Finance & Investments:

Tutorial 1
General info

1. There are 3 TAs for this course

• Elena Ecker
• Sul Kim
• Tomas Jankauskas
Tutorial information

1. Apply the theory that was discussed during the lectures

2. Often start off with a brief overview of the most important concepts
3. Then we will solve the exercises
4. Please:
• Be prepared in advance and (try to) solve the questions
• Ask and answer questions
5. Two rules:
• Be on time
• If you have a question – please ask! There is no such thing as a stupid question ☺
 ❖ Advantages:
1.4 ① Limited liability,
What are the main • A corporation is solely responsible for its own obligations

advantages and ② Liquidity,

• There is no limitation on who can own its stock – free trade in the shares
disadvantages of
organizing a firm ③ Infinite life

as a corporation? ❖ Domination: the top five companies by sales volume in (2018) (Walmart,
Sinopec, PetroChina, Royal Dutch Shell, and Volkswagen Group) had
combined sales exceeding $1.8 trillion, an amount significantly larger than the
total sales of the more than 24 million U.S. sole proprietorships.)

❖ Disadvantages:
① Double taxation,
• Corporate tax (profit) and personal income taxes (dividend)

② Separation of ownership and control

• Board of directors v.s. Chief Executive Officer (CEO)
1.6 ❖Double taxation:
You are a shareholder in a C ❖Which tax will be paid first?
corporation. The corporation
1. First, the corporation pays the taxes. After
earns $2 per share before
taxes. Once it has paid taxes
taxes:
it will distribute the rest of its
earnings to you as a $2 × 1 − 0.4 = $1.20 𝑙𝑒𝑓𝑡 𝑡𝑜 𝑝𝑎𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
dividend. The corporate tax
rate is 40% and the personal
tax rate on (both dividend 2. Once the dividend is paid, personal tax must
and non-dividend) income is be paid:
30%. How much is left for
you after all taxes are paid?
$1.20 × 1 − 0.3 = $0.84

❖So, after all the taxes are paid, you are left with
$0.84
 ❖ Three types of financial decisions:
1.8
You have decided to 1. Investment (costs v.s. benefits):
form a new start-up You will make investment decisions such as determining
company developing which type of iPhone application projects will offer your
company a positive NPV and that your company,
applications for the therefore, should develop
iPhone. Give
examples of the three 2. Financing (debt v.s. equity):
distinct types of You will make the decision on how to fund your iPhone
application investments and what mix of debt and equity
financial decisions your company will have
you will need to
make. 3. Cash Management (day-to-day obligations):
You will be responsible for the cash management of your
company, ensuring that your company has the necessary
funds to make investments, pay interest on loans, and pay
your employees
1.14 ❖Private companies have a limited set of
What is the shareholders and their shares are not
regularly traded, the value of their shares
difference between
can be difficult to determine.
a public and a
private
corporation? ❖Public companies are traded on organized
markets called stock market (or stock
exchange). For example, New York Stock
Exchange (NYSE) and the National
Association of Security Dealers Automated
Quotation (Nasdaq).
1.16 ❖ What is bid-ask spread?
❖ Market makers matched buyers and sellers.
Explain why the
bid-ask spread is a ❖ The price at which market makers are willing to buy a
transaction cost. stock (the bid price) and the price at which market
markets are willing to sell a stock (the ask price).

❖ Investors always buy at the ask (the higher price) and

sell at the bid price (the lower price). Since ask prices
always exceed bid prices, investors “lose” this
difference.

