An Overview of Finance

Defining 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 and between individuals, business, and governments. Study of finance consist of three interrelated areas: Financial markets and institutions Investments (efficient) Managerial finance or business finance which involves the actual managements of the firm.

Managerial Finance:
Managerial finance is concerned with the duties of the financial managers in the business firms. The type of tasks one encounters in managerial finance jobs range from making decisions regarding plant expansions to choosing what types of securities to issue to finance expansion. Financial managers also have the responsibility for deciding : The credit terms under which customers can buy, How much inventory the firm should carry, How much cash to keep on hand, Whether to acquire other firms and How much of the firms earnings to pull back into the business versus payout as dividend

Financial Managers Responsibility:

The financial managers task is to make decisions concerning the acquisition and use the funds for the greatest benefit to the firm. Specific activities are Forecasting and Planning: Financial managers must forecast the future and make plan that will shape the firms future position. Major investment and financing decision: To support the rapid growth in the sales and to strengthen future position, financial managers must make investment on the specific assets and decide the best way to finance those assets.

Co-ordination and Control: Financial managers must ensure that the firm is operating efficiently by co-ordinating with all department. All business decision have financial implications and all managers must take those implications into account.
Dealing with the financial markets: The financial managers must deal with the capital and money market efficiently.

Alternative forms of business organization

There are three forms of business organizations:
Proprietorship Partnership Corporation In terms of numbers, 71% of business are operated as proprietorship, 9% are partnership and remaining 20% are corporation. Based on the dollar value of sales, 85% of all business is conducted by corporation, and remaining 15% is generated by both proprietorships and partnerships.

Proprietorship:
A proprietorship is an unincorporated business owned by one individual who operate it for his/her own profit, bear all the risk. Advantages of Proprietorship: It is easy and inexpensively formed It is subject to few government regulations It is taxed like an individual, not a corporation Disadvantages of Proprietorship: The proprietor has unlimited personal liability Limited life as the life of individual who created it Transferring ownership is somewhat difficult Problem in obtaining large sums of capital

Partnership:
A partnership consist of two or more owners doing business together for profit. Advantages of Partnership: Formation is easy and relatively inexpensive It is subject to few government regulations It is taxed like an individual, not a corporation. Disadvantage of Partnership: Unlimited liability Limited life of the organization Difficulty of transferring ownership Difficulty of raising large amount of capital

Corporation:
A corporation is a legal entity by a state. It is separate and distinct from its owners and managers. Advantages of corporation: Unlimited life Easy transferability Limited liability Disadvantages of corporation: Corporation is subject to double taxation Expensive and complex formation

Setting up a corporation:
When a corporation is created, a charter and a set of bylaws must be created for the business. Corporate Charter: a document filed with the secretary of the state in which the firm is incorporated that provides information about the company. The corporate charter includes the: 1. Name of the proposed corporation. 2. Types of activities it will pursue. 3. Amount of capital stock. 4. Number of directors. 5. Names and address of directors.

Bylaws: A set of rules drawn up by the founders of the corporation to aid in governing the internal management of the company. Included are such points as1. 2. 3. How directors are to be elected, Whether the existing stockholders will have the first right to buy any new shares of the firm issues, Procedures for changing provisions in the bylaws.

The goals of the Corporation

Maximizing Profit?
Some people believe that the firms objective is always to maximize profit. To achieve this goal, the financial manager would take only those actions that ware expected to make a major contribution to the firms overall profit. Corporation commonly measure profits in terms of EPS, which represent the amount earned during the period, on behalf of each outstanding share of common stock. But profit maximization is not a reasonable goal, it fails for a number of reasons-

But profit maximization is not a reasonable goal, it fails for a number of reasons1. Timing of return: the firm can earn a return on funds it receives, the receipt of funds sooner rather than later is preferred. Cash flows: profits do not necessarily result in cash flows available to the stockholders. Owner receive cash flow in the form of cash dividend or from selling their share for a higher price than initially paid. Risk: profit maximization also disregards risk-the chance that actual outcomes may differ from those expected. Return and risk in fact the key determinations of share price. In general stockholders are risk-averse, that is, they want to avoid risk.

2.

3.

Goal of the Firm Maximizing Shareholders Wealth The goal of the firm and therefore all managers and employees, is to maximize the wealth of the owners for whom it is being operate. The wealth of the corporate owners is measured by the share price of the stock, which in tern is based on the timing of the return (cash flow), their magnitude and their risk. Financial managers should accept only those actions that are expected to increase share price.

Firms stock price is dependent on the following factors1. Projected earning per share Management should concentrate on earnings per share rather than total corporate profits. 2. Timing of the earning stream Management should concentrate on project that adds the most value of the stock 3. Riskiness of the projected earningsRiskiness of the project is another area of concentration depending upon how averse stockholders are to risk 4. Use of debtProjected EPS depend on how firm is financed. Use of debt financing might increase projected EPS. 5. Dividend policyThe financial managers must decide exactly how much of the current earnings to pay out as dividend rather than to retain.

Agency Relationship: An agency relationship exists when one or more individuals, who are called the Principals, hire another person, the Agent, to perform a service and delegate decision-making authority to that agent. In corporations, important agency relationships exist(1) Between shareholders and managers (2) Between stockholders and creditors (debtors)
Agency problem: A potential conflict of interest between (1) the outside shareholders and the managers or (2) stockholders and creditors.

Stockholders Vs Managers: Potential agency problems arises whenever the managers of a firm owns less than 100% or do not any of the firms common stock. Managers might decide not to work as hard to maximize shareholders wealth because less of this wealth will go to him.

Several mechanisms are used to motivate managers to act in the shareholders best interest, these include 1. Managerial compensation. 2. The threat of firing 3. The threat of takeover and
1. Managerial Compensation (incentives): Firms try to give incentives to managers on companys performance and this motivates managers to operate in a manner consistent with stock price maximization. These plans are-

(i) Performance Shares: Shares of stock are awarded on the basis of the firms Performance- as measured by earnings per share, return on assets, return on equity, and so on.

(ii) Executive Stock Options: It allows managers to purchase stock at some future time at a given price. (iii) Restricted Stock Grants: Restrictive stock to employees as an incentives for reaching certain financial and nonfinancial goals. Restriction in the sense that is, employee does not have the right to ownershipuntil some period in the future, say five year.

2. The Threat of Firing: Usually much of the stock of an average large corporation is owned by a relatively few large institution rather than by thousands of individual investors, and the institutional money managers have the clout to influence a firms operations. 3. The Threat of Takeover: Hostile takeovers occur when a firms stock is undervalued relative to its potential. In a hostile takeover, the managers of the acquired firm generally are fired, and any who are able to stay on lose the power they had prior to the acquisition.

Tactics managers use to avoid hostile takeovers are: Poison Pill: A poison pill is an action a firm can take that practically kills it and thus makes it unattractive to potential buyers thus make the hostile takeover is avoided. Greenmail: The organization buy back stock at a price higher than in markets from shareholders how may takeover.
All incentives plans accomplished two goals: First, it motivates the mangers to contribute to stock price maximization. Second, such plans help companies attract and retain top level executives.