Nature of Financial Management

Definition of Financial Managemet

• Financial Management involves the application of general management principles to a particular financial operations.

• It is concerned basically with two steps:

• 1. Raising of funds most economically

• 2. Planning future operations andcontrolling current performances andfuture developments through financialmeans

Scope of finance

Scope of finance

• Traditional approach and

• modern approach

Traditional approach

• It refers to its subject matter,in academic literature in the initial stages of its evolution.as a separate branch of economic study.

• It evolved during the 1920s and 1930s and dominated academic thinking during the forties and through the early fifties.it has now discarded as it suffers from limitations.

Traditional approach(Features)

-Emphasis was on raising of fundsEpisodic Finance Function

-It was only outsider looking approachIt was from the point of view of investors

No importance to the decision making

Traditional approach contd.

• Over emphasis on the topics of securities• Over emphasis on promotion and

incorporation of companies• Mergers and acquisitions in the nature of

hostile mergers and forced takeovers

Traditional approach contd.

• Emphasis on Long term finance only• Emphasis on only corporate entities

Weaknesses of Traditional approach

• It ignored the central issues of financial management.These issues are reflected in the following fundamental questions which a finance manager should address,like:

• Should an enterprise commit capital funds to certain purpose? What is the cost of capital of funds to the enterprise?

Weaknesses Contd.

• It failed to consider day to day managerial problems.

• It ignored management – overemphasis to lender

• It neglected the consideration of the question of allocation of capital into different assets

• It ignored optimum combination of finance

Modern approach

• It provides a solution to those shortcomings.• It views the term financial management in a

broad sense and provides a conceptual and analytical framework for financial decision making.The main contents of this are…

• what is the total volume of funds an enterprise should commit?what specific asset a firm should acquire?

Modern approach

• How should the funds required be financed?• How large an enterprise be and how fast

should it grow?• What should be the composition of its

liabilities?• In what form should it hold asset?

Finance Functions

• Investment or Long Term Asset Mix Decision

• Financing or Capital Mix Decision• Dividend or Profit Allocation Decision• Liquidity or Short Term Asset Mix Decision

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Finance Manager’s Role

• Raising of Funds• Allocation of Funds• Profit Planning• Understanding Capital Markets

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1st decision ofof modern approach

• Investment decisions:it refers to the selection of asset in which funds will be invested by a firm.it has two broad groups.

• Long- term asset which yield a return over a period of time in future.

• Short term asset which in the normal course of business are convertible into cash

In long term category, acquisition of assets is popularly known in

financial literature as

• Capital budgeting: it relates to the selection of an asset or investment proposal which likely to be available in future over the lifetime of the project.

The aspect of financial decisions making with reference to current

assets is termed as

Working capital management: concerned with management of current asset. it is an important and integral part of short term survival for long term success.

2nd decision

• Financing decision:it is concerned with the financing-mix or capital structure.

• The term capital structure refers to the proportion of debt(fixed interest source of financing)and equity capital(variable dividend securities).it relates to the choice of the proportion of these sources to finance the investment requirements.

3rd decision

• Dividend policy :it should be analysed in relation to the financing decision of a firm.they can be distributed to the shareholders in the form of dividend or they can be retained in business itself. The decision as to which course should be followed depends largely on a significant elements in the dividend decision,the dividend payout ratio..that is what proportion of net profits should be paid out to the shareholders.The final decision Will depend upon the preference of the shareholders and investments opportunity available within the firm

Objective of financial management.

Financial Goals or Objectives of financial management

• Profit maximization

• wealth maximization

Profit maximization

• According to this approach,actions that increase profits should be undertaken and those that decrease profits are to be avoided.it implies that investment,financing and dividend policy decisions should be oriented to the maximization of profit.

• Term ‘profit’ can be used in two senses.as a owner-oriented and where output exceeds inputs.

Profit maximization

• Owner oriented profit: it refers to the amount and share of income which is paid to the owners those who supply equity capital.

• Output exceeds input: the value created by the use of resources is more than the total of the input resources.

• It means that firm should be guided in financial decisions making by projects &decisions which are profitable.

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 – Unrealistic– Difficult– Inappropriate – Immoral.

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Shareholders’ 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.• Measuring profit in cash flow avoids the

ambiguity associated with accounting profit• Fundamental objective—maximize the market

value of the firm’s shares.

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Basic Tools of Wealth maximisation

(I) Ensuring a fair return to shareholders(II) Building up reserves for growth and expansion(III) Ensuring maximum operational efficiency by efficient and effective utilization of resources

Risk-return Trade-off

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

• 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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Managers Versus Shareholders’ Goals

• A company has stakeholders such as employees, debt-holders, consumers, suppliers, government and society.

• 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 pursue their own personal goals at the cost of shareholders, or may play safe and create satisfactory wealth for shareholders than the maximum.

• 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.

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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

In short financial discipline in the organisation

Results in maximum value of the share of the firm

End of presentation

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