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Fundamentals of Finance


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Table of Contents

Preface ix PART 1: FINANCIAL SYSTEMS Chapter 1: An overview of finance Introduction 3 Definition of finance 4 The financial system Finance as a discipline for study 5 The interdisciplinary nature of finance Finance and business 7 The business environment and stakeholder protection * The four levels of financial decision-making * Personal level * Sole proprietorship level * Partnership level * Corporation level The ethics dilemma 13 Agency problems * Conflict of interest Financial markets 13 The existence of private wealth * Freedom of choice * Incentives * Efficient markets * The role of government Careers in finance 16 Conclusion 18 Self-test question and answer 19 Questions and problems 19 Chapter 2: Financial markets Introduction 20 Financial assets 20 Debt versus equity claims * Prices of financial assets * The roles of financial assets Financial markets 22 The roles of financial markets * Market participants * Types of financial market Money markets 25 Market operation and participants * Types of instruments traded Capital markets 26 The debt markets * The equities market Foreign exchange (FX) market 29 Market operations and participants * Types of instruments traded Derivative markets 30 Types of derivative instruments * The operation of the market * Participants in the futures market * Forward contracts * Options contracts * Participants in the options market Conclusion 36 Self-test questions and answers 37 Questions and problems 37 Chapter 3: Financial institutions Introduction 38 The development of the modern financial system 38 The modern role of government in the financial intermediation process * Regulations to control the soundness of the financial system Credit creation 43 Credit multiplier Monetary policy - three control mechanisms 44 The official cash rate * The inflation problem Modern financial intermediaries 47 Depository institutions * Non-depository institutions * The benefits of financial intermediation Ethics and financial institutions 51 Classifying types of financial transfers 51 Conclusion 52 Self-test questions and answers 53 Questions and problems 53 PART 2: FINANCE TOOLS Chapter 4: Time value of money - Single payments Introduction 55 Simple interest and future value 56 Simple interest and calculating the present value 58 Compound interest and future value 58 Other methods of calculation * The present value of a single payment * Compounding frequency * Continuous compounding/discounting Nominal and effective interest rates 70 Solving for an unknown interest rate 72 Solving for an unknown time period 73 Conclusion 75 Self-test questions and answers 75 Questions and problems 77 Chapter 5: Time value of money - Multiple payments Introduction 79 Multiple cash flows 79 Future value of multiple cash flows * Present value of multiple cash flows Level cash flows: Annuities and perpetuities 82 Future value of an annuity * Present value and annuities Finding the amount of a regular payment 88 Annuity due 90 Perpetuities 92 Asset valuation: Calculating the price of a bond 93 Loan types 97 Conclusion 99 Self-test questions and answers 100 Questions and problems 100 PART 3: PERSONAL FINANCE Chapter 6: Risk and return Introduction 104 Risk-free assets 105 The two components of a return * Nominal interest rate Term structure of interest rates 107 Shape of yield curves Risky assets 109 Risk and return - the trade-off 111 Measuring historical risk and return 113 Returns from investment * Holding period returns and yields * Standard deviation as a measure of risk Measuring future risk and return 119 The benefit of diversification 121 The capital asset pricing model and the security market line relationship 125 Conclusion 127 Self-test questions and answers 128 Questions and problems 135 Chapter 7: Personal financial management Introduction 136 The personal financial planning activity 136 Money management 138 Gathering financial information * Preparing an income statement * Budget preparation * Developing a personal balance sheet Financial planning for life 141 Financial goal attainment 143 Funding a retirement plan 144 Retirement income gap * KiwiSaver * Choosing a KiwiSaver fund Residential property and mortgages 149 Criteria for choosing residential property * Financing the purchase of residential property Starting or buying a business 153 Personality traits * Preliminary evaluation * Business plan Conclusion 163 Self-test question and answer 164 Questions and problems 167 PART 4: FINANCIAL MANAGEMENT Chapter 8: Financial management Introduction 169 Role of financial management 170 Financial management * Organisational context Objective of financial management 172 What about profit maximisation? * Time value of money * Cash flows * Risk * Managers as agents * Economic implications of wealth maximisation The external environment 179 Financial markets * Regulatory environment Risk and return 180 Conclusion 183 Self-test questions and answers 184 Questions and problems 185 Chapter 9: Investment in net working capital Introduction 189 Net working capital 189 Risk-profitability trade-off 190 Management of net working capital 190 Managing cash 191 Cash and near-cash * Motives for holding cash * Forecast cash flow statement Management of accounts receivable 194 Setting credit policy Management of inventory 195 Economic order quantity model * Computerised inventory control system * Just-in-time system Management of current liabilities 196 Cash conversion cycle 201 Conclusion 203 Self-test questions and answers 204 Questions and problems 206 Chapter 10: Financing the firm Introduction 212 Features of debt and equity 212 Funding a firm's life cycle 213 Start-up stage * Growth stage * Maturity stage Choosing the financing mix 228 Short-term or long-term sources? * Internal or external funding? * Debt or equity finance? Cost of capital 232 Cost of debt capital * Cost of equity capital * Weighted average cost of capital Conclusion 237 Self-test questions and answers 238 Questions and problems 240 Chapter 11: Investment in long-term assets - Concepts Introduction 247 Capital budgeting process 247 Measuring the costs and benefits 248 Investment outlay * Operating cash flows * Terminal value Conclusion 258 Self-test question and answer 259 Questions and problems 261 Chapter 12: Investment in long-term assets - Evaluation techniques Introduction 263 Techniques of investment evaluation 263 Accounting return on investment * Payback period * Net present value * Assumptions of the weighted average cost of capital * NPV(ER) * Internal rate of return * Comparing NPV and IRR Other capital budgeting considerations 276 Capital budgeting and inflation * Capital budgeting and risk Conclusion 279 Self-test question and answer 279 Questions and problems 280 Glossary 287 Appendix 1 - Some useful formulae 297 Appendix 2 - Suggested solutions for selected end-of-chapter questions and problems 301 Index 303 Acknowledgements 308 About the authors 309

About the Author

Andrea Bennett is a senior tutor in Masseys School of Business and her research focuses on financial systems, investments and financial planning, and financial literacy. Jenny Parry is a former senior lecturer in the Department of Finance, Banking and Property at Massey University, and is now a self-employed consultant. Carolyn Wirth holds a PhD in Finance from Massey University and her current research investigates the corporate financial implications of country-level environmental regulatory stringency.

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