Strategic Financial Management (AcFn 621)

Course Contents
1. Overview of Financial Management:
1.1. Definition of Financial Management
1.2. Scope of Finance
1.3. Financial Management Decisions
1.4. Goal of the Firm: Profit vs. Wealth
1.5. Role of Corporate Finance Manager
1.6. The Agency Relationship
2. Assessing the Financial Health of A firm
2.1 Overview of the basic financial statement
2.1.1 The Balance Sheet
2.1.2 The Income Statement
2.1.3 Statement of Retained Earnings
2.2 Interpretation and analysis of financial ratios
3. Planning Future Financial Performance
3.1 Financial Forecasting
3.2 Pro Forma statements & financial planning
4. Valuation of Financial Assets:
4.1 Introduction to the time value of money
4.2 Cost of Capital
4.3 Bond Valuation
4.4 Stock Valuation
5. Risk and Return
5.1 Introduction to risk and return
5.2 Standalone risk and return
5.3 Risk and return of a portfolio
6. Investment Decisions /Capital Budgeting decisions/:
6.1. The concept of capital budgeting
6.2. Investment appraisal techniques
6.3. Non-Discounting Cash Flow Techniques
6.4 Discounted Cash Flow Techniques
6.5 Comparison of IRR and NPV
7. Long-term Financing and capital structure
7.1 Long-term Financing
7.2 The concept of capital structure
7.3 Theories of capital structure
8. Dividend Policy
8.1 Concepts of dividend
 Chapter 1
Introduction to Financial Management
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1.1. Definition of Financial Management
1.2. Scope of Finance
1.3. Financial Management Decisions
1.4. Goal of the Firm: Profit vs. Wealth
1.5. Role of Corporate Finance Manager
1.6. The Agency Relationship
1.1. What is Financial Management?
 Financial management is a managerial activity which is concerned
with the planning and controlling of the firm’s financial resources.
 “Financial Management deals with procurement of funds and
effective utilization resources in the business”.
 Relation of Finance and Related Disciplines
• Financial management, as an integral part of management, is not a
totally independent area.
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• It draws heavily on related disciplines and fields of study such as
Accounting, Economics, Marketing, Production, and Quantitative
models.
Finance and Accounting
• Finance and accounting functions are closely related.
• Finance and accounting are often considered indistinguishable or at
least substantially overlapping.
Relationship
• Accounting is referred to as an input to the finance functions through
the financial statements it provides.
• I.e. finance generally begins where accounting ends.

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 Differences

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 Finance and Economics
• Firm grounding in micro-economic principles sharpens his/her analysis of
decision alternatives.
•6 Finance, in essence, is applied micro-economics.
• For example, the principle of marginal analysis – a key principle of micro-
economics according to which a decision should be guided by a comparison of
incremental benefits and costs– is applicable to a number of managerial decisions
in finance.
Relationship of finance with other management functions
• Apart from economics and Accounting, finance also draws for its day to day
decisions on supportive disciplines such as marketing, production and
quantitative methods.
• Almost all kinds of business activities, directly or indirectly, involve the
acquisition and use of funds.
• And hence, finance is considered as a life blood of any organization.
• Marketing, production and quantitative methods are only indirectly
related to day to day decision making by financial manager and are
supportive in nature while economics and accounting are the
primary disciplines on which the financial 04/20/2024
manger draws
 1.2. Scope of Finance
 What are a firm's financial activities?
 How are they related to the firm's other activities?
• The three most important activities of a business firm are: Production, Marketing and
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Finance.
• A firm secures whatever capital it needs and employs it (finance activity) in activities which
generate returns on invested capital (production and marketing activities).
• A firm needs real assets to carry on its business. Real assets can be tangible or intangible.
• The firm sells financial assets or securities, such as shares and bonds or debentures, to
investors in capital markets to raise necessary funds.
• Funds applied/allocated to assets by the firm are called capital expenditures or investment.
• The firm expects to receive return on investment and distribute return as dividends to
investors.
• The raising of capital funds and using them for generating returns and paying returns to the
suppliers of funds are called the finance functions of the firm.
• There are two types of funds that a firm raises: equity funds and borrowed funds.
• A company can also secure funds by retaining a portion of the returns available for
shareholders. This method of acquiring funds is called retained earnings.
• The funds raised by a company will be invested in the available investment opportunities.

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1.3. Financial Decisions(functions) In A Firm
 A firm performs finance functions simultaneously and continuously in the

normal course of the business. While performing the finance functions,

8 the financial manager should strive to maximize the value of shares.

 They do not necessarily occur in a sequence. Finance functions call for

skillful planning, control and execution of a firm's activities.

 There are four finance functions or decision areas of finance:-

1. Investment decision
2. Financing decision
3. Dividend decision
4. Liquidity decision
1. Investment decision
• Investment decision involves the decision of allocation of capital or
commitment of funds to long term assets like plant and machinery that would
yield benefits in the future.
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2. Financing decision
 Once a firm has decided the investment projects it wants to undertake, it has to

figure out ways and means of financing them.

