Introduction

In our day to day life money is an indispensable element. In the business

world without money no activity can be imagined. In our personal life, family
life, social life, business life and national life we are always dealing with
money. To achieve what we want to do with these money we need to use them
properly. That means we have to manage the flow of money in the every sphere of
our life. This is the simplest definition of finance; that is the management of
cash flows.

All though finance is a distinct subject, as an academic subject it is not an

independent subject. Finance draws on heavily on related discipline like
Economics, Statistics, Accounting, Marketing, etc.

Whatever is the type of the business organization, it must operate in the

macroeconomic environment of the country. So without properly understanding the
macroeconomic situation of the country a financial manager can not be able to
perform his job successfully. The theories of macroeconomics analyze the
components that are essential for the effective operations of business firms. A
financial manager should have sufficient knowledge of economics, not only of the
macroeconomics but also of the microeconomics because it tells him how to take
decision when dealing with the individual component. Accounting and Finance are
functionally very close. Accounting provides input to finance. Accounting supplies
the financial statements that help financial manager in taking decision.
Statistical tools are very often used in finance. Marketing also helps finance by
providing continuous information as input to financial management.

• Meaning of finance and management

Finance

In the Oxford Advanced learner’s Dictionary there are four meaning of the
word ‘Finance’. Three are of these are noun and the rest is verb.

# (n): ‘Money used to run a business, an activity or a project’.

# (n): ‘The activity of managing money especially by a government or
commercial organization’.
# (n): ‘The money available to a person, an organization or a country; the
way this money is managed’.
# (v): ‘To provide money for a project’.

In the Cambridge International Dictionary of English there are two meaning of

the word ‘Finance’. One is noun and the other is verb.

# (n): ‘The management of a supply of money’

# (v): ‘Finance something means providing the money needed for it to happen’

After closely analyzing these lexicographical meanings of finance we can say

that finance is the set of activities which are related to the management of money
and monetary assets.
 Management

In the Cambridge International Dictionary of English the meaning of the word

‘management’ is given as:
“Management is the control and organization of something”

Here the word ‘something’ may be an organization, a part of an organization

or the resources of that organization.

The Oxford Advanced Learners Dictionary of English tells the meaning of the
word ‘Management’ as:

“The act of running and controlling a business or similar organization”

“The act or skill of dealing with people or situations in a successful way”

Here the situation may be of several of kind.

• Evolution of Financial Management

As a distinct discipline, the origin of financial management did not happen

over the night. With the passage of time in the ever changing environment after
being affected and affected by different types of situations the financial
management got its modern shape.

Before 1890, it was a branch of economics. After 1890 the concept was changed
and financial management became a separate discipline.
From 1890 to 1900 management was mainly concerned with investment, business
integration, corporate debenture etc. In 1897 the famous writer Tomas L Green
wrote a book named ‘Corporate Finance’ which was the first book of finance based
on old concept. In the USA several companies were integrated at that time.

The next decade was a time of governmental control over the business.
Preparation of financial statements was encouraged at that time. At the same time
an attention was given to fulfill the investor’s interest. After the industrial
revolution a huge number of industries were established. Those large industries
faced acute financing problem. As a result then financial institutions were born
to solve these finance problems.

The 1920-1930 was a decade of application of analytical technique. As a tool of

analysis computer was started to be used at that time. The use of computer made it
easy to take decisions easily. The next decade was a time of depression and
recovery. Between 11929 and 1932 share prices were decreased about 89% on an
average. The share price of U S Steel Company decreased to $21 from $262 and
General Motor’s to $7 from $92.

In the next decade fund analysis, capital budgeting, internal financing etc.
were started. After 1950 it was a time of growth of modern finance. In 1952
Markowitz invented the ‘Portfolio Theory’. Later on, in 1958 some other scholars
named Sharpe, Lintner, Famaxy developed the ‘Portfolio Theory’ and showed the
appropriate application in finance. In 1970 Sharpe invented ‘Capital Asset Pricing
Model’ (CAPM).

In the same year Black and Scholes gave another new theory named ‘Option
Model’. At present computer is indispensable to take financial decisions. Several
colleges and universities included “Financial Management” as a distinct subject.
Many scholars are still researching to develop this subject more and more.

• Definition of Financial Management

From a lexicographical point of view we can say ‘Financial Management’

refers to the organizing and using the assets of a firm which can be measured by
money.

Several scholars on this field gave several similar definitions.

The Indian scholar and professor of this subject, I M Panday, says

“Financial management is the managerial activity which is concerned with the

planning and controlling of the firms financial resources”.

