LECTURE– 1

INTRODUCTION
TO
BUSINESS FINANCE
&
FUNDAMENTALS OF FINANCE

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 Why some companies are successful?

• Like Apple & Hewlett-Packard are successful

• It is all about:
– Acquisition
– Financing &
– Management of assets
• Goal is to maximize shareholders’ wealth
• Three (3) Major Areas:
I. Investment Decisions
II. Financing Decisions
III. Asset management Decisions
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 Financial Management
• Investment Decisions
• Total amount of assets a firm needs to hold (Most important)
• Assets & liabilities depending on size of the firm; decision of
composition of assets; cash or inventory related decisions
• Invest or divest (reduce/eliminate/replace assets)
• Financing Decisions
• Liabilities & equity side
• Right Financing mix of debt (short / long term, heavily debt / debt
free) & equity, dividends, retained earnings
• Physical acquisition of needed funds (sale of bonds or stock)
• Asset management Decisions
• Efficient management of assets
• Financial Manager  Current assets management
• Operating Manager  Fixed assets management 4
 Agency Theory & Problems
• Agency Theory:
– relating to behavior of owners & their agents.
– a separation exists between owners & managers in
modern corporations.
– Management  Agents of owners
– Authorized by owners to act on their behalf
– Incentives (stock option, bonuses, perks) must be given to
Management to act in the best interest of owners
– Monitoring activities & performance
• Agency Problems:
– Conflicts between ownership & management
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 Corporate Social Responsibility (CSR)
• Acknowledges a firm’s responsibilities to its
stakeholders & natural environment
– Interests of stakeholders
• creditors, employees, customers, suppliers, communities
– Sustainability: Meeting needs of the present without
compromising ability of future generations to meet their
own needs.
– Protecting consumer rights,
– clean water, air;
– Supporting education;
– Addressing issues as climate change, oil depletion, energy

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 Corporate Governance
• A system by which corporations are managed &
controlled.
• Encompasses relationships among a company’s
shareholders, board of directors (BoD) & senior
management.
• Provides a framework to set corporate objectives &
monitors performance, which is measured by BoD
• Three (3) categories of individuals are key to success:
– common shareholders, who elect board of directors
– company’s board of directors themselves
– top executive officers led by chief executive officer (CEO)
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 Board of Directors
• A critical link between shareholders & managers
• Keep an independent check on corporate
management
• Ensure that management acts in shareholder’s best
interest
• Typical Responsibilities include:
• Set company-wide policy
• Advise CEO & other senior executives
• Hire, fire & set compensation of CEO
• Review & approve strategy, significant investments &
acquisitions
• Oversee operating plans, capital budgets & financial
reports to common shareholders
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 Organization of Financial Management
• Board of Directors
 President (Chief Executive Officer)
Executive Vice Presidents Operations
(EVPs) Marketing
(EVPs) Finance
Vice President (Treasurer)
 Investment (capital budgeting, pension management)
 Financing (commercial & investment banking
relationships, investor relations, dividend
disbursement)
 Asset management (cash & credit management)
Vice President (Controller)
 Accounting in nature; cost accounting, budgets,
forecasts

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 (Sole) Proprietorship
• Owned by one individual; Ideal for small businesses
• Easy to start business set-up after obtaining licenses
• Advantages:
– easily & inexpensively formed
– subject to few government regulations
– no corporates taxes
– income is taxed as part of personal income
• Limitations:
– difficult to obtain capital when needed for growth
– unlimited personal liability for business’s debts,
– losses can exceed the money invested (seizing properties )
– life of a proprietorship is limited to the life of its founder 10
 Partnership
• More than one owner
• Partners can be added as business grows
• Can be:
– Informal (oral understandings)
– Formal agreements
• Profits & losses sharing ways are defined
• Advantages & disadvantages are similar as a
proprietorship
• As per law, if bankrupted, each partner is liable for & may
lose all of their personal assets, even those not invested.

