Chapter 1 FINANCIAL MANAGEMENT : AN OVERVIEW

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OUTLINE
Forms of Business Organisations
Financial Decisions in a Firm Goal of Financial Management The fundamental Principle of Finance Building Blocks of Modern Finance Risk-return Tradeoff Agency problem Business ethics and social responsibility Relationship of Finance to Economics and Accounting Emerging Role of the Financial Manager in India
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FORMS OF BUSINESS ORGANISATIONS

Sole Proprietorship
One owner Very simple Unlimited liability The firm has no separate status from a legal and tax point of view Partnership Two or more owners Fairly simple Unlimited liability The firm has a separate status

Private Limited Company

Upto 50 owners Not too complex Limited liability A distinct legal person
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FORMS OF ORGANISATION
Public Limited Company
Many owners Somewhat complex Limited liability Distinct legal person Free transferability of shares

Public Limited Companys Attraction

The potential for growth is immense because of access to substantial funds Investors enjoy liquidity because of free transferability of securities The scope for employing talented managers is greater
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ABBREVIATED COMPANY NAMES

Private UK Germany Japan Netherlands France Italy Ltd GmbH YK BV Sarl Srl Public plc AG KK NV SA SpA

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FINANCIAL DECISIONS IN A FIRM

Capital Budgeting

Capital Structure

Working Capital Management

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GOAL OF FINANCIAL MANAGEMENT FINANCE THEORY RESTS ON THE PREMISE THAT MANAGERS SHOULD MANAGE THEIR FIRMs RESOURCES WITH THE OBJECTIVE OF ENHANCING THE FIRMs MARKET VALUE. The quest for value drives scarce resources to their most productive uses and their most efficient users. The more effectively resources are deployed, the more robust will be the economic growth and the rate of improvement in our standard of living. Adam Smiths invisible hand is at work when investors private gain is a public value.
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CRITIQUE AND DEFENCE OF SHAREHOLDER WEALTH MAXIMISATION GOAL

Critique The capital market sceptics argue that stock prices fail to reflect true values Defence Financial economists argue that stock prices are the least biased estimates of intrinsic values in developed markets Balancing the interests of various stakeholders is not a practical governing objective The only social responsibility of business is to create value and do so legally and with integrity

The balancers argue that a firm should seek to balance the interests of various stakeholders Advocates of social responsibility argue that a business firm must assume wider social responsibilities

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SHAREHOLDER ORIENTATION IN INDIA

In the wake of liberalisation, globalisation, and institutionalisation of the capital market, there is a greater incentive to focus on creating value for shareholders. The following observations are clear indications. Dhirubai Ambani : In everything that we do, we have only one supreme goal, that is to maximise your wealth as India's largest investor family. Anand Mahindra : All of us are beginning to look at companies as owned by shareholders. The key is to raise shareholder returns
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ALTERNATIVE GOALS
Maximisation of Profit This goal is not as inclusive a goal as maximisation of shareholders wealth. Its limitations are: Profit in absolute terms is not a proper guide to decision making. It should be expressed either on a per share basis or in relation to investment. It leaves considerations of timing and duration undefined. It glosses over the factor of risk Maximisation of EPS or ROE While these goals do not suffer from the first limitation mentioned above, they suffer from the other two limitations.
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THE FUNDAMENTAL PRINCIPLE OF FINANCE

A business proposal-regardless of whether it is a new investment or acquisition of another company or a restructuring initiative raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal.
CASH ALONE MATTERS

Investors Shareholders Lenders

Investors provide the initial cash required to finance the business proposal

The business proposal

The proposal generates cash returns to investors

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EVOLUTION OF FINANCIAL MANAGEMENT

The study of financial management as a distinct field of study emerged in the early 20th Century. The evolution of the same can be divided into three phases:

y Traditional Phase (Early 1900s to 1940): Focused on

Formation, issuance of Capital, major expansion, merger, reorganization and liquidation in the life cycle of the firm. y Transitional Phase (1940 to 1950): Similar to Traditional Phase, focused shifted to working capital management. y Modern Phase (Mid 1950s): Focused shifted to rational matching of funds to their uses so as to maximize the wealth of shareholders. The approach has become more analytical and quantitative.

