INTRODUCTION
FINANCE AS THE AREA OF STRUDY
What is exactly managerial finance or finance in general? What are the major responsibilities
and duties of managers of finance? In order to answer these question, you need to understand the
areas that finance cover. Finance, I general, consists of three interrelated areas: (1) Money and
capital markets, which deal with securities markets and financial institutions; (2) investments,
which focus on the decision of investors, both individuals and institutions, as the choose among
securities for their investment portfolios; ;and (3) financial management or "business finance"
which involves the actual management of business firms. The career opportunities within each
field are many and varied, but managers of finance must have a knowledge of all three areas if
they are to perform their jobs well.
1) Money and Capital Markets:- Most of the finance professionals go to work for financial
institutions, including banks, insurance companies, investment companies, credits and savings
associations. For you to succeed in doing such jobs you nee a knowledge of the factors that
cause interest rates to rise and fall, the regulations to which financial institutions are subjected,
and the various types of financial instruments such as bonds, shares, mortgages, certificates of
deposits and so on. You also need a general knowledge of all aspect of business administration,
because the management of financial institutions involves accounting, marketing, personnel
management, computer science as well as financial management. An ability to get people to do
their job (i.e. people skills) is very critical.
2) Investments:- Finance graduates who go into investment areas generally work for
brokerage houses in the sales of securities or as security analysts. Others work for banks
and insurance companies in the management of investment portfolios, or the work for
financial consulting firms which advise individual investors or pension funds on how to
invest their funds. The three major functions I the investment area are (1) sales of
securities (2) the analysis of individual securities, and (3) determining the optimal mix
of securities for a given investor.
3) Financial management:- Financial management is the focus of this material. In the
entire body of this text, the discussions are specific to financial management. It is the
broadest area in finance and the one with greatest number of job opportunities. Financial
management is important in all types of businesses, including banks, and other financial
institutions as well as other form of businesses. Financial management is also important
in governmental operations, from schools to hospitals and from zonal administrative
levels to states administrative levels and even beyond that.
The types of jobs encountered in financial management range from decisions regarding plant
expansion to choosing what types of securities to issue to finance the expansion. Financial
managers also have the responsibility for deciding the credit terms under which customers
may buy, how much inventory the company should carry, how much cash to keep on hand
whether to acquire other company (merger analysis) and how much of the firms earnings to
retain in the business versus payout as dividends.
Regardless of which specific area of finance you are emphasing on you need a knowledge of
all the three areas (i.e. money and capital market, investments, and financial management).
For example a banker lending to businesses cannot do his or her job properly with out a good
understanding of financial management, because he or she must be able tot judge how well
the businesses are operating. In the same way, company's financial managers need to know
what their bankers consider important and how investors are likely to judge their company's'
performance and thus determine their stock prices.
The Central Role of Capital:
Capital, as you know, is essential for the operation any form of Financial Management may
be defined in terms of the relationship between capital and the business firm. A business
firms, whether it is a newly established or an existing on , must obtain a certain amount of
capital to finance itself in order to produce and sell goods and services to its customers. An
initial capital/funds of the newly formed firm consists of funds secured from the owners of
the firm in the form of equity capital and from the creditors in the form of both short-term
and long-term loans. An existing firm may finance itself by retaining part of its earnings in
addition to the two sources indicated. The capital of the firm, whether it is generated
internally from operations or provided, by owners and creditors, constitutes the sources of the
firms capital and recorded on the right-hand side of the balance sheet as liabilities and
owners' equity.
The acquired capital is thus used to employ personnel, to obtain offices and other
manufacturing facilities, inventories, and other assets. The capital is also used for producing
goods and services to meet customers' demands. The acquired assets constitute the uses of
the capital of the firm and are listed in the left-hand side of the balance sheet (i.e assets). The
balance sheet of the firm is thus contains both the uses and sources of the capital of the firm.
