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Introduction to Finance

TCHE302(2-1112).1_LT

Lecturer: MSc Nguyen Thu Thuy The Faculty of Banking and Finance Email: nguyenthuthuy279@gmail.com

Outline
1. Introduction to Finance 2. The Time Value of Money 3. The Financial System 4. Valuation 5. Introduction to Corporate Finance

1. Introduction to Finance
1.1. What is Finance? 1.2. Time and Risk 1.3. Unifying Principles of Finance 1.4. Financial Management 1.5. Forms of Business Organization

1.1. What is Finance?


Finance is the study of how people allocate scarce resources overtime.

Every business is a process of acquiring and disposing assets


Real assets (tangible and intangible assets) Financial assets

Two objectives of business


Grow assets (create value) Use assets effectively to meet economic needs

A business decision means Valuation of assets (the central issue of finance) Management of assets

Real Assets Determine the productive capacity

Financial Assets - Means by which investors hold the assets of the economy (corporate bonds, stocks,)

of an economy
Land Buildings

- Also used to allocate payoffs between


investors (derivatives, insurance contracts, loans)

Machines
Knowledge

- Define the allocation of income and wealth


among investors - Trade on financial markets

Questions we would like to answer


1. How financial markets determine asset prices? 2. How households make financial decisions? 3. How firms make financial decisions?

Financial Decisions of Households


Consumption and savings decisions
How to allocate wealth over time?

Investment decisions
How to grow wealth? How to allocate wealth over states?

Financing decisions
How to finance consumption and investment?

Risk management decisions


How to reduce financial uncertainties and when should increase risk?

Financial decisions of Firms


Investment decisions
What projects to invest in?

Financing decisions
How to finance a project?

Payout decisions
What to pay back to shareholders?

Risk management decisions


What risks to hedge and how?

Cash Flows and Financial Decisions


Cash flows and financial decisions of Households
Cash raised by selling financial assets
Cash invested in real assets Cash generated by real assets

Cash consumed and reinvested


Cash invested in financial assets
(2) Real Economic Activities (3) (1) Financial Assets/ Liabilities - Bonds - Stocks - Mortgages

Households

(4)

(5)

Cash Flows and Financial Decisions


Cash flows and financial decisions of Firms
Cash raised from investors by selling financial assets Cash invested in real assets Cash generated by operations Cash reinvested Cash returned to investors (mandatory and discretionary)
(2) Firms Operations (3) Financial Manager (1)

(5)

Investors - Individuals - Institutions -

(4)

Financial Decisions and Asset Valuation


Real Investment Decisions
How real assets are priced?

Financing and Payout Decisions


How financial assets are priced?

Financial Decisions and Asset Management

Risk management decisions


How to meet future financing/investment needs?

Personal savings/ financing/ financial investment


decisions

How to meet personal consumption needs?

1.2. Time and Risk


An asset A cash flow
Time Cash out Cash in Net cash flow 0 CF0 - CF0 1 CF1 CF1 2 CF2 CF2

Value of an asset = Value of its cash flow Value of investment = Value ({CF0, CF1, , CFn})

Two characteristics of a cash flow


Time

A dollar today is worth more than a dollar tomorrow


Example: $1000 today verses $1000 next year Risk A safe dollar is worth more than a risky dollar Example: $1000 each year for sure vs. $0 today and $2000
next year

1.3. Unifying Principles of Finance


Assumption of a perfect financial market No Arbitrage Preference Optimization Market in Equilibrium

Assumption of A Perfect Financial Market


Financial market is where financial assets are traded. The financial market is perfect:
A rich set of securities being traded Security contracts are enforceable

Free access
Competitive trading process No frictions/constraints in trading (frictionless markets)

st 1

principle: No Arbitrage

Definition: An arbitrage is a set of transactions such that


Requires non-positive initial investment Yields non-negative payoffs at least one of the inequalities is strict

Examples:
HSBCs 3 month lending rate is 5.85% and Citibank is selling 3 month
CDs at an interest rate of 6%.

IBM is trading at $80 in New York, 50 in London and the current


dollar/sterling exchange rate is $1.50/.

There are no arbitrage opportunities in the financial markets


Assets having same payoffs must have same prices

2nd Principle: Preference


A preference is a complete ranking of pairs of consumption (cash
flow) streams

Given any pair of cash flow, a household can decide which one is
better

Each household has a preference expressed by its (expected) utility


Assumptions:

Consistency Non-satiability (more cash is preferred to less) Impatience (cash now is preferred to cash later) Risk- aversion (safe cash is preferred to risky cash)

3rd Principle: Optimization


Consider a household:
Endowed with certain resources (endowments) Facilitated by a financial market
A risk free bond offering interest rate rf A risky stock offering return Face with the choice Optimize to achieve maximum utility feasible Utility function satisfies

Each household optimizes

4th Principle: Market in Equilibrium


The optimization behavior of households and firms
determines their demands for financial assets, which depends on: Endowments and preferences Expectation of asset payoffs (timing and risk) Asset prices (demand = supply market in equilibrium)

Market equilibrium determines security prices in terms of


fundamentals Expectation of future cash flow Investors preferences for the cash flow

1.4. Financial Management


Financial manager 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, accounting and data processing

cost

accounting,

financial

Objectives of Financial Manager


Maximizes current market value of the firm Maximizing current market is the only plausible financial
objective

Timing Risk Accounting

Long- run value

Current market value incorporates present value of all current and


future cash flows, adjusted for timing and risk

Market value rule is independence of shareholders differences

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?
Debt or Equity?

Working Capital Management


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

Goal of Financial Management


What should be the goal of financial management?
Maximize profits?

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

Does this mean we should do anything to maximize owners


wealth?

Forms of Business Organization


Three major forms in the U.S
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 Taxes 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 taxes once as personal income Disadvantages Unlimited liability Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership

Corporation
Advantages Disadvantages Limited liability Separation of ownership and Unlimited life management Separation of ownership and Double taxation (income management taxed at the corporate rate Transfer ownership is easy and then dividends taxed at Easier to raise capital personal rate)

The agency problem


Agency relationship
Principals hire an agent to represent their interest Shareholders (principals) hire managers (agents) to run the company

Agency problem
Conflict of interest between agent and principal

Solutions
Tough screening processes

Incentives for good behavior and punishments for bad behavior


Quick Quiz
1. What are the three types of financial decision? 2. What determines the value of an asset? 3. What are the three major forms of business organization? 4. What is the goal of financial management? 5. What are agency problems and why do they exist within a
corporation?