Financial management slide material.

1. A dvANCED FINANCIAL
MANAGEMENT

2. C HAPTER ONE
OVERVIEW OF FINANCIAL
MANAGEMENT

3. Accounting
• Is a financial information system, is a
process of identifying, recording, and
communicating the economic events of
an organization or non-
financial
business)
statements
(business
that preparing
to interested users for
decision making

4. Communication
Accomplished by
Reporting
The Accounting
Process:
Accomplished by
storage & preparation of
data
Decision makers
Economic
Activities:
Actions
(decisions)
Accounting
“links” decision
makers with
economic
activities  and
with the results of
their decisions.

5. Financial Management and its Roles
Financial Management is the study of
methods which help us plan, raise and
use firms’ financial resources of an
organization in an efficient and effective
manner to achieve corporate objectives.

6. Con’t..
• Financial management can be defined
as the management of capital
sources and their uses so as to
attain the desired goal of the firm
(maximizations of share holders
wealth)

7. Financial
Management
Production mgt
Purchasing mgt
Human
Resource mgt
Customers mgt Marketing mgt
R & D Technology
Quality mgt
Central Role of Financial Management

8. Goals of Financial Management
• Possible goals
– Maximize Profit
– Maximize sales or market share
– Minimize cost
– Maintain Growth
– Survival
– Avoid financial distress and Bankruptcy
– Shareholders Wealth Maximization

9. Types of Businesses
1. Manufacturing businesses change basic
inputs into products that are sold to
individual customers
2. Merchandising businesses also sell
products to customers. However, rather
than making the products, they purchase
them from other businesses (such as
manufacturers).
3. Service businesses provide services
rather than products to customers.

10. Business Goals, Activities, & Performance Measures
A business is an economic unit that aims
to sell goods and services to customers at
prices that will provide an adequate
return to its owners.
Businesses, though diverse, have similar
goals and engage in similar activities.

11. (Business Goals, Activities Cont’d)
Business Goals
1. Profitability
A business must take in enough money to pay all
the costs of doing business, with enough left over
as profit for the owners to want to stay in business.
2.Liquidity
A business must have enough funds available to pay
debts when they are due.

12. (Business Goals, Activities Cont’d)
Business
Goals
Business
Activities
Profitability
Liquidity
Financing Operating
Investing

13. (Business Goals, Activities Cont’d)
Business Activities
1) Financing Activities:
 Obtaining capital from owners and creditors
 Repaying creditors and a return to owners.
2) Investing Activities:
 Spending the capital it receives in ways that are productive
and will help the business achieve its objectives.
 Buying and selling long-term assets to be used in the
business.
1) Operating Activities:
 Selling of goods and services to customers.
 Employing managers and workers, buying and producing
goods and services, and paying taxes.

14. Goals of financial management
There are two basic goals of financial management
 Profit maximization and
 Wealth Maximization
1. Profit maximization
 is maximizing the birr or any other currency such as dollar
income of the firm.
 According to this approach, actions that increase profits should
be undertaken and actions that decrease profits are avoided.
15

15. Cont…
To maximize profit , a firm either produces maximum out puts
for a given level of input or use of minimum input for
producing a given out put.
Limitations of profit maximization
1. Ambiguity:
It is ambiguous and vague, which profit should be maximized
2. Timing of benefits:
It does not consider time value of money.
It ignores that the difference in time pattern of the benefits
received from investment proposals or course of actions.
16

16. Cont..
• Decision is made based on the total profits received from
the working life of the asset irrespective of where they were
received.
3. Quality of benefits
• It does not consider the quality of benefits.
• The term quality here refers the degree of certainty with
which benefits can be expected.
• As a result the more certain the expected return, the higher
the quality of benefits and vice versa.
17

17. Wealth(value) maximization
 This is also known as value maximization or net present worth
maximization
 The modern financial management theory operates on the
assumption that the primary goal of a firm to maximize wealth of
share holders
 It is concerned with the maximization of the price of the firms
common stock.
 With in this assumption all the technical limitations of profit
maximization removes.
18

18. Finance
 Virtually all individuals and organizations earn or
raise money and spend or invest money.
 Finance is concerned with the process, institutions,
markets, and instruments involved in the transfer
of money among individuals, businesses and
governments.
 The general areas of finance are business, personal
and public finance.
 Finance is important to individuals, business and
government to achieve their economic objectives.

19. Cont’d
 Finance plays a pivotal role to everyone in general, for
individuals to earn and invest money; for business to raise and
invest funds; and to the government to plan expenses and
incomes, to execute goals of government and to achieve
development of a country.
 FINANCE uses accounting information as inputs to decision-
making.
 The study of how to raise money and invest it productively.

