Course Title: Financial Management

Course Code: FIN312 / FIN533

LECTURE SHEET

Lectured By:
Md. Shahbub Alam
Lecturer, Dept. of Business Administration
Sonargaon University (SU)

Chapter: Introduction

Questions at a glance:
 Md. Shahbub Alam
Lecturer, Dept. of Business Administration
1. Define Finance

Answer: Finance means money; money related all liquidities and money related all activities. It is the
commercial activity of providing funds and capital.
Finance: Finance is the study of fund management and asset allocation over time. Funds consist of money
and other assets. Finance is concerned with the acquisition and conservation of capital funds in meeting
the financial needs and over all objectives of business enterprise. In a word, finance is the art and science
of managing money.

2. Describe the Function/ Decisions/ Principles of finance

Answer: Finance function is the most important function of a business. Finance Functions are closely
inter-connected. Finance functions can be classified into four broad categories that are given below:
A. Investment Decision: Investment decisions relate to selection of assets in which funds are to be
invested by the firm. The investment decisions result in purchase of assets. It involves -
• Long-term Investment Decisions: The long-term capital decisions are referred to as capital
Budgeting decisions, which relate to fixed assets.
• Short-term Investment Decisions: The short-term investment decisions are, generally,
referred as working capital management.
Two important aspects of investment decisions are -
a. The evaluation of the prospective profitability of new investments.
b. The measurement of a cut - off rate against that the prospective return of new investment
could be compared.

B. Financing Decision: Financing decision is concerned with the mix or composition of the sources of
raising the funds required by the firm. In finance decision, the financial manager is required to
determine the proportion of equity and debt, which is known as capital structure. The financing
decision covers two inter-related aspects :
a. Capital structure theory
b. Capital structure decision.
C. Dividend Decision: Dividend decision is concerned with the amount of profits to be distributed and
retained in the firm. The dividend policy should be analyzed in relation to the financial decision of a
firm. The most significant two elements are the dividend payout ratio and the determining dividend
policy of a firm in practice.
D. Liquidity Decision: Liquidity decision is that current asset s should e managed efficiently for
safeguarding the firm against the dangers of illiquidity and insolvency. Investment in current assets
affects the firm's profitability, liquidity and risk.

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 Md. Shahbub Alam
Lecturer, Dept. of Business Administration
3. How does investment decision help to achieve firm's goal

Answer: 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 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.
Investment decision helps to achieve corporate goal by determining its value by influencing the following
factors:

1. Growth: The effects of investment decisions extend into the future and have to be endured for a
longer period than the consequences of the current operating expenditure. A firm's decision to
invest in long term assets has decisive influence on the rate and direction of its growth.
2. Risk: A long-term commitment of funds may also change the risk complexity of the firm. If the
adoption of an investment increases average gain but causes frequent fluctuations in its earnings,
the firm will become more risky. Thus, investment decisions shape the basic character of a firm.
3. Funding: Investment decisions generally involve large amount of funds, which make it imperative
for the firm to plan its investment programmers very carefully and make an advance arrangement
for procuring finances internally or externally.

4. Describe the goals of a firm / state the objectives of finance

Answer: The goals of a firm can be classified into the following categories -

A. Profit Maximization: Profit maximization is the traditional and narrow approach, which aims at,
maximizes the profit of the concern. Profit maximization consists of the following favorable
Arguments:
1. Profit is the parameter of the business operation.
2. It is the indicator of economic efficiency
3. Profit reduces risk of the business concern.
4. Profit is the main source of finance.
5. Profitability meets the social needs also;

Unfavorable argument I Drawbacks of Profit Maximization:

1. It ignores the time value of money: The profit maximization objective does not make a
distinction between returns received in different time period. It gives no consideration to the time
value of money and it values benefits received today and benefits received after a period as the
same.
2. It ignores risk: Profit maximization also fails to account for risk-the chance that actual
outcomes may differ from those expected. There is a direct relationship between risk and return.
Return and risk are, in fact, the key determinants of share price, which represents the wealth of the
owners in the firm.
3. It ignores cash flow: Profits do not necessarily result in cash flows available to the stockholders.
There is no guarantee that the board of directors will increase dividends when profits increase. In

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 Md. Shahbub Alam
Lecturer, Dept. of Business Administration
addition, the accounting assumptions and techniques that a firm adopts can sometimes allow
a firm to show a positive profit even when its cash outflows exceed its cash inflows.

B. Wealth Maximization: Wealth maximization is one of the modem approaches, which involves
latest innovations and improvements in the field of the business concern. Wealth maximization
means maximizing the net present value or wealth of a course of action to shareholders.

Favorable arguments for Wealth Maximization:

1. Time Value of Moneys: The wealth maximization objective makes a distinction between returns
received in different time periods. It gives consideration to time value of money.
2. Risk and Return: The objective of shareholders wealth maximization takes care of the questions
of the risk of the expected returns.
3. Cash Flows: It is important to emphasize that benefits are measured in terms of cash flows, which
is important for investment and financing decisions.
4. Economic Welfare: Maximizing the shareholders economic welfare is equivalent to maximizing
the utility of their consumption over time.
5. Increase Market Value: The wealth maximization principle implies that the fundamental
objective of a firm is to maximize the market value of its shares.
Unfavorable Arguments for Wealth Maximization:

1. Wealth maximization creates ownership-management controversy.

2. Management alone enjoys certain benefits.
3. The ultimate aim of the wealth maximization objectives is to maximize the profit.
4. It can be activated only with the help of the profitable position of the business concern.

From the above discuss on we can undoubtedly declare that wealth maximization is superior to the
profit maximization. So it is said that wealth maximization is the main goal of the firm.

5. State the differences between Profit Maximization and Wealth Maximization

Answer: Differences between profit maximization and wealth maximization are given below:

Points of profit maximization wealth maximization

distinctions
Definition Profit maximization means Wealth maximization means maximizing
maximizing the profit of the firm. the net present value or wealth of a course
of action to shareholders.
Matter To increase profit amount. To increase wealth not profit.
Risk Risk would not be considered. Risk would be considered.
Time Value Time value is not considered. Time value is considered.
Inflation Inflation would not be evaluated. Inflation would be evaluated.
Concept It is ambiguous concept. It is unambiguous concept.
Welfare Social Social welfare is not considered. Social welfare is considered.

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 Md. Shahbub Alam
Lecturer, Dept. of Business Administration
Keeps interest It keeps interest only for owners. It keeps interest for all interested parties
of the firms.
Indicator It indicates increasing EPS. It indicates increasing share price.
Comment Profit maximization should not be the Wealth maximization should e the main
goal of the finance as well as firms. goal of the finance as well as firms.

6. Describe Agency Problem / Describe the impediments to shareholder wealth

maximization

Answer: Agency problem refers to the conflict of interest between shareholders vs. bondholders, Managers
vs. Shareholders and Major Shareholders vs. minor Shareholders.
1. Shareholders vs. Bondholders: Bondholders get a fixed, contractual payment (interest) during
the term of the bond but have a prior claim on the assets of the company; whereas equity investors
have a residual claim on the cash flows of the company as they are owners. Bondholders can
suffer opportunity wealth loss due to the company's investment, financing and dividend decisions.
If the project succeeds, shareholders enjoy the upside potential but bondholders get fixed
interest payment; if the project fails, shareholders have nothing to lose.
Potential conflicts can arise due to the firm's dividend decision as well. Ifthe firm chooses
to distribute that money to shareholders in the form of dividends, the bondholders will be left with
an empty shell.

2. Managers vs. Shareholders: Investment in projects generates cash flows, which can either be
reinvested in the business or returned to shareholders in the form of dividends. Managers, as
agents of shareholders, have discretion over investment of residual cash flow. Increasing dividends
reduces the resources under the manager's control and limits growth. Since managers are
appraised on the basis of growth, it is likely that they may pursue unprofitable projects that do not
yield adequate returns; leaving the shareholders in a lurch. This leads to conflict of interest
between managers and shareholders.
3. Shareholder vs. Shareholder: There is a conflict of interest between major shareholder and
minor shareholders. Majority shareholders exploits minority shareholders in the following three
ways -
a. Discretionary dividend policy.
b. Related party transactions - a subtle way to exploit minority shareholders.
c. Additional share offerings

Thus, there exists a conflict of interest between major shareholders and minor shareholders.

7. Explain how to minimize agency problems

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 Md. Shahbub Alam
Lecturer, Dept. of Business Administration
Answer: The agency problem can be minimized by acts of the followings:

A. Market Forces: Market forces act to minimize agency problems in two ways:

1. Major Shareholders: To exercise the major shareholders legal voting rights, the large
institutional shareholders communicate with and exert pressure on, corporate management to
perform or face replacement.
2. Threat of Takeover: The constant threat of a takeover would motivate management to act in
best interests of the owners despite the fact that techniques are available to define against seat
takeover.
B. Agency Costs: To mm1m1ze agency problems and contribute to the maximization of owners'
wealth, shareholders incur agency cost. The different types of agency costs are :
1. Monitoring Expenditures: The monitoring outlays relate to payment for audit and control
procedures to ensure that managerial behavior is tuned to actions that tend to be in the best
interest of the shareholders.
2. Bonding Expenditures: The firm pays to obtain a fidelity bond from a third-party bonding
company to the effect that the latter will compensate the former up to a specified amount for
financial losses caused by dishonest acts of managers.
3. Opportunity Costs: Such costs result from the inability of large companies from responding
to new opportunities.
4. Structuring Expenditures: The most popular, powerful and expensive method is to structure
management compensation to correspond with share price maximization. The two key type's
compensation plans are:
a. Incentive Plans: The most popular incentive plan is the granting of stock options to managers.
b. Performance Plans: The forms of performance-based compensation are cash bonuses, cash
payments tied to the achievement of certain performance goals.

8. List and explain the financial factors that influence the value of a business.

Answer: The three factors that affect the value of a firm's stock price are cash flow, timing, and risk.

1. The Importance of Cash Flow: In business, cash is what pays the bills. It is also what the firm
receives in exchange for its products and services. Cash is therefore of ultimate importance , and the
expectation that the firm will generate cash in the future is one of the factors that gives the firm its
value.
2. The Effect of Timing on Cash Flows: Owners and potential investors look at when firms can expect
to receive cash and when they can expect to pay out cash. All other factors being equal, the sooner
companies expect to receive cash and the later they expect to pay out cash, the more valuable the firm
and the higher its stock price will be.
3. The Influence of Risk: Risk affects value because the less certain owners and investors are about a
firm's expected future cash flows, the lower they will value the company. The more certain owners
and investors are about a firm's expected future cash flows, the higher they will value the company. In

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 Md. Shahbub Alam
Lecturer, Dept. of Business Administration
short, companies whose expected future cash flows are doubtful will have lower values than
companies whose expected future cash flows are virtually certain.

9. Define efficient market & state the types of efficient market

Answer: A market that allocates funds to their most productive uses as a result of competition among wealth-
maximizing investors and that determines and publicizes prices that are believed to be close to their true value. It
has the following characteristics:

1. All having the same information and expectations with respect to securities;
2. No restrictions on investment;
3. No taxes;
4. No transaction costs,
5. Investors are rational

Efficient market can be divided into the following types:

a. Strong-Form Market Efficiency: A level of market efficiency in which all relevant information,
both public and private, is fully and immediately reflected in security prices.
b. Semi strong-Form Market Efficiency: A level of market efficiency in which all relevant
publicly available information is fully and immediately reflected in security prices.
c. Weak Form Market Efficiency: A level of market efficiency in which all previous security price
and volume data are fully and immediately reflected in current security prices.

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