• Book: Fundamentals of Financial Management
• Authors: Eugene F. Brigham
Joel F. Houston
• Edition: 12th
1
First Session
i. Introduction to Finance
2
Introduction to Finance
3
What is Finance?
• Roots of word Finance – French language.
• Today Finance has emerged as a huge academic
discipline.
• Finance today is organized as a branch of
Economics.
– Dealing with the problem of allocating financial
resources
– Decision making under conditions of uncertainty
4
What is Finance?
• As a term ‘Finance’ is defined in various ways:
– Finance primarily deals with
and a key component of finance is the
.
– Finance is the
in an
organization which
within
an organization so that the organization will have
the
as satisfactorily
as possible and in the meantime also
.
5
What is Finance?
• As a term ‘Finance’ is defined in various ways:
– The study of finance addresses the way in
which individuals, business entities and other
organizations
.
– Finance deals with
or
more appropriately
These
decisions determine
.
6
Areas of Finance
• Finance is traditionally sub-divided into 3 interrelated segments:
Finance
Financial
Management
Investments
Financial
Markets and
Institutions
7
1. Financial Management
• Specialty area of finance.
• Financial management is an
interrelated decision making process
concerned with
• Three main types of financial
management decisions.
• Important for financial managers to
evaluate these decision on an
interrelated basis.
Financial
Decision
Making
Financial
Management
Managerial
Decision
Making
Investment
Decision
Making
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i. Investment Decisions
Assets are any item owned
by an individual or company
which have value (i.e. they
could be sold).
• Long term in nature, known as ‘capital budgeting’
decisions.
• Example: Sale of a division or business, change in method of
advertising have potential to impact firm’s expenditures and
benefits in the long run and are known as capital budgeting
decisions.
• Involves determining the
the firm wants to buy and hold.
– Example: Spinning machine for a textile unit, setting up an
electric power generating facility for a sugar mill.
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i. Investment Decisions
• Mainly revolve around spending capital on
assets that will yield highest return for the
company over a period of time.
• In other words investment decisions are about
what to buy in order to help the company gain
maximum value.
• Involve finding a right balance between longterm and short-term goals.
10
i. Investment Decisions
• Asset side of balance sheet (left-hand side) is
related to investment decisions.
Investment decision
Assets
Total Current Assets
Total Long Term Assets
Machinery
Total Assets
5
100
105
11
i. Investment Decisions
• Common investment decisions to be
undertaken by the financial manager:
– In what lines of business should the firm engage?
– Should the firm acquire other companies?
– Should the firm modernize or sell an old
production facility?
12
ii. Financing Decisions
• The second question that a financial manager
faces.
• Concerned with the
through
which firm
long term
financing it needs to support long term
investments.
• Long term financing for firm mainly comes from 2
main sources: debt and equity financing.
• A
refers to the specific
mixture of debt and equity the firm uses to
finance its investments.
13
ii. Financing Decisions
• An important part of manager’s financing decisions is to answer the question,
‘How to raise cash for meeting firm’s
?
• The answer to this questions involves the right side of the balance sheet, the
firm’s capital structure.
Stockholders’ equity
representing owner
investment into assets of
the company.
Liabilities and Equity
Liabilities
Owner's Equity
x
105
Total Liabilities and Equity
105
Financing decision
14
ii. Financing Decisions
• Types of Financing:
– Equity financing
– Debt Financing
15
ii. Financing Decisions
• Common Financing decisions to be
undertaken by the financial manager:
– How to finance?
– Short-term or long-term?
– People or banks?
– Wait or to invest now?
16
iii. Managerial Decisions
• Concerned with day-to-day decision making
– Making investing and financing decisions that
improve the firms value for its owners.
– What should be the growth rate of the firm?
– Does a firm need external (debt) financing? If Yes,
then work to improve credibility so that financial
institutions would grant loans.
