4105: Principles of
Finance
Introduction
Tanzina Haque FCMA
Associate Professor
Dept. of AIS
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What is Finance?
 Finance – area of business responsible for finding the
best sources of funds and the best way to use them.
 Finance is the art and science of managing money.
 Business finance is the activity concerned with
planning, raising, controlling, administering of the
funds used in the business.
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Finance consists of three interrelated areas:
1) Money and Capital Markets, which deals
with securities markets and financial
institutions.
2) Investments, which focuses on the decisions
made by both individual and institutional
investors as they choose securities for their
investment portfolios.
3) Financial Management or Business Finance,
which involves decision within firms.
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Finance
 The study of how a present known amount of
cash is converted into a future perhaps
unknown amount of cash (S.M.Archer; G.M. Choate;
G.A. Racette)
 To raise money by sell of stocks, bonds or notes
(J.M. Rosenberg-Investor Dictionary)
 Finance is the study of how people and
businesses evaluate investments and raise
capital to fund them.
 Finance is the accumulation of fund and proper
utilization of the accumulated fund to achieve
organizational goal of shareholder’s wealth
maximization.
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Finance
Finance is a body of facts, principles and
theories dealing with the raising and using
of money by individual, business and
government
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Why Study Finance?
 Knowledge of financial tools is critical to making good decisions in
both professional world and personal lives.
 Finance is an integral part of corporate world
 Some important questions that are answered using finance
 What long-term investments should the firm take on?
 Where will we get the long-term financing to pay for the investments?
 How will we manage the everyday financial activities of the firm?
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Investment Decision
 The investment decision is the most important of
the three major decisions when it comes to
value creation. It begins with a determination of
the total amount of assets needed to be held by
the firm. A firm’s investment decision involve
capital expenditures. They are, therefore,
referred as capital budgeting decisions. Two
important aspects of investment decisions are:
a) the evaluation of the prospective profitability
of new investments and b) the measurement of
a cut-off rate against that the prospective return
of new investments could be compared.
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Financing Decision
Financing decision is the second important function to
be performed by the financial manager. Broadly,
he or she must decide when, where from and how
to acquire funds to meet the firm’s investment
needs. The central issue before him or her is to
determine the appropriate proportion of debt and
equity. The mix of debt and equity is known as the
firm’s capital structure. The financial manager must
strive to obtain the best financing mix or the
optimum capital structure for his or her firm. The
firm’s capital structure is considered optimum when
the market value of share is maximized. In addition,
dividend policy must be viewed as an integral part
of the firms financing decisions.
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Asset Management Decisions
The third important decision of the firm is the asset
management decision. Once assets have be
acquired and appropriate financing provided,
these assets must still be managed efficiently. The
financial manager is charged with varying degree
of operating responsibility over existing assets. These
responsibilities require that the financial manager be
more concerned with the management of current
assets than with that of fixed assets. Current assets
should be managed efficiently for safeguarding the
firm against the risk illiquidity or lack of liquidity which
in extreme situations can lead to the firm’s
insolvency.
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Functions of Financial
Managers
 The term financial manager refer to any person
responsible for a significant corporate investment or
financing decisions (Brealey
& Myres)
 Executive Finance Functions
 Incidental Finance Functions
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Executive finance functions
 Analysing, forecasting & planning
 Determining the sources of funds
 Determining feasible project to invest the fund
 Coordination & control
 Interaction with capital markets
 Negotiation with outside financer
 Establishing asset-management policies
 Determination of the allocation of the net profit
 Estimating the cash flow requirements & the
control of cash flow
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Incidental finance functions
 Supervision of cash transaction & safeguarding of cash
 Custody & safeguarding of valuable papers
 Taking care of mechanical details of outside financing
 Record keeping & reporting
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According to John J. Hampton
 Functions leading to liquidity
 Forecasting the cash flows
 Raising funds
 Managing the flow of internal funds
 Functions leading to profitability
 Cost control
 Pricing
 Forecasting profit
 Measuring required return
 Management functions
 Managing assets
 Managing funds
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 According to Paul G. Hasings, "finance" is the
management of the monetary affairs of a company.
It includes determining what has to be paid for and
when, raising the money on the best terms
available, and devoting the available funds to the
best uses.
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Objectives of financial management
Efficient financial management requires the
existence of some objectives or goals, because
judgment as to whether or not a financial
decision is efficient must be made in light of
some standard. It is generally agreed in theory
that the financial goal of the firm should be
shareholder’s wealth maximization, as
represented by the market price per share of
the firm’s common stock, which, in turn is a
reflection of the firm’s investment, financing and
asset management decisions.
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Profit maximization
Actions that increase profits should be
undertaken and those that decrease profits are
to be avoided
Wealth maximization
When operating under a shareholder wealth
maximization objective, management has to
coordinate its profit-plan so that shareholders
receive the highest combination of dividends
and increase in share value or price of any given
period.
