CHAPTER ONE: Introduction to

Financial
Management
1
An Overview of Financial Management
Financial Management is:
A process of planning, organizing, directing and
controlling the financial activities such as
procurement and utilization of funds of the
enterprise.
 It is about applying general management
principles to financial resources of the
enterprise.
Management of the finances of an organization
in order to achieve financial objectives.
2
Example includes:
pay bills (materials, electricity, advertising),
Pay wages and salaries,
Acquire resources,
Develop new products, and etc.
Concerned with the acquisition, financing, and
management of assets with some overall goal in mind.
Sound financial management is essential in all types of
organizations whether it be profit or non-profit.

3
Objectives of Financial Management
Taking a commercial business as the most common
organizational structure, the key objectives of financial
management would be to:
1. Ensure regular and adequate supply of funds
2. Ensure adequate return on investment bearing in mind the
risks that the business is taking and the resources invested
3. Ensure optimum funds utilization. Once the funds are
procured, they should be utilized in maximum possible way
at least cost.
4. Plan a sound capital structure. There should be sound and
fair composition of capital so that a balance is maintained
between debt and equity capital.
4
Functions of Financial Management
There are three key functions of financial management:
(1) Financial Planning
Management need to ensure that sufficient funding is
available at the right time to meet the needs of the
business.
In the short term, funding may be needed to
invest in equipment and stocks, pay employees
and fund sales made on credit.
In the medium and long term, funding may be
required for significant additions to the productive
capacity of the business or to make acquisitions.
5
(2) Financial Control
Financial control helps to ensure that the business
is meeting its objectives.
Financial control addresses questions such as:
Are assets being used efficiently?
Are the businesses assets secure?
Does management act in the best interest
of shareholders and in accordance with
business rules?

6
(3) Financial Decision-making
The key aspects of financial decision-making relate to
investment, financing and dividends:
Investments must be financed in some way –
however there are always financing alternatives that
can be considered.
 For example it is possible to raise finance from
selling new shares, borrowing from banks or taking
credit from suppliers
A key financing decision is whether profits earned by
the business should be retained rather than
distributed to shareholders via dividends. If dividends
are too high, the business may be starved of funding
to reinvest in growing revenues and profits further.
7
Financial Management Decisions
The financial manager must be concerned with three
basic types of decisions.
Capital Budgeting (Investment Decisions):
The process of planning and managing a firm’s
long-term investments
In capital budgeting, the financial manager tries to
identify investment opportunities that are worth more to
the firm than they cost to acquire.
This means that the value of cash flow generated
by an asset exceeds the cost of that asset.
8
Regardless of the specific investment under
consideration, financial managers must be concerned
with,
How much cash they expect to receive,
When they expect to receive it, and
How likely they are to receive it.
Evaluating the size, timing, and risk of future cash
flows is the essence of capital budgeting.
In fact, whenever we evaluate a business decision,
the size, timing, and risk of the cash flows will be, by
far, the most important things we will consider.
9
Capital Structure (Financing Decisions):
A firm’s capital structure refers to the specific
mixture of long-term debt and equity the firm uses to
finance its operations.
This decision concerns how the firm obtains the
financing it needs to support its long-term
investments.
The financial manager has two concerns in this area:
First: How much should the firm borrow?
Second: What are the least expensive sources
of funds for the firm?
10
In addition to deciding on the financing mix, the
financial manager has to decide exactly how
and where to raise the money.
The expenses associated with raising long-term
financing can be considerable, so different
possibilities must be carefully evaluated.
Also, businesses borrow money from a variety
of lenders in a number of different ways.
Choosing among lenders and among loan types
is another job handled by the financial manager.
11
Working Capital Management:
The term working capital refers to a firm’s short-
term assets, such as inventory, and its short-
term liabilities, such as money owed to suppliers.
Managing the firm’s working capital is a day-to-
day activity that ensures the firm has sufficient
resources to continue its operations and avoid
costly interruptions.
This involves a number of activities related to
the firm’s receipt and disbursement of cash.
12
Some questions about working capital that
must be answered are:
How much cash and inventory should
we keep on hand?
Should we sell on credit to our
customers?
How will we obtain any needed short-
term financing? If we borrow in the short
term, how and where should we do it?
13
The Goal of the Firm
The goal of a firm is the framework for making
decisions in an organization.
It serves as an objective function a decision
maker is trying to achieve.
It could be set as either:
Maximizing a variable; such as value,
profit, revenue, and size, or
Minimizing a variable; such as risk or costs.
14
Any decision in an organization should be made
to achieve the objective function adopted.
The problem with business organizations is they
have got multiple stakeholders.
So whose interest shall management try to
maximize? Shall management give priority
to the benefits of the society, the
satisfaction of its employees, its own return,
the return to its creditors or owner’s value?

