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Introduction

In our day to day life money is an indispensable element. In the businessworld without money no activity can be imagined. In our personal life, familylife, social life, business life and national life we are always dealing with

money. To achieve what we want to do with these money we need to use themproperly. That means we have to manage the flow of money in the every sphere ofour life. This is the simplest definition of finance; that is the management ofcash flows.

All though finance is a distinct subject, as an academic subject it is not anindependent subject. Finance draws on heavily on related discipline likeEconomics, Statistics, Accounting, Marketing, etc.

Whatever is the type of the business organization, it must operate in themacroeconomic environment of the country. So without properly understanding themacroeconomic situation of the country a financial manager can not be able toperform his job successfully. The theories of macroeconomics analyze the

components that are essential for the effective operations of business firms. Afinancial manager should have sufficient knowledge of economics, not only of themacroeconomics but also of the microeconomics because it tells him how to takedecision when dealing with the individual component. Accounting and Finance arefunctionally very close. Accounting provides input to finance. Accounting suppliesthe financial statements that help financial manager in taking decision.Statistical tools are very often used in finance. Marketing also helps finance byproviding continuous information as input to financial management.

• Meaning of finance and management

Finance

In the Oxford Advanced learner’s Dictionary there are four meaning of theword ‘Finance’. Three are of these are noun and the rest is verb.

# (n): ‘Money used to run a business, an activity or a project’.# (n): ‘The activity of managing money especially by a government or

commercial organization’.# (n): ‘The money available to a person, an organization or a country; the

way this money is managed’.# (v): ‘To provide money for a project’.

In the Cambridge International Dictionary of English there are two meaning ofthe word ‘Finance’. One is noun and the other is verb.

# (n): ‘The management of a supply of money’# (v): ‘Finance something means providing the money needed for it to happen’

After closely analyzing these lexicographical meanings of finance we can saythat finance is the set of activities which are related to the management of moneyand monetary assets.



Management

In the Cambridge International Dictionary of English the meaning of the word‘management’ is given as:“Management is the control and organization of something”

Here the word ‘something’ may be an organization, a part of an organizationor the resources of that organization.

The Oxford Advanced Learners Dictionary of English tells the meaning of theword ‘Management’ as: “The act of running and controlling a business or similar organization”“The act or skill of dealing with people or situations in a successful way”

Here the situation may be of several of kind.

• Evolution of Financial Management

As a distinct discipline, the origin of financial management did not happenover the night. With the passage of time in the ever changing environment afterbeing affected and affected by different types of situations the financialmanagement got its modern shape.

Before 1890, it was a branch of economics. After 1890 the concept was changedand financial management became a separate discipline.From 1890 to 1900 management was mainly concerned with investment, businessintegration, corporate debenture etc. In 1897 the famous writer Tomas L Greenwrote a book named ‘Corporate Finance’ which was the first book of finance basedon old concept. In the USA several companies were integrated at that time.

The next decade was a time of governmental control over the business.

Preparation of financial statements was encouraged at that time. At the same timean attention was given to fulfill the investor’s interest. After the industrialrevolution a huge number of industries were established. Those large industriesfaced acute financing problem. As a result then financial institutions were bornto solve these finance problems.

The 1920-1930 was a decade of application of analytical technique. As a tool of



analysis computer was started to be used at that time. The use of computer made iteasy to take decisions easily. The next decade was a time of depression andrecovery. Between 11929 and 1932 share prices were decreased about 89% on anaverage. The share price of U S Steel Company decreased to $21 from $262 andGeneral Motor’s to $7 from $92.

In the next decade fund analysis, capital budgeting, internal financing etc.were started. After 1950 it was a time of growth of modern finance. In 1952

Markowitz invented the ‘Portfolio Theory’. Later on, in 1958 some other scholarsnamed Sharpe, Lintner, Famaxy developed the ‘Portfolio Theory’ and showed theappropriate application in finance. In 1970 Sharpe invented ‘Capital Asset PricingModel’ (CAPM).

In the same year Black and Scholes gave another new theory named ‘OptionModel’. At present computer is indispensable to take financial decisions. Severalcolleges and universities included “Financial Management” as a distinct subject.Many scholars are still researching to develop this subject more and more.

