Unit I

Introduction
In our present day economy, finance is defined as the provision of money at
the time when it is required. Every enterprise, whether big, medium or small,
needs finance to carry on its operations and to achieve its targets. In fact,
finance is so indispensable today that it is rightly said to be the lifeblood of
an enterprise. Without adequate finance, no enterprise can possibly
accomplish its objectives.
The subject of finance has been traditionally classified into two classes:
(i) Public Finance; and
(ii) Private Finance.
Public finance deals with the requirements, receipts and disbursements of
funds in the government institutions like states, local self-governments and
central government. Private finance is concerned with requirements, receipts
and disbursements of funds in case of an individual, a profit seeking business
organization and a non-profit organization.
Thus, private finance can be classified into:
(i) Personal finance;
(ii) Business finance; and
(iii) Finance of non-profit organizations.

Personal finance deals with the analysis of principles and practices involved
in managing ones own daily need of funds. The study of principles,

practices, procedures, and problems concerning financial management of

profit making organizations engaged in the field of industry, trade, and
commerce is undertaken under the discipline of business finance.
The finance of non-profit organization is concerned with the practices,
procedures and problems involved in financial management of charitable,
religious, educational, social and other similar organizations.
Meaning of Business Finance:
Literally speaking, the term business finance connotes finance of business
activities.
It is composed of two words:
(i) Business, and
(ii) Finance.
Thus, it is essential to understand the meaning of the two words, business
and finance, which is the starting point to develop the whole concept and
meaning of the term business finance.
The word business literally means a state of being busy. All creative
human activities relating to the production and distribution of goods and
services for satisfying human wants are known as business. It also includes
all those activities which indirectly help in production and exchange of goods,
such as, transport, insurance, banking and warehousing, etc.
Broadly speaking
commerce.

the

term

business

includes

industry,

trade

and

Finance may be defined as the provision of money at the time when it is

required. Finance refers to the management of flows of money through an
organization. It concerns with the application of skills in the manipulation,
use and control of money. Different authorities have interpreted the term
finance differently.
However, there are three main approaches to finance:

(i) The first approach views finance as to providing of funds needed by a

business on most suitable terms. This approach confines finance to the
raising of funds and to the study of financial institutions and instruments
from where funds can be procured.
(ii) The second approach relates finance to cash.
(iii) The third approach views finance as being concerned with rising of funds
and their effective utilization.
Having studied the meaning of the two terms business and finance; we can
develop the meaning of the term business finance as an activity or a
process which is concerned with acquisition of funds, use of funds and
distribution of profits by a business firm. Thus, business finance usually deals
with financial planning, acquisition of funds, use and allocation of funds and
financial controls.
Business finance can further be sub-classified into three categories, viz.;
(i) Sole-Propritory finance,
(ii) Partnership firm finance, and
(iii) Corporation or company finance.

The above classification of business finance is based upon the three major
forms of organization for a business firm. In sole proprietorship form of
organization, a single individual promotes, finances, controls and manages
the business enterprise. He also bears the whole risk of business.
A partnership, on the other hand, is an association of two or more persons to
carry on as co-owners of a business and to share its profits and losses. It may
come into existence either as a result of the expansion of sole-trade business
or by an agreement between two or more persons.

The liability of the partners is unlimited and they collectively share the risks
of the business. A joint stock company or a corporation is an association of
many persons who contribute money or moneys worth to a common stock
and employs it in some trade or business and who share profit and loss
arising there from.
In the words of Chief Justice Marshall, a corporation is an artificial being,
invisible, intangible and existing only in contemplation of the law. Being a
mere creation of law, it possesses only the properties which the charter of its
creation confers upon it either expressly or as incidental to its very
existence.
Corporation is a legal entity having limited liability, perpetual succession and
a common seal. A corporation is regarded as something different from its
owners. The assets of the corporation are owned by it rather than its
members and a corporations liabilities are the obligations of the corporation,
not the owners or the members.

