Introduction to Finance?

 A foremost concept in 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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 The Role of
Financial Management
 What is Financial Management?
 The Goal of the Firm
 Corporate Governance
 Organization of the Financial Management
Function

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 SUCCESS
 The key success of any business is taking
right decisions at right time.
 Making good investment and financing
decisions are the chief task of the financial
manager.

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 What is Financial
Management?
 Concerns the acquisition, financing,
and management of assets with
some overall goal in mind

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 Investment Decisions
Most important of the three decisions.
It starts with the identification of investment
opportunities
 What is the optimal firm size?

 What specific assets should be acquired?

 What assets (if any) should be reduced or

eliminated?
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 Financing Decisions
Determine how the assets (LHS of balance sheet)
will be financed (RHS of balance sheet).
This is to raise finance that the firm needs for its
investments & operations.
 What is the best type of financing?

 What is the best financing mix?

 What is the best dividend policy (e.g., dividend-

payout ratio)?
 How will the funds be physically acquired?

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 Asset Management Decisions
 How do we manage existing assets
efficiently?
 Financial Manager has varying degrees of
operating responsibility over assets.
 Greater emphasis on current asset
management than fixed asset management.

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What is the Goal of the Firm?
Maximization of Shareholder
Wealth!
Value creation occurs when we maximize the
share price for current shareholders.

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 Shortcomings of Alternative
Perspectives
 Profit Maximization
 Maximizing a firm’s earnings after taxes.
 Problems
 Could increase current profits while harming
firm (e.g., defer maintenance, issue common
stock to buy T-bills, etc.).
 Ignores changes in the risk level of the firm.

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 Shortcomings of Alternative
Perspectives
 Earnings per Share Maximization
 Maximizing earnings after taxes divided by
shares outstanding.
 Problems
 Does not specify timing or duration of
expected returns.
 Ignores changes in the risk level of the firm.
 Calls for a zero payout dividend policy.
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 Strengths of Shareholder Wealth
Maximization
 Takes account of: current and future profits
and EPS;
EPS the timing, duration, and risk of
profits and EPS;
EPS dividend policy;
policy and all
other relevant factors.
 Thus, share price serves as a barometer for
business performance.

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 What companies say about their
corporate goal
 Cadbury Schweppes: “governing objective is growth
in shareowner value”
 Credit Suisse Group: “achieve high customer
satisfaction, maximize shareholder value and be an
employer of choice”
 Dow Chemical Company: “maximize long-term
shareholder value”
 ExxonMobil: “long-term, sustainable shareholder
value”

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 The Modern Corporation
Modern Corporation

Shareholders Management

There exists a SEPARATION between owners

and managers.

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 Role of Management
Management acts as an agent
for the owners (shareholders)
of the firm.
 An agent is an individual authorized by
another person, called the principal, to act
in the latter’s behalf.

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 Agency Theory
 Jensen and Meckling developed a theory of
the firm based on agency theory.
theory
 Agency Theory is a branch of economics
relating to the behavior of principals and their
agents.

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 Agency Theory
 Principals must provide incentives so that
management acts in the principals’ best
interests and then monitor results.
 Incentives include, stock options, perquisites,
and bonuses.
bonuses

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 Organization of the Financial
Management Function
Board of Directors
President (Chief Executive Officer)

Vice President Operations VP of Finance (CFO) Vice President Marketing

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Organization of the Financial
Management Function
VP of Finance

Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
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 ASSETS
 REAL ASSETS: Used to produce goods &
services. (Tangible & Intangible)
 FINANCIAL ASSETS: Financial claims to
the income generated by the firm’s real
assets. (Stock, short & long term interest
bearing issues)

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 Two examples of common corporate
financial decisions
 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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 Example of common investments
type financial decisions
 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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 Forms of business organization
 Sole proprietorship
 Partnership
 Corporation
 Most large firms are organized as corporations.
 Advantages: unlimited life, easy transfer of ownership (stock),

limited liability for owners, relative ease of raising capital, and can
use stock for acquisitions
 Disadvantages: Double taxation of earnings, cost of set-up and report

filing, and issues relating to the separation of ownership and control

 Hybrid forms; Limited Liability Corporations (LLC), S Corporations,
etc., firms having characteristics of the three forms above.

