Lesson one: 3hours CHAPTER 1 Introduction to finance: Definition

Lesson one: 3hours
CHAPTER 1
Introduction to finance:
Definition
Finance is the study of how individuals, institutions, governments and businesses acquire, spend
and manage money and other financial assets.
It can also be said to be a branch of economics that studies the management of money and other assets.
A company that has funds to manage will, more than likely, employ the services of a finance manager
who is likely an expert in the field of economics.
Finance has its origin in economics and accounting.
This type of management uses funds either from internal resources or external and allocates them to
areas to maximize profit.
The term optimization is used to explain the procedure whereby finance is maximized by reducing costs
and increasing the return.
Poor finance is the cause of depressed markets caused when managers have not followed the
optimization rule which leads to lower production and lower sales globally.
Economics uses a supply and demand framework to explain how the prices and quantities of goods and
services are determined in a free market economies system.
Economics refers to a science that study on the ways and means that people use in order to survive.
Accounting provides the record-keeping mechanism for showing ownership of the financial instrument
used in the flow of financial funds, between savers and borrowers.
Accountant also record revenues, expenses and profitability of organization that produces and
exchange goods and services.
Understanding finance is important to all students regardless of the discipline or area of study because
nearly all businesses and economics decisions have implications.
Why study finance/ importance of finance.
Knowledge of the basics of finance should help you:
1. Make informed economic decision. The operation of the financial system and the performance of the
economy are influenced by policy makers
2. Gain knowledge and the skills that are needed to assist businesses in their financial decisions.
3. To make informed personal and business investment decision.
An understanding of finance should help you better understand how institutions, government units or
businesses you work for finance its operations.
At personal level, the understanding will enable you to better manage your financial resources and
provide the basis for making decisions for accumulations of wealth over time.
The decision to spend or consume now (for new cloths or dinner at a fancy restaurant) rather than save
or invest (for spending or consuming more in the future) is an everyday decision that we all face.
From such context, we can then still define finance as a branch of economics concerned with resource
allocation as well as resource management, acquisition and investment.
Simply, finance deals with matters related to money and the markets.
In short, we can say that finance addresses the ways in which individuals, business entities and other
organizations allocate and use monetary resources over time.
Six principles of finance
1. Money has a time value- interaction of lenders with borrowers sets an equilibrium rate of interest.
Borrowing is only worthwhile if the return on the loan exceeds the cost of the borrowed funds. Lending is
only worthwhile if the return is at least equal to that which can be obtained from alternative opportunities
in the same risk class. Interest rate received by the lender is made up of:
i) The time value of money: the receipt of money is preferred sooner rather than later. Money can be used
to earn more money. The earlier the money is received, the greater the potential for increasing wealth.
Thus, to forego the use of money, you must get some compensation.
ii) The risk of the capital sum not being repaid. This uncertainty requires a premium as a hedge against
the risk; hence the return must be commensurate with the risk being undertaken.
iii) Inflation: money may lose its purchasing power over time. The lender must be compensated for the
declining spending/purchasing power of money. If the lender receives no compensation, he/she will be
worse off when the loan is repaid than at the time of lending the money.
2. Diversification of investments can reduce more risks- Diversification of investment can
reduce risks. Therefore one should spread their assets over a variety of different investments. If
you diversify your portfolio, your investment performance should fluctuate less because losses
from some investments are offset by gains in others. Therefore, you should have less risk than if
you put all your money in one type of investment, such as stocks and bonds.
Diversification also makes sense because no single asset class performs best in all economic
environments
3. Higher returns are expected on for taking more risks.
4. Financial markets are efficient in pricing securities.
5. Manager and shareholders objectives may differ.
6. Reputation matters.
The financial environment encompasses the financial systems, institutions or intermediaries,
financial markets, business firms, individuals and global interactions that contribute to an efficient
economy. Financial institutions are organizations or intermediaries that help the financial system
operate efficiently and transfer funds from savers and investors to individuals, businesses and
governments that seek to spend or invest the fund in physical assets (inventories, buildings,
equipments). Financial markets are physical locations or electronics forum that facilitates the flow
of funds among investors, businesses and government.
Scope of finance
The term finance incorporates any of the following:
a) Investment decisions (capital budgeting).
b) Financing the business (capital structure decisions).
c) Financial management of the firm (working capital management).
a) Investment decision- Capital budgeting is very a vital activity in business.
Vast sums of money can be easily wasted if the investment turns out to be wrong or
uneconomic.
Major investment decisions are mostly made by investors and investment managers. Investors
commonly perform investment analysis by making use of fundamental analysis and technical
analysis.
These decisions on investment, which take time to mature, have to be based on the returns
which that investment will make.
Investment areas involve the sale or marketing of securities, the analysis of securities and the
management of Investment risk through portfolios diversification.
It is concerned with the use of funds i.e. the buying, holding, or selling of all types of assets. A
systematic approach to capital budgeting implies:

The controlling of expenditures and careful monitoring of crucial aspects of project execution.

The formulation of long-term goals.

The creative search for and identification of new investment opportunities.

The estimation and forecasting of current and future cash flows.

There is need for set of decision rules which can differentiate acceptable from unacceptable
alternatives.

A suitable administrative framework capable of transferring the required information to the
decision level.

