Chapter One: Introduction to Financial Management

Introduction:

Business concern needs finance to meet their requirements in the economic world. Any kind of
business activity depends on the finance. Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need finance to fulfill their business
activities.

In the modern world, all the activities are concerned with the economic activities and very
particular to earning profit through any venture or activities. The entire business activities are
directly related with making profit. (According to the economics concept of factors of
production, rent given to landlord, wage given to labour, interest given to capital and profit given
to shareholders or proprietors), a business concern needs finance to meet all the requirements.
Hence finance may be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any kind of economic
activity.

To have a good understanding of financial management, you need to understand first what
finance is. Literally, finance means the money used in day-to-day activities of an individual or a
business for exchange of goods and services. But here our focus rather should be to consider
finance as a separate and distinct field of study like accounting, economics, mathematics, history,
geography etc...

The Meaning of Finance

Finance includes financial service and financial instruments. It is also referred as the provision of
money at the time when it is needed. The finance function mainly focuses on the procurement of
funds and their effective utilization in business concerns.

The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important part of
the business concern.

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Definition of finance:
According to Khan and Jain, “Finance is the art and science of managing money”. This is
because in addition to principles and techniques, finance requires individual judgment of the
person making the financial decision. Finance is a distinct area of study that comprises facts,
theories, concepts, principles, techniques and practices related with raising and utilizing of funds
(money) by individuals, businesses, and governments.

Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore, finance
is also an area of study that deals with how, where, by whom, why, and through what money is
transferred among and between individuals, businesses, and governments. It is concerned with
the processes, institutions, markets, and instruments involved in the transfer of funds.

Types of finance
Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names.

Finance can broadly be classified into three major categories:

 Personal finance
 Public finance
 Business finance

I. Personal finance: - This deals with the mobilization of funds from own sources. Here funds
may imply cash and non-cash items also.
II. Public finance: - This kind of finance which deals with the mobilization or administration of
public funds. It includes the aspects relating to the securing of funds by the government from
public through various methods viz. taxes, borrowings from public and foreign markets etc.
III. Business finance: - Financial management actually concerned with business finance.
Business finance is pertaining to the mobilization of funds by various business enterprises.
Business finance is a broad term includes both commerce and industry. It applies to all the
financial activities of trade and auxiliaries of trade such as banking, insurances, mercantile
agencies, service organizations, and the manufacturing enterprises.

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Meaning of Financial Management
Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm. The term financial management can be defined as
the efficient use of an important economic resource namely, capital funds”.

The most popular and acceptable definition of financial management as given by S.C. Kuchal is
that “Financial Management deals with procurement of funds and their effective utilization in the
business”.

Financial management refers to that part of the management activity, which is concerned with
the planning, & controlling of firm’s financial resources. It deals with finding out various sources
for raising funds for the firm and using the raised funds effectively.

Financial management is practiced by many corporate firms and can be called corporate finance
or Business Finance. According to Guttmann and Douglas: “Business finance can be broadly
defined as the activity concerned with the planning, raising, controlling and administrating the
funds used in the business.”According to Joseph & Massie: “Financial Management is the
operational activity of a business that is responsible for obtaining and effectively utilizing the
funds necessary for efficient operations”

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.

Financial Management is the application of the general management principles in the area of
financial decision-making, namely in the areas of investment of funds, financing various
activities, and disposal of profits.

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Financial management is the art of planning; organizing, directing and controlling of the
procurement and utilization of the funds and safe disposal of profits to the end that, individual,
organizational and social objectives are accomplished.

Major Areas of Finance

The areas of finance can be referred to as the parts that are included in finance. And these major
areas of finance are:

i) Corporate finance/financial management

Finance is regarded as the lifeblood of a business enterprise. It is the guide for regularizing
investment decisions and expenditure, and endeavors to squeeze the most out of every available
birr. It is the sinew of business activity. And it has been rightly said that business needs money to
make more money. However, it is also true that money begets more money only when it is
properly managed. Hence, efficient management of every business enterprise is closely linked
with efficient management of its finance; i.e., corporate finance/financial management.

