What is Finance?

 Finance is the study of how people and businesses evaluate

investments and raise capital to fund them. (-- How to get and use
money)
 Finance describes the management, creation and study of money,
banking, credit, investments, assets and liabilities that make up
financial systems, as well as the study of those financial instruments.
 Three questions addressed by the study of finance
1. What long-term investments should the firm undertake? (capital
budgeting decisions – how to spend the money?)
2. How should the firm fund these investments? (capital structure
decisions -- How to get the money?)
3. How can the firm best manage its cash flows as they arise in its day-
to-day operations? (working capital management decisions – how to
manage cash (liquid) money?)
1 FIN3000, Liuren Wu
 CONT.….

 Many of the basic concepts in finance come from micro and macroeconomic theories.
One of the most fundamental theory is the time value of money, which essentially states
that a dollar today is worth more than a dollar in the future.

 Finance is the application of economic principles that involves the Creation allocation or
managing of money under condition of uncertainty.
 Finance provides the framework for making decisions as to how to get funds and what
we should do with them once we have them.
TYPES OF FINANCE
 Public Finance

 Corporate Finance

 Personal Finance
PUBLIC FINANCE

 Public finance includes tax systems, government expenditures,

budget procedures, stabilization policy and instruments, debt
issues and other government concerns. The federal government
helps prevent market failure by overseeing allocation of
resources, distribution of income and stabilization of the
economy. Regular funding for these programs is secured mostly
through taxation. Borrowing from banks, insurance companies
and other governments and earning dividends from its
companies also help finance the federal government. State and
local governments also receive grants and aid from the federal
government. In addition, user charges from ports, airport
services and other facilities; fines resulting from breaking laws;
revenues from licenses and fees, such as for driving; and sales of
government securities and bond issues are also sources of public
finance.
CORPORATE FINANCE

 Corporate finance involves managing assets, liabilities, revenues

and debt for a business. Businesses obtain financing through a
variety of means, ranging from equity investments to credit
arrangements. A firm might take out a loan from a bank, or
arrange for a line of credit. Acquiring and managing debt
properly can help a company expand and ultimately become more
profitable. Startups may receive capital from angel investors or
venture capitalists in exchange for a percentage of ownership. If a
company thrives and decides to go public, it will issue shares on a
stock exchange; such initial public offerings (IPO) bring a great
influx of cash into a firm. Established companies may sell
additional shares, or issue corporate bonds to raise money.
Businesses may purchase dividend-paying stocks, blue-chip
bonds or interest-bearing bank certificates of deposit; they may
even buy other companies in an effort to boost revenue.
PERSONAL FINANCE

 Personal financial planning generally involves analyzing

an individual's or a family's current financial position,
predicting short-term and long-term needs, and
executing a plan to fulfill those needs within individual
financial constraints.
AIMS OF FINANCE FUNCTION:
 Acquiring Sufficient Funds: The main aim of finance function is to assess the
financial needs of an enterprise and then finding out suitable sources for raising
them. If funds are needed for longer periods then long-term sources like share
capital, debentures, term loans may be explored.
 Proper Utilization of Funds: Though raising of funds is important but their
effective utilization is more important. The funds should be used in such a way
that maximum benefit is derived from them. The returns from their use should
be more than their cost.
 Increasing Profitability: The planning and control of finance function aims at
increasing profitability of the concern. It is true that money generates money.
To increase profitability, sufficient funds will have to be invested. Finance
function should be so planned that the concern neither suffers from inadequacy
of funds nor wastes more funds than required. The cost of acquiring funds also
influences profitability of the business. If the cost of raising funds is more, then
profitability will go down. Finance function also requires matching of cost and
returns from funds.
 Maximizing Firm’s Value: Finance function also aims at maximizing the
value of the firm. It is generally said that a concern’s value is linked with its
profitability. Even though profitability influences a firm’s value but it is not all.
Besides profits, the type of sources used for raising funds, the cost of funds, the
condition of money market, the demand for products are some other
considerations which also influence a firm’s value.
FINANCE AND ITS RELATION TO OTHER FIELDS

