Financial Management

Financial Management
Prescribed Text Book:
Corporate Finance by Ross, S. A.Westerfield, R. W. and
Jaffe, J., The McGraw-Hill Companies, 2010.
Other Reference/Suggested Books:
Corporate Finance by Ross, S. A.Westerfield, R. W.-Jaffe, J. and
Kakani, R. K., The McGraw-Hill Education (India) Pvt. Ltd, 2014.
Corporate Finance: A Focussed Approach by Brigham, E. and
Ehrhardt, M. C., South Western Cengage Learning, 2013.
Financial Management by Khan, M. Y. and Jain, P. K., McGraw-Hill
Education (India) Pvt. Ltd, 2014.
Principles of Corporate Finance by Brealey, R.-Myers, S. and Allen,
F. The McGraw-Hill Companies, 2014.
Corporate Financial Analysis with Microsoft Excel by Francis J.
Clauss, The McGraw-Hill Companies, 2010.

Financial Management:
An Overview

Finance
Finance may be defined as the art and science of managing
money. The major areas of finance are:
1. Financial Services
Financial services is concerned with the design and delivery of advice and
financial products to individuals,
business and governments.
2. Financial Management
Financial Management is that managerial activity which is concerned
with planning, controlling and managing the financial resources of a
given firm.
Financial managers actively manage the financial affairs of any type of
business, namely, financial and non-financial, private
and public, large and small, profit-seeking and not-for-profit.

Finance and Related Disciplines

Finance and Economics

Finance is closely related to both macroeconomics and
microeconomics.
Macroeconomics provides an understanding of the institutional
structure in which the flow of finance takes place.
Microeconomics provides various profit maximization strategies
based on the theory of the firm.
One of the fundamental principle of financial management
suggests that financial decisions should be based on Marginal
Analysis.
Marginal Analysis suggests that financial decisions should be
made on the basis of comparison of marginal revenues and
marginal costs/added benefits exceed added costs.
A financial manager uses these to run the firm efficiently and
effectively.

Illustration of a Financial Decision using Marginal Analysis

A financial manager of a department store is

contemplating to replace one of its online computers
with a new, more sophisticated one that would both
speed up processing time and handle a large volume of
transactions. The new computer would require a cash
outlay of Rs 8,00,000 and the old computer could be sold
to net Rs 2,80,000. The total benefits from the new
computer and the old computer would be Rs 10,00,000
and Rs 3,50,000 respectively. Should the manager
replace the old computer by the new one?

Illustration of a Financial Decision using Marginal Analysis

Benefits with new computer

Less: Benefits with old computer

Rs 10,00,000
3,50,000

Marginal Revenue (a)

Cost of new computer
Less: Proceeds from sale of old
computer

Rs 6,50,000
8,00,000
2,80,000

Marginal Cost (b)

5,20,000

Net Benefits [(a) (b)]

1,30,000

As the store would get a net benefit of Rs 1,30,000, the old computer should
be replaced by the new one.

Finance and Accounting

Accounting
generates
information/data
to
operations/activities of a firm. The end product of
accounting is the generation of financial statements of
a firm.
A financial manager depends on these financial
statements as a source of information/data relating to
the past, present and future financial position of the
firm for making any financial decision.
However, finance and accounting differ in two ways:
1. Treatment of Funds and
2. Decision Making.

Finance and Accounting

Treatment of Funds: The measurement of funds in
accounting is based on the accrual principle where as
the in finance it is based on cash flows.
Accrual method recognizes revenue at the point of sale
and not when collected and expenses when they are
incurred rather than when actually paid.
Cash flows method recognizes revenues and expenses
only with respect to actual inflows (when cash is
actually received) and outflows of cash (when cash is
actually paid).

To illustrate, total sales of a trader during the year amounted to Rs

10,00,000 while the cost of sales was Rs 8,00,000. At the end of the
year, it has yet to collect Rs 8,00,000 from the customers. The
accounting view and the financial view of the firms performance during
the year are given below.
Accounting view

Financial view

(Income statement)

(Cash flow statement)

Sales
Less: Costs
Net profit

Rs 10,00,000 Cash inflow

8,00,000 Less: Cash outflow
2,00,000 Net cash outflow

Rs 2,00,000
8,00,000
(6,00,000)

Finance and Accounting

Decision Making: The focus of finance is on the
decision making where as accounting concentrates on
collection, compilation and presentation of financial
data.

