FINANCIAL MANAGEMENT - UNIT 1

I. ROLE OF FINANCE MANAGER

The function of finance manager now is to manage the funds. In particular, the
finance manager has to focus his attention on:
(i) Procuring the required quantum of funds as and when necessary, at the lowest
cost.
(ii) Investing these funds in various assets in the most profitable way, and
(iii) Distributing returns to the shareholders in order to satisfy their expectations from
the firm.
These three functions of the finance manager encompass most of the financial
events in any firm. Thus, the functions of finance manager may be summarized to
include the following
(i) Overall financial planning and control,
(ii) Raising funds from different sources,
(iii) Selection of fixed assets,
(iv) Management of working capital, and
(v) Any other individual financial event.
While performing these functions, finance manager has to operate as intermediary
between the firm’s operations one hand and the capital market on the other. The role
of finance manager as an intermediary arises because of two-way cash flows
between the firm and the investors. In the first instance, the investors provide funds
through capital market, to the firm, and second, the firm distributes profits among the
investors in the form of interest or dividends. The firm raises funds by selling
ownership securities or debt securities or borrowings in the capital market. The funds
raised in this way become the pool of the investible funds which are committed to the
investment decisions of the firm. The investment projects generate profit which are
either distributed to the suppliers of investible funds or retained in the business for
reinvestment in the future projects. The finance manager has to take care of the
interest of the investors as well as the firm.
II. SCOPE OF FINANCING DECISIONS:
(i) Investment Decisions: The investment decisions are the decisions relating to
assets composition of the firm. Assets represent investment or uses of the funds that
the firm makes in expectation of earning a return for its investors. Broadly, these
assets can be classified into fixed assets and current assets, and therefore, the
investment decisions can also be bifurcated into Capital Budgeting decisions
(relating to fixed assets) and the Working Capital Management (relating to current
assets).
The fixed assets of a firm are the primary factors and the determinants of the
profitability of a firm. The earnings of the firm are basically caused by the fixed
assets composition and also the total fixed assets vis-a-vis total assets of the firm.
The Capital Budgeting decisions are more crucial for any firm. A finance manager
may be asked to decide about
(1) which asset should be purchased out of different alternative options,
(2) to buy an asset or to get it on lease,
(3) to produce a part of the final product or to procure it from some other supplier,
(4) to buy or not another firm as a running concern,
(5) proposal of merger of other group firms to avail the synergies of consolidation,
etc.
All these decisions have long term ramifications and are generally irreversible. The
objective of Capital Budgeting decisions is to identify those assets which are worth
more than they cost. A finance manager, therefore, has to take utmost care in
dealing with these decisions.
Working Capital Management, on the other hand, deals with the management of
current assets of the firm. Though the current assets do not contribute directly to the
earnings, yet their existence is necessitated for the proper, efficient and optimum
utilization of fixed assets. There are dangers of both the excessive working capital as
well as the shortage of working capital. A finance manager has to ensure sufficient
and adequate working capital to the firm.
(ii) Financing Decisions: Firms have also to decide how they should raise
resources. There are two main sources of finance for any firm, the shareholders’
funds and the borrowed funds. These sources have their own peculiar features and
characteristics. The key distinction between these two sources lies in the fixed
commitments created by borrowed funds to pay interest and the principal.
The borrowed funds are always repayable (except when the debt instrument is
convertible into shares) and require payment of a committed cost in the form of
interest on a periodic basis. The borrowed funds are relatively cheaper but always
entail a risk. This risk is known as the financial risk i.e., the risk of insolvency due to
non-payment of interest or non-repayment of capital amount.
The shareholders’ funds is the main source of funds to any firm. This may comprise
of the equity share capital, preference share capital and the accumulated profits.
There is no committed outflow for equity shares capital neither in the form of a return
nor in the form of repayment of capital.
However, the preference share capital has a commitment to be paid a minimum
dividend (which is of course conditional) and also for repayment of capital when
these shares are to be redeemed after some time (as the preference share in India
can only the redeemable preference shares).
(iii) Dividend Decision: This deals with the appropriation of after-tax profits. These
profits are available to be distributed among the shareholders (subject to legal
provisions) or can be retained by the firm for reinvestment within the firm. The profits
which are not distributed are impliedly retained in the firm. All firms whether small or
big, have to decide how much of the profits should be reinvested back in the
business and how much should be taken out in form of dividends i.e., return on
capital. On one hand, paying out more to the owners may help satisfying their
expectations, on the other, doing so has other implications as a business that
reinvests less will tend to grow slower. There cannot be any readymade policy for
any firm regarding how much profit is to be distributed
and how much portion is to be retained. Retention of profit is of course related to:
1. Reinvestment opportunities available to the firm,
2. The opportunity rate of return of the shareholders.
The distribution of profits by any firm is required to satisfy the expectations of the
shareholders. The profits can be distributed to shareholders either as current
revenue (i.e. the dividends) or as capital receipt (i.e. bonus share). These have their
own tax implications in the hands of the shareholders as well as the firm. Both have
their effect on the market value of the firm also. The finance manager is required to
take various decisions regarding distribution of profit as dividend or as bonus shares.
In his attempt, he has to look into the funds requirements of the firm and the
shareholder’s interest.

