1 Chapter One Principles of Finance By Farhana Rob Shampa.

11

Chapter OneChapter One

Principles of FinancePrinciples of Finance

By By

Farhana Rob ShampaFarhana Rob Shampa

22

Definition: What is Finance?Definition: What is Finance?

““Finance is the methodology of allocating Finance is the methodology of allocating financial resources with a financial value, financial resources with a financial value, is an optimal manner to maximize the is an optimal manner to maximize the wealth of a business enterprise.”wealth of a business enterprise.”

“ “ Finance is the process of channeling Finance is the process of channeling funds from savers to users in the form of funds from savers to users in the form of credit, loans or invested capital through credit, loans or invested capital through agencies including commercial banks agencies including commercial banks savings and loan associations.”savings and loan associations.”

33

Career Opportunities Career Opportunities in Finance:in Finance:

Financial marketsFinancial markets InvestmentsInvestments Managerial financeManagerial finance

Financial institutionsFinancial institutions• BanksBanks• Insurance companiesInsurance companies• Savings and loansSavings and loans• Credit unionsCredit unions

44

The Financial Manager’s The Financial Manager’s Responsibilities:Responsibilities:

Obtain and use funds in a way that will Obtain and use funds in a way that will maximize the value of the firm:maximize the value of the firm:1. Forecasting and planning.1. Forecasting and planning.

2. Major investment and financing decisions2. Major investment and financing decisions

3. Coordination and control3. Coordination and control

4. Dealing with financial markets4. Dealing with financial markets

55

Finance Function:Finance Function:

1) Investment Decision.1) Investment Decision. 2) Financing Decision.2) Financing Decision. 3) Dividend Decision.3) Dividend Decision.

66

Basic Forms of Business Basic Forms of Business Organization:Organization:

Sole ProprietorshipSole Proprietorship Owned by one person, operated for personal Owned by one person, operated for personal

profit.profit. PartnershipsPartnerships

Owned by two or more people, operated for Owned by two or more people, operated for joint profit.joint profit.

CorporationsCorporations ““Legal entity”, owned by individuals, operated Legal entity”, owned by individuals, operated

for joint profit.for joint profit.

77

Sole Proprietorship:Sole Proprietorship:

STRENGTHS:STRENGTHS: Low organizational Low organizational

costcost Income taxed once as Income taxed once as

personal incomepersonal income IndependenceIndependence SecrecySecrecy Ease of dissolutionEase of dissolution

WEAKNESSES:WEAKNESSES: Unlimited liabilityUnlimited liability Limited fundingLimited funding Proprietor must be allProprietor must be all Difficult to develop Difficult to develop

staff career staff career opportunitiesopportunities

Lack of continuity on Lack of continuity on death of proprietordeath of proprietor

88

PartnershipsPartnerships

STRENGTHSSTRENGTHS:: Improved funding Improved funding

sourcessources Increased managerial Increased managerial

talenttalent Income split by Income split by

partnership contract, partnership contract, taxed as personal taxed as personal incomeincome

WEAKNESSES:WEAKNESSES: Unlimited liability to all Unlimited liability to all

partnerspartners Partnership dissolved Partnership dissolved

upon death of partnerupon death of partner Difficult to liquidate or Difficult to liquidate or

transfer ownershiptransfer ownership

99

Principles of Finance:Principles of Finance:

A) Principles of Risk and Return.A) Principles of Risk and Return. B) Principles of Time value of MoneyB) Principles of Time value of Money C) Principles of Cash Flow.C) Principles of Cash Flow. D) Principles of Profitability and Liquidity.D) Principles of Profitability and Liquidity. E) Principles of Diversity.E) Principles of Diversity. F) Hedging Principles.F) Hedging Principles.

