CHAPTER ONE

1. FINANCIAL MANAGEMENT: AN OVERVIEW

Introduction
To have a good understanding of financial management, you need to understand first what
finance is. Literally, finance means the money used in day-to-day activities of an individual or a
business for exchange of goods and services. But here our focus rather should be to consider
finance as a separate and distinct field of study like accounting, economics, mathematics, history,
geography etc.

What Is Finance?
Finance is a distinct area of study that comprises facts, theories, concepts, principles, techniques
and practices related with raising and utilizing of funds (money) by individuals, businesses, and
governments. Finance is a very wide and dynamic field of study. It directly affects the decisions
of all individuals and organizations that earn or raise money and spend or invest it. Therefore,
finance is also an area of study that deals with how, where, by whom, why, and through what
money is transferred among and between individuals, businesses, and governments. It is
concerned with the processes, institutions, markets, and instruments involved in the transfer of
funds.
In addition to principles and techniques, finance requires individual judgment of the person
making the financial decision. Hence, finance can also be defined as the art and science of
managing money.

Major Areas of Finance

Finance is the application of economic principles and concepts to business decision-making and
problem solving. Since the concepts and areas of finance are very broad, the academic discipline
of finance can be viewed as made of specialized areas. The major areas in finance generally are:
a. Investments: This area of finance focuses on the behavior of financial markets and the
pricing of securities. It deals with financial assets like stocks and bonds with respect to:
 Factors that determine the price of financial assets
 The potential risks associated with investing in financial assets
 The best mix of the different types of financial assets
An investment manager’s tasks, for example, may include valuing common stocks,
selecting securities for a pension fund, or measuring a portfolio’s performance.
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.
Financial institutions are financial intermediaries, which are specialized financial firms
that facilitate the transfer of funds from savers to demanders of capital. They accept
savings from customers and lend this money to other customers or they invest it. In many
instances, they pay savers interest on deposited funds. In some cases, they impose service
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 charges on customers for the services they render. For example, many financial
institutions impose service charges on current accounts. The key participants in financial
transactions of financial institutions are individuals, businesses, and government. The
major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance
companies. Among these, commercial banks are by far the most common financial
institutions in many countries worldwide.
Financial instruments are written and formal documents of transferring funds between
and among individuals, businesses, and governments. They include loans and borrowing
contracts, promissory notes, commercial papers, treasury bills, bonds, and stocks.

c. International Finance: This area of finance is concerned with the international aspects
of corporate finance, investments or financial institutions.
d. Public Finance: This area of finance deals with government finance.
e. 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 decisions include maintaining cash balances, extending
credit, acquiring other firms, borrowing from banks, and issuing stocks and bonds.
Financial management is concerned with the acquisition and use of funds by business
enterprises. Financial management is that managerial activity which is concerned with the
planning and controlling of the firm’s financial affairs. It is management of capital
sources and uses so as to attain the desired goals. Financial management is concerned
with the financial decisions of a business firm. This firm can be large or small, private or
public, financial or non-financial, profit – seeking or not-for-profit. It involves specific
financial functions of the firm.

No matter the particular category of finance, business situations that call for the application of
the theories and tools of finance generally involve either investing (using funds) or financing
(raising funds).
1.1. The Nature And Scope Of Financial Management
Meaning of Financial Management
Financial management can be clearly defined by viewing it as a subject, a process, or a function.
Financial management is one major area of study under finance. It deals with decisions made by
a business firm that affect its finances. Financial management is sometimes called corporate
finance, business finance, and managerial finance. These terms are used interchangeably in
this material.
Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.
There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management. Financial

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management is one of the important functions of a firm. It is a specified business function that
deals with the management of capital sources and uses of a firm.

The Scope of Financial Management

The scope of financial management refers to the range or extent of matters being dealt with in
financial management.
Traditionally, financial management was viewed as a field of study limited to only raising of
money. Under the traditional approach, the scope and role of financial management was
considered in a very narrow sense of procurement of funds from external sources. The subject of
finance was limited to the discussion of only financial institutions, financial instruments, and the
legal and accounting relationships between a firm and its external sources of funds. Internal
financial decision makings as cash and credit management, inventory control, capital budgeting
were ignored. Simply stating, the old approach treated financial management in a narrow sense
and the financial manager as a less important person in the overall corporate management.