 Generally, the central issue of financing decision is to determine the appropriate

proportion of equity and debt. The mix of debt and equity is known as the firm’s
capital structure decision.
 The key issues in capital structure decisions are:

 What is the optimal debt-equity ratio for the firm?

 Which specific instruments of equity and debt finance should the firm
employ?
 Which capital markets should the firm access?
 When should the firm raise finances?
 At what price should the firm offer its securities?

• The objective should be to minimize the cost of financing without impairing

the ability of the firm to raise finances required for value creating investment
3. Dividend decision
• Dividend decision is the third major financial decision. The financial
manager must decide whether the firm should distribute all profits, or
10 retain them, or distribute a portion and retain the balance.

4. Liquidity decision
 It is also known as Working capital management.
 It also referred to as short-term financial management, refers to the day-
to-day financial activities that deal with current assets and current liabilities.
 Current assets should be managed efficiently for safeguarding the firm
against the dangers of illiquidity and insolvency.
 Investment in current assets affects the firm's profitability, liquidity and risk.
• The key issues in working capital management are:
• What is the optimal level of inventory for the operations of the firm?
• Should the firm grant credit to its customers and, if so, on what
terms?
• How much cash should the firm carry on hand?
• Where should the firm invest its temporary cash surpluses?
 Summary of Financial Decisions
 Capital budgeting
11  What long-term investments or projects should the
business take on?
 Capital structure
 How should we pay for our assets?
 Should we use debt or equity?
 Dividend decision
 What to do regarding the profit?
 whether the firm should distribute all profits, or retain
them or distribute a portion and retain the balance.
 Working capital management
 How do we manage the day-to-day finances of the firm?
 1.4. Goal of the Firm: Profit Vs Wealth
Goal of Financial Management
 In order to make the firm's financial decisions rationally, the firm must have a

12 goal.

 There are two widely-discussed alternative approaches which can be used as a

decision criterion for the maximization of owners' economic welfare:

(i) Profit maximization approach, and
(ii) Wealth maximization approach.
Profit maximization approach
 According to this approach, actions that increase profits should be

undertaken and those that decrease profits are to be avoided.

 Some people believe that firm’s objective is to maximize profits, as measured

by the earning per share(EPS). To achieve this goal, the financial manager
would take only those actions that were expected to contribute to the firms
overall profit.
 In specific operational terms, as applicable to financial management, the profit

maximization criterion implies that the investment, financing and dividend

policy decisions of a firm should be oriented to the maximization of profits.
• Is profit maximization an operationally feasible criterion?
• The answer is no b/s it fails to serve as an operational criterion for maximizing the
owners' economic welfare due to the following drawbacks:
1.13 Ambiguity
 The term profit is a vague and ambiguous concept. It has no precise connotation. It
is amenable to different interpretations by different people.
2. It ignores Timing of benefits ( time value of money)
 Profit maximization ignores the time value of money. I.e. It ignores the differences
in the time pattern of the benefits received from investment proposals or courses
of action.
 While working out profitability, 'the bigger the better' principle is adopted, as the
decision is based on the total benefits received over the working life of the asset,
irrespective of when they were received
3. Quality of benefits
 It ignores the quality aspect of benefits associated with a financial course of action.
The term quality here refers to the degree of certainty with which benefits can be
expected.
 As a rule, the more certain the expected return, the higher is the quality of the
benefits. Against it, uncertain and fluctuating return implies risk to the investors.
Wealth Maximization Approach
 It is also termed as value maximization or net present worth

maximization. In current academic literature value maximization is

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almost universally accepted as an appropriate operational decision
criterion for financial management decisions.
 Its operational features satisfy all the three requirements of a suitable

operational objective of financial courses of action, namely,

 exactness,
 quality of benefits and
 the time value of money.
• The wealth of corporate owner is measured by the share price of the
stock, which in turn is based on the timing of returns, their magnitude
and their risk.
• Simply SWM means maximizing the NPV (wealth) of a course of
action to stockholders.
1.5. Role of Corporate Finance Manager
• Financial management is in many ways an integral part of the jobs of managers
who are involved in planning, allocation of resources, and control.
•15 The responsibilities for financial management are dispersed throughout the
organization. For example:
• The technocrat who proposes a new plant shapes the investment policy
of the firm.
• The marketing analyst provides inputs in the process of forecasting and
planning.
• The purchase manager influences the level of investment in inventories.
• The sales manager has a say in the determination of the receivables
policy.
• Departmental managers, in general, are important links in the financial
control system of the firm.
• There are many tasks of financial management which are specialized in nature
and which are attended to by specialists.
• These tasks and their typical distribution between the two key financial officers
of the firm, the treasurer and the controller.
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• Note that the treasurer is responsible mainly for financing and investment
 Functions of the Treasurer and the controller
Treasurer Controller
Obtaining finance Financial accounting
Banking relationship Internal auditing
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Cash management Taxation
Credit administration Management accounting and control
Capital budgeting
Organization of Finance function

