BCM 2303

Financial Management
Dr. N Subrahmanya Kumar
Associate Professor,
Department of Commerce, Manipal Academy of Higher Education, Manipal

Unit 1
Unit 1: Financial Management Function
Learning Objectives

• The nature and purpose of nancial management.

• Explain the nature and purpose of nancial management.

• Financial objectives and the relationship with corporate strategy.

• Explain the relationship between nancial objectives, corporate objectives, and corporate strategy.

• Describe nancial objectives - shareholder wealth maximisation, pro t maximisation, and earnings per share growth.

• Stakeholders and impact on corporate objectives.

• Identify the range of stakeholders and their objectives.

• Discuss the possible con ict between stakeholder objectives.

• Discuss the role of management in meeting stakeholder objectives, including application of agency theory.

• Explain ways to encourage the achievement of stakeholder objectives.

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 Nature and Purpose of Financial Management
De nition

• Financial management is concerned with the e cient acquisition and

deployment of short-term and long-term nancial resources to ensure the
objectives of the enterprise are achieved.

• Three key areas

• Investment

• Finance

• Dividend
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Nature and Purpose of Financial Management
Investment

• Short-term in current assets/working capital

• Liquidity

• Long-term in non-current assets

• Investment appraisal/identi cation of right projects

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Nature and Purpose of Financial Management
Finance & Dividend

• Finance

• From what sources should funds be raised?

• Long-term

• Short-term

• Demands of investors - Cost !! (Cost of Capital)

• Capital structure

• Dividend

• Allocation of cash funds to shareholders and its in uence on value of the business
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Nature and Purpose of Financial Management
Environment

• Financial manager has to take into account

• The organisation’s commercial and nancial objectives

• The broader economic environment in which business operates

• The potential risks associated with the decision and methods of managing
that risk
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The Relationship Between Corporate Strategy and Corporate and Financial
Objectives
Meaning - Objective and Strategy

• Objectives de ne what the organisation is trying to achieve.

• Increase brand awareness

• Strategy considers how to go about it.

• Advertisements in relevant YouTube videos/channels

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 The Relationship Between Corporate
Strategy and Corporate and Financial
Objectives
Objectives and Strategy

• Overall Mission —> Why the

organisation exists or what is its
purpose

• Broad Based Goals —> Objectives

to pursue to achieve the mission

• Commercial Objectives —>

Objectives that can not be expressed
e ectively in nancial terms

• Financial Objectives —> Objectives

expressed clearly in nancial terms
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Financial Objectives
Shareholder Wealth Maximisation

• The fundamental objective/principle of nancial management is shareholder wealth

management

• Shareholders own the company or the rm

• Firms are set-up to make money for the owners i.e., shareholders

• Shareholders’ wealth increases when

• Market price of the shares increase

and/or

• Dividend pay-out takes place

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 Financial Objectives
Pro t Maximisation

• Shareholder wealth maximisation and pro t maximisation are not necessarily same.

• Pro t is estimated using the accrual principle - transactions are recorded in the time period in which they
occur, regardless of when the actual cash ows for the transaction take place.

• Pro t is, hence, a paper gure and does not represent the cash the rm has for its requirements.

• Therefore, the market price of shares may have little or no relationship with the pro t earned by the rm.

• Potential problems of adopting pro t maximisation as an objective are

• Firms can boost short-term pro ts at the expense of long-term pro ts. Example; spending on R&D,
Advertising, Training

• Pro ts may be increased by taking high levels of risk that may endanger returns to shareholders

• Accounting pro t is not cash. Dividends are paid with cash.

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Financial Objectives
Earnings Per Share (EPS) Growth

• We generally measure corporate success using EPS.

• It is a measure of return to equity shareholders.

• However, it is a measure of pro tability and shows the investor’s share in the
earnings generated by the company using accounting gures that follow accrual
principle.

• EPS, hence, does not show the income of the shareholders.

• EPS is open for criticism as that of pro t maximisation.

