UNIT 01

INTRODUCTION TO BUSINESS FINANCE

Learning Objectives:

At the end of discussion on this topic one should be able to

 Describe the field of finance?

 Differentiate between business and public finance.

 Define financial management.

 Identify three major decisions taken by the financial manager.

 Discuss the role of a financial manager.

 Describe the responsibilities of the finance team of an organization.

 Identify the basic role of the firm.

 List the factors that affect the value of the firm.

 Discuss the legal and ethical challenges in financial management.

 Identify the different forms of business organizations.

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 FINANCE

Finance is the art and science of managing money.1

It is concerned with resource allocation as well as resource management, acquisition and

investment. Simply, finance deals with matters related to monetary resources and the financial
markets.

Finance studies and addresses the ways in which individuals, businesses and organizations raise,
allocate and use monetary resources over time, taking into account the risks entailed in their
projects. It is the art or science of managing revenues and resources for the best advantage of the
organization. The term finance may thus incorporate any of the following:

 The study of money and other monetary assets

 The management of those assets

 Profiling and managing project risks

The two major categories of finance:

1. 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. This includes
spending by public bodies, taxation, incomes from government properties, and debt and
borrowing. Governments, like any other legal entity, can take out loans, issue securities and
invest. Based on the taxing authority of the entity, they issue bonds such as tax increment bonds
or revenue bonds. A public bond or security (Defence saving certificates) may give tax
advantages to its owners. 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
2. Business finance:

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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.

1
Gitman, “Principles of Managerial Finance”
FINANCIAL MANAGEMENT

Financial management is essentially a combination of Economics and Accounting. First,

financial Manager uses accounting information-balance sheets, income statements and so on-to
analyze, plan and allocate financial resources for business firms.
Second, financial managers use economic principles to guide them in making financial decisions
that are in the best interests of the firm.
In other words, finance is an applied area of economics that relies on accounting for input.

Definition:
Financial Management concerns the acquisition, financing and management of assets with some
overall goal in mind.2
It can also be defined as,
Financial Management is the 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.

Investment decision;
Investment decision is the most important of firm’s three major decisions. It begins with total
amount of assets that needs to be held by the firm. The financial manager needs to determine the
dollar amounts of the total assets of the firm, that is, the size of the firm.
Even when this number is known, the composition of assets must still be decided. For example,
how much of the firm’s total asset should be devoted to cash or inventory?
Also the flip side of investment-disinvestments- must not be ignored. Assets that no longer be
economically justified may need to be reduced, eliminated or replaced.

Financing decision;
The second major decision of the firm is the financing decision. There are marked differences in
the financing mix of firms across industries. Some firms have relatively large amount of debt,
while others are almost debt free.
The financial manager has to decide as to what type of financing suites the firm and what
financing mix is best for the firm.
Dividend policy is also an integral part of firm’s financing decision. The dividend payout ratio
determines the amount of earnings that can be retained in the firm. Retaining greater amount of
earnings in the firm means that fewer earnings will be available for current dividend payments.
The value of the dividends paid to stockholders must therefore be balanced against the
opportunity cost of retained earnings lost as means of equity financing.

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Once the financing mix has been decided, the financial manager must still determine the best
way to physically acquire the needed funds. This deals with the mechanics of getting a short-
term loan, entering into a long-term lease agreement, or negotiating a sale of bonds or stock.

2
James C. Van Horne, John M. Wachowicz, Jr., “Fundamentals of Financial Management”

Asset Management Decision;

The third important decision of the firm is the asset management decision. Once assets have been
acquired and appropriate financing provided, these assets must still be managed efficiently. The
financial manager is charged with varying degrees of operating responsibility over the existing
assets. These responsibilities require the financial manager to be more concerned with the
management of current assets than that of fixed assets.

Summary of financing decisions;

Balance Sheet
Assets = Liability + Equity

Assets Liability & Equity

Current Assets:
Cash eg. Cash Management
Marketable Securities- Portfolio
Management
Accounts Receivable – Credit
Policy
Inventory – Inventory Management
Current Liability:
Accounts Payable – Procurement
Policy
Long Term Debt:
Notes Payable – eg Bank Loan for
a period of three years

Fixed Assets: Equity:

Equipment, Plant and Machinery – Share Capital – Issuance of Shares
Purchase of Equipment Retained Earnings – Source of
Financing
Total Assets Total Liability and Equity

Current asset and Current liability constitutes the working capital. Its management is called Asset
management. Decisions about the fixed assets are the Investing decisions while the decisions
about long term liability and equity are the financing decisions.

