Ch-1- FM- overview.pdf

Chapter 1
FINANCIAL MANAGEMENT:
AN OVERVIEW

Contents:
1. Finance Functions/Scope of Financial Mgt.
2. Finance Manager’s Role.
3. Financial Goals/Objectives of Financial Management.
4. Shareholder Orientation in India.
5. Need for a Valuation Approach.
6. Finance and Management Functions.
7. Agency Problems.
8. Organisation of the Finance Functions
2

Finance Functions (Decisions)/Scope of Financial Mgt
Finance functions or decisions can be divided as follows:
• Long-term financial decisions
1. Investment Decision.
2. Financing Decision.
3. Dividend Decision.
• Short-term financial decisions
• Short-term asset-mix or liquidity decision or working capital
management.
3

Finance Functions/Scope of Financial Mgt. ……………………….
1. Investment Decision (Capital Budgeting):
• Long-term asset-mix or investment decision or capital budgeting
decisions.
• Yield benefits (cash flows) in future.
• Two important aspects:
1. Evaluation of prospective profitability of new
investment……uncertain…… expected return & risk (physical
volume of sales, level of prices etc.)
2. Measurement of cut-off rate/hurdle rate/required
rate/minimum rate of return…..opportunity cost of capital.

2. Financing Decision:
• When, where from and how to acquire funds.
 When should the firm raise finances?
 Which capital markets should the firm access?
 Which specific instruments of equity and debt finance should the firm employ?
 At what price should the firm offer its securities?
• Determine appropriate proportion of equity and debt (Capital Structure: optimum
when market value of shares is maximised).
• Absence of debt : Shareholder’s return = Firm’s return.
• Use of debt : Increase shareholder’s return but also increases risk.
• Change in shareholder’s return…..change in profits…..use of debt = Financial
Leverage.

3. Dividend Decision:
• Distribute all profits or retain them or distribute a portion and retain the
balance.
• The portion of profit distributed as dividend = Dividend Payout Ratio
(DPS).
• The retained portion of profits = Retention Ratio
• Decision should be taken in terms of impact on shareholder’s value.
• Dividend = Cash or Bonus Shares or Both.

Short-term asset-mix/Liquidity decision/Working capital Decision:
• Management of current assets and current liabilities.
• Investment in Current Assets
1. Liquidity: sufficient investment is made in current assets. Illiquidity can lead to
firm’s insolvency.
2. Profitability: Idle current assets would not earn anything.
• The key issues in working capital management are:
1. What is the optimal level of inventory for the operations of the firm?
2. Should the firm grant credit to its customers and, if so, on what terms?
3. How much cash should the firm carry on hand?
4. Where should the firm invest its temporary cash surpluses?
5. What sources of short-term finance are appropriate for the firm?
• Profit-Liquidity trade-off requires that the finance manager should develop sound
techniques of managing current assets.

Financial Procedures and Systems
• For effective finance function some routine functions have to be
performed. Some of these are:
 Supervision receipts and payments and safeguarding of cash
balances.
 Custody and safeguarding of securities, insurance policies and
other valuable papers.
 Taking care of the mechanical details of new outside financing.
 Record keeping and reporting.
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Finance Manager’s Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets
9
EMERGING ROLE OF THE FINANCIAL MANAGER IN INDIA
The job of the financial manager in India
has become more important, complex and
demanding due to the following factors:
• Liberalization
• Globalization
• Technological developments
• Volatile financial prices
• Economic uncertainty
• Tax law changes
• Ethical concerns over financial dealings
• Shareholder activism
The key challenges for the financial
manager appear to be in the following
areas:
• Investment planning and resource
allocation.
• Financial structure.
• Working capital management.
• Mergers, acquisitions, and
restructuring
• Performance management
• Risk management
• Corporate governance
• Investor relations

Financial Goals/Objectives of Financial Management:
Profit Maximization vs Wealth Maximization
 The capital market sceptics argue that the
stock market displays myopic tendencies,
often wrongly prices securities, and fails to
reflect long-term values
 The strategic visionaries argue that the firms
should pursue a product market goal like
• maximizing the market share,
• enhancing customer satisfaction,
• minimizing costs in relation to competitors,
 The balancers argue that a firm should seek to
'balance' the interest of various stake-holders,
viz. customers, employees, share-holders,
creditors, suppliers, community and others.
Critique
 Extensive empirical evidence: in
developed capital markets, share prices
are the least biased estimates of intrinsic
values.
 It is true, however beyond a certain point
customer satisfaction comes at the cost
of shareholder value.
 There is no way to figure out what the
right 'balance' is: managers confront
complex problems involving numerous
tradeoffs, they will have no clear
guidelines on how to resolve the
differences.
Defence
There are three compelling arguments in support of the goal of shareholder wealth
maximization, viz., legal, economic, and decisional.

