BA I

FINANCIAL MANAGEMENT
NATURE AND SCOPE OF FINANCIAL
MANAGEMENT
 Learning outcomes
• At the end of the topic each student should be able to
a) Define finance, financial management and identify key areas of finance
b) Enumerate the relationship of financial management with other disciplines
c) Explain the scope of financial management
d) Explain the role of financial management and finance manager
e) Explain the goal of a firm (wealth maximization or profit maximization)
f) Articulate agency problem (managers Versus Shareholders goal)
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 Nature of Financial Management
• Finance is defined as the art and science of managing money
• Finance also is referred as the provision of money at the time when it is
needed
• Financial management (FM) is the managerial activity which is concerned
with the planning and controlling of the financial resources
• Financial management Also means the efficient and effective management
of money in such a manner as to accomplish the objectives of the
organization.
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 Types of Finance
• Finance can be classified into three major parts:
✓ Personal finance
✓ Corporate finance
✓ Public finance
➢ Personal Finance is managing the finance or funds of an individual and helping
them achieve the desired goals in terms of savings and investments. Personal
finance includes investment in education, assets like real estate, cars, life insurance
policies, medical and other insurance

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 Cont..
• Corporate Finance is about funding the company expenses and building
the capital structure of the company. It focuses on maintaining a balance
between the risk and opportunities and increasing the asset value.
• Public Finance; this type of finance is related to states, municipalities,
provinces in short government required finances. It includes long term
investment decisions related to public entities.
• Funds are obtained majorly from taxes, borrowing from banks or insurance
companies.
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 Objectives of Financial Management
• To ensure regular and adequate supply of funds to the concern.
• To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
• To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
• To ensure safety on investment, i.e., funds should be invested in safe ventures so
that adequate rate of return can be achieved.
• To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.

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 Relationship of financial management with
other disciplines
RELATIONSHIP TO ECONOMICS
• Financial managers must understand the economic framework and be able to
use economic theories as guidelines for efficient business operations.
• Examples include supply and demand analysis, profit-maximizing strategies
and price theory. A basic knowledge of economics is therefore necessary to
understand both the environment and the decision techniques of managerial
finance.

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 Cont..
RELATIONSHIP TO ACCOUNTING
• The firm’s finance and accounting activities are closely related activities and generally
overlap. Indeed managerial finance and accounting are not often easily distinguishable.
In small firms the accountant often carries out the finance function. However, there are
two basic differences between finance and accounting:
Emphasis on cash flows
• The accountant’s primary function is to develop and provide data for measuring the
performance of the firm, assessing its financial position and paying taxes. Using certain
standardized and generally accepted principles the accountant prepares financial
statements that recognize revenue at the point of sale and expenses when incurred i.e.
accrual basis accounting
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 Cont..

• The financial manager on the other hand places primary emphasis on cash flows.
He or she maintains the firm’s solvency by planning the cash flows necessary to
satisfy its obligation and to acquire assets needed to achieve the firm’s goals. The
financial manager uses this cash basis to recognize the revenues and expenses
only with respect to actual inflows and outflows of cash. Regardless of its profit
or loss, a firm must have sufficient cash flows to meet its obligation as they fall
due.

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 Cont..
Decision making
• Whereas accountants devote most of their attention to the collection and
presentation of financial data, financial managers evaluate the accounting
statements, develop additional data and make decisions based on their assessment
of the associated return and risks
• Accountants provide consistently developed and easily interpreted data about the
firms past, present and future operations. Financial managers use these data, either
in raw form or after adjustments and analysis, as inputs to the decision making
process.

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 Scope of Financial Management
• It may be difficult to separate the finance functions from production,
marketing and other functions, but the functions themselves can be readily
identified. The functions of raising funds, investing them in assets and
distributing returns earned from assets to shareholders are respectively
known as financing decisions, investment decision and dividend decision.
• A firm attempts to balance cash inflow and outflows while performing
these functions. This is called liquidity decision and it is among the
finance decisions or functions. Thus finance functions include:
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 Cont..
• Long-term assets-mix or investment decision
• Capital mix or financing decision
• Profit allocation or dividend decision
• Short-term asset mix or liquidity decision
• A firm performs finance functions simultaneously and continuously in the normal
course of the business. They do not necessarily occur in a sequence. Finance
functions call for skillful planning, control and execution of a firm’s activities.

