Topic 1: Introduction to Finance FIN1FOF
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Lesson 1.1
1.1.1 Why study Finance?
1.1.2 Business Organisations
1.1.3 Types of Companies
1.1.4 The Role of the Financial
Manager
1.1.5 The Goal of the Financial
Manager
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 2
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1.1.1 Why study Finance?
FINANCIAL DECISION-MAKING
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 3
This subject is about decision-making;
specifically financial decision-making
We make day-to-day decisions by making a
subjective judgement about the value to us
of the costs and benefits of each decision
Financial decisions are decisions where we
can quantify the costs and benefits using
dollar values
Value of
benefits
Value of
costs
We should make
that decision
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1.1.1 Why study Finance?
FUNDAMENTALS OF FINANCE
4 Valuation of Securities
10 Market Efficiency
2 Time Value of Money
3 Financial Mathematics
9 Portfolio Theory
8 Risk and Return
11 Options
5 Cost of Capital
7 Project Evaluation
6 Capital Budgeting
1 Introduction to Finance
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 4
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1.1.1 Why study Finance?
PERSONAL FINANCIAL DECISIONS
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 5
Examples of
personal
financial
decisions
Whether to
retire with a
lump sum or
purchase an
annuity
Which
investments
to make (e.g.
shares)
Whether to
lease a car
or borrow to
purchase it
How to
evaluate the
terms for a
home
mortgage
When to start
saving and how
much to save for
retirement
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1.1.1 Why study Finance?
PERSONAL FINANCIAL DECISIONS
Investing in shares and
other securities
Leasing or borrowing?
Evaluating a mortgage
Saving for retirement
Lump sum or annuity?
Topic 4 – Valuation of Securities
Topic 2 – Time Value of Money
Topic 3 – Financial Mathematics
Topic 10 –Market Efficiency
Topic 9 – Portfolio Theory
Topic 8 – Risk and Return
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 6
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1.1.1 Why study Finance?
BUSINESS FINANCIAL DECISIONS
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 7
Examples of
business
financial
decisions
How to
raise capital
for a new
start‐up firm
Whether to
issue shares
or borrow
money to
expand
Whether to
launch a
new product
or enter a
new market
Whether to
buy new
plant and
equipment
How to reduce
exposure to risk
Whether to invest
in a new project
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1.1.1 Why study Finance?
BUSINESS FINANCIAL DECISIONS
Raising start‐up capital or
raising funds to expand
Investing in a new project
Launching a new product
Buying new equipment
Reducing
exposure to risk
Topic 11 –
Options
Topic 4 – Valuation
of Securities
Topic 2 – Time Value of Money
Topic 3 – Financial Mathematics
Topic 7 – Project Evaluation
Topic 6 – Capital Budgeting
Topic 5 –
Cost of
Capital
Topic 9 –
Portfolio
Theory
Topic 8 – Risk
and Return
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 8
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1.1.1 Why study Finance?
