1.Introduction to Financial Management

8/7/2019 1.Introduction to Financial Management

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Introduction to financial

Management


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Concept of finance

Finance can be defined as the art and

science of managing money.

Finance is the study of money

management, the acquiring of funds

(cash) and the directing of these funds

to meet particular objectives.


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What is Financial

Management?

Concerns the acquisition,

financing, and management

of assets with some overalloverall

goalgoal in mind.


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Financial

Management

Financial management is that managerial

activity which is concerned with the

planning and controlling of the firms

financial resources.


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Scope of Finance Includes fund procurement and fund utilisation

Long-term and short-term financing and investment

decisions

All forms of organisation not only corporate

enterprises.

Addresses routine problems as well as episodic

events (eg. Incorporation, mergers, expansion, etc).

Influences the operations and reconcilesinterests of other functional areas - production,

marketing and human resources.

Financial management is an integral part of overallmana ement - not merel a staff function.


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Significance of Finance

Helps maximize returns and minimize risks Affect the firms very survival which depends on

strategic decisions made in such importantmatters such as

product and market development, entry in new product line or retrenchment of a product,

expansion of the plant,

change in location, etc.

In all these matters assessment of financialimplications is inescapable.


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Finance Functions

(Financial Decisions)

Investment or Long Term Asset Mix

Decision Financing or Capital Mix Decision

Dividend or Profit Allocation Decision

Liquidity or Short Term Asset MixDecision


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Investment Decisions (Capital

Budgeting Decisions)

Involve capital expenditures.

Investment proposals include new

investment proposals and replacementproposals.

Involve the decision of allocation of capital orcommitment of funds to long-term assets thatwould yield benefits (cash flows) in the future.


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Budgeting Decisions)

Investment proposals should be evaluated in

terms of

expected return and

risk(uncertainty of returns).


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Budgeting Decisions)Important aspects

Evaluation of the prospective profitability ofnew investments

Measurement of a cut-off rate (required rateof return) against which the prospective returnof new investments could be compared.

The opportunity cost of capital is taken as the cut-off. The opportunity cost of capital is the expected rate of

return that an investor could earn by investing moneyin financial assets of equivalent risk.


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Financing DecisionsDetermine how the assets will beDetermine how the assets will be

financed.financed.

Decision on w hen, w herefrom and

how to acquire funds to meet t

he firmsinvestment needs.


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Financing or Capital Mix

Decision What is the best type of financing?

What is the best financing mix?

How will the funds be physicallyacquired?

Central issue- determination of optimal debt-equity ratio (capital structure).

Capital structure is optimum when the market

value of shares is maximised.


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Decision

Main considerations

CostRisk

Flexibility


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Decision Once optimum capital structure isdetermined the appropriate amount must beraisedthrough the best available sources.

Key issues here are: Which specific instruments of equity and debt

finance should the firm employ?

Which capital markets should the firm access?

When should the firm raise finances?

At what price should the firm offer itssecurities?


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Dividend Decision

It is the decision on profit allocation-should the firm

Distribute allprofits

Retain allprofitsDistribute a portion and retain thebalance.

The proportion of profits distributed asdividends is called the dividend-payment ratio.


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What is t he optimumdividend policy?

One that maximises the market

value of the firms share.


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Liquidity or ShortTerm

Asset Mix Decision

It is t he decision on how much toinvest in current assets and mix

of current assets.


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Liquidity or ShortTerm

Asset Mix Decision

Current assets should be managed

efficiently to avoid risk of illiquidity

and at the same time take into

consideration profitability.


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But .There is a conflict betweenprofitability and liquidity.

Solution

Profitability-liquidity trade-off through sound tec hniques of current asset management.


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Finance Managers Role

Raising of Funds

Allocation of Funds

Profit Planning

Understanding Capital

Markets


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What is the GoalWhat is the Goal

of the Firm?of the Firm?


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Maximization ofMaximization of

ShareholderWealth!ShareholderWealth!

Value creation occurs when we

maximize the share price for current

shareholders.


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Profit MaximizationProfit Maximization

Maximizing the Rupee Income of FirmAdvantages :

Resources are efficiently utilized

Appropriate measure of firmperformance

Serves interest of society also

Maximizing a firms earnings aftertaxes.


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Maximizing EPS

Maximizing earnings after taxesdivided by shares outstanding.


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Shortcomings ofShortcomings of

Maximizing EPS Ignores the Timing of Returns i.e. time value of

money

Ignores risk Calls for a zero payout dividend policy so long

as funds can be invested at positive rate of return

Market value is not a function of EPS. Hence

maximizing EPS will not result in highest price for

company's shares


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ShareholderWealth MaximizationShareholderWealth Maximization

Concept of Net Present Value

The net present value (NPV) of an investment

represents the contribution of the investment to

the value of the firm

NPV = PV of cash inflows - PV of cash

outflows To maximize shareholder wealth, reject all

projects with a negative NPV


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yTo maximize shareholder wealth, the financial manager

must maximize the market value of the firms common

stock

yThree factors determine the market value of common

stock:

ySize of the firms cash flow

yTiming of the firms cash flow

yRisk of the firms cash flow stream

ShareholderWealth MaximizationShareholderWealth Maximization


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ShareholderWealthShareholderWealth

MaximizationMaximization

Brealey & Myers: "Success is usually

judged by value: Shareholders are made

better off by any decision which increases

the value of their stake in the firm... The

secret of success in financial

management is to increase value."