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 Book versus Market values
 The book value of an asset is determined based on
accounting rules.
 The book value is at best a rough approximation of
the asset’s replacement cost.
 The market value of an asset is that investors are
willing to pay today for stocks and bonds in order to
receive a risky stream of future expected cash flows.

Market values are forward looking.

Stocks and bonds represent claims on the future cash
flows that a firm’s assets generate.

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 Book versus market values
 Market value of a firm

Assets Liabilities + Equity

Market value of the Mkt. value of debt
asset’s earning power
Mkt. value of equity
(as a going concern)

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 Book versus market values
 The Book value of a firm often contrasts
sharply with the Market value.
Assets Liabilities + Equity
Physical assets at Book debt
historical book value
Book equity

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 Book versus market values: a
hypothetical example
 A firm begins with $2000 of debt and $4000 of
equity in order to purchase $6000 of assets. These
become the original accounting book values.
 In contrast, Market values are based on today’s
expectations of future performance, i.e., what cash
amounts are expected to be paid out and the
perception of risk. Assume the following:

Investors are willing to pay $2000 for the bonds.

Investors are willing to pay $10,000 for the equity.

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 Book versus market values for the
hypothetical example
 Book values of firm:
Assets Liabilities + Equity
$6,000 physical assets $2,000 Book debt
$4,000 Book equity
 Market values of firm:
Assets Liabilities + Equity
$12,000 M.V. as a $2,000 M.V. debt
going concern
$10,000 M.V. equity
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 Intrinsic (fundamental) values
 Market values are what investors are willing to
either buy or sell an asset for, based on investors’
expectations of future performance.

Market values are very often publicly observed, e.g., the
transactions in the stock markets.
 In contrast, intrinsic values are usually considered as
private estimates of what something, e.g., a common
stock, is actually worth.

Intrinsic value is not something that you can prove.

If ten analysts are asked to value IBM stock, then there
will likely be ten different intrinsic value estimates!

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 Intrinsic (fundamental) values
 Assume that a New York Stock Exchange listed firm
has an equity market value of $10 billion.
 However, those that manage the firm (insiders)
believe the firm is actually worth $12 billion
(intrinsic value), based on their private or inside
forecasts of future cash flow performance.
 For the most part, market prices are driven by public
expectations and consensus, while intrinsic values
represent private forecasts.
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 Financial goals of the corporation
 The primary financial goal is shareholder
wealth maximization — a function of future
cash flow and risk.
 In reality, this is maximizing intrinsic value
 For now we will assume that this is synonymous
with maximizing the market value, i.e., stock price
maximization.
 Warren Buffett states that his goal is to
maximize Berkshire Hathaway’s intrinsic
value, and hopefully, the stock’s market value
will be close to the intrinsic value.

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Stock price maximization is NOT
profit or earnings maximization?
 Market (and intrinsic) values are driven by risk and
expectations (forecasts) of future cash flows.
 Earnings and other accounting profitability
measures are not cash flows and have limited use in
estimating financial values.
 Some actions may cause an increase in reported
earnings, yet cause the stock price to decrease (and
vice versa).

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 Wealth maximization and societal
welfare
 Is the general welfare of society advanced when
individual agents pursue wealth maximization?

Is intrinsic or market value maximization good or bad for
society. Should firms behave ethically?
 The following slide contains a quote is from Adam
Smith’s Inquiry into the Nature and Causes of the
Wealth of Nations, 1776.

Adam Smith believed that an economic system in which
individual agents strive to increase their market value
results in the most efficient level of general welfare, as it
facilitates the allocation of resources to their most
productive use.

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Wealth maximization and societal
welfare (Adam Smith, 1776)
“As every individual, endeavours as much as he can
both to employ his capital in the industry, and to direct
that industry that its produce may be of the greatest
value, every individual necessarily labours to render the
annual revenue of the society as great as he can. In
doing so he generally, indeed, neither intends to promote
the public interest, nor knows how much he is
promoting it. By directing that industry in such a
manner as its produce may be of the greatest value, he
intends only his own gain, and he is in this, as in many
other cases, led by an invisible hand to promote an end
which was no part of his intention. Thus, by pursuing
his own interest he frequently promotes that of the
society more effectually than when he really intends to
promote it. I have never known much good done by
those who pretended to trade for the public good.”

