UNIT ONE

CORE CONCEPTS
OF FINANCIAL
MANAGEMENT
UNIT ONE
CHAPTER ONE

INTRODUCTION Lesson 1
Chapter
1
Introduct
ion Unit
1
Core concepts in financial management

After reading this lesson you will be able to understand the following: -

> Concept of 'Finance' under different approaches.

> Significance of 'Finance'.
 > Nature of financial management.
> Relationship between finance and other important functions of the organization.
> Role of a Finance Manager in an organization.
> New challenges faced by the finance manager.

A very warm welcome to all my students in second semester of MBA course. I will be
teaching you financial management; I must tell you that I find this subject as the most
interesting subject and all my efforts will be to make it very interesting for you as well.
Lets discuss

Almost every firm, government agency, and organization has one or more financial
managers who oversee the preparation of financial reports, direct investment activities, and
implement cash management strategies. As computers are increasingly used to record and
organize data, many financial managers are spending more time developing strategies and
implementing the long-term goals of their organization.
The duties of financial managers vary with their specific titles, which include controller,
treasurer or finance officer, credit manager, cash manager, and risk and insurance manager.
Controllers direct the preparation of financial reports that summarize and forecast the
organization's financial position, such as income statements, balance sheets, and analyses of
future earnings or expenses. Regulatory authorities also in charge of preparing special
reports require controllers. Often, controllers oversee the accounting, audit, and budget
departments. Treasurers and finance officers direct the organization's financial goals,
objectives, and budgets. They oversee the investment of funds and manage associated risks,
supervise cash management activities, execute capital-raising strategies to support a firm's
expansion, and deal with mergers and acquisitions. Credit managers oversee the firm's
issuance of credit. They establish credit-rating criteria, determine credit ceilings, and
monitor the collections of past-due accounts. Managers specializing in international finance
develop financial and accounting systems for the banking transactions of multinational
organizations.
Cash managers monitor and control the flow of cash receipts and disbursements to meet the
business and investment needs of the firm. For example, cash flow projections are needed to
determine whether loans must be obtained to meet cash requirements or whether surplus
cash should be invested in interest-bearing instruments. Risk and insurance managers
oversee programs to minimize risks and losses that might arise from financial transactions
and business operations undertaken by the institution. They also manage the organization's
insurance budget.
Financial institutions, such as commercial banks, savings and loan associations, credit
unions, and mortgage and finance companies, employ additional financial managers who
oversee various functions, such as lending, trusts, mortgages, and investments, or programs,
including sales, operations, or electronic financial services. These managers may be required
to solicit business, authorize loans, and direct the investment of funds, always adhering to
Federal and State laws and regulations.
Branch managers of financial institutions administer and manage all of the functions of a
branch office, which may include hiring personnel, approving loans and lines of credit,
establishing a rapport with the community to attract business, and assisting customers with
account problems. Financial managers who work for financial institutions must keep abreast
of the rapidly growing array of financial services and products. In addition to the general
duties described above, all financial managers perform tasks unique to their organization or
industry. For example, government financial managers must be experts on the government
appropriations and budgeting processes, whereas healthcare financial managers must be
knowledgeable about issues surrounding healthcare financing. Moreover, financial managers
must be aware of special tax laws and regulations that affect their industry.
Financial managers play an increasingly important role in mergers and consolidations, and
in global expansion and related financing. These areas require extensive, specialized
knowledge on the part of the financial manager to reduce risks and maximize profit.
Financial managers increasingly are hired on a temporary basis to advise senior managers on
these and other matters. In fact, some small firms contract out all accounting and financial
functions to companies that provide these services.
The role of the financial manager, particularly in business, is changing in response to
technological advances that have significantly reduced the amount of time it takes to
produce financial reports. Financial managers now perform more data analysis and use it to
offer senior managers ideas on how to maximize profits. They often work on teams, acting
as business advisors to top management. Financial managers need to keep abreast of the
latest computer technology in order to increase the efficiency of their firm's financial
operations.

We all have heard about the term finance, let us discuss on what does it mean and why do
you as a student of MBA want to study it?

