Unit 1

The nature and scope of financial management

What Is Finance?
Finance is a distinct area of study that comprises facts, theories, concepts, principles, techniques and
practices related with raising and utilizing of funds (money) by individuals, businesses, and governments.
Finance is a very wide and dynamic field of study. It directly affects the decisions of all individuals and
organizations that earn or raise money and spend or invest it. Therefore, finance is also an area of study that
deals with how, where, by whom, why, and through what money is transferred among and between
individuals, businesses, and governments. It is concerned with the processes, institutions, markets, and
instruments involved in the transfer of funds.
Finance can also be defined as the art and science of managing money.
Major Areas of Finance
There are several ways to summarize the major areas of finance. One way is to review the career
opportunities under it. Another way is based on the differences in the objectives of different organizations.
The career opportunities again can be divided into
i) Financial Services:-Comprise
Services:-Comprise of various functions and services that are provided by financial
institutions in a financial system.
ii) Financial Management is
-The management of the finance of an organization in orders to achieve the financial objective of an
organization.
-The management of capital source and uses in order to maximize the wealth of stockholders.
-It is the management activity which involves the planning and controlling the firm’s financial resources.
Reason for study of Financial Management (Why Study Financial Management)?
Many business decisions made by firms have financial implications. Accordingly, financial management
plays a significant role in the operation of the firm. People in all functional areas of a firm need to
understand the basics of financial management. Accountants, information systems analysts, marketing
personnel and people in operations, all need to be equipped with the basic theories, concepts, techniques,
and practices of managerial finance if they have to make their jobs more efficient and achieve their goals.
That is why the course Financial Management is offered to students in the fields of accounting,
management, business administration, and management information’s systems.
HISTORICAL DEVELOPMENT OF FINANCIAL MANAGEMENT
Finance emerged as a field separate and distinct from economics around 1900. The first major focus of
financial management during its early years of development was the menses how large corporations of the
time could raise capital. This was a period when the establishment of very large companies like the
Rockefeller oil and Morgan steel was marked.
The economic depression of the 1930s made financial management to shift to topics like preservation of
capital, maintenance of liquidity, reorganization of financially troubled companies, and the bankruptcy
process.
Until 1950s, the study of financial management had been descriptive or definitional in nature. But in the
mid 1950s, more analytical, decision – oriented approach began to evolve. These include capital budgeting,
cash and inventory management, capital structure formulation, and allocation of income as dividends and
retained earnings.
Starting the late 1960s, the primary focus of financial management has been on the relationships between
risk and return of a firm’s financial decision. That is financial management has focused on the
maximization of earnings (return) for a given level of risk; or minimization of risk for a given level of
return.
SCOPE OF FINANCIAL MANAGEMENT
The scope of financial management refers to the range or extent of matters being dealt with in financial
management.
Traditionally, financial management was viewed as a filed of study limited to only raising of money. Under
the traditional approach, the scope and role of financial management was considered in a very narrow sense
of rising of funds from external sources. Internal financial decision makings as cash and credit
management, inventory control, capital budgeting were ignored.
However, the modern or contemporary approach views financial management in a broad sense. Unlike the
old approach, here, the financial manager’s role includes both acquiring of funds from external sources and
allocating of the funds efficiently within the firm thereby making internal decisions.
THE FUNCTIONS OF FINANCIAL MANAGEMENT
The functions of financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.
The finance function mainly deals with the following three decisions:

1. Investment Decision.
2. Financing Decision.
3. Dividend Decision.
The optimal combination of these finance functions will maximize the value of the firm to its shareholders.
 Investment
Decisions
Return

