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Principles of Finance
BBS Actuarial science, BBS Finance and BBS Financial Economics
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1. Introduction to Finance

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Content
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1.1 Finance and Financial Management 1.2 Scope of finance and functions 1.3 Goals of the firm 1.4 Agency theory 1.5 Return and risk

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1.1 Finance and Financial Management

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Finance is a branch of economics that deals with the optimal use of scarce resources. Finance aims at helping organizations identify how resources can be used to maximise returns. Returns will be discussed later.

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1.1 Finance and Financial management

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Financial management: involves raising and allocating funds to the most productive end user so as to achieve the objectives of a business or firm.

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1.1. Finance and Financial Management

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Before we look at the role of finance, it is important to discuss briefly the types of businesses that can be operated. There are three basic forms of businesses:

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2.Objectives of financial Accounting

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Sole proprietorshi p

Partnerships

Companies Types of businesses

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1.1 Finance and Financial Management

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Sole Proprietorship A proprietorship is an organization in which a single person owns the business, holds title to all the assets and is personally responsible for all liabilities. The main virtue of a proprietorship is that it can be easily established and is subject to minimum government regulation and supervision.

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1.1 Finance and Financial Management

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Partnership

A partnership is similar to a proprietorship, except that it is owned by two or more persons. In a general partnership each partner is personally responsible for the obligations of the business.

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1.1 Finance and Financial Management

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A formal agreement (partnership deed) is necessary to set forth the privileges and duties of each partner, the distribution of profits, capital contributions, procedures for admitting new partners and modalities of reconstitutions of the partners in the event of death or withdrawal of a partner.

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1.1 Finance and Financial Management

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Company A company is a legal person that is empowered to own assets, to incur liabilities, engage in certain specified activities, and to sue and be sued. They are normally set up by a legal process that requires registration with the regulators (registrar of companies)

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1.1 Finance and Financial Management

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Companies are owned by shareholders whose ownership is evidenced by ordinary shares. The shareholders expect to earn a return by receiving a dividend.

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1.1 Finance and Financial Management

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A Board of Directors, elected by the owners, has ultimate authority in guiding the companys affairs and in making strategic policy decisions. The directors management of the company, who run the company on a day-to-day basis and implement the policies established by the directors.

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1.1 Finance and Financial Management

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The next sections discuss the strengths and weaknesses of each type of business

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1.1 Finance and Financial Management Sole proprietorships

Limitations

Benefits

1. Owner receives all profits (as well 1. owner has unlimited liability total wealth can be taken to satisfy debts as losses) 2.Low organizational costs

3. Not taxed separately: rather 2. Limited fund raising ability tends to inhibit income included on proprietors growth return. 3. proprietor must be a jack-of-all-trades 4. A high degree of independence 5. A degree of secrecy is achievable 6. There is ease of dissolution

4.Difficult to motivate employees career prospects

5. Continuity dependent on presence of proprietor 14

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1.1 Finance and Financial Management Partnerships

Limitations
1.Owners have unlimited liability and may have to cover the debts of other partners 2. Partnership is dissolved on the death or withdrawal of a partner

Benefits
1. Can raise more capital than a sole proprietorship 2. Borrowing power enhanced by more owners 3. More available brainpower and managerial skills

4. Not taxed separately. The partners 3. Difficult to liquidate or transfer are taxed after receiving share of partnership interest profits

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1.1 Finance and Financial Management Companies

Limitations

Benefits

1. Owners have limited liability which 1. Taxes generally higher due to double guarantees they cannot lose more than they taxation- on dividends and corporate invest. profits 2. Growth is not restricted by lack of funds. (can see shares) 3. Ownership (shares) is readily transferable

2. More expensive to organize

4. Endless life of firm (does not depend on life 3. Subject to greater regulation of owners)

5. Can hire professional managers (separation 4. Lacks secrecy, because stockholders of ownership from control) must receive financial report 6. Can raise funds more easily

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1.2 Scope of finance and functions

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The following are the decision areas in finance: 1. Financing /Capital structure decision The financial manager needs to understand the firms capital requirements whether short, medium or long term.