Finance can be defined as the art and science of managing money. Virtually all individuals
and organizations earn or raise money and spend or invest money. Finance is concerned
with the process, institutions, markets, and instruments involved in the transfer of money
among and between individuals, businesses, and governments.
Why study finance?

An understanding of the concepts, techniques, and practices presented in this course will
fully acquaint you with the financial manager's activities. Because most business decisions
are measured in financial terms, the financial manager plays a key role in the operation of
the firm. People in all areas of responsibility accounting, information systems, management,
marketing, and operations- need a basic understanding of the managerial finance function.
All managers in the firm, regardless of their job descriptions, work with financial personnel
to justify personnel requirements, negotiate operating budgets, deal with financial
performance appraisals, and sell proposals based at least in part on their financial' merits.
Clearly, those managers who understand the financial decision- making process will be
better able to address financial concerns, and will therefore more often get the resources
they need to accomplish their own goals.

To make informed decisions about where to get and put money in order to maximize value
in both personal and business decisions.

I know you want to ask the following question: -

If I have no intention of becoming a financial manger, why do I need to understand

financial management?

One good reason is " to prepare yourself for the workplace of the future". More and more
businesses are reducing management jobs and squeezing together the various layers of the
corporate pyramid. This is being done to reduce costs and boost productivity. As a result, the
responsibilities of the remaining management positions are being broadened. The successful
manager will need to be much more of a team player that has the knowledge and ability to
move not just vertically within an organization but horizontally as well. Developing cross-
functional capabilities will be the rule, not the exception. Thus, a mastery of basic financial
management skills is key ingredient that will be required in the work place of your not too
distant future.

Finance is the study of money management, the acquiring of funds (cash) and the
directing of these funds to meet particular objectives. Good financial management helps
businesses to maximize returns while simultaneously minimizing risks.
Hardly anybody wants to work in a field where there is no room for experience, creativity,
judgment and a pinch of luck but study of finance is not so. There are many reasons that the
financial manager's job is challenging and interesting. Here are four important ones.

-Securities Markets
-Understanding
Values -Time and
uncertainty
-Understanding
People.

I. Securities Markets include Money Markets and Capital Markets.

Money Markets includes:

* Markets for short-term claims with original maturity of one year or less.
* High-grade securities with little or no risk of default.
* Examples:

l.Treasury Bills.
2. Commercial Paper.
3.Certificates of Deposit.

Capital markets include:

* Market for long-term securities with original maturity of more than one year. *Securities
may be of considerable risk.
*Example:

l.Stocks
2.Corporate bonds
3.Government bonds
Primary Markets

A primary market is a market for newly created securities. The proceeds from the sale of
securities in primary markets go to the issuing entity. A security can trade only once in the
primary market.

Secondary Markets
A secondary market is a market for previously issued securities. The issuing firm is not
directly affected by transactions in the secondary markets. A security can trade an unlimited
number of times in secondary markets. The volume of trade in secondary markets is such
higher than in primary markets.
Investment Bankers

An investment banker specializes in marketing new securities in the primary market.

Examples of Investment bankers are: Merrill Lynch, Sigma Manufactures Merchant Bank,
etc.

Brokers and Dealers

These generally participate in the secondary markets. A broker helps investors in buying or
selling securities. A broker charges commissions, but never takes title to the security. A
dealer buys securities from sellers, and sells them to buyers.

Financial Intermediaries

These are institutions that assist in the financing of firms. Example include; commercial
banks and pension funds. These institutions invest in securities of other firms, but they are
themselves financed by other financial claims. On the other hand, it is a sort of indirect
financing in which savers deposit funds with the banks and financial institutions rather than
directly buying bonds or shares and the financial institutions, in turn lend the money to
ultimate borrowers. The Commercial Banks, Financial Institutions, Finance and Investment
Companies, Insurance Companies, Unit Trust, Pension Funds etc., are examples of financial
intermediaries.

