Chapter - 1 Financial Management An Introduction

Text Book Material adopted for classroom purpose

Business Activities
The Financial Managers role has become more

significant in the past few decades . It has, therefore, become imperative that he is thoroughly equipped with an in depth study of Financial Management which enables him to analyze and identify the most profitable financial choices for his Company.
Business Firms have the following main activities
Production Marketing Finance
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Finance Functions
Various Finance activities happen in a Company

simultaneously . It is not necessary that they happen in a sequence.

There are mainly four functions of finance in an

organization.
Investment or Long Term Asset Mix Decision
Financing or Capital Mix Decision Dividend or Profit Allocation Decision Liquidity or Short Term Asset Mix Decision The functions of a finance manager requires good
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planning, control, review and execution . Special skills in

Investment Decisions
There are two aspects to an investment decision.

To find out the future profitability or the present value of future cash flows arising out of that Investment 2. Benchmarking a minimum or cut-off rate of return against which the future rates of return from the investment could be compared.
1. Financial Managers have agreed that this cut-off rate

would be equal to the opportunity cost of capital. Opportunity cost of capital is the rate of return that could be expected by the investor in employing his funds in an alternative investment bearing equivalent risk.

Financing Decision
This function involves deciding when, from where,

how much and how funding or financing should take place to meet the investment requirement.
The proportion at which Debt and Equity of a

Company is mixed is called the capital structure of the company. The Finance manager will obviously strive to get the optimum capital structure which would maximize the market value of shares.
Finance Managers consider various other factors too

in deciding the capital structure . To name a few Flexibility to operate , legal commitments or bindings, Control and loan conditions.

Dividend Decision
Profits that are distributed as dividends form the

dividend pay-out ratio and the retained portion of profit in the business is called retention ratio.
Bonus shares is another form of returns

distributed to existing shareholders without any charge or receipt of money from them.
Finance Manager strives to follow an optimum

dividend policy which is nothing but maximization of the market value of the shares.

Liquidity Decision
Current Assets should be managed efficiently so that

there is neither any idle asset nor an exposure of the firm to a position of liquidity crunch. In its attempt to maximize profit the Company should not end up becoming illiquid which may, at times, even lead to insolvency.
A conflict exists between profitability and liquidity and

the profitability-liquidity trade-off requires that the finance manager manages the current assets such that he is able to provide funds whenever needed for the Companys operations.
He has to ensure that the assets of the company are

not wastefully allowed to idle away without earning any profits.

Finance Managers Role

Raising of Funds
Allocation of Funds Profit Planning

Understanding Capital Markets

Financial Goals
Profit maximization (profit after tax)

Maximizing Earnings per Share

Shareholders Wealth Maximization

Profit Maximization
Maximizing the Rupee Income of Firm
Resources are efficiently utilized Appropriate measure of firm performance Serves interest of society also

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Objections to Profit 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.

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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

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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 objectivemaximize the market value of the firms shares.

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Risk-return Trade-off
Risk and expected return move in tandem; the

greater the risk, the greater the expected return. 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.

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Managers Versus Shareholders Goals

A company has stakeholders such as employees, debt-

holders, consumers, suppliers, government and society. Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders view of managers role may compromise with the objective of SWM. Managers may pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum. 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.
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Financial Goals and Firms Mission and Objectives

Firms primary objective is maximizing the welfare of

owners, but, in operational terms, they focus on the satisfaction of its customers through the production of goods and services needed by them Firms state their vision, mission and values in broad terms Wealth maximization is more appropriately a decision criterion, rather than an objective or a goal. Goals or objectives are missions or basic purposes of a firms existence

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Financial Goals and Firms Mission and Objectives

shareholders wealth maximization is the second-level criterion ensuring that the decision meets the minimum standard of the economic performance. In the final decision-making, the judgement of management plays the crucial role. The wealth maximization criterion would simply indicate whether an action is economically viable or not.
The

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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.

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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.

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Role of Treasurer and Controller

Two

more officersthe treasurer and the controllermay be appointed under the direct supervision of CFO to assist him or her. The treasurers function is to raise and manage company funds while the controller oversees whether funds are correctly applied.

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Conclusion
Organizations have realized the importance of the

role of Finance Managers and the Management of Finance. Earlier Finance Managers duties were combined with other functions. But not anymore. Funds Management a vital resource for the organisations survival and growth cannot be clubbed with other functions. Therefore, organizations spend substantial amount in recruiting CFOs with extraordinary skills in Financial Management who is allowed to focus his full time on this.