Financial Management

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Financial Management:

Financial Management Neeraj Chitkara Samalkha Group of Instituions Email- Neeraj Chitkara

Financial Management:

Financial Management Neeraj Chitkara

Meaning of Finance:

Meaning of Finance In our present day economy, finance is defined as the provision of money at the time when it is required. Every enterprise, whether big or small, needs finance to carry its operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly to be said to be the lifeblood of an enterprise. Neeraj Chitkara

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The subject of finance has been traditionally classified into two classes: Government Institutions State Governments Local Self-Government Central Government Personal Finance Business Finance Finance of Non-Profit Organizations Neeraj Chitkara

Meaning of Business Finance :

Meaning of Business Finance The word ‘business’ literally means a ‘state of being busy’. All creative human activities relating to the production and distribution of goods and services for satisfying human wants are known as business. It also includes all those activities which indirectly help in production and exchange of goods such as, transport, insurance, banking and warehousing, etc. Broadly speaking, the term ‘business’ includes industry, trade and commerce. Finance may be defined as the provision of money at the time when it is required. Finance refers to the management of flows of money through an organization. It concern with the application of skills in the manipulation, use and control of money. Neeraj Chitkara

Approaches to Finance:

Approaches to Finance The first approach views finance as to providing of funds needed by a business on most suitable terms. This approach confines the raising of funds and to the study of financial institutions and instruments from where funds can be produced. The second approach relates finance to cash. The third approach views fiancé as being concerned with raising of funds and their effective utilizations. Neeraj Chitkara

Classification of Business Finance:

Classification of Business Finance Neeraj Chitkara

Financial Management:

Financial Management Financial Management is a managerial activity which is concerned with the planning and controlling of the firms financial resources. In the words of Weston and Brigham, “Financial Management is an area of financial decision-making, harmonizing individual motives and enterprise goals.” Neeraj Chitkara

Definition Of Financial Management:

Definition Of Financial Management According to J.L.Massie, “ Financial Management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds for efficient operations .” Neeraj Chitkara

Evolution of Financial Management:

Evolution of Financial Management Its evolution may be divided in to three board phases : Traditional Phase Transitional Phase Modern Phase Neeraj Chitkara

Traditional Phase:

Traditional Phase The focus of financial management was mainly on certain episodic events like formation, issuance of capital, major expansion, merger, reorganization and liquidation in the life cycle of firm. The approach was mainly descriptive and institutional. The instruments of financing, the institutions and procedures used capital markets, and the legal aspects of financial events formed the core of financial management. Financial management was viewed mainly from the point of view of the investment bankers, lenders, and other outside interests. Neeraj Chitkara

Transitional Phase:

Transitional Phase It began around the early 1940s and continued through the early 1950s. The nature of financial management during this phase was similar to that of traditional phase, greater emphasis was placed on the day-to-day problems faced by financial managers in the areas of fund analysis, planning, and control. In this phase the main focus shifted to working capital management. Neeraj Chitkara

Modern Phase:

Modern Phase The modern phase began in the mid 1950s and has witnessed an accelerated pace of development with the infusion of ideas from economic theory and application of quanititaive methods of analysis. The central concern of financial management is considered to be a rational matching of funds to their uses so as to maximize the wealth of current shareholders. The approach of financial management has become more analytical and quantitative. Neeraj Chitkara

Importance of Financial Management:

Importance of Financial Management Financial Planning and successful promotion of an enterprise. Acquisition of funds as when required at the minimum possible cost. Proper use and allocation of funds. Taking sound financial decisions. Improving the profitability through financial controls. Increasing the wealth of the investors and the nation. Promoting and mobilizing individual and corporate savings. Neeraj Chitkara

Scope of Financial Management:

Scope of Financial Management Estimating Financial Requirements Deciding Capital Structure Selecting a Source of Finance Selecting a Pattern of Investment Proper Cash Management Implementing Financial Controls Proper Use of Surpluses Neeraj Chitkara

Relationship of Finance with other Business Functions/ Disciplines:

Relationship of Finance with other Business Functions/ Disciplines ‘ Business function’ means functional activities that an enterprises undertakes in achieving its desired objectives. The functions may be classified in the basis of its operational activities: Purchase Functions Productivity Functions Neeraj Chitkara

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Distribution Function Accounting Function Personnel Function Research and development Function Financial Management and Economics Neeraj Chitkara

Objectives of Financial Management:

Objectives of Financial Management Financial management is concerned with procurement and use of funds. Its main aim is to use business funds in such a way that the firms value/ earning are maximised.The main objectives of business is to maximize the owner’s economic welfare. The objective can be achieved by: Profit Maximization Wealth Maximization Neeraj Chitkara

Profit Maximization:

Profit Maximization Profit earning is the main aim of every economic activity. A business being an economic institution must earn profit to cover its costs and provides funds for its growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profit also serve as a protection against risk which cannot be ensured. Neeraj Chