1. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 1 Introduction to Finance Lecture Outline I.What is finance? II.Types of businesses III.Corporate securities as contingent claims IV.The principal-agent problem V.Self study reading

2. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 2 What is Finance? Specific questions addressed by finance: 1.How should funds be acquired? 2.How should funds be spent? 3.How should short-term assets/liabilities be managed? I. Introduction to Finance

3. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 3 Finance Questions in a Corporate Context (i.e., corporate finance) 1.Where will you get the long-term financing to invest? Bring in other owners (issue equity/stocks) Borrow (issue debt/bonds) 2.What long-term investments should be undertaken Buildings Machinery Equipment Research and development (R&D) 3.How will you manage the company’s short-term cash flow? Collecting from customers paying suppliers

4. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 4 Flows of funds and decisions important to the financial manager Financial Manager Financial Markets Real Assets

5. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 5 Goals of the Financial Manager  Finance in the least costly way.  Invest in assets that generate more value than they cost. In order for us, as financial managers, to achieve these goals, we must understand how to determine value: identify cash flows and their timing, and consider risk.

6. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 6 II. Types of Businesses 1.Sole Proprietorship 2.Partnership 3.Corporation

7. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 7 The Sole Proprietorship Formed by a single individual  Simplest and least regulated  Owner keeps all profits and pays taxes as personal income  Owner has an unlimited liability  Ceases to exist once the owner dies or withdraws  Cannot raise equity beyond the owner’s wealth (limits growth)

8. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 8 Forms of Business Organization The Partnership Formed by 2 or more individuals  General Partnership An agreement between partners to provide work/cash and share profits/losses Control resides with a majority of the general partners Unlimited liability of each general partner  Limited Partnership Limited liability for some partners (not involved in management) – Limited partners are silent partners – no control There must be at least one general partner  Owners pay taxes as personal income  Ceases to exist once a general partner dies or withdraws  Difficult to raise equity capital

9. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 9 Forms of Business Organization The Corporation  A distinct legal entity owned by one or more individuals  Owned by shareholders who elect directors – oversee managers  More complicated (articles of incorporation, bylaws)  Liquidity and marketability of ownership – more easily transferable than with proprietorships or partnerships.  Limited liability of shareholders  Continuity of Existence  Double taxation: corporate tax and tax of the owners/shareholders

10. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 10 III. Corporate Securities as Contingent Claims on the Firm’s Assets  Debt (bonds):  Equity (stocks):

11. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 11 Value of Debt at time of Repayment (repayment due = $10 million) 0 5 10 15 20 25 30 35 051015202530354045 Value of the Firm's Assets at the time the debt is due ($ millions) Contingent Value of the Firm's Securities ($ millions)

12. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 12 Value of Equity at time of Debt Repayment (repayment due = $10 million) 0 5 10 15 20 25 30 35 051015202530354045 Value of the Firm's Assets at the time the debt is due ($ millions) Contingent Value of the Firm's Securities ($ millions)

13. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 13 Total Value of the Firm = Debt + Equity 0 5 10 15 20 25 30 35 051015202530354045 Value of the Firm's Assets at the time the debt is due ($ millions) Contingent Value of the Firm's Securities ($ millions)

14. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 14 IV. The Principal-Agent (PA) Problem  Corporations are owned by shareholders but are run by management  Shareholders are said to be the principals  Managers are the agents of shareholders

15. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 15 Principal-Agent (PA) Problem and Conflicting Goals  Shareholders would like management to act in their best interest by maximizing the value for the shareholders – shareholder wealth maximization  Managers, through human nature, maximize their personal well being subject to the constraints under which they operate

16. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 16 How is shareholder control exercised over management?  Elect the board of directors...

17. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 17 Agency Costs and Residual Losses  The PA Problem can never be perfectly eliminated  Agency costs are the costs of monitoring management and the incentive schemes used to try to align management with shareholders  Residual losses are the losses that remain due to the divergence of interests between managers and shareholders

18. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 18 Corporate Goals Revisited  Shareholder Wealth Maximization (North American & UK view) vs. Consideration of Stakeholders (Japan & European view) Customers Suppliers Employees Society Environment Government Stockholders Bondholders

19. Dua, Falk, Jacoby, Scott, Stangeland and Wajeeh © 2005 19 V. Self study – will be examined  Financial Institutions  Financial Markets Money vs. Capital Markets Primary vs. Secondary Markets Listing Foreign Exchange Trends in Finance