BMOS II Notes 3 - BMOS II Part 3 CHAPTER 6 Intro to Finance...

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BMOS II Part 3 CHAPTER 6: Intro to Finance Finance: Science or study of the management of funds o How & under what terms money is allocated between lenders & borrowers o Distinct from econ as isn’t just about how resources are allocated, it is under what terms and through what channels is the allocation made Role of Finance in Business: Addresses three basic issues in study o Capital Budgeting Decision: What LT investments should we undertake? o Capital Structure Decision: How should raise money to fund investments? o Operating Decision: How to manage cash flows arising from operations Financial Manager: Take money raised and invest in operations to increase profit Finance Function: Investors raise funds. Receive obligations. FM invests. Receives cash from operations. Reinvest some and distribute some to investors. Principles of Finance: o Principle 1: Cash flow is what matters. Accounting profits aren’t equal to cash flows. Possible to generate profit but not have cash or have cash flows but not generate profit. Must determine additional CF when deciding. o Principle 2: Money has time value. Money received today is worth more than money received in future. Can earn interest. Present Value: F n / (1 + r) n F n = future value. R = IR n = years Net Present Value: Calculate present value of cash inflows, cash outflows and then subtract present value of outflows from inflows Positive is acceptable. Zero, acceptable, Negative isn’t. Outflows: Initial investment, operating costs, repairs Inflows: incremental revenues, lower OC, salvage value Cost of Capital: Minimum required rate of return. Average rate of return must pay to long-term creditors for use of their funds. (-) INV + YR 1 CF/1+IR + YR 2 CF/(1+IR) 2 o Principle 3: Risk Requires Reward. Risk is uncertainty about outcome or payoff of an investment in the future. Rational investors go risky if they feel expected return is high enough to justify greater adverse ( Risk Adverse) All risk isn’t same. Portfolio can diversify risk by investing in others Firm Specific (Unsystematic): Management team making decisions about risk. Industry/Firm specific. Can diversify away. Market Specific: Can’t diversify away. Whole market/portfolio. o Principle 4: Market prices are generally right. A financial market is “information efficient” if at any time, prices of securities reflect available information. Prices change to reflect new info. Efficient markets provide liquidity and fair prices. Behavioral biases create inefficiencies and distort. o Principle 5: Conflicts of Interest Cause Agency Problems. Separation of management and ownership of firm creates agency problem. Owners or equity investors want to maximize ROI Principle Agent Problem: Managers may have other goals and owner isn’t there to watch. Goal congruence is an issue.
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