"Finance" Bodie and Merton

ECOM 061 Financial Economics

Joo Mergulho
Office hours: Fridays 3pm - 5pm Email: j.mergulhao@qmul.ac.uk Internet: All material are available through www.elearning.qmul.ac.uk (login required). First weeks materials will be publicly available in my webpage http://joaomergulhao.eu

ECOM 061 Financial Economics

Module description
define and provide rigorous training in Finance show how firms or individuals allocate scarce resources over time under conditions of uncertainty.

Optimization over Time

Asset Pricing

Risk
Management

ECOM 061 Financial Economics

Topic 1: Financial Economics Topic 2: Financial Markets and Institutions Topic 3: Allocating Resources Over Time Topic 4: The Analysis of Investment Projects Topic 5: Principles of Market Valuation Topic 6: Valuation of Known Cash Flows: Bonds Topic 7: Valuation of Common Stocks Topic 8: Principles of Risk Management Topic 9: Hedging, Insuring, and Diversifying Topic 10: Portfolio Opportunities and Choice *Topic 11: Capital Market Equilibrium3

ECOM 061 Financial Economics

Main Reference
Bodie, Merton and Cleeton (2009), Financial Economics, Second Edition, Pearson International Edition.
Companion Website: www.prenhall.com/bodie

Additional References
Bodie, Kane & Marcus (2008), Investments, Eighth Edition, McGraw-Hill La Porta, Lopez-de-Silanes, Shleifer and Vishny, Law and Finance, Journal of Political Economy, vol. 106(6), pages 1113-1155, December. Haugen, The Inefficient Stock Market: what pays off and why, 2001, Prentice Hall
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ECOM 061 Financial Economics

Assessment
Final examination (50%) Midterm exam (30%) 02/11/2010 Coursework (20%)

ECOM 061 Financial Economics

Coursework
Starting point: La Porta, Lopez-de-Silanes, Shleifer and Vishny, Law and Finance,
Journal of Political Economy, vol. 106(6), pages 1113-1155, December

Group formation: one lawyer, one economist, maximum 3 persons per group. Coursework proposal submission 05-Nov-2010 Coursework submission 02-May-2011
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Chapter 1

"Finance" Bodie and Merton

Topic 1: Financial Economics

Objectives
To Define Finance The Value of Finance Introduction to the Players.

Chapter 1 Contents
1.1 Defining Finance 1.2 Why Study Finance 1.3 Financial Decisions of Households 1.4 Financial Decisions of Firms 1.5 Forms of Business Organization 1.6 Separation of Ownership and Management
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1.7 The Goal of Management 1.8 Market Discipline: Takeovers

Readings
BMC ch. 1
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1.1 Defining Finance

Finance is the study of how people allocate scarce resources over time
costs and benefits are distributed over time but the actual timing and size of future cash flows are often known only probabilistically

Defining Finance
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 assets and risks

Understanding finance helps you evaluate these uncertain cash flows

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Defining Finance
Financial theory consists of:
the set of concepts that help to organize ones thinking about how to allocate resources over time the set of quantitative models used to help evaluate alternatives, make decisions, and implement them
These concepts and models apply at all levels and scales of decision making
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Defining Finance
A basic tenet of finance is that the existence of economic organizations (e.g. firms and governments) facilitate the satisfaction of peoples consumption

preferences

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Chapter 1

"Finance" Bodie and Merton

1.2 Why Study Finance?

To manage your personal resources To deal with the world of business To pursue interesting and rewarding career opportunities To make informed public choices as a citizen The intellectual challenge
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1.3 Financial Decisions of Households

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

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Important Terms
Assets Personal investing & Asset allocation Liability, Debt Net Worth = Assets - Liabilities Exogenous and endogenous elements
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1.4 Financial Decisions of Firms

Business Firms
entities whose primary function is to produce goods and services they vary widely in size from part-time businesses run from a spare room, to giant corporations (e.g. Mitsubishi or General Motors) with hundreds of thousands of employees, and an even larger ownership
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Financial Decisions of Firms

Strategic plans specify the business the firm is in
strategic plans may change radically over time the firms business may be defined in terms of a group of products, technologies or customers
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Financial Decisions of Firms

The Capital Budgeting Process
The preparation of a plan for acquiring factories, machinery, research laboratories, show rooms, warehouses, and human assets to implement the strategic plan The basic unit of analysis is the investment project. Investment projects are identified, triaged, and implemented in the capital budgeting process
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Chapter 1

"Finance" Bodie and Merton

Financial Decisions of Firms

The Financing Process
Once a new set of approved projects has been identified, it must be financed with retained earnings, stock, bonds, et cetera Capital structure is the amount of the firms market value allocated to each category of issued securities. It determines ownership and risk level of the firms future cash flows Capital structures unit of analysis is the firm as a whole (not an investment project )
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Financial Decisions of Firms

The capital structure also determines who controls the firm under different contingencies
Common stock holders usually determine the membership of the board of directors Preferred stock holders usually gain some control if preferred dividends are not paid Bondholder covenants restrict decisions that could adversely affect bond values
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Financial Decisions of Firms

Working Capital
all firms (including highly profitable ones) that do not pay sufficient attention to working capital management may be seriously damaged by the resulting loss of investor and creditor confidence
delayed in investment schedules sub-optimal temporary finance unscheduled sale of the firms assets
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1.5 Forms of Business Operation

Sole Proprietorship
a firm owned by an individual or family the assets and liabilities are the personal assets and liabilities of the proprietor unlimited liability low administrative costs

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Forms of Business Operation

Partnership
A firm with 2 owners sharing the equity. A partnership agreement usually stipulates how decisions and profits (losses) are shared
General partners 1 (unlimited liability) Limited partners 0 (dont manage business)

Forms of Business Operation

Corporation
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 (not sub-chapter S Corp.) limited liability (corporate veil may be lifted) 24

Changes in ownership involve dissolving the old partnership and forming a new one
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Chapter 1

"Finance" Bodie and Merton

1.6 Separation of Ownership and Management

Owners delegate management if agency conflicts have a cost-effective resolution
professional managers have specialized skills efficiencies of scale diversification of owners portfolio savings in the cost of information gathering learning curve/going concern issues
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1.7 Goal of Management

Management rule: Maximize the wealth of current shareholders
Rule depends only upon production technology, market interest rates, market risk premiums, and security prices Alternative rules stated in terms of profit maximization are fraught with unresolved issues, and are better avoided
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1.8 Market Discipline: Takeovers

The ownership of a corporation generally
is widely dispersed & indirect (mutual funds) lacks internal communication channels is often ill-informed about mismanagement isnt willing to pay for & organize change cant wrestle control from a united selfperpetuating board of directors just sell stock when dissatisfied, contributing to downward share price pressures
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Market Discipline: Takeovers

In a competitive market, a mechanism that reduces mismanagement is the corporate take-over. Example:
a customer, supplier, competitor, or professional raider gains specialized knowledge of the mismanagement the raider purchases a controlling interest in the stock, and installs new management The value of the stock rises, and the raider liquidates ownership at a profit
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Chapter 1