The balance sheet records these values at the particular point in time. To complete the
balance sheet, the firm records the results of its operations during a given period of time,
such as a year in its income statement. The income statement, as you know, lists the firms
revenues generated, expenses incurred, and profit earned over a span of time and provides a
measure of the ability of the firm to manage its capital sources and uses. These two financial
statements (balance sheet and incomes statement) picture a firm as an entity that finances
itself with capital from various sources and puts this capital into various uses in order to
generate the desired amount of revenues and profits.
Financial Management and Capital
Capital sources and uses must be carefully managed if the firm needs to be profitable for its
financiers. Financial management is the specialized business function that deals with this
problem.
In general, financial management can be defined as the management of capital sources and
uses so as to attain the desired goals of the firm (i.e maximization of shareholders' wealth).
Firm is capital consists of items of value that are owned and used and items that are used but
not owned. For example, the office space that a business firm has rented for doing business
and th bank loans that the firm has taken to finance its operations are items of values that the
business firm can use but doesn't own. Similarly, inventories and fixed assets purchased by
the firm. Capital sources are those items found on the right-hand side of the balance sheet
(i.e., the liabilities and equity section as indicated earlier.) Example of the use of the capital
of the firm are receivables, inventories, and fixed assets. As an area of study, financial
management is concerned with two distinct functions. These are: (1) the financing function,
and (2) the investing function. The financing function describes the management of the
sources of capital. The investing function, on the other hand, concentrates on the type, size
and percentage composition of capital uses. It deals with the question "how much of the total
capital provided by the financing sources should be invested in receivables, marketable
securities, inventories, and fixed assets?" The specialized set of management duties and
responsibilities that center around the financing and investing functions are referred to as
financial management.
One additional concept contained in the definition of financial management is concerned
with the goal directed behavior or goral orientation. The problems and opportunities that
financial managmers face and the business decisions they are required to make entirely
depend on the purposes or goals of their organizations. Profit seeking organizations should
actually behave in a way they maximize the wealth o their shareholders. It is very important
for you at this point to distinguish between wealth maximization and profit maximization as
goals of business firms.
There are two ways in which the wealth of shareholders change. These are: (1) Through
changing dividend payments, and (2) through the change in the market price of common
shares. Hence, the change in shareholders wealth of business firms may be calculated as
follows:
1. Multiply the dividend per share paid during the period by the number of shares
owned.
2. Multiply the change in shares price during the period by the number of shares owned.
3. Add the dividends and the change in the market value computed in step 1 and 2 to
obtain the change in the share holder's wealth during the period.
In order to maximize the wealth of shareholders, a business firm must seek to provide the larges
attainable combination of dividends per share and stock price appreciation. But the problem is
that while a business firm may have some degree of freedom in setting its dividend policy that is
in accordance with wealth maximization goal, it can't influence the shares prices which are
basically set by the interaction of buyers and sellers in the securities/stocks markets. Stock
prices tend to reflect the perception of the stockholders on the ability of the business firm to earn
profits and the degree of risks that the business firm assumes in earning; its profit. The ultimate
risk that the business firm usually faces is the probability that it will fail or go bankrupt. In such
an event, the owners/shareholders of the business firm would see their investment becoming
worthless; and the creditors would likely see that at least some portion of their loans go unpaid.
These events have impacts on the market prices of shares which in turn have impacts on the
objective of business firm, that is wealth maximization of shareholders.
Profit-maximization, on the other hand, is a traditional micro economics theory of business firm
which was historically considered as the goal of the firm. Profit maximization stresses on the
efficient use of financial/capital resources of the firm. Profit maximization as a goal of the
business firm ignores however, many of the real world complexities that financial managers try
to address in their decisions. Profit maximization functions largely as a theoretical goal;
economists use it to prove how firms behave rationally to increase profit. When finance was
emerged as a separate area of study, it has retained profit maximization which is the new
concept, profit maximization looks at the total company profit rather than profit per share. Profit
maximization doesn't speak about the company's dividends as either a return to shareholders or
the impact of dividend policy on stock prices. In the more applied discipline of financial
management, however, firms must deal every day with two major factors: These are uncertainty
and timing.
