Introduction on finance

© 2003 McGraw-Hill Ryerson Limited

Business Finance

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Learning Goals

1. Define finance, its major areas and opportunities available in this field, and the legal forms of business organization.

2. Describe the managerial finance function and its relationship to economics and accounting.

3. Identify the primary activities of the financial manager.

4. Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue.

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What is Finance?

Finance can be defined as the science and art of managing money.

At the personal level, finance is concerned with individuals’ decisions about how much of their earnings they spend, how much they save, and how they invest their savings.

In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors.


Finance: Concepts….

Finance can also be defined as the science of money management.

Finance aims to price assets based on their risk level and their expected rate of return. Finance can be broken into three different sub-categories: public finance, corporate finance and personal finance.


CAREER OPPORTUNITIES IN FINANCE

(1) Financial services and(2) Managerial Finance.

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Area of Finance

Personal Finance Corporate Finance Public Finance


i. Personal Finance

Questions in personal finance revolve around Protection against unforeseen personal events, as well as events in

the wider economy Transference of family across generations (bequests and inheritance) Effects of tax policies (tax subsidies and/or penalties) on

management of personal finances Effects of credit on individual financial standing Planning a secure financial future in an environment of economic

instability Personal finance may involve paying for education,

financing durable goods such as real estate and cars, buying insurance, e.g. health and property insurance, investing and saving for retirement.


ii. Corporate Finance

Corporate finance is the area of finance dealing with the sources of funding and the capital structure of corporations and the actions that managers take to increase the value of the firm to the shareholders, as well as the tools and analysis used to allocate financial resources.

Corporate finance generally involves balancing risk and profitability.


iii. Public Finance

Public finance describes finance as related to sovereign states and sub-national entities (states/provinces, counties, municipalities, etc.) and related public entities (e.g. school districts) or agencies. It is concerned with:

Identification of required expenditure of a public sector entity Source(s) of that entity's revenue The budgeting process Debt issuance (municipal bonds) for public works projects


Areas of Finance

1. Financial Markets- Markets of users and savers of funds.

- Money markets deal in short-term securities (<=1 year) Ex.; Treasury Bills, commercial paper

- Capital markets deal in long-term securities Ex.; common stock, preferred stock, corporate bonds, government bonds

2. Financial Services- Design and delivery of financial advice and products to individuals, businesses,

government.3. Managerial Finance

- Financial management of business firms.- Financial management involves the efficient use of financial resources in the

production of goods A well-developed financial system is a hallmark and essential characteristic of any

modern developed nation.


Financial Management Decisions

Capital budgeting What long-term investments or projects should the business

take on? Capital structure

How should we pay for our assets? Should we use debt or equity?

Working capital management How do we manage the day-to-day finances of the firm?

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Assets Taka Liabilities and Equity Taka

CashMarketable securitiesAccounts receivableInventoriesTotal Current assetsNet Fixed AssetsTotal Assets

50,00010,000

255,000340,000655,000700,000

1355,000

Accounts PayablesAccrualsOther Current LiabilitiesTotal current liabilitiesLong term DebtCommon StockRetained earningsTotal Liabilities & Owners Equity

400,00055,00030,000

485,000350,000300,000220,000

1355,000


Investment Decisions

What is the optimal firm size? What specific assets should be acquired? What assets (if any) should be reduced or eliminated?

Most important of the three decisions.


Financing Decisions

What is the best type of financing? What is the best financing mix?What is the best dividend policy (e.g.,

dividend-payout ratio)?How will the funds be physically acquired?

Determine how the assets (LHS of balance sheet) will be financed (RHS of balance

sheet).


Working capital Management Decisions

How do we manage existing assets efficiently?

Financial Manager has varying degrees of operating responsibility over assets.

Greater emphasis on current asset management than fixed asset management.


The Firm and Its Goals

The Firm The Goal of the Firm Do Companies Maximize Profits? Maximizing the Wealth of Stockholders


The Firm

Definition A firm is a collection of resources that is transformed into

products demanded by consumers.


The Firm

Why does a firm exist? transactions costs

• contracting and enforcement costs• uncertainty• frequency of transaction• asset-specificity

• opportunistic behavior


The Firm

Limits to Firm Size tradeoff between

external transactions and the cost of internal operations


The Goal of the Firm

Throughout the text we will assume that the goal of the firm is to maximize profits. profit-maximization hypothesis

What is profit? revenue minus cost



Economic Objectives market share profit margin return on investment technological advancement customer satisfaction shareholder value

•Other goals that the firm might pursue:



Noneconomic Objectives workplace environment product quality service to community

•Other goals that the firm might pursue:



Knowing the firm’s goals allows the manager to make effective decisions

How might different goals lead to different decisions by the firm?


