INTRODUCTION

Management of funds is a critical aspect of financial management. Management of

funds acts as the foremost concern whether it is in a business undertaking or in an
educational institution. Financial management simply means dealing with
management of money matters.

Financial management is the management of the finances of an entity or an

organization in order to achieve financial objectives. The key objective of financial
management would be to Maximize Shareholders wealth which can be achieved by:
• Creating wealth for the business
• Generating cash, and
• Providing return on investment keeping in mind the risks that the business
is taking and the resources it invested.

Objectives of Financial Management

Efficient Financial management requires the existence of some objectives, which
are as follows:

1) Profit Maximization:
The objective of financial management is the same as the objective of a
company which is to earn profit. But profit maximization alone cannot be the
sole objective of a company. It is a limited objective. If profits are given
undue importance then problems may arise.

The term profit is vague and it involves much more contradictions. Profit
maximization must be attempted with a realization of risks involved. A
positive relationship exists between risk and profits. So both risk and profit
objectives should be balanced. Profit maximization fails to take into account
the time pattern of returns and Profit maximization does not take into
account the social considerations.

2) Wealth Maximization:
It is commonly understood that the objective of a firm is to maximize value
and wealth. The value of a firm is represented by the market price of the
company's stock. The market price of a firm's stock represents the
assessment of all market participants as to what the value of the particular
firm is. It takes into account the present and prospective future earnings per
share, the timing and risk of these earning, the dividend policy of the firm
and many other factors that bear upon the market price of the stock. Market
price acts as the performance index or report card of the firm's progress and
potential.

Prices in the share markets are affected by many factors like general
economic outlook, outlook of the particular company, technical factors and
even mass psychology. Normally this value is a function of two factors:

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 The likely rate of earnings per shares depends upon the assessment of how
profitable a company may be in the future and the capitalization rate reflects
the liking of the investors for the company.

Financial management duplicates with the financial function of the Accounting

profession. However, financial accounting is more concerned with the reporting of
historical financial information, while the financial management is directed toward
the future of the firm.

Financial management would mean efficient use of economic resources namely

capital funds. Financial management is concerned with the managerial decisions
that result in the acquisition and financing of short term and long term credits for
the firm. Here it deals with the situations that require selection of specific assets, or
a combination of assets and the selection of specific problem of size and growth of
an enterprise. Herein the analysis is conducted considering the expected inflows
and outflows of funds and their effect on managerial objectives. In short, Financial
Management deals with procurement of funds and their effective utilization in the
business. Thus, financial management has two main aspects, procurement of funds
and an effective use of funds to achieve business objectives.

Procurement of funds:
As funds can be procured from multiple sources, procurement of funds is
considered to be the important problem of business concerns. Funds obtained from
different sources have different characteristics in terms of potential risk, cost and
control.

Funds raised by the issue of equity shares are the best from risk point of
view for the company as there is no question of repayment of equity capital
except when the company is liquidated. From the cost point of view equity
capital is the most expensive source of funds as dividend expectations of
shareholders are normally higher than that of prevailing interest rates.
Therefore, one of the main questions in financial management is what will be
the source of funds.

Financial management constitutes risk, cost and control. The cost of funds should
be at minimum for a proper balancing of risk and control. In the globalized
competitive scenario, mobilization of funds plays a very significant role. Funds can
be raised either through the domestic market or from abroad.

Utilization of Funds:
Effective utilization of funds as an important aspect of financial management avoids
the situations where funds are either kept idle or proper uses are not being made.
Funds procured involve a certain cost and risk. If the funds are not used properly
then running business will be too difficult. In case of dividend decisions we also
consider this. So it is crucial to employ the funds properly and profitably.

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Scope of Financial Management
Sound financial management is essential in all types of organizations whether it be
profit or non-profit. Financial management is essential in a planned economy as
well as in a capitalist set-up as it involves efficient use of the resources.
From time to time it is observed that many firms have been liquidated not because
their technology was obsolete or because their products were not in demand or
their labor was not skilled and motivated, but that there was a mismanagement of
financial affairs. Even in a boom period, when a company make high profits there is
also a fear of liquidation because of bad financial management.

Financial management optimizes the output from the given input of funds. In newly
started companies with a high growth rate it is more important to have sound
financial management since finance alone guarantees their survival.