Here the word managerial activity is important. That means finance functions
are decisional function or related with decision making. Another important word is
‘financial asset’. Financial assets refer to financial papers or instruments such
as shares and bonds or debentures. Financial assets also include lease obligations
and borrowing from banks, financial institutions and other sources.

Guthman and Dougall, another school of scholars, say

“Business finance can be broadly defined as the activity concerned with planning,
raising, controlling and administering of funds used in business.”

Brigham and Ehrhardt defined perhaps the most complete definition:

“The job opportunity of financial management ranges from making decisions

regarding plant expansions to choosing what type of securities to issue when
financing an expansion. Finance manager also have the responsibility for deciding
the credit terms under which customers may buy, how much inventory the firm should
carry, how much cash to keep on hand, whether to acquire other firms (merger
analysis) and how much of the firm’s earnings to plow back into the business
versus payout as dividend”.

• Scope of Financial Management:

For the purposes of exposition, the approach to the scope and functions of
financial management is divided into two categories:
(i)Traditional categories
(ii)Modern approach

(i)Traditional approach:

The traditional approach to the scope of the financial function evolved

during the 1920s and 1930s dominated the academic thinking during the forties and
through the early fifties. The traditional approach to the scope of financial
management refers to its subject matter in the academic literature in the initial
stages of its evolution as a separate branch of academic study. The concern
corporation finance was with the financing of corporate enterprises. In other
words, the scope of a financial function was treated by the traditional approach
in the narrow sense of procurement of funds by the corporate enterprises to meet
their financing needs. The coverage of corporation finance or financial management
was concerned to describe the rapidly evolving complex of capital market
institutions, instruments and practices. A related aspect was that firms require
funds at certain episodic events such as merger, liquidation, re-organization,
promotion, consolidation etc.

This approach is criticized for several reasons:

Firstly, it only includes the suppliers of funds such as investors, investment
bankers and so on, i.e. the outsiders; the traditional treatment was the
“Outsider-looking-in-approach”. The limitation was the internal decision-making
(i.e. insider-looking-out) was completely ignored.
The second group of criticism was that the treatment was built too closely
around episodic events. The day-to-day financial problems of a normal company did
not receive any attention.
Finally, the focus was on long term financing.

(ii)Modern approach:

According to it, the finance covers both acquisitions of funds as well as

their allocation. Thus apart from the issues involved in acquiring external funds
the main concern of financial management is the efficient and wise allocation of
funds to various uses.

Today financial management does not perform the passive role of score keepers
of financial data and information, and arranging funds. Rather they occupy key
positions in the top management areas and play a dynamic role in solving complex
management problems. They are now involved in the most vital management decision
of allocation of capital. It is their duty to ensure that the funds are raised
most economically and used in the most efficient and effective manner. Because of
this change in emphasis, the descriptive treatment of the subject of financial
management is being replaced by growing analytical content and sound theoretical
underpinnings.
• Fields of Finance:

Where there is money there is finance. There are five generally recognized
fields of finance. The core concept is the same in each field that is the
management of money and claims against money. Difference is the objectives and
problems.

Public Finance:

The management of the money and the monetary assets of the government are called
public finance. Public finance deals with the income and expenditure of the
government. Government collect huge amount of money from different internal and
external sources with a view to utilize these money in accordance with the
policies and procedures of the government. The objective of a private organization
is to maximize the shareholders wealth. But the objective of the government is to
social welfare. As a distinct field of finance, public finance deals with the
governmental financial matters.

Securities and Investment Analysis:

This field is concerned with the investor. When an investor purchases stocks,
bonds and other securities he must study the risk, probable performance of the
market etc. In this case, the investors do not have any direct control over the
business. The field of investment analysis deals with these matters and attempts
to develop techniques to help the investor reduce the risk and increase the likely
return from the purchases of selected securities.

International Finance:
In modern age each country has its own currency system. Each country imposes
restrictions on dealing with other currency. The currency of one country is
useless in other country. Through international trade, foreign aid, loan etc.
money is moving around the whole world and creates several types of difficulties.
International finance is concerned about these financial problems.

Institutional Finance:

Institutional finance is concerned with the financial problems and their

solution of several institutions serves an important role in capital formation.
Institutional finance deals with issues of capital information and the
organizations that perform the financing function of the economy.

Financial Management:

It is also known as corporate finance. Financial management is concerned with

the management of financial assets and money of a business firm. Financial
management studies financial problems in the individual firms and tries to solve
it

• Functions of finance

The definition of financial management indicates that finance functions are

arranging necessary funds, investing those funds, and distributing returns earned
from those investment to shareholders. To perform these functions managers need to
perform another function that is they have to balance cash inflows and outflows.
These functions are known as financing decision, investment decision, dividend
decision and liquidity decision respectively. These functions are not a sequential
process. They occur simultaneously and continuously in the business.

Investment decision or long term asset mix:

Investment decision relates to the selection of assets in which funds will be

invested. Investment decisions are capital expenditures in nature. They are also
called Capital Budgeting. This is probably the most crucial financial decision of
a firm. Capital budgeting relates to the selection of an asset or investment
proposal whose benefits are likely to be available in the future.

There are two aspects of capital budgeting. The first aspect relates to the
evaluation of the prospective profitability of new investment. Weather an asset
will be accepted or not will depend upon the relative benefits and returns
associated with it. The second aspect is the analysis of risk and uncertainty.
Since the benefits from the investment are to be received in the future, their
accrual is not certain. They are to be assumed. As a result risk always exists.
The return of an investment should be evaluated in relation to its risk.

Financing decision or capital mix:

Financing decision or capital mix is the second major function performed by a

finance manager. Financing decision includes deciding when, from where and how to
arrange necessary funds to finance the investment requirements. Funds can be
arranged by issuing shares or taking loans from lenders. These are called equity
and debt respectively. The main theme of financing decision is the capital
structure. In an organization the use of debts affects the returns and risk of
debts of shareholders.

The use of debt implies a higher return to the shareholders as also the risk.
The change in the shareholders’ return caused by the changed in the profits is
called the financial leverage. It is the main concern to find a proper balance
between risk and return.

Dividend decision or profit allocation:

 This is the third major decision
funds and then invest those funds. As
important to take decision about what
available in dealing with the profits
shareholders and (2) retention in the
of financial management. Managers arrange
a result earn profit. Now it is also
to do with this profit. Two alternatives are
of a firm- (1) distribution among the
business.

Which one should be done – distribution or retention? It is better to

distribute a portion of the profit among the shareholders. The portion of profit
distributed as dividend among the stockholders is called the dividend payout
ratio. The dividend policy that maximizes the market value of the firms share is
called the optimum dividend policy. Dividends are generally paid in cash. But a
firm may issue bonus shares also.

Liquidity decision or short term mix asset:

Liquidity decision is concerned with the management of current asset of the

firm. A firm’s profitability is and liquidity is affected by investment in current
assets. The prerequisite of long term success of a firm is short term survival. A
conflict is exists between profitability and liquidity.

One aspect of working capital management is the trade off between profitability
and risk. Say a firm does not invest sufficient fund in current assets. By doing
so it may become illiquid and thus risky. On the other hand, if the current assets
are too large the profitability is adversely affected. Thus a proper trade off
between liquidity and profitability must be achieved.
Many scholars argued that the working capital management or liquidity decision
can be covered under the definition off investment decision. So according to them
the finance functions are mainly investment decision, financing decision and
dividend decisions. Two most important concept of financial management are risk
and return. Financial decisions incur different degrees of risk. Financial
decisions of a firm are guided by the risk return trade off. An overview of
financial management can be presented as:

Financial management

Maximization of share value

Financial decision

Investment Liquidity Financing

Dividend
Decision Management Decision
Decision

Return Trade off Risk

Figure 1: An overview of Financial Management

(Source: I M Pandey, Financial Management, Ninth Edition, Page No: 10)

The financial manager should strive to maximize returns in relation to the given
risk in order to maximize shareholders wealth. He should take necessary actions
that avoid unnecessary risk. All the financial decisions should be taken from a
strategic point of view so that the best tradeoff between risks and return it’s
achieved.

• Factors influencing financial decisions

Finance managers have to take investment decision, financing decision and

dividend decision mainly. These decision, are influenced by some external and
internal factors.

Internal Factors:

Nature of business: The nature of the business influences the decisions

significantly specially financing and dividend decisions are influenced by the
nature of business. For example in productive organizations it needs to invest
more in permanent assets than current assets. On the other hand in service giving
organizations investment in current assets is more necessary.

Size of Business:

Finance decisions largely depend on the size of the business. The bigger the
organization the more capital it requires. In general large companies invest a
considerable portion of their capital in permanent assets because their finance
capability is very strong. But a proprietorship or a partnership lacks financing
capability hence they can’t invest more in permanent asset.

Expected return, cost and risk:

In general, if investors behave rationally, they are risk averse. Finance
manager takes decisions that are best suited for avoid risk. Investor always looks
for higher return. If they take any risky investment decision they will expect
higher return. They always try to be cost effective. Among the alternatives those
are similar in risk; financial manager will choose one that is least costly.

