Transcript for:
Introduction to Finance Theory

the following content is provided under a creative commons license your support will help mit opencourseware continue to offer high quality educational resources for free to make a donation or to view additional materials from hundreds of mit courses visit mit opencourseware at ocw.mit.edu so on behalf of the sloan school i want to welcome all of you to 15 401 finance theory this course is meant for first-year mba students and so that's the focus and i'm going to assume that that's the background that all of you will have we may have a few other students in the class but primarily it will be first year mbas who are thinking about a career in finance as well as those of you who aren't sure about a career in finance but are curious about it hopefully over the next 13 weeks we'll be able to satisfy that curiosity i want to start by talking a little bit about what finance is and you know how i got interested in it because i think it's often helpful in order to motivate a subject to get a sense of how somebody else decided to choose this as a profession to do that i have to go back a little bit and give you some background about you know my own educational experiences so let me start uh by mentioning that i've been at mit for the past 20 years uh and uh been in the finance group all that time before that i taught at the wharton school for four years and before that i got my phd in economics from harvard university then graduated in 1980 from from yale also majoring in economics and during that time i've learned an enormous amount both about finance and the real world but one of the things that i keep coming back to is the fact that the finance field is almost unique in how it applies to practical management problems and what i want to try to do over the next 13 weeks is to convince you of the fact that finance is in fact the most important subject that you'll ever encounter that in fact finance is at the core of everything that you will ever do in business and in management now that's a tall order i recognize and i suspect that some of you are quite skeptical about the role that finance might play in your own career objectives and i know many of you have very different career objectives and i'm not even trying to convince all of you to go into a career in finance but i am trying to convince all of you that finance is really the lifeblood and the basic lingua franca of all of business and that's one of the reasons why finance is such an important subject now before i begin let me let me ask you a question how many people have had no finance background whatsoever well that's great i i look forward to a challenge but the other reason it's great is i have to tell you that it's a real privilege for me to be here in front of you to tell you about finance for the very first time and it reminds me a little bit of my younger son who is an extraordinarily fussy eater he's eight years old now but ever since he was born he had some allergies and he just refused to eat most of everything in fact my wife often say that my younger son is a vegetarian except he doesn't need vegetables so he's an incredibly fussy eater and somehow when he was one year old he saw my older son eating an ice cream cone and figured that that's something he ought to try how he figured that out i don't know but he tasted it for the very first time and you could see his face change in about four seconds from disgust to curiosity to absolute you know enthrallment with the taste and feel of ice cream he just loved it thereafter that's one of his major food groups now it's ice cream and so i feel privileged to to be able to share that experience here in the sense that once you get a taste of finance i think you're going to be incredibly excited and enthralled by the subject because it's one of the few subjects in fact it's the only subject that i've encountered that is both rigorous it's extraordinarily challenging from a research an intellectual perspective and at the end of the day it's extremely practical in fact i would say it's indispensable for financial management so i'm going to try to convince you of that over the next 13 weeks and i'm going to do that by going over material that you will find indispensable you know as many of you know at the end of the course we have a ritual where we hand out teaching ratings and among the finance faculty among all the faculty we're very concerned about about good teaching so these teaching ratings actually matter and i've always thought that having a teaching rating survey at the end of the semester is somewhat misguided what i'd like to do and what i've proposed hasn't been adopted yet i propose to have teaching ratings submitted five years after a course is done now this may be problems for you know for some people who you know aren't uh up to speed in the classroom but the reason that i say this is because it will only be after you get into your jobs into your careers before you realize how useful finance is and five years from now i suspect all of you will come back and say gee this is one of the most important courses you've ever taken not not because of me but because of the substance of what we're going to cover over the next 13 weeks because of you and all of the work that you will put into this course uh this will be the most challenging course you will ever love so uh uh stealing from the military i think that you'll really appreciate uh how the discipline of financial logic will help you to think smarter about all of your management decisions no matter what you decide to do with your careers now that's a very tall order i've built up expectations so i'm going to have to deliver over the next 13 weeks and we'll see whether or not we can do that but let me start now by talking about what we're going to cover today i want to start with a little bit of motivation uh and then talk about the dramatus personae these are the cast of characters that we're going to be focusing on over the next 13 weeks and then i'm going to lay out the fundamental challenges of financial analysis it turns out there are only two there are only two challenges in financial analysis once you figure both of those out you're done so if by chance you can figure that out before the end of the class you don't need to come back for the rest of the lectures then i'm going to turn to providing you with a framework for thinking about these financial challenges to me it's very important to have a framework to start with because i like to organize my thoughts into things that i know and things that i don't know and of the things that i know how did it relate to the stuff that i already knew or thought i knew so i want to give you a sense of that kind of framework to think about financial analysis up front you probably won't fully appreciate it at this point but sometime over the next 13 weeks you will get it and so i want to give that to you so that you can start thinking about it subconsciously unconsciously and then eventually you will understand how all the pieces fit together i then want to talk about the importance