However, the modern or contemporary approach views financial management in a broad sense.
Corporate finance is defined much more broadly to include any business decisions made by a
firm that affect its finance. According to the modern approach, financial management provides a
conceptual and analytical framework for the three major financial decision making functions of a
firm. Accordingly, the scope of managerial finance involves the solution to investing, financing,
and dividend policy problems of a firm. Besides, unlike the old approach, here, the financial
manager’s role includes both acquiring of funds from external sources and allocating of the funds
efficiently within the firm thereby making internal decisions. The increased globalization of
business has expanded the scope of financial management
1.2. Financial Markets and Financial Institutions
Financial Markets and Corporation
Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.
Functions of Financial Markets
Generally, financial markets play three important roles in functioning of corporate finance.
1. They assist the capital formation process: Financial markets serve as a way through
which firms can obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments: They create
continuous liquid markets where firms can obtain the capital they need from individuals
and other businesses easily (serve as a secondary market).
3. They play a role in setting the prices of securities: The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.
Cash Flows To and From the Firm

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The interplay between the corporation and the financial markets is illustrated in Figure 1.1. The
arrows in Figure 1.1 trace the passage of cash from the financial markets to the firm and from the
firm back to the financial markets. Suppose we start with the firm selling shares of stock and
borrowing money to raise cash. Cash flows to the firm from the financial markets (A). The firm
invests the cash in current and fixed assets (B). These assets generate cash (C), some of which
goes to pay corporate taxes (D). After taxes are paid, some of this cash flow is reinvested in the
firm (E). The rest goes back to the financial markets as cash paid to creditors and shareholders
(F). 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. Some of these differences
are discussed next.
Figure 1.1. Cash Flows between the Firm and the Financial Markets

Classification of Financial Markets

There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.

1. Classification on the basis of maturity and source of their value

Based on the maturity dates of securities and source of their value, financial markets can be:

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 i) Money Markets: are financial markets in which securities traded have maturities of
one-year or less. The most common money market securities are treasury bills,
commercial paper, negotiable certificates of deposit, and bankers acceptance.
 Treasury bills (T-bills) are short-term securities issued by the government; they have original
maturities of either four weeks, three months, or six months. Unlike other money market
securities, T-bills carry no stated interest rate. Instead, they are sold on a discounted basis:
Investors obtain a return on their investment by buying these securities for less than their face
value and then receiving the face value at maturity.
 Commercial paper is a promissory note—a written promise to pay—issued by a large,
creditworthy corporation. These securities have original maturities ranging from one day to
270 days. Most commercial paper is backed by bank lines of credit, which means that a bank
is standing by ready to pay the obligation if the issuer is unable to. Commercial paper may be
either interest bearing or sold on a discounted basis.
 Certificates of deposit (CDs) are written promises by a bank to pay a depositor. Nowadays
they have original maturities from six months to three years.
 Bankers’ acceptances are short-term loans, usually to importers and exporters, made by
banks to finance specific transactions. An acceptance is created when a draft (a promise to
pay) is written by a bank’s customer and the bank “accepts” it, promising to pay. The bank’s
acceptance of the draft is a promise to pay the face amount of the draft to whomever presents
it for payment. The bank’s customer then uses the draft to finance a transaction, giving this
draft to her supplier in exchange for goods. Since acceptances arise from specific
transactions, they are available in a wide variety of principal amounts. Typically, bankers’
acceptances have maturities of less than 180 days. Bankers’ acceptances are sold at a
discount from their face value, and the face value is paid at maturity. Since acceptances are
backed by both the issuing bank and the purchaser of goods, the likelihood of default is very
small.
Money market securities are short-term indebtedness. By “short term” we usually imply an
original maturity of one year or less. Money market securities are backed solely by the issuer’s
ability to pay. With money market securities, there is no collateral; that is, no item of value
(such as real estate) is designated by the issuer to ensure repayment. The investor relies primarily
on the reputation and repayment history of the issuer in expecting that he or she will be repaid.

ii) Capital Markets: are financial markets in which securities of long-term funds are
traded. Major securities traded in capital markets include bonds, preferred and
common stocks.

