LECTURE 1

INTRODUCTION

Business Finance
Relates to the study of how financial resources (assets) are obtained and used effectively in the accomplishment of firms objective,

The role of business finance has evolved over the years from the a descriptive study (procurement of funds) to a normative field ( management of assets, allocation of capital and valuation of firm in the overall market place)

Economic environment and finance

Raising finance to fund business operation is an important role for finance managers It is essential that the firms funding requirement are put into overall economic context Economic sectors are divided into
Personal (household) Business Public (government) Foreign (international trade) Finance match need of borrower (deficit unit) and lender (surplus unit)

Financial Intermediaries (sectors)

Businesses that exist to match the needs of borrower (personal and business sector) and lenders (personal sector). Financial intermediaries seen as providing the following services:
Collect small savings and pool them into larger amount Transform short term deposit into long term loans Spread the risk of small depositors by investing into wide enterprises Reduce transaction cost of borrowers and lenders

Once funds are attracted, it purchases financial assets from other economic unit (enterprises) to generate return on the invested fund. i.e. Insurance company ,pension fund, unit trust, finance companies, commercial banks, merchant banks

Objective of Business Firm

Maximize return Whos return?
Community at large Employees shareholders

firms objective is to maximize shareholders wealth by maximizing the firms value Firms value is reflected in the movement of the share price This objective is affected by two factors
rate of return earned on the shares (future earning Risk attached to earning that return (uncertainty)

Risk and Return

All decisions making involves future earning. Such earnings are always associated with certain degree of uncertainty. The future earning are known as return and the uncertainty associated with the return is known as risk. Risk refers not to the possibility of total loss but the likelihood of actual return varying form forecast Risk and return has a liner positive relationship, where higher risk is associated with higher expected return. .(we will discuss this in detail later)

How to achieve the firms objective?

To achieve firms objective (maximize shareholders wealth), 3 types of decisions should be considered by the finance manager
Investment decision Financing decision Dividend decision

Role of a finance manager

Uses the information provided by accountant to make decisions involving finance
Plan the financial objective of a firm Determine the capital structure Plan and control use of funds for long term investment Plan and control the use of funds for short term investment

Exercise
1. How are risk and return related?

2. What is the role of financial intermediaries ?

LECTURE 2
INTRODUCTION PART 2

Financial Market
Financial market are institutions and procedures that facilitate transactions in all types of financial claims Financial markets perform the functions of allocating savings (surplus unit) in the economy to the ultimate demanders (deficit unit) of the saving. Without these financial market the total wealth of the economy would be lessened. Financial market helps the formation of capital in an economy, diversification of risk from various economic sectors, hedging and arbitrage Financial market are divided into
Capital market Money market Foreign exchange market Futures and options exchange market

Capital market and Money market

Capital market is a form of financial market that trades long term securities (shares, loan stock, bonds) Also known as stock exchange Capital market can be categorized into primary market secondary market Money market trades short term financial instruments such as commercial paper, negotiable certificates of deposit, bankers acceptance and treasury bill.

Primary Market
Market in which new securities are traded
IPO (initial public offering) is the first time a companys share is sold to the public Seasonal new issue refers to offering of new share by company that already has ordinary shares traded in the market

Secondary Market
Market in which shares previously issued by the firm is traded. Total stock of financial assets are unaffected by such transaction

Public offering and Private Placement

Public offering takes place in a financial market in which both individual and institutional investors have the opportunity to acquire securities. The issuing firm and investors does not meet face to face. Private Placement takes place in a more personal manner, in which only a limited number of investor have the opportunity to purchase a portion of the shares. The issuing firm and investor develop a face to face transaction.

Exercise
1.Explain what is a financial market. How is an economy worse off without them? 2. Distinguish capital market and money market? 3. Distinguish primary market and secondary market.