Uncertainty of Returns:
Profit maximization as the goal of business firms ignores uncertainty and risks in order to
present the theory more easily. Projects and investment alternatives are compared by examining
their expected values or weighted average profits. Whether or not one project is riskier than
another doesn't enter these calculations; economists do discuss risk, but tangentially. In reality
project differ a great deal with respect to the risk characteristics, and disregarding these
difference can result in incorrect decisions.
To better understand the implication of ignored risks, let us look at two mutually exclusive
investment alternatives (that is, only one of the two can be accepted). The first project involves
the use of existing plant to produce plastic combs, a product with an extremely stable demand.
The second project uses existing plant to product electric vibrating combs. These latter products
may catch on and do well, but it could also fail. The optimistic, pessimistic, and expected
production are given as follows:
Profit figures
Optimistic outcome
Expected outcome
Pessimistic Out come
Plastic Comb
$10,000
10,000
10,000
Electric Com
$20,000
10,000
0
There is no variability that is associated with the possible outcomes of producing and selling
plastic combs because demand for this product is stable. If things go well (optimistic), poorly
(pessimistic), or as expected, the profit will still be the same 10,000 Birr. With that of the
electric combs however the range of possible profit figures vary from 20,000 Birr if things go
well (optimistic), to 10,000 Birr if things go as expected, or to the profit figure of zero if things
go wrong (pessimistic). Here, if you look at just the expected profit figure of 10,000 Birr, it is
the same for both projects and you conclude that both projects are equivalent. They are not,
however. The returns (profit figures) associated with electric combs involve a much greater
degree of uncertainty or risk.
The goal of profit maximization, however, ignores uncertainty (risk) and considers these projects
equivalent in terms of desirability as it refers only to the expected profit figures from the
projects.
Thing of Returns: Another problem with profit maximization as the goal of business firm is
that it ignores the timing of the returns from projects. To illustrate, let us reexamine our plastic
comb versus electric comb investment decisions. This time let us ignore risk and say that each of
these projects is going to return a profit of 10,000 Birr during the first year (year 1) but it is after
one year before the electric comb can go into production, while the plastic comb can begin
production immediately. The timing of the profit from these project are as follow:
Profit figures
Year 1
Year 2
Plastic Comb
$10,000
0
Electric Com
$0
10,000
In this the total profits from each project are the same, but the timing of earning the profits
differs. As we will see later on in the chapter of "the time value" of money, money has a definite
time value. Thus, the plastic com project is the better of the two. The 10,000 Birr profit comb
project during year 1 could be invested in the saving account that earns an interest of 5 percent
per annum. At the end of the second year the money would have grown to 10,500 birr as
opposed to the 10,000 Birr profits to be reported at the end of the second year for the electric
comb project. since investment opportunities are available for the money on hand, we are not
indifferent to the timing of the returns (profits) from these investment opportunities. given
equivalent cash flows from profits, we want the cash flows to occur sooner rather than later.
Therefore, the financial manager must always consider the possible timing of returns (profits) in
financial decision making.
Therefore, the real-world factors of uncertainty and timing of returns force financial managers to
look beyond a simple profit maximization as the goal of the business firm. These limitations of
profit maximization as the goal of business firms leads us to the maximization of the more robust
goal of the business firm that is maximization of shareholders wealth.
Maximization of Shareholder's Wealth:
In formulating the goal of maximization of shareholder's wealth we are doing nothing more than
modifying the goal of profit maximization to deal with the complexities of the operation
environment. We have chosen maximization of shareholder's wealth, that is maximization of the
total market value of the existing shareholders' common stock because the effect of all financial
decisions is reflected through these prices. The shareholders react to poor investment or
dividend decisions by causing the total value of the firm's stock to fall and they react to good
decisions by pushing the price of the stock up.
Obviously, there are some series practical problems in direct use of this goal and evaluating the
reaction to various financial decisions by examining changes in the firm's stock value. Many
things affect stock prices. To employ wealth maximization as the goal of your business firm,
you need not consider every stock price change to be the market interpretation fo the worth of
you decision. Other factors such as economic expectations, also affect stock price movements.
