Synopsis-01

Introduction to Financial Management

1. Real and Financial Assets

 Real Assets: Can be Tangible or Intangible

 Tangible real assets are physical assets that include plant, machinery, office,
factory, furniture and building.
 Intangible real assets include technical know-how, technological
collaborations, patents and copyrights.
 Financial Assets are also called securities, are financial papers or instruments such
as shares and bonds or debentures.

Equity and Borrowed Funds

 Shares represent ownership rights of their holders. Shareholders are owners of the
company. Shares can of two types:
 Equity Shares
 Preference Shares
 Loans, Bonds or Debts: represent liability of the firm towards outsiders. Lenders are
not owners of the company. These provide interest tax shield.
 Equity Shares are also known as ordinary shares.
 Do not have fixed rate of dividend.
 There is no legal obligation to pay dividends to equity shareholders.
 Preference Shares have preference for dividend payment over ordinary shareholders.
 They get fixed rate of dividends.
 They also have preference of repayment at the time of liquidation.

2. Meaning of Finance
Finance may be defined as the art and science of managing money. It includes financial
service and financial instruments. Finance also is referred as the provision of money at the
time when it is needed. Finance function is the procurement of funds and their effective
utilization in business concerns. The concept of finance includes capital, funds, money, and
amount. But each word is having unique meaning. Studying and understanding the concept of
finance become an important part of the business concern.

3. Definition of Business Finance

Business finance is that business activity which concerns with the acquisition and
conversation of capital funds in meeting financial needs and overall objectives of a business
enterprise.

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According to the Guthumann and Dougall, “Business finance can broadly be defined as the
activity concerned with planning, raising, controlling, administering of the funds used in the
business”.
In the words of Parhter and Wert, “Business finance deals primarily with raising,
administering and disbursing funds by privately owned business units operating in non-
financial fields of industry”.
Corporate finance is concerned with budgeting, financial forecasting, cash management,
credit administration, investment analysis and fund procurement of the business concern and
the business concern needs to adopt modern technology and application suitable to the global
environment.

4. Definition of Financial Management

Financial management is an integral part of overall management. It is concerned with the
duties of the financial managers in the business firm.
The most popular and acceptable definition of financial management as given by S.C. Kuchal
is that “Financial Management deals with procurement of funds and their effective utilization
in the business”.
Weston and Brigham: Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be
called as Corporation Finance or Business Finance.

5. Scope of Financial Management and the Role of the Financial

Manager in a Modern Enterprise
The scope of the financial management is to secure the capital needed by the enterprise,
and employ it in production and marketing activities, in such a way that it can generate the
sufficient returns on invested capital, with an intention to maximize the wealth of the owners.
The financial manager plays the crucial role in the modern enterprise by supporting
investment decision, financing decision, and also the profit distribution decision. He/she also
helps the firm in balancing cash inflows and cash outflows, and in turn to maintain the
liquidity position of the firm.

6. Finance Functions
Finance functions or decisions can be divided as follows
 Long-term financial decisions
• Long-term asset-mix or investment decision or capital budgeting
decisions.

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 • Capital-mix or financing decision or capital structure and leverage
decisions.
• Profit allocation or dividend decision
 Short-term financial decisions
• Short-term asset-mix or liquidity decision or working capital
management.

7. Financial Procedures and Systems

For effective finance function some routine functions have to be performed. Some of
these are:
 Supervision receipts and payments and safeguarding of cash balances
 Custody and safeguarding of securities, insurance policies and other
valuable papers
 Taking care of the mechanical details of new outside financing
 Record keeping and reporting

8. Finance Manager’s Role

 Raising of Funds
 Allocation of Funds
 Profit Planning
 Understanding Capital Markets

9. Financial Goals

Effective procurement and efficient use of finance lead to proper utilization of the finance by
the business concern. It is the essential part of the financial manager. Hence, the financial
manager must determine the basic objectives of the financial management. Objectives of
Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.

1. Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional
and narrow approach, which aims at, maximizes the profit of the concern. Profit
maximization consists of the following important features.
a. Profit maximization is also called as cashing per share maximization. It leads
to maximize the business operation for profit maximization.

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 b. Ultimate aim of the business concern is earning profit, hence, it considers all
the possible ways to increase the profitability of the concern.
c. Profit is the parameter of measuring the efficiency of the business concern. So
it shows the entire position of the business concern.
d. Profit maximization objectives help to reduce the risk of the business.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives of
the business concern:
 Main aim is earning profit.
 Profit is the parameter of the business operation.
 Profit reduces risk of the business concern.
 Profit is the main source of finance.
 Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:
 Profit maximization leads to exploiting workers and consumers.
 Profit maximization creates immoral practices such as corrupt practice, unfair
trade practice, etc.
 Profit maximization objectives leads to inequalities among the sake holders
such as customers, suppliers, public shareholders, etc.