❖ The bid-ask spread is a transaction cost investors

pay in order to trade. Since the market makers take
the other side of the trade, they earn this difference
as a profit by providing a liquid market.
Financial decision making

❖The time value of money is the difference in value between money today and
money in the future
❖The rate at which we can exchange money today for money in the future is
determined by the current interest rate. The interest rate allows us to convert
money from one point in time to another.
❖The present value (PV) of a cash flow is its value in terms of cash today. The
net present value (NPV) of a project is:
𝑁𝑃𝑉 = 𝑃𝑉 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑉(𝐶𝑜𝑠𝑡𝑠)
❖A good project is the one with a positive NPV
❖The NPV Decision Rule states that when choosing from among a set of
alternatives, choose the one with the highest NPV
The law of one price

❖The Law of One Price states that if equivalent investment opportunities

trade simultaneously in different competitive markets, they must trade for
the same price in all markets
❖This law is equivalent to saying that no arbitrage opportunities should
exist
❖The No-Arbitrage Price of a Security is:
𝑃 = 𝑃𝑉 𝐴𝑙𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑝𝑎𝑖𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
❖No-arbitrage implies that all risk-free investments should offer the same
return
 ❖ The benefit of the rebate is that Honda will sell more
3.1 vehicles and earn a profit on each additional vehicle
Honda Motor Company is sold:
considering offering a $1,600 ❖ Benefit = Profit of $5,400 per vehicle × 18,000
rebate on its minivan, additional vehicles sold = $97.2 million.
lowering the vehicle’s price
❖ The cost of the rebate is that Honda will make less on
from $29,000 to $27,400. The the vehicles it would have sold:
marketing group estimates
that this rebate will increase ❖ Cost = Loss of $1,600 per vehicle × 42,000 vehicles
sales over the next year from
that would have sold without rebate = $67.2 million.
42,000 to 60,000 vehicles. ❖ Thus, Benefit – Cost = $97.2 million – $67.2 million
Suppose Honda’s profit = $30 million, and offering the rebate looks attractive.
margin with the rebate is
$5,400 per vehicle. If the ❖ (Alternatively, we could view it in terms of total, rather
change in sales is the only than incremental, profits. The benefit as
consequence of this decision, $5,400/vehicle × 60,000 sold = $324 million, and the
what are its costs and cost is $7,000/vehicle × 42,000 sold = $294 million.)
benefits? Is it a good idea?
❖ It seems like a good idea!
3.6 ❖Time value of money…
Suppose the risk-free interest a) Having $500 today is equivalent to having
rate is 3.2%. $500 × 1.032 = $516 in one year.
a) Having $500 today is
equivalent to having
what amount in one b) Having $500 in one year is equivalent to
year? having $500 / 1.032 = $484.50 today.
b) Having $500 in one year
is equivalent to having
what amount today? c) Because money today is worth more than
c) Which would you prefer, money in the future, $500 today is
$500 today or $500 in preferred to $500 in one year. This answer
one year? Does your is correct even if you don’t need the money
answer depend on when
you need the money?
today, because by investing the $500 you
Why or why not? receive today at the current interest rate,
you will have more than $500 in one year.
 ❖ Can you make any comment without making any
3.10 calculation?
Your firm has identified three
potential investment projects.
a) Calculating each project NPV:
The projects and their cash flows $19
𝑁𝑃𝑉𝐴 = −$14 + = $4.10
are shown here: 1 + 0.05
Project Cash Flow Today ($) Cash Flow in One Year ($)

