Module 1: Introduction to Finance

Goals and Functions of Finance

Module-wise list of topics
Module 1: Introduction to Finance Module 2: Working Capital Management
• Session 1 – Goals and Functions of Finance • Session 4 – Working Capital Planning
• Session 2 – Financial Statements: from • Session 5 – Managing the Receivables
Accounting to Finance
• Session 6 – Working Capital Management
• Session 3 – Financial Planning and Forecasting

Module 3: Valuation, Risk and Return Module 4: Introduction to Corporate

•Session 7 – Time Value of Money Financing
•Session 8 – Bond Valuation • Session 12 – Financial System
•Session 9 – Stock Valuation • Session 13 – Financial Markets
•Session 10 – Basics of Risk and Return • Session 14 – Market Efficiency
•Session 11 – Introducing Asset Pricing Models
• Session 15 – Integrating the Essentials of Finance
with the Financial Environment
Session 1 – Goals and Functions of Finance
Agenda of the Session
• What is Finance and its coverage?
• Types of Business Organizations
• Functions of Finance
• Decisions of Corporate Finance
• Agency Problem
• Goal of the Firm
• How to maximise value for shareholder?
“Management of Money”
“How Individuals, Governments and Businesses
Acquire, Spend and Manage Money or Financial
assets”
• Three Levels of Finance
• Public Finance
• Corporate Finance (Including Business Finance)
• Personal Finance
Why is corporate finance important to all managers?

• Corporate finance provides the skills managers

need to:
• Identify and select the corporate strategies and
individual projects that add value to their firm.
• Forecast the funding requirements of their
company, and devise strategies for acquiring
those funds.
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Type of Business Organizations

• Sole proprietorship
• Partnership
• Corporation

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 The THREE Important Decisions in Finance
• Corporate finance attempts to find the answers to the following questions:

• What investments should the business take on? Or Where to Invest?

THE INVESTMENT DECISION

• How can finance be obtained to pay for the required investments? Or

Source of Funding?
THE FINANCE/FINANCING DECISION

• Should dividends be paid? If so, how much?- How to Pay and How much
to retain?
THE DIVIDEND DECISION
THREE IMPORTANT Decisions of Finance
Balance Sheet Model of a Firm
Total Value of Assets Total Firm Value to Investors

Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets
What Long term
1 Tangible investments Shareholders’
2 Intangible should the firm Equity
engage in ?
The Investment Decision
 Capital budgeting is the planning and control of cash
outflows in the expectation of deriving future cash
inflows from investments in non-current assets.

 Involves evaluating the:

 size of future cash flows
 timing of future cash flows
 risk of future cash flows.
Evaluation criteria of a Investment Decision
 Question

Which of the following are NOT capital budgeting decisions? 

a. Intel decides to spend $1 billion to develop a new
microprocessor. 
b. Volkswagen borrows 350 million euros (€350 million) from
Deutsche Bank. 
c. BP constructs a pipeline to bring natural gas onshore from a
production platform in the Gulf of Mexico. 
d. Budweiser spends €200 million to launch a new brand of beer in
European markets. 
 Examples of Investment Decision
Company Recent Investment Decisions

Boeing (U.S.) Delivers first Dreamliner after investing a reported $30 billion in development costs.

ExxonMobil (U.S.) Spends $7 billion to develop oil sands at Fort McMurray in Alberta.

GlaxoSmith-Kline (UK) Spends $4 billion on research and development for new drugs.

LVMH (France) LVMH acquires the Italian Jeweler, Bulgari, for $5 billion.
Procter & Gamble (U.S.) Spends $8 billion on advertising.

Tata Motors (India) Opens a plant in India to produce the world's cheapest car, the Nano. The facility costs
$400 million.
Union Pacific (U.S.) Invests $330 million in 100 new locomotives and 10,000 freight cars and chassis.

Vale (Brazil) Opens a copper mine at Salobo in Brazil. The project cost nearly $2 million.

