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CHAPTER ONE

OVERVIEW OF FINANCIAL MANAGEMENT


1.1. FINANCE AS AN AREA OF STUDY
What is exactly managerial finance or finance in general? What are the major responsibilities and
duties of managers of finance? In order to answer these questions, you need to understand the areas
that finance covers. Finance, in general, consists of three interrelated areas:
1. Money and capital markets, which deal with securities markets and financial
institutions;
2. Investments, which focus on the decision of investors, both individuals and institutions,
as they choose among securities for their investment portfolios; and
3. Financial management, (or "business finance", "corporate finance", or "managerial
finance"), which involves the actual management of business firms
The career opportunities within each of the above fields are many and varied, but managers of finance
must have knowledge of all three areas if they are to perform their jobs well.
1. Money and Capital Markets
Most of the finance professionals go to work for financial institutions, including banks, insurance
companies, investment companies, credits and savings associations.
♣ For you to succeed in doing such jobs, you need a knowledge of the factors that cause interest
rates to rise and fall, the regulations to which financial institutions are subjected, and the
various types of financial instruments such as bonds, shares, mortgages, certificates of
deposits, and so on.
♣ You also need a general knowledge of all aspects of business administration, because the
management of financial institutions involves accounting, marketing, personnel management,
computer science as well as financial management.
♣ An ability to get people to do their job (i.e. people skills) is very critical.
2. Investments
Finance graduates who go into investment areas:
♣ Generally work for brokerage houses in the sales of securities or as security analysts
♣ Others work for banks and insurance companies in the management of investment portfolios,
or
♣ The rest work for financial consulting firms, which advise individual investors or pension
funds on how to invest their funds
♣ The three major functions in the investment area are:
 Sales of securities,
 Analysis of individual securities, and
 Determining the optimal mix of securities for a given investor
3. Financial management-Financial management is the focus of this course.Financial
management is important in all types of businesses, including banks, and other financial
institutions as well as other form of businesses.(See the chart depicted below)

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SCOPE OF FINANCIAL MANAGEMENT

ANALYETHICAL WAY OF VIEWING THE FINANCIAL PROBLEMS OF A FIRM

BALANCE SHEET PERSPECTIVE


INCOME STATEMENT PERSPECTIVE
"How Large should an Enterprise be?"
"How Fast should it Grow?"

USES OF FUNDS SOURCES OF FUNDS CAPITAL INTENSITY


TARGET CAPITAL STRUCTURE
"Sales per invested capital, Investment turnov
"In what form should it hold its
"What
Assets?"
should be the composition of its claims?"
"Leverage, Retention and Dividend policy"

SUSTAINABLE GROWTH RATE


MIX AND TYPE OF ASSETS "Sales growth rate with out increasing leverage or issuing new shares"
"Current, Long-term, Real, and Financial" DEBT AND EQUITY USAGE
"Leverage and Equity financing"

INVESTING DECISION FINANCING DECISION DIVIDEND


DECISION

FUNCTIONS OF FINANCE (Decision Areas) (To be dealt in the first part of the course)

PLUS

MANAGEMENT OF FINANCIAL RESOURCES ( To be dealt in the second part of the course)

Multi-national Financial Management


Exchange rate
issues
(Currency Valuation), Deriv
Cash Receivables Inventory
Management Management Management

EQUALS

FINANCIAL MANAGEMENT AS A SPECIALISED FIELD OF STUDY

Financial management is also important in governmental operations, from schools to hospitals,


from zonal administrative levels to state administrative levels, and even beyond that.

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The type of jobs encountered in financial management range from decisions regarding plant
expansion to choosing what types of securities to issue to finance the expansion.

