financial management overview1

7/31/2019 Financial Management Overview1

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Financial Management


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Finance

A firm secures the amount of capital it requires,employs it in activities which generate returnson invested capital.


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Introduction

Basic issues in finance are essentially thesame for diverse businesses.

The key issues in finance are: Where to raise financial resources from? Wherein to invest the resources? How best to manage the production-distribution

function? How much of profit to distribute and how much to

retain?

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Nature And Scope Of Financial Management

Concerned with the management of financial

resources.

Covers all decisions having monetaryimplications.

Finance is central to all business activities.

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Financial Management

FM is concerned with that managerial activitywhich is concerned with the planning andcontrolling of the firms financial resources.


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Evolution of Financial ManagementTraditional Approach

(1920-1950)

Modern Approach

(1950 onwards)

Procurement of Funds

Outsider Looking Approach Limited Scope (not oriented

towards working capitalmanagement)

Limited Financial Instruments

Not part of managerialfunctions

Integrated finance functions

No Longer an outsider lookingapproach

Management Functions

Covers tools and techniques ofvarious finance areas, i.e.

capital budgeting, cost ofcapital, working capital etc.


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Finance Functions / Decisions

Financial decision-making involves procurement

of funds and their optimal utilization through:

Investment or Long Term Asset Mix Decision

Financing or Capital Mix Decision

Dividend or Profit Allocation Decision Working Capital or Short Term Asset Mix Decision


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Investment Decisions Investment Decision or Capital Budgeting involves the decision of

allocation of capital or commitment of funds to long term assetswhich would yield benefit in future.

Aim at selecting the most productive avenues that maximize theROI.

Examples include: Expansion

Modernization and replacement

R&D expenditure.

Also referred to as capital budgeting decisions.


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Are critical for long-term survival and growth

Involve huge capital outlay.

Have long-term implications.

Are usually irreversible.


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Financing Decision

Also called Capital Structure Decision.

Decision regarding when, where and how to acquire funds to meet

thefirms

investment needs.

Important is to determine the proportion of equity and debt.

Should have balance between risk and return of the shareholders.

When shareholders return is maximized with minimum risk, themarket value per share will be maximized, and firms capitalstructure would be considered optimum.


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The main issues involved are:

Where from to procure the requisite funds?

What should be the optimal mix of various sources ofcapital?

How much should be the proportion of short-term andlong-term funds?

How do the expectations of providers of each source ofcapital change with alteration in the capital mix


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Dividend Decision Decisions regarding whether the firm should distribute all profits, or

retain them, or distribute a portion and retain the balance.

Are mainly concerned with deciding the mix of profits to be

distributed as dividends and those to be ploughed back for future

financing needs of business.

Depend on trade off between future financing needs of the firm andcurrent consumption requirements of the shareholders.

Determining the payout ratio and the method of dividend payment

are the two concerns of dividend policy.


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Liquidity (Working Capital)

Decisions Decision regarding management of current assets.

Current assets should be managed efficiently for safeguard the firmagainst the danger of illiquidity and insolvency.

Investment in current assets affects firms profitability, liquidity andrisk.

The two key decision points in working capital management are:

Level of investment in current assets

Financing of current assets. Proper trade-off is required between profitability and liquidity.


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Key Issues In

Financial Decision-makingInvestmentDecision

What business to be in?

What assets to acquire?

FinancingDecision

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 debtequity mix?

DividendDecision

How much of the profit should be distributed as dividends and howmuch should be ploughed back

Can we change value of the firm by changing the amount ofdividend?

What should be the mode of dividend payment

WorkingCapitalDecision

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 minimizedwithout compromising with profits?


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Finance Managers RoleThe role of a finance manager has moved beyond traditional

accounting functions. Financial management now

involves a broader horizon where value maximization hasgained prime importance.

Raising of Funds

Allocation of Funds Profit Planning

Understanding Capital Markets


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A Hypothetical Organizational Chart

with Focus on Finance Department


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Financial Management & Financial Accounting They are complementary, but different areas of study.

Accounting is a resource or an input to financialmanagement decisions.

Financial statements are used to project to thestakeholders the profitability of the firm to ensure a goodreputation of the firm. The same statements are used infinancial management for taking decisions relating toinvestment, financing, and dividends to reach the goal ofwealth maximization.


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Difference between FM & FA

Cash Flow Approach

Time Value of Money

Treatment of Funds

Activities


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Objectives of Financial Management

Profit Maximization

Wealth Maximization


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Profit Maximization

The primary objective of any business.

Represents the process or the approach by whichprofits (EPS) of the business are increased.

All the decisions whether investment, financing,or dividend etc are focused to maximize theprofits to optimum levels.


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Limitation of Profit Maximization

Haziness of the concept Profit

Ignores Time Value of Money

Ignores the Risk

Analyses the firms utilization of resourcesrather than interest of shareholders.


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Wealth Maximization

Wealth maximization is a modern approach to financialmanagement.

It is a superior goal compared to profit maximization as ittakes broader arena into consideration.

Value of a business is defined as the market price of the

capital invested by shareholders.

Wealth maximization simply means maximization ofshareholders wealth. Wealth of a shareholder maximizeswhen the net worth of a company maximizes.


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The shareholders economic value (wealth) is thedividend they receive presently and future dividendbenefits and capital appreciation of the share.


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How to calculate wealth?

Wealth is said to be generated by any financial decision ifthe present value of future cash flows relevant to that

decision is greater than the costs incurred to undertakethat activity. Wealth is equal to the present value of allfuture cash flows less the cost.

In essence, wealth is the net present value of afinancial decision.


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Wealth = Present Value of cash inflows

Cost.

Where,

Present Valueof cash inflows = CF1 + CF2 +.+ CFn

(1 + K) (1 + K) 2 (1 + K) n

CF = Cash inflows expected if a course of action is adopted.

K = Appropriate discounting rate


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Problem of Agency Cost 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.

To resolve such agency problems monitoring and control

mechanisms become imperative.


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Agency problem is the likelihood that managers mayplace personal goals ahead of corporate goals.

Such mechanisms entail costs that are termed as agency

costs.

Agency costs take the form of either incentives tomanagement like bonuses, stock options or monitoringand control costs like audit fees etc.

financial management overview1

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