Finance Chapter 1 Finance is broken down into 3 parts Financial management investments and financial markets and institutions Financial Markets and institutions studies the determinants of interest rates the regulation of financial institutions banks savings and loans insurance companies pension funds and so on the structure and functioning of the various financial markets such as the stock and bon markets and the various financial assets and the secondary markets for the assets issued by financial institutions such as mortgages auto loans collateralized mortgage obligations and certificates of deposit Investments focuses on how individuals and financial institutions make decisions concerning the allocation of securities within their investment portfolios The major securities studied in Investments are stocks bonds options and future contracts Corporate Financial Management also often referred to as business or corporation finance involves the actual financial management and business enterprise This is the broadest subject area of finance Finance is concerned with the process through which funds are transferred from savers to borrowers Savers or surplus units are those households businesses and governments whose income exceeds their consumption Borrowers or deficit units are those households businesses and governments whose consumption exceeds their income Most deficit units are businesses and most surplus units are households Surplus units AKA investors The transfer of funds from surplus units investors to deficit units businesses takes place in a financial market or through a financial institution Businesses deficit units borrow money to purchase physical assets such as machinery raw materials real estate plant and equipment This money is obtained either directly from surplus units through a financial market such as the stock or bond market or indirectly through a financial institution In exchange for funds they receive these deficit units issue claims called financial assets against the cash flows that the physical assets that they purchase are expected to generate Investors lend money that is purchase financial assets to earn expected return As long as the actual cash flow equals or exceeds the expected cash flow investors are content If however the actual cash flow is less than the expected cash flow the investor loses In the extreme the actual cash flow can even be negative implying that investors can lose part or all of their initial investment There are two drawbacks to the sole proprietorship business organization First it is very difficult for such companies to raise large amounts of capital The main sources of capital for sole proprietorships are the owner friends and family and commercial banks A bank generally will not contribute any more to a business than the owner of the business is willing to contribute A second drawback is that the owner has unlimited personal liability to the debt of the business Partnerships unlimited personal liability applies to all owners regardless of the percent of ownership In one of the owners of the business dies or decides to leave the business the other owners must buy out the departed owner or survivors More than 85 of all businesses in the US are organized as sole proprietorships or partnerships In terms of revenue however more than 80 of all businesses in the country is conducted by corporations The corporate form of business organization offers three distinct advantages over the other forms of organization Limited liability the owners or shareholders of a corporation cannot ever lose any more than the amount the invested in the company Ability to raise capital companies whose stock trades publicly have access to almost unlimited capital And Easy Transfer of Ownership the ownership of a corporation is represented by shares of stock Stockholders are the owners of the corporation and their basic reason for investing in the company in the first place is to make money Agents are hired by owners to run the company to create as much value for the owners as possible To a stockholder value is represented by the price of the company s common stock The price per share multiplied by the total number of shares outstanding is simply equal to the total value of the equity of the company If the price per share increases the value of each stockholder s stake in the company their personal wealth increases Finance is the study of all of future cash that the firms current and prospective collection of assets can potentially earn Purchase price salvage value useful life annual depreciation 1 yr worth Book value is what was actually paid for the assets market value is what the assets is are worth in ability to produce expected cash flow within the context of a firm The price of an investment depends upon how much money that investment will generate The value of an investment is determined by the future cash flows that the investment generates for the investor