Introduction to Finance

Goal of firm

to create value for the firm’s owners by maximizing the price of the existing common stock

good financial decisions

______________ will increase stock price, and poor financial decisions will lead to a decline in stock price

customers, employees, suppliers, communities, and financiers

The primary stakeholders include…

Stockholders and bondholders

Financers are…

Capital budgeting decision

what long-term investments should the firm undertake?

Capital structure decision

How should the firm raise money to fund these investments?

Working capital decision

How should cash flows arising from day-to-day operations be managed?

capital budgeting decision, capital structure decision, and working capital decision

Three basic issues are addressed by the study of finance which include…

Cash flow is what matters

What is principle 1?

Money has a time value

What is Principle 2?

Risk requires a reward

What is Principle 3?

Market prices are generally right

What is Principle 4?

Conflicts of interest cause agency problems

What is Principle 5?

Principle 1

accounting profits are not equal to cash flows, as it is possible for a firm to generate account profits but not have cash, and vice versa

cash flow

What drives the value of a business

Incremental cash flow

the difference between the projected cash flows if the project is selected versus what they will be if the project is not selected

Principle 2

a dollar received today is worth more than a dollar received in the future as we can earn interest on money received today

Opportunity cost

the cost of making a choice in terms of next best alternative that must be forgone

Example of opportunity cost

lending money to your friend at zero percent interest, there is an opportunity cost of 5% that could potentially be earned by depositing the money in a savings account in a bank

Principle 3

Investors will not taken on additional risk unless they expect to be compensated with additional reward or return

delaying consumptions and taking on risk

Investors expect to be compensated for _________________________

Example of delaying consumption

expect a return when they deposit their savings in a bank

example of Taking on risk

expect to earn a relatively higher rate of return on stocks compared to a bank savings account

Principle 4

In an efficient market, the market prices of all traded assets fully reflect all available information at any moment in time

behavioral biases

There are inefficiencies in the market that may distort the market prices from value of assets such as…

stock prices

_________ are a useful indicator of the value of the firm

Price changes

______________ reflect changes in expected future cash flows

good decisions

________________ will tend to increase in stock price

Principle 5

The separation of management and the ownership of the firm creates an agency problem, where managers may make decisions that are not consistent with the goal of the corporation

Agency conflict

_______________ is reduced through monitoring, compensation schemes, and market mechanisms

Sole proprietorship, partnership, corporation and hybrid

What are the Legal forms of business organization?

S-Corp and LLC

What are the two types of hybrid business forms?

Sole proprietorship

owned by an individual, owner maintains title to assets and profits, unlimited liability, and termination occurs on owner’s death or by the owner’s choice

Partnership

two or more persons come together as co-owners

general partnership

all partners are fully responsible for liabilities incurred by the partnership

limited partnership

one or more partners can have limited liability, restricted to the amount of capital invested in the partnership

one general partner

In limited partnerships, there must be at least _______________ with unlimited liability

____________ cannot participate in the management of the business, and their names cannot appear in the name of the firm

Corporation

functions legally as a separate entity and apart from its owners, owners dictate direction and policies, owners liability is restricted to amount of investment in the company, and life of the company does not depend on the owners, as it continues to run by managers after transfer of ownership through sale or inheritance

Benefits of the corporate form

limited liability, easy to transfer ownership, easier to raise capital, unlimited life

Drawbacks of corporate form

no secrecy of information, maybe delays in decision making, greater regulation, double taxation

S-Corporations

owners must be people so cannot be used for a joint venture between two corporations, limited liability, taxed as partnership

Limited Liability Companies

What does LLC stand for?

LLCs

Limited liability, taxed like a partnership, qualifications vary from state to state, cannot appear like a corporation otherwise it will be taxed like one

financial markets

________________ help facilitate the transfer money from those who have the money to those who need it

Direct transfer, indirect transfer using the investment banker, indirect transfer using the financial intermediary

What are the three ways to transfer capital in the economy?

Direct transfer

firm seeking funds directly approaches a wealthy investor

Indirect transfer using the investment banker

acts as a link between the firm needing funds and the investors

Indirect transfer using the financial intermediary

collects funds from savers in exchange for its own securities, and the collected funds are then used to acquire securities from the firm

Commercial Bank

a “normal bank” which lends to people, businesses, and corporations

Investment bank

advises on investment transactions that include mergers and acquisitions, initial public offerings, equity raises, debt raises, and private equity buyouts

Public offering

both individuals and institutional investors have the opportunity to purchase securities, and the issuing firm never actually meets the ultimate purchaser of securities

private/direct placement

securities are offered and sold directly to a limited number of investors

Primary market

the market in which new issues of a securities are sold to initial buyers, and is the only time the issuing firm ever gets any money for the securities

Seasoned Equity Offering

What does SEO stand for?

