Chapter one

Nature and scope of financial management

Finance consists of three interrelated areas:1) money and capital markets,2) investments,
and 3) financial management or business finance
1. Money and Capital Markets: deals with securities markets and financial institutions.
Knowledge required relate to factors that cause interest rates to rise and fall, the
regulations to which financial institutions are subject, and the various types of financial
instruments ( mortgages, auto loans, certificates of deposit, and so on). Besides these a
general knowledge of all aspects of business administration such as accounting,
marketing, personnel, and computer systems, as well as financial management is
required. Job areas include banks, insurance companies, investment companies, savings
and loans, credit unions, etc.
2. Investments: focuses on the decision of investors, both individuals and institutions, as
they choose securities for their investment portfolios. The three main functions in the
investments area are a) sales b) the analysis of individual securities, and 3) determining
the optimal mix of securities for a given investor. Areas of job includes brokerage firms,
banks, mutual funds, insurance companies in the management of investment portfolios, or
for financial consulting firms which advise individual investors or pension funds on how
to invest their funds.
3. Financial management: is the management of capital sources and uses so as to attain
a desired goal. It is the process of planning for, acquiring and utilizing funds in ways that
maximizes owners’ wealth.
• Capital sources: investors and creditors
• Capital uses: assets owned (real and financial assets)

Financial management is the broadest of the three areas. Financial management is

important in all types of businesses, including banks and other financial institutions, as
well as industrial and retail firms. It is also important in governmental operations and
other not for profit firms.
N.B. Regardless of which area you go in to, you will need knowledge of all three areas.
For example a banker lending to businesses cannot do his or her job well with out a good
understanding of financial management, because he or she mist be able to judge how well
a business is operated.

Financial management versus economics and accounting

Economics: is the study of how scarce resources should be allocated among competing
uses.
• Financial management is applied economics because it is concerned with the allocation
of scarce financial resources among competing choices.
• Financial managers should have good understanding of economic concepts such as:
demand and supply; profit maximization principle (MR=MC); pricing concepts; etc.

Accounting: is the careful preparation and presentation of financial reports to users.

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• Financial managers use data prepared and presented by the accountant as an input in
making decisions. The financial manager analyses the figures in the financial reports in
an understandable form.
• Accountants typically rely on accounting method that recognizes revenues at time of
sale and expenses when incurred (accrual accounting) while financial managers
emphasize the actual inflows and outflows of cash.

Fundamental financial management decisions

1. Investment decisions (management of capital uses)
• What assets should the firm own?
• Involves the selection of assets to be held by the firm as it attempts to generate future
revenues.
i. capital budgeting ( long term investment decisions)
• involves planning and controlling a firm’s long term investments.
• Here financial managers try to identify investment opportunities that are worth more
than they cost to acquire, i.e. the value of the cash flow generated by the asset
exceeds the cost of the asset.
• Financial managers must be concerned with not only how much cash they expect to
receive (return) but also when they expect to receive it (time value of the future
flows) and how likely they are to receive it (risk).
ii. Working capital (liquidity) management
• Managing the firms shot term assets, such as inventory and other short term
liabilities such as money owed to suppliers.
• This helps managers to ensure that the firm has sufficient resources to continue its
operations and avoid costly interruptions.
2. Financing decisions (management of capital sources)
• Once the firm has committed itself to new investments it must decide how to;
finance them.
• Financing decisions comprise both the regular ongoing needs for funds as well as
episodic needs.
• These decisions address not only how best to finance new assets but also the best
over all mix of financing the firm. If the firm borrows, it generates debt claims; if it
obtains funds from owners, it generates equity claims.
i. capital structure decisions
• is the mixture of debt and equity maintained by the firm (type, size and percentage
composition of sources). Two concerns:
a) how much should the firm borrow i.e. what mixture of debt and equity is best
(risk)
b) what are the least expensive sources of funds for the firm (choosing among
lenders and loan types)
ii. Dividend decisions
• deciding how much of the firm’s earnings to pay out to stock holders and how much
to retain in the firm for investment decisions.
• By paying out part of its earnings directly to stockholders, a firm has less internal
funds available for investment, and it may have to raise funds externally in the
capital markets. And so dividend decision is one of the most important issues.