III. FINANCIAL MARKET

A financial market may be defined as the market of financial assets i.e., the market in
which the financial assets are transacted.
Issue of shares and debentures by a company, issue of mutual fund units, working
capital loans by commercial banks, long-term financial assistance by financial
institutions, inter-bank call money transactions are a few examples of financial
transactions which are undertaken in financial markets.
The financial market may be divided into four parts i.e.,
1.Money market: It is a market for short term debt transactions. The money market
in India consists of informal money market and formal money market. The informal
money market includes the indigenous money lenders, nidhis, chit funds, etc. Their
operations are not governed by Government regulations but by traditional practices.
Usually, their operations are restricted to a particular geographical area only. The
basic characteristics of the informal money market are informal procedures, high rate
of interest, flexible terms and loan as per mutual convenience of the parties, etc. The
formal money market is basically characterized by the presence of the Reserve Bank
of India, Discount and Finance House of India Limited, Mutual Funds, Non-Banking
Financial Companies, Commercial Banks, Financial Institutions, etc. These
participants in the formal money market transact in Treasury Bills, Inter-Bank Call
Money, Commercial Bills of Exchange, Inter-Corporate Deposits, etc. The basic
characteristics of the formal money market are:
(i) Regulated by the RBI by way of regulation of interest rate and reserve
requirements of commercial banks,
(ii) Fairly strict and rigid rules of operations, and
(iii) Low rates of interests. In the money market, funds are available for periods
ranging from a single day upto a year.
2. Capital market: It is a market for long-term financial assets such as shares,
bonds, debentures, mutual fund units, etc. It can be divided into New Issue Market
(primary market) and Secondary Market. The New Issue Market provides a system
wherein different companies, mutual funds and institutions issues (sells) their
financial instruments e.g. shares, debentures etc. and the investors (both individuals
and institutional) subscribe (buys) these instruments. The New Issue Market in
India is well regulated by the Securities and Exchange Board of India (SEBI) which
has issued guidelines for the issue of these instruments. The secondary market is
the market in which the subsequent sale and purchase of these securities and
instruments are undertaken. The secondary market is basically provided by the stock
exchanges. At present, there is a network of stock exchanges operating in India. The
stock exchanges and their transactions are regulated by the Securities Contracts
(Regulation) Act, 1956 and Guidelines issued by the SEBI.
3. Government securities market: It is a market where the securities/loans of
Central Government, State Governments and other Government authorities are
traded. These securities, primarily in the form of Government loans, are also known
as Gilt-edged securities. The main participants in the Government securities market
are the commercial banks, provident funds, etc. Interest rates on these securities are
low.
4. Foreign Exchange Market: It refers to the network of dealers of foreign
currencies. These dealers provide services:
(i) To convert one currency into another currency, and
(ii) To make available various types of structured products dealing with the foreign
exchange risk.

IV. OBJECTIVES OF THE FIRM

1. Profit Maximization
Main aim of any kind of economic activity is earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. Profit maximization
is also the traditional and narrow approach, which aims at, maximizing the profit of
the concern. Profit maximization consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit; hence, it considers all the
possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So, it
shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploitation of workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair
trade practice, etc.
(iii) Profit maximization objectives lead to inequalities among the stake holders such
as customers, suppliers, public shareholders, etc.

