Fundamentals of Finance: Investments, Corporate Finance, and Financial Institutions
By Mustafa Akan and Arman Teksin Tevfik
Contents
About the Authors VII
List of Figures XV
List of Tables XVII
Preface XXI
Part I: Introduction to Finance, Money and Interest Rates, and Time Value of Money
1 Introduction to Finance 3
1.1 Introduction 3
1.2 What is Finance? 3
1.3 Why Study Finance? 4
1.4 Eleven Principles of Finance 5
1.5 The Financial System and its Functions 6
1.6 Types of Financial Institutions 8
1.7 Types of Financial Markets 10
1.8 Types of Securities 11
1.9 Summary 12
2 Money and Interest Rates 13
2.1 Introduction 13
2.2 Overview of Monetary System 13
2.3 The Definitions of Money Supply and Control of Money Supply 14
2.4 Money Supply and Economic Activity 16
2.5 Interest: Cost of Money 18
2.6 Structure of Interest Rates 20
2.7 The Yield Curve 22
2.8 Central Banks 26
2.9 Central Bank Balance Sheet 27
2.10 Banking Regulation and Supervision 29
2.11 Summary 29
3 Time Value of Money 31
3.1 Introduction 31
3.2 Conceptual Background 31
3.3 Simple Interest 32
3.4 Compound Interest: Future Value Calculations 32
3.5 Compound Interest: Present Value Calculations 34
3.6 Annuities 35
3.7 Perpetuities and Uneven Payment Streams 37
3.8 More Frequent Compounding 38
3.9 Continuous Compounding 39
3.10 Amortized Loans 40
3.11 Sinking Fund 41
3.12 Summary 43
Part II: Investments and Portfolio Management
4 Bonds and the Markets 47
4.1 Introduction 47
4.2 Bond Terminology and Features of Bond Markets 47
4.3 Bond Valuation 51
4.4 Pure Discount Bonds 54
4.5 Bond Price Changes 55
4.6 Measuring Bond Price Volatility: Duration 56
4.7 Convexity 59
4.8 Immunization 60
4.9 Bond Portfolio Management Strategies 62
4.10 Bond Portfolio Performance Measurement 64
4.11 Summary 64
5 Stocks and the Markets 66
5.1 Introduction 66
5.2 Types of Common Stock and Stockholders’ Rights 66
5.3 Inside Information and Stock Transactions 68
5.4 Initial Public Offering (IPO) and Costs of IPOs 70
5.5 Trading Securities and Trading Commissions 73
5.6 Stock Market Indices 74
5.7 Evaluating the Corporation 75
5.8 Stock Valuation: Dividend Discount Model (DDM) 76
5.9 Stock Valuation: Relative Valuation Model 81
5.10 Stock Valuation: Free Cash Flow to Firm Method 82
5.11 Summary 87
6 Risk, Rate of Return, and Portfolio Theory 89
6.1 Introduction 89
6.2 Efficient Markets 89
6.3 Behavioral Finance 92
6.4 Measures of Return and Risk (The Case of a Single Security) 92
6.5 Historical Risk and Return for Asset Classes 97
6.6 Measures of Return and Risk (The Case of a Portfolio) 99
6.7 Investment Analysis and Portfolio Management 111
6.8 Summary 117
7 Basic Derivatives 119
7.1 Introduction 119
7.2 Forward Contracts 119
7.3 Futures 121
7.4 Options 130
7.5 Swaps 149
7.6 Credit Default Swap 151
7.7 Summary 152
Part III: Financial Management/Corporate Finance
8 Basics of Corporate Finance 157
8.1 Introduction 157
8.2 Overview of Corporate Finance 157
8.3 Financial Manager 158
8.4 Business Organizations 159
8.5 Mission and Vision 161
8.6 The Goal of the Firm, Agency Relationship, Corporate Governance, and Ethics 162
8.7 Summary 164
9 Financial Analysis and Financial Planning 165
9.1 Introduction 165
9.2 Overview of Financial Statements 165
9.3 Annual Reports 166
9.4 Balance Sheet (Statement of Financial Position) 166
