Finance Lecture 1: Intro To Finance
What is Finance?
The science or study of the management of funds.
Role of management
Management serves as an arbitrator and moderator between conflicting
interest groups or stakeholders and objectives.
Creditors, managers, employees and customers hold contractual claims
against the firm’s revenues.
Shareholders have residual claims against the company.
Function of a Financial Manager
Maximizing Shareholder Wealth
The objective of financial management is to maximize shareholder
Six Principles of Finance
1. Time Value of Money
Money in hand today is worth more than the promise of receiving
the same amount of money in the future.
Time value of money exists because a sum of money today could
be invested and “grow” over time.
Computation of Present Value
An investment can be viewed in two ways – its future value or its present
Present Value Future Value The Theory of Interest
Assume a bank pays 8% interest on a $100 deposit made today. How much
will the $100 be worth in one year?
Future Value of $1
Periods 8% 10% 12%
1 1.080 1.100 1.120
2 1.166 1.210 1.254
3 1.260 1.331 1.405
4 1.360 1.464 1.574
5 1.469 1.611 1.762
Present Value – an example
If a bond will pay $100 in two years, what is the present value of the $100 if
an investor can earn a return of 12% on investments?
The Process is called discounting. We have discounted the $100 to its present
value of $79.72. The interest rate used to find the present value is called discount
Lets verify that if we put $79.72 in the bank today at 12% interest that it
would grow to $100 at the end of two years.
If $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years.
2. Risk-Return Tradeoff
Risk is the uncertainty about the outcome or payoff of an investment in the
Rational Investors would choose a riskier investment only if they feel the
expected return is high enough to justify the greater risk. 3. Diversification of Investments
All investment risk is not the same
Some risk can be removed or diversified by investing in several different
assets or securities.
o Firm Specific (unsystematic)
o Market (systematic)
4. Efficient Financial Markets
A financial market is “information efficient” if at any point in time the prices
of securities reflect all information available to the public
When new information becomes available, prices quickly change to reflect
Information efficient markets provide liquidity and fair prices.
5. Management vs. Owner Objectives
Management objectives may differ from owner objectives (called principle-
Owners or equity investors want to maximize the returns on their
Managers may seek to emphasize the size of firm sales, assets, or other perks.
Solution: tie manager compensation to performance measures beneficial to
6. Reputation Matters!
o How an individual or organization treats others legally, fairly, and
o High reputation value reflects high quality ethical behavior, so
employing high ethical standards is the “right” thing to do.
Real Vs. Financial Assets
Real Assets are tangible things owned by persons and businesses
o Residential structures and property
o Major appliances and automobiles
o Office towers, factories, mines
o Machinery and equipment
Financial Assets are what one individual has lent to another
o Consumer credit
The Functions of Money
Medium of Exchange o How transactions are conducted: something that is generally
acceptable in exchange for goods and services. In this function money
removes the need for double coincidence of wants by separating
sellers from buyers.
Standard of Value
o How the value of goods and services are denominated: something
that circulates and provides a standardized means of evaluating the
relative price of goods and services.
Store of Value
o How the value of goods and services are maintained in monetary
terms: the ability of money to command purchasing power int eh
The Financial System
Banks and other deposit-taking institutions
Channels of Intermediation Financial Markets
Financial Instruments issued by Corporations
Debentures - unsecured debt. Backed only by the general assets off the
Secured Debt (Mortgage Debt) – secured by specific assets.
Subordinated Debt – in default, holders get payments only after other debt
holders get their full payment.
Senior Debt – in default holders get payment before other debt holders get.
Zero Coupon – pay face value at maturity only, sold at discounts.
Junk Bonds – bonds with below investment grade rating.
Callable (Redeemable) Financial Instruments issued by corporation:
The common stockholders are the owners of the corporation’s equity
Do not have a specified maturity date and the firm is not obliged to pay
dividends to shareholders.
Returns come from dividends and capital gains.
Have face value, predetermined periodical (dividend) payments with priority
over common stockholders
If dividend payment is NOT paid, preferred stockholders may get voting
Securities whose value is derived from the value of some underlying asset.
