Q:- What is Finance and what are the Objectives of Financial Management?

Finance is a term used to describe both the money resources available to governments, firms, or
individuals, and the management of these funds. Maness (1988) defines finance as the study of
the acquisition and investment of cash for the purpose of enhancing value and wealth. Brigham
and Houston, explain that Finance consists of three interrelated areas:

a. money and capital markets, which deals with securities markets and financial institutions;
b. investments, which focuses on the decisions made by both individual and institutional
investors as they choose securities for their investment portfolios; and
c. financial management, or “business finance,” which involves decisions within firms.

Financial Management is the acquisition, management and financing of resources for firms by
means of money, with due regard for process in the external economic markets (Pinches, 1990).
This is primarily concerned with financial decision making within the business entity. Decision
areas in the study and practice of Financial Management include: Maintaining Cash Balances;
Extending Credit; Investing in new assets; replacing old assets; acquiring other firms; borrowing
among others. Brealey, Myers and Marcus (2001) understand that financial manager faces two
basic problems:

a. How much money should the firm invest, and what specific assets should the firm invest
in? This is the firm’s investment, or capital budgeting decision.
b. How should the cash required for an investment be raised? This is the financing
decision.

Marfo-Yiadom (2009) also groups the decision areas in Financial Management into three,
namely:

a. Investment Decision, which is concerned selection of Long-term and Short-term assets in

which funds will be invested by the firm.
b. Financing or Capital-Mix Decision, involves deciding when, where and how to acquire
funds to meet the firm’s investment needs as well as determine the proportion of equity
and debt holders must provide.
c. Dividend or Profit Allocation Decision, deciding whether the firm should distribute a
portion of its profits and retain the balance or otherwise.

The Objectives of Financial Management

According to Hill (2008), the normative objective of financial management is: “To implement
investment and financing decisions using risk-adjusted wealth maximising criteria, which satisfy
the firm’s owners (the shareholders) by placing them all in an equal, optimum financial
position.” This emphasizes the importance of Share-holder wealth maximization as the main
objective of Financial Management. The objectives are:

a. Shareholder Wealth Maximization

Maximizing wealth can be defined as maximizing the market value of shareholder interest in the
organization. This is represented by the market price of equity also referred to as market
capitalization. This market price is the net present value of all future cash flows to the owners
(dividends) and it translates into the price that buyers and sellers in a free market are willing to
pay for the Shares. The Market value of shareholders’ equity is therefore the value of all owners;
interest in the corporation and is calculated as the product of the market value of a share of stock
and the number of shares of stock outstanding.
A smart and effective financial manager makes decisions which increase the current value of the
company’s shares and the wealth of its stockholders. Wealth Maximization takes account of both
return and risk simultaneously. It also balances short and long term benefits. The objectives of
financial managers in Maximizing Shareholder wealth therefore aim at taking decisions that
balances returns and risk in a way as to maximize the benefits, through dividends and
enhancement of share price to the shareholder.

b. Profit Maximization
 Another objective of Financial Managers is Profit Maximization which entreats Financial
Managers to put in place measures and policies that will increase the financial position of the
firm. Shareholders need to receive periodic amounts to solidify their interest in the organization.
A firm that does not make and declare profits continuously will not attract investors to put their
money in it.
However, profit maximization is acceptable to a certain limit. If the profits are as a result of
expansion in scale of operations of the firm and other capital investments, then shareholders will
benefit and profit maximization can be acceptable. However, where the profits are as a result of
mere raising of additional external finance, it might mean that profit per share could decrease and
shareholders will not benefit.
Profit as an objective is also hindered by some important facts. First the term profit is vague,
different definitions or forms exist, for example, accounting profits: which is based on book
value or economic profit: which is based on market value. Also profits do not take into
consideration the time value of money and ignores risk differences between alternative
investments.

