Introduction to finance.pptx

Introduction to Finance
FIN2319 :: FIN504 :: EFIN504
Prof. Dr. Md Mohan Uddin

Definition and Scope of
Finance

 The science and art of managing money:
• collection of money
• utilization of money.
Finance - Definition
Science: A
systematically
organized body
of knowledge
on a particular
subject
Art: Subjects of
study primarily
concerned with
human
creativity and
social life
Definition and Scope of Finance

Financial Decisions
Personal
Level
•How much of earnings to
spend.
•How much to save.
•How to invest the savings.
savings.
Business
Level
•How to raise capital.
•How to invest for profit.
•Whether reinvest or
distribute profit.

Areas of Business Finance
Capital
Markets

Corporate
Finance
Managing
short term
assets and
liabilities
Amount,
timing, and
and
sources of
capital
Amount,
timing, and
and type of
of assets to
to acquire

Financial
Markets
Manage-
ment and
regulation
of financial
financial
institutions
Market
efficiency
and
behavioral
finance
Prices and
return of
the debt &
equity
securities

Investment
& Portfolio
Manage-
ment
Structuring
and
Managing
investment
portfolios
Identifying
the trend of
of the
financial
market
Analyzing
the values
of stocks
and bonds

Finance vs. Economics & Accounting
Accounting provides
information about
cash flows.
Economics provides
the notion of
valuation based on
future cash flows.
Knowledge of both accounting and
economics is needed for financial
valuation and analysis
As a discipline
Finance grew
out of
Economics &
Accounting

Finance vs. Economics
 Financial managers must
• understand the economic framework and
• be alert to the consequences of varying levels of economic activity
and changes in economic policy.
• be able to use economic theories as guidelines for efficient business
operation.
 Marginal cost–benefit analysis is the economic principle that
states that financial decisions should be made and actions taken
only when the added benefits exceed the added costs.

Finance vs. Accounting
 The firm’s finance and accounting activities are closely-related
and generally overlap.
• In small firms accountants often carry out the finance function,
• In large firms financial analysts often help compile accounting
information.

 One major difference in perspective and emphasis between
finance and accounting is that
• accountants generally use the accrual method
• while in finance, the focus is on cash flows.

 Finance and accounting also differ with respect to decision-
making:
• Accountants devote most of their attention to
 the collection of financial data, and
 the presentation of financial data.
• Financial managers, on the other hand
 evaluate the accounting statements,
 develop additional data, and
 make decisions on the basis of their assessment of the associated
returns and risks.

Finance – Career Scope
 Financial Services
• design and delivery of advice and financial products to individuals,
businesses, and governments.
 Career opportunities include:
• banking
• personal financial planning
• Investments
• real estate
• insurance

 Managerial finance
• duties of the financial manager working in a business.
 Financial managers administer the financial affairs of all types
of businesses—private and public, large and small, profit-seeking
and not-for-profit. Tasks include:
• developing a financial plan or budget
• extending credit to customers
• evaluating proposed large expenditures
• raising money to fund the firm’s operations.

 Career Opportunities in Managerial Finance

 Accounting, management, marketing, human resources – all
decisions in these areas need to be assessed against the financial
implications –
• hence students in these area needs to learn basic finance.
 Finance is important to individuals regardless of their jobs –
• it improves their decision-making skills.

Forms of Business
Organizations

Legal Forms of Business Organization
Forms of Business Organizations
 Sole proprietorship
• business owned by one person and operated for his or her own
profit.
 Partnership
• business owned by two or more people and operated for profit.
 Corporation
• entity created by law
• have the legal powers of an individual
 it can sue and be sued,
 make and be party to contracts, and
 acquire property in its own name.

Strengths and Weaknesses
of the Legal Forms of Business Organization
Forms of Business Organizations

Main Financial Goal and
Agency Conflicts

Goal of the Firm
Main Financial Goal and Agency Conflicts
 Maximize Shareholder Wealth
• only take actions that are expected to increase the share price.

