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Financial Management

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Financial Management
Prescribed Text Book:
• Corporate Finance by Ross, S. A.−Westerfield, R. W. and
Jaffe, J., The McGraw-Hill Companies, 2010.
Other Reference/Suggested Books:
• Corporate Finance by Ross, S. A.−Westerfield, R. W.-Jaffe, J. and
Kakani, R. K., The McGraw-Hill Education (India) Pvt. Ltd, 2014.
• Corporate Finance: A Focussed Approach by Brigham, E. and
Ehrhardt, M. C., South Western Cengage Learning, 2013.
• Financial Management by Khan, M. Y. and Jain, P. K., McGraw-Hill
Education (India) Pvt. Ltd, 2014.
• Principles of Corporate Finance by Brealey, R.-Myers, S. and Allen,
F. The McGraw-Hill Companies, 2014.
• Corporate Financial Analysis with Microsoft Excel by Francis J.
Clauss, The McGraw-Hill Companies, 2010.

Financial Management:
An Overview

Financial Services Financial services is concerned with the design and delivery of advice and financial products to individuals. . profit-seeking and not-for-profit. large and small. Financial managers actively manage the financial affairs of any type of business. The major areas of finance are: 1. business and governments. controlling and managing the financial resources of a given firm. 2. namely. Financial Management Financial Management is that managerial activity which is concerned with planning.Finance Finance may be defined as the art and science of managing money. financial and non-financial. private and public.

Finance and Related Disciplines .

Macroeconomics provides an understanding of the institutional structure in which the flow of finance takes place. Microeconomics provides various profit maximization strategies based on the theory of the firm. Marginal Analysis suggests that financial decisions should be made on the basis of comparison of marginal revenues and marginal costs/added benefits exceed added costs. . One of the fundamental principle of financial management suggests that financial decisions should be based on Marginal Analysis. A financial manager uses these to run the firm efficiently and effectively.Finance and Economics Finance is closely related to both macroeconomics and microeconomics.

The new computer would require a cash outlay of Rs 8.80.50.000.000 and Rs 3. more sophisticated one that would both speed up processing time and handle a large volume of transactions.000 and the old computer could be sold to net Rs 2. The total benefits from the new computer and the old computer would be Rs 10.Illustration of a Financial Decision using Marginal Analysis A financial manager of a department store is contemplating to replace one of its online computers with a new.00.00.000 respectively. Should the manager replace the old computer by the new one? .

000.000 8.50.000 As the store would get a net benefit of Rs 1.30.000 Marginal Cost (b) 5.000 2.000 Marginal Revenue (a) Cost of new computer Less: Proceeds from sale of old computer Rs 6.30.000 Net Benefits [(a) – (b)] 1.000 3.00.00. the old computer should be replaced by the new one.Illustration of a Financial Decision using Marginal Analysis Benefits with new computer Less: Benefits with old computer Rs 10.20.80.50. .

. Treatment of Funds and 2. A financial manager depends on these financial statements as a source of information/data relating to the past. present and future financial position of the firm for making any financial decision. finance and accounting differ in two ways: 1. The end product of accounting is the generation of financial statements of a firm. However.Finance and Accounting Accounting generates information/data to operations/activities of a firm. Decision Making.

.Finance and Accounting Treatment of Funds: The measurement of funds in accounting is based on the accrual principle where as the in finance it is based on cash flows. Cash flows method recognizes revenues and expenses only with respect to actual inflows (when cash is actually received) and outflows of cash (when cash is actually paid). Accrual method recognizes revenue at the point of sale and not when collected and expenses when they are incurred rather than when actually paid.

