CHAPTER ONE

INTRODUCTION:
NATURE AND SCOPE OF
Financial managment

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 Definitions
J.F. Bradley :-“financial management is the area of business
management devoted to a judicious use of capital and a
careful selection of sources of capital in order to enable a
business firm to move in the direction of reaching its goals
Guttmann and Douglas:-” business finance can be broadly
defined as the activity concerned with the planning, raising,
controlling and administering the funds used in the
business”.
Financial Management: is concerned with the efficient
acquisition and deployment of both short and long term
financial resources, to ensure that the objectives of the
enterprise are achieved.
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 Financial Management
FM is the management of the source and
use of funds in an organization to help it
achieve its objectives.
Sources of funds: Debt vs Equity
Use of funds: Assets (both real and
financial)

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 Financial Management Decisions
Investment decision – both long term investment in non-
current assets and short term investment in working capital

a. Capital budgeting (investment appraisal)

b. Working capital management
c. Risk management

Financing decision – from what source should

funds be raised?
 Dividend Decision – how should cash be
allocated to shareholders and how will the value of
4 the business be affected by this?
 Organization structure of finance

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 Scope of financial management.
1.Estimating financial requirements
2.Deciding capital structure
3.Selecting source of finance
4.Selecting pattern of investment
5.Cash management
6.Profit management
7.Ensuring liquidity
8. Meeting statutory requirements.

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 Scope of FM
Finance is used by individuals (personal finance), by
governments (public finance), by businesses (
corporate finance) and by a wide variety of other
organizations, including schools and non-profit
organizations.
In general, the goals of each of the above activities are
achieved through the use of appropriate financial instruments
and methodologies, with consideration to their institutional
setting.
So the scope of FM is so broad that it applies in any
organization be it government, NGO, or business.
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 Objectives of Financial Management

1) Profit Maximization

2)Wealth Maximization

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 1. Profit Maximization
a. This is not a very precise objective.
Short run Vs Long run ambiguities.
More to the point, this goal doesn't tell us the
appropriate trade-off between current and future
profits.
b. It ignores:
Time value of money
Risk associated with returns
Benefits to owners

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 2) Wealth maximization
Wealth maximization means maximizing
share/stock holders wealth by maximizing the
current price of their share.

symbolically

Share holder’s = no of shares × Current stock price

wealth owned per share

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 Factors that affect price of a stock

Size of Projected earnings

Riskiness of future earnings
Timings of the earning stream
Debt utilization
 Dividend policy

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1.13
The Agency Problem
 Agency relationship
 Principal hires an agent to represent their interests
 Stockholders (principals) hire managers (agents) to run the
company
 Agency problem
 Conflicts of interest can exist between the principal and the agent
 Agency costs
Direct agency costs – the purchase of something for
management that can’t be justified from a risk-return
standpoint, monitoring costs.
Indirect agency costs – management’s tendency to
forgo risky or expensive projects that could be justified
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from a risk-return standpoint.
1.14
Managing Managers
Managerial compensation
Incentives can be used to align management
and stockholder interests
The incentives need to be structured carefully
to make sure that they achieve their goal
Corporate control (hostile takeover)
The threat of a takeover may result in better
management
Proxy fight (threat of firing)
 Conflicts with other stakeholders

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1.16 What is the role of financial markets in corporate
finance?

Cash flows to and from the firm

Money vs. capital markets
Primary vs. secondary markets
How do financial markets benefit
society?

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 Financial Markets and institutions
Financial markets are markets for financial
instruments, also called financial claims or securities.
Places where financial instruments are purchased
and sold
Financial institutions (also called financial
intermediaries) facilitate flows of funds from savers to
borrowers.

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 Exhibit 1.1 – Transfer of Funds

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 Financial market and Institution …

Surplus spending units ( SSUs) have income for the

period that exceeds spending, resulting in savings.
Other words for “SSU” are saver, lender, or investor.
Most SSUs are households.
Deficit spending units (DSUs) have spending for the
period that exceeds income.
Another word for “DSU” is “borrower”. Most DSUs
are businesses or governments.

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 Indirect Financing (“Financial
Intermediation”):
Financial intermediaries “transform” claims:
 raise funds by issuing claims to SSUs;
 use funds to buy claims issued by DSUs.
In the process:
SSU has claim against intermediary;
Intermediary has claim against DSU.

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 Primary and Secondary Markets
Primary markets are where financial claims are “born”:
DSUs receive funds, claims are first issued.
Secondary markets are where financial claims “live”—
claims are resold and re-priced.
 Claims become more liquid
 Trading sets prices and yields of widely
held securities

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 Money and Capital Markets

Money markets: wholesale markets for short-term

debt instruments resembling money itself
Capital markets: where “capital goods” are
permanently financed through long-term financial
instruments.
(“Capital goods”—real assets held long-term to
produce wealth—land, buildings, equipment, etc.)

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 Money Markets
Help participants adjust liquidity—
Borrow money for short-term to fund current
operations
Lend money for short-term to avoid holding idle
cash
Common characteristics of money market
instruments—
 Short maturities (usually 90 days or less)
 High liquidity (active secondary markets)
 Low risk (and consequently low yield)

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 Examples of Major Money Market Instruments

Treasury Bills
Negotiable Certificates of Deposit
Commercial Paper

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 Capital Markets
Help participants build wealth
 Provides long-term financing for capital projects
 Generate highest possible return for investors
Differences from money markets—
Long maturities (5 to 30 years)
Less liquidity
Higher risk in most cases
Examples for capital market instruments are Common
stock, Preferred stocks and bonds

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1.20
Quick Quiz
What are the three types of financial management
decisions and what questions are they designed to
answer?
What are the three major forms of business
organization?
What is the goal of financial management?
What are agency problems and why do they exist
within a corporation?
What is the difference between a primary market and a
secondary market?

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1.21

Summary 1.9
You should know:
The advantages and disadvantages between a sole
proprietorship, partnership and corporation
The primary goal of the firm
What an agency relationship and cost are
The role of financial markets

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 Financial Goals of the Corporation
The primary financial goal is shareholder
wealth maximization, which translates to
maximizing stock price.
 Do firms have any responsibilities to
society at large?
Is stock price maximization good or bad for
society?
Should firms behave ethically?

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 THANK YOU…..

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