Chapter 1: Introduction

Copyright 2002 McGraw-Hill Australia Pty Ltd.

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Learning Objectives
Identify the major types of business entities.
Explain the role of the financial manager.
Specify the objective that is necessary to
ensure the financial manager makes rational
investment and financing decisions.
Identify the major financial decisions made
by the managers of business entities.
Identify and explain the basic concepts of
finance.
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The Nature of Business

Finance
Broad aspects of finance:
corporate finance the financial
management of companies
financial institutions and markets
investments
Focus is mainly on corporate finance,
but also considers financial
institutions and markets, and
investments.
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Financial Decisions
Major financial decisions are:
investment decisions decisions that
determine the asset profile of a business
(amount and composition of investments)
financing decisions how the assets are
to be funded (debt and equity)
financing decisions also involve dividend
decisions

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Business Structures
Sole proprietorship
business owned by one person

Partnership
business owned by two or more people
acting as partners

Company
separate legal entity formed under the
Corporations Act

Focus is on financial decision making

by managers of public companies.
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Sole Proprietorship
Advantages
1. Control of the business rests with the owner
2. It is easy and inexpensive to form and to
disolve
3. It is not treated as a separate entity for tax
purpose
Disadvantages
1. Unlimited liability to the owner for debts
2. The size of the business is limited by the
wealth of the owner
3. Ownership can be transferred only by
selling the business

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Partnership
Advantages
1. It is easy and inexpensive to form
2. It can combine the wealth and talents

Disadvantage
1. Partners are personally liable for the
debts
2. It is difficult to withdraw the investment
3. Disputes between partners is damaging

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Company
Advantages
1. It is a separate legal entity
2. It has an indefinite life
3. It can raised fund from public

Disadvantages
1. It is expensive to establish
2. It face a proliferation of regulations
3. Managers and staffs are the employees
(motivation)
4. Double tax on income and dividends paid
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The Finance Function:

Major Roles of Financial
Managers
Project evaluation
Evaluating, obtaining and servicing shortand long-term financing
Dividend distributions
Collection and custody of cash and
payment of bills
Management of investments in current
assets
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The Finance Function: Major

Roles of Financial Managers
(cont.)
Assessing the viability of growth
through acquisitions
Planning the future development of the
business
Interest rate and exchange rate risk
management
Development and implementation of
financial policies
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A Companys Financial
Objective
The maximisation of market value of a
companys shares is the overriding
objective.

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Basic Concepts of Finance

Value
The value of a company (V ) on the
financial markets may be expressed as :
V = D + E
where D = the value of debt
E = the value of equity

Financial markets will value debt and

equity, taking into account the risk and
expected return from investing in these
securities.

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Basic Concepts of Finance

(cont.)
Time and Uncertainty
The value of an investment will depend on
the amount and timing of the cash flows
generated by the investment.
Time value of money: a dollar today is
worth more than a dollar in the future.

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Basic Concepts of Finance

(cont.)
Nominal and Real Amounts
The cost of an asset expressed as the
number of dollars paid to acquire the asset
is the nominal price.
However, due to inflation and deflation, the
purchasing power of money changes.
Therefore, it is necessary to distinguish
between the nominal or face value of
money and the real or inflation-adjusted
value of money.
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Basic Concepts of Finance

(cont.)
Market Efficiency and Asset Pricing
Market efficiency means that we should expect
securities and other assets to be fairly priced,
given their expected risks and returns.
Trade-off between risk and expected return under
the capital asset pricing model (CAPM):
Systematic risk: market-wide factors (nondiversifiable or market risk).
Unsystematic risk: factors that are specific to a
particular company (diversifiable or unique risk).

According to the CAPM, investors can diversify

their investments to eliminate unsystematic risk.

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Basic Concepts of Finance

(cont.)

Arbitrage

If two identical assets were to trade in the

same market at the same time at different
prices, and if there were no transaction costs,
then an arbitrage opportunity would exist.
A risk-free profit could be made by
simultaneously purchasing at the lower price
and selling at the higher price.
However, competition among traders will force
the two alternative prices to become the
same.
Arbitrage precludes perfect substitutes from
selling at different prices in the same market.

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Basic Concepts (Summary)

The companys objective is to
maximise shareholders wealth,
A dollar receive today is preferred to a
dollar received later; and
Investors prefer less risk to more risk,
other things being equal - that is, they
are risk-averse.

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Basic Concepts of Finance

(cont.)
Agency Relationships
One party, the principal, delegates
decision-making authority to another
party, the agent.
In a company:
managers = agents
shareholders = principals

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Basic Concepts of Finance

(cont.)
Agency Relationships (cont.)
Agency costs: conflict of interest between
parties creates costs
reduced value due to managers acting in
their own best interests
costs associated with monitoring
managers behaviour
bonding costs

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Summary
Business entities include sole
proprietorship, partnership and company.
We focus on public companies.
We study corporate finance along with
investments and the structure of
financial markets and institutions.
We consider broad finance issues such
as valuations, market efficiency, asset
pricing and arbitrage, along with agency
issues.
Copyright 2002 McGraw-Hill Australia Pty Ltd.

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