Concept of Finance

The process of…

 determining the required fund for an activity or a purpose,
 identifying the available sources for raising the fund,
 calculating the cost of each source,
 collecting the fund from the minimum cost source, and
 allocating the collected fund in such a way that maximizes the target
…is called finance.

Types of Finance

1) Business Finance- The process of determining the required fund for an activity or a purpose by
a business enterprise, identifying the available sources for raising the fund, calculating the cost
of each source, collecting the fund from the minimum cost source and utilizing the collected
fund in such a way that maximizes the profit is called business finance.

2) Public/Government Finance- The process of determining the required fund for an activity or a
purpose by the government of a particular country, searching the available sources for
collecting the required fund, estimating the cost of each source, raising the fund from the
minimum cost source and disbursing the collected fund in such a way that maximizes the
welfare of the common people of the country is called public finance.

3) Personal/Private Finance- The process of determining the required fund for an activity or a
purpose by an individual, identifying the available sources for raising the fund, calculating the
cost of each source separately, collecting the fund from the minimum cost source and using the
fund for maximizing personal and family benefit is called personal finance.

Functions of Financial Manager

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Functions of Finance

1) Procurement of Funds: There are alternative sources of fund like a company can take loan or
it can issue common stock, preferred stock, debenture or bond to raise the fund required, based
on cost minimization and it is the goal of financing. Finance managers need to select the best
possible sources of funds among the available alternatives and it is called Capital structure
Decision. Ordinary stock holders are the owners of the firm (like they have voting rights) but
debtors are not the owners. So, common stock is called internal source; and bond, debenture
and loan are called external sources.
2) Utilization of Funds: Capital Budgeting Decision. Long term investment decision is made on
the basis of risk and return. The goal is profit maximization and it is the most important and
challenging function of finance. To predict future profit is difficult as
1. Profit=TR-TC
2. TR=P.Q TC=FC+TVC
3) Short Term Asset Management: Working Capital Management by considering liquidity and
profitability.
4) Distribution of Funds: Dividend Policy Decision, Dividend Policy, Repurchase of Shares and
Amortization of Debt.

Forms of Business

 Proprietorship
 Partnership
 Corporations
 S Corporations

Proprietorship
Has only one owner, who receives all profits and suffers all losses, shares control with no one,
personally liable for all debts incurred by the business. Creditors can look to the proprietor’s
personal assets to satisfy business related claims. Sole proprietor raises capital from personal
resources or by borrowing and is responsible for all business decisions.

Partnership
Has more than one owner. In general partnership all partners have unlimited liability but in limited
partnership liability is limited to the capital contributed to the organization and they cannot
participate in managing the enterprise. Most partnership is established by a written contract known
as article of partnership.

Corporations
Legal entities separate from its owners, able to buy assets, raise funds. A corporation is formed
through articles of incorporation, which specify the rights and limitations of the entity. The owners
have claims on the firm through their ownership evidenced by common or preferred stock; they
have limited liability generally no greater than their initial investment. Stockholders expect to earn
return by receiving dividends- periodic distribution of earnings- or by realizing gains through
increases in share price.

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S Corporations
It has 35 or fewer stockholders and its income is taxed as direct personal income to the
stockholders, so they do not have to pay double tax but their liability is limited. In case of
corporation one of the key disadvantages is double taxation of earning. Since corporation is a
separate legal entity, it pays tax on its own income and any remaining income paid to shareholders
in the form of dividends will require a second tax by the shareholders.

Goals of the Corporation/Financial Goals of a Company

The conventional goal of a firm is profit maximization. However, since profit is reported by the
management so it can be manipulated. Moreover, accounting profit is not estimated on cash basis.
So, the modern goal of firm is shareholders’ wealth maximization, which refers to maximizing
stock prices at the market.

Moreover financial goals of a company are:

o Maximize sales.
o Maximize cash flow.
o Maximize market share.
o Maximize profit.
o Minimize costs.
o Maximize return on sales, investment and equity.
o Ensure earnings stability.
o Achieve target goals for sales, profits, market share or return.

Profit Maximization vs. Wealth Maximization

 Vagueness in Definition- There is many definitions of profit and so it is vaguely defined.

Wealth is the present value of all future dividends which is readily observed in current share
price at the market.

 Profit is an annual concept and so it is a short term concept but wealth is a long term concept.

 Profit can be manipulated by the management (like window dressing) but wealth is beyond the
direct manipulation of management.

 Risk consideration- The theory of risk says that risk and return is proportional. Profit cannot be
increased without increasing risk.

Why is Wealth Maximization?

 Long Term Concept

 Cannot be manipulated by the management (like window dressing)
 Risk Consideration
 Time Value of Money Consideration
 Clear in Definition
 Easy to Calculate

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Principles of Financial Management

Expected Cash Flows: To maximize shareholder’s wealth the managers should, other things being
equal, seek to maximize the value of cash flows received by stockholders. The owner of common
stock holder can expect to receive the following cash flows:
i) Cash dividend ii) Capital gain or loss

Timing of Cash Flows: It is important because of the time value of money principle. This simple
principle states that a dollar received today is more valuable than a dollar received in future because
the dollar today can be reinvested to produce additional cash flows.

Risk and Return: Risk is the uncertainty surrounding a future outcome. Risk is the probability that
the actual outcome in the future will be unequal to the outcome that was expected. Risk and return
are closely related, the greater the return greater the risk.

Agency Relationship

The managers can be viewed as agents of the owners who are given them decision making
authority to manage the firm. There is a potential conflict between owners and managers because
their objectives differ from those of the owners. Owners hope that mangers will act in their best
interest through compensation like stock options, bonuses etc. and monitoring like auditing
financial statements. If the managers have more ownership percentage then it is more probable that
they will behave in a manner that is consistent with maximizing shareholder wealth.

The Principal-Agent Problem

o Whenever ownership is independent of management, there exists potential problem of conflicts.

o The owner’s goals for the firm are best described as maximizing shareholder wealth.
o Managers are also concerned with personal wealth, job security, lifestyle, and benefits. These
concerns may conflict with shareholder interests.

Resolving the Agency Problem

 Good corporate governance by the Board of Directors is the heart of any resolution.
 Agency Costs – the costs of this governance:
-Monitoring costs
-Bonding costs
-Structuring compensation costs
 Market forces, such as the potential for hostile takeover provide some deterrence.
 Legal forces, fraud, and fiduciary misconduct laws aim to act as deterrents as well.

Financial Markets

Places where financial assets are traded. Financial asset represents a monetary claim on some
issuer. Financial assets- money, notes payable, common stock etc.

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Purpose of Financial Market

 Facilitating the acquisition and investment

 Encouraging capital formation
 Establishing market prices

Classifications of Financial Market

1) Money Markets: Short term financial markets i.e. financial claims will be outstanding less than
one year, high degree of safety and liquidity. Three major money market instruments:
a) Treasury bills
b) Negotiable certificate of deposit
c) Commercial paper

2) Capital Markets: Long term financial market, where financial claims lives equal to greater
than a year are traded. The most common types of securities traded are:
a) Bonds
b) Preferred stock
c) Common stock
d) Convertible securities

3) Primary Market: In Primary market where new securities are purchased and sold for the first
time. Middlemen are usually required to bring buyers and sellers together.

4) Secondary Market: In Secondary market existing securities are traded. When one investor
sells a security to another, it is through the secondary market.

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