Chapter 1 Introduction

1. Chapter 1Introduction

2. Learning Objectives • Identify the major types of business entity. • Explain the role of the financial manager. • Specify the objective that is necessary to ensure the financial manager makes rational investment and financing decisions. • Identify the major financial decisions made by the managers of business entities. • Identify and explain the basic concepts of finance.

3. The Nature of Business Finance • Broad aspects of finance • Corporate finance: the financial management of companies. • Financial institutions and markets. • Investments. • Focus is mainly on corporate finance, but also considers financial institutions and markets, and investments.

4. Financial Decisions • Major financial decisions are: • Investment decisions — decisions that determine the asset profile of a business (amount and composition of investments). • Financing decisions — how the assets are to be funded (debt and equity). Financing decisions also involve dividend decisions. • Ultimate objective of investment and financing decisions is to maximise the owners’ wealth.

5. Business Structures • Sole proprietorship • Business owned by one person. • Partnership • Business owned by two or more people acting as partners. • Company • Separate legal entity formed under the Corporations Act 2001. • Focus is on financial decision making by managers of public companies.

6. The Finance Function: Major Roles of Financial Managers • Project evaluation. • Dividend and share repurchase decisions. • Dividend distributions. • Collection and custody of cash and payment of bills. • Management of investments in current assets.

7. The Finance Function: Major Roles of Financial Managers (cont.) • Assessing the viability of growth through acquisitions. • Planning the future development of the business. • Interest rate and exchange rate risk management. • Development and implementation of financial policies.

8. A Company’s Financial Objective • In order to study the behaviour of financial managers and understand their decisions, we need to understand the objective of their decision making. • The maximisation of market value of a company’s shares is the overriding objective. • We are able to rationalise theories and important results in finance by appealing to this ultimate objective of financial decision makers.

9. Basic Concepts of Finance • Value • The value of a company (V ) on the financial markets may be expressed as: • Financial markets will value debt and equity, taking into account the risk and expected return from investing in these securities.

10. Basic Concepts of Finance (cont.) • Time and uncertainty • The value of an investment will depend on the amount and timing of the cash flows generated by the investment. • Time value of money: a dollar today is worth more than a dollar in the future.

11. Basic Concepts of Finance (cont.) • Nominal and real amounts • The cost of an asset expressed as the number of dollars paid to acquire the asset is the nominal price. • However, due to inflation and deflation, the purchasing power of money changes. • Therefore, it is necessary to distinguish between the ‘nominal’ or ‘face’ value of money and the ‘real’ or ‘inflation-adjusted’ value of money.

12. Basic Concepts of Finance (cont.) • Market efficiency and asset pricing • Market efficiency means that we should expect securities and other assets to be fairly priced, given their expected risks and returns. • Trade-off between risk and expected return under the capital asset pricing model (CAPM): • Systematic risk — market-wide factors (non-diversifiable or market risk). • Unsystematic risk — factors that are specific to a particular company (diversifiable or unique risk). • According to the CAPM, investors can diversify their investments to eliminate unsystematic risk.

13. Basic Concepts of Finance (cont.) • Arbitrage • If two identical assets were to trade in the same market at the same time at different prices, and if there were no transaction costs, then an arbitrage opportunity would exist. • A risk-free profit could be made by simultaneously purchasing at the lower price and selling at the higher price. • However, competition among traders will force the two alternative prices to become the same. • Arbitrage precludes perfect substitutes from selling at different prices in the same market.

14. Basic Concepts of Finance (cont.) • Agency relationships • Where one party, the principal, delegates decision-making authority to another party, the agent. • In a company setting: • The agents are usually managers. • The principals are usually shareholders.

15. Basic Concepts of Finance (Cont.) • Agency relationships (cont.) • Agency costs reflect the fact that there is a conflict of interest between the principal and agent. • Reduced value due to managers acting in their own best interests rather than in the interests of shareholders. • Costs associated with monitoring managers’ behaviour to ensure their actions are consistent with shareholders’ interests. • Bonding costs: costs of incentive and remuneration schemes that align the interests of managers with those of shareholders.

16. Summary • Business entities include sole proprietorships, partnerships and companies. We focus on public companies. • We study corporate finance, along with investments and the structure of financial markets and institutions. • We consider broad finance issues such as valuations, market efficiency, asset pricing and arbitrage, along with agency issues.