Nature, Purpose and Scope of Financial Management

Financial Management, also referred to as managerial finance, corporate finance, and business finance is
a decision-making process concerned with planning, acquiring and utilizing funds in a manner that
achieves the firm’s desired goals.

The Goal of Financial Management

- The goal of financial management is to make money and add value for the owners. This goal,
however, is a little vague and a more precise definition is needed in order to have an objective
basis for making and evaluating financial decisions.
- The goal of financial management is to maximize the current value per share of the existing stock
or ownership in a business firm.

Scope of Financial Management

Traditionally, financial management is primarily concerned with acquisition, financing and

management of assets of business concern in order to maximize the wealth of the firm for its
owners. The basic responsibility of the Finance Manager is to acquire funds needed by the firm
and investing those funds in profitable ventures that will maximize the firm’s wealth, as well as,
generating returns to the business concern. Briefly, the traditional view of Financial Management
looks into the following functions that a financial manager of a business firm will perform:

1. Procurement of short-term as well as long-term funds from financial institutions

2. Mobilization of funds through instruments such as equity shares, preference shares,
debentures, bonds, notes, and so forth
3. Compliance with legal and regulatory provisions relating to funds procurement, use and
distribution as well as coordination of the finance function with the accounting function.

Types of Financial Decisions

Three major types of decisions that the Finance Manager of a modern business firm will be
involved in are:
1. Investment decisions – are those which determine how scarce or limited resources in terms
of funds of the business firms are committed to projects.
2. Financing decisions – assert that the mix of debt and equity chosen to finance investments
should maximize the value of investments made
3. Dividend decisions – concerned with the determination of quantum profits to be distributed
to the owners, the frequency of such payments and the amounts to be retained by the firm.
- All these decisions aim to maximize the shareholders’ wealth through maximization of the firm’s
wealth

Financial Management and Economics

1, Microeconomics – deals with the economic decisions of individuals and firms. Helps the finance
manager in decisions like pricing, taxation, determination of capacity and operating levels, break-even
analysis, volume-cost-profit analysis, capital structure decisions, dividend distribution decisions,
profitable product-mix decisions fixation of levels of inventory, setting the optimum cash balance, pricing
of warrants and options, interest rate structure, present value of cash flows, and so forth.

2. Macroeconomics – looks at the economy as a whole in which a particular business concern is operating.
The success of the business firm is influenced by the overall performance of the economy and is
dependent upon the money and capital markets, since the investible funds are to be procured from the
financial markets.

Short-term and Long-term Financial Objectives of a Business Organization

Among the primary financial objectives of a firm are the following:

Short and Medium-term

· Maximization of return on capital employed or return on investment

· Growth in earnings per share and price/earnings ratio through maximization of net income or
profit and adoption of optimum level of leverage
· Minimization of finance charges
· Efficient procurement and utilization of short-term, medium-term, and long-term funds

Long-term

· Growth in the market value of the equity shares through maximization of the firm’s market share
and sustained growth in dividend to shareholders
· Survival and sustained growth of the firm

Responsibilities to Achieve the Financial Objectives

Investing

- The finance manager is responsible for determining how scarce resources or funds are committed
to projects. The investing function deals with managing the firm’s assets.

Financing

- The finance manager is concerned with the ways in which the firm obtains and manages the
financing it needs to support its investments.

Operating

- The third responsibility area of the finance manager concerns working capital management.
Managing the firm’s working capital is a day-to-day responsibility that ensures that the firm has
sufficient resources to continue its operations and avoid costly interruptions.
Role of Finance Manager

Financial Manager Makes Decisions Involving

Analysis and Planning Acquisition of Funds Utilization of Funds

Impact on Risk and

Return

Affect the Market Price

of Common Stock

Lead to Shareholder’s
Wealth Maximization

PII: Applications of Microeconomics and Macroeconomics Theory as a Basis for Understanding

Divisions of Economics

· Microeconomics – focuses on the behavior and purchasing decisions of individual and firms
· Macroeconomics – study of national economy and the determination of national income

Microeconomics

Demand is the quantity of a good or service that consumers are willing and able to purchase at a range of
prices at a particular time.
- The QUANTITY DEMANDED of a good is the amount that consumers plan to buy during a period
at a particular price
- The LAW of DEMAND states that “ceteris paribus, the higher the price of a good, the smaller the
quantity demanded” Higher prices decreases the quantity demanded for two reasons:
1. Substitution Effect – a higher relative price raises opportunity cost of buying a good; as a
result, people buy less of the good as there could be other available goods with a lower price
2. Income Effect – a higher relative price reduces the amount of goods can afford to buy.
· A Demand Curve shows the inverse relationship between the quantity demanded and price,
ceteris paribus. Demand curves are negatively sloped.

