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Introduction to Finance

Lecture Outline
I. What is finance?
II. Types of businesses
III. Corporate securities as contingent
claims
IV. The principal-agent problem
V. Self study reading

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I. Introduction to Finance
What is Finance?

Specific questions addressed by finance:


1. How should funds be acquired?
2. How should funds be spent?
3. How should short-term assets/liabilities be managed?

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Stangeland and Wajeeh 2005

Finance Questions in a Corporate


Context (i.e., corporate finance)
1.

Where will you get the long-term financing to invest?

2.

What long-term investments should be undertaken

3.

Bring in other owners (issue equity/stocks)


Borrow (issue debt/bonds)

Buildings
Machinery
Equipment
Research and development (R&D)

How will you manage the companys short-term cash flow?

Collecting from customers


paying suppliers

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Flows of funds and decisions


important to the financial manager

Real Assets

Financial
Manager

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Financial
Markets

Goals of the Financial Manager


Finance in the least costly way.
Invest in assets that generate more
value than they cost.
In order for us, as financial managers, to
achieve these goals, we must understand
how to determine value: identify cash flows
and their timing, and consider risk.

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II. Types of Businesses


1. Sole Proprietorship
2. Partnership
3. Corporation

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The Sole Proprietorship


Formed by a single individual
Simplest and least regulated
Owner keeps all profits and pays taxes as
personal income
Owner has an unlimited liability
Ceases to exist once the owner dies or
withdraws
Cannot raise equity beyond the owners
wealth (limits growth)

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Forms of Business Organization

The Partnership
Formed by 2 or more individuals

General Partnership

Limited Partnership

An agreement between partners to provide work/cash and


share profits/losses
Control resides with a majority of the general partners
Unlimited liability of each general partner
Limited liability for some partners (not involved in
management) Limited partners are silent partners no
control
There must be at least one general partner

Owners pay taxes as personal income


Ceases to exist once a general partner dies or withdraws
Difficult to raise equity capital

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Forms of Business Organization

The Corporation
A distinct legal entity owned by one or more
individuals
Owned by shareholders who elect directors oversee
managers
More complicated (articles of incorporation, bylaws)
Liquidity and marketability of ownership more easily
transferable than with proprietorships or partnerships.
Limited liability of shareholders
Continuity of Existence
Double taxation: corporate tax and tax of the
owners/shareholders

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III. Corporate Securities as Contingent


Claims on the Firms Assets
Debt (bonds):

Equity (stocks):

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Contingent Value of the


Firm's Securities ($
millions)

Value of Debt at time of Repayment


(repayment due = $10 million)
35
30
25
20
15
10
5
0
0

10

15

20

25

30

35

40

45

Value of the Firm's Assets at the time the debt


is due ($ millions)
Dua, Falk, Jacoby, Scott,
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Contingent Value of the


Firm's Securities ($
millions)

Value of Equity at time of Debt Repayment


(repayment due = $10 million)
35
30
25
20
15
10
5
0
0

10

15

20

25

30

35

40

45

Value of the Firm's Assets at the time the debt


is due ($ millions)
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005

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Contingent Value of the Firm's


Securities ($ millions)

Total Value of the Firm


= Debt + Equity
35
30
25
20
15
10
5
0
0

10

15

20

25

30

35

40

45

Value of the Firm's Assets at the time the debt


is due ($ millions)
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Stangeland and Wajeeh 2005

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IV. The Principal-Agent (PA) Problem


Corporations are owned by shareholders
but are run by management
Shareholders are said to be the principals
Managers are the agents of shareholders

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Principal-Agent (PA) Problem and


Conflicting Goals
Shareholders would like management to act in their
best interest by maximizing the value for the
shareholders shareholder wealth maximization

Managers, through human nature, maximize their personal


well being subject to the constraints under which they
operate

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How is shareholder control


exercised over management?
Elect the board of directors . . .

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Agency Costs and Residual Losses


The PA Problem can never be perfectly
eliminated
Agency costs are the costs of monitoring
management and the incentive schemes
used to try to align management with
shareholders
Residual losses are the losses that remain
due to the divergence of interests between
managers and shareholders
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Corporate Goals Revisited


Shareholder Wealth
Maximization (North
American & UK view) vs.
Consideration of
Stakeholders (Japan &
European view)

Customers
Suppliers
Employees
Society
Environment
Government
Stockholders
Bondholders

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V. Self study will be examined


Financial Institutions
Financial Markets

Money vs. Capital Markets


Primary vs. Secondary Markets
Listing
Foreign Exchange
Trends in Finance

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