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Finance School of Management
FINANCE
Zvi Bodie
Robert C,Merton
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Finance School of Management
?About my name
?About my TA
?About the course
?About the requirements
– 20% assignment & class performance
– 15% mid-term test
– 65% final test
?About the book and authors
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Finance School of Management
Chapter 1,
What is Finance?
Objective
? To Define Finance
? The Value of Finance
? Introduction to
the Players
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Finance School of Management
Chapter 1 Contents
? Defining Finance
? Why Study Finance
? Household Finance
? Financial Decisions-Firms
? Forms of Business
Organization
? Separation of Ownership
and Management
? The Goal of management
? Market Discipline-
Takeovers
? Role of the Financial
Specialists in a
Corporation
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Finance School of Management
Defining Finance
?What do you know about ?Finance??
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Finance School of Management
Defining Finance
?Finance,as a scientific discipline,is the
study of how people allocate scarce
resources over time under conditions of
uncertainty,
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Finance School of Management
Analytical,Pillars” to Finance
?Optimization over time
?Asset valuation
?Risk management
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Finance School of Management
Finance Theory
?consists of
– a set of concepts that help to organize one’s
thinking about how to allocate resources over
time
– a set of quantitative models to help one evaluate
alternatives,make decisions,and implement
them
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Finance School of Management
Financial System
?The financial system is defined as the set of
markets and other institutions used for
financial contracting and the exchange of
assets and risks,
?The ultimate function of the system is to
satisfy people’s consumption preferences,
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Finance School of Management
Why Study Finance?
? To manage your personal resources
? To deal with the world of business
? To pursue interesting and rewarding career
opportunities
? To make informed public choices as a citizen
? To expand your mind
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Finance School of Management
Harry M,Markowitz (1927~)
? Awarded to the 1990
Nobel Prize
? Main Contribution,
– The father of modern
portfolio theory
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Finance School of Management
William F,Sharpe (1934~)
? Awarded to the 1990
Nobel Prize
? Main Contribution,
– Developing the Capital
Asset Pricing Model
(CAPM) theory
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Finance School of Management
Merton H,Miller (1923~)
? Awarded to the 1990
Nobel Prize
? Main Contribution,
– The M&M
(Modigliani-Miller)
Theorem
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Finance School of Management
Robert C,Merton (1944~)
? Awarded to the 1997
Nobel Prize
? Main Contribution,
– The pricing of options
and other derivatives
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Finance School of Management
Myron S,Scholes (1941~)
? Awarded to the 1997
Nobel Prize
? Main Contribution,
– The pricing of options
and other derivatives
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Finance School of Management
Financial Decisions of Households
?Consumption and saving decisions
?Investment decisions
?Financing decisions
?Risk-management decisions
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Finance School of Management
?Assets
?Personal investing & Asset allocation
?Liability,Debt
?Net Worth = Assets – Liabilities
?Consumption preferences,exogenous
and endogenous elements
Important Terms
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Finance School of Management
Financial Decisions of Firms
? Strategic planning & Capital budget decisions
– What businesses to be in
– Identifying ideas for new investment projects
– Evaluating the projects,and deciding which ones to
undertake
– Implementing them,a plan for acquiring assets and
for training the personnel
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Finance School of Management
Financial Decisions of Firms
? Financing (Capital structure) decision
– A feasible financing plan
– The decisions about how much debt and equity to
have
– Wide range of financial instruments and claims
– A corporation?s capital structure determines who
gets what shares of its cash flows,and partially
determines who gets to control the company,
? Working capital management decision
– How the firm?s management attend to the day-to-
day prosaic financial affairs?
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Finance School of Management
? Dividend decision
– How much cash to distribute to shareholders
? Risk-management Decision
– How and on what terms should the firm seek to
reduce the financial uncertainties it faces?
