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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 1

Introduction

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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 2001.

• Focus is on financial decision-making by managers of public companies.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

EDV

equity of valuethe

debt of valuethe where

E

D

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.

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Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides 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.