of two aspects of financial analysis that make finance different from every other discipline you will ever encounter here at mit and elsewhere and that is time and risk without those two factors it turns out that finance is actually done in other words there's no real research challenges no open questions left once you eliminate time and risk put another way the only reason that there exists a finance department and finance faculty and finance journals and a finance industry the only reason is because of time and risk so i'm going to come back to that then i'm going to conclude by giving you the six basic principles of finance these are principles that you will encounter in all of your finance courses for the rest of your stay at mit and elsewhere these are the ideas the fundamental ideas that have shaped financial markets and that are at the root cause of all of the financial market innovations as well as all of the financial market crises that we've seen including what's been going on over the last several months in the subprime mortgage market in fact we're going to talk about the subprime mortgage problems after we cover fixed income securities right now i suspect most of you know that there's something going on know that it's bad stuff but you don't know why how where when and what to do about it well in about five lectures you will it's not complicated but it's different from anything that you've ever encountered and in fact financial analysis i suspect is different from anything most of you have ever encountered i'm hoping that by the end of the course it will change the way you think about everything and again i recognize that that's a tall order but you tell me 13 weeks from now whether or not i've delivered okay and then i'll conclude by talking about a course overview and then finally i want to say a few words about how as a student you can get the most out of this course this is a part of the lecture that i've always felt is critical at the very start of a course like this because there are a number of challenges that you will face over the next 13 weeks regarding this material and i've always thought that it would be helpful for the instructor to let me know where those challenges might come from and what i should do in advance to prepare for those challenges so i'm going to do that at the end of this uh hour and a half for next time i'd like you to read brilliant myers chapters one and two uh we are going to be covering that today as well as uh next monday so uh please keep up with your readings all right and at the end of this lecture i will talk a bit about uh the course requirements and other aspects of the course mechanics okay any questions all right let me start with some motivation about why you might want to study finance and why finance is so important and i've always found that with motivation it's really best to do it in a personal way that is to try to find an individual or a group of individuals that personify a particular discipline or endeavor and so there are three people that i'd like to introduce you to i suspect you'll know at least two out of the three my guess is you won't know all of them the first person before i do that i want to introduce a very simple definition of what finance is so this is the very first equation that you'll ever see in this course and there'll be many others of course but the first expression of exactly what is finance is this finance is simply equal to mathematics plus money now that suggests that mathematics as a discipline is equal to finance without the money but really that's not that's not my that's not my point although it's true by the way that's not my point my point is that finance is the study the systematic and disciplined study of financial transactions of money now when you see this you might think well gee i don't really have a strong math background maybe i'm in the wrong place or the wrong class and i want to explain to you that that's completely inaccurate and and inappropriate when i say mathematics i'm actually talking about a very wide range of mathematics everything from the extraordinarily complex and profound to the extremely pedestrian and obvious so literally the range from differential geometry and partial differential equations on one end of the spectrum to arithmetic and high school algebra at the other end of the spectrum now since this is an introductory finance class i assume that you know nothing what i mean by that is i assume that there are no prerequisites that you have other than what it took for you to get into here which is pretty substantial by the way congratulations to all of you for getting in but we're not requiring that you have any background in quantitative analysis computers upper level mathematics so when i say finance is equal to mathematics plus money there's a variety of kinds of mathematics that could be appropriate for creating an extraordinarily profitable career in this industry and now here are the three examples anybody know who james simons is who is here you know about renaissance technologies do you know what james simons did before he started renaissance technologies yeah he's a math professor that's right james simons uh is a math professor well was a math professor in fact he was quite a well-known math professor uh when i first heard of him it wasn't because of renaissance technologies which is a hedge fund that he started about 15 or 20 years ago james simons was a differential geometer who for many years was the chairman of the math department at the stony brook in new york and he authored with ss churn a particular field of study in differential geometry called churn simon's theory which has subsequently proved to be extraordinarily useful in an area of physics known as string theory extraordinarily abstract and simon started a hedge fund about 20 years ago and this is probably the single most successful hedge fund in the history of the industry in terms of its performance record over the course of 15 or 20 years he's put together a track record that has literally beaten every other hedge fund manager's track record by a lot so it's not just a little bit he's just sort of way out there he's the michael phelps of quantitative investment strategies by the way just to give you a sense of how successful he has been in 2006 two years ago it was reported by institutional investors alpha magazine this is a trade publication for the hedge fund industry it was reported that james simons was the single most highly paid hedge fund manager that year with a take-home pay of 1.7 billion dollars now that's not wealth that's income that's his that was on his w-2 that was one year's compensation and he did it he did this by building a quantitative investment management company with 75 phds in mathematics physics computer science and so on and nobody nobody knows what he does or how he does it it's extraordinarily secret but there's no doubt that he's incredibly successful so that's one end of the spectrum that kind of mathematics can make money uh and can be extraordinarily relevant financial analysis now at the other end