Unit 1

Introduction to Financial Management

Finance
• It is the provision of money at a time it is wanted.
• It is required in every aspect of business activities.
• Organization cannot survive without healthy financing activities.
• Finance can be broadly defined as the activity concerned with
planning, raising, controlling and administering of the funds used in
the business.
• Business finance is that business activity which is concerned with the
acquisition and conservation of the capital funds in meeting of the
financial needs and overall objectives of a business enterprise.
Financial Management
• Financial Management is the management of flow of funds.
• Financial Management is the planning, organizing, directing and
controlling the financial activities such as procurement of funds in the
most economic manner and employment of those funds in the most
optimum manner.
• It is concerned with the effective and judicious employment of funds.
• The basic objective is to maximize the value of the firm i.e. maximize
the shareholder’s wealth represented by the market value of the
shares.
Cont..
• “Financial Management is concerned with the efficient use of an
important economic resource namely capital funds”- Solomon
• “Financial Management is concerned with the acquisition, financing
and management of assets with some overall goal in the mind”-
James ‘C’ Van Home
• “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
• Wealth Maximization
• Profit Maximization
• Focus on stakeholders
• Estimation of capital requirements
• Optimum utilization of funds
• Management of cash
• Coordination with other financial departments
• Ensuring maximum operational efficiency
• Ensuring financial discipline in the organization
Finance Functions
• Long term finance decisions:
a) Investment decisions (Capital Budgeting decisions)
b) Financing decisions (Capital structure decisions)
c) Dividend decisions ( distribution of profits or dividend and Retained
earnings)
• Short term finance decisions:
a) Liquidity decisions (working capital decision)
Scope of Financial Management
Traditional Approach (Finance upto 1950s)
• Arrangement of funds from financial institutions.
• Procurement of funds through different financial sources (Equity
share capital, Preference Share capital, Debt in the form of loans,
debentures, bonds, public deposits, commercial papers, Retained
earnings.
• Looking after the legal and accounting relationship between a
corporation and its sources of funds.
Cont..
Traditional Approach was criticised on following grounds:
• Outsider-looking approach (treated finance from the viewpoint of the
supplier of the funds- outsiders, bankers, investors, lenders etc.)
• Ignored routine problems (focused on episodic or infrequent
happenings)
• Ignored working capital financing
• No emphasis on allocation of funds (only focus on procurement)
Modern Approach
• The modern approach is an analytical way of looking into financial
problems of the firm.
• According to this approach, the finance function covers both
acquisition of funds as well as the allocation of funds to various uses.
• Financial management is concerned with the issues involved in raising
of funds and efficient and wise allocation of funds.
Cont..
• Modern Approach (Since 1950s)
Where to invest funds?

What are the

sources of funds?

What to do with
those earnings?
Functions of Financial Management/
Manager
• Estimation of capital requirements.
• Determination of capital composition (long term or short term funds).
• Choice of sources of funds (Equity, Preference, debt, retained earnings).
• Disposal of surplus (payment of dividend, retained earnings).
• Cash Management (how much cash is required and how it will be
generated such as salary, bills, stocks, raw materials etc.)
• Financial Control (ratio analysis, forecasting, budgeting, standard
costing).
• Investment of funds.
• Evaluation of financial performance.
Functions/Role of Financial Manager
in Modern Age
• Corporate Governance
• Management Information system (MIS)
• Treasury and Risk Management
• Investor Relations
• Capital Structure
• Mergers and Acquisitions
Financial Management and other
areas of Management
• FM and Production Department
• FM and Materials Department
• FM and Personnel Department
• FM and Marketing Department
• FM and Financial Accounting
• FM and Assets Management
• FM and Strategic Management
Goals of FM
• Profit Maximization vs Wealth Maximization
Profit Maximization
• It is the capability of the firm in producing maximum output in limited
input.
• It aims at maximizing profit of the company at a given point of time.
• Profit= Total revenue- Total cost.
• A firm is able to ascertain the input-output level which maximizes the
profit of the organization.
• Only those activities which increases the profit of the concern are
considered and those which decreases the profitability are avoided.
• Profit is an operational concept which signifies output is more than
input.
Cont..
• Advantages of Profit Maximization:
• Best criteria for decision-making.
• Efficient allocation of resources.
• Optimum utilization.
• Disadvantages of Profit Maximization:
• It ignores time value of money.
• It ignores risk factor.
• It is a vague concept (short term or long term profit).
• It mainly focuses on short period (draws concept from the field of accounting).
• It may widen the gap between perception of management and shareholders.
• It overlooks the quality aspect (society)
Wealth Maximization
• It is the ability of the company to increase the market value of its common stock over time.
• Market value is based on the goodwill, sales, services and quality of the products.
• The main objective is to maximize the market value of firm’s share and accounting the risk
factor present in the market.
• The fundamental goal is to increase the wealth of the shareholders as they are the owners
of the undertakings.
• This concept is widely acceptable operational decision for finance manager.
• The measure of wealth used in the financial management is economic value. The
economic value is defined as the present value of the future cash flows generated by a
decision, discounted at appropriate rate of discount which reflects the degree of
associated risk.
• Measure of economic value is based on cash flows rather than the profit.
Cont…
• The shareholders wealth is represented by the present value of all the
future cash flows in the form of dividends and other benefits expected from
the firm.
• Financial decisions are taken in such a way that the shareholders receive
the highest combination of dividends and the increase in market price of
the share.
• Shareholders wealth maximization means maximizing the net present
value. Financial action resulting in negative NPV should be rejected.
• Between mutually exclusive projects the one with highest NPV should be
adopted.
• NPV(A) + NPV(B) = NPV(A+B)
Cont…
• Advantages of Wealth Maximization
• It focuses on the long run.
• It considers the time value of money.
• It incorporates the risk factor.
• It maintains the market price of the shares of the company.
• Quality and quantity both are considered.
• Lays emphasis on regular dividend payment to shareholders.
Profit Maximization vs Wealth
Maximization
Basis of comparison Profit Maximization Wealth Maximization
Concept Process through which company is Ability of the company to increase
able to increase its profit earning the value of the stock
capacity
Objective To earn profit To maximize shareholder’s value
Emphasis Short run Long run
Time value of money It ignores time value of money It considers the time value of
money
Risk and Uncertainty It ignores risk and uncertainty It considers risk and uncertainty

