Financial Management

1. Chapter -One
Introduction to Financial
Management

2. Introduction
Finance:
 No business activity can be undertaken without finance
and hence, finance is the lifeblood of business.
 Every business requires money to make more money
regardless of its size.
 Efficient management of business is only possible with
efficient management of finance
 Finance can be divided into three main areas:
1. Personal Finance: This focuses on the financial
decisions made by individuals or families to manage
their money, budgeting, saving, investing, retirement
planning, and managing debts.
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3. 2. Corporate Finance:
 involves financial management within organizations and
businesses.
 It includes making investment decisions, managing
capital structure, analyzing financial performance, and
determining the optimal allocation of resources to
maximize shareholder value
3. Public Finance:
 This deals with the financial management of public
entities such as governments, municipalities, and other
public institutions.
 It encompasses budgeting, taxation, public expenditure,
and the management of public assets and liabilities
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Introduction

4. Introduction
Financial Management :
Is an integral part of overall management decision-making
process
Can be defined as the art and science of managing
money
is part of the management activity which is concerned
with the planning and controlling of firms financial
resources.
Deals with the acquisition of funds and their optimum
utilization.
Financial management is concerned with three types of
decisions; namely:
1. Investment,
2. Financing, and
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5. Financial management decisions:
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1. The investment decision: decisions have to be made as to
where capital is to be invested. It generally answers the
question that:
 Is it worth acquiring another company?
 Is it worth expanding the factory?
 is it worth launching a new product?
 Is it worth to invest in stock or bond of another firms?
 In what mix should investment be made in stock/bond of
other firms?
 It is the financial manager’s role to decide on which criteria
to be used in making these kind of investment decisions.
2. The financing decision(capital structure decisions):
 The company needs finance for investment
 Finance can be raised from shareholders or from debt
 It is the job of the Financial Manager to be aware of the

6. Financial management decisions:
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3. 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

7. Goal of Financial Management
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 Is concerned with the goal or objective that is used to
evaluate the soundness of financial decisions
 Objectives of Financial Management may be broadly
divided into two
1. Profit maximization( net income)
2. Wealth maximization( capital gain)

8. Profit maximization goal
 Is based on the presumption that the most important
financial goal is to “ earn the highest possible profit
for the firm.”
 It is assumed that profit is the most important measure of
economic efficiency or the yardstick for judging the
economic performance.
 Each financial decision is evaluated on the basis of its
overall contribution to the firm’s profit.
 Limitations of profit maximization as a goal include:
o Ignores the time value of money
o Ignores changes in the risk level of the firm
o It leads to exploiting workers and consumers.
o May encourage immoral practices such as corrupt
practice, unfair trade practice, etc.
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9. Wealth maximization goal
 Wealth maximization is one of the modern approaches of FM
goal.
 Wealth is the value of the firm as indicated by the share price
 Share price today is equal to the present value of all future
expected dividends from the shares.
 Value creation occurs when we maximize the share price for
the shareholders
 The strength of value maximization as the goal of financial
management is that it addresses the limitation of profit
maximization goal as it :
 Considers both time and risk of the business
 Considers general economic activity
 Considers conditions in the stock market, Interest rates
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10.  Top three US Companies ranked by wealth
1. Apple
 Market cap: $3.03 trillion
2. Microsoft
 Market cap: $2.43 trillion
3. Alphabet (Google)
 Market cap: $1.62 trillion
P.V. Viswanath
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11. Financial management assumptions, contexts
and principles
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12. Financial management assumptions, contexts and
principles
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 Financial management is studied:
A. Under the assumptions of existence Financial
Markets
B. In the context of corporate form of business
organizations and
C. Under the guidance of the basic principles that form
the financial management

13. A. Financial Management Assumptions- Existence of Financial
Markets
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 Financial management assumes the existence of financial market
 Financial markets:
 are markets that channel funds (savings) to those individuals and
institutions that need more funds for spending .
 Are where debt and equity securities are traded(bought and sold)
 Participants in the financial markets include individuals,
businesses, governments, banks, brokers, insurance companies
 The corporation raises capital in the financial markets by selling
shares and bonds .
 The corporation invests the raised capital in return generating assets
or new projects.
 And finally, the cash flow from those assets/projects are reinvested
in the corporation , given back to the investors(dividend) and paid
to government in the form of taxes.