of the spectrum we have this guy you may have heard of him warren buffett he uh is currently the richest man on earth in 2008 forbes ranked him number one in terms of wealth at the time february of 2008 he was worth 62 billion dollars in fact in a private conversation i was told that uh you know when simon's found out he said really 62 billion how did he get that that's amazing that's an extraordinary amount of wealth for an individual to put together and what's extraordinary about it is how he did it as many of you know warren buffett is an investor based in omaha nebraska his office is probably smaller than many of the conference rooms here at sloan the number of people he has working for him i suspect is fewer than many of you who have done your startups or planned to he's got an extraordinarily small staff mainly it's charlie munger and him and a couple of secretaries and maybe a few accountants here and there and lawyers of course but what he does is to read company prospectuses income statements balance sheets and with literally high school arithmetic he's built this incredible investment empire by looking at valuation simple accounting now i say simple accounting but there's nothing simple about what he does and so clearly he has certain skills that it also involve mathematics but not the kind of mathematics that james simons uses and finally the third individual that i'd like to introduce you to is this fellow jack welch now again many of you know him or know of him you know that he actually teaches a course here at sloan but you may not know that his phd was actually in engineering and he started out at general electric in 1960 became ceo in 1981 and at that time the revenues of general electric was about 26 billion dollars a year so it was already a big and successful company and jack welch took it over in 1981 at the time there were four hundred thousand employees for general electric five years later there were three hundred thousand employees at general electric he eliminated a hundred thousand jobs that's one of the reasons why he developed the nickname neutron jack because like a neutron bomb he eliminated a huge segment of the population but five years later with three hundred thousand employees he increased the market value of general electric by several fold and at the end of his tenure in 2001 20 years later general electric's revenues was not 26 billion was 130 billion he increased it by a factor of four and a half over the course of 20 years it's an extraordinary accomplishment for an individual now why do i put him up here it's because one of the things that welch did at general electric one of the things that he was extraordinarily good at was making good decisions about investments making good decisions about costs being able to understand the language of finance despite the fact that he used none of his phd skills in his job he was an engineer by training not a a manager he didn't go to management school although he did a lot of executive education after his phd the reason that i give you these three cast of characters is because they are so different in what they do they have such different backgrounds they're all extraordinarily successful but there's one thing in common the thing in common is that they all understand innately deeply fundamentally the language of finance and what we're going to cover over the next 13 weeks are the very basics things that they take for granted things that they use on a daily basis to do their jobs so it's not to say that if you do well in this course you'll end up being one of these guys but it's certainly a prerequisite i would say there's nobody that's been successful in business truly successful without having an understanding at least an innate or instinctive understanding of the concepts that we're going to cover over the next 13 weeks so to me that's exciting now again i i'm not trying to motivate you by greed uh i'd rather motivate you by the intellectual challenge of finance and there will be some extraordinarily challenging ideas ideas that are not natural for any of you at this point but which i hope will be very natural at the end of this 13 weeks okay so let me start with the cast of characters that we're going to be studying over the next 13 weeks there are going to be four components of the economy that we're going to focus on now this is a flow diagram of the economy since we're at mit we have to have flow diagrams at some point right so here's my version of a flow diagram there are this is a flow model of the economy and there are four components that comprise the financial system households financial intermediaries non-financial corporations and then capital markets now obviously the economy is comprised of additional components like labor markets and product markets we're not going to focus on that although there are certain financial aspects of those markets given that we only have 13 weeks our attention will be spent on those four components and i'm going to cover each of those four components both in parallel and to a certain degree sequentially all right so i want you to be familiar with these four because we're going to be talking about them interchangeably at various points in time financial analysis applies to all of these components in exactly the same way but once you apply them to the specific context the terminology may change the particular applications may look different what i'm going to try to teach you in this 13 weeks is the underpinning theories that unify all of the various different kinds of ideas all right so these are the four components that we're going to be looking at uh from now and then now let me talk about the fundamental challenges of finance i told you that there are only two right and here they are there are two aspects of financial analysis that we're going to be focused on the first is the valuation of assets and the second is very simply the management of assets that's it that's all there is to it valuing and managing and i can tell you exactly what the managing part is going to look like managing is going to involve figuring out which of two possibilities is more valuable and then you know what you take the more valuable option that's it that's all there is to it figuring out the value that's going to be challenging so we're going to take that first challenge to start with and try to understand valuation i'm going to argue that all business decisions any kind of business decision involves those two challenges valuing something and then once you value it make a decision on what you want to do with that value right this is why i've argued that finance is the most important subject because literally any business decision that you will ever engage in constitutes those two components valuation and management now valuation is going to be a challenge by itself because it's not at all clear what value we're talking about in other words what what is value is water valuable well life can't be sustained without it at least carbon based forms of life so water is pretty valuable but water is not that expensive at least before poland