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 Cont..
Let us note at the outset that shareholders are made better off by a financial
decision that increases the value of their shares. Thus while performing the
finance functions, the financial manager should strive to maximize the market
value of shares
1. INVESTMENT DECISION [CAPITAL BUDGETING]
• A firm’s investment decisions involve capital expenditure. They are therefore
referred to as capital budgeting decisions. A capital budgeting decision involves
the decision of allocation of capital or commitment of funds to long-term assets
that would yield benefit (cash flows) in the future. Two important aspects of
investment decision are;

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 Cont..
a) The evaluation of the prospective profitability of new investments
• Future benefits of investments are difficult to measure and cannot be
predicted with certainty. Risk in investment arises because of the uncertain
returns. Investment proposals should be evaluated in terms of both expected
return and risk. Beside the decision to commit funds in new investment
proposals, capital budgeting also involves replacement decision, which is
the decision of recommitting funds when asset becomes less productive or
non-profitable.
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 Cont..
b) The measurement of the standard/required rate of return or hurdle
rate against which the expected return of new investment could be
compared.
• There is a broad agreement that the correct required rate of return on
investments is the opportunity cost of capital. The opportunity cost of
capital is the expected rate of return that an investor could earn by investing
his or her money in financial assets of equivalent risk. However, there are
problems in computing opportunity cost of capital in practice from the
available data.
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 Cont..
2. FINANCING DECISION [CAPITAL MIX DECISION]
• A financial manager must decide when and where to acquire funds to meet the
firm’s investment needs. The central issue before him/her is to determine the
appropriate proportion of equity and debt. The mix of debt and equity is known as
the firm’s capital structure. The financial manager must strive to obtain the best
financing mix or optimum capital structure for the firm. The firm’s capital
structure is considered optimum when the market value of share is maximized.
• In absence of debt, the shareholders’ return is equal to the firm’s return. The use of
debt affects the return and risk of shareholders; it may increase the return on equity
fund, but it always increases risk as well.
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 Cont..
• A proper balance will have to be struck between return and risk. When
shareholders return is maximized with minimum risk the market value per
share will be maximized and the firm’s capital structure will be considered
optimum. Once financial manager is able to determine the best combination
of debt and equity, he/she must raise the appropriate amount through the
best available sources. In practice the firm considers many other factors such
as control, flexibility, loan covenants, legal aspects etc in deciding its capital
structure.

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 Cont..
3. DIVIDEND DECISIONS
• The financial manager must decide whether the firm should distribute all profits, or
retain them, or distribute the portion and retain the balance. The proportion of
profits distributed as dividends is called dividend payout ratio and the retained
portion of profits is known as the retention ratio. Like debt policy, the dividend
policy should be determined in terms of its impact on the shareholders’ value.
• The optimum dividend policy is one that maximizes the market value of the
firm’s shares. Thus, if shareholders are not indifferent to the firm’s dividend policy,
the financial manager must determine the optimum dividend payout ratio.
Dividends are generally paid in cash; however the firm may issue bonus shares.

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 Cont..
• Bonus shares are shares issued to the existing shareholders without any charge.
The financial manager should consider the questions of dividend stability, bonus
shares and cash dividends in practice
• 4. LIQUIDITY DECISION
• Investment in current assets affects the firm’s profitability and liquidity. Current
assets should be managed efficiently for safeguarding the firm against the risk of
illiquidity. Lack of liquidity (or illiquidity) in extreme situations can lead to the firm’s
insolvency. A conflict exists between profitability and liquidity while managing
current assets. If the firm does not invest sufficient funds in current assets, it may
become illiquid and therefore, risky.

