Definition and Basic concepts. Definition of Finance Finance is the art and science of managing money which is concerned with the process, institutions,

Definition and Basic concepts

Definition of FinanceFinance is the art and science of

managing money which is concerned with the process, institutions, markets and instruments involved in the transfer of money among and between individuals, business and governments.

Finance is a body of facts, principles, and theories dealing with the raising and using of money by a firm.

Definition of FinanceFinance is the branch of economics

that focuses on investment in real and financial assets and their management.

A real asset is a physical item such as a truck, land, or building.

A financial asset is a claim for a future financial payment, such as a savings account at a bank.

Definition of Finance Financial assets generate future

payments, whereas real assets alter the physical environment in some way.

Financial management is concerned with the acquisition, financing, and management of assets with overall goal in mind.

Benefits of Knowledge of Finance

Careers in Finance-As a Corporate Financial ManagerAs a StockbrokerExecutive- Financial AnalystInvestment Consultant in an Investment Bank

or Financial InstitutionLoan Analyst/ Loan Officer in a Bank

Financial Manager Financial managers actively manage

the financial affairs of many types of business- financial or non financial, private and public, large and small, profit-seeking and not for profit.

They perform such varied financial tasks as planning, extending credit to customers, evaluating proposed large expenditures, and raising money to the firm’s operations.

Functions of Financial Managers1. Performing financial analysis and planning

2. Investment Decision Making3. Making Financing Decision4. Asset management Decision5. Accounting and Control6. ForecastingPricing, credit and collections, insurance and

incentive planning are some other responsible duties to the financial managers.

Functions of Fin. Mgr. (cont.)

Investment and financial decisions deals with assets and liability sides of the Balance Sheet:

Investment Financing

Decisions Decisions

AssetsAssets L + OEL + OE

Current Current AssetsAssets

Current Current LiabilitiesLiabilities

Fixed Fixed AssetsAssets

Long-Long-Term Term

LiabilitiesLiabilities

EquityEquity

Corporate Structure

Sole Proprietorships

Corporations

Partnerships

Limited Liability

Corporate tax on profits +

Personal tax on dividends

Unlimited Liability

Personal tax on profits

Organizing a Business Sole

Proprietorship Partnership Corporation

Who owns the business?

The Manager

Partners Shareholders

Are managers and owners separate?

No No Usually

What is the owner’s liability?

Unlimited Unlimited (exceptions)

Limited

Are owners & the business taxed separately?

No No Yes

Finance vs. Economics

Marginal Benefits vs. Marginal Cost: Economics accepts projects for which the benefits are greater than the costs, finance does the same. The difference is finance takes the time value in consideration, economics does not.

Finance vs. AccountingAccrual vs. Cost Basis:

Finance recognizes revenues and expenses only on the basis of cash inflows and outflows - A bird in hand is better than two in the bush. Where as accounting follows accrual basis- it recognizes revenue at the time of sale and expenses at the time when they are incurred.

Profit Maximization or Wealth Maximization?

Goals of the Corporation

Profit Maximization or Wealth Maximization?

Profit maximization is not a reasonable goal because it fails to consider some important facts. It ignores:

The timing of returns- the receipt of funds sooner rather than later is preferred.

Cash flows available to stockholders/ effect of dividend policy.

Risk- the chance that actual outcome may differ from those expected.

Maximize Shareholder Wealth: The goal of the corporation, and therefore of all managers and employees, is to maximize the wealth of the owners for whom it is being operated.

Shareholders wealth is represented by the market price per share of the corporation’s common stock. The market price serves as a barometer for business performance; it indicates how well management is doing on behalf of its shareholders.

EPS & Share

EPS are calculated by dividing the period’s total earnings available for the firm’s common stockholders by the number of shares of common stock outstanding.

Share: A share is a piece of paper/document which represents the ownership of a particular company.

Or, a share is a chose in action, conferring on its legal right to the part of the company’s profits (usually by payment of a dividend) and to any voting rights attaching to that share.

Stakeholders rather than Stockholders

The stakeholders include creditors, employees, customers, suppliers, communities in which a company operates and others. Only through attention to the legitimate concerns of the firm’s various stakeholders can attain its ultimate goal- maximizing shareholders wealth.

Social Responsibility of the Firm:Protecting the consumer rights. They

shouldn’t charge abnormal prices for their product or services and act as a monopoly type. Every firm should ensure quality product and services for ultimate consumers.

Paying fair wages to employees and provide rewards as a motivational drive to increase their productivity. Firms must ensure welfare of their workers and employees.

Social Responsibility of the Firm: (Continue)

Maintaining fair hiring practice or selection process and safe working condition.

Giving support for proper education to grass-root level. In this case established firms may provide various types of scholarship for poor students.

Social Responsibility of the Firm: (Continue)Becoming involved in such environmental issues as clean water and air. Firm may take social awareness activities against environment pollutions, AIDS, acid terrorism, and other negative matter which creates social distress and hampered normal life.

Agency Problems There is a potential conflict of interest

between the owners, who expect the managers to act on their behalf, and managers, who have their own interests as well. This gives rise to what has been called “the agency problem”, that is, the divergence of interests that arisen between a principal and his agent.

Agency Cost for Prevention of Agency Problems: Several mechanisms are used to motivate

managers to act in the shareholders’ best interests. These include-

Structuring managerial incentives The threat of takeover The threat of firing Monitoring Expenditures This outlays pay for audits and control

procedures that are used to asses and limit managerial behavior to those actions that tend to be in the best interest of the owners.

Agency Cost for Prevention of Agency Problems:

Bonding expenditures Protect against the potential consequences

of dishonest acts by managers. Typically, the owners pay a third- party bonding company to obtain a fidelity bond. This bond is a contract under which the bonding company agrees to reimburse the firm for up to a stated amount if a bonded manager’s dishonest act results in financial loss to the firm.

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