14. Types of financial Market
A. Based on maturity of financial instrument traded
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(short term note), 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( participants)
1. Primary markets
2. Secondary markets
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15. Types of financial Market -Based on Nature of
transactions
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16. B. In the context of corporate form of business
organizations
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 Financial management theories have developed in the
context of corporate form (share company) of business
organizations due its to characteristics as listed below:
 Advantages
 Limited liability
 Unlimited life
 Separation of ownership
and management
 Transfer of ownership is
easy
 Easier to raise capital(
financial market)
 Disadvantages
 Separation of ownership
and management
 Double taxation (income
taxed at the corporate rate
and then dividends taxed
at personal rate)

17. B. In the context of corporate form of business
organizations-
Types of business organization
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18. Business Organization
 The new Ethiopian Commercial Code recognizes the
following business organization(forms of business
organizations):
1. General partnership;
2. Limited partnership
3. Limited liability Partnership
4. Joint Venture,
5. Private Limited Company
6. One person private limited company
7. Share Company

19. Business Organization
A. General partnership: is a business organization consisting of
partners who are each jointly liable with the partnership itself
for the obligations of the business
B. Limited partnership : comprises partners with different types
of liability፡ general partners who are in full liable
for the obligations of the partnership and limited partners who
are liable for the obligations of the partnership only to the
extent of their capital contributions.
C. Limited liability Partnership: is a business organization
formed by two or more persons to render professional
service in which the liability of partners is limited to the
amount of their contributions.
D. Joint Venture: A joint venture is a business organization
established by
an agreement among two or more persons. It has no legal

20. Business Organization
E. Private Limited Company: a business organization whose
capital is fully paid in advance, divided into shares and whose
members are not liable for the debts of the company provided
that they have paid up their contribution.
 shares of the company shall not be open for
subscription by the public.
F. One person private limited company: is a business
organization incorporated by the unilateral declaration
of a single person
 The Company has its own legal personality separate
and distinct from that of the member
 the member shall not be personally liable for debts due
by the company in so far as he has fully made his
contribution

21. Business Organization
G. Share Company : A share company is a company whose capital is
fixed in advance and divided in to shares and whose liabilities are
met only by the assets of the company.
 The obligation of the shareholders shall be limited to making the
contribution they pledged to make to the company.
 All business organizations other than joint venture shall acquire
legal personality upon registration in the commercial register.
 With the exception of a share company, a business
organization may not issue transferable securities

22. C. Basic principles that form the financial management
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 Are principles that form the foundations of financial
management
1. The Time Value of Money
 A dollar received today is worth more than a dollar received in
the future.
 Because we can earn interest on money received today, it is
better to receive money earlier rather than later.
2. The risk –return trade-off
 In financial decision making, we don’t take additional risk unless
we expect to be compensated with additional return
 Investors demand a high return for taking additional risks.
 The risk– return relationship will be a key concept in the valuation
of stocks and bonds and proposal of new projects for acceptance
 The more risk an investment has, the higher its expected return
will be

23. 3. Don’t Put Your Eggs in One Basket
 Investors can achieve a more favorable trade-off
between risk and return by diversifying their investment
portfolios .
4. Markets are competitive
 If an industry is generating large profits, new entrants are
usually attracted.
 The additional competition and added capacity can result in
profits being driven down to the required rate of return.
5. Efficient Capital Markets
 The markets are quick and the prices are right.
 The values of all assets and securities at any instant in time
fully reflect all available information.
The Core Principles of Finance

24. 6. No Arbitrage
 Arbitrage refers to a trading strategy in which an
investor simultaneously buys and sells the same
asset in different markets at different prices to earn
an instant, risk-free profit.
7. Cash –Not profits –is a king
 In measuring wealth or value , we will consider
cash flows, not accounting profits, because it is
the cash flows, not profits that are actually
received by the firm, relevant for decision making
and can be reinvested .Accounting profits on the
other hand, appear when they are earned rather
than when the money is actually in hand
The Core Principles of Finance

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8. There is Agency Problem
 There is the separation of ownership and
management(control) in corporations.
 The owners (shareholders) cannot control what the
managers do, except indirectly through the board of directors.
 Agency Problems is a conflict of interest between the firm’s
owners(shareholders) and managers.
 In most large companies the managers are not the owners
and they might be tempted to act in ways that are not in the
best interests of the owners.
 For example, they might buy luxurious jets for their travel, or
overindulge in expense-account dinners.
 They might shy away from attractive but risky projects
because they are worried more about the safety of their jobs
The Core Principles of Finance

26. The Agency Problem cont…
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 Agency problems are mitigated by good systems of corporate
governance
 List of good corporate governance arrangements that help to
ensure that the shareholders and managers are working toward
common goals.
a. Legal and Regulatory Requirements: Managers have a legal
duty to act responsibly and in the interests of investors.( SEC in
US, National bank in Ethiopia)
b. Compensation Plans ( Incentive package based on
performance)
c. The Board of Directors: when company performance starts to
slide, and managers don’t offer a credible recovery plan, boards
do act
d. Takeovers. Poorly performing companies are also more likely to
be taken over by another firm. After the takeover, the old
management team may find itself out on the street.
e. Specialist Monitoring. Finally, managers are subject to the

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10. Taxes bias business decisions
 The cash flows we consider are the after-tax incremental
cash flows to the firm as a whole.
10. All risk is not equal
 Some risk can be diversified away, and some cannot
 The process of diversification can reduce risk, and as a
result, measuring a project’s or an asset’s risk is very
difficult.
10. Ethical Behavior Is Doing the Right Thing, and Ethical
Dilemmas Are Everywhere in Finance
 Each person has his or her own set of values, which forms
the basis for personal judgments about what is the right thing
The Core Principles of Finance

28.  END
P.V. Viswanath
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