Chapter One

Overview of Financial Management

The concept of Finance
To start any business we need capital.
Capital is the amount of money required to start a business.
Finance is a scarce resource, they are limited, we cannot waste
them.
Any business organization depends on finance therefore, it is
called the life blood of business organization.
 Finance is the study of money management.
In every organization, where funds are involved, sound
financial management is necessary.
It helps in monitoring the effective deployment of funds in
fixed assets and in working capital.
 Collins Brooks has remarked “Bad production
management and bad sales management have slay in
hundreds, but fault financial management has slain in
thousands.”

 Finance consists of three interrelated areas particularly in

association with the career of graduates.
• Finance consists of three interrelated areas;
1. Financial Economics
2. Investments
3. Financial management or business finance
1. Financial Economics

 This deals with securities market and financial institutions;

professionals with knowledge in finance go to work for financial
institutions, including banks, insurance companies, mutual funds and
investment banking firms.
 Knowledge of valuation techniques, the factors that cause interest rate
to rise and fall, the regulations to which financial institutions are
subject, and the various types of financial instruments.
 General knowledge of all aspects of business administrations,
because the management of a financial institution involves
accounting, marketing, personnel, computer system as well as
financial management.
 2. Investments
• Investment focuses on the decisions made by both individual and
institutional investors as they choose securities for their investment
portfolios.
• The investment area deals with financial assets such as stock/share and
bonds
• Major decisions
1. Security analysis deals with finding the proper values of individual
securities (i.e., stocks and bonds).
2. Portfolio theory deals with the best way to structure portfolios, or
“baskets,” of stocks and bonds. Rational investors want to hold
diversified portfolios in order to limit risks.
3. Market analysis deals with the issue of whether stock and bond markets
at any given time are “too high,”“too low,” or “about right.”
 3. Financial Management or Business
Finance
• Involves decisions within firms. It is the broadest of the three
areas.
• Financial management, also called corporate finance,
• Focuses on decisions relating to
a) How much and what types of assets to acquire
b) How to raise the capital needed to buy assets
c) How to run the firm so as to maximize its value.
• The same principles apply to both for-profit and not-for-profit
organizations
• Although we separate these three areas, they are closely
interconnected
 Evolutions of Financial Management
 Financial management is not a revolutionary concept but an
evolutionary.
 The definition and scope of financial management has been changed
from one period to another period and applied various
innovations.
 But as a discipline financial management is a recently recognized
discipline which still has no unique body of knowledge of its own,
and draws heavily on economics for its theoretical concept even
today.
 It is an area exposed for changes related with the concurrent
globalization effect and increase in information technology.
 Brigham (2001) described the historical perspective and the evolution of
financial management as:

Years Concerns or involvement

1900  Legal aspects of merger, formations of new firms.

During economic  Bankruptcy and reorganization, corporate liquidity, and the

depression of 1930,  Regulation of security markets.

1940s & early 1950  Viewed as a theoretical analysis to managerial decisions

 For maximizing the value of the firm.
 Definition of Finance

 Different scholars define financial management in different technicalities,

however, with similar emphasis:
 According to Khan and Jain:
 “Finance is the art and science of managing money”.
 Guthumann and Dougall:
 Business finance can broadly be defined as the activity concerned with
planning, raising, controlling, administering of the funds used in the
business”.
Definition of Financial Management
 Pandey (1999) stated financial management in the form of
managerial activity which is concerned with the planning and
controlling of a firm’s financial resources.
 According to Solomon (1969) financial management is concerned
with the efficient use of important economic resources namely,
capital funds.
 Generally, financial management can be simply defined as the
decision and process of making optimal use of a firm’s financial
resources for the purpose of maximizing the owner’s/shareholders
wealth.
Scope and function of financial Management

