By Dr. B. Krishna ReddyProfessor and Head_SKIM

1.1. Introduction1.2. Defining finance1.3. The Firm: a sistemic approach1.4. Corporate Finance: the financial

function1.5. The financial objective: value

creation1.6. Financial main principles1.7. Finance: historic evolution1.8. Main programmes in Finance

I am saving for retirement. Should I use a pension fund, mutual fund, direct stock market investment ? I want that new car. Should I use my cash saving, lease, borrow?Which is the best way to pay for my holidays, for my house? I’m thinking about starting a new business. Will it reward me adequately?Marocco has asked for major project financing.

Should my organization provide the funds?

Why study finance?

To manage your personal resources

To deal with the world of business

To pursue interesting and rewarding career opportunities

To make informed public choices as a citizen

For the intellectual challenge

Household Business Firms Government Foreign Sector

SURPLUS SPENDING UNITS

DEFICIT SPENDING UNITS

Has more cash income flow than expenditure on consumption and real investments in a period of time. The surplus is then allocated to the financial sector.

Other terms for surplus unit are saver, lender, buyer of financial assets, financial investor, supplier of loanable funds, buyer of securities.

The surplus unit may buy financial assets, hold more money, or pay off financial liabilities issued earlier when in a deficit situation

The household and foreign sectors are usually a surplus sector

Has more expenditures on consumption and real goods (investment) in the real sector than income during a period of time

The deficit unit must participate (borrow) in the financial sector to balance cash inflows with outflows

Other terms for deficit expending unit are borrower, demander of loanable funds, and seller of securities.

The deficit spending unit may issue financial liabilities, reduce money balances, and sell financial assets acquired previously when in a surplus situation

Contracts related to the transfer of funds from surplus to deficit budget units

Financial claims are also called financial assets and liabilities, securities, loans, and financial investments.

For every financial asset, there is an offsetting financial liability.

Total receivable equal total payable in the financial system

Loans outstanding match borrowers’ liabilities

Financial markets offer opportunity for:

› Financing for DSUs (primary)› Financial investing for SSUs (primary and

secondary)› Providing liquidity via trading financial

claims in secondary markets

THE FLOW OF FUNDS DIAGRAM

Deficit SpendingUnit (DSU)

Surplus Spending Unit (SSU)

FundsFunds

Financial Assets = Financial Claims

THE FLOW OF FUNDS DIAGRAM

Deficit SpendingUnit (DSU)

Surplus Spending Unit (SSU)

FundsFunds

Financial Assets = Financial Claims

Borrower demander of loanable funds

seller of securities

Saver, lender buyer of financial assets

financial investorsupplier of loanable funds

buyer of securities.

Assets: any possession that has value in an exchange

› tangible: value depends on particular physical properties (reproducible and non-reproducible)

› intangible: legal claims to some future benefit. Financial assets

Main properties of financial assets

› Rate of return (R): expected return

› Risk (r): credit risk, market risk

› Liquidity (L): how much sellers stand to lose if they wish to sell immediately against engaging in a costly and time-consuming search (J.Tobin)

THE FLOW OF FUNDS DIAGRAM

DIRECT FINANCING (Markets)

Deficit SpendingUnit (DSU)

Surplus Spending Unit (SSU)

INDIRECT FINANCIAL INVESTMENT

OR INTERMEDIATION FINANCING

BrokersDealers

Intermediaries

FundsFunds

Funds Funds

THE FLOW OF FUNDS DIAGRAM

DIRECT

Deficit SpendingUnit (DSU)

Surplus Spending Unit (SSU)

INDIRECT

BrokersDealers

Intermediaries

FundsFunds

Funds Funds

Direct Financial Assets Purchase

Indirect Financial Assets Purchase

Direct Financial Assets Issue

Direct Financial Assets Issue

What is Finance? Types of Finance definitions

› Lack of any specific definition› Raising and spending funds› Economic decisions with a time

component› Micro/Macro: need for integration

Finance is analytical. Finance is based on economic

principles. Finance uses accounting information

as an input for decision-making. Finance is international in perspective. Finance is constantly changing. Finance is the study of how to invest

and raise money productivelyhttp://garnet.acns.fsu.edu/~ppeters/fin3403/

Finance is the study of how people allocate scarce resources over time› costs and benefits are distributed over

time› but the actual timing and size of future

cash flows are often known only probabilistically

Understanding finance helps you evaluate these uncertain cash flows

Bodie and Merton

When implementing decisions, people make use of the Financial System which can be defined as the set of markets and other institutions used for financial contracting and exchange of assets and risks