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 Limited Partnership
– General partners enjoy:
• Unlimited liability;
• Controlling powers
– Limited partners:
• Lose only amount of their investment;
• No control
– Examples:
• Real estate, oil, venture capital

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 Corporations
• Artificial entity created by law
• Separate entity from its owners
• Own assets & liabilities
• Advantages:
– Limited liability
– East transfer of ownership
– Unlimited life
– Easier to raise large quantities of capital
• Disadvantages:
– Corporate Taxes
– More difficult to establish
– More expensive to setup & maintain 13
 Limited Liability Companies
• Hybrid form that combines the best aspects of both
corporation & partnership
• Owners enjoy limited personal liability with tax treatment of
partnership
• Ideal for small & medium sized firms
• Advantages:
– Limited liability
– Eliminates double taxation
– No restriction on number or type of owners
– Easier to raise additional capital
• Disadvantages:
– Limited life (generally)
– Transfer of ownership difficulties (generally)
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 Corporate Taxes
• Corporation’s taxable income is found by deducting
all allowable expenses, including depreciation &
interest, from revenues.
• Marginal Rate:
– Tax rate (% of taxable income that must be paid in taxes)
applied to each income bracket
• Double Taxation:
– Taxation of same income twice.
– E.g., Taxation of income @ corporate level & again as
dividend income when received by shareholder;
– imposed on corporates
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 Depreciation
• Systematic allocation of cost of a capital asset over a
period of time for financial reporting / tax purposes.
• Treated as an Expense item
• Lowers taxable income
• Accelerated Depreciation:
– writes off cost of a capital asset faster (Preferred for tax)
• Straight line Depreciation:
– allocates expenses evenly over the depreciable life of an asset.
• Declining Balance Depreciation:
– annual charge based on a fixed percentage of asset’s
depreciated book value (cost minus accumulated depreciation)
at the beginning of the year
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 Interest Expense, Dividends, Capital Gains
• Interest paid on outstanding corporate debt is treated as
expense & is tax deductible.
• Debt (e.g., bonds) results in a significant tax advantage
• Dividends paid to preferred or common stockholders are
not tax deductible.
• Capital Gains & Losses
– When a capital asset is sold, capital gain / loss is incurred
• Carry back &/or Forward net operating loss
– to balance taxable income & to avoid penalizing companies that
have sharply fluctuating net operating income, net operating
loss may be:
• Carried back 2 years and/or
• Forward up to 20 years 17
 Financial Markets
• All institutions & procedures for bringing buyers & sellers
of financial instruments together to invest idle funds in
marketable securities.
• Purpose of financial markets is to allocate savings
efficiently to ultimate users
• Marketable securities:
– To be sold within a year such as:
• Treasury Bills (T-bills), shares, Certificates of Deposits (CoDs), etc.
• Financial Markets can be broken into 2 classes:
– Money Markets
– Capital Markets
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Financial Markets in a developed economy
• Physical asset markets
• Spot markets & futures markets
• Money markets
• Capital markets
• Mortgage markets
• World, national, regional & local markets
• Primary markets
• Secondary markets
• Public markets
• Private markets
• Initial Public Offering (IPO) market
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 Financial Markets
• Money Markets
– For short-term (less than 01 year original
maturity) government & corporate debt securities.
• E.g., T-bills, commercial paper, certificate of deposits
• Capital Markets
– For relatively long-term (greater than 01 year
original maturity) financial instruments.
• E.g., bonds, stocks, Term Finance Certificates (TFCs)

