CHAPTER ONE

FINANCIAL
MANAGEMENT: AN
OVERVIEW
 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.
 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.
It is concerned with the processes,
institutions, markets, and instruments
involved in the transfer of funds.
 Major Areas of Finance

a. Investments: This area of finance focuses on

the behavior of financial markets and the
pricing of securities. It deals with financial
assets like stocks and bonds with respect to:
Factors that determine the price of financial
assets
The potential risks associated with investing in
financial assets
The best mix of the different types of financial
assets
An investment manager’s tasks
b. Financial Institutions: This area of
finance deals with banks and other firms
that specialize in bringing the suppliers of
funds together with the users of funds.
Financial instruments are written and formal
documents of transferring funds between and
among individuals, businesses, and
governments. They include loans and
borrowing contracts, promissory notes,
commercial papers, treasury bills, bonds, and
stocks.
c. International Finance: This area of finance is
concerned with the international aspects of corporate
finance, investments or financial institutions.
d. Public Finance: This area of finance deals with
government finance.
e. Financial Management: Sometimes called
corporate finance or business finance, this area of
finance is concerned primarily with financial decision-
making within a business entity.
Financial management decisions include maintaining
cash balances, extending credit, acquiring other firms,
borrowing from banks, and issuing stocks and bonds.
 The Nature And Scope Of Financial
Management

Meaning of Financial Management

Financial management can be clearly defined by
viewing it as a subject, a process, or a function.
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 material.
 The Scope of Financial Management

Traditionally, financial management was viewed as a

field of study limited to only raising of money.
Under the traditional approach, the scope and role of
financial management was considered in a very
narrow sense of procurement of funds from external
sources.
The subject of finance was limited to the discussion of
only financial institutions, financial instruments, and
the legal and accounting relationships between a firm
and its external sources of funds.
Internal financial decision makings as cash and credit
management, inventory control, capital budgeting
were ignored.
However, the modern or contemporary approach
views financial management in a broad sense.
Corporate finance is defined much more broadly to
include any business decisions made by a firm that
affect its finance.
The scope of managerial finance involves the solution
to investing, financing, and dividend policy problems
of a firm.
Unlike the old approach, here, the financial manager’s
role includes both acquiring of funds from external
sources and allocating of the funds efficiently within
the firm thereby making internal decisions.
 Financial Markets and Financial
Institutions
Financial Markets and Corporation
Financial markets are markets in which financial
instruments are bought and sold by suppliers and
demanders of funds. They, unlike financial
institutions, are places in which suppliers and
demanders of funds meet directly to transact
business.
Functions of Financial Markets
1. They assist the capital formation process
2. Financial markets serve as resale markets for
financial instruments
3. They play a role in setting the prices of
securities
Cash Flows To and From the Firm
Classification of Financial Markets