II. Understanding Value

Understanding how capital markets work amounts to understanding how financial

assets are valued. This is a subject on which there has been remarkable progress over the
past 10 to 20 years. New theories have been developed to explain the prices of bonds and
stocks. And, when put to the test, these theories have worked well. I, therefore, would like to
give more stress in this area because the implication of this is applying in almost all parts of
the corporate finance.

III. Time and Uncertainty

 The financial manager cannot avoid coping with time and uncertainty. Firms often
have the opportunity to invest in assets which cannot pay their way in the short run and
which expose the firm and its stockholders to considerable risk. The investment, if
undertaken, may have to be financed by debt, which cannot be fully repaid for many years.
The firm cannot walk away from such choices- someone has to decide whether the
opportunity is worth more than it costs and whether the additional debt burden can be safely
borne.

IV. Understanding People

The financial manager needs the opinions and cooperation of many people. For
instance, many new investment ideas come from plant managers. The financial manager
wants these ideas to be presented fairly; therefore, the proposers should have no personal
incentives to be either overconfident or overcautious. Take another example. In some firms
the plant manager needs permissions from the head office to buy a company car but not to
lease it, and the line of least resistance may be to lease the car. In other firms the plant
manager needs permission from the head office to buy or lease, and the line of least
resistance may be to travel everywhere by cab. The financial manager has to be aware of
these effects and has to devise procedures that will avoid as far as possible any conflicts of
interest.

These are not the only reasons that financial management is interesting and also
challenging.

Concept of Finance

Different finance scholars have interpreted the term 'finance' in real world variably. More
significantly, as noted at the very outset of this chapter, the concept of finance has changed
markedly with change in times and circumstances. For convenience of analysis different
viewpoints on finance can be categorized into following three major groups:

F.1. The first category incorporates the views of all those who contend that finance concerns
with acquiring funds on reasonable terms and conditions to pay bills
promptly. This approach covers study of financial institutions and instruments from which
funds can be secured, the types and duration of obligations to be issued, the timing of the
borrowing or sale of stocks, the amounts required, urgency of the need and cost. The
approach has the virtue of shedding light on the very heart of finance function. However, the
approach is too restrictive. It lays stress on only one aspect of finance. The traditional
scholars hold this approach of finance

F.2. The second approach holds that finance is concerned with cash. Since almost all
business transactions are expressed ultimately in terms of cash, every activity within the
enterprise is the primary concern of a finance manager. Thus, according to this approach,
finance manager is required to go into details of every functional area of business activity,
be it concerned with purchasing, production, marketing, personnel, administration, research
or other associated activities. Obviously, such a definition is too broad to be meaningful.

F.3. A third approach to finance, held by modern scholars, looks at finance as being
concerned with procurement of funds and wise application of these funds.
Protagonists of this approach opine that responsibility of a finance manager is not only
limited to acquisition of adequate cash to satisfy business requirements but extends beyond
this to optimal utilisation of funds. Since money involves cost, the central task of a finance
manager while allocating resources is to match the benefits of potential uses against the cost
of alternative sources so as to maximise value of the enterprise. This is the managerial
approach of finance which is also known as problem-centered approach, since it emphasizes
that finance manager in his endeavor to maximise value of the enterprise has to deal with
vital problems of the enterprise, viz., what capital expenditures should the enterprise make?
What volume of the funds should the enterprise invest? How should the desired funds be
obtained?

Let us move on to financial management, you all being students of management know the
meaning of management. So let us discuss financial management now.

Nature of Financial Management

Financial management is an integral part of overall management and not merely a staff
function. It is not only confined to fund raising operations but extends beyond it to cover
utilisation of funds and monitoring its uses. These functions influence the operations of
other crucial functional areas of the firm such as production, marketing and human
resources. Hence, decisions in regard to financial matters must be taken after giving
thoughtful consideration to interests of various business activities. Finance manager has to
see things as a part of a whole and make financial decisions within the framework of overall
corporate objectives and policies.
The financial management of a firm affect its very survival because the survival of the firm
depends on strategic decisions made in such important matters such as product development,
market development, entry in new product line, retrenchment of a product, expansion of the
plant, change in location, etc. In all these matters assessment of financial implications is
inescapable.

