Course outlineCourse outlineOverviewFundamental Valuation ConceptsCost of CapitalCapital BudgetingWorking Capital ManagementLeverageCapital Structure Dividend Policy

FINANCIAL MANAGEMENT : AN OVERVIEW

OUTLINE

• Introduction

• Evolution of Financial Management

• Financial Decisions in a Firm

• Goal of Financial Management

• The fundamental Principle of Finance

• Risk-return Tradeoff

• Forms of Business Organizations

• Agency problem

• Emerging Role of the Financial Manager in India

Introduction Introduction Finance: art and science of managing

money.Major areas:

– Financial services: concerned with the design and delivery of advice and financial products to individuals, businesses and governments within the areas of banking and related institutions, personal financial planning, investments, real estate, insurance and so on.

Introduction(cont.)Introduction(cont.)

– Financial management: Financial Management or business finance is concerned with managing an entity’s money.

For example, a company must decide:− where to invest its money.− whether or not to replace an old asset.− when to issue new stocks and bonds.− whether or not to pay dividends.

EVOLUTION OF FINANCIAL MANAGEMENT

• Financial management emerged as a distinct field of study at

the turn of the 20th century. Its evolution may be divided into

three broad phases - the traditional phase, the transitional

phase, and the modern phase.

• The modern phase began in mid-1950s and has been marked

by infusion of ideas from economic theory and application of

quantitative methods

• The distinctive features of the modern phase are:

Central concern : Shareholder wealth maximization Approach : Analytical and quantitative

FINANCIAL DECISIONS IN A FIRM

• Capital Budgeting: Capital budgeting refers to the process of deciding how to allocate the firm’s scarce capital resources (land, labor, and capital) to its various investment alternatives.

• Capital Structure: A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.

• Working Capital Management: Working Capital refers to Working Capital refers to that part of the firm’s capital, which is required for financing that part of the firm’s capital, which is required for financing short-term or current assets such a cash marketable securities, short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. this cash flow out again in exchange for other current assets.

Goal Of Financial Goal Of Financial ManagementManagement

What should be the goal of a corporation?– Maximize profit?– Minimize costs?– Maximize market share?– Maximize the current value of the company’s

stock?

Does this mean we should do anything and everything to maximize owner wealth?

GOAL OF FINANCIAL MANAGEMENT

FINANCE THEORY RESTS ON THE PREMISE THAT MANAGERS SHOULD MANAGE THEIR FIRM’s RESOURCES WITH THE OBJECTIVE OF ENHANCING THE FIRM’s MARKET VALUE.

The theory in corporate finance is based on assumption

that the goal of the firm should be to maximize the wealth of its current shareholders.

Wealth maximisationWealth maximisationAlso known as Value Maximisation or Net

Worth Maximisation.The wealth maximization criterion is based

on the concept of cash flows generated by the decision rather than accounting profit which is the basis of the measurement of benefits in the case of the profit maximisation criterion.

The wealth maximization criterion is that it considers both the quantity and quality dimensions of benefits.

CRITIQUE AND DEFENCE OF SHAREHOLDER WEALTH MAXIMISATION GOAL

Critique

• The capital market sceptics argue that stock prices fail to reflect true values

Defence

• Financial economists argue that stock prices are the least biased estimates of intrinsic values in developed markets

• The balancers argue that a firm should seek to ‘balance’ the interests of various stakeholders

• Balancing the interests of various stakeholders is not a practical governing objective

• Advocates of social responsibility argue that a business firm must assume wider social responsibilities

• The only social responsibility of business is to create value and do so legally and with integrity

SHAREHOLDER ORIENTATION IN INDIA

In the wake of liberalisation, globalisation, and institutionalisation of the capital market, there is a greater incentive to focus on creating value for shareholders. The following observations are clear indications.

Dhirubai Ambani : In everything that we do, we have only one supreme goal, that is to maximise your wealth as India's largest investor family.

Anand Mahindra : All of us are beginning to look at companies as owned by shareholders. The key is to raise shareholder returns

ALTERNATIVE GOALS

Maximisation of Profit

Profit maximisation criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximisation of profits/EPS. Profit maximisation would imply that a firm should be guided in financial decision making by one test; select assets, projects and decisions which are profitable and reject thase which are not. This goal is not as inclusive a goal as maximisation of shareholders’ wealth.

Its limitations are:

• Profit in absolute terms is not a proper guide to decision making. It should be expressed either on a per share basis or in relation to investment.

• It leaves considerations of timing and duration undefined.

• It glosses over the factor of risk

Maximisation of EPS or ROE

While these goals do not suffer from the first limitation mentioned above, they suffer from the other two limitations.

THE FUNDAMENTAL PRINCIPLE OF FINANCE

A business proposal-regardless of whether it is a new investment or acquisition of another company or a restructuring initiative –raises 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.

CASH ALONE MATTERS

Investors Investors provide the initial cash required The business proposal

• Shareholders to finance the business proposal

• Lenders  

The proposal generates

cash returns to investors

 

Risk-Return TradeoffRisk-Return Tradeoff The principle that potential return rises with an

increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns.  