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Forms of business organizations
1. Sole proprietorship
• owned by a single individual
• has no separate legal existence
Advantage: close control, ease of establishment, not doubly taxed.
Disadvantage: unlimited liability, limited access to outside financing, limited life
2. Partnership
• Proprietorships with more than one owner.
Advantage: ease of establishment, tight control, single tax entity, combined capital,
combined skill
Disadvantage: unlimited liability, limited access to outside financing, possible
interpersonal problems among partners, limited liability, difficulty of transferring
ownership.
3. Corporation
• Limited liability, Co.s, joint stock Cos., public limited Co.s, (plc), cooperative with
limited liability, etc.
• A legal entity distinct from its owners and managers.
Advantage: limited liability, unlimited life, good access to outside finance, readily
transferable ownership
Disadvantage: lose control, double taxation, difficult to establish
Goal of financial managers
Decisions are not made in vacuum, but rather with some objective in mind. Financial
management is a goal oriented activity. What are these goals?
Possible goals:
1. survive
2. avoid financial distress and bankruptcy
3. beat competition
4. maximize sales
5. minimize costs
6. maximize profit
7. maintain a steady earnings growth
8. maximize stock price
I. Maximize profit?
If the owners’ objective is always to maximize profits, the financial manager takes only
those actions that are expected to make a major contribution to the firm’s overall profits.
However, profit maximization as a goal fails for a number of reasons.
i. It is vague i.e. it is not a precise objective

Is it profit this year (short run)? If so actions such as deferring maintenance, letting
inventories run down, and other short run cost cutting measures will increase profits
now.

If it is long run, what does long run mean? In the long run we are all dead.

Is it reported income or earnings per share?
ii. It ignores a) the timings of returns b) cash flows available to stockholders, and c)

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risk.

a) Timings of returns: Because the firm can earn a return on funds it receives, the
receipts of funds sooner rather than later is preferred. E.g. Suppose one project will cause
earnings per share to rise by $0.2 per year for 5 years or $1 in total, another has no effect
on earnings for 4 years bur increases earnings by $1.25 in the fifth year. Which project is
better depends on the time value of the money to investors.
b) Risk: is the chance that actual outcomes may differ from those expected.
E.g. One projected is expected to increase earnings per share by $1 and another project
by $1.20. The first is not very risky, if it is undertaken, earnings almost certainly rise by
about $1.00 per share. However the other project is very risky, so, although our best
guess is that earnings will rise by $1.20 per share, we must recognize the possibility that
there may even be a loss. The riskiness of earnings per share also depends on how the
firm is financed. The greater the use of debt, the greater the thereat of bankruptcy.
Therefore, while the use of debt increases EPS, debt also increases riskiness of future
earnings.
c) Cash flows: A firm’s earnings do not represent cash flows available to the
stockholders. Owners receive returns either through cash dividends paid to them or by
selling their shares for higher than initially paid. However,

A greater EPS does not necessarily mean that dividend payments will increase
since the payments of dividends results solely from the action of the board of
directors.

A higher EPS does not necessarily translate into a higher stock price. Firms
sometimes experience earnings increases without any corresponding favorable
change in stock price.

II. Maximize shareholders’ wealth?

Financial managers in a corporation make decisions for the stockholders of the firm. A
good financial manager is, therefore, one that acts in the stockholders’ best interests
(seeking to gain financially) by making decisions that increase the value of the stock.
Thus the goal of financial management is to maximize the current value per share of the
existing stock. This goal avoids the problems of profit maximization. No short run versus
long run issue, just maximize current stock value.
The firm’s stock price is dependent on the following factors:

Projected earnings per share

Riskiness of the projected earnings

Timings of the earnings stream

The firm’s use of debt financing

The firm’s dividend policy
Every significant decision should be analyzed in terms of its effect on these factors,
hence on the price of the firm’s stock.
N.B. If the firm has no traded stock, the goal may be stated as maximize the market
value of owners’ equity. This is because total value of stock is the owners’ equity.