In every organization, where funds are involved, sound financial management is necessary. It
helps in monitoring the effective the effective deployment of funds in fixed assets and in
working capital. Hence, it can be said that sound financial management is indispensible for any
organization, whether it is profit oriented or non-profit oriented. It helps in profit planning,
capital spending, measuring costs, controlling inventories, accounts receivable etc. In addition to
the routine problems, financial management also deals with more complex problems like
mergers, acquisitions and reorganizations.

ii) Investments
Investment as an area of finance deals with the study of techniques used by
individuals/businesses to manage portfolios and provide financial planning. The success of a
business unit depends upon the investment of resources in such a way that bring in benefits or
best possible returns from any investments. The investment in general means an expenditure in
cash or its equivalent during one or more time periods in anticipation of enjoying a net cash
inflows or its equivalent in some future time period or periods. The investment in any project
will bring in desired profits or benefits in future. If the financial resources were in abundance, it
would be possible to accept several investment proposals which satisfy the norms of approval or

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acceptability. Since, we are sure that resources are limited; a choice has to be made among the
various investment proposals by evaluating their comparative merit.

iii) Financial Markets & Institutions

Financial markets and financial institutions comprise the third area of business finance. Financial
markets include everything from the stock and bond markets, the primary and second markets,
and the money and capital markets.

Financial markets, such as the stock market, help facilitate the transfer of funds between savers
of funds and users of funds. Savers are usually households, and users are generally businesses
and the government. The stock market, for instance, provides a seamless exchange of ownership
of a company between one person or business and another.

The financial institutions work hand in hand with the financial markets. Financial institutions
generally act as intermediaries that help make transfers of funds between businesses and savers
(working as a broker or agent for the trade). For example, an individual might deposit money
into a savings account. Then, the financial institution would take that money and loan it out to a
business.
iv) International finance
International finance – sometimes known as international macroeconomics – is the area of
finance that deals with the monetary interactions that occur between two or more countries. This
section is concerned with topics that include foreign direct investment and currency exchange
rates.

Why do We 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

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isbeing offered to students in the fields of accounting, management, business administration, and
management information systems.

If you develop the necessary training and skills in financial management, you have career
opportunities in a good deal of positions as a financial analyst, capital budgeting, project finance,
cash, and credit manager, financial manager, banker, financial consultant, and even as a general
manager. The author hopes you will appreciate the importance of financial management as you
learn it more.

Finance and related fields

Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches.

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.

1. Finance versus Economics

Finance and economics are closely related in many aspects. First, economics is the mother field
of finance. Second, the economic environment within which a firm operates influences the
decisions of a financial manager. A financial manger must understand the interrelationships
between the various sectors of the economy. He must also understand such economic variables
as a gross domestic product, unemployment, inflation, interests, and taxes in making financial
decisions.

Financial managers must also be able to use the structure of decision-making provided by
economics. They must use economic theories as guidelines for their efficient financial decision
making. These theories include pricing theory through the relationships between demand and
supply, return analysis, profit maximization strategies, and marginal analysis. The last one,
particularly, is the primary economic principle used in financial management.

Basic Differences between Finance and Economics

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 i) Finance is less concerned with theory than is economics. Finance is basically
concerned with the application of theories and principles.
ii) Finance deals with an individual firm; but economics deals with the industry and the
overall level of the economic activity.

2. Finance Vs Accounting
Accounting provides financial information through financial statements. Therefore, these two
fields are closely linked as accounting is an important input for financial decision-making.
Besides, the accounting and finance functions generally overlap; and usually it is difficult to
distinguish them. In many situations, the accounting and finance activities are within the control
of the financial manager of a firm.
Basic Differences between Finance and Accounting
i) Treatment of income: - in accounting income measurement is on accrual basis.
Under this method revenues are recognized as earned and expenses as incurred. In
finance, however, the cash method is employed to recognize the revenue and
expenses.
ii) Decision-making: - the primary function of accounting is to gather and present
financial data. Finance, on the other hand, is primarily concerned with financial
planning, controlling and decision-making. The financial manger evaluates the
financial statements provided by the accountant by applying additional data and then
makes decisions accordingly.
iii) Accounting is highly governed by generally accepted accounting principles.

Primary Disciplines

Financial Decision areas 1. Accounting

Support 2. Economics
1. Investment analysis
2. Working capital management
3. Sources and costs of funds
4. Capital structure decisions
Other Related Discipline
5. Dividends policy
1. Marketing
6. Analysis of risk and return Support
2. Production
3. Quantitative Methods
Resulted in

Shareholder wealth maximization

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The scope of financial management
The scope of financial management refers to the range or extent of matters being dealt with in
financial management.

