CHAPTER 1

OVERVIEW OF FINANCIAL MANAGEMENT

1. Meaning of Finance

 Finance is the art and science of managing money.

 Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money between/among
individuals, businesses, and governments.
 The major areas in finance are:
a. Investments
 Deal with locating, selecting, & managing income producing assets for individuals and groups
 Deal 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
 Deal also with long-term investments in physical assets or capital projects
 The major career opportunities in investment include stockbroker, portfolio management, and security analyst.
b. Financial Markets and Institutions
 Financial institutions are basically businesses that deal primarily with financial matters or services. They include banks,
insurance companies, pension funds, saving and credit associations etc.
 Financial Markets and institutions focus on the flow of money through financial institutions and the markets in which
financial assets are exchanged. They also focus on the impact of interest rate on the flow of money.
 What type of knowledge is expected of a finance specialist who is working in the field of Financial Markets and
institutions?
 Factors that cause interest rates to rise and fall
 The regulations to which financial institutions are subject
 All aspects of business administration i.e. accounting, marketing, personnel, computer systems, operations,
managerial finance.

c. Financial Management (managerial or corporate finance)

 Is concerned with the acquisition and use of funds by business enterprises.
 Is that managerial activity which is concerned with the planning and controlling of the firm’s financial affairs
 Is the management of capital sources and uses so as to attain the desired goals. Capital may include:
 Items of value that are owned and used such as land, buildings, inventories etc

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  Items of value that are used but not owned like leased or rent buildings

 Is the area of business management devoted to a judicious (prudent or rational) use of capital and a careful selection of
sources of capital in order to achieve the desired goals
 Is the broadest of the other areas of finance
 Is important in all types of businesses (private or public)
 Involves tasks ranging from making decisions regarding plant expansions to choosing what types of securities to issue to
finance expansion

d. International Finance
 Is concerned with the international aspect of either corporate finance, investments, or financial institutions
 The major factors that distinguish the practice of finance in domestic firms and multinationals are:
1. Different currency denominations
2. Economic and legal ramifications (e.g. Differences in tax laws and legal systems)
3. Language differences
4. Cultural differences
5. Role of governments
6. Political risk

2. Financial Management Decisions

 Financial management is concerned with three types of decisions; namely, investment, financing, and dividend decisions.
a. Investment decisions
 Most important of the three decisions
 Concerned with the selection of assets (asset mix or composition of assets) in which funds will be invested by a firm
 Involve decisions with respect to:
 The optimal firm size
 The specific assets (assets mix) that should be purchased
 The assets that should be reduced or eliminated (disinvestments)
 Assets to be purchased may fall in to two broad categories:
i. Long-term assets (yield returns over a period of time in the future)
 Capital budgeting or long-term investment decisions

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 ii. Short-term assets (or current assets)
 Working capital management

b. Financing (capital structure, or fund mobilization) decisions

 Concerned with the financing mix (mixture of long-term debts and equity) of the firm
 Concerned with decisions with respect to:
 The amount of additional funds
 The various sources of funds
 The least expensive sources of funds
c. Dividend decisions
 Decisions with respect to:
 Whether the firm should distribute all profits, partial profit or no profit from current earnings
 Whether dividend should be distributed in cash, stock or other form

3. Relationship of Financial Management to other disciplines

 Financial management is an integral part of the overall management of the organization

 It is not a totally independent area
 It draws heavily on related disciplines such as economics, accounting, marketing, production, quantitative methods etc.

Reading Assignment
How financial management is related to other disciplines?
4. The financial goals of the firm

 Is concerned with the goal or objective that is used to evaluate the soundness of financial decisions
 Is the framework for optimal financial decision-making
 Generally, there are two approaches to the financial goals of a firm.
a. Profit maximization
 Is based on the presumption that the most important financial goal is to “ earn the highest possible profit for the firm.”
 Each financial decision is evaluated on the basis of its overall contribution to the firm’s earnings or profit.
 It is assumed that profit is the most important measure of economic efficiency or the yardstick for judging the economic
performance.

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  Limitations of profit maximization as a goal include:
1. Timing of benefits (ignores the time value of money)
2. Ignores changes in the risk level of the firm
3. Impossible to measure profit accurately
4. Short term concept (increase current profit at the expense of future benefit)

b. Wealth maximization
 Wealth refers to value.
 The wealth of the owners is determined by the market value of the firm.
 The value of the firm is indicated by the stock price
 The financial goal is to maximize the current value per share of the existing stock or the market value of owner’s equity.
 Value creation occurs when we maximize the share price for the current shareholders
 The share price serves as a barometer for business performance
 The strength of value maximization as the goal of financial management is that it takes in to account factors that affect the
value of the firm such as:
a. Current and future profits and earning per share (EPS)
b. The timing, duration, and risk of cash flows and EPS
 Assuming other factors remain constant, the higher the expected cash inflows and the lower expected cash
outflows, the higher the firm’s stock price will be.
 Cash received sooner is better than cash received later.
 All other things being equal, the sooner companies expect to receive cash and the later they expect to pay out
cash, the more valuable the firm and the higher its stock price will be.
 The less certain owners and investors are about the firm’s expected future cash flows, the lower they will value
the company. The more certain owners and investors are about the firm’s expected future cash flows, the
higher they will value the company.

c. Dividend policy
d. General economic activity
e. Tax law
f. Use of debts
g. Interest rates
h. Conditions in the stock market

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  Wealth maximization does not preclude the firm from being socially responsible because the firm is assumed to produce private
as well as social goods.

