ECOM 061 Financial Economics. ECOM 061 Financial Economics. ECOM 061 Financial Economics. ECOM 061 Financial Economics. ECOM 061 Financial Economics

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1 João Mergulhão Office hours: Fridays 3pm - 5pm j.mergulhao@qmul.ac.uk Internet: All material are available through (login required). First weeks materials will be publicly available in my webpage Module description define and provide rigorous training in Finance show how firms or individuals allocate scarce resources over time under conditions of uncertainty. Optimization over Time Asset Pricing Risk 1 2 Topic 1: Financial Economics Topic 2: Financial Markets and Institutions Topic 3: Allocating Resources Over Time Topic 4: The Analysis of Investment Projects Topic 5: Principles of Market Valuation Topic 6: Valuation of Known Cash Flows: Bonds Topic 7: Valuation of Common Stocks Topic 8: Principles of Risk Topic 9: Hedging, Insuring, and Diversifying Topic 10: Portfolio Opportunities and Choice Main Reference Bodie, Merton and Cleeton (2009), Financial Economics, Second Edition, Pearson International Edition. Companion Website: Additional References Bodie, Kane & Marcus (2008), Investments, Eighth Edition, McGraw-Hill La Porta, Lopez-de-Silanes, Shleifer and Vishny, Law and Finance, Journal of Political Economy, vol. 106(6), pages , December. Haugen, The Inefficient Stock Market: what pays off and why, 2001, Prentice Hall *Topic 11: Capital Market Equilibrium 3 4 Assessment Final examination (50%) Midterm exam (30%) 02/11/2010 Coursework (20%) Coursework Starting point: La Porta, Lopez-de-Silanes, Shleifer and Vishny, Law and Finance, Journal of Political Economy, vol. 106(6), pages , December Group formation: one lawyer, one economist, maximum 3 persons per group. Coursework proposal submission 05-Nov-2010 Coursework submission 02-May Chapter 1 1

2 Topic 1: Chapter 1 Contents Objectives To Define Finance The Value of Finance Introduction to the Players. Readings BMC ch. 1 Financial Economics Why Study Finance 1.3 Financial Decisions of Households 1.4 Financial Decisions of Firms 1.5 Forms of Business Organization 1.6 Separation of Ownership and 1.7 The Goal of 1.8 Market Discipline: Takeovers 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 When implementing decisions, people make use of the Financial System defined as the set of markets and other institutions used for financial contracting and exchange of assets and risks Understanding finance helps you evaluate these uncertain cash flows 9 10 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 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 Chapter 1 2

3 1.2 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 The intellectual challenge Financial Decisions of Households Consumption and saving decisions Investment Decisions Financing Decisions Risk-management decisions 14 Important Terms Assets Personal investing & Asset allocation Liability, Debt Net Worth = Assets - Liabilities Exogenous and endogenous elements 1.4 Financial Decisions of Firms Business Firms entities whose primary function is to produce goods and services they vary widely in size from part-time businesses run from a spare room, to giant corporations (e.g. Mitsubishi or General Motors) with hundreds of thousands of employees, and an even larger ownership Strategic plans specify the business the firm is in strategic plans may change radically over time the firm s business may be defined in terms of a group of products, technologies or customers 17 The Capital Budgeting Process The preparation of a plan for acquiring factories, machinery, research laboratories, show rooms, warehouses, and human assets to implement the strategic plan The basic unit of analysis is the investment project. Investment projects are identified, triaged, and implemented in the capital budgeting process 18 Chapter 1 3

4 The Financing Process Once a new set of approved projects has been identified, it must be financed with retained earnings, stock, bonds, et cetera Capital structure is the amount of the firm s market value allocated to each category of issued securities. It determines ownership and risk level of the firms future cash flows Capital structure s unit of analysis is the firm as a whole (not an investment project ) 19 The capital structure also determines who controls the firm under different contingencies Common stock holders usually determine the membership of the board of directors Preferred stock holders usually gain some control if preferred dividends are not paid Bondholder covenants restrict decisions that could adversely affect bond values 20 Working Capital all firms (including highly profitable ones) that do not pay sufficient attention to working capital management may be seriously damaged by the resulting loss of investor and creditor confidence delayed in investment schedules sub-optimal temporary finance unscheduled sale of the firms assets Forms of Business Operation Sole Proprietorship a firm owned by an individual or family the assets and liabilities are the personal assets and liabilities of the proprietor unlimited liability low administrative costs 22 Forms of Business Operation Partnership A firm with 2 owners sharing the equity. A partnership agreement usually stipulates how decisions and profits (losses) are shared General partners 1 (unlimited liability) Limited partners 0 (don t manage business) Changes in ownership involve dissolving the old partnership and forming a new one 23 Forms of Business Operation Corporation a legal entity, distinct from its ownership may own property, borrow, sue, be sued, and enter into legal contracts not dissolved when shares are transferred shareholders elect directors, who appoint management pays corporate taxes, resulting in double taxation of owner (not sub-chapter S Corp.) limited liability (corporate veil may be lifted) 24 Chapter 1 4

5 1.6 Separation of Ownership and Owners delegate management if agency conflicts have a cost-effective resolution professional managers have specialized skills efficiencies of scale diversification of owner s portfolio savings in the cost of information gathering learning curve/going concern issues Goal of rule: Maximize the wealth of current shareholders Rule depends only upon production technology, market interest rates, market risk premiums, and security prices Alternative rules stated in terms of profit maximization are fraught with unresolved issues, and are better avoided Market Discipline: Takeovers The ownership of a corporation generally is widely dispersed & indirect (mutual funds) lacks internal communication channels is often ill-informed about mismanagement isn t willing to pay for & organize change can t wrestle control from a united selfperpetuating board of directors just sell stock when dissatisfied, contributing to downward share price pressures 27 Market Discipline: Takeovers In a competitive market, a mechanism that reduces mismanagement is the corporate take-over. Example: a customer, supplier, competitor, or professional raider gains specialized knowledge of the mismanagement the raider purchases a controlling interest in the stock, and installs new management The value of the stock rises, and the raider liquidates ownership at a profit 28 Chapter 1 5