Another striking feature of financial management that explains its generic nature is the
imperativeness of the continuous review of the financial decisions. As a matter of fact,
financial decision-making is a continuous decision-making process, which goes on
throughout the corporate life. Since a firm has to operate in an environment that is dynamic,
it has, therefore, to interact constantly with various environmental forces in addition to
changing conditions of the firm and adapt and adjust its objectives and strategies including
financial policies and strategies. A one-time financial plan not subjected to periodic review
and modifications in the context of changed conditions will be a fiasco because conditions
may change to such an extent that the plan is no longer relevant and acts as a hindrance
rather than help. Financial planning should, therefore, not be static. It has to be continuously
adapted to changing conditions.

As you all are MBA students it is essential for you to know the interface between finance
and other functions let us discuss. You all are studying other management subjects also let
us relate those with finance.

Interface between finance and other functions

Till now you might have understood about the pervasive nature of finance. Let us discuss in
greater detail the reasons why knowledge of the financial implications of their decisions is
important for the non-finance managers. One common factor among all managers is that
they use resources and since resources are obtained in exchange for money, they are in
effect making the investment decision and in the process of ensuring that the investment is
effectively utilized they are also performing the control function.

Marketing-Finance Interface
There are many decisions, which the Marketing Manager takes which have a significant
impact on the profitability of the firm. For example, he should have a clear understanding of
the impact the credit extended to the customers is going to have on the profits of the
company. Otherwise in his eagerness to meet the sales targets he is liable to extend liberal
terms of credit, which is likely to put the profit plans out of gear. Similarly, he should weigh
the benefits of keeping a large inventory of finished goods in anticipation of sales against
the costs of maintaining that inventory. Other key decisions of the Marketing Manager,
which have financial implications, are:
 > Pricing
> Product promotion and advertisement
> Choice of product mix
> Distribution policy.

Production-Finance Interface
As we all know in any manufacturing firm, the Production Manager controls a major part of
the investment in the form of equipment, materials and men. He should so organize his
department that the equipments under his control are used most productively, the inventory
of work-in-process or unfinished goods and stores and spares is optimized and the idle time
and work stoppages are minimized. If the production manager can achieve this, he would be
holding the cost of the output under control and thereby help in maximizing profits. He has
to appreciate the fact that whereas the price at which the output can be sold is largely
determined by factors external to the firm like competition, government regulations, etc. the
cost of production is more amenable to his control. Similarly, he would have to make
decisions regarding make or buy, buy or lease etc. for which he has to evaluate the financial
implications before arriving at a decision.

Top Management-Finance Interface

The top management, which is interested in ensuring that the firm's long-term goals are met,
finds it convenient to use the financial statements as a means for keeping itself informed of
the overall effectiveness of the organization. We have so far briefly reviewed the interface
of finance with the non-finance functional disciplines like production, marketing etc.
Besides these, the finance function also has a strong linkage with the functions of the top
management. Strategic planning and management control are two important functions of the
top management. Finance function provides the basic inputs needed for undertaking these
activities.

Economics - Finance Interface

The field of finance is closely related to economics. Financial managers must understand the
economic framework and be alert to the consequences of varying levels of economic activity
and changes in economic policy. They must also be able to use economic theories as
guidelines for efficient business operation. The primary economic principle used in
managerial finance is marginal analysis, the principle that financial decisions should be
made and actions taken only when the added benefits exceed the added costs. Nearly all-
financial decisions ultimately come down to an assessment of their marginal benefits and
marginal costs.
Accounting - Finance Interface

The firm's finance (treasurer) and accounting (controller) activities are typically within the
control of the financial vice president (CFO). These functions are closely related and
generally overlap; indeed, managerial finance and accounting are often not easily
distinguishable. In small firms the controller often carries out the finance function, and in
large firms many accountants are closely involved in various finance activities. However,
there are two basic differences between finance and accounting; one relates to the emphasis
on cash flows and the other to decision making.

Now that you have related finance with other functions can you discuss on the role of a
financial manager?

