Impact of Other Disciplines on Financial Management

Financial Decision Areas Primary Disciplines

1)Investment Analysis 1) Accounting
2)Working Capital Support 2) Macro Economics
Management 3) Micro Economics
3)Sources and Cost of
Funds
4)Determination of Other related Disciplines
Capital structure 1) Marketing
Support
5)Dividend Policy 2) Production
6)Analysis of Risk and 3) Quantitative methods
Returns
Result

Share Holders Wealth

Maximisation
 Meaning of Financial Management

It is the application of general managerial

principles to the area of financial management.

Financial Management is the operational

activity of a business that is responsible for
obtaining and effectively utilising the funds
necessary for efficient operations.

It is an area of financial decision making

which harmonises individual motives and
enterprise goals.
 Scope of Financial Management

Traditional Approach :
At the initial stages of the evolution of FM, it was
described as ‘Corporation Finance’, means financing of
corporate enterprises.
In the narrow sense, it was treated as procurement
of funds by the corporate enterprises to meet their
financial needs – It was simply a process of raising funds.
It encompasses :
1) the institutional arrangements in the form of
Financial Institutions.
2) the financial instruments through which the
funds can be raised.
3) the legal and accounting relationship between
the firm and its sources of funds.
Thus, Financial Management was considered as
how the resources could best be raised from the
combination of the available sources.

It was criticised because it was confined to the

issue of procurement of funds

The focus was on the financial problems of

corporate enterprises – to that extent it was
limited to industrial enterprises and the non-
corporate enterprises are out of the purview.

It deals with the problem of long term financing.

Modern Approach :
Finance function covers both acquisition of funds as
well their allocations.
Apart from the issues involved in acquiring funds, the
main concern is the efficient and wise allocation of
funds to various uses.

The main contents of this approach are :

1) What is the total volume of funds an enterprise should
commit?
2) What specific assets should an enterprise acquire?
3) How should the funds required be financed?

Solution of these three major financial problems is the

subject matter of Modern Financial Management.
Financial Management, in the modern sense of the
term, can be broken down into three major
decisions as functions of finance:

1)The Investment Decisions

2)The financing Decisions
3)The Dividend Policy Decisions

1) Investment Decisions relates to the selection of

assets in which funds will be invested by a firm.

The assets acquired fall into two broad

groups :
a) Long term assets which yield a return over a
period of time in future
b) Short term or current assets, are those
assets which are easily convertible into cash
with in a year, without losing any value.

In the financial literature, the first one is

known as ‘Capital Budgeting’ ;
The second is known as ‘Working Capital
Management’
2) Financing Decisions :
It is the financing-mix or capital
structure or leverage
Capital Structure refers to the
proportion of Debt to Equity.
It is the choice of these proportions
There should be a proper balance
between debt and equity to ensure trade
off between risk and returns to the share
holders.
A capital structure with a reasonable
proportion of debt and equity is called the
optimum capital structure.
3)Dividend Policy Decisions :
Profits can be either ;
a)Distributed as dividends to the share holders ; or
b)They can be retained in the business itself.

The dividend pay-out ratio will determine what

proportion of net profits should be paid out to the
share holders.

Another aspect of dividend decision is the

factors determining dividend policy of a firm in
practice.
Objectives of Financial Management :

1)Profit Maximisation decision criterion:

Those actions which increases profit
should be undertaken and those which
decreases profits are to be avoided.

This criterion implies that the

investment, financing and dividend policy
decisions of a firm should be oriented to
the maximisation of profits.
What is profit?
- As a owner oriented concept - It refers to
the amount and share of national income
which is paid to the owners
 As a variant, it is the profitability - it signifies the
economic efficiency.

Profitability refers to a situation where output

exceeds input, ie. the value created by the use of
resources is more than its total input.

Select those projects which are profitable and

reject those which are not.

Which is acceptable ?
In the present financial literature, profit is used in the
second sense.