• Definition of Financial Management

From a lexicographical point of view we can say ‘Financial Management’refers to the organizing and using the assets of a firm which can be measured bymoney.

Several scholars on this field gave several similar definitions.The Indian scholar and professor of this subject, I M Panday, says

“Financial management is the managerial activity which is concerned with theplanning and controlling of the firms financial resources”.

Here the word managerial activity is important. That means finance functionsare decisional function or related with decision making. Another important word is‘financial asset’. Financial assets refer to financial papers or instruments suchas shares and bonds or debentures. Financial assets also include lease obligationsand borrowing from banks, financial institutions and other sources.

Guthman and Dougall, another school of scholars, say

“Business finance can be broadly defined as the activity concerned with planning,raising, controlling and administering of funds used in business.”

Brigham and Ehrhardt defined perhaps the most complete definition:

“The job opportunity of financial management ranges from making decisionsregarding plant expansions to choosing what type of securities to issue whenfinancing an expansion. Finance manager also have the responsibility for decidingthe credit terms under which customers may buy, how much inventory the firm shouldcarry, how much cash to keep on hand, whether to acquire other firms (merger



analysis) and how much of the firm’s earnings to plow back into the businessversus payout as dividend”.

• Scope of Financial Management:

For the purposes of exposition, the approach to the scope and functions offinancial management is divided into two categories:

(i)Traditional categories(ii)Modern approach

(i)Traditional approach:

The traditional approach to the scope of the financial function evolvedduring the 1920s and 1930s dominated the academic thinking during the forties andthrough the early fifties. The traditional approach to the scope of financialmanagement refers to its subject matter in the academic literature in the initialstages of its evolution as a separate branch of academic study. The concern

corporation finance was with the financing of corporate enterprises. In otherwords, the scope of a financial function was treated by the traditional approachin the narrow sense of procurement of funds by the corporate enterprises to meettheir financing needs. The coverage of corporation finance or financial managementwas concerned to describe the rapidly evolving complex of capital marketinstitutions, instruments and practices. A related aspect was that firms requirefunds at certain episodic events such as merger, liquidation, re-organization,promotion, consolidation etc.

This approach is criticized for several reasons:Firstly, it only includes the suppliers of funds such as investors, investmentbankers and so on, i.e. the outsiders; the traditional treatment was the“Outsider-looking-in-approach”. The limitation was the internal decision-making

(i.e. insider-looking-out) was completely ignored.The second group of criticism was that the treatment was built too closely

around episodic events. The day-to-day financial problems of a normal company didnot receive any attention.

Finally, the focus was on long term financing.

(ii)Modern approach:

According to it, the finance covers both acquisitions of funds as well astheir allocation. Thus apart from the issues involved in acquiring external fundsthe main concern of financial management is the efficient and wise allocation offunds to various uses.

Today financial management does not perform the passive role of score keepers

of financial data and information, and arranging funds. Rather they occupy keypositions in the top management areas and play a dynamic role in solving complexmanagement problems. They are now involved in the most vital management decisionof allocation of capital. It is their duty to ensure that the funds are raisedmost economically and used in the most efficient and effective manner. Because ofthis change in emphasis, the descriptive treatment of the subject of financialmanagement is being replaced by growing analytical content and sound theoreticalunderpinnings.



• Fields of Finance:

Where there is money there is finance. There are five generally recognizedfields of finance. The core concept is the same in each field that is themanagement of money and claims against money. Difference is the objectives and

problems.

Public Finance:

The management of the money and the monetary assets of the government are calledpublic finance. Public finance deals with the income and expenditure of thegovernment. Government collect huge amount of money from different internal andexternal sources with a view to utilize these money in accordance with thepolicies and procedures of the government. The objective of a private organizationis to maximize the shareholders wealth. But the objective of the government is tosocial welfare. As a distinct field of finance, public finance deals with thegovernmental financial matters.

Securities and Investment Analysis: This field is concerned with the investor. When an investor purchases stocks,bonds and other securities he must study the risk, probable performance of themarket etc. In this case, the investors do not have any direct control over thebusiness. The field of investment analysis deals with these matters and attemptsto develop techniques to help the investor reduce the risk and increase the likelyreturn from the purchases of selected securities.

