financial management- maseno

8/12/2019 Financial Management- Maseno

1/42

Financial Accounting Hand out 1

DEFINITION OF FINANCIAL MANAGEMENT

Financial Management is a discipline concerned with the generation and allocation of scarce

resources (usually funds) to the most efficient user within the firm (the competing projects)

through a market pricing system (the required rate of return).

A firm requires resources in form of funds raised from inestors. !he funds must "e allocated

within the organi#ation to projects which will yield the highest return.

$e shall refer to this definition as we go through the su"ject.

1. 2 Required Rate of Return (Ri)

!he required rate of return (Ri) is the minimum rate of return that a project must generate if it has

to receie funds. %t&s therefore the opportunity cost of capital or returns e'pected from the

second "est alternatie. %n general

equired ate of eturn * isk+free rate , isk premium

isk free rate is compensation for time and is made up of the real rate of return (r) and the

inflation premium (%p). !he risk premium is compensation for risk of financial actions reflecting-

- !he riskiness of the securities caused "y term to maturity

- !he security marketa"ility or liquidity

- !he effect of e'change rate fluctuations on the security etc.

!he required rate of return can therefore "e e'pressed as follows-

Rj= Rr+IRp+DRp+MRp+ LRp+ ERp+ SRp+ ORp.

$here-

r is the real rate of return that compensate inestors for giing up the use of their funds in

an inflation free and risk free market.

%p is the %nflation isk remium which compensates the inestor for the decrease in

purchasing power of money caused "y inflation.

1

er"#


2/42


/p is the /efault isk remium which compensates the inestor for the possi"ility that

users of funds would "e una"le to repay the de"ts.

Mp is the Maturity isk remium which compensates for the term to maturity.

0p is the 0iquidity isk remium which compensates the inestor for the possi"ility that

the securities gien are not easily marketa"le (or conerti"le to cash).

p is the 'change isk remium which compensates the inestors for the fluctuation in

e'change rate. !his is mainly important if the funds are denominated in foreign currencies.

2p is the 2oereign isk remium which compensates the inestors for the possi"ility of

political insta"ility in the country in which the funds hae "een proided.

3p is the 3ther isk remium e.g. the type of product the type of market etc.

2. SCOE OF FINANCE F!NCTIONS

!he functions of Financial Manager can "roadly "e diided into two- !he outine functions and

the Managerial Functions.

2.1 Mana"eria# Finan$e Fun$tion%

equire skilful planning control and e'ecution of financial actiities. !here are four important

managerial finance functions. !hese are-

(a) In&e%t'ent of Lon"ter' a%%et'i de$i%ion%

!hese decisions (also referred to as capital "udgeting decisions) relates to the allocation of funds

among inestment projects. !hey refer to the firm4s decision to commit current funds to the

purchase of fi'ed assets in e'pectation of future cash inflows from these projects. %nestment

proposals are ealuated in terms of "oth risk and e'pected return.

%nestment decisions also relates to recommitting funds when an old asset "ecomes less

productie. !his is referred to as replacement decision.

(") Finan$in" de$i%ion%

5

er"#


3/42


Financing decision refers to the decision on the sources of funds to finance inestment projects.

!he finance manager must decide the proportion of equity and de"t. !he mi' of de"t and equity

affects the firm4s cost of financing as well as the financial risk. !his will further "e discussed under

the risk return trade+off.

(c) Di&i%ion of earnin"% de$i%ion

!he finance manager must decide whether the firm should distri"ute all profits to the shareholder

retain them or distri"ute a portion and retain a portion. !he earnings must also "e distri"uted to

other proiders of funds such as preference shareholder and de"t proiders of funds such as

preference shareholders and de"t proiders. !he firm4s diided policy may influence the

determination of the alue of the firm and therefore the finance manager must decide the optimum

diidend + payout ratio so as to ma'imi#e the alue of the firm.

(d) Liquidit* de$i%ion

!he firm4s liquidity refers to its a"ility to meet its current o"ligations as and when they fall due. %t

can also "e referred as current assets management. %nestment in current assets affects the firm4s

liquidity profita"ility and risk. !he more current assets a firm has the more liquid it is. !his

implies that the firm has a lower risk of "ecoming insolent "ut since current assets are non+

earning assets the profita"ility of the firm will "e low. !he conerse will hold true.

!he finance manager should deelop sound techniques of managing current assets to ensure that

neither insufficient nor unnecessary funds are inested in current assets.

2.2 Routine fun$tion%

For the effectie e'ecution of the managerial finance functions routine functions hae to "e

performed. !hese decisions concern procedures and systems and inole a lot of paper work and

time. %n most cases these decisions are delegated to junior staff in the organi#ation. 2ome of the

important routine functions are-

(a) 2uperision of cash receipts and payments

(") 2afeguarding of cash "alance

(c) 6ustody and safeguarding of important documents

(d) ecord keeping and reporting

7

er"#


4/42


!he finance manager will "e inoled with the managerial functions while the routine functions

will "e carried out "y junior staff in the firm. He must howeer superise the actiities of these

junior staff.

+. O,-ECTIES OF A ,!SINESS ENTIT/

Any "usiness firm would hae certain o"jecties which it aims at achieing. !he major goals of a

firm are-

rofit ma'imi#ation

2hareholders4 wealth ma'imi#ation

2ocial responsi"ility

8usiness thics

9rowth

(a) rofit 'ai'i0ation

!raditionally this was considered to "e the major goal of the firm. rofit ma'imi#ation refers to

achieing the highest possi"le profits during the year. !his could "e achieed "y either increasing

sales reenue or "y reducing e'penses. :ote that-

rofit* eenue ; 'penses

!he sales reenue can "e increased "y either increasing the sales olume or the selling price. %t

should "e noted howeer that ma'imi#ing sales reenue may at the same time result to increasing

the firm4s e'penses.

!he pricing mechanism will howeer help the firm to determine which goods and serices to

proide so as to ma'imi#e profits of the firm.

!he profit ma'imi#ation goal has "een critici#ed "ecause of the following-

(a) %t ignores time alue of money

years) after which

holders can force the company to receiership to redeem their capital and interest outstanding.

i&) Irredee'a5#e De5enture% (4er4etuitie%)

7>

er"#


36/42


!hese are neer "ought "ack in which case they form permanent source of finance for the

company. Howeer these are rare and are usually sold "y company&s with a history of sta"le

ordinary diidend record.

&) C#a%%ifi$ation a$$ordin" to $on&erti5i#it*

6onerti"le de"entures ; 6an "e conerted into ordinary shares although they can also "e

conerted into preference shares.

6onersion price * par alue of a de"entureJ:o. of shares to "e receied.

6onersion ratio * ar alue of de"enture

ar alue of ordinary shares

Ea'4#e

A86 6ompany 0td "ooks-

1I.III 2h.5I ordinary share capital

1IIII 2hs.1I EO preference share capital

>III 2hs.1II 15O de"entures

!he a"oe de"entures are due for conersion-

S%.

5IIIII

1IIIII

>IIIII

Required

i) 6ompute the conersion price

ii) 6ompute the conersion ratio

iii) 6ompute new capital structure.

So#ution

i) 6onersion price * par alue of de"entureJ:o. of shares to "e receied.

:o. of shares to "e receied * 1II-5I * >-1

7

er"#


37/42


!herefore * 5I>

1II=

ii) 6onersion ratio * par alue of de"entureJpar alue of share * I.>5I

1II=

eceie > ordinary shares for eery 1 de"enture held.

iii) :ew capital structure

:o. of new ordinary shares * >III ' > * 5>III

2hs.

7>III 2hs.5I ordinary shares DIIIII

1IIII 2hs.1I EO preference shares 1IIIII

!otal capital EIIIII

&i) Non$on&erti5#e de5enture%

!hese cannot "e conerted into ordinary preference shares and they are usually redeema"le.

&ii) Su5ordinate de5enture%

=sually last for as long as 1I years and they are sold "y financially strong companies. 2uch are

not secured and they rank among general creditors in claiming on assets during liquidation. !his

means that they are su"+ordinate to senior de"t "ut superior to ordinary and preference share

capital.

Rea%on% 5eind !n4o4u#arit* of De5enture% of en*a% Finan$ia# Mar@et

i) !heir par alue is an e'tremely high alue and as such they are unafforda"le to purchase

"y would "e inestors.

ii) !hey are in most cases secured de"t and as such constrain the selling company in so faras getting sufficient securities is difficult.

iii) Most of the would+"e sellers hae low credit worthiness which is difficult.

i) Penya&s capital markets are not deeloped and as such there is no secondary de"enture

market where they can "e discounted or endorsed.

7D

er"#


38/42


) /e"entures finance is not known among the general "usiness community and as such

many would "e sellers and "uyers are ignorant of its e'istence.

i) 8eing long term finance there are a few "uyers who may "e willing to stake their saings

for a long period of time.

ii) 2uch finance calls for a fi'ed return which in the long rum will "e eroded "y inflation.