FINANCIAL NEWS AND EVENTS
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This subject will introduce and develop the
principles and mathematical tools needed to
make these kinds of decisions
Financial news is becoming more prevalent,
and an understanding of finance helps to
comprehend and utilise this information
Financial events such as the recent Global
Financial Crisis have far-reaching
consequences, and highlight the need for a
good understanding of financial principles
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1.1.2 Business Organisations
THE THREE TYPES OF FIRMS
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A number of topics will provide tools to assist
with personal financial decision-making, but
the bulk of this subject will focus on business
finance and the role of the financial manager
in running a firm
There are three
types of firms
that financial
managers run:
Sole traders
Partnerships
Corporations
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Disadvantages:
1.1.2 Business Organisations
THE THREE TYPES OF FIRMS
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 11
A business owned and
run by one person
Sole trader
Although not
accounting for much
sales revenue, the most
common type of firm
- No separation of
ownership and control - The owner has
unlimited liability for
the firm’s debts - The life of a sole
trader is limited to the
life of the owner, and
it is difficult to
transfer ownership
Advantage
Easy to set up
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Disadvantages
1.1.2 Business Organisations
THE THREE TYPES OF FIRMS
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A business owned and
run by more than one
person
Partnership
Typically used when
the reputation of the
firm is based on the
reputation of the
owners (e.g. law firms,
medical practices and
accounting firms) - The partnership ends
with the death or
withdrawal of a
partner (although this
can be varied) - All of the partners are
liable for the firm’s
debts – a lender can
require any partner to
repay the firm’s debts
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Advantages:
More costly to set up
Disadvantage
1.1.2 Business Organisations
THE THREE TYPES OF FIRMS
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A legal entity separate
from its owners
Corporation
The dominant
business form (in
terms of revenue) all
over the world - Owners have limited
liability for the firm’s
debts - The corporation exists
indefinitely and
ownership is easily
transferred - Separation of control
and ownership allows
for external investors
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1.1.3 Types of Companies
THE THREE TYPES OF COMPANIES
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 14
Private company
Restricted to 50 nonemployee
shareholders
Not required to
appoint an auditor
Public company
Unlimited shareholders
Required to appoint an
auditor and submit
statements to ASIC
A company listed on the ASX
Denoted by “Pty Ltd” Denoted by “Ltd”
Listed public company
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1.1.3 Types of Companies
THE THREE TYPES OF COMPANIES
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About 2 million
About 200,000
Private companies
Public company
Listed public companies About 2000
Although few in number, listed companies
dominate the Australian share market, and
account for over 99% of share trading
Much of this subject will concentrate on the
financial management of this type of company
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1.1.3 Types of Companies
OWNERSHIP OF A COMPANY
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Ownership of a
company
Referred
to as
equity
Owners do not
exercise dayto‐
day control
over the firm
This enables corporations to raise
money, or capital, from a large
number of investors, and as a result
they dominate the economy
Divided
into
shares
Shareholders are entitled to
dividends in proportion to the
number of shares they own
Owners of the corporation are
referred to as shareholders
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1.1.4 The Role of the Financial Manager
THE ROLE OF THE FINANCIAL MANAGER
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The financial manager makes financial
decisions on behalf of the owners of the firm
The financial manager has three main tasks:
Make investment
decisions
Make financing
decisions
Manage cash flow from
operating activities
Topic 6 (Capital Budgeting) &
Topic 7 (Project Evaluation)
Topic 4 (Valuation of Securities)
& Topic 5 (Cost of Capital)
This is not covered in
detail in this subject
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1.1.4 The Role of the Financial Manager
Consider a simple balance sheet for a firm:
INVESTMENT AND FINANCING DECISIONS
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The items on the left‐hand
side of the balance sheet
are typically real assets –
they are used to generate
income for the firm
Investment decisions
are decisions about
which real assets to
acquire to generate
that income
Assets
Current assets
Long‐term assets
Liabilities & Equity
Current liabilities
Long‐term debt
Owners’ equity
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1.1.4 The Role of the Financial Manager
Consider a simple balance sheet for a firm:
INVESTMENT AND FINANCING DECISIONS
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 19
Assets
Current assets
Long‐term assets
Financing
decisions are
decisions about
which financial
assets to issue
The items on the right‐side are
called financial assets – they are
issued to raise the capital to buy
real assets, and represent claims
on the income of the firm
Liabilities & Equity
Current liabilities
Long‐term debt
Owners’ equity
INCOME
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1.1.5 The Goal of the Financial Manager
All business financial decisions should be
made in the context of the overriding goal of
financial management:
THE GOAL OF THE FINANCIAL MANAGER
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… to maximise the wealth of the
owners, the shareholders
The shareholders have invested in the
corporation, putting their money at risk, and
the financial manager acts as their agent, or
as caretaker of their money, making decisions
