FINA 3001 - Fundamentals of Finance

Lecture Notes Set One

Spring Semester 2016
The Financial Decision and the Firm

Types of Business Organizations

Sole Proprietorships
Partnerships
Corporations
Hybrids
Limited Partnerships
LLP
LLC
PC

Business Organizations
Sole
Partnership Corporation
Proprietorship
Who owns the The Manager
business?

Partners

Shareholders

Are managers
and owners
separate?
What is the
owners
liability?
Are owners &
the business
taxed
separately?

No

No

Usually

Unlimited

Unlimited
(exceptions)

Limited

No

No

Yes

Why do Corporations Dominate the

Business Landscape
Limited Liability
Shareholders avoid risk beyond investment.
Encourages risk taking behavior.
Continuity
Outlasts the individual owners.
Ownership can be easily transferred.
Easier to Raise External Funds
Large projects can be undertaken.
Growth can be supported.
As a result most of this course will focus on finance as practiced
in corporations.

Framework for Finance

Finance focuses on the evaluation of the financial impact
of decisions made managing the firm.
Good decisions require a framework (model) or set of
theories to guide your actions.
Finance has developed a set of theories to explain the
way these decisions should be consistently evaluated.
These theories have worked well to guide decision
making, and we will spend a considerable amount of
time talking about the ramifications of these theories.

The Finance Model of the Firm

Firms apply real assets (inventory, labor, technical
expertise ) through operations to provide products
and services.
Investment Decision: Determining which real
assets the firm should acquire.
In Finance we refer to the evaluation of alternative
investment decisions as the Capital Budgeting
Decision.
Financing Decision: Raising money to acquire real
assets.
In Finance we refer to the mix of long term
financing decisions made by a firm as the Capital
Structure Decision.

The Finance Model of the Firm

It is helpful to use a slightly different framework than
presented in accounting to define the firm for the
purposes of financial management.
The Firm - Accounting
Model

Current Assets Current Liabilities

Long-Term Assets

Long-Term Liabilities

Equity

The Firm - Finance Model

Net Working Capital

Real Assets

Financial Assets

Real Assets & Financial Assets

Real Assets
Tangible Real Assets
Inventory and Supplies
Plant & Machinery
Offices & Equipment
Intangible Real Assets
Technical Expertise
Patents
Trademarks
Selecting Among & Acquiring
Real Assets is Capital
Budgeting

Financial Assets
Bank Loans
Bonds
Shares of Stock
Other Securities
Selecting Among & Raising
Funds for the Purchase of
Real Assets is the Financing
Decision

What is Corporate Finance

Capital Budgeting

Financing Decision
Corporate Finance

Short Term Investments

Short Term Financing

(Money Markets)

Real Assets

Financial Assets
(Capital Markets)

Corporate Finance is the financial evaluation of capital

budgeting and financing decisions.

Questions
Are the following capital budgeting or financing decisions?
Determining how much to spend on a new computer.
Issuing Shares of Stock to finance the construction of a
new manufacturing plant.
Buying the rights to use NCAA logos on clothing.
Borrowing money from the bank to repurchase shares of
stock in the market.
Deciding to lay-off 50 workers at a manufacturing plant.
Paying the annual dues to an industry organization.
Hiring a new research chemist at a plastics company.

Goal of the Firm

Maximize Shareholder Wealth
Why Maximizing Shareholder Wealth?
Shareholders may disagree on the objectives of the
firm.
Control vested in the Board of Directors.
Management delegated with the responsibility to
operate the firm.
Shareholders can independently decide what to do with
the increased wealth.
Firm will not survive for long if the value of financial
assets decline.

Maximizing Shareholder Wealth versus

Other Objectives
Maximizing Accounting Profits
Maximizing Market Share
Maximizing Revenue
Minimizing Expenses

The Agency Problem

Agency relationships and information asymmetries
Managers are Agents and may not work in the
Shareholders best Interests?
Direct Agency Costs
Corporate Perks
Growth that Doesnt Add Value or Empire Building

Indirect Agency Costs

Risk Avoidance
Reduced Effort
Entrenchment

How do agency costs affect firm value (and

shareholder wealth)?

Financial Markets
Firms are not left on their own to value the capital
budgeting and financing alternatives they face.
Financing the firm involves going to the Capital
Markets or Money Markets to raise cash for
investment in the selected capital budgeting
alternatives.
In Capital Markets outsiders provide long-term funds
in exchange for fixed payments, in the case of debt,
or a share of future profits, in the case of equity.
In Money Markets outsiders provide short-term (<1yr)
funds in exchange for fixed payments.
Both the capital structure and financing decisions are
influenced by capital markets.

Public versus Private Markets

Public Market Investments are sold to the general public
and are called securities and regulated by the Securities
and Exchange Commission (S.E.C.)
Private Market Investments are sold only to Financial
Institutions and Qualified Institutional Investors. The
S.E.C. regulates how these investments can be
marketed.
Analysis of decisions is the same whether the firm is
public or private

Cash Flows between the Firm and the

Financial Markets
Total Value of the Firm
to Investors in
the Financial Markets

Total Value of
Firms Assets

B.

Firm
invests in
assets

Current
Assets
Fixed

A. Firm issues securities

E. Retained cash flows

F. Dividends and
debt payments

C. Cash flow from

firms assets

Assets
D. Government

Financial
Markets
Short-term debt
Long-term debt
Equity shares

Financial Markets
Firms issue debt or equity by selling Securities to
investors.
Primary Market - The initial sale of securities from the
Issuer (the firm) to the investor.
IPOs and New Debt Issues
Seasoned Equity Offerings
Secondary Market - The subsequent trading of these
securities among investors.
Exchange Markets - NYSE, Amex
Over-the-counter (OTC) NASDAQ or Broker/Dealer

Secondary Markets Are Important

Secondary markets establish the value of a firms
securities.
Understanding how these values are established is
obviously important to the Financial Manager.
Secondary markets evaluate a firms capital budgeting
decisions.
Successful capital budgeting decisions increase the
value of the firm.
Understanding how investors evaluate these
decisions is important.

Careers In Finance
Corporate Finance
Financial Analyst
Controller functions
Treasury functions

Financial Services
Banks
Insurance Companies
Finance Companies and
Mortgage Banking
Financial Planning

Investments
Sales (Retail/Institutional)
Analyst
Operations

Management
Consulting
Strategic Consulting
Operational Consulting

Real Estate
Brokerage
Property Management
Property Development