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FINANCIAL MANAGEMENT: Principles and

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Financial Management: Principles and Practice

FINANCIAL MANAGEMENT:
Principles and Practice

Lawyer C. Obara
Bassey O. Eyo
Financial Management: Principles and Practice
fii

FINANCIAL MANAGEMENT:

Principles and Practice

Lawyer C. Obara
Bassey O. Eyo
 Iv Financial Management: Principles and Practice

Published in Nigeria by: Springfield Publishers

Copyright 2000 Lawyer Obara & Bassey Eyo
ISBN: 978-8001-57-2
1st impression 1,000 copies
Reprinted in 2002

All Rights Reserved

This book will not be reproduced in part or in full, or stored in a
retrieval system or transmitted in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise (except for brief
quotation in critical articles or reviews) without the prior written permission
of the copyright owner.
This book is sold subject to the condition that it should not by way
of trade or otherwise be lent, re-sold, hired out or otherwise circulated
without the copyright owner's consent, in any.form of binding or cover
than that in which it is published and this condition being imposed on'
the subsequent purchaser.

LA WYER OBARA & BASSEY EYO

. Financial Management: Principles and Practice

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Financial Management: Principles and Practice v
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Preface

Financial Management: Principles and Practice is a text designed to assist the

readers to develop an understanding of the rapidly evolving and existing theory of
finance. It is also aimed at familiarizing readers with the ways in which analytical
techniques are applied to a variety of problems in financial management. Our
pedagogical aids include the use of local examples and application of financial
management principles in solving practical problems.
Practical questions are raised at the end of each topic and solutions to such
problems are provided using the principles discussed. End of chapter questions on
topical issues relevant to the chapter discussions are also provided to challenge readers
to apply financial management principles to actual problems. We have adopted this
approach to lessen the burden of students in knowing how best to apply financial
management principles and (often difficult quantitative tools) to solve practical
financial management problems. Based on our experience in the teaching of the
course over the years, in addition to our consultancy with business firms on financial
prohlems and policies, we have been able to identify some of the most significant
responsibilities of financial managers, the most fundamental problems facing firms
in Nigeria and the possible feasible approaches to practical decision-making within
the context of local inputs and environmental constraints. We hope the use of local
examples will offer added clarity to the understanding of the issues.
The book contains materials that will benefit both practitioners and students
in under-graduate and graduate levels.
The order of the chapters reflects our preference for teaching the course, but
other users may approach them in whatever order they deem appropriate. The field
of finance and its development are known to be contingent on the development of
the Global economy. As the economy experiences growth and dynamic changes,
these changes impact on finance and its tools of analysis. We hope that this book
will contribute to a better understanding of these developments.

Obara, Lawyer C. & Eyo, Bassey O.

Port Harcourt, Rivers State
October. 20tXl
 ::,illlllliiillllll:

vi Financial Management: Principles and Practice

ACK-"O'YLEDGE\IE~TS

Every textbook owes .ts existence to the work and wisdom of numerous predecessors lID

and colleagues..-\ great debt [5 owed to the pioneers of finance who first identified
the field's major issues. clarified finance's purpose and scope and contributed major :I
ideas tv as development. We acknowledge the contributions of our teachers, such
,3l
as. Professor P.?". Umoh, Dr. J J. M. Braide and ChiefE. O. Obele.
We do express our gratitude to the staff and students of the Faculty of
Management Science, (RSUST), Port Harcourt for their contributions. Our specific
41! ."
thanks go to the following colleagues: Dr. J. J. M. Braide, Mr. N. A. Ukpai, Mr. B.
D. Kiabel, Mr. TA. Keme, Chief E. O. Obele, Dr. D. W. Maclayton, Prof. B. A.
Tubara, Prof. P. B. Johnie, Dr. O. 0 Eni, Mrs T A. Udenwa, Mr. M. D. Tamunomiebi,
Mr. D. S. MacOdo, Rev. T A. Amangala, Mr. D. 1. Hamilton, Dr. (Mrs) E. 1. Ugorji,
Dr. P. P. Ekerete, Dr. S. N. Amadi, Dr. Steve Okorodu.
We are grateful to the Institute of Chartered Accountants of Nigeria (lCAN)
and the Dryden Press, Hussdale, Illinois, for allowing us use their past examination
questions and materials.
For the encouragement and understanding, we thank our families, and above
all, we are most grateful to God Almighty for his guidance and protection.

