GREAT LAND COLLEGE

DEPARTMENT OF MANAGEMENT
MBA PROGRAM
ADVANCED FINANCIAL
MANAGEMENT
ADVANCED FINANCIAL
MANAGEMENT

ADAMU TERFA (PhD)

Email: [email protected]
 PRESENTATION ONE

OVERVIEW OF FINANCIAL MANAGEMENT

 Objectives in this presentation

• Explain the scope and function of financial

management.
• Conceptualize the objective of the business
firm.
• Identify the major decision area of the
financial management.
• Define agency problem
 Questions to be addressed in this presentation

• What is finance?
• What are the major areas of finance?
• What is financial Management?
• Is there meaning or scope difference between finance and
financial management?
• What are the basic decisions in financial management?
• What is the ultimate objective of the firm?
• What is agency problem?
 What is Finance?
The origin of finance is as old as human
life on earth.
In the 18th century, it was adapted by
English speaking communities to mean
“the management of money.” Since then,
it has found a permanent place in the
English dictionary.
Finance emerged as a field separate and
distinct from economics around 1900.
 According to Khan and Jain, Finance can be
defined as the art and science of 6
 What is Finance?
Webster’s Ninth New Collegiate
Dictionary defines finance as:
“The Science on study of the
management of funds’ and the
management of fund as the system
that includes the circulation of
money, the granting of credit, the
making of investments, and the
provision of banking facilities.
Finance is a distinct area of study that
comprises facts, theories, concepts,
 What is finance?
 "Finance" is a broad term that describes two related
activities: the study of how money is managed and the
actual process of acquiring needed funds.
 Because individuals, businesses and government entities
all need funding to operate, the field is often separated
into three subcategories: personal finance, corporate
finance and public finance.
 Two Facts About Finance
1. Finance is required everywhere
 Finance is the essential requirement of every
organization.
 All activities, be it production, marketing, human
resources development, purchases and even
research & development, depend on the adequate &
timely availability of finance both for commencement
& their smooth continuation to completion.

Finance is regarded as the life-blood of every

business enterprise.
 Two Facts About Finance…

2. Efficient Utilization is More

Important:
Efficient management of an
organization is closely linked with the
efficient mgt of its finances.
The need of finance starts with the
setting up of business.
 So why Study Finance?
Many personal decisions require financial
knowledge (for example: buying a house,
planning for retirement, leasing a car).
Virtually all individuals & organizations
raise money & invest the money.
 All individuals, businesses & government
entities need funding to operate.
The field is often applicable in personal
finance, corporate finance & public finance.
11
Three Questions Addressed by the Study
of Finance:

1. What long-term investments should

the firm undertake? (capital
budgeting decisions).
2. How should the firm fund these
investments? (capital structure
decisions).
3. How can the firm best manage its
12
 Co…

• Thus, finance is the science of managing financial resources

in an optimal pattern i.e. the best use of available financial
resources.
• Finance consists of three interrelated areas:
• Money & Capital markets, which deals with securities markets
& financial institutions.
• Investments, which focuses on the decisions of both
individual and institutional investors as they choose assets for
their investment portfolios.
• Financial Management, or corporate finance which involves
the actual management of firms.
 Con’d
• Financial management is one of the broadest area in finance.
• It is important in all types of business such as financial
institutions, other types of business organizations, and in
governmental organizations.
• The requirement of good understanding about financial
management is unquestionable for the person who is working
in finance area of the firm, basically as financial managers.
 EVOLUTION OF FINANCIAL MANAGEMENT/CORPORATE FINANCE
Every decision that a business makes has financial
implications, and any decision which affects the
finances of a business is a corporate finance
decision.
The first major focus of financial management during
its early years of development was the way how
large corporations of the time could raise capital.
This was a period when the establishment of very
large companies like the Rockefeller oil & Morgan
steel was marked.
But the economic depression of the 1930s made FM
to shift to topics like preservation of capital,
maintenance of liquidity, reorganization of financially
troubled companies, and the bankruptcy process. 15
 EVOLUTION OF FINANCIAL MANAGEMENT…

