FIN 502 Business Finance

Lecture 1: Introduction

Professor Ran Duchin

Foster School of Business

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 Basic Information
 Ran Duchin
Office: 573 Paccar Hall;
Email: [email protected]
Phone: 543-4377
 All course materials will be made available on Canvas

 Lectures will focus on key concepts, with applications & examples

 You are responsible for digital or hard copies of the lecture slides (Canvas)

 Textbook: “Corporate Finance: The Core” by Berk and DeMarzo,

4th edition
 Good coverage of key concepts; Used in some elective finance classes

 We will use a financial calculator & Excel

 I will use the TI BA II Plus calculator in class

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 Basic Information - Continued

 Homework available on Canvas

 Individual and team assignments

 Three cases done in teams

 Ocean Carriers and Flash Memory, Inc. included in the course pack.
It can be purchased from Harvard Publishing at:
https://hbsp.harvard.edu/import/684031
 The Stock Market Case

 Syllabus has grading policy

 Midterm exam -- 30%
 Final exam -- 30%
 Homework assignments -- 16%
 Cases -- 24%

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 The Stock Market Case
 Pick a portfolio of 4 stocks in which to invest a total of $100,000
 Goal: earn the largest returns
 Up to $40,000 in any one stock

 Work in study teams

 Next Monday (January 13th)

 Summary with stock picks: name and ticker symbol, amount, reason

 You will buy the shares at the close of trading on Friday, January 17th
 Enter information at http://faculty.washington.edu/duchin/stockdata.html

 Beginning Friday (January 24th)

 Enter new portfolio value every Friday after close of trading

 Liquidation date is Friday, March 6th

 Summary of performance and events on Wednesday, March 11th 4

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 Financial Decisions Made by Individuals

Personal Income

Savings
Consumption
(Investments)

Investment Horizon Risk Expected Return

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 Consumption vs. Savings

Personal Savings Rate in the U.S.

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 Financial Decisions Made by
Individuals: Examples
 What part of income to set aside as savings?
 Retirement planning (e.g. 401K)
 Meeting future financial goals (e.g. children’s education)

 How to invest savings?

 Asset allocation: what asset classes? (e.g. stocks vs. bonds)
 Security selection: which particular stocks or bonds?

 This course
 Valuing bonds and stocks
 Assessing the risk of financial assets
 Introduction to modern portfolio theory

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 Financial Decisions Made by
Corporations
Basic
Business
Decisions

Investment: Financing: Managing Cash Flow:

What projects should How should the firm How should the firm
the firm invest in? finance its projects? manage its cash flow?

Debt Equity

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 The Capital Budgeting Decision

Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
What long-term
1 Tangible investments Shareholders’
should the firm
2 Intangible Equity
choose?
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 The Capital Structure Decision

Current
Liabilities
Current Assets
Long-Term
How should the Debt
firm raise funds
for the selected
Fixed Assets
investments?
1 Tangible
Shareholders’
2 Intangible Equity

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 Short-Term Asset Management

Current
Liabilities
Current Assets Net
Working Long-Term
Capital Debt

How should
Fixed Assets
short-term assets
1 Tangible be managed and
financed? Shareholders’
2 Intangible Equity

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 Financial Decisions Made by
Corporations: Examples
 In what projects should the company invest?
 Apple announces the iPad Mini as competition rose from 7" devices
such as the Kindle Fire HD and Nexus 7 (2012)

 Where to get the funding for the company’s

investments?
 IPO: Alibaba (2014, $25 billion); Facebook (2012, $16 billion)
 Bond issue: Apple (2013, $17 billion)

 How to manage cash flow?

 Microsoft (2003) and Apple (2012) start paying dividends
 General Electric, U.S. Bancorp, and Wells Fargo cut dividends
(2009)

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 Why Should I Care about Finance?
 “I don’t want to be a financial manager.”

 Suppose you’re in marketing; you need finance to:

 Decide whether an ad campaign is worth the cost;
 Determine the value of a brand

 If you’re in IS, you’ll need finance to:

 Decide whether your company should invest in new managerial software
 Decide whether to invest in a new, faster server

 If you’re in accounting:
 Investors and lenders will use the financial statements you put together to
conduct financial analyses
 Knowing how your numbers are used will make you a better accountant

Any time your company needs to spend money on something to help it make money
in the future, you will need to use finance to determine whether it is worth it!
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 What is a Corporation?
 A corporation is a legal form of business organization
characterized by:

(1) Limited liability

 Owners‘ personal wealth is shielded from the obligations of
the corporation

(2) Separation of ownership from the management

 “You do not have to know everything we do to profit from it”
(United Technologies marketing campaign, 2008)

(3) Right to issue financial securities

 Access to capital markets

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 Stakeholders of a Corporation

Society
Government
(Taxation)
Employees
(HR)

Investors
Suppliers (Finance)
Corporation
(Operations)

Competitors
(Strategy) Customers
(Marketing)
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 Pros and Cons of the Corporate
Form of Business
Advantages Disadvantages

 Limited liability  Conflict of interest between

 Unlimited life
management and owners
(i.e. agency problems)
 Use of management
 Double taxation:
expertise
 Income taxed at the
 Easy transfer of
ownership corporate rate
 Dividends taxed at the
 Access to capital markets
personal rate

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 The Goal of Financial Management
 What is the correct goal?
 Survive
 Avoid financial distress and bankruptcy
 Beat the competition
 Maximize sales or market share
 Maximize profit
 Minimize risk
 Minimize costs
 Maximize current value per share of existing
stock
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 The Agency Problem

 Agency relationship
 Principal hires an agent to represent his/her interest
 Stockholders (principals) hire managers (agents) to run the
company

 Agency problem
 Conflict of interest between principal and agent
 management may make decisions that benefit their self-interest
rather than those of the stockholders

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 Managerial Goals

 Managerial goals may be different from shareholder

goals
 Expensive perquisites
 Survival
 Control or “Empire-Building”

 Agency costs: The costs of the conflict of interest

between the firm’s owners and its management
 Direct costs
 Indirect costs

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 Managing Managers

 Managerial compensation
 Incentives can be used to align management and stockholder
interests
 The incentives need to be structured carefully to make sure that
they achieve their intended goal

 Corporate control
 The threat of a takeover may result in better management

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 Financial Markets
 Financial Market is a mechanism that facilitates the
transfer of capital between investors and
corporations

 Institutions that support financial markets:

 Stock exchanges
 Brokerage houses
 Investment banks
 Regulatory bodies

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 Financial Markets
Financial
Markets Individual
Corporation Investors

capital acquisition of issued stocks/bonds savings

earnings dividends/interest, consumption

share repurchases

reinvestment

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 Role of Financial Markets

 Facilitate allocation of capital

 Transfer resources from investors to corporations

 Disseminate information via prices

 When asset prices fully reflect public information, financial markets are
considered efficient

 Improve allocation of risk

 Opportunities for risk sharing and hedging

 Facilitate consumption smoothing across time

 Invest now to consume in the future

 Separate owners from managers

 Facilitate deployment of managerial expertise in running companies

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 Assets Traded in Financial Markets

 Main types of financial assets traded in

financial markets:
 Bond (debt): firm’s obligation to repay the principal and interest at
pre-specified dates in the future
 Essentially, a loan from an investor to a corporation

 Stock (equity): investor’s share of ownership in a corporation

 The right to share in a firm’s cash flow after senior obligations
(e.g. taxes, interest, etc.) have been met

 Derivative (option, future, forward, and swap): asset whose payoff

is determined by (derived from) the price of another asset
 We will briefly introduce options
 Mostly studied in elective courses 24

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 Comparing Bonds and Stocks

Stocks Bonds

Payment (dividend) is uncertain Payment is fixed

More risky Less risky

Right of ownership Loan

Infinite life Finite life (expires at maturity)

Dividends are paid from after-tax Interest is a tax-deductable

profit expense

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 Historical Performance of Stocks and Bonds

*adjusted for inflation

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 Stocks vs. Bonds as an Investment
"The upward movement of stock values over time overwhelms the
short-term fluctuations in the market. There is no compelling reason
for long-term investors to significantly reduce their stock holdings,
no matter how high the market seems."

Jeremy Siegel, author of Stocks for the Long Run

(one of the 10 best investment books of all time by the Washington Post)

Why invest in bonds at all?

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 Range of Annual Returns of Stocks & Bonds

Source: Granite Research

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 Building Intuition: Asset Pricing
 Evaluate the following argument:
“Russian stocks are too risky for any prudent
investor. There is no market for such securities”

 How does the market induce investors to buy high-

risk stocks when low-risk stocks are available?

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 Summary

Corporation
 Limited liability and separation of ownership and
management
 Easier access to capital markets

Financial markets
 Facilitate capital transfer from investors to corporations
 Disseminate information via prices

Next:
1. Review TVM tools
2. Discuss interest rates and inflation
3. Use TVM tools to evaluate securities (bonds and stocks)
and investment projects
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