CHAPTER ONE
AN OVERVIEW OF
FINANCIAL
MANAGEMENT
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Contents
Overview of financial management
Responsibility of the financial staff
The Goal of Corporation
Agency Relationship
Managerial actions to maximize
shareholders wealth
Does it make sense to maximize earnings
per share?
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Introduction
Financial Management deals with three things:
Investment: deals with decisions related to the acquisition of
assets.
Eg. Purchase of financial assets, tangible
asset, inventory
Left side of the balance sheet
Financing: deals with the mix of debt and equity used to
finance assets.
Right side of the balance sheet
Capital structure
Asset/Liability Management: deals with the effective and
efficient use of assets acquired.
Eg. Inventory Management, Cash
Management, A/R management, Liability Management etc
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Con’t
Financial management is the organization activity that
is concerned with management of financial resources.
Its main activity cover
the mobilization and utilization of funds.
planning for the future for a business enterprise to ensure a
positive cash flow.
the acquisition and management of financial assets.
Besides, financial management covers the process of
identifying and managing risk and valuation issues
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Evolution of financial
management
Financial management emerged as a distinct
field of study at the turn of the 20th century
Its evolution may be divided into three broad
phases
The traditional phase
The transitional phase and
The modern phase
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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 outsider point of view was dominant. Financial
management was viewed mainly from the point of the
investment bankers, lenders, and other outside
interests.
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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.
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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
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Responsibility of the financial
staff
The financial staff’s task is to raise fund, acquire assets
and utilize resources so as to maximize the value of the
firm. Here are some specific activities:
Forecasting and planning. The financial staff must make
various forecasts and plan its external fund requirement.
The forecasting and planning process extends to all other
areas essential to maximize the value of the firm.
Major investment and financing decisions. The financial
staff must help
to determine the optimal sales
to decide what specific assets to acquire, and
To choose the best way to finance those assets.
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Coordination and control. The financial staff must
interact with other personnel to ensure that the firm is
operated as efficiently as possible. All business decisions
have financial implications, and all managers — financial
and otherwise — need to take this into account.
Dealing with the financial markets. The financial staff
must deal with the money and capital markets.
Risk management. All businesses face risks, therefore,
the financial staffs 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
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In summary, people working in financial
management make decisions regarding
which assets their firms should acquire,
how those assets should be financed, and
how the firm should conduct its operations.
If these responsibilities are performed optimally,
financial managers will help to maximize the values
of their firms, and this will also contribute to the
welfare of consumers and employee
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The Goal of the corporation
What is the goal of financial management? Profit or wealth
maximization?
Possible Goals
Survival- But does this maximize shareholders’
benefit?
Avoidance of financial distress
Maximization of sales or market share?
Minimize costs- cutting costs such as R & D costs.
Maintain steady earning growth
Maximize profit
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Con’t
What are some shortcomings of the goal of profit maximization?
Profit maximization:
Profit maximization would probably be the most commonly cited
business goal, but this is not a very precise objective.
Profit maximization 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 doesn’t consider time value of money
Profit is not cash and not immediately available for
reinvestment.
There is no guide for comparing profit now with the future
(arbitrary
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bench mark)
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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.
If a firm attempts to maximize its stock price, it is good to the
society.
How does the goal of stock price maximization benefit society
at large
The stock price maximization requires
Efficient, low-cost and high-quality goods and services,
the development of new products and services that consumers
want and need
Does the goal of maximizing shareholder wealth conflict with
interest of management and society?
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Sometimes the goal of wealth maximization may conflict with
the society
To solve the conflict with society
companies should take socially desirable actions
even if certain actions like pollution control may at
times conflict with this goal.
companies should be social responsible, if not,
this will lead to a backlash of anti business
sentiment.
Managers should strictly follow the rules of
fairness and honesty.
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Agency Relationship
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 the agent sells the car. In such
relationships there is a possibility of a conflict of interest
between the principal and the agent.
Take the following two cases
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Take these two alternative agreement
1. A flat commission fee, let say Birr 5,000 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.
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The Firm’s Agency Problem
Sources of Conflict
Conflicts can exist between the self-seeking goals
of (agent) managers and the value maximization
goal of (principal) stockholders.
Causes of Agency Problems between
management and shareholders
1. Risk-avoidance problems. (Risk attitudes of
management and shareholders).
Risk-averse managers may leave profitable
opportunities in which the firm's shareholders would
prefer they invest
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2. Information asymmetry
Information asymmetry can complicate
monitoring.