There are many types of financial markets and

hence several ways to classify them. For our
purpose, here we shall consider the following two
classifications.
1. Classification on the basis of maturity and
source of their value
a. Money Markets: are financial markets in which
securities traded have maturities of one-year or
less. The most common money market securities
are treasury bills, commercial paper, negotiable
certificates of deposit, and bankers acceptance.
 Treasury bills (T-bills) are short-term
securities issued by the government; they
have original maturities of either four weeks,
three months, or six months.
Unlike other money market securities, T-bills
carry no stated interest rate. Instead, they
are sold on a discounted basis: Investors
obtain a return on their investment by buying
these securities for less than their face value
and then receiving the face value at maturity.
 Commercial paper is a promissory note—a
written promise to pay—issued by a large,
creditworthy corporation. These securities
have original maturities ranging from one day
to 270 days. Commercial paper may be either
interest bearing or sold on a discounted
basis.
 Certificates of deposit (CDs) are written
promises by a bank to pay a depositor.
Nowadays they have original maturities from
six months to three years.
 Bankers’ acceptances are short-term loans,
usually to importers and exporters, made by
banks to finance specific transactions. An
acceptance is created when a draft (a
promise to pay) is written by a bank’s
customer and the bank “accepts” it,
promising to pay. The bank’s acceptance of
the draft is a promise to pay the face amount
of the draft to whomever presents it for
payment.
Money market securities are short-term
indebtedness. By “short term” we usually imply
an original maturity of one year or less. Money
market securities are backed solely by the
issuer’s ability to pay. With money market
securities, there is no collateral.
b. Capital Markets: are financial markets in
which securities of long-term funds are traded.
Major securities traded in capital markets include
bonds, preferred(Share Capital preference) and
common stocks(Share Capital ordinary).
2. Classification on the basis of the nature of
securities
This is based on: whether the securities are new
issues or have been outstanding in the market
place; whether or not it has a physical location.
a. Primary Markets: are financial marketers in
which firms raise capital by issuing new securities.
When a security is first issued, it is sold in the
primary market. This is the market in which new
issues are sold and new capital is raised. So it is the
market whose sales directly benefit the issuer of the
securities.
b. Secondary Markets: are financial markets
in which existing and already outstanding
securities are traded among investors. Here
the issuing corporation does not raise new
finance. Trading takes place among investors.
Investors who buy and sell securities on the
secondary markets may obtain the services of
stock brokers, individuals who buy or sell
securities for their clients.
There are two types of secondary markets
Exchanges are actual places where buyers and
sellers (or their representatives) meet to trade
securities. Examples are the New York Stock
Exchange and the Tokyo Stock Exchange.
Over-the-counter (OTC) markets are
arrangements in which investors or their
representatives trade securities without sharing a
physical location. For the most part, computer and
telephone networks are used for this purpose.
These networks are owned and managed by the
market’s members. An example is the Nasdaq
system, which is operated by the National
Association of Securities Dealers (NASD).
 FINANCIAL MANAGEMENT
DECISIONS
The functions of financial management are
planning for acquiring and utilizing funds by
a firm as well as distributing funds to the
owners in ways that achieve goal of the firm.
In general, the functions of financial
management include three major decisions a
firm must make. These are:
1. Investment decisions
2. Financing decisions
3. Dividend decisions
1. Investment Decisions
This deals with allocation of the firm’s scarce
financial resources among competing uses. These
decisions are concerned with the management of
assets by allocating and utilizing funds within the
firm. Specifically, the investment decisions include:
Determining the asset mix or composition
Determining the asset type
Managing the asset structure
the investment decisions of a firm deal with the left
side of the basic accounting equation: A = L + OE
2. Financing Decisions
The financing decisions deal with the financing of
the firm’s investments, i.e., decisions whether the
firm should use equity or debt funds in order to
finance its assets.
They are also concerned with determining the most
appropriate composition of short – term and long – term
financing.
Deal with determining the best financing mix or capital
structure of the firm.
The financing decisions of a firm are generally
concerned with the right side of the basic accounting
equation.
3. Dividend Decisions
The dividend decisions address the question
how much of the cash a firm generates from
operations should be distributed to owners in
the form of dividends and how much should
be retained by the business for further
expansion.
The dividend decision of a firm should be
analyzed in relation to its financing decisions.
 The Goal of a Firm in Financial
Management

Recall that financial management is

concerned with decision making to achieve
the goal of a firm.
A goal or an objective provides a framework
for the decision maker.
In most cases, the goal is stated in terms of
maximizing or minimizing some variable.
 Profit Maximization as a Decision Rule

Meaning of Profit Maximization

Profit maximization is a function of
maximizing revenue and /or minimizing costs.
If a firm is able to maximize its revenues for a
given level of costs or minimizing costs for a
given level of revenues, it is considered to be
efficient.
Limitations of Profit Maximization
1. Ambiguity: The term profit or income is vague and
ambiguous concept. in accounting profit might refer
to short-term or long-term profit, total profit or
profit on a per share basis (earnings per share), and
before or after tax profit.
2. Cash flows: The profit a firm has reported does not
represent the cash flows to the business. Firms
reporting a very high total profit or earnings per
share might face difficulty of paying cash dividends
to stockholders.
3. Timing of Benefits: the profit maximization
ignores the time value of money, i.e., money today is
better than money tomorrow.
4.Quality of Benefits (Risk of Benefits): Profit
maximization assumes that risk or uncertainty of
future benefits is of no concern to stockholders. Risk
is defined as the probability that actual benefit will
differ from the expected benefit. Financial decision
making involves a risk-return trade-off. This means
that in exchange for taking greater risk, the firm
expects a higher return.
For example, Agar PLC must choose between two
projects. Both projects cost the same. Project A has
a 50% chance that its cash flows would be actual
over the next three years. Project B, on the other
hand, has a 90% probability that its cash flows for
the next three years would be realized.
BENEFITS

