ADMAS UNIVERSITY

Postgraduate Program
Course: Advanced Corporate Finance
Course Code: AcFn 514
Credit Hr. 3hr
Instructor: Giday G. (Ph.D)
Con’t….

CHAPTER ONE
Introduction: Basics of the Financial
Management
 Learning Objectives
 The purpose of this chapter is to give you an idea of
what financial management is all about.
 After you finish the chapter, you should have a
reasonably good idea of what finance majors might do
after graduation (Reading Assignment)

After
After studying
studying this
this
chapter,
chapter, you
you
should
should be
be able
able to:
to:
Con’t…
 What are the most common decision criteria that are
highly emphasized in financial management?
 Why is wealth maximization is considered to be
superior over profit maximization as a goal of a firm
and how the agency issue is related to it
 What are the threats to the wealth maximization goal
of a firm?
 Explain the 10 principles that form the basics of
financial management.
 MEANING OF FINANCE
• 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.
• Virtually all individuals and organizations
earn or raise money and spend or invest
money.
• Finance is the art and science of managing
money.
• Finance is concerned with the process,
institutions, markets, and instruments
involved in the transfer of money among
individuals, businesses, and govern-ments.
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• According to Oxford dictionary, the word ‘finance’
connotes ‘management of money’.

• Finance is the application of economic principles and

concepts to business decision-making and problem
solving. Suc as:
• Recognize and understand how monetary policies affect the
cost of funds and the availability of funds.
• Be versed in fiscal policy and how it affects the economy
• Supply and demand relationship and wealth maximization
strategies
• The principle of marginal analysis.
 Con’t…
• Financial management. Sometimes called corporate finance or
business finance, this area of finance is concerned primarily
with financial decision-making within a business entity.

Financial Management is:

• A process of planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the
enterprise.
 It is about applying general management principles to
financial resources of the enterprise.
• Management of the finances of an organization in order to
achieve financial objectives. Eg.
 pay bills (materials, electricity, advertising),
 Pay wages and salaries,
 Acquire resources,
 Develop new products, and etc.
 Con’t…
• FM is the management of financial resources – how to best
find and use investments and financing opportunities in
an ever-changing and increasingly complex environment.

• 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.

• Financial management decisions includes:

 maintaining optimum cash balances,
 extending credit,
 acquiring other firms,
 borrowing from banks, and
 issuing stocks and bonds.
 Con’t…
• Financial managers also have the responsibility for:
 deciding the credit terms under which customers may buy,
 how much inventory the firm should carry,
 how much cash to keep on hand,
 whether to acquire other firms (merger analysis), and
 how much of the firm’s earnings to plow back into the
business versus pay out as dividends.
 Con’t…
• In general;
• Financial management is concerned with the
maintenance and creation of economic value or
wealth for the firm.
• As such, we will deal with financial decisions such as:
When to introduce a new product,
When to invest in new assets,
When to replace existing assets,
When to borrow from banks,
When to issue stocks or bonds,
 When to extend credit to a customer, and
How much cash to maintain.
The Functions of Financial Management
Imagine that you were to start your own business. No matter
what type you started, you would have to answer the
following three questions in some form or another:
1. What long-term investments should you take on? That is,
what lines of business will you be in and what sorts of
buildings, machinery, and equipment will
you need?
2. Where will you get the long-term financing to pay for your
investment? Will you bring in other owners or will you
borrow the money?
3. How will you manage your everyday financial activities
such as collecting from customers and paying suppliers?
These are not the only questions by any means, but they are
among the most important.
 Con’t…
• Corporate finance, broadly speaking, is the study of ways
to answer these questions and others too:
• Generally, financial management is concerned with four
major issues. We can classify these decisions in to:
• (i) The investment decision/Capital Budgeting,
• (ii) the financing decision/Capital Structure,
• (iii) the liquidity decision/Working Capital MgMt and
• (iv) the dividend policy decision.
1. Investment decisions :
The investment decision relates to the selection of assets
in which funds will be invested by a firm.
• The assets which can be acquired fall into two broad
groups:
 (I) long-term assets which is also popularly anamed as capital
budgeting yield a return over a period of time in future,
 (ii) short-term or current assets, defined as those assets
which in the normal course of business are
convertible into cash without diminution in value,
usually within a year.
 The aspect of financial decision making with
reference to current assets or short-term assets is
popularly termed as working capital management.
 con't....
• Capital Budgeting: the first question concerns the
firm’s long-term investments.

