1 Lecture 1

An Overview of Financial
Lecture 1 Management, Financial
Markets, Institutions and
Interest Rates

Dr. Aamir Amanat

 What is Finance?
Finance is the art and science of managing money.
The term finance may incorporate any of the
following:
The study of money and other monetary assets
The management of those assets
Profiling and managing project risks

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 Public Finance Vs. Business Finance
• Public Finance: Country, state, province, county, city or municipality finance is
called pubic finance. It is the branch of finance that deals with managing the
monetary resources of government.
• Public finance is concerned with:
• Identification of required expenditure of a public sector entity
• Source(s) of that entity's revenue
• The budgeting process
• Debt issuance (municipal bonds) for public works projects
• Business finance: It is the art and science of managing monetary resources of a
business. Business finance, managerial finance or corporate finance is the task of
providing the funds for the corporations' activities. It generally involves
balancing risk and profitability.

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 Role of Financial Managers
The financial manager’s primary task is to plan for the
acquisition and use of the funds so as to maximize the
value of the firm.
The following are some specific activities that are
involved:
Forecasting and Planning.
Investment and Financing Decisions.
Coordination and Control.
Interaction with Financial Markets.

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 Financial Management
Financial management is essentially a combination
of Economics and Accounting.
Financial Management concerns the acquisition,
financing and management of assets with some
overall goal in mind.
It can also be defined as a process of obtaining,
deploying and utilizing monetary resources in
order to achieve organization’s goal.
The decision function of Financial Management
can be broken down into three major areas; the
investment, financing and asset management
decisions.
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 Financial Management
Investment Decisions : Decisions about fixed assets
e.g., Size of the firm i.e., total assets, Composition of
Assets, Disinvestments.
Financing Decisions : Decisions about long term
financing and Equity e.g., Type of Financing,
Financing Mix, Dividend Policy.
Asset Management Decisions : Working Capital
Management.

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 Summary of Financing Decisions
Balance Sheet : Assets = Liabilities + Owner’s Equity
Assets Liability & Equity

Current Assets: Current Liability:

Cash e.g.. Cash Management Accounts Payable – Procurement
Marketable Securities- Portfolio Policy
Management Long Term Debt:
Accounts Receivable – Credit Policy Notes Payable – e.g. Bank Loan for a
Inventory – Inventory Management period of three years
Equity:
Fixed Assets: Share Capital – Issuance of Shares
Equipment, Plant and Machinery – Retained Earnings – Source of
Purchase of Equipment Financing

Total Assets Total Liability and Equity

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 THE ORGANIZATION OF THE
FINANCE TEAM
Board of Directors
(Representatives of
Shareholders)

Chief Executive
Officer (CEO)

Chief
Financial
officer

VP- VP-IT VP- VP- VP-

HRM R&D Marketing Production

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 THE ORGANIZATION OF THE
FINANCE TEAM

In most business firms, the finance team is organized as follows:

Chief Financial
Officer (CFO)

Treasurer Controller

Cash Credit Financial Cost Financial Information

Management Management planning Accounting systems
Accounting

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 Principal Forms of Business Organizations

Sole
proprietorship

Partnership

Corporation

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 Sole Proprietorship
ADVANTAGES DISADVANTAGES
 Owned by one person  Unlimited liability
 Easy formation  Difficulty raising
funds
 Taxed only once  Lacks continuity

Many large corporations started as a sole

proprietorship

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 Partnership
 Owned by two or more persons
Partners
 Classified as general or limited
 Partnership agreement
Type of partnership
Responsibilities
Share of profits
 Disadvantage: Partnership dissolves when a general
partner dies or leaves the business.

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 Liability of Partners
General Partner
Has unlimited liability for all obligations of
the business: disadvantage
Limited Partner
Liability limited to the partnership
agreement: advantage
Limited partnership involves at least one
general partner and one or more limited
partners

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 Corporation
 Limited liability
 Permanency
 Ability to raise capital
 Has a board of directors All advantages
 Owners are stockholders
 Flexibility
 Legal entity
 Easy marketability of shares of
ownership
 Too Many Legal Requirements Disadvantages
 Double Taxation

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Financial Markets, Institutions, and Interest Rates
 The Capital Allocation Process
 In a well-functioning economy, capital flows efficiently from
those who supply capital to those who demand it.
 Suppliers of capital – individuals and institutions with
“excess funds”. These groups are saving money and looking
for a rate of return on their investment.
 Demanders or users of capital – individuals and institutions
who need to raise funds to finance their investment
opportunities. These groups are willing to pay a rate of
return on the capital they borrow.