Profit is the yardstick by which economic

performance can be judged.
Efficient utilisation of resources in terms of
profitability - It provides maximum social welfare.
 Financial Management is concerned with the efficient
use of an important economic input, namely Capital.
Therefore, it is argued that profit maximisation should
serve as the basic criterion for financial management
decisions.

The main technical flaws of this criterion for financial

decision making are :

a) Ambiguity : the term ‘profit’ is a vague and ambiguous

concept – different interpretations are there for it –
profit may be short term or long term, it may be total
profit or rate of profit, before tax or after tax, it may be
return on total capital employed or on total assets or
on share holders funds.
The question arises, which of these variant is to be
taken.
b) Timings of benefit : It ignores the differences in the time pattern of
the benefits received from the investment proposals.
Time – pattern of benefits ( profits )
Alternative A Alternative B
( Rs. In Lakhs ) ( Rs. In Lakhs )

Period I 50 -
Period II 100 100
Period III 50 100
Total 200 200

“ Bigger the Better or “ Earlier the Better”

c) Quality of benefits : It ignores the quality of benefits associated
with financial course of action. Quality refers to the degree of
certainty with which benefits can be expected.
Uncertainty about expected benefits ( profits )
Alternative A Alternative B
( Profits Rs. In Crores ) ( Profits Rs. In Crores )

Recession Period 9 0
Normal Period 10 10

Boom Period 11 20

Total 30 30

There is wide range of variation in alternative B

There is uncertainty in the earnings, hence it is risky.

Obviously, alternative A is better in terms of risk and

uncertainty.
The profit maximisation criterion fails to reveal this.
2) Wealth Maximisation Decision Criterion :

It is also known as net present worth maximisation

or value maximisation.
This is accepted as an appropriate operational
decision criterion for financial management decisions
because it satisfies all the three requirements of exactness,
quality of benefits and the time value of money.
The value of an asset can be viewed in terms of the
benefits it can produce.
The worth of a financial course of action is judged in
terms of the value of the benefits it produces less the cost
incurred for undertaking it.
Wealth maximisation criterion is based on the
concept of cash flows generated by the financial decision
rather than the accounting profit.
Cash Flow is the first operational feature of wealth
maximisation criterion.
 The second important feature of this criterion is
that it considers both the quantity and quality dimensions
of benefits. It also incorporates the time value of money.
The benefits emanating from a financial decision is
adjusted by discounting its element back to the present at
a capitalisation rate ( discount rate ) that reflects both
time and risk.
In applying the value maximisation criterion , the
term value is used in terms of worth to the owners, that is
the ordinary share holders.
The discount rate that is employed is, therefore, the
rate that reflects the time and risk preferences of the
owners or suppliers of capital.
The wealth Maximisation criterion is superior to
Profit maximisation because it compares value with cost
and it reflects both time and risk.
Actions with less value than cost will reduce the
wealth and should be rejected.
 Wealth or Net Present Worth is the difference
between gross present worth and the amount of capital
investment required to achieve the benefits being
discussed.
Any financial action which creates wealth or which
has a net present worth above zero is a desirable one and
should be undertaken.
Therefore, the focus of financial management is on
the value to the owners or suppliers of equity capital.
The wealth of owners is reflected in the market
value of shares. So wealth maximisation implies the
maximisation of the market price of shares.
Using Ezra Solomon’s symbols and methods, the net
present worth can be calculated as shown below :

W=V–C

Where : W = Net Present Worth

V = Gross Present Worth
C = Investment ( Equity Capital ) required
to acquire the asset or to purchase the course of action.

E
V= -----
K

Where : E = Size of future benefits available to the

suppliers of the input capital
K = The capitalisation ( discount ) rate
reflecting the quality and timing of benefits attached to E
 E=G–(M+I+T)

Where : G = Average future flow of gross annual

earnings expected from the course of action, before
maintenance charges, taxes and interest and other
charges like preference dividend.
M = Average annual reinvestment
required to maintain G at the projected level.
T = Expected annual outflow on
account of taxes.
I = Expected flow of annual paymnets
on account of interest, preference dividend and other
charges
Conflict of Goal between Management and Owners :