FINANCIAL MANAGEMENT - I

CHAPTER ONE: OVERVIEW OF MANAGERIAL FINANCE

1.1 Introduction
Finance is the management of money, both the acquisition and investment of money.

Finance may be defined as the art and science of managing money.

The major areas of finance are: Financial services and (2) managerial finance/ corporate finance/
financial management.
 Financial service is concerned with 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, and insurance and so
on.
 Financial management is concerned with the duties of the financial managers in the
business firm. Financial managers actively manage the financial affairs of any type of
business namely, financial and non-financial, private and public, large and small, profit
seeking and not- for- profit.
 financial management can be also defined as the management of capital sources and their
uses so as to attain the desired goal of the firm (i.e. maximization of share holders’
wealth).financial management involves sourcing of funds, making appropriate
investments and promulgating the best mix of financial and dividends in relation to the
value of the firm.
Sources of finance
a. Equity funds; - acquired by selling shares to investors (shareholders).Example: selling
common stock and preferred stock
b. Borrowed funds/ Debt: Debt is owned by the lenders, these may be banks, who have
loaned the company money, or individual or institutional investors who have bought
bonds issued by the company. Issuing bonds is another way for companies to borrow
money.
c. Retained earnings:- re-invested in the company in activities that are expected to
add value for the shareholders
1.2 Functions/ Important of Financial Management
 Investment Decision: This decision is called capital budgeting decision. It generally
answers the question that what assets should the firm owns, investment decision or
capital budgeting involves the decision of allocation of capital or commitment of funds to
long- term assets that would yield benefits in the future.
 Financing Decision: - The second major decision involved in financial management is
the financing decision. The investment decision is broadly concerned with the asset mix
or the composition of the assets of the firm. The concern of the financing decision is with
the financing mix or capital structure, or leverage. The term capital structure refers to the
proportion of debt (fixed – interest source of financing) and equity capital (variable –

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dividend securities/ source of funds). The financing decision of a firm relates to the
choice of the proportion of these sources to finance the investment requirements.
 Dividend Policy Decision: - The third major decision area of financial management is
the decision relating to the dividend policy. The dividend decision should be analyzed in
relation to the financing decision of a firm. Two alternatives are available in dealing
with the profits of a firm:
1. They can be distributed to the shareholders in the form of dividends or
2. They can be retained in the business itself.
 Asset Management Decision: After the assets are acquired the need to be managed
effectively. The financial manager is charged with the varying degree of operating
responsibility over existing assets.
Specific tasks include:
1. Maintain constant control of the company’s overall financial position:
i. Analysis of current and past financial results
ii. Determine financial SWOT.
iv. Interact with the other functional areas of the company.
v. Preparation and distribution of internal and external financial statements.
vi. Payroll and taxes.
2. Working Capital Management
i. Cash management - current and forecasted position
ii. Management of other working capital items
3. Manage the company’s capital structure
i. Plan and forecast short- and long-term financial needs and position.
ii. Deal with providers of funds and financial intermediaries.

1.3 Goals of Financial Management

The term ‘ goal or objective refers to an exploit operational guide or decision criterion to be
used by the financial manager by which to judge the financial decision making of a firm, which
are investment, financing and dividend policy decisions.
The two alternative decision criterions for financial management which are widely discussed in
the financial literature are:
 Profit maximization
 Wealth maximization
 Profit maximization as a decision criterion
Implies that the investment, financing and dividend policy decision of a firm should be oriented
to the maximization of profits
Wealth maximization as a decision criterion
- also known as value maximization or NPV maximization
- The value maximization criterion satisfies all the three requirements of a suitable
operational objective of financial course of action, namely: exactness, quality of benefits
and timing of benefits.

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- Wealth maximization as a decision criterion involves a comparison of value to cost

- The goal of financial management should be to maximize the value of the outstanding
common shares (maximize shareholder wealth) while treating all stakeholders equitably.
- The two ways of achieving this goal are
 Net present Value (NPV)
 Economic value added (EVA)
- The NPV of a project is the difference between present value of future inflows and the
cost of the funds invested in the project cost of invested
- The EVA of a project is the difference between the after-tax operating cash flows and the
cost of the funds invested in the project.
Example: ABC Co. is evaluating the purchase of a new piece of equipment costing $250,000.
The equipment is expected to have a life of 15 years. The firms after-tax cost of financing is
15.3%. The additional before-tax operating cash flows associated with the acquisition of the
equipment are expected to average $60,625 per year. The firm’s tax rate is 20%. Using an EVA
analysis, should ABC acquire the new piece of equipment?

