Introduction to Finance

Content

Defining finance. Evolution of finance Finance function The firm’s goal. Role of financial managers Financial Markets and financial systems Agency theory

The practice of “finance” exists for the creation of value

Financial contracting brings about the substitution of real wealth (i.e. real business assets) for financial wealth (i.e. securities) Investing in financial securities has better attributes that in real assets. Value is created in tthe real assets held by businesses, and then transmitted into the value of financial wealth issued by businesses and held by investors.

What is finance?Defining Finance: a new paradigm. The Value Creation Function of Finance

Norton y Scott, “A new Paradigm: the value creation

function of finance”, january 2001

Early View of Financial Management In the past, the finance manager was only

involved in simple book keeping such as documentations, record keeping, financial reports preparation, and simple payments of the company’s bills (Van Horne, James 2005.).

As time went on, the task of the finance manager evolved going deeply into the major parts of the firm’s activities, a role that critically developed to what is now known as financial management.

Modern

Approach

1900-

1950-

1970-

1980-

1990-

Classical Approach

APT Model(Ross, 1970)

Options Valuation Models (Black y Scholes, 1973)

Portfolio selection Theory (Markowitz, 1952,1959)

CAPM (widening and reformulation)

Dividends Policy (Modigliani, Miller, 1963)

Capital Assets Pricing Model (CAPM) (Sharpe, 1963-4, Lintner, 1965)

Efficient Market Theory

(Fama, 1970)

Financial Structure (Modigliani, Miller, 1958)

Agency Theory

Information

Theory

Financial Innovation

Methods based on Fuzzy Sets Theory

(Kaufmann y Gil, 1986-87)

Chaos Theory,Non Linear Dynamics

Markets Efficiency

Para

dig

m y

ears

70

Behavioral finance

2000-

Finance: historic evolution

Finance Function-managing the cash flow

Operations (plant, equipment, projects)

Financial Manager

Financial Markets (investors)

1a.Raising funds2.Investments

3.Cash from operational activities

4.Reinvesting

1b.Obligations (stocks, debt securities)

5.Dividends or interest payments

Real and Financial asset

Real assets can be tangible or intangible Firms sell financial assets to raise funds

Equity and Borrowed fund

Shares Ordinary Preference

Creditors and Lenders

Finance Functions

Investment or long term asset mix decisions Financing or capital-mix decisions Dividend or profit allocation decisions Liquidity or short-term asset mix decisions

THE FIRM’S GOAL Economic theory holds that individuals want to maximize their utility. People always have the options to choose what to do with their

earnings. They can spend, save or invest it. Spending could satisfy individuals’ wants but have not maximized

their utility because of losing the opportunity to have more earnings if saved.

maximizing their utility could be hampered because of a lost of opportunity to earn more in the near future.

If people chose to save their money and invest it in a firm, the primary objective of the finance manager of that firm is to maximize the return that it could offer to the people who trust the company.

THE FIRM’S GOAL

The people who bought the shares of stocks become the common stockholder’s of the company and therefore collectively own it. In turn running it is delegated to managers who are to perform well in maximizing their wealth or utility. In maximizing that wealth, these managers must seek to maximize the value of the firm’s common stock. And in doing so, they must increase the market price or the current price of the stock.

THE FIRM’S GOAL

How is it done?

the firm must be able to increase its value by creating a good name

in terms of profitability, liquidity, effectiveness of management and

sustainability of the operations. The firm must be able to create a

good impression that they play a major role in the economy and in

the industry to which it belongs.

In this way, the market forces will favor them and create value by

creating more demands for their shares. As the demand for their

shares increase, and with limited authorized capital stocks to issue,

the price of the stock will go higher.

Why not maximize profit? Finance people : Maximizing share holder wealth Accounting people : Maximizing Profit

Arguments against Profit Maximization Profit maximization does not consider risk or uncertainty whereas

wealth maximization does Profit can be incensed by increasing the credit term but it may

hamper the cash flow. In wealth maximization, before the increase in credit term is offered,

the cost and benefit will first be measured. The firm will try to answer questions like:

It fails to determine the timing of benefits.