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Profit maximization Versus Wealth
Maximization
Wealth maximization is superior to the profit
maximization since wealth is precisely defined as
net present value and it accounts for time value of
money and risk. The market price of a firm’s stock
represents the focal judgment of all market
participants as to the value of the particular firm. It
takes into account present and expected future
earnings per share, the timing, duration, and the risk
of these earnings; the dividend policy of the firm;
and other factors that bear on the market price of
the stock. The market price serves as a barometer
for business performance; it indicates how well
management is doing on behalf of its shareholders.
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Favourable arguments of profit maximization
 Economic efficiency
 Social economic welfare
 Monopoly right over market
 Economic survivability
 Increase management confidence
 Expansion of business
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Criticism of profit maximization
 Not suitable for perfect competitive market
 Managers have some social responsibility
 It fails to provide an operationally feasible measure
for ranking alternative courses of actions in terms of
their economic efficiency
 Conceptual ambiguity
 Ignores timing of return
 It ignores risks
 It emphasis a short time outlook
 Profit has no earning capacity
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Focus of Wealth Maximization
 Focus on shareholders rather than the firm
 Emphasis on future events
 Introduce the idea that capital market evaluates
the activities of the firms and establishes the
share prices
 Emphasis cash payments to shareholders
 Consider risk and uncertainty
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How Does Finance Fit into the Firm’s
Organizational Structure?
 In a corporation, the Chief Financial Officer (CFO) is responsible
for managing the firm’s financial affairs.
 Figure 1-2 shows how the finance function fits into a firm’s
organizational chart.
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The Modern Corporation
Modern Corporation
Shareholders
Management
There exists a SEPARATION between owners and managers.
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Role of Management
Management acts as an agent
for the owners (shareholders)
of the firm.

An agent is an individual authorized by another person,
called the principal, to act in the latter’s behalf.
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Agency Considerations in Finance
Management
 Agency relationship exists when one or more persons (known as
the principal) contracts with one or more persons (the agent) to
make decisions on their behalf.
 In a corporation, the managers are the agents and the
stockholders are the principal.
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 Agency problems arise when there is conflict
of interest between the stockholders and the
managers. Such problems are likely to arise
more when the managers have little or no
ownership in the firm.
 Examples:
◦ Not pursuing risky project for fear of losing jobs,
stealing, expensive perks.
 All else equal, agency problems will reduce
the firm value.
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How to Reduce Agency Problems?
1.
2.
3.
Monitoring
(Examples: Reports, Meetings, Auditors,
board of directors, financial markets,
bankers, credit agencies)
Compensation plans
(Examples: Performance based bonus,
salary, stock options, benefits)
Others
(Examples: Threat of being fired, Threat of
takeovers, Stock market, regulations such as
SOX)
The above will help to reduce agency
problems/costs thus maximizing
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shareholders wealth.
Basic Principles of Finance
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PRINCIPLE 1: Money Has a Time Value.
 A money received today is more valuable than a money
received in the future.
 We can invest the money received today to earn interest. Thus, in the
future, you will have more money, as you will receive the interest on
your investment plus your initial invested amount.
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PRINCIPLE 2: There is a Risk-Return
Trade-off.
 We only take risk when we expect to be compensated for the
extra risk with additional return.
 Higher the risk, higher will be the expected return.
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PRINCIPLE 3: Cash Flows Are The Source of
Value.
 Profit is an accounting concept designed to measure a
business’s performance over an interval of time.
 Cash flow is the amount of cash that can actually be taken out
of the business over this same interval.
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Profits versus Cash
 It is possible for a firm to report profits but have no cash.
 For example, if all sales are on credit, the firm may report profits
even though no cash is being generated.
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Incremental Cash Flow
 Financial decisions in a firm should consider “incremental cash
flow” i.e. the difference between the cash flows the company
will produce with the potential new investment it’s thinking about
making and what it would make without the investment.
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PRINCIPLE 4: Market Prices Reflect
Information.
 Investors respond to new information by
buying and selling their investments.
 The speed with which investors act and the
way that prices respond to new information
determines the efficiency of the market. In
efficient markets like United States, this
process occurs very quickly. As a result, it is
hard to profit from trading investments on
publicly released information.
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PRINCIPLE 4: Market Prices Reflect
Information. (cont.)
 Investors in capital markets will tend to react positively to good
decisions made by the firm resulting in higher stock prices.
 Stock prices will tend to decrease when there is bad information
released on the firm in the capital market.
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The Financial Environment
Financial system of a country is consists of a
number of institutions and markets serving
business firms, individuals and governments.