Objections to Profit Maximization

 It is Vague
 It Ignores the Timing of Returns
 It Ignores Risk
 Assumes Perfect Competition
 In new business environment profit maximization is regarded as
 Unrealistic
 Difficult
 Inappropriate
 Immoral

2. Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth
or the wealth of the persons those who are involved in the business concern. Wealth
maximization is also known as value maximization or net present worth maximization. This
objective is an universally accepted concept in the field of business.

Favourable Arguments for Wealth Maximization

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  Wealth maximization is superior to the profit maximization because the main
aim of the business concern under this concept is to improve the value or
wealth of the shareholders.
 Wealth maximization considers the comparison of the value to cost associated
with the business concern. Total value detected from the total cost incurred for
the business operation. It provides extract value of the business concern.
 Wealth maximization considers both time and risk of the business concern.
 Wealth maximization provides efficient allocation of resources.
 It ensures the economic interest of the society.
Unfavourable Arguments for Wealth Maximization

 Wealth maximization leads to prescriptive idea of the business concern but it

may not be suitable to present day business activities.
 Wealth maximization is nothing, it is also profit maximization, it is the
indirect name of the profit maximization.
 Wealth maximization creates ownership-management controversy.
 Management alone enjoys certain benefits.
 The ultimate aim of the wealth maximization objectives is to maximize the
profit.
 Wealth maximization can be activated only with the help of the profitable
position of the business concern.

10. The wealth maximizing objective is superior to the profit

maximization objective- Explain.
The wealth maximizing objective means maximizing the net present value, i.e., wealth of
the owner. The net wealth of the owner is the difference between the present value of its
benefits and the present value of its costs. Any action that has a positive NPV creates wealth
for the owner. The profit maximizing objective tries to maximize the profit after tax, i.e., net
profit, which in the long term may reduce the net worth of the owner. The profit maximization
concept basically ignores the time value of money and the risk involved in firm's activities,
which are very well taken care by wealth maximization concept.

11. Overview of Financial Management

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12. Agency Problems: Managers versus Shareholders’ Goals

There is a Principal Agent relationship between managers and shareholders. In theory,

Managers should act in the best interests of shareholders. In practice, managers may
maximise their own wealth (in the form of high salaries and perks) at the cost of
shareholders. Managers may perceive their role as reconciling conflicting objectives of
stakeholders. This stakeholder’s view of manager’s role may compromise with the objective
of shareholders wealth maximization. Managers may avoid taking high investment and
financing risks that may otherwise be needed to maximize shareholders’ wealth. Such
“satisfying” behaviour of managers will frustrate the objective of shareholders wealth
maximization as a normative guide. This conflict is known as Agency problem and it results
into Agency costs.

Since shareholders get their wealth only when the firm has created value for customers and
kept the employees satisfied, the wealth maximization is generally in harmony with the
interests of all stakeholders. It is also consistent with the management objective of survival.

Agency Costs

 Direct costs
Unnecessary expenses such as monitoring costs.

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  Indirect costs
For example, a manager may choose not to take on the optimal investment. She/he
may prefer a less risky project so that she/he has a higher probability keeping her/his
tenure.

Resolving Agency Problem:

The agency problem can be minimized by acts of:

A. Market Forces: market forces acts to minimize agency problem in two ways:
i. Major Shareholders: To exercise the major shareholders voting rights, the large
institutional shareholders communicate with and exert pressure on, corporate
management to perform or face replacement.
ii. Threat to Takeover: The constant threat of a takeover would motivate management to
act in the best interests of the owners despite the fact that techniques are available to
define against a threat takeover.

B. Agency Cost: To minimize agency problems, the owners have to incur four types of cost
which are:
i. Monitoring expenditures: The monitoring outlay relates to payment for audit and
control procedures to ensure that managerial behavior is tuned to actions that tend to
be in the best interest of the shareholders.
ii. Opportunity Cost: Such costs result from an inability of a large companies from
responding to new opportunities. The management may face difficulties in seizing
upon profitable investment opportunities quickly.
iii. Structuring Expenditures: The most popular, powerful and expensive method is to
structure management compensation to correspond with share price maximization.
The objective is to give managers incentives to act in the best interest of the owners.
The two key type’s compensation plans are:
a. Incentive Plans: The most popular incentive plan is the granting of stock
options to managers. These options allow managers to purchase stock, if the
market price raises managers will be rewarded.
b. Performance Plans: The forms of performance based compensation are cash
bonuses, cash payments tied to the achievement of certain performance goals.

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