1.b Explain any three Sources of Short term Finance

Short-term funds usually finance the current needs for cash inventory at a time when cash
requirements exceed available finance (Marfo-Yiadom, 2009). Short-term sources of funds are
usually repayable within a year. Among the sources of Short-term finance are: Trade Credit,
Unsecured Bank Loans, Bank Overdrafts etc.
Trade Credit
Where a person, or a firm purchases goods with an agreement that payment for such products
received would be effected on a later date, it is a Trade Credit. By reason that the supplier does
not demand the payment immediately, the supplier becomes a lender. For example, where Casey,
a Night Club Manager, buys 100 crates of Beer from Sam’s Breweries with the agreement that
the payment for the crates delivered would be done in a month’s time, it is a trade credit.
Trade Credit is usually based on mutual trust, and it helps firms and individuals get necessary
inventory where there is limited or no cash. In Trade credit buyers may receive goods along with
invoices stating the credit terms. Sellers deliver the goods on faith the due payments would be
made on the agreed date. Trade Credit may also exist where sellers want more reassurance and
insist that buyers sign a legally binding promissory note before the goods are delivered. Some
Sellers may also demand posted dated cheques which would be presented for payment on the
agreed date.
Bank Overdraft
Businesses and individuals who have Current accounts with banks, subject to the bank’s
regulations, may be allowed to from time to time withdraw amounts in excess of the balance
standing in such accounts. The believe that the account may be credited with some funds later
after which the bank would recover the overdraft and some service charges. Overdrafts are more
likely to be made available to businesses that need short-term funds for a seasonal trade or for a
specific contract.

QUESTION 2
2. What do you mean by the terms “capitalization” and “capital structure”? Check the
causes of under and over capitalisation with their solutions.
Capitalization refers to the amount and types of long-term financing used by a firm. A firm with
capitalization including little or no long-term debt is considered to be financed very
conservatively. Capitalization in simple terms refers to Long-term debt plus preferred stock plus
net worth.
The Capital Structure of a firm is its mix of different securities issued by that firm. It looks at the
combination of short and long-term debt securities, preferred stocks and equity that will be used
to finance a firm’s assets. The optimal capital structure should strike a balance between risk and
returns and thus maximize the price of a firm’s shares.
Causes of under capitalization
Under capitalization refers to any situation where a business cannot acquire the long-term funds
they need. It is often as a result of improper financial planning. However, a viable business may
have difficulty raising sufficient capital during an economic downturn or in a country that
imposes artificial constraints on capital investment.
The causes include:
 Financing growth with short –term capital, rather than permanent capital.
 Failing to secure an adequate bank loan at a critical time.
 Failing to obtain insurance against predictable business risks.
 Adverse macroeconomic conditions.
Over- capitalization
This occurs when the total capital (both debt and equity) exceeds the true value of its assets. It is
wrong to identify over-capitalization with excess of capital because most of the over-
capitalization firms suffer from the problems of liquidity.
The causes include:
 Decline in the earnings of the company
 Fall in the dividend rates.
 Market value of company’s share falls, and company loses investor confidence.
 Company may collapse at anytime because of anaemic financial conditions- it will affect its
employees, society, consumers and its shareholders.
The solution to the problem of under and over capitalization is in effective capital structure
management. By considering such factors like sales stability of its securities, asset structure, the
firm’s tax position, Financial flexibility, operating leverage, growth rate, profitability, control,
management attitude, among others. The firm can reduce the tendency that the firm cannot
acquire the funds that it requires or a situation where the firm’s total capital exceeds the true
value of its assets.

QUESTION 3

Explain the features of an ideal capital structure

The Capital Structure of a firm is its mix of different securities issued by that firm. It looks at the
combination of short and long-term debt securities, preferred stocks and equity that will be used
to finance a firm’s assets. The optimal capital structure should strike a balance between risk and
returns and thus maximize the price of a firm’s shares. This is because using more debt raises the
risk borne by stockholders since more debt increases the riskiness of the firm’s earning stream
which reduces share value. However, using more debt generally leads to a higher expected rate
of return on equity. Higher risk tends to lower a stock’s price, but a higher expected rate of return
raises it. The firm usually analyzes some factors to come out with a target ratio of its securities.
This would enable the firm know whether to issue out debt security of equity security from time
to time. In choosing an ideal capital structure, financial managers are to consider the following
factors:

a. Sales Stability: where the sales of a firm are relatively stable a firm can take on more debt
and incur higher fixed charges as compared to a firm with unstable sales.
b. Asset Structure: Every industry requires some level of investment in capital assets. Firms
with large sums of fixed capital assets can use these assets as security for loans. These
firms can therefore issue out more debt securities as compared with equity.
c. The firm’s tax position: Interest is deductible expense while dividends are not deductible;
this lowers the effective cost of debt. However, if most of a firm’s income is already
sheltered from taxes by depreciation tax shields, by interest on currently outstanding debt,
or by tax loss carry-forwards, its tax rate will be low, so additional debt will not be as
advantageous as it would be to a firm with a higher effective tax rate. Therefore, the
higher the corporate tax, the greater the advantage of using debt.
d. Financial flexibility refers to the ability to easily raise capital. Where a firm has the
ability to select the type and amount of capital the firm chooses to use at the particular
time rather than to have to choices dictated by the investment dealers or to unable the
firm raise capital at all.

Other factors include: operating leverage, growth rate, profitability, control, management
attitude, among others.

QUESTION 4
4.a Define Working Capital Management. Explain the types of Working Capital
Working Capital Management involves managing the level and mix of current assets and current
liabilities and some long-term sources (Archer et al, 1983). It also involves the planning and
utilization of a firm’s current or short-term funds to finance the short-term liabilities that are
needed to support the current assets of a firm. Short-term, or current, assets and liabilities are
collectively known as working capital.
Net working capital is the difference between current assets and current liabilities. It helps
indicate the liquidity position of firm and the extent to which working capital needs may be
financed by the permanent sources of funds. Working capital policy involves two basic
questions:
(1) What is the appropriate amount of current assets for the firm to carry, both in total and for
each specific account?; and
(2) how should current assets be financed?
Baker (1991) gave five reasons why working capital is important

a. Working Capital comprises a large portion of the firm’s total assets.

b. Working capital represents those assets that are most manageable.
c. Working capital management consumes the largest portion of the financial managers’
time.
d. Working capital management directly affects the firm’s long-term growth and survival.
e. It directly affects the firm’s liquidity and profitability.

The Working Capital of a firm refers to investments in short-term assets—cash, marketable

securities, inventory, and accounts receivable. Pandey (1991) gave out the types of Working
Capital to include:

a. Cash,
b. Inventory or stock,
c. Accounts receivables, and
d. Marketable securities

Cash Management is the process of managing a firm’s liquid assets. Cash is the amount of
currency the firm has on hand, cheques and bank balances. This is the firm’s most liquid asset.
The goal in cash management is to determine the target cash balance required to maintain
liquidity while minimizing the total costs related to investments in cash. The decisions areas in
this include managing collections and disbursements, determining appropriate cash balances and
investing idle cash. The firm incurs some liabilities when it holds more cash or less. For
example, where a firm keeps little cash than it is required there may be loss in discounts from
suppliers, inability to cope with emergencies and high costs of borrowing. Whereas the cost of
holding too much cash would have opportunity cost of investing that amount in an interest
bearing security.
Inventory refers to the stockpile of the products a firm is offering for sale and the components
that make up the product (Bolton, 1975). Inventory provides the firm with greater flexibility in
timing the purchases of raw materials, scheduling production and meeting unexpected demand.
Inventory may be Raw materials, work-in progress or finished goods. The reasons for holding
inventory include;

a. Balance ordering and carrying costs

b. To meet delivery dates and satisfy customer demands
c. Avoid shutting down the facility

