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Topic 1 Introduction To Business Finance
Topic 1 Introduction To Business Finance
Topic 1 Introduction To Business Finance
Corporate Finance is a body of knowledge which focuses on explaining and interpreting capital markets. It provides an analytical framework to guide managers of firms and to assist them to evaluate corporate financial decisions.
Bishop, Crapp, Faff and Twite (1993)
What is Finance?
Finance is a sub field of economics where the primary focus is on the working of capital markets and the supply and pricing of capital assets. A fundamental concern of finance is valuation - what is something worth? In the end all prices depend on someones estimate of future income
Williams J.B. The Theory of Investment Value (1938)
eg the value today of an investment equals the present value of its expected future returns
Value Of A Firm
A Firm is a collection of real assets (eg
plant, equipment, tools, stock, buildings, land, Intellectual capital) that generate cashflows How to Value the Firm? one approach is to value the real assets of the firm Problem: real assets are not frequently traded
Alternative Approach value the Income Claims/ Financial Assets ( eg debt and equity) of those having a claim on the income produced by the real assets of the firm by having provided financing to the firm.
Financial Markets
Short-term debt F. Dividends and Long-term debt Equity shares debt payments
D. Government
Financial DecisionMaking
Financial decision-making involves the application of a coherent body of theory to enable individuals and firms to choose among alternatives and allocate risky cash flows through time to achieve a desired goal
Conceptual Framework
Investment Decision
Financing Decision
Cash
Time
Risk
Time:
Risk:
A dollar today is worth more than a dollar at some future date. There is a trade-off between the size of an investments cash flow and when the cash flow is received.
Year 1 2 3 Total
Cash Flow
-100
11
11
11
If the required rate of return of the firm is 10% p.a. is this a worthwhile investment?
Suggestion 1: After 9 years you have already received $99 and still have a further 16 years to continue receiving $11 per year an additional $176. However this ignores the time value of money
Suggestion 2: This investment is returning 11% interest. If the firm requires a return of 10% then it must be a worthwhile investment. However this ignores the notion of interest on interest (compounding)
Amount of money re-invested each year increases so interest earned in year 25 would be $135 not $11.
to maximise its
market value
The greater the market value of a company's shares, the greater will be The wealth of its shareholders and therefore the greater will be their utility
Economic Profit
Economic profit for a period is measured by the change in the value of the firm over the period Firm value at a point in time is equal to the present value of the future net cash flows Given these concepts of economic profit and value, the maximisation of a firm's value and the maximisation of economic profit are equivalent
Pursuit of other goals will not necessarily result in the maximisation of the market value of the firm Each of these goals presents problems. These goals are either associated with increasing profitability or reducing risk. It is necessary to find a goal that can encompass both profitability and risk. There is nothing intrinsically objectionable in these goals. However, given the model of the firm put forward, they are subsidiary to the goal of maximising the market value of the firm
Agency Problems
Agency problems arise when one party (principal) engages another party (agent) to perform actions on their behalf Agents may not always act in best interest of principal
A firm is an example where an agency problem arises because of the separation of ownership and control Managers/agents may not always act in the best interests of shareholders/principals
schemes;
Financing Decision
Deals with determination of the firm's capital structure How should the firm finance the investment in real assets, in order to maximise its market value Is it possible to create wealth on the financing side of the balance sheet? Can the value of the firm be affected by the way it is financed?
Both disciplines are concerned with a firms assets and liabilities Accounting, with its emphasis on review and compliance, generally has an historical outlook Finance, with its emphasis on valuation and decision-making, generally has a focus on the future
cause comparability problems when analysing reports of different companies enable deliberate manipulation of financial reports ( creative accounting or window dressing)
Financial Markets
Financial markets bring together the buyers and sellers of debt and equity securities. Money markets involve the trading of short-term debt securities. Capital markets involve the trading of long-term debt securities and equity securities. Primary markets involve the original sale of securities. Secondary markets involve the continual buying and selling of already issued securities.