2. Classification on the basis of the nature of securities

This is based on whether the securities are new issues or have been outstanding in the market
place. The primary function of a securities market—whether or not it has a physical location—is
to bring together buyers and sellers of securities. Securities markets can be classified by whether

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they are involved in original sales or resales of securities, and by whether or not they involve a
physical trading location.
i) Primary Markets: are financial marketers in which firms raise capital by issuing new
securities. When a security is first issued, it is sold in the primary market. This is the
market in which new issues are sold and new capital is raised. So it is the market whose
sales directly benefit the issuer of the securities.
ii) Secondary Markets: are financial markets in which existing and already outstanding
securities are traded among investors. Here the issuing corporation does not raise new
finance. A secondary market is one in which securities are resold among investors. No
new capital is raised and the issuer of the security does not benefit directly from the sale.
Trading takes place among investors. Investors who buy and sell securities on the
secondary markets may obtain the services of stock brokers, individuals who buy or sell
securities for their clients.
There are two types of secondary markets: exchanges and over-the-counter markets.
i) Exchanges are actual places where buyers and sellers (or their representatives) meet to
trade securities. Examples are the New York Stock Exchange and the Tokyo Stock
Exchange.
ii) Over-the-counter (OTC) markets are arrangements in which investors or their
representatives trade securities without sharing a physical location. For the most part,
computer and telephone networks are used for this purpose. These networks are owned
and managed by the market’s members. An example is the Nasdaq system, which is
operated by the National Association of Securities Dealers (NASD).

1.3. FINANCIAL MANAGEMENT DECISIONS

This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.
In general, the functions of financial management include three major decisions a firm must
make. These are:
 Investment decisions
 Financing decisions
 Dividend decisions
Investment Decisions
This deals with allocation of the firm’s scarce financial resources among competing uses. These
decisions are concerned with the management of assets by allocating and utilizing funds within
the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: determining the total amount of the
firm’s finance to be invested in current and fixed assets.
ii) Determining the asset type: determining which specific assets to maintain within the
categories of current and fixed assets.

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 iii) Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.

Investment decisions are concerned with the use of funds— the buying, holding, or selling of all
types of assets: Should we buy a new die stamping machine? Should we introduce a new product
line? Sell the old production facility? Buy an existing company? Build a warehouse? Keep our
cash in the bank?
The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current assets and
short – term liabilities. The later, on the other hand, involves long – term investment decisions
like acquisition, modification, and replacement of fixed assets.

Generally, the investment decisions of a firm deal with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

Financing Decisions
The financing decisions deal with the financing of the firm’s investments, i.e., decisions
whether the firm should use equity or debt funds in order to finance its assets. They are also
concerned with determining the most appropriate composition of short – term and long – term
financing. In simple terms, the financing decisions deal with determining the best financing mix
or capital structure of the firm.

The financing decisions of a firm are generally concerned with the right side of the basic
accounting equation. Financing decisions are concerned with the acquisition of funds to be used
for investing and financing day-to-day operations. Should managers use the money raised
through the firms’ revenues? Should they seek money from outside of the business? A
company’s operations and investment can be financed from outside the business by incurring
debts, such as though bank loans and the sale of bonds, or by selling ownership interests.
Because each method of financing obligates the business in different ways, financing decisions
are very important.

Dividend Decisions
The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should be
retained by the business for further expansion. There are tradeoffs on the dividend policy of a
firm. On the one hand, 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. So the
dividend decision of a firm should be analyzed in relation to its financing decisions.

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1.4. The Goal of a Firm in Financial Management
Recall that financial management is concerned with decision making to achieve the goal of a
firm. But the question is what this goal of a firm is? Before trying to address the question, let us
first describe the meaning of a goal.

A goal or an objective provides a framework for the decision maker. In most cases, the goal is
stated in terms of maximizing or minimizing some variable. A goal, therefore, is an explicit
operational guide or decision rule for the decision maker.

A firm might have a number of alternative possible goals at a point in time when evaluating a
given course of action. These goals include maximization of profits, size, value, social welfare or
minimization of costs, risk, Survive, Avoid financial distress and bankruptcy, Beat the
competition, Maximize sales or market share, Maintain steady earnings growth. etc. Although it
is very difficult, a firm should be able to have a specific goal for the following two basic reasons.

1. If a goal is not chosen, there is no way to select among alternative decision criteria.
Without an objective to achieve, there would be a number of approaches to select from
available decision rules.
2. If multiple goals are chosen, it is hardly possible to prioritize the decision criteria; and the
firm might end up achieving none of them.
Profit Maximization as a Decision Rule
Meaning of Profit Maximization
Profit maximization is a function of maximizing revenue and /or minimizing costs. If a firm is
able to maximize its revenues for a given level of costs or minimizing costs for a given level of
revenues, it is considered to be efficient.

