Introduction To Finance I. Setting The Stage

Introduction to Finance
I. Setting the stage
Jaap Spronk
1.The financial system: players, markets, institutions and financial flows

2.The individual: Taste & Perception
3.The firm: Where Value comes from
4.The goal of the firm: neo-classical view
5.The goal of the firm: other stakeholders
6.The financial manager
7.Financial markets and institutions
© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

1.The Financial System:
Players on the
market:
• individuals
• firms (fin and non-fin)
• (semi-)governmental
• etc.
Institutions:
• special roles of
Markets:
government • Virtual
• special role of central bank (majority)
• international organisation • Physical
• supervisory bodies
• data & information
business
Money
Information

1.The Financial System:
Dynamic Systems
Processes Networks
Money
Information

1.1 Who is involved (different fields of study)

Following parties take part in the financial system
(including financial markets and financial institutions)
Individuals: - families (Personal Finance)

- partnerships (Investment)
- etc, etc...
Firms: - Non-Financials (Corporate Finance)
- Financials (Banking & Insurance)
Other organisations
Government, governmental (Public Finance)

and semi-governmental (Etc, Etc.)

1.All market players face two types of decisions:
A. Allocation of scarce financial resources over time

Consumption, saving, financing, investment and production
result in future cash outflows and cash inflows.
(Both timing and size of cash flows is uncertain)
Need to analyze and manage risk
(Two issues: perception and taste)
B. Allocation of scarce financial resources over productive opportunities:
What can we do best to get the best value for money?
(What do parties mean by value and)
(Same two issues: perception and taste)

Bodie & Merton:
• “Finance is”
• Valuation
• Risk management
• Optimization Decision-Making

3. Intro
We will concentrate on one type of player: The Firm
So we will concentrate on the two types of allocation decisions faced by the
firm (see slide #5)
Both timing and size of cash flows is uncertain

Need to analyze and manage risk
(Two issues: perception and taste)
What can we do best to get the best value for money?

What does the firm mean by value, firm’s objectives
(Same two issues: perception and taste)
We will also have to address the perception and taste of individuals

3.The individual ‘taste’ (preferences, objectives)
The principle of self-interested behavior
Why?
Goal: Max{ personal wealth }

The principle of self-interested behavior is to MAXIMIZE the personal
wealth!
wealth  value  future cash flows
The principle of time preference

dollar today  dollar tomorrow
-- productivity of economic goods

-- positive time preference
“time is money”
interest rate

wealth  value  future cash flows
The principle of risk aversion
safe dollar  risky dollar
risk premium

3.The individual ‘perception’

3.The individual ‘taste’ and ‘perception’
• time value of money

• perception of risk
• attitude towards risk : different for different persons
But claims on future, uncertain cash flows are traded in financial markets
 prices for borrowing & lending
 pricing of risks
 max { value } = interpersonal objective

: pattern of underlying cash flow stream can be changed on capital market ...

4.The firm, where value comes from
labor goods
transformation process
capital
goods services
info
• takes time !
• has risk !
• creates value ?
View: firm has right to exist if: V(outputs) > V(inputs)

4.The firm
expertise is an important production factor:
specific: generate value-added through specialization

core competence  core activities
general: management (planning implementation driving control) :

• organization of firm activities
• adequate response to changes
in firm’s environment
 firm management has the task to optimize the portfolio of expertise

5.The goal of the firm, neo-classical view :
Property rights perspective
The firm is owned by the shareholders,

so the firm should act in the interest of the shareholders
(The financial manager is the intermediary between the

shareholders and the ‘real’ operation of the firm)

What shareholders want
Shareholders want to maximize the value of their financial

claims on the firm.
Positive time preference. Risk aversion.
Different shareholders have different

perceptions / different preferences.
So what is the appropriate guideline for the firm?

The claims of shareholders (i.e. their shares) are traded on

the stock market.
Thus market prices exists for claims on the future cash flows
of the firm.
Implicitly, there are market prices for lending/borrowing and

for risk.
This means that for each claim on future cash flows the
Market Value can be calculated/ estimated.
Inclusion of options / contingent claims.