EVA = after-tax operating profits - (funds invested × cost of the funds)

= [$60,625 × (1 - 0.20%)] - ($250,000 × 15.3%)
= $48,500 - $38,250
= $10,250
Based on the EVA analysis, ABC should replace the robotics equipment. The EVA is positive
indicating the benefits of the project are greater than the costs of financing the project.

o The goal of the maximization of shareholder wealth does not mean that a
corporation can do anything they wish in pursuit of this goal - that anything goes
in dealings with creditors, employees, customers, suppliers, etc. It also doesn’t
mean the firm should engage in unethical behaviors while attempting to maximize
shareholder wealth.
o Firms that treat stakeholders poorly or who engage in unethical practices, always
find that the value of the company declines, therefore disappointing shareholders
and all other who have contact with the company.
1.4 Agency problem
We’ve seen that the financial manager acts in the best interests of the stockholders by taking
actions that increase the value of the stock. However, in large corporations ownership can be
spread over a huge number of stockholders. This dispersion of ownership arguably means that
management effectively controls the firm. In this case, will management necessarily act in the
best interests of the stockholders? Put another way, might not management pursue its own goals
at the stockholders’ expense?

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Agency Relationships
The relationship between stockholders and management is called an agency relationship. Such a
relationship exists whenever someone (the principal) hires another (the agent) to represent his or
her interests. For example, you might hire someone (an agent) to sell a car that you own while
you are away at school. In all such relationships there is a possibility of a conflict of interest
between the principal and the agent. Such a conflict is called an agency problem.

Suppose you hire someone to sell your car and you agree to pay that person a flat fee when he or
she sells the car. The agent’s incentive in this case is to make the sale, not necessarily to get you
the best price. If you offer a commission of, say, 10 percent of the sales price instead of a flat fee,
then this problem might not exist. This example illustrates that the way in which an agent is
compensated is one factor that affects agency problems.
Management Goals
To see how management and stockholder interests might differ, imagine that a firm is
considering a new investment. The new investment is expected to favorably impact the share
value, but it is also a relatively risky venture. The owners of the firm will wish to take the
investment (because the stock value will rise), but management may not because there is the
possibility that things will turn out badly and management jobs will be lost. If management does
not take the investment, then the stockholders may lose a valuable opportunity.
This is one example of an agency cost. More generally, the term agency costs refer to the costs of
the conflict of interest between stockholders and management. These costs can be indirect or
direct. An indirect agency cost is a lost opportunity, such as the one we have just described.
The available theory and evidence are consistent with the view that stockholders control the firm
and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there
will undoubtedly be times when management goals are pursued at the expense of the
stockholders, at least temporarily.

1.5 Close related fields of financial management

Financial management as an integral part of overall management is not a totally independent
area. It draws heavily on related disciplines and fields of study, such as economics, accounting,
marketing, production and quantitative methods. Although these disciplines are interrelated,
there are key differences among them .In this section we discuss these relationships.

1.5.1. Finance and Economics

The relevance of economics to financial management can be described in the light of the two
broad areas of economics: Macro -Economics and Micro- Economics.

Macroeconomics - is concerned with the overall institutional environment in which the firm
operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional
structure of the banking system, money and capital markets, financial intermediaries, monetary,
credit and fiscal policies and economic policies dealing with, and controlling level of activity

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within an economy. Since business firms operate in the macroeconomic environment, it is

important for financial managers to understand the broad economic environment specifically,
they should: (1) recognize and understand how monetary policy affects the cost and availability
of funds; (2) be versed in fiscal policy and its effects on the economy; (3) be aware of the various
financial institutions / financing outlets; (4) understand the consequences of various levels of
economic activity and changes in economic policy for their decision environment.

Microeconomics: - Deals with the economic decisions of individuals and organizations .It
concerns itself with the determination of optimal operating strategies. In other words, the
theories of Microeconomics provide for effective operations of business firms. They are
concerned with defining actions that will permit the firms to achieve success. The concepts and
theories of microeconomics relevant to financial management are, for instance, those involving
(1) supply and demand relationships and profit maximization strategies (2) issues related to the
mix of productive factors; optimal’ sales level and product pricing strategies (3) measurement of
utility preference, risk and the determination of value 4) the rationale of depreciating assets.
Thus, knowledge of economics is necessary for a financial manager to understand both the
financial environment and the decision theories which underline contemporary financial
management. A basic knowledge of economics therefore, necessary to understand both the
environment and decision making techniques of financial management.

