Course outline

 Overview
 Fundamental Valuation Concepts
 Cost of Capital
 Capital Budgeting
 Working Capital Management
 Leverage
 Capital Structure
 Dividend Policy
FINANCIAL MANAGEMENT : AN
OVERVIEW
 OUTLINE
• Introduction
• Evolution of Financial Management
• Financial Decisions in a Firm
• Goal of Financial Management
• The fundamental Principle of Finance
• Risk-return Tradeoff
• Forms of Business Organizations
• Agency problem
• Emerging Role of the Financial Manager in India
 Introduction
 Finance: art and science of managing
money.
 Major areas:
– Financial services: concerned with the design
and delivery of advice and financial products to
individuals, businesses and governments within
the areas of banking and related institutions,
personal financial planning, investments, real
estate, insurance and so on.
 Introduction(cont.)
– Financial management: Financial Management
or business finance is concerned with managing
an entity’s money.
 For example, a company must decide:
− where to invest its money.
− whether or not to replace an old asset.
− when to issue new stocks and bonds.
− whether or not to pay dividends.
 EVOLUTION OF FINANCIAL MANAGEMENT
• Financial management emerged as a distinct field of study at
the turn of the 20th century. Its evolution may be divided into
three broad phases - the traditional phase, the transitional
phase, and the modern phase.

• The modern phase began in mid-1950s and has been marked

by infusion of ideas from economic theory and application of
quantitative methods

• The distinctive features of the modern phase are:

Central concern : Shareholder wealth maximization
Approach : Analytical and quantitative
 FINANCIAL DECISIONS IN A FIRM
• Capital Budgeting: Capital budgeting refers to the process
of deciding how to allocate the firm’s scarce capital resources
(land, labor, and capital) to its various investment alternatives.
• Capital Structure: A mix of a company's long-term debt,
specific short-term debt, common equity and preferred equity.
The capital structure is how a firm finances its overall
operations and growth by using different sources of funds.
• Working Capital Management: Working Capital refers to
that part of the firm’s capital, which is required for financing
short-term or current assets such a cash marketable securities,
debtors and inventories. Funds thus, invested in current assets
keep revolving fast and are constantly converted into cash and
this cash flow out again in exchange for other current assets.
 Goal Of Financial
Management
What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s
stock?
Does this mean we should do anything and
everything to maximize owner wealth?
 GOAL OF FINANCIAL MANAGEMENT

FINANCE THEORY RESTS ON THE PREMISE THAT

MANAGERS SHOULD MANAGE THEIR FIRM’s
RESOURCES WITH THE OBJECTIVE OF
ENHANCING THE FIRM’s MARKET VALUE.

The theory in corporate finance is based on assumption

that the goal of the firm should be to maximize the
wealth of its current shareholders.
 Wealth maximisation
 Also known as Value Maximisation or Net Worth
Maximisation.
 The wealth maximization criterion is based on the
concept of cash flows generated by the decision rather
than accounting profit which is the basis of the
measurement of benefits in the case of the profit
maximisation criterion.
 The wealth maximization criterion is that it considers
both the quantity and quality dimensions of benefits.
 CRITIQUE AND DEFENCE OF SHAREHOLDER
WEALTH MAXIMISATION GOAL
Critique
• The capital market sceptics
argue that stock prices fail
to reflect true values
• The balancers argue that a
firm should seek to
‘balance’ the interests of
various stakeholders
• Advocates of social
responsibility argue that a
business firm must assume
wider social responsibilities
Defence
• Financial economists argue
that stock prices are the
least biased estimates of
intrinsic values in developed
markets
• Balancing the interests of
various stakeholders is not
a practical governing
objective
• The only social
responsibility of business
is to create value and do so
legally and with integrity
 SHAREHOLDER ORIENTATION IN INDIA

In the wake of liberalisation, globalisation, and

institutionalisation of the capital market, there is a greater
incentive to focus on creating value for shareholders. The
following observations are clear indications.

Dhirubai Ambani : In everything that we do, we have only

one supreme goal, that is to maximise your wealth as India's
largest investor family.

Anand Mahindra : All of us are beginning to look at

companies as owned by shareholders. The key is to raise
shareholder returns
 ALTERNATIVE GOALS
Maximisation of Profit
Profit maximisation criterion implies that the investment, financing
and dividend policy decisions of a firm should be oriented to the
maximisation of profits/EPS. Profit maximisation would imply that a
firm should be guided in financial decision making by one test; select
assets, projects and decisions which are profitable and reject thase
which are not. This goal is not as inclusive a goal as maximisation of
shareholders’ wealth.
Its limitations are:
• Profit in absolute terms is not a proper guide to decision
making. It should be expressed either on a per share basis or
in relation to investment.
• It leaves considerations of timing and duration undefined.
• It glosses over the factor of risk
  Maximisation of EPS or ROE
 While these goals do not suffer from the
first limitation mentioned above, they
suffer from the other two limitations.
 THE FUNDAMENTAL PRINCIPLE OF FINANCE
A business proposal-regardless of whether it is a new
investment or acquisition of another company or a
restructuring initiative –raises 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.
CASH ALONE MATTERS

Investors Investors provide the initial cash required The business proposal
• Shareholders to finance the business proposal
• Lenders

The proposal generates

cash returns to investors
 Risk-Return Tradeoff
 The principle that potential return rises with an increase in
risk. Low levels of uncertainty (low risk) are associated
with low potential returns, whereas high levels of
uncertainty (high risk) are associated with high potential
returns.
 Risk: risk is the chance that an investment's actual return
will be different than expected. Technically, this is
measured in statistics by standard deviation. Risk means
you have the possibility of losing some, or even all, of our
original investment.
 Return: The return earned on investments represents the
marginal benefit of investing.

