Chapter One

Introduction
1.1 An Overview of Financial Management
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.
governments.
 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.
Broadly speaking, financial management (or Corporate finance), is the study of ways to
answer the following three questions:
i. What long-term investments should you take on? That is, what lines of business will you be
in and what sorts of buildings, machinery, and equipment will you need?
ii. Where will you get the long-term financing to pay for your investment? Will you bring in
other owners or will you borrow the money?
iii. How will you manage your everyday financial activities such as collecting from customers
and paying suppliers? These are not the only questions by any means, but they are among the
most important.
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. 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.

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a. 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.

b. 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. Thus, financial management means the entire
range of managerial efforts devoted to the management of finance – both its sources and uses –
of the enterprise.
Who Is the Financial Manager?
A unique feature of large corporations is that the owners (the stockholders) are usually not
directly involved in making business decisions, particularly on a day-to-day basis. Instead, the
corporation employs managers to represent the owners’ interests and make decisions on their
behalf. In a large corporation, the financial manager would be in charge of answering the three
questions we raised above. The financial management function is usually associated with a top
officer of the firm, such as a vice president of finance or some other chief financial officer
(CFO).

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 Board of Directors

President and Chief

Operations Officer
(COO)

Vice President Vice President Vice President

marketing Finance (CFO) Production

Treasurer Controller

Cash Credit Tax Acct Cost Acct

manager Manage manager Manager

Capital Financi
Financial Data
Expenditur al
acct Processing
es Plannin

The above Figure is a simplified organizational chart that highlights the finance activity in a
large firm. As shown, the vice president of finance coordinates the activities of the treasurer and
the controller. The controller’s office handles cost and financial accounting, tax payments, and
management information systems. The treasurer’s office is responsible for managing the firm’s
cash and credit, its financial planning, and its capital expenditures. These treasury activities are
all related to the three general questions raised earlier.

1.2Basic Assumptions and Principles of financial management

There are ten principles and assumptions that form the basics of Financial Management. These
can be called as the foundation of finance that plays significant role in decision making made by

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financial managers.
Principle 1: The risk returns trade off – investors won’t take additional risk unless they expect
to be compensated with additional return.
Principle 2: Time Value of Money - a dollar received today is worth more than a dollar
received a year from now.
Principle 3: CASH, not profits is KING - it is cash flows not profits that are actually received
by the firm and can be reinvested.
Principle 4: Incremental Cash Flows- It's only what changes that counts. The incremental cash
flow is the difference between the cash flows if the project is taken on versus what they will be if
the project is not taken on.
Principle 5: The Curse of Competitive Markets-Why it's hard to find exceptionally profitable
projects.
Principle 6: Efficient Capital Markets-the markets are quick and the prices are right. An
efficient market is characterized by a large number of profit-driven individuals who act
independently.
Principle 7: The Agency Problem-a problem resulting from conflicts of interest between the
manager/agent and the stockholder.
Principle 8: Taxes Bias Business Decisions
Principle 9: All Risk is not equal-some risk can be diversified away, and some cannot.
Principle 10: Ethical Behavior is doing the right thing, and ethical dilemmas are everywhere in
finance.

1.3 Scope of Financial Management

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

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 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 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.

