Financial

Management

Dakito Alemu (PhD)

– Assistance Professor @AAU
– Email: dakito.alemu@aau.edu.et
Brainstorming Questions
• What is
• Finance?
• Management?
–Financial management?
–Financial market/System?
• What is/are your expectation/s
from the course?
 Course Outline
1. An Overview of Financial
Management
2. Evaluation of Financial Performance
3. Time value of money
4. Cost of Capital
5. Long-term Investment (Capital budgeting)
Decisions
6. Financing Decision (leverage)
 Chapter One

An overview of Financial
Management
 Meaning of Finance
• The term finance should be understood in two perspectives -
finance as a resource and finance as a discipline.
– Finance, as a resource, refers to monetary means of financing
assets of an entity.
– Finance as a subject/ discipline of study, describes how
individuals, governments and corporate organizations manage
the flows of financial resources/money through an
organization.
• Therefore, it is important for
– individuals,
– businesses,
– governments and
– non-government organizations to appreciate the significance of finance in
their day-to-day operation.
 Scope Of Finance as a Discipline
The academic discipline of finance includes
the following specialized main areas:
– Public Finance
– Institutional Finance
– International Finance
– Securities And Investment Analysis
– Financial Management
 a) Investments Area
• It deals with financial assets such as stocks
and bonds.
– What are the potential risks and rewards associated
with investing in financial assets?
• What is the best mixture of the different
types of financial assets to hold?
– It covers mainly measurement of risk and
return on investment in securities
 b) Financial Institutions
• Institutional finance deals with issues of capital formation and
the organizations that perform the financing function of the
economy such as banks,
• Financial institutions are basically businesses that deal primarily
in financial matters.
• For example, a commercial loan officer at a bank would
evaluate whether a particular business has a strong enough
financial position to warrant extending a loan.
• At an insurance company, an analyst would decide whether
a particular risk was suitable for insuring and what the
premium should be.
 D) Business Finance/FM
J.F. Bradley :-“financial management is the area of business
management devoted to a judicious use of capital and a
careful selection of sources of capital in order to enable a
business firm to move in the direction of reaching its goals
Guttmann and Douglas:-” business finance can be broadly
defined as the activity concerned with the planning, raising,
controlling and administering the funds used in the business”.
Thus, it studies financial problems in individual firms, seeks
low-cost funds and seeks profitable business activities.

