Chapter 1

The Financial Environment

© 2008 John Wiley and Sons

 Chapter Outcomes
 Define what is meant by finance
 Describe the six principles of finance
 Explain why finance should be
studied
 Identify and discuss some career
opportunities in finance
 Describe the financial functions
performed in an effective financial
system
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 Chapter Outcomes
(Continued)
 Describe the functions and
development of money
 Briefly explain the M1, M2, and M3
definitions of the money supply
 Explain possible relationships
between money supply and
economic activity
 Comment on developments in the
international monetary system
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 What is Finance?
 FINANCIAL ENVIRONMENT:
Encompasses the financial system,
institutions, markets, and individuals that
make the economy operate efficiently
 FINANCE:
Study of how individuals, institutions,
governments, and businesses acquire,
spend, and manage money and other
financial assets

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Three Areas of Finance within the
Financial System
 Institutions and Markets
 Investments
 Financial Management

[Note: These areas do not operate in

isolation but rather interact or intersect
with each other. Figure1.1 provides a
graphic illustration. ]
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 Finance Area Definitions
 FINANCIAL INSTITUTIONS:
Help the financial system
operate efficiently and transfer
funds from savers to investors

6
Examples of Financial Institutions
 They include commercial banks,
thrift institutions, investment banks
(merchant banks), credit unions,
pension funds, investment companies,
insurance companies, securities
brokers and dealers, real estate
investment trusts, stock exchanges, and
others.

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 Finance Area Definitions
 FINANCIAL MARKETS:
Physical locations or electronic
forums that facilitate the flow of
funds.
 A financial market is a market in which
people trade financial securities and
derivatives at low transaction costs.
 Some examples of financial markets and
their roles include the stock market, the
bond market, and the real estate market.
Financial markets can also be broken
down into capital markets, money markets
, primary markets, and secondary markets.
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 Finance Area Definitions
(Continued)
 INVESTMENTS:
An investment is an asset intended to
produce income or capital gains.

 Area involves sale or marketing of

securities, analysis of securities, and
management of investment risk.
 Investments can be stocks, bonds, mutual 
funds, interest-bearing accounts, land, 
derivatives, real estate, artwork, old comic
books, jewelry -- anything an investor
believes will produce income (usually in the
form of interest or rents) or become worth9
 Finance Area Definitions
(Continued)
 FINANCIAL MANAGEMENT:
Involves financial planning, asset
management, and fund raising
decisions to enhance firm value

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 Financial Management - Meaning,
Objectives and Functions
 Financial Management means planning,
organizing, directing and controlling the
financial activities such as procurement
and utilization of funds of the enterprise.
It means applying general management
principles to financial resources of the
enterprise.

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 Financial Management - Meaning,
Objectives and Functions
 Scope/Elements
1. Investment decisions includes
investment in fixed assets (called as
capital budgeting). Investment in current
assets are also a part of investment
decisions called as working capital
decisions.

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Financial Management - Meaning,
Objectives and Functions
2. Financial decisions - They relate to
the raising of finance from various
resources which will depend upon
decision on type of source, period of
financing, cost of financing and the
returns thereby.

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 Financial Management - Meaning,
Objectives and Functions
3. Dividend decision - The finance
manager has to take decision with
regards to the net profit distribution. Net
profits are generally divided into two:
a. Dividend for shareholders- Dividend and
the rate of it has to be decided.
b. Retained profits- Amount of retained
profits has to be finalized which will depend
upon expansion and diversification plans of the
enterprise.
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 Objectives of Financial
Management
 The financial management is generally concerned with
procurement, allocation and control of financial resources of a
concern. The objectives can be-
 To ensure regular and adequate supply of funds to the concern.
 To ensure adequate returns to the shareholders which will depend
upon the earning capacity, market price of the share, expectations
of the shareholders.
 To ensure optimum funds utilization. Once the funds are procured,
they should be utilized in maximum possible way at least cost.
 To ensure safety on investment, i.e, funds should be invested in
safe ventures so that adequate rate of return can be achieved.
 To plan a sound capital structure-There should be sound and fair
composition of capital so that a balance is maintained between
debt and equity capital.

