Rift valley university Jimma campus
CHAPTER ONE
AN OVERVIEW OF FINANCIAL MANAGEMENT
Financial management: financial management can be defined as the management of capital
sources and their uses so as to attain the desired goal of the firm (i.e. maximization of share
holders’ wealth).financial management involves sourcing of funds, making appropriate
investments and promulgating the best mix of financial and dividends in relation to the value of
the firm. Note: capital sources means items found on the right-hand side of the balance sheet i.e.
liabilities and owners’ equity whereas uses of capital means items found on the left hand side of
the balance sheet i.e. assets.
Financial Management is concerned with the acquisition, financing, & management of assets
with some overall goal in mind.
Major areas in the decision function of financial management:
•
Investment decision
•
Financing decision
•
Asset management decision
Historical development of financial management
Finance emerged as a field separate and distinct from economics around 1900. The first major
focus of financial management during its early years of development was the means how large
corporations of the time could raise capital. This was a period when the establishment of very
large companies like the Rockefeller oil and Morgan steel was marked. The economic depression
of the 1930s made financial management to shift to topics like preservation of capital,
maintenance of liquidity, reorganization of financially troubled companies, and the bankruptcy
process.
Until 1950s, the study of financial management had been descriptive or definitional in nature.
But in the mid 1950s, more analytical, decision – oriented approach began to evolve. These
include capital budgeting, cash and inventory management, capital structure formulation, and
allocation of income as dividends and retained earnings. Starting the late 1960s, the primary
focus of financial management has been on the relationships between risk and return of a firm’s
financial decision. That is financial management has focused on the maximization of earnings
(return) for a given level of risk; or minimization of risk for a given level of return
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
Major Areas of Finance
Since the concepts and areas of finance are very broad, the academic discipline of finance can be
viewed as made of specialized areas. There are several ways to summarize the major areas of
finance. One way is to review the career opportunities under it. Another way is based on the
differences in the objectives of different organizations. For the sake of simplifying our
discussion, we summarize the major fields of finance based on career opportunities in finance.
The career opportunities again can be divided into different categories. For our convenience,
these opportunities can be categorized into two broad areas.
Financial Services
This is a part of finance which involves personal career opportunities as a loan officer, financial
planner, stockbroker, real estate agent, and insurance broker. It is generally concerned with the
design, development, and delivery of these financial services to individuals, business
organizations, and governments.
Financial Management
Financial management is concerned with the financial decisions of a business firm. This firm can
be large or small, private or public, financial or non-financial, profit seeking or not-for-profit.
It involves specific financial functions of the firm.
Meaning of Financial Management
Financial Management can be clearly defined by viewing it as a subject, a process, or a function.
Financial management is one major area of study under finance. It deals with decisions made by
a business firm that affect its finances. Financial management is sometimes called corporate
finance, business finance, and managerial finance. These terms are used interchangeably in this
material.
Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.
There are many specified business functions performed by a business unit. These include
marketing, production, human resource management, and financial management.
Financial management is one of the important functions of a firm. It is a specified business
function that deals with the management of capital sources and uses of a firm.
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
Why Study Financial Management
If you are approaching financial management for the first time, you might wonder why students
like you study the field of financial management and what career opportunities exist. Many
business decisions made by firms have financial implications. Accordingly, financial
management plays a significant role in the operation of the firm. People in all functional areas of
a firm need to understand the basics of financial management. Accountants, information systems
analysts, marketing personnel and people in operations, all need to be equipped with the basic
theories, concepts, techniques, and practices of managerial finance if they have to make their
jobs more efficient and achieve their goals. That is why the course Financial Management is
offered to students in the fields of accounting, management, business administration, and
management information systems.
Finance and related fields
Though finance had ceded itself from economics, it is not totally an independent field of study. It
is an integral part of the firm’s overall management. Finance heavily draws theories, concepts,
and techniques from related disciplines such as economics, accounting, marketing, operations,
mathematics, statistics, and computer science. Among these disciplines, the field of finance is
closely related to economics and accounting.
Finance and Economics
The relevance of economics to financial management can be described in the light of the two
broad areas of economics: Macro -Economics and Micro- Economics.
Macroeconomics - is concerned with the overall institutional environment in which the firm
operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional
structure of the banking system, money and capital markets, financial intermediaries, monetary,
credit and fiscal policies and economic policies dealing with, and controlling level of activity
within an economy. Since business firms operate in the macroeconomic environment, it is
important for financial managers to understand the broad economic environment specifically,
they should: (1) recognize and understand how monetary policy affects the cost and availability
