LECTURE ONE/TWO: PRELUDE

OVERVIEW OF FINANCIAL MANAGEMENT

INTRODUCTION:
This lecture discusses the objectives and scope of financial management, the factors that
shape the operating environment of financial managers, and the owner/manager agency
problem and possible solutions to the problem

Objectives
At the end of this lecture students should be able
to:
1. Define finance and discuss the scope
and decision areas/functions of finance
in financial management.
2. Describe the environments that impact
on financial management decision.
3. Discuss the goals/objectives of
financial management.
4. Explain the shareholder/management
(agency) conflicts and possible
solutions.

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SCOPE OF FINANCE

We begin the study of finance by taking a broad overview of it as an academic discipline

as well as a professional practice. It will become clear that the field of finance is dynamic
in its orientation and pervasive in its impact on the lives of almost every economic person.
The discipline borrows and interfaces with many other academic disciplines and offers
diverse and varied career opportunities.

Definition of Financial Management

Financial management can be defined as the art and science of managing money. Every
organization and individual who has an objective must decide from where to source for
money, in what assets to invest the money, and how to manage its assets in the most
efficient way. Finance is concerned with the process, institutions, markets, and instruments
involved in the transfer money among and between individuals, businesses and the
government.

Why study Finance

All managers in a firm work with finance personnel to justify manpower requirements,
negotiate operating budgets, deal with performance appraisals, and sell proposals based on
their financial merits. Clearly, those managers who understand the theories, concepts, and
practices of financial management will perform their responsibility efficiently and will also
justify their needs for financing. Career opportunities in finance are many and diverse.
Proficiency in financial management could enable one work as financial analyst,
investment analyst, project finance manager, treasurer, and credit manager, pension fund
manager, to mention but a few. Although this course focuses on profit making
organizations, the decision-making principles are just as relevant for public, non-profit
making organizations and even individuals.

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Decision Functions of Financial Management
Financial management is concerned with the acquisition, financing and management of
assets with the goal of maximizing shareholders’ wealth. These three broad decisions
functions of financial managements are briefly discussed below.

1. The Investment Decision

This is one the most important decision contributing to value creation. It entails the
decision of the amount of assets to be held and the composition of the assets (asset
structure).
2. The Financing Decision
The function involves deciding on the optimal capital structure (the proportion of debt and
share capital) to be employed by the firm. The long term sources of financing which form
the capital structure of the firm comprise basically three components: debt capital,
preference share capital, and ordinary share capital. These components each have different
costs and it is the responsibility of the finance manager to ensure the firm’s overall cost of
financing is as low as possible.
3. Dividend decision
The value of dividends paid to shareholders must be balanced against the opportunity cost
of retained earnings lost as a means of equity financing.
4. The Asset management decision
The asset acquired must be managed effectively. The task requires an analysis of the risk
and return of the various assets in order to ensure firm’s assets are held in efficient
combinations. While the responsibility of managing fixed assets may reside with the
operating managers, the financial manager will have to devote considerable attention to the
management of current assets and liabilities (working capital management).

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 LECTURE 2:
FINANCIAL MANAGEMENT ENVIRONMENTS

The environments that impact on the functions of a financial manager can be broadly
viewed in terms of social, political, economic, and legal contexts. Although all four
environments affect a finance manager’s functions and decisions, the political and social
dynamics are driven by events on which the manager has little or no influence.
Consequently, in this section we restrict the discussion only to aspects of the legal and
economic environment, namely the various types of business organizations, the tax
legislation, and the financial system (market institutions and intermediaries).

1. Business Organizations
The three basic forms of business organizations are a proprietorship, a partnership and a
corporation (limited liability companies)
Sole Proprietorship
A proprietorship is an organization in which a single person owns the business, holds title
to all the assets and is personally responsible for all liabilities. The main virtue of a
proprietorship is that it can be easily established and is subject to minimum government
regulation and supervision. The proprietorship’s shortcomings include the owner’s
unlimited liability for the all-business debts, the limitations in raising capital, and the
difficulty in transferring ownership.
The proprietorship pays no separate income taxes. Rather the income or losses from the
proprietorship are included on the owner’s personal tax return.

