1-1 Chapter 1: Overview of Finance 1. Introduction 2. Defining finance 3. The Firm: a systemic approach 4. Corporate Finance: the financial function 5

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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


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


Management

Subsystem

Subsistema de


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


Autofinanciación

Beneficio

INVERSIÓN



Costes


humanos

Subsistema de

operaciones



y gestión


Valores


Dividendos

Impuestos

ENTORNO

Dinero

Recurso

s

In

AmortizaciónReservas

Planificación FinancieraFinancial Planning

FINANCIACIÓN


Autofinanciación

FINANCING

External Financing

Retained earnings

BeneficioBenefit

INVERSIÓN



Costes

INVERSIÓN



INVESTMENT

Fixed Asset

Current Assets

Costs


humanos

Human Recourses

Subsystem

Subsistema de

operaciones

Operations

Subsystem


Commercial Subsystem


y gestión

Management Subsytem


Valores


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?

Documents

1-1 Chapter 1: Overview of Finance 1. Introduction 2. Defining finance 3. The Firm: a systemic approach 4. Corporate Finance: the financial function 5