Week 1: Introduction to Finance

Question 1

What is finance?

Answer 1

The discipline that deals with decisions concerning how money (or, more appropriately, cash flows) is raised and used by businesses, governments, and individuals.

Finance is concerned with decisions about money. It is integral to:
. Economic and business
. Household
. Individuals
. Politics 

Finance is everywhere here. This unit provides you with a framework for understanding the financial world and gives you a ‘language’ with which you communicate to people about finance.

Question 2

What must you understand in order to make sound financial decisions?

Answer 2

To make sound financial decisions, you must understand three general, yet reasonable, concepts: Everything else being equal,

(1) More value is preferred to less;
(2) The sooner cash is received, the more valuable it is; and
(3) Less risky assets are more valuable than (preferred to) riskier assets.

Question 3

What happens when firms make decisions with the three general/reasonable concepts in mind?

Answer 3

They are able to:
. Provide better products to customers at lower prices,
. Pay higher salaries to employees, and
. Still provide greater returns to investors who put up the funds needed to form and operate the businesses.

In general, then, sound financial management contributes to the well-being of both individuals and the general population.

Question 4

What are the general areas of finance?

Answer 4

The study of finance consists of four interrelated areas:
. Financial markets and institutions
. Investments
. Financial services
. Managerial (business) finance.

Question 5

Explain the following general area of finance: Financial markets and institutions.

Answer 5

Financial institutions are an integral part of the general financial services marketplace.

They include banks, insurance companies, savings and loans, and credit unions.

The success of these organisations requires an understanding of many things (on next flash card).

Question 6

What does the success of financial markets and institutions require?

Answer 6

The success of these organisations requires an understanding of:
. Factors that cause interest rates and other returns in the financial markets to rise and fall,
. Regulations that apply to such institutions, and
. Various types of financial instruments (such as mortgages, auto loans, and certificates of deposit) that financial institutions offer.

Question 8

Explain the following general area of finance: Investments.

Answer 8

This area of finance focuses on the decisions made by businesses and individuals as they choose securities for their investment portfolios.

The major functions in the investments area are:

(a) Determining the values, risks, and returns associated with such financial assets as stocks and bonds and
(b) Determining the optimal mix of securities that should be held in a portfolio of investments.

Question 9

Explain the following general area of finance: Financial services.

Answer 9

Financial services refers to functions provided by organisations that deal with the management of money.

Persons who work in these organisations (includes banks, insurance companies, brokerage firms, and similar companies) provide services that help individuals and companies determine how to invest money to achieve goals such as:
. Home purchase
. Retirement
. Financial stability and sustainability
. Budgeting, and 
. Related activities.

Question 10

Explain the following general area of finance: Managerial (business) finance.

Answer 10

Managerial finance deals with decisions that all firms make concerning their cash flows, both inflows and outflows.

As a result, managerial finance is important in all types of businesses.

Financial managers also have many responsibilities.

Question 11

What responsibilities do financial managers have?

Answer 11

Financial managers have the responsibility for:
. Deciding the credit terms under which customers can buy,
. How much inventory the firm should carry,
. How much cash to keep on hand,
. Whether to acquire other firms (merger analysis), and
. How much of each year’s earnings should be paid out as dividends and how much should be reinvested in the firm.

Question 12

What are the types of duties encountered in managerial finance?

Answer 12

The types of duties encountered in managerial finance range from making decisions about plant expansions to choosing what types of securities to issue to finance such expansions.

Question 13

What are some of the non-finance areas of business which relate to finance?

Answer 13

. Management 
. Marketing
. Accounting
. Information systems 
. Economics.

Question 14

Explain how the following non-finance area of business relates to finance: Management.

Answer 14

When we think of management, we often think of:
. personnel decisions and employee relations,
. strategic planning, and
. the general operations of the firm.

Strategic planning (one of the most important activities of management) - cannot be accomplished without considering how such plans impact the overall financial well-being of the firm.

Personnel decisions (such as setting salaries, hiring new staff, and paying bonuses) - must be coordinated with financial decisions to ensure that needed funds are available.

Thus, managers must have at least a general understanding of financial management concepts to make informed decisions in their areas.

Question 15

Explain how the following non-finance area of business relates to finance: Marketing.

Answer 15

The four Ps of marketing - product, price, place, and promotion - determine the success of products that are manufactured and sold by companies.

Clearly, the price that should be charged for a product and the amount of advertising a firm can afford for the product must be determined in conjunction with financial managers because the firm will lose money if the price of the product is too low or too much is spent on advertising.

Coordination of the finance function and the marketing function is critical to the success of a company, especially for a small, newly formed firm, because it is necessary to ensure that sufficient cash is generated to survive.

