Wollo University

College of Business & Economics

Department of Accounting &
Finance

Course Title: Advanced Financial Management

Course Code: AcFn 541
 Chapter - 1

Introduction to Financial
Management
1.1 MEANING AND DEFINITION OF
FINANCE
 Any kind of business activity depends on the finance.

Therefore, finance is called as lifeblood of business

organization.
 Finance is the art and science of managing money.

 It includes financial service and financial instruments.

 Finance also is referred as the provision of money at the

time when it is needed.

 Finance function is the procurement of funds and their

effective utilization in business concerns.

3
 Meaning ….(cont..)
Finance consists of three interrelated areas:

1. Money and capital markets,

2. Investments, and

3. Business finance (financial management).

4
 Meaning… (cont….)
1. Money and capital markets
It deals with securities markets and financial

institutions.

2. Investments
Which focuses on the decisions made by both

individual and institutional investors as they

choose securities for their investment portfolios
5
 Meaning …. (cont…)
3. Business finance (financial management)
It is that business activity which concerns with the

acquisition and conversation of capital funds in

meeting financial needs and overall objectives of a
business enterprise.
Business finance can broadly be defined as the

activity concerned with planning, raising,

controlling, administering of the funds used in the
business.
6
 Meaning …… (cont…)
It is the operational activity of a business that is

responsible for obtaining and effectively utilizing the

funds necessary for efficient operations.
It deals with procurement of funds and their effective

utilization in the business.

Thus, Business finance (Financial Management) is
mainly concerned with the effective funds
management in the business.

7
 1.2 Finance Functions

Investment or Long Term Asset Mix

Decision
Financing or Capital Mix Decision

Dividend or Profit Allocation Decision

Liquidity or Short Term Asset Mix Decision

8
 Investment or Long Term Asset Mix
Decision
Most important of the three decisions.

 What is the optimal firm size?

 What specific assets should be acquired?

 What assets (if any) should be reduced or

eliminated?

9
 Financing or Capital Mix Decision
 Determine how the assets (LHS of balance sheet) will be
financed (RHS of balance sheet).
What is the best type of financing?

What is the best financing mix?

How will the funds be physically acquired?

 Dividend or Profit Allocation Decision

What is the best dividend policy (e.g., dividend-payout

ratio)?
What are the factors which affect the dividend or profit
allocation decision (e.g. economic condition, investment
opportunities, types of investors', e.t.c.
10
 Liquidity or Short Term Asset Mix
Decision
 How do we manage existing assets (current) efficiently?

 Financial Manager has varying degrees of operating

responsibility over assets.

 Greater emphasis on current asset management than

fixed asset management.

 How do we finance our firm current assets?

 What is the best financing mix?

 What approach we follow to finance current assets?

11
 1.3 Financial Manager’s Role
Financial Planning or determine financial
requirements
Raising of Funds

Allocation of Funds

Profit Planning

Understanding Capital Markets

Risk management

12
 1.4 Financial Management Goals
Profit maximization (profit after tax)

Maximizing Earnings per Share

Shareholder’s Wealth Maximization

13
 i. Profit Maximization
Maximizing the birr Income of Firm

Profit is the parameter of measuring the efficiency

of the business concern.

Profit maximization objectives help to reduce the

risk of the business

Resources are efficiently utilized

Appropriate measure of firm performance

Serves interest of society also

14
 Drawbacks of Profit Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit
maximization is regarded as
Unrealistic
Difficult
Inappropriate
Immoral.

15
 ii. Maximizing EPS
Ignores timing and risk of the expected benefit

Market value is not a function of EPS. Hence

maximizing EPS will not result in highest price

for company's shares
Maximizing EPS implies that the firm should

make no dividend payment so long as funds can

be invested at positive rate of return—such a
policy may not always work
16
 iii. Shareholders’ Wealth Maximization
Maximizes the net present value of a course of

action to shareholders.
Accounts for the timing and risk of the expected

benefits.
Benefits are measured in terms of cash flows.

Fundamental objective—maximize the market

value of the firm’s shares.
17
 The reasons that wealth maximization
superior to the profit maximization
i. Wealth maximization considers the comparison of the
value to cost associated with the business concern.

ii. Wealth maximization considers both time and risk of the

business concern.

iii. Wealth maximization provides efficient allocation of

resources.

iv. It ensures the economic interest of the society.

18
 1.5 AGENCY RELATIONSHIPS

An agency relationship exists whenever a

principal hires an agent to act on their behalf.

Within a corporation, agency relationships

exist between:

Shareholders and managers

Shareholders and creditors

19
 Managers Versus Shareholders
 Managers are naturally inclined to act in their own best interests.

 managers’ primary goal seems to be to maximize the size of their

firms.
 By creating a large and rapidly growing firm managers;

(1) increase their job security, because a aggressive takeover is less

likely;

(2) increase their own power, status, and salaries, and

(3) create more opportunities for their lower- and middle-level

managers.

20
 Cont…
But the following factors affect managerial

behavior which encouraged managers to act in

stockholders’ best interests;
 Managerial compensation plans

 Direct intervention by shareholders

 The threat of firing

 The threat of takeover

21
 Shareholders versus Creditors
Shareholders (through managers) could
take risky actions to maximize stock price,
but are harmful to creditors.
In the long run, such actions will raise the
cost of debt and ultimately lower stock
price.
Creditors attempt to protect themselves
against stockholders by placing restrictive
covenants in debt agreements.
22
Factors that affect stock price
Projected cash flows
to shareholders
Timing of the cash
flow stream
Riskiness of the
cash flows
 Basic Valuation Model
CF1 CF2 CFn
Value  1
 2

(1  k) (1  k) (1  k)n
n
CFt
 t
.
t 1 (1  k)

To estimate an asset’s value, one estimates the

cash flow for each period t (CFt), the life of the
asset (n), and the appropriate discount rate (k)
Throughout the course, we discuss how to
estimate the inputs and how financial
management is used to improve them and thus
maximize a firm’s value.
 1.9 Organisation of the Finance Functions
Reason for placing the finance functions in
the hands of top management
Financial decisions are crucial for the
survival of the firm.
The financial actions determine solvency
of the firm
Centralisation of the finance functions can
result in a number of economies to the firm.

25
 Status and Duties of Finance Executives
The exact organisation structure for
financial management will differ across
firms.
The financial officer may be known as the
financial manager in some organisations,
while in others as the vice-president of
finance or the director of finance or the
financial controller.

26
 Role of Treasurer and Controller
Two more officers—the treasurer and the
controller—may be appointed under the direct
supervision of CFO to assist him or her.
The treasurer’s function is to raise and manage
company funds while the controller oversees
whether funds are correctly applied.
Treasurer – oversees cash management, credit
management, capital expenditures and financial
planning.
Controller – oversees taxes, cost accounting,
financial accounting and data processing.
27
 Role of Finance in a Typical
Business Organization
Board of Directors

President

VP: Sales VP: Finance VP: Operations

Treasurer Controller

Credit Manager Cost Accounting

Inventory Manager Financial Accounting

Capital Budgeting Director Tax Department

 Assignment I
If you were the manager of a large, publicly owned

corporation, would you make decisions to maximize

stockholders’ welfare or your own personal
interests? What are some actions stockholders could
take to ensure that management’s interests and those
of stockholders coincided? What are some other
factors that might influence management’s actions?

29