20. Financial management defined:
 It is an integral part of overall management. concerned
with the efficient use of an important economic resource
namely, capital funds”
 “Financial Management deals with procurement of
funds and their effective utilization in the business”
 In simple words, Financial Management as practiced by
business firms can be called as corporation Finance or
business Finance.
Cont’d

21. There are five broad areas of financial decision making in
a firm. These are:
1. Investment decisions (Capital budgeting)
2. Financing decisions (capital structure)
3. Asset management( resources allocation )
4. Liquidity decisions (working capital
management/short term asset mix decision)
5. Dividend decisions
Scope of Financial Management/
Financial decisions in a firm/

22.  Afirm’s investment decisions involve capital expenditures.
 They are, therefore, referred as capital budgeting decision.
 Capital investment is the allocation of capital to investment
proposals
 Involves commitment of funds to long term assets that would
yield long term benefits
 Two important aspects of investment decision are:
1. The evaluation of the prospective profitability of new
investment, and
2. The measurement of a cut-off rate against that the prospective
return of new investments could be compared.
 Investment proposal should be evaluated in terms of both expected
return and risk.
1. Investment decisions:

23.  Once a firm has decided the investment projects it wants to
undertake, it has to figure out ways and means of financing
them.
 This is the function of raising funds.
 The central issue here is to determine the appropriate
proportion of equity and debt; the mix of debt and equity is
called capital structure.
 The financial manager must strive to obtain the best financing
mix or the optimum capital structure.
 The use of debt affects the return and risk of shareholders; it
may increase the return on equity funds, but it always increases
risk as well.
2. Financing decisions:

24.  Once a firm has get the required finance it wants to
undertake, it has to figure out ways and means of
allocating the finance in to current and long term
asset as well as efficient utilization of the finance to
achieved its stated objective or goal of the business .
 This is the function of classified in to current and
long term/plan assets .
 The financial manager must strive to obtain the best
assets mix
3. Asset management decisions:

25. Also referred as short term financial management that deals with
current assets and current liabilities.
Investment in current assets affect the firm’s profitability and
liquidity.
Current assets should be managed efficiently for safeguarding the
firm against the risk of illiquidity.
If the firm does not invest sufficient funds in current assets, it may
become illiquid and therefore, risky; but it would lose profitability,
as idle current assets would not earn anything.
Conflict exists between profitability and liquidity while managing
current assets and hence it deals with proper trade-off between
liquidity and profitability.
4. Capital management (Liquidity)
decision:

26.  The financial manager must decide whether the firm should
distribute all profits, or retain them or distribute a portion and
retain the balance.
 The proportion of profits distributed as dividends is called the
dividend payout ratio and the retained portion of profit is
known as the retention ratio.
 The optimum dividend policy is that one maximizes the
market value of the firm’s shares
5. Dividend Decision

27. Business Organizations in Ethiopia
1. Sole proprietorship
2. Partnerships ( 1960 Commercial code, Art. 212)
– Ordinary Partnership
– Joint Venture
– General partnership
– Limited partnership
3. Companies (1960 Commercial code, Art. 212)
–
–
Private Limited Companies (PLCs)
Share Companies
4. Cooperatives (Unions)
5. Public Enterprises

28. The Role Of The Financial Manager
• Business Finance Questions
1. What long-term investments should you make
• Examples: machinery, new plants, new products,
buildings
2. Where will you get the long-term financing?
• Profits? Equity? Debt?
3. Short-term cash management
– How will you collect from customers and pay your bills?
– How do we manage the day-to-day finances of the firm?
•Financial managers try to answer some, or all, of these questions
•The top financial manager within a firm is usually the Chief
Financial Officer (CFO)

29. 1-39
Financial Managers
•Two more officers under Chief
Financial Officer (CFO):;-
1. treasurer(financing function
2. controller(accounting
functions)—
T
reasurer:Oversees cash management,
credit management,capitalexpenditures,
and financial planning
Controller:Oversees taxes,cost
accounting,financial accountingand data
processing

30. 4
0
Treasurer
Capital Budgeting
Cash Management
Credit Management
Dividend
Disbursement
Fin Analysis/Planning
Pension Management
Insurance/Risk Mngmt
Controller
Cost Accounting
Cost Management
Data Processing
General Ledger
Government Reporting
Internal Control
Preparing Fin Stmts
Preparing Budgets
Preparing Forecasts
Treasurer responsibilities(
FINANCE):
The treasurer’s function is to
raise and manage company
funds
Controller responsibilities
(ACOUNTING):
controller oversees
whether funds are
correctly applied

31. Corporate Organization Chart
1-41

32. Cash Flows Between the Firm and the Financial Markets
Figure 1.2

33. Financial Markets and The
Corporation
 Primary versus Secondary Markets
 Primary Market: the original sale of securities by
governments and corporations.
 Method of raising capital in primary market
a. Initial Public Offering (IPO) – the first time issued in
market to the public
b. In right issue: Offering of securities may be made
only to the existing shareholders.
c. Private Placements – a negotiated sale involving a
specific buyer
 Secondary Markets: these securities are bought and
sold after the original sale.