of funds; (2) be versed in fiscal policy and its effects on the economy; (3) beware of the various
financial institutions / financing outlets; (4) understand the consequences of various levels of
economic activity and changes in economic policy for their decision environment.
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
Microeconomics: - Deals with the economic decisions of individuals and organizations .It
concerns itself with the determination of optimal operating strategies. In other words, the
theories of Microeconomics provide for effective operations of business firms. They are
concerned with defining actions that will permit the firms to achieve success. The concepts and
theories of microeconomics relevant to financial management are, for instance, those involving
(1) supply and demand relationships and profit maximization strategies (2) issues related to the
mix of productive factors; optimal’ sales level and product pricing strategies (3) measurement of
utility preference, risk and the determination of value 4) the rationale of depreciating assets.
Thus, knowledge of economics is necessary for a financial manager to understand both the
financial environment and the decision theories which underline contemporary financial
management.
A basic knowledge of economics therefore, necessary to understand both the environment and
the decision techniques of financial management
Finance and Accounting
Conceptually speaking, the relationship between finance and accounting has two dimensions (i)
they are closely related to the extent that accounting is an important input in financial decision
making and (ii) there are key differences in view point between them. Accounting function is a
necessary input in to the finance function. That is accounting is a sub function of finance.
Accounting generates information/ data relating to operations/ activities of the firm. The end
product of accounting constitutes financial statements such as the balance sheet, the income
statement, and the changes in financial position/ sources and uses of funds statement/ cash flow
statement. The information contained in these statements and reports assists financial managers
in assessing past performance and future directions of the firm and in meeting legal obligation
such as payment of taxes and so on. Thus, accounting and finance are functionally closely
related. But there are two key differences between finance and accounting.
Treatment of Funds: The view point of accounting relating to the funds of the firm is different
from that of finance. The measurement of funds (income and expense) in accounting is based on
accrual principle / system. Revenue is recognized at the point of sale and not when collected.
Similarly, expenses are recognized when they are incurred rather than when actively paid.
But the view point of finance relating to the treatment of funds is based on cash flow. The
revenues are recognized only when actually received in cash (i.e. cash inflow) and expenses are
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
recognized on actual payment (cash out flow). This is so because the financial manager is
concerned with maintaining solvency of the firm by providing the cash flows necessary to satisfy
its obligations and acquiring and financing the assets needed to achieve the goals of the firm.
Decision making: - Finance and accounting also differ in respect of their purpose. The purpose
of accounting is collection and presentation of financial data. It provides consistently developed
and easily interpreted data on the past, present and future operations of the firm. The primary
focus of the function of accountants is on collection and presentation of data while the financial
manager’s major responsibility relates to financial planning, Controlling and decision -making.
Thus, in a sense, finance begins where accounting ends.
Scope of Financial Management
The approach to the scope and functions of financial management is divided, for purposes of
exposition into two broad categories: a) the traditional approach and (b) the modern approach.
a) Traditional Approach: - The traditional approach to the scope of financial management
refers to its subject-matter, in academic literature in the initial stages of its evolution as a
separate branch of an academic study.
b) Modern Approach: - The modern approach views the term financial management in abroad
sense and provides a conceptual and analytical framework for financial decision making.
According to it, the finance function covers both acquiring of funds as well as their allocations.
Thus, apart from the issues involved in acquiring external funds, the main concern of financial
management is the efficient and wise allocation of funds to various uses. It is viewed as an
integral part of the overall management. The main contents of this approach are: What is the total volume of funds an enterprise should commit?
 What specific assets should an enterprise acquire?
 How should the funds required be financed?
Financial institutions
Financial institutions serve as intermediaries by channeling the savings of individuals,
businesses, and governments into loans or investments. They are major players in the financial
marketplace, with a huge financial asset of most economies under their control. They often serve
as the main source of funds for businesses and individuals. According to Saunders and Cornett
(2004) financial intermediaries are also defined as companies whose primary function is to
intermediate between lenders and borrowers in the economy. Financial institutions perform the
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
essential functions of channeling funds from those with surplus funds to those with shortages of
funds. Some financial institutions accept customers’ savings deposits and lend this money to
other customers or to firms. In fact, many firms rely heavily on loans from institutions for their
financial support. Financial institutions are required by the government to operate within
established regulatory guidelines.
Financial institutions are what make financial markets work. Without financial institutions,
financial markets would not be able to move funds from who save to people who have
productive investment opportunities; and thus have important effects on the performance of the
economy as a whole. The most important financial institution in the financial system of an
economy is the central bank, the government agency responsible for the conduct of monetary
policy (Mishkin and Eakins, 2006). In addition to this, institutions in the financial system