• The process of planning and managing a firm’s

long-term investments is called capital budgeting.

• First, In capital budgeting, the financial manager

tries to identify investment opportunities that are
worth more to the firm than they cost to acquire.
• Whether an investment alternative will be accepted
or not will depend upon the relative benefits and
returns associated with it.
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• The second element of the capital budgeting decision is
the analysis of risk and uncertainty.

• Finally, the evaluation of the worth of a long-term

invesestment implies a certain norm or standard
against which the benefits are to be judged.

• The requisite norm is known by different names such as

cut-off rate, hurdle rate, required rate, minimum
rate of return and so on.
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2. Working Capital Management: Working capital
management is concerned with the management of
current assets and current liabilities.

• The term working capital refers to a firm’s short-term

assets, such as Cash, Receivables, Supplies, inventory,
and its short-term liabilities, such as money owed to
suppliers. Therefore;

• It is an important and integral part of financial

management as short-term survival is a prerequisite
for long-term success.
• One aspect of working capital management is the
trade-off between profitability and risk (liquidity).
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• There is a conflict between profitability and
liquidity.
• If a firm does not have adequate working
capital, that is, it does not invest sufficient funds
in current assets, it may become illiquid and
consequently may not have the ability to meet its
current obligations and, thus, invite the risk of
bankruptcy.
• If the current assets are too large, profitability is
adversely affected. The key strategies and
considerations in ensuring a trade-off between
profitability and liquidity is one major
dimension of working capital management.
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• Some questions about working capital that must be
answered are:
– (1) How much cash and inventory should we keep on
hand?
– (2) Should we sell on credit? If so, what terms will we
offer, and to whom will we extend them?
– (3) How will we obtain any needed short-term
financing? Will we purchase on credit or will we borrow
in the short term and pay cash? If we borrow in the short
term, how and where should we do it?
 The financial manager will have to make sure that there
exists a fair balance of the current assets with that of the
fixed assets of the firm. Failure to do so will have
significant consequences on its normal operation.
 3. Financing decisions
• Capital Structure: the other question for the financial
manager concerns ways in which the firm obtains and
manages the long-term financing it needs to support its
long-term investments.
• A firm’s capital structure is the specific mixture of long-
term debt and equity the firm uses to finance its operations.
 The financial manager has two concerns in this area:
 First, how much should the firm borrow? That is, what
mixture of debt and equity is best? The mixture chosen
will affect both the risk and the value of the firm.
 Second, what are the least expensive sources of funds for
the firm?
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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, 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.
• They are also concerned with determining the most
appropriate composition of short – term and long – term
financing.
Con’t…
The Financing Decisions of a firm are generally
concerned with the right side of the basic
accounting equation.
 A = L + OE (Assets = Liabilities + Owners’ Equity).

