Financial
Management
Dr. Neha Gupta
What is Financial Management?
Imagine you were to start your own business. What questions you
would have to answer?
1. What long-term investments should you take on? That is, what
lines of business will you be in, and what sorts of buildings,
machinery, and equipment will you need?
2. Where will you get the long-term financing to pay for your
investments? Will you bring in other owners, or will you borrow the
money?
3. How will you manage your everyday financial activities, such as
collecting from customers and paying suppliers?
Forms of Business Organization
Sole proprietorship-A sole proprietorship is a business owned by one person. This is the simplest
type of business to start and is the least regulated form of organization.
The owner of a sole proprietorship keeps all the profits.
The owner has unlimited liability for business debts. This means that creditors can look to the
proprietor’s personal assets for payment.
Partnership- A partnership is similar to a proprietorship, except that there are two or more
owners (partners). In a general partnership, all the partners share in gains or losses, and all
have unlimited liability for all partnership debts, not just some particular share.
In a limited partnership, one or more general partners will run the business and have unlimited
liability, but there will be one or more limited partners who do not actively participate in the
business.
(1) unlimited liability for business debts on the part of the owners, (2) limited life of the business,
and (3) difficulty of transferring ownership.
Forms of Business Organization
Corporation- A corporation is a legal “person” separate and distinct from its
owners, and it has many of the rights, duties, and privileges of an actual person.
Starting a corporation is somewhat more complicated than starting the other forms
of business organization.- articles of incorporation.
Advantages: Ownership (represented by shares of stock) can be readily
transferred, and the life of the corporation is, therefore, not limited.
The corporation borrows money in its own name. As a result, the stockholders in a
corporation have limited liability for corporate debts. The most they can lose is
what they have invested.
The relative ease of transferring ownership, the limited liability for business debts,
and the unlimited life of the business are the reasons the corporate form is
superior when it comes to raising cash.
Forms of Business Organization
Disadvantages:
Because a corporation is a legal person, it must pay taxes.
Moreover, money paid out to stockholders in the form of dividends
is taxed again as income to those stockholders
Goldman Sachs, one of Wall Street’s last remaining partnerships,
decided to convert from a private partnership to an LLC (it later
“went public,” becoming a publicly held corporation)
[Link].
A typical Organizational Chart
Role of Financial Manager
The vice president of finance supervises the roles of both the treasurer and the
controller.
The controller's office manages cost accounting, financial accounting, tax
obligations, and management information systems.
Conversely, the treasurer’s office is in charge of overseeing the company’s cash
flow and credit, as well as its financial planning and capital investments. These
treasury functions are interconnected with the three main questions mentioned
earlier.
Three Key decisions
01 02 03
INVESTMENT FINANCING DIVIDEND
DECISION DECISION DECISION
INVESTMENT DECISION
• Invest in one of the three basic areas:
• Capital Assets
Return, risk, cash flow and profit
• Working capital
Inventory and receivables
• Financial Assets
Risk, liquidity and return
FINANCING DECISION
DIVIDEND DECISION
Examples of investment and financing
decisions by major public corporations
Objective?
In traditional financial management, the objective in decision making is to maximize
the value of the firm.
Profit Maximization?
Do we mean profits this year?
Long run profits?
From the stockholders’ point of view, what is a good financial management decision?
A narrower objective is to maximize stockholder wealth. When the stock is traded
and markets are viewed to be efficient, the objective is to maximize the stock price.
Maximize the market value of the existing owners’ equity.
Good financial decisions increase the market value of the owners’ equity and poor
financial decisions decrease it.
The Case of Vijay Mallya and Kingfisher Airlines - Seven Pillars Institute
Problem with Profit Maximization?
It is argued that profit maximization assumes perfect competition
and in imperfect competition, this objective will not hold.
Profit maximization fails to serve as an operational criterion for
maximizing the owner’s economic welfare.
Meaning of the profit is unclear
Time Value of Money: It does not make an explicit distinction
between returns received in different time periods.
Uncertainty of returns.
Let us assume that a company has 10,000 shares outstanding,
PAT of 50,000$ and EPS of $5. If the company sells 10,000
additional share at $50 per share and invests the 5,00,000$ at 5%
after taxes, then the total profits after taxes will increase to
$75,000. However, the EPS will decrease to $3.75. What happened
here?
Wealth Maximization is the
solution!
From shareholder’s point of view, the wealth
created by a company through its actions is
reflected in the market value of the company’s
shares.
Maximizing the shareholders’ economic welfare is
equivalent to maximizing the utility of their
consumption over time.
Our goal does not imply that the financial manager should take
illegal or unethical actions in the hope of increasing the value of
the equity in the firm.
What we mean is that
the financial manager
best serves the owners
of the business by
identifying goods and
services that add value
to the firm because
they are desired and
valued in the free
marketplace
Case: The Rise and Fall of Enron - The Biggest Scandal in the History of American Finance -
[Link]
[Link] [Link]
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articles/profitpressu
[Link]
Agency Problem
The financial manager in a corporation acts in the best interests of the stockholders
by taking actions that increase the value of the firm’s stock.