 Risk-Return Tradeoff(cont.)
 The risk/return tradeoff is the balance
between the desire for the lowest possible
risk and the highest possible return. This is
demonstrated graphically in the chart
below. A higher standard deviation means a
higher risk and higher possible return.
DECISIONS, RETURN, RISK,
AND MARKET VALUE

Capital Budgeting
Decisions

Return
Capital Structure
Decisions
M arket Value of
the Firm
Dividend
Decisions
Risk

W orking Ca
pital
Decisions
 FORMS OF BUSINESS ORGANISATIONS
Sole Proprietorship
• One owner
• Very simple
• Unlimited liability
• The firm has no separate status from a legal and tax
point of view
Partnership
• Two or more owners
• Fairly simple
• Unlimited liability
• The firm has a separate status
Private Limited Company
• Upto 50 owners
• Not too complex
• Limited liability
• A distinct legal person
 FORMS OF ORGANISATION
Public Limited Company

• Many owners
• Somewhat complex
• Limited liability
• Distinct legal person
• Free transferability of shares

Public Limited Company’s Attraction

• The potential for growth is immense because of access to
substantial funds
• Investors enjoy liquidity because of free transferability of
securities
• The scope for employing talented managers is greater
 Agency Problem
 Principal vs Agent
– Principal: Firm owners
– Agent: Management

 Agency Problem: The possibility of conflict of

interest between stockholders and management of
a firm  Agency Cost(are costs borne by shareholders to
prevent/ minimise agency problems as to contribute to maximise
owners wealth.)
 Examples: managerial perks, attitude towards risk,
empire building, etc.
 Stock value may not be maximized!
 AGENCY PROBLEM

• While there are compelling reasons for separation of

ownership and management, a separated structure leads
to a possible conflict of interest between managers and
shareholders.

• The lack of perfect arrangement between the interests of

managers and shareholders results in the agency problem.

• To diminish the agency problem, effective monitoring has

to be done and appropriate incentives have to be offered.
 Solutions to Agency Problem
 Managerial Compensations to align incentives

 Control of the Firm

– Stockholders elect Board of Directors who have
rights to HIRE and FIRE managers
– well-established management
– Hostile takeover(is the acquisition of the firm by another
firm that is not supported by management) due to low
prices, market for corporate control

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 Organisation of the finance function
ALL MANAGERS ARE FINANCIAL MANAGERS
• The engineer, who proposes a new plant, shapes the
investment policy of the firm
• The marketing analyst provides inputs in the process of
forecasting and planning
• The purchase manager influences the level of investment
in inventories
• The sales manager has a say in the determination of the
receivables policy
• Departmental managers, in general, are important links
in the finance control system of the firm
 Functions of the Treasurer and
the Controller
Treasurer Controller
 Obtaining finance  Financial accounting
 Banking relationship  Internal auditing
 Cash management  Taxation
 Credit administration  Management accounting
 Capital budgeting and control
ORGANISATION OF FINANCE FUNCTION

Chief Finance
Officer

Treasurer Controller

Financial Cost
Cash Credit
Accounting Accounting
Manager Manager
Manager Manager

Capital Fund Tax Data

Budgeting Raising Manager Processing
Manager Manager Manager

Portfolio Internal
Manager Auditor
 EMERGING ROLE OF THE
FINANCIAL MANAGER IN INDIA
The job of the financial manager in India has become more
important, complex and demanding due to the following factors:
• Liberalisation
• Globalisation
• Technological developments
• Volatile financial prices
• Economic uncertainty
• Tax law changes
• Ethical concerns over financial dealings
• Shareholder activism
 EMERGING ROLE OF THE
FINANCIAL MANAGER IN INDIA

The key challenges for the financial manager appear to be in

the following areas:
• Investment planning and resource allocation
• Financial structure
• Mergers, acquisitions, and restructuring
• Working capital management
• Performance management
• Risk management
• Corporate governance
• Investor relations
 SUMMING UP
• There are three broad areas of financial decision making, viz., capital
budgeting, capital structure, and working capital management.

• Finance theory, in general, rests on the premise that the goal of financial
management should be to maximise the wealth of shareholders.

• A business proposal raises 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.

• A confluence of forces appears now to be prodding Indian companies to

accord greater importance to the goal of shareholder wealth
maximisation.

• In general, when you take a financial decision, you have to answer the
following questions : What is the expected return ? What is the risk
exposure ? Given the risk-return characteristics of the decision, how
would it influence value ?
• The important forms of business organisation are : sole proprietorship,
partnership, private limited company, and public limited company.
While each form of organisation has certain advantages and limitations,
the public limited company form of organisation generally appears to be
the most appropriate form from the point of view of shareholder wealth
maximisation.

• While there are compelling reasons for separation of ownership and

management, a separated structure leads to a possible conflict of interest
between managers and shareholders.

• The lack of perfect alignment between the interests of managers and

shareholders results in the agency problem. To mitigate the agency
problem, effective monitoring has to be done and appropriate incentives
have to be offered.
• Financial management is in many ways an integral part of the jobs of
managers who are involved in planning, allocation of resources, and
control.

• Thanks to the changes in the complexion of the economic and financial

environment in India from early 1990s, the job of the financial manager
in India has become more important complex, and demanding.