FRAMEWORK OF FINANCIAL MANAGEMENT

DEFINITION OF FINANCIAL MANAGEMENT

Financial Management is a discipline concerned with the generation and allocation of scarce
resources (usually funds) to the most efficient user within the firm (the competing projects)
through a market pricing system (the required rate of return).
A firm requires resources in form of funds raised from investors. The funds must be allocated
within the organization to projects which will yield the highest return.
We shall refer to this definition as we go through the subject.

Required Rate of Return (Ri)

The required rate of return (Ri) is the minimum rate of return that a project must generate if it has
to receive funds. It’s therefore the opportunity cost of capital or returns expected from the
second best alternative. In general,
Required Rate of Return = Risk-free rate + Risk premium

Risk free rate is compensation for time and is made up of the real rate of return (Rr) and the
inflation premium (IRp). The risk premium is compensation for risk of financial actions reflecting:

- The riskiness of the securities caused by term to maturity

- The security marketability or liquidity
- The effect of exchange rate fluctuations on the security, etc.

The required rate of return can therefore be expressed as follows:

Rj = Rr +IRp +DRp +MRp + LRp + ERp + SRp + ORp.

Where:
 Rr is the real rate of return that compensate investors for giving up the use of their funds in
an inflation free and risk free market.
 IRp is the Inflation Risk Premium which compensates the investor for the decrease in
purchasing power of money caused by inflation.
 DRp is the Default Risk Premium which compensates the investor for the possibility that
users of funds would be unable to repay the debts.
 MRp is the Maturity Risk Premium which compensates for the term to maturity.
 LRp is the Liquidity Risk Premium which compensates the investor for the possibility that
the securities given are not easily marketable (or convertible to cash).
 ERp is the Exchange Risk Premium which compensates the investors for the fluctuation in
exchange rate. This is mainly important if the funds are denominated in foreign currencies.
 SRp is the Sovereign Risk Premium which compensates the investors for the possibility of
political instability in the country in which the funds have been provided.
 ORp is the Other Risk Premium e.g. the type of product, the type of market, etc.

SCOPE OF FINANCE FUNCTIONS

The functions of Financial Manager can broadly be divided into two: The Routine functions and
the Managerial Functions.

Managerial Finance Functions

Require skilful planning, control and execution of financial activities. There are four important
managerial finance functions. These are:

(a) Investment of Long-term asset-mix decisions

These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds
among investment projects. They refer to the firm's decision to commit current funds to the
purchase of fixed assets in expectation of future cash inflows from these projects. Investment
proposals are evaluated in terms of both risk and expected return.

Investment decisions also relates to recommitting funds when an old asset becomes less
productive. This is referred to as replacement decision.

(b) Financing decisions

Financing decision refers to the decision on the sources of funds to finance investment projects.
The finance manager must decide the proportion of equity and debt. The mix of debt and equity
affects the firm's cost of financing as well as the financial risk. This will further be discussed under
the risk return trade-off.

(c) Division of earnings decision

The finance manager must decide whether the firm should distribute all profits to the shareholder,
retain them, or distribute a portion and retain a portion. The earnings must also be distributed to
other providers of funds such as preference shareholder, and debt providers of funds such as
preference shareholders and debt providers. The firm's divided policy may influence the
determination of the value of the firm and therefore the finance manager must decide the optimum
dividend - payout ratio so as to maximize the value of the firm.

(d) Liquidity decision

The firm's liquidity refers to its ability to meet its current obligations as and when they fall due. It
can also be referred as current assets management. Investment in current assets affects the firm's
liquidity, profitability and risk. The more current assets a firm has, the more liquid it is. This
implies that the firm has a lower risk of becoming insolvent but since current assets are non-
earning assets the profitability of the firm will be low. The converse will hold true.
The finance manager should develop sound techniques of managing current assets to ensure that
neither insufficient nor unnecessary funds are invested in current assets.

Routine functions
For the effective execution of the managerial finance functions, routine functions have to be
performed. These decisions concern procedures and systems and involve a lot of paper work and
time. In most cases these decisions are delegated to junior staff in the organization. Some of the
important routine functions are:

(a) Supervision of cash receipts and payments

(b) Safeguarding of cash balance
(c) Custody and safeguarding of important documents
(d) Record keeping and reporting

The finance manager will be involved with the managerial functions while the routine functions
will be carried out by junior staff in the firm. He must however, supervise the activities of these
junior staff.

OBJECTIVES OF A BUSINESS ENTITY

Any business firm would have certain objectives which it aims at achieving. The major goals of a
firm are:

 Profit maximization
 Shareholders' wealth maximization
 Social responsibility
 Business Ethics
 Growth

(a) Profit maximization

Traditionally, this was considered to be the major goal of the firm. Profit maximization refers to
achieving the highest possible profits during the year. This could be achieved by either increasing
sales revenue or by reducing expenses. Note that:

Profit = Revenue – Expenses

The sales revenue can be increased by either increasing the sales volume or the selling price. It
should be noted however, that maximizing sales revenue may at the same time result to increasing
the firm's expenses.
The pricing mechanism will however, help the firm to determine which goods and services to
provide so as to maximize profits of the firm.

