1. introduction to finance

8/6/2019 1. Introduction to Finance

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Principles of FinanceBBS Actuarial science, BBS Finance

and BBS Financial Economics

1. Introduction to Finance

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Content

1.1 Finance and Financial

Management

1.2 Scope of finance and functions1.3 Goals of the firm

1.4 Agency theory

1.5 Return and risk

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1.1 Finance and Financial Management

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 maximisereturns. Returns will be discussed

later.3

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1.1 Finance and Financial management

Financial management:

involves raising and

allocating funds to the most

productive end user so as to

achieve the objectives of a

business or firm.4


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1.1. Finance and Financial Management

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 ofbusinesses:

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2.Objectives of financial Accounting

Types of

businesses

PartnershipsSole

proprietorshi

p

Companies

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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 beeasily established and is subject to

minimum government regulation and

supervision.7

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Partnership

A partnership is similar to a

proprietorship, except that it is ownedby two or more persons.

In a general partnership each partner is

personally responsible for the

obligations of the business.

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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 thepartners in the event of death or

withdrawal of a partner.9

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Company

A company is a legal person that is

empowered to own assets, to incurliabilities, 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)10


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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 adividend.

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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.12


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The next sections discuss the

strengths and weaknesses of

each type of business

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Sole proprietorships

Benefits Limitations

1. Owner receives all profits (as well

as losses)

1. owner has unlimited liability total wealth

can be taken to satisfy debts

2.Low organizational costs

3. Not taxed separately: rather

income included on proprietors

return.

2. Limited fund raising ability tends to inhibit

growth

4. A high degree of independence 3. proprietor must be a jack-of-all-trades

5. A degree of secrecy is achievable 4.Difficult to motivate employees careerprospects

6. There is ease of dissolution 5. Continuity dependent on presence ofproprietor 14


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1.1 Finance and Financial Management Partnerships


1. Can raise more capital than a sole

proprietorship

1.Owners have unlimited liability and

may have to cover the debts of other

partners2. Borrowing power enhanced by

more owners

3. More available brainpower and

managerial skills

2. Partnership is dissolved on the

death or withdrawal of a partner

4. Not taxed separately. The partnersare taxed after receiving share of

profits

3. Difficult to liquidate or transferpartnership interest

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Companies


1. Owners have limited liability which

guarantees they cannot lose more than they

invest.

1. Taxes generally higher due to double

taxation- on dividends and corporate

profits

2. Growth is not restricted by lack of f unds. (cansee shares)

3. Ownership (shares) is readily transferable 2. More expensive to organize

4. Endless life of firm (does not depend on life

of owners)

3. Subject to greater regulation

5. Can hire professional managers (separation

of ownership from control)

4. Lacks secrecy, because stockholders

must receive financial report

6. Can raise funds more easily

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1.2 Scope of finance and functions

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.17

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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.18


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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. 19

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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.20


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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 bemade between expansion and paying

owners part of the return.

. 21

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1.3 Goals of the firm

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.22


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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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Profit is the difference between

revenues/Incomes and

expenses/costs. To report highprofits a business will either

increase revenues and maintain

costs, or reduce costs and

maintain revenues or both.

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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 managerneeds to be careful. Profit as we shall

see in accounting is not reliable.

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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.26


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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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By discounting cash flows over time

using the concepts of compound

interest, Value maximization takes

account of both risk and the timevalue of money.

In many cases the wealth of owners will

be represented by the market value

of the firms shares.

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That is the reason why

maximization of shareholders

wealth has become

synonymous with maximizing

the price of the companysstock.

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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 presentand 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.30


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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 effectson shareholders value (share

prices).31

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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

Some decisions that result in a

conflict with shareholders:

1. Managers may use company

resources for personal use.

2. Managers may award themselveshefty pay rises

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1.4 Agency Theory

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

Suggested solutions to agency

problem:

1. Performance based remuneration

2. Agency costs e.g. Auditing

3. Threat of take over4. Legal action

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1.4 Agency Theory

5. Good governance principles

(qualified management/

organization structure etc)

There is also an agency problem

between the business and

lenders.40


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1.4 Agency Theory

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

1. The company can invest in risky

projects

2. Drawings and dividends toowners can be very high

3. Business can borrow more so put

the initial lenders at risk of

default.42


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1.4 Agency Theory

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?43

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1.4 Agency Theory

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

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

4. The company cannot undertake

certain business activities

especially the ones deemed to berisky 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. 46


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1.5 Return and Risk

Return and risk are very

important concepts in

finance.

Please remember that a business

must invest in assets thatgenerate a high return.

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1.5 Return and Risk

Return

Return as used in financial

management and investmentmanagement 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

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 ofthe year, then her return over

the year is KShs. 5,000.49

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1.5 Return and Risk

The amount over and above the

beginning value of the

investment. We say she hasearned a return of 5% during

the year.

A common form of return for

investors is holding period50


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1.5 Return and Risk

The holding period return,

which may also be actual or

expected, of an investment is

measured as the total gain or

loss experienced or expectedby the investor over a given

period of time.51

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1.5 Return and Risk

It has two components:

1. Yield: This is the periodic

cash flows paid to theinvestor on his/her

investment, usually in the

form of interest or dividend.52


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1.5 Return and Risk

2. Capital (or Price) Change:

This is the difference

between the beginning price

and the ending price of the

asset (security) held by theinvestor

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1.5 Return and Risk

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.54


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1.5 Return and Risk

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

If we let,

R = actual, expected or required rate of

return on the asset;

P1 = securitys price at the end of periodt;

P0 = securitys price at the beginning of

period t;

Ct= cash flow received or anticipated

from the security during period t. 56


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1.5 Return and Risk

Then, the holding period

return (HPR) on the security

over period tis obtained a

HPR = Capital Change +

YieldHPR = (P1-Po) + Ct

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1.5 Return and Risk

HPR in %

= (P1-P0) + Ct X 100

P0

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1.5 Return and Risk

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.59

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1.5 Return and Risk

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

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.63

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1.5 Return and Risk

2. Uncertainty of incomes

This is a risk to which ordinary

shareholders face. Companies are not

obligated to pay dividend toshareholders. The dividends to these

investors generally depend on the

companys profitability, which, in turn,

is exposed to changes in general

economic performance.64


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1.5 Return and Risk

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

4. Inflation risk (Purchasing power

risk)

This is the chance that the purchasing

power of the invested amount willdecline 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.66


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1.5 Return and Risk

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.67

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1.5 Return and Risk

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 formulalinking 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

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 currency71

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1.5 Return and Risk

7. Political, country or sovereign risk

This is the uncertainty about the political

environment of a country. Political

issues of concern include the type ofgovernment 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

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

Before we look at how to measure risk in

relation to investments, there are

typically three categories of investors

with regard to their attitude towardsrisk.

1. Risk Averse (Aversion)

2. Risk Taker (taking)

3. Risk Indifferent (Indifference)74


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1.5 Return and Risk

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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1.5 Return and Risk

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 riskand 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

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 thecontrary we assume that an average

investor is generally risk averse.77

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1.5 Return and Risk

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:78


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1.5 Return and Risk

79

1n

)xx(s

2i

n1i2

=

=

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1.5 Return and Risk

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

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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1.5 Return and Risk

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 investment82

1. introduction to finance

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