Financial Management I

(ACFN 3041)

Chapter One
Overview of Financial
Management
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Financial Management I (ACFN 3041)

Outline:
Chapter I: Overview of FM
Chapter II: IFRS- Based F/ Stat. Analysis Intro.

Chapter III: The Time value of Money Fund

Chapter IV: Risk and Return Concepts
of FM

Chapter V: Cost of Capital LT Inv.

Chapter VI: Capital budgeting Decision
making
Decisions

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Chapter Outline
◼ Defining finance
◼ Relationship of finance with other disciplines
◼ Major areas of finance
◼ Scope of financial management
◼ Goals of financial management
◼ Agency problem

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 What is Finance?
• Finance
• Is the bottom line of every business activity
• is a prerequisite for obtaining physical resources, which
are needed to perform productive activities and
carrying business operations [such as sales, pay
compensations, reserve for contingencies and so on].
• is concerned with the process, institutions , markets,
and instruments involved in the transfer of money
between/among individuals, businesses, and
government.

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Defining Corporate/Business Finance
▪ Finance:
▪ Is the art and science of managing money
▪ Is the managerial activity that is concerned with the planning and
controlling of the firm’s financial affairs.
▪ Is the area of business management devoted to rational use of capital and
careful selection of sources of capital in order to achieve the desired goals
◼ Some important questions that are answered using finance:
❑ What long-term investments should the firm take on?

❑ Where will we get the long-term financing to pay for the

investment?
❑ How will we manage the everyday financial activities of the

firm?

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Relationship with other Disciplines
◼ The field of finance is closely relation to Economics and
Accounting.
◼ With Economics:
❑ Economics provides a structure of decision making in
such areas as risk analysis, pricing theory through DD
and SSS relationships, comparative return analysis, etc.
❑ Economics also provides the broader picture of the

economic environment in which companies must

continual make decisions.
❑ Further more, economic variables such as: GDP, FDI,
industrial production (output), disposable income, unemployment,
inflation, interest rates, taxes, etc. must be in the decision model of a
finance manager

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Relationship with other Disciplines
◼ With Accounting :
❑ Accounting is often said the language of finance

because it provides financial data through income

statements, balance sheets, and cash flow statements.
Finance managers must know how to interpret and use
these statements in allocating firm’s financial resources.

❑ Finance links economic theory with the numbers of

accounting. Hence, managers must know what it means
to assess the financial performance of the firm.

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Relationship…
➢ With Mathematics
◼ Modern approaches of the financial management applied
large number of mathematical and statistical tools and
techniques. They are also called as econometrics.
◼ Economic order quantity, discount factor, time value of
money, present value of money, cost of capital, capital
structure theories, dividend theories, ratio analysis and
working capital analysis are used as mathematical and
statistical tools and techniques in the field of financial
management.

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Relationship …
➢ With Production/Operations
◼ Profit of the concern depends upon the production
performance. Production performance needs finance,
because production department requires raw material,
machinery, wages, operating expenses etc. These
expenditures are decided and estimated by the financial
department and the finance manager allocates the
appropriate finance to production department.
◼ The financial manager must be aware of the operational
process and finance required for each process of
production activities.

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Relationship …
◼ With Marketing/Sales
◼ Produced goods are sold in the market with innovative
and modern approaches. For this, the marketing
department needs finance to meet their requirements.
◼ The financial manager or finance department is
responsible to allocate the adequate finance to the
marketing department. Hence, marketing and financial
management are interrelated and depends on each
other.

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Relationship …
◼ With HR
◼ Financial management is also related with human
resource department, which provides manpower to all
the functional areas of the management.
◼ Financial manager should carefully evaluate the
requirement of manpower to each department and
allocate the finance to the human resource department
as wages, salary, remuneration, commission, bonus,
pension and other monetary benefits to the human
resource department.
◼ Hence, financial management is directly related with
human resource management.

