1st CHAPTER

Introduction to Principles of
Finance

Definition and Basic

concepts
 Definition of Finance
• Finance 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 Finance
• Finance 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.
 What is Finance?
• Finance is the study of how people and businesses
evaluate investments and raise capital to fund them. (--
How to get and use money)
• Three questions addressed by the study of finance
1. What long-term investments should the firm
undertake? (capital budgeting decisions – how to
spend the money?)
2. How should the firm fund these investments? (capital
structure decisions -- How to get the money?)
3. How can the firm best manage its cash flows as they
arise in its day-to-day operations? (working capital
management decisions – how to manage cash
(liquid) money?)
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 Benefits of Knowledge of Finance

• Careers in Finance-
As a Corporate Financial Manager
As a Stockbroker
Executive- Financial Analyst
Investment Consultant in an Investment Bank
or Financial Institution
Loan 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.
 A stockbroker

• Licensed agent who has to pass certain

qualifying tests to be certified to offer securities
investment advice to investors. He or she may
(1) counsel what and when to buy, (2) counsel
whether to hold or sell securities, (3) execute
buy-sell orders on behalf of the investors, and
(4) charge a percentage of the transaction
amount as brokerage fee for the services
rendered. Also called registered representative.
 Financial Analyst
• An employee of a bank, brokerage, advisor, or mutual
fund who studies companies and makes buy and sell
recommendations, often specializing in a single sector or
industry. Financial analysts use a wide variety of
techniques for researching and making
recommendations. The reports and recommendations
they publish are often used by traders, mutual fund
managers, portfolio managers and investors in their
decision making processes. also called securities
analyst or analyst.
•
Investment Consultant in an Investment
Bank or Financial Institution

• A person or business that provides long-term

investment advice to a client in exchange for a
fee. Generally speaking, investment consultants
interact directly with a client e.g. by managing
assets and/or making specific recommendations
in accordance with the client's long-term
investment goals. Investment consultants are a
type of investment adviser, and as such, if they
manage more than a certain amount of money,
they must register with the SEC. See also:
 Loan Officer in a Bank

• Analysis of various financial statements and tax return in order to

determine disposition of the loan requested
• Identification of potential loan risks
• Work with lenders to obtain all necessary loan information
• Maintain the integrity of each credit file
• Annually audit credit files
• Collect financial reporting data from loan operations specialists
• Review collection activity on delinquent accounts
• Communicate with clients regarding pending credit requests
• Participate in routine aging review meetings with management
 Definition of Financial
Management
• Financial management is concerned with the
acquisition, financing, and management of
assets with overall goal in mind.
 Functions of Financial Managers
1. Performing financial analysis and
planning- which includes:
• Monitoring the firms financial condition,
• Evaluating the need for increased (or
reduced ) productive capacity, and
• Determining what financing is required.
 Functions of Financial Managers

2. Investment Decision Making:

It is the most important decision of the firm
when it comes to value creation. It begins with
a determination of the total amount of assets
needed to be held by the firm.
 Functions of Financial
Managers
3. Making Financing Decision:
Here the financial manager is concerned with the
makeup of the right-hand side of the balance
sheet. It involves two major areas. First, the most
appropriate mix of short term and long-term
financing must be established. A second important
concern is which individual short term or long term
sources of financing are best at a given point in
time.
 Functions of Financial Managers
4. Asset management Decision:
Assets must be managed efficiently and
financial manager must be more concerned
in this respect. Otherwise firm may fall in
difficulty in several cases.
5. Accounting and Control:
Maintaining financial records; controlling
financial activities, identifying deviations from
planned and efficient performance, and
managing payroll, tax matters, inventories,
fixed assets and computer operations.
 Functions of Financial Managers
6. Forecasting:
Forecasting costs technological changes,
capital market conditions, funds needed for
investments, demand for the firm’s products
and using forecasts and historical data to
plan future operations.
Pricing, credit and collections, insurance
and incentive planning are some other
responsible duties to the financial managers
 Organization of the Financial
Management Function

Board of Directors

President
(Chief Executive Officer)

Vice President VP of Vice President

Operations Finance Marketing
 Organization of the Financial
Management Function

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 Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
 Forms of Business Organization

• Proprietorship
• Partnerships
• Corporations
 Sole Proprietorship
• It is a business owned by a single individual that is
entitled to all the firm’s profits and is responsible for all
the firm’s debt.
• There is no separation between the business and the
owner when it comes to debts or being sued.
• Sole proprietorships are generally financed by personal
loans from family and friends and business loans from
banks.
• Advantages:
– Easy to start
– No need to consult others while making decisions
– Taxed at the personal tax rate
• Disadvantages:
– Personally liable for the business debts
– Ceases on the death of the proprietor

