Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
MODULE 1: Introduction
Learning Objectives
X Identify the axioms of finance
X Identify the importance of studying finance for professionals and nonprofessionals
X Identify the difference between Debt and Equity
X Recognize the role of the financial manager
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Contents
1
The Axioms of Finance
2
Why Study Finance?
3
Debt and Equity: The Two Flavors of Capital
4
The Corporate Financial Manager’s Goals
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 1: The Risk-Return Tradeoff
We won’t take additional risk unless we expect to be compensated with
additional return
Almost all financial decisions involve some sort of risk-return trade off
The higher the risk, the higher the return
If you would invest in a risky business like junk bonds or oil wells, you
should demand a greater return
Risk evaluation should always be present in every decision you make
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
> Example
When Floyd Mayweather and Connor McGregor were about to fight, people
who would bet on McGregor would get higher returns than betting on
Mayweather
A lot of people expected Mayweather to win the match because he was
more experienced and had more boxing talent than McGregor
In order to entice people to bet on McGregor, a higher reward would be
given to those who bet on the MMA star
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 2: The Time Value of Money
A dollar received today is worth more than a dollar received in the future
How many candies could a dollar buy back in the 90s?
How many candies can your dollar buy now?
A dollar in the past could purchase more candies than today
The money you have today could be invested in order to earn more
This would compensate for inflation
The sooner you invest, the better
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 3: Cash – Not Profits – Is King
In measuring value, cash flows are used rather than accounting profits
because it is only cash flows that the firm receives and is able to reinvest
You cannot entirely spend “profit” or “net income”
These accounts are only paper figures and includes both realized and unrealized gains, cash and receivables
Cash is the primary asset of an entity that can be reinvested or used to pay
bills
Cash flow could be more vital than the income statement because it shows
the actual amount that could be used in the regular business operations
In finance, cash is king
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 4: Incremental Cash Flows
It’s only what changes that counts
In making business decisions we will only concern our self with what happens as a result of that decision
The increase or decrease in cash is what really counts and not the increase
or decrease in profit
When deciding on whether to invest in a certain project or not, the difference between the cash flows if the project is pushed through vs the scenario
if the project is not done is what matters
Will the purchase of a photocopying machine increase your cash throughout
the years?
What will be the effect on your cash if you construct a new building?
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 5: The Curse of Competitive Markets
Why it’s hard to find exceptionally profitable projects?
That is because high profit projects attract competition
As a result, profitable projects can only be found if the market is made less
competitive, either through product differentiation or by achieving a cost
advantage
You’ll have to use different techniques to stay relevant in a highly competitive market like using product differentiation (Apple), providing low
cost of products and services (Toyota), and providing high service quality
(Mercedes)
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 6: Efficient Capital Markets
The markets are quick and the prices are right
Information is incorporated into security prices at the speed of light!
That’s the reason why stock prices rise and fall all the time
Assuming the information is correct, then the prices will reflect all
publicly available information regarding the value of the firm
The Exploding Samsung Galaxy Note 7 immediately affected Samsung’s
stock prices
The death of Steve Jobs had an effect in Apple’s stock too
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 7: The Agency Problem
Managers won’t work for the owners unless it’s in their best interest
The agency problem is a result of the separation between the decision
makers (managers) and the owners of the firm (stockholders)
As a result managers may make decisions that are not in line with the goal
of maximization of shareholder wealth
Because the primary purpose of creating a corporation is to increase shareholder’s wealth
This is a problem that is existent in almost all businesses
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 8: Taxes Bias Business Decisions
As the saying goes, there are only two things that are certain in this world:
Death and Taxes
When there’s a business, there’s also tax
And because cash is king, businesses must always consider the after-tax
cash flow on an investment
The tax consequences of a business decision will impact (reduce) cash
flows
Companies are given tax incentives by the government to influence their
decisions
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 9: All Risk Is Not Equal
Some risk can be diversified away and some cannot
The process of diversification can reduce risk, and as a result, measuring
a project’s or an asset’s risk is very difficult
Diversification can be explained by the adage (don’t put all your eggs in
one basket)
Diversification can create offsets between good results and bad results
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
Axiom 10: Ethical Behavior Is Doing The Right Thing
Ethical behavior is doing the right thing, and ethical dilemmas are everywhere in finance
Unethical behavior and bad image eliminates trust, which results in the loss
of public confidence
In turn, Shareholder value suffers and it takes a long time to recover
If corporations do the right thing, the value of the business would increase
Unfortunately, precisely how we define what is and what is not ethical
behavior is sometimes difficult
Nevertheless, we should not give up the quest
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
2. Why Study Finance?
Individuals are taking charge of their personal finances with decisions such
as:
– When to start saving and how much to save for retirement?
– Whether a car loan or lease is more advantageous?
– Whether a particular stock is a good investment?
– How to evaluate the terms for a home mortgage?