YEAR PROJECT A PROJECT B

1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000
 Expected benefit of project A = Br. 220,000 x 50% = Br.
110,000
 Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000
 Wealth Maximization as a Decision Rule

Wealth maximization means maximization of the

value of a firm. Hence, wealth maximization is also
called value maximization or net present value
(NPV) maximization.
The Measure of Owner’s Economic Well-Being
The price of a share of stock at any time, or its
market value, represents the price that buyers in a
free market are willing to pay for it.
The market value of shareholders’ equity is the
value of all owners’ interest in the corporation.
Market value of shareholders’ equity = Market
value of a share of stock × Number of shares of
stock outstanding
Investors buy shares of stock in anticipation
of future dividends and increases in the
market value of the stock.
They are willing to pay exactly what they
believe it is worth today, an amount that is
called the present value. The present value of
a share of stock reflects the following factors:
 The uncertainty associated with receiving future
payments
 The timing of these future payments
 Compensation for tying up funds in this investment
Wealth maximization as a decision criterion is
considered to be an ideal goal of a firm in financial
management. There are several reasons why wealth
maximization decision criterion is superior to other
criteria.
First, it has an exact measurement unlike profit
maximization.
Second, it consider the quality as well as the time
pattern of benefits.
Third, it emphasizes on the long-term and sustainable
maximization of a firm’s stock price in the financial
market.
Fourth, it gives a recognition to the interest of other
stakeholders and to the societal welfare on the long-term
basis.
 Limitations of Wealth Maximization

When managers of a corporation are separate

from owners, there is a potential for a conflict
of interest between them.
When the goal of a firm is stated in terms of
stockholders wealth, actions that increase the
wealth of stockholders could be taken as the
expense of other stakeholders like debt
holders.
Wealth maximization is normally reflected in
the firm’s stock price.
 The Agency Relationship

If you are the sole owner of a business, then you

make the decisions that affect your own well-being.
But what if you are a financial manager of a
business and you are not the sole owner? you, the
financial manager, are an agent.
An agent is a person who acts another person or
group of persons.
The persons who are represented by the agent is
referred to as the principal.
The relationship between the agent and his or her
principal is an agency relationship.
 Problems with the Agency Relationship

In a corporate form of business organization

owners (stockholders) do not run the
activities of the firm. Rather, the stockholders
elect the board of directors, who in turn
assign the management on behalf of the
owners. So, basically, managers are agents of
the owners of the corporation and they
undertake all activities of the firm on behalf
of these owners. Managers are agents in a
corporation to maximize the common
stockholders’ well-being.
The natural conflict of interest between
stockholders and managerial interest create
agency problems.
Agency problems are the likelihood that
mangers may place their personal goals a
head of corporate goals.
Theoretically, agency problems are always
there as long as managers are agents of
owners.
 Costs of the Agency Relationship

Corporations (owners) are aware of these

agency problems and they incur some costs
as a result of agency. Such costs are called
agency costs. These costs include:
1. Monitoring costs In a corporation,
shareholders may require managers to
periodically report on their activities via audited
accounting statements, which are sent to
shareholders. The accountants’ fees and the
management time lost in preparing such
statements are monitoring costs. fees paid by
corporations to external auditors.
2. Bonding costs – are cost incurred to
protect dishonesty of mangers and other
employees of a firm. 3. Structuring costs are
made to make managers fell sense of
ownership to the corporation. These include
stock options, performance shares, cash bonus
etc.
4. Opportunity costs: unlike the previous
three, these costs are not explicit expenditures.
Motivating Managers: Executive Compensation

