Principles of Business I: Introduction to Finance

1. Introduction to Finance Professor Whitaker Sotheby’s Institute New York Principles of Business I October 5, 2011

2. Agenda for today History of Markets and Structure of Markets Time Value of Money

3. Housekeeping: Things to See Moneyball Occupy Wall Street Will be optional question on problem set.

4. 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). http://www.youtube.com/watch?v=0fKBhvDjuy0

5. 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.

6. Separation of Owner and ManagerPrincipal-Agent Problems

7. 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

8. 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.

9. 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.”

10. NYSE Criteria Minimum pretax income for two years $2mn Revenues $75mn Market value publicly held $100mn Holders of 100+ shares 400

11. 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

12. Traders Owners of a seat on the exchange, floor brokers, specialists

13. 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)

14. 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

15. 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.

16. Stock Exchanges and Indices Dow Jones Industrial Average (“The Dow”) Standard and Poor’s 500 (“S&P 500”)

18. Stocks and Art

19. 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 - ?

20. Black Tuesday, October 29, 1929

21. 1987

22. Long Term Capital Management Myron Scholes John Meriweather From $2.3bn to $400mn $100bn in liabilities 250-1 leverage

23. LTCM

24. 2008 – Lehman Brothers

25. The Great Depression: start of regulatory history of the stock market

26. 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

27. 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.”

28. 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)

29. 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

30. 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

31. EDGAR 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.

33. Resale restrictions

34. No more than 35 “unaccredited investors”

35. Warm-up period, circulation of “offering documents”

36. 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.

37. Self-Regulatory Organizations NASD - National Association of Securities Dealers (founded 1939) FINRA – Financial Industry Regulatory Authority (founded 2007)

38. 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

39. Opportunity Cost and Arbitrage

40. 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

41. 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

42. 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

43. Time Value of Money A dollar today is worth more than a dollar tomorrow because you could invest it: $1 $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

44. 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

45. 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

46. 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

47. Breakeven Analysis At what point to I recoup my costs and start making a profit? Example: 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

48. 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?

49. 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?

50. 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?

51. 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.