17
2. Investment
• Definition: An asset or item that is purchased
with the hope that it will generate income or
appreciate in value in the future.
Example:
– The building of a factory used to produce goods
– Purchase of bonds, stocks or real estate property.
18
2. Investment
• Major functions in the investment area:
– Determining the value, risk and return associated
with financial assets such as stocks and bonds.
– Determining the optimal mix of securities that
should be held in a
of investments.
19
Investments
• This area of finance carries special
significance.
• Decisions made by individuals and businesses
as they choose securities for their investment
portfolios.
20
Company’s future
plans; investments
the company is
looking to
undertake in future
Financial
position of the
company
(Balance sheet)
Rate of
Return on
different
stocks.
Gather information
about different
investing
opportunities (gold,
silver, bonds, stocks,
mutual funds)
Individual
looking to
make
investments
Interest Rate
in case of
bonds etc.
21
Businesses before making an
investment determine:
• Proper value of individual securities (Security Analysis).
• Optimal way to structure portfolios or the ‘baskets’ of
stocks and bonds (Portfolio Theory).
• Determining if stock prices in market have been raised to
unreasonable highs or lows (Market Analysis)
22
3. Financial Markets and Institutions
• Financial Markets
– Markets where financial securities (such as stocks and
bonds) are bought and sold.
– In financial markets financial securities are bought and
sold.
– Different types of financial markets.
• Financial Institutions
– Financial institutions refer to private and public
organizations that act as channels between savers and
borrowers of funds.
– Two main types of financial institutions in Pakistan are:
• Scheduled Banks
• Non Bank Financial Institutions (NBFIs)
23
Finance
Financial
Management
Investment
Decisions
Financing
Decisions
Investment
Financial
Markets and
Institutions
Managerial
Decisions
24
Second Session
i. Savings (Flow of funds)
ii. Financial Assets
iii. The legal forms of business
organization
25
Financing of Business: The Movement of Funds Through the Economy
SAVINGS (FLOW OF FUNDS)
26
Flow of funds (Transfer of Savings)
• Savings
– The portion of income not spent on consumption
of consumer goods.
• Transfer of savings
• A country’s economy can be divided into 3
sectors:
– Households (consumers)
– Businesses (producers)
– Government (both a consumer and a producer)
27
• Each of these 3 sectors can have a:
– Balanced budget (I=E)
– Surplus budget (I>E)
– Deficit budget (I<E)
• Whenever a sector’s I>E, it will be a saving
surplus sector (SSS).
• Whenever a sector’s I<E, it will be a saving
deficit sector (SDS).
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• At a group level, households comprise SSS
while businesses and governments are
typically considered to form the SDS.
• Why household is generally a SSS?
• Why governments and businesses considered
SDS?
– Example
29
• So, the households have surplus funds (SSS)
while governments & businesses need funds
(SDS).
• Thus, the funds flow from SSS to SDS.
• The flow of funds can occur in one of three ways:
1. Direct finance
2. Indirect finance (facilitated by investment bank)
3. Indirect finance (facilitated by financial
intermediaries)
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1. Direct Finance
• Security
– A claim on issuer’s future income.
• Direct finance
– Here the firm seeking cash sells its securities directly to savers
(investor) without going through any financial intermediary or
financial institution.
• A startup company is a good example of this process at work.
The new business may go directly to a wealthy private
investor called an angel investor or business angel for funds
or it may go to a venture capitalist for early funding.
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1. Direct Finance
Example
• That’s how Koofers.com got up and running. The founders of
Koofers were students at Virginia Tech who put together an
interactive Web site that provides a place for students to share
class notes and course and instructor ratings/grade distributions,
along with study guides and past exams. The Web site proved to
be wildly popular, and in 2009 received $2 million of funding
from two venture capitalists to expand, who, in return, received
part ownership of Koofers.
32
2. Indirect Finance
(facilitated by investment bank)
• Indirect money transfer generally takes place with the help of an
investment bank.
