BBA207 – Financial Management

UNIT 1. Introduction to Financial Management

1. Meaning, Importance and Objectives of Financial Management

2. Conflicts in profit verses value maximization principle

3. Sources of Finance

Definition
It means planning organizing, directing and controlling the financial activities such as
procurement and effective utilization of funds to accomplish the objectives of the organization.

Nature of Financial Management

 Financial management is an integral part of overall management. Acquisition,
maintenance, replacement of assets, sources and costs of different capital, production,
marketing, finance and personal decisions are the activities in a firm.
 The Central focus of financial management is valuation of firm. That is financial
decisions are directed at optimizing the value of the firm.
 It involves risk return, trade off. Decisions on investment involve choosing the type of
assets, which generate returns accompanied by risks. Generally higher the risk, returns
must be greater and vice-versa.
 It affects the survival, growth and vitality of the firm. The amount, type, sources,
conditions and cost of finance influence the functioning of the unit.
 It is the concern of every concern – small or big, individual or corporate undertakings.
 It is a sub-system of the business system, which has other sub-systems like production,
marketing etc.
 The external legal and economic environment influences it. The investor preferences,
stock market conditions etc affect financial decisions of the business.
 Finance functions are generally centralized, i.e., more decisions are taken at the top level
and ensure unified directions to investment and financing functions.

Finance and related disciplines

Financial management is related to different fields and study such as Economics, accounting,
marketing, production and quantitative methods.

1. Finance and Economics

Business firms operate in macro and micro economic environment.
Macroeconomics deals with money, Banking system, capital markets, monitory and fiscal
policies and ETC. so, there is a need of the financial managers to understand the following.
- Monitory policy and availability of funds.
- Fiscal policy which effect on economy.
- Financial institutions.
 - Levels of economic activity and changes in economic policy.
Micro economics deals with the economic decisions of individuals and organization. It involves
- Supply and demand relationship and profit maximization strategies.
- optimal sales and product pricing strategies
- measurement of risk
- The rationale of depreciating assets.

It also discusses on marginal analysis which suggests that decisions should be take based on
marginal cost and marginal reference.

1. Finance and accounting:

Accounting is an input in financial decision making. It is a sub- function of finance. It generates
data relating to activities of the organization. Financial statement such as the balance sheet, the
income statement (P and L), cash flow statements are obtained from accounting. This
information assists the finance managers in assessing the company’s past performance and future
directions of the firm, in meeting legal obligations like taxes, ETC. finance and accounting
activities are within the control of VP finance or CFO

Difference between finance and accounting

-Treatment of fund:
Accounting: Accrual principle (when incurred and not when actually collected are payed)
Finance: cash flows (when actually cash is received are paid
-Decision making:
Purpose of accounting is collection of data and primary focus of financial manager is
planning, controlling and decision making.

3. Finance and other disciplines

Marketing: promotion plans, new product development.
Production: process and capital expenditure.
Quantitative methods: analyze complex financial problems.

Financial management approaches

Traditional Modern
Traditional approach:
1. Focuses on procurement of funds from investors, financial institutions, and
investment bankers.
2. Decision making is ignored.
3. Focus was on long term financial problems, working capital management was
not givenimportant.
4. Financial management was confined to important events like mergers and
acquisitions. This approach ignores cost and capital, capital structure valuation
 of firms, etc.

Modern approach:
Modern approach focuses on effective utilization of funds which were raised efficiently. It
discusses on investment decision, financing decision and dividend decision.

Objectives of financial management

Two important objectives of financial management:

Profit / EPS maximization wealth maximization

According to this approach those that increase profit are given atmost importance and those that
decrease profit are to be avoided. Profit is a measurement for economic performance. It leads to
efficient allocation of resources and ensures maximum social welfare.

Drawbacks:
1. Ambiguity:
The term profit is a vague and ambiguous concept. Profit may be short term or long term; it may
be before tax or after tax, may be return on capital employed or total assets or shareholder’s
equity. There is a question as to which profit should a firm consider.

2. Timing of benefit:

It ignores the differences in the time of the benefits received. It does not value the cash flow
highly when received early. In practice benefits received sooner are more valuable than benefits
received later. Receipt of funds immediately should always be preferred to future promise of
funds because these earnings or returns could be reinvested for other projects to provide greater
future earnings.

3. Risk: It ignores risk. Investors are generally risk averters so they expect returns with
minimum risk. It does not consider time, economy and other factors making the returns highly
uncertain. The risk that actually occurs may differ from those expected. A trade-off exists
between return and risk. Return and risk are the key determinants of share price. Higher profit
pushes share price higher, whereas higher risk tends to result in a lower share price because
shareholders will be paid higher return when there is high risk.

Wealth maximization:
The goal of the finance function is to maximise the wealth of the owners for whom the firm is
being carried on. The wealth of corporate owners is measured by the share prices of the stock,
which is turn is based on the timing of return, cash flows and risk. While taking decisions, only
that action that is expected to increase share price should be taken. The market price of shares
(excluding impact of speculation) serves as the standard to judge whether financial decisions
have been taken and implemented efficiently or not. Therefore, maximisation of the
firm’s market value is considered to be the proper objective.
 Merits

1. It is based on the concept and cash flow generated by decision. Thus it avoidsambiguity.
2. It considers both quality and quantity dimensions of benefits. Amount of return and risk
taken is analyzed. Time value of money is considered. Cash flow stream is calculated by
discounting.
3. The discount role reflects risk and returns. Higher discount rate means high risk because it
takes a longer time to get back the return.

4. It implies maximization of the market price of the shares which means value/ wealth/NPV
maximizatin
5. It focuses on EVA - economic valueadded
6. Focus on stakeholders: Maintaining positive shareholders relationship minimizes conflict and
litigation. So, a firm can better achieve its goal of shareholder’s wealth maximization with
cooperation with stakeholders.

Stakeholders customers, supplier, employees, banks, loan provider, etc.

Demerits

Shareholder’sinterest:
The goal of maximizing share prices does not imply that
managers should seek to improve the value of the common stock
at the expense of debt/debenture holders.
 Finance function/ decisions in financial management

1. The investment decision:

Selection of assets in which the fund is invested

Long term assets Short term

assets

Long term assets Short term assets/Current assets

Return over a period of time Assets which are convertible to cash in the
cause normal course of business
Capital budgeting Working capital management
Selection of an asset or investment, proposal it Management of current assets:
depends on:
i) Ensuring a trade – off between profitability
i) Selecting the asset based on alternatives
and liquidity.
available.
ii) Individual current assets should be efficiently
ii) Analysis of risk and uncertainty
managed
iii) Worth of long term project depending on So that funds are not locked up. (cash,
the benefits that is rate of return called as cost receivables and inventory.)
of capital.
2. Financing decision:
It relates to the choice of the proportion of debt and equity sources of financing. It is termed as
capital structure. There are two aspects of financing decision;
i) Theory of capital structure: shows the relationship between the use of debt and returns to the
shareholders which is also termed as financial risk. A capital structure with reasonable
proportion after and equity capital is called as the optimum capital structure.
ii) Capital structure decision: Determination of appropriate capital structure

3. Divided policy decision:

The profit of a firm is distributed to the shareholders in the form of dividends or is retained in the
business. The proportion of net profits distributed to shareholders is termed dividend payout
ratio.
Dividend payout ratio = Total div/net income or Dividend per share/Earnings per share

Roles/ activities of the financial manager

Financial Planning

This is a decision making function. It involves three basic steps namely i) determining short-
term and long-term financial objectives ii) Formulating financial policies and iii) Making
adjustments and readjustments. In setting out the objective, profitability and financial risk
should be considered. Among various objectives profit maximisation and wealth maximisation
are notable. After setting objectives, the following policies are likely to be formulated. i
)policies determining the total amount of capital required ii) policies determining the selection
of source of capital iii) policies determining debt-equity ratio iv) policies guiding the dividend
policy v) credit policy terms and vi) policies determining the investment of funds in fixed assets
and current assets.
Financial Control:

Success of a financial plan depends upon suitably designed control system and measures.
Control is essential for checking actual performance with planned one. For control the
following steps are needed:
1. Developing standards of performance and 2. Comparing actual performance with these
standards. For proper control a system of reports must be established. The function of financial
control should be continuously performed because the working of a firm is continuously
changing.
 Financing decisions:

Financing decisions relate to proportion of debt capital and equity capital in total capital
employed. While making this decision, the financial manager aims at securing optimal
financing mix which secure maximum market price per share in the long run. Financing
decisions are concerned with the choice of sources of funds and the amounts to be raised from
the sources. The cost of financing, the nature of commitment and the period of raising funds
govern selection of sources of particular source of finance.

Investment decisions:

Investment decisions involve the decision of allocation of funds to long term assets and current
assets which determines the firm’s risk. Costs of various methods of financing are affected by
this risk. The financial manager is to see that fund on profitable investments. Some special
investments decisions such as merger, acquisitions, reorganization etc. are also are taken by
financial manager.

Management of Income and Dividend Decisions:

Net profits can be allocated either in the form of dividend to share holders or to employees in
profit sharing plans or by retaining them for further expansion of the concern. The financial
manager is to decide to extent to which funds to be allocated for each purpose. Usually, the
amount to be paid to employees under profit sharing plans is statutorily fixed, therefore, there

is problem in them. He has paid considerable attention to the remaining two choices.
Decisions relating to dividend relate Dividend payout ratio, stability of dividends over a period
of time, and dividends in the form of shares. The financial manager has to study the following
to determine the optional dividend payout ratio:
- The preference of investors or current dividends and for capital appreciation.
- The impact of retained earnings on capital structure and the impact of decisions relating

Liquidity Decisions:

Liquidity decisions relate current assets management. It should be managed efficiently

otherwise the firm may become insolvency. Investment in current assets affects firm’s
profitability and liquidity. In order to ensure that insufficient and unnecessary funds are
invested in current assets the executive should develop sound techniques of managing current
assets. He should estimate them and make sure that funds should be made available when
needed.
Deciding upon borrowing policy:

Every organization plans for the expansion of the business for which he requires additional
resources. Personal resources being limited borrowing from banks or by issue of new shares
and new debentures. The financial manager at this juncture will take a decision about the time
when the funds borrowed from outside sources, how long they will be needed and from what
source they will be repaid. He must choose the capital structure keeping various points such as
cost of capital, return expected and financial risks involved etc. into mind.

Checking upon financial performance:

The financial manager is under an obligation to check the financial performance of the funds
invested in the business. It requires retrospective analysis of the operating period to evaluate the
efficiency of financial planning.
The executive functions discussed are interrelated. Therefore, a change in decision with
regard to one of the functions is likely to affect change in decision concerning some or all
others.

Organisation of finance function

Board of directors

MD/chairman

VIP/directors finance

Treasurer Controller

Capital expenditure management Tax manager

Financial planning and fund raising manager corporate accounting management
Cash manager Cost accounting manager
Credit manager Financial Accounting manager
Foreign exchange management
 The main roles of treasurer;
1. Obtaining finance.
2. Banking relationship
3. Investor relationship
4. Short term financing
5. Cash management
6. Credit administration
7. Investment
8. Insurance
Functions of controller:
1. Financial accounting
2. Internal audit
3. Taxation
4. Management Accounting and control.
5. Budgeting, planning and control.
6. Economic appraisal.

Sources of finance
(a) Long Term source

Financing means providing money for investment in the form of fixed assets and also in the form
of working capital needed for day to day operations. Funds can be secured from various sources.
While the availability of finance is of vital importance to any firm, securing it from proper
sources is of prime concern to the finance manger.

External sources

1. Preference Shares:
Preference shares have two preferential rights.
i) At the time of payment of dividend.
ii) Repayment of capital at the time of liquidation of the company.
A fixed rate is paid and they do not have voting rights, so they have no say in the management of
company. There are many kinds of preference shares. Investors who do not like to risk their
investment prefer these shares. The preference shares are issued in various types and each of
them having change by its nature. They are Participating preference shares, non- participating
preference shares, and cumulative preference shares. Non-cumulative preference shares,
redeemable preference shares, irredeemable preference shares, convertible preference shares and
non-convertible preference shares.

Merits:
- No voting rights and normally has no control over the policies.
- The property need not be mortgaged for issue of preference shares.
- Finance through preference shares is less costly as compared to the equity shares.
- Common investors and institutional investors may have special attraction for this share
because of fixed and higher of income. It extends the availability of funds in the market.
Demerits:
 - Compared to equity capital it is a very expensive source of financing.
- Though there is no legal obligation to pay preference dividends, skipping them can
adversely affect the image of the firm in the capital market.

- Preference shares may lead for insolvency of the company in case where the Directors
continue to pay dividends on them inspite of lower profits to maintain their attractiveness.
2. Equity Shares:
The equity shares are the main sources of finance and the owners of the company contribute it. It
is the source of permanent capital since it does not have a maturity date. The holders of equity
shares have a control over the working of the company. The rate of dividend on them depends
upon the profits of the company. These shares are issued without creating any charge over the
assets of the company.
Merits:
- It does not involve any fixed obligation for payment of dividends.
- The larger the equity base, the higher the ability of the company to detain credit.
- It can be issued without creating any charge on the assets of the company.
- The liability of the firm is limited to the extent of their capital contribution.
- Equity shares are of small face value. Even the small investors can become members of
big organization. This enhances the opportunity to raise the finance from the market.

Demerits:
- The cost of equity capital is high. The rate of return required by equity shareholders is
Generally higher than the rate of return required by other investors.
- The cost of issuing equity share is generally higher than the cost of issuing other types of
securities. Underwriting commission, brokerage cost and other issue expenses are higher
for equity capital.
- Issuing excess equity shares may lead to over capitalization.
- The control of the company can be easily absorbed through cornering of shares by a
group of shareholders for their personal advantage at the cost of company’s interest.

3. Debentures:
Debentures are certificates issued by the company acknowledging the debt due by to its holders
with or without a charge on the assets of the company. It is payable at some specified time
mentioned in the instrument. A fixed interest has to be paid regularly till the principal has been
fully repaid by the company. Debentures provide an opportunity for trading on equity. They do
not entitle to participate in the management of the company. Cautious investors prefer them.
Companies such as transport, electricity etc may get more benefits from debentures.

Merits:
- The Company is able to secure capital without giving any control to the debenture
holders.
- The Company can raise this capital at lesser flotation cost.
- It provides an opportunity to the company to trade on equity and increase the return on
 equity and to increase the return on equity capital.
Demerits:

- Raising of funds through debentures is risky, since in the event of failure of the company
to pay interest or the principal installment in time, the debenture holder may go for the
remedy if filing a petition for winding up of the company.
- Debentures are particularly not suitable for companies whose earnings are always
fluctuating.
2. Institutional Assistance:
The Government has set up certain special financial corporation with the object of stimulating
industrial development in the country. These include IFC, SFC, ICICI, IDBI etc. Such
corporations provide both long term and medium term loans on easy installments to big
industrial houses. The assistance of these institutions are help in promotion of new companies,
expansion and developments of existing companies. They exist in direct subscription to company
securities, under writing of shares and meeting the financial requirements of companies during
economic depression.

3. Public Deposits:
Public deposits are the important source for the firms. Companies prefer public deposits because:

- These deposits carry lower rate of interest

- These are unsecured deposits
- These deposits are comparatively for a long period in comparison with the sources of
working capital.

4. Lease Finance:
Lease financing involves the acquisition of the economic use of an asset through a contractual
commitment to make periodic payments called lease rentals to the person who owns the asset.
Thus this is a mode of financing to acquire the use of assets. Through the ownership of the asset
is not with the business enterprise, the right to use the asset is vested with the business unit.
Leasing allows flexibility for the funds in the hands of the business firms and the cost of
obtaining long-term finance is reduced to a large extent.

5. Hire Purchase:
Hire purchase is also a form of acquiring the assets. Assets involving huge amounts if other
sources of long-term finance are too costly may be acquired through hire purchase. The terms of
hire purchase are set out at the time of entering into the contact itself. As per the contractual
agreement, the business firm will pay a hire purchase charge for a fixed duration till the hire
purchase price of the equipment is fully paid. Hire purchase formalities are lesser and are easier
and less costly mode of financing long-term needs.

6. Government Assistance:
Government subsidies and concessions are other modes of financing long-term requirement.
Subject to the government regulations, subsidies and concessions are granted to business
enterprises. This relieves to a large extent to obligations which otherwise the company would
have to incur. Though there are procedural delays in obtaining this form of finance, this is the
cheapest and most beneficial source of long-term finance for the business firms.

7. Mortgage Bonds:
Mortgage bonds are secured by a lien on fixed assets of the company. It is a written promise
given by the company to the investor to repay a specified sum of money at a specified rate of
interest at a specified time. If the company defaults in any of the provisions of bond agreement,
the trustee on behalf of the bond holders has the power to take over and sell it, using the amount
to pay the bond. If the sale proceeds is less than the amount of the issue outstanding the
bondholders become unsecured creditors for the balance amount.

Internal sources
1. Retained Earnings:
A company out of its profits, a certain percentage is retained ad that amount is re-invested into
the business for its development. This is also known ploughing back of profits. According to this
device, a part of total profits is transferred to various reserves. These reserves can help the units
to come over depression. These methods are cheaper and best source of internal financing. This
method adds credit worthiness of the company and increases public confidence in the solvency
of the company. A Company with adequate surplus can follow stable dividend policy. It is an
ideal source of finance for expansion and modernization. By going for this source the firm has
the following advantages.
- It enables business reputation and also increases the capacity of the business to absorb
unexpected and sudden business shocks.
- This method of financing has been found to be useful financing improvements and
expansion.
- As compared to other sources of financing this method of financing is least costly since it
does not involve any flotation cost.
The disadvantages of raising funds by this way of are:
- The management can misuse the retained earnings.
- The shareholders may also object for the continuous use of retained earnings.

2. Depreciation:
Depreciation means decrease in the value of the asset due to wear and tear, lapse of time and
accident. This is also considered as one of the source of financing to business. Depreciation does
not generate funds but it definitely saves funds. The firm can get the benefit of reducing its
income by deducting this non-cash expense in its profit and loss account. So that the income tax
liability for the period is reduced.

(b) Short term finance:

Short-term financing deals with raising of money required for a shorter periods i.e. periods
varying from a few days to one year. There are, however, no rigid rules about the term. It may
sometimes exceed one year but still be called as short-term finance.
1. Trade Credit
Just as a firm grants credit to its customers it can also get credit from the manufacturers or
wholesalers or suppliers. It is known as trade or mercantile credit. The usual duration of this
credit ranges from 30 to 90 days. It is granted to the company or firm on “Open account” without
any security except that of the goodwill and financial standing of the buyer. The willingness of
the supplier to extend credit is also depending upon the following factors:
- The financial resources of the supplier.
- His eagerness to dispose of his stock.
- Degree of competition in the market.
- Credit worthiness of the firm.

2. Consumer Credit or Customer Advance:

Many times the manufacturers or the suppliers insist on, advance by the customers particularly in
case of special orders or big orders. The customer advance forms part of the price of the products
ordered by him. This is an interest free source of finance. The period of such credit depends upon
the time taken to deliver the goods.

3. Accounts Receivable Financing:

Under this method, a financing company purchases the account receivables from the customersor money is
advanced on the security of the accounts receivable. In short, it is a method of getting credit by pledging book
debts. In financial accounting, it is denoted as Sundry Debtors or Trade Debtors, and this item appears on the
asset side of the Balance Sheet
NOTE- You are required to prepare the following questions for Unit 1 & 2 and required to submit as
per the deadline (on or before 15 March 2023).
Practice Sheet Unit 1 and Unit 2

PART A Very Short and Short Questions

1. Meaning of Financial Management
2. Definition of Financial Management
3. Importance of Financial Management
4. Objectives of Financial Management
5. What is the primary objective of financial management?
6. What do you understand by time value of money?
7. Ms.Banu has deposited Rs. 50,000 in IOB. Interest is compounded at 6% p.a. for 3years. Compute
the amount of maturity.
8. What do you understand by the Time value of Money?

PART B Long Questions

1. What is meant by financial management? State the primary objective of financialmanagement.

2. If you deposit Rs 5000 today at 6% rate of interest ,in how many years will this amount doubles ?
3. Explain, how does proper financial management helps in the growth of business?
4. Give the meaning of Investment and financing decisions of financial management.
5. Explain the concept and the objective of financial management.
6. Calculate the compound value of Rs 10,000 at the end of 3 Years at 12 % rate of interest when interest is calculated (a)
yearly basis and (b) Monthly basis.
7. Mr X deposits Rs 50000 at the end of every year for 6 years and the deposit earns a compound interest of 10%PA
.Determine how much money will he have at the end of 4 years?
8. Solve q.07 in case he deposits Rs 50000 at the beginning of every year and rest conditions are same.
9. Mr. Z has to receive Rs 10000 at the beginning of each year for 5 years .Calculate the present value of the annuity
assuming 12 % interest rate.
10. Calculate the present value of Rs 2000 received in perpetuity for an infinite period taking discount rate 10%.
11. A company has Rs 200000 Debentures outstanding today. The Company has to redeem the debentures after 5 Years
and establishes a sinking fund for redemption .SFI earns interest @10%pa.The investments are made at the end of
every year. What annual payments must the firm make to ensure that the needed Rs 200000is available on the
designated date.(Vn=Vo*ACFi,n)
12. A Company has raised a loan of Rs 500000 from a FI at 8% pa rate of interest .The amount has to be paid in 5 equal
installments .What shall be the size of installments.(Hint Vo=Vn *ADFi,n)
13. What is the minimum amount which a person should be ready to accept today from a debtors who
otherwise has to pay a sum of Rs. 10,000, Rs.12,000, Rs.16,000, Rs.18,000, and Rs.20,000 at the end of
year 1,2,3 and4 respectively from today. The rate of interest may be taken as 14%.