What is Finance?

• FINANCE:
Study of how individuals, institutions, governments, and
businesses acquire, spend, and manage money and other
financial assets
FINANCIAL ENVIRONMENT:
• Encompasses the financial system, institutions, markets,
and individuals that make the economy operate efficiently
• Why Study Finance?
1. To make informed economic decisions
2. To make informed personal and business investment
decisions
3. To make informed career decisions based on a basic
understanding of business finance
 Financial Management Decisions
Capital budgeting
 The process of planning and managing a firm’s long-
term Investments
Capital structure
 The mixture of debt and equity maintained by a firm.
Working capital
 A firm’s short-term assets and liabilities.
Dividend policy
 It’s the decision to pay out earnings versus retaining
and reinvesting them.
 How much the portion of income must be paid to
shareholders
 The Balance-Sheet Model of the Firm
Total Value of Assets: Total Firm Value to Investors:

Current Liabilities
Current Assets

Long-Term Debt

Fixed Assets
1 Tangible
Shareholders’
2 Intangible Equity
 1. Capital Budgeting
• Process of planning and managing a firm’s
long-term investments.
• Financial manager identifies investment
opportunities that are worth more to the
firm than they cost to acquire.
• Example: A chocolate firm deciding
whether or not to open a new factory is a
capital budgeting decision.
The Balance-Sheet Model of the Firm

The Capital Budgeting Decision

(Investment Decision) Current Liabilities
Current Assets

Long-Term Debt

Fixed Assets What long-term

1 Tangible investments Shareholders’
2 Intangible should the firm Equity
engage in?
 Key Questions

• How much cash does the firm expect to receive?

- size of cash inflows and outflows
• When does the firm expect to receive it?
- timing of cash flows
• How likely is the firm to receive it?
- riskiness of cash flows
The Balance-Sheet Model of the Firm

The Capital Structure Decision

(Financing Decision) Current Liabilities
Current Assets

Long-Term Debt

How can the

firm raise the
Fixed Assets money for the
1 Tangible required
Shareholders’
2 Intangible investments? Equity
 2. Capital Structure
• How should the firm obtain and manage
the long-term financing it needs to support
its long term investments?
• Capital Structure is the specific mix of
short-term debt, long-term debt and equity.
• Raising long-term financing can be
expensive, so the different possibilities
must considered carefully.
 Key Questions

• How should the firm pay for its assets?

Debt or equity?
• How much should the firm borrow?
• What is the least expensive source of
funds?
• How, when and where to raise the money?
The Balance-Sheet Model of the
Firm
The Net Working Capital Investment Decision
(Financial Decision) Current Liabilities
Current Assets

Net Long-Term Debt

Working
Capital

Fixed Assets How much

1 Tangible
short-term cash
2 Intangible
flow does a Shareholders’
Equity
company need
to pay its bills?
 3. Working Capital Management
• Working capital refers to the firm’s short-
term assets including inventory and
liabilities, such as cash owed to suppliers.
• Managing working capital is a day to day
activities related to the firm’s receipt and
disbursement of cash.
 Forms of Business Organization

Sole proprietorship
A business owned by a single individual.

Partnership
A business formed by two or more individuals or
entities
 Corporation
A business created as a distinct legal entity
composed of one or more individuals or entities.
 Sole Proprietorship
 No distinction between owner and business
 Owner Keeps all profits and losses
 Unlimited Liability
 Small ventures owned by a single person
- Doctor or dentist’s practice
- Lemonade Stand at HEC
- Dairy Farm,
- Tea House in the Mile End
 Sole Proprietorship

Advantages Disadvantages

 Easy and  Unlimited liability –

inexpensive to can lose personal
setup assets.
 Profits are taxed  Equity capital
once as personal limited to
income proprietor’s wealth
 Difficult to transfer
– must sell entire
business to new
owner
 Partnership
 Similar to a proprietorship, but
 Two or more owners
 Shared resources, revenues and responsibilities
 One partner can act on behalf of others