KEY ACTIVITIES OF THE FINANCIAL MANAGER

PERFORM BASIC TASKS MAKE DECISIONS MANAGE FINANCIAL RESOURCES

Multi- National Financial Manage


INVESTMENT DECISIONS
FIANANCIAL PLANNING (FORCASTING) FINANCIAL ANALYSIS
"Short term and long-term investments Management of Current Assets
"Evaluate productive capacity
"Transform
andfinancial
determinedata
financing
in to usable form to monitor financial condition "
requirement"
FINANCING DECISIONS "Capital structure and Financing policy

"Currency Valuation, Derivatives, Transfer Pri


"Increase or Decrease capacity;
"Capital
additional
budgeting
funds or
and "Financial
reduction
measurement
of funds"
leverage
of expected "Management
and credit
rate ofpolicy
return"
plus retention
of Working/dividend
Capital, Cash,
policyReceivable, Inventory"
"Techniques (Financial ratios) and Interpretations"

Measurement
CostofofRisk
Capital (required rate of return) and Valuation

♣ Financial managers also have the responsibility for deciding:


 The credit terms under which customers may buy,
 How much inventory the company should carry,

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 How much cash to keep on hand,
 Whether to acquire other company (merger analysis), and
 How much of the firm's earnings to retain in the business versus payout as dividends
Regardless of which specific area of finance you are emphasizing on, you need knowledge of all the
three areas (i.e. money and capital market, investments, and financial management).
♣ For example, a banker lending to businesses cannot do his or her job properly with out a good
understanding of financial management, because he or she must be able to judge how well the
businesses are operating.
♣ In the same way, company financial managers need to know what their bankers consider
important and how investors are likely to judge their company performance and thus,
determine their stock prices.
1.2. THE CENTRAL ROLE OF CAPITAL
Capital, as you all know, is essential for the operation of any firm. Financial Management, in this
regard, may be defined in terms of the relationship between capital and the business firm.
♣ A business firm, whether it is a newly established or an existing one, must obtain certain
amount of capital to finance itself in order to produce and sell goods and services to its
customers.
♣ Initial capital/funds/ of the newly formed firm consists of funds secured from the owners of
the firm in the form of equity capital and from the creditors in the form of both short-term and
long-term loans.
♣ An existing firm may finance itself by retaining part of its earnings in addition to the two
sources indicated.
♣ The capital of the firm, whether it is generated internally from operations or provided by
owners and creditors, constitute the source of the firm's capital and hence, recorded on the
right-hand side of the balance sheet as liabilities and owners' equity.
The acquired capital is used to employ personnel, to obtain offices and other manufacturing facilities,
inventories, and other assets. The capital is also used for producing goods and services to meet
customers' demands.
♣ The acquired assets constitute the uses of the capital of the firm and are listed in the left-hand
side of the balance sheet (i.e. assets).
♣ The balance sheet of the firm, thus, contains both the uses and sources of the capital of the
firm.
♣ The balance sheet records these values at the particular point in time.
♣ To complete the balance sheet, the firm records the results of its operations during a given
period, such as a year in its income statement.
♣ The income statement, in this regard, lists the firms revenues generated, expenses incurred,
and profit earned over a span of time and provides a measure of the ability of the firm to
manage its capital sources and uses.
These two financial statements, (balance sheet and incomes statement), picture a firm as an entity that
finances itself with capital from various sources and puts this capital into various uses in order to
generate the desired amount of revenues and profits.

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1.3. FINANCIAL MANAGEMENT AND CAPITAL
1.3.1. Capital: Sources and Uses
Capital sources and uses must carefully be managed if the firm needs to be profitable for its
financiers. Financial management, in this regard, is the specialized business function that deals with
this problem.
♣ In general, financial management can be defined as the management of capital sources and
uses so as to attain the desired goals of the firm (i.e. maximization of shareholders' wealth).
♣ A firm's capital consists of items of value that are owned and used and items that are used but
not owned. For example, the office space that a business firm has rented for doing business
and the bank loans that the firm has taken to finance its operations are items of values that the
business firm can use but does not own. Similarly, inventories and fixed assets purchased by
the firm.
♣ Capital sources are those items found on the right-hand side of the balance sheet (i.e., the
liabilities and equity section as stated earlier).
♣ Examples of the uses of capital of the firm are receivables, inventories, and fixed assets.
1.3.2. Financial Management: Basic Functions
As an area of study, financial management is concerned with two distinct functions. These are:
♣ The financing function, and
♣ 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 around the
financing and investing functions are referred to as financial management.
1.3.3. Goal of the Firm: Profit vs. Wealth Maximization
One additional concept contained in the definition of financial management is concerned with the goal
directed behavior or goral orientation.
♣ The problems and opportunities that financial managers face and the business decisions they
are required to make entirely depend on the purposes or goals of their respective
organizations.
♣ Profit seeking organizations should actually behave in a way they maximize the wealth of
their shareholders.
 It is very important for you at this point to distinguish between wealth maximization
and profit maximization as goals of business firms.
1. Profit Maximization
Profit-maximization is a traditional microeconomics theory of business firm, which was historically
considered as the goal of the firm.
 Profit maximization stresses on the efficient use of financial/capital resources of the
firm.
 Profit maximization as a goal of the business firm ignores, however, many of the real
world complexities that financial managers try to address in their decisions.
 Profit maximization functions largely as a theoretical goal; economists use it to prove
how firms behave rationally to increase profit.

