CHAPTER ONE

BASIC CONCEPTS OF FINANCIAL MANAGEMENT

After successfully completing this chapter, you will be able to:

Define Financial Management Explain the evolution of financial management; Identify the major decision functions of financial management; Distinguish the difference between profit maximization versus stockholders wealth,
maximization goal of a firm;

Describe agency problem; Identify mechanisms of resolving agency problem.

Financial Management Concepts & Practices Page 1 of 9

1.1. Definition of Financial Management

Financial management comprises the forecasting, planning, organizing, directing, coordinating and controlling of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with its financial objective. Raymond Chambers. Another very elaborate definition given by Phillippatus is Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm. Financial Management is that managerial activity which is concerned with the planning and controlling of the firms financial resources. It is the process of making optimal use of financial and real, or physical resources to increase the value of the firm. In other words, it is the form of management aimed at making optimal use of a firms financial resources for the purpose of maximizing the owners wealth.

1.2. Evolution of Financial Management Financial management evolved gradually over the past 50 years. The evolution of financial management is divided into three phases. Financial Management evolved as a Separate field of study at the beginning of the century. The three stages of its evolution are:

The Traditional Phase Financial Management Concepts & Practices Page 2 of 9

During this phase, financial management was considered necessary only during occasional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking financial decisions in the organization, the needs of outsiders (investment bankers, people who lend money to the business and other such people) to the business was kept in mind.

The Transitional Phase During this phase, the day-to-day problems that financial managers faced were given importance. The general problems related to funds analysis, planning and control were given more attention in this phase.

The Modern Phase Modern phase is still going on. The scope of financial management has greatly increased now. It is important to carry out financial analysis for a company. This analysis helps in decision making. During this phase, many theories have been developed regarding efficient markets, capital budgeting, option pricing, valuation models and also in several other important fields in financial management.

1.3. Goals and Objectives of Financial Management

Before management can take any decisions it must identify the goals of the firm. Although some firms may have specific goals peculiar to their organizations, the primary goal for most firms is to maximize shareholder wealth. Other goals are important, too, but are usually subordinate to this goal.

Financial Management Concepts & Practices Page 3 of 9

The wealth of shareholders is directly affected by both the market price of the common stock they own and the dividends they receive. Since the price of a firms common stock reflects both aspects of investor returns, the goal of management is to maximize the value of the firms common stock. The goal of maximizing shareholder wealth is done by maximizing the value of the firms common stock.

Maximizing shareholder wealth is the process of making financing decisions and investment decisions for both long and short run, which maximize the market value of the stock. Wealth maximization requires serious efforts from the part of the management. In order to encourage the management to work hard for maximizing the wealth, a number of managerial incentives may be necessary. Healthy threats can also be used to encourage them.

The firm should no way ignore the social responsibility in its hurry to maximize the wealth. When the firms focus on their shareholders interests, they must bear in mind that they are responsible for the welfare of their employees, customers and the communities in which they operate. The firms have an ethical responsibility to provide a safe working condition, to avoid polluting the air and water and to produce safe products.

Profit Maximization Frequently, maximization of profits is required as the proper objective of the firm, but it is not an inclusive a goal as that of maximizing shareholder value. For one thing, total profits are not as important as Earnings per Share. A firm could always raise total profits by issuing stock and using the proceeds to invest in Treasury Bills. Maximizing firm profits is often mistaken as the primary goal of the firm. While increasing firm profits is important to firms, it is not the primary goal because shareholder wealth can actually decline despite rising profits.

Wealth Maximization Vs Profit Maximization

Wealth Maximization differs from Profit Maximization in their goals. The main areas of difference between the two are:

Financial Management Concepts & Practices Page 4 of 9

1. Risk: Risk is the possibility that actual returns may be less than expected returns. Profit Maximization doesnt recognize risk whereas wealth maximization takes risk into account.

2. Timing: Wealth Maximization takes the timing seriously into account, but profit maximization does not take the timing of receipts seriously. Wealth maximization is interested in 100 Birr of today than 100 Birr of tomorrow.