Profit maximization focuses on the total amount of benefits of any courses of action. This
decision rule as applied to financial management implies that the functions of managerial finance
should be oriented to making of money. Under the profit maximization decision criteria, actions
that increase profit of a firm should be undertaken; and actions that decrease profit should be
rejected. Similarly, given alternative courses of actions, decisions would be made in favor of the
one with the highest expected profits.

Profit maximization, though widely professed, should not be used as a good goal of a firm in
financial management. This is because it fails to meet many of the characteristics of a good goal.

Limitations of Profit Maximization

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1. Ambiguity: The term profit or income is vague and ambiguous concept. It is very illusive and
has no precise quonotation. Different people understand profit in different ways. There are many
different economic and accounting definitions of profit, each open to its own set of
interpretations. Even in accounting profit might refer to short-term or long-term profit, total
profit or profit on a per share basis (earnings per share), and before or after tax profit. Then, the
question or the problem would be which profit is to be maximized? Maximizing one may lead to
minimizing the other.

Furthermore, problems related to inflation and international currency transactions complicate the
issue of profit maximization.

2. Cash flows: The profit a firm has reported does not represent the cash flows to the business.
Firms reporting a very high total profit or earnings per share might face difficulty of paying cash
dividends to stockholders. Sometimes, companies might even declare bankruptcy though
reporting a positive income.

3. Timing of Benefits: The profit maximization criterion ignores the differences in the time
pattern of benefits received from investment proposals. This criterion does not consider the
distinction between returns (benefits) received in different time periods and treats all benefits as
equally valuable irrespective of the time pattern differences in benefits. In other words, the profit
maximization ignores the time value of money, i.e., money today is better than money tomorrow.
Also it does not consider the sooner, the better principle.

To understand this limitation better let us consider the following example.

For example, KK Manufacturing Share Company wants to choose between two projects: project
X and project Y. Both projects cost the same, are equally risky and are expected to provide the
following benefits over three years period.

BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 50,000 50,000
3 –0- 25,000
TOTAL Br. 75,000 Br. 75,000

The profit maximization criterion ranks both projects as being equal. However, project X
provides higher benefits in earlier years and project Y provides larger benefits in later years. The
higher benefits of project X in earlier years could be reinvested to earn even higher profits for
later years. Profit seeking organizations must consider the timing of cash flows and profits
because money received today has a higher value than money received tomorrow. Cash flows in
early years are valued more highly than equivalent cash flows in later years.
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4. Quality of Benefits (Risk of Benefits): Profit maximization assumes that risk or uncertainty
of future benefits is of no concern to stockholders. Risk is defined as the probability that
actual benefit will differ from the expected benefit. Financial decision making involves a
risk-return trade-off. This means that in exchange for taking greater risk, the firm expects a
higher return. The higher the risk, the higher the expected return.

For example, Nyala Merchandising Private Limited Company must choose between two
projects. Both projects cost the same. Project A has a 50% chance that its cash flows would be
actual over the next three years. Project B, on the other hand, has a 90% probability that its cash
flows for the next three years would be realized.
BENEFITS

YEAR PROJECT A PROJECT B

1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000

Under profit maximization, project A is more attractive because it adds more to Nyala than
project B. However, if we consider the risk of the two projects, the situation would be reversed.

Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000

Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000

In fact, risk can be measured in different ways, and different conclusions about the riskness of a
course of action can be reached depending on the measure used. In addition to the probability
distribution, illustrated above, risk can also be measured on the basis of the variation of cash
flows.

The more certain the expected cash flow (return), the higher the quality of benefits (i.e., low risk
to investor). Conversely, the more uncertain or fluctuating the expected benefits, the lower the
quality of benefits (i.e., high risk to investors).

1.2.2. Wealth Maximization as a Decision Rule

1.2.2.1. Meaning of Wealth Maximization
Wealth maximization means maximization of the value of a firm. Hence, wealth maximization is
also called value maximization or net present value (NPV) maximization.

