FINANCIAL MANAGEMENT Part 1: An introduction to finance Lecture 1: What is finance?

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FINANCIAL MANAGEMENTPart 1 An introduction to
financeLecture 1 What is finance?
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Lecture 1 What is finance?

• 1.1. Introduction
• 1.2. Defining finance
• 1.3. The Firm a sistemic approach
• 1.4. Corporate Finance the financial function
• 1.5. The financial objective value creation
• 1.6. Financial main principles
• 1.7. Finance historic evolution
• 1.8. Main programmes in Finance

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Lecture 1 What is finance?1.1. Introduction (1)

• I am saving for retirement. Should I use a
  pension fund, mutual fund, direct stock market
  investment ?
• I want that new car. Should I use my cash
  saving, lease, borrow?
• Which is the best way to pay for my holidays, for
  my house?
• Im thinking about starting a new business. Will
  it reward me adequately?
• Marocco has asked for major project financing.
• Should my organization provide the funds?

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Lecture 1 What is finance?1.1. Introduction (2)

• Why study finance?
• To manage your personal resources
• To deal with the world of business
• To pursue interesting and rewarding career
  opportunities
• To make informed public choices as a citizen
• For the intellectual challenge

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Lecture 1 What is finance?Introduction
Macroeconomic/Spending Sectors

• Household
• Business Firms
• Government
• Foreign Sector

SURPLUS SPENDING UNITS DEFICIT SPENDING UNITS
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Lecture 1 What is finance?1.1. Introduction
Surplus Spending Unit (1)

• Has more cash income flow than expenditure on
  consumption and real investments in a period of
  time. The surplus is then allocated to the
  financial sector.
• Other terms for surplus unit are saver, lender,
  buyer of financial assets, financial investor,
  supplier of loanable funds, buyer of securities.

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Lecture 1 What is finance?1.1. Introduction
Surplus Spending Unit (2)

• The surplus unit may buy financial assets, hold
  more money, or pay off financial liabilities
  issued earlier when in a deficit situation
• The household and foreign sectors are usually a
  surplus sector

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Lecture 1 What is finance?1.1.
IntroductionDeficit Spending Unit (1)

• Has more expenditures on consumption and real
  goods (investment) in the real sector than income
  during a period of time
• The deficit unit must participate (borrow) in the
  financial sector to balance cash inflows with
  outflows

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Lecture 1 What is finance?1.1.
IntroductionDeficit Spending Unit (2)

• Other terms for deficit expending unit are
  borrower, demander of loanable funds, and seller
  of securities.
• The deficit spending unit may issue financial
  liabilities, reduce money balances, and sell
  financial assets acquired previously when in a
  surplus situation

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Lecture 1 What is finance?1.1.
IntroductionFinancial Claims (1)

• Contracts related to the transfer of funds from
  surplus to deficit budget units
• Financial claims are also called financial assets
  and liabilities, securities, loans, and financial
  investments.
• For every financial asset, there is an offsetting
  financial liability.
• Total receivable equal total payable in the
  financial system
• Loans outstanding match borrowers liabilities

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Lecture 1 What is finance?1.1.
IntroductionFinancial Claims (2)

• Financial markets offer opportunity for
• Financing for DSUs (primary)
• Financial investing for SSUs (primary and
  secondary)
• Providing liquidity via trading financial claims
  in secondary markets

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THE FLOW OF FUNDS DIAGRAM
Funds
Funds
Deficit Spending Unit (DSU)
Surplus Spending Unit (SSU)

Financial Assets Financial Claims
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THE FLOW OF FUNDS DIAGRAM
Funds
Funds
Deficit Spending Unit (DSU)
Surplus Spending Unit (SSU)
Saver, lender buyer of financial
assets financial investor supplier of loanable
funds buyer of securities.
Borrower demander of loanable funds seller of
securities

Financial Assets Financial Claims
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Lecture 1 What is finance?1.1.
IntroductionReal Financial assets

• Assets any possession that has value in an
  exchange
• tangible value depends on particular physical
  properties (reproducible and non-reproducible)
• intangible legal claims to some future
  benefit. Financial assets

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Lecture 1 What is finance?1.1.
IntroductionFinancial assets main properties

• Main properties of financial assets
• Rate of return (R) expected return
• Risk (r) credit risk, market risk
• Liquidity (L) how much sellers stand to lose if
  they wish to sell immediately against engaging in
  a costly and time-consuming search (J.Tobin)

