Semester-I 2023/2024

1. Define finance and financial management

2. Identify basic types of financial management decisions and role of a
financial manager
3. Explain the goal of a firm/financial management
4. Articulate the financial implications of the different forms of business
organization
5. Explain the conflicts of interest that can arise between managers and
owners.
Definition
The field of finance is broad and dynamic.
Finance influences everything that firms do, from hiring personnel to
building factories to launching new advertising campaigns.
It has many facets, which makes it difficult to provide one concise definition.
“the system that includes the circulation of money, the granting of credit, the
making of investments, and the provision of banking facilities.” Webster’s
Dictionary
“the science and art of managing money” Gitman
 Finance as taught in universities is generally divided into three areas:
1) Financial management,
Financial management, also called corporate finance, focuses on decisions
relating to:
how much and what types of assets to acquire,
how to raise the capital needed to purchase assets, and
how to run the firm so as to maximize its value.
whether to reinvest profits in the business or distribute them back to
investors.
2) Capital markets,
Capital markets relate to the markets where interest rates, along with stock
and bond prices, are determined. Also studied here are the financial
institutions that supply capital to businesses.
3) Investments.
 Investments relate to decisions concerning stocks and bonds and include a
number of activities:
i. Security analysis deals with finding the proper values of individual securities (i.
e., stocks and bonds).
ii. Portfolio theory deals with the best way to structure portfolios, or “baskets,” of
stocks and bonds.
Rational investors want to hold diversified portfolios in order to limit risks,
so choosing a properly balanced portfolio is an important issue for any
investor.
iii. Market analysis deals with the issue of whether stock and bond markets at
any given time are “too high,” “too low,” or “about right.”
Relationship with other fields
Finance, as we know it today, grew out of economics and accounting.
 Economics….. economists developed the notion that an asset’s value is
based on the future cash flows the asset will provide
 Accounting…. accountants provided information regarding the likely size
of those cash flows.
 statistics/mathematics e.g., forecasting tools
 marketing e.g., responsible for generating revenues
 production e.g., responsible for producing goods for sale
What is the goal of a firm/an organization?

Possible goals
Survive.
Avoid financial distress and bankruptcy.
Beat the competition.
Maximize sales or market share.
Minimize costs.
Maximize profits.
Maintain steady earnings growth.
Shareholder wealth maximization
Limitations of profit maximization
Subjective e.g., different revenue and expense measurement methods
Investment in a new branch
Items SL DDB
Gross profit Br.10,000 Br.10,000
Expenses other than depreciation (7,000) (7,000)
Income before depreciation Br.3,000 Br.3,000
expenses
Depreciation expenses (1,800) (4,400)
Income (Loss) before taxes Br.1,200 (Br.1,400)

Shall we open the new branch?

 Vagueness
Maximize profits? Which year’s profits?
A corporation may be able to increase current profits by cutting back on
outlays for maintenance or staff training, but that will not add value
unless the outlays were wasteful in the first place.
Shareholders will not welcome higher short-term profits if long-term
profits are damaged.
A company may be able to increase future profits by cutting this year’s
dividend and investing the freed-up cash in the firm.
This is not in the shareholders’ best interest if the company earns only a
very low rate of return on the extra investment.
 Ignores timing of returns and time value of money
Forecasted net income (in millions of cash)
Investment
2018 2019 2020 2021 Total
New branch 400 800 900 900 3,000
New product 900 900 800 400 3,000

Which investment is attractive to the firm in terms of net income?

 Ignores cash flows available to shareholders – cash is means of transferring
wealth to shareholders
o Profits do not necessarily result in cash flows available to the stockholders.
 Ignores risk – the chance that actual outcomes may differ from those
expected
Maximization of profit vs. maximization of wealth
Vague vs clear
Ignoring time value of money vs. considering time value of money
Increasing efficiency to maximize profit vs. increasing values of shares
Ignoring risk/uncertainty vs. considering risk inherent in company business
model
Short-term profit maximization vs. long-term maximization of value of equity
Goal of a firm
maximize wealth of shareholders measured in terms of share/stock price
Maximizing—or at least maintaining—value is necessary for the long-run survival
of the corporation.
Financial managers add value whenever the corporation can invest to earn a
higher return than its shareholders can earn for themselves.
If we ask managers to maximize value, can the corporation also be a good citizen?
Won’t the managers be tempted to try unethical or illegal financial tricks?
 Basis Wealth Maximization Profit Maximization
It is defined as managing It is defined as the
financial resources to increase management of financial
Definition
the value of the company’s resources to increase the
stakeholders. company’s profit.
Focuses on increasing the Focuses on increasing the
Focus value of the company’s profit of the company in the
stakeholders in the long term. short term.
It considers the risks and It does not consider the risks
Risk uncertainty inherent in the and uncertainty inherent in the
company’s business model. company’s business model.
It helps achieve a larger value It helps achieve efficiency in
of a company’s worth, which the company’s day-to-day
Usage
may reflect in the company’s operations to make the
increased market share. business profitable.
 Basic types of decisions/areas of concern within scope of financial management

Investment Financing
1.long-term = capital budgeting 1.long-term financing = capital structure
2.short-term = working capital management 2.profit distribution = dividend + retained
profit
Definition
Process of planning and managing long-term investment/investment in non-current assets
Decision to invest in tangible or intangible assets.
o Involves evaluating the size, timing, and risk of future cash flows
Investment decisions spend money.
Decision criteria
return on investment > cost of financing investment

