Business Finance Topic 1

1. Introduction to Finance

Finance Definition:

Finance is the science that describes the management, creation and study of money, banking, credit,
investments, assets and liabilities. Finance consists of financial systems, which include the public, private
and government spaces, and the study of finance and financial instruments, which can relate to
countless assets and liabilities. Some prefer to divide finance into three distinct categories: public
finance, corporate finance and personal finance. All three of which would contain many sub-categories.

Finance Categories:

1. Public Finance - The government helps prevent market failure by overseeing allocation of
resources, distribution of income and stabilization of the economy. finance the government.

2. Corporate Finance - Businesses bring in financing through equity investments and credit
arrangements, and by purchasing securities.

3. Private Finance – Earning more money and spending less money is the basis of personal finance.
Individuals may earn more money by starting a business, taking on additional jobs or investing.

Primary Activities of Financial Managers

1. Determining asset-management policies:

All finance functions are concerned with the control of both cash flows and non-cash assets. The reason
is easy to find out. The finance managers must know how much cash will be ‘tied up’ in various kinds of
non-cash (or non-liquid) assets.

2. Determining the allocation of net profits:

This relates to retained earnings (corporate savings) and dividend policy. Most companies have to
achieve balance between two alternatives, i.e., payment of dividends and the retention of earnings for
acquiring additional assets.

3. Estimating cash flow requirements and control of such flows:

An important responsibility of the finance manager is to ensure an adequate flow of cash as and when it
is needed. Otherwise, the smooth operation of a company may not be possible. Since cash flow
originates from sales and cash requirements are closely related to sales volume, adequate cash can be
provided at the proper time only after forecasting cash needs.
4. Taking decision on needs and sources of new external finance:

On the basis of sales forecasts, the financial managers will have to draw a plan to borrow funds from
external sources. Such debt capital will add to the firm’s own cash resources and thus improve its
financial position. External capital may be obtained by borrowing funds from commercial banks.

The finance manager must be competent enough to determine exactly when additional funds from
external sources will be needed. He (she) has also to judge how long they will be needed, how
economically they can be raised (i.e., at the lowest possible cost) and from which sources will they be
repaid.

5. Carrying on negotiations with outside financiers:

The finance manager has also to carry on negotiations with outsiders to be able to arrange for necessary
external financing in required amount and on time. For obtaining working capital, a line of credit has to
be established with commercial banks. Again sufficient time has to be devoted for completing
arrangements for long-term financing. Long-term financing requires more skillful negotiations than
short-term financing.

6. Checking upon financial performance:

It is also necessary for the finance manager to evaluate the wisdom and efficiency of financial planning.
Such evaluation is to be based on past performance of the company. This will enable the finance
manager to improve the standards, tech-niques and procedures of financial planning and control which
are important aspects of the finance function.

Role of Financial Institutions and Markets

A financial institution is an establishment that conducts financial transactions such as investments,

loans and deposits. Almost everyone deals with financial institutions on a regular basis. Everything from
depositing money to taking out loans and exchanging currencies must be done through financial
institutions. Here is an overview of some of the major categories of financial institutions and their roles
in the financial system.

Types of Financial Institutions

Commercial Banks
Commercial banks accept deposits and provide security and convenience to their customers. Part of the
original purpose of banks was to offer customers safe keeping for their money. By keeping physical cash
at home or in a wallet, there are risks of loss due to theft and accidents, not to mention the loss of
possible income from interest. With banks, consumers no longer need to keep large amounts of
currency on hand; transactions can be handled with checks, debit cards or credit cards, instead.
Investment Banks

 Investment banking is a specific division of banking related to the creation of capital for
other companies, governments and other entities.
 Investment banks underwrite new debt and equity securities for all types of
corporations, aid in the sale of securities, and help to facilitate mergers and acquisitions,
reorganizations and broker trades for both institutions and private investors.
 Investment banks also provide guidance to issuers regarding the issue and placement of
stock.
For example, suppose that Pete’s Paints Co., a chain supplying paints and other hardware,
wants to go public. Pete, the owner, gets in touch with Jose, an investment banker working for
a larger investment banking firm. Pete and Jose strike a deal wherein Jose (on behalf of his firm)
agrees to buy 100,000 shares of Pete’s Paints for the company’s IPO at the price of $24 per
share, a price at which the investment bank’s analysts arrived after careful consideration. The
investment bank pays $2.4 million for the 100,000 shares and, after filing the appropriate
paperwork, begins selling the stock for $26 per share. Yet, the investment bank is unable to sell
more than 20% of the shares at this price and is forced to reduce the price to $23 per share in
order to sell the remaining shares. For the IPO deal with Pete’s Paints, then, the investment
bank has made $2.36 million [(20,000 x $26) + (80,000 x $23) = $520,000 + $1,840,000 =
$2,360,000]. In other words, Jose’s firm has lost $40,000 on the deal because it overvalued
Pete’s Paints.

