CHAPTER ONE

AN OVERVIEW OF FINANCIAL
MANAGEMENT

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 Contents
1-1 What Is Finance?
1-2 What is Financial Management
1-3 Responsibilities of Financial Staff
1-4 The Main Goal of Financial
1-5 Forms of Business Organization
1-6 Stockholder–Manager Conflict

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 1.1. WHAT IS FINANCE?
• “Finance is the system that includes the circulation of
money, the granting of credit, the making of investments,
and the provision of banking facilities.” Webster’s
Dictionary
• Finance grew out of economics and accounting.
• Economists developed the notion that an asset’s value is
based on the future cash flows the asset will provide, and
accountants provided information regarding the likely size
of those cash flows.
• People who work in finance need knowledge of both
economics and accounting.

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• Finance is the application of economic principles
and concepts to business decision-making and
problem solving.
• Finance has many facets, which makes it difficult
to provide one concise definition.
• Finance is generally divided into three areas:
(1) financial management,
(2) capital markets, and
(3) investments

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• (1) Financial management, also called corporate
finance, focuses on decisions relating to how much and
what types of assets to acquire, how to raise the capital
needed to purchase assets, and how to run the firm so
as to maximize its value.
• The same principles apply to both for-profit and not-for-
profit organizations, and as the title suggests, much of
this book is concerned with financial management.
• (2) Capital markets relate to the markets where
interest rates, along with stock and bond prices, are
determined.
• Also studied here are the financial institutions that
supply capital to businesses.
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• Banks, investment banks, stockbrokers, mutual funds,
insurance companies, and the like bring together
“savers” who have money to invest and businesses,
individuals, and other entities that need capital for
various purposes.
• Governmental organizations such as the Federal
Reserve System, which regulates banks and controls the
supply of money, and the Securities and Exchange
Commission (SEC), which regulates the trading of stocks
and bonds in public markets, are also studied as part of
capital markets.

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• (3) Investments relate to decisions concerning stocks
and bonds and include a number of activities:
(i) Security analysis deals with finding the proper values
of individual securities (i.e., stocks and bonds).

(ii) Portfolio theory deals with the best way to structure

portfolios, or “baskets,” of stocks and bonds. Rational
investors want to hold diversified portfolios in order to limit
risks, so choosing a properly balanced portfolio is an
important issue for any investor.

(iii) Market analysis deals with the issue of whether stock

and bond markets at any given time are “too high,” “too
low,” or “about right.”
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• Included in market analysis is behavioral finance, where
investor psychology is examined in an effort to determine
whether stock prices have been bid up to unreasonable
heights in a speculative bubble or driven down to
unreasonable lows in a fit of irrational pessimism.
• Although we separate these three areas, they are closely
interconnected.
• Banking is studied under capital markets, but a bank
lending officer evaluating a business’ loan request must
understand corporate finance to make a sound decision.
• Similarly, a corporate treasurer negotiating with a banker
must understand banking if the treasurer is to borrow on
“reasonable” terms.
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• Moreover, a security analyst trying to determine a
stock’s true value must understand corporate finance
and capital markets to do his or her job.
• In addition, financial decisions of all types depend on
the level of interest rates; so all people in corporate
finance, investments, and banking must know
something about interest rates and the way they are
determined.

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 1.2. WHAT IS FINANCIAL MANAGEMENT?
• In most businesses and not-for-profit organizations the
Chief Executive Officer (CEO) or the Chief Operating
Officer (COO), or the president directs the firm’s
operations, which include marketing, manufacturing,
sales, and other operating departments.
• The chief financial officer (CFO), who is generally a
senior vice president is in charge of accounting, finance,
credit policy, decisions regarding asset acquisitions, and
investor relations, which involves communications with
stockholders and the press.

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• Financial Management deals with three issues:
1. Investment Decision:
deals with decisions related to the acquisition
of assets.
 What is the optimal firm size?
 What specific assets should be acquired?
 What assets (if any) should be reduced or
eliminated?
• Eg. Purchase of financial assets, tangible asset,
inventory
• ( L) Asset = Liability + Owners equity (R)
• Left Side of the Balance Sheet

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 2. Financing Decision:
deals with the Mix of Debt and Equity used to
finance assets.
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?
• Right side of the balance sheet
• Capital structure

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 3. Asset/Liability Management Decision:
deals with the Effective and Efficient use of
assets acquired.
• 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.
 Eg. Inventory Management, Cash
Management, A/R management, Liability
Management etc

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• Hence, Financial management is the various
activities of an organization concerning the
management of financial resources owned.

• Its main activity cover

 the mobilization and utilization of funds.

 the acquisition and management of assets.

 planning for the future for a business enterprise to

ensure a positive cash flow.

