1ST CHAPTER

INTRODUCTION TO PRINCIPLES OF FINANCE

DEFINITION OF FINANCEFinance 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.

DEFINITION OF FINANCEFinance 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.

BENEFITS OF KNOWLEDGE OF FINANCE

Careers in Finance-As a Corporate Financial ManagerAs a StockbrokerExecutive- Financial AnalystInvestment Consultant in an Investment Bank or Financial Institution

Loan Analyst/ Loan Officer in a Bank

MAJOR AREAS & OPPORTUNITIES IN FINANCE

Financial Services- The part of finance concerned with the design and delivery of advice and financial products to individuals, business and government.

Managerial Finance- Concerns the duties of the financial manager in the business firm.

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 firm’s operations.

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.

FUNCTIONS OF FINANCIAL MANAGERS

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.

FUNCTIONS OF FINANCIAL MANAGERS3. 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.

FUNCTIONS OF FINANCIAL MANAGERS

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.

FUNCTIONS OF FINANCIAL MANAGERS 6. Forecasting: Forecasting costs, technological

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

Pricing, credit and collections, insurance and incentive planning are some other responsible duties to the financial managers.

PROFIT MAXIMIZATION OR WEALTH MAXIMIZATION?

Goals of the Corporation:

PROFIT MAXIMIZATION OR WEALTH MAXIMIZATION?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.

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

STAKEHOLDERS RATHER THAN STOCKHOLDERS

The stakeholders include creditors, employees, customers, suppliers, communities in which a company operates and others.

Only through attention to the legitimate concerns of the firm’s various stakeholders can attain its ultimate goal- maximizing shareholders wealth.

EPS & SHARE EPS are calculated by dividing the period’s

total earnings available for the firm’s 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 company’s profits (usually by payment of a dividend) and to any voting rights attaching to that share.

SOCIAL RESPONSIBILITY OF THE FIRM:

Protecting the consumer rights- Companies shouldn’t 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.

SOCIAL RESPONSIBILITY OF THE FIRM: (CONTINUE)

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.

SOCIAL RESPONSIBILITY OF THE FIRM: (CONTINUE)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.

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.

AGENCY COST FOR PREVENTION OF AGENCY PROBLEMS:

Several mechanisms are used to motivate managers to act in the shareholders’ best interests. These include-

The threat of takeover Structuring managerial

incentives Monitoring Expenditures The threat of firing

AGENCY COST FOR PREVENTION OF AGENCY PROBLEMS:

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 manager’s dishonest act results in financial loss to the firm.

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