Partnership
A partnership is similar to a proprietorship, except that it is owned by two or more persons.
The profit of the partnership is taxed on the individual partners after sharing.
A potential advantage of a partnership compared to a proprietorship is that a greater amount
of capital can be raised.
In a general partnership each partner is personally responsible for the obligations of the
business. A formal agreement (partnership deed) is necessary to set forth the privileges and

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duties of each partner, the distribution of profits, capital contributions, procedures for
admitting new partners and modalities of reconstitutions of the partners in the event of
death or withdrawal of a partner.
In a limited partnership, limited partners contribute capital and their liability is confined to
that amount of capital. There must be however, at least one general partner in the
partnership who manages the firm and his liability is unlimited.
Corporation
A corporation is an “artificial entity” created by law. A corporation is empowered to own
assets, to incur liabilities, engage in certain specified activities, and to sue and be sued. The
principal features of this form of business organization are that the owner’s liability is
limited; there is ease of transfer of ownership through sale of shares; the corporation has
unlimited life apart from its owners and; the corporation has the ability to raise large
amounts of capital.
A possible disadvantage is that corporation profits are subject to double taxation. A minor
disadvantage is the difficulties and expenses encountered in the formation. Corporation are
owned by shareholders whose ownership is evidenced by ordinary stocks shareholders
expect earn a return by receiving a dividend or gain through increasing share prices.

Corporations are formed under the provisions of the Companies Act (CAP486). A Board
of Directors, elected by the owners, has ultimate authority in guiding the corporate affairs
and in making strategic policy decisions. The directors appoint the executive officers (often
referred to as management) of the company, who run the company on a day-to-day basis
and implement the policies established by the directors. The chief executive officer (CEO)
is responsible for managing day-to-day operations and carrying out the policies established
by the board. The CEO is required to report periodically to the firm's directors.

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Figure 1.1 Strengths and weaknesses of the basic forms of business organizations

Sole proprietorship Partnership Corporation

Strengths
1. Owner receives all 1. Can raise more 1. Owners have limited
profits (as well as losses) capital than a sole liability which
proprietorship guarantees they cannot
lose more than they
invest.
2.Low organizational costs 2. Borrowing power 2. Growth is not
enhanced by more restricted by lack of
owners funds. (can see shares)
3. Not taxed separately: 3. More available 3. Ownership (shares)
rather income included on brainpower and is readily transferable
proprietor’s return. managerial skills
4. A high degree of 4. Not taxed 4. Endless life of firm
independence separately. The (does not depend on
partners are taxed life of owners)
after receiving share
of profits
5. A degree of secrecy is 5. Can hire professional
achievable managers (separation
of ownership from
control)
6. There is ease of 6. Can raise funds more
dissolution easily

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 Weaknesses
1. owner has unlimited 1.Owners have 1. Taxes generally
liability – total wealth can be unlimited liability higher due to double
taken to satisfy debts and may have to taxation- on
cover the debts of dividends and
other partners corporate profits

2. Limited fund raising 2. Partnership is 2. More expensive to

ability tends to inhibit dissolved on the organize
growth death or withdrawal
of a partner
3. proprietor must be a jack- 3. Difficult to 3. Subject to greater
of-all-trades liquidate or transfer regulation
partnership interest
4.Difficult to motivate 4. Lacks secrecy,
employees’ career prospects because stockholders
must receive
financial report
5. Continuity dependent on
presence of proprietor

2. Tax Environment
Taxation by central and local government has profound influence on the behavior of
business and their owners. Tax considerations are especially important in financial
management. Let us also appreciate that tax laws are so numerous and complex and their
impact so profound that firms require the input of a tax expert in many decisions.
Ordinary income tax. The income of all business organizations is liable to tax by the
government. As we noted before the income of proprietorships and partnerships added to
that of its owners and taxed at graduated rates for individuals. How much tax is charged