Most important derivatives are options and futures
Stock Options – not a tool of fundraising, it is a method of compensation.
Prices of financial instruments are determined in equilibrium by demand and
They reflect market expectations regarding the future as a inferred from
currently available information.
Finance Lecture 2: Financing and Distributing
Initial Funding of the Firm
o The process by which many entrepreneurs raise “seed” money and
obtain other resources necessary to start their businesses.
o The initial “seed” money usually comes from the entrepreneur or
Venture capitalists are individuals or firms that help new businesses get
started and provide much of their early-stage financing.
Individual venture capitalists or angel investors are typically wealthy
individuals who invest their own money in emerging businesses at the very
early stages in small deals.
Three reasons exist as to why tradition sources of funding do not work for
new or emerging businesses: 1. The high degree of risk.
2. Types of productive assets.
3. Informational asymmetry problems.
The venture capitalists’ investments give them an equity interest in the
Often in the form of preferred stock that is convertible into common stock at
the discretion of the venture capitalist.
How Venture Capitalists Reduce their Risk:
Venture capitalists know that only a handful of new companies will survive
to become successful firms
Tactics to reduce risk:
o Funding the ventures in stages
o Requiring entrepreneurs to make personal investments
o Syndicating investments
o and maintaining in-depth knowledge about the industry in which they
It is a common practice to syndicate seed- and early-stage venture capital
Syndications occurs when the origination venture capitalist sells a
percentage of a deal to other venture capitalists.
Syndications reduces risk in two ways:
1. It increases the diversification of the originating venture capitalist’s
2. The willingness of other venture capitalists to share in the investment
provides independent corroboration that the investment is a reasonable
The Exit Strategy
Venture capitalists are not long-term investors in the companies, but usually
exit over a period of three to seven years.
Every venture capital agreement includes provisions identifying who has the
authority to make critical decisions concerning the exit process.
There are three principle ways in which venture capital firms exit venture-
o Sell part of the firm’s equity to a strategic buyer in the private market.
o Sales to financial buyers.
o Initial Public Offering: selling common stock in an initial public
Venture Capitalists Provide More Than Financing
The extent of the venture capitalists’ involvement depends on the experience
of the management team.
One of their most important roles is to provide advice. Because of their industry and general knowledge about what it takes for a
business to succeed they provide counsel for entrepreneurs when a business
is being started and during early stages of operation.
Initial Public Offering
One way to raise larger sums of cash or to facilitate the exit of a venture
capitalist through and IPO of the company’s common stock.
First-time stock issues are given a special name because the marketing and
pricing of these issues are distinctly different from those of seasoned
Advantages of Going Public
The amount of the equity capital that can be raised in the public equity
markets is typically larger than the amount that can be raised through
Once and IPO has been completed, additional equity capital can usually be
raised through follow-on seasoned public offerings at a low cost.
Going public can enable an entrepreneur to fund a growing business without
giving up control.
After the IPO, there is an active secondary market in which stockholders can
buy and sell its shares.
Publicly traded firms find it easier to attract top management talent and to
better motivate current managers if a firm’s stock is publicly traded.
Disadvantages of Going Public
High cost of the IPO itself.
The costs of complying with ongoing SEC disclosure requirements.
The transparency that results from the compliance can be costly for some
*Managers may focus on short-term profits rather than long-term wealth
Private vs. Public Markets
o Because many smaller firms and firms of lower credit standing have
limited access, or no access, to the public markets, the cheapest source
of external funding is often the private markets.
o When market conditions and unstable, some smaller firms that were
previously able to sell securities in the public markets no longer can.
o Bootstrapping and venture capital financing are part of the private
market as well. o Many private companies are owned by entrepreneurs, families, or
family foundations, and are sizeable companies of high credit quality,
prefer to sell their securities in the private markets even though they
can access public markets.
Private placement occurs when a firm sells unregistered securities directly to
investors such as insurance companies, commercial banks, or wealthy
Private lenders are more willing to negotiate changes to a bond contract.
If a firm suffers financial distress, the problems are more likely to be resolved
without going to a bankruptcy court.
Other advantages include the speed of private placement deals and flexibility
in issue size.
