Chapter One

An Overview of Financial Management

Introduction
A successful study of financial management requires the need for a conceptual framework or assumptions,
contexts and principles in which financial management theories can be developed. Therefore, we study financial
management under the assumptions of capital markets, in the context of corporate form of business
organizations and under the guidance of the basic principles that form the basis for financial management.

A. Existence of well-developed capital markets

Financial management is studied under the assumption that there is capital market and capital exchange in the
business environment concerned with free and competitive interaction and reasonable costs and prices like any
commodity market. This interaction in a well-developed capital market exists between the corporation and
financial markets in the following manner. Initially, the corporation raises capital in the financial markets by
selling securities such as stocks and bonds. Secondly, the corporation then invests this in return generating
assets-new projects. Thirdly, the cash flow from those assets is either reinvested in the corporation, given back
to the investors, paid to government in the form of taxes.
B. The context of corporate form of business organizations
Financial management is studied in the context of a corporate form of business organization and its decisions
due to the following characteristics and advantages of a corporation.
I. Basic characteristics
 Separate legal existence  Indefinite life time
 Limited liability  Double taxation
 Ease of transfer of ownership right  Ability to issue shares
 Separation of ownership from management
II. Advantages
 Ease of raising huge amount of capital  Corporations have a better chance of growth
 Ease of transfer of ownership right  Limited liability
 Continuous existence
C. Basic principles that form the basis for financial management
i. The risk return trade-off: - In financial decision making, we don’t take additional risk unless we
expect to be compensated with additional return that is, investors demand a high return for taking
additional risks. The risk return relationship will be a key concept in the valuation of stocks and bonds
and proposal of new projects for acceptance.
ii. The time value of money: - A dollar received today is worth more than a dollar to be received in the
future. The time value of money is the opportunity cost of passing up the earning potential of a dollar
today.
iii. Cash Not profits is a king: - In measuring wealth or value, we will consider cash flows, not accounting
profits, because it is the cash flows, not profits that are actually received by the firm, relevant for
decision making and can be reinvested. Accounting profits on the other hand, appear when they are
earned rather than when the money is actually in hand.

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 iv. Incremental cash flows: - It is only what changes that counts. In making business decisions in creating
wealth ,we only consider incremental cash flow which is the difference between the cash flows if the
decision is made versus what they will be if the decision is not made/Relevant cash flow analysis/.
v. The curse of competitive markets: - Why it is hard to find exceptionally profitable projects? If an
industry is generating large profits, new entrants usually attracted. The additional competition and
added capacity can result in profits being driven down to the required rate of return, then some
participants in the market drop out, reducing capacity and competition.
vi. Efficient capital markets: - Capital markets are efficient and the prices are right. An efficient capital
market is a market in which the values of all assets and securities at any instant in time fully reflect all
available public information. Such markets characterized by the existence of a large number of profit
driven individuals acting independently.
vii. The Agency problem: - Managers won’t work for owners unless it’s in their best interest. It is the
problem resulting from conflicts of interest between the managers (agents of the stockholders) and the
stockholders.
viii. Taxes bias business decision: - In incremental cash flow analysis, the cash flow to be considered
should be after-tax incremental cash flows to the firm as a whole.
ix. All risks are not equal: - Some risks can be diversified away, and some cannot be. Risk diversification
is the process of reducing risk through increasing the alternatives of risk full investment and other
business decisions.
x. Ethical behavior is doing the right thing and ethical dilemmas are everywhere in the business.

Nature and Scope of Financial Management

The term ‘nature’ as applied to financial management refers to its relationship with the closely related fields of
economics and accounting, its functions, scope and objectives. Finance is the application of economic
principles and concepts to business decision making and problem solving.

Classification of Finance
Finance as taught in universities is generally divided into three areas: (1) financial management, (2) money &
capital markets, and (3) investment analysis.
Financial management: also called corporate finance, focuses on decisions relating to how much and what
types of assets to acquire, how to raise the capital needed to buy assets, and how to run the firm so as to
maximize its value. As an area of study, financial management is concerned with two distinct functions. These
are: (1) the financing function, and (2) the investing function. The financing function describes the
management of the sources of capital. The investing function, on the other hand, concentrates on the type, size
and percentage composition of capital uses. It deals with the question "how much of the total capital provided
by the financing sources should be invested in receivables, marketable securities, inventories, and fixed assets?"
The specialized set of management duties and responsibilities that center on the financing and investing
functions are referred to as financial management.

Money and Capital market: - deals with securities markets and financial institutions. Relate to the markets
where interest rates, along with stock and bond prices, are determined. Also studied here are the financial
institutions that supply capital to businesses.

