FINANCIAL

ANAGEMENT-I

CHAPTER ONE
OVERVIEW OF FINANCIAL MANGEMENT
1. 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.
Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore, finance
is also an area of study that deals with how, where, by whom, why, and through what money is
transferred among and between individuals, businesses, and governments. It is concerned with
the processes, institutions, markets, and instruments involved in the transfer of funds.
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.

1.1. Major Areas of Finance

Since the concepts and areas of finance are very broad, the academic discipline of finance can be
viewed as made of specialized areas. There are several ways to summarize the major areas of
finance. One way is to review the career opportunities under it. Another way is based on the
differences in the objectives of different organizations (Corporate Finance, Investments,
Financial Markets & Institutions). For the sake of simplifying our discussion, we summarize the
major fields of finance based on career opportunities in finance.
The career opportunities again can be divided into different categories. For our convenience,
these opportunities can be categorized into two broad areas.
i) Financial Services
This is a part of finance which involves personal career opportunities as a loan officer, financial
planner, stockbroker, real estate agent, and insurance broker. It is generally concerned with the
design, development, and delivery of these financial services to individuals, business
organizations, and governments.

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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. It involves specific financial functions of the firm.

1.2. 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.
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.
finance. These terms are used interchangeably in this
material.

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.

unit. These include
marketing, production, human resource management, and financial management. Financial
management is one of the important functions of a firm. It is a specified business function that
deals with the management of capital sources and uses of a firm.
firm.

1.3. Finance and related fields

Though finance had ceded itself from economics, it is not totally an independent field of study. It 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, and computer science. Among these disciplines, the field of finance is
closely related to economics and accounting.

1.3.1. Finance versus Economics

Finance and economics are closely related in many aspects.

 First, economics is the mother field of finance.
finance.
 Second, the economic environment within which a firm operates influences the decisions of a
financial manger. A financial manger must understand the interrelationships between the
various sectors of the economy.
economy. He must also understand such economic variables as a gross
domestic product, unemployment, inflation, interests, and taxes in making financial decisions.

 Financial managers must also be able to use the structure of decision-making provided by
economics.
economics. They must use economic theories as guidelines for their efficient financial

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decision making.
making. These theories include pricing theory through the relationships between
demand and supply, return analysis, profit maximization strategies, and marginal analysis.
 The last one, particularly, is the primary economic principle used in financial management.
management.

Basic Differences between Finance and Economics

i) Finance is less concerned with theory than is economics. Finance is basically concerned with
the application of theories and principles.
ii) Finance deals with an individual firm; but economics deals with the industry and the overall
level of the economic activity.
1.3.2. 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

i) Treatment of income: - in accounting income measurement is on accrual basis.
basis. Under this
method revenues are recognized as earned and expenses as incurred. In finance, however,
the cash method is employed to recognize the revenue and expenses.
ii) 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.
iii) Accounting is highly governed by generally accepted accounting principles.
principles.

1.4. Sources of Finance

Some sources of finance are short term and must be paid back within a year. Other sources of
finance are long term and can be paid back over many years.
Sources of finance can be classified as:
1. Internal sources of finance are funds found inside the business. For example, profits can be
kept back to finance expansion. Alternatively the business can sell assets (items it owns) that
are no longer really needed to free up cash.
2. External sources of finance are found outside the business, eg from creditors or banks.
banks.

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Sources of external finance to cover the short term include:

 An overdraft facility - where a bank allows a firm to take out more money than it has in its
bank account.
 Trade credits - where suppliers deliver goods now and are willing to wait for a number of
days before payment.
 Factoring - where firms sell their invoices to a factor such as a bank. They do this for some
cash right away, rather than waiting 28 days to be paid the full amount.
Long-term sources of external finance
Sources of external finance to cover the long term include:
 Owners who invest money in the business. For sole traders and partners this can be their
savings.
savings. For companies, the funding invested by shareholders is called share capital.
capital.
 Loans from a bank or from family and friends.
 Debentures are loans made to a company.
 A mortgage,
mortgage, which is a special type of loan for buying property where monthly payments
are spread over a number of years.
 Hire purchase or leasing,
leasing, where monthly payments are made for use of equipment such as
a car. Leased equipment is rented and not owned by the firm. Hired equipment is owned
by the firm after the final payment.
 Grants from charities or the government to help businesses get started, especially in areas
of high unemployment.
1.5. Scope of Financial Management (Traditional Vs Modern Views)
The scope of financial management refers to the range or extent of matters being dealt with in
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. Simply stating, the old approach treated financial management in a narrow sense and the
financial manager as a less important person in the overall corporate management.