• What is an Investment bank?
– Underwriting (Helping companies raise capital)
– Providing advice to companies on mergers and other corporate reorganizations
• Investment bank serves as a middleman which facilitates transfer of
funds between the SSS and the SDS.
• Most common type of underwriting arrangement:
– Investment banker buys new securities from the issuing company and then resells
them to the investors.
• Why hire investment bank why not do we issue the securities on our
own?
– By committing to purchase securities at a set price, investment banks underwrite
any risks associated with a new issue.
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2. Indirect Finance
(facilitated by investment bank)
• Underwriting
– Literally means ‘Assuming risk’.
– Name of the process in which I.B. buys new security issues from
issuing company and then resells them to the investors.
ABC corp. shares
ABC corp.
(SDS)
$30 per share
ABC corp. shares
Investment
Bank
$32 or 29 per share
Investor
(SSS)
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• ILLUSTRATED EXAMPLE =>
• A bank has agreed to underwrite an issue of 50 million shares by ABC
Corporation. In negotiations between the bank and the corporation
the target net price to be received by the corporation has been set at
$30 per share. This means that the corporation is expecting to raise 30
× 50 million dollars or $1.5 billion in total. The bank agrees to buy the
shares from ABC Corporation for $30 per share.
• Two things may happen:
– Either stock sells below $30 or above $30
• If banks sells the shares for $32 (above $30 case), it makes a profit of
(32 − 30) × 50 = $100 million because it has agreed to pay ABC
Corporation $30 per share. However, if it can only sell the shares for
$29 per share (below $30 case), it loses (30 − 29) × 50 = $50 million
because it still has to pay ABC Corporation $30 per share.
35
2. Indirect Finance
(facilitated by investment bank)
ABC corp. shares
ABC corp.
(SDS)
$30 per share
ABC corp. shares
Investment
Bank
$32 or 29 per share
Investor
(SSS)
• Investment bank promises to buy ABC corp. security issue at a
fixed price, but it will offer to savers at a higher offering price.
This differential of ($32-$30=$2/share) is what is investment
bank’s compensation and is called the ‘underwriting spread’.
36
2. Indirect Finance
(facilitated by financial intermediary)
• Funds can also transfer from SSS to SDS through a F.I.
• Here the F.I. obtains funds from investors issues them its own
(indirect) security and then uses the money to purchase
another company’s (direct)securities.
• Direct Securities: Directly issued by a company.
• Indirect Securities: Issued by a financial intermediary.
37
2. Indirect Finance
(facilitated by financial intermediary)
• Example of funds transfer through a F.I. (AMC)
• Funds transfer from SSS to SDS facilitated by AMC.
• Asset Management Company: Licensed by SECP to launch
mutual funds, AMC invests clients funds into securities that
meets its desired objectives.
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A
$2000
B
$2000
C
$2000
AMC
D
$2000
E
$2000
Blue arrow shows investors giving money to AMC
Red arrow shows AMC giving its own shares (indirect)
to investors
AMC investment into diff. securities
Return from securities (direct)
39
Financial Assets
• Asset
– Resources owned by businesses or individuals
with the expectation that they will provide future
benefit.
40
• Assets can be classified into:
– Tangible assets
• Value depends on particular physical properties
– Intangible assets
• Represents legal claim to future benefit
41
Financial Assets
• Intangible assets
• Value of intangible assets is the claim to future
income of the company.
• Issuer
– The entity that agrees to make future cash payments
is called the issuer of the financial assets or borrower
of money.
• Investor or Lender
– The owner of the financial assets is the investor or
lender.
42
Role of Financial Assets
• Two principal economic functions
– Transfer of funds (SSS TO SDS)
– Redistribute the unavoidable risk from the issuer
of the security (person needing funds) to those
supplying the funds (investors).
43
Illustration of the two functions of financial assets
with the help of an example
• Joe needs $300,000 to setup a wristwatch manufacturing
plant.