To understand and appreciate the essence of wealth maximization, we need to consider the
various stakeholders in a given corporation. Stakeholders are all individuals or group of

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individuals who have a direct or indirect interest in the firm. They include stockholders, debtors,
managers, employees, customers, governmental agencies and others. But among these, managers
should give priority to stockholders. In fact, the overriding premise of financial management is
that a firm should be managed to enhance the well-being or wealth of its existing common
stockholders. Stockholders’ wellbeing depends on both current and expected dividend payments
and market price of the firm’s common stock.
The Measure of Owner’s Economic Well-Being
The price of a share of stock at any time, or its market value, represents the price that buyers in a
free market are willing to pay for it. The market value of shareholders’ equity is the value of all
owners’ interest in the corporation. It is calculated as the product of the market value of one
share of stock and the number of shares of stock outstanding:
Market value of shareholders’ equity = Market value of a share of stock × Number of
shares of stock outstanding
The number of shares of stock outstanding is the total number of shares that are owned by
shareholders.
Investors buy shares of stock in anticipation of future dividends and increases in the market
value of the stock. How much are they willing to pay today for this future—and hence uncertain
—stream of dividends?
They are willing to pay exactly what they believe it is worth today, an amount that is called the
present value. The present value of a share of stock reflects the following factors:
 The uncertainty associated with receiving future payments
 The timing of these future payments
 Compensation for tying up funds in this investment

The market price of a share is a measure of owners’ economic well-being. Does this mean that if
the share price goes up, management is doing a good job? Not necessarily. Share prices often can
be influenced by factors beyond the control of management. These factors include expectations
regarding the economy, returns available on alternative investments (such as bonds), and even
how investors view the firm and the idea of investing.
These factors influence the price of shares through their effects on expectations regarding future
cash flows and investors’ evaluation of those cash flows. Nonetheless, managers can still
maximize the value of owners’ equity, given current economic conditions and expectations. They
do so by carefully considering the expected benefits, risk, and timing of the returns on proposed
investments.
Wealth maximization as a decision criterion is considered to be an ideal goal of a firm in
financial management. There are several reasons why wealth maximization decision criterion is
superior to other criteria. First, it has an exact measurement unlike profit maximization. It
depends on cash flows (inflows and outflows). Second, wealth maximization as a decision
criterion consider the quality as well as the time pattern of benefits. Third, it emphasizes on the
long-term and sustainable maximization of a firm’s common stock price in the financial market.

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Fourth, wealth maximization gives a recognition to the interest of other stakeholders and to the
societal welfare on the long-term basis.

Technically, wealth maximization as a decision rule involves a comparison of value to cost.

Thus, an action that has a discounted value that exceeds its cost can be said to create value and
such action should be undertaken. Whereas an action with less discounted value than cost
reduces wealth and, therefore, should be rejected. The discounted value is a value which takes
risk and timing of benefits into account.

Limitations of Wealth Maximization

The limitations of wealth maximization refer to the potential side costs of wealth maximization if
adopted as a decision criterion.
1. If wealth maximization is taken as the sole decision rule, there is a possibility that the
benefits of the society at large might be forgone. Fortunately, however, this problem is
not unique to wealth maximization. Even if an alternative goal is used, still this problem
continues to persist.
2. When managers of a corporation are separate from owners, there is a potential for a
conflict of interest between them. This conflict of interest can lead to the maximization of
manages’ interest instead of the welfare of stockholders.
3. When the goal of a firm is stated in terms of stockholders wealth, actions that increase the
wealth of stockholders could be taken as the expense of other stakeholders like debt
holders.
4. Wealth maximization is normally reflected in the firm’s stock price. But if there are
inefficiencies in financial markets, wealth maximization decision rule may lead to
misallocation of scarce resources.

1.5. The Agency Relationship

If you are the sole owner of a business, then you make the decisions that affect your own well-
being. But what if you are a financial manager of a business and you are not the sole owner? In
this case, you are making decisions for owners other than yourself; you, the financial manager,
are an agent. An agent is a person who acts for—and exerts powers of— another person or group
of persons. The person (or group of persons) the agent represents is referred to as the principal.
The relationship between the agent and his or her principal is an agency relationship. There is an
agency relationship between the managers and the shareholders of corporations.

1.5.1. Problems with the Agency Relationship

In an agency relationship, the agent is charged with the responsibility of acting for the principal.
Is it possible the agent may not act in the best interest of the principal, but instead act in his or
her own self-interest? Yes—because the agent has his or her own objective of maximizing
personal wealth.

