Dua, Falk, Jacoby, Scott,

Stangeland and Wajeeh 2005

1
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

Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
2
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?

I. Introduction to Finance
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
3
Finance Questions in a Corporate
Context (i.e., corporate finance)
1. Where will you get the long-term financing to invest?
Bring in other owners (issue equity/stocks)
Borrow (issue debt/bonds)

2. What long-term investments should be undertaken
Buildings
Machinery
Equipment
Research and development (R&D)

3. How will you manage the companys short-term cash flow?
Collecting from customers
paying suppliers


Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
4
Flows of funds and decisions
important to the financial manager
Financial
Manager
Financial
Markets
Real Assets
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
5
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.
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
6
II. Types of Businesses
1. Sole Proprietorship
2. Partnership
3. Corporation
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
7
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)
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
8
Forms of Business Organization


The Partnership
Formed by 2 or more individuals
General 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 Partnership
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
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
9
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
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
10
III. Corporate Securities as Contingent
Claims on the Firms Assets
Debt (bonds):


Equity (stocks):




Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
11
Value of Debt at time of Repayment
(repayment due = $10 million)
0
5
10
15
20
25
30
35
0 5 10 15 20 25 30 35 40 45
Value of the Firm's Assets at the time the debt
is due ($ millions)
C
o
n
t
i
n
g
e
n
t

V
a
l
u
e

o
f

t
h
e


F
i
r
m
'
s

S
e
c
u
r
i
t
i
e
s

(
$


m
i
l
l
i
o
n
s
)

Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
12
Value of Equity at time of Debt Repayment
(repayment due = $10 million)
0
5
10
15
20
25
30
35
0 5 10 15 20 25 30 35 40 45
Value of the Firm's Assets at the time the debt
is due ($ millions)
C
o
n
t
i
n
g
e
n
t

V
a
l
u
e

o
f

t
h
e


F
i
r
m
'
s

S
e
c
u
r
i
t
i
e
s

(
$


m
i
l
l
i
o
n
s
)

Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
13
Total Value of the Firm
= Debt + Equity
0
5
10
15
20
25
30
35
0 5 10 15 20 25 30 35 40 45
Value of the Firm's Assets at the time the debt
is due ($ millions)
C
o
n
t
i
n
g
e
n
t

V
a
l
u
e

o
f

t
h
e

F
i
r
m
'
s


S
e
c
u
r
i
t
i
e
s

(
$

m
i
l
l
i
o
n
s
)

Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
14
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




Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
15
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





Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
16
How is shareholder control
exercised over management?
Elect the board of directors . . .


Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
17
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
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
18
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

Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh 2005
19
V. Self study will be examined
Financial Institutions
Financial Markets
Money vs. Capital Markets
Primary vs. Secondary Markets
Listing
Foreign Exchange
Trends in Finance