CHAPTER ONE

FINANCIAL MANAGEMENT: AN OVERVIEW

 Financial Management
• FM is a recently emerged discipline which
still:
 has no unique body of knowledge of its own,

 draws heavily on economics for its theoretical

concept even today.
• It is an area exposed for changes related with the
concurrent globalization effect and increase in
information technology.
 Definition
• D/t scholars define FM in d/t techniques,
however, with similar major emphasis.
• Pandey (1999) stated FM in the form of
managerial activity which is concerned with the
planning and controlling of a firm’s financial
resources.
• According to Solomon (1969) FM is concerned with
the efficient use of important economic resources
namely, capital funds.
• Phillippatus presented FM as:
• It is concerned with managerial decisions that result
in:
 the financing and acquisition of long-term
and short-term credits for the firm.
• it deals with the situation that requires selection
of:
 specific assets,
specific liability

as well as the problem of size and growth of

an enterprise.
• Generally, FM can be simply defined as :
 the decision and process of making optimal use
of a firm’s financial resources for:
 the purpose of maximizing the
owner’s/shareholders wealth
 Areas of Finance
• Finance consists of three interrelated areas:
1. Money and Capital Market:
• This deals with:
 securities market and
 financial institutions
• In FM, for success, one needs knowledge of:
 valuation techniques,

 the factors that cause interest rate to rise and fall,

 the regulations to which financial institutions are subject, and

 the various types of financial instruments.

 a general knowledge of all aspects of business administrations,

2. Investments
• It focuses on decisions made by both individual and
institutional investors as:
 they choose securities for their investment portfolios.
• Investment area deals with financial assets such as
stock/share and bonds.
• Some of the most important determinants in Investments
are:

 price of financial assets

 the potential risks and rewards associated with

investing in financial assets;
 determination of the best mixtures of the d/t
financial assets to be held.
3. Financial Management/Business
Finance:
• It involves decisions within firms.
• It is the broadest of the three areas.
 
 Other Disciplines Related to Finance
a. Finance and Economics

 The relevance of economics to FM can be seen from

the two broader areas of economics:

• macroeconomics and

• microeconomics.

• Since macroeconomics is concerned with

 the overall institutional environment and

 firms operate in the macroeconomics environment,

 the awareness of this broader economic environment is

fundamental for financial management decisions.

• Specifically, a financial manager has to:
 recognize and understand how monetary policy
affects the cost and the availability of funds;
 fiscal policy and its effect on the economy;
 be aware of the various financial institutions;

 understand the consequences of various levels

of economic activity and
 understand the changes in economic policy for
decision environment.
• Microeconomics is mainly dealt with the economic
decisions of individuals and organizations,
 it defines the actions that will permit firms to achieve
their objectives.

• Fundamental features of microeconomics relevant in FM

 The theories of supply and demand r/nship and profit
maximization strategies;
 issues related to mix of production factors,

 optimal sales level and pricing strategies;

 the concept of measurement of utility preference,
 risk and determination of value; and
 the rationale of depreciating assets
b. Finance and Accounting
• Finance and accounting are closely related and
they also have distinctive features.
 They are closely related b/c:
• accounting is an important input in financial decision
making.
 They are different b/c:
• they treat funds differently,
• finance begins when accounting ends.
• Accounting measurement of funds (income and
expenses) is mainly based on accrual principles
while the viewpoint of finance relating to funds is
based on cash flows.
 The purpose of:
• accounting is mainly collection and presentation of
financial data.
• finance is for making decisions based on accounting
data.
c. Marketing and Finance:
• If you are interested in marketing:
 you need to know finance b/c:

» marketers constantly work with budgets, and

» they need to understand how to get greatest payoff

from marketing expenditures and programs.

