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Chapter 1: Overview of Finance

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Title: Chapter 1: Overview of Finance


1
Chapter 1 Overview of Finance
  1. Introduction
  2. Defining finance
  3. The Firm a systemic approach
  4. Corporate Finance the financial function
  5. The financial objective value creation
  6. Financial main principles
  7. Finance historic evolution
  8. Main programs in Finance

2
Introduction Finance !!!
  • 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?
  • Country X has asked for major project financing.
  • Should my organization provide the funds?

3
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.

4
What is Finance ???
  • The discipline that deals with decisions
    concerning how money is raised and used by
    businesses, governments and individuals.
  • 3 success keys
  • More value is preferred to less.
  • The sooner cash is received, the more valuable it
    is.
  • Less risky assets are more valuable than riskier
    assets.

5
What is Finance ?
  • Finance is the study of how and under what terms
    savings (money) are allocated between lenders and
    borrowers.
  • Finance is distinct from economics in that it
    addresses not only how resources are allocated
    but also under what terms and through what
    channels.
  • Financial contracts or securities occur whenever
    funds are transferred from issuer to buyer.

6
Finance Allocation of resources
  • 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.

7
Finance An inter-temporal decision
  • Finance Theory is the study of the behavior of
    individuals in the inter-temporal 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.

8
Finance Financial System
  • 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.

9
Finance Financial Theory
  • 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.

10
A Basic of 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.

11
Finance A Process
  • 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.

12
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 than in real assets. Value is created
    in the real assets held by businesses, and then
    transmitted into the value of financial wealth
    issued by businesses and held by investors.

13
Finance Examples (1)
  • Finance concerns how individuals interact in
    order to allocate resources (capital) and/or
    shift consumption across time by borrowing or
    investing.
  • If you receive 1 million today, then what
    decision would you make regarding consumption and
    investment?
  • Suppose you spend (consume) 100,000 now.
  • This leaves you with 900,000. You can postpone
    consumption to future time periods by investing
    the 900,000 today.
  • On the other hand, what if you have 20,000 but
    need to consume 30,000. You can borrow the
    10,000 and pay it back in a future period along
    with the interest.

14
Finance Examples (2)
  • A firm must spend 100 million for the required
    assets if a proposed project is approved.
    Important issues are
  • Should the project be accepted or rejected? What
    do investors demand as a (minimum acceptable)
    project rate of return?
  • What are the projects forecasted future cash
    flows? How risky are these forecasted cash
    flows?
  • Where will the 100 million come from, i.e., what
    mix of equity and debt financing should be used?
  • If a firm has 200 million of cash flow, but
    needs reinvest 120 million, what should be done
    with the remaining 80 million of cash.
  • Pay it out as a dividend or repurchase some stock?

15
Finance Examples (3)
  • A mutual fund manager that manages a fund with
    10 billion portfolio receives an additional 100
    million in cash from new investors.
  • Which stocks or bonds to purchase?
  • How will any proposed new investments affect the
    expected return and risk of the overall
    portfolio?

16
General areas of Finance
  1. Financial markets and Institutions banks,
    insurance companies, savings and loans, and
    credits unions
  2. Investments determining the values, risks, and
    returns of financial assets (stocks, bonds) and
    the optimal mix of securities to be held in a
    portfolio of investments
  3. Financial Services how to invest money (home
    purchase, financial stability, budgeting)
  4. Managerial (Business) Finance firms decisions
    about their cash flows (plant expansion, credit
    terms, inventory, cash on hand, earnings,
    dividends,).

17
The importance of finance in non-finance areas
  • Finance concepts used everyday.
  • Finance is part of your life no matter what
    career you choose.
  • Every student of business, regardless of her/his
    major, should be concerned with finance.
  • Finance is related to non-finance areas
    management, marketing, accounting, information
    systems, economics.

18
Finance Disciplines
  • Public finance is about the taxing and spending
    activities of the government.
  • Focus is on microeconomic functions of government
    policies that affect overall unemployment or
    price levels are left for macroeconomics.
  • Scope of public finance unclear government has
    role in many activities, but focus will be on
    taxes and spending.
  • Corporate finance is every decision that a
    business makes has financial implications, and
    any decision which affects the finances of a
    business.
  • Personal Finance is managing your personal
    budget, money and investment.

19
Corporate Finance
  • Corporate Finance addresses the following three
    major questions
  • What long-term investments should the firm engage
    in?
  • How can the firm raise money for the required
    investments?
  • How much short-term cash flow does a company need
    to pay its bills?

20
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 (raisings of funds).