Information available to the insiders (managers) are not
the same to the public or outsiders
Asymmetry of information does not allow the principals to
be sure whether the agents are carrying out the duties
that they should according to the contract
3. Time horizon of management:
Managers focus on short-term performance at the
expense of long-term growth
Remuneration basically linked to short-term performance goal,
Horizon problem
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Con’t
4. Shirk- Mgt may not apply its best effort
[Link] of assets for personal use
6. Purchase of luxurious equipment
7. Approve unreasonably large salary for
themselves.
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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
3. Managerial Compensation
Fair salary, bonus depending on profitability
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Con’t
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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STOCKHOLDERS VERSUS CREDITORS: A
SECOND AGENCY CONFLICT
Creditors have the primary claim on part of the firm's
earnings in the form of interest and principal
payments on the debt.
The stockholders, however, maintain control of the
operating decisions (through the firm's managers)
that affect the firm's cash flows and their
corresponding risks.
Creditors lend capital to the firm at rates that are
based on the riskiness of the firm's existing assets
and on the firm's existing capital structure of debt
and equity financing, as well as on expectations
concerning changes in the riskiness of these two
variables.
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Example:
The shareholders, acting through management,
have an incentive to encourage the manager to take
on new projects that have a greater risk than was
anticipated by the firm's creditors.
The increased risk will raise the required rate of
return on the firm's debt, which in turn will cause the
value of the outstanding bonds to fall.
If the risky capital investment project is successful,
all of the benefits will go to the firm's stockholders,
because the bondholders' returns are fixed at the
original low-risk rate.
If the project fails, however, the bondholders are
forced to share in the losses
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Managerial Actions To Maximize
Shareholder Wealth
What types of actions can managers take to maximize
the price of a firm’s stock?
To answer this question, first we need to ask, “What factors
determine the price of a company’s stock?”
There are three basic facts. These are
1. Cash flows: Value of financial assets, including a company’s
stock, is the present value of its future cash flows.
2. The timing of the cash flows matters — cash received sooner is
better, because it can be reinvested to produce additional income.
3. Risk. Investors are generally averse to risk, and they will pay
more for a stock whose cash flows are relatively certain than for
one with relatively risky cash flows.
Because of these three factors, managers can enhance their
firms’ value (and the stock price) by increasing expected
cash flows, speeding them up, and reducing their riskiness
(variability or predictability of cash flows).
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In addition, within the firm,
Managers make investment decisions regarding the types of
products or services to be produced, as well as the way goods and
services are produced and delivered.
managers must decide how to finance the firm— what mix of debt
and equity should be used, and what specific types of debt and
equity securities should be issued?
manager must decide what percentage of current earnings to pay
out as dividends rather than retain and reinvest; this is called the
dividend policy decision.
Each of these investment and financing decisions is likely
to affect the level, timing, and riskiness of the firm’s cash
flows, and therefore the price of its stock.
Generally, managers should make investment, financing
and dividend policy decisions in a way they can
maximize the firm’s stock price.
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Does It Make Sense to try to Maximize Earnings Per
Share as Goal of Firms?
We have said that
wealth maximization is the goal of firm’s which can be
explained by stock price,
the traditional objective, profit maximization is not a
proper goal of corporation.
But, Earnings per share (EPS) is the portion of a company’s
profit that is allocated to each outstanding share of
common stock, serving as an indicator of the company’s
profitability.
EPS is often considered to be one of the most important
variables in determining a stock’s value that explains the
wealth of the firms.
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Stock Value per Share can be calculated by
using
Earnings per Share (EPS) * price earning ratio
For example, if price earning ratio is $22 and
earnings per share over the last 12 months were
$1.95, what is the current price of the stock?
Current stock price = $22 * $1.95 = $42.9 .
Thus, net income is supposed to be reflective of the
firm’s potential to produce cash flows over time.
But given the limitations of profit max’n as a goal,
this also
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However, there is a high correlation
between EPS, cash flow, and stock price,
and all of them generally rise if a firm’s sales
increases.
Nevertheless, stock prices depend not just on
today’s earnings and cash flows—future cash
flows and the riskiness of the future earnings
stream also affect stock prices.
Some actions may increase earnings and yet
reduce stock price, while other actions may boost
stock price but reduce earnings.
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For example,
consider a company that undertakes large expenditures today that
are designed to improve future performance and
a decision to change an inventory accounting policy that increases
reported expenses but might increases cash flow due to reduction of
current taxes
In the first case, it makes sense for the manager to make the
expenditures decision that will reduce earnings per share, yet
the stock market may respond positively if it believes that
these expenditures will significantly enhance future earnings.
In the second case, it also makes sense for the manager to adopt
the policy because it generates additional cash, even though it
reduces reported profits
Note, though, that management must communicate the reason
for the earnings decline, for otherwise the company’s stock
price will probably decline after the lower earnings are reported
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END
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