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Sotheby's Institute Week 5 Whitaker 20111005
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Sotheby's Institute Week 5 Whitaker 20111005



Principles of Business I: Introduction to Finance

Principles of Business I: Introduction to Finance



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  • http://www.studio-h.org/wp-content/uploads/2010/10/powersof10.jpg
  • http://www.canalmuseum.com/photos/1908_miraflores.jpgLicorice and applesSo capital intensive, needed common ownership
  • 1.15 marker on the filmSeparation of owner and manager – huge amount of management science as a fieldAlso separate markets – free flow of exchange of ownership. Fluid and connected
  • A right to sell or a right to buyCDOs, CDS, ABS
  • Building by architectural design competition George Post 1903World’s largest stock exchange. $14.5 billion listed companies. $150bn daily trading volume.http://itsjustmicheal.com/wp-content/uploads/2008/06/nyse.jpg
  • Global Market and Capital Market (Cap has 5mn, then 1mn, then 15mn, then $4, then 750k then 300 shareholders)
  • Dorinda, John Thain, locker room, ash wednesday
  • Stock exchange – publicly traded companies
  • 20 million shares out of 170 million. Now 270 million. Stockpile cash. Be able to make acquisitions. Be advised on them by banks.
  • Shift in perspective – individual stock to Stock exchange and index – pull up the Dow on Google Finance
  • Stop to look at newspapers
  • Ways of taking the temperature on the whole economy
  • Fell by 12.8 percent. Dropped to 260. Didn’t recover for 25 years.August 24, 1921 – was at 63.9. Sept 3, 1929, was at 381.2.
  • Lost 22% of valueSome economies lost 30-60%
  • Show on website -- http://www.pbs.org/wgbh/pages/frontline/shows/crash/etc/cron.html
  • Show historic banking film – then break?
  • From http://www.sec.gov/about/laws.shtml
  • Registration of exchanges, insider trading laws, registration of “broker-dealers” etc
  • Volker Rule
  • Commercial, Investment, Private BankDepository Institutions Deregulation and Monetary Control Act of 1980, the Garn–St. Germain Depository Institutions Act of 1982, and the Gramm–Leach–Bliley Act of 1999.The repeal enabled commercial lenders such as Citigroup, which was in 1999 the largest U.S. bank by assets, to underwrite and trade instruments such as mortgage-backed securities and collateralized debt obligations and establish so-called structured investment vehicles, or SIVs, that bought those securities.[20] Elizabeth Warren,[21] author and one of the five outside experts who constitute the Congressional Oversight Panel of the Troubled Asset Relief Program,
  • Oversees 4500 brokerage firms. Administers exams. Disciplinary infractions. Series 7 and 63. Series 24.
  • Paid in small percentages vs find every dollar for a school teacher
  • For a firm or a market
  • Here is an example. Don’t be thrown by the Excel notation. . . . If you invest $10,000 to make $12,000, that seems like a good deal. You make a 20% return. But, that’s only if you get the return in the same time frame. The theory of “net present value” is that you can discount future cash flows (DCF or discounted cash flow analysis) so you can figure out what they are “worth” to you now in the present. Let’s say, in this example, you get the cash flows over four years ($12,000 total but in increments). The formula to calculate net present value (NPV) is to take the cash flow and divide it by 1 plus the interest rate you think you could get otherwise. If you weren’t investing 10,000 here, you could get 5% return each year from the bank, so the rate – “r” is 5%. Then you reflect the dimension of time by raising 1+r to the number of years (or whatever time frame if 5% is a monthly or quarterly, not annual return). So if I get 2,000 in year 2, my denominator is 1+ 0.05 raised to the 2nd power which is 1.05 x 1.05 which is 1.25. You can see how that number gets bigger exponentially as you go across. So you discount the cash flows and analytically 5,000 in year 4 is really only worth 4,114 to you. (If you had 4,114 in year zero, it would be 5,000 in year 4.) The key takeaway is just again to be mindful of the timing of the cash flows because your investors will – and the real economic value of a project will need to reflect this. An everyday example is when someone wins the lottery, they will offer you a lump sum payment or a payment annually for decades. They’ve done this calculation. The annual payments look bigger but since you don’t get the money for a long time (and someone else gets the investment return on it), it isn’t as good of a deal as it may look.
  • This is a way of comparing options by taking into consideration the probability of whether they will happen. You multiply the odds by the payout, as in the example above. It’s a good mental habit for knowing the scale of something (eg lottery payouts are huge but odds of winning tiny, so the expected value is – I have to imagine since lotteries are huge fundraisers for governments – less than the price of a ticket).
  • Pulitzer Prize vs Income. Odds re pitching work. What your goals are. When to buy a lottery ticket and when to play it safe.
  • A good way of knowing “what success looks like.” This identifies the point at which you shift from loss to profit.

Sotheby's Institute Week 5 Whitaker 20111005 Sotheby's Institute Week 5 Whitaker 20111005 Presentation Transcript

  • Introduction to Finance
    Professor Whitaker
    Sotheby’s Institute New York
    Principles of Business I
    October 5, 2011
  • Agenda for today
    History of Markets and Structure of Markets
    Time Value of Money
  • Housekeeping: Things to See
    Occupy Wall Street
    Will be optional question on problem set.
  • 1. Change in perspective: Powers of 10, Charles and Ray Eames. Economics is at the level of the picnic blanket. Finance can be really granular (as in a stat arb strategy) or really big picture (investing in whole companies, looking at whole economies).
  • How did this all come about?
    Some people say that the advent of the railroad create the real necessity of the stock market because the project was so capital intensive there had to be joint ownership.
  • Separation of Owner and ManagerPrincipal-Agent Problems
  • Ownership: owning and owing
    The principal you own = equity
    The mortage you owe the bank = debt
    The bank selling the mortgage on to another bank = derivative
    That bank slicing up that mortgage into different risk bands = derivative
  • Securities: Stocks, Bonds, Derivatives
    A security: an investable instrument, a store of financial instrument that can be bought and sold
    Equity – what you own  stocks
    Debt – what you owe  bonds
    Derivatives – contracts based on other underlying securities
    Options – common derivatives types, a right and an obligation to buy or sell in the future (put or call)
    Commodities – gold, oil, etc.
  • New York Stock Exchange
    “On May 17, 1792, twenty-four stockbrokers gathered outside 68 Wall Street under a buttonwood tree to sign an agreement that would establish the rules for buying and selling bonds and shares of companies. The Buttonwood Agreement, as it is known, is so named because the tree served as the regular meeting place for these pioneers of Wall Street. The signers of the Buttonwood Agreement drafted their first constitution on March 8th, 1817, and named their nascent organization the New York Stock & Exchange Board.”
  • NYSE Criteria
    Minimum pretax income for two years $2mn
    Revenues $75mn
    Market value publicly held $100mn
    Holders of 100+ shares 400
  • NASDAQ Criteria (Global Market)
    Shareholders’ Equity $15mn
    Shares in public hands 1.1mn
    Market value of publicly traded shares $8mn
    Minimum Stock Price $4
    Pretax Income $1mn
    Shareholders >400
  • Traders
    Owners of a seat on the exchange, floor brokers, specialists
  • Life Cycle of a Company
    Start-up (Friends and family)
    Fledgling(move from garage to office building)
    Grows to scale (Later stage venture capital financing)
    Goes Public (IPO)
    Traded on Exchange (becomes part of an index)
  • March 1997 – began as a research project
    August 1998 – Andy Bechtolsheim, founder of Sun Microsystems, gives them $100,000
    September 1998 – incorporated as Google Inc. in a friend’s garage in Menlo Park
    March 1999 – moved into offices in Palo Alto (kept outgrowing offices, moved to current 2003)
    June 1999 – receive $25 million from Kleiner Perkins Caufield & Buyers and Sequoia Capital
    March 2001 – hired CEO as condition of keeping funding
    January 2004 – hired Goldman Sachs and Morgan Stanley to handle IPO. IPO filing showed a profit since 2001 and a 2003 profit of $105mn on $960mn of earnings
  • Google IPO
    August 25, 2004 – floated 19,605,052 shares at $85 per share. (Google cut out Goldman and left Morgan Stanley and Credit Suisse as the underwriters)
    The stock price at the end of the first day was $100.34, with a trading volume of 22mn shares.
