Introduction: Corporate

finance and financial

markets
Marco Heimann

Principles for Responsible

Management Education

Aims of the lecture

> To enable you to assess the financial situation of a firm and
to be in a position to understand the financial documents
issued by this firm: this is the financial analysis of the firm

> To enable you to value a firm and/or to use tools that allow
you to determine whether a company is correctly valued:
this is the valuation analysis of the firm

> The two former analyses enable you to understand and

drive the financial policy of the firm: in particular financial
structure, investment policy, dividend policy, external
growth, etc.

1. What is finance made for?

Finance is here to create a balance between agents

who have money but no ideas and agents who have
ideas but no money

Surplus of  Deficit of 
Financial system
resources resources

2. Money has a cost

Cost of money is the interest rate. It derives from the

renunciation of immediate consumption in order to enjoy a
greater revenue in the future

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 3. The three roles of the CFO
• To provide the firm with sufficient funds to finance its development
• To make sure that the investment undertaken by the firm generates
in the long term, at least the return required by investors
• To take care of (financial) risks
A good CFO will understand his/her clients (funds providers)
and propose appropriate financial instruments to them

Market Money Financial

instrument
Demand Firms Investors
Supply Investors Firm
Target Minimise interest Maximise value
rate

4. Financial instrument
Definition: series of cash flows to be received (or paid)
according to a set timetable. The value of the financial
instrument is equal to the sum of its discounted cash flows

The CFO segments the investors’ market. He/she creates

financial instruments for each market segment depending on
the risk that the investor is ready to bear

Cash flows generated

shares

debt
time

Three features allow us to differentiate debt from equity:

– Debt always needs to be repaid, not equity

– Debt generates a fixed return, interest, whereas payment

of dividends is not compulsory. The lack of payment of
interest can lead to bankruptcy

– In case of bankruptcy, creditors will be repaid prior to

shareholders

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 5. The financial investor

Three types of behaviour:

> Speculation:
Bet with potential loss or profit. To speculate is to
take a risk

> Hedging:
The opposite of speculation. To hedge is to transfer
a pre-existing risk to an investor who accepts to
bear that risk

> Arbitrage:
Risk-free transaction that generates a profit for sure.
Arbitrage opportunities are rare in general but
more frequent when markets are illiquid. Arbitrage
kills arbitrage

buyer
seller
Speculation Hedging Arbitrage
Speculation
Hedging
Arbitrage

Common point to investors: the expected return

Expected return = rF + β(kM – rF)
rF = risk-free rate
kM = market return

Risk of an instrument = market risk + specific risk

Only the non diversifiable risk (market risk) generates a

return as specific risk can be avoided thanks to portfolio
diversification

6. Financial markets: key concepts

Difference between primary and secondary markets:

> Primary market: market for new instruments issued by firms.

Direct source of financing for firms

> Secondary market: market for investors to exchange

financial instruments. This does not provide the firm with new
funds. This market allows investors to realise their investment
before the contractual maturity (if any) of the instrument

Primary and secondary markets are closely linked, the prices

observed on the secondary market define the price for new issues
(primary markets)

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Development of derivatives market

> Derivatives (options, futures, forwards, swaps)

derive from an underlying asset. They don’t provide
financing to the firm but allow the firm to more
easily hedge or speculate

> The derivatives market is a zero profit market (what

is earned by one is lost by another) that does not
generate wealth

7. Financial risk

Risk (the components of which we have already seen)

is equivalent to the change in value of the financial
instrument. The greater the price changes, the greater
the risk