CHAPTER ONE:

Introduction to Financial
CHAPTER Management & Analysis
1 Discussion Points:
Introduction
Relation of Finance with Economics
Financial Institutions and Financial Markets
 Functions of Financial Institutions
Types of Financial Institutions
Financial Markets
Financial Management Decisions
Goal of the Firm: Profit vs. Wealth
The Agency Relationship
Costs of the Agency Relationship
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 1. INTRODUCTION
 Financial management is generally defined as the
management of capital sources and uses in order to
achieve a desired goal.

Financial management is that managerial activity which

is concerned with the planning and controlling of the
firm’s financial resources.
The role of the financial manager is to ensure that there
is capital sufficient enough to finance activities, and this
capital is available at the right amount, at the right time,
and at the lowest cost.
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 Introduction…Cont’d

Relations of Finance with

Economics
Financial management
 The field of finance is closely is, in effect, applied
related to economics. The economics because it is
financial manager must concerned with the
understand the economic allocation of a
framework within which his company’s scarce
firm is operating, and also financial resources
be able use economic
among competing
theories as guidelines for
efficient business operation.
choices.

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 Introduction…Cont’d

 The wide array of topics under the title finance may be

categorized under three broad sub-headings: Business
Finance, Investment Analysis, and Financial Markets.
Financial management deals with the management of a
firm’s principal activities – investing in assets and raising
funds to pay for those assets.
A financial manager’s job is to determine how these crucial
activities (investing & financing) may best be carried out. In
doing so, the financial manager typically will use data
prepared and presented by accountants.
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 Introduction…Cont’d

 Whereas the accountant’s focus is

on the careful and correct
preparation of financial data, the
financial manager’s focus is on
using that data as an input in
making decisions.
 Furthermore, accountant’s typically
rely on an accounting method that
recognizes revenues at the time of
sale and expenses when incurred,
while financial managers emphasize
the actual inflows and outflows of
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 …Cont’d
Introduction…Cont’d

Investment Analysis Financial Markets

Refers to the study of the Are markets where firms
analysis and issue and investors buy and
sell financial securities.
management of financial
These markets range from
securities.
specialized businesses that
It is concerned with the assist corporations in selling
evaluation of securities their securities to large
(usually stocks & bonds) secondary markets where
from the perspective of investors can buy and sell the
investors. stocks and other securities of
major corporations.
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 …Cont’d
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 These markets involve a

variety of financial
intermediaries and
middlemen such as
investment bankers and
stockbrokers. The study of
these markets and financial
intermediaries is the study
of financial markets.

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 …Cont’d
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Financial Institutions and Financial Markets

 Firms that require funds from external sources can obtain them
in three ways: (i) through a financial institution in the form of
loan, (ii) through financial markets, and (iii) through private
placement.
Financial Institutions
Financial institutions are intermediaries that channel the
savings of individuals, businesses, and governments into loans
or investments.
These are institutions (public or private) that raise funds (from
the public or other institutions) and invests them in financial
assets such as deposits, loans, and bonds.
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Functions of Financial Institutions

(1) They play as intermediary role in
transferring funds from surplus
economic unit (savers &
investors) to those in need of
the funds (deficit economic
units).
(2) Provide liquidity i.e., the
presence of financial institutions
facilitates the flow of monies
through the economy.
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Types of Financial Institutions

 There are two types of
financial institutions viz.,
depository financial institutions
and non-depository financial
institutions.
Depository Financial
Institutions – are financial
institutions that accepts deposits
and channels the money into
lending activities.
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 Introduction…Cont’d

o Depository institutions such as banks and credit

unions pay interest on deposits and use the deposits
to extend loans.
o Non-depository Financial Institutions – like insurance
companies, brokerage firms, and mutual fund
companies, sell financial products.
o Non-depository financial institutions fund their
investment activities through the sale of securities or
insurance.

