Principles of Finance - 1 [PDF]

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PRINCIPLES OF FINANCE TCH 302

Lecturer: Chu Mai Linh, Ms. Email: [email protected]

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ASSIGNMENTS & ASSESSMENTS • ATTENDANCE Attendance is compulsory in accordance with FTU regulations. Students are strongly advised not to miss lecture hours since success is closely related with attendance. • ASSIGNMENTS & ASSESSMENTS % Contribution

Form of Assessment

10% of the final mark 30% of the final mark

Attendance Examination

60% of the final mark

Examination

Size of the assessment Duration

Feedback method

45 minutes (4 pages) Multiple Choices and Short answer questions

Correct answers

60 Minutes

Correct answers

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TEXTBOOKS 1. The Economics of Money, Banking, and Financial Markets, Frederic S. Mishkin, 11th edition, 2016

2. Money, Banking and Financial Markets, Stephen G. Cecchetti and Kermit L. Schoenholtz, 5th edition, 2017

3. Finance: Applications and Theory, Marcia M. Cornett, 2nd edition, 2012

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SYLLABUS PLAN Modules

Compulsory readings

1 Introduction to Finance

Mishkin, Chapter 1 Cecchetti, Chapters 1,2 & 3 Cornett, Chapter 1

2 Financial Statements 3 Analyzing financial statements

Bodie, Chapter 3 Cornett, Chapters 2 & 3 Bodie, Chapters 4 & 5,8 & 9 Mishkin, Chapter 4 Cornett, Chapters 4 & 5

4 Time Value of Money 5 Understanding Financial Markets and Institutions

Mishkin, Chapters 1,2,3 & 8 Cecetti, Chapter 11 Cornett, Chapter 6,7 & 8

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INTRODUCTION TO FINANCE

Mishkin, Chapter 1 Cecchetti, Chapters 1,2 & 3 Cornett, Chapter 1 Introduction to Finance

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Content 1. Defining Finance 2. Why study Finance? 3. Financial Functions 4. Business Organization 5. Firm Goals 6. Financial Markets, Intermediaries and the Firm 7. The Financial System 8. Six Parts of the Financial System 9. Flows of Funds through the Financial System

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Finance in Business and in Life Example #1 • Lucas has a plan to provide an online learning platform for students. He has finally designed the websites and feels that he is offering a perfect educational service, combining tutorial and selflearning. As the result, his business runs well and starts bringing some profits. Lucas would like to invest more in this website and expand the customer base. Lucas needs more money to upgrade the technology and hire and train more people. • How can he get the capital he needs to expand?

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Finance in Business and in Life Example #2 • Song is interested in finance and would like to invest some money in stocks. However, she has heard about loss and failure of the corporations. In the past years, Song learned about the delisting of CotecLand (2021), the bankruptcy cases of Lehman Brothers (2008). These firm stockholders lost their entire money in these firms. • Song would like to know what guarantee she has as an investor against losing her investment.

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Defining Finance

• Type 2 = individual investors • Type 3 = corporations or other types of companies

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Defining Finance • Return of capital to investors

-----------------------------------------------------------------• Not all of the cash will return to the investors

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Defining Finance • Investments

---------------------------------------------------------------• Financial managements

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Defining Finance

Investments

• methods and techniques for making decisions about: • what kinds of securities to own, which firms’ securities to buy, • and how to pay the investor back in the form that the investors wishes (e.g., the timing and certainty of the promised cashflows).

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Defining Finance

Financial Management • deals with a firm’s decisions in acquiring and using the cash that is received from investors or from retained earnings.

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Defining Finance

Financial Management 1. How to or organize the firm in a manner that will attract capital 2. How to raise capital (e.g., bonds versus stocks). 3. Which projects to fund. 4. How much capital to retain for ongoing operations and new projects. 5. How to minimize taxation. 6. How to pay back capital providers. Introduction to Finance

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Defining Finance

Financial Institutions and Markets • The organization that facilitate the flow of capital between investors and companies. • e.g.: banks, insurance companies, stock companies, mutual funds

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Defining Finance

International Finance The use of finance theory in a global business environment. e.g.: law, risks and business relationships across different countries

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Defining Finance • Finance is the study of applying specific value to things we own, services we use, and decision we make. • E.g.: shares of stock in a company, payments on a home mortgage, the purchase of an entire firms.. • In finance, cash flow is the term that describes the process of paying and receiving money.