Financing Market Value

Decisions of the firm

Risk

Dividend
Decisions

1. Investment Decision
These decisions are concerned with the management of assets by allocating and utilizing funds within the
firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total amount of the firm’s finance
to be invested in current and fixed assets.
ii) Determining the asset type: - determining which specific assets to maintain within the
categories of current and fixed assets.
iii) Managing the asset structure,
structure, i.e., maintaining the composition of current and fixed assets and
the type of specific assets under each category.
The investment decisions of a firm also involve working capital management and capital budgeting
decisions.
Generally, the investment decisions of a firm deal with the left side of the basic accounting equation: A = L
+ OE (Assets = Liabilities + Owners’ Equity).
2. Financing Decisions
The financing decisions deal with the financing of the firm’s investments, i.e., decisions whether the firm
should use equity or debt funds in order to finance its assets. The financing decisions of a firm are
generally concerned with the right side of the basic accounting equation. A = L + OE
3. Dividend Decisions
The dividend decisions address the question how much of the cash a firm generates from operations should
be distributed to owners in the form of dividends and how much should be retained by the business for
further expansion.
GOAL OF FINANCIAL MANAGEMENT
Recall that financial management is concerned with decision making to achieve the goal of a firm. But the
question is what the goal of a firm is? Before trying to address the question, let us first describe the
meaning of a goal.
A goal or an objective provides a framework for the decision maker. In most cases, the goal is stated in
terms of maximizing or minimizing some variable. A goal, therefore, is an explicit operational guide or
decision rule for the decision maker.
A firm might have a number of alternative goals at a point in time when evaluating a given course of
action. These goals include maximization of profits, size, value, social welfare or minimization of costs,
risk etc.
CHARACTERISTICS OF A GOOD GOAL
-It is clear and unambiguous
-It provides a clear and timely measure to evaluate the success or failure of decisions.
-It does not affect the specific benefits of a firm.
- It does not affect the welfare of the society.
- It is based on long-term success of the firm.
The goal of financial management is
-Profit maximization:-
maximization:- Maximizing the dollar profit of the firm.
-Maximizing earnings per share:-
share:- Maximizing earnings of individual’s shares.
-Shareholders wealth maximization:-
maximization:- Maximizing market value of the firm.
PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION
Profit Maximization:- is a single period or at most a short term goal to be achieved. Under the profit
maximization decision actions that increase profit of a firm should be undertaken; and actions that
decrease profit should be rejected.
Limitations of Profit Maximization
1. Ambiguity. The term profit or income is vague and ambiguous concept.
2. Cash flows. The profit a firm has reported does not represent the cash flows to the business.
Firms reporting a very high total profit or earnings per share might face difficulty of paying cash
dividends to stockholders. Sometimes, companies might even declare bankruptcy though reporting a
positive income
3. Timing of Benefits. The profit maximization criterion ignores the differences in the time pattern of
benefits received from investment proposals. In other words, the profit maximization ignores the time value
of money, i.e., money today is better than money tomorrow. Example ABC Company wants to choose
between two projects: project X and project Y. both projects cost the same, are equally risky and are
expected to provide the following benefits over three years period.

BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 50,000 50,000
3 –0- 25,000
TOTAL Br. 75,000 Br. 75,000

The profit maximization criterion ranks both projects as being equal. However, project X provides
higher benefits in earlier years and project Y provides larger benefits in latter years.
4. Quality of Benefits (Risk of Benefits). Profit maximization assumes that risk or uncertainty of future
benefits is of on concern to stockholders. Risk is defined as the probability that actual benefit will differ
from the expected benefit. Financial decision making involves a risk-return trade-off. This means that
in exchange for taking greater risk, the firm expects a higher return. The higher the risk, the higher the
expected return. Example ABC Company must choose between two projects. Both projects cost the
same. Project A has a 50% chance that its cash flows would be actual over the next three years. Project
B, on the other hand, has a 90% probability that its cash flows for the next three years would be
realized.

BENEFITS

YEAR PROJECT A PROJECT B

1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000
Under profit maximization, project A is more attractive. However, if we consider the risk of the two
projects, the situation would be reversed.
Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000
Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000
The more certain the expected cash flow (return), the higher the quality of benefits (i.e., low risk to
investor). Conversely, the more uncertain or fluctuating the expected benefits, the lower the quality of
benefits (i.e., high risk to investors).
Exercise 1.
The following two projects that are having equal cost but with different variability in expected returns.
BENEFITS
YEAR PROJECT C PROJECT D
1 Br. 2,700 Br. – 0 –
2 3,000 3,000
3 3,300 6,000
TOTAL Br. 9,000 Br. 9,000

1. Which project is preferable under profit maximization criterion?

2. Which project is more risky?
Wealth Maximization:-is a long term goal. Wealth maximization means maximizing the net present value
(NPV) and it accounts for time value of money and risk.
Operational features of Wealth maximization is:-
-Measuring benefits in terms of cash flows avoid the ambiguity.
-It considered the quality and the time value of money.
Wealth maximization as a decision rule involves a comparison of value to cost. Thus, an action that has a
discounted value that exceeds its cost can be said to create value and such action should be undertaken.
Whereas an action with less discounted value than cost reduces wealth and, therefore, should be rejected.
The discounted value is a value which takes risk and timing of benefits into account.
Limitations of Wealth Maximization
1. If wealth maximization is taken as the sole decision rule, there is a possibility that the benefits of
the society at large might be forgone.
2. When managers of a corporation are from owners, there is a potential for a conflict of interest
between them.
 3. When the goal of a firm is stated in terms of stockholders wealth, actions that increase the wealth of
stockholders could be taken as the expense of other stakeholders like debthodlers.
4. Wealth maximization is normally reflected in the firm’s stock price. But if there are inefficiencies
in financial markets, wealth maximization decision rule may lead to misallocation of scarce
resources.
Agency problem