 Two types of partnership agreements:

 General partnership

 Limited partnership
 General Partnership

• Everything is shared

• All general partners have unlimited liability

• Partnership terminates when a general

partner wishes to sell out or dies
 Limited Partnership

• General partners run the business and have

unlimited liability, but some partners have
limited liability.
• Limited partners do not actively participate in
the business and liability is limited to what they
contributed to the business.
• A limited partner’s interest can be sold without
dissolving the partnership
 Partnership

Advantages Disadvantages
 Relatively easy to  Unlimited liability
start for general partners
 Profits taxed once  Partnership
as personal income dissolves when one
 More capital general partner
available wishes to sell or
dies
 Difficult to transfer
ownership
 Corporation

 Most important form of business

organization.
 Exists as a separate legal entity from

the owners.
 Unique powers

- can occur debts

- can sue and be sued
- enter into legal contracts
- limited liability of owners
(shareholders)
 Coporation
The charter includes the following information: (1) name of
the proposed corporation, (2) types of activities it will pursue,
(3) amount of capital stock, (4) number of directors, and (5)
names and addresses of directors. The charter is filed with
the secretary of the state in which the firm will be
incorporated, and when it is approved, the corporation is
officially in existence.
The bylaws are a set of rules drawn up by the founders of
the corporation. Included are such points as (1) how
directors are to be elected (all elected each year or perhaps
one-third each year for 3-year terms); (2) whether the
existing stockholders will have the first right to buy any new
shares the firm issues; and (3) procedures for changing the
bylaws themselves, should conditions require it.
 Corporation

Advantages Disadvantages

 Limited liability  Separation of

 Transfer of ownership and
ownership is easy management
 Unlimited lifespan  Double taxation
 Easier to raise - corporate income
capital tax
- dividends are taxed
 Slightly complicated
to setup
 Articles of incorporation
 A Simplified Organizational Chart

Corporate
Finance
primarily
concerned
with activities
of the
treasurer’s
office

Source: Ross, Westerfield, Jordan, and Roberts, Fundamentals of Corporate

Finance, 5th Canadian edition, McGraw-Hill Ryerson.
 Financial Manager

 This course focuses on the role of the Financial

Manager
 Chief financial officer (CFO) or the vice-president of
finance.
 Reports to the president or Chief Operating Officer
(COO) and coordinates the activities of the
treasurer and controller. We focus on the Treasurer.
 Successful financial managers increase value –
“buy low, sell high”.
 CFO is concerned with answering the 3 basic
questions.
 The goal of Financial Management

Possible goals
 Survive
 Avoid financial disasters and bankruptcy
 Beat competition
 Increase market share
 Minimize cost
 Maximize profit
 Maintain steady earnings growth
 Over all Goal of F.M.

• “goal of financial management is to

maximize the current value of the exiting
stock”
•
• A more general goal

• Maximize the market value of the existing

owners’ equity.
 Goal in a For-Profit Business

 Managers work for the board of directors, who

represent shareholders / the owners.
 Goal is to make money for the shareholders.
 Shareholders are better off when the value of the stock
is high.
 Maximize the current price per share of the firm’s
existing stock.
Managers should maximize the value of the firm’s
equity!
 The agency problem and control of the
corporation

Agency relationship
The relationship between stockholders and
management is called an agency relationship.

Such a relationship exists whenever someone (the

principal) hires another (the agent) to represent his/her
interests.

Agency Problem
The possibility of conflict of interest between the
stockholders and management of a firm Management
goals

Agency cost refers to the costs of the conflict between

the stockholders and management.
 Answers to Agency Problems

 Compensation plans tied to increases in firm

value. Aligns management and shareholder
interests.
 Control of the firm. Takeovers can result in loss
of jobs for management.
 Outside monitoring and auditing.

 Stakeholders – creditors, clients, suppliers and

others who have a stake on the cash flows of
the firm. Important long-term relationships.
 Do managers act in the stockholders’ interest?