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 What is a market?
A market is a venue where goods and services are
exchanged.
A financial market is a place where individuals and
organizations wanting to borrow funds are brought
together with those having a surplus of funds.

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 Types of financial markets
Physical assets vs. Financial assets
Money vs. Capital
Primary vs. Secondary
Spot vs. Futures
Public vs. Private

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 How is capital transferred between
savers and borrowers?

Direct transfers
Investment banking
house
Financial
intermediaries

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 Financial Markets

Secondar
Primary
y

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 Financial Markets

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 Primary Markets

Savers Channel funds to Borrowers

• Households as a group are net savers

• Businesses and government, as a group, tend to be
net borrowers

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 Primary Claims of A Corporation
Debt
Mortgage bonds
Debenture bonds
Commercial paper
Lines of credit
Equity offerings
Common stock
Preferred stock

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 Offering Common Stock to the Public

IPO

Seasoned
equity
offering
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 What is an IPO?
An initial public offering (IPO) is where a
company issues stock in the public market for the
first time.
“Going public” enables a company’s owners to
raise capital from a wide variety of outside
investors. Once issued, the stock trades in the
secondary market.
Public companies are subject to additional
regulations and reporting requirements.

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 Stock Market Transactions
Apple Computer decides to issue additional
stock with the assistance of its investment
banker. An investor purchases some of the
newly issued shares. Is this a primary market
transaction or a secondary market transaction?

What if instead an investor buys existing

shares of Apple stock in the open market – is
this a primary or secondary market
transaction?

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 Indirect Flow of Funds to
Borrowers
Financial intermediaries include:
commercial banks
thrift institutions
investment companies
pension funds
Insurance companies
finance companies.
Savers invest in secondary claims of financial
intermediaries, which in turn invest in primary
claims of borrowers

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 Financial Intermediaries

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 Potential Benefits of Financial
Intermediaries
Diversification
Expertise
Liquidity
Convenience
Risk management

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 FINANCIAL MARKETS
Money markets
Short-term securities

Capital markets
Long-term securities

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 Market Instruments

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 Benefits of Secondary Markets

Liquidity

Efficient pricing and

information disclosure
Efficient allocation of
capital

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 Interest
Interest represents the return or compensation a lender demands before
agreeing to loan money

It is the charge for the privilege of borrowing money. Whenever people

agree to lend money to others, they take risk as a number of factors might
prevent them from taking all their money back. This risk requires a
monetary compensation that is referred to as interest.

Interest is normally expressed in percentage terms, called the interest rate.

Thus if a person lends Rs.1,000 to another person, and the return he
requires for doing so is Rs.100, we could say the interest rate charged is
10% (100/1000).

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 DETERMINANTS OF INTEREST
The prevailing rate of interest in any situation
is called nominal rate of interest. For example
in the above example the nominal interest rate
is 10%.
The following are the components of nominal
interest rate. The nominal interest rate is
composed of real interest rate plus a number
of premiums.

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 DETERMINANTS OF INTEREST

Maturity Risk
Premium

Liquidity Risk
Maturity Risk Premium
Premium
Default Risk
Inflation Liquidity Risk Premium
Premium Premium
Inflation
Default Risk Premium
Real Rate of Premium
Interest Real Rate of
Interest

Nominal Risk-Free + Risk Premiums = Nominal Interest Rate

Interest Rate

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 THE YIELD CURVE
A yield curve is a graphical depiction of interest rates
on securities that differ only in the time remaining
until their maturity.
It is a line that plots and depicts the interest rates, at
a set point in time, of securities having equal credit
quality but differing maturity dates.

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 THE SHAPE OF THE YIELD
CURVE

A normal yield curve is one in which longer maturity bonds have a

higher yield compared to shorter-term bonds, due to the risks associated
with time. It is sometimes referred to as "positive yield curve".

An inverted yield curve is one in which the shorter-term yields are

higher than the longer-term yields, which can be a sign of upcoming
recession.

A flat (or humped) yield curve is one in which the shorter- and
longer-term yields are very close to each other, which is also a predictor
of an economic transition. The slope of the yield curve is also seen as
important: the greater the slope, the greater the gap between short- and
long-term rates.
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 THE SHAPE OF THE YIELD
CURVE

Normal Yield Curve Inverted Yield Curve

Yield Yield

Maturity Maturity
Flat Yield Curve

Yield

39 Maturity
 End of Lecture 1…..
Questions ????

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