CHAPTER-ONE

OVERVIEW OF
FINANCIAL
MANAGEMENT

1.1
 1.1. Basic Areas of Finance

• Finance is the application of economic principles

and concepts to business decision-making and
problem solving.
• The field of finance can be considered to comprise
three broad categories:
• investments,
• financial institutions, and
• financial management
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A. Investments

• This area of finance focuses on the behaviour of

financial markets and the pricing of securities.
• Investment decisions are concerned with the use of
funds—the buying, holding, or selling of all types of
assets.

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B. Financial Institutions

• This area of finance deals with banks and other firms

that specialize in bringing the suppliers of funds
together with the users of funds.
• For example, a manager of a bank may make
decisions regarding granting loans, managing cash
balances, setting interest rates on loans, and dealing
with government regulations.

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C. Financial Management

• Sometimes called corporate finance or business

finance.
• this area of finance is concerned primarily with
financial decision-making within a business entity.
• Financial Management Concerns the acquisition,
financing, and management of assets with some
overall goal in mind.

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• Some important questions that are answered using finance
❖ What long-term investments should the firm take on? (investment
decisions)
❖ Where will we get the long-term financing to pay for the investment?
(financing decisions)
❖ How will we manage the everyday financial activities of the firm?
(Working capital Management Decisions)

1.6
 Investment Decisions
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?
 Financing Decisions
❖ What is the best type of financing?
❖ What is the best financing mix?
❖ What is the best dividend policy (e.g.,
dividend-payout ratio)?
❖ How will the funds be physically acquired?
 Asset Management Decisions
working capital management

❖ How do we manage existing assets efficiently?

❖ Financial Manager has varying degrees of
operating responsibility over assets.
❖ Greater emphasis on current asset management
than fixed asset management.
1.2 THE ROLE OF FINANCIAL
MANAGERS
• The financial manager of a firm plays an important
role in the company’s goals, policies, and financial
success.
1. Financial analysis and planning: Determining the
proper amount of funds to employ in the firm, i.e.,
designating the size of the firm and its rate of
growth
2. Investment decisions: The efficient allocation of funds
to specific assets
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3. Financingand capital structure
decisions: Raising funds on as favourable
terms as possible, i.e., determining the
composition of liabilities.
4. Management of financial resources
(such as working capital)
5. Risk management: protecting assets.

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 1.3. Forms of Organization

• Three major forms

❖ Sole proprietorship
❖ Partnership
• General
• Limited
❖ Corporation

1.12
 Sole Proprietorship
• Advantages • Disadvantages
• Easiest to start • Limited to life of owner
• Least regulated • Equity capital limited to
owner’s personal wealth
• Single owner keeps all the
profits • Unlimited liability
• Taxed once as personal • Difficult to sell ownership
income interest

1.13
 Partnership
• Advantages • Disadvantages
• Two or more owners • Unlimited liability
• More capital available • General partnership

• Relatively easy to start • Limited partnership

• Income taxed once as • Partnership dissolves when

one partner dies or wishes to
personal income
sell
• Difficult to transfer
ownership

1.14
 Corporation
• Advantages • Disadvantages
• Limited liability • Separation of ownership and
management
• Unlimited life
• Separation of ownership and • Double taxation (income
taxed at the corporate rate
management
and then dividends taxed at
• Transfer of ownership is easy personal rate)
• Easier to raise capital

1.15
 1.4. Goal Of Financial Management

• What should be the goal of managers when choosing financial

alternatives?
• Two widely discussed goals of financial management.
❖ Profit Maximization
❖ Stockholders’ wealth Maximization

1.16
a) Profit Maximization
• Is maximizing the birr income of firms.
• Is based on Accounting profit.
• The actions of the financial manager is profit oriented,
i.e., only actions and projects that will increase profit are
undertaken.
• Advantages:
• Simple to achieve-no much calculation
• Helps for efficient allocation of resources.
• Limitations
• Does not consider the time value of money.
• Ignores risk. 17
b) Stockholders’ Maximization
• Considers the limitations of profit maximization
approach.
• Is based on cash flows/ benefits from projects.
• Is based on Maximization of market value of shares.
• Projects that maximize Net Present value (wealth) are
under taken.

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• Additional goals of firms include
• Social responsibility- work for the welfare of:
• Employees
• Customers, and
• Community at large.

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 1.5. The Agency Problem
• Agency relationship
• Principal hires an agent to represent their
interest
• Stockholders (principals) hire managers
(agents) to run the company
• Agency problem
• Conflict of interest between principal and
agent
• Management lead more relaxed life style and do not work more seriously.
• Management may consume more perquites.
1.20
Mechanisms to control Managers

• Managerial compensation
• Incentives can be used to align management and stockholder interests
• The incentives need to be structured carefully to make sure that they
achieve their goal

• Corporate control
• The threat of a takeover may result in better management
• Direct intervention – by Other stakeholders

1.21
THE
END
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