Lecture 1

Introduction to
Business Finance

© 2008 Introduction to Business Finance BA 5401

Prepared by: Sunilla Faisal 1
 What is Finance
 Finance can be defined as the art and science of managing money.
Making the best decision when that decision involves money
 At the macro level, finance is the study of financial institutions
and financial markets and how they operate within the financial
system in both the U.S. and global economies.
 At the micro level, finance is the study of financial planning, asset
management, and fund raising for businesses and financial
institutions.
 Finance is essentially concerned with the process, institutions,
markets, and instruments involved in the transfer of money among
and between individuals , businesses and governments
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 What is Finance (cont.)
 A well-developed financial system is a hallmark and
essential characteristic of any modern developed nation.
 Financial markets, financial intermediaries, and
financial management are the important components.
 Financial markets and financial intermediaries facilitate
the flow of funds from borrowers to savers.
 Financial management involves the efficient use of
financial resources in the production of goods.
 Career opportunities include banking, personal
financial planning, investments, real estate, and
insurance.
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(Refer to the next slide)
Career Opportunities

Read Only 4
 Basic forms of business
organization

 Sole proprietorship:- A business

owned by one person and operated for
his or her own profit

 Partnership:- A business owned by two

or more people and operated for profit.

 Corporation:- An intangible business

entity created by law
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 Sole Proprietorship

 Advantages:
 Ease of formation
 Subject to few regulations
 No corporate income taxes

 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital

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 Partnership

 A partnership has roughly the same

advantages and disadvantages as a
sole proprietorship.

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 Corporation

 Advantages:
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital

 Disadvantages:
 Double taxation
 Cost of set-up and report filing

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Basic Forms of Business
Organization

Read Only 9
 Percentage share of
business organizations
Corp.
15%
S Prop.
P'ship 75%
10%

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 Corporate Organization

S T O C K H O L D E R S

Board of Directors Stockholders

usually meet
President once a year.
(CEO)

Vice President VP of Vice President

Operations Finance Marketing
{CFO}
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Corporate Organization

VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government
Pension Management Reporting
Insurance/Risk Mngmt Internal Control
Tax Analysis/Planning Preparing Fin Stmts
Preparing Budgets
Preparing Forecasts
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 Corporate Organization

Another
Example

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 The Financial Environment

Financial Institutions
 Financial institutions are intermediaries that channel
the savings of individuals, businesses, and
governments into loans or investments.These
institutions accepts money from savers and use those
funds to make loans and other financial investments
in their own name. They include commercial banks,
saving institutions, mutual funds etc

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 The Financial Environment
Financial Markets
 Financial markets provide a forum in which suppliers
of funds and demanders of funds can transact business
directly.
 The two key financial markets are the money market
and the capital market. Transactions in short term
marketable securities take place in the money market
while transactions in long-term securities take place in
the capital market.
 Within the money and capital markets are the primary
& secondary market.(Refer to the next slide)
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 Primary & Secondary Markets
 Primary Market
The primary market is the one in which a corporation or
government is directly involved in and receives the proceeds
from the transaction.When a corporation issues securities,
cash flows from investors to the firm.
(Usually an underwriter is involved)

 Secondary Markets
The secondary markets involve the sale of “used” securities
from one investor to another. Once issued, securities then
trade on the secondary markets such as the Karachi Stock
Exchange or NASDAQ.Securities may be exchange traded or
trade over-the-counter in a dealer market.
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 Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money Ali Sami
money

Primary Market
Secondary
Market

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Types of Financial Decisions

Investment Decisions

Financing Decisions

Asset Management Decisions

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 Investment Decisions

Most important of the three decisions.

 What is the optimal firm size?

 What specific assets should be
acquired?
 What assets (if any) should be
reduced or eliminated?

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 Financing Decisions

Determine how the assets (LHS of balance

sheet) will be financed (RHS of balance sheet).

 What is the best type of financing

mix?
 What is the best dividend policy?
 How will the funds be physically
acquired?