Asset structure:
Finance decision depends on the asset structure of the firm. Those firms who
have more capital assets can finance from long term sources. On the other hand if
current assets are huge then firm focuses on short term financing.

Structure of ownership:
Ownership structure may be proprietorship, partnership or company.
Proprietorship business can’t finance from long term sources since they are not
going concern. The scope of finance in a proprietorship or partnership is very
short. But companies can finance from suitable sources. Finance functions in a
company are complicated.

Age of the company:

In general, it is easy for the old companies to finance their investment
requirement from suitable sources. Because lenders view the old companies less
risky. Old companies are required to maintain strict dividend policy.

Restrictions in debt agreements:

If there is any restriction in debt agreements about the finance function
them it should be considered when taking decision. For example, they may be
convents that specify how much risk the organization can take.

Except these some other factors such as probabilities of regular and steady
earning, liquidity position of the company and its working capital requirements.
Management attitudes are influential when a manager performs finance decisions.

External Factors:

State of economy:
If the economic condition of the country is uncertain and unstable then it
gives an incentive to the investor not to invest more. In this situation the
finance manager takes liberal dividend policy. On the other hand if state of
economy is developing gradually then it increases investment.

Structure of capital and money market:

If the capital and money market is developed and well organized then finance
manager can easily finance from that money market. In such a circumstance manager
can evaluate the alternatives.

Government control:
Government control also influence the decisions of finance manage. Sometimes
government fixes the ratio of equity and debt. In the communism government
strictly control the money market.

Taxation policy:
Strict taxation policy discourages the investment. On the other hand a
liberal taxation policy encourages the taxation policy. If incentives are given in
tax act then it encourages investment in the country.

Except these some other factors such as lending policy of financial institutions,
requirement of investment etc are influence to finance decisions.

• Goal of Financial Management:

From a lexicographical point of view the word ‘goal’ means the ultimate
destination. In other words, goal is something which someone tries to achieve.
The goal or objective or financial management provides the framework for
financial decision-making.
In the Oxford Advanced learner’s Dictionary the meaning of the word ‘Goal’ is
given as:
‘Something that you hope to achieve’

In the Cambridge International Dictionary of English the meaning of the word

‘Goal’ is given as:
‘An aim or purpose’
 In order to perform the finance functions rationally the firms must have a
goal to accomplish. In other words, that is financial goal, which the financial
managers try to achieve by performing the finance functions.
There are two widely discussed goals of financial management-
(i)Profit Maximization
(ii)Stockholders’ wealth maximization

Necessities of a unique goal or objective:

The goal provides a framework for optimum financial decision-making. In
other words, they are concerned with designing a method of operating the internal
investment and financing of a firm. An objective gives the rationale of the effort
of a person of what the wants to achieve. It also provides the measure to choose
between alternative. In the business world, if there is no objective or goal then
there will be no systematic way to make decisions. Without a destination how could
a captain make the decision of which direction to go?
If there is more than one goal the problem created by them is different.
These will create indecision and dilemma when come to making decision. Say there
are two objectives and the result of accepting one project is positive to one and
negative to the other and vice-versa. In this situation the decision-making become
extremely complex.

Characteristics of the ‘right’ objective:

Selecting the best objective perhaps this is the most important decision. If
the chosen objective is not the right one then there causes a haphazard situation.
One of the characteristics of a right objective is that it is clear and
ambiguous then it can not help the decision maker to take decision in a logical
way because it itself is illogical. For example the objective ‘maximization of
firms profit in long term’ is an ambiguous objective. It is not clear which profit
is meant here? Is it net profit before tax or after tax, or EPS or gross profit?
It is also not clear what is meant by long term. Is it three years or five years
or more? The right objective should answer these questions.
A right objective should provide a measure that can be used to evaluate the
success or failure of decisions. If there is no available standard to measure the
performance of the manager then the shareholders will gradually lose control over
management.
A right objective does not create costs for other entities or groups. We will
say that objective the right objective, on the way of achieving that no cost is
created by the firm to other entities or society.

Profit maximization as the goal:

One of the most discussed goals of financial management is “Profit

Maximization”. Profit maximization goal implies that a firm either produces
maximum amount of output for a given amount of input or uses minimum amount of
input to produce a given amount of output. The underlying logic of profit
maximization is efficiently. It is assumed that profit maximization causes the
efficient allocation of resources under the competitive market condition and
profit is considered as the most performance. According to this approach actions
that increase profit should be under taken and those that decrease profit are to
be avoided. The profit maximization criterion implies that the investment,
financing and dividend policy decisions of a firm should be oriented to
maximization of profit.
Criticism of Profit maximization:
Profit maximization assumes perfect competition. But in reality perfect
competition is very rare. In the face of imperfect competition it does not serve
well. This old concept was evolved when the objective of the business was only to
aim enhance the owners’ personal wealth. But the aim has been changed now.
In the new business environment, profit maximization is regarded as unrealistic,
difficult, inappropriate and immoral. Sometimes profit maximization gives
incentives to produce goods and services that are wasteful and unnecessary from
the society’s point of view. It leads to inequality of income and wealth in the
society.

