Management— Chapter l Financial INTRODUCTION An Overview Learning Objectives accounting and economics Describe the scope of financial management and identify the key activities of the financial manager Explain why wealt = thivalue maximisation, rather than profivEPS. isa- tion, is the goal of financial management and how Se mee oat (EVA) and focus on shareholders relate to its achievement and summarise the major objectives of corporate finance by Indian corporates Disciss the agency problemissue as it relates to owners wealth maximisa- n Outline the organisation of finance function and the emer Managers ini India 9 role of finance Finance Finance may be defined as the art and science of managing money. The major areas | isthe art and of finance Financial management is concemed with the duties of the financial managers in the re: (1) financial services and (2) managerial finance/corporate finance/_| science of financial management. While financial services is concemed with the design and delivery of advice and financial products to individuals, businesses and governments within the areas of banking and related institu- | Financial tions, personal financial planning, investments, real estate, insur- | services ance and so on, financial management is concerned with the _} #8 concemed duties of the financial managers in the business firm. Financial managers actively manage the financial affairs of any type of ‘managing money. with the design and delivery of advice and business firm. business, namely, financial and non-financial, private and public, | francial products large and small, profit-secking and not-for-profit. They perform 16 individuals, such varied tasks as budgeting, financial forecasting, cash management, credit | businesses and governments.sas ts MAME 4 on, a re a the compleiy 25 well as he Beg ‘ult, the napa managemeg PO See sro, ra noe gic) Stew pen tit cron Be Se ee a EES] SET tc tn, TESS]: Serie creten ne “oegrtt pe Tame ote Boo secon [FINANCE AND RELATED ISCPLNES Fasc naan aan eng ele RTE Poet meet at eof ch 8 occ Tv en ar ach tree ton ne anes and Eanomi ‘Re lone eames toil agent ne sb he ge ate enone mo nl oom Vn tone cea al ECW suicide Conny treme iaoucoumis cnceoe wih ee Pag telaning cn oneySl pal akt ftl edey, eee [tel sr pales lng ths owing te cy a Exc bam ti epone oc ncuron eovtoanen 6 pcre ser onunevand brad eense etree Seto they tae a ‘cng tow oeay py es ec he aly of Re) hep Sates ee ee a oe ee ees Marta Change in cone pkey ce fetes viene seer] Hc de wih coi too i an gu ne] ole ee re re oe) ate ae ee Seimei] succes The concept apd thers micoceenomcr elena fo ane ao Sn] Se te tea te ae maple sts lee an produ! pring seep (3) mennrenat ee a ‘Sibiu a4 the deerninaion of vale and (0 te exonale of ep een i ‘exceed added] on, the primary principle that applies in financial mar tae asda) ‘onnll unset ta ancl deans shoul be me oh he hae ofa se he ass compara int Magnet reise 5 mal eve and mang om Sich eins wile an et in pris ofthe fm 1 ett npn sco manage be a wh bse moreneMN hs he anc manger a depen se srselatg to eplce one of nine empath pew eee ett weal bah seed up feces re an ‘Sn evome of waco Te ey spar no ee ote 8000 tthe i ampere ahd wnt Cee The wa enc an ew! cP ithe ot mrt wea e100, an 300 rpc. Api aga ‘eta a po corp ‘ug wes scoot Coat ome son000 er Pceae ton saeco corpume S000 = ow Th 2 koe of komm i ese for Bran amet Vertnd oth he tea mtn se Sc hs aie arp el an ‘a ings th no pay wich in ci one Opn ‘ondentn bh th event andthe deci techniques ef faunal anancat ‘Diy ne dy rene net dau acouing an parent pt scl Sosen (ii a te ah eens newpct Aces nc cea pt ato th ae tin. Ta cui e ‘Stome serie pian kn sctcur) and he cement changes n Eman posto eur Seis nie anterior Tw sao come hese See ‘cu ps ang ppt edo SEs meaty coe lied. Meworen he faucet econ Cor {eats ne pa sala he onl of he veeweasen/ der hes et ar Ueptcroy ss own ig 12 The nc sect tela a penal ve {ES onal mame scum hey tay tin es ‘jr ihae ae two hy ences Damen Gance and acouning. The fist diferencia tothe wees of nds hi he send ts decom make18 Financia Management cnn] ema of Fide ‘Th ens f cnn ge eno tot of fan The mere aes Gantt Sona Waseem creme Suiiotatenarrns owen Since Monegeeeremeay ‘bviowt te fm gute profile in assuming see, ancl le ro ‘aa oe i it tel ais ep pd a totem a Decal Making ance acon ko ie pest th pues Te ep cy npc ato eas pres alopecia pe ‘sera da fr tance mane hose mea thease a ea ‘fre ras agen cl Bt pay fee ao art ‘Son caeton and esr fue te func ges mae pay sana nin ng an cn maT, oe, Bae he nance and Other Related Dips = ‘gun om ea nd sug ane ho dan be yoy eso pee 30 |TABLE 1.2 Uncertainty About Expected Benefits (Profts) | Profit (& crore) the two alternatives are identical native B, while itis ins associated wi js inappropriate and unsuitable as an operational 2 orn is not only vague and ambigu- and time value ts, and Civ) recognise the time value ‘maximisation is one such measure, f benefitFinancial Management—An Overview AAS all the three requirements of * profit maximisation criterion. Its operational features satisfy quality of benefits a suitable operational objective of financial course of action, namely, exactness, and the time value of money. oie bp an asset should be viewed in terms of the benefits cost of ond on can similarly be judged in terms of the value of the benefit undertaking it. A significant element in computing the value of a financi the precise estimation of the benefits associated with it. The wealth maximisation crit on