Chapter - 1

Nature of Financial Management

Introduction
Financial management is that managerial activity which is concerned with the planning and controlling of the firms financial resources.

Business Activities
Production Marketing Finance

Real & Financial Assets

Tangible Real assets Intangible Real assets Financial assets Primary market Secondary market Lease

Equity & Borrowed Funds

Shares- ownership rights Shareholders: Preference & Ordinary Dividend Retained Earnings- Internal Equity Rights issue Public issue Creditors/lenders Interest and tax shield Sources of borrowed funds
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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

Investment decision
Capital budgeting decision - involves commitment of funds to long term assets that would yield benefits in future Replacement decision - decision of recommitting funds when an asset becomes less productive or non profitable Required rate of return Risk & Return
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Financing Decision
Capital Structure mix of debt and equity is known as the firms capital structure Optimum capital structure best financing mix Financial leverage change in shareholders return caused by change in profits When the shareholders return is maximized with given risk, the market value per share will be
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Dividend Decision
Dividend payout ratio proportion of profits distributed as dividends Retention ratio - retained portion of profits Optimum dividend policy that maximizes the market value of the firms shares Bonus shares shares issued to the existing shareholders without any charge
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Liquidity Decision
Investment in current assets affects the firms profitability and liquidity Current asset management an important function Illiquidity may lead to insolvency Proper profitability-liquidity trade-off estimation of firms needs for current assets and also the timely availability of funds whenever required
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Routine Finance Functions

Supervision of cash 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 Managers Role

Raising of Funds traditional approach dominating scope of finance Allocation of Funds efficient and effective use of funds Profit Planning operating decisions in the areas of pricing, costs, volume of output and the firms selection of product lines Understanding Capital Markets capital markets bring the investors

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Financial Goals
Profit maximization (profit after tax) Maximizing Earnings per Share Shareholders Wealth Maximization

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Profit Maximization
Firms producing goods and services may function in a market economy, or a government economy Price system in a market economy Profit maximization implies that a firm either produces maximum output for a given amount of input, or uses minimum input for producing a given output 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

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Unrealistic Difficult Inappropriate Immoral.

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 return such a policy may not always work

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SWM means maximizing the net present value of a course of action to shareholders. Net present value is the difference between the present value of its benefits and the present value of its cost Accounts for the timing and risk of the expected benefits. Benefits are measured in terms of cash flows.

Shareholders Wealth Maximization

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 tradeoff. The return and risk relationship: Return = Risk-free rate + Risk premium Risk-free rate is a compensation

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 A company has stakeholders such as employees, debtholders, 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 satisficing behaviour of managers will frustrate the objective of SWM as a normative guide.

Managers Versus Shareholders Goals

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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 For e.g. BHEL large Indian co states its multiple objectives in terms of leadership, growth, profitability, consumer satisfaction, employee needs, technology and image

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Financial Goals and Firms Mission and Objectives

The 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.

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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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