>. enture Ca4ita#

@enture capital is a form of inestment in new small risky enterprises required to get them

started "y specialists called enture capitalists. @enture capitalists are therefore inestment

specialists who raise pools of capital to fund new entures which are likely to "ecome pu"lic

corporations in return for an ownership interest. !hey "uy part of the stock of the company at a

low price in anticipation that when the company goes pu"lic they would sell the shares at a

higher price and therefore make a considera"ly high profit.

@enture capitalists also proide managerial skills to the firm. 'ample of enture capitalists are

pension funds wealthy indiiduals insurance companies Acacia fund ock fella etc.

2ince the goal of enture capitalists is to make quick profits they will inest only in firms with a

potential for rapid growth.

@enture capitalists will only inest in a company if there is a reasona"le chance that the

company will "e successful. !heir pu"licity material states that successful inestments hae

three common characteristics.

a) !here is a good "asic idea a product or serice which meets real customer needs.

") !here is finance in the right form to turn the idea into a solid "usiness.

c) !here is the commitment and drie of an indiidual or group and the determination to

succeed.

Attri5ute% of &enture $a4ita#

i) quity participation ; @enture 6apital participate through direct purchase of shares or

fi'ed return securities (de"entures and preference shares)

7E

er"#


39/42


40/42


!he directors of the company then contract enture capital organi#ations to try to find one ormore which would "e willing to offer finance. A enture capital organi#ation will only gie

funds to a company that it "eliees can succeed.

Rea%on% for Si"nifi$ant Gro3t in enture Ca4ita# in te De&e#o4ed Countrie%

i) u"lic attitude i.e a faoura"le attitude "y the pu"lic at large towards entrepreneurship

success as well as failure.

ii) /ynamic financial system e.g efficient stock e'change and a competitie "anking system.

iii) 9oernment support ; e.g ta'ation system to encourage enture capital e.g ta'

concessions and inestment allowance ta'es.

i) sta"lishment of enture capital institutions e.g inestors in the industry.

) 9rowth in the num"er of Management "uyers (M83) which hae created a demand for

equity finance.

Con%traint% of enture Ca4ita# in en*a

1. 0ack of rich inestors in Penya hence inadequate equity capital.

5. %nefficiencies of stock market ; :2 is inefficient and inestors cannot sell the shares in

future. rices do not reflect all the aaila"le information in the market.

7. %nfrastructural pro"lems ; this limits the growth rate of small firms which need raw

materials and unlimited access to the market factors of production.


41/42


. Focus on low risk entures e.g confining to low technology low growth sectors with

minimum inestment risks.

D. 6onseratie approach "y the enture capitalists.

E. /elay in project ealuation e.g months or more hence entrepreneurs loose interest in theproject.

. 0ack of goernment support and inefficient financial system.

Su''ar*

%n sum enture capital "y com"ining risk financing with management and marketing assistance

could "ecome an effectie instrument in fostering deeloping countries. !he e'periences of

deeloped countries and the detailed case study of enture capital howeer indicate that the

following elements are needed for the success of enture capital in any country.

A "road+"ased (and less family "ased) entrepreneurial traditional societies and goernment

encouragement for innoations creatiity and enterprise.

A less regulated and controlled "usiness and economic enironment where attractie

customer opportunities e'ists or could "e created from high+tech and quality products.

'istence of disinestments mechanisms particularly oer+the counter stock e'change

catering for the needs of enture capitalists.

Fiscal incenties which render the equity inestment more attractie and deelops Bequity

cult& in inestors.

A more general "usiness and entrepreneurship oriented education system where scientists

and engineers hae knowledge of accounting finance and economics and accountants

understand engineering or physical sciences.

An effectie management education and training programme for deeloping professionally

competent and committed enture capital managersC they should "e trained to ealuate and

manage high technology high risk entures.

A igorous marketing thrust promotional efforts and deelopment strategy employing new

concepts such as enture fair clu"s enture networks "usiness incu"ators etc. for the

growth of enture capital.


42/42


0inkage "etween uniersitiesJtechnology institutions R /. 3rganisations industry and

financial institutions including enture capital firms.

ncouragement and funding or R / "y priate pu"lic sector companies and the

goernment for ensuring technological competitieness.

Di%ad&anta"e% of enture Ca4ita#

/ilute ownership position of a firm

/ilute control of a firm

financial management- maseno

Documents