Principles of FinancePrinciples of Finance

Definition and Basic Definition and Basic conceptsconcepts

1st CHAPTER1st CHAPTER

Definition of Finance:Definition of Finance:Finance is the art and science of Finance is the art and science of

managing money which is concerned managing money which is concerned with the process, institutions, markets with the process, institutions, markets

and instruments involved in the and instruments involved in the transfer of money among and between transfer of money among and between individuals, business and governments.individuals, business and governments.

Finance is a body of facts, principles, Finance is a body of facts, principles,

and theories dealing with the raising and theories dealing with the raising and using of money by a firm.and using of money by a firm.

Finance is the branch of economics Finance is the branch of economics that focuses on investment in real that focuses on investment in real and financial assets and their and financial assets and their management.management.

A real assetA real asset is a physical item is a physical item such as a truck, land, or building.such as a truck, land, or building.

A financial assetA financial asset is a claim for a is a claim for a future financial payment, such as a future financial payment, such as a savings account at a bank.savings account at a bank.

Finance is the branch of economics Finance is the branch of economics that focuses on investment in real that focuses on investment in real and financial assets and their and financial assets and their management.management.

A real assetA real asset is a physical item is a physical item such as a truck, land, or building.such as a truck, land, or building.

A financial assetA financial asset is a claim for a is a claim for a future financial payment, such as a future financial payment, such as a savings account at a bank.savings account at a bank.

(Continuation)(Continuation) Financial assets generate future Financial assets generate future

payments, whereas real assets alter payments, whereas real assets alter the physical environment in some the physical environment in some way. way.

Financial management is concerned Financial management is concerned with the acquisition, financing, and with the acquisition, financing, and management of assets with overall management of assets with overall goal in mind.goal in mind.

Financial Manager:Financial Manager: Financial managers actively manage Financial managers actively manage

the financial affairs of many types of the financial affairs of many types of business- financial or non financial, business- financial or non financial, private and public, large and small, private and public, large and small, profit-seeking and not for profit. profit-seeking and not for profit. They perform such varied financial They perform such varied financial tasks as planning, extending credit tasks as planning, extending credit to customers, evaluating proposed to customers, evaluating proposed large expenditures, and raising large expenditures, and raising money to the firm’s operations.money to the firm’s operations.

Functions of Financial Functions of Financial Managers:Managers:

11. Performing financial analysis . Performing financial analysis and planning-and planning- which includes: which includes:

Monitoring the firms financial Monitoring the firms financial condition, condition,

Evaluating the need for increased Evaluating the need for increased (or reduced ) productive capacity, (or reduced ) productive capacity, and and

Determining what financing is Determining what financing is required.required.

Functions of Fin Mgr (cont.)Functions of Fin Mgr (cont.) 2. Investment Decision Making:2. Investment Decision Making: It is the most important decision of the firm It is the most important decision of the firm

when it comes to value creation. It begins when it comes to value creation. It begins with a determination of the total amount of with a determination of the total amount of assets needed to be held by the firm. assets needed to be held by the firm.

3. Making Financing Decision:3. Making Financing Decision: Here the financial manager is concerned with Here the financial manager is concerned with

the makeup of the right-hand side of the the makeup of the right-hand side of the balance sheet. It involves two major areas. balance sheet. It involves two major areas. First, the most appropriate mix of short term First, the most appropriate mix of short term and long-term financing must be established. and long-term financing must be established. A second important concern is which A second important concern is which individual short term or long term sources of individual short term or long term sources of financing are best at a given point in time.financing are best at a given point in time.

Functions of Fin. Mgr. (cont.)Functions of Fin. Mgr. (cont.)

Investment and financial decisions deals Investment and financial decisions deals with assets and liability sides of the with assets and liability sides of the Balance SheetBalance Sheet

InvestmentInvestmentFinancing Financing

DecisionsDecisionsDecisionsDecisions

BalanceBalance SheetSheet

Current Current AssetsAssets

Current Current LiabilitiesLiabilities

Fixed Fixed AssetsAssets

Long-Term Long-Term AssetsAssets

4. Asset management Decision:4. Asset management Decision: Assets must be managed efficiently Assets must be managed efficiently

and financial manager must be more and financial manager must be more concerned in this respect. Otherwise concerned in this respect. Otherwise firm may fall in difficulty in several firm may fall in difficulty in several cases.cases.

5. Accounting and Control:5. Accounting and Control: Maintaining financial records; Maintaining financial records;

controlling financial activities, controlling financial activities, identifying deviations from planned identifying deviations from planned and efficient performance, and and efficient performance, and managing payroll, tax matters, managing payroll, tax matters, inventories, fixed assets and inventories, fixed assets and computer operations.computer operations.

