PRINCIPLES OF FINANCE

FINN 100

Bushra Naqvi, PhD, FRM 1

Bushra Naqvi
PhD from Paris 1 (Panthéon Sorbonne) 2011
FRM (GARP, USA) 2010
MSc Money Banking and Finance 2008
MBIT (Finance) 2007

2
Recommended
Text Book
Chapter 1 & 2
The Role and
Environment
of Managerial
Finance
Learning Goals
1. Define finance
2. Major area in Finance and Functions of
Managerial Finance
3. Relationship to economics and accounting.
4. Identify the primary activities of the
financial manager.
5. Explain the goal of the firm and Finance Manager
6. Agency Problem, Corporate Governance and
Ethics

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Learning Goals (cont.)

7. Understand financial institutions and

markets, and the role they play in
managerial finance.

8. Business Taxes

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1. What is Finance?

• Finance can be defined as the art and

science of managing money.

• Finance is concerned with the process,

institutions, markets, and instruments
involved in the transfer of money among
individuals, businesses, and governments.

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2. For Whom we do Managerial
Finance?
• Managerial finance is concerned with
the duties of the financial manager in the
business firm.
• Financial Services is the area of finance
concerned with the design and delivery of
advice and financial products to
individuals, businesses, and government.

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2. For Whom we do Managerial
Finance?
• For all legal forms of Business
– Sole Proprietorship
– Partnership
– Corporate
• In small companies, the finance function is
limited and usually are performed by
accountants
• As the business expands, finance typically
evolves into a separate department

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3. Relationship to Economics

• The field of finance is actually an

outgrowth of economics.
• In fact, finance is sometimes referred to as
financial economics.
• Financial managers must understand the
economic framework within which they
operate in order to react or anticipate to
changes in conditions.
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3. Relationship to Economics (cont.)

• The primary economic principal used by

financial managers is marginal cost-
benefit analysis which says that financial
decisions should be implemented only
when added benefits exceed added costs.

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3. Relationship to Accounting

• The firm’s finance (treasurer) and

accounting (controller) functions are
closely-related and overlapping.

• In smaller firms, the financial manager

generally performs both functions.

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Corporate Organization & Function
of Managerial Finance

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3. Relationship to Accounting (cont.)

• Finance and accounting also differ with respect

to decision-making.
• While accounting is primarily concerned with the
presentation of financial data, the financial
manager is primarily concerned with analyzing
and interpreting this information for decision-
making purposes.

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3. Relationship to Accounting (cont.)

• Accountants generally use the accrual

method while in finance, the focus is on
cash flows.

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3. Relationship to Accounting (cont.)

• The Nassau Corporation experienced the

following activity last year:
Sales $100,000 (1 yacht sold, 100% still uncollected)
Costs $ 80,000 (all paid in full under supplier terms)

• Now contrast the differences in

performance under the accounting method
versus the cash method.
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3. Relationship to Accounting (cont.)

INCOME STATEMENT SUMMARY

ACCRUAL CASH
Sales $100,000 $ 0
Less: Costs (80,000) (80,000)
Net Profit/(Loss) $ 20,000 $(80,000)

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4. Primary Activities of
the Financial Manager

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5. Goal of the Firm: Maximize Profit???

Which Investment is Preferred?

Earnings per share (EPS)

Investment Year 1 Year 2 Year 3 Total (years 1-3)
Rotor $ 1.40 $ 1.00 $ 0.40 $ 2.80
Valve $ 0.60 $ 1.00 $ 1.40 $ 3.00

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5. Goal of the Firm: Maximize
Profit???
• Profit maximization fails to account for
differences in the level/size/magnitude of
cash flows (as opposed to profits), the
timing of these cash flows, and the risk of
these cash flows.

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5. Goal of the Firm:
Maximize Shareholder Wealth!!!
• Why?
• Because maximizing shareholder wealth properly
considers cash flows, the timing of these cash flows, and
the risk of these cash flows.
• This can be illustrated using the following simple stock
valuation equation:
level & timing
of cash flows
Share Price = Future Dividends
risk of cash
Required Return
flows

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5. Goal of the Firm:
Maximize Shareholder Wealth!!! (cont.)
• The process of shareholder wealth
maximization can be described using the
following flow chart:

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6. The Agency Issue:
Shareholders vs. Managers
• Whenever a manager owns less than 100% of the firm’s
equity, a potential agency problem exists.
• In theory, managers would agree with shareholder
wealth maximization.
• However, managers are also concerned with their
personal wealth, job security, fringe benefits,
and lifestyle.
• This would cause managers to act in ways that do not
always benefit the firm shareholders.

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6. Corporate Governance

• Corporate Governance is the system used to

direct and control a corporation and agency
relationship.
• It defines the rights and responsibilities of key
corporate participants such as shareholders, the
board of directors, officers and managers, and
other stakeholders.
• The structure of corporate governance was
previously described in Figure 1.1.
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6. What About Other Stakeholders?

• Stakeholders include all groups of individuals who have

a direct economic link to the firm including employees,
customers, suppliers, creditors, owners, and others who
have a direct economic link to the firm.
• The "Stakeholder View" prescribes that the firm make a
conscious effort to avoid actions that could be
detrimental to the wealth position of its stakeholders.
• Such a view is considered "socially responsible."