00.00.000 Less: Cash outflow 2.00.000 8.00.00.000 while the cost of sales was Rs 8. At the end of the year.000.000 Net cash outflow Rs 2.00.000 Cash inflow 8.000) .00. total sales of a trader during the year amounted to Rs 10. The accounting view and the financial view of the firms performance during the year are given below. Accounting view Financial view (Income statement) (Cash flow statement) Sales Less: Costs Net profit Rs 10.00.000 from the customers. it has yet to collect Rs 8.00.To illustrate.000 (6.

operations. production. HR and quantitative methods.Finance and Accounting Decision Making: The focus of finance is on the decision making where as accounting concentrates on collection. Finance and Other Related Disciplines Apart from economics and accounting. compilation and presentation of financial data. finance also draws—for its day-to-day decisions—on supportive disciplines such as marketing. .

Determination Structure of Support Capital Support Other Related Disciplines 5. Analysis of Risks and Returns • Production • Operations • Quantitative methods • HR Resulting in Shareholder Wealth Maximization .The relationship between Financial Management and supportive Disciplines Financial Decision Areas Primary Disciplines • Accounting 2. Sources and Cost of Funds • Microeconomics 1. Investment Analysis 4. Working Capital Management • Macroeconomics 3. Dividend Policy • Marketing 6.

How can the firm raise the money for the required investments? 3.Scope of Financial Management Financial Management addresses the following three questions: 1. What long-term and short-term investments should the firm engage in? 2. What proportion of net profits can be distributed to the shareholders in the form of dividends and what proportion can be retained in the business itself ? .

It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project. The assets which can be acquired fall into two broad groups: (a) fixed-assets/long-term assets (Capital Budgeting) (b) short-term /current assets (Working Capital). It is an important and integral part of financial management as short-term survival is a prerequisite for long-term success. . (a) Capital Budgeting: Capital budgeting is probably the most crucial financial decision of a firm. (b) Working Capital Management: Working capital management is concerned with the management of current assets.Scope of Financial Management The scope of financial management can be broken down into three major decisions as functions of finance: (1) Investment Decision The investment decision relates to the selection of assets in which funds will be invested by a firm.

the concern of the financing decision is with the financing-mix or capital structure or leverage. that is. There is one major aspect of the financing decision.(2) Financing Decision Financing decision relates to the choice of the proportion of debt and equity sources of financing. While the investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. . the dividend-pay out ratio. The decision as to which course should be followed depends largely on a significant element in the dividend decision. The two alternatives available with the firm are: (i) Net profits can be distributed to the shareholders in the form of dividends or (ii) they can be retained in the business itself. called the optimum capital structure. (3) Dividend Policy Decision The dividend decision relates to the distribution and retention of net profits of a firm. what proportion of net profits should be paid out to the shareholders and what proportion should be retained in the business.

Financial Decisions a Firm Financial Decisions Investment Decision Financing Decision Internal Sources Dividend Policy Decision External Sources (Sources of Funds) Fixed Assets Working Capital (Uses of Funds) Distribution Retention (Dividend-pay out ratio) .

The Balance-Sheet Model of the Firm Total Firm Value to Investors: Total Value of Assets: Fixed Assets Shareholders’ Equity 1 Tangible 2 Intangible Long-Term Debt Current Assets Current Liabilities .

The Balance-Sheet Model of the Firm The Capital Budgeting and Working Capital Decision Fixed Assets Shareholders’ Equity What Long-term investments should the firm engage in? 1 Tangible 2 Intangible Long-Term Debt Current Liabilities What Short-term investments should the firm engage in? Current Assets .

The Balance-Sheet Model of the Firm The Financing Decision Fixed Assets Shareholders’ Equity 1 Tangible 2 Intangible Long-Term Debt Current Liabilities How can the firm raise the money for the required investments? Current Assets .

The Balance-Sheet Model of the Firm The Net Working Capital Decision Fixed Assets Shareholders’ Equity 1 Tangible 2 Intangible Long-Term Debt Net Working Current Liabilities Capital Current Assets .

Organization of Financial Management Function .

Organization of Financial Management Function Board of Directors Managing Director/Chairman/CEO Vice-President/Director (Finance)/Chief Finance Officer (CFO) Controller Treasurer Financial planning and fund-raising manager Capital expenditure manager Cash Manager Credit Manager Foreign exchange manager Pension fund manager Tax manager Corporate accounting manager Cost accounting manager Financial accounting manager .