3. Measurement: Profits may differ if different profit measuring methods are employed. For example, inventory valuation methods such as FIFO, LIFO etc will make the differences in profits. On the other hand, wealth maximization needs to have a uniform measuring method. If not, doubts may be developed on the firm.

4. Short-run Vs Long-run objectives: Profit Maximization may employ a number of short-term planning strategies, which may not maximize wealth in the long run. It may try to cut costs by reducing quality of the product to maximize profit. It doesnt consider the long run effects of such cost reduction techniques. Wealth maximization always considers the long run effects of the business activities and thus has long-term objectives unlike profit maximization.

1.4. Functions of Financial Management and Roles of Financial Manager Financial management has varied functions. It includes such varied tasks as budgeting, financial forecasting, asset management, credit administration, investment analysis, acquiring finance funds etc. In general, the decision functions of financial management can be broken down into four major areas: Investment decision function Financing decision function, Dividend decision, and Asset management decision functions. Investment decisions - The Investment (Allocation) decision focuses on where to invest the scarce resources of business organization and how to make a good investment. The investment decisions are the most important of the firms financial decisions. Investment decisions determine both the mix and the type of assets found on the firms balance sheet. This activity is concerned with the left hand side of the balance sheet. Mix or composition of assets refers to the amount of investment in current assets and fixed assets. Once the mix is established, the financial manager must determine and attempt to maintain certain optimal levels of each type of current asset like cash, inventories, and accounts receivable. The Financial Management Concepts & Practices Page 5 of 9

financial manager must also decide on the best-fixed assets to acquire and know when existing fixed assets need to be modified, replaced or liquidated. These decisions are important because they affect the firms success in achieving its goals. Financing decisions- The second major decision of the firm is the financing decision. The Financing decision is directed to where to raise the funds for these investments. Generically, what mix of owners money (equity) or borrowed money (debt) to use is the effect of the financing decision. Financing decisions deal with the right hand side of the firms balance sheet. They involve two major areas. First, the most appropriate mix of short term and long term financing must be established. A second and equally important issue is which individual short term or long-term sources of financing are best at a given time. The way of getting a short-term loan, entering into a longterm lease arrangement, or negotiating a sale of bonds or stock must be understood. Many of these decisions are dictated by necessity, but some will require a detailed analysis of the available financing alternatives, their costs, and their long-tem implications on the firm. Dividend Decision: Dividend decision is the third major financial decision. How much of a firms funds should be reinvested in the business and how much should be returned to the owners should be determined and set as a policy. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders value. The optimum dividend policy is one that maximizes the market value of the firms shares. Thus if shareholders are not indifferent to the firms dividend policy, the financial manager must determine the optimum dividend payout ratio. The payout ratio is equal to the percentage of dividends to earnings available to shareholders. The financial manager should also consider the questions of dividend stability, bonus shares and cash dividends in practice. Most profitable companies pay cash dividends regularly. Periodically, additional shares, called bonus share (or stock dividend), are also issued to the existing shareholders in addition to the cash dividend. Asset management decisions - The fourth important financial decision of the firm is the asset management decision. Once the assets are acquired and appropriate financing is provided, these assets must still be efficiently managed. To make these decisions, financial analysis and planning should be made. Financial analysis and planning is concerned with (1) transforming financial data in a form that can be used to monitor the firms financial condition and performance, and (2) determining what additional (or reduced) financing is required. These activities encompass the entire balance sheet as well as the firms income statement and other financial statements. 1.5. Relationship of Financial Management with Other Fields

Financial Management and Economics

Financial Management Concepts & Practices Page 6 of 9

The field of Economics is closely related to Economics. Economics is a sort of Mother Science to Finance. Financial managers must understand the framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. He must have the knowledge of the institutional structure such as the banking system and the relationship between the various sectors of the economy. He must be thorough with the economic variables such as GNP, Disposable Income, unemployment, inflation, interest rates, taxes etc. and be able to use economic theories as guidelines for efficient business operation.

