Chapter 1 - Introduction to Fundamentals of Finance.pdf

AQ002-3-0 Fundamentals of Finance Chapter 1 Introduction to Finance AQ002-3-0-FOF Introduction to Finance  Learning Outcome At the end of the chapter, you should be able to: Describe finance and...

AQ002-3-0 Fundamentals of Finance Chapter 1 Introduction to Finance AQ002-3-0-FOF Introduction to Finance  Learning Outcome At the end of the chapter, you should be able to: Describe finance and career opportunities in finance Identify the primary activities of the financial manager. Describe the legal forms of business organization. Describe the financial institutions & markets Describe the goal of the firm and explain why maximizing the value of the firm is an appropriate goal for a business. Describe the nature of the principle-agent relationship between the owners and managers of a corporation. AQ002-3-0-FOF Introduction to Finance  What is Finance? Finance is the study of how people and businesses evaluate investments and raise capital to fund them. At the personal level, finance is concerned with individuals’ decisions about how much of their earnings they spend, how much they save, and how they invest their savings. In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors. AQ002-3-0-FOF Introduction to Finance  Career Opportunities in Finance Financial Services is the area of finance concerned with the design and delivery of advice and financial products to individuals, businesses, and governments. Career opportunities include banking, personal financial planning, investments, real estate, and insurance. Managerial finance is concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of all types of businesses— private and public, large and small, profit-seeking and not-for-profit. They perform such varied tasks as developing a financial plan or budget, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations. AQ002-3-0-FOF Introduction to Finance  Legal Forms of Business Organization A sole proprietorship is a business owned by one person and operated for his or her own profit. A partnership is a business owned by two or more people and operated for profit. A corporation is an entity created by law. Corporations have the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property in its own name. AQ002-3-0-FOF Introduction to Finance  Strengths and Weaknesses of the Common Legal Forms of Business Organization AQ002-3-0-FOF Introduction to Finance  Corporate Organization AQ002-3-0-FOF Introduction to Finance  Financial Institutions & Markets: Financial Markets Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. The primary market is the financial market in which securities are initially issued; the only market in which the issuer is directly involved in the transaction. Secondary markets are financial markets in which preowned securities (those that are not new issues) are traded. Transactions in short term marketable securities take place in the money market while transactions in long-term securities take place in the capital market. A private placement occurs when a company makes an offering of securities to an individual or a small group of investors. Most firms, however, raise money through a public offering of securities, which is the sale of either bonds or stocks to the general public. AQ002-3-0-FOF Introduction to Finance  The Money Market The money market is created by a financial relationship between suppliers and demanders of short-term funds. Most money market transactions are made in marketable securities which are short-term debt instruments, such as U.S. Treasury bills, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions, respectively. Investors generally consider marketable securities to be among the least risky investments available. AQ002-3-0-FOF Introduction to Finance  The Capital Market The capital market is a market that enables suppliers and demanders of long-term funds to make transactions. The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity, or ownership). Bonds are long-term debt instruments used by businesses and government to raise large sums of money, generally from a diverse group of lenders. Common stock are units of ownership interest or equity in a corporation. Preferred stock is a special form of ownership that has features of both a bond and common stock. AQ002-3-0-FOF Introduction to Finance  Flow of Funds AQ002-3-0-FOF Introduction to Finance  Goal of the Firm: Maximize Shareholder Wealth Wealth maximization is a modern approach to financial management. It simply means maximization of shareholder’s wealth. A wealth of a shareholder maximizes when the net worth of a company maximizes. A shareholder’s holding share in the company/ business will improve if the share price in the market increases which in turn is a function of net worth. This is because wealth maximization is also known as net worth maximization. AQ002-3-0-FOF Introduction to Finance  Goal of the Firm: Maximize Profit Profit maximization is the traditional approach and the primary objective of financial management. All the decisions with respect to new projects, acquisition of assets, raising capital etc are studied for their impact on profits and profitability. If the result of a decision is perceived to have a positive effect on the profits, the decision is taken further for implementation. Limitations which are discussed below: - Vague concept of profit - It has short term focus - Ignores risk AQ002-3-0-FOF Introduction to Finance  Goal of the Firm: Stakeholders Stakeholders are groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well-being but to preserve it. Such a view considered to be socially responsible. AQ002-3-0-FOF Introduction to Finance  Governance and Agency: Corporate Governance Corporate governance refers to the rules, processes, and laws by which companies are operated, controlled, and regulated. It defines the rights and responsibilities of the corporate participants such as the shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and procedures for making corporate decisions. AQ002-3-0-FOF Introduction to Finance  Governance and Agency: Individual versus Institutional Investors Individual investors are investors who own relatively small quantities of shares to meet personal investment goals. Institutional investors are investment professionals, such as banks, insurance companies, mutual funds, and pension funds, that are paid to manage and hold large quantities of securities on behalf of others. Unlike individual investors, institutional investors often monitor and directly influence a firm’s corporate governance by exerting pressure on management to perform or communicating their concerns to the firm’s board. AQ002-3-0-FOF Introduction to Finance  Governance and Agency: The Agency Issue A principal-agent relationship is an arrangement in which an agent acts on the behalf of a principal. For example, shareholders of a company (principals) elect management (agents) to act on their behalf. Agency problems arise when managers place personal goals ahead of the goals of shareholders. Agency costs arise from agency problems that are borne by shareholders and represent a loss of shareholder wealth. AQ002-3-0-FOF Introduction to Finance  The Agency Issue: Management Compensation Plans In addition to the roles played by corporate boards, institutional investors, and government regulations, corporate governance can be strengthened by ensuring that managers’ interests are aligned with those of shareholders. A common approach is to structure management compensation to correspond with firm performance. AQ002-3-0-FOF Introduction to Finance  The Agency Issue: Management Compensation Plans Incentive plans are management compensation plans that tie management compensation to share price; one example involves the granting of stock options. Performance plans tie management compensation to measures such as EPS or growth in EPS. Performance shares and/or cash bonuses are used as compensation under these plans. AQ002-3-0-FOF Introduction to Finance  The Agency Issue: The Threat of Takeover When a firm’s internal corporate governance structure is unable to keep agency problems in check, it is likely that rival managers will try to gain control of the firm. The threat of takeover by another firm, which believes it can enhance the troubled firm’s value by restructuring its management, operations, and financing, can provide a strong source of external corporate governance. AQ002-3-0-FOF Introduction to Finance  Summary / Recap of Main Points If you have mastered this topic, you should be able to use the following terms : Financial Services Financial Institutions Financial Market Money Market Capital Market Business Organizations Agency Theory AQ002-3-0-FOF Introduction to Finance  What To Expect Next Week In Class (Tutorial) Preparation for Class Describe financial institutions. Chapter 2 – An overview of the Distinguish money market and capital Financial System and The market. organization and structure of Explain in detail career opportunity in Banking and the financial service finance. Distinguish THREE common Legal Forms of Business Organization with example. Describe THREE goals of a firm. Distinguish between individual investors and institutional investors. AQ002-3-0-FOF Introduction to Finance