    Listed on the NASDAQ under GOOG.
  • Stock Exchanges and Indices
    Dow Jones Industrial Average (“The Dow”)
    Standard and Poor’s 500 (“S&P 500”)
  • Stocks and Art
  • Booms, Busts, Crises
    1929 – Great Depression (Black Thursday, Black Tuesday)
    1987 – Black Monday (October 19 – Dow lost 22%)
    1990s – Savings and Loan
    1998 – Long Term Capital Management
    2001 – Tech bubble
    2008 – Mortgage crisis, credit crisis
    2011 - ?
  • Black Tuesday, October 29, 1929
  • 1987
  • Long Term Capital Management
    Myron Scholes
    John Meriweather
    From $2.3bn to $400mn
    $100bn in liabilities
    250-1 leverage
  • LTCM
  • 2008 – Lehman Brothers
  • The Great Depression: start of regulatory history of the stock market
  • The Securities Act of 1933
    “The truth in securities act” or “the paper act”
    require that investors receive financial and other significant information concerning securities being offered for public sale; and
    prohibit deceit, misrepresentations, and other fraud in the sale of securities
    Filings, IPOs, disclosures of public companies – includes exemption for private placement
  • The Securities Act of 1934
    The “Exchange act” created the Securities and Exchange Commission (SEC):
    “The Act empowers the SEC with broad authority over all aspects of the securities industry. This includes the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation's securities self regulatory organizations (SROs). The various stock exchanges, such as the New York Stock Exchange, and American Stock Exchange are SROs. The National Association of Securities Dealers, which operates the NASDAQ system, is also an SRO.”
  • 1940 Acts
    The Investment Company Act of 1940
    Requires investment companies (e.g., mutual funds) to make disclosures to the public initially and ongoing
    The Investment Advisers Act of 1940
    Companies paid to advise on investments must register with the SEC (since 1996, only companies that manage at least $25 million must do so)
  • Sarbanes-Oxley Act of 2002
    Heightened disclosures and oversight
    Created a “Public Company Accounting Oversight Board” (PCAOB) to oversee auditors
    In response to scandals like Enron, Tyco, and Worldcom
  • Banking Act of 1933
    “Glass-Steagall Act”
    Created the FDIC
    Separated Investment and Commercial Banking
    Was repealed in 1999, allowing commercial banks to created mortgage-backed securities
    Companies with more than $10 million in assets whose securities are held by more than 500 owners must file annual and other periodic reports. These reports are available to the public through the SEC's EDGAR database.
  • Private Placement – “Reg D”
    The exemption to public filings:
    • No general solicitation (no advertisement)
    • Resale restrictions
    • No more than 35 “unaccredited investors”
    • Warm-up period, circulation of “offering documents”
    • Fewer than 500 investors (or $10 million in investments)
    “Accredited Investor”
    1933 Act - $1mn in investible net worth or income above $200,000 (singly) or $300,000 (jointly) for each of the past two years, and belief that will continue.
    “Qualified Purchaser”
    1940 Act – “Qualified Person” (QP) - $5mn in investable net worth for a natural person or investment entity, $25mn for unrelated company.
  • Self-Regulatory Organizations
    NASD - National Association of Securities Dealers (founded 1939)
    FINRA – Financial Industry Regulatory Authority (founded 2007)
  • Risk and Return
    Corporations as amoral, needing regulation to set boundaries
    Goldman Sachs as “giant vampire squid”
    “There’s no such thing as a free lunch.”
