1
The Financial System & Market Context
How the Financial System Works
The financial system channels savings from fund suppliers (households, corporations, governments) through financial intermediaries (banks, pension funds, insurance companies, mutual funds) to fund demanders (corporations, governments, individuals).
- Direct transfer: Securities sold directly to investors (e.g., IPOs)
- Indirect transfer through intermediaries: Banks collect deposits and make loans; pension funds pool capital and invest in markets
- Key function: Price discovery — markets aggregate information to determine the cost of capital
Market Performance: 10-Year Returns (to 2024)
| Index | 10-Year Return | Since GFC (2009) |
|---|---|---|
| S&P/TSX (Canada) | +125% | +247% |
| S&P 500 (US) | +216% | +700% |
| NASDAQ | +336% | +1,400% |
Concentration Risk: Magnificent Seven = 35% of S&P 500, up 700% vs. 150% for remaining stocks. Top 10 stocks = 27% of S&P 500 — a 70-year high. This concentration is a systemic risk.
The Four Big Picture Questions
1 — Market Overvalued?
Forward P/E of 22.9x vs. 30-year average of 17.1x. Expensive by historical standards.
2 — AI Valuations Frothy?
Massive capex on AI infrastructure; monetization still unproven at scale for most companies.
3 — Mag 7 Concentration Risk
35% in 7 stocks. Any negative catalyst in one name has outsized index impact.
4 — Macro Uncertainty
US federal debt ~125% of GDP. World Uncertainty Index at all-time high. Geopolitical fragmentation.
Long-Run Compounded Returns (1938–2014)
| Asset Class | Annual Return | $1 Grows To |
|---|---|---|
| Canada T-Bills | 4.73% | $35,114 |
| Canada Bonds | 5.95% | $85,659 |
| Canadian Stocks | 9.91% | $1,444,991 |
| US Stocks | 11.15% | $3,427,906 |
Equity risk premium is real: equities dramatically outperform bonds over multi-decade horizons.
2
Corporate Governance & Executive Compensation
The Agency Problem
A conflict of interest arises when management (agents) make decisions on behalf of shareholders (principals) but may pursue their own interests instead.
- Agency costs: Monitoring costs (audits, board oversight), bonding costs (management covenants), residual losses (value destroyed by misaligned decisions)
- Solution: Align executive incentives with shareholder value through equity compensation (stock options, RSAs)
- Board of directors: Primary mechanism for shareholder oversight; should be independent
Exam concept: The agency problem is a foundational justification for performance-based pay. When compensation is purely salary, management has no incentive to maximize shareholder value.
Executive Compensation Structure
Cash Compensation
- Base salary (fixed)
- Annual bonus (performance-linked)
Long-Term Incentives
- Stock options
- Restricted share awards (RSAs)
- Performance share units (PSUs)
Other Benefits
- Retirement/pension plans
- Insurance (life, disability)
- Perquisites (car allowance, club memberships)
Executive Stock Options — Key Features
| Feature | Detail |
|---|---|
| Transferability | Not sellable — must be exercised or expire |
| Maturity | 10-year term |
| Vesting period | 3–5 years (cliff or graded) |
| Strike price | At-the-money (current market price) on grant date |
| Dividends | No dividends received while holding options |
| Purpose | Align management with shareholder long-term value creation |
CEO Pay Data & Pay-for-Performance Debate
- US (2021): Average CEO pay = 399× average worker
- Canada (2023): Average CEO pay = 210× average worker
- Since 1978: CEO compensation up 1,322% vs. worker pay
- Institute for Policy Studies (2012): 40% of top-25 highest-paid US CEOs over prior 20 years were "busted, bailed out, or booted"
Key tension: High pay is justified by the market for talent and alignment benefits, but empirical evidence suggests pay-for-performance links are weak. Boards face difficulty setting truly rigorous targets.
3
Financial Management Decisions, Bonds & Covenants
Three Core Financial Management Decisions
- 1Capital Budgeting: Which long-term assets (real investments) should the firm acquire? This is the "left side" of the balance sheet decision. Tools: NPV, IRR, payback period.
- 2Capital Structure: How should the firm finance its assets? What mix of debt and equity? This determines WACC and risk. Debt is tax-advantaged but creates bankruptcy risk.
- 3Working Capital Management: How to manage short-term assets and liabilities (cash, receivables, inventory, payables)? Ensures the firm can meet its obligations day-to-day.
