Paper PGP-3.

2 FM
Financial Management
Narain
narainfms@gmail.com
Course of studies
AIM: To introduce the fundamentals of
corporate financial management to the
students
❑ The finance function
❑ Capital Budgeting

❑ Capital Structure

❑ Dividend Policy

❑ Working Capital Decision

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Books for studies
❑ Brealey, Myers, Allen & Mohanty –
“Principles of Corporate Finance”
❑ Damodaran – “Corporate Finance”

❑ Berk, DeMarzo & Harford –

“Fundamentals of Corporate
Finance”

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Some more …………
❑ Ross, Westerfield & Jordan –
“Fundamentals of Corporate Finance”
❑ Megginson & Smart – “Introduction to
Corporate Finance”
❑ Van Horne & Wachowicz –
“Fundamentals of Financial Management”
❑ McMenamin – “Financial Management”

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Some Indian authors ……
❑ Pandey – “Financial Management”
❑ Khan & Jain – “Basic Financial
Management”

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 Assessment Scheme
Activity Weightage
Class Participation 10%
Assignments 10%
Quizzes 20%
Mid-term Exam 30%
End-term Exam 30%

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Finance?
FINANCE is concerned with the
process, institutions, markets,
instruments and services
involved in the transfer of
money, among and between,
individuals, businesses and
Governments.
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Segments of Finance

Financial Process

Financial Institutions

Financial Markets

Financial Instruments

Financial Services
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Entities in Finance

Business
Personal Finance
Finance

Individuals Businesses

Governments

Public
Finance Narain
Financial Management
Corporate Financial Management is a part
of Business Finance

Financial Management is the study

about the decisions of procuring and
judicious use of the financial resources
of the firm with a view to maximise the
wealth of the firm.
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 Judicious?
Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
✓The hurdle rate should be higher for riskier projects and should reflect the financing mix
used - either owner’s funds or borrowed money.
✓Returns on projects should be measured on the basis of cash flows generated, the timing of
these cash flows and both positive & negative side effects of these projects.

Choose a financing mix that maximises the value of the firm and matches the
assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to
the owners of the firm.
The form of returns – dividends and stock buybacks – will depend on the
stockholders’ characteristics.

Objective: Maximise the value of the firm

 Corporate Organisation
S T O C K H O L D E R S
elects
Owners Board of Directors
hires
Managers President
(MD/CEO)

VP-HR VP-Operations VP-Finance VP-Marketing VP-IT

(CFO)

Treasurer Controller

• Financial planning • Corporate Accounting manger

• Fund raising manager • Financial Accounting manager
• Capital expenditure • Cost Accounting manager
• Credit manager • Tax manager
• Cash manager
• Pension fund manager
• Foreign exchange manager
Finance managerial functions

 Provision of capital
 Realistic programmes
 Investor relation
 Market for company’s securities
 Liaison with Ivt. bankers, analysts & major S/hs
 Short term financing
 Adequate sources
 Commercial banks etc
 Banking & Custody
 Banking relations
 Custodian of company’s money & securities
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Finance managerial functions

 Credit & collection

 Supervising special offers e.g. sales discount,
exchange offer, lease, etc.
 Investment
 Making real investments
 Policies for external investments
 Insurance
 Adequate risk coverage
 Planning for control
 Establish, coordinate & administer
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Finance managerial functions

 Reporting & Interpreting

 Compare with established plans
 Interpret the results to managers, owners, etc
 Evaluating & Consulting
 Consult all business segments
 Effectiveness of organisational goals
 Tax administration
 Tax policies and procedures
 Government Reporting
 Supervise and coordinate
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Finance managerial functions

❑ Protection of Assets
– Internal control, internal checks and internal
audit coverage
❑ Economic Appraisal
– Appraise continuously the economic & social
forces
– Interpret their impact on business

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 Objective of Financial Management
❑ To provide framework for optimum financial
decision making
❑ Operationally useful criteria to judge business
decision
❑ Provide a normative framework
– What the company should try to
achieve
– May not necessarily is followed in
actual practice
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Basis criteria of objectives
❑ Precise and Exact
– As far as possible
❑ Based on “Bigger the better” principle
❑ Considers both quantity and quality of
benefits
– Stability of benefits over time
– High probability of occurrence
❑ Recognises the “Earlier the better”
principle
– Time value of money
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 Some competing objectives
Bigger the Quantity & Earlier the
Objectives Preciseness
better Quality better Rule

Profit
maximisation

Current Ratio
maximisation

EPS
maximisation

Share Price
maximisation
Value Maximisation
 E (Cash Flowi ) 
Value =   
i  (1 + k ) i

