CHAPTER ONE

FINANCIAL
MANAGEMENT: AN
OVERVIEW
Contents

 Introduction
 Evolution of Financial
management
 Goal of financial management
 Form of Business Organization
 The agency problem
 The role of financial manager in a
corporation
 Financial system
 Introduction
 Suppose we need to start our own business. No matter
what the nature of our proposed business, what
questions that need to be raised?
 What capital investment should we make? (That is what kind
of equipment, building, machinery etc)
 (Capital Budgeting)
 Where will we raise money to pay for the proposed capital
investment? That is the mix of equity and debt in your
financing plan.
 (capital structure)
 How will we handle the day to day financial activities like
collecting receivables and paying our suppliers?
 (WCM)
 Thus, to achieve our proposed business objective, we
must understand the concept of Financial management
 Definition
Financial management is the organization
activity that is concerned with management of
financial resources.

Its activity cover

 the mobilization and utilization of funds.

 planning for the future for a business enterprise to

ensure a positive cash flow.

 the administration and maintenance of financial assets.

Besides, financial management covers the

process of identifying and managing risk.
 Evolution of financial management
Financial management emerged as a distinct
field of study at the turn of the 20 th century

Its evolution may be divided into three broad

phases
The traditional phase

The transitional phase and

The modern phase

The Traditional Phase
The traditional phase lasted for about four
decades.
The following were its important features:

1. The focus of financial management was mainly on

certain episodic events like formation, issuance of
capital, major expansion, merger, reorganization, and
liquidation in the life cycle of the firm.

2. The approach was mainly descriptive and

institutional.

3. The outsiderpoint of view was dominant. Financial

management was viewed mainly from the point of
the investment bankers, lenders, and other outside
interests.
 The Transitional Phase
The transitional phase begins around the early
1940’s and continues through the early
1950’s.
The nature of financial mgt during this phase
was
Almost similar to that of the traditional phase,

greater emphasis was placed on the day to day

problem faced by the finance managers in the area
of funds analysis, planning, and control.
Such problems however were discussed within
limited analytical framework.
The modern phase
The modern phase begin in mid 1950s and
has witnessed an accelerated pace of
development with the infusion of ideas from
economic theories and applications of
quantitative methods of analysis.
The distinctive features of modern phase are:
 The scope of financial management increased.

 The central concern of financial management is

considered to be a rational matching of funds to their
uses in the light of appropriate decision criteria
 The approach of financial management has become
more analytical and quantitative
 The point of view of the managerial decision maker has
become dominant
Goal of Financial Management
Does Profit or wealth maximization?
Profit maximization:
Profit maximization would probably be the most
commonly cited business goal, but this is not a
very precise objective.
 Do we mean profit of this year? If so, some activities
like inventories run down, and other short-run, cost-
cutting measures will tend to increase profits now
The goal of maximizing profits may refer to
some sort of “long-run” or “average” profits, but
still it's unclear exactly what this means.
 Wealth maximization:
The primary goal is shareholder wealth
maximization because the firm is owned by
the shareholders.
This goal should be measured in terms of
market share price, which is a value that
investors collectively are prepared to pay.
The goal of maximizing shareholder wealth
may conflict with
- interests of management (their
compensation)
- social/ethical goals
Firms should take socially desirable actions
even if certain actions like pollution control
may at times conflict with this goal.
Ignoring social responsibility can lead to a
backlash of anti business sentiment, reflected
in legislation.
Managers should strictly follow the rules of
fairness and honesty.
In general maximization of profit is not as
inclusive a goal of maximization of
shareholders’ wealth.
It suffers from several limitations
 Profit in absolute terms is not a proper guide to decision
making. It should be expressed either on a per share
basis or in relation to investment
 It leaves considerations of timing and duration
undefined. There is no guide for comparing profit now
with in the future
Therefore, Wealth maximization reasonably
appears to be the most appropriate goal for
financial management
 Agency Problem
The relationship between stockholders and
management is called an agency relationship.
Such a relationship exists whenever someone
(the principal) employ another (the agent) to
represent his/her interests.