 Analyzing costs and benefits of projects of all types

is one of the most important aspects of finance.
 The financial manager has also to consider the
impact of new product development and
promotion plans in marketing areas.
 Scope and Functions Financial Management
 
• FM, in the modern sense can be broken down into
three major decisions as functions of finance:
1. The investment decisions,

2. The financing decisions,

3. The dividend policy decision
1) Investment (Asset-Mix) Decisions
• It relates to the selection of assets in which funds will
be invested by the firm.
• The assets may be:
 long term assets which yield return in the future
over longer periods; and
 short term assets which are coverable into cash
at normal operation of the business without
decrease in value, usually within a year.
• When the investment is made on long-term assets it is
considered as capital budgeting while the other is
working capital.
 i) Capital budgeting decision (Long-term Inv’t Decision
 is concerned with long-term assets and their
compositions.
 It Measures investment proposals
 It evaluates the business risk composition of
the firm
 It is concerned with judgment of the benefit of
the firm with concept of the cost of capital.
ii) Working capital management

• is concerned with the mgt of current assets.

• It is an important and integral part of FM b/c:

 a short term survival is the prerequisite for the long term
success.
2) Financing (Capital-Mix) Decisions
• It is emphasized 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.
• The mix of debt and equity is known as the firm’s
capital structure.
• The FMgr must strive to obtain the best financing
mix or the optimum capital structure for the firm.
• The firm’s capital structure is considered to be
optimum when the market value of shares is
maximized.
• The use of debt affects the return and risk of
shareholders:
 it may increase the Return on Equity funds but
 it always increases risk.
3) Dividend or Profit Allocation Decisions
• The emphasis is whether the firm should distribute:
 all profits, or
 retain them, or
 distribute a portion and
 retain the balance.

• Like the debt-equity policy, the dividend policy should be

determined in terms of its impact on the shareholders’ value.

• The optimum dividend policy is one that maximized the

market value of firm’s shares.

• The FMgr should also consider the questions of:

 dividend stability,

 bonus share and

 cash dividends in practice.  

 Objectives of Financial Management
• Objectives provide a framework for optimal
financial decision making.
• There two main objectives of FM:
the profit maximization and

wealth maximization
 A) Profit Maximization
• It is well considered to be an important objective of financial
management.
• It is maximizing birr income of firms.

• In market economy, prices of G& S are determined in competitive

markets.
• Firms in a market economy are expected to produce G & S
desired by society as efficiently as possible.
• Increase in demand of G&S results higher prices.
• This results in higher profit for firms;

• A higher profit opportunity attracts other firms to produce such

G&S.
• In the case of G&S which are not required by society, their prices
and profits fall.
• In the economic theory:
 the behavior of firm is analyzed in terms of profit maximization
 But, the profit maximization suffers from the following
limitations:
 i) Ambiguity in Definition
• The precise meaning of the profit maximization objective is not
clear.
• Definition of the term profit is ambiguous.
 Does it mean short-or-long-term profit?
 Does it refer to profit before or after tax?
 Total profits or profit per share?
 Does it mean total operating profit or profit accruing to shareholder?

• These cases are difficult to specify and make the term vague.
 ii) It ignores Time Value of Money

• The profit maximization objective does not make a distinction b/n returns

received at different time periods.

• It gives no consideration to the TVM or timing of benefits.

• It values benefits received today and benefits received after a period as the

same.
 
iii) Quality of Benefits /It ignores risk

• The term quality refers to the degree of certainty with which benefits are

expected.

• Generally, profit maximization criterion is inappropriate and unsuitable as an

operational objective of
 investment,

 financing and dividend

 decisions of a firm.
 B) Wealth Maximization
• It is also known as value maximization or NPV
maximization.
• Value maximization is almost universally accepted
as an appropriate operational decision criterion for
FM decisions.
• It removes the technical limitations of profit
maximization criterion.
• Its operational features satisfy
 exactness,

 quality of benefits and

 the time value of money.
• A financial action that has:
 a positive NPV creates wealth for
shareholders and, is desirable.
negative NPV should be rejected since it
would destroy shareholders’ wealth.
• In general, wealth maximization is identified as:
 theoretically logical,
 operationally feasible, and

 normative framework for guiding the financial

decision making.
 The Role of Financial Managers 

 Survival

 Avoid financial distress

 Beat competition

 Maximizes sales

 Minimizes cost

 Maintains steady earnings and growth

 Forecasting and Planning

 Major Investment and Financing Decision

 Contribution and Control

 Dealing with the Financial Markets

 Risk Management