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depends on the personal tax status of the owners. A corporation’s taxable income is found
by deducting all allowable expenses from the revenue. The taxable income is then subject
to the corporate tax rate to determine the amount of tax liability (The current corporate tax
rate in Kenya is 30%).
Capital allowance and tax credit. Capital allowance is allowable in place of depreciation
and is granted to businesses engaged in investment activities and that operate fixed asset.
Tax credits are reduction in tax liability granted by the government to a taxpayer. Capital
allowances and tax credits lower the purchase price of capital assets and a major
consideration in investment decisions. The government grants the allowance and credits
for the purpose of stimulating economic development.
Interest Vs Dividends Interest paid on outstanding corporate debt is a tax-deductible
expense. However, dividends paid to shareholders are not tax deductible. Thus, for a
profitable company, the use of debt (bonds) in its financing mix results in significant tax
advantage relative to the use of share capital.
Capital gains tax. This is the tax levied on the gain (or loss) on the sale of fixed assets.
The capital gains tax rate is usually lower than the ordinary income tax rate (Capital gains
tax is currently suspended in Kenya).
3. Financial System
The primary role of the financial system in the economy is to facilitate in the transformation
of saving into investments. The financial system provides the principal means by which a
person who has saved money out of current income can transfer their savings to someone
else who has productive investments opportunities and is in need of money to finance them.
This transfer of money results in the creation of a financial asset for the saver and a
financial liability for the borrower. Consequently, the financial system provides the means
for risk transfer and risk sharing among the market participants.
Figure 1.2 illustrates the instruments used in financial system, the way they flow and the
main participants in the system.

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 Figure 1.2 The financial system comprises of financial markets, financial
institutions that intermediate, the financial instruments that represent claims, and the
savers and demanders of funds who are the government, individuals and businesses.

Funds Funds
Financial institutions
Banks, insurance
companies, Pension Loans
Deposit /shares funds, Saccos etc. /shares
- Saving + compensation
Funds
Suppliers of Demanders of
funds (Savers) funds
Business, Funds (Investors)
Government Private placement Business,
Households Securities Government
Households

Securities
Funds
Funds Financial markets
Primary Vs.
supp
Securities Secondary Securities
Money v Capital

Financial assets
Financial assets are divided into three general classes; money, debt and shares. Money is
issued by government as currency notes and coins and by some commercial banks through
their checking accounts. The issuer of debt promises to pay the creditor a specific amount
of money at a future date whereas the company that issues shares is selling ownership
rights in the company to the shareholder.

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Savers and demanders of funds
The key suppliers and demanders of funds are individuals, businesses, and governments.
The savings of individuals provide financial institutions with a large portion of their funds.
Individuals are not only suppliers of funds, but also demand funds from financial
institutions in the form of loans. Individuals as a group are the net suppliers for financial
institutions: They save more money than they borrow.
Business firms also deposit some of their funds in financial institutions, primarily in
checking accounts with various commercial banks. Firms, like individuals, also borrow
funds from these institutions. As a group, business firms are net demanders of funds:
borrowing more money than they save.
Governments maintain deposits of temporarily idle funds, certain tax payments, and Social
Security payments in commercial banks. Although governments do not borrow funds
directly from financial institutions, by selling their securities to various institutions, they
indirectly borrow from them. The government is typically a net demander of funds (budget
deficits).

Financial Intermediaries

Financial intermediaries facilitate the indirect transfer of money from savers to lenders.
Intermediaries confer the following advantages to those who consume their services.
1. Flexibility and liquidity Intermediaries provide a large sum of money to a borrower
by pooling the savings several investors. They also engage in maturity
transformation of assets and claims, providing investors with financial assets which
maybe liquid money at the same time as they are making long-term loans.
2. Diversification by sourcing funds from savers with diverse characteristics the
intermediary is able to provide relatively low risk capital to investors.
3. Convenience by dealing with an intermediary a person gets a variety of financial
services provided at one point in time and place.
4. Expertise Because of continuous engagement in financial transactions the
intermediary accumulates expertise that can be availed to customers.

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 The major financial institutions in Kenya economy are commercial banks, savings and
loans, credit unions, savings banks, life insurance companies, pension funds, and mutual
funds. These institutions attract funds from individuals, businesses, and governments,
combine them, and make loans available to individuals and businesses. A brief description
of the major financial institutions follows.

