ch 1 - introduction to fm

8/6/2019 CH 1 - Introduction to FM

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N.R. Institute of Business Management

GLS Institute of Computer Technology

CHAPTER - 1

Nature of Financial Management

Presenter:

Prof. Rajsee Joshi


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Financial Management: Definition

Scope of Finance

Finance

F

unctions Financial Managers Role

Financial Goal

Agency Theory

Financial system

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Topics Covered


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What is Your Goal?


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Introduction Definition: Financial management is that managerial

activity which is concerned with the planning and

controlling of the firms financial resources.


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Scope ofF

inance A firm secures whatever capital it needs and employs it

(financial activity) in activities, which generate returns on

invested capital (production and marketed activities)

The scope of Finance can be broadly described as under:

1. Real & Financial Assets

2. Equity & Borrowed Funds

3. Finance and Management Functions


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1. Real and Financial Assets:

Tangible Real assets are physical assets such as plant,

machinery, office, etc.

Intangible Real Assets include technical know-how, patents,

copyrights.

Financial Assets, also called securities, are instruments such as

shares and bonds or debentures.

Scope of Finance Cont


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2. Equity and Borrowed Funds:

Shares represent ownership rights of their holders.

A company can also obtain equity funds by retaining earnings

available for shareholders.

New capital can be acquired from existing shareholders by issue of

right shares and from new shareholders by a public issue.

Dividend is to be paid on owners funds. No Tax shield

Another important source of securing capital is creditors or lenders.

Funds obtained from these source is borrowed fund and interest is to

be paid. Interest provides tax shield to a firm

Scope of Finance Cont


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3. Finance and Management Functions:

There exists an inseparable relationship between finance

and production, marketing and other functions.

eg. recruitment and promotion of employees is clearly a

function of human resource department but it requires

payment of wages and salaries and other benefits which

involves finance.

Scope ofF

inance Cont


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F

inanceF

unctions The finance function includes:

1. Investment or Long Term Asset Mix Decision

2.F

inancing or Capital Mix Decision3. Dividend or Profit Allocation Decision

4. Liquidity or Short Term Asset Mix Decision


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F

inanceF

unctions - Cont...1. Investment or Long Term Asset Mix Decision:

A firm's investment decision involves capital expenditure.

It involves the decision of allocation of capital to long term assets that

would yield benefits (cash flows in the future)

Investment decisions should be evaluated in terms of both the expected

return and risk.

Capital budgeting also involves replacement decisions that is

recommitting funds when an asset becomes less productive or non-profitable.


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F

inanceF

unctions - Cont...2. Financing or Capital Mix Decision:

A finance manager must decide from where, when and how to

acquire funds to meet the firm's investment needs.

The mix of debt and equity is known as capital structure.

A manager must strive to obtain the best financing mix or

optimum capital structure of his firm. It is optimum when the

market value of share is maximized.

Once the financial manager is able to to determine the best

combination of debt and equity, he must raise the appropriate

amount through best possible resources.


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F

inanceF

unctions - Cont...3. Dividend or Profit Allocation Decision:

The proportion of dividends distributed as dividends is called the

dividend-payout ratio

The retained portion of profits is known as the retention ratio

The optimum dividend policy is one that maximizes the market

value of shares

Dividends are generally paid in cash, but a firm may issue bonus

shares to the existing shareholders without any charge.


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F

inanceF

unctions - Cont...4. Liquidity or Short Term Asset Mix Decision:

Investment in current assets affects a firm's liquidity and

profitability.

If the firm does not invest sufficient funds in current assets it may

become illiquid and therefore risky, but it would lose profitability,

as idle current assets would not earn anything.

The profitability-liquidity trade-off requires that the financial

manager should develop sound techniques of managing currentassets.


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Finance Managers Role

Financial manager is a person who is responsible, in a significant

way, to carry out the finance functions.

He/ She is now responsible for shaping the fortunes of the

enterprise, and is involved in the most vital decision of the allocationof capital.

He/ She must realize that his or her actions have far-reaching

consequences for the firm because they influence the size,

profitability, growth, risk and survival of the firm. Four broad functions are:

1. Raising of Funds 2. Allocation of Funds

3. Profit Planning 4. Understanding Capital Markets


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1. Funds Raising: The traditional approach dominated the scope

of financial management and limited the role of the financial

manager simply to funds raising.

- The traditional approach did not go unchallenged even duringthe period of its dominance.

- It lacked a conceptual framework for making financial

decisions, misplaced emphasis on raising of funds, and

neglected the real issues relating to the allocation and

management of funds.

Episodic Financing: Financing at the time of some major events

like mergers, consolidations, reorganizations,

recapitalizations, etc.

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Finance Managers Role Cont


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2. Funds Allocation: The new or modern approach to finance is

an analytical way of looking into the financial problems of the

firm. The financial manager is now concerned with the efficient

allocation of funds. He has to answer the following threequestions:

a) How large should an enterprise be, and how fast should it

grow?

b) In what form should it hold its assets?c) How should the required funds be raised?

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3. Profit Planning: The functions of the financial manager maybe

broadened to include profit-planning function.

It refers to the operating decisions in the areas of pricing, costs

& volume of output.

The cost structure of the firm i.e. the mix of fixed costs and

variable costs has a significant influence on a firms

profitability.

Because of Fixed costs, profits fluctuate at a higher degreethan the fluctuations in sales.

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Ex. Fixed Cost is Rs. 10, Variable Cost is Rs. 2 per unit, Selling Price

is Rs. 20 p.u. If the units sold in Jan are 5 units. There is an increase

in sales by 100% in Feb. Does the fixed cost cause more fluctuation

in the profit than the fluctuation in sales?What will happen if the sale decreased by 50%?

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Profit = Sales (Fixed Cost + Variable Cost)

January: Profit = Rs. 100 (Rs. 10 + Rs. 10)= Rs. 80

February: Profit = Rs. 200 (Rs. 10 + Rs. 20) = Rs. 170

Therefore with the increase in sales by 100%, profit has increased

by 112.5%


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4. Understanding Capital Markets: Capital markets bring

investors(lenders) and firms (borrowers) together.

He or she should fully understand the operations of the capital

markets and the way in which the capital markets valuesecurities.

For example: If a firm uses excessive debt to finance its

growth, investors may perceive it as risky. The value of the

firms share may therefore decline. Similarly investors may not like the decision of a highly

profitable, growing firm to distribute dividend. They may like

to reinvest the profits in attractive oppurtunities.

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Financial Goals

1. Profit maximization

2. Maximizing Earnings per Share

3. ShareholdersWealth Maximization


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Goal 1:Profit Maximization

Profit Maximization implies that a firm either produces

maximum output for a given amount of input, or uses minimum

input for producing a given output.

The underlying logic of profit maximization is efficiency.

Through Profit Maximization:

Resources are efficiently utilized

Appropriate measure of firm performance

Serves interest of society also as optimum use of resources is

done.


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Different stakeholders have different objectives that may conflict

with each other.

The manager of the firm has the difficult task of balancing and

reconciling these conflicting objectives

In the new business environment, profit maximization is regarded

as Unrealistic, Difficult & Inappropriate

It ignores Time value of money & risk involved

It is Vague: The definition of the term profit is ambiguous. Does itmean PAT or PBT? Does it mean long-term ?

Objections to Profit Maximization


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Goal 2: Maximizing EPS

Objections:

Maximizing EPS implies that the firm should make nodividend payment so long as funds can be invested atpositive rate of returnsuch a policy may not alwayswork

Ignores time value of money and risk of the expectedbenefit


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Goal 3: Shareholders Wealth

Maximization

A financial action that has a positive NPV creates wealth for

shareholders and is therefore desirable

Net Present value of a course of action means the difference

between the present value of cash inflows and the present valueof cash outflows.

Accounts for the timing and risk of the expected benefits.

Benefits are measured in terms of cash flows.

From the shareholders point of view, the wealth created by acompany is reflected in the market value of the companys shares.


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The Business generates cash

returns to investors

The Fundamental Principle of Finance

Investors provide the initial Cash

required to finance the businessInvestors

Shareholders

Lenders

Business

A business regardless of whether it is a new investment or acquisition of

another company or a restructuring initiativeraises 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.


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Risk-return Trade-off/ Relationship

Risk-Free Return

Risk Premium


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Agency Theory

In various businesses the responsibility of management is entrusted

to professional mangers who may have little or no equity stake in

the firm.

Thus, the ownership and management in such businesses lie inseparate hands.

The decision taking authority in a company lies in the hands of

managers.

Shareholders as the owners are the principals and managers theiragents.

Thus their exists a principal-agent relationship.

The conflict between interests of shareholders and managers is

referred to as agency problem.


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There are several reasons for the separation of ownership and

management in companies:

Due to large scale capital requirement, necessary capital is

pooled from thousand of investors (owners), making itimpractical for them to participate actively in management.

Professional managers may be more qualified to run the

business because of their technical expertise, experience and

personality traits. It ensures that the knowhow of the firm is not impaired,

despite changes in ownership.

Agency Theory Cont


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Agency Theory: Managers Versus

Shareholders Goals

A company has stakeholders such as employees, debt-holders,

consumers, suppliers, government and society.

Managers may perceive their role as reconciling conflicting

objectives of stakeholders.

