Lebanese University

Faculty of Engineering

Finance for Engineers

Dr. Zouhour EL-ABIAD

February 2023
 Chapter 1: INTRODUCTION TO FINANCE

PLAN:

q Why to study finance?

q Overview of Finance Areas
q Five principles that forms the foundations of finance
q Simple Accounting Definitions
q Why to study finance?

• Very important to any successful business;

• Evaluate the financial feasibility of an investment project;

• Evaluate the cost of financial resources;

• Calculate the cost of capital;

 q Why to study finance?

• Understanding Finance is very important for managers who

want to advance their career;

• How to determine and measure the financial performance

of a company;

• Know how to establish a budget;

• How can a company create more wealth;

 q Why to study finance?
• Understand how and why financial decisions are made in
large and small companies;

• Helps individuals increase their own compensations;

• Understand the tradeoffs we face in making personal

financial choices and help us to select the most
appropriate action;
• …
q Overview of Finance Areas

4 main interconnected and interrelated areas:

qCorporate Finance

q Investments

qFinancial Institutions and Markets

q International Finance
 q Five principles that forms the foundations of finance
It is necessary to understand these principles in order to understand
finance.

Now let’s introduce the five principles.

Principle 1: Cash Flow Is What Matters

It’s important to understand that cash flows, not profits, represent
money that can be spent.
Consequently, it is cash flow, not profits, that determines the value
of a business.
 q Five principles that forms the foundations of finance
For this reason when we analyze the consequences of a managerial
decision we focus on the resulting cash flows, not profits.

Principle 2: Money Has a Time Value

Perhaps the most fundamental principle of finance is that money

has a “time” value.

Very simply, a dollar received today is more valuable than a dollar

received one year from now because we can invest the dollar we
have today to earn interest so that at the end of one year we will
have more than one dollar.
 q Five principles that forms the foundations of finance
For example, suppose you have a choice of receiving $1 000 either
today or one year from now.

If you decide to receive it a year from now, you will have passed up
the opportunity to earn a year’s interest on the money.

Economists would say you suffered an “opportunity loss” or an

“opportunity cost.”

The cost is the interest you could have earned on the $1,000 if you
invested it for one year.
 q Five principles that forms the foundations of finance
Question 1: Which is worth more for you if I give you $1 000 today
or $1000 after 1 year?
1st Answer to Question 1 - investment opportunity: $1 000 is worth
more to you today because you could invest it in an interest-bearing
account, for example you can put it as a deposit at a bank for year,
and benefit for the interest you will get from it.
Therefore your $1000 will grow and become $1 120 if it was
deposited at an interest rate of 12% per year.
Value of the money after 1 year = Amount deposited + Interest
received =
$1 000 + $1 000 x 0.12 = 1 000 + 120 = $1 120
 q Five principles that forms the foundations of finance
Question 1: Which is worth more for you if I give you $1 000 today
or $1000 after 1 year?

2st Answer to Question 1 - Inflation: With $1 000 today I can buy

more products and services than $1 000 a year later due to
inflation.
Because yearly inflation rate is around 3%, the $1 000 today will be
worth ($1 000 + $1 000 x 0.03) = $ 1 030. Therefore in order to buy
the same quantity of products and services a year later I need to
pay $ 1 030 instead of your $1 000.
 q Five principles that forms the foundations of finance
Question 1: Which is worth more for you if I give you $1 000 today
or $1000 after 1 year?

Therefore $1 000 today is worth more than $1 000 later, the $1 000
I receive later will have less purchasing power and will buy me less
products and services.
 q Five principles that forms the foundations of finance
Question 2: If I was supposed to pay you $1 000 today but I could
not. I promised to pay you in 1 year’s time. How much do you think I
should be paying you in 1 year’s time?

If you believe for example that I should pay you $1 100 after 1 year,
then you believe that the $1 000 today is equivalent in value to $1 100
after 1 year.
This makes you indifferent of either obtaining $1 000 now or $1 100
one year later.

The $100 you will get in interest is the time value of money à it is the
value of waiting for your payment for 1 year.
 q Five principles that forms the foundations of finance
Principle 3: Risk Requires a Reward

Without exception, investors will not invest if they do not expect to

receive a return on their investment. They will want a return that
satisfies two requirements:

- The investment would at least compensate the initial cost;

- An additional return for taking on risk. Investors generally don’t like
risk. Thus, risky investments are less attractive—unless they offer
the prospect of higher returns.
 q Five principles that forms the foundations of finance

Principle 3: Risk Requires a Reward

If you are trying to persuade investors to put money into a risky

project you are pursuing, you will have to offer them a higher
expected rate of return.

The risk–return relationship (Trade-off) will be a key concept as we

value for investment on financial markets and while investing in new
projects.
 q Five principles that forms the foundations of finance

Principle 4: Market Prices Are Generally Right

To understand how securities such as bonds and stocks are valued or

priced in the financial markets, it is necessary to have an
understanding of the concept of an efficient market.

An efficient market is one where the prices of the assets traded in

that market fully reflect all available information at any instant in
time.
 q Five principles that forms the foundations of finance

Principle 5: Conflicts of Interest Cause Agency Problems

In Finance, we learn how to make financial decisions that increase

the value of a firm’s shares.

