MOS 1023A / Finance Lecture #1.pdf

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Management and Organizational Studies
Management and Organizational Studies 1023A/B
Maria Ferraro

Oct  31,  2012  /  Wednesday   • Finance is the science or study of the management of funds. Another definition would be, the study of how and under what terms savings (money) are allocated between lenders and borrowers. • Management serves as an arbitrator and moderator between conflicting interest groups or stakeholders. • Shareholders are stakeholders in a corporation, but stakeholders are not always shareholders. A shareholder owns part of a company through stock ownership, while a stakeholder is interested in the performance of a company for reasons other than just stock appreciation. • Stakeholders could be; • Employees who, without the company would have no jobs, • Bondholders who would like a solid performance from the company and, therefore, a reduced risk of default, • Customers who may rely on the company to provide a particular good or service, • Suppliers who may rely on the company to provide a consistent revenue stream. • Creditors, managers, employees and customers hold contractual claims against the firm’s revenues. • Shareholders have residual claims against the company. • Contractual claim is an amount that by legal agreement must be paid periodically to the buyer of a security; contractual claim may also specify the time at which the principal must be repaid and other details. • Residual claim is the right of a shareholder or some other party to the profit of a company after all prior obligations have been paid. • Function of Financial manager are as following; • Raising funds (issuing shares), obligations (stocks, debt securities), • Investments (operations; plant, equipment, projects), • Cash from operational activities, • Reinvesting, • Paying dividends or interest payments to investors, • Main function is managing the cash flow. • The objective of financial management is to maximize shareholder wealth. 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 is the idea that an investment can be viewed in two ways [its future value or present value]. • The theory of interest; • Present value; 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? • It is P = n / (1 + r) • Hence, P = $100 / (1 + 0.12) à P = $79.72. This 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 the discount rate. • It can be verified 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. • As seen above, if $79.72 is put in the bank today and earns 12%, it will be worth $100 in two years. • The net present value; • Calculate the present value of cash inflows, • Calculate the present value of cash outflows, • Subtract the present value of the outflows from the present value of the inflows. • The figure below shows the general decision rule for every case of net present value; • There are 4 typical cash outflows; repairs and maintenance, initial investment, working capital and incremental operating costs. • There are 4 typical cash inflows; salvage value, release of working capital, reduction of costs and incremental revenues. • The firm’s cost of capital is usually regarded as the minimum required rate of return. • The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. • Recovery of the original investment is explained by figures below. • Kubilay Special Services is considering the purchase of an attachment for its roentgen machine. • No investments are to be made unless they have an annual return of at least 10%. • Zero means that the project is acceptable and it promises a return equal to the required rate of return. 2) Risk-Return Tradeoff • Risk is the uncertainty about the outcome or payoff of an investment in the future. • 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. • Firm specific (unsystematic) • Market specific (systematic) 4) Efficient Financial Markets • A financial market is
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