First, how closely are management goals

aligned with stockholder goals? This
question relates to the way managers are
compensated.
Second, can management be replaced if
they do not pursue stockholder goals?
This issue relates to control of the firm.
Cash flows between the firm and the financial
markets
 Primary versus Secondary Markets

• Financial markets function as both primary and

secondary markets for debt and equity securities.
• The term primary market refers to the original sale of
securities by governments and corporations.

• The secondary markets are those in which these

securities are bought and sold after the original sale.

• Equities are, of course, issued solely by corporations.

• Debt securities are issued by both governments and
corporations.
 Dealer versus Auction Markets

• Dealer markets in stocks and long-term debt are

called over-the-counter (OTC) markets. Most trading
in debt securities takes place over the counter.
• The expression over the counter refers to days of old
when securities were literally bought and sold at
counters in offices around the country.
• Today, a significant fraction of the market for stocks
and almost all of the market for long term debt have
no central location; the many dealers are connected
electronically.
• Trading in Corporate Securities
 Auction Markets

 The equity shares of most of the large firms in the United

States trade in organized auction markets. The largest
such market is the New York Stock Exchange (NYSE),
which accounts for more than 85 percent of all the
shares traded in auction markets. In addition to the stock
exchanges, there is a large OTC market for stocks.

 1971, the National Association of Securities Dealers

(NASD) made available to dealers and brokers an
electronic quotation system called NASDAQ (NASD
Automated Quotation system, pronounced “naz-dak” and
now spelled “Nasdaq”).
• Karachi Stock Exchange
• Lahore Stock Exchange
• Islamabad Stock Exchange
• Merged in Pakistan stock Exchange
 Financial Markets

– Money markets versus capital markets

– Primary markets versus secondary

markets
 Money and Capital Markets

 Money Markets
-A financial market for debt securities with maturities of
less than 1 year (short-term).

 Capital Markets
-Capital markets are the financial markets for long-term
debt and corporate stocks. The New York Stock
Exchange is an example of a capital market.

Dealer markets brokers and agents match buyers and

sellers. Those are OTC (over-the-counter) markets,
e.g., NASDAQ
Auction Markets, e.g., Toronto Stock Exchange, NYSE
 Managerial Actions to Maximize
Shareholder Wealth
• In a nutshell, it is a company’s ability to generate cash
flows now and in the future.
• (1) any financial asset, including a company’s stock, is
valuable only to the extent that it generates cash flows;
• (2) the timing of cash flows matters—cash received
sooner is better; and
• (3) investors are averse to risk.
• The cash flows that matter are called free cash flows
(FCF), not because they are free, but because they are
available (or free) for distribution to all of the company’s
investors.
• FCF = Sales revenues − Operating costs −
Operating taxes − Required new investments in
operating capital
 Managerial Actions to Maximize Shareholder
Wealth

• financial manager’s roles is to help others (HRM, MM,

PM, and etc.) see how their actions affect the
company’s ability to generate cash flow and, hence, its
intrinsic value.
• Financial managers also must decide how to finance
the firm.
• Weighted average cost of capital (WACC).
 Intrinsic Stock Value Maximization and
Social Welfare
 1. To a large extent, the owners of stock are society.
 2. Consumers benefit.
 3. Employees benefit.

AN OVERVIEW OF THE CAPITAL ALLOCATION PROCESS

Type of Claim: Debt, Equity, or erivatives
• Debt instruments: typically have specified payments and
a specified maturity. For example, an Alcoa bond might
promise to pay 10% interest for 30 years, at which time it
promises to make a $1,000 principal payment
• Equity instruments are a claim upon a residual value.
For example, Alcoa’s stockholders are entitled to the cash
flows generated by Alcoa after its bondholders, creditors,
and other claimants have been satisfied. Because stock
has no maturity date, it is a capital market security.
• Derivatives are securities whose values depend on, or
are derived from, the values of some other traded assets.
For example, options and futures are two important types
of derivatives, and their values depend on the prices of
other assets.
 The Process of Securitization