Institution Description

Commercial bank Accepts both demand (checking) and time (saving) deposits. Also
offers negotiable order of withdrawal (NOW), and money market
deposit accounts. Commercial banks also make loans directly to
borrowers or through the financial markets.
Saving and loan These are similar to a commercial bank except chat it may not hold
demand (checking) deposits. They obtain funds from savings,
negotiable order of withdrawal (NOW) accounts, and money
market deposit accounts. They lend primarily to individuals and
businesses in the form of real estate mortgage loans.
Credit union Commonly known as Savings co-operative societies (Sacco’s),
credit unions deal primarily in transfer of funds between members.
Membership in credit unions is generally based on some common
bond, such as working for a given employer. Credit unions accept
members’ savings deposits, NOW account deposits, and money
market account deposits and lend funds to members, typically to
finance automobile or appliance purchase, or home improvements.

Savings banks These are similar to a savings and loan in that it holds savings,
NOW, and money market deposit accounts. Savings banks lend or
invest funds through financial markets, although some mortgage
loans are made to individuals.

Life insurance Company it is the largest type of financial intermediary handling

individual savings. It receives premium payments and invests them to accumulate funds

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to cover future benefit payments. It lends funds to individual, businesses, and
governments, typically through the financial markets.

Pension fund Pension funds are set up so that employees can receive income after
retirement. Often employers match the contribution of their
employees. The majority of funds is lent or invested via the financial
market.

Mutual fund Pools funds from the sale of shares and uses them to acquire bonds
and stocks of business and governmental units. Mutual funds create
a professionally managed portfolio of securities to achieve a
specified investment objective, such as liquidity with a high return.
Hundreds of funds, with a variety of investment objectives exist.
Money market mutual funds (open end funds) provide competitive
returns with very high liquidity.

Unit trusts Unit trusts are investment funds which are closed ended, that is, the
size of the fund and number of shares or units issued depends on the
level of demand from the investor. More units are issued as and
when investors subscribe, additional money to the fund. The value
of this unit is based on the market value of the investment held by
the trust.

Unit trust provides 2 main services to individual investors.

(a) Opportunity to invest in relatively will diversified portfolio

(b) The expertise of professional investment managers. The cost of
the management services is reflected in the purchase price of the
units.
In order to safeguard the interest of the unit holders, trustees are
appointed under the terms of the trust deed. A management

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 company will also be appointed with responsibility both for
marketing and selling the units and investing the funds
subscribed.

Financial Markets
Financial markets provide a forum in which suppliers of funds and demanders of funds can
transact business directly. Whereas the loans and investments of intermediaries are made
without the direct knowledge of the suppliers of funds (savers), suppliers in the financial
markets know where their funds are being lent or invested. It is important to understand
the following distinctions in the market.
Money versus Capital markets. The two key financial markets are the money market and
the capital market. Transactions in the money market take place in short-term debt
instruments, or marketable securities, such as Treasury bills, commercial paper, and
negotiable certificates of deposit. The market brings together government units,
households, businesses and financial institutions who have temporary idle funds, and those
in need of temporary or seasonal financing.
Long-term securities—bonds and stocks—are traded in the capital market. The main actor
in the capital markets is the securities exchanges, which provide the market place in which
demanders can raise long-term funds and investors can maintain liquidity by being able to
sell securities easily. The Nairobi Stock Exchange (NSE) was established in 1954 and is
one of the most active stock markets in sub-Saharan Africa. It currently (2005) has 48
companies listed and 20 brokerage company members.
Private placements versus Public offerings. To raise money, firms can use either private
placements or public offerings. Private placement involves the sale of a new security issue,
typically bonds or preferred stock, directly to an investor or group of investors, such as an
insurance company or pension fund. However, most firms raise money through a public
offering of securities, which is the nonexclusive sale of either bonds or stocks to the general
public,
Primary market versus Secondary market. All securities, whether in the money or capital
market, are initially issued in the primary market (Initial public offerings (IPOs) and
seasoned equity offerings (SEOs)). This is the only market in which the corporate or

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government issuer is directly involved in the transaction and receives direct benefit from
the issue. That is, the company actually receives the proceeds from the sale of securities.
Once the securities begin to trade in the stock exchange, between savers and investors, they
become part of a secondary market. The primary market is the one which “new” securities
are sold; the secondary market can be viewed as “used,” or “pre-owned,” securities market.

