Financial

Management
Unit: I
Definition of FM
• FM is an area of financial decision making, harmonising
individual motives and enterprise goals.
Weston and Brigham
• FM is the application of the planning and control functions to
the finance function.
Howard and Upon
• FM is the operational activity of a business that is responsible
for obtaining and effectively utilizing the funds for efficient
operations.
Ezra Solomn and Pringle
Nature/ Characteristics
• Branch of Business Management
• Essence of Managerial Decisions
• Scientific and Analytical
• Continuous
• Pervasive
• Centralised
• Basis of Managerial Process
• Measure of Performance
Scope of FM
• Concerned with the management of financial resources.
• Performs facilitation, reconciliation, and control functions.
• Covers all decisions having monetary implications. These
decisions may be:
 Financing Decision: Financial planning: How much money, time,
Explore various sources, Cost of capital, capital structure,
leverage analysis, selection of best source, raise the money
from that source
 Working Capital Decision: investment in current assets
 Investment Decision: investment in fixed asset, capital
budgeting
 Dividend Decision: liberal dividend, strict dividend: Dividend
decision
Continued
Investment Decision
• What business to be in?
• What growth rate is appropriate?
• What assets to acquire?
Financing Decision
• What mix of debt and equity to be used?
• Can we change value of the firm by changing the capital mix?
• Is there an optimal debt–equity mix?
Dividend Decision
• How much of the profit should be distributed as dividends and how much should be ploughed
back
• Can we change value of the firm by changing the amount of dividend?
• What should be the mode of dividend payment
Working Capital Decision
• What level of inventory is ideal?
• What level of credit should be given to the customers?
• What level of cash should be maintained?
• How can the blockage of funds in the current assets be minimized without compromising with
profits?
3 A’s of FM
• Anticipating Financial Needs: How much money, time
• Acquiring Financial resource: exploring sources, compare
all sources- cost of capital, capital structure, leverage
analysis, select best source, raising the money
• Allocation of Resources: Working capital investment, FA
investment, Dividend decision
Functions of FM
Financial Searching
Management of Planning Financial Sources
Cash

Comparison of
Division of Possible Sources
Surplus and selection of
Functions Best

Working Capital
Management
Raising
Investment of Finance
Funds
Goals of FM
• Profit Maximization
• Shareholder’s Wealth Maximization

Arguments in favour of Profit Maximization:

• Profit is the test of economic efficiency
• Internal Resource for Expansion
• More Competitive
• Avoid Dilution of Ownership
• Basis of Decision-making
Continued
Shareholder’s Wealth Maximization Approach:
Shareholders wealth maximization criterion proposes that
a business concern should only consider the decisions that
maximize the market value of the share or
the shareholders' wealth.
Wealth = Number of shares X MP
The market value of share is treated as an indicator of
efficiency and effectiveness of the firm.
Continued
Comparison of both Goals:
Profit maximization is an inappropriate goal because it's short
term in nature and focus more on what earnings are generated
rather than value maximization which comply to shareholders
wealth maximization.  Critics have given following arguments
against profit maximization approach:
• Profit is a vague term
• Overlook Social welfare
• Ignores time value of money
• Narrow outlook
• Short term achievement
• Ignores Risk
Wealth maximization overcomes all the limitations that profit
maximization possesses.
Agency Problem
The stakeholders in business are multiple, their stakes are varied
and their objectives are often conflicting. Conflict of interest
between the varied stakeholders causes agency problems.
Conflicts may be between:
 Shareholders and managers of companies
 Shareholders and bond holders (Creditors)
Continued
Conflict between Shareholders and Managers:
The conflict of interest between shareholders and management
may relate to what proportion of the company’s profit should be
paid in the form of dividend and what proportion should be
retained for future investments and for capital investment
purposes. 
Further due to SELF-INTERESTED BEHAVIOR managers may seek
to maximize their own utility at the expense of corporate
shareholders. Agents have the ability to operate in their own self-
interest rather than in the best interests of the firm because of
asymmetric information (e.g., managers know better than
shareholders whether they are capable of meeting the
shareholders' objectives) and uncertainty (e.g., myriad factors
contribute to final outcomes, and it may not be evident whether
the agent directly caused a given outcome, positive or negative).
Continued
Shareholders and bond holders (Creditors)
Creditors have the primary claim on part of the firm's
earnings in the form of interest and principal payments on
the debt as well as a claim on the firm's assets in the event
of bankruptcy.
The stockholders, however, maintain control of the operating
decisions (through the firm's managers) that affect the
firm's cash flows and their corresponding risks.
Shareholder-creditor agency conflicts can result in situations
in which a firm's total value declines but its stock price rises.
This occurs if the value of the firm's outstanding debt falls
by more than the increase in the value of the firm's
common stock.
Continued
To resolve such agency problems monitoring and control
mechanisms become imperative. Such mechanisms entail costs
that are termed as agency costs. Agency costs take the form of
either incentives to management like bonuses, stock options or
monitoring and control costs like audit fees, credit rating fees
etc.
Corporate governance is another mechanism to protect the
interest of the shareholders. Set of rules, processes, and
customs that enable the effective management of firms in the
best interest of shareholders are termed as corporate
governance.
FM and Accounting
FM and Economics
Proper Financial Management

Higher Profitability, More Production, Maximization

of Shareholder’s Wealth

Growth in GDP

Improvement in Balance of Payment

Economic Growth
Economics and FM

Demand Forecasting,
Cost Optimization,
Optimum Production Financial
Economics Function, Break-Even Management
Analysis, Competitive
Pricing