Chapter 01 - Introduction to Finance
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Transcript of Chapter 01 - Introduction to Finance
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Introduction to Finance
TCHE302(2-1112).1_LT
Lecturer:MSc Nguyen Thu Thuy
The Faculty of Banking and Finance
Email: [email protected]
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Outline
1. Introduction to Finance
2. The Time Value of Money
3. The Financial System
4. Valuation
5. Introduction to Corporate Finance
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1. Introduction to Finance
1.1. What is Finance?
1.2. Time and Risk
1.3. Unifying Principles of Finance
1.4. Financial Management
1.5. Forms of Business Organization
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1.1. What is Finance?
Finance is the study of how people allocate scarce resources overtime.
Every business is a process of acquiring and disposing assets
Real assets (tangible and intangible assets)
Financial assets
Two objectives of business
Grow assets (create value)
Use assets effectively to meet economic needs
A business decision means
Valuation of assets (the central issue of finance)
Management of assets
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Real Assets Financial Assets
Determine the
productive capacity
of an economy
Land
Buildings
Machines
Knowledge
- Means by which investors hold the assets of
the economy (corporate bonds, stocks,)
- Also used to allocate payoffs between
investors (derivatives, insurance contracts,
loans)
- Define the allocation of income and wealth
among investors- Trade onfinancial markets
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Questions we would like to answer
1. How financial markets determine asset prices?
2. How households make financial decisions?
3. How firms make financial decisions?
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Financial Decisions of Households
Consumption and savings decisions
How to allocate wealth over time?
Investment decisions
How to grow wealth? How to allocate wealth over states?
Financing decisions
How to finance consumption and investment?
Risk management decisions
How to reduce financial uncertainties and when should increase risk?
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Cash Flows and Financial Decisions
Cash flows and financial decisions of Households
Cash raised by selling financial assets
Cash invested in real assets
Cash generated by real assets
Cash consumed and reinvested
Cash invested in financial assets
Real
Economic
Activities
Households
Financial Assets/
Liabilities
- Bonds
- Stocks
- Mortgages
(2)
(3)
(1)
(5)
(4)
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Cash Flows and Financial Decisions
Cash flows and financial decisions of Firms
Cash raised from investors by selling financial assets Cash invested in real assets
Cash generated by operations Cash reinvested Cash returned to investors (mandatory and discretionary)
Firms
Operations
Financial
Manager
Investors- Individuals
- Institutions
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(1)(2)
(5)
(4)(3)
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Financial Decisions and Asset Valuation
Real Investment Decisions How real assets are priced?
Financing and Payout Decisions
How financial assets are priced?
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Financial Decisions and Asset Management
Risk management decisions How to meet future financing/investment needs?
Personal savings/ financing/ financial investment
decisions
How to meet personal consumption needs?
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1.2. Time and Risk
An assetA cash flow
Value of an asset = Value of its cash flow
Value of investment = Value ({CF0, CF1, , CFn})
Time 0 1 2
Cash out CF0 - -
Cash in - CF1 CF2
Net cash flow - CF0 CF1 CF2
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Two characteristics of a cash flow
Time
A dollar today is worth more than a dollar tomorrow
Example: $1000 today verses $1000 next year
Risk
A safe dollar is worth more than a risky dollar
Example: $1000 each year for sure vs. $0 today and $2000next year
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1.3. Unifying Principles of Finance
Assumption of a perfect financial market
No Arbitrage
Preference
Optimization
Market in Equilibrium
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Assumption of A Perfect Financial Market
Financial market is where financial assets are traded.
The financial market is perfect:
A rich set of securities being traded
Security contracts are enforceable
Free access
Competitive trading process
No frictions/constraints in trading (frictionless markets)
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1st principle: No Arbitrage
Definition: An arbitrage is a set of transactions such that
Requires non-positive initial investment
Yields non-negative payoffs
at least one of the inequalities is strict
Examples:
HSBCs 3 month lending rate is 5.85% and Citibank is selling 3 month
CDs at an interest rate of 6%.
IBM is trading at $80 in New York, 50 in London and the current
dollar/sterling exchange rate is $1.50/.
There are no arbitrage opportunities in the financial markets
Assets having same payoffs must have same prices
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2nd Principle: Preference
A preference is a complete ranking of pairs of consumption (cash
flow) streams
Given any pair of cash flow, a household can decide which one is
better
Each household has a preference expressed by its (expected) utility
Assumptions:
Consistency
Non-satiability (more cash is preferred to less)
Impatience (cash now is preferred to cash later)
Risk- aversion (safe cash is preferred to risky cash)
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3rd Principle: Optimization
Consider a household:
Endowed with certain resources (endowments)
Facilitated by a financial market
A risk free bond offering interest rate rf
A risky stock offering return
Face with the choice
Optimize to achieve maximum utility feasible
Utility function satisfies
Each household optimizes
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4th Principle: Market in Equilibrium
The optimization behavior of households and firms
determines their demands for financial assets, which dependson:
Endowments and preferences
Expectation of asset payoffs (timing and risk)
Asset prices (demand = supply market in equilibrium)
Market equilibrium determines security prices in terms of
fundamentals
Expectation of future cash flow Investors preferences for the cash flow
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1.4. Financial Management
Financial manager try to answer some or all of thesequestions
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
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Objectives of Financial Manager
Maximizes current market value of the firm
Maximizing current market is the only plausible financial
objective
Timing
Risk
Accounting
Long- run value
Current market value incorporates present value of all current and
future cash flows, adjusted for timing and risk
Market value rule is independence ofshareholders differences
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Financial Management Decisions
Capital Budgeting What long term investments or projects should the business
take on?
Capital Structure How should we pay for our assets?
Debt or Equity?
Working Capital Management How to manage the day- to- day finances of the firm?
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Goal of Financial Management
What should be the goal of financial management? Maximize profits?
Minimize costs?
Maximize market share?
Maximize the current value of the companys stock?
Does this mean we should do anything to maximize owners
wealth?
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Forms of Business Organization
Three major forms in the U.S
Sole proprietorship
Partnership
General
Limited
Corporation
S-corp
Limited liability company
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Sole proprietorship
Advantages Disadvantages
Easiest to start
Least regulated
Single owner keeps all theprofits
Taxes once as personal
income
Limited to life of owner
Equity capital limited to
owners personal wealth Unlimited liability
Difficult to sell ownership
interest
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Partnership
Advantages Disadvantages
Two or more owners
More capital available
Relatively easy to start
Income taxes once as
personal income
Unlimited liability
Partnership dissolves when
one partner dies or wishes to
sell
Difficult to transfer
ownership
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Corporation
Advantages Disadvantages
Limited liability
Unlimited life
Separation of ownership and
management
Transfer ownership is easy
Easier to raise capital
Separation of ownership and
management
Double taxation (income
taxed at the corporate rate
and then dividends taxed at
personal rate)
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The agency problem
Agency relationship
Principals hire an agent to represent their interest
Shareholders (principals) hire managers (agents) to run the company
Agency problem
Conflict of interest between agent and principal
Solutions
Tough screening processes
Incentives for good behavior and punishments for bad behavior
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Quick Quiz
1. What are the three types of financial decision?
2. What determines the value of an asset?
3. What are the three major forms of business organization?
4. What is the goal of financial management?
5. What are agency problems and why do they exist within a
corporation?