Chapter 1
Introduction
Md. Al Amin
Lecturer
Department of Marketing
Jagannath University
E-mail: alaminmkt62jnu@gmail.com
Introductory Chapter of Finance 1
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.
That means 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 and then
controlling the investment.
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So in a nut shell the term
Finance can be defined as
The science and art of managing money. Finance is
the process of planning, identification, selection, raising
and utilization of fund in order to achieve the objective of
an organization.
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Functions of Finance:
(1) Financial planning: Financial planning establishes
guidelines for any change in the firm. That include:
(I) Identification of the financial goals of the firm
(II) An analysis of the difference between these goals and the
current financial status of the firm and
(III) A statement of actions to achieve the financial goals of the
firm
A detailed financial plan is needed for each organization.
The amount of cash flow, timing, risk and the different
constraints have to be considered in financial planning.
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Functions of Finance………
(2) Identification of sources: Funds may be collected from
internal sources (such as retained earnings) and external
sources (such as institutional sources).
(3) Raising of fund: After considering all the sources, funds
have to be subsequently acquired from the appropriate
source or sources.
(4) Investment of fund: The investment of fund in different
projects is another important task of Finance. In the
Investment decision, the costs and benefits of the project
have to be considered.
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Functions of Finance………
(5) Protection of fund: Every investment decision
has some degree of risk. Projects should be
rejected where funds may be lost. So, Risk and
Return have to be balanced in management and
protection of fund.
(6) Distribution of Profit: The financial manager
decides the amount of profit to be retained and the
amount to be distributed as dividend based on the
financial need of the firm.
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What is Business Finance
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. 7
Introductory Chapter of Finance
Functions of Finance Manager
Functions of Finance Manager
Managerial Functions Routine Functions
• Financial planning,
• Source identification,
Investment Financing Dividend
Decision Decision Decision • Raising of fund,
• Investment of fund,
• Distribution of fund,
Working Capital Capital
Management Budgeting • Protection of capital,
• Managing of fund,
• Forecasting of cashflow,
• Managing assets,
• Cost Control, 8
Introductory Chapter of Finance
• Pricing.
Managerial Functions
Three Fundamental Decisions
in Financial Management
Investment Financing Dividend
Decision Decision Decision
Working Capital
Capital Budgeting
Management
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Introductory Chapter of Finance
1. Investment Decision
It is the most important decision of a financial
manager. Here Financial Manager identifies the
investment project which can generate maximum
financial benefit for the organization. So future
cash flow from investment is evaluated here.
As future cash flow involves with uncertainty,
so risk is also taken in to consideration along with
cash flow.
It focuses on working capital management and
capital budgeting.
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1.a: Working Capital Management
Working Capital Management Decision involves
with the administration of Current asset and
current liabilities within the policy guidelines.
Managing the firm’s working capital is a day-to
day activity which ensures that, the firm has
sufficient resources to continue its operations
and avoid costly interruption.
The ultimate objective of working capital
management is to trade-off between
profitability and liquidity.
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1.b: Capital Budgeting
It is the process of planning and managing a firm’s
current assets into long term investment in anticipation
of an expected flow of benefit over a series of years.
In this case a financial manager involves with
identifying investment opportunities that are worth
more to the firm than they cost.
Various capital budgeting techniques such as Net
Present value (NPV), Internal Rate of Return (IRR).
Profitably index (PI), Net terminal Value (NTV), Pay
Back Period (PBP) and Average rate of return (ARR)
can be applied in the project evaluation.
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2. Financing Decision
Financing decision involves with identifying and
determining the sources of fund from which the
firm can obtain and manage long-term financing
in order to support its long term investment.
Determining the optimal capital structure (a
combination of debt capital & equity capital
which results least cost of capital and maximizes
the market value of shares) is the main function
under financing decision.
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3. Dividend Decision
Dividend decision is concerned with determining the
portion of profit to be distributed among
shareholders as dividend out of the firm’s total
earning.
Here financial manager specially concentrates the
impact on share price as a result dividend payment
as well as the need for further investment in any
profitable venture.
Ultimate objectives of this decision are: satisfying
the stockholders through dividend payment,
arrangement of fund for further investment and
thereby maximizing the market value of shares. 14
Introductory Chapter of Finance
Principles of Finance
1) Principle of risk and return: Before investing to
any particular investment project or sector, risk
and return involves with that project has to be
considered.
2) Principle of Time value of money: When
expecting return from a source, timing of cash
flow has to be considered.