The biggest drawback of private placements involves restrictions on the
resale of the securities.
Private Equity Firms
Like venture capitalists, private equity firms pool money from wealthy
investors, pension funds, insurance companies, and other sources to make
Private equity firms invest in more mature companies, and they often
purchase 100 percent of a business.
Private equity firm managers look to increase the value of the firms they
acquire by closely monitoring their performance and providing better
Once value is increased, they sell the forms for a full profit. Private equity
forms generally hold investments for 3 to 5 years.
The term dividend policy is generally used to refer to a firm’s overall policy
regarding distributions of value to stockholders.
A dividend is something of value that is distributed to a firm’s stockholders
on a pro-rata.
A dividend can involve the distribution of cash, assets, or something else,
such as discounts on the firm’s products that are available only to
When a firm distributes value through a dividend it reduces the value of the
stockholders’ claims against the firm.
A dividend reduces the stockholders investment in a firm by returning some
of the investment to them.
Types of Dividends:
o The most common form is the regular cash dividend. o These dividends are generally paid quarterly.
o The size of a firm’s regular cash dividend is typically set at a level that
management expects the company to be able to maintain in the long
run, barring some major change in the fortunes of the company.
o Management does not want to have to reduce the dividend.
o Management can afford to err on the side of setting the regular
dividend too low.
o Extra dividends are often paid at the same time as regular cash.
The Dividend Payment Process Time Line for a Public Company
They do not represent a pro-rata distribution of value to the stockholders,
because not all stockholders participate.
When a company repurchases its own shares, is removes them from
Stock repurchases are taxed differently than dividends.
How Stock is Repurchased:
o They can simply purchase shares in the market,
o It can repurchase shares using a tender offer, which is an open offer
by a company to purchase shares.
o Through direct negotiation with a specific stockholder.
Stock Dividends and Stock Splits
One type of “dividend” that does not involve the distribution of value
is known as a stock dividend.
When a company pays a stock dividend, it distributes new shares of
stock on a pro-rata basis to existing stockholders. Value of company does not change.
The stockholder is left with exactly the same value as before.
A stock split is quite similar to a stock dividend but it involves the
distribution of a larger multiple of the outstanding shares.
We can often think of a stock split as an actual division of each share
into more than one share.
One real benefit of stock splits is that they can send a positive signal
to investors about the outlook that management has for the future and
this, in turn, can lead to a higher stock price.
Management is unlikely to want to split the stock of a company two-
for-one or three-for-one if it expects the stock price to decline.
Reverse Stock Splits – opposite of stock split.
Practical Considerations in Setting a Dividend Policy
A company’s dividend policy is about how the excess value in a company is
distributed to its stockholders.
It is extremely important that managers choose their firm’s dividend policies
in a way that enables them to continue to make the investments necessary
for the firm to compete in its product markets.
Managers should consider several practical questions when selecting a
1. Over the Long Term, how much does the company’s level of earnings
(cash flows from operations) exceed its investment requirements?
How certain is this level?
2. Does the firm have enough financial reserves to maintain the
dividend payout in periods when earnings are down or investment
requirements are up?
3. Does the firm have sufficient financial flexibility to maintain
dividends if unforeseen circumstances wipe out its financial reserves
when earnings are down?
4. Can the firm quickly raise equity capital if necessary?
5. If the company chooses to finance dividends by selling equity, will the
increased number of stockholders have implications for the control of
Finance Lecture 3: Derivatives
Financial Derivative Securities: derive all or part of their value from
another (underlying) security
Why trade these indirect claims?
o Expand investment opportunities
o Lower cost
o Increase leverage Options
Options are created by investors, sold to other investors
Call: Buyer has the right, but not the obligation, to purchase a fixed quantity
from the seller at a fixed price up to a certain date.
Put: Buyer has the right, but not the obligation, to sell a fixed quantity to the
seller at a fixed price up to a certain date.
Exercise (Strike) Price: the per-share price at which the common stock may
be purchased or sold.
Expiration Date: last date at which an option can be exercised.
Option Premium: the price paid by the option buyer to the writer of the
option, whether put or call.
How Options Work
Call buyer expects the price of the underlying security to increase.