International Finance:In modern age each country has its own currency system. Each country imposes

restrictions on dealing with other currency. The currency of one country isuseless in other country. Through international trade, foreign aid, loan etc.money is moving around the whole world and creates several types of difficulties.International finance is concerned about these financial problems.

Institutional Finance:

Institutional finance is concerned with the financial problems and theirsolution of several institutions serves an important role in capital formation.Institutional finance deals with issues of capital information and the

organizations that perform the financing function of the economy.

Financial Management:

It is also known as corporate finance. Financial management is concerned with



the management of financial assets and money of a business firm. Financialmanagement studies financial problems in the individual firms and tries to solveit

• Functions of finance

The definition of financial management indicates that finance functions are

arranging necessary funds, investing those funds, and distributing returns earnedfrom those investment to shareholders. To perform these functions managers need toperform another function that is they have to balance cash inflows and outflows.These functions are known as financing decision, investment decision, dividenddecision and liquidity decision respectively. These functions are not a sequentialprocess. They occur simultaneously and continuously in the business.

Investment decision or long term asset mix:

Investment decision relates to the selection of assets in which funds will beinvested. Investment decisions are capital expenditures in nature. They are alsocalled Capital Budgeting. This is probably the most crucial financial decision of

a firm. Capital budgeting relates to the selection of an asset or investmentproposal whose benefits are likely to be available in the future.

There are two aspects of capital budgeting. The first aspect relates to theevaluation of the prospective profitability of new investment. Weather an assetwill be accepted or not will depend upon the relative benefits and returnsassociated with it. The second aspect is the analysis of risk and uncertainty.Since the benefits from the investment are to be received in the future, theiraccrual is not certain. They are to be assumed. As a result risk always exists.The return of an investment should be evaluated in relation to its risk.

Financing decision or capital mix:

Financing decision or capital mix is the second major function performed by afinance manager. Financing decision includes deciding when, from where and how toarrange necessary funds to finance the investment requirements. Funds can bearranged by issuing shares or taking loans from lenders. These are called equityand debt respectively. The main theme of financing decision is the capitalstructure. In an organization the use of debts affects the returns and risk ofdebts of shareholders.

The use of debt implies a higher return to the shareholders as also the risk.The change in the shareholders’ return caused by the changed in the profits iscalled the financial leverage. It is the main concern to find a proper balance

between risk and return.

Dividend decision or profit allocation:



This is the third major decision of financial management. Managers arrange

funds and then invest those funds. As a result earn profit. Now it is alsoimportant to take decision about what to do with this profit. Two alternatives areavailable in dealing with the profits of a firm- (1) distribution among theshareholders and (2) retention in the business.

Which one should be done – distribution or retention? It is better to

distribute a portion of the profit among the shareholders. The portion of profitdistributed as dividend among the stockholders is called the dividend payoutratio. The dividend policy that maximizes the market value of the firms share iscalled the optimum dividend policy. Dividends are generally paid in cash. But afirm may issue bonus shares also.

Liquidity decision or short term mix asset:

Liquidity decision is concerned with the management of current asset of thefirm. A firm’s profitability is and liquidity is affected by investment in currentassets. The prerequisite of long term success of a firm is short term survival. Aconflict is exists between profitability and liquidity.

One aspect of working capital management is the trade off between profitabilityand risk. Say a firm does not invest sufficient fund in current assets. By doingso it may become illiquid and thus risky. On the other hand, if the current assetsare too large the profitability is adversely affected. Thus a proper trade offbetween liquidity and profitability must be achieved.

Many scholars argued that the working capital management or liquidity decisioncan be covered under the definition off investment decision. So according to themthe finance functions are mainly investment decision, financing decision anddividend decisions. Two most important concept of financial management are riskand return. Financial decisions incur different degrees of risk. Financialdecisions of a firm are guided by the risk return trade off. An overview of

financial management can be presented as:

Financial management

Maximization of share value

Financial decision

Investment Liquidity Financing

DividendDecision Management DecisionDecision

Return Trade off Risk



Figure 1: An overview of Financial Management

(Source: I M Pandey, Financial Management, Ninth Edition, Page No: 10)

The financial manager should strive to maximize returns in relation to the givenrisk in order to maximize shareholders wealth. He should take necessary actionsthat avoid unnecessary risk. All the financial decisions should be taken from astrategic point of view so that the best tradeoff between risks and return it’sachieved.

