Addis Ababa Medical and Business College

Department Of Business and Economics

Course Name: Finacial Management

Academic Year: 2016/17 E.C

Instructor Name: Alexander Z.

 Unit 1: Introduction to financial management
Introduction
To have a good understanding of financial management, you
need to understand first what finance is. Literally, finance
means the money used in day-to-day activities of an
individual or a business for exchange of goods and
services. But here our focus rather should be to consider
finance as a separate and distinct field of study like
accounting, economics, mathematics, history, geography etc.

1.1 What Is Finance?

Finance is a distinct area of study that comprises facts,
theories, concepts, principles, techniques and practices related
with raising and utilizing of funds (money) by individuals,
businesses, and governments.
In addition to principles and techniques, finance
requires individual judgment of the person
making the financial decision. Hence, finance
can also be defined as the art and science of
managing money.
Finance can be defined as art and science of
managing money. Finance means to arrange
payment for. It is basically concerned with the
nature, creation, behavior, regulation and
problems of money. It focuses on how the
individuals, businessmen, investors, government
and financial institutions deal.
We need to understand what money is and
does is the foundations of financial
knowledge. In this content it is relevant to
study the structure and behavior of
financial system and the role of financial
system in the development of economy and
the profitability of business enterprises.
Classification of finance:
Personal finance
Public finance
Business finance
Personal finance: - This deals with the mobilization
and administration of funds from own sources. Here
funds may imply cash and non-cash items also.
Public finance: - This kind of finance deals with the
mobilization or administration of public funds. It
includes the aspects relating to the securing the funds
by the government from public through various
methods viz. taxes, borrowings from public and
foreign market
Business finance: - Financial management actually
concerned with business finance. Business finance is
pertaining to the mobilization of funds by various
business enterprises.
Major Areas of Finance -The major fields of finance
based on career opportunities in finance. The career
opportunities again can be divided into different
categories.
i) Financial Services
This is a part of finance which involves personal
career opportunities as
 a loan officer
financial planner,
Stockbroker
 real estate agent
insurance broker.
It is generally concerned with the design, development
and delivery of these financial services to
individuals,
business organizations,
and governments.
ii) Financial Management
Financial management is concerned with the financial
decisions of a business firm. This firm can be
large or small
private or public,
financial or non-financial,
profit – seeking or not-for-profit.
Finance related disciplines or fields
Finance is an integral part of the firm’s overall
management.Finance heavily draws theories,
concepts, and techniques from related disciplines such
as
Economics
accounting,
marketing,
operations,
mathematics,
statistics,
Among these disciplines, the field of finance is closely
related to
Economics
Accounting
Finance versus Economics
Finance and economics are closely related
Economics is the mother field of finance.
The economic environment within which a firm
operates influences the decisions of a financial
manger.
Basic Differences between Finance and Economics
•Finance is less concerned with theory than is
economics. Finance is basically concerned with the
application of theories and principles.
•Finance deals with an individual firm; but economics
deals with the industry and the overall level of the
economic activity.
Finance versus Accounting
Accounting provides financial information through
financial statements. Therefore, these two fields are
closely linked as accounting is an important input for
financial decision-making. Besides, the accounting
and finance functions generally overlap; and usually it
is difficult to distinguish them.
 Basic Differences between Finance and Economics

Accounting Finance
 income measurement  the cash method
is on accrual basis.
 gather and present  Deals with financial
financial data planning, controlling
 Highly governed by & decision making.
generally accepted  Not governed
accounting principles
The role and importance of financial management.
1.2.1 Meaning of Financial Management
Financial management is one major area of study under
finance. It deals with decisions made by a business firm that
affect its finances. Financial management is sometimes called
corporate finance, business finance, and managerial
finance. These terms are used interchangeably in this course.
Financial management can also be defined as a decision
making process concerned with planning for raising, and
utilizing funds in a manner that achieves the goal of a firm.
There are many specified business functions performed by a
business unit. These include
marketing,
production,
human resource management,
and financial management.
Financial management involves the management of
finance function. It is concerned with the
planning,
 organizing,
directing and controlling the financial activities of
an enterprise.
It deals mainly with raising funds in the most
economic and suitable manner; using these funds as
profitably as possible; planning future operations; and
controlling current performance and future
developments through
 financial accounting,
cost accounting,
budgeting, statistics and other means.
Basic principles that form the basis for financial
management
1. The risk –return trade-off
2. The time value of money
3. Cash –Not profits –is a king
4. Incremental cash flows
5. The course of competitive markets
6. Efficient capital markets
7. The Agency problem.
8. Taxes bias business decision
9. All risks are not equal
10. Ethical behavior
Objectives of financial management
To make wise decisions, a clear understanding
of the objectives which are sought to be
achieved is necessary. The objectives provide a
framework for optimum financial decision
making. Let us now review the well known and
widely discussed approaches available in
financial literature
Profit Maximization
Wealth Maximization.
The profit maximization theory is based on
the following important assumptions:
•This theory is bases purely on the rationality of
the individuals and the firms.
•It promotes the use of resources to the best of
their advantage of gain maximum out of them.
•It leads to the economic selection of the
resources.’
•It enhances the National Income of the country
through efficient and increased production.
The profit maximization objective has been criticized
It is argued that profit maximization is a
consequence of perfect competition and in the context
of today’s imperfect competition; it cannot be taken as
a legitimate objective of the firm.
It is also argued that profit maximization, as a
business objective, developed in the early 19 th Century
when the characteristic features of the business
structure were self-financing, private property and
single entrepreneurship.
There is a lack of unanimity regarding the concept
of profit. There are various terms such as gross profit,
net profit, earnings, short-term profit and long-term
profit.
There exists no perfect competition in the market.
Similarly, all countries do not favor the idea of free
enterprises economy. There exist certain controls,
which will limit the profit maximizing capacity of the
undertakings.