Methods of Financial Management:

In the field of financing there are multiple methods to procure funds. Funds may be
obtained from long term sources as well as from short term sources. Long term
funds may be procured by owners that are shareholders, lenders by issuing
debentures (debt securities), from financial institutions, banks and the general
public at large. Short term funds may be availed from commercial banks, public
deposits, etc. Financial leverage or trading on equity is an important method by
which a finance manager may increase the return to common shareholders.

There are three primary elements to the process of financial management:

(1) Financial Planning
Management need to ensure that sufficient funding is available to meet the
needs of the business. In short term point of view, funding may be needed to
invest in equipment and stocks, pay employees and fund sales made on
credit. In the medium and long term point of view, funding may be needed
for significant additions to the productive capacity of the business or to
facilitate acquisitions.

(2) Financial Control

Financial control is a critically important activity to help the business ensure
that said business is meeting its goals. Financial control addresses questions
such as:
• Are assets being used efficiently?
• Are the businesses assets secure?
• Does management act in the best interest of the shareholders and in
accordance with business rules?

(3) Financial Decision Making

The primary aspects of financial decision making relate to investment,
financing and dividends:
• Investments must be financed in some way; however there are
always financing alternatives that can be considered. For example
it is possible to raise funds from selling new shares, borrowing
from banks or taking credit from suppliers.

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 • The key to financing decision is whether profits earned by the
business should be retained rather than distributed to shareholders
via dividends. If dividends are too high, the business may be
starved of funding to reinvest in growing revenues and profits.

Capital
Capital is the money which gives the business the power to buy goods to be used in
the production of other goods or the offering of a service.

Types of Capital
Borrowed capital
This is capital which the business borrows from institutions or people, and
includes debentures:
 Redeemable debentures
 Irredeemable debentures
 Debentures to bearer
 Hardcore debentures

Own capital
This is capital that owners of a business (shareholders and partners, for example)
provide:
 Preference shares:
o Ordinary preference shares
o Cumulative preference shares
o Participating preference shares
 Ordinary shares
 Bonus shares
 Founders' shares

Differences between shares and debentures

 Shareholders are effectively owners; debenture-holders are creditors.
 Shareholders may vote and be elected as directors; debenture-holders may
do not vote nor be elected as directors.
 Shareholders receive profit in the form of dividends; debenture-holders
receive a fixed rate of interest.
If there is no profit, the shareholder does not receive a dividend; interest is paid
to debenture-holders regardless of whether or not a profit has been made.

Sources of capital

Financial market
Financial market is a mechanism that allows people to easily buy and sell (trade)
financial securities (such as stocks and bonds), commodities (such as precious
metals or agricultural goods), and other fungible items of value at low transaction
costs and at prices that reflect the efficient market hypothesis.

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The term Financial markets can be a cause of much confusion. Financial markets
could mean:
1. organizations that facilitate the trade in financial products. i.e. Stock
exchanges facilitate the trade in stocks, bonds and warrants.
2. the coming together of buyers and sellers to trade financial products. i.e.
stocks and shares are traded between buyers and sellers in a number of
ways including: the use of stock exchanges; directly between buyers and
sellers etc.

Financial markets have evolved significantly over several hundred years and are
undergoing constant innovation to improve liquidity. Both general markets (where
many commodities are traded) and specialized markets (where only one or specific
commodity is traded) exist. Markets work by placing many interested sellers in one
"place", thus making them easier to find for prospective buyers. An economy which
relies primarily on interactions between buyers and sellers to allocate resources is
known as a market economy.

Financial markets facilitate:

 The raising of capital (in the capital markets);
 The transfer of risk (in the derivatives markets); and
 International trade (in the currency markets).
They are used to match those who want capital to those who have it. Typically a
borrower issues a receipt to the lender promising to pay back the capital. These
receipts are securities which may be freely bought or sold. In return for lending
money to the borrower, the lender will expect some compensation in the form of
interest or dividends.