• Factors influencing financial decisions

Finance managers have to take investment decision, financing decision anddividend decision mainly. These decision, are influenced by some external andinternal factors.

Internal Factors:

Nature of business: The nature of the business influences the decisionssignificantly specially financing and dividend decisions are influenced by thenature of business. For example in productive organizations it needs to investmore in permanent assets than current assets. On the other hand in service giving



organizations investment in current assets is more necessary.

Size of Business:

Finance decisions largely depend on the size of the business. The bigger theorganization the more capital it requires. In general large companies invest aconsiderable portion of their capital in permanent assets because their finance

capability is very strong. But a proprietorship or a partnership lacks financingcapability hence they can’t invest more in permanent asset.

Expected return, cost and risk:In general, if investors behave rationally, they are risk averse. Finance

manager takes decisions that are best suited for avoid risk. Investor always looksfor higher return. If they take any risky investment decision they will expecthigher return. They always try to be cost effective. Among the alternatives those

are similar in risk; financial manager will choose one that is least costly.

Asset structure:Finance decision depends on the asset structure of the firm. Those firms who

have more capital assets can finance from long term sources. On the other hand ifcurrent assets are huge then firm focuses on short term financing.

Structure of ownership:Ownership structure may be proprietorship, partnership or company.

Proprietorship business can’t finance from long term sources since they are notgoing concern. The scope of finance in a proprietorship or partnership is veryshort. But companies can finance from suitable sources. Finance functions in a

company are complicated.

Age of the company:In general, it is easy for the old companies to finance their investment

requirement from suitable sources. Because lenders view the old companies lessrisky. Old companies are required to maintain strict dividend policy.

Restrictions in debt agreements:If there is any restriction in debt agreements about the finance function

them it should be considered when taking decision. For example, they may beconvents that specify how much risk the organization can take.

Except these some other factors such as probabilities of regular and steadyearning, liquidity position of the company and its working capital requirements.Management attitudes are influential when a manager performs finance decisions.

External Factors:

State of economy:If the economic condition of the country is uncertain and unstable then it

gives an incentive to the investor not to invest more. In this situation the



finance manager takes liberal dividend policy. On the other hand if state ofeconomy is developing gradually then it increases investment.

Structure of capital and money market:If the capital and money market is developed and well organized then finance

manager can easily finance from that money market. In such a circumstance managercan evaluate the alternatives.

Government control:Government control also influence the decisions of finance manage. Sometimes

government fixes the ratio of equity and debt. In the communism governmentstrictly control the money market.

Taxation policy:Strict taxation policy discourages the investment. On the other hand a

liberal taxation policy encourages the taxation policy. If incentives are given intax act then it encourages investment in the country.

Except these some other factors such as lending policy of financial institutions,requirement of investment etc are influence to finance decisions.

• Goal of Financial Management:

From a lexicographical point of view the word ‘goal’ means the ultimatedestination. In other words, goal is something which someone tries to achieve.

The goal or objective or financial management provides the framework forfinancial decision-making.

In the Oxford Advanced learner’s Dictionary the meaning of the word ‘Goal’ isgiven as:‘Something that you hope to achieve’

In the Cambridge International Dictionary of English the meaning of the word‘Goal’ is given as:

‘An aim or purpose’



In order to perform the finance functions rationally the firms must have agoal to accomplish. In other words, that is financial goal, which the financialmanagers try to achieve by performing the finance functions.

There are two widely discussed goals of financial management-(i)Profit Maximization(ii)Stockholders’ wealth maximization

Necessities of a unique goal or objective:The goal provides a framework for optimum financial decision-making. In

other words, they are concerned with designing a method of operating the internalinvestment and financing of a firm. An objective gives the rationale of the effortof a person of what the wants to achieve. It also provides the measure to choosebetween alternative. In the business world, if there is no objective or goal thenthere will be no systematic way to make decisions. Without a destination how coulda captain make the decision of which direction to go?

