Title: Summary of Courses in Finance Revision for the State Exam
1Summary of Coursesin Finance (Revision for
the State Exam)
2Business 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
3Business 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
4Markowitzs 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
5Markowitzs 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.
6Markowitzs portfolio theory Maximization of
expected utility, risk-aversion and rationality
Decreasing marginal utility of the wealth
7Portfolio theory Diversification, diversifiable
and nondiversifiable risk
8Portfolio theory Diversification, diversifiable
and nondiversifiable risk
- By diversifying the investments (creating
portfolio), the risk (variance of the return)
will be decreased.
9Portfolio theory Diversification, diversifiable
and nondiversifiable risk
10Portfolio theory Diversification, diversifiable
and nondiversifiable risk
11Portfolio theory Diversification, diversifiable
and nondiversifiable risk
- While the diversification is free, and useful,
all investors hold efficient portfolios.
A
12Portfolio 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)
13Portfolio 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
14CAPM 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
15CAPM 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.
16CAPM 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.
17CAPM 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.
18CAPM by Sharpe Beta and the security market line
19CAPM by Sharpe Beta and the security market line
20CAPM by Sharpe Beta and the security market line
E(r)
ß
21Market 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.
22Market 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.
23Market 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)
24Market 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.
25Weak 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.
26Weak 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.
27Semi-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.
28Event Market efficiencystudies
Forms of market efficiency, tests
29Market 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.
30Basics 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.
31Basics 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.
32Basics 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
33Basics of investment decisions Opportunity cost
from the capital market, through CAPM
34Basics 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.
35TaxationPrinciples 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)
36TaxationValue 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)
37TaxationValue 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.
38TaxationValue 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.)
39TaxationConsideration 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.