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PRINCIPLES OF
FINANCE
I.K. Gunarta
Slide Contents
¨  Learning Objectives
¨  Introduction

1.  Finance: An Overview


2.  Three Types of Business Organizations
3.  The Goal of the Financial Manager
4.  The Five Basic Principles of Finance
¨  Key Terms
Learning Objectives
1.  Understand the importance of finance
in your personal and professional lives
and identify the three primary business
decisions that financial managers make.

2.  Identify the key differences between


the three major legal forms of business.
Learning Objectives (cont.)
3.  Understand the role of the financial
manager within the firm and the goal
for making financial choices.

4.  Explain the five principles of finance


that form the basis of financial
management for both businesses and
individuals.
FINANCE: AN OVERVIEW
What is Finance?

Finance is the study of how


people and businesses evaluate
investments and raise capital to
fund them.
What is Finance?
¨  Finance is an important part of modern life.
¨  Large firms and individuals use the same
financial concepts to increase wealth.
¨  Money is the object of finance’s attention:
how to spend and to invest it to create
wealth.
¨  Finance looks at investment alternatives and
provides guidelines to make better decisions.
¨  Neither more finance nor more money can
make you a happier person, but they help!
Three Basic Questions Addressed
by the Study of Finance:
1.  What long-term investments should the
firm undertake?
2.  How should the firm raise money to
fund these investments?
3.  How can the firm best manage its cash
flows as they arise in its day-to-day
operations?
Goal of Finance

Relative Value (worth)

•  What’s it worth?
n  Difficult to judge in the real world.
n  Depends on forecasts, formulas,
and common sense.

•  Valuation is art and science.


Law of One Price
¨  Identical items should sell for the same price.
¨  If you try to price one of two identical cars too high, what
will happen? (No sale, right?)
¨  If the car is priced too low, what happens? (Too cheap,
eh?)
¨  The car’s opportunity cost matters: the amount for which
you can buy or sell an identical item in the same place.
¨  The difficulty occurs when the items are not exactly
“similar” or when they have unique characteristics: such as
a house with an ocean view vs. one with an alley view.
Investments, Projects, and Firms

¨  Finance usually examines the cash flows of a project, plus


all benefits and expenses, including opportunity costs, to
find its value.
¨  Finance can examine the value of very small
investments or multibillion dollar firms in the same way
it looks at projects.
¨  Cash is cash. You also need to understand the operating
characteristics of the business, which produce and consume
cash, so that you can improve your valuation estimate.
¨  When investors invest on good information they are
rewarded over the long term: so good valuation practices
are a part of creating wealth.
Financial Management

Concerned with the


maintenance and
creation of economic
value or wealth.

focuses on decision making


with an eye toward
creating wealth
Financial Decisions
¨  Keputusan pengembangan produk baru.
¨  Keputusan investasi pada asset-asset baru.

¨  Keputusan penggantian asset eksisting.

¨  Keputusan peminjaman dana dari bank.

¨  Keputusan penerbitan saham atau obligasi.

¨  Keputusan untuk menambah kredit ke


pelanggan.
¨  Keputusan seberapa besar me maintain kas.
Who Created Wealth

MERCK GENERAL
VS MOTORS
At the end of 2003, the Valued at $30 billion at the
total market value of end of 2003; but over the
Merck, a large years, GM's investors had
pharmaceutical company, actually invested $85 billion.
was $103 billion.
Over the life of the
business, Merck's investors
had invested about $30
billion in the business.
Goal of the Firm?

Memaksimumkan kekayaan
pemegang saham dengan cara
memaksimumkan harga saham
perusahaan.
Profit Maximization
Ø  Stresses the efficient use of capital resources
Ø  Not specific to time frame for profits to be
measured
Ø  Ignores uncertainty and timing
Major Functions in Finance

(2) (1)

Financial
Firm’s (4a) Financial
Operations manager Market

(3) (4b)

(1) Cash raised from investors


(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
Hubungan Korporasi dan Pasar Uang

Korporasi Kas Investor

Pasar sekunder
Korporasi
Surat-surat berharga (Sekuritas)
melakukan
investasi
dalam asset Investasi kembali
yang dapat Surat-surat
menghasilkan berharga yang
diperdagangkan
imbal hasil Aliran kas operasi Modal dibagi ke investor
antar investor

Pajak

Pemerintah
Why Study Finance?
¨  Knowledge of financial tools is critical to
making good decisions in both corporate
world and personal lives.

¤  How
will Krakatau Steel’s (Indonesian
biggest steel industry) decision to invest
$2.4 billion to produce the steel require the
expertise of different disiplines within the
business school?
THREE TYPES OF BUSINESS
ORGANIZATIONS
Business Organizational Forms

Business
Forms

Sole
Partnerships
Proprietorships Corporations
Sole Proprietorship
¨  It is a business owned by a single
individual who is entitled to all of the
firm s profits and is responsible for all of
the firm s debt.

