Introduction

FINANCIAL MANAGEMENT- AN OVERVIEW

Oxford Higher EducationPrepared By Sumit Goyal-LPU

CONTENTS

• Introduction• Nature and Scope of Financial Management• Role of finance function• Finance decisions for the firm

• Investment decisions• Financing decisions• Dividend decisions• Working capital decisions

• Integrated view of finance decision-making• Financial decision making framework

Prepared By Sumit Goyal-LPU

CONTENTS

• Key issues in financial decision making• Objective function in finance• Agency cost and Corporate Governance• Financial Management and Accounting• Financial objectives and organisational strategy

Prepared By Sumit Goyal-LPU

Introduction

•Basic issues in finance are essentially the same 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.•Performs facilitation, reconciliation, and control functions. •Covers all decisions having monetary implications.

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Role Of Finance Function

•Finance is central to all business activities. •Finance function reconciles the conflicting interests of:• varied stakeholders and • different functional units.

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Finance Manager’s Role

• Raising of Funds• Allocation of Funds• Profit Planning• Understanding Capital Markets

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Financial Goals

• Profit maximization (profit after tax)• Maximizing earnings per share

• Wealth maximization

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Profit Maximization

• Maximizing the rupee income of firm Resources are efficiently utilizedAppropriate measure of firm performanceServes interest of society also

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Objections to Profit Maximization

It is VagueIt Ignores the Timing of ReturnsIt Ignores RiskIn new business environment profit maximization is regarded as • Unrealistic• Difficult• Inappropriate • Immoral

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Maximizing Profit after Taxes or EPS

• Maximising PAT or EPS does not maximise the economic welfare of the owners. • Ignores timing and risk of the expected benefit• Maximizing EPS implies that the firm should make no dividend payment

so long as funds can be invested at positive rate of return—such a policy may not always work.

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Shareholders’ Wealth Maximization

• Maximizes the net present value of a course of action to shareholders.• Accounts for the timing and risk of the expected benefits.• Benefits are measured in terms of cash flows.• Fundamental objective—maximize the market value of the firm’s

shares.

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Risk-return Trade-off

• Financial decisions of the firm are guided by the risk-return trade-off.• The return and risk relationship: Return = Risk-free rate + Risk

premium• Risk-free rate is a compensation for time and risk premium for risk.

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Risk Return Trade-off

Risk and expected return move in tandem; the greater the risk, the greater the expected return.

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Agency Problems: Managers Versus Shareholders’ Goals

•There is a Principal Agent relationship between managers and shareholders.

• In theory, Managers should act in the best interests of shareholders.

• In practice, managers may maximise their own wealth (in the form of high salaries and perks) at the cost of shareholders.

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Agency Problems: Managers Versus Shareholders’ Goals

•Managers may perceive their role as reconciling conflicting objectives of stakeholders. This stakeholders’ view of managers’ role may compromise with the objective of SWM.

•Managers may avoid taking high investment and financing risks that may otherwise be needed to maximize shareholders’ wealth. Such “satisfying” behaviour of managers will frustrate the objective of SWM as a normative guide.

• This conflict is known as Agency problem and it results into Agency costs.

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Agency Costs

• Agency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of managers and control their behaviour.

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FINANCE DECISIONS FOR THE FIRM

•Financial decision-making involves procurement of funds and their optimal utilization through:• Financing• Investment•Dividend and •Working capital decisions.

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Financing Decisions

•Referred to as capital structure decisions.•Mainly concerned with:• Identifying the suitable sources of funds• Tapping of these sources.

•Determine the financial risk.•Thrust is to bring down the cost of financing.

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Financing Decisions

•The main issues involved are:•Where from to procure the requisite funds?•What should be the optimal mix of various sources of capital?• How much should be the proportion of short-term and long-

term funds?• How do the expectations of providers of each source of capital

change with alteration in the capital mix?

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Financing Decisions

•Are taken in the light of their likely impact on the wealth of the stockholders. •A right blend of debt–equity affects the risk return

profile of the business.

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Investment Decisions

•Aim at selecting the most productive avenues that maximize the ROI.•Examples include: • Expansion•Modernization and replacement• R&D expenditure.

•Also referred to as capital budgeting decisions.•Are critical for long-term survival and growth.

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Investment Decisions

•Are taken in the light of their probable impact on the wealth of shareholders.• Involve huge capital outlay.•Have long-term implications.•Are usually irreversible.

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Dividend Decisions

•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 and current consumption requirements of the shareholders.

•Generally, firms in sectors with a high-growth rate follow a policy of high retention and low payout.

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Dividend Decisions

•Determining the payout ratio and the method of dividend payment are the two concerns of dividend policy. •The payout ratio is decided in the light of its probable

impact on shareholders’ wealth•Normally, firms follow a policy of stable dividends•Dividend policy is considered as a residue of investment

and financing policy.

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Working Capital Decisions

•Are concerned with the management of current assets. •The two key decision points in working capital

management are:• Level of investment in current assets• Financing of current assets.

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Integrated View Of Finance Decision-making

•The four key decision areas in finance are the part of an integrated decision making framework in finance.

•They are directly linked and reinforce each other.

•All the decisions have a common objective function-shareholders’ wealth maximization.

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Financial Decision Making Framework

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Key Issues In Financial Decision-making

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?

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Objective Function In Finance

•The goal of wealth maximization is the widely accepted goal of the business.• It reconciles the varied, often conflicting,

interest of the stakeholders. • It is free from the limitations that other

objectives are faced with.

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FINANCIAL MANAGEMENT AND ACCOUNTING

•Financial management is intricately related to financial and management accounting.•The accounting information provides inputs for

financial decision making.•Financial decisions in turn get reflected in the

accounting statements.

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Financial Management And Accounting

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Financial Objectives And Organizational Strategy

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