When a firm invests temporarily idle funds in
marketable securities, it has direct contact
with financial markets. Most firms use
financial markets to help finance their
investment in assets. In the final analysis, the
market price of a company’s securities is the
test whether the company is a success or a
failure.
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Market – Financial market
 The place where purchaser and sellers gather to
publicly trade called market (J.M.
Rosenberg)
 Transactions in which the creation and transfer of
financial assets and financial liabilities take place
(Weston & Brigham)
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The Purpose of Financial Markets
 The purpose of financial markets in an
economy is to allocate savings efficiently to
ultimate users. If those economic units that
saved were the same as those that engaged
in capital formation, an economy could
have prosper without financial markets. In
modern
economies,
however,
most
nonfinancial corporations use more that their
savings for investing in real assets. Most
households, on the other hand have total
savings in excess of the total investment.
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Types of Financial Markets
There are different types of markets in developed and
developing countries and each market deals with a somewhat
different types of instruments in terms of the instruments maturity
and the assets backing it. Also, different markets serve different
types of customers, or operate in different parts of the country.
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Physical asset vs. Financial asset
markets
Physical asset markets also called
tangible or real asset markets are those
for such products as rice, autos, real
estate, machineries etc. Financial asset
markets on the other hand deals with
stocks, bonds, mortgages and other
claims on the real assets, as well as with
derivative securities whose values are
derived from changes in the prices of
other assets.
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Spot vs. Future markets
Spot markets are markets in which assets
are bought or sold on-the-spot delivery.
Futures markets are markets in which
participants agree today to buy or sell an
asset at some future date. For example, a
farmer may enter into a future contract in
which he agrees today to sell 5,000
bushels of soybeans six months from now
at a price of $5 a bushel.
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Money Market vs. Capital Market
Financial markets can be broken down into
two basic classes-the money market and the
capital market. The money market is
concerned with the buying and selling of
short-term (less than one year original
maturity) government and corporate debt
securities. The capital market, on the other
hand, deals with relatively long-term (greater
than one year original maturity) debt and
equity instruments (e.g., bonds and stocks).
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Primary Market vs. Secondary
Market
Within money and capital markets there
exists both primary and secondary markets. A
primary market is a “new issues” market. The
corporations selling the newly created stock
receives the proceeds from the sale in a
primary market transaction. Secondary
markets are markets in which existing,
already outstanding, securities are traded
among investors.
Transactions in these
already existing securities do not provide
additional
funds
to
finance
capital
investment.
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Private vs. Public Markets
Private
markets
are
markets
where
transactions are worked out directly
between two parties. On the other hand, in
public markets standardized contracts are
traded on organized exchanges. Public
securities must have fairly standardized
contractual features, both to appeal to a
broad range investors and also because
public investors cannot afford the time to
study unique, non-standardized contracts.
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Financial Intermediaries
Financial Intermediaries consist of financial
institutions, such as commercial banks,
savings institutions, insurance companies,
pension funds, finance companies and
mutual
funds.
Financial
intermediaries
purchase direct (or primary) securities and, in
turn, issue their own indirect (or secondary)
securities to the public. For example, the
direct security that a savings and loan
associated purchases in a mortgage; the
indirect claim issued is a savings account or
a certificate of deposit.
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Deposit Institutions
Commercial banks are the most important source of funds for
business firms in the aggregate. Banks acquire demand
(checking) and time (savings) deposits from individuals,
companies and governments and in turn, make loans and
advances.
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Insurance Companies
There are two types of insurance companies: property and
casualty companies and life insurance companies. Property and
casualty companies insure against fires, theft, car accidents and
similar unpleasantness. Life insurance companies insure against
the loss of life.
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Pension Funds
Pension and other retirement funds are established to provide
income to individuals when they retire. During their working lives,
employees usually contribute to these funds, as do employers.
Funds invest these contributions and either pay out the
cumulative amounts periodically to retired workers or arrange
annuities.
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Mutual Funds
Mutual funds accept monies contributed by individuals and
invest them in specific type of financial assets. Mutual investment
funds invest heavily in corporate stocks and bonds. The mutual
fund is connected with a management company, to which the
fund pays a fee (frequently 0.5 percent of total assets per
annum) for professional investment management.
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Financial Brokers
Certain financial institutions perform a
necessary
brokerage
functions.
When
brokers bring together parties who need
funds with those who have savings, they are
not performing a direct lending but rather
are acting as match makers, or middlemen.
Investment bankers are middlemen involved
in the sale of corporate stocks and bonds.
Mortgage bankers are involved in the
acquiring and placing mortgages.
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Flow of funds used in the Economy
-Investment Bankers
-Mortgage Bankers
Secondary
Market
Security Exchanges
OTC Market
Savings Sector
Household
Businesses
Financial Intermediaries
Commercial Banks
Savings Institutions
Insurance Companies
Pension Funds
Finance Companies
Mutual Funds
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