L. C. Obara and B. O. Eyo

Financial Management: Pnncip.es a::j P:-ac:lce

TABLE OF CONTENTS

Preface v

Acknowledgements VI

1 The Role Of Finance In An Organization 1

2 Financial Markets In A Market Economy 19

3 Nature And Structure Of Financial Institutions In Nigeria 34

4 Sources Of Finance 38

5 Concepts In Valuation 50

6 Valuation And Rate Of Return On Financial Assets 72

7 Working Capital Management and Short Term Financing 102

8 Cost Of Capital 130

9 Financial Structure And The Use Of Leverage 154

10 Capital Budgeting 165

11 Anal ysis And Interpretation Of Financial Statement 245

12 Introduction To International Finance 271

13 Failure and Reorganization 291

14 Dividend Policy 305

15 Mergers And Acquisition 315

Tables 330

Index

 Financial Management: Principles and Practice

THE ROLE OF FINANCE

IN AN ORGANIZATION

Introduction
Finance has been variously defined (Schall and Haley (1977), Van Horne
(1977), Solomon and Pringle (1980. Most authors prefer to look at finance in
terms of its function in an organization. Finance function involves three decisions
namely: . Investment, Financing and Dividend decisions. Investment decision
involves the deployment of funds to investment proposals whose benefits are to
be realized in the future. The financing decision is concerned with the choice of
acceptable level of the mix of owner's money and borrowed funds used to run the
organization. It also involves the acquisition of borrowed funds at the least
possible cost and using the most convenient instrument. The dividend decision
relates to the rules guiding how the organization shares the earned profit between
share holders and reinvestment in the business. Van Home (1986) argues that
investment decision is the most important of these decisions. This is so because
the level and choice of investment dictates the level of fund to be raised. Also the
level of investment has a direct influence on returns.
These three decisions jointly determine the value of the firm. Finance is
also define as a body of facts, principles, and theories dealing with the raising and
using of money by individuals, businesses and government (Schall and Haley,
1977) .: This definition does not seem to link finance with its functions. Looking
at finance from this perspective, the authors tend to emphasize the scope of
finance rather than the function it performs. Finance courses cover areas such as:
Personal finance, business finance, public finance, investments, financial markets,
financial institutions, international finance, et cetera.
Finance can also be defined in the context of the functions of finance
officers (Weston and Brihgham, 1979). The major functions are:
(a) Raising of funds,
(b) Investing the funds in worthwhile projects.
(c) . Managing the cash flows released from the project and
2 Financial Management: Principles and Practice

(d) Returning the funds to funding sources.

In Nigeria, a Finance Controller is put at the helm of affairs to direct these

functions in most corporations.

The linking of finance to its functions as shown above is regarded as the

"grass-roots" approach to the definition and scope of financial management.
Solomon and Pringle (1980) reject this approach. They argued that in most
organizations, responsibility for financial management "is often highly diffused
within a business corporation". Also "investment and financing decisions often
involve committees of senior officers of the firm and in the case of major
decisions, the Board of Directors itself'. But one thing that is indisputable is the
fact that finance is a discipline developed over time in recognition of certain
functions. These functions determine the scope of finance.

NATURE AND SCOPE OF FINANCIAL MANAGEMENT

Although financial management is relevant to any organisation be it public
or private, our sphere of discourse shall be focused on the business firm, the
aspect most aptly referred to as Corporate Finance. Thus in the scope of
financial management, we will examine how financial decision is important in
addressing the questions posed by Ezra Solomon (1963) namely:
1. What specific assets should the firm acquire?
2. What total volume of funds should an enterprise commit?
3. How should the funds required be financed?
These are strategic questions which answers must be provided as the
entrepreneur makes a decision on what to produce, how to produce, how much to
produce and where to produce. Finance is the ultimate criterion and measurable
determinant in the decision process. Financial Management therefore should not
be left to finance manager alone since all business decisions have financial
implications. Managers should primarily be concerned with 4 major decisions
namely: Investment Decision, Liquidity Decision, Financing Decision and
Dividend (pay Back) Decision.
Let us note that shareholders are made better off by any decision which
increases value of their shares. Thus while performing the finance functions, the
finance manager should strive to maximize the market value of shares.
Investment Decision
Investment decision or capital budgeting is the "oldest" area of the recent
thinking in finance. It relates to allocation of capital and involves decisions to commit
funds to long-term assets which would yield benefits in future. One very significant
aspect of

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 Financial Management: Principles and Practice

this decision is the task of measuring the prospective profitability of new

investments. Future benefits are difficult to measure and cannot be predicted
with certainty. Because of the uncertain future, capital budgeting decision
involves risk. Investment proposals should, therefore, be evaluated in terms of
both expected return and risk. Besides the decision to commit funds in new
investment proposals, capital budgeting also involves the question of
recommitting funds when an old asset becomes less productive or non-profitable.

FINANCIAL DECISION
Financing decision is the second important function to be performed by
the finance manager. Broadly, he must decide when, where, and how to acquire
funds to meet the firm's investment needs. The central issue before him is to
determine the proportion of equity and debt. The mix of debt and equity is known
as the firm's capital structure. The finance manager must strive to obtain the best
financing mix or optimum capital structure for his firm. The firm's capital
structure is optimum when the market value of shares is maximized.

Dividend Decision
Dividend decision is the third major financial decision. The financial manager
must decide whether the firm should distribute all profits, or retain them, or distribute a
portion and retain the balance. Like the debt policy, the dividend policy should be
determined in terms of its impact on the shareholders' value. The optimum dividend
policy is one which maximizes the market value of the firm's share.

Liquidity Decision
Current assets management which affects a firm's liquidity is yet another
important finance function, in addition to the management of long-term assets. Current
assets should be managed efficiently for safeguarding the firm against the dangers of
illiquidity and insolvency. Investment in current asset affects a firm's profitability,
liquidity and risk. Financing decisions thus directly concern the firm's decision to
acquire or dispose of assets and require commitment or recommitment of funds on a
continuous basis. It is in this context that finance functions are said to influence
. production, marketing and other functions of the firm. This in consequence, will affect
the size;growth, profitability and risk of the finn and ultimately, the value of the firm.
Ezra (1969) argues that the function of financial management is to review and control
decisions to commit or recommit funds to new or on going uses. Thus, in addition.to
raising funds, financial management is directly concerned with production, marketing
and other functions within an enterprise whenever decisions are made about the
. acquisition or distribution of assets:
4 Financial Management: Principles and Practice

