Chapter 1

FINANCIAL MANAGEMENT : AN
OVERVIEW
 OUTLINE
• Forms of Business Organisations
• Financial Decisions in a Firm
• Goal of Financial Management
• The fundamental Principle of Finance
• Building Blocks of Modern Finance
• Risk-return Tradeoff
• Agency problem
• Business ethics and social responsibility
• Relationship of Finance to Economics and Accounting
• Emerging Role of the Financial Manager in India
 FORMS OF BUSINESS ORGANISATIONS
Sole Proprietorship
• One owner
• Very simple
• Unlimited liability
• The firm has no separate status from a legal and tax
point of view
Partnership
• Two or more owners
• Fairly simple
• Unlimited liability
• The firm has a separate status
Private Limited Company
• Upto 50 owners
• Not too complex
• Limited liability
• A distinct legal person
 DECISIONS, RETURN, RISK,
AND MARKET VALUE

Capital Budgeting
Decisions

Return
Capital Structure
Decisions
Market Value of
the Firm
Dividend
Decisions
Risk

Working Capital
Decisions
 FORMS OF ORGANISATION
Public Limited Company

• Many owners
• Somewhat complex
• Limited liability
• Distinct legal person
• Free transferability of shares

Public Limited Company’s Attraction

• The potential for growth is immense because of access to
substantial funds
• Investors enjoy liquidity because of free transferability of
securities
• The scope for employing talented managers is greater
 ABBREVIATED COMPANY NAMES

Private Public

UK Ltd plc

Germany GmbH AG

Japan YK KK

Netherlands BV NV

France Sarl SA

Italy Srl SpA

 EVOLUTION OF FINANCIAL MANAGEMENT
• Financial management emerged as a distinct field of study at
the turn of the 20th century. Its evolution may be divided into
three broad phases - the traditional phase, the transitional
phase, and the modern phase.

• The modern phase began in mid-1950s and has been marked

by infusion of ideas from economic theory and application of
quantitative methods

• The distinctive features of the modern phase are:

Central concern : Shareholder wealth Maximisation
Approach : Analytical and quantitative
 FINANCIAL DECISIONS IN A FIRM

• Capital Budgeting

• Capital Structure

• Working Capital Management

 GOAL OF FINANCIAL MANAGEMENT

Finance theory rests on the premise that managers should manage their
firm’s resources with the objective of enhancing the firm’s market value.

“The quest for value drives scarce resources to their most productive
uses and their most efficient users. The more effectively resources are
deployed, the more robust will be the economic growth and the rate of
improvement in our standard of living. Adam Smith’s ‘invisible hand’ is
at work when investors’ private gain is a public value.”
 CRITIQUE AND DEFENCE OF SHAREHOLDER
WEALTH MAXIMISATION GOAL
Critique Defence
• The capital market sceptics • Financial economists argue
argue that stock prices fail that stock prices are the
to reflect true values least biased estimates of
intrinsic values in developed
markets
• The balancers argue that a • Balancing the interests of
firm should seek to various stakeholders is not
‘balance’ the interests of a practical governing
various stakeholders objective

• Advocates of social • The only social

responsibility argue that a responsibility of business
business firm must assume is to create value and do so
wider social responsibilities legally and with integrity
 SHAREHOLDER ORIENTATION IN INDIA

In the wake of liberalisation, globalisation, and institutionalisation of the

capital market, there is a greater incentive to focus on creating value for
shareholders. The following observations are clear indications.
Dhirubai Ambani : In everything that we do, we have only one supreme
goal, that is to maximise your wealth as India's largest investor family.
Anand Mahindra : All of us are beginning to look at companies as owned
by shareholders. The key is to raise shareholder returns
 ALTERNATIVE GOALS
Maximisation of Profit
This goal is not as inclusive a goal as maximisation of
shareholders’ wealth. Its limitations are:
• Profit in absolute terms is not a proper guide to decision
making. It should be expressed either on a per share basis or
in relation to investment.
• It leaves considerations of timing and duration undefined.
• It glosses over the factor of risk
Maximisation of EPS or ROE
While these goals do not suffer from the first limitation mentioned
above, they suffer from the other two limitations.
 THE FUNDAMENTAL PRINCIPLE OF FINANCE
A business proposal-regardless of whether it is a new investment or
acquisition of another company or a restructuring initiative –raises
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.
CASH ALONE MATTERS

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

The proposal generates

cash returns to investors
 BUILDING BLOCKS OF MODERN
FINANCE
 Efficient markets theory: Analysis of how prices change over
time in speculative markets.
 Portfolio theory: Formation of an optimal portfolio of
securities.
 Capital asset pricing theory: Determination of asset prices
under conditions of uncertainty.
 Option pricing theory: Determination of the prices of
contingent claims such as call options.
 Agency theory: Analysis of incentive conflicts in contractual
relations.
 Behavioural Finance : Consideration of social, cognitive, and
emotional factors that influence decisions.
 AGENCY PROBLEM