The central issue before the finance manager is to

determine the proportion of equity capital and debt
capital. i.e.
 Should managers use the money raised through the firms’
revenues?
 Should they seek money from outside of the business?
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• The use of debt capital affects the return and risk of shareholders.
• As a general rule, there should be an appropriate mix of funds in
the capital structure of a firm.
The manner in which assets have been financed has a number of
implications:
1. Debt is more risky from the firms point of view. The firm has
legal obligation to pay to its bond holders at stipulated time both
interest and principal, irrespective of the year's performance. If
it fails, an action may be taken on firm's assets.
2. Highly burdened, or highly geared firms will find difficulty in
raising additional funds from creditors and owners in the
future.
 Always the owners' equity is assumed as margin of safety for the
investment by creditors. If the base is thin, the creditor's risk will
be high.
Con’t….
• The following points are to be considered while
determining the appropriate capital structure of a
firm:
 Factors which have bearing on the capital structure.
 Relationship between earnings before interest and taxes
(EBIT) and earnings per share (EPS).
 Relationship between return on investment (ROI) and
return on equity (ROE).
 Debt capacity of the firm.
 Capital structure policies in practice.
4. Dividend Decision
• 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.

 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.
 Con’t..
• 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.
– The final decision will depend upon the preference of
the shareholders and investment opportunities available
within the firm. i.e.
 The finance manager has to develop such a dividend policy
which divides the net earnings into dividends and retained
earnings in an optimum way to achieve the objective of
maximizing the market value of firm.
Overview of Financial Management

26
 The Goal of a Business Firm/Financial Management

• Recall that financial management is concerned with

decision making to achieve the goal of a firm.

• Efficient financial management requires the existence of some

objectives or goals because judgment as to whether or not a financial
decision is efficient must be made in the light of some objective.

• But the question is what is this goal of a firm? Before

trying to address the question, let us first describe the
meaning of a goal.
• A goal is a well-known objective the firm strives in all its
action to achieve it.
Con’t….
• Therefore there are two approaches for the goal of the
firm:
A. Profit Maximization
B. Wealth Maximization
Profit maximization:
– Considers profit as the most appropriate measure of a firm’s
performance.
– Maximizing the birr income of firms.

 Profit maximization: implies either “producing maximum out put for the
given amount of input or “use minimum input to produce a given level of
out put.

• 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.
 Con’t…
• Under the profit maximization decision criteria,
actions that increase profit of a firm should be
undertaken; and actions that decrease profit should be
rejected. But it is not specific with respect to the time
frame over which profits are to be measured.

• Do we maximize profits over the current year, or do we

maximize profits over some longer period? A financial
manager could easily increase current profits by
eliminating research and development expenditures and
cutting down on' routine maintenance.
Con’t….
• There are various measures of profit that
could be maximized, including the following:
– Operating profit (profit before interest and
taxation)
– Net profit before tax
– Net profit after tax
– Net profit available to ordinary share holders
– Net profit per ordinary share , and so on
Limitations of Profit Maximization
1. Ambiguity: The term profit or income is vague and ambiguous
concept. It is very illusive and has no precise quonotation.
• Different people understand profit in different several ways.
Because there are many different economic and accounting
definitions of profit. i.e

 Does it mean an absolute figure expressed in dollar or a rate of

profitability or
 Does it mean short-term or long-term profits?
 Does it refer to profit after tax or before tax?
 Net profit available to ordinary share holders
 Does it total profit or profit per share or

• Then, the question or the problem would be which profit is to

be maximized?
 Con’t…
2. It could increase current profits while harming the firm future survival .
• A business might increase short term profits at the expense of long-
term competitiveness and performance of a business.
• It could be done by reducing operating expenses:
– Cutting research and development expenditure

– Defer/postpone important maintenance costs

– Cutting staff training and development

– Buying lower quality materials

– Cutting quality control mechanisms

• These policies may all have a beneficial effect on short term

profits but may undermine the long term competitiveness and
performance of a business.
 Con’t….
3. Ignore time value of money concept/Timing of Benefits:
 The profit maximization criterion ignores the differences
in the time pattern of benefits received from investment
proposals.
 Profit Maximization criterion does not consider the
distinction between returns (benefits) received in different
time periods and treats all benefits as equally valuable
irrespective of the time pattern differences in benefits.
 Con’t…
 In other words, the profit maximization ignores the
time value of money concept, i.e.,
 Money today is better than money tomorrow.

 Also it does not consider the sooner, the better principle.

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4. Does not consider Quality of Benefits (Risk of
Benefits): Profit maximization assumes that risk or
uncertainty of future benefits is of on concern to
stockholders.
Risk is defined as the probability that actual benefit
will differ from the expected benefit.

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.
 Con’t…
5. It doesn’t show cash flow available to
shareholders
• Profit does not represent cash flow available to
shareholders.
 Owners receive returns either through cash dividends or by
selling their shares for a better price. Higher Earning per
Share (EPS) doesn’t necessarily mean dividend payments will
increase.

• Above all, accounting profit is affected by the

accounting method followed and is prone to
manipulation by the management.
Shareholders Wealth Maximization
• You must be aware that many companies sell their
shares in the stock market.
• People buy the shares as an investment. It means that
they expect these shares to give them some returns.
• It is the duty of the finance manager to see that the
shareholders get good returns on the shares.
• So, this means that the finance manager has the power to
influence decisions regarding finances of the company.
• The decisions should be such that the share value does
not decrease. Thus, wealth or value maximization is
the most important goal of financial management.
Wealth maximization means maximization of the value of a
firm. Hence wealth maximization is also called value
maximization or net present value (NPV) maximization.

 How do we measure the value/wealth of a firm? According to

Van Horne, “Value of firm is represented by the market price
of the company’s common stock.

• Financial managers are charged with the responsibility of

making decisions that maximize owners’ wealth.  i.e.
managers should give priority to stockholders.
 There are two ways in which the ownership of common
stocks can change a person's wealth:
• (a) dividends can be paid to the stockholder and;
• (b) the market price of the stocks can change.
 Con’t….
 During any period of time, the change in a person's
wealth due to ownership of common stock may be
calculated as follows:
– i. Multiply the dividend per share paid during the
period by the number of shares owned.
– ii. Multiply the change in the stock's price during the
period by the number of shares owned or stock price
appreciation.
– iii. Add the dividends and the change in the market
value computed to obtain the change in the
shareholders wealth during the period.
 Con’t…
• Shareholders Wealth Maximization (SHWM) means
maximizing the net present value of a course of action to
shareholders.
• Net Present Value or wealth of course of action is the
difference between the present value of its benefits and the
present value of its costs.

• A financial action resulting in positive NPV creates wealth

for shareholders and therefore it is desirable.
• A financial action resulting in negative NPV should be
rejected because it would destroy the shareholders wealth.
 NPV = PV of cash inflows less PV of cash out flows.
A1 A2 An
W=  ...... C
(1 k) (1 k)
1 2
(1 k)n
 Con’t…
Where:
• W = Net Present Wealth
• A1, A2, ….. An = Stream of cash inflows expected to
occur from a course of action over a period of time.
• K = Appropriate discount rate to measure risk and
timing.
• C = Initial outlay to acquire that asset or pursue the
course of action.
• There are several reasons why wealth maximization decision
criterion is superior to Profit Maximization criteria.

– First, it has an exact measurement unlike profit

maximization. It depends on cash flows (inflows and
outflows).
– Second, wealth maximization as a decision criterion
consider the quality as well as the time pattern of benefits.
– Third, it emphasizes on the long-term and sustainable
maximization of a firm’s common stock price in the
financial market.
– Fourth, wealth maximization gives a recognition to the
interest of other stakeholders and to the societal welfare
Example:
• Shaba Agro Industry Company intends to open a branch
either in Goba or Jijiga. Opening of both branches cost
Br. 135,000 each and the expected cash inflows from each
branch over the next ten years is Br. 25,000 per year.
However, the required rates of return are 9% and 10%
respectively for Goba and Jijiga respectively.

1. Under profit maximization decision rule, where should

Sehaba open a branch?
2. If the goal of Shaba is wealth maximization, which town
is providing more value?
 Answer
1. The total benefits (cash flows) over a period of ten
years is Br. 250,000 (Br. 25,000 x 10) for each project.
Therefore, it is all the same for Shaba Agro
Industry whether it opens its branch in Goba or Jijiga
under profit maximization decision rule.