9.5 Income Statement 168
9.6 Cash Flow Statement 170
9.7 Free Cash Flow to Firm 171
9.8 Economic Value Added (EVA) and Market Value Added (MVA) 172
9.9 Overview of Financial Statement Analysis 174
9.10 Ratio Analysis 176
9.11 Long-Term Financial Planning 185
9.12 Cost-Volume-Profit Analysis 189
9.13 Operating and Financial Leverage 191
9.14 Summary 194
10 The Basics of Capital Budgeting 196
10.1 Introduction 196
10.2 Data and Stages in Capital Budgeting 196
10.3 Capital Budgeting Techniques 197
10.4 Separating Project Cash Flows 203
10.5 Approaches to Estimating Project Cash Flows 204
10.6 Risk Considerations 208
10.7 Real-Options Analysis 212
10.8 Mergers and Acquisitions (M&A) 218
10.9 Summary 225
11 The Cost of Capital, Capital Structure, and Distributions
to Stockholders 227
11.1 Introduction 227
11.2 Capital Structure 227
11.3 Required Rate of Return and the Cost of Capital 228
11.4 Weighted Average Cost of Capital 230
11.5 Determining the Optimal Capital Structure 231
11.6 Distributions to Shareholders: Dividends and Repurchases 237
11.7 Summary 244
12 Managing Working Capital 246
12.1 Introduction 246
12.2 Working Capital and Working Capital Requirement 246
12.3 Cash Budgets 249
12.4 Cash Management 251
12.5 Accounts Receivable Management and Credit Analysis 254
12.6 Inventory Management 255
12.7 Summary 259
13 Short-Term and Intermediate-Term Business Financing 261
13.1 Introduction 261
13.2 Strategies for Financing Working Capital 261
13.3 Factors Affecting Short-Term Financing 263
13.4 Short-Term Financing Sources 264
13.5 Asset-Based Lending for Short-Term Financing 267
13.6 Intermediate-Term Financing 269
13.7 Summary 277
14 International Financial Management 278
14.1 Introduction 278
14.2 International Monetary System 278
14.3 Balance of Payments 279
14.4 European Unification 284
14.5 Currency Exchange Markets and Rates 286
14.6 International Parity Relations 289
14.7 Arbitrage 293
14.8 Multinational Corporations (MNCs) 294
14.9 Investing Overseas 295
14.10 International Capital Budgeting 296
14.11 Exposure to Exchange Rate Risk 299
14.12 Conducting International Business 300
14.13 International Financial Markets 302
14.14 Export Financing 303
14.15 An Example of Trade Financing: Letter of Credit 308
14.16 International Institutions 308
14.17 Summary 312
Part IV: Management of Financial Institutions
15 Management of Financial Institutions: The Basics 317
15.1 Introduction 317
15.2 The Bank Balance Sheet and Income Statement 317
15.3 Measuring Bank Performance 322
15.4 Basics of Banking: T-Account Analysis 328
15.5 General Principles of Bank Management 329
15.6 Off-Balance-Sheet Activities 336
15.7 Summary 337
16 Risk Management in Financial Institutions 339
16.1 Introduction 339
16.2 The Risks 339
16.3 Managing Credit Risk 340
16.4 Managing Interest-Rate Risk 342
16.5 Market Risk Management 348
16.6 Foreign Exchange or Currency Risk 351
16.7 Technology and Operational Risk 353
16.8 Country (Sovereign) Risk 353
16.9 Liquidity Risk 354
16.10 Hedging with Financial Derivatives 355
16.11 Summary 360
Appendix A: Basic Calculus 361
Appendix B: Introduction to Matrix Algebra 369
Appendix C: Review of Statistics 375
Appendix D: Time Value of Money Tables 387
Appendix E: Cumulative Standard Normal Distribution Table 397
References 399
Index 403