springs came along now what about diamonds as far as i know humans do not need diamonds to survive and yet diamonds are extraordinarily expensive there are certain gems that are invaluable how could that be clearly we have to think more carefully about what we mean by value and of course once value is established then management is relatively easy to do objectives plus valuations obviously leads to decisions so once you tell me what you're trying to achieve and then you value all the various different possibilities then i can tell you what the right decision is pick the decision that is the most valuable for achieving the objectives that you want now that doesn't really help a lot if we can't apply this to specific context and come up with specific value so i want to hammer this home and to do that i want to talk about how it is that financial markets helps us establish value through the price discovery mechanism and to do that i i'm gonna do a simple demonstration now you know when i was growing up i uh i went to one of these uh specialized high schools that focused on science so we were always getting these various different kinds of neat demonstrations you know of the tesla kind of coil and you know i've always been very jealous of these science teachers because they have these cool demonstrations that we in finance don't so i've developed a little demonstration of my own it's a very simple one that has to do with the price discovery mechanism and because i teach two sections i'm gonna have to make it a little bit more involved than normally so i need two volunteers the first volunteer thank you i'd like you to take these two pieces of paper these are blank pieces of paper on one of them right heads and the other right tails and then place them face down and shuffle them so you don't know which is which okay and then i know another volunteer who has a coin that they can flip because thank you so as soon as he's done i'm going to ask you to flip a coin do you have a coin by the way okay i have two items here one of which is going to be auctioned off in this section and the other is going to be auctioned off in the later section and since i don't know what your preferences are for one or the other i want to randomize this so there's no chance that i favor one section or the other okay so are you done with that you shuffled them you don't know which is which okay i'd like you to take these two face down and put one in front of one of these uh packages and the other in front of the other face down as well okay while you do that can you go ahead and flip your coin and as soon as he puts that on there i want you to tell me whether you flip heads or tails and based upon that the particular object that is uh chosen will be auctioned off in this particular section okay go ahead what have you got tails okay so tails this is heads and this is tails so here is the item that i'm going to auction off before i do that i'm going to ask somebody anybody know what's in here nobody knows what's in that box well what do you think its value is zero negative can't be negative right there's limited liabilities you can't owe me for something that's in there so good that's we've established some information there's a zero lower bound okay well i don't know what the value is so what we're going to do is we're going to figure it out rather you're going to figure it out i'm going to auction this off and now this is for real so don't bid if you can't pay me and and and by the way i expect to be paid in cash all right so i'm serious this is a serious game so if you don't want to participate you're not prepared to pay me in cash at the end of this lecture do not bid all right okay i'm going to open it up anybody want to start bidding for this item dollar three dollars six all right six dollars can't do that all right six dollars is the high bid ten okay we got two tens here you were the first so that's your bid your bid is a high bid ten dollars twenty we got twenty whoa twenty dollars you do see that this package is smaller than this one right it's a tiny little thing twenty dollars thirty dollars thirty dollars high bid any more than thirty dollars yes i get the money that's a great question that's a great question this is going to go to the foundation to support andrew lowe it's uh i'm the charity so this is not a this is not a charity auction this is going to go to me by the way i paid for these items so that's why it's going to go to reimburse my my teaching costs right okay 30 high bid any any higher bid than that 30 dollars nothing higher 31. 35. okay do i hear 40 anybody want to do 40. dollars forty dollars all right we got forty dollars anybody willing to go 45 45 dollars all right forty five dollars wow okay do we hear fifty fifty dollars forty five is the high bid anybody for 50. no shorting sorry i'm the only auctioneer here 45 is the high bid anybody here 50 going once going twice all right sold 45 dollars now you're going to pay me right all right we established the value it's 45 dollars that's the market at work none of you knew what was in here it could be it could be nothing actually but but but isis but i suspect i suspect that you didn't think it was nothing because you bid for it right moreover i didn't let you touch it i didn't let you feel it i didn't let you shake it there was no information whatsoever other than this very pretty packaging and yet somehow magically you were able to come up with a value now we could argue whether that value is good or bad but it's a number and it's a number that can now be used for analysis now again i'm not commenting on how good or bad the number is in a minute we're going to find out because i'm going to open this or let this gentleman here open it and see what he bought but before he does that i want to comment that knowing nothing without any information whatsoever we've established value that's remarkable now it's not true though that there's no information in fact there's a tremendous amount of information in this room tremendous amount because you know a number of things you know about the size of packages you know about the fact that i'm a professor and if i really cheat you that i might get in trouble uh with the dean you there are a number of constraints that uh are in place and with this audience those constraints affected the value for the next five weeks that's what we're going to be doing is talking about valuation and trying to understand how what just happened happened okay would you like to open it up and let us know what you got for your forty five dollars and you let me know whether this has been a good deal or a bad deal for for you and for me oh just rip it my wife does this all the time it drives me crazy just you know my sons are just fair point fair point anybody know what the retail value of that is it's an ipod nano four gig version 149 to be precise so you got a good deal you're welcome thank you because what we did was to engage in a price discovery process with limited information with limited information i couldn't get the value out of that that i wanted to i would love to