FINANCIAL

MANAGEMENT

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 CHAPTER – 1

INTRODUCTION

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Financial Management – Definition:
 It is defined as the management of flow of funds and deals
with the financial decision making

FINANCIAL
MANAGEMENT
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Scope of Finance Function

 Financial management performs facilitation, reconciliation

and control functions in an organization

 Sourcing of finances and their rational allocation to achieve

organizational goals is the major scope of finance function

 Finance function is significant for all organizations from both

functional and stakeholders’ perspective

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FUNCTIONAL VIEW OF ORGANISATION

FIRM

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STAKEHOLDERS’ VIEW OF ORGANISATION

FIRM

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FINANCE FUNCTIONS:

 Host of decisions are to be taken by a finance manager

 Some of these are routine operating decisions that are repetitive in

nature and affect the business on a day-to-day basis

 Other decisions are of strategic in nature and will have long-term

implications for the business

 The decisions (functions) are aimed at procurement and utilization

of funds in an optimal way to achieve the desired goals of an

organization

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FINANCE FUNCTIONS (Cont.):

 The scope of financial management extends to four key

decision (functional) areas:

1. Investment decisions

2. Financing decisions

3. Dividend decisions

4. Working capital decisions

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1. INVESTMENT DECISIONS (CAPITAL BUDGETING DECISIONS):

 These decisions pertain to the selection of the most productive

avenues with a view to maximize the returns on investment

 These decisions are concerned with the expansion,

modernization and replacement of long-term (fixed) assets

 These decisions are crucial for survival and growth of any firm

 Productivity capacity of a business depends upon the quality

and the scale of its investments

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 INVESTMENT DECISIONS

Acquisition of Fixed Assets

Survival
Land
Building Long-term assets and
Machines (what and when to buy)
Intangibles Growth

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2. FINANCING DECISIONS (CAPITAL STRUCTURE DECISIONS):

 These are concerned with the procurement of required

amount of funds on most convenient terms as and when

needed

 They determine the financial risk profile of the business

 The thrust of financing decisions is on bringing down the cost

of financing keeping the risk constant

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 1. What is the mix of
various forms of
capital used by the
firm?
2. What is the optimal
Value Recedes

Value Enhances
mix of the various
sources of capital?
3. How do the
expectations of
providers of each
source of capital
change with
alteration in the
capital mix?
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3. DIVIDEND DECISIONS:

 These decisions focuses upon identifying what portion of residual

profits to distribute to shareholders as dividends and how much to

plough back for future financing needs of the business

 The dividend payout ratio depends on the future financing

requirements and the expectations of the shareholders for current

income

 Dividend decisions can be of two kinds:

 As a residue of investment and financing decisions

 As an independent policy decision

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4. WORKING CAPITAL DECISIONS:

 These decisions are related to the management of current

assets

 The two key decision points are

 The level of investment in current assets and

 The mode of their financing

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 • What business to be in?
Investment Decisions • What growth rate is appropriate?
• What assets to acquire?
• What mix of debt and equity to be used?
• Can we change the value of firm by changing the
Financing Decisions
capital mix?
• Is there an optimal debt-equity mix?
• How much of the profit should be distributed as
dividends and how much should be ploughed
back?
Dividend Decisions • Can we change the value of firm by changing the
amount of dividend?
• What should be the mode of dividend payment?

• What level of inventory of goods is ideal?

• What level of credit should be given to
customers?
Working Capital Decisions • What level of cash should be maintained?
• How can the blockage of funds in the current
assets be minimized without compromising
profits? 15
FINANCIAL DECISION MAKING:

 It involves carrying out the four functions of finance in an

efficient and effective way

 In order to make this process of financial decision making an

efficient and effective way, the following points are

important:

1) To identify the groups whose interest is to be considered,

and

2) To identify the goals, the achievement of which helps in

measuring the impact of these decisions on the relevant

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Goals or Objectives of Financial Decision Making:

- Goal is defined as a target against which the firm’s operating

performance can be measured

- Goals serve as a point of reference to a decision maker

- Objective specifies what the decision maker is trying to accomplish

- Objective provides a framework for analyzing different decision rules

- Objective is stated in terms of maximizing or minimizing some

function or variable

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 The following two objectives are often considered in
financial management:

1. Profit maximization

2. Shareholders’ wealth maximization

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1. Profit Maximization

 Maximizing the rupee income of a firm (Accounting profit)

 It is regarded as a yardstick for economic efficiency of a firm

 Resources are efficiently utilized

 Appropriate measure of firm performance

 Serves interest of society also

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Objections to Profit Maximization

 It is Vague (short-term or long-term; before or after tax; profit on

total funds or shareholders’ funds)

 It Ignores the Timing of Returns and Costs (Time value of money)

 It Ignores Risk

 Assumes Perfect Competition

 In new business environment Profit maximization is regarded as

o Unrealistic

o Difficult

o Inappropriate

o Immoral 20
2. Shareholders’ Wealth Maximization

 Maximizes the net present value of a course of action to

shareholders.

 Accounts for the timing and risk of the expected benefits.

 Benefits are measured in terms of cash flows.

 Fundamental objective – maximize the market value of the firm’s

shares.

 This objective requires a valuation model.

 The financial manager must know,

 How much should a particular share be worth?

 Upon what factor or factors should its value depend? 21

Profit Maximization versus Stockholder Wealth Maximization

 Profit maximization is basically a single-period or, at the

most, a short-term goal.

 It is usually interpreted to mean the maximization of profits

within a given period of time.

 A firm may maximize its short-term profits at the expense of

its long-term profitability and still realize this goal.

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Profit Maximization versus Stockholder Wealth Maximization (Cont.)

 In contrast, stockholder wealth maximization is a long-term

goal, since stockholders are interested in future as well as

present profits.

 Wealth maximization is generally preferred because it

considers

1) wealth for the long term

2) risk or uncertainty

3) the timing of returns

4) the stockholders’ return 23

Profit Maximization versus Stockholder Wealth Maximization

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Agency Problems: Managers Versus Shareholders’ Goals

 There is a Principal and Agent relationship between

managers and shareholders.

 In theory, Managers should act in the best interests of

shareholders.

 In practice, managers may maximize their own wealth (in

the form of high salaries and perks) at the cost of

shareholders.

 They are the major source of agency problems

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Agency Problems: Managers Versus Shareholders’ Goals (Cont.)

 The costs associated with the agency problem, such as a reduced

stock price and various ‘‘perks,’’ is called agency costs.

 Several mechanisms are used to ensure that managers act in the

best interests of the shareholders:

1. golden parachutes or severance contracts

2. performance-based stock option plans

3. the threat of firing

4. the threat of takeover

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Risk-return Trade-off

 Financial decisions of the firm are guided by the risk-return

trade-off.

 The return and risk relationship:

Return=Risk-free rate + Risk premium

 Risk-free rate is a compensation for time and risk premium for risk

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