• Besides, financial management covers the

process of Identifying and Managing Risk and
Valuation issues. Financial Management
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 1.3. RESPONSIBILITY OF THE
FINANCIAL STAFF
• The financial staff’s task is to raise fund, acquire
assets and utilize resources so as to maximize the
value of the firm. Here are some specific activities:
• Forecasting & Planning. The financial staff must
make various forecasts and plan its external fund
requirement.
– The forecasting and planning process extends to all
other areas essential to maximize the value of the firm.
• Major Investment and Financing Decisions. The
financial staff must help
– to determine the optimal sales
– to decide what specific assets to acquire, and
– To choose the best way to finance those assets.

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• Coordination and control. The financial staff must
interact with other personnel to ensure that the
firm is operated as efficiently as possible. All
business decisions have financial implications,
and all managers - financial and otherwise -
need to take this into account.
• Dealing with the Financial Markets. The financial
staff must deal with the Money and Capital
Markets.
• Risk Management. All businesses face risks, therefore,
the financial staffs is responsible for the firm’s overall
risk management program, including identifying the
risks that should be managed and then managing
them in the most efficient manner
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• In summary, people working in Financial
Management make decisions regarding
which assets their firms should acquire,
how those assets should be financed, and
how the firm should conduct its operations.
• If these responsibilities are performed
optimally, financial managers will help to
maximize the values of their firms, and this will
also contribute to the welfare of consumers
and employee.

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 1.4. THE GOAL OF FINANCIAL
MANAGEMENT
• What is the goal of financial management?
Profit or wealth maximization? Or some other
goals?
• Possible Goals
– Survival- But does this maximize shareholders’
benefit?
– Avoidance of financial distress
– Maximization of sales or market share
– Minimize costs- cutting costs such as R & D
costs.
– Maintain steady earning growth
– Maximize profit
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Profit maximization:
– Profit maximization would probably be the most
commonly cited business goal, but this is not a very
precise objective.
• Profit maximization suffers from several limitations
• Profit in absolute terms is not a proper guide to
decision making. It should be expressed either on
a per share basis or in relation to investment
• It doesn’t consider time value of money
• Profit is not cash and not immediately available
for reinvestment.
• There is no guide for comparing profit now with the
future (arbitrary bench mark)

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 Wealth (Value) Maximization:
• The Primary Goal is Shareholder Wealth Maximization
because the firm is owned by the shareholders.
• This goal should be measured in terms of market share
price, which is a value that investors collectively are
prepared to pay.
• By maximizing shareholder wealth, we mean to
maximize the Fundamental Price of the firm’s
common stock, just the current market price.
• Firms do have other objectives like personal satisfaction of
managers & their employees welfare, and in the good of the
communities & society at large.
• Still, for various reasons, maximizing intrinsic stock value
is the most important objective for most corporations.

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 Value Maximization and Social Welfare
• If a firm attempts to maximize its intrinsic stock value, is
this good or bad for society?
• In general, it is good, benefits the society. Reasons..
To a large extent, the owners of stock are
society
Consumers benefit
• Efficient, low-cost and high-quality goods and services,
• the development of new products and services that
consumers want and need
Employees benefit
 In general, increase in stock prices also grow and add
more employees, thus benefiting society.
 company’s ability to attract, develop, and retain talented
people (fortune magazine’s key criteria to determine its list
most admired companies.
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Financial Management 21
• Sometimes the goal of wealth maximization may
conflict with the society
• To solve the conflict with society
 companies should take Socially Desirable actions
even if certain actions like pollution control may at
times conflict with this goal.
 Companies should never choose to act Unethically
at any cost
 companies should be socialy responsible, if not, this
will lead to a backlash/objection of anti business
sentiment.
 Managers should strictly follow the rules of fairness
and honesty.

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 1-5 FORMS OF BUSINESS ORGANIZATION
• The basics of financial management are the same for
all businesses, large or small, regardless of how they
are organized.
• Still, a firm’s legal structure affects its operations and
thus should be recognized.
• There are four main forms of business organizations:
– (1) proprietorships,
– (2) partnerships,
– (3) corporations, and
– (4) limited liability companies (LLCs) and limited liability
partnerships (LLPs).

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• A proprietorship is an unincorporated business owned
by one individual.
• Advantages:
– (1) They are easy and inexpensive to form,
– (2) they are subject to few government regulations, and
– (3) they are subject to lower income taxes than are
corporations.
• Limitations:
– (1) Proprietors have unlimited personal liability for the
business’ debts.
– (2) The life of the business is limited to the life of the individual
who created it.
– (3) Because of the first two points, proprietorships have
difficulty obtaining large sums of capital.
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• A partnership is a legal arrangement between two or
more people who decide to do business together.
• Advantages:
– (1) They are easy and inexpensive to form,
– (2) they are subject to few government regulations, and
– (3) they are subject to lower income taxes than are
corporations.
• Limitations:
– (1) Partners have unlimited personal liability for the business’
debts.
– (2) The life of the business is limited to the life of the
individuals who created it.
– (3) Because of the first two points, proprietorships have
difficulty obtaining large sums of capital.
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• A Corporation is a legal entity created by a state,
separate and distinct from its owners and managers,
having unlimited life, easy transferability of ownership,
and limited liability.
• Advantages:
– (1) Limited Liability,
– (2) Unlimited Life, and
– (3) Access to Capital.
• Limitations:
– (1) Double taxation
– (2) Not easy and it is relatively costly to form the business.

