Chapter 1

Introduction

Principles of Finance
Topics To Be Covered
 Definition of Finance
 Functions of Finance
 Classification of Finance
 Functions of The Finance Manager
 Profit maximization vs. wealth
maximization
 Business Ethics
What is Finance?

Finance in general terms is the raising of required fund.

Finance is the function of raising fund and then properly

managing the collected fund.

Finance deals with the analyzing of fund requirement,

identifying the sources of fund, selecting the best source
by analyzing their costs, raising fund from the best
possible sources, utilizing the fund properly to
accomplish the objective.
Functions of Finance
 Financial Planning:
 The Amount of Required Fund
 Timing of Fund Requirement
 The Probable Sectors for Investment
 Identification of Sources:
 Borrowing from Individuals or Friends
 Financial Institution
 External Sources
 Raising of Fund
 Investment of Funds
 Protection of Fund
 Manage the Risk
 Distribution of Profit
Classification of Finance

Finance

Private Finance Public Finance

Personal Finance Business Finance Non-Business Finance

Business Finance
 Business Finance is the accumulation of the required
capital of a business organization according to its
financial planning and the proper utilization of that
accumulated capital in order to achieve the
objectives of that organization.

 In other words, after the financial planning the

process of collection of the capital from the most
suitable sources which would minimize the capital
cost and proper utilization of that capital in the most
suitable projects that will lead the maximum cash
flow for the firm so that the firm can reach to its goal
is known as business finance.
 Financial Manager

Managerial Functions Routine Functions

Financial Planning
Investment Financing Dividend
Decision Decision Decision Source Identification

Raising of Fund

Investment of Fund
Working
Capital
Capital
Budgeting
Mgt.
 Managerial Function
 Investment Decision: The finance manager takes decision about
the investable projects. He/she evaluates the prospects of each
investable projects and also the risk of the projects. Then he/ she
finds out the most attractive project that will help the firm to
achieve its objectives.
 Working Capital Management: Involves investment in
current assets to get benefit for a period of 1 year or less.
Profitability Vs Liquidity
 Capital Budgeting: Deals with investment in those projects
which will provide income for many years.
 Amount of Capital Required
 Time Horizon of the Project
 Expected Income from the Project
 Associated Risk
Managerial Function
 Financing Decision: To finance the investment the
financial manager has to find out the best source and
identify the timing of collection of the fund.

 Dividend Decision: To distribute the profit out of

the invested project among the shareholders.
Routine Function

 Financial Planning
 Source Identification
 Raising of Fund
 Investment Fund
 Distribution of Fund
 Protection of Capital
 Managing of Fund
 Forecasting Cash-flow
 Forecasting Future Profits
 Managing Assets
 Cost Control
 Pricing
Profit maximization Vs.
Wealth maximization

What should be the

goal of a firm???
How profit can be maximized?
 Reducing cost: production, administration,
marketing etc.

 Producing high quality product: increasing

product quality and the price as well.

 Creating excess demand: Introduce something

new to the customer or improve the quality of the
existing product. Do something innovative.
Goal of a Financial Manager

The financial manager's goal is to maximize the economic

welfare of the firm's shareholders.

Profit Maximization:

For corporations, profits are commonly measured in terms

of earnings per share (EPS), which represents the total
earnings available for the firm common stockholders - the
firm's owners- divided by the number of shares of
common stock outstanding.
Example:
A financial manager is attempting to provide the following earnings
per share over its three-year life.

Earnings per share

Investment Year 1 Year 2 Year 3 Total
X $1.40 $1.00 $0.40 $2.80
Y $0.60 $1.00 $1.40 $3.00

Based on the profit-maximization goal, investment Y would be

preferred over investment X since it results in higher earnings per
share over the three-year period ($3.00 EPS for Y is greater than $
2.80 EPS for X).
Limitations of Profit Maximization
1) The timing of return:

The receipt of funds sooner as opposed to later is preferred. In

spite of the fact that the total earnings from investment X are
smaller than those from investment Y, X may be preferred due to
the greater EPS it provides in the first year. These earlier returns
could be reinvestment in order to provide greater future earnings.

2) Cash flows:

A greater EPS does not necessarily mean that dividend payments

will increase, since the payment of dividends results solely from
the action of the firm's board of directors.
Limitations of Profit Maximization

3) Risk:

Profit maximization disregards risk

A trade-off exists between return (profit) and risk.

4) Ambiguity or Vague:

The word profit is vague. Because when we say profit is it

short term or long term profit, is it before tax or after tax
profit, is it net profit or gross profit, is it total profit or per
share profit.
Maximizing Shareholder Wealth

The goal of the financial manager is to maximize the

wealth of the owners for whom the firm is being managed.
The wealth of corporate owners is measured by the share
price of the stock, which in turn is based on the timing of
returns, cash flows, and most important, on risk.

Although profit is considered in the wealth maximization

process, it is not the key decision variable.
Rationale behind wealth maximization as
the goal of a firm
 Clear concept: In wealth maximization net
cash benefit is used as measurement.
 It considers risk, timings of return and time
value of money
 Focus on the market price of share: It is
possible when the price of the investment
increase. Increase of wealth ensures
positive impact in stock price.
 Both are important.
 Profit maximization should be the primary
goal
 Wealth maximization should be the ultimate
goal.
 Wealth maximization is possible by ensuring
profit maximization.
Mechanisms to motivate managers
 Managerial Incentives: A common method is used to
motivate managers to operate in a manner consistent
with stock price maximization is to tie managers
compensation to the company’s performance.
 The threat of firing: Major corporations whose
managements have been ousted include United
Airlines, Disney, and IBM.
 Hostile takeovers (the acquisition of a company over
the opposition of its management) are most likely to
occur when a firm’s stock is undervalued relative to its
potential. In a hostile takeover, the managers of the
acquired firm generally are fired.
Managers strategy to ward off (discourage) a
hostile takeover

 Poison Pill:
An action taken by management to make a firm
unattractive to potential buyers and thus to avoid a
hostile takeover.
Example includes Disney’s plan to sell large blocks of
its stocks at low prices to friendly parties.
 Greenmail:
A situation in which a firm, trying to avoid a takeover,
buys back stock at a price above the existing market
price from the person(s) trying to gain control of the
firm.
Business Ethics

 Companies attitude and conduct toward its

employees, customers, communities and
stockholders.
 High standard of ethical behavior demand
that a firm treat each party it deals with fair
and honest manner.
Business ethics and long run profitability

1. Avoids fines and legal expenses.

2. Building public trust.
3. Attracts business from customers who
appreciate and support its policies.
4. Attracts and keeps employees of the
highest caliber
5. Supports the economic viability of the
companies in which it operates.
Thank You