Text Book: Financial Management: Theory and PracticePrasanna Chandra, 7th edition, Tata McGraw Hill Publishing Company

Ltd.

MODULE: I CHAPTER: 1 FINANCIAL MANAGEMENT: AN OVERVIEW

Introduction

For any type of business following financial questions are to be addressed:

y Capital Investment y Sources of funds y Handling of day-to-day financial activities

Topics to be discussed
Evolution of financial management Financial decisions in a firm Goal of financial management The fundamental principle of finance Risk-Return Tradeoff Forms of Business Organisations Agency Problem Organisation of the finance function Relationship of finance to Economics and Accounting Emerging role of the financial manager in India

Evolution of Financial Management

The study of financial management as a distinct field of study emerged in the early 20th Century. The evolution of the same can be divided into three phases:
y Traditional Phase (Early 1900s to 1940): Focused on

Formation, issuance of Capital, major expansion, merger, reorganization and liquidation in the life cycle of the firm. y Transitional Phase (1940 to 1950): Similar to Traditional Phase, focused shifted to working capital management. y Modern Phase (Mid 1950s): Focused shifted to rational matching of funds to their uses so as to maximize the wealth of shareholders. The approach has become more analytical and quantitative.

Financial Decisions in a Firm

Goal of Financial Management

Profit Maximization:
y It is regarded as the objective of a business enterprise. But

this objective does not take into account the time and pattern of returns. Secondly, the objective of maximizing profits does consider the uncertainty of future earning stream. As a result of such, far more risky investment projects, perspective stream of earnings would be more uncertain.

Limitations of the maxim:

y It relates to the problem of uncertainty as the future profits

cannot be exactly calculated to be expressed now. y Most decisions involve a balancing between expected return and risk. The combinations of expected returns with risk variations and related capitalization rate are ignored in the concept of profit maximization. y The decision maker may not have enough confidence in the estimates of prospective earnings and he does not attempt further to maximize. y It fails to take into consideration time value of money.

Goal of Financial Management (Cont.)

Wealth Maximization: It considers the time value of money. It guides the management in framing consistent strong dividend policy, to reach maximum returns to the equity holders. Limitations of wealth maximization:

y The

concept of wealth maximization is not descriptive. y The 20th century has confronted the business with a more demanding socio-economic environment, which is omitted. y It ignores the firms obligations to government, employees, creditors, etc.

Shareholder Orientation in India

Over the period shareholders wealth maximization has gained importance as a result of confluence of following forces:
y Foreign Exposure y Greater Dependence on Capital Market y Growing importance of institutional investors y Abolition of wealth tax on financial assets

The Fundamental Principle of Finance

Investors Shareholders Lenders Investors provide the initial Cash required to finance the business proposal The business proposal

The proposal generates cash returns to investors A business proposalregardless of whether it is a new investment or acquisition of another company or a restructuring initiativeraises the value of the firm only if the present value of the future stream of net cash benefits expected from the proposal is greater than the initial cash outlay required to implement the proposal.
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Risk-Return Tradeoff
The alternative courses of action typically have different risk-return implication. A hot stock, compared to a defensive stock, may offer a higher expected return but also a greater possibility of loss.

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Risk-Return Tradeoff (Cont.)

Capital Budgeting Decisions Return Capital Structure Decisions Dividend Decisions Risk Working Capital Decisions

Market Value of the Firm

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Agency Problem

In various businesses the responsibility of management is entrusted to professional mangers who may have little or no equity stake in the firm. Thus, the ownership and management in such businesses lie in separate hands. There are several reasons for the separation of ownership and management in companies:
y Due to large scale capital requirement, necessary capital is

pooled from thousand of investors (owners), making it impractical for them to participate actively in management. y Professional managers may be more qualified to run the business because of their technical expertise, experience and personality traits. y It ensures that the knowhow of the firm is not impaired, despite changes in ownership. y Diversification of portfolio is only possible when ownership and management are separated.
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Agency Problem (Cont.)