SEO

Refers to sale of additional shares by a company with shares that are already publicly traded

Secondary market

the market in which previously issued securities are traded, and the issuing corporation does not get any money for stocks traded

SEC

Primary and secondary markets are regulated by the _______________ where they must get approval before the sale of securities in the primary market, and must report financial information to them on a regular basis

Money Market

the market for short-term debt instruments with a maturity period of one year or less

Examples of items in the money market

treasury bills, commercial paper, negotiable CDs, bankers’ acceptances

Capital market

the market for long-term financial securities with a maturity greater than one year

Example of items in the capital market

corporate bonds, common stocks, treasury bonds, term loans, financial leases

Cash markets

the market in which something sells immediately

futures markets

the market for buying and selling at some future date

Organized securities exchanges

tangible entities where financial instruments are traded on its premises

New York Stock Exchange

The oldest of the organized exchanges is the…

Over-the-Counter markets

What does OTC stand for?

OTC market

all securities market except organized exchanges

NASDAQ

Most prominent OTC market is the…

Benefits for the _________________ is that it provides a continuous market, establishes and publicizes fair security prices, and it helps businesses raise new capital

Investment banker/underwriter

financial specialists involved as an intermediary in the sale of securities, where they buy the entire issue of securities from the issuing firm and then resell it to the general public

Underwriter’s spread

difference between the price the corporation gets and the public offering price

Underwriting, distributing, advising

What are the functions of an investment banker?

Underwriting

assuming risk because money for securities is paid to the issuing firm before the securities are sold

Distributing

once the securities are purchased from the issuing firm, they are given out to ultimate investors

Advising

Investment bankers guide them on timing of sale, type of security, ect.

Negotiated purchase

issuing firm selects an investment banker to underwrite the issue and the firm and the investment banker negotiate the terms of the offer

Competitive bid purchase

Several investment bankers bid for the right to underwrite the firm’s issue, and the firm selects the banker offering the highest price

Commission or Best-efforts basis

Issue is not underwritten, and the investment bank, acting as an agent, attempts to sell the stocks in return for a commission

Privileged Subscription

Investment banker helps market the new issue to a select group of investors such as current stockholders, employees, or customers

Dutch auction

Investors place bids indicating how many shares they are willing to buy and at what price, which is followed by the bids being ranked by price highest to lowest, and then the selling price is calculated as the highest price that allows for all the stock to be sold

Direct sale

Issuing firm sells the securities directly to the investing public and not investment banker is involved

Sarbanes-Oxley Act

What does SOX stand for?

SOX

hold senior corporate advisors responsible for any instance of misconduct and attempts to protect the interest of investors by improving transparency and accuracy of corporate disclosures

higher risks

Higher returns are associated with…

Standard deviation

dispersion or variability around the mean rate of return in the financial markets

Opportunity cost

rate of return on next best investment alternative to the investor

Basis point

one one-hundredth of 1 percent

Maximum employment

highest level of employment the economy can sustain without generating unwelcome inflation

Price stability

Prices are considered stable when consumers and businesses don’t have to worry about rising or falling prices when making plans, or when borrowing or lending for long periods

price index for personal consumption expenditures

The Fed uses _______________ most consistently to measure inflation

direct

Inflation and interest rates have a _________ relationship

Nominal rate of interest

the interest rate paid on debt securities without an adjustment for any loss in purchasing power

real risk-free rate + inflation premium + default-risk premium + maturity-risk premium + liquidity-risk premium

Equation for calculating the nominal rate of interest

Inflation premium

a premium to compensate for the anticipated inflation that is equal to the price change expected to occur over the life of the bond or investment instrument

Default-risk premium

The additional return required by investors to compensate for the risk of default

Calculation for default-risk premium

30-year AAA-Rated Corporate Bond % - 30-year Treasury Bond %

Calculation for real risk-free rate

3-month treasury bill % - anticipated rate of inflation %

Maturity-risk premium

additional return required by investors in long-term securities to compensate for greater risk of price fluctuations on those securities caused by interest rate changes

Liquidity-risk premium

additional return required by investors in securities that cannot be quickly converted into cash at a reasonably predictable price