Introduction to Finance

Professor A. A. Azeez

Faculty of Graduate Studies

University of Colombo
 What is Finance?
• Finance can be defined as the science and art of
managing money.

• At the personal level, finance is concerned with

individuals’ decisions about how much of their
earnings they spend, how much they save, and how
they invest their savings.
• In a business context, finance involves the same types
of decisions: how firms raise money from investors,
how firms invest money in an attempt to earn a profit,
and how they decide whether to reinvest profits in the
business or distribute them back to investors.
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 What is Financial Management?
• Financial Management is the management of financial
resources of a business to achieve its objectives.

• In that sense, financial management involves main

three managerial decisions, namely, Capital budgeting,
Capital structure and Working Capital Management.

• By performing these three managerial functions, it is

expected to achieve the main objective of the firm;
maximizing the wealth of the owners of the business.
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Financial Management Decisions
• Capital budgeting/ Investment
–What long-term investments or projects should
the business take on?
• Capital structure/ Financing
–How should we pay for our assets?
–Should we use debt or equity?
• Working capital management/ Short-term
asset management
–How do we manage the day-to-day finances of
the firm?
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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 (RHS of
balance sheet) will be financed (LHS
of balance sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy?
• How will the funds be physically acquired?

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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 Financial Manager
• Financial managers try to answer some or
all of these questions.
• The top financial manager within a firm is
usually the General Manager–Finance.
– Corporate Treasurer or Financial
Manager⎯oversees cash management,
credit management, capital expenditures and
financial planning.
– Accountant⎯oversees taxes, cost accounting,
financial accounting 1-8
and data processing.
 The Financial Manager
The Financial Manager’s primary goal is to
increase the value of the firm by:

1. Selecting value creating projects

2. Making smart financing decisions
 The Firm and the Financial
Markets
Firm Firm issues securities (A) Financial
markets
Invests
Retained
in assets cash flows (D)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (F)
Equity shares

Taxes (E)
The cash flows from the
Ultimately, the firm must
firm must exceed the cash
be a cash generating
Government flows from the financial
activity.
markets.
 Finance Function: Relationship to
Accounting
• The firm’s finance and accounting activities are
closely-related and generally overlap.
• In small firms accountants often carry out the finance
function, and in large firms financial analysts often
help compile accounting information.
• One major difference in perspective and emphasis
between finance and accounting is that accountants
generally use the accrual method while in finance,
the focus is on cash flows.

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 Finance Function: Relationship to
Accounting
• Objective of accounting is to measure the performance
of the firm, assess its financial condition, and determine
the base for tax payment.
• The principal goal of FM is to create shareholder value
by investing in positive NPV projects and minimizing
the cost of financing.
• Whether a firm earns a profit or experiences a loss, it
must have a sufficient flow of cash to meet its
obligations as they come due.
• The significance of this difference can be illustrated
using the following simple example.
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 Finance Function: Relationship to
Accounting

•The Nasar Corporation experienced the following

activity last year:

Sales Rs.100,000 (1 yacht sold, 100% still uncollected)

Costs Rs. 80,000 (all paid in full under supplier terms)

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 Finance Function: Relationship to
Accounting

•Now contrast the differences in performance under the

accounting method (accrual basis) versus the financial
view (cash basis):
Income Statement Summary
Accrual basis Cash basis
Sales Rs.100,000 Rs. 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) Rs. 20,000 (80,000)

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 Finance Function: Relationship to
Accounting

•Finance and accounting also differ with respect to

decision-making:
– Accountants devote most of their attention to the
collection and presentation of financial data.
– Financial managers evaluate the accounting
statements, develop additional data, and make
decisions on the basis of their assessment of the
associated returns and risks.

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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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 Maximizing Shareholder Wealth
• To maximize shareholder wealth, the
financial manager must maximize the
market value of the firm’s common stock
• Three factors determine the market value
of common stock:
– Size of the firm’s cash flow
– Timing of the firm’s cash flow
– Risk of the firm’s cash flow stream

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 Strengths of Shareholder
Wealth Maximization
• Takes account of: current and future profits
and EPS; the timing, duration, and risk of
profits and EPS; dividend policy; and all
other relevant factors.
• Thus, share price serves as a barometer for
business performance.

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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.).
• Ignores changes in the risk level of the firm.