LECTURE 3
INTRODUCTION PART 3

Legal form of business firm

1. Sole proprietorship a business own by single person
Advantage
Easily establish with few complications Minimal organizational cost Does not have to share profit or control with others

Disadvantage
Unlimited liability Owner must absorb all losses Equity capital limited to the owners personal investment Business terminates immediately upon death of owner

Legal form of Business Firm

2. Partnership an association of two or more individuals coming together as coowners to operate a business for profit. There are 2 types of partnership
i) General partnership
advantage
Minimal organizational requirements Negligible government regulations

disadvantage
All partners have unlimited liability Difficult to raise large amounts of capital Partnership dissolve by the death or withdrawal of a general partner

Partnership -cont
ii) Limited partnership
Advantage
For limited partners, liability is limited to the amount of capital invested Withdrawal or death of a limited partner does not affect continuity of the business Stronger inducement in raising capital

Disadvantage
There must be at least one general partner who has unlimited liability in the partnership Limited partners may not participate in the management of the business More expensive to organize than general partnership, as a written agreement is mandatory

Legal form - cont

3. Corporation legal entity having the power to purchase and sell, own assets, incur liability while existing separately from its owners. Ownership is evidence by shareholdings.
Advantage
Limited liability of owners Ease of transferability of ownership Death of owner does not result in the discontinuity of business operation Ability to raise large amount of capital

Disadvantage
Most difficult and expensive form of business Control of firm is not guaranteed by ownership of shares

Sources of finance
1. Long term financing Ordinary share Preference share Debenture or loan stock Bonds Term loan 2. Short term financing Bank finance Trade credit Hire purchase Leasing Factoring Bills of exchange

Exercise
1. The shareholders are owners of a limited company but the position of a shareholder differs from that of a sole trader Discuss.

LECTURE 4
BUSINESS OBJECTIVES

Business Objectives
Although most finance studies assume the objective of maximization of shareholders wealth it is important that in real world companies may be working toward other objective:
1. 2. 3. 4. 5. 6. Maximization of profit Maximization of the return on capital employed Survival Long term stability Growth Maximization satisfaction of interested parties (employees, creditors, public and others)

Maximization of profit vs. Maximization of shareholders wealth

Maximization of profit
Suboptimal decision for shareholders The use of profit as a measure of return is misleading in that profit could be increased through external financing (acquisition) which will dilute the equity and eventually decrease earning per share The use of EPS also not an appropriate objective in that it does not represent the actual income of the shareholders. It only represent investors share of income according to accounting formula. Ignore timing of return (earning) and uncertainty (risk)

Maximization of shareholders wealth

Means maximization of firms value, max share price Takes into account present and future earning (return) per share, timing, duration and risk of the earning Takes into account dividend yield and capital gain Efficient allocation of resources in the society

Agency Theory
Relationship between various interested parties in the firm Agency relationship occur when one party (principle) employs another party (the agent) to perform a task on their behalf Example: Manager agents for shareholders, employees agents of managers and manager and shareholders agents of creditors Conflict of interest may exist in most of these agent-principle relationship known as agency theory:
Employees may desire high wages for shorter hours while management might require lower unit cost Creditors prefer less risky investment decisions made by managers, unlike shareholders Managers may make decision not in the best interest of shareholders. Managers might seek to max their welfare.
Paying themselves high salary and perks Provide themselves with large decision making power Increase opportunities for promotions Reduce risk through diversification Defend acquisition and takeover

How to reduce agency problem (shareholder manager)?

audit/monitor mangers decision. The cost of monitoring and the cost of sub optimal decision for shareholders are known as agency cost. Design remuneration package for managers which would motivate managers to take decisions which are consistent with the objective Managers compensation should be linked to changes in the shareholders wealth Time horizon of managers decision should match that of shareholders Shareholders and managers attitude toward risk should be encouraged to be similar

Exercise
1. Why are investment and financing decision important to a firm? 2. Why is profit maximization considered incomplete as a business objective 3. Discuss the problem that might exist in the relationship between shareholder and manager and how to overcome the problem.