Routine Finance Function

Routine finance functions, on the other hand, do not require a great :::t
pi
managerial ability to carry. them out. They are chiefly clerical in nature and are.
incidental to the effective handling of the managerial functions. 15
For the effective execution of the managerial finance functions, routine liil
t]
finance function have to be performed. These decisions concern procedures and
.aul
system and involve a lot of paper work and time. Some of the important routine
finance functions are: M
1. Supervision of cash receipts and payments and safeguarding of cash .."
._!,
balances;
2. Custody and safeguarding of securities, insurance policies and other
Ilbn
valuable papers,
!lim
3. Taking care of the mechanical details of new (outside) financing;
au.
4. Record keeping and reporting.
unn
The finance manager in the modem enterprises is mainly involved in the
.~
managerial finance functions; the routine finance functions are carried out by the
:lII1I
people at lower levels. His involvement in the routine functions is to the extent of
setting up rules and procedures, selecting forms to be used, establishing standards ....
for the employment of competent personnel and to check up the performance to
see that the rules are observed and the forms properly used. ~
The involvement of the financial executives in the managerial financial II:Jl
functions is recent. About two or three decades ago, the scope of finance piI
functions or the role of the financial manager was limited to routine activities.
How the scope of finance function has widened or changed is discussed in the \\WI

following sections. IttIlI

JFlI!
Illln
THE FINANCIAL MANAGER'S RESPONSIBILITIES
The financial manager's primary task is to plan for the acquisition and use
of funds so as to maximize the value of the firm. Put another way, he or she
makes decisions about alternative sources and uses of funds. Here are some .~

specific activities which are involved: 1. Forecasting and Planning n

The financial manager must interact with other executives as they jointly C
look ahead and lay the plans which will shape the firm's future position Fi
mm
$I~
Major Investment and Financing Decisions On the basis of long-run
ilblll
plans, the financial manager must raise the capital needed to support growth.
lCI
A successful firm usually achieves a high rate growth in sales, which requires
1Iiw
increased investments in the plant, equipment and current assets necessary to lie:!
produce goods and services. The financial manager must help determine If1ll
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 Financial Management: Principles and Practice 5

the optimal rate of growth in sales, which requires increased investments in the
plant, equipment' and current assets necessary to produce goods and services. The
financial manager must help determine the optimal rate of sales growth, and he or
she must help decide on the specific investments to be made as well as on the
types of funds to be used to finance these investments. Decisions must be made
about the use of internal versus external funds, the use of debt versus equity and
the use of long-term versus short-term debt.

3. Coordination and Control

The Financial Manager must interact with executives in other parts of the
business if the firm is to operate as efficiently as possible. All business decisions
have financial implications, and all managers - financial and otherwise - need to take this into
account. For example, marketing decisions affect sales growth, which in tum changes
investment requirements. Thus, marketing decision makers must take into account how their
actions affect (and are affected by) such factors as the availability of funds, inventory policies,
and plant capacity utilization.

4. Investment with Capital Markets

The Financial Manager must deal with the money and capital markets. As we shall
see later, each finn affects and is affected by the general fmancial markets, where funds are
raised, where the finn's securities are traded, and where its investors are either rewarded or
penalized.
In sum, the central-responsibilities of financial managers involve decisions such as
which investments their firms should make, how these projects should be financed, and how
the firm can most effectively manage its existing resources. If these responsibilities are
performed optimally, financial managers will help to maximize the value of their firms and
this will also maximize the long-run welfare of those who buy from or work for the finn.

EVOLUTION OF FlNANCE
Finance was originally taught in schools as a part of economics. It emerged as a
separate field of study in the early part of the 20th Century. In 1920, Professor Arthur Stone
Dewing, a Harvard Professor of Finance, published a book tittle "The Financial Policy of
Corporations". The publication can be said to have marked the turning point for the study of
Finance. (Umoh, P.N. 1986). Prior to this publication, finance studies dealt with only the
instruments, institutions and procedural aspects of capital markets (Van-Home, J.e. 1986). It
should be noted that the work of Dewing was in direct response to the economic and
business activity of the time. As at that period, technological innovation and new industries
created a need for more funds. This need prompted the study of fmance to emphasize
liquidity and financing aspect of the firm. The focus of finance at this period turned to
external financing rather than internal management. Between 1920 and 1930 finance study
elicited intense interest in securities particularly common stock. Investment banker became a
significant figure to study in corporate finance of the period.
6 Financial Management: Principles and Practice

\alu;:IU1LJI
Evolution of finance is greatly influenced by economic and business activity of the time
as these determined what was of primary importance in the field of finance (Keown, AJ. ~lodi~

et al, 1985). The depression of the 1930s, for instance, realigned the study of finance with lOqumr.\
defensive aspects of survival, preservation of liquidity, bankruptcy, liquidation and contmllCIJI
reorganization. Conservatism dominated financial thoughts at this period. There was ona iCli

more emphasis on a sound financial structure and government regulations. staraed

Finance during the 1940s through the 1950s, dealt on the traditional concept of firm,
financial management. Then, the firm was analyzed from the view point of an outsider IN.
such as a lender or investor. The study of finance at this period emphasized economic \\ri~
institutions and descriptive materials on stocks, bond, stock exchanges, rules and devess
regulations of financial markets. The study of external financing at this time was still manag
\\35 :~:ll
largely descriptive. Students were however, taught the analysis of cash flows and the
planning and control of these flows from within. numbe
In the 1950s, the works of Friederich and Vera Lutz in their book "The Theory of shouJhct
Investment of the Firm" (1951) and Joel Dean on capital budgeting (1951) served as but r::llIl1I
building blocks for subsequent theoretical and managerial development in finance. of asSIC
Capital budgeting and allied consideration moved to the forefront. assess
While the economic environment continued to affect financial thought:, many de .. dhll
factors together helped to bring about dramatic changes in the mid-1950s. During this
time the field of finance evolved to one dealing with all aspects of acquiring and prOOk:
efficiently utilizing those funds. Finance study has expanded in scope and contents. Ch3nIu
Currently, almost all universities with a school or Faculty of Business Administration invesa
have Departments of Finance and/or Banking. The courses in such departments include: (19551
Corporation Finance, Security Analysis, Investment Management, Portfolio Theory, col'llllljIDllt:
Financial institutions, Money and Banking, Internal Finance, Insurance, Real Estate invesa
Finance and Public Finance. There is also emphasis on development finance. This
aspect is currently gaining wide popularity because of indispensable role of finance in
\alW1illlllJ
development. to ~

Finally, the advent of computer technology brought about easy access to complex betwlOl
information systems which aid the financial manager with data from which to make sound ofeqllJ
decisions. Finance study therefore developed a focus on the means by which companies, the c:au
banks etc. pay their bills, collect debt owed them and transfer cash. Continued improvement CapiD
on computer and electronic technologies have further expanded the scope of finance both 11965,:
within and across international boundaries as funds could easily be sourced and invested in Il~1
any part of the world. I 1C}1'/(f]11
th3l Jinn
GROWfH OF MODERN FINANCE retlllMllll
The immense and sporadic developments in the field of finance in the 1950s brought
the financial manager to grips with the way in which investors and creditors valued the firm the liIDllI
and how a particular decision affected their respective valuations. The classic 1938 work J.~
of John Bum Williams on the theory of investment values provided the offshoots for the bees :II
 Financial Management: Principles and Practice 7

valuation models developed in the 1950s. The path breaking articles by

Modigliani and Miller in 1958 and 1961 set the stage for extended theoretical
inquiry which continues till today. Miller and Modigliani (1958) started a long
controversy over the question of whether a firm's capital structure has any effect
on a company's value and its cost of capital. Also Miller and Modigliani (1961)
started another controversy over the effect of dividend policy on the value of the
firm. The major contributors in these debates included Myron Gordon (1962)
Irwin Lend and Marshall Puckett (1964). The controversies shifted financial
writings from being descriptive to being analytical. The 1960s witnessed the
development of portfolio theory and its eventual application on financial
management. This theory was first developed by Harris Markowitze in 1952 and
was later extended and considerably refined by Sharpe, Lintner, Fama and a
number of others. The theory explains the fact that the risk of an individual asset
should not be judged on the basis of possible deviations from its expected return
but rather in relation to its marginal contribution to the overall risk of a portfolio
of assets. The riskiness of the asset depends more on the correlation of those
assets in the portfolio. The contribution of portfolio theory also aided
development in the functioning of financial market.
Specific analytical techniques were employed in solving financial
problems. Linear programming was used in the costing of the business funds by
Charnes, Cooper and Miller (1959), Robichek, Teichrowe and Jones (1965). On
investment decisions, analytical contributions were made by Lorie and Savage
(1955) who discussed how a company can allocate available capital between
competing investments. Frederick Hiller( 1963) showed how to optimise risky
investment decisions by the use of probabilistic information.
In the 1970's, the application of Sharpe's capital -asset pricing model for
valuing financial assets was introduced in Financial Management. This gave rise
to equilibrium theories. The theories made statements about the relationship
between security expected returns and some attributes of the security. Two types
of equilibrium theories have been advocated in the finance literature. These are
the capital Asset Pricing theory and the Arbitrage Pricing theory. The original
Capital Asset Pricing Model (CAPM) was introduced by Sharpe (1964), Lintner
(1965) and Mossin (1966). Extentions of the Model were made be Lintner
(1969) Breman (1970), Black (1972), Morton (1973), Krans and Ditzenberger
(1976), Breman (1972), Breeden (1979) and others. The original CAPM assumes
that investors care only about portfolio risk and expected return. The expected
return relates to systematic risk as measured by beta.
In the landmark contribution in the 1970s, Black and Scholes developed
the option pricing model for the relative valuation of financial claims. The
application of the option pricing model to corporate finance is expanding and has
been a rich lode of intellectual inquiry in recent years.
8 Financial Management: Principles and Practice

Development of Financial Management

The evolution of finance has greatly impacted the role and importance of
financial management. The critical areas of focus must be identified. Finance
has changed from primarily a descriptive study to one that encompasses rigorous
analysis and normative theory, from a field that was concerned primarily with
the procurement of funds to one that includes the management of assets, the
allocation of capital, and the valuation of the firm to one that stresses decision
making within the firm. Some of the areas that have contributed to the
complexity of modern financial management and which have contributed to the
development of financial management include:
1. An increase in size of business
2. Diversification both in products and geographically
3. Increase in investment in research and development to produce new
techniques and new products
4. Increasing emphasis on growth in the economy and in industry
5. Environmental and social factors such as pollution and unemployment are
of increasing concern to management
6. Increased competition has resulted in pressure on profit margins
7. Inflation rate and the problem of high interest rate and profit measurement
8. Improved communications and development of multinational corporation.
9. Imposition of wage control by government in an attempt to halt inflation.
10. The development of new financial techniques such as forecasting, capital
budgeting, statistical analysis and computer simulations demand a greater
technical ability from management.

