UNIT-IV

LESSON

12
FINANCIAL MANAGEMENT
CONTENTS
12.0 Aims and Objectives 12.1 Introduction 12.2 Finance and Related Disciplines 12.2.1 Finance and Economics 12.2.2 Finance and Accounting 12.3 Profit Maximization 12.3.1 Criticism 12.4 Wealth Maximization 12.5 Objectives & Functions of Financial Management 12.6 Let us Sum up 12.7 Lesson-end Activity 12.8 Keywords 12.9 Questions for Discussion 12.10 Suggested Readings

12.0 AIMS AND OBJECTIVES

In this lesson we shall discuss about financial management. After going through this lesson you will be able to: (i) discuss finance and related disciplines (ii) analyse profit maximisation and wealth maximisation (iii) understand objectives and functions of financial management

12.1 INTRODUCTION
The financial management was initially perceived that the study with reference to only procurement of funds but later it was extended to one more additional feature that efficient utilization of funds. It is imperative to understand the meaning of the term Finance l Money with objective l Money with purpose l Money with direction l Money with target l Money with achievement
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Money with aim

The above explanation is able to understand the real meaning of the term finance which is nothing but effective utilization raised money with some purpose to achieve in desired direction.

Accounting and Finance for Managers

12.2 FINANCE AND RELATED DISCIPLINES

The study of role of finance in the organization is with reference to financial management. The financial management is the course which has drawn major focus points from the many more disciplines. To study them, the inter relationship in between the financial management and other related disciplines. The following are the related disciplines viz
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Finance and Economics Finance and Accounting Finance and Marketing Finance and production Finance and Quantitative Methods

12.2.1 Finance and Economics

The relationship in between these two disciplines are studied in two different headings viz Micro and Macro economics The major part of the financial management is to raise the financial resource to the requirements. While raising the financial resources, the availability is subject to the macro economic influences.
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Banking system Money and capital markets Financial intermediaries Monetary and credit policies

12.2.2 Finance and Accounting

The two are embedded with different disciplines. The finance is the discipline which is mainly based on the cash basis of operations but the accounting is totally governed by the accrual system. Accounting is mainly vested with the collection and presentation of data, but the finance is closely connected with the decision making of the organization. Till this moment, the differences are discussed only to know the role of finance over the accounting of any organization. The following is the major relationship which lies in between the finance and accounting as follows "Finance begins where accounting ends" l Finance and Marketing: These two are disciplines are interrelated to plan for introduction of new product. The major reason is that the introduction of new product normally warrants huge sum of money for research and development ; which needs immense planning and execution to succeed over the other competitors l Finance and Production: The changes in the production policy of the organization will impact the capital expenditures. The fixed assets of the organization should be effectively utilized which neither over capitalization nor under capitalization
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Finance and Quantitative methods: These are inter related to solve complex problems in order to take decisions.

The objectives of the financial management are classified into two categories viz
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Profit maximization Wealth maximization

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Let us discuss these two one after the another. The objectives of the financial management is discussed only to the tune of normative framework in between the financing, investment and dividend functions of the management.

Check Your Progress

Financial Management

Financial management is the course which has drawn major focus points from the many more disciplines. Discuss.

12.3 PROFIT MAXIMIZATION

The projects are considered on the basis of the following criterion: If the project is having the scope to have an increase in the volume of profits, the project is suggested to accept and vice versa. The financing, investment and dividend decisions of the enterprise is dome shaped towards the profit maximization. Under this, the profit is defined in two different angles viz. Owner's and Operational perspective. Owners' perspective definition of profit is the share of national income paid to the owners. Operational perspective defines the term profit as when the output exceeds the inputs of the process. The testing, selecting of the assets and projects are normally on the basis of the profitability of the firm. If the firm is found to be profitable, suggested to accept, otherwise, the decision is vice versa. Profit is a test of economic efficiency which is individual aim to achieve at always though it is closely associated with the social welfare.