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

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that affect its finance. According to the modern approach, financial management provides a
conceptual and analytical framework for the three major financial decision making functions of a
firm. Accordingly, the scope of managerial finance involves the solution to investing, financing,
and dividend policy problems of a firm. Besides, 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.

The increased globalization of business has expanded the scope of financial management further to
include financial decisions pertaining to the international financial environment.

1.6. The Functions of Financial Management

This refers to the special activities or purposes of financial management. 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:
 Investment decisions  Financing decisions  Dividend decisions
1.6.1. Investment Decisions
They deal 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:
i) Determining the asset mix or composition: - determining the total amount of the firm’s
finance to be invested in current and fixed assets.
ii) Determining the asset type: - determining which specific assets to maintain within the
categories of current and fixed assets.
iii) Managing the asset structure,
structure, i.e., maintaining the composition of current and fixed assets
and the type of specific assets under each category.
The investment decisions of a firm also involve working capital management and capital budgeting
decisions. The former refers to those decisions of a firm affecting its current assets and short – term
liabilities. The later, on the other hand, involves long – term investment decisions like acquisition,
modification, and replacement of fixed assets.

Generally, the investment decisions of a firm deal with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

1.6.2. Financing Decisions

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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. In simple
terms, the financing decisions 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.

1.6.3. 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. There are tradeoffs on the dividend policy of a firm. Paying out
more dividends will make the firm to be perceived strong and healthy by investors; on the other
hand, it will affect the future growth of the firm. So the dividend decision of a firm should be
analyzed in relation to its financing decisions.
1.7. The Goal Of A Firm In Financial Management
1.7.1. The Need for a Goal and Characteristics of a Good Goal
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. A goal, therefore, is an explicit
operational guide or decision rule for the decision maker.
Although it is very difficult, a firm should be able to have a specific goal for the following two
basic reasons.
1. If a goal is not chosen, there is no way to select among alternative decision criteria. Without
an objective to achieve, there would be a number of approaches to select from available
decision rules.
2. If multiple goals are chosen, it is hardly possible to prioritize the decision criteria; and the
firm might end up achieving none of them
If a firm cannot choose its right goal, it can suffer severe consequences even to the extent of going
out of business. In fact, selecting the right goal is not such a simple task; but a good objective has
the following characteristics.
1. It is clear and unambiguous – a clear goal will lead to decision criteria that do not vary
from case to case and from person to person.
2. It provides a clear and timely measure to evaluate the success or failure of decisions.
decisions.
3. There should be some means to measure the objective.
4. It does not affect the specific benefits of a firm.
5. It does not affect the welfare of the society.

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6. It is based on long-term success of the firm.

Even though there are many alternative decision rules, in the sections that follow, we describe and
evaluate the decision criteria for financial management which are widely discussed in many
finance literature.
1.7.2. Profit Maximization As A Decision Rule
16.2.1. 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.
Profit maximization focuses on the total amount of benefits of any courses of action. This
decision rule as applied to financial management implies that the functions of managerial finance
should be oriented to making of money. Under the profit maximization decision criteria, actions
that increase profit of a firm should be undertaken;
undertaken; and actions that decrease profit should be
rejected.
rejected. Similarly, given alternative courses of actions, decisions would be made in favor of the
one with the highest expected profits.

Profit maximization, though widely professed, should not be used as a good goal of a firm in
financial management. This is because it fails to meet many of the characteristics of a good goal.
16.2.2. Limitations of Profit Maximization
1. Ambiguity. The term profit or income is vague and ambiguous concept. Different people
understand profit in different several ways.
There are many different economic and accounting definitions of profit, each open to its own
set of interpretations. Even 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 text profit.
Then, the question or the problem would be which profit is to be maximized? Maximizing
one may lead to minimizing the other.
Furthermore, problems related to inflation and international currency transactions complicate
the issue of profit maximization.
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 criterion ignores the differences in the time
pattern of benefits received from investment proposals. This criterion does not consider the
distinction between returns (benefits) received in different time periods and treats all benefits
as equally valuable irrespective of the time pattern differences in benefits. In other words, the

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profit maximization ignores the time value of money, i.e., money today is better than money
tomorrow. Also it does not consider the sooner, the better principle.

To understand this limitation better let us consider the following example.

