Lecture Note 1 The Investment Environment Cover image Real Versus Financial Assets Investment current commitment of resources in the expectation of reaping future benefits Reduced current consumption Real Assets Assets used to produce goods and services e g land machines and knowledge determines the production capacity of the economy Financial Assets Means by which people hold their claims on real assets Real assets generate net income to the economy Financial assets simply define the allocation of income or wealth among investors Cover image Financial assets and allocation of resources Investors buy securities from companies and firms use the money raised to pay for real assets Securities are negotiable instruments representing financial value e g debt and equity securities Return on securities ultimately comes from the income produced by the real assets that were financed by the issuance of the securities Cover image Roles played by Financial Assets Informational Role in the allocation of capital resources If a firms has good prospects for future profitability investors bit up its stock price The firms find it easy to issue new shares or borrow fund to expand Consumption Timing Can help to shift purchasing power from high earnings to low earnings period Allow individuals to separate decisions concerning current consumption from constraints imposed by current earnings Can store wealth in financial assets shift consumption Allocation of Risk Cover image All real assets involve risk When building a plant do not know for sure what the cash flow would be The risk can be born by all investors that are willing to bear risk in financial market Types of Financial Assets Fixed income or debt securities Promise a fixed stream of income or income that is determined according to a specified formula i e i 2 the rate paid on T Bill Common stock or equity Represents an ownership share in the corporation Price and Div depends on the success of the corporation Derivatives options futures CDS Cover image Financial instruments that derive their value from other F I Provide payoffs that are determined by the prices of other assets Types of Financial Assets There are two types of debt securities Money market debt securities Short term highly marketable easily converted into cash and generally very low risk like U S Treasury bills and bank CDs T bills are short term obligations backed by U S gov w maturities of 1 3 or 6 months Have not interest payments but are sold in discount from par Fixed income capital market securities Long term Treasury bonds bonds issued by federal agencies state local municipalities and corporations Cover image Types of Financial Assets Derivative securities Derivative is a financial instrument whose characteristics and value depend upon the characteristics and value of an underlier typically a commodity bond equity or currency Derivates are to manage the risk associated with the underlying security or to protect against fluctuations in value from periods of inactivity or decline Also used for speculation Cover image Derivative Securities Options and Futures Cover image Option The right but not the obligation to buy for a call option or sell for a put option a specific amount of a given security stock commodity currency index or debt at a specified price the strike price during a specified period of time Futures A standardized transferable exchange traded contract that requires delivery of a commodity bond currency or stock index at a specified price on a specified future date Unlike options futures convey an obligation to buy Derivative Securities Credit Default Swaps A CDS is a contract in which one party the protection seller agrees to reimburse another party the protection buyer against a default on a financial obligation by a third party the reference entity Cover image What Is Corporate Finance Corporate Finance addresses the following three questions 1 What long term investments should the firm choose 2 How should the firm raise funds for the selected investments 3 How should short term assets be managed and financed Cover image Financial Statements Balance sheet is a snapshot of the firm It is a convenient means of organizing and summarizing what a firms owns its assets what a firm owes its liabilities and the difference between the two firm s equity at a given time Cover image Balance Sheet Model of the Firm Total Value of Assets Current Assets Total Firm Value to Investors Current Liabilities Long Term Debt Fixed Assets 1 Tangible 2 Intangible Cover image Shareholder s Equity Assets Liabilities Equity Equity Net Worth Assets Liabilities The Capital Budgeting Decision Current Liabilities Current Assets Fixed Assets 1 Tangible 2 Intangible Cover image Long Term Debt What long term investments should the firm choose Shareholder s Equity The Capital Structure Decision Current Assets How should the firm raise funds for the selected Fixed Assets investments 1 Tangible 2 Intangible Cover image Current Liabilities Long Term Debt Shareholder s Equity Short Term Asset Management Current Assets Fixed Assets 1 Tangible 2 Intangible Cover image Current Liabilities Net Working Capital How should short term assets be managed and financed Long Term Debt Shareholder s Equity The Financial Manager The Financial Manager s primary goal is to increase the value of the firm by 1 Selecting value creating projects 2 Making smart financing decisions Cover image Forms of Business Organization The Sole Proprietorship A business owned by on person The Partnership Two or more people get together and form a partnership The Corporation the standard method for solving the problems encountered in raising large amounts of cash Has a name and enjoys many legal powers of natural persons Cover image Corporation and the Agency Problem Separation of Ownership and Management share holders cannot actively participate in the day to day management of the firm Must hire a manager The Agency Problems Principal hires an agent to represent his her interest Stockholders principals hire managers agents to run the company Agency Problem Conflict of interest between principal and agent Cover image Managerial Goals Managerial goals may be different from shareholder goals Expensive perquisites Survival Independence Increased growth and size are not necessarily equivalent to increased shareholder wealth Cover image Managing Managers Managerial compensation Incentives can be used to align management and stockholder