FINANCIAL MANAGEMENT

Unit-1 Nature Of Financial

Management
 Finance is the life blood of the business.
Financial Management study about the process of
procuring and judicious use of Financial Recourses
with a view to maximize the value of the firm thereby
the value of the owners i.e. equity shareholders in a
company is maximized.
 Financial Management
-is that managerial activity which is concerned with the
planning and controlling of the firms financial resources.
 Finance functions
The function of raising funds, investing them in
assets and distributing returns earned from assets to
shareholders are respectively known as Financing,
investment decision and dividend decision.

A firm attempts to balance cash inflows and outflows

while performing these functions. This is called
Liquidity Decisions.
 Finance Functions
1. Investment decisions or long term asset mix
2. Financing Decisions or capital mix
3.Dividend Decisions or Profit allocation
4.Liquidity Decisions or Short-term asset mix

A firm performs finance functions simultaneously and

continuously in the normal course of the business. Finance
function call for skilful planning, control and execution of a firms
activities.
 Investment Decisions
A firms investment decision involve capital
expenditures. They are, referred as a capital
budgeting decisions. A capital budgeting
decisions involves the decision of allocation of
capital or commitment of funds to long term assets
that would yield benefits(cash flows) in the future.
 The investment decision should aim at investment in
assets only when they are expected to earn a return
greater than a minimum acceptable return, which is
also called as Hurdle rate

The finance function involves not only in investment

decisions, but also in disinvestment decision, for eg
withdrawing from unsuccessful projects or restructuring
with a strategic motive.
 The Investment Decision cover
the following

Ascertainment of total volume of funds,a firm can commit.

Appraisal and selection of capital investment Proposals
Measurement of risk and uncertainty in the investment
proposal
Prioritizing Of Investment Decisions
Funds allocation and its rationing.
 Determination of Fixed asset to be acquired
Determination of level of Investments in current assets
such as inventory,receivables,cash,marketable securities,
etc and its management.
Buy Or lease decisions
Asset replacement decision
Restructuring,reorganization,mergers and acquisitions.
Securities analysis and Portfolio Management.
 Financing Decisions
He must decide when, where from and how to
acquire funds to meet the firms investment need
and also the working capital requirement.
The central issues before him is to determine the
appropriate proportion of equity and debt. The mix
of debt and equity is known as the firms Capital
structure.
Equity
The raising of fund through issue of shares. The
shareholders expects the return in the form of dividends and
capital appreciation of their investment reflected in the
increase in stock market price. The dividend payment are
made only if the distributable profit are available with the
company.
Debt
The debts funds are raised in the form of
debentures,bonds,term loans etc..The interest should be paid
irrespective of the profitability of the firm.
The finance manager must strive to obtain the best
financing mix or the optimum capital structure for
his firm.
The firms capital structure is considered optimum
when the market value of shares is maximised.The
change in the shareholders return caused by the
change in the profits is called the financial
Leverage
 In fund raising decision, he should keep in view the cost of
funds from various sources, determination of debt equity mix,
the advantages and disadvantages of debt components in the
capital mix.
E.g. of Finance Decision Include-
Arrangement of Funds from banks and Financial Institutions for
long term, medium term and short term needs.
Arrangement of Finance for working capital requirement.
Consideration of Interest burden on the firm
Evaluation of alternative use of funds.
 Dividend Decision
The financial manager must decide whether the firm
should distribute a portion and retain the balance. The
proportion of profit distributed as dividends is called
dividend pay out ratio and the retained portion of profit
is known as retention ratio.
The dividend decision
The amount to be paid out and its influence on share
price.
The amount of profits to be retained for internal
investment which maximizes the value of firm and
ultimately improves the share value of the firm.

The optimum Dividend policy in one that maximizes

the market value of the shares.
Bonus shares are shares issued to the existing
shareholders without any charge
(Dividends are usually paid in cash)
 Liquidity Decisions
Liquidity ensures the ability of the firm to honor its
short term obligations. The liquidity means the firms
ability to pay trade creditors as and when due, ability
to honor its bills payable on due dates, ability to pay
salaries and wages on time when it is due, ability to
meet unexpected expenses etc.
It also reflects firms ability to converts its assets in to
cash, cash equivalents and other most liquid assets.
 Liquidity and profitability
There is a inverse relationship between Liquidly
and profitability. The higher the liquidity the
lower will be the profitability and vice-versa.
 ROLE OF THE FINANCE MANAGER
Fund Raising
Fund Allocation
Cash Management
Profit Planning
Understanding Capital Market
Forecasting Financial Requirements
Investment Decision
Interrelation with Other Departments
 FINANCIAL GOALS/Objective of
FM

