What is Finance?

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Chapter
McGraw -Hill/Irwin

The Goals and Functions of Financial Management

Im saving for retirement. Should I use a

bank CD ? mutual fund? direct stock market investment?

I want that new car. Should I use

saved cash? lease? borrow? (Borrow from Who?)

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Defining Finance
Im thinking about starting a new business
will it reward me adequately?

Finance is the study of how people allocate scarce resources over time
costs and benefits are distributed over time but the actual timing and size of future cash flows are often known only probabilistically

Nepal has asked for major project financing

should my organization provide the funds?

Understanding finance helps you evaluate these uncertain cash flows

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Financial theory consists of: the set of concepts

that help to organize ones thinking about how to allocate resources over time

Why Study Finance?

To manage your personal resources To deal with the world of business

the set of quantitative models

used to help evaluate alternatives, make decisions, and implement them To pursue interesting and rewarding career opportunities To make informed public choices as a citizen The intellectual challenge
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These concepts and models apply at all levels and scales of decision making

Financial Management
Financial Management or business finance is concerned with managing an entitys money. For example, a company must decide:
where to invest its money. whether or not to replace an old asset. when to issue new stocks and bonds. whether or not to pay dividends.
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Relationship between Finance, Economics and Accounting

Economics provides structure for decision making in many important areas.
- Provides a broad picture of economic environment.

Accounting provides financial data in various forms.

Income statements, balance sheets, and statement of cashflows.

Finance links economic theory with the numbers of accounting.

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Recent Issues in Finance

Recent focus has been on:
Risk-return relationships. Maximization of returns for a given level of risk. Portfolio management. Capital structure theory.

Recent Issues in Finance (contd)

The following are significant to financial managers during decision making:
Effects of inflation and disinflation on financial forecasting. Required rates of return for capital budgeting decisions. Cost of capital.

New financial products with a focus on hedging are being widely used.

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Functions of the Financial Manager

Risk-Return Trade-Off
Influences operational side (capital versus labor/ Product A versus Product B) Influences financial mix (stocks versus bonds versus retained earnings)
- Stocks are more profitable but riskier. - Savings accounts are less profitable and less risky (or safer)

Financial manager must choose appropriate combinations

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Sole Proprietorship
Represents single-person ownership Advantages:
Simplicity of decision-making. Low organizational and operational costs.

Partnership
Similar to sole proprietorship except there are two or more owners.
Articles of partnership: Specifies ownership interest, the methods for distributing profits, and the means of withdrawing from the partnership. Limited partnership: One or more partners are designated as general partners and have unlimited liability of the debts of the firm; other partners designated limited partners and are liable only for their initial contribution.
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Drawback
Unlimited liability to the owner. Profits and losses are taxed as though they belong to the individual owner.

Corporation
Corporation
- Articles of incorporation: Specify the rights and limitations of the entity. - Its owned by shareholders who enjoy the privilege of limited liability. - Has a continual life.

Corporation (contd)
Disadvantage:
The potential of double taxation of earnings.
Subchapter S corporation: Income is taxed as a direct income to stockholders and thus is taxed only once as normal income.

- Key feature is the easy divisibility of ownership interest by issuing shares of stock.
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conflict of interest
There may be some conflict of interest between managers and the owners. Suppose you have to decide between two alternative investments: Safe ( With lower expected return) or Risky ( with higher expected return)? Which one to go for?
Some owners may want safe, but if they want safe, they can pull out their shares and put in safe assets. If risky investment makes to increase the market value of the fi rm, you should go for the risky one.

Goals of Financial Management

Valuation Approach Maximizing shareholder wealth (shareholder wealth maximization) Management and stockholder wealth
- Retention of position of power in long run is by becoming sensitized to shareholder concerns. - Sufficient stock option incentives to motivate achievement of market value maximization. - Powerful institutional investors are increasing management more responsive to shareholders.
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Would you do it? Conflict of interest may come to play.

Management rule:
Maximize the wealth of current shareholders
Rule depends only upon production technology, market interest rates, market risk premiums, and security prices Alternative rules stated in terms of profit maximization are fraught with unresolved issues, and are better avoided

Profit maximization OR Wealth maximization?

