UNIT-1

INTRODUCTION
 Concept of Finance
 Business concern needs finance to meet their
requirements in the economic world.
 Any kind of business activity depends on the finance.
 Hence, it is called as lifeblood of business firm.
 Whether the business concerns are big or small, they
need finance to fulfil their business activities.
 The entire business activities are directly related with
making profit.
 Hence, finance may be defined as the art and science
of managing money.
Financial Management – An Overview
 Suppose you are planning to start your own business.
 No matter what the nature of your proposed
business is, you will have to answer the following
questions:
 What long-term investments should you take on?
That is, what lines of business will you be in and what
sorts of buildings, machinery, and equipment will you
need?
 Where will you get the long-term financing to pay for
your proposed investment? That is, will you bring in
other owners or will you borrow the money?
 How will you manage your everyday financial
activities like collecting your receivables and paying
your suppliers?
While these are not the only concerns of financial
management, they are certainly the central ones.
Financial management, broadly speaking, is the
study of ways to answer these three questions.
Therefore, financial management could then be
defined as any decisions made by a business firm
that affect its finances.
 Functions of Finance Manager
A person who deals finance related activities in a
business firm may be called finance manager.
Therefore, financial management is also
concerned with the duties of the financial
manager in the business firm.
Financial manager actively manage the financial
affairs of any type of business.
Finance manager is one of the important role
players in the field of finance function.
He must have entire knowledge in the area of
accounting, finance, economics and management.
His position is highly critical and analytical to solve
various problems related to finance.
He performs such varied tasks/functions as
investment choice,
forecasting financial requirements,
acquiring necessary capital,
cash management,
Interrelation with other departments and so on.
Investment choice
 The finance manager must carefully select best
investment alternatives and consider the reasonable
and stable return from the investment.
 He must be well versed in the field of capital
budgeting techniques to determine the effective
utilization of investment.
 The finance manager must concentrate to principles
of safety, liquidity and profitability while investing
capital.
Forecasting Financial Requirements
He is responsible to estimate the financial
requirement of the business concern.
He should estimate, how much finances required
to acquire fixed assets and forecast the amount
needed to meet the working capital requirements
in future.
Acquiring Necessary Capital
After deciding the financial requirement, the
finance manager should concentrate how the
finance is mobilized and where it will be
available.
Cash Management
Present days cash management plays a major role
in the area of finance because proper cash
management is not only essential for effective
utilization of cash but it also helps to meet the
short-term liquidity position of the concern.
Interrelation with Other Departments
 Finance manager deals with various functional
departments such as marketing, production,
accounting, personnel, system, research and
development, etc.
 Finance manager should have sound knowledge not
only in finance related area but also well versed in
other areas.
 He must maintain a good relationship with all the
functional departments of the business organization.
 Financial Decisions in a Business Firm
Financial management, in the modern sense of
the firm, can be broken down into three major
financial decisions:
The investment decision,
The financing decision, and
Dividend decision.
 Investment decision
 The first and perhaps the most important decision that any
frim has to make is to define the business that it wants to
be.
 Once the managers of a firm choose the business they want
to be in, they have to develop a plan to invest in
 (i) long-term assets (fixed assets) which yield a return over
a period of time in future
 (ii) short-term or current assets, defined as those assets
which in the normal course of business are convertible into
cash without diminution in value, usually within a year.
 The first of those involving the first category of fixed assets
is popularly known in financial literature as Capital
budgeting.
 The aspect of financial decision making with reference to
current assets is popularly termed as working capital
management.
 Capital budgeting
 Capital budgeting is probably the most crucial decision of a
firm.
 It relates to the selection fixed asset or investment in fixed
assets or course of action whose benefits are like to be
available in future over the lifetime of the project.
 The first aspects of the capital budgeting decision relates to
the choice of the investment in fixed assets out of the
alternatives available.
 Whether an asset will be accepted or not will depend upon
the relative benefits and returns associated with it.
 The measurement of the worth of the investment proposals
is, therefore, a major element in the capital budgeting
exercise.
 This implies a discussion of the methods of appraising
investment proposals.
 The second element of the capital budgeting decision
is the analysis of risk and uncertainty.
 Since the benefits from the investment proposals
extend into the future, their accrual is uncertain.
 They have to be estimated under various
assumptions of the physical volume of sale and the
level of prices.
 An element of risk in the sense of uncertainty of
future benefits is, thus, involved in the exercise.
 The returns from the capital budgeting decisions
should, therefore, be evaluated in relation to the risk
associated with it.
