INTRODUCTION TO BUSINESS FINANCE STUDY NOTES
TABLE OF CONTENTS
CHAPTER 1. .................................................................................................................................................................2
NATURE OF BUSINESS FINANCE ............................................................................................................................2
Objectives......................................................................................................................................................................2
Financial goals of the firm. ...........................................................................................................................................3
Non-financial goals .......................................................................................................................................................4
AGENCY THEORY. .....................................................................................................................................................5
Types of Business Organizations ..................................................................................................................................8
CHAPTER 2 ................................................................................................................................................................ 13
FINANCIAL STATEMENTS ANALYSIS .................................................................................................................. 13
Objectives.................................................................................................................................................................... 13
Sources of Information ............................................................................................................................................... 14
Types of ratios ............................................................................................................................................................. 15
Financial forecasting. ................................................................................................................................................. 20
CHAPTER 3: ............................................................................................................................................................... 27
TIME VALUE OF MONEY. ....................................................................................................................................... 27
Objectives.................................................................................................................................................................... 27
1.compounding ........................................................................................................................................................... 28
2. Discounting .......................................................................................................................................................... 32
CHAPTER 4 ............................................................................................................................................................... 39
COST OF CAPITAL ................................................................................................................................................... 39
Objectives.................................................................................................................................................................... 39
Specific costs of capital ............................................................................................................................................... 40
CHAPTER 5: ............................................................................................................................................................... 49
CAPITAL BUDGETING DECISIONS ....................................................................................................................... 49
Objectives.................................................................................................................................................................... 49
CAPITAL BUDGETING TECHNIQUES. .................................................................................................................. 53
Non-discounted cash flow techniques ....................................................................................................................... 54
discounted cashflow techniques ................................................................................................................................ 56
CHAPTER 6 : .............................................................................................................................................................. 66
BASIC VALUATION MODELS ................................................................................................................................. 66
Objectives.................................................................................................................................................................... 66
Bond valuation ............................................................................................................................................................ 67
preference shares valuation ........................................................................................................................................ 71
valuation of ordinary shares ....................................................................................................................................... 71
CHAPTER 7: .............................................................................................................................................................. 78
WORKING CAPITAL MANAGEMENT................................................................................................................... 78
Content. ...................................................................................................................................................................... 78
a .management of inventory ...................................................................................................................................... 85
b. Management of cash ............................................................................................................................................. 87
c management of receivables ..................................................................................................................................... 91
d. Management of current liablities........................................................................................................................... 97
CHAPTER: 8 ............................................................................................................................................................. 103
,SOURCES OF FUNDS .............................................................................................................................................. 103
Objectives.................................................................................................................................................................. 103
EQUITY FINANCE .................................................................................................................................................. 104
1) ordinary share capital ........................................................................................................................................... 104
2. Term loan .............................................................................................................................................................. 110
3. Preference shares (quasi-equity) .......................................................................................................................... 111
4. Venture capital ..................................................................................................................................................... 112
5.lease financing ....................................................................................................................................................... 112
6.hire purchase ......................................................................................................................................................... 115
Mortgages .................................................................................................................................................................. 116
CHAPTER 9: ............................................................................................................................................................ 118
DIVIDEND POLICY ................................................................................................................................................ 118
CHAPTER 10: .......................................................................................................................................................... 124
FINANCIAL MARKETS ......................................................................................................................................... 124
Financial markets
i. Primary and secondary market 125
capital market authority (cma) ................................................................................................................................ 129
money market instruments ...................................................................................................................................... 131
special financial institutions..................................................................................................................................... 134
other specialised financial institutions .................................................................................................................... 135
ANSWERS TO REINFORCING QUESTIONS ........................................................................................................ 137
GLOSSARY. .............................................................................................................................................................. 178
TABLES ......................................................................................................................... Error! Bookmark not defined.
CHAPTER 1.
