CHAPTER ONE

An
Overview Of Financial
Management
 Introduction
• According to Khan and Jain (n.d), Finance is the art and
science of managing money and it concerned with;
– the process of transferring money,
– The way or markets where the money were transferred
– the granting of credit and
– instruments involved in transfer of money.
• Finance:- is the application of economic principles and
concepts to business decision-making and financial problem
solving.
 Areas of finance: Finance consists of three interrelated areas.

• (1) Money and capital market:- deals with securities markets

and financial institutions.
1

• (2) Investments:- focuses on the decisions made by investors

as they choose securities for their investment portfolios.
2
• (3) financial management, or “business finance,” which involves
decisions within firms.
• financial managers must have a knowledge of all three areas if they
3 are to do their jobs well.
 Evolution of Financial Management
• For long period though finance is considered as a part of economics,
corporation finance emerged as a separate field of study in the early 20th
centuries.
• Thus, 20th century was a turning point for emerging as a Financial
management , as a distinct field of study under corporate finance.
• Generally, the evolution of financial management may be divided into three
broad phases (though the demarcating
lines between these phases are somewhat
arbitrary);
• I. The traditional phase:- lasted for about four
decades & its important features were:
– Formation, issuance of capital, major expansion,
merger, reorganization, and liquidation & outsider’s
point of view was dominant.
 Cont’d….
• II. The transitional phase:- begins around the
early 1940’s – to the early 1950’s.
– Greater emphasis was placed on the day to day
problem faced by the finance managers in the
area of;
• funds analysis,
• planning, and control.
 Cont’d…
• III. The modern phase:- Begin in mid 50s until now.
• This period is known by accelerated development of ideas
from economic theories and applications of quantitative
methods of analysis.
• The distinctive features of modern phase are:
– The scope of financial management has broadened.
• E.g:- Risk analysis are included.
– The approach of financial management has become more
analytical and quantitative.
– The point of view of the managerial decision maker has
become dominant in corporate finance than earlier period.
 Definition
• Financial management: is one part of corporate finance that
concerns with acquisition, financing, and management of
assets with some overall goal of the firm in mind.
• “It is concerned with the efficient use of an important
economic resource namely, capital funds”
• Fund management includes;
– source of the fund/money and their costs
– circulation of money,
– the making of investments and others to achieve the overall goal of the
firm.
• Financial management is sometimes called business/ corporate
finance.
 The Scope of Financial Management
• The scope of FM:- refers to the range or extent of matters being dealt
with in financial management.
• A. Traditional approach:
• FM was viewed as a field of study limited to only raising of money.
– It is a very narrow sense of procurement of funds from external sources.
• B. Modern approach:
• FM provides a conceptual and analytical framework for the three major
financial decision making functions of a firm.
• Those functions are;
– Investment function ,
– Finance function, and
– Dividend function including
– international financial environment
 The Functions of Financial Management
• This refers to the special activities or purposes of financial
management.
• In general, the functions of financial management include
three major decisions;
– Investment decisions
– Financing decisions
– Dividend decisions
 A. Investment Decisions
• Most important of the three decisions are;
– What is the optimal firm size?
– What specific assets should be acquired?
– What assets (if any) should be reduced or
eliminated?
 B. Financing Decisions
• Determine how the assets (LHS of balance
sheet) will be financed (RHS of balance sheet).
– What is the best type of financing?
– What is the best financing mix?
– What is the best dividend policy (e.g., dividend-
payout ratio)?
– How will the funds be physically acquired?
 C. Dividend Decision
• The financial manager or BoDs must decide whether the
firm should distribute all profits, or retain them
or distribute a portion and retain the balance.
– The proportion of profits distributed as dividends is called the
dividend payout ratio and retention ratio.
– There are trade-offs on the dividend policy of a firm.
• Paying out more dividends will make the firm to be perceived
strong and healthy by investors;
• on the other hand, it will affect the future growth of the firm.
– The optimum dividend policy is that one
maximizes the market value of the firm’s shares.
 Principles of Financial Management
• Principle 1: The risk-return trade-off
– we won't take additional risk unless we expect to be compensated
with additional return.
• Principle 2: The time value of money.
– A dollar received today is worth more than a dollar received in the
future.
• Principle 3: Cash -- Not Profits -- is King.
– In measuring value we will use cash flows rather than accounting
profits. Why?
• B/C it is only cash flows that the firm receives and is able to reinvest.
 Cont’d….
• Principle 4: Incremental cash flows : In business decision we
will only concern what changes that count has brought-
increase cash flow.
• Principle 5: The curse of competitive markets:
– why it's hard to find exceptionally profitable projects?
• In competitive markets, extremely large profits cannot exist
for very long.
– Profitable projects can only be found if the market is made less
competitive.
– How? either through product differentiation or by achieving a cost
advantage.
 Cont’d…
• Principle 6: Efficient Capital Markets - The markets are quick
and the prices are right for perfect market.
• Principle 7: The agency problem - managers won't work for
the owners unless it's in their best interest.
– Managers may make decisions that are not in line with the
goal of maximization of shareholder wealth- this is called
agency problem
• Principle 8: Taxes bias business decisions.
• Principle 9: All risk is not equal since some risk can be
diversified away and some cannot.
– The process of diversification can reduce risk.
 Cont’d….
• Principle 10: Ethical behavior: means doing the right thing.
Ethical behavior is important in financial management.
• But ethical dilemmas are everywhere in finance.
– Unfortunately, how we define what is and what is not
ethical behavior is sometimes difficult and this called
ethical dilemma.
Goal or objective of financial management
• Typical goals of the firm can be seen from two
perspective.
– The traditional (economist)approach:- profit
maximization- is not sufficient for most firms of today.
• Maximizing firm’s earnings after taxes.
– Modern managerial finance approach:- is to maximize the
wealth of its stockholders.
• Maximizing earnings after taxes divided by shares
outstanding.
Profit Vs Wealth Maximization
 THE ROLE OF FINANCIAL MANAGERS
• The financial manager’s role and responsibilities include:
• 1. Financial analysis and planning:
– Determining the proper amount of funds to employ in the firm.
i.e., designating the size of the firm and its rate of growth.
• 2. Investment decisions:
– The efficient allocation of funds to specific assets
• 3. Financing and capital structure decisions:
– Determining the composition of capital.
• 4. Management of financial resources
– Example such as working capital.
• 5. Risk management:
– protecting assets by buying insurance or by hedging.
 AGENCY PROBLEMS
• An agent is an individual authorized by another person, called
the principal, to act in the principal’s behalf.
E.g:- In business, management acts as an agent for the owners
(shareholders).
– Principals must provide incentives so that management acts in the
principals’ best interests.
– Incentives include; stock options, Perquisites (Extra), and bonuses.
– A Primary agency relationships exist between shareholders and
managers.
– As a result of the separation, managers may make decisions that
are not in line with the goal of the firm.
• For example, they may work less eagerly and benefit themselves in terms
of salary and bonuses that reduces stock price and various bonuses is
called agency costs.
 End of Chapter One

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