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1.2 Scope of finance and functions

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To this end he will ask himself this question where will we get the financing to pay Assets? The capital structure refers to the mixture of owners capital and liabilities. The financial manager aims to use the funds that will result in the lowest possible cost to the company.

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1.2 Scope of finance and functions

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2. Capital budgeting decision

In capital budgeting the financial manager tries to identify resources (assets) that are worth more (benefits) than they cost to acquire. The essence of capital budgeting is evaluation of assets size, risk, and return.

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1.2 Scope of finance and functions

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3. Working capital management The term Working capital refers to a firms current assets and current liabilities. The financial manager has to ensure that the firm has adequate funds to continue with its operations and meet day to day obligations. These funds are called working capital.

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1.2 Scope of finance and functions

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4. Distribution decision This is the payment of part of the earnings to owners of the business. In companies we pay dividends and for sole traders and partnerships we talk about drawings. A balance has to be made between expansion and paying owners part of the return. .

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1.3 Goals of the firm

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One of the major questions in finance is why do businesses exist? Businesses exist to achieve certain goals. Even though there are many goals we can classify them into: 1. Financial goals 2. Non financial goals.

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1.3 Goals of the firm

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1. Financial goals These are two: Maximising profits and maximising owners wealth. Maximising profits: A business undertakes activities that increase profits.

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1.3 Goals of the firm

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Profit is the difference between revenues/Incomes and expenses/costs. To report high profits a business will either increase revenues and maintain costs, or reduce costs and maintain revenues or both.

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1.3 Goals of the firm

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Financial management is concerned with the efficient use of one economic resources. The goal of profit maximization in most cases serves as the basic decision criterion for the financial manager but the manager needs to be careful. Profit as we shall see in accounting is not reliable.

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1.3 Goals of the firm

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Major limitations of this goal are: 1. It does not take account of risk, 2. It does not take account of time value of money, 3. It is ambiguous and sometimes arbitrary in its measurement, 4. It does not incorporate the impact of non-quantifiable events.

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1.3 Goals of the firm

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Maximising owners wealth Because of the limitations of profit maximization, Value-maximization has is now the preferred goal of the firm. By measuring benefits in terms of cash flows, value maximization avoids much of the ambiguity of profit measurement.

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1.3 Goals of the firm

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By discounting cash flows over time using the concepts of compound interest, Value maximization takes account of both risk and the time value of money. In many cases the wealth of owners will be represented by the market value of the firms shares.

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1.3 Goals of the firm

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That is the reason why maximization of shareholders wealth has become synonymous with maximizing the price of the companys stock.

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1.3 Goals of the firm

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The market price of a firms stocks represent the judgment of all market participants as to the values of that firm - it takes into account present and expected future profits, the timing, duration and risk of these earnings, the dividend policy of the firm; and other factors that bear on the viability and health of the firm.

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1.3 Goals of the firm

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Management must focus on creating value for shareholders. This requires Management to judge alternative investments, financing and assets management strategies in terms of their effects on shareholders value (share prices).

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1.3 Goals of the firm

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2.Non Financial goals These relates to social responsibility of the business. These goals include: 1. Being socially responsible (Helping needy) 2.Safe products, ethical practices, environmental safety and others.

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1.4 Agency Theory

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Even though a business has goals to be achieved and meet the needs of various stakeholders, in some cases a problem may arise due to various relations in the business. Remember that owners employ management who are in charge of day to day running of the business.

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1.4 Agency Theory

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In this case we say that the owners have appointed the management to act on their behalf. The person appointing someone to act on their behalf s called the principal and the person appointed is called an agent.

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1.4 Agency Theory

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Therefore management act as agents of owners. In a company directors being managers act on behalf of shareholders. There is a problem when management act on behalf of the owners.

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1.4 Agency Theory

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According to the agency theory, management will tend to benefit at the expense of owners. There is a conflict of interest. Owners would like to get higher profits hence return while managers would also like to take care of their interest.

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1.4 Agency Theory

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Some decisions that result in a conflict with shareholders: 1. Managers may use company resources for personal use. 2. Managers may award themselves hefty pay rises

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1.4 Agency Theory

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3. Managers may expand the business for their benefit only and not for the benefit of shareholders. 4. Managers may use confidential information for their benefit (insider trading)

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1.4 Agency Theory

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Suggested solutions to agency problem: 1. Performance based remuneration 2. Agency costs e.g. Auditing 3. Threat of take over 4. Legal action

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1.4 Agency Theory

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5. Good governance principles (qualified management/ organization structure etc)

There is also an agency problem between the business and lenders.