In short run profit maximization can be considered but in the long run wealth maximization should be
considered as it affects the interests of the shareholders. For day to day decision making profit maximization
can be considered.
Risk- Return Trade-off
• In FM risk is defined as the variability of expected returns from an
investment.
• Investment in government bonds are less risky as interest rate is
known and default risk is less but return is also less. However, risk
increases if one invests in shares as return is not certain. Risk and
return move in tandem.
• Greater the risk, the greater the expected return.
• Return= Risk free rate + Risk premium
Cont..
An overview of Financial
Management
Important Decisions concerning
Financial Management
There are three decisions to be made by Finance Manager:
• Investment decision
• Financing decision
• Dividend decision
What is Investment Decision?

• Investment decision refers to the decisions that involve

the investment of various resources of the firm to gain
the highest possible return on investment for their
investors.
• An investment decision is categorized as a long-term
(Capital- Budgeting Decisions) and short-term (Working
capital Decisions) investment decision.
• A firm has to also keep in mind the scarcity of
resources.
Capital Budgeting Decisions
• Capital budgeting is a process that businesses use to evaluate
potential major projects or investments.
• Building a new plant or taking a large stake in an outside venture are
examples of initiatives that typically require capital budgeting
before they are approved or rejected by management.
• As part of capital budgeting, a company might assess a prospective
project's lifetime cash inflows and outflows to determine whether
the potential returns it would generate meet a sufficient target
benchmark.
• The capital budgeting process is also known as investment
appraisal.
Capital Budgeting Decisions
• Ideally, businesses could pursue any and all projects and
opportunities that might enhance shareholder value and profit.
• However, because the amount of capital any business has available
for new projects is limited, management often uses capital
budgeting techniques to determine which projects will yield the best
return over an applicable period.
• These decisions generally involve vast amounts of investment and
are mostly irreversible except when there is a huge cost.
• The size of assets, profitability, and competitiveness are all
influenced by investment decisions.
Working Capital Decisions
• A short-term investment decision is known as a Working Capital Decision.
• Such decisions involve decisions regarding the levels of cash, inventory,
and receivables.
• Short-term decisions are required in the everyday working of a business and
also influence the liquidity as well as the profitability of a business.
• The essential elements of sound working capital management are efficient
cash management, inventory management, and receivables management.
There are several projects available for the firm to invest in.
• The projects have to be analyzed cautiously and are selected or rejected
based on the volume of return.
 Conti……
• Cash Flows of the Project: Whenever an investment decision involving a huge amount is
taken, the firm looks forward to generating some cash flows over a period. The form in which
such cash flows are presented is usually in the form of a series of cash receipts and payments
over the life of an investment. Before taking any capital budgeting decision, these cash flows
should be properly measured and evaluated.
• The Rate of Return: In any project undertaken by the firm, the most important part of it is
the rate of return received from them. The evaluation of such projects is done based on the
returns expected from them. Also, the estimation of risk is done depending on the returns. For
example, if there are two projects, X and Y (with the same risk involved), with a rate of return
of 10 percent and 15 percent, respectively, under any normal circumstance, project Y should
be opted for. This is because project Y has a higher rate of return and therefore, more profit.
• The Investment Criteria Involved: The decision of investment in any of the projects is
concerned with the calculation and evaluation of several elements, such as the amount of
investment, interest rate, cash flows, and rate of return. The selection of any particular project
is based on different evaluation techniques known as capital budgeting techniques. Such
techniques are applied to the projects before choosing a certain one.
Financing Decisions
The financing decision is about the amount of finance to be raised from
various long-term sources, this determines the various sources of
finance, as well as it also provides the cost of each source of finance.
The main sources of finance are:
• Shareholders’ Funds
• Borrowed Funds

