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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 DE 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