NATURE OF BUSINESS FINANCE
Objectives
At the end of this lecture students should be able to:
1. Define finance and discuss the scope and decision areas in financial management.
2. Discuss the goals of financial management.
3. Explain the shareholder/management (agency) conflicts and possible solutions.
4. Describe the types of Business Organizations
5. Describe Risk and required rate of return.
6. Describe investor’s risk profile.
Introduction
What is finance?
Finance is derived from the Latin word which implies to complete a contract. Hence we can define finance as
the application of and optimal utilization of scarce resources. The discipline of finance applies economic
principles and concepts in solving business problems.
Financial management: involves raising and allocating funds to the most productive end user so as to achieve
the objectives of a business or firm.
BUSINESS FINANCE notes Prepared by Mr. Antony Ambia Page 2
,The following are the decision areas in finance:
Financing /Capital structure decision
The financial manager needs to understand the firms capital requirements whether short, medium or long term.
To this end he will ask himself this question “where will we get the financing to pay for investments?”
The capital structure refers to the mix of long term debt, such as debentures, and equity such as reserves and
retained earnings. The financial manager aims at employing the source of funds that will result in the lowest
possible cost to the company.
/Capital budgeting decision
In capital budgeting the financial manager tries to identify investment opportunities that are worth more
(benefits) than they cost to acquire. The essence of capital budgeting is evaluation of investments’ size, risk, and
return the funds raised in the financing decision have to be allocated to a viable investment.
Working capital management
The term Working capital refers to a firm’s current assets and current liabilities. The financial manager has to
ensure that the firm has adequate funds to continue with its operations and meet any day to day obligations.
Maintaining an optimal level is therefore important.
Distribution decision
This involves the distribution of dividend which is payment of a share of the earnings of the company to
ordinary shareholders.
Further details of the above decisions will be discussed later in the text.
The goal of the firm from a financial management perspective could be broadly classified in two;
a. Financial goals.
b. Non-financial goals
Financial goals could be either profit maximization goal or wealth maximization.
Non-financial goals include survival, service provision, growth, or the welfare of employees.
Financial goals of the firm.
Profit-Maximization
Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion:
markets managers of firms direct their efforts toward areas of attractive profit potential using market prices as
their signals. Choices and actions that increase the firm’s profit are undertaken while those that decrease profits
are avoided. To maximize profits the firm must maximize output for a given set of scarce resources, or
equivalently, minimize the cost of producing a given output.
Applying Profit-Maximization Criterion in Financial Management
Financial management is concerned with the efficient use of one economic resource, namely, capital funds. The
goal of profit maximization in many cases serves as the basic decision criterion for the financial manager but
needs transformation before it can provide the financial manger with an operationally useful guideline. As a
benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not take
account of risk; it does not take account of time value of money; it is ambiguous and sometimes arbitrary in its
measurement; and it does not incorporate the impact of non-quantifiable events.
Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of uncertainty: When, as
is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it is no longer
clear what is to be maximized. When faced with uncertainty (risk), most investors providing capital are risk
averse. A good decision criterion must take into consideration such risk.
BUSINESS FINANCE notes Prepared by Mr. Antony Ambia Page 3
, Timing Another major shortcoming of simple profit maximization criterion is that it does not take into account
of the fact that the timing of benefits expected from investments varies widely. Simply aggregating the cash
flows over time and picking the alternative with the highest cash flows would be misleading because money has
time value. This is the idea that since money can be put to work to earn a return, cash flows in early years of a
project’s life are valued more highly than equivalent cash flows in later years. Therefore the profit
maximization criterion must be adjusted to account for timing of cash flows and the time value of money.
Subjectivity and ambiguity A third difficulty with profit maximization concerns the subjectivity and ambiguity
surrounding the measurement of the profit figure. The accounting profit is a function of many, some subjective,
choices of accounting standards and methods with the result that profit figure produced from a given data base
could vary widely.
Qualitative information Finally many events relevant to the firms may not be captured by the profit number.
Such events include the death of a CEO, political development, and dividend policy changes. The profit figure
is simply not responsive to events that affect the value of the investment in the firm. In contrast, the price of
the firms share (which measures wealth of the shareholders of the company) will adjust rapidly to incorporate
the likely impact of such events long before they are their effects are seen in profits.