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 Financial Markets
• Within Money & Capital markets there exist both:
• Primary Markets:
– New securities are bought & sold for the first time (a “new issues”
market)
• Secondary Markets:
– Existing (used) securities are bought & sold,
– Increase the liquidity of financial assets
– Organized exchanges:
• Efficiently match buy and sell orders;
• Forces of supply & demand determine price (NYSE, KSE)
– Over-The-Counter (OTC) market:
• Un-listed stocks & bonds & some listed securities are traded;
• Brokers & dealers ready to buy & sell securities at quoted prices;
• Highly mechanized;
• Connected by telecommunication network (e.g., NASDAQ) 21
 What are Financial Intermediaries?
• Financial institutions that accept money from savers &
use it to make loans & other financial investments in
their own name.
• Purchase direct (or primary) securities & in turn, issue
their own indirect (or secondary) securities to the public.
• Include:
– commercial banks
– savings institutions
– insurance companies
– pension funds
– finance companies
– mutual funds 22
 Financial Intermediaries
• Deposit institutions:
– Acquire demand (checking) & time (savings) deposits from
individuals, companies, governments & in turn make
investments & loans (short or medium term or mortgage).
– Include: commercial banks, mutual savings banks, credit
unions, savings & loan associations
• Insurance Companies:
– Build reserves & invest in financial assets by collecting
periodic payments (premium) from clients & insuring in
exchange to payout in case of adverse events.
• Property & casualty insurance: against fires, thefts, car
accidents
• Life insurance: investment in long-term based on predictability
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 Other Financial Intermediaries
• Pension & Retirement funds
– Both employees & employers contribute in funds
– Invest in long-term securities
– Provide income to retired individuals
• Mutual funds
– Invest individuals’ money heavily in corporate stocks &
bonds
– Charge Management fee for their services
• Finance companies
– Raise capital through stock (share) issues & borrowings
– Make consumer installment loans, personal loans, secured
loans to business enterprises 24
 Financial Brokers
• Investment Banker
– A financial institution (middlemen) that
underwrites new securities for resale.
– Underwriting: is to purchase at a fixed price on a
fixed date.
• Mortgage Banker
– A financial institution that originates (buys)
mortgages primarily for resale to individuals,
businesses, builders & real estate agents.

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 Funds are allocated considering…
• Price (expected rate of return)
• Different degrees of Risk:
– Default risk:
• Failure to meet terms of a contract, such as failure to make
interest or principal payments when due on a loan.
• Investors demand a risk premium (extra expected return) to
invest in securities that are not default free.
• Treasury securities (T-Bills & Government Bonds) are usually
default free.
– Marketability risk
– Maturity
– Taxability & embedded options
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 Funds are allocated considering…
• Assigned Ratings
– Quality ratings are assigned & published by principal rating
agencies for the use of investors.
– Highest-grade securities are rated as triple-A, judged to have
negligible default risk.
– “Investment grade quality” – Credit ratings in the top four
categories:
• Moody’s Investors Service: Aaa to Baa
• Standard & Poor’s: AAA to BBB
– “Speculative grade” securities are rated below top four
categories & must offer higher expected returns than others.
– Regulatory agencies use ratings to identify securities that are
eligible for investment by financial institutions.
– In Pakistan, rating agencies include JCR-VIS & PACRA 27
 What is Marketability (Liquidity)?
• Ability to sell a significant volume of securities in a short
period of time in secondary market without significant
price reduction.
• Two interrelated dimensions:
– Price realized
– Amount of time required to sell asset
• Lower the marketability of a security, greater the yield
(expected return) necessary to attract investors.
• Yield differential between different securities of same
maturity is due to differences in:
– Default risk
– Marketability 28
 Maturity
• Life of a security
– Period or Term such as 1 year, 3 years, 5 years, etc.
• Amount of time before the principal amount
of a security becomes due.
• Securities with same default risk, marketability
& tax implications can still be traded at
different yields because of ‘Time’ or Maturity.
• Maturity of a security can have a powerful
effect on expected return or yield.
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 Yield Curve depending on Maturity
• Yield curve: is a graph of relationship between yields &
term to maturity for particular securities.
– Maturity is plotted on the horizontal axis
– Yield is plotted on the vertical axis
• Most commonly observed yield pattern is positive (upward-
sloping) also known as the yield curve.
• Longer the maturity, Greater the risk of fluctuation in
market value of a security.
• Investors need to be offered risk premiums to attract them
to invest in long-term securities.
• Only when interest rates are expected to fall significantly
investors will invest in long-term securities
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 Option Features
• They are conversion privileges or warrants.
• If the investors receive options, the issuing
company should be able to borrow funds at a
lower interest cost.
• If the issuing company receives an option,
such as a call feature, investors must be
compensated with a higher yield.
• Call feature:
– enables a company to prepay its debt
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 Inflation
• Rise in the average level of prices of goods &
services.
• Inflation expectations have a substantial
influence on interest rates overall.
• Higher the expected inflation, higher the yield
on security.

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