Introduction to Finance

Finance: Finance is concerned with decisions about money or more appropriately, cash flows. Finance
decisions deal with how money is raised and used by businesses, governments and individuals. 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 to earn a
profit and how they decide whether to reinvest profits in the business or distribute them back to
investors.

Business finance is that business activity which concerns with the acquisition and conversation of capital
funds in meeting financial needs and overall objectives of a business enterprise. Business finance can
broadly be defined as the activity concerned with planning, raising, controlling, administering of the
funds used in the business.

Traditional approach of finance: The traditional approach to the scope of financial management refers
to its subject-matter, in academic literature in the initial stages of its evolution, as a separate branch of
academic study. In other words, the scope of the finance function was treated by the traditional
approach in the narrow sense of procurement of funds by corporate enterprise to meet their financing
needs. The field of study dealing with finance was treated as encompassing three interrelated aspects of
raising and administering resources from outside: (i) the institutional arrangement in the form of
financial institutions which comprise the organization of the capital market; (ii) the financial instruments
through which funds are raised from the capital markets and the related aspects of practices and the
procedural aspects of capital markets and (iii) the legal and accounting relationships between a firm and
its sources of funds.

The traditional approach has now been discarded as it suffers from serious limitations. The first
argument was based on its emphasis on issues relating to the procurement of funds by corporate
enterprises. Further, the finance function was woven around the viewpoint of the suppliers of funds
such as investors, investment bankers and so on, that is, the outsiders. It implies that no consideration
was given to viewpoint of those who had to take internal financial decisions. The traditional treatment
was, in other words, the outsider-looking-in approach.

Yet another basis was that the treatment was built too closely around episodic events, such as
promotion, incorporation, merger, consolidation, reorganization and so on. As a logical corollary, the
day-to-day financial problems of a normal company did not receive much attention.

Finally, the traditional treatment was found to have a lacuna to the extent that the focus was on long-
term financing. Its natural implication was that the issues involved in working capital management were
not in the purview of the finance function.

The limitations of the traditional approach were fundamental. The conceptual and analytical
shortcoming of this approach arose from the fact that it confined financial management to issues
involved in procurement of external funds, it did not consider the important dimension of allocation of
capital.

Modern approach of finance: The modern approach views the term financial management in a broad
sense and provides a conceptual and analytical framework for financial decision making. According to it,
the finance function covers both acquisition of funds as well as their allocations. Defined in a broad
sense, it is viewed as an integral part of overall management. The financial management, according to
the new approach, is concerned with the solution of three major problems relating to the financial
operations of a firm.

1. Capital budgeting: The concern of the capital budgeting decision is with the long-term assets
which yield a return over a period of time in future.
2. Working capital management: The aspect of working capital management deals with short-term
or current assets which in the normal course of business are convertible into cash without
diminution in value, usually within a year.
3. Capital structure: The concern of financing-mix or capital structure or leverage has two aspects.
One dimension of the financing decision discusses whether there is an optimum capital
structure and in what proportion funds should be raised to maximize the return to the
shareholders. The second aspect of the financing decision is the determination of an appropriate
capital structure, given the facts of a particular case.

Capital budgeting: Capital budgeting relates to the selection of an asset or investment proposal or
course of action whose benefits are likely to be available in future over the lifetime of the project. The
first aspect of the capital budgeting decision relates to the choice of the new asset out of the
alternatives available or the reallocation of capital when an existing asset fails to justify the funds
committed. Whether an asset will be accepted or not will depend upon the relative benefits and returns
associated with it.

The second element of the capital budgeting decision is the analysis of risk and uncertainty. Since the
benefits from the investment proposals extend into the future, their accrual is uncertain. The returns
from capital budgeting decisions should, therefore, be evaluated in relation to the risk associated with it.

Finally, the evaluation of the worth of a long-term project implies a certain norm or standard against
which the benefits are to be judged. This standard is broadly expressed in terms of the cost of capital.
The concept and measurement of the cost of capital is, thus, another major aspect of capital budgeting
decision.