Value Maximization
Because of the reasons stated above, Value-maximization has replaced profit-maximization as the operational
goal of the firm. By measuring benefits in terms of cash flows value maximization avoids much of the ambiguity
of profits. By discounting cash flows over time using the concepts of compound interest, Value maximization
takes account of both risk and the time value of money. By using the market price as a measure of value the
value maximization criterion ensures that (in an efficient market) its metric is all encompassing of all relevant
information qualitative and quantitative, micro and macro. Let us note here that value maximization is with
respect to the interests of the providers of capital, who ultimately are the owners of the firm. – The
maximization of owners’ wealth is the principal goal to be aimed at by the financial manager.
In many cases the wealth of owners will be represented by the market value of the firm’s shares - that is the
reason why maximization of shareholders wealth has become synonymous with maximizing the price of the
company’s stock. 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 present and 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. Management must focus on creating value for shareholders. This requires Management to judge
alternative investments, financing and assets management strategies in terms of their effects on shareholders
value (share prices).
Non-financial goals
Social Responsibility and Ethics
It has been argued that the unbridled pursuit of shareholders wealth maximization makes companies unscrupulous,
anti social, enhances wealth inequalities and harms the environment. The proponents of this position argue that
maximizing shareholders wealth should not be pursued without regard to a firm’s corporate social responsibility.
The argument goes that the interest of stakeholders other than just shareholders should be taken care of. The other
stakeholders include creditors, employees, consumers, communities in which the firm operates and others. The firm
will protect the consumer; pay fair wages to employees while maintaining safe working conditions, support
education and be sensitive to the environment concerns such as clean air and water. A firm must also conduct itself
ethically (high moral standards) in its commercial transactions.
Being socially responsible and ethical cost money and may detract from the pursuit of shareholders wealth
maximization. So the question frequently posed is: is ethical behavior and corporate social responsibility
inconsistent with shareholder wealth maximization?
BUSINESS FINANCE notes Prepared by Mr. Antony Ambia Page 4
TABLE OF CONTENTS
CHAPTER 1. .................................................................................................................................................................2
NATURE OF BUSINESS FINANCE ............................................................................................................................2
Objectives......................................................................................................................................................................2
Financial goals of the firm. ...........................................................................................................................................3
Non-financial goals .......................................................................................................................................................4
AGENCY THEORY. .....................................................................................................................................................5
Types of Business Organizations ..................................................................................................................................8
CHAPTER 2 ................................................................................................................................................................ 13
FINANCIAL STATEMENTS ANALYSIS .................................................................................................................. 13
Objectives.................................................................................................................................................................... 13
Sources of Information ............................................................................................................................................... 14
Types of ratios ............................................................................................................................................................. 15
Financial forecasting. ................................................................................................................................................. 20
CHAPTER 3: ............................................................................................................................................................... 27
TIME VALUE OF MONEY. ....................................................................................................................................... 27
Objectives.................................................................................................................................................................... 27
1.compounding ........................................................................................................................................................... 28
2. Discounting .......................................................................................................................................................... 32
CHAPTER 4 ............................................................................................................................................................... 39
COST OF CAPITAL ................................................................................................................................................... 39
Objectives.................................................................................................................................................................... 39
Specific costs of capital ............................................................................................................................................... 40
CHAPTER 5: ............................................................................................................................................................... 49
CAPITAL BUDGETING DECISIONS ....................................................................................................................... 49
Objectives.................................................................................................................................................................... 49
CAPITAL BUDGETING TECHNIQUES. .................................................................................................................. 53
Non-discounted cash flow techniques ....................................................................................................................... 54
discounted cashflow techniques ................................................................................................................................ 56
CHAPTER 6 : .............................................................................................................................................................. 66
BASIC VALUATION MODELS ................................................................................................................................. 66
Objectives.................................................................................................................................................................... 66
Bond valuation ............................................................................................................................................................ 67