 Financial management emerged as a distinct field of study at the turn of the 20th century. Its evolution may be divided into three broad phases - the traditional phase, the transitional phase, and the modern phase. The modern phase began in mid-1950s and has been marked by infusion of ideas from economic theory and application of quantitative methods The distinctive features of the modern phase are: Central concern Approach : Shareholder wealth maximisation : Analytical and quantitative

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BUILDING BLOCKS OF MODERN FINANCE

y y y y y y

Efficient markets theory: Analysis of how prices theory: change over time in speculative markets. markets. Portfolio theory: Formation of an optimal portfolio theory: of securities. securities. Capital asset pricing theory: Determination of theory: asset prices under conditions of uncertainty. uncertainty. Option pricing theory: Determination of the prices theory: of contingent claims such as call options. options. Agency theory: Analysis of incentive conflicts in theory: contractual relations. relations. Behavioral Finance: Consideration of social, Finance: cognitive, and emotional factors that influence decisions. decisions.

DECISIONS, RETURN, RISK, AND MARKET VALUE

Capital Budgeting Decisions Return Market Value of the Firm Dividend Decisions Risk Working Capital Decisions

Capital Structure Decisions

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AGENCY PROBLEM
While there are compelling reasons for separation of ownership and management, a separated structure leads to a possible conflict of interest between managers and shareholders. 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.

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BUSINESS ETHICS AND SOCIAL RESPONSIBILITY

Business Ethics Business ethics refers to the standards of conduct or moral
behaviour as applied to business practices. Fraud involves violating the law, whereas unethical behaviour involves breaching the code of ethics or moral behaviour. In general, ethical behaviour and long-run profitability are positively correlated. Given the subjective nature of ethics, in many cases the choice between the ethics and profits is not unambiguous.
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BUSINESS ETHICS AND SOCIAL RESPONSIBILITY

Corporate Social Responsibility (CSR) The World Business Council: Corporate social responsibility
is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as the local community and society at large. While Hayek and Friedman argued that a business firm should not swerve from its economic goal, many business firms in practice do contribute to various social causes.
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ALL MANAGERS ARE FINANCIAL MANAGERS The engineer, who proposes a new plant, shapes the investment policy of the firm The marketing analyst provides inputs in the process of forecasting and planning The purchase manager influences the level of investment in inventories The sales manager has a say in the determination of the receivables policy Departmental managers, in general, are important links in the finance control system of the firm
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ORGANISATION OF FINANCE FUNCTION

Chief Finance Officer

Treasurer

Controller

Cash Manager

Credit Manager

Financial Accounting Manager

Cost Accounting Manager

Capital Budgeting Manager

Fund Raising Manager

Tax Manager

Data Processing Manager

Portfolio Manager

Internal Auditor

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RELATIONSHIP OF FINANCE TO 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 Microeconomic theory provides the conceptual underpinnings for the tools of financial decision making. Finance, in essence, is applied microeconomics
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RELATIONSHIP OF FINANCE TO ACCOUNTING

Accounting is concerned with score keeping, whereas

finance is aimed at value maximising. The accountant prepares the accounting reports based on the accrual method. The focus of the financial manager is on cash flows. Accounting deals primarily with the past. Finance is concerned mainly with the future.
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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: Liberalisation Globalisation Technological developments Volatile financial prices Economic uncertainty Tax law changes Ethical concerns over financial dealings Shareholder activism
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EMERGING ROLE OF THE FINANCIAL MANAGER IN INDIA The key challenges for the financial manager appear to be in the following areas: Investment planning and resource allocation Financial structure Mergers, acquisitions, and restructuring Working capital management Performance management Risk management Corporate governance Investor relations
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SUMMING UP
There are three broad areas of financial decision making, viz., capital budgeting, capital structure, and working capital management. Finance theory, in general, rests on the premise that the goal of financial management should be to maximise the wealth of shareholders. A business proposal raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal. A confluence of forces appears now to be prodding Indian companies to accord greater importance to the goal of shareholder wealth maximisation. In general, when you take a financial decision, you have to answer the following questions : What is the expected return ? What is the risk exposure ? Given the risk-return characteristics of the decision, how would it influence value ?
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 The important forms of business organisation are : sole proprietorship, partnership, private limited company, and public limited company. While each form of organisation has certain advantages and limitations, the public limited company form of organisation generally appears to be the most appropriate form from the point of view of shareholder wealth maximisation. While there are compelling reasons for separation of ownership and management, a separated structure leads to a possible conflict of interest between managers and shareholders. 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.

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 Fraud involves violating the law, whereas unethical behaviour involves breaching the code of ethics or moral behaviour. In general, ethical behaviour and long-term profitability are positively correlated. Corporate social responsibility is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as of the local community and society at large. Financial management is in many ways an integral part of the jobs of managers who are involved in planning, allocation of resources, and control.

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 The treasurer is responsible mainly for financing and investment activities and the controller is concerned primarily with accounting and control. Financial management has a close relationship to economics on the one hand and accounting on the other. Thanks to the changes in the complexion of the economic and financial environment in India from early 1990s, the job of the financial manager in India has become more important complex, and demanding.

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