3) Principle of Cash flow: When expecting return
from any investment, its cash flow pattern has to
be considered whether cash flow will be received
on yearly, half yearly, quarterly or monthly basis.
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Principles of Finance….
4) Principle of profitability and liquidity: Trade-off
has to be made between profitability and liquidity
that means before making investment in any
particular project.
5) Hedging principle: To minimize the risk, hedging
mechanism need to be considered i.e. current
assets and fixed assets should be financed with
short term and long term sources respectively.
6) Principle of diversity: Investment has to be
made in different sectors so that risk can be
diversified.
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Principles of Finance….
7) Principle of business cycle: While making
investment decision, business cycle has to be
considered whether the economy is in
recession or booming or is affected by
inflation.
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Career Opportunities in Finance
1. Financial Market & Institutions:
Financial Institutions: FIs are firms that specialize in the
sale, purchase, & creation of financial assets. Example-
commercial banks, savings & loan association, credit union,
insurance companies.
Financial Market: In a financial market, financial assets.
2. Investment: stock brokerage firms, banks, investment
companies etc.
The three main functions in the investment area are-
•Sales
•The analysis of individual securities
•Determining the optical mix of securities for a given investor.
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3. Managerial Finance:
It is the broadest of the three areas and the one with the
greatest number of job opportunities, deals with the
decisions that firm make concerning their cash flows
The financial Manager’s Responsibilities
The financial manager’s task is to make decisions
concerning the acquisition & use of funds for the
Greatest benefit of the firm.
1.Forecasting & Planning
2.Major investment & Financing Decisions
3.Coordination & Control
4.Dealing with Financial Market
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Introductory Chapter of Finance
Goal of Financial Management
Objectives of Financial Management may be
broadly divided into two parts such as:
1.Profit maximization
2.Wealth maximization.
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Profit maximization
Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the
profit of the concern.
Profit = Total Income- Total Expenses.
• Ultimate aim of the business concern is earning
profit, hence, it considers all the possible ways to
increase the profitability of the concern.
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Profit maximization
Project Year 1 Year 2 Year 3 Total income
A 25 20 5 50
B 5 15 32 52
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Favorable Arguments for Profit
Maximization:
• Main aim is earning profit.
• Profit is the parameter of the business operation.
• Profit reduces risk of the business concern.
• Profit is the main source of finance.
• Profitability meets the social needs also.
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Drawbacks of Profit Maximization
• Profit maximization objective consists of certain
drawback also:
• It is not clear
• It ignores the time value of money
• It ignores risk
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What is the Goal of Financial
Management?
Major objective is to -
Maximize the shareholders wealth
To maximize the value of a firm
To maximize the price of the firm’s common
stock
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Maximizing the Stockholders’ Wealth
• Wealth maximization is one of the modern
approaches, which involves latest innovations
and improvements in the field of the business
concern.
• The term wealth means shareholder wealth or
the wealth of the persons those who are involved
in the business concern.
• Wealth maximization is also known as value
maximization or net present worth maximization.
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Maximizing the Stockholders’ Wealth
• Wealth maximization is superior to the profit
maximization because the main aim of the
business concern under this concept is to
improve the value or wealth of the shareholders.
• Wealth maximization considers both time and risk
of the business concern.
• Wealth maximization provides efficient allocation
of resources.
• It ensures the economic interest of the society.
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Agency Relationship
An agency relationship exists when one or more
people (the principals) hire another person (the agent)
to perform a service & then delegate decision making
authority to that agent.
– Important relationship exist-
• between stockholders & managers
• between stockholders & creditors
Agency Problem: A potential conflict of interest
between the parties.
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Stockholders Vs Managers
– Managerial compensation
• Performance Share
• Incentives plan
• Cash bonuses
– Shareholder intervention
– The threat of takeover
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Stockholders Vs Creditors
Risky investment: Managers might choose to
invest the fund which is raised from the lenders to
a risky project to give greater benefit to the
stockholder at the expense of the creditors
(lenders).
How the Creditors Protect their Interest?
First, Creditors protect themselves through restrictions
in credit agreements.
Second, If potential creditors perceive that a firm will try
to make advantage of them, they will either refuse to
deal with the firm or else will require a much higher
return.
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Multinational Corporations
• A firm that operates in two or more countries.
• Reasons for going international:
– To seek new markets
– To seek raw materials
– To seek new technology
– To seek production efficiency
– To avoid political & regulatory hurdles
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