Title: Principles of Finance
1Principles of Finance
1st CHAPTER
- Definition and Basic concepts
2Definition of Finance
- Finance is the art and science of managing money
which is concerned with the process,
institutions, markets and instruments involved in
the transfer of money among and between
individuals, business and governments. -
- Finance is a body of facts, principles, and
theories dealing with the raising and using of
money by a firm.
3- Finance is the branch of economics that focuses
on investment in real and financial assets and
their management. - A real asset is a physical item such as a truck,
land, or building. - A financial asset is a claim for a future
financial payment, such as a savings account at a
bank.
4(Continuation)
- Financial assets generate future payments,
whereas real assets alter the physical
environment in some way. - Financial management is concerned with the
acquisition, financing, and management of assets
with overall goal in mind.
5Financial Manager
- Financial managers actively manage the
financial affairs of many types of business-
financial or non financial, private and public,
large and small, profit-seeking and not for
profit. They perform such varied financial tasks
as planning, extending credit to customers,
evaluating proposed large expenditures, and
raising money to the firms operations.
6Functions of Financial Managers
- 1. Performing financial analysis and planning-
which includes - Monitoring the firms financial condition,
- Evaluating the need for increased (or reduced )
productive capacity, and - Determining what financing is required.
7Functions of Fin Mgr (cont.)
- 2. Investment Decision Making
- It is the most important decision of the firm
when it comes to value creation. It begins with a
determination of the total amount of assets
needed to be held by the firm. - 3. Making Financing Decision
- Here the financial manager is concerned with
the makeup of the right-hand side of the balance
sheet. It involves two major areas. First, the
most appropriate mix of short term and long-term
financing must be established. A second important
concern is which individual short term or long
term sources of financing are best at a given
point in time.
8Functions of Fin. Mgr. (cont.)
- Investment and financial decisions deals with
assets and liability sides of the Balance Sheet - Investment Financing
- Decisions Decisions
Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Assets
9- 4. Asset management Decision
- Assets must be managed efficiently and
financial manager must be more concerned in this
respect. Otherwise firm may fall in difficulty in
several cases. - 5. Accounting and Control
- Maintaining financial records controlling
financial activities, identifying deviations from
planned and efficient performance, and managing
payroll, tax matters, inventories, fixed assets
and computer operations.
10- 6. Forecasting
- Forecasting costs technological changes,
capital market conditions, funds needed for
investments, demand for the firms products and
using forecasts and historical data to plan
future operations. - Pricing, credit and collections, insurance and
incentive planning are some other
responsibilities of the financial managers
11Organizing a Business
- Types of Business Organizations
- Sole Proprietorships
- Partnerships
- Corporations
- Hybrids
- Limited Partnerships
- LLP (Limited Liability Partnership)
- LLC (Limited Liability Corporations)
Irwin/McGraw-Hill
12Organizing a Business
Irwin/McGraw-Hill
13Corporate Structure
Sole Proprietorships
Partnerships
Corporations
14Finance vs. Economics
- Marginal Benefits vs. Marginal Cost Economics
accepts projects for which the benefits are
greater than the costs, finance does the same.
The difference is finance takes the time value in
consideration, economics does not.
15Finance vs. Accounting
- Accrual vs. Cost Basis Finance recognizes
revenues and expenses only on the basis of cash
inflows and outflows - A bird in hand is better
than two in the bush. Where as accounting follows
accrual basis- it recognizes revenue at the time
of sale and expenses at the time when they are
incurred.
16Goals of the CorporationProfit Maximization or
Wealth Maximization?
17- Profit maximization is not a reasonable goal
because it fails to consider some important
facts. It ignores -
- The timing of returns- the receipt of funds
sooner than later is preferred. - Cash flows available to stockholders/ effect of
dividend policy. - Risk- the chance that actual outcome may differ
from those expected.
18- Profit Maximizes emphasizes on maximizing the
value of EPS. EPS are calculated by dividing the
periods total earnings available for the firms
common stockholders by the number of shares of
common stock outstanding. - Share A share is a piece of paper/document
which represents the ownership of a particular
company. - Or, a share is a chose in action, conferring on
its legal right to the part of the companys
profits (usually by payment of a dividend) and to
any voting rights attaching to that share.
19Maximize Shareholders Wealth
- The goal of the corporation, and therefore of
all managers and employees, is to maximize the
wealth of the owners for whom it is being
operated. -
- Shareholders wealth is represented by the
market price per share of the corporations
common stock. The market price serves as a
barometer for business performance it indicates
how well management is doing on behalf of its
shareholders. -
20-
- The stakeholders include creditors, employees,
customers, suppliers, communities in which a
company operates and others. Only through
attention to the legitimate concerns of the
firms various stakeholders can attain its
ultimate goal- maximizing shareholders wealth.
21Profit Maximizing vs. Wealth Maximizing
- EVA as a representation of shareholders wealth
EVA is calculated by subtracting the cost of
funds used to finance an investment from its
after tax operating profits. - EVA OPAT Cost of Funds
- The projects with positive EVA are desirable and
the projects with negative EVA are undesirable.
22Social Responsibility of the Firm
- Protecting the consumer rights They shouldnt
charge abnormal prices for their product or
services and act as a monopoly type. Every firm
should ensure quality product and services for
ultimate consumers. - Paying fair wages to employees and provide
rewards as a motivational drive to increase their
productivity. Firms must ensure welfare of their
workers and employees.
23Social Responsibility of the Firm(cont.)
- Maintaining fair hiring practice or selection
process and safe working condition. - Giving support for proper education to grass-root
level. In this case established firms may provide
various types of scholarship for poor students. - Becoming involved in such environmental issues as
clean water and air. Firm may take social
awareness activities against environment
pollutions, AIDS, acid terrorism, and other
negative matter which creates social distress and
hampered normal life.
24Agency Problems
- There is a potential conflict of interest
between the owners, who expect the managers to
act on their behalf, and managers, who have their
own interests as well. This gives rise to what
has been called the agency problem, that is,
the divergence of interests that arisen between a
principal and his agent.
25Agency Cost for Prevention of Agency Problems
- Managerial Compensation (incentives). One
compensation plan that many firm use is to give
managers performance shares. - Monitoring Expenditures- This outlays pay for
audits and control procedures that are used to
asses and limit managerial behavior to those
actions that tend to be in the best interest of
the owners.
26- Bonding expenditures protect against the
potential consequences of dishonest acts by
managers. Typically, the owners pay a third-
party bonding company to obtain a fidelity bond.
This bond is a contract under which the bonding
company agrees to reimburse the firm for up to a
stated amount if a bonded managers dishonest act
results in financial loss to the firm.
27Agency Problem Solutions
- 1 - Compensation plans
- 2 Decision making authority given to the
Board of Directors - 3 - Takeover threat
- 4 - Specialist monitoring such as third party
bonding and - 5 - The role of the auditors
28Web Resources
Web Links
www.financewise.com www.forbes.com www.wiso.gwdg.d
e/ifbg/finance.html www.edgeonline.com www.corpmon
.com crcse.business.pitt.edu/pages/biblio.html pw1
.netcom.com/jstorres/internalaudit/resources.html