If there is more than one goal the problem created by them is different.

These will create indecision and dilemma when come to making decision. Say thereare two objectives and the result of accepting one project is positive to one andnegative to the other and vice-versa. In this situation the decision-making becomeextremely complex.

Characteristics of the ‘right’ objective:

Selecting the best objective perhaps this is the most important decision. Ifthe chosen objective is not the right one then there causes a haphazard situation.

One of the characteristics of a right objective is that it is clear andambiguous then it can not help the decision maker to take decision in a logicalway because it itself is illogical. For example the objective ‘maximization offirms profit in long term’ is an ambiguous objective. It is not clear which profit

is meant here? Is it net profit before tax or after tax, or EPS or gross profit?It is also not clear what is meant by long term. Is it three years or five yearsor more? The right objective should answer these questions.

A right objective should provide a measure that can be used to evaluate thesuccess or failure of decisions. If there is no available standard to measure theperformance of the manager then the shareholders will gradually lose control overmanagement.

A right objective does not create costs for other entities or groups. We willsay that objective the right objective, on the way of achieving that no cost iscreated by the firm to other entities or society.

Profit maximization as the goal:

One of the most discussed goals of financial management is “ProfitMaximization”. Profit maximization goal implies that a firm either producesmaximum amount of output for a given amount of input or uses minimum amount ofinput to produce a given amount of output. The underlying logic of profitmaximization is efficiently. It is assumed that profit maximization causes theefficient allocation of resources under the competitive market condition andprofit is considered as the most performance. According to this approach actionsthat increase profit should be under taken and those that decrease profit are tobe avoided. The profit maximization criterion implies that the investment,financing and dividend policy decisions of a firm should be oriented tomaximization of profit.



Criticism of Profit maximization:Profit maximization assumes perfect competition. But in reality perfect

competition is very rare. In the face of imperfect competition it does not servewell. This old concept was evolved when the objective of the business was only toaim enhance the owners’ personal wealth. But the aim has been changed now.In the new business environment, profit maximization is regarded as unrealistic,difficult, inappropriate and immoral. Sometimes profit maximization gives

incentives to produce goods and services that are wasteful and unnecessary fromthe society’s point of view. It leads to inequality of income and wealth in thesociety.

Limitations of Profit Maximization:The profit maximization objective is not an operationally feasible criterion.

It has three major limitations.It is a vague objective. The definition of the term ‘profit’ is not clear.

The actual meaning of the profit maximization objective is not clear. What ismeant by ‘profit’? Does it mean short or long term profit? Does it mean profitbefore tax or after tax? Is it total profit or earning per share?

Profit maximization criterion does not consider the time value of money. Itvalues benefits received from different periods of time as the same.

It ignores risk. Two firms may have some total expected earnings butdifferent degree of risk. It fails to explain this different.

Shareholders’ wealth maximization:This objective is also known as ‘value maximization’ or ‘Net Present worth

Maximization”. In the modern financial management academic literature universallyaccepted as the objective of financial management. It removes the drawbacks ofprofit maximization objective. Shareholders wealth maximization means maximizingthe net present of a course of action to shareholders. Net present value (NVP) ofa course of action is the difference between the present values of its cost.Investment, financing and dividend decisions should be directed to stockholderswealth maximization.

The stockholders hire the managers to run the business for them. It is the

manager, not the owner who takes the decision where to invest, how to finance themand how much return to the owner. Since managers act as agent of the shareholders,managers should therefore focus on maximizing the wealth of those who hired themin the first place. Now the question arises how we measure stockholder wealth? Ina publically traded company the stock price is an observable and real measure ofstockholders wealth. So the objective of financial management should be stockprice maximization.

Advantages of stock price maximization as the objective:

Stock price maximization has three advantages because of why it is accepteduniversally.(i)Stock prices are the most observable of all measures that can be used to judgethe performance of a publicly traded company.(ii)Stock prices, in a market with traditional investors, reflect the long termeffect of the firm’s decision.(iii)The stock price is a real measure of stockholders wealth, since thestockholders can sell their stock and receive the price now. ( Source of contents: Damodaran, Corporate Finance: Theory and Practice. 2ndEdition, Chapter 2.)



