Business Finance Reviewer PDF

Module 1: Introduction to Business Finance 1. Definition of Finance - Finance is the study of how people and businesses evaluate investments and raise capital to fund them. It addresses how money is obtained and used, and how savings are allocated between lenders and borrowers. 2. Differences Betw...

Module 1: Introduction to Business Finance 1. Definition of Finance - Finance is the study of how people and businesses evaluate investments and raise capital to fund them. It addresses how money is obtained and used, and how savings are allocated between lenders and borrowers. 2. Differences Between Finance and Economics - While both involve resource allocation, finance focuses on the terms and channels through which money flows, as opposed to broader economic theories. 3. Key Finance Decisions - Capital Budgeting: What long-term investments should the firm undertake? - Capital Structure: How should the firm fund these investments? - Working Capital Management: How can the firm best manage its cash flow for day-to-day operations? 4. Areas of Finance - Corporate Finance (Business Finance) - Investments - Financial Institutions - International Finance 5. Examples of Finance in Action - Investing: Personal money in stocks or bonds. - Borrowing: Companies issuing bonds. - Lending: Providing mortgages. - Budgeting: Using financial models to manage corporate budgets. - Saving: In high-interest accounts. - Forecasting: Government spending and revenue predictions. 6. Four Principles of Finance - Time Value of Money: Money received today is worth more than the same amount in the future. - Risk-Return Trade-Off: Higher risks are justified only with the expectation of higher returns. - Cash Flows vs. Profits: Cash flow, not profit, drives the value of a business. - Market Prices Reflect Information: Investors react to new information, impacting investment prices. 7. Corporate Organization in Finance - Chief Financial Officer (CFO): Top financial manager responsible for overall financial strategy. - Treasurer: Manages cash, credit, and capital expenditure. - Controller: Manages taxes, accounting, and data processing. 8. Goals of the Financial Manager - Maximize firm value and shareholders’ wealth (share price). - Align with corporate mission and stakeholder interests. 9. Finance-Related Careers - Stockbroker or Financial Advisor - Portfolio Manager - Security Analyst 10. Financial Institutions - Banks (commercial and investment), credit unions, and savings institutions. - Insurance Companies and Brokerage Firms 11. International Finance - Specialization in finance with a focus on exchange rates, political risk, and international financial regulations. Module 2: Financial Instruments, Intermediaries, Markets, and Institutions 1. Financial Instruments - Contracts for monetary assets that can be traded, purchased, created, or settled. They include: - Cash Instruments: Securities, deposits, and loans, whose values are directly influenced by the market. - Derivative Instruments: Contracts whose values derive from underlying assets (e.g., futures, options, swaps). - Foreign Exchange Instruments: Agreements in the foreign market involving currency exchanges (e.g., spots, forwards, currency swaps). Asset Classes: - Debt-Based Instruments: Bonds, debentures, mortgages, etc., which are obligations to pay. - Equity-Based Instruments: Stocks and shares that represent ownership in a company. 2. Financial Intermediaries Institutions that act as middlemen between parties in a financial transaction. They include: - Commercial Banks - Investment Banks - Mutual Funds - Pension Funds Functions: - Asset Storage: Safe storage for cash and valuables. - Loans: Provide short- and long-term loans. - Investments: Help clients grow their investments through portfolios. Benefits: - Risk Spreading: Spread risk across multiple borrowers. - Economies of Scale: Provide financial services at lower costs due to the large number of transactions. - Economies of Scope: Offer a variety of services to meet client needs. 3. Financial Institutions - Types: - Central Banks - Commercial Banks - Credit Unions - Mutual Funds - Mortgage Companies - Investment Banks - Insurance Companies 4. Financial Markets - Provide avenues for the sale and purchase of financial assets (stocks, bonds, foreign exchange, and derivatives). - Functions: - Channel savings into more productive uses. - Determine prices of securities. - Make financial assets liquid by providing a marketplace. - Lower transaction costs for participants. Types of Financial Markets: - Stock Market: Where ownership shares in companies are traded. - Bond Market: Where companies and governments issue debt instruments. - Commodities Market: For trading natural resources (oil, gold, etc.). - Derivatives Market: Where contracts based on asset prices are traded. Importance of Financial Markets - Facilitate fair treatment for investors and debtors. - Provide access to capital for businesses and governments. - Help lower unemployment by creating job opportunities within the financial sector. Module 3: Financial Planning 1. Financial Planning Overview - Financial planning refers to the estimation and allocation of financial resources for the company’s activities. It ensures that the organization can achieve its strategic goals with the available and potential resources. 2. Key Components of Financial Planning - Financial Plans: - Outline expected income and the resources needed for future activities. - Help identify resource allocation and ensure financial resources are used efficiently - Financial Control: - Involves the execution of the financial plan and the preparation of detailed operating plans and budgets for upcoming years. - Budgeting: - Details specific sources of revenue and expected expenses for the coming year. It also involves projections of financial requirements for 3-5 years. 