FUNDAMENTALS OF THE

FINANCIAL SYSTEM
FINVA100 MODULE 1 PART 1
ANNABELLE A. ALOVA, MBA
COURSE OBJECTIVES:
At the end of the module, the students will have:
u Distinguished between and among the three areas of finance, which are
corporate finance, capital markets and investments;
u Explained corporate life cycle and funding sources available to proprietors,
partners and incorporators;
u Described the concept of shareholder maximization and identify the issues
involved in securing/increasing the firm’s value;
u Justified the role of financial markets and financial intermediaries
u Evaluated which varied asset classes and financial instruments they can
invest in
 Three Areas of Finance as Taught
in Universities

Finance as taught in universities is generally divided into three areas:

(1) financial management;

(2) capital markets; and ,
(3) investments.
 Areas of Finance: (1) FINANCIAL
MANAGEMENT

u Financial management (corporate finance)

focuses on decisions relating to how much and
what types of assets to acquire, how to raise the
capital needed to buy assets, and how to run the
firm so as to maximize its value, both for-profit
and not-for-profit organizations.
 Areas of Finance: (2) CAPITAL MARKETS

u Capital Markets relate to the markets where

interest rates, along with stock and bond prices, are
determined.
u Financial institutions that supply capital to businesses
(Banks, investment banks, stockbrokers, mutual funds, insurance
companies, and the like bring together “savers” who have money to
invest and businesses, individuals, and other entities that need
capital for various purposes)
u Government institutions (like the Federal Reserve System, which
regulates banks and controls the supply of money), and the SEC (which
regulates the trading of stocks and bonds in public markets).
Areas of Finance: (3) INVESTMENTS

u Investments relate to decisions concerning stocks

and bonds and include a number of activities:
u (1) Security analysis deals with finding the proper values of
individual securities (i.e., stocks and bonds).
u (2) Portfolio theory deals with the best way to structure portfolios,
or “baskets,” of stocks and bonds. Rational investors want to hold
diversified portfolios in order to limit risks, so choosing a properly
balanced portfolio is an important issue for any investor.
u (3) Market analysis deals with the issue of whether stock and bond
markets at any given time are “too high,” “too low,” or “about
right.”
 The Corporate Life Cycle

u Proprietorship – an unincorporated business owned by one individual.

u Partnership – an unincorporated business owned by two or more
persons.
u Corporation – a legal entity created by a state, separate and distinct
from its owners and managers, having unlimited life, easy
transferability of ownership, and limited liability.
u Limited Liability Company (LLC) – a relatively new type of organization
that is a hybrid between a partnership and a corporation.
u Limited Liability Partnership (LLP) – similar to an LLC but used for
professional firms in the fields of accounting, law, and architecture. It
has limited liability like corporations but is taxed like partnerships.
 Sole Proprietorship

u Advantages
u Easily formed
u Subject to few government regulations
u income is not subject to corporate taxation; taxed as part of the
proprietor’s personal income.
u Limitations
u difficult to obtain the capital for growth
u unlimited personal liability resulting in losses that exceed the
money invested
u the life is limited to the life of its founder.
 Partnership

u Profits and losses based on partnership agreements

u Each partner is liable for the business’s debts.
u In limited partnership, certain partners are designated
general partners (unlimited liability, full control) and
others limited partners (limited liability, few control)
u In limited liability partnership (LLP) (also limited liability
company (LLC), all partners enjoy limited liability and
their potential losses are limited to their investment,
increasing the risk faced by an LLP’s lenders, customers,
and suppliers.
 Corporation
u Advantages
u unlimited life—continuance after death of owners
u easy transferability of ownership interest—ownership interests
(shares of stock, transferrable)
u limited liability— actual funds invested.
u Limitations
u Double taxation for corporate earnings (taxed at the
corporate level, and then earnings paid out as dividends are
taxed again as income to the stockholders)
u Complex and time- consuming preparations of documents
Sources of Funds for Business Growth

u Personal resources (savings, loans, credit cards)

