Chapter-1

Business Finance:

It is concerned with the determination of the various sources of funds, acquisition of the necessary funds, and
proper utilization of the funds in order to attain the goal of finance. It also includes financial forecasting, planning,
and control.

Corporate Finance/ Financial Management:

It involves management of company’s financial resources and includes the following major decisions.

Basic Financial Management Decisions:

1) Investment Decision: It involves decision regarding asset mix i.e. acquisition of short and long-
term assets of the company.

2) Capital Budgeting: Process of planning and managing long-term investment in real assets.

3) Working Capital: Short-term assets and liabilities management.

4) Capital Structure/ Financing Decision: Determination of mixture of long-term debt and

equity.

5) Dividend Policy Decision: It involves decision regarding amount of dividend and retained
earnings and timing of dividend.

The Goal of Finance/ Financial Management:

To maximize the wealth of the owners i.e. to maximize the current market price of the outstanding or existing
shares. In case there are no outstanding shares- the goal is to maximize the existing owners’ equity.

The debate over Profit Maximization versus Wealth Maximization

Profit maximization: The main technical flaws of profit maximization criteria are as follows:

Ambiguity: It is vague and ambiguous concept. E.g. profit may be short-term or long-term; it may be total profit or
rate of profit; it may be before tax or after tax; it may be return on total capital employed or total assets or
shareholders equity etc. The question arises which of these variants of profits should a firm try to maximize?
Obviously, a loose expression like profit cannot form the basis of operational financial management.

Timing of Benefits: A more important technical objection to profit maximization, as a guide to financial decision
making, is that it ignores the differences in the time pattern of the benefits received from investment proposal. It
is evident from the table that total profits of alternatives A and B are identical. As per profit maximization criteria,
both the alternatives are equally ranked. However, if the cash flow pattern of the alternatives is examined, it will
be seen that most of the benefits of alternative A are received earlier than the alternative B. Benefits received
Mokta Rani Sarker
Assistant Professor
Department of Finance
Jagannath University
sooner are more valuable than the benefits received later as the cash flows received earlier can be reinvested.
Therefore, alternative A is better than alternative B even though the total amount of benefit of both the
alternatives is identical. The profit maximization criterion fails to recognize this fact.

Alternative A Alternative B

Year 1 10000 1000

Year 2 7000 2000

Year 3 3000 17000

Total 20000 20000

Quality of Benefits: Profit maximization criterion also fails to recognize the quality aspect of benefits. Quality here
indicates the degree of certainty of future expected benefits. As a rule the more certain the expected returns the
higher the quality of benefits. Uncertain and fluctuating returns imply risk to the investors. The profit maximization
criterion considers only the size of the total profits instead of the risk factor associated with the benefits. This is
another deficiency of the profit maximization criterion.

Alternative A Alternative B

Year 1 6500 4000

Year 2 6000 13000

Year 3 7500 3000

Total 20000 20000

Wealth Maximization: This is also known as value or net present worth maximization. This criterion is almost
universally accepted in financial management decision as it overcomes all of the limitations of the profit
maximization criterion.

First, the wealth maximization criterion is based on cash flows generated by investment decision as opposed to
accounting profit. Measuring benefits in terms of cash flows avoids the ambiguity associated with accounting
profit. Secondly, it considers both the quantity and quality dimensions of benefits. At the same time it also
considers the time pattern of benefits. These criterion places higher value to the earlier received and more certain
benefits. Conversely, the less certain the flows the lower the quality and benefits as per the rule. As such, the
wealth maximization criterion values the future cash flows by discounting them to present keeping in view the
timing and uncertainty factors. Therefore, for the above reasons this is the appropriate criterion for financial
decision making.

Agency relationship:

The relationship between stockholders and management is known as agency relationship.

Mokta Rani Sarker

Assistant Professor
Department of Finance
Jagannath University
Agency problem:

In such a relationship, there is a possibility of conflict of interest between principal and the agent. Such a conflict is
called agency problem.

Agency Costs:

It refers to the costs of the conflict of interest between stockholders and management. E.g. management forgoes a
profitable project for risk of losing job. Agency costs may be Indirect Agency Cost and Direct Agency Cost.

Indirect Agency Cost: Lost profitable opportunity.

Direct Agency Cost: Can be of two types. The first type is a corporate expenditure that benefits management but
costs the stockholders. The second type arises from the need to monitor management actions. E.g. paying outside
auditors for assessing the accuracy of financial statements.

Does management act in shareholders’ best interest?

It depends on two factors:

i. Compensation: Management will frequently have a significant economic incentive to increase share value
for two reasons:

a. Management compensation is usually tied to financial performance in general and oftentimes to

share value in particular.

b. The second incentive relates to managers’ job prospects. Better performers within the firm will
tend to get promoted. Those managers who are successful in pursuing stockholders’ goals will be
in greater demand in the job market.

ii. Control of the firm: The stockholders elect the board of director, who, in turn, hire and fire management.
The mechanism by which unhappy stockholders can act to replace existing management is called a proxy
fight. Another way is by takeover. Those firms that are poorly managed are more attractive for
acquisition. To avoid a takeover by another firm gives management another incentive to act in the
stockholders’ interest.

Stakeholders:

Employees, customers, suppliers, and even the government all have a financial interest in the firm. These various
groups are called stakeholders in the firm. Stakeholders have potential claim on the cash flows of the firm. They
also try to exert control over the firm.

Financial Market:

It is a mechanism or process through which funds are transferred from surplus units (usually individuals and
households) to deficit units (business organizations and companies). Corporations raise funds or capital by selling
stocks and bonds in the financial markets.

Mokta Rani Sarker

Assistant Professor
Department of Finance
Jagannath University
Types of Financial Markets:

1. Primary Market: Where for the first time stocks and bonds are sold to the public for subscription.
Example Commercial Banks, ICB in Bangladesh.

2. Secondary Market: Where already issued securities are traded. There are two types of secondary
markets. They are given below:

I. Auction Market: The middleman i.e. broker matches the bid or purchase price and ask or the selling
price of the securities. However, he generally never buys the securities for selling in future.

II. Dealer Market: It is a computerized network of dealers connected with each other electronically. The
middleman or the dealer buys the securities for selling at higher price in future.

Over the counter Market (OTC): Dealer market in stocks and long-term bonds is known as over the
counter market.

Mokta Rani Sarker

Assistant Professor
Department of Finance
Jagannath University