 Finally, the evaluation of the worth of a long-term
project implies a certain norm or standard against
which the benefits are to be judged.
 Working Capital Management:
 It is concerned with the management of current assets.
 It is an important and integral part of financial management
as short-term survival is a prerequisite for long-term
success.
 One aspect of WCM is the trade-off between profitability
and risk (liquidity).
 There is a conflict between profitability and liquidity.
 If a firm does not have adequate WC, that is,
 it does not invest sufficient funds in current assets, it may
become illiquid and consequently may not have the ability to
meet its current obligations and, thus, invite the risk of
bankruptcy.
 If the current assets are too large, profitability is adversely
affected.
 The key strategies and considerations in ensuring a trade-
off between profitability and liquidity is one major
dimension of WCM.
Financing decision (Capital structure decision):
Once a firm has decided on the investment
projects it wants to undertake, it has to figure out
ways and means of financing them.
The concern of the financing decision is with the
financing-mix or capital structure.
The term capital structure refers to the proportion
of debt and equity capital.
The key issues in capital structure decision are:
What is the optimal debt-equity ratio for the
firm?
Which specific instruments of equity and debt
finance should the firm employ?
Which capital markets should the firm access?
When should the firm raise finance?
At what price should the firm offer its securities?
 Dividend policy decision:
 The financial manager must decide whether the firm
should distribute all profits, or retain them, or
distribute a portion and retain the balance.
 The choice would obviously hinge on the effect of the
decision on the maximization of shareholder’s
wealth.
 That is, the firm would be well advised to use the net
profits for paying dividends to the shareholders if the
payment will lead to the maximization of wealth of
the owners.
 If not, the firm should rather retain them to finance
investment programs.
 The relationship between dividends and value of the
firm should, therefore, be the decision criterion.
 Agency problem
 The relationship between stockholders and
management is called an agency relationship.
 Such a relationship exists whenever someone (the
principal) hires another (the agent) to represent
his/her interests.
 For example, ABC business firm might hire someone
(an agent) to sell its asset say machinery.
 In all such relationships, there is a possibility of
conflict of interest between the principal and the
agent.
 Such a conflict is called an agency problem.
Suppose that ABC business firm hires someone to
sell its asset and that firm agree to pay that
person a flat fee when he/she sells the asset.
The agent’s incentive in this case is to make the
sale, not necessarily to get firm the best price.
If firm offers a commission of, say, 10 percent of
the sales price instead of a flat fee, then this
problem might not exist.
 In a large business firm, for example, the managers
may enjoy many fringe benefits, such as golf club
memberships, access to private jets, and firm cars.
 These benefits (also called perquisites, or “perks”)
may be useful in conducting business and may help
attract or retain management personnel, but there is
room for abuse.
 What if the managers start spending more time at
the golf course than at their desks?
 What if they use the company jets for personal
travel?
 What if they buy company cars for their teenagers to
drive?
The abuse of perquisites imposes costs on the
firm—and ultimately on the owners of the firm.
There is also a possibility that managers who feel
secure in their positions may not bother to
expend their best efforts toward the business.
This is referred to as shirking, and it too imposes a
cost to the firm.
Another possibility that managers will act in their
own self-interest, rather than in the interest of
the shareholders when those interests clash.
 Finally, to see how management and stockholder
interests might differ, imagine that the firm is
considering a new investment.
 The new investment is expected to favorably impact
the share value, but it is also a relatively risky
venture.
 The owners of the firm will wish to take the
investment (because the stock value will rise), but
management may not because there is the possibility
that things will turn out badly.
 If management does not take the investment, then
the stockholders may lose a valuable opportunity.
 This is one example of an agency cost.
To mitigate the agency problem, the following
agency costs may incur:
1. Monitoring costs are costs incurred by the
principal to monitor or limit the actions of the
agent.
In a business firm, shareholders may require
managers to periodically report on their activities
via audited accounting statements, which are sent
to shareholders.
The accountants’ fees and the management time
lost in preparing such statements are monitoring
costs.
2. Bonding costs are incurred by agents to assure
principals that they will act in the principal’s best
interest.
The name comes from the agent’s promise or
bond to take certain actions.
A manager may enter into a contract that
requires him or her to stay on with the firm even
though another company acquires it.
3. Executive Compensation. Incentives may be
offered in the form of cash bonus and perks that
are linked to certain performance targets.
Stock options that grant managers the right
purchase equity shares at a certain price thereby
giving them a stake in ownership when certain
goals are achieved, and so on.