Role of a financial manager

Role and responsibilities of a finance manager have undergone a remarkable transformation
during the past four decades. Not too many years ago, finance manager had a very limited
role in a business enterprise. He was responsible only for maintaining financial records,
preparing reports on the company's status and performance and arranging funds needed by
the company so that it could meet its obligations in time. Finance manager, as a matter of
fact, was regarded as specialised staff officer in the company concerned only with
administering sources of funds. He was called upon only when his specialty was needed. For
example, when the company experienced the problem of dearth of funds, the management
expected the finance manager to locate suitable sources of funds and procure additional
funds. However, the finance manager transcended his traditional role of garnering external
funds for the enterprise following technological changes in major industries, increased
business complexities, tightening money market conditions and despondent state of stock
market, and has now become part and parcel of general management. He occupies the role
of an executive who is actively associated with problems and decisions related to wise
application of funds. He deals with the total funds deployed by the organisation, allocation
of funds among varying projects and activities and with evaluation of results of each
allocation. He is, therefore, directly concerned with production, marketing and other
activities within a business enterprise whenever decisions are made that Involve
commitment of funds to new or ongoing uses.

Role of finance managers has increased tremendously and their tasks have become
complicated following cataclysmic changes in recent times in the entire global economic
environment and the world market place resulting in globalisation of business and increased
competitiveness" The multinational corporations of today conduct their operations world-
wide as if the entire world were a single entity with a major thrust on quality, cost and
speed."

So as to cope with challenges stemming out of globalisation of world economy and to

exploit tremendous potential opportunities, most of the developing countries including India
have, of late, decided to liberalise their economic policies and open the floodgates of their
domestic markets to multinationals. Various economic and financial policy reforms have
been introduced with a view to freeing business from the grip of administered growth and
demolishing the protecting walls of yesteryears.

The combined impact of all these measures has resulted in swelling wave of transnational
from Japan, USA, Germany and France pouring in India in every conceivable product
segment posing serious challenges to the very survival of Indian corporate who were
hitherto operating in highly sheltered and closed economy.

In order to face these challenges and to ensure their survival many Indian corporate giants
have desperately formed strategic alliances with global majors and some of them embarked
hurriedly on internal restructuring.

Since ferocity of competition is likely to deepen further, it would be worthwhile for Indian
companies to take strategic measures for their survival and growth. They should formulate
strategy to achieve the competitive advantage and sustain their edge over the rivals. The
focal points of such strategy have to be on quality and cost which together contribute
significantly to organisational effectiveness.

In translating this strategy into action the finance manager has to play a very effective and
integrated role by helping the top management in making financial decisions to reduce cost,
improve productivity and maximise corporate value.

To handle the new responsibilities the finance manager must have clear conception of the
corporate objectives of his organization as he has to act in conformity with these objectives.
Furthermore, he has to evaluate the effectiveness of financial decisions in the light of some
standards. Corporate objectives of the organisation provide such standards. The finance
manager should also have stronger grasp of the nature, functions and scope of financial
management.
Further, he needs a variety of qualitative and quantitative skills so as to carry out his
complex and diverse responsibilities.

We all know it very well that environment keeps changing and thus brings in new challenges
every time, let us discuss on the new challenges been faced by finance manager.

Finance managers are presently facing some new challenges as indicated

below:

> TREASURY OPERATIONS: Short-term fund management must be more

sophisticated. Finance managers could make speculative gains by anticipating interest
rate movements.

> FOREIGN EXCHANGE: Finance Managers will have to weigh the costs and benefits
of playing with foreign exchange particularly now that the Indian economy is going
global and the future value of the rupee visa a vis foreign currency has become
difficult to predict.

> FINANCIAL STRUCTURING: An optimum mix between debt and equity will be
essential. Firms will have to tailor financial instruments to suit their and investors'
needs. Pricing of new issues is an important task in the Finance Manager's portfolio
now.

> MAINTAINING SHARE PRICES: In the premium equity era, firms must ensure that
share prices stay healthy. Finance managers will have to devise appropriate dividend
and bonus policies.