 Until 1950s, the study of FM had been descriptive or definitional

in nature.
 It focus on certain episodic events like formation, issuance of
capital, major expansion, merger, reorganization, and liquidation
in the life cycle of the firm.
 In the mid 1950s, FM moves to more analytical, decision
oriented approach. It is the transitional phase that focus on
working capital mgt.
 Starting the late 1960s, the primary focus of FM has been on the
relationships between risk and return of a firm’s financial
decision. It is modern phase that focus on matching of funds to
their uses. 16
 Summary on Evolution of FM
Period Focus of FM
Pre-1930 Descriptive emphasis on financial markets and securities.
Little attention given to asset mgt.
1930s &1940s focus on legal matters dealing with bankruptcy and reorganization & the
effects of newly emerging gov’t regulation.

1950s Increasing emphasis on asset mgt. significant theoretical developments in

valuation theory.
1960s Application of mathematical models to allocation of current and fixed
assets. Additional theoretical dev’ts in valuation theory, cost of capital,
dividend policy and risk analysis.
1970s Dev’t of more precise theories and measures of risk. Application of these
theories to investment analysis & valuation.
1980s Increasing application of computer technology to assist in financial
decision making.
Late 1980s & Reemphasis on value maximization concepts and the role of competitive,
1990s efficient, and complete capital markets.
1990s Increased attention to international competition and the mgt of multinational firms.
Renewed concern for the ethical implications of business decisions.
 Scope of Financial Management
• The scope and functions of financial management can be seen from
two approaches:
 Traditional approach
 Modern approach
 Traditional Procurement
approach of funds

FM
Procurement
of funds &
Modern
effective
Approach utilization of
funds
The scope of financial management as per traditional approach:
(A) Estimation of requirements of finance,
(B) Arrangement of funds from financial institutions,
(C)Arrangement of funds through financial instruments
such as shares, debentures, bonds and loans, and
(D)Looking after the accounting and legal work
connected with the raising of funds.
 Limitations of FM in traditional approach:

1. No Involvement in Application of Funds:

The finance manager had not been involved
in decision-making in allocation of funds.
2. No Involvement in day to day
Management: The focus was on providing
long-term funds from a combination of
sources with one time happening process.
The finance manager was not involved in day
to day administration of working capital
management.
3. Not Associated in Decision-Making
Allocation of Funds: The issue of allocation
of funds was kept outside finance manager
 The Modern Approach of FM
• In the words of Solomon, “The
central issue of financial policy
is the use of funds. It is helpful
in achieving the broad financial
goals which an enterprise sets for
itself”.
• The emphasis of FM has been
shifted from raising of funds only
to the effective and judicious
utilization of funds.
 So what Is Corporate Finance/Financial
Management?
 Financial Management (FM) is planning, organizing,
directing & controlling the financial activities of
organization/s.
 It is the efficient & effective management of money
(funds) in a manner to achieve the goals of
organizations.
Corporate Finance is nothing but management of the
limited financial resources the organization has, to its
utmost advantage.
It is concerned with budgeting, financial forecasting,
cash management, credit administration,
investment analysis and fund procurement of the
business concern that adopt modern technology &
application suitable to the global environment. 23
 Financial Management Decisions

 Some important questions that would be answered using

finance
– What long-term investments should the firm take on?
– Where will we get the long-term financing to pay for the
investments?
– How will we manage the everyday financial activities of
the firm?
 Decisions in Financial Management

 FM is used to help make three major decisions:

1. Which assets should we invest in?..

Investment decisions.
2. How will we pay for these assets?.. Financing
decisions.
3. What should we do with the earnings
generated by the assets? …dividend decisions.
25
Objectives in Decision Making
 =========
• Financial manager must be concerned with three
major decisions:
 Investment decisions
 Financing decisions
 Dividend decisions
o Each of these decisions must be considered in
relation to the objective of the firm: an optimal
combination of the three decisions will maximize
the value of the share to its shareholders.
o Their joint impact should be considered on the
market price of the firms stock.
 a. Investment decisions

• It is the most important one among the three decisions.

