INTRODUCTION

What is Finance ?
Finance is a broad term that describes two related activities : the study of how money is
managed and the actual process of acquiring needed funds .Because individuals , businesses
and government entities all need funding to operate.

So the term finance can be defined as the management of the flows of money through an
organization ,whether it can be a corporation , school, bank or government agency. Finance
concerns itself with the actual flows of money as well as any claim against money.

Business finance

Business finance, the raising and managing of funds by business organizations.

Planning, analysis, and control operations are responsibilities of the financial manager,
who is usually close to the top of the organizational structure of a firm. In very large
firms, major financial decisions are often made by a finance committee. In small firms,
the owner-manager usually conducts the financial operations. Much of the day-to-day
work of business finance is conducted by lower-level staff; their work includes handling
cash receipts and disbursements, borrowing from commercial banks on a regular and
continuing basis, and formulating cash budgets.

Financial decisions affect both the profitability and the risk of a firm’s operations. An
increase in cash holdings, for instance, reduces risk; but, because cash is not an earning
asset, converting other types of assets to cash reduces the firm’s profitability. Similarly,
the use of additional debt can raise the profitability of a firm (because it is expanding its
business with borrowed money), but more debt means more risk. Striking a balance—
between risk and profitability—that will maintain the long-term value of a firm’s
securities is the task of finance.
History of finance
The origin of finance can be traced to the start of civilization. The earliest historical
evidence of finance is dated back from 3000 BC. Banking originated in the Babylonian
empire, where temples and palaces were used as safe places for the storage of
valuables. Initially, the only valuable that could be deposited was grain, but cattle and
precious materials were eventually included. During the same time period, the Sumerian
city of Uruk in Mesopotamia supported trade by lending as well as the use of interest. In
Sumerian, “interest” was mas, which translates to "calf". In Greece and Egypt, the
words used for interest, tokos and ms respectively, meant “to give birth”. In these
cultures, interest indicated a valuable increase, and seemed to consider it from the
lender’s point of view.[6] During the Reign of Hammurabi (1792-1750 BC) in Babylon,
the Code of Hammurabi included laws governing banking operations. The Babylonians
were accustomed to charge interest at the rate of 20 per cent per annum.
In the Biblical world point of view within the Jewish Civilization (1500 BC), Jews were
not allowed to take interest from other Jews, but they were allowed to take interest from
the gentiles. The reason for the non-prohibition of the receipt by a Jew of interest from a
Gentile, and vice versa, is held by modern rabbis to lay in the fact that the Gentiles had
at that time no law forbidding them to practice usury. As they took interest from Jews,
the Torah considered it equitable that Jews should take interest from Gentiles. In
Hebrew, interest is neshek. As opposed to other ancient civilizations, interest is
considered from borrower's point of view.[citation needed]
By 1200 BC, Cowrie shells were used as a form of money in China, and by 640 BC,
the Lydians had started to use coin money. Lydia was the first place where permanent
retail shops opened. (Herodotus mentions the use of crude coins in Lydia in an earlier
date, i.e. 687 BC.)[citation needed]
In 500 BC, Pythius became the first banker that had records, and operated in both
Western Anatolia and Greece. The use of coins as a means of representing money
began in the years between (600-570 BC). Cities under the Greek empire, such as
Aegina (595 B.C.), Athens (575 B.C.) and Corinth (570 B.C.), started to mint their own
coins. Leading thinkers and statesmen, such as Cato the Elder, Cato the
Younger, Cicero, and Plutarch were against usury. In the Roman Republic, interest was
outlawed altogether by the Lex Genucia reforms. Under the banner of Julius Caesar, a
ceiling on interest rates of 12% was set, and later under Justinian, it was lowered even
further to between 4% and 8%
 Types of Finance

• Public Finance,
• Personal Finance,
• Corporate Finance and
• Private Finance.

Public Finance:
Public finance deals with the study of the state’s expenditure and income. It
considers only the government’s finances. The scope of public finance includes the
fund’s collection and its allocation among different sectors of state activities that are
considered as essential functions or duties of the government.
Public finance can be classified into three types:
• Public Expenditure
• Public Revenues
• Public Debt

i. Public Expenditure:
Public expenditure means the expenses incurred by the government for its
maintenance and for the welfare and preservation of the economy, society, and the
nation.

ii. Public Revenues:

Broadly public revenues include all the receipts and income irrespective their nature
and source, which the government acquires during any given period. It will also
include the loans raised by the government. Narrowly, it will include only the income
from revenue resources which include taxes, price, fees, penalties, fines, gifts, etc.

iii. Public Debt:

Public debt means the loans raised which is a source of public finance carrying with it
the repayment obligation to the individuals and the interest.
Personal Finance:
Personal finance denotes the application of finance’s principles to the monetary
decisions of a family or an individual. It includes the ways in which families or
individuals get, budget, spend and save monetary resources over a period, considering
different future life events and financial risks. Financial position is focused on
understanding the available personal resources by examining the household cash flows
and net worth. Net worth is an individual’s balance sheet, derived by summing up all
assets under that individual’s control, minus the household’s all liabilities at a time.