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• A limited liability company (LLC) is a popular type of organization
that is a hybrid between a partnership and a corporation.
• A limited liability partnership (LLP) is similar to an LLC.
• LLPs are used for professional firms in the fields of accounting, law,
and architecture, while LLCs are used by other businesses.
• Similar to corporations, LLCs and LLPs provide limited liability
protection, but they are taxed as partnerships.
• Further, unlike limited partnerships, where the general partner has
full control of the business, the investors in an LLC or LLP have
votes in proportion to their ownership interest.

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 1.6. STOCKHOLDER–MANAGER CONFLICT
• The relationship between Stockholders and
Management is called an Agency Relationship. Such a
relationship exists whenever someone (the principal)
employees another (the agent) to represent his/her
interests.

• In this relationship the Principal delegates or hires an

Agent to act on behalf of the principal.
– For example, you might delegate someone (an
agent) to sell a car that you own while you are away
at school. And you agree to pay a commission fee
when the agent sells the car. In such relationships
there is a possibility of a conflict of interest between
the principal and the agent.

• Take the following

9 December 2020 two
Financial cases
Management 28
• Take these two alternative agreement

1. A flat commission fee, let say Birr 5,000 or

2. A 10% of the sales price

1. The agent's incentive in this case is to make the sale, not

necessarily to get you the best price.

2. If you offer a commission of, say, 10 percent of the sales

price instead of a flat fee, then the above problem might
not exist.

• This example illustrates that the way in which an agent is

compensated is one factor that affects agency problems.

• In all such relationships, there is a possibility of a conflict of

interest between the principal and the agent. Such a conflict is
called an agency problem.

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 The Firm’s Agency Problem
 Sources of Conflict
 Conflicts can exist between the self-seeking goals
of (agent) managers and the Value Maximization
goal of (Principal) stockholders.
 Causes of Agency Problems between management
and shareholders
1. Risk-avoidance problems. (Risk attitudes of
management and shareholders).
 Risk-averse managers may leave profitable
opportunities in which the firm's shareholders
would prefer they invest

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 2. Information Asymmetry
• Information asymmetry can complicate monitoring.
– Information available to the insiders (managers) are
not the same to the public or outsiders
– Asymmetry of information does not allow the
principals to be sure whether the agents are
carrying out the duties according to the contract
– This is the belief that agents do not work as a
prudent man
3. Time Horizon of Management:
– Managers focus on short-term performance at the
expense of long-term growth
• Remuneration basically linked to short-term
performance goal, Horizon problem

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4. Shirk- Management may not apply its
best effort
5.Use of assets for personal use
6. Purchase of luxurious equipment
7. Approve unreasonably large salary for
themselves.

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 Actions to Reduce Agency Problem
1. The threat of firing
This is also known as proxy fight
Unhappy stockholders can vote for a new board which replaces
existing mgt
2. The threat of takeover
Best example is the hostile takeover- In such a situation, another
company can acquire the poorly performing firm, replace its
managers, increase free cash flow, and improve market value
added
(MVA = Market value of company - Book value of company)
3. Managerial Compensation
Fair salary, bonus based on performance of the firm
•Options to buy stocks
Example: An option to buy, say, 5,000 shares of stock at, say,
$50/share during the next five years.

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 STOCKHOLDERS Vs CREDITORS: A SECOND AGENCY
CONFLICT

• Creditors have the primary claim on part of the

firm's earnings in the form of interest and principal
payments on the debt.
• The stockholders, however, maintain control of
the operating decisions (through the firm's
managers) that affect the firm's cash flows and
their corresponding risks.
• Creditors lend capital to the firm at rates that are
based on the riskiness of the firm's existing assets
and on the firm's existing capital structure of debt
and equity financing, as well as on expectations
concerning changes in the riskiness of these two
variables.

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• Example:
• The shareholders, acting through management,
have an incentive to encourage the manager to
take on new projects that have a greater risk than
was anticipated by the firm's creditors.
• The increased risk will raise the required rate of
return on the firm's debt, which in turn will cause
the value of the outstanding bonds to fall.
• If the risky capital investment project is successful,
all of the benefits will go to the firm's stockholders,
because the bondholders' returns are fixed at the
original low-risk rate.
• If the project fails, however, the bondholders are
forced to share in the losses … decline in the value
of the bond on which creditors invested.