have gotten a bid of 149 but would any of you be willing to pay that for a box with no information at all probably not so the lack of transparency the lack of information actually reduced the value of that object but nevertheless it did have a value because some of you were willing to take a chance that there might be something interesting in that package that is what we're going to try to understand over the next 13 weeks and for the first five of those weeks we're going to try to take it apart we're going to try to understand how it is that the market comes up with the value and it's going to be a challenge this is hard to do because just like if we decided to spend the rest of the lecture figuring out how you came up with a 45 bid or why you weren't willing to go to 50 it's going to be really hard for us to to tease out all of the thinking that went into this kind of discussion so that's why we have work to do it'll be exciting work because at the end we are going to come up with specific quantitative analysis that will tell us how valuation is done so that's what we're going to focus on for the next few weeks okay clearly once we figure out valuation we can then focus on management and the first two thirds of this class will be focused on valuation the last one third will be focused on taking those ideas and applying them to management contexts like capital budgeting and risk management okay for evaluation the kind of questions that we're going to tackle are ones that implicitly we did in just a few minutes here it's going to be how are financial assets valued versus how should they be valued and is that always the same is it the case that financial assets are valued the way they should be valued and what do we even mean by whether or not it should be valued in a way or not and finally we're going to ask the question for valuation how well do financial markets really work can we always rely on them to work well in this case i don't know if you would call this particular auction uh a one that worked out well certainly worked out well for you but it didn't work out well so for me so in what sense did it work out well well it worked out well in the sense that if i really wanted to get rid of that box if i really wanted to unload it i actually was able to do that and i got something for it sight unseen with no information whatsoever i actually got forty five dollars roughly a third of the value of the asset that's actually not too bad if you're trying to sell an asset sight unseen and you need to do it immediately a 66 discount is actually pretty fair now we're going to see more examples of that over the next few weeks once we determine value then the question is management how much should i save or spend that's a management question that all of you have to deal with at some point or another in your lives what should i buy what should i sell when should i buy and sell it and how should i finance the transaction those are the problems of financial analysis plain and simple these are problems that apply to jack welch to james simons to warren buffett and to you and it applies to you not just from the corporate perspective but from the personal perspective as well every one of you have to think about these issues on a daily basis and so finance really is completely uh inclusive in the sense that it applies to virtually everything that you will ever encounter in life okay to do that i have to go over the framework of financial analysis and the starting point is accounting accounting is the language the the the lexicon of finance in that it's the beginning of how to measure economic concepts like profit and loss revenues and and costs and so on so while many of you may not have accounting backgrounds you will learn a fair bit of accounting in this course just because you're going to have to in order to understand the material in the lectures okay so you'll need to get familiar with the basic terms of accounting and in particular you're going to have to focus on two concepts that are probably alien to you the notion of a stock and a flow now when i say stock i don't mean common stock or equities i have a different term in mind by stock in this context i mean the stock of assets the level of assets and by flow i mean the rate of change of assets you know when i was in grad school we started discussing this concept in the first day of macroeconomics and then one of the students in the back of the room said excuse me professor but isn't that just the the distinction between a variable and its first derivative and uh you know the uh the professor was a little bit uh taken aback and said well yes that's right but let me give you another way of thinking about it it's somewhat more intuitive and that is think about a bathtub and think about the faucet turned on and the water flowing into it the stock is the level of the water the flow is how fast the water is coming into the tub and so after that explanation the student still seemed confused and so the professor said you know what some people find bathtubs intuitive other people find derivatives intuitive so to each his own this these two concepts are extraordinarily critical to financial analysis and the accounting counterparts are nothing more than the balance sheet and the income statement the balance sheet measures the stock of wealth of a company what your assets are and what your claims on those assets or liabilities are on the other hand the flow of wealth into a company or out of a company is measured by the income statement this tells you how much the company is making per unit time versus uh its losses okay so the framework for financial analysis that we're going to be coming back to time and again is this framework of a corporation a corporation has a certain set of assets it's got claims on those assets which are called liabilities so this picture this snapshot measures the level of the bathtub but that's not enough to understand how a company is doing you also have to look at the income statement which tells you the sources of funds and the uses of funds over any time period typically on a quarterly basis so we're going to come back to this concept as the framework for financial analysis and by the way this is the sum total of the tools that warren buffett uses for analyzing his investments that's it believe it or not nothing fancier so it's an incredibly powerful set of ideas if you know how to to uh to read it okay that framework when you think about it from a corporate financial decision perspective involves making decisions at five points in time corporate financial decisions involve thinking about how to deal with cash raised from investors how to think about cash invested in real assets and how to deal with cash generated by operations how much cash to reinvest and how much cash you give back to your investors so from this you should get the idea that as a corporate financial officer you are focused on cash the flow of cash in fact cash you can think of as the lifeblood of a company if you follow the cash you will eventually hit upon every important aspect of the modern corporation's