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1.4 Agency Theory

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This is because when a business borrows money from lenders, then they use the funds on behalf of the lenders so that lenders can get a return. How does the agency problem arise?

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1.4 Agency Theory

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1. The company can invest in risky projects 2. Drawings and dividends to owners can be very high 3. Business can borrow more so put the initial lenders at risk of default.

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1.4 Agency Theory

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4. The business can sell assets that are meant to be a security to the lenders 5. The business can also invest in loss making activities

How can this problem be minimised?

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1.4 Agency Theory

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Mainly through restrictive covenants i.e. lenders can include in the agreement (bond or trust deed) various restrictions such as: 1. Dividends to be paid only if the company meets certain level of profits or cash flows

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1.4 Agency Theory

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2. Company cannot borrow more loans within a specified period or unless the current one has been repaid. 3. Company cannot sell some of its assets especially the ones being used as a security.

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1.4 Agency Theory

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4. The company cannot undertake certain business activities especially the ones deemed to be risky by the lenders. In addition the lenders can also require the company to repay the loan before maturity or be given right to convert loan into shares.

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1.5 Return and Risk

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Return and risk are very important concepts in finance. Please remember that a business must invest in assets that generate a high return.

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1.5 Return and Risk

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Return Return as used in financial management and investment management generally refers to gain or loss over time, usually expressed as an annual percentage of some other value.

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1.5 Return and Risk

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For instance, if an investor starts the year with an investment valued at KShs. 100,000 and her investment is worth KShs.105,000 at the end of the year, then her return over the year is KShs. 5,000.

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1.5 Return and Risk

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The amount over and above the beginning value of the investment. We say she has earned a return of 5% during the year. A common form of return for investors is holding period

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1.5 Return and Risk

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The holding period return, which may also be actual or expected, of an investment is measured as the total gain or loss experienced or expected by the investor over a given period of time.

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1.5 Return and Risk

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It has two components: 1. Yield: This is the periodic cash flows paid to the investor on his/her investment, usually in the form of interest or dividend.

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1.5 Return and Risk

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2. Capital (or Price) Change: This is the difference between the beginning price and the ending price of the asset (security) held by the investor

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1.5 Return and Risk

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Capital appreciation arises if the ending price (or value) is higher than the beginning price. The investor suffers a capital loss (or depreciation) if the ending value of the asset is lower than the beginning value.

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1.5 Return and Risk

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The two components of return are additive so that the total return on a security is simply the sum of yield and price change.

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1.5 Return and Risk

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If we let, R = actual, expected or required rate of return on the asset; P1 = securitys price at the end of period t; P0 = securitys price at the beginning of period t; Ct = cash flow received or anticipated from the security during period t.

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1.5 Return and Risk

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Then, the holding period return (HPR) on the security over period t is obtained a HPR = Capital Change + Yield HPR = (P1-Po) + Ct

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1.5 Return and Risk

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HPR in %

= (P1-P0) + Ct X 100 P0

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1.5 Return and Risk

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Another common description of return is Expected return. If we are dealing with one security then expected return is simply the average return. We can use mean or probability. If we have several securities, then the Expected return is the weighted average return of investing in the various securities.

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1.5 Return and Risk

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Risk

In general, the term risk means exposure to loss or injury. Risk occurs when one is not certain about the outcome of an event. The presence of uncertainty in the outcome of an event or action implies that there can be more than one outcome

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1.5 Return and Risk

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For an investment, the term risk therefore refers to the chance that actual return may be different from the expected return. More formally, risk is used interchangeably with the term uncertainty to mean the variability in the returns associated with a given investment. The greater this variability, the higher is the risk of an investment.

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1.5 Return and Risk

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Forms of risk Risk is caused by many factors. This section will not cover all the forms of risk. 1. Default risk: The risk that the investor may lose as a result of the borrower being unable to pay the initial amount and in some cases interest.