2. Both projects have equal cash flows and costs; but

the required rate of return for investment in Jijiga
(10%) is higher than that of investment in Goba (9%).
In financial management, the more return expected
from investments of equal cost and cash flows
indicates it is more risky. Hence, under wealth
maximization criterion, investment in Goba provides
more value than investment in Jijiga
 Limitations of Wealth Maximization
• The limitations of wealth maximization refer to the
potential side costs of wealth maximization if adopted as
a decision criterion.
1. If wealth maximization is taken as the sole decision rule,
there is a possibility that the benefits of the society at large
might be forgone. Fortunately, however, this problem is
not unique to wealth maximization. Even if an alternative
goal is used, still this problem continues to persist.
2. When managers of a corporation are separate from
owners, there is a potential for a conflict of interest
between them. This conflict of interest can lead to the
maximization of manages’ interest instead of the welfare
of stockholders.
 Con’t…
3. When the goal of a firm is stated in terms of
stockholders wealth, actions that increase the wealth
of stockholders could be taken as the expense of
other stakeholders like debt holdlers.

4. Wealth maximization is normally reflected in the

firm’s stock price. But if there are inefficiencies in
financial markets, wealth maximization decision
rule may lead to misallocation of scarce resources.
 Con’t…
• Check your progress:
 The wealth maximization goal is generally preferred to
other decision criteria regardless of the above limitations.
What short and precise explanation do you have for this?
 Real-world conflicts of interest in a firm –
The agency Theory
• In large businesses separation of ownership and
management is a practical necessity.
• Major corporations may have hundreds of thousands of
shareholders. There is no way for all of them to be
actively involved in management: authority has to be
delegated to managers.
• The separation of ownership and management has
clear advantages.
– It allows share ownership to change without interfering with
the operation of the business.
– It allows the firm to hire professional managers.
 con't...
• But it also brings problems if the managers' and
owners' objectives differ. You can see the
danger:
• Rather than attending to the wishes of
shareholders, managers may seek a:
• more leisurely or luxurious working lifestyle;
• they may shun unpopular decisions, or
• they may attempt to build an empire with their shareholders'
money.
• Such conflicts between shareholders and managers'
objectives create principal agent problems.
con't...
• In the context of a firm, three agency conflicts
exist. These are briefly described below
• Agency Conflict I: Stockholders vs. Managers
• Managers might not focus only on maximizing the
shareholders’ interests; they might instead take decisions
that give them more personal wealth, leisure or perks
(such as corporate jets, big corner offices etc.).

• This action of the managers true will conflict with the

interest of the shareholders where their interest is in as
much as possible to reduce corporate expenses in order to
increase their wealth.
 con't...
• Agency Conflict II: Stockholders vs. Creditors
• Key Issue: Creditors (or lenders or bondholders) get paid a
fixed amount and they get paid before the stockholders get
paid.
• It is true that, in general, stockholders like riskier projects
compared to creditors. This is the agency conflict between
stockholders and creditors.
• Creditors see this “cheating” coming, and seek to protect
themselves by:
I. Restrictive covenants, on what projects can be taken up, who gets
to lend to the company later on etc. etc.
II. Threats of no future lending.
con't...
• Agency Conflict III: Stockholders, Managers and Creditors
• When a firm is facing financial distress (during
possible bankruptcy), there are usually two routes
available to a firm:
• i. Reorganization, and continuation as a going
concern – Managers like this, as they can exercise
control over what goes on during the organization
• ii. Liquidation and selling off of the assets of the
company.
con't...
• Conflict 1: In the objective evaluation of the
stockholders and the creditors, the firm is “worth more
dead than alive” i.e. liquidation is better – Managers do
not like this option and may resist.