include; commercial and savings banks, insurance companies, mutual funds, stock and bond
markets, credit unions and non-formal financial institutions (that are common in least developed
countries including Ethiopia).
The major services of financial institutions as identified on Fabozi (2004) are to one or more of
the following
1. Transforming financial assets acquired through the market and constituting them into a
different and more preferable type of asset—which becomes their liability. This is the
function performed by financial intermediaries, the most important type of financial
institution.
2. Exchanging financial assets on behalf of customers.
3. Exchanging financial assets for their own account.
4. Assisting in the creation of financial assets for their customers and then selling those
financial assets to other market participants.
5. Providing investment advice to other market participants.
6. Managing the portfolios of other market participants.
Financial intermediaries include: depository institutions that acquire the bulk of their funds by
offering their liabilities to the public mostly in the form of deposits; insurance companies (life
and property and casualty companies); pension funds; and finance companies. The second and
third services in the list above are the broker and dealer functions. The fourth service is referred
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
to as securities underwriting. Typically, a financial institution that provides an underwriting
service also provides a brokerage and/or dealer service.
Some nonfinancial businesses have subsidiaries that provide financial services. For example,
many large manufacturing firms have subsidiaries that provide financing for the parent
company’s customer. These financial institutions are called captive finance companies.
Function of financial institution
Financial intermediaries is a financial entity which performs the role of efficient allocation of
funds when they are conditions that makes it difficult for lenders or investors funds to deal
directly which borrowers of funds directly which borrowers of funds in financial markets.
Financial intermediaries includes depository institutions, insurance companies regulated
investment companies, investment banks and role of financial intermediaries is to create more
favorable transaction terms than could be sized by lenders /investors and borrowers dealing
which other in the financial market.
Financial intermediaries are engaged: Obtain funds from lenders or investors and
 Lending or investing the funds that they borrow to those who need funds
 Maturity intermediation
 Risk reduction via diversification
 Facilitating the trade of financial assets for financial intermediary’s customers.
 Facilitating the trade of financial assets by using it is capital to take a position in
financial asset, the financial intermediary’s customer want to transact in.
 Providing investment advice to customer.
 Manage the financial assets of customer.
 Providing payment mechanisms.
Role of Financial Institutions
Obtain funds by issue of financial claims and they invest those funds in the financial instruments
issued by other participants. The investment made by the financial intermediaries, their assets,
can be in the form of loans or securities. Thus the financial intermediaries plays a basic role of
transforming the financial assets which are less desirable for large part of public into other
financial assets, their own liability, which are widely preferred by public. The intermediaries
perform the following economic function:
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Rift valley university Jimma campus
1. Risk reduction through diversification
2. Maturity intermediation
3. Reduce the cost of contracting
4. Information Production
5. Providing payment mechanism
Each of this listed functions are discussed in brief below:
Risk reduction through diversification:
By choosing portfolio of investment rather than investing all one’s resources in a single asset, the
financial intermediary reduces the total risk to which they are expensed. Even if individuals can
also do this on their own, they may not be able to do this as cost effective as institutions
depending on the amount of funds they have to invest.
Maturity Intermediation:
Financial intermediaries provide the service of intermediating across maturity or borrowing short
and lending long.
This means that they accepts fund from investors who desire to lend their funds for short period
and they gives those funds to their borrowers who desire a long maturity. Maturity
intermediation presents two implications to financial markets:
(a) Investors have more choice concerning the maturity of their investment; borrowers have more
choice for length of their debt obligation.
(b) Counting up on successive short term deposits (which has a lower interest rate) providing
fund until maturity, the financial institutions can provide fund to borrowers at a rate lower
than that offered by individual investors.
Reduces the cost of contacting:
Intermediaries can reduce the cost of writing and understanding financial contract. They can also
reduce the cost of monitoring the activities of the contracting parties to ensure that the terms of
contract are observed. This is possible by appointing professional by financial intermediaries as
investment of funds are their normal business and they have large amount of fund to be invested.
The intermediaries can promise better service to lenders compared to borrowers of the fund.
1. Information Production:
Financial intermediaries provide the services of production of information about the value of
assets. Intermediaries expend considerable resources in collecting, processing, analyzing and
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
interpreting facts and opinions about future profitability and financial strength of the firm they
are financing. Intermediaries can also hire specialists in the production of the information. The
collection and analysis of information is important to them as their success depends on the
management of investment based on their information.
Providing a payment mechanism
Most of the business transactions made today is not done with cash. Instead payments are made
using checks, credit cards, debit cards, and electronic transfer of funds. Financial intermediaries
provide these methods of making payments
Types of Financial Intermediaries or Financial Institutions
Financial institutions are divided into three types:

Depository Financial Institutions

Non-Depository Financial Institutions

Investment Companies
Financial Markets
Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.
Functions of Financial Markets
Generally, financial markets play three important roles in functioning of corporate finance.
They assist the capital formation process. Financial markets serve as a way through which
firms can obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments.
They create
continuous liquid markets where firms can obtain the capital they need from individuals and
other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.
Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.
1. Classification on the basis of maturity
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
This is based on the maturity dates of securities
i) Money Markets - are financial markets in which securities traded have maturities of oneyear or less. Examples of securities traded here include treasury bills, commercial papers, short –
term promissory notes and so on.
ii) Capital Markets - are financial markets in which securities of long-term funds are traded.
Major securities traded in capital markets include bonds, preferred and common stocks.
2. Classification on the basis of the nature of securities
This is based on whether the securities are new issues or have been outstanding in the market
place.
i)
Primary Markets - are financial marketers in which firms raise capital by issuing new
securities.
ii)
Secondary Markets - are financial markets in which existing and already outstanding
securities are traded among investors. Here the issuing corporation does not raise new
finance.
Important Decision in Financial Management
1. Investment Decision: This decision is called capital budgeting decision. It generally answers
the question that what assets should the firm owns, investment decision or capital budgeting
involves the decision of allocation of capital or commitment of funds to long- term assets that
would yield benefits in the future.
2. Financing Decision: - The second major decision involved in financial management is the
financing decision. The investment decision is broadly concerned with the asset mix or the
composition of the assets of the firm. The concern of the financing decision is with the financing
mix or capital structure, or leverage. The term capital structure refers to the proportion of debt
(fixed – interest source of financing) and equity capital (variable – dividend securities/ source of
funds). The financing decision of a firm relates to the choice of the proportion of these sources to
finance the investment requirements.
3. Dividend Policy Decision: - The third major decision area of financial management is the
decision relating to the dividend policy. The dividend decision should be analyzed in relation to
the financing decision of a firm. Two alternatives are available in dealing with the profits of a
firm:
1. They can be distributed to the shareholders in the form of dividends or
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
2. They can be retained in the business itself.
The decision as to which course should be followed depends largely on a significant element in
the dividend decision, the dividend payout ratio that is what portion of net profits should be paid
out to shareholders. The final decision will depend up on the preference of the shareholders and
investment opportunities available within the firm. The second major aspect of the dividend
decision is the factors determining dividend policy on a firm in practice.
4. Asset Management Decision: After the assets are acquired the need to be managed
effectively. The financial manager is charged with the varying degree of operating responsibility
over existing assets.
1.4. Key Activities of the Financial Manager: The primary activities of a financial manager are
(1) performing financial analysis and planning (2) making investment decision, and (3) making
financial decisions.
Objectives of Financial Management
To make wise decisions a clear understanding of the objectives which are sought to be achieved
is necessary. The objective provides a framework for optimum financial decision-making. The
term objective is used in the sense of a goal or decision criterion for the four decisions involved
in financial management.
The financial manager uses the overall company’s goal of shareholders’ wealth maximization
which is reflected through the increased dividend per share, and the appreciations of the prices of
shares in formulating the financial policies and evaluating alternative course of actions. In order
to do so, this overall goal of wealth maximization needs to be related to take the following
specific objectives of financial management in account. These are:

Financial management aims at determining how large the business firm should be and
how fast should it grow?

