TOPIC ONE- INTRODUCTION

FRAMEWORK OF FINANCIAL MANAGEMENT

1.1 DEFINITION OF FINANCIAL MANAGEMENT

Financial Management is a discipline concerned with the generation and allocation of scarce
resources (usually funds) to the most efficient user within the firm (the competing projects)
through a market pricing system (the required rate of return).
A firm requires resources in form of funds raised from investors. The funds must be
allocated within the organization to projects which will yield the highest return.
We shall refer to this definition as we go through the subject.

Financial Management is concerned with efficient acquisition and deployment of both short
and long term financial resources to ensure the objectives of the enterprise are achieved.
The above definition has got 2 aspects.
1. Raising of financial resources (funds) with in a firm.
2. Effective allocation of financial resources.

(1) Raising of financial resources with in a firm. Financial managers have the
responsibility of ensuring that sufficient short & long term capital is available to the firm at
the time it’s needed and the surplus funds are invested at suitable high rates of return.

(ii) The allocation of funds with in the firm. Once the financial manager has raised the
required funds they have to be committed into long term requirements of the firm.
Today’s business environment is characterized by external forces of stiff corporate
competition, technological changes volatility in inflation and interest rates and global
economic uncertainty all of which have an increasing impact on the business performance
and survival.

The business manager today must have the flexibility to adapt to changing external
business environment effectively & efficiently invest in those assets that enhance success of
the economy in which the business operates.

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 1. 2 Required Rate of Return (Ri)
The required rate of return (Ri) is the minimum rate of return that a project must generate
if it has to receive funds. It’s therefore the opportunity cost of capital or returns expected
from the second best alternative. In general,
Required Rate of Return = Risk-free rate + Risk premium
Risk free rate is compensation for time and is made up of the real rate of return (Rr) and the
inflation premium (IRp). The risk premium is compensation for risk of financial actions
reflecting:
- The riskiness of the securities caused by term to maturity
- The security marketability or liquidity
- The effect of exchange rate fluctuations on the security, etc.
The required rate of return can therefore be expressed as follows:
Rj = Rr +IRp +DRp +MRp + LRp + ERp + SRp + ORp.
Where:
 Rr is the real rate of return that compensate investors for giving up the use of their funds in
an inflation free and risk free market.
 IRp is the Inflation Risk Premium which compensates the investor for the decrease in
purchasing power of money caused by inflation.
 DRp is the Default Risk Premium which compensates the investor for the possibility that
users of funds would be unable to repay the debts.
 MRp is the Maturity Risk Premium which compensates for the term to maturity.
 LRp is the Liquidity Risk Premium which compensates the investor for the possibility that
the securities given are not easily marketable (or convertible to cash).
 ERp is the Exchange Risk Premium which compensates the investors for the fluctuation in
exchange rate. This is mainly important if the funds are denominated in foreign currencies.
 SRp is the Sovereign Risk Premium which compensates the investors for the possibility of
political instability in the country in which the funds have been provided.
 ORp is the Other Risk Premium e.g. the type of product, the type of market, etc

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2. SCOPE OF FINANCE FUNCTIONS
The functions of Financial Manager can broadly be divided into two: The Routine functions
and the Managerial Functions.
2.1 Managerial Finance Functions
Require skilful planning, control and execution of financial activities. There are four important
managerial finance functions. These are:
(a) Investment of Long-term asset-mix decisions
These decisions (also referred to as capital budgeting decisions) relates to the allocation of
funds among investment projects. They refer to the firm's decision to commit current funds
to the purchase of fixed assets in expectation of future cash inflows from these projects.
Investment proposals are evaluated in terms of both risk and expected return.
Investment decisions also relates to recommitting funds when an old asset becomes less
productive. This is referred to as replacement decision.

(b) Financing decisions

Financing decision refers to the decision on the sources of funds to finance investment
projects. The finance manager must decide the proportion of equity and debt. The mix of debt
and equity affects the firm's cost of financing as well as the financial risk. This will further be
discussed under the risk return trade-off.

(c) Division of earnings decision

The finance manager must decide whether the firm should distribute all profits to the
shareholder, retain them, or distribute a portion and retain a portion. The earnings must also
be distributed to other providers of funds such as preference shareholder, and debt providers
of funds such as preference shareholders and debt providers. The firm's divided policy may
influence the determination of the value of the firm and therefore the finance manager must
decide the optimum dividend - payout ratio so as to maximize the value of the firm.

(d) Liquidity /working capital decision

The firm's liquidity refers to its ability to meet its current obligations as and when they fall
due. It can also be referred as current assets management. Investment in current assets affects
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the firm's liquidity, profitability and risk. The more current assets a firm has, the more liquid
it is. This implies that the firm has a lower risk of becoming insolvent but since current assets
are non-earning assets the profitability of the firm will be low. The converse will hold true.
The finance manager should develop sound techniques of managing current assets to ensure
that neither insufficient nor unnecessary funds are invested in current assets.