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 Common types of financial institutions are listed below:

o Brokerage firm, securities firm – stock broker’s act as
an intermediary between buyers and sellers of
securities. In return for the services they provide, they
charge a fee.
o Insurance Company, insurance underwriter, insurers,
underwriters – are financial institutions that sell
insurance.
o Pension fund - a financial institution that collects
regular contributions from employers and employees
to provide retirement benefit to employees.
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o Investment Company, investment firm, investment trust fund

– is a financial institution that sells shares to individuals and
invests in securities issued by other companies.
o Finance Companies – are financial institutions (often affiliated
with a holding company or manufacturer) that makes loan to
individuals or businesses.
o Credit Union – a cooperative depository financial institution
whose members can obtain loans from their combined
savings.
o Agent bank – a bank that acts as an agent for a foreign bank.
o Commercial Bank – a financial institution that accepts deposits
and makes loans and provides other services for the public.
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o Merchant Bank – a credit card processing bank where

merchants receive credit for credit card receipts less a
processing fee.
o Acquirer – a bank gaining financial control over another
financial institution through a payment in cash or an
exchange of stock.
o Thrift Institution – a depository financial institution
intended to encourage personal savings and home
buying.

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 Generally, financial
institutions are required Therefore, due to their
to operate within sensitivity and their
established regulatory potential far-reaching
guidelines. This is consequences, there are
because any failure in guidelines which they
financial institutions will have to observe in their
have a contagious effect operations.
on the payment system
and the whole economy.

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 Introduction…Cont’d

 Thus, every country has its

own central or national bank
responsible for regulating
and supervising financial
institutions operating in an
economy.
 In Ethiopia, such regulatory
body is the National Bank of
Ethiopia.

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Financial Markets
Financial markets could mean:
(1) the market in which financial assets (such as stock
& bonds) are created or transferred.
(2) The coming together of buyers and sellers to trade
financial products, i.e., stocks and bonds are traded
between buyers and sellers in a number of ways
including the use of stock exchanges; directly between
buyers and sellers, etc.

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 Financial markets provide

a forum in which suppliers Primary market refers to
of funds and those who a market in which new, as
need funds can transact opposed to previously
business directly. issued, securities are
traded.
 Financial markets can be This is the only time that
both primary and the issuing company
secondary markets for actually receives money
debt and equity securities. for its stock.

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 There are three ways in which a corporation may raise

capital in the primary market:
(i) Public Issue – involves sales of securities to members of
the general public (it’s also called initial public offering (IPO).
(ii) Rights Issue – involves raising capital from existing
shareholders by offering additional securities to them on a
preemptive basis.
(iii) Private Placement – a way of selling securities
privately to a small group of investors.

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 Once the newly issued securities The proceeds from the sale
are in the public’s hands, it then of a share of IBM stock in
begins trading in the secondary the secondary market go to
market. the previous owner of the
 Secondary markets are markets in stock, not to IBM. That is
which existing, already because the only time IBM
outstanding, securities are traded ever receives money from
among investors. the sale of one of its
 The corporation whose shares are securities is in the primary
being traded is not involved in markets.
the secondary market transaction
and, thus, does not receive any
funds from such a sale.
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 In general, financial
markets facilitate:
o The raising of capital (in 2

1
the capital markets),
o The transfer of risk (in
the derivatives
markets); and
o International trade (in
the currency markets).

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Types of Financial Markets

 The financial markets can be divided
into different types as follows:
a) Capital Markets which consists of:
Stock markets – which provide
financing through the issuance of
shares or common stock and enable
the subsequent trading thereof.
 Bond markets – which provide
financing through the issuance of
bonds, and enable the subsequent
trading thereof.

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b) Commodity market – which facilitate the trading of commodities.

c) Money market – which is a market for short-term, highly
liquid debt instruments are traded.
d) Derivatives market – which provide instruments for the
management of financial risk.
 Futures markets, which provide standardized forward
contracts for trading products at some future date.
e) Insurance market – which facilitate the redistribution of
various risks.
f) Foreign exchange market – which facilitate the trading of
foreign currencies.
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Derivative Products Derivative products are

 During the 1980s and 1990s, financial products which
a major growth in financial are used to control risk
markets is the trading of or unexpectedly exploit
derivative products, or risk.
derivatives for short. The major participants in
 In the financial markets this markets are hedgers
stock prices, bond prices, (who want to manage
currency rates, interest price movement risk)
rates, and dividends go up and speculators (who
and down, creating risk. take risk in expectation
of profit).
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Primary vs. Secondary Markets