    Concentration of benefit, diffusion of risk
    Private gain, public loss
  • Opportunity Cost and Arbitrage
  • Concentration of Risk
    If you are what you eat, and especially if you eat industrial food, as 99 percent of Americans do, what you are is "corn.” – Michael Pollan
  • Stock Market Returns
    Beta – correlation to the market. “A rising tide lifts all boats.” The market itself has a beta of 1.
    Alpha – “absolute return.” Gains unrelated to the upward trajectory of the market. Uncorrelated returns, gains from insight and performance.
    Measure of Alpha: Sharpe Ratio
  • Modern Portfolio Theory
    Harry Markowitz: it is better to own the entire basket of the market, as the positions will move in slightly different directions, having the effect of insuring each other, giving you a higher risk adjusted return.
    Vanguard Funds vs. David Swenson Approach
  • Time Value of Money
    A dollar today is worth more than a dollar tomorrow because you could invest it:
    $1.05 - $1.09 next year
    The long-run average U.S. stock-market return is 9%. A treasury bill returns 5%.
    © Amy Whitaker amy.whitaker@gmail.com
  • Looks like a $10,000 investment leads to $12,000 in income, a $2,000 return.
    Apply the “opportunity cost of capital.”
    C/(1+r)^t means that the
    denominator gets bigger.
    At a discount rate of 5%, the net present value = $10,335.
    © Amy Whitaker amy.whitaker@gmail.com
  • Expected Value
    If I play poker with Bob and Anne, these three things could happen:
    A 50% chance of making $20
    A 30% chance of losing $20
    A 20% chance of breaking even
    Expected value = the probability of an outcome x the value of the outcome
    What is the expected value of each outcome?
    50% chance of $20 = .5 x $20 = +$10
    30% chance of $20 = .3 x -$20 = -$6
    20% chance of zero = .2 x $0 = 0
    © Amy Whitaker amy.whitaker@gmail.com
  • Expected Value
    Example 2:
    I am going to teach a class and charge $30.
    If I get great attendance, 100 people will come.
    ($30 x 100 people = $3,000)
    If I get poor attendance, 20 people will come.
    ($30 x 20 people = $600)
    At 50/50 odds, that is $1500 + $300 = $1800
    At 20/80 odds, that is $600 + 480 = $1080
    © Amy Whitaker amy.whitaker@gmail.com
  • Breakeven Analysis
    At what point to I recoup my costs and start making a profit?
    To start a school, I need $5000 for rent, supplies, equipment. For each student, a foundation gives me $150. I have to spend $50 of that on supplies for that student. At what point do I break even?
    Break Even = Total Fixed Cost = 5000 = 5000 =
    Revenue – Variable Cost 150 – 50 100
    50 students
    © Amy Whitaker amy.whitaker@gmail.com
  • Lottery Ticket
    You have one the lottery!
    Would you rather have a lump sum payment of $10 million, or $500,000 every year for 30 years?
  • Investing in School
    It costs you $50,000 to go to graduate school.
    Without school you will earn $40,000 per year. With school, you will earn $45,000 per year, and be promoted to management in the middle of your career.
    Is it worth it? What does this look like in numbers?
  • Artist’s Retainer
    There is a hot young artist you really want to sign to your gallery. It is the 1980s and people are paying artists retainers.
    If you pay this artist, Fred Lois Smith, $40,000 per month for a year, he will make work you can sell in your gallery in one year’s time. Because of Fred’s cost of materials, he requests that you pay the amount up front at the start of the year. How much do you have to make from Fred’s show for this to be worth it?
  • Takeaways related to art
    Your clients will be invested in these arenas.
    Your savings will be invested in these arenas.
    Investment in art is usually viewed as an “alternative asset” – in the same class as hedge funds.
    You may need to be aware of private placement law.
    Your investors may be looking to art as a “correlation buster.” They may also love art.