preference shares valuation ........................................................................................................................................ 71
valuation of ordinary shares ....................................................................................................................................... 71
CHAPTER 7: .............................................................................................................................................................. 78
WORKING CAPITAL MANAGEMENT................................................................................................................... 78
Content. ...................................................................................................................................................................... 78
a .management of inventory ...................................................................................................................................... 85
b. Management of cash ............................................................................................................................................. 87
c management of receivables ..................................................................................................................................... 91
d. Management of current liablities........................................................................................................................... 97
CHAPTER: 8 ............................................................................................................................................................. 103
,SOURCES OF FUNDS .............................................................................................................................................. 103
Objectives.................................................................................................................................................................. 103
EQUITY FINANCE .................................................................................................................................................. 104
1) ordinary share capital ........................................................................................................................................... 104
2. Term loan .............................................................................................................................................................. 110
3. Preference shares (quasi-equity) .......................................................................................................................... 111
4. Venture capital ..................................................................................................................................................... 112
5.lease financing ....................................................................................................................................................... 112
6.hire purchase ......................................................................................................................................................... 115
Mortgages .................................................................................................................................................................. 116
CHAPTER 9: ............................................................................................................................................................ 118
DIVIDEND POLICY ................................................................................................................................................ 118
CHAPTER 10: .......................................................................................................................................................... 124
FINANCIAL MARKETS ......................................................................................................................................... 124
Financial markets
i. Primary and secondary market 125
capital market authority (cma) ................................................................................................................................ 129
money market instruments ...................................................................................................................................... 131
special financial institutions..................................................................................................................................... 134
other specialised financial institutions .................................................................................................................... 135
ANSWERS TO REINFORCING QUESTIONS ........................................................................................................ 137
GLOSSARY. .............................................................................................................................................................. 178
TABLES ......................................................................................................................... Error! Bookmark not defined.
CHAPTER 1.
NATURE OF BUSINESS FINANCE
Objectives
At the end of this lecture students should be able to:
1. Define finance and discuss the scope and decision areas in financial management.
2. Discuss the goals of financial management.
3. Explain the shareholder/management (agency) conflicts and possible solutions.
4. Describe the types of Business Organizations
5. Describe Risk and required rate of return.
6. Describe investor’s risk profile.
Introduction
What is finance?
Finance is derived from the Latin word which implies to complete a contract. Hence we can define finance as
the application of and optimal utilization of scarce resources. The discipline of finance applies economic
principles and concepts in solving business problems.
Financial management: involves raising and allocating funds to the most productive end user so as to achieve
the objectives of a business or firm.
BUSINESS FINANCE notes Prepared by Mr. Antony Ambia Page 2
,The following are the decision areas in finance:
Financing /Capital structure decision
The financial manager needs to understand the firms capital requirements whether short, medium or long term.
To this end he will ask himself this question “where will we get the financing to pay for investments?”
The capital structure refers to the mix of long term debt, such as debentures, and equity such as reserves and
retained earnings. The financial manager aims at employing the source of funds that will result in the lowest
possible cost to the company.
/Capital budgeting decision
In capital budgeting the financial manager tries to identify investment opportunities that are worth more
(benefits) than they cost to acquire. The essence of capital budgeting is evaluation of investments’ size, risk, and
return the funds raised in the financing decision have to be allocated to a viable investment.
Working capital management
The term Working capital refers to a firm’s current assets and current liabilities. The financial manager has to
ensure that the firm has adequate funds to continue with its operations and meet any day to day obligations.
Maintaining an optimal level is therefore important.
Distribution decision
This involves the distribution of dividend which is payment of a share of the earnings of the company to
ordinary shareholders.
Further details of the above decisions will be discussed later in the text.
The goal of the firm from a financial management perspective could be broadly classified in two;
a. Financial goals.
b. Non-financial goals
Financial goals could be either profit maximization goal or wealth maximization.
Non-financial goals include survival, service provision, growth, or the welfare of employees.
Financial goals of the firm.