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 Cont..
• But it would lose profitability, as idle current assets would not earn anything. Thus a
proper trade-off must be achieved between profitability and liquidity. The
profitability-liquidity trade-off requires that the financial manager should develop
sound techniques of managing current assets. He/she should estimate firm’s needs
for current assets and make sure that funds would be made available when needed.
• Financial decisions are directly concerned with the firm’s decision to acquire or
dispose off assets and require commitment or recommitment of funds on
continuous basis. It is in this context that finance functions are said to influence
production, marketing and other functions of the firm. Hence finance functions
may affect the size, growth, profitability and risk of the firm, and ultimately, the
value of the firm
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 Cont..
• To quote Ezra Solomon: the function of financial management is to review
and control decisions to commit or recommit funds to new or ongoing uses.
Thus, in addition to raising funds, financial management is directly
concerned with production, marketing and other functions, within an
enterprise whenever decision are made about the acquisition or distribution
of assets.

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 REAL AND FINANCIAL ASSETS
• A firm requires assets to carry on its business and these assets include real and
financial assets. Funds used to acquire assets by the firm are called capital
expenditures or investment. The firm expects to receive return on investment and
might distribute return (profit) as dividends to investors.
REAL ASSETS
• Real assets can be either tangible or intangible. Tangible real assets are physical
assets that include plant, machinery, factory, furniture, buildings etc. Intangible real
assets include technical know-how, technological collaborations, patents and
copyrights.

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 FINANCIAL ASSETS [SECURITIES]
• These are financial papers or instruments such as shares, bonds or debentures.
Firms issue securities to investors in the primary capital markets to raise
necessary funds. The securities issued by firms are traded i.e. bought and sold in the
secondary capital markets, referred to as stock exchanges. Financial assets also
include lease obligations, borrowings from banks, financial institutions and other
sources.
EQUITY AND BORROWED FUNDS
• There are two types of funds that a firm can raise: equity fund (simply called equity)
and borrowed funds (debt).

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 EQUITY FUND
• Firms sell shares to acquire equity funds. Shares represent ownership rights of their
holders. Buyers of shares are called shareholders (or stockholders), and they are the
legal owners of the firm whose shares they hold. Shareholders invest their money in
the shares of the company in the expectation of return on their invested capital.
The returns of shareholders consist of dividend and capital gain. Shareholders
make capital gain (or loss) by selling their shares.
• There are two types of shareholders i.e. ordinary and preference. Preference
shareholders receive dividend at fixed rate, and they have a priority over ordinary
shareholders. The dividend rate for ordinary shareholders is not fixed, and it can
vary from year to year depending on the decisions of board of directors.

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 Cont..
• The payment of dividends to shareholders is not a legal obligation; it depends on
the discretion of the board of directors. Since ordinary shareholders receive
dividend (or repayment of invested capital, or when the company is wound up) after
meeting the obligations of others, they are generally called owners of residue.
Dividends paid by the company are not tax deductible expenses for calculating
corporate income taxes, and they are paid out of profits after corporate taxes.
• A company can also obtain equity funds by retaining earnings available for
shareholders. Retained earnings, which could be referred to as internal equity are
undistributed profits of equity capital. The retention of earnings can be considered
as a form of raising new capital
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 Cont..
• . If the company distributes all earnings to shareholders, then it can reacquire new
capital from the same source (existing shareholders) by issuing new shares called
rights shares. Also, a public issue of share may be made to attract new (as well as the
existing shareholders) shareholders to contribute equity capital.
• BORROWED FUND
• Another important source of securing capital is creditors or lenders. Lenders are not
the owners of the company. They make money available to the firm as loan or debt
and retain title to the funds lent. Loans are generally furnished for a specified period
at a fixed rate of interest. For lenders, the return on loan or debt comes in a form
of interest paid by the firm. Interest is a cost of debt to the firm

