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Lecture 2: Finance Under Certainty vs Uncertainty

Types of Finance - Q&A Review​

Personal Finance Examples​

  • Fixed vs Adjustable Rate Mortgage: Personal decision about home financing
  • 401K Contribution: Personal retirement planning decision
  • Student Loan Choice: Government vs private bank loans for tuition

Corporate Finance Examples​

  • Machine Purchase vs Lease: Corporate investment decision
  • Dividend vs Reinvestment: Corporate payout policy decision
  • LLC vs Sole Proprietorship: Business structure choice

Public Finance Examples​

  • Municipal Bonds vs Property Taxes: City financing for infrastructure
  • Tax Rate Increases: Government budget management
  • Public-Private Partnerships: Joint infrastructure projects

Finance Under Certainty​

Definition: All future cash flows are known with 100% certainty

Example: House investment

  • Initial Investment: $100,000
  • Annual Rent: $5,000 for 10 years
  • Sale Price: $105,000 after 10 years
  • Required Return: 3%

Decision: Compare project return vs alternative investment

Simple Analogy: Like a government bond - you know exactly how much you'll get back and when. No surprises, no uncertainty.

Finance Under Uncertainty​

Definition: Future outcomes have known probabilities

Example: Apple stock analysis

  • Current Price: $100
  • Possible Outcomes:
    • High state (10% probability): $160 (+60% return)
    • Medium states: Various returns
    • Low state: Lower returns

Holding Period Return:

HPR=P1−P0P0\text{HPR} = \frac{P_1 - P_0}{P_0}

Simple Analogy: Like weather forecasting - you know there's a 30% chance of rain, 50% chance of clouds, 20% chance of sun. You don't know exactly what will happen, but you know the probabilities.

Finance Under Ambiguity​

Definition: Cannot estimate probabilities or outcomes

Examples:

  • New payment app in country with unclear regulations
  • Private company acquisition with no audited statements
  • New token offering with no historical data

Analyst's Task: Move from ambiguity to uncertainty by gathering data

Simple Analogy: Like trying to predict the weather on a planet you've never been to - you have no idea what the climate is like, what the seasons are, or even if it has weather at all. You need to gather data first.

Financial System Players​

Capital Suppliers​

  • Households: Net suppliers (savings, investments)
  • Exceptions: When borrowing (mortgages, auto loans)

Capital Demanders​

  • Corporations: Net demanders (investment, operations)
  • Governments: Can be borrowers or lenders
    • US: Net borrower (deficit)
    • China: Net lender (surplus)
    • Norway: Net lender (oil reserves)

Financial Intermediaries​

Brokers vs Dealers:

  • Broker: Connects buyers/sellers, earns commission
  • Dealer: Owns inventory, takes risk, earns spread

Simple Analogy:

  • Broker = Real estate agent (doesn't own houses, just helps you buy/sell)
  • Dealer = Car dealership (owns cars, takes risk if they can't sell them)

Types of Intermediaries:

  • Pension Funds: Manage retirement savings
  • Mutual Funds: Pool investor money
  • Insurance Companies: Premium investments
  • Banks: Commercial vs Investment

Commercial vs Investment Banks​

Commercial Banks​

  • Assets: Loans, government bonds
  • Liabilities: Deposits
  • Activity: Deposit-taking and lending

Investment Banks​

  • Primary Market: Underwriting new securities
  • Secondary Market: Market making, trading
  • Services: M&A, advisory, research

Primary vs Secondary Markets​

Primary Market​

  • IPO Process: Company → Investment Bank → Investors
  • Book Building: Collecting investor indications
  • Underwriting Risk: Bank takes inventory risk

Simple Example: When Tesla first went public, they sold new shares to investors through investment banks (primary market)

Secondary Market​

  • Exchange Trading: Centralized, automated
  • OTC Trading: Direct between parties
  • Market Makers: Provide liquidity with bid-ask spreads

Simple Example: When you buy Tesla stock today on Robinhood, you're buying from another investor, not from Tesla (secondary market)

Five Tasks of Financial Manager​

  1. Raise Cash: Sell financial assets (debt/equity)
  2. Invest Cash: Buy real assets (equipment, facilities)
  3. Generate Cash: Operations create profits
  4. Manage Cash: Reinvest or distribute
  5. Risk Management: Balance growth vs stability

Goal of Financial Manager​

Primary Objective: Maximize shareholder value

Why Shareholders?

  • Residual Claimants: Last to be paid
  • Risk Takers: Bear most uncertainty
  • Value Maximization: Benefits all stakeholders

Payment Hierarchy:

  1. Government: Taxes (mandatory)
  2. Debt Holders: Interest and principal (contractual)
  3. Shareholders: Dividends (discretionary)

Simple Analogy: Like a restaurant - first you pay taxes to the government, then you pay your suppliers (debt holders), and only if there's money left do you pay yourself (shareholders get dividends)