1010

CorporationsCorporations

STRENGTHS:STRENGTHS: Owners’ liability limitedOwners’ liability limited Large capitalization Large capitalization

possible, greater fundingpossible, greater funding Ownership readily Ownership readily

transferabletransferable Indefinite lifeIndefinite life Professional Professional

managementmanagement

WEAKNESSES:WEAKNESSES: Higher tax ratesHigher tax rates Expensive organizationExpensive organization Greater government Greater government

regulationregulation When publicly traded, When publicly traded,

lacks secrecylacks secrecy

1111

Goal of the Firm /Corporation:Goal of the Firm /Corporation:

There are two approaches in the There are two approaches in the corporation goal are:corporation goal are:

•A) Profit MaximizationA) Profit Maximization•B) B) Wealth MaximizationWealth Maximization

1212

Goal of a ManagerGoal of a Manager

•Profit MaximizationProfit Maximization

Or Or

Wealth MaximizationWealth Maximization

1313

Profit Maximization:Profit Maximization:

Corporations commonly define profit as Corporations commonly define profit as “Earnings per Share” (EPS). EPS “Earnings per Share” (EPS). EPS represent the amount of profit earned represent the amount of profit earned during the period on behalf of each during the period on behalf of each outstanding share of common stock. (A outstanding share of common stock. (A measure of total earnings divided by total measure of total earnings divided by total number of ownership shares. )number of ownership shares. )

1414

Profit maximizationProfit maximization

Profit maximization means maximizing the Profit maximization means maximizing the income of the firm. Profit maximization income of the firm. Profit maximization ensures that firms ensures that firms utilize its resources utilize its resources efficiently.efficiently. Profit maximization leads to Profit maximization leads to efficiently. Profit maximization leads to efficiently. Profit maximization leads to efficient allocation of resources. It is a short efficient allocation of resources. It is a short term view.term view.

1515

Profit Maximization:Profit Maximization:

EPS ignores critical factors of / Limitations EPS ignores critical factors of / Limitations of profit maximization are :of profit maximization are : It ignores the timing of the returns.It ignores the timing of the returns. It ignores cash flows available to common It ignores cash flows available to common

shareholders.shareholders. It ignores risk factors facing the firm.It ignores risk factors facing the firm.

1616

Shareholder Wealth Maximization:Shareholder Wealth Maximization:The Goals of the CorporationThe Goals of the Corporation

Management’ primary goal is stockholder wealth Management’ primary goal is stockholder wealth maximization. Shareholder wealth maximization maximization. Shareholder wealth maximization is the value of the firm as measured by the price is the value of the firm as measured by the price of the firm’s common stock.of the firm’s common stock.

Stock price maximization is the most important Stock price maximization is the most important goal of most corporations. Shareholder wealth goal of most corporations. Shareholder wealth maximization is a more comprehensive goal for maximization is a more comprehensive goal for the firm, its managers and employees. It is a the firm, its managers and employees. It is a long term view.long term view.

1717

Shareholder Wealth Maximization Shareholder Wealth Maximization (SWM)(SWM)

Shareholder Wealth Maximization (SWM) means Shareholder Wealth Maximization (SWM) means maximizing owners economic welfaremaximizing owners economic welfare..

Maximizing owners economic welfare is Maximizing owners economic welfare is equivalent to Maximizing the utility of their equivalent to Maximizing the utility of their consumption over time.consumption over time.

A firm should be maximize the market value of A firm should be maximize the market value of its shares. Market price of a share is reflection of its shares. Market price of a share is reflection of the firm’s financial performance.the firm’s financial performance.

Maximized value of the firm as measured by the Maximized value of the firm as measured by the price of the firm’s common stock.price of the firm’s common stock.

1818

SWMSWM

Because it (SWM) evaluating Shareholder Because it (SWM) evaluating Shareholder wealth addresses factors of timing wealth addresses factors of timing associated with expected earnings per associated with expected earnings per share , cash flows and risk ignored by the share , cash flows and risk ignored by the EPS.EPS.

This can be explored through This can be explored through “economic“economic valued addedvalued added” and ” and a focus on a focus on stakeholders.stakeholders.

1919

Shareholder Wealth Maximization: Shareholder Wealth Maximization: Financial goal Financial goal

Wealth maximization is the net present Wealth maximization is the net present value (or wealth) of a firm.value (or wealth) of a firm.

