FINANCIAL ECONOMICS

Role of Finance in Business - Business Owners & Managers make

decisions and take actions in
consideration of the financial
implications of those actions.
Finance - science and art of managing money.
- Study of how individuals, institutions,
governments, and businesses acquire,
spend, and manage money and other
financial assets.
- the focus of finance is the cash flow
Marginal Cost-Benefit Analysis - economic principle that states that
financial decisions should be made
and actions taken only when the added
benefits exceed the added costs.
Financial Service - Delivery of advice and financial
- products
- Financial institutions
- Financial markets
Financial Environment - Encompasses the financial system,
institutions, markets, and individuals
that make the economy operate
efficiently
- The areas in finance are all part of the
financial environment
- These areas do not operate in isolation
but interact or intersect with each
other

Legal Form of Business - most basic decision that all businesses

make (choosing).

Financial Manager’s Role - for each opportunity, the financial

manager should select the option that
 would bring in the highest expected
profit. Also called as “maximizing per
share (EPS)”.
Maximizing Per Share (EPS) - the amount earned on behalf of each
outstanding share of common stock.
- Earnings per share figures are
inherently backward-looking,
reflecting what has happened rather
than what will happen.
-
- an investment project with high profits and high risk could be less valuable than one
with lower profits and lower risk.
- to maximize shareholder wealth which is measured by the firm’s stock price.
- Shareholders are the residual claimants of a firm.
Stock price - considers the timing, magnitude, and
risk of the cash flows that investors
anticipate a firm to generate over time.
Stakeholders - a person, group or organization with a
vested interest, or stake, in the
decision-making and activities of a
business, organization or project.
How can financial managers maximize - By performing the five basic duties of
shareholder’s wealth?
corporate finance: External financing,
capital budgeting, financial
management, risk management,
corporate governance.
- Marginal Benefits > Marginal Cost
Why focus on stakeholders? - provides long-term benefits to
shareholders and is in line with the
primary goal of maximizing
shareholder wealth.

Business Ethics - standards of conduct or moral

judgment that apply to persons
engaged in commerce.
- Negative Publicity = Negative Impact

Corporate Governance - rules, processes, and laws by which

companies are operated, controlled,
and regulated.

- defines the rights and responsibilities

of the corporate participants.

Principal-Agent Relationship - arrangement in which an agent acts on

behalf of a principal. For example,
shareholders of a company
(principals) elect management (agents)
to act on their behalf.

Agency problems - Manager’s Personal Goals > Goals of

Shareholders

Agency costs - arise from agency problems that are

borne by shareholders and represent a
loss of shareholder wealth.

- Finance is actually a consequence of economics.

- Finance managers also use economic theories and principles as guidelines for an
 efficient operation of a business. These theories include supply-and-demand analysis,
profit-maximizing strategies, and price theory.

- Business decisions are based on an economic principle called marginal-cost-benefit

analysis.
Valuation process that links risk and return to determine
the worth of an asset.

- three key inputs to the valuation

process:
 Cash flows (returns).
 Timing; and
 Measure of risk which determines the
required return.
Formula:

V0 = Value of the asset at time zero

CFT = cash flow expected at the end of year t
r = appropriate required return (discount rate) n = relevant time period
Cash Flow (Returns) - The value of any asset depends on
the cash flow(s) it is expected to
provide over the ownership period.

Timing - The combination of the cash flow

and its timing fully defines the return
expected from the asset.

Risk and Required Return - The level of risk associated with a

given cash flow can significantly
affect its value.
- Greater risk can be included in a
valuation analysis by using a higher
required return or discount rate.
- the greater the risk of (or the less
certain) a cash flow, the lower its
value.
- the lower the risk, the less the
required return.

Risk-averse Investor - to purchase a given asset, the

investor must expect at least enough
return to compensate for the asset’s
perceived risk.
Problems with Solutions:
Bond Valuation - The value of a bond is the present
value of the payments its issuer is
contractually obligated to make, from
the current time until it matures.
Bonds - fixed income securities because you
know the exact amount of cash you
will get back if you hold the security
until maturity.
Face Value/Par Value or Principal - the amount of money a holder will get
back once a bond matures.
Coupon (The Interest Rate) - The amount the bondholder will
receive as interest payments.
Maturity - The date in the future on which the
investor’s principal will be repaid.
Issuer - The issuer of a bond is crucial factor
to consider.
Bond Rating - Helps investors determine a
company’s credit risk
Formula:

Where:

B0 = value of the bond at time zero

I = annual amount of interest paid

n = number of years to maturity

M = par value in amount

rd = required return on bond

 Please note that since the annual interest payment cash flow stream is an annuity we
can use the formula of the PRESENT VALUE ANNUITY which we already discussed
in the topic Time Value of Money.
 The same goes with the lump sum (M) cash flow stream at the end of maturity in
which we can use the formula of PRESENT VALUE SINGLE AMOUNT already
discussed in the topic Time Value of Money.

Steps:
a. Convert annual interest to the specified number of periods.
b. Convert the number of years to maturity to the specified number of periods.
c. Convert the required stated (rather than effective) annual return to the specified number
of periods.
– 2 semi-annual
– 4 quarterly
– 52 weekly
– 365 daily
Problems with Solutions:

Yield and Price - Yield is a figure that shows the return

you get on a bond
Formula:

Current Yield = Annual coupon amount ÷ current price

Capital Gains Yield Formula
Capital Gains Yield = ΔPrice/Beginning Price; or
Capital Gains Yield = Current Price – Beginning Price/Beginning Price

 If you trade bonds below their par value, you are trading at a discount.
 If you trade bonds above their par value, you are trading at a premium.
 If you trade bonds equal to their par value, you are trading at par
Yield to Maturity - An estimate of what the bond
investor will receive if the bond is
held to its maturity date.
- The compound annual rate of return
earned on debt security purchased on
a given day and held to maturity.

Yield to Maturity Formula

YTM = (Expected CY) + (Expected CGY)

Call Feature (Bond) - they may not reach maturity if the
issuer, after a specified time period,
call them back.
Yield to Call (YTC) - represents the rate of return that
investors earn if they buy a callable
bond at a specific price and hold it
until it is called back, and they
receive the call price.
 Call Price - set above the bond’s par value.

Problems with solution:

Stock Valuation - Common stockholders expect to be

rewarded through periodic dividends
and an increasing share value.
- Investors buy shares when they think
the shares are undervalued and sell
when they think the shares
are overvalued.
- Important tool among financial
managers.
Undervalue - when its true value is greater than its
market price.
Overvalue - when its true value is lesser than its
market price.
- In competitive markets with many active participants, the interactions of many buyers
and sellers result in an equilibrium price – the market value – for each security.
- Buyers and sellers are assumed to absorb new information immediately as it becomes
available and, through their purchase and sale activities, create a new market
equilibrium price quickly.
Market Efficiency - This price reflects the collective
actions that buyers and sellers take on
the basis of all available information.
Zero-growth Model - an approach to dividend valuation that
assumes a constant, non-growing
dividend stream.
Constant Growth Model - widely cited dividend valuation
approach that assumes that dividends
will grow at a constant rate, but a rate
that is less than the required return.