THE GOAL/OBJECTIVES OF THE FIRM IN A MARKET ECONOMY

A market economy is one in which goods and services are bought and sold at prices
determined in free competitive markets. Business firms are the principal agents charged
with the task of producing as efficiently as possible the goods and services the society
needs. Given this broad goal of efficiency, what standard or benchmark should financial
management practice be measured? In sum, what is the goal of the firm from a financial
management perspective?
Profit-Maximization
Microeconomic theory of the firm is founded on profit maximization as the principal
decision criterion: markets managers of firms direct their efforts toward areas of attractive
profit potential using market prices as their signals. Choices and actions that increase the
firm’s profit are undertaken while those that decrease profits are avoided. To maximize
profits the firm must maximize output for a given set of scarce resources, or equivalently,
minimize the cost of producing a given output.

Applying Profit-Maximization Criterion in Financial Management

Financial management is concerned with the efficient use of one economic resource,
namely, capital funds. The goal of profit maximization in many cases serves as the basic
decision criterion for the financial manager but needs transformation before it can provide
the financial manager with an operationally useful guideline. As a benchmark to be aimed
at in practice, profit maximization has at least four shortcomings: it does not take account
of risk; it does not take account of time value of money; it is ambiguous and sometimes
arbitrary in its measurement; and it does not incorporate the impact of non-quantifiable

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events.
Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of
uncertainty: When, as is normal, future profits are uncertain, the criteria of maximizing
profits lose meaning as for it is no longer clear what is to be maximized. When faced with
uncertainty (risk), most investors providing capital are risk averse. A good decision
criterion must take into consideration such risk.
Timing Another major shortcoming of simple profit maximization criterion is that it does
not take into account of the fact that the timing of benefits expected from investments varies
widely. Simply aggregating the cash flows over time and picking the alternative with the
highest cash flows would be misleading because money has time value. This is the idea
that since money can be put to work to earn a return, cash flows in early years of a project’s
life are valued more highly than equivalent cash flows in later years. Therefore, the profit
maximization criterion must be adjusted to account for timing of cash flows and the time
value of money.
Subjectivity and ambiguity A third difficulty with profit maximization concerns the
subjectivity and ambiguity surrounding the measurement of the profit figure. The
accounting profit is a function of many, some subjective, choices of accounting standards
and methods with the result that profit figure produced from a given data base could vary
widely.
Qualitative information Finally many events relevant to the firms may not be captured
by the profit number. Such events include the death of a CEO, political development, and
dividend policy changes. The profit figure is simply not responsive to events that affect the
value of the investment in the firm. In contrast, the price of the firm’s shares (which
measures wealth of the shareholders of the company) will adjust rapidly to incorporate the
likely impact of such events long before they are their effects are seen in profits.

Value Maximization

Because of the reasons stated above, Value-maximization has replaced profit-

maximization as the operational goal of the firm. By measuring benefits in terms of cash
flows value maximization avoids much of the ambiguity of profits. By discounting cash

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flows over time using the concepts of compound interest, Value maximization takes
account of both risk and the time value of money. By using the market price as a measure
of value the value maximization criterion ensures that (in an efficient market) its metric is
all encompassing of all relevant information qualitative and quantitative, micro and macro.
Let us note here that value maximization is with respect to the interests of the providers of
capital, who ultimately are the owners of the firm. – the maximization of owners’ wealth
is the principal goal to be aimed at by the financial manager.

In many cases the wealth of owners will be represented by the market value of the firm’s
shares - that is the reason why maximization of shareholders’ wealth has become
synonymous with maximizing the price of the company’s stock. The market price of a
firms’ stocks represents the judgment of all market participants as to the values of that firm
- it takes into account present and expected future profits, the timing, duration and risk of
these earnings, the dividend policy of the firm; and other factors that bear on the viability
and health of the firm. Management must focus on creating value for shareholders. This
requires Management to judge alternative investments, financing and assets management
strategies in terms of their effects on shareholders’ value (share prices).

Difficulty of Achieving Shareholders Wealth Maximization

Two difficulties complicate the achievement of the goal of shareholder wealth

maximization in modern corporations. These are caused by the agency relationships in a
firm, and the requirements of corporate social responsibility.

Agency Conflict/Problem
In modern corporations, control (vested in management) is divided from ownership (vested
in shareholders). This separation is the cause of myriad conflicts of interests between
management and owners. During the past years a body of financial theory, the agency
theory, has emerged dealing with the conflict between shareholders and the resolution of
these conflicts.