Financial management aims at determining the best percentage composition of the firm’s
assets (asset portfolio decision of related to capital uses)

Financial management aims at determining the best percentage composition of the firm’s
combined liabilities and equity decisions related to capital sources.
Financial objective is:
•
To maximize the economic well-being, or wealth, of owners
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
•
Whenever a decision is to be made, management should choose the alternative
that most increases the wealth of the owners or the value of the firm.
Profit and Wealth Maximization
Meaning of Profit Maximization
Profit maximization is a function of maximizing revenue and /or minimizing costs. If a firm is
able to maximize its revenues for a given level of costs or minimizing costs for a given level of
revenues, it is considered to be efficient. Profit maximization focuses on the total amount of
benefits of any courses of action. This decision rule as applied to financial management implies
that the functions of managerial finance should be oriented to making of money. Under the profit
maximization decision criteria, actions that increase profit of a firm should be undertaken; and
actions that decrease profit should be rejected. Similarly, given alternative courses of actions,
decisions would be made in favor of the one with the highest expected profits. Profit
maximization, though widely professed, should not be used as a good goal of a firm in financial
management. This is because it fails to meet many of the characteristics of a good goal.
Profit Maximizations as a Decision Criterion
Profit maximization is considered as the goal of financial management, in this approach, actions
that increase profits should be undertaken and actions that decrease profits are avoided. Thus, the
investment, financing and dividend decisions also be noted that the term objective provides a
normative framework decisions should be oriented to the maximization or profit. The term
profits are used in two senses. In one sense it is used as an owner oriented.
In this concept it refers to the amount and share of national income that is paid to the owners of
business. The second way is operational concept i.e. profitability, this concept signifies economic
efficiency i.e. profitability refers to the situation where output exceeds input and, the value
credited by the use of resources is greater than the input resources.
Thus, in the entire decisions one test is used i.e. select asset, projects and decision that are
profitable and reject those which are not profitable.
Profit maximization criterion is criticized on several grounds .Firstly; the reasons for the
opposition that are based on misapprehensions about the workability and fairness of the private
enterprise itself. Secondly, profit maximization suffers from the difficulty of applying this
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
criterion in the actual real world situations. We shall now discuss some of the limitations of
profit maximization objective of financial management.
Ambiguity: The term profit maximization as a criterion for financial decision is vague and
ambiguous concept it lacks precise connotation. The term’ is amenable to different
interpretations by different people. For example, profit may be long-term or short term, it may be
total profit or rate of profit, it can be net profit before tax or net profit after tax, it may be return
on total capital employed or shareholders equity and so on.
Timing of Benefits: - Another technical objection to the profit maximization criterion is that it
ignores the differences in the time pattern of the benefits received from investment proposals or
course of action when the profitability is worked out, the bigger the better principle is adopted as
the decision is based on the total benefits received over the working life of the asset, irrespective
of when they were received
Example :- Jimma industrial park Company wants to choose between two projects: project X
and project Y. both projects cost the same, are equally risky and are expected to provide the
following benefits over three years period.
The profit maximization criterion ranks both projects as being equal. However, project X
provides higher benefits in earlier years and project Y provides larger benefits in later years. The
higher benefits of project X in earlier years could be reinvested to earn even higher profits for
later years. Profit seeking organizations must consider the timing of cash flows and profits
because money received today has a higher value than money received tomorrow. Cash flows in
early years are valued more highly than equivalent cash flows in later years.
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
Quality of Benefits: Another important technical limitation of profit maximization is that it
ignores the quality aspects of benefits which are associated with the financial course of action.
The term, quality means the degree of certainty associated with which benefits can be expected
to be gain.
Therefore, the more certain the expected return, the higher the quality of benefits. As against
this, the more uncertain or fluctuating the expected benefits, the lower the quality of benefits.
The profit maximization criterion is not appropriate and suitable as an operational objective. It is
unsuitable and inappropriate as an operational objective of investment, financing, and dividend
decisions of a firm. It is vague and ambiguous. It ignores important dimensions of financial
analysis, risk and time value of money.
An appropriate operational decision criterion for financial management should poses the
following quality.

It should be precise and exact.

It should be based on the bigger the better principle.

It should consider both quantities and quality dimensions of benefits.