The profit maximization goal has been criticized because of the following:

(a) It ignores time value of money

(b) It ignores risk and uncertainties
(c) it is vague
(d) it ignores other participants in the firm rather than the shareholders

(b) Shareholders' wealth maximization

Shareholders' wealth maximization refers to maximization of the net present value of every
decision made in the firm. Net present value is equal to the difference between the present value of
benefits received from a decision and the present value of the cost of the decision. (Note this will
be discussed further in Lesson 2).
A financial action with a positive net present value will maximize the wealth of the shareholders,
while a decision with a negative net present value will reduce the wealth of the shareholders.
Under this goal, a firm will only take those decisions that result in a positive net present value.

Shareholder wealth maximization helps to solve the problems with profit maximization. This is
because, the goal:

i. considers time value of money by discounting the expected future cashflows to

the present.
ii. it recognises risk by using a discount rate (which is a measure of risk) to discount
the cashflows to the present.

(c) Social responsibility

The firm must decide whether to operate strictly in their shareholders' best interests or be
responsible to their employers, their customers, and the community in which they operate. The
firm may be involved in activities which do not directly benefit the shareholders, but which will
improve the business environment. This has a long term advantage to the firm and therefore in the
long term the shareholders wealth may be maximized.

(d) Business Ethics

Related to the issue of social responsibility is the question of business ethics. Ethics are defined as
the "standards of conduct or moral behaviour". It can be thought of as the company's attitude
toward its stakeholders, that is, its employees, customers, suppliers, community in general,
creditors, and shareholders. High standards of ethical behaviour demand that a firm treat each of
these constituents in a fair and honest manner. A firm's commitment to business ethics can be
measured by the tendency of the firm and its employees to adhere to laws and regulations relating
to:

i. Product safety and quality

ii. Fair employment practices
iii. Fair marketing and selling practices
iv. The use of confidential information for personal gain
v. Illegal political involvement
vi. bribery or illegal payments to obtain business

(e) Growth
This is a major objective of small companies which may even invest in projects with negative NPV
so as to increase their size and enjoy economies of scale in the future.

CORPORATE GOVERNANCE

Definition of corporate governance

Corporate governance can be defined in various ways, for example:
The Private Sector Corporate Governance Trust (PSCGT) states that corporate governance,
“Refers to the manner in which the power of the corporation is exercised in the stewardship of
the corporation total portfolio of assets and resources with the objective of maintaining and
increasing shareholders value through the context of its corporate vision” (PSCGT, 1999)
The Cadbury Report (1992) defines corporate governance as the system by which companies are
directed and controlled.
The Capital Market Authority (CMA) in year 2000 defined corporate governance as the process
and structures used to direct and manage business affairs of the company towards enhancing
prosperity and corporate accounting with the ultimate objective of realizing shareholders long-
term value while taking into account the interests of other stakeholders.

Rationale for corporate governance

The organization of the world economy (especially in current years) has seen corporate
governance gain prominence mainly because:
 Institutional investors, as they seek to invest funds in the global economy, insist on high
standard of Corporate Governance in the companies they invest in.
 Public attention attracted by corporate scandals and collapses has forced stakeholders to
carefully consider corporate governance issues.

Corporate governance is therefore important as it is concerned with:

 Profitability and efficiency of the firm.

 Long-term competitiveness of firms in the global economy.
 The relationship among firm’s stakeholders

EFFICIENT MARKET HYPOTHESIS (EMH)

6.1 Types of Efficiency

Efficient market hypothesis can be explained in 3 ways:

a) Allocative Efficiency
A market is allocatively efficient if it directs savings towards the most efficient productive
enterprise or project. In this situation, the most efficient enterprises will find it easier to raise
funds and economic prosperity for the whole economy should result.

Allocative efficiency will be at its optimal level if there is no alternative allocation of funds
channelled from savings that would result in higher economic prosperity. To be allocatively
efficient, the market should have fewer financial intermediaries such that funds are allocated
directly from savers to users, therefore financial disintermediation should be encouraged.

b) Operational Efficiency
This concept relates to the cost, to the borrower and lender, of doing business in a particular
market. The greater the transaction cost, the greater the cost of using financial market and
therefore the lower the operational efficiency. Transaction cost is kept as low as possible
where there is open competition between broker and other market participants. For a market
 to be operationally efficient, therefore, we need to have enough market markers who are able
to play continuously.

c) Information Efficiency
This reflects the extent to which the information regarding the future prospect of a security is
reflected in its current price. If all known (public information) is reflected in the security
price, then investing in securities becomes a fair game. All investors have the same chances
mainly because all the information that can be known is already reflected in share prices.
Information efficiency is important in financial management because it means that the effect
of management decision will quickly and accurately be reflected in security prices. Efficient
market hypothesis relates to information processing efficiency. It argues that stock markets
are efficient such that information is reflected in share prices accurately and rapidly.