4. Making Financing Decisions Financing decisions involve two major areas: first. The mix refers to the amount of current assets and fixed assets. the most appropriate mix of short-term and long-term financing.Key Activities/Functions of the Financial Manager 1. (b) evaluating the need for increased (reduced) productive capacity and (c) determining the additional/reduced financing required. the best individual short-term or long-term sources of financing at a given point of time. Making Investment Decisions Investment decisions determine both the mix and the type of assets held by a firm. . second. 2. Making Dividend Policy Decisions The dividend decision relates to the distribution and retention of net profits of a firm (the dividend-pay out ratio). 3. Performing Financial Analysis and Planning The concern of financial analysis and planning is with (a) transforming financial data into a form that can be used to monitor financial condition.

Separation of Ownership and Control: Agency Problem Board of Directors Assets Equity Shareholders Debt Debtholders Management .

firms incur agency costs in the form of monitoring and bonding expenditures. . In addition.Agency Problem An agency problem results when managers as agents of owners (principal) place personal goals ahead of corporate goals. opportunity costs and structuring expenditures which involve both incentive and performance-based compensation plans to motivate management to act in the best interest of the shareholders. Market forces and the threat of hostile takeover tend to act to prevent/minimise agency problems.

Stockholder Wealth Maximization (Maximizing the price of the firm’s common stock) . Profit Maximization (Profit/Earning per Share (EPS) Maximization---Profit refers to the amount and share of income which is paid to the owners of business who supply equity capital) 2.Objectives / Goals of the Corporation 1.

Ambiguity (Short-term. total profit or rate of profit. Time Value of Money (the value of a stream of cash flows is calculated by discounting its element back to the present at a discount rate which reflects both time and risk) . No Ambiguity (Concept of cash flows generated by the decision rather than accounting profit) 2. No Time Value of Money (Ignores the difference in the time pattern of the benefits received in different time period and treats all benefits irrespective of the timing as equally valuable) 2.Objectives / Goals of the Corporation Profit Maximization v/s Wealth Maximization Profit Maximization Wealth Maximization 1. long-term. profit before tax or after tax. return on total capital employed or total assets or shareholder's equity) 1.

Quality of Benefits (The ignores degree of certainty with discount rate reflects the risk which benefits can be expected) preference and time of the owners or suppliers of capital). No Quality of Benefits (It 3.Objectives / Goals of the Corporation Profit Maximization v/s Wealth Maximization Profit Maximization Wealth Maximization 3. .

as a guide to financial decision making. is that it ignores the differences in the time pattern of the benefits received over the working life of the asset. Time-Pattern of Benefits (Profits) Time Alternative A (Rs in lakh) Period I 50 Period II 100 Period III 50 Total 200 Alternative B (Rs in lakh) — 100 100 200 . irrespective of when they were received.Timing of Benefits A more important technical objection to profit maximisation.

Quality of Benefits Probably the most important technical limitation of profit maximization as an operational objective. The term quality here refers to the degree of certainty with which benefits can be expected. is that it ignores the quality aspect of benefits associated with a financial course of action. Risk and Uncertainty About Expected Benefits (Profits) State of Economy Profit (Rs crore) Alternative A Alternative B Recession (Period I) Normal (Period II) Boom (Period III) 9 10 11 0 10 20 Total 30 30 .

The Firm and the Financial Markets .

. Financial Markets Dividends and debt payments (F) Taxes (D) Firm Government Long-term Debt Equity Shares The cash flows from the firm must exceed the cash flows from the financial markets. the firm must be a cash generating activity.The Firm and the Financial Markets: Invests in Assets (B) Current Assets Fixed Assets Firm issues securities/shares (A) Retained cash flows (E) Short-term Debt Cash flow from firm (C) Ultimately.