Chapter 1
1.1 Finance and the Firm
Finance can be defined as the science and art of managing money.
- Personal level: it is concerned with individuals’ decisions about: how much of their
earnings they spend, how much they save and how they invest their savings.
- Business context: how firms raise money from investors, how firms invest money and
how firms decide whether to reinvest profits or distribute them back to investors.
Managerial finance concerns the duties of the financial manager in a business.
The goal of a firm is to maximize shareholder wealth. This equals maximizing stock price or
share price.
- Profit maximization does NOT lead to the highest possible share price, as a result of
timing, cash flows and risk.
Some firms argue managers should maximize the wealth of stakeholders, however there are
several flaws in recommending this broader perspective.
Stakeholders are groups such as employees, customers, suppliers, creditors, and others who
have a direct economic link to the firm but are not owners, members of the local community
where a firm is located too, for example. They have a direct economic link to a firm.
Dividends ultimately received by stockholders come from the firm’s profits.
Corporations commonly measure profits in terms of earnings per share (EPS): the amount
earned during the period on behalf of each outstanding share of stock.
- Divide the period’s total earnings available for the stockholders by the number of shares
of stock outstanding.
Business ethics are the standards of conduct or moral judgments that apply to people engaged
in commerce. The goal of these ethics is to motivate business and market participants to adhere
to both the letter and the spirit of laws and regulations concerned with business.
Corporate owners earn a return by realizing gains through increases in share price & cash
dividends.
1.2 Managing the Firm
Financial manager’s key decisions include: investment decisions, capital budgeting decisions
and financing decisions. Investment decisions are decisions that focus on how a company will
spend its financial resources on long-term projects that ultimately determine whether the firm
successfully creates value for its owners. 2 financing decisions are:
1. Capital structure decisions: the money that firms raise to finance their activities.
2. Working capital decisions: refers to the management of a firm’s short-term resources.
When making these decisions, the balance sheet is used.
Capital budgeting is a technique that helps managers decide which projects create the most
value for shareholders.
Financing decisions are decisions that determine how companies raise the money they need to
pursue investment opportunities.
,Capital is the money that firms raise to finance their activities.
The principles that guide managers’ decisions are: the time value of money, the tradeoff
between risk and return, “cash is king” and competitive financial markets.
Accrual based accounting recognizes revenue at the time of the sale and recognizes expenses
when they are incurred → this is the accounting view.
Cash based accounting recognizes revenues and expenses only with respect to actual inflows
and outflows of cash → this is the financial view.
There are 3 forms of businesses, their strengths are:
- Sole proprietorship: owner receives all profits and sustains all losses, low organizational
costs, income included and taxed on proprietor’s personal tax return, independence,
secrecy & ease of dissolution. Unlimited liability (gives creditors the right to make claims
against the owner’s personal assets to recover debts owed by the business).
- Partnership: can raise more funds than sole proprietorship, borrowing power enhanced
by more owners, more available brain power & skill, income included and taxed on
partner’s personal tax return.
- Corporation: owners have limited liability (they can’t lose more than they invested), can
achieve large size via sale of ownership (stock), stocks are readily transferable, long life
of firm and can hire professional managers, also more access to financing.
They also have weaknesses:
- Sole proprietorship: owner has unlimited liability (total wealth can be taken to satisfy
debts), limited fund-raising, difficult to give employees career opportunities and lacks
continuity when proprietor dies.
- Partnership: owners have unlimited liability (may have to cover debts of partners),
partnership is dissolved when partner dies & difficult to liquidate or transfer partnership.
- Corporation: taxes are higher (corporate income is taxed, dividends paid to owners are
also taxed), more expensive to organize than other business forms, subject to bigger
government regulation and it lacks secrecy.
1.3 Organizational Forms, Taxation, and the Principal-Agent Relationship
Large firms have many shareholders, and the majority of them have no direct managerial
responsibility. The professional managers who run these firms are the agents of the
shareholders: they’re entrusted to make decisions that are in the shareholders’ best interests.
Agency costs: costs that shareholders bear due to managers’ pursuit of their own interest. An
example is a private jet used by the CEO or the cost of hiring outside editors to verify reports.
- The principal-agent problem arises because the owners of a firm and its managers are
not the same people and the agent does not act in the interest of the principal.
Corporate governance: the rules, processes, and laws by which firms are operated & controlled.
- Internal corporate governance mechanisms are:
- Stock options: allows managers to buy shares of a stock at a fixed price.
- Restricted stock: shares of stock paid out as part of compensation that do not
fully transfer from the company to the employee until certain conditions are met.
, - External corporate governance mechanisms are:
- Individual vs. institutional investors: individuals are regular people who buy
stocks in Google, for example (usually a small % of the value of the firm).
Institutional investors are making huge trades, these people own a bigger % of
the company.
- Government regulation: things that are set up that if you don’t comply with certain
rules, you’ll be fined or penalized.
Stockholders are the owners of a corporation, whose ownership (or equity) takes the form of
common or preferred stock.
Stock is a security that represents an ownership interest in a corporation.
Dividends are periodic distributions of cash to the stockholders of a firm.
- Stockholders are paid last, after the corporation pays employees, suppliers, tax
authorities and lenders and anyone else to whom it owes money.
Chapter 2
2.1 Financial Institutions
Financial institutions (or banks) are intermediaries that channel the savings of individuals,
businesses, and governments into loans or investments. The key suppliers and demanders of
funds are also individuals, businesses and governments.
- Usually: individuals as suppliers, while businesses and governments as demanders.
3 financial institutions:
1. Commercial banks: institutions that provide savers with a secure place to invest their
funds offer loans to individual and business borrowers. The issue today is in order to
park your funds at a bank, you’re going to get little to no interest. These are backed by
the government.
2. Investment banks: assist companies in raising capital, advice firms on major transactions
and engage in trading and market making activities. These focus on the security side of
the company. They also give advice.
3. Shadow banking system: a group of institutions that engage in lending activities, like
traditional banks, but do not accept deposits and therefore are not subject to the same
regulations as traditional banks. These use their own funds to get their own loans into
the market. Because of that, they’re not government backed & there’s more risk.
2.2 Financial Markets
Financial markets are forums in which suppliers and demanders of funds can transact business
activity. 2 key financial markets are the money market and the capital market.
- Transactions in short-term securities take place in the money market.
- Transactions in long-term securities take place in the capital markets.
Raising money can be done using either private placements or public offerings.
A private placement involves the sale of a new security directly to an investor or group of
investors.
