Chapter

Zero
Introduction To
Finance

2003 The McGraw-Hill Companies, Inc. All rights

What is Finance?
Finance studies the issue of optimal capital
allocation.
Who makes the decision
Business: Corporate Finance
Individual: Personal Finance

Where the capital gets allocated

Capital Markets: Investment

What determines the allocation

Price of capital: Valuation

Key Question about this Course

How do households make financial decisions?
Savings decision
How to allocate wealth over time?

Investment decision
How to grow wealth and spend contingent on different situations?

Financing Decision:
How to finance consumption and investment?

How do firms make financial decisions

Investment decision
Which project to invest?

Financing decision
How to finance a project?

Payout decision
What to pay to stockholders and how much to keep for firms future
growth?

Finance Principles
How do financial markets determine asset prices?
Assumptions: Perfect Market
Frictionless markets
Large number of financial securities covering various
contingencies
Contracts are enforceable
Competitive trading process

Principles
No arbitrage
Riskless profit motive: stronger condition

Equilibrium
Preference maximization: weaker condition

Corporate Finance
What does a financial manager do?
2

Firms
Operation

Financial
Manager

Three pillars of corporate finance

Investment: (2 to 3)
Financing: (1 and 4)
Payout Policy: (4 and 5)

Investor
Individual
Institution

Personal Finance
What does an investor/consumer do?
2

Real
Economic
Activity

Household

4
5

Personal Finance Decisions

Real Investment: (2 to 3)
Financing: (1 and 4)
Saving and Financial Investment: (5)

Financial
Asset and
Liabilities

Asset Valuation
What determines the value of an asset?
Time and Risk!
Time
A dollar today is worth more than a dollar tomorrow

Risk
A safe dollar is worth more than a risky dollar

Absolute Valuation
Value equals risk-adjusted discounted cash flow

Relative Valuation
Value equals the price of other (portfolio of) assets
with the cash flow of the same timing and risks

Corporate Finance
Some important questions that are answered
using finance
What long-term investments should the firm take
on?
Where will we get the long-term financing to pay
for the investment?
How will we manage the everyday financial
activities of the firm?

Financial Manager
Financial managers try to answer some or all of
these questions
The top financial manager within a firm is
usually the Chief Financial Officer (CFO)
Treasurer oversees cash management, credit
management, capital expenditures and financial
planning
Controller oversees taxes, cost accounting,
financial accounting and data processing

Financial Management Decisions

Capital budgeting
What long-term investments or projects should the
business take on?

Capital structure
How should we pay for our assets?
Should we use debt or equity?

Working capital management

How do we manage the day-to-day finances of the
firm?

Forms of Business Organization

Three major forms in the united states
Sole proprietorship
Partnership
General
Limited

Corporation
S-Corp
Limited liability company

Sole Proprietorship
Advantages
Easiest to start
Least regulated
Single owner keeps all
the profits
Taxed once as personal
income

Disadvantages
Limited to life of owner
Equity capital limited to
owners personal wealth
Unlimited liability
Difficult to sell
ownership interest

Partnership
Advantages

Two or more owners

More capital available
Relatively easy to start
Income taxed once as
personal income

Disadvantages
Unlimited liability
General partnership
Limited partnership

Partnership dissolves
when one partner dies or
wishes to sell
Difficult to transfer
ownership

Corporation
Advantages
Limited liability
Unlimited life
Separation of ownership
and management
Transfer of ownership is
easy
Easier to raise capital

Disadvantages
Separation of ownership
and management
Double taxation (income
taxed at the corporate rate
and then dividends taxed
at personal rate)

Goal Of Financial Management

What should be the goal of a corporation?

Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the companys
stock?

Does this mean we should do anything and

everything to maximize owner wealth?

The Agency Problem

Agency relationship
Principal hires an agent to represent their interest
Stockholders (principals) hire managers (agents) to
run the company

Agency problem
Conflict of interest between principal and agent

Management goals and agency costs

Managing Managers
Managerial compensation
Incentives can be used to align management and
stockholder interests
The incentives need to be structured carefully to
make sure that they achieve their goal

Corporate control
The threat of a takeover may result in better
management

Other stakeholders

Investment process
Investment
Trade present for future payoff
Bank deposit, stock purchase, education

Real v.s. Financial Assets

Real Asset: assets for generating goods and
services
Factory, farm, gas station, restaurant, etc.