21
Corporate Finance First Principles
  • Invest in projects that yield a return greater
    than the minimum acceptable hurdle rate.
  • Choose a financing mix that minimizes the hurdle
    rate and matches the assets being financed.
  • If there are not enough investments that earn the
    hurdle rate, return the cash to stockholders.
  • Objective Maximize the Value of the Firm

22
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
23
Corporate Governance Separation of Ownership
and Control
Board of Directors
Management
Debtholders
Shareholders
Debt
Assets
Equity
24
The Traditional Accounting Balance Sheet
25
The Financial View of the Firm
26
The Objective in Decision Making
  • In traditional corporate finance, the objective
    in decision making is to maximize the value of
    the business you run (firm).
  • A narrower objective is to maximize shareholder
    wealth. When the share is traded and markets are
    viewed to be efficient, the objective is to
    maximize the share price.
  • All other goals of the firm are intermediate ones
    leading to firm value maximization, or operate as
    constraints on firm value maximization.

27
The Classical Objective Function
SHAREHOLDERS
Hire fire managers - Board - Annual Meeting
Maximize shareholder wealth
Lend Money
No Social Costs
SOCIETY
Managers
BONDHOLDERS
Costs can be traced to firm
Protect bondholder Interests
Reveal information honestly and on time
Markets are efficient and assess effect on value
FINANCIAL MARKETS
28
What Can Go Wrong?
SHAREHOLDERS
Managers put their interests above shareholders
Have little control over managers
Significant Social Costs
Lend Money
BONDHOLDERS
Managers
SOCIETY
Bondholders can get ripped off
Some costs cannot be traced to firm
Delay bad news or provide misleading information
Markets make mistakes and can over react
FINANCIAL MARKETS
29
The Only Self Correcting Objective
SHAREHOLDERS
Managers of poorly run firms are put on notice.
1. More activist investors 2. Hostile takeovers
Good Corporate Citizen Constraints
Protect themselves
Managers
SOCIETY
BONDHOLDERS
1. Covenants 2. New Types
1. More laws 2. Investor/Customer Backlash
Firms are punished for misleading markets
Investors and analysts become more skeptical
FINANCIAL MARKETS
30
The Firm a systemic approach
31
The Firm a systemic approach
32
Sum Up Financial main principles
  • Rational Financial behavior
  • Risk aversion
  • Budgetary diversification
  • Existence of two parts/sides 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.

33
History of Financial Markets
  • Early 1900s - banks were full service financial
    organizations
  • Devastating financial crisis of 1907
  • Bank failures during 1920s
  • Great depression 1929 - 1933
  • Legislative reform-regulation and restrictions
  • Deregulation since 1970s

34
History of Investments
  • Early 1900s investments dominated by small group
    of wealthy investors
  • Industrialization during world war I
  • Growth of investment firms by 1920s
  • Stock market crash 1929 1932 market value
    decreased gt 80

35
History of Investments
  • Regulations of securities
  • Prosperity after world war II
  • Inflation and high interest in 1970s
  • Increase in individual and institutional investors

36
History of Managerial Finance
  • Emergence as a separate field of study
  • Early 1900s
  • Emphasis on mergers and capitalization
  • Wave of mergers during 1920s
  • Bankruptcies in 1930s
  • Liquidity stressed during 1940s 50s
  • Analysis and maximizing value in late 1950s and
    the 1960s
  • Innovative risk management in 1970s

37
History of Managerial Finance
  • Focus on valuation continued in 1980s, analysis
    expanded to include
  • Inflation and effects on business decisions
  • Deregulation of financial institutions
  • Increase in computer analysis and electronic
    information transfer
  • Increased importance of global markets
  • Innovative financial products

38
Importance of Managerial Finance
  • Financial managers no longer merely fund the
    business needs
  • Financial managers coordinate decisions
  • People in marketing, accounting, production, and
    personnel need to understand finance to do their
    job well.

39
Main programs 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

40
Career Opportunities in Finance
  • Financial markets
  • Investments
  • Managerial finance

41
Career Opportunities in Financial Markets
  • Financial institutions
  • Banks
  • Insurance companies
  • Savings and loans
  • Credit unions

42
Career Opportunities in Investments
  • Stock brokerage firms
  • Banks
  • Investment companies
  • Insurance companies

43
Responsibility of the Financial Staff
  • To acquire funds and then help operate resources
    so as to maximize the value of the firm.
  • Some specific activities
  • Forecasting and planning coordinating
  • Investment and financing decisions
  • Coordination and control
  • Transactions in the financial markets money and
    capital markets
  • Managing risk insurance and hedging in the
    derivatives markets.

44
Role of Finance in a Typical Business Organization
45
QUIZ 1(15 min)
  • Define Finance in terms of allocation of
    resources and as an inter-temporal decision
  • What is the main difference between Public
    Finance and Corporate Finance?
  • Discuss and comment the relationship between
    Managers and Debtholders in a corporate business?
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