Do Companies Maximize Profit?

Criticism: Companies do not maximize profits but instead their aim is to “satisfice.” Two components to criticism:

• Position and power of stockholders• Position and power of professional

management



Position and power of stockholders

• Medium-sized or large corporations are owned by thousands of shareholders who may own only minute interests in the firm, and, in addition, own interests in an entire portfolio of firms.

• Shareholders are concerned with performance of entire portfolio and not individual stocks.



Position and power of stockholdersMost stockholders are not well informed

on how well a corporation can do and thus are not capable of determining the effectiveness of management.

Not likely to take any action as long as they are earning a “satisfactory” return on their investment.



Position and power of professional management High-level managers who are responsible for major decision

making may own very little of the company’s stock.



Managers follow their own objectives rather than those of the stockholders. Concern over job security may lead them to be too

conservative and instead pursue a steady performance. Management compensation may be based on some measure

other than profits.



Counter-arguments which support the profit maximization hypothesis. Stock prices are a reflection of a company’s

profitability. If managers do not seek to maximize profits, stock prices fall and firms are subject to takeover bids and proxy fights.

The compensation of many executives is tied to stock price.


Maximizing the Wealth of Stockholders

Views the firm from the perspective of a stream of earnings over time, i.e., a cash flow.

Must include the concept of the”time value of money.” Dollars earned in the future are worth less than dollars

earned today.


Maximizing the Wealth of Stockholders Future cash flows must be “discounted” to the present. The discount rate is affected by risk. Two major types of risk:

• Business Risk• Financial Risk


Maximizing the Wealth of Stockholders Business risk involves variation in returns due to the ups and

downs of the economy, the industry, and the firm. All firms face business risk to varying degrees



Financial Risk concerns the variation in returns that is induced by leverage.

Leverage is the proportion of a company financed by debt.

The higher the leverage, the greater the potential fluctuations in stockholder earnings.

Financial risk is directly related to the degree of leverage.


Maximizing the Wealth of Stockholders The present price of a firm’s stock should reflect the

discounted value of the expected future cash flows.

yearsinfirmoflifenratediscountk

yearperreceiveddividendsDstockofpricepresentPwhere

P nn

kD

kD

kD

kD

)1()1()1()1( 3

32

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Maximizing the Wealth of Stockholders If the firm is assumed to have an infinitely long life, the price of

a share of stock which earns a dividend D per year is determined by the equation

P = D/k


Maximizing the Wealth of Stockholders Given an infinitely lived firm whose dividends grow at a

constant rate (g) each year, the equation for the stock price becomes

P = D1/(k-g)where D1 is the dividend to be paid during the coming year.


Maximizing the Wealth of Stockholders Under this framework, maximizing the wealth of the

shareholder means that a company tries to manage its business in such a way that the dividends over time paid from its earnings and the risk incurred to bring about the stream of dividends always create the highest price for the company’s stock.


Maximizing the Wealth of Stockholders The equation for a company’s stock price shows us how the

price is affected by changes in the parameters.P = D1/(k-g)

How is the stock price affected by:

• changes in the size of the dividend?• changes in the growth of dividends?• changes in the risk faced by the firm?


Maximizing the Wealth of Stockholders The total value of the company’s common equity is

determined by multiplying the firm’s stock price by the number of shares outstanding.


Maximizing the Wealth of Stockholders Another measure of the wealth of stockholders is called

Market Value Added (MVA)®

MVA represents the difference between the market value of the company and the capital that the investors have paid into the company.


Maximizing the Wealth of Stockholders MVA includes adjustments for accumulated R&D and goodwill. While the market value of the company will always be

positive, MVA may be positive or negative.



Another measure of the wealth of stockholders is called Economic Value Added (EVA)®

EVA is calculated asEVA=(Return on Total Capital – Cost of Capital)

•Total Capital

If EVA is positive then shareholder wealth is increasing. If EVA is negative, then shareholder wealth is being destroyed.


Maximizing the Wealth of Stockholders Another measure used to rank companies is Future Growth

Value (FGV). FGV measures how much of the company’s value is due to

expected growth.