5. Organization of the Financial Management functions & the Role of Financial Manager

 The financial Management function is associated with a top officer of the firm, such as Vice President of finance, Chief Financial
Officer (CFO) etc.

BOD
CEO
President

V.P. Production
V.P. Marketing V.P. Finance
Generally, the role of financial manager can be summarized as follows:

 Treasurer
Perform financial analysis and planning Controller
 Concerned with thethesources
 Assess and
financial performance of the business
 Is concerned with accounting and
 Assess the funds requirement
utilization of funds
Identify the sources of funds Control
 Cash management
Allocation of funds and income
 Tax management
 Controlling the utilization of funds
 Credit management
 Provide leadership in the cost-effective use of financial resources  Financial accounting
 Financial planning
 Involve actively in organizational decision-making (investment, financing & dividend) by providing timely and reliable
 Cost management
information
 Risk management  Data processing
 Portfolio management 5
  Prepare financial plan at the time of new business promotion
 Prepare financial readjustment during liquidity crisis
 Valuation of enterprise at the time of merger or reorganization
 Other non-recurring activities of greater financial implication

6. Agency Relationships
 In modern corporations, there exists a separation between owners and management.
 Management acts as an agent for the owners of the firm.
 An agent is an individual authorized by another person, called principal, to act in the latter’s behalf.
 Thus, agency relationship exists between management and owners (shareholders-principal).
 It is assumed that management acts in the best interest of the owners.
 Agency problem occurs if managers place their personal goals ahead of the corporate goals. Agency problem refers to the possibility of
conflict of interest between managers and owners.
 Agency problem creates two types of costs:
a. Direct agency costs
 Purchase of luxurious and unneeded cars
 Unnecessarily furnished offices
 Make favor to others with corporate resources
 Auditor’s fee

b. Indirect agency costs

 Avoid beneficial projects that involve greater risk (lost opportunities)

 The possible means of reducing conflict of interest between managers and owners are:
a. 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 else’s 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

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  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 firm’s 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.
 However, tactics that managers can use to ward off a hostile takeover are:
1. Poison pill
 Is an action taken by the management to make a firm unattractive to potential buyers and thus to avoid
hostile takeover.
Examples include:
 Decision to make all of the firm’s debts immediately payable if its management changed
 Decisions to give huge retirement bonuses to its managers if the firm was takeover (golden
parachutes)
2. Greenmail
 Is a situation in which a firm buys back stock at a price above the existing market price from the person(s)
trying to gain control of the firm

7. Financial Markets

 Markets are channels through which buyers and sellers meet to exchange goods, services, and resources.
 Markets may be classified in to labor market, capital market, and financial markets.
 Financial markets are markets that channel funds (savings) to those individuals and institutions that need more funds for spending
than are provided by their current income.
 Financial markets are mechanisms by which borrowers and lenders get together. They are described as being a system comprised of
individuals and institutions, instruments, and procedures that bring together borrowers and savers, no matter the location.
 In financial markets, debt and equity securities are traded/bought and sold.
 Participants in the financial markets include individuals, businesses (banks, brokers, insurance companies), and governments.

 Financial markets may be classified in various ways.

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 a. Based on maturity
1. Money market
 Provides short-term funds using securities having short-term maturities, and low risk of default.
 Financial securities (instruments) traded in the money market include Treasury bill (T-bill), commercial papers,
and negotiable Certificate of Deposits (CDs).
2. Capital market
 Provides long-term funds for long-term investments.
 Financial securities (instruments) traded in the capital market include, among others, stock and bonds.

b. Based on Nature of transactions

1. Primary markets
 Is a market that is used to trade new securities never issued before for the purpose of raising capital to finance new
investments.
 Primary market transactions may be:
i. Public offerings (selling securities to the general public)
ii. Private placement (selling securities to the specific buyers such as financial institutions)

2. Secondary markets
 Is a market in which the owner of the security sells the security to another (existing securities are traded)
 Provides the means for transferring ownership of corporate securities.
 Secondary markets may be divided in to:
a. Auction market
 Involves brokers and agents.
 Try to match buyers and sellers, but they do not actually own the commodity.
 Has physical location
b. Dealer market
 Is the market in which dealers buy and sell securities for themselves

Review Questions

1. What is finance? Distinguish between finance and finance management?

2. What are the major areas of finance?

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3. If a person specializes in the field of financial markets and institutions, s/he is not required to have knowledge about other fields of
finance. Do you agree? If not, why?
4. How has managerial finance changed from the early 1900s through the 1990s?
5. What are the key differences between sole proprietorship, partnership, and corporation?
6. What is the primary goal of financial management? What is the indication for the achievement of this goal?
7. List the factors that affect stock price.
8. What are the limitations of profit maximization as the financial goal of the firm?
9. What is an agency relationship? What is agency problem? Give at least three examples of potential agency problems between
managers and shareholders.
10. List several factors that motivate managers to act in the best interest of the owners.
11. List the major roles of financial manager in business
12. What is financial market? Who are the participants in financial markets? What are the two major types of financial markets?
13. Mention the types of securities traded in money markets? In capital markets?
14. Who are the two major subordinates of Chief Finance Officer in a typical large corporation?
15. What roles are played by treasurer? By the controller?
16. What tactics may be used by the management to avoid hostile takeover?
17. What major factors distinguish managerial finance as practiced by domestic firms from that of multinational corporations?