operations and as a financial officer you will be responsible for analyzing that flow and as a decision maker as a leader of a corporation you're going to have to make decisions about that cash flow jack welch uses the information to be able to make those decisions but he doesn't just get those decisions pre-packaged for him he has to understand what those numbers mean just like warren buffett now the corporate financial decisions involved obviously have a variety of different uh different components from a perspective of career career paths from the management perspective real investment decisions involve two and three so if you're thinking about investing in a new division or a new plant or getting involved in a new product area you've got to focus on two and three on the other hand if you're the chief financial officer and you're thinking about how should the company finance its operations you're going to be focused on one and four if you're the board of directors and you're deciding how much to pay out to the shareholders you're going to be thinking about five and if you're engaged in managing the risks of the corporation you're going to be worried about one and five and ultimately your objective as a shareholder and as a manager of this corporation is to do well by the owners so your objective is to maximize shareholder wealth and the framework that i've introduced is going to allow you to do that now again this may seem kind of theoretical to you and i realize that so i'm going to ask you to make this more personal and to do that i'm going to ask you to turn this into your own personal household financial decision making framework so i'd like you to take all of these ideas and literally apply them to yourself think about the cash flows that are flowing through your own life there may not be that much right now since you're at school but believe me it will grow so the household this is you sits in between real economic activities in other words your job and financial assets and liabilities which are all of the financial transactions that you deal with so this cash flow process that i outline for corporations it works for you too so there's cash raised from financial institutions right like student loans or borrowing or home equity loans there's cash invested in real assets what's the biggest real asset that you are all investing in right now exactly human capital yourselves your own education okay cash generated by labor supply well obviously when you get a job you're going to be generating cash cash consumed and reinvested in real assets so consumed means beer or pretzels whatever and invested in real assets means you invested either in yourself or you invest it in a home or or your children those are real assets sometimes they're also real liabilities but that's a separate issue and finally cash invested in financial assets most of you may not have a lot of financial assets at this point but you actually have some i suspect 401k plans retirement social security those are financial assets that whether you know it or not you're invested in and so when you think about management think about personal management how are you managing yourself you've got to think about real investment consumption and financing savings and investment risk management and obviously what is your overall objective in life and what you ought to be doing is with that objective in mind managing your real and financial assets to maximize the likelihood of achieving those objectives right so what i'm asking you to do is i want you to take this course personally i want you to take the ideas every single idea that i mention and whether i tell you to or not for the next 13 weeks i want you to take that idea and ask the question how does that make my life better off how can i use that in my own personal management activities to improve the kind of decisions that i'm making because if you could do that if you learn how to do that instinctively you will then take those ideas and apply them to management contexts in your career and it'll make it much more likely that you'll get more out of this course than you otherwise might now there are two other factors that i described that make financial analysis challenging and those two factors are time and risk i've argued before that without these two elements finance is complete there is no more research to be done there's no more analysis to be done and all of you probably will already be able to intuit a lot of the decisions that you're going to be forced to make because without time and by time i mean decisions at different points in time without time and without risk financial decisions actually reduced to basic microeconomic analysis if you've taken an undergraduate course in microeconomics supply equal demand well you've learned all there is to learn about finance without time and risk the only reason that finance is interesting the only challenging aspects of what we do are because of time and risk the fact that cash flows now are not the same as cash flows later and the time flows in only one direction in about four lectures i'm going to give you an alternative proof of the theory of special relativity and this proof will have to do with the fact that interest rates are non-negative it turns out that there's a very deep philosophical connection between finance and physics that we're going to get to okay but this is something that you don't need to be physicists to understand in fact i would argue that warren buffett although he may not be able to articulate these principles these are principles that are somehow inbred in his world view he knows that a dollar today is not the same as a dollar next year and he also knows that a dollar today without risk is not the same as a dollar today with a little bit of risk even a tiny little bit of risk he knows that and at the end of this course you will too so risk we have to talk about in a much more serious way we're not going to get to that for probably six weeks because that's going to take a whole different set of tools to understand so what i'd like to do for the first three or four weeks is to focus on time and just time and then i'm going to bring in risk once we develop a little bit more machinery to understand how to capture risk and when we put these two together we're gonna get modern finance so that'll happen sometime in weeks six seven and eight now finally i want to talk about the fundamental principles of finance and then i'm going to talk specifically about this course there are six fundamental ideas that finance has come up with that really will change the way you think about the world and you won't appreciate it today i know that but i want to put it into your subconscious today because sometime over the next 13 weeks at least i hope over the next 13 weeks your face will light up and you're going to get it one day you're going to get it in the sense that you will understand at that point in time how these six principles can be used to make any financial decision that you need to make for the rest of your careers the first principle is pretty obvious