INTRODUCTION TO FINANCE
FIN242
MR. KHAIRUL LATIF
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Definition of finance
The goal of the firm
Basic principles of foundation of finance
The role of finance in business
What is finance
• Definition :
• Finance is the process by which money is transferred (financing and
investing) among businesses, individuals, and governments.
(sources: introduction to finance, Pearson. 1.Lawrence J. Gitman
2.Jeff Madura)
• Finance also is the study of how people and businesses evaluate
investments and raise capital to fund them
• Financial management is planning, organizing and controlling the
acquisition and use of financial resources for the purpose of
achieving organizational goal.
The goal of the firm
• The fundamental goal of a business is to
create value for the company’s owners
(that is, its shareholders).
• “maximization of shareholder wealth”
• Making decision that will maximize the
price of the existing common stock
Principles That form the foundations of
Finance
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Cash flow is what matter
Money has a time value
Risk requires as a reward
Market price are generally right
Conflict of interest cause agency problems
Cash flow is what matter
• Company profit can differ dramatically from
its cash flow
• Cash flow, not profit, represent money that
can be spent.
• Cash flow, not profits, that determines the
value of a business.
• For this reason when we analyze the
consequences of managerial decision, we
focus on the resulting cast flow, not profits.
• For example: Was Harry potter and the order
of the phoenix a successful movie? discuss
Money has a time value
• Money has a “time” value
• Simply, a RM receive today is more
valuable than a RM receive one year from
now
– “You have a choice of receiving RM1000 either today or one
year from now. If you decide to receive it a year from now, you
will have passed up the opportunity to earn a year’s interest on
the money”
• Opportunity cost is the highest- valued
alternative that you had to give up when
you made the choice
• Finance focus on the creation and
measurement of value
• We use the concept of the time value of
money to bring future benefits and costs of
project, measured by its cash flow, back to
the present.
Risk Requires a Reward
• Investor expect to receive a return on their
investment.
– A return for delaying consumption
– An additional return for taking on risk
Keep referring to the expected return rather
than the actual return
Market Price Are Generally Right
• Efficient market is one where the prices of
the assets traded in that market fully
reflect all available information at any
instant in time
• Thus stock price are useful indicator of the
value of the firm. Price changes reflect in
expected future cash flow. Good decision
will tend to increase the stock price and
verse versa.
• Example:
– While Nike CEO William Perez flew aboard
the company’s Gulfstream jet one day in
November 2005, traders on the ground sold of
a significant amount of Nike’s stock. Why?
Conflicts of Interest Cause Agency
Problems.
• The separation of management and the
ownership of the firm creates an agency
problem. Manager may make decisions
that are not consistent with the goal of
maximizing shareholder wealth.
• Agency conflict is reduced through
monitoring (ex. Annual reports),
compensation scheme, etc.
• Example:
– Shutting down an unprofitable plant is the
best interests of the firm’s stockholders, but in
doing so the managers will find themselves
out of a job or having to transfer to a different
job. What will happen?
The Role of Finance in Business
• Three basic type of issues that are addressed
by the study of finance:
• Capital budgeting: What long term
investment should the firm undertake?
(where to invest)
• Capital structure decision: How should the
firm raise money to fund these investment?
(how to raise capital)
• Working capital management: How can the
firm best manage its cash flows as they arise
in its day-to-day operation? (how to manage
The role of Financial Manager
The Legal Forms of Business Organization
• Sole Proprietorships
• Partnerships
• Corporations
Sole Proprietorships
• A business owned by an individual
 Advantages
 Easily established
 Minimal organizational cost
 Does not have to share profits or control with
others
 Disadvantages
 Unlimited liability for the owner
 Owner must absorb all losses
 Termination occurs on owner’s death or by
owner’s choice
Partnerships
• Partnership an association of two or more
individuals joining together as co-owners
to operate a business for profit
• Two type of partnership
– General partnership: a partnership in which all
partners are fully liable for the indebtedness
incurred by the partnership.
– Limited partnership: a partnership in which
one or more of the partner has limited liability,
restricted to the amount of capital he or she
invests in the partnership.
Corporation
• Corporation an entity that legally functions
separate and apart from its owners.
• Owner (shareholder) dictate direction and
policies of the corporation
• Ownership is reflected in common stock
certificates
• The number of shares owned/total number of
shares outstanding determines the
proportionate ownership of the stockholder in
business.
• Owner elect a board of directors whose
members select the president, vice president,
secretary, and treasurer.
Double taxation
• This occurs when a corporation earns a
profit, pays taxes on those profits (the 1st
taxation of earnings), and pays some of
those profits back to the shareholder in the
form of dividend, and then the
shareholders pay personal income taxes
on those dividend (the 2nd taxation of
those earnings)
QnA