Financial Goals/Objectives of Financial Management:
Profit Maximization vs Wealth Maximization
 It is Vague
 It Ignores the Timing of Returns
 It Ignores Risk
 Assumes Perfect Competition
 In new business environment profit
maximization is regarded as:
• Unrealistic
• Difficult
• Inappropriate
• Immoral
11
Profit Maximization
 Efficient allocation and
utilization of resources.
 Appropriate measure of
firm performance.
 Serves interest of society
also.
Objections to Profit Maximization

1. Vague: Term profit is ambiguous. It has no precise connotation.
• Short term or long term profit.
• Profit before tax or after tax.
• Total profit or profit per share.
• Operating profit or total profit.
• Return on total capital employed or total assets or shareholder’s equity.
12
Objections to Profit Maximization
2. Time value of money: It ignores the difference in the time pattern of benefit
received over the working life of the asset.
Time Project A
(profits/benefits)
Project B
(profits/benefits)
I 50 ----
2 100 100
3 50 100
Total 200 200

3. Quality of returns: Degree of certainty with which benefits can be expected.
• The more certain the expected return, the higher is the quality of benefits.
• An uncertain and fluctuating return implies risk to the investors.
• It is assumed that investors are risk averters.
13
Objections to Profit Maximization:
Time/
State of Economy
Project A
(profits/benefits)
Project B
(profits/benefits)
I (Recession) 9 0
2 (Normal) 10 11
3 (Boom) 11 20
Total 30 30

Shareholders’ Wealth Maximization
1. It means maximizing the net present value (NPV) of a course of
action to shareholders.
• NPV= Present value of cash inflows - Present value of cash
outflows
• A financial decision with positive NPV creates wealth for
shareholders and therefore, is desirable.
• In case of mutually exclusive project, project with highest NPV
should be adopted.
2. Benefits are measured in terms of cash flows.
3. Accounts for the timing and risk (quality) of the expected benefits
through discount rate.
Fundamental objective—maximize the market value of the firm’s
shares.

Need for a Valuation Approach
• SWM requires a valuation model.
• The financial manager must know,
• How much should a particular share be worth?
• Upon what factor or factors should its value depend?
Risk-return Trade-off:
• Financial decisions of the firm are guided by
the 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.
Risk and expected return move in tandem; the greater the risk, the greater
the expected return.

Risk-return Trade-off
Capital
Budgeting
Decisions
Should the firm set up a plant
which has a capacity of one million
tons or two million tons?
Large Plant
• Return: High
• Risk: High
Small Plant
• Return: Return
• Risk: Low
Capital
Structure
Decisions
Should the debt-equity ratio of the
firm be 2:1 or 1:1?
High debt-equity ratio
• Return: High Tax Savings
• Risk: Increases
Low debt-equity ratio
• Return: Low Tax Savings
• Risk: Low
Dividend
Decisions
Should the firm retain or distribute
earnings?
High Dividend
• Return: High/Stable MPS
• Risk: External fund
dependence.
High Dividend
• Return: Dec./Stable MPS
• Risk: Less dependence on
external funds.
Working
Capital
Decisions
Should the firm pursue a generous
credit policy or niggardly credit
policy?
Should the firm carry a large
inventory or a small inventory?
Large Inv.
• Return: Low
• Risk: Low
Small Inv.
• Return: High
• Risk: High

Overview of Financial Management
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Finance and Economics:
• Macroeconomic environment defines the setting within which the firm
operates. GDP growth rate, savings rate, fiscal deficit, interest rates,
inflation rate, exchange rates, tax rates, and so on have an impact on the
firm.
• Knowledge of macroeconomics in necessary to understand the
environment in which the firm operates (opportunities and threats).
• Microeconomic theory provides the conceptual underpinnings for the
tools of financial decision making. Finance, in essence, is applied
microeconomics.
1. Principle of marginal analysis.
2. Opportunity cost: time value of money.
3. Price, demand and supply relationship etc.
Finance and Management Functions

Finance and Accounting:
• Accounting is concerned with score keeping, whereas finance is aimed at value
maximizing.
• The accountant prepares the accounting reports based on the accrual method.
The focus of the financial manager is on cash flows (magnitude, timing, risk of
cash flows).
• Accounting deals primarily with the past (more objective and certain). Finance
is concerned mainly with the future (more subjective and uncertain).
Finance and Other Disciplines:
• Marketing: Impact of new product development and promotion plans requires
assessment of capital outlays and impacts project cash flows.
• Production: Changes in production process requires capital expenditure.
• Quantitative Methods: Analysing complex financial management problems.
E.g..: Linear programing, Decision theory, transportation models, PERT/CPM
etc.

