Introduction to Finance Lecture 1

Course Instructor: Koray Sayili Goodes Hall, LL188

Original PowerPoint slides prepared by Professor Fabio Moneta, QSB

Lecture 1: Overview

Introduction to Finance:

Firm financial decisions Core ideas Finance versus accounting

Financial Institutions, Financial Markets, and the Corporation A financial view of the firm

Contingent claims

Readings: Chapter 1
2

Why Finance is Important?

You need finance literacy for:

Distinguishing yourself in the job market Developing a more comprehensive and more efficient business acumen Making healthier (real-life) decisions regarding your consumption, savings, and investments Becoming more intellectual and understanding the underlying reasons of global trends/events etc.

E.g. Recent financial crisis

3

What Is Finance?

Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers.

Finance is similar to economics but focuses not only on how resources are allocated but also under what terms and through what channels

Financial contracts or securities are created whenever funds are transferred from an issuer to a buyer.
4

Firm Financial Decisions

Most financial decisions that we will study are related to two broad questions:
What investments should the firm undertake?

Capital Budgeting: The process of making and managing expenditures on long-lived assets.

How should the firm finance these investments?

Capital Structure: The mixture of debt and equity capital maintained by the firm and used to finance its investment activities.
5

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 2. Intangible

Shareholders Equity
6

The Balance-Sheet Model of the Firm

The Capital Budgeting Decision

Current Liabilities
Current Assets Long-Term Debt Fixed Assets 1. Tangible 2. Intangible

What long-term investments should the firm engage in?

Shareholders Equity
7

The Balance-Sheet Model of the Firm

The Capital Structure Decision

Current Liabilities
Current Assets Long-Term Debt

Fixed Assets 1. Tangible 2. Intangible

How can the firm raise the money for the required investments?

Shareholders Equity
8

Capital Structure
The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. The Capital Structure decision can be viewed as how best to slice up the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.
9

30% 70% Debt Equity

Finance Core Ideas:

Absence of arbitrage (law of one price)

An entertaining introduction to arbitrage

Arbitrage involves exploiting price differences to earn riskless profit

Time value of money Risk-return tradeoff

10

Finance versus Accounting: An example

Cash flow versus Earnings:

During 2001, the True North Tire Co. had gross sales of $1 million. The firms cost of goods sold and selling expenses were $300,000 and $200,000 respectively. Depreciation was $100,000. True Norths tax rate in 2001 was 40%.

What is the companys net income? What is the companys cash from operations?

11

Important Aspects of Cash Flow

Timing

Project A: Invest $1 MM today for a payoff of $1.5 MM in one year Project B: Invest $1MM today for a payoff of $1.7 MM in two years Project C: Invest $1MM today for a payoff of $1.4 MM in 9 months

12

Important Aspects of Cash Flow

Risk

Project D: Invest $1MM in a low risk project that pays off $1.5 MM in one year Project E: Invest $1MM in a high risk project that pays off $2 MM in one year

13

Financial system: Markets and Institutions

Financial markets are markets where you can trade (buy and/or sell) financial instruments, also called financial claims or securities. Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers. (e.g. Banks, Insurance companies, Mutual Funds etc.)

14

Direct vs. Indirect Financing

The role of the financial system is to transfer funds in the most efficient manner possible.

It can be done by:

Direct financing Indirect financing or financial intermediation

15

The Financial System

Funds suppliers

Deposits

Financial intermediaries

Loans

Funds demanders

Funds suppliers

Financial intermediaries

Funds demanders

16

The Firm and the Financial Markets (Figure 1.4)

Firm
Invests in assets (B) Current assets Fixed assets Firm issues securities (A)

Financial markets

Retained cash flows (D) Short-term debt Cash flow from firm (C) Dividends and debt payments (F) Taxes (E) Long-term debt Equity shares

Ultimately, the firm must be a cash generating activity.

Government

The cash flows from the firm must exceed the cash flows from the financial markets.
17

Financial Instruments

There are two major categories of financial securities:

Debt Instruments

Commercial paper T-bills and notes Mortgage loans Bonds

Equity Instruments

Common stock Preferred stock

18

U.S. Capital Markets 2009 (Source: SIFMA and Federal Reserve)

19

Global Capital Markets 2012 (Source: World Federation of Exchanges)

In 2012 the global equity market capitalization was US$55 trillion In 2012 the global turnover value of bonds was US$26 trillion
Rank
1 2 3 4 5 6 7 8 9 10

Exchange
NYSE Euronext (US) NASDAQ OMX (US) Tokyo Stock Exchange Group London Stock Exchange Group NYSE Euronext (Europe) Hong Kong Exchanges Shanghai SE TMX Group Deutsche Borse Australian SE

US$bn end of 2012

$14,086 4,582 3,479 3,397 2,832 2,832 2,547 2,059 1,486 1,387

US$bn end of 2011

$11,796 3,845 3,325 3,266 2,447 2,258 2,357 1,912 1,185 1,198

% Change In US$
19.4% 19.2% 4.6% 4.0% 15.8% 25.4% 8.1% 7.7% 25.5% 15.7%

% Change In Local $
19.4% 19.2% 17.6% 2.4% 14.0% 25.2% 7.0% 5.3% 23.6% 14.3%

20

Financial Markets

Money versus Capital Markets

Money Markets

For short-term debt instruments

Capital Markets

For long-term debt and equity

21

Financial Markets

Primary versus Secondary Markets

Primary Market

When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved

Secondary Market

Involve the sale of used securities from one investor to another. Securities may be traded in an exchange or traded over-the-counter in a dealer market.
22

Corporate Securities as Contingent Claims on Total Firm Value

The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount by a certain date. The shareholders claim on firm value is the residual amount that remains after the debt holders are paid. If the value of the firm is less than the amount promised to the debt holders, the shareholders get nothing.
23

Debt and Equity as Contingent Claims

Payoff to debt holders If the value of the firm is more than F, debt holders get a maximum of F. F Payoff to shareholders If the value of the firm is less than F, share holders get nothing.

F Value of the firm (V) Debt holders are promised F. If the value of the firm is less than F, they get whatever the firm is worth. Algebraically, the bondholders claim is: Min[F,V]

F Value of the firm (V) If the value of the firm is more than F, share holders get everything above F. Algebraically, the shareholders claim is: Max[0,V F]
24

Combined Payoffs to Debt and Equity

Combined Payoffs to debt holders and shareholders If the value of the firm is less than F, the shareholders claim is: Max[0,V F] = 0 and the debt holders claim is Min[F,V] = V. The sum of these is = V

Payoff to shareholders

Payoff to debt holders

F Value of the firm (V)

If the value of the firm is more than F, the shareholders claim is: Max[0,V F] = V F and the debt holders claim is:
Min[F,V] = F. The sum of these is = V

Debt holders are promised F.

25

Summary of Lecture 1

Introduction to Finance:

Firm financial decisions Core ideas Finance versus accounting

Financial Markets and Institutions The Corporation A financial view of the firm

Contingent claims

Any questions, comments, or concerns?

26