1-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Chapter 1 Introduction

1-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Learning Objectives Identify the major types of business entities. Explain the role of financial managers. Specify the objective that is necessary to ensure that financial managers make rational investment and financing decisions. Identify the major financial decisions made by the managers of business entities. Identify and explain the basic concepts of finance.

1-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Nature of Business Finance Broad aspects of finance: –Corporate finance — the financial management of companies. –Financial institutions and markets. –Investments. Business finance mainly focuses on corporate finance, but it also considers financial institutions, markets and investments.

1-4 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Financial Decisions Major financial decisions are: –Investment decisions — decisions that determine the asset profile of a business (amount and composition of investments). –Financing decisions — how the assets are to be funded (debt and equity). Financing decisions also involve dividend decisions. Ultimate objective of investment and financing decisions is to maximise the owners’ wealth.

1-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Business Structures Sole proprietorship: –Business owned by one person. Partnership: –Business owned by two or more people acting as partners. Company: –Separate legal entity formed under the Corporations Act Focus is on financial decision-making by managers of public companies.

1-6 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Finance Function: Major Roles of Financial Managers Project evaluation. Dividend and share re-purchase decisions. Dividend distributions. Collection and custody of cash and payment of bills. Management of investments in current assets.

1-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University The Finance Function: Major Roles of Financial Managers (cont.) Assessing the viability of growth through acquisitions. Planning the development of the business. Risk management of interest rate and exchange rate. Development and implementation of financial policies.

1-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University A Company’s Financial Objective In order to study the behaviour of financial managers and understand their decisions, we need to understand the objective of their decision making. The maximisation of the market value of a company’s shares is the overriding objective. We are able to rationalise theories and important results in finance by appealing to this ultimate objective of financial decision-makers.

1-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Basic Concepts of Finance Value: –The value of a company (V) on the financial markets may be expressed as: –Financial markets will value debt and equity, taking into account the risk and expected return from investing in these securities.

1-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Basic Concepts of Finance (cont.) Time and uncertainty: –The value of an investment will depend on the amount and timing of the cash flows generated by the investment. –Time value of money: A dollar today is worth more than a dollar in the future. Risk aversion: –Investors prefer lower risk rather than higher risk for a given return. –Investors invest in risky investment as long as return on the investment is high enough to compensate investors for bearing risk.

1-11 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Basic Concepts of Finance (cont.) Nominal and real rates: –The cost of an asset expressed as the number of dollars paid to acquire the asset is the nominal price. –However, the purchasing power of money changes because of inflation and deflation. –Therefore, it is necessary to distinguish between the nominal or face value of money and the real or inflation-adjusted value of money.

1-12 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Basic Concepts of Finance (cont.) Market efficiency and asset pricing: –Market efficiency means that we should expect securities and other assets to be fairly priced, given their expected risks and returns. –Trade-off between risk and expected return under the capital asset pricing model (CAPM):  Systematic risk — market-wide factors (non-diversifiable or market risk).  Unsystematic risk — factors that are specific to a particular company (diversifiable or unique risk). –According to the CAPM, investors can diversify their investments to eliminate unsystematic risk.

1-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Basic Concepts of Finance (cont.) Derivative instruments: –The value of derivative securities depends on the value of some underlying security. Examples of derivative securities are: forward, futures, swaps and options. Arbitrage: –If two identical assets were to trade in the same market at the same time at different prices, and if there were no transaction costs, then an arbitrage opportunity would exist. –A risk-free profit could be made by simultaneously purchasing at the lower price and selling at the higher price. –However, competition among traders will force the two alternative prices to become the same. –Arbitrage precludes perfect substitutes from selling at different prices in the same market.

1-14 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Basic Concepts of Finance (cont.) Agency relationships: –Where one party — the principal — delegates the decision-making authority to another party — the agent. –In a company setting:  The agents are usually managers.  The principals are usually shareholders.

1-15 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Basic Concepts of Finance (cont.) Agency relationships (cont.): –Agency costs reflect the fact that there is a conflict of interest between the principal and agent. –Reduced value due to managers acting in their own best interests rather than in the interests of shareholders. –Costs associated with monitoring managers’ behaviour to ensure their actions are consistent with shareholders’ interests. –Bonding costs: Costs of incentive and remuneration schemes that align the interests of managers with those of shareholders.

1-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian National University Summary Business entities include sole proprietorships, partnerships and companies. We focus on public companies. We study corporate finance, along with investments (risk and return trade-off) and the structure of financial markets and institutions. We consider broad finance issues such as company valuations, market efficiency, risk aversion, asset pricing, derivative instrument and arbitrage, along with agency issues.