Chapter - I

NATURE OF FINANCIAL
MANAGEMENT
 Important Business
Activities
• Production
• Marketing
• Finance

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 Real And Financial
Assets
• Real Assets: Can be Tangible or Intangible
o Tangible real assets are physical assets that include plant,
machinery, office, factory, furniture and building.
o Intangible real assets include technical know-how, technological
collaborations, patents and copyrights.
• Financial Assets are also called securities, are
financial papers or instruments such as shares
and bonds or debentures.

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 Equity and
Borrowed Funds
• Shares represent ownership rights of their
holders. Shareholders are owners of the company.
Shares can of two types:
o Equity Shares
o Preference Shares

• Loans, Bonds or Debts: represent liability of the

firm towards outsiders. Lenders are not owners of
the company. These provide interest tax shield.

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 Equity and
Preference Shares
• Equity Shares are also known as ordinary
shares.
o Do not have fixed rate of dividend.
o There is no legal obligation to pay dividends to equity shareholders.

• Preference Shares have preference for dividend

payment over ordinary shareholders.
o They get fixed rate of dividends.
o They also have preference of repayment at the time of liquidation.

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 Management
Functions
• All business activities involve acquisition and use
of funds.
• Finance function makes money available to meet
the costs of production and marketing operations.
• Financial policies are devised to fit production and
marketing decisions of a firm in practice.

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 Finance Functions
Finance functions or decisions can be divided as
follows
o Long-term financial decisions
• Long-term asset-mix or investment decision or capital budgeting
decisions.
• Capital-mix or financing decision or capital structure and leverage
decisions.
• Profit allocation or dividend decision
o Short-term financial decisions
• Short-term asset-mix or liquidity decision or working capital
management.

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 Procedures and
Systems
• For effective finance function some routine
functions have to be performed. Some of these
are:
 Supervision receipts and payments and safeguarding of cash
balances
 Custody and safeguarding of securities, insurance policies and
other valuable papers
 Taking care of the mechanical details of new outside financing
 Record keeping and reporting

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 Finance Manager’s
Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets

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Financial Goals
• Profit maximization (profit after tax)
• Maximizing earnings per share
• Wealth maximization

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 Profit Maximization
• Maximizing the rupee income of firm
 Resources are efficiently utilized
 Appropriate measure of firm performance
 Serves interest of society also

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 Objections to Profit
Maximization
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
Assumes Perfect Competition
In new business environment profit maximization
is regarded as
o Unrealistic
o Difficult
o Inappropriate
o Immoral

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 Maximizing Profit
after Taxes or EPS
• Maximising PAT or EPS does not maximise the
economic welfare of the owners.
• Ignores timing and risk of the expected benefit
• Market value is not a function of EPS.
• Maximizing EPS implies that the firm should make
no dividend payment so long as funds can be
invested at positive rate of return—such a policy
may not always work.

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 Wealth
Maximization
• Maximizes the net present value of a course of
action to shareholders.
• Accounts for the timing and risk of the expected
benefits.
• Benefits are measured in terms of cash flows.
• Fundamental objective—maximize the market
value of the firm’s shares.

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Need for a Valuation
Approach
• SWM requires a valuation model.
• The financial manager must know,
o How much should a particular share be worth?
o Upon what factor or factors should its value depend?

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 Risk-return Trade-
off
• Financial decisions of the firm are guided by the
risk-return trade-off.
• The return and risk relationship:
Return = Risk-free rate +
Risk premium
• Risk-free rate is a compensation for time and risk
premium for risk.

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 Risk Return Trade-
off

Risk and expected return move in tandem; the greater the risk, the greater
the expected return.

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 Financial
Management

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 Managers Versus
Shareholders’ Goals
• There is a Principal Agent relationship
between managers and shareholders.

• In theory, Managers should act in the best

interests of shareholders.

• In practice, managers may maximise their

own wealth (in the form of high salaries
and perks) at the cost of shareholders.

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 Agency Problems:
Managers Versus
Shareholders’ Goals
• Managers may perceive their role as reconciling
conflicting objectives of stakeholders. This
stakeholders’ view of managers’ role may
compromise with the objective of SWM.

• Managers may avoid taking high investment and

financing risks that may otherwise be needed to
maximize shareholders’ wealth. Such “satisfying”
behaviour of managers will frustrate the objective
of SWM as a normative guide.

• This conflict is known as Agency problem

and it results into Agency costs.
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 Agency Costs
• Agency costs include the less than optimum
share value for shareholders and costs incurred
by them to monitor the actions of managers and
control their behaviour.

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 Financial Goals and Firm’s
Mission and Objectives
• Firms’ primary objective is maximizing the welfare
of owners, but, in operational terms, they focus on
the satisfaction of its customers through the
production of goods and services needed by them.
• Firms state their vision, mission and values in
broad terms.
• Wealth maximization is more appropriately a
decision criterion, rather than an objective or a
goal.
• Goals or objectives are missions or basic purposes
of a firm’s existence.

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 Financial Goals and Firm’s
Mission and Objectives
• The shareholders’ wealth maximization is the
second-level criterion ensuring that the decision
meets the minimum standard of the economic
performance.
• In the final decision-making, the judgement of
management plays the crucial role.
• The wealth maximization criterion would simply
indicate whether an action is economically viable or
not.

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 Organisation of the Finance
Functions
• Reason for placing the finance functions in the
hands of top management
o Financial decisions are crucial for the survival
of the firm.
o The financial actions determine solvency of the
firm
o Centralisation of the finance functions can
result in a number of economies to the firm.

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 Organisation of
Finance Function

Organization for finance function in

Organization for finance function a multidivisional company
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Status and Duties of Finance
Executives
• The exact organisation structure for financial
management will differ across firms.
• The financial officer may be known as the
financial manager in some organisations, while in
others as the vice-president of finance or the
director of finance or the financial controller.

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 Role of Treasurer
and Controller
• Two officers—the treasurer and the controller—
may be appointed under the direct supervision of
CFO to assist him or her.
• The treasurer’s function is to raise and manage
company funds while the controller oversees
whether funds are correctly applied.

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