FI 305 Notes Quiz I/ Exam 1
Introduction
Finance – the discipline concerned with or the study of the efficient acquisitions and utilization of capital
Study of the creation of value as it is measured in monetary terms
Capital – wealth that is used to generate more wealth
Value – the sum of all future cash flows expected to be generated by an asset (real or financial) or an entity discounted to the present time at an appropriate cost of capital
Arbitrage – the ability to increase you wealth without investing any money or taking any risk
No arbitrage principal (law of one price)- in well-functioning markets, the incentive to increase ones wealth eliminates arbitrage opportunities
Risk – a potential future negative impact to value and or cash flows.
Discussed in terms of probability of loss and expected magnitude of loss
The law of one price
Financial markets are very transparent and liquid, which eliminates most arbitrage opportunities
Traders can easily observe prices and can buy and sell virtually simultaneously
Traders can also ‘short sale’ a security, which means they borrow the stock, sell it, and then repurchase the stock at a later date to return it to the owner
If price goes up, the trader gains
Limitations and transaction costs can impede the ability of the market to eliminate all arbitrage opportunities
Identical goods in a well-functioning market will have the same price
Market value and intrinsic value
Intrinsic value – sum of future cash flows, discounted to the present time at the appropriate cost of capital
Discounting adjusts for timing ( lost opportunity of interest) and risk
No arbitrage principle and the law of one price suggest that market value should equal intrinsic value
This implies that securities should be correctly priced such that investors receive the appropriate compensation for the risk that is borne
Role of financial manager
Two types of assets
Real asset- tangible property ex. Machinery or intangible benefits ex. Patents, expertise
Financial assets – a claim on a real asset, formalized in the form of a financial security
Two decisions made
What real assets should firm invest in – capital investment or capital budgeting decision
How capital is raised – financing decision
3 primary areas of finance
Investments
Investors holding financial assets – stocks, bonds, notes, loans ect.
Corporate finance – financial managers make real and financial asset decisions
Financial markets – the conduit between the firm and the investors
Where the value of the financial assets is determined
Types of business structures
Proprietorship
Individual owner
Bears all cost, keeps all profits
Unlimited liability
Partnership
One or more associates
Each partner has unlimited liability
Partners pay personal taxes on share of profits
Limited partnership – general partner assumes unlimited liability whil limited parners are only liable for the amount the put in
Corporation
Firm legally distinct from its owners
A legal entity created by a state that provides a nexus of contracts binding together owners, managers, employees, creditors, suppliers ect
Unlimited life
Limited liability
Ownership easily transferable
Separation of ownership and control
Advantages
Limited liability – less risky
Easier to attract capital and finance growth
Alienability increases liquidity and value
Disadvantages
Double taxations
Agency conflicts – everyone has different incentives
Agent – managers
Principle – stock holders
Manager vs. share holders
Cannot fully monitor agents actions
When managers own stock, more likely to a line with stock holders wishes
Goal:
Number one goal is to maximize stockholder wealth
Carefully considering how to bring additional funds to into the firm – retained earnings
Which projects to invest in
How to return the profits over time to owners
Others:
Maximize net income
Maximize costs
Maximize market share
Other goals
Social responsibility
Ethics
Stakeholders
Subchapter ‘S’