Introduction to Financial Management
Unit - 1
Introduction to Financial Management
• An overview of Financial Management
• The finance functions
• Finance within an organization
• The main financial goal: creating value for investors
• Agency relationship and problems
• Balancing shareholder interests and the interests of society
Meaning of Financial Management
• Financial Management means planning,
organizing, directing and controlling the
financial activities such as procurement and
utilization of funds of the enterprise.
• It means applying general management
principles to financial resources of the
enterprise.
Scope/Elements of Financial Management
1. Investment decisions includes investment in fixed assets (called as capital
budgeting). Investment in current assets are also a part of investment
decisions called as working capital decisions.
2. Financial decisions- They relate to the raising of finance from various
resources which will depend upon decision on type of source, period of
financing, cost of financing and the returns thereby.
3. Dividend decision- The finance manager has to take decision with regards
to the net profit distribution. Net profits are generally divided into two:
Dividend and the rate of it has to be
decided.
Amount of retained profits has to be finalized which
will depend upon expansion and diversification plans of
the enterprise.
Objectives of Financial Management
• To ensure regular and adequate supply of funds to the concern.
• To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders.
• To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
• To ensure safety on investment, i.e, funds should be invested in safe ventures so
that adequate rate of return can be achieved.
• To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Functions of Financial Management
A finance manager has to make estimation
with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmes and policies of a concern.
Estimations have to be made in an adequate manner which increases
earning capacity of enterprise.
Once the estimation have been made,
the capital structure have to be decided.
This involves short-term and long-term debt equity analysis. This will depend
upon the proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.
contd........
For additional funds to be
procured, a company has many choices like-
- Issue of shares and debentures
- Loans to be taken from banks and financial
institutions
- Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of
each source and period of financing.
contd.......
The finance manager has to decide to
allocate funds into profitable ventures so that there is safety
on investment and regular returns is possible.
The net profits decision have to be
made by the finance manager. This can be done in two ways:
- It includes identifying the rate of
dividends and other benefits like bonus.
- The volume has to be decided which
will depend upon expansional, innovational,
diversification plans of the company.
Contd...........
Finance manager has to make
decisions with regards to cash management.
Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to
creditors, meeting current liabilities, maintainance of enough
stock, purchase of raw materials, etc.
Contd..........
The finance manager has not only
to plan, procure and utilize the funds but he also has to
exercise control over finances.
This can be done through many techniques like ratio
analysis, financial forecasting, cost and profit control, etc.
The Finance Functions
• Investment Decision
• Financial Decision
• Dividend Decision
• Liquidity Decision
Investment Decision
• One of the most important finance functions is to intelligently allocate capital to long
term assets. This activity is also known as capital budgeting.
• It is important to allocate capital in those long term assets so as to get maximum
yield in future.
• Since the future is uncertain therefore there are difficulties in calculation of expected
return.
• Along with uncertainty comes the risk factor which has to be taken into consideration.
This risk factor plays a very significant role in calculating the expected return of the
prospective investment.
• Therefore while considering investment proposal it is important to take into
consideration both expected return and the risk involved.
• Investment decision not only involves allocating capital to long term assets but also
involves decisions of using funds which are obtained by selling those assets which
become less profitable and less productive.
• It is a wise decision to decompose depreciated assets which are not adding value
and utilize those funds in securing other beneficial assets.
Financial Decision
• Financial decision is yet another important function which a financial manger
must perform. It is important to make wise decisions about when, where and how
should a business acquire funds.
• Funds can be acquired through many ways and channels. Broadly speaking a
correct ratio of an equity and debt has to be maintained. This mix of equity capital
and debt is known as a firm’s capital structure.
• A firm tends to benefit most when the market value of a company’s share
maximizes this not only is a sign of growth for the firm but also maximizes
shareholders wealth. On the other hand the use of debt affects the risk and return
of a shareholder. It is more risky though it may increase the return on equity
funds.
• A sound financial structure is said to be one which aims at maximizing
shareholders return with minimum risk. In such a scenario the market value of the
firm will maximize and hence an optimum capital structure would be achieved.