 Many companies focus on maximizing a broad range of financial
objectives, such as
• growth, earnings per share, market share.
 These goals should not take precedence over the main financial
goal - create value for investors.
Main Financial Goal – Creating Value for Investors

Goal of the Firm: Maximize Profit?
• Profit maximization may not lead to the highest possible share price
for at least three reasons:
1. Timing is important—the receipt of funds sooner rather than later is
preferred
2. Profits do not necessarily result in cash flows available to stockholders
3. Profit maximization fails to account for risk
Which Investment is Preferred?

 In equilibrium, a stock’s price should equal its “true” or intrinsic
value.
 Intrinsic value is a long-run concept.
 To the extent that investor perceptions are incorrect, a stock’s
price in the short run may deviate from its intrinsic value.
 Ideally, managers should avoid actions that reduce intrinsic
value, even if those decisions increase the stock price in the
short run.
Stock Prices and Intrinsic Value

Managerial Actions, the Economic
Environment, Taxes, and the Political Climate
“True”
Investor
Cash Flows
“True” Risk
Stock’s Intrinsic Value
“Perceived”
Investor
Cash Flows
“Perceived”
Risk
Stock’s Market Price
Market Equilibrium:
Intrinsic Value = Stock Price
Determinants of Intrinsic Values and Stock Prices

Actual Prices vs Intrinsic Values over Time

Governance and Agency:
The Agency Issue
• A principal-agent relationship is an arrangement in which an
agent acts on the behalf of a principal. For example,
shareholders of a company (principals) elect management
(agents) to act on their behalf.
• Agency problems arise when managers place personal goals
ahead of the goals of shareholders.
• Agency costs arise from agency problems that are borne by
shareholders and represent a loss of shareholder wealth.

 Managers are naturally inclined to act in their own best interests
(which are not always the same as the interest of stockholders).
 But the following factors affect managerial behavior:
• Managerial compensation packages
• Direct intervention by shareholders
• The threat of firing
• The threat of takeover
Stockholder-Manager Conflicts

The Agency Issue:
Management Compensation Plans
• Incentive plans are management compensation plans that tie
management compensation to share price; one example involves
involves the granting of stock options.
• Performance plans tie management compensation to measures
such as EPS or growth in EPS. Performance shares and/or cash
bonuses are used as compensation under these plans.

The Agency Issue: The Threat of Takeover
• When a firm’s internal corporate governance structure is
unable to keep agency problems in check, it is likely that rival
managers will try to gain control of the firm.
• The threat of takeover by another firm, which believes it can
enhance the troubled firm’s value by restructuring its
management, operations, and financing, can provide a strong
source of external corporate governance.

 Stockholders are more likely to prefer riskier projects, because
they receive more of the upside if the project succeeds. By
contrast, bondholders receive fixed payments and are more
interested in limiting risk.
 Bondholders are particularly concerned about the use of
additional debt.
 Bondholders attempt to protect themselves by including
covenants in bond agreements that limit the use of additional
debt and constrain managers’ actions.
Stockholder-Debtholder Conflicts

 The primary financial goal of management is shareholder wealth
maximization, which translates to maximizing stock price.
• Value of any asset is present value of cash flow stream to owners.
• Most significant decisions are evaluated in terms of their financial
consequences.
• Stock prices change over time as conditions change and as investors
obtain new information about a company’s prospects.
 Managers recognize that being socially responsible is not inconsistent
with maximizing shareholder value.
Balancing Shareholder Interests and Society Interests

Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees, customers,
suppliers, creditors, owners, and others who have a direct
economic link to the firm.
• A firm with a stakeholder focus consciously avoids actions that
would prove detrimental to stakeholders. The goal is not to
maximize stakeholder well-being but to preserve it.
• Such a view is considered to be "socially responsible."

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