unit 1_nature of financial management

8/6/2019 Unit 1_Nature of Financial Management

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Nature of Financial Management

Unit I


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Why Financial Management?

Need to answer some essential questions when starting abusiness: how much of capital investments are required, thesources of funds for these investments, how much moneywould be required for the day-to-day running of the businessor working capital management.

Financial management, especially corporate finance ormanagerial finance, has evolved over the years, and today itscentral concern is to rationally match the sources and uses offunds in order to maximize shareholders wealth.

Financial Decisions of a Firm: The three broad areas of

financial decision making are: capital budgeting, capitalstructure and working capital management.

The approach of financial management todayhas becomemore analytical and quantitative.


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Framework of Financial Management


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Goals of Financial Management

Finance theory is based on the premise that the goal shouldbe to maximize the wealth of its current shareholders. Thereare often different views expressed regarding this approach.

For example, some believe that capital markets are not

unbiased estimators of intrinsic values, while others believethat a firm cannot forget its social responsibility.

Others advocate a more balanced approach: the firm should`balance the interests of various stakeholders: customers,employees, shareholders, creditors, suppliers, the community,etc.

Further, managers may believe that the intrinsic value of thefirms shares differs from the current market price of theshares.


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Goals of Financial Management

Business firms often pursue several goals: high rate of growth,substantial market share, product and technologicalleadership, customer satisfaction, support research, socialsupport schemes, etc.

Pursuing other goals in addition to shareholder wealth

maximization usuallyhelps in the long run by improving theimage of the firm and strengthening its relationship with theenvironment.

However, it is generally accepted that maximizing the wealthof its equity shareholders constitutes the principal guarantee

for efficient allocation of resources in the economy. When other goals seem to be in conflict with the goal of

shareholder wealth maximisation, it is helpful to know thecost and benefit of pursuing these goals. The trade-offhas tobe understood.


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Financial Decisions


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Financial Decisions

In the modern approach, the discussions on financialmanagement can be divided into three major decisions:

(1) Investment decision; (ii) Financing decision; and (iii)Dividend decision.

A firm takes these decisions simultaneously and continuouslyin the normal course of its business. Firm may not take thesedecisions in a sequence, but decisions have to be taken withthe objective of maximizing shareholders wealth.

The Investment decision entails the involvement of Long-termassets and Short-term assets.


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Financial Decisions

The Financing decision is related to the financing mix orcapital structure or leverage and he has to determine theproportion of debt and equity. It should be the optimumfinance mix, which maximizes shareholders wealth.

The Dividend decision entails choosing between two optionsavailable in dealing with the net profits of a firm, viz.,distribution of profits as dividends to the ordinaryshareholders, or retaining the profits in the business itself.The Financial manager should determine optimum dividend

policy, which maximizes market value of the share therebymarket value of the firm.


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Risk-Return Trade-off

Financial decisions usually involve alternate courses

of action.

Such alternate courses of action mayhave different

risk-return implications.

Capital budgeting decisions, capital structure

decisions, dividend decisions, etc. will impinge upon

risk and return, and thus market value of the firm.


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Functional Areas of Financial Management


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Organisation of the Finance Function

The finance function can be broadly classified intotwo parts:

(i) Routine financial matters like, custody of cash and

bank accounts, collection or loans, payment of cashetc.

(ii) Special financial functions like financial planningand budgeting, profit analysis, investment decisions

etc. These two functions can be looked after by two

executives and ultimately by the top management.


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Organisation of the Finance Function


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Key Challenges for the Finance Manager

Investment planning

Financial structure

Treasury operations

Foreign exchange

Investor communications

Management control


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Agency Problem

Unlike other forms of business structures, in the case ofcompanies, particularly large public limited companies,owners may not be active managers.

Despite changes in ownership (on account of transfer ofshares) the company continues to do business in the normalway.

Enables shareholders to hold a diversified portfolio ofsecurities. However, this is possible only when we haveseparation between ownership and management.

Impractical for many equity owners to participate inmanagement. Sometimes, with the separation of ownershipand management, the shareholders take little interest in themanagement of companies, with the understanding thatsomebody else will do the monitoring.

Professional managers may be more qualified to runcomplicated businesses.

There may be a conflict between owners and managers.


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Agency Problem

Managers may pursue their own agenda after keeping theshareholders satisfied with a certain minimum amount ofreturns: empire building, pursuing pet projects, payingthemselves excessive salaries and perquisites, etc.

The lack of perfect alignment between the interests of

managers and shareholders leads to agency costs. Another related problem is when a group of minority

shareholders control the management of a public limitedcompany typical in the case of family run businesses

To mitigate the agency problem, effective monitoring(including auditing) has to be done while offering appropriateincentives to managers in the form of cash bonuses and stockoptions as well as perquisites linked to performance targets.

Corporate governance has become an important issue.


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Relationship of Finance to Economics and

Accounting

Relationship to Economics:

Key macro-economic factors such as growth rate of theeconomy, domestic savings rate, tax environment, etc.

In a number of areas, finance is applied micro-economics,wherein managerial decisions in finance is guided by marginalanalysis or the comparison of incremental benefits and costs.

Relationship to Accounting:

Score-Keeping vs Value Maximising

Accrual Method vs Cash Flow Method Certainty vs Uncertainty


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Financial Markets


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Classification of Financial Markets

Nature of Claims: Debt vs Equity Markets

Maturity of Claim: Money Market vs Capital Market

Type of Claim: Primary Market vs Secondary Market

Timing of Delivery: Cash or Spot Market vs Forwardor Futures Market

Organisational Structure: Exchange-traded vs Over-the-counter Market


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The Financial System

Financial Institutions

Commercial Banks

Insurance Companies

Mutual Funds

Provident/ Pension Funds

NBFCs

Suppliers of Funds

Individuals

Businesses

Governments

Transfer Mechanisms

Public Issue

Private Placement

Instruments: Shares, Loans,

Securities

Demanders of Funds

Individuals

Businesses

Governments

Financial Markets

MoneyMarket

Capital Market


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Indian Financial System

Formal Financial System Informal

Financial

System

Regulators Financial

Institutions

(Intermediaries)

Financial

Markets

Financial

Instruments

Financial

Services

Money

Lenders

Local

Bankers

Traders

Landlords

Pawn

Brokers

Ministry of

Finance

SEBI

RBI

IRDA

PensionRegulator

Banking

Institutions

Non-Banking

Institutions

Mutual Funds

Insurance Cos.

Housing Fin.

Cos.

Capital

Market

Money

Market

Term (Short,

Medium, Long

Term)

Type (Primary &

Secondary incl.

Equity,

Preference,Debt), Time

deposits, MF

units, Insurance

policies

Depositories

Custodial

Credit rating

Factoring

Forfaiting

Merchant

Banking

Leasing

Hire Purchase

Portfolio Mng.

Underwriting


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Changing Scenario in India

Interest rates are free from regulations.

Rupee is fully convertible on current account.

Merger and Acquisitions are possible

Maintaining share prices are also crucial. In aliberalized scenario, the capital market is animportant avenue of funds for business.

Ensuring management control is vital especially inthe light of foreign participation.

Foreign portfolio investment

Foreign direct Investment

Growing and volatile capital market.

unit 1_nature of financial management

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