Chapter 1:
What is
Objective
Finance?
To Define Finance
The Value of Finance
Introduction to
the Players
Copyright © Prentice Hall Inc. 2000. Author: Nick Bagley, bdellaSoft, Inc.
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Chapter 1 Contents
1.
2.
3.
4.
5.
Defining Finance
Why Study
Finance
Household
Finance
Financial
Decisions of Firms
Forms of Business
Organization
6.
7.
8.
9.
Separation of
Ownership and
Management
The Goal of
Management
Market Discipline:
Takeovers
Role of the Finance
Specialists in a
Corporation
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Finance: Definition


1)
2)
Finance is the study of how people
allocate scarce resources over
time.
Two features: The costs and
benefits of financial decisions are
Spread out over time
Usually not known with certainty in
advance by either the decision
makers or anybody else.
3
Financial System: Definition
The set of markets and other
institutions used for financial
contracting and the exchange of
assets and risks.
Including:
 The markets for stocks, bonds, and
other financial instruments, financial
intermediaries, financial services
firms, and the regulatory bodies
that govern all of these institutions.

4
Finance Theory
Consists of a set of concepts that
help you to organize your thinking
about how to allocate resources
over time and a set of quantitative
models to help you evaluate
alternatives, make decisions, and
implement them.
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The ultimate function of the system
Satisfying people’s consumption
preferences, including all the basic
necessities of life.
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Why study Finance





To manage your personal resources.
To deal with the world of business.
To pursue interesting and rewarding
career opportunities.
To make informed public choices as
a citizen.
To expand your mind.
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Financial Decisions of Households




Consumption and saving decisions
Investment decisions
Financing decisions
Risk-management decisions
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Some Terms




Asset: Anything that has economic
value
Asset allocation: Choosing how to
hold a pool of accumulated savings
Liability = debt
Net worth: Assets - Liabilities
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Financial Decisions of Firms



Capital budgeting: Consists of
identifying ideas for new investment
projects, evaluating them, deciding
which ones to undertake, and then
implementing them.
Capital structure: How to Finance the
firm as a whole.
Working capital management:
Managing the firm’s cash flow.
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Forms of Business Organization
1.
Sole proprietorship: A firm owned
by an individual or a family, assets
and liabilities of the firm are the
personal assets and liabilities of
the proprietorship.
A sole proprietor has unlimited
liability.
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Forms of Business Organization
2.
Partnership: A firm with two or
more owners, called the partners,
who share the equity in the
business.
Partners have all unlimited
liability, or at least one of them,
called the general partner, has
unlimited liability and the others
limited liability.
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Forms of Business Organization
3.
Corporation: A firm that is a legal
entity distinct from its owners.
Shareholders are entitled to a
share of any distributions from the
corporation in proportion to the
number of shares they own.
Shareholders have limited liability.
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Separation of Ownership and
Management: Reasons
1.
2.
Professional managers may be
found who have a superior ability
to run the business.
The need to pool resources to
achieve an efficient scale of
production calls for a structure
with many owners, not all of whom
can be actively involved in
managing the business.
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Separation of Ownership and
Management: Reasons
3.
4.
In an uncertain economic
environment, owners will want to
diversify their risks across many
firms. An efficient diversification is
difficult to achieve without
separation of ownership and
management.
The separated structure allows for
savings in the costs of information
gathering.
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Separation of Ownership and
Management: Reasons
5.
There is the “learning curve” or
“going concern” effect, which
favors the separated structure.
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Separation of Ownership and
Management: Drawback
The separated structure creates the
potential for a conflict of interest
between the owners and the
managers.
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The Goal of Management
Maximizing the wealth of current
shareholders


Leads to the same investment
decisions that each individual owner
would have made
It does not depend upon the risk
aversion or wealth of the owners
The Right Rule
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The Goal of Management


Profit Maximization Criterion
If the production process requires
many periods, then which period’s
is to be maximized?
If either future revenues or
expenses are uncertain, and profits
are described by a probability
distribution?
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Difficult Task for Managers


Estimating the impact of their
decisions on the value of the firm’s
share
Existence of a stock market make
precious information about the
shares’ values accessible
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The Market Discipline: Takeovers



What forces are there to compel
managers to act in the best interests
of the shareholders?
An important mechanism for aligning
the incentives of managers with those
of shareholders, is takeover.
Managers know that if they fall to
maximize the market value of the
firm’s shares, the firm will be
vulnerable to a takeover in which
managers might loose their jobs.
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The Market Discipline: Takeovers
The takeovers identify significantly
mismanaged firms and buy enough
shares to gain the control, then
they replace the managers with
ones who will operate the firms
optimally. Having announced the
change in the firm’s investment
plans, they sell the shares of the
firms at the new market price for an
immediate profit.
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