THE FINANCIAL ENVIRONMENT

WEEK 1
 WHAT IS FINANCE?
The science and art of managing money
• At the personal level, finance is concerned with individuals’
decisions about how much of their earnings they spend, how
much they save, and how they invest their savings.

• In a business context, finance involves the same types of

decisions: how firms raise money from investors, how firms
invest money in an attempt to earn a profit, and how they decide
whether to reinvest profits in the business or distribute them
back to investors.
 THREE AREAS OF FINANCE WITHIN
THE FINANCIAL SYSTEM

✓ Financial Institutions

✓ Financial markets

✓ Financial Management
Areas of Finance within the Financial System
FINANCIAL INSTITUTIONS: Help the financial system
operate efficiently and transfer funds from savers to
investors.

FINANCIAL MARKETS: Forums in which suppliers of

funds and demanders of funds can transact business
directly. (ex. money market and capital market)

FINANCIAL MANAGEMENT: Involves financial planning,

asset management, and fund raising decisions to enhance
firm value

4
 FOUR PILLARS OF FINANCE
• Money has a time value
• Higher Returns are expected for taking on
more risk
• Financial markets are efficient in pricing
securities
• Reputation matters
 TIME VALUE OF MONEY
• Money in hand today is worth more than
the promise of receiving the same amount
of money in the future

• Time value of money exists because a

sum of money today could be invested
and “grow” over time
 RISK-RETURN TRADEOFF

• Risk is the uncertainty about the outcome

or payoff of an investment in the future

• Rational investors would choose a riskier

investment only if they feel the expected
return is high enough to justify the greater
risk
 EFFICIENT FINANCIAL MARKETS
• A financial market is “information efficient” if
at any point in time the prices of securities
reflect all information available to the public

• When new information becomes available,

prices quickly change to reflect that
information

• Information efficient markets provide liquidity

and fair prices
 REPUTATION MATTERS!
• Ethical Behavior:
How an individual or organization treats
others legally, fairly, and honestly.

• High reputation value reflects high

quality ethical behavior, so employing
high ethical standards is the “right” thing
to do
MANAGERIAL FINANCE FUNCTION:
RELATIONSHIP TO ACCOUNTING

• One major difference in perspective and

emphasis between finance and accounting is
that accountants generally use the accrual
method while in finance, the focus is on cash
flows.
Whether a firm earns a profit or
experiences a loss, it must have a sufficient
flow of cash to meet its obligations as they come due.
MANAGERIAL FINANCE FUNCTION:
RELATIONSHIP TO ACCOUNTING
Finance and accounting also differ with respect to
decision-making:

• Accountants devote most of their attention to the

collection and presentation of financial data.

• Financial managers evaluate the accounting

statements, develop additional data, and make
decisions on the basis of their assessment of the
associated returns and risks.
 The Goal of the Financial Manager
❖ The goal of the financial manager must be consistent with the mission of the
corporation, which is to maximize shareholder’s wealth.

❖ While shareholder wealth maximization is the goal of the company, it also

includes other broader goals (such as social responsibility) that will ultimately
benefit shareholders in the long-run.

❖ While managers have to cater to all the stakeholders (such as consumers,

employees, suppliers etc.), they need to pay particular attention to the
shareholders.

❖ If managers fail to pursue shareholder wealth maximization, they will lose the
support of investors and lenders. The business may cease to exist and ultimately,
the managers will lose their jobs!
Thank you

The end