Finance Exam 1Finance – management of money, principles related to investing money and how money should be raised for investmentsCash related criteria investments –1. Amount of money received from investment2. Timing when you expect to receive cash flows from investment3. Risk associated with receiving moneyThree Area’s in Finance1. Corporate Finance – how companies raise money, invest money, and how they manage their financial resources2. Capital Markets and Institutions – role of financial institutions, structure of capital markets, process of financial intermediation and how money flows in the economy3. Investments – uses valuation techniques to value alternative investment opportunities provided through financial markets and institutions1. Investment Decision – corporate mangers make sure money is invested in projects that will be worth more than they cost2. Financing Decision – corporate mangers need to decide what combination of debt and equity they should use to raise funds3. Dividend Decision – corporate managers need to decide what percent of the company’s profits should be paid to shareholders and what percentage should be reinvested into the companyFinancial Toolbox- Financial Statements and Ratio Analysis – ratios used to establish relationships between variables and financial statements- Present Value and Future Value – ‘time value of money’- Models of Risk and Return – investors require higher rates of return for taking on more risk- Spreadsheet Modeling Methods – spreadsheet programs (excel)The Ten Principles of FinancePrinciple 1. Return v. Risk – higher returns, higher risk (positive relationship – want higher returns) Higher standard deviation = higher risk*- Treasury Bills – lowest risk- Small company stock – highest risk- Ibbotson & Sinquefield Study – showed direct relationship between expectedreturn of asset class and risk associated with receiving that return- Stock Return = (P1– P2) + D/ P2Principle 2. Efficient Capital Markets are tough to beat – prices of stocks and bonds react instantaneously and very quickly incorporate new information- Random walk – stock prices random- CAPM – trade-off between risk and expected return- Unsystematic risk – specific to firm- Systematic risk – specific to marketPrinciple 3. Risk Preference – Rational investors are risk averse (individual investors prefer less risk)Principle 4. Supply & Demand drive prices in short run – Fundamentals drive stock prices in long run- Market Capital = current stock price x amount of shares outstandingPrinciple 5. Corporate managers should make decisions to maximize shareholder value- Invest in projects that create positive net present value – value associated with investing in a project or venue- If positive, project creates value- If negative, project should not be invested- Capital budgeting – valuation, planning and managing of corporate investments for a firm (investments for growth)- Cost of Capital – cost of raising debt and equity for firm- Capital Structure Decision – minimizing cost of capital by using right mix ofdebt and equity (debt/equity for financial investments)- Working Capital Management – managing a firms short term assets and short term liabilities (daily activities)- Short Term Assets – accounts receivable, inventory- Short Term Liabilities – loans due within one year, accounts payablePrinciple 6. Transaction costs, taxes and inflation are enemies – can greatly reduce the real return on your investments (as they increase, return on investment decreases)- Investors should work to minimize tax liabilityPrinciple 7. Time and Value of money are inversely related – a dollar today is worth more than a dollar tomorrow- FV = PV (1+r)^n- PV – stock is worth, r – rate, n – yearsPrinciple 8. Asset allocation is a very important decision – decision to invest in stocks, bonds or cash is critical in determining your range of expect returns- Brinson Study – asset allocationPrinciple 9. Asset Diversification Reduces Risk – spread your wealth- Goal – invest in a group of assets that will provide you with the best return possible given a level of risk- If risk averse, diversification way to goPrinciple 10. Valuation – Asset pricing use to value investments – used to put a price on risk- CAPM (Capital Asset Pricing Model) – estimate rate of return investor shouldexpect to receive on risky assetCorporate Finance, Creating Shareholder Value & Corporate GovernanceTraditional Finance Behavioral FinanceChoice Expected utility maximization Flaws in utility functionDecisions Rational expectation Not always rational emotions andbiases (rules of thumb)Prices Reflect expected outcomes Reflect emotions and biasesMarkets Prices reflect value Market efficiency?Market Corrections Arbitrageurs correct mispricing Limits to arbitrageCFO (Chief Financial Officer) – head financial manager in company who oversees financing activities- Responsibilities – work with bankers, advisors and participants in financial market, fulfill capital needs, financial spokesperson- Traditional Role – controller and treasurer- Expanded Role - Corporate Strategist – assist in strategy formation- Financing and capitalization – insure capital available to fund strategic plan- Risk Management- Growth and Acquisitions – provide for growth opportunities- “Communicator with markets”Command & Control – controlled financial information but was not accountable for company’s overall performance- “Corporate Cop” – oversaw company spending and made sure company’s books were closed by deadlineCompetitive Team (new model) – individuals that made up finance function act as business advocates and assigned to individual business units- Generate and share financial information to help in decision making- All members of financial function accountable for business unit performanceElements in New Corporate Finance –- Technology – advancements in telecommunications and information systems have reduced transaction costs; especially opportunity costsTreasurer – finance Controller – accounting (books)1. Capital budgeting – long-term investment decisions2. Capital structure decision – where/how raise funds to finance investments3. Capital management decisions – manage day-to-day finance activities – Cash inventory management – Credit/collection policy– Paying suppliers4. Working capital5. Capital