12.3.1 Criticism
There is misapprehension about the workability of the private enterprise which normally strives for the profit maximization but not by considering the welfare of the society The next most important criticism is that in ability to fit into the practical considerations The second set of criticism is that the set of technical flaws or set backs associated with the financial management. The technical flaws of the profit maximization is studied under three different headings viz: Ambiguity Timing of benefits Quality of benefits Ambiguity: Profit is to be maximized; which profit has to be maximized? Either Net profit or Gross profit is to be maximized? Whether the short term or long term profit is to be maximized? Whether total profit or rate of profit is to be maximized? Whether the return on the total assets employed or the return on the total capital employed is to be maximized? The maximization of profit is vague due unclear definition of the term profit.
Timing of Benefits
Project Period 1 Period 2 Period 3 Total Alternative A Rs Lakh 50 100 50 200 Alternative B Rs Lakh ------100 100 200

From the above table, the two alternative projects A and B are found to be identical with reference to profit maximization due to equivalent volume of profits of them. Really speaking, these two projects are not identical, why?
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Accounting and Finance for Managers

One missing phenomenon is that timing of benefits. The timing of benefits should be relatively given greater importance for weighing the project at the moment of consideration. Project alternative A is better than the project alternative B, why? Project alternative A is able to generate the benefits during the period 1 which is known as earlier benefits, facilitating the A alternative to go for reinvestment, but in the case of reinvestment opportunity is denied due to non availability of profits during the early season i.e. period 1
Quality of Benefits
Project Recession Normal Boom Total Alternative A Rs Lakh 9 10 11 30 Alternative B Rs Lakh 0 10 20 30

Under the profit maximization, the quality of benefits are not considered what is meant by the quality of benefits? It means the certainty of benefits. The more certain the benefits is better the quality of benefits and vice versa. The profit maximization failed in its attempt to consider the quality of benefits. It has considered the both project are identical but really they are not. Alternative B project is more volatile returns in other words they are more uncertain unlike the project A. The project A is having only least volatility in the earning pattern during the three seasons. A is the better project which has greater certainty in accruing benefits over the others, are normally preferred by the risk averters.

12.4 WEALTH MAXIMIZATION

The next important set of objectives taken for discussion is Wealth maximization Only in order to replace bottlenecks which were associated with the profit maximization. Wealth maximization means that value / net worth maximization. The Worth of Action normally happens only at when the Value of benefits are more than the Cost of its undertaking. In other words, the wealth maximization is defined in the angle of the concept of cash flows. The Cash flows are clearly dealt only in accordance with the "CASH SYSTEM"-Definite Connotation
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It eliminates the ambiguity associated with accounting profits Second feature - timing of benefits and quality of benefits are jointly considered Operational implications of timing of benefits and quality of benefits

The timing and quality of benefits are given greater importance under the wealth maximization through the incorporation of capitalization rate which is applied to the tune of risk and timing of benefits associated with the project. The discounting component mainly depends upon the time and risk preferences of the owners of the capital The importance of the wealth maximization is explained through the discount rate component Higher the discount Rate reveals that Higher Risk and Higher uncertainty
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Lower the discount Rate portrays that Lower Risk and Lower uncertainty

The Decision Criterion is based on the comparison in between the Value and Cost The Creation of Value takes place only at when the economic benefits are more than Cost The Reduction of wealth just contrary to the earlier which normally produces lesser Economic Benefits than Cost The decision of either acceptance or rejection is subject to the net present value It is imperative to refer the words of Ezra's Solomon to illustrate the importance of the wealth maximization "The gross present worth of a course of action is equal to the capitalised value of the flow future expected benefit, discounted at a rate which reflects their certainty/uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which rates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive, then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth"
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Financial Management

