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: Current Assets Cash & M.S. Accounts receivable Inventory Liabilities & Equity: Current Liabilities Accounts payable Notes Payable Total Current Liabilities Long-Term Liabilities Total Liabilities Equity: Common Stock Paid-in-capital Retained Earnings Total Equity Total Liabilities & Equity

Working Capital

Total Current Assets Fixed Assets: Gross fixed assets Less: Accumulated dep. Goodw ill Other long-term assets

Working Capital

Investment Decisions

Total Fixed Assets Total Assets

Financing Decisions

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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.
Corporation 1,011,973 1,292,081 622,908 Partnership 2,584,427 Sole Proprietorship
Source: U.S. Census 2008 SUSB Annual Data
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Size of Payroll (000s)

$1,068,232,095 S-Corporation $479,673,700 $2,808,013,079

$149,121,474

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.

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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:  Low organizational cost  Income taxed once as personal income  Independence  Secrecy  Ease of dissolution WEAKNESSES:  Unlimited liability  Limited funding  Proprietor must be all  Difficult to develop staff career opportunities  Lack of continuity on death of proprietor

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

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Corporations
STRENGTHS:  Owners liability limited  Large capitalization possible, greater funding  Ownership readily transferable  Indefinite life  Professional management
WEAKNESSES:  Higher tax rates/Double Taxation  Expensive organization  Greater government regulation  When publicly traded, lacks secrecy  Improper corporate structures may lead to Agency Problems

Corporate Organization Chart

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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.
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What is a Corporation?
 Corporation-A business organized as a separate legal entity owned by stockholders.  Types of Corporations:
Public Corporations Private Corporations

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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.

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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

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The Ethics of Maximizing Value

Does value maximization justify unethical behavior?

Recent examples:
Enron WorldCom Bernard Madoff
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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

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

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Agency Problem Solutions

Compensation plans Board of Directors Blockholders

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Agency Problem Solutions

Takeovers Specialist Monitoring Legal and Regulatory Requirements

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Role of the Financial Manager

Firms Operations
(2) (1)

Investors Financial Manager

(3) (4a)

Real assets
(4b)

Financial Assets 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
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The Flow of Capital: Closely Held Corporations

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The Flow of Capital: Public Corporations

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Financial Markets
Financing Decision
Source of Funds (Capital) Capital Structure

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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.
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Financial Markets
Initial Public Offering (IPO):
First offering of stock to the general public.

Fixed-Income Market:
Market for debt securities

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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

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Information Provided by Financial Markets:

Commodity Prices Interest Rates

Company Value

Cost of Capital
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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

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Flow of Cash Example: Mutual Fund

$ Bank of America
Sells shares

$ Explorer Fund
Issues shares

Investors

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A Closer Look: Financial Institutions

Commercial Bank Investment Bank Insurance Company

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Companies and Intermediaries

Company
Obligations Funds

Intermediaries
Banks Insurance Companies Brokerage Firms
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Intermediaries and Investors

Intermediaries
Obligations Funds

Investors
Depositors Policyholders Investors
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Cash Flow Example: Banks

Company
Loan $2.5 mil

Banks

Intermediary
Deposits Cash

Depositors

Investor

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Cash Flow Example: Insurance Company

Company
Issue Debt $2.5 mil

Insurance Company

Intermediary
Sell Policies Cash

Policyholders

Investor

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Function of Financial Markets

 Transport cash across time  Risk transfer and diversification  Liquidity

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Function of Financial Markets

 Payment mechanism  Provide information

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