Shareholder Orientation in India
1. Foreign Exposure.
2. Greater dependence on capital market:
• Increase in investment opportunities for the private sector, due to
liberalization.
• Freedom in pricing equity issues.
3. Growing importance on institutional investors.
• Mutual funds, Private equity funds, Financial Institutions and Foreign
Institutional Investors.
4. Abolition of wealth tax on financial assets.
In the new environment there is a greater incentive and compulsion to focus on
creating value for shareholders.

Agency Problems: Managers Versus Shareholders’
Goals
Reasons of separation of ownership and management in
companies:
• Large number of shareholders: It is impractical for many owners to
participate actively in management.
• Professional managers: technical expertise, experience, and
personality traits.
• Unrestricted change in owners: the 'knowhow' of the firm is not
impaired, despite changes in ownership.
• Given economic uncertainties, investors would like to hold a
diversified portfolio of securities. Such diversification is achievable
only when ownership and management are separated.
21

Agency Problems: Managers Versus Shareholders’ Goals
• There is a Principal Agent relationship between managers and shareholders.
• In theory, Managers should act in the best interests of shareholders i.e. their
actions and decisions should lead to SWM. In practice, managers may maximise
their personal goals like :
 presiding over a big empire,
 pursuing their pet projects,
 diminishing their personal risks,
 and enjoying generous compensation and lavish perquisites tend to acquire
priority over shareholder welfare
• Managers may avoid taking high investment and financing risks that may
otherwise be needed to maximize shareholders’ wealth. Such “satisfying”
behaviour of managers will frustrate the objective of SWM as a normative guide.
• Managers may perceive their role as reconciling conflicting objectives of
stakeholders (employees, debenture holders, consumers, suppliers, government
and society). This stakeholders’ view of managers’ role may compromise with the
objective of SWM.
This conflict is known as Agency problem and it results into Agency costs.
22

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 lack of perfect alignment between the interests of managers and
shareholders results in the agency problem.
• To mitigate the agency problem, effective monitoring has to be done and
appropriate incentives have to be offered.
• Measures to mitigate the agency problem:
1. Behaviour of security market participants: Effective monitoring has to be
done.
 by bonding managers,
 by auditing financial statements,
 by limiting managerial discretion in certain areas,
 by reviewing the actions and performance of managers periodically, and so
on.
2. Appropriate incentives have to be offered: Stock Options, monetary and non
monetary incentives based on performance.
3. Hostile takeovers: The constant threat of takeover would motivate
management to act in the best interest of the owners. 23

Organisation of Finance Function
24
Organization for finance function
Organization for finance function
in a multidivisional company

Organisation of the Finance Functions
Reason for placing the finance functions in the hands of top management:
• Financial decisions are crucial for the survival of the firm.
• The financial actions determine solvency of the firm.
• Centralisation of the finance functions can result in a number of economies to
the firm.
25
Status and Duties of Finance Executives:
• The exact organisation structure for financial management will differ across
firms.
• The financial officer may be known as the financial manager in some
organisations, while in others as the vice-president of finance or the director of
finance or the financial controller.
Role of Treasurer and Controller:
• Two officers—the treasurer and the controller—may be appointed under the
direct supervision of CFO to assist him or her.
• The treasurer’s function is to raise and manage company funds while the
controller oversees whether funds are correctly applied.

Test Your Understanding
1. In a corporation, the ultimate decisions regarding business matters are made by:
A. The Board of Directors.
B. Debt holders.
C. Shareholders.
D. Investors.
26
2. The Principal-Agent Problem arises:
A. Because managers have little incentive to work in the interest of
shareholders when this means working against their own self-interest.
B. Because of the separation of ownership and control in a corporation.
C. Both A and B
D. None of the above
3. If shareholders are unhappy with a CEO's performance, they are most likely to:
A. Buy more shares in an effort to gain control of the firm.
B. File a shareholder resolution.
C. Replace the CEO through a grassroots shareholder uprising.
D. Sell their shares.

