MBA Sem II

FINANCIAL MANAGEMENT
Financial Management – An Overview

DR. VINOD M LAKHWANI

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 IMPORTANT BUSINESS ACTIVITIES
• Production
• Marketing
• Finance
 REAL AND FINANCIAL ASSETS
• Real Assets: Can be Tangible or Intangible
• Tangible real assets are physical assets that include plant, machinery, office, factory, furniture and building.
• 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.
 EQUITY AND BORROWED FUNDS
• Shares represent ownership rights of their holders. Shareholders are owners of the company. Shares can of
two types:
• Equity Shares
• 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.
• Equity Shares are also known as ordinary shares.
✓ Do not have fixed rate of dividend.
✓ There is no legal obligation to pay dividends to equity shareholders.
• Preference Shares have preference for dividend payment over ordinary shareholders.
✓ They get fixed rate of dividends.
✓ They also have preference of repayment at the time of liquidation.
 FINANCE AND 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.
• Finance functions or decisions can be divided as follows
• 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
• Short-term financial decisions
✓ Short-term asset-mix or liquidity decision or working capital management.
 FINANCIAL 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
 FINANCE MANAGER’S ROLE AND
FINANCIAL GOAL
Finance Manager’s Role Financial Goal
• Raising of Funds • Profit maximization (profit after tax)
• Allocation of Funds • Maximizing earnings per share
• Profit Planning • Wealth maximization
• Understanding Capital Markets
 FINANCIAL GOALS
Profit maximization (profit after tax) ✓Difficult
• Maximizing the rupee income of firm ✓ Inappropriate
✓ Immoral
✓ Resources are efficiently utilized
✓ Appropriate measure of firm performance Maximizing Profit after Taxes or EPS
• Maximizing PAT or EPS does not maximize the
✓ Serves interest of society also
economic welfare of the owners.
Objections to Profit Maximization
• Ignores timing and risk of the expected benefit
• It is Vague • Market value is not a function of EPS.
• It Ignores the Timing of Returns
• Maximizing EPS implies that the firm should
• It Ignores Risk make no dividend payment so long as funds
• Assumes Perfect Competition can be invested at positive rate of return—
such a policy may not always work.
• In new business environment profit maximization
is regarded as
✓ Unrealistic
 FINANCIAL GOALS
Shareholders’ Wealth Maximization (SWM)
• 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.
• SWM requires a valuation model.
• The financial manager must know,
✓ How much should a particular share be worth?
✓ Upon what factor or factors should its value depend?
 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.
OVERVIEW OF FINANCIAL
MANAGEMENT
 AGENCY PROBLEMS: 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 maximize their own wealth (in the form of high salaries and perks) at the cost
of shareholders.
• 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.
• 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.
 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.
• 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.
ORGANISATION OF FINANCE
FUNCTION
• Reason for placing the finance functions in
the hands of top management
✓ Financial decisions are crucial for the
survival of the firm.
✓ The financial actions determine solvency
of the firm
✓ Centralization of the finance functions
can result in a number of economies to
the firm.
 STATUS AND DUTIES OF FINANCE
EXECUTIVES
• The exact organization structure for financial management will differ across firms.
• The financial officer may be known as the financial manager in some organizations, while in others as the
vice-president of finance or the director of finance or the financial 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.
 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.
THANK YOU