New Generation University College

Department of Management
Masters of Business Administration
Individual assignment

Course Title: Financial Managerial

Submitted By
Robsan Kidane
ID: NGU/22/2830
Section: E

Submitted To
Dasalegn M (Assist. Prof, PhD Cand)

Date of Submission: 15/10/22

1. Discuss what you understand about Finance, why we need finance and how finance becomes
essential requirement of every organization and in our daily life of social, political and economic
 arenas? Furthermore, discuss what financial management means and why it is required in the
personal and business arenas. What are major components of financial management and what
decisions are made by financial managers?
Answer
Finance is a broad term that describes activities associated with banking, leverage or debt, credit, capital markets,
money, and investments. Basically, finance represents money management and the process of acquiring needed
funds. Finance also encompasses the oversight, creation, and study of money, banking, credit, investments,
assets, and liabilities that make up financial systems.

Financial planning involves analyzing the current financial position of individuals to formulate strategies for
future needs within financial constraints. Personal finance is specific to every individual's situation and activity;
therefore, financial strategies depend largely on the person's earnings, living requirements, goals, and desires.

Corporate finance refers to the financial activities related to running a corporation, usually with a division or
department set up to oversee the financial activities.

We need finance because it involves analyzing the current financial position of individuals to formulate
strategies for future needs within financial constraints. Personal finances are specific to the situation and activity
of each individual; therefore, financial strategies largely depend on the person’s income, needs, goals and
wishes.

5 reasons why Finance is important aspect of every organization

1. Without financial management business cannot exists

Finance is the backbone of any business or organization without which it cannot function.
2. Adequate funds availability:
Sufficient funds are necessary to meet daily expenses to purchase long term assets for the company's requirement
accordingly; also funds should be there to deal with future unforeseen over costs which may arise. 
3. Cash flow management system:
In an organization, excess cash flow can also become difficult to manage. Having excess amount of funds and
not using it in a genuine much useful way is a greater waste of resources.
4. Always keeping long term goals
Having long term goals in life or business is a very important aspect to keep, once it is done the responsibility
has to be fulfilled as per the plan made at any cost to get fulfil the targeted goals to achieve success. 
5. Financial Planning value and importance in a business
Financial planning creates immense value to the company, without this any of the business entity cannot function
properly. It is a major vital venture for all kinds of businesses worldwide. It is done for an entire year to have
control over financial activities of the company. 

Discuss what financial management means and why it is required in the personal and business arenas. What are
major components of financial management and what decisions are made by financial managers?
Answer
Meaning of Financial Management
Financial Management means planning, organizing, directing and controlling the financial activities such as
procurement and utilization of funds of the enterprise. It means applying general management principles to
financial resources of the enterprise.

Major Components of Financial Management

1. Budgeting- Budgeting is a key component of financial management because it provides the overall plan
for spending, both across the organization and on specific activities, within a given timeframe.
Budgeting requires accounting for both revenues and expenditures at unit, project, and program levels. It
also provides an ongoing check for reasonableness by comparing actual expenditure requests against
projected expenditures.
 2. Cost Principles- Federal cost principles are a key component of financial management because they
keep ineligible and excessive spending in check. Cost principles are the regulations that determine
eligible costs for specific activities, which are outlined in grant agreements and contracts.
3. Accounting and Records- Accounting is also key component of financial management because it
ensures that program costs and expenditures are recorded and documented properly.
4. Reporting- The fourth key component of financial management is reporting because it summarizes for
the grantee and HUD the fiscal and programmatic activities and shows whether the program is attaining
its objectives.
Decisions made by financial managers

1. Investment decisions: includes investment in fixed assets (called as capital budgeting). Investments in
current assets are also a part of investment decisions called as working capital decisions.
2. Financial decisions: They relate to the raising of finance from various resources which will depend
upon decision on type of source, period of financing, cost of financing and the returns thereby.
3. Dividend decision: The finance manager has to take decision with regards to the net profit distribution.
Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.
4. Retained profits: Amount of retained profits has to be finalized which will depend upon expansion and
diversification plans of the enterprise.