Example Akaki Manufacturing Share Company wants to choose between two projects: project X
and project Y. both projects cost the same, are equally risky and are expected to provide the
following benefits over three years period.
BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 50,000 50,000
3 –0- 25,000
TOTAL Br. 75,000 Br. 75,000

The profit maximization criterion ranks both projects as being equal. However, project X provides
higher benefits in earlier years and project Y provides larger benefits in later years. The higher
benefits of project X in earlier years could be reinvested to earn even higher profits for later years.
Profit seeking organizations must consider the timing of cash flows and profits because money
received today has a higher value than money received tomorrow. Cash flows in early years are
valued more highly than equivalent cash flows in later years.

4. Quality of Benefits (Risk of Benefits). Profit maximization assumes that risk or uncertainty
of future benefits is not 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. The higher the risk, the higher the expected return.

Example: - Nyala Merchandising Private Limited Company 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

Under profit maximization, project A is more attractive because it adds more to Nyala than
project B. However, if we consider the risk of the two projects, the situation would be

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reversed.
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
In fact, risk can be measured in different ways, and different conclusions about the riskiness
of a course of action can be reached depending on the measure used. In addition to the
probability distribution, illustrated above, risk can also be measured on the basis of the
variation of cash flows.
The more certain the expected cash flow (return), the higher the quality of benefits (i.e., low
risk to investor). Conversely, the more uncertain or fluctuating the expected benefits, the
lower the quality of benefits (i.e., high risk to investors).
1.7.3. Wealth Maximization As A Decision Rule
1.7.3.1. Meaning Of Wealth Maximization
Wealth maximization means maximization of the value of a firm. Hence wealth
maximization is also called value maximization or net present value (NPV) maximization.
To understand and appreciate the essence of wealth maximization, we need to consider the
various stakeholders in a given corporation. Stakeholders are all individuals or group of
individuals who have a direct or indirect interest in the firm. They include stockholders,
debtors, managers, employees, customers, governmental agencies and others. But among
these, managers should give priority to stockholders. In fact, the overriding premise of
financial management is that a firm should be managed to enhance the well-being or wealth
of its existing common stockholders. Stockholders’ wellbeing depends on both current and
expected dividend payments and market price of the firm’s common stock.

There are several reasons why wealth maximization decision criterion is superior to other
criteria.
 First,
First, it has an exact measurement unlike profit maximization. It depends on cash flows
(inflows and outflows).
 Second,
Second, wealth maximization as a decision criterion considers the quality as well as the
time pattern of benefits.
 Third,
Third, it emphasizes on the long-term and sustainable maximization of a firm’s common
stock price in the financial market.
 Fourth, wealth maximization gives recognition to the interest of other stakeholders and
to the societal welfare on the long-term basis.
Technically, wealth maximization as a decision rule involves a comparison of value to cost.
Thus, an action that has a discounted value that exceeds its cost can be said to create value

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and such action should be undertaken. Whereas an action with less discounted value than cost
reduces wealth and, therefore, should be rejected. The discounted value is a value which
takes risk and timing of benefits into account.
1.7.3.2. Limitations of Wealth Maximization
The limitations of wealth maximization refer to the potential side costs of wealth
maximization if adopted as a decision criterion.
1. If wealth maximization is taken as the sole decision rule, there is a possibility that the
benefits of the society at large might be forgone. Fortunately, however, this problem is not
unique to wealth maximization. Even if an alternative goal is used, still this problem
continues to persist.
2. When managers of a corporation are separate from owners, there is a potential for a
conflict of interest between them. This conflict of interest can lead to the maximization of
manages’ interest instead of the welfare of stockholders.
3. 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.
4. Wealth maximization is normally reflected in the firm’s stock price. But if there are
inefficiencies in financial markets, wealth maximization decision rule may lead to
misallocation of scarce resources.
1.8. Conflict of goals between management and owners: Agency problem
As you understand, 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.

However, there is a conflict of goals between managers and owners of a corporation and
mangers may act to maximize their interest instead of maximizing the wealth of owners.
Managers are interested to maximize their personal wealth, job security, life style and fringe
benefits.

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 mangers
are agents of owners.

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Corporations (owners) are aware of these agency problems and they incur some costs as a
result of agency. These costs are called agency cost and include:

1. Monitoring expenditures – are expenditures incurred by corporations to monitor or

control the activities of managers. A very good example of a monitoring expenditure is
fees paid by corporations to external auditors.
2. Bonding expenditures – are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.
3. Structuring expenditures – expenditures 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.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as a
result of their organizational structure and hierarchy.
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. These ways include to make know managers
that they would be fired if they do not act to maximize shareholders wealth and that the
corporation could be overtaken by others if its value is very much lower than other firms.

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