Financial Management

Module-1
Introduction to Financial Management
Business concern needs finance to meet their
requirements in the economic world.
Any kind of business activity depends on the finance.
Hence, it is called as lifeblood of business
organization.
The entire business activities are directly related with
making profit.
Increasing the profit is the main aim of any kind of
economic activity.
Meaning of Finance
Finance may be defined as the art and science of
managing money.
The concept of finance includes capital, funds, money,
and amount.
Khan and Jain, “Finance is the art and science of
managing money”.
Definition of Business Finance
Wheeler, “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”.
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”.
F.W.Paish, Finance may be defined as the provision of money
at the time it is wanted.
Parhter and Wert, “Business finance deals primarily with
raising, administering and disbursing funds by privately
owned business units operating in nonfinancial fields of
industry”.
 Definition of Financial Management
Solomon, “It is concerned with the efficient use of an important
economic resource namely, capital funds”.
S.C. Kuchal is that “Financial Management deals with procurement
of funds and their effective utilization in the business”.
Howard and Upton : Financial management “as an application of
general managerial principles to the area of financial decision-making.
Weston and Brigham : Financial management “is an area of financial
decision-making, harmonizing individual motives and enterprise
goals”.
Joshep and Massie : Financial management “is the operational
activity of a business that is responsible for obtaining and effectively
utilizing the funds necessary for efficient operations.
Thus, Financial Management is mainly concerned with the effective
funds management in the business.
Functions of Financial Management
Investment decisions- includes investment in fixed
assets (called as capital budgeting). Investment in
current assets are also a part of investment decisions
called as working capital decisions.
Evaluation of new investment in terms of profitability
Comparison of cut off rate against new investment and
prevailing investment.
 Financial decisions - They relate to the raising of
finance from various resources which will depend
upon decision on type of source, period of financing,
cost of financing and the returns thereby.
Dividend decision: The finance manager has to take
decision with regards to the net profit distribution. Net
profits are generally divided into two:
Dividend for shareholders- Dividend and the rate of it has
to be decided.
Retained profits- Amount of retained profits has to be
finalized which will depend upon expansion and
diversification plans of the enterprise.
Liquidity Decision: It is very important to maintain a
liquidity position of a firm to avoid insolvency. Firm’s
profitability, liquidity and risk all are associated with the
investment in current assets. In order to maintain a
tradeoff between profitability and liquidity it is important
to invest sufficient funds in current assets.
Scope of Financial Management
The definition and scope of financial management has
been changed from one period to another period and
applied various innovations.
Traditional Approach
Traditional approach is the initial stage of financial
management, which was followed, in the early part of
during the year 1920 to 1950.
Main part of the traditional approach is rising of
funds for the business concern.
Traditional approach consists of the following
important area.
Arrangement of funds from lending body.
Arrangement of funds through various financial
instruments.
Finding out the various sources of funds.
Modern approach
This approach is concerned not only with the raising of
funds, but their administration also. This approach
encompasses:
Determination of the sum total amount of funds to
employ in the firm.
Allocation of resources efficiently to various assets.
Procuring the best mix of financing – i.e. the type and
amount of corporate securities.
IMPORTANCE OF FINANCIAL
MANAGEMENT
Financial Planning
Acquisition of Funds
Proper Use of Funds
Financial Decision
Improve Profitability
Increase the Value of the Firm
Promoting Savings
OBJECTIVES OF FINANCIAL
MANAGEMENT
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.
Objectives of Financial Management may be broadly
divided into two parts such as:
Profit maximization
Wealth maximization.
Profit Maximization
Main aim of any kind of economic activity is 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.
Features of Profit Maximization
Profit maximization is also called as cashing per share
maximization. It leads to maximize the business
operation for profit maximization.
Ultimate aim of the business concern is earning profit,
hence, it considers all the possible ways to increase the
profitability of the concern.
Profit is the parameter of measuring the efficiency of the
business concern. So it shows the entire position of the
business concern.
Profit maximization objectives help to reduce the risk of
the business.
Favourable Arguments for Profit Maximization
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
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.
Drawbacks of Profit Maximization
It is vague: In this objective, profit is not defined
precisely or correctly. It creates some unnecessary
opinion regarding earning habits of the business concern.
It ignores the time value of money: Profit
maximization does not consider the time value of
money or the net present value of the cash inflow. It leads
certain differences between the actual cash inflow and net
present cash flow during a particular period.
It ignores risk: Profit maximization does not consider
risk of the business concern. Risks may be internal or
external which will affect the overall operation of the
business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches,
which involves latest innovations and improvements in
the field of 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
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.
Wealth Maximization
W= V-C

