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 firm’s 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

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 firm’s 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. Unlimited Liability Personal tax on profits Limited Liability Corporate tax on profits + Personal tax on dividends 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 Corporation:Profit 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 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.

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 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.

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 firm’s 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 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.

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 manager’s 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.de/ifbg/finance.html www.edgeonline.com www.corpmon.com crcse.business.pitt.edu/pages/biblio.html pw1.netcom.com/~jstorres/internalaudit/resources.html