Topic 1: Introduction to Finance FIN1FOF

Topic OverviewLesson 1.11.1.1 Why study Finance?1.1.2 Business Organisations1.1.3 Types of Companies1.1.4 The Role of the FinancialManager1.1.5 The Goal of the FinancialManagerFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 2La Trobe Business School1.1.1 Why study Finance?FINANCIAL DECISION-MAKINGFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 3 This subject is about decision-making;specifically financial decision-making We make day-to-day decisions by making asubjective judgement about the value to usof the costs and benefits of each decision Financial decisions are decisions where wecan quantify the costs and benefits usingdollar valuesValue ofbenefitsValue ofcostsWe should make that decisionLa Trobe Business School1.1.1 Why study Finance?FUNDAMENTALS OF FINANCE4 Valuation of Securities10 Market Efficiency2 Time Value of Money3 Financial Mathematics9 Portfolio Theory8 Risk and Return11 Options5 Cost of Capital7 Project Evaluation6 Capital Budgeting1 Introduction to FinanceFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 4La Trobe Business School1.1.1 Why study Finance?PERSONAL FINANCIAL DECISIONSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 5Examples ofpersonalfinancialdecisionsWhether toretire with alump sum orpurchase anannuityWhichinvestmentsto make (e.g.shares)Whether tolease a caror borrow topurchase itHow toevaluate theterms for ahomemortgageWhen to startsaving and howmuch to save forretirementLa Trobe Business School1.1.1 Why study Finance?PERSONAL FINANCIAL DECISIONSInvesting in shares andother securitiesLeasing or borrowing?Evaluating a mortgageSaving for retirementLump sum or annuity?Topic 4 Valuation of SecuritiesTopic 2 Time Value of MoneyTopic 3 Financial MathematicsTopic 10 Market EfficiencyTopic 9 Portfolio TheoryTopic 8 Risk and ReturnFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 6La Trobe Business School1.1.1 Why study Finance?BUSINESS FINANCIAL DECISIONSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 7Examples ofbusinessfinancialdecisionsHow toraise capitalfor a newstartup firmWhether toissue sharesor borrowmoney toexpandWhether tolaunch anew productor enter anew marketWhether tobuy newplant andequipmentHow to reduceexposure to riskWhether to investin a new projectLa Trobe Business School1.1.1 Why study Finance?BUSINESS FINANCIAL DECISIONSRaising startup capital orraising funds to expandInvesting in a new projectLaunching a new productBuying new equipmentReducingexposure to riskTopic 11 OptionsTopic 4 Valuationof SecuritiesTopic 2 Time Value of MoneyTopic 3 Financial MathematicsTopic 7 Project EvaluationTopic 6 Capital BudgetingTopic 5 Cost ofCapitalTopic 9 PortfolioTheoryTopic 8 Riskand ReturnFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 8La Trobe Business School1.1.1 Why study Finance?FINANCIAL NEWS AND EVENTSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 9 This subject will introduce and develop theprinciples and mathematical tools needed tomake these kinds of decisions Financial news is becoming more prevalent,and an understanding of finance helps tocomprehend and utilise this information Financial events such as the recent GlobalFinancial Crisis have far-reachingconsequences, and highlight the need for agood understanding of financial principlesLa Trobe Business School1.1.2 Business OrganisationsTHE THREE TYPES OF FIRMSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 10 A number of topics will provide tools to assistwith personal financial decision-making, butthe bulk of this subject will focus on businessfinance and the role of the financial managerin running a firm There are threetypes of firmsthat financialmanagers run:Sole tradersPartnershipsCorporationsLa Trobe Business SchoolDisadvantages:1.1.2 Business OrganisationsTHE THREE TYPES OF FIRMSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 11A business owned andrun by one personSole traderAlthough notaccounting for muchsales revenue, the mostcommon type of firm No separation ofownership and controlThe owner hasunlimited liability forthe firms debtsThe life of a soletrader is limited to thelife of the owner, andit is difficult totransfer ownershipAdvantageEasy to set upLa Trobe Business SchoolDisadvantages1.1.2 Business OrganisationsTHE THREE TYPES OF FIRMSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 12A business owned andrun by more than onepersonPartnershipTypically used whenthe reputation of thefirm is based on thereputation of theowners (e.g. law firms,medical practices andaccounting firms)The partnership endswith the death orwithdrawal of apartner (although thiscan be varied)All of the partners areliable for the firmsdebts a lender canrequire