Note: The approach discussed in this blog post has been superseded by a new approach discussed in the more recent blog post “Teaching financial concepts (v1.1).”

With enough explanations, in-class examples and practice on the homework, students eventually learn how to solve numerical finance problems. However, they seem to have a much harder time understanding financial concepts.

I therefore try to have them think much more about financial concepts in class. During each class, I present them with a number of concept questions before discussing the material (see examples below). Students know that they’ll have to write an in-class essay answering at least one of the questions during the same class, but don’t know which one it will be. In addition, students are told that a few of the questions will be on the final exam. They are thus motivated to pay attention to all questions.

Students typically have five minutes for each question. I allow my students to talk to their neighbors while writing the essay, thus stimulating discussion and peer-to-peer teaching. After the time is over, I explain the correct answer and take questions. The essays are graded and students earn up to one percent of the total course grade for each essay.

A sample of essay questions are given below for several areas of study.

Legal form of ownership and corporate governance

• What are the advantages and disadvantages of each form of ownership?
• What is the agency problem in corporations and how can you mitigate it?

Financial statements

• What is the difference between the average and the marginal tax rate?
• What is the purpose of the Du Pont identity?
• What is the difference between the internal and sustainable growth rates?

Time Value of Money and interest rates

• Why do we discount when calculating a present value?
• APR and EAR: Which one is better for making decisions and why?

Bonds

• What is a bond and what are typical characteristics of corporate bonds in the USA?
• Why do companies issue more bonds than stocks every year?
• What is the yield to maturity?
• Why do investors like convexity?
• How does immunization work?

Stocks

• What are differences between bonds and stocks?
• Why does the DDM focus only on dividends?
• A higher retention ratio b leads to a higher growth rate g. Since P0=D1/(k-g), does a higher b always lead to a higher P? Why or why not?

Capital budgeting

• Why is NPV a better decision rule than payback period?
• Why should we consider changes in net working capital for capital budgeting purposes?
• What cash flows should we include for capital budgeting purposes?

Cost of capital

• Why can diversification eliminate some risk, but not all risk?
• What is beta?
• What is the economic/intuitive justification for the expected return-beta relationship from the CAPM?
• What is the cost of capital?
• What does the cost of capital depend on?
• What happens if the WACC is used as the discount rate for all projects?
• Under what conditions is it appropriate to use the WACC as the discount rate for a new project?

Capital Structure

• What is leverage?
• How does leverage affect free cash flow and free cash flow per share?
• Why does leverage affect free cash flow and free cash flow per share in that way?
• Justify your answer. What is the optimal capital structure
  – without taxes and bankruptcy?
  – with taxes, but without bankruptcy?
  – in reality?
• Why do airlines have higher D/V ratios than drug companies?

Dividends

• Do dividends matter?
• Does dividend policy matter?

Raising long-term capital

• Why do firms raise long-term capital?
• What are sources of long-term financing?
• How are new securities sold to the public?
• What are the most common underwriting methods?

Working capital management

• What is working capital?
• Why does working capital management matter?
• What is the cash cycle and why does it matter?
• What are advantages and disadvantages of a flexible financial policy
• What are advantages and disadvantages of a restrictive financial policy?
• What is a cash budget?
• What are sources and uses of cash?