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Summary - Finance (BT1209)
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Summary of all required literature and lectures for the course Finance (Erasmus University Rotterdam)
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Table of contents★ Week 1: introduction to financial concepts and Hirschleifer model
★ Week 2: capital budgeting
★ Week 3: capital budgeting
★ Week 4: bonds
★ Week 5: stock (and bonds)
★ Week 6: mean variance analysis
★ Week 7: portfolio theory and mean variance analysis
★ Week 8: capital asset pricing model (CAPM)
★ Week 9: efficient market hypothesis (EMH)
★ Week 10: mergers and acquisitions, and efficient market hypothesis (EMH)
,Week 1
Chapter Hillier 1: introduction to corporate finance
The main purpose of the firm is to create value for its owners. This is reflected in the balance
sheet model of the firm. Assets are all the valuable things a company owns and the liabilities
show how these assets have been financed.
From this model we can tell more about the following concepts:
1. Capital budgeting: process of making and managing expenditures on long-lived
assets -> left side of balance sheet
2. Capital structure: proportions of the firm’s financing from current and long-term debt
and equity -> right side of balance sheet
3. Net working capital: the current assets minus current liabilities. It is about how
short-term operating cash flows should be managed.
The perfect level of net working capital depends on the business and the type of operations.
It can be tricky to have very little net working capital as that could mean that you can’t
finance your short-term operations or don’t have any cash saved for emergencies. On the
other hand, a high net working capital may mean that the company is not using its money
efficiently enough, because the excess cash could be used for profitable investments.
Before a company can invest in an asset, it must obtain financing, which means it must raise
money to pay for the investment. The forms of funding are on the right side of the balance
sheet. A firm will issue pieces of paper called bonds (debt or loan agreements) or shares
(certificates representing fractional ownership of the firm). People that lend money to (buy
debt from) the firm are called creditors, bondholders and debtholders. The holders of equity
are the shareholders.
The value of a firm is defined by V = D + E, in which D is the market value of the debt
(bonds) and E is the market value of the equity (shares). The goal is that V is large.
The chief financial officer (CFO) is the most important in a company. A treasurer is
responsible for handling cash flows, managing capital expenditure decisions and making
financial plans. He/she has to report to the CFO. The financial controller handles the
accounting function, which includes taxes, financial and management accounting, and
information systems -> also provides CFO with information.
The most important job of financial managers is to create value from the firm’s capital
budgeting, financing and net working capital activities. This value is created by ensuring that
the firm generates more cash flow than it uses. They can do this by:
1. Try to buy assets that generate more cash than they cost
2. Sell bonds, shares and other instruments that raise more cash than they cost
,This means, the cash flow put into the firm by bondholders and shareholders should be less
than the cash flows paid to bondholders and shareholders.
If the cash paid to shareholders and bondholders (F) is greater than the cash raised in the
financial markets (A), value will be created.
There are two main ways a company can approach risk:
1. Speculate and attempt to benefit by leaving the company exposed to future
fluctuations in prices or cash flows -> risky and may lead to extremely good or bad
outcomes
2. Hedge against the risk and reduce its impact on the company’s future cash flows. If a
firm hedges too much, it will be exposed to big shifts in cash flows or prices
If a firm needs money for new investments, it can borrow or give up ownership. When a firm
borrows, it can go to a bank for a loan, or it can issue debt securities in the financial markets.
Debt securities are contractual obligations to repay corporate borrowing. If a firm gives up
ownership, it can do this through a public share or private negotiation. A public share is
undertaken through marketing and sale of equity securities. Equity securities are shares that
represent non-contractual claims to the residual cash flow of the firm.
The financial markets are composed of money markets and capital markets. Money markets
are for debt securities that will pay off in the short term -> applies to a group of loosely
connected markets (also dealer markets). Capital markets are for long-term debt and
equities. The difference between the dealer’s buying and selling price is the bid-ask spread.
The primary market is used when governments and public corporations sell securities for the
first time. Corporations can raise money through public offerings or private placements.
A secondary market transaction involves one owner or creditor selling to another. These
provide the means for transferring ownership of corporate securities. They are also
important, because investors are more willing to purchase
securities in a primary market transaction when they know that
those securities can be later resold if desired.
There are two kinds of secondary markets: dealer and auction
markets. Dealers buy and sell for themselves, at their own risk.
Dealer markets in equities and long-term debt are called
over-the-counter (OTC) markets. Auction markets differ from
dealer markets, because they have a physical location and their
goal is to match those who wish to sell with those who want to
buy.
, Chapter Hillier 2: corporate governance
A sole proprietorship is a business owned by one person. Important factors are:
1. Cheapest form of business
2. No payment of corporate income taxes -> all profits are taxed as individual income
3. Unlimited liability for business debts and obligations
4. Life of the sole proprietorship is limited by the life of the owner
5. Cash that can be raised is limited to the proprietor’s own personal wealth
There can be two partnerships: general and limited. In a general partnership all partners
agree to provide some fraction of the work and cash, and share the profits/losses. Limited
partnerships permit the liability of some partners to be limited to the amount of cash each
has contributed to the partnership. They always require one partner to be a general partner
and the limited partners do not participate in managing the business. Important factors are:
1. Usually inexpensive and easy to form
2. General partners have unlimited liability for all debts
3. The general partnership is terminated when a general partner dies or withdraws.
Limited partners may sell their interest in a business.
4. Difficult to raise large amounts of cash
5. Income is taxed as personal income to the partners
6. Management control resides with the general partners
The advantages of these two types of ownership is the low starting cost. The most difficult
disadvantages are unlimited liability, limited life of enterprise and difficulty of transferring
ownership. These lead to a difficulty in raising cash.
A corporation is a distinct legal entity -> it can have a name and enjoy many of the legal
powers of natural persons. Starting a corporation is more difficult as you should prepare
articles of incorporation and the memorandum of association. The first one must include the
name, intended life, business purpose, number of shares that it is authorized to issue, nature
of rights granted to shareholders and number of members of the initial board of directors.
Two types of corporations are private limited ones and public corporations.
The advantages are that it has limited liability, ease of ownership transfer and perpetual
succession. The big disadvantage is that many countries tax corporate income in addition to
the personal income tax that shareholders pay on dividend income they receive.
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