Limitations of Profit Maximization:

The profit maximization objective is not an operationally feasible criterion.
It has three major limitations.
It is a vague objective. The definition of the term ‘profit’ is not clear.
The actual meaning of the profit maximization objective is not clear. What is
meant by ‘profit’? Does it mean short or long term profit? Does it mean profit
before tax or after tax? Is it total profit or earning per share?
Profit maximization criterion does not consider the time value of money. It
values benefits received from different periods of time as the same.
It ignores risk. Two firms may have some total expected earnings but
different degree of risk. It fails to explain this different.

Shareholders’ wealth maximization:

This objective is also known as ‘value maximization’ or ‘Net Present worth
Maximization”. In the modern financial management academic literature universally
accepted as the objective of financial management. It removes the drawbacks of
profit maximization objective. Shareholders wealth maximization means maximizing
the net present of a course of action to shareholders. Net present value (NVP) of
a course of action is the difference between the present values of its cost.
Investment, financing and dividend decisions should be directed to stockholders
wealth maximization.
The stockholders hire the managers to run the business for them. It is the
manager, not the owner who takes the decision where to invest, how to finance them
and how much return to the owner. Since managers act as agent of the shareholders,
managers should therefore focus on maximizing the wealth of those who hired them
in the first place. Now the question arises how we measure stockholder wealth? In
a publically traded company the stock price is an observable and real measure of
stockholders wealth. So the objective of financial management should be stock
price maximization.

Advantages of stock price maximization as the objective:

Stock price maximization has three advantages because of why it is accepted

universally.
(i)Stock prices are the most observable of all measures that can be used to judge
the performance of a publicly traded company.
(ii)Stock prices, in a market with traditional investors, reflect the long term
effect of the firm’s decision.
(iii)The stock price is a real measure of stockholders wealth, since the
stockholders can sell their stock and receive the price now.

( Source of contents: Damodaran, Corporate Finance: Theory and Practice. 2nd

Edition, Chapter 2.)
• Agency cost

We know a proprietorship business is managed by its owner i.e. the owner is

the manager. The owner-manager enjoys all the profits and bears all the right of
the business. There is no conflict between the goal of the manager and the gold of
the owner since the owner is the manager. But in large companies the management is
separated from the ownership. It is the owner or stockholder who has the right to
take decision or manage the business. But in large companies there are hundreds of
owner and so it is not possible to manage the business by all stockholders. So the
stockholders hire the managers as their agent to work for the stockholder’s
interest. There is a principal and agent relationship between stockholder and
manager.

In theory, managers should act in the best interest of the owner, that is
their decision and actions should lead to shareholders wealth maximization.
In practice, managers may set aside the interest of the shareholders and work for
to achieve their own interest. This problem is known as agency conflict.
Michael C. Jensen and William H. Meckling were the first to develop a
comprehensive agency theory of the firm in 1976. An agency relationship arises
whenever one or more individuals, called a principal, hires another individual or
organization, called an agent to perform some service and then delegates decision
making authority to that agent.
There are two primary agency relationships within the content of Financial
Management
1. Between stockholders and managers and
2. Between stockholders and creditors

Agency conflict: Shareholders Vs managers

Since in large firms the managers generally own a small percentage of stock,
potential agency conflicts are very important. It is very possible that managers
are trying to achieve their personal goal by setting aside SWM as their goal.
Since the managers are owner of a small fraction of the ownership of the business
they may decide to lead a more relaxed lifestyle and not work strenuously to
maximize shareholders wealth because less of the incremental wealth will accrue to
him or her. The manager will not enjoy all the benefits of wealth created by his
or her effort and also will not bear all the costs of perquisites. This is the
reason why managers are looking for achieving their own goal.

What are the personal goals of a manager? Those are increasing job security,
increasing own power, status, salary. Indeed managers have a voracious appetite
for salaries and perquisites.

On the other hand, managers can be encouraged by the stockholders to act for
their interest through a set of incentives, constraints and punishments. All the
costs that are created by the stock holders when they are encouraging the managers
to act for SWM are called agency costs.