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Cash flows are not guaranteed! • Future cash flows are uncertain in term of timing and size, and we refer to this uncertainty as risk. • E.g.: investors experience risk about the return of the capital. • Comparing rewards with risks involves assessing the value today of cash flows that we expcect to receive in the future.

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Finance vs Accounting • In the most companies, the financial function is usually closely associated with the accounting function. Accountant’s job what happened in the past

Finance job historical figures + current information  what should happen now and in the future with the firm’s money.

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Why study Finance? Example #3 • Suppose you have some savings money. What kinds of financial assets should you choose these days?

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Why study Finance? 1. To manage your personal resources (e.g. to borrow money to buy a new car, to refinance your shop house at a lower rate…) 2. To deal with the world of business 3. To pursue interesting and rewarding career opportunities 4. To make informed public choices as a citizen 5. To expand your mind Introduction to Finance

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Financial Decisions

1. Financial decisions of households 2. Financial decision of firms 3. Financial decision of government

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Financial decisions of households Households face 4 basic types of financial decision: • 1. Consumption and saving decisions • 2. Investment decisions • 3. Financing decisions (if they borrow, they incur a liability = debt, • Their wealth or net worth = assets – liabilities) • 4. Risk-management decisions

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Financial decision of firms The branch of finance dealing with financial decisions of firms is called business finance or corporate finance. • Capital budgeting process such as whether to build a plant or produce a new product. • Capital structure decision such as how much debt and how much equity it should have in its capital structure. • Working capital management, such as whether it should extend credit to customer or demand cash on delivery. Introduction to Finance

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Financial decision of government • A government budget is a government document presenting the government's proposed revenues and spending for a financial year that is often passed by the legislature (parliament", "congress", and "assembly“)- Government budgets are of three types: • Balanced Budget: when government revenue and expenditure are equal. • Surplus Budget: when anticipated revenues exceed expenditure. • Deficit Budget: when anticipated expenditure is greater than revenues.

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The Financial Function • How the financial function fits in and interacts with other areas of the firm?

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The Financial Function • Finance affects the firm in many ways and throughout all levels of a company’s organizational chart, providing guidance for both strategic and day-to-day decisions of the firm and collecting information for control and feedback about the firm’s financial decisions.

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Financial Manager (CFO) • Both the company treasurer and the controller report to the chief financial officer.

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Business Organization • The number of owners is the key to how business structures are classified. • Who controls the firm. • Who owns the firm. • What the owners’ risks are • What access to capital exists. • What the tax ramifications are. Introduction to Finance

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Business Organization

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Business Organization

Types of U.S firms

Source: www.irs.gov, 2017

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Business Organization

Corporations

• A public corporation is legally independent entity that completely separate from its owners. Limited liability Double taxation

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Business Organization

Corporations

• Double taxation You are a shareholder in a corporation. The corporation earns $5 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The dividend is income to you, so you will then pay taxes on these earnings. The corporate tax rate is 40% and your tax rate on dividend income is 15%. How much of the earnings remains after all taxes are paid?

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Business Organization

Puzzles

1. Why must an entrepreneur give up some control of the business as it grows into a public corporation? 2. What advantages doe the corporate form of organization hold over a sole proprietorship?

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Firm Goals • To maximize shareholder wealth vs to maximize total satisfaction of all stakeholders in a business. • Maximizing owners’ equity can also stated as maximizing the current value per share, or stock price of existing shares. • Common alternatives goals are: o income or profit o costs o market share. Introduction to Finance

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Firm Goals

Puzzles

• Are these the same goals? Please explain your answer.

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Agency Theory • Whenever one party (the principal) hires someone else (the agent) to work for him/her, their interaction is called an agency relationship.

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Agency Problem • Because of the separation of ownership and control in a corporation, managers have little incentive to work in the interests of the shareholders when this means working against their own self-interest.