However, managers do not always follow through with these

decisions.

Often they make decisions that actually lead to a decrease in the

value of the firm’s shares.
 q Five principles that forms the foundations of finance

Principle 5: Conflicts of Interest Cause Agency Problems

When this happens, it is frequently because the managers’ own

interests are best served by ignoring shareholder interests.

In other words, there is a conflict of interest between what is best

for the managers and the stockholders.

Conflicts of interest lead to what are referred to by economists as an

agency cost or agency problem.
 q Five principles that forms the foundations of finance
Principle 5: Conflicts of Interest Cause Agency Problems
For example, a large firm may be run by professional managers or
agents who have little or no ownership in the firm.

Because of this separation of the decision makers and owners,

managers may make decisions that are not in line with the goal of
maximizing shareholder wealth.

They may approach work less energetically and attempt to benefit

themselves in terms of salary at the expense of shareholders.
 q Five principles that forms the foundations of finance

Principle 5: Conflicts of Interest Cause Agency Problems

Managers might also avoid any projects that have risk associated
with them—even if they are great projects with huge potential
returns and a small chance of failure.
 q Simple Accounting definitions

Accounts Payable

Accounts payable (AP) tracks money owed to creditors.

Examples include unpaid bills and invoices, debts to suppliers or

vendors, and line of credit debts.
 q Simple Accounting definitions

Accounts Receivable

Accounts receivable (AR) tracks the money owed to a person or

business by its debtors.

It is the functional opposite of accounts payable.

In most cases, accounts receivable derive from products or services

supplied on credit or without an upfront payment.
 q Simple Accounting definitions

Assets

These refer to resources or items that the company owns.

Examples of a company's assets include:

investments, cash, inventory, accounts receivable, land,

supplies, equipment, buildings and vehicles, intellectual
property,…
 q Simple Accounting definitions

Liabilities

These refer to the legal financial obligations or debts that

companies incur during business operations and that are
intended to be paid at a later date.

For example, loans, accounts payable.

 q Simple Accounting definitions

Equity
Equity, also known as shareholder's equity.
When it’s a company composed by Stocks, so equity means traded
equity. More often, we hear the words “stock” and “equity” used
interchangeably, or referred to as “equity shares”.

Expenses
Expenses refer to the costs of operations that businesses incur to
generate revenue. Common expenses include employee wages,
payments to suppliers, equipment depreciation and factory leases.
 q Simple Accounting definitions

Revenue

Revenue refers to the income that a company generates from its

normal business operations.
 q Simple Accounting definitions
Sales

These are transactions in which products/services are transferred

from buyers to sellers for cash or credit.

Purchases

These are transactions that businesses require to obtain materials

and services necessary to accomplish their goals. Purchases made in
cash and credit.
 q Simple Accounting definitions

Employees’ compensation

This requires information about the total of compensation

paid for employees.
 q Simple Accounting definitions

Depreciation

The term depreciation refers to an accounting method used to

allocate the cost of a tangible or physical asset over its useful
life.

Depreciation represents how much of an asset's value has been

used. It allows companies to earn revenue from the assets they
own by paying for them over a certain period of time.
q Simple Accounting definitions

Each period's depreciation amount is calculated using the formula:

Annual depreciation = Value of the Asset x Depreciation rate.
With: Depreciation rate = 100
N (excepted life of the asset)

Or, simply Annual depreciation = Value of the Asset/ Excepted life of

this asset.
 q Simple Accounting definitions

Example: Value of an vehicle is $ 15 000, excepted life = 5 years

Two ways to calculate the annual depreciation:

Way 1: Depreciation rate : 100/ 5 = 20 %,

Annual depreciation = 15 000 x 20 % = $ 3 000

Way 2: Annual depreciation = 15 000 = $ 3 000

5
 q Simple Accounting definitions

Financial statements
Three documents:

-Income statement: This document contains information

about the company's revenues and deducts all expenses
incurred to determine the net profit or loss for the
reporting period.
 q Simple Accounting definitions
Income statement Example

Sales and other sources of

income
Cost of Good already sold or
Cost of Raw materials already
used
Other expenses

Total expenses

Difference between
Revenues and expenses
 q Simple Accounting definitions

Financial statements
Three documents:

-Balance sheet: This document contains information

about a company's assets, liabilities and equity as of the
end of the reporting period.

It shows the financial position of an organization as of a

point in time and is carefully reviewed.
 q Simple Accounting definitions
Financial statements
Balance sheet Example

Assets < 1 year Liabilities < 1 year

Liabilities > 1 year

Assets > 1 year

Equity
 q Simple Accounting definitions

Financial statements
Three documents:

-Statement of cash flows: This document contains

information about the uses and sources of cash during
the reporting period.
 q Simple Accounting definitions
Statement of Cash Flows Example

Cash flows based on their

source or type of
activities

Cash flows coming from the previous

year, 2021 in this example

The final Cash Flows of the year, 2022 in this example, which will be considered as Cash at the beginiging of year
2023
 q Simple Accounting definitions

Accounting Period

An accounting period defines the length of time covered by a

financial statement or operation.

Examples of commonly used accounting periods include fiscal years,

calendar years, and three-month calendar quarters.

Some organizations also use monthly periods.