Probability
Mathematics
theory

Financial Statistica
accounting l
theory

Economics Finance Psychology

MAJOR AREAS IN FINANCE

Financial
management

Capital markets,
Investment
capital
management
market theory and
Institution
FINANCIAL MANAGEMENT
 Financial Management Concerns the acquisition, financing,
and management of assets with some overall goal in mind.
 Financial managers are primarily concerned with investment
decisions ; financing decisions and Assets Management
decisions.
INVESTMENT DECISIONS
 Investment decisions are concerned with the use of fund.
 buying, holding, or selling of all types of assets:
 Most important Investment decisions.
 Should a business purchase a new machine?
 Should a business introduce a new product line?
 Sell the old production facility?
 Acquire another business?
 Build a manufacturing plant?
 FINANCING DECISIONS
 Financing decisions are concerned with the procuring of funds that
can be used for long-term investing and financing day-to-day
operations.
 Should financial managers use profits raised through the company’s
revenues or distribute those profits to the owners?
 Should financial managers seek money from outside of the business?
 company’s operations and investments can be financed from outside the
business by incurring debt—such as through bank loans or the sale of bonds
—or by selling ownership interests
ASSET MANAGEMENT DECISIONS
 How do we manage existing assets efficiently?
 Financial Manager has varying degrees of operating
responsibility over assets.
 Greater stress on current asset management than fixed
asset management.
CONT.……….
 A financial manager must also make decisions about a
company’s current assets.
 Current assets are those assets that could reasonably be
converted into cash within one operating cycle or one year.
 Another critical task in financial management is the risk
management of a company.
RISK MANAGEMENT
 The process of risk management involves determining
which risks to accept, which to neutralize, and which to
transfer.
 The four key processes in risk management are risk:
 Identification
 Assessment (valuation)
 Mitigation (justification; modification)
 Transference (Transfer)
WHAT IS THE GOAL OF THE FIRM?
 SHORTCOMINGS OF ALTERNATIVE
PERSPECTIVES
Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
 Profit maximization is an understandable goal of management, but it
does not necessarily suggest that short-term profit increases will
produce long-term sustainable gains. For example, a reduction in
product quality that lowers production costs will produce a quick
increase in profit, but lowered quality standards can also tarnish a
company's reputation and provide the competition with an advantage.
 Lowering or eliminating a company's employee training or research
and development budget will lessen operating expenses and also
maximize short-term profits. However, the competition may not follow
suit and instead produce a much better product or service. The long-
term result could be a significant loss of market share for the company
that decided to lower its budget to pursue a short-term profit gain .
 SHORTCOMINGS OF
ALTERNATIVE PERSPECTIVES
Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
 Change in profit may also represent change in risk
 A conservative firm that earn 1.25 per share may be a less desirable investment if its earning per
share increase to 1.50, but risk inherent in the operation increases even more.
 Could increase current profits while harming firm (e.g., defer maintenance).
 Ignores changes in the risk level of the firm. The critics of profit maximization objective
argue that it ignores the risk associated with stream of cash flow of the project. For
example, the total profit from two projects may be same but the profit from one project
may be fluctuating widely than the profit from the other project. The firm with wider
fluctuation in profit is riskier. This fact is ignored by profit maximization objective
 SHORTCOMINGS OF ALTERNATIVE
PERSPECTIVES

Earnings per Share Maximization

 Maximizing earnings after taxes divided by
shares outstanding.
Problems
 Does not specify timing or duration of expected returns.
 Ignores changes in the risk level of the firm.
 Calls for a zero payout dividend policy.
 STRENGTHS OF SHAREHOLDER
WEALTH MAXIMIZATION
 Takes account of: current and future profits and EPS; the timing,
duration, and risk of profits and EPS; dividend policy; and all other
relevant factors.
 Thus, share price serves as a barometer for business performance.
ROLE OF MANAGEMENT

Management acts as an agent for the

owners (shareholders) of the firm.

 An agent is an individual authorized by another

person, called the principal, to act in the latter’s
behalf.
AGENCY THEORY

 Jensen and Meckling developed a

theory of the firm based on agency
theory.
 Agency Theory is a branch of economics relating
to the behavior of principals and their agents.
AGENCY THEORY

 Principals must provide incentives so

that management acts in the principals’
best interests and then monitor results.

 Incentives include stock options, perquisites, and

bonuses.
 ORGANIZATION OF THE
FINANCIAL MANAGEMENT
FUNCTION

Board of Directors

President
(Chief Executive Officer)

Vice President VP of Vice President

Operations Marketing
Finance
 ORGANIZATION OF THE
FINANCIAL MANAGEMENT
FUNCTION

VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts