Lecture Notes

Course Title: Financial Management

Program: Bachelor Degree, , Faculty of commerce

Grade: Four

Instructor

Professor Nesma Ahmed Heshmat

Business Administration Department
Faculty of commerce, Assiut University

Dr. Hend Mohamed Abdelazim Teleb

Lecturer in the department of Business
Administration
Faculty of commerce, Assiut University

2
 Financial
Management

Prepared by

Professor Nesma Ahmed Heshmat Business

Administration Department Faculty of commerce,
Assiut University

Dr. Hend Mohamed Abdelazim Teleb

Lecturer in the department of Business
Administration
Faculty of commerce, Assiut University

3
 Contents

Chapter 1 Introduction to financial management

Chapter 2 Financial statements and ratio analysis

Chapter 3 Cash Flow and Financial Planning

Chapter 4 Capital budgeting techniques

Chapter 5 Cost of capital

Chapter 6 Operating and Financial Leverage

Chapter 7 Working Capital

4
 CH 1:
Introduction to financial management

Business concerns require financing in order to satisfy their

needs in the global economy. The financial situation affects
all corporate activities. It is therefore referred to as the
lifeblood of a company organization. No matter how big or
little, businesses require funding to carry out their
operations.

1/ MEANING OF FINANCE:
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 can be broadly divided into two main categories:

- Private Finance, which includes the Individual, Firms,

Business or Corporate Financial activities to meet the
requirements.
- Public Finance, which includes tax systems,
government expenditures, budget procedures, debt
issues, and other government concerns.

5
1/2 SOURCES OF FINANCE:

Sources of finance may be classified under various

categories according to the following important heads:

1/2/1 Based on the period:

Sources of Finance may be classified under various

categories based on the period of financial requirement ,it
may be long term and short-term financial requirements.
a) Long-term sources:

When the finance mobilized with large amount and the

repayable over the period will be more than five years, it
may be considered as long-term sources. Long-term source
of finance needs to meet the capital expenditure of the firms
such as purchase of fixed assets such as , land and buildings,
furniture etc. Long term financial requirement is also called
as fixed capital requirements.

Long-term sources of finance include:

- Shares: The capital of a company is divided into

shares. Each share forms a unit of ownership of a
company and is offered for sale so as to raise capital
for the company. A share is issued by a company or
can be purchased from the stock market.
Shares can be broadly divided into two categories -
equity and preference shares. Equity shares give their
holders the power to share the earnings/profits in the
6
 company as well as a vote in the AGMs of the
company. Such a shareholder has to share the profits
and also bear the losses incurred by the company.
On the other hand, preference shares earn their holders
only dividends, which are fixed, giving no voting
rights. Equity shareholders are regarded as the real
owners of the company. When the shares are offered
for sale directly by the company for the first time, they
are offered in the primary market, whereas the trading
of shares takes place in the secondary market.
- Debenture /Bonds: are loans made to a company.
They normally carry a fixed interest rate and a certain
date of maturity. Interest is paid every year and
principal is paid on the date of maturity.
- Long-term Loans: are generally considered to be a
loan with a repayment term longer than five years.
- Fixed Deposits: It is a financial instrument offered by
banks or non-bank financial institutions that provide
investors with a higher rate of interest than a regular
savings account, until the specified maturity date,
where no withdrawals can be made before maturity.
- Retained earnings (RE): are the amount of net
income left over for the business after it has paid out
dividends to its shareholders. The decision to retain the
earnings or distribute them among shareholders is
usually left to company management. The company's
undistributed or retained earnings are utilized to meet
its financial obligations.
- A mortgage: A mortgage is a type of loan that's used
to finance the purchase or maintenance of a property,
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 land, or other types of rental properties. The lender
agrees to pay back the loan over some time, generally
in a series of regular installments divided into principal
and interest. Mortgages are " secured loans".
(b) Short-term sources
Money needed for a short time, often less than a year, is
raised through short-term finance. to finance the current
assets and operating expenses of a business, like
procurement of raw materials, payment of wages, day-to-day
expenditures, etc. Short-term financial requirements are
popularly known as working capital.

Short-term source of finance include:

- Bank Credit: Commercial banks grant short-term

finance to business firms, which are known as bank
credit. When bank credit is granted, the borrower gets
the right to draw the amount of credit at one time or in
installments as and when needed. Bank credit may be
granted by way of loans, cash credit, overdrafts, and
discounted bills.
- Short term Loans: When a bank advances money that
must be paid back after a particular length of time.
- Cash credit: is an arrangement by which a bank
allows his customer to borrow money up to certain
limit against the security of the commodity.
- Overdraft: Overdraft is an arrangement with a bank
by which a current account holder is allowed to
withdraw more than the balance to his credit up to a

8
 certain limit. This limit is granted purely on the basis
of credit worthiness of the borrower.
- Bill discounting: is short-term finance for traders
wherein they can sell unpaid invoices, due on a future
date, to financial institutions in lieu of a commission.
The Bank purchases the bill (Promissory Note) before
its due date and credits the bill‘s value after a discount
charge to the customer‘s account. The Bank will
realize the bill amount on the bill‘s due date directly
from the debtor. This helps the traders optimize their
cash flows and business (payment) cycles without
disturbing their balance sheets.
- Trade Credit: is a type of commercial financing in
which a customer is allowed to purchase goods and
services and pay the supplier at a later scheduled date.
This type of credit does not make the funds available in
cash but it facilitates purchases without making
immediate payment.
- Customer Advances: are payments received by a
business from a customer before the goods are
delivered or services are rendered. Customers
generally agree to make advances when such goods are
not easily available in the market or there is an urgent
need of goods. Customer advances also known as
unearned revenue or deferred revenue.
- Installment credit: A small amount of money is paid
at the time of delivery of consumer goods like
television, refrigerators as well as for industrial goods.
The balance is paid in a number of installments. The
supplier charges interest for extending credit. The
9
 amount of interest is included while deciding on the
amount of installment.
1/2/2 Based on Ownership

On the basis of ownership, the source can be classified into

Owner's funds and Borrowed funds

(a) Owner's funds: funds which are procured by the

owners of a business which may be a sole
entrepreneur or partners or shareholders of a business.
This source of finance does not cost the business, as
there are no interest charges applied. Owner's funds
include
- Shares capital: is the money a company raises by
issuing common or preferred stock.
- Retained earnings: is when the business makes a
profit, it can leave some or all of this money in the
business and reinvest it in order to expand.
- Venture Capital: refers to an individual or group
that is willing to invest money into a new or
growing business in exchange for an agreed share
of the profit.
(b) Borrowed funds: are referred to as the funds that a
business needs to borrow from outside the company in
order to provide a source of capital for the business.
These funds are different from the capital owned by
the company which is called equity funds.

The source of borrowed funds includes:

10
 - Debenture: is a medium-to long term debt
instrument used by large companies to borrow
money at a fixed rate of interest.
- Loans from commercial banks: is adept –based
funding arrangement between a business and a
financial institution such as a bank. It's used to
fund major capital expenditures or cover
operational cost. A loan may be secured by
collateral such as mortgage or it may be
unsecured, such as a credit card.
- Public deposits: are those deposits made directly
to an institution by the general public. On deposits
of the general public, companies pay higher
interest rates than bank. Public deposit s is an
unsecured deposit. There is usually no charge on
the company's assets when it comes to public
deposits
- Trade credit: a customer is allowed to purchase
goods or services and pay the supplier at a later
scheduled late.
Borrowed funds can be short term, medium-term or long
term, based on the requirement of the business.
Businesses need to make regular interest payment for the
loans obtained as funds as well as need to pay the
principle amount after a fixed time. Generally, borrowed
funds are provided on the security of some assets of the
borrower.

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1/2/3 Based on Sources of Generation:

Sources of Finance may be classified into internal

source or external source of finance

(a) Internal source of finance : are those that are

generated inside the business. Internal source of finance
includes

- Retained earnings
- owners capital
- selling assets
The internal source of funds has the same characteristics
of owned capital. The best part of the internal sourcing
of capital is that the business grows by itself and does
not depend on outside parties.

(b) External sources of finance: are the sources that

lie outside an organization, such as suppliers, lenders,
and investors. When a large amount of money is needed
to be raised, it is generally done through the external
sources. External funds may be costly as compared to
those raised through internal sources. External source of
finance may be include:

- Share capital
- Debenture
- Public deposits
- Loans from Banks and Financial institutions

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1/2/4 LEASE FINANCING
Lease financing is one of the popular and common
methods of assets based finance, which is the alternative
to the loan finance. Lease is a contract. A contract under
which one
party, the leaser (owner) of an asset agrees to grant the
use of that asset to another leaser, in exchange for
periodic rental payments.

Lease is contractual agreement between the owner of the

assets and user of the assets for a specific period by a
periodical rent.

1/2/4/1 DEFINATION OF LEASING

Lease may be defined as a contractual arrangement in

which a party owning an asset provides the asset for use
to another, the right to use the assets to the user over a
certain period of
time, for consideration in form of periodic payment, with
or without a further payment.

According to the equipment leasing association of UK

definition, leasing is a contract between the lesser and the
leaser for hire of a specific asset selected from a
manufacturers or vender of such assets by the lessee. The
leaser retains the ownership of the asset. The lessee pass
possession and uses the asset on payment for the specified
period.

1/2/4/2 ELEMENTS OF LEASING

Leasing is one of the important and popular parts of asset

based finance. It consists of the following essential

13
elements. One should understand these elements before
they are going to study on leasing.

1. Parties: These are essentially two parties to a

contract of lease financing, namely the owner and user
of the assets. The owner is also called the lessor and
the user of assets the lessee.

2. Lessor: Leaser is the owner of the assets that are

being leased. Leasers may be individual partnership,
joint stock companies, corporation or financial
institutions.

3. Lessee: Lessee is the receiver of the service of the

assets under a lease contract.

4. Lease broker: Lease broker is an agent in between

the leaser (owner) and lessee.
He acts as an intermediary in arranging the lease deals.
Merchant banking divisions of foreign banks,
subsidiaries banking and private foreign banks are
acting as lease brokers.

5. Lease assets: The lease assets may be plant,

machinery, equipment's, land, automobile, factory,
building etc.

6. Duration of lease: The right to enjoy the property

must be transferred for a certain time, express or
implied or in perpetuity. The lease should commence
either in the present or on some date in future or on the
happening of some contingency, which is bound to
happen. Though the lease can commence from a past
day, but that is for the purpose of computation of lease
14
period, as the interest of the lessee begins from the
date of execution. No interest passes to the lessee
before execution. Consideration- The consideration
for lease is either premium or rent, which is the price
paid or promised in consideration of the demise. The
premium is the consideration paid of being let in
possession, such as Salami, even if it is to be paid in
installments.

1/2/4/3 Type of Leasing

Leasing, as a financing concept, is an arrangement

between two parties for a specified period. Leasing
may be classified into finance lease and operating
lease according to the nature of the agreement.

a. Finance Lease: is also called as full payout lease, a

capital lease or sales lease. It is one of the long-term
leases and cannot be cancelable before the expiry of
the agreement. It means a lease for terms that approach
the economic life of the asset; the total payments over
the term of the lease are greater than the lessors initial
cost of the leased asset.

For example: Hiring a factory, or building for a long

period. It includes all expenditures related to
maintenance.
Finance leases offer companies both advantages and
disadvantages as far as costs, liabilities, and
accounting.

Some advantages are as follows:

15
  The Lessee is able to use a needed asset without
purchasing it
 Lease financing is usually less expensive than
other types of financing options
 A lessee is able to spread payments out over
several years
 There is no burden of a lump-sum cost for an
asset
 The lessee claims depreciation on the leased asset
reducing tax liability
 Even if the asset rises in price, the lessee only has
to pay the installments already agreed upon
 The lessee retains the right to purchase the asset
at the end of the lease period, usually at a bargain rate

Some limitations or disadvantages of a bargain lease

include the following:

 The lessee is responsible for all maintenance or

repairs on the asset
 The lessee is liable for all risks involved with the
asset
 The lessee cannot cancel a finance lease

b. Operating Lease: Operating lease is also called as

service lease. An operating lease is a contract that allows
a business to use an asset for a specified period of time,
usually shorter than its useful life, in exchange for
periodic payments to the owner or lessor. The business
does not own the asset, nor does it assume the risks and
benefits of ownership, such as depreciation, maintenance,
or disposal. The lessor retains the ownership and control
of the asset, and can lease it to another party or sell the
equipment secondhand after the contract expires.
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 Operating leases offer several advantages such as:
 Improving the liquidity and solvency ratios of the
business.
 Enhancing the flexibility and efficiency of the
business, and avoiding the risks and costs of
ownership. This is because operating leases reduce
the amount of debt and assets on the balance sheet,
increase cash flow from operations,
 Allow access to the latest technology and
equipment without committing to long-term
ownership, and enable adjustment to changing
market conditions and customer demands.
 Shift the burden of depreciation, obsolescence,
maintenance, or disposal of the asset to the lessor.

1/2/4/4 The Impact of Operating and Financing Leases

on Financial Statement:
Financing leases
A financing lease is a type of lease that transfers the
ownership or the risks and rewards of the asset to the lessee.
The lessee effectively purchases the asset and pays for it
over time. Financing leases are treated as assets and
liabilities on the balance sheet and as interest and
depreciation expenses on the income statement. Therefore,
financing leases increase organizational assets and liabilities
and reduce net income and operating cash flow. Financing
leases also worsen some of your financial ratios, such as the
17
debt-to-equity ratio, the asset turnover ratio, and the return
on assets ratio, because they increase your debt and decrease
your asset efficiency.
An operating lease:
An operating lease is a type of lease that does not transfer
the ownership or the risks and rewards of the asset to the
lessee. The lessee only pays for the use of the asset and
returns it at the end of the lease term. Operating leases are
treated as expenses on the income statement and do not
affect the balance sheet. Therefore, operating leases reduce
net income and operating cash flow, but they do not affect
your assets, liabilities, or equity. Operating leases also
improve some of financial ratios, such as the debt-to-equity
ratio, the asset turnover ratio, and the return on assets ratio,
because they lower your debt and increase your asset
efficiency.
1/2/4/5 Evaluation of lease:

Example:
A company is evaluating the lease of a new computer (cost:
150).
 The computer‗s economic life is 5 years after which it is
obsolete.

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  The annual lease payments are 31, payable in five
installments, the first being payable when the contract is
signed.
 The firm can borrow at the long term rate of 9%, the tax
rate is 20%, and depreciation is straight line in 5 years (the
first installment after one year).
Should the company lease or borrow to buy the asset?
Answer:
Yr0 Yr1 Yr2 Yr3 Yr4 Yr5

Initial cost 150

Depreciation 30 30 30 30 30

Lost depreciation tax -6 -6 -6 -6 -6

shield

Lease payment -31 -31 -31 -31 -31

Tax shield on lease 6.2 6.2 6.2 6.2 6.2

payment

Lease cash flow 125.2 - - - - -6

30.8 30.8 30.8 30.8

NPV at after-tax rate 17.1

9%* (1-0.20)

The NPV of the lease contract is +17.1

The company should lease rather than borrow to buy the
computer.

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1/2/4/5 Advantages of Leasing

Leasing finance is one of the modern sources of finance,

which plays a major role in the part of the asset based
financing of the company. It has the following important
advantages.
1.Financing of fixed asset
Lease finance helps to mobilize finance for large
investment in land and building, plant and machinery and
other fixed equipment's, which are used in the business
concern.
2.Assets based finance
Leasing provides finance facilities to procure assets and
equipment's for the company. Hence, it plays a important
and additional source of finance.
3.Convenient
Leasing finance is convenient to the use of fixed assets
without purchasing. This type of finance is suitable where
the company uses the assets only for a particular period or
particular purpose. The company need not spend or invest
huge amount for the acquiring of the assets or fixed
equipment's.

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4.Low rate of interest
Lease rent is fixed by the lease agreement and it is based
on the assets which are used by the business concern.
Lease rent may be less when compared to the rate of
interest payable to the fixed interest leasing finance like
debt or loan finance.
5.Simplicity
Lease formalities and arrangement of lease finance
facilities are very simple and easy. If the leaser agrees to
use the assets or fixed equipment's by the lessee, the
leasing arrangement is mostly finished.
6. Transaction cost
When the company mobilizes finance through debt or
equity, they have to pay some amount as transaction cost.
But in case of leasing finance, transaction cost or floating
cost is very less when compared to other sources of
finance.
7. Reduce risk
Leasing finance reduces the financial risk of the lessee.
Hence, he need not buy the assets and if there is any price
change in the assets, it will not affect the lessee.

21
 8. Better alternative
Now a day, most of the commercial banks and financial
institutions are providing lease finance to the industrial
concern. Some of them have specialized lease finance
company. They are established to provide faster and
speedy arrangement of lease finance.
Finally, having known that there are many alternatives to
finance or capital, a company can choose from. Choosing
right source and the right mix of finance is a key challenge
for every finance manager. The process of selecting right
source of finance involves in-depth analysis of each and
every source of fund. For analyzing and comparing the
sources, it needs the understanding of all the characteristics
of the financing sources It is helpful to keep the following
points in mind:
1. Successful companies consider all financing choices.
2. Successful companies combine various sources of
financing. Firms do not just pick one source – the goal is to
match appropriate sources with particular needs. You do not
incur long-term debt to purchase an asset with a short life.
You combine debt and equity to maximize your rate of
return to investors.
22
3. Successful companies focus on management, debt or
equity is interested in the company‗s management as the
goods or services the company sells.
4. Successful companies maintain a good relationship with a
banker, lawyer, accountant, investment banker, insurance
broker, and various consultants.

1/3 DEFINITION OF FINANCIAL

MANAGEMENT
An essential component of general management is financial
management. It is focused on the responsibilities of the
business firm's financial management.

Business finance is that business activity which concerns

with the acquisition and conversation of capital funds in
meeting financial needs and overall objectives of a business
enterprise.

According to the Guthumann and Dougall, ―Business

finance can broadly be defined as the activity concerned
with planning, organizing, coordinating and controlling of
the funds used in the business‖.

if the finance not being properly arranged, the business

system will stop. Arrangement of the required finance to
each department of business concern is highly a complex
one and it needs careful decision. Quantum of finance may
be depending upon the nature and situation of the business
concern.

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Financial Management as practiced by business firms can be
called as Corporation Finance or Business Finance.

1/4 FUNCTIONS OF FINANCIAL MANAGER

A financial manager of a large organization has a very
crucial responsibility to shoulder as he has to take all
decision about raising & utilization of resources have been
taken efficiently and at no time resources should remain idle.
As the size of organization grows and volume of financial
transactions increases, his role and functions assumes greater
importance. The key functions of a financial manager can be
as follows:

1-Planning –A financial manager has to make

financial planning in the form of short term and long
term plans. He is responsible to estimate the financial
requirement of the business concern. He should
estimate, how much, finances required to acquire fixed
assets and forecast the amount needed to meet the
working capital requirements in future. And then frame
policies relating to sources of finance, investment of
funds including capital expenditure and distribution of
profit.

2-Organizing–creating and monitoring proper

organizational structure of finance looking to the needs
of organization.

3-Coordination –A financial manager has to

coordinate with all other department so that no
department suffers for want of funds. Finance manager
deals with various functional departments such as
marketing, production, Human resources, system,
research, development, etc. Finance manager should
24
 have sound knowledge not only in finance related area
but also well versed in other areas. He must maintain a
good relationship with all the functional departments of
the business organization
4-Controlling –A financial manager has to fix/ set
standards of performance, compare actual with
standards fixed and exercise control on differences. He
can apply techniques of budgetary control and for this;
he has to develop a system of collecting/
processing/analyzing information.

Subsidiary functions: Besides core functions as above, a

financial manager has to perform following equally
important functions such as:

- Maintaining liquidity –Adequate liquidity need to

be maintained for paying obligations in time as well
as meeting day to day expenses and for this, he has
to keep close eyes on cash in-flows, cash out flows.
Hence cash budget and cash for-casting becomes his
important function.

- Profitability – For ensuring adequate profit and

maximizing shareholders wealth a financial manager
has to look in to:

- Evaluation of financial performance & reporting

– A Financial manager has to periodically review
financial performance against set standards, take
corrective measures as well as report performance to
25
 the board & management for facilitating timely
decisions pertaining to finance at top level.
- Upkeep of records and other routine functions –
A financial manager has to look in to following
aspects:
ion of cash receipts

1/5 NATURE OF FINANCE FUNCTION:

The finance function is the process of acquiring and utilizing

funds of a business. Finance functions are related to overall
management of an organization. Finance function is
concerned

with the policy decisions such as line of business, size of

firm, type of equipment used, use of debt, liquidity position.
These policy decisions determine the size of the profitability
and riskiness of the business of the firm. Prof.
K.M.Upadhyay has outlined the nature of finance function as
follows:

1- Finance functions are performed in all business firms,

irrespective of their sizes /legal forms of organization.
They contribute to the survival and growth of the firm.
2- Finance function is primarily involved with the data
analysis for use in decision making.
3- Finance functions are concerned with the basic
business activities of a firm, in addition to external

26
 environmental factors which affect basic business
activities, namely, production and marketing.
4- Finance functions comprise control functions also
5- The central focus of finance function is valuation of the
firm.
1/6 MAJOR SCOPE OF FINANCIAL:
Some of the major scope of financial management are as
follows: 1. Raising of funds 2. Investment of funds 3.
Distribution of funds.

I – Raising of funds –Based on the total requirements of

capital/funds for use in fixed assets, current assets as well as
intangible assets like goodwill, patent, trade mark, brand etc.
crucial decision are:

- When to raise (time)

- Sources from which to raise
- How much (quantum of money)
- In which form (debt or equity(
- Cost of raising funds
2 – Investment of funds –Funds raised need to be
allocated/invested in:

Fixed assets –also known as capital assets or Capital

budgeting decision. These decisions are based upon cost and
return analysis through various techniques.

Current assets –also known on working capital management.

These are assets for day today running the business like
cash, receivables, inventory, short form investments etc.
Decision about investment of funds is taken keeping in view
two important aspects.

27
 - Profitability
- Liquidity
3 - Distribution of funds - Profit earned need to be
distributed in the form of dividend. Higher the rates of
dividend, higher world are the price of shares in market. Net

profits are generally divided into two:

- Dividend for shareholders- Dividend

and the rate of it has to be decided.
- Retained profits- Amount of retained
profits has to be finalized which will
depend upon expansion and
diversification plans of the enterprise.
Another crucial decision under it would be the quantum of
profit to be retained. The retained profit is cost free money to
the organization.

1/7 IMPORTANCE OF FINANCIAL

MANAGEMENT

I – Importance to all types of organizations

a) Business organizations
Financial management is important to all types of
business organization i.e. Small size, medium size or a
large size organization. As the size grows, financial
decisions become more and more complex as the
amount involves also is large.

b) Charitable organization / nonprofit

organization / Trust:
In all those organizations, finance is a crucial aspect to
be managed. A finance manager has to concentrate
28
 more on collection of donations/ revenues etc. and has
to ensure that every currency spent is justified and is
towards achieving Goals of organization.
c) Government / Govt. or public sector
undertaking
In central/ state Govt. finance is a key/ important
portfolio generally given to most capable or
competent person. Preparation of budget, monitoring
capital /revenue receipt and expenditure
are key functions to be performed by the person in
charge of finance. Similarly, in a Govt. or public sector
organization, financial controller or Chief finance
officer has to play a key role in performing/ taking all
three financial decisions i.e. raising of funds,
investment of funds and distributing funds.
d) Other organizations
In all other organizations or even in a family finance is
a key area to be looked in to seriously by a competent
person so that things do not go out of gear.
2- Importance to all stake holders: - Financial Management
is important to all stake holders as explained below:

a) Shareholders–Share holders are interested in

getting optimum dividend and maximizing their
wealth which is basic objective of financial
management.
b) Investors / creditors –these stake holders are
interested in safety of their funds, timely repayment
of the principal amount as well as interest on the
same. All these aspect are to be ensured by the
person managing funds/ finance.
c) Employees –They are interested in getting timely
payment of their salary/ wages, bonus, incentives
and their retirement benefits which are possible only
29
 if funds are managed properly and organization is
working in profit.
d) Customers – They are interested in quality products
at reasonable rates which are possible only through
efficient management of organization including
management of funds.
e) Public –Public at large is interested in general
public welfare activities under corporate social
responsibility and this aspect is possible only when
organization earns adequate profit.
f) Government –Govt. is interested in timely payment
of taxes and other revenues from business world
where again efficient finance manager has a definite
role to play.
g) Management –Management is interested in overall
image building, increase in the market share,
optimizing shareholders wealth and profit and all
these aspect greatly depends upon efficient
management of financial resources.

3- Importance of financial management to all

deportments of an organization.
A large size company has many departments like
o finance dept.
o Production/ Manufacturing Dept.
o Marketing Dept.
o Human resource Dept.
o Material/ Inventory Dept.
All these departments look for availability of adequate
funds so that they could manage their individual
responsibilities in an efficient manner. Lot of funds are
required in production/manufacturing dept. for ongoing
/ completing the production process as well as
maintaining adequate stock to make available goods
30
for the marketing dept. for sale. Hence, finance
department through efficient management of funds has
to ensure that adequate funds
are made available to all department and these
departments at no stage starve for want of funds.
Hence, efficient financial management is of utmost
importance to all other department of the organization.

1/8 Goals of Financial Management

There are two goals of financial management:

1- Profit maximization
2- Wealth maximization

There are two schools of thought in this regard i.e.

traditional and modern. While tradition approach
favors profit maximization as key goal, the modern
thinker‘s favors shareholders wealth maximization as
key goal of financial management.
Traditional thinkers believe that profit is appropriate
yardstick to measure operational efficiency of an
enterprise. They are of the view that a firm should
undertake only those activities that increase the profit.

1/8/1 Profit Maximization

Profit maximization is one of the basic objectives of

financial management. According to this concept, a
firm should undertake all those activities which add to
its profits and eliminate all others which reduce its
profits. This goal highlights the fact that all decisions-
financing,dividend and investment, should result in

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profit maximization. Following arguments are given in
favor of profit maximization concept.
a) Profit is a yardstick of efficiency on the basis of
which economic efficiency of a business can be
evaluated.
b) It helps in efficient allocation and utilization of
scarce means because only such resources are
applied which maximize the profits.
c) The rate of return on capital employed is
considered as the best measurement of the profits.
d) Profits act as motivator which helps the business
organization to be more efficient
through hard work.
By maximizing profits, social and economic welfare is
also maximized.

Modern thinkers criticize the profit maximization

objective on the following grounds:
- Profit is an ambiguous concept–Profit can be
long-term or short-term, profit before Tax or after
Tax, profit can be operating profit or gross profit
etc. The economist‘s concept of profit is different
than accountant‘s concept of profit.
- Profit motto may lead to exploitation of
customers, workers, employees and ignore ethical
trade practices.
- Profit motto also ignores social considerations or
corporate social responsibility or general public
welfare.
- Profit always goes hand- to hand with risk. The
owners of business will not like to earn more and
more profit by accepting more risk.

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 - The profit maximization was taken as objective
when business was self-financed and self-
controlled.

Today, most of large business under taking witness a

divergence between ownership and management and
business is dependent largely on loan and borrowed
funds and only a small fraction being financed out of
owner‘s funds. Hence, profit maximization will only
act as a narrow objective.

1/8/2 Wealth Maximization

Another basic goal of financial management is

maximization of shareholders‘ wealth.
This goal is also known as value maximization or net
present-worth maximization.
According to this concept, finance manager should
take such decisions which increase net present value of
the firm and should not undertake any activity which
decrease net present value. This concept eliminates all
the three basic criticisms of the profit maximization
concept.
In view of above, modern thinkers consider wealth
maximization as key goal of financial management.
This is also known as value maximization or net
present worth
maximizations. This shareholders wealth maximization
is evident from increase in the price of shares in the
market. They are of the view that wealth maximization
is supposed to be superior over profit maximization
due to following reasons:
- This uses the concept of future expected cash flows
rather than ambiguous term of profit.
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 - It takes in to accent time value of money.
- It also takes care of risk factors associated with project
as the discount rate used for calculating present value
is generally a risk adjusted discount rate.
- It is consistent with the objective of maximizing
owner‘s welfare.
Equity shares of a company are traded in stock market
and stock market quotation of a share serves as an
index of performance of the company. The wealth of
equity share holders in maximized only when market
value of equity share of the company is maximized. In
this context, the term wealth maximization is redefined
as value maximization.
At macro level, a firm has obligation to the society
which is fulfilled by maximizing production of goods
and services at least cost, thereby maximizing wealth
of society.

PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION

S.N
PROFITMAXIMIZATION WEALTH MAXIMIZATION
O.
1 Profit are earned, maximized, so Wealth is maximized, so that
the firm can overcome future risks wealth of shareholders can be
which are uncertain. maximized
2 Profit maximization is a yard stick wealth maximization, Stockholder
for calculating efficiency and the current wealth is evaluated in
economic prosperity of the order to maximize the value of
concern. shares in the market.
3 Profit is measured in terms of Wealth is measured in terms of
efficiency of the firm. Market price of shares.
Wealth maximization involves
Profit maximization Involves
problems related to
4 problem of uncertainty because
Maximizing Shareholder's
profits are uncertain.
wealth or wealth of the firm

Profits are earned maximized, so that firm can over-come

future risks which are uncertain.

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 Profit maximization is a yards stick for calculating
efficiency and economic

Conclusion Profits are earned maximized, so that firm

can over-come future risks which are uncertain.
Profit maximization is a yards stick for calculating
efficiency and economic.

1/9 OBJECTIVES OF FINANCIAL MANAGEMENT

The objectives involved in financial management

include:

- Maintaining enough supply of funds for the

organization.
- Ensuring shareholders get good returns on
their investment.
- Optimum and efficient utilization of funds .
- Creating real and safe investment
opportunities. funds should be put into safe
venture in order to get a sufficient rate of
return.
1/10 THE ROLE OF THE FINANCIAL
MANAGER
The financial management department of any company is
handled by a financial manager .This department has
numerous functions, such as:

1. Calculating the capital required. The financial

manager has to calculate the amount of capital an
organization requires. This depends on the policies of
the company with regards to expected expenses and
profits. The amount required has to be estimated in
such a way that the earnings in the company increase.
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2. Formation of capital structure. Once the amount of
capital has been estimated, a capital structure needs to
be formed. This involves a debt-equity analysis, both
short-term and long-term. The outlook of the structure
depends on the amount of capital the company owns,
and the amount that needs to be raised via external
sources.
3. Investing the capital. Every organization or
company needs to invest money in order to raise more
capital and gain regular returns. This means the
financial manager needs to invest funds in safe and
profitable ventures.
4. Allocation of profits. Once the organization has a
solid net profit, it is the financial manager‘s duty to
efficiently allocate it. This could involve keeping a
part of the net profit for contingency, innovation, or
expansion purposes, while another part of the profit
can be used to provide dividends to the shareholders.
5. Effective management of money. The financial
manager is also responsible for effectively managing
the company‘s money. Money is required for various
purposes in the company such as payment of salaries
and bills, maintaining stock, meeting liabilities, and
the purchase of any materials and/or equipment.
6. Financial control. Not only does the financial
manager have to plan, organize, and obtain funds, but
he/she also has to control and analyze the company‘s
finances. This can be done using tools such as
financial forecasting, ratio analysis, risk management,
and profit and cost control.

36
 Questions in chapter1:

When making investment decisions, professional investors mainly

consider the size of their expected returns on investment.
a. True
b. False

1- The job of a finance manager is confined to

(a) Raising funds
(b) Management of cash
(c) Raising of funds and their effective utilization
(d) None of these

2- Marginal cost of capital is the cost of:

(a) Additional Sales
(b) Additional Funds
(c) Additional Interests
(d) None of the above

3- Financial decision involve:

(a) Investment ,financing and dividend decision
(b) Investment ,financing and sales decision
(c) Financing, dividend and cash decision
(d) None of these

4- __ analysis is done to ascertain financial viability of a project

(a) Network
(b) financial
(c) techno-economic
(d) input

5- Which of the following is NOT a function of financial

management:
(a) Deciding the best sources of finance.
(b) Spending money on capital expansion
(c) Preparation of Tax Returns
(d) Evaluating how much dividends to pay shareholders.

37
6- What is the best criterion in evaluating the performance of a
financial manager:
(a) Maximization of Corporate Profits.
(b) Maximizing a company's market share.
(c) Maximizing shareholder wealth
(d) Beating the competition.

7- Which of the following would be part of a financial manager's

dividend (or operating) decisions:
a. Spending money on Capital Expenditure.
b. Raising money using equity finance.
c. Spending money on revenue expenditure.
d. Borrowing Funds.

8- Which of the following would be part of a financial manager's

investment decision:
a. Spending money on Capital Expenditure.
b. Raising money using equity finance.
c. Spending money on revenue expenditure.
d. Borrowing Funds.
9- The market value of a firm can be affected by:
a. Investors' perceptions of the firm.
b. The investments a firm's managers may make
c. The dividend payments made by the firm
d. All of the above

10- Rank the following claims in order from least risk to most risk,
from an investor's viewpoint: 1 - Mortgage, 2 - ordinary shares, 3 -
Debentures, 4 - Unsecured Notes, 5 - Preference Shares:
a. 1-3-2-4-5
b. 1-3-4-5-2
c. 1-3-5-4-2
d. 1-3-4-2-5

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11- Wealth maximization is superior to profit maximization as the
goal of financial management, because:
a. Profits include estimates, in addition to cash flows.
b. Profits ignore time value of money.
c. Profit maximization disregards financial risk.
d. All of the above
12- Management of Finance for individuals are called as .....

(a) Business Finance

(b) Firm Finance
(c) Personal Finance
(d) Corporation Finance

13- What is the main criticism in using shareholder wealth as

the best criterion in evaluating the performance of a financial
manager:
(a) It does not take into account the shareholder's exposure to
financial risk.
(b) It does not take into account the size of the shareholders
investment.
(c) Maximizing profits is a more suitable criterion.
(d) Share market prices can be manipulated in the short term.

14- The part of finance concerned with design and delivery of

advice and financial products to individuals, business, and
government is called
A) Managerial Finance.
B) Financial Manager.
C) Financial Services.
D) none of the above.

15- Managerial finance

A) involves tasks such as budgeting, financial forecasting, cash
management, and funds procurement.
B) involves the design and delivery of advice and financial
products.
C) recognizes funds on an accrual basis.
D) devotes the majority of its attention to the collection and
39
presentation of financial data.

16- Finance can be defined as

A) the system of debits and credits.
B) the science of the production, distribution, and consumption
of wealth.
C) the art and science of managing money.
D) the art of merchandising products and services.

17- Financial service

A) is concerned with the duties of the financial manager.
B) involves the design and delivery of advice and financial
products.
C) provides guidelines for the efficient operation of the business.
D) handles accounting activities related to data processing.

18- Career opportunities in financial services include all of the

following EXCEPT
A) investments.
B) real estate and insurance.
C) capital expenditures management.
D) personal financial planning.