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
2. Why Study Finance?
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
(Cont.)
In your business career, you may face questions such as:
– Should your firm launch a new product?
– Which supplier should your firm choose?
– Should your firm produce a part or outsource production?
– Should your firm issue new stock or borrow money instead?
– How can you raise money for your start-up firm?
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
2. Why Study Finance?
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
(Cont.)
The financial manager takes potential critical decisions inside any business
enterprise:
– What products to launch?
– How to pay to develop those products?
– What profits to keep and how to return profits to investors?
The financial manager does all of this with the goal of maximizing the
value of the firm
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
3. Debt and Equity: The Two Flavors of Capital
Businesses have access to many different types of long-term funding, or
capital: debt and equity
– Debt capital includes all of a company’s long-term borrowing from creditors
– The borrower is obliged to pay interest and to repay the principal amount
at the debt’s maturity according to a fixed schedule
– If the company defaults on any of its debt payments, creditors can take
legal action to force repayment
– In some cases, this means that creditors can force the borrowing firm into
bankruptcy, forcing them out of business and into selling their assets to
raise cash to repay creditor claims
Budget Restrictions
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
3. Debt and Equity: The Two Flavors of Capital
Notes
(Cont.)
Business owners contribute equity capital, which is expected to remain
permanently invested in the company
– The two basic sources of equity capital are common stock and preferred
stock
– Common stockholders bear most of the firm’s business and financial risk
– Similar to creditors, preferred stockholders are promised a fixed annual
payment on their invested capital
– Unlike debt, preferred stockholders’ claims are not legally enforceable
– If a company falls into bankruptcy and has to be liquidated, preferred stockholders’ claims are paid off before any money is paid to common stockholders
Budget Restrictions
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
4. The Corporate Financial Manager’s Goals
In large, publicly traded corporations, owners are typically distinct from
managers
Traditionally, finance teaches that managers should act according to the
interests of the firm’s owners
We discuss:
– What the corporate manager’s goals should be?
– What a corporate manager should maximize?
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
⊕ What Should a Financial Manager Try to Maximize?
Maximize Profit?
Some people believe that the manager’s objective should always be
to try to maximize profits
For this, managers should only take those actions that they expect
will increase the firm’s revenues more than its costs
From a practical standpoint, this objective translates into maximizing
the Earnings Per Share (EPS)
Although it seems a reasonable objective for corporate managers,
profit maximization as a goal suffers from several flaws
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
⊕ What Should a Financial Manager Try to Maximize? (Cont.)
Figures for EPS are always historical, reflecting past performance
If managers only seek to maximize profits over a period of time, they may
ignore the timing of those profits
Large profits that pay off many years in the future may be less valuable
than smaller profits received next year
When firms compute profits, they follow certain accounting principles
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
⊕ What Should a Financial Manager Try to Maximize? (Cont.)
A firm that is profitable according to accounting principles may spend more
cash than it receives
In finance, we place more emphasis on cash
than on profits or earnings
Focusing only on earnings ignores risk
Corporate finance presumes a trade-off
between risk and expected return,
which are the key determinants of share prices
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
⊕ What Should a Financial Manager Try to Maximize? (Cont.)
Maximize Shareholder Wealth?
Current theory asserts that the firms’ proper goal is to maximize
shareholder wealth
A firm’s stock price reflects the timing, magnitude, and risk of the
cash flows that investors expect a firm to generate over time
When considering alternative strategies, managers should only undertake the actions that will increase the value of the firm’s future cash
flows:
– Why does finance regard share value maximization as the primary
corporate objective?
– Why not focus instead on satisfying the desires of customers, employees, suppliers, creditors, or any other stakeholders?
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
⊕ What Should a Financial Manager Try to Maximize? (Cont.)
Theoretical and empirical arguments support the assertion that managers
should focus on maximizing shareholder wealth
Shareholders have claims only on any of the firm’s cash flows that remain
after employees, suppliers, creditors, governments, and other stakeholders
are paid in full
By accepting their position as residual claimants, shareholders agree to
bear most of the risk of running the firm
If firms did not operate to maximize shareholder wealth, investors would
have little incentive to accept the risks necessary to buy stocks and provide
the funds necessary for a business to thrive
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Financial Management
Introduction
Time Value of Money
Valuing Bonds
1.
2.
3.
4.
The Axioms of Finance
Why Study Finance?
Debt and Equity: The Two Flavors of Capital
The Corporate Financial Manager’s Goals
Notes
⊕ What Should a Financial Manager Try to Maximize? (Cont.)
Focus on Stakeholders?
Although the primary goal of managers should be to maximize shareholder wealth, many firms have broadened their focus to include the
interests of other stakeholders
A firm with a stakeholder focus consciously avoids actions that would
harm stakeholders
The goal is not so much to maximize others’ interests as it is to
preserve those interests
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Financial Management
Notes
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