Financial Management and Accounting Indeed, financial management and accounting are not often easily distinguishable. Accounting is said to be the Language of Finance. It provides financial data through income statements, balance sheets and the statement of cash flows. The financial manager must know how to interpret and use these statements. In small firms, the controller often carries out the finance function, and in large firms, many accountants are intimately involved in various finance activities. However, there are two basic differences between finance and accounting: The accountants employ accrual method, which recognizes revenue at the point of sale and expenses when incurred, for preparing financial statements. But, the financial manager places primary emphasis on cash flows, the intake and outgo of cash. However, the financial manager must be able to use and understand accrual based financial statements. Whereas the accountant devotes most of his attention to collection and presentation of financial data, the financial manager evaluates the accountants statements, develops additional data, and makes decisions based on his assessment of the associated returns and risks. This doesnt mean that accountants never take decisions or the financial managers never gather data; but the primary focuses of accounting and finance are distinctly different.

Financial Management and Politics Political awareness is necessary for a financial manager to be successful. This will help him predict the changes that might take place in the economic and financial areas of the country, especially increase or decrease in taxes, interests and so on. The financial manager must also be in touch with the international politics, especially when the firm tries to be an MNC (Multinational Corporation).

Financial Management Concepts & Practices Page 7 of 9

Financial Management and Law The financial management should be carried out taking the laws of the country into account. The commercial laws, especially contract laws, company and partnership laws, and laws of negotiable instrument are very important for financial management. The financial manager should also be acquainted with the labor laws and industrial laws of the country. He should also be alert towards the proclamations made by the government now and then.

Financial Management and Ethics A business enterprise actually strengthens its competitive position by maintaining high ethical standards. Financial management without ethics will lead to a number of conflicts between the society and the firm. The firm should not try to maximize its profit unethically. The firm should not forget that it is using the resources of the society and the society will restrict the usage of such resources if they are not properly used for the benefit of the society. Employment of ethical concepts in financial management practices will reduce potential litigation and judgment costs, maintain a positive corporate image, build shareholders confidence and gain the loyalty, commitment and respect of all the firms stakeholders. Ethical behavior is therefore viewed as necessary for achievement of the firms goal of owner wealth maximization.

1.6. Agency Problems and Social Responsibility An agency relationship exists when one or more persons (called principals) employ one or more other persons (called agents) to perform some tasks. Primary agency relationships exist (1) between shareholders and managers and (2) between creditors and shareholders. They are the major source of agency problems. Shareholders versus Managers The agency problem arises when a manager owns less than 100 percent of the company's ownership. As a result of the separation between the managers and owners, managers may make decisions that are not in line with the goal of maximizing stockholder wealth. For example, they may work less eagerly and benefit themselves in terms of salary and bonus. The costs associated with the agency problem are: a. Direct agency costs Purchase of luxurious and unneeded cars Unnecessarily furnished offices Make favor to others with corporate resources Financial Management Concepts & Practices Page 8 of 9

b.

Indirect agency costs Avoid beneficial projects that involve greater risk (lost opportunities)

a.

The possible means of reducing conflict of interest between managers and owners are: Attractive incentives Stock options (the option to buy stock at a bargain price perquisites (Bonus, privileges, better salary, promotion etc) Performance shares (shares of stock given to executives on the basis of performance as measured by earnings per share, return on assets, return on equity etc) b. Proxy fight (the threat of firing managers) A Proxy is the authority to vote someone elses stock. A proxy fight is a mechanism by which unhappy stockholders can act to replace the existing board, and thereby replace the existing management c. The threat of hostile takeovers Hostile takeover refers to the acquisition of the firm over the opposition of its management. In hostile takeover, management does not want the firm to be taken over. It occurs when the firms stock is undervalued relative to its potential. In hostile takeover, the managers of the acquired firm are fired, and lose their prior benefits. Thus, managers have strong incentives to take actions that maximize stock price. Creditors versus Shareholders Conflicts develop if (1) managers, acting in the interest of shareholders, take on projects with greater risk than creditors anticipated and (2) raise the debt level higher than was expected. These actions tend to reduce the value of the debt outstanding.

Financial Management Concepts & Practices Page 9 of 9