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 Managerial Actions To Maximize Shareholder Wealth

• What types of actions can managers take to

maximize the price of a firm’s stock?
– To answer this question, first we need to ask, “What factors
determine the price of a company’s stock?”
– There are three basic factors. These are
1. Cash flows: Value of financial assets, including a
company’s stock, is the present value of its future cash
flows.
2. The timing of the cash flows matters - cash received
sooner is better, because it can be reinvested to produce
additional income.
3. Risk. Investors are generally averse to risk, and they
will pay more for a stock whose cash flows are
relatively certain than for one with relatively risky cash
flows.
 Because of these three factors, managers can enhance their
firms’ value (and the stock price) by increasing expected cash
flows, speeding them up, and reducing their riskiness (variability
or predictability of cash flows).
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• The Cash Flows that matter are called Free
Cash Flows (FCF), not because they are free,
but because they are available (or free) for
distribution to all of the company’s investors,
including creditors and stockholders.
• FCFs depend on three factors:
– Sales revenues,
– Operating costs and taxes, and
– Required New Investments in operating capital.

• One of the financial manager’s roles is to help others see how

their actions affect the company’s ability to generate cash flow
and, hence, its intrinsic value.
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Financial Management 37
• In addition, within the firm,
– Managers make Investment Decisions regarding the
types of products or services to be produced, as well as
the way goods and services are produced and
delivered.
– managers must decide how to finance the firm - what
mix of debt and equity should be used, and what specific
types of debt and equity securities should be issued?
– manager must decide what percentage of current
earnings to pay out as dividends rather than retain and
reinvest; this is called the dividend policy decision.
• Each of these investment and financing decisions
is likely to affect the Level, Timing, and Riskiness of
the firm’s cash flows, and therefore the Price of its
Stock.
• Generally, managers should make investment,
financing and dividend policy decisions in a way
they can maximize the firm’s stock price.
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• Along with these decisions, the general level of interest
rates in the economy, the risk of the firm’s operations,
and investors’ overall attitude toward risk determine the
rate of return that is required to satisfy a firm’s investors.
• This rate of return from an investor’s perspective is a Cost
from the company’s point of view.
• Therefore, the Rate of Return required by investors is
called the Weighted Average Cost of Capital (WACC).
• The r/p b/n a firm’s fundamental value, its free
cash flows, and its cost of capital is defined by:

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 Does It Make Sense to try to Maximize Earnings
Per Share as Goal of Firms?
• We have said that
– wealth maximization is the goal of firms which can
be explained by Stock Price,
– the traditional objective, Profit Maximization, is not
a proper goal of corporation.
• But, Earnings per share (EPS) is the portion of a
company’s profit that is allocated to each
outstanding share of common stock, serving as an
indicator of the company’s profitability.
• EPS is often considered to be one of the most
important variables in determining a stock’s value
that explains the wealth of the firms.
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• Stock Value per Share can be calculated by using
– Earnings per Share (EPS) * Price Earning ratio

– For example, if price earning ratio is $22 and earnings per

share over the last 12 months were $1.95, what is the current
price of the stock?

– Earnings per share ( EPS) = Net income/ Common shares

outstanding

– Price-earning ratio (P/E) ratio = market price of equity/EPS

– Current stock price = $22 * $1.95 = $42.9 .

• Thus, net income is supposed to be reflective of the

firm’s potential to produce cash flows over time.

• But given the limitations of profit maximization as a

goal, this also fails to be a precise goal.
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• However, there is a high correlation
between EPS, cash flow, and stock price,
and all of them generally rise if a firm’s sales
increases.
• Nevertheless, stock prices depend not just on
today’s earnings and cash flows - future
cash flows and the riskiness of the future
earnings stream also affect stock prices.
• Some actions may increase earnings and yet
reduce stock price, while other actions may
boost stock price but reduce earnings.

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• For example,
 consider a company that undertakes large expenditures today
that are designed to improve future performance and
 a decision to change an inventory accounting policy that
increases reported expenses but might increases cash flow
due to reduction of current taxes
• Income before CGS & Taxes=100,000, T=40%.
– CGS LIFO=40,000
– FIFO=20,000,
• Which alternative is best? Which alternative
Maximizes EPS?
• In the first case, it makes sense for the manager to make the
expenditures decision that will reduce earnings per share, yet
the stock market may respond positively if it believes that
these expenditures will significantly enhance future earnings.
• In the second case, it also makes sense for the manager to adopt
the policy because it generates additional cash, even though it
reduces reported profits.
• Note, though, that management must communicate the reason for
the earnings decline, for otherwise the company’s stock price will
probably decline after the
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lower earnings are reported
Financial Management 43
 End of Chapter One

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