Definition of Financial Management:

Corporation finance or broadly speaking business finance can be defined as

the process of rising, providing and administering of all money/funds to be
used in a corporate (business) enterprise.
Wheeler defines business finance as, That business activity which is
concerned with the acquisition and conservation of capital funds in meeting
the financial needs and overall objectives of business enterprise.
According to Guthmann and Dougall, Business finance can be broadly defined as the
activity concerned with the planning, raising, controlling and administering the funds used
in the business.

In the words of Prather and Wert, Business finance deals primarily with
raising, administering and disbursing funds by privately owned business
units operating in non-financial fields of industry.
According to the Encyclopedia of Social Sciences, Corporation finance deals
with the financial problems of corporate enterprises. These problems include
the financial aspects of the promotion of new enterprises and their
administration during early development, the accounting problems
connected with the distinction between capital and income, the
administrative questions created by growth and expansion, and finally, the
financial adjustments required for the bolstering up or rehabilitation of a
corporation which has come into financial difficulties.
Thus, the scope of corporation finance is so wide as to cover the financial
activities of a business enterprise right from its inception to its growth and
expansion and in some cases to its winding up also. Corporation finance,
usually, deals with financial planning, acquisition of funds, use and allocation
of funds, and financial controls.
To sum up in simple words, we can say that financial management as
practiced by corporate (business) firms can be called corporation finance or
business finance. Finance function has become so important that it has given
birth to Financial Management as a separate subject.
Financial management refers to that part of the management activity which
is concerned with the planning and controlling of firms financial resources.
It deals with finding out various sources for raising funds for the firm. The
sources must be suitable and economical for the needs of the business. The
most appropriate use of such funds also forms a part of financial
management. As a separate managerial activity, it has a recent origin. This
draws heavily on Economics for its theoretical concepts.
In the words of Weston and Brigham, Financial management is an area of financial decisionmaking, harmonizing individual motives and enterprise goals.
J.F.Bradley defines financial management as, The area of the business
management devoted to a judicious use of capital and a careful selection of
sources of capital in order to enable a spending unit to move in the direction
of reaching its goals.

According to J.L. Massie, Financial management is the operational activity of

a business that is responsible for obtaining and effectively utilizing the funds
necessary for efficient operations.
Howard and upon are of the opinion that financial management is the
application of the planning and control functions to the finance function.

Evolution of Financial Management:

Corporation finance emerged as a distinct field of study only in the early part
of this century as a result of consolidation movement and formation of large
sized business undertakings. In the initial stages of the evolution of
corporation finance, emphasis was placed on the study of sources and forms
of financing the large sized business enterprises.
The grave economic recession of 1930s rendered difficulties in rising finance
from banks and other financial institutions. Thus, emphasis was laid upon
improved methods of planning and control, sound financial structure of the
firm and more concern for liquidity. The ways and means of evaluating the
credit worthiness of firms were developed.
The post-World War II era necessitated reorganization of industries and the
need for selecting sound financial structure. In the early 50s the emphasis
shifted from the profitability to liquidity and from institutional finance to day
to day operations of the firm. The techniques of analyzing capital investment
in the form of capital budgeting were also developed.
Thus, the scope of financial management widened to include the process of
decision-making within the firm.
The modern phase began in mid-fifties and the discipline of corporation
finance or financial management has now become more analytical and
quantitative. 1960s witnessed phenomenal advances in the theory of
portfolio analysis by Microwitz, Sharpe, Lintner etc. Capital Asset Pricing
Model (CAPM) was developed in I970s.
The CAPM suggested that some of the risks in investments can be
neutralized by holding of diversified portfolio of securities. The Option

Pricing Theory was also developed in the form of the Binomial Model and the
Black-Scholes Model during this period. The role of taxation in personal and
corporate finance was emphasized in 80s.
Further, newer avenues of raising finance with the introduction of new capital
market instruments such as PCDs, FCDs, PSBs and CPPs etc. were also
introduced. Globalization of markets has witnessed the emergence of
Financial Engineering which involves the design, development and
implementation of innovative financial instruments and the formulation of
creative optimal solutions to problems in finance.
The techniques of models, mathematical programming and simulations are
presently being used in corporation finance and it has achieved the prime
place of importance. We may conclude that financial management has
evolved from a branch of economics to a distinct subject of detailed study of
its own.

