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 Financial Management is that managerial activity which is concerned

with the planning and controlling of the firm¶s financial resources. It is an
integrated decision making process concerned with acquiring, financing and
managing assets to accomplish the overall goal of a business organisation. It
can also be stated as the process of planning decisions in order to maximise
the shareholder¶s wealth. Financial managers have a major role in cash
management, acquisition of funds and in all aspects of raising and allocating
capital. As far as business organisations are concerned, the objective of
financial management is to maximise the value of business.

Financial management is defined as: ³Financial Management is concerned

with the managerial decisions that result in the acquisition and financing of
short term and long term loans credits for the firm.´

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The firm¶s investment and financing decisions are unavoidable and
continuous. In order to make them rationally, the firm must have an
objective. Financial management evaluates how funds are used and
procured. The core of financing policy is to maximise earnings in the long
run and optimise them in the short run. It is generally agreed that the
financial goal of the firm should be shareholder wealth maximisation. The
maximisation of profits is considered to be a goal or an alternative goal of
the firm.

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Financial management is concerned with the efficient use of an improved

resource, mainly capital funds. Profit maximisation should serve as the basic
criterion for decisions arrived at by financial managers of privately owned
and controlled firms. Profit maximisation implies that a firm either produces
maximum output for a given amount of input, or uses minimum input for
producing a given output. Profit is a barometer through which the
performance of a business unit can be measured. Profits ensure maximum
welfare to the shareholders, employees and prompt payment to creditors of
a company. Profit maximisation increases the confidence of management in
expansion and diversification programmes of a company. Profit maximisation
attracts the investors to invest in their savings in securities of time. Profit
ensures efficient use of funds for different requirements.

The profit maximisation objective has been criticised. It is argued that

profit maximisation assumes perfect competition, and in the face of the
imperfect modern markets, it cannot be a legitimate objective of the firm. It
encourages practices to increase the profits. Profit maximisation does not
consider the elements of risks. It does not consider the impact of time value
of money. Estimating the exact amount of profit of a company under the
changing world is a difficult and impracticable task.

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The goals of financial management may be such that they should be

beneficial to the owners, management, employees and customers. These
goals may be achieved only by maximising the value of the firm. The
elements involved in the maximisation of the value of the firm are:

(i)c Increase in Profits:

A firm should formulate and implement all possible plans of
expansions and take every opportunity to maximise its profits.
(ii)c Reduction in Cost:
A firm has to make every effort to reduce the cost of capital and
launch an economy drive in all its operations.
(iii)c Sources of Funds:
A firm has to assess the risks involved in each source of fund and
make a judicious choice of funds.
(iv)c Minimum Risks:
A firm should calculate business risk, financial risks or any other
risks that may work to the disadvantage of the firm.
(v)c Long ± run Value:
The goal of financial management should be to maximise the
long run value of the firm.

Wealth maximisation is a clear term. Here the present value of cash flow
is taken into consideration. It considers the concept of time value of money.
The present values of cash inflows and outflows help the management to
achieve the overall objective of a company. Wealth maximisation guides the
management in framing a consistent strong dividend policy, to reach
maximum returns to the equity holders. The concept of wealth maximisation
considers the impact of risks factor.

The concept of wealth maximisation is criticised for not being descriptive.

The concept of increasing the wealth of the shareholders differs from one
entity to another business entity. It also leads to confusion and
misinterpretation of financial policy.

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Scope of Financial Management has undergone drastic changes playing two

basic roles;

a) To participate in the process of putting funds to work within the business

and to control their productivity;

b) To identify the needs for funds and select sources (with acquiring costs at
minimum) from which they may be obtained.

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The functions of financial management may be classified on the basis of:

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1. Forecasting cash flows is primary part of finance function. It also

involves raising funds, managing internal generation of funds.

2. Raising Funds. The activity invites the manager to ascertain the

sources from which funds may be raised and the time when these
funds are needed.

3. Managing the flows of internal funds i.e. keeping its accounts.


': all future profits need to be forecast; pricing, cost control;
Measuring and administering cost of capital forms a part of profitability.

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 The financial manger will have to keep the asset intact, for assets are
the resources which enable a firm to conduct a business .Asset management
has assumed an important role in financial management. It is also necessary
for the manager to ensure that sufficient funds are available for smooth
conduct of business. Although business failure may not always be the result
of financial mismanagement but it leads positively to business failure.


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c(c are also part of function of financial
management. It also involves taking into account risk of foreign trade and
international liquidity, foreign exchange factors.

Financial management may be divided into two broad areas:

-c The management of long term funds which is associated with the plans
for development and expansion and which involves
land,building,m/c,transport facilitues....and so on.
-c The management of short term funds which is associated with the
overall cycle of activities of an enterprise .These are the needs which
may be described as working capital needs

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c cc#c+cThe financial manager anticipates
the financial needs by consulting an array of documents as the cash
budget, the pro ± forma income statement, the pro ± forma balance
sheet, the statement of the sources and uses of funds, etc.c
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c+cFunds should be acquired well
before the need for them is actually felt. The financial manager may
require both short term and long term funds.c
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ccc.c+cThe financial manager must
allocate funds according to their profitability, liquidity and leverage.
So, while primary financial responsibility from the owner¶s viewpoint
may be to maximise value.c
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c
cc+cnce the funds are
allocated on various investment opportunities, it is the basic
responsibility of the finance manager to watch the performance of
each rupee that has been invested.c
0c 'c c
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cc+c|ecision making
becomes easy for a financial manager after administration of funds.
Through budgeting, he can compare the actual with standards.c
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cc+cThe financial
manager has to advise and supply information about the
performance of finance to the top management and is also
responsible for maintaining up to date records of the performance
of financial decisions.c

