You are on page 1of 7

B.

COM- V SEMESTER-FINANCIAL MANAGEMENT (THEORY)


CHAPTER 1- NATURE OF FINANCIAL MANAGEMENT
INTRODUCTION:
Financial Management is concerned with management of finance or finance function. Finance function is
the process of planning, raising, providing and managing of the funds used in the business. Financial
Management as a separate discipline is of recent origin. The development in science and technology has brought
about significant changes in industry and business. This change has contributed to the development of Financial
Management as a separate discipline.

MEANING AND DEFINITION OF FINANCIAL MANAGEMENT:


Ezra Solomon has given a simple definition “Financial Management is concerned with efficient use of
important economic resource that is capital funds.”
According to Phillipats, “Financial Management is concerned with managerial decisions that result in the
acquisition and financing of long-term and short-term credits for the firm as such it deals with situations that
require the selection of specific assets, the selection of liability as well as the problem of size and growth of an
enterprise.”

SCOPE OF FINANCIAL MANAGEMENT:


The approach to the scope and functions of financial management is divided into 2 broad categories.
a) The Traditional Approach
b) The Modern Approach

a)The Traditional Approach:


This approach was popular till the first half of 20th century. This approach limited the role of financial manager
to rising and administering of funds needed by corporate enterprises, to meet their financial needs. This
approach limited the scope of F.M. to the following areas.

1) Raising funds: Every business needs funds. These funds should be raised from various sources. The finance
manager selects the source that gives maximum benefit at minimum cost to the organization.
2) External reporting: In case of joint stock company there is a compulsion to prepare the annual accounts, get
them audited and send copies of them to the necessary govt. departments and shareholders. This is called
external reporting.
3) Institutions and instruments: Financial management studies the institutions operating in capital market as
well as money market and instruments that are used for mobilizing funds.

Limitations of traditional approach:


1) Over- emphasis on external reporting: In case of joint stock companies(JSC), there is a need to prepare the
annual accounts, get them audited and send copies to the necessary offices. Though, reporting to
shareholders is important, it takes place once in a year. Far more serious problem are tackled by financial
management very frequently.
2) Corporate bias: F.M is concerned with finances of Joint Stock Companies. Non-corporate bodies like
partnership firms, co-operatives etc. also operate on a large scale. However, these organizations are not
covered under the scope of financial management in traditional approach.
3) Insignificant role to working capital management: This approach of FM turns to focus on long term
financing. The role assigned to working capital management is very insignificant.
4) Ignoring routine problems: Under traditional approach, too much importance was given to rare events like
mergers and acquisitions, financial restructuring etc. Majority of the companies never experience these
events even once. On the other hand, the routine problems were not given due importance.

b) The Modern Approach:


The development of technology made many JSC highly profitable. This led to the widening of the scope of
financial management. The modern approach covers three important functions.
1) Financing decisions
2) Investment decisions
3) Dividend policy decisions

I. Financing Decisions:
a) Estimation of fund requirement: Since there are different sources to large size funds, the requirement
should be estimated in advance.

b) Procurement of funds: Once the requirement is estimated they should be procured from the relevant
sources. While selecting the sources, certain principles a=like cost of funds, procedure, security to be
offered cost of raising funds etc. should be considered.

REF: FUNDAMENTALS of FINANCIAL MANAGEMENT by B.V.RAGHUNANDAN Page 1


B.COM- V SEMESTER-FINANCIAL MANAGEMENT (THEORY)
c) Planning the capital structure: The funds can be raised from 2 sources. Ownership funds and creditorship
funds. Ownership funds include equity shares and preference shares. Creditorship funds include
debentures long term loans etc. The Financial manager also plans how much should be ownership and
creditorship funds.
d) Negotiating with funding agency: There are many funding agencies like mutual funds, financial
institutions, insurance companies, venture capital funds etc. The finance manager is always engaged in
negotiating with funding agency.