15
Profit Maximization Vs Wealth Maximization
Profit maximization:
Considers profit as the most appropriate
measure of a firm’s performance.
Maximizing the birr income of firms.
While maximizing profit, a firm either produces
maximum output for a given amount of input, or
uses minimum input for producing a given output.
Thus the underlining logic of profit maximization is
efficiency.
16
There are various measures of profit that could
be maximized, including the following:
Operating profit (profit before interest
and taxation)
Net profit before tax
Net profit after tax
Net profit available to ordinary share
holders
Net profit per ordinary share , and so on
17
Limitations:
1. It could increase current profits while harming the firm.
A business might increase short term profits at the expense of
long-term competitiveness and performance of a business.
It could be done by reducing operating expenses:
Cutting research and development expenditure
defer important maintenance costs
Cutting staff training and development
Buying lower quality materials
Cutting quality control mechanisms
These policies may all have a beneficial effect on short term
profits but may undermine the long term competitiveness and
performance of a business.
18
2. Ignores changes in the risk level of the firm.
A profit maximization policy should lead managers
to invest in a high-risk projects and such a policy
may not reflect the needs of the shareholders.
Attaining very high rates of return would not
necessarily maximize the value of the firm if it is
achieved by taking unjustifiably high risks.

19
3. Profit Maximization fails to take into
account the time pattern of returns
It ignores any difference in timing of returns
and simply compares the total profits
irrespective of how much is to occur and
when.
The receipt of funds sooner is preferred as it
could be reinvested to provide greater future
earnings.

20
4. It doesn’t show cash flow available to
shareholders
Profit does not represent cash flow available to
shareholders.
Owners receive returns either through cash
dividends or by selling their shares for a better
price. Higher EPS doesn’t necessarily mean dividend
payments will increase.
Above all, accounting profit is affected by the
accounting method followed and is prone to
manipulation by the management.
21
Shareholder’s Wealth Maximization
The contemporary view of the goal of the firm is
maximizing shareholders value.
Therefore management tries to maximize the value of
shareholders and only satisfies the needs of the other
stakeholders.
For a publicly traded enterprise this goal could be
interpreted as maximization of the firm’s stock price.

Shareholder’s Wealth = Number of Shares Hold (X)

Current price per share
22
The value of a firm is represented by the market price of the
company's stock.
The market price of a firm's stock represents the assessment
of all market participants as to what the value of the
particular firm is.
It takes in to account,
Present and prospective future earnings per share,
The timing and risk of these earning,
The dividend policy of the firm and many other
factors that price
Market bearacts
upon theperformance
as the market price
indexof
or the stock.
report card of the firm's progress and potential.

23
This goal is justified because:
Shareholder wealth is better
defined than profits
Considers timing of profits
Considers risk differences among
alternative courses of action

