What is Finance?

• Finance can be defined as the art and

science of managing money. Virtually all
individuals and organizations earn or raise
money and spend or invest money.
Finance is concerned with the process,
institutions, markets, and instruments
involved in the transfer of money among
and between individuals, businesses, and
governments.
What is Financial Management?
• Financial Management is that managerial
activity which is concerned with the
planning and controlling of the firm’s
financial resources.
 Objectives of Financial
Management
• The objective of the financial management is to increase
or maximize the wealth of the owners by increasing the
value of the firm which is reflected in its earning per
share and the market prize of the shares.
• What do a finance manager do? Suppose he makes
available the required funds at an acceptable cost and
those funds are suitably invested and that every thing
goes according to plan because of the effective control
measures he uses.
• If the firm is a commercial or profit seeking then the
results of good performance are reflected in the profits
the firm makes. How are profits utilized? They are partly
distributed among the owners as dividends and partly
reinvested in to the business.
 Objectives of Financial
Management
• As this process continues over a period of time
the value of the firm increases.
• If the share of the organization is traded on stock
exchange the good performance is reflected
through the market price of the share, which
shows an upward movement. When the market
price is more a shareholder gets more value
then what he has originally invested thus his
wealth increases. Therefore we can say that the
objective of financial management is to increase
the value of the firm or wealth maximization.
Three decision areas in finance:
• Investment decisions - What assets should the
company hold? This determines the left-hand
side of the balance sheet.
• Financing decisions - How should the company
pay for the investments it makes? This
determines the right-hand side of the balance
sheet.
• Dividend decisions - What should be done with
the profits of the business?
 Nature of Financial Management
• Financial management is an integral part of overall
management and not merely a staff function.
• It is not only confined to fund raising operations but
extends beyond it to cover utilisation of funds and
monitoring its uses.
• These functions influence the operations of other crucial
functional areas of the firm such as production,
marketing and human resources.
• Hence, decisions in regard to financial matters must be
taken after giving thoughtful consideration to interests of
various business activities.
 Nature of Financial Management
• Hence, decisions in regard to financial matters must be
taken after giving thoughtful consideration to interests of
various business activities.
• Finance manager has to see things as a part of a whole
and make financial decisions within the framework of
overall corporate objectives and policies.
The financial management of a firm affect its very survival
because the survival of the firm depends on strategic
decisions made in such important matters such as
product development, market development, entry in new
product line, retrenchment of a product, expansion of the
plant, change in location, etc. In all these matters
assessment of financial implications is inescapable.
 Scope of 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)
 Finance Functions
• Function of raising funds, investing them
in assets and distributing returns earn
from them to share holders respectively
known as financing, investment and
dividend function.
• While performing these function, a firm
attempt to balance cash inflows and
outflows. This is called liquidity function.
 Investment decision
• Investment decision involves the decision of
allocating capital to long term assets that would
yield benefits in the future.
• Two important aspects of the investments
decisions are:
1. The evaluation of the prospective
profitability of new investment.
2. Measurement of a cut-off rate against that the
prospective return of new investments could
be compared
 Investment decision
• Future benefits of investments are difficult
to measure and cannot be predicted with
certainty.
• Because of the uncertain future,
investment decisions involve risk.
Investment proposal should, therefore, be
evaluated in terms of both expected return
and risk.
 Financial Decision
• Must decide when, where and how to acquire funds to
meet the firm’s investment needs.
• The central issue is to determine the proportion of equity
and debt.
• The mix of debt and equity is known as the firm’s capital
structure.
• The financial manager must strive to obtain the best
financing mix or the optimum capital structure for the
firm.
• The firm’s capital structure is considered to be optimum
when the market value of shares is maximized.
 Dividend Decision
• The financial manager must decide
whether the firm should distribute all
profits, or retain them, or distribute a
portion and retain the balance.
 Liquidity Function
• Current assets that affect a firm’s liquidity
is yet another finance function, in addition
to the management of long-term assets.
• Current assets should be managed
efficiently for safeguarding the firm against
the danger of illiquidity and insolvency.
