Nature of

Financial Management

Dr Saif Siddiqui
 Business Activities

 Production
 Marketing
 Finance
 Finance Functions

 Investment or Long Term Asset Mix Decision

 Financing or Capital Mix Decision
 Dividend or Profit Allocation Decision
 Liquidity or Short Term Asset Mix Decision
 Finance Manager’s Role

 Raising of Funds
 Allocation of Funds
 Profit Planning
 Understanding Capital Markets
 Financial Goals

 Profit maximization (profit after tax)

 Maximizing Earnings per Share
 Shareholder’s Wealth Maximization
 Profit Maximization

 Maximizing the Rupee Income of Firm

 Resources are efficiently utilized
 Appropriate measure of firm performance

 Serves interest of society also

 Objections to Profit
Maximization
 It is Vague
 It Ignores the Timing of Returns
 It Ignores Risk
 Assumes Perfect Competition
 Shareholders’ Wealth
Maximization
 Maximizes the net present value of a course
of action to shareholders.
 Accounts for the timing and risk of the
expected benefits.
 Benefits are measured in terms of cash
flows.
 Fundamental objective—maximize the
market value of the firm’s shares.
 Risk-return Trade-off

 the greater the risk, the greater the return.

 Financial decisions of the firm are guided
by the risk-return trade-off.
 Risk-return Trade-off

 The return and risk relationship:

Return = Risk-free
rate + Risk premium
 Risk-free rate is a compensation for time
and risk premium for risk.
 Managers Versus Shareholders’
Goals

 Managers may perceive their role as reconciling

conflicting objectives of stakeholders.
 Managers may pursue their own personal goals
at the cost of shareholders,
 may play safe and create satisfactory wealth for
shareholders than the maximum.
 Organisation of the Finance
Functions

 Reason for placing the finance functions in the

hands of top management
 crucial for the survival of the firm.

 determine solvency of the firm

 can result in a number of economies to the

firm.
Concepts of Value
and Return
 Time Preference for Money

 Time preference for money

 is an individual’s preference
 for possession of a given amount of
money now,
 rather than the same amount
 at some future time.
 Time Preference for Money

 Three reasons may be attributed to the

individual’s time preference for money:
 risk
 preference for consumption
 investment opportunities
 Required Rate of Return

 The time preference for money is expressed

by an interest rate.
 This rate ,in the absence of any risk, called
the risk-free rate.
 investor requires compensation for assuming
risk, which is called risk premium.
 Required Rate of Return

 The investor’s required rate of return is:

Risk-free rate + Risk premium.
 Time Value Adjustment

 Two most common methods of adjusting cash

flows for time value of money:
 Compounding—the process of calculating
future values of cash flows and
 Discounting—the process of calculating
present values of cash flows.
 Future Value

 Compound interest is the interest that is received

on the original amount (principal) as well as on
any interest earned but not withdrawn during
earlier periods.
 Simple interest is the interest that is calculated
only on the original amount (principal), and thus,
no compounding of interest takes place.
 Present Value

 Present value of a future cash flow (inflow or

outflow) is the amount of current cash that is of
equivalent value to the decision-maker.
 Discounting is the process of determining present
value of a series of future cash flows.
 The interest rate used for discounting cash flows
is also called the discount rate.
 Example

 Suppose that an investor wants to find out the

present value of Rs 50,000 to be received after
15 years. Her interest rate is 9 per cent. First, we
will find out the present value factor, which is
0.275. Multiplying 0.275 by Rs 50,000, we
obtain Rs 13,750 as the present value:

PV = 50,000  PVF15, 0.09 = 50,000  0.275 = Rs 13,750

 Net Present Value

 Net present value (NPV) of a financial

decision is the difference between the
present value of cash inflows and the
present value of cash outflows.
n
Ct
NPV =  t
 C0
t 1 (1 + k )
 Internal Rate of Return

 The rate of return of an investment is called

internal rate of return since it depends
exclusively on the cash flows of the investment.
 The formula for Internal Rate of Return is given
below. Here, all parameters are given except ‘r’
which can be found by trial and error.
n
Ct
NPV =  t
 C0  0
t 1 (1 + r )