Michael C. Jensen and William H. Meckling showed that the principals, in

this case the stockholders can assure themselves that the agent (management) will
make optimal decision only if appropriate incentives are given and only if agent
is monitored. Incentives include stock options, bonuses, and perquisites.
Monitoring can be done by bonding the agent, systematically reviewing management
perquisites, auditing financial statements and explicitly limiting management
decisions.

Some very useful mechanisms used to motivate managers to act in shareholders

best interest are managerial compensation plan, direct intervention by
shareholders, the threat of fiving and the threat of takeover.

Agency conflict: Stockholders Vs Creditors

There is another conflict of interest that is between stockholders (through

managers) and creditors. Creditors usually lend money at a rate they negotiate at
the time of the loan which is based on their assessment of the risk of the firm
they are lending to. Creditors have a claim on part of the firm’s earnings stream
for payment of interest and principal on the debt and they have a claim on the
firm’s assets in the event of bankruptcy.

We know stockholders have the control (through managers) of decisions that

affect the risk of the firm. In short the main theme of the conflict is that what
is good for stockholders may not necessarily be good for lenders to the firm. For
instance, say a lender lends money to a business at a fixed rate. The lender
should expect payment of interest and principal from the firm and its risk should
be the same. Now say the stockholders, acting through the management, sell some
relatively safe assets and invest the proceeds in a large new project that is far
riskier than the firm’s old assets. This increased risk will cause the required
rate of return on the firm’s debt to increase. If the risky project is successful
all the benefits go to the stockholders because creditors rate of return is fixed
at the old, low risk rate. If the project is unsuccessful the creditors may have
to share in the loss. This is the conflict that is which is good, for stockholders
may be detrimental to the creditors.

But in general the stockholders cannot expropriate wealth from creditors

because every kind of unethical behavior is not acceptable in the business world.
Lenders attempt to protect themselves from stockholders by placing restrictive
covenant in the debt agreements. Moreover if lenders realize that the managers are
trying to exploit them they refuse to deal further with it or may charge a higher
than normal interest rate. In essence, to best serve their stockholders in the
long run manager must play fairly with creditors. Managers should take decision in
that which balances between the interest of stockholders and creditors.

Stock price maximization with Lower agency cost.

As a goal stock price maximization is universally accepted but it is not

flawless. It is flawed primarily by the conflict between stockholders and
managers, stockholders and lenders. However stock price maximization will be the
best objective if we can figure out a way to reduce agency costs. If a manager
takes advantage of shareholders he will find himself faced with stockholder
revolts and hostile takeover. If lenders are exploited they will protect
themselves in subsequent lending. Here are the ways to reduce agency costs:

Stock holders and Managers

Giving managers the ownership opportunity:

The conflict of interests between the stockholders and the managers exist
since their interests are not the same one of the ways to reduce this conflict is
give the managers with an equity stake in the firms. If the managers are provided
with equity stake in the firm the benefit received from the stock prices may
provide an inducement to maxim be share prices.

More effective Board of Directors:

The board of directors is the body that oversees the management of a
publicly traded firm. As elected representatives of the shareholders the directors
are obligated to ensure that managers are looking out for stockholders interest.
This board of directors should be effective. Survey on board of director’s reveals
that smaller boards are more effective than larger boards. Stock compensation for
the directors makes it more likely that directors will think like stockholders.

Increasing stockholders power:

There are several ways of increasing stockholders power. Stockholders should
demand and keep more and more updated information so that they can make better
judgments on how the management is doing. Some stockholder can be a part of the
management and can manage the firm. Stockholders should be more active so that
they can be remained informed about the overall management policy.

The threat of takeovers:

Hostile takeovers (when management does not want the firm to be taken over)
are most likely to occur when a firm’s stock is undervalued relative to its
potential because of poor management. In a hostile takeover the managers of the
acquired are generally fired. Takeovers operate as a disciplinary mechanism. Often
the very threat of takeover is sufficient to make firms restructure their assets
and become more responsive to stockholders concern.
Shareholders and managers

Shareholders and Bondholders

Bond covenant:
The most common way adopted by the lenders to protect them is to write
covenants in their bond agreement specifically prohibiting or restricting actions
that may be detrimental to the lenders. Some covenants strictly restrict the
firm’s actions when the manager wants to make a risky investment which is
detrimental to the lenders. Many bond agreements restrict how much firm can pay as
dividend. Some covenants also require firms to get the consent of existing
bondholders before borrowing more.

