FIN 301 NOTESChapter 1: Introduction - Basic Principles of Finance● 1.1 Finance○ Finance involves the management of money○ Study of finance 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 stocksthat have risky payos that are expected to be received in thefuture○ Decision to make an investment should be based upon three cash-relatedcriteria■ Conservative projection of the amount of money that you expect toreceive on the investment■ Probable timing of the money that you expect to receive on theinvestment■ Reasonable assessment of the probability or risk associated withreceiving the money○ Once you estimate the amount, timing, and risk of the cash flowsassociated with an investment, you use financial techniques to determinethe true value of the project, investment, or stock○ Finance involves how governments, government agencies, financialinstitutions, financial markets, companies, and individuals raises, invests,and manages its money○ Study of finances is generally broken down into three areas■ Corporate finance● Involves how companies raise and invest money andmanage their financial resources■ Capital markets and financial institutions● Examine the structure of capital markets, the role offinancial institutions, the process of financialintermediation, and how money flows in the economy● Capital markets are the financial markets where issuers andinvestors buy and sell debt and equity securities○ In order to invest in plant and equipment,technology, and other assets, companies raisecapital either through transactions with financialinstitutions or by issuing securities directly in thecapital markets■ Companies can raise capital in the financialmarkets by selling debt instruments (usuallyhave a fixed or variable interest payment andthe repayment of principal) or by sellingequity (also known as stock, which representsownership in the company) to investors○ To provide capital, financial institutions must raisemoney by oering attractive investmentopportunities and financial services, such aschecking and savings accounts, life, health, andcasualty insurance, or pension programs, toindividuals, households, and firms■ Investments and valuation● Focus on valuation techniques and how to value alternativeinvestment opportunities that are provided primarilythrough financial markets and institutions○ Debt represents an obligation to repay borrowed moneys○ Stock represents ownership in a company● 1.2 Ten Principles of Finance1. Return vs Risk → Higher Returns Require Taking More Riska. There is a positive relationship between risk and return2. Market Eciency → Ecient Capital Markets are Tough to Beata. The pieces of stocks and bonds in the capital markets react veryquickly to incorporate new information3. Risk Preference → Rational Investors are Risk Aversea. Individual investors usually are risk averse and prefer less risk tomore4. Supply and Demand → Supply and Demand Drive Asset Prices in theShort-Runa. On a day-to-day basis, security prices in the markets are driven byshort-term supply and demand conditions for similar securities5. Corporate Finance and Governance → Corporate Managers ShouldMake Decisions that Maximize Shareholder Valuea. The goal of management should be to maximize the value of thefirm’s common stock6. Minimizing the Cost of Investing → Transaction Costs, Taxes andInflation are your Enemiesa. To the extent possible, minimize your transaction costs and thenegative eects of taxes and inflation on your investment returns7. The Time Value of Money → Time and the Value of Money are inverselyRelateda. A dollar today is worth more than a dollar tomorrow8. Asset Allocation → Your Asset Class Allocation is a Very ImportantDecisiona. The decision to invest in stocks, bonds, or cash is critical indetermining your range of expected returns9. Diversification → Asset Diversification Will Reduce Your Riska. Spread your money around. DO NOT put all your eggs in onebasket10. Investment Valuation → Value Equals the Sum of Expected Cash FlowsDiscounted for Time and Riska. The value of any financial investment is the sum of its expectedcash flows discounted for timing and risk● 1.3 Corporate Finance○ The world’s capital markets include a wide variety of organizedexchanges where financial claims are traded.■ These claims include debt and equity capital ( the bond and stockmarkets) as well as currencies, commodities, and other financialassets○ For any country, the level of its government’s interest rate, relativecurrency values, and the performance of the country’s stock marketsare primary gauges of the health of its economy○ For a business or a company, the ultimate indicator of its success orfailure is the market of its common stock○ Financial markets tend to function most eciently in a deregulatedenvironment■ However, regulation and oversight are necessary to reducecorruption, greed, and fraud in the financial markets○ With the internationalization of finance, the increased speed of trading,and the low cost of transactions, capital flows freely and rapidly aroundthe globe■ The downside of the free flow of capital is the volatility that may beassociated with it■ In the international stock markets during the Fall of 2008,volatility had increased to historically unprecedented levels withstock markets regularly moving from 3% to 5% per day - and in theextreme to over 10% per day● This volatility aected not only stock prices but alsoaected credit markets, interest rate movements, currencyfluctuations, and other variables that directly impact theeconomy○ Global financial markets are interdependent that ever before○ Corporate financial managers are the interface between the providers ofcapital (institutional and individual investors) and the financing of thefirm■ Financial managers in a corporation face three basic sets ofdecisions:● The Investment Decision○ How corporate managers should allocate funds of thecompany to buy or build projects and investmentsthat will be worth more than they cost● The Financing Decision○ How corporate managers should raise money frominstitutional and individual investors through thesale of debt and equity claims for the company tofinance the investment project of the firm●