mcd2170 Lecture Ppts WK 1 2017 03

MCD2170
Foundations of Finance
Introduction to Finance
COMMONWEALTH OF AUSTRALIA
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Learning Objectives
 Define finance, introducing the basic principles of finance

 Understand the role of finance in business;
 Introduce the concept of a financial system
– Define financial systems
– Distinguish between surplus and deficit units
– Explain the role of the flow of funds in the financial
system
– Identify the link between financial systems and the
economy
What is finance?
 Textbooks defines Finance as:
– “… the science or study of the management of money”
– The science that describes the management, creation
and study of money, banking, credit, investments,
assets and liabilities.”
– A study of allocating funds across different entities and
across different periods of time
 Can be broadly classified as study of

– personal finance (importance of financial literacy),
– corporate finance (focus of our attention),
– government finance (also called public finance),
– international finance
Foundations of finance- 5 Basic principles
 Principle 1: Cash flow is what matters
 Principle 2: Money has a time value
 Principle 3: Risk requires a reward
 Principle 4: Market prices are generally right
 Principle 5: Conflicts of Interest cause agency problems
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 incremental or marginal cash flows
when making financial decisions.
– Incremental cash flow is the difference between the
projected cash flows if the project is selected, versus
what they will be, if the project is not selected.
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.
– Since we can earn interest on money kept today, it is better to pay

money later rather than sooner.
Principle 3: Risk requires a reward
 Investors will not take on additional risk unless they expect to be
compensated with additional reward or return.
 Investors expect to be compensated for “delaying consumption” and
“taking on risk.”
– Thus, investors expect a return when they deposit their savings in
a bank (ex. delayed consumption) and they expect to earn a
relatively higher rate of return on stocks compared to a bank
savings account (ex. taking on risk).
Principle 4: Market prices are generally right
 In an efficient market, the market prices of all traded

assets (such as stocks and bonds) fully reflect all available
information at any instant in time.
 Thus stock prices are a useful indicator of the value of the
firm. Price changes reflect changes in expected future cash
flows. Good decisions will tend to increase in stock price
and vice versa.
 Note there are inefficiencies in the market that may distort
the market prices from value of assets. Such inefficiencies
are often caused by behavioral biases.
Principle 5: Conflicts of Interest cause agency
problems
 The separation of management and the ownership of the firm creates
an agency problem. Managers may make decisions that are not
consistent with the goal of maximizing shareholder wealth.
– Agency conflict is reduced through monitoring (ex. annual
reports), compensation schemes (ex. stock options), and market
mechanisms (ex. takeovers)
Role of Finance in Business
Sole Proprietorship
 Business owned by an individual
 Owner maintains title to assets and profits
 Unlimited liability
 Termination occurs on owner’s death or by the owner’s choice
Partnership
 Two or more persons come together as co-owners
 General Partnership: All partners are fully responsible for
liabilities incurred by the partnership.
 Limited Partnerships: One or more partners can have
limited liability, restricted to the amount of capital invested in
the partnership. There must be at least one general partner
with unlimited liability. Limited partners cannot participate in
the management of the business and their names cannot
appear in the name of the firm.
Corporation
 Legally functions separate and apart from its owners
– Corporation can sue, be sued, purchase, sell, and own property
 Owners (shareholders) dictate direction and policies of the
corporation, oftentimes through elected board of directors.
 Shareholder’s liability is restricted to amount of investment
in company.
 Life of corporation does not depend on the owners …
corporation continues to be run by managers after transfer
of ownership through sale or inheritance.
The Trade-offs: Corporate Form
 Benefits: Limited liability, easy to transfer ownership, easier to raise
capital, unlimited life (unless the firm goes through corporate
restructuring such as mergers and bankruptcies).
 Drawbacks: No secrecy of information, maybe delays in decision

making, greater regulation, double taxation.
(Note that double taxation of corporations and shareholders applies to U.S. NOT Australia)
Hybrid Organizations:
S-Corporation and Limited Liability Companies (LLCs)
 S-Type Corporations
– Benefits
• Limited liability
• Taxed as partnership (no double taxation like corporations)
– Limitations
• Owners must be people so cannot be used for a joint ventures
between two corporations
 Limited Liability Companies (LLC)
– Benefits
• Limited liability
• Taxed like a partnership
– Limitations
• Qualifications vary from state to state
• Cannot appear like a corporation otherwise it will be taxed like one
The Goal of the Firm
 The goal of the firm is to create value for the firm’s owners (that is, its
shareholders). Thus the goal of the firm is to “maximize shareholder
wealth” by maximizing the price of the existing common stock.
 Good financial decisions will increase stock price and poor financial
decisions will lead to a decline in stock price.
The Role of Finance in Business
Three basic issues addressed by finance:
 Capital budgeting decision
– What long-term investments should the firm undertake?
 Capital structure decision

– How should the firm raise money to fund these investments?
 Working capital decision

– How to manage cash flows arising from day-to-day operations?
Financial system
 Financial system
– Comprises financial institutions, instruments and markets
– Facilitates the flow of funds between surplus unit and deficit
units through the interaction of its three components
Deficit and Surplus Units
 Income - Consumption expenditure = Saving
• Saving - Investment expenditure (e.g. home purchase) = Surplus (or
Deficit)
− Investment refers to the acquisition of new physical assets
− Saving means the change in a unit or sector’s net worth
− Dissaving occurs when consumption exceeds income
Implications
 Surplus units
– lend to other
– increase their net assets
– issue financial claims
 Deficit units
– borrow from others
– run down their net assets
– take on financial obligations
Flow of funds
Summary
 Finance is the study of the management of money
 Five basic principles in Finance
– Principle 1: Cash flow is what matters
– Principle 2: Money has a time value
– Principle 3: Risk requires a reward
– Principle 4: Market prices are generally right
– Principle 5: Conflicts of Interest cause agency problems
 The goal of the firm is to “maximize shareholder wealth”

 Finance in Business involves making decision mainly on
– Capital budgeting
– Capital structure
– Working capital management
Summary
 The financial system is composed of financial institutions,
instruments and markets facilitating the flow of funds
between deficit units and surplus units.
 Deficit units
– borrow from others
– run down their net assets
– take on financial obligations
 Surplus units
– Investment < savings
– lend to other
– increase their net assets
– issue financial claims

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MCD2170

 Define finance, introducing the basic principles of finance

 Can be broadly classified as study of

– Since we can earn interest on money kept today, it is better to pay

 In an efficient market, the market prices of all traded

 Drawbacks: No secrecy of information, maybe delays in decision

 Capital structure decision

 Working capital decision

 The goal of the firm is to “maximize shareholder wealth”

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