Financial management has undergone significant changes over the years as regards its scope and
coverage. As such the role of finance manager has also undergone fundamental changes over the
years. In order to have a better exposition to these changes, it will be appropriate to study both
the traditional concept and the modern concept of the finance function.

Traditional View:
In the beginning of the present century, which was the starting point for the scholarly writings on
Corporation Finance, the function of finance was considered to be the task of providing funds
needed by the enterprise on terms that are most favorable to the operations of the enterprise. The
traditional scholars are of the view that the quantum and pattern of finance requirements and
allocation of funds as among different assets, is the concern of non-financial executives.
According to them, the finance manager has to undertake the following three functions:
i. arrangement of funds from financial institutions;
ii. arrangement of funds through financial instruments, Viz., shares, bonds, etc
iii. Looking after the legal and accounting relationship between a corporation and its sources
of funds.

The traditional concept found its first manifestation, though not systematically, in 1897 in the
book ‘Corporation Finance’ written by Thomas Greene. It was further impetus by Edward Meade
in 1910 in his book, ‘Corporation Finance’. Later, in 1919, Arthur Dewing brought a classical
book on finance entitled “The Financial Policy of Corporation.”

Traditionally, financial management was viewed as a field of study limited to only raising of
money. Under the traditional approach, the scope and role of financial management was
considered in a very narrow sense of procurement of funds from external sources. The subject of
finance was limited to the discussion of only financial institutions, financial instruments, and the
legal and accounting relationships between a firm and its external sources of funds. Internal
financial decision makings as cash and credit management, inventory control, capital budgeting
were ignored. Simply stating, the old approach treated financial management in a narrow sense
and the financial manager as a less important person in the overall corporate management.

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The traditional concept evolved during 1920s continued to dominate academic thinking during
the forties and through the early fifties. However, in the later fifties the traditional concept was
criticized by many scholars including James C. Van Horne, Pearson Hunt, Charles W.
Gerstenberg and Edmonds Earle Lincoln due to the following reasons:
1. The emphasis in the traditional concept is on ra ising of funds, This concept takes
into account only the investor’s point of view and not the finance manager’s view point.
2. The traditional approach is circumscribed to the episodic financing function as it places
overemphasis on topics like types of securities, promotion, incorporation, liquidation,
merger, etc.
3. The traditional approach places great emphasis on the long-term problems and ignores
the importance of the working capital management.
4. The concept confined financial management to issues involving procurement of funds. It
did not emphasis on allocation of funds.
5. It blind eye towards the problems of financing non-corporate enterprises has yet been
another criticism.

In the absence of the coverage of these crucial aspects, the traditional concept implied a very
narrow scope for financial management. The modern concept provides a solution to these
shortcomings.
Modern Concept:
The traditional concept outlived its utility due to changed business situations since mid-1950’s.
Technological improvements, widened marketing operations, development of a strong corporate
structure, keen and healthy business competition – all made it imperative for the management to
make optimum use of available financial resources for continued survival of the firm.

The financial experts today are of the view that finance is an integral part of the overall
management rather than mere mobilization of the funds. The finance manager, under this
concept, has to see that the company maintains sufficient funds to carry out the plans. At the
same time, he has also to ensure a wise application of funds in the productive purposes. Thus, the
present day finance manager is required to consider all the financial activities of planning,
organizing, raising, allocating and controlling of funds. In addition, the development of a number
of decision making and control techniques, and the advent of computers, facilitated to implement
a system of optimum allocation of the firm’s resources.

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These environmental changes enlarged the scope of finance function. The concept of managing a
firm as a system emerged and external factors now no longer could be evaluated in isolation.
Decision to arrange funds were to be seen in consonance with their efficient and effective use.
This systems approach to the study of finance is being termed as ‘Financial Management’. The
term ‘Corporation Finance’ which was used in the traditional concept was replaced by the
present term ‘Financial Management.’

The modern approach view the term financial management in a broad sense and provides a
conceptual and analytical framework for financial decision-making. According to it, the finance
function covers both acquisitions of funds as well as their allocation.

The functions of financial management

The finance functions are very important in the management of a business organization.
Irrespective of any difference in structure, ownership and size, the financial organization of the
enterprise ought to be capable of ensuring that the various finance functions planning and
controlling are carried at the highest degree of efficiency. The profitability and stability of the
business depends on the manner in which finance functions are performed and related with other
business functions.