Walmart (U.S.) Invests 12.7 billion, primarily to open 458 new stores around the world.
Cash Flow Size
 Accounting income does not mean Cash flow.
Both are different
 For example, a sale is recorded at the time of sale and a
cost is recorded when it is incurred, not when the cash is
exchanged.
 Accounting profits are on Accrual basis whereas cash
flow is based on Real cash.
Cash Flow Timing
 A rupee today is worth more than a rupee at some future
date.

 There is a trade-off between the size of an investment’s

cash flow and when the cash flow is received.
 Cash Flow Timing – Time value for Money

Rs100 ≠ Rs100 in 10 years time

With a discount rate the Rs100 could be Rs150 ten

years later.

Rs100 Rs150
Compounding

Rs100 Rs150
Discounting
Cash Flow Timing
Which is the better project?
Future Cash Flows (in Rs)
Year Project A Project B
1 0 20 000
2 10 000 10 000
3 20 000 0
Total 30 000 30 000
 Cash Flow Timing
 With the discount rate of 10%
-Year 1 factor = 0.9091
-Year 2 factor =0.8264
-Year 3 factor =0.7513

Discounted Cash Flow :

Year Project A (Rs) Project B( Rs)
1 0 18,182
2 8,264 8,264
3 15,026 0
Total 23,290 26,446

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 Examples of Investment Decisions
•Maharatna PSU Steel Authority of India (SAIL) will invest an additional Rs 42,000 crore
in West Bengal over the next 10 years under its capacity expansion programme .

•Board of ONGC, has two major investment decisions valued over Rs. 10,600 crores for
further enhancing production from its Western Offshore fields.
•The projects are- Redevelopment (Phase-III) of its giant offshore field - Mumbai High
(South) involving a capital investment of Rs 6,069 crores and Integrated Development of
Mukta, Bassein and Panna Formations at an estimated Capex of Rs. 4,620 Crore
(Source:http://ongcindia.com/wps/wcm/connect/ongcindia/home/media/press_releas
e/ongc-decides-invest-10600crore)

• Parle Agro is planning to invest Rs 150 crores to expand its manufacturing and distribution
this year.
Balance Sheet Model of a Firm
2. Capital Structure/ Financing Decision
Total Firm Value to Investors
Total Value of Assets
Current
Liabilities

Current Assets
How can the firm Long-Term
raise the money Debt
for the require
investments?

Fixed Assets
1 Tangible Shareholder
s’ Equity
2 Intangible
 Finance Decision (Capital Structure)
 A firm’s capital structure is the specific mix of debt and
equity used to finance the firm’s operations.

 Decisions need to be made on both the financing mix and

how and where to raise the money.

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 Finance Decision (Capital Structure)

Q1 : How much finance is needed? ( Large or small amount?)

Q2: What type of source of finance? ( Debt? Equity? Reserve?
Long term? Short term?)
Q3: What is the advantages and disadvantages of Debt and
Equity?
Q4: How much is the cost of finance?
Q5: What is the impact to the optimal capital structure?
 Question
Which of the following are financing decisions? 
a. Intel decides to spend $1 billion to develop a new microprocessor. 
b. Volkswagen borrows 350 million euros (€350 million) from Deutsche Bank. 

c. BP constructs a pipeline to bring natural gas onshore from a production

platform in the Gulf of Mexico. 
d. Budweiser spends €200 million to launch a new brand of beer in European
markets. 
e. Pfizer issues new shares to buy a small biotech company.
 Capital Structure

The value of the firm can be thought of as

a pie.
70 %Debt
30% Equity
The goal of the manager is to increase 50% Debt

the size of the pie.

75%
50%
Equity
The Capital Structure decision can be
viewed as how best to slice up the pie.

If how you slice the pie affects the size of the pie, then the capital
structure decision matters.
More on How to
Grow The PIE
 Working Capital Management

 AlsoKnown as Liquidity Decision

 How much cash and inventory should be kept on
hand?

 Should credit terms be extended? If so, what are the

conditions?

 How is short-term financing acquired?