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Strengths ofShareholder

Wealth MaximizationBenefits are measured in terms of cash

flows.

Takes account of:

currentcurrent andand futurefuture benefitsbenefits (profits(profits andandEPS)EPS);

thethe timing,timing, duration,duration, andand riskrisk ofof expectedexpectedbenefitsbenefits (profits(profits andand EPS)EPS);

dividenddividend policypolicy; and all other relevantfactors.

yIs an impersonal objective

yIs concerned for social responsibility


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The Modern Corporation

There exists a SEPARATION

between owners and managers.

Modern Corporation

Shareholders Management


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Role of Management

An agentagentis an individual authorized by

another person, called the principal, to actin the latters behalf.

Management acts as an agentagent

for the owners (shareholders)of the firm.


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Impractical for many owners to participate actively in

management.

Professional managers may be more qualified to runthe business.

To permit unrestricted change in ownership through

share transfers without affecting the operations of the

firm or impairing the knowhow of t he firm.

To enable investors to hold diversified portfolio of

securities given economic uncertainties.

Reasons for separation of ownership

and management in companies:


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Managers Versus

Sh

areh

olders Goals A company has stakeholders such as employees,

debt-holders,

consumers, suppliers,

Government, and

society.

Managers may perceive their role as reconcilingconflicting objectives of stakeholders. This role

may compromise with the objective of

shareholder wealth maximization(SWM).


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Managers Versus Shareholders

Goals Managers may pursue their own personal goals at

the cost of shareholders, or may play safe and

create satisfactory wealth for shareholders than the

maximum.

Job Security-Managements decisions may be

based on retaining management, rather than

Shareholder Wealth Maximization

Managers may avoid takinghigh investment andfinancing risks that may otherwise be needed to

maximize shareholders wealth. Such satisfying

behaviour of managers will frustrate the objective of

SWM as a normative guide.


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AgencyTheory

Agency TheoryAgency Theory is a branch of economics

relating to the behavior of principals andtheir agents.

Jensen and Meckling developed

a theory of the firm based onagency theoryagency theory.


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AgencyTheory

Managers are naturally inclined to act intheir own best interests.

But the following factors affect managerialbehavior:

Managerial compensation plans

Direct intervention by shareholders

The threat of firing

The threat of takeover


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AgencyTheory

Incentives include stockstock optionsoptions,,perquisitesperquisites,, and bonusesbonuses.

Principals must provide

incentivesincentives so that management

acts in the principals bestinterests and then monitormonitor

results.


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Agency Costs

Costs incurred by shareholders tominimize agency problems

Examples: Management incentives

Monitor performance

Owners protection

Complex organization structures

Recent Trend: flatter organizational

structures have emerged to reduce

costs.


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Another Agency Problem

Owners CreditorsCaused by

separation of

Solution:

Creditors insert protective covenants inloan agreements

E l f P i


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Examples of Protective

Covenants

Limitations on

Dividends

Capital expenditures

Asset divestitures

Incurring additional debt


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Organisation of the Finance

Functions

The exact organisation structure for financial

management will differ across firms.

The financial officer may be known as the

financial manager in some organisations, while in

others as the vice-president of finance or the

director of finance or the financial controller.


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Reason for placing the finance functions in

the hands of top management

Financial decisions are crucial for the survival of

the firm.

The financial actions determine solvency of the

firmCentralisation of the finance functions can result

in a number of economies to the firm.


Functions


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Two more officersthe treasurer and the

controllermay be appointed under the direct

supervision ofCFO to assist him or her.

The treasurers function is to raise and manage

company funds while the controller oversees

whether funds are correctly applied. Controllersoversee the accounting, audit, and budget

departments.


Functions


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Board ofDirectors

President

(Chief Executive Officer)

Vice President

Operations

Vice President

MarketingVP of

Finance


Functions


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Functions

TreasurerCapital Budgeting

Cash Management

CreditManagement

Dividend

DisbursementFinAnalysis/Planning

Pension Management

Insurance/RiskMngmt

TaxAnalysis/Planning

VP of Finance

ControllerCostAccounting

Cost Management

Data Processing

General LedgerGovernment Reporting

Internal Control

Preparing Fin Stmts

Preparing Budgets

Preparing Forecasts


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Chief Finance

Officer

ControllerTreasurer

Fund

RaisingManager

Capital

BudgetingManager

Internal

AuditorPortfolio

Manager

CostAccounting

Manager

FinancialAccounting

Manager

Credit

manager

Cash

manager

Tax

Manager

Data

ProcessingManager

1.Introduction to Financial Management

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