Risk: risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of our original investment.

Return: The return earned on investments represents the marginal benefit of investing.

Risk-Return Tradeoff(cont.)Risk-Return Tradeoff(cont.)

The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.

DECISIONS, RETURN, RISK, AND MARKET VALUE

Capital Budgeting Decisions

Capital Structure Decisions

Dividend Decisions

Working Capital Decisions

Return

Risk

Market Value of the Firm

FORMS OF BUSINESS ORGANISATIONS

Sole Proprietorship• One owner• Very simple• Unlimited liability• The firm has no separate status from a legal and tax point of view

Partnership• Two or more owners• Fairly simple• Unlimited liability• The firm has a separate status

Private Limited Company• Upto 50 owners• Not too complex• Limited liability• A distinct legal person

FORMS OF ORGANISATION

Public Limited Company

• Many owners

• Somewhat complex

• Limited liability

• Distinct legal person

• Free transferability of shares

Public Limited Company’s Attraction

• The potential for growth is immense because of access to substantial funds• Investors enjoy liquidity because of free transferability of securities • The scope for employing talented managers is greater

Agency ProblemAgency Problem Principal vs Agent

– Principal: Firm owners– Agent: Management

Agency Problem: The possibility of conflict of interest between stockholders and management of a firm Agency Cost(are costs borne by shareholders to prevent/ minimise agency problems as to contribute to maximise owners wealth.)

Examples: managerial perks, attitude towards risk, empire building, etc.

Stock value may not be maximized!

AGENCY PROBLEM

• While there are compelling reasons for separation of

ownership and management, a separated structure leads

to a possible conflict of interest between managers and

shareholders.

• The lack of perfect arrangement between the interests of

managers and shareholders results in the agency problem.

• To diminish the agency problem, effective monitoring has

to be done and appropriate incentives have to be offered.

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Solutions to Agency ProblemSolutions to Agency Problem Managerial Compensations to align

incentives

Control of the Firm– Stockholders elect Board of Directors who

have rights to HIRE and FIRE managers – well-established management– Hostile takeover(is the acquisition of the firm by

another firm that is not supported by management) due to low prices, market for corporate control

Organisation of the finance function

ALL MANAGERS ARE FINANCIAL MANAGERS

• The engineer, who proposes a new plant, shapes the investment policy of the firm

• The marketing analyst provides inputs in the process of forecasting and planning

• The purchase manager influences the level of investment in inventories

• The sales manager has a say in the determination of the receivables policy

• Departmental managers, in general, are important links in the finance control system of the firm

Functions of the Treasurer and Functions of the Treasurer and the Controller the Controller

Treasurer Obtaining finance Banking relationship Cash management Credit administration Capital budgeting

Controller Financial accounting Internal auditing Taxation Management accounting

and control

ORGANISATION OF FINANCE FUNCTION

Chief Finance Officer

Treasurer

Controller

Cash Manager

Credit Manager

Capital Budgeting Manager

Fund Raising

Manager

Financial Accounting Manager

Cost Accounting Manager

Tax Manager

Data Processing Manager

Internal Auditor

Portfolio Manager

EMERGING ROLE OF THE

FINANCIAL MANAGER IN INDIA

The job of the financial manager in India has become more important, complex and demanding due to the following factors:

• Liberalisation

• Globalisation

• Technological developments

• Volatile financial prices

• Economic uncertainty

• Tax law changes

• Ethical concerns over financial dealings

• Shareholder activism

EMERGING ROLE OF THE

FINANCIAL MANAGER IN INDIA

The key challenges for the financial manager appear to be in the following areas:

• Investment planning and resource allocation

• Financial structure

• Mergers, acquisitions, and restructuring

• Working capital management

• Performance management

• Risk management

• Corporate governance

• Investor relations

SUMMING UP

• There are three broad areas of financial decision making, viz., capital budgeting, capital structure, and working capital management.

• Finance theory, in general, rests on the premise that the goal of financial management should be to maximise the wealth of shareholders.

• A business proposal raises 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.

• A confluence of forces appears now to be prodding Indian companies to accord greater importance to the goal of shareholder wealth maximisation.

• In general, when you take a financial decision, you have to answer the following questions : What is the expected return ? What is the risk exposure ? Given the risk-return characteristics of the decision, how would it influence value ?

• The important forms of business organisation are : sole proprietorship, partnership, private limited company, and public limited company. While each form of organisation has certain advantages and limitations, the public limited company form of organisation generally appears to be the most appropriate form from the point of view of shareholder wealth maximisation.

• While there are compelling reasons for separation of ownership and management, a separated structure leads to a possible conflict of interest between managers and shareholders.

• The lack of perfect alignment between the interests of managers and shareholders results in the agency problem. To mitigate the agency problem, effective monitoring has to be done and appropriate incentives have to be offered.

• Financial management is in many ways an integral part of the jobs of managers who are involved in planning, allocation of resources, and control.

• Thanks to the changes in the complexion of the economic and financial environment in India from early 1990s, the job of the financial manager in India has become more important complex, and demanding.