Working capital management: Working capital management is concerned with the management of
current assets. It is an important and integral part of financial management as short-term survival is a
prerequisite for long-term success. One aspect of working capital management is the trade-off between
profitability and liquidity. There is a conflict between profitability and liquidity. If a firm does not have
adequate working capital, it may become illiquid and consequently may not have the ability to meet its
current obligations and, thus, invite the risk of bankruptcy. If the current assets are too large,
profitability is adversely affected. The key strategies and considerations in ensuring a trade-off between
profitability and liquidity is one major dimension of working capital management. In addition, the
individual current assets should be efficiently managed so that neither inadequate nor unnecessary
funds are locked up.

Capital structure: Capital structure refers to the proportion of debt (fixed-interest sources of financing)
and equity capital (variable-dividend securities/source of funds). The financing decision of a firm relates
to the choice of the proportion of these sources to finance the investment requirements. A proper
balance between debt and equity to ensure a trade-off between risk and return to the shareholders is
necessary. A capital structure with a reasonable proportion of debt and equity capital is called the
optimum capital structure.

Objectives of financial management: The term ‘objective’ is used in the sense of a goal or decision
criterion for the three decisions involved in financial management. It implies that what is relevant is an
operationally useful criterion by which to judge a specific set of mutually interrelated business decisions,
namely, investment, financing and dividend policy. Objectives of financial management may be broadly
divided into two parts such as: profit maximization and wealth maximization.

Profit maximization: The profit maximization criterion implies that the investment, financing and
dividend policy decisions of a firm should be oriented to maximize the profits. The rationale behind
profitability maximization is simple. Profit is a test of economic efficiency. Moreover, it leads to efficient
allocation of resources, as resources tend to be directed to uses which in terms of profitability are the
most desirable. Finally, it ensures maximum social welfare. Financial management is concerned with the
efficient use of capital. It is, therefore, argued that profitability maximization should serve as the basic
criterion for financial management decisions.

The profit maximization criterion has been questioned and criticized on several grounds. The main
technical flaws of this criterion are:

1. Ambiguity: One practical difficulty with profit maximization criterion is that profit is a vague and
ambiguous concept. Profit may be short-term or long-term; it may be total profit or rate of
profit; it may be before-tax or after-tax; it may return on total capital employed or total assets
or shareholders’ equity and so on. If profit maximization is taken to be the objective, the
question arises, which of these variants of profit a firm should try to maximize.
2. Time value of money: A basic dictum of financial planning is the earlier the better as benefits
received sooner are more valuable than benefits received later. The reason for the superiority of
benefits now over benefits later lies in the fact that the former can be reinvested to earn a
return. This is referred to as time value of money. The profit maximization criterion does not
consider the distinction between returns received in different time periods and treats all
benefits, irrespective of the timing, as equally valuable.
3. Risk: As a rule, the more certain the expected return, the higher is the quality of the benefits. An
uncertain and fluctuating return implies risk to the investors. It can be safely assumed that the
investors are risk-averters, that is, they want to avoid or at least minimize risk. The problem of
uncertainty renders profit maximization unsuitable as an operational criterion for financial
management as it considers only the size of benefits and gives no weight to the degree of
uncertainty of the future benefits.

Wealth maximization: Wealth maximization is also known as value maximization or net present worth
maximization. In current academic literature value maximization is almost universally accepted as an
appropriate operational decision criterion for financial management decisions as it removes the
technical limitations which characterize the earlier profit maximization criterion. Its operational features
satisfy all the three requirements of a suitable operational objective of financial course of action-
exactness, quality of benefits and the time value of money.

The worth of a course of action can be judged in terms of the value of the benefits it produces less the
cost of undertaking it. The wealth maximization criterion is based on the concept of cash flows
generated by the decision rather than accounting profit which is the basis of the profit maximization
criterion. Measuring benefits in terms of cash flows avoids the ambiguity associated with accounting
profits. This is the first operational feature of the net present worth maximization criterion.

The second important feature of the wealth maximization criterion is that it considers both the quantity
and quality dimensions of benefits. At the same time, it also incorporates the time value of money. The
operational implication is that adjustments should be made in the cash-flow pattern, firstly, to
incorporate risk and secondly, to make an allowance for differences in the timing of benefits.