19- Which of the following is a career opportunity in managerial

finance?
A) Investment.
B) Real Estate and Insurance.
C) Capital Expenditures Management.
D) Personal Financial Planning.
20- ________ is concerned with the duties of the financial
manager in the business firm.
A) Financial Services
B) Financial Manager
C) Managerial Finance
D) None of the above

40
21- The ________ is responsible for evaluating and
recommending proposed asset investments.
A) Financial Manager
B) Credit Manager
C) Pension Fund Manager
D) Capital Expenditures Manager

22- The treasurer is commonly responsible for

A) taxes.
B) data processing.
C) making capital expenditures.
D) cost accounting.

23- Which of the following legal forms of organization is most

expensive to organize?
A) Sole proprietorships.
B) Partnerships.
C) Corporations.
D) Limited partnership.

24- Which of the following legal forms of organization's income

is NOT taxed under individual income tax rate?
A) Sole proprietorships.
B) Partnerships.
C) Limited partnership.
D) Corporation.

25- Which of the following legal forms of organization is

characterized by limited liability?
A) Sole proprietorship.
B) Partnership.
C) Corporation.
D) Professional partnership.

26- The primary goal of the financial manager is

A) minimizing risk.
B) maximizing profit.
C) maximizing wealth.
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D) minimizing return.

27- Profit maximization fails because it ignores all EXCEPT

A) the timing of returns.
B) earnings per share.
C) cash flows available to stockholders.
D) risk.

28- As the risk of a stock investment increases, investors'

A) return will increase.
B) return will decrease.
C) required rate of return will decrease.
D) required rate of return will increase.

29- Lessee is the person who

a) is owner of the asset
b) has right to use of asset and pays annual rentals
c) has right to use of assets and receive annual rentals
d) all of the above

30- A lease is a contractual arrangement between

A) Lessor and Lessee
B) Lessee and Buyer
C) Seller and Lessee
D) None of the Above

31- Ramy leases a car from Uptown Motors and pays $225 a
month as a lease payment. Which one of the following terms
applies to Ramy?
A. lessee
B. lessor
C. Guarantor
D. trustee

32- The party who owns a leased asset is called the:

A. lessee
B. lessor
C. Guarantor
D. trustee
42
33- Aya is leasing some equipment from Ajax Leasing for a
period of one-year. Ajax pays the maintenance, taxes, and
insurance costs for this equipment. The life of the equipment is 7
years. Which type of lease does Aya have?
A. open
B. straight
C. operating
D. financial

34- Ahmed has a non-cancelable, five year lease on an industrial

grade sewing machine for stitching upholstery. For accounting
purposes, this is considered to be a capital lease. The life of the
sewing machine is five years. Ahmed must pay all taxes and
insurances related to this lease. Which type of lease does Ahmed
have on this sewing machine?
A. open
B. straight
C. operating
D. financial

35- You are comparing a lease to a purchase. The NPV associated

with this analysis is referred to as the:
A. open interest net present value.
B. depreciated net present value.
C. net advantage to leasing.
D. profitability index.
E. net value of purchasing.

36- An operating lease has which of the following

characteristics?
I. lessee has responsibility for the maintenance and insurance
II. lease payments cover the full cost of the asset
III. economic life of the asset exceeds the lease term
IV. lessee can cancel the lease prior to the expiration date
A. I and III only
B. II and IV only
C. I and II only
D. III and IV only
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37- A financial lease:
A. is generally called a capital lease by accountants.
B. requires the lessor to maintain the asset.
C. is a partially amortized lease.
D. is often called a single net lease.
E. can generally be cancelled without penalty.

38- Which one of the following statements is correct concerning

the lease versus buy decision?
A. The lessor is primarily concerned with returning the asset at
the end of the lease term without incurring any additional
charges.
B. The lessor is primarily concerned about the use of the asset.
C. Lessors provide a source of financing for lessees
d. None of the above

39- ABCD is trying to decide whether to lease or buy some new

equipment. The equipment costs $48,000 and has a 6-year life.
The equipment will be worthless after the 6 years and will have
to be replaced. The company has a tax rate of 31 percent, a cost
of borrowed funds of 7.5 percent, and uses straight-line
depreciation. The equipment can be leased for $10,600 a year.
What is the amount of the after tax lease payment?
A. $3,286.00
B. $7,314.00
C. $7,862.55
D. $8,406.16
E. $10,928.60

40- A decision to acquire a new and modern plant to upgrade an

old one is a:
a) Financing decision
b) Working capital decision
c) Investment decision
d) Dividend decision

44
41- The decision in financial management which determines the
proportion between debt and equity is called
a) Financing decision
b) Investment decision
c) Capital structure
d) Dividend decision

42- Which decisions are taken by the Financial Manager?

a) Investment Decisions
b) Financing decision
c) Dividend Decisions
d) All the above

43- Financial decisions involve with:

a. Investment, financing and dividend decisions
b. Investment, financing and sales decisions
c. Financing, dividend and cash decisions

44- The sources for raising borrowed funds include

a) Retained Earnings, and Venture Fund
b) Loans from financial institutions, and issue of debentures
c) Convertible Debentures, and Retained Earnings
d) Private Equity

45- The art of the recording and reporting financial transactions,

so as to ascertain the financial position and profitability of the
company at the end of financial year.
a) Finance
b) Financial management
c) Accounting
d) Financial Economy

45