Financial Management1

Financial Management
Finance
• Blood of business
• Promote or establish business

– Acquire assets
– Make necessary investigation
– Develop product
– Keep man & machine working
– Make progress & create values
Financial Management
• Def:
– Application of Planning and Control function of
finance function
– Concerns the acquisition, financing and

management of assets with some overall goal
in mind.
Key decisions
• Investment
• Financing
• Dividend
Investment Decisions
Most important of the three decisions.
• What is the optimal firm size?
• What specific assets should be acquired?
• What assets (if any) should be reduced or

eliminated?
Financing Decisions
Determine how the assets (LHS of balance
sheet) will be financed (RHS of balance
sheet).
• What is the best type of financing?
• What is the best financing mix?
• What is the best dividend policy (e.g., dividend-payout

ratio)?
• How will the funds be physically acquired?

Asset Management Decisions
• How do we manage existing assets efficiently?
• Financial Manager has varying degrees of

operating responsibility over assets.
• Greater emphasis on current asset

management than fixed asset management.
What is the Goal of
the Firm?
Maximization of
Shareholder Wealth!
Value creation occurs when we
maximize the share price for current
shareholders.
Shortcomings of Alternative
Perspectives
Profit Maximization
 Maximizing a firm’s earnings after taxes.
Problems
• Could increase current profits while harming firm
(e.g., defer maintenance, issue common stock to
buy T-bills, etc.).
• Ignores changes in the risk level of the firm.

Shortcomings of Alternative
Perspectives
Earnings per Share Maximization
 Maximizing earnings after taxes divided by
shares outstanding.
Problems
• Does not specify timing or duration of expected
returns.
• Ignores changes in the risk level of the firm.
• Calls for a zero payout dividend policy.
Strengths of Shareholder
Wealth Maximization
• Takes account of:
– current and future profits and EPS;
– the timing, duration, and risk of profits and EPS;
– dividend policy;
– all other relevant factors.
• Thus, share price serves as a barometer for

business performance.
Organization of the Financial
Management Function
Board of Directors
President
(Chief Executive Officer)
Vice President VP of Vice President

Operations Marketing
Finance
Organization of the Financial
Management Function
VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
Cost of capital
Rate of return it must earn on its investments for
market value of firm to remain unaffected
or
Rate of return required by investor on capital
– Estimate cost of capital required

– Decision on leasing, long-term financing and working
capital policy
– To maximize: cost of inputs should be minimized
Evaluation of cost of capital
• Long term funds point of view
– Components
• Equity
• Preference capital
• Long term debt
• Deferred
n credits
k   wi ki
k=avg. cost of capital
wi= prop. Or wt. of ith source
i 1 ki=cost of ith source
Cost of specific source
• Rate of discount which equates present value of
expected payments to that source with net funds
received n
Ct
P
i 1 (1  k )
t
• P=net funds received

• Ct=expected payment to the source at the end of year t
• n= maturity period
Financial appraisal
• Valuation of project worth
– Discounting
• NPV
• B-C Ratio
• IRR
– Non-discounting
• Urgency
• Payback period
• Accounting rate of return
NPV
CF0 CF1 CF2 CFn
NPV     ....... 
(1  k ) (1  k ) (1  k )
0 1 2
(1  k ) n
• CFt= cash flow at the end of year t

• n = life of project
• k = cost of capital
NPV
• Accept if NPV is “+”  earn excess return
• Reject if NPV is “-”
• NPV =0  cash flow just enough to recoup the

investment
• Assumption
– Intermediate cash flow reinvested
Benefit cost ratio
PVB
BCR 
I
PVB = present value of benefits
I = investments
NBCR = net benefit cost ratio
PVB
NBCR  1
I
IRR
• Rate of return of unrecovered investment balance
• Rate of return on initial investment
CF0 CF1 CF2 CFn
0    .......
(1  k ) (1  k ) (1  k )
0 1 2
(1  k )n
F t  F t  1 (1  r )  CF t
• Ft = unrecovered investment balance at the end of year t

Liquidity ratio
• Current ratio
• Acid test ratio

Quick assets to current liabilities
• Bank finance to working capital gap ratio

ST borrowings to working capital gap
• Interval measure
Quick assets to avg. daily exp.

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Financial Management

• Promote or establish business

– Concerns the acquisition, financing and

• What is the optimal firm size?

• What specific assets should be acquired?

• What assets (if any) should be reduced or

• What is the best financing mix?

• What is the best dividend policy (e.g., dividend-payout

• How will the funds be physically acquired?

• How do we manage existing assets efficiently?

• Financial Manager has varying degrees of

• Greater emphasis on current asset

• Ignores changes in the risk level of the firm.

• Thus, share price serves as a barometer for

Vice President VP of Vice President

– Estimate cost of capital required

• P=net funds received

• CFt= cash flow at the end of year t

• Reject if NPV is “-”

• NPV =0  cash flow just enough to recoup the

• Ft = unrecovered investment balance at the end of year t

• Acid test ratio

• Bank finance to working capital gap ratio

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