FINANCIAL MANAGEMENT

INTRODUCTION

 Financial management is that managerial activity which is concerned with the planning and controlling of the
firm’s financial resources.
 It encompasses the procurement of the funds in the most economic and prudent manner and employment of these
funds in the most optimum way to maximize the return for the owner.
EVOLUTION OF FINANCE AS A DISCIPLINE
Broadly there are three phases of evolution of finance function:
 The Traditional Phase (Up to 1940s)
 Initially, finance was a part of economics.
 Concerned with procuring of funds to finance the expansion or diversification activities and thus the occurrence of finance function was episodic
in nature.
 Finance function was viewed particularly from the point of view of supplier of funds i.e., lenders. The emphasis was to consider the interest of
outsiders.
 The focus of attention was on the long term resources and only long term finance was of any concern. The concept of working capital and its
management was virtually non-existent.
 The treatment of different aspects of finance was more of descriptive nature rather than analytical.
 The Transitional Phase (1940-1950)
 The shorter transitional phase had a similar focus but put more emphasis on the financial problems faced by managers on a day-to-day basis, and
thus was more concerned with working capital management.
 The Modern Phase (after 1950)
 Scope of finance function has widened and includes not only procurement of funds but also optimum utilization of funds through analytical
decision making.
SCOPE OF FINANCIAL MANAGEMENT

 Financial management framework is an analytical way of viewing the financial problems of a firm. It is concerned
with three major decisions:
1. Investment decision
2. Financing decision
3. Dividend decision
SCOPE OF FINANCIAL MANAGEMENT

1) Investment decision
 Relates to selection of assets in which funds will be invested by a firm.
 Assets can be classified into Fixed assets/Long term assets and Current assets/Short term assets.
 Therefore, investment decisions can be bifurcated into:
1. Capital budgeting (relating to fixed assets)
2. Working capital management (relating to current assets)
SCOPE OF FINANCIAL MANAGEMENT
1. Capital budgeting
 A capital budgeting decision involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits (cash flows)
in the future.
 Capital budgeting decisions involve decision to commit funds in new investment proposals and replacement decisions (i.e., decision of recommitting funds
when an asset becomes less productive or non-profitable).
 Most crucial financial decision of a firm.
 Commitment of large amount of funds.
 Irreversible, or reversible at substantial loss.
 Long term effects.
 Affect the capacity and strength of firm to compete

 Two important aspects of capital budgeting decisions are:

 Evaluation of the prospective profitability of new investments
 The measurement of a cut-off rate (or required rate of return or opportunity cost of capital) against which the prospective return of new investments could be
compared.

 Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns.
SCOPE OF FINANCIAL MANAGEMENT

2. Working capital management

 Working capital management is concerned with the management of current assets.

 Investment in current assets affects the firm’s profitability and liquidity.

 If a firm does not have adequate working capital, it may not have the ability to meet its current obligations. Lack of liquidity in
extreme situations can lead to the firm’s insolvency.

 If current assets are too large, profitability is adversely affected.

 The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current
assets.

 In addition, individual currents assets should be efficiently managed so that they are neither inadequate nor unnecessary funds
are locked up.
SCOPE OF FINANCIAL MANAGEMENT
2) Financing decision
 As firms make decision concerning where to invest resources, they also have to decide how to acquire funds.
 Financing decisions relates to financing mix or capital structure of a firm.
 There are two main sources of finance for any firm- equity and debt. The mix of debt and equity is known as the firm’s
capital structure.
 The key distinction between these two sources lies in the fixed commitment created by borrowed funds to pay interest
and principal. Borrowed funds are cheaper but always entail a financial risk i.e., the risk of insolvency due to non-
payment of interest or non-repayment of capital amount.
 The use of debt affects the return and risk of shareholders; it may increase the return on equity funds, but it always
increases risk as well.
 The financial manager must strive to obtain the best financing mix or the optimum capital structure for his or her firm.
 Leverage analysis, EBIT-EPS analysis, capital structure models, are some of the tools available to finance manager for
this purpose.
SCOPE OF FINANCIAL MANAGEMENT

