Introduction to Finance

Major Areas in Finance

• Investment

  • Financial Assets Valuation

  • Investment Risk and Return

• Corporate Finance

  • Capital Budgeting

  • Cost of Capital

  • Working Capital Management

• Capital Markets and Financial Institutions

  • Financial Intermediaries

Investment

• Why do we invest?

  • For future consumption

  • To increase wealth

• What do we invest in?

  • Physical assets

  • Financial assets

• How do we invest?

  • Trade-off between risk and returns

  • Portfolio management

Corporate Finance

• Capital budgeting

  • What long-term investments or projects should the business take on?

• Cost of capital

  • How expensive are our capitals?

  • Should we use debt or equity?

• Working capital management

  • How do we manage day-to-day finances of the firm?

Financial Markets

• Financial markets

  • Intermediaries between investors and companies

  • Banks, stock exchanges, etc.

• Primary vs. secondary markets

  • Primary market is where companies raise funds

  • Secondary market is where investors trade their financial assets

  • Why do we need secondary market?

Forms of Business Organization

• Three major forms in the United States

  • Sole proprietorship

  • Partnership

    • General

    • Limited

  • Corporation

Sole Proprietorship

• Advantages

  • Easiest to start

  • Least regulated

  • Single owner keeps all the profits

  • Taxed once as personal income

• Disadvantages

  • Limited to life of owner

  • Limited equity capital

  • Unlimited liability

  • Difficult to sell ownership interest

Partnership

• Advantages

  • Two or more owners

  • More capital available

  • Relatively easy to start

  • Income taxed once as personal income

• Disadvantages

  • Unlimited liability

    • General partnership

    • Limited partnership

  • Partnership dissolves when one partner dies or wishes to sell

  • Difficult to transfer ownership

Corporation

• Advantages

  • Limited liability

  • Unlimited life

  • Separation of ownership and management

  • Transfer of ownership is easy

  • Easier to raise capital

• Disadvantages

  • Separation of ownership and management

  • Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate)

Financial Manager

• The top financial manager within a firm is usually the Chief Financial Officer (CFO)

  • Treasurer — oversees cash management, credit management, capital expenditures and financial planning

  • Controller — oversees taxes, cost accounting, financial accounting and data processing

Goal of Financial Management

• What should be the goal of a corporation?

  • Maximize profit?

  • Maximize costs?

  • Maximize market share?

  • Maximize the current value of the company’s stock?

• Does this mean we should do anything and everything to maximize owner wealth?

The Agency Problem

• Agency relationship

  • Principal hires an agent to represent their interest

  • Stockholders (principals) hire managers (agents) to run the company

• Agency problem

  • Conflict of interest between principal and agent

• Management goals and agency cost

Managing Managers

• Managerial compensation

  • Incentives can be used to align management and stockholder interests

  • The incentives need to be structured carefully to make sure that they achieve their goal

• Corporate control

  • The threat of a takeover may result in better management

• Other stakeholders