LECTURE-1

TOPIC 1: INTRODUCTION
Finance

Every decision that a business makes has financial implications, and

any decision which affects the finances of a business is a corporate fi
nance decision.
Defined broadly, everything that a business does fits under the rubric
of corporate finance.

Definition of Finance: Finance is concerned with the process, instit

utions, markets, and instruments involved in the transfer of money am
ong individuals, businesses, and governments.

Corporate Finance

Financing Decision Investment Decision Dividend Decision

 Financial Markets and the firm
The Big Picture
Financial Intermediaries (Banks
and Investment Banks)

Product Markets (Suppliers and Firm Financial market investors

Customers) (Managers) (stocks, bonds etc.)

Subsidies Taxes

Government
Players in Financial Markets
Borrowers: need funds
Lenders / investors: wish to invest funds
Hedgers: want to reduce risk
Speculators: are willing to take risk
Arbitrageurs: lock in profits by exploiting market inefficiencies
Arbitrage opportunity / profit: riskless profit with zero initial inve
stment
Arbitrage strategy: buy cheap and sell expensive
Financial Intermediaries (FI): Commercial Banks
Other Financial Intermediaries:
Investment Banks: help companies to obtain funding directly fro
m lenders.
Brokers: match investors wishing to trade with each other.
Market makers: have the commitment to buy and sell from or to i
nvestors.
Products traded on financial markets
Bonds / FI securities (deterministic CF stream): e.g. classification acc

ording to issuer: government bonds and corporate bonds

Shares (random CFs): common stock and preferred stock

Derivatives: forwards, futures, swaps and options

Currencies / foreign exchange (FX)

Commodities
Classification of financial markets
according to types of markets / traded products: bond market, stoc
k market, derivatives market, FX market, commodities market
according to investors horizon: money market (spot market) vs.
capital market (future market)
Issuance vs. trading of securities: primary market vs. secondary
market
according to the trading system: auction market, dealer market an
d hybrid systems ( combination of auction and dealer market)
Principles of Finance
Invest in projects that yield a return greater than the minimum acce
ptable hurdle rate.
The hurdle rate should be higher for riskier projects and reflec
t the financing mix used - owners funds (equity) or borrowed
money (debt).
Returns on projects should be measured based on cash flows gen
erated and the timing of these cash flows; they should also conside
r both positive and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches t
he assets being financed.
If there are not enough investments that earn the hurdle rate, return t
he cash to stockholders.
The form of returns - dividends and stock buybacks - will depend u
pon the stockholders characteristics.
Major Areas & Opportunities in Finance: Financial Serv
ices
Financial Services is the area of finance concerned with the design
and delivery of advice and financial products to individuals, businesse
s, and government. Career opportunities include banking, personal fin
ancial planning, investments, real estate, and insurance.
Managerial finance is concerned with the duties of the financial man
ager in the business firm. The financial manager actively manages th
e financial affairs of any type of business, whether private or public, la
rge or small, profit-seeking or not-for-profit. They are also more involv
ed in developing corporate strategy and improving the firms competiti
ve position.
Increasing globalization has complicated the financial management f
unction by requiring them to be proficient in managing cash flows in di
fferent currencies and protecting against the risks inherent in internati
onal transactions. Changing economic and regulatory conditions also
complicate the financial management function.
Career Opportunities
Financial objective of firm
Minimising costs?

Maximising sales or market shares?

Minimising risk?

Maximising profit?

Maximising shareholders wealth?

Maximising firm value or value per share?

Why or why not?

Corporate Governance
Corporate Governance is the system used to direct and control a cor
poration.
It defines the rights and responsibilities of key corporate participants
such as shareholders, the board of directors, officers and managers,
and other stakeholders.
Individual versus Institutional Investors
Individual investors are investors who purchase relatively small quan
tities of shares in order to earn a return on idle funds, build a source o
f retirement income, or provide financial security. Institutional investor
s are investment professionals who are paid to manage other people
s money.
Institutional investors hold and trade large quantities of securities for
individuals, businesses, and governments and tend to have a much g
reater impact on corporate governance.
The Role of Ethics: Considering Ethics

Robert A. Cooke, a noted ethicist, suggests that

the following questions be used to assess the ethi
cal viability of a proposed action:
Does the action unfairly single out an individual
or group?
Does the action affect the morals, or legal rights of any i
ndividual or group?
Does the action conform to accepted moral standards?
Are there alternative courses of action that are less likel
y to cause actual or potential harm?
The Role of Ethics: Considering Ethics

Cooke suggests that the impact of a proposed decision s

hould be evaluated from a number of perspectives:
Are the rights of any stakeholder being violated?
Does the firm have any overriding duties to any stakeholder?
Will the decision benefit any stakeholder to the detriment of anothe
r stakeholder?
If there is a detriment to any stakeholder, how should it be remedie
d, if at all?
What is the relationship between stockholders and stakeholders?
 Agency Theory : Agency Problem
An agency relationship exists
when: Agency
Shareholders
Relationship
(Principals)
Risk Bearing Specialist
(Principal)
Hire Managerial Decision-
Firm Owners Making Specialist
(Agent)

Managers
(Agents)
which creates
Decision
Makers
Agency Theory
The Agency problem occurs when:
The desires or goals of the principal and agent
conflict and it is difficult or expensive for the
principal to verify that the agent has behaved
appropriately
Any loss of value that results from such conflict
is termed an agency cost:
Manager do not attempt to maximise firm value
Shareholders incur costs to monitor managers
Deal with Agency problem

Corporate control:
Board of directors
Management audits & reporting requirement
Managerial compensation
Incentives can be used to align management and stockholder inter
ests
Incentives need to be carefully structured to insure that they achie
ve their goal
Corporate control
Threat of a takeover may result in better management
Other stakeholders