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6. Ethics in Finance

• Ethics is the standards of conduct or

moral judgment—have become an
overriding issue in both our society and
the financial community

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6. Ethics (cont.)

• Cooke suggests that the impact of a proposed decision

should be evaluated from a number of perspectives:
– Are the rights of any stakeholder being violated?
– Does the firm have any overriding duties to any stakeholder?
– Will the decision benefit any stakeholder to the detriment of
another stakeholder?
– If there is a detriment to any stakeholder, how should it be
remedied, if at all?
– What is the relationship between stockholders
and stakeholders?

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 CHAPTER 2

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7. Financial Institutions & Markets

• Firms that require funds from external

sources can obtain them in three ways:
– through a bank or other financial institution
– through financial markets
– through private placements

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Financial Institutions & Markets

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Financial Institutions

• Financial institutions are intermediaries that

channel the savings of individuals, businesses,
and governments into loans or investments.
• The key suppliers and demanders of funds are
individuals, businesses, and governments.
• In general, individuals are net suppliers of
funds, while businesses and governments are
net demanders of funds.

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Financial Markets

• Financial markets provide a forum in which

suppliers of funds and demanders of funds can
transact business directly.
• The two key financial markets are the money
market and the capital market.
• Transactions in short term marketable securities
take place in the money market while
transactions in long-term securities take place in
the capital market.
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The Money Market

• The money market exists as a result of the

interaction between the suppliers and
demanders of short-term funds (those having
a maturity of a year or less).
• Most money market transactions are made in
marketable securities which are short-term
debt instruments such as T-bills and
commercial paper.
• Money market transactions can be executed
directly or through an intermediary.
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The Capital Market

• The capital market is a market that enables suppliers

and demanders of long-term funds to make transactions.
• The key capital market securities are bonds (long-term
debt) and both common and preferred stock (equity).
• Bonds are long-term debt instruments used by
businesses and government to raise large sums of
money or capital.
• Common stock are units of ownership interest or equity
in a corporation.

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Primary vs Secondary Markets

• Whether subsequently traded in the money or

capital market, securities are first issued through
the primary market.
• The primary market is the only one in which a
corporation or government is directly involved in
and receives the proceeds from the transaction.
• Once issued, securities then trade on the
secondary markets such as the New York
Stock Exchange or NASDAQ.
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Organized Exchanges

• Organized securities exchanges are tangible

secondary markets where outstanding securities
are bought and sold.
• They account for about 46% of the total dollar
volume of domestic shares traded.
• Only the largest and most profitable companies
meet the requirements necessary to be listed
on the New York Stock Exchange.

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Organized Exchanges (cont.)

• Only those that own a seat on the

exchange can make transactions on the
floor (there are currently 1,366 seats).
• Trading is conducted through an auction
process where specialists “make a
market” in selected securities.
• As compensation for executing orders,
specialists make money on the spread
(bid price – ask price).
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The Role of Securities Exchanges

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Over-the-Counter Exchange

• The over-the-counter (OTC) market is an

intangible market for securities transactions.
• Unlike organized exchanges, the OTC is both a
primary market and a secondary market.
• The OTC is a computer-based market where
dealers make a market in selected securities
and are linked to buyers and sellers through the
NASDAQ System.
• Dealers also make money on the “spread.”

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8. Business Taxes

• Both individuals and businesses must pay taxes

on income.
• The income of sole proprietorships and partnerships is
taxed as the income of the individual owners, whereas
corporate income is subject to corporate taxes.
• Both individuals and businesses can earn two types of
income—ordinary income and capital gains income.
Under current law, tax treatment of ordinary income and
capital gains income change frequently due frequently
changing tax laws.

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Business Taxes: Ordinary Income

• Ordinary income is earned through the sale of a

firm’s goods or services and is taxed at the rates
depicted in Table 1.4 on the following slide.

Example
Calculate federal income taxes due if taxable income is $80,000.
Tax = .15 ($50,000) + .25 ($25,000) + .34 ($80,000 - $75,000)
Tax = $15,450

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Business Taxation: Ordinary Income

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Business Taxation:
Average & Marginal Tax Rates
• A firm’s marginal tax rate represents the
rate at which additional income is taxed.
• The average tax rate is the firm’s taxes
divided by taxable income.
Example
What is the marginal and average tax rate for the previous example?
Marginal Tax Rate = 34%
Average Tax Rate = $15,450/$80,000 = 19.31%

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Business Taxation:
Tax on Interest & Dividend Income
• For corporations only, 70% of all dividend
income received from an investment in the stock
of another corporation in which the firm has less
than 20% ownership is excluded from taxation.
• This exclusion is provided to avoid triple
taxation for corporations.
• Unlike dividend income, all interest income
received is fully taxed.

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Business Taxation: Capital Gains

• A capital gain results when a firm sells an asset

such as a stock held as an investment for more
than its initial purchase price.
• The difference between the sales price and the
purchase price is called a capital gain.
• For corporations, capital gains are added to
ordinary income and taxed like ordinary income
at the firm’s marginal tax rate.

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