CHAPTER 1 NATURE OF FINANCIAL MANAGEMENT

LEARNING OBJECTIVES
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 Explain the nature of finance and its interaction with other

management functions
 Review the changing role of the finance manager and his/her
position in the management hierarchy
 Focus on the Shareholders’ Wealth Maximization (SWM)
principle as an operationally desirable finance decision
criterion
 Discuss agency problems arising from the relationship
between shareholders and managers
 Illustrate the organization of finance function
 Important Business Activities
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 Production
 Marketing
 Finance
 Real And Financial Assets
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 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
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 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 and Preference Shares
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 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.
 PreferenceShares 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.
 Finance and Management Functions
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 All business activities involve acquisition and use

of funds.
 Finance function makes money available to meet
the costs of production and marketing operations.
 Financial policies are devised to fit production and
marketing decisions of a firm in practice.
 Finance Functions
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Finance functions or decisions can be divided as

follows
 Long-term financial decisions
• Long-term asset-mix or investment decision or capital
budgeting decisions.
• 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.
 Financial Procedures and Systems
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 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
 Finance Manager’s Role
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 Raising of Funds
 Allocation of Funds
 Profit Planning
 Understanding Capital Markets
 Financial Goals
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 Profit maximization (profit after tax)

 Maximizing earnings per share
 Wealth maximization
 Profit Maximization
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 Maximizing the rupee income of firm

✓ Resources are efficiently utilized
✓ Appropriate measure of firm performance
✓ Serves interest of society also
 Objections to Profit Maximization
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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
 Maximizing Profit after Taxes or EPS
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 Maximising PAT or EPS does not maximise the

economic welfare of the owners.
 Ignores timing and risk of the expected benefit
 Market value is not a function of EPS.
 Maximizing EPS implies that the firm should make
no dividend payment so long as funds can be
invested at positive rate of return—such a policy
may not always work.
 Shareholders’ Wealth Maximization
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 Maximizes the net present value of a course of

action to shareholders.
 Accounts for the timing and risk of the expected
benefits.
 Benefits are measured in terms of cash flows.
 Fundamental objective—maximize the market
value of the firm’s shares.
 Need for a Valuation Approach
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 SWM requires a valuation model.

 The financial manager must know,
 How much should a particular share be worth?
 Upon what factor or factors should its value depend?
 Risk-return Trade-off
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 Financial decisions of the firm are guided by the

risk-return trade-off.
 The return and risk relationship:
Return = Risk-free rate + Risk premium
 Risk-free rate is a compensation for time and risk
premium for risk.
 Risk Return Trade-off
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Risk and expected return move in tandem; the greater the risk, the greater
the expected return.
 Overview of Financial Management
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 Agency Problems: Managers Versus Shareholders’
Goals
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 Thereis a Principal Agent relationship between

managers and shareholders.

 Intheory, 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.
 Agency Problems: Managers Versus
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Shareholders’ Goals
 Managers may perceive their role as reconciling conflicting
objectives of stakeholders. This stakeholders’ view of
managers’ role may compromise with the objective of SWM.

 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 SWM as a normative guide.

 Thisconflict is known as Agency problem and it results into

Agency costs.
 Agency Costs
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 Agency costs include the less than optimum share

value for shareholders and costs incurred by them
to monitor the actions of managers and control their
behaviour.
 Financial Goals and Firm’s Mission and Objectives
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 Firms’ primary objective is maximizing the welfare of owners,

but, in operational terms, they focus on the satisfaction of its
customers through the production of goods and services
needed by them.
 Firms state their vision, mission and values in broad terms.
 Wealth maximization is more appropriately a decision
criterion, rather than an objective or a goal.
 Goals or objectives are missions or basic purposes of a firm’s
existence.
 Financial Goals and Firm’s Mission and Objectives
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 The shareholders’ wealth maximization is the second-

level criterion ensuring that the decision meets the
minimum standard of the economic performance.
 In the final decision-making, the judgement of
management plays the crucial role.
 The wealth maximization criterion would simply
indicate whether an action is economically viable or
not.
 Organisation of the Finance Functions
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 Reason for placing the finance functions in the

hands of top management
 Financial decisions are crucial for the survival of the firm.
 The financial actions determine solvency of the firm
 Centralisation of the finance functions can result in a
number of economies to the firm.
 Organisation of Finance Function
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Organization for finance function

Organization for finance function in a multidivisional company
 Status and Duties of Finance Executives
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 The exact organisation structure for financial

management will differ across firms.
 The financial officer may be known as the financial
manager in some organisations, while in others as
the vice-president of finance or the director of
finance or the financial controller.
 Role of Treasurer and Controller
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 Two officers—the treasurer and the controller—

may be appointed under the direct supervision of
CFO to assist him or her.
 The treasurer’s function is to raise and manage
company funds while the controller oversees
whether funds are correctly applied.