Why require Financial Management

1. To guarantee optimal use of the budget. Once funds are obtained, they should be used as
efficiently and effectively as feasible.
2. To make sure that shareholders receive acceptable returns, this will rely on their earning
potential, the Share’s market price, and their expectations.
3. To guarantee a consistent and sufficient flow of funding to the organization
4. To assure safety on investment- Funds should be put into safe endeavors in order to get a
sufficient rate of return.
5. To plan a sound capital structure- A fair and sound capital composition is necessary to develop
a solid
6. Capital structure and to keep the ratio of debt to equity capital. Capital structure and to keep the
ratio of debt to equity capital.
2. Differentiate profit maximization from wealth maximization? Which one of them comes first and
discuss how the managers negotiate the conflicts among them.

The focus on short-term profits distinguishes the maximization of profits from the maximization of wealth,
which places more emphasis on the long-term growth of the business entity's total value. As will be seen below,
these variations are significant.

 Duration of planning: In a profit-maximizing strategy, it may be chosen by management to forego

paying for discretionary costs like maintenance, advertising, and market research. Management always
covers these discretionary costs in the context of wealth maximization.
 Risk management: Profit maximization reduces expenses, making it less likely for management to pay
for hedges that could lower the organization's risk profile. A business that prioritizes wealth would focus
on risk reduction to lower its risk of suffering a loss.
 Pricing strategy: To maximize profits, management will set product prices as high as possible in order
to boost margins. The alternative would be for a company with a focus on wealth to choose to lower
prices over the long run in order to increase market share.
 Planning for capacity: A company that prioritizes profits will invest just enough in expanding its
capacity to handle current sales levels and possibly upcoming short-term sales forecasts. A business that
prioritizes wealth will invest more in capacity in order to hit its long-term sales targets.
 Maximizing profits comes first, followed by maximizing wealth because profits are made in the short term
and then saved up over a long period of time to increase wealth.
Managers emphasize price for profits while emphasizing customer base for wealth.

3. Discuss what you know about risk and return issues, differentiate systematic risk from
unsystematic risk. Furthermore, discuss what good risk and return model should perform and
how we can manage the risk-return trade off.
The relationship between risk and return is a fundamental investment concept. The concept states that an
increased probability for return is highly correlated with the increase in the level of risk taken. The return is
expressed as a percentage and refers to the gains or losses made from an investment, whereas the risk element is
associated with the volatility of that return. In theory, an investor could expect higher return on investment only
if willing to accept a higher level of risk.
There is always a risk incorporated in every investment like shares or debentures. The two major components of
risk: systematic risk and unsystematic risk, which when combined results in total risk.
The systematic risk is a result of external and uncontrollable variables, which are not industry or security
specific and affects the entire market leading to the fluctuation in prices of all the securities.

On the other hand, unsystematic risk refers to the risk which emerges out of controlled and known variables
that are industry or security specific.

Systematic risk cannot be eliminated by diversification of portfolio, whereas the diversification proves helpful in
avoiding unsystematic risk.

Basis for Comparison

systematic Risk Unsystematic Risk
Meaning Systematic risk refers to the hazard which Unsystematic risk refers to the risk associated with
is associated with the market or market a particular security, company or industry.
segment as a whole.
Nature Uncontrollable Controllable
Factors External factors Internal factors
Affects Large number of securities in the market. Only particular company.
Types Interest risk, market risk and purchasing Business risk and financial risk
power risk.
Protection Asset allocation Portfolio diversification

Higher risk is associated with greater probability of higher return and lower risk with a greater probability of
smaller return. This trade off which an investor faces between risk and return while considering investment
decisions is called the risk return trade off.

The theory deals with how much an investor is willing to risk in order to increase the chances of higher returns.

The main focus risk and return model is to maximize the returns and minimize risks. It measures the expected
return of a portfolio as well as the risk of a portfolio held using the standard deviation where the risk depends on
the correlation between returns of securities and the portfolio, the risk inherent in an individual security, and the
proportion of securities in the portfolio.