Goal of the Firm: Maximize Shareholder Wealth!!! (cont.)

The process of shareholder wealth maximization can be described using the following flow chart:

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Figure 1.3 Share Price Maximization


Finance as related to Accounting and Economics

Finance is related to: Accounting, which provides information in financial

statements

Economics, which provides: analysis tools such as pricing theory through supply and

demand analysis, cost-benefit analysis etc. information on the economic and financial environment

in which the company operates for sound financial decisions. These include inflation rate, exchange rate, international capital flows, unemployment rate, etc.

All of these factors must fit into the financial decisions

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Difference Between Finance and Accounting Recognition of Revenue and Expenses

Accrual Basis: recognizes sales revenue and expenses incurred to make sale at time of sale.

Cash Basis: recognizes revenues and expenses as they occur. Accounting vs Financial View

Accounting View(Accrual Basis)

Income StatementPeakes Quay, Inc.

For year ended 12/31

Financial View(Cash Basis)

Cash Flow StatementPeakes Quay, Inc.

For year ended 12/31

Sales revenue $100,000Less: Costs 80,000Net Profit $ 20,000

Cash inflow $ 0Less: Cash outflow 80,000Net cash flow ($80,000)


Career Opportunities in Finance

Financial Analyst – prepares and analyze firm’s financial plans and budgets; other duties include financial forecasting, financial ratio analysis.

Capital budgeting analyst/manager – evaluation/recommendation of proposed asset investments, implementation of approved projects.

Project finance manager –arranges financing for approved asset investments; coordinates with investment bankers and legal counsel.

Cash manager - maintain and control firm’s daily cash balances; manages cash collection, short-term investment/borrowing, disbursement activities and banking relationships.

Credit analyst/manager – administers firm’s credit policy by analyzing/managing the evaluation of credit applications, extending credit, monitoring/collecting A/R’s.


Why Study Finance?

Marketing Budgets, marketing research, marketing financial

products Accounting

Dual accounting and finance function, preparation of financial statements

Management Strategic thinking, job performance, profitability

Personal finance Budgeting, retirement planning, college planning, day-

to-day cash flow issues

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Agency Theory: The Principal-Agent Problem Agency Theory is about the conflict that may arise between

management and owners whenever owners are not also the managers.

Management may not always act in the best interest of the owners because management has interest of its own, like personal wealth, job security, lifestyle, and benefits. Thus, these concerns may conflict with shareholder interests.

The pursuit of socially or ethically acceptable goals may have to come at the expense of shareholder’s wealth.


Importance of Ethics to Stakeholders

Stakeholders are those groups that have direct economic links to the firm.

Stakeholders include not only owners, but also employees, customers, suppliers, unions, and creditors.

Honesty, trustworthiness, fair dealing are foundations of sustainable business relations with these stakeholders.

Ethical behaviour is necessary to achieve the goal of maximizing shareholder wealth.

Maintaining positive stakeholder relationships helps maximize long-term benefits to shareholders.


Financial Manager–Key Activities

Activities include: Short-Term Financial Decisions

Working Capital Management - ex., careful monitoring of cash position on a day-to-day basis Financial Analysis and Planning

Investment Decisions (Capital Budgeting) long-term (L/T) financial decisions (>1 year) - ex., purchasing a new machine in the future

Financing decisions (capital structure) how to raise money: loans? leases? shares? bonds?

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A business owned byone person

FreedomSimplicity

Low Start UpCosts

Tax Benefits

Unlimited Liability

Lack of ContinuityDifficulty in Raising Money

Reliance on One Person

Advantages Disadvantages

Forms of Organization: Sole Proprietorships

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Greater Talent Pool

More Capital

Ease of FormationTax Benefits

Unlimited LiabilityLack of Continuity

OwnershipTransferDifficultPossibility of Conflict

A business venture with two or more owners


Forms of Organization: Partnerships

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Limited Liability Continuity

Greater Likelihood of Professional Management Easier Access to Money

Potential Shareholder Revolts

Higher Start-Up Costs

Regulation Double TaxationA corporation

is a separate legal entity


Forms of Organization: Corporations

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Summary and Conclusions

The financial manager: controls the daily cash inflows and outflows resulting from business operationsmakes the occasional investment and financing decisions essential for the future financial success of the businessmay work in a corporation or other form of business organization

Their overriding goal is to maximize the wealth of the owners by earning an attractive return in the business at an acceptable level of risk

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Introduction on finance

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