u Angel Investors (an individual that provides capital for start-ups using his own
money)
u Venture Capitalists (an investor that provides capital from other people’s
money to potential high-growth firms for high return of investment)
u Initial Public Offering (selling stocks to the public at large)
u Bank Loans
u Bonds Issuance
Be aware:
u For proprietorships, partnerships, and small
corporations, the firm’s owners are also its
managers.
u Stockholders are represented by managers, who are
hired as agents and will act in their best interests.
u Agency problem could occur.
u Agency problems can be addressed by a company’s
corporate governance, which is the set of rules
that control the company’s behavior towards its
directors, managers, employees, shareholders,
creditors, customers, competitors, and community.
Shareholder Wealth Maximization

u The primary goal for managers of publicly-

owned companies implies that decisions should be
made to maximize the long-run value of the firm’s
common stock.
u The market price is the stock price observed in
the financial markets. If the market price reflects
all relevant information, then the observed price
is also the intrinsic, or fundamental, price.
Intrinsic Stock Value Maximization and
Social Welfare

u The same actions that maximize intrinsic stock values also

benefit society.

u To a large extent, the owners of stock

are society. Pension funds, life insurance companies,
and mutual funds own more than 61% of all stock, which
means that most individuals have an indirect stake in the
stock market. Therefore, when a manager takes
actions to maximize the stock price, this
improves the quality of life for millions of
ordinary citizens.
Intrinsic Stock Value Maximization and
Social Welfare

u The same actions that maximize intrinsic stock values also benefit
society.

u Consumers benefit. Stock price maximization requires

efficient, low-cost businesses that produce high-quality goods and
services at the lowest possible cost. This means that companies must
develop products and services that consumers want and need, which
leads to new technology and new products. Also, companies that
maximize their stock price must generate growth in
sales by creating value for customers in the form of
efficient and courteous service, adequate stocks of
merchandise, and well-located business establishments.
Intrinsic Stock Value Maximization and
Social Welfare

u The same actions that maximize intrinsic stock values also benefit
society.
u Employees benefit. Companies that successfully increase
stock prices also grow and add more employees, thus
benefiting society. Moreover, studies show that newly privatized
companies tend to grow and thus require more employees when they are
managed with the goal of stock price maximization.
 Managerial Actions to Maximize
Shareholder Wealth
What determines the firm’s value (the ability to generate cash flows
now and then in the future)?
u The company’s ability to generate cash flows now and in the future
determines the firm’s value.
u 1) any financial asset, including a company’s stock, is valuable only to the extent
that it generates cash flows;
u (2) the timing of cash flows matters—cash received sooner is better; and
u (3) investors are averse to risk, so all else equal, they will pay more for a stock
whose cash flows are relatively certain than for one whose cash flows are more
risky.
u Because of these three facts, managers can enhance their firm’s value by
increasing the size of the expected cash flows, by speeding up their receipt,
and by reducing their risk.
COURSE OBJECTIVES:

u Distinguished between and among the three areas of finance, which are
corporate finance, capital markets and investments;
u Explained corporate life cycle and funding sources available to proprietors,
partners and incorporators;
u Described the concept of shareholder maximization and identify the issues
involved in securing/increasing the firm’s value;
u Justified the role of financial markets and financial intermediaries
u Evaluated which varied asset classes and financial instruments they can invest
in
 LIST OF REFERENCES
Bodie, Z., Kane, Alex, Marcus, Alan J., Jain, Ravi. (2014). Investments. Asia Global edition.
McGraw-Hill Education. Singapore.

Brigham, E.F, & Houston, J.F. 2009. Fundamentals of Financial Management. 12th edition. Cengage Learning.

Higgins, R. C. (2016). Analysis for Financial Management. 11th ed. . McGraw-Hill Education.
Singapore.
Madura, J. 2018. Financial Markets and Institutions. 12th edition. Cengage Learning.

Mayo, H. B. (2019). Basic Finance: An introduction to financial institutions, investments and

management. 12th ed. Cengage Learning, Inc. United States of America.

Ross, S. A., Westerfield, Randolph W., Jaffe, Jeffrey F., and Jordan, Bradford D. (2018). Corporate
Finance: Core principles and applications. 5th ed. McGraw-Hill Education. United States of
America.