Class Sessions 5 and 6: Foundations of Finance

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1 Class Sessions 5 and 6: Foundations of Finance Associated Reading: Text Chapter 1 Key Terms modern corporate finance limited liability valuation assets debt equity sole proprietorship partnership corporation stakeholder view of the firm cash flow shareholder wealth maximization Summary of Chapter 1 With time value under our belts, we can go back and look at the softer side of finance. After defining modern corporate finance, you are asked to think about the corporation as a collection of contracts, to consider the types of contracts formed by the groups of people who contract through the corporation, and finally to consider the goals and objectives of each group. This discussion leads into a set of important and complex issues, such as whose goals should the corporation satisfy? These class sessions also introduce four basic economic principles that form the foundation of financial decision making. With the four principles at hand, and with consideration of time and risk, financial managers can make decisions that are consistent with the objective known as shareholder wealth maximization Andrew Hall Class Notes to FOMGT301 Spring Page 23

2 Class Outline I. Defining Corporate Finance: A. Corporation: According to Random House: a corporation is an association of individuals, created by law and existing as an entity with powers and liabilities independent of those of its members. Corporation: According to Chambers and Lacey: a corporation is a legal entity defined by collections of contracts that serve to link groups of people together. Class Application #1: Using Chambers and Lacey s definition of a corporation, try to list of at least six such groups. shareholders, who provide risk capital to the firm. The shareholder s contract includes limited liability, meaning they can lose only the amount of money invested Andrew Hall Class Notes to FOMGT301 Spring Page 24

3 B. Finance: According to Chambers and Lacey: Finance is the study of the allocation of scarce resources through time and with uncertainty. 1. Two examples of allocating scarce resources would be: Deciding which assets to own? (The investment decision) Deciding which securities to use to finance those assets? (The financing decision) 2. Time: An immediate outlay in exchange for future inflows. 3. Uncertainty: An expectation, not a guarantee, that inflows will be received. Class Application #2, Time and Risk: Would you invest $1,000 today for the chance to receive $1,250 in the future? Consider both time and risk. Answer: How long in the future? Using 10% interest rates: $1,000 received in 10 years is worth about $390 today $1,000 received in 25 years is worth about $90 today $1,000 received in 50 years is worth about $10 today Andrew Hall Class Notes to FOMGT301 Spring Page 25

4 How much risk? If the future is 5 years, then this investment has a return approximately Class Application #9, Corporate Ethics, Text Chapter 14, Problem 7: The Keystone Pharmaceutical Company received permission from the FDA to sell Cardizone. Cardizone is a breakthrough drug that has potential of saving thousands of lives. However the research indicates that the drug can cause serious side effects in a small percentage of potential users. Keystone s President calls the Board of Directors together and four options are discussed: 1. Drop all plans of selling Cardizone. The risk of serious illness, or death, although remote, is a risk that the company will not take no matter what the benefits. 2. Place a visible warning label of the potential side effects on the package. This warning will significantly lower the risk of injury or death, but will also lower the usage. The firm s liability will be significantly lower. 3. Put a rather limited warning on the package. Such a warning would permit higher sales, but would lead to higher risks and would provide less protection from lawsuits. 4. Do nothing. What would you recommend, keeping in mind corporate goals? Andrew Hall Class Notes to FOMGT301 Spring Page 26

5 What should the goal or objective of the firm be? Class Application #7: Back to the groups of people who contract through a corporation: What do you think is the most important objective for each of these groups? For example, shareholders; who want the stock price to be as high as possible. bondholders employees managers suppliers governments community customers bankers retirees landlord auditors and accountants Andrew Hall Class Notes to FOMGT301 Spring Page 27

6 II. Economic Principles: Key Terms positive marginal utility diminishing marginal utility diminishing marginal return conservation of value market values agency relationship agency cost Prices are accurate measures of value, and that prices adjust to reflect the tastes and preferences of consumers. The next four economic principles support this result: A. Principle 1. Positive Marginal Utility (PMU): Given a choice, rational people prefer more wealth to less wealth, where wealth is defined as the sum of the value of all of the things owned. Class Application #3: PMU, Text Chapter 1, Problem 1: You won a CD through a local radio station at a store offering full cash refunds - no questions asked. Which of the following would you choose? Why? 1. Greatest Chants of the 11th Century. $ Greatest Rock Hits of the 20th Century. $ Saddest Country Hits of the 80 s. $ Most Exciting V.P. Memoirs. $19.99 Answer: The best choice is the one that produces the most wealth, as long as markets allow people to exchange whatever assets they own for whatever assets they prefer. This principle states that people should concentrate their productive efforts wherever they own a comparative advantage, and also provides the basis for what is known as separation, or the ability to make certain decisions separately from the tastes and preference of the beneficiaries. 1. Why is PMU important for financial managers? Andrew Hall Class Notes to FOMGT301 Spring Page 28

7 B. Principle 2. Diminishing Marginal Utility (DMU): More and more units of consumption create less and less additional happiness when compared with previous units of consumption. Class Application #4: DMU, Workshop 1.1 in Text Chapter 1: Given an amount of money to spend, how much pizza and root beer should you consume? Amount of Pizza or Root Beer Total Happiness Pizza Total Happiness Root Beer Answer: Consume pizza until the point where the marginal happiness of that next slice is less than the marginal happiness of consuming root beer (or any other products desired). But there's more. DMU is the reason that people limit the amount of risk they bear, because risk offers opportunities for higher wealth, but dangers of lower wealth. For most people, the unhappiness that comes from losing money is greater than the happiness der 1. Why is DMU important for financial managers? C. Principle 3. Diminishing Marginal Return (DMR): Investment occurs up to the point where benefits earned are just equal to the cost of investment. Class Application #5: DMR: When to stop investing: From this list of projects, try to determine where investment should stop. What other information might be useful? Andrew Hall Class Notes to FOMGT301 Spring Page 29

8 Project Investment Today Inflow One Year From Today Answer: Project 1 is a great choice with a 25% return, and Project 2 looks very good, returning 15%. Project 7 is horrible, losing 2%, while Project s 6 & 5 are bad, returning 0% and 1%. Project 4 is unexciting with a 3% return. But what about Project 3? What additional information would be useful? 1. Why is DMR important for financial managers? D. Principle 4. Conservation of Value (CV), also known as the Law of One Price (LOOP): Identical goods must have identical values. Class Application #6: From Text Window 1.5: If we break the T-Bond into its two components, should the value of the whole equal the sum of its parts? Answer: It should. The best explanation is to ask what would happen if it weren t true? 1. Why is CV or LOOP important for financial managers? Andrew Hall Class Notes to FOMGT301 Spring Page 30

Class Notes for FOMGT301 Corporation Finance Spring 2004

Class Notes for FOMGT301 Corporation Finance Spring 2004 These notes are a compilation from: 1. Class Notes Supplement to Modern Corporate Finance Theory and Practice by Donald R. Chambers and Nelson J.