What you do focus on is the effect that your decision should have on the stock price if every
thingelse where held constant. The market price of the business firm's stock reflect the value of
the firm as seen by its owners. the wealth maximization as the goal of business firm takes into
account uncertainty or risk, time, and any other factors that are important to the owners of the
firm. Thus, again, the frame work of maximization of shareholders' wealth allows for a
decisions environment that includes the complexities and complications of the real-world.
The Agency Problem
While the goal of the business firm will be maximization of shareholders' wealth, in reality the
agency problem may interfere with the implementation of this goal. The agency problem is the
result of a separation of the management and the ownership of the firm. For example, a large
business firm may be run by professional managers who have little or no ownership position in
the firm. As the result of this separation between the decision makers and owners, managers
may make decisions that are no in line with goal of business firm, or the interest of owners, that
is maximization of shareholders' wealth. Professional managers may attempt to benefit them
selves I terms of salary and perquisites at the expense of shareholders. The exact significance of
this problem is difficult to measure. However, while it may interfere with the implementation of
the goal's of maximization of shareholders' wealth I some firms, it does not affect the goal's
validity. The costs associated with the agency problem are also difficult to measure, but
occasionally we can see the effect of this problem in the marketplace. For example, if the market
feels that the management of business firm in damaging shareholders' wealth, we might see a
positive reaction in the stock price to the removal of that management.
The Objective of 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 financial policies and evaluating alternative course of operation. In order
to do so, this overall goal of wealth maximization needs to be related to take the following
specific objectives of financial management into account. These are:
1) Financial management aims at determining how large the business firm should be and
how fast should it grow.
2) Financial management aims at determining the best percentage composition of the
firm's assets (asset port of lio decision, or decisions related to capital uses).
3) Financial management also aims are determining the best percentage composition of
the firm's combined liabilities and equity decisions related to capital sources).
1) Determining the Size and Growth Rate:
The size of the business firm is measured by the value of its total assets. If the book values are
used the size of the firm is equal to the total assets as indicated I the balance sheet. When this
method of size determination is used, the growth rate of the business firm is measured by the
yearly percentage change in the book values of all the items I the assets section of the balance
sheet.
As the student of financial management, you should be able to understand that business firm that
is large and growing fast and larger doesn't necessarily produce increasing earnings.
2) Determining Assets Composition (Portfolio):
As indicated earlier, assets represent investments or uses of capital that the business firm makes
in seeking to earn a rate of return for its owners. The most common asset categories are cash,
inventories, and fixed assets. However, financial institutions, such as banks and insurance
companies, have some what different assets categories. they may list loans and advances and
negotiable securities as assets. The percentage composition of the assets of the firm is computed
as ratio of the book value of each asset to total book values of all assets. The choice of the
percentage composition of assets item affect the level of business risk. The asset structure
decision relate to what products and services the business firm should produce. The financial
manager is directly involved in decisions related to the assets structure that makes business firm
more successful in a way it will maximize the wealth of shareholders. The wealth maximizing
assets structure can be described in either of the following ways:
1) The asset structure that yields the larges profits for a given level of exposures to
business risk, or
2) The asset structure that minimizes exposure to business risk that is needed to generate
the desired profits.
In both of the cases (i.e. 1 and 2), the financial manager should recognize that the asset structure
of the business firm is the major determinant of the overall risk-return profile of the firm.
3) Determining the Composition of Liabilities and Equity
As it was stated, liabilities and equity are the sources of capital of the business firms. They are
the financing sources that business firms use to make investment I various types of assets. The
most common financing sources are accounts and notes payable, accruals for items such as taxes,
wages, loans and debt securities of various maturity dates, common stocks, preferred stocks and
retained earnings. Here again, banks ad insurance companies might secure funds from liability
accounts such as time deposits, demand deposit, and saving deposits. As it was done for the
percentage composition of assets, the liability and equity percentage composition of the business
firm is measured by dividing the book value of each liability of equity item by the total book
values of all liabilities and equity. The mix of liabilities and equity of the business is what is
known as the capital structure.