10
 Definition of FM
• Financial management refers to the efficient
and effective management of money (funds)
in such a manner as to accomplish the
objectives of the organization. It is the
specialized function directly associated with
the top management.
• It is the planning, directing, monitoring,
organizing, and controlling of the monetary
resources of an organization.
 Cont’d…
• FM is the management of the
source and use of funds in an
organization to help it achieve its
objectives.
• Sources of funds: Debt vs Equity
• Use of funds: Assets (both real and
financial)
 Financial Management Decisions
Investment decision
a. Capital budgeting
b. Working capital management
Financing decision
a. Capital structure
b. Debt ratio
Dividend policy
a. Dividend payout
b. Retained earning
14
Cont’d… .
• As a management process it focuses on
decision making with an eye toward creating
and maximizing wealth.
• The decisions involved are financial decisions
such as
– when to introduce a new product,
– when to invest in new assets,
– when to replace existing assets,
– when to borrow from banks,
– when to issue stocks or bonds,
– when to extend credit to a customer and
– how much cash to maintain.
 Basic Assumptions that Underlies FM
• A successful study of financial management requires
the need for a conceptual framework or assumptions,
contexts and principles in which financial management
theories can be developed.
• Basic Assumptions that Underlies FM
–Existence of well developed
capital market
– Corporate forms of business organization
 Types and Forms of Business
• Types of Business organization
– Manufacturing
– Merchandising
– Service providing/rendering
• Forms of business organization, in general
– Sole Proprietorship
– Partnership
– Corporation
• According to the 1960’s commercial code of Ethiopia,
there are 6 forms of business organizations. These are:
– Sole Proprietorship; General and Limited p/ship;
Joint Venture; Private limited company (PLC); and
Corporation
1.7
Sole Proprietorship
• Advantages • Disadvantages
– Easiest to start
– Unlimited liability
– Least regulated – Limited to life of owner
– Single owner keeps all – Equity capital limited to
the profits owner’s personal wealth
– Taxed once as personal – Difficult to sell
income ownership interest
1.8
Partnership
• Advantages
– Two or more owners
– More capital available
– Relatively easy to start
– – Partnership dissolves
Income taxed once as
personal income
• Disadvantages
– Unlimited liability
• General partnership
• Limited partnership
when one partner dies
or wishes to sell
– Difficult to transfer
ownership
1.9
Corporation
• Advantages • Disadvantages
– Limited liability – Separation of ownership
– Unlimited life and management
– Separation of ownership – Double taxation (income
and management is taxed at the corporate
– Transfer of ownership is rate and then dividends
easy are taxed at the
personal rate)
– Easier to raise capital
 Corporation
• Basic characteristics
• - Separate legal existence
• - Limited liability
• - Ownership possession and transfer
through stocks.
• - Separation of ownership from
management
• - Indefinite life time
• - Double taxation
• - Ability to issue shares.
• II. Advantages
• 1. Ease of raising capital/ mobilization of huge
amount of capital
 Basic Principles of FM
1. The risk –return trade-off
2. The time value of money
3. Cash –Not Accounting profits –is a king
4. Incremental cash flows
5. The curse of competitive markets
6. Efficient capital markets
7. Taxes bias business decision
8. All risks are not equal
9. Ethical behavior
10.The Agency problem
 1. Risk –return trade-off
• In financial decision making, we don’t
take additional risk unless we expect to
be compensated with additional return
– that is, investors demand a high return for
taking additional risks.
• The risk– return relationship will be a
key concept in the valuation of stocks
and bonds and proposal of new
projects/investments for acceptance.
 2. Time value of money
• The time value of money is the
opportunity cost of passing up/ Not
accept the earning potential of a
dollar today.
• A dollar received today is worth
more than a dollar to be received in
the future . Because of inflation, risk
and timing of return
3. Cash –Not accounting profits –is a king
• In measuring wealth or value, we will
consider cash flows, not accounting
profits, because
– it is the cash flows, not profits that are
actually received by the firm, relevant for
decision making and can be reinvested.
• Accounting profits on the other hand,
appear when they are earned rather than
when the money is actually in hand.
 4. Incremental cash flows
• It is only what changes that counts.
• In making business decisions in
creating wealth ,we only consider
incremental cash flow which
– is the difference between the cash
flows if the decision is made versus
what they will be if the decision is
not made/Relevant cash flow analysis
 5. The curse of competitive markets
• It is hard to find exceptionally profitable
projects.
• If an industry is generating large profits, new
entrants usually attracted.
• The additional competition and added capacity
can result in profits being driven down to the
required rate of return, then some participants
in the market drop out, reducing capacity and
competition.
• So we need to assume that the market is
competitive.
 6. Efficient capital markets
• Capital markets are efficient and the
prices are right.
• An efficient capital market is a market
in which the values of all assets and
securities at any instant in time fully
reflect all available public information.
• Therefore, there will be no information
asymmetry
 7. Taxes bias business decision
• In incremental cash flow analysis, the cash flow to be
considered should be after- tax incremental cash
flows to the firm as a whole.
8. All risks are not equal
• Some risks can be diversified away, and some cannot
be.
• Risk diversification is the process of reducing risk
through increasing the alternatives of risk full
investment and other business decisions.
9. Ethical behavior
• Doing the right thing and ethical dilemmas are
everywhere in the business.
 10. Agency Problem
An agency relationship has arisen between two (or
more) parties when one, designated as the agent, acts
for the other, designated as the principal, in a
particular domain of decision problems (Eisenhardt,
1989).
In corporation, a separation between ownership
and management creates conflict as some decisions
taken by the agent may be in his own interest and
may not maximize the principal’s welfare (Jensen and
Meckling, 1976).
This is known as “moral-hazard”/Dishonesty of
agents, and it is a consequence of the information
asymmetry between the agent and the principal.
• Related to the main assumptions, agency theory
considers that humans are rationally bound,
self-interested and prone to opportunism.
• The delegation of decision-making power from
the principal to the agent is problematic in that:
• (i) the interests of the principal and agent will
typically diverge;
• (ii) the principal cannot perfectly monitor the
actions of the agent without incurring any costs;
and
• (iii) the principal cannot perfectly monitor and
acquire information available to or possessed
by the agent without incurring any costs.
Information asymmetry
 Scope of Financial Management
1.Estimating financial requirements
2.Deciding capital structure
3.Selecting source of finance
4.Selecting pattern of investment
5.Cash management
6.Profit management
7.Ensuring liquidity
8. Meeting statutory requirements.