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Investment Analysis: the study of the analysis and management of financial securities and is mainly concerned
with the evaluation of securities from the perspective of investors and the construction and management of
portfolios of securities. Relate to decisions concerning stocks and bonds and include a number of activities: (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, so choosing a properly balanced portfolio is
an important issue for any investor. (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.”

Finance versus Economics and Accounting

Finance as we know it today grew out of economics and accounting. Economists developed the notion that an
asset’s value is based on the future cash flows the asset will provide, and accountants provided information
regarding the likely size of those cash flows. Finance then grew out of and lies between economics and
accounting, so people who work in finance need knowledge of those two fields.

The Functions of Financial Management

1. Investment Decisions
These decisions are referred also as capital budgeting decisions. The capital budget of the firm outlines the
planned expenditures on the fixed assets, and capital budgeting is the whole process of analyzing projects
whose returns are expected to extend beyond the period of one year and deciding which project should be
included in the capital project.
2. Financing Decisions
It is a decision as to when, where and how to acquire funds to meet the firm’s investment needs. The central
issue here is to determine the proportion of equity and debt. It’s the second important function to be performed.
The mix of debt and equity is known as the firm’s capital structure. So the finance manager must strive to
obtain the best financing mix or optimum capital structure. The firm’s capital structure is considered to be
optimum when the market value of share is maximized.
3. Dividend Decisions
The financial manager must decide whether the firm should: distribute all profits, or retain them, or distribute a
portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its
impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the
firm’s shares.
4. Asset Management Decisions
After the assets are acquired, they need to be managed effectively. The financial manager is charged with the
varying degree of operating responsibility over the existing assets.
5. Liquidity Decisions
Current assets management that affects a firm’s liquidity is yet another important finance function, in addition
to the management of long-term assets. Current assets should be managed efficiently for safeguarding the firm
against the dangers of liquidity and insolvency. Investment in current assets affects the firm’s: profitability and
liquidity. A conflict exists between profitability and liquidity while managing current assets. If a firm does not
invest sufficient funds in current asset, it may become illiquid. On the other hand, if a firm invests sufficient
funds in current asset, it would lose its profitability, since idle current asset would not earn anything. Thus,
proper trade-off must be achieved between profitability and liquidity. In order to ensure that neither insufficient

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nor unnecessary fund is invested in current assets, sound techniques of managing current assets should be
developed.

The Goal of a Business Firm in Financial Management

 A goal is a well-known objective the firm strives in all its action to achieve, and then efficient financial
management requires the existence of some objective so as to decide efficiently in light of these standards.
 Possible goals: Survive, Avoid financial distress and bankruptcy, Beat competition, Maximize sales or
market share, Minimize cost, Maximize profit, Maintain steady earnings growth… etc.
 Most of the goals mentioned above are vague however to use them as a guideline for decision-making.

I. Would profit maximization serve as a goal of the firm?

Let us investigate the profit maximization as a goal of the firm. It fails with respect to the following operational
infeasibilities:
A. The concept is vague: The first thing is to agree on the term. It is vague because the definition of the
term profit is ambiguous.
 Does it mean an absolute figure expressed in dollar or a rate of profitability or does it mean short-
term or long-term profits?
 Does it refer to profit after tax or before tax?
 Total profit or profit per share or
 Is it a percentage dollar a firm can have or an increased amount simply by issuing a stock and
investing on Treasury bill?
B. The time dimension of financial decision is ignored.
 This means the profit maximization objective does not make a distinction between returns received
in different time periods.
 It gives no considerations to the time value of money, and it values benefits received today and
benefit received after a period as the same.
C. The risk dimension of financial decision is ignored.

II. Would wealth maximization serve as a goal of the firm?

In formulating the goal of maximization of shareholder's wealth, we are doing nothing more than modifying the
goal of profit maximization to deal with the complexities of the operation environment. We have chosen
maximization of shareholder's wealth that is maximization of the total market value of the existing shareholders'
common stock because the effect of all financial decisions is reflected through these prices. The shareholders
react to poor investment or dividend decisions by causing the total value of the firm's stock to fall and they react
to good decisions by pushing the price of the stock up.

Obviously, there are some series practical problems in direct use of this goal and evaluating the reaction to
various financial decisions by examining changes in the firm's stock value. Many things affect stock prices. To
employ wealth maximization as the goal of your business firm, you need not consider every stock price change
to be the market interpretation of the worth of you decision. Other factors such as economic expectations, also
affect stock price movements. What you do focus on is the effect that your decision should have on the stock
price if everything elsewhere held constant. The market price of the business firm’s stock reflects the value of
the firm as seen by its owners. The wealth maximization as the goal of business firm takes into account
uncertainty or risk, time, and any other factors that are important to the owners of the firm. Thus, again, the
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framework of maximization of shareholders' wealth allows for a decisions environment that includes the
complexities and complications of the real-world.