Owners –managers have no conflict of interest in their management of the business, because they work
themselves. In most large companies the manager are not the owners & they might be tempted to act in
ways that are not in the best interest of the owners .This is called agency problem.
-Agency problem is the possibility of conflict of interest between the corporation’s (owners) &
management of the firms.
-Agency problems are the likelihood that mangers may place their personal goals a head of corporate
goals.
Corporations (owners) are aware of these agency problems and they incur some costs as a result of agency.
These costs are called agency cost and include:
 Monitoring expenditures – are expenditures incurred by corporations to monitor or control the
activities of managers.
 Bonding expenditures – are cost incurred to protect dishonesty of mangers and other employees of
a firm.
 Structuring expenditures – expenditures made to make managers fell sense of ownership to the
corporation.
 Opportunity costs – unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as a result
of their organizational structure and hierarchy.
FINANCE AND RELATED FIELDS
Though finance had ceded itself from economics, it is not totally an independent field of study. It is an
integral part of the firm’s overall management. Finance heavily draws theories, concepts, and techniques
from related disciplines such as economics, accounting, marketing, operations, mathematics, statistics, and
computer science. Among these disciplines, the field of finance is closely related to economics and
accounting.
Finance versus Economics
Economics is the mother field of finance. The economic environment within a firm operates influences the
decisions of a financial manger. A financial manger must understand the interrelationships between the
various sectors of the economy. He must also understand such economic variables as a gross domestic
product, unemployment, inflation, interests, and taxes in making financial decisions.
Basic Differences between Finance and Economics
 Finance is less concerned with theory than is economics. Finance is basically concerned with the
application of theories and principles.
 Finance deals with an individual firm; but economics deals with the industry and the overall level of
the economic activity.
Finance versus Accounting
Accounting provides financial information through financial statements. Therefore, these two fields are
closely linked as accounting is an important input for financial decision-making. Besides, the accounting
and finance functions generally overlap; and usually it is difficult to distinguish them. In many situations,
the accounting and finance activities are within the control of the financial manager of a firm.
Basic Differences between Finance and Accounting
i) Treatment of income: - in accounting income measurement is on accrual basis. Under this
method revenues are recognized as earned and expenses as incurred. In finance, however, the
cash method is employed to recognize the revenue and expenses.
ii) Decision-making: - the primary function of accounting is to gather and present financial data.
Finance, on the other hand, is primarily concerned with financial planning, controlling and
decision-making.
iii) Accounting is highly governed by generally accepted accounting principles.
AN OVERVIEW OF THE FINANCIAL ENVIRONMENT
Finance people must understand not only the internal environment, but also the financial environment and
markets within which the firm operates. They need to know where capital required is raised, where the
financial instruments are traded, and how stock prices are determined.
Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms that facilitate the
transfer of funds from savers to demanders of capital. They accept savings from customers and lend this
money to other customers or they invest it. In many instances, they pay savers interest on deposited funds.
In some cases, they impose service charges on customers for the services they render. Example commercial
bank, savings and loan associations, credit union, pension funds, life insurance Company etc.
Financial Instruments
Financial instruments are written and formal documents of transferring funds between and among
individuals, businesses, and governments. They include loans and borrowing contracts, promissory notes,
commercial papers, treasury bills, bonds, and stocks.
Under normal circumstances, two parties are involved in any financial instrument. For holders, who have
invested their money and the issuer?
The issuer gives the financial asset to the purchaser (holder) in exchange for some valuable consideration,
usually in the form of cash or another financial asset.
Financial Markets
Financial markets are markets in which financial instruments are bought and sold by suppliers and
demanders of funds. They, unlike financial institutions, are places in which suppliers and demanders of
funds meet directly to transact business.
Functions of Financial Markets
Financial markets play important roles in functioning of corporate finance.
1. They assist the capital formation process. Financial markets serve as a way through which firms can
obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments. They create continuous liquid
markets where firms can obtain the capital they need from individuals and other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial instrument is determined
through the interaction of demand and supply of the security in the financial markets.
Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them.
1. Classification on the basis of maturity
This is based on the maturity dates of securities
i) Money Markets - are financial markets in which securities traded have maturities of one-year or
less. Examples of securities traded here include treasury bills, commercial papers, and short –
term promissory notes and so on.
ii) Capital Markets - are financial markets in which securities of long-term funds are traded. Major
securities traded in capital markets include bonds, preferred and common stocks.
2. Classification on the basis of the nature of securities
This is based on whether the securities are new issues or have been outstanding in the market place.
i) Primary Markets - are financial marketers in which firms raise capital by issuing new
securities.
 ii) Secondary Markets - are financial markets in which existing and already outstanding securities
are traded among investors. Here the issuing corporation does not raise new finance.
3. Classification on the basis of organizational structure :
i. Auction market- all financial assets are traded in the centralized trading facility through bidding.
ii. Over- the- counter market- markets that do no operate in a specific fixed location- rather
transactions occur via telephone, wire transfers, computer trading. This type of market allows a
number of dealers (seller and buyer of financial instruments) without any restriction.
iii. Intermediated market –is a market where an entity called financial intermediary issues financial
claims against itself. With the funds it receives, it purchases financial assets.
4. Classification based on type financial claims:-the financial claims traded in a financial market may
be either for a fixed dollar amount or for a residual amount.
The financial assets traded under a fixed dollar amount are referred to as debt instruments. The
financial market where debt instruments (bonds, treasury bills, commercial papers others) are traded is
known as debt markets. Financial assets traded under the residual amount are referred as equity
instruments. The financial market where equity instruments (stocks) are traded is referred to as equity
market.