Profit-Maximization
Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion:
markets managers of firms direct their efforts toward areas of attractive profit potential using market prices as
their signals. Choices and actions that increase the firm’s profit are undertaken while those that decrease profits
are avoided. To maximize profits the firm must maximize output for a given set of scarce resources, or
equivalently, minimize the cost of producing a given output.
Applying Profit-Maximization Criterion in Financial Management
Financial management is concerned with the efficient use of one economic resource, namely, capital funds. The
goal of profit maximization in many cases serves as the basic decision criterion for the financial manager but
needs transformation before it can provide the financial manger with an operationally useful guideline. As a
benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not take
account of risk; it does not take account of time value of money; it is ambiguous and sometimes arbitrary in its
measurement; and it does not incorporate the impact of non-quantifiable events.
Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of uncertainty: When, as
is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it is no longer
clear what is to be maximized. When faced with uncertainty (risk), most investors providing capital are risk
averse. A good decision criterion must take into consideration such risk.
BUSINESS FINANCE notes Prepared by Mr. Antony Ambia Page 3
, Timing Another major shortcoming of simple profit maximization criterion is that it does not take into account
of the fact that the timing of benefits expected from investments varies widely. Simply aggregating the cash
flows over time and picking the alternative with the highest cash flows would be misleading because money has
time value. This is the idea that since money can be put to work to earn a return, cash flows in early years of a
project’s life are valued more highly than equivalent cash flows in later years. Therefore the profit
maximization criterion must be adjusted to account for timing of cash flows and the time value of money.
Subjectivity and ambiguity A third difficulty with profit maximization concerns the subjectivity and ambiguity
surrounding the measurement of the profit figure. The accounting profit is a function of many, some subjective,
choices of accounting standards and methods with the result that profit figure produced from a given data base
could vary widely.
Qualitative information Finally many events relevant to the firms may not be captured by the profit number.
Such events include the death of a CEO, political development, and dividend policy changes. The profit figure
is simply not responsive to events that affect the value of the investment in the firm. In contrast, the price of
the firms share (which measures wealth of the shareholders of the company) will adjust rapidly to incorporate
the likely impact of such events long before they are their effects are seen in profits.
Value Maximization
Because of the reasons stated above, Value-maximization has replaced profit-maximization as the operational
goal of the firm. By measuring benefits in terms of cash flows value maximization avoids much of the ambiguity
of profits. By discounting cash flows over time using the concepts of compound interest, Value maximization
takes account of both risk and the time value of money. By using the market price as a measure of value the
value maximization criterion ensures that (in an efficient market) its metric is all encompassing of all relevant
information qualitative and quantitative, micro and macro. Let us note here that value maximization is with
respect to the interests of the providers of capital, who ultimately are the owners of the firm. – The
maximization of owners’ wealth is the principal goal to be aimed at by the financial manager.
In many cases the wealth of owners will be represented by the market value of the firm’s shares - that is the
reason why maximization of shareholders wealth has become synonymous with maximizing the price of the
company’s stock. 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 present and 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. Management must focus on creating value for shareholders. This requires Management to judge
alternative investments, financing and assets management strategies in terms of their effects on shareholders
value (share prices).
Non-financial goals
Social Responsibility and Ethics
It has been argued that the unbridled pursuit of shareholders wealth maximization makes companies unscrupulous,
anti social, enhances wealth inequalities and harms the environment. The proponents of this position argue that
maximizing shareholders wealth should not be pursued without regard to a firm’s corporate social responsibility.
The argument goes that the interest of stakeholders other than just shareholders should be taken care of. The other
stakeholders include creditors, employees, consumers, communities in which the firm operates and others. The firm
will protect the consumer; pay fair wages to employees while maintaining safe working conditions, support
education and be sensitive to the environment concerns such as clean air and water. A firm must also conduct itself
ethically (high moral standards) in its commercial transactions.
Being socially responsible and ethical cost money and may detract from the pursuit of shareholders wealth
maximization. So the question frequently posed is: is ethical behavior and corporate social responsibility
inconsistent with shareholder wealth maximization?
BUSINESS FINANCE notes Prepared by Mr. Antony Ambia Page 4