• It relates to the selection of assets in which funds are
invested by the firm.
• The acquired assets can be categorized into two broad
groups:
o Long term assets
o Short term/ current assets
 Investment decision that relate to the long term assets is
popularly known as capital budgeting.
 Where as that related to short-term assets is usually
designated as liquidity decision.
 a1. Capital Budgeting Decision
• This decision focuses on answering a question like :
• What long-term investments should you take on?( What
lines of business will you be in and what sorts of buildings,
machinery, and equipment will you need?)

• In the capital budgeting decisions, the financial manager

tries to identify investment opportunities that are worth
more to the firm than they cost to acquire.

• This aspect of capital budgeting decision is the choice of the

investment out of the available alternatives based on the
returns ( benefits) expected from the investment proposal
under considerations.
 Con’d
• Another aspect of capital budgeting decision is the
analysis of risk and uncertainty.
• As the benefits from the proposed investment relates to
the future period, their accrual is uncertain.
• Therefore, the return from the proposed investment
should be evaluated in relation to the risk associated
with future.
• Finally, this return should be judged with a certain norm
which is referred by several names such as cut-off rate,
required rate, hurdle rate, minimum rate of return.
• Company’s cost of capital is used for this purpose as a
standard.
 a2.Liquidity/working capital Decision
• It is concerned with the management of current assets.
It tries to answer the following questions:
• How much cash and inventory should we keep on hand?
• Should we sell on credit? What terms will we offer and
to whom will we extend? And so on.
• The main objective of the current asset management is
the trade-off between profitability and liquidity for
which conflict concepts exist between two
• If the firm does not have adequate working capital it
may become illiquid which might result in bankruptcy.
• On the contrary, if the current assets are too large, the
profitability is adversely affected.
 b. Financing Decision(Capital Structure)
• The following question could be answered by capital
structure decision of the firm:
• Where will you get the long term financing to pay for
your investment?
• Financing decision is concerned with determining the
best financing mix (capital structure) of the firm.
• It is the determination of the proportion of the
equity and debt capital.
 C. Dividend Decision
• Activity: a portion of a given period profit
should be distributed for the shareholders.
React to this statement.
 Con’d
• The financial manager must decide whether the firm
should distributes all profits or retain it in the firm or
distribute part and retain the balance.
• The dividend decision should be taken in terms of its
impact on the shareholders’ wealth.
• The optimum dividend policy is one which maximizes the
market value of share.
Principles of Financial Management
It is necessary to understand these principles in order
to understand finance.
Principle 1: The Risk-Return Trade-off
 Risk and expected return move in tandem; the greater the
risk, the greater the expected return.
 Financial decisions of the firm are guided by the risk-
return trade-off.
 The return and risk relationship: Return = Risk-free rate + Risk premium

 Risk-free rate is a compensation for time and risk

premium for risk. 35
Principle 2: 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.
Principle 3: Cash—Not Profits—Is King
• Cash Flow, not accounting profit, is used as our
measurement tool.
• Cash flows, not profits, are actually can be reinvested.
Principle 4: Incremental Cash Flows
The incremental cash flow is the difference between the
projected cash flows if the project is selected, versus what
they will be, if the project is not selected.
36
 Principle 5: The 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
separate products from competition
Principle 6: 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.
37
 Principle 7: The Agency Problem
• Managers won’t work for the owners unless it is in their best
interest
• A agency problem resulting from conflicts of interest between the
manager/agent and the stockholder/owners.
– Managers may make decisions that are not in line with the goal of
maximization of shareholder wealth.
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).
Principle 8: Taxes Bias Business
Decisions
• The cash flows we consider are the after-tax incremental38
 Principle 9: All Risk is Not Equal
• Some risk can be diversified away & 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.
Principle 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.

39
 Goal of Financial Management
What should be the goal of a corporation?
 Maximize profit?
 Minimize costs?
 Maximize market share?
 Maximize the current value of the company’s
stock?

