those cash related decisions differently

  • Real investment: 2, 3
  • Financing: 1, 4
  • Payout: 5
  • Risk management: 1, 5

Ultimately your objective as a shareholder or manager of the corporation is to do well by the owners: maximize shareholder wealth

Six fundamental principles of finance

  1. There is no such thing as a free lunch. (No systematic transfer of wealth)
  2. Other things equal, individuals:
    1. prefer more money to less (non-satiation)
    2. prefer money now to later (impatience)
    3. prefer to avoid risk (risk aversion)
  3. All agents act to further their own self-interest.
  4. Financial market prices shift to equalize supply and demand.
  5. Financial markets are highly adaptive and competitive.
  6. Risk-sharing and frictions are central to financial innovation.

Present value relations

The core idea: money has a time value.

Would you rather have 100 one year from now? People will say today, as per principle above “prefer money now to later”. So 100 in the future.
This is called the time value of money.

We use interest rate (or discount rate) to measure how much future money is “worth less” today.

In finance, we talk about cash flows — the actual inflows and outflows of money over time (not accounting profits, but real money moving).

  • You spend $1,000 now to buy a machine.
  • It earns you 400 payments are future cash inflows.

Assets and valuation

What is an “Asset” ? Being it a visible property or invisible knowledge, from a business perspective, an asset is a sequence of cashflows.

Attention the word is sequence, not summation, meaning that the asset is a list of cashflows at different points in the future, including the present but not the past. When talking about assets, all it matters is current and future cashflows.

Valuation means estimating what that asset is worth today, based on the present value of its future cash flows.

So valuation of the asset means the valuation of the cash flow, but how to value the future cash flow? We use the interest rate to bring future cash flows back to today’s value.
If the interest rate is 5%, then 100 in one year is equal to $95.24 today.

The present value (PV) formula is based on this idea:
Money in the future is worth less today because it could earn interest in the meantime. At the 5% interest, how much money today will grow to 95.24 today** will become $100 in one year if it earns 5% interest.

Now, Net Present Value (NPV) adds up all those discounted future inflows and subtracts the cost today.

NPV=(Present value of inflows)−(Present value of outflows)

So:
Positive NPV → good investment
Negative NPV → reject it

In short:

  • NPV is how we judge if an investment is good.
  • Assets are things that generate future cash flows.
  • Valuation is applying NPV logic to find what those assets are worth today.

Graph View

Backlinks