Introduction to Finance
LUBS1036
Overview of the Module & Introduction to Foundations of Finance
Lecture 1
Module Overview
Module Details
• 20 credit module running across Semester 1 and Semester 2.
• 21 lectures, 10 seminars, and 2 workshops.
• Lectures: Explain theoretical issues using textbook and journal article materials.
• Seminars: Problem-solving sessions requiring active participation.
• Workshops: Supervised sessions introducing the Bloomberg terminal.
Assessment
• Three-hour exam at the end of Semester 2 (100% of module marks).
• Section A: Multiple choice questions (MCQs) — 25% of marks.
• Section B: 75% of marks — six questions; answer three. Mix of longer numerical and
essay questions, possibly with sub-questions.
Core Text
• Foundations of Finance (10th Global Edition) by Keown, Martin and Petty.
• Fundamentals of Corporate Finance (4th Edition) — additional text.
Introduction to Foundations of Finance
The Goal of the Firm
• The goal of the firm is to maximise shareholder wealth by maximising the price of
existing common stock.
• Good financial decisions increase stock price; poor financial decisions lead to a decline.
Five Principles That Form the Foundations of Finance
Principle 1: Cash Flow Is What Matters
• Accounting profits ≠ cash flows. A firm can generate accounting profits without cash,
or generate cash without reported profits.
• Cash flow, not profits, drives business value.
• Incremental cash flow = the difference between projected cash flows if the project is
accepted vs. rejected.
Principle 2: Money Has a Time Value
• A dollar received today is worth more than a dollar received in the future because of the
interest that can be earned.
• Opportunity cost = the cost of making a choice in terms of the next best alternative
forgone. Example: Lending money at 0% has an opportunity cost of 1% if a savings
account would have paid 1%.
Principle 3: Risk Requires a Reward
• Investors will not take on additional risk unless they expect additional reward or return.
• Investors expect compensation for both delaying consumption and for bearing risk.
Figure 1.1 The Risk-Return Trade-off
The horizontal axis of the graph is labeled Risk; the vertical axis is labeled Expected return. One line
extends from the vertical axis, parallel to the horizontal axis, representing the minimal expected return
investors want for delaying consumption. A second line slopes upward from the same point on the
vertical axis, showing that the more risk that is taken, the more additional return investors will expect.
Principle 4: Market Prices Are Generally Right
• In an efficient market, the prices of all traded assets fully reflect all available information
at any moment.
• Price changes reflect changes in expected future cash flows. Inefficiencies can exist due
to behavioural biases.
Principle 5: Conflicts of Interest Cause Agency Problems
• Separation of management and ownership creates an agency problem: managers may
not act in the best interest of shareholders.
• Agency conflict is reduced through monitoring (annual reports), compensation
schemes (stock options), and market mechanisms (takeovers).
Ethics and Trust in Business
• Ethical dilemma: Each person has their own set of values. Sound ethical standards are
important for business and personal success.
• Unethical decisions can destroy shareholder wealth (e.g., the Enron scandal).
The Role of Finance in Business
Three Basic Issues
• Capital budgeting decision: What long-term investments should the firm undertake?
• Capital structure decision: How should the firm raise money to fund these
investments?
• Working capital decision: How should cash flows arising from day-to-day operations
be managed?
Organisation of the Finance Function (Figure 1.2)
Figure 1.2 How the Finance Area Fits into a Firm
The organizational chart shows that the Board of Directors is at the top; the Chief Executive Officer
(CEO) reports directly to the Board. Three Vice Presidents (Marketing, Finance, and Production and
Operations) report to the CEO. The chart notes that the Vice President—Finance is sometimes
referred to as the Chief Financial Officer (CFO). Duties of this office are identified as (1) overseeing
financial planning, (2) strategic planning, and (3) controlling cash flow. A Treasurer and a Controller
report directly to the CFO. Duties of the Treasurer are identified as (1) cash management, (2) credit
management, (3) capital expenditures, (4) raising capital, (5) financial planning, and (6) management
of foreign currencies. Duties of the Controller are identified as (1) taxes, (2) financial statements, (3)
cost accounting, and (4) data processing.
• Treasurer: cash management, credit management, capital expenditures, raising capital,
financial planning, foreign currencies.
• Controller: taxes, financial statements, cost accounting, data processing.
