LESSON ONE: FINANCIAL MANAGEMENT

1.0 Definition: Finance is the art and science of managing money. Financial management is
concerned with duties of financial managers in the business firms, which may include,
budgeting, financial forecast, cash management, credit administration, investment analysis, funds
management etc

1.1FINANCE AND RELATED DISCIPLINES

Financial management is an integral part of overall management. It draws heavily on related
disciplines and fields of study, such as economics, accounting, marketing, production and
quantitative methods.

 Finance and economics

This can be viewed from two areas of economics
i) Macroeconomics
ii) Microeconomic

Macroeconomics is concerned with overall institutional environment in which the firm operates.

It is concerned with institutional structure of the banking system, money and capital markets,
financial intermediaries, monetary, credit and fiscal policies and economic policies dealing with
and controlling level of activities within an economy.

Since business firms operate in macroeconomic environment it is important for financial

managers to understand the broad economic environment.

Specifically they should;

i) Recognize and understand the broad macroeconomic environment

ii) Be versed with fiscal policies and its effect on economic environment
iii) Beware of various financial institutions and markets
iv) Understand the consequences of various levels of economic activity and changes in
economic policy for the decision environment
Microeconomics deal with the economic decisions of individuals and organization. They are
concerned with defining actions that will permit the firms to achieve success. The concepts and
theories of microeconomics relevant to financial management are;

i) Supply and demand relationships and profit maximization strategies

ii) Issues related to the mix of productive factors , optimal sales level and product
pricing strategies
iii) Measurement of utility preference , risk and the determination of value
iv) The rationale of depreciating assets

A knowledge of economics is necessary for a financial manager to understand both financial

environment and the decision theories which underline contemporary financial management.

 Finance and Accounting

Finance and accounting are closely related to the extent that accounting is an important input in
financial decision making though there are key differences between them

Accounting is a sub-function of finance. It generates information / data relating to

operation/activities of the firm. The end product of accounting constitutes financial statements
such as balance sheet, the income statements and statement of changes in financial position.

Information contained in this statements and reports assists financial managers in assessing the
past performance and future direction of the firm in meeting legal obligations such as payment of
taxes etc

Moreover, finance (treasurer) and accounting (controller) activities are typically within the
control of the director (finance/ chief Finance Officer CFO). This functions are closely related
and sometimes overlap.

There are two key differences between finance and accounting

i) treatment of funds
 measurement of funds in accounting is based on accrual principle/ system where revenues
are recognized at the point of sale and not when collected, similarly expenses are
recognized when they are incurred rather than when actually paid
  The view point of finance in relation to treatment of funds is based on cash flows. The
revenues are recognized when actually received in cash (i.e cash inflow) and expenses are
recognized on actual payment (i.e cash outflow).
 This is so because the finance manager is concerned with maintaining solvency of the
firm by providing the cash flows necessary to satisfy its obligations and acquiring and
financing the assets needed to achieve the goal of the firm
ii) Decision Making
The purpose of accounting is collection and presentation of financial data. It provides
consistently developed and easily interpreted data on the past, present and future
operations of the firm. The financial manager uses such data for financial decision
making.
The major responsibility of an accountant is on collection and presentation of data
while financial managers major responsibilities relates to financial planning
controlling and decision making.
 Assignment 1.

“Apart from accounting and economics, finance also draws on supportive disciplines such
as marketing, production and quantitative methods in day to day decision making of a
firm”. Explain (12mks)

