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CA Intermediate
Financial Management

CHAPTER 1

SCOPE AND OBJECTIVES

OF FINANCIAL MANAGEMENT
Handwritten Notes
MV Sir

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Other Definitions of Financial Management

 Financial management is that managerial activity which is concerned with planning

and controlling of the firm’s financial resources. In other words it is concerned
with acquiring, financing and managing assets to accomplish the overall goal of a
business enterprise (mainly to maximise the shareholder’s wealth).

 Financial Management can also be defined as planning for the future of a business
enterprise to ensure a positive cash flow.

 Some experts also refer to financial management as the science of money

management. It can be defined as “Financial Management comprises of forecasting,
planning, organizing, directing, co-ordinating and controlling of all activities relating
to acquisition and application of the financial resources of an undertaking in
keeping with its financial objective.

 Another very elaborate definition given by Phillippatus is

“Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of short term and long term credits for the firm.”

MV Sir

Aspects of Financial Management

Procurement of funds Utilization of Fund

a a
Equity Utilization for Fixed Assets

b b
Debentures Utilization for Working Capital

c
Funding from Banks

d
International Funding

MV Sir

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Aspects of Financial
Management Procurement of funds
 The cost of funds should be at the minimum level for that a proper balancing of risk and control
factors must be carried out.
 Another key consideration in choosing the source of new business finance is to strike a balance
between equity and debt to ensure the funding structure suits the business.
 The funds raised by the issue of equity shares are the best from the risk point of view for
the firm, since there is no question of repayment of equity capital except when the firm is
under liquidation.
a
 From the cost point of view, however, equity capital is usually the most expensive source of
Equity funds. This is because the dividend expectations of shareholders are normally higher than
prevalent interest rate and also because dividends are an appropriation of profit, not
allowed as an expense under the Income Tax Act.
 Also the issue of new shares to public may dilute the control of the existing shareholders.
 Debentures as a source of funds are comparatively cheaper than the shares because of
their tax advantage.
 The interest the company pays on a debenture is free of tax, unlike a dividend payment
b
which is made from the taxed profits. However, even when times are hard, interest on
Debentures
debenture loans must be paid whereas dividends need not be.
 However, debentures entail a high degree of risk since they have to be repaid as per the
terms of agreement. Also, the interest payment has to be made whether or not the company
makes profits.
MV Sir

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Aspects of Financial
Management Procurement of funds

c  Apart from supporting businesses in their routine activities (deposits, payments etc.) they
Funding help in meeting the long term and short term needs of a business enterprise.
from Banks
 Different lending services provided by Commercial Banks are-

d  Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major
International routes for raising funds from foreign sources besides ADR’s (American depository receipts)
Funding and GDR’s (Global depository receipts). [Depository receipt is traded in local markets but
represent the equity of a company listed in another country.]

MV Sir

Aspects of Financial
Management Utilization of Fund

 The finance manager is also responsible for effective utilisation of funds. He has to point out
situations where the funds are being kept idle or where proper use of funds is not being made.

 The funds are to be invested in the manner so that the company can produce at its optimum
a
level without endangering its financial solvency. For this, the finance manager would be
Utilization
required to possess sound knowledge of techniques of capital budgeting.
for Fixed
Assets  Capital budgeting (or investment appraisal) is the planning process used to determine
whether a firm's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects would provide the desired return
(profit).

b
Utilization  The finance manager must also keep in view the need for adequate working capital and ensure
for Working that while the firms enjoy an optimum level of working capital they do not keep too much
Capital funds blocked in inventories, book debts, cash etc.

MV Sir

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How do we measure the value/wealth of a firm?

According to Van Horne,
• “Value of a firm is represented by the
market price of the company's common
stock. The market price of a firm's stock
represents the focal judgment of all
market participants as to what the value
of the particular firm is.

• It takes into account present and

prospective future earnings per share,
the timing and risk of these earnings, the
dividend policy of the firm and many
other factors that bear upon the market
price of the stock.

• The market price serves as a

performance index or report card of the
firm's progress. It indicates how well
management is doing on behalf of
stockholders.”

Value of a firm (V) = Number of Shares (N) ×Market price of shares (MP)
Or
V = Value of equity (Ve ) + Value of debt (Vd ) MV Sir

Profit maximization cannot be the sole objective of the firm. If profit is given undue
importance, a number of problems can arise.

 The term profit is vague. It does not clarify what exactly it means. It conveys a
different meaning to different people.
 For example, profit may be in short term or long term period; it may be total profit or
rate of profit etc.

 Profit maximisation has to be attempted with a realisation of risks involved. There is a

direct relationship between risk and profit. If profit maximisation is the only goal, then
risk factor is altogether ignored.

