chapter 01 - introduction to finance

7/31/2019 Chapter 01 - Introduction to Finance

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Introduction to Finance

TCHE302(2-1112).1_LT

Lecturer:MSc Nguyen Thu Thuy

The Faculty of Banking and Finance

Email: [email protected]


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Outline

1. Introduction to Finance

2. The Time Value of Money

3. The Financial System

4. Valuation

5. Introduction to Corporate Finance


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1. Introduction to Finance

1.1. What is Finance?

1.2. Time and Risk

1.3. Unifying Principles of Finance

1.4. Financial Management

1.5. Forms of Business Organization


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1.1. What is Finance?

Finance is the study of how people allocate scarce resources overtime.

Every business is a process of acquiring and disposing assets

Real assets (tangible and intangible assets)

Financial assets

Two objectives of business

Grow assets (create value)

Use assets effectively to meet economic needs

A business decision means

Valuation of assets (the central issue of finance)

Management of assets


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Real Assets Financial Assets

Determine the

productive capacity

of an economy

Land

Buildings

Machines

Knowledge

- Means by which investors hold the assets of

the economy (corporate bonds, stocks,)

- Also used to allocate payoffs between

investors (derivatives, insurance contracts,

loans)

- Define the allocation of income and wealth

among investors- Trade onfinancial markets


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Questions we would like to answer

1. How financial markets determine asset prices?

2. How households make financial decisions?

3. How firms make financial decisions?


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Financial Decisions of Households

Consumption and savings decisions

How to allocate wealth over time?

Investment decisions

How to grow wealth? How to allocate wealth over states?

Financing decisions

How to finance consumption and investment?

Risk management decisions

How to reduce financial uncertainties and when should increase risk?


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Cash Flows and Financial Decisions

Cash flows and financial decisions of Households

Cash raised by selling financial assets

Cash invested in real assets

Cash generated by real assets

Cash consumed and reinvested

Cash invested in financial assets

Real

Economic

Activities

Households

Financial Assets/

Liabilities

- Bonds

- Stocks

- Mortgages

(2)

(3)

(1)

(5)

(4)


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Cash Flows and Financial Decisions

Cash flows and financial decisions of Firms

Cash raised from investors by selling financial assets Cash invested in real assets

Cash generated by operations Cash reinvested Cash returned to investors (mandatory and discretionary)

Firms

Operations

Financial

Manager

Investors- Individuals

- Institutions

-

(1)(2)

(5)

(4)(3)


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Financial Decisions and Asset Valuation

Real Investment Decisions How real assets are priced?

Financing and Payout Decisions

How financial assets are priced?


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Financial Decisions and Asset Management

Risk management decisions How to meet future financing/investment needs?

Personal savings/ financing/ financial investment

decisions

How to meet personal consumption needs?


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1.2. Time and Risk

An assetA cash flow

Value of an asset = Value of its cash flow

Value of investment = Value ({CF0, CF1, , CFn})

Time 0 1 2

Cash out CF0 - -

Cash in - CF1 CF2

Net cash flow - CF0 CF1 CF2


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Two characteristics of a cash flow

Time

A dollar today is worth more than a dollar tomorrow

Example: $1000 today verses $1000 next year

Risk

A safe dollar is worth more than a risky dollar

Example: $1000 each year for sure vs. $0 today and $2000next year


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1.3. Unifying Principles of Finance

Assumption of a perfect financial market

No Arbitrage

Preference

Optimization

Market in Equilibrium


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Assumption of A Perfect Financial Market

Financial market is where financial assets are traded.

The financial market is perfect:

A rich set of securities being traded

Security contracts are enforceable

Free access

Competitive trading process

No frictions/constraints in trading (frictionless markets)


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1st principle: No Arbitrage

Definition: An arbitrage is a set of transactions such that

Requires non-positive initial investment

Yields non-negative payoffs

at least one of the inequalities is strict

Examples:

HSBCs 3 month lending rate is 5.85% and Citibank is selling 3 month

CDs at an interest rate of 6%.

IBM is trading at $80 in New York, 50 in London and the current

dollar/sterling exchange rate is $1.50/.

There are no arbitrage opportunities in the financial markets

Assets having same payoffs must have same prices


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2nd Principle: Preference

A preference is a complete ranking of pairs of consumption (cash

flow) streams

Given any pair of cash flow, a household can decide which one is

better

Each household has a preference expressed by its (expected) utility

Assumptions:

Consistency

Non-satiability (more cash is preferred to less)

Impatience (cash now is preferred to cash later)

Risk- aversion (safe cash is preferred to risky cash)


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3rd Principle: Optimization

Consider a household:

Endowed with certain resources (endowments)

Facilitated by a financial market

A risk free bond offering interest rate rf

A risky stock offering return

Face with the choice

Optimize to achieve maximum utility feasible

Utility function satisfies

Each household optimizes


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4th Principle: Market in Equilibrium

The optimization behavior of households and firms

determines their demands for financial assets, which dependson:

Endowments and preferences

Expectation of asset payoffs (timing and risk)

Asset prices (demand = supply market in equilibrium)

Market equilibrium determines security prices in terms of

fundamentals

Expectation of future cash flow Investors preferences for the cash flow


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1.4. Financial Management

Financial manager try to answer some or all of thesequestions

The top financial manager within a firm is usually the Chief

Financial Officer (CFO) Treasurer: oversees cash management, credit management,

capital expenditures and financial planning

Controller: oversees taxes, cost accounting, financial

accounting and data processing


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Objectives of Financial Manager

Maximizes current market value of the firm

Maximizing current market is the only plausible financial

objective

Timing

Risk

Accounting

Long- run value

Current market value incorporates present value of all current and

future cash flows, adjusted for timing and risk

Market value rule is independence ofshareholders differences


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Financial Management Decisions

Capital Budgeting What long term investments or projects should the business

take on?

Capital Structure How should we pay for our assets?

Debt or Equity?

Working Capital Management How to manage the day- to- day finances of the firm?


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Goal of Financial Management

What should be the goal of financial management? Maximize profits?

Minimize costs?

Maximize market share?

Maximize the current value of the companys stock?

Does this mean we should do anything to maximize owners

wealth?


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Forms of Business Organization

Three major forms in the U.S

Sole proprietorship

Partnership

General

Limited

Corporation

S-corp

Limited liability company


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Sole proprietorship

Advantages Disadvantages

Easiest to start

Least regulated

Single owner keeps all theprofits

Taxes once as personal

income

Limited to life of owner

Equity capital limited to

owners personal wealth Unlimited liability

Difficult to sell ownership

interest


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Partnership


Two or more owners

More capital available

Relatively easy to start

Income taxes once as

personal income

Unlimited liability

Partnership dissolves when

one partner dies or wishes to

sell

Difficult to transfer

ownership


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Corporation


Limited liability

Unlimited life

Separation of ownership and

management

Transfer ownership is easy

Easier to raise capital

Separation of ownership and

management

Double taxation (income

taxed at the corporate rate

and then dividends taxed at

personal rate)


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The agency problem

Agency relationship

Principals hire an agent to represent their interest

Shareholders (principals) hire managers (agents) to run the company

Agency problem

Conflict of interest between agent and principal

Solutions

Tough screening processes

Incentives for good behavior and punishments for bad behavior


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Quick Quiz

1. What are the three types of financial decision?

2. What determines the value of an asset?

3. What are the three major forms of business organization?

4. What is the goal of financial management?

5. What are agency problems and why do they exist within a

corporation?

chapter 01 - introduction to finance

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