OBJECTIVES OF THE FIRM

One of the main objectives of the firm is profit maximisation. Others are:
shareholders' wealth maximisation (SWM), sales maximisation, satisficing,
expense preference, revenue maximisation

Profit Maximisation Objective

In economic theory, profit maximisation is the established objective of a
firm operating ina perfect market. This is achieved by the firm producing at the
output level where marginal revenue equals marginal cost (MC=MR). This
ensures that investments are maximised and that only profitable investment; are
embarked upon thus leading to efficiency in resource allocation.
Though a company may pursue the profit motive it is .arguable that
achieving this objective alone guarantees the satisfaction of all constituents
interests and corporate survival. A company driven exclusively by the profit
motive may, in an attempt to maximise profit embark on high risk projects. High
 Financial Management: Principles and Practice 9

risk projects have the potential for high returns but at the same time puts at jeopardy the
interest of the owners, especially fixed interest owners who do not often bargain for such
level of risk.
Profit maximisation can at best be a short run objective. It implies that the firm
pursue only those decisions that will lead to immediate profit and not those that will
enhance the future earning potential. It assumes that a firm is evaluated on the basis of
current earnings alone to the exclusion of future earning stream.

Need For Profit

Though short term decisions may reduce or eliminate profits, in the long term a
company must earn profits in order to meet the need of the following constituencies:
1. Shareholders: who expect a return on their investment commensurate with
alternative investment opportunities and the risk involved and a growth in the
value of their shareholding.
2. Employees: whose security may depend on the continued existence of the
company and whose level of earning may also depend on its prosperity measured
by the level of profit made.
3. The community: industry and commerce have a responsibility to the community
in which they operate. This responsibility also extend to environmental aspects
such as the prevention of pollution and the provision and supply of local
amenities. It is only enhanced profit that can ensure. the performance of this
responsibility.
4. Government: contribution through taxes to the national fund towards social
services, defence and public investment.
5. The Company: in form of reserves for future investment.

Profit Maximisation
Despite its lofty advantages, profit maximisation is a narrow and inadequate goal
to pursue. The main criticism of this objective is that it assumes away many of the
complexities of the real world.
1. It does not take into consideration the risks involved in the profit attainment. A
company's management may undertake very risky projects with high initial rates
of return (high returns are usually rewards for high risks). In reporting the high
profit rates, mention is hardly made of the low quality of the company's
investments. In a few years time, the company may be bankrupt because of the
questionable quality of its investments. The case of high rate of bank failure in
Nigeria in the later part of the 1990s after huge profits have been declared by
these banks in the late 1980s and early 1990s attest to this fact.
2. Profit maximisation is also criticized because it assumes away timing
differences of returns.
3. The problem of lack of consensus on the reality and nature of profit
among accountants.
10 financial Management: Principles and Practice

Current development in accountancy principles and concepts is that the Ilm1ill:llil1~::,

stated profit figures are at best only estimates in any situation (Obele, :alSII::aiI
1998). The following reasons attest to these facts:
a. provision for depreciation or amortisation of fixed asset S'~'E
b. Valuation of finished goods and work in progress I!,l',n:mll

c. Credit taken for profit on partly completed long term ;gm;_1

contracts emmI~liJl
d. The matching of expenses with income, especially where duf'w,llit

there is an element of deferred revenue expenditure N~1t

e. Adjustment for changing in the value of money.
f. The treatment of exceptional gains or losses (including unrealized ~
losses) whether of a capital or revenue nature. In all but the
simplest of businesses, the profit is an approximate figure very p:::auc1r
much dependent on the conventions which have been applied. The mIIIIIIIlU
economic profit is gi yen as Revenue less expenditure. This will IC"I\fClIDI

not treat a to f as expenditure (Solomon, D, BE:20 1) PJIDfI1IIl

4. Profit maximisation objective can only be practicable in a perfect market.
But most modern markets are not perfect and therefore the pursuance of ~
profit maximisation as an objective becomes inappropriate. Undue drive
for profit by a firm could be detrimental to other interests. The firm could Ito.
~.
as a consequence create externalities in the form of pollution, unsafe work
practices and products. 1'IImue \
Satisficing objective ~11e:11
This objective directs the interest of managers towards satisfying rather i.mIDinflill
than maximising. Maximising involves seeking the best possible outcome while ~'
satisficing involves a willingness to settle for something less (Weston, J .F.,1966). olIiMlII5
In carrying out this objective, management prefer moderate goals to risky lilfUl
ventures even when possible gains to stock holders are commensurate with the el.fJif
risk. This objective is often pursued to ward off setbacks for managers. ooQ~

Shareholders are viewed as being well diversified, holding portfolios of many is W

different stocks, adverse outcome in one company may not necessarily affect their \o\i~

holdings in others. The case for management is different, as set back affects them .~
more. Studies have shown that it is difficult to determine whether a particular lD3I'J'
management team is pursuing 'satisficing' or maximizing objectives. This is so fd
because conservative decision taken to avoid excessive risk may be viewed as IBMI
satisficing even where the aim was to avoid a loss that would affect the ofm
shareholders' wealth. Also where a large, well-entrenched corporation decides to I1UIIIII
keep stockholder returns at fair or "reasonable level and then devote part of its to 'm
efforts and resources to public service activities, to employee benefits, to higher COIlIl~

management salaries or to sport developments due to peculiar social/economic "-\m.U

conditions in its area of operation such effort may be for the safety of the remmmi
 Financial Management: Principles and Practice n

J!1,anagers or it could also be for that of the shareholders who may reap the fruit of
a stable enterprise.
The records of growth in earnings, market share and profits attained by
Nigerian companies rule out the possibility of a planned satisficing behaviour
(Urnoh 1986). Recent development however suggests that firms in Nigeria are
graduaIly pursuing satisficing objectives in view of excessive demands for
enhanced workers' well being and, for companies to participate in community
development in the country, This objective was never part of a firm's goal in
Nigeria in the past.

Sales Maximisation
The goal of sales maximisation IS traced to the classic bureaucratic
practice of empire building. Once the managers have achieved a specified
minimum profitability, corporate efforts are then directed towards more sales
even when thesales do not contribute to profitability. This objective is not very
popular among firms in Nigeria.

Expense preference
The expense preference theory of the firm asserts that managers may seek
to achieve a higher level of personal utility through higher salaries, additional
staff and other prerequisites for which the managers have positive preference.
The result would be an expansion of expenditures beyond the profit maximizing
level and a sub-optimality in efficient use of the company's resources. The
implications of expense preference goal arise from the use of corporate funds for
purposes other than financing fixed assets and working capital. Dmoh (1986)
observed that, given the highly regulated and the uncompetitive nature of many of
the industries in Nigeria, the behaviour is likely to be prevalent in Nigeria. Given
expense preference behaviour of managers for example, the company's operating
costs are likely to increase more than the increase in turnover. The net profit level
is likely to be below what would have been obtained if profit maximizing goal
were followed. The cash-flow position of the company is also likely to suffer.
Again, given a satisficing objective, the standards set and being met by managers
may lead to sub-optimization of the company's financial resources. Umoh (1986)
further posits that the minimum standards set would naturally be governed by
management's utility preference function which may differ from those of owners
of the company. But where there is a divergence between the goals of
management and those of owners, the compensation of managers should be tied
to the achievement of owners goals. Alternatively, if such managers are
consistently unable to pursue owner's goals, the management should be changed.
Attempts by owners to get management to pursue owners' goals and lor the
removal of erring managers all have financial costs to the company.
10 financial Management: Principles and Practice

Current development in accountancy principles and concepts is that the

stated profit figures are at best only estimates in any situation (Obele,
1998). The following reasons attest to these facts:
a. provision for depreciation or amortisation of fixed asset
b. Valuation of finished goods and work in progress
c. Credit taken for profit on partly completed long term
contracts
d. The matching of expenses with income, especially where
there is an element of deferred revenue expenditure
e. Adjustment for changing in the value of money.
f. The treatment of exceptional gains or losses (including unrealized
losses) whether of a capital or revenue nature. In all but the
simplest of businesses, the profit is an approximate figure very
much dependent on the conventions which have been applied. The
economic profit is given as Revenue less expenditure. This will
not treat a to f as expenditure (Solomon, D, BE:201)
4. Profit maximisation objective can only be practicable in a perfect market.
But most modern markets are not perfect and therefore the pursuance of
profit maximisation as an objective becomes inappropriate. Undue drive
for profit by a firm could be detrimental to other interests. The firm could
as a consequence create externalities in the form of pollution, unsafe work
practices and products.
Satisficing objective
This objective directs the interest of managers towards satisfying rather
than maximising. Maximising involves seeking the best possible outcome while
satisficing involves a willingness to settle for something less (Weston, J.F.,1966).
In carrying out this objective, management prefer moderate goals to risky
ventures even when possible gains to stock holders are commensurate with the
risk. This objective is often pursued to ward off setbacks for managers.
Shareholders are viewed as being well diversified, holding portfolios of many
different stocks, adverse outcome in one company may not necessarily affect their
holdings in others. The case for management is different, as set back affects them
more. Studies have shown that it is difficult to determine whether a particular
management team is pursuing 'satisficing' or maximizing objectives. This is so
because conservative decision taken to avoid excessive risk may be viewed as
satisficing even where the aim was to avoid a loss that would affect the
shareholders' wealth. Also where a large, well-entrenched corporation decides to
keep stockholder returns at fair or "reasonable level and then devote part of its
efforts and resources to public service activities, to employee benefits, to higher
management salaries or to sport developments due to peculiar social/economic
conditions in its area of operation such effort may be for the safety of the

~~---
 Financial Management: Principles and Practice II

':ll.anagers or it could also be for that of the shareholders who may reap the fruit of
a stable enterprise.
The records of growth in earnings, market share and profits attained by
Nigerian companies rule out the possibility of a planned satisficing behaviour
(Umoh 1986). Recent development however suggests that firms in Nigeria are
gradually pursuing satisficing objectives in view of excessive demands for
enhanced workers' well being and for companies to participate in community
development in the country. This objective was never part of a firm's goal in
Nigeria in the past.

Sales Maximisation
The goal of sales maximisation IS traced to the classic bureaucratic
practice of empire building. Once the managers have achieved a specified
minimum profitability, corporate efforts are then directed towards more sales
even when thesales do not contribute to profitability. This objective is not very
popular among firms in Nigeria.

Expense preference
The expense preference theory of the firm asserts that managers may seek
to achieve a higher level of personal utility through higher salaries, additional
staff and other prerequisites for which the managers have positive preference.
The result would be an expansion of expenditures beyond the profit maximizing
level and a sub-optimality in efficient use of the company's resources. The
implications of expense preference goal arise from the use of corporate funds for
purposes other than financing fixed assets and working capital. Umoh (1986)
observed that, given the highly regulated and the uncornpetitive nature of many of
the industries in Nigeria, the behaviour is likely to be prevalent in Nigeria. Given
expense preference behaviour of managers for example, the company's operating
costs are likely to increase more than the increase in turnover. The net profit level
is likely to be below what would have been obtained if profit maximizing goal
were followed. The cash-flow position of the company is also likely to suffer.
Again, given a satisficing objective, the standards set and being met by managers
may lead to sub-optimization of the company's financial resources. Umoh (1986)
further posits that the minimum standards set would naturally be governed by
management's utility preference function which may differ from those of owners
of the company. But where there is a divergence between the goals of
management and those of owners, the compensation of managers should be tied
to the achievement of owners goals. Alternatively, if such managers are
consistently unable to pursue owner's goals, the management should be changed.
Attempts by owners to get management to pursue owners' goals and lor the
removal of erring managers all have financial costs to the company.
12 Financial Management: Principles and Practice
cons:
Revenue Maximisation resoei
. Some organisations such as governments and non-profit making
companies, clubs or societies pursue the financial objective of revenue cash
maximisation. invCSII
Federal and State Governments, Ministries, extra-ministerial expo:
departments/agencies or local authorities pursue the financial objective of revenue appa
maximisation. They aim to earn as much revenue from taxation, levies, rates,
royalties and rents to be able to provide social services and maintain law and ofaR
order. By pursuing revenue maximisation objective, government hopes to by 1lIDl
employ fiscal policy to achieve economic stability and growth. is IR'
Since charities, clubs or societies are not established to make profit, their sho81ll
financial objectives are the maximisation of revenue which they use to provide infom
service to their members and pursue any other interest. Ill&1DIII
THE CONFLICT BETWEEN PROFITABILITY AND LIQUIDITY ~
Recognising the need for profit for the long term survival of the firm, and 0I'II1lil:mr
the use of profitability as an index for measuring managerial performance, it is iDllii:lf
natural that most company management should consider maximising return on t:Ial umJ
investment to be their prime objective. Improved profitability can be achieved by
application of cost reduction techniques such as inventory control, the most sa.:!
important source is from increase volume and the development of new products. l1IIils I