 Profit maximisation as an objective does not take into account the time pattern of
returns.
 Proposal A may give a higher amount of profits as compared to proposal B, yet if the
returns of proposal A begin to flow say 10 years later, proposal B may be preferred
which may have lower overall profit but the returns flow is more early and quick.

 Profit maximisation as an objective is too narrow.

 It fails to take into account the social considerations as also the obligations to various
interests of workers, consumers, society, as well as ethical trade practices. If these
factors are ignored, a company cannot survive for long.
 Profit maximization at the cost of social and moral obligations is a short sighted policy.
MV Sir

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Some of the other goals a business enterprise

 Achieving a higher growth rate
 Attaining a larger market share
 Gaining leadership in the market in terms of products and technology
 Promoting employee welfare
 Increasing customer satisfaction
 Improving community life, supporting education and research, solving societal problems, etc.

 Though, the above goals are important but the primary goal remains to be wealth
maximization, as it is critical for the very existence of the business enterprise.

 If this goal is not met, public/institutions would lose confidence in the enterprise and will not
invest further in the growth of the organization.

 If the growth of the organization is restricted than the other goals like community welfare will
not get fulfilled.

MV Sir

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Conflicts In Profit Versus Value Maximisation Principle

 In any company, the management is the decision taking authority. As a normal tendency the
management may pursue its own personal goals (profit maximization).

 But in an organization where there is a significant outside participation (shareholding,

lenders etc.), the management may not be able to exclusively pursue its personal goals due
to the constant supervision of the various stakeholders of the company-employees,
creditors, customers, government, etc.

 Every entity associated with the company will evaluate the performance of the
management from the fulfilment of its own objective. The survival of the management will
be threatened if the objective of any of the entities remains unfulfilled.

 The wealth maximization objective is generally in accord with the interests of the various
groups such as owners, employees, creditors and society, and thus, it may be consistent with
the management objective of survival.

 Owing to limitation (timing, social consideration etc.) in profit maximization, in today’s real
world situations which is uncertain and multi-period in nature, wealth maximization is a
better objective. Where the time period is short and degree of uncertainty is not great,
wealth maximization and profit maximization amount to essentially the same.
MV Sir

Advantages and Disadvantages of both

Profit maximization and Wealth maximization goals
Goal Objective Advantages Disadvantages
Profit Large amount of 1) Easy to calculate profits 1) Emphasizes the short term gains
Maximization profits 2) Easy to determine the link 2) Ignores risk or uncertainty
between financial decisions and 3) Ignores the timing of returns
profits. 4) Requires immediate resources.
Shareholders Highest market 1) Emphasizes the long term gains 1) Offers no clear relationship
Wealth value of shares. 2) Recognises risk or uncertainty between financial decisions and
Maximisation 3) Recognises the timing of returns share price.
4) Considers shareholders’ return. 2) Can lead to management anxiety
and frustration.

 Profit maximization can be achieved in the short term at the expense of the long term goal,
that is, wealth maximization.

 For example, a costly investment may experience losses in the short term but yield substantial
profits in the long term. Also, a firm that wants to show a short term profit may, for example,
postpone major repairs or replacement, although such postponement is likely to hurt its long term
profitability.

MV Sir

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Why wealth maximization is a preferred objective than profit maximization ?

ILLUSTRATION 1
Profit maximization does not consider risk or uncertainty, whereas wealth maximization considers
both risk and uncertainty. Suppose there are two products, X and Y, and their projected earnings
over the next 5 years are as shown below:
Year Product X Product Y
1 10,000 11,000
2 10,000 11,000
3 10,000 11,000
4 10,000 11,000
5 10,000 11,000
50,000 55,000

 A profit maximization approach would favour product Y over product X. However, if product Y is
more risky than product X, then the decision is not as straightforward as the figures seem to
indicate. It is important to realize that a trade-off exists between risk and return.

 Stockholders expect greater returns from investments of higher risk and vice-versa. To choose
product Y, stockholders would demand a sufficiently large return to compensate for the
comparatively greater level of risk.
MV Sir

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Financial Distress And Insolvency

 There are various factors like price of the product/ service, demand, price of inputs e.g. raw
material, labour etc., which is to be managed by an organisation on a continuous basis.

 Proportion of debt also need to be managed by an organisation very delicately. Higher debt
requires higher interest and if the cash inflow is not sufficient then it will put lot of
pressure to the organisation. Both short term and long term creditors will put stress to the
firm.

 If all the above factors are not well managed by the firm, it can create situation known as
distress, so financial distress is a position where Cash inflows of a firm are inadequate to
meet all its current obligations.

 Now if distress continues for a long period of time, firm may have to sell its asset, even
many times at a lower price. Further when revenue is inadequate to revive the situation, firm
will not be able to meet its obligations and become insolvent.