the concept of cash flows generated by the decision rather than accounting profit whic! basis of the measurement of benefits in the case of the profit maximisation criterion. Cash-flow is a precise concept with a definite connotation, Measuring benefits in terms of cash flows avoids the ambiguity associated with accounting profits. This is the first operational feature of the net present worth maximisation criterion. The second important feature of the wealth maximisation criterion is that it considers both the quantity and quality dimensions of benefits. At the same time, it also incorporates the time value of money. The operational implication of the uncertainty and timing dimensions of the benefits ema- nating from a financial decision is that adjustments should be made in the cash-flow pattern, firstly, to incorporate risk and, secondly, to make an allowance for differences in the timing of benefits. The value of a stream of cash flows with value maximisation criterion is calculated by discounting its element back to the present at a capitalisation rate that reflects both time and risk. The value of a course of action must be viewed in terms of its worth to those providing the resources necessary for its undertaking. In applying the value maximisation criterion, the term value is used in terms of worth to the owners, that is, ordinary shareholders. The capitalisation (discount) rate that i employed is, therefore, the rate that reflects the time and risk preferences of the owners or sup pliers of capital. As a measure of quality (risk) and timing, it is expressed in decimal notation. A discount rate of, say, 15 per cent is written as 0.15. A large capitalisation rate is the result of higher risk and longer time period. Thus, a stream of cash flows that is quite certain might be associated with a rate of 5 per cent, while a very risky stream may carry a 15 per cent discount rate. ‘ For the above reasons, the net present value maximisation is superior to the profit maximisation as an operational objective. As a decision criterion, it involves a comparison of value to cost. An action that has a discounted value—reflecting both time and risk—that exceeds its cost can be said to create value. Such actions should be undertaken. Conversely, actions, with less value than cost, reduce wealth and should be rejected. In the case of mutually exclusive alternatives, when only one has to be chosen, the alternative with the greatest net present value should be selected. In the words of Ezra Solomon,‘ can produce. The worth of a it produces less the I course of action is iterion is based h is the The gross present worth of a course of action is equal to the capitalised value of the flow of future ex: pected benefit, discounted (or captialised) at a rate which reflects their certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutu- ally exclusive (ie. if only one can be undertaken), then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. Using Ezra Solomon's symbols and methods, the net present worth can be calculated as shown below:1.16 Financial Management . @ W=V-C Where W= Net present worth Gross present worth , C= Investment (equity capital) required to acquire the asset or to Purchase the of action ny V=BK Where £= Size of future benefits available to the suppliers of the input capital K= The capitalisation (discount) rate reflecting the quality (certainty/uncertain timing of benefits attached to E ty) E=G-(M+I+1 Where G= Average future flow of gross annual earings ex tion, before maintenance charges, taxes and inte1 preference dividend M-= Average annual reinvestment required to maintai T= Expected annual outflow on account of taxes 7= Expected flow of annual payments on account of interest, preference divi and other prior charges 0 The operational objective of financial mana; natively, W can be expressed symbolically by worth) or wealth is Gi) pected from the course rest and other prior change! in G at the projected leyg) igement is the maximisation of Win Eq. (1. a short-cut method as in Eq. (14), Net presen Ae Ay An +—F + — a+Ky +x)" where Ay dy = dy tepresents the stzeam of cash flows expected to occur from a course of ey over a period of time; action Kis the appropriate discount rate to measure risk and timing; and a Cis the initial outlay to acquire that asset or pursue the course of action, bs: It can, thus, be seen that in the value maximisation decision criterion, the time value of mo and handling of the risk as measured by the uncertainty of the expected benefits is an ine Of the exercise. It is, moreover, a precise and unambiguous concept, and therefore, an appropriag and operationally feasible decision criterion for financial management decisions, . It would also be noted that the focus of financial management is on the value to the owners oF suppliers of equity capital. The wealth of the owners is reflected in the market value of So wealth maximisation implies the maximisation of the market Price of shares. In other words — maximisation of the market price of shares is the operational substitute for value/wealth/net pracy value maximisation as a decision criterion. In brief, what is relevant is not the overall goal of a firm but a decision criterion which Buide the financial course of action. Profiv/EPS maximisation was initially the generally accepted. theoretical criterion for making efficient economic decisions, using profit as an economic ‘cone and defining profit maximisation as a criterion for economic efficiency. In