LECTURE 5
FINANCIAL STATEMENT

Basic Financial Statement

Income statement
Reports the results from operating the business for a period of time, such as a year

Balance sheet
Provides a snapshot of the firms financial position at a specific point in time, presenting its assets, liabilities and capital

Cash flow statement

Provides an insight to the sources and uses of cash over a period. The income statement measures profit for a period on accrual basis rather than cash basis.

Income Statement
SALES Cost of Goods Sold GROSS PROFIT Operating Expenses OPERATING INCOME (EBIT) Interest Expense EARNINGS BEFORE TAXES (EBT) Income Taxes EARNINGS AFTER TAXES (EAT) Preferred Stock Dividends
NET INCOME AVAILABLE

TO COMMON STOCKHOLDERS

Balance Sheet
Fixed Assets Machinery & Equipment Buildings and Land Investments & patents Current Assets Cash Marketable Securities Accounts Receivable Inventories Prepaid Expenses Current Liabilities Accounts Payable Accrued Expenses Short-term notes Finance By: Equity Preferred Stock Common Stock (Par value) Paid in Capital (Share Premium) Firms Retained Earnings Long-Term Liabilities (Debts) Long-term notes Mortgages

Capital Structure made of equity and debts

Problems using accounting information

Income measurement

Costs are not expressed in the same terms as the revenues where there are changing prices. Since the cost tend to be incurred before the revenue are recognized there is a tendency for cost to be understated and profit overstated.
Balance sheet values

The theoretical framework used in preparation of asset accounts tends to understate the amount of wealth invested.

Financial ratio
Profitability ratios Activity ratios Liquidity ratios Capital gearing ratios investment ratios

Limitation of ratios
Lack of standard definition

Some accounting ratios may be defined in more than one way. This makes it difficult to compare ratios calculated by different accountants, for the same ratios.
Unrepresentative balance sheet figures

Balance sheet only shows a snapshot of a companys financial position on a single date, whereas profit and loss account covers entire accounting period. Therefore if the assets and liabilities on the balance sheet date are not typical of the year as a whole, any ratio that combines a balance sheet figure with profit and loss figure might produce a misleading result.

Limitation of ratios - cont

Accounting policies

Accounting policies with regard to depreciation and stock valuation might be very different to those of another company. These differences make it difficult to have a meaningful comparison between companies
Misinterpretation

Accounting ratios are open to misinterpretations unless all available evidence is taken into account. For example reduction in gross profit margin is seen as a bad sign, when in fact the company has deliberately dropped selling price to boost sales.

Benefit of ratios
Easily understood by all users Useful for comparison Remedial action can be taken on weakness revealed through ratio Certain ratios focuses on investors attention

Profitability Ratio
Concern with the effectiveness of firm in generating profit
a. Return on capital employed

Net profit before long-term interest and tax x 100% Total asset less current liabilities
b. Return on equity

Net profit after long-term interest and tax x 100% Share capital and reserves
c. Gross profit margin

Gross profit x 100% Sales

d. Net profit margin

Net profit before long-term interest and tax x 100% Sales

Activity Ratios
To asses the effectiveness of firm in utilizing its asset
a. Net asset turnover

Sales Total asset less current liabilities

b. Stock holding period

Stock held x 365 Stock used

c. Debtor collection period

Trade debtor x 365 Credit sales

d. Creditor payment period

Trade creditor x 365 Credit purchase

Liquidity Ratio

To assess how well the firm is managing its working capital

a. Current ratio

Current asset Current liabilities

b. Quick ratio

Current asset less closing stock Current liabilities

Capital gearing ratios

These ratios are concern with the relative sizes of fund provided by shareholders and by the loan creditors.
a. Debt to equity

borrowing (long and short term) total equity (share capital plus reserve)
b. Times interest covered

Profit before interest and tax Interest charges

Investment ratio
- assess firms strength from the investors point of view
a. Earning per share

Profit after interest and tax No of ordinary share

b. Price/ earning ratio

Current market price per share Earning per share

c. Dividend yield

Dividend per share x 100% Current market price per share

d. Dividend cover

Profit after interest and tax Total dividend paid

Exercise
1. Explain what are financial ratios, indicate the benefits and limitation in using them