Monitoring can be done by bonding the agent, systematically reviewing managementperquisites, auditing financial statements and explicitly limiting managementdecisions.

Some very useful mechanisms used to motivate managers to act in shareholdersbest interest are managerial compensation plan, direct intervention byshareholders, the threat of fiving and the threat of takeover.

Agency conflict: Stockholders Vs Creditors

There is another conflict of interest that is between stockholders (throughmanagers) and creditors. Creditors usually lend money at a rate they negotiate atthe time of the loan which is based on their assessment of the risk of the firmthey are lending to. Creditors have a claim on part of the firm’s earnings streamfor payment of interest and principal on the debt and they have a claim on thefirm’s assets in the event of bankruptcy.

We know stockholders have the control (through managers) of decisions thataffect the risk of the firm. In short the main theme of the conflict is that whatis good for stockholders may not necessarily be good for lenders to the firm. For

instance, say a lender lends money to a business at a fixed rate. The lendershould expect payment of interest and principal from the firm and its risk shouldbe the same. Now say the stockholders, acting through the management, sell somerelatively safe assets and invest the proceeds in a large new project that is farriskier than the firm’s old assets. This increased risk will cause the requiredrate of return on the firm’s debt to increase. If the risky project is successfulall the benefits go to the stockholders because creditors rate of return is fixedat the old, low risk rate. If the project is unsuccessful the creditors may haveto share in the loss. This is the conflict that is which is good, for stockholdersmay be detrimental to the creditors.

But in general the stockholders cannot expropriate wealth from creditorsbecause every kind of unethical behavior is not acceptable in the business world.

Lenders attempt to protect themselves from stockholders by placing restrictivecovenant in the debt agreements. Moreover if lenders realize that the managers aretrying to exploit them they refuse to deal further with it or may charge a higherthan normal interest rate. In essence, to best serve their stockholders in thelong run manager must play fairly with creditors. Managers should take decision inthat which balances between the interest of stockholders and creditors.

Stock price maximization with Lower agency cost.

As a goal stock price maximization is universally accepted but it is notflawless. It is flawed primarily by the conflict between stockholders andmanagers, stockholders and lenders. However stock price maximization will be the

best objective if we can figure out a way to reduce agency costs. If a managertakes advantage of shareholders he will find himself faced with stockholderrevolts and hostile takeover. If lenders are exploited they will protectthemselves in subsequent lending. Here are the ways to reduce agency costs:

Stock holders and Managers

Giving managers the ownership opportunity:The conflict of interests between the stockholders and the managers exist

since their interests are not the same one of the ways to reduce this conflict isgive the managers with an equity stake in the firms. If the managers are provided



with equity stake in the firm the benefit received from the stock prices mayprovide an inducement to maxim be share prices.

More effective Board of Directors:The board of directors is the body that oversees the management of a

publicly traded firm. As elected representatives of the shareholders the directorsare obligated to ensure that managers are looking out for stockholders interest.This board of directors should be effective. Survey on board of director’s reveals

that smaller boards are more effective than larger boards. Stock compensation forthe directors makes it more likely that directors will think like stockholders.

Increasing stockholders power:There are several ways of increasing stockholders power. Stockholders should

demand and keep more and more updated information so that they can make betterjudgments on how the management is doing. Some stockholder can be a part of themanagement and can manage the firm. Stockholders should be more active so thatthey can be remained informed about the overall management policy.

The threat of takeovers:Hostile takeovers (when management does not want the firm to be taken over)

are most likely to occur when a firm’s stock is undervalued relative to its

potential because of poor management. In a hostile takeover the managers of theacquired are generally fired. Takeovers operate as a disciplinary mechanism. Oftenthe very threat of takeover is sufficient to make firms restructure their assetsand become more responsive to stockholders concern.Shareholders and managers

Shareholders and Bondholders

Bond covenant:The most common way adopted by the lenders to protect them is to write

covenants in their bond agreement specifically prohibiting or restricting actions

that may be detrimental to the lenders. Some covenants strictly restrict thefirm’s actions when the manager wants to make a risky investment which isdetrimental to the lenders. Many bond agreements restrict how much firm can pay asdividend. Some covenants also require firms to get the consent of existingbondholders before borrowing more.