Finance is a multifaceted field that plays a critical role in the decision-making process of a firm.
While accounting and economics are foundational to finance, it also draws heavily on supportive
disciplines such as marketing, production, and quantitative methods. This interplay between
finance and these supportive disciplines is essential for effective decision-making within a firm.
Here's an explanation of how these disciplines are interconnected:
Accounting:
Financial Data: Accounting provides the financial data and reports that finance professionals use
to assess the firm's current financial health. This data includes income statements, balance sheets,
and cash flow statements, which are essential for financial analysis.
Economics:
Economic Context: Finance operates within an economic framework. Economic factors like
inflation rates, interest rates, and overall market conditions directly impact financial decisions.
Understanding economic principles helps finance professionals make informed choices about
investments, financing, and risk management.
Marketing:
Revenue Projections: Finance relies on marketing forecasts to estimate future revenues. Accurate
revenue projections are crucial for budgeting, resource allocation, and investment decisions.
Marketing strategies directly influence a firm's financial performance.
Production:
Cost Management: The production department's activities affect the firm's cost structure. Finance
professionals work closely with production teams to optimize cost-efficiency, which is critical
for profitability. Decisions regarding production processes, inventory management, and supply
chain logistics have significant financial implications.
Quantitative Methods:
Risk Assessment: Quantitative methods such as statistics and financial modeling are vital for
assessing and managing financial risks. These tools help finance professionals evaluate
investment opportunities, determine the optimal capital structure, and make informed decisions
about hedging strategies.
Decision Making:
Integration of Disciplines: Finance integrates information from these supportive disciplines to
make strategic decisions. For example, when deciding to launch a new product, finance
professionals consider marketing forecasts, production costs, and potential economic fluctuations
to assess the project's financial viability.
Capital Budgeting:
Project Evaluation: Finance uses quantitative methods to evaluate capital investment projects.
Marketing's input regarding expected sales and production's input regarding costs are crucial for
estimating project cash flows. These inputs are then used in financial models to assess project
profitability and feasibility.
Risk Management:
Hedging Strategies: In managing financial risks, finance professionals often collaborate with
production teams to implement hedging strategies. For example, commodity price fluctuations
can impact production costs, so finance and production teams must work together to mitigate
such risks.
In summary, finance is not an isolated discipline but rather an integral part of a firm's decision-
making process that draws on the expertise of accounting, economics, marketing, production,
and quantitative methods. The collaborative efforts of these disciplines enable finance
professionals to make informed, strategic decisions that optimize a firm's financial performance
and contribute to its overall success.
 1.2 SCOPE OF FINANCIAL MANAGEMENT

It is divided into;

a) Traditional approach
b) The modern approach

 The Traditional Approach

The term corporation finance was used to refer to what is today known as financial
management. The concern of corporation finance was with financing of corporate
enterprises.
The scope of the finance function was treated in a narrow sense of procurement of funds
by corporate enterprise to meet their financial needs
The field of study dealing with finance was treated as encompassing three interrelated
aspects of raising and administering resources from outside. Thus;
i) The institutional arrangements in the form of financial institutions which
comprise the organization of the capital markets
ii) The financial instruments through which funds are raised from capital markets
iii) Legal and accounting relationship between a firm and its sources of finance

The coverage of corporation finance was conceived to the rapidly evolving complex
capital markets institutions, instruments and practices. A related aspect was that firms
required funds for some episodic events such as merger, liquidation, reorganization etc.

Weaknesses of traditional approach

 Issues relating to procurement of funds by corporate enterprise; finance function was

equated to raising and administering funds. No consideration was given to the views of
those who had to make internal financial decisions. It was the outsider looking in
approach. Insider looking out (internal decision making) was ignored.
 The focus was on financing problems of the corporate enterprises. The scope of financial
management was confined only to a segment of industrial enterprises, as non-corporate
enterprises lay outside its scope.
 The treatment was closely built around episodic events. Financial management was
confined to a description of this frequent happenings in the life of the corporation e.g
promotion, incorporation, merger etc. the day to day financial problems of the
corporation did not receive much attention.
 The focus was on long-term financing. Issues involving working capital management
were not a concern of finance function
 Modern Approach

Finance function covers both acquisition and allocation of funds. Apart from the issues
involved in the acquiring of external funds, the main concern of financial management is the
efficient and wise allocation of funds to various uses. It is viewed as integral part of overall
management.

The main content of this approach are

i) What is the total volume of funds and enterprise should commit

ii) What specific assets should an enterprise acquire
iii) How should the funds required be financed
iv) How large should an enterprise be and how fast should it grow
v) In what form should it hold its assets
vi) What should be the composition of its liabilities
The financial manager of a firm is concerned with the solutions of the above
problems relating to investment decision, the financing decision and the dividend
policy decisions

 Investment Decision
It is selection of the assets in which funds will be invested. It can be long-term or short-
term assets. It is concerned with asset mix and the composition of assets of the firm.
Long-term assets yield returns over a period of time in future, while short-term or current
assets are those that in the normal course of the business are converted to cash without
diminution in value, usually within a year.
The long-term assets is popularly known as capital budgeting while short-term assets are
referred to as working capital management.
  Financing decision
It is concerned with financing mix or capital structure or leverage. Capital structure is the
proportion of debt and equity capital. The financing decision of the firm is concerned
with the proportion of this sources to finance investments requirements.

