BA3204 – Financial Management

Unit I – Introduction to
Financial Management
 Unit I Contents
◉ Introduction - Financial Management – Definition, Scope and
Objectives, Objectives of Financial Management –
◉ Major financial decisions – Profit maximization and Wealth
maximization
◉ Functions and Roles of Finance Manager
◉ Long term Sources of Finance – Shares, Debentures, Preferred
stock, Debt, Retained earnings, Lease, Hire Purchase, Venture
Capital financing, Private Equity.
◉ Time Value of Money
◉ Concept of Risk and Return – single asset and of a portfolio.
 Finance As a Management Function

◉ FINANCE: defined as a scientific discipline that studies how to allocate scarce

resources over time under conditions of uncertainty.
◉ Emerged from macroeconomics and deals with:
○ Resource allocation
○ Time factor
○ Uncertainty
◉ Examples:
○ Corporations initiating a new project that requires substantial investments;
○ Individuals investing their savings for future usages such as buying a car;
○ Students making career choices based on investment and future outcomes.
◉ All these examples involve:
○ Initial investment (Resource allocation)
 Finance As a Management Function

◉ Finance and financial thinking are everywhere in our daily lives. For example,
savings vs. spending, buying a car vs. renting one, MBA vs. MTech.
◉ Some financial decisions are simple, however, most are more complex:
○ Should a firm launch a new product? Selected areas vs. country-wide?
○ Should a firm borrow money or issue shares to raise money?
○ Which supplier should a firm choose?
○ Should a firm produce in-house or outsource production?
○ How do you raise money for your start-up firm?
◉ All of these decisions in your personal life and professional experience inside a
business are essentially tied together by one principle of corporate finance:
Valuation!
◉ Valuation Principle: shows how to make costs and benefits comparable for
decision-making.
 Introduction to Financial Management
◉ Finance is the life blood of a business.
◉ Definition:
◉ “Financial management is the process of procuring and
judicious use of financial resources with a view to
maximizing the value of the firm thereby the value of the
owners.”
◉ “Financial management is the strategic planning,
organizing, directing, and controlling of an organization's
financial activities.”
 Corporate Finance Theory
◉ A set of concepts that help to organize one’s thinking about
how to allocate resources over time;
◉ A set of quantitative tools that help us to evaluate
alternatives, make decisions, and implement them.
◉ Major aspects of finance:
○ Optimization over time: maximize profits and minimize risk/costs; •
○ Valuation of assets: of all types, e.g., financial assets, real assets,
etc.;
○ Management of risk: arising out of uncertainty and other factors.
 Important Financial decisions
Investme
nt
Decisions

MAJOR
Financing Dividend
Decisions
FINANCIAL Decisions
DECISIONS

Working
Capital
Decisions
1. Investment decisions (deployment of funds)
 1. Investment decisions (deployment of funds)
◉ Investment decisions relate to the careful selection and allocation of funds
of viable and profitable investment proposals.
◉ Ascertainment of total volume of funds a firm can commit.
◉ Appraisal and selection of capital investment proposals
◉ Measurement of risk and uncertainty
◉ Prioritization of investment decisions
◉ Funds allocation and its rationing
◉ Determination of fixed assets to be acquired
◉ Determination of levels of investment in current assets
◉ Buy or lease decisions
2. Financing Decisions (Mobilization of funds)
 2. Financing Decisions (Mobilization of funds)
Financing decisions are concerned about procurement of funds and working capital requirements.
Determination of financial pattern of long term and short term funds requirement.
◉ Raising of funds through issue of financial instruments
◉ Arrangement of funds from banks and financial institutions
◉ Arrangements of funds for working capital requirements
◉ Consideration of interest burden
◉ Consideration of cost of capital
◉ Consideration of various modes of improving EPS and market price
◉ Optimization of financing mix
◉ Study the impact of stock market and economic conditions
◉ Consideration of impact of over and under capitalization
◉ Consideration of foreign exchange risk
3. Dividend decisions
 3. Dividend decisions

◉ Dividend decisions are mainly concerned with decisions

relating to the distribution of earnings of the firm among its
shareholders and the amount retained.
◉ Determination of dividend and retention policies of the firm
◉ Consideration of impact of dividend and retention on market
value of the share
◉ Consideration of possible required funds for expansion and
diversification
◉ Reconsideration of policies in boom and recession periods
4. Liquidity decisions - Also called as Working Capital decision
Finance Function

◉ Finance function covers financial planning, forecasting of

cash receipts and disbursements, realizing of funds, use
and allocation of funds and financial control.
Who takes care of finance function in a business?

◉ Financial controller or treasurer – finance officer

◉ Managing Director or Agent of company
◉ Committee of Board of Directors
Scope of Finance Function

◉ What specific assets should a firm acquire?