 Insolvency basically means inability of a firm to repay various debts and is a result of
continuous financial distress.

MV Sir

Relationship Of Financial Management With Related Disciplines

Financial Management and Accounting
 Accounting is an important input in financial decision making or financial management function.
 Financial accounting generates information relating to operations of the organisation. The outcome of
accounting is the financial statements such as balance sheet, income statement, and the statement of
changes in financial position.
 The information contained in these statements and reports helps the financial managers in gauging the
past performance and future directions of the organisation.
 Some of the differences between financial management and accounting are:-

 In accounting, the measurement of funds is based on the accrual principle i.e. revenue & expense
is recognised at the point of sale or incurred, and not when actually collected or paid. An
organisation which has earned profit (sales less expenses) may said to be profitable in the
Treatment accounting sense but it may not be able to meet its current obligations due to shortage of
liquidity Such an organisation will not survive.
of Funds
 The treatment of funds in financial management is based on cash flows. The revenues are
recognised only when cash is actually received (i.e. cash inflow) and expenses are recognised on
actual payment (i.e. cash outflow).

 The purpose of accounting is to collect and present financial data of the past, present and future
Decision
operations of the organization. The financial manager uses these data for financial decision making.
making Thus, in a way it can be stated that financial management begins where accounting ends.
MV Sir

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Relationship Of Financial Management With Related Disciplines

 For its day to day decision making process, financial management also draws on other related disciplines such
as marketing, production and quantitative methods apart from accounting.

 For instance, financial managers should consider the impact of new product development and promotion
plans made in marketing area since their plans will require capital outlays and have an impact on the
projected cash flows.

 Likewise, changes in the production process may require capital expenditures which the financial managers
must evaluate and finance. Finally, the tools and techniques of analysis developed in the quantitative methods
discipline are helpful in analyzing complex financial management problems.

MV Sir

Agency Problem & Agency Cost

 Though in a sole proprietorship firm, partnership etc., owners participate in management but in
corporates, owners are not active in management so, there is a separation between owner/
shareholders and managers.

 In theory managers should act in the best interest of shareholders however in reality,
managers may try to maximise their individual goal like salary, perks etc., so there is a
principal agent relationship between managers and owners, which is known as Agency Problem.

 In a nutshell, Agency Problem is the chances that managers may place personal goals ahead
of the goal of owners. Agency Problem leads to Agency Cost.

 Agency cost is the additional cost borne by the shareholders to monitor the manager and
control their behaviour so as to maximise shareholders wealth. Generally, Agency Costs are of
four types (i) monitoring (ii) opportunity (iii) bonding (iv) structuring

MV Sir

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Addressing the agency problem

 The agency problem arises if manager’s interests are not aligned to the interests of the debt
lender and equity investors.

 The agency problem of debt lender would be addressed by imposing negative covenants i.e.
the managers cannot borrow beyond a point.

 Agency problem between the managers and shareholders can be addressed if the interests of
the managers are aligned to the interests of the share- holders. It is easier said than
done.

 However, following efforts have been made to address these issues:

 Managerial compensation is linked to profit of the company to some extent and also with
the long term objectives of the company.
 Employee is also designed to address the issue with the underlying assumption that
maximisation of the stock price is the objective of the investors.
 Effecting monitoring can be done.

MV Sir

For Knowledge Purpose

Agency Problem & Agency Cost

Monitoring  Cost of keeping a check on activities of management.

Cost  Expenses of audit & control procedures

 Cost of lost opportunity

Opportunity  There is a project that management can undertake but it may lead to termination
Cost of their jobs. However, shareholders are of the opinion that if company undertakes
the project it will improve the shareholders’ values and if the management rejects
the project it will have to face a huge loss in terms of shareholders’ stake.

Bonding  Contractual obligations are entered between the company and the agent. A manager
Cost continues to stay with a company even after it is acquired.

Structuring
 Cost incurred in structuring incentive plans. Eg- Employee stock option.
Cost

MV Sir

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Theoretical Questions in ICAI SM

1. POINT OUT the difference between Financial Management & Financial Accounting?

2. “Financial management is concerned with acquisition & financing of short term & long-
term credit”. ELABORATE.

3. DISCUSS the two main aspects of the finance function?

4. DISCUSS three main considerations in procuring funds?

5. EXPLAIN “Wealth maximisation” and “Profit maximisation” objectives of financial

management.

6. DISCUSS the role of a chief financial officer.

7. In recent years, there have been a number of environmental, pollution and other
regulations imposed on businesses. In view of these changes, is maximisation of
shareholder wealth still a realistic objective? EXPLAIN.

MV Sir

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