1.4Functions of Financial Management

As the preceding discussion suggests, the financial manager must be concerned with three basic
types of questions. We consider these in greater detail next.
i. Capital Budgeting: The first question concerns the firm’s long-term investments. The
process of planning and managing a firm’s long-term investments is called capital
budgeting. In capital budgeting, the financial manager tries to identify investment
opportunities that are worth more to the firm than they cost to acquire. Loosely speaking, this
means that the value of the cash flow generated by an asset exceeds the cost of that asset.
ii. Capital Structure: The second question for the financial manager concerns ways in which
the firm obtains and manages the long-term financing it needs to support its long-term
investments. A firm’s capital structure (or financial structure) is the specific mixture of
long-term debt and equity the firm uses to finance its operations. The financial manager has
two concerns in this area. First, how much should the firm borrow? That is, what mixture of
debt and equity is best? The mixture chosen will affect both the risk and the value of the
firm. Second, what are the least expensive sources of funds for the firm?
iii. Working Capital Management: The third question concerns 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
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 day-to-day activity that ensures that 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.
Some questions about working capital that must be answered are the following:
1) How much cash and inventory should we keep on hand?
2) Should we sell on credit? If so, what terms will we offer, and to whom will we extend them?
3) How will we obtain any needed short-term financing? Will we purchase on credit or will we
borrow in the short term and pay cash? If we borrow in the short term, how and where
should we do it? These are just a small sample of the issues that arise in managing a firm’s
working capital.
1.5The Goal of Financial Management
If we were to consider possible financial goals, we might come up with some ideas like the
following:
 Survive.
 Avoid financial distress and bankruptcy.
 Beat the competition.
 Maximize sales or market share.
 Minimize costs.
 Maximize profits.
 Maintain steady earnings growth.
These are only a few of the goals we could list. Furthermore, each of these possibilities presents
problems as a goal for the financial manager.
For example: it’s easy to increase market share or unit sales; all we have to do is lower our
prices or relax our credit terms. Similarly, we can always cut costs simply by doing away with
things such as research and development. We can avoid bankruptcy by never borrowing any
money or never taking any risks, and so on. It’s not clear that any of these actions are in the
stockholders’ best interests.
Profit maximization would probably be the most commonly cited goal, but even this is not a
very precise objective. The following reasons make profit maximization less precise as a goal of
financial management.
i. The term profit is Ambiguous: it has different meanings

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  Do we mean Gross profit or net profit; or is it before tax or after tax
 Do we mean profits the current year?
If so, taking short-run cost-cutting measures will tend to increase profits now, but these activities
aren’t necessarily desirable.
ii. Profit doesn’t show cash flow
Eg. Consider the following two projects A and B.
Projects A B
Revenue 12, 000 12,000
Expenses (9, 000) (9, 000)
Profit 3, 000 3, 000
iii. Profit Ignores time value of money: it doesn’t use discounted cash flows
Eg. Project A Project B

Benefits in Birrs Benefits in Birrs

Period 1 5, 000 _

2 10, 000 10, 000

3 5, 000 10, 000

20, 000 20, 000

Though A and B generate equal profit (cash flows). But A is preferred to B because the present
value its cash flows is greater than B. That is higher quality of benefits.

These points made the term profit ambiguous. Thus, we need some other goal of financial
management.
Wealth Maximization as the Goal of Financial Management
The financial manager in a corporation makes decisions for the stockholders of the firm. Given
this, instead of listing possible goals for the financial manager, we really need to answer a more
fundamental question: From the stockholders’ point of view, what is a good financial
management decision?

If we assume that stockholders buy stock because they seek to gain financially, then the answer
is obvious:

 Good decisions increase the value of the stock, and

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  Poor/ bad decisions decrease the value of the stock.
Given our observations, it follows that the financial manager acts in the shareholders’ best
interests by making decisions that increase the value of the stock. The appropriate goal for the
financial manager can thus be stated quite easily.

The goal of financial management is to maximize the current value per share of the existing
stock. The goal of maximizing the value of the stock avoids the problems associated with the
different goals we listed earlier. There is no ambiguity in the criterion, and there is no short-run
versus long-run issue. We explicitly mean that our goal is to maximize the current stock value.
If this goal seems a little strong or one-dimensional to you, keep in mind that the stockholders in
a firm are residual owners. By this we mean that they are only entitled to what is left after
employees, suppliers, and creditors (and anyone else with a legitimate claim) are paid their due.
If any of these groups go unpaid, the stockholders get nothing. So, if the stockholders are
winning in the sense that the leftover, residual, portion is growing, it must be true that everyone
else is winning also.

Because the goal of financial management is to maximize the value of the stock, we need to learn
how to identify those investments and financing arrangements that favorably impact the value of
the stock. This is precisely what we will be studying.
In fact, we could have defined corporate finance as the study of the relationship between
business decisions and the value of the stock in the business.
A More General Goal
Given our goal as stated in the preceding section (maximize the value of the stock), an obvious
question comes up: What is the appropriate goal when the firm has no traded stock?

Corporations are certainly not the only type of business; and the stock in many corporations are
not traded, so it’s difficult to say what the value per share is at any given time.
As long as we are dealing with for-profit businesses, only a slight modification is needed. The
total value of the stock in a corporation is simply equal to the value of the owners’ equity.
Therefore, a more general way of stating our goal is as follows: maximize the market value of
the existing owners’ equity.