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 Cont..
• Payment of interest is a legal obligation. The amount of interest paid by a firm is a
deductible expense for computing corporate income taxes. Thus interest provides
tax shield to firm. The interest tax shield is valuable to a firm. The firm may borrow
funds from a large number of sources, such as banks, financial institutions, public
or by issuing bond or debentures.
• A bond or a debenture is a certificate acknowledging the amount of money lent by
the bondholder or debenture holder to a company. It states the amount, the rate of
interest and the maturity of the bond or debenture. Since bond or debenture is a
financial instrument, it can be traded in the secondary capital markets.
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 FINANCIAL MANAGER’S ROLE
1. FUND RAISING
• This is the traditional approach which dominated the scope of financial
management and limited the role of the financial manager simply to raising
fund. It was during the major events such as promotion, re-organization,
expansion, or diversification in the firm that the financial manager was called
up on to raise fund. In his day to day activities his significant duty was to see
that the firm had enough cash to meet its obligations. The traditional
approach had been criticized because it failed to consider the day to day
management problems from management point of view.
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 Cont..
• Thus the traditional approach of looking at the role of financial manager lacked a
conceptual framework for making financial decisions; it misplaced emphasis of
raising fund and neglected the real issues related to allocation and management of
funds.
2. ALLOCATION OF FUNDS
• It is an analytical way of looking into financial problems of the firm. Financial
management is considered as a vital and integral part of overall management. In this
broader view the central issue of financial policy is the wise use of funds and the
central process involved is a rational matching of advantages of potential uses
against the cost of alternative potential source so as to achieve a broad financial
goal which an enterprise sets for itself
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 Cont..
• Thus, in a modern enterprise, the basic finance function is to decide about the
expenditure decisions and to determine the demand for capital for these
expenditures. In other words, the financial manager has got a role of ensuring
efficient allocation of funds.
• In his/her role of using funds wisely, the financial manager must find the rationale
for answering the following three questions:
• I. How large should an enterprise be and how fast should it grow?
• II. In what form should it hold its assets?
• III. How should the fund required be raised?

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 Cont..
3. PROFIT PLANNING
• The functions of a financial manager may be broadened to include profit
planning function. The term profit planning refers to the operating decision
in the areas of pricing, cost, volume of output and firms’ selection of
product line. Profit planning is therefore a prerequisite for optimizing
investment and financial decisions. Profit planning helps in anticipating the
relationship between cost, volume and profit (CVP) and to develop action
plans to face unexpected surprises
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 Cont..
4. UNDERSTANDING CAPITAL MARKETS
• Capital markets bring investors (lenders) and firms (borrowers) together.
Hence financial manager has to deal with capital markets where securities are
traded. He/she should fully understand the operations of capital markets
and the way in which securities are valued. He should also know how risk is
measured in capital markets and how to cope with investment and financing
decisions which often include considerable risk

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FINANCIAL GOAL: PROFIT MAXIMIZATION
VERSUS WEALTH MAXIMIZATION
• The firm’s investment and financing decisions are unavoidable and
continuous. In order to make them rationally, the firm must have a goal. It is
generally agreed in theory that the financial goal of the firm should be
shareholders’ wealth maximization (SWM), as reflected in the market
value of the firm’s shares. Wealth maximization is theoretically logical and
operationally feasible normative goal for guiding financial decision making.

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 PROFIT MAXIMIZATION
• In economic theory, the behavior of a firm is analyzed in terms of profit
maximization. Profit maximization implies that a firm either produces maximum
output for a given amount of input, or uses minimum input for producing a given
output. The underlying logic of profit maximization is efficiency.
• It is assumed that profit maximization causes the efficient allocation of resources
under the competitive market condition, and profit is considered as the most
appropriate measure of a firm’s performance. Historically this was the objective of
the firm, but it has been generally criticized in financial management because of the
following:
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 Cont..
I. It is argued that profit maximization as business objective was developed in
the early 19th century when the characteristic features of the business structure
were self-financing, private property and single entrepreneurship.
• The only aim of the single owner was to enhance his individual wealth and personal
power which could easily be satisfied by the profit maximization objective. However,
the modern business is characterized by limited liability and a divorce between
management and ownership. The business firm today is financed by shareholders
and lenders but it is controlled and directed by professional management. The other
interested parties are customers, employees, government and the society
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 Cont..
• In practice, the objectives of these stakeholders or constituents of the firm differ and may
conflict with each other. The manager of the firm has a difficult task of reconciling and
balancing these conflicting objectives. In new business environment profit maximization is
regarded as unrealistic, difficult, inappropriate and immoral.
II. THE DEFINITION OF PROFIT IS VAGUE
• The precise meaning of profit maximization objective is unclear. The definition of the term
profit is ambiguous. Does it mean short or long term profit? Does it refer to profit before or
after tax? Total profit or profit per share? Does it mean total operating profit or profit
accruing to shareholders? Economists define profit differently from accountants and
therefore as financial manager the objective becomes elusive.