34
 What is the role of financial markets
in corporate finance?
• Cash flows to and from the firm

• Money vs. capital markets

• Primary vs. secondary
markets
• How do financial markets
benefit society?
 Financial System
• The financial system consists of the
money market and capital market.
• A financial system  is a system that
allows the exchange of funds between
lenders, investors, and borrowers. 
• Financial systems operate at national,
global, and firm-specific levels.
 Objectives of Financial Management
• Financial management is concerned with the
goal directed behavior or goal orientation.
• Capital sources and uses must be carefully
managed if the firm needs to be profitable for
its financiers.
• Hence, 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).
 Cont’d………

• As an area of study, financial

management is concerned with two
distinct functions. These are:
– (1) the financing function, and
– (2) 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.
 Cont’d …..
• 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.
–How it could be possible to
change stock price??
 Cont’d… .
• In order to maximize the wealth of
shareholders, a business firm must seek to
provide the largest attainable combination
of dividends per share and stock price
appreciation.
• Stock prices tend to reflect the perception
of the stockholders on the ability of the
business firm to earn profits and the degree
of risks (bankruptcy) that the business firm
assumes in generating its profit.
 Cont’d……

• Profit-maximization, on the other hand, is a

traditional micro economics theory which
stresses on the efficient use of financial/capital
resources of the firm.
• However, it ignores many of the real world
complexities that financial managers try to
address in their decisions (such as uncertainty &
Time Value of Money) .
• Profit maximization looks at the total company
profit rather than profit per share.
 Example
• 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.
 
Profit figures
 Economic Situation Plastic Comb Electric Com
Optimistic outcome $10,000 $20,000
Expected outcome 10,000 10,000
 Example 2
• 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
• Time value of money
 
Profit figures
 
Plastic Comb Electric Comb
Year 1 $10,000 $0
Year 2 0 10,000
 
• Which project do you prefer???
 Cont’d…

Wealth maximization means maximizing

share/stock holders wealth by
maximizing the current price of their
share.
Symbolically

Shareholder’s = no of shares × Current stock price

wealth owned per share

44
 Specific Objectives

• In order attain the overall goal of wealth

maximization, it needs to be related to
take the following decisions. These are:
– Determining how large the business firm
should be ?
– Determining the best percentage
composition of the firm's assets
– Determining capital structure
• Note: Business firm that is large and growing fast and
larger doesn't necessarily produce increasing earnings.
 The Evolution of the Finance
Function (Reading Assignment)
• Finance becomes a separate area of study around
1900 for the first time.
• The two main reasons for the ongoing change in
the functions of finance are
– (1) the continuous growth and increasing diversity of
the national and international economy, and
– (2) the time to time development of new analytical
tools that have been adopted by financial managers.
 Summary
• You should know:
–The advantages and disadvantages of
a sole proprietorship, partnership and
corporation
–The primary goal of the firm
–What an agency relationship and cost
are
–The role of financial markets
 Quick Quiz
• What are the three types of financial
management decisions and what questions
are they designed to answer?
• What are the three major forms of business
organization?
• What is the goal of financial management?
• What are agency problems and why do they
exist within a corporation?
• What is the difference between a primary
market and a secondary market?
Do you have any
question?