What is Finance?

• Finance can be defined as the art and

science of managing money.
• Finance is concerned with the process,
institutions, markets, and instruments
involved in the transfer of money among
individuals, businesses, and governments.
Major Areas & Opportunities in
Finance: Financial Services
• Financial Services is the area of finance
concerned with the design and delivery of
advice and financial products to
individuals, businesses, and government.
• Career opportunities include banking,
personal financial planning, investments,
real estate, and insurance.
 Major Areas in Finance
• Business Finance Which involves financing and
managing the resources (assets) of the business.
• Managerial finance is concerned with the duties of
the financial manager in the business firm.
• The financial manager actively manages the
financial affairs of any type of business, whether
private or public, large or small, profit-seeking or
not-for-profit.
• They are also more involved in developing corporate
strategy and improving the firm’s competitive
position.
Legal Forms of Business
Organization
• A sole proprietorship is a business owned by one
person and operated for his or her own profit.
• A partnership is a business owned by two or more
people and operated for profit.
• A corporation is an entity created by law.
Corporations have the legal powers of an individual
in that it can sue and be sued, make and be party to
contracts, and acquire property in its own name.
• Finance theories and techniques apply to all.

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The Nature of Business Finance

• Business Finance
– Which involves financing and managing the resources (assets) of
the business.
– The manager are concerned with the acquiring , financing and
managing the business’s assets.
– The business’s assets have to be paid for and to do this the
manager may need to raise funds
– A business may borrow from a financial institution such as bank
– Or if a business is public company, it can raise funds from many
investors by issuing financial assets or securities, such as shares.
Primary Activities of
the Financial Manager
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Investment Decisions
Most important of these
decisions.
• What is the optimal firm size?
• What specific assets should be acquired?
• What assets (if any) should be reduced or
eliminated?
Investment Decision
• decisions that determine the asset profile of a
business (amount and composition of investments)
• Investment in assets are important because assets
generate cash flows that are needed to meet
operating expenses, pay interest to lenders, taxes
to government, and ultimately provide returns to the
owners of the business.
• Acquisition of non-current assets, can have long
term effects on the profitability of business.
• Manager also ensure the business’s investment in
current assets at appropriate level.
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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?
• What is the best financing mix?
• What is the best dividend policy (e.g., dividend-
payout ratio)?
• How will the funds be physically acquired?
Financing Decision
• how the assets are to be funded (debt and equity)
• This involve generating funds internally or externally.
• Dividend decisions also affect financing decisions
• Dividend payout ratio determines the amount of
earnings that can be retained in the firm.
• When formulating financial policy, manger also have
to consider the appropriate balance between short-
term and long-term finance and the appropriate mix
of sources of finance.
Major Responsibilities of
Financial Managers
 Management of investments in non-current assets
 Managing investment in current assets such as
cash, marketable securities etc.
 Project evaluation
 Evaluating, obtaining and servicing short- and
long-term financing
 Dividend distributions
 Collection and custody of cash and payment of
bills
Major Responsibilities of
Financial Managers (cont.)
 Assessing the viability of growth through
acquisitions
 Managing risks associated with changes in
interest rates
 Planning the future development of the
business
 Development and implementation of financial
policies
The Managerial Finance Function:
Relationship to Economics
• Financial managers must understand the
economic framework within which they
operate in order to react or anticipate to
changes in conditions.
• The primary economic principal used by
financial managers is marginal cost-benefit
analysis which says that financial decisions
should be implemented only when added
benefits exceed added costs.
The Managerial Finance Function:
Relationship to Accounting (cont.)
• Finance and accounting also differ with respect to
decision-making.
• While accounting is primarily concerned with the
presentation of financial data, the financial
manager is primarily concerned with analyzing
and interpreting this information for decision-
making purposes.
• The financial manager uses this data as a vital
tool for making decisions about the financial
aspects of the firm.
Should Firms Maximize Profit?

