Principles of Finance Chapters 1 & 2

1.1 What Is Finance?

Finance is the study of managing, moving, and raising money, focusing on the trade-off between risk and return. It is divided into three main areas:

Business Finance: Focuses on maximizing shareholder value through working capital management, capital budgeting, and capital structure decisions.

Investments: Involves creating and growing wealth through financial instruments like stocks, bonds, and derivatives.

Financial Markets and Institutions: Includes firms and regulatory agencies that oversee the financial system, such as the SEC and FINRA.

1.2 The Role of Finance in an Organization

Finance plays a critical role in organizations by managing cash flow, budgeting, forecasting, and strategic planning. Key roles include:

Controller: Oversees financial reporting and accounting.

Treasurer: Manages cash flow, investments, and external financing.

CFO: Sets financial policies, oversees capital structure, and ensures long-term financial health.

1.3 Importance of Data and Technology

Data is crucial for financial decision-making, with advancements in technology making it easier to gather, analyze, and store information. Financial planning relies on accurate data from income statements, cash flow statements, and balance sheets. Cloud storage and digitization have revolutionized data management, though they also bring risks like data breaches.

1.5 Markets and Participants

Financial markets are divided into:

Primary Markets: Where new securities are issued.

Secondary Markets: Where existing securities are traded.

Key players include:

Dealers: Trade from their own portfolios.

Brokers: Facilitate trades between buyers and sellers.

Financial Intermediaries: Institutions like banks and mutual funds that facilitate financial transactions.

1.6 Microeconomic and Macroeconomic Matters

Microeconomics: Focuses on individual and business decisions, such as supply and demand.

Macroeconomics: Examines the economy as a whole, including inflation, unemployment, and GDP.

Understanding both is crucial for financial forecasting and decision-making.

1.7 Financial Instruments

Financial instruments are categorized by maturity:

Money Markets: Short-term, low-risk securities like Treasury bills and commercial paper.

Capital Markets: Long-term securities like stocks and bonds, which finance long-term projects.

1.8 Concepts of Time and Value

Time and value are central to finance, focusing on the trade-off between consumption now and in the future. The time value of money (TVM) is a key concept, emphasizing that money today is worth more than the same amount in the future due to its earning potential.

2.1 Business Structures

The most common business structures are:

Sole Proprietorships: Easy to form but with unlimited liability.

Partnerships: Shared ownership but also shared liability.

Corporations: Separate legal entities with limited liability but subject to double taxation.

Hybrids (LLCs and LLPs): Combine features of corporations and partnerships, offering liability protection and tax advantages.

2.2 Relationship Between Shareholders and Company Management

Shareholders: Owners of the company who elect the board of directors.

Management: Responsible for day-to-day operations and implementing the board’s strategies.

Stakeholders: Anyone with an interest in the company’s success, including employees, customers, and suppliers.

2.3 Role of the Board of Directors

The board oversees the company’s management, sets strategic goals, and ensures the company operates in the best interest of shareholders. Key responsibilities include:

Hiring and firing CEOs.

Setting dividend policies.

Ensuring the company has the resources it needs to succeed.

2.4 Agency Issues: Shareholders and Corporate Boards

Agency problems arise when managers (agents) act in their own interest rather than in the best interest of shareholders (principals). Common issues include:

Stockholders vs. Management: Conflicts over executive compensation and short-term vs. long-term goals.

Investors vs. Creditors: Conflicts over risky investments that could jeopardize debt repayment.

Stockholders vs. Other Stakeholders: Conflicts over wages, benefits, and other stakeholder interests.

2.5 Interacting with Investors, Intermediaries, and Other Market Participants

Investor Relations (IR): Manages communication between the company and its investors, ensuring transparency and compliance with regulations.

Quarterly Earnings Calls: Provide updates on financial performance and future outlook.

Press Releases: Used to communicate important company news, such as financial results or new product launches.

2.6 Companies in Domestic and Global Markets

Companies expand internationally to access new markets, reduce costs, and diversify risk. However, operating globally introduces complexities, such as different regulatory environments and accounting standards (GAAP vs. IFRS).