Where,
W= Net present worth
V= Gross Present Worth
C= Investment

V=E/K
Where,
E= Size of the future benefits
K= Capitalisation ( Discount) Rate
Unfavourable Arguments for Wealth Maximization
Wealth maximization is nothing, it is also profit
maximization, it is the indirect name of the profit
maximization.
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.
Functions of Finance Manager
Forecasting Financial Requirements
Acquiring Necessary Capital
Investment Decision
Cash Management
Interrelation with Other Departments
Relationships between Finance and other Disciplines

Financial Management and Economics: Economic

concepts like micro and macroeconomics are directly applied
with the financial management approaches.
Financial Management and Accounting: Accounting
records includes the financial information of the business
concern. But nowadays financial management and accounting
discipline are separate and interrelated.
Financial Management and Production Management:
Production management is the operational part of the business
concern, which helps to multiple the money into profit. The
financial manager must be aware of the operational process
and finance required for each process of production activities.
Relationships between Finance and other Disciplines

Financial Management and Marketing: Produced goods

are sold in the market with innovative and modern
approaches. For this, the marketing department needs
finance to meet their requirements.
Financial Management and Human Resource: Financial
management is also related with human resource
department, which provides manpower to all the functional
areas of the management.
Financial Management or Mathematics: Modern
approaches of the financial management applied large
number of mathematical and statistical tools and techniques.
Indian Financial System
 Financial System
Financial System encompasses a group of intermediaries
which facilitates the flow of funds from the areas of surplus
to the areas of deficit. It is a composition of various
institutions, markets and laws, practices, money managers,
analysts, transactions and claims and liabilities.
This facilitates the exchange of financial instruments like
deposits and loans, corporate stocks and bonds, government
bonds etc.
The financial system is the process by which money flows
from savers to users.
Meaning of financial system
Van Horne, “financial system allocates savings
efficiently in an economy to ultimate users either
for investment in real assets or for consumption”.
Prasanna Chandra, “financial system consists of a
variety of institutions, markets and instruments
related in a systematic manner and provide the
principal means by which savings are transformed
into investments”.
Financial System
Financial System
Financial markets and flow of funds relationship
Financial System
Financial System
Savers
Users
Financial Institutions
Financial Markets

Savings is a function of many variables.

Funds can be transferred between users and savers

directly or indirectly.
Functions of the Financial System
An efficient financial system
Encourages savings
Savings flow to the most efficient users
Implements the monetary policy of governments by
influencing interest rates
The combination of assets and liabilities comprising the
desired attributes of return, risk, liquidity and timing of
cash flows
Financial Concepts
Financial assets
Financial intermediaries
Financial markets
Financial rates of return
Financial instruments
Financial Assets
There should be creation or transfer of financial asset.
Classification of financial assets:
Marketable assets- easily transferred from one person to
another.
Non marketable assets-assets cannot be transferred
easily.
 Financial Assets

Financial
assets

Non
Marketabl
marketabl
e assets
e assets

Mutual
Govt. Debenture Bank LIC P.O .
Shares Bonds Funds P.F.
Securities s deposits Schemes Certficates
Units
Attributes of financial assets
Attributes of financial assets
Return or yield
 Total financial compensation received from an investment
expressed as a percentage of the amount invested
Risk
 Probability that actual return on an investment will vary from the
expected return
Liquidity
Ability to sell an asset within reasonable time at current
market prices and for reasonable transaction costs
Time-pattern of the cash flows
When the expected cash flows from a financial asset are
to be received by the investor or lender
Classification of Assets
Cash Assets
Debt Assets
Stock Assets
Financial Instruments
Equity
Ownership interest in an asset
Residual claim on earnings and assets
 Dividend
 Liquidation
Types
 Ordinary share
 Hybrid (or quasi-equity) security
 Preference shares
 Convertible notes
Financial Instruments
Debt
Contractual claim to
 Periodic interest payments
 Repayment of principal
Ranks ahead of equity
Can be secured or unsecured