In general, the functions of financial management include three major decisions areas that a firm
must make. These are:
Investment decisions
Financing decisions
Dividend decisions

Each of these functions must be considered in relation to the objective of the firm. The optimal
combination of these finance functions will maximize the value of the firm to its shareholders.

Investment Decisions
The investment decision relates to the selection of assets in which funds will be invested by a
firm. They deal with allocation of the firm’s scarce financial resources among competing uses.
These decisions are concerned with the management of assets by allocating and utilizing funds
within the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total amount of the
firm’s finance to be invested in current and fixed assets.

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 ii) Determining the asset type: - determining which specific assets to maintain within
the categories of current and fixed assets.
iii) Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.

The assets which can be acquired fall into two broad groups: (i) long-term assets which will yield
a return over a period of time in future, (ii) short-term or current assets defined as those assets
which are convertible into cash usually within a year. Accordingly, the asset selection decision of
a firm is of two types. The first of these involving fixed assets is popularly known as ‘Capital
Budgeting’. The aspect of financial decision-making with reference to current assets or short-
term assets is designated as ‘Working Capital Management.’

Capital Budgeting:
Capital budgeting refers to the decision making process by which a firm evaluates the purchase
of major fixed assets, including buildings, machinery and equipment. It deals exclusively with
major investment proposals which are essentially long-term projects. It is concerned with the
allocation of firm’s scarce financial resources among the available market opportunities. It is a
many-sided activity which includes a search for new and more profitable investment profitable
investment proposals and the making of an economic analysis to determine the profit potential of
each investment proposal.

Capital Budgeting involves a long-term planning for making a financing proposed capital
outlays. Most expenditures for long-lived assets affect a firm’s operations over a period of years.
They are large and permanent commitments, which influence firm’s long-run flexibility and
earning power. It is a process by which available cash and credit resources are allocated among
competitive long-term investment opportunities so as to promote the highest profitability of
company over a period of time. It refers to the total process of generating, evaluating, selecting
and following up on capital expenditure alternatives.

Capital budgeting decision, thus, may be defined as the firm’s decision to invest its current funds
most efficiently in long term activities in anticipation of an expected flow of future benefits over
a series of years.

Because of the uncertain future, capital budgeting decision involves risk and return analysis.
The investment proposals should, therefore, be evaluated in terms of both expected return and

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the risk associated with the return. Besides a decision to commit funds in new investment
proposals, capital budgeting also involves the question of recommitting funds when an old asset
becomes non-profitable. The other major aspect of capital budgeting theory relates to the
selection of a standard or hurdle rate against which the expected return of new investment can be
assessed.

Working Capital Management:

Working Capital Management is concerned with the management of the current assets. The
finance manager should manage the current assets efficiently for safe-guarding the firm against
the dangers of liquidity and insolvency. Involvement of funds in current assets reduces the
profitability of the firm. But the finance manager should also equally look after the current
financial needs of the firm to maintain optimum production. Thus, a conflict exists between
profitability and liquidity while managing the current assets. As such the finance manager must
try to achieve a proper trade-off between profitability and liquidity.

Another aspect to which the finance manager of a company has to pay attention is maintenance
of a sound working capital position. He often times confronted with excess and shortages of
working capital. While an excessive working capital leads to un remunerative use of scarce
funds; inadequate working capital interrupts the smooth flow of business activity and impairs
profitability. History is replete with instances where paucity of working capital has posed to be
the major contributing factor for business failures. Nothing can be more frustrating for the
operating managers of an enterprise than being compelled to function in a continuing atmosphere
of lack of availability of funds to meet their important and urgent operating needs.

Not only will the inadequacy of working capital pose a threat to the finance manager, but also its
abundance. Availability of more than required amount of funds causes an unchecked
accumulation of inventories. Further, there may be a tendency to grant more and more credit
without properly looking into the credentials or the customers. Moreover, idle cash earns nothing
and it is unwise to keep large quantities of cash with the firm. Thus, the need to have adequate
working capital in a firm need not be overemphasized.

Financing Decisions
The financing decisions deal with the financing of the firm’s investments, i.e., decisions whether
the firm should use equity or debt funds in order to finance its assets. They are also concerned
with determining the most appropriate composition of short – term and long – term financing. In

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simple terms, the financing decisions deal with determining the best financing mix or capital
structure of the firm.

In this function, the finance manager has to estimate carefully the total funds required by the
enterprise, after taking into account both the fixed and working capital requirements. In this
context, the financial manager is required to determine the best financing mix or capital structure
of the firm. Then, he must decide when, where and how to acquire funds to meet the firm’s
investment needs.

