FINANCIAL

MANAGEMENT
SUBJECT CODE : 18MBA22
KARTHIK REDDY S
 Unit 1 and Unit 3 Theory
Financial management – Introduction to financial management, objectives of financial
management – profit maximization and wealth maximization. Changing role of finance
managers. Interface of Financial Management with other functional areas. Sources of
Financing: Shares, Debentures, Term loans, Lease financing, Hybrid financing, Venture
Capital, Angel investing and private equity, Warrants and convertibles (Theory Only)
Emerging Issues: Risk management, Behavioral finance and Financial engineering
Some Definitions

“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious

use of capital and a careful selection of the source of capital in order to enable a
spending unit to move in the direction of reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for

obtaining and effectively utilizing the funds necessary for efficient operations.”- Massie
Objectives of Financial Management
1. Profit maximization
Main aim of any kind of economic activity is earning profit. A business concern is
also functioning mainly for the purpose of earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern.
The finance manager tries to earn maximum profits for the company in the short-
term and the long-term. He cannot guarantee profits in the long term because of
business uncertainties. However, a company can earn maximum profits even in the
long-term, if:
The Finance manager takes proper financial decisions
He uses the finance of the company properly
Objections To Profit Maximisation
It is Vague
It Ignores the Timing of Returns
It Ignores Risk
In new business environment profit maximization is regarded as
◦ Unrealistic
◦ Difficult
◦ Inappropriate
◦ Immoral.
2. Wealth maximization

Wealth maximization (shareholders’ value maximization) is also a main objective of

financial management. Wealth maximization means to earn maximum wealth for the

shareholders. So, the finance manager tries to give a maximum dividend to the shareholders.

He also tries to increase the market value of the shares. The market value of the shares is

directly related to the performance of the company. Better the performance, higher is the

market value of shares and vice-versa. So, the finance manager must try to maximize

shareholder’s value
Wealth or Net Present Value
It is the difference between the present value of benefits and the present value of its
costs.

OR

The difference between the present value of cash inflows and the present value of
cash outflows.
Net Present Value
n
C
NPV   (1  k )
t 1
t
t
C 0

Where,
Ct represents the stream of cash flows expected to occur if a course of action is adopted.
Co is the cash out flow of that action
K is the appropriate discount rate which have both time and risk benefits ( opportunity cost
of capital)
Thus Wealth is the difference between the present value of the stream of benefits and the
initial cost
What role should the financial manager play in a
modern enterprise?
The financial manager plays the crucial role in the modern
enterprise by supporting investment decision, financing
decision, and also the profit distribution decision. He/she also
helps the firm in balancing cash inflows and cash outflows, and
in turn to maintain the liquidity position of the firm
How does the modern financial manager differ
from the traditional financial manager?
The traditional financial manager was generally involved in the
regular finance activities, e.g., banking operations, record keeping,
management of the cash flow on a regular basis, and informing
the funds requirements to the top management, etc. But, the role
of financial manager has been enhanced in the today's
environment; he/she takes an active role in financing, investment,
distribution of profits, and liquidity decisions. In addition, he/she
is also involved in the custody and safeguarding of financial and
physical assets, efficient allocation of funds, etc
Does the modern financial manager's role differ
for the large diversified firm and the small to
medium size firm?
The role of financial manager in case of diversified firm
is more complicated in comparison with a small and
medium size firm. A diversified firm has several
products and divisions and varied financial needs. The
conflicting interests of divisional managers make the
work of financial manager quite difficult in a diversified
firm
Interface of Financial Management
with other functional areas
 Financial Management and Production Department:

The financial management and the production department are interrelated. The
production department of any firm is concerned with the production cycle, skilled
and unskilled labour, storage of finished goods, capacity utilisation, etc. and the
cost of production assumes a substantial portion of the total cost. The
production department has to take various decisions like replacing machinery,
installation of safety devices, etc. and all the decisions have financial
implications.
2. Financial Management and Material Department:

The financial management and the material department are also interrelated.
Material department covers the areas such as storage, maintenance and supply of
materials and stores, procurement etc. The finance manager and material manager
in a firm may come together while determining Economic Order Quantity, safety level,
storing place requirement, stores personnel requirement, etc. The costs of all these
aspects are to be evaluated so the finance manager may come forward to help the
material manager.
3. Financial Management and Personnel Department:
The personnel department is entrusted with the
responsibility of recruitment, training and placement of
the staff. This department is also concerned with the
welfare of the employees and their families. This
department works with finance manager to evaluate
employees’ welfare, revision of their pay scale,
incentive schemes, etc.
4. Financial Management and Marketing Department:
The marketing department is concerned with the selling of
goods and services to the customers. It is entrusted with
framing marketing, selling, advertising and other related
policies to achieve the sales target. It is also required to frame
policies to maintain and increase the market share, to create a
brand name etc. For all this finance is required, so the finance
manager has to play an active role for interacting with the
marketing department.
Sources of Financing
Owned Capital
Owned capital also refers to equity capital. It is sourced from promoters of the company or
from the general public by issuing new equity shares. Promoters start the business by
bringing in the required capital for a startup. Following are the sources of Owned Capital :
Equity Capital, Preference Capital, Retained Earnings, Convertible Debentures, Venture Fund
or Private Equity
Further, when the business grows and internal accruals like profits of the company are not
enough to satisfy financing requirements, the promoters have a choice of selecting
ownership capital or non-ownership capital. This decision is up to the promoters. Still, to
discuss, certain advantages of equity capital are as follows:
It is a long-term capital which means it stays permanently with the business.
There is no burden of paying interest or installments like borrowed capital. So, the risk of
bankruptcy also reduces. Businesses in infancy stages prefer equity capital for this reason.
Borrowed Capital
Borrowed or debt capital is the capital arranged from outside sources. These sources of
debt financing include the following: Financial institutions, Commercial banks or The
general public in case of debentures
In this type of capital, the borrower has a charge on the assets of the business which
means the company will pay the borrower by selling the assets in case of liquidation.
Another feature of borrowed capital is regular payment of fixed interest and repayment
of capital. Certain advantages of borrowing capital are as follows:
There is no dilution in ownership and control of the business.
The cost of borrowed funds is low since it is a deductible expense for taxation purpose
which ends up saving on taxes for the company.
It gives the business a leverage benefit.
Term Loan

The Term Loan is the primary source of long-term debt raised

by the companies to finance the acquisition of fixed assets and
working capital margin. It is also called as a term finance which
means the money raised through the term loans is generally
repayable in regular payments i.e. fixed number of installments
over a period of time.
Advantages of Term Loan

oInterest on debt is tax-deductible, whereas the equity or preference

dividends are paid out of profit after tax.

oThere is no dilution of control of the management, since, in the debt

financing, the lenders have no right to vote.

oThe lenders are not entitled to the profits of the firm as they are only
paid the principal and the interest amount.
Disadvantages of Term Loan

The firm is legally obliged to pay the fixed interest and principal
amount to the lenders, the failure of which could lead to its
bankruptcy.
 LEASING
A famous quote “Why own a cow when the milk is so
cheap? All you really need is milk and not the cow. ” 
A lease can be defined as an arrangement between the lessor 
(owner of the asset) and the lessee (user of the asset) whereby
the lessor purchases an asset for the lessee and allows him to
use it in exchange for periodical payments called lease rentals
or minimum lease payments (MLP). Leasing is beneficial to
both the parties for availing tax benefits or doing tax planning
At the conclusion of the lease period, the asset goes back to the lessor (the owner) in an
absence of any other provision in the contract regarding compulsory buying of the asset by
the lessee (the user). There are four different things possible post-termination of the lease
agreement.

•The lease is renewed by the lessee perpetually or for a definite period of time.

•The asset goes back to the lessor.

•The asset comes back to the lessor and he sells it off to a third party.

•Lessor sells to the lessee.