❑ It involves precise estimation of benefits:
– Cash Flow
❑ Higher cash flow will accumulate the value of
the firm
– Bigger the better
❑ Recognises the time of receipt of cash flows
– Earlier the better
❑ Considers both quantity & quality of cash flows
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Maximisation of Share Price
❑ Corporate mangers should strive to achieve
maximisation of value of the firm
– Firm includes both investors & lenders
❑ Lenders can protect themselves contractually
❑ Maximise the value of the owners for whom it
is being operated
– Share price is an observable & real measure
of owners’ value, if not perfect measure
– Market may make a mistake in its
assessment of shareholders’ value
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VALUE FOR WHOM??
 VALUE SPECTRUM ACROSS STAKEHOLDERS
Value Added Enterprise Net Net Income to
Income Net Income to Net Income to
Investors Shareholders Residual Income
Equity (EVA)

Employees, Govt., Lenders, Preference Equity Equity

Government, Lenders, Shareholders Shareholders, Shareholders Shareholders

Lenders, Shareholders Equity

Shareholders Shareholders

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INDIAN PRACTICES

Which is the most important

objective of management
decision making in
corporate finance in India?
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 RELATIVE IMPORTANCE OF OBJECTIVES

TO REDUCE THE SIDE COSTS IN THE FORM

OF CONFLICTS AMONGST VARIOUS STAKE 33.00%
HOLDERS

TO MAXIMIZE MARKET VALUE ADDED (MVA) 53.80%

OF THE FIRM

TO MAXIMIZE THE SPREAD BETWEEN CFROI 54.40%

AND WACC (CVA)

TO MAXIMIZE THE SPREAD BETWEEN ROI 75.90%

AND WACC (EVA)
85.10%

TO MAXIMIZE EBIT/EPS

Anand, M (2002) ‘Corporate Finance Practices in India: A Survey’ Vikalpa

INTERNATIONAL PRACTICES …

❑ Firms give importance to the corporate

goals of maximizing profits, sustainable
growth, and market position.

❑ Least priorities to – dividend and leverage.

❑ British and US firms give shareholders

wealth top priority while for French and
German firms consider this goal as less
important.
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Who is the important stakeholder?

❑ The order is ……
1. CUSTOMERS
2. EMPLOYEES
3. MANAGEMENT
4. SHAREHOLDERS
5. SUPPLIERS OF GOODS AND SERVICES
6. SUPPLIERS OF DEBT
7. GENERAL PUBLIC
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 IMPEDIMENTS IN THE
IMPLEMENTATION OF OBJECTIVE
Agency issue
❑ Goal of the finance manager is the
maximisation of the wealth of the owners of
the firm
❑ Management can be viewed as agents of the
owners
– Owners hires the management
– Gives the decision making authority to manage the firm
for owner’s benefits
❑ In practice, managers concerned with their
own benefits
– E.g. personal wealth, job security, lifestyle, benefits, etc.
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 Corporate Organisation
S T O C K H O L D E R S
elects
Owners Board of Directors
hires
Managers President
(MD/CEO)

VP-HR VP-Operations VP-Finance VP-Marketing VP-IT

(CFO)

Treasurer Controller

• Financial planning • Corporate Accounting manger

• Fund raising manager • Financial Accounting manager
• Capital expenditure • Cost Accounting manager
• Credit manager • Tax manager
• Cash manager
• Pension fund manager
• Foreign exchange manager
Agency issue
❑ Manager’s personal goals may make managers
reluctant or unwilling to take more than moderate
risk if they perceive it to be in conflict with their
personal goals
❑ The result of such a “satisficing approach” is
– A compromise between satisfaction & maximisation
– less than the maximum return & potential loss of
wealth for the owners
❑ The resolution is-
A. Market Forces
B. Agency costs

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 A: Market Forces

1. Institutional Investors:
– E.g. Insurance companies, Mutual Funds,
Pension Funds, etc.
– Holds large blocks of a firm’s stocks
– They actively uses their votes to oust under
performing managers and replace them with
more competent managers
– Also communicate with the companies and
exert pressure on management to perform or
be fired

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A: Market Forces

2. Hostile Takeovers
– Acquisition of a firm (the target) by another
firm or group (the acquirer) that is not
supported by management
– Typically occurs when the acquirer feels that
the target firm is being poorly managed, and
as a result, is undervalued in the market
place
– Attempt techniques available to defend
against hostile takeovers, its constant threat
motivates mgt. to act in the best interest of
firm’s owners Narain
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 ❑ Incurred to respond to
potential market forces
B: Agency by preventing or
Costs minimising agency
problems and
contributing to the
maximisation of
owner’s wealth
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Types of Agency Costs

1. Monitoring expenditures-
– Payment for audit & control

2. Bonding expenditures-
– Payment to third party to obtain a fidelity bond

3. Opportunity costs-
– Loss of profit due to the longer response time of the
complex organisational structure

4. Structuring expenditures-
– Results from structuring managerial compensation to
correspond with stock price maximisation

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Types of structuring expenses

1. Incentive Plans-
– To tie management compensation with share
price
– E.g. Stock Options- allow manager to
purchase stock
– Is been criticised as positive effort may be
accompanied by the negative market
2. Performance Plans-
a. Cash bonuses
b. Performance shares
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THANKS FOR YOUR TIME!