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Unit 1 Nature of Financial Management
Unit 1 Nature of Financial Management
Unit 1 Nature of Financial Management
MODULE - 1
Nature of Financial
UNIT 1 NATURE OF FINANCIAL Management
MANAGEMENT
NOTES
Structure
1.0 Introduction
1.1 Unit Objectives
1.2 Scope of Finance
1.2.1 Real and Financial Assets; 1.2.2 Equity and Borrowed Funds
1.2.3 Finance and Management Functions
1.3 Financial Functions
1.3.1 Investment Decision; 1.3.2 Financing Decision; 1.3.3 Dividend Decision;
1.3.4 Liquidity Decision; 1.3.5 Financial Procedures and Systems
1.4 Financial Manager’s Role
1.4.1 Funds Raising; 1.4.2 Funds Allocation
1.4.3 Profit Planning; 1.4.4 Understanding Capital Markets
1.5 Financial Goal: Profit Maximisation Versus Wealth Maximisation
1.5.1 Profit Maximisation; 1.5.2 Objections to Profit Maximisation
1.5.3 Maximising Profit after Taxes; 1.5.4 Maximising EPS
1.5.5 Shareholders’ Wealth Maximisation (SWM)
1.5.6 Need for a Valuation Approach; 1.5.7 Risk-return Trade-off
1.6 Agency Problems: Manager’s Versus Shareholders’ Goals
1.7 Financial Goal and Firm’s Mission and Objectives
1.8 Organisation of the Finance Functions
1.8.1 Status and Duties of Finance Executives
1.8.2 Controller’s and Treasurer’s Functions in the Indian Context
1.9 Let us Summarize
1.10 Key Concepts
1.11 Answers to ‘Check Your Progress’
1.12 Questions and Exercises
1.0 INTRODUCTION
Financial management is that managerial activity which is concerned with the planning and
controlling of the firm’s financial resources. It was a branch of economics till 1890, and as a
separate discipline, it is of recent origin. Still, it has no unique body of knowledge of its own, and
draws heavily on economics for its theoretical concepts even today.
The subject of financial management is of immense interest to both academicians and practising
managers. It is of great interest to academicians because the subject is still developing, and there
are still certain areas where controversies exist for which no unanimous solutions have been
reached as yet. Practising managers are interested in this subject because among the most crucial
decisions of the firm are those which relate to finance, and an understanding of the theory of
financial management provides them with conceptual and analytical insights to make those
decisions skilfully.
marketing
finance
A firm secures whatever capital it needs and employs it (finance activity) in activities, which
generate returns on invested capital (production and marketing activities).
8 Self-Instructional Material 1. Robichek, A., Financial Research and Management Decision, John Wiley, 1967, p. 6.
1.3.4 Liquidity Decision Nature of Financial
Management
Investment in current assets affects the firm’s profitability and liquidity. Current assets management
that affects a firm’s liquidity is yet another important finance function. 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 NOTES
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. 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 or she should estimate firm’s
needs for current assets and make sure that funds would be made available when needed.
In sum, financial decisions directly concern the firm’s decision to acquire or dispose off assets
and require commitment or recommitment of funds on a 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. To quote Ezra Solomon:2
... 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
decisions are made about the acquisition or distribution of assets.
6. Ibid., p. 2.
7. Solomon, op. cit., pp. 8–9.
8. Mao, James C.T., Quantitative Analysis of Financial Decisions, Macmillan, 1969, p. 4. Self-Instructional Material 11
Financial Management value of the firm’s share may, therefore, decline. Similarly, investors may not like the decision of a
highly profitable, growing firm to distribute dividend. They may like the firm to reinvest profits in
attractive opportunities that would enhance their prospects for making high capital gains in the
future. Investments also involve risk and return. It is through their operations in capital markets
that investors continuously evaluate the actions of the financial manager.
NOTES
1.5 FINANCIAL GOAL: P ROFIT M AXIMISATION
VERSUS WEALTH MAXIMISATION
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 maximisation (SWM), as reflected in the market value of
the firm’s shares. In this section, we show that the shareholders’ wealth maximisation is
theoretically logical and operationally feasible normative goal for guiding the financial decision-
making.
16. Porterfield, James C.T., Investment Decision and Capital Costs, Prentice-Hall, 1965.
17. Solomon, op. cit., p. 22.
18. The net present value or wealth can be defined more explicitly in the following way:
n
(1 tk ) t
C1 C2 Cn C
NPV W ... C0 C0
(1 k ) (1 k ) 2
(1 k ) n
t 1
where C1, C2 ... represent the stream of cash flows (benefits) expected to occur if a course of action is
adopted, C0 is the cash outflow (cost) of that action and k is the appropriate discount rate (opportunity cost
of capital) to measure the quality of C’s; k reflects both timing and risk of benefits, and W is the net present
value or wealth which is the difference between the present value of the stream of benefits and the initial
cost. The firm should adopt a course of action only when W is positive, i.e. when there is net increase in
the wealth of the firm. This is a very simple model of expressing wealth maximisation principle. A
complicated model can assume capital investments to occur over a period of time and k to change with
time. Self-Instructional Material 15
19. Solomon, op. cit., p. 20.
Financial Management Financial decisions of the firm are guided by the risk-return trade-off. These decisions are
interrelated and jointly affect the market value of its shares by influencing return and risk of the
firm. The relationship between return and risk can be simply expressed as follows:
Team playing.
Zeal to excel.