2.2 Routine functions

For the effective execution of the managerial finance functions, routine functions have to be
performed. These decisions concern procedures and systems and involve a lot of paper work
and time. In most cases these decisions are delegated to junior staff in the organization. Some
of the important routine functions are:
(a) Supervision of cash receipts and payments
(b) Safeguarding of cash balance
(c) Custody and safeguarding of important documents
(d) Record keeping and reporting
The finance manager will be involved with the managerial functions while the routine
functions will be carried out by junior staff in the firm. He must however, supervise the
activities of these junior staff.

3. OBJECTIVES OF A BUSINESS ENTITY

Any business firm would have certain objectives which it aims at achieving. The major goals
of a firm are:
 Profit maximization
 Shareholders' wealth maximization
 Social responsibility
 Business Ethics
 Growth
Financial Objectives
(a) Profit maximization

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Traditionally, this was considered to be the major goal of the firm. Profit maximization refers
to achieving the highest possible profits during the year. This could be achieved by either
increasing sales revenue or by reducing expenses. Note that:
Profit = Revenue – Expenses
The sales revenue can be increased by either increasing the sales volume or the selling price.
It should be noted however, that maximizing sales revenue may at the same time result to
increasing the firm's expenses.
The pricing mechanism will however, help the firm to determine which goods and services to
provide so as to maximize profits of the firm.
The profit maximization goal has been criticized because of the following:
i. It ignores time value of money
ii. It ignores risk and uncertainties
iii. it is vague
iv. it ignores other participants in the firm rather than the shareholders

(b) Shareholders' wealth maximization

Shareholders' wealth maximization refers to maximization of the net present value of every
decision made in the firm. Net present value is equal to the difference between the present
value of benefits received from a decision and the present value of the cost of the decision.

A financial action with a positive net present value will maximize the wealth of the
shareholders, while a decision with a negative net present value will reduce the wealth of the
shareholders. Under this goal, a firm will only take those decisions that result in a positive net
present value.
Shareholder wealth maximization helps to solve the problems with profit maximization. This
is because, the goal:
i. Considers time value of money by discounting the expected future cashflows
to the present.
ii. It recognizes risk by using a discount rate (which is a measure of risk) to
discount the cash flows to the present.
Non-Financial Objectives
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(c) Social responsibility
The firm must decide whether to operate strictly in their shareholders' best interests or be
responsible to their employers, their customers, and the community in which they operate.
The firm may be involved in activities which do not directly benefit the shareholders, but
which will improve the business environment. This has a long term advantage to the firm and
therefore in the long term the shareholders wealth may be maximized.
(d) Business Ethics
Related to the issue of social responsibility is the question of business ethics. Ethics are defined
as the "standards of conduct or moral behavior". It can be thought of as the company's attitude
toward its stakeholders, that is, its employees, customers, suppliers, community in general,
creditors, and shareholders. High standards of ethical behavior demand that a firm treat each
of these constituents in a fair and honest manner. A firm's commitment to business ethics can
be measured by the tendency of the firm and its employees to adhere to laws and regulations
relating to:
i. Product safety and quality
ii. Fair employment practices
iii. Fair marketing and selling practices
iv. The use of confidential information for personal gain
v. Illegal political involvement
vi. bribery or illegal payments to obtain business
(e) Growth
This is a major objective of small companies which may even invest in projects with negative
NPV so as to increase their size and enjoy economies of scale in the future.

4. 0 AGENCY THEORY

An agency relationship may be defined as a contract under which one or more people (the
principals) hire another person (the agent) to perform some services on their behalf, and
delegate some decision making authority to that agent. Within the financial management
framework, agency relationship exist between:
(a) Shareholders and Managers

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(b) Debt holders and Shareholders

4.1 Shareholders versus Managers

A Limited Liability company is owned by the shareholders but in most cases is managed by a
board of directors appointed by the shareholders. This is because:
i) There are very many shareholders who cannot effectively manage the firm all at the
same time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.
Conflict of interest usually occur between managers and shareholders in the
following ways:
i) Managers may not work hard to maximize shareholders wealth if they perceive that
they will not share in the benefit of their labour.
ii) Managers may award themselves huge salaries and other benefits more than what a
shareholder would consider reasonable
iii) Managers may maximize leisure time at the expense of working hard.
iv) Manager may undertake projects with different risks than what shareholders would
consider reasonable.
v) Manager may undertake projects that improve their image at the expense of
profitability.
vi) Where management buy out is threatened. ‘Management buy out’ occurs where
management of companies buy the shares not owned by them and therefore make the
company a private one.
Solutions to this Conflict

In general, to ensure that managers act to the best interest of shareholders, the firm will:
(a) Incur Agency Costs in the form of:
i) Monitoring expenses such as audit fee;
ii) Expenditures to structure the organization so that the possibility of undesirable
management behaviour would be limited. (This is the cost of internal control)

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 iii) Opportunity cost associated with loss of profitable opportunities resulting from
structure not permit manager to take action on a timely basis as would be the
case if manager were also owners. This is the cost of delaying decision.