there's no such thing as a free lunch actually all of these principles are approximations to a much more complex truth so if you really want to be strict about it it should read there may be free lunches on occasion but there's no such thing as a free lunch program there isn't systematic free lunches you might be able to find one or two every now and then if you're lucky and if you work hard but systematic transfers of wealth for no reason at all are unlikely second principle other things equal and this is a phrase that you'll hear economists utter all the time and of course other things are never equal but let's pretend that they are other things equal individuals satisfy three characteristics they prefer more money to less that's often called non-satiation they prefer money now to money later and they prefer less risk to more risk when risk is defined properly now i'd argue that these principles are in fact fairly universal not that you can't find exceptions every now and then for every individual but by and large over periods of time and over a large population this is generally true and if you don't believe me or if you know people that don't satisfy these principles please introduce them to me after class i'd like to get to know them and do some business with right principle three all agents act to further their own self-interest now again this is not to say that there aren't mother teresa's out there that there aren't people that care about the general welfare of the public but economists in their own unique and annoying way have been able to redefine preferences to even argue that mother teresa is incredibly selfish because her utility function is the function the utility function of other people and so by doing all this good mother teresa was only furthering her own self-interests isn't she so selfish now so in a way when the economist defines preferences they almost define it as a tautology but finance makes economics practical in the sense that i'll describe in a few weeks exactly what kinds of preferences are actually embodied in decision making and why this principle is more often than not a pretty good approximation to a much more complex reality now the last uh three principles i'm not going to talk about in great detail because those really embody a much larger set of issues about economics and finance we're going to talk about those three principles but only in the last lecture oddly enough we're going to use them we're going to use these principles but in the last lecture i'm going to question all of the framework that i've developed for you and show you where the holes are for the first 13 weeks i'm going to need you to willingly suspend your disbelief as we describe the relatively straightforward and standardized framework for thinking about financial problems and in the last lecture i'm going to describe to you where the approximations were made and why you need to take advanced courses in finance to fill those gaps okay so with that said let me now turn to course overview and then i'll take questions about course mechanics they're going to be four sections of the course as outlined in the syllabus the four sections are the introductory material which we've gone over today section b which we will cover for the next three or four lectures is valuation discounting in the mathematics of net present value pricing stocks bonds futures forwards and options and the relative kinds of issues that come up across those different asset classes okay section c will focus on risk and introduce risk into the framework of section b so once we complete section c we will then focus we will then have focused on time and risk and finally section d will be how to apply those principles to problems in corporate finance what jack welch did from 1981 to 2001. how do you take these ideas and apply them to practical circumstances okay and then the last lecture will be a lecture this is not the same last lecture as other last lectures i'm not going to die but so i don't mean to call it the final lecture that sounds a little ominous the idea behind this last lecture is to put it all together and explain how these financial theories interact with imperfections in the marketplace and what is or is not good approximations okay let me talk about course requirements now obviously the lectures and the readings uh and attendance and participation will be an important part of the course we are not going to cover the entire tome of breeley myers and allen this is a book which if dropped off of a six-story building could actually kill somebody if it hit them so we can't possibly cover the entire textbook we'll cover selected chapters but this is finance 401 so it's an introductory course and so the readings that you're going to be responsible for are the ones that are outlined on the reading list and that i've listed in every lecture okay so for example chapters one and two you are now responsible for and we will be grading class participation so i expect you to come to class prepared and ready to discuss material and possibly questions that we may have raised in the previous lecture and there will be one case study that you will be responsible for writing up and handing in and that will be worth 10 of the grade and attendance and participation will be worth another 10 so that's 20 of your grade and then finally the midterm and final exam will be worth 25 and 55 percent let me explain a little bit about how the midterm and final exam works because it's a little different in this class than in some of the other classes and by the way this grading scheme and the particular mechanisms are identical in these two sections that i teach and in the sections that professor wang teaches so he and i have coordinated to have the same approach so as not to advantage or disadvantage any one section in your readings packet will be a collection of of problems that we've put together and actually i don't know if it's in there right now or if it's being photocopied but we will prepare uh a list of problems that you can work on these are completely optional and there are far too many problems for you to be able to do uh even in one full semester the reason we give them to you is because the only way to learn finance is to do finance if you come into the class and listen to my lectures you may be entertained for an hour and a half you won't learn the material in fact i've now changed the way i talk about the course and i don't describe what i do as teaching anymore because teaching implies that i can force feed knowledge into your brains it turns out it can't be done and my two sons have proven that to me time and again you have to want to learn the material so you have to pull the knowledge from me into you in other words you have to be an active participant you know my 12th grade math teacher used to say that mathematics is not a spectator sport that's the same for finance finance is not a spectator sport you actually have to do it you have to confront yourself with problems time and again and think about how to apply the principles in our lecture to those problems the