Teaching financial concepts with in-class essays

Note: The approach discussed in this blog post has been superseded by a new approach discussed in the more recent blog post “Teaching financial concepts (v1.1).”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