• There is correlation between earnings of the company and wealth of shareholders ,

but they are not the same.
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 Maximising and Satisfying
Distinction

• Maximising

• seeking the maximum level of returns, even though this might involve exposure to risk
and much higher management workloads.

• Satisfying

• nding a merely adequate outcome, holding returns at a satisfactory level, avoiding risky
ventures and reducing workloads.

• Management might seek maximising the returns to some groups (like shareholders) and
satisfy the requirements of other (like employees)

• Discussion on objectives is all about which group’s returns management is trying to

maximise?
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Stakeholder Objectives and Conflicts

• Stakeholders have a vested interest in the company

• Internal

• Company Employees - wages/salaries and bonuses

• Company managers/directors - can follow their own aims at the expense of others

• Connected

• Equity investors or Ordinary shareholders - provide the risk nance

• Customers - value for money products

• Suppliers - long term contracts with prompt payment terms

• Finance providers (debt holders/bankers) - repayment with interest

• Competitors
• External

• The Government - political, nancial, and social

• The Community at large - environment

• Regulators - compliance to regulations

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Stakeholder Objectives and Conflicts
Answer to additional question – Stakeholder conflicts
Stakeholders
Employees  Shareholders
Customers  Community at
large
liabilities from
1.7 to 1.85.
Potential conflict
Employees may resist the
introduction of automated
processes that would improve
efficiency but cost jobs.
Shareholders may resist wage
rises demanded by employees as
uneconomical.
Customers may demand lower
prices and greater choice, but in
order to provide them a company
may need to squeeze vulnerable
suppliers or import products at
great environmental cost.
KAPLAN PUBLISHING
Chapter 1
Stakeholders Potential conflict
Shareholders  Finance Shareholders may encourage
providers management to pursue risky
strategies in order to maximise
potential returns, whereas
finance providers prefer stable
lower-risk policies that ensure
liquidity for the payment of debt
interest.
Customers  Shareholders/ Customers may require higher
managers service levels (such as 24 rather
than 48 hour delivery) which are
resisted by shareholders as too
expensive or by management
due to increased workload.
Government  Shareholders Government will often insist upon
levels of welfare (such as the
minimum wage and health and
safety practices) which would
otherwise be avoided as an
unnecessary expense.
Shareholders  Managers Shareholders are concerned with
the maximisation of their wealth.
Managers may instead pursue
strategies focused on growth as
these may bring the greatest
personal rewards.
Stakeholder Objectives and Conflicts
The Stakeholder View

• Many argue that a business must adopt the stakeholder view.

• Stakeholder view involves balancing the competing claims of a wide range of stakeholders,
and taking account of broader economic and social responsibilities.

• Professor Charles Handy is a prominent advocate of this view

• Argument:

• Maximisation of shareholder wealth, while important, cannot be the single overall

objective of organisations, and account must be taken of broader economic and social
responsibilities.

• Increasing globalisation, and the fact that some multinational companies have revenue in
excess of the incomes of small countries, put these responsibilities sharply into focus.
The Role of Management and Goal Congruence
Agency Theory

• Agency relationships occur when one party, the principal, employs another party, the agent, to
perform a task on their behalf.

• In particular, directors (agents) act on behalf of shareholders (principals).

• The divorce of ownership and control

• Shareholders are the owners but the company is managed by managers/directors.

• Shareholders rely on management of the company to understand and pursue the objectives set
for them.

• Shareholders can intervene through resolutions at general meetings but the managers have
manage the rm on day-to-day basis

• Management may take decisions that maximise their own wealth rather than that of shareholders
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 The Role of Management and Goal Congruence
Agency Theory

• Corporate decisions by the managers for their own bene t

• Remuneration - awarding large increase in pay to the managers/directors

• Empire building - managers gaining prestige by building a large conglomerate through takeovers

• Creative accounting - selection of accounting policies - capitalising expenses like advertising, not
depreciating non-current assets, maximising the value of intangibles, recognising revenue at the
earliest

• O balance sheet nancing - nancing assets where the method of funding is not recorded in
balance sheet. Example - rather than buying equipment outright, a company rents or leases it and
then purchases it at a minimal price when the lease period ends.

