Principles of Principles of FinanceFinance

TODAY’S SESSION

‘Introduction to Finance’

Chapter One : An overview of managerial Finance

What is Finance?

Finance is the study of money that refers raising fund, managing them and determining their best use.

Finance can be defined as the art and science of managing money.

Finance is concerned with the process, institution, markets and instruments involved in the transfer of money among individuals, businesses, and governments.

The financial Managers’ responsibilities

The major responsibilities of a financial managers:

1. Forecasting & Planning

2. Major Investment and Financing decision

3. Coordination and Control

4. Dealing with the Financial Markets

5. Risk Management

Legal Forms of Business Organization

The three most common forms of business organization:

1. Proprietorship or Sole Proprietorship

2. Partnership

3. Corporation

Sole Proprietorship

“A business owned and managed by one individual. An unincorporated business owned by one individual”.

Advantages: Ease of starting Control depends on own decision Sole participation in profit and losses No business tax ( Only individual income tax) Secrecy Ease of dissolving

Disadvantages or Limitations: Unlimited personal liabilities Difficult ownership transfer Unavailability of large Capital

Partnership

“A business owned by two or more people. An unincorporated business owned by two or more people”.

Advantages: More capital Ease of starting (as its a private contractual agreement) No business tax (Only the partners or owners pay taxes on their

business earnings)

Disadvantages or Limitations: Unlimited liabilities for each General partners for debt. Potential conflict between partners Investment withdrawal difficulty

Corporation

“A business that is a legal entity separate from its owners.”

Advantages: Limited liability (liability only on the invested amount of

stockholder) Easy to transfer the ownership Stability

Disadvantages or Limitations: Municipal taxation (double taxation) Difficulty & expense of starting Lack of control Govt. involvement Lack of secrecy Credit limitation

Some Terminologies

Stockholders: The owners of a corporation, whose ownership or equity, is evidences by either common stock or preferred stock.

Stakeholder: Groups such as employees, customers, supplies, creditors, owners, govt. and others who have a direct economic link to the firm.

Dividends: Periodic distributions of earnings to the stockholders of a firm.

Common Stock: The purest and most basic forms of corporate ownership.

Preferred Stock: A special form of ownership having a fixed periodic dividend that must be paid prior to payment of any common stock dividend.

EPS (Earning per Share):The amount earned during the period on behalf of each outstanding share of common stock.

EPS = Total earnings from the common SH / Number of common SH

The Goals of a Corporation

What should be the prime goal of a corporation-----

Profit Maximization??

Stockholders’ wealth Maximization or Stock price Maximization??

Answer: The primary goal of a financial manager should maximize the stockholders wealth by maximizing the price of the firms common stocks. Firms do, of course, have other objectives but stock price maximization is the most important goal for most corporation. Further more, the action that maximize the stock price also increase social welfare.

Agency Relationships

An agency relationship exist when one or more people (the principals) hire another person (the agent) to perform a service and then delegate decision-making authority to that agent.

Important agency relationships exist between-

Stockholders and managers and

Stockholders and creditors (debtholders)

Agency Problem: A potential conflict of between (1) the principals (outside shareholders) and the agent (manager) or (2) stockholders and creditors (debtholders).

Stockholders versus managers

If conflict exist several mechanisms are used to motivate manager to act in the

shareholders’ best interests. These includes:

1. The Threat of firing

2. The Threat of takeover: The acquisition of a company over the opposition of its management. Managers may use the following techniques to prevent the hostile takeover---

3. Structuring managerial incentives

Stockholders versus Creditors

A second agency problem involves conflict between stockholders and creditors (debt holders). Creditors lend funds to the firm at the rates that based on

1. The Riskness of the firms’ existing assets.

2. Exceptions concerning the riskness of future assets additions

3. The firms existing capital structure

4. Change of future capital structure