Finance and Other Related Disciplines

Apart from economics and accounting, finance also
drawsfor its day-to-day decisionson supportive
disciplines such as marketing, operations, production, HR
and quantitative methods.

The relationship between Financial

Management and supportive Disciplines
Financial Decision Areas
Primary Disciplines

Accounting

2. Working Capital Management

Macroeconomics

3. Sources and Cost of Funds

Microeconomics

1. Investment Analysis

4. Determination
Structure

of

Support

Capital
Support

Other Related Disciplines

5. Dividend Policy

Marketing

6. Analysis of Risks and Returns

Production

Operations

Quantitative methods

HR

Resulting in
Shareholder Wealth Maximization

Scope of Financial Management

Financial Management addresses the following
three questions:
1. What long-term and short-term investments should
the firm engage in?
2. How can the firm raise the money for the required
investments?
3. What proportion of net profits can be distributed to
the shareholders in the form of dividends and what
proportion can be retained in the business itself ?

Scope of Financial Management

The scope of financial management can be broken down into three major
decisions as functions of finance:
(1) Investment Decision
The investment decision relates to the selection of assets in which funds
will be invested by a firm. The assets which can be acquired fall into two
broad groups: (a) fixed-assets/long-term assets (Capital Budgeting) (b)
short-term /current assets (Working Capital).
(a) Capital Budgeting: Capital budgeting is probably the most crucial
financial decision of a firm. It relates to the selection of an asset or
investment proposal or course of action whose benefits are likely to be
available in future over the lifetime of the project.
(b) Working Capital Management: Working capital management is
concerned with the management of current assets. It is an important and
integral part of financial management as short-term survival is a
prerequisite for long-term success.

(2) Financing Decision

Financing decision relates to the choice of the proportion of debt and equity
sources of financing. While the investment decision is broadly concerned
with the asset-mix or the composition of the assets of a firm, the concern of
the financing decision is with the financing-mix or capital structure or
leverage.
There is one major aspect of the financing decision, called the optimum
capital structure.
(3) Dividend Policy Decision
The dividend decision relates to the distribution and retention of net profits of
a firm.
The two alternatives available with the firm are:
(i) Net profits can be distributed to the shareholders in the form of dividends
or (ii) they can be retained in the business itself. The decision as to which
course should be followed depends largely on a significant element in the
dividend decision, the dividend-pay out ratio, that is, what proportion of net
profits should be paid out to the shareholders and what proportion should be
retained in the business.

Financial Decisions a Firm

Financial Decisions

Investment Decision

Financing Decision

Internal Sources

Dividend Policy Decision

External Sources

(Sources of Funds)

Fixed Assets

Working Capital

(Uses of Funds)

Distribution

Retention

(Dividend-pay out ratio)

The Balance-Sheet Model

of the Firm
Total Firm Value to Investors:

Total Value of Assets:

Fixed Assets

Shareholders
Equity

1 Tangible
2 Intangible

Long-Term
Debt
Current Assets
Current
Liabilities

The Balance-Sheet Model

of the Firm
The Capital Budgeting and Working Capital
Decision
Fixed Assets
Shareholders
Equity

What Long-term
investments
should the firm
engage in?

1 Tangible
2 Intangible

Long-Term Debt

Current
Liabilities

What Short-term
investments
should the firm
engage in?

Current Assets

The Balance-Sheet Model

of the Firm
The Financing Decision
Fixed Assets
Shareholders
Equity

1 Tangible
2 Intangible

Long-Term Debt

Current
Liabilities

How can the firm

raise the money for
the required
investments?

