CHAPTER 1: An Overview

of Finance

Concept of Finance
Types of Finance
Functions of Finance
Forms of Businesses
Goals of the Corporation
Agency Relationship
Financial Markets

1-1

Concept of Finance
The process of:
determining the required fund for an
activity or a purpose,
identifying the available sources for
raising the fund,
calculating the cost of each source,
collecting the fund from the minimum
cost source and
allocating the collected fund in such a
way that maximizes the target is
called finance.

1-2

Types of Finance
1. Business finance: The process of
determining the required fund for an activity
or a purpose by a business enterprise,
identifying the available sources for raising
the fund, calculating the cost of each
source, collecting the fund from the
minimum cost source and utilizing the
collected fund in such a way that maximizes
the profit is called finance.
2. Public/Government finance: The process
of determining the required fund for an
activity or a purpose by the government of
a particular country, searching the available
sources for collecting the required fund,
1-3

Types of Finance
estimating the cost of each source, raising
the fund from the minimum cost source
and disbursing the collected fund in such
a way that maximizes the welfare of the
common people of the country is called
public finance.
3. Personal/Private finance: The process
of determining the required fund for an
activity or a purpose by an individual,
identifying the available sources for
raising the fund, calculating the cost of
each source separately, collecting the
fund from the minimum cost source and1-4
using the fund for maximizing personal

Functions of Financial
Manager

1-5

Functions of Finance
1. Procurement of funds: There are alternative
sources of fund like a company can take loan or it
can issue common stock, preferred stock,
debenture or bond to raise the fund required,
based on cost minimization and it is the goal of
financing. Finance managers need to select the
best possible sources of funds among the
available alternatives and it is called Capital
structure Decision. Ordinary stock holders are the
owners of the firm (like they have voting rights)
but debtors are not the owners. So, common
stock is called Internal source; and bond,
debenture and loan are called external sources.
1-6

Functions of Finance
2. Utilization of funds: Capital Budgeting
decision. Long term investment decision is
made on the basis of risk and return. The goal
is profit maximization and it is the most
important and challenging function of finance.
To predict future profit is difficult as Profit=TRTC. TR=P.Q. TC=FC+TVC.
3. Short term asset management: Working
capital management by considering liquidity
and profitability.
4. Distribution of funds: Dividend policy
decision. Dividend policy, repurchase of shares
and amortization of debt.
1-7

Forms of Business
Proprietorship
Partnership
Corporations
S Corporations

1-8

Proprietorship
Has only one owner, who receives all
profits and suffers all losses, shares control
with no one, personally liable for all debts
incurred by the business. Creditors can
look to the proprietors personal assets to
satisfy business related claims.
Sole proprietor raises capital from personal
resources or by borrowing and is
responsible for all business decisions.
1-9

Partnerships
More than one owner. In
general
partnership all partners have unlimited
liability but in limited partnership liability
is limited to the capital contributed to the
organization and they cannot participate
in managing the enterprise.
Most partnership is established by a
written contract known as article of
partnership.
1-10

Corporations
Legal entities separate from its owners, able to
buy assets, raise funds. A corporation is formed
through articles of incorporation, which specify
the rights and limitations of the entity. The
owners have claims on the firm through their
ownership evidenced by common or preferred
stock, they have limited liability generally no
greater
than
their
initial
investment
.
Stockholders expect to earn return by receiving
dividends- periodic distribution of earnings- or by
realizing gains through increases in share price.
1-11

S Corporations
It has 35 or fewer stockholders and its
income is taxed as direct personal income to
the stockholders, so they do not have to pay
double tax but their liability is limited. In
case of corporation one of the key
disadvantage is double taxation of earning.
Since corporation is a separate legal entity it
pays tax on its own income and any
remaining income paid to shareholders in the
form of dividends will require a second tax
by the shareholders.
1-12

Goals of the
Corporation/Finance
The conventional goal of a firm is
profit-maximization. However, since
profit is reported by the management
so it can be manipulated. Moreover,
accounting profit is not estimated on
cash basis. So, the modern goal of firm
is shareholders wealth maximization,
which refers to maximizing stock
prices at the market.
1-13

Profit Maximization Vs. Wealth

Maximization
Vagueness in definition: There are many
definitions of Profit and so it is vaguely defined.
Wealth is the present value of all future
dividends which is readily observed in current
share price at the market.
Profit is an annual concept and so it is a short
term concept but wealth is a long term concept.
Profit can be manipulated by the management
(like window dressing) but wealth is beyond the
direct manipulation of management.
Risk consideration. The theory of risk says that
risk and return is proportional. Profit can not be
increased without increasing risk.
1-14

Why is Wealth
Maximization?
Long-term concept
Cannot be manipulated by the
management (like window dressing)
Risk consideration
Time value of money consideration
Clear in definition
Easy to calculate
1-15

Agency Relationship
The managers can be viewed as agents of the
owners who are given them decision making
authority to manage the firm. There is a potential
conflicts between owners and managers because
their objective differ from those of the owners.
Owners hope that mangers will act in their best
interest through compensation like stock options,
bonuses etc. and
monitoring like auditing
financial statements. If the managers have more
ownership percentage then it is more probable
that they will behave in a manner that is
consistent with maximizing shareholder wealth.
1-16

Principles of Financial
Management
Expected Cash flows
Timing of Cash flows
Risk and Return
Expected Cash flows : To maximize
shareholders wealth the managers should,
other things being equal, seek to maximize the
value of cash flows received by stockholders.
The owner of common stock holder can expect
to receive the following cash flows:
i) Cash dividend ii) Capital gain or loss
1-17

Principles of Financial
Management

Timing of cash flows are important because of

the time value of money principle. This simple
principle states that a dollar received today is
more valuable than a dollar received in future
because the dollar today can be reinvested to
produce additional cash flows.
Risk is the uncertainty surrounding a future
outcome. Risk is the probability that the actual
outcome in the future will be unequal to the
outcome that was expected. Risk and return are
closely related, the greater the return greater
the risk.
1-18

Financial Markets
Places where financial assets are traded.
Financial asset represents a monetary
claim on some issuer. Financial assetsmoney, notes payable, common stock etc.
Purpose of financial market:
Facilitating the acquisition and investment
Encouraging capital formation
Establishing market prices
1-19

Classifications of
Financial Market
Money Markets
Capital Markets
Primary Market
Secondary Market

1-20

Money Markets
Short term financial markets i.e.
financial claims will be outstanding
less than one year, high degree of
safety and liquidity. Three major
money market instruments:
Treasury bills
Negotiable certificate of deposit
Commercial paper
1-21

Capital Market

Long term financial market, where

financial claims lives equal to greater
than a year are traded. The most
common types of securities traded are
Bonds
Preferred stock
Common stock
Convertible securities
1-22

Primary & Secondary

Market

In Primary market where new

securities are purchased and sold for
the first time. Middlemen are usually
required to bring buyers and sellers
together.
In Secondary market existing
securities are traded. When one
investor sells a security to another , it
is through the secondary market.
1-23