The central issue before the finance manager is to determine the proportion of equity capital and
debt capital. He must strive to obtain the best financing mix or optimum capital structure for
his firm. The mix of debt & Equity used to finance the firm’s asset is known as capital
structure.The use of debt capital affects the return and risk of shareholders. The return on equity
will increase, but also the risk. A proper balance will have to be struck between return and risk.
When the shareholders return is maximized with minimum risk, the market value per share will
be maximized and firm’s capital structure would be optimum. Once the financial manager is able
to determine the best combination of debt and equity, he must raise the appropriate amount
through best available sources.

The following points are to be considered while determining the appropriate capital structure of a
firm:
1. Factors which have bearing on the capital structure.
2. Relationship between earnings before interest and taxes (EBIT) and earnings per share
(EPS).
3. Relationship between return on investment (ROI) and return on equity (ROE).
4. Debt capacity of the firm.
5. Capital structure policies in practice.

Dividend Decisions
It is a fact that in spite of the various other factors which influence the market value of shares,
dividend payment has been considered to be the foremost. In this context, the finance manager
must decide whether the firm should distribute all profits or retain them, or distribute a portion
and retain the balance. Sometimes, the profits of the company are fully diverted towards its
capital expenditure or establishment of new projects so as to minimize further borrowings. While

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there may be some justification in diverting profits to some extent, the claims of shareholders for
dividends cannot be completely overlooked.

More specifically, the dividend decisions address the question how much of the cash a firm
generates from operations should be distributed to owners in the form of dividends and how
much should be retained by the business for further expansion. There are trade-offs on the
dividend policy of a firm. On the one hand, paying out more dividends will make the firm to be
perceived strong and healthy by investors; on the other hand, it will affect the future growth of
the firm. So the dividend decision of a firm should be analyzed in relation to its financing
decisions.

Jobs of the financial manager

Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which reflects the
entire operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.

Finance manager is one of the important role players in the field of finance function. He must
have entire knowledge in the area of accounting, finance, economics and management. His
position is highly critical and analytical to solve various problems related to finance. A person
who deals finance related activities may be called finance manager. Finance manager performs
the following major functions:
i) Performing Financial Analysis: - financial analysis is concerned with obtaining of
the basic financial statements, applying some tools and techniques, and converting the
raw information into a standardized form. The purpose here is to give the finance
person a better opportunity to understand the firm’s financial affairs, the results of its
operations, and its cash flows.
ii) Performing Financial Forecasting: - financial forecasting is concerned with
forecasting of the firm’s sales for a given future period upon which the firm projects
its assets needs, and finally, it will evaluate whether additional finance is required.
iii) Making Investment Decisions: - include credit management, inventory control, cash
management, capital budgeting and other investment activities of a firm.

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 iv) Making Financing Decision: - include any activities associated with procurement or
acquisition of funds. Examples include borrowing decisions, decisions to issue shares
of common stock and preferred stock, bonds, and other securities.
v) Cash Management: - Present day’s cash management plays a major role in the area
of finance because proper cash management is not only essential for effective
utilization of cash but it also helps to meet the short-term liquidity position of the
concern.
vi) Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound
knowledge not only in finance related area but also well versed in other areas. He must
maintain a good relationship with all the functional departments of the business organization .

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 criteria for the three decisions
involved in the financial management. In this regard, the term ‘objective/goal” is used in a
narrow sense of what a firm should attempt to achieve with its investment, financing, and
dividend policy decisions.

There are two alternative approaches in financial literatures as to the objectives of financial
management. These are:
1. Profit maximization as an objective of financial management; &
2. Wealth maximization as an objective of financial management.

Profit Maximization as an Objective of FM

According to this approach, actions that increase profit (EPS) should be undertaken and those
that reduce profits are to be avoided. In specific operational terms, as applicable to financial
management, the profit maximization criterion implies that the investment, financing and
dividend policy decisions of a firm should be oriented to the maximization of profit/EPS.

The term ‘profit’ can be seen in two senses. As owner-oriented concept, it refers to the amount
and share of national income which is paid to the owners of business, that is, those who supply
equity capital. As a variant, it is described as a profitability, which refers to a situation where

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output exceeds input, that is, the value created by the use of resources is more than the total of
the input resources.In this sense, profit maximization would imply that a firm should be guided
in financial decision making by one test, that is, select assets/projects and decisions which are
profitable and rejects those which are not. The general agreement is that the profit maximization
is used in the current financial literature from the profitability point of view not as owner-
oriented.

