Introduction to Finance
Lecture Outline
I. What is finance?
II. Types of businesses
III. Corporate securities as contingent
claims
IV. The principal-agent problem
V. Self study reading
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I. Introduction to Finance
What is Finance?
Specific questions addressed by finance:
1. How should funds be acquired?
2. How should funds be spent?
3. How should short-term assets/liabilities be managed?
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Finance Questions in a Corporate
Context (i.e., corporate finance)
1.
Where will you get the long-term financing to invest?
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2.
What long-term investments should be undertaken
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3.
Bring in other owners (issue equity/stocks)
Borrow (issue debt/bonds)
Buildings
Machinery
Equipment
Research and development (R&D)
How will you manage the company’s short-term cash flow?
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Collecting from customers
paying suppliers
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Flows of funds and decisions
important to the financial manager
Real Assets
Financial
Manager
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Financial
Markets
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Goals of the Financial Manager
 Finance in the least costly way.
 Invest in assets that generate more
value than they cost.
In order for us, as financial managers, to
achieve these goals, we must understand
how to determine value: identify cash flows
and their timing, and consider risk.
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II. Types of Businesses
1. Sole Proprietorship
2. Partnership
3. Corporation
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The Sole Proprietorship
Formed by a single individual
 Simplest and least regulated
 Owner keeps all profits and pays taxes as
personal income
 Owner has an unlimited liability
 Ceases to exist once the owner dies or
withdraws
 Cannot raise equity beyond the owner’s
wealth (limits growth)
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Forms of Business Organization
The Partnership
Formed by 2 or more individuals
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General Partnership
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Limited Partnership
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An agreement between partners to provide work/cash and
share profits/losses
Control resides with a majority of the general partners
Unlimited liability of each general partner
Limited liability for some partners (not involved in
management) – Limited partners are silent partners – no
control
There must be at least one general partner
Owners pay taxes as personal income
Ceases to exist once a general partner dies or withdraws
Difficult to raise equity capital
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Forms of Business Organization
The Corporation
 A distinct legal entity owned by one or more
individuals
 Owned by shareholders who elect directors – oversee
managers
 More complicated (articles of incorporation, bylaws)
 Liquidity and marketability of ownership – more easily
transferable than with proprietorships or partnerships.
 Limited liability of shareholders
 Continuity of Existence
 Double taxation: corporate tax and tax of the
owners/shareholders
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III. Corporate Securities as Contingent
Claims on the Firm’s Assets
 Debt (bonds):
 Equity (stocks):
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Contingent Value of the
Firm's Securities ($
millions)
Value of Debt at time of Repayment
(repayment due = $10 million)
35
30
25
20
15
10
5
0
0
5
10
15
20
25
30
35
40
45
Value of the Firm's Assets at the time the debt
is due ($ millions)
Dua, Falk, Jacoby, Scott,
Stangeland and Wajeeh © 2005
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Contingent Value of the
Firm's Securities ($
millions)
Value of Equity at time of Debt Repayment
(repayment due = $10 million)
35
30
25
20
15
10
5
0
0
5
10
15
20
25
30
35
40
45
Value of the Firm's Assets at the time the debt
is due ($ millions)
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Stangeland and Wajeeh © 2005
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Contingent Value of the Firm's
Securities ($ millions)
Total Value of the Firm
= Debt + Equity
35
30
25
20
15
10
5
0
0
5
10
15
20
25
30
35
40
45
Value of the Firm's Assets at the time the debt
is due ($ millions)
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Stangeland and Wajeeh © 2005
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IV. The Principal-Agent (PA) Problem
 Corporations are owned by shareholders
but are run by management
 Shareholders are said to be the principals
 Managers are the agents of shareholders
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Principal-Agent (PA) Problem and
Conflicting Goals
 Shareholders would like management to act in their
best interest by maximizing the value for the
shareholders – shareholder wealth maximization
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Managers, through human nature, maximize their personal
well being subject to the constraints under which they
operate
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How is shareholder control
exercised over management?
 Elect the board of directors . . .
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Agency Costs and Residual Losses
 The PA Problem can never be perfectly
eliminated
 Agency costs are the costs of monitoring
management and the incentive schemes
used to try to align management with
shareholders
 Residual losses are the losses that remain
due to the divergence of interests between
managers and shareholders
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Corporate Goals Revisited
 Shareholder Wealth
Maximization (North
American & UK view)
vs. Consideration of
Stakeholders (Japan &
European view)
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Customers
Suppliers
Employees
Society
Environment
Government
Stockholders
Bondholders
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V. Self study – will be examined
 Financial Institutions
 Financial Markets
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Money vs. Capital Markets
Primary vs. Secondary Markets
Listing
Foreign Exchange
Trends in Finance
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