in their interests and on their behalf
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1.1.5 The Goal of the Financial Manager
Since the wealth of shareholders is related to
the value of their shares, and since the value
of each share is, by definition, a specified
proportion of the total value of the corporation
THE GOAL OF THE FINANCIAL MANAGER
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 21
As we shall see in many topics in this subject,
financial decisions are made in the context of
these equivalent objectives
Maximisation of
shareholder wealth
Maximisation of
the value of the
corporation =
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Topic Overview
Lesson 1.2
1.2.1 Valuation
1.2.2 The Share Market
1.2.3 Stock Exchanges
1.2.4 Stock Quotes
1.2.5 Stock Indices
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 22
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1.2.1 Valuation
THE VALUATION PRINCIPLE
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 23
A critical principal underlying the study of
finance is valuation
Topics 4 & 5 apply
these principles to
the valuation of
financial assets
Topics 6 & 7 apply
them to the valuation
of investments
(real assets)
The Value of
any Asset
The present value (the
value today) of all
future cash flows
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1.2.1 Valuation
CRITICAL FACTORS IN FINANCE
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There are three factors
that are critical to the
study of finance and
which will be referred to
and relied upon
throughout this subject:
CASH
TIME
RISK
All financial decision-making requires
careful consideration to all three of these
factors, and the remaining topics in this
subject will continually refer to them
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1.2.1 Valuation
CASH
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 25
CASH
Only cash can be
used to pay costs,
pay dividends,
and increase the
wealth of
shareholders
measures performance over a
specified time period, but does
not represent overall firm value
includes non‐cash book entries
such as accruals & depreciation
Accounting profit…
Highlighted in
Topics 6 & 7
is subject to inconsistency and
deliberate manipulation
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1.2.1 Valuation
TIME
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 26
TIME
The value of a
cash flow is
affected by the
time period in
which it occurs
treats all dollars as being of
equal value, no matter when
they are paid or received
in other words, does not allow
for the “time value of money”
Accounting profit…
We need to be
aware of time in
calculating value
Explained in detail in Topic 2
and used in many other topics
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1.2.1 Valuation
RISK
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 27
RISK
The future is
uncertain, and
the probability
of a cash flow
affects its value
treats the future as certain and
treats all dollars as if they will be
received or paid with certainty
in other words, does
not allow for risk
Accounting profit…
We need to be
aware of risk in
calculating value
Explained in detail in Topic 8
and used in a number of topics
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1.2.2 The Share Market
THE THREE TYPES OF COMPANIES
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 28
The financial manager’s goal is to maximise
shareholder wealth, and this is determined
by share price, so an alternative way to state
this goal is the maximisation of share price
Limited number
of owners and
no market for
shares
Private
companies
The public can
buy shares, but
they are rarely
traded
Public
companies
Shares are
traded on an
organised
exchange
Listed public
companies
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1.2.2 The Share Market
PRIMARY AND SECONDARY MARKETS
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Most capital markets, including the market for
company shares, have a primary and a
secondary market
A market in which
shares are first created
and funds flow to the
company raising capital
by issuing shares
Primary market
E.g. Initial public offers
A market in which
shares are bought and
sold among investors –
this does not directly
benefit the company
Secondary market
E.g. The stock exchange
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1.2.2 The Share Market
ISSUING SHARES IN THE PRIMARY MARKET
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There are three main ways to issue shares:
The public
are invited to
subscribe for
shares
Public offer
Expensive,
but a large
amount of
capital can
be raised
Shares are placed
with one or a
small number of
large investors
Private placement
Cheap and quick,
but results in the
dilution of the
shareholdings of
existing owners
Existing
shareholders
are given the
right to buy
new shares
Rights issue
Allows them
to maintain
their current
shareholding
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1.2.2 The Share Market
TRADING IN THE SECONDARY MARKET
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 31
The stock exchange…
A market is said
to be liquid if investments can
be easily turned into cash at a
price which reflects fair value
Liquid
provides investors
with a liquid market
in which they can
buy or sell shares
This occurs when there
are lots of buyers and
sellers willing to trade
at prices above and
below the current price
allows the market
value of shares to
be established by the forces of
supply and demand as investors
continually buy and sell shares
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1.2.2 The Share Market
TRADING IN THE SECONDARY MARKET
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 32
Like most exchanges, the ASX does not have
a traditional “trading floor”
Stock brokers buy and sell shares (on behalf
of their clients) via a computerised trading
system called Tradematch
Each share has two prices displayed:
The highest price at
which you can sell
Bid price
The lowest price at
which you can buy
Ask (or offer) price
<
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1.2.3 Stock Exchanges
STOCK EXCHANGES AROUND THE WORLD
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 33
Largest exchange
in the US?