 Dividend policy decisions

Two alternatives are available in dealing with profits of a firm
i) They can be distributed to shareholders in the form of dividends
ii) They can be retained in the business itself

The decision as to which should depend on the dividend pay-out-ratio, i.e. what
proportion of the net profits should be paid out to shareholders. The final decision should
depend upon the preference of the shareholders and the investment opportunity available
within the firm. Factors determining dividend policy should also be considered in
practice.

1.3 Objectives of a Firm.

 Profit maximization

A company is an entity which invests its resources so as to gain maximum profit –this is a
traditional objective of business or cardinal objective. The business must make profits;
i. To give a return to its owners (shareholders)
The return must be satisfactory i.e. higher than the bank rate on savings account. The owners
may pull out of the company if it is making losses.

ii. It must give a reasonable reward to employees –good salaries and benefits.

iii. The company must make profits some of which should contribute to social causes.
Nevertheless this objective cannot be fully achieved under perfect competition as a number of
firms will compete for a limited number of customers; also maximization of profits must not be
done at the expense of customer welfare i.e. the firm should not achieve this objective by
exploiting its customers as it owes them a duty of care.

Under these circumstances, profit is the rational objective because:

1) The profit of the firm became the income of the owner. Maximization of profit then ensured
the self-interests of the owner/manager, who both decide the actions of the firm and ensure that
these are carried out.

(2) The force of competition imposed profit maximization upon the firm to survive in business.
The behavioral assumption of profit maximization has served economic theory well. Because
profit is the difference between revenue and costs, once revenue and costs are identified the
assumption of profit maximization enables predictions to be readily made about the consequence
of any environmental change.

The profit maximization objective of a firm is criticized for the following reasons:

 The concept of profit maximization is vague and narrow.

 It ignores the risk factor, as well as, timing of returns.
 It may allow decisions to be taken at the cost of long-run stability and profitability of the
concern.

 It emphasizes the short-run profitability and short-term projects.

 It may cause to decrease in share price.
 The profit is only one of the many objectives of a modern firm in which the different
stakeholders participate in firm’s success like shareholders, debenture holders, financial
institutions, banks, managers, employees, Government, creditors, suppliers, customers
etc.
 It fails to consider the social responsibility of business, maximization of firm’s profit at
the cost of society is very much short sighted view.

 Wealth Maximization Objective:

Wealth maximization means maximizing the net present value (or wealth) of a course of action.
The net present value of a course of action is the difference between the present value of its
benefits and present value of its costs. A financial action which has a positive net present value
creates wealth and, therefore, is desirable.
A financial action resulting in negative net present value should be rejected. Between a number
of desirable mutually exclusive projects, the one with the higher net present value should be
adopted. The maximization of wealth is possible by making decisions of the firm to get a benefit
that exceeds costs. For long-range planning and management controls, a company establishes its
overall goals.

Because profit is the difference between revenue and costs and profit maximization leads to
wealth maximization of the firm. The separation of ownership from management, the increase in
the intensity of competition has led to the redefinition of profit maximization goal of a firm.

As the owners of the company are its shareholders, the primary financial objective of corporate
finance is usually stated to be maximization of shareholders wealth. Since shareholders receive
their wealth through dividends and capital gains, shareholders wealth will be maximized by
maximizing the value of dividends and capital gains that shareholders receive overtime.

The shareholder wealth maximization goal states that management should seek to maximize the
present value of the expected future returns to the owners of the firm. The present value is
defined as the value today of some future payment or stream of payments, evaluated at an
appropriate discount rate.

The discount rate takes into account the returns that are available from alternative investment
opportunities during a specific future time period. The wealth maximization objective takes into
consideration the time and risk of expected benefits. The difficulty arises in selecting appropriate
rate for discounting future cash flow.

If greater risk is associated with receiving of future economic benefit, the higher the discount rate
is adopted and it lowers the value of investor’s wealth. Since an organization is a coalition of
groups viz., owners, managers, employees, suppliers, customers, Government etc., maximization
of wealth is not just for shareholders but for all the stakeholders in the firm.

The wealth maximization goal is advocated on the following grounds:

(a) It takes into consideration long-run survival and growth of the firm.
(b) It is consistent with the object of owner’s economic welfare.

(c) It suggests the regular and consistent dividend payments to the shareholders.

(d) The financial decisions are taken with a view to improve the capital appreciation of the share
price.

(e) It considers the risk and time value of money.

(f) It considers all future cash-flows, dividends and earnings per share.