Drawbacks
(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates
some unnecessary opinion regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider the
time value of money or the net present value of the cash inflow. It leads certain
differences between the actual cash inflow and net present cash flow during a
particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business
concern. Risks may be internal or external which will affect the overall operation of
the business concern.
So, the profit maximization fails to be an operationally feasible objective of financial
management.
2. Wealth Maximization
Wealth maximization is one of the modern approaches. The term wealth means
shareholder wealth or the wealth of the persons those who are involved in the
business concern. Wealth maximization is also known as value maximization or net
present worth maximization. This objective is a universally accepted concept in the
field of business.
Stockholder’s current wealth in a firm = (Number of shares owned) x (Current Stock
Price share)

Favourable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim
of the business concern under this concept is to improve the value or wealth of the
shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated
with the business concern. Total value detected from the total cost incurred for the
business operation. It provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv)Wealth maximization provides efficient allocation of resources.
(iv) It ensures the economic interest of the society.
Unfavourable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it may
not be suitable to present day business activities.
(ii) Wealth maximization creates ownership-management controversy.
(iii) Management alone enjoys certain benefits.
(iv) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(v) Wealth maximization can be activated only with the help of the profitable position
of the business concern.

V. TIME VALUE OF MONEY

The concept of TVM refers to the fact that the money received today is different in its
worth from the money receivable at some other time in future. Every individual or a
firm definitely has a preference to receive money today against the money receivable
tomorrow. For example, if an individual is given an option to receive Rs 1,000 today
or to receive the same amount after one year, he will definitely choose to receive the
amount today (of course he is presumed to be a rational being). The obvious reason
for this preference for receiving the money today is that the rupee received today has
a higher value than the rupee receivable in future. This preference for current money
as against future money is known as the time preference for money or simply TVM.
This concept of TVM is applicable in equal strength to individuals as well as to the
business firms. In case of most of the decision particularly those taken by a firm, the
financial implications may occur over a period of time and quite often over a long
period of time even up to ten years or more.
Therefore, TVM becomes an important consideration for any financial decision.
There are several reasons for this preference for current money as follows:
1. Future Uncertainties: One of the reasons for preference for current money is that
there is a certainty about it whereas the future money has an uncertainty. There may
be an apprehension that the other party (the creditor) may become insolvent or
untraceable.
2. Preference for Present Consumption: Besides certainty, every person also has a
preference for present consumption, though this preference may be subjective and
differ from one person to another. The present money may be required for some
specific purpose e.g. to buy a consumer durable or otherwise. Moreover, in an
inflationary situation, the money received today has a greater purchasing power.
3. Reinvestment opportunities: Both the individuals and the firm have preference for
present money because they have reinvestment opportunities available to them. If
they have got the money, they can invest this money to get further returns on this.
This opportunity to get returns will not be available if the money is not invested now.
The existence of reinvestment opportunities and the urge to earn a return by
investing this current money seem to be the obvious reason for the time preference
for money. This expected return which can be earned by investing the present
money is in fact the TVM.
VI. RISK RETURN ANALYSIS
Every financial decision has two aspects i.e. the risk and the return. There is a risk
involved in every decision. The degree of risk, however, may differ from one decision
to another. A riskless decision is difficult to be visualized. Further, every decision has
a return also. It may be emphasized that the risk and return go together and there is
always a conflict between the return from a decision and the risk it brings into the
firm. A finance manager cannot avoid the risk altogether nor can he
make a decision by considering the return aspect only. Usually, as the return from an
investment increase, its risk also increases. In an attempt to increase the return, the
finance manager will have to undertake greater degree of risk also. Therefore, a
finance manager is often required to trade-off between the risk and return. At the
time of taking any financial decision, the finance manager has to optimize the risk
and return. A particular combination of risk and return where both are optimized may
be known as Risk-Return Trade off. Every financial decision involves such trade-off
between risk and return. At this level of risk-return, the market price of the share will
be maximized.
The financial decisions affect the market price of a share not directly but by affecting
the risk and profitability of the firm. This risk-return composition in fact, ultimately
affect the value of the firm reflected in the market price of a share. In other words,
the financial decisions which are made subject to legal constraints, affect both risk
and return which jointly determine the value of the firm.