Lecture 1 Introduction Financial Management PDF

INTRODUCTION TO
‘FINANCIAL MANAGEMENT’
In this session we shall cover:
• Meaning and scope of financial Management
• Decision areas of a finance manager
• Objective of maximization of shareholders’
wealth vis-à-vis profit maximization
• Concept of agency theory
Basic issues of finance
• Any business, whether
new or existing, big or
small, having any
structural form, varying in
terms of industry,
product, service, location
etc. would be dealing
with
MONEY!
Basic issues of finance
• Where to raise the funds from?
• Where to deploy / invest the funds?
• How much of the profits to be retained and
what portion to be distributed in form of
dividend?
• Whether the funds are being effectively used
in the day to day operations?
Balance sheet
LAIBILITIES SIDE ASSETS SIDE
Shareholder funds Long term assets
Other long term liabilities Current assets
Current liabilities
Value of the firm
V = f (I, F, D), WC Mgt

Here,
V: Value of the firm
I: Investment decision
F: Financing decision
D: Dividend decision
WC Mgt: Working capital management
Objective of Financial Management
• To maximize the value of the firm or

shareholders’ wealth
• This would be done through various types of
decisions (by a finance manager)
– Investment decisions
– Financing decisions
– Dividend decisions
– WC management
Investment decisions
• Allocation of funds in various assets
• Risk profile of choices made to be considered
• Investments decisions reflected on the assets side of the
balance sheet
Capital budgeting decisions

Investment evaluation criteria
Determining cash flows
Risk analysis in capital budgeting
Cost of capital
Financing decisions
• Sources of raising finance
• Choosing from a wide variety of institutions and markets
• Internal source of finance – Retained earnings
• Conventional sources of raising finance vs. Modern sources of
raising finance
• Reflected on the liabilities side of balance sheet
Capital structure theories

EBIT-EPS analysis
Leverage analysis
Dividend decisions
• Finance manager has to strike a balance between the
amount of earnings to be retained and the amount
to be paid to shareholders as dividend
• Reflected on the liabilities side of the balance sheet
Factors affecting dividend

Dividend theories
Forms of dividend
Working capital management
• The finance manager shall be ongoingly
engaged in looking at how to manage the
working capital effectively striking a balance
between liquidity and profitability.
Cash Management
Inventory Management
Receivables Management
Other important areas
• Risk and return
• Portfolio theory
• Corporate restructuring
Inter-relationship between activities
Investment: Company decides to take on a large number of attractive

investment projects
Finance: Company will need to raise finance in order to take up

projects
Dividend: If finance is not available from external sources, dividends

may be reduced in order to increase internal financing
Dividends: Company decides to pay higher levels of dividend to its
shareholders
Finance: Lower level of retained earnings available for investment

meaning that company may have to resort to external sources
Investment: If finance not available from external sources, the

company may have to postpone future investment projects
Finance: Company finances itself using more expensive sources,
resulting in higher cost of capital
Investment: Due to a higher cost of capital, the number of projects

attractive for the company decreases
Dividend: The company’s ability to pay dividends in the future will be

adversely affected
Why value maximization as an
objective?
• What’s wrong with ‘profit maximization’ as an
objective?
• How is value maximization going to be
different from profit maximization?
Customers
Suppliers Government
CORPORATE
AND ITS
STAKEHOLDERS
Banks /
Financial Researchers
institutions
Owners / Employees /
investors management
Stakeholders with varying objectives
• Varying objectives:
– Maximization of profits
– Maximization of market share
– Maximization of ROI
– Beating the competition
– Minimization of costs
– Good product quality and service levels
None provide a unfailing framework for financial

decision making.
Stakeholders with varying objectives
• Limitations of different objectives:
– Ignore the viewpoint of other stakeholders
– Are non-quantifiable
– Do not account for risk
– Not based on cash flows
– Does not account for TVM
The only objective that stands the rigorous test

is MAXIMISATION OF SHAREHOLDERS’ WEALTH!
Maximization of shareholders’ wealth
• A company sells its product/service offering, pays to the suppliers of raw
material, pays wages and salaries to employees and meets all other expenses
• It services its obligations towards lenders by paying interest before

generating the final profit.
• As a corporate citizen, it must also pay taxes to the government.
• If any profit is left, it goes to the shareholders
• THIS IS TO SAY THAT SHAREHOLDERS ARE ENTITLED TO RESIDUAL PROFITS