2) Dividend decision
 Dividend decision deal with the appropriation of after tax profits.
 These profits are available to be distributed among shareholders or can be retained by the firm for reinvestment.
 Although distribution of profits is required to satisfy expectations of shareholders but doing so has other
implications as a business that reinvests less will tend to grow slower.
 Retention of profits is related to:
 Reinvestment opportunities available to firm
 Opportunity rate of return of shareholders
 Dividends are generally paid in cash. But a firm may issue bonus shares.
 The optimum dividend policy is one that maximizes the market value of the firm’s shares.
FINANCIAL MANAGEMENT AND RELATED DISCIPLINES

 Financial Management and Economics

 Financial Management and Accounting
 Financial Management and Decision making
FINANCIAL MANAGEMENT AND RELATED DEPARTMENTS

 Financial Management and Production Department

 Financial Management and Material Department
 Financial Management and Personnel Department
 Financial Management and Marketing Department
OBJECTIVE OR GOAL OF FINANCIAL DECISION MAKING

 There are generally two widely discussed objectives of financial management.

1. Profit maximization
2. Wealth maximization
PROFIT MAXIMIZATION

 Profit maximization implies that a firm either produces maximum output for a given amount of input, or uses
minimum input for producing a given output.
 Profit maximization would imply that a firm should be guided by financial decision making by one test; select
assets and projects which are profitable and reject those which are not.
 The rationale behind profit maximization is simple. Profit is a test of economic efficiency. It provides the yardstick
by which economic performance can be judged.
 Moreover, it leads to efficient allocation of resources as resources tend to be directed towards uses which in
terms of profitability are the most desirable.
 If all business firms are working towards profit maximization, the economic resources of the society as a whole
would have been most efficiently used and will ensure maximum social welfare.
PROFIT MAXIMIZATION
 The profit maximization objective suffers from the following limitations:
 Vague and ambiguous: The definition of the term profit is ambiguous. Does it mean short or long-term profit? Does it refer to profit before or
after tax? Does it mean total operating profit or profit accruing to shareholders?
 Time value of money: The profit maximization objective does not make distinction between returns received in different time periods. It gives
no consideration to the time value of money, and it values benefits received in different periods of time as the same.
 Uncertainty of returns: The problem of uncertainty renders profit maximization unsuitable as it considers only the size of the benefits and
gives no weight to uncertainty of the future benefits.

State of economy Alternative A (profit in crore) Alternative B (profit in crore)

Recession 9 0

Normal 10 10

Boom 11 20

Total 30 30

Earning associated with alternative B are more uncertain (risky) as they fluctuate widely depending on the state of the economy. Alternative A
is better in terms of risk and uncertainty. The profit maximization criteria fails to reveal this.
WEALTH MAXIMIZATION
 The focus of financial management is on the value to the owners or suppliers of equity capital. The wealth of owners is reflected
in the market value of the shares. So wealth maximization implies the maximization of the market price of shares.
 The objective of wealth maximization considers all three aspects i.e., preciseness, considering time value of money and risk.
 The wealth maximization criteria is based on the concept of cash flows generated by a decision rather than accounting profits.
Cash flow is a precise concept with definite connotation.
 It considers timing and risk of the expected benefits by selecting an appropriate rate of discount (that reflects both time and risk)
for discounting the expected flow of future cash flows.

Where,
𝐶1, 𝐶2, …. 𝐶𝑛, represent the stream of cash flows (benefits) expected to occur if a course of action is adopted
𝐶𝑜 is the cash outflow (cost) of that action
k is the appropriate discount rate to measure timing and risk of benefits,
W is the net present value or wealth which is the difference between the present value of the stream of benefits and the initial cost.

The firm should adopt a course of action only when W is positive.