CHAPTER - 1

Nature of Financial Management

Presenter: Prof. Rajsee Joshi

N.R. Institute of Business Management GLS Institute of Computer Technology

Topics Covered
Financial Management: Definition Scope of Finance Finance Functions Financial Managers Role Financial Goal Agency Theory Financial system

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What is Your Goal?

Introduction
Definition: Financial management is that managerial activity which is concerned with the planning and controlling of the firms financial resources.

Scope of Finance
A firm secures whatever capital it needs and employs it (financial activity) in activities, which generate returns on invested capital (production and marketed activities) The scope of Finance can be broadly described as under: 1. Real & Financial Assets 2. Equity & Borrowed Funds 3. Finance and Management Functions

Scope of Finance Cont

1. Real and Financial Assets: Tangible Real assets are physical assets such as plant, machinery, office, etc. Intangible Real Assets include technical know-how, patents, copyrights. Financial Assets, also called securities, are instruments such as shares and bonds or debentures.

Scope of Finance Cont

2. Equity and Borrowed Funds: Shares represent ownership rights of their holders. A company can also obtain equity funds by retaining earnings available for shareholders. New capital can be acquired from existing shareholders by issue of right shares and from new shareholders by a public issue. Dividend is to be paid on owners funds. No Tax shield Another important source of securing capital is creditors or lenders. Funds obtained from these source is borrowed fund and interest is to be paid. Interest provides tax shield to a firm

Scope of Finance Cont

3. Finance and Management Functions: There exists an inseparable relationship between finance and production, marketing and other functions. eg. recruitment and promotion of employees is clearly a function of human resource department but it requires payment of wages and salaries and other benefits which involves finance.

Finance Functions
The finance function includes: 1. Investment or Long Term Asset Mix Decision 2. Financing or Capital Mix Decision 3. Dividend or Profit Allocation Decision 4. Liquidity or Short Term Asset Mix Decision

Finance Functions - Cont...

1. Investment or Long Term Asset Mix Decision: A firm's investment decision involves capital expenditure. It involves the decision of allocation of capital to long term assets that would yield benefits (cash flows in the future) Investment decisions should be evaluated in terms of both the expected return and risk. Capital budgeting also involves replacement decisions that is recommitting funds when an asset becomes less productive or nonprofitable.

Finance Functions - Cont...

2. Financing or Capital Mix Decision:  A finance manager must decide from where, when and how to acquire funds to meet the firm's investment needs.  The mix of debt and equity is known as capital structure.  A manager must strive to obtain the best financing mix or optimum capital structure of his firm. It is optimum when the market value of share is maximized.  Once the financial manager is able to to determine the best combination of debt and equity, he must raise the appropriate amount through best possible resources.

Finance Functions - Cont...

3. Dividend or Profit Allocation Decision:  The proportion of dividends distributed as dividends is called the dividend-payout ratio  The retained portion of profits is known as the retention ratio  The optimum dividend policy is one that maximizes the market value of shares  Dividends are generally paid in cash, but a firm may issue bonus shares to the existing shareholders without any charge.

Finance Functions - Cont...

4. Liquidity or Short Term Asset Mix Decision:  Investment in current assets affects a firm's liquidity and profitability.  If the firm does not invest sufficient funds in current assets it may become illiquid and therefore risky, but it would lose profitability, as idle current assets would not earn anything.  The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets.

Finance Managers Role

Financial manager is a person who is responsible, in a significant way, to carry out the finance functions. He/ She is now responsible for shaping the fortunes of the enterprise, and is involved in the most vital decision of the allocation of capital. He/ She must realize that his or her actions have far-reaching consequences for the firm because they influence the size, profitability, growth, risk and survival of the firm. Four broad functions are: 1. Raising of Funds 2. Allocation of Funds 3. Profit Planning 4. Understanding Capital Markets

Finance Managers Role Cont

1. Funds Raising: The traditional approach dominated the scope of financial management and limited the role of the financial manager simply to funds raising. - The traditional approach did not go unchallenged even during the period of its dominance. - It lacked a conceptual framework for making financial decisions, misplaced emphasis on raising of funds, and neglected the real issues relating to the allocation and management of funds. Episodic Financing: Financing at the time of some major events like mergers, consolidations, reorganizations, recapitalizations, etc.
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Finance Managers Role Cont

2. Funds Allocation: The new or modern approach to finance is an analytical way of looking into the financial problems of the firm. The financial manager is now concerned with the efficient allocation of funds. He has to answer the following three questions: a) How large should an enterprise be, and how fast should it grow? b) In what form should it hold its assets? c) How should the required funds be raised?

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Finance Managers Role Cont

3. Profit Planning: The functions of the financial manager may be broadened to include profit-planning function. It refers to the operating decisions in the areas of pricing, costs & volume of output. The cost structure of the firm i.e. the mix of fixed costs and variable costs has a significant influence on a firms profitability. Because of Fixed costs, profits fluctuate at a higher degree than the fluctuations in sales.

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Finance Managers Role Cont

Ex. Fixed Cost is Rs. 10, Variable Cost is Rs. 2 per unit, Selling Price is Rs. 20 p.u. If the units sold in Jan are 5 units. There is an increase in sales by 100% in Feb. Does the fixed cost cause more fluctuation in the profit than the fluctuation in sales? What will happen if the sale decreased by 50%? Profit = Sales (Fixed Cost + Variable Cost) January: Profit = Rs. 100 (Rs. 10 + Rs. 10)= Rs. 80 February: Profit = Rs. 200 (Rs. 10 + Rs. 20) = Rs. 170 Therefore with the increase in sales by 100%, profit has increased 02/06/10 by 112.5%

Finance Managers Role Cont

4. Understanding Capital Markets: Capital markets bring investors(lenders) and firms (borrowers) together. He or she should fully understand the operations of the capital markets and the way in which the capital markets value securities. For example: If a firm uses excessive debt to finance its growth, investors may perceive it as risky. The value of the firms share may therefore decline. Similarly investors may not like the decision of a highly profitable, growing firm to distribute dividend. They may like to reinvest the profits in attractive oppurtunities.
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Financial Goals
1. Profit maximization 2. Maximizing Earnings per Share 3. Shareholders Wealth Maximization

Goal 1:Profit Maximization

Profit Maximization implies that a firm either produces maximum output for a given amount of input, or uses minimum input for producing a given output. The underlying logic of profit maximization is efficiency. Through Profit Maximization: Resources are efficiently utilized Appropriate measure of firm performance Serves interest of society also as optimum use of resources is done.

Objections to Profit Maximization

Different stakeholders have different objectives that may conflict with each other. The manager of the firm has the difficult task of balancing and reconciling these conflicting objectives In the new business environment, profit maximization is regarded as Unrealistic, Difficult & Inappropriate It ignores Time value of money & risk involved It is Vague: The definition of the term profit is ambiguous. Does it mean PAT or PBT? Does it mean long-term ?

Example:
Company XYZ has 20,000 shares outstanding, profit after taxes of Rs. 80,000. Hence earnings per share is Rs. 4. If the company issues 20,000 additional shares at Rs. 50 per share and invests the proceeds (Rs. 10,00,000) at 5% after taxes, then the total profits would increase to Rs. 1,30,000. (80000 + 50000) (Profit is Maximized) Is it beneficial to the shareholders? No, as the earnings per share will fall to Rs. 3.25 (1,30,000/40,000) This clearly indicates that maximizing profits after taxes does not necessarily serve the best interests of owners.

Goal 2: Maximizing EPS

Objections: Maximizing EPS implies that the firm should make no dividend payment so long as funds can be invested at positive rate of returnsuch a policy may not always work Ignores time value of money and risk of the expected benefit

Goal 3: Shareholders Wealth Maximization

A financial action that has a positive NPV creates wealth for shareholders and is therefore desirable Net Present value of a course of action means the difference between the present value of cash inflows and the present value of cash outflows. Accounts for the timing and risk of the expected benefits. Benefits are measured in terms of cash flows. From the shareholders point of view, the wealth created by a company is reflected in the market value of the companys shares.

The Fundamental Principle of Finance

Investors Shareholders Lenders Investors provide the initial Cash required to finance the business Business

The Business generates cash returns to investors A business regardless of whether it is a new investment or acquisition of another company or a restructuring initiativeraises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal.

Risk-return Trade-off/ Relationship

Risk Premium

Risk-Free Return

Agency Theory
In various businesses the responsibility of management is entrusted to professional mangers who may have little or no equity stake in the firm. Thus, the ownership and management in such businesses lie in separate hands. The decision taking authority in a company lies in the hands of managers. Shareholders as the owners are the principals and managers their agents. Thus their exists a principal-agent relationship. The conflict between interests of shareholders and managers is referred to as agency problem.

Agency Theory Cont

There are several reasons for the separation of ownership and management in companies: Due to large scale capital requirement, necessary capital is pooled from thousand of investors (owners), making it impractical for them to participate actively in management. Professional managers may be more qualified to run the business because of their technical expertise, experience and personality traits. It ensures that the knowhow of the firm is not impaired, despite changes in ownership.

Agency Theory: Managers Versus Shareholders Goals

A company has stakeholders such as employees, debt-holders, consumers, suppliers, government and society. Managers may perceive their role as reconciling conflicting objectives of stakeholders. Managers may pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum. Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders wealth. Such satisfying behaviour of managers will frustrate the objective of SWM as a normative guide.

Agency Theory Cont

Agency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behaviour.

One way to mitigate the agency problems is to give ownership rights through stock options to managers. A close monitoring by other stakeholders and outside analysts also may help in reducing the agency problems.

Finance and Related Disciplines

Financial management, as an integral part of the over-all management, is not a totally independent area. It draws heavily on related disciplines and fields of study, namely, economics, accounting, marketing, production and quantitative methods.

Finance and Economics

The relevance of economics to financial management can be described in the light of the two broad areas of economics: macroeconomics and microeconomics. Macroeconomics is concerned with the over-all institutional environment in which the firm operates. It is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary, credit and fiscal policies. Finance, in essence, is applied micro-economics. For example, the principle of marginal analysis a key principle of microeconomics according to which a decision should be guided by a comparison of incremental benefits & costs is applicable to a number of managerial decisions in finance.

Finance and Accounting

 The relationship between finance and accounting, conceptually speaking, has two dimensions:  They are closely related to the extent that accounting is an important input in financial decision making; but there are key differences in viewpoints between them. 1. Score Keeping vs. Value Maximizing

2. Accrual Method vs. Cash Flow Method 3. Certainty vs. Uncertainty

Finance and Accounting

1. Score Keeping vs. Value Maximizing: The primary objective of accounting is to measure the performance of the firm, assess its financial condition, and determine the base for tax. Principal goal of financial management is to create shareholder value by investing in projects with positive NPV. 2. Accrual Method vs. Cash Flow Method: The focus of financial manager is on cash flows. About their magnitude, risk, timing. 3. Certainty vs. Uncertainty: Accounting deals with past data. Finance is concerned mainly with the future.

Introduction Financial System

The financial system comprises a variety of intermediaries, markets, and instruments that are related. It provides the principal means by which savings are transformed into investments. An understanding of the financial system is useful to all informed citizens, it is particularly relevant to the financial managers.

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Functions of Financial System

Payment System: Banks and Financial Institutions are the pivot of the payment system. Pooling of funds: Financial intermediaries facilitate the pooling of household savings for financing business. Transfer of resources: Facilitates the transfer of economic resources from the households to the most productive use in the business sector. Risk Management: It enables to manage risk through hedging, diversification and insurance.

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Functions of Financial System Cont..

Price information for decentralized decision-making: They provide information like interest rates and security prices which help the households or their agents in making their consumption-saving decisions and these also provide important signals to managers of firms in their selection of investment projects and financing Dealing with information asymmetry problem: It provides other information to households and business so that there is least information asymmetry.

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Financial Markets
Classifications of Financial Markets: Based on Type of financial Claim: Debt Market Equity Market Based on Maturity of Claim: Short-term: Money Market Long-term: Capital Market Based on Claim Representing New issues or Outstanding Issues: Primary Market Secondary Market

Financial Market Returns

Interest Rates: An interest rate is a rate of return promised by the borrower to the lender. Rates of returns on Risky Assets: Many assets do not promise a given return. The return from such assets comes from two sources: Cash dividend and Capital Gain (or Loss). The first component is called the dividend income component (or dividend yield) and the second component is called the capital change component (or capital yield)

Financial Intermediaries in India

Regulatory Infrastructure
The two major regulatory arms of GOI are the RBI and the SEBI. Reserve Bank of India: It provides currency and operates the clearing system for the banks. It formulates and implements monetary and credit policies. It functions as the bankers bank. It supervises the operations of credit institutions. It regulates foreign exchange transactions. It moderates the fluctuations in the exchange value of the rupee. It seeks to integrate the unorganized financial sector with the organized financial sector. It encourages the extension of the commercial banking system in the rural areas. It influences the allocation of credit. It promotes the development of new institutions

Regulatory Infrastructure (Cont.)

Securities Exchange Board of India (SEBI):
Regulate the business in stock exchanges and any other securities markets. Register and regulate the capital market intermediaries. Register and regulate the working of mutual funds. Promote and regulate self-regulatory organizations. Prohibit fraudulent and unfair trade practices in securities markets. Promote investors education and training of intermediaries of securities markets. Prohibit insider trading in securities. Regulate substantial acquisition of shares and takeovers of companies. Perform such other functions as may be prescribed.