• Solutions: o To ignore it. Corporate Governance

o To monitor managers’ actions o To align managers’ personal interest with those of owners (e.g.: options, employee stock options plan ESOP) Introduction to Finance

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Corporate Governance • A set of laws, policies, incentives, and monitors designed to handle the issues arising from the separation of ownership and control. • CG balances the needs of shareholders and managers.

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Financial markets, Intermediaries and the Firm

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Financial System • Financial system is defined as the set of markets and other institutions used for financial contracting and exchange of assets and risks. • The financial system includes markets, stocks, bonds and other financial instruments, financial intermediaries and the regulatory bodies that govern all of these institutions.

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Six Parts of the Financial System 1.Money 2.Financial Instruments 3.Financial Markets 4.Financial Institutions 5.Regulatory Agencies 6.Central Bank

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Money • Money is the medium of exchange and to store value • Money is at the heart of the payments system. ………………………………………………………………. • What is the difference between wealth and income? • What about liquidity? Introduction to Finance

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Financial Instruments • The written legal obligation of one party to transfer something of value, usually money, to another party at some future date, under certain conditions.

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Financial Instruments 1. Financial instruments act as a means of payment (like money). Employees take stock options as payment for working. 2. Financial instruments act as stores of value (like money). Financial instruments generate increases in wealth that are larger than from holding money. Financial instruments can be used to transfer purchasing power into the future. 3. Financial instruments allow for the transfer of risk (unlike money). Examples: Insurance contracts, future contracts.

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Examples of financial instruments • The basic types of financial assets are debt, equity and derivatives. • Debt instruments are issued by anyone who borrows money: corporate bonds, government bonds, residential and commercial mortgages and consumer loans. • Derivative instrument are those where their value and payoffs are “derived” from the behaviors of the underlying. • Underlying instruments are used by saver/lenders to transfer resources directly to investors/borrowers.

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Features of Financial Instruments • These contracts are very complex. This complexity is costly, and people do not want to bear these costs. • Standardization of financial instruments overcomes potential costs of complexity. Most mortgages feature a standard application with standardized terms. • Introduction to Finance

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Features of Financial Instruments • Financial instruments also communicate information, summarizing certain details about the issuer. • Financial instruments are designed to handle the problem of asymmetric information.

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Financial Markets Financial markets are places where financial instruments are bought and sold. • These markets are the economy’s central nervous system. • These markets enable both firms an individuals to find financing for their activities. • These markets promote economic efficiency. They ensure resources are available to those who put them to their best use. They keep transactions costs low.

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Stock Market Indexes

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Financial Institutions • Firms that provide access to the financial markets, both to savers who wish to purchase financial instruments directly and to borrowers who want to issue them. • Also known as financial intermediaries. ▫ Examples: commercial banks, investment banks, insurance companies, securities firms, and pension funds. Introduction to Finance

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Government regulatory agencies • Government regulatory agencies provide wide-ranging financial regulation – rules and supervision. Increasing Information Available to Investors Ensuring the Soundness of Financial Intermediaries (Restrictions on Entry, Disclosure, Restrictions on Assets and Activities, Deposit Insurance, Limits on Competition, Restrictions on Interest Rates)

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Government regulatory agencies

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Central banks • Central banks began as large private banks to finance wars. • Central banks control the availability of money and credit to ensure low inflation, high growth and stability of financial system

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Flow of Funds Through the Financial System

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Flow of Funds Through the Financial System

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Summary A healthy and constantly evolving financial system is the foundation for economic efficiency and economic growth. It has six parts: 1. Money is used to pay for purchases and to store wealth. 2. Financial instruments are used to transfer resources and risk. 3. Financial markets allow people to buy and sell financial instruments. 4. Financial institutions provide access to the financial markets, collect information and provide a variety of other services. 5. Government regulatory agencies aim to make the financial system operate safely and reliably. 6. Central banks stabilize the economy.

