JIMMA UNIVERSITY

SCHOOL OF POSTGRADUATE STUDIES

DEPARTMENT OF ACCOUNTING & FINANCE

Programme: MBA
Academic Year: 2019/20
Semester: II
Credit Hours: 2

Financial Management
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MBA 662
Overview of Financial Management
Financial Management: Defined
• Financial Management is concerned with the
acquisition, financing, & management of assets
with some overall goal in mind.
• Major areas in the decision function of financial
management:
• Investment decision
• Financing decision
• Asset management decision

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1. Investment Decision
• Value creation
• Determination of total amount of assets
needed to be held
• Concerned with the left-hand side of
balance sheet
• Also,
• Deciding composition of assets
• Disinvestment: reducing, eliminating, &
replacing
2. Financing Decision
• Concerned with the makeup of the right-
hand side of the balance sheet
• Mix of financing the assets
• Dividends policy:
• Integral part of the financing decision
• What dividend-payout ratio?
• Mechanics of how to get the funds
required
3. Asset Management Decision
• Once assets acquired & financing provided,
handling them efficiently follows
• Finance Manager:
• Charged with varying degrees of
operating responsibility over the assets
• But, more concerned with the
management of current assets than fixed
ones
Major Areas of Finance: Financial
Services Vs. Financial Management
• Finance can be defined as the art and science of
managing money.
• Major Areas in Finance:
• Financial Services: Concerned with the design
and delivery of advice and financial products
to individuals, businesses, and government.
• Financial Management: Concerns the duties
of the financial manager in the business firm.
• Financial manager: actively manages the
financial affairs of any type of business, whether
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financial or nonfinancial, private or public, large
or small, profit seeking or not-for-profit.
Roles of Financial Managers

Financial
Firm’s 2 1 Markets
Operations Financial (financial
(a bundle of Manager 4 assets) and
real assets)
Financial
3 5 Institutions

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Finance and Related Disciplines
• Relationship to Accounting
• A firm’s finance (treasurer) and accounting (controller)
activities are closely related and generally overlap.
• Emphasis on Cash flows vs. decision making
• Relationship to Economics
• Understanding the economic framework and
consequences of varying levels of economic activities and
changes in economic policy.
• Use of economic theories
• Relationship to Other Disciplines
• Marketing 9
• Production
• Quantitative Methods
Scope of Financial Management
• Financial Management cuts across wide range
of sectors and organizations:
• Old & new organizations
• Profit-oriented & not-for-profit organizations
• Government & non-government organizations
(NGOs)
• All the above, do make use of the concepts of
finance.
• Thus, it can be difficult to limit its boundaries.
• Even the legal practitioners rely on time-value of
money to the claims that involve financial 10
compensation.
Objectives of Financial Management
• Profit/EPS Decision Criterion
• Maximize profit?
• Firms commonly measure profits in terms of earnings
per share (EPS), represent the amounts earned during a
period on behalf of each outstanding share of common
stock.
• But, is profit/EPS maximization a reasonable goal?
• No. it fails for a number of reasons:
• It ignores
1. The timing of returns,
2. Cash flows available to stockholders, and 11
3. Risk.
Objectives of Financial…

• Wealth Maximization Decision Criterion

• What goal(s) do managers have in mind when
they choose between financial alternatives?
• One ultimate financial objective:
• To maximize the economic well-being, or
wealth, of owners
• Whenever a decision is to be made,
management should choose the alternative that
most increases the wealth of the owners or the
value of the firm. 12
Measure of Owners' Economic Well-Being
• Stock purchase in anticipation of:
• 1. future dividends
• 2. increase in price of the stock
• How much are investors willing to pay today?
• They are willing to pay exactly what they believe it is worth
today-the present value
• Present value of a share of stock reflects:
• Uncertainty associated with receiving future payments
• Timing of the payments
• Compensation for tying up funds to the investment
• The market price of a share is the measure of
owners’ economic well-being
Economic Profit Vs. Accounting Profit
• In Economics: Objective of a firm
• To maximize profit
• In Finance: the Objective
• To maximize owners’ wealth
• Is that a contradiction?
• No, different terminologies used to express same
goal.
• Difference arises from the distinction between
accounting profit and economic profit
1. Economic Profit
• Difference between revenues & costs, where
costs include both actual costs (explicit costs) &
the implicit costs.
• Implicit Costs
• Cost of Capital - depends on:
• The time value of money, and
• The uncertainty associated with the
investment
• The greater the Uncertainty, the greater the
Cost of Capital.
2. Accounting Profit
• Difference between revenues & costs, recorded
as per accounting principles, where costs are
primarily the actual costs of doing business.
• No implicit cost or opportunity cost
• Not a reasonable gauge of shareholders’ return
on their investment
• Thus, maximization of accounting profit is not
equivalent to the maximization of shareholders’
wealth
Financial Management & Maximization
of Owners' Wealth
• For a Corporation:
• Maximizing the value of Shareholders Equity
• In Efficient Markets:
• Value of a share reflects investors’ expectations
regarding future prospect of the corporation.
• The value changes as investors’ expectations about
the future change.
• For financial managers’ decisions to add value:
• Present Value of benefits resulting from decisions
must outweigh associated costs including the cost
of capital.
Financial Management & …
• If there is a separation of ownership &
management:
• What if a decision is in the best interests of the
firm, but not the managers’?
• How can owners ensure that managers are
watching out for the owners’ interest?
• How can owners motivate managers to make
decisions that are the best for the owners?
The Agency Relationship

−Principals: Shareholders/owners
−Agents: Board Directors and Managers
−The agency relationship: the relationship
created between the principals and the
agents of a company
Problems with the Agency
Relationship
• Agent:
−Objective of maximizing own personal wealth
−Costs of the firm:
 Abuse of perquisites (“perks”)
 Not bothering to expend best efforts toward the business –
shirking
Costs of the Agency Relationship
• Agency Costs:
−Costs involved with any effort to minimize the
potential for conflicts between the principals’
interest & agents’ interest
−3 Types of Costs:
 Monitoring Costs
 Bonding Costs
 Residual Loss
Motivating Mangers:
Executive Compensation
−Salary
−Bonus
−Stock Appreciation Right
−Performance Shares
−Stock Option
−Restricted Stock Grant
Shareholder Wealth Maximization &
Accounting “Irregularities”

−Scandals and allegations regarding financial

information
−The creation of awareness in the:
−Importance of corporate governance
−Independence of the public accounting auditing
function
−Role of financial analysts
−Responsibilities of CEOs and CFOs
Shareholder Wealth Maximization &
Social Responsibility

−Discontinuing Investment
−Stakeholders - affected
−Externalities - effects
−Market Solution - efforts
Chapter
Ends

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