Chapter 1 Overview of FM For MBA

Financial Management, Market
and Institutions
MBA Students
Arba Minch University
Department of Accounting and Finance
By:- Wondwossen Jerene (Ph.D)
5/14/2021 Dr. Wondwossen J. 1
Financial Management, Market and Institutions
 Chapter 1: Overview of FM
 Chapter 2: Financial Statement Analysis
 Chapter 3: Time Value of Money and Capital
Budgeting
 Chapter 4: Dividend Decision and Capital
Structure
 Chapter 5: Financial Markets
 Chapter 6: Bond and Stock Valuation
 Chapter 7: Depository and Non-depository FI

Chapter One
Overview of Financial Management

Outline
 1. Overview of Financial Management
 2. Scope of Financial Management
 3. Basic Areas of Finance
 4. Functions of Financial Management
 5. Financial Manager
 6. Forms of Business
 7. The Goal of Financial Management
 8. The Agency Problems
 9. Constituents of the Financial System

What is FM?
 Financial management refers to the efficient
and effective management of money (funds)
- in such a manner as to accomplish the
objectives of the organization.
 It is the specialized function directly associated
with the top management.
 It includes how to raise the capital and how to
allocate capital, i.e. capital budgeting.

 Not only for long term budgeting, but also
how to allocate the short term resources like
current liabilities.
 It also deals with the dividend policies of the
share holders.

Scope of Financial Management
 A) Estimating the Requirement of Funds.
 Businesses make forecast on funds needed in
both short run and long run.
 Hence, they can improve the efficiency of funding.
 B) Determining the Capital Structure.
 Capital structure is how a firm finances its overall
operations and growth by using different sources
of funds.
 C) Investment Fund
 A good investment plan can bring businesses
huge returns
Functions of Financial Management
 The function of FM is:
 Raising funds,
 Investing them in assets and
 Distributing returns earned from assets to
shareholders.
 These are respectively known as financing
decision, investment decision and dividend
decision.
 A firm also attempts to balance cash inflows
and outflows while performing these functions.
 This is called liquidity decision
 Thus, FM functions include:
Long term asset-mix or investment decision.
Capital-mix or financing decision.
Profit allocation or dividend decision.
Short- term asset-mix or liquidity decision.
1. Investment Decision
 A firm’s investment decisions involve capital
expenditures.
 They are, therefore, referred as capital
budgeting decision.

 A capital budgeting decision involves the
decision of allocation of capital or commitment
of funds to long- term assets that would yield
benefits (cash flow) in the future.
 Two important aspects of investment decision
are:
 i) The evaluation of the prospective
profitability of new investment, and
 ii) The measurement of a cut-off rate against
that the prospective return of new investments
could be compared.
 2. Financing Decision
 Financing decision is the second important
function to be performed by the financial
manager.
 It is the decision of the time (when), place
(where from) and the method (how) to
acquire funds to meet the firm’s investment
needs.
 The central issue is to determine the
appropriate proportion of equity and debt.
 The mix of debt and equity is known as the
firm’s capital structure.
 3. Dividend Decision
 Dividend decision is third major financial
decision.
 The financial manager must decide whether
the firm should distribute all profits, or retain
them or distribute a portion and retain the
balance.
 The proportion of profits distributed as
dividends is called the dividend payout ratio
and the retained portion of profit is known as
the retention ratio.

 Like the debt policy, the dividend policy should be
determined in terms of its impact on the
shareholders’ value.
 The optimum dividend policy is that one
maximizes the market value of the firm’s shares.
 4. Liquidity Decision
 Investment in current assets affects the firm’s
profitability and liquidity.
 Current assets management that affects a firm’s
liquidity is yet another important finance function.
 A conflict exists between profitability and liquidity
while managing current assets.
The Role of the Financial Manager
 Flow of cash between capital markets and the firm’s operations.
 Key: (1) Cash raised by selling financial assets to investors; (2) cash
invested in the firm’s operations; (3) cash generated by the firm’s
operations; (4a) cash reinvested; (4b) cash returned to investors.

Financial Decisions and Financial Manager
 Financing decision – where is money going to come from?
 Investment decision – how much to invest and in what assets?

Financial Decisions and Financial Manager

Forms of Business

The Goal of Financial Management
Possible financial goals of Profit-oriented organization
involves:
Survive
Avoid financial distress and bankruptcy
Beat the competition
Maximize sales or market share
Minimize costs
Maximize profits
Maintain steady earnings growth
The question is, are these objectives in the best

interests of the stockholders?
The Goal of Financial Management…
Classification of goals
Earning or Increasing Profits Controlling risks/safety
• Maximize sales or market share • Survive

• Minimize costs • Avoid financial distress and
• Maximize profits bankruptcy
• Maintain steady earnings growth • Beat the competition
The pursuit of profit normally involves some element of risk, so it isn’t
really possible to maximize both safety and profit.
 What we need, therefore, is a goal that encompasses both factors.