On top of the above costs assumed by corporations,

there are also other ways to motivate managers to act
in the best interest of owners this include:
Salary: The direct payment of cash of a fixed amount
per period.
Bonus: A cash reward based on some performance
measure, say earnings of a division or the company.
Stock appreciation right: A cash payment based on
the amount by which the value of a specified number
of shares has increased over a specified period of
time.
Performance shares: Shares of stock given the
employees, in an amount based on some measure
of operating performance, such as earnings per
share.
Stock option: The right to buy a specified
number of shares of stock in the company at a
stated price—referred to as an exercise price at
some time in the future.
Restricted stock grant: The grant of shares of
stock to the employee at low or no cost,
conditional on the shares not being sold for a
specified time.
 CLOSLY RELATED FIELD OF
FINANCIAL MANAGEMENT
Finance versus Economics
Finance and economics are closely related in
many aspects.
First, economics is the mother field of finance.
Second, the economic environment within which
a firm operates influences the decisions of a
financial manager.
A financial manger must understand such
economic variables as a gross domestic product,
unemployment, inflation, interests, and taxes in
making financial decisions.
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. In many situations, the
accounting and finance activities are within
the control of the financial manager of a firm.
Basic differences between Finance and
Accounting
 Treatment of income: in accounting, income
measurement is on accrual basis. In finance,
however, the cash method is employed to recognize
the revenue and expenses.
 Decision-making: the primary function of
accounting is to gather and present financial data.
Finance, on the other hand, is primarily concerned
with financial planning, controlling and decision-
making. The financial manger evaluates the financial
statements provided by the accountant by applying
additional data and then makes decisions
accordingly.
 Basic forms of Business Organization

Sole Proprietorship
 A sole proprietorship is a business owned by one
person.
This is the simplest type of business to start and is
the least regulated form of organization.
The owner of a sole proprietorship keeps all the
profits. That’s the good news. The bad news is that
the owner has unlimited liability for business debts.
This means that creditors can look beyond business
assets to the proprietor’s personal assets for
payment.
The life of a sole proprietorship is limited to the
owner’s life span, and the amount of equity that can
be raised is limited to the amount of the proprietor’s
Partnership
A partnership is similar to a proprietorship
except that there are two or more owners
(partners).
In a general partnership, the entire partners
share in gains or losses, and all have unlimited
liability for all partnership debts, not just some
particular share.
The way partnership gains (and losses) are
divided is described in the partnership
agreement.
In a limited partnership, one or more general
partners will run the business and have
unlimited liability, but there will be one or
more limited partners who will not actively
participate in the business.
A limited partner’s liability for business debts
is limited to the amount that partner
contributes to the partnership.
Based on our discussion, the primary
disadvantages of sole proprietorships and
partnerships as forms of business organization
are:
 unlimited liability for business debts on the part of the
owners,
 limited life of the business, and

 Difficulty of transferring ownership.

These three disadvantages add up to a single,

central problem: the ability of such businesses
to grow can be seriously limited by an inability
to raise cash for investment.
Corporation
The corporation is the most important form (in
terms of size) of business organization.
 A corporation is a legal “person” separate and
distinct from its owners, and it has many of the
rights, duties, and privileges of an actual person.
Corporations can borrow money and own property,
can sue and be sued, and can enter into contracts.
A corporation can even be a general partner or a
limited partner in a partnership, and a corporation
can own stock in another corporation.
Not surprisingly, starting a corporation is
somewhat more complicated than starting the
other forms of business organization.
Forming a corporation involves preparing
articles of incorporation (or a charter). The
articles of incorporation must contain a
number of things, including the corporation’s
name, its intended life (which can be
forever), its business purpose, and the
number of shares that can be issued.
The bylaws are rules describing how the
corporation regulates its existence.
For example, the bylaws describe how directors
are elected. These bylaws may be a simple
statement of a few rules and procedures, or they
may be quite extensive for a large corporation
In a large corporation, the stockholders and the
managers are usually separate groups.
The stockholders elect the board of directors, who
then select the managers. In principle,
stockholders control the corporation because they
elect the directors.
As a result of the separation of ownership
and management, the corporate form has
several advantages.
Ownership (represented by shares of stock)
can be readily transferred, and the life of the
corporation is therefore not limited.
The corporation borrows money in its own
name. As a result, the stockholders in a
corporation have limited liability for
corporate debts. The most they can lose is
what they have invested.
The corporate form has a significant
disadvantage. Because a corporation is a
legal person, it must pay taxes. Moreover,
money paid out to stockholders in the form of
dividends is taxed again as income to those
stockholders.
This is double taxation, meaning that
corporate profits are taxed twice: at the
corporate level when they are earned and
again at the personal level when they are
paid out as a dividend.
END OF CHAPTER
ONE THANK YOU