Four basic derivative contracts

Futures
Forward
Option contract
Swap
Financial Instruments
Those documents which represents financial claim on
assets.
Primary or direct securities
Secondary or indirect securities
Primary Securities: These securities directly issued by
the ultimate users to the ultimate savers.
Secondary Securities: These securities directly issued by
the ultimate intermediaries to the ultimate savers. Short,
medium and long term.
Characteristic features of financial
instruments
 Most of the instruments can be easily transferred from one
hand to another.
 They have a ready market.
 They possess liquidity
 Most of the securities possess security value.
 Some securities enjoy tax status.
 They carry risk.
 The return of these instruments is directly in proportion to
the risk undertaken.
 These instruments may be short or medium or long term
depending upon the maturity period of these instruments.
Financial Intermediaries
Includes all kind of organization which intermediate
and facilitate financial transactions of both individual
and corporate customers.
Capital Market Intermediaries- provide long term funds.
Ex: LIC, FIs
Money Market Intermediaries- supply only short term
funds. Ex: Banks
 Financial Intermediaries In India

Financi
al
Interm
ediarie
s In
India
Organi Unorga
zed nized
Sector Sector

Capital Money Trader

Money Indigen Pawn
Market Market s and
Lender ous Broker
Interme Interme landlor
diaries diaries s banker s
ds
Agricul
Insura ture
Develo Comm Cooper
nce Financi Govern EXIM Govern
pment UTI IRBI NBFC RBI ercial ative
Compa ng ment Bank ment
Banks Instituti Bank Bank
nies
ons
Hire
Invest Financ
Purcha Leasing ment e
se
Role and Importance of Financial System
in Economic Development
It links the savers and investors. It helps in mobilizing
and allocating the savings efficiently and effectively.
It promotes the process of capital formation.
Financial Instruments
Debt
Contractual claim to
 Periodic interest payments
 Repayment of principal
Ranks ahead of equity
Can be secured or unsecured
Financial Markets
A financial market can be defined as the market in
which financial assets are created or transferred.
Money Market- for short-term funds (less than a
year)
Organised (Banks)
Unorganised (money lenders, chit funds, etc.)
Capital Market- for long-term funds
Primary Issues Market
Stock Market
Bond Market
 Importance of capital market
The capital market serves as an important source for the productive use
of the economy's savings.
It provides incentives to savings and facilitates for capital formation.
It provides avenue for investors.
It facilitates increase in production and productivity in the economy thus
enhances the economic welfare of the society.
The operations of different institutions in the capital market induce
economic growth.
A healthy capital market consisting of expert intermediaries
promotes stability in values of securities representing capital funds.
It serves as an important source for technological up gradation in
the industrial sectors.
Industrial securities
Industrial securities market consists of New Issues
Market and Stock Exchange.
The new issues market encompasses all institutions
dealing in fresh claim.
The stock exchange is market for those which have
been already issued and listed on a stock exchange.
Functions of New issues market
The main function of new issue market is to
facilitate transfer of resources from savers to the
users.
The NIM can be classified as:
IPOs: firms go to the public for the first time.
FPOs: raise additional capital.
The main functions:
Origination
Underwriting
Distribution
Origination
 The work of investigation, analysis and processing of new
project proposals
 A careful study of the technical, economic and financial
viability to ensure soundness of the project.
 Advisory services which improve the quality of capital
issues and ensure its success.
 The advisory services includes:
 Types of issues
 Magnitude of issues
 Time of floating an issues
 Pricing of an issue
 Methods of issue
 Underwriting
Is an agreement whereby the underwriter promises to
subscribe to a specified number of shares or
debentures or a specified amount of stock in the event
of public not subscribing to the issue.
If the issue is fully subscribed then there is no liability
for the underwriter.
Methods of underwriting
 Standing behind the issue: the underwriter guarantees the sale of
a specified number of shares within a specified period. If the
public do not subscribe to the specified amount of issue, the
underwriter buys the balance in the issue.
 Outright purchase: in this method makes outright purchase of
shares and resells them to the investors.
 Consortium method: underwriting is jointly done by a group of
underwriters. Underwriters form a syndicate.
Advantages of underwriting
 The issuing company is relieved from the risk of finding
buyers for the issue.
 The company is assured of getting the minimum
subscription within stipulated time.
 Underwriters undertake the burden of highly specialized
function of distributing securities.
 They provide expert advice with regard to timing of
security issues, pricing and size and type of issue.
 Public confidence on the issues is enhanced when
underwritten is done by reputed underwriters.
Types of underwriters
Institutional Underwriters: IDBI,ICICI
Non Institutional Underwriters: Brokers