Classification of projects and recognition of economically and/or statistically dependent
proposals.
What short-term and long-term investment should the firm undertake?
The following steps are followed in making an investment decision;
Analyze- Optimize- design portfolio- formulize- implement- monitor.
Step1. Analyze the current situation.
Step2. Design optimal portfolio. This is guided by-:
R- Risk tolerance. How much money are you willing to lose in a given period?
A-Classes of assets (Equities, fixed income, cash).
T- Time horizon.
E- Expected or desired rate of return.
Step3. Formulize investment policy statement- Investment policy acts as a stabilizer. Its mere existence
should force fiduciaries to pause and consider the external and internal circumstances that promoted
the development of existing policy.
Step4.Implementation
Effective management skills are most critical in the implementation stage. The successful investor will
intuitively follow the time-proven maximum of doing what one knows best and delegating the rest to
others.
Step5.Monitoring and supervision- Whenever significant events occur that warrants a review, one
should ensure that they are examined. At least monthly, investors should analyze their custodian’s
appraisal report containing the current market value. There should be formal review to determine
whether investment objectives are being attained or have changed. In summary, Investment
management involves making decisions relating to issuing and investing in stock and bonds.
b) Financing decision (capital structure)
• Investment= Equity+ Dept+ internal+ other.
Financial decision is made on two conditions:

Existence of alternative.

Existence of objectives or goal.
The firm’s management seeks to find out how the firm can raise funds to invest. There are costs
connected with obtaining financing and compensating providers of various sources of funds both shortterm and long-term, which must be considered by management in making any financing decision.
• Using any types of fund entails an economic cost to the company in one form or another.
• One of the management obligations is to develop a pattern of funding that both matches the
risk/rewards profile of the business and is sufficiently adapted to meeting the evolving needs of the
company.
C) Financial management- It involves financial planning and assets management to enhance the value of
the businesses.
Assets management- Is the set of activities associated with the following?
 Identifying what assets are needed.
 Identifying funding requirement.
 Acquiring assets.
 Providing logistics and maintenances.
 Support system for asset.
 Disposing or reviewing assets.
Benefits
a. Minimum overall cost of ownership for the asset, through cost-effectiveness, asset creation
preservation and replacement.
b. Keep the organization focused on the objective of customer satisfaction through effective
services and product delivery.
c. Create ownership and buy-in through involvement of staff that ensures there is always a
business focus on creating new assets preserving or replacing current assets.
d. Eliminating funding crises situation (requiring major injection of funds to upgrade and replace
assets that can no longer meet performance standards.
e. Financial management in businesses involves making decision relating to the efficient use of
financial resources
Conclusion
In the production and sale of goods and services. The goal of a financial manager in a profit-seeking
organization is to maximize owner’s wealth. This is accomplished through effective financial planning
and analysis, assets management and its acquisition of financial capital.
Lesson 2
Agency theory
Agency theory also known as ‘principal-agent theory’ focuses on mechanisms to reduce the ‘problem’,
such as selecting certain types of agents, and instituting forms of monitoring and various amounts of
positive and negative sanctions.Whenever there is separation of the owners (principals) and the
managers (agents) of a firm, the potential exists for the wishes of the owners to be ignored. Managers
are employed and delegated with the responsibility of decision making by owners, hence creating an
agency relationship between the two parties. However, when the interests of managers diverge from
those of owners, then manager’s decisions are more likely to reflect their preferences rather than the
owner’s preference. Owners have access to only a relatively small portion of the information that is
available to executives about the performance of the firm. As a result, executives are often free to
pursue their own interests a condition known as moral hazard problem. This at times put investor’s
wealth at risk. Similarly, shareholders have limited ability to precisely determine the competencies and
priorities of executives at the time they are being hired. These make it difficult for the principal to verify
an executive’s appropriateness as an agent of the owners hence, creating unanticipated problems of
non-overlapping priorities between owners and agents. This is referred to as adverse selection.
Though many top executives earn princely salaries, occupy luxurious offices, and wield enormous power
within their organization, they are mortal and capable of making mistakes or a poor decision. Errors
made by business managers are difficult to predict and can harm the investors and as a result imparts a
needlessly skeptical outlook. Agency theory therefore provides investigators with an opportunity to
replace skeptism with informed insight as they endeavor to analysis subjective management risk .There
are different kinds of problems that can arise because of agency relationship.
First the executives may pursue growth in company size rather than in earnings, as they are more
heavily compensated for increases in size than for earning growth. As a result, managers may
recommend strategies that yield company growth such as mergers and acquisitions. In addition,
managers’ stature in the business community is commonly associated with company size. Hence
managers gain prominence by directing the growth of an organization and they benefit in terms of
career advancement and job mobility that are associated with increase in company size. On the other
hand shareholders generally want to maximize earnings, because earnings growth yields stock
appreciation.
Secondly the executives may avoid risk since they are often fired for failure, but rarely for mediocre
corporate performance.
Thirdly, managers in most cases act to optimize their personal payoffs. Similarly, executives may pursue
a range of expensive perquisites that have a negative effect on shareholder returns such as, elegant
corner offices, corporate jets, large staffs, golf club memberships and extravagant retirement programs
for executive’s benefits which are rarely good investments for stockholders.