purpose of lecture is to give you the motivation and take you through the most difficult aspects of the principles and the theories of financial analysis but it's your job to do the analysis and to to that end we're gonna give you some motivation and the motivation is that the midterm and the final exams are structured so that most of the weight is placed on the final the reason is the final is cumulative so it's going to cover twice the material as the midterm therefore it should be worth roughly double but the other reason is that financial analysis is alien to the typical human cognitive process none of you are hardwired to engage in net present value calculations and so it's going to take some time before you get it before it sinks in and i've taught this class many times before and usually somewhere between week 8 and week 13 a light goes off in your head and you get it and i see this by the the bright smiles on your face around that time it could be because you're getting to the end of the semester and you're glad to be done with the class but i like to think that it's because at some point you actually get it in a few rare cases it happens in week 14 which is not so good but hopefully before the final exam now in order to provide you with extra incentive to do problems and given this is an mba class i realize that all of you have very busy schedules and you can schedule your own activities better than we can so rather than have weekly problem sets that are due and you have to hand them in we have to hand them back it's a hassle for everybody there are no problem sets in this class none however we're going to give you a package of problems and solutions up front you'll get that within the next few days and i will promise you that the majority of exam questions will come verbatim from this package of problems majority meaning more than 50 of the points will come from the package so if all you did was to memorize this entire stack you could ace the course but of course that wouldn't that would mean you would spend enormous amounts of time in finance which is not such a bad outcome either so we want to do this to eliminate a lot of the fear and anxiety with financial analysis it is challenging but it's a lot of fun too we want you to have fun because that's the only way you're going to learn this material well so it's up to you as to how much you want to do the recitations will cover selected problems so you're not going to be left on your own the recitations will go over problems and how to solve them i'll do a few in class the ones that are particularly challenging but then you'll need to do more on your own and if you do that you will be prepared for the final exam better than most the other material will be readings and lecture material and therefore there will be some customization because my lecture style is different from professor huang's but the majority of the exam will be identical and it will be drawn from these problem uh banks that you're going to get a copy of in advance okay now frankly i have to tell you that i don't really like to give grades at all but i'm forced to do so and so that's why we set up this uh this process for assigning grades in fact a few years ago i came up with what i thought was a brilliant way to assign grades but i haven't been able to convince the dean's office to let me do that and you know what it is it goes like this let me show you i propose to give everybody in this class a b that's it everybody gets a b now before i do this how many people would object to that raise your hand are those of you with your hands up you get a's done you see how brilliant that is i get a great distribution no work the only problem is it only works once and when you're teaching two sections uh somehow the second section it doesn't work as well so i'm sorry i have to give grades uh you're all adults i realize that and uh but nevertheless this is a necessary part of the curriculum so that's how we're going to be assigning grades okay in the last four minutes and i think we we i'm going to try to keep on time for the entire semester so we end it at uh five before the half hour and we start five after the hour in the last four minutes i want to tell you a little bit about how to get the most out of this course and we can take this up next time if you've got questions but i want you to spend time thinking about this most of this course will be devoted to theory but finance is not a theoretical subject unlike algebraic topology that's a theoretical subject i've never heard anybody become a practical or applied algebraic topologist finance on the other hand there's there's no finance without practice so while the course will be focused on the theory i need you to think about the practical elements of it and i'm going to help you in a couple of different ways one is by problems but the other is to encourage you to to sit in on a pro seminar called the practice of finance this is a new pro seminar that we're launching september 17th is the first meeting it doesn't carry any units so you can come and go as you please but it'll give you a sense of the practical aspects of the industry and in particular information about the career aspects of the industry like what are starting salaries for financial analysts or how do i get a job in finance if i don't have any background in it it'll go through those kinds of issues so i'd encourage you to keep that in mind the second thing is with respect to the course i will give you lecture notes ahead of time for all of the lectures i expect you to take a look at them in advance just skim them you don't have to read them and try to sort out what i'm saying but i want you to skim it at least and then in class i urge you to take lots of notes because the lecture notes are not meant to be complete in fact they are purposefully incomplete so that you have to use your hand and write down your impressions of the material as i'm speaking because in that method you will actually absorb more of the material and it'll stay with you longer okay i would urge you to review the lectures afterwards review what i said because you may have heard what i said but you may not have understood what i said and you may not be able to apply what i said so you need to spend time afterwards soaking it in i urge you to work on the assignments in groups but also alone because when you do the midterm and final exams you'll be doing them alone so do both don't just assume that you can do the same in groups what you will do alone and finally i would ask you to ask plenty of questions i'm going to manage the class discussion so that if we have time i'd be happy to talk about issues that are are current and on your mind uh even you know whether or not you should refinance your auto loan we're happy to take those kind of questions assuming that it's apropos and that we have the time to be able to cover that i want you to get engaged i want you to take this course personally because that's the only way you're going to really learn the material all right thank you very much we're out of time we'll see you next monday