Financial Assets: a claim on real asset

Bank loans, stocks, bonds, options, etc.

Investment process
Five step approach
Generating sufficient funds

1. Setting investment objectives

Guarantee a payment at
some time in the future

2. Establishing investment policy

Asset allocation decision:

stocks, bonds, real estate

3. Selecting a portfolio strategy

Active strategy,
passive strategy, structured
strategy

4. Selecting the assets

Portfolio formation:
market timing or asset pick

5.Measuring and evaluating performance

Benchmarking:
S&P500, risk adjustment

Taxonomy of Financial Assets

Money and Capital Markets
Derivative Securities

Debt Instruments

Maturity < 1

Money
Market

Common Stock & Preferred Stock

Maturity 1

Capital Market

Taxonomy of Financial Assets

Why financial assets?
Consumption timing: to shift consumers need for
consumption across time
Savings to buy a BMW Z8

Allocation of risk: real asset too risky

Amazons stock for the brave and bond for the less
adventurous souls

Separation of ownership & management: real asset

too big
Its inefficient for GEs half-million stock owners to
participate day-to-day operations

Players and Vehicles

Who are they?
Companies

$
Financial Intermediaries
Commercial Bank
Taking deposit and making loans

Investment Bank
Selling securities to investors

$
Consumers/Investors

Government

Players and Vehicles

$ for
Corporate bond: a promise by company to pay
back interest and principal
Investor makes money on interest payment

Treasury Securities: a promise by government to

pay interest and principal
Stock: an ownership share of a company
Investor profits from companys success

Option: a security deriving value from stock

Investor takes bet on stock price movement

Market Microstructure
Primary Market
New issue of securities offered to public

Secondary Market
Trading places for existing securities
OTC Market
(Over-the-Counter)
Exchange

Market Microstructure
Direct Search Market
Buyer/seller search each other directly

Brokered Market
Broker search buyer/seller for seller/buyer
Moderate trading activity, e.g. real estate, IPO

Dealer Market
Dealers buy/sell for its own account
Active trading, e.g. OTC, NASDAQ stock trading

Auction Market
Players buy/sell out of one central place
Active trading, e.g. NYSE stock trading

Recent Trends
How far finance has traveled?
Return-Risk Tradeoff
Markowitz (1951; Nobel Prize in 1990)
Security selection from a view of overall portfolio Risk
preference (or tolerance)

Equity Valuation and Asset Allocation

Tobins q (1958; Nobel Prize in 1983)
Mutual Funds

Performance Evaluation
CAPM, Sharpe-Linter (1964; Nobel Prize in 1990).
Mutual fund performance

Derivative Security Valuation

Black-Scholes, Merton (1973, Nobel Prize in 1997).

Recent Trends
Globalization
An Integration of worldwide economic environment and
national capital markets
Major Activities
International diversification
US market down, Asia markets up, average out

Cross border trading

Local stocks, ADRs, Yankee bonds, mutual funds, WEBS (World
Equity Benchmark Shares), etc.

Foreign exchange risk

Exchange rate fluctuation affects foreign stock returns.
hedge to eliminate non-company specific factors

Recent Trends
Securitization
Pooling loans/mortgages/debts to create
standardized securities
Efficiency gain
Improved information flow based on market activity
increases liquidity
Service and financing separation encourages
specialization and results better risk allocation
Reduced cost for originator
Enhanced yield for investor

Recent Trends
Financial Engineering
The process of creating customized securities
tailored to investors need
Bundling
Combining cash flows together
Straight bond+call option=convertible bond

Unbundling
Slicing and dicing cash flow of an asset to several
classes
CMO to mortgage pass-through tranches and treasury
strips.

Quick Quiz
What are the three types of financial
management decisions and what questions are
they designed to answer?
What are the three major forms of business
organization?
What is the goal of financial management?
What are agency problems and why do they
exist within a corporation?
What is the difference between a primary
market and a secondary market?