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cTime value of money is an individual¶s preference for a possession of a

given amount of money now, rather than the same amount at some future
time The time value of money is the value of money figuring in a given
amount of interest earned over a given amount of time. Three reasons may
be attributed to the individuals¶ time preference for money:

(i)c Risk
(ii)c Preference for consumption
(iii)c Availability of investment opportunities

Two methods used for finding cash flows are:

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In compounding, future values of cash flow at a given interest rate

at the end of a given period of time are found. The future value (F) of
a lump sum today (P) for µn¶ periods at µi¶ rate of interest is given by
the following formula:

Fn=P (1+i) n =P (CVFn,i)

Where, CVFn,i is compound value factor.

The future value of annuity (i.e. the same amount of cash every year)
for µn¶ periods at µi¶ rate of interest is given by the following equation:

Fn= P [{(1+i) n-1}/i] = P (CVFAn,i)

Where CVFAn,i is compound value of an annuity factor.


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The present value of cash flows at a given rate of interest at the beginning
of a given period of time is computed in the discounting procedure. The
present value concept is the most important concept in financial decision
making. The present value (P) of lump sum (F) occurring at the end of µn¶
period at µi¶ rate of interest is given by the following equation:

P= Fn/(1+r)n =Fn(PVFn,i)

Where PVFn,i is the present value factor.

The present value of an annuity (A) occurring for µn¶ periods at µi¶ rate of
interest can be found out as follows:

P=A[1-(1/(1+i)n)/i] = ((i+1)n-1)/ i*(1+i)n

=A (PVFAn,i)

Where PVFAn,i is the present value of annuity factor.

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5 6#ccc5#) ± The Net Present Value of cash flows

is calculated by the following method:

NPV=[(C1/(1+k))+ (C2/(1+k)2)+.........+(Cn/(1+k)n)]



=l ± C0

 

Acceptance Rule:

jc If NPV>0, i.e., NPV is positive, then accept

jc If NPV<0, i.e., NPV is negative, then reject
jc If NPV=0, i.e., project may be accepted
Merits:

-Consider all cash flows

-True measure of profitability

-Based on the concept of time

-Satisfies the value additivity principle

-Consistent with the shareholders wealth Maximisation principle

|emerits:

-Requires estimates of cash flows which is tedious task

-requires calculation of opportunity cost of capital which poses

practical problem

-Sensitive to discount rate value of money.

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cc5) ± The discount rate which equates the
present value of an investment¶s cash inflows and outflows is internal rate of
return.


IRR =l ± C0

 

Acceptance Rule:

jc If IRR>k (opportunity cost), then accept

jc If IRR<k, then reject
jc If IRR=0, accept

Merits:

-IRR considers all cash flows.

-It measures the profits accurately. B

-Based on the concept of time value of money. C

-Consistent with the shareholder¶s wealth maximisation principle.

|emerits:
 - It requires estimates of cash flows which is a tedious task.

-It does not hold the value additivity principle, i.e., IRR¶s of two
or more projects cannot be added.

- IRR at times fails to indicate correct choice between mutually

exclusive projects.

-Calculation of IRR sometimes yields multiple rates.

5-6 .$ 7c#
!c56 ± The ratio of present value of the

cash flows to the initial outlay is profitability index or benefit cost ratio.

PI= Present value of Annual cash flows

Initial Investment


PI = l

 

C0

Acceptance Rule:

jc If PI>1, accept
jc If PI<1, reject
jc If PI=1, accept

Merits:

-PI considers all cash flows.

-It measures the profits relatively accurately.

-It is based on the concept of time value of money.

-It is consistent with the shareholder¶s wealth maximisation

principle.

|emerits:
 -It requires estimates of cash flows which is a tedious task.

-PI at times fails to indicate correct choice between mutually

exclusive projects.

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(1)c 'c.9c5.6 ± The number of years required to recover the

initial outlay of the investment is called payback.

PB = Initial Investment

Annual Cash Flow

= Co/C

Acceptance Rule

-c Accept if PB < Standard Payback

-c Reject if PB > Standard payback

Merits:

-Easy to understand and compute

-Emphasizes on liquidity

-easy and crude way to cope with risk

-use cash flows information

|emerits:

-Ignores the time value of money

-Ignores the flows occurring after the payment period

-Not a measure of profitability

-No objective way to determine the standard payback

-No relation with the wealth maximisation principle

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c'9 ± The number of years required in
recovering the cash outlay on the present value basis is the discounted
payable period. Except using discounting cash flow in calculating
payback this method has all the demerits of payback method.
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cc56 ± An average rate of return is
the ratio of average net operating profit to the average investment.
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ARR = Average net operating profit

Average Investment

Acceptance Rule :

-Accept if ARR > minimum rate

-Reject if ARR < minimum rate

Merits:

-c oses accounting data with which executives are familiar

-c Easy to understand and calculate
-c Gives more weightage to future receipts

|emerits:

-Ignore time value of money

-|oes not use case flows

-No objective way to determine the minimum acceptable rate of

return.