Project A Project BDiscount @

10%Discounted

CF A

Discounted CF B

1 100 25 0.909 91 23

2 50 50 0.826 41 41

3 25 100 0.751 19 75

NPV 151 139

Profit Maximization versus Stockholder Wealth Maximization

Goal Objective Advantages Disadvantages Profit maximization      Stockholder wealth maximization

 Large amount of profits      Highest market value of common stock

 1. Easy to calculate profits2. Easy to determine the link between financial decisions and profits  1. Emphasizes the long term2. Recognizes risk or uncertainty3. Recognizes the timing of returns4. Considers stockholders’ return

 1. Emphasizes the short-term2. Ignores risk or uncertainty3. Ignores the timing of returns4. Requires immediate resources 1. Offers no clear relationship between financial decisions and stock price2. Can lead to management anxiety and frustration

Source: Shim, Jae K., and Siegel, Joel G., Managerial Finance, McGraw Hill Book Company, 2006.

THE ROLE OF FINANCIAL MANAGERS Investment decisions Financing decisions Dividend decisions Liquidity decisions

Investment Decisions

Investment decisions involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in the future.

Financing Decisions

FM has to decide when, where and how to acquire funds. The central issue is to decide the proportion of equity and debt. When share holders’ return is maximized firms’ capital structure would be optimum.

Dividend Decisions

FM must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. The optimum dividend policy is one that maximizes the market value of firm’s shares

Liquidity Decisions

Current assets should be managed efficiently for safeguarding the firm against the dangers of liquidity and insolvency.

The structure of the Finance function in a Corporation

Financial markets

The main goal of financial markets:

Take savings from those who do not wish to consume (savings surplus units) and to channel them to those who wish to invest more than they have presently (saving deficit units)

Financial markets and financial system

Financial markets

Ф

Saving surplus units (savers)

Saving deficit units (investors)

Financial intermediaries

Financial system

money

Return on investments

Return on investments

money

money

Return on investments

Return on investments

money

Financing decisions

Financing decisions

Internal corporate financing

External sources of funds

Retained earningsDirect financing

(financial markets Instruments)

Indirect financing(financial

Intermediaries)

Stocks

Debt instruments (bonds, CPs etc.)

Loans

Financial markets

Financial markets

Primary marketsSecondary markets

Money marketCapital market

Organized exchangesOver-the-counter

Money and capital markets

Money markets – short-term assets (maturity less than 1 year) are traded:Certificates of deposits (CDs)Commercial papers (CPs)Treasury bills

Capital markets – long-term assets (maturity longer than 1 year) are traded:StocksCorporate bondsLong-term government bonds

Organized exchanges and over-the-counter Organized exchange – most of stocks, bonds and

derivatives are traded. Has a trading floor where floor traders execute transactions in the secondary market for their clients.

Stocks not listed on the organized exchanges are traded in the over-the-counter (OTC) market. Facilitates secondary market transactions. Unlike the organized exchanges, the OTC market doesn’t have a trading floor. The buy and sell orders are completed through a telecommunications network.

Agency theory Agency theory is known as a potential conflict of interest

between the stockholders and managers. Such conflict starts when the stockholders entrust the

managers to make decision for the firm. With the power vested among the managers, it has been recognized that managers may have personal goals that conflicts with the stockholders’ wealth maximization.

Agency Relationship: Stockholders and Managers This agency theory exists due to the creation

of an agency relationship. This relationship is borne as soon as an individual or group of people called the principals, hire the service of an individual or organization called agent to perform a service and exercise decision making for the principal.

Agency theory is known as a potential conflict of interest between the stockholders and managers. Such conflict starts when the stockholders entrust the managers to make decision for the firm. With the power vested among the managers, it has been recognized that managers may have personal goals that conflicts with the stockholders’ wealth maximization

In many large corporations, potential agency conflicts have to be noted specially when the managers own a small percentage of the company’s stocks. However, managers may be encouraged to act in maximizing stockholders’ wealth by giving them incentives for good performance and punishment for poor performance.

Some of the incentives that maybe offered good performance are: increase in salary, bonus, stock options, promotions and travel etc. For poor performance, the punishment maybe as follows: no bonus, threat of termination if he or she has been a poor performer for several periods, no increase in salary etc. Other devices that may be used by the company so that the managers will act in accordance with the interest of the stockholders are threat of takeovers by another company and shutdown.

Misconceptions of Financial Management Financial Management is not accounting Financial Management is not a review of

mathematics. Financial Management is not a branch of

statistics.

Social Responsibility

It is understandable that firms have to be responsible to provide their employees with good working conditions, keep away from polluting the air and water, and to produce goods or services to customers in the safest way. However, to be socially responsible, the firm has to incur costs.

However, socially responsible endeavors may not be costly at all