Principles of Finance

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Principles of Finance
1st CHAPTER

• Definition and Basic concepts

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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.

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• 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.

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(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.

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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.

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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.

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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.

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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
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• 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.

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• 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

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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
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Organizing a Business
Irwin/McGraw-Hill
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Corporate Structure
Sole Proprietorships
Partnerships
Corporations
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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.

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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.

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Goals of the CorporationProfit Maximization or
Wealth Maximization?
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• 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.

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• 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.

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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.

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• 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.

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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.

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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.

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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.

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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.

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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.

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• 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.

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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

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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