Importance of Financial Management:

Finance is the life blood and nerve centre of a business, just as circulation of
blood is essential in the human body for maintaining life, finance is very
essential to smooth running of the business. It has been rightly termed as
universal lubricant which keeps the enterprise dynamic. No business,
whether big, medium or small can be started without an adequate amount of
finance.
Right from the very beginning, i.e. conceiving an idea to business, finance is
needed to promote or establish the business, acquire fixed assets, make
investigations such as market surveys, etc., develop product, keep men and
machine at work, encourage management to make progress and create
values. Even an existing concern may require further finance for making
improvements or expanding the business.
Thus, the importance of finance cannot be over-emphasized and the subject
of business finance has become utmost important both to the academicians
and practicing managers. The academicians find interest in the subject
because the subject is still in its developing stage and the practicing
managers are interested in the subject because among the most crucial
decisions of a firm are those related to finance.

The importance of corporation finance (which is a constituent of business

finance) has arisen because of the fact that present day business activities
are predominantly carried on company or corporate form of organization.
The advent of corporate enterprises has resulted into:
(i) The increase in size and influence of the business enterprises,
(ii) Wide distribution of corporate ownership, and
(iii) Separation of ownership and management.
The above three factors have further increased the importance of
corporation finance. As the owners (shareholders) in a corporate enterprise
are widely scattered and the management is separated from the ownership,
the management has to ensure the maximization of owners economic
welfare.
The success and growth of a firm depends upon adequate return on its
investment. The investors or shareholders can be attracted by a firm only by
maximization of their wealth through the application of principles and
procedures as laid down by Corporation Finance.
The knowledge of the discipline of Corporation Finance is important not only
to the practicing managers, but also to others who deal with a corporate
enterprise, such as investors, lenders, bankers, creditors, etc., as there is
always a scope for the management to manipulate and window dress the
financial statements.
In the present day capitalistic regime, the size of the business enterprises is
increasing resulting into corporate empires empowered with a lot of social
and political influence. This makes corporation finance all the more
important.
Further, if we refer to corporation finance as the financial management
practiced by business firms, the importance of financial management can
well be described as the importance of corporation finance.
Financial management is applicable to every type of organization,
irrespective of its size, kind or nature. It is as useful to a small concern as to

a big unit. A trading concern gets the same utility from its application as a
manufacturing unit may expect.
This subject is important and useful for all types of ownership organizations.
Where there is a use of finance, financial management is helpful. Every
management aims to utilize its funds in a best possible and profitable way.
So this subject is acquiring a universal applicability.
Financial management is indispensable to any organization as it helps in:

Financial planning and successful promotion of an enterprise;

Acquisition of funds as and when required at the minimum possible

cost;

Proper use and allocation of funds;

Taking sound financial decisions;

Improving the profitability through financial controls;

Increasing the wealth of the investors and the nation; and

Promoting and mobilizing individual and corporate savings.

Factors Influencing Financial Decisions:

There are a number of (both external as well as internal) factors that

influence the financial decisions.
A list of the important external as well as internal factors influencing the decisions is given
below:
External Factors:
i. State of economy
ii. Structure of capital and money markets.
iii. Requirements of investors

iv. Government policy

v. Taxation policy
vi. Lending policy of financial institutions.
Internal Factors:
i. Nature and size of business
ii. Expected return, cost and risk
iii. Composition of assets
iv. Structure of ownership
v. Trend of earnings
vi. Age of the firm
vii. Liquidity position
viii. Working capital requirements
ix. Conditions of debt agreements.

