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Contents

Definitions Of Finance, Basic Principles Of Finance, Functions Of Finance, Sectors Of Finance, Responsibility Of Financial Manager, Financial Management Issue Of The New Millennium, Forms Of Business Organizations, Financial Goals Of The Corporations, Profit Maximization Vs. Wealth Maximization And The Agency Problems.

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What is Finance?

• Finance is the relationship between deficit sector and surplus sector of the society.

• The commercial activity of providing funds and capital

• The branch of economics that studies the management of money and other assets

• The management of money and credit and banking and investments

• Finance represents the processes that transfer money among businesses, individuals, and governments

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• Finance is the management of money.

• Finance is the process of raising fund and utilizing the fund to earn highest profit.

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Principles of Finance:

1. Principles of Risk and Return

2. Principles of the Time Value of Money

3. Principles of Cash Flow

4. Principles of Profitability and Liquidity

5. Hedging Principles

6. Principles of Diversity

7. Principles of Business Cycle

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Functions of Finance

(Responsibilities of Financial Manager)

1. Financial Planning

2. Identification of Sources

3. Analyzing and Selecting of Sources

4. Raising of Funds

5. Investment of Funds/Utilization of Fund

6. Protection of Funds

7. Distributions of Profit

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• Agency conflict/ agency problem:• Agent: When somebody represent any

individual or firm is called agent.• Agency problem: Agency problem is a

conflict of interest between the shareholders and the managers or stockholders and creditors.

• Overcoming the agency problem:• Several mechanism are used to motivate

managers to act in the shareholders best interests. These includes-

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• Managerial compensation incentives)

• The threat of firing

• Shareholders intervention

• The threat of takeover.

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Sectors of Finance(Career Fields in Finance)

• Financial Markets & Institutions– Money and capital markets:

• Investments– Investment in Existing Business– Expansion of Existing Business– Investment in New Project– Research and Development

• Financial management

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Role of Finance in a Typical Business Organization (Career Opportunities in

Finance)

Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager

Inventory Manager

Capital Budgeting Director

Cost Accounting

Financial Accounting

Tax Department

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Finance in The 20th Century

Some issues are observed and discussed in the 20th century’s ----

• Inflation and its effects on business decisions• Deregulation of financial institutions and the resulting

trend toward large, broadly diversified financial services companies------------------- Mergers and Acquisitions

• The dramatic increase in both the use of computers for analysis and the electronic transfer of information

• The increased importance of global markets and business operations

• Innovations in the financial products offered to investors• The effect of changing technology• The globalization of business

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Alternative Forms of Business Organization

• Sole proprietorship

• Partnership

• Corporation

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Sole Proprietorship

Advantages– Easiest to start– Least regulated– Single owner

keeps all the profits

– Taxed once as personal income

Sole Proprietorships: A business owned by a single individual

Disadvantages–Limited to life of

owner–Equity capital

limited to owner’s personal wealth

–Unlimited liability–Difficult to sell

ownership interest

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A partnership has roughly the same advantages and disadvantages as a sole proprietorship with two or more owners.

Partnership

Advantages1. Two or more

owners2. More capital

available3. Relatively easy to

start4. Income taxed once

as personal income

Disadvantages– Unlimited liability

– Partnership dissolves when one partner dies or wishes to sell

– Difficult to transfer ownership, but less difficult than sole proprietorship – add partners

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Corporation

Advantages– Limited liability– Unlimited life– Separation of ownership and management– Transfer of ownership is easy– Easier to raise capital

Generally, any business organization which shares are traded in the share market is called Corporation.A business entity that legally functions separate and apart from its owners.

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Corporation: Disadvantages

1. Separation of ownership and management (Agency Problem)

2. Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate) – proposal to have dividends deductible as interest is now or to not tax dividend distributions

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Quick Quiz

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Partnership vs. Corporation

…………………Raising of Fund

…………………Capital Size

…………………Liability

…………………Life Duration

…………………Owners and Mangers

…………………Taxation

…………………Transferability of ownership

…………………Starting

CorporationPartnershipIssues

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Financial Goals of the Corporation

• The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price.– Do firms have any responsibilities to society

at large?– Is stock price maximization good or bad for

society?– Should firms behave ethically?

Two opinion

1. Profit Maximization

2. Wealth Maximization

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Is stock price maximization the same as profit maximization?

• No, despite a generally high correlation amongst stock price, EPS, and cash flow.

• Current stock price relies upon current earnings, as well as future earnings and cash flow.

• Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

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Quick Quiz!

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The Agency Problems & Relationships

• Agency problem– Conflict of interest between principal and agent

• Agency relationship

An agency relationship exists whenever a principal hires an agent to act on their behalf.– Stockholders (principals) hire managers (agents) to run

the company

• Within a corporation, agency relationships exist between:

– Shareholders and managers

– Shareholders and creditors

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Examples of Agency Problem

• Common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range.

• Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs.

• Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.

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Managers are naturally intended to act in their own best interests.

But the following factors affect managerial behavior:

1. Managerial compensation plans

2. Direct intervention by shareholders

3. The threat of firing

4. The threat of takeover

Tools for Mitigating the Agency Problems

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Preparation!!Following are the sample questions to take preparation!!

• Explain the Term “Finance”. Discuss the different principles of Finance.

• Discuss the main functions of Finance (or the responsibilities of a Financial manager).

• Define and discuss the Characteristics of Sole proprietorship, partnership and Corporation.

• Differentiate between partnership and Corporation.• What is agency problems and Agency

Relationships? What are the ways to reduce/mitigate the agency problem. Discuss in details.