Modern Financial Theory
Recap of steps to introduce financial calculations
We left accounting to turn to finance
One of the purposes of finance is to evaluate investments:
Another purpose is to get the proper kind of financing for investments selected as good.
In finance, future cash flows are not sure (except for the future value of short term government bonds of prosperous countries)
Random variables (therefore we need to talk about the experiment which generates them)
We began by studying simple financial securities, or physical investments with just one future CF
Having two securities S and T (and for T we don't know the price), if S has the same risk pattern as T, we saw how to compute the price of T
The procedure is called discounting ; it leads to Present Values
We saw that the profitability of a securiy (or a one-year investment) is the figure r such that the NPV computed with r is zero
We used this property to define the "generalised profitability" of a multi CF investment: the exact name is IRR (Internal Rate of Return)
It is possible to find a security that has the same risk as a stream of future cash flows: then, the profitability of that security is called the Opportunity Cost of Capital of the investment
For a given stock, the series of past prices in the stock market over n years is not a series of n outcomes of one random variable; the whole path is one outcome of a random walk
But the series of past profitabilities from one year to the next is a series of outcomes of the RV Profitability.
For any projected investment I (C0, C1, C2, C3, ..., Cn) there are two fundamental rates to take into consideration
Except for weird cases, an investment has a positive NPV (i.e. creates value right now) if and only if the IRR is greater than the Op Cost of Cap
What Op cost of cap to use for a given investment ?