6. Forecasting:6. Forecasting:

Forecasting costs technological Forecasting costs technological changes, capital market conditions, changes, capital market conditions, funds needed for investments, demand funds needed for investments, demand for the firm’s products and using for the firm’s products and using forecasts and historical data to plan forecasts and historical data to plan future operations.future operations.

Pricing, credit and collections, Pricing, credit and collections, insurance and incentive planning are insurance and incentive planning are some other responsibilities of the some other responsibilities of the financial managers financial managers

Irwin/McGraw-Hill

Organizing a BusinessOrganizing a Business

Types of Business OrganizationsTypes of Business Organizations Sole ProprietorshipsSole Proprietorships PartnershipsPartnerships CorporationsCorporations HybridsHybrids

Limited PartnershipsLimited Partnerships LLP (Limited Liability Partnership)LLP (Limited Liability Partnership) LLC (Limited Liability Corporations)LLC (Limited Liability Corporations)

Irwin/McGraw-Hill

Sole Proprietorship

Partnership Corporation

Who owns the business?

The Manager

Partners Shareholders

Are managers and owners separate?

No No Usually

What is the owner’s liability?

Unlimited Unlimited (exceptions)

Limited

Are owners & the business taxed separately?

No No Yes

Organizing a BusinessOrganizing a Business

Corporate StructureCorporate Structure

Sole Proprietorships

Corporations

Partnerships

Limited Liability

Corporate tax on profits +

Personal tax on dividends

Unlimited Liability

Personal tax on profits

Finance vs. EconomicsFinance vs. Economics

Marginal Benefits vs. Marginal Cost: Marginal Benefits vs. Marginal Cost: Economics accepts projects for which Economics accepts projects for which the benefits are greater than the the benefits are greater than the costs, finance does the same. The costs, finance does the same. The difference is finance takes the time difference is finance takes the time value in consideration, economics value in consideration, economics does not.does not.

Finance vs. AccountingFinance vs. Accounting

Accrual vs. Cost Basis: Finance Accrual vs. Cost Basis: Finance recognizes revenues and expenses recognizes revenues and expenses only on the basis of cash inflows and only on the basis of cash inflows and outflows - A bird in hand is better outflows - A bird in hand is better than two in the bush. Where as than two in the bush. Where as accounting follows accrual basis- it accounting follows accrual basis- it recognizes revenue at the time of recognizes revenue at the time of sale and expenses at the time when sale and expenses at the time when they are incurred.they are incurred.

Goals of the Corporation:Goals of the Corporation:

Profit Maximization or Profit Maximization or Wealth Maximization?Wealth Maximization?

Profit maximization is not a reasonable Profit maximization is not a reasonable goal because it fails to consider some goal because it fails to consider some

important facts. It ignores:important facts. It ignores:

The timing of returns- the receipt of The timing of returns- the receipt of

funds sooner than later is preferred.funds sooner than later is preferred. Cash flows available to stockholders/ Cash flows available to stockholders/

effect of dividend policy. effect of dividend policy. Risk- the chance that actual outcome Risk- the chance that actual outcome

may differ from those expected.may differ from those expected.

Profit Maximizes emphasizes on maximizing Profit Maximizes emphasizes on maximizing the value of EPS. the value of EPS. EPSEPS are calculated by are calculated by dividing the period’s total earnings available dividing the period’s total earnings available for the firm’s common stockholders by the for the firm’s common stockholders by the number of shares of common stock number of shares of common stock outstanding. outstanding.

ShareShare:: A share is a piece of A share is a piece of paper/document which represents the paper/document which represents the ownership of a particular company.ownership of a particular company.

Or, a share is a chose in action, conferring Or, a share is a chose in action, conferring on its legal right to the part of the on its legal right to the part of the company’s profits (usually by payment of a company’s profits (usually by payment of a dividend) and to any voting rights attaching dividend) and to any voting rights attaching to that share. to that share.

Maximize Shareholders’ Wealth:Maximize Shareholders’ Wealth:

The goal of the corporation, and therefore of The goal of the corporation, and therefore of all managers and employees, is to maximize all managers and employees, is to maximize the wealth of the owners for whom it is being the wealth of the owners for whom it is being operated. operated.

Shareholders wealth Shareholders wealth is represented by the is represented by the

market price per sharemarket price per share of the of the corporation’s common stock. The market corporation’s common stock. The market price serves as a barometer for business price serves as a barometer for business performance; it indicates how well performance; it indicates how well management is doing on behalf of its management is doing on behalf of its shareholders.shareholders.