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 Revenue -
Expense= Net
Income
ASSETS

Financial
Analysis
Working
Capital
Asset
Manageme
Capital Manageme
nt
Budgeting nt

Capital
Structure
LIABILITIE EQUITY
S
Cost of
Capital

Dividend
Valuation Policy
of
Securities
Financing
&
Leverage
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 Long-term
Financing
ROLE OF FINANCIAL MANAGER
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. Put another way, he/she makes decisions about alternative
sources and uses of funds. The following are some specific activities that are involved;

1. Forecasting and Planning;

The financial manager must interact with other executives as they jointly look ahead and lay
plans, which will shape the future position. They must be able to communicate, analyze and
make decisions based on information from many sources. They must determine what the
financial consequences will be if the firm maintains its present course or changes it and also
plan and recommend how the firm should use its assets. e.g. Cash budget is a financial plan.

2. Investment and Financing Decisions;

On the basis of long run plans, the financial manager must raise the capital needed to support
growth. A successful firm usually achieves a high rate of growth in sales, which requires
increased investment in plant, equipment and current assets necessary to produce goods and
services. The financial manager must help determine the optimal rate of sales growth, and
he/she must help decide on the specific investments to be made as well as on the types of
funds to be used to finance these investments. Decisions must be made about the use of
internal (retained earnings) versus external funds (debt, shares), the use of debt versus equity
and use of long term versus short-term debt.

3. Coordination and Control;

The financial manager must interact with executives in other parts of the business if the firm
is to operate as efficiently as possible. All business decisions have financial implications, and
all managers- financial or otherwise- need to take this into account. For example marketing
decisions affect sales growth, which in turn changes financial requirements. Thus marketing
decision makers must take into account of how their actions affect and are affected by the
factors as availability of funds, inventory policies and plant capacity utilization.

4. Interaction with Capital Markets;

The financial must deal with the money(short term) and capital markets(long term). Each
firm effects and is affected by the general financial markets, where funds are raised, where
the firm’s securities are traded and where its investors are either rewarded or penalized.

In sum, the central responsibilities of the financial managers involve decisions such as which
investments their firm should make, how these projects should be financed, and how the firm can
most effectively manage its existing resources. If these responsibilities are performed optimally,
financial managers will help to maximize the value of their firms, and this will also maximize the
long run welfare of those who invest in the firm, buy from or work for the firm.

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 FINANCE IN ORGANIZATION OF THE FIRM
Financial managers work in collaboration with other managers. For instance, they rely on
accountants for raw financial data and on marketing manager for information about products and
sales. Financial managers coordinate with technology experts to determine how to communicate
financial information to others in the firm. Financial managers also provide advice and
recommendations to the top management.

THE ORGANIZATION OF THE FINANCE TEAM

In most medium-to-large business firms, a chief financial officer (CFO) supervises a team of
employees who manage the financial activities of the firm.

The organization of a typical corporation is as follows;

Board of Directors
(Representatives of
Shareholders)

Chief Executive
Officer (CEO)
Chief
Financial
officer

VP- VP-IT VP- VP- VP-

HRM R&D Marketing Production

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

Chief Financial
Officer (CFO)

Treasurer Controller

Cash Credit Financial Cost Financial Information

Manage- Manage- planning Accounting Accounting systems
ment ment

The chief financial officer (CFO) directs and coordinates the financial activities of the firm. The
CFO supervises a treasurer and controller. The detail responsibilities of both are as under:
Treasurer;

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  Capital budgeting: Process of determining whether or not the project is worthwhile
(Investment Appraisal).
 Cash management: The process of budgeting, saving, investing, spending or otherwise in
overseeing the cash usage of a company.
 Commercial banking and investment banking relationships
 Credit management: Managing the borrowing of a firm.
 Dividend disbursement: Distribution of a portion of earnings to stockholders.
 Financial analysis and planning: Analyzing the firm’s current financial position and
planning for the achievement of firm’s goal.
 Investor relations
 Pension management
 Insurance and risk management
 Tax analysis and planning
Controller;
 Cost accounting
 Cost management
 Data processing
 General ledger
 Government reporting
 Internal control
 Preparing financial statements
 Preparing budgets
 Preparing forecasts
At a small firm one or two people may perform all the duties of the treasurer and the controller.
In very small firm one person may perform all the functions.

