1-1 chapter 1: overview of finance 1. introduction 2. defining finance 3. the firm: a systemic...
TRANSCRIPT
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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
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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? I’m 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?
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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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What is Finance ??? The discipline that deals with decisions
concerning how money is raised and used by businesses, governments and individuals.
3 success keys:1. More value is preferred to less.
2. The sooner cash is received, the more valuable it is.
3. Less risky assets are more valuable than riskier assets.
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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.
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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.
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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.
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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.
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Finance: Financial Theory Financial theory consists of:
the set of concepts that help to organize one’s 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.
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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 people’s consumption preferences.
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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.
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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.
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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.
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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 project’s 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?
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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?
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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,…).
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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.
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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.
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Corporate Finance
Corporate Finance addresses the following three major questions:
1. What long-term investments should the firm engage in?
2. How can the firm raise money for the required investments?
3. How much short-term cash flow does a company need to pay its bills?
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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).
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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
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Corporate Finance: The financial function
FINANCIALMANAGEMENT(CORPORATEFINANCE)
r ( r > k ) k
FINANCIAL SYSTEMREAL SYSTEM
INVESTMENT FINANCING
INVESTMENT / FINANCIAL SUBSYTEM
RETURNREPAYMENT AND RETURN
FINANCIAL MARKETS
FIRM OPERATIONS(Real goods & services
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Corporate Governance Separation of Ownership and Control
Board of Directors
Management
AssetsDebt
Equity
Shareholders
Debtholders
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The Traditional Accounting Balance Sheet
Assets Liabilities
Fixed Assets
Debt
Equity
Short-term liabilities of the firm
Intangible Assets
Long Lived Real Assets
Assets which are not physical,like patents & trademarks
Current Assets
Financial InvestmentsInvestments in securities &assets of other firms
Short-lived Assets
Equity investment in firm
Debt obligations of firm
Current Liabilties
Other Liabilities Other long-term obligations
The Balance Sheet
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The Financial View of the Firm
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible
Residual Claim on cash flowsSignificant Role in managementPerpetual Lives
Growth Assets
Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and
short-lived(working capital) assets
Expected Value that will be created by future investments
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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.
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The Classical Objective Function
SHAREHOLDERS
Maximizeshareholder wealth
Hire & firemanagers- Board- Annual Meeting
BONDHOLDERS
Lend Money
ProtectbondholderInterests
FINANCIAL MARKETS
SOCIETYManagers
Revealinformationhonestly andon time
Markets areefficient andassess effect onvalue
No Social Costs
Costs can betraced to firm
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What Can Go Wrong?
Managers puttheir interestsabove shareholders
Have little controlover managers
Lend Money
Bondholders canget ripped off
Delay badnews or provide misleadinginformation
Markets makemistakes andcan over react
Significant Social Costs
Some costs cannot betraced to firm
SHAREHOLDERS
BONDHOLDERS Managers SOCIETY
FINANCIAL MARKETS
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The Only Self Correcting Objective
Managers of poorly run firms are puton notice.
1. More activistinvestors2. Hostile takeovers
Protect themselves
1. Covenants2. New Types
Firms arepunishedfor misleadingmarkets
Investors andanalysts becomemore skeptical
Good Corporate Citizen Constraints
1. More laws2. Investor/Customer Backlash
SHAREHOLDERS
BONDHOLDERS Managers SOCIETY
FINANCIAL MARKETS
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Subsistema de
recursos humanos
Subsistema de
dirección y gestión
Subsistema de
dirección y gestión
Subsistema
comercial
Subsistema de
operaciones
Din
ero
Din
ero
Person
al
Perso
nal
Bienes y servicios
Personal
Personal
Goods and
Services
Resourses Expenses Sales
Incomes
Subsistema de
recursos humanos
Human Resources
Subsystem
Subsistema de
dirección y gestión
Management
Subsystem
Subsistema de
dirección y gestión
Finance Subsystem
Commercial
Subsystem
Operations
Subsystem
Fun
ds
Fun
ds
Human re
source
s
Human
reso
urce
s
Goods and Services
Personnel
Human Resources
Resourses
The Firm: a systemic approach
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The Firm: a systemic approach
FINANCIAL SUBSYTEM
Planificación FinancieraPlanificación Financiera
FINANCIACIÓN
Financiación Externa
Autofinanciación
Beneficio
INVERSIÓN
Financiación en activo fijo
Inversión en activo circulante
Costes
Subsistema de recursos
humanos
Subsistema de
operaciones
Subsistema comercial
Subsistema de dirección
y gestión
Demanda de créditos
Valores
Mercados Financieros
Dividendos
Impuestos
ENTORNO
Dinero
Recurso
s
Expenses
Resources
AmortizaciónReservas
Planificación FinancieraPlanificación Financiera
FINANCIACIÓN
Financiación Externa
Autofinanciación
Beneficio
INVERSIÓN
Financiación en activo fijo
Inversión en activo circulante
Costes
Subsistema de recursos
humanos
Subsistema de
operaciones
Subsistema comercial
Subsistema de dirección
y gestión
Demanda de créditos
Valores
Mercados Financieros
Dividendos
Impuestos
ENTORNO
Dinero
Recurso
s
In
AmortizaciónReservas
Planificación FinancieraFinancial Planning
FINANCIACIÓN
Financiación Externa
Autofinanciación
FINANCING
External Financing
Retained earnings
BeneficioBenefit
INVERSIÓN
Financiación en activo fijo
Inversión en activo circulante
Costes
INVERSIÓN
Financiación en activo fijo
Inversión en activo circulante
INVESTMENT
Fixed Asset
Current Assets
Costs
Subsistema de recursos
humanos
Human Recourses
Subsystem
Subsistema de
operaciones
Operations
Subsystem
Subsistema comercial
Commercial Subsystem
Subsistema de dirección
y gestión
Management Subsytem
Demanda de créditos
Valores
Mercados Financieros
Dividendos
Impuestos
ENTORNO
Debt
Securities
Financial Market
Dividends
Taxes
ENV IRONMENT
Funds
Resource
s
Income
Empoloyees
DepreciationReserves
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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.
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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
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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 > 80%
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History of Investments Regulations of securities Prosperity after world war II Inflation and high interest in 1970s Increase in individual and institutional
investors
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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
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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
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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.
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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
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Career Opportunities in Finance
Financial markets Investments Managerial finance
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Career Opportunities in Financial Markets
Financial institutions Banks Insurance companies Savings and loans Credit unions
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Career Opportunities in Investments
Stock brokerage firms Banks Investment companies Insurance companies
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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.
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Role of Finance in a Typical Business Organization
Board of Directors
President
VP: Sales VP: Finance VP: Operations
Treasurer Controller
Credit Manager
Inventory Manager
Capital Budgeting Director
Cost Accounting
Financial Accounting
Tax Department
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QUIZ 1(15 min)
1. Define Finance in terms of allocation of resources and as an inter-temporal decision
2. What is the main difference between Public Finance and Corporate Finance?
3. Discuss and comment the relationship between Managers and Debtholders in a corporate business?