A financial action which has a positive A financial action which has a positive value creates wealth.value creates wealth.

2020

Economic Value Added Economic Value Added –– EVA EVA::

EVA measures whether an EVA measures whether an investment investment contributes to shareholder wealth.contributes to shareholder wealth.

EVA is calculated by subtracting cost of EVA is calculated by subtracting cost of funds used from after-tax operating profits.funds used from after-tax operating profits.

While popular, EVA is essentially derived While popular, EVA is essentially derived from the concept of “from the concept of “net present value.net present value.””

2121

StakeholdersStakeholders

Stakeholders include groups that have Stakeholders include groups that have direct economic linksdirect economic links to the firm. to the firm.

Stakeholders include not only owners, but Stakeholders include not only owners, but also employees, customers, suppliers, and also employees, customers, suppliers, and creditors.creditors.

Maintaining positive stakeholder Maintaining positive stakeholder relationships helps maximize long-term relationships helps maximize long-term benefits to shareholders.benefits to shareholders.

2222

Shareholder Wealth Maximization:Shareholder Wealth Maximization:

Shareholder Wealth Maximization (SWM) means Shareholder Wealth Maximization (SWM) means maximizing owners economic welfare.maximizing owners economic welfare.

Maximizing owners economic welfare is Maximizing owners economic welfare is equivalent to Maximizing the utility of their equivalent to Maximizing the utility of their consumption over time.consumption over time.

A firm should be maximize the market value of A firm should be maximize the market value of its shares. Market price of a share is reflection of its shares. Market price of a share is reflection of the firm’s financial performance.the firm’s financial performance.

Maximized value of the firm as measured by the Maximized value of the firm as measured by the price of the firm’s common stock.price of the firm’s common stock.

2323

Rationale Behind Wealth Rationale Behind Wealth Maximization as the Goal of a Firm:Maximization as the Goal of a Firm: A) Clear concept.A) Clear concept. B) It considers risk, timing of return and B) It considers risk, timing of return and

time value of money.time value of money. C) Focus on market price of share.C) Focus on market price of share. D) Economic Vale Addition.D) Economic Vale Addition. E) Stake holders E) Stake holders

2424

From the social perspective wealth From the social perspective wealth maximization:maximization:

1) Is to maximize shareholders wealth 1) Is to maximize shareholders wealth maximize stock price.maximize stock price.

2) Employee welfare, achieve personal 2) Employee welfare, achieve personal goal.goal.

3) Ecological/ environment harmony.3) Ecological/ environment harmony.

2525

What about Stakeholders?What about Stakeholders?

Stakeholders include groups that have Stakeholders include groups that have direct economic links to the firm.direct economic links to the firm.

Stakeholders include not only owners, but Stakeholders include not only owners, but also employees, customers, suppliers, and also employees, customers, suppliers, and creditors.creditors.

Maintaining positive stakeholder Maintaining positive stakeholder relationships helps maximize long-term relationships helps maximize long-term benefits to shareholders.benefits to shareholders.

2626

Agency Issues:Agency Issues:

An agency relationship exists when one or more An agency relationship exists when one or more people (the principals) hire another person (the people (the principals) hire another person (the agent) to perform a service and then delegate agent) to perform a service and then delegate decision-making authority to that agent . The decision-making authority to that agent . The important agency relationship exist :important agency relationship exist :

1) The principles (share holders ) and the 1) The principles (share holders ) and the managers.managers.

2) Stockholders and creditors (debt holders).2) Stockholders and creditors (debt holders).

2727

Agency Issues: Agency Issues: The Principal-Agent ProblemThe Principal-Agent Problem

Whenever ownership is independent of Whenever ownership is independent of management there exists potential problem of management there exists potential problem of conflicts.conflicts.

The owner’s goals for the firm are best The owner’s goals for the firm are best described as maximizing shareholder wealth.described as maximizing shareholder wealth.

Managers are also concerned with personal Managers are also concerned with personal wealth, job security, lifestyle, and benefits. wealth, job security, lifestyle, and benefits. These concerns may conflict with shareholder These concerns may conflict with shareholder interests.interests.

