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Evolution of finance

Evolution

The word finance originates from the French and is subsequently adopted by English-speaking
regions to refer to the ‘management of money’. ‘Finance’, today, is more than just a word; it has
emerged into a highly significant professional and academic discipline.

Traditional Approach

Traditionally, finance itself in any organization aimed to achieve optimal use of the limited financial
resources. The scope of finance is mostly confined to the procurement of funds by business houses
to address financial needs.
Earlier, finance as a function remained focused on funding activities and involved extensive decision
making around financial instruments, investment houses and practices. This period (the mid-1950s)
is referred to as corporation finance.
As the demand for funds continued to increase rapidly, episodic events including liquidation, merger,
acquisition and consolidation have become an integral part of the finance function. The scope,
however, does not concern with aspects relating to the allocation of funds. The emphasis is on three
C’s – compliance, cost and control.
Traditional finance ignored the significance of working capital management and the need for an
internal financial system. The focus of finance is by and large on matters relating to suppliers of
funds, including investment bankers, investors and financial institutions, that is to say, outsiders.

Modern Approach

Going further, a number of factors such as the rapid technological advancements, intense
competition, growing population, industrialization and government interference have contributed to
the increased focus on the effective and efficient use of financial resources.
Essential matters such as the cost of capital, valuation of the firm, optimum allocation of resources
have become the core of finance in a modern approach. The shift from episodic financing to
managerial financing is a visible pointer to the emergence of finance as a function.
Modern finance leverages technology across main accounting and finance processes for enhanced
performance. The finance as a function takes a broader view on various business aspects, including
profitability planning, determining the asset mix, risk analysis, optimal capital structure, financing,
investment and dividend decisions as well as the direction of business growth.
Under this approach, finance as a function emphasizes more on managerial aspects of business and
stretches the responsibilities of a finance manager to include all decision-making associated with the
efficient use of resources.

Role of a Financial Manager


Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in
order to take care of these activities a financial manager performs all the requisite financial activities.

A financial manger is a person who takes care of all the important financial functions of an organization.
The person in charge should maintain a far sightedness in order to ensure that the funds are utilized in
the most efficient manner. His actions directly affect the Profitability, growth and goodwill of the firm.

Following are the main functions of a Financial Manager:


Financial Manager Responsibility # 1. Forecasting and
Planning:
The financial manager must interact with other executives as they look
ahead and lay the plans which will shape the firm’s future.

Financial Manager Responsibility # 2. Major Investment and


Financing Decisions:
A successful firm usually has rapid growth in sales, which requires
investments in plant, equipment and inventory.

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It is the task of the financial manager to help determine the optimal


sales growth rate, and he (she) must help decide what specific assets to
acquire and the best way to finance those assets. For example, should
the firm finance with debt, equity, or some combination of the two,
and if debt is used, how much should be long term and how much
should be short term?

Financial Manager Responsibility # 3. Coordination and


Control:
The financial manager must interact with other executives to ensure
that the firm is operated as efficiently as possible. All business
decisions have financial implications, and all managers financial and
otherwise need to take this into account.

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For example, marketing decisions affect sales growth, which, in turn,


influences investment requirements. Thus, marketing decision makers
must take account of how their actions affect (and are affected by)
such factors as the availability of funds, inventory policies and plant
capacity utilisation.

Financial Manager Responsibility # 4. Dealing with the


Financial Markets:
The financial manager must deal with the money and capital markets.
Each firm affects and is affected by the general financial markets
where funds are raised, where the firm’s shares and debentures are
traded, and where its investors either make or lose money.

Financial Manager Responsibility # 5. Risk Management:


All business face risks, including natural disasters such as fires and
floods, uncertainties in commodity and share prices, changing interest
rates and fluctuating foreign exchange rates. However, many of these
risks can be reduced by purchasing insurance or by hedging.

The financial manager is usually responsible for the firm’s overall risk
management programmes, including identifying the risks that should
be hedged and then hedging them in the most efficient manner.

In short, financial managers make decisions regarding which assets


their firms should acquire, how those assets should be financed, and
how the firm should manage its existing resources. If these
responsibilities are performed optimally, financial managers will help
to maximise the values of their firms, and this will also maximise the
long-run welfare of consumers and employees.
Profit Maximisation vs Wealth Maximisationnn

BASIS FOR PROFIT WEALTH


COMPARISON MAXIMIZATION MAXIMIZATION

Concept The main objective of a The ultimate goal of the


concern is to earn a larger concern is to improve the
amount of profit. market value of its shares.