THE GOAL OF THE FIRM

Efficient financial management requires the existence of some objective or goal because
judgment as to whether or not a financial decision is efficient must be made in light of some
standard. Although various objectives are possible, we assume that the goal of the firm is to
maximize the wealth of the firm’s present owners.
Shares of common stock give evidence of ownership in a corporation. Shareholder wealth is
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. The idea is that
the success of a business decision should be judged by the effect that it ultimately has on share
price.

Profit Maximization
Maximization of the firm’s earnings or profit is frequently offered as the appropriate objective of
the firm. However under this goal the manager could continue to show profit increases by merely
issuing stocks and using the proceeds to invest in Treasury bills. For most firms this will
decrease each owner’s share of profits that is earning per share will fall.
Maximizing earning per share, therefore, is often advocated as an improved version of profit
maximization. However the maximization of EPS is not a fully appropriate goal because

 It does not specify the timing and duration of expected returns

 It does not consider the risk on investments

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  It does not consider the effect of dividend policy on the market price of the stock.

Value Creation
The primary financial goal of a firm is the maximization of firm’s owner’s wealth. Wealth refers
to value. The value of a firm is determined by whatever people are willing to pay for it. The more
valuable people think the firm is, the more they will pay to own it. Then the existing owners can
sell it to investors for more than their original purchase price thereby increasing current
stockholder wealth. Thus the goal is to maximize the market value of the stock so as to increase
its value. The market price of a firm’s stock represents the focal judgemet of all market
participants as to the value of particular firm. It takes into account present and prospective future
earnings per share; the timing, duration and risk of these earnings; the dividend policy of the
firm, Financing mix and other factors that bear upon the market price of the stock.

We see then, that the firm’s stock price is depended on the following factors:
 Projected earnings per share
 Timing of the earning stream
 Riskiness of these projected earnings
 The firm’s use of debt
 Dividend policy
The market price serves as barometer for business performance; it indicates how well the
management is doing on behalf of its stockholders.

The importance of cash flows;

In business, cash is what pays the bills. It is also what the firm receives in exchange for its
products and services. Cash is therefore of ultimate importance, and the expectation that the firm
will generate cash in future is one of the factors that give the firm its value.
Cash flow means cash moving through a business. Financial managers concentrate on increasing
cash inflows-cash that flows into the business-and decreasing cash outflows- cash that flows
away from a business. Cash outflows will be approved if they result in cash inflows of sufficient
magnitude and if those inflows have acceptable timing and risk.
Cash inflows are not the same as sales. Businesses often sell goods and services on credit, so no
cash changes hands at the time of the sale. If the cash from sale is never collected, the sale
cannot add any value to the firm. Owners care about actual cash collections from sales-that is,
cash inflows.
Likewise, businesses may buy goods and services to keep the firm running, but may make the
purchase on credit- so no cash changes hands at that time. However bills always come due
sooner or later, so owners care about cash expenditures for purchase-cash outflows. For any
business (assuming that other factors remain constant), the higher the expected cash inflows and
the lower the expected cash outflows, the higher the firm’s stock price will be.

The effect of timing on cash flows;

The timing of cash flows also effects a firm’s value.
Consider this: Would you rather receive Rs.100 cash today and Rs.0 one year from now, or
would you rather receive Rs.0 cash today and Rs.100 one year from now?
Both alternatives promise the same amount of cash, but most people will choose the first one
because they realize that they could invest the Rs.100 today and earn interest on it during the
year. By doing so they would end up having more money at the end of the year. So keeping all
other factors constant, cash received sooner is better than cash received later.

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Owners and potential investors look at when firms can expect to receive cash and when they can
expect to payout cash. All other factors being equal, the sooner companies expect to receive cash
and the later they expect to pay out cash, the more valuable the firm is and the higher is its stock
price.

The influence of risk:

Risk affects value because the less certain the owners and investors are about a firm’s expected
cash flows, the lower they will value the firm and vice versa. In short, companies whose future
cash flows are doubtful will have lower values then the companies whose future cash flows are
virtually certain.
Quantifying as to how much risk effects the stock price of a firm is a difficult task. For example,
if a company’s cash flows are twice as risky as another company’s cash flows, is its stock worth
half as much? We cannot say. However this can be easily estimated that as risk increases, stock
price goes down and vice versa.

The effect of dividend policy:

Still another issue is the matter of paying dividends versus retaining earnings and reinvesting
them in the firm, thereby causing the earning stream to grow over time. Stockholders like cash
dividends but they also like growth in earnings of the firm that results from plowing earnings
back into the business. The financial manager must decide and suggest to the BOD exactly how
much of the earnings to payout as dividend rather than to retain and invest-this is called dividend
policy decision. The optimal dividend policy is one that maximizes the firm’s stock price.