In this relationship the principal delegates or

hires an agent to perform work.
For example, you might delegate someone (an agent)
to sell a car that you own while you are away at school.
And you agree to pay a commission fee when he/she sells
the car.
 Take these two alternative agreement

1. A flat commission fee or

2. A 10% of the sales price

1. The agent's incentive in this case is to make the sale, not
necessarily to get you the best price.

2. If you offer a commission of, say, 10 percent of the sales price

instead of a flat fee, then the above problem might not exist.

 This example illustrates that the way in which an agent is

compensated is one factor that affects agency problems

 In all such relationships, there is a possibility of a

conflict of interest between the principal and the agent.
Such a conflict is called an agency problem.
Conflicts of Interest
• Reduced effort on the part of the agent
• Excessive perks consumption
• Empire building
• Entrenchment
• Risk avoidance
 The Firm’s Agency Problem
 Sources of Conflict Within Firms
 Conflicts can exist between the self-seeking goals
of (agent) managers and the value maximization
goal of (principal) stockholders.
 Conflict can exist between stockholders (through
managers) and creditors
 Types of Agency Problems
 Excessive risk-taking or risk-avoidance problems
can emerge.
 Managers can be short sighted.
 Information asymmetry can complicate monitoring.
Forms of business
organization

1. Sole Proprietorships
2. Partnerships
3. Corporations
 Sole Proprietorship
 A sole proprietorship is an unincorporated
business owned by one individual.
 It has three important advantages:
1. It is easily and inexpensively formed,
2. it is subject to few government regulations, and
3. the business avoids corporate income taxes.
 The proprietorship also has three important
limitations:
1. It is difficult for a proprietorship to obtain large sums
of capital;
2. the proprietor has unlimited personal liability for the
business’s debts; and
3. the life of a business organized as a proprietorship is
limited to the life of the individual who created
Partnership
 A partnership:- is a business which conducted
by two or more persons.
 It has an advantage of
1. low cost,
2. ease of formation and
3. tax treatment .
 The disadvantages are similar to those
associated with proprietorships:
1. unlimited liability,
2. limited life of the organization,
3. difficulty of transferring ownership, and
4. difficulty of raising large amounts of capital.
 Corporations
 A corporation is a legally defined, artificial being (a
legal entity), separate from its owners.
 This separateness gives the corporation three major
advantages:
1. Unlimitedlife. A corporation can continue after its original
owners and managers are deceased.

2. Easy transferability of ownership interest and

3. Limited liability. Losses are limited to the actual funds invested.

 These three factors—unlimited life, easy transferability

of ownership interest, and limited liability—make it
much easier for corporations than for proprietorships
or partnerships to raise money in the capital markets.
Formation of a Corporation
Corporations must be legally formed.

The state in which it is incorporated must formally

give its consent to the incorporation by chartering it.
Setting up a corporation is considerably more costly
than setting up a sole proprietorship.
Most firms hire lawyers to create a corporate charter
that includes formal articles of incorporation and a
set of bylaws.
The corporate charter specifies the initial rules that
govern how the corporation is run.
Ownership of a Corporation
There is no limit on the number of owners a
corporation can have or who can own its stock.

The entire ownership stake of a corporation is

divided into shares known as stock.

The collection of all the outstanding shares of a

corporation is known as the equity of the
corporation.
An owner of a share of stock in the corporation
is known as a shareholder, stockholder, or
equity holder.
Entities

A corporation’s profits are subject to taxation

separate from its owners’ tax obligations.

Shareholders of a corporation pay taxes twice.

 First, the corporation pays tax on its profits, and then

 when the remaining profits are distributed to the

shareholders, the shareholders pay their own
personal income tax on this income.

 This is sometimes referred to as double taxation.