Both sources have their own merits and demerits

Conti….
• The shareholders’ funds or owners’ funds consist of equity capital and
retained earnings, whereas borrowed funds refer to finance raised as
debentures or other forms of debt.
• The borrowed funds contain risk because they involve a commitment of
fixed interest payment, although there will be loss in the organisation.
• On the other hand, owners’ funds have less risk because there is no such
commitment regarding payment of dividends and replacement of the
capital amount.
• Financing decisions involve analysing the risk and cost associated with
each source of finance.
Conti….
1. Cost:
• The cost of raising funds from different sources is different. A financing manager
generally prefers the cheapest source of finance.
2. Risk:
• The risk associated with different sources of finance is a different borrowed fund has a
high degree of risk, as compared to the owners. The financial manager considers the risk
involved with each source before taking a financing decision. In the case of equity, the
risk is low, and in the case of debt, the risk is high.
3. Floatation Cost:
• Floatation cost refers to the cost, which is involved in the issue of securities. In the case of
equity, floatation cost is low, and in the case of debt, floatation cost is high. Some of the
examples are underwriting commission, broken range stamp duty, etc. The firm prefers
securities with the least floatation cost.
4. Cash Flow Position:
• A company with a strong cash flow position can take the advantage of debt because interest
payment and re-payment of principal amount can be preferred by companies when there will be
a shortage of cash.
5. Level of Fixed Operating Costs:
• Owner’s fund is preferred by firms with a higher level of operating costs, like rent, salaries,
insurance premiums, etc., because interests payment on debt will further add to the cost burden.
And in case of moderate or low fixed operating costs, firms can go for borrowed funds.
6. Control Consideration:
• The issue of more equity shares may lead to a dilution of management control over the business.
Debt financing has no such implication. Companies that are afraid of taking over will prefer
debt. It means if existing shareholders want to retain complete control of the company, then the
debt should be preferred. However, if they don’t mind the loss of control, then the company
may go for equity. So we can say that equity dilutes control, whereas debt doesn’t affect control.
7. State of Capital Market:
• The condition of the stock market also helps in making the source of finance. In the case when
the stock market is rising, during this period it is also easy to raise funds for the issue of shares
because people are interested to invest in equity shares. But in case of a depressed market,
company may face difficulties for issue equity shares.
Dividend Decision

• The dividend is that portion of the profit that is distributed to the shareholders.
• The decision involved here is how much of the profit earned by the company
after paying the taxes is to be distributed to the shareholders.
• It also includes the part of the profit that should be retained in the business.
• When the current income is re-invested, the retained earnings increase the
firm’s future earning capacity.
• This extent of retained earnings also influences the financing decision of the
firm.
• The dividend decision should be taken keeping in view the overall objective of
maximizing shareholders’ wealth.
Conti….
• Amount of Earnings: Dividends are paid out of the current and previous year’s
earnings. More earnings will ensure greater dividends, whereas fewer earnings will
lead to the declaration of a low rate of dividends.

• Stability of Earning: A company that is stable and has regular earnings can afford
to declare higher dividend as compared to those company which doesn’t have such
stability in earnings.

• Stability of Dividend: Some companies follow the policy of playing a stable

dividend because it satisfies the shareholders and helps in increasing companies
reputation. If earning potential is high, it is declared as a high dividend, whereas if
the earning is temporary or not increasing, then it is declared as a low or normal
dividend.
• Growth Opportunities: Companies with growth opportunities prefer to retain more money
out of their earnings to finance the new project. So, companies that have growth prospects in
near future will declare fewer dividends as compared to companies that don’t have any growth
plan.