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 Functions of Financial
Management
1. Estimation of capital requirements: A finance
manager has to make estimation with regards to
capital requirements of the company. This will
depend upon expected costs and profits and future
programmes and policies of a concern. Estimations
have to be made in an adequate manner which
increases earning capacity of enterprise.
2. Determination of capital composition: Once the
estimation have been made, the capital structure
have to be decided. This involves short- term and
long- term debt equity analysis. This will depend
upon the proportion of equity capital a company is
possessing and additional funds which have to be
raised from outside parties. 16
 Functions of Financial
Management
3. Choice of sources of funds: For additional funds to
be procured, a company has many choices like-
– Issue of shares and debentures
– Loans to be taken from banks and financial institutions
– Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and
demerits of each source and period of financing.
4. Investment of funds: The finance manager has to
decide to allocate funds into profitable ventures so that
there is safety on investment and regular returns is
possible.

17
 Functions of Financial
Management
5. Disposal of surplus: The net profits
decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes
identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be
decided which will depend upon expansional,
innovational, diversification plans of the
company.
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 Two Themes within the
Finance Topic
 ENTREPRENEURIAL FINANCE:
Study of how growth-driven, performance-
focused, early-stage firms raise funds and
manage operations and assets
 PERSONAL FINANCE:
Study of how individuals prepare for
financial emergencies, protect against
premature death and the loss of property,
and accumulate wealth
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 Functions of Financial
Management
6. Management of cash: Finance manager has to make
decisions with regards to cash management. Cash is
required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment
to creditors, meeting current liabilities, maintenance of
enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not
only to plan, procure and utilize the funds but he also has
to exercise control over finances. This can be done
through many techniques like ration analysis, financial
forecasting, cost and profit control, etc.

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 Six Principles of Finance

 Money has a time value

 Higher Returns are expected for
taking on more risk
 Diversification of investments can
reduce risk

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Six Principles of Finance (Cont’d)

 Financial markets are efficient in

pricing securities
 Manager and stockholder
objectives may differ
 Reputation matters

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 1. 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

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 2. 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

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 3. Diversification of Investments

 All investment risk is not the same

 Some risk can be removed or
diversified by investing in several
different assets or securities

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 4. 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
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5. Management Vs. Owner Objectives
 Management objectives may differ from
owner objectives (called principal-agent
problem)
 Owners or equity investors want to
maximize the returns on their investments
 Managers may seek to emphasize the size
of firm sales, assets, or other perks
 Solution: tie manager compensation to
performance measures beneficial to
owners
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 6. 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

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 Why Study Finance?

1. To make informed economic

decisions
2. To make informed personal and
business investment decisions
3. To make informed career decisions
based on a basic understanding of
business finance

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 Careers in Finance

 Financial management
 Depository financial institutions
 Contractual savings and real
property organizations
 Securities markets and investment
firms

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 Entry-Level Finance Positions

Financial Management
 Cash management analyst

 Capital expenditures analyst

 Credit analyst
 Financial analyst

 Cost analyst
 Tax analyst

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 Entry-Level Finance Positions

Depository Financial Institutions

 Loan analyst

 Bank teller
 Investments research analyst

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 Entry-Level Finance Positions

Contractual Savings and Real

Property Organizations
 Insurance agent (broker)

 Research analyst
 Real estate agent (broker)

 Mortgage analyst

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 Entry-Level Finance Positions

Securities Markets and

Investment Firms
 Stock broker (account executive)

 Security analyst
 Investment banking analyst

 Financial planner assistant

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Overview of the Financial System
 Policy Makers
President, Congress & U.S. Treasury
Federal Reserve Board
Role: Pass laws & set fiscal & monetary
policies
 Monetary System
Federal Reserve Central Bank
Commercial Banking System
Role: Create & transfer money

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Overview of the Financial System
 Financial Institutions
Depository Institutions, Contractual
Savings organizations, Securities Firms,
and Finance Firms
Role: Accumulate & lend/invest savings
 Financial Markets
Securities Markets, Mortgage Markets,
Derivatives Markets, and Currency
Exchange Markets
Role: Market & facilitate transfer of
financial assets
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Financial System Components and
Financial Functions
MONETARY SYSTEM:
 Creating money
 Transferring money

FINANCIAL INSTITUTIONS:
 Accumulating savings
 Lending/investing savings

FINANCIAL MARKETS:
 Marketing financial assets
 Transferring financial assets

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 Money and Related Basic Definitions
 MONEY:
Anything that is generally accepted
as payment
 BARTER:
Exchange of goods or services
without using money
 LIQUIDITY:
How easily an asset can be
exchanged for money
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 Functions of Money
 MEDIUM OF EXCHANGE:
The basic function of money
 STORE OF VALUE:
Money can be held for some period
of time, without losing its value,
before it is spent
 STANDARD OF VALUE:
Exists when prices and debts are
stated in terms of the monetary unit
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