Types of financial markets

(Financial markets can be domestic or they can be international.)
 Capital markets which consist of:
o Stock markets, which provide financing through the issuance
of shares or common stock, and enable the subsequent
trading thereof.
o Bond markets, which provide financing through the issuance
of Bonds, and enable the subsequent trading thereof.
 Commodity markets, which facilitate the trading of commodities.
 Money markets, which provide short term debt financing and investment.
 Derivatives markets, which provide instruments for the management of
financial risk.
o Futures markets, which provide standardized forward contracts
for trading products at some future date; see also forward
market.
 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign exchange.

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TYPES OF CAPITAL MARKET
Primary market
The primary is that part of the capital markets that deals with the issuance
of new securities. Companies, governments or public sector institutions can obtain
funding through the sale of a new stock or bond issue. This is typically done
through securities dealers. The process of selling new issues to investors is called
underwriting. In the case of a new stock issue, this sale is an initial public offering
(IPO). Dealers earn a commission that is built into the price of the security offering,
though it can be found in the prospectus.

Features of Primary Market are:

1. This is the market for new long term capital. The primary market is the market
where the securities are sold for the first time. Therefore it is also called New
Issue Market (NIM).
2. In a primary issue, the securities are issued by the company directly to
investors.
3. The company receives the money and issue new security certificates to the
investors.
4. Primary issues are used by companies for the purpose of setting up new business
or for expanding or modernizing the existing business.
5. The primary market performs the crucial function of facilitating capital formation
in the economy.
6. The new issue market does not include certain other sources of new long term
external finance, such as loans from financial institutions. Borrowers in the
new issue market may be raising capital for converting private capital into
public capital; this is known as ‘going public’.

Methods of issuing securities in the Primary Market

1. Initial Public Offer;
2. Rights Issue (For existing Companies); and
3. Preferential Issue.

Secondary market
The secondary market is the financial market for trading of securities that have
already been issued in an initial private or public offering. Alternatively, secondary
market can refer to the market for any kind of used goods. The market that exists
in a new security just after the new issue, is often referred to as the aftermarket.
Once a newly issued stock is listed on a stock exchange, investors and speculators
can easily trade on the exchange, as market makers provide bids and offers in the
new stock.

Function
In the secondary market, securities are sold by and transferred from one investor
or speculator to another. It is therefore important that the secondary market be
highly liquid, the normal way to create this liquidity was for investors and
speculators to meet at a fixed place regularly (Stock Exchange).

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Secondary marketing is vital to an efficient and modern capital market.
Fundamentally, secondary markets mesh the investor's preference for liquidity (the
investor's desire not to tie up his or her money for a long period of time, in case the
investor needs it to deal with unforeseen circumstances) with the capital user's
preference to be able to use the capital for an extended period of time. For
example, a traditional loan allows the borrower to pay back the loan, with interest,
over a certain period. For the length of that period of time, the bulk of the lender's
investment is inaccessible to the lender, even in cases of emergencies. Likewise, in
an emergency, a partner in a traditional partnership is only able to access his or her
original investment if he or she finds another investor willing to buy out his or her
interest in the partnership. With a securitized loan or equity interest (such as
bonds) or tradable stocks, the investor can sell, relatively easily, his or her interest
in the investment, particularly if the loan or ownership equity has been broken into
relatively small parts (smaller par value per share). This selling and buying of small
parts of a larger loan or ownership interest in a venture is called secondary market
trading.

Under traditional lending and partnership arrangements, investors may be less

likely to put their money into long-term investments, and more likely to charge a
higher interest rate (or demand a greater share of the profits) if they do. With
secondary markets, however, investors know that they can recoup some of their
investment quickly, if their own circumstances change.

The term secondary market may also refer to markets in things of value other than
securities. For example, the ability to buy and sell intellectual property such as
patents, or rights to musical compositions, is considered a secondary market
because it allows the owner to freely resell property entitlements issued by the
government. Similarly, secondary markets can be said to exist in some real estate
contexts as well (e.g. ownership shares of time-share vacation homes are bought
and sold outside of the official exchange set up by the time-share issuers). These
have very similar functions as secondary stock and bond markets in allowing for
speculation, providing liquidity, and financing through securitization.

BOND MARKET
The bond market (also known as the debt, credit, or fixed income market) is a
financial market where participants buy and sell debt securities, usually in the form
of bonds.

