Slide Contents

Chapter 1 • Learning Objectives

• Introduction
Getting 1. Finance: An Overview
Started— 2. Three Types of Business Organizations
Principles of 3. The Goal of the Financial Manager
Finance 4. The Five Basic Principles of Finance
• Key Terms

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-2

Learning Objectives
1. Understand the importance of finance in your
personal and professional lives and identify the
three primary business decisions that financial
managers make. 1.1 FINANCE:
2. Identify the key differences between the three AN OVERVIEW
major legal forms of business.
3. Understand the role of the financial manager
within the firm and the goal for making financial
choices.
4. Explain the five principles of finance that form the
basis of financial management for both businesses
and individuals.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-3 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-4

Three Basic Questions Addressed by

What is Finance?
the Study of Finance:

• Finance is the study of how people and 1. What long-term investments should the
businesses evaluate investments and raise firm undertake?
capital to fund them. 2. How should the firm raise money to fund
these investments?
3. How can the firm best manage its cash
flows as they arise in its day-to-day
operations?

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-5 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-6

1
Why Study Finance?

• Knowledge of financial tools is critical to

making good decisions in both corporate
world and personal lives. 1.2 THREE TYPES OF
BUSINESS ORGANIZATIONS
– How will GM’s strategic decision to invest $740
million to produce the Chevy Volt require the
expertise of different disciplines within the
business school?

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-7 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-8

Business Organizational Forms Sole Proprietorship

• It is a business owned by a single individual

who is entitled to all of the firm’s profits and
Business is responsible for all of the firm’s debt.
Forms

• The sole proprietors typically raise money

by investing their own funds and by
borrowing from a bank.
Sole
Partnerships
Proprietorships Corporations

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-9 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-10

Sole Proprietorship (cont.) Partnership

• Advantages: A general partnership is an association of

– Easy to start two or more persons who come together as
– No need to consult others while making decisions co-owners for the purpose of operating a
– Taxed at the personal tax rate business for profit.

• Disadvantages:
– Personally liable for the business debts
– The business ceases on the death of the
proprietor
– Harder to raise money

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-11 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-12

2
Partnership (cont.) Partnership (cont.)

• Advantages: • In limited partnerships, there are two

– Relatively easy to start classes of partners: general and limited.
– Taxed at the personal tax rate
– Access to funds from multiple sources or • The general partner runs the business and
partners
faces unlimited liability for the firm’s debts,
whereas the limited partner is only liable up
• Disadvantages: to the amount the limited partner invested.
– Partners jointly share unlimited liability
– It is not always easy to transfer ownership

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-13 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-14

Corporation Corporation (cont.)

If very large sums of money are needed to • Corporation legally functions separately and
build a business, then the typical apart from its owners (the shareholders).
organizational form chosen is the corporation. Corporation can individually sue and be
The corporation is legally owned by its current sued.
set of stockholders, or owners.
• The Board of directors are elected by the
shareholder, and the board appoints the
senior management of the firm.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-15 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-16

Corporation (cont.) Limited Liability Company (LLC)

• Advantages Limited liability company (LLC) combines

– Liability of owners is limited to invested funds the tax benefits of a partnership (no double
– Life of corporation is not tied to the owner taxation of earnings) with the limited liability
– Easier to transfer ownership benefit of corporation (the owner’s liability is
– Easier to raise Capital limited to what they invest).
• Disadvantages
– Greater regulation
– Double taxation of dividends

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-17 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-18

3
Figure 1.1 Characteristics of Figure 1.2 How the Finance Area
Different Forms of Business Fits into a Corporation

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-19 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-20

The Goal of the Financial Manager

The goal of the financial manager must be

consistent with the mission of the corporation,
1.3 THE GOAL OF THE which is to maximize shareholder’s wealth.
FINANCIAL MANAGER

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-21 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-22

Coca-Cola’s Vision Statement Corporate Mission

To achieve sustainable growth, we have • While managers have to cater to all the
established a vision with clear goals for: stakeholders (such as consumers,
– Profit employees, suppliers etc.), they need to pay
– People particular attention to the shareholders.
– Portfolio
– Partners • If managers fail to pursue shareholder
– Planet wealth maximization, they will lose the
support of investors and lenders. The
business may cease to exist and ultimately,
the managers will lose their jobs!

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-23 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-24

4
Ethics in Finance

• What do we mean by Ethics?