Managers may pursue their own personal goals at the cost of

shareholders, or may play safe and create satisfactory wealth

for shareholders than the maximum.

Managers may avoid taking high investment and financing risksthat may otherwise be needed to maximize shareholders

wealth. Such satisfying behaviour of managers will frustrate

the objective of SWM as a normative guide.


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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.

One way to mitigate the agency problems is to give ownership

rights through stock options to managers.

A close monitoring by other stakeholders and outside analysts

also may help in reducing the agency problems.

Agency Theory Cont


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Finance and Related Disciplines

Financial management, as an integral part of the over-all

management, is not a totally independent area.

It draws heavily on related disciplines and fields of study,

namely, economics, accounting, marketing, production andquantitative methods.


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Finance and Economics

The relevance of economics to financial management can bedescribed in the light of the two broad areas of economics:macroeconomics and microeconomics.

Macroeconomics is concerned with the over-all institutionalenvironment in which the firm operates. It is concerned with theinstitutional structure of the banking system, money andcapital markets, financial intermediaries, monetary, credit andfiscal policies.

Finance, in essence, is applied micro-economics. For example,

the principle of marginal analysis a key principle of micro-economics according to which a decision should be guided bya comparison of incremental benefits & costs is applicableto a number of managerial decisions in finance.


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F

inance and Accounting1. Score Keeping vs. Value Maximizing: The primary objective of

accounting is to measure the performance of the firm, assess its

financial condition, and determine the base for tax. Principal goal

of financial management is to create shareholder value byinvesting in projects with positive NPV.

2. Accrual Method vs. Cash Flow Method: The focus of financial

manager is on cash flows. About their magnitude, risk, timing.

3. Certainty vs. Uncertainty: Accounting deals with past data.Finance is concerned mainly with the future.


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Introduction Financial System

The financial system comprises a variety of intermediaries,

markets, and instruments that are related.

It provides the principal means by which savings are

transformed into investments.

An understanding of the financial system is useful to all

informed citizens, it is particularly relevant to the financial

managers.

36Compiled by: Prof. Rajsee Joshi


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Functions of Financial System

Payment System: Banks and Financial Institutions are the pivot

of the payment system.

Pooling of funds: Financial intermediaries facilitate the pooling

of household savings for financing business.

Transfer of resources: Facilitates the transfer of economic

resources from the households to the most productive use in the

business sector.

Risk Management: It enables to manage risk through hedging,diversification and insurance.

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Compiled by: Prof. Rajsee Joshi


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Functions of Financial System Cont..

Price information for decentralized decision-making: They

provide information like interest rates and security prices which

help the households or their agents in making their

consumption-saving decisions and these also provide importantsignals to managers of firms in their selection of investment

projects and financing

Dealing with information asymmetry problem: It provides other

information to households and business so that there is leastinformation asymmetry.

38Compiled by: Prof. Rajsee Joshi


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Financial Markets

Classifications of Financial Markets:

Based on Type of financial Claim:

Debt Market

Equity Market

Based on Maturity of Claim:

Short-term: Money Market

Long-term: Capital Market

Based on Claim Representing New issues or OutstandingIssues:

Primary Market

Secondary Market


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Financial Market Returns

Interest Rates: An interest rate is a rate of return promisedby the borrower to the lender.

Rates of returns on Risky Assets: Many assets do not promisea given return. The return from such assets comes from twosources: Cash dividend and Capital Gain (or Loss).

The first component is called the dividend i

ncome

comp

onent(or dividend yield) and the second component is called the

capital change component(or capital yield)


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Financial Intermediaries in India


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Regulatory Infrastructure

The two major regulatory arms of GOI are the RBI and the SEBI.

Reserve Bank of India: It provides currency and operates the clearing system for the

banks.

It formulates and implements monetary and credit policies. It functions as the bankers bank. It supervises the operations of credit institutions. It regulates foreign exchange transactions. It moderates the fluctuations in the exchange value of the rupee.

It seeks to integrate the unorganized financial sector with theorganized financial sector. It encourages the extension of the commercial banking system in

the rural areas. It influences the allocation of credit. It promotes the development of new institutions


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Regulatory Infrastructure (Cont.)

Securities Exchange Board of India (SEBI): Regulate the business in stock exchanges and any other securities

markets. Register and regulate the capital market intermediaries.

Register and regulate the working of mutual funds. Promote and regulate self-regulatory organizations. Prohibit fraudulent and unfair trade practices in securities markets. Promote investors education and training of intermediaries of

securities markets.

Prohibit insider trading in securities. Regulate substantial acquisition of shares and takeovers of

companies. Perform such other functions as may be prescribed.

ch 1 - introduction to fm

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