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 Cont..
III. TIME VALUE OF MONEY
• Profit maximization ignores the concept of time value of money i.e. it ignores the
timing of returns. It does not make distinction between returns received in different
time periods. It gives no consideration to the time value of money, and it values
benefits received in different periods of time as the same.
IV. COMPETITION ASSUMPTION
• It is argued that profit maximization assumes perfect competition and in the face of
imperfect modern market it can’t be a legitimate objective of the firm.
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 Cont..
V. IT IGNORES RISK
• In almost all investments, there is uncertainty of returns. The streams of benefits
may possess different degree of uncertainty. Two firms may have the same total
expected earning but if the earnings of one firm fluctuate considerably as compared
to the other, it will be more risky. Possibly owners of the firm prefer smaller but
surer profits to a potentially larger but less certain stream of benefits.
• Hence; Profit maximization fails to serve as operational criteria for maximizing the
owners’ economic welfare. It also fails to provide an operation feasible measure for
ranking alternative courses of action in terms of their economic efficiency

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 SHAREHOLDERS’ WEALTH
MAXIMIZATION [SWM]
• SWM means maximizing the net present value (NPV) of a course of action to
shareholders. Wealth is the net cash flows expected from all assets which resources
of the firm have been committed. These cash flows have to be discounted to their
present worth using a discount rate that takes into account all business stakeholders.
𝑨𝒊
• WEALTH MAXIMIZATION = σ𝒏𝒊=𝟏 (𝟏 +𝒌)𝒊
- 𝑰𝒐
OR
𝑨 𝑨 𝑨 𝑨 𝑨𝒏
• NPV = (𝟏+𝑲)𝟏
+
(𝟏+𝑲)𝟐
+
(𝟏+𝑲)𝟑
+
(𝟏+𝑲)𝟒
……………+
(𝟏+𝒌)𝒏
- 𝑰𝑶
• 𝑨𝒊 =Net cash flows in a period, 𝐼𝑜 =Initial outlay, K=discount rate, n=No. of years
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 Cont..
• The NPV of the course of action is the difference between the present value
of its benefits and the present value of its costs. A financial action which has
a positive NPV creates wealth and therefore is desirable while financial action
resulting into a negative NPV should be rejected. Between mutually exclusive
projects the one with the highest NPV should be adopted.
• The objective of wealth maximization takes into consideration the questions
of timing and risks of expected benefits. These problems are handled by
selecting appropriate rate for discounting the expected flow of future
benefits.
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 Cont..
• It is important to emphasize that benefits are measured in terms of cash flows. In
investment and financing decisions, it is the flow of cash which is important and
not the accounting profits.
• The wealth maximization objective is consistent with the objective of maximizing
owners’ economic welfare. Maximizing economic welfare of owners is equivalent to
maximizing the utility of their consumption over time. Therefore the wealth
maximization principle implies that the fundamental objective of a firm
should be to maximize the market value of its shares. The value of the
company shares is represented by its market price which in turn is a reflection of
the firm’s financial decisions. The market price serves as the firm’s performance
indicator
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 THE CONCEPT OF RISK
• Risk is the probability that the actual return will deviate from what is expected. The higher
the risk of an action the higher will be the risk premium leading to the higher required rate
of return from that action. A proper balance between return and risk should be maintained
to maximize the market value of firm’s shares. Such a balance is called the risk return trade-
off. The relationship between the risk and return can be simply expressed as follows:
RETURN= Risk-Free Rate + Risk Premium
• Risk-Free Rate is the rate obtainable from a default-risk free government security. It is a
compensation for time. On the other hand an investor assuming risk from his/her
investment requires a risk premium above the risk free rate. The interrelation between
market value, financial decisions and risk-return trade-off is depicted in figure below. It also
gives an overview of the functions of financial management.
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Cont..

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 Cont..
• The financial manager in a bid to maximize returns in relation to a given risk; he/she
should seek course of actions that avoid unnecessary risk. To ensure maximum return,
fund flowing in and out of the firm should be constantly monitored to assure that they
safeguarded and properly utilized. In financing decision (capital mix) the concept of risk
can be incorporated when investing in securities. Risk is thought as a probability that the
actual return from holding a security will deviate from the expected return. The expected
return and standard deviation are used as parameters to estimate risk.
• In making investment decision (capital budgeting), because future benefits from the
investment are not known with certainty, thus investment proposals involve risk.
Proposals should be evaluated in relation to their expected returns and risk. In capital
budgeting therefore, risk is adjusted by using discount rate.

