Lecture 1 Overview of Finance &

Financial Environment

Jamil Ahmed
Assistant Professor
 What is Finance?
• At the macro level, finance is the study of financial
institutions and financial markets and how they operate
within the financial system in both the Local and global
economies.
• At the micro level, finance is the study of financial
planning, asset management, and fund raising for
businesses and financial institutions.
• Financial management can be described in brief using
the following balance sheet.
 What is Finance?
Macro Finance

Assets: Liabilities & Equity:

Current Assets Current Liabilities
Cash & M.S. Accounts payable
Accounts receivable Notes Payable
Inventory Total Current Liabilities
Working Total Current Assets Long-Term Liabilities
Working
Fixed Assets: Total Liabilities
Capital Capital
Gross fixed assets Equity:
Less: Accumulated dep. Common Stock
Goodw ill Paid-in-capital
Other long-term assets Retained Earnings
Investment Total Fixed Assets Total Equity
Financing
Decisions Total Assets Total Liabilities & Equity
Decisions

1-3
 Goals and Governance of the
Corporation
This Lecture introduces the corporation, its goals, and the roles
of financial managers.

Number of Firms in the U.S. Size of Payroll (000s)

Corporation
1,011,973 $1,068,232,
1,292,081
S-Corporation 095
622,908 $2,808,013,
Partnership 079
$479,673,70
Sole 0
Proprietorship $149,121,474
2,584,427
Source: U.S. Census 2008 SUSB Annual Data

1-4
 Financial Services Industry in
UK
 In UK industry accounts for about a
proportion of National Output as the whole of
Manufacturing Industry (2008).
 The growth is still amazing. It contributed
$200 billions, accounting for 10% of total
economic output.

1-5
Areas of Specialization in Finance

 Financial Markets
 Markets of users and savers of funds.
 Financial Services
 Design and delivery of financial advice and
products to individuals, businesses, government.
 Managerial Finance
 Financial management of business firms.
 Basic Forms of Business
Organization
 Sole Proprietorship
 Owned by one person, operated for personal profit.
 Partnerships
 Owned by two or more people, operated for joint
profit.
 Corporations
 “Legal entity”, owned by individuals, operated for
joint profit.
 Sole Proprietorship
STRENGTHS: WEAKNESSES:
 Low organizational  Unlimited liability
cost  Limited funding
 Income taxed once as  Proprietor must be all
personal income  Difficult to develop
 Independence staff career
 Secrecy opportunities
 Ease of dissolution  Lack of continuity on
death of proprietor
 Partnerships

STRENGTHS:
WEAKNESSES:

 Improved
Unlimited funding
liability sources
to all partners

 Increased
Partnershipmanagerial
dissolved talent
upon death of partner
 Income split by partnership contract, taxed
 Difficult to liquidate or transfer ownership as
personal income

1-9
 Corporations
STRENGTHS: WEAKNESSES:
 Higher tax rates/Double
 Owners’ liability Taxation
limited  Expensive organization
 Large capitalization  Greater government
possible, greater regulation
 When publicly traded, lacks
funding secrecy
 Ownership readily  Improper corporate
transferable structures may lead to
“Agency Problems”
 Indefinite life
Corporate Organization Chart

1-11
Organization of Finance Functions
 CFO – Chief Financial Officer
 Treasurer responsibilities:
 Financial planning, fund raising, capital
expenditure decisions, cash and credit
management.
 Controller responsibilities:
 Corporate accounting, cost accounting, and tax
management.

1-12
 What is a Corporation?

 Corporation-A business organized as a

separate legal entity owned by stockholders.

 Types of Corporations:
 Public Corporations
 Private Corporations

1-13
 Goals of The Corporation
 Managers/Investors forced to make decisions and choices in
the harsh environment.
 All must therefore be very clear about the purpose of the
organization and its imperative for the management teams to be
aware of, respect and contribute to the objectives.
 Achieving Target Market Share.

 Keeping Employees at peace.

