Lecture Notes Week 1 FINS1613

Introduction

3/16/2014 10:37:00 PM

Fundamental questions What projects should a firm purchase? How should a firm raise money for and distribute profits from projects? o How do they raise capital? o How do they raise profits? A business plan Evaluating the opportunity Projects Key Characteristics o Profits and costs cash flows determined by (i) expected amount and (ii) expected timing o Uncertainty risk described by possible outcomes from

the project Types of Firms Terminology o Ownership The right to share in a firms profits o Control The right to directly manage or elect management of a firm o Personal Liability The responsibility to pay a firms financial obligations using personal assets when the firm cannot o Limited liability A limit that the owner can only lose the value of their investment when the firm cannot pay its financial obligations Sole Trader o Business owned and controlled by a single person o Personally liable for firms debts o Business ceases existence with death or withdrawal of the sole trader o Profits taxed at personal level o Also known as sole proprietorships o If the business fails, the bank can force the business (and owner) to sell assets to repay the loan General Partnership o Equal partnership between all parties o Equal liabilities

o If the business fails, the bank can lay claim against the assets of all the General Partners Limited Partnership o At least one limited partner; has ownership, but no control o If the business fails, the bank can lay claim against the assets of all the General Partners, only. Partnerships o Business owned by several partners General partners Ownership, control, and personal liability Limited partners Ownership, no control and limited liability o Profits taxed at personal level o Business ceases to exist with death or withdrawal of a single general partner unless other provisions are made Corporation o Includes shareholders o Board of Directors Each director is elected by the firms owners Hired the CEO o CEO Monitors firm and sets high level strategy Objective is to maximize firm value Everyday manager of the firm Implements rules and policies set by the board of directors Advised by high level executives Objective is to maximise firm value

o Chief Financial Officer (CFO) Evaluates investment decisions for the fimr Evaluates financing decisions for the firm Objective is to maximise firm value Key features of a corporation It is its own legal entity, distinct from the owners There is a separation of powers o Advantages over partnerships and sole traders Limited liability for the owners

Business continues operation when ownership

changes o Disadvantages Agency costs We assume that employees have their own objectives These personal objectives may not always agree with the value of maximizing objective of the firms owners An agency cost arises when an employee takes an action that serves their own interests instead of maximizing firm value Taxation o If the business fails, the bank can lay claim only against the assets of the company The Financial Manager Two primary responsibilities o Investment decisions Which projects should the firm pursue? o Financial decisions How should the firm raise capital to finance these projects? How should the firm distribute profits to investors? Section 1: Financial Mathematics Time Value of Money The difference in value between money today and money in the future. Or, the observation that two cash flows at two different points in time have different values (A dollar today is worth more than a dollar tomorrow) In order to compare or combine cash flows it is necessary to

convert all values to the same units by moving them to a common point in time Compounding Interest = Principle x (Interest Rate/100) Compounding Assumption We will always assume that interest is kept in the account. Therefore, the ending value in one period becomes the starting principle used to compute the interest payment in the subsequent period

Compounding Interest = Principle x (1+Interest Rate

Decimal)^n Discounting To calculate the equivalent present value of a cash flow in the future, multiply the future cash flow by a discount factor, or equivalently, divide by the appropriate interest rate factor. Discounting = P x (1/(1+r)n)

Lecture Notes Week 2 FINS1613