FINS1613 CLASS NOTES

Week 1: Introduction and Basic Concepts

There are 4 main areas in finance:
1. Corporate finance (also called business finance/corporate management)
- The basis of FINS1613
- Entails making corporate decisions
- Related tasks: making corporate investments, raising capital, distributing earnings to
shareholders
- financial institutions involved are referred to as the sellside of the market (Goldman
Sachs, Morgan Stanley, JP Morgan Chase these banks are called the south side of the
market)
- Jobs: many in management, financial analyst, investment banker, consulting, corporate
lawyer
2. Investments (also known as asset pricing you are pricing risk in this area of finance)
- Also covered in FINS 1613
- Area of finance related to investment decisions for the purpose of personal wealth
management
- Related tasks: pricing of risk, forecasting returns, stock picking/trading.
- Financial institutions involved are referred to as the buyside of the market (Fidelity,
Bridgewater, Quantum, BlackRock, Barclays, Citi).
- Jobs: investment advisor, stock broker, equity investment strategist, portfolio manager,
trader, securities/research analyst
3. Financial Institutions (dont think about this as an area but more like the big players in
finance)
- Organisations that deal with financial matters serving commercial and/or consumer
clients
- Commercial side is involved in originations + extensions of loans to businesses,
revolving lines of credit, etc.
- Consumer side is involved in origination + extension of mortgage loans, personal loans,
credit card loans, etc. (more involved in individual agents in the economy as opposed to
businesses)
- Insurers are focused on determining risks and extending protection against risks to
clients.
- Jobs: mortgage/loan officer, appraiser, insurance analyst.
4. International Finance:
- More like a specialization rather than a separate area in finance.
- Many corps + financial institutions are multinationals with intercountry operations (e.g.
Apple, Citi, HSBC)
- Many companies look to international markets for financing (e.g. Manchester Utd., Rio
Tinto)
- The international scope of business and finance poses challenges to managers.
- Managers must contend with political risk, international tax and accounting laws,
exchange rate risk, commodities risk, economic risk, financial risk, etc.
- International Finance involves international aspects of corporate finance, investments
and banking.
Business Finance and the Different Roles of the Corporate Manager
The 3 important questions that can be addressed with Business Finance
1) What longterm investments should a manager accept?
2) Where/how will we get the financing to pay for investments?
- use retained profits
- bring fresh new cash from the owners of the business (equity capital)
- borrow from creditors (debt capital)
3) How will we manage the everyday financial activities of the firm?
- Such as collecting payments from customers and paying suppliers
The financial manager is concerned primarily with 3 types of decisions:
(1) Capital Budgeting (Weeks 56, Ch 8, 9):
- What long term projects to consider?

- What product to produce and sell?

- What assets to invest for production?
- Is the project a viable investment for the company?
(2) Getting the Capital:
- How to finance the acquisition of assets? Retained earnings, debt or equity? (Week 10,
Ch 13)
- Where and how to get longterm financing? (Week 12, Ch 15)
(3) Working Capital Management:
- How to manage the collection and payments to/from customers and suppliers? (Ch.
17)
Other major decisions that concern the financial manager:
Dividend Policy (week 12, Ch 14):
- How to distribute and manage distributions to business owners?
Corporate Restructurings:
- Ownership and Corporate Control (Mergers and Acquisition and Takeovers)
- Capital structure (Week 11, Ch 13) Operations (can be viewed as capital budgeting
problem Weeks 56)

The 3 Forms of Business Organisations

Sole Proprietorships:
Owned by one person who keeps all of the profits of the business
Many large corporations start out as sole proprietorships
There are many more sole proprietorships (medium sized business, stores etc.) than
corporations in Australia
Proprietorships are significant contributors to the economy (jobs, taxes, wages)\
Pros:
- Simplest form of business organization and least regulated.
- Easiest to start.
- Profits taxed as personal income (not double-taxed)
- Owner keeps all
Cons:

Limited to lifespan of the owner

The owners ability to raise cash is tied to his own personal wealth
Owner has unlimited liability creditors can go after other assets (not just those of the
business) if unable to pay their fees/debts
Transfer of ownership requires the outright sale of the business to a new owner
May face difficulty raising investment capital

Partnerships:
Very similar to a proprietorship, just have more than one person ( formed by two or
more individuals or entities).
How business is split depends on the agreement between partners. Income is still taxed
individually.
General partnerships: similar to proprietorships except gains and losses are shared
amongst the partners according to the partnership agreement
Limited partnership: a limited partners liability is limited to his contribution to the
business only rides along as an investor and their personal assets cannot be seized as
liability for the business.
- Contrary to general partners, limited partners are not normally involved in important
business decisions.
- Termination occurs when one of the general partners sells out or dies, in which case, a
new partnership can be formed.
As with proprietorships, partnerships may face difficulties raising investment capital.
Except for limited partners, the pros and cons of partnerships are the same as sole
proprietorships.
Corporation:
A legal entity with many of the same rights, duties and privileges as a person.
An entity separate from its owners. Owners can be one or more person or entity.
Forming a corporation involves preparing a constitution, or forming a charter. A charter
of incorporation includes:
- the purpose of the business, the name, and intend life of the organization
- the directors on the Board and how they are elected
- the number of shares it can issue
- whether shares are to be issued to new investors or to existing owners.
Pros:
- Owners have limited liability.
- Relatively easy to raise capital and transfer ownership can just extend amount of
stocks that exist.
- Separation of ownership and management
Cons:
- Profits subject to double taxation Because a corporation is a separate legal entity,
although it may generate profits from one sole source, it gets taxed twice. Income tax
+ tax of business (before distributed to shareholders)
- Separation of ownership and management
The Managers Main Objective
Q: What is the managers main objective?
Short (correct) answer: Maximize the value of the company. STOCK PRICES REFLECT VALUATIONS.
Common (wrong) answers:
maximize accounting profits or
earnings
maximize revenues
customer awareness or brand
recognition

minimize operating costs

maximize the managers own
personal wealth
increase the size of the company


Objective: Maximize Firm Value
Why? Decisions that increase the value of the firm increases the financial gains of the
investors. The same logic applies to sole proprietorships and partnerships Implications
for the manager: take actions that increase the value of the firm.