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With this in mind, it doesn’t matter whether the business is a proprietorship, a partnership, or a
corporation. For each of these,
 Good financial decisions increase the market value of the owners’ equity and
 Poor/bad financial decisions decrease it.
1.6Agency Problems
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
Suppose that you hire someone to sell your car and that you agree to pay that person a flat fee
when he/she sells the car. The agent’s incentive in this case is to make the sale, not necessarily to
get you the best price. If you offer a commission of, say, 10 percent of the sales price instead of a
flat fee, then this problem might not exist.
 This example illustrates that the way in which an agent is compensated is one factor that
affects agency problems.
Management Goals
To see how management and stockholder interests might differ, imagine that the firm is
considering a new investment. The new investment is expected to favorably impact the share
value, but it is also a relatively risky venture.
The owners of the firm will wish to take the investment (because the stock value will rise), but
management may not because there is the possibility that things will turn out badly and
management jobs will be lost. If management does not take the investment, then the stockholders
may lose a valuable opportunity. This is one example of an agency cost.
More generally, the term agency costs refer to the costs of the conflict of interest between
stockholders and management. These costs can be indirect or direct.
 Indirect agency cost is a lost opportunity, such as the one we have just described.
 Direct agency costs come in two forms.

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 The first type is a corporate expenditure that benefits management but costs the stockholders.
E.g. the purchase of a luxurious automobile and unneeded corporate jet would fall under this
heading.
 The second type of direct agency cost is an expense that arises from the need to monitor
management actions. Paying outside auditors to assess the accuracy of financial statement
information could be one example.
It is sometimes argued that, left to themselves, managers would tend to maximize the amount of
resources over which they have control or, more generally, corporate power or wealth. This goal
could lead to an overemphasis on corporate size or growth. For example, cases in which
management is accused of overpaying to buy up another company just to increase the size of the
business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does
take place, such a purchase does not benefit the stockholders of the purchasing company.
Our discussion indicates that management may tend to overemphasize organizational survival to
protect job security. Also, management may dislike outside interference, so independence and
corporate self-sufficiency may be important goals.
Do Managers Act in the Stockholders’ Interests?
Whether managers will, in fact, act in the best interests of stockholders depends on two factors.
 First, how closely are management goals aligned with stockholder goals? This question
relates to the way managers are compensated.
 Second, can management be replaced if they do not pursue stockholder goals? This issue
relates to control of the firm.
There are a number of reasons to think that, even in the largest firms, management has a
significant incentive to act in the interests of stockholders.
Managerial Compensation: Management will frequently have a significant economic incentive
to increase share value for two reasons.

 First, managerial compensation, particularly at the top, is usually tied to financial

performance in general and oftentimes to share value in particular. For example,
managers are frequently given the option to buy stock at a bargain price. The more the
stock is worth, the more valuable is this option. Therefore, managers will work to
increase the value of the stock.

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  Second incentive managers have relates to job prospects. Better performers within the
firm will tend to get promoted. More generally, those managers who are successful in
pursuing stockholder goals will be in greater demand in the labor market and thus
command higher salaries.

Control of the Firm: Control of the firm ultimately rests with stockholders. They elect the board
of directors, who, in turn, hire and fire management. Since stockholders control the corporation
they can replace the managers through their elected directors.

Mechanisms to replace existing management

 Proxy fight: A proxy is the authority to vote someone else’s stock. A proxy fight
develops when a group solicits proxies in order to replace the existing board, and thereby
replace existing management.
 Takeover: Those firms that are poorly managed are more attractive as acquisitions than
well-managed firms because a greater profit potential exists. Thus, avoiding a takeover
by another firm gives management another incentive to act in the stockholders’ interests.
1.7Closely related field of financial Management
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.

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

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 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.
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 manger. A financial manger must understand the interrelationships
between the various sectors of the 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. They must use economic theories as guidelines for their efficient financial decision
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.

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.
Primary Disciplines
1. Investment analysis 1. Accounting
Support
2. Working capital management 2. Macro economics
3. Sources and costs of funds 3. Micro-economics
4. Capital structure decisions
Results in
5. Dividends policy
Other Related Discipline
6. Analysis of risk and return
1. Marketing
2. Production
Shareholder wealth maximization
3. Quantitative Methods

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