440 Lecture 1

FIN 440; Lecture 1
In simple terms, finance is the art and the science of managing money.
Financial Management Decision Making
1. Investment means the money corporations spend to buy fixed assets. In other
words, the expenditure corporations/firms make to fulfill capital requirements.
Firms need to invest to buy assets, which they use to create products/services,
which in-turn generates revenue.
Now, in order to make sure whether an investment is justifiable or not, firms have to
do some evaluations. This part of decision making is known as capital budgeting .
Capital budgeting means budgeting or appraising your capital requirements. In our
example, the capital requirement was $50. Before making the investment, we need
to make sure that this will worthy investment (return on this investment will be
more than the cost of making this investment).
Few capital budgeting techniques: NPV, IRR, Valuation, PP, Forecasting, some ratios,
ROI, ROI, ROA etc..
2. Financing decision: how to finance our capital investment. This is a layered

decision process.
 How much money the firm needs?

 Where can the firm get the money?
 Do we have the capacity to take external money?
 What is the cost of raising capital?
 Based on the cost we set an optimal capital structure. Capital structure is
very important for any corporation. Why? Because it dictates the amount of
risk a firm is taking while raising capital.
Debt (30%):
100 CR
- 40 crore payback - lenders

Equity (70%):
Sales – cogs- oe -int -tax = net profit
Tax benefit = 10%; the cost/risk of loan is 12% = loss of 2%

100 = 10
60 in my pocket; 60 = 6
60 + 40 = 7 – 2 = 5
Leverage
Source of capital?
 Internal Source/financing (money coming operational earnings)

 External Financing
o Equity (money provided by owners)
o Debt (money provided by lenders)
This is a common area of confusion. Sometimes, people thing equity money is also
internal. The answer is NO, because, even owners are separated from the
corporation to limit owner’s liability and to establish efficient management. In a
corporation, the management/firm is separated from the owners.
Who has the full on net profit? Owners. So, as retained earnings is part of net profit (
a portion of net profit that company decides to keep rather than giving back to
owners), so the amount of RE is added to owner’s equity account.
Example:
RE: 10, new equity: 30, bond: 10; total investment 50
Assets Liability
50 10
Equity
10 + 30
Total = 50 Total = 50
Debt: 10/50 = 20%
Equity: 40/50 = 80%
Our capital structure is D/E = 20/80 = ¼
Let’s say in order to take the $10 loan from bran bank, the coffee shop has to pay $2
interest each year. What is cost of debt? 20%
And let’s say owner’s expectation is 25%. Cost of equity is 25%
Why is capital structure important?
Because we’ve to understand no money is free. Even the 30 dollar that the owners
invested is not free. Because when the owners invested 30 USD they had some
expectation from the coffee company. And this expectation is the cost of raising
capital through equity for the coffee shop.
3. Working Capital Decision:
Corporations seek operational income to make operational costs. Firms want to use
money from sales to carry out all operational obligations. But sometimes, sales
might not be enough. In that case, temporarily, firms use money from their cash
balance to keep operations running. This cash reserve along with other current
assets, net of current obligations is known as your working capital.
There are 3 basic types of business organizations:
1. Sole Proprietorship
a. Business and owner are the same entity. No separation
2. Partnership
a. Business and owners are still the same entity. Still no separation
3. Corporations (limited company/ LLC)
a. Strengths:
i. Limited liability: separation of company from owners
ii. More access to capital
iii. Proper distribution of work
iv. Diversification in decision making
v. Corporations receive few benefits from the government under
the company law
b. Weakness:
i. Double taxation: corporate tax and personal income tax
ii.
iii. Agency problem: is the economic downturn or reduction that
results from agency problems. Agency problems and issues are
basically conflicts between owners and employees.
Goals of a business corporation:
 Profit maximization
 Cost management
 Increasing or maximizing value of a company
 Growth of a company
 Innovation
 Customer satisfaction
 Employee satisfaction
 Ethical business
 Sustainability
 Brand value
Investment > company x > assets > return
Profit is a periodic variable. High or low
Assets = sustain.
1. Profit 2. Asset value increase
100……….120
In this year GP paid dividend of $5 (profit)
{5 + (120-100)}/100 = 25%
The ultimate goal of a corporation:
What is the most important goal of a company?
Profit vs. Value
Profit = inflow – outflow = Sales – overall expenses
Profit is an accounting number/information.
Solely focusing on Profit ignores 4 basic things
 Risk
 Cash
o Sales – expense = profit
 It may ignore quality
 Time
Value maximization
There are 2 types of basic investors in the market:
 Value investors: seeking inexpensive stocks