Distribution
Is the function of sale of securities to ultimate investors.
Methods of floating New issues:
 Public issues
 Offer for sale
 Placement
 Rights issues
 Issues

Rights Bonus Private

Public Issue Issue
Issue Placement

Initial Public Further Public

Offer(IPO) Offer(FPO) Preferential
Issues
Fresh Issue Fresh Issue

Offer for Qualified

Sale Offer for Sale Institutiona
l Placement
Public issues

 The issuing company directly offers to the general public/

institutions a fixed number of shares at a stated price through
document called prospectus.
 The prospectus must state the following:
 Name of the company
 Address of the registered office of the company
 Existing and proposed activities.
 Location of the company
 Name of the directors
 Authorized and proposed issue capital to the public
 Dates of opening and closing the issue
 Names of brokers/ underwriters/ bankers/ managers and registers to the issue.
 A statement by the company that it will apply to the stock exchange for
quotations of its shares.
Merits of issue through prospectus
Sale through prospectus has the advantage of inviting a
large section of the investing public through
advertisement.
It is a direct method and no intermediaries are
involved in it.
Share, under this method are allotted to a large section
of investors on a non discriminatory basis. Avoids of
concentration of power in few hands.
Demerits

It is an expensive method.

This method is suitable only for large issues.
Offer of sale
 Outright sale of securities through the intermediary of issue houses or
brokers.
 Shares are not offered directly to the public.
 Direct sale by the issuing company to the issue houses or stock brokers
at an agreed price.
 The intermediaries resell the above securities to the ultimate investors
at a higher price.
 Advantages:
 Obtain funds with a minimum cost without the fear of under subscription.
 company is relieved from the problem of printing and advertisement of
prospectus.
 Private Placement
The issue houses or brokers buy the securities outright with
the intention of placing them with their clients afterwards.
Advantages:
 Is useful method of flotation of shares irrespective of timing of issue.
 This method is suitable when small companies issue their shares.
 It avoids delays involved in public issues and also reduces the
expenses involved in public issue.
 There are no entry barriers for a company to access the private
placement market.
 There is greater flexibility in the working out the terms of issue.
 This method is also suitable to first generation entrepreneurs.
Rights issue
Is method of raising funds in the market by an existing
company.
A right mean an option to buy certain securities at a certain
privileged price within a certain specified period. Share, so
offered to the existing shareholders are called rights shares.
Advantages:
 The cost is minimum. There is no underwriting, brokerage,
adverting and printing of prospectus expenses.
 It ensures equitable distribution of shares to all existing
shareholders and so control of company remains undisturbed as
proportionate ownership in the company remains the same.
 Money market
Market for dealing with financial assets and securities which
have a maturity period up to one year.
Call money market
Commercial bills market
Treasury bills market
Short term loans market
Call Money market: Extremely short period. 1-14 days.
Commercial bills market: Bills of exchange market.
Treasury bills market: Ordinary treasury bills are issued to the
public banks and other financial institutions. Ad hoc treasury
bills are issued in favour of the RBI. 91, 182 and 364 Days.
Short term loans market: are given to corporate customers for
meeting their working capital requirements. Banks.
 Foreign Exchange Market
Process of converting one national currency into another.
Functions:
To make necessary arrangements to transfer.
To provide adequate credit facilities for the promotion of foreign
trade.
To cover foreign exchange risks by providing hedging facilities.
Trading between banks and their commercial customers.
Trading between banks through authorized brokers.
Trading with banks abroad.
 Forex Market- Types of transactions
Spot Transactions: An inter-bank transactions whereby the
purchase of foreign exchange, and delivery and payment
for the same takes place between banks on the following
second business day is referred to as ‘spot transaction’ and
the rate quoted in such transaction is called ‘spot rate’. The
date of settlement is known as value date.
Forward Transaction: Where a specified amount of one
currency is exchanged for a specified amount of another
currency at a future value.

