FIN 301 NOTES Chapter 1 Introduction Basic Principles of Finance 1 1 Finance Finance involves the management of money Study of nance includes Principles relating to how money should be invested How money should be raised for investment Why how and whether to invest in projects ventures or stocks that have risky payo s that are expected to be received in the future criteria Decision to make an investment should be based upon three cash related Conservative projection of the amount of money that you expect to receive on the investment Probable timing of the money that you expect to receive on the Reasonable assessment of the probability or risk associated with investment receiving the money Once you estimate the amount timing and risk of the cash ows associated with an investment you use nancial techniques to determine the true value of the project investment or stock Finance involves how governments government agencies nancial institutions nancial markets companies and individuals raises invests Study of nances is generally broken down into three areas and manages its money Corporate nance Involves how companies raise and invest money and manage their nancial resources Capital markets and nancial institutions Examine the structure of capital markets the role of nancial institutions the process of nancial intermediation and how money ows in the economy Capital markets are the nancial markets where issuers and investors buy and sell debt and equity securities In order to invest in plant and equipment technology and other assets companies raise capital either through transactions with nancial institutions or by issuing securities directly in the capital markets Companies can raise capital in the nancial markets by selling debt instruments usually have a xed or variable interest payment and the repayment of principal or by selling equity also known as stock which represents ownership in the company to investors To provide capital nancial institutions must raise money by o ering attractive investment opportunities and nancial services such as checking and savings accounts life health and casualty insurance or pension programs to individuals households and rms Investments and valuation Focus on valuation techniques and how to value alternative investment opportunities that are provided primarily through nancial markets and institutions Debt represents an obligation to repay borrowed moneys Stock represents ownership in a company 1 2 Ten Principles of Finance 1 Return vs Risk Higher Returns Require Taking More Risk a There is a positive relationship between risk and return 2 Market E ciency E cient Capital Markets are Tough to Beat a The pieces of stocks and bonds in the capital markets react very quickly to incorporate new information 3 Risk Preference Rational Investors are Risk Averse a Individual investors usually are risk averse and prefer less risk to 4 Supply and Demand Supply and Demand Drive Asset Prices in the more Short Run a On a day to day basis security prices in the markets are driven by short term supply and demand conditions for similar securities 5 Corporate Finance and Governance Corporate Managers Should Make Decisions that Maximize Shareholder Value a The goal of management should be to maximize the value of the 6 Minimizing the Cost of Investing Transaction Costs Taxes and rm s common stock In ation are your Enemies a To the extent possible minimize your transaction costs and the negative e ects of taxes and in ation on your investment returns 7 The Time Value of Money Time and the Value of Money are inversely a A dollar today is worth more than a dollar tomorrow 8 Asset Allocation Your Asset Class Allocation is a Very Important Related Decision a The decision to invest in stocks bonds or cash is critical in determining your range of expected returns 9 Diversi cation Asset Diversi cation Will Reduce Your Risk a Spread your money around DO NOT put all your eggs in one 10 Investment Valuation Value Equals the Sum of Expected Cash Flows Discounted for Time and Risk a The value of any nancial investment is the sum of its expected cash ows discounted for timing and risk 1 3 Corporate Finance The world s capital markets include a wide variety of organized exchanges where nancial claims are traded These claims include debt and equity capital the bond and stock markets as well as currencies commodities and other nancial basket assets For any country the level of its government s interest rate relative currency values and the performance of the country s stock markets are primary gauges of the health of its economy For a business or a company the ultimate indicator of its success or failure is the market of its common stock Financial markets tend to function most e ciently in a deregulated environment However regulation and oversight are necessary to reduce corruption greed and fraud in the nancial markets With the internationalization of nance the increased speed of trading and the low cost of transactions capital ows freely and rapidly around the globe associated with it The downside of the free ow of capital is the volatility that may be In the international stock markets during the Fall of 2008 volatility had increased to historically unprecedented levels with stock markets regularly moving from 3 to 5 per day and in the extreme to over 10 per day This volatility a ected not only stock prices but also a ected credit markets interest rate movements currency uctuations and other variables that directly impact the economy Global nancial markets are interdependent that ever before Corporate nancial managers are the interface between the providers of capital institutional and individual investors and the nancing of the rm Financial managers in a corporation face three basic sets of decisions The Investment Decision How corporate managers should allocate funds of the company to buy or build projects and investments that will be worth more than they cost The Financing Decision How corporate managers should raise money from institutional and individual investors through the sale of debt and equity claims for the company to nance the investment project of the rm The Dividend Decision The percentage of the company s pro ts and cash from operations that the company should reinvest in the business and how much should be returned to the company s shareholders in the form of dividends Financial managers are responsible for raising and investing capital for new projects that will