 Growth investors: seeking value, potential, growth opportunity
Market Capitalization?
GP: each share is trading at 150; outstanding shares of GP is 1,000,000
GP mkt cap= 150 * 1,000,000 = 15 crore
2017
Sales
Amzn 80B
Alibaba 300 B
Ebay 120B
Price:
Ebay 60
Alibaba 350
Amazon 1200
Amzn: 60 million USD; 1200 USD
Alibaba: 1 billion USD; 140 USD
Ebay: 400 million USD ; 67 USD
The 3 most important financial statements are:
 Income statement (performance measurement: how well the company is

managing sales and expenses)
o IS are periodic
o All the items in IS are temporary
 Balance sheet: Position, strength, financial health etc.
o Cumulative, dynamic, continuously updated
o Hence, all the items in the BS are permanent
 Statement of Cash flow: cash position and performance
2019, Dec 31
Assets: Liabilities
Cash 18,000
Land
Property Equity
Equipment
+4000 2019 cash changes = +++------++++------ = +4000
Operations, investment and finance
2018, Dec 31
Cash 14,000
Throughout 2018:
+++ -----+-+-+ = +400
 Operations (all the operation inflow net off all operational outflow)
 Investment (the money we spend on fixed assets)
 Finance
 Owner’s equity
Financial Markets:
1. Supply side: givers/investors of money (surplus of money)

a. Individual
b. Institution
c. Government
2. Demand side: takers/seekers (deficit of money)
a. Individual
b. Institution
c. Government
There are 2 main types of intermediaries, who connects the givers and the takers
 Institutional intermediary
o Commercial banks
o Investment banks
o Funds
 Mutual
 Pension
 Hedge
o Private Placement
o Venture Capital/Private Equity
 Market intermediary
o Money market
o Capital Market
 Debt market/ Bond Market
 Equity/ Stock market
 Primary market
 Secondary market: is basically the conventional stock
exchanges that we are aware of.

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FIN 440; Lecture 1

Financial Management Decision Making

2. Financing decision: how to finance our capital investment. This is a layered

 How much money the firm needs?

- 40 crore payback - lenders

Sales – cogs- oe -int -tax = net profit

Tax benefit = 10%; the cost/risk of loan is 12% = loss of 2%

 Internal Source/financing (money coming operational earnings)

RE: 10, new equity: 30, bond: 10; total investment 50

Debt: 10/50 = 20%

Equity: 40/50 = 80%

Our capital structure is D/E = 20/80 = ¼

Why is capital structure important?

3. Working Capital Decision:

There are 3 basic types of business organizations:

Investment > company x > assets > return

Profit is a periodic variable. High or low

1. Profit 2. Asset value increase

In this year GP paid dividend of $5 (profit)

The ultimate goal of a corporation:

What is the most important goal of a company?

Profit vs. Value

Profit = inflow – outflow = Sales – overall expenses

Profit is an accounting number/information.

Solely focusing on Profit ignores 4 basic things

 Value investors: seeking inexpensive stocks

GP: each share is trading at 150; outstanding shares of GP is 1,000,000

GP mkt cap= 150 * 1,000,000 = 15 crore

Amzn: 60 million USD; 1200 USD

Alibaba: 1 billion USD; 140 USD

Ebay: 400 million USD ; 67 USD

The 3 most important financial statements are:

 Income statement (performance measurement: how well the company is

+4000 2019 cash changes = +++------++++------ = +4000

Operations, investment and finance

+++ -----+-+-+ = +400

1. Supply side: givers/investors of money (surplus of money)

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