• Many types of assets can be securitized, but

we will focus on mortgages because they
played such an important role in the global
financial crisis. At one time, most mortgages
were made by savings and loan associations
(S&Ls), which took in the vast majority of their
deposits from individuals who lived in nearby
neighborhoods.
 The Process of Securitization

• This situation led to the development of “mortgage

securitization,” a process whereby banks, the
remaining S&Ls, and specialized mortgage
originating firms would originate mortgages and then
sell them to investment banks, which would bundle
them into packages and then use these packages as
collateral for bonds that could be sold to pension
funds, insurance companies, and other institutional
investors. Thus, individual loans were bundled and
then used to back a bond—a “security”—that could
be traded in the financial markets.
 THE COST OF MONEY
• In a free economy, capital from those with available
funds is allocated through the price system to users
who have a need for funds. The interaction of the
providers’ supply and the users’ demand determines
the cost (or price) of money, which is the rate users
pay to providers.
• For debt, we call this price the interest rate. For
equity, we call it the cost of equity, and it consists of
the dividends and capital gains stockholders expect.
• Keep in mind that the “price” of money is a cost
from a user’s perspective but a return from the
provider’s point of view.
 Fundamental Factors That Affect the Cost of Money

(1) Production opportunities,

(2) time preferences for consumption,
(3) risk, and
(4) inflation
1. By production opportunities, we mean the ability to turn
capital into benefits. If a business raises capital, the benefits are
determined by the expected rates of return on its production
opportunities. If a homeowner borrows, the benefits are the
pleasure from living in his or her own home, plus any expected
appreciation in the value of the home. Observe that the
expected rates of return on these “production opportunities” put
an upper limit on how much users can pay to providers.
2. The time preference for consumption has a major impact on
the cost of money.
Fundamental Factors That Affect the Cost of Money (continue)

Providers can use their current funds for consumption or saving.

By saving, they give up consumption now in the expectation of
having more consumption in the future. If providers have a strong
preference for consumption now, then it takes high interest rates
to induce them to trade current consumption for future
consumption.

3. If the expected rate of return on an investment is risky, then

providers require a higher expected return to induce them to take
the extra risk, which drives up the cost of money.

4. Inflation also leads to a higher cost of money. For example,

suppose you earned 10% one year on your investment but
inflation caused prices to increase by 20%.
 Economic Conditions and Policies That Affect
the Cost of Money

• These include:
• (1) Federal Reserve policy; (2) the federal budget
deficit or surplus; (3) the level of Business Activity.
• 1. Federal Reserve Policy. If the Federal Reserve
Board wants to stimulate the economy, it most often
uses open market operations to purchases Treasury
securities held by banks. Because banks are selling
some of their securities, the banks will have more
cash, which increases their supply of loanable funds,
which in turn makes banks willing to lend more money
at lower interest rates.
 Economic Conditions and Policies That Affect
the Cost of Money
2. Budget Deficits or Surpluses. If the federal
government spends more than it takes in from tax
revenues then it’s running a deficit, and that deficit must
be covered either by borrowing or by printing money
(increasing the money supply).
3. Business Activity. Notice that interest rates and
inflation typically rise prior to a recession and fall
afterward.
There are several reasons for this pattern. Consumer
demand slows during a recession, keeping companies
from increasing prices, which reduces price inflation.
Companies also cut back on hiring, which reduces wage
inflation.
 Economic Conditions and Policies That Affect
the Cost of Money
Less disposable income causes consumers to reduce
their purchases of homes and automobiles, reducing
consumer demand for loans.
 International Country Risk. International risk factors
may increase the cost of money that is invested
abroad. Country risk is the risk that arises from
investing or doing business in a particular country, and
it depends on the country’s economic, political, and
social environment.
 Economic Conditions and Policies That Affect
the Cost of Money

 International Trade Deficits or Surpluses.