Example 1.1 Taxation of Corporate
Earnings
Assume that you are a shareholder in a
corporation. The corporation earns Birr 5
per share before taxes. After it has paid
taxes, it will distribute the rest of its
earnings to you as a dividend. The
dividend is income to you, so you will then
pay taxes on these earnings. The corporate
tax rate is 40% and your tax rate on
dividend income is 15%.
How much of the earnings remains after all
taxes are paid?
Solution:-
Birr 5 per share  0.40 = Birr 2 in taxes
at the corporate level, leaving
Birr 5 – Birr 2 = Birr 3 in after-tax earnings per
share to distribute.
You will pay Birr 3  0.15 = Birr 0.45 in
taxes on that dividend, leaving you with
Birr 2.55 (Birr 5 – Birr 2.45) 0r (3-0.45) from the
original Birr 5 after all taxes.
The amount Birr 2 + Birr 0.45 = Birr
2.45 is paid as taxes.
Thus, your total effective tax rate is 2.45/5
= 49%. Or (0.4+0.15)-(0.4*0.15) =0.55-
0.06=0.49
 Characteristics of Business organizations
Sole proprietorship Partnership Corporation

Owner Proprietor—only Partners—two or Stockholders—

one owner more owners generally many owners

Life of organization Limited by the owner’s Limited by the owner’s Indefinite

choice, or death choice, or death

Legal viewpoint Owner and business entity are not Owners and business entity Separate entity from owners
regarded as separate are not regarded as
separate

Accounting viewpoint Business entity is separated from Business entity is Business entity is separated
other affairs of owner separated from other affairs from other affairs of owners
of owners

Separate taxable entity No No Yes

from owner

Ease of formation Very easy Partnership agreement is Articles of corporation

helpful generally requires

Management Owner May be divided among Board of directors

partners

Personal liability Proprietor is Partners are Stockholders are not

of the owner(s) for personally liable personally liable personally liable
the business’s debts
Transferability of Only by sale of entire business or Can sell all or a portion of Can easily transfer(sell) all
ownership creation of different entity partnership interest or a portion of stock
 Hybrid types of business
organizations
A limited partnership is a partnership with two
kinds of owners, general partners and limited
partners.
General Partners have unlimited liability for all
obligations of the business
Limited Partners have their liability limited to
the partnership agreement (usually the amount
of the investment)
In a limited liability company (LLC), all the
owners have limited liability—but unlike
limited partners, they can also run the business.
The role of financial manager in a
corporation
Here are some specific activities:
Forecasting and planning. The financial staff
must coordinate the planning process.
 This means they must interact with people from other
departments as they look ahead and lay the plans that
will shape the firm’s future.
Major investment and financing decisions.
The financial staff must help determine the
optimal sales growth rate, help decide what
specific assets to acquire, and then choose the
best way to finance those assets.
 For example, should the firm finance with debt, equity, or
some combination of the two, and if debt is used, how
much should be long term and how much short term?
Coordination and control. The financial
staff must interact with other personnel to
ensure that the firm is operated as efficiently
as possible.
Dealing with the financial markets. The
financial staff must deal with the money and
capital markets.
 Each firm affects and is affected by the general financial
markets where funds are raised, where the firm’s
securities are traded, and where investors either make
or lose money.
Risk management. The financial staff is
responsible for the firm’s overall risk
management program, including identifying
the risks that should be managed and then
managing them in the most efficient manner.
 In general, the financial manager has three
main tasks:

1. Make investment decisions,

2. Make financing decisions, and

3. Manage cash flow from operating activities.

Making Investment Decisions

The financial manager must weigh the costs and

benefits of each investment or project and
decide which qualify as good uses of the
stockholders’ money invested in the firm.

