Lecture Note 1: The Investment EnvironmentReal Versus Financial AssetsFinancial assets and allocation of resourcesRoles played by Financial AssetsTypes of Financial AssetsSlide 6Types of Financial Assets: Derivative securitiesDerivative Securities: Options and FuturesDerivative Securities: Credit Default SwapsWhat Is Corporate Finance?Financial StatementsBalance Sheet Model of the FirmThe Capital Budgeting DecisionThe Capital Structure DecisionShort-Term Asset ManagementThe Financial ManagerForms of Business OrganizationCorporation and the Agency ProblemManagerial GoalsManaging ManagersFinancial IntermediariesInvestment BankersKey Trends - SecuritizationSlide 24Key Trends - Financial EngineeringStock Market IndexesSlide 27Examples of Indexes - Int’lCoverCoverimageimageLecture Note 1:Lecture Note 1:The Investment EnvironmentThe Investment EnvironmentCoverCoverimageimageReal 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 investorsCoverCoverimageimageFinancial 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.CoverCoverimageimageRoles 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–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 marketCoverCoverimageimageTypes 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–Financial instruments that derive their value from other F.I. Provide payoffs that are determined by the prices of other assets.CoverCoverimageimageTypes of Financial AssetsThere 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.CoverCoverimageimageTypes 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 speculationCoverCoverimageimageDerivative Securities: Options and Futures•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.CoverCoverimageimageDerivative 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).CoverCoverimageimageWhat 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?CoverCoverimageimageFinancial 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 timeCoverCoverimageimageBalance Sheet Model of the FirmCurrent AssetsFixed Assets1 Tangible 2 IntangibleTotal Value of Assets:Shareholders’ EquityCurrent LiabilitiesLong-Term DebtTotal Firm Value to Investors:Assets = Liabilities + Equity Equity/Net Worth = Assets - LiabilitiesCoverCoverimageimageThe Capital Budgeting DecisionCurrent AssetsFixed Assets1 Tangible 2 IntangibleShareholders’ EquityCurrent LiabilitiesLong-Term DebtWhat long-term investments should the firm choose?CoverCoverimageimageThe Capital Structure DecisionHow should the firm raise funds for the selected investments?Current AssetsFixed Assets1 Tangible 2 IntangibleShareholders’ EquityCurrent LiabilitiesLong-Term DebtCoverCoverimageimageShort-Term Asset ManagementHow should short-term assets be managed and financed?Net Working CapitalShareholders’ EquityCurrent LiabilitiesLong-Term DebtCurrent AssetsFixed Assets1 Tangible 2 IntangibleCoverCoverimageimageThe Financial ManagerThe Financial Manager’s primary goal is to increase the value of the firm