Introduction to Finance Lecture 1

Introduction to Finance

• Definition of Finance

  • The science of managing money matters.

  • Pronunciation can be either "finance" or "finance."

Main Areas of Finance

• Managerial Finance

  • Focuses on the financial management of a company.

  • Involves decisions on asset buying/selling and financing choices.

  • Example:

    • Buying a car: Trade-in versus selling outright, paying cash versus financing or leasing.

    • Companies face similar decisions with assets like computers.

• Investments

  • Concerns buying, holding, and selling assets and securities (stocks and bonds).

  • Companies might have departments to manage extra cash, deciding whether to invest in securities.

  • Personal financial planners help individuals decide on investments based on personal criteria.

• Financial Markets

  • Includes money markets (short-term securities) and capital markets (long-term securities).

  • Treasury bills are an example of money market instruments.

  • Capital markets encompass stock exchanges.

  • Financial intermediaries, like banks and credit unions, facilitate borrowing and saving.

  • Financial Intermediation: The process of banks using deposited savings to provide loans.

  • Financial Disintermediation: Occurs when the lending process fails.

Major Principles of Finance

• Risk-Return Trade Off

  • Higher risk investments should offer higher returns as compensation.

  • Example: Stock market investments carry risk for potentially high returns; safer investments like savings accounts offer lower returns.

• Time Value of Money

  • Money now is worth more than the same amount in the future due to its potential earning capacity.

  • Example: A company deciding whether to invest $100,000 in machinery for a projected return of $30,000 annually over 5 years.

  • Important to analyze present value versus future profits.

• Cash is King

  • Profitability on paper doesn’t equate to cash flow.

  • Importance of maintaining cash flow within a company; differences between accounts receivables and accounts payables are critical.

  • Companies can appear profitable while being low on cash.

• Incremental Cash Flows

  • Focus on the additional cash flows that result from a decision.

  • Example: Switching from an old machine to a new one, looking at cost savings rather than total costs.

• Competitive Markets

  • Markets are typically efficient due to competition, influencing operational success.

• Efficient Capital Markets

  • Information spreading quickly makes insider trading less feasible.

  • Belief in overall market efficiency but acknowledges exceptions.

• Agency Issue

  • Employees in corporations must act in the interest of stockholders rather than themselves.

  • Distinction between owning a business versus working for someone else.

• Tax Impact

  • Need to evaluate decisions based on after-tax consequences, as tax regulations affect profitability.

• Diversification

  • Avoid risk by spreading investments across various assets.

  • Companies should diversify while still aligning with their core operations.

• Ethics

  • Importance of ethical decision-making in finance.

  • Ethical practices are crucial in maintaining trust and integrity in financial dealings.

Business Organizational Structures

• Sole Proprietorship

  • Owned by one person; personal responsibility for taxes and liabilities.

  • Simplicity in decision making and taxes.

• General Partnership

  • Owned by two or more partners, sharing liabilities and profits.

  • Risk involved if one partner cannot cover liabilities.

• Limited Partnerships

  • Offers limited liability to some partners, with at least one partner managing the business.

  • Limited partners risk only their investment.

• Limited Liability Partnerships (LLP)

  • Combines features of partnerships and corporations, limiting liability for all partners while maintaining tax benefits.

• Corporations

  • Separate legal entities with perpetual existence; taxed separately from owners.

  • Profits distributed as dividends are taxed twice (corporate and personal tax).

• Subchapter S Corporations

  • Taxed as a partnership, providing benefits to smaller family businesses while limiting liabilities.

Raising Capital and Continuity

• Sole proprietorships face challenges raising capital compared to corporations.

• Ease of selling shares in a corporation, while partnerships may face difficulties.

• Corporations have continuity, as they endure despite changes in ownership or management.