2828

Agency Problem:Agency Problem:

A potential A potential conflict of interest betweenconflict of interest between::

1) The principles (share holders ) and the 1) The principles (share holders ) and the managers.managers.

2) Stockholders and creditors (debt 2) Stockholders and creditors (debt holders).holders).

2929

Agency Problem:Agency Problem:

Agency problem the like hood that Agency problem the like hood that managers may place personal goals managers may place personal goals ahead of corporate goals.ahead of corporate goals.

3030

Ways to motive managers to act in Ways to motive managers to act in the best interest of shareholders:the best interest of shareholders:

1) The Threat of firing.1) The Threat of firing.

2) The Threat of Takeover.2) The Threat of Takeover.

3) Structuring Managerial Incentives.3) Structuring Managerial Incentives.

3131

1) The Threat of firing.1) The Threat of firing.

Existing share holders attempt of Existing share holders attempt of oustedousted the present management team by the present management team by stockholders to stockholders to voting rightsvoting rights and elected and elected new management team.new management team.

3232

The Threat of firing resistance by The Threat of firing resistance by present management team:present management team:

Current Management attempt of Current Management attempt of gain controlgain control of of a firm by a firm by soliciting stockholders to vote forsoliciting stockholders to vote for a a new management team.new management team.

It wasn’t long ago that the management teams of It wasn’t long ago that the management teams of large firms felt secure in their positions, because large firms felt secure in their positions, because the chances of the chances of oustedousted by being stockholders by being stockholders were so remote that managements rarely felt were so remote that managements rarely felt their jobs are in their jobs are in jeopardy. jeopardy. This situation existed This situation existed because ownership of most of thebecause ownership of most of the

3333

Proxy fight:Proxy fight:

firms ownership was so widely distributed, firms ownership was so widely distributed, and management’s can control over the and management’s can control over the voting system by proxy (voting) voting system by proxy (voting) mechanism was so strong, that it was mechanism was so strong, that it was almost impossible for dissident almost impossible for dissident stockholders to gain enough votes to stockholders to gain enough votes to overthrow the managers.overthrow the managers.

3434

2) The Threat of Takeover.2) The Threat of Takeover.

A) Hostile takeovers: The acquisition of a A) Hostile takeovers: The acquisition of a company over the company over the oppositionopposition of its of its management.management.

3535

The Threat of Takeover.The Threat of Takeover.resistance by present management team:resistance by present management team:

i) Poison Pill.i) Poison Pill. ii) Green mail.ii) Green mail.

3636

i) Poison Pill.i) Poison Pill.

An action a firm can take that practically An action a firm can take that practically kills it and thus to make a firm unattractive kills it and thus to make a firm unattractive to potential buyers and thus to avoid a to potential buyers and thus to avoid a hostile takeovers.hostile takeovers.

““If you want to keep control, don’t let your If you want to keep control, don’t let your company’s stock sell at a bargain price.”company’s stock sell at a bargain price.”

3737

Poison Pill.Poison Pill.(Con)(Con)

Actions to increase the firm’s stock price Actions to increase the firm’s stock price and to keep it form being a bargain and to keep it form being a bargain obviously are good from the standpoint of obviously are good from the standpoint of the stockholders, but other tactics that the stockholders, but other tactics that managers can use to ward off a hostile managers can use to ward off a hostile takeover might not be.takeover might not be.

(Golden Parachutes, Golden Handshake)(Golden Parachutes, Golden Handshake)

3838

ii) Green mail.ii) Green mail.

Which is like blackmail.Which is like blackmail. A situation in which a firm, trying to avoid a A situation in which a firm, trying to avoid a

takeover, buys back stock at a price above takeover, buys back stock at a price above the existing market price from the person the existing market price from the person (s) trying to gain control of the firm.(s) trying to gain control of the firm.

