Meaning of Managerial Finance

 Finance is the common denominator, for a vast range of

corporate objectives, and the major part of any, corporate
plan, must be expressed in financial terms.
 Managerial finance provides oxygen to the life of a firm by
providing uninterrupted flow of funds throughout the firm
and thus helps achieving the ultimate objectives of the firm.
 Managerial finance can also be defined as an administrative
area or set of administrative functions, in an organization
which have to do with the management of flow of cash, so
that the organization will have the means to carry out its
objectives as satisfactorily as possible.
 The Managerial finance may be defined as the provision of
money at the time it is wanted. Managerial finance
administers economic activities.
 Meaning of Managerial Finance
 The scope of finance is vast and determined by financial needs of
the business, which have to be identified before any corporate
plan is formulated.
 Managerial finance is a specialized finance function field found,
under the general classification of business administration viewed
in the light of other functions, it appears that Managerial finance
is a specialized function — more particularly, a service function.
 There are various service functions, such as accounting,
personnel, marketing, vigilance and security. Transformation of
savings into investments and consumption is done in managerial
Finance.
 The process of transformation is aided by various types of
financial assets suiting the individual needs and demands of both
the investors and users.
SCOPE OR OBJECTIVES

Depending upon the nature and size of the firm or corporate

the Managerial finance is required to perform all or mainly three
functions from time to time. While performing the policy
different decisions are required to be taken, viz.,

(i) the investment decision

(ii) the financing or capital decision

(iii) the dividend decision

 Investment Decision
 (i) Investment decisions:
 Corporate have scarce resources that must be allocated among competitive
uses. The managerial finance provides a framework for firms/corporates to take
decisions wisely.
 The investments decisions include not only those that create revenues and
profits (e.g., introducing a new product live/service) but also those that save
money (e.g., introducing a more efficient distribution system. So, the
investment decisions are the decisions relating to the assets composition of the
firm.
 Assets represent investment or uses of the funds that the firm/corporate makes
in expectation of earning a return for its investors. Broadly, these assets can be
classified into fixed assets and current assets and therefore the investment
decisions can also be bifurcated into Capital Budgeting decisions (relating to
fixed assets) and the Working Capital Management (relating to current assets).

 The fixed assets of a firm/corporate are the primary factors and the
determinates of the profitability a firm/corporate. The earnings of the firm are
basically created by the fixed assets and also the total fixed assets. The Capital
Budgeting decisions are more important for the firm/corporate.
 Investment Decision
Managerial Finance decides:
 (a) which asset to be purchased
 (b) to buy the asset or get on lease
 (c) to produce a part of the final product, or to procure
 (d) to buy or not, from a branded company/local company
 (e) proposal of merger of other group/firms to avail the synergies of
consolidation etc.

 Working Capital Management deals with the management of current

assets of the firm/corporate. Though the current assets do not
contribute directly to the earnings, yet their existence is necessitated
for the proper, efficient and optimum utilization of fixed assets. The
managerial finance has to ensure sufficient and adequate working
capital to the firm/corporate. A trade-off between liquidity and
profitability is required.
 Financing decisions
 Another kind of decision is called financing decision, which deals with the financing
pattern of the firm. As firms make decisions concerning where to invest these
resources, they have also to decide how they should raise resources. There are two
main sources of finance for any firm, the shareholders’ funds and borrowed funds.
These sources have their own peculiar features and characteristics. The key
distinction between these two sources lies in the fixed commitments created by
borrowed funds to pay interest and the principal.
 The borrowed funds are always repayable (except where the debt instrument is
convertible into shares) and require payment of a committed cost in the form of
interest, on a periodic basis. The borrowed funds are relatively cheaper but always
entail a risk. This risk is known as the FINANCIAL RISK, i.e., the risk of insolvency due
to non-payment of interest or non-payment of capital amount.
 On the other hand, the shareholders’ funds is the main source of funds to any firm.
This may comprise of the equity share capital, preference share capital and the
accumulated profits. There is no committed outflow for equity share capital, however,
the preference share capital has a commitment to be paid a minimum dividend and
also for repayment of share capital where these shares are to be redeemed after
certain minimum period.
 Corporates usually, adopt a policy of employing both the borrowed funds as well as
the shareholders funds to finance. The question of whether there is an optimal mix of
debt and equity to finance the investment needs and, if so, what that optimal mix is
Dividend decisions
 Another major area of decision making by the Managerial
finance is known as the dividend decisions which deal with the
appropriation of after tax on profits. These profits are available
for distribution among the shareholders OR can be retained for
reinvestment within the company.