(g) Maximization of firm’s value is reflected in the market price of share, since it depends on
shareholders’ expectations as regards profitability, long-run prospects, timing differences of
returns, risk, distribution of returns etc. of the firm.

(h) Profit maximization partly enables the firm in wealth maximization.

(i) The shareholders always prefer wealth maximization rather than maximization of inflow of
profits.

The wealth maximization objective of a firm is criticized as narrow and it ignores the concept of
wealth maximization of society, since society’s resources are used to the advantage of a
particular firm. The society’s resources should be optimally allocated, it should result in capital
formation and growth of the economy, which ultimately leads to maximization of economic
welfare of the society.

The welfare to the people is gauged through optimum utilization of resources, reasonable prices
of goods made available to society, supply of quality products, payment of taxes to the
Government, contentment of suppliers, meeting the financial obligations in time, repayment of
principal and interest of loans to banks and financial institutions etc.

Value Maximization Objective:

The goal of firm is to maximize the present wealth of the owners i.e., equity shareholders in a
company. A company’s equity shares are actively traded in the stock markets, the wealth of the
equity shareholders is represented in the market value of the equity shares.

The prime goal for company form of organization is to maximize the market value of equity
shares of the company. The market price of a share serves as an index of the performance of the
company. It takes into account present and prospective future earnings per share, risk associated
with the business, dividend and retention policies of the firm, level of gearing etc.

The shareholder’s wealth is maximized only when the market value of the share is maximized. In
the present context, the term ‘wealth maximization’ of financial management is redefined as
‘value maximization’. The objective of maximizing economic welfare of shareholders is
achieved through maximization of their wealth. The maximization of utility value of
shareholders can be achieved by maximizing their economic welfare.

In company form of business, the wealth created is reflected in the market value of its shares.
Therefore, the financial decisions will cause to create wealth and it is indicated or reflected in
market price of company’s shares. Hence the prime objective of financial management is to
maximize the value of the firm.

 Other Maximization Objectives:

 Sales Maximization Objective:

The interests of the company are best served by the maximization of sales revenue, which brings
with it the benefits of growth, market share and status. The size of the firm, prestige, and
aspirations are more closely identified with sales revenue than with profit.

 Growth Maximization Objective:

Managers will seek the objectives which give them satisfaction, such as salary, prestige, status
and job security. On the other hand, the owners of the firm (shareholders) are concerned with
market values such as profit, sales and market share.
These differing sets of objectives are reconciled by concentrating on the growth of the size of the
firm, which brings with it higher salaries and status for managers and larger profits and market
share for the owners of the firm.

 Maximization of ROI:

The strategic aim of a business enterprise is to earn a return on capital. If in any particular case,
the return in the long-run is not satisfactory, then the deficiency should be corrected or the
activity be abandoned for a more favorable one. Measuring the historical performance of an
investment center calls for a comparison of the profit that has been earned with capital employed.

The rate of return on investment is determined by dividing net profit or income by the capital
employed or investment made to achieve that profit. Return on investment analysis provides a
strong incentive for optimal utilization of the assets of the company.

This encourages managers to obtain assets that will provide a satisfactory return on investment
and to dispose of assets that are not providing an acceptable return. In selecting amongst
alternative long-term investment proposals, ROI provides a suitable measure for assessment of
profitability of each proposal.

 Social Objectives:

The business enterprise is an integral part of the functioning of a country. As such, in return for
the privileges and rights granted to it by the state, the business firm should be made increasingly
responsible for social objectives.

 Group of Objectives:

According to Cyert and March, the firm as an organization is not a unified structure but a
coalition of individuals, some organized into groups, each with varying interests and objectives,
and they have the following five objectives of a firm:

a. Production Goal:
This would ensure that output neither fluctuated widely nor fell below some previously
determined minimum acceptable level.

b. Inventory Goal:

Sufficient stocks of raw materials, components and finished goods should be held to ensure that
production is uninterrupted by shortages and that there is enough stock to satisfy customer needs.

c. Sales Goal:

The management of the firm, and particularly those responsible for marketing, are both

Judged and judge themselves by the ability to maintain and expand sales levels.

d. Market Share Goal:

Market share should not fall below an acceptable level. As a performance indicator market share
is easily measured, and often used by shareholders.

e. Profit Goal:

Sufficient profit must be made to be able to finance capital investments and to distribute as
dividends to shareholders.

The profits are not merely an objective, they are the very reason for the existence of the business
enterprise. The assumption of profit maximization has the enormous advantage of enabling
decisions to be modelled. But at the same time non-profit maximizing theories cannot be
ignored.