> ENSURING MANAGEMENT CONTROL: Equity issues at premium means

managements may lose control if they are unable to take up their share entitlements.
Strategies to prevent this are vital.
IMPORTANT
Slide 1

FINANCIAL MANAGEMENT
JULY 2004 - DEC 2004

Instructors RU Faculty
Lecture Times:
As per the time table
Slide 16

COURSE DESCRIPTION & OBJECTIVE

The main objective is to provide an understanding of financial decision

making and financial theory from the point of view of corporate
financial managers in competitive financial markets. This course serves
as an introduction to business finance (corporate financial management
and investments) for both non-finance concentration students and those
electing a finance concentration preparing for upper-level course work.
The course's objective is to provide a framework, concepts, and tools
for analyzing corporate finance problems and issues, based on
fundamental principles of modern financial theory, with an
understanding of application to "real-world" scenarios. The approach is
rigorous and analytical. Topics covered include discounted cash flow
techniques; corporate capital budgeting and valuation; investment
decisions under uncertainty; including capital
structure, cost of policy, and working capital capital, dividend
management.

PRESCRIBED TEXT
M Y KHAN & P K JAIN,

Financial Management: Text

r
and Problems
Tata McGraw-Hill Publishing
Company Limited

Lecture presentations will generally consist of notes

(presentation, slides, and
whiteboard) and in-class
discussions and problem solving.
The course pedagogy will involve
the use of the case method.
Problems and selected solutions
will also be given to students.
Suggested practice problems from
the end of chapter questions in the
text are identified in the detailed
course outline. Students are
required to read all assigned
chapters prior to the lecture
period during which the topic is to
be discussed.

POLICIES & GUIDELINES

Purpose
The purposes of these Guidelines are: v i To provide students
with an input into the structure and content of the course;
v i To focus on the rights and obligations of both student and

instructor;
v i To foster collaborative learning and to encourage

individuals to take responsibility for their learning both

during and after the completion of the course.
Slide 17

* STUDENTS ACCEPT the individual and collective responsibility of obtaining and

becoming familiar with a copy of the Course Outline. STUDENTS AGREE to avail
themselves of copies of the required readings and to duly undertake the assigned
readings. STUDENTS AGREE to be in possession of the computer skills necessary
to send and retrieve MS Word, Excel, and PowerPoint documents via the Internet.
v.t STUDENTS AGREE to regularly conduct searches via the World Wide Web or
journals maintained by the library of the University.

POLICIES & GUIDELINES

STUDENTS AGREE to visit suggested web sites as necessary to obtain materials
relevant to the course.
v < STUDENTS AGREE to read the recommended material prior to each class.

it STUDENTS AGREE to attend all classes in the absence of

extenuating circumstances. v ' STUDENTS AGREE to participate as fully as possible
in class discussions.
^ STUDENTS AGREE to share all relevant information with other
members of the class. ^ STUDENTS RECOGNIZE that the presentation of other
people's work as their own represents the worst form of academic misconduct.
Slide 18

The Faculty
vi The Faculty AGREES to treat each student fairly and impartially.
The Faculty AGREES to respect the opinions and ideas of all students.
v i The Faculty AGREES to make himself/herself available for consultation with
individual students or groups of students as necessary.
v = The Faculty AGREES at all times to ensure that the course is delivered at the
highest possible academic standard.
v = The Faculty AGREES to ensure that sufficient and relevant material made is
available for students.
v ; The Faculty AGREES except in extenuating circumstances to be punctual at
all times and where this is not possible to explain his/her tardiness.
v = The Faculty AGREES to maintain ongoing consultation with the students to
ensure that the course is at all times meeting the needs of the students.

Group Work
Students will form themselves into
groups for purposes of doing their
course assignments and for
purposes of collaborative
learning.
v < Each member will fully participate
in the work of the group ensuring
that (s)he makes an equitable
contribution to the work of the
group.
Each group member will honestly,
fairly, and independently evaluate
his work and that of her/his fellow
group members using forms
provided by the instructor and will
return those forms to the
instructor at the time prescribed
by the course outline.
Slide 19

■J Core concepts of financial management

Long-term investment decisions
■'Financing decision
'Dividend policy decision
^Management of Working Capital Recent
trends

10