3. Financial Planning Process 1. Analyze: Identify current and potential revenue sources. 2. Estimate Revenues: Make conservative revenue estimates. 3. Estimate Expenses: Make a detailed estimate of expenses. 4. Calculate: Ensure revenues cover expenses. 5. Revise: Adjust the plan if necessary. 6. Prepare: Draft year-by-year estimates. 4. Importance of Financial Planning & Budgeting - Defines the financial framework of a strategic plan. - Helps evaluate financial performance. - Controls costs and assists in the allocation of funds for planned activities. 5. Budget Preparation - Sales Budget: Predicts the sales and revenue figures. - Production Budget: Identifies the resources required for production. - Operating Budget: Covers the daily operational costs. - Cash Budget: Details cash inflows and outflows. - Projected Financial Statements: Estimate financial health in the future. 6. Financial Monitoring - Regular comparison of actual expenditures and revenues with the planned budget. Adjustments are made if revenues are lower or expenses are higher than anticipated. Time Value of Money (TVM) The Time Value of Money (TVM) - **Money today is worth more than the same amount in the future** because it can be invested to earn interest. Types of Interest - Simple Interest: Earned only on the original amount (Principal). - Formula: \( SI = P_0(i)(n) \) - Example**: Deposit $1,000 at 7% for 2 years: - \( SI = 1,000(0.07)(2) = 140 \) - Future Value \( FV = P0 + SI = 1,000 + 140 = 1,140 \) - Compound Interest: Earns interest on both the original principal and the accumulated interest. - Formula: \( FV_n = P_0 (1+i)^n \) - Example: Deposit $1,000 at 7% for 2 years: - \( FV_2 = 1,000(1.07)^2 = 1,144.90 \) Present Value (PV) - Present Value: The value today of a future amount of money. - Formula: \( PV_0 = \frac{FV_n}{(1+i)^n} \) - Example: You need $1,000 in 2 years at 7%: - \( PV_0 = \frac{1,000}{(1.07)^2} = 873.44 \) 4. Rule of 72 - To estimate how long it will take to double your money at a specific interest rate: - Formula: \( \text{Years to Double} = \frac{72}{i\%} \) - Example: At 12%, it will take approximately 6 years to double your money. Annuities - An annuity is a series of equal payments made at regular intervals. - Ordinary Annuity: Payments occur at the end of each period. - Annuity Due: Payments occur at the beginning of each period. - Future Value of an Ordinary Annuity: - \( FVAn = R \times \left[\frac{(1+i)^n - 1}{i}\right] \) - Present Value of an Ordinary Annuity: - \( PVAn = R \times \left[\frac{1 - (1+i)^{-n}}{i}\right] \) Amortizing a Loan - Loan Amortization: A loan paid off over time with regular payments. - Steps: 1. Calculate the payment per period using \( R = \frac{PV_0}{PVIFA_{i,n}} \). 2. Compute the interest and principal for each period. Risk and Return Trade-offs Risk: - The chance that an outcome or investment's actual returns will differ from the expected returns. It includes the possibility of losing some or all of an investment. Return: - The money gained or lost on an investment over a specific period. This can be expressed as a percentage or a monetary value. Risk-Return Trade-off: - The principle that higher risk is associated with the potential for higher returns, and lower risk is linked to lower returns. Types of Risk 1. Political Risk: - The risk of returning suffering due to political changes or instability (e.g., terrorism, war, unrest). 2. Currency Risk (Exchange Risk): - The risk of financial losses due to exchange rate fluctuations. 3. Interest Rate Risk: - The risk that bond prices will decrease when interest rates rise. 4. Business Risk: - The risk of a company being unable to generate enough revenue to cover its expenses. 5. Inflation Risk: - The risk that rising inflation will decrease the purchasing power of money. 6. Management Risk: - The risk associated with poor management decisions in a company. 7. Liquidity Risk: - The risk of not being able to sell an investment quickly enough to avoid or minimize a loss. 8. Credit Risk: - The risk that a borrower will default on a loan or bond repayment. Factors Affecting Risk 1. Investor’s Risk Tolerance: - Factors like goals, timeline, age, portfolio size, and comfort level with risk influence how much risk an investor is willing to take. 2. Investor’s Time Horizon: - Short-term investments are typically less risky, while long-term investments involve more risk. 3. Issuer of Investment: - The credibility and stability of the investment issuer (company, government, etc.) can affect risk. 4. Type of Investment: - Different asset classes (stocks, bonds, savings accounts) carry varying levels of risk. Types of Investors 1. Conservative: - Prefer low-risk investments to avoid losses, such as savings accounts or government bonds. 2. Moderate: - Balance between safe and risky investments, accepting moderate risk for steady returns. 3. Aggressive: - Seek high returns and are willing to take on significant risk, often investing in stocks or volatile markets. Ways to Minimize Risk 1. Monitor the Market: - Stay informed about factors that affect investments to know when to buy or sell. 2. Diversify Your Portfolio: - Spread investments across various asset classes (stocks, bonds, etc.) to reduce exposure to risk in any single area. Understanding Trade-offs - Trade-off: You may have to sacrifice either time, money, or energy to achieve a balance between risk and return.