Financial Management Financial Management (An Introduction)(An Introduction)

Contents of the Chapter

• Meaning of Finance• Meaning of Financial Management• Three Major Decisions of Financial

Management• Evolution of financial Management• Scope of Financial Management• Objectives of Financial Management• Agency Problem

Finance

Finance is an art and science of managing money.

What is Financial Management?

Concerns the acquisition, financing, and management of assets with some overall overall goal goal in mind.

Evolution of financial Management

• Evolution of Financial Management can be divided in three phases:– The traditional Phase– The modern Phase

The Traditional Phase(upto 1950)

• Finance function was concerned with procurement of funds only

• Finance function was viewed from the suppliers point of view only

• The focus of attention was on the long term resources and the long term sources was the major concern

• This approach was descriptive rather than analytical• As concerned with procurement so the knowledge of

pros and cons of the sources was needed.• It is viewed only from outsider point of view.

The Modern Phase

• The scope of financial management was broadened means not only to procure the funds but also includes optimum utilize of that fund

• The approach of financial management has become more analytical and quantitative as knowledge of securities, financial markets and institution is also necessary.

• The point of view of the managerial decision(insider) maker has become dominant

Decisions of financial Management

• The function of raising funds, investing them in assets and distributing returns earned from assets to shareholders are respectively known as– Financing Decisions or capital Mix Decisions– Investment Decisions or Long Term Asset Mix

Decision– Dividend Decisions or Profit Allocation Decision

Investment Decisions

Most important of the three decisions.Most important of the three decisions.• What is the optimal firm size?• What specific assets should be acquired? • What assets (if any) should be reduced or

eliminated?– capital budgeting decisions– Working capital managent

Investment decision

• Which assets should be purchased out of different alternatives

• To buy or to get it on lease• To produce a part or to procure it from supplier• Proposal of merger of other groups to avail the

synergies of consolidation• Trade off b/w liquidity and profitability• How much and what inventory to be maintained• Whether and how much credit is to be given

Financing Decisions

Determine how the assets (RHS of balance Determine how the assets (RHS of balance sheet) will be financed (LHS sheet) will be financed (LHS

of balance sheet).of balance sheet).• What is the best type of financing? – Borrowed funds of owned funds

• What is the best financing mix (Capital Structure)

• How will the funds be physically acquired?

Dividend Decisions

• Whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance.

• The proportion of profits distributed as dividends is called the dividend pay-out ratio

• The retained portion of profits is known as the retention ratio.

• The optimum dividend policy is one that maximize the market value of the firm’s shares.

Financial Manager’s Role

• A financial Manager is one who is responsible to carry out the finance functions.

• Main Functions:– Financial forecasting and planning– Funds acquisition– Funds Allocation– Profit Planning– Understanding capital Markets– Maintaining proper Liquidity

Objectives of Financial Management

• The main aim of financial management is to use business funds in such a way that the firm’s value/ earnings are maximized. The objective can be achieved by– Profit Maximization – Wealth Maximization

Objective of Profit Maximization

• Profit MaximizationProfit Maximization Maximizing a firm’s earnings Maximizing the Rupee Income of Firm • Resources are efficiently utilized• Appropriate measure of firm performance• Serves interest of society also

Objections to Profit Maximization

• It is Vague• It Ignores the Timing of Returns• It Ignores Risk• It widens the gap b/w mgt and shareholders• In new business environment profit

maximization is regarded as – Unrealistic– Difficult– Inappropriate – Immoral

Objective of Profit Maximization

• Maximizing Profit After Taxes– Profit means PAT but some times it results in

increasing PAT and reducing EPS– Which will not maximize economic welfare of

shareholders.

• Maximizing EPS– Market value is not a function of EPS. Hence

maximizing EPS will not result in highest price for company's shares

– Also ignores timing and risk of the expected profits

Objective of Wealth Maximization

• Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders.

• Net present value is the difference between the present value of its benefits and the present value of its costs.

• A financial action that has positive NPV creates wealth for shareholders and is desirable and vice versa.

Features of Wealth Maximization

• It also incorporates the time value of money.• It measures the benefit in terms of cash flow

and avoids the ambiguity associated with the accounting profits.

• It takes care of the questions of the timing and risk of expected profits by selecting an appropriate rate for discounting the expected flow of future benefits.

• Fundamental objective—maximize the market value of the firm’s shares.

Agency problemManagers versus Shareholders Goals

• There is a principal agent relationship between shareholders and the managers

• In theory managers should act in best interest of the shareholders(increase shareholders wealth) but they may pursue their own personal goals.

• They may maximize their own wealth at the cost of shareholders or

• They may work for satisfactory wealth instead of maximum wealth

• The conflict between the shareholders and managers is called agency problem and results into agency costs.

How to resolve Agency Problem

• To give ownership rights through stock options to managers.

• To offer them monetary and non-monetary incentives to managers to act in their interest.

• Close monitoring by stakeholders may also help in reducing this problem.