Valuation Concepts Cost of Capital Capital Budgeting Working Capital Management Leverage Capital Structure Dividend Policy
FINANCIAL MANAGEMENT : AN OVERVIEW
• Introduction • Evolution of Financial Management
• Financial Decisions in a Firm • Goal of Financial Management • The fundamental Principle of Finance • Risk-return Tradeoff • Forms of Business Organizations • Agency problem • Emerging Role of the Financial Manager in India
businesses and governments within the areas of banking and related institutions. Major areas:
– Financial services: concerned with the design
and delivery of advice and financial products to individuals.Introduction
art and science of managing
money. insurance and so on.
. personal financial planning. investments. real estate.
Introduction(cont. − whether or not to replace an old asset. a company must decide:
− where to invest its money. − when to issue new stocks and bonds. − whether or not to pay dividends.
– Financial management: Financial Management
or business finance is concerned with managing an entity’s money.
the traditional phase. Its evolution may be divided into three broad phases .EVOLUTION OF FINANCIAL MANAGEMENT
• Financial management emerged as a distinct field of study at the turn of the 20th century. and the modern phase. the transitional phase. • The modern phase began in mid-1950s and has been marked by infusion of ideas from economic theory and application of quantitative methods • The distinctive features of the modern phase are: Central concern Approach : Shareholder wealth maximization : Analytical and quantitative
and capital) to its various investment alternatives. which is required for financing short-term or current assets such a cash marketable securities. common equity and preferred equity. Funds thus. labor. • Capital Structure: A mix of a company's long-term debt. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. specific short-term debt. invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets.
. debtors and inventories. • Working Capital Management: Working Capital refers to that part of the firm’s capital.FINANCIAL DECISIONS IN A FIRM • Capital Budgeting: Capital budgeting refers to the process of deciding how to allocate the firm’s scarce capital resources (land.
Goal Of Financial Management
should be the goal of a corporation?
– Maximize profit? – Minimize costs? – Maximize market share? – Maximize the current value of the company’s
this mean we should do anything and everything to maximize owner wealth?
.GOAL OF FINANCIAL MANAGEMENT FINANCE THEORY RESTS ON THE PREMISE THAT MANAGERS SHOULD MANAGE THEIR FIRM’s RESOURCES WITH THE OBJECTIVE OF ENHANCING THE FIRM’s MARKET VALUE.
The theory in corporate finance is based on assumption that the goal of the firm should be to maximize the
wealth of its current shareholders.
known as Value Maximisation or Net Worth Maximisation. The wealth maximization criterion is that it considers both the quantity and quality dimensions of benefits.
. The wealth maximization criterion is based on the concept of cash flows generated by the decision rather than accounting profit which is the basis of the measurement of benefits in the case of the profit maximisation criterion.
CRITIQUE AND DEFENCE OF SHAREHOLDER WEALTH MAXIMISATION GOAL
Critique • The capital market sceptics argue that stock prices fail to reflect true values Defence • Financial economists argue that stock prices are the least biased estimates of intrinsic values in developed markets • Balancing the interests of various stakeholders is not a practical governing objective • The only social responsibility of business is to create value and do so legally and with integrity
• The balancers argue that a firm should seek to ‘balance’ the interests of various stakeholders • Advocates of social responsibility argue that a business firm must assume wider social responsibilities
Dhirubai Ambani : In everything that we do. The key is to raise shareholder returns
. Anand Mahindra : All of us are beginning to look at companies as owned by shareholders. there is a greater incentive to focus on creating value for shareholders. that is to maximise your wealth as India's largest investor family. we have only one supreme goal.SHAREHOLDER ORIENTATION IN INDIA
In the wake of liberalisation. globalisation. The following observations are clear indications. and institutionalisation of the capital market.
• It glosses over the factor of risk
Maximisation of Profit
Profit maximisation criterion implies that the investment. Profit maximisation would imply that a firm should be guided in financial decision making by one test. financing and dividend policy decisions of a firm should be oriented to the maximisation of profits/EPS. projects and decisions which are profitable and reject thase which are not. select assets. Its limitations are: • Profit in absolute terms is not a proper guide to decision making. This goal is not as inclusive a goal as maximisation of shareholders’ wealth. • It leaves considerations of timing and duration undefined. It should be expressed either on a per share basis or in relation to investment.
. they suffer from the other two limitations. Maximisation While
of EPS or ROE
these goals do not suffer from the first limitation mentioned above.
CASH ALONE MATTERS
Investors • Shareholders • Lenders
Investors provide the initial cash required to finance the business proposal
The business proposal
The proposal generates cash returns to investors
.THE FUNDAMENTAL PRINCIPLE OF FINANCE
A business proposal-regardless of whether it is a new investment or acquisition of another company or a restructuring initiative –raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal.
of our original investment. Low levels of uncertainty (low risk) are associated with low potential returns. Technically.Risk-Return Tradeoff
principle that potential return rises with an increase in risk. Risk: risk is the chance that an investment's actual return will be different than expected. Return: The return earned on investments represents the marginal benefit of investing.
