Kabul University

Economics Faculty

Hamayoun GHAFOURZAY, Ph.D.

‫پوهندوی دکتور همایون غفورزی‬
[Link]@[Link]

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 Finance

Chapter 1: Introduction to Finance

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 Three Basic Function Of Business Organizations

• Three Basic Function of Business Organizations:

– Finance
– Operations
– Marketing
• Operation is responsible for producing the goods or providing the
services offered by the organizations.
• Marketing is responsible for assessing consumer wants and needs,
selling and promoting the organization’s goods and services.
• Finance is responsible for securing financial resources at favorable
prices and allocating those resources throughout the organization, as
well as budgeting, analyzing investment proposals, and providing funds
for the operations.
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 The Field of Finance

• Finance is the application of economic principles and

concepts to business decision-making and problem solving.
The field of finance can be considered to comprise three
broad categories:
– Financial Management (Corporate Finance or Business finance),
– Investments
– and Financial Institutions.

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 The Field of Finance (cont.)

• Financial Management: Sometimes called corporate finance

or business finance, this area of finance is concerned
primarily with financial decision-making within a business
entity. Financial management decisions include maintaining
cash balances, extending credit, acquiring other firms,
borrowing from banks, and issuing stocks and bonds.
• Investments: This area of finance focuses on the behavior of
financial markets and the pricing of securities. An investment
manager’s tasks, for example, may include valuing common
stocks, or measuring a portfolio’s performance.

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 The Field of Finance (cont.)
• Financial Institutions: This area of finance deals with banks and
other firms that specialize in bringing the suppliers of funds
together with the users of funds. For example, a manager of a
bank may make decisions regarding granting loans, managing
cash balances, setting interest rates on loans, and dealing with
government regulations.
– No matter the particular category of finance, business situations
that call for the application of the theories and tools of finance
generally involve either investing (using funds) or financing
(raising funds).

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 Types of Finance

• Types of Finance: Because individuals, businesses, and

government entities all need funding to operate, the finance field
includes three main subcategories:
– Personal finance
– Corporate finance
– Public finance
• The term “Public Financial Management” commonly describes
elements of an annual budget cycle, which typically centers
around (1) budget formulation; (2) budget execution; (3)
accounting and reporting; and (4) external security and audit.
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 Financial Management

Financial Management: Sometimes called corporate

finance or business finance, this area of finance is
concerned primarily with financial decision-making
within a business entity. Financial management
decisions include maintaining cash balances, extending
credit, acquiring
other firms, borrowing from banks, and issuing stocks
and bonds.

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 The Role of the Financial Manager in the Corporation

The controller’s office handles cost and financial

accounting, tax payments, and management
information systems. The treasurer’s office is
responsible for managing the firm’s cash and credit,
its financial planning, and its capital expenditures.
These treasury activities are all related to the three
general questions (Ross, Westerfield, & Jordan,
2010):
1:Capital Budgeting, 2: Capital Structure and 3:
Working Capital Management
Accountants generally use the accrual method
while in finance the focus is on cash flows.

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 Financial Manager
In a large corporation, the financial manager would be in charge of answering the
three basic questions:
1. Capital Budgeting: The first question concerns the firm’s long-term
investments. The process of planning and managing a firm’s long-term
investments is called capital budgeting.
2. Capital Structure: The second question for the financial manager concerns ways
in which the firm obtains and manages the long-term financing it needs to
support its long-term investments. A firm’s capital structure (or financial
structure) is the specific mixture of long-term debt and equity the firm uses to
finance its operations.
3. Working Capital Management: The third question concerns working capital
management. The term working capital refers to a firm’s short-term assets, such
as inventory, and its short-term liabilities, such as money owed to suppliers.

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 Financial Management
(Decisions)
• Financial Management encompasses many different types of
decisions.
We can classify these decisions into three groups:
– Investment decisions (I),
– Financing decisions(F),
– Dividend decisions (D) .
• Whether a financial decision involves investing, financing, or
dividend, it also will be concerned with two specific factors:
– Expected Return (R)
– and Risk (R)

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Goal of Financial Management (Business
Finance)/Goal of the firm
Possible Goals: If we were to These are only a few of the goals we
consider possible financial goals, we could list. Furthermore, each of these
might come up with some ideas like possibilities presents problems as a
the following: goal for the financial manager.
– Survive. For example, it’s easy to increase
– Avoid bankruptcy. market share or unit sales: All we have
– Beat the competition. to do is lower our prices or relax our
– Maximize sales or market share. credit terms. Similarly, we can always
– Minimize costs. cut costs simply by doing away with
– Maximize profits. things such as research and
– Maintain steady earnings growth development. We can avoid
bankruptcy by never borrowing any
money or never taking any risks, and
so on. It’s not clear that any of these
actions are in the stockholders’ best
interests.
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Goal of Financial Management/Goal of
the firm(cont.)
The goal of maximizing profits may refer to some The goals we’ve listed here are all different, but
sort of “long-run” or “average” profits, but it’s they tend to fall into two classes:
still unclear exactly what this means. The first of these relates to profitability. The
First, do we mean something like accounting net goals involving sales, market share, and cost
income or earnings per share? control all relate, at least potentially, to different
these accounting numbers may have little to do ways of earning or increasing profits.
with what is good or bad for the firm. The goals in the second group, involving
Second, what do we mean by the long run? As a bankruptcy avoidance, stability, and safety, relate
famous economist once remarked, in the long run, in some way to
we’re all dead! More to the point, this goal doesn’t controlling risk.
tell us what the appropriate tradeoff is between Unfortunately, these two types of goals are
current and future profits. somewhat contradictory. The pursuit of profit
normally involves some element of risk, so it isn’t
really possible to maximize
both safety and profit. What we need, therefore,
is a goal that encompasses both factors.