Balance Sheet Model of a Firm
3. Net Working Capital Investment Decision
Total Value of Assets: Total Firm Value to Investors:

Current
Net
Net
Current Assets Working
Working
Liabilities
Capital
Capital

Long-Term
How much short Debt
term cash flow
does a company
Fixed Assets needs to pay its
1 Tangible bills?
2 Intangible Shareholder
s’ Equity
Dividend Decision
 Involves the decision of whether to pay a dividend to
shareholders or maintain the funds within the firm for
internal growth.

 Factors important to this decision include growth

opportunities, taxation and shareholders’ preferences.
 Dividend Decision
 Pay or not to pay?

 Impact to the internal growth of the company

 Long term and Short term investors

Agency Problem
Separation of Ownership and Management

Board of Directors

Debtholders

Shareholders
Management

Debt
Assets
Equity
Agency Relationship and Conflicts
 Agency Relationships
 The agency relationship is the relationship between the shareholders
(owners) and the management of a firm.

 The agency problem is the possibility of conflict of interests between

these two parties.

 Agency costs refer to the direct and indirect costs arising from this
conflict of interest.
 Agency costs
Direct Agency Costs:
Corporate Expenditure
Cost incurred in monitoring the managers

Indirect Agency Cost:

Lost of opportunities by the firm- Principle 1 (Delaying
projects or decreasing value creating activities- Earning
management)
Mergers and Acquisitions
 Do Managers Act in Shareholders’ Interests?

The answer to this will depend on two factors:

 How closely management goals are aligned with shareholder

goals. (Compensations)- Refer discussion in HBR article

 The ease with which management can be replaced if it does

not act in shareholders’ best interests. (Fear motivation /
Threaten)
 Alignment of Goals
The conflict of interests is limited due to:

 management compensation schemes

(Share option scheme, bonus, performance related salary, etc.) -Refer HBS
note “ Ten ways to create shareholder value” Principal 6-9.

 monitoring of management ( To conduct internal audit, control of unnecessary

costs, etc.)

 the threat of takeover

(Poorly operate firm increase the risk of acquisition / takeover, Job security.)

 Others (Free trip, proxy fight, promotion, etc.)

Understand the goal of financial management.
 Possible Goals of Financial Management
 Survival – No growth
 Avoid financial distress and bankruptcy – No growth
 Beat the competition – Benchmark?
 Maximize sales – Relax credit term? Offer discounted price?
 Maximize market share – Long term or Short term?
 Minimize costs – Reduce R&D costs, quality of raw materials?
 Maximize profits – Risk attached? Deferring maintenance?
 Maintain steady earnings growth – Rate as compare to the market
growth?
 Problems with these Goals
 Each of these goals presents problems.

 These goals are either associated with increasing profitability or

reducing risk.

 They are not consistent with the long-term interests of shareholders.

(Refer Principle 2, 3 and 4 of Ten ways to create shareholder value)

 It is necessary to find a goal that can encompass both profitability

and risk.
What should be management’s primary
objective?
 The primary objective should be shareholder wealth
maximization, which translates to maximizing the
fundamental stock price.
 Should firms behave ethically? YES!
 Do firms have any responsibilities to society at large? YES!
Shareholders are also members of society.
 Is maximizing stock price good?
 Consumer welfare is higher in capitalist free market
economies than in communist or socialist economies.
 Fortune lists the most admired firms. In addition to
high stock returns, these firms have:
 high quality from customers’ view
 employees who like working there
 concerns for social issues like climate change!

In recent years issues like ESG metrics proved market

discount the variables like E, S G factors
What three aspects of cash flows affect
an investment’s value?
 Amount of expected cash flows (bigger is better- early
recovery is preferred over late.)
 Timing of the cash flow stream (sooner is better- Time value
of money)
 Risk of the cash flows (less risk is better- Investor are risk
averse)
Managers can the firm’s value by size of expected Cash
flow, by speeding up Receipt of cash and by reducing the Risk
Free Cash Flows (FCF)

 Free cash flows are the cash flows that are available (or
free) for distribution to all investors (stockholders and
creditors).
 FCF = sales revenues - operating costs - operating taxes -
required investments in new operating capital.

