FINANCIAL MANAGEMENT

YONAS M. (PHD CANDIDATE)

04/30/2024
 General Overview
 Explain the nature of financial management
 Analyze the performance of an organization using its financial statements
 Manage the finance of business organizations
 Determine the values of financial assets
 Apply different techniques in evaluating the profitability of capital projects
 Discuss the pros and cons of various sources of long term financing;

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CHAPTER ONE

Introduction to Financial Management

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■ Any kind of business activity depends on the finance. Hence, it is called as
lifeblood of business organization.
DEFINITION OF FINANCE
■ According to Khan and Jain, “Finance is the art and science of managing
money”.

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 DEFINITION OF FINANCIAL
MANAGEMENT
Financial management is an integral part of overall management. It is concerned
with the

 Duties of the financial managers in the business firm.

 “is the operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations.

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 Cont…
■ Is concerned with the acquisition, financing, and management of assets with
some overall goal in mind.

■ The management of capitalsources and their uses so as to attain the desired goal of
the firm (i.e. maximization of share holders’ wealth)

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Decision function of financial management

■ Investment Decision
■ Financing Decision
■ Asset management decision
■ Dividend policy decision

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 …. Cont’d

■ 1. Investment Decision
■ Value creation
■ Determination of total amount of assets
needed to be held
■ Concerned with the left-hand side of
balance sheet
■ Also,
– Deciding composition of assets
– Disinvestment: reducing, eliminating, &
replacing
 …. Cont’d

■ 2. Financing Decision
■ Concerned with the makeup of the right-
hand side of the balance sheet
■ Mix of financing the assets
■ Dividends policy:
– Integral part of the financing decision
– What dividend-payout ratio?
■ Mechanics of how to get the funds
required
 …. Cont’d
■ 3. Asset Management Decision
■ Once assets acquired & financing provided,
handling them efficiently follows
■ Finance Manager:
– Charged with varying degrees of operating
responsibility over the assets
– But, more concerned with the management of
current assets than fixed ones
 SCOPE OF FINANCIAL MANAGEMENT

■ Financial Management or Mathematics

■ Finance and Economics

■ Finance and Accounting

■ Financial Management & Production management

■ Financial Management & Marketing

■ Financial Management & Human Resource

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OBJECTIVES OF FINANCIAL
MANAGEMENT
■ Profit Maximization
■ Wealth maximization

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 Introduction…Cont’d
…Cont’d

Goal of the Firm: Profit vs. Wealth

 If we were to consider possible financial goals we
might come up with many ideas such as the following:
 Survival
 To avoid financial distress and bankruptcy
 Beat competition, maintain control, achieve flexibility
 Maximize sales or market share
 Minimize costs & risks
 Maximize profits
 Maintain steady earnings growth [i.e., maximization of
earnings per share & maximization of RoE].

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 Introduction…Cont’d
…Cont’d

 The goals listed above are all different, but they tend to fall
into two groups. The first of these which involves sales,
market share, and cost control relates to increasing
profitability. Whereas the goals involving bankruptcy,
avoidance, stability and safety relates in some way to
controlling risk.
 Unfortunately, there is some trade-offs between the goals of
profitability & risk. The pursuit of profitability normally
involves some element of risk, thus it is not possible to
maximize both safety and profitability simultaneously.
 What we need, therefore, is a goal that encompasses both of
these factors.

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 Introduction…Cont’d
…Cont’d

Profit Maximization
 Would profit maximization serve as a goal of the firm?
 If we investigate profit maximization as a goal of the firm, it
fails with respect to the following operational infeasibilities:
1) It is vague because the definition of the term profit is
ambiguous.
 Does it mean an absolute figure expressed in Birr or a rate of profitability?
 Does it mean short-term or long term profit?
 Does it refer profit before tax or after tax?
 Does it refer total profit or profit per share?

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 Introduction…Cont’d

2) It ignores the time dimension

of financial decision.
 It does not make a distinction
between returns received at
different time periods.
3) It ignores the risk dimension
of the financial decision
 Risk & returns are positively
correlated. A figure that
maximizes profit might
generate excessive risk &
thereby a lower stock price.

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 Introduction…Cont’d
…Cont’d

 Therefore, if we are For the reasons given,

to base financial the goal of maximizing
decisions on a goal, profits usually is not the
that goal must be same as maximizing
precise, not allow for market price per share.
misinterpretation, The market price of a
and deal with all the
firm's stock represents
complexities of the
the value that market
real world.
participants place on the
company.

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 Introduction…Cont’d
…Cont’d

Shareholders’ Wealth Maximization (SWM)

 The objective of shareholders’ wealth maximization
(SWM) is an appropriate and operationally feasible
criterion to choose among the alternative financial
actions.
 It provides a clear measure of what financial
management should seek to maximize in making
investment and financing decisions on behalf of owners
(shareholders).
 Shareholders’ wealth maximization means maximizing
the net present value (or wealth) of a course of action to
shareholders.
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 …Cont’d
Introduction…Cont’d

 The objective of shareholders’ wealth maximization

addresses the questions of the timing and risk of the
expected benefits. These problems are handled by selecting
an appropriate rate (the shareholders’ opportunity cost of
capital) for discounting the expected flow of future
benefits.
 It is important to emphasize that benefits are measured in
terms of cash flows, not in terms of the accounting profits.
 The wealth maximization principle implies that the
fundamental objective of a firm is to maximize the market
value of existing shareholders’ common stock.

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Role of Management

Management acts as an agent for the

owners (shareholders) of the firm.

■ An agent is an individual authorized by another person, called the

principal, to act in the latter’s behalf.

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 Agency Theory

 Jensen and Meckling developed a

theory of the firm based on agency
theory.
■ Agency Theory is a branch of economics relating to the behavior of
principals and their agents.

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 Agency Theory

 Principals must provide incentives so that

management acts in the principals’ best
interests and then monitor results.

■ Incentives include perquisites, and bonuses.

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 Actions to Reduce Agency Problem
1. The threat of firing
 This is also known as proxy fight
 Unhappy stockholders can vote for a new board which replaces existing mgt
2. The threat of takeover
 Best example is the hostile takeover- In such a situation, another company
can acquire the poorly performing firm, replace its managers, increase free
cash flow, and improve market value added
(MVA = Market value of company - Book value of company)
3. Managerial Compensation
 Fair salary, bonus based on performance of the firm
■ Options to buy stocks
 Example: An option to buy, say, 5,000 shares of stock at, say, $50/share
during the next five years

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4
 End of Chapter One!
THANK YOU
For
Your
ATTENTION!

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