• Conflict 2: Lenders like liquidation, as they stand to get

their money from the liquidation value first. However,
managers may not want this to happen.

• They may seek to “bribe” the creditors with a promise of

getting more money than they should if the latter agree
to a reorganization. This is not in the interest of the
stockholders.
Agency costs incurred by shareholders
• Agency costs incurred by shareholders: such as
I. Expenditures to structure the organization in a way
that will minimize the incentives for management to take
actions contrary to shareholder interests, such as providing a
portion of compensation in the form of the stock in the
company .
II. Expenditures to monitor management's performance,
such as internal and external audits.
III. Lost profits (opportunity costs) of complex
organizational structures.
IV. Limited flexibility to exploit opportunities due to
restrictive covenants in the bond contracts (indentures)
by creditors
Mechanisms to reduce agency problems:-
• Several methods of reducing the agency problem have
been suggested. These include:
• (a) Devising a remuneration package for executive
directors and senior managers that gives them an
incentive to act in the best interests of the shareholders.
– For example, one way to encourage managers to act in ways
that increase shareholder wealth is to offer them share
options.
• Share options will encourage managers to make
decisions that are likely to lead to share price increases
(such as investing in projects with positive net present
values), since this will increase the rewards they receive
from share options.
con't....
• (b) Having enough independent non-executive
directors inside the board.
• They have no executive role in the company and are not
full-time employees. They are able to act in the best
interests of the shareholders, particularly in hiring and
firing executive management of the firm
• (c) Independent non-executive directors should also
take the decisions where there is (or could be) a conflict
of interest between executive directors and the best
interests of the company.
– For example, non-executive directors should be responsible
for the remuneration packages for executive directors and
other senior managers.
 con't...
• (d)Threat of takeovers: When management
underperforms, the company’s stock is undervalued with
respect to its potential, and makes it a ripe target for a
hostile takeover.
• Usually, in such takeovers, poor management is fired.
This potential threat keeps management in line with
shareholder interests.
• (e) Direct Intervention: There is a greater trend towards
institutional ownership. These investors can intervene in
management issues by either talking to management
directly, or through shareholder-sponsored proposals.
 Ten Principles That Form The
Foundations of Financial Management
1. Risk-Return Trade-off:
• We won’t take on additional risk unless we expect
to be compensated with additional return.
• Investment alternatives have different amounts of
risk and expected returns.
• The more risk an investment has, the higher will
be its expected return.
Con’t…
2. Time value of money
• A dollar received today is worth more than a
dollar received in the future.
• A dollar received today is worth more than a
dollar received a year from now. Because we
can earn interest on money received today, it is
better to receive money earlier rather than later.
 Con’t
• 3. Cash—Not Profits—is King
• Cash Flow, not accounting profit, is used to measure
wealth.
• Cash flows, not profits, are actually received by the
firm and can be reinvested.
4. Incremental Cash flow
• It is only what changes that counts;
• The incremental cash flow is the difference between
the projected cash flows if the project is accepted,
versus what they will be, if the project is not
accepted.
Con’t…
5. Efficient capital market
• The values of all assets and securities at any instant in
time fully reflect all available information.
6. The curse of competitive markets
• Why it is hard to find exceptionally profitable
projects;
7. Taxes affect business decisions
The cash flows we consider are the after-tax incremental
cash flows to the firm as a whole.
 Con’t…
8. The agency problem
• Managers won’t work for the owners unless it is
in their best interest.
• The separation of management and the
ownership of the firm creates an agency problem.

• Managers may make decisions that are not in line

with the goal of maximization of shareholder
wealth.
Con’t…
9. All risks are not equal
• Some risk can be diversified away, and some
cannot.
10. Ethical Behavior Is Doing The Right Thing,
and Ethical
• Dilemmas Are Everywhere In Finance;
• Each person has his or her own set of values,
which forms the basis for personal judgments
about what is the right thing.
The
The End
End