Will elaborate FCF more in coming slides and Session 2 in

detail.
How Managers can Increase FCF?
 Each Manager can contribute to increase FCF.
 Marketing Manager/ Brand Manager
 Understanding the need of Customer, Designing product that customer
want.
 This will lead to increase in Sales and contribute to Cash flow
 Human Resource Manager
 Increasing or improving productivity by Training and development, employee
retention
 Production and Logistic Manager
 Can improve profit margin, reducing inventory and improved output by
implementing SCM, JIT and Lean processes
 Finance Manger
 Selecting the projects that generate cash flow (refer Principle 4
of HBS article- Carry only assets that maximise value)
 How to finance the firm
 Selecting the low cost source's of finance . This will result in increase in
Intrinsic Value.

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What determines a firm’s fundamental, or
intrinsic value?

Intrinsic value is the sum of all the future expected free

cash flows when converted into today’s Rupees:

FCF1 FCF2 FCF∞

Value = + +…+
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

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 What is the weighted average cost of capital
(WACC)?
 WACC is the average rate of return required by all of the
company’s investors.
 WACC is affected by:
 Capital structure (the firm’s relative use of debt and equity as sources of
financing)
 Interest rates
 Risk of the firm
 Investors’ overall attitude toward risk
 Determinants of Intrinsic Value: The Big Picture
Sales revenues

− Operating costs and taxes

Required Investment − Required investments in operating capital
in operating capital =
Net operating working capital
Free cash flow
+ =
(FCF)
Operating long term assets

FCF1 FCF2 FCF∞

Value = + + +...
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

Goals of Firms
 At P&G, we are focused on building consumer-preferred
brands and products that create value for consumers and
shareowners.
 Nestle- Beyond meeting our commitments on
environmental sustainability and compliance we aim to
create shared value for society and shareholders.
 Tata group is committed in improving the quality of life of
the communities . Our practice of returning to society
what we earn evokes trust among consumers,
employees, shareholders and the community.

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 Vision of Indian Companies
HUL
 We meet everyday needs for nutrition, hygiene and personal care with brands that help people feel good, look good and get more out
of life. Sustainability is at the heart of our business, and through our brands, we seek to inspire people to take small everyday actions
that can add up to a big difference for the world.
 Our deep roots in local cultures and markets around the world give us our strong relationship with consumers and are the foundation
for our future growth. We will bring our wealth of knowledge and international expertise to the service of local consumers – a truly multi-
local multinational.
 Our long-term success requires a total commitment to exceptional standards of performance and productivity, to working together
effectively, and to a willingness to embrace new ideas and learn continuously.
 To succeed also requires, we believe, the highest standards of corporate behaviour towards everyone we work with, the communities
we touch, and the environment on which we have an impact.
 This is our road to sustainable, profitable growth, creating long-term value for our shareholders, our people, and our business partner
 TCS
 "TCS will be recognized and respected as professional,
innovative, profitable information, and knowledge based
logistics/services enterprise. TCS embeds internet based
technologies into its internal operating structures and as
business solutions for customers; with customer,
employee and shareholder interests at the core of its
operations; demonstrating a clear concern for ethical
conduct and good corporate citizenship; with the
objective of growing into a regional and global player,
with emphasis on the Middle East, Europe and North
America".
 Reliance Industries Limited
 Create value for all stakeholders
 Grow through innovation
 Lead in good governance practices
 Use sustainability to drive product development
and
 enhance operational efficiencies
 Ensure energy security of the nation
 Foster rural prosperity
Ranbaxy
ICICI Bank
Coco -Cola
Recap
 What is Finance?
 Types of Business Organizations
 Functions of Finance
 Decisions of Corporate Finance
 Agency Problem
 Goal of the Firm
 How to maximise value for shareholder?
Questions ?

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