Insurance Companies
Insurance companies pool risk by collecting premiums from a large group of people who want to protect
themselves and/or their loved ones against a particular loss, such as a fire, car accident, illness, lawsuit,
disability or death. Insurance helps individuals and companies manage risk and preserve wealth.

Brokerages
A brokerage acts as an intermediary between buyers and sellers to facilitate securities transactions.
Brokerage companies are compensated via commission after the transaction has been successfully
completed. For example, when a trade order for a stock is carried out, an individual often pays a
transaction fee for the brokerage company's efforts to execute the trade.

Nonbank Financial Institutions

The following institutions are not technically banks but provide some of the same services as banks.

Savings and loan associations, also known as S&Ls or thrifts, resemble banks in many respects. Savings
and loans typically offered lower borrowing rates than commercial banks and higher interest rates on
deposits; the narrower profit margin was a byproduct of the fact that such S&Ls were privately or
mutually owned.

Credit Unions
Credit unions are another alternative to regular commercial banks. Credit unions are almost always
organized as not-for-profit cooperatives. Like S&Ls, credit unions typically offer higher rates on deposits
and charge lower rates on loans in comparison to commercial banks.

Financial Market

The financial market is a broad term describing any marketplace where trading of securities
including equities, bonds, currencies and derivatives occurs. Although some financial markets are very
small with little activity, some financial markets including the New York Stock Exchange (NYSE) and
the forex markets trade trillions of dollars of securities daily.

Types of Financial Market

Stock Market

The stock market is a financial market that enables investors to buy and sell shares of publicly traded
companies. The primary stock market is where new issues of stocks are first offered. Any subsequent
trading of stock securities occurs in the secondary market.

Over-The-Counter Market

The over-the-counter (OTC) market is an example of a secondary market. An OTC market handles the
exchanging of public stocks not listed on the NASDAQ, New York Stock Exchange, or American Stock
Exchange. Companies with stocks trading on the OTC market are usually smaller organizations as this
financial market require less regulation is less expensive to be traded on.

Bond Markets

A bond is a security in which an investor loans money for a defined period of time at a pre-established
rate of interest. Bonds are not only issued by corporations but may also be issued by municipalities,
states and federal governments from around the world. Also referred to as the debt, credit or fixed-
income market, the bond market also sells securities such as notes and bills issued from the United
States Treasury.

Money Market

A money market is a portion of the financial market that trades highly liquid and short-term maturities.
The intention of the money market is for short-term borrowing and lending of securities with a maturity
typically less than one year. This financial market trades certificates of deposit, banker’s acceptances,
certain bills, notes and commercial paper.
Derivatives Market

The derivatives market is a financial market that trades securities that derive its value from its
underlying asset. The value of a derivative contract is determined by the market price of the underlying
item. This financial market trades derivatives including forward contracts, futures, options, swaps and
contracts-for-difference.

A derivative is a financial contract with a value that is derived from an underlying asset. Derivatives have
no direct value in and of themselves -- their value is based on the expected future price movements of
their underlying asset.

HOW IT WORKS (EXAMPLE):

Derivatives are often used as an instrument to hedge risk for one party of a contract, while offering the
potential for high returns for the other party. Derivatives have been created to mitigate a remarkable
number of risks: fluctuations in stock, bond, commodity, and index prices; changes in foreign exchange
rates; changes in interest rates; and weather events, to name a few.

One of the most commonly used derivatives is the option. Let's look at an example:

Say Company XYZ is involved in the production of pre-packaged foods. They are a large consumer of
flour and other commodities, which are subject to volatile price movements.

In order for the company to assure any kind of consistency with their product and meet their bottom-
line objectives, they need to be able to purchase commodities at a predictable and market-friendly
rate. In order to do this, company XYZ would enter into an options contract with farmers or wheat
producers to buy a certain amount of their crop at a certain price during an agreed upon period of time.
If the price of wheat, for whatever reason, goes above the threshold, then Company XYZ can exercise
the option and purchase the asset at the strike price. Company XYZ pays a premium for this privilege,
but receives protection in return for one of their most important input costs. If XYZ decides not to
exercise its option, the producer is free to sell the asset at market value to any buyer. In the end,
the partnership acts as a win-win for both parties: Company XYZ is guaranteed a competitive price for
the commodity, while the producer is assured of a fair value for its goods.

Forex Market

The forex market is a financial market where currencies are traded. This financial market is the most
liquid market in the world as cash is the most liquid of assets. The inter-bank market is the financial
system that trades currency between banks.