 The primary market is that
part of the capital markets The process of selling
that deals with the issuance of new issues to
new securities. investors is called
 Companies, governments or underwriting. In the
public sector institutions can case of new stock
obtain funding through the issue, this sale is an
sale of a new stock or bond initial public offering
issue. This is typically done (IPO).
through a syndicate of
securities dealers.
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Features of Primary Markets

1) It is a market for new long-term
capital
2) The securities are issued by the
company directly to investors.
3) The company receives the money and
issue new security certificates to the
investors.
4) Primary issues are used by companies
for the purpose of setting up new
business or for expanding or
modernizing the existing business.
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5) The primary market performs

the crucial function of facilitating
capital formation in the economy.
6) It does not include certain
other sources of new long-term
external finance, such as loans
from financial institutions.
Borrowers in the new issue
market may be raising capital for
converting private capital into
public capital; this is known as
‘going public’.
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 Corporations engage in two types of primary market

transactions: public offerings and private
placements.
 A public offering, as the name suggests, involves
selling securities to the general public, while a
private placement is a negotiated sale involving a
specific buyer.
 By law, public offering of debt and equity securities
must be registered with the authority entrusted
with such responsibility.
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 Registration requires the firm

to disclose a great deal of
information before selling any
securities. The accounting,
legal, and selling costs of
public offerings can be
considerable. But, on the other
side, it enables the firm to have
access to a large market – the
public at large – and thus raise
large sum of money.

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 Introduction…Cont’d

 Partly to avoid the various

regulatory requirements and
the expense of public offerings,
debt and equity are often sold
privately to large financial
institutions such as life
insurance companies or mutual
funds. Such private placements
do not have to be registered
with the authoritative body
and do not require the
involvement of underwriters.
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Secondary Markets
 It is the financial market for trading of securities that have
already been issued in an initial private or public offering.
 Once a newly issued stock is listed on a stock exchange,
investors and speculators can easily trade on the exchange, as
market makers provide bids and offers in the new stock.
 This market is a market on which an investor purchases an
asset from another investor rather than an issuing corporation.
A good example is The New York Stock Exchange (NYSE).
 All stock exchanges are part of the secondary market, as
investors buy securities from other investors instead of an
issuing company.
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Money Market vs. Capital Market

 Financial markets can also be classified in terms of the
maturity period of the securities traded. The two key financial
markets are the money market and the capital market.
 Money Market – is the market for short-term securities,
i.e., securities that have a maturity period of one year or
less.
 Capital Market – is the market for long-term financial
securities (usually bonds and stocks).

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Real vs. Financial Assets The firm sells financial

Real assets: can be tangible or assets or securities, such
intangible. as shares and bonds or
 Plant, machinery, office, debentures, to investors
factory, furniture and in capital markets to raise
building are examples of necessary funds.
tangible real assets, while Financial assets also
technological know-how, include lease obligations
technological collaborations, and borrowings from
patents and copy rights are banks, financial
intangible real assets. institutions and other
sources.
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Funds applied to assets

by the firm are called
capital expenditures or
investment. The firm
expects to receive return
on investment and
distribute return as
dividends to investors.

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 …Cont’d
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Equity vs. Borrowed Funds

 There are two types of funds that a firm can raise: equity
funds and borrowed funds.
 A firm sells shares (stock) to acquire equity funds. Shares
represent ownership rights of their holders.
 Buyers of shares are called shareholders, and they are the
legal owners of the firm whose shares they hold.
 Shareholders invest their money in the shares of a company
in the expectation of a return on their invested capital.
 The return on the shareholders’ capital consists of dividend
and capital gain.
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 Shareholders can be of two types: ordinary (or common)

and preference.
 Preference shareholders receive dividend at a fixed rate,
and they have a priority over ordinary shareholders.
 Preference shareholders also have preferential right over
assets of a firm when the firm is liquidated.
 The payment of dividends to shareholders is not a legal
obligation; it depends on the discretion of the board of
directors.

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 Equity funds can also be obtained by a company by

retaining a portion of earnings available for
shareholders. This method of acquiring funds internally
is called earnings retention.
 Retained earnings are undistributed profits of equity
capital; they are, therefore, rightfully a part of the equity
capital.
 The retention of earnings can be considered as a form of
raising new capital.