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THE FLOW OF FUNDS DIAGRAM
DIRECT FINANCING (Markets)
Brokers Dealers
Funds
Funds
Deficit Spending Unit (DSU)
Surplus Spending Unit (SSU)
Funds
Funds
Intermediaries
INDIRECT FINANCIAL INVESTMENT OR INTERMEDIATION
FINANCING
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THE FLOW OF FUNDS DIAGRAM
DIRECT
Direct Financial Assets Purchase
Direct Financial Assets Issue
Brokers Dealers
Funds
Funds
Deficit Spending Unit (DSU)
Surplus Spending Unit (SSU)
Funds
Funds
Intermediaries
Indirect Financial Assets Purchase
Direct Financial Assets Issue
INDIRECT
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Lecture 1 What is finance?1.2. Defining Finance

• What is Finance?
• Types of Finance definitions
• Lack of any specific definition
• Raising and spending funds
• Economic decisions with a time component
• Micro/Macro need for integration

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Lecture 1 What is finance?1.2. Defining Finance

• Finance is analytical.
• Finance is based on economic principles.
• Finance uses accounting information as an input
  for decision-making.
• Finance is international in perspective.
• Finance is constantly changing.
• Finance is the study of how to invest and raise
  money productively

http//garnet.acns.fsu.edu/ppeters/fin3403/
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Lecture 1 What is finance?1.2. Defining Finance

• Finance is the study of how people allocate
  scarce resources over time
• costs and benefits are distributed over time
• but the actual timing and size of future cash
  flows are often known only probabilistically
• Understanding finance helps you evaluate these
  uncertain cash flows

Bodie and Merton
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Lecture 1 What is finance?1.2. Defining Finance

• When implementing decisions, people make use of
  the Financial System which can be defined as the
  set of markets and other institutions used for
  financial contracting and exchange of assets and
  risks

Bodie and Merton
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Lecture 1 What is finance?1.2. Defining Finance

• Financial theory consists of
• the set of concepts that help to organize ones
  thinking about how to allocate resources over
  time
• the set of quantitative models used to help
  evaluate alternatives, make decisions, and
  implement them
• These concepts and models apply at all levels and
  scales of decision making

Bodie and Merton
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Lecture 1 What is finance?1.2. Defining Finance

• A basic tenet of finance is that the existence of
  economic organizations (e.g. firms and
  governments) facilitate the satisfaction of
  peoples consumption preferences

Bodie and Merton
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Lecture 1 What is finance?1.2. Defining
Finance Definition 1

• Finance Theory is the study of the behaviour of
  individuals in the intertemporal allocation (over
  time) of their resources in an uncertain
  environment, and the study of the function of
  economic institutions and markets in making these
  allocations possible.

Economía Financiera Marín, José M. / Rubio,
Gonzalo Antoni Bosch, Editor, Barcelona, 2001
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Lecture 1 What is finance?1.2. Defining
Finance a new paradigm. The Value Creation
Function of Finance

• The practice of finance exists for the creation
  of value
• Financial contracting brings about the
  substitution of real wealth (i.e. real business
  assets) for financial wealth (i.e. securities)
  Investing in financial securities has better
  attributes that in real assets. Value is created
  in tthe real assets held by businesses, and then
  transmitted into the value of financial wealth
  issued by businesses and held by investors.

Norton y Scott, A new Paradigm the value
creation function of finance, january 2001
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Lecture 1 What is finance?1.2. Defining
Finance a new paradigm.Definition 2

• Finance is the process of transforming existing
  assets into new, contractual forms, as well as
  the analytical techniques needed to support this
  process, for the purpose of wealth creation in
  modern, capitalistic economies.

Norton y Scott, A new Paradigm the value
creation function of finance, january 2001
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Lecture 1 What is finance?1.2. Defining
Finance the three primary areas of finance

• Financial management (Corporate finance) deals
  with how firms raise and use funds to make
  short-term and long-term investments.
• Investment deals with how the securities markets
  work and how to evaluate and manage investments
  in stocks and bonds.
• Financial Markets and Institutions includes the
  study of the banking system and markets.