(b) The Shareholder may offer the management profit-based remuneration. This
remuneration includes:
i) An offer of shares so that managers become owners.
ii) Share options: (Option to buy shares at a fixed price at a future date).
iii) Profit-based salaries e.g. bonus

(c) Threat of firing: Shareholders have the power to appoint and dismiss managers which
is exercised at every Annual General Meeting (AGM). The threat of firing therefore
motivates managers to make good decisions.
(d) Threat of Acquisition or Takeover: If managers do not make good decisions then the
value of the company would decrease making it easier to be acquired especially if the
predator (acquiring) company believes that the firm can be turned round.

4.2 Debt holders versus Shareholders

A second agency problem arises because of potential conflict between stockholders and
creditors. Creditors lend funds to the firm at rates that are based on:
i. Riskiness of the firm's existing assets
ii. Expectations concerning the riskiness of future assets additions
iii. The firm's existing capital structure
iv. Expectations concerning future capital structure changes.
These are the factors that determine the riskiness of the firm's cash flows and hence the safety
of its debt issue. Shareholders (acting through management) may make decisions which will
cause the firm's risk to change. This will affect the value of debt. The firm may increase the
level of debt to boost profits. This will reduce the value of old debt because it increases the
risk of the firm.
Creditors will protect themselves against the above problems through:

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 a) Insisting on restrictive covenants to be incorporated in the debt contract. These
covenants may restrict:
 The company’s asset base
 The company’s ability to acquire additional debts
 The company’s ability to pay future dividend and management remuneration.
 The management ability to make future decision (control related covenants)
b. If creditors perceive that shareholders are trying to take advantage of them in unethical
ways, they will either refuse to deal further with the firm or else will require a much higher
than normal rate of interest to compensate for the risks of such possible exploitations.

It therefore follows that shareholders wealth maximization require fair play with creditors.
This is because shareholders wealth depends on continued access to capital markets which
depends on fair play by shareholders as far as creditor's interests are concerned.

FINANCE & OTHER MANAGEMENT FUNCTIONS

When considering the financial functions in a firm, a financial manager must to some extent
be concerned with the way in which finance interacts with other activities in an
organization such as production, personnel, marketing, research and development.

The financial manager must ensure that the individual objectives of each function do not
conflict with the overall corporate objective of the business. For example a marketing
manager who seeks to increase sales or market share must do so with in budgetary
constraints and profitably in the long term. Budgeting is a useful way of coordinating all
functional activities.

FINANCIAL AND OTHER OBJECTIVES OF NOT FOR PROFIT ORGANISATIONS

The primary objective of Not for Profit Organizations (NFPS) is not to make profit but to
benefit prescribed groups of people.
Planning influences.
A number of factors influence the way in which management objectives are determined in
NFPS, which distinguish them from commercial businesses.
(i) Wide range stakeholders
(ii) High levels of interest from stakeholders’ groups
(iii)Significant degree of involvement from funding bodies & sponsors.
(iv) Little or no financial impact from the ultimate recipients of the service
(V) Government influence / government macro economic policy.

FINANCIAL OBJECTIVES OF NOT FOR PROFIT (NFPS)

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Since the services provided are limited primarily by funds available key objectives for
NFPS will be to.
- Raise as large a sum as possible
- Spend funds as effectively as possible.
- Targets may then be set for different aspects of each accounting period finances
such as amounts to be spent on specified projects meeting budgets & breaking even
in the long run etc

VALUE FOR MONEY (VFM) AS AN OBJECTIVE

Value for money can be defined as achieving the desired level and quality of service at the
most economical cost.
The concept VFM is of particular importance in NFPS because they often use public funds
raised through taxation or donation, face an increasing demand for accountability and do
not produce financial results such as profit figures.

The 3 ES
These are categorized as Economy, Efficiency and Effectiveness.
Economy: Involves minimizing the costs of inputs required to achieve a defined level of out
put.
Efficiency: Maximizing the useful output from a given level of resources or minimizing the
inputs required to produce the required level of outputs.
Effectiveness: Ensuring that the output from any given activity is achieving the desired
result.

REVIEW QUESTIONS
1(a) Financial management relies on an organizations’ having well defined financial and
non financial objectives. Discuss.

(b) Identify the different aspects of the financial management function with in an
organization and discuss the role of the financial manager as an “image maker” in relation
to these aspects.

2. For the purpose of achieving long term objective of a company the financial manager will
be faced with decisions on investment policy, on financing policy, and on dividend policy.
(i) Explain the nature of these types of decisions and the extent to which they are
interrelated

(ii) Explain the concept of value for money as an objective of Not for Profit Organizations’ &
briefly explain the use of the 3ES as a performance measure and a way to assess value for
money.

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