Basic Concepts of Finance
Lecture 2
Basic Concepts of Finance:
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Value,
Time and uncertainty,
Nominal and real amounts,
Market efficiency and asset pricing,
Agency Relationships.
Value:
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Investment and financing decisions made with
the objective of maximizing the market value of
shareholder’s equity.
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Buyers and sellers in the financial market
determine the prices of securities and therefore,
the value of the company in the market
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Risk and expected return from investment
determines the value that the financial markets
place on company’s debt and equity.
Time & Uncertainty:
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Amount and timing of cash flows determines the
value of the investment,
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Time value of money,
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Amount and timing of cash flows are not known
with certainty.
Nominal & Real Amounts:
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Price at which exchange takes place is the
nominal price of the asset,
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Purchasing power of money changes as a result
of price increases (inflation) and decreases
(deflation),
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Difference between nominal (face) value of
money and the real (inflation adjusted) value of
money.
Market Efficiency:
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The basic assumption is that markets are
efficient, i.e. securities and other assets be fairly
priced, given their expected risks and returns.
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Market participants are well informed
individuals whose trading activities cause prices
to change.
Market Efficiency (contd.):
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Even if markets are efficient, investors should
still hold diversified portfolio of stock across
various industries to maximize their risk
adjusted returns.
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As the stock prices reflect publicly available
information and fairly priced, thus difficult to
outperform market averages.
Asset Pricing:
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The price one pays for an asset when buying it.
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The price represents the value, the market has
assigned to the asset.
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The theory of asset pricing is concerned with
explaining the price of financial assets in an
uncertain world.
Asset Pricing Theories:
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Capital Asset Pricing Model (CAPM),
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Arbitrage Pricing Theory (APT).
CAPM:
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A model that describes the relationship between
risk and expected return and is used in the
pricing of risky securities.
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General idea behind CAPM is that investors
need to be compensated in two ways:
Time value of money,
Risk.
APT:
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Simultaneous purchase and sale of an asset in
order to profit from the difference in the price.
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Arbitrage Opportunity,
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Competition among traders bring the prices to
same level.
Risk:
The chances that an investment's actual return will
be different from expected return.
Classification of Risk:
Systematic Risk:
 Unsystematic Risk:
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Systematic Risk:
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Systematic risk is the market risk, caused due to
factors which cannot be controlled by
diversification.
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Also known as Non-diversifiable Risk.
Unsystematic Risk:
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Unsystematic risk is the Business risk, which is
the measure of risk associated with a particular
security.
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It is also known as Diversifiable risk and refers
to the risk associated with a specific issuer of a
security.
Agency Relationship:
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In Agency relationship, one party called
principal delegates decision making authority to
another party called agents.
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The managers in the company are the agents and
the shareholders are the principals.
Agency Problem:
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A potential conflict of interests between the
agent (manager) and the principals i.e.
stockholders and debt-holders.
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Agency Cost.
Mechanism for Motivation of
Managers:
Managerial compensation,
 Direct intervention by shareholders,
 The threat of firing,
 The threat of takeover.
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Reference:

Peirson, Brown, Easton and Howard (8th
Edition) Business Finance, McGraw Hill.

Brigham, E. and Houston, J. ( 10th Edition)
Fundamentals of Financial Management,
Prentice Hall.