It should consider time value of money
Example: jimma industrial park must choose between two projects. Both projects cost the same.
Project A has a 50% chance that its cash flows would be actually over the next three years.
Project B, on the other hand, has a 90% probability that its cash flows for the next three years
would be realized.
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By: Abebe ku.(MSC)
Rift valley university Jimma campus
Under profit maximization, project A is more attractive because it adds more to jimma industrial
park than project B. However, if we consider the risk of the two projects, the situation would be
reversed.
 Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000
 Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000
In fact, risk can be measured in different ways, and different conclusions about the riskiness of a
course of action can be reached depending on the measure used. In addition to the probability
distribution, illustrated above, risk can also be measured on the basis of the variation of cash
flows. The more certain the expected cash flow (return), the higher the quality of benefits (i.e.,
low risk to investor). Conversely, the more uncertain or fluctuating the expected benefits, the
lower the quality of benefits (i.e., high risk to investors).
Goal of the firm
As you understand, in a corporate form of business organization owners (stockholders) do not
run the activities of the firm. Rather, the stockholders elect the board of directors, who in turn
assign the management on behalf of the owners. So, basically, managers are agents of the owners
of the corporation and they undertake all activities of the firm on behalf of these owners.
Managers are agents in a corporation to maximize the common stockholders’ well-being.
However, there is a conflict of goals between managers and owners of a corporation and mangers
may act to maximize their interest instead of maximizing the wealth of owners. Managers are
interested to maximize their personal wealth, job security, life style and fringe benefits.
The natural conflict of interest between stockholders and managerial interest create agency
problems. Agency problems are the likelihood that mangers may place their personal goals a
head of corporate goals. Theoretically, agency problems are always there as long as mangers are
agents of owners. Corporations (owners) are aware of these agency problems and they incur
some costs as a result of agency. These costs are called agency cost and include:
1. Monitoring expenditures – are expenditures incurred by corporations to monitor or
control the activities of managers. A very good example of a monitoring expenditure is
fees paid by corporations to external auditors.
2. Bonding expenditures – are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.
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Rift valley university Jimma campus
3. Structuring expenditures – expenditures made to make managers fell sense of ownership
to the corporation. These include stock options, performance shares, cash bonus etc.
4. Opportunity costs – unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as
a result of their organizational structure and hierarchy.
The goal of the firm and financial management
The characteristics of a good goal
If a firm cannot choose its right goal, it can suffer severe consequences even to the extent of
going out of business. The failure of many public enterprises in Socialist Ethiopia, for example,
can be attributed to their failure to follow clear objectives. They were considered as successful
for they created job opportunities for thousands of people. But they had failed to produce
products accepted by the general public. In fact, selecting the right goal is not such a simple task;
but a good objective has the following characteristics.
1. It is clear and unambiguous – a clear goal will lead to decision criteria that do not vary from
case to case and from person to person.
2. It provides a clear and timely measure to evaluate the success or failure of decisions.
There should be some means to measure the objective.
 It does not affect the specific benefits of a firm.
 It does not affect the welfare of the society.
. It is based on long-term success of the firm. Even though there are many alternative decision
rules, in the sections that follow, we describe and evaluate the decision criteria for financial
management which are widely discussed in many finance literature.
Basic forms of business organizations
a. Sole proprietorship: is the business entity owned by one person (owner).
An incorporated business owned by one person proprietor such as:
 A sole trader
 Someone provide services
 Someone making goods
No legal entities formalities to set up
 Capital is restricted to what owners can invest.
 Owners are has sole liability (Unlimited liability).
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 Must keep accounting records, but no requirement to disclosure financial
information.
b. Partnership: is a small business entity owned by two or more than two people with
contractual agreement is called partnership.

Join two or more than two person together as co-workers.

Are business entities, but no legal entities.

Have debt for which each partners is personally liable (Unlimited liability).

Capital is restricted to what partner can invest.

Must keep accounting records, but no requirement to disclosure financial
information.
c. Corporation: is a business entity owned by stockholder or shareholder.
o A company are separate legal entity identify from its owner (members).
o Capital raised by issuing share to members.
o Shareholders have limited liability.

The business itself is liable for all debt.
o Must keep accounting records, including disclosure financial information.
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Rift valley university Jimma campus
Summary questions
I. Choice questions, select the best answer from the given alternatives.
1. One of the following is not among the characteristics of a good goal of a firm
A) It provides a timely measure to evaluate performance.
B) It provides a clear decision criterion.
C) It gives priority to stockholders at the expense of the society.
D) It is based on long-term success.
2. The goal of a firm in financial management is:
A) To maximize profits
B) To minimize costs
C) To maximize societal welfare
D) To maximize common stock prices
3. Given alternative investment choices, an investment that should be selected under wealth
maximization goal of a firm is the one that:
A) Provides the most fluctuating cash flows for a given level of cost.
B) Has the lowest required rate of return for a given level of expected cash flows.
C) Provides the highest earnings per share.
D) Have the lowest costs.
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By: Abebe ku.(MSC)