Bond market usually refer to the government bond market, because of its size,
liquidity, lack of credit risk and, therefore, sensitivity to interest rates. Because of
the inverse relationship between bond valuation and interest rates, the bond
market is often used to indicate changes in interest rates.

Market structure
Bond markets in most countries remain decentralized and lack common exchanges
like stock, future and commodity markets. This has occurred, in part, because no
two bond issues are exactly alike, and the number of different securities
outstanding is far larger.

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Types of bond markets
The Securities Industry and Financial Markets Association classifies the broader
bond market into five specific bond markets.
 Corporate
 Government & Agency
 Mortgage Backed, Asset Backed, and Collateralized Debt Obligation
 Funding

Bond market participants

Bond market participants are similar to participants in most financial markets and
are essentially either buyers (debt issuer) of funds or sellers (institution) of funds
and often both.
Participants include:
 Institutional investors;
 Governments;
 Traders; and
 Individuals
Because of the specificity of individual bond issues, and the lack of liquidity in many
smaller issues, the majority of outstanding bonds are held by institutions like
pension funds, banks and mutual funds.

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EXERCISE 1-1

Name: __________________________ Time:____________ Date: ________

TRUE or FALSE.
_____1. Inflation is assumed to be a temporary problem that does not affect
financial decisions.

_____2. Timing is not a particular important consideration in financial decisions.

_____3. Institutional investors have had increasing influence over corporations

with their ability to vote large blocks of stock and replace poor performing
boards of directors.

_____4. The higher the profit of a firm, the higher the value the firm is assured of
receiving in the market.

_____5. Social responsibility and profit maximization are synonymous.

_____6. Maximizing the earnings of the firm is the ultimate goal of financial
management.

_____7. The primary market includes the sale of securities by way of initial public
offerings.

_____8. The secondary market includes the sale of securities for the first time.

_____9. Money markets refers to those markets dealing with short-term securities
having life of one year or less.

_____10. Existing securities are traded in the secondary market.

_____11. Capital markets refers to those markets dealing with short-term

securities having a life of one year or less.

_____12. New issues are sold in the primary market.

_____13. Holders of debentures are considered as owners of the corporation

therefore have voting powers.

_____14. Acquisition of a subsidiary is an example of financial decision made in

financial management.

_____15. Financial management also deals with making investment decisions.

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EXERCISE 1-2

Name: __________________________ Time:____________ Date: ________

MULTIPLE CHOICE.
1. What is the primary goal of financial management?
a. Increased earnings
b. Maximizing cash flow
c. Maximizing shareholder wealth
d. Minimizing risk of the firm

2. The financial manager’s goal of maximizing current or short-term earnings

a. it fails to consider the timing of the benefits.
b. increased earnings may be accompanied by unacceptably higher levels of
risk
c. earnings are subjective; they can be defined in various ways such as
accounting or economic earnings.
d. all of the above

3. Capital markets do not include which of the following securities?

a. common stock
b. commercial paper
c. government bonds
d. preferred stock

4. Maximization of shareholder wealth is a concept in which

a. increased earnings is of primary importance
b. profits are maximized on a quarterly basis
c. virtually all earnings are paid as dividends to common stockholders.
d. optimally increasing the long-term value of the firm is emphasized.

5. Companies that have higher risk than a competitor in the same industry will
generally have
a. to pay a higher interest rate than its competitors
b. a lower relative stock price than its competitors
c. a higher cost of funds than its competitor
d. all of the above.

6. Money markets would include which of the following securities?

a. common stock and corporate bonds
b. treasury bills and commercial papers
c. certificates of deposit and preferred stock
d. all of the above

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7. When a corporation uses the financial markets to raise new funds, the sale of
securities is made in the
a. primary market
b. secondary market
c. on-line market
d. third market

8. A corporation is
a. owned by stockholders who enjoy the privilege of limited liability.
b. easily divisible between owners.
c. a separate legal entity with perpetual life.
d. all of the above.

9. One of the major disadvantages of a sole proprietorship is

a. that there is unlimited liability to the owner
b. the simplicity of decision making
c. low organizational costs
d. low operating costs

10. The partnership form of organization

a. avoids the double taxation of earnings and dividends found in the
corporate form of organization.
b. usually provides limited liability to the partners.
c. has unlimited life.
d. simplifies decision making.

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