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Major Areas in the field of finance
◼ As the application of economic principles and
concepts to business decision making and problem
solving, finance consists of three categories:
❑ Financial management

❑ Investments

❑ Financial institutions

❑ Others:

◼ Personal finance
◼ Public finance

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Major Areas in the field of finance
◼ Financial management
❑ The area is concerned with financial decision making within a
business entity
❑ Include maintaining optimum cash balance, extending credit,
merger and acquisitions, raising of funds and the instruments to
be used for raising funds etc.
◼ Investments
❑ The area of finance focuses on the behavior of financial markets
and pricing of financial instruments
◼ Financial institutions
❑ This area deals with banks and other financial institutions that
specializes in bringing suppliers of funds together with the users
of funds.

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What is Financial Management?

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What is…
◼ Financial management can be seen as a subject, a
process, or a function.
◼ As a subject:
❑ It deals with decisions made by a business firm that

affects its finances.

◼ As a decision process:
❑ It is concerned with planning for raising, and utilizing

funds in a manner that achieves the goal of a firm.

◼ As a function
❑ It deals with the management of capital sources and

uses of a firm

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What is..
◼ Financial Management:
❑ Is the application of general management standards to the
financial resources of the firm
❑ Is broadly concerned with the acquisition and use of funds by a
business firm.
◼ The scope of financial management has grown in recent
years, but traditionally it is concerned with the following:
❑ How large should a firm be and how fast should it grow?
❑ What should be the composition of the firm’s assets?
❑ What should be the mix of the firm’s financing?
❑ How should the firm analyze, plan, and control its financial
affairs?

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Evolution of Financial Management
◼ FM emerged as a distinct field of study at the
turn of the 20th C.
◼ Its evolution may be divided into three broad
phases:
❑ Traditional,
❑ Transitional, and
❑ Modern

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Evolution…
◼ Traditional phase:
❑ Lasted for decades
❑ FM focused mainly on certain periodic events like
formation, issuance of capital, major expansion, merger,
reorganization, and liquidation in the life cycle of the firm.
❑ The approach was mainly descriptive and institutional.
The instruments of financing, the institutions and
procedures used in capital markets, and the legal aspects
of financial events formed the core of FM.
❑ The outsider’s point of view was dominant. FM was
viewed mainly from the point of view of the investment
bankers, lenders, and other outside interests

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Evolution…
◼ Traditional phase:
❑ Lasted for decades
❑ FM focused mainly on certain periodic events like
formation, issuance of capital, major expansion, merger,
reorganization, and liquidation in the life cycle of the firm.
❑ The approach was mainly descriptive and institutional.
The instruments of financing, the institutions and
procedures used in capital markets, and the legal aspects
of financial events formed the core of FM.
❑ The outsider’s point of view was dominant. FM was
viewed mainly from the point of view of the investment
bankers, lenders, and other outside interests

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Evolution…
◼ Transitional phase:
❑ Began around the early 1940s and continued through early
1950s
❑ During this phase greater emphasis was placed o the day
to day problems faced by financial managers in the areas
of fund analysis, planning, and control.
❑ The focus of FM was shifted to WCM

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Evolution…
◼ Modern phase:
❑ Began in the mid 1950s and has witnessed an accelerated
pace of development with the infusion of ideas from
economic theory and application of quantitative methods of
analysis
❑ The distinctive nature of this phase are:
◼ The central focus of FM is considered to be a rational matching of
funds raised to their uses [ to maximize wealth of owners]
◼ The approach of FM has become more analytical and quantitative
❑ Since the beginning of this phase significant development
have occurred in fields of capital budgeting, capital structure
theory, efficient market theory, option pricing theory, agency
theory, arbitrage pricing theory, valuation models, dividend
policy, WCM, financial modeling, and behavioral finance.

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 What did we discussed last time?