• Give examples of recent financial scandals

and discuss what went wrong from an
ethical perspective.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-25 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-26

Reaction Paper
• Relate the movie to issues and cases in the
Philippine setting. Cite a specific PH case
and discuss in the context of movie “The
Corporation”.
• Is the environment the responsibility of a
business entity? Why or why not?
• Reaction paper = NO copy pasting. Your
OWN words, your own comments.
• TNR size 11, 1 ½ spacing. Maximum 3
pages.
• Worth 20 points.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-27 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-28

The ENRON story

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-29 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-30

5
 Sarbanes-Oxley Act (SOX)

• SOX Act was passed in 2002 “to protect

investors by improving the accuracy and
reliability of corporate disclosures made
pursuant to the securities laws, and for
other purposes”.

• SOX Act mandates senior executives to take

responsibility for the accuracy and
completeness of financial reports.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-31 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-32

PRINCIPLE 1: CASH IS KING

• Cash Flows Are the Source of Value

• Profit is an accounting concept and
1.4 THE FIVE BASIC measures a business’s performance. Cash
PRINCIPLES OF FINANCE flow is the amount of cash that can actually
be taken out of the business.

• It is possible for a firm to report profits but

have no cash.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-33 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-34

Incremental Cash Flow

Financial decisions in a firm should consider

“incremental cash flow” i.e. the difference
between the cash flows the company will
produce with the potential new investment
and what it would make without the
investment.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-35 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-36

6
PRINCIPLE 2:Money Has a Time PRINCIPLE 3: There is a Risk-Return
Value Trade-off

• A dollar received today is worth more than a • The HIGHER the ASSUMED RISK, the
dollar received in the future. HIGHER the REQUIRED RETURN
• We won’t take on additional risk unless we
• We can invest the dollar received today to expect to be compensated with additional
earn interest. Thus, in the future, you will return.
have more than one dollar, as you will
receive the interest on your investment. • Higher the risk, higher will be the expected
return. Note expected return may not be
equal to the realized rate of return.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-37 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-38

Figure 1.3 There Is a Risk-Return PRINCIPLE 4: Market Prices Reflect

Tradeoff Information

Investors react quickly to news/information

and decisions made by managers.

Good News ==> Higher stock prices

Bad News ==> Lower stock price.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-39 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-40

PRINCIPLE 5: Individuals Respond PRINCIPLE 5: Individuals Respond

to Incentives to Incentives (cont.)

Managers (as agents) respond to incentives The agency problems/costs can be mitigated through:
they are given in the workplace. If their 1. Compensation plans that reward managers when
incentives are not properly aligned with those they act to maximize shareholder wealth
of the firm’s stockholders (the principal) they 2. Monitoring by the board of directors
may not make decisions that are consistent 3. Monitoring by financial markets (such as auditors,
with increasing shareholder value leading to bankers, security analysts, credit agencies)
agency costs. 4. The underperforming firms seeing their stock
prices fall and face threat of being taken over and
have their management teams replaced.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-41 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-42

7
Key Terms Key Terms (cont.)

• Agency problem • Financial markets

• Capital budgeting • General partner
• Capital structure • General partnership
• Corporation • Limited liability company (LLC)
• Debt • Limited partner
• Dividends • Limited partnership
• Equity • Opportunity cost

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-43 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-44

Key Terms (cont.)

• Partnership Chapter 2
• Shareholders
• Shares Firms and
• Sole proprietorship the Financial
• Stockholders Market
• Working capital management

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-45

Slide Contents Learning Objectives

• Learning Objectives 1. Describe the structure and functions of

• Principles Applied in this Chapter financial markets.
1.The Basic Structure of the U.S. Financial 2. Distinguish between commercial banks and
Markets other financial institutions in the financial
2.The Financial Marketplace: Financial marketplace.
Institutions 3. Describe the different securities markets
3.The Financial Marketplace: Securities for bonds and stocks.
Markets
• Key Terms

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-47 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-48

8
Principles Applied in this Chapter

• Principle 2: There is a Risk-Return Tradeoff

2.1 THE BASIC STRUCTURE

• Principle 4: Market Prices Reflect
Information OF THE U.S. FINANCIAL
MARKETS
• Principle 5: Individual Respond to Incentives

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-49 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-50

Three Players in the Financial Figure 2-1 Financial Markets,

Markets Institutions, and the Circle of Money

Within the financial markets, there are three

principal sets of players that interact:

– Borrowers (individuals and businesses)

– Savers (mostly individuals)
– Financial Institutions (Intermediaries) (ex.
Commercial banks)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-51 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-52

Financial Intermediaries

Financial institutions like commercial banks,

finance companies, insurance companies,
2.2 THE FINANCIAL investment banks, and investment companies
MARKETPLACE: are called financial intermediaries as they
help bring together those who have money
FINANCIAL INSTITUTIONS
(savers) and those who need money
(borrowers).