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1.5 Return and Risk

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Default risk is common in loans. In practice loans given to the government called treasuries bills (short-term) and treasury bonds (long term) are said to be default free because governments do not default. The government can increase taxes to pay the loans back. Therefore such loans are referred to as risk free investments to investors.

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1.5 Return and Risk

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2. Uncertainty of incomes This is a risk to which ordinary shareholders face. Companies are not obligated to pay dividend to shareholders. The dividends to these investors generally depend on the companys profitability, which, in turn, is exposed to changes in general economic performance.

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1.5 Return and Risk

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3. Interest Rate Risk This is the variability in return resulting from movements in the level of interest rates. Changes in interest rates affect investors return on loans issued. For example a reduction on market interest rates may reduce the expected future interest on loans already given.

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1.5 Return and Risk

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4. Inflation risk (Purchasing power risk) This is the chance that the purchasing power of the invested amount will decline due to an increase in general price level of consumption goods and services over the investment period. General increase in price levels is referred to as inflation.

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1.5 Return and Risk

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In most cases, all investments must have a return that compensates investors an amount that covers inflation rates. Therefore, rates of return are described to have two components of return i.e. That is the inflation rate (inflation premium) and the real rate of return. The total return is called Nominal rate of return.

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1.5 Return and Risk

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For example if an investment has a nominal or total return of 15% and general inflation is about 5%, then the real rate of return is 10%. A formula linking the three rates of return is given as follows: (1+Nom) = (1+Real rate)(1+ infln. Rate)

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1.5 Return and Risk

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5. Liquidity risk This is the risk that an investor may not be able to realize the investment when terms of cash flows or may take long to realize cash on the same. This is especially common for those investments that are not traded publicly like for private companies.

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1.5 Return and Risk

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6. Exchange rate risk This is the uncertainty about the exchange rate at which a foreign currency may be exchanged for an investors domestic currency in the future. This risk faces those who invest in foreign countries and in currencies other than their domestic currency.

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1.5 Return and Risk

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An exchange rate is basically the price at which one currency can be exchanged with another. For example a rate like $1 = sh.80 means that if you have a dollar then you get sh.80 or if you are to buy a dollar then you need to pay sh.80. An adverse movement in exchange rate may reduce the value of investments quoted in foreign currency

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1.5 Return and Risk

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7. Political, country or sovereign risk This is the uncertainty about the political environment of a country. Political issues of concern include the type of government structures, government policies and actions with regard to law, tax and the economy and the general political climate (stability)

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1.5 Return and Risk

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NB) As stated earlier risk is an important factor to consider and generally we say that investors should be compensated for nearly all the risks that have been discussed. So that means that the higher the risk then the higher the return, but this may not apply in all cases.

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1.5 Return and Risk

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Before we look at how to measure risk in relation to investments, there are typically three categories of investors with regard to their attitude towards risk. 1. Risk Averse (Aversion) 2. Risk Taker (taking) 3. Risk Indifferent (Indifference)

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1.5 Return and Risk

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Risk Aversion: This is attitude toward risk in which the required rate of return increases for an increase in risk. Individuals with this attitude shy away from risk and will require higher expected returns to compensate them for taking greater risk.

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Risk-taking: This is the attitude toward risk in which a decreased return would be accepted for an increase in risk. Individuals with this attitude enjoy risk and will be willing to give up some return in order to take more risk. This attitude is commonly observed among gamblers.

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1.5 Return and Risk

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Risk Indifference: This is the attitude in which no change in return would be expected as risk changes. It is also known as risk neutrality.

Unless given information to the contrary we assume that an average investor is generally risk averse.

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1.5 Return and Risk

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Measurement of risk

This section will only introduce two methods of measuring risk. The two methods are variance and standard deviation. They are also related. Variance:

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n 2 i=1(xi x) 2 1 s =

n1

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Where s2 - variance n number of data items x a data item Bar x Mean of the data

Standard deviation is S2

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1.5 Return and Risk

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To make a decision on whether to undertake an investment preference should be given to those investments with the highest rate of return and/or lowest risk. You also have to consider the risk preference of the investors. We can also combine risk and return.

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This is normally done by use of coefficient of variation which is described as risk per unit of expected return. = Standard deviation Expected return The lower the coefficient of variation the better the investment

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