• Corporations commonly define profit as

“Earnings per Share” (EPS).
– A measure of total earnings divided by total
number of outstanding shares.
• EPS ignores critical factors of
– the timing of the returns.
– cash flows available to common
shareholders.
– risk factors facing the firm.
Or Should Firms Maximize
Shareholder Wealth?
• Evaluating Shareholder Wealth addresses
factors of timing, cash flows and risk
ignored by the EPS.
• Therefore, Maximizing Shareholder
Wealth is a more comprehensive goal for
the firm, its managers and employees.
Goal of the Firm:
Maximize Shareholder Wealth!!! (cont.)
• The process of shareholder wealth
maximization can be described using the
following flow chart:
Goal of the Firm:
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, and others who
have a direct economic link to the firm.
• The "Stakeholder View" prescribes that the firm make a
conscious effort to avoid actions that could be
detrimental to the wealth position of its stakeholders.
• Such a view is considered to be "socially responsible."
Individual versus Institutional Investors

• Individual investors are investors who purchase relatively

small quantities of shares in order to earn a return on idle
funds, build a source of retirement income, or provide
financial security.
• Institutional investors are investment professionals who are
paid to manage other people’s money. Its a company or
organization that invests money on behalf of other people.
Mutual funds, pension funds, and insurance companies
• They hold and trade large quantities of securities for
individuals, businesses, and governments and tend to have
a much greater impact on corporate governance.
Corporate Organization

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 Corporate Organization
• Board of Directors: has the ultimate authority in guiding
corporate affairs and in making general policy.
• The directors include key corporate personnel as well as
outside individuals who typically are successful business
people and executives of other major organizations.
Outside directors for major corporations are generally paid
an annual fee.
• Also, they are frequently granted options to buy a specified
number of shares of the firm’s stock at a stated—and often
attractive—price.
The president or chief executive officer (CEO) is
responsible for managing day-to-day operations and
carrying out the policies established by the board. The CEO
is required to report periodically to the firm’s directors.
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Corporate Governance

• Corporate governance: represents the

system by which corporations are
managed and controlled.
• Includes shareholders, board of
directors, and senior management.
• Then shareholder wealth maximization
remains the appropriate goal in governing
the firm.
Governance and Agency:
The Agency Issue
• A principal-agent relationship is an arrangement in
which an agent acts on the behalf of a principal. For
example, shareholders of a company (principals) elect
management (agents) to act on their behalf.
• Agency problems arise when managers place personal
goals ahead of the goals of shareholders.
• Agency costs borne by shareholders to maintain a
governance structure that minimizes agency problems
and contributes to the maximization of owner’s
wealth.

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Agency Theory

– One party, the principal, delegates decision-

making authority to another party, the agent.

– In a company:
• Managers = Agent is a person who has the
implied or actual authority to act on behalf of
another.
• Shareholders = Principal the owners to whom
the agents represent are the principals.
The Agency Issue:
The Agency Problem
• In theory, managers would agree with
shareholder wealth maximization.
• However, managers are also concerned with
their personal wealth, job security, fringe
benefits, and lifestyle.
• This would cause managers to act in ways that
do not always benefit the firm shareholders.
 Agency Theory
• Agency costs: conflict of interest between
parties creates costs
• reduced value due to managers acting in
their own best interests rather than in the
interests of shareholders
• costs associated with monitoring
managers’ behavior to ensure their actions
are consistent with shareholders’ interests.
i.e. auditing cost
The Agency Issue:
Management Compensation Plans

• Incentive plans are management compensation plans

that tie management compensation to share price; one
example involves the granting of stock options.
• Performance plans tie management compensation to
measures such as EPS or growth in EPS.
Performance shares and/or cash bonuses are used as
compensation under these plans.

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The Agency Issue: The Threat
of Takeover
• When a firm’s internal corporate governance
structure is unable to keep agency problems in check,
it is likely that rival managers will try to gain control
of the firm.
• The threat of takeover by another firm, which
believes it can enhance the troubled firm’s value by
restructuring its management, operations, and
financing, can provide a strong source of external
corporate governance.

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How to deal with agency conflict?

• There are two extreme positions regarding how

to deal with shareholder-manager agency
conflict.
– At one extreme, if a firm’s manager were
compensated solely on the basis of stock price
changes, agency cost would be low because
managers would have a great deal of incentive to
maximize shareholder wealth.
– At the other extreme, stockholders could monitor
every managerial action, but this would be costly and
inefficient.
How to deal with agency conflict?

• The optimal solution lies some where in the

middle, where executive compensation is tied to
performance but some monitoring is also done.
– Managerial compensation plans (Stock options,
performance plans, performance shares, cash
bonuses)
– Direct intervention by shareholders
– The threat of firing
– The threat of takeover (when management does not
want the firm to be taken over)