The investment necessary for growth require substantial and normally irregular porJ!18D
flows of cash. Unless proper financial arrangements are made, a rapidly growing uJIJiJm
ok
company, although profitable, may run into serious liquidity problems. which can
ecDlIIIl1I
be more damaging to its survival than even a loss making situation. It is
eDIIJIIIIIllI
important, therefore that efforts to maximise profit through growth do not lead to sMcl
overtrading and a liquidity crises. It is the duty of the Finance Manager to co c:. lij
ordinate the growth plans of various departments such as production and sales and iIIimmJ
to interpret them in financial terms so as to ensure that adequate finance is dE,1C!l
available to sustain the project growth.
D1IillIMilll
Shareholders' Wealth Maximisation slum:
~.~
The wealth of an enterprise is increased when the present value of its cash in
skim
flow is greater than the present value of cash outflow. The maximisation of the value ~
of the firm is recognised as the most appropriate financial objective which should drive
the investing and financing action of financial manager. .,
Ia:i;Ji

The financial objective of value or wealth maximisation recognises the time

value of money and the riskness of the earnings stream. It accounts for the possible
variety in the source of finance and the differences in the expectations of the
16'.
~

CI'lJII1II
stakeholders. m~

Since the equity interest is residual, their maximisation in essence accounts for
the interests of the others. Hence the financial objective of wealth maximisation is
 Financial Management: Principles and Practice 13

consistent with maximising the owners economic welfare and efficiency in

resource allocation.
Value or wealth maximisation objective is not ambiguous it emphasises
cash flows rather than profit. It takes the potential earning capacity since
investment in a company is not made for its own sake but rather because of the
expectation of returns, the wealth maximisation objective is therefore most
appropriate and realistic.
This goal is also regarded as the most acceptable one because the effects
of all financial decisions are included in this goal. This goal can be accomplished
by maximizing the price of the company's shares (Brigham, 1978:3-4). The goal
is predicated on the existence of a well functioning capital market. Such a market
should be an efficient one, such that share prices should reflect all available public
information about the company and the economy. Thus, shareholders' wealth
maximisation takes into account the demand for and the supply of the company's
shares in the market. It also considers the risk inherent in the share-holding. In
order to employ this goal, we need not consider every price change to be a market
interpretation of the worth of our decisions. What we do focus on is the effect
that our decision would have on the stock price if everything was held constant.
It also means that by formulating the firm's objectives in terms of the
shareholder's interest, the discipline of the financial markets is implemented.
Thi"s means that firm with better performance will have higher stock prices. The
purpose of capital markets is to allocate savings efficiently in an economy, from
ultimate saver to ultimate users of funds who invest in real assets. If savings are
to be channelled to the most promising investment opportunities, a rational
economic criterion must govern their flow. The allocation of savings in an
economy occurs on the basis of expected return and risk. The prevailing price of
stock in the market must be a reflection of all these decisions. This conclusion
can only be correct if the capital market is efficient. Here, we mean public
information about the company issuing the security, the financial market and about
the economy are reflected instantly on the price of the firm's stock.
In Nigeria, due to lack of adequate information on these variables, and in
most part, due to the attitudes of shareholders, the prices prevailing in the market for
shares have little or nothing to do with the intrinsic values of the companies issuing
the shares. Because of this most managements do not take into consideration
shareholders' reaction when taking serious decisions that affect the employees and
other stake holders in their firms. Besides, the Nigeria capital market seems to be
lacking in depth and breadth. The volume of stocks in the market are not impressive
and the value of the total shares traded are equally a far cry from those of other
developed capital markets like the US or Britain. Although the situation is changing
with the reformation of the capital markets in Nigeria its efficiency is still in doubt.
Consequently, the shareholder maximisation objective is not widely pursued by firms
in Nigeria. The goal is best used as a check on profit maximisation.
14 Financial Management: Principles and Practice