Security Innovation:
Some bond agreement gave the lenders the right to sell their bonds back to
the firm at face value in the event of a special situation.
Equity stakes:
The dissimilar nature of the interest of stockholders and bondholders are
the main reason of the conflict. To avoid this problem bondholder can buy stock at
the same time as bonds or can be allowed to convert their bonds into stock.

• Some basic concepts of Financial Management:

Risk and Return

Risk and return are the two fundamental concepts of financial management. In
a very simple way risk can be defined as the probability to happen or not to
happen something in the future. Where there is future there is uncertainty.
Uncertainty is risk. Risk analysis should be one in the capital budgeting
exercise. Capital budgeting decision is based on the benefits derived from the
project. These benefits are measured in terms of cash flows, cash flows are
estimates. The estimation of future returns is done on the basis of various
assumptions. The actual return in terms of cash inflows depends on several of
factors such as price, sales, competition, and cost of raw materials and so on. It
is very possible that the actual return will not precisely correspond to the
estimate. In other words the actual return will vary from the estimate. This is
technically referred to as risk. Risk results from the variation between the
estimated and actual return. The greater the variability the riskier is the
project.
n finance all investment is done with a view to earn some extra money. This
extra money or asset which is received from an investment is called the return. In
short, it can be expressed as
Dollar Return = Amount received – Amount invested
The rate of return is the return per dollar. In other words,

Amount received – Amount invested

Rate of return =
Amount invested

The relationship between risk and return is very important and interesting.
We know the more the risk the more the return. But if there is no risk the rate of
return will be positive because of time preference for money. This is called risk
free rate. In reality each investment is associated with some risk. Hence a rate
of return is required for the risk over the risk free rate. This is called risk
premium.

Thus,

Required rate of return = Risk free rate + Risk premium

This relationship can be shown graphically.

 Rate Risk premium
of
return

Risk free rate

Risk

Figure 2: Risk – return relationship

This figure shows that the more the risk the more the return. Risk free rate is
fixed. Risk premium is increasing with the increase of risk.

(Source: I M Pandey, Financial Management, Ninth Edition, Page No: 10)

Time value of money

Time value of money is the principal of finance that analyzes the

relationship between $1 today and $1 in the future. Since the objective is wealth
maximization for the today’s firm, maximum of the financial decisions taken by the
firm are future oriented. These decisions incur cash inflows for the firm. For
instance a firm may finance its any investment requirement by issuing share or
taking loan. There is a cash inflow when the firm takes the loan or issues the
share as well as the obligation of paying interest or dividend and return the
principal in the future. These cash inflows or outflows of today certainly have
not the same value as the cash inflows or outflows in the future. They must be
compared to a common point of time. Many of the finance decisions are based on the
logical comparison of the outlays and benefits.

If we think logically and rationally we should value the opportunity to

receive a certain amount of money now more than the opportunity to receive the
same amount of money at a future date. In other words a dollar today is worth more
than a dollar in the future. That means the value of money always diminishes.
Individuals prefer, if they behave rationally, one dollar today to one dollar in
the future. This is called the time value of money concept. The time value of
money can also be referred to as time preference for money (M Y KHAN and P K JAIN;
FINANCIAL MANAGEMENT: Text and Problems; 2nd edition, Page: 230). Time value of
money is al so called discounted cash flow (DCF) analysis (Eugene F. Brigham and
Michale C. Ehrhardt; FINANCIAL MANAGEMENT: Theory and practice, 10th edition;
Page: 286).
 Time preferences for money is an individuals preferences for possession of money
a given amount of money now, rather than the same amount of money at a future
time.

Three reasons attribute to individuals time preferences for money (I M Pandey):

• Risk
• Preferences for consumption
• Investment opportunities

Since future is uncertain and risky people want money now to avoid this risk. Most
of the people prefer present consumption. So they want money now. The main reason
is investment opportunities. If people invest money now they will earn some money
whereas idle money does not earn money.

Future value:

Future value refers to the amount of an investment is worth after one or

more period. Future value is equal to the sum of principal and interest earned on
that principal.
Here, compounding is an important concept. Compounding is the process of
having money and accumulated interest in an investment for more than one period,
thereby re-investing the interest is called compounding.
The simple formula for calculating the future value of a lump sum amount

FV = P (1+i) n
Where, P stands for principal amount, i for interest rate, n for numbers of
years.