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In a large corporation, for example, the managers may enjoy many fringe benefits, such as golf
club memberships, access to private jets, and company cars. These benefits (also called
perquisites, or “perks”) may be useful in conducting business and may help attract or retain
management personnel, but there is room for abuse. What if the managers start spending more
time at the golf course than at their desks? What if they use the company jets for personal travel?
What if they buy company cars for their teenagers to drive? The abuse of perquisites imposes
costs on the firm—and ultimately on the owners of the firm. There is also a possibility that
managers who feel secure in their positions may not bother to expend their best efforts toward
the business. This is referred to as shirking, and it too imposes a cost to the firm. Finally, there is
the possibility that managers will act in their own self-interest, rather than in the interest of the
shareholders when those interests clash. For example, management may fight the acquisition of
their firm by some other firm even if the acquisition would benefit shareholders. Why? In most
takeovers, the management personnel of the acquired firm generally lose their jobs. Envision that
some company is making an offer to acquire the firm that you manage. Are you happy that the
acquiring firm is offering the shareholders of your firm more for their stock than its current
market value? If you are looking out for their best interests, you should be. Are you happy about
the likely prospect of losing your job? Most likely not.
As you understand, in a corporate form of business organization owners (stockholders) do not
run the activities of the firm. Rather, the stockholders elect the board of directors, who in turn
assign the management on behalf of the owners. So, basically, managers are agents of the owners
of the corporation and they undertake all activities of the firm on behalf of these owners.
Managers are agents in a corporation to maximize the common stockholders’ well-being.

However, there is a conflict of goals between managers and owners of a corporation and mangers
may act to maximize their interest instead of maximizing the wealth of owners. Managers are
interested to maximize their personal wealth, job security, life style and fringe benefits.

The natural conflict of interest between stockholders and managerial interest create agency
problems. Agency problems are the likelihood that mangers may place their personal goals a
head of corporate goals. Theoretically, agency problems are always there as long as mangers are
agents of owners.

1.5.2. Costs of the Agency Relationship

There are costs involved with any effort to minimize the potential for conflict between the
principal’s interest and the agent’s interest. Such costs are called agency costs. Corporations
(owners) are aware of these agency problems and they incur some costs as a result of agency.
These costs include:

1. Monitoring costs are costs incurred by the principal to monitor or limit the actions of the
agent. In a corporation, shareholders may require managers to periodically report on their
activities via audited accounting statements, which are sent to shareholders. The
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 accountants’ fees and the management time lost in preparing such statements are
monitoring costs. Another example is the implicit cost incurred when shareholders limit
the decision-making power of managers. By doing so, the owners may miss profitable
investment opportunities; the foregone profit is a monitoring cost. In other words,
monitoring costs are costs incurred by corporations to monitor or control the activities of
managers. A very good example of a monitoring expenditure is fees paid by corporations
to external auditors.
The board of directors of corporation has a fiduciary duty to shareholders; that is, the
legal responsibility to make decisions (or to see that decisions are made) that are in the
best interests of shareholders. Part of that responsibility is to ensure that managerial
decisions are also in the best interests of the shareholders. Therefore, at least part of the
cost of having directors is a monitoring cost.
2. Bonding costs are incurred by agents to assure principals that they will act in the
principal’s best interest. The name comes from the agent’s promise or bond to take
certain actions. A manager may enter into a contract that requires him or her to stay on
with the firm even though another company acquires it; an implicit cost is then incurred
by the manager, who foregoes other employment opportunities. In other words, bonding
costs – are cost incurred to protect dishonesty of mangers and other employees of a firm.
Example: fidelity guarantee insurance premium. Even when monitoring and bonding
devices are used, there may be some divergence between the interests of principals and
those of agents. The resulting cost, called the residual loss, is the implicit cost that results
because the principal’s and the agent’s interests cannot be perfectly aligned even when
monitoring and bonding costs are incurred.
3. Structuring costs are made to make managers fell sense of ownership to the corporation.
These include stock options, performance shares, cash bonus etc.
4. Opportunity costs: unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as
a result of their organizational structure and hierarchy.
Even when monitoring and bonding devices are used, there may be some divergence between the
interests of principals and those of agents. The resulting cost, called the residual loss, is the
implicit cost that results because the principal’s and the agent’s interests cannot be perfectly
aligned even when monitoring and bonding costs are incurred.
Motivating Managers: Executive Compensation
On top of the above costs assumed by corporations, there are also other ways to motivate
managers to act in the best interest of owners. These ways include to make know managers that
they would be fired if they do not act to maximize shareholders wealth and that the corporation
could be overtaken by others if its value is very much lower than other firms.
One way to encourage management to act in shareholders’ best interests, and so minimize
agency problems and costs, is through executive compensation—how top management is paid.
There are several different ways to compensate executives, including:
Salary: The direct payment of cash of a fixed amount per period.
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 Bonus: A cash reward based on some performance measure, say earnings of a division or
the company.
Stock appreciation right: A cash payment based on the amount by which the value of a
specified number of shares has increased over a specified period of time (supposedly due
to the efforts of management).
Performance shares: Shares of stock given the employees, in an amount based on some
measure of operating performance, such as earnings per share.
Stock option: The right to buy a specified number of shares of stock in the company at a
stated price—referred to as an exercise price at some time in the future. The exercise
price may be above, at, or below the current market price of the stock.
Restricted stock grant: The grant of shares of stock to the employee at low or no cost,
conditional on the shares not being sold for a specified time.
1.6. CLOSLY RELATED FIELD OF FINANCIAL MANAGEMENT
Though finance had ceded itself from economics, it is not totally an independent field of study. It
is an integral part of the firm’s overall management. Finance heavily draws theories, concepts,
and techniques from related disciplines such as economics, accounting, marketing, operations,
mathematics, statistics, and computer science. Among these disciplines, the field of finance is
closely related to economics and accounting.
1.6.1. Finance versus Economics
Finance and economics are closely related in many aspects. First, economics is the mother field
of finance. Second, the economic environment within which a firm operates influences the
decisions of a financial manager. A financial manger must understand the interrelationships
between the various sectors of the economy. He must also understand such economic variables
as a gross domestic product, unemployment, inflation, interests, and taxes in making financial
decisions.