Questions
What investment opportunities are there?
How much do they cost?
What is the level of risk and return?
Which ones shall a firm undertake?
Definition
Mixture of long-term debt and equity maintained by a firm to finance its operations…or
The choice between debt and equity financing …………………the capital structure decision.
Decision on the sources and amounts of financing
o Involves evaluating type of source, period of financing, cost of financing and the returns
thereby
Financing decisions raise money for investment.
Decision criteria
Cost of finance – least expensive source of finance/risk of bankruptcy

Questions
What long-term sources of finance are available for a firm?
What mixture of equity and debt is best/how much to borrow?
What are the least expensive sources of funds for the firm?
How and where to raise the money?
Definition
Working capital refers to a firm’s short-term assets, such as inventory, and
its short-term liabilities, such as money owed to suppliers.
a day-to-day activity that ensures that the firm has sufficient resources to
continue its operations and avoid costly interruptions.
o deciding on the optimal balances of current assets and current
liabilities
Decision criteria
Impact on liquidity vs. profitability
Question: how are working capital and liquidity/risk and working capital
and profitability relate?
Questions
How much cash and inventory should we keep on hand?
Should we sell on credit? If so, what terms will we offer, and to whom will we
extend them?
How will we obtain any needed short-term financing? Will we purchase on
credit, or will we borrow in the short term and pay cash? If we borrow in the
short term, how and where should we do it?
Shall we invest in short-term equity/debt securities? Shall we issue short-term
debt securities?
Definition
Process of evaluating allocation of profit between dividends and retained earnings

Decision criteria
Signal to the market/investors – thus, market value of shares
Fund requirement for expansion
Profit nd
e
Questions v id
Di
Shall we pay dividends, how much and when?
Shall we retain profit and reinvest it, how much and why?
What are the consequences of not paying dividend and not retaining profit?
How do financial management decisions affect goal of a firm?
Capital budgeting
Working capital management
Capital structure
Profit distribution
Sole-proprietorship Partnership
owned by one person more than one owners/partners
not a legal entity not a legal entity
unlimited liability unlimited liability to general partners
limited life liability limited to equity for limited
ownership transfer needs sale of entire partners
business limited life e.g., withdrawal of general
difficult to raise additional investment fund partner
difficult to transfer ownership
difficult to raise additional investment fund
Corporation  limited liability
legal entity/artificial person  unlimited life
do business in its own name  easy to raise additional funds
one/more owners (individuals or entities)  dual taxation (profit earned vs. dividends
separate ownership and management paid)
ownership divided into transferable units/  agency problem
shares
Which of the financial management decisions are applicable to a
1.Sole-proprietorship
2.Partnership
3.Corporation
How and why?
Definition
Sole proprietors face no conflicts in financial management.
o They are both owners and managers, reaping the rewards of good decisions and hard work and
suffering when they make bad decisions or slack off.
For large corporations, separation of ownership and management is a practical
necessity.
o Managers are agents for stockholders and are tempted to act in their own interests rather than
maximizing value.
 E.g. they may shy away from valuable but risky investment projects because they worry
more about job security than maximizing value.
 Agency relationship – relationship between principal and an agent
 shareholders vs. management; creditors vs. management
 shareholders vs. auditors; management vs. lower level employees
 Agency problem – conflict of interest between management and shareholders
 stakeholders – parties other than management and shareholders with interest in
a corporation e.g., employees, customers, suppliers/creditors, regulatory bodies,
general public, etc.
 Agency cost – Value lost from agency problems or from the cost of mitigating
agency problems.
 direct – management incentives/bonus, monitoring costs (e.g., auditor fees)
 indirect – loss of wealth due to suboptimal behavior of managers
Do you think managers will act in the best interest of stockholders/
shareholders? Why?
Managers are human beings, not perfect servants who always and everywhere
maximize value.
Causes
separation of ownership and management
o incompatible interest
o management may not act in the best interest of owners
o management may pursue its on goal at owners’ expense
How could agency problem be managed?
 Agency problems are controlled in practice in three ways:
1. Corporations set up internal controls and decision-making procedures to prevent wasteful
spending and discourage careless investment
2. Corporations try to design compensation schemes that align managers’ and shareholders’
interests
 incentives/compensation plans e.g., performance based bonus and share purchase
3. The corporations are constrained by systems of corporate governance.
• How corporate governance helps to align the interests of managers and shareholders.
 Legal Requirements… Good governance requires laws and regulations that protect investors from self-
dealing by insiders.
 Boards of Directors
 threat of firing e.g., through vote
 shareholders board of directors hire/fire managers
 threat of takeover – poorly managed firms more attractive for takeover because a greater profit
potential exists
 A shareholder activist
o direct intervention by shareholders e.g., institutional investors
The compensation packages of top executives are almost always tied to the
financial performance of their companies.
The package typically includes a fixed base salary plus an annual award tied to earnings or
other measures of financial performance.
compensation is not all in cash, but partly in shares.
Well-designed compensation schemes alleviate agency problems by encouraging
managers to maximize shareholder wealth.
Eg. Stock options
1. What are the basic areas of finance?
2. What are the basic types of financial management decisions, and what
questions are they designed to answer?
3. What are the three major forms of business organization?
4. What is the goal of a firm?
5. What are the objectives of financial management?
6. What are agency problems and how could they be managed?
7. Why do agency problems prevail within a corporation?
8. What are agency costs?