Nature of Finanacial Management

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Chapter 1

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Important Business ActivitiesImportant Business Activities

Production

Marketing

Finance

What are the financial instruments and tools that a financial manager has

to deal with?


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Real And Financial AssetsReal 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, patentsand 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 FundsEquity and Borrowed Funds

Shares represent ownership rights of their holders. Shareholders are

owners of the company. Shares can of two types:

EquityShares

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 SharesEquity and Preference Shares

Equity Shares are also known as ordinary shares.

Do not have fixed rate of dividend.

Thereis no legal obligation to pay dividends to equity shareholders.

Preference Shares have preference for dividend payment over

ordinary shareholders.

Theyget fixed rate of dividends.

They also have preference of repayment at the time of liquidation.

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Finance and Management FunctionsFinance 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.

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Finance FunctionsFinance Functions

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.

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Financial Procedures and SystemsFinancial 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 Managers RoleFinance Managers Role

Raising of Funds

Allocation of Funds

Profit Planning

Understanding Capital Markets

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Objective Of Corporate Finance


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The Classical ViewpointThe Classical Viewpoint

Van Horne: "In this book, we assume that the objective of the firm is

to maximize its value to its stockholders"

Brealey & Myers: "Success is usually judged by value: Shareholders

are made better off by any decision which increases the value of their

stake in the firm... The secret of success in financial management is to

increase value."

Copeland & Weston: The most important theme is that the objective

of the firm is to maximize the wealth of its stockholders."

Brigham and Gapenski: Throughout this book we operate on the

assumption that the management's primary goal is stockholder wealth

maximization which translates into maximizing the price of the

common stock.

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The Objective in Decision MakingThe Objective in Decision Making

In traditional corporate finance, the objective in decision making is to

maximize the value of the firm.

A narrower objective is to maximize stockholder wealth. When the

stock is traded and markets are viewed to be efficient, the objective is

to maximize the stock price.

All other goals of the firm are intermediate ones leading to firm value

maximization, or operate as constraints on firm value maximization.


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The Criticism of Firm Value MaximizationThe Criticism of Firm Value Maximization

Maximizing stock price is not incompatible with meeting employee

needs/objectives. In particular:

- Employees are often stockholders in many firms

- Firms that maximize stock price generally are firms that have treated

employees well.

Maximizing stock price does not mean that customers are not critical

to success. In most businesses, keeping customers happy is the route to

stock price maximization.

Maximizing stock price does not imply that a company has to be a

social outlaw.

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Why traditional corporate financial theory focuses onWhy traditional corporate financial theory focuses onmaximizing stockholder wealth.maximizing stockholder wealth.

Stock price is easily observable and constantly updated

(unlike other measures of performance, which may not be

as easily observable, and certainly not updated as

frequently).

If investors are rational (are they?), stock prices reflect the

wisdom of decisions, short term and long term,instantaneously.

The objective of stock price performance provides some

very elegant theory on:

how to pick projects

how to finance them

how much to pay in dividends


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The Classical Objective FunctionThe Classical Objective Function

STOCKHOLDERS

Maximize

stockholder

wealth

Hire & fire

managers

- Board

- Annual Meeting

BONDHOLDERSLend Money

Protect

bondholder

Interests

FINANCIAL MARKETS

SOCIETYManagers

Reveal

information

honestly and

on time

Markets are

efficient and

assess effect on

value

No Social Costs

Costs can be

traced to firm

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What can go wrong?What can go wrong?

STOCKHOLDERS

Managers put

their interests

above stockholders

Have little control

over managers

BONDHOLDERSLend Money

Bondholders canget ripped off

FINANCIAL MARKETS

SOCIETYManagers

Delay bad

news or

provide

misleading

information

Markets make

mistakes and

can over react

Significant Social Costs

Some costs cannot be

traced to firm


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Profit MaximizationProfit 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 MaximizationObjections to Profit Maximization

It is Vague

It Ignores the Timing of Returns

It Ignores Risk

Assumes Perfect Competition

In new business environment profit maximizationis regarded as

Unrealistic

Difficult

Inappropriate

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Maximizing Profit after Taxes or EPSMaximizing Profit after Taxes or EPS

Maximising PAT or EPS does not maximise theeconomic 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 shouldmake no dividend payment so long as funds canbe invested at positive rate of returnsuch apolicy may not always work.

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Shareholders Wealth MaximizationShareholders 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 objectivemaximize the market value of

the firms shares.

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Need for a Valuation ApproachNeed for a Valuation Approach

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?

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RiskRisk--return Tradereturn Trade--offoff

Financial decisions of the firm are guided by the risk-return trade-

off.

The return and risk relationship:

Return = Risk-freerate + Risk premium

Risk-free rate is a compensation for time and risk premium for risk.

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Risk Return TradeRisk Return Trade--offoff

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

expected return.

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Overview of Financial ManagementOverview of Financial Management

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Agency Problems:Agency Problems: Managers VersusManagers VersusShareholders GoalsShareholders Goals

There is a Principal Agent relationship betweenmanagers and shareholders.

In theory, Managers should act in the best interestsof shareholders.

In practice, managers may maximise their ownwealth (in the form of high salaries and perks) atthe cost of shareholders.

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Agency Problems: Managers VersusAgency Problems: Managers VersusShareholders GoalsShareholders Goals

Agency Theory-Jensen and Meckling (1976)

Managers may perceive their role as reconcilingconflicting objectives of stakeholders. This stakeholdersview of managers role may compromise with theobjective of SWM.

Managers may avoid taking high investment and financingrisks that may otherwise be needed to maximizeshareholders wealth. Such satisfying behaviour ofmanagers will frustrate the objective of SWM as anormative guide.

This conflict is known as Agency problem and it resultsinto Agency costs.

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Agency CostsAgency Costs

Agency costs include the less than optimum share value for

shareholders and costs incurred by them to monitor the actions of

managersand control their behaviour.

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Financial Goals and Firms MissionFinancial Goals and Firms Missionand Objectivesand 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 decisioncriterion, rather than an objective or a goal.

Goals or objectives are missions or basic purposes of a

firms existence.

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Financial Goals and Firms MissionFinancial Goals and Firms Missionand Objectivesand 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 FinanceOrganisation of the FinanceFunctionsFunctions

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

Centralisation of the finance functions can result in anumber of economies to the firm.

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Status and Duties of FinanceStatus and Duties of FinanceExecutivesExecutives

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 financialcontroller.

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Role of Treasurer and ControllerRole of Treasurer and Controller

Two officersthe treasurer and the controllermay be appointed

under the direct supervision of CFO to assist him or her.

The treasurers function is to raise and manage company funds while

the controller oversees whether funds are correctly applied.

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Next SessionNext Session

Bring Calculators and Book for every class

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Fall of RupeeFall of Rupee


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Ownership vs. ManagementOwnership vs. Management

Difference in

Information

Stock prices and

returns Issues of shares and

other securities

Dividends

Financing

Different Objectives

Managers vs.

stockholders

Top mgmt vs.operating mgmt

Stockholders vs. banks

and lenders


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Nature of Finanacial Management

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