Emphasizes on Achieving short term Achieving long term


objectives. objectives.

Consideration of No Yes
Risks and
Uncertainty

Advantage Acts as a yardstick for Gaining a large market


computing the operational share.
efficiency of the entity.

Recognition of Time No Yes


Pattern of Returns

Definition of Profit Maximization

Profit Maximization is the capability of the firm in producing maximum output


with the limited input, or it uses minimum input for producing stated output. It is
termed as the foremost objective of the company.

It has been traditionally recommended that the apparent motive of any business
organisation is to earn a profit, it is essential for the success, survival, and growth
of the company. Profit is a long term objective, but it has a short-term perspective
i.e. one financial year.

Profit can be calculated by deducting total cost from total revenue. Through profit
maximization, a firm can be able to ascertain the input-output levels, which gives
the highest amount of profit. Therefore, the finance officer of an organisation
should take his decision in the direction of maximizing profit although it is not
the only objective of the company.
Definition of Wealth Maximization

Wealth maximizsation is the ability of a company to increase the market value of


its common stock over time. The market value of the firm is based on many
factors like their goodwill, sales, services, quality of products, etc.

It is the versatile goal of the company and highly recommended criterion for
evaluating the performance of a business organisation. This will help the firm to
increase their share in the market, attain leadership, maintain consumer
satisfaction and many other benefits are also there.

It has been universally accepted that the fundamental goal of the business
enterprise is to increase the wealth of its shareholders, as they are the owners of
the undertaking, and they buy the shares of the company with the expectation
that it will give some return after a period. This states that the financial decisions
of the firm should be taken in such a manner that will increase the Net Present
Worth of the company’s profit. The value is based on two factors:

1. Rate of Earning per share


2. Capitalization Rate

# MERITS AND DEMERITS –ALL DOCUTES-IMAGES!

Risk and return as basic dimension of financial decisions & must show flow
chart.

Risk and return are opposing concepts in the financial world, and the tradeoff between
them could be thought of as the “ability-to-sleep-at-night test.” Depending upon factors
like your age, income, and investment goals, you may be willing to take significant
financial risks in your investments, or you may prefer to keep things much safer. It’s
crucial that an investor decide how much risk to take on while still remaining
comfortable with his or her investments.

For investors, the basic definition of “risk” is the chance that an investment’s actual
return will be different from what was expected. One can measure risk in statistics
by standard deviation. Because of risk, you have the possibility of losing a portion (or
even all) of a potential investment. “Return,” on the other hand, is the gains or losses
one brings in as a result of an investment.

Generally speaking, at low levels of risk, potential returns tend to be low as well. High
levels of risk are typically associated with high potential returns. A risky investment
means that you’re more likely to lose everything; but, on the other hand, the amount
you could bring in is higher. The tradeoff between risk and return, then, is the balance
between the lowest possible risk and the highest possible return. We can see a visual
representation of this association in the chart below, in which a higher standard
deviation means a higher level of risk, as well as a higher potential return.

(Source: Investopedia.com)

It’s crucial to keep in mind that higher risk does NOT equal greater return. The
risk/return tradeoff only indicates that higher risk levels are associated with
the possibility of higher returns, but nothing is guaranteed. At the same time, higher risk
also means higher potential losses on an investment.

On the safe side of the spectrum, the risk-free rate of return is represented by the return
on U.S. Government Securities, as their chance of default is essentially zero. Thus, if
the risk-free rate is 6% at any given time, for instance, this means that investors can
earn 6% per year on their assets, essentially without risking anything.

While a 6% return might sound good, it pales compared to returns of many popular
investment vehicles. If index funds average about 12% per year over the long run, why
would someone prefer to invest in U.S. Government Securities? One explanation is that
index funds, while safe compared to most investment vehicles, are still associated with
some level of risk. An index fund which represents the entire market carries risk, and
thus, the return for any given index fund may be -5% for one year, 25% for the following
year, etc. The risk to the investor, particularly on a shorter timescale, is higher, as is
volatility. Comparing index funds to government securities, we call the addition return
the risk premium, which in our example is 6% (12%-6%).

One of the biggest decisions for any investor is selecting the appropriate level of risk.

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