Financial Economics Lecture #2 ABCs of Finance

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# Financial Economics

## Lecture 2 ABCs of Finance

### Definition of Finance

Finance is the study of how individual/real companies/financial institutions allocate **scarce** resources over time.

> real company : companies that produce actual products

* Costs and benefits are distributed over time
* The actual timing and size of future cash flows are often known only **probabilistically**.

Three topics : Financial institutions and markets; Return; Risk

When implementing decisions, people make use of the Financial System defined as the set of markets and other institutions used for financial contracting and exchange of rights and obligations (权利和义务).

> Every contract specifies considerations under different conditions:
> 
> Example : debt financing contract (借贷关系)
> 
> Obligations and rights *(under conditions)* for creditors (债权人)
> 
> Obligations and rights *(under conditions)* for debtors (债务人)
> 
> Contract define the certain time periods (when should the creditor borrow the money and when should the debtor pay back) and deal with accidents (e.g. the debtor can't pay the money on time)

**Financial theory** consists of :

* The set of concepts that help to organize one's thinking about how to allocate resources over time
* The set of quantitative models that can explain stylized facts
* Implications of such quantitative models help evaluate alternatives, make decisions, and implement them.

Basic tenet of finance : the existence of economic organizations (e.g. firms and governments) facilitate the **satisfaction of people's consumption preferences** (maximization of social welfare).

* Individuals' consumption; Firms' profits; Economic productivity and growth (and innovation)

### Why Study Finance

Manage your personal resources;

Deal with the world of business;

Pursue interesting and rewarding career opportunities;

Make informed public choices as a citizen.

### Roles of Financial Intermediations

* Matching 匹配 : Market making
* Credit enhancing 增信 : Trust providing/guarantee

### Financial Decision of Households

* Consumption and saving decisions
* Investment and Financing decisions
* Risk-management decisions

Assets:

* Cash, current deposit, fixed term deposit
* Physical assets
* *Human Capital (人力资源)*

Liabilities or Debts:

* Short or long-term loan
* Cutoff between short term and long term?
  
  $< 1$ year short term; $\geq 1$ year long term

$$
\text{Net Worth}=\text{Assets}-\text{Liabilities}
$$

### Financial Decisions of Firms

**The capital budgeting process 资本预算**

How to acquire human capital?

* Recruiting
* Develop or buy a business created by a team
* Good working environment

**The financing process 融资**

Once a new set of approved projects has been identified, it must be financed with retained earnings (盈余公积), stock (股票), and bonds (债券).

> Retained earning stand for internal financing; Stock and bonds are external.

Capital structure is the amount of the firm's market value allocated to each category of issued securities. It determines ownership and risk level of the firm's future cash flows.

**Fixed-income securities (debts) 固定收益证券/债券证券**

* Promise either a specified stream of income.
* Claims on *guaranteed* cash flows.

**Common stocks and preferred stocks (equity) 股权证券**

* Represent an ownership share the corporation
* Claims on the *possibility* that the firm may earn in the future (uncertainty)

**Derivative securities 衍生证券**

* Provide payoffs that are determined by the prices of other assets.
* Claims on cash flows generated by cash flows.

Capital structure's unit of analysis is the firm as a whole

> Cash in-/out- flows could be cancelled out or amplified among projects.

Capital structure also determines who **controls** the firm under different contingencies:

* Common stock holders usually determine the membership of the board of directors.
* Bondholder covenants restrict decisions that could adversely affect bond values.

**Working capital 营运资本 or liquidity 流动性**

The difference between a company's current assets minus its current liabilities.

Possible damages if *not managed well*:

Sub-optimal temporary finance; Delayed in investment schedules; Unscheduled sale of the firm assets; Loss of investor and creditor confidence.

### Forms of Business Operation

**Sole Proprietorship 个人独资制**

A firm owned by an individual or family

Assets and liabilities are the personal assets and liabilities of the proprietor

Unlimited liability (无限责任制)

Low administrative costs

**Partnership 合伙制**

A firm with $\geq 2$ owners sharing the equity

May own property, borrow, sue, be sued, and enter into legal contracts

Changes in ownership involve dissolving the old partnership and forming a new one

*Usually* unlimited liabilities.

Current examples : Law firms, Architectural firms, Accounting firms

**Corporation 有限责任制**

A legal entity, distinct from its ownership

May own property, borrow, sue, be sued, and enter into legal contracts

**Not dissolved** when shares are transferred

Shareholders elect directors, who appoint management

Pays corporate taxes, resulting in double taxation of owner

**Limited liability** (*corporate veil may be lifted*)

### Separation of Ownership and Management

**Owners 股东，董事长**

Contribute money and receive dividends (分红)

Make decisions

**Managers 总裁，首席执行官，首席财务官**

Execute decisions

Provide professional suggestions

Pros : Specialization : capital + professional skills ; capital and skills are more flexible

Cons : Agency problem ; costs of information gathering

### Goal of Management : Maximize the wealth of current shareholders

The right production plan;

The right recruiting plan;

The right development strategy;

Could be simplified as "*profit maximization*"

Last modification：February 14, 2023

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Financial Economics Lecture #2 ABCs of Finance

Bi_Gu • 2023 年 02 月 14 日

# Financial Economics

## Lecture 2 ABCs of Finance

### Definition of Finance

Finance is the study of how individual/real companies/financial institutions allocate **scarce** resources over time.