NYSE or
“Wall Street”
The largest in
the world
Most countries have at least one major stock
exchange (some, such as the US, have more)
Examples include:
14th largest in
the world
Hi‐tech US
stocks?
New York
Stock Exchange
England? Japan? NASDAQ
Australia?
London Stock
Exchange (LSE)
Tokyo Stock
Exchange (TSE)
Australian Securities
Exchange (ASX)
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1.2.3 Stock Exchanges
THE AUSTRALIAN SECURITIES EXCHANGE
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 34
Independent stock
exchanges developed
in a number of cities
History of Mid‐1800s
the ASX The six capital city
exchanges began to
meet informally
1903
An association (Australian
Associated Stock Exchanges
or AASE) was created
The six capital city exchanges 1937
merged to form the Australian
Stock Exchange – the first in the
world to be listed on itself
1987
2006 The ASX merged with the Sydney Futures Exchange
to form the Australian Securities Exchange (ASX)
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1.2.4 Stock Quotes
STOCK QUOTES
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 35
Bid Offer High Low Open Prev
5.28 5.30 5.33 5.28 5.32 5.27
Vol Trades Value
709,786 684 3,773,280
The
highest
price at
which you
can sell
The lowest price at
which you can buy
AMP LTD
The highest
and lowest
prices at which
the share has
traded today
The first price the
share traded at today
The last price the share
traded at last night
The number of shares,
number of trades and value
of shares traded today
$5.29 $0.02
The following is a
typical stock quote
The last price at which the
stock traded and the change
since last night’s close
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1.2.4 Stock Quotes
STOCK QUOTES
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 36
Buyers Sellers
No. Volume Price Price Volume No
22 90,591 5.28 5.30 36,390 15
17 102,246 5.27 5.31 78,538 13
13 88,466 5.26 5.32 97,793 19
Bid
price
Offer
price
The
number of
brokers
willing to
buy at the
bid price
The number of shares for
which there are orders
to buy at the bid price
The number of shares
available for sale at
the offer price
The number of
brokers willing to sell
at the offer price
Bids and offers at
lower and higher
prices, respectively
The following is also shown
in a typical stock quote
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1.2.5 Stock Indices
SHARE PRICE INDICES
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 37
Each stock exchange has one or more share
price indices, designed to capture the overall
performance of stocks on that exchange
A share price index measures the overall
change in the value of a subset of stocks on
the exchange
These are typically the largest stocks on the
exchange and hence the index, in most cases,
covers stocks representing the majority of
stocks on the exchange by market value
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1.2.5 Stock Indices
SHARE PRICE INDICES
FIN1FOF Fundamentals of Finance – Topic 1 – Introduction to Finance 38
Dow Jones Industrial
Average (the “Dow”)
Examples of major share price indices:
S&P
500
FTSE 100 (the “Footsie”)
Nikkei 225
Hang Seng
DAX
CAC 40
New York
Stock Exchange
London
Tokyo
Hong Kong
Germany
France
NASDAQ
Australian
Securities Exchange
All Ordinaries
(the “All Ords”)
S&P/ASX
200
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