What shareholders want
Given the above,

the goal of the firm is
to maximize the Market Value of the claims of the present
shareholders.

Firm can also be viewed as a set of contracts between stakeholders
• exchange relations: volatile

long lasting
• participants together determine the direction the firm is taking

The importance of games
• Example average number

7.The financial manager

firm
balance sheet
assets liabilities
4a 3
2
5
4b
1
investors
2. generate funds
3. investment in real activities
4. returns from real activities
a. re-investment in firm projects
b. distribute to participants: dividends, interests, amortization
7.The task of the financial manager
In the neo-classical view, the goal of the firm is the

to maximize the Market Value of the claims of the
present shareholders.
Tasks financial (manager):
Every decision is to be evaluated in terms of their effect

on Market Value!
(Taking account of the financing)

7.The financial management cycle: the process of adding value is a

structured process of identification and selection of present and future
value adding opportunities (“projects”, incl. disinvestments), taking account
of the financing of these projects over time
the firm: the change process:
uncer-tainty
description picture of the
of the firm firm’s future
criteria for evaluation of
firm evaluation prefe- this future
rences
alternative selection of
opportunities alternatives
feasi-bility

8.Financial Markets
The individual ‘taste’ and ‘perception’ , i.e.
• time value of money
• perception of risk
• attitude towards risk : is different for different persons
But claims on future, uncertain cash flows are traded in financial markets
 prices for borrowing & lending
 pricing of risks
 max { value } = interpersonal objective
markets to find prices

markets as benchmark
markets as alternative opportunity

8.Financial markets
deal with (uncertain) cash flows over time
• financial instruments / securities are traded on capital markets

• financial instrument = claim on future cash flows
Purpose: to optimally allocate scarce savings to productive investments
allocation efficiency: no large impediments

• transaction costs
• taxes
• constraining regulations
• imperfect competition
8.Allocative efficiency
-----------------------------------
The principle of informational efficiency
prices fully & instantaneously reflect all available info
: prices are accurate signals for capital allocation ( value )

FINANCIAL ECONOMICS:
ALLOCATIVE DECISIONS, taken on the basis of
VALUE that is formed as a MARKET PRICE.
Value comes from future & uncertain cash flows
The aspects of TIME & RISK are incorporated in value by

the mechanisms of ARBITRAGE & EQUILIBRIUM
aspects: time risk
market value allocation
mechanisms: arbitrage equilibrium

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Introduction to Finance

1.The financial system: players, markets, institutions and financial flows

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

1.1 Who is involved (different fields of study)

Individuals: - families (Personal Finance)

Government, governmental (Public Finance)

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

1.All market players face two types of decisions:

A. Allocation of scarce financial resources over time

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

Bodie & Merton:

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

Both timing and size of cash flows is uncertain

What can we do best to get the best value for money?

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

3.The individual ‘taste’ (preferences, objectives)

The principle of self-interested behavior

Goal: Max{ personal wealth }

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

The principle of time preference

-- productivity of economic goods

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

3.The individual ‘taste’ (preferences, objectives)

wealth  value  future cash flows

The principle of risk aversion

safe dollar  risky dollar

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

3.The individual ‘perception’

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

3.The individual ‘taste’ and ‘perception’

• time value of money

 prices for borrowing & lending

 max { value } = interpersonal objective

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

4.The firm, where value comes from

View: firm has right to exist if: V(outputs) > V(inputs)

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

specific: generate value-added through specialization

general: management (planning implementation driving control) :

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

5.The goal of the firm, neo-classical view :

Property rights perspective

The firm is owned by the shareholders,

(The financial manager is the intermediary between the

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

5.The goal of the firm, neo-classical view :

What shareholders want

Shareholders want to maximize the value of their financial

Positive time preference. Risk aversion.

Different shareholders have different

So what is the appropriate guideline for the firm?

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

5.The goal of the firm, neo-classical view :

The claims of shareholders (i.e. their shares) are traded on

Implicitly, there are market prices for lending/borrowing and

© 2019 Jaap Spronk UOC & GEMFM-Global Network NY

5.The goal of the firm, neo-classical view :