• Investment in current assets affect the
firm’s profitability, liquidity and risk.
Financial Goal: Profit Vs Wealth
• The firm’s investment and financing
decision are unavoidable and continuous.
In order to make them rationally, the firm
must have a goal. It is generally agreed in
theory that the financial goal of the firm
should be maximizing the shareholder’s
wealth as reflected in the market value of
shares.
 Profit Maximization
• Profit maximization means maximizing the rupee income
of firms.
• In market economy, prices of goods and services are
determined in competitive market.
• A legitimate question may be raised. Would the price
system in free market economy serve the interest of the
society? The answer has been given by Adam Smith
many year ago. According to him under the condition of
free competition, businessmen pursuing their own self-
interest also serve the interest of society.
• It is also assumes that when individual firms pursue the
interest of profit maximization, society resource are
efficiently utilized.
• While maximizing profit, firm either produces maximum
output and uses minimum input. Thus the underlying
logic of profit maximization is efficiency. It is assumed to
cause the efficient allocation of resources under the
competitive market conditions, and profit is considered as
the most appropriate measure of firm’s performance.
 Profit Maximization
• Advocates of the profit maximisation objective are of the
view that this objective is simple and has the in-built
advantage of judging economic performance of the
enterprise.
• Further, it will direct the resources in those channels that
promise maximum return. This, in turn, would help in
optimal utilisation of society's economic resources.
• Since the finance manager is responsible for the efficient
utilisation of capital, it is plausible to pursue profitability
maximisation as the operational standard to test the
effectiveness of financial decisions.
Objection to Profit Maximization
• The profit maximization objective has, however, been
criticized in recent years. It is argued that profit
maximization assumes assume perfect competition, and
in the face of imperfect modern market cannot be
legitimate objective of the firm.
• It is also argued that profit maximization, as a business
objective, developed in the early 19th century when the
characteristics features of the business structure were
self financing, private property single ownership.
• The only aim of the single owner than was to enhance
his or her individual wealth, which could easily be
satisfied by the profit maximization objective.
Objection to Profit Maximization
• Modern business environment is characterized
by limited liability and divorce between
management and ownership. Business today is
financed by shareholders, lenders but is
controlled and directed by professional
management. The other interested parties are
customers, employees, government and society.
In practice, the objectives of these constituents
(Stake holders) of a firm differ and may conflict
with each other. In the new business
environment, profit maximization is regarded as
unrealistic, difficult, inappropriate and immoral.
Objection to Profit Maximization
• Oligopolies and monopolies are quite common
phenomenon of modern economies. Firms producing
same goods and services differ substantially in terms of
technology and cost.
• In view of such conditions, it is difficult to have a truly
competitive price system and thus, it is doubtful if the
profit maximizing behavior will lead to optimum social
welfare.
• However it is not clear that abandoning profit
maximization as a decision criterion would solve the
problem.
• Rather government intervention may be sought to
correct market imperfections and to promote competition
among business firm.
• A market economy, characterized by a high degree of
competition, would certainly ensure efficient production
of goods and services desired by the society.
Objection to Profit Maximization
• Profit maximisation objective suffers from
several drawbacks rendering it an
ineffective decisional criterion. These
drawbacks are:
A. Definition of Profit
B. Time value of money
C. Uncertainty of returns
 Wealth Maximization
• Wealth maximisation objective is a widely
recognised criterion with which the performance
a business enterprise is evaluated.
• The word wealth refers to the net present worth
of the firm. Therefore, wealth maximisation is
also stated as net present worth.
• Net present worth is difference between gross
present worth and the amount of capital
investment required to achieve the benefits.
Gross present worth represents the present
value of expected cash benefits discounted at a
rate.
 Wealth Maximization
• Thus, wealth maximisation objective as decisional
criterion suggests that any financial action, which creates
wealth or which, has a net present value above zero is
desirable one and should be accepted and that which
does not satisfy this test should be rejected.
• The objectives of shareholders wealth maximization
takes care of the question of the timing and risk of the
expected benefits. These problems are handled by
selecting an appropriate rate (The shareholder’s
opportunity cost of capital) for discounting the expected
flow of future benefits.