II.Investment Decisions:
a) Cash management: Cash is the most liquid asset but least earning. However, cash is required to make
payments. Hence, finance manager should intelligently manage cash.
b) Working capital management: It includes sundry debtors, various stocks and short term investments of
surplus funds. The management of working capital also requires special attention of the finance manager.
c) Capital budgeting:I provides necessary tools to evaluate the long term investment. Long term investment
is more complicated because they have long lasting impact on the company.
d) Portfolio management: Many corporate houses invest their surplus funds in a portfolio of investment. In
addition, this portfolio is shuffled very often to maximize the returns. Managing the portfolio of
investment involves complicated statistical and mathematical models.
e) Evaluation by bench marking: Benchmarks are established for evaluating the performance of various
financial components like sales, gross profit, net profit. Financial performance is evaluated in the light of
these benchmarks.

III. Dividend Policy Decisions:


a) Profit allocation: Profit is to be allocated among various types of resources. Such allocation is made in line
with the plans of the organization regarding the growth. Moreover there is also a legal compulsion to
transfer certain amount to the general reserve, whenever dividend is declared.
b) Framing dividend policy: Corporate have to decide whether they will follow liberal dividend policy or
conservative dividend policy. Many of the companies are attracting shareholders through special dividend
in addition to interim dividends within one financial year. Issuing bonus shares have become a common
feature.

Objectives of Financial Management


1) Profit Maximization
2) Wealth Maximization
3) Maintenance of Adequate Liquid Assets
4) Adding to Shareholders’ Value
5) Corporate Governance

1) Profit Maximization:
A business firm is a profit seeking organization so naturally maximization of profit is one of the basic or
important objectives of F.M. The profits or earnings of the firm can be maximized by undertaking the
following measures.
(i) By increasing sales
(ii) By reducing cost of production
The objective of profit maximization is criticizes by many authors. The main objectives are:
(a) Vagueness: this concept is not clarifying as to which profits are to be maximized short term or long term
profit. The period reference to profit is totally lacking.
(b) Ignoring time value of money: the concept of profit maximization does not recognize the difference
between the returns received in different periods of time and treats them at par. In otherwords, profit
maximization does not take into consideration the timings of the returns.
(c) Ignoring risk and uncertainty: while evaluating the projects, the profits estimated should be suitably
discounted for the risk and uncertainty. Profit maximization relies on the return on investment
estimated on each project. However the expected rate of return is far more reliable.
(d) Ignoring role of growth: a business unit is not running solely with the objective of earning maximum
profits. Many corporate sacrifice the profit in order to achieve long term growth. Profit maximization
objective totally ignores role of growth.

2) Wealth Maximization:
This is maximizing Net Present Value (NPV) of different courses of action. Wealth is the difference between
NPV of future benefits and the present value of the cost. Here, time value of money is taken into
consideration. For doing so, the future cash flows re discounted and matched against the present cash
outflows for making the investment.
Ezra Solomon describes Wealth Maximization as “the gross present worth of a course of action is equal
to the capitalized value of the flow of future benefits discounted at rate which reflects the certainty or

REF: FUNDAMENTALS of FINANCIAL MANAGEMENT by B.V.RAGHUNANDAN Page 2


B.COM- V SEMESTER-FINANCIAL MANAGEMENT (THEORY)
uncertainty. Net Present worth is the difference between gross present worth and the amount of capital
investment required to achieve the benefits.”
Wealth maximization is measured by following formula
W = A1 + A2 + A3 + A4 …………. An - C0
(1+R)1 (1+R)2 (1+R)3 (1+R)4 (1+R)n
Here A represents annual cash flows, R is rate of discounting and C is cost of initial investment and W is
wealth created.
This concept has many merits.
a) This concept is very clear and not vague. It means the present value of future cash flows arising from a
financial action minus the cost of investment.
b) The wealth maximization concept considers the time value of money. It recognizes the fact that a rupee
received today has more value than a rupee received after a year. Hence the cash flows from a project in
different years are not equal.
c) The concept takes into account the risk factors. It gives due importance to the risk factors by applying
different rates of discount while discounting the cash flows from projects.
d) It also helps in framing dividend policy

3) Maintenance of Adequate Liquid Assets:


The objective of liquidity implies that Finance Manager should ensure that there are adequate cash funds in
the hands of the firm at all time to meet its obligations. Adequate liquidity of funds will enable the firm to
meet normal obligations and avoid loss to reputation among the public.
However profit maximization and ensuring liquidity are contrasting objectives. More the assets are liquid
less they are profitable and vice versa. Carrying more cash will increase liquidity but will reduce profitability,
because cash is an idle asset. Higher debt equity ratio will increase profitability but will reduce liquidity. The
finance manager has to make a compromise between the two, in the form of risk return trade-off.
4) Adding to Shareholders’ Value:
Any corporate worth its name tries hard to see that the shareholders get the highest reward out of the
shares purchased. This may be in the form of higher dividend, frequent interim dividend, bonus shares etc.
Capital appreciation through a higher price quote on the stock exchange is an important reward for the
shareholders

5) Corporate Governance:
Every corporate should operate in such a way that it does not make any of the stakeholders like customers,
suppliers, employees, creditors etc.
In India, Securities and Exchange Board of India (SEBI) puts a clause in the listing agreement of stock
exchange. It is for the stock exchange to watch the price sensitive information is furnished without loss of
time. Effectively protection of shareholders interest by the stock exchange is called ‘Corporate Governance.’

Growing importance of Financial Management in Business:


In the last 3 decades, FM has grown by leaps and bounce. Following factors will explain importance of FM.
1. Risk-Return trade off: Every project and securing of funds are analysed in the light of risk an returns. Higher
returns are accompanied by higher risk. Modern FM uses advanced statistical and mathematical tools to
develop an optimum mix of risk and return. This complexity adds to the importance of financial
management.
2. Financial Restructuring: There are many opportunities to reduce the cost of capital through financial
restructuring. Borrowing fresh to repay existing expensive funds is a technique that should be used to
increase profitability.
3. Portfolio management: Highly efficient and profitable corporate generate huge cash surplus after the
decades of operation. This can be profitably invested in long term and short term securities. By actively
managing the portfolio of investment, the finance department adds to the profits of the corporate
substantially.
4. Designing innovative financial instruments: The instruments through which corporate borrow can be
designed to benefit the company and the investor. FM helps in changing the features of such instruments.
5. Novel ways of rewarding shareholders: Many companies started developing new methods of rewarding
shareholders. Corporate not only maximize their profits but also maximize the profits of the shareholders on
investments in shares of the company. It helps in rewarding shareholders in following ways.
 Annual dividend
 Interim dividend
 Special divided
 Bonus securities
 Buy back shares
 Sponsored American Depository Receipts (ADR) or Global Depository Receipts (GDR)
 Splitting of shares into smaller denominations

REF: FUNDAMENTALS of FINANCIAL MANAGEMENT by B.V.RAGHUNANDAN Page 3


B.COM- V SEMESTER-FINANCIAL MANAGEMENT (THEORY)
6. Legal compliance: FM helps the business to comply with various legal requirements. For money market
operations RBI regulations are to be complied with. For capital market operations, SEBI regulations are to be
observed. For corporate governance stock exchange listing agreements provisions are to be taken care of.
7. Monitoring share price movement: There are few companies like Reliance industries Ltd. which do not allow
the price of their shares to be depressed by speculation. They establish investment trust for buying the
shares when the share prices fall below the particular level due to speculation. This calls for continues
monetary of the price movement in the stock market.
8. Searching for investment opportunities: The organized markets like foreign exchange commodities
exchange and money market are very well developed. Since the funds can be moved very quickly,
investment opportunities are plenty. FM enables the companies to identify such opportunities.

9. Facilitating organic growth: It means increasing the profitability by expanding the capacity or entering new
areas of activity. FM studies such possibilities and helps the business in evaluating the projects.
10. Enabling inorganic growth: This is a traditional function of FM. Many corporate are always interested in
mergers and acquisitions. In India also many leading corporate are always on the lookout for taking over
competing firms or the other firms.
*****************************************
CHAPTER 2- CAPITAL STRUCTURE
Meaning:
Capital structure plays an important role in determining the profitability of the organization. Weston and
Bringham define capital structure as “The permanent financing of the firm represented by long-term debt,
preferred stock and networth”.
Fixed assets of an organization are funded through sources which have longer period of repayment.
Long term debt like debentures is repayable over a long period stretching to even 5 years. Long term loan may
also be the loan taken from term lending institutions for as many as 10-15 years. Preference shares can have
tenure of even 10 years. And networth representing equity shares and reserves have a permanent existence and
do not have to be repaid.
The important task for the finance manager is to determine how much should be the debt and how
much should be the equity. This will have a long lasting consequence throughout the life of the corporate.
Having huge size of the debt for a project with a long gestation period may render it hopelessly unprofitable and
sick in the long run. In the modern times, corporate are avoiding debt to avoid the risk of the compulsion to pay
interest even when losses are incurred.

DEBT
Any source of finance that gives Creditorship status to the supplier of funds is called Debt. Creditorship status
means the provider of the funds has a right to receive interest at an agreed rate. The interest is payable
irrespective of whether the corporate makes profit or not. Interest is the cost and charged to p&l account. It
reduces the tax liability of the company as interest of the company as interest on debt reduces the taxable
income.
Features:
1. Compulsory payment of interest:
As per the borrowing agreement the interest is payable periodically on debentures and long term loans
irrespective of whether the corporate makes profit or not. Failure of interest payment leads to the legal
consequences.
2. Compulsory Repayment:
When it is due, principal should be repaid as per agreement. For debentures, face value is paid on maturity
and interest paid annually. For bonds, the maturity value (principal + interest) is payable at the end of the
tenure. Long term loans are repaid in installments over long period of time.
3. Only fixed interest:
The lenders do not have any claim on profits of the company under any circumstance. As the result the
lenders do not enjoy the capital appreciation of the company.
4. No claim for receiving annual report:
The Investors in debt securities are not entitled to receive the notice to Annual General Body meetings and
annual reports of the corporate.
5. No voting rights:
Lenders do not have voting rights except where their interest is involved in resolutions to be passed.

MERITS:
1. Benefit of leverage:
The Investors in debt securities enjoy the benefits of leverage when the company achieve the return on
investment higher than the rate of interest on debt.

REF: FUNDAMENTALS of FINANCIAL MANAGEMENT by B.V.RAGHUNANDAN Page 4


B.COM- V SEMESTER-FINANCIAL MANAGEMENT (THEORY)
2. Tax advantage:
Any interest paid is chargeable to P &l account. Thus it reduces the income tax of the corporates.
3. Cost of raising funds:
The expenses incurred in obtaining debt, such as, cost of preparing project report, stamp duty involved in
loan documents, commission payable to the financial intermediate, are far lower than in the case of issue of
equity shares.
4. Managerial Stability:
As the debenture holders do not have any voting rights, they do not pose any threat to the management of
the company, especially in the case of takeovers.
5. Easier SEBI norms
Comparing to the equity shares, the SEBI norms regarding scope of protecting rights of the lenders is very
limited.
6. Flexible features:
Due to the flexible nature of debt securities regarding the interest payment, rate of interest, period of
payment etc., different classes of Investors can be satisfied due to this feature.

Demerits:
1. Compulsory pay of interest:
The company should lay interest on debt securities irrespective of the incurrence of profit or losses.

2. Solvency effected:
Nonpayment of interest on debt securities leads to the liquidation of the companies through lawsuits. The
conversion of debt into equity shares or preference shares is the only option for the companies to tackle this
situation.
3. Compulsory redemption:
The company cannot postpone the repayment of debt irrespective of the financial position of the company
on the date of repayment.
4. Charge on assets:
A charge in the form of mortgage on the physical assets of a company may have to be created in favour of
the lenders. Sale of such assets call for redemption of the debt before the actual sale.
5. Credit rate shopping:
As per SEBI regulations, every debt security like bonds and debentures is rated by the credit rating agency
vlikebCRISIL, ICRA, CAREBand FITCH. There is the risk of the agency downgrading the rating of the security
subsequently.

DETERMINANTS OF CAPITAL STRUCTURE:


1. Trading on equity: The desire to trade on equity is one of the most important factors. When a company
desires to trade on equity, it’s capital structure is made up of equity shares and preference shares and
debentures.
2. Desire to retain control: As only the equity share holders are having a say in the management of the
company, if the management wants to raise funds without losing control over the affairs of the company,
they have to issue preference shares or debentures. Thus the desire to retain control over the company’s
affairs is possible through capital structure.
3. Nature of the company: Companies like public utility companies enjoy the monopoly in the market and
stability in earnings can easily raise capital through issue of preference shares and debentures. The
manufacturing companies which are subject to trade cycles and competition and which do not have stable
earnings have to depend on equity shares for raising funds.
4. Size of the company: Small companies do not have Betty bargaining power to raise funds comparing to large
companies as their financial position is weak and small scale operation.
5. Purpose of finance: If funds are required for the productive purposes, like establishment of new project,
new factory construction etc., the companies can raise it through issue of debentures. If the funds are
required for welfare of the employees and other non-productive purposes, it can be raised through equity
shares.
6. Period of finance: If the funds are required for long period of time (permanent) then it can be raised through
equity shares issue. If the funds are required for the period of 8-10years then it can be raised from issue of
the debentures or redeemable preference shares.
7. Desire to have flexibility in financial plan: Generally a company which desires to have flexibility in financial
plan raises it’s capital through the issue of equity shares and preference shares. It resorts to the issue of
debentures only at a later stage to raise funds for financing the expansion.
8. Need to make provision for the future: If the company wants to make adequate provision for the future, it
would be advisable for the companies not to issue all types of securities at one time. It would always be safe
to keep the best security till the last.
9. Legal recruitment: Under the banking regulation act 1949, a banking company cannot issue any security
other than equity shares.

REF: FUNDAMENTALS of FINANCIAL MANAGEMENT by B.V.RAGHUNANDAN Page 5


B.COM- V SEMESTER-FINANCIAL MANAGEMENT (THEORY)
10. Requirement of Investors: As the Investors have different Investors, to cater to the preferences of the
different types of Investors, different types of securities to be issued. Equity share are suited for the
Investors who are ready to risk their capital for the maximum returns. The preference shares are suited to
those Investors who want higher returns with safety to their capital.

EQUITY:
Equity represents shareholders funds or ownership capital. It is the basic for capital structure of the
company. It also means the networth of the company. It is the sum of equity share capital, preference share
capital, and reserves and surplus. The reserves and surplus are created out of profits and the preferences shares
are raised on the promise of paying dividend before the payment of dividend to equity shareholders.

Equity shares:
This is the only class of securities that give the full, fledged ownership status to the Investors. The equity
shareholders are entitled to receive notice of every general body meetings and vote on all resolutions passed in
the meetings. He is entitled to share full surplus income and assets. His dividend depends on the profits. When
company incurs loss the equity shareholders have to scarify the dividend and when the profits are made, sky is
the limit for their dividend.

Benefits:
1. Basic for capital structure:
No company can have a capital structure without equity shares. Certificate of incorporation of a company is
possible only with the equity share capital. It is inevitable.
2. Better solvency:
Equity share holder is the ultimate bearer of all the losses of the company. Hence, non declaration of
dividend will never threaten the survival of the company as in the case of nonpayment of debt.
3. Suitable for gestation period:
The period between obtaining the certificate of incorporation to the first year of Profit is called gestation
period. during this period there may be no sales and the expenses exceed income. so there is no need of
payment of dividend to the equity shareholders.
4. No Redemption:
Once the shares are sold to the investors, there is no compulsion to sell the shares back to the companies. In
order to reward the shareholder, company may buy back their shares where there is no compulsion for the
shareholders to sell the shares to the company.
5. No charge on assets:
As the equity shareholders have general claim on all the assets, after all the claims of the company are
satisfied. No charge is ever created on specific assets in favour of equity shareholders. Thus it avoids the
time, procedure and expenses involved in the creation of charge as in the case of debt.
6. No shopping for credit rating:
The value of the equity share is difficult to determine unlike the debt securities. All over the world there are
no credit rating for the IPO of Equity shares. However in India from the ear 2007 credit rating is created for
the IPO.
7. Evaluation of the sure value
The market value of the traded is universally known through news Channel, broker computer terminals and
mobile phone. This helps the investors to know and evaluate the what off their investment anywhere.
8. Better image:
Companies building equity culture help them in raising billions of rupees easily for the future projects. It will
create better image in the world at large.

