An Introduction To Finance

Section 1The Role and Scope of

Finance

2

What is Finance?

A term that refers to two main activities;othe actual process of attracting money;oand the management of these funds;

3

The Functions of Finance

Analysis;

Decision-making;

4

The Areas of Finance

Business or Corporate Finance-the firm’s ability to make good finance decisions;

Personal Finance-retirement provision, saving plans etc.,;

Public Finance-income distribution, stability plans etc.,;

5

Finance v Accounting Financial Accounting

concentrates on record keeping and submitting of financial statements;

Finance focuses on making decisions and carrying out analysis based on information presented by accounting;

6

Finance v Accounting(cont.)

Financial Accounting tends to be more concerned with the past;

Finance tend to be more interested in present and the future;

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Finance v Accounting(cont.)

Financial Accounting tends to have an income focus;

Finance tends to have a cash flow focus;

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Business FinanceTypes of Financial Decisions

Investment Decisions;

Financing Decisions;

Asset Management Decisions;

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Investment Decisions

Should we built this component or buy it? What specific assets should be acquired? Should we introduce a new product? Which projects should be undertaken?

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Financing Decisions

What is the best structure of financing(debt versus equity)?

How much of our debt should be short-term as opposite to long-term?

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

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Asset-Management Decision

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 Business

13

The target of business is the maximize shareholder’s wealth;

It’s measured as the price of stocks;

Wealth maximization concept adjusts for deficiencies of previous concept;

Profit Maximization Short-Term Oriented;

Can not account for risk;

Can lead mismanagement;

Wealth Maximization Long-term Oriented;

The risk factor is taken account;

Recognizes the timing of returns;

14

Comparison of Two Concepts

Section 2An Overview of Business

Environment

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Types of BusinessesSole Proprietorships

A business that owned and operated by one individual;

The owner and the business are legally identical;

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The Pros and Cons of Sole Proprietorships

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Partnerships

A business that owned and controlled by two or more persons who are equally liable for losses;

Typically governed by partnership agreement;

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The Pros and Cons of Partnerships

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Company• Business that owned by

shareholders;

• Shareholder liability is limited to nominal value of shares that they own;

• Business is legally separate from it’s owners;

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The Pros and Cons of Company

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Section 3Corporate Structure

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The Modern Corporation

There exists a SEPARATION between owners and managers.

Modern Corporation

Shareholders Management

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Organizational Chart of Corporate Structure

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Role of Management

An agenagentt is an individual authorized by another person, called the principal, to act in the latter’s behalf;

Management acts as an agentagent for the owners (shareholders) of the firm;

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Agency Theory

Principals must provide incentives incentives so that management acts in the principals’ best interests and then monitormonitor results;

Incentives include stock stock options, perquisites, options, perquisites, and bonusesbonuses;

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Section 4A Quick Tour to Financial

Environment

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Financial Markets

Businesses interact continually with the financial markets;financial markets;

Composed of all institutions and procedures for bringing buyers and sellers of financial instruments together;

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The Purpose of Financial Markets

Mobilization of savings-uselessly lying fund is made to flow the place where it is really needed;

Facilitate price discovery-the price is determined by the forces of demand and supply;

Provide liquidity to financial assets-buyers or sellers of securities are available all the times;

Reduce the cost of transaction-making all necessary

information available without any cost;29

Flow of Funds in the Economy

INVESTMENT SECTOR

FIN

AN

CIA

LIN

TER

ME

DIA

RIE

S

SAVINGS SECTOR

FINANCIAL BROKERS

SECONDARY MARKET

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Types of Financial Markets Money Market-market for trading of short-term

securities(Repo, CDO, commercial paper, T-bills);

Capital Market-where the transaction of long-term securities takes place(corporate bonds, government bonds);

Primary Market-newly issued instruments are bid;

Secondary Market-already issued stocks are sold and bought;

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Financial Intermediaries Come between

ultimate borrowers and lenders by transforming direct claims to indirect claims;

Commercial banks, insurance funds,mutual funds;

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Efficient Allocation of Funds Funds will flow to economic units that are willing

to provide the greatest expected return;

The highest expected returns will be offered only by those economic units with the most promising investment opportunities;

Result:Result: Savings tend to be allocated to the most efficient uses;

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What Influences Security Expected Returns?

Default Risk-the failure to meet the terms of contract;Default Risk-the failure to meet the terms of contract;

Marketability-Marketability- is the ability to sell a significant volume of securities in a short period of time in the secondary market without significant price concession;

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What Influences Expected Security Returns?

Maturity-Maturity- is concerned with the life of the security; the amount of time before the principal amount of a security becomes due;

Embedded Options- Embedded Options- provide the opportunity to change specific attributes of the security;

InflationInflation -the greater inflation expectations, then the greater the expected return;

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Risk-Expected Return Profile

RISK

EX

PE

CTE

D R

ETU

RN

(%)

U.S. Treasury Bills (risk-free securities)U.S. Treasury Bills (risk-free securities)Prime-grade Commercial PaperPrime-grade Commercial Paper

Long-term Government BondsInvestment-grade Corporate Bonds

Medium-grade Corporate BondsPreferred Stocks

Conservative Common StocksSpeculative Common Stocks

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Term Structure of Interest Rates

A yield curve is a graph of the relationship between yields and term to maturity for particular securities.

Upward Sloping Yield CurveUpward Sloping Yield Curve

Downward Sloping Yield Curve

0 2

4

6

8 1

0

YIE

LD (%

)

0 5 10 15 20 25 30

(Usual)

(Unusual)

YEARS TO MATURITY

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