So, what is an objective that encompasses both
factors?
 A good objective from a shareholder’s point of view
since it is assumed that managers (finance managers)
acts in the shareholders’ best interests.

 Therefore, the goal of financial management is to maximize the
current value per share of the existing stock.
o maximize the price of the stock
 Share price today = Present value of all future expected dividends at

required rate of return;
FM studies the relationship between business decisions and the

value of the stock in the business.

The Set-of-Contracts Perspective
 The firm can be viewed as a set of contracts.

 One of these contracts is between shareholders and
managers.
 The managers will usually act in the shareholders’
interests.
◦ The shareholders can devise contracts that align the incentives
of the managers with the goals of the shareholders.
◦ The shareholders can monitor the managers behavior.
 This contracting and monitoring is costly.

The Nexus of Contracts
Theory of the Firm
Share-
Lessors holders Board of
Lessees Directors
Suppliers Firm Managers
Customers Employees
Bond-
holders
Managerial Goals
 Managerial goals may be different from

shareholder goals
◦ Expensive perquisites
◦ Survival
◦ Independence
 Increased growth and size are not necessarily

the same thing as increased shareholder
wealth.
Do Shareholders Control Managerial Behavior?
 Shareholders vote for the board of directors, who in turn
hire the management team.
 Contracts can be carefully constructed to be incentive

compatible.
 There is a market for managerial talent—this may provide

market discipline to the managers—they can be replaced.
 If the managers fail to maximize share price, they may be

replaced in a hostile takeover.

THE PRIMARY OBJECTIVE OF THE
CORPORATION: VALUE MAXIMIZATION
 Shareholders are the owners of a corporation,
and they purchase stocks
 Because they want to earn a good return on their
investment without undue risk exposure.
 In most cases, shareholders elect directors, who
then hire managers to run the corporation on a
day-to-day basis.
 Because managers are supposed to be working on
behalf of shareholders, they should pursue policies
that enhance shareholder value.
 Management’s primary objective is stockholder
wealth maximization.
The Agency Problem
 Agency problem – is the possibility of conflict of interest
between the stockholders and management of a firm.
 Agency Problems: Goals of the parties are not aligned
Agent someone who is hired to represent the principal’s

interest
1. Equity: Potential conflict between shareholders and
managers (principal-agent problem)
2. Debt: Potential conflict between shareholders and debt

holders

The Agency Problem…..
 Managers can be encouraged to act in stockholders’ best
interests through incentives that reward them for good
performance but punish them for poor performance.
◦ managerial compensation,
◦ direct intervention by shareholders
◦ the threat of firing, and
◦ the threat of takeover.

Agency Cost
Jensen and Meckling provide a definition of

agency costs that divides these costs into
their individual components:
Agency Monitoring Bonding Residual

Costs = Costs + Costs + Loss
Out-of-Pocket Opportunity
Costs Costs
Financial System
 There are three main constituents of the
financial system:
 (a) the financial assets,
 (b) the financial market and
 (c) the financial institutions.

Financial Markets
 The main goal of financial markets is channeling funds
from savers to investors.
 Financial markets are critical for producing an efficient

allocation of CAPITAL (wealth, either financial or
physical, that is employed to produce more wealth),
which contributes to higher production and efficiency for
the overall economy.

Financial Market and Financial System

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Financial Management, Market

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 Flow of cash between capital markets and the firm’s operations.

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 Investment decision – how much to invest and in what assets?

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The question is, are these objectives in the best

Earning or Increasing Profits Controlling risks/safety

• Maximize sales or market share • Survive

The pursuit of profit normally involves some element of risk, so it isn’t

really possible to maximize both safety and profit.

 What we need, therefore, is a goal that encompasses both factors.

5/14/2021 Dr. Wondwossen J. 26

 Share price today = Present value of all future expected dividends at

FM studies the relationship between business decisions and the

5/14/2021 Dr. Wondwossen J. 27

 The firm can be viewed as a set of contracts.

◦ The shareholders can monitor the managers behavior.

 This contracting and monitoring is costly.

5/14/2021 Dr. Wondwossen J. 28

Suppliers Firm Managers

 Managerial goals may be different from

 Increased growth and size are not necessarily

 Contracts can be carefully constructed to be incentive

 There is a market for managerial talent—this may provide

 If the managers fail to maximize share price, they may be

5/14/2021 Dr. Wondwossen J. 31

 Agency Problems: Goals of the parties are not aligned

Agent someone who is hired to represent the principal’s

2. Debt: Potential conflict between shareholders and debt

5/14/2021 Dr. Wondwossen J. 39

◦ direct intervention by shareholders

◦ the threat of firing, and

◦ the threat of takeover.

5/14/2021 Dr. Wondwossen J. 40

Jensen and Meckling provide a definition of

Agency Monitoring Bonding Residual

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 Financial markets are critical for producing an efficient

5/14/2021 Dr. Wondwossen J. 44

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5/14/2021 Dr. Wondwossen J. 46

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