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Chapter 1
Introduction
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
1-1
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.
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
1-2
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.
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
1-3
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.
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
1-4
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.
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
1-5
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.
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
1-6
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.
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
1-7
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.
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
1-8
Basic Concepts of Finance
• Value:
– The value of a company (V) on the financial markets
may be expressed as:
V  DE
where D  the value of debt
E  the value of equity
– Financial markets will value debt and equity, taking
into account the risk and expected return from
investing in these securities.
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
1-9
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.
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
1-10
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.
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
1-11
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.
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
1-12
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.
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
1-13
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.
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
1-14
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.
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
1-15
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.
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
1-16