Call seller expects the price of the underlying security to decrease or stay the
Put buyer expects the price of the underlying security to decrease.
Put seller expects the price of the underlying security to increase or stay the
Possible courses of action
o Options may expire worthless, be exercised, or be sold prior to expiry.
Example- Call Options
Writer sells a call option for $1.00 to you to purchase 1000 shares at $10.00
You must expect shares to increase, writer expects shares to decrease
If shares increase to $15.00 you will exercise option – buy shares at $10.00
and sell for $15.00 (you earned $4.00 profit on option contract)
If shares decrease to below $10.00 you will not exercise – seller gets the
Example – Put Options
Writer sells a put option for $1.00 to you to sell 1000 shares at $10.00
You must expect shares to decrease, writer expects shares to increase
If shares decrease to $5.00 you will exercise option – buy shares at $5.00 and
sell for $10.00 (you earned $4.00 profit on an option contract)
If shares rise over $10.00 you will not exercise – seller gets the $1.00
Options Exchanges o Montreal Exchange (ME)
o Chicago Board Options Exchange (CBOE)
Standardized exercise dates, exercise prices and quantities
o Facilitate offsetting positions through a clearing corporation
o Clearing Corporation is guarantor, handles deliveries.
In-the-money options have a positive cash flow if exercised immediately
o Call options: Stock price (S) > Exercise price (E)
o Put options: S < E
Out-of-the-money options should NOT be exercised immediately
o Call options: S < E
o Put options: S > E
If S = E, an option is money
Factors Affecting Prices
Time to maturity
Rights and Warrants
Right – to purchase a stated number of common shares at a specified price
with a specified time (often a few months)
o Issued by the corporation
o Are transferrable
o Option to purchase shares a price often lower than the market price
o Certificates mailed to current shareholders on a pro-rata basis
Warrant – to purchase a stated number or common shares at a specified
price with a specified time (often several years)
o Often attached to debt or preferred shares as a sweetener
o Are detachable
Understanding Future Markets
Spot or Cash Market
o Price refers to item available for immediate delivery
o Price refers to item available for delayed delivery
o Sets features (contract size, delivery date, and conditions) for delivery **An obligation to buy or sell a fixed amount of an asset on a specified future
date at a price set today
Future Market Characteristics
o Centralized marketplace allows investors to trade with each other
o Performance is guaranteed by a clearing house
Commodities – agricultural, metals, and energy related
Financials – foreign currencies as well as debt and equity instruments
Where futures contracts are traded
Voluntary, nonprofit associations, typically unincorporated
Organized marketplaces where established rules govern conduct
o Financed by membership dues and fees for services rendered
Members trade for self or for others
The Clearing Corporation
A corporation separate from, but associated with, each exchange
Exchange members must be members or pay a member for these services
o Buyers and sellers settle with clearing corporations NOT with each
Helps facilitate an orderly market
Keeps track of obligations
The Mechanics of Trading
Through open-outcry, seller and buyer agree to take or make delivery on a
future date a price agreed on today
o Short position (seller) commits a trader to deliver an item at
o Long position (buyer) commits a trader to purchase an item at
Like options, futures trading is a zero-sum game
Good faith deposit made by both buyer and seller to ensure completion of the
o NOT an amount borrowed from broker
Each clearing house sets its own requirements
o Brokerage houses can require higher margin
Initial margin usually less than 10% of contract value
Margin calls occur when price goes against investor
o Must deposit more cash or close account
o Position marked-to-market daily
o Profit can be withdrawn Each contract has maintenance or variation margin level below which the
investor’s net equity cannot drop
Using Future Contracts
o At risk with a spot market asset and exposed to unexpected price
o Buy or sell future to offset the risk
o Used as a form of insurance
o Willing to forgo some profit in order to reduce risk
Hedges return has smaller chance of low return but also
smaller change of high return.
o Buy or sell future contracts in an attempt to earn a return
o Absorb excess demand or supply generated by hedgers
o Assuming the risk of price fluctuations that hedgers wish to avoid
o Speculation encouraged by leverage, ease of transacting, low costs
Finance Lecture 4: Mergers and Acquisitions & International Finance
o The transfer