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. Therefore, one can conclude that the underlined concept
of profit maximization objective is Economic efficiency, where its yardstick/test of performance
is profit.

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 consists of the following important features.

1. Profit maximization is also called as earning per share (EPS)
maximization. It leads to maximize the business operation for
profit maximization.
2. Ultimate aim of the business concern is earning profit; hence, it
considers all the possible ways to increase the profitability of the
concern.
3. Profit is the parameter of measuring the efficiency of the
business concern. So it shows the entire position of the business
concern.

Drawbacks/limitations of Profit Maximization

The main technical flaws of the profit maximization criteria are:
a) It is vague:

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One practical difficulty with profit maximization criterion for financial
decision making is that the term profit is a vague and ambiguous concept. In
this objective, profit is not defined precisely or correctly. It leads to different
interpretations and meanings to different people. For ex. Profit may be short-
term or long-term, it may be total profit or rate of profit, it may be before tax
or after tax, it may be return on total capital employed or total assets or
shareholders equity, and so on. If profit maximization is taken to be the
objective, the question arises, which of these variants of profit should a firm
try to maximize?

b) It ignores the time value of money

The other major technical objection to profit maximization, as a goal of
financial management, is that it ignores the differences in the time pattern of
the benefits received over the working life of the asset/project, irrespective
of when they were received. That is, profit maximization does not consider
the time value of money or the net present value of the cash inflow. To
understand this limitation better let us consider the following example.

The reason for the superiority of benefits now over benefits later lies in the fact that the former
can be reinvested to earn even higher profits over later years. This is referred to as time value of
money. The profit maximization criterion does not consider the distinction between returns
received in different time periods and treats all benefits irrespective of the timing, as equally
valuable. This is not true in actual practice as benefits in early years should be valued more
highly than equivalent benefits in later years.

c) It ignores risk (the quality of benefits)

Probably the most important technical limitation of profit maximization as an
operational objective is that, it ignores the quality aspect of benefits
associated with a financial course of action. The term “quality” here refers
to the degree of certainty with which benefits can be expected. As a rule, the
more certain the expected return, the higher is the quality of the benefits.
Conversely, the more uncertain/fluctuating is the expected benefits; the
lower is the quality of the benefits. An uncertain and fluctuating return

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implies ‘risk’ to investors. Risk refers to the probability/ chance that actual
outcomes may differ from those expected.

Profit maximization assumes that risk or uncertainty of future benefits is of no concern to

stockholders. Financial decision making involves a risk-return trade-off. This means that in
exchange for taking greater risk, the firm expects a higher return. The higher the risk, the higher
the expected return.

d) Cash flow problems

The profit a firm has reported does not represent the cash flows to the business. Firms reporting a
very high total profit or earnings per share might face difficulty of paying cash dividends to
stockholders. Sometimes, companies might even declare bankruptcy though reporting a positive
income

Wealth maximization as an objective of FM

This approach is also known as Value Maximization or Net Present Wealth Maximization.
Wealth maximization means maximizing the net present value (NPV) of a course of action. The
NPV of a course of action is the difference between the gross present value (GPV) of the benefits
of that action and the amount of investment required to achieve those benefits. The GPV of a
course of action is found out by discounting or capitalizing its benefits at a rate which reflects
their timing and uncertainty. A financial action which has a positive NPV creates wealth and
therefore, is desirable. A financial action resulting in negative NPV should be rejected. Between
a number or desirable mutually exclusive projects, the one with the highest NPV should be
adopted. The wealth or NPV of the firm will be maximized if this criterion is followed in making
financial decisions.

Stockholder’s current wealth in the firm = (No. Of shares owned) * (Current stock price Per share)

The operational objective of financial management is the maximization of ‘Wealth (W)’.

Alternatively ‘W’ can be expressed symbolically by a short-cut method:
A1 A2 An
1
+ 2
+. . .. ..+ −C
W = (1+k ) (1+ k ) (1+ k )n

Where W = Net Present Wealth

A1, A2, An = Stream of cash flows expected to occur from a course of action over a period
of time.

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 K = Appropriate discount rate to measure risk and timing.
C = Initial outlay to acquire that asset or pursue the course of action.