Present value:
Present value of a future cash flow is the amount of current cash flow that
is of equivalent value to the decision makers.
The simple procedure for calculating the present value of a single cash flow:
P = ¬¬¬¬FV/ (1+i) n
Where, FV stands for future value, i for interest rate, P for present value, n for
number of years.
Portfolio Theory:

In general investment risky and investors are risk averse. Portfolio theory
is a theory that describes how an investor can minimize risk. Portfolio says that
if an investor invests his all money in sector then the risk is very high. On the
other hand, if he invests his money in more than one sector, it will decrease his
risk. Portfolio is a group of investment sectors that minimizes the risk of the
investors.
In the words of IM Pandey,
“A portfolio is a bundle or a combination of individual assets or securities. The
portfolio theory provides a normative approach to investors to make decisions to
invest their wealth in assets or securities under risk.”
That is portfolio theory tells us the best arrangement of investment options
under risk. This theory is based on the assumption that investors are risk averse.
When an investor holds a well diversified portfolio then he will be concerned
about the expected rate or risk and return of that portfolio not about the
expected rate of risk and return of the individual asset.
The portfolio return is equal to the weighted average of the returns of
individual assets (or securities) in the portfolio with weight being equal to the
proportion of investment value in each asset (IM Pandey).
The portfolio risk is measured by its variance and standard deviation

Cost of Capital:
A firm can collect its required capital to finance an investment project by
issuing equity share, preferred share or creating debt mainly. When individuals
provide a company these required fund they expect the company should earn
sufficient return on those funds. From the company’s point of view the investor’s
expected return is a cost. This cost is known as cost of capital. This is one of
the most complexes in finance theory. For capital collected from different sources
the cost of capital will be different. For example, the cost of equity capital is
the minimum expected required return of the investors. Under this rate the
investors do not will to invest. That is the required return that a firm must
earn.
Cost of capital depends on the interest rates, tax policy, regulatory
environment, the risk of the projects and the type of fund. A firm must consider
the cost of capital when taking decision either a project will be accepted only
when the expected rate of return of the project is greater than the cost of
capital.
Limitation of financial management

Many scholars think that the corporate finance is not flawless. Corporate
finance posses some limitations. It is criticized in recent years for its
limitations. Some believes that the objective of shareholders wealth maximization
is liable for increasing wealth inequality in the society. The financial
management assumes that the financial markets are efficient. But in the real world
an efficient financial market is very rare. When the goal of the financial
management is stock holders wealth maximization then the inefficient financial
market acts as a limitation of corporate finance.

Some believes that financial management is unethical since many of the

decisions may increase the wealth of shareholders but may be harmful for the other
stakeholder. Any kind of activities that harms the other is not acceptable in the
business world.

Financial management assumes that manager will not make any decision that is
harmful to other but in reality it is not true. Since there is a conflict between
the Interest of the shareholders and that of the other stakeholders the goal of
financial management should be increasing the wealth of the stakeholders not only
the stockholders.

Conclusion

Financial management, a ever developing field of study, provides the most

logical and accurate means of managing the financial resources of an organization.
Financial manager performs with a view to maximize the wealth of that firm. All
the decisions taken by the financial manager i.e. investment decisions, financing
decisions, dividend decisions and liquidity decisions are directed to maximize the
firms wealth. Managers perform these functions as agent of the shareholders.
There are agency conflicts between the shareholders and managers and shareholders
and creditors since each of the three parties has separate goal. Since the
objective of the financial management is wealth maximization many of the decisions
are future oriented. Where there is future there is risk. Normally investors are
risk avers. As a result, the riskier the project the higher is the return.
Financial decisions of the firm are guided by risk return trade off.

Bibliography

Text books

1. Damodaran, A. Corporate Finance: theory and Practice. 2nd Edition. New

York. N Y John Willy & Sons Inc. 2001.

2. Eugene F. Brigham and Michael C. Ehrhardt. FINANCIAL MANAGEMENT: Theory and

Practice.10th edition. Singapore. South-western.2001.

3. James C.Van Horne. FINANCIAL MANAGEMENT AND POLICY. 12th edition. New delhi.
Pearson Education. 2002.

4. JHON J HAMPTON. Financial Decision Making: Concepts, Problems and Case. 4th
Edition. New Delhi. Prentice Hall of India Pvt. Ltd. 1989.

5. Pandey, I M. FINANCIAL MANAGEMENT. 9th Edition. New Delhi. Vikas Publishing

House Pvt. Ltd. 2005.

6. KHAN, M Y and JAIN, P K. FINANCIAL MANAGEMENT: Text and Problems. 2nd

edition. New Delhi. Tata McGraw-Hill Publishing Company Limited.1997.

Web Address

1. http://en.wikipedia.org/wiki/finance

Others

1. Cambridge International Dictionary of English. Cambridge University Press.

1995.

2. Hornby, A S. Oxford Advanced Learner’s Dictionary. 6th Edition. Oxford

University Press. 2001.