LECTURE-1

TOPIC 1: INTRODUCTION
Finance

 Every decision that a business makes has financial implications, and

any decision which affects the finances of a business is a corporate
finance decision.
 Defined broadly, everything that a business does fits under the rubric
of corporate finance.

 Definition of Finance: Finance is concerned with the process,

institutions, markets, and instruments involved in the transfer of
money among individuals, businesses, and governments.

Corporate Finance

Financing Decision Investment Decision Dividend Decision

A Flow Model of the Economy

Households

Labor Product Capital Markets

Markets Markets

Nonfinancial
Corporations

The Financial System

Players in Financial Markets
 Borrowers: need funds
 Lenders / investors: wish to invest funds
 Hedgers: want to reduce risk
 Speculators: are willing to take risk
 Arbitrageurs: lock in profits by exploiting market inefficiencies
 Arbitrage opportunity / profit: riskless profit with zero initial
investment
 Arbitrage strategy: buy cheap and sell expensive
 Financial Intermediaries (FI): Commercial Banks
 Other Financial Intermediaries:
 Investment Banks: help companies to obtain funding directly
from lenders.
 Brokers: match investors wishing to trade with each other.
 Market makers: have the commitment to buy and sell from or to
investors.
Products traded on financial markets

 Bonds / FI securities (deterministic CF stream): e.g. classification

according to issuer: government bonds and corporate bonds

 Shares (random CFs): common stock and preferred stock

 Derivatives: forwards, futures, swaps and options

 Currencies / foreign exchange (FX)

 Commodities
Classification of financial markets
 according to types of markets / traded products: bond market,
stock market, derivatives market, FX market, commodities market
 according to investor’s horizon: money market (spot market) vs.
capital market (future market)
 Issuance vs. trading of securities: primary market vs. secondary
market
 according to the trading system: auction market, dealer market
and hybrid systems (… combination of auction and dealer market)
Principles of Finance
 Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and
reflect the financing mix used - owners’ funds (equity) or
borrowed money (debt).
• Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.
 Choose a financing mix that minimizes the hurdle rate and matches
the assets being financed.
 If there are not enough investments that earn the hurdle rate, return
the cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend
upon the stockholders’ characteristics.
Other Fundamental Principles of Finance
 P1:There Is No Such Thing As A Free Lunch

 P2: Other Things Equal, Individuals :

 Prefer more money to less (non-satiation)
 Prefer money now to later (impatience)
 Prefer to avoid risk (risk aversion)

 P3: All Agents Act To Further Their Own Self-Interest

 P4: Financial Market Prices Shift to Equalize Supply and Demand
 P5: Financial Markets Are Highly Adaptive and Competitive
 P6: Risk-Sharing and Frictions Are Central to Financial Innovation
Major Areas & Opportunities in Finance: Financial
Services
 Financial Services is the area of finance concerned with the design
and delivery of advice and financial products to individuals,
businesses, and government. Career opportunities include banking,
personal financial planning, investments, real estate, and insurance.
 Managerial finance is concerned with the duties of the financial
manager in the business firm. The financial manager actively
manages the financial affairs of any type of business, whether private
or public, large or small, profit-seeking or not-for-profit. They are also
more involved in developing corporate strategy and improving the
firm’s competitive position.
 Increasing globalization has complicated the financial management
function by requiring them to be proficient in managing cash flows in
different currencies and protecting against the risks inherent in
international transactions. Changing economic and regulatory
conditions also complicate the financial management function.
Fundamental Challenges of Finance
All Business Activities Reduce To Two Functions:
 Valuation of assets (real/financial, tangible/intangible)
 Management of assets (acquiring/selling)

Business Decisions Involve Valuation and Management

 “You cannot manage what you cannot measure”
 Valuation is the starting point for management
 Once value is established, management is easier

Objectives + Valuations = Decisions

Two Other Factors That Make Finance Challenging

Time
 Cash flows now are different from cash flows later
 Time flows in only one direction.
 How should we model temporal differences?
Risk
 Under perfect certainty, finance theory is complete
 Risk creates significant challenges
 How should we model the unknown?
Financial objective of firm
 Minimising costs?

 Maximising sales or market shares?

 Minimising risk?

 Maximising profit?

 Maximising shareholders’ wealth?

 Maximising firm value or value per share?

• Why or why not?

Corporate Governance
 Corporate Governance is the system used to direct and control a
corporation.
 It defines the rights and responsibilities of key corporate participants
such as shareholders, the board of directors, officers and managers,
and other stakeholders.
Individual versus Institutional Investors

 Individual investors are investors who purchase relatively small

quantities of shares in order to earn a return on idle funds, build a
source of retirement income, or provide financial security. Institutional
investors are investment professionals who are paid to manage other
people’s money.

 Institutional investors hold and trade large quantities of securities for

individuals, businesses, and governments and tend to have a much
greater impact on corporate governance.
The Role of Ethics: Considering Ethics

 Robert A. Cooke, a noted ethicist, suggests that

the following questions be used to assess the
ethical viability of a proposed action:
 Does the action unfairly single out an individual
or group?
 Does the action affect the morals, or legal rights of any
individual or group?
 Does the action conform to accepted moral standards?
 Are there alternative courses of action that are less
likely to cause actual or potential harm?
The Role of Ethics: Considering Ethics

 Cooke suggests that the impact of a proposed decision

should be evaluated from a number of perspectives:
 Are the rights of any stakeholder being violated?

 Does the firm have any overriding duties to any stakeholder?

 Will the decision benefit any stakeholder to the detriment of

another stakeholder?
 If there is a detriment to any stakeholder, how should it be
remedied, if at all?
 What is the relationship between stockholders and stakeholders?
 Agency Theory : Agency Problem
An agency relationship exists
when: Agency
Shareholders
Relationship
(Principals)
Risk Bearing Specialist
(Principal)
Hire Managerial Decision-
Firm Owners Making Specialist
(Agent)

Managers
(Agents)
which creates
Decision
Makers
Agency Theory
The Agency problem occurs when:
 The desires or goals of the principal and agent
conflict and it is difficult or expensive for the
principal to verify that the agent has behaved
appropriately
 Any loss of value that results from such conflict
is termed an agency cost:
Manager do not attempt to maximise firm value
Shareholders incur costs to monitor managers
Deal with Agency problem
Corporate control:
 Board of directors
 Management audits & reporting requirement
Managerial compensation
 Incentives can be used to align management and stockholder
interests
 Incentives need to be carefully structured to insure that they
achieve their goal
Corporate control
 Threat of a takeover may result in better management
Other stakeholders