Nature and scope of Financial Management

Financial management is one of the important aspects in finance. Finance

links itself directly to several functional departments like marketing,
production and personnel.
Here we will list out some of the major scope of financial management which
will help in decision making process.
Key Scope of Financial Management. Major scope of financial management
are divided in four categories. Lets learn and understand about the nature
and scope of financial management through the below details notes.
1. Investment Decision:

Evaluating the risk involved, measuring the cost of fund and estimating
expected benefits from a project comes under investment decision. It
is one of the important scope of financial management. The two major
components of investment decision are Capital budgeting and
liquidity. Capital budgeting is commonly known as the investment
appraisal. It deals with the allocation of capital and funds in such a
manner that they will yield earnings in future. Capital budgeting
determines the long term investment which includes replacement and
renovation of old assets. It is all about maintaining an appropriate
balance between fixed and current assets in order to maximize
profitability and to maintain desired liquidity in the firm for its smooth
functioning.
2. Working Capital Decision:
Decision related to working capital is another crucial scope of financial
management. Decisions involving around working capital and short
term financing are known as working capital decision. It also manages
the relationship between short term assets and its liabilities. Short
term assets include cash in hand, receivables, inventory, short-term
securities, etc. Creditors, bills payable, outstanding expenses, bank
overdraft, etc are a firms short term liabilities. Short term assets can
be exchanged with cash within one calendar year. Similarly, the
liabilities are to be settled within an accounting year.
3. Dividend Decision:
The Dividend Decision plays a crucial role in todays corporate era. It
determines the amount of taxation that stockholders pay. A good
dividend policy helps to achieve the objective of wealth maximization.
Distributing the entire profit in the form of dividends or distributing
only a certain percentage of it is decided by dividend policy. It is known
as deciding the optimum dividend payout ratio i.e. proportion of net
profits to be paid out to shareholders. Stability of cash dividends and
stock sets the parameter which determines the number of investment
opportunities. Expansion of an economic activity depends on
effectiveness of dividend decisions and scope of financial
management.
4. Financing Decision:
Financing Decisions focuses on the accountabilities and stockholders
equity side of the firms balance sheet, for example decision to issue
bonds is a kind of financing decision. The main aim of financing
decision is to cover expenses and investments. The decision involves

generating capitals by various methods, from different sources, in

relative proportion and considering opportunity costs, with respect to
time of flotation of securities, etc.
Scope of financial management is to meet the expenses of the firm, a
suitable capital structure for the enterprise should be developed by the
finance manager.
Only an optimum finance mix can maximize the market price of the
companys shares in the long run. To decrease the risk, a stable equilibrium
is required between debt and equity.
Return and risk to the equity shareholders depends on how optimally the
debts and financial leverages are used. Only when the risk and return are in
synchronization, the market value per share is maximized. The apt timing for
raising funds is to be decided by the financial manager time to raise the
funds.

Financial Goals

All businesses aim to maximize their profits, minimize their expenses and
maximize their market share. Here is a look at each of these goals.
Maximize Profits A company's most important goal is to make money and
keep it. Profit-margin ratios are one way to measure how much money a
company squeezes from its total revenue or total sales.
There are three key profit-margin ratios: gross profit margin, operating profit
margin and net profit margin.
1. Gross Profit Margin
The gross profit margin tells us the profit a company makes on its cost of
sales or cost of goods sold. In other words, it indicates how efficiently
management uses labor and supplies in the production process.
Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
Suppose that a company has $1 million in sales and the cost of its labor and
materials amounts to $600,000. Its gross margin rate would be 40% ($1
million - $600,000/$1 million).

The gross profit margin is used to analyze how efficiently a company is using
its raw materials, labor and manufacturing-related fixed assets to generate
profits. A higher margin percentage is a favorable profit indicator.
Gross profit margins can vary drastically from business to business and from
industry to industry. For instance, the airline industry has a gross margin of
about 5%, while the software industry has a gross margin of about 90%.
2. Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating
profit margins show how successful a company's management has been at
generating income from the operation of the business:
Operating Profit Margin = EBIT/Sales
If EBIT amounted to $200,000 and sales equaled $1 million, the operating
profit margin would be 20%.
This ratio is a rough measure of the operating leverage a company can
achieve in the conduct of the operational part of its business. It indicates
how much EBIT is generated per dollar of sales. High operating profits can
mean the company has effective control of costs, or that sales are increasing
faster than operating costs. Positive and negative trends in this ratio are, for
the most part, directly attributable to management decisions.
Because the operating profit margin accounts for not only costs of materials
and labor, but also administration and selling costs, it should be a much
smaller figure than the gross margin.
3. Net Profit Margin
Net profit margins are those generated from all phases of a business,
including taxes. In other words, this ratio compares net income with sales. It
comes as close as possible to summing up in a single figure how effectively
managers run the business:
Net Profit Margins = Net Profits after Taxes/Sales
If a company generates after-tax earnings of $100,000 on its $1 million of
sales, then its net margin amounts to 10%.
Often referred to simply as a company's profit margin, the so-called bottom
line is the most often mentioned when discussing a company's profitability.