The Agency Problem

While the goal of the business firm will be maximization of shareholders' wealth, in reality the agency problem
may interfere with the implementation of this goal. The agency problem is the result of a separation of the
management and the ownership in firms. For example, a large business firm may be run by professional
managers who have little or no ownership position in the firm, owners being the shareholders. As the result of
this separation between the decision makers and owners, managers may make decisions that are no in line with
goal of business firm, or the interest of owners, that is maximization of shareholders' wealth. Professional
managers may attempt to benefit themselves in terms of salary and promotions at the expense of shareholders.
The exact significance of this problem is difficult to measure. However, while it may interfere with the
implementation of the goal of maximization of shareholders' wealth, in some firms, it does not affect the goal's
validity. The costs associated with the agency problem are also difficult to measure, but occasionally we can
see the effect of this problem in the marketplace. For example, if the market feels that the management of
business firm in damaging shareholders' wealth, we might see a positive reaction in the stock price to the
removal of that management.

Financial Markets and Intermediaries

The primary advantages of the corporate form of organization are that ownership can be transferred more
quickly and easily than with other forms and that money can be raised more readily. Both of these advantages
are significantly enhanced by the existence of financial markets.
A financial market, like any market, is just a way of bringing buyers and sellers together. Financial markets
differ from other markets in detail. The most important differences concern the types of securities that are
traded, how trading is conducted, and who the buyers and sellers are.

 Financial markets can be characterized as to:

1. Whether the assets are being issued for the first time or have previously entered the market and
2. The maturity dates of the assets.
 Primary and Secondary Financial Markets
A primary financial market is a market whereby new financial assets are issued. Whereas Secondary financial
market is a market whereby previously issued financial instruments are offered for resale.

 Money and Capital Markets

When a financial asset has a relatively short maturity, it is said to appear and be sold in the money markets,
whereas, financial assets with longer or indefinite lifetimes are said to appear in the capital markets. In financial
markets, it is financial assets that are bought and sold. Financial asset is a claim against the income and assets of
its issuer. They are assets to the holder of the claim but they are also liabilities or equity items to the issuer.
Debt and equity securities are considered as financial assets.

The process of transferring funds from savers to ultimate users through a third party is called intermediation.
The third party is said to be financial intermediaries, which are often called financial institutions. These are
commercial banks, insurance companies, pension funds, cooperatives, and others.

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The Evolution of the Finance Function
Finance becomes a separate area of study around 1900 for the first time. Since that time, the duties and
responsibilities of the financial managers have undergone continuous change, and expected to change in the
future as well. The two main reasons for the ongoing change in the functions of finance are (1) the continuous
growth and increasing diversity of the national and international economy, and (2) the time to time development
of new analytical tools that have been adopted by financial managers.

Finance Before 1930

Up to 1900, finance was considered as a part of applied economics. The 1890s and 1900s were the periods of
major corporate mergers and consolidations in the American economy. These mergers and consolidations were
gradually transmitted to other economics all over the world. These activities required unprecedented amount of
financing. The management of the capital structure of companies that had been formed as a result of mergers
and consolidations become an important task, and finance was emerged as distinct functional area of business
management.

The major technological innovations of the 1920s created entirely new industries such as radio and broadcasting
stations. These new industries produce not only large quantities of output but also earned high profit margin.
Financial management was found to be important in dealing with problems related to planning and controlling
the liquidity of the newly emerged industries of that time.

The stock market crash of 1929 and the subsequent economic depression occurred in the American economy
resulted in the worst economic conditions that occurred in the 20th century. Bankruptcy, reorganization, and
mere survival become major problems for many corporations. The capital structure which was dominated by
debt aggravated the solvency and liquidity problems of companies. Financial management is additionally
responsible for the planning of the rehabilitation and survival of the business firm.

Finance Since 1950

These days, a large number of people are employed and work in manufacturing and service industries that didn't
exist before. Much of this rapid economic growth occurred because the increased rate of technological
advancement. The computerization process in almost all of these industries is an example of the extent to which
our economy has become dependent on new technologies.

As new industries have arisen and as older industries have sought ways to adapt to the rapidly changing
technologies, finance has become increasingly analytical and decision oriented. This evolution of the finance
function has been influenced by the development of computer science, operations research and isometrics as
tools for financial management functions.

To summarize, the evolution of finance functions contains the following three important points:
1. Finance is relatively new as a separate business management function.
2. Financial management, as it is presently practiced, is decision oriented and uses analytical tools such
as quantitative and computerized techniques, economics, and managerial accounting:
3. The continuing rapid pace of economic development virtually guarantees that the finance function
will not only continue to develop but also have to accelerate its pace of development to keep up with
the complex problems and opportunities that corporate manger are facing.

The End!
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