 Businesses and individuals in the United States
buy from and sell to people and firms in other
countries. If we buy more than we sell (that is, if we
import more than we export), we are said to be
running a foreign trade deficit.
 Financial Institutions

 When raising capital, direct transfers of funds from

individuals to businesses are most common for small
businesses or in economies where financial markets and
institutions are not well developed. Businesses in
developed economies usually find it more efficient to
enlist the services of one or more financial institutions to
raise capital.
Investment Banks and Brokerage Activities

Investment banking houses help companies raise

capital. Such organizations underwrite security
offerings, which means they
(1) advise corporations regarding the design and pricing
of new securities,
(2) buy these securities from the issuing corporation,
and
(3) resell them to investors.
 Deposit-Taking Financial Intermediaries
 Some financial institutions take deposits from savers and then
lend most of the deposited money to borrowers.
 Following is a brief description of such intermediaries.
 Deposit-Taking Financial Intermediaries
 Some financial institutions take deposits from savers and then
lend most of the deposited money to borrowers.
 Savings and Loan Associations (S&Ls).
 S&Ls originally accepted deposits from many small savers and
then loaned this money to home buyers and consumers.
 Credit Unions:- Credit unions are cooperative associations
whose members have a common bond, such as being
employees of the same firm or living in the same geographic
area
 Deposit-Taking Financial Intermediaries

• Commercial Banks. Commercial banks raise funds

from depositors and by issuing stock and bonds to
investors. For example, someone might deposit
money in a checking account. In return, that person
can write checks, use a debit card, and even receive
interest on the deposits. Those who buy the banks’
stocks expect to receive dividends and interest
payments.
• At some financial institutions, savers have an
ownership interest in a pool of funds rather than
owning a deposit account.
 Investment Funds
• Mutual Funds. Mutual funds are corporations that accept
money from savers and then use these funds to buy
financial instruments. These organizations pool funds,
which allows them to reduce risks by diversification and
achieve economies of scale in analyzing securities,
managing portfolios, and buying/selling securities.

• Money market funds invest in short-term, low-risk

securities, such as Treasury bills and commercial paper.
Many of these funds offer interest-bearing checking
accounts with rates that are greater than those offered
by banks, so many people invest in mutual funds as an
alternative to depositing money in a bank.
 A special type of mutual fund, the exchange traded
fund (ETF), allows investors to sell their share at any
time during normal trading hours. ETFs usually have
very low management expenses and are rapidly
gaining in popularity.
Private Equity Funds. Private equity funds are similar to
hedge funds in that they are limited to a relatively small
number of large investors, but they differ in that they
own stock (equity) in other companies and often
control those companies, whereas hedge funds usually
own many different types of securities.
 Life Insurance Companies and Pension
Funds
• Life insurance companies take premiums,
invest these funds in stocks, bonds, real estate,
and mortgages, and then make payments to
beneficiaries. Life insurance companies also
offer a variety of tax-deferred savings plans
designed to provide retirement benefits.
• Traditional pension funds are retirement plans
funded by corporations or government
agencies. Pension funds invest primarily in
bonds, stocks, mortgages, hedge funds, private
equity, and real estate.
 FINANCIAL MARKETS
Here are some ways to classify markets:
1. Physical asset markets (also called “tangible” or “real” asset
markets) are those for such products as wheat, autos, real
estate, computers, and machinery.

2. Financial asset markets, on the other hand, deal with stocks,

bonds, notes, mortgages, derivatives, and other financial
instruments.

3. Money markets are the markets for short-term, highly liquid

debt securities, while capital markets are the markets for
corporate stocks and debt maturing more than a year in the
future.
 FINANCIAL MARKETS

4. Mortgage markets deal with loans on residential, agricultural,

commercial, and industrial real estate, while consumer credit
markets involve loans for autos, appliances, education,
vacations, and so on.

5. World, national, regional, and local markets also exist. Thus,

depending on an organization’s size and scope of operations, it
may be able to borrow or lend all around the world, or it may be
confined to a strictly local, even neighborhood, market.