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 Key Activities of the
Financial Manager

After the investment and financing decisions, the

next task is the asset management decisions.

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 Asset Management Decisions

 How do we manage existing assets

efficiently?
 Financial Manager has varying
degrees of operating responsibility
over assets.
 Greater emphasis on current asset
management than fixed asset
management.
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 The Goal of the Firm?

 Profit Maximization

 Earnings per Share Maximization

 Maximization of Shareholder Wealth

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 Shortcomings of
Alternative Perspectives
Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
 Could increase current profits while harming firm (e.g., defer
maintenance, issue common stock to buy T-bills, etc.).
 It fails to account for the level, timing and the risk of the cash
flows. (Consider the figure below)
Product Year 1 Year 2 Year 3 Total earnings
A $10,000 $10,000 $10,000 $30,000
B $11,000 $11,000 $11,000 $33,000
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 Shortcomings of
Alternative Perspectives
Earnings per Share Maximization
 Maximizing earnings after taxes divided by
shares outstanding.

Problems
 Similarly to profit maximization, it does
not specify timing or duration of expected
returns and ignores changes in the risk
level of the firm.
 Calls for a zero payout dividend policy.
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What is the Goal of the Firm?

Maximization of
Shareholder Wealth!
Value creation occurs when we
maximize the share price for
current shareholders.

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 Strengths of Shareholder
Wealth Maximization
 Takes account of: current and future profits and EPS;
EPS the
timing, duration, and risk of profits and EPS;
EPS dividend policy;
policy
and all other relevant factors.

 Thus, share price serves as a barometer for business

performance and any activity that is expected to increase a
firm’s share price should be pursued. 27
Environment for Financial
Managers

 The Internal environment.

 The External environment.

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The Internal Environment
 Availability or lack of human
resources.

e.g. Gillette company effort to market

electronic calculators and digital watches
were not successful because it lacked the
proper type of marketing expertise.

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The External Environment
 Political and legal framework.
include law makers, law and law enforcers.
 Cultural and social values.
what perception company create in the society.
 Economic/Climatic conditions.
e.g. companies importing raw material depend highly on
fluctuation of Pak rupees against dollar. (Edible oil
companies)

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Cont’d external environments

 Technological trends.
If comp. utilizes most modern equipment available to
start a production line, a year later competitors are under
pricing and making it non productive.
 Investors Attitude.
A company cannot one perception. It takes time to
influence the attitude of the investors.
The firm can provide timely information to help its
investors be as objective as possible.

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Framework for Financial Management

External
Environment
Business
Asset Structure
risk
Financial Risk Price Returns
considerations and
decisions
Financial Financial
Structure risk
Internal
Environment

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 The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between

owners and managers.
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 Agency Issues
 Management acts as an agent for the owners
(shareholders) of the firm. An agent is an
individual authorized by another person, called the
principal, to act in the latter’s behalf.
 Managers may be more concerned with personal
wealth, job security, fringe benefits, and lifestyle so
may not always act in ways that benefit the
shareholders.
 Managers must be kept in check by monitoring
management behavior and structuring
management compensation (known as agency
costs) to better align management interests with
shareholder interests.
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 Agency Theory

 Jensen and Meckling developed a

theory of the firm based on agency
theory.
theory

 Agency Theory is a branch of

economics relating to the behavior
of principals and their agents.

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 Agency Theory

 Principals must provide incentives so that

management acts in the principals’ best
interests and then monitor results.
 Incentives include stock options,
perquisites, and bonuses.
 Monitoring is done by systematically
reviewing management perquisites,
auditing financial statements & limiting
management decisions.

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 What About Other
Stakeholders
Stakeholders include all groups of individuals who have a direct
economic link to the firm including:
 Employees
 Customers
 Suppliers
 Creditors
 Owners

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 Goals of the Corporation

 As discussed before, the primary goal is

shareholder wealth maximization, which
translates to maximizing stock price.

 Should firms behave ethically? YES!

 Do firms have any responsibilities to

society at large? YES! Shareholders are
also members of society.

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