This theory is also criticized for ignoring the timing

of returns and risk. It doesn’t take the returns in terms
of their present value.
Ex. 1 Project A Project B
Benefits in Birrs Benefits in Birrs
Period1 5, 000 _
2 10, 000 10, 000
3 5, 000 10, 000
20, 000 20, 000
Though A, B generating some profit A is preferred quality of
benefits
Ex. 2 Uncertainty about expected profits
Profits in Birrs
State of Economy A B
Recession 1, 000 0
Normal 1, 000 1, 000
Boom 1, 000 2, 000
3, 000 3, 000
Again we prefer A than B
Wealth Maximization:
This approach is also known as Value Maximization or Net
Present Wealth Maximization. Wealth maximization means
maximizing the net present value (NPV) of a course of action.
The NPV of a course of action is the difference between the
gross present value (GPV) of the benefits of that action and
the amount of investment required to achieve those benefits.

Where W = Net Present Wealth

A1, A2, An = Stream of cash flows expected to occur from a
course of action over a period of time.
K = Appropriate discount rate to measure risk and timing.
C = Initial outlay to acquire that asset
The wealth maximization objective acceptable as
an operationally feasible criterion to guide
financial decisions only when it is consistent with
the interests of all those groups such as
shareholders,
creditors,
employees,
management
and the society.
wealth maximization is the most appropriate and
operationally feasible decision criterion for
financial management decisions.
The finance functions may be broadly divided into
two categories.
•Executive finance functions and
•Non-executive/Routine finance functions
The routine functions are repetitive in nature and the
focus of financial management will be on the
executive functions.
The finance function mainly deals with the following
three decisions:
•Investment Decision.
•Financing Decision.
•Dividend Decision.
 I.Investment Decision
The investment decision relates to the selection of
assets in which funds will be invested by a firm. The
assets which can be acquired fall into two broad
groups:
(i) long-term assets which will yield a return over
period of time in future (Capital Budgeting)

(ii) short-term or current assets defined as those assets

which are convertible into cash usually within a year.
(Working Capital Management.)
 II Financing Decision
In this function, the finance manager has to estimate
carefully the total funds required by the enterprise,
after taking into account both the fixed and working
capital requirements.

In this context, the financial manager is required to

determine the best financing mix or capital structure
of the firm. Then, he must decide when, where and
how to acquire funds to meet the firm’s investment
needs.
The following points are to be considered while
determining the appropriate capital structure of a
firm:
Factors which have bearing on the capital
structure.
Relationship between earnings before interest
and taxes (EBIT) and earnings per share (EPS).
Relationship between return on investment
(ROI) and return on equity (ROE).
Debt capacity of the firm.
Capital structure policies in practice.
 III Dividend Decision:
It is a fact that in spite of the various other factors
which influence the market value of shares, dividend
payment has been considered to be the foremost. In
this context, the finance manager must decide whether

the firm should distribute all profits

or retain them,
or distribute a portion and retain the balance.
Conflict of goal (Agency problem)
The relationship between stockholders and
management is called an agency relationship. Such a
relationship exists whenever someone (the principal)
hires another (the agent) to represent his/her interests.
For example, you might hire someone (an agent) to
sell a car that you own while you are away at school.

In all such relationships, there is a possibility of

conflict of interest between the principal and the
agent. Such a conflict is called an agency problem.
The management may not necessarily act in the
interest of owners or a conflict may occur between the
Financial Markets
Financial markets are a place where the business
houses can raise their long and short-term financial
requirements. The financial markets are broadly
divided as
•Capital market and
•Money market
Capital market
Capital market is defined as a place where all buyers
and sellers of capital funds as well as the entire
mechanism for facilitating and effecting long term
funds. It provides the long-term funds that are needed
for investment purpose.
Further the capital markets are divided into two
Primary market – In the primary market only new
securities are issued to the public. It is a place where
borrowers exchange financial securities for long-term
funds. It facilitates the formation of capital. The
securities may be issued directly to the individuals,
institutions, through the underwriters etc.

Secondary market – The shares subsequent to the

allotment are traded in the secondary market.
Anybody can either buy or sell the securities in the
market. Secondary market consists of stock exchange.
Money Market
Money market deals with short-term requirements of
borrowers. It is concerned with the supply and demand
for a commodity or service. In money market funds
can be borrowed for short period varying from a day
to a year.
Financial Instruments
There are mainly two kinds of securities namely
ownership securities
loan securities.
Further ownership securities are classified into
common stock
preference stock. These securities or instruments are
being traded in capital markets.
Common stock
It is also known as equity shares, who are the real
owners of the business will enjoy the profit or loss
suffered by the company.
Dividend payment is not compulsory.
Preferential stock – By name these holders have two
preferential rights
to get fixed rate of dividend at the end of every year
irrespective of profits / losses of the company
to get back the investment first when the company
goes into liquidation.
Bonds – Bondholders are the money suppliers to a
business unit entitled for a fixed rate of interest at the