A separated structure leads to a possible conflict of interest between managers (agents) and shareholders (principals). Though managers are the agents of shareholders of shareholders they are likely to act in ways that may not maximize the welfare of shareholders. The lack of perfect alignment between the interests of managers and shareholders results in agency costs which may be defined as the difference between the value of an actual firm and the value of a hypothetical firm in which management and share holders are perfectly aligned. To mitigate the agency problem, effective monitoring has to be done and appropriate incentives have to be offered.
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Organisation of the Finance Function

The finance function in an organisation can be classified in to:

y Treasurer Function

Obtaining finance, banking relationship, cash management, credit administration, capital budgeting, etc.
y Controller Function Financial accounting, internal auditing, management accounting and control, etc.

taxation

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Finance and Related Disciplines

Financial management, as an integral part of the over-all management, is not a totally independent area. It draws heavily on related disciplines and fields of study, namely, economics, accounting, marketing, production and quantitative methods.

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Finance and Economics

The relevance of economics to financial management can be described in the light of the two broad areas of economics: macroeconomics and microeconomics. Macroeconomics is concerned with the over-all institutional environment in which the firm operates. It is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary, credit and fiscal policies and economic policies dealing with and controlling level of activity within an economy. Microeconomics deals with the economic decisions of individuals and organisations. It concerns itself with the determination of optimal operating strategies. In other words, the theories of microeconomics provide for effective operations of business firms. They are concerned with defining actions that will permit the firms to achieve success.
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Finance and Accounting

The relationship between finance and accounting, conceptually speaking, has two dimensions:
y They

are closely related to the extent that accounting is an important input in financial decision making; y There are key differences in viewpoints between them.

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Finance and Related Disciplines

1. 2. 3. 4. 5. 6. Investment analysis Working capital management Sources and cost of funds Determination of capital structure Dividend policy Analysis of risk and returns Primary Disciplines: 1. Accounting 2. Macroeconomics 3. Microeconomics Other Related Disciplines: 1. Marketing 2. Production 3. Quantitative methods

Shareholder wealth maximization

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Emerging Role of the Financial Manager in India

The key challenges for the financial manager appear to be in the following areas:
y y y y y y y y

Investment Planning Financial Structure Mergers, acquisitions and restructuring Working capital management Performance management Risk management Corporate governance Investor relations
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The Pressures of Being a CFO in Todays World

Chief Financial Officers (CFOs) are looked at differently today following the events of Enron and Worldcom. Once the position as CFO brought automatic respect from employees and investors. Today, CFOs are viewed with skepticism and doubt. Who is the next Andy Fastow or Scott Sullivan? Who else is cooking the books and has yet to be caught? CFOs are responsible for overseeing the financial operations and reporting for a firm. During the market bubble of the 90s, CFOs became central figures in the game of profits. The goal was to exceed investor expectations meaning that firms wanted more and more profit. Merger and acquisition (M&A) activity flourished as firms sought ways to increase profits. Accounting for complex transactions became more and more creative. Paper profits flourished. Stock prices rose and investors were happy. Then the house of cards collapsed. Investors lost millions. Employees lost jobs. Executives are going to jail. Today CFOs are left with the responsibility of recreating public trust in their honesty and gaining dignity once again for their positions. CFOs are now spending a significant percentage of their time in this endeavor. In addition, they are busy reviewing all aspects of their accounting systems and revising any methods that appear questionable even if they are abiding by current accounting standards. Todays CFOs have to get down in the trenches to really know what is going on and ensure that nothing is questionable and that proper checks and balances are in place. In other words, they are going back to the basics and doing the numbers crunching and internal reviewing that diligent financial executives have been doing all along
Lead story-dateline: Fortune, 9 December 2002
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Talking it over and thinking it through!!

What should be the responsibility of a CFO? 2. Explain why the job of CFO is harder today than it was five years ago? 3. What role does the Board of Directors have in overseeing the CFO?
1.

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