• It is important to emphasize that benefits are measured
in terms of actual cash flows, not the accounting profits.
 Wealth Maximization
• The wealth created by a company through
its actions is reflected in the market value
of the company’s shares.
 What is undercapitalization?
• Undercapitalization refers to any
situation where a business cannot acquire
the funds they need. An undercapitalized
business may be one that cannot afford
current operational expenses due to a lack
of capital, which can trigger bankruptcy,
may be one that is over-exposed to risk, or
may be one that is financially sound but
does not have the funds required to
expand to meet market demand.
 What is undercapitalization?
• When a company does not have sufficient
capital to conduct normal business operations
and pay creditors. This can occur when the
company is not generating enough cash flow or
is unable to access forms of financing such as
debt or equity. If a company can't generate
capital over time, it increases its chance of going
bankrupt as it loses the ability to service its
debts. Undercapitalized companies also tend to
choose high-cost sources of capital, such as
short-term credit, over lower-cost forms such as
equity or long-term debt.
 What is undercapitalization?
• There are several situations that can lead to an
undercapitalized state for a company. When
changes in consumer habits render the most
profitable products manufactured by the
corporation undesirable, the dwindling sales may
not be enough to offset the costs of operation. In
order to correct the state of undercapitalization,
the company will need to either curtail
production of the obsolete products to service a
smaller market, or develop new products that will
be able to attract the attention of a new
consumer market.
 What is undercapitalization?
There are several different causes of
undercapitalization including:
• Financing growth with short-term capital,
rather than permanent capital
• Failing to secure an adequate bank loan at
a critical time
• Failing to obtain insurance against
predictable business risks
 What is undercapitalization?
• A second scenario that may develop into a lack of
sufficient capital involves a start up company. Generally,
a new company will attempt to secure backing that
provides resources to cover operational costs until the
company can begin to generate revenue and make a
profit. When the new company fails to attract enough
business to meet the production costs within the
projected time frame, the venture will be considered
undercapitalized. At this juncture, investors can choose
to invest additional resources into the company or cut
the losses and pull out of the business.
 What is undercapitalization?
• At other times, changes in consumer tastes or
advances in technology will trigger a period in
which the company must adapt in order to
remain profitable. During this transition, the
company may need to seek outside assistance
in order to make the adjustments needed to
remain a viable entity, or at least cash in assets
that are not essential to the base operation in
order to keep going. Without correction of this
state of undercapitalization, the business will not
make it through this transitory period and will
eventually fail.
 What is over capitalization?
• When a company has too much capital for
the needs of its business.
• You might think that more capital is always
better, but this isn't the case. If a business
has more money than it can work with, it
will be burdened with high interest charges
and/or dividend payments. To reduce
overcapitalization a company can repay its
debt or do a share buyback.
 What is over capitalization?
• A concern is said to be over-capitalized if its earnings are
not sufficient to justify a fair return on the amount of
share capital and debentures that have been issued. It is
said to be over capitalized when total of owned and
borrowed capital exceeds its fixed and current assets.
• An over capitalized company can be like a very fat
person who cannot carry his weight properly. Such a
person is prone to many diseases and is certainly not
likely to be sufficiently active. Unless the condition of
overcapitalization is corrected, the company may find
itself in great difficulties.
 What is over capitalization?
Some of the important reasons of over-capitalization are:
• Idle funds: The company may have such an amount of funds that it
cannot use them properly. Money may be living idle in banks or in the
form of low yield investments.
• Over-valuation: The fixed assets, especially good will, may have been
acquired at a cost much higher than that warranted by the services which
that asset could render.
• Fall in value: Fixed assets may have been acquired at a time when prices
were high. with the passage of time prices may have been fallen so that
the real value of the asset may also have come down substantially even
though in the balance sheet the assets are being being shown at book
value less depreciation written off. Then the book values will be much
more than the economic value.
• Inadequate depreciation provision: Adequate provision may not have
been provided on the fixed assets with the result the profits shown by
books may have been distributed as dividend, leaving no funds with
which to replace the assets at the proper time.