· The factors that affect the demand for a product are the following:

FACTOR Effect on DEMAND

Price of SUBSTITUTE goods DIRECT. Example: If the price of pork
increases, the demand for beef may increase
Price of COMPLEMENTARY goods INVERSE. Example: If the price of gasoline
increases, the demand for cars tends to
decrease
Expected future prices DIRECT. If the price of the good is expected to
increase in the future, there will be an
increase in demand
Consumer wealth/income DIRECT for NORMAL goods. As consumer
income goes up, the demand for many
products (normal goods) increases
Consumer wealth/income INVERSE for INFERIOR goods. Demand for
inferior goods (e.g., instant noodle, sardines)
increases as consumer income decreases,
since consumers buy more inferior goods
when they are short of money.
Population growth DIRECT. An increase in population increases
number of potential buyers.
Size of market DIRECT. As market size expands, demand for
the product also increases.
Consumer tastes/preference INDETERMINATE. The effect depends on
whether the shift in taste or preference is
favorable or unfavorable to the demand for
the product

· ELASTICITY Of DEMAND, which measures the sensitivity of demand to changes in price, is

computed:

ED = Proportionate change in quantity demanded/Proportionate change in price

- If ED>1 , demand is said to be ELASTIC (sensitive to price changes)

 - If ED=1, demand is said to be UNIT-ELASTIC/UNITARY (insensitive to price changes)
- If ED<1, demand is said to be INELASTIC (not that sensitive to price changes)

The elasticity of demand is greater for a product when there are more SUBSTITUTES for the good, a larger
proportion of income is spent on the good, and a longer period of time is considered. For example, the
demand for LUXURY goods tends to be more elastic than the demand for NECESSITIES.

The effect of price changes may be summarized as follows:

Price ED<1 (Inelastic

Change ED>1 (Elastic Demand) Demand) ED = 1 (Unitary)
Increase Total revenue decreases Total revenue increases Total revenue is the same
Decrease Total revenue increases Total revenue decreases Total revenue is the same

SUPPLY

Law of Supply is a principle that states that, there will be a direct relationship between the price of a good
and the amount of it offered for sale. Other things constant (ceteris paribus), a higher price will increase
the producer’s incentive to supply the good.

· The QUANTITY SUPPLIED is the amount of a good that producers plan to sell at particular price
during a given time period
· A Supply Curve shows that positive relationship between the quantity supplied and price, ceteris
paribus. Supply curves are positively sloped.

The factors that affect the supply for a product are the following:

FACTOR EFFECT on SUPPLY

Production costs INVERSE. As production costs go up, fewer

products will be supplied at a given price. If costs
go down, more products will be produced.

Number of producers DIRECT. An increase in the number of producers

will cause an increase in the amount of goods
supplied at a certain level of price.

Price of substitute goods INVERSE. If other products can e produced with

greater returns, producers will product those
goods.

Price of complementary goods. DIRECT. A rise in the price of a complement in

production increases supply and shifts the supply
curve rightward.
 Expected future prices DIRECT. If it is expected that prices will be higher
for the good in the future, production of the good
will increase.

Technology DIRECT. Technological advancement increases

supply and thus shifts the supply curve rightward.

Government subsidies DIRECT. Subsidies reduce the production cost of

goods and, therefore, increase the goods supplied
at a given price.

Government tax and tariffs INVERSE. Increase in taxes would raise production
costs, thereby decreasing supply.

Special influences Government restrictions, weather conditions, and

innovations or new method may affect supply of
goods. Example: Unexpected storms may destroy
farms, decreasing the supply of certain crops.

· Elasticity of Supply, which measures the percentage change in quantity supplied of a product
resulting from a change in product price, is computed:
o ES = Proportionate change in quantity supplied/Proportionate change in price
o If ES>1, supply is said to be ELASTIC (sensitive to price changes)
o IF ES=1, supply is said to be UNIT-ELASTIC/UNITARY (insensitive to price changes)
o If ES<1, supply is said to be INELASTIC (not that sensitive to price changes)
· Elastic supply means that a percentage increase in price will create a larger percentage increase
in supply.