PURPOSE OF LEASING

BENEFITS OF TAXES
The tax benefit is availed to both the parties, i.e. Lessor and Lessee. Lessor, being
the owner of the asset, can claim depreciation as an expense in his books and
therefore get the tax benefit. On the other hand, the lessee can claim the MLPs i.e.
lease rentals as an expense and achieve tax benefit in a similar way.
AVOID OWNERSHIP AND THEREBY AVOIDING RISKS OF OWNERSHIP
Ownership is avoided to avoid the investment of money into the asset. It
indirectly keeps the leverage low and hence opportunities of borrowing money
remain open for the business. A Lease is an off-balance sheet item.
ADVANTAGES OF LEASING

BALANCED CASH OUTFLOW

The biggest advantage of leasing is that cash outflow or payments
related to leasing are spread out over several years, hence saving the
burden of one-time significant cash payment. This helps a business to
maintain a steady cash-flow profile.
BETTER USAGE OF CAPITAL
Given that a company chooses to lease over investing in an asset by
purchasing, it releases capital for the business to fund its other capital
needs or to save money for a better capital investment decision.
LOW CAPITAL EXPENDITURE
Leasing is an ideal option for a newly set-up business given that it means
lower initial cost and lower Capital Expenditure requirements.
NO RISK OF OBSOLESCENCE
For businesses operating in the sector, where there is a high risk of
technology becoming obsolete, leasing yields great returns and saves
the business from the risk of investing in a technology that might soon
become out-dated. For example, it is ideal for the technology business.
TERMINATION RIGHTS
At the end of the leasing period, the lessee holds the right to buy the
property and terminate the leasing contract, thus providing flexibility to
business.
DISADVANTAGES OF LEASING

REDUCED RETURN FOR EQUITY HOLDERS

Given that lease expenses reduce the net income without any appreciation in value, it means limited
returns or reduced returns for an equity shareholder. In such a case, the objective of wealth
maximization for shareholders is not achieved.
PROCESSING AND DOCUMENTATION
Overall, to enter into a lease agreement is a complex process and requires thorough documentation and
proper examination of an asset being leased.
NO OWNERSHIP
At the end of the leasing period, the lessee doesn’t end up becoming the owner of the asset though
quite a good sum of payment is being done over the years towards the asset.
MAINTENANCE OF THE ASSET
The lessee remains responsible for the maintenance and proper operation of the asset
being leased.
Hybrid Financing
Is the financial security that possesses the characteristics of both the
debt and equity.

The debt and equity are the two extreme points and in the
midpoint lies the hybrid financing that offers the investors the
benefits of both the equity and debt. Equity gives the right to have
a residual claim on the cash flows and assets of the firm and
have control over the management. Whereas, the debt represents
the fixed claim over the cash flows and the assets of the firm, but
generally, do not give the right to control the management.
Types of Hybrid Financing
Stock Warrants

The Stock Warrants are like the options that give the holder the right, but not the
obligation to buy or sell the security at a specific time and a specific date.

The companies usually add the warrants with its new securities or offerings and
therefore whenever the investor exercises his warrant, he gets the newly issued
stock rather than the existing outstanding stock. Due to this, the warrant causes
the dilution as the company is obligated to issue new shares whenever the
investor exercises his warrant
Venture Capital

Venture Capital can be defined as the financing for startup

companies and small enterprises, that involves a considerable
amount of risk but are supposed to have long-term growth
potential, i.e. the project can earn a high rate of return.
A Venture Capitalist, invest in the equity or debt of the firm promoted by
new professionally or technically qualified but an unproven entrepreneur,
whose business idea is relatively unique, but does not possess financial
backing.

Venture Capitalist Company (VCC) is quite interested in entrepreneurial

businesses with high growth prospects managed by an experienced team
who have the potential to turn the business plans into reality.
Method of Venture Capital Financing

Equity Financing: A firm needs funds for a longer period to survive and
grow, but as venture capital firm is a new company the firm is not able to
give timely returns to its investors, for which equity financing proves
beneficial. The investor’s contribution is not more than 49% of the total
stake, and so the ultimate power remains with the entrepreneur.
Conditional Loan: Conditional loans are the one that does not carry
interest and are repayable to the lender in the form of royalty after
the venture capital undertaking is able to make revenue. The royalty
rate may vary from 2% to 15%, on the basis of factors such as
gestation period, external risk and cash flow patterns.
Income Note: A form of hybrid financing, that combines the
characteristics of the traditional loan and conditional loan, on which
the venture capital firm pays both royalty and interest, but at low
rates.
Participating Debentures: The interest on participating
debentures is payable at three various rates, as per the phase
of operation:
◦ Start-up phase — Nil
◦ Initial operations phase — Low rate of interest
◦ After a particular level of operations – High rate of interest
Convertible loans: The loans which are convertible into equity
when interest on the loan is not paid within the stipulated
period