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SYLLABUS PLAN Modules

Compulsory readings

1 Introduction to Finance

Mishkin, Chapter 1 Cecchetti, Chapters 1,2 & 3 Cornett, Chapter 1

2 Financial Statements 3 Analyzing financial statements

Bodie, Chapter 3 Cornett, Chapters 2 & 3 Bodie, Chapters 4 & 5,8 & 9 Mishkin, Chapter 4 Cornett, Chapters 4 & 5

4 Time Value of Money 5 Understanding Financial Markets and Institutions

Mishkin, Chapters 1,2,3 & 8 Cecetti, Chapter 11 Cornett, Chapter 6,7 & 8

Financial Statements

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REVIEWING FINANCIAL STATEMENTS

Bodie, Chapter 3 Cornett, Chapters 2 & 3

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Content 1.Balance Sheet 2.Income Statement 3.Statement of Cash Flows 4.Free Cash Flow 5.Statement of Retained Earnings

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Looking for a perfect company

• Song wants to invest in DPH Tree Farm Inc. Song has a set of recent financial statements from DPH Tree Farm’s annual report but is not sure how to read them or what are the meanings of all these numbers and reports. • What are the four financial statements? • What information can she gets from these statements? Financial Statements

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An annual report • Four basic financial statements: 1. The balance sheet 2. The income statement 3. The statement of cash flows 4. The statement of retained earnings • A financial statement provides an accountingbased picture of a firm’s financial position.

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The balance sheet • Assets = Liabilities + Equity

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Financial Statements

Balance Sheet

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Net working capital

• Net working capital = Current assets – Current liabilities

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Book vs Market Value • Balance Sheet shows its book (or historical cost) value based on generally accepted accounting principles. • Because of inflation and market forces, many assets are more worth now thatn they were worth when the firm bought them. • Book values can differ widely from market values for the same assets. Financial Statements

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Computing Book vs Market Value • D2K Inc. lists fixed assets and current assets of $25 million and $10 million respectively on its balance sheet. The firm’s fixed assets and current assets were recently appraised at $32 and $ 11 million respectively. • The current liabilities’ book and market values stand at $6 million and the firm’s long-term debt is $15 million. • What are the book value and market value of the firm’s shareholders equity? Construct the book value and market value balance sheet for D2K Inc. Financial Statements

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Income Statement

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Some equations 1. EPS 2. DPS 3. BVPS

4. MVPS = Market price of the firms’ common stock

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Financial Statements

Income Statement

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Corporate Income Taxes • Corporate Tax Rates as of 2012

• The U.S tax structure is progressive, meaning that the larger the income, the higher the taxes assessed. Financial Statements

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Average Tax Rate vs Marginal Tax Rate • Average tax rate = • Marginal tax rate is the additional taxes a firm must pay out for every additional dollar of taxable income it earns.

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Calulating the tax rate • E.g: Antonio Inc. earned $17 mill taxable income (EBT) in 2012. Use the tax schedule to compute the firm’s 2012 tax liability, its average tax rate and its marginal tax rate.

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Effect of Debt vs Equity Financing on Returns • Supposed you wonder between two alternative investments (in Firm A or Firm B). Both are active in the same industry and have identical operating incomes of $10 million. Firm A finances its $24 million in assets with $22 million in debt (on which it pays 10% interest) and $2 million in equity. Firm B finances its $24 million in assets with $24 million in equity and no debt. Both firm has pay 30% tax on their taxable income. • Calculate the income that each firm has available to pay its debt and shareholders and the ROEs. Financial Statements

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The Statement of Cash Flow • Financial managers and investors are far more interested in actual cash flows than in the backwardlooking profit listed on the income statement. • A financial statement that shows the firm’s cash flows over a given period of time.

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The Statement of Cash Flow

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The Statement of Cash Flow

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Financial Statements

Statement of Cash Flows

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Free Cash Flow • The cash that is actually available for distribution to the investors in the firm after the investments that are necessary sustain the firm’s ongoing operations are made.

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Computing FCF • What was DPH Tree Farm’s free cash flow for 2012?

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Statement of Retained Earnings • Increases in retained earnings occur not just because a firm has net income, but also because the firm’s common shareholders agree to let management reinvest net income back into the firm rather than pay it out as dividends. • Reinvesting net income back into retained earnings allows the firm to grow by providing additional funds that can be spent on plant and equipment, inventory, and other assets needed to generate even more profit. Financial Statements

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Financial Statements

Statement of Retained Earnings

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