 Traditional concept
 Finance manager has to undertake the following three
functions:
1. Arrangement of funds from financial institutions;
2. Arrangement of funds through financial instruments
Viz. shares, bonds, etc
3. Looking after the legal and accounting relationship
between a corporation and its sources of funds
 Critics of Traditional Concept
1. The emphasis on rising of funds, this concept takes into
account only the investor’s point of view and not the finance
manager’s view point.
2. Circumscribed to the episodic financing function as it places
overemphasis on topics like types of securities, promotion,
incorporation, liquidation, merger, etc.
3. Places great emphasis on the long-term problems and ignores
the importance of the working capital management.
4. The concept confined financial management to issues
involving procurement of funds. It did not emphasis on
allocation of funds.
•Traditional concept implied a very narrow scope for financial management.
•The modern concept provides a solution to these shortcomings

Modern Concept
•Finance is an integral part of the overall management rather than
mere mobilization of the funds.

Finance manager;
•See that the company maintains sufficient funds to carry out the plans.
•Ensure a wise application of funds in the productive purposes.
• Consider all the financial activities of planning, organizing, raising,
allocating and controlling of funds.
•The modern approach view the term financial management in a broad sense
and provides a conceptual and analytical framework for financial decision-
making.
•According to modern approach the finance function covers both
acquisitions of funds as well as their allocation.
• According to Khan and Jain, 2000) financial management can be
broken down into three major decisions as functions of finance:
• Investment decisions
• Financing decisions
• Dividend policy decision
1. Investment (Asset-Mix) Decisions the investment decisions relates
to the selection of assets in which funds will be invested by the firm.

When the investment is made on long-term assets it is considered as

capital budgeting while the other is working capital

 Capital budgeting to describe the process of making and managing

expenditures on long-lived assets.
 Capital budgeting decision is concerned with long-term assets and their
compositions
Measurement of investment proposals
How should short-term operating cash flows be managed
Management of cash flow is associated with a firm’s net working capital
which is the difference of current assets minus current liabilities
 Working capital management
• Is concerned with the management of current assets.
• Integral part of financial management as a short term survival
is the prerequisite for the long term success.
2. Financing (Capital-Mix) Decisions
• It is emphasized when, where and how to acquire funds to
meet the firm’s investment needs.
• Determine the proportion of equity and debt.
• The mix of debt and equity is known as the firm’s capital
structure.
• When the shareholder’s return is maximized with minimum risk, the
market value per share will be maximized and the firm’s capital structure
would be considered optimum.
 3. Dividend or Profit Allocation Decisions
• The emphasis is whether the firm should distribute all
profits, or retain them, or distribute a portion and retain the
balance
• The optimum dividend policy is one that maximized the
market value of firm’s shares.
 Formation of business organization

1. Proprietorship
• Many companies begin as a proprietorship.
• Starting a business as a proprietor is easy
 Advantages of Proprietorship:
1. Easily and inexpensively formed
2. Subject to few government regulations
3. Income is not subject to corporate taxation but is taxed as part
of the proprietor’s personal income.
 Disadvantages of Proprietorship:
1. It may be difficult for a proprietorship to obtain the capital
needed for growth
2. The proprietor has unlimited personal liability for the
business’s debts
3. The life of a proprietorship is limited to the life of its
founder.
2. Partnership
• Some companies start with more than one owner, and some
proprietors decide to add a partner as the business grows.
• A partnership exists whenever two or more persons or entities
associate to conduct a non corporate business for profit.
• Partnership agreements define the ways any profits and losses
are shared between partners.
• A partnership’s advantages and disadvantages are generally
similar to those of a proprietorship.
 Partnership
-Limited
-General
• Limited partners can lose only the amount of their investment
in the partnership,
• General partners have unlimited liability.
• However, the limited partners typically have no control—it
rests solely with the general partners.
Advantages Disadvantages
 Easily and inexpensively  Difficult to obtain the
formed capital needed for growth
 Subject to few government  Unlimited liability
regulations  Limited life
 Income is not subject to
corporate taxation

Note: Partners can potentially lose all of their personal assets, even assets not
invested in the business, because under partnership law, each partner is liable for the
business’s debts.
 Corporation