Again, just like gross and operating profit margins, net margins vary between
industries. By comparing a company's gross and net margins, we can get a
good sense of its non-production and non-direct costs like administration,
finance and marketing costs.
For example, the international airline industry has a gross margin of just 5%.
Its net margin is just a tad lower, at about 4%. On the other hand, discount
airline companies have much higher gross and net margin numbers. These
differences provide some insight into these industries' distinct cost
structures: compared to its bigger, international cousins, the discount airline
industry spends proportionately more on things like finance, administration
and marketing, and proportionately less on items such as fuel and flight crew
salaries.
In the software business, gross margins are very high, while net profit
margins are considerably lower. This shows that marketing and
administration costs in this industry are very high, while cost of sales and
operating costs are relatively low.
When a company has a high profit margin, it usually means that it also has
one or more advantages over its competition. Companies with high net profit
margins have a bigger cushion to protect themselves during the hard times.
Companies with low profit margins can get wiped out in a downturn. And
companies with profit margins reflecting a competitive advantage are able to
improve their market share during the hard times, leaving them even better
positioned when things improve again.
Like all ratios, margin ratios never offer perfect information. They are only as
good as the timeliness and accuracy of the financial data that gets fed into
them, and analyzing them also depends on a consideration of the company's
industry and its position in the business cycle. Margins tell us a lot about a
company's prospects, but not the whole story.

Minimize cost
Companies use cost controls to manage and/or reduce their business expenses. By identifying
and evaluating all of the business's expenses, management can determine whether those costs are
reasonable and affordable. Then, if necessary, they can look for ways to reduce costs through
methods such as cutting back, moving to a less expensive plan or changing service providers.
The cost-control process seeks to manage expenses ranging from phone, internet and utility bills
to employee payroll and outside professional services.

To be profitable, companies must not only earn revenues, but also control costs. If costs are too
high, profit margins will be too low, making it difficult for a company to succeed against its
competitors. In the case of a public company, if costs are too high, the company may find that its
share price is depressed and that it is difficult to attract investors.
When examining whether costs are reasonable or unreasonable, it's important to consider
industry standards. Many firms examine their costs during the drafting of their annual budgets.
Maximize Market Share
Market share is calculated by taking a company's sales over a given period and dividing it by the
total sales of its industry over the same period. This metric provides a general idea of a
company's size relative to its market and its competitors. Companies are always looking to
expand their share of the market, in addition to trying to grow the size of the total market by
appealing to larger demographics, lowering prices or through advertising. Market share increases
can allow a company to achieve greater scale in its operations and improve profitability.
The size of a market is always in flux, but the rate of change depends on whether the market is
growing or mature. Market share increases and decreases can be a sign of the relative
competitiveness of the company's products or services. As the total market for a product or
service grows, a company that is maintaining its market share is growing revenues at the same
rate as the total market. A company that is growing its market share will be growing its revenues
faster than its competitors. Technology companies often operate in a growth market, while
consumer
goods
companies
generally
operate
in
a
mature
market.
New companies that are starting from scratch can experience fast gains in market share. Once a
company achieves a large market share, however, it will have a more difficult time growing its
sales because there aren't as many potential customers available.
Conflict of interest between the stakeholders

Stockholders and managers have their own goals for a company. In an ideal situation, managers'
goals will be the same as the goals set forward by the stockholders via the board of directors.
Unfortunately, this is not always the case. As an owner of a business you need to acknowledge
that the goals set by you and your fellow shareholders may differ from those of your managers;
acknowledging this allows you to make changes and to bring your goals into alignment.