FINANCIAL OBJECTIVES OF DIFFERENT TYPES OF

ORGANISATIONS
The financial objective of an organisation defines what financial
management should seek to maximise in making investment and financial
decisions. The knowledge of the financial objective of an organisation therefore
gives direction and focus to financial management.
Below is a summary of the financial objectives of different type of
organisations.
Organisation Financial Objectives
Companies (Limited and Unlimited) Wealth or Value Maximisation
Public Corporations Profit/Revenue Maximisation
Federal, State or Local Government Revenue Maximisation
Charities, Clubs, Societies Revenue Maximisation
Relationship Between Management And Stakeholders
A company and any organization is a constituent of various interested
parties. These are the owners, employees, suppliers, creditors, customers,
government and the public. Collectively they are known as stakeholders.
The interest of the stakeholders more often conflicts with each other.
Thus the company becomes the umbrella for the resol ution of these conflicts.
The responsibility for resolving these conflicts lies with the management which
must manage the disparage forces for their common good.
The management of a company is in the hands of the board of directors
who mayor may not have financial stake in the company. As agents of the
owners they are expected to act in the best interest of the owners of the business.
Managers of the business exercise control over its affairs and may use
their dominant position to pursue their private agenda. One of the private benefits
of being in control have been identified as the prerequisites enjoyed by top
managers. For example, top managers can enjoy luxury accommodation and cars,
or put company resources for private uses.
Managers also have access to information about the company business and
potential opportunities. These may be used for personal gains. Ezra Solomon
(1969) opined that financial management is directly concerned wherever
decisions are made about the acquisition and distribution of assets.

Technique of Financial Management

In view of the all pervading scope of financial management in the firm, the
techniques and tools that aid in decisions making draw from a multiple of
disciplines. David Pith Francis sees financial management as involving use of
accounting knowledge, economic models, mathematical rules and aspects of
system analysis and behavioural sciences for the purpose of helping management
in planning and control.
 Financial Management: Principles and Practice 15

Brockington (1982) says that a knowledge of Financial and Management

Accounting, Law, Economics, Quantitative methods (including Mathematics and
Statistics and Taxation are though not part of financial management but they
support it in providing useful information for decision making as well as
providing the framework for understanding the constraints within the activity of
financial management.
FUNCTION OF THE FINANCE MANAGER
Within the organisational structure, the Finance Manager or Director
maintains a staff relationship with other functional managers such as production,
marketing, personnel, by proffering advice on the financial implications of
operational and strategic decisions.
The functions of the finance manager are the duties or responsibilities
which he must perform in order to achieve effectively the ohjective of efficient
resource mobilisation and utilisation.
The finance function is typically separated into two and possibly overseen
by different officers. These are:
11) The Treasurer
i ::: ) The Controller
FUNCTIONS OF THE TREASURER
The treasurer is responsible for the acquisition and custody of funds. The
following functions arc incidental to the effective handling of this primary
function:

1. Supervision of cash receipt and payments.

Safeguarding and investing cash balances.
Custody and safeguarding of securities, and other valuable documents of
title ..
Directing the granting of credit and the collection of account receivahles.
Arranging insurance coverage of company assets.
6. Establish and manage a good pension scheme and other trust fund.
Maintaining proper accounting records.
Maintaining a good relationship with investors fund providers as well as
debtors, ego Commercial and Merchant banks.

F unctions of The Controller

The Controller is responsible for accounting, reporting and control. To
execute this primary responsibility, below are the related functions:
T (1 coordinate the plan for the control of operations usually through budget
~:1d budgetary control.
:- = prepare and report on corporate performance in the fonn of financial
16 Financial Management: Principles and Practice
Srk
3. To establish and administer corporate tax policies and maintain relations
with the tax authorities. A:n
4. To establish. a functional internal auditing and internal control system to R -.
~,

protect corporate assets.

5. To evaluate economic and social forces and interpret their effects on GJ5
corporate activity.
6. To manage the payroll and the management information system. B~"1

REVIEW QUESTIONS Ben

l. What are the main finance decisions in a firm?
2. Investment decision is often regarded as the most important finance
decision, do you agree? [)(l,!'1

3. Explain the main functions of finance in a public company.

4. What are routine finance functions
5. What factors do you think have accounted for the growth of financial FJ1.[T1
management?

F~JI]JIl:

R'(JliH

V,JJl:1l1i

BrL~

l- m

?lll:r.J

K::'

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 Financial Management Principles and Practice 17

Selected References

Anthony, R.N. (1960) "The trouble with profit maximisation" Harvard Business
Review 38, Nov.-Dec.

Gaskill, W. J. "What's Ahead for Corporations in Social Responsibilities.

Barnea, A.R. et-al, (1984), "Management of Corporate Risk" working paper

University of Wisconsin, Madison.

Beranek, W. (1981) "Research Directions 111 Finance, Quarterly Review of

Economics and Business.

Donaldson, G. (1963) "Fi nancial Goals: Management vs Stockholders" Harvard

Business Review, 41 May - June. 116-129

Fama, E. F. (1980) "Agency Problems and the Theory of the Firm" Journal of
political Economy, 88, April, page 288-307

Findley, M.C. III, and Whitmore .G.A. (197-.j.) "Beyond Shareholder Wealth
Maximisation" Financial Management . 3 page 25-35

RolL R. and Ross, S. A. (198-1-) "The Arbitrage Pricing Theory Approach to

Strategic Portfolio Planning" Financing Analysts Journal, May-June, page
14-26

Van Horne, J. C. (1986) Financial Management and Policy, 7th Edition

Prentice-Hall International Editions, Engle Wood Cliffs, New Jersey.

Brigham, W. F. (1978) Managerial Finance 6th Edition. Dryden Press USA.

Umoh, P. N. (1995) Principles of Finance, Page Publishers Services Ltd. Lagos

Pandy, I, M. (1995) Financial Management Vikas Publishing House PVT. Ltd.

Delhi

Keown, AJ, Scot, Jr. D.F., Martin, J.D., and Petty, S.W (1985) Basic Financial
Management 3rd Edition. (Study Guide) Prentice-Hall, Inc, Engle Wood
Cliffs, New-Jersey.