• While there are compelling reasons for separation of

ownership and management, a separated structure leads
to a possible conflict of interest between managers and
shareholders.
• The lack of perfect alignment between the interests of
managers and shareholders results in the agency problem.
• To mitigate the agency problem, effective monitoring has
to be done and appropriate incentives have to be offered.
 BUSINESS ETHICS AND SOCIAL
RESPONSIBILITY

Business Ethics
• Business ethics refers to the standards of conduct or moral
behaviour as applied to business practices.
• Fraud involves violating the law, whereas unethical behaviour
involves breaching the code of ethics or moral behaviour.
• In general, ethical behaviour and long-run profitability are
positively correlated.
• Given the subjective nature of ethics, in many cases the choice
between the ethics and profits is not unambiguous.
 BUSINESS ETHICS AND SOCIAL
RESPONSIBILITY

Corporate Social Responsibility (CSR)

• The World Business Council: “Corporate social responsibility
is the continuing commitment by business to behave ethically
and contribute to economic development while improving the
quality of life of the workforce and their families as well as the
local community and society at large.”
• While Hayek and Friedman argued that a business firm should not
swerve from its economic goal, many business firms in practice
do contribute to various social causes.
 ALL MANAGERS ARE FINANCIAL MANAGERS

• The engineer, who proposes a new plant, shapes the

investment policy of the firm
• The marketing analyst provides inputs in the process of
forecasting and planning
• The purchase manager influences the level of investment
in inventories
• The sales manager has a say in the determination of the
receivables policy
• Departmental managers, in general, are important links
in the finance control system of the firm
ORGANISATION OF FINANCE FUNCTION

Chief Finance
Officer

Treasurer Controller

Financial Cost
Cash Credit
Accounting Accounting
Manager Manager
Manager Manager

Capital Fund Tax Data

Budgeting Raising Manager Processing
Manager Manager Manager

Portfolio Internal
Manager Auditor
 RELATIONSHIP OF FINANCE
TO ECONOMICS

• Macroeconomic environment defines the setting within

which the firm operates. GDP growth rate, savings rate,
fiscal deficit, interest rates, inflation rate, exchange
rates, tax rates, and so on have an impact on the firm

• Microeconomic theory provides the conceptual

underpinnings for the tools of financial decision making.
Finance, in essence, is applied microeconomics
 RELATIONSHIP OF
FINANCE TO ACCOUNTING

• Accounting is concerned with score keeping, whereas

finance is aimed at value maximising.

• The accountant prepares the accounting reports based

on the accrual method. The focus of the financial
manager is on cash flows.

• Accounting deals primarily with the past. Finance is

concerned mainly with the future.
 EMERGING ROLE OF THE
FINANCIAL MANAGER IN INDIA
The job of the financial manager in India has become more important,
complex and demanding due to the following factors:
• Liberalisation
• Globalisation
• Technological developments
• Volatile financial prices
• Economic uncertainty
• Tax law changes
• Ethical concerns over financial dealings
• Shareholder activism
 EMERGING ROLE OF THE
FINANCIAL MANAGER IN INDIA

The key challenges for the financial manager appear to be in the

following areas:
• Investment planning and resource allocation
• Financial structure
• Mergers, acquisitions, and restructuring
• Working capital management
• Performance management
• Risk management
• Corporate governance
• Investor relations
 SUMMING UP
• There are three broad areas of financial decision making, viz., capital
budgeting, capital structure, and working capital management.

• Finance theory, in general, rests on the premise that the goal of financial
management should be to maximise the wealth of shareholders.

• A business proposal raises 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.

• A confluence of forces appears now to be prodding Indian companies to

accord greater importance to the goal of shareholder wealth
maximisation.

• In general, when you take a financial decision, you have to answer the
following questions : What is the expected return ? What is the risk
exposure ? Given the risk-return characteristics of the decision, how
would it influence value ?
• The important forms of business organisation are : sole proprietorship,
partnership, private limited company, and public limited company.
While each form of organisation has certain advantages and limitations,
the public limited company form of organisation generally appears to be
the most appropriate form from the point of view of shareholder wealth
maximisation.

• While there are compelling reasons for separation of ownership and

management, a separated structure leads to a possible conflict of interest
between managers and shareholders.

• The lack of perfect alignment between the interests of managers and

shareholders results in the agency problem. To mitigate the agency
problem, effective monitoring has to be done and appropriate incentives
have to be offered.
• Fraud involves violating the law, whereas unethical behaviour involves
breaching the code of ethics or moral behaviour.

• In general, ethical behaviour and long-term profitability are positively

correlated.

• Corporate social responsibility is the continuing commitment by business

to behave ethically and contribute to economic development while
improving the quality of life of the workforce and their families as well as
of the local community and society at large.

• Financial management is in many ways an integral part of the jobs of

managers who are involved in planning, allocation of resources, and
control.
• The treasurer is responsible mainly for financing and investment
activities and the controller is concerned primarily with accounting
and control.

• Financial management has a close relationship to economics on the

one hand and accounting on the other.

• Thanks to the changes in the complexion of the economic and financial

environment in India from early 1990s, the job of the financial manager
in India has become more important complex, and demanding.