PROFIT MAXIMISATION
SHARE HOLDERS WEALTH MAXIMISATION
Value maximization
 PROFIT MAXIMISATION
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

It is assumed that the profit maximization causes the

efficient allocation of resources under the competitive
market conditions, and profit is considered as the most
appropriate measures of a firms performance.
 SHARE HOLDERS WEALTH MAXIMIZATION

SWH means maximizing the net present value of a course of actions

to shareholders.NPV or wealth of a course of action is the difference
between the present value of its benefits and the present value of its
costs.
A financial action resulting in a positive NPV creates wealth for
shareholders and therefore desirable. A financial action resulting in a
negative NPV should be rejected since it would destroy shareholders
wealth. Between mutually exclusive projects the one with the highest
NPV should be adopted.
 SHARE HOLDERS WEALTH MAXIMIZATION

Therefore wealth maximization principle implies that the fundamental

objective of a firm is to maximize the market value of its shares. The value of
a companies shares is represented by their market price that,inturn, is a
reflection of shareholders perception about quality of the firms financial
decisions.
The market price serve as the firms performance indicator.
The wealth maximization objective takes in to consideration the time and
risk of expected befefits.The difficulty arises in selecting appropriate rate of
discounting future cash flows, if greater risk is associated with receiving of
future economic benefits, the higher is the discount rate is adopted and it
lowers the value of investors wealth.
 VALUE MAXIMISATION

The goal of a firm is to maximize the present wealth of the owner i.e.,
equity shareholder in a company. A company equity shares are actively
traded in the stock markets, the wealth of the equity shareholders is
represented in the market value of the equity shares.
The prime goal for company form of organization is to maximize the
market value of equity shares of the company.
The market price of a share serves as an index of the performance of
the company. The share holders wealth is maximized only when the
market value of the share is maximized.
Sources of funds
 Sources of funds
There are many alternatives of finance or capital, a company can
choose from. Choosing right source and right mix of finance is a
key challenge for every finance manager.
The process of selecting right source of finance involves in-depth
analysis of each and every source of finance. For analyzing and
comparing the sources of finance, it is required to understand all
characteristics of the financing sources. There are many
characteristics on the basis of which sources of finance are
classified.
 Long Term Sources of Finance:Long term financing means
capital requirements for a period of more than 5 years to 10, 15,
20 years or may be more depending on other factors. Capital
expenditures in fixed assets like plant and machinery, land and
building etc of a business are funded using long term sources of
finance.

Part of working capital which permanently stays with the business

is also financed with long term sources of finance.
 Financial Management
-External Long-term Sources of Funds

Share capital:
The most important source of funds for a limited company. It is often
considered as permanent capital as it is not repaid by the business, but the
shareholder can have a share in the profit, called dividend.
Three types of shares are:
1. Ordinary shares: The most common types of shares, and the most riskiest shares
since no guaranteed dividend. Dividend depends on how much profit is made by
the firm. But all ordinary shareholders have voting rights.
2. Preference shares: The share owners receive a fixed rate of return. They carry
less risk because shareholders are entitled to the dividend before the ordinary
shares. But they are not strictly owners of the company.
3. Deferred shares: These shares are often held by the founders of the company.
Deferred shareholders only receive the dividend after the ordinary shareholders
have been paid.
 Loan capital
Definition:
Any money which is borrowed for a long period of time by a business is
called loan capital.
Types:
There are four major types of loan capital: Debentures, Mortgage, Loan
specialists funds, Government assistance.
 Types of loan capital:
1. Debentures: The holder of a debenture is a creditor of the company, not an
owner. Holders are paid with an agreed fixed rate of return, but having no
voting rights. The amount of money borrowed must be repaid by the expiry
date.
2. Mortgage: These are long-term bank loans (usually over one year period) from
banks or other financial institutions. The borrowers land or property must be
used as a security on such as a loan.
3. Loan specialists funds: These are venture capitalists or specialists who
provide funds for small businesses, especially for high tech investment projects
in their start-up stage. There are also individuals who invest in such businesses,
which are often called business angels.
4. Government assistance: To encourage small businesses and high
employment, governments may be involved in providing finance for businesses.
In the USA, there is an organization which is called the Small Business
Administration (SBA). SBA provides guarantees for small businesses loans and
they even offer some loans themselves.
 Financial Management
-External Short-term Sources of Funds
Definition:
Short term sources of funds are usually the funds which are less than one year for
maturity. They are less stable sources of funds for businesses.
Types:
The main types of external short term sources of funds include:
1. Bank overdraft
2. Bank loan
3. Leasing
4. Credit card
5. Trade credit
 Table 13-2 External short-term sources of loans
Major types Main characteristics
Bank This is a short term financing from banks.
overdraft The amount to be overdrawn depends on the needs of the business at
the time and its credit standing.
Interest is calculated from the time the account is overdrawn..
Bank loan This is a loan which requires a rigid agreement between the borrower
and the bank. The amount borrowed must be repaid over a certain
period or in regular installments.
Sometimes, banks change persistent overdrafts into loans, so
borrowers must repay at regular intervals.
Leasing Leasing allows businesses to buy plant, machinery or equipment
without paying large sums of money immediately.
The leasing company or bank hires or buys the equipment and for the
use of the hire company for a certain period of time. If the user can
never owns the equipment, it is an operating lease, while if it is given the
choice to own the equipment at the expiry time, it is a finance lease.
Lease payments are made by the hire company yearly or monthly, etc.
 Financial Management
-External Short-term Sources of Funds