AFTER MEETING COMMITMENTS TOWARDS ALL OTHER STAKEHOLDERS!
Advantages of ‘Value maximization’
as an objective
• stands the rigorous test taking into account
the expectations of different stakeholders
• Based on Cash flows
• Accounts for TVM
• Accounts for risk
Agency problem
• As per the agency theory, there exists a principal-agent
relationship between the shareholders and management
• The finance manager (representing management) acts on
behalf of the shareholders and ideally should be taking
actions consistent to maximizing the value of the firm
• Why does agency exist?

– When managers are clearly not
acting in the best interests of the
shareholders
Agency problem
• Factors contributing to the problem of agency:
– Divergence of ownership and control
– Goals of management differ from that of owners
– Asymmetry of information
• Conflict between shareholders and debt holders

– Shareholders have a preference for higher risk projects
when compared to debt holders
– Return of shareholders is unlimited whereas loss is limited
to the value of their shares
– Risk of failure also borne by debt holders but their return is
not unlimited
Agency problem
• This possibility of conflict between the
interests of shareholders and management is
referred to as AGENCY PROBLEM and gives
rise to AGENCY COSTS.
• AGENCY COST is a type of internal cost that
arises from and must be paid to an agent
acting on behalf of the principal
Dealing with agency problem
Monitoring and
control costs
Incentives
• Monitoring the actions of management
– Independently audited financial statements
– Additional reporting requirements
– Use of external analysts
• Costs of monitoring to be weighted against benefits accruing there from
• Free ride: Small shareholders would allow large shareholders, who would
be more keen to monitor managerial actions, to incur bulk of monitoring
costs while reaping the benefits there from
• Incorporation of clauses in managerial contracts in form of:

– Constraints
– Incentives
– Punishments
• Performance related pay (in form of bonuses and profit
sharing)
• Executive stock option scheme

Quick Recap
• Financial managers are responsible for making decisions about raising
(financing decision), allocating funds (investment decision) and how much
to distribute to shareholders (dividend decision)
• While objectives such as profit maximization, social responsibility and
survival represent important supporting objectives, the main objective in
corporate finance is maximization of shareholders’ wealth
• A financial manager can maximize the company’s value by making sound
investment, financing and dividend decisions
• Managers do not always act in the best interest of shareholders, giving rise
to ‘agency problem’
• Monitoring and performance related benefits are two potential ways to
optimize managerial behavior
• Due to difficulties associated with monitoring, incentives such as
performance related pay and Employee stock option plans can be adopted
Thanks!

Lecture 1 Introduction Financial Management PDF

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Lecture 1 Introduction Financial Management PDF

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INTRODUCTION TO

Shareholder funds Long term assets

Other long term liabilities Current assets

V = f (I, F, D), WC Mgt

• To maximize the value of the firm or

Capital budgeting decisions

Capital structure theories

Factors affecting dividend

Investment: Company decides to take on a large number of attractive

Finance: Company will need to raise finance in order to take up

Dividend: If finance is not available from external sources, dividends

Finance: Lower level of retained earnings available for investment

Investment: If finance not available from external sources, the

Investment: Due to a higher cost of capital, the number of projects

Dividend: The company’s ability to pay dividends in the future will be

None provide a unfailing framework for financial

The only objective that stands the rigorous test

• It services its obligations towards lenders by paying interest before

• As a corporate citizen, it must also pay taxes to the government.

• If any profit is left, it goes to the shareholders

• THIS IS TO SAY THAT SHAREHOLDERS ARE ENTITLED TO RESIDUAL PROFITS

• Why does agency exist?

• Conflict between shareholders and debt holders

• Costs of monitoring to be weighted against benefits accruing there from

• Incorporation of clauses in managerial contracts in form of:

• Executive stock option scheme

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