Case I: Suppose initial outlay for two projects is $ 1 Million. Return from
Year 1 Year 2 Profit Project A $1.05 Million $0.05 Million = $ 50,000 Project B $ 1.1 Million $ 0.1 Million = $ 100,000

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How do you apply profit maximization rule?

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Profit maximization OR Wealth maximization?

CASE II: (Uncertain environment) Return from
Year 1 Project A $1.05 Million Project B $ 1.2 Million OR $ 0.9 Million with prob. 0.5 each $ 0.2 Million OR $0.9 Million = $ 200,000 OR a loss of $100,000 ( With 50% Chance of each)

The agency problem

Managers wont work for the owners unless it is in their best interest (From Harvard Business review) Shareholders rely on CEOs to adopt policies that maximize the value of their shares.
Like other human beings, however, CEOs tend to engage in activit ies that increase their own well being.

Profit

$0.05 Million = $ 50,000 (With certainty)

One of the most critical roles of the board of directors is to create incentives that make it in the CEOs best interests. Conceptually this is not a difficult challenge. Some combination of three basic policies will create the right monetary incentives for CEOs to maximize the values of their companies:
Boards can require that CEOs become substantial owners of company stock. Salaries, bonuses, and stock options can be structured so as to provide big rewards for superior performance and big penalties for poor performance. The threat of dismissal for poor performance can be made real

What is the meaning of choosing investment that maximizes profit? Why managers have to act for the interest of shareholders?
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Social Responsibility
Adoption of policies that maximize values in the market attracts capital, provides employment and offers benefits to the society. Certain cost-increasing activities may have to be mandatory rather than voluntary initially, to ensure burden falls equally over all business firms.
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Ethical Behavior
Ethical behavior creates invaluable reputation. Insider trading Protected against by the Securities and Exchange Commission (SEC).

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Is ethics really relevant?

This is a good question to answer.
First, although business errors can be forgiven, ethical errors tend to end careers and terminate future opportunities. Why? Because unethical behavior eliminates trust, and without trust businesses cannot interact. Second, the most damaging event a business can experience is a loss of publics confidence in its ethical standards.
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The Role of Financial Markets

Financial markets are indicators of maximization of shareholder value and the ethical or the unethical behavior that may influence the value of the company. Participants in the financial market range over the public, private and government institutions.
Public financial markets Corporate financial markets
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Structure and Functions of the Financial Markets

Money markets
- Securities in this market include commercial paper sold by corporations to finance their daily operations or certificates of deposit with maturities of less than 12 months sold by banks.

Stocks versus Bonds

Stock = ownership or equity
- Stockholders own the company

Bond = debt or IOU

- Bondholders are owed $ by company

Capital markets
- Long-term markets - Securities include common stock, preferred stock and corporate and government bonds.
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Allocation of Capital
Primary market
When a corporation uses the financial markets to raise new funds, the sale of securities is made by way of a new issue.

Return Maximization and Risk Minimization

Investors can choose risk level that meets their objective and maximizes return for that given level of risk. Companies that are rewarded with highpriced securities can raise new funds in the money and capital markets at a lower cost compared to competitors. Firms pay a penalty for failing to perform competitively.
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Secondary market
When the securities are sold to the public (institutions and individuals). Financial managers are given a feedback about their firms performance.
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Restructuring
Restructuring can result in:
Changes in the capital structure (liabilities and equity on the balance sheet). Selling of low -profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities. Removal or large reductions in the of current management team.

Internationalization of Financial Markets

Allocation of capital and the search for low cost sources of financing on the rise in global market. The impact of international affairs and technology has resulted in the need for future financial managers to understand
- International capital flows. - Computerized electronic funds transfer systems. - Foreign currency hedging strategies.
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It has resulted in acquisitions and mergers.

Technological Impact on Capital Market

Consolidation among major stock markets and mergers of brokerage firms with domestic and international partners. Electronic markets have gained popularity as against traditional organized exchanges and NASDAQ. Resulted in the merger of NYSE with Archipelago and NASDAQ bought out Insinet from Reuters.
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