For these reasons, people in marketing must understand how marketing decisions affect and are affected by such issues as funds availability, inventory levels, and excess plant capacity.

Question 16

Explain how the following non-finance area of business relates to finance: Accounting.

Answer 16

. In many firms (especially small ones), it is difficult to distinguish between the finance function and the accounting function.
. Often, accountants make finance decisions, and vice versa, because the two disciplines are closely related.
. As you will discover, financial managers rely heavily on accounting information because making decisions about the future requires information about the past.
. As a consequence, accountants must understand how financial managers use accounting information in planning and decision making so that it can be provided in an accurate and timely fashion.
. Similarly, accountants must also understand how accounting data are viewed (used) by investors, creditors, and others who are interested in the firm’s operations so that they provide appropriate financial information.

Question 17

Explain how the following non-finance area of business relates to finance: Information systems.

Answer 17

.

Question 18

Explain how the following non-finance area of business relates to finance: Economics.

Answer 18

.

Question 19

The flow of funds.

Answer 19

The flow of funds begins with INVESTORS, who invest funds in CAPITAL MARKETS.

CORPORATIONS acquire funds from capital markets by selling financial assets.

CORPORATIONS then use these funds to acquire real assets to generate cash flows.

These cash flows can then be repaid to INVESTORS or retained as source of finance.

Question 20

Financial markets and institutions.

Answer 20

Financial markets:
. Stock (share), credit (bond), futures, foreign exchange and etc.

Financial institutions:
. Banks - Big four, BoQ
. Managed funds - ETFs, superannuation funds
. Insurance companies - QBE, CGU, Allianz and etc.
. Credit unions - CUA

Question 21

Investments.

Answer 21

Major functions:
. Determine the VALUES, RISKS and RETURNS of
- FINANCIAL ASSETS refers to claims to cash flows (eg. Equity/debt securities).
- REAL ASSETS are to produce goods/services, eg. Machinery, equipment, intellectual properties.
. Determining the optimal mix of securities that should be held in a portfolio.
- portfolio management

Question 22

Financial services.

Answer 22

• Deal with the management of clients’ money
• Help individuals and companies determine how to invest money
• One of the largest industries in the world

Question 23

Managerial finance (importance).

Answer 23

•Important in all areas of business
•Decisions made by financial managers:
–Strategic (Key) decisions
•Capital budgeting
•Capital structure
•Dividend policy
–Tactical decisions
•The credit terms under which customers can buy
•How much inventory/cash the firm should carry
•Financial managers’ responsibility is to obtain and use
funds in a way that will maximize the value of the firm.

Question 24

Recent developments in finance.

Answer 24

Sustainability
–A long-run process that focuses on improving the quality of life of all stakeholders for all generations both current and future

Lean Manufacturing
–A system the integrates the entire production process so that the least amount of resources is used

Question 25

What are the forms of business?

Answer 25

. Sole proprietorships
. Partnerships
. Corporations

Question 26

Financial decisions and value (wealth) maximisation.

Answer 26

Investors purchase corporate stocks because they expect to earn good returns on their investments. In fact, everything else being equal, we know that investors want to increase their wealth positions as much as possible.

Because investors (stockholders) are not involved with firms’ day-to-day operations, they expect those who are respon- sible for daily decisions—that is, executives and managers—to run the businesses with the stockholders’ best interests in mind.

First, the value of any investment, such as a stock, is based on the cash flows the asset is expected to generate during its life—both the amount and the timing of the cash flows.

Question 27

When does the value of an asset change?

Answer 27

All else being equal, we know that the value of any asset changes when there are changes in the asset’s expected future cash flows (both the amounts and the timings), when there are changes in the certainty of the expected cash flows, or when a combination of these actions occurs.

Question 28

What is value?

Answer 28

The worth of the future cash flows, stated in current dollars, that an asset is expected to generate during its life.

Question 29

What is sustainability?

Answer 29

The concept that we should improve the quality of life of all stakeholders for all generations, both current and future.

Sustainability recognizes the effects that the practices and behaviors we pursue in the current period have on future generations. “Good sustainability” focuses on improving the quality of life of all stakeholders—that is, all interested parties—for all generations, both current and future. A business that does not consider the well-being of either its employees, customers, and shareholders or the environment in which it operates will not survive.

Question 30

What is lean manufacturing?

Answer 30

Lean manufacturing is the concept that products should be produced using the least amount of resources such that wasted resources are eliminated.

The primary goal of lean manufacturing is complete efficiency in the production process. To maximize value, which is a firm’s primary goal, it must be lean.

As you will discover later in the book, one of the ways a firm attempts to maximize its value is by decreasing the cost of the funds that it uses to finance investments in assets. At the same time, everything else being equal, the firm wants to invest at the highest returns possible. Thus, we can say that the goal of the firm is to become “financially lean.”