◉ What total volume of funds should a firm commit?
◉ How should the funds required be raised?
◉ How large and how fast a company should grow?
◉ What should be the composition of its liabilities?
◉ In what specific forms should it hold its assets?
Key Activities of Financial Management

Management Financial Analysis, Management

of the firm’s Planning and control of the firm’s
asset Balance Sheet asset
structure Long term Fixed assets structure

financing
Short term Current
financing assets
 Corporate Finance Axioms
◉ 1. The risk-return trade-off: We will not take on additional risk
unless we expect to be compensated with additional returns.
◉ 2. The time value of money: A rupee received today is worth
more than a rupee received in the future.
◉ 3. Cash is King: It’s the ultimate (quantifiable) measure to aid
decision-making.
◉ 4. Incremental cash-flows: It is only what changes (due to a
decision) that counts.
◉ 5. The curse of competitive markets: Let us learn why it is hard to
find exceptionally profitable opportunities.
 Corporate Finance Axioms
◉ 6. Efficient capital markets: The markets are quick and the prices are
right. Are they?
◉ 7. The agency problem: Managers won’t work for the owners unless it’s
in their best interest.
◉ 8. Taxes: bias our decision-making skills (and business decisions).
◉ 9. Ethical behavior: essentially doing the right thing, and ethical
dilemmas are everywhere, even in finance.
Relationship between key financial decisions, return,
risk and market value
Capital budgeting decisions
Or Return
Investment decisions

Capital structure decisions Market value of firm

Or
Financing decisions

Dividend decisions

Risk

Working Capital decisions

Or
Liquidity decisions
 Modern Finance Manager – roles and responsibilities
◉ Debt Restructuring activity – due to changing financial scenario of ‘softer
interest rates’ (raising low cost loans to swap high cost funds and improve
profitability by reducing costs).
Example – Arvind Mills – after debt restructuring exercise – reduced interest
cost from Rs. 80 crores to Rs. 40 crores and enhanced profits by Rs. 160
crores per annum.
◉ Concerned not just with quantum of funds but the cost of funds – not in just
domestic markets but at the international level through ECBs – Euro
Commercial Borrowings, or GDRs – Global Depository Receipts or ADRs –
American Depository Receipts.
◉ Save his company from any hostile takeover bid
◉ Concerned with buying back shares from market rather than issuing them
◉ Preparing the game plan to arrange huge funding for takeover bids
– Brownfield expansions or growth of the company (acquiring
companies not only in India but also across the frontiers).
◉ “Value creation” for its shareholders – must know the nitty gritty of
EVA (Economic Value Added), SVC (Shareholders Value Creation)
◉ Structuring appropriate ESOP to motivate employees – attractive
for employees and not be expensive for company. Ex: Infosys
◉ Must also see to fresh issue of rights shares (Ex: Reliance Industries)
or preferential allotment to existing promoters, LBO (Leveraged
Buyouts – raising loans for acquisition).
 Financial Objectives of a firm
◉ Basic financial objective – to increase or maximize owners’
wealth
◉ Return on capital employed (or) ROI
◉ Value addition and profitability
◉ Growth in EPS and Price Earnings ratio
◉ Growth in Market value of shares
◉ Growth in dividend
◉ Optimum level of leverage
◉ Survival and growth of firm
◉ Minimization of finance charges - interest
◉ Efficient utilization of short, medium and long term finance
 Goals of Financial Management: Profit versus Wealth

◉ Profit Maximization – means maximizing the rupee (or

any other currency) income of the firm.
◉ Adam Smith’s logic is that when individual firms pursue
the interest of maximizing profits, society’s resources are
efficiently utilized.
◉ Therefore, the underlying logic of profit maximization is
efficiency.
 Objections to Profit Maximization
◉ Criticized in recent years. Apart from shareholders, the other
interested parties are customers, employees, government and
society.
◉ In modern business environment, profit maximization is
regarded as unrealistic, difficult, inappropriate and immoral.
◉ It fails to serve as an operational criterion for maximizing
owner’s economic welfare.
◉ It suffers from following limitations:
○ It is vague – definition of profit is ambiguous – short term or long term,
before tax or after tax.
○ It ignores time value of money
○ It ignores risk – earnings may fluctuate
 Shareholders’ Wealth Maximization (SWM)
◉ SWM means maximizing the net present value or wealth of a course of
action to shareholders.
◉ The NPV of a course of action is the difference between the present
value of its benefits and the present value of its costs. Ex: Merck
Pharmaceutical Co., USA
◉ Positive NPV – creates wealth and therefore desirable
◉ Negative NPV – would destroy wealth and so rejected.
◉ SWM takes care of timing and risk of expected benefits. The benefits
are measured in terms of cash flows and not accounting profits.
◉ SWM is in harmony with interests of various groups – owners,
employees, creditors, customers and society.