Does this mean we should do anything

and everything to maximize owner
40
Objectives/ Goals Of Financial Management
Objectives of FM

Profit Maximization

Wealth Maximization
 Profit Maximization

• Main aim of any kind of economic activity is

earning profit.
• Profit maximization is also the traditional and
narrow approach aims at, maximizing the profit
of the concern.
• A business concern is also functioning mainly
for the purpose of earning profit.
• Profit is the measuring techniques to
understand the business efficiency of the
concern.
• Profit is the parameter of measuring the
efficiency of the business concern. So it shows
the entire position of the business concern and
helps to reduce risks of the businesses.
 Arguments for Profit Maximization objectives:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.
Arguments against Profit Maximization objectives:
 Profit maximization leads to exploiting workers and
consumers.
 It creates immoral practices such as corrupt & unfair
trade practice,
 It leads to inequalities among the stake holders such
as customers, suppliers, public shareholders..
 It is vague: profit is not defined precisely or correctly.
It creates some unnecessary opinion regarding
earning habits of the business concern.
 It ignores the time value of money: It leads certain
differences between the actual cash inflow and net
present cash flow during a particular period.
 It ignores risk: Profit maximization does not consider
risk of the business concern. Risks may be internal or
external which will affect the overall operation of the
business concern.
 2. Wealth Maximization
Wealth maximization (WM) is one of the
modern approaches, which involves
latest innovations & improvements in
the field of the business concern.
• The term wealth means shareholder
wealth or the wealth of the persons
those who are involved in the business
concern.
• WM is also known as value maximization
or net present worth maximization. This
objective is a universally accepted
concept in the field of business.
 2. Wealth Maximization
 The primary goal is shareholder wealth
maximization. This means:
Maximizing Firm Value
=market price per share of common stock X number of
outstanding shares
Maximizing stock price; the sum of present
and future dividends.
• Share price serves as a barometer for business
performance.
 Arguments for Wealth Maximization
(i) Wealth maximization (WM) is superior
to the profit maximization because the
main aim of the business concern
under this concept is to improve the
value or wealth of the shareholders.
(ii) WM considers the comparison of the
value to cost associated with the
business concern.
(iii) WM considers both time and risk of
the business concern.
(iv) WM provides efficient allocation of
resources.
 Arguments against Wealth Maximization
(i) WM leads to prescriptive(rigid and narrow)
idea of the business concern but it may not be
suitable to present day business activities.
(ii) WM is nothing, it is also profit maximization, it
is the indirect name of the profit maximization.
(iii) WM creates ownership- management
controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization
objectives is to maximize the profit.
(vi) WM can be activated only with the help of the
profitable position of the business concern.
 Is wealth maximization good for society,
employees, and customers?
• Unless engaged in creating monopoly, violating
safety codes, polluting environment; the same
actions that maximize stock prices will also benefit
the society.
• Some reasons:
– To a large extent, the owners of stock are society.
– Consumers benefit from efficiency.
– Employees benefit (additional employment pay).
 The Corporation and Financial Markets

Corporation cash Investors

securities
reinvest
Secondary
markets
dividends,
Cash flow
etc.

tax

Government
 The Corporation and Financial Markets
• Primary Market
– Market in which new issues of a security are
sold to initial buyers.
• Secondary Market
– Market in which previously issued securities
are traded.
The Corporation and Financial Markets

• Initial Public Offering (IPO)

– The first time the firm’s stock is sold to
the general public.
• Seasoned New Issue
– A new stock offering by a firm that
already has stock that is traded in the
secondary market.
 Social Responsibility

• Wealth maximization does not preclude the

firm from being socially responsible.
• Assume we view the firm as producing both
private and social goods.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
 Corporate Governance

• Corporate governance: represents the system

by which corporations are managed and
controlled.
– Includes shareholders, board of directors,
and senior management.
• Then shareholder wealth maximization
remains the appropriate goal in governing the
firm.
 ===============

• END
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