© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

Introduction To Finance

Chapter Zero

What is Finance?

• Finance studies the issue of optimal capital allocation.

• Who makes the decision– Business: Corporate Finance– Individual: Personal Finance

• Where the capital gets allocated– Capital Markets: Investment

• What determines the allocation– Price of capital: Valuation

Key Question about this Course

• How do households make financial decisions?– Savings decision

• How to allocate wealth over time?

– Investment decision• How to grow wealth and spend contingent on different situations?

– Financing Decision:• How to finance consumption and investment?

• How do firms make financial decisions– Investment decision

• Which project to invest?

– Financing decision• How to finance a project?

– Payout decision• What to pay to stockholders and how much to keep for firm’s future

growth?

Finance Principles

• How do financial markets determine asset prices?

• Assumptions: Perfect Market• Frictionless markets• Large number of financial securities covering various

contingencies• Contracts are enforceable• Competitive trading process

• Principles– No arbitrage

• Riskless profit motive: stronger condition

– Equilibrium• Preference maximization: weaker condition

• What does a financial manager do?

• Three pillars of corporate finance– Investment: (2 to 3)– Financing: (1 and 4)– Payout Policy: (4 and 5)

Financial Manager

Firm’s Operation

InvestorIndividualInstitution

Corporate Finance

1

4

3

2

5

• What does an investor/consumer do?

• Personal Finance Decisions– Real Investment: (2 to 3)– Financing: (1 and 4)– Saving and Financial Investment: (5)

House-hold

Real Economic Activity

Financial Asset and Liabilities

Personal Finance

1

4

3

2

5

Asset Valuation

• What determines the value of an asset?• Time and Risk!

– Time• A dollar today is worth more than a dollar tomorrow

– Risk• A safe dollar is worth more than a risky dollar

• Absolute Valuation– Value equals risk-adjusted discounted cash flow

• Relative Valuation– Value equals the price of other (portfolio of) assets

with the cash flow of the same timing and risks

Corporate Finance

• Some important questions that are answered using finance– What long-term investments should the firm take

on?– Where will we get the long-term financing to pay

for the investment?– How will we manage the everyday financial

activities of the firm?

Financial Manager

• Financial managers try to answer some or all of these questions

• 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

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?– Should we use debt or equity?

• Working capital management– How do we manage the day-to-day finances of the

firm?

Forms of Business Organization

• Three major forms in the united states– Sole proprietorship– Partnership

• General

• Limited

– Corporation• S-Corp

• Limited liability company

Sole Proprietorship

• Advantages– Easiest to start

– Least regulated

– Single owner keeps all the profits

– Taxed once as personal income

• Disadvantages– Limited to life of owner

– Equity capital limited to owner’s personal wealth

– Unlimited liability

– Difficult to sell ownership interest

Partnership

• Advantages– Two or more owners

– More capital available

– Relatively easy to start

– Income taxed once as personal income

• Disadvantages– Unlimited liability

• General partnership

• Limited partnership

– Partnership dissolves when one partner dies or wishes to sell

– Difficult to transfer ownership

Corporation

• Advantages– Limited liability

– Unlimited life

– Separation of ownership and management

– Transfer of ownership is easy

– Easier to raise capital

• Disadvantages– Separation of ownership

and management

– Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate)

Goal Of Financial Management

• What should be the goal of a corporation?– Maximize profit?– Minimize costs?– Maximize market share?– Maximize the current value of the company’s

stock?

• Does this mean we should do anything and everything to maximize owner wealth?

The Agency Problem

• Agency relationship– Principal hires an agent to represent their interest– Stockholders (principals) hire managers (agents) to

run the company

• Agency problem– Conflict of interest between principal and agent

• Management goals and agency costs

Managing Managers

• Managerial compensation– Incentives can be used to align management and

stockholder interests– The incentives need to be structured carefully to

make sure that they achieve their goal

• Corporate control– The threat of a takeover may result in better

management

• Other stakeholders

Investment process

• Investment– Trade present for future payoff

• Bank deposit, stock purchase, education

• Real v.s. Financial Assets– Real Asset: assets for generating goods and

services• Factory, farm, gas station, restaurant, etc.