Table 13-2 External short-term sources of loans (continued)

Major types Main characteristics

Credit card Credit cards can be used to pay for hotel bills,
meals,
shopping and materials, etc. They are convenient,
and secure because it can avoid the use of cash and
the payment of interests within credit periods.
Cards may not be suitable for certain purchases,
especially a large sum of order because they have a
credit limit.

Trade credit It is a common method for businesses to buy

materials and to pay for them at a later date, usually
between 30 and 90 days. Such trade credit given by
the seller is usually an interest free way of short
term financing.
 Internal source of finance may be broadly classified into two categories:
Depreciation Funds
Retained earnings

Depreciation Funds
Depreciation funds are the major part of internal sources of finance, which is
used to meet the working capital requirements of the business concern.
Depreciation means decrease in the value of asset due to wear and tear, lapse of
time, obsolescence, exhaustion and accident. Generally depreciation is charged
against fixed assets of the company at fixed rate for every year. The purpose of
depreciation is replacement of the assets after the expired period. It is one kind
of provision of fund, which is needed to reduce the tax burden and overall
profitability of the company.
 Retained Earnings

Retained earnings are another method of internal sources of finance. Actually is not a
method of raising finance, but it is called as accumulation of profits by a company for its
expansion and diversification activities.

Retained earnings are called under different names such as; self finance, inter finance, and
plugging back of profits. According to the Companies Act 1956 certain percentage, as
prescribed by the central government (not exceeding 10%) of the net profits after tax of a
financial year have to be compulsorily transferred to reserve by a company before declaring
dividends for the year.

Under the retained earnings sources of finance, a part of the total profits is transferred to
various reserves such as general reserve, replacement fund, reserve for repairs and renewals,
reserve funds and secrete reserves, etc.
 Financial Management
-Factors affecting the choice of funds

Costs of the fund

Costs in terms of interest payments and other expenses: Long term and short term.
Use or purpose of funds
For example, the building of a new plant is usually financed by mortgage or share capital,
while the purchase of raw materials by trade credit or bank overdraft.
Status and size of the business
For a large firm, there are more sources of finance and often with lower interest rates.
Financial situations of a firm
For example, a business in poor financial situation is forced to pay high interest rate for
loans. And the bank often requires security or collaterals for their financing.
FINANCIAL SYSTEM
 FINANCIAL SYSTEM
Financial system is the basic concept for the industrial
development of the nation. Financial system provides adequate
and smooth flow of finance to the needed parts. Indian financial
system consists of the four important components such as:
Financial Institutions
Financial Markets
Financial Instruments
Financial Services.
 Financial system

In finance, thefinancial systemis the system that allows the

transfer of money between savers (and investors) and
borrowers.A financial system can operate on a global, regional or
firm specific level
According to Christy, the objective of the financial system is to
supply funds to various sectors and activities of the economy in
ways that promote the fullest possible utilization of resources
without the destabilizing consequence of price level changes or
unnecessary interference with individual desires.
 According to Robinson, the primary function of
the system is to provide a link between savings and
investment for the creation of new wealth and to
permit portfolio adjustment in the composition of
the existing wealth.
 Features of Financial system

The features of a financial system are as follows

1.Financial system provides an ideal linkage between depositors and investors,
thus encouraging both savings and investments.
2.Financial system facilitates expansion of financial markets over space and time.
3.Financial system promotes efficient allocation of financial resources for socially
desirable and economically productive purposes.
4.Financial system influences both the quality and the pace of economic
development.
 Financial Institutions

Financial institutions are providing various services to the

economic development with the help of issuing of the financial
instruments.