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 Agency relationships — the
separation of ownership and control
 An agency relationship exists whenever a principal
(owner of a resource) hires an agent to act on their
behalf. Examples are:

Citizen (principal) and elected official (agent)

Stockholder (principal) and corporate manager (agent)
 Within a corporation, agency relationships exist
between:

Shareholders and managers

Shareholders and creditors

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 Shareholders versus Managers
 Managers are naturally inclined to act in their
own best interests.
 But the following factors affect managerial
behavior:
 Managerial compensation plans
 Direct intervention by shareholders
 The threat of firing
 The threat of corporate takeover

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 Shareholders versus Creditors
 Shareholders (through managers) could take
actions to maximize stock price that are
detrimental to creditors, i.e., actions that
result in a wealth transfer from creditors to
stockholders.
 In the long run, such actions will raise the
cost of debt and ultimately lower the stock
price.

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 Factors that affect stock prices
 As implied in earlier slides, stock prices are a
function of:
 Projected cash flows to shareholders
 Timing of the cash flow stream
 Riskiness of the cash flows

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 Basic financial valuation model
CF1 CF2 CFn
Value     
(1  k)1 (1  k) 2 (1  k) n
n
CFt
 t
.
t 1 (1  k)

 To estimate any asset’s value, one must estimate the cash

flow for each period t (CFt), the life of the asset (n), and
the appropriate discount rate or cost of capital (k), based
on the level of estimated risk.
 Throughout this course, we discuss how to estimate the
model’s’ inputs and how financial management is used to
improve them and thus maximize a firm’s value.
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 Factors that affect the level and
riskiness of future cash flows
 Decisions made by financial managers:
 Investment decisions, i.e., decisions concerning
the firm’s assets.
 Financing decisions; the combination of debt and
equity financing used to finance the assets.
 The external environment
 Capital markets
 Industry and economic events

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 Understanding risk and investor
attitudes toward risk
 The following two slides illustrate two possible investments
that can be made today. The payoff of each will occur
exactly one year from today. Investment #1 costs $100
today. The current cost of Investment #2 is not given.
 Assume that one of three possible states of the
macroeconomy will prevail next year. Today, we can only
assign probabilities to these future economic states.

Good economy, probability of 30%

Average economy, probability of 40%

Bad economy, probability of 30%
 Probabilities must sum up to 100%.

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Investment #1, an apparently risk
less investment
 Investment #1: next year’s payoff is identical (all
result in $110) in each future economic state.
$110
Good economy,
probability=30%

Average economy,
Investment costs probability=40%
$100 today $110

Bad economy,
probability=30%

$110
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 Investment #2, an apparently risky
investment
 Investment #2: next year’s payoff varies with
future state of the economy.
$130
Good economy,
probability=30%

Average economy,
probability=40%
Today’s cost = ? $110

Bad economy,
probability=30%

$90
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 Summarizing risk less Investment #1
and risky Investment #2
 Investment #1 costs $100 today and has a certain $110
payoff in any economic state next year. It thus currently
offers a risk less one year investment return of 10%
 Investment #2, on the other hand, offers a risky payoff next
year. However, a glance at the payoff pattern does reveal
that the expected payoff is $110.
 Now, if risk less Investment #1 costs $100 today, then what
would you be willing to pay today for risky Investment #2,
given that each both investments offer an expected payoff of
$110 next year?

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 Summarizing risk less Investment #1
and risky Investment #2
 Most individuals are averse to risk and would pay less than
$100 for Investment #2, e.g., $85, $90, or $95, etc.
 Most risk averse individuals will accept risk, but only if they
expect to earn a higher return than what they can already
make on the risk less investment.
 The only way for Investment #2 to offer expected return
greater than 10% is to pay less than $100 today for
Investment #2.
 Practical example: Any corporation’s common stock is more
risky that its bonds (and also U.S. Treasury bonds). Investors
therefore expect to earn a higher return on the corporation’s
common stock.

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