 All firms whether small or big, have to decide how much of the
profits should be reinvested back in the business and how much
should be taken out in the form of dividends, i.e., Return on
capital. The distribution of profits by any company is required to
satisfy the expectation of the shareholders. The profit can be
distributed to shareholders either as a CURRENT REVENUE (i.e.,
dividends) or as CAPITAL RECEIPT (i.e., bonus share).

 In managing the assets structure of the company, the

Managerial finance guides to determine the mix and type of
assets to be acquired by the company.
 Objectives of Company

1. Dominant market share (retail industry)

Leads to high reward for managers
Improved profitability
2. Profit maximisation – much more acceptable objective
3. Maximisation of shareholder wealth
Shareholders provide funds to a business in expectation that they receive the
maximum possible increase in wealth for the level of risk which they face.
Finance experts consider it as superior.
4) Survival
There are circumstances where the overriding objective becomes the survival of
the firm, e.g. severe economic and market shock may force managers to focus
purely on the short issues to ensure continuance of the business. MG took over
Rover at Long bridge plant with the immediate objective to survive. Another
example is the Northern Rock case in UK.
5) Maintain happy and stable workforce
All resources are directed at mollifying employees.
MANAGERIAL FINANCE AND DECISION MAKING

 The process of decision making in Managerial finance is goal oriented one. The goal
orientation is required to be well defined because the evaluation of opportunities
faced and the decision taken depend a great deal on the goal of financial decision
making or in other words the objective of the Managerial finance without a well
defined goal, the financial decisions may wander without a direction going one way
and then another way. The objective of managerial finance will provide a
selection/decision criterion for the relevant decision fields, i.e., the investment
decisions, the financing decision and the dividend decisions. The good objective of
Managerial finance plan should have the following characteristics:
(i) It should be clear and unambiguous
(ii) It comes with a clear and timely measure that can be used to
evaluate the success or failure of a decision, and
(iii) It should be consistent with the long-term existence of the
company.

Several goals of Managerial finance have been cited, viz., maximization of sales
revenue, net profit return of investment, size of the firm, percentage market share, etc.
The two major goals of financial policy:
(a) Maximization of profits of the company.
(b) Maximization of shareholders’ wealth.
 Maximisation of Profits
 Managerial finance evaluates how funds are used and procured. In all cases it
involves a sound judgement, combined with a logical approach to decision
making.
 The core of Managerial finance is to maximize earnings in the long run and
optimize them in the short run.
 This calls for an evaluation of the condition of alternative uses of funds and
the allocation of resources after a consideration of production and marketing
interrelationships.
 Managerial Financial Policy is concerned with the efficient use of an improved
resource, mainly capital funds.
 Profit maximization should serve as the basic criterion for decisions arrived at
by financial managers of privately owned and controlled firms. Different
alternatives are available to a business enterprise in the process of decision
making. Each alternative has certain implications.
 Different courses of action have to be evaluated on the basis of some
analytical framework, and for this purpose, commercial strategies of an
enterprise have to be considered. The availability of funds depends upon the
kind of commercial strategies, adopted by the company during a particular
period of time.
 The theory of financial management provides an analytical framework, for an
 Maximisation of Profits
• The maximization of profits is often considered to be a goal or an
alternative goal of a company. However, this is somewhat narrower
in concept than the goal of maximizing the value of the company
because of the following reasons:

a. The maximization of profits, as reflected in the earnings per share, is not

an adequate goal in the first place, because it does not take into
consideration the time value of money.

b. The concept of maximization of earnings per share does not include the
risk of streams of alternative earnings. A project may have an earning
stream that will attain the goal of maximum earnings per share; but when
compared to the risks involved in it, it may be totally unacceptable to a
stockholder, who is generally hostile to risk bearing activities and,

c. This concept of maximization of earnings per share does not take into
account the impact of dividend policy upon market price or value of the
firm. Theoretically, a firm would never pay a dividend if the objective is to
maximize earnings per share. Rather, it would reinvest all its earning so
as to generate greater earnings in future.
 problems in maximization of profits
i. It ignores the risk which firm undertakes in attempting to increase the profits. The
management may undertake all profitable investment opportunities regardless of the
associated risk, whereas that investment may not be worth the risk, despite its potential
profitability.
ii. (Profit is not in clear terms. Is it accounting profit or economic profit? Profit before tax or
after tax?
iii. It encourages corrupt practices to increase the profits.
iv. Does not consider the impact of time value of money.
v. The true and fair picture of the organization is not reflected through profit maximization.
vi. It attracts cut-throat competition.
vii. Huge profits attracts government intervention.
viii. Huge profits invites problems from workers’ unions for high salaries and fringe benefits.
ix. In modern marketing huge profits mean exploitation of customers.
x. Profit maximization is a narrow concept, it affects the liquidity of the company.
xi. Profit maximization concentrates on the profitability and ignores the financing aspect.
xii. It ignores the time-value of money.
xiii. The profit maximization may widen the gap between the perception of the management
and that of the shareholders.
xiv. Profit maximization tends to concentrate on the immediate profit and do not consider the
decision on the costs and benefits scattered over many years.
Managerial finance is interested in providing
answers to the following questions:

(a) Market position/market demand for products/production

capacity/investment opportunities/purchase of essential assets
— all these are related to CAPITAL BUDGETING.
(b) Given a company’s market position and investment
opportunities, what is the total volume of funds that it should
commit? It is called COMPOSITION OF ASSETS.
(c) How should it acquire the funds necessary for the
implementation of its investment decisions? This underscores
the approach to CAPITAL FINANCING.
 Wealth Maximisation
 The goals of Managerial finance may be such that they should be beneficial to the owners, management,
employees and customers. These goals may be achieved only by maximising the value of the company.
The elements involved in the maximization of the value of the company are:
 Increase in Profits: The company should formulate and implement all possible plans of expansion and
take every opportunity to maximise its profits. In theory, profits are maximised when a firm is in
equilibrium. An increase in sales will not necessarily result in the rise in profits unless there is a market
for increased supply of goods and unless the overhead costs are properly controlled.
 Reduction in Cost: Capital and equity funds are factor inputs in production. A company has to make
every effort to reduce the cost of capital and launch an economy drive in all its operations.
 Sources of Funds: A company has to make a judicious choice of funds so that they maximise its value.
The sources of funds are not risk free. A company will have to access the risks involved in each source of
funds. While issuing equity shares, it will have to increase ownership funds into the corporate. While
issuing debentures and preference shares, it will have to accept both fixed and recurring obligations. The
advantages of leverage, too, will have to be weighed properly
 Minimum Risks: Different type of risks confront the company. NO RISK NO GAIN is a common adage.
However, in the world of business uncertainties, a corporate management will have to calculate business
risks, financial risks or any other risks that may work to the disadvantage of the firm before embarking
on any particular course of action.
 Long Run Value: The goal of Managerial finance should be to maximise the long run value of the
company. It may be worthwhile for company to maximise profits by pricing its products high, or by
pushing an inferior quality product into the market, or by ignoring interest of employees, or to be
precise, by restoring to cheap and GETTING RICH QUICK methods. Such tactics, however, are bound to
affect the prospects of a firm rather adversely over a period of time. For a permanent progress and
sound reputation, it will have to adopt an approach which is consistent with the goals of Managerial
financein the long run. MORE HASTE, LESS SPEED — is the principle of profitability.
 Advantages of Wealth Maximisation

(a) Present value of cash flow is taken into consideration and is

measured quantatively.
(b) There is concept of time value of money. The present value
of outflows and inflows helps to achieve the overall objective of
the company.
(c) The concept is universally accepted, since it takes care of
interest of organisations/ shareholders/employees and society
at large.
(d) It guides the consistent strong dividend policy, to reach
maximum returns to the equity holders.
(e) It considers the impact of risk factor and adjustment is being
made to cover the risk that is associated with the investments.
Disadvantages/Criticism of Wealth Maximisation

 Objective is not descriptive.

 As corporates have grown bigger and more powerful, their influence has
become more pervasive; they have created an imbalance which is widely
believed to have an instrumental in generating a movement to promote
more socially conscious business behaviour.
 Managerial finance should not only maintain business in financial health,
but should help to produce the rate of earnings which will reward
shareholders adequately for the use of the capital they provide.
 There are factors like legal obligations to its employees, which may
support frustrate financial management by supportive and non-supportive
policies.
 The share price in the stock exchange market is subject to the influence of
so many extraneous factors (and not only of wealth maximisation) like
overall economic, political and developed nation’s actions in the world. The
market price of a share may also fluctuate because of speculative
activities.
 Profit Maximisation versus Wealth Maximisation