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 When finance was emerged as a separate area of study, it has retained profit
maximization, which is the new concept.
 Profit maximization looks at the total company profit rather than profit per share.
 Profit maximization does not speak about the company's dividends as either a return to
shareholders or the impact of dividend policy on stock prices.
In the more applied discipline of financial management, however, firms must deal every day with two
major factors: These are uncertainty and timing.
A. Uncertainty of Returns
Profit maximization as the goal of business firms ignores uncertainty and risks in order to present the
theory more easily.
 Projects and investment alternatives are compared by examining their expected values or
weighted average profits.
 Whether or not one project is riskier than another doesn't enter these calculations;
economists do discuss risk, but tangentially (or imaginatively).
 In reality, projects differ a great deal with respect to the risk characteristics, and
disregarding these differences can result in incorrect decisions.
To better understand the implication of ignored risks, let us look at two mutually exclusive investment
alternatives (that is, only one of the two can be accepted). The first project involves the use of
existing plant to produce plastic combs, a product with an extremely stable demand. The second
project uses existing plant to produce electric vibrating combs. The latter product may catch on and
do well, but it could also fail. The optimistic, pessimistic, and expected outcomes are given as
follows:
Profit Figures
Plastic Comb Electric Comb
Optimistic outcome $10,000 $20,000
Expected outcome 10,000 10,000
Pessimistic out come 10,000 0
There is no variability associated with the possible outcomes of producing and selling plastic combs
because demand for this product is stable. If things go well (optimistic), poorly (pessimistic), or as
expected, the profit will still be the same, i.e. Birr 10,000. With that of the electric combs, however,
the range of possible profit figures varies from Birr 20,000, if things go well (optimistic), to Birr
10,000, if things go as expected, or to the profit figure of zero, if things go wrong (pessimistic). Here,
if you look at just the expected profit figure of Birr 10,000, it is the same for both projects and you
conclude that both projects are equivalent. They are not, however. The returns (profit figures)
associated with electric combs involve a much greater degree of uncertainty or risk.
 The goal of profit maximization, however, ignores uncertainty (risk) and considers these
projects equivalent in terms of desirability as it refers only to the expected profit figures
from the projects.
B. Timing of Returns
Another problem with profit maximization as the goal of business firm is that it ignores the timing of
the returns from projects. To illustrate, let us reexamine our plastic comb versus electric comb
investment decisions. This time let us ignore risk and say that each of these projects is going to return
a profit of Birr 10,000. assume that while the electric comb can go into production after one year, the
plastic comb can begin production immediately. The timing of the profit from these projects are as
follow:

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Profit Figures

Plastic Comb Electric Comb


Year 1 $10,000 $0
Year 2 0 10,000
In this case, the total profit from each project is the same, but the timing of earning the profits differs.
As we will see later in this course, in the chapter dealing with the concept of "Time Value of Money
", money has a definite time value as people have definite preference for current benefits over future
benefits. Thus, the plastic comb project is the better of the two. Assume that the Birr 10,000 profit
from Plastic comb project during year 1is invested in a saving account that earns an interest of 5
percent per annum. This money would have grown to birr 10,500 at the end of the second year as
opposed to the Birr 10,000 profits to be reported by the electric comb project at the end of the second
year.
Since investment opportunities are available for the money on hand, we are not indifferent to the
timing of the returns (profits) from these investment opportunities. In other words, the returns
obtained can be re-invested at the prevailing rate of return.
 Given equivalent cash flows from profits, we want the cash flows to occur sooner rather
than later.
 The financial manager must always consider the possible timing of returns (profits) in
financial decision-making.
Therefore, the real-world factors of uncertainty and timing of returns force financial managers to look
beyond simple profit maximization as the goal of the business firm.
 These limitations of profit maximization as the goal of business firms lead us to the
maximization of the more robust goal of the business firm, that is, shareholders' wealth.
2. Wealth Maximization
Wealth maximization, on the other hand, is a more comprehensive model dealing with the goal of the
firm. According to this model, it is made clear that there are two ways in which the wealth of
shareholders changes. These are:
 Through changing dividend payments, and
 Through the change in the market price of common shares
Hence, the change in shareholders' wealth, or change in the value of business firms, may be calculated
as follows:
i. Multiply the dividend per share paid during the period by the number of shares owned.
ii. Multiply the change in shares price during the period by the number of shares owned.
iii. Add the dividends and the change in the market value of shares, computed in step 1 and
2 above, to obtain the change in the shareholders' wealth during the period.
In order to maximize the wealth of shareholders, a business firm must seek to provide the larges
attainable combination of dividends per share and stock price appreciation.
 Nevertheless, the problem is that while a business firm may have some degree of freedom in
setting its dividend policy that is in accordance with wealth maximization goal, it cannot
influence the share prices, which are basically set by the interaction of buyers and sellers in
the securities/stock markets.

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 Stock prices tend to reflect the perception of the stockholders regarding the ability of the
business firm to earn profits and the degree of risks that the business firm assumes in earning
its profit.
The ultimate risk that the business firm usually faces is the probability that it will fail or go bankrupt.
In such an event,
 The owners/shareholders of the business firm would see their investment becoming
worthless; and
 The creditors would likely see that at least some portion of their loans go unpaid.
These events have impacts on the market prices of shares, which, in turn, have impacts on the
objective/goal of a business firm, that is, wealth maximization of shareholders.

1.4. MAXIMIZATION OF SHAREHOLDER'S WEALTH


In formulating the goal of maximization of shareholders' wealth, we are doing nothing more than
modifying the goal of profit maximization to deal with the complexities of the operating environment.
 We have chosen maximization of shareholders' 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 (or investors) 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.
 In reality, different factors/aspects affect stock prices.
 To employ wealth maximization as the goal of your business firm, therefore, you need not
consider every stock price change to be the market interpretation of the worth of your
decision.
 Other factors such as economic expectations, also affect stock price movements.
Apparently, what you do focus on is the effect that your decision should have on the stock price if
every thing else where 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 a business firm takes into account uncertainty or
risk, time, and other factors that are important to the owners of the firm.
 Thus, again, the framework of maximization of shareholders' wealth allows for a decision
environment that includes the complexities and complications of the real world.
1.5. THE AGENCY PROBLEM
While the goal of the business firm is the 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 of
the firm. For example, a large business firm may run by professional managers, who are
agents and have little or no ownership position/stake in the firm.
 Because of the separation between the decision makers and owners, managers may make
decisions that are not in line with the goal of the business firm, or not consistent with the
interests of owners, that is outlined as maximization of shareholders' wealth.