Stockholders' Goals
In general, stockholders have one chief goal: increasing the value of the company. This goal can
manifest itself in a variety of measures, such as stock price, profitability or market share.
Individual stockholders don't set goals, however; they are ultimately set by the directors chosen

by the stockholders. If you are a majority shareholder in your company, you can dictate these
goals, but otherwise your influence is equal to your share of ownership.

Managers' Goals
Managers will have specific goals set for them, such as sales levels, customer satisfaction or
increased market share. Additionally, managers will have their own personal goals. These may
include financial goals, career goals or simply ego-based goals. The goals that are set for the
manager may or may not be in line with the manager's personal goals.

Principal-Agent Problem
The principal-agent problem can occur when a principal hires an agent on his behalf. When
stockholders hire managers, they expect them to act as agents for them, attempting to meet the
stockholders' goals. Adding to this is the fact that stockholders cannot directly supervise their
managers, creating information asymmetry where the stockholders don't know exactly what the
manager is doing or if it is in line with their goals. For example, a manager may meet his own
goals by awarding a contract to a company that he owns an interest in, instead of the most
qualified company.

Aligning Goals
Stockholders should take care to align their own goals with the goals of their managers. One of
the simplest ways to do this is to pay managers partially in stock, making them stockholders
themselves who have an interest in seeing the company succeed. Alternatively, stockholders can
set specific goals and provide bonuses for meeting the goals. Additionally, stockholders can
monitor the managers more closely, for example hiring outside consultants to evaluate the work
performed by managers.

The agency view of the corporation suggests that the decision rights of the corporation
should be entrusted to a manager to act in shareholders' interests. Agency costs mainly
occur when ownership is separated, or when managers have objectives other than
shareholder value maximization.
Typically, the CEO and other top executives are responsible for making decisions about
high-level policy and strategy. Shareholders, on the other hand, are individuals or
institutions that legally own shares of corporation stock. Shareholders typically concede
control rights to managers.
There are various conflicts of interest that can impact manager's decisions to act in
shareholders' interests. Management may, for example, buy other companies to expand
power. Venturing onto fraud, they may even manipulate financial figures to optimize
bonuses and stock-price-related options.
Contemporary discussions of corporate governance argue that corporations should respect
the rights of shareholders and help shareholders to exercise those rights. Disclosure and

transparency

are

intimately

intertwined

with

these

goals.

Different stakeholders have different objectives. The interests of different stakeholder

groups can conflict. For example:

Owners generally seek high profits and so may be reluctant to see the business pay high
wages to staff.

A business decision to move production overseas may reduce staff costs. It will therefore
benefit owners but work against the interests of existing staff who will lose their jobs.
Customers also suffer if they receive a poorer service

Functions of Financial Managers

Some of the major functions of a financial manager are as follows:

1.Estimating the Amount of Capital Required 2.Determining Capital Structure
3.Choice of Sources of Funds 4.Procurement of Funds 5.Utilization of Funds
6.Disposal of Profits or Surplus 7.Management of Cash 8.Financial Control.
Financial Manager is the executive who manages the financial matters of a
business.
The functions of Financial Manager are discussed below:
1. Estimating the Amount of Capital Required:
This is the foremost function of the financial manager. Business firms require
capital for:

Purchase of fixed assets.

Meeting working capital requirements.
Modernization and expansion of business.

The financial manager makes estimates of funds required for both short-term
and long-term.
2. Determining Capital Structure:
Once the requirement of capital funds has been determined, a decision
regarding the kind and proportion of various sources of funds has to be
taken. For this, financial manager has to determine the proper mix of equity
and debt and short-term and long-term debt ratio. This is done to achieve
minimum cost of capital and maximise shareholders wealth.

3. Choice of Sources of Funds:

Before the actual procurement of funds, the finance manager has to decide
the sources from which the funds are to be raised. The management can
raise finance from various sources like equity shareholders, preference
shareholders, debenture- holders, banks and other financial institutions,
public deposits, etc.
4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the
business. It might require negotiation with creditors and financial institutions,
issue of prospectus, etc. The procurement of funds is dependent not only
upon cost of raising funds but also on other factors like general market
conditions, choice of investors, government policy, etc.
5. Utilization of Funds:
The funds procured by the financial manager are to be prudently invested in
various assets so as to maximize the return on investment: While taking
investment decisions, management should be guided by three important
principles, viz., safety, profitability, and liquidity.
6. Disposal of Profits or Surplus:
The financial manager has to decide how much to retain for ploughing back
and how much to distribute as dividend to shareholders out of the profits of
the company. The factors which influence these decisions include the trend
of earnings of the company, the trend of the market price of its shares, the
requirements of funds for self- financing the future program and so on.
7. Management of Cash:
Management of cash and other current assets is an important task of
financial manager. It involves forecasting the cash inflows and outflows to
ensure that there is neither shortage nor surplus of cash with the firm.
Sufficient funds must be available for purchase of materials, payment of
wages and meeting day-to-day expenses.
8. Financial Control:
Evaluation of financial performance is also an important function of financial
manager. The overall measure of evaluation is Return on Investment (ROI).
The other techniques of financial control and evaluation include budgetary
control, cost control, internal audit, break-even analysis and ratio analysis.
The financial manager must lay emphasis on financial planning as well.

Changing financial environment and Emerging challenges faced by the Fin managers

Profit Maximization vs. Wealth Maximization

The financial management has come a long way by shifting its focus from
traditional approach to modern approach. The modern approach focuses on
wealth maximization rather than profit maximization. This gives a longer
term horizon for assessment, making way for sustainable performance by
businesses.
A myopic person or business is mostly concerned about short term benefits.
A short term horizon can fulfill objective of earning profit but may not help in
creating wealth. It is because wealth creation needs a longer term horizon
Therefore, financial management emphasizes on wealth maximization rather
than profit maximization. For a business, it is not necessary that profit should
be the only objective; it may concentrate on various other aspects like
increasing sales, capturing more market share etc, which will take care of
profitability. So, we can say that profit maximization is a subset of wealth and
being a subset, it will facilitate wealth creation.
Giving priority to value creation, managers have now shifted from traditional
approach to modern approach of financial management that focuses on
wealth maximization.

This leads to better and true evaluation of the

business. For e.g., under wealth maximization, more importance is given to cash flows rather
than profitability. As it is said that profit is a relative term, it can be a figure in some currency, it
can be in percentage etc. For e.g. a profit of say $10,000 cannot be judged as good or bad for a

business, till it is compared with investment, sales etc. Similarly, duration of earning the profit is
also important i.e. whether it is earned in short term or long term.
In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate
various alternatives for decision making, cash flows are taken into consideration. For e.g. to
measure the worth of a project, criteria like: present value of its cash inflow present value of
cash outflows (net present value) is taken. This approach considers cash flows rather than
profits into consideration and also use discounting technique to find out the worth of a project.
Thus, maximization of wealth approach believes that money has time value.
An obvious question that arises now is that how can we measure wealth. Well, a basic principle
is that ultimately wealth maximization should be discovered in increased net worth or value of
business. So, to measure the same, value of business is said to be a function of two factors
earnings per share and capitalization rate. And it can be measured by adopting following relation:
Value of business = EPS / Capitalization rate
At times, wealth maximization may create conflict, known as agency problem. This describes
conflict between the owners and managers of firm. As, managers are the agents appointed by
owners, a strategic investor or the owner of the firm would be majorly concerned about the
longer term performance of the business that can lead to maximization of shareholders wealth.
Whereas, a manager might focus on taking such decisions that can bring quick result, so that
he/she can get credit for good performance. However, in course of fulfilling the same, a manager
might opt for risky decisions which can put the owners objectives at stake.
Hence, a manager should align his/her objective to broad objective of organization and achieve a
tradeoff between risk and return while making a decision; keeping in mind the ultimate goal of
financial management i.e. to maximize the wealth of its current shareholders.