34. Social Responsibility
Shareholder Wealth Maximization is beneficial for the society:
Stock price maximization requires:
1. Company to produce high quality goods and services at the lowest possible
cost.
2. produce goods needed by people  so new technology, new products
3. Requires effective services, adequate stocks of merchandise and good
business location.
•Firms should provide a safe environment, avoid air pollution and
produce safe products. Unless Incentives against for firms to act in a
socially responsible manner are:
– Disadvantage in attracting funds due to extra costs incurred
– Inability to compete due to higher prices of products
– Constraints by capital market factors
•Therefore…Social Responsibility actions should be enforced on a
mandatory rather than a voluntary basis
Stock Price Maximization and Social Welfare

35. Agency Problems: Managers Versus Shareholders’ Goals
• The separation of management and the ownership of the firm
creates an agency problem.
• Stockholders (principals) hire managers (agents) to run the
company and maximize share holders wealth
– In theory managers should act in the best interest of
shareholders ; that is their action and decisions should lead to
shareholders’wealth maximization.
• In practice, managers may maximise their own wealth in the
form of high salaries and bonus) at the cost of shareholders
or may play safe and create satisfactory wealth for
shareholders than the maximum.
– This Conflict of interest between shareholders and agent
is Agency problem
• Example–A decision to retain suppliers rather than selecting
45new suppliers providing higher quality or lower cost

36. How to Reduce Agency Problems?
1. Monitoring
(Examples: Reports, Meetings, Auditors, board of
directors, financial markets, bankers, credit agencies)
2. Compensation plans
(Examples: Performance based bonus, salary, stock
options, benefits)
3. Others
(Examples: Threat of being fired, Threat of takeovers,
Stock market, regulations
The above will help to reduce agency problems/costs.

37. Ten Principles That Form The
Foundations of Financial Management
• “…although it is not necessary to understand
finance in order to understand these principles, it
is necessary to understand these principles in
order to understand finance.”

38. Financial Management Axioms
• 1) Time value of money
• 2) Risk - return trade-off
• 3) Cash - not profits - is king
• 4) Incremental cash flows count
• 5) The curse of competitive markets
• 6) Efficient capital markets
• 7) The agency problem
• 8) Taxes bias business decisions
• 9) All risk is not equal
• 10) Ethical dilemmas are everywhere in finance

39. PRINCIPLE 1: Time Value of Money.
• A dollar received today is more valuable than a
dollar received in the future because of opportunity
cost/
–Because we can earn interest on money
received today, it is better to receive money
earlier rather than later.
–Thus, in the future, you will have more than
one dollar, as you will receive the interest
on your investment plus your initial invested
dollar.

40. PRINCIPLE 2: Risk-Return Trade-off.
• We won’t take additional risk unless we expect to be compensated
with additional return.
• We only take risk when we expect to be compensated for (the extra
risk) with additional return.
• The higher the risk, the higher will be the expected return.
– Realized return >=< Expected return
🗸1st Choice = Buy T-bills
🗸2nd Choice = Buy stocks
Application of Risk-Averse Behavior
Consider the following Alternatives:
Choice Expected Return Risk Units
A 10% 20
B 10% 25
C 16% 25 3.
1. Comparing A & B, which
would you choose?
2. Comparing B & C, which
would you choose?
Comparing A & C, which
would you choose?

41. Principle 3: Cash—Not Profits—Is King
Cash Flows Are The Source of Value.
• Cash Flow, not accounting profit, is used as our
measurement tool.
• Cash flows, not profits, are actually received by the firm
and can be reinvested.
Profit:-
• Profit is an accounting concept used to measure business
performance over an interval period.
• Cash flow is the amount of cash that can actually be taken out of the
business over this same interval.

42. Principle 4: Incremental Cash Flow
• Financial decisions in a firm should consider
“incremental cash flow” i.e. the difference between
the cash flows the company will generate with the
potential new investment and what it would make
without such investment.
– Project A = Existing product
– Project B = New product

43. Principle 5: Efficient Capital Markets
: Market Prices Reflect Information.
• The values of all assets and securities at any instant in time fully
reflect all available information.
• Price adjustments to new information is quick and
correct
• Investors respond to new information by buying and selling
securities.
– Investors in stock markets tend to react positively to good decisions or
good news made by the firm resulting in higher stock prices.
– Whereas stock prices tend to decrease when there is bad news about the
firm.
– Thus, the market prices of stocks reflect information.

44. Principle 6: 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.
• Diversification Eliminates Certain Type of Risk
– Diversifiable/Firm Specific/Unsystematic Risk
– Non-diversifiable/Market/Systematic Risk

45. Principle 7. Curse of Competitive Markets
• It is hard to find exceptionally profitable projects
• 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.
– Product Differentiation, Service and Quality can
insulate products from competition

46. 8 The Agency Problem
• Managers won’t work for the owners unless it is in
their best interest
• The separation of management and the ownership of
the firm creates an agency problem.
– Managers may make decisions that are not in line with the
goal of maximization of shareholder wealth.

47. 9. Taxes Bias Business Decisions
• The cash flows we consider are the
after-tax incremental cash flows to
the firm as a whole.

48. Principle 10:- Ethics in Finance
• What do we mean by ethics?
– Acting in an ethical manner morally correct
– Ethics is a necessary ingredient to long-term
business and personal success
– To maximize shareholders’ wealth, corporation
must conduct its business in an ethical way.

49. END OF THE CHAPTER
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