However, we’ve also seen that in large corporations, ownership can be spread over
a huge number of stockholders.
This dispersion of ownership arguably means that management effectively controls
the firm.
The relationship between stockholders and management is called an agency
relationship.
Such a relationship exists whenever someone (the principal) hires another (the
agent) to represent his or her interest.
Agency costs refer to the costs of the conflict of interest between stockholders and
management
In all such relationships, there is a possibility of conflict of interest
between the principal and the agent. Such a conflict is called an
agency problem.
While the financial manager acts in the stockholders' best interests by increasing
stock value, in large corporations, ownership can be widely distributed among
numerous shareholders.
This diffusion of ownership often leads to management exerting control over the
firm. Therefore, it raises the question: Will management always act in stockholders'
best interests?
Example
Suppose you hire someone to sell your car and you agree to pay her a
flat fee when she sells the car. The agent’s incentive in this case is to
make the sale, not necessarily to get you the best price. If you paid a
commission of, say, 10 percent of the sales price instead of a flat fee,
then this problem might not exist. This example illustrates that the way
an agent is compensated is one factor that affects agency problems.
Management may tend to overemphasize organizational survival to
protect job security. Also, management may dislike outside interference,
so independence and corporate self-sufficiency may be important goals.
Managers who are successful in pursuing stockholder goals will be
in greater demand in the labor market and thus command higher
salaries
How to ensure that managers act in
interest of stockholders?
Whether managers will, in fact, act in the best interests of stockholders
depends on two factors. First, how closely are management goals aligned
with stockholder goals? This question relates to the way managers are
compensated. Second, can management be replaced if they do not
pursue stockholder goals? This issue relates to control of the firm.
First, managerial compensation, particularly at the top, is usually tied to
financial performance in general and oftentimes to share value in
particular. For example, managers are frequently given the option to buy
stock at a fixed price. The more the stock is worth, the more valuable is
this option.
Control of the firm ultimately rests with stockholders. They elect
the board of directors, who, in turn, hires and fires management.
Stakeholders
The financial manager should consider the ethical implications of their actions on three levels:
1. Society Level: How the decision impacts society as a whole and whether it aligns with societal values and norms.
Case: The Story of Bottled Water –
[Link]
2. Corporate Level: How the decision fits within the company's ethical standards and values.
Case: The Rise and Fall of Enron - The Biggest Scandal in the History of American Finance -
[Link]
Case: The Collapse of Carillion: Inside the Financial Scandal –
[Link]
3. Individual Level: How the decision affects individuals, including employees, customers, and other stakeholders,
and whether it considers their rights and well-being.
Time Value of Money
Exercises
E.g. 1 - Suppose you were to invest $100 in a savings account that pays 10 percent
interest per year.
(a) How much would you have in one year?
(b) What will you have after two years, assuming the interest rate doesn’t change?
E.g. 2 - Suppose you locate a two-year investment that pays 14 percent per year. If
you invest $325, how much will you have at the end of the two years?
E.g. 3 - Suppose you need to have $10,000 in 10 years, and you can earn 6 percent on your
money. How much do you have to invest today to reach your goal?
E.g. 4 - You are offered an investment that will pay you $200 in one year, $400 the next
year, $600 the next year, and $800 at the end of the next year. You can earn 12 percent on
very similar investments. What is the most you should pay for this one?
E.g. 5- You have just received notification that you have won the $1.25 million first
prize in the Centennial Lottery. The prize will be awarded on your 100th birthday, 79
years from now. The appropriate discount rate is 6.4 percent, compounded annually.
What is the present value of your winnings?
E.g. 6- Javier and Alex plan on retiring 27 years from today. At that time, they plan to
have saved the same amount. Javier is depositing $15,000 today at an annual interest
rate of 5.2 percent. How will Alex's deposit amount vary from Javier's if Alex also
makes a deposit today, but earns an annual interest rate of 6.2 percent? Alex’s deposit
will need to be ______ than Javier’s. (Assume annual compounding on both accounts.)
E.g. 7- What is the present value of $45,000 to be received 50 years from today if
the discount rate is 8 percent, compounded annually?
E.g. 8 -Sara wants to establish a trust fund to provide $75,000 in scholarships each
year. She believes the fund can earn a fixed 6.15 percent annual rate of return. How
much money must she contribute to establish the fund?
E.g. 9- A student organization plans to invest annual payments of $60,000, $70,000,
$75,000, and $50,000, respectively, over the next four years. The first payment will
be invested one year from today. Assuming the investment earns 5.5 percent
annually, how much will the organization have available four years from now?
E.g. 10- Your company proposes to buy an asset for $335. This investment is very
safe. You will sell the asset in three years for $400. You know you could invest the
$335 elsewhere at 10 percent with very little risk. What do you think of the
proposed investment?