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 Cont..
• Risk in financial management is further seen when deciding optimum level of
working capital to invest and keep. A large investment in current assets would mean
a lower return on investment for the firm. A small investment on the other hand
would mean interrupted production and sales because of frequent stock out. Since
it is not possible to estimate working capital needs accurately, the company must
decide about the level of current assets to be carried which will depend on working
capital policy i.e. either conservative or aggressive.
• The concept of risk is also seen in dividend decision. The important aspect of
dividend policy is to determine the amount of earnings distributed to shareholders
and the amount to be retained by the firm
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 Cont..
• Retained earnings are the most significant internal sources for financing the
growth of the firm. On the other hand, dividends are desirable from the
shareholders point of view as they tend to increase current wealth. Under
condition of risk, investors tend to discount distant dividends at a higher rate
than they discount near dividends. Accordingly, when dividend policy is
considered in the context of uncertainty the appropriate discount rate k
increases with the uncertainty

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 AGENCY PROBLEMS: MANAGERS Vs
SHAREHOLDERS GOALS
• In large companies there is a divorce between management and ownership.
The decision-taking authority in a company lies in the hands of the
managers. Shareholders as owners of the company are the principals and the
managers are the agents. Thus, there is principal-agent relationship
between shareholders and managers.
• In theory, managers should act in the best interests of shareholders; that is
their actions and decisions should lead to shareholders wealth maximization
(SWM). However, in practice managers may not necessarily act in the best
interest of the shareholders, and they may pursue their own personal goals.
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 Cont..
• Managers may maximize their own wealth (in form of salaries and perks) at the cost
of shareholders, or may play safe and create satisfactory wealth for shareholders
than the maximum. They may avoid taking high investment and financing risks that
may otherwise be needed to maximize shareholders’ wealth. Such satisficing
behavior of managers will frustrate the objective of SWM as a normative guide. It is
in the interest of managers that the firm survives over the long-run
• Managers also wish to enjoy independence and freedom from outside interference,
control and monitoring. Thus their actions are very likely to be directed towards the
goals of survival and self-sufficiency. Further a company is a complex organization
consisting of multiple stakeholders such as employees, debt-holders, consumers,
suppliers, government and society
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 Cont..
• Managers in practice may, thus perceive their role as that of reconciling conflicting
objectives of stakeholders. These stakeholders’ view of managers’ role may
compromise with the objective of SWM.
• Continuous monitoring of company’s activities by the shareholders would help to
restrict managers’ freedom to act in their own self-interest at the cost of
shareholders. Employees, creditors, customers and government also keep an eye on
managers’ activities. Thus, the possibility of managers pursuing exclusively their
own personal goals is reduced. Managers can survive only when they are successful;
and they are successful when they manage the company better than someone else.
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 Cont..
• Every group connected with the company will, however evaluate management success
from the point of view of the fulfilment of its own objective. The survival of the
management will be threatened if the objective of any of these groups remains unfulfilled.
In reality, the wealth of shareholders in the long-run could be maximized only when
customers and employees, along with other stakeholders of the firm, are fully satisfied.
• The wealth maximization objective may be generally in harmony with the interests of
various groups such as owners, employees, creditors and society, and thus, it may be
consistent with management objective of survival. There can, however still arise situations
where conflict may occur between the shareholders’ and managers’ goals. Finance theory
prescribes that under such situations, shareholders wealth maximization goal should have
precedent over other goals of other stakeholders.

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 Cont..
• The conflict between the interest of shareholders and managers is referred to as agency problem
and it results into agency costs. Agency costs include the less than optimum share value for
shareholders and costs incurred by them to monitor the actions of managers and control their
behavior.
The agency problems vanish:
• When managers own the company. Thus one way to mitigate agency problems is to give ownership
rights through stock options to managers.
• When shareholders offer monetary and nonmonetary incentives to managers to act in their interest.
• When there is a close monitoring by other stakeholders, board of directors and outside analysts may
also help in reducing the agency problem.
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END