What good risk and return model should perform?

 It should develop a risk measurement that is generic and not asset-specific.

 It should develop uniform risk assessment techniques.
 It should specify in detail which kinds of risk are rewarded and which are not, and it should explain why.
  The risk measurement should be converted into a rate of return that the investor should expect in
exchange for taking on the risk.
 It should be effective in forecasting projected future returns as well as in explaining historical results.

The risk-return trade-off is based on the relationship between risks of an investment and potential returns from
the investment. It connects high risks with high returns and low risks with low returns. Therefore, in managing
the risk-return trade-off it is important to understand the investors' attitude towards risk and their wealth
(Returns) preference. The investors can be risk-averse, risk-neutral or risk-takers

4. Compare and contrast the Capital Asset Pricing Model with that of Arbitrage Pricing Theory.
Which model is broad, inclusive and appropriate way of measuring risk and return of assets?

The Capital Asset Pricing Model is a model that is used to relate the expected return of an asset to the
systematic risk as measured by Beta factor. Where Beta factor is: a measure of the sensitivity of securities to the
market.
The Capital Asset Pricing Model is a single period model that is also based on the assumption that Capital
markets are efficient and thus security prices reflect all available information. It also assumes that returns of
security are normally distributed, no transaction costs Investors are risk-averse thus, and Investors can borrow or
lend money at a risk-free rate of interest. CAPM provides a basis for determining the risk-adjusted discounted
rate therefore, useful in estimating the required rate of return that is used in evaluating the performance of
investments.

The CAPM equation is Rs=Rf+ [be (ERm-Rf)]

Where: Rs= Return of the asset
be =Beta factor of security,
ERm=Expected return of the market
Rf=Risk free rate
The Arbitrage Pricing Theory is a multi-factor model under which expected returns of an asset are determined
by several factors which may be macro-factors or specific investment factors like interest rates, market returns,
and industrial growth among other factors. The Arbitrage Pricing Model or Theory is a multi-period model and
does not assume a normal distribution of returns. It provides security returns depending on several independent
factors and the returns of an asset are given by:

Rs=Rf+ [bef1 (ERmf1-Rf)] + [bef2 (ERmf2-Rf)]........ [befi (ERmfi-Rf)]

Where:
 Rs= Return of the asset,
 ERmfi=Expected return of the market under factor i
 befi (ERmfi-Rf)] =The risk premium under factor i
Therefore, the Arbitrage Pricing model is a broad, inclusive, and appropriate way of measuring risk and return of
assets. However, it is difficult to identify and measure all factors that affect specific security.

5. Clearly discuss the issues of Long Term financing, justify why we need capital budgeting and
discuss the reason why it becomes very critical on doing capital budgeting issues. Compare and
contrast Long Term financing with that of short Term financing. Discuss in detail about
Investment Banking and lease financing.
Capital Budgeting is the formal process of investments or expenditure that is huge in amount. It involves the
company’s major decision where to invest the current fund in the development of the organization, such as for
addition, disposition, modification, or replacement of fixed assets. Capital budgeting becomes vital due to the
vast amount of investment that is involved and the risk associated with the same.
Here is the top 10 importance of capital budgeting –
 Long Term Effect on Profitability
 Huge Investments
 Decision cannot be Undone
  Expenditure Control
 Information Flow
 Helps in Investment Decision
 Wealth Maximization
 Risk and Uncertainty
 Complicacies of Investment Decisions
 National Importance
Long Term vs. Short Term Financing
Short-Term Financing Long-term financing
The term Short-term financing means a business or The term Long-term financing means personal loans or
personal loans which have a time span less than the the business which have a time span of more than the
average one to repay the loan, either one year or even average one to repay the loan, the time span could be
less than that. more than a year.
The funds that are raised from this kind of financing is The funds raised from long term financing is costlier
less costly than long term financing since, than the short term because
 The cost of flotation is low.  The cost of flotation is high.
 It does not involve any maturity risk premium  It involves maturity risk premium etc.
etc.
The loan term agreements of short term loans are not The loan agreements in the long term consist of certain
as strict as long term loans. restricted provisions that limit certain actions by the
firm.
The short term loans might not need any security The long term loans need certain assets as security or
collateral.
The short term financing is much flexible than the long The long term financing is not as much flexible as
term since the number of funds raised using financing other financings, as the number of funds raised by
sources can be altered as per the needs. using the sources of this kind of financing cannot be
altered according to the needs. Even though with the
provision of repayment, long term debt can be paid
earlier, the penalties of prepayment could be charged.
The organizations can raise the funds only in a limited The organizations can raise the funds in large amounts
amount by the assistance of this financing. by the assistance of this financing.
It involves certain risks than other modes of financing It is not as much riskier than other modes of financing
as, as,
 The rate of interest on short term loans is  The rate of interest on the long term loan is
unstable. stable
 The temporary recession can be left with no  The temporary recession does not influence
debt payments and could lead to bankruptcy. this as much.
The funds raised from short-term financing must be The fund’s raise from long-term sources might be used
used to enhance the level of current assets and working to finance other types of assets such as current or fixed
capital rather than to be used to get fixed assets such as assets.
building and land, furniture, vehicles, plant machinery,
etc.

What is investment banking?

Investment banking is a special segment of banking operation that helps individuals or organizations raise capital
and provide financial consultancy services to them. They act as intermediaries between security issuers and
investors and help new firms to go public. They either buy all the available shares at a price estimated by their
experts and resell them to public or sell shares on behalf of the issuer and take commission on each share.
What is Lease financing?

Lease financing is one of the important sources of medium- and long-term financing where the owner of an asset
gives another person, the right to use that asset against periodical payments. The owner of the asset is known as
lessor and the user is called lessee.

The periodical payment made by the lessee to the lessor is known as lease rental. Under lease financing, lessee is
given the right to use the asset but the ownership lies with the lessor and at the end of the lease contract, the asset
is returned to the lessor or an option is given to the lessee either to purchase the asset or to renew the lease
agreement.

6. Does following the residual theory of dividends lead to a stable dividend? Is this approach
consistent with dividend relevance? How do you explain the issues of clientele effect in dividend
policy? Justify the theories of dividends with the values of the firm. Contrast the basic arguments
about dividend policy advanced by MM model and by Gordon model. How do you relate this with
the real world? Explain in detail and support yourself with practical evidence.
Answer: The residual theory of dividends suggests that the firm's dividend payment should be the
amount left over (the residual) after all acceptable investment opportunities have been undertaken. Since
investment opportunities would tend to vary year to year, this approach would not lead to a stable
dividend. This theory considers dividends irrelevant, representing earnings residual rather than an active
policy component affecting the firm's value.

The clientele effect explains the movement in a company's stock price according to the demands and goals of its
investors. These investor demands come in reaction to a tax, dividend, or other policy change or corporate action
which affects a company's shares.
Clientele effect is a theory which states that different policies attract different types of investors, and changes to
those policies will. They consider a variety of factors that could affect payout policy, including institutional
monitoring, free-cash flow problems, taxation & regulatory in company.
The Clientele Effect is essentially a theory that explains a specific relationship between the stock prices of a
company and the goals of its investors. The theory also establishes how a company’s policy changes can directly
impact the price movements of a company’s stock due to its investors. Among the many features related to stock
investments, the Clientele Effect theory largely focuses on the rate of dividends and payouts offered by a
company.
A dividend theory is a formulation of an apparent relationship which purports to explain a connection between
dividend patterns and various causal factors impacting these patterns. Practiced dividend policies on the other
hand are based upon observed corporate behavior describing its payout procedures.  Practiced policies often
cannot be fully explained by pure theory.

Dividend decision is irrelevant of the value of the firm. Modigliani and Miller contributed a major approach to
prove the irrelevance dividend concept.