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Scope of Financial Management
◼ Three Broad decisions areas or functions of
financial management are:
❑ Investment
❑ Financing
❑ Dividend
❑ Liquidity

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Scope of Financial Management
◼ Investment Decision/function:
❑ Also called Capital Budgeting decision which
involves the decision for allocation of capital or
commitment of funds to long-term assets like PPE
that would yield benefits for longer future
❑ Two important aspects of investment decisions
are:
◼ The evaluation of prospective profitability of new
investments and
◼ The measurement of a cut-off rate against that the
prospective return of new investments could be
compared

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Scope of Financial Management
◼ Financing Decision/function:
❑ Also called capital structure decision which
involves decisions on when, where, and how to
acquire funds to meet the firm’s investment
needs.
❑ The central issue is to determine the proportion of
equity and debt, i.e. mix of debt and equity
❑ Hence, what is important is to obtain best
financing mix.

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Scope of Financial Management
◼ Dividend Decision
❑ Is concerned about whether to decide to distribute
all the profits in the form of dividends or to distribute
a part of the profits and retain the balance.
❑ Finance managers should consider the investment
opportunities available to the firm, plans for
expansion and growth, etc.
◼ Liquidity
❑ Also called working capital management decision,
which refers to a firm’s short term assets, such as
its short-term liabilities.

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 Function of Financial Manager
1a.Raising
2.Investments funds

Operations Financial Financial

1b.Obligations
(plant, Manager (stocks, debt Markets
equipment, securities) (investors)
3.Cash from
projects) operational
activities
4.Reinvesting 5.Dividends or
interest
payments

Finance function – managing the cash flow

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Goals & Objectives of Financial Management
Mkt price of a firm’s stock represents
the value that mkt participants place
◼ Possible Goals on the company
❑ Maximizing shareholder’s wealth

Not Profit.
❑ Maximizing stock price in the mkt Even Not
EPS!!
◼ Objectives
❑ Maximizing economic welfare of shareholders or
owners welfare

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Why Not EPS?
◼ Not EPS as it
❑ Is based on accounting profits & affected by the
choice of accounting policies
❑ Doesn’t consider timing or expected return (risk
and return)
❑ Is subject to management’s manipulations

◼ While a company's EPS will often influence

the market price of its stock, the relationship
is rarely inverse.

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Objective of FM
◼ Maximization of economic welfare of shareholders
(owners) is accepted as the financial objective of the firm
◼ Q: how?.
◼ There are two criteria for this:
❑ Profit maximization
❑ Wealth maximization
◼ Profit maximization (PM)
❑ According to this criteria, the financial decisions (I/F/D) of a firm
should be oriented to the maximization of profits (i.e. select those
assets, projects, and decisions which are profitable and reject
those which are not profitable).
❑ As a criteria, PM can be justified on the following grounds:

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Objective of FM
❑ As a criteria, PM can be justified on the following
grounds:
◼ Rational
◼ Test of business performance
◼ Main source of inspiration
◼ Basis of decision – making
❑ However, it has the following drawback also
◼ The term ‘profit’ is vague
◼ It ignores time value of money
◼ It ignores risk
◼ It ignores social responsibility

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Objective of FM
◼ Wealth maximization (WM)
❑ It is also know as, value maximization.
❑ According to this criteria, the financial decisions (I/F/D) of a firm
should be oriented to the maximization of profits (i.e. select those
assets, projects, and decisions which are profitable and reject those
which are not profitable).
❑ As a criteria, WM can be justified on the following grounds:
◼ It measures income in terms of cash flows, and avoids the ambiguity now
associated with accounting profits as, income from investments is
measured on the basis of cash flows rather than on accounting profits
◼ It recognizes time value of money by discounting the expected income of
different years at a certain discount rate (cost of capital)
◼ It analyses risk and uncertainty so that the best course of action can be
selected from different alternatives
◼ It is not in conflict with other motives like maximization of sales or market
value of shares. It helps rather in the achievement of all these other
objectives
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 Agency Theory

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Agency Theory
◼ Agent:
◼ Refers individuals(s) authorized by another person, called the
principal, to act in the latter’s benefit.