W = V-C W = Net present worth V = Gross present worth C = Investment required to acquire the asset/purchase the course of action V = E/K E = Size of the benefits available to the suppliers of capital K = capitalization rate reflecting quality and E = G(M+I+T) G = Average future flow of gross earnings expected from the course of action, before the maintenance charges, taxation, expected flow of interest, preference dividend M = Average annual required investment to maintain G I =Expected flow of annual payments of Interest, Preference Dividend and other prior charges T=Expected annual outflow of taxes

Timing of benefits attached to E

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Alternate method:
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A1 A2 A3 An + + -C ....... + 1 2 3 (1 + K) (1 + K) (1 + K) (1 + K) n

A1, A2, A3--------depicts the flow of cash resources from a course of action over the period of time K=is an appropriate discount rate C=Initial outlay to acquire the asset If the out come is positive means that net present worth is positive i.e., more than the initial investment, considered to be fruitful for the investment and vice versa Wealth of the investors= market value of the shareholding of the investors If net worth is positive then the wealth of the investors will go up ; it means that the market value of the share holding of the investors will pile up. It is called in other words as Maximization of market value of the shares.
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Accounting and Finance for Managers

12.5 OBJECTIVES & FUNCTIONS OF FINANCIAL MANAGEMENT

The next aspect is that organization of finance function. The finance function is classified into two categories viz routine functions and functions of special importance. The routine functions are normally Accounting aspects of transactions of the business enterprise which mainly given controller of the finance department. The functions of special importance are normally involved in the process of preparing the policies of the organization with reference to finance administration ; which is mainly earmarked to the Treasurer of the finance department of the organization The following are the important functions of the Treasurer which normally have special importance in characteristics:
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Obtaining finance Banking relationship Investor relationship Short-term financing Cash management Credit administration Investments Insurance Financial accounting Internal audit Taxation Management accounting and control Budgeting, planning and control Economic appraisal and so on
Check Your Progress

The following are the vital functions of the Controller which regularly include:
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1.

Finance is the
(a) (c) Money with motive Money with objective (b) (d) Money with purpose (a), (b) and (c)

2.

Wealth is defined as
(a) (c) Gross cash flow Initial investment (b) (d) Net cash flows None of the above

3.

Why profit maximization is sidelined ?

(a) (c) Ambiguous Timing of benefits (b) (d) Lack of quality of benefits (a), (b) and (c)

4.

Which of the following function is the treasurer of the organisation?

(a) Obtaining finance Internal audit (b) (d) Financial accounting None of the above

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(c)

12.6 LET US SUM UP

The major part of the financial management is to raise the financial resource to the requirements. While raising the financial resources, the availability is subject to the macro economic influences. Accounting is mainly vested with the collection and presentation of data. But the finance is closely connected with the decision-making of the organization. The objectives of the financial management are classified into two categories viz l Profit maximization l Wealth maximization Profit is defined in two different angles viz. Owner's and Operational perspective. Owners' perspective definition of profit is the share of national income paid to the owners. Operational perspective defines the term profit as when the output exceeds the inputs of the process. "The gross present worth of a course of action is equal to the capitalised value of the flow future expected benefit, discounted at a rate which reflects their certainty/uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits.

Financial Management

12.7 LESSON-END ACTIVITY

What factors would you look at while taking capital structure decisions? Give your opinion.

12.8 KEYWORDS
Finance: A study of money with objective and desired direction Profit: In terms of operations - Input < Output Treasurer: Who carries out the financial management operation with special importance Controller: Who carries out the routine functions of finance Wealth maximization: Net present worth maximization; maximization of the market value of the shares

12.9 QUESTIONS FOR DISCUSSION

1. 2. 3. 4. 5. 6. What is meant by finance? Explain the relationship in between the finance and their related disciplines. Explain the objectives of financial management. Elucidate the profit maximization in detail. List out the drawbacks associated with the profit maximization. Highlight the importance of Wealth maximization.

12.10 SUGGESTED READINGS

R.L. Gupta and Radhaswamy, Advanced Accountancy V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting S.N. Maheswari, Management Accounting S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
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