 The objective of profit maximisation measures the performance of a firm by looking

at its total profit. It does not consider the risk which the firm may undertake in
maximisation of the profits. The profit maximisation, as an objective, does not
consider the effect of earning per share, dividends paid or any other return to
shareholders on the wealth of the shareholders.
 On the other hand, the objective of maximisation of shareholders’ wealth considers
all future cash flows, dividends, earnings per share, risk of decision, etc. So the
objective of maximisation of shareholders’ wealth is operational and objective in its
approach. A firm that wishes to maximise the profits may opt to pay NO DIVIDENDS
and to reinvest the retained earnings, whereas a company that wishes to maximise
the shareholders’ wealth may pay regular dividends. The shareholder would
certainly prefer an increase in wealth against the generations of increasing flow of
profits to the company. Moreover, the market price of a share, explicitly reflects the
shareholders’ expected return, considers the long-term prospects of the company,
reflects the differences in timing of the returns, considers risk and recognises the
importance of distribution of returns. Therefore, the maximisation of shareholders’
wealth as reflected in the price of a share is viewed as a proper goal of financial
policy. The profit maximisation can be considered as a part of the wealth
maximisation strategy but should never be permitted to overshadow the latter.
Agency Theory
 It has long been recognised that the separation of ownership and control in
the modern corporation results in potential conflict between owners and
managers. In particular, management objectives may differ from those of
the firm’s shareholders. The primary engines which drive agency situations
are conflicts of interest.

 First, to a problem in agency, there must be an “agent”. An agent is an

individual or group appointed to act on behalf of a principal. Principals
are those who feel the ultimate effects of the decisions taken by the
agents. Managers may consume company resources by spending on
‘perks’ such as thick carpets, private jets, attractive secretaries which
return less in improved company performance than they provide as
consumption to managers. Managers can also ‘consume’ company paid
time by shirking duties.
Managing the Agency Problem
firm agency relationship

 1 Shareholders and management

 2 Shareholders and creditors
 3 Shareholders and the government
 4 Shareholders and auditors
1. Shareholders and management
The separation of ownership and control in most modern corporations’
causes a conflict of interest between the personal interest of appointed
managers (agent) and the interests of the owners of the firms
(principals). this conflict is known as the agency conflict. :
 • Managers may use corporate resources for personal use.
 • Managers may award themselves hefty pay rises
 • Managers may organize mergers which are intended for their
benefit only and not for the benefit of shareholders.
 • Managers may take holidays and spend huge sums of
company money.
 • Managers may use confidential information for their benefit
(insider trading)
 Resolution of conflict
1. Performance based remuneration
 This will involve remunerating managers for actions they take that maximize
shareholders wealth.
 The remuneration scheme should be restructured in order to enhance the
harmonization of the
 interest of shareholders with those of management. Managers could be given bonuses,
commissions for superior performance in certain periods.
2. Incurring agency costs
 Agency costs refer to costs incurred by shareholders in trying to control management
behaviour and actions and therefore minimize agency conflicts.
 These costs include:
 • Monitoring costs. They arise as a result of mechanisms put in place to ensure
interests of shareholders are met. They include cost of hiring external auditors, bonding
assurance which is insurance taken out where the firm is compensated if manager commits
an infringement, internal control system implementation.
 • Opportunity costs which are incurred either because of the benefit foregone from not
investing in a riskier but more profitable investment or in the due to the delay in decision
making as procedures have to be followed (hence, a timely decision will not be made)
 • Restructuring costs are those costs incurred in changing or altering an organization’s
structure so as to prevent undesirable management activities.
 • Board of directors- a properly constituted board plays the oversight role on
management for the shareholders.
 Resolution of conflict
3. Threat of corporate takeover
 When management of a firm under performs this result in the shares of that firm being undervalued there is the
threat of a hostile takeover. This threat acts to force managers to perform since should the firm be taken over, they
will be replaced.
4. Shareholders intervention
 The shareholders as owners of the company have a right to vote. Hence, during the company’s AGM the
shareholders can unite to form a bloc that will vote as one for or against decisions by managers that hurt the
company. This voting power can be exercised even when voting for directors. Shareholders could demand for an
independent board of directors.
5. Legal protection
 The companies act and bodies such as the capital markets authority have played their role in
 ensuring trying to minimize the agency conflict. Under the companies act, management and board of directors owe
a duty of care to shareholders and as such can face legal liability for their acts of omission or commission that are
in conflict with shareholders interests. The capital market authority also has corporate governance guidelines.
6. Use of corporate governance principles
 Which specify the manner in which organizations are controlled and managed. The duties and rights of all
stakeholders are outlined.
7. Stock option schemes for managers could be introduced.
 These entitle a manager to purchase from the company a specified number of common shares at a price below
market price over duration. The incentive for managers to look at shareholders interests and not their own is that, if
they deliver and the company’s share price appreciates in the stock market then they will make a profit from the
sale.
8. Labour market actions such as hiring tried and tested professional managers and firing poor
 performers could be used. The concept of 'head hunting' is fast catching on in Kenya as a way of getting the best
professional managers and executives in the market but at a fee of course.
 2. Shareholders vs. creditors
 In this relationship the shareholders (agent) are expected to manage the credit funds
provided by the creditors (principal). The shareholders manage these funds through
management.
 Debt providers/creditors are those who provide loan and credit facilities to the firm. They
do this after gauging the riskiness of the firm.
 The following actions by shareholders through management could lead to a conflict
between them and creditors
 Shareholders could invest in very risky projects. The management under the directive of the
shareholders may undertake highly risky investments than those anticipated by the providers of long
term debt finance. The creditors would not be interested in highly risky projects because they stand to
lose their funds when the investments collapse. Even if the risky projects succeed, they would not
benefit because they only get a fixed rate of return.
 The dividend payments to shareholders could be very high. An increase in the dividend rate in most
cases is financed by a decrease in investments. This in turn reduces the value of bonds. If the firm is
liquidating and it pays a liquidating dividend to its shareholders, the providers of capital could be left
with worthless claims.
 Default on interest payments to bondholders
 Shareholders could organize mergers which are not beneficial to creditors
 Shareholders could acquire additional debt that increases the financial risk of the firm
 Manipulation of financial statements so as to mislead creditors
 Shareholders could dispose of assets which are security for the credit given
 Under investments. The shareholders may invest in projects with a negative net present value.
 The shareholders may adopt an aggressive management of working capital. This may bring conflicts in
Resolution of this conflict