Bodie and Merton

Financial theory consists of:› the set of concepts that help to organize

one’s thinking about how to allocate resources over time

› the set of quantitative models used to help evaluate alternatives, make decisions, and implement them These concepts and models apply at all

levels and scales of decision making

Bodie and Merton

A basic tenet of finance is that the existence of economic organizations (e.g. firms and governments) facilitate the satisfaction of people’s consumption preferences

Bodie and Merton

Finance Theory is the study of the behaviour of individuals in the intertemporal allocation (over time) of their resources in an uncertain environment, and the study of the function of economic institutions and markets in making these allocations possible.

Economía FinancieraMarín, José M. / Rubio, GonzaloAntoni Bosch, Editor, Barcelona, 2001

The practice of “finance” exists for the creation of value

Financial contracting brings about the substitution of real

wealth (i.e. real business assets) for financial wealth (i.e. securities) Investing in financial securities has better attributes that in real assets. Value is created in tthe real assets held by businesses, and then transmitted into the value of financial

wealth issued by businesses and held by investors.

Norton y Scott, “A new Paradigm: the value creation

function of finance”, january 2001

Finance is the process of transforming existing assets into new, contractual forms, as well as the analytical techniques needed to support this process, for the purpose of wealth creation in modern, capitalistic economies.

Norton y Scott, “A new Paradigm: the value creation

function of finance”, january 2001

Financial management (Corporate finance) deals with how firms raise and use funds to make short-term and long-term investments.

Investment deals with how the securities markets work and how to evaluate and manage investments in stocks and bonds.

Financial Markets and Institutions includes the study of the banking system and markets.

Peterson and Fabozzi

1.1. Introduction1.2. Defining finance1.3. The Firm: a sistemic approach1.4. Corporate Finance: the financial

function1.5. The financial objective: value

creation1.6. Financial main principles1.7. Finance: historic evolution1.8. Main programmes in Finance