EQUILIBRIUM

- State wherein the demand and supply are in balance

· Below the equilibrium price, a SHORTAGE exists (i.e., quantity demanded exceeds quantity
supplied) and the price will rise;
· Above the equilibrium price, a SURPLUS exists (i.e., quantity supplied exceeds quantity
demanded) and the price will fall.
· Equilibrium is a MARKET-CLEARING situation where neither surpluses nor shortages exist.
· A PRICE CEILING is a maximum price that seller may charge for a good while a PRICE FLOOR is a
minimum price. If set below equilibrium price, a price ceiling results in shortages; if set above
equilibrium price, a price floor results in surpluses.
· GOVERNMENT INTERVENTION may change market equilibrium through taxes and subsidies:
Ø A subsidy paid to farmers will reduce cost of producing farm goods; equilibrium price will be
lower.
Ø Import taxes increase cost of imported products causing the equilibrium price to be higher.
 · Another factor that causes inefficiencies in the pricing of goods in the market is the existence of
EXTERNALITIES – damage to environment caused by production (e.g., pollution)

MARKET

· A market is any institution, mechanism, or situation which brings together the buyers and sellers
of a particular product. It is a place where sellers and buyers meet (e.g., grocery, internet)
· The four basic MARKET MODELS are:

Number of Type of Control over Conditions

Market Producers Product Price of Entry Examples
Virtually Agricultural
Large None Very Easy
PURE COMPETITION identical Products
Retail trade,
Food,
Many Differentiated Limited Easy
MONOPOLISTIC Gasoline,
COMPETITION Fashion
Appliances,
Standardized/
Few Limited or Wide Hard Cigars, Cars,
Differentiated
OLIGOPOLY Computers
Government
One Unique Wide Blocked Franchise,
PURE MONOPOLY Utilities

Ø Competition denotes rivalry between among producers, each of which seeks to deliver a
better deal to buyers when quality, price and product information are all considered.
Ø In pure competition, the firm’s demand curve is PERFECTLY ELASTIC(Horizontal). The firm can
sell many goods it can produce at the equilibrium price (i.e., very low sales at a higher price)
Ø In monopolistic competition, consumers go for a certain product based on DIFFERENTIATION.
Ø In pure monopoly, the firm has no or very little market incentive to innovate or control costs;
hence pure monopolies are usually subject to GOVERNMENT REGULATION.
Ø Oligopoly is a competition among few; if left unregulated, oligopolists tend to establish
CARTEL that engage in price fixing through collusion.
Ø A Monopsony is a market where only one buyer exists for all sellers
Ø A Black Market is an illegal market wherein people conduct transactions at prices (usually
high) forbidden by government.

Macroeconomics

- Study of the effects on the national economy and the global economy of the choices that
individuals, businesses, and governments make.
- It focuses on measures of economic output, employment, inflation and trade surpluses or deficits.

· Nominal Gross Domestic Product (GDP) – The price of all goods and services produced by a
domestic economy for a year at current market prices.
 · Real GDP – the price of all goods and services produced by the economy at price level adjusted
(constant) prices. Price level adjustment eliminates the effect of inflation on the measure
· Potential GDP – the maximum amount of production that could take place in an economy without
putting pressure on the general level of prices.
· Net Domestic Product – GDP minus depreciation
· Gross National Product – The price of all goods and services produced by labor and property
supplied by the nation’s residents.

Calculation of GDP

1. INCOME approach – adds the compensation of employees, net interest, rental income, dividends,
and so forth.
2. EXPENDITURE approach – adds up all expenditures to purchase final goods and services by
household (consumers), businesses and the government

· Economic growth is an increase in real GDP while RECESSION is a period of negative GDP growth.

Inflation and Unemployment

· Inflation exists when there is a sustained increase in the price level. The PRICE LEVEL is the average
level of prices.
· Primary causes of Inflation:
o Demand-pull Inflation – happens when there is excess or too much demand for certain
goods and services that are not met by a corresponding increase in the supply of those
goods and services (i.e., excess demand propels prices to go up, which results to inflation)
o Cost-push Inflation – happens when there is a general increase in the cost of production
that may be due to higher wages (wage-push theory) or increase in the cost of raw
materials and other inputs (supply-shock theory)
· There is an inverse relationship between the inflation rate and the unemployment rate.
Ø When an unemployment rate is low, inflation tends to increase
Ø When unemployment rate is high, inflation tends to decrease
· People are unemployed because of frictional, structural, or cyclical causes:
Ø Frictional Unemployment – occurs because individuals are forced or voluntarily change jobs;
new entrants into the workforce also fall into this category
Ø Structural Unemployment – occurs due to changes in demand for products, or technological
advances causing not as many individuals with a particular skill to be needed; this can be
reduced by retraining programs
Ø Cyclical Unemployment – occurs as a result of the business cycle; cyclical unemployment
increases during RECESSION and decreases during EXPANSION