any partner torepay the firms debtsLa Trobe Business SchoolAdvantages:More costly to set upDisadvantage1.1.2 Business OrganisationsTHE THREE TYPES OF FIRMSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 13A legal entity separatefrom its ownersCorporationThe dominantbusiness form (interms of revenue) allover the worldOwners have limitedliability for the firmsdebtsThe corporation existsindefinitely andownership is easilytransferredSeparation of controland ownership allowsfor external investorsLa Trobe Business School1.1.3 Types of CompaniesTHE THREE TYPES OF COMPANIESFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 14Private companyRestricted to 50 nonemployeeshareholdersNot required toappoint an auditorPublic companyUnlimited shareholdersRequired to appoint anauditor and submitstatements to ASICA company listed on the ASXDenoted by Pty Ltd Denoted by LtdListed public companyLa Trobe Business School1.1.3 Types of CompaniesTHE THREE TYPES OF COMPANIESFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 15About 2 millionAbout 200,000Private companiesPublic companyListed public companies About 2000 Although few in number, listed companiesdominate the Australian share market, andaccount for over 99% of share trading Much of this subject will concentrate on thefinancial management of this type of companyLa Trobe Business School1.1.3 Types of CompaniesOWNERSHIP OF A COMPANYFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 16Ownership of acompanyReferredto asequityOwners do notexercise daytoday controlover the firmThis enables corporations to raisemoney, or capital, from a largenumber of investors, and as a resultthey dominate the economyDividedintosharesShareholders are entitled todividends in proportion to thenumber of shares they ownOwners of the corporation arereferred to as shareholdersLa Trobe Business School1.1.4 The Role of the Financial ManagerTHE ROLE OF THE FINANCIAL MANAGERFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 17 The financial manager makes financialdecisions on behalf of the owners of the firm The financial manager has three main tasks:Make investmentdecisionsMake financingdecisionsManage cash flow fromoperating activitiesTopic 6 (Capital Budgeting) &Topic 7 (Project Evaluation)Topic 4 (Valuation of Securities)& Topic 5 (Cost of Capital)This is not covered indetail in this subjectLa Trobe Business School1.1.4 The Role of the Financial Manager Consider a simple balance sheet for a firm:INVESTMENT AND FINANCING DECISIONSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 18The items on the lefthandside of the balance sheetare typically real assets they are used to generateincome for the firmInvestment decisionsare decisions aboutwhich real assets toacquire to generatethat incomeAssetsCurrent assetsLongterm assetsLiabilities & EquityCurrent liabilitiesLongterm debtOwners equityLa Trobe Business School1.1.4 The Role of the Financial Manager Consider a simple balance sheet for a firm:INVESTMENT AND FINANCING DECISIONSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 19AssetsCurrent assetsLongterm assetsFinancingdecisions aredecisions aboutwhich financialassets to issueThe items on the rightside arecalled financial assets they areissued to raise the capital to buyreal assets, and represent claimson the income of the firmLiabilities & EquityCurrent liabilitiesLongterm debtOwners equityINCOMELa Trobe Business School1.1.5 The Goal of the Financial Manager All business financial decisions should bemade in the context of the overriding goal offinancial management:THE GOAL OF THE FINANCIAL MANAGERFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 20 to maximise the wealth of theowners, the shareholders The shareholders have invested in thecorporation, putting their money at risk, andthe financial manager acts as their agent, oras caretaker of their money, making decisionsin their interests and on their behalfLa Trobe Business School1.1.5 The Goal of the Financial Manager Since the wealth of shareholders is related tothe value of their shares, and since the valueof each share is, by definition, a specifiedproportion of the total value of the corporationTHE GOAL OF THE FINANCIAL MANAGERFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 21 As we shall see in many topics in this subject,financial decisions are made in the context ofthese equivalent objectivesMaximisation ofshareholder wealthMaximisation ofthe value of thecorporation =La Trobe Business SchoolTopic OverviewLesson 1.21.2.1 Valuation1.2.2 The Share Market1.2.3 Stock Exchanges1.2.4 Stock Quotes1.2.5 Stock IndicesFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 22La Trobe Business School1.2.1 ValuationTHE VALUATION PRINCIPLEFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 23 A critical principal underlying the study offinance is valuationTopics 4 & 5 applythese principles tothe valuation offinancial assetsTopics 6 & 7 applythem to the valuationof investments(real assets)The Value ofany AssetThe present value (thevalue today) of allfuture cash flowsLa Trobe Business School1.2.1 ValuationCRITICAL FACTORS IN FINANCEFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 24 There are three factorsthat are critical to thestudy of finance andwhich will be referred toand relied uponthroughout this subject:CASHTIMERISK All financial decision-making requirescareful consideration to all three of thesefactors, and the remaining topics in thissubject will continually refer to themLa Trobe Business School1.2.1 ValuationCASHFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 25CASHOnly cash can beused to pay costs,pay dividends,and increase thewealth ofshareholdersmeasures performance over aspecified time period, but doesnot represent overall firm valueincludes noncash book entriessuch as accruals & depreciationAccounting profitHighlighted inTopics 6 & 7is subject to inconsistency anddeliberate manipulationLa Trobe Business School1.2.1 ValuationTIMEFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 26TIMEThe value of acash flow isaffected by thetime period inwhich it occurstreats all dollars as being ofequal value, no matter whenthey are paid or receivedin other words, does not allowfor the time value of moneyAccounting profitWe need to beaware of time incalculating valueExplained in detail in Topic 2and used in many other topicsLa Trobe Business School1.2.1 ValuationRISKFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 27RISKThe future isuncertain, andthe probabilityof a cash flowaffects its valuetreats the future as certain andtreats all dollars as if they will bereceived or paid with certaintyin other words, doesnot allow for riskAccounting profitWe need to beaware of risk incalculating valueExplained in detail in Topic 8and used in a number of topicsLa Trobe Business School1.2.2 The Share MarketTHE THREE TYPES OF COMPANIESFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 28 The financial managers goal is to maximiseshareholder wealth, and this is determinedby share price, so an alternative way to statethis goal is the maximisation of share priceLimited numberof owners andno market forsharesPrivatecompaniesThe public canbuy shares, butthey are rarelytradedPubliccompaniesShares aretraded on anorganisedexchangeListed publiccompaniesLa Trobe Business School1.2.2 The Share MarketPRIMARY AND SECONDARY MARKETSFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 29 Most capital markets, including the market forcompany shares, have a primary and asecondary marketA market in whichshares are first createdand funds flow to thecompany raising capitalby issuing sharesPrimary marketE.g. Initial public offersA market in whichshares are bought andsold among investors this does not directlybenefit the companySecondary marketE.g. The stock exchangeLa Trobe Business School1.2.2 The Share MarketISSUING SHARES IN THE PRIMARY MARKETFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 30 There are three main ways to issue shares:The publicare invited tosubscribe forsharesPublic offerExpensive,but a largeamount ofcapital canbe raisedShares are placedwith one or asmall number oflarge investorsPrivate placementCheap and quick,but results in thedilution of theshareholdings ofexisting ownersExistingshareholdersare given theright to buynew sharesRights issueAllows themto maintaintheir currentshareholdingLa Trobe Business School1.2.2 The Share MarketTRADING IN THE SECONDARY MARKETFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 31The stock exchangeA market is saidto be liquid if investments canbe easily turned into cash at aprice which reflects fair valueLiquidprovides investorswith a liquid marketin which they canbuy or sell sharesThis occurs when thereare lots of buyers andsellers willing to tradeat prices above andbelow the current priceallows the marketvalue of shares tobe established by the forces ofsupply and demand as investorscontinually buy and sell sharesLa Trobe Business School1.2.2 The Share MarketTRADING IN THE SECONDARY MARKETFIN1FOF Fundamentals of Finance Topic 1 Introduction to Finance 32 Like most exchanges, the ASX does not havea traditional trading floor Stock brokers buy and sell shares (on behalfof their clients) via a computerised tradingsystem called Tradematch Each share has two prices displayed:The highest price atwhich you can sellBid priceThe lowest price atwhich you can buyAsk (or offer) price

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