March 2024 – Knec Notes

NATURE OF PROJECT FINANCING Objectives At the end of this lecture students should be able to: Define finance and discuss the scope and decision areas in financial management. Discuss the goals of financial management. Explain the shareholder/management (agency) conflicts and possible solutions. Describe the types of Business Organizations Describe Risk and required rate of return. Describe investor’s risk profile. Introduction What is finance? Finance is derived from the Latin word which implies to complete a contract. Hence we can define finance as the application of and optimal utilization of scarce resources. The discipline of finance applies economic principles and concepts in solving business problems. Financial management: involves raising and allocating funds to the most productive end user so as to achieve the objectives of a business or firm. The following are the decision areas in finance: Financing /Capital structure decision The financial manager needs to understand the firms capital requirements whether short, medium or long term. To this end he will ask himself this question “where will we get the financing to pay for investments?” The capital structure refers to the mix of long term debt, such as debentures, and equity such as reserves and retained earnings. The financial manager aims at employing the source of funds that will result in the lowest possible cost to the company. /Capital budgeting decision In capital budgeting the financial manager tries to identify investment opportunities that are worth more (benefits) than they cost to acquire. The essence of capital budgeting is evaluation of investments’ size, risk, and return the funds raised in the financing decision have to be allocated to a viable investment. Working capital management The term Working capital refers to a firm’s current assets and current liabilities. The financial manager has to ensure that the firm has adequate funds to continue with its operations and meet any day to day obligations. Maintaining an optimal level is therefore important. Distribution decision This involves the distribution of dividend which is payment of a share of the earnings of the company to ordinary shareholders. Further details of the above decisions will be discussed later in the text. The goal of the firm from a financial management perspective could be broadly classified in two; Financial goals. Non-financial goals Financial goals could be either profit maximization goal or wealth maximization. Non-financial goals include survival, service provision, growth, or the welfare of employees. Financial goals of the firm. Profit-Maximization Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion: markets managers of firms direct their efforts toward areas of attractive profit potential using market prices as their signals. Choices and actions that increase the firm’s profit are undertaken while those that decrease profits are avoided. To maximize profits the firm must maximize output for a given set of scarce resources, or equivalently, minimize the cost of producing a given output. Applying Profit-Maximization Criterion in Financial Management Financial management is concerned with the efficient use of one economic resource, namely, capital funds. The goal of profit maximization in many cases serves as the basic decision criterion for the financial manager but needs transformation before it can provide the financial manger with an operationally useful guideline. As a benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not take account of risk; it does not take account of time value of money; it is ambiguous and sometimes arbitrary in its measurement; and it does not incorporate the impact of non-quantifiable events. Uncertainty (Risk) The microeconomic theory of the firm assumes away the problem of uncertainty: When, as is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it is no longer clear what is to be maximized. When faced with uncertainty (risk), most investors providing capital are risk averse. A good decision criterion must take into consideration such risk. Timing Another major shortcoming of simple profit maximization criterion is that it does not take into account of the fact that the timing of benefits expected from investments varies widely. Simply aggregating the cash flows over time and picking the alternative with the highest cash flows would be misleading because money has time value. This is the idea that since money can be put to work to earn a return, cash flows in early years of a project’s life are valued more highly than equivalent cash flows in later years. Therefore the profit maximization criterion must be adjusted to account for timing of cash flows and the time value of money. Subjectivity and ambiguity A third difficulty with profit maximization concerns the subjectivity and ambiguity surrounding the measurement of the profit figure. The accounting profit is a function of many, some subjective, choices of accounting standards and methods with the result that profit figure produced from a given data base could vary widely. Qualitative information Finally many events relevant to the firms may not be captured by the profit number. Such events include the death of a CEO, political development, and dividend policy changes. The profit figure is simply not responsive to events that affect the value of the investment in the firm. In contrast, the price of the firms share (which measures wealth of the shareholders of the company) will adjust rapidly to incorporate the likely impact of such events long before they are their effects are seen in profits. Value Maximization Because of the reasons stated above, Value-maximization has replaced profit-maximization as the operational goal of the firm. By measuring benefits in terms of cash flows value maximization avoids much of the ambiguity of profits. By discounting cash flows over time using the concepts of compound interest, Value maximization takes account of both risk and the time value of money. By using the market price as a measure of value the value maximization criterion ensures that (in an efficient market) its metric is all encompassing of all relevant information qualitative and quantitative, micro and

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