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 Professional managers, being mere agents of owners, may attempt to benefit themselves in
terms of salary and perquisites 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, however.
 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 a business firm is
damaging shareholders' wealth, we might see a positive reaction in the stock price
to the removal of that management.
1.6. THE OBJECTIVE OF FINANCIAL MANAGEMENT
The financial manager uses the overall company's goal of shareholders' wealth maximization, which is
reflected through the increased dividend per share and the appreciations of the prices of shares, in
formulating financial policies and evaluating alternative courses of operations. In order to do so, this
overall goal of wealth maximization needs to be related to and/or take the following specific
objectives of financial management into account:
1. Financial management aims at determining how large the business firm should be and
how fast should it grow.
2. Financial management aims at determining the best percentage composition of the
firm's assets (asset part of the decision, or decisions related to capital uses).
3. Financial management also aims at determining the best percentage composition of the
firm's combined liabilities and equity decisions related to capital sources).
1. Determining the Size and Growth Rate
The size of the business firm is measured by the value of its total assets.
♣ If the book values are used, the size of the firm is equal to the total assets as indicated in the
balance sheet.
♣ When this method of size determination is used, the growth rate of the business firm is
measured by the yearly percentage change in the book values of all the items in the assets
section of the balance sheet.
As a student of financial management, however, you should be able to understand that a business
firm that is large and growing faster & larger does not necessarily produce increased earnings.
2. Determining Assets Composition (Portfolio)
As indicated earlier, assets represent investments or uses of capital that the business firm makes in
seeking to earn a rate of return for its owners.
♣ The most common asset categories are cash, inventories, and fixed assets.
♣ However, financial institutions, such as banks and insurance companies, have some what
different assets categories. They may list loans, advances, and negotiable securities as assets.
♣ The percentage composition of the assets of the firm is computed as ratio of the book value of
each asset to total book values of all assets.
♣ The choice of the percentage composition of asset items affects the level of business risk.
♣ The asset structure decision relate to what products and services the business firm should
produce. The financial manager is directly involved in decisions related to the assets structure
that makes the business firm more successful in a way it will maximize the wealth of
shareholders.

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The wealth maximizing assets structure can be described in either of the following ways:
i. The asset structure that yields the larges profit for a given level of exposure to business
risk, or
ii. The asset structure that minimizes exposure to business risk that is needed to generate
the desired profit.
In both of the cases, the financial manager should recognize that the asset structure of the business
firm is the major determinant of the overall risk-return profile of the firm.
3. Determining the Composition of Liabilities and Equity
As it was stated earlier in this chapter, liabilities and equity are the sources of capital of business
firms.
♣ They are the financing sources that business firms use to make investment in various types of
assets.
♣ The most common financing sources are accounts and notes payable; accruals for items such
as taxes, wages, and interests; loans and debt securities of various maturity dates; and
common stocks, preferred stocks, and retained earnings.
♣ Here again, banks and insurance companies might secure funds from liability accounts such
as time deposits, demand deposits, and saving deposits.
♣ As it was done for the percentage composition of assets, the liability and equity percentage
compositions of the business firm is measured by dividing the book value of each liability or
equity item by the total book values of all liabilities and equity.
♣ The mix of liabilities and equity of the business is what is known as the capital structure.
When the business firm finances its investment by using debt capital, ("leverage" being the jargon
used in Finance to refer this), the business firm and its shareholders face added risks along with the
possibility of added returns. This is due to the effects of leverage, which is resulting from using debt
capital in financing investments.
♣ The added risk is the possibility that the firm may face difficulty to repay its debts as they
mature. (This is referred to as a negative leverage)
♣ The added returns come from the ability of the firm to earn the rate of return higher than the
interest payments and related financing costs of using liabilities. (This is referred to as a
positive leverage)
♣ The added returns may be paid as dividends and/or re-invested in the firm to generate more
profit. This, in effect, would maximize the wealth of shareholders of the business firm.
Stock prices, therefore, react to the manner of financing of a business firm as well as to the
subsequent ability or inability of the firm to manage its capital structure.
1.7. EVOLUTION OF THE FINANCE FUNCTION
Finance for the first time became a separate area of study around 1900. Since then, 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:
i. The continuous growth and increasing diversity of the national and international economy,
and
ii. The time to time development of new analytical tools that have been adopted by financial
managers

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1. 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 due to mergers
and consolidations become an important task. Hence, 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.
2. Finance Since 1950
These days, large number of people is employed and works in manufacturing and service industries
that didn't exist before.
♣ Much of this rapid economic growth occurred because of 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.

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