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 Retained earnings are used as a source of financing for the

following reasons:
a) to alleviate problem of financing from common stock
b) when there is difficulty to raise capital from external
sources
c) when there is high cost of issuing additional shares
d) to save the company’s cash which could be paid as a
cost of capital.

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 …Cont’d
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 Another important
source of securing capital The return on loans or
is creditors or lenders. borrowed funds is
 Lenders are not the called interest.
The amount of interest
owners of a company. is allowed to be
They make money treated as expense for
available to the firm on a computing corporate
lending basis and retain income taxes; thereby
title to the funds lent. provide a tax shield to
the firm.

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 Discussion Questions
1. What are financial institutions? Discuss the types and
purposes of financial institutions.
2. In the absence of financial institutions, what problems or
difficulties would borrowers and savers face?
3. Define and elaborate financial markets.
4. Discuss the types of financial markets. What are the
major distinguishing characteristics of the primary and
secondary markets?
5. What are the major contributions of a secondary market
to an economy? Discuss in detail.

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 …Cont’d
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Financial Management Decisions

 The functions of raising funds, investing them in assets and
distributing returns earned from assets to shareholders are
respectively known as financing, investment and dividend
decisions.
 While performing these functions, a firm attempts to balance
cash inflows and outflows. This is called liquidity decision;
and added to the list of important finance decisions.

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 …Cont’d
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 Important finance functions or decisions include:
1. Investment (or long-term asset-mix) Decision
Investment or capital budgeting involves the decision of
allocation of capital or commitment of funds to long-term assets
that would yield benefits in the future.
The two important aspects of investment decision are: (a)
evaluation of the prospective profitability of new investments,
and (b) the measurement of a cut-off rate against which the
prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and
cannot be predicted with certainty. Because of the uncertain
future, investment decisions involve risk. Investment proposals
should, therefore, be evaluated in terms of both expected return
and risk.
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2. Financing (Capital Structure) Decision

 Financing decision involves the financial manager decide when,
where and how to acquire funds to meet the firm’s investment
needs.
 The central issue before him or her is to determine the proportion
of equity and debt. The mix of debt and equity is known as the
firm’s capital structure.
 The financial manager must strive to obtain the best financing mix
or the optimum capital structure for his/her 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.

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 …Cont’d
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 A proper balance will

have to be struck
between return and risk.
When the shareholders’
return is maximized with
minimum risk, the
market value per share
will be maximized and
the firm’s capital
structure would be
considered optimum.
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3. Working Capital (Liquidity)

Decision
The third question concerns
working capital management.
Working Capital refers to the
firm’s short-term assets and
liabilities.
Managing the firm’s working
capital is a day-to-day activity
that ensures the firm has
sufficient resources to
continue its operations and
avoid costly interruptions.
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 Introduction…Cont’d

 Some of the questions about

working capital that must be
answered are:
a) how much cash and inventory
should be kept on hand?
b) Should there be a credit sale?
If so, at what terms, and to
whom shall it be extended?
c) how will any needed short-
term financing be obtained?

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Goal of the Firm: Profit vs. Wealth

 If we were to consider possible financial goals we might come
up with many ideas such as the following:
Survival
To avoid financial distress and bankruptcy
Beat competition, maintain control, achieve flexibility
Maximize sales or market share
Minimize costs & risks
Maximize profits
Maintain steady earnings growth [i.e., maximization of
earnings per share & maximization of RoE].
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 The goals listed above are all different, but they tend to fall
into two groups. The first of these which involves sales,
market share, and cost control relates to increasing
profitability. Whereas the goals involving bankruptcy,
avoidance, stability and safety relates in some way to
controlling risk.
 Unfortunately, there is some trade-offs between the goals of
profitability & risk. The pursuit of profitability normally
involves some element of risk, thus it is not possible to
maximize both safety and profitability simultaneously.
 What we need, therefore, is a goal that encompasses both of
these factors.
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Profit Maximization
 Would profit maximization serve as a goal of the firm?
 If we investigate profit maximization as a goal of the firm, it fails
with respect to the following operational infeasibilities:
1) It is vague because the definition of the term profit is
ambiguous.
Does it mean an absolute figure expressed in Birr or a rate of
profitability?
Does it mean short-term or long term profit?
Does it refer profit before tax or after tax?
Does it refer total profit or profit per share?

