Introduction to

Finance
MOS 1023
Lesson 6
Today’s Agenda

1. What is Finance?
2. Principles of Finance
3. Real Assets vs Financial Assets
4. The Financial System
5. Financial Instruments and Markets

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What Is Finance?

“The study of how and

under what terms
savings (money) are
allocated between
lenders and
borrowers.” 3
The Goal of the Firm

• The goal of the firm is to create value for the firm’s

shareholders.
• How? Maximizing the price of the existing common
stock.
• Good financial decisions will help increase stock
price and poor financial decisions will lead to a
decline in stock price.

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Role of Management

• Management serves as an arbitrator

and moderator between conflicting interest groups
or stakeholders and objectives.
• Creditors, managers, employees and customers hold
contractual claims against the company.
• Shareholders have residual claims against the
company.

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The Role of Finance in Business

Three basic issues addressed by the study of finance:

1. What long-term investments should the firm
undertake? (Capital budgeting decision)
2. How should the firm raise money to fund these
investments? (Capital structure decision)
3. How to manage cash flows arising from day-to-
day operations? (Operating decision)

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Principles of Finance

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Principle 1:
Cash Flow Is What Matters
• Accounting profits are not equal to cash flows.
• It is possible for a firm to generate accounting
profits but not have cash or to generate cash flows
but not report accounting profits in the books.
• Cash flow, and not profits, drive the value of a
business.
• We must determine additional cash flows when
making financial decisions.

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Principle 2:
Money Has a Time Value
• A dollar received today is
worth more than a dollar
received in the future.
• Since we can earn interest on
money received today, it is
better to receive money
sooner rather than later.

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 Computation of Present Value

An investment can be viewed in two

ways—its future value or its present
value.

Present Future
Value Value

10
The Theory of Interest – Future Value
Assume a bank pays 8% interest on a $100 deposit made today.
How much will the $100 be worth in one year?
How much will the $100 be worth in two years?
How much will the $100 be worth in three years?

Future Value of $1
Periods 8% 10% 12%
1 1.080 1.100 1.120
2 1.166 1.210 1.254
3 1.260 1.331 1.405
4 1.360 1.464 1.574
5 1.469 1.611 1.762

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Present Value – An Example

If a bond will pay $100 in two years, what is

the present value of the $100 if an
investor can earn a return of 12% on
investments?

Fn
P=
(1 + r) n

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Present Value – An Example (cont’d)

$100
P=
(1 + .12)2
P = $79.72

This process is called discounting. We have discounted the

$100 to its present value of $79.72. The interest rate of 12%
used to find the present value is called the discount rate.
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Present Value – An Example (cont’d)
Let’s verity that if we put $79.72 in the bank today at 12%
interest that it would grow to $100 at the end of two
years.

Year 1 Year 2
Beginning balance $ 79.72 $ 89.29
Interest @ 12% $ 9.57 $ 10.71
Ending balance $ 89.29 $ 100.00

If $79.72 is put in the bank today and earns

12%, it will be worth $100 in two years. 14
The Net Present Value Method

To determine net present value (NPV) we . . .

Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows
from the present value of the inflows.

Role of Finance:
1. What long term investments should firms
undertake? 15
The Net Present Value Method
General decision rule . . .

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Typical Cash Outflows and Inflows

Outflows:
•Initial Investment (cash need to purchase asset)
•Incremental operating costs
•Repairs and Maintenance of new equipment
•Additional investment in inventory

Inflows:
•Incremental revenues
•Reduction of operating costs
•Salvage value
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Choosing a Discount Rate

• The firm’s cost of capital is usually regarded as

the minimum required rate of return.

• The cost of capital is the average rate of return

the company must pay to its long-term creditors
and stockholders for the use of their funds.

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Net Present Value – Carver Tech Example
Carver Tech is considering the purchase of an
attachment for its X-ray machine.

No investments are to be made unless they have an

annual return of at least 10%.
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Net Present Value – Carver Tech
Example

No investments are to be made unless they have an annual

return of at least 10%.
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Should we invest in the attachment?
Principle 3:
Risk Requires a Reward

• Risk is the uncertainty about

the outcome or payoff of an
investment in the future.
• Rational investors would
choose a riskier investment
only if they feel the expected
return is high enough to
justify the greater risk.

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Diversification of Investments

• All investment risk is not the same.

• Some risk can be removed or diversified by
investing in several different securities.