Question 31

What is a proprietorship?

Answer 31

Proprietorship - an unincorporated business owned by one individual.

Advantages
•Easy and inexpensive to form
•Subject to few government regulations
•Taxed like an individual

Disadvantages
•Proprietor has unlimited personal liability for business debts
•Life of proprietorship is limited to time the creator owns it
•Transferring ownership can be difficult
•Difficult for proprietorship to obtain large sums of capital (funds)

Question 32

What is a partnership?

Answer 32

Partnership - unincorporated business owned by two or more persons.

Advantages
•Easy and inexpensive to form
•Subject to few government regulations
•Taxed like an individual

Disadvantages
•Partners have unlimited personal liability for business debts
•Life of partnership is limited to time the same group of partners owns it
•Transferring ownership can be difficult
•Difficult for partnership to obtain large sums of capital (funds); but better than for a proprietorship

Question 33

What is a corporation?

Answer 33

Corporation - a legal entity created by a state, separate and distinct from its owners and managers, having unlimited life, easy transferability of ownership, and limited liability.
legal entity created by a statute (Corporation Act 2001)

Advantages
•Limited liability
•Easy transferability of ownership; stock (share) represents ownership
•Easier for corporations than for proprietorships and partnerships to raise money in the financial markets by issuing stocks (shares) and/or bonds
•Unlimited life
•Separate and distinct from its owners

Disadvantages
•Setting up and filing regulatory reports is complex
•Earnings are subject to double taxation in many countries, but not Australia (imputation tax system)

Question 34

What is a corporate charter?

Answer 34

A document filed with the secretary of the state in which a business is incorporated that provides information about the company, including its name, address, directors, and amount of capital stock.

Question 35

What are bylaws?

Answer 35

A set of rules drawn up by the founders of the corporation that indicate how the company is to be governed; includes procedures for electing directors, the rights of the stockholders, and how to change the bylaws when necessary.

Question 36

What are the goals of a corporation?

Answer 36

Stockholder wealth maximisation
–Considers the risk and timing associated with expected cash flows to maximize the price of the firm’s common share
–Will profit maximization accomplish the same mission? Not necessarily…
•Proxy of net profit: Earnings Per Share (EPS) = Net After-tax Profit/# of outstanding shares
•Drawbacks:
1)ignoring risk and timing of cash flows
2)subject to the choice of accounting principles

Social responsibility
–Stock price maximization and social welfare

Question 37

What is a limited liability partnership?

Answer 37

A partnership wherein one (or more) partner is designated the general partner(s) with unlimited personal financial liability, and the other partners are limited partners whose liability is limited to amounts they invested in the firm.

Question 38

What is a limited liability company?

Answer 38

A business structure that offers the limited personal liability associated with a corporation, but the company’s income is taxed like a partnership.

Question 39

What is a S corporation?

Answer 39

A corporation with no more than 100 stockholders that elects to be taxed the same as proprietorships and partnerships so that business income is taxed only once.

Question 40

Agency relationships (problem).

Answer 40

Owner/principal hires an agent and delegates decision-making authority to that AGENT to act on behalf of the PRINCIPAL.

Problem exists when there are conflicts of interest between shareholders (owners) and:

• managers
• creditors

Question 41

Stockholders Vs Managers.

Answer 41

Several mechanisms are used to motivate managers to act in the shareholders’ best interests. These include:

1. Managerial compensation(incentives)
   –Remuneration package (bonus)
   –Performance shares
   –Executive stock options
2. Shareholder intervention – ‘proxy fight’
3. The threat of hostile takeover
   - The acquisition of a company over the opposition of its management.
   – due to underpriced stock (cause by poor management)

Question 42

Stockholders Vs Creditors.

Answer 42

Conflicts between stockholders and creditors (debt holders) can also exist. Creditors lend funds to the firm at rates that are based on (1) the riskiness of the firm’s exist- ing assets, (2) expectations concerning the riskiness of future asset additions, (3) the firm’s existing capital structure (i.e., the amount of debt financing it uses), and (4) expectations concerning future capital structure changes. These factors determine the riskiness of the firm’s debt, so creditors (lenders) base the interest rates they charge on expectations regarding these factors.

Creditors have no ownership, but lend at rates based on:
–Riskiness of the firm’s existing assets
–Expectations concerning the riskiness of future asset additions
–The firm’s existing mix of financing (capital structure)
–Expectations concerning future capital structure changes (amount of debt)

Stakeholders must be treated fairly

Question 43

What goal(s) businesses pursue?

Answer 43

Depending on the form of business, the primary goal of a firm might differ some- what. But in general, every business owner wants the value of his or her investment in the firm to increase.