These investment decisions fundamentally

shape what the firm does and whether it will
add value for its owners.
Making Financing Decisions
The financial manager must decide whether to
raise more money from new and existing owners
by selling more shares of stock (equity) or to
borrow the money instead (debt).
Managing Short-Term Cash Needs
The financial manager must ensure that the firm
has enough cash on hand to meet its obligations
at each point in time. This job is also commonly
known as managing working capital.
Financial System
 Financial system
Financial system is the system that enables
lenders and borrowers to exchange funds.
The global financial system is basically broader
than a regional system that encompasses
all financial institutions, borrowers and lenders
within the global economy
Therefore, financial system is the collection of
financial markets, financial institutions, financial
instruments, laws, regulations and techniques
through which bonds, stocks, and other financial
instruments are traded, interest rates determined,
and financial services produced and delivered.

35 Financial markets and Institutions

  In general, Financial system is a
framework for describing set of markets,
organisations, and individuals that
engage in the transaction of financial
instruments (securities), as well as
regulatory institutions.

 The basic role of financial system is

essentially channelling of funds within the
different units of the economy – from surplus
units to deficit units for productive purposes.

36 Financial markets and Institutions

 1.1 Financial assets
What is an asset?
 An asset is any possession that has
value in an exchange.
 Assets can be classified as tangible or
intangible.
Tangible Assets
Value is based on physical properties
Examples include buildings, land,
machinery
37 Financial markets and Institutions
 …..
Intangible Assets
Claim to future income
Examples include financial assets
Financial assets are intangible assets.
 For financial assets, the typical benefit
or value is a claim to future cash.
The entity that has agreed to make future
cash payments is called the issuer of the
financial assets
The owner of the financial assets is
referred to as the investor.
38 Financial markets and Institutions
 Examples of financial assets
A loan by Bank to an individual for
purchase a car
 A bond issued by the government as the
Treasury
A bond issued by the municipal (City
administrative)
A bond issued by the government of other
country
A share of common stock issued by a
company
39 Financial markets and Institutions
 Explanation of the nature of the
financial assets
In the case of the car loan, the terms of the
loan establish that the borrower must meet
specified payments to the commercial bank
over time. The payments include repayment
of the amount borrowed plus interest
In the case of a Treasury bond, the
government the issuer) agrees to pay the
bond holder interest payments every period
until the bond matures, then at the maturity
date repay the amount borrowed plus the
last period interest.
etc

40 Financial markets and Institutions

 Types of Financial Asset
instruments:
 Debt Instruments ( bond, Treasury bill, saving pass
book, Demand deposit, Certificate of Deposit (time
deposit) etc
 The claim that the holder of a financial asset has a
fixed dollar amount.
 Equity Instruments (Common stock). An equity
instrument (also called a residual claim) obligates the
issuer of the financial asset to pay the holder an amount
based on earnings, if any, after holders of debt
instruments have been paid.
 Hybrid instrument (Preferred stock). Some
securities fall into both categories. Preferred stock, for
example, is an equity instrument that entitles the
investor to receive a fixed dollar amount.
Both debt and preferred stock that pay fixed dollar
amounts are called fixed income instruments.
41 Financial markets and Institutions
  Another "combination" instrument is a
convertible bond, which allows the investor to
convert debt into equity under certain
circumstances.
Derivative instruments (Options contract,
forward/future contract)
Futures/forward contracts are obligations that
must be fulfilled at maturity.
Options contracts are rights, not obligations, to
either buy (call) or sell (put) the underlying
financial instrument.
Protect against different types of investment
risks, such as purchasing power risk, interest
rate risk, exchange rate risk.
42 Financial markets and Institutions
 The Role of Financial Assets
Financial assets have two principal economic
functions.
Transfer of funds from surplus economic units
to deficit economic units
 The first is to transfer funds from those who
have surplus funds to invest to those who need
funds to invest in tangible assets.
Redistribute the unavoidable risk
 The second economic function is to transfer
funds in such a way as to redistribute the
unavoidable risk associated with the cash flow
generated by tangible assets among those
seeking and those providing the funds.