Subsistema de

recursos humanos

Subsistema de

dirección y gestión

Subsistema de

dirección y gestión

Subsistema

comercial

Subsistema de

operaciones

Din

ero

Din

ero

Person

al

Perso

nal

Bienes y servicios

Personal

Personal

Goods and

Services

Resourses Expenses Sales

Incomes

Subsistema de

recursos humanos

Human Resources

Subsystem

Subsistema de

dirección y gestión

Management

Subsystem

Subsistema de

dirección y gestión

Finance Subsystem

Commercial

Subsystem

Operations

Subsystem

Fun

ds

Fun

ds

Human re

source

s

Human

reso

urce

s

Goods and Services

Personnel

Human Resources

Resourses

FINANCIAL SUBSYTEM

Planificación FinancieraPlanificación Financiera

FINANCIACIÓN

Financiación Externa

Autofinanciación

Beneficio

INVERSIÓN

Financiación en activo fijo

Inversión en activo circulante

Costes

Subsistema de recursos

humanos

Subsistema de

operaciones

Subsistema comercial

Subsistema de dirección

y gestión

Demanda de créditos

Valores

Mercados Financieros

Dividendos

Impuestos

ENTORNO

Dinero

Recurso

s

Expenses

Resources

AmortizaciónReservas

Planificación FinancieraPlanificación Financiera

FINANCIACIÓN

Financiación Externa

Autofinanciación

Beneficio

INVERSIÓN

Financiación en activo fijo

Inversión en activo circulante

Costes

Subsistema de recursos

humanos

Subsistema de

operaciones

Subsistema comercial

Subsistema de dirección

y gestión

Demanda de créditos

Valores

Mercados Financieros

Dividendos

Impuestos

ENTORNO

Dinero

Recurso

s

In

AmortizaciónReservas

Planificación FinancieraFinancial Planning

FINANCIACIÓN

Financiación Externa

Autofinanciación

FINANCING

External Financing

Retained earnings

BeneficioBenefit

INVERSIÓN

Financiación en activo fijo

Inversión en activo circulante

Costes

INVERSIÓN

Financiación en activo fijo

Inversión en activo circulante

INVESTMENT

Fixed Asset

Current Assets

Costs

Subsistema de recursos

humanos

Human Recourses

Subsystem

Subsistema de

operaciones

Operations

Subsystem

Subsistema comercial

Commercial Subsystem

Subsistema de dirección

y gestión

Management Subsytem

Demanda de créditos

Valores

Mercados Financieros

Dividendos

Impuestos

ENTORNO

Debt

Securities

Financial Market

Dividends

Taxes

ENV IRONMENT

Funds

Resource

s

Income

Empoloyees

DepreciationReserves

• Corporations face two broad financial questions:- What investments should the firm make?- How should it pay for those investments?

Financial managers are concerned with :

• Investment Decisions (use of funds):– The buying, holding or selling of types of assets

• Financing Decisions (acquisitions of funds)

FINANCIALMANAGEMENT(CORPORATE

FINANCE)

r ( r > k ) k

FINANCIAL SYSTEMREAL SYSTEM

INVESTMENT FINANCING

INVESTMENT / FINANCIAL SUBSYTEM

RETURNREPAYMENT AND RETURN

FINANCIAL MARKETS

FIRM OPERATIONS

(Real goods & services

• Goal of management: maximize the economic well-being, or wealth, of the owners (current shareholders)

=> maximize the price of the stock

• Share price today = Present value of all future expected dividends at required return

1 1

.max.Pr..i

i

i

k

diceShareMax

• Financial managers must create or generate value for their shareholders.

• Economic Value Added (EVA) is a measure of a company's financial performance based on the residual wealth calculated by deducting cost of capital from its operating profit (adjusted for taxes on a cash basis).

• The formula for calculating EVA is as follows:

EVA = Net Operating Profit After Taxes - (Capital * Cost of Capital)

• Rational Financial behavior • Risk aversion• Budgetary diversification • Existence of two parts in all financial transaction• Measurement by cash flows • Signaling and informative asymmetry • Efficiency of financial markets • Direct relation of risk and return • Existence of valuable ideas • Financial conduct initiative • The Time Value of the money and value additivity.

Principles of century XX: Beginning of the research in finance

EVENTS

Finance at the present

- Expansion of the Years 20 - The 29 Crises - Economy military of the 40 - Expansion of the 50- Crises of the petroleum of the 73

Modern

Approach

1900-

1950-

1970-

1980-

1990-

Classical Approach

APT Model(Ross, 1970)

Options Valuation Models (Black y Scholes, 1973)

Portfolio selection Theory (Markowitz, 1952,1959)

CAPM (widening and reformulation)

Dividends Policy (Modigliani, Miller, 1963)

Capital Assets Pricing Model (CAPM) (Sharpe, 1963-4, Lintner, 1965)

Efficient Market Theory

(Fama, 1970)

Financial Structure (Modigliani, Miller, 1958)

Agency Theory

Information

Theory

Financial Innovation

Methods based on Fuzzy Sets Theory

(Kaufmann y Gil, 1986-87)

Chaos Theory,Non Linear Dynamics

Markets Efficiency

Para

dig

m y

ears

70

Behavioral finance

2000-

Lecture 1: What is finance? (II)1.10. Finance: historic evolution

• Managements of Investments- Capital Budgeting.• Capital Structure and Dividend Policy.• Market Efficiency.• The Capital Asset Pricing Model.• Options Theory• Agency Theory• Financial Planning• Small Firms

Kidwell, Peterson, Blackwell, Whidbee: Financial Institutions, Markets, and Money, Eighth Edition, John Wiley & Sons, 2003

Fabozzi, Modigliani: Capital Markets. Institutions and Instruments. Prentice Hall, 2003

Bodie, Zvi and Merton, Robert C.: Finance. Prentice Hall, 1999

Pamela P. Peterson and Frank Fabozzi: Financial Management and Analysis, 2nd Edition, John Wiley & Sons, 2003