From the above, it is clear that the wealth maximization criterion is based on the concept of cash
flows generated by the decision rather than accounting profit which is the basis of the
measurement of benefits in the case of profit maximization criterion. In addition to this, wealth
maximization criterion considers both the quantity and quality dimensions and timing of
benefits.

Wealth maximization model is a superior over profit maximization model because it overcomes
all the drawbacks of profit maximization as a goal of a financial decision.
Firstly, the wealth maximization is based on cash flows and not profits. Unlike the
profits, cash flows are exact and definite and therefore avoid any ambiguity associated
with accounting profits.
Secondly, profit maximization presents a shorter term view as compared to wealth
maximization. Short-term profit maximization can be achieved by the managers at the
cost of long-term sustainability of the business.
Thirdly, wealth maximization considers the time value of money. It is important as we all
know that a dollar today and a dollar one-year latter do not have the same value. In
wealth maximization, the future cash flows are discounted at an appropriate discounted
rate to represent their present value.
Fourthly, the wealth-maximization criterion considers the risk and uncertainty
factor while considering the discounting rate. The discounting rate reflects both time and
risk. Higher the uncertainty, the discounting rate is higher and vice-versa.

Drawbacks Wealth Maximization

1. It is a prescriptive idea. The objective is not descriptive of what the firm actually does.
2. The objective of wealth maximization is not necessarily socially desirable.
3. There is some controversy as to whether the objective is to maximize the stockholder’s
wealth or the wealth of the firm, which includes other financial claimholder’s such as
debenture holders, preference shareholders.
4. The objective of wealth maximization may also face difficulties when ownership and
management are separated, as is the case in most of the corporate form of organizations.
When managers act as the agents of the real owner, there is the possibility for a conflict
of interest between shareholders and the managerial interests.

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Conflict of goals: agency problem
A characteristic feature of corporate enterprise is the separation between ownership and
management as a practice of which the latter enjoys substantial autonomy in regard to the affairs
of the business. That means, in such business organizations, 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
ahead 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.
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.

On top of the above costs assumed by corporations, there are also other ways to motivate
managers to act in the best interest of owners. These ways include making know managers that

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they would be fired if they do not act to maximize shareholders wealth and that the corporation
could be overtaken by others if its value is very much lower than other firms.

An overview of the financial environment

Finance people must understand not only the internal environment, but also the external and
financial environment within which the firm operates. They need to know where capital required
is raised, where the financial instruments are traded, and how stock prices are determined. The
financial environment which directly affects the financial management decisions are grouped in
to three broad areas as discussed below:
1. Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms, that
facilitate the transfer of funds from savers to demanders of capital. They accept savings form
customers and lend this money to other customers or they invest it. In many instances, they pay
savers interest on deposited funds. In some cases, they impose service charges on customers for
the services they render. For example, many financial institutions impose service charges on
current accounts.

The key participants in financial transactions of financial institutions are individuals, businesses,
and government. By accepting the savings from these parties, financial institutions transfer again
to individuals, business firms, and governments. Since financial institutions are generally large,
they gain economies of scale in the transfer of money between savers and demanders. By pooling
risks, they help individual savers to diversify their risk.

The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance companies.
Among these, commercial banks are by far the most common financial institutions in many
countries worldwide. In Ethiopia too, commercial banks are the major institutions that handle the
savings and borrowing transactions of individuals, businesses, and governments.
2. Financial Instruments
Financial instruments are written and formal documents of transferring funds between and
among individuals, businesses, and governments. They include loans and borrowing contracts,
promissory notes, commercial papers, treasury bills, bonds, and stocks.
Under normal circumstances, two parties are involved in any financial instrument. For holders,
who have invested their money, financial instruments are financial assets. A financial asset gives

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the holder the right to claim against the income and assets of its issuer. For the issuer, on the
other hand, financial instruments represent either liabilities or equity items. For instance, if you
consider a bond, it represents an investment (financial asset) for the holder and a debt item for its
issuer. Similarly, if you consider a common stock, it represents an investment and equity item for
the holder and issuer respectively.

The issuer gives the financial asset to the purchaser (holder) in exchange for some valuable
consideration, usually in the form of cash or another financial asset.
3. 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.
a. Functions of Financial Markets
Generally, financial markets play three important roles in functioning of corporate finance.
1. 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.
b. 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
This is based on the maturity dates of securities
i) Money Markets - are financial markets in which securities traded have maturities of
one-year or less. Examples of securities traded here include treasury bills, commercial
papers, and 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

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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.

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