 1. Restrictive covenants- these are agreements entered into between the firm
and the creditors to protect the creditor’s interests.
 These covenants may provide restrictions/control over:
 i. Asset based covenants- These states that the minimum asset base to be
maintained by the firm.
 ii. Liability based covenant- This limits the firm’s ability to incur more debt.
 iii. Cashflow based covenant- States minimum working capital to be held by the
firm. This may restrict the amount of dividends to be paid in future.
 iv. Control based covenant – Limits management ability to make various
decisions e.g. providers of debt fund may require to be represented in the BOD
meetings.
 2. Creditors could also offer loans but at above normal interest rates so as to
encourage prompt
 payment
 3. Having a callability clause to the effect that a loan could be re-called if the
conflict of interest is severe
 4. Legal action could also be taken against a company
 5. Incurring agency costs such as hiring external auditors
 6. Use of corporate governance principles so as to minimize the conflict.
Shareholders and the government

 The shareholders operate in an environment using the license given by the

government.
 The government expects the shareholders to conduct their business in a
manner which is beneficial to the government and the society at large.
 The government in this agency relationship is the principal and the company
is the agent.
 The company has to collect and remit the taxes to the government. The
government on the other hand creates a conducive investment environment
for the company and then shares in the profits of the company in form of
taxes. The shareholders may take some actions which may conflict the
interest of the government as the principal. These may include;
 The company may involve itself in illegal business activities
 The shareholders may not create a clear picture of the earnings or the profits it
generates in order to minimize its tax liability. (tax evasion)
 The business may not response to social responsibility activities initiated by the
government
 The company fails to ensure the safety of its employees. It may also produce sub
standard products and services that may cause health concerns to their consumers.
 The shareholders may avoid certain types of investment that the government
Solutions to shareholders-
government agency problem
 (i) The government may incur costs associated with statutory audit, it may also
order investigations under the company’s act, the government may also issue
VAT refund audits and back duty investigation costs to recover taxes evaded in
the past.
 (ii) The government may insure incentives in the form of capital allowances in
some given areas and locations.
 (iii) Legislations: the government issues a regulatory framework that governs the
operations of the company and provides protection to employees and customers
and the society at large.ie laws regarding environmental protection, employee
safety and minimum wages and salaries for workers.
 (iv) The government encourages the spirit of social responsibility on the activities
of the company.
 (v) The government may also lobby for the directorship in the companies that it
may have interest in. i.e. directorship in companies such as KPLC, Kenya Re. etc
 3. Shareholders and auditors

 Auditors are appointed by shareholders to monitor the

performance of management.
 They are expected to give an opinion as to the true and fair view
of the company’s financial position as reflected in the financial
statements that managers prepare.
 The agency conflict arises if auditors collude with management
to give an unqualified opinion (claim that the financial
statements show a true and fair view of the financial position of
the firm) when in fact they should have given a qualified opinion
(that the financial statements do not show a true and fair view).
 The resolution of this conflict could be through legal action,
removal from office, use of disciplinary actions provided for by
regulatory bodies such as ICPAK.
 Individual Assignment

 Explore the nature and importance of internal

structure of a Firm
 Explain the transaction cost theory of a firm: Ronald
Coase and Williamson, its advantages and criticisms
 Explain the Alternative theories of a firm, their
advantages and criticisms