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The genesis of the conflict is the opportunistic behavior of management, which makes them
place their (management) interest above that of shareholders. Consequently, shareholders’
wealth maximization goal is sacrificed. For instance, they may grant themselves excessive
salaries, consume large amounts of perquisites, engage in empire building, and make sub-
optimal investment decisions (retaining profits and investing in negative NPV projects
rather distributing profits as dividends).

Mechanism to Align Shareholder/Management Interests

In order to ensure that managers act in the best interests of the shareholders several
mechanisms may be employed. The most common measures are discussed below.
(i) Monitoring
Shareholders design mechanism to monitor management actions to ensure their interests
are not hurt. Monitoring of management by shareholders themselves is, however,
complicated for the following reasons:
- It is impossible for a shareholder without exception expertise to know to what
extend management have underperformed management can even conceal
alliaceous frauds they have committed form shareholders and throughout.
- Underperformance may result from extraneous circumstances beyond
management’ control. For example, changes in world prices of important inputs
(oil) could escalate costs, or changing tastes may make demand for a company’s
product to evaporate (i.e., cigars and pipe tobacco).
Shareholders are obligated to contract with external parties in order to effectively monitor
management. Some of the monitoring arrangements include the following:
Hiring auditors- who report annually to shareholders at the Annual General Meeting
(AGM) on the management’s stewardship of the company.
Board of directors- a properly constituted board plays the oversight role on management
for the shareholders
Bonding insurance. Taking fidelity insurance whereby the firm is compensated if the
insured management commits an infringement.

(ii). Executive compensations schemes

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Appropriate compensation schemes should be designed to address management’s aversion
to risk and their obsession with short-term decision horizon. Such schemes include;
- Stock options that make managers part owners help align interest of management
and shareholders
- Cash and stock bonus pegged to performance.

(iii). Shareholder-activism
The threat of bad publicity by disgruntled shareholders who can confront management and
create dissent among other stockholders, if the grievance is founded. can act as a deterrent
to managerialism.

(iv). Legal sanctions

Corporate boards and management also face legal liability for their acts of commission and
omission which betray their fiduciary duty to shareholders.

(v). Corporate takeover market (market for corporate control)

The possibility of an outside takeover of the company can be a powerful deterrent to

mismanagement. Management of firms that under-perform become target for take-over
bids. If a takeover bid succeeds incumbent management teams vacate their positions to
replace by new management teams

(vi). Market for executive labor.

In an efficient labor market, executives who underperform will lose their jobs and this may
adversely affect their reputational capital. They will find it hard to secure similar positions
in other companies. On the other hand, managers who maximize shareholders’ wealth can
keep their jobs. Inefficient managers will thus be driven out of the executive labor market
or be forced to take less rigorous jobs.

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Social Responsibility and Ethics

It has been argued that the unbridled pursuit of shareholders’ wealth maximization makes
companies unscrupulous, anti-social, enhances wealth inequalities and harms the environment.
The proponents of this position argue that maximizing shareholders’ wealth should not be
pursued without regard to a firm’s corporate social responsibility. The argument goes that the
interest of stakeholders other than just shareholders should be taken care of. The other
stakeholders include creditors, employees, consumers, communities in which the firm operates
and others. The firm will protect the consumer; pay fair wages to employees while maintaining
safe working conditions, support education and be sensitive to the environment concerns such
as clean air and water. A firm must also conduct itself ethically (high moral standards) in its
commercial transactions.
Being socially responsible and ethical cost money and may detract from the pursuit of
shareholders’ wealth maximization. So the question frequently posed is: is ethical behavior
and corporate social responsibility inconsistent with shareholder wealth maximization?

Scholars and practitioners concur that, in the long run, the firm has no choice but to act in
socially responsible ways. It is argued that the corporation’s very survival depends on it being
socially responsible. The implementation of a pro-active ethics and corporate social
responsibility (CSR) program is believed to enhance corporate value. Such a program can
reduce potential litigation costs, maintain a positive corporate image, build shareholder
confidence, and gain the loyalty, commitment and respect of firm’s stakeholders. Such actions
conserve firm’s cash flows and reduce perceived risk, thus positively effecting firm share price.
It becomes evident that behavior that is ethical and socially responsible helps achieve firm’s
goal of owner wealth maximization.

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