Current Assets

The Balance-Sheet Model

of the Firm
The Net Working Capital Decision
Fixed Assets
Shareholders
Equity

1 Tangible
2 Intangible

Long-Term Debt

Net
Working

Current
Liabilities

Capital

Current Assets

Organization of Financial Management Function

Organization of Financial Management Function

Board of Directors
Managing Director/Chairman/CEO
Vice-President/Director (Finance)/Chief Finance Officer (CFO)

Controller

Treasurer

Financial
planning and
fund-raising
manager

Capital
expenditure
manager

Cash
Manager

Credit
Manager

Foreign
exchange
manager

Pension
fund
manager

Tax
manager

Corporate
accounting
manager

Cost
accounting
manager

Financial
accounting
manager

Key Activities/Functions of the Financial Manager

1. Performing Financial Analysis and Planning
The concern of financial analysis and planning is with (a) transforming
financial data into a form that can be used to monitor financial condition,
(b) evaluating the need for increased (reduced) productive capacity and
(c) determining the additional/reduced financing required.
2. Making Investment Decisions
Investment decisions determine both the mix and the type of assets held
by a firm. The mix refers to the amount of current assets and fixed
assets.
3. Making Financing Decisions
Financing decisions involve two major areas: first, the most appropriate
mix of short-term and long-term financing; second, the best individual
short-term or long-term sources of financing at a given point of time.
4. Making Dividend Policy Decisions

The dividend decision relates to the distribution and retention of net

profits of a firm (the dividend-pay out ratio).

Separation of Ownership and Control:

Agency Problem

Board of Directors

Assets
Equity

Shareholders

Debt

Debtholders

Management

Agency Problem
An agency problem results when managers as
agents of owners (principal) place personal goals
ahead of corporate goals. Market forces and the
threat of hostile takeover tend to act to
prevent/minimise agency problems. In addition,
firms incur agency costs in the form of monitoring
and bonding expenditures, opportunity costs and
structuring expenditures which involve both
incentive and performance-based compensation
plans to motivate management to act in the best
interest of the shareholders.

Objectives / Goals of the Corporation

1. Profit Maximization (Profit/Earning per Share
(EPS) Maximization---Profit refers to the amount
and share of income which is paid to the owners
of business who supply equity capital)
2. Stockholder Wealth Maximization (Maximizing
the price of the firms common stock)

Objectives / Goals of the Corporation

Profit Maximization v/s Wealth Maximization
Profit Maximization

Wealth Maximization

1. Ambiguity
(Short-term, long-term, total profit
or rate of profit, profit before tax or
after tax, return on total capital
employed or total assets or
shareholder's equity)

1. No Ambiguity (Concept of cash

flows generated by the decision
rather than accounting profit)

2. No Time Value of Money (Ignores

the difference in the time pattern of
the benefits received in different time
period and treats all benefits
irrespective of the timing as equally
valuable)

2. Time Value of Money (the value of

a stream of cash flows is calculated
by discounting its element back to
the present at a discount rate which
reflects both time and risk)

Objectives / Goals of the Corporation

Profit Maximization v/s Wealth Maximization
Profit Maximization

Wealth Maximization

3. No Quality of Benefits (It 3. Quality of Benefits (The

ignores degree of certainty with discount rate reflects the risk
which benefits can be expected) preference and time of the
owners or suppliers of capital).

Timing of Benefits

A more important technical objection to profit maximisation, as a guide

to financial decision making, is that it ignores the differences in the
time pattern of the benefits received over the working life of the asset,
irrespective of when they were received.
Time-Pattern of Benefits (Profits)
Time
Alternative A (Rs in lakh)
Period I
50
Period II
100
Period III
50
Total
200

Alternative B (Rs in lakh)

100
100
200

Quality of Benefits
Probably the most important technical limitation of profit maximization
as an operational objective, is that it ignores the quality aspect of
benefits associated with a financial course of action. The term quality
here refers to the degree of certainty with which benefits can be
expected.
Risk and Uncertainty About Expected Benefits (Profits)
State of Economy

Profit (Rs crore)

Alternative A

Alternative B

Recession (Period I)
Normal (Period II)
Boom (Period III)

9
10
11

0
10
20

Total

30

30

The Firm and the Financial Markets

The Firm and the Financial Markets:

Invests
in Assets
(B)
Current Assets
Fixed Assets

Firm issues securities/shares (A)

Retained
cash flows (E)

Short-term Debt
Cash flow
from firm (C)

Ultimately, the firm must

be a cash generating

activity.

Financial
Markets

Dividends and
debt payments (F)
Taxes (D)

Firm

Government

Long-term Debt
Equity Shares

The cash flows from

the firm must
exceed the cash
flows from the
financial markets.