 Survival.

 Creating an Industrial Empire.

 Maximization of profit.

 Maximization of Shareholders Wealth.

1-14
 Goals of The Corporation
 Wealth maximization vs. profit maximization:
 Prospects: Identical profits by two firms but one is valued
more and other less by shareholders. As profits fails to
reflect the relative potential of two firms.
 Risk: Same profits and same future prospectus. But the
returns of one firms have a greater variability.
 Accounting Problems
 Communications

1-15
 The Ethics of Maximizing Value
Does value maximization justify unethical behavior?

Recent examples:
 Enron

 WorldCom

 Bernard Madoff

1-16
 Agency Problem

Do managers really maximize value?

 Agency Problems
• Managers are agents for stockholders, but the
managers may act in their own interests rather than
maximizing value

 Shareholders vs. Stakeholders

1-17
 Agency Problem
Different Information Different Objectives
 Stock prices vs.  Managers vs.
returns shareholders
 Top managers vs.
 Dividend Policy lower managers
 Stockholders vs.
 Financing Decisions banks and lenders

1-18
 Agency Problem Solutions

Compensation plans

Board of Directors

Blockholders

1-19
 Agency Problem Solutions
Takeovers

Specialist Monitoring

Legal and Regulatory Requirements

1-20
 Role of the Financial Manager
(1)
Firm’s (2)
Investors
Operations
Financial
(4a)
Manager
Financial
Real assets Assets
(3) (4b)

1. Cash raised from investors (how?)

2. Cash invested in firm
3. Cash generated by operations
4A. Cash reinvested in the firm
4B. Cash returned to investors
1-21
 The Flow of Capital:
Closely Held Corporations

2-22
The Flow of Capital:
Public Corporations

2-23
 Financial Markets

Financing Decision

Source of Funds (Capital)

Capital Structure

2-24
 The Flow of Capital:
Public Corporations
Financial Market:
Market where securities are issued and traded.

Primary Market:
Market for the sale of new securities by corporations.

Secondary Market:
Market in which previously issued securities are traded among
investors.
2-25
 Financial Markets

Initial Public Offering (IPO):

First offering of stock to the general public.

Fixed-Income Market:
Market for debt securities

2-26
 Financial Markets:
Markets for Debt
Capital Markets are used for long-term financing

Example of long-term debt: Bonds

Money Markets are used for short-term financing.

Example of short-term debt: Commercial Paper

2-27
 Information Provided by
Financial Markets:

• Commodity Prices

• Interest Rates

• Company Value

• Cost of Capital

2-28
 Financial Intermediaries
• Mutual Fund
• An investment company that pools the savings of many
investors and invests in a portfolio of securities
• Hedge Fund
• A private investment pool, open to wealthy or institutional
investors, that is only lightly regulated and therefore can pursue
more speculative policies than mutual funds
• Pension Fund
• Fund set up by an employer to provide for employees’
retirement

2-29
 Flow of Cash Example:
Mutual Fund
$ $
Bank of Explorer
Investors
America Fund
Sells Issues
shares shares

2-30
 A Closer Look:
Financial Institutions

Commercial Bank

Investment Bank

Insurance Company

2-31
Companies and Intermediaries
Company

Obligations Funds

Intermediaries
Banks
Insurance Companies
Brokerage Firms
2-32
Intermediaries and Investors
Intermediaries

Obligations Funds

Investors
Depositors
Policyholders
Investors
2-33
 Cash Flow Example:
Banks
Company
Loan $2.5 mil

Banks Intermediary

Deposits Cash

Investor
Depositors

2-34
 Cash Flow Example:
Insurance Company
Company
Issue Debt $2.5 mil
Insurance
Company Intermediary

Sell Policies Cash

Investor
Policyholders

2-35
 Function of Financial Markets

 Transport cash across time

 Risk transfer and diversification

 Liquidity

2-36
 Function of Financial Markets

 Payment mechanism

 Provide information

2-37