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-53 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-54

9
 Commercial Banks – Everyone’s
Money versus Capital Market
Financial Marketplace

• Money market - markets for short-term

debt instruments (such as T-bills, Commercial banks collect the savings of
Commercial paper). individuals as well as businesses and then
lend those pooled savings to other
• Capital market - markets for long-term individuals and businesses. They earn
debt and equity instruments (such as money by charging a rate of interest to
Common stock, Preferred stock, Corporate borrowers that exceeds the rate they pay to
bond, U.S. Treasury bond). savers.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-55 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-56

Non-Bank Financial Intermediaries Financial Services Corporations

• These include: • Financial services corporation are in the

– Financial services corporations, such as GE lending or financing business, but they are
Capital Division; not commercial banks.
– Insurance companies, such as Prudential;
– Investment banks, such as Goldman Sachs; – For example: GE capital – it provides commercial
– Investment companies, including mutual funds, loans, financing programs, commercial
hedge funds and private equity firms. insurance, equipment leasing, and other services
in over 35 countries. It also provides credit
services to more than 130 million customers

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-57 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-58

Insurance Companies Investment Banks

• Insurance companies sell insurance to Investment banks are specialized financial

individuals and businesses to protect their intermediaries that help companies and
investments. governments raise money and provide
advisory services to client firms when they
• They collect premium and hold the premium enter into major transactions such as mergers
in reserves until there is an insured loss and
then pay out claims to the holders of the
insurance contracts. These reserves are
deployed in various types of investments
including loans to individuals and
businesses.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-59 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-60

10
Mutual Funds and Exchange Traded Mutual Funds and Exchange Traded
Funds (ETFs) Funds (ETFs) (cont.)

Mutual funds are professionally managed An exchange-traded fund (ETF) is similar to

according to a stated investment objective. a mutual fund except that the ownership
Individuals can invest in mutual funds by shares in the ETF can be bought and sold on
buying shares in the mutual fund at the net the stock exchange. Most ETFs track an index,
asset value (NAV). Mutual funds can either such as the the S&P 500.
be load or no-load funds. Load refers to
sales commission.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-61 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-62

Mutual Funds and Exchange Traded

Hedge Funds
Funds (ETFs) (cont.)

Mutual funds and ETFs provide a cost- Hedge funds are similar to mutual funds but
effective way to diversify and reduce risk. For are less regulated, take more risk, and are
example, by buying a mutual fund or ETF that generally open only to high net worth
invests in S&P 500,you can indirectly investors (typically $1 million and above). In
purchase a portfolio that tracks 500 stocks addition to management fee (about 2%),
with just one transaction. most funds include an incentive fee (typically
20% of profits) based on the fund’s overall
performance.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-63 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-64

Private Equity Firms Private Equity Firms (cont.)

Private equity firms is a financial Venture capital firms provide financing for
intermediary that invests in equities that are private start-up companies when they are first
not traded on the public capital markets. Two founded. For example, initial financing of
types of private equity firms dominate this Google was provided by a venture capital
group: Venture capital (VC) firms and firm.
Leveraged buyout (LBO) firms.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-65 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-66

11
Private Equity Firms (cont.)

Leveraged buyout (LBO) firms acquire

established firms that typically have not been
performing well with the objective of making 2.3 THE FINANCIAL
them profitable again and then selling them. MARKETPLACE: SECURITIES
An LBO typically uses debt to fund the
MARKETS
purchase of a firm.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-67 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-68

Security Primary versus Secondary Market

• A security is a negotiable instrument that • Primary market – a market in which

represents a financial claim. It can take the securities are bought and sold for the first
form of ownership (stocks) or a debt time. The firm selling securities receives the
agreement. money raised.