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 Financing of Sole Proprietorship
Business
• Internal sources
1. Owner,s Initial Capital
2. Sale of Asset
3. Retained Earning
4. Provision for Depreciation
Outstanding Expenses
Provident fund of officers and Employees
Sale of Surplus Fixed Asset
Over use of Fixed Asset
External Sources
Institutional sources
Commercial bank
Investment Bank
Insurance Company
Development Bank
Leasing Company

Specialized Financial Institution:

Bangladesh House Building Finance Corporation-BHBFC
Bangladesh Krishi Bank- BKB, RAKUB
Bangladesh Small and Cottage Industries Corporation-BSCIC
Non-Institutional Sources Source
1. Trade Credit
2. Outstanding Expense
3. Mortgage
4. Friends and relatives
5. Money Leaders
 Partnership
• A general partnership is an association of two or more persons
who come together as co-owners for the purpose of operating a
business for profit.
• There is no separation between the partnership and the owners with
respect to debts or being sued.
• Advantages:
– Relatively easy to start
– Taxed at the personal tax rate
– Access to funds from multiple sources or partners
• Disadvantages:
– Partners jointly share unlimited liability

24 FIN3000, Liuren Wu
 Financing of Partnership Business
• Internal sources
1.Partner,s Initial Capital
2. Sale of partner’s personal Asset
3. Retained Earning
4. Provision for Depreciation
Outstanding Expenses
Provident fund of officers and Employees
Sale of Surplus Fixed Asset
Over use of Fixed Asset
5. Loan from partners
External Sources
Institutional sources
Commercial bank
Investment Bank
Insurance Company
Development Bank
Leasing Company

Specialized Financial Institution:

Bangladesh House Building Finance Corporation-BHBFC
Bangladesh Krishi Bank- BKB, RAKUB
Bangladesh Small and Cottage Industries Corporation-BSCIC
 Corporation
• Corporation is “an artificial being, invisible, intangible,
and existing only in the contemplation of the law.”
• Corporation can individually sue and be sued, purchase,
sell or own property, and its personnel are subject to
criminal punishment for crimes committed in the name of
the corporation.
• Corporation is legally owned by its current stockholders.
• The Board of directors are elected by the firm’s
shareholders. One responsibility of the board of directors
is to appoint the senior management of the firm.

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 Corporation Pros & Cons
• Advantages
– Liability of owners limited to invested funds
– Life of corporation is not tied to the owner
– Easier to transfer ownership
– Easier to raise Capital
• Disadvantages
– Greater regulation
– Double taxation of dividends

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 Financing of corporate
• Internal sources
1. Promoters Initial Capital
2. Sale of Asset
3. Retained Earning
4. Provision for Depreciation
5. Outstanding Expenses
6. Provident fund of officers and Employees
7. Sale of Surplus Fixed Asset
8. Over use of Fixed Asset
9.
External Sources
Institutional sources
Commercial bank
Investment Bank
Insurance Company
Development Bank
Leasing Company

Specialized Financial Institution:

Bangladesh House Building Finance Corporation-BHBFC
Bangladesh Krishi Bank- BKB, RAKUB
Bangladesh Small and Cottage Industries Corporation-BSCIC
Non-Institutional Sources Source
1. Trade Credit
2. Outstanding Expense
3. Mortgage
4. Friends and relatives
5. Money Leaders
 The Four Basic Principles of
Finance
1. Money has a time value.
– A dollar received today is more valuable than a dollar received
in the future (due to interests, investment returns,…)
2. There is a risk-return trade-off.
– One shall take extra risk only if one expects to be compensated
for extra return.
3. Cash flows are the source of value.
– Profit is an accounting concept designed to measure a
business’s performance over an interval of time.
– Cash flow is the amount of cash that can actually be taken out of
the business over this same interval.
4. Market prices reflect information.
– Investors respond to new information by buying and selling their
investments.

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Goals of the Corporation:

Profit Maximization or
Wealth Maximization?
 What is the Goal
of the Firm?
Maximization of
Shareholder Wealth!
Value creation occurs when we
maximize the share price for current
shareholders.
 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.).
• Ignores changes in the risk level of the firm.
 Shortcomings of
Alternative Perspectives
Earnings per Share Maximization
Maximizing earnings after taxes divided
by shares outstanding.
Problems
• Does not specify timing or duration of expected returns.
• Ignores changes in the risk level of the firm.
• Calls for a zero payout dividend policy.
 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 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.
 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.
The Modern Corporation

Modern Corporation

Shareholders Management

There exists a SEPARATION between

owners and managers.
 Role of Management

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.
 Agency Theory

Jensen and Meckling developed

a theory of the firm based on
agency theory.
• Agency Theory is a branch of
economics relating to the behavior of
principals and their agents.
 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.
 Social Responsibility

• Wealth maximization does not preclude the firm

from being socially responsible.
• Assume we view the firm as producing both
private and social goods.
• Then shareholder wealth maximization remains
the appropriate goal in governing the firm.
 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-
• The threat of firing
• The threat of takeover
• Structuring managerial incentives
• 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.
Thank You