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INTRODUCTION TO

‘FINANCIAL MANAGEMENT’
In this session we shall cover:
• Meaning and scope of financial Management
• Decision areas of a finance manager
• Objective of maximization of shareholders’
wealth vis-à-vis profit maximization
• Concept of agency theory
Basic issues of finance
• Any business, whether
new or existing, big or
small, having any
structural form, varying in
terms of industry,
product, service, location
etc. would be dealing
with

MONEY!
Basic issues of finance
• Where to raise the funds from?
• Where to deploy / invest the funds?
• How much of the profits to be retained and
what portion to be distributed in form of
dividend?
• Whether the funds are being effectively used
in the day to day operations?
Balance sheet
LAIBILITIES SIDE ASSETS SIDE

Shareholder funds Long term assets

Other long term liabilities Current assets

Current liabilities
Value of the firm

V = f (I, F, D), WC Mgt


Here,
V: Value of the firm
I: Investment decision
F: Financing decision
D: Dividend decision
WC Mgt: Working capital management
Objective of Financial Management

• To maximize the value of the firm or


shareholders’ wealth
• This would be done through various types of
decisions (by a finance manager)
– Investment decisions
– Financing decisions
– Dividend decisions
– WC management
Investment decisions
• Allocation of funds in various assets
• Risk profile of choices made to be considered
• Investments decisions reflected on the assets side of the
balance sheet

Capital budgeting decisions


Investment evaluation criteria
Determining cash flows
Risk analysis in capital budgeting
Cost of capital
Financing decisions
• Sources of raising finance
• Choosing from a wide variety of institutions and markets
• Internal source of finance – Retained earnings
• Conventional sources of raising finance vs. Modern sources of
raising finance
• Reflected on the liabilities side of balance sheet

Capital structure theories


EBIT-EPS analysis
Leverage analysis
Dividend decisions
• Finance manager has to strike a balance between the
amount of earnings to be retained and the amount
to be paid to shareholders as dividend
• Reflected on the liabilities side of the balance sheet

Factors affecting dividend


Dividend theories
Forms of dividend
Working capital management
• The finance manager shall be ongoingly
engaged in looking at how to manage the
working capital effectively striking a balance
between liquidity and profitability.

Cash Management
Inventory Management
Receivables Management
Other important areas
• Risk and return
• Portfolio theory
• Corporate restructuring
Inter-relationship between activities

Investment: Company decides to take on a large number of attractive


investment projects

Finance: Company will need to raise finance in order to take up


projects

Dividend: If finance is not available from external sources, dividends


may be reduced in order to increase internal financing
Inter-relationship between activities
Dividends: Company decides to pay higher levels of dividend to its
shareholders

Finance: Lower level of retained earnings available for investment


meaning that company may have to resort to external sources

Investment: If finance not available from external sources, the


company may have to postpone future investment projects
Inter-relationship between activities
Finance: Company finances itself using more expensive sources,
resulting in higher cost of capital

Investment: Due to a higher cost of capital, the number of projects


attractive for the company decreases

Dividend: The company’s ability to pay dividends in the future will be


adversely affected
Why value maximization as an
objective?
• What’s wrong with ‘profit maximization’ as an
objective?
• How is value maximization going to be
different from profit maximization?
Customers

Suppliers Government

CORPORATE
AND ITS
STAKEHOLDERS
Banks /
Financial Researchers
institutions

Owners / Employees /
investors management
Stakeholders with varying objectives

• Varying objectives:
– Maximization of profits
– Maximization of market share
– Maximization of ROI
– Beating the competition
– Minimization of costs
– Good product quality and service levels

None provide a unfailing framework for financial


decision making.
Stakeholders with varying objectives
• Limitations of different objectives:
– Ignore the viewpoint of other stakeholders
– Are non-quantifiable
– Do not account for risk
– Not based on cash flows
– Does not account for TVM

The only objective that stands the rigorous test


is MAXIMISATION OF SHAREHOLDERS’ WEALTH!
Maximization of shareholders’ wealth
• A company sells its product/service offering, pays to the suppliers of raw
material, pays wages and salaries to employees and meets all other expenses

• It services its obligations towards lenders by paying interest before


generating the final profit.

• As a corporate citizen, it must also pay taxes to the government.

• If any profit is left, it goes to the shareholders

• THIS IS TO SAY THAT SHAREHOLDERS ARE ENTITLED TO RESIDUAL PROFITS


AFTER MEETING COMMITMENTS TOWARDS ALL OTHER STAKEHOLDERS!
Advantages of ‘Value maximization’
as an objective
• stands the rigorous test taking into account
the expectations of different stakeholders
• Based on Cash flows
• Accounts for TVM
• Accounts for risk
Agency problem
• As per the agency theory, there exists a principal-agent
relationship between the shareholders and management
• The finance manager (representing management) acts on
behalf of the shareholders and ideally should be taking
actions consistent to maximizing the value of the firm

• Why does agency exist?


– When managers are clearly not
acting in the best interests of the
shareholders
Agency problem
• Factors contributing to the problem of agency:
– Divergence of ownership and control
– Goals of management differ from that of owners
– Asymmetry of information

• Conflict between shareholders and debt holders


– Shareholders have a preference for higher risk projects
when compared to debt holders
– Return of shareholders is unlimited whereas loss is limited
to the value of their shares
– Risk of failure also borne by debt holders but their return is
not unlimited
Agency problem
• This possibility of conflict between the
interests of shareholders and management is
referred to as AGENCY PROBLEM and gives
rise to AGENCY COSTS.
• AGENCY COST is a type of internal cost that
arises from and must be paid to an agent
acting on behalf of the principal
Dealing with agency problem

Monitoring and
control costs

Incentives
Dealing with agency problem
• Monitoring the actions of management
– Independently audited financial statements
– Additional reporting requirements
– Use of external analysts

• Costs of monitoring to be weighted against benefits accruing there from

• Free ride: Small shareholders would allow large shareholders, who would
be more keen to monitor managerial actions, to incur bulk of monitoring
costs while reaping the benefits there from

• Incorporation of clauses in managerial contracts in form of:


– Constraints
– Incentives
– Punishments
Dealing with agency problem
• Performance related pay (in form of bonuses and profit
sharing)

• Executive stock option scheme


Quick Recap
• Financial managers are responsible for making decisions about raising
(financing decision), allocating funds (investment decision) and how much
to distribute to shareholders (dividend decision)
• While objectives such as profit maximization, social responsibility and
survival represent important supporting objectives, the main objective in
corporate finance is maximization of shareholders’ wealth
• A financial manager can maximize the company’s value by making sound
investment, financing and dividend decisions
• Managers do not always act in the best interest of shareholders, giving rise
to ‘agency problem’
• Monitoring and performance related benefits are two potential ways to
optimize managerial behavior
• Due to difficulties associated with monitoring, incentives such as
performance related pay and Employee stock option plans can be adopted
Thanks!