• The securities market allow businesses and • Secondary market – a market for
individual investors to trade the securities subsequent trading of previously issued
issued by public corporations. securities. The issuing firm does not receive
any new money.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-69 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-70

Figure 2.2 Security Markets Provide a Link

between the Corporation and Investors Types of Securities

Debt Securities: Firms borrow money by

selling debt securities in the debt market.
Debt is classified based on maturity period:
Less than one year (issued in money market),
one to ten years (called Note, issued in
capital market), more than 10 years (called
bond, issued in capital market)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-71 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-72

12
Types of Securities (cont.) Types of Securities (cont.)

Equity securities represent ownership of the • Common stock represents equity

corporation. There are two major types of ownership in a corporation, provides voting
equity securities: common stock and rights, and entitles the holder to profits in
preferred stock. the form of dividends.

• Preferred stock is an equity security. It

gives preference, relative to common
stockholders, with regard to dividends and
claim on assets.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-73 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-74

Stock Markets Stock Markets (cont.)

A stock market is a public market in which the • Organized security exchanges physically
stock of companies is traded. Stock markets occupy space and financial instruments are
are classified as either organized security traded on their premises. For example, the
exchanges or the over-the-counter (OTC) New York Stock Exchange (NYSE) located in
markets. New York.

• Today, the NYSE is a hybrid market,

allowing for face-to-face trading on the floor
of the stock exchange in addition to
automated electronic trading.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-75 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-76

Stock Markets (cont.) Figure 2-3 Common Stock Price Quotes

NASDAQ (National Association of Securities

Dealers Automated Quotations) is an over-
the-counter market and describes itself as a
“screen-based, floorless market”. In 2013,
nearly 3,200 companies were listed on
NASDAQ, including Starbucks, Google, Intel
and Whole Foods.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-77 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-78

13
 Table 2.2 Characteristics of
Other Financial Instruments
Different Financial Instruments

Table 2.2 provides a list of different financial

instruments beginning with the shortest-
maturity instruments (U.S. Treasury bills) that
are traded in the money market and moving
through to the longest-maturity instruments
(common stock) that are traded in the capital
market.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-79 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-80

Table 2.2 Characteristics of Different Table 2.2 Characteristics of Different

Financial Instruments (cont.) Financial Instruments (cont.)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-81 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-82

Table 2.2 Characteristics of Different Table 2.2 Characteristics of Different

Financial Instruments (cont.) Financial Instruments (cont.)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-83 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-84

14
Financial Markets and the Financial Financial Markets and the Financial
Crisis Crisis (cont.)

• Year 2007 - Financial crisis in the United Securitization Process

States that lead to recession and spread 1. Homebuyers borrow money by taking out
worldwide. a mortgage loan
• Main Causes – Real estate defaults and 2. Lender sells the mortgage to another firm
MBSs or financial institution.
• Effects - The government bailed out 3. Financial institution pools together a
institutions, unemployment skyrocketed, the portfolio of mortgages. The purchase of
stock market plummeted, there were no that portfolio is financed through sale of
major stand-alone investment banks left. MBS.

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-85 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-86

Financial Markets and the Financial Financial Markets and the Financial
Crisis (cont.) Crisis (cont.)

4. MBSs are sold to investors who can hold In 2010 the Dodd-Frank Wall Street Reform
them as investments or resell them to and Consumer Protection Act was passed,
others. which subjects banks and non-bank financial
institutions to more oversight and greater
transparency. One of the rules, “Volker”
Since the original lender gets the money back rule, prohibits banks from proprietary
quickly and does not have to worry about trading.
repayment, it may not adequately screen
the loan applicants. Financial crisis began
with poor screening and spread worldwide
through sale of MBSs.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-87 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-88

Key Terms Key Terms (cont.)

• Accredited investor • Debt securities

• Bond • Defined benefit plan
• Capital market • Defined contribution plan
• Commercial bank • Equity securities
• Common stock • Exchange-traded funds (ETFs)
• Coupon rate • Face or par value
• Credit default swaps • Financial intermediaries

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-89 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-90

15
Key Terms (cont.) Key Terms (cont.)

• Hedge fund • Mutual fund

• Investment bank • Net asset value (NAV)
• Investment company • Note
• Leveraged buyout fund • No-load fund
• Load fund • Organized security exchanges
• Maturity • Over-the-counter markets
• Money market • Preferred stock

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-91 Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-92

Key Terms (cont.)

• Primary market
• Private equity firm
• Proprietary trading
• Secondary market
• Security
• Venture Capital firm

Copyright ©2014 Pearson Education, Inc. All rights reserved. 1-93

16