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 Goal of the Firm: 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.

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 Goal of the Firm:
What About Stakeholders?
• Stakeholders are groups such as employees, customers,
suppliers, creditors, owners, and others who have a direct
economic link to the firm.
• A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to stakeholders.
The goal is not to maximize stakeholder well-being but
to preserve it.
• Such a view is considered to be "socially responsible."

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 The Agency Problem
• Agency relationship
– Principal hires an agent to represent his/her
interest
– Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
Conflict of interest between principal and agent
• Agency costs
Refer to the costs of the conflict of interest
between shareholders and the management.
 Do Managers Act in
Shareholders’ Interests?
The answer to this will depend on two
factors:

• How closely management goals are

aligned with shareholder goals

• The ease with which management can be

replaced if it does not act in shareholders’
best interests. 1-23
 Alignment of Goals
The conflict of interests is limited due to:

• Management compensation schemes

• Monitoring of management

• The threat of takeover

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 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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 Monitoring of Management:
Individual versus Institutional Investors

• Individual investors are investors who own relatively small

quantities of shares so as to meet personal investment goals.
• Institutional investors are investment professionals, such as
banks, insurance companies, mutual funds, and pension funds,
that are paid to manage and hold large quantities of securities
on behalf of others.
• Unlike individual investors, institutional investors often
monitor and directly influence a firm’s affairs by exerting
pressure on management to perform or communicating their
concerns to the firm’s board.

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 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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 Financial system
• Financial system is defined as the set of markets and
other institutions used for financial contracting and the
exchange of assets and risks.

• The financial system includes the markets for stocks,

bonds and other financial instruments, and financial
intermediaries.

• Financial intermediaries are banks, insurance

companies, investment banks, financial service firms
such as financial advisory firms.
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 Financial Markets
• Primary Market
– Issuance of a security for the first time
• Secondary Markets
– Buying and selling of previously issued
securities
– Securities may be traded in either a dealer or
auction market
• Colombo Stock Exchange
• New york Stock Exchange
 Financial Markets

Stocks and
Investors
Bonds
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market
 Financial Markets
• Financial markets are markets in which funds are
transferred from people who have an excess funds to
people who have a shortage.
• A security is a claim on the issuers’ future income or
assets.
• A stock is a security that is a claim on the earnings
and assets of a corporation.
• A bond is a debt security that promises to make
payments periodically for a specified period.
• Foreign Exchange Market is where the currency
conversion takes place, and it is instrumental in moving
funds between countries.

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 Financial Markets
• Markets are classified as money and capital markets depending
the length of the financial instruments that are traded .

– The money market concerned with buying and selling of

short term (less than one year original maturity) government
and corporate debt securities; Treasury Bill, Foreign
Exchange, Inter bank money market, commercial paper
market.

– The capital market deals with the relatively long term

(greater than one year original maturity) debt and equity
instruments (bonds and stocks)
 Financial Institutions

• Financial institutions are what make financial

markets work.
• Financial institutions include banks, insurance
companies, mutual funds,finance companies
and investment banks.
• Financial intermediaries play important role in
indirect finance.
• Why are financial intermediaries and indirect
finance so important in financial markets?
1. Transaction costs could be reduced
2. Asymmetric information.
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 What is an Investment?
Investment: any asset into which funds can
be placed with the expectation that it will
generate positive income and/or preserve or
increase its value.

Return: the reward for owning an investment

– Income from investment
– Increase in value of investment
 Types of Investments
• Securities or Property
– Securities: stocks, bonds, options
– Real Property: land, buildings
– Tangible Personal Property: gold,
•Debt or Equity
– Debt: investor lends funds in exchange for
interest income and repayment of loan in future
(bonds)
– Equity: represents ongoing ownership in a
business or property (common stocks)
 Types of Investments

• Short-Term or Long-Term
– Short-Term: mature within one year
– Long-Term: maturities of longer than a year

• Low Risk or High Risk

– Risk: the uncertainty surrounding the return
that a particular investment will generate
The Investment Process

Financial Markets are forums in

which suppliers and demanders of
funds trade financial assets
 Quiz
• What are the three basic questions
Financial Managers must answer?
• What is the goal of financial management?
• What are agency problems, and why do
they exist within a corporation?
• What is the difference between a primary
market and a secondary market?