Dividend Decision
• Earning profit or a positive return is a common aim of all the
businesses. But the key function a financial manger performs
in case of profitability is to decide whether to distribute all the
profits to the shareholder or retain all the profits or distribute
part of the profits to the shareholder and retain the other half
in the business.
• It’s the financial manager’s responsibility to decide a optimum
dividend policy which maximizes the market value of the firm.
Hence an optimum dividend payout ratio is calculated. It is a
common practice to pay regular dividends in case of
profitability. Another way is to issue bonus shares to existing
shareholders.
Liquidity Decision
• It is very important to maintain a liquidity position of a firm to
avoid insolvency. Firm’s profitability, liquidity and risk all are
associated with the investment in current assets.
• In order to maintain a tradeoff between profitability and liquidity
it is important to invest sufficient funds in current assets. But
since current assets do not earn anything for business
therefore a proper calculation must be done before investing in
current assets.
• Current assets should properly be valued and disposed of from
time to time once they become non profitable. Currents assets
must be used in times of liquidity problems and times of
insolvency.
What is Profit Maximization?
• The process of increasing the profit earning capability
of the company is referred to as Profit Maximization.
• It is mainly a short-term goal and is primarily restricted
to the accounting analysis of the financial year.
• It ignores the risk and avoids the time value of money.
• It primarily concerns the company’s survival and
growth in the existing competitive business
environment.
Contd..............
• Profit is the basic building block of a company to accrue
capital in the shareholder’s equity.
• Profit maximization helps the company survive against all
the odds of the business and requires some short-term
perspective to achieve the same.
• Though the company can ignore the risk factor in the short
term, it can not do the same in the long term as shareholders
have invested their money in the company with expectations
of getting high returns on their investment.
What is Wealth Maximization?
• The ability of a company to increase the value of its stock for
all the stakeholders is referred to as Wealth Maximization.
• It is a long-term goal and involves multiple external factors
like sales, products, services, market share, etc.
• It assumes the risk. It recognizes the time value of money
given the business environment of the operating entity.
• It is mainly concerned with the company’s long-term growth
and hence is concerned more about fetching the maximum
chunk of the market share to attain a leadership position.
Contd..........
• Wealth Maximization considers the interest concerning
shareholders, creditors or lenders, employees, and other
stakeholders.
• Hence, it ensures building up reserves for future growth and
expansion, maintaining the market price of the company’s
share, and recognizing the value of regular dividends.
• So, a company can make any number of decisions for
maximizing profit, but when it comes to decisions concerning
shareholders, then Wealth Maximization is the way to go.
Comparative table
Basis Wealth Maximization Profit Maximization
Definition It is defined as managing financial It is defined as the management of financial
resources to increase the value of the resources to increase the company’s profit.
company’s stakeholders.
Focus Focuses on increasing the value of the Focuses on increasing the profit of the
company’s stakeholders in the long term. company in the short term.
Risk It considers the risks and uncertainty It does not consider the risks and uncertainty
inherent in the company’s business inherent in the company’s business model.
model.
Usage It helps achieve a larger value of a It helps achieve efficiency in the company’s
company’s worth, which may reflect in day-to-day operations to make the business
the company’s increased market share. profitable.
Features of profit maximization obctives
• Profit maximization objective is not clear
• Profit maximization objective ignores the timing of return
• Profit maximization objective ignoires quality of benefit
• Profit maximization objective overlooks the quality
aspect of future activity
Features of wealth maximization obctives
• Wealth maximization objective is clear
• Considers the time value of money
• Considers quality and quantity aspect of future activity
Focused on:
• Avoidance of higher risk
• Payment of dividend
• Seeking growth
• Maintaining the market price of stock
Agency relationship and problems
• Incompatibility arises when two parties must act in each
other’s best interest, creating a conflict. It can arise when the
incentives received by the agent are not compensatory
enough for them to stay motivated to continue acting in the
principal’s best interest.
• It can be avoided by compensating each group so that the
incentive or compensation keeps them motivated to work for
a more significant interest. We may note that agency
problems cannot be avoided but reduced.