43 Financial markets and Institutions

 1.2. Financial Markets
 What is Financial Market?
 Financial market performs the essential function of
channeling funds from economic players that have
saved surplus funds to those that have a shortage of
funds
 At any point in time in an economy, there are
individuals or organizations with excess amounts of
funds, and others with a lack of funds they need for
example to consume or to invest.
 An exchange between these two groups of
agents is settled in financial markets
 The first group is commonly referred to as
lenders, the second group is commonly
referred to as the borrowers of funds.
44 Financial markets and Institutions
 A financial market is a market where
financial assets are exchanged (i.e.. traded).
Although the existence of a financial
market is not a necessary condition for the
creation and exchange of a financial
assets ， in most economies financial
assets are created and subsequently
traded in some type of financial market.
Role of Financial Markets
We previously explained the two primary
economic functions of financial assets.
Financial markets provide three additional
economic functions.

45 Financial markets and Institutions

 ….
A. Transfer of funds
B. Redistribution of risk
C. The price discovery process
 The interactions of buyers and sellers in a financial
market determine the price of the traded asset.
 This is called the price discovery process.

D. Liquidity Function
 financial market offers liquidity.
 In the absence of financial markets, the owner
would be forced to hold a debt instrument until it
matures and an equity instrument until the
company is either voluntarily or involuntarily
liquidated.

46 Financial markets and Institutions

 E. Reducing the cost of transacting
 The two costs associated with transacting are search
costs and information processing costs.
 Search costs represent explicit costs, such as the
money spent to advertise one’s intention to sell or
purchase a financial asset, and implicit costs, such as
the value of time spent in locating counterparty.
 The presence of some form of organized financial
market reduces search costs.
 Information costs are associated with assessing the
investment merits of a financial asset, that is, the
amount and likelihood of the cash flow expected to
be generated from a financial asset.
 If we don’t have the skill to evaluate the amount and
likelihood of the cash flow from a financial asset, we can
depend on the market to buy or sell a security.

47 Financial markets and Institutions

Classification of financial Markets
 There are many ways to classify financial
markets.
 The following are some of the ways to classify
financial markets:
1. By type ( nature) of financial claim
 Based on this, financial markets are classified as:
 Debt market : it is a market for debt securities (including
both short term and long-term debts).
 Equity Market: Equity market is a market for residual claim
securities, namely common stock and preferred stock.
2. By maturity of financial claim
 Based on this factor, financial markets are
classified as:
 Money market : It is designed for marketing of short term
loan and security that are maturing within one year or less is
considered to be a money market
 Capital market: A capital market is designed to finance
long term investments by businesses, governments, and
48 households.
Financial markets and Institutions
 3. By seasoning of financial claim
 Primary market- is a market that is dealing
with financial claims that
are newly issued
 Secondary market –is a market that is
dealing with financial
claims previously issued
4. By immediate delivery or future delivery
 Based on this classification, financial markets
could be:
 Cash or spot market –A spot market is one
where securities or financial services are
traded for immediate delivery (usually within
one or two business days)
 Derivative market- A derivative market is
designed to trade contracts calling for the
future delivery of financial instruments.
Financial markets and Institutions
49
 Financial Market Participants
Households
Business units
Federal, state, and local
governments
Government agencies
Regulators

50 Financial markets and Institutions

 1.5. Financial Institutions: an
overview
 Business organizations may categorized into
financial and non-financial business
organizations
 Financial institutions provide different financial
services in an economy and can be classified in
a variety of different ways. We may classified as
1. Depositary institutions and
2. Non-depository financial institutions.
(commercial
1. Depository financial institutions
banks, savings and loan associations,
savings banks and credit unions) obtain the
bulk of their loanable funds from deposit
accounts sold to the public.
51 Financial markets and Institutions
 2. While non- depository institutions
(insurance companies, investment
companies and pension funds) obtain
funds by offering legal contracts to
protect the saver against risk (e.g.
Insurance companies and pension
funds) or sell shares to the public and
invest the proceeds in stocks, bonds,
and other securities ( e.g. Investment
companies).

