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Notes - Chapter 1 - Intro To Finance

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13 views

Notes - Chapter 1 - Intro To Finance

Uploaded by

Ms. Smith
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Chapter 1

Introduction to Finance

Many companies face crucial decision points where in they need to decide on issues
related the corporate finance and other related areas:

Some examples of decision points could be:


• Do we shift production overseas as opposed to domestic production?
• What is the appropriate level of compensation for senior management?
• How do we balance social concerns as opposed to maximizing shareholder wealth?

In specific in Chapter 1 we will try to answer some questions on:


1. What do finance majors do after graduation?
2. Types of organizations that can legally exist
3. The place of finance in an organization
4. Nine axioms of financial management

1. Career opportunities in finance:


Three broad areas that do have a lot of overlap are:
• Money and capital markets (deals with financial institutions and securities markets)
Many finance majors’ go to work for financial institutions that include: banks, insurance
companies, mutual funds and investment banking firms. Important techniques that this
career path requires are
1. Valuation methods,
2. Understanding the factors that effect interest rates,
3. Regulations a their effect on financial assets,
4. And in general a good business administration background.
Examples: bank teller, specialist in real estate, trusts, insurance companies etc.
• Investments
Work as a financial or securities analyst for a brokerage house such as Merrill lynch
Job responsibilities include:
1. Analysis if individual securities
2. Determine the optimal mix of securities of a given investor
3. And help businesses raise capital
• General Financial management (decisions within firms)
This a more broad area than the other two and obviously has more number of jobs:

Beyond Career needs personally finance helps in planning


• Personal financial decisions
• Understand the business that you are in

In order to fulfill the goal of the firm the financial staff is required to acquire the skills
and some specific skill include:
• Forecasting and planning (work with people in the other departments to shape up the
firms future)
• Major investment and financial decisions (investment in plant and equipment,
inventories, should it be debt or equity for external funding etc.
• Coordination and control (capacity utilization, inventory policies, working capital
requirements, plant capacity utilization etc. and their financial implications, this skill
requires interactions with other personnel from other departments)
• Dealing with the financial markets
• Risk management (identifying risks and hedging them, risks may include natural
disasters, uncertainty in securities prices, volatile interest rates and fluctuating foreign
exchange rates)

2. The place of finance in business

What is the goal of financial management?


Maintenance and Creation of Wealth
And what is the goal of the firm:
Maximization of Shareholder Wealth
Why not maximization of profits?
Assumes away uncertainty of returns (financial effects of a decision can be in the form of
long term benefits)
And however, Maximization of Shareholder Wealth Includes effects of all the financial
decisions

Financial management over the last century took a lot of twists and turns:
• To begin with in the early 1900’s its emphasis was more on the legal aspects of
mergers, formation of new firms, and the various types of securities that a firm could
issue to raise new capital.
• In the 1930’s its concentration was more on the bankruptcies and reorganization of
firms, regulation of the securities markets etc.
• 1950s were the best time for finance in the sense that researchers started looking at
finance form the standpoint of the financial theory behind the managerial decisions.
• Obviously, the most recent trend being globalization of the financial markets.

Some factors that led or leading to globalization include:


1. Improvement in transportation and communications
2. Ability of consumers to desire low cost high quality products
3. Joint ventures to keep cost low
4. In general keeping costs low

Finance in the organizational structure (refer page 15)

3. Types of organizations

Sole proprietorship is an unincorporated business owned by an individual. Should be


licensed by a governmental unit.
Sole proprietorship:
Advantages
• Easily established with few complications
• Minimal organizational costs
• No sharing of profits
• Avoid corporate income taxes
Disadvantages
• Unlimited liability for the owner
• Equity capital limited to personal resources
• Business terminates with the death of the owner (limited life of business)

Partnership: exists whenever two or more than two persons associate to conduct non
corporate business
General
Limited
General partnership
Advantages
• Minimal organizational costs
• Negligible government regulations
Disadvantages
• All partners have unlimited liability
• Difficult to raise large amounts of capital
• Partnership dissolved with the death or withdrawal of a general partner
• Difficulty in transferring ownership
Limited Partnership
Advantages
• Liability limited to the capital invested
• Withdrawal does not affect the continuity of business
• Stronger inducement in raising capital
Disadvantages
• One general partner is a must
• More expensive to organize

Corporation: legal entity created by the stet and distinct from its owners and mangers
Advantages
• Limited liability of owners
• Easy transferability of ownership and unlimited life
• Death of owner does not affect the business
• Ability to raise large amounts of capital
Disadvantages
• More difficult and expensive to establish
• Control of corporation not guaranteed
• Corporate earnings subject to double taxation
Three reasons why one would choose a corporation as opposed to other legal forms of
business
• The lower the firm’s risk the higher its value.
• More growth opportunities
• Liquidity

For a corporation to be formed, a charter needs to be filed to the secretary of state in


which the firm is incorporated. The charter includes:
Name
Type of activities
Amount of capital stock
Number of directors
Name and address of directors
Bylaws of the corporation:

Hybrid forms of business organizations:


Limited liability partnership (LLP)
Professional corporation (PC) or professional association (PA).
4. Nine Axioms: Foundations of Financial management:

• The Risk-Return Tradeoff - we won’t take on additional risk unless we expect to be


compensated with additional return.
• The Time Value of Money - a dollar received today is worth more than a dollar
received in the future.
• Cash is King - measuring the timing of costs and benefits.
• Incremental Cash Flows - it’s only what changes that count.
• The Curse of Competitive Markets - why is it hard to find exceptionally profitable
projects?
• Efficient Capital Markets - the markets are quick and the prices are right.
• The Agency Problem - managers won’t work for the owners unless it’s in their best
interests. Also between the creditors and the mangers.
Some ways to overcome this problem
Performance shares
Executive stock options
Direct intervention by shareholders
The threat of firing
The threat of takeovers especially hostile takeovers
• Taxes bias Business Decisions
• Ethical Behavior is doing the Right Thing - ethical dilemmas are everywhere in
Finance.

Other issues that remain dilemmas in finance are:


• Is shareholder wealth or social responsibility important?
• Do we maximize earnings per share?

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