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 Introduction…Cont’d

2) It ignores the time

dimension of financial decision.
 It does not make a distinction
between returns received at
different time periods.
3) It ignores the risk dimension
of the financial decision
 Risk & returns are positively
correlated. A figure that
maximizes profit might
generate excessive risk &
thereby a lower stock price.

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 The goal of profit maximization, for example, compares

investment alternatives by examining their expected
values or weighted average profits. Whether one project
is riskier than another does not enter into these
calculations. In reality, projects differ a great deal with
respect to risk characteristics, and to ignore these
differences in the practice of financial management can
result in incorrect decisions.

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 Therefore, if we are For the reasons given,

to base financial the goal of maximizing
decisions on a goal, profits usually is not the
that goal must be same as maximizing
precise, not allow for market price per share.
misinterpretation, and The market price of a
deal with all the firm's stock represents
complexities of the the value that market
real world. participants place on
the company.
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Shareholders’ Wealth Maximization (SWM)

 The objective of shareholders’ wealth maximization
(SWM) is an appropriate and operationally feasible
criterion to choose among the alternative financial actions.
 It provides a clear measure of what financial management
should seek to maximize in making investment and
financing decisions on behalf of owners (shareholders).
 Shareholders’ wealth maximization means maximizing the
net present value (or wealth) of a course of action to
shareholders.

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The net present value A financial action that has a

positive NPV creates wealth
of a course of action is
for shareholders and,
the difference between therefore, desirable. A
the present value of its financial action resulting in
benefits and the negative NPV should be
present value of its rejected since it would
costs. destroy shareholders’ value.

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 The objective of shareholders’ wealth maximization

addresses the questions of the timing and risk of the
expected benefits. These problems are handled by
selecting an appropriate rate (the shareholders’
opportunity cost of capital) for discounting the expected
flow of future benefits.
 It is important to emphasize that benefits are measured in
terms of cash flows, not in terms of the accounting profits.
 The wealth maximization principle implies that the
fundamental objective of a firm is to maximize the market
value of existing shareholders’ common stock.
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 Discussion Questions
1. Why does profit maximization fail to serve as an
operationally feasible and enduring goal of the firm?
2. In what way is the wealth (SWM) objective superior to
the profit maximization objective? Explain.

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 …Cont’d
Introduction…Cont’d

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.
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 …Cont’d
Introduction…Cont’d

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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 …Cont’d
Introduction…Cont’d

 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.
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 Introduction…Cont’d

 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.

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 …Cont’d
Introduction…Cont’d

 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
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 …Cont’d
Introduction…Cont’d

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,
and they are of three types:
monitoring costs, bonding
costs, and residual loss.

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 …Cont’d
Introduction…Cont’d

(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
reports, which are sent to shareholders. The accountants’
fees and the management time lost in preparing such
reports 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.

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 …Cont’d
Introduction…Cont’d

 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.

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 …Cont’d
Introduction…Cont’d

(2) Bonding Costs: are A manager may enter

incurred by agents to into a contract that
assure principals that they requires him or her to
will act in the principal’s stay on with the firm
best interest. The name even though another
comes from the agent’s company acquires it; an
promise or bond to take implicit cost is then
certain actions. incurred by the
manager, who foregoes
other employment
opportunities.
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 …Cont’d
Introduction…Cont’d

(3) Residual Loss: despite

using monitoring and bonding
devices, there may still 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.

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 …Cont’d
Introduction…Cont’d

Motivating Managers: Executive Compensation

 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.
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).

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 …Cont’d
Introduction…Cont’d

Performance shares. Shares of stock given to 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.
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 …Cont’d
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 The basic idea behind stock options and restricted stock

grants is to make managers owners, since the incentive
to consume excessive perks and to shirk are reduced if
managers are also owners.
 As owners, managers not only share the costs of perks
and shirks, but they also benefit financially when their
decisions maximize the wealth of owners. Hence, the
key to motivation through stock is not really the value
of the stock, but rather ownership of the stock.

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END OF CHAPTER ONE

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