Financial managers must also be able to use the structure of decision-making provided by
economics. They must use economic theories as guidelines for their efficient financial decision
making. These theories include pricing theory through the relationships between demand and
supply, return analysis, profit maximization strategies, and marginal analysis. The last one,
particularly, is the primary economic principle used in financial management.

Basic differences between Finance and Economics

i) Finance is less concerned with theory than is economics. Finance is basically
concerned with the application of theories and principles.
ii) Finance deals with an individual firm; but economics deals with the industry and the
overall level of the economic activity.

1.6.2. Finance Versus Accounting

Accounting provides financial information through financial statements. Therefore, these two
fields are closely linked as accounting is an important input for financial decision-making.
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Besides, the accounting and finance functions generally overlap; and usually it is difficult to
distinguish them. In many situations, the accounting and finance activities are within the control
of the financial manager of a firm.

Basic differences between Finance and Accounting

i) Treatment of income: in accounting, income measurement is on accrual basis. Under
this method revenues are recognized as earned and expenses as incurred. In finance,
however, the cash method is employed to recognize the revenue and expenses.
ii) Decision-making: the primary function of accounting is to gather and present
financial data. Finance, on the other hand, is primarily concerned with financial
planning, controlling and decision-making. The financial manger evaluates the
financial statements provided by the accountant by applying additional data and then
makes decisions accordingly.
iii) Accounting is highly governed by generally accepted accounting principles. Further
to include financial decisions pertaining to the international financial environment.

1.7. Basic forms of Business Organization

Large firms in the United States, such as Ford and Microsoft, are almost all organized as
corporations. We examine the three different legal forms of business organization—sole
proprietorship, partnership, and corporation—to see why this is so. Each form has distinct
advantages and disadvantages for the life of the business, the ability of the business to raise cash,
and taxes. A key observation is that as a firm grows, the advantages of the corporate form may
come to outweigh the disadvantages.

Sole Proprietorship
A sole proprietorship is a business owned by one person. This is the simplest type of business to
start and is the least regulated form of organization. Depending on where you live, you might be
able to start a proprietorship by doing little more than getting a business license and opening
your doors. For this reason, there are more proprietorships than any other type of business and
many businesses that later become large corporations start out as small proprietorships.

The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is
that the owner has unlimited liability for business debts. This means that creditors can look
beyond business assets to the proprietor’s personal assets for payment. Similarly, there is no
distinction between personal and business income, so all business income is taxed as personal
income.

The life of a sole proprietorship is limited to the owner’s life span, and the amount of equity that
can be raised is limited to the amount of the proprietor’s personal wealth. This limitation often
means that the business is unable to exploit new opportunities because of insufficient capital.

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Ownership of a sole proprietorship may be difficult to transfer because this transfer requires the
sale of the entire business to a new owner.