Corporate Finance:

Corporate finance includes financial activities pertaining to running a corporation. It

is a department or division which oversees the financial functions of a company. The
primary concern of corporate finance is the maximization of shareholder value
through short-term and long-term financial planning and different strategies’
implementation.

Private Finance:

Private finance denotes an alternative method of corporate finance helping a

company raise fund to avoid monetary problems with a limited time frame. Basically,
this method helps a company which is not listed on a securities exchange or is
incapable to obtain finance on such markets. A private financial plan can also be
suitable for a nonprofit organization.
 Finance and Other Related Disciplines
The following are the related disciplines viz
• Finance and Economics
• Finance and Accounting
• Finance and Marketing
• Finance and production
• Finance and Quantitative Methods

Finance and Economics

The relationship in between these two disciplines are studied in two different
headings viz Micro and Macro economics
The major part of the financial management is to raise the financial resource to the
requirements. While raising the financial resources, the availability is subject to the
macro economic influences.
• Banking system
• Money and capital markets
• Financial intermediaries
• Monetary and credit policies
 Finance and Accounting

The two are embedded with different disciplines. The finance is the discipline
which is mainly based on the cash basis of operations but the accounting is totally
governed by the accrual system.
Accounting is mainly vested with the collection and presentation of data, but the
finance is closely connected with the decision making of the organization.
Till this moment, the differences are discussed only to know the role of finance
over the accounting of any organization. The following is the major relationship
which lies in between the finance and accounting as follows "Finance begins where
accounting ends"

• Finance and Marketing: These two are disciplines are interrelated to plan for
introduction of new product. The major reason is that the introduction of new
product normally warrants huge sum of money for research and development;
which needs immense planning and execution to succeed over the other
competitors
• Finance and Production: The changes in the production policy of the
organization will impact the capital expenditures. The fixed assets of the
organization should be effectively utilized which neither over capitalization nor
under capitalization
• Finance and Quantitative methods: These are inter related to solve complex
problems in order to take decisions.
 Goal of The Firm
• In finance , the goal of the firm is always described as "maximization
of shareholders' wealth".

Profit Maximization - is always used as a goal of the firm in

microeconomics. Focus on short term goal to be achieved within a
year. It stresses on the efficient use of capital resources. In order to
maximize profit, the financial manager will implement actions that
would result in maximum profits without considering the
consequence of his actions towards the company's future
performance.

Drawbacks of Profit Maximization

- Profit maximization is a short-term concept.
- Profit maximization does not consider the timing of returns.
- Profit maximization ignores risk.

Maximization of Shareholders' Wealth

The goal is o maximize the shareholders' wealth for whom it is being

operated. It being measured by the share price of the stock, which in
turn is based on the timing of returns, the amount of the returns and
the risk or uncertainty of the returns.

It also means maximizing the total market value of the existing

shareholders' common stock. All financial decisions will affect the
achievement of this goal. Shareholders' wealth maximization can be
achieved by considering the present and potential future earnings per
share, timing of returns, dividend policy and other factors that affect
the market price of the company's stock.
Agency Issues
What is a Principal-Agent Problem/Agency Problem

A principal-agent problem arises when there is a conflict of interest between the agent
and the principal, which typically occurs when the agent acts solely in his/her own
interests. In a principal-agent relationship, the principal is the party that legally appoints
the agent to make decisions and take actions on its behalf.

To learn more about similar topics you can take CFI’s behavioral finance fundamentals
course, which explores the fundamental issues of psychology on the behavior of
financial agents.

The separation of the “ownership” (principal) and the “control” (agent) in principal-agent
relationships creates the grounds for potential conflict of interests between the two
parties.

Reasons Behind Principal-Agent Problems

The main reasons for the principal-agent problem are conflicts of interests between two
parties and the asymmetric information between them (agents tend to possess more
information than principals). The principal-agent problem generally results in agency
costs that the principal should bear. Because agents can act in their interests at the
principals’ expense, the principal-agent problem is an example of a moral hazard.

The principal-agent problem was conceptualized in 1976 by American

economists, Michael Jensen and William Meckling.
The problem has applications in political science and in economics. It is especially
significant in the understanding of corporate governance.

Examples of Principal-Agent Problem

The following cases are among the most common examples of the principal-agent
problem:

• Shareholders (principal) vs. management (agent)

• Voters (principal) vs. politicians (agent)
• Financial institutions (principal) vs. rating agencies (agent)

Resolving Agency Problem:

Solutions to the Problem

Solutions to the principal-agent problem aim to align the interest of both parties. There
are two main areas of improvement to address the problem:

#1. Contract design

The main purpose of contract design is the creation of a contract framework between
the principal and the agent to address issues of information asymmetry, stimulate the
agent’s incentives to act in the best interests of the principal, and to determine
procedures for monitoring agents.
#2. Performance evaluation and compensation

The agent’s compensation is the primary method of aligning the interests of both
parties. In order to address the principal-agent problem, the compensation must be
linked to the performance of the agent.

The performance of the agent is usually measured by subjective evaluation because it is

a more flexible and balanced assessment method for complex jobs. Common methods
of agent compensation include stock options, profit-sharing, and deferred
compensation. Tying the agent’s compensation closely to the benefits obtained for the
principal helps to eliminate conflicts of interest.