FINANCIAL MANAGEMENT

CHAPTER-ONE
OVERVIEW OF FINANCIAL
MANAGEMENT

1.1
 1.1. Basic Areas of Finance

• Finance is the application of economic principles

and concepts to business decision-making and
problem solving.
• The field of finance can be considered to comprise
three broad categories:
• investments,
• financial institutions, and
• financial management

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A. Investments

• This area of finance focuses on the behaviour of

financial markets and the pricing of securities.

• Investment decisions are concerned with the use of

funds—the buying, holding, or selling of all types
of assets.

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B. Financial Institutions

• This area of finance deals with banks and other

firms that specialize in bringing the suppliers of
funds together with the users of funds.
• For example, a manager of a bank may make
decisions regarding granting loans, managing cash
balances, setting interest rates on loans, and dealing
with government regulations.

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C. Financial Management

• Sometimes called corporate finance or business

finance.

• this area of finance is concerned primarily with

financial decision-making within a business entity.

• Financial Management Concerns the acquisition,

financing, and management of assets with some overall
goal in mind.
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• Some important questions that are answered using finance

• What long-term investments should the firm take on?

(investment decisions)
• Where will we get the long-term financing to pay for the
investment? (financing decisions)
• How will we manage the everyday financial activities of the
firm? (Working capital Management Decisions)

1.6
 Investment Decisions

Most important of the three decisions.

What is the optimal firm size?

What specific assets should be acquired?

What assets (if any) should be reduced or

eliminated?
Financing Decisions

• 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?

 Asset Management Decisions
working capital management

• How do we manage existing assets efficiently?

• Financial Manager has varying degrees of
operating responsibility over assets.
• Greater emphasis on current asset management
than fixed asset management.
1.2 THE ROLE OF
FINANCIAL MANAGERS
• The financial manager of a firm plays an important role
in the company’s goals, policies, and financial success.

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
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3. Financing and capital structure decisions: Raising funds on
as favourable terms as possible, i.e., determining the
composition of liabilities.

4. Management of financial resources (such as working capital)

5. Risk management: protecting assets.

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 1.3. Forms of Organization

• Three major forms

• Sole proprietorship

• Partnership

• Corporation

1.12
 Sole Proprietorship

• Advantages • Disadvantages
• Easiest to start • Limited to life of owner

• Least regulated • Equity capital limited to

• Single owner keeps all the owner’s personal wealth

profits • Unlimited liability

• Taxed once as personal • Difficult to sell ownership

income interest

1.13
 Partnership
• Advantages • Disadvantages
• Two or more owners
• More capital available
• Relatively easy to start
• Income taxed once as
personal income
1.14
• Unlimited liability
• General partnership
• Limited partnership
• Partnership dissolves when
one partner dies or wishes
to sell
• Difficult to transfer
ownership
 Corporation
• Advantages
• Limited liability
• Unlimited life
• Separation of ownership and
management
• Transfer of ownership is
easy
• Easier to raise capital
• Disadvantages
• Separation of ownership and
management
• Double taxation (income
taxed at the corporate rate
and then dividends taxed at
personal rate)

1.15
1.4. Goal Of Financial Management

• What should be the goal of financial managers when

choosing financial alternatives?

• Two widely discussed goals of financial management.

• Profit Maximization

• Stockholders’ wealth Maximization

1.16
 a) Profit Maximization (Traditional Goal)
• Is maximizing the birr income of firms.
• Is based on Accounting profit.
• The actions of the financial manager is profit oriented, i.e., only
actions and projects that will increase profit are undertaken.
• Advantages:
• Simple to achieve-no much calculation
• Helps for efficient allocation of resources.
• Limitations
• Does not consider the time value of money.
• Ignores risk.

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 b) Stockholders’ Maximization (Modern Goal)

• Considers the limitations of profit maximization

approach.

• Is based on cash flows/ benefits from projects.

• Is based on Maximization of market value of shares.

• Projects that maximize Net Present value (wealth) are

under taken.

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• Additional goals of firms include
• Social responsibility- work for the welfare of:
• Employees
• Customers, and
• Community at large.

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 1.5. The Agency Problem
• Agency relationship

• Principal hires an agent to represent their interest

• Stockholders (principals) hire managers (agents) to run the

company

• Agency problem

• Conflict of interest between principal and agent

• Management lead more relaxed life style and do not work

more seriously.
• Management may consume more perquisite.
1.20
 Mechanisms to control Managers
• Managerial compensation

• Incentives can be used to align management and stockholder

interests
• The incentives need to be structured carefully to make sure
that they achieve their goal

• Corporate control

• The threat of a takeover may result in better management

• Direct intervention – by Other stakeholders

1.21
 1.6.Financial Markets and Corporation
 A financial market, like any market, is just a way of
bringing buyers and sellers together.

In financial markets, it is debt and equity securities that

are bought and sold.

Financial markets differ in detail, however. The most

important differences concern the types of securities
that are traded, how trading is conducted, and who the
buyers and sellers are.
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