INTRODUCTION TO FINANCIAL MANAGEMENT

Scope of Financial Management

The three most important activities of a business firm are

1. Production 2. Marketing 3. Finance

Tangible Assets Intangible Assets Primary Capital Markets Secondary Capital Markets Equity and Borrowed Funds

Finance Functions
1. Investment or Long Term Asset Mix Decision Function of investing raised funds in assets are known as investment decision
- The 2 important aspect of investment decision are (a) Evaluation of the prospective profitability of new investments (b) the measurement of a cut-off rate; against that the prospective return of new investments could be compared. - Capital budgeting decisions - Replacement decisions

2. Financing or Capital Mix Decision

The functions of raising funds are known as financing decision. The central issue is to determine the appropriate proportion of equity and debt. The mix of debt and equity is known as the firms capital structure.

Finance Functions
3. Dividend or Profit Allocation Decision
Distributing returns earned from assets to shareholders are known as dividend decision. The financial manager must decided whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. The proportion of profits distributed as dividends is called the dividend payout ratio and the retained portion of profits is known as retention ratio. Dividends are generally paid in cash, but it can also be given in form of bonus shares.

4. Liquidity or Short Term Asset Mix Decision

A firm attempts to balance cash inflows and outflows while performing these functions. These are called liquidity decisions. Current asset management affect the firms liquidity. A proper trade-off must be achieved between profitability and liquidity.

Financial Manager Role

1. 2. 3. 4. Funds Raising Funds Allocation Profit Planning Understanding Capital Markets

What should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize Earning per share? Maximize the current value of the companys stock?

Financial Goal

Financial Goal
Profit Maximization
Profit maximization implies maximizing the profit out of given amount of resources. Its limitations are It is vague. It ignores the time value of money. It ignores risk.

Maximizing EPS
Ignores timing and risk of the expected benefit Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of returnsuch a policy may not always work

 Maximizes the net present value of a course of action to shareholders. Net present value (NPV) or wealth of a course of action is the difference between the present value of its benefits and present value of its cost. Accounts for the timing and risk of the expected benefits. Return = Risk-free rate + Risk Premium Agency relationship Principal hires an agent to represent their interest Stockholders (principals) hire managers (agents) to run the company Agency problem Conflict of interest between principal and agent

Shareholders Wealth Maximization

The Agency Problem