24
The three basic facts that need to be considered in addressing the
goal of maximizing value (stock price of common stock) are:
1. Any financial asset, including a firm’s stock, is valuable only to
the extent that it generates cash flows.
a. Stocks that could generate higher cash flows have higher
value (price) than those that could fetch lower amount of
cash flows.
b. In theory a stock that couldn’t generate cash to the holder
has a value of zero.
2. The timing of cash flows matters-cash received sooner is
better.
3. Investors generally are risk averse. Keeping other things
constant, investors pay more for a stock whose cash flows are
less risky than for one with risky cash flows.
25
The Agency Relationship and Conflicts of
Interest
An agency relationship explains the relationship
between individual(s) (principal) that hires another
individual or organization (an agent) to perform
some service and delegates decision-making
authority.
In financial management there are two primary
agency relationships: between
Shareholders and managers, and
Shareholders and creditors.
26
Conflict of Interest between Managers and
Shareholders
In a corporate firm management and ownership are
separated.
It is the managers who are concerned with the day-to-
day management of operations.
Even if the goal of any business firm is to maximize the
wealth of shareholders, management may take
unobserved actions in their behalf because it is virtually
impossible for shareholders to monitor all managerial
actions. This creates conflict of interest between
managers and shareholders.
27
The possible objectives management may
follow apart from the goal of the firm include:
Maximizing its personal returns
(salaries, bonuses and perquisites)
Increasing its prestige (generously
donating in charities, maximizing the size
of the firm and its market share)
Increase job security by making
takeovers less likely
28
Some specific examples of conflict of interest
between managers and shareholders include:
Takeovers
Research has shown that shareholders in
hostile takeovers often earn large amount of
financial returns.
However, management in an effort to save its
job, devote large amount of time and money
to defend their company against takeovers.
This costs the shareholders.
29
Time horizon
The performance of managers
usually is judged based on short-term
achievements.
Shareholders wealth on the other
hand depends on long-term
performance of the firm. Hence,
management takes the short-term
ones. 30
Risk
Shareholders appraise (assess) risks by looking at
the overall risk of the investments in a wide variety
of investments.
On the other hand, management’s career depends
on the performance of the firm.
Hence, management becomes less aggressive
even if that could add value to shareholders.
Management can do the same when it comes to
taking additional loans. Management would restrain
from taking loans even if the firm could benefit.
31
In general, to reduce the above agency conflicts stock holders
incur costs, called agency costs, which include all costs borne
by shareholders to maximize the firm’s stock price rather than
act in their own self-interest.
The agency costs incurred by the shareholders are:
1. expenditures to monitor managerial actions such as
auditing costs
2. expenditures to structure the organization in a way
that will limit undesirable managerial actions, such as
appointment of BODs, and
3. Opportunity costs; some decisions are made by the
BODs or shareholders vote, this makes the decisions
untimely and sub-optimal (as share holders and BODs
may lack the necessary expertise)
32
There are two extreme positions in dealing with
shareholder-manager agency conflicts.
 At one extreme, shareholders provide
incentives for management with no efforts to
monitor management’s actions.
 On the other extreme stockholders monitor
every managerial action.
The optimal solution lies in between the above
options:
 Where management compensation is tied to
performance but monitoring is also done.
33
Some of the mechanisms used to motivate managers
to act in the shareholders best interest include:
Managerial compensation plans: -
Shareholders devise compensation packages in order
to attract and retain able managers and to align
manager’s actions with their interests.
The common compensation plans include:
 Salary, bonuses paid at the end of the year
based on profitability and performance, and
stock options.
34
Direct intervention by shareholders: -
today-institutional investors such as pension
funds, mutual funds and insurance
companies own the majority shares of
publicly traded firms. These investors made
investments in huge amounts and hence they
cannot exit easily from their investments. In
addition their significant ownership makes
direct intervention on the actions of the
management possible.
35
The threat of firing
The threat of takeovers: -
Hostile takeovers are acquisitions of a firm
without the consent of the management.
Hostile takeovers are most likely to occur when
a stock’s price is under-valued relative to its
potential because of poor management.
In a hostile takeover management usually
loses its job.
36
Conflict of Interest between Stockholders and
Creditors
The owners and creditors contribute the resources of business
enterprises.
Shareholders control resources through the management and
creditors do not have such privileges.
Hence, shareholders (with the management) act as an agent
for the debt holders. However; shareholders expropriate value
from debt holders by following selfish investment strategies
i.e. invest on risky assets.
If the investment turns out to be successful the
benefits is to the shareholders (as the claim of debt
holders is fixed) but the value of debt holders claim
(such as bonds) goes down.
37
To protect themselves from such expropriation
creditors put restrictive covenants.
This restricts the firm from involving in
certain risky investments which could limit
the firm from making additional profits.
This is an agency cost for the
shareholders.

38