The firm’s financing mix:

Financing mix or capital structure deals with the mixture of debt and equity a firm utilizes. Debt
capital is cheaper than equity capital because lenders demand a lower rate of return than do
stockholders of a firm. However, the more a company borrows, the more it increases its financial
leverage and financial risk. The additional risk causes lenders and stockholders to demand a
higher rate of return. Financial mangers use capital structure theory to determine the adequate
financing mix at which the cost of capital is the lowest and earnings are magnified so as to
increase the value of the firm. An ideal financing mix model given by Modigliani and Miller
states that optimal capital structure is 100 percent debt financed. However, in the real world,
there is no fixed percentage and the optimal capital structure depends upon large number of
factors like the kind of business, debt paying ability, strength of the business in terms of equity
capital and credibility etc.

LEGAL AND ETHICAL ISSUES IN FM

Several legal and ethical challenges influence financial managers as they pursue the goal of
wealth maximization for the firm’s owners. Examples of legal considerations include
environmental statuses mandating pollution control equipment, work place safety standards that
must be met, civil rights laws that must be obeyed and intellectual property laws that regulate the
use of other’s ideas. Ethical concerns include fair treatment of employees, customers, the
community and the society as a whole.
Three legal and ethical influences of special note include agency issues, interests of stakeholders
and interests of the society as a whole.

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AGENCY ISSUES:

Agent is a person who has implied or actual authority on the behalf of another. The financial
manager and the other managers of the firm are agents for the owners for the firm.
Principals are the owners whom the agents represent.
For example, the board of directors and the senior management of PTC are agents for PTC
stockholders, the principals.
Agents have a legal and ethical responsibility to make decisions that further the interests of the
principals. The interests of the principals are supposed to be paramount when agents make
decisions. This is often easier said than done. For example, the managing director of a
corporation might like the convenience of a private jet on call twenty-four hours a day, but do the
common stockholders receive enough value to justify the cost of a jet? It looks like the interest of
the principals and the agent are in conflict here.

Agency Problems:
An agency problem is created when the interests of the agents and that of the principals are in
conflict. In the above example the agency problem occurs if the managing director buys the jet,
even if he knows the benefits to stockholders do not justify the cost.
Another example of he agency problem occurs when managers must decide whether to undertake
a project with high potential payoff but high risk. Even if the project is more likely to be
successful than not, managers may not want to take a risk that owners would be willing to take.
This is because an unsuccessful project may result in such significant financial loss that the
managers, who approved the project, lost their jobs and all the income from their paycheck. The
stockholder owners, however, may have a much smaller risk because their investment in
company stock represents only a small fraction of their financial investment package. Because
the risk is so much larger to the manager as compared to the stockholder, a promising but
somewhat risky project may be rejected even though it was likely to benefit the firm’s owners.
Tying the managers’ compensation to the performance of the company and it s stock price can
lessen the agency problem. This tie brings the interests of the agents and the principals close
together. That is why companies often make shares of stock a part of the compensation package
offered to managers, especially top executives. The idea is if the managers are also stockholders,
then the agency problem can be reduced.

Agency Costs:
The time and money firms spend to monitor and reduce agency problems is called agency costs.
One common example of the agency cost is an accounting audit of a corporation’s financial
statements. If a business is owned and operated by the same person, the owner would not need an
audit-she could trust her own self to report her finances accurately. Most companies of any size,
however, have agency costs because managers, not owners, report the finances. Owners audit the
company’s financial statements to see whether the agents have acted in owners’ interests by
reporting the finances accurately.

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INTERESTS OF STAKE HOLDERS-ETHICAL RESPOSIBILITY:

Stockholders and managers are not the only groups that have a stake in business firm. There are
also non-manager workers, creditors, suppliers, customers and members of the community where
the firm is located. These people are called stakeholders-people who have stake in the business.
Although the primary goal of the firm is to maximize the wealth of the owners, the interests of
these stakeholders can influence the business decisions.
One example of the outside stakeholder influence is the pressure from political lobbyists and
consumer groups.