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• In general, a financial mangers perform financial analysis and
planning
• Assess the financial performance of the business
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• Assess the funds requirement
• Identify the sources of funds
• Allocation of funds and income
• Controlling the utilization of funds
• Provide leadership in the cost-effective use of financial resources.
• Involve actively in organizational decision making (I/F/D) by
providing timely and reliable information.
• Prepare financial plan at the time of new business promotion
• Prepare financial readjustment during liquidity crises
• Valuation of enterprise at the time of merger or reorganization
• Other non-recurring activities of greater financial implications

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1.6. The Agency Relationship
 If you are the sole owner of a business, then you make the decisions
that affect your own well-being. But what if you are a financial
18 manager of a business and you are not the sole owner? In this case,

you are making decisions for owners other than yourself; you, the
financial manager, are an agent.
 An agent is a person who acts for—and exerts powers of—another
person or group of persons.
 The person (or group of persons) the agent represents is referred to as
the principal. The relationship between the agent and his or her
principal is an agency relationship.
 There is an agency relationship between the managers and the
shareholders of corporations.

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 Problems with the Agency Relationship
In an agency relationship, the agent is charged with the responsibility of acting for
the principal. Is it possible the agent may not act in the best interest of the
principal, but instead act in his or her own self-interest? Yes—because the agent
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has his or her own objective of maximizing personal wealth.
 In a large corporation, for example, the managers may enjoy many fringe benefits,
such as golf club memberships, access to private jets, and company cars. These
benefits (also called perquisites, or “perks”) may be useful in conducting business
and may help attract or retain management personnel, but there is room for abuse.
• What if the managers start spending more time at the golf course than at their desks?
What if they use the company jets for personal travel? What if they buy company
cars for their teenagers to drive? The abuse of perquisites imposes costs on the firm
—and ultimately on the owners of the firm.
• There is also a possibility that managers who feel secure in their positions may not
bother to expend their best efforts toward the business. This is referred to as shirking,
and it too imposes a cost to the firm.
 Finally, there is the possibility that managers will act in their own self-interest, rather
than in the interest of the shareholders when those interests clash.
 For example, management may fight the acquisition of their firm by some other firm
even if the acquisition would benefit shareholders. 04/20/2024
 Why? In most takeovers, the management personnel of the acquired firm generally
 Costs of the Agency Relationship
There are costs involved with any effort to minimize the potential for conflict
between the principal’s interest and the agent’s interest.
20Such costs are called agency costs, and they are of three types: monitoring costs,
bonding costs, and residual loss.
1) Monitoring Costs - are costs incurred by the principal to monitor or limit the
actions of the agent.
 In a corporation, shareholders may require managers to periodically report on their
activities via audited accounting reports, which are sent to shareholders.
 The accountants’ fees and
 the management time lost in preparing such reports are monitoring costs.
– Another example is the implicit cost incurred when shareholders limit the
decision-making power of managers.
– By doing so, the owners may miss profitable investment opportunities;
the foregone profit is a monitoring cost.
 The board of directors of corporation has a fiduciary duty to shareholders; that is the
legal responsibility to make decisions (or to see that decisions are made) that are in
the best interests of shareholders.
 Part of that responsibility is to ensure that managerial decisions are also in the best
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interests of the shareholders.
2) Bonding Costs: are incurred by agents to assure principals that they will act in the
principal’s best interest. The name comes from the agent’s promise or bond to take
certain actions.
• A manager may enter into a contract that requires him or her to stay on with
the firm even though another company acquires it; an implicit cost is then
incurred by the manager, who foregoes other employment opportunities.
3) Residual Loss: despite using monitoring and bonding devices, there may still be
some divergence between the interests of principals and those of agents.
• The resulting cost, called the residual loss, is the implicit cost that results
because the principal’s and the agent’s interests cannot be perfectly aligned.
• That is a “residual loss,” occurs whenever the actions that would promote the self-
interest of the principal differ from those that would promote the self-interest of the
agent, despite monitoring and bonding activities.

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 Motivating Managers: Executive Compensation
One way to encourage management to act in shareholders’ best interests, and
so minimize agency problems and costs, is through executive compensation—
how top management is paid.
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There are several different ways to compensate executives, including:
Salary: The direct payment of cash of a fixed amount per period.
Bonus: A cash reward based on some performance measure, say earnings of a
division or the company.
Stock appreciation right: A cash payment based on the amount by which the
value of a specified number of shares has increased over a specified period of
time (supposedly due to the efforts of management).
Performance shares. Shares of stock given to the employees, in an amount
based on some measure of operating performance, such as earnings per share.
Stock option. The right to buy a specified number of shares of stock in the
company at a stated price—referred to as an exercise price at some time in the
future. The exercise price may be above, at, or below the current market price
of the stock.
Restricted stock grant. The grant of shares of stock to the employee at low
or no cost, conditional on the shares not being sold for a specified time.
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 The basic idea behind stock options and restricted stock
grants is to make managers owners, since the incentive to
consume excessive perks (benefits) and to shirk(not to
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exercise best efforts) are reduced if managers are also
owners.
 As owners, managers not only share the costs of perks and
shirks, but they also benefit financially when their decisions
maximize the wealth of owners. Hence, the key to motivation
through stock is not really the value of the stock, but rather
ownership of the stock.

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