1.5.2. Finance and Accounting

Conceptually speaking, the relationship between finance and accounting has two dimensions (i)
they are closely related to the extent that accounting is an important input in financial decision
making and (ii) there are key differences in view point between them. Accounting function is a
necessary input in to the finance function. That is accounting is a sub function of finance.
Accounting generates information/ data relating to operations/ activities of the firm. The end
product of accounting constitutes financial statements such as the balance sheet, the income
statement, and the changes in financial position/ sources and uses of funds statement/ cash flow
statement. The information contained in these statements and reports assists financial managers
in assessing past performance and future directions of the firm and in meeting legal obligation
such as payment of taxes and so on. Thus, accounting and finance are functionally closely
related. But there are two key differences between finance and accounting.

Treatment of Funds: The view point of accounting relating to the funds of the firm is different
from that of finance. The measurement of funds (income and expense) in accounting is based on
accrual principle / system. Revenue is recognized at the point of sale and not when collected.
Similarly, expenses are recognized when they are incurred rather than when actively paid.
But the view point of finance relating to the treatment of funds is based on cash flow. The
revenues are recognized only when actually received in cash (i.e. cash inflow) and expenses are

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recognized on actual payment (cash out flow). This is so because the financial manager is
concerned with maintaining solvency of the firm by providing the cash flows necessary to satisfy
its obligations and acquiring and financing the assets needed to achieve the goals of the firm.
Decision making: - Finance and accounting also differ in respect of their purpose. The purpose
of accounting is collection and presentation of financial data. It provides consistently developed
and easily interpreted data on the past, present and future operations of the firm. The primary
focus of the function of accountants is on collection and presentation of data while the financial
manager’s major responsibility relates to financial planning, Controlling and decision -making.
Thus, in a sense, finance begins where accounting ends.

1.5.3. Finance and Other Disciplines

Apart from economics and accounting; finance is also being used for day to day decision on
supportive disciplines such as marketing, production and quantitative methods. For example,
financial managers should consider the impact of new product development and promotion plans
made in marketing area since their plans will require capital outlays and have an impact on the
projected cash flows:-
The marketing, production and quantitative methods are, thus, only indirectly related to day
today decision making by financial managers and are supportive in nature while economics and
accounting are the primary disciplines on which the financial managers draws substantially.

1.6 Financial market and corporation

Firms offer two basic types of securities to investors:
Debt securities are contractual obligations to repay corporate borrowing.
Equity securities are share of common stock and preferred stock that represent non contractual
claims to the residual cash flow of the firm. Issues of debt and stock that are publicly sold by the
firm are then traded in the financial markets.
The financial markets are composed of the money markets and the capital markets. Money
markets are the markets for debt securities that will pay off in the short term (usually less than
one year). Capital markets are the markets for long-term debt (with a maturity of over one year)
and for equity shares.
The term money market applies to a group of loosely connected markets. They are dealer
markets. Dealers are firms that make continuous quotations of prices for which they stand ready
to buy and sell money market instruments for their own inventory and at their own risk. Thus,
the dealer is a principal in most transactions. This is different from a stockbroker acting as an
agent for a customer in buying or selling common stock on most stock exchanges; an agent does
not actually acquire the securities. The financial markets can be classified further as the primary
market and the secondary markets.
The Primary Market: New Issues
The primary market is used when governments and corporations initially sell securities.
Corporations engage in two types of primary market sales of debt and equity: public offerings
and private placements. Most publicly offered corporate debt and equity come to the market
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underwritten by a syndicate of investment banking firms. The underwriting syndicate buys the
new securities from the firm for the syndicate’s own account and resells them at a higher price.
Publicly issued debt and equity must be registered with the United States Securities and
Exchange Commission (SEC). Registration requires the corporation to disclose any and all
material information in a registration statement.
The legal, accounting, and other costs of preparing the registration statement are not negligible.
In part to avoid these costs, privately placed debt and equity are sold on the basis of private
negotiations to large financial institutions, such as insurance companies and mutual funds, and
other investors. Private placements are not registered with the SEC.
Secondary Markets
A secondary market transaction involves one owner or creditor selling to another. Therefore, the
secondary markets provide the means for transferring ownership of corporate securities.
Although a corporation is directly involved only in a primary market transaction (when it sells
securities to raise cash), the secondary markets are still critical to large corporations. The reason
is that investors are much more willing to purchase securities in a primary market transaction
when they know that those securities can later be resold if desired.