Security Innovation:Some bond agreement gave the lenders the right to sell their bonds back to

the firm at face value in the event of a special situation.



Equity stakes:The dissimilar nature of the interest of stockholders and bondholders are

the main reason of the conflict. To avoid this problem bondholder can buy stock atthe same time as bonds or can be allowed to convert their bonds into stock.

• Some basic concepts of Financial Management:

Risk and ReturnRisk and return are the two fundamental concepts of financial management. In

a very simple way risk can be defined as the probability to happen or not tohappen something in the future. Where there is future there is uncertainty.Uncertainty is risk. Risk analysis should be one in the capital budgetingexercise. Capital budgeting decision is based on the benefits derived from the

project. These benefits are measured in terms of cash flows, cash flows areestimates. The estimation of future returns is done on the basis of variousassumptions. The actual return in terms of cash inflows depends on several offactors such as price, sales, competition, and cost of raw materials and so on. Itis very possible that the actual return will not precisely correspond to theestimate. In other words the actual return will vary from the estimate. This istechnically referred to as risk. Risk results from the variation between theestimated and actual return. The greater the variability the riskier is theproject.

n finance all investment is done with a view to earn some extra money. Thisextra money or asset which is received from an investment is called the return. Inshort, it can be expressed asDollar Return = Amount received – Amount invested

The rate of return is the return per dollar. In other words,

Amount received – Amount investedRate of return =Amount invested

The relationship between risk and return is very important and interesting.We know the more the risk the more the return. But if there is no risk the rate ofreturn will be positive because of time preference for money. This is called riskfree rate. In reality each investment is associated with some risk. Hence a rateof return is required for the risk over the risk free rate. This is called riskpremium.

Thus,

Required rate of return = Risk free rate + Risk premium

This relationship can be shown graphically.



Rate Risk premiumofreturn

Risk free rate

Risk

Figure 2: Risk – return relationship

This figure shows that the more the risk the more the return. Risk free rate isfixed. Risk premium is increasing with the increase of risk.

(Source: I M Pandey, Financial Management, Ninth Edition, Page No: 10)

Time value of money

Time value of money is the principal of finance that analyzes therelationship between $1 today and $1 in the future. Since the objective is wealthmaximization for the today’s firm, maximum of the financial decisions taken by thefirm are future oriented. These decisions incur cash inflows for the firm. Forinstance a firm may finance its any investment requirement by issuing share ortaking loan. There is a cash inflow when the firm takes the loan or issues theshare as well as the obligation of paying interest or dividend and return theprincipal in the future. These cash inflows or outflows of today certainly havenot the same value as the cash inflows or outflows in the future. They must becompared to a common point of time. Many of the finance decisions are based on thelogical comparison of the outlays and benefits.

If we think logically and rationally we should value the opportunity toreceive a certain amount of money now more than the opportunity to receive thesame amount of money at a future date. In other words a dollar today is worth morethan a dollar in the future. That means the value of money always diminishes.Individuals prefer, if they behave rationally, one dollar today to one dollar inthe future. This is called the time value of money concept. The time value ofmoney can also be referred to as time preference for money (M Y KHAN and P K JAIN;FINANCIAL MANAGEMENT: Text and Problems; 2nd edition, Page: 230). Time value ofmoney is al so called discounted cash flow (DCF) analysis (Eugene F. Brigham andMichale C. Ehrhardt; FINANCIAL MANAGEMENT: Theory and practice, 10th edition;Page: 286).



Portfolio Theory:

In general investment risky and investors are risk averse. Portfolio theoryis a theory that describes how an investor can minimize risk. Portfolio says thatif an investor invests his all money in sector then the risk is very high. On theother hand, if he invests his money in more than one sector, it will decrease hisrisk. Portfolio is a group of investment sectors that minimizes the risk of theinvestors.

In the words of IM Pandey,

“A portfolio is a bundle or a combination of individual assets or securities. Theportfolio theory provides a normative approach to investors to make decisions toinvest their wealth in assets or securities under risk.”