¨  The sole proprietors typically raise


money by investing their own funds and
by borrowing from a bank.
Sole Proprietorship (cont.)
¨  Advantages:
¤  Easy to start
¤  No need to consult others while making
decisions
¤  Taxed at the personal tax rate

¨  Disadvantages:
¤  Personally liable for the business debts
¤  The business ceases on the death of the
proprietor
¤  Harder to raise money
Partnership
A general partnership is an association
of two or more persons who come
together as co-owners for the purpose of
operating a business for profit.
Partnership (cont.)
¨  Advantages:
¤  Relativelyeasy to start
¤  Taxed at the personal tax rate

¤  Access to funds from multiple sources or


partners

¨  Disadvantages:
¤  Partners jointly share unlimited liability
¤  It is not always easy to transfer ownership
Partnership (cont.)
¨  In limited partnerships, there are two
classes of partners: general and limited.

¨  The general partner runs the business


and faces unlimited liability for the firm s
debts, whereas the limited partner is
only liable up to the amount the limited
partner invested.
Corporation
If very large sums of money are needed to
build a business, then the typical
organizational form chosen is the
corporation. The corporation is legally
owned by its current set of stockholders,
or owners.
Corporation (cont.)
¨  Corporation legally functions separately
and apart from its owners (the
shareholders). Corporation can
individually sue and be sued.

¨  The Board of directors are elected by the


shareholder, and the board appoints the
senior management of the firm.
Corporation (cont.)
¨  Advantages
¤  Liability of owners is limited to invested
funds
¤  Life of corporation is not tied to the owner

¤  Easier to transfer ownership

¤  Easier to raise Capital

¨  Disadvantages
¤  Greater regulation
¤  Double taxation of dividends
Limited Liability Company
(LLC)
Limited liability company (LLC)
combines the tax benefits of a partnership
(no double taxation of earnings) with the
limited liability benefit of corporation (the
owner s liability is limited to what they
invest).
Characteristics of Different Forms
of Business
How the Finance Area Fits into
a Corporation
THE GOAL OF THE FINANCIAL
MANAGER
The Goal of the Financial Manager

The goal of the financial manager must be


consistent with the mission of the
corporation, which is to maximize
shareholder s wealth.
Coca-Cola s Vision Statement

To achieve sustainable growth, we have


established a vision with clear goals for:
¤  Profit

¤  People
¤  Portfolio

¤  Partners

¤  Planet
Corporate Mission
¨  While managers have to cater to all the
stakeholders (such as consumers,
employees, suppliers etc.), they need to
pay particular attention to the shareholders.

¨  If managers fail to pursue shareholder


wealth maximization, they will lose the
support of investors and lenders. The
business may cease to exist and ultimately,
the managers will lose their jobs!
Ethics in Finance
¨  What do we mean by Ethics?

¨  Give examples of recent financial


scandals and discuss what went wrong
from an ethical perspective.
Sarbanes-Oxley Act (SOX)
¨  SOX Act was passed in 2002 to protect
investors by improving the accuracy and
reliability of corporate disclosures made
pursuant to the securities laws, and for
other purposes .

¨  SOX Act mandates senior executives to


take responsibility for the accuracy and
completeness of financial reports.
THE FIVE BASIC PRINCIPLES OF
FINANCE
PRINCIPLE 1:Money Has a
Time Value
¨  A dollar received today is worth more
than a dollar received in the future.

¨  We can invest the dollar received today


to earn interest. Thus, in the future, you
will have more than one dollar, as you
will receive the interest on your
investment.
PRINCIPLE 2: There is a Risk-
Return Trade-off
¨  We won t take on additional risk unless
we expect to be compensated with
additional return.

¨  Higher the risk, higher will be the


expected return. Note expected return
may not be equal to the realized rate of
return.
There Is a Risk-Return
Tradeoff
PRINCIPLE 3: Cash Flows Are
the Source of Value
¨  Profit is an accounting concept and
measures a business s performance.
Cash flow is the amount of cash that can
actually be taken out of the business.

¨  It is possible for a firm to report profits


but have no cash.
Incremental Cash Flow
Financial decisions in a firm should
consider incremental cash flow i.e. the
difference between the cash flows the
company will produce with the potential
new investment and what it would make
without the investment.
PRINCIPLE 4: Market Prices
Reflect Information
Investors react quickly to news/
information and decisions made by
managers.

Good News ==> Higher stock prices


Bad News ==> Lower stock price.
PRINCIPLE 5: Individuals Respond
to Incentives
Managers (as agents) respond to
incentives they are given in the workplace.
If their incentives are not properly aligned
with those of the firm s stockholders (the
principal) they may not make decisions
that are consistent with increasing
shareholder value leading to agency costs.
PRINCIPLE 5: Individuals Respond
to Incentives (cont.)
The agency problems/costs can be mitigated through:
1.  Compensation plans that reward managers when they act to
maximize shareholder wealth
2.  Monitoring by the board of directors
3.  Monitoring by financial markets (such as auditors, bankers,
security analysts, credit agencies)
4.  The underperforming firms seeing their stock prices fall and
face threat of being taken over and have their management
teams replaced.
Key Terms
¨  Agency problem
¨  Capital budgeting

¨  Capital structure

¨  Corporation

¨  Debt

¨  Dividends

¨  Equity
Key Terms (cont.)
¨  Financial markets
¨  General partner

¨  General partnership

¨  Limited liability company (LLC)

¨  Limited partner

¨  Limited partnership

¨  Opportunity cost


Key Terms (cont.)
¨  Partnership
¨  Shareholders

¨  Shares

¨  Sole proprietorship

¨  Stockholders

¨  Working capital management