Throughout this book, we operate on the assumption that management’s primary goal is stockholder wealth maximization, which, as we will see, translates into maximizing the value of the firm as measured by the price of its common stock.

Firms do, of course, have other objectives: In particular, managers who make the actual decisions are interested in their own personal satisfaction, in their employees’ welfare, and in the good of the community and of society at large. Still, stock price maximization is the most important goal of most corporations.
If a firm attempts to maximize its stock price, is this good or is this bad for so

Question 44

What is stockholder wealth maximisation?

Answer 44

The appropriate goal for management decisions; considers the risk and timing associated with expected cash flows to maximize the price of the firm’s common stock.

Question 45

Managerial decisions to maximise shareholder wealth.

Answer 45

The financial manager makes decisions about the expected cash flows of the firm, which include decisions about:
. how much and what types of debt and equity should be used to finance the firm (capital structure decisions)
. what types of assets should be purchased to help generate expected cash flows (capital budgeting decisions), and
. what to do with net cash flows generated by the firm—reinvest in the firm or pay dividends (dividend policy decisions).

Question 46

What is value?

Answer 46

The present, or current, value of the cash flows an asset is expected to generate in the future.

Question 47

What is profit maximisation and earning per share (EPS)?

Answer 47

Profit maximisation - Maximisation of the firm’s net income each year.

EPS - Net income divided by the number of shares of
common stock outstanding.

Question 48

What is the agency problem?

Answer 48

A potential conflict of interest between outside shareholders (owners) and managers who make decisions about how to operate the firm.

Question 49

What are stakeholders?

Answer 49

Those who are associated with a business; stakeholders include managers, employees, customers, suppliers, creditors, stockholders, and other parties with an interest in the firm.

Question 50

What is business ethics?

Answer 50

A company’s attitude and conduct toward its stakeholders— employees, customers, stockholders, and so forth; ethical behavior requires fair and honest treatment of all parties.

Question 51

When does a firm have good ethics?

Answer 51

A firm with good ethics:
–Avoids fines and legal expenses
–Builds public trust
–Attracts business from customers who appreciate and support the firm’s policies
–Attracts and keeps employees of the highest caliber
–Supports the economic viability of the communities in which it operates

Question 52

What is corporate governance?

Answer 52

The “set of rules” that a firm follows when conducting business; these rules identify who is accountable for major financial decisions.

Should provide stakeholders with an understanding of :
–How executives run the business
–Who is accountable for important decisions

Question 53

Small and medium-size enterprises.

Answer 53

Small business is key to Australia economy as per their contribution in terms of their employment and production.

But SMEs pay more, on average, for borrowings than both households and larger businesses (RBA 2012).

SMEs have more difficulties in obtaining finance due to
–Basel III capital requirements: risk-based
–Evolution of the bank business model: more quantitative models applied in the pricing of finance and collateral requirements
–Other challenges for SMEs: inadequate security and business plan

Potential solutions
–Overcoming the lack of information
–‘Crowd funding’, Credit Guarantee Scheme (CGS), P2P lending

Question 54

Introduction to income tax.

Answer 54

Depends on:
. Type of taxpayer 
   - Individual
   - Partnership (partner's individual income tax)
   - Corporate (company)
. Taxable income 
   - Assessable income minus allowed deductions 
. Tax rate 
   - Marginal (individuals) VS
   - Flat (Corporations)

Question 55

Calculating tax.

Answer 55

1. Determine assessable income
2. Calculate taxable income (assessable income less allowable deductions)
3. • If individual, follow the marginal tax table to work or tax payables
   • If corporate, multiply the taxable income by flat tax rate
4. Pay tax to government (cash outflow)
5. Retain net (after-tax) income

Question 56

Individual income taxes.

Answer 56

Progressive tax: higher tax (rate) on higher incomes

Taxable income = gross income - allowable deductions

Tax payable is the actual tax owed (paid) to the government.
- In practice, wages are taxed when paid.

Marginal tax rate: the tax rate on the last unit of taxable income.

Question 57

Individual income tax table.

Answer 57

Taxable income —— Tax in this income
0 - $18,200 —— Nil
$18,201 - $37,000 —— 19c for each $1 over $18,200
$37,001 - $80,000 —— $3,562 + 32.5c for each $1 over $37,000
$80,001 - $180,000 —— $17,547 + 37c for each $1 over $80,000
$180,001 and over —— $54,547 + 45c for each $1 over $180,000

Question 58

Tax payable: business-partnership

Answer 58

–Net profit of the partnership is shared among the partners.
–A partnership doesn’t pay income tax on the profit it earns – each partner pays tax on the share of profit they receive.

Question 59

Tax payable: business-company

Answer 59

Australian company tax rate: 30%