Legal Forms of Business Organisation
Sole Proprietorship
• Owned by one individual who maintains title to all assets and profits. Unlimited personal
liability. Terminates on owner’s death or choice.
Partnership
• General Partnership: All partners are fully responsible for liabilities.
• Limited Partnership: One or more partners may have limited liability (restricted to
capital invested). At least one general partner must have unlimited liability. Limited
partners cannot participate in management.
Corporation
• Functions as a separate legal entity — can sue, be sued, own property.
• Shareholder liability restricted to the amount invested. Indefinite life.
• Benefits: limited liability, easy ownership transfer, easier capital raising, unlimited life.
• Drawbacks: no secrecy, potential decision delays, greater regulation, double taxation.
Double Taxation Example
• Earnings before tax = $1,000. Federal tax @ 25% = $250. After-tax income = $750.
• If $750 is distributed as dividends taxed @ 15%: dividend tax = $112.50. Total taxes =
$362.50.
S-Corporations
• Benefits: limited liability; taxed as a partnership (no double taxation).
• Limitations: owners must be individuals; cannot be used for corporate joint ventures.
Limited Liability Companies (LLCs)
• Benefits: limited liability; taxed like a partnership.
• Limitations: qualifications vary by state; must not appear as a corporation.
Table 1.1 — Summary of Business Organisational Forms
Form Owners Liability Dissolves on Taxation
Change
Sole Proprietorship One Yes Yes Personal/Pass-
Through
General Partnership No Limit Each partner Yes Personal/Pass-
fully liable Through
Limited Partnership At least 1 GP: Yes; LP: GP: Yes; LP: No Personal/Pass-
GP, no limit No Through
LPs
Corporation No Limit No No Corporate +
Personal
S-Corporation Max 100 No No Personal/Pass-
Through
LLC No Limit No No Personal/Pass-
Through
Finance and the Multinational Firm
• Many large firms (e.g., Coca-Cola) receive significant profits from overseas. U.S. firms
increasingly look to international expansion.
• Foreign firms also make their mark in the U.S. (e.g., Toyota, Honda, BMW in the auto
industry).
Flashcards
Flashcard 1
Q: What is the primary goal of the firm?
A: To maximise shareholder wealth by maximising the price of existing common stock.
Flashcard 2
Q: What is Principle 1 of the Foundations of Finance?
A: Cash Flow Is What Matters — accounting profits ≠ cash flows; cash flow drives business
value.
Flashcard 3
Q: What is the time value of money?
A: A dollar received today is worth more than a dollar in the future because today's dollar can
earn interest.
Flashcard 4
Q: What is an opportunity cost?
A: The cost of making a choice measured by the next best alternative that must be forgone.
Flashcard 5
Q: What is Principle 3: Risk Requires a Reward?
A: Investors will not take on additional risk unless they expect additional compensation
(reward).
Flashcard 6
Q: What is an efficient market?
A: A market in which security prices fully reflect all available information at any moment in time.
Flashcard 7
Q: What is an agency problem?
A: Conflict arising from the separation of ownership and management, where managers may
not act in shareholders' best interests.
Flashcard 8
Q: What are the three basic financial decisions?
A: Capital budgeting (investment), capital structure (financing mix), and working capital (day-to-
day cash management).
Flashcard 9
Q: What is a sole proprietorship?
A: A business owned by one individual with unlimited personal liability.
Flashcard 10
Q: What is double taxation in a corporation?
A: Profits are taxed at the corporate level and then again at the individual level when distributed
as dividends.
Flashcard 11
Q: What is the key advantage of an LLC?
A: Limited liability combined with pass-through taxation (taxed like a partnership, no double
taxation).
Flashcard 12
Q: What is the role of the Treasurer in a corporation?
A: Responsible for cash management, credit management, capital expenditures, raising capital,
financial planning, and foreign currencies.
Flashcard 13
Q: What is incremental cash flow?
A: The additional cash flows (inflows or outflows) that occur specifically as a result of accepting
a project.
Flashcard 14
Q: What is the benefit of a limited partnership structure?
A: Limited partners have liability restricted to their capital investment, while the general partner
retains unlimited liability.
Flashcard 15
Q: Why do corporations have unlimited life?
A: Because ownership (shares) can be transferred without dissolving the corporation, unlike a
sole proprietorship or general partnership.