• Cash flow Position: Payment of dividends is related to the outflow of cash. A company may
be profitable, but it may have a shortage of cash. In case the company has surplus cash, then
the company can pay more dividends, but during a shortage of cash, the company can declare a
low dividend.

• Taxation Policy: The rate of dividends also depends on the taxation policy of the government.
In the present taxation policy, dividend income is tax-free income to the shareholders, so they
prefer higher dividends. However, dividend decision is left to companies.

• Stock market reaction: The rate of dividend and market value of a share are directly related
to each other. A higher rate of dividends has a positive impact on the market price of the
shares. Whereas, a low rate of dividends may hurt the share price in the stock market. So,
management should consider the effect on the price of equity shares while deciding the rate of
dividend.
Time Value of Money
• The concept of time value of money refers to the fact that the money
received today is different in its worth from the money receivable at
some other time in future. In other words, money receivable in future
is less valuable than the money received today.
• “A bird in hand is worth two in the bush”
• One rupee of different periods can be compared by introducing the
interest factor. This interest factor is one of the crucial exclusive
concept of the theory of finance. This concept is also known as “Time
Value of Money”
Time Value of Money
• An important principle in finance is that the value of money is time
dependent.
• The value of a unit of money is different in different time periods.
• The value of a sum of money received today is more than its value
received after some time.
• Conversely, a sum of money received in future is less valuable than it
is today.
• The time value of money is also referred as time preference for
money.
Reasons for Time Value of
Money
• Investment Opportunities: Money has the potential to grow over a
period of time because it can be invested somewhere. For example, if
Rs. 1000 can be invested in a fixed deposit for one year at 7% p.a., the
money will grow to Rs, Rs. 1070 at the end of one year. Therefore,
given the choice of Rs. 1000 now or the same amount in one year’s
time, it is always preferable to take Rs. 1000 now.
• Inflation: Inflation is the fall in the purchasing power of money. It
makes money cheaper and the goods and services costlier. Suppose
you can buy 1 kg of rice with Rs. 50 today. If the inflation rate is 10%,
You need Rs. 55 to buy 1 kg of rice a year from now.
Reasons for Time Value of
Money
• Risk: Money received now is certain, whereas money tomorrow is less
certain. This ’bird in the hand’ principle is extremely important in
investment appraisals.
• Personal consumption preference: Many people have a strong
preference for immediate rather than delayed consumption. For a
hungry man, promise of a meals next month means nothing.
Techniques

Two methods to calculate the time value of money

• Compounding Technique
• Discounting Technique

Compounding emphasizes the future value of money by accounting for

the growth of investments over time. On the other hand, discounting
focuses on the present value of money by considering the current
worth of future cash flows.
 Future value (FV):
• The amount to which a cash flow or a series of cash flows will grow over a period
of time when compounded at a given interest rate.
• Future value of Lump-Sum amount can be calculated as;
FV = PV (1+i)n
Where,
• FV = future value or ending amount
• PV = present value or beginning amount
• i = interest rate per period
• n = the number of periods
• (1+i)n = future value (interest) factor
FV (of a lump sum) = PV x CVFn,i
Future value of Annuity
• Annuity is a constant periodic amount for a certain specified number
of periods.
• Future value (FV) of an Annuity= Annuity x CVFAn,i

• Where;
• FVn = future value of an annuity over n periods
• A = Annual payments/receipts
• CVFA = annuity future value interest factor
• i = interest rate
• n = number of periods
Present value :
• Present value is the value today of a future lump sum cash flow or a series of cash flows.
• The present value of a cash flow due n years in the future is the amount which, if it were on hand today,
would grow to equal the future amount.
• Present value of a lump-sum can be calculated as;

• Where,
• PV = present value
• FV = future value
• i = interest rate or rate of return
• n = number of periods
• 1/(1+i)n = present value (interest) factor
Hence,

PV= FV x PVFi, n
Present value of Annuity
• Present value of an annuity:
• PV= Annuity x ( PVFAi,n )
• Where;
• PV = present value of an annuity of n periods
• Annuity = periodic payments
• PVFAi,n = present value interest factor annuity
• i= interest rate
• n= number of years
Formulas at Glance
• FV (of lump-sum) = PV x CVFn,i
• FV (of annuity)= Annuity x CVFAn,i
• PV (of lump-sum) = FV x PVFi, n
• PV= Annuity x ( PVFAi,n )
Sinking Fund
• Sinking funds are traditionally used by businesses to set
money aside each month to pay off a debt or a bond.
• Using a sinking fund means the company won’t have to
pay as much out of pocket when the debt is due.
• Rule of 72
• Rule of 69
• Rule of 114
• Rule of 144
• Rule of 100