◼ Agency theory:
◼ Describes the fundamental conflict between self-interested
managers and owners, when the former have the control of the firm
but the latter bear most of the wealth effects.

◼ Agency Problem:
◼ A potential conflict of interest between the agent (manager) and:
❑ The stockholders or

❑ The creditors (debt holders) or

❑ Customers

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Agency Relationship
◼ In financial management, the primary agency
relationships are between:
◼ (1) stockholders and managers and
◼ (2) stockholders and debt holders /Creditors/.

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Agency Conflict 1: Stockholders Vs Managers
◼ In most public corporations, agency conflicts are
important, because their managers generally own only a
small percentage of the stock.
◼ Studies indicate some managers try to maximize the size
of their firms. Why?
◼ Increase their job security
◼ Increase their personal power and status
◼ Since compensation is positively correlated with size that
justify a higher salary and bonus

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Agency Costs
◼ Managers can be encouraged to act in the stockholders’
best interests through a set of incentives, constraints,
and punishments.
◼ However, to reduce agency conflicts, stockholders must
incur agency costs, which include all costs borne by
shareholders to encourage managers to maximize the
firm’s long-term stock price rather than act in their own
self-interests.
◼ Because managers can manipulate the information that
is available in the market, it is critical that good incentive
compensation plans be based on stock prices over the
long term rather than the short term.

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Agency Costs
◼ Include:
❑ Direct
◼ Monitoring costs (the cost of reports and audits)
◼ Structural costs (by appointing outside investors in
the BoD)
◼ The opportunity cost of any contractual constraints
(limit the ability of managers to take timely actions).
◼ The cost of manager’s incentives and bonus fees
❑ Indirect
◼ The loss of wealth due to suboptimal behavior
by the agent

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Agency…
◼ Means of reducing agency conflict
❑ Attractive Incentives /Compensation Plans/
◼ Cash/Stock options
◼ Perquisites (bonus, better salary, promotion, etc)
❑ Proxy fight at Annual General Meeting (AGM)
◼ Voting to replace the existing management
❑ The threat of takeovers

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Agency Conflict 2: Stockholders Vs Creditors

◼ Creditors lend funds at rates that are based on the firm’s

perceived risk at the time the credit is extended, which in
turn is based on
◼ (1) the riskiness of the firm’s existing assets,
◼ (2) expectations concerning the riskiness of future asset
additions,
◼ (3) the existing capital structure, and
◼ (4) expectations concerning future capital structure
changes.

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Agency Conflict 2: Stockholders Vs Creditors
◼ Two of the most common types of conflicts that may arise
between stockholders and debt-holders.
❑ Investment in riskier assets
❑ Increasing leverage situations

1. Investment in riskier assets

Stockholders, acting through management, may decide to take on a large new

project that is far riskier than was anticipated by the creditors. This increased
risk will cause the required rate of return on the firm’s debt to increase, and that
will cause the value of the outstanding debt to fall. If the risky project is
successful, all the benefits go to the stockholders, because creditors’ returns
are fixed at the old, low-risk rate. However, if the project is unsuccessful, the
bondholders may have to share in the losses.

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Agency Conflict 2: Stockholders Vs Creditors
◼ Two of the most common types of conflicts that may arise
between stockholders and debt-holders.
2) Increasing leverage situation

Similarly, suppose its managers borrow additional funds and use the proceeds
to repurchase some of the firm’s outstanding stock in an effort to “leverage up”
stockholders’ return on equity. The value of the debt will probably decrease,
because more debt will have a claim against the firm’s cash flows and assets.

◼ In general, in both the riskier asset and the increased leverage situations,
stockholders tend to gain at the expense of creditors.

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