FINANCE

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FINANCE

• Zvi Bodie
• Robert C. Merton

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• About the instructors
• About the TA
• About the course
• About the requirements
• 20 assignment class performance
• 15 mid-term test
• 65 final test
• About the book and authors

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Chapter 1 What is Finance?

• Objective
• To Define Finance
• The Value of Finance
• Introduction to
• the Players

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Chapter 1 Contents

• Defining Finance
• Why Study Finance
• Household Finance
• Financial Decisions-Firms
• Forms of Business Organization
• Separation of Ownership and Management

• The Goal of management
• Market Discipline-Takeovers
• Role of the Financial Specialists in a Corporation

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Defining Finance

• What do you know about Finance?

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Defining Finance
Finance, as a scientific discipline, is the
study of how to allocate scarce resources over
time under conditions of uncertainty.
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Analytical Pillars to Finance

• Optimization over time
• Asset valuation
• Risk management

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Finance Theory

• consists of
• a set of concepts that help to organize ones
  thinking about how to allocate resources over
  time,
• a set of quantitative models to help one evaluate
  alternatives, make decisions, and implement them.

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Financial System

• The financial system is defined as the set of
  markets and other institutions used for financial
  contracting and the exchange of assets and risks.
• The ultimate function of the system is to satisfy
  peoples consumption preferences.

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Why Study Finance?
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Why Study Finance?
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Why Study Finance?
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Why Study Finance?

• To manage your personal resources
• To deal with the world of business
• To pursue interesting and rewarding career
  opportunities
• To make informed public choices as a citizen
• To expand your mind

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Harry M. Markowitz (1927)

• Awarded to the 1990 Nobel Prize
• Main Contribution
• The father of modern portfolio theory

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William F. Sharpe (1934)

• Awarded to the 1990 Nobel Prize
• Main Contribution
• Developing the Capital Asset Pricing Model (CAPM)
  theory

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Merton H. Miller (19232000)

• Awarded to the 1990 Nobel Prize
• Main Contribution
• The MM (Modigliani-Miller) Theorem

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Robert C. Merton (1944)

• Awarded to the 1997 Nobel Prize
• Main Contribution
• The pricing of options and other derivatives

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Myron S. Scholes (1941)

• Awarded to the 1997 Nobel Prize
• Main Contribution
• The pricing of options and other derivatives

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Financial Decisions of Households

• Consumption and saving decisions
• Investment decisions
• Financing decisions
• Risk-management decisions

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Important Terms

• Assets
• Personal investing Asset allocation
• Liability, Debt
• Net Worth Assets Liabilities
• Consumption preferences, exogenous and endogenous
  elements

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Financial Decisions of Firms

• Strategic planning Capital budget decisions
• What businesses to be in
• Identifying ideas for new investment projects
• Evaluating the projects, and deciding which ones
  to undertake
• Implementing them, a plan for acquiring assets
  and for training the personnel

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Financial Decisions of Firms

• Financing (Capital structure) decision
• A feasible financing plan
• The decisions about how much debt and equity to
  have
• Wide range of financial instruments and claims
• A corporations capital structure determines who
  gets what shares of its cash flows, and partially
  determines who gets to control the company.
• Working capital management decision
• The day-to-day prosaic financial affairs of the
  business.

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Financial Decisions of Firms

• Dividend decision
• How much cash to distribute to shareholders
• Risk-management Decision
• How and on what terms should the firm seek to
  reduce the financial uncertainties it faces?

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Forms of Business Organization

• A sole proprietorship(?????)
• unlimited liability
• A partnership (???)
• unlimited liability
• general partner limited partner
• A corporation(?????)
• a legal entity distinct from its owners
• ownership, board of directors and limited
  liability
• public corporations private corporations

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Quick Check

• Is a corporation owned by a single person a sole
  proprietorship? Why?

• In a corporation the liability of the single
  shareholder would be limited to the assets of the
  corporation.

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Separation of Ownership and Management

• The owners of a firm delegate the responsibility
  of running the business to professional managers
  who may not own any shares.

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Reasons for Separation of Ownership and Management

• The owner need not have both the talents of a
  manager and the financial resources.
• The need to pool resources to achieve an
  efficient scale of production.
• The need of owners to diversify their risk in an
  uncertain economic environment.
• Allowing for savings in the costs of information
  gathering.
• The learning curve or going concern effect
  favors the separated structure.

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Separation of Ownership and Management

• The corporate form is especially well suited to
  the separation of owners and managers because it
  allows relatively frequent changes in owners by
  share transfer without affecting the operations
  of the firm.

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Conflicts of Interest

• The separated structure creates the potential for
  a conflict of interest between the owners and the
  managers.
• An agency problem exists where the principal has
  to entrust their interests to an agent who acts
  on their behalf.
• Contractual arrangements, incentive schemes, and
  monitoring are used to control principal?agency
  conflicts.
• The social cost for resolving the conflict.

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The Goal of Management

• The difficulties of the goal of corporate
  management to serve the best interests of the
  shareholders.
• To be feasible and effective, the right rule for
  the goal of management should be independent of
  who the owners are.

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Shareholder-Wealth-Maximization Rule

• An illustration the decision between a risky
  investment and a safe one
• The role of well-functioning capital markets
• The rule depends only upon
• the firms production technology
• market interest rates
• market risk premiums
• security prices
• The rule does not depend upon the risk aversion
  or wealth of the owners.

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Ambiguities of Profit-Maximization Rule

• Multi-periodic profits
• Uncertain future revenues or expenses
• An illustration
• Each of project A, B, and C require an initial
  outlay of 1 million.
• Project A will return 1.05 million one year from
  now and then over.
• Project B will last for two years, return nothing
  in the first year, and then 1.1 million two
  years from now.
• Project C will either pay 1.2 million or 0.9
  million one year from now and then over.

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A Well-Functioning Stock Market

• Implementation of the management goal and
  market-price information
• The existence of an efficient stock market allows
  the manager to substitute one set of external
  information which is relatively easy to obtain?
  namely stock prices?for another set which is
  virtually impossible to obtain?information about
  the shareholders wealth, preferences, and other
  investment opportunities.

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Market Discipline Takeovers

• The value of voting rights as a means of
  enforcement
• The mechanism of takeover(??) for aligning the
  incentives of managers with those of shareholders
• The threat of a takeover and the subsequent
  replacement of management provides a strong
  incentive for current managers (acting in their
  self-interest) to act in the interests of the
  firms current shareholders by maximizing market
  value.

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The Roles of Corporate Financial Specialists

• Financial executive?a person with authority in
  the following functions

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Role of the Financial Manager
(1)
Financial
Firm's
Financial
manager
operations
markets
(1) Cash raised from investors
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Role of the Financial Manager
(1)
(2)
Financial
Firm's
Financial
manager
operations
markets
(1) Cash raised from investors
(2) Cash invested in firm
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Role of the Financial Manager
(1)
(2)
Financial
Firm's
Financial
manager
operations
markets
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
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Role of the Financial Manager
(1)
(2)
Financial
Firm's
Financial
(4a)
manager
operations
markets
(3)
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
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Role of the Financial Manager
(1)
(2)
Financial
Firm's
Financial
(4a)
manager
operations
markets
(4b)
(3)
(5)
Tax paid to Government
(5) Tax leakage
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
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Financial Functions in a Corporation

• Planning
• Provision of Capital
• Administration of Funds
• Accounting and Control
• Protection of Assets
• Tax Administration
• Investor Relations
• Evaluation and Consulting
• Management Information Systems

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Assignments

• 1, 3, 4, 6, 7
• Team Work 8