• Takeover bids - defending against takeovers that are bene cial to shareholders

• Unethical activities - testing products on animals, emitting pollution

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The Role of Management and Goal Congruence
Managerial Reward Schemes

• How to ensure managers take decisions that are consistent with shareholders’
objectives?

• Introduce carefully planned remuneration schemes/packages

• The schemes should …

• be carefully de ned, impossible to manipulate, and easy to monitor

• be linked to shareholder wealth

• match managers’ time horizons to shareholders’ time horizons

• encourage managers to adopt the same attitude to risk as shareholders

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The Role of Management and Goal Congruence
Managerial Reward Schemes

• Common types of reward schemes include

• Remuneration linked to

• Minimum pro t levels

• Economic value added (EVA)

• Revenue growth

• Executive share option schemes (ESOP)

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The Role of Management and Goal Congruence
Managerial Reward Schemes

• Remuneration linked to minimum pro t levels

• Easy to set up and monitor

• Disadvantage

• Short-term pro ts at the expense of long-term pro tability.

• Underachieving

• Creative accounting
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The Role of Management and Goal Congruence
Managerial Reward Schemes

• Remuneration linked to Economic value added (EVA)

• Economic value added, or EVA, is also known as economic rent.

• It is a widely-recognised tool for measuring the e ciency of a company’s resource use.

• EVA is the di erence between the return achieved on resources invested and the cost of resources.

• The higher the EVA, the better the level of resource utilisation.

• EVA can be calculated as net operating pro t after tax minus a charge for the opportunity cost of the
capital invested. EVA is based on the idea that a company must cover both the operating costs and
capital costs.

• EVA is therefore a measure of increase in the value of shareholder wealth

• A potential drawback is that calculation of the bonus may be complex

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The Role of Management and Goal Congruence
Managerial Reward Schemes

• Remuneration linked to Revenue growth

• Growth of business and higher volume of production —> economies of

scale —> business can win price based competition

• However, revenue growth can be achieved by reducing selling price at the

expense of pro tability, selecting high revenue product lines that may not
be pro table

• Hence, maximising revenue need not maximise shareholder wealth

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The Role of Management and Goal Congruence
Managerial Reward Schemes

• Executive share option schemes (ESOP)

• The employer gives certain stocks of the company to the employee for negligible or less costs which remain in the ESOP trust fund, until
the options vests and the employee exercises them or the employee leaves/retires from the company or institution.

• Set-up over a long period of time

• Encourages managers to maximise the value of shares i.e., wealth of shareholders

• May be penalised at times when share prices are falling

• Criticism

• Managers may sell shares immediately after exercising the option to make pro t.

• Once the option is exercised managers have no further interest in maximising the share price.

• If share prices fall after awarding ESOP there is no incentive for managers

• If large quantity of shares are o ered under ESOP there could be dilution of the equity interests of existing shareholders. Cost of
ESOP to the shareholders must be recognised.

• Directors may use creative accounting to distort reported pro ts to protect share price and value of their share options.
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 The Role of Management and Goal Congruence
Corporate governance codes

• Corporate Governance is a mechanism based on certain systems and principles by which a company is governed.

• The governance ensures that a company is directed and controlled in a way so as to achieve the goals and objectives which include providing
bene ts to the stakeholders like shareholders, employees, suppliers, customers and society in the long term and adding value to the company.

• The board should consist of appropriate combination of executive directors, independent directors and non-independent non-executive
directors to prevent one individual or a small group of individuals from dominating the board's decision.

• The board's size and scale should be in proportion with the level of diversity of the organisation.

• Appropriate board committees may be formed to assist the board in e ective performances to ful l the duties.

• Guided by;

• The Companies Act, 2013

• Securities and Exchange Board of India (SEBI)

• Standard Listing Agreement of Stock Exchanges

• Accounting Standards issued by the ICAI

• Secretarial standards issued by ICSI (Institute of Company Secretaries of India)

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