Irrelevance Theory of Dividend

The advocates of this school of thought argue that the dividends have no impact on the share price or market
value of the firm. The argue that the shareholders do not differentiate between the present dividend and the
future capital gains and are basically interested in higher returns either earned by the firm by investing the profits
in future profitable investments.
They believe that the profits are distributed as dividends only if no adequate investment opportunities for
investments for the business.

Modigliani and Miller’s Approach

According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does
not affect the value of the firm.
“Under conditions of perfect market, rational investors, absence of tax discrimination between dividend income
and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the
market price of shares”.
Assumptions
MM approach is based on the following important assumptions:
1. Perfect capital market.
2. Investors are rational.
3. There are no taxes.
4. 4. The firm has fixed investment policy. 5. No risk or uncertainty.
RELEVANCE OF DIVIDEND
According to this concept, dividend policy is considered to affect the value of the firm. Dividend relevance
implies that shareholders prefer current dividend and there is no direct relationship between dividend policy and
value of the firm. Relevance of dividend concept is supported by two eminent persons like Walter and Gordon.

The main hypothesis by Modigliani-Miller is that dividend policies are completely irrelevant, i.e., dividends
have no impact on stock price in a perfectly competitive world. This is because individual’s investors could also
use homemade dividends to replicate the desired dividend streams through buying and selling stocks.

The primary arguments about dividend policy advanced by Gordon and Lintner state that there is no immediate
connection between the firm and dividend policy the market esteem. As per Gordon and Lintner, financial
specialists are risk-averse, and current dividends reduce the investors' uncertainty.

CONTRASTING THESE ARGUMENTS

Gordon’s Model Modigliani and Miller’s model
One very popular model explicitly relating the According to Modigliani and Miller (M-M),
market value of the firm to dividend policy is dividend policy of a firm is irrelevant as it does
developed by Myron Gordon not affect the wealth of the shareholders. They
Gordon’s model is based on the following argue that the value of the firm depends on the
assumptions. firm’s earnings

1. All equity firm Perfect capital market

2. No external financing Constant investment policy
3. Constant return No risk of uncertainty
4. Constant cost of capital Future profit known certainty
5. Perceptual earning Information about company is available
6. Constant retention
7. Cost of capital is greater than the growth
rate

 If you own stock in a company, and that company makes a profit, you have a right to some of that profit,
in proportion to how much of that company you own. Each quarter the company’s board of directors
decides if and how much of a dividend to give to the stockholders. If you are investing for long term
gains, you should reinvest the dividend. However, some people use the dividends to supplement their
retirement. So taking dividends can be a source of income in retirement, and that’s why they still exist.
 7. What is the relation between the expected growth rate of common stock dividends and the
dividend payout? What is the rationale behind this relation? If the dividend rate on preferred
stock is reset every year to the going market yield on preferred stocks of similar risk, at what price
would a share of preferred stock trade?
ANSWER- Dividend expected growth rate and dividends payout ratio has a positive relationship between them.
Because the more expected growth rate will be, the more dividends will be paid and more dividends will increase
the dividend payout ratio, so we can say that they have positive relation.

Let's understand this by an example, stock price is $100 and dividend expected growth rate is 100% which
means equal to $5 because last year the dividend was $2.5 per share, and its earnings per share is expected to be
$10. So, dividend payout ratio = Dividend per share / earnings per share = $5 / $10 =50%

Now the expected growth rate of dividend = 200%, so, the new dividend will be $7.5 and dividend payout ratio
will be = $7.5 / $10 = 75%. Thus, we can say that with the increase in the growth rate of dividends, its payout
ratio will also increase.

If the dividend rate of the preferred shares is reset every year, their cash flow will also change every year, which
means they will receive different payments in different years which further mean that the risk and volatility will
increase. Their risk will increase because their cash flow will depend on the market yield.

As the risk will increase, the expected return on the preferred stock will also increase, because preferred stock
holders will say we demand more return because we are taking risks. Because expected rate or discount rate will
increase their future expected cash flows will be discounted at a higher rate and present value of these will
decline. So, this means the price will go down.

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