Demerits:
1. Tax implications:
The company having only equity has to pay higher income tax than the company having debt as part of their
capital structure. As dividend is the part of profit not a business expense and is not taxable in the hands of
the shareholders, the company has to pay the dividend tax.
2. Management control:
In the event of any hostile takeover, the rival company can buy the shares directly or through the stock
exchange. With the shares, the rival companies can increase their voting power and may remove the
management which results in dilution of the management control.
3. High rate of dividend:
Companies accustomed to declare high percentage of dividend is forced the hike the dividend continuously
year after year. So the profit cannot be reserved for future growth.
4. Lack of flexibility:
Once the equity shares are issued, it is very difficult for the company to reduce the equity capital. The
company can offer buy-back of shares but there is no certainty that the shareholders will respond positively
for that.

REF: FUNDAMENTALS of FINANCIAL MANAGEMENT by B.V.RAGHUNANDAN Page 6


B.COM- V SEMESTER-FINANCIAL MANAGEMENT (THEORY)
5. Stringent SEBI norms:
SEBI imposes severe restriction and conditions on the companies whose shares are listed on the stock
exchange, to protect the interest of the Investors. It also calls for the assistance of the heavily paid
consultants and financial intermediaries.
6. Rigid corporate governance:
While making public issue of shares the company has to enter into agreement with the stock exchange. It
contains many clauses of which clause 49 is for corporate governance to protect the interest of the
shareholders. As per this clause the companies have to appoint independent director to board of directors
which is very difficult task.
7. Huge issue expense: Issuing equity shares to the public includes huge expenses involving appointment of
underwriters, merchant bankers, brokers, registrar And banker, provision of Companies act, SEBI act,
directives of stock exchange, advertisement expenditure, printing postage and commission etc.
8. High volatility in the stock market: the prices of the shares in stock market fluctuate vary widely. The
uncertainty of the market adversely affects the primary market which forces the companies to postpone
their public issue.

DEBT-EQUITY RATIO:
In order to maximize the returns by minimizing the risk, a mixture of debt and equity is preferred for the
capital structure of the company. Therefore it is necessary for the financial manager to determine the
composition of the capital structure. For the lenders also debt- equity mix of the company is important, to
ensure that the equity capital is large enough to absorb any future losses.
Significance of high DEBT-EQUITY mix:
A high level of debt component offers the advantages of the debt like reduced tax liability, higher EPS for
equity shareholders etc. But one single demerit removes all the benefits of debt that is the obligation to pay the
interest, even when the losses are incurred continuously. In the modern day business, risk management is very
important to the survival of the company. Therefore debt is being reduced as short term fund.

Significance of low DEBT-EQUITY mix


It is an indication that the company is relying more on the equity than the debt. There is an increasing
trend in the companies to have equity orientation which helps the companies to get the benefits of equity. Non-
payment of profits for the future growth of the company at the time of gaining of profits, are the main benefits
of equity shares.
Zero debt capital structure
Ever since the new generation companies like Information Technology corporations made their powerful
presence in the equity market, debt is getting ignored full stop that is getting not only a lesser roll comma but
also has its role removed. many companies including public sector companies are moving towards removing
debt from their capital structure many companies identified that as a villain of the peace for their prolonged and
sustained incurring of losses the factors that lead to zero debt capital structure are summarised in the following
manner:
 Reducing corporate tax rates
Corporate tax rates are been reduced all over the world full stop in order to attract investment, many
countries like to offer 0% corporate tax rates this reduces the benefit of tax accruing from debt
 Equity image
Company that are oriented towards equity are able to raise enormous funds from foreign market like USA
and Europe bread foreign investment prefer widely held company with a very high liquidity for the shares in
the stock market
 Opportunity for mergers and acquisitions
Both competing and other companies are are easily taken over by equity oriented company either the huge
reason they have built up fund the takeover hour they can borrow a huge funds as they have a bit free
capital structure
 Benefits
Many more benefits like lesser risk solvency at cetera, also approved to companies having low debt equity
ratio

*******************************************************************************************

REF: FUNDAMENTALS of FINANCIAL MANAGEMENT by B.V.RAGHUNANDAN Page 7