Balance Sheet Model of the Firm
Balance Sheet Identity
Current Assets + Fixed Assets = Current Liabilities + LT Debt + Shareholders' Equity
Net Working Capital = Current Assets − Current Liabilities
Capital budgeting = investment decisions (left side); capital structure = financing decisions (right side).
Financial Analysis Framework
Earnings Quality
Gross margin, ROCE (Return on Capital Employed), EBITDA margin. Is the business generating economic profit?
Cash Flow & Coverage
EBITDA/Interest coverage, free cash flow generation. Can the company service its debt?
Balance Sheet & Flexibility
Leverage (Debt/EBITDA), liquidity (current ratio). Is there headroom for downturns and investment?
Business Strength
Industry position, management quality, competitive moat, diversification of revenue streams.
Corporate Bonds vs. Equity
| Feature | Corporate Bonds | Common Equity |
|---|---|---|
| Priority in liquidation | Senior | Residual claimant |
| Voting rights | None | Yes |
| Tax treatment | Interest is tax-deductible | Dividends are after-tax |
| Investor protection | Covenants in loan agreement | Board oversight / law |
| Default risk | Yes — can trigger bankruptcy | No contractual payments |
Financial Covenants
Types of Tests
- Coverage: EBITDA / Interest > threshold
- Leverage: Debt / EBITDA < threshold
- Liquidity: Current Assets / Current Liabilities > threshold
Bank Debt vs. Bonds
- Bank debt: Maintenance covenants — tested quarterly at all times
- Bonds: Incurrence covenants — only tested when taking an action (e.g., issuing more debt)
Non-financial covenants: Cross-default (default on one obligation = default on all), negative pledge (no new liens), affirmative covenants (maintain insurance, provide financials), negative covenants (restrict dividends, asset sales, additional debt).
Credit Rating Illustrative Ratios
| Rating | EBIT Coverage | Debt/EBITDA | LTD/Capital |
|---|---|---|---|
| AAA | 21.4× | 0.4× | 13.3% |
| AA | 10.1× | 1.0× | 28.3% |
| A | 6.1× | 1.6× | 33.9% |
| BBB | 3.7× | 2.2× | 42.5% |
| BB | 2.1× | 3.5× | 57.2% |
| B | 0.8× | 5.3× | 69.7% |
Moody's IG vs. Non-IG Summary
Investment Grade: Coverage 11.4× | Leverage 36.1% | CF/Debt 63%
Non-Investment Grade: Coverage 1.7× | Leverage 76.0% | CF/Debt 11.8%
Yield Spread
Definition: The difference between the YTM of a corporate bond and a government bond of the same maturity. Compensates investors for default risk.
- Widens in pessimism/recessions: Investors demand more risk premium → corporate bond prices fall
- Narrows in expansions: Confidence rises → spreads compress → corporate bonds rally
- BBB spreads are the narrowest investment-grade spread; HY/junk spreads are much wider
4
Time Value of Money
Core Concept
A dollar today is worth more than a dollar in the future because it can be invested to earn a return. The discount rate is the "exchange rate" that lets us compare cash flows at different points in time — "time travel for money."
Key insight: Lower discount rates → larger PVs. This is why pension funds fight for high discount rates — a lower rate makes their liabilities look much larger in present-value terms.
Future Value & Present Value
Future Value
FV_n = PV_0 × (1 + k)^n
(1 + k)^n = compound interest factor
Present Value
PV_0 = FV_n / (1 + k)^n
1/(1 + k)^n = discount factor
| Problem Type | Solving For | Formula | Excel |
|---|---|---|---|
| Future Value | FV | PV × (1+k)^n | =FV(rate, nper, pmt, pv, type) |
| Present Value | PV | FV / (1+k)^n | =PV(rate, nper, pmt, fv, type) |
| Rate of Return | k | (FV/PV)^(1/n) − 1 | =RATE(nper, pmt, pv, fv, type, guess) |
| Number of Periods | n | ln(FV/PV) / ln(1+k) | =NPER(rate, pmt, pv, fv, type) |
Worked Examples
FV Example:
$1,000 at 8% for 5 years
FV = $1,000 × (1.08)^5 = $1,469.33
Excel: =FV(0.08, 5, 0, -1000, 0)
PV Example:
Want $1M in 40 years at 10%
PV = 1,000,000 / (1.10)^40 = $22,094.93
Excel: =PV(0.10, 40, 0, -1000000, 0)
Rate Example:
$5,000 → $10,000 in 6 years
k = (10,000/5,000)^(1/6) − 1 = 12.25%
Excel: =RATE(6, 0, -5000, 10000, 0, 0.10)
Periods Example:
$25,000 → $40,000 at 8%
n = ln(40,000/25,000) / ln(1.08) = 6.11 years
Excel: =NPER(0.08, 0, -25000, 40000, 0)
Class Question (Lottery): $20,000 today vs $31,000 in 5 years at 10%.