Financial rates of return

Rate of returns is very important for the investors.
Emerging Issues in Financial
Management
Derivatives
A derivative is a financial instrument whose value
derives from the value of underlying asset or
something else.
A derivative is a financial instrument whose value
derives from the value of something else, generally
called the underlying(s).
Underlying: a barrel of oil, a financial asset, an interest
rate, the temperature at a specified location.
Derivative markets
Have a long history.
Futures markets: date back to the Middle Ages.
Options markets: date back to 17th century Holland.
Last 35 years: extraordinary growth worldwide.
Today: derivatives are used to manage risk exposures
in interest rates, currencies, commodities, equity
markets, the weather.
Types of Derivatives
Forward
Futures
Options and
Swaps
Forward contract
A forward contract is an agreement between two
parties, a buyer and a seller, to exchange an asset at a
later date for a price agreed to in advance, when the
contract is first entered into.
We call this price the delivery price.
Trades in the OTC market.
Futures contract
A futures contract is an agreement between two
parties, a buyer and a seller, to exchange an asset at a
later date for a price agreed to in advance, when the
contract is first entered into.
We call this price the futures price.
Trades on a futures exchange.
Options
An option gives the buyer the right, but not the
obligation, to buy/sell the underlying at a later date for
a price agreed to in advance, when the contract is first
entered into.
We call this price the strike/exercise price.
The option buyer pays the seller a sum of money
called the option price or premium.
Trades OTC or on an exchange.
Types of options
Call option: an option to buy the underlying at the
strike price
Put option: an option to sell the underlying at the strike
price
American options can be exercised at any time up to
the expiration date.
European options can be exercised only on the
expiration date itself.
Most of the options that are traded on exchanges are
American.
Swaps
A swap is a derivative contract through which two
parties exchange financial instruments. These
instruments can be almost anything, but most swaps
involve cash flows based on a notional principal
amount that both parties agree to.
EX: Interest rate swap, currency swap
Traders of derivatives
Hedgers are in the position where they face risk
associated with the price of an asset. They use
derivatives to reduce or eliminate this risk.
Speculators wish to bet on future movements in the
price of an asset. They use derivatives to get extra
leverage.
Arbitrageurs are in business to take advantage of a
discrepancy between prices in two different markets.
 Risk management
Risk management (RM) is the process by which
various risk exposures are identified, measured, and
controlled.
Risk management process
1. Identify a company’s current risk profile and set a
target risk profile.
2. Achieve the target risk profile by coordinating
resources and executing transactions.
3. Evaluate the altered risk profile.
Risk management
Risk management has gained prominence in the last 35
years:
Increased market volatility.
Deregulation of markets.
Globalization of business.
Behavioural Finance
Behavioural finance is the study of the influence of
psychology on the behaviour of financial practitioners
and the subsequent effect on markets. Behavioural
finance is of interest because it helps explain why and
how markets might be inefficient.
Behavioral finance is a relatively new field that seeks
to combine behavioral and cognitive psychological
theory with conventional economics and finance to
provide explanations for why people make irrational
financial decisions.
 Financial Modelling
The process by which a firm constructs a financial representation of some, or
all, aspects of the firm or given security. The model is usually characterized
by performing calculations, and makes recommendations based on that
information. The model may also summarize particular events for the end
user and provide direction regarding possible actions or alternatives.
Financial modeling is the task of building an abstract representation (a model)
of a real world financial situation. This is a mathematical model designed to
represent (a simplified version of) the performance of a financial asset or
portfolio of a business, project, or any other investment.
Financial Modeling is a tool that can be used to forecast a picture of a security
or a financial instrument or a company’s future financial performance based
on the historical performance of the entity. Financial Modeling includes
preparing of detailed company specific models which are then used for the
purpose of decision making and performing financial analysis.
 Financial Engineering
Financial engineering is the use of mathematical techniques to
solve financial problems. Financial engineering uses tools and
knowledge from the fields of computer science, statistics,
economics and applied mathematics to address current financial
issues as well as to devise new and innovative financial products.
Financial engineering is sometimes referred to as quantitative
analysis and is used by regular commercial banks, investment
banks, insurance agencies and hedge funds.
Financial engineering is the application of mathematical methods
to the solution of problems in finance. It is also known as financial
mathematics, mathematical finance, and computational finance.
Financial engineering draws on tools from applied mathematics,
computer science, statistics, and economic theory.