Introduction to Financial Management

What is the goal of Financial Management?

The goal of Financial Management arises from the purpose of the firm.
In a market based economy the purpose of the firm is to create value for
society and do so legally and with integrity.
The contribution to society is maximized by maximizing the value of the
firm.
The market value of the firm increases with improvement in its
competitiveness which is reflected in increases in its share price
and consequently increases the wealth of its shareholders.
MV = MVE + MVD ,
where MV=market value of firm,MV E=market value of equity shares,
MVD=market value of long term debt
If market value and book value of debt is same, then maximizing value
of firm implies maximizing market value of the equity share or
shareholders wealth.

Introduction to Financial Management

Competitiveness has to necessarily take into account, besides shareholders, the
interests of other stakeholders, namely, customers, employees, suppliers,
creditors, government and society at large; in other words, all those who have a
direct link with the firm.
The stakeholders view is considered part of the firms social responsibility and
implies that a firm can better achieve its goal of shareholders wealth maximization
with the cooperation of, rather than conflict with, its other stakeholders.

What are the limitations Profit Maximization as the goal of

Financial Management?
a) Profit is subject to different interpretations depending upon the firm and its
accounting policies.
b) It focuses on the absolute value of profits & does not take into account timing
of the profit and its duration.
c) It overlooks the risk factor. In other words, it does not distinguish between an
investment that gives a certain profit and one that gives a variable profit with
different expectations.

Introduction to Financial Management

What are the key activities of Financial Management?
The three broad activities of financial management are :
a) Financial Analysis, Planning & Control involving i) assessing the
financial performance and condition of the firm, ii) planning the financial
future of the firm, iii) estimating the financing needs, iv) establishing
appropriate control systems to ensure that managerial actions are
compatible with the goals of the firm.
b) Management of the Firms Asset Structure --- Asset side of
Balance Sheet--- which involves i) determining the capital budget, ii)
working capital management which involves a) cash management, b)
establishing the credit policy, c) controlling he inventory level.
c) Management of the Firms Financial Structure--- Liability side of
Balance Sheet--- which involves i) establishing the debt-equity ratio or
financial leverage, ii) choosing the instruments of financing, iii) determining
the dividend policy, iv) negotiating with various suppliers of finance.

Introduction to Financial Management

Broadly, the principal decisions that the finance manager has to take can be
categorized under :
a) Investment Decision
b) Financing Decision
c) Dividend Decision
All these decisions are inter-related as subsequent discussions will elaborate.
What is Risk Return Tradeoff ?
Financial decisions usually involve alternative courses of action.
Should a firm set up a large plant or a small plant that can be expanded later?
Should the debt equity ratio of the firm be 2:1 or 1:1?
Should the firm pursue a liberal credit policy or a tight one?
What should be the inventory policy?

In order to make the financial decision, the following questions need to be

answered:
What is the expected return?
What is the risk?
How will it influence the value the firm?

Introduction to Financial Management

What is the relationship between the Accounting & Finance functions ?
The accounting and finance functions are closely related and falls within the responsibilities of the Chief
Financial Officer, whatever be the designation. However there are important differences between the two as
given below:
i) Score keeping vs. Value Maximizing
The primary objective of accounting is to measure the performance of the firm and assess its financial
condition. Whereas, the principal goal of financial management is to create shareholder value by
investing in positive net present value projects and minimizing the cost of financing. The accountants
role is to provide accounting data on the firms past and present which can be used for decision making.
ii) Accrual vs. Cash Flow Method
The accountant prepares the accounting reports based on the accrual method which recognizes
revenues when the sale occurs regardless whether the cash is realized or not and matches expenses to
sales regardless whether cash is paid or not. The finance manager focuses on value of cash flows and
their timing and risk as these determine value.
iii) Certainty vs. Uncertainty
Accounting deals mainly with the past and records what has happened. It is more objective.
Finance is
concerned mainly with the future and involves decision making under imperfect information
and
uncertainty. There is more subjectivity.

Introduction to Financial Management

ChiefCFO
Finance
Officer

Treasurer

Controller
Credit/Cash
LT Funds
Capital
Budgeting
Portfolio

Financial Acctg
Cost Acctg
Taxation
Data Proc.

Introduction to Financial Management

What is the Agency Problem?
In a firm the shareholders are the Principal and the Manager is the Agent. The
Agency problem is the likelihood that managers may place personal goals ahead of
the firms goals, that is, the interests of the shareholders.
Market forces act to prevent/minimize Agency problems in two ways : a) behaviour
of security participants, namely, shareholders holding large blocks of the firms
shares, b) hostile takeovers.

What are Agency Costs?

To deal with the Agency problem, shareholders have to incur following types of
costs:
a) Monitoring --- the monitoring expenses relate to payment for audit and control
systems to ensure that managerial behaviour is in the best interests of the
shareholders;
b) Incentive and Performance Plans --- expenses incurred to motivate Managers to
act in the best interest of the shareholders.
c) Opportunity Costs --- to ensure that profitable opportunities are not missed,
firms appoint external Directors and Management Consultancy firms to advise the
Board on strategic options, the costs of which have to be borne by the firm.