Peterson and Fabozzi
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FINANCIAL MANAGEMENTPart 1 An introduction to
financeLecture 1 What is finance?(II)
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Lecture 1 What is finance? (II)

• 1.1. Introduction
• 1.2. Defining finance
• 1.3. The Firm a sistemic approach
• 1.4. Corporate Finance the financial function
• 1.5. The financial objective value creation
• 1.6. Financial main principles
• 1.7. Finance historic evolution
• 1.8. Main programmes in Finance

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Lecture 1 What is finance? (II)1.3. The Firm
a sistemic approach
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Lecture 1 What is finance? (II)1.4. The Firm
a sistemic approach
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Lecture 1 What is finance? (II)1.5. Corporate
Finance the financial function

• Corporations face two broad financial questions
• - What investments should the firm make?
• - How should it pay for those investments?
• Financial managers are concerned with
• Investment Decisions (use of funds)
• The buying, holding or selling of types of assets
• Financing Decisions (acquisitions of funds)

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Lecture 1 What is finance? (II)1.6. Corporate
Finance the financial function
INVESTMENT / FINANCIAL SUBSYTEM
FINANCIAL SYSTEM
REAL SYSTEM
r ( r gt k )
k
FINANCIAL MANAGEMENT (CORPORATE FINANCE)
INVESTMENT
FINANCING
FINANCIAL MARKETS
FIRM OPERATIONS (Real goods services
REPAYMENT AND RETURN
RETURN
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Lecture 1 What is finance? (II)1.7. The
Financial objective value creation

• Goal of management maximize the economic
  well-being, or wealth, of the owners (current
  shareholders)
• gt maximize the price of the stock
• Share price today Present value of all future
  expected dividends at required return

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Lecture 1 What is finance? (II)1.8. The
Financial objective value creation

• Financial managers must create or generate value
  for their shareholders.
• Economic Value Added (EVA) is a measure of a
  company's financial performance based on the
  residual wealth calculated by deducting cost of
  capital from its operating profit (adjusted for
  taxes on a cash basis).
• The formula for calculating EVA is as follows
• EVA Net Operating Profit After Taxes -
  (Capital Cost of Capital)

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Lecture 1 What is finance? (II)1.9. Financial
main principles

• Rational Financial behavior
• Risk aversion
• Budgetary diversification
• Existence of two parts in all financial
  transaction
• Measurement by cash flows
• Signaling and informative asymmetry
• Efficiency of financial markets
• Direct relation of risk and return
• Existence of valuable ideas
• Financial conduct initiative
• The Time Value of the money and value
  additivity.

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Lecture 1 What is finance? (II)1.10. Finance
historic evolution
Principles of century XX Beginning of the
research in finance
EVENTS

• - Expansion of the Years 20
• The 29 Crises
• Economy military of the 40
• Expansion of the 50
• Crises of the petroleum of the 73

Finance at the present
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Lecture 1 What is finance? (II)1.10. Finance
historic evolution
M o d e r n A p p r o a c h
2000-

• Behavioral finance

Chaos Theory, Non Linear Dynamics
Markets Efficiency
1990-
Methods based on Fuzzy Sets Theory (Kaufmann y
Gil, 1986-87)
Financial Innovation
1980-
Options Valuation Models (Black y Scholes, 1973)
APT Model (Ross, 1970)
CAPM (widening and reformulation)
1970-
Efficient Market Theory (Fama, 1970)
Capital Assets Pricing Model (CAPM) (Sharpe,
1963-4, Lintner, 1965)
Financial Structure (Modigliani, Miller, 1958)
Portfolio selection Theory (Markowitz, 1952,1959)
Dividends Policy (Modigliani, Miller, 1963)
1950-
Classical Approach
1900-
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Lecture 1 What is finance? (II)1.11. Main
programmes in finance

• Managements of Investments- Capital Budgeting.
• Capital Structure and Dividend Policy.
• Market Efficiency.
• The Capital Asset Pricing Model.
• Options Theory
• Agency Theory
• Financial Planning
• Small Firms

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Lecture 1 What is finance?Bibliography

• Kidwell, Peterson, Blackwell, Whidbee Financial
  Institutions, Markets, and Money, Eighth Edition,
  John Wiley Sons, 2003
• Fabozzi, Modigliani Capital Markets.
  Institutions and Instruments. Prentice Hall, 2003
• Bodie, Zvi and Merton, Robert C. Finance.
  Prentice Hall, 1999
• Pamela P. Peterson and Frank Fabozzi Financial
  Management and Analysis, 2nd Edition, John Wiley
  Sons, 2003