The focus of financial management is on the value to the owners or suppliers of equity capital. The
wealth of the owners is reflected in the market value of shares. So, maximization of the market price of
shares is the operational substitute for wealth maximization as a decision criterion.

Legal forms of business organization: One of the most basic decisions that all businesses confront is
how to choose a legal form of organization. This decision has very important financial implications
because how a business is organized legally influences the risks that the firm’s owners must bear, how
the firm can raise money and how the firm’s profits will be taxed. The three most common legal forms
of business organization are the sole proprietorship, the partnership and the corporation.

1. Sole proprietorship: A proprietorship is an unincorporated business owned by one individual. Going

into business as a sole proprietor is easy—a person begins business operations. Proprietorships have
three important advantages: (1) They are easy and inexpensive to form. (2) They are subject to few
government regulations. (3) They are subject to lower income taxes than are corporations. However,
proprietorships also have three important limitations: (1) Proprietors have unlimited personal
liability for the business’ debts, so they can lose more than the amount of money they invested in
the company. (2) The life of the business is limited to the life of the individual who created it and to
bring in new equity, investors require a change in the structure of the business. (3) Proprietorships
have difficulty obtaining large sums of capital; hence, proprietorships are used primarily for small
businesses. However, businesses are frequently started as proprietorships and then converted to
corporations when their growth results in the disadvantages outweighing the advantages.
2. Partnership: A partnership consists of two or more owners doing business together for profit.
Partnerships are common in the finance, insurance and real estate industries. Public accounting and
law partnerships often have large numbers of partners. The advantages of a partnership are the
same as for a proprietorship: (1) Formation is easy and relatively inexpensive. (2) It is subject to few
government regulations. (3) It is taxed like an individual, not a corporation. The disadvantages are
also similar to those associated with proprietorships: (1) Owners have unlimited personal liability.
(2) The life of the organization is limited. (3) Transferring ownership is difficult. (4) Raising large
amounts of capital is difficult. Under partnership law, each partner is liable for the debts of the
business. Therefore, if any partner is unable to meet his or her pro rata claim in the event the
partnership goes bankrupt, the remaining partners must make good on the unsatisfied claims,
drawing on their personal assets if necessary.
3. Corporation: A corporation is a legal entity created by a state. It is separate and distinct from its
owners and managers. This separateness gives the corporation four major advantages: (1) A
corporation can continue after its original owners and managers no longer have a relationship with
the business. (2) Ownership interests can be divided into shares of stock, which in turn can be
transferred far more easily. (3) A corporation offers its owners limited liability. (4) Unlimited life,
 easy transferability of ownership interest and limited liability make it much easier for corporations
to raise money in the financial markets. Even though the corporate form of business offers
significant advantages over proprietorships and partnerships, it does have two major disadvantages:
(1) Setting up a corporation, as well as subsequent filings of required reports, is more complex and
time consuming than for a proprietorship or a partnership. (2) Corporate earnings are subject to
double taxation—the earnings of the corporation are taxed at the corporate level and then any
earnings paid out as dividends are again taxed as income to stockholders. The owners of a
corporation are its stockholders whose ownership or equity takes the form of either common stock
or preferred stock. Stockholders expect to earn a return by receiving dividends—periodic
distributions of cash—or by realizing gains through increases in share price. The stockholders vote
periodically to elect members of the board of directors and to decide other issues such as amending
the corporate charter. The board of directors is typically responsible for approving strategic goals
and plans, setting general policy, guiding corporate affairs and approving major expenditures.

The agency issue: The duty of the financial manager is to maximize the wealth of the firm’s owners.
Shareholders give managers decision-making authority over the firm; thus, managers can be viewed as
the agents of the firm’s shareholders. This separation of owners and managers is representative of the
classic principal–agent relationship, where the shareholders are the principals. This arrangement works
well when the agent makes decisions that are in the principal’s best interest but doesn’t work well when
the interests of the principal and agent differ. In reality, managers are also concerned with their
personal wealth, job security and fringe benefits. Such concerns may cause managers to make decisions
that are not consistent with shareholder wealth maximization.