> real company : companies that produce actual products

* Costs and benefits are distributed over time
* The actual timing and size of future cash flows are often known only **probabilistically**.

Three topics : Financial institutions and markets; Return; Risk

**Financial theory** consists of :

Basic tenet of finance : the existence of economic organizations (e.g. firms and governments) facilitate the **satisfaction of people's consumption preferences** (maximization of social welfare).

* Individuals' consumption; Firms' profits; Economic productivity and growth (and innovation)

### Why Study Finance

Manage your personal resources;

Deal with the world of business;

Pursue interesting and rewarding career opportunities;

Make informed public choices as a citizen.

### Roles of Financial Intermediations

* Matching 匹配 : Market making
* Credit enhancing 增信 : Trust providing/guarantee

### Financial Decision of Households

* Consumption and saving decisions
* Investment and Financing decisions
* Risk-management decisions

Assets:

* Cash, current deposit, fixed term deposit
* Physical assets
* *Human Capital (人力资源)*

Liabilities or Debts:

* Short or long-term loan
* Cutoff between short term and long term?
  
  $< 1$ year short term; $\geq 1$ year long term

$$
\text{Net Worth}=\text{Assets}-\text{Liabilities}
$$

### Financial Decisions of Firms

**The capital budgeting process 资本预算**

How to acquire human capital?

* Recruiting
* Develop or buy a business created by a team
* Good working environment

**The financing process 融资**

Once a new set of approved projects has been identified, it must be financed with retained earnings (盈余公积), stock (股票), and bonds (债券).

> Retained earning stand for internal financing; Stock and bonds are external.

Capital structure is the amount of the firm's market value allocated to each category of issued securities. It determines ownership and risk level of the firm's future cash flows.

**Fixed-income securities (debts) 固定收益证券/债券证券**

* Promise either a specified stream of income.
* Claims on *guaranteed* cash flows.

**Common stocks and preferred stocks (equity) 股权证券**

* Represent an ownership share the corporation
* Claims on the *possibility* that the firm may earn in the future (uncertainty)

**Derivative securities 衍生证券**

* Provide payoffs that are determined by the prices of other assets.
* Claims on cash flows generated by cash flows.

Capital structure's unit of analysis is the firm as a whole

> Cash in-/out- flows could be cancelled out or amplified among projects.

Capital structure also determines who **controls** the firm under different contingencies:

* Common stock holders usually determine the membership of the board of directors.
* Bondholder covenants restrict decisions that could adversely affect bond values.

**Working capital 营运资本 or liquidity 流动性**

The difference between a company's current assets minus its current liabilities.

Possible damages if *not managed well*:

Sub-optimal temporary finance; Delayed in investment schedules; Unscheduled sale of the firm assets; Loss of investor and creditor confidence.

### Forms of Business Operation

**Sole Proprietorship 个人独资制**

A firm owned by an individual or family

Assets and liabilities are the personal assets and liabilities of the proprietor

Unlimited liability (无限责任制)

Low administrative costs

**Partnership 合伙制**

A firm with $\geq 2$ owners sharing the equity

May own property, borrow, sue, be sued, and enter into legal contracts

Changes in ownership involve dissolving the old partnership and forming a new one

*Usually* unlimited liabilities.

Current examples : Law firms, Architectural firms, Accounting firms

**Corporation 有限责任制**

A legal entity, distinct from its ownership

May own property, borrow, sue, be sued, and enter into legal contracts

**Not dissolved** when shares are transferred

Shareholders elect directors, who appoint management

Pays corporate taxes, resulting in double taxation of owner

**Limited liability** (*corporate veil may be lifted*)

### Separation of Ownership and Management

**Owners 股东，董事长**

Contribute money and receive dividends (分红)

Make decisions

**Managers 总裁，首席执行官，首席财务官**

Execute decisions

Provide professional suggestions

Pros : Specialization : capital + professional skills ; capital and skills are more flexible

Cons : Agency problem ; costs of information gathering

### Goal of Management : Maximize the wealth of current shareholders

The right production plan;

The right recruiting plan;

The right development strategy;

Could be simplified as "*profit maximization*"

Financial Economics Lecture #2 ABCs of Finance

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Financial Economics Lecture #2 ABCs of Finance