FV of $20K = $20,000 × (1.10)^5 = $32,210.20 > $31,000 → Choose $20,000 today.
PV of $31K = $31,000 / (1.10)^5 = $19,248.56 < $20,000 → confirms same answer (Answer B).
Indifference rate: k = (31,000/20,000)^(1/5) − 1 = 9.16% (Answer C)
PV of $31K = $31,000 / (1.10)^5 = $19,248.56 < $20,000 → confirms same answer (Answer B).
Indifference rate: k = (31,000/20,000)^(1/5) − 1 = 9.16% (Answer C)
Simplification Formulas
Critical rule: All perpetuity and annuity formulas assume the first payment occurs at the end of period 1 (i.e., the formula values cash flows as of one period before they start).
Perpetuity — constant payments forever
PV = C / r
Growing Perpetuity — grows at g forever (critical for equities/DDM)
PV_τ = C_(τ+1) / (r − g)
Example: D1=$1.30, r=10%, g=5%
PV = 1.30 / (0.10 − 0.05) = $26.00
Annuity — constant payments for T periods (critical for bonds)
PV = (C/r) × [1 − 1/(1+r)^T]
= C × A_r^T
(A = annuity factor)
Example: $1M/yr × 25yr, r=10%
PV = (1M/0.10)[1−1/(1.10)^25]
= $9,077,040
→ Take $10M lump sum instead!
Complex Cash Flow Example
Problem: Buy property. Sell in 6 years for $4,000,000. Earn $200,000/yr rent for years 1–3, then $250,000/yr for years 4–6. Rate = 8%.
Split into: Annuity 1 + Deferred Annuity 2 + Lump Sum
PV = (200,000/0.08)[1−1/(1.08)^3]
+ (250,000/0.08)[1−1/(1.08)^3] × 1/(1.08)^3
+ 4,000,000/(1.08)^6
= $3,547,543.57
Technique: Any complex cash flow can be decomposed into individual cash flows, annuities, and perpetuities. Calculate PV of each component separately and sum.
TVM Problem-Solving Tips
- 1Draw a timeline that precisely identifies when each cash flow occurs
- 2Find an anchor — either the PV or FV of the cash flow stream that you need
- 3Ensure the discount rate matches the compounding and payment frequencies (annual rate for annual payments; semi-annual for semi-annual)
- 4Perpetuity and annuity formulas assume first payment at end of period 1 — adjust if payments start differently
★
Formula Reference — Session 1
Complete Formula Sheet
Future Value
FV_n = PV_0 × (1 + k)^n
Present Value
PV_0 = FV_n / (1 + k)^n
Rate of Return
k = (FV_n / PV_0)^(1/n) − 1
Number of Periods
n = ln(FV / PV) / ln(1 + k)
Perpetuity PV
PV = C / r
Growing Perpetuity PV (Gordon Growth / DDM base)
PV_τ = C_(τ+1) / (r − g) [requires r > g]
Annuity PV
PV = (C / r) × [1 − 1/(1+r)^T]
Annuity Factor
A_r^T = (1/r) − 1/[r(1+r)^T]
Coverage Ratio (Covenant)
Coverage = EBITDA / Interest Expense
Leverage Ratio (Covenant)
Leverage = Total Debt / EBITDA
Excel Function Quick Reference
| Goal | Excel Function | Argument Order |
|---|---|---|
| Future Value | =FV() | rate, nper, pmt, [pv], [type] |
| Present Value | =PV() | rate, nper, pmt, [fv], [type] |
| Rate / Yield | =RATE() | nper, pmt, pv, [fv], [type], [guess] |
| Number of Periods | =NPER() | rate, pmt, pv, [fv], [type] |
| Net Present Value | =NPV() | rate, value1, value2, … |
| Internal Rate of Return | =IRR() | values, [guess] |
Sign convention: Cash outflows are negative, inflows are positive. Inconsistent signs cause errors. E.g., if PV = -1000 (you invest), FV = +1469 (you receive).