FINC 5000 LESSON NOTES – WEEK 1
CHAPTER 1
Overview of Finance and Financial Markets
Description of Finance: (Chapter 1)
- First, what finance is about
-- Similar to accounting in many respects
-- Accounting is figuring out how much money you have
-- Finance is deciding what to do with it
--- ie, Finance is the act/process/study of managing money
(in such a way that you get and keep more of it, and lose less of it)
Some Introductory concepts:
- Forms of business; we will deal with three:
-- Sole proprietorship: one person owns everything
-- Partnership: two or more people jointly own everything
-- Corporation: owners may be any number of people who all own shares of the
business (the shares are called shares of stock)
- Note that the Corporation itself is a legal entity
-- therefore the owners are not personally liable for the corporation’s debts
(Corporations will be what we deal with mostly in this course)
Basic Financial Goal of the corporation: (burn this into your memory forever)
To maximize the wealth of the owners (stockholders in the case of corporations)
- Why finance people say this is so:
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-Consider this train of thought:
-- Most people would agree that the goal of the firm is to make lots of money for
the owners
--- That is, to make them rich, or "wealthy"
--- The question is, how do you measure "wealth"?
--- What each owner possesses as a result of being an owner is a piece of
paper (share of stock) that gives the owner the right (or claim) to
receive money from the corporation
--- So, owners’ wealth is measured by how much their stock (the piece
of paper) is worth
--- So what determines how much the stock is worth?
--- Answer: The market’s (that is, the investing public, potential owners)
perception as to how much money the corporation will distribute to the
owners in the future. The more money that people think will flow to
the stock’s owners in the future, the more valuable they will consider
the stock to be (and vice versa)
-- So now the question is, what influences people’s opinion as to how much
money a company will give to its owners in the future?
-- Answer: Pretty much anything people know or believe about the company
-- Some broad factors that influence stock prices:
-- The ability to generate cash flows now and in the future (more are
better, less are worse; can get more per share by taking in more cash or
by decreasing the number of shares outstanding)
-- Timing of cash flows (sooner is better, later is worse; but a big one
later may be better than a small one up front, as
we shall see)
-- Risk (of getting the cash flows, and of having to pay them to someone
else, which is a function of the amount of money the firm
borrows)
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Next subject: The financial environment (in which the firm operates)
Capital Allocation, Financial Markets, Securities
- Question: Why is this important?
- Answer: because firms need to raise money to operate and grow
-- Consider this simplified balance sheet:
Assets: $1,000,000
Liabilities: $100,000
Equity:
$900,000
Tot L & E: $1,000,000
-- You’d like to make the asset figure bigger, but to do so you must increase
liabilities, equity, or both (the balance sheet must balance--all assets are
claimed by somebody)
-- One way to do it is to sell more goods and services: you get money; cash
increases, equity increases
--- But frequently money from profits is not enough
--- For example, suppose you want to build a new plant in Montana. The
plant will cost $2,000,000
--- You don't have $2,000,000 saved up, so you must borrow $ (increase
liabilities) or sell some more shares in the company (increase equity) to
get the money
- To borrow or sell shares, you go to the "market" (in essence, “to buy money”)
Securities in the Financial Markets:
- Securities: Pieces of paper that “secure” an investors claim on some interest or cash
flow that is expected to occur in the future (think of securities as “claim checks”)
-- Debt securities: “IOUs” that promise to pay a certain amount on a specified
date in the future, and possibly periodic interest payments until that time
(examples, CDs, commercial paper, treasury bills, corporate bonds)
-- Equity securities: Claims on the future earnings of a company (example:
common stock)
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- Securities markets:
-- Debt securities that mature in less than 1 year are said to trade in the money
market
-- Debt securities that mature in more than one year and equity securities that
don’t have any maturity date are said to trade in the capital market
-- The Primary market consists of transactions between those that want money
and those that give it to them--new issues
-- The Secondary market consists of transactions between holders of existing
securities--trades among owners
-- The "Real Asset" markets consist of transactions involving real things, not just
claims on them
Going to the market for money:
- Alternatives:
-- Get a loan from the bank (debt, a liability)
-- Go to investment banker (Drexal Bernham Lambert, Goldman Sachs, Salomon
Bros, Merrill Lynch, etc.) and issue bonds (in effect, borrow from investors)
-- Go to investment banker and issue stock (let more people become owners of the
company for a price)
-- Sell some other type of security (a bunch of them are described in the book in
Table 1-1 on page 16)
- In each case, the people who have money won't let you have it for free, you have to pay
a "price" for it
-- For debt, the cost is normally referred to as the “interest rate” (covered in detail
in chapter 5)
-- For equity, the cost is normally referred to as the “cost of equity” (covered in
detail in chapter 9)
End of notes
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