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Lecture 1: Overview
Introduction to Finance:
Financial Institutions, Financial Markets, and the Corporation A financial view of the firm
Contingent claims
Readings: Chapter 1
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Distinguishing yourself in the job market Developing a more comprehensive and more efficient business acumen Making healthier (real-life) decisions regarding your consumption, savings, and investments Becoming more intellectual and understanding the underlying reasons of global trends/events etc.
What Is Finance?
Finance is the study of how and under what terms savings (money) are allocated between lenders and borrowers.
Finance is similar to economics but focuses not only on how resources are allocated but also under what terms and through what channels
Financial contracts or securities are created whenever funds are transferred from an issuer to a buyer.
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Most financial decisions that we will study are related to two broad questions:
What investments should the firm undertake?
Capital Budgeting: The process of making and managing expenditures on long-lived assets.
Capital Structure: The mixture of debt and equity capital maintained by the firm and used to finance its investment activities.
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Current Liabilities
Current Assets Long-Term Debt Fixed Assets 1. Tangible 2. Intangible
Shareholders Equity
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Current Liabilities
Current Assets Long-Term Debt Fixed Assets 1. Tangible 2. Intangible
Shareholders Equity
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Current Liabilities
Current Assets Long-Term Debt
How can the firm raise the money for the required investments?
Shareholders Equity
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Capital Structure
The value of the firm can be thought of as a pie. The goal of the manager is to increase the size of the pie. The Capital Structure decision can be viewed as how best to slice up the pie. If how you slice the pie affects the size of the pie, then the capital structure decision matters.
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During 2001, the True North Tire Co. had gross sales of $1 million. The firms cost of goods sold and selling expenses were $300,000 and $200,000 respectively. Depreciation was $100,000. True Norths tax rate in 2001 was 40%.
What is the companys net income? What is the companys cash from operations?
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Timing
Project A: Invest $1 MM today for a payoff of $1.5 MM in one year Project B: Invest $1MM today for a payoff of $1.7 MM in two years Project C: Invest $1MM today for a payoff of $1.4 MM in 9 months
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Risk
Project D: Invest $1MM in a low risk project that pays off $1.5 MM in one year Project E: Invest $1MM in a high risk project that pays off $2 MM in one year
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Financial markets are markets where you can trade (buy and/or sell) financial instruments, also called financial claims or securities. Financial institutions (also called financial intermediaries) facilitate flows of funds from savers to borrowers. (e.g. Banks, Insurance companies, Mutual Funds etc.)
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The role of the financial system is to transfer funds in the most efficient manner possible.
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Funds suppliers
Deposits
Financial intermediaries
Loans
Funds demanders
Funds suppliers
Financial intermediaries
Funds demanders
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Financial markets
Retained cash flows (D) Short-term debt Cash flow from firm (C) Dividends and debt payments (F) Taxes (E) Long-term debt Equity shares
Government
The cash flows from the firm must exceed the cash flows from the financial markets.
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Financial Instruments
Debt Instruments
Equity Instruments
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In 2012 the global equity market capitalization was US$55 trillion In 2012 the global turnover value of bonds was US$26 trillion
Rank
1 2 3 4 5 6 7 8 9 10
Exchange
NYSE Euronext (US) NASDAQ OMX (US) Tokyo Stock Exchange Group London Stock Exchange Group NYSE Euronext (Europe) Hong Kong Exchanges Shanghai SE TMX Group Deutsche Borse Australian SE
% Change In US$
19.4% 19.2% 4.6% 4.0% 15.8% 25.4% 8.1% 7.7% 25.5% 15.7%
% Change In Local $
19.4% 19.2% 17.6% 2.4% 14.0% 25.2% 7.0% 5.3% 23.6% 14.3%
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Financial Markets
Money Markets
Capital Markets
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Financial Markets
Primary Market
When a corporation issues securities, cash flows from investors to the firm. Usually an underwriter is involved
Secondary Market
Involve the sale of used securities from one investor to another. Securities may be traded in an exchange or traded over-the-counter in a dealer market.
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The basic feature of a debt is that it is a promise by the borrowing firm to repay a fixed dollar amount by a certain date. The shareholders claim on firm value is the residual amount that remains after the debt holders are paid. If the value of the firm is less than the amount promised to the debt holders, the shareholders get nothing.
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F Value of the firm (V) Debt holders are promised F. If the value of the firm is less than F, they get whatever the firm is worth. Algebraically, the bondholders claim is: Min[F,V]
F Value of the firm (V) If the value of the firm is more than F, share holders get everything above F. Algebraically, the shareholders claim is: Max[0,V F]
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Payoff to shareholders
If the value of the firm is more than F, the shareholders claim is: Max[0,V F] = V F and the debt holders claim is:
Min[F,V] = F. The sum of these is = V
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Summary of Lecture 1
Introduction to Finance:
Financial Markets and Institutions The Corporation A financial view of the firm
Contingent claims