20. Donaldson, G., Managing Corporate Wealth: The Operations of a Comprehensive Financial Goals
System, New York : Praeger, 1984. Self-Instructional Material 17
Financial Management the point of view of the fulfilment of its own objective. The survival of 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 maximised only when customers and employees, along with
other stakeholders of a firm, are fully satisfied. The wealth maximisation objective may be generally
in harmony with the interests of the various groups such as owners, employees, creditors and
NOTES society, and thus, it may be consistent with the management objective of survival.21 There can,
however, still arise situations where a conflict may occur between the shareholders’ and managers’
goals. Finance theory prescribes that under such situations, shareholders wealth maximisation
goal should have precedent over the goals of other stakeholders.
The conflict between the interests 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
behaviour. The agency problems vanish when managers own the company. Thus one way to
mitigate the agency problems is to give ownership rights through stock options to managers.
Shareholders can also offer attractive monetary and non-monetary incentives to managers to act
in their interests. A close monitoring by other stakeholders, board of directors and outside
analysts also may help in reducing the agency problems. In more capitalistic societies such as
USA and UK, the takeovers and acquisitions are used as means of disciplining managers.
NOTES
and the financial manager or director is under the control of the board of directors. Figure 1.4
shows the organisation for the finance function of a large, multi-divisional Indian company.
CFO has both line and staff responsibilities. He or she is directly concerned with the financial
planning and control. He or she is a member of the top management, and he or she is closely
associated with the formulation of policies and making decisions for the firm. The treasurer and
controller, if a company has these executives, would operate under CFO’s supervision. He or she
must guide them and others in the effective working of the finance department.
The main function of the treasurer is to manage the firm’s funds. His or her major duties include
forecasting the financial needs, administering the flow of cash, managing credit, floating securities,
maintaining relations with financial institution and protecting funds and securities. On the other
hand, the functions of the controller relate to the management and control of assets. His or her
duties include providing information to formulate accounting and costing policies, preparation of
financial reports, direction of internal auditing, budgeting, inventory control, taxes etc. It may be
stated that the controller’s functions concentrate the asset side of the balance sheet, while
treasurer’s functions relate to the liability side.
20 Self-Instructional Material
1.8.2 Controller’s and Treasurer’s Functions in the Indian Context Nature of Financial
Management
The controller and the treasurer are essentially American terms. Generally speaking, the American
pattern of dividing the financial executive’s functions into controllership and treasurership
functions is not being widely followed in India. We do have a number of companies in India
having officers with the designation of the controller, or the financial controller. The controller or NOTES
the financial controller in India, by and large, performs the functions of a chief accountant or
management accountant. The officer with the title of treasurer can also be found in a few companies
in India.
The controllership functions, as stated by the Financial Executives’ Institute of the USA, can
prove to be useful under the Indian context. But presently the company secretary in India
performs some of these duties. His or her duties, for example, include asset control and protection,
maintaining records and preparing reports and government reporting. The economic appraisal
function is generally performed at the top level in India. Some companies do have separate
economics and statistical departments for this purpose. Some other functions, such as internal
audit, can be brought within the fold of the controllership functions, if this concept is developed
in the Indian context.
It should be realised that the financial controller does not control finances; he or she develops,
uses and interprets information—some of which will be financial in nature—for management
control and planning. For this reason, the financial controller may simply be called as the controller.
Management of finance or money is a separate and important activity. Traditionally, the accountants
have been involved in managing money in India. But the difference in managing money resources
and information resources should be appreciated.
In the American business, the management of finance is treated as a separate activity and is being
performed by the treasurer. The title of the treasurer has not found favour in India to the extent the
controller has. The company secretary in India discharges some of the functions performed by
the treasurer in the American context. Insurance coverage is an example in this regard. The
function of maintaining relations with investors (particularly shareholders) may now assume
significance in India because of the development in the Indian capital markets and the increasing
awareness among investors.
The general title, financial manager or finance director, seems to be more popular in India. This
title is also better than the title of treasurer since it conveys the functions involved. The main
function of the financial manager in India should be the management of the company’s funds.
The financial duties may often be combined with others. But the significance of not combining
the financial manager’s duties with others should be realised. The managing of funds—a very
valuable resource—is a business activity requiring extraordinary skill on the part of the financial
manager. He or she should ensure the optimum use of money under various constraints. He or
she should, therefore, be allowed to devote his or her full energy and time in managing the money
resources only.
4. What are the basic financial decisions? How do they involve risk-return trade-off?
5. “The profit maximisation is not an operationally feasible criterion”. Do you agree? Illustrate
your views.
6. In what ways is the wealth maximisation objective superior to the profit maximisation objective?
Explain.
7. “The basic rationale for the objective of shareholders’ wealth maximisation is that it reflects
the most efficient use of society’s economic resources and thus leads to a maximisation
of society’s economic wealth” (Ezra Solomon). Comment critically. no the management has to harmoize the intersts of shareholders
with stakeholders
8. How should the finance function of an enterprise be organised? What functions do
the financial officer perform?
9. Should the titles of controller and treasurer be adopted under Indian context? Would you like
to modify their functions in view of the company practices in India? Justify your opinion.
10. When can there arise a conflict between shareholders’ and managers’ goals? How does
wealth maximisation goal take care of this conflict?
Self-Instructional Material 23
8- CFO has both line and staff responsibilities. He or she is directly concerned with the financial
planning and control. He or she is a member of the top management, and he or she is closely
associated with the formulation of policies and making decisions for the firm.
10- the conflict arising when the manager seeks acheiving thier interests over the shareholders interests and try to make high incentives
for thierselves, increase their salaries and so on.
and wealthy goal take care on this by provide them ownership rights as stock
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