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Financial Management--Lecture Note

The document provides an overview of financial management, emphasizing its importance as the lifeblood of business organizations. It defines finance, classifies its branches, and discusses the objectives of financial management, contrasting profit maximization with wealth maximization. Additionally, it outlines the functions of finance managers and key principles of financial management, such as the time value of money and risk-return trade-off.

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6 views

Financial Management--Lecture Note

The document provides an overview of financial management, emphasizing its importance as the lifeblood of business organizations. It defines finance, classifies its branches, and discusses the objectives of financial management, contrasting profit maximization with wealth maximization. Additionally, it outlines the functions of finance managers and key principles of financial management, such as the time value of money and risk-return trade-off.

Uploaded by

bsamsonworku
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter I

An Overview of Financial Management


1. Introduction
Business concern needs finance to meet their requirements in the economic world. Any kind of
business activity depends on the finance. Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need finance to fulfil their business
activities.
2. The Meaning of Finance
In simple terms finance means money. Finance may be defined as the art and science of
managing money. It includes financial service and financial instruments. Finance also is referred
as the provision of money at the time when it is needed. Finance function is the procurement of
funds and their effective utilization in business concerns.
3. Classification of Finance
Finance as a field of study has several branches.
1. Financial Management/Corporate Finance/Business Finance, which deals with
proprietary Finance, Partnership Finance, Corporate Finance.
2. Financial Economics, composed of Financial Markets (Capital Markets & Money
Markets); Financial Institutions; Financial Instruments (Shares, Bonds, Currencies and
others).
3. Investment, composed of securities analysis, portfolio theory, market analysis, behavioral
finance.
4. Personal Finance
5. Public Finance
They can be categorized into three:
 Personal Finance
 Public Finance
 Private Finance
4. Definition of Financial Management
Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm. The term financial management has been defined
by Solomon, “It is concerned with the efficient use of an important economic resource namely,
capital funds”.
The most popular and acceptable definition of financial management as given by S.C. Kuchal is
that “Financial Management deals with procurement of funds and their effective utilization in the
business”.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.

pREPARED BY: sAMSON WORKU (MBA,MA,COC CERTIFIED) 1


5. Objectives of Financial Management: Profit Maximization vs. Wealth Maximization
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization
Profit Maximization

Main aim of any kind of economic activity is earning profit. A business concern is also functioning
mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business
efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at,
maximizes the profit of the concern.
Profit maximization objective consists of certain drawback also:

 It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
 It ignores the time value of money: Profit maximization does not consider the time
value of money or the net present value of the cash inflow. It leads certain differences
between the actual cash inflow and net present cash flow during a particular period.
 It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business
concern.

Example:

Profit maximization does not consider risk or uncertainty, whereas wealth maximization does.
Example: XY 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. And Project B
has a 90% probability that its cash flows for the next three years would be realized.

Expected Return (Benefit)


Year Project A Project B
1 $ 60,000 $ 45,000
2 65,000 50,000
3 95,000 85,000
Total $ 220,000 $ 180,000
 Under profit maximization, project A is more attractive because it adds more to XY than
project B. But if we consider the risk of the two projects, the situation would be reversed.
• Expected benefit of project A = $ 220,000 x 50% = $ 110,000
• Expected benefit of project B = $ 180,000 x 90% = $ 162,000
 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).

pREPARED BY: sAMSON WORKU (MBA,MA,COC CERTIFIED) 2


Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or the
wealth of the persons those who are involved in the business concern. Wealth maximization is also known
as value maximization or net present worth maximization. This objective is universally accepted concept
in the field of business. It is maximizing the price of the stock of the firm.

6. Functions of Finance Manager


The finance functions include:
 Investment decision—long term asset-mix
 Finance decision—capital -mix
 Dividend decision—profit allocation
 Liquidity decision—short term asset-mix

7. Principles of Financial Management

Time value of money


• A Birr received today is worth more than a Birr received in the future.
• A Birr received today is worth more than a Birr received a year from now. Because we can
earn interest on money received today, it is better to receive money earlier rather than
later.

Risk-Return Trade-off
 We won’t take on additional risk unless we expect to be compensated with additional
return.
 Investment alternatives have different amounts of risk and expected returns.
 The more risk an investment has, the higher will be its expected return.
The agency problem
 Managers won’t work for the owners unless it is in their best interest.
 The separation of management and the ownership of the firm creates an agency problem.
Managers may make decisions that are not in line with the goal of maximization of
shareholder wealth.
Cash—Not Profits—is King
 Cash Flow, not accounting profit, is used to measure wealth.
 Cash flows, not profits, are actually received by the firm and can be reinvested.

Efficient capital market


 The values of all assets and securities at any instant in time fully reflect all available
information.
All risks are not equal
 Some risk can be diversified away, and some cannot.

pREPARED BY: sAMSON WORKU (MBA,MA,COC CERTIFIED) 3


8. Organizational Chart of the Finance Function

pREPARED BY: sAMSON WORKU (MBA,MA,COC CERTIFIED) 4

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