INTERESTS OF SOCIETY AS A WHOLE-SOCIAL RESPOSIBILITY:

The interests of a business firm and that of the society may not be same. For example, the cost of
properly disposing of toxic waste can be so high that companies may be tempted to simply dump
their waste in near by river. In doing so, the companies can keep the costs low and profits high.
However many people suffer from the polluted environment. To protect such interests of the
society many environmental and similar laws have been formulated giving society’s interest
precedence over the interests of the company owners. When businesses take a long-term view,
the interests of the owners and the society often (but not always) coincide. When companies
encourage recycling, sponsor programs for disadvantaged young people, run media campaigns
highlighting social issues and contribute money to worthwhile civil causes, the goodwill
generated as a result of these activities causes long-term increase in the firm’s sales and cash
flows, which translate into additional wealth for the owners.

FORMS OF BUSINESS ORGANIZATION

Businesses are organized in a variety of ways. The three most common types of organization are
Sole Proprietorships, Partnerships and Corporations. The distinguishing characteristics give each
form its own advantages and disadvantages.

The Sole Proprietorship:

Sole Proprietorship is a business owned by one person. It is a simplest way to organize a
business. An individual raises some money, finds some location from which to operate and starts
selling a product or service. This form of business has the following advantages and
disadvantages;

Advantages:
 It is easily and inexpensively formed.
 It is subject to few governmental regulations.
 Liability generated by the business is taxed at individual tax rate and avoids corporate
income taxes.

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Disadvantages:
 The sole proprietor has unlimited liability for matters relating to business. He is
responsible for all the obligations of the business even if those obligations that exceed the
amount the proprietor has invested in the business.
 It is difficult for a sole proprietor to obtain large sums of capital therefore it is a small-
scale business.
 The life of the business is limited to the life of the individual who created it.

For these disadvantages, the sole proprietorships are used primarily for small-business
operations. However, businesses are frequently started as proprietorships and then converted
into corporations when their growth causes the disadvantages of being a proprietorship to
outweigh the advantages.

The Partnership:
A partnership exists whenever two or more persons associate to conduct non-corporate business.
Partnerships may operate under different degrees of formality, ranging from informal, oral
understandings to formal agreements filed with SECP.

Advantages:
 It has low cost and ease in formation
 Tax treatment is same as that of a proprietorship i.e. tax is charged at individual tax rate
avoiding corporate taxes.

Disadvantages:
 Unlimited liability
 Limited life of the organization
 Difficulty in transferring ownership
 Difficulty in raising large sums of capital

Some partnerships contain two different forms of partners, general partners and limited partners.
General partners are almost always active participants in the management of the business,
while limited partners are not. As a result, general partners usually contract for a more
favorable allocation of ownerships, profits and losses as compared to limited partners.
General partners have unlimited liability for the partnership’s activities. Limited partners are
only liable for the amounts they invest in the partnership. If a limited partner invests Rs. 150,000
then this amount is the most he could lose. For this reason, every partnership must have one
general partner; it could not have all limited partners.

Corporation:
A corporation is a legal entity created by law that has the following characteristics;
 Separate and distinct from its owners and managers
 Transferable ownership; ownership interests can be divided into share of stock, which in
turn can be transferred far more easily than can proprietorship and partnership interests.
 Unlimited life; a corporation can continue after its original owners and managers are
deceased.
 Limited liability; losses are limited to the actual funds invested
 Can sue and can be sued.

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Corporations generally have a professional management team and board of directors elected by
the owners. It is the board’s job to look after the interests of the owners (the stockholders).
Stockholders especially in case of large organizations usually do not take an active role in
management of the business, so it is board of directors’ job to represent them.
Corporations are taxed as separate legal entities. That is, corporations must pay their own income
tax just as they were individuals. Corporations are liable to double taxation. First, the corporation
pays tax on the revenue it receives. Then the corporations must distribute the profit-they are left
with after paying tax-to its owners. These distributions, called dividend, count as ordinary
income for the owners and are taxed at individual tax rate.

Advantages:
 Separate legal entity
 Unlimited life
 Limited liability
 Easy transference of ownership
 Ease in raising money in the capital market
Disadvantages:
 Earnings are subject to double taxation
 Formal rules and regulations make the formation complex, costly and time consuming.

Summary of characteristics of the three forms of business;

Form of Formation Scale of Capital Liability Life Ownership Taxation
Business business generation

Sole Easily and Small Difficult to Unlimited Limited Difficult to Taxed at

Proprietorship inexpensively scale obtain transfer individual
formed business large sums ownership tax rate
of capital
Partnership Easily and Medium Difficult to Unlimited Limited Difficult to Taxed at
inexpensively scale obtain transfer individual
formed business large sums ownership tax rate
of capital
Corporation Complex, Large Have Limited Unlimited Easily Double
costly and scale access to transferable taxation
time business Capital and
consuming Money
markets
Can raise
huge funds

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