The stakeholdersThe stakeholders include include creditors, employees, customers, creditors, employees, customers, suppliers, communities in which a suppliers, communities in which a company operates and others. company operates and others. Only through attention to the Only through attention to the legitimate concerns of the firm’s legitimate concerns of the firm’s various stakeholders can attain its various stakeholders can attain its ultimate goal- maximizing ultimate goal- maximizing shareholders wealth.shareholders wealth.

Profit Maximizing vs. Wealth Profit Maximizing vs. Wealth MaximizingMaximizing

EVAEVA as a representation of shareholders as a representation of shareholders wealth: EVA is calculated by subtracting wealth: EVA is calculated by subtracting the cost of funds used to finance an the cost of funds used to finance an investment from its after tax operating investment from its after tax operating profits.profits.

EVA = OPAT – Cost of FundsEVA = OPAT – Cost of Funds

The projects with positive EVA are desirable The projects with positive EVA are desirable and the projects with negative EVA are and the projects with negative EVA are undesirable.undesirable.

Social Responsibility of the Firm:Social Responsibility of the Firm: Protecting the consumer rights: They Protecting the consumer rights: They

shouldn’t charge abnormal prices for shouldn’t charge abnormal prices for their product or services and act as a their product or services and act as a monopoly type. Every firm should monopoly type. Every firm should ensure quality product and services for ensure quality product and services for ultimate consumers.ultimate consumers.

Paying fair wages to employees and Paying fair wages to employees and provide rewards as a motivational drive provide rewards as a motivational drive to increase their productivity. Firms to increase their productivity. Firms must ensure welfare of their workers must ensure welfare of their workers and employees.and employees.

Social Responsibility of the Firm:Social Responsibility of the Firm:(cont.)(cont.)

Maintaining fair hiring practice or selection Maintaining fair hiring practice or selection process and safe working condition.process and safe working condition.

Giving support for proper education to Giving support for proper education to grass-root level. In this case established grass-root level. In this case established firms may provide various types of firms may provide various types of scholarship for poor students.scholarship for poor students.

Becoming involved in such environmental Becoming involved in such environmental issues as clean water and air. Firm may issues as clean water and air. Firm may take social awareness activities against take social awareness activities against environment pollutions, AIDS, acid environment pollutions, AIDS, acid terrorism, and other negative matter terrorism, and other negative matter which creates social distress and which creates social distress and hampered normal life.hampered normal life.

Agency Problems:Agency Problems:

There is a potential conflict of interest There is a potential conflict of interest between the owners, who expect the between the owners, who expect the managers to act on their behalf, and managers to act on their behalf, and managers, who have their own managers, who have their own interests as well. This gives rise to interests as well. This gives rise to what has been called what has been called “the agency “the agency problem”problem”,, that is, the divergence of that is, the divergence of interests that arisen between a interests that arisen between a principal and his agent.principal and his agent.

Agency Cost for Prevention of Agency Cost for Prevention of Agency Problems:Agency Problems:

Managerial Compensation Managerial Compensation (incentives).(incentives). One compensation plan One compensation plan that many firm use is to give managers that many firm use is to give managers performance shares. performance shares.

Monitoring Expenditures-Monitoring Expenditures- This outlays This outlays pay for audits and control procedures that pay for audits and control procedures that are used to asses and limit managerial are used to asses and limit managerial behavior to those actions that tend to be behavior to those actions that tend to be in the best interest of the owners.in the best interest of the owners.

Bonding expendituresBonding expenditures protect protect against the potential consequences of against the potential consequences of dishonest acts by managers. dishonest acts by managers. Typically, the owners pay a third- Typically, the owners pay a third- party bonding company to obtain a party bonding company to obtain a fidelity bond. This bond is a contract fidelity bond. This bond is a contract under which the bonding company under which the bonding company agrees to reimburse the firm for up to agrees to reimburse the firm for up to a stated amount if a bonded a stated amount if a bonded manager’s dishonest act results in manager’s dishonest act results in financial loss to the firm.financial loss to the firm.

Agency Problem: SolutionsAgency Problem: Solutions

1 - 1 - Compensation plansCompensation plans

2 – 2 – Decision making authority given Decision making authority given to the to the Board of DirectorsBoard of Directors

3 - 3 - Takeover threatTakeover threat

4 - 4 - Specialist monitoring such as Specialist monitoring such as third third party bonding and party bonding and

5 - 5 - The role of the auditorsThe role of the auditors

Web ResourcesWeb Resources

www.financewise.com

www.forbes.com

www.wiso.gwdg.de/ifbg/finance.html

www.edgeonline.com

www.corpmon.com

crcse.business.pitt.edu/pages/biblio.html

pw1.netcom.com/~jstorres/internalaudit/resources.html