HERIOT-WATT MBA PROGRAMME FINANCE LECTURER: Dundee Thomas dundeet@sbcstnt.

com Introduction to Finance

Lecture 1:

About Finance Finance is a very broad subject area and knowledge of the principles of finance affects decision making and resource allocation decisions at personal, organisational and governmental levels. Resources Textbook Many of the modules in the textbook focus on the key issues in corporate finance decision making: The investment decision The financing decision The dividend decision The text also covers: Financial economics of interest rates Quantitative financial techniques and financial principles of security valuation; debt and equity Capital budgeting project analysis Options, Forwards and Futures Dividends, capital structure, and the broad role of financial markets The contents of the textbook are the ingredients on which the examination assessment will be based for this core class. Financial calculator Absolutely necessary!!! Recommendation: Texas Instruments BA II Plus Other resources Bloomberg Television Financial Times (ft.com) Daily newspapers, esp. business section Another book? Brealey, Myers & Marcus: Fundamentals of Corporate Finance
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Through the course shall use reference to real corporate examples, to illustrate concepts and behaviour. This will help cement your learning of finance. Types of businesses Sole Proprietorships Owner of a business which has no partners and no shareholders. The proprietor is personally liable for all the firms obligations. Partnerships Owned by two or more persons who are personally responsible for all its liabilities. A partnership agreement will set out the terms of the partnership. Corporations It is legally distinct from its owners. Owned by stockholders who are not personally liable for the businesss liabilities. It is based on articles of incorporation that set out the purpose of the business, how many shares can be issued, the number of directors to be appointed, etc. From a legal perspective, the corporation is considered a resident of the state/country. Corporations have limited liability. This means shareholders cannot be held personally liable for the obligations of the firm. Although stockholders are the owners, they usually elect a board of directors which in turn appoints the top managers. There is a separation of ownership and control.

Objectives of the Firm Maximise the shareholders wealth What is meant by wealth in this context? Is it just financial wealth, or can it mean other things? Finance theory indicates that the manager of a firm should aim to maximise the wealth of shareholders, which would indicate that share prices are key to their concern. The assumption is that managers (including finance directors), in charge of companies should maximise shareholders wealth, as their objective function. Following from this assumption they will take decisions which will be primarily in the interests of the shareholder.
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Areas of conflict Managers can act in interests of shareholders but not bondholders Managers can act in own interests and not shareholders o Projects o Capital structure o Dividends o Remuneration The financial decisions that are made by most companies of differing size and shape can typically be classified into: 1. The investment decision. 2. The financing decision. 3. The dividend decision.

Real/Financial assets Real assets are used to produce goods and services. Real assets can be tangible or intangible Financial assets are claims to the income generated by real assets. Financial assets are also called securities

For example, if a company borrows money from the bank, the bank has a financial asset. That financial asset gives it a claim to a stream of interest payments and to the repayment of the loan. The companys real assets need to produce enough cash to satisfy these claims. Financial markets are markets in which financial assets are traded.

Hence, To help finance the business activity, companies will sell the rights to the cash flows generated by the business assets. This is done by selling securities, namely debt (bonds) and equity (shares). These rights will have differing claims against the cash flows of the company. Decisions involving finance are taken by all levels of businesses, government, financial institutions and individuals in both a working and personal environment.
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Within a company the Finance Director becomes the intermediary between the providers of finance (the investors), and the providers of physical assets (the suppliers). The process of managing business finances will involve engaging the company in a number of contracts and implicit agreements with persons and organisations outside the company.

So what are the financial markets for? Pooling of savings Institutions like pension funds, insurance companies collect savings and invest across markets. Companies can access that pool of savings to raise capital for investment projects. Transfer across time and space Stakeholder pensions can be set up today for a new born they will not access it until they are 50, but by then it will be a huge pot. Others will save for retirement 10, 20, 30 years hence. People at different stages in their life cycle. Companies at different stages in life cycle. Pooling of risk Insurance companies offer protection. Fund managers offer savings diversification for investors. Derivatives offer risk insurance for companies. Information costs Financial markets gather info about companies assess their creditworthiness, work out what the value of the companies should be. On a daily basis the value of companies is confirmed by millions of investors. They have to have confidence in the system. All the participants work together providing info that keeps the whole show on the road. Markets are efficient (although there is still the probability of human irrationality)