Financial institutions can be classified into banking and non-

banking institutions. Now in India, all the financial institutions
are systematically regulated and controlled by respective act.
1.Banking
Institution

A banking institutions
financing activities
generally involve
various types of lending,
such as corporate
finance, housing, project
finance, retail,short-term
finance, small-medium
enterprises, trade and
others.
Eg. Bhutan National
Bank
Non-Banking
Insurance

More broadly put,insurance

companiescreate value by
pooling and redistributing
various types of risk.
Itdoesthis by collecting
liabilities (i.e. premiums) from
everyone that it insures and
then paying them out to the few
that actually need them.

E.g. RICBL
Housing
The housing finance group aims
to establish sustainable, efficient,
secure and market-based
housing finance systems, to
create mechanisms allowing
lenders to raise long-term
resources for lending in local
currency, and to support
increased access to housing and
housing finance for the poor.

Chanjiji Housing Complex.

Pensions

The pension group

aims to assist
countries in building
sustainable and fair
pension systems
 Non-bank financial institutions (NBFIs), in BHUTAN

RICBL
NPPF
BIL
NHDCL
 3. Development finance
institution(DFI)

Adevelopment finance institution(DFI) is an

alternativefinancial institutionwhich
includesmicrofinance institutions,community
development financial institutionandrevolving loan funds.
These institutions provide a crucial role in providing credit
in the form of higher risk loans, equity positions and risk
guarantee instruments to private sector investments in
developing countries.
Regulatory Financial Institution

Is a government agency that is independent from

other branches or arms of the Government.
E.g. Central Bank
FINANCIAL MARKETS

 FINANCIAL MARKETS

Financial market provides money and capital supply to the industrial

concern as well as promote the savings and investments habits of the
public. In simple senses financial market is a market which deals with
various financial instruments (share, debenture, bonds, treasury bills,
commercial bills etc.) and financial services (merchant banking,
underwriting etc).
Financial markets may be divided into two major classifications:

A. Capital market
B. Money market
 Capital markets include
Primary markets
The primary market is where securities are created. It's in this market that firms
sell (float) new stocks and bonds to the public for the first time. For our
purposes, you can think of the primary market as being synonymous with
aninitial public offering(IPO). Simply put, an IPO occurs when a private
company sells stocks to the public for the first time.
Secondary markets
Most capital market transactions take place on the secondary market. On the
primary market, each security can be sold only once, and the process to
create batches of new shares or bonds is often lengthy due to regulatory
requirements. On the secondary markets, there is no limit on the number of
times a security can be traded, and the process is usually very quick.
Capital market consists of:(The capital market is a market for financial assets
which have a long or indefinite maturity)
1.Industrial securities market:
It is a market for industrial securities namely equity shares or ordinary shares,
preference shares & debentures or bonds. It is a market where industrial
concerns raise their capital or debt by issuing appropriate instruments. It can
be further subdivided into primary & secondary market.
2.Government securities market:
It is otherwise called gilt-edged securities market. It is a market where
government securities are traded.In India there are many kinds of govt
securities- short-term & long-term. Long-term securities are traded in this
market while short term securities are traded in the money market.
 3.Long-term loans market:
Development banks & commercial banks play a
significant role in this market by supplying long term
loans to corporate customers. Long-term loans
market may further be classified into:
Term loans market
Mortgages market
Financial guarantees market
Money market consists of:(Money market is a market for dealing with
financial assets & securities which have a maturity period of upto one year.)
Call money market:
Call money market is a market for extremely short period loans say one day to
fourteen days. It is highly liquid.
Commercial bills market:
It is a market for bills of exchange arising out of genuine trade transactions. In
the case of credit sale, the seller may draw a bill of exchange on the buyer.
The buyer accepts such a bill promising to pay at a later date the amount
specified in the bill. The seller need not wait until the due date of the bill.
Instead, he can get immediate payment by discounting the bill.
 Treasury bills market:
It is a market for treasury bills which have short-term maturity.
A treasury bill is a promissory note or a finance bill issued by
the government. It is highly liquid because its repayment is
guaranteed by the government.
Short-term loan market:
It is a market where short- term loans are given to corporate
customers for meeting their working capital requirements.
Commercial banks play a significant role in this market.
 3. Financial Instruments:

Financial instruments refers to those document which represents financial

claims on assets. As discussed earlier, financial assets refers to a claim to the
repayment of certain sum of money at the end of specified period together with
interest or dividend. Examples : bills of exchange, promissory notes, treasury
bills, government bonds, deposit receipts, shares debentures etc.

Financial instruments can also be called financial securities. Financial securities

can be classified into:
i.Primary or direct securities
ii.Secondary or indirect securities.
 Primary securities
These are securities directly issued by the ultimate
investors to the ultimate savers. Examples, shares and
debentures issued directly to the public.
Secondary securities
These are securities issued by some intermediaries called
financial intermediaries to the ultimate savers. E.g. unit
trust of India and Mutual funds issue securities in the form
of units to the public and money pooled is invested in
companies.
 4.Financial Services

Financial intermediaries provide key financial services such

as merchant banking, leasing hire purchases, credit-rating,
and so on. Financial services rendered by the financial
intermediaries bridge the gap between lack of knowledge
on the part of investors and increasing sophistication of
financial instruments and markets. These financial services
are vital for creation of firms, industrial expansion, and
economic growth
 Mutual fund

A mutual fund is an investment vehicle for investors

who pool their savings for investing in diversified
portfolio of securities with the aim of attractive yields
and appreciation in their value. Mutual fund is a trust
that attracts savings which are then invested in capital
markets.

 Venture Capital
According to Jame Koloski Morries, venture capital is defined as providing seed, start up and
first stage financing and also funding expansion of companies that have already demonstrated
their business potential but do not yet have access to the public securities market or to credit
oriented institutional funding sources.
Features of Venture Capital
Venture Capital consists of high risk and high return based financing.
Venture Capital provides moderate interest bearing instruments.
Venture Capital reduces the financial burden of the business concern at the initial stage.
Venture Capital is suitable for risky oriented and high technology based industry.
 Leasing
Definition of Leasing
Lease may be defined as a contractual arrangement in which a party owning
an asset provides the asset for use to another, the right to use the assets to the
user over a certain period of time, for consideration in form of periodic
payment, with or without a further payment.
According to the equipment leasing association of UK definition, leasing is a
contract between the lesser and the leaser for hire of a specific asset selected
from a manufacturers or vender of such assets by the lessee. The leaser retains
the ownership of the asset. The leassee pass possession and uses the asset on
payment for the specified period.
 Hire Purchasing
Hire-purchase finance company (HPFC) means any company
which is carrying on as its principal business, hire-purchase
transactions or the financing of such transactions.
A system by which a buyer pays for a thing in regular installments
while enjoying the use of it. During the repayment period,
ownership of the item does not pass to the buyer. Upon the full
payment of the loan, the title passes to the buyer.
Installment buying
 Merchant Banking Meaning

Merchant Banking is a combination ofBankingand

consultancy services. It provides consultancy to its clients
for financial,marketing, managerial and legal matters.
Consultancy means to provide advice, guidance and service
for a fee. It helps a businessman to start abusiness. It helps
to raise (collect)finance.
 Credit Rating Agency

Company that collects information about individuals' and businesses'

debts, and assigns a numerical value called a credit score that
indicates the borrower's creditworthiness.

Creditors and lenders, such as credit card companies and banks,

report their customers' borrowing activity and history to credit
agencies. Individuals and businesses can obtain copies of the
information reported about them by contacting the credit agency
or a related third-party company, and paying a nominal fee.
 Rating Symbols of Credit Rating
Information Service of India Limited
 Project Counseling
Financial services has expertise on giving counseling relating to
Project management.
E.g Project Finance, Project Report preparation, Project Feasibility
etc..
 Relationship of Finance to Economies

Macro economics is the study of the whole economy. It looks at

aggregate variables, such as aggregate demand, national output
and inflation, tax enviroment,availability of funds to the corporate
sector, rate of interest, role of Govt in economy affairs etc

Microeconomics is the study of particular markets, and segments

of the economy. It looks at issues such as consumer behaviour,
individual labor markets, and the theory of firms.
 Basic knowledge of macro economics is necessary for understanding
the environment in which the firm operates and a good grasp of
micro economic principles is helpful in sharpening the tools of
financial decision making.
 Relationship of Finance to Accounting

Score keeping Vs Value Maximizing

Accrual Method Vs Cash flow method
Certainty Vs Uncertainty
 Agency Cost
It refers to the conflict between shareholder and their
Company's managers. A share holder wants the
manager to make decisions which will increase the
share value.
Managers instead, would prefer to expand the
business and increase their salaries, which may not
necessarily increase share value.