. or even all. this is measured in statistics by standard deviation. Risk means you have the possibility of losing some. whereas high levels of uncertainty (high risk) are associated with high potential returns.
risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below.Risk-Return Tradeoff(cont. A higher standard deviation means a higher risk and higher possible return.
DECISIONS. RISK. RETURN. AND MARKET VALUE
Capital Budgeting Decisions Return M arket Value of the Firm
Capital Structure Decisions
Dividend Decisions Risk W orking Ca pital Decisions
FORMS OF BUSINESS ORGANISATIONS
• One owner • Very simple • Unlimited liability • The firm has no separate status from a legal and tax point of view Partnership • Two or more owners • Fairly simple • Unlimited liability • The firm has a separate status • Upto 50 owners • Not too complex • Limited liability • A distinct legal person
Private Limited Company
FORMS OF ORGANISATION
Public Limited Company
• Many owners • Somewhat complex • Limited liability • Distinct legal person • Free transferability of shares
Public Limited Company’s Attraction
• The potential for growth is immense because of access to substantial funds • Investors enjoy liquidity because of free transferability of securities • The scope for employing talented managers is greater
Stock value may not be maximized!
. attitude towards risk.Agency Problem
– Principal: Firm owners – Agent: Management
Problem: The possibility of conflict of interest between stockholders and management of a firm Agency Cost(are costs borne by shareholders to
prevent/ minimise agency problems as to contribute to maximise owners wealth.)
managerial perks. empire building. etc.
• The lack of perfect arrangement between the interests of managers and shareholders results in the agency problem. • To diminish the agency problem. effective monitoring has to be done and appropriate incentives have to be offered. a separated structure leads to a possible conflict of interest between managers and shareholders.AGENCY PROBLEM
• While there are compelling reasons for separation of ownership and management.
Solutions to Agency Problem
Managerial Compensations to align incentives Control of the Firm
– – –
Stockholders elect Board of Directors who have rights to HIRE and FIRE managers well-established management Hostile takeover(is the acquisition of the firm by another firm that is not supported by management) due to low prices. market for corporate control
in general. are important links in the finance control system of the firm
. who proposes a new plant.Organisation of the finance function
ALL MANAGERS ARE FINANCIAL MANAGERS • The engineer. shapes the investment policy of the firm • The marketing analyst provides inputs in the process of forecasting and planning • The purchase manager influences the level of investment in inventories • The sales manager has a say in the determination of the receivables policy • Departmental managers.
Functions of the Treasurer and the Controller
Obtaining finance Banking relationship Cash management Credit administration Capital budgeting
Financial accounting Internal auditing Taxation Management accounting and control
ORGANISATION OF FINANCE FUNCTION
Chief Finance Officer
Financial Accounting Manager
Cost Accounting Manager
Capital Budgeting Manager
Fund Raising Manager
Data Processing Manager
EMERGING ROLE OF THE FINANCIAL MANAGER IN INDIA
The job of the financial manager in India has become more important. complex and demanding due to the following factors: • Liberalisation • Globalisation • Technological developments • Volatile financial prices • Economic uncertainty • Tax law changes • Ethical concerns over financial dealings • Shareholder activism
and restructuring • Working capital management • Performance management • Risk management • Corporate governance • Investor relations
. acquisitions.EMERGING ROLE OF THE FINANCIAL MANAGER IN INDIA The key challenges for the financial manager appear to be in the following areas: • Investment planning and resource allocation • Financial structure • Mergers.
in general. how would it influence value ?
. • A business proposal raises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal. when you take a financial decision. capital budgeting. • Finance theory. rests on the premise that the goal of financial management should be to maximise the wealth of shareholders. you have to answer the following questions : What is the expected return ? What is the risk exposure ? Given the risk-return characteristics of the decision. • A confluence of forces appears now to be prodding Indian companies to accord greater importance to the goal of shareholder wealth maximisation. viz. • In general.. capital structure. and working capital management.SUMMING UP
• There are three broad areas of financial decision making.
. • While there are compelling reasons for separation of ownership and management. • The lack of perfect alignment between the interests of managers and shareholders results in the agency problem. the public limited company form of organisation generally appears to be the most appropriate form from the point of view of shareholder wealth maximisation. private limited company. effective monitoring has to be done and appropriate incentives have to be offered. and public limited company. While each form of organisation has certain advantages and limitations. To mitigate the agency problem.• The important forms of business organisation are : sole proprietorship. a separated structure leads to a possible conflict of interest between managers and shareholders. partnership.
and demanding.• Financial management is in many ways an integral part of the jobs of managers who are involved in planning. allocation of resources. the job of the financial manager in India has become more important complex.
. and control. • Thanks to the changes in the complexion of the economic and financial environment in India from early 1990s.