Financial Decisions of Firms
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Finance School of Management
Forms of Business Organization
? A sole proprietorship
– unlimited liability
? A partnership
– unlimited liability
– general partner & limited partner
? A corporation
– a legal entity distinct from its owners
– ownership,board of directors and limited liability
– public corporations & private corporations
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Finance School of Management
Separation of Ownership and Management
?The owners of a firm delegate the
responsibility of running the business to
professional managers,
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Finance School of Management
Reasons for Separation of Ownership and
Management
? The owner need not have both the talents of a manager
and the financial resources,
? The need to pool resources to achieve an efficient scale
of production
? The need of owners to diversify their risk in an
uncertain economic environment
? Allowing for savings in the cost of information
gathering
? The,learning curve” or,going concern” effect favors
the separated structure
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Finance School of Management
Separation of Ownership and Management
?The corporate form is especially well
suited to the separation of owners and
managers because it allows relatively
frequent changes in owners by share
transfer without affecting the operations
of the firm,
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Finance School of Management
Conflicts of Interest
? The separated structure creates the potential for a
conflict of interest between the owners and the
managers,
? An agency problem exists where the principal has
to entrust their interests to an agent who acts on
their behalf,
? Contractual arrangements,incentive schemes,and
monitoring are used to control principal?agency
conflicts,
? The social cost for resolving the conflict
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Finance School of Management
The Goal of Management
?The difficulties of the goal of corporate
management to serve the best interests of
the shareholders
?To be feasible and effective,the right rule
for the goal of management should be
independent of who the owners are,
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Finance School of Management
Shareholder-Wealth-Maximization Rule
? An illustration,the decision between a risky
investment and a safe one
? The role of well-functioning capital markets
? The rule depends only upon
– the firm?s production technology
– market interest rates
– market risk premiums
– security prices
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Finance School of Management
Ambiguities of Profit-Maximization Rule
? Multi-periodic profits
? Uncertain future revenues or expenses
? An illustration
– Each of project A,B,and C require an initial outlay of
$1 million,
– Project A will return $1.05 million one year from now
and then over,
– Project B will last for two years,return nothing in the
first year,and then $1.1 million two years from now,
– Project C will either pay $1.2 million or $0.9 million
one year from now and then over,
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Finance School of Management
A Well-Functioning Stock Market
? Implementation of the management goal and
market-price information
? The existence of an efficient stock market allows
the manager to substitute one set of external
information which is relatively easy to obtain?
namely stock prices?for another set which is
virtually impossible to obtain?information about
the shareholders’ wealth,preferences,and other
investment opportunities,
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Finance School of Management
Market Discipline,Takeovers
? The value of voting rights as a means of enforcement
? The mechanism of takeover for aligning the
incentives of managers with those of shareholders
– The threat of a takeover and the subsequent
replacement of management provides a strong incentive
for current managers (acting in their self-interest) to act
in the interests of the firm?s current shareholders by
maximizing market value,
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Finance School of Management
The Roles of Corporate Financial
Specialists
?Financial executive?a person with authority
in the following functions,
VP Operations
Treasurer VP Financial Planning Controller
Chief Financial Officer VP Marketing
Chief Executive Officer
Board of Directors
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Finance School of Management
Role of the Financial Manager
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors
(1)
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Finance School of Management
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors
(2) Cash invested in firm
(1) (2)
Role of the Financial Manager
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Finance School of Management
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(1) (2)
(3)
Role of the Financial Manager
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Finance School of Management
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(1) (2)
(3)
(4a)
Role of the Financial Manager
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Finance School of Management
Financial
manager
Firm's
operations
Financial
markets
(1) Cash raised from investors
(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested (4b) Cash returned to investors
(1) (2)
(3)
(4a)
(4b)
Tax paid to
Government
(5)
(5) Tax leakage
Role of the Financial Manager
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Finance School of Management
Financial Functions in a Corporation
? Planning
? Provision of Capital
? Administration of Funds
? Accounting and Control
? Protection of Assets
? Tax Administration
? Investor Relations
? Evaluation and Consulting
? Management Information Systems