4. A ________ is when a rich individual or organization purchases a large fraction of
the stock of a poorly performing firm and in doing so gets enough votes to replace
the board of directors and the CEO.
A. Shareholder proposal
B. Leveraged buyout
C. Shareholder action
D. Hostile takeover
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5. Which of the following statements is FALSE?
A. In bankruptcy, management is given the opportunity to reorganize the firm
and renegotiate with debt holders.
B. Because a corporation is a separate legal entity, when it fails to repay its
debts, the people who lent to the firm, the debt holders are entitled to seize
the assets of the corporation in compensation for the default.
C. As long as the corporation can satisfy the claims of the debt holders,
ownership remains in the hands of the equity holders.
D. If the corporation fails to satisfy debt holders' claims, debt holders may lose
control of the firm.

6. The most senior financial manager in a corporation is usually called:
A. the chief executive officer.
B. the chief financial officer.
C. the chief operating officer.
D. the chairman of the board.
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7. You overhear your manager saying that she plans to book an Ocean-view
room on her upcoming trip to Miami for a meeting. You know that the
interior rooms are much less expensive, but that your manager is
traveling at the Company's expense. This use of additional funds comes
about as a result of:
A. an agency problem.
B. an adverse selection problem.
C. a moral hazard.
D. a publicity problem.

8. An agency problem can be alleviated by:
A. requiring all firms to be sole proprietorships.
B. compensating managers in such a way that acting in the best interest
of shareholders is also in the best interest of managers.
C. asking managers to take on more risk than they are comfortable
taking.
D. A and B.
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9. Do corporate decisions that increase the value of the firm's equity
benefit society as a whole?
A. Yes, as long as the value of the firm's equity increases, society is better
off.
B. Yes, as long as the increase in the value of the firm's equity does not
come at the expense of others.
C. No, any gain in the value of the firm's equity is always less than the
cost to society.
D. No, any gains in the value of the firm's equity are perfectly offset by
societal costs.

10. What strategies are available to shareholders to help ensure that
managers are motivated to act in the interest of the shareholders
rather than their own interest?
A. The threat of a hostile takeover
B. Shareholder initiatives
C. Performance based compensation
D. All of the above.
30
11. What type of company trades on an organized stock exchange?
A. A limited liability company
B. A private company
C. A Statutory corporation
D. A public company

12. If you buy shares of Coca-Cola on the primary market:
A. Coca-Cola receives the money because the company has issued
new shares.
B. you buy the shares from another investor who decided to sell
the shares.
C. you buy the shares from the New York Stock Exchange.
D. you buy the shares from the Federal Reserve.
31
13. If you buy shares of Coca-Cola on the secondary market:
new shares.
the shares.

12. If you buy shares of Coca-Cola on the primary market:
new shares.
the shares.
32
13. If you buy shares of Coca-Cola on the secondary market:
new shares.
the shares.

14. The objective of wealth maximization takes into account:
A. Amount of returns expected
B. Timing of anticipated returns
C. Risk associated with uncertainty of returns
D. All of the above
33
15. Match the following
List-I (Items) List-II (Features)
(A) Capital budgeting decision 1. Inventory Control
(B) Cash Position Ratio 2. Issue Expenses
(C) EOQ 3. Fixed Assets
(D) Cost of Capital 4. Liquid Ratio
5. Planning

16. "Shareholder wealth" in a firm is represented by:
A. the number of people employed in the firm.
B. the book value of the firm's assets less the book value of its liabilities
C. the amount of salary paid to its employees.
D. the market price per share of the firm's common stock
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17. The market price of a share of common stock is determined by:
A. the board of directors of the firm.
B. the stock exchange on which the stock is listed.
C. the president of the company.
D. individuals buying and selling the stock.
18. ___________________ of a firm refers to the composition of its long-term
funds and its capital structure.
A. Capitalisation
B. Over-capitalisation
C. Under-capitalisation
D. Market capitalization

19. XYZ is an oil based business company, which does not have adequate working
capital. It fails to meet its current obligation, which leads to bankruptcy. Identify
the type of decision involved to prevent risk of bankruptcy.
A. Investment decision
B. Dividend decision
C. Liquidity decision
D. Finance decision
35
20. A capital investment is one that
A. Has the prospect of long-term benefits.
B. Has the prospect of short-term benefits.
C. Is only undertaken by large corporations.
D. Applies only to investment in fixed assets

Ch-1- FM- overview.pdf

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