– Financial Assets: a claim on real asset• Bank loans, stocks, bonds, options, etc.

Investment process

• Five step approach

1. Setting investment objectives

2. Establishing investment policy

3. Selecting a portfolio strategy

4. Selecting the assets

5.Measuring and evaluating performance

Generating sufficient funds

Guarantee a payment at some time in the future

Asset allocation decision: stocks, bonds, real estate

Active strategy,passive strategy, structured strategy

Portfolio formation:market timing or asset pick

Benchmarking:S&P500, risk adjustment

Taxonomy of Financial Assets

• Money and Capital Markets

Debt Instruments Common Stock & Preferred Stock

Maturity < 1 Maturity 1

Money Market

Capital Market

Derivative Securities

Taxonomy of Financial Assets

• Why financial assets?– Consumption timing: to shift consumer’s need for

consumption across time• Savings to buy a BMW Z8

– Allocation of risk: real asset too risky• Amazon’s stock for the brave and bond for the less

adventurous souls

– Separation of ownership & management: real asset too big

• It’s inefficient for GE’s half-million stock owners to participate day-to-day operations

Players and Vehicles

• Who are they?

Financial Intermediaries

Commercial Bank

Taking deposit and making loans

Investment Bank

Selling securities to investors

Consumers/Investors

Companies

Government$

$

$

Players and Vehicles

• $ for …– Corporate bond: a promise by company to pay

back interest and principal• Investor makes money on interest payment

– Treasury Securities: a promise by government to pay interest and principal

– Stock: an ownership share of a company• Investor profits from company’s success

– Option: a security deriving value from stock• Investor takes bet on stock price movement

Market Microstructure

• Primary Market– New issue of securities offered to public

• Secondary Market– Trading places for existing securities

OTC Market (Over-the-Counter)

Exchange

Market Microstructure

• Direct Search Market– Buyer/seller search each other directly

• Brokered Market– Broker search buyer/seller for seller/buyer– Moderate trading activity, e.g. real estate, IPO

• Dealer Market– Dealers buy/sell for its own account– Active trading, e.g. OTC, NASDAQ stock trading

• Auction Market– Players buy/sell out of one central place– Active trading, e.g. NYSE stock trading

Recent Trends

• How far finance has traveled?– Return-Risk Tradeoff

• Markowitz (1951; Nobel Prize in 1990)• Security selection from a view of overall portfolio Risk

preference (or tolerance)

– Equity Valuation and Asset Allocation• Tobin’s q (1958; Nobel Prize in 1983)• Mutual Funds

– Performance Evaluation• CAPM, Sharpe-Linter (1964; Nobel Prize in 1990).• Mutual fund performance

– Derivative Security Valuation• Black-Scholes, Merton (1973, Nobel Prize in 1997).

Recent Trends

• Globalization– An Integration of worldwide economic environment and

national capital markets

– Major Activities• International diversification

– US market down, Asia markets up, average out

• Cross border trading– Local stocks, ADRs, Yankee bonds, mutual funds, WEBS (World

Equity Benchmark Shares), etc.

• Foreign exchange risk– Exchange rate fluctuation affects foreign stock returns.

– hedge to eliminate non-company specific factors

Recent Trends

• Securitization– Pooling loans/mortgages/debts to create

standardized securities– Efficiency gain

• Improved information flow based on market activity increases liquidity

• Service and financing separation encourages specialization and results better risk allocation

• Reduced cost for originator

• Enhanced yield for investor

Recent Trends

• Financial Engineering– The process of creating customized securities

tailored to investor’s need– Bundling

• Combining cash flows together• Straight bond+call option=convertible bond

– Unbundling• Slicing and dicing cash flow of an asset to several

classes• CMO to mortgage pass-through tranches and treasury

strips.

Quick Quiz

• What are the three types of financial management decisions and what questions are they designed to answer?

• What are the three major forms of business organization?

• What is the goal of financial management?• What are agency problems and why do they

exist within a corporation?• What is the difference between a primary

market and a secondary market?