Types of agency problem
Management Customers Seniors Employees Creditors
Vs Vs Vs Vs Vs
Owners Owners Juniors Owners Owners
In Financial Management
• It refers to a conflict of interest that occurs when agents:
• (e.g., Management of a company) are entrusted by principals
(e.g., Shareholders and investors) with the responsibility of
protecting their interests (e.g., Wealth maximization),
• But instead, these agents use their authority and power to
serve their own personal benefits (e.g., Buying expensive
cars on the expense of the company for their personal use).
• In corporate finance, the agency problem definition is given,
such as the conflict of interest that arises between
stockholders and the management of a company.
Contd.......
• This agency conflict can be observed in several organizations,
whether it is a company, a club, or a governmental institution.
• The reason why a party would prioritize its personal interests
over professional duties is because of the conflict of interest.
• Managers are motivated by maximizing their personal
compensations, whereas shareholders mainly focus on
maximizing their return on investment.
Contd....
• The agency problem is considered unethical since it
exploits a party's interests for personal profit.
• Therefore, to reduce this problem, regulations or
incentives are used to protect the principal's interests.
• These incentives include the threat of takeovers or firing,
performance-based compensation, or direct influence by
shareholders either by recruiting their own managers or
being involved directly.
Stockholders vs. Management
• Larger companies are generally financed via equity owned
by various investors (e.g., Shareholders), and separating
ownership from the management is a common practice.
• This is because there is no valid reason for shareholders to
take part in the management of the company (e.g.,
Shareholders don't have the expertise).
• This separation is highly beneficial and advantageous for
shareholders as it does not require any implications for the
daily operations of the business.
Contd.........
• However, hiring managers can create troubles and issues for
stockholders in some cases.
• These hired managers can potentially make unjust and wrong
decisions or even exploit shareholders' money to pursue a
luxurious working lifestyle.
• This conflict of interest between both parties gives rise to the
agency problem.
• Therefore, introducing incentives and bonuses can be
beneficial to minimize this agency issue.
• By using this strategy, managers are more motivated to make
decisions in the best interest of shareholders and
simultaneously increase their pay.
Stockholders vs. Creditors
• Apart from the agency conflict occurring between managers
and stockholders, creditors and stockholders may also face a
conflict of interest.
• Stockholders control the regular operating decisions that
impact the cash flows and risk.
• On the other hand, creditors have a claim on a portion of the
company's earnings, either interest or debt principal
payments, and on the company's assets in case of
bankruptcy.
• They lend capital at rates depending on risk, existing assets,
and capital structure of equity financing and debt.
Contd............
• Acting through management, the shareholders seek new
projects with greater risk than what the creditors expect.
• Higher risk increases the required rate of return on debt, thus
causing the outstanding value of bonds to fall.
• If the risky project is successful, all the profits and benefits will
be acquired by stockholders since bondholders have fixed
returns at the low-risk rate.
• However, if the risky project fails, bondholders will have to
share the loss incurred, creating an agency problem.
Contd...............
• One way to diminish this agency problem is to impose
restrictions or remove negative ones.
• On the one hand, having clear restrictions is
advantageous for creditors to build trust with the agent.
• On the other hand, removing unnecessary restrictions
strengthens the confidence in stockholders to take
decisions freely.
Stockholders vs. Other Stakeholders
• A firm's stakeholders may include employees,
communities, customers, and suppliers, who have
different interests and may want to keep an eye on the
management and equity holders' behavior.
Contd................
• For instance, owners might want to pay inadequate wages
and allowances, whereas employees are more interested in
increasing their allowances and salary to a sufficient degree.
• Moreover, all customers want to purchase goods and
services at lower prices, which contradicts the owners'
desire to sell at higher prices.
• These types of conflicts create an agency problem in the
relationship between stockholders and stakeholders.
• Both parties highly encourage transparency to agree on
just and fair transactions and decisions to minimize this
type of agency problem.
• This will reduce the conflict by removing confusion
regarding decision-making and minimizing the two
parties' implications against each other.