How to increase firm value? By creating and investing in assets that increase firm
value.
The managers reward: maintains good rapport with shareholders and the investment
community; keeps job; gets raises in compensation. Research shows that 40% of the
time, managers are known to spend dealing with investor relations.

Corporate Ownership vs Control

While the shareholders are the rightful owners of assets of the company, the manager
effectively controls the company. This leads to a separation of corporate ownership and
control. The ownership of large corporations tend to be scattered across a large number
of shareholders, making it difficult to monitor the manager. Separation of ownership and
control raises concerns of whether manager will act in best interest of shareholders. i.e.,
Will manager maximize firm value?
Agency relationship: Whenever a Principal hires an Agent to represent his/her interests;
akin to a relationship between a home seller and the real estate agent, or a business
owner and a hired employee working behind the cash register. In corporate finance, the
shareholders represent the Principal and the manager is the Agent in the relationship.
Agency costs: costs that arise from conflicts of interest between the manager and
shareholders of the company.

Agency problems: When managers, despite being hired as the agents of shareholders,
put their own self-interest ahead of the interests of those shareholders.

Ways to minimize agency costs:

(1) Managerial compensation Place incentives to align the managers interests with
shareholders
(2) Corporate control The threat of a takeover may result in better management.
(3) Regular scrutiny and monitoring of the manager

The Financial Markets and the Corporate Manager

The primary advantage of corporations is the relative ease of access to capital.

Markets bring buyers and sellers together for the exchange of a commodity. In financial
markets, buyers are the investors and the sellers are the corporations. The commodity
being exchanged is financial capital (money!). Terms of trade: market value of shares
+ bonds.

Stock options: a fixed contract that allows someone to buy stocks at a fixed price.

Hostile bids: can be fought off with the golden parachute, the poison pill (inc amount
of shares), green mail/male (pay them more than they wanted to acquire the company
for), the white knight (find another corp to buy it).

Primary markets:
corporations are the primary sellers of shares or bonds
makes raising cash relatively easy for corporations
2 ways to raise capital: public offerings and private placements

Secondary markets:
sellers of shares or bonds can be anyone
makes transfer of ownership relatively easy for corporations
Two kinds: dealer markets (Over the Counter or OTC: NASDAQ) + organized auction
markets (Exchanges: ASX, NYSE, LSE)

CONCLUSION
Corporate decisions are evaluated on the basis of value creation; Sound
business decisions require a strong understanding of financial concepts;
FINS1613 covers the foundations of Finance necessary for a corporate
manager to make value maximizing decisions.
Textbook problems: Critical thinking and concept reviews 1.2, 1.3, 1.5, 1.6,
1.7, 1.8, 1.10, 1.12, 1.13 and 1.14

04/08/16

Topic: Financial Mathematics.

1.

2.

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Time Value of Money

Q) If you win the lottery with a jackpot advertised as $1,000,000 promising to pay
$100,000 once a year for the next 10 years (hence, the total jackpot of $1,000,000), is
the prize money really worth $1,000,000?
Interest (opportunity cost)
Inflation
Taxes

Why is the actual prize value less than the advertised prize of $1,000,000?
Time value of money: people value a dollar today more than a dollar tomorrow. Why?
Getting the money later poses some inconveniences
Getting the money later means you cant invest or lend it today and earn more for later
consumption
Getting the money later means you can do less with it than if you received the money
today
Risk: people are risk averse
A dollar in the future is uncertain, whereas a dollar in your pocket today does not come
with any uncertainty.

Implications for managerial decisions:

Everything else equal, a dollar received in the future should have a lower cash value today.
This is called discounting.
Conversely, a dollar received today should have a greater nominal value in the future. This
is called compounding.
Everything else equal, the riskier the future dollar the less it should be worth today. This is
called compensation for risk (Week 8)

Time Value of Money: Future Value and Compounding

Future Value (FV) refers to the amount of money an investment today will grow over
some period of time at some given interest rate or return rate. FV is a function of 4
things:
The actual dollar investment today, or principal.
The interest rate (or return rate)
The time horizon or the length of time the money is invested
How frequently the interest is compounded (assume 1 year for now)

Q) Suppose you invest $100 in a savings account for 1 year at 10% interest per year.
How much is your investment worth 1 year from now?

A)

Compounding: FV of $100 at 10%

Time Value of Money: Present Value and Discounting

PV and FV of Multiple Cash Flows

So far, we only considered the FV or the PV of a single amount. For multiple cash flows
distributed across time:
1. determine the PV or the FV of each cash flow as before, then
2. add up the PV or FV of each individual cash flow to determine the PV or the FV of the
stream of cash flows.

PV and FV calculations are additive.

PV and FV of Annuities

Perpetuities

Percentage
Return Rate vs Effective Return Rate

The Different Kinds of Loans

Conclusions
Discounting, compounding, present and future values are fundamental
concepts in finance.
Discounting is used extensively when valuing investment opportunities
(projects) that deliver cash flows in the future. This is how financial markets
price financial securities such as stocks and bonds.
Textbook exercises: Questions and Problems 17,915, 2932,34,35, 4759