FIN 3403 Chapter 1 - Concepts

Finance

The science of managing money

Fama and Miller

Allocating resources under uncertainty through time

"Allocating Resources"

Resources are scarce, cannot fund all ideas

"Under Uncertainty"

Cannot predict the future, unexpected can happen

"Through Time"

Dynamic process, multiple decisions across time

Finance for Marketing

marketers work within budgets, must understand payoff of marketing expenditures and programs to: Design distribution channels, Price products, Analyze costs and benefits of marketing campaigns

Finance for Accounting

cost accounting and business finance are very similar: Financial analysts and accountants use the same information for different purposes, How and why firms make decisions is key to understanding outcomes in accounting

Finance for Management

Strategy is nothing without understanding financial strategy: Must understand the financial implications of a business plan for the plan to matter at all!, Profitability is the most important aspect of management

Finance in General

You'll be responsible for your own retirement and future financial well-being.: How much do I need to put away each month to retire comfortably at 65? Is it smart to buy a new car? Should I pay down this credit card debt or my student loans first? What do I need to do now to afford a home in 5 years?

Guiding Principles of Finance

Maximization of Wealth, Time Value of Money, Risk and Return, Leverage, Diversification

Maximization of Wealth

The firm's goal is to maximize wealth!

Time Value of Money

A dollar today is worth more than a dollar tomorrow

Risk and Return

Was return appropriate given level of risk? Investors are risk-averse... so, greater risk should equal greater returns! Always consider risk and return together

Leverage

Refers to the use of debt to fund investments. Borrower must make fixed interest payments on debt... which increases risk! If interest payment is missed, could be forced into bankruptcy

Diversification

Refers to investing in multiple projects/firms at same time. Can reduce overall risk without reducing return

Five Main Areas of Finance

Corporate Finance, Investments, Financial Institutions, International Finance, Fintech

Corporate Finance

The financial decisions of a business and the basis for all finance

Investments

Stocks and bonds, How are they priced?, What are the risks and rewards of investing?

Financial Institutions

Banks and insurance companies. Evaluating loans. Evaluating risk

International Finance

Specialization of the other areas. How does operating across national borders change our calculations?

Fintech

Providing financial services through technology

What is Corporate Finance?

The science of answering three questions: 1. What long-term investments do I need for my line of business? (buildings, machinery, equipment) 2. How will I pay for it? Rich partners/co-owners? Ask the bank for a loan? 3. How will I manage my financial activities day-to-day? Can customers buy on credit and pay later? How will I pay my suppliers?

The Financial Manager

In large corporations, the owners (stockholders) usually don't make the financial decisions! They hire managers to operate in their best interests (to maximize profits)

CFO

oversees Treasurer and Controller

Controller

handles accounting, tax payments

Treasurer

manages firm's cash and credit, financial planning, capital expenditures

Three Main Forms of Business Organizations

Sole Proprietorship, Partnership, Corporation

Sole Proprietorship

Sole proprietorships are best for companies with low startup costs, simple operations, and relatively low exposure to liability

Sole Proprietorship Advantages

Simple to start, Less regulation, Owner keeps all profits

Sole Proprietorship Disadvantages

Owner has unlimited liability for business debts, All business income is taxed as personal income, Life of company limited to owner's life, Equity limited to owner's personal wealth, Ownership is difficult to transfer

Partnership

Formed by two or more individuals or entities

Partnership Advantages and Disadvantages

Advantages and disadvantages are basically the same as sole proprietorship

Corporation

By far the most important form of business organization in the U.S. Created as a distinct legal entity that can: Borrow money, Own property, Sue and be sued, Enter into contracts, Be a partner or limited partner in a partnership

Corporation Advantages

Ownership (stock) easy to transfer, Can raise money relatively easily and quickly, Unlimited life, Limited liability for owners (stockholders)

Corporation Disadvantages

Double taxation: corporate profits are taxed at the corporate level when earned and at the personal level when paid out

Agency Relationship

the relationship between stockholders and management

Agency Problem

Because management may want to do things that maximize their own interests over the interests of the owners, there is an agency problem.

Agency Costs

the costs of the conflict of interest between stockholders and management

Indirect agency costs

lost opportunities

Direct agency costs

1. Corporate expenditures that benefits management but costs the stockholders 2. Expenses that arise from the need to monitor management actions

How to Avoid Agency Problems

Managerial Compensation, Control of the firm

Managerial Compensation

Tying managerial compensation to financial performance. Managers who are better at maximizing stakeholder value will be more sought after by other companies; demand higher salary

Control of the firm

Stockholders elect the board of directors, who hire management. Managers can be replaced by stockholders by proxy fights or takeovers

Stakeholder

someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm

Stakeholder Theory

Stakeholder theory is becoming more popular over time, arguing that stockholder value isn't the only thing a firm should care about

Financial markets

bring buyers and sellers together to buy and sell debt and equity

Primary Market

the corporation is the seller, and the transaction raises money for the corporation: IPOs, Bond Issuance

Secondary Market

one owner or creditor sells to another; does not raise money for the corporation. Ex. Selling your stock or bonds on Robinhood

There are two types of secondary markets

Dealer Markets, Auction Markets

Dealer Markets

Dealer markets in stock and long-term debt are called over-the-counter (OTC) markets, meaning the dealers are connected electronically instead of transacting in a central location

Auction markets differ from dealer markets in two ways

An auction market or exchange has a physical location. Primary purpose is to match those who wish to sell with those who wish to buy (with dealers playing a limited role), whereas most of the buying and selling is done by the dealer in a dealer market

Largest organized auction market

NYSE (New York Stock Exchange)

Listed Stocks

Stocks that trade on an organized exchange are said to be listed on that exchange, with exchanges having different criteria (e.g., asset size and number of shareholders)