Partnership
A partnership is similar to a proprietorship except that there are two or more owners (partners).
In a general partnership, the entire partners share in gains or losses, and all have unlimited
liability for all partnership debts, not just some particular share. The way partnership gains (and
losses) are divided is described in the partnership agreement. This agreement can be an informal
oral agreement, such as “let’s start a lawn mowing business,” or a lengthy, formal written
document.

In a limited partnership, one or more general partners will run the business and have unlimited
liability, but there will be one or more limited partners who will not actively participate in the
business. A limited partner’s liability for business debts is limited to the amount that partner
contributes to the partnership. This form of organization is common in real estate ventures, for
example.

The advantages and disadvantages of a partnership are basically the same as those of a
proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to
form. General partners have unlimited liability for partnership debts, and the partnership
terminates when a general partner wishes to sell out or dies. All income is taxed as personal
income to the partners, and the amount of equity that can be raised is limited to the partners’
combined wealth. Ownership of a general partnership is not easily transferred because a transfer
requires that a new partnership be formed. A limited partner’s interest can be sold without
dissolving the partnership, but finding a buyer may be difficult.

Because a partner in a general partnership can be held responsible for all partnership debts,
having a written agreement is very important. Failure to spell out the rights and duties of the
partners frequently leads to misunderstandings later on. Also, if you are a limited partner, you
must not become deeply involved in business decisions unless you are willing to assume the
obligations of a general partner. The reason is that if things go badly, you may be deemed to be a
general partner even though you say you are a limited partner.
Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as
forms of business organization are:
1) unlimited liability for business debts on the part of the owners,
2) limited life of the business, and
3) Difficulty of transferring ownership. These three disadvantages add up to a single, central
problem: the ability of such businesses to grow can be seriously limited by an inability to
raise cash for investment.

Corporation

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The corporation is the most important form (in terms of size) of business organization in the
United States. A corporation is a legal “person” separate and distinct from its owners, and it has
many of the rights, duties, and privileges of an actual person. Corporations can borrow money
and own property, can sue and be sued, and can enter into contracts. A corporation can even be a
general partner or a limited partner in a partnership, and a corporation can own stock in another
corporation.

Not surprisingly, starting a corporation is somewhat more complicated than starting the other
forms of business organization. Forming a corporation involves preparing articles of
incorporation (or a charter) and a set of by laws. The articles of incorporation must contain a
number of things, including the corporation’s name, its intended life (which can be forever), its
business purpose, and the number of shares that can be issued. This information must normally
be supplied to the state in which the firm will be incorporated. For most legal purposes, the
corporation is a “resident” of that state.

The bylaws are rules describing how the corporation regulates its existence. For example, the
bylaws describe how directors are elected. These bylaws may be a simple statement of a few
rules and procedures, or they may be quite extensive for a large corporation. The bylaws may be
amended or extended from time to time by the stockholders.

In a large corporation, the stockholders and the managers are usually separate groups. The
stockholders elect the board of directors, who then select the managers. Managers are charged
with running the corporation’s affairs in the stockholders’ interests. In principle, stockholders
control the corporation because they elect the directors.

As a result of the separation of ownership and management, the corporate form has several
advantages. Ownership (represented by shares of stock) can be readily transferred, and the life of
the corporation is therefore not limited. The corporation borrows money in its own name. As a
result, the stockholders in a corporation have limited liability for corporate debts. The most they
can lose is what they have invested.

The relative ease of transferring ownership, the limited liability for business debts, and the
unlimited life of the business are why the corporate form is superior for raising cash. If a
corporation needs new equity, for example, it can sell new shares of stock and attract new
investors. Apple is an example. Apple was a pioneer in the personal computer business. As
demand for its products exploded, Apple had to convert to the corporate form of organization to
raise the capital needed to fund growth and new product development. The number of owners
can be huge; larger corporations have many thousands or even millions of stockholders. For
example, in 2008, General Electric Corporation (better known as GE) had about 4 million
stockholders and about 10 billion shares outstanding. In such cases, ownership can change
continuously without affecting the continuity of the business.

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The corporate form has a significant disadvantage. Because a corporation is a legal person, it
must pay taxes. Moreover, money paid out to stockholders in the form of dividends is taxed
again as income to those stockholders. This is double taxation, meaning that corporate profits are
taxed twice: at the corporate level when they are earned and again at the personal level when
they are paid out as a dividend.

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