That is portfolio theory tells us the best arrangement of investment optionsunder risk. This theory is based on the assumption that investors are risk averse.

When an investor holds a well diversified portfolio then he will be concernedabout the expected rate or risk and return of that portfolio not about theexpected rate of risk and return of the individual asset.

The portfolio return is equal to the weighted average of the returns ofindividual assets (or securities) in the portfolio with weight being equal to theproportion of investment value in each asset (IM Pandey).

The portfolio risk is measured by its variance and standard deviation

Cost of Capital:A firm can collect its required capital to finance an investment project by

issuing equity share, preferred share or creating debt mainly. When individualsprovide a company these required fund they expect the company should earnsufficient return on those funds. From the company’s point of view the investor’sexpected return is a cost. This cost is known as cost of capital. This is one ofthe most complexes in finance theory. For capital collected from different sourcesthe cost of capital will be different. For example, the cost of equity capital isthe minimum expected required return of the investors. Under this rate theinvestors do not will to invest. That is the required return that a firm must

earn.Cost of capital depends on the interest rates, tax policy, regulatory

environment, the risk of the projects and the type of fund. A firm must considerthe cost of capital when taking decision either a project will be accepted onlywhen the expected rate of return of the project is greater than the cost ofcapital.



Limitation of financial management

Many scholars think that the corporate finance is not flawless. Corporate

finance posses some limitations. It is criticized in recent years for itslimitations. Some believes that the objective of shareholders wealth maximizationis liable for increasing wealth inequality in the society. The financialmanagement assumes that the financial markets are efficient. But in the real worldan efficient financial market is very rare. When the goal of the financialmanagement is stock holders wealth maximization then the inefficient financialmarket acts as a limitation of corporate finance.

Some believes that financial management is unethical since many of thedecisions may increase the wealth of shareholders but may be harmful for the otherstakeholder. Any kind of activities that harms the other is not acceptable in thebusiness world.

Financial management assumes that manager will not make any decision that isharmful to other but in reality it is not true. Since there is a conflict betweenthe Interest of the shareholders and that of the other stakeholders the goal offinancial management should be increasing the wealth of the stakeholders not onlythe stockholders.

Conclusion

Financial management, a ever developing field of study, provides the mostlogical and accurate means of managing the financial resources of an organization.Financial manager performs with a view to maximize the wealth of that firm. Allthe decisions taken by the financial manager i.e. investment decisions, financing



decisions, dividend decisions and liquidity decisions are directed to maximize thefirms wealth. Managers perform these functions as agent of the shareholders.There are agency conflicts between the shareholders and managers and shareholdersand creditors since each of the three parties has separate goal. Since theobjective of the financial management is wealth maximization many of the decisionsare future oriented. Where there is future there is risk. Normally investors arerisk avers. As a result, the riskier the project the higher is the return.Financial decisions of the firm are guided by risk return trade off.

Bibliography

Text books

1. Damodaran, A. Corporate Finance: theory and Practice. 2nd Edition. NewYork. N Y John Willy & Sons Inc. 2001.

2. Eugene F. Brigham and Michael C. Ehrhardt. FINANCIAL MANAGEMENT: Theory andPractice.10th edition. Singapore. South-western.2001.

3. James C.Van Horne. FINANCIAL MANAGEMENT AND POLICY. 12th edition. New delhi.Pearson Education. 2002.

4. JHON J HAMPTON. Financial Decision Making: Concepts, Problems and Case. 4thEdition. New Delhi. Prentice Hall of India Pvt. Ltd. 1989.

5. Pandey, I M. FINANCIAL MANAGEMENT. 9th Edition. New Delhi. Vikas Publishing

House Pvt. Ltd. 2005.

6. KHAN, M Y and JAIN, P K. FINANCIAL MANAGEMENT: Text and Problems. 2ndedition. New Delhi. Tata McGraw-Hill Publishing Company Limited.1997.

Web Address

1. http://en.wikipedia.org/wiki/finance

Others

1. Cambridge International Dictionary of English. Cambridge University Press.1995.

2. Hornby, A S. Oxford Advanced Learner’s Dictionary. 6th Edition. OxfordUniversity Press. 2001.

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