An important theme of corporate governance is to ensure the accountability of managers in an

organization through mechanisms that try to reduce or eliminate the principal–agent problem; however,
when these mechanisms fail, agency problems arise. Agency problems arise when managers deviate
from the goal of maximization of shareholder wealth by placing their personal goals ahead of the goals
of shareholders. These problems in turn give rise to agency costs. Agency costs are costs borne by
shareholders due to the presence or avoidance of agency problems and in either case represent a loss of
shareholder wealth.

In addition to the roles played by corporate boards, institutional investors and government regulations,
corporate governance can be strengthened by ensuring that managers’ interests are aligned with those
of shareholders.

1. Management compensation plans: A common approach is to structure management compensation

to correspond with firm performance. In addition to combating agency problems, the resulting
performance-based compensation packages allow firms to compete for and hire the best managers
available. The two key types of managerial compensation plans are incentive plans and performance
plans. Incentive plans tie management compensation to share price. One incentive plan grants stock
options to management. If the firm’s stock price rises over time, managers will be rewarded by
being able to purchase stock at the market price in effect at the time of the grant and then to resell
the shares at the prevailing higher market price. Many firms also offer performance plans that tie
management compensation to performance measures such as EPS or growth in EPS. Compensation
under these plans is often in the form of performance shares or cash bonuses. Performance shares
 are shares of stock given to management as a result of meeting the stated performance goals,
whereas cash bonuses are cash payments tied to the achievement of certain performance goals.
2. Threat of takeover: As agency problems represent a misuse of the firm’s resources and impose
agency costs on the firm’s shareholders, the firm’s stock is generally depressed, making the firm an
attractive takeover target. The threat of takeover by another firm can provide a strong source of
external corporate governance. The constant threat of a takeover tends to motivate management to
act in the best interests of the firm’s owners.

Organization of the finance function: The size and importance of the managerial finance function
depend on the size of the firm. In small firms, the finance function is generally performed by the
accounting department. As a firm grows, the finance function typically evolves into a separate
department linked directly to the company president or CEO through the chief financial officer (CFO).
Reporting to the CFO are the treasurer and the controller. The treasurer (chief financial manager)
typically manages the firm’s cash, investing surplus funds when available and securing outside financing
when needed. The treasurer also oversees a firm’s pension plans and manages critical risks related to
movements in foreign currency values, interest rates and commodity prices. The controller (chief
accountant) typically handles the accounting activities, such as corporate accounting, tax management,
financial accounting and cost accounting. The treasurer’s focus tends to be more external, whereas the
controller’s focus is more internal. If international sales or purchases are important to a firm, it may well
employ one or more finance professionals whose job is to monitor and manage the firm’s exposure to
loss from currency fluctuations. A trained financial manager can hedge or protect against such a loss, at
a reasonable cost by using a variety of financial instruments. These foreign exchange managers typically
report to the firm’s treasurer.

Relationship to Economics and Accounting: The field of finance is closely related to economics. Financial
managers must understand the economic framework and be alert to the consequences of varying levels
of economic activity and changes in economic policy. They must also be able to use economic theories
as guidelines for efficient business operation. The primary economic principle used in managerial finance
is marginal cost–benefit analysis, the principle that financial decisions should be made and actions taken
only when the added benefits exceed the added costs.

The firm’s finance and accounting activities are closely related and generally overlap. However, there are
two basic differences between finance and accounting. Firstly, the accountant’s primary function is to
develop and report data for measuring the performance of the firm, assess its financial position, comply
with and file reports required by securities regulators and file and pay taxes. Using GAAP, the
accountant prepares financial statements that recognize revenue at the time of sale and recognize
expenses when they are incurred. This approach is referred to as the accrual basis. The financial
manager, on the other hand, places primary emphasis on cash flows, the intake and outgo of cash. He
maintains the firm’s solvency by planning the cash flows necessary to satisfy its obligations and to
acquire assets needed to achieve the firm’s goals. 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. The second major
difference between finance and accounting has to do with 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. Of course, this does not mean that accountants never make decisions
or that financial managers never gather data but rather that the primary focuses of accounting and
finance are distinctly different.