• Joe has $200,000 in life savings – not willing to take risk, not
willing to invest all, will invest only $100,000.
• Susan has inherited $130,000, plans to invest 100,000 (excess
funds)
• Larry earned $100,000 in bonus, plans to invest all of it
(excess funds)
44
• Suppose the three (Joe, Susan and Larry) meet.
Reduction of owner’s
risk (meets second goal).
JOE
Personal funds of $100,000
i
SUSAN
Gives $100,000 and gets 30%
share in company
Wristwatch
business needs
$300,000
LARRY
Lends $100,000
Equity
Meets the
first goal.
Debt
These two financial assets allow funds
to be transferred from Susan and
Larry to Joe who needs funds.
45
The Legal Forms of Business
Organization
46
Forms of Business Organizations
• A business can be structured in various ways.
• Important to study because a firm’s legal
structure affects its operations.
• Traditionally single owners (proprietorship),
partnership and corporations operate
business.
47
Sole Proprietorship
• Business owned by a single individual.
• Popular because easier to start and lighter
regulatory and paperwork requirement than
any other business forms.
• This form of business is initiated by the mere
act of beginning the business operations.
48
Sole Proprietorship
• Advantages:
1. Easy, inexpensive to form.
2. Fewer government regulations.
3. Owner’s complete control over business
activities.
4. Income of business not taxed separately.
49
Sole Proprietorship
• Disadvantages:
1. Unlimited personal liability
~ Proprietors have unlimited personal liability for business debts so they can lose more
than the amount of money they initially invested. You might invest $10,000 to start a
business, but can be sued for $1 million if during company time one of your
employees runs over someone with a car.
2. Life is limited to that of the owner who created it.
~ When the owner dies, the sole proprietorship no longer exists.
3. Difficulty in obtaining capital.
~ Banks are also hesitant to lend to a sole proprietorship because of a
perceived lack of credibility, when it comes to repayment, if the business
fails or owner dies.
~ In order to bring in new equity investors require a change in the
structure of the business which is another reason why it is difficult for a
proprietorship to raise new capital.
50
Partnership
• The primary difference between a partnership and a sole
proprietorship is that the partnership has more than one
owner.
• A partnership is an association of two or more persons
coming together as co-owners for the purpose of operating a
business for profit.
51
Partnership
• Advantages
1. Low cost and easy to form.
2. Partnership’s income is taxed on an individual
basis.
3. As compared to sole proprietorship banks are
more willing to grant loans to partnerships.
52
Partnership
• Disadvantages
– Unlimited personal liability
• If one of partners is unable to meet his/her share of
firm’s liabilities the remaining partners will have to
fulfill any unsatisfied claims.
– Life is limited to the life of the owners.
• It may end upon the withdrawal or death of a partner.
– Difficulty in transferring ownership.
• Transfer of ownership requires that a new partnership
be formed.
53
Corporation
(From Latin word ‘corpus’ meaning body)
• Large firms across the world are normally organized as
corporations.
• Public corporations are legally independent entities entirely
separate from their owners.
• Most large businesses are incorporated as companies.
• Corporations hold rights and obligations of individual persons
(own property, sign contracts, pay taxes).
• Ownership of corporation is reflected in common stock
certificates, each designating the number of shares owned by
its holder.
54
Corporation
• Advantages
– Transfer of ownership
• Through exchange of stock.
– Limited liability
• Shareholders are not personally liable for the debts of the business.
• For example, in a well-structured corporation, creditors cannot pursue
owner's/shareholder's personal assets for the corporation’s debts.
– Ease of raising large amount of capital to operate large
businesses
• For example, corporations have the option of issuing bonds or share
certificates to investors.
• Can borrow money at lower rates.
– Unlimited life
• Perpetual existence.
55
Corporation
• Disadvantages
– Earnings subjected to ‘double taxation’.
– Starting a company is a costly and time consuming
process.
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