52 Financial markets and Institutions

 1. Financial Institutions & Capital
Transfers.
 Transfers of capital between savers and those who need
capital take place in three different ways:
A. Direct transfers :Direct transfers of money and
securities, as shown in the top section, occur when a
business sells its stocks or bonds directly to savers,
without going through any type of financial institution.
The business delivers its securities to savers, who in turn
give the firm the money it needs.
Securities (stocks or Bonds )

Business Savers

Money
Money

53 Financial markets and Institutions

B. Indirect Transfers through Investment Bankers:
The company sells its stocks or bonds to the
investment bank, which in turn the investment bank
sells these same securities to savers.
Securities
Securities

Business Investment bank Savers

Money
Money

 The businesses’ securities and the savers’ money

merely “pass through ’’the investment bankers

54 Financial markets and Institutions

C. Indirect transfers Here the
through a financial intermediary:
intermediary obtains funds from savers in exchange for
its own securities, and it then uses this money to
purchase and then hold a business’s securities

Business’s securities Intermediary’s Securities

Business Financial intermediary

Savers

Money Money

 For example, a saver might deposit money in a bank,

receiving from it a certificate of deposit, and then the
bank might lend the money to a business in the form of
a mortgage loan.

55 Financial markets and Institutions

 Services of Financial Institutions
1. Transforming of financial assets
2. Exchanging of financial assets on behalf of
customers (brokerage services).
3. Exchanging of financial assets for their own
accounts (dealer function).
4. Assisting in the creation of financial assets
for their customers, and then selling those
financial assets to other market participants.
This service is referred to as underwriting.
5. Providing investment advice to other market
participants.
6. Managing the Portfolios of other market
participants. The best example is the
services of a mutual fund
7. Providing risk protection
56 Financial markets and Institutions
 1.6. Role of Financial
Intermediaries
With financial intermediaries in an
economy, the flow of savings from savers
to users of funds can be indirect.
These intermediaries come between
ultimate borrowers and lenders by
transforming direct claims into indirect
ones. They purchase primary securities
and, in turn, issue their own securities.
Financial intermediaries provide a variety
of economic functions that make the
transformation of claims attractive
57 Financial markets and Institutions
 These economic functions include:
1. Maturity intermediation
 Savers want short-term securities (indirect
securities)
 The maturity of the indirect security is usually
short term.
 Borrowers want to issue long-term securities
(direct securities)
 But, financial intermediaries help to fulfill the
needs of both (savers and borrowers)
 Certain types of deposit are payable upon
demand
 A financial intermediary is able to transform a
primary security of a certain maturity into
indirect securities of different maturities.
 Due to this function, the maturities of the
primary and the indirect securities may be more
attractive to the ultimate borrower and lender
58 Financial markets and Institutions
 2. Reducing Risk via Diversification
 If an investor places his funds in an investment
company, in turn the company invests the funds
received in the stock of a large number of companies.
 By doing so, the financial intermediary (or the
investment company) is able to diversify risk
3. Reducing search costs & information processing
costs
 The presence of some form of organized financial
intermediaries reduce search costs and information
costs.
 Information costs are associated with assessing the
investment merits of a financial asset, that is, the
amount and likelihood of the cash flow expected to be
generated from a financial asset.
4. Divisibility and Flexibility
 The offering of indirect securities of varying
denomination makes financial intermediaries more
attractive to the saver
59 Financial markets and Institutions
 5. Providing a payments Mechanism
 Most transactions made today are not done with cash.
Instead, payments are made using checks, credit cards,
debit cards, and electronic transfer of funds.
 These methods for making payments, called payment
mechanisms, are provided by certain financial
intermediaries.
5. Expertise and convenience
 The financial intermediary is an expert in dealing
with the ultimate borrower and savers.
 Financial intermediaries must channel funds from
the ultimate lender to the ultimate borrower at a
lower cost or with more convenience or both than is
possible through a direct purchase of primary
securities by the ultimate lender.
60 Financial markets and Institutions