current financial lite it has been replaced by the wealth maximisation decision criterion because of the shor of the former as an operational criterion, as (i) it does not take account of uncertainty of rig Ai it ignores the time value of money, and (ii) itis ambiguous in its computation. Owing to these _ technical limitations, profit maximisation cannot be applied in real world situations. Its ‘modified form is the value maximisation criterion. It is important to note that value maximisation is simply extension of profit maximisation to a world that is uncertain and multiperiod in nature, Where the time period is short and degree of uncertainty is not great, value maximisation and profit maxi tion Amount to easel eee eeFinancial Management—An Overview 1.17 Hower ve rata oeee ‘wo important issues are related to the vale/share price-maximisation, J Economic value ae nomic value added and focus on stakeholders. sided conomic V: aa er eres (EVA) It is a popular measure currently being used by | after-tax ‘© determine whether an existing/proposed investment positively con- J operating profits tributes to the owner es to the owners’/shareholders’ wealth, The EVA is equal to after-tax operating J of a firm less Boe ot firm less the cost of funds used to finance investments. A postive EVA feo cae Foul Be dene ones value/wealth, Therefore, only investments with postive EVA ee” bee asa le from the viewpoint of maximising shareholders’ wealth. To ile #1nv* arate, assuming an after-tax profit of 840 crore and associated costs of financing stments of %38 crore, the EVA = %2 crore %40 crore — %38 crore) With a Positive EVA, the investment would add value and increase the wealth of the owners and should Pe accepted. The computation of the after-tax operating profits attributable (o the investment under consideration as well as the cost of funds used to finance it would, however, involve numerous accounting and financial issues, The merits of EVA are: (a) its relative simplicity and (b) its strong misation of the owners. It prima facie exhibits a strong link to share prices, that is, pos associated with increase in prices of shares and vice versa. However, EVA is, in effect, a repackaged and well-marketed application of the NPV technique of investment decision. But EVA is certainly a useful tool for operationalising the owners’ value maximisation goal, particularly with respect to the investment decision. Focus on Stakeholders The shareholders wealth maximisation as the primary goal vi z : notwithstanding, there is a broader focus in financial management to include the Sonu interest of the stakeholders as well as the sharcholders. The stakeholders include J groups such employees, customers, suppliers, creditors and owners and others who have a direct] as employees, link to the firm. The implication of the focus on stakeholders is that a firm should} customers, avoid actions detrimental to them through the transfer of their wealth to the firm _} suppliers, and, thus, damage their wealth. The goal should be preserve the well-being of the _ | creditors, owners stakeholders and not to maximise it. and others who ‘The focus on the stakeholders does not, however, alter the shareholders’ wealth _} have a direct link maximisation goal. It tends to limit the firm's actions to preserve the wealth of the _[ #0 the firm stakeholders. The stakeholders view is considered part of its “social responsibility” and is expected to provide maximum long-term benefit to the shareholders by maintaining positive stakeholders relationship which would minimise stakeholder turnover, conflict and litigation. In brief, a firm can better achieve its goal of shareholders’ wealth maximisation with the cooperation of, rather than conflict with, its other stakeholders, Shareholder Orientation in India Traditionally, the corporate industrial sector in India was domi- nated by group companies with close links with the promoter groups. Their funding primarily was through institutional borrowings from public/ development finance institutions like IFCI, ICICI, IDBI and so on. There was preponderance of loan capital in their financial structure and shareholders equity played a rather marginal role. It was no wonder, therefore, that corporate India paid scant attention to shareholders’ wealth maximisation with few exceptions such as Reliance Industries Ltd. In the post-90 liberalisation era, the goal of shareholders’ wealth maximisation has emerged almost at the centre-stage. The main contributory factors have been (i) greater dependence on capital market, Gd growing importance of institutional investors, (ii) tax concessions/incentives to shareholders and (iv) foreign exposure.1.18 Financial Management ‘cance of the development/public financial/term, ,ppearance from the Indian financial scene rece gence of the capital ma ind other financi ‘rentive to corporates to enhance share prices and, thus, focus on, 3 sales, assets and market capitalisation), high grow gm. and firs with high exports significantly focus on maximising EVA than smal and low exports fms respectively. There is no significant difference in the EVA as a corporate finance objective fg by the firms in public and private sectors The spread between cash flow retum on investment (CFROI) and the WACG, the third most important objective (54 per cent of rge firms based on market capitalisati market capitalisation, They (market value added) objective is more likely to be followed by public sector un by private sector firms. . The overwhelming