• Firm specific risk vs. market risk

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Financial Assets &
The Financial System

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Real Versus Financial Assets
Real assets are tangible things owned by persons and
businesses
Residential structures and property
Major appliances and automobiles
Office towers, factories, mines
Machinery and equipment
Financial assets are what one individual has lent to
another
Consumer credit
Loans
Mortgages
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1 - 24
 The Functions of Money
• Medium of Exchange
• How transactions are conducted:
Something that is generally acceptable in exchange for goods and
services. In this function, money removes the need for double
coincidence of wants by separating sellers from buyers.
• Standard of value
• How the value of goods & services are denominated:
Something that circulates and provides a standardized means of
evaluating the relative price of goods and services.
• Store of value
• How the value of goods & services are maintained in monetary
terms:
The ability of money to command purchasing power in the future.

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The Financial System

Role of Finance:
2. How should the firm raise money to fund these
investments? 26

1 - 26
Channels of money transfer
• Financial intermediaries– transform the nature of the
securities they issue and invest in (bank, insurance company)

• Market intermediaries– make the markets work better (i.e.

real estate broker, stock broker)

• Non-market transactions– in which the markets are not

involved (i.e. lending money to your sibling so they can buy a
car)

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Intermediation
• Intermediation – the transfer of funds from lenders to
borrowers
• First channel - Direct intermediation – the lender provides
money directly to the borrower (non-market transaction)
• Second channel - Direct intermediation through a market
intermediary – the borrower uses a market intermediary to
help find suitable lenders
• Market intermediary= an entity that facilitates the working of
markets (mortgage brokers, insurance brokers, stockbrokers)
• Third channel – Indirect intermediation – the financial
intermediary lends the money to the ultimate borrowers but
raises the money itself by borrowing directly from other
individuals 28
Channels of Intermediation

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 The Financial System
Financial Intermediaries

• Banks and other deposit-taking institutions

• Insurance companies
• Pension Funds

• Mutual Funds- simply act as a “pass through” for individuals,

providing them with a convenient way to invest in the equity
and debt markets.
• Do not change the nature of the underlying financial security.

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1 - 30
 LO3

Quick Check 
Which of the following is true about finance?
A. Finance is different from economics because economics
does not study how resources are allocated.
B. Business finance is the only important part of finance.
C. Finance is the study of how and under what terms savings
(money) is allocated between lenders and borrowers.

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 LO3

Quick Check 
Which of the following is not a real asset?
A. Social Science building
B. Paper certificate showing you own shares in Google
C. Tables at Tim Hortons
D. City of London transit buses

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 LO3

Quick Check 
Which of the following financial intermediaries does not
transform the nature of the underlying financial securities?
A. Banks
B. Insurance Firms
C. Mutual Funds
D. Pension Funds

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Financial Instruments and
Markets

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Financial Instruments
Debt Instruments Equity Instruments
•Legal obligations to repay •Ownership stakes in a company
borrowed funds at a specified •Common shares- part
maturity date and to provide ownership in a company,
interim interest payments usually gives voting rights on
•Bank loans, commercial paper, major decisions affecting the
treasury bills (T-Bills), etc. company
•Preferred shares- equity
instruments that usually entitle
the owner to fixed dividend
payments that must be made
before dividends are paid to
common shareholders 35
Equity instruments issued by
Corporations: Common stocks
• The common stockholders are the owners of the corporation’s
equity
• Voting rights
• No specified maturity date and the firm is not obliged to pay
dividends to shareholders
• Returns come from dividends and capital gains
• On liquidation of company, common stockholders are last in list for
company assets, only after creditors, bondholders, and preferred
shareholders are paid out

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Preferred Stock
• Equity instruments
• Usually entitle the owner to fixed dividend payments that
must be made before any dividends are paid to common
shareholders
• Generally do not have voting rights in the company
• Have characteristics of both bonds and stocks
• On liquidation of the company, preferred stockholders will be
paid out before common stockholders (but after
creditors/bondholders)

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 Financial markets

Financial markets

Organized exchanges
Primary markets Money market
Over-the-counter
Secondary markets Capital market
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Financial Markets
• Primary markets  Involve the issue of new securities by the
borrower in return for cash from investors (or lenders) [i.e.
new securities are created]
• Secondary markets  Provide trading (or market)
environments that permit investors and buy and sell existing
securities
• These markets are critical to the functioning of primary markets
since it would be difficult to raise financing if investors were
unable to sell their investments when necessary (allows for
investment liquidity)
• Secondary market trading in equity securities is many times the
size of the primary market, whereas it is the opposite for debt
securities. 39
Financial Markets
• Money market securities – short term debt instruments
(maturities less than one year i.e. T-bills)
• Capital market securities – include debt securities with
maturities greater than one year (i.e. bonds & equity
securities) & equity securities

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Financial Markets
• Exchanges or auction markets – secondary markets that
involve a bidding process that takes place in a specific location

• Dealer or over-the-counter (OTC) markets – secondary

markets that do not have a physical location and consist of a
network of dealers who trade directly with one another

The distinction has become blurred in recent years because

trading on most of the major exchanges in the world is now
fully computerized, making the physical location of the
exchanged of little consequence.
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