Summary of Courses in Finance (Revision for the State Exam)

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Summary of Coursesin Finance (Revision for
the State Exam)

• Mihály Ormos

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Business Economics Corporate Finance

• 4. Markowitzs 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

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Business Economics Corporate Finance

• 7. Basics of investment decisions
• Owners 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

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Markowitzs 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

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Markowitzs 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.

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Markowitzs portfolio theory Maximization of
expected utility, risk-aversion and rationality
Decreasing marginal utility of the wealth
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Portfolio theory Diversification, diversifiable
and nondiversifiable risk
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Portfolio theory Diversification, diversifiable
and nondiversifiable risk

• By diversifying the investments (creating
  portfolio), the risk (variance of the return)
  will be decreased.

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Portfolio theory Diversification, diversifiable
and nondiversifiable risk
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Portfolio theory Diversification, diversifiable
and nondiversifiable risk
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Portfolio theory Diversification, diversifiable
and nondiversifiable risk

• While the diversification is free, and useful,
  all investors hold efficient portfolios.

A
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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)

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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 .

E(r)
A
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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

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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.

All investors hold the same risky portfolio
(M),independently toits preferences.This risky
portfolio will be combined with risk-free assets,
by its preferences.
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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.

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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.

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CAPM by Sharpe Beta and the security market line
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CAPM by Sharpe Beta and the security market line

• So the CAPM is

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CAPM by Sharpe Beta and the security market line
E(r)
ß
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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.

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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 securitiess price,
• Strong form of market efficiency
• all public and non-public information is
  immediately built in the prices as well.

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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)

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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.

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Weak Market efficiencyform Forms
of market efficiency, tests

• The technical analyses try to find some kind of
  stochastic relation between secs historical
  prices and other things.
• Predictability testes
• Correlation tests
• auto-correlation
• cross-correlation (with other secs, indexes,
  volumes)
• The correlation coefficients are very small,
  almost random-walk.
• Runs tests
• Return patterns
• January-December effect
• Day of the week effect
• etc.

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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.

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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.

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Event Market efficiencystudies
Forms of market efficiency, tests
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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.

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Basics of investment decisionsOwners value
maximisation, the opportunity cost approach

• Development 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 shareholders
  value.

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Basics of investment decisionsOwners 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
  shareholders 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.

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Basics of investment decisions Opportunity cost
from the capital market, through CAPM
E(r)
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.
ß
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Basics of investment decisions Opportunity cost
from the capital market, through CAPM
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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 shareholders 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.

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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 solvency
• Determining 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)

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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)

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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.

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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.)

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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 shareholders value, the
  main difference is the level on which they act.
• The two tax types are summarized in the so called
  effective tax rate
• teff1-(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.