Non- Financial Objectives

1. Welfare of employees. A firm should make good remuneration to the human resource. This
may involve provision of good training to employees as well as career development skills.
2. Welfare of the management. Improving management's welfare may include providing good
salary packages, enrolment to entertainment facilities and provision of good transport
mechanism.
3. Welfare of society. Organizations do not operate in a vacuum. Therefore, firms must be
involved in social activities for the benefit of the society.
4. Welfare of the government. Firms should pay taxes to the government and adhere to the rules
of the country.
5. Welfare of customers and suppliers. An organization should always satisfy customers and
suppliers since they are the main stakeholders of the organization.
6. Business ethics. Firms should practice human behavior which is acceptable and considered
ideal. For example, firms ought to practice healthy

1.4 AGENCY THEORY

An agency relationship may be defined as a contract under which one or more people (the
principals) hire another person (the agent) to perform some services on their behalf, and delegate
some decision making authority to that agent. Within the financial management framework,
agency relationship exist between:

(a) Shareholders and Managers

(b) Debtholders/creditors and Shareholders

 Shareholders versus Managers

A Limited Liability company is owned by the shareholders but in most cases is managed by a
board of directors appointed by the shareholders. This is because:

i) There are very many shareholders who cannot effectively manage the firm all at the same
time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.

Conflict of interest usually occur between managers and shareholders in the following ways:
i) Managers may not work hard to maximize shareholders wealth if they perceive that they
will not share in the benefit of their labour.
ii) Managers may award themselves huge salaries and other benefits more than what a
shareholder would consider reasonable
iii) Managers may maximize leisure time at the expense of working hard.
iv) Manager may undertake projects with different risks than what shareholders would
consider reasonable.
v) Manager may undertake projects that improve their image at the expense of profitability.
vi) Where management buy -out is threatened. Management buy- out occurs where
management of companies buy the shares not owned by them and therefore make the
company a private one.

Solutions to this Conflict

In general, to ensure that managers act to the best interest of shareholders, the firm will:

(a) Incur Agency Costs in the form of:

i) Monitoring expenses such as audit fee;

ii) Expenditures to structure the organization so that the possibility of undesirable
management behaviour would be limited. (This is the cost of internal control)
iii) Opportunity cost associated with loss of profitable opportunities resulting from
structure not permit manager to take action on a timely basis as would be the case if
manager were also owners. This is the cost of delaying decision.

(b) The Shareholder may offer the management profit-based remuneration. This remuneration
includes:
i) An offer of shares so that managers become owners.
ii) Share options: (Option to buy shares at a fixed price at a future date).
iii) Profit-based salaries e.g. bonus
(c) Threat of firing: Shareholders have the power to appoint and dismiss managers which is
exercised at every Annual General Meeting (AGM). The threat of firing therefore
motivates managers to make good decisions.
(d) Threat of Acquisition or Takeover: If managers do not make good decisions then the value
of the company would decrease making it easier to be acquired especially if the predator
(acquiring) company beliefs that the firm can be turned round.

 Debt holders versus Shareholders

A second agency problem arises because of potential conflict between stockholders and creditors.
Creditors lend funds to the firm at rates that are based on:

i. Riskiness of the firm's existing assets

ii. Expectations concerning the riskiness of future assets additions

iii. The firm's existing capital structure

iv. Expectations concerning future capital structure changes.

These are the factors that determine the riskiness of the firm's cashflows and hence the safety of its
debt issue. Shareholders (acting through management) may make decisions which will cause the
firm's risk to change. This will affect the value of debt. The firm may increase the level of debt to
boost profits. This will reduce the value of old debt because it increases the risk of the firm.

Creditors will protect themselves against the above problems through:

iv) Insisting on restrictive covenants to be incorporated in the debt contract.

These covenants may restrict:
 The company’s asset base
 The company’s ability to acquire additional debts
 The company’s ability to pay future dividend and management remuneration.
 The management ability to make future decision (control related covenants)
a. If creditors perceive that shareholders are trying to take advantage of them in unethical ways,
they will either refuse to deal further with the firm or else will require a much higher than
normal rate of interest to compensate for the risks of such possible exploitations.
It therefore follows that shareholders wealth maximization require fair play with creditors. This is
because shareholders wealth depends on continued access to capital markets which depends on fair
play by shareholders as far as creditor's interests are concerned.