majority of corporates (70 per cent) consider maximising pe retum on investment in assets as the most important © Another perferred go ‘aximise aggregate eami Wealth maximisation/maximisation of share prices is the least preferred goal ofp sample corporates. dra $ Yadav, “Financial Management Practices in india, i Management & Accounting Research, Vol. 3, No, ance Practices in India, a Survey’, Vikalp,a Financial Management—An Overview _1.19 SECTION [4] AGENCY PROBLEM A\ characteristic feature of comporate enterprise is the separation between ownership and manage- ment as a corollary of which the latter enjoys substantial autonomy in regard to the affairs of the firm, With widely-clffused ownership, scattered and ill-organised shareholders hardly exercise any controV/influence on management which may be inclined to act in its own interest rather than those of the owners. However, shareholders as owners of the enterprise have the right to change the management, Due to the threat of being dislodged/dismissed for poor performance, the manage- ment would have a natural inclination to achieve a minimum acceptable level of performance to satisfy the shareholders’ requirements/goals, while focusing primarily on their own personal goals. ‘Thus, in furtherance of their objective of survival, management would aim at satisfying instead of maximising sharcholders’ wealth. Resolving the Agency Problem Agency problem From this conflict of management objective of survival (personal goals) and maximis- is the likelihood ing owners value arises the agency problem, that is, the likelihood that managers | that managers may place personal goals ahead of corporate goals. The agency problem can be | may place prevented/minimised by acts of () market forces and (i) agency costs pera ee of Market Forces “Market forces act to prevent/minimise agency problems in two ways: | corporate goals. (A) behaviour of security market participants and (2) hostile takeovers. Behaviour of Security Market Participants ‘The security market participants/ shareholders in gen- eral and large institutional investors like mutual funds, insurance organisations, financial institu- tions and so on which hold large blocks of shares of corporates, in particular, actively participate in management. To ensure competent management and minimise agency problems, they have in recent years actively exercised their voting rights to replace more competent management in place of under-performing management. In addition to exercising their legal voting rights, Hostile takeover the large institutional shareholders also from time to time communicate with, and is the acquisition exert pressure on, corporate management to perform or face replacement. of the firm Hostile Takeovers Another market force that has in recent years threatened corporate | (###e0 by management to perform in the best interest of the owners/shareholders is the pos- | other fm (tbe sibility of a hostile takeover, that is, the acquisition of the (target) firm by another | *¢4Uie) that's firm/group (i.e. acquirer) that is not supported by management. Such takeovers typi- | NOL S'PPonsd by cally occur when the acquirer is of the view that the target firm is undevalued due to poor management and that its acquisition at its current low price may result in the enhancement of its value (i.e. share price) through restructuring its management, operations and financing. The constant threat of a takeover would motivate manage- ment to act in the best interests of the owners despite the fact that techniques are available to defend against a hostile takeover. Agency costs are costs borne by shareholders to preven minimise agency Agency Costs To respond to potential market forces by preventing/maximising _} Problems s 10 agency problems and contributing to the maximisation of owners’ wealth/value, the | Sontrbale shareholders/owners have to incur four types of costs: @) monitoring, (ii) bonding, | Yeah ay Gi) opportunity and (iv) structuring. Monitoring Expenditures Such expenditures relate to monitoring the activities of the management (agents) to prevent a satisfying in contrast to share price maximising behaviour by them. 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What is the primary Prineple used should possess a ba managerial finance? ct to (@) empha I are the major differences between accounting and finance with respect to (a) emp) on cash flows and (b) decision making? oe Briefly explain the three key activities of the financial man ais be, omen Briefly describe the three basic reasons why profit/EPS maximisation fa Wealth maximisation. achievement of this goal. What is the goal of the firm? Discuss how to measure achievement What is economic value added (EVA? How is it used? to them in pursuing the fr Who are a firm's stakeholders and what consideration is often given 18 the finns goal? Why? event/minimise this probleme es act to preven ‘What is the agency problem? How do market forces act inners Deis spert ere) oe es incr tere What ae secu Serene aa they used? Describe and differentiate between incentives cae Ce ee Describe the salient features of the modern pe eat Describe the three broad areas of financial decision ma vealer inpoftance 1 the’ goa Oa Outline the factors behind Indian companies according g} 15 wealth maximisation, sachin Comment on the emerging role of the finance manager Se organiondera How is the finance function typically organised in ou in India? What are the primary objectives of corporate managemet rf