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Principles of Finance

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Title: Principles of Finance


1
Principles of Finance
1st CHAPTER
  • Definition and Basic concepts

2
Definition 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.

5
Financial 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.

6
Functions 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.

7
Functions 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.

8
Functions 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

11
Organizing a Business
  • Types of Business Organizations
  • Sole Proprietorships
  • Partnerships
  • Corporations
  • Hybrids
  • Limited Partnerships
  • LLP (Limited Liability Partnership)
  • LLC (Limited Liability Corporations)

Irwin/McGraw-Hill
12
Organizing a Business
Irwin/McGraw-Hill
13
Corporate Structure
Sole Proprietorships
Partnerships
Corporations
14
Finance 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.

15
Finance 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.

16
Goals 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.

19
Maximize 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.

21
Profit 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.

22
Social 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.

23
Social 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.

24
Agency 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.

25
Agency 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.

27
Agency 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

28
Web 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
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