3939

ii) Green mail.ii) Green mail.

i) A potential acquirer (firm or individual) i) A potential acquirer (firm or individual) buys a block of stock in a company.buys a block of stock in a company.

ii) The target company’s management ii) The target company’s management becomes frightened that the acquirer will becomes frightened that the acquirer will make a tender offer and gain control of the make a tender offer and gain control of the company.company.

iii) To head off a possible takeover, iii) To head off a possible takeover, management offers to pay greenmail, management offers to pay greenmail, buying the stock owned by the potential buying the stock owned by the potential

4040

ii) Green mail (Con)ii) Green mail (Con)

Raider at a price above the existing Raider at a price above the existing market price without offering the same market price without offering the same deal to other stockholders.deal to other stockholders.

4141

3) Structuring Managerial 3) Structuring Managerial IncentivesIncentives

Executive compensation packages Executive compensation packages generally include incentive plans that grant generally include incentive plans that grant stock options, performance based shares, stock options, performance based shares, or cash bonuses upon meeting or or cash bonuses upon meeting or exceeding corporate goals.exceeding corporate goals.

Such packages may also include long-Such packages may also include long-term benefits that can protect the manager term benefits that can protect the manager against poor corporate performance.against poor corporate performance.

4242

Current View on Incentive Plans:Current View on Incentive Plans:

A type of incentives plan that allows A type of incentives plan that allows managers to purchase stock at some managers to purchase stock at some future time at a given price.future time at a given price.

1) Executive Stock Option.1) Executive Stock Option. 2) Performance Share.2) Performance Share. 3) Cash Bonus3) Cash Bonus

4343

2) Shareholders versus Creditors:2) Shareholders versus Creditors:

It stockholders approve actions that harm It stockholders approve actions that harm the position of the firm’s creditors, it is the position of the firm’s creditors, it is likely that the firm’s creditors, it is likely likely that the firm’s creditors, it is likely that the firm will find it difficult to borrow that the firm will find it difficult to borrow funds in the future.funds in the future.

4444

Resolving the Agency ProblemResolving the Agency Problem

DirectorsDirectors is the heart of any resolution. is the heart of any resolution. 1) Market Forces.1) Market Forces. 2) Agency Costs – the costs of this governance:2) Agency Costs – the costs of this governance:

Monitoring costs,Monitoring costs, Structuring compensation costs.Structuring compensation costs.

1) Market Forces : Market forces, such as the 1) Market Forces : Market forces, such as the potential for hostile takeover provide some potential for hostile takeover provide some deterrence. deterrence.

Legal forces, fraud, and fiduciary misconduct Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.laws aim to act as deterrents as well.

4545

Resolving the Agency Problem:Resolving the Agency Problem:

A) A) Monitoring costs,Monitoring costs,

B) Structuring compensation costs :B) Structuring compensation costs :

1) Executive Stock Option.1) Executive Stock Option. 2) Performance Share.2) Performance Share. 3) Cash Bonus3) Cash Bonus

4646

Factors Influencing Financial Factors Influencing Financial Decisions:Decisions:

A) Internal Factors.A) Internal Factors. External Factors.External Factors.

4747

Internal Factors:Internal Factors:

1) Size of the Business.1) Size of the Business. 2) Nature of Business.2) Nature of Business. 3) Situation of Business Cycle.3) Situation of Business Cycle. 4) Assets Structure4) Assets Structure 5) Terms of Credit.5) Terms of Credit. 6) Management Philosophy.6) Management Philosophy.

4848

External Factors:External Factors:

1) Govt Regulations.1) Govt Regulations. 2) Tax System.2) Tax System. 3) Economic Condition of the Country.3) Economic Condition of the Country. 4) Condition of Money Market & Capital 4) Condition of Money Market & Capital

Market.Market.

4949

Questions:Questions:

1) Define what is Finance?1) Define what is Finance? 2) What role should financial managers 2) What role should financial managers

play in the modern enterprise?play in the modern enterprise? 3) Write down the function of Finance?3) Write down the function of Finance? 4) In what way is the wealth maximization 4) In what way is the wealth maximization

objectives superior to the profit objectives superior to the profit maximization? Explainmaximization? Explain

5) What is management’ primary goal?5) What is management’ primary goal?