Social Responsibility

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Social responsibility is another factor to be considered. Managers are stock price
maximizers who operate subject to a socially imposed constraints, business ethics and
social welfare. Thus wealth maximization should be consistent with the preservation of
the wealth of stakeholder groups, such as employees, customers, suppliers, creditors, and
others who have a direct economic link to the firm.
Agency relationship
An agency relationship exists any time one or more people (the principals) hire another
person (the agent) to perform a service and then delegate decision-making authority to
that agent. The two most important agency relationships are those 1) between managers
and stockholders and 2) between managers and creditors (debt holders). A potential
agency problem arises when there is an agency relationship.

Conflict of interest between Stockholders and managers

Managers (as agents) can have different interest than shareholders (principal), such as:
more leisure, prestige (e.g. "empire building"), myopia, risk attitudes, high pay, etc.
# Implications: Managers, as rational individuals, seek to look for their own self-
interest. Thus, if they are left alone, they will not act in the best interest of
shareholders.Thus, they need to be monitored and given incentives.
# Problem: Shareholders incur costs associated with monitoring management behavior.
# Solution: Principal needs to write a compensation contract that specifies the
performance expected from the agents, and how it will be measured. One such contract is
an executive stock option. Several mechanisms are used to motivate managers to act in
the shareholders’ best interests. These include:
a) The threat of firing (proxy fight). Threat of being fired by shareholders or board of
directors.
b) The threat of takeover (hostile takeover). Threat of firm being taken-over by
another firm through hostile takeover by purchasing stock of the target company. Hostile
takeovers are most likely to occur when a firm’s stock is undervalued relative to its
potential. In hostile takeover, the managers of the acquired firm are generally fired, and
any who are able to stay on lose the autonomy they had prior to the acquisition. Thus,
managers have a strong incentive to take actions which maximize stock prices. i.e. if you
want to keep your control don’t let your stock sell at a bargain price.
c) Structuring managerial incentives. This involves tying managers’ compensation to
the company’s performance so that managers should operate in a manner consistent with
price maximization.
Conflict of Interest between Creditors and Shareholders
A second agency problem involves conflicts between stockholders (through the
firm’s managers) and creditors (debt holders). Examples:

Shareholders may borrow $10,000 and distribute it to themselves. This is a trouble
for creditors.

Stockholders through management cause the firm to take on new ventures that have
much risk than was anticipated by the creditors. This increased risk will cause the
value of the outstanding debt to fall. If the risky ventures turn out to be successful, all

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 the benefits will go to the stockholders because the creditors get only a fixed return.
But, if things go sour, the bondholders will have to share the losses.

The firm may increase its use of debt in an effort to boost the return to stockholders.
This decreases the value of the old debt, i.e. old creditors may be disadvantaged.
To avoid these all problems creditors need to write a contract to protect themselves (i.e.
reduce adverse risk) against games played by shareholders. However, there are potential
problems with contracts: Contract can be very restrictive to the firm, very costly to
firm; for example, a contract prohibiting any future debt financing, even if debt is
desirable! Therefore, creditors and shareholders need to design a contract that is win-win.

Financial institutions and markets

Financial institution: is an intermediary that channels the savings of individuals,
businesses, and governments in to loans and investments.
E.g. banks, credit unions, life insurance Co.s, pension funds, mutual funds, etc.
Financial markets: are markets where financial asses are bought, sold and traded. They
provide a forum in which suppliers of funds and demanders of loans and investments can
transact business directly.

Classification of financial markets

1. Based on maturity of the assets
► Money market: is a market where transactions in short term (of maturities of one year
or less) debt instruments or marketable securities, take place. They are characterized by
high degree of safety and liquidity, and low interest rates. Assets traded in these markets
involve treasury bills, certificates of deposits, commercial papers, etc.
► Capital markets: are markets where long-term financial securities, of maturity
exceeding one year (bonds and stocks), are traded.
2. Based on the issuance-status of the assets
► Primary markets: are those in which securities are initially issued. A primary market
is the only market in which the issuer (government or corporations) is actually receives
the proceeds from the sale of the securities.
► Secondary markets are those in which preowned securities are sold. A secondary
market can be viewed as a “used” or “preowned” security market.

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