Forms of Efficiency

Informational efficiency is usually broken down into 3 different levels (forms):

a. Weak form level of efficiency

This level states that share prices fully reflect information in historic share price movement and
patterns (past information/historic information). If this hypothesis is correct, then, it should be
possible to predict future share price movement from historical patterns. E.g. If the company’s
shares have increased steadily over the past few months to the current price of Shs.30, then this
price will already fully reflect the information about the company’s growth and therefore the
next change in share prices could either be upward, downward or constant with equal probability.
It therefore follows that technical analysis or Chartism will not enable investors to make
arbitrage profits. In markets that have achieved this level then security prices follow a trendles
random walk.

Studies to test this level have been based on the principle that:

 The share price changes are random

 That there is no connection between share price movement and new share price changes. It
is possible to prove statistically that there is no correlation between successive changes in
price of shares and therefore trend in share price changes cannot be detected. This can be
done by using serial correlation (or auto-correlation) test such as Durbin Watson Statistics.

b) Semi-Strong form level of Efficiency

This level states that share prices reflects all available public information. (past and present
information). If the market has achieved this level, then fundamental analysis will not enable
investors to earn consistently higher than average returns. Fundamental analysis involves the
study of company’s accounts to determine its theoretical value and thereby find any undervalued
share. Fundamental theory states that every share in the market has an intrinsic value, which is
equal to the present value of cash flows expected from the security.
Tests to prove semi-strong form of efficiency have concentrated on the ability of the market to
anticipate share price changes before new information is formally announced. These tests are
referred to as Event Studies. E.g. if two companies plans to merge, share prices of the 2
companies will change once the merger plans are made public. The market would show semi-
strong form of efficiency if it were able to anticipate such changes so that share prices of the
company would change in advance of the merger plans being confirmed. Other events that can
affect share prices are:

a) Stock splits
b) Death of CEO of company
c) Investment in major profitable projects
d) Changes in dividend policy, etc

c) Strong form level of Efficiency

This level states that price reflects all the available public and private information (past, present
and future information). If the hypothesis is correct, then, the mere publication of information
that was previously confidential should not have impact on share prices. This implies that insider
trading is impossible. It follows therefore, that in order to maximize shareholders’ wealth,
managers should concentrate on maximizing the NPV of each investment.

Tests that have been carried out on this level have concentrated on activities of fund managers
and individual investors. If the markets have reached the strong form levels, then fund managers
cannot consistently perform better than individual investors in the market.

IMPLICATIONS OF EMH FOR FINANCIAL DECISION MAKERS

a) The Timing Of Financial Policy
Some financial managers argue that there is a right or wrong time to issue securities i.e. new
shares should only be issued when the market is at the top rather than the bottom. If the
market is efficient, however, price follows a trendless random walk and its impossible for
managers to know whether today’s price is the highest or the lowest. Timing other policies
e.g release of financial statements, announcement of stock splits, etc has no effect on share
prices.

b) Project Evaluation Based Upon NPV

When evaluating new projects, financial managers use the required rate of return drawn from
securities traded in the capital market. For example, the rate of return required on a particular
project may be determined by observing the rate of return required by shareholders of firms
investing in projects of similar risk. This assumes that securities are fairly priced for the
risks that they carry (i.e. the market is efficient).

If the market is inefficient, however, financial managers could be appraising projects on a

wrong basis and therefore making bad investment decisions since their estimate on NPV is
unreliable.
c) Creative Accounting
In an efficient market, prices are based upon expected future cash flow and therefore they
reflect all current information. There is no point therefore in firms attempting to distort
current information to their advantage since investors will quickly see through such attempts.
Studies have been done for example to show that changes from straight-line depreciation to
reducing balance method, although it may result to increasing profit, may have no long-term
effect on share prices. This is because the company’s cash flows remain the same. Other
studies support the conclusion that investors cannot be fooled by manipulation of accounting
profit figure or charges in capital structure of company. Eventually, the investors will know
the cash flow consequences and alter the share prices consequently.

d) Mergers and Takeovers

If shares are correctly priced then the purchase of a share is a zero NPV transaction. If this is
true then, the rationale behind mergers and takeovers may be questioned. If companies are
acquired at their correct equity position then purchasers are breaking even. If they have to
make significant gains on the acquisition, then they have to rely on synergy in economies of
scale to provide the saving. If the acquirer (or the predator) pays the current equity value
plus a premium, then this may be a negative NPV decision unless the market is not fully
efficient and therefore prices are not fair.

e) Validity of the current market price

If markets are efficient then they reflect all known information in existing share prices and
investors therefore know that if they purchase a security at the current market price they are
receiving a fair return and risk combination. This means that under or over valued shares or
market securities do not exist. Companies shouldn’t offer substantial discounts on security
issues because investors would not need extra incentives to purchase the securities.