A -14 19 $3
𝑁𝑃𝑉𝐵 = $5 + = $7.86
B 5 3 1 + 0.05
C 21 -7
Suppose all cash flows are $7
certain and the risk-free interest 𝑁𝑃𝑉𝐶 = $21 − = $14.33
rate is 5%. 1 + 0.05
a) What is the NPV of each
project? b) If we can choose only one project, we will choose the
one with the highest NPV i.e. project C
b) If the firm can choose only
one of these projects, which
should it choose? c) If we can choose two projects, we will choose the
c) If the firm can choose any project C and project B that gives us the highest
two of these projects, which combined NPV.
should it choose?
3.13 ❖ This is NOT an arbitrage opportunity, but why?
Throughout the 1990s, ❖ There is a significant exchange rate risk
interest rates in Japan were ❖ If the value of the dollar falls relative to the yen by
lower than interest rates in more than the difference between the interest rates,
the United States. As a result, the strategy will incur a loss. Because a profit is not
many Japanese investors guaranteed, this is not an arbitrage opportunity.
were tempted to borrow in
Japan and invest the
❖ A simple example:
proceeds in the United ❖ Assume that it is the beginning of the year the exchange
States. Explain why this rate is 1 JPY to 1 USD, the interest on JPY is 0%, and the
interest on USD is 10%
strategy does not represent
an arbitrage opportunity. ❖ Assume you are a Japanese investor with 100 JPY to
invest
❖ 100 JPY are exchanged to 100 USD
❖ Now, after one year, you want to take your money back, but
realize that the exchange rate is 1 JPY to 2 USD
❖ You own 110 USD which worth only 55 JPY
3.16 a) We can value the portfolio (ETF) by summing the value of the
securities in it
An Exchange-Traded Fund (ETF) is a
security that represents a portfolio of
individual stocks. Consider an ETF for Price per share of ETF =
which each share represents a 2 × $28 + 3 × $38 + 3 × $17 = $221
portfolio of two shares of Hewlett-
Packard (HPQ), three shares of Sears
(SHLD), and three shares of General
Electric (GE). Suppose the current b) The ETF is too cheap. The rule of arbitrage: buy the cheap/sell
stock prices of each individual stock the expensive
are as shown here:
▪ Buy one ETF share: −$203
Stock Current Market Price Number of Shares ▪ Sell two HPQ share: $56
HPQ $28 2
▪ Sell three SHLD shares: $104
SHLD $38 3
GE $17 3 ▪ Sell three GE shares: $51
▪ Total: $18
a) What is the price per share of
the ETF in a normal market?
b) If the ETF currently trades for c) The ETF is too expensive. The rule of arbitrage: buy the
$203, what arbitrage opportunity cheap/sell the expensive
is available? What trades would ▪ Sell one ETF share: $233
you make?
▪ Buy two HPQ share: −$56
c) If the ETF currently trades for
$233, what arbitrage opportunity ▪ Buy three SHLD shares: −$104
is available? What trades would
you make? ▪ Buy three GE shares: −$51
▪ Total: $12
A4 a) If the security is half as variable, it should only
earn half the risk premium of the market
Suppose a risky security
pays an expected cash flow ❖Finding the risk premium (RP):
of $79 in one year. The risk-
free rate is 4.4%, and the
expected return on the 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑃 = 9.6% − 4.4% = 5.2%
market index is 9.6%. 1
𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑅𝑃 = 5.2% × = 2.6%
a) If the returns of this 2
security are high when b) First, we need to find the expected return of
the economy is strong the security:
and low when the
economy is weak, but
the returns vary by only 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝐸𝑥𝑝. 𝑅𝑒𝑡. = 𝑟𝑓 + 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑅𝑃
half as much as the = 4.4% + 2.6% = 7%
market index, what risk
premium is appropriate
for this security? $79
𝑃𝑟𝑖𝑐𝑒 = = $73.83
b) What is the security’s 1 + 7%
market price?
 a) There is an arbitrage opportunity. The Nasdaq ask
A5 price is too low, and the NYSE bid price is too high
Suppose Hewlett-Packard (HPQ)
stock is currently trading on the ▪ Buy a share from the Nasdaq dealer −$27.52
NYSE with a bid price of $27.54
▪ Sell a share to the NYSE dealer $27.54
and an ask price of $27.66. At the
same time, a Nasdaq dealer posts ▪ Total. $0.02
a bid price for HPQ of $27.40 and
an ask price of $27.52.
a) Is there an arbitrage b) There is no arbitrage opportunity.
opportunity in this case? If so,
how would you exploit it?
b) Suppose the Nasdaq dealer c) To eliminate any arbitrage opportunity, the highest
revises his quotes to a bid
price of $27.52 and an ask bid price should be lower than the lowest ask price.
price of $27.64. Is there an 27.66 27.66
arbitrage opportunity now? If 27.64
so, how would you exploit it?
c) What must be true of the 27.54
highest bid price and the 27.54
0.02 27.52
lowest ask price for no
27.52
arbitrage opportunity to exist?

27.40
Arbitrage No Arbitrage