In monitoring the inventory working capital management employs some inventory management
techniques like Economic Order Quantity Model, and other Stock level computation techniques.
Accounts Receivables refers to money owed to a firm for goods or services sold on credit. The
level of accounts receivables depend on the volume of credit sales and average collection period.
The goal of account receivable management is to ensure that firm’s investments in accounts
receivables is appropriate and contributes to shareholder wealth maximization. It involves
establishing credit policy and conducting credit analysis. That is determining the bases to grant
credit to an individual and assessing the probability that an individual can pay back the amount
borrowed.
Marketable Securities are held as a substitute for cash and as a temporary investment to meet
seasonal needs or to cover unpredictable financing needs. Idle funds are normally invested in
marketable securities like treasury bills and commercial paper. The appropriate level of
marketable security depends on several factors like: predictability of cash flows, transaction
costs and interest rates. Other factors to be considered when selecting such a security to invest in
are: default risk, maturity period, rate of return, minimum purchase size among others. Types of
marketable securities include; Discount papers, interest bearing securities, treasury bills,
commercial papers, negotiable certificates of deposit, money market mutual funds, among
others.
4.b Define operating leverage with its utility in business
Operating Leverage refers to degree or extent to which costs are fixed. If a high percentage of
costs are fixed, hence do not decline when demand falls, then the firm is exposed to a relatively
high degree of business risk. This factor is called operating leverage. Business risk depends in
part on the extent to which a firm builds fixed costs into its operations—if fixed costs are high,
even a small decline in sales can lead to a large decline in Return on Equity. So, other things held
constant, the higher a firm’s fixed costs, the greater its business risk. Higher fixed costs are
generally associated with more highly automated, capital intensive firms and industries.
However, businesses that employ highly skilled workers who must be retained and paid even
during recessions also have relatively high fixed costs.
If a high percentage of total costs are fixed, then the firm is said to have a high degree of
operating leverage. In physics, leverage implies the use of a lever to raise a heavy object with a
small force. In politics, if people have leverage, their smallest word or action can accomplish a
lot. In business terminology, a high degree of operating leverage, other factors held constant,
implies that a relatively small change in sales results in a large change in Return on Equity.

QUESTION 5
5. Write notes on the following
1. Factors affecting working capital
Working capital refers to the current assets and current liabilities of a firm. It refers to
investments in short-term assets—cash, marketable securities, inventory, and accounts
receivable. So many factors affect the level of working capital that firm should maintain, among
these are;

a. Price level changes

Generally, rising price levels will require a firm to maintain higher amounts of working capital.
The firm may incur higher cost if it fails to keep more working capital like inventory. Where the
general price levels keep rising, the market price of the inventory for example would not be
stable, these may cause production inconsistencies. Cash would also have to be increased so as to
be able meet the rising price levels. This means that where there is a falling price levels, less
working capital may be maintained.

b. Availability of credit facility from suppliers

The credit terms granted by a firms creditors as well as whether creditors are willing to give
firms the necessary credit demanded also affects how much working capital a firm should
maintain. A firm will need less working capital if the credit terms are liberal and are available to
it. A firm which gets credit easily and under favourable conditions will operate with less working
capital. However, where creditors are not willing to give credit facility to a firm or the terms of
the credit facility is not liberal, firms must keep higher levels of working capital.

c. Growth and expansion activities

The belief here is that industries that are static require less working capital than those that are
growth industries. Where a business is expanding it would require more working capital to
facilitate its expansion process. For example, a small company that wants to become a larger one
would need increased sales volumes by producing more, it would also need more cash to
facilitate it production and other activities.

d. Market Conditions

The level of competition in a particular market would also determine how much working capital
firms are to keep to meet this competition. Where there is high level of competition, firms would
need to ensure that there is no short fall in stocks to meet the consumers’ needs. This it ensures
by maintaining higher levels of working capital. In a Monopolistic market where consumers have
no other alternatives, a fall in supply may not necessarily reduce the demand for the products.
Such market may not require huge working capital.
Also, strong competition may result in firms giving favourable credit terms to customers to buy
its products. This increases the level of accounts receivable which is a type of working capital.
 e. Conditions of Supply

This looks at the reliability of suppliers of the inputs that firms need to operate. Where supply of
these inputs is prompt, adequate, and reliable, the firm can manage fewer levels of inventory and
other working capital. However, where it is unpredicted and unreliable, firms need to maintain
higher levels of inventory to carry on the objects of the firm.