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 Goal of Financial Management
(Business Finance)/Goal of the firm
(cont.)
The financial manager in a corporation makes decisions for the stockholders of the firm.
Given our observations, it follows that the financial manager acts in the shareholders’ best
interests by making decisions that increase the value of the stock. The appropriate goal for
the financial manager can thus be stated quite easily:
The goal of financial management is to maximize the current value per share of the
existing stock.
If this goal seems a little strong or one-dimensional to you, keep in mind that the
stockholders in a firm are residual owners. By this we mean that they are entitled to only
what is left after employees, suppliers, and creditors (and anyone else with a legitimate
claim) are paid their due. If any of these groups go unpaid, the stockholders get nothing.
So, if the stockholders are winning in the sense that the leftover, residual portion is
growing, it must be true that everyone else is winning also.

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Goal of Financial Management/Goal of
the firm (cont.)
• As long as we are dealing with for-profit businesses, only a slight
modification is needed. The total value of the stock in a corporation
is simply equal to the value of the owners’ equity. Therefore, a more
general way of stating our goal is as follows: Maximize the market
value of the existing owners’ equity.
• 1900 (the goal was Profit Maximization). But, in (1960), the article of
Robert Anthony: The Trouble With Profit Maximization. Harvard
Business Review.
• So the more general goal is: Maximize the market value of the
existing owners’ equity (Maximization of owner’s wealth)
• Max (V) = F (R, R) (I, F, D)
• Balance Sheet ( Investment, Financing and Dividend sides)
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 Financial Analysis

• Financial analysis is a tool of financial management. It consists of the evaluation

of the financial condition and operating performance of a business firm, an
industry, or even the economy, and the forecasting of its future condition and
performance.
• It is, in other words, a means for examining risk and expected return.
• Data for financial analysis may come from other areas within the firm, such as
marketing and production departments, from the firm’s own accounting data,
• or from financial information vendors such as Bloomberg Financial Markets,
Moody’s Investors Service, Standard & Poor’s Corporation, Fitch Ratings, and
Value Line,
• as well as from government publications, such as the Federal Reserve Bulletin.

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 Financial Analysis (cont.)

• Financial publications such as Business Week, Forbes, Fortune, and the

Wall Street Journal also publish financial data (concerning individual
firms) and economic data (concerning industries, markets, and economies),
much of which is now also available on the Internet.
• Within the firm, financial analysis may be used not only to evaluate the
performance of the firm, but also its divisions or departments and its
product lines.
• Outside the firm, financial analysis may be used to determine the
creditworthiness of a new customer, to evaluate the ability of a supplier to
hold to the conditions of a long-term contract, and to evaluate the market
performance of competitors.

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 The Agency Theory

• Agency relationships: The relationship between stockholders and management is called an

agency relationship. Such a relationship exists whenever someone (the principal) hires
another (the agent) to represent his or her interests.
• In all such relationships, there is a possibility of conflict of interest between the principal
and the agent. Such a conflict is called an agency problem.
• More generally, the term agency costs refers to the costs of the conflict of interest between
stockholders and management. These costs can be indirect or direct. An indirect agency
cost is a lost opportunity.
• Direct agency costs come in two forms . The first type is a corporate expenditure that
benefits management but costs the stockholders. Perhaps the purchase of a luxurious and
unneeded corporate jet would fall under this heading. The second type of direct agency
cost is an expense that arises from the need to monitor management actions . Paying
outside auditors to assess the accuracy of financial statement information could be one
example.
• The solution to the agency problem: Management has a significant incentive to act in the interests of
stockholders: Salary, Bonus, etc.

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Financial Markets and the Corporation

• Financial markets provide a forum in which suppliers of funds and demanders of funds
can transact business directly.
• The money market is the interaction between the suppliers and demanders of short-term
funds (those having a maturity of a year or less). Mostly made in marketable securities
which are short-term debt instruments such as T-bills and commercial paper. The capital
market is a market that enables suppliers and demanders of long-term funds to make
transactions. The key capital market securities are bonds (long-term debt) and both
common and preferred stock (equity).
• Primary Versus Secondary Markets: Financial markets function as both primary and
secondary markets for debt and equity securities. The term primary market refers to the
original sale of securities by governments and corporations. The secondary markets are
those in which these securities are bought and sold after the original sale.
• Listing: Stocks that trade on an organized exchange are said to be listed on that exchange.
To be listed, firms must meet certain minimum criteria concerning, for example, asset size
and number of shareholders. These criteria differ from one exchange to another.

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Chapter
1
END

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