When the business firm finances its investment by using debt capital, the business firm and its
shareholders face added risks along with the possibility of added returns. The added risk is the
possibility that the firm may face difficulty to repay its debts as they mature. Stock prices react
to the manner of financing of business firm, as well as, to the subsequent ability or inability of
the firm to manage its capital structure. The added returns come from the ability of the firm to
earn the rate of return higher than the interests and related financing costs of using liabilities.
The added returns may be paid as dividends and/or reinvested in the firm to generate more
profits. This in effect would maximize the wealth of shareholders of the business firm .
The Evolution of the Finance Function
Finance become a separate area of study around 1900 for the first time. Since that time, the
duties and responsibilities of the financial managers have undergone continuous change, and
expected to change in the future as well. The two main reasons for the ongoing change in the
functions of finance are (1) the continuous growth and increasing diversity of the national and
international economy, and (2) the time to time development of new analytical tools that have
been adopted by financial managers.
Finance Before 1930
Up to 1900, finance was considered as a part of applied economics. The 1890s and 1900s were
the periods of major corporate mergers and consolidations in the American economy. These
mergers and consolidations were gradually transmitted to other economics all over the world.
These activities required unprecedented amount of financing. The management of the capital
structure of companies that had been formed as a result of mergers and consolidations become an
important task, and finance was emerged as distinct functional area of business management.
The major technological innovations of the 1920s created entirely new industries such as radio
and broadcasting stations. These new industries produces not only large quantities of output but
also earned high profit margin. Financial management was found to be important in dealing with
problems related to planning and controlling the liquidity of the newly emerged industries of
that time.
The stock market crash of 1929 and the subsequent economic depression occurred in the
American economy resulted in the worst economic conditions that occurred in the 20th century.
Bankruptcy, reorganization,, and mere survival become major problems for many corporations.
The capital structure which was dominated by debt aggravated the solvency and liquidity
problems of companies. Financial management is additionally responsible for the planning of
the rehabilitation and survival of the business firm.
Finance Since 1950
These days, large number of people are employed and work I manufacturing and service
industries that didn't exist before. Much of this rapid economic growth occurred because the
increased rate of technological advancement. The computerization process in almost all of these
industries is an example of the extent to which our economy has become dependent on new
technologies.
As new industries have arisen and as olders industries have sought ways to adapt to the rapidly
changing technologies, finance has become increasingly analytical and decision oriented. This
evolution of the finance function has been influenced by the development of computer science,
operations research and isometrics as tools for financial management functions.
To summarize, the evolution of finance functions contains the following three important points:
1. Finance is relatively new as a separate business management function.
2. Financial management, as it is presently practiced, is decision oriented and uses
analytical tools such as quantitative and computerized techniques, economics, and
managerial accounting:
3. The continuing rapid pace of economic development virtually guarantees that the
finance function will not only continue to develop but also have to accelerate its pace
of development to keep up with the complex problems and opportunities that
corporate manger are facing.
Chapter Summary
This first chapter has provided you an introduction to finance as the area of study and to
managerial finance as an important business function.
The chapter also examined the goal of the business firm the commonly accepted goal of profit
maximization is contrasted with the more compete goal of the maximization of shareholders'
wealth. This is because of the fact that walth maximization foal deals with uncertainity and time
in a real world environment., this goal is found to be the proper goal of the firm. In other words
shareholders' wealth maximization attempts to take into account both risk and return and is
superior in a number of important ways to that of the traditional economic goal of profit
maximization.
Finance first appeared as a distinct area of study around 1900 and initially focused on capital
structure composition.
During the great depression, bankruptcy and reorganization finance
became an important consideration. Since 1950, finance became an important consideration.
Since 1950, finance became decision oriented with respect to both asset and capital structure
management and also became increasingly analytical in nature. The tools of the financial
manager now include accounting, economics, computer science, and quantitative analysis of
operations research.