• A corporation is a legal entity created under state laws, and it is

separate and distinct from its owners and managers.
• This separation gives the corporation three major advantages:
1. Unlimited life—a corporation can continue after its original
owners and managers are deceased
2. Easy transferability of ownership interest—ownership interests
are divided into shares of stock, which can be transferred far more
easily than can proprietorship or partnership interests
3. Limited liability—losses are limited to the actual funds invested.
 Disadvantage of Corporation
1. Corporate earnings may be subject to double taxation
2. Setting up a corporation involves preparing a charter, writing a
set of bylaws, which is more complex and time consuming than
creating a proprietorship or a partnership.
Objective of financial Management
Profit Maximization
Wealth Maximization
 Profit Maximization

• A business firm is profit-seeking organization.

• Hence, profit maximization is well considered to be an
important objective of financial management.
• Profit maximization means maximizing birr income of firms
• While maximizing profit, a firm either produces maximum
output for a given amount of output, or uses minimum input for
producing a given output.
• The underlying logic of profit maximization is efficiency
Limitation of profit maximization
A. Ambiguity in Definition
 The precise meaning of the profit maximization objective is
not clear because of the following ambiguity:
1. Definition of the term profit is ambiguous.
2. Does it mean short-or-long-term profit?
3. Does it refer to profit before or after tax?
4. Total profits or profit per share?
5. Does it mean total operating profit or profit accruing to
shareholder?
2. Quality of Benefits
 The streams of benefits may possess different degree of
certainty.
 Two firms may have same total expected earnings, but if the
earnings of one firm fluctuate considerably as compared to the
other, it will be more risky.
 Profit maximization criterion is inappropriate and unsuitable as
an operational objective of investment, financing and dividend
decisions of a firm.
 It is not only vague but it also ignores two important
dimensions of financial analysis namely risk and time value of
money.
2. Wealth Maximization
 Wealth Maximization is also known as value maximization or net present
worth maximization.
 Shareholder wealth is the number of shares outstanding times the market
price per share. For example, if you own 100 shares of GE’s stock and the
price is $40 per share, your wealth in GE is $4,000.

• Value maximization is almost universally accepted.

• It removes the technical limitations of profit maximization criterion
namely, exactness, quality of benefits and the time value of money
• In applying the value maximization criterion, the time value is used in
terms of worth to the owners
• A large discount rate is the result of higher risk and longer time period.
• Net present value maximization is superior to the profit maximization as an
operational objective.
 A financial action that has a positive NPV is desirable.
 A financial action resulting in negative NPV should be rejected since it
would destroy shareholders’ wealth.

NPV (W) = A1 + A2 + A3 +… + An
1 2 3 n
(1+i) (1+i) (1+i) (1+i) - C
The role of Financial Manager
• Specific tasks of financial staff can be stated as major
responsibilities.
 Forecasting and Planning
 Major Investment and Financing Decision
 Contribution and Control
 Dealing with the Financial Markets
 Risk Management
 Exercise
• Assume that a certain firm is considering two projects X and
Y. Both projects are four year projects and the cash flow of
each projects are given below;
• Cost of capital is 10% and the initial investment is 1000.
Calculate NPV of each project and in which project the firm
should invest.

Year X Cash flow Y Cash flow

1 5000 1000
2 4000 3000
3 3000 4000
4 1000 6750
 Exercise
• Assume that a certain firm is considering two projects X and
Y. Both projects are four year projects and the cash flow of
each projects are given below;
• Cost of capital is 10% and the initial investment is 10,000.
Calculate NPV of each project and in which project the firm
should invest.

Ye X Cash flow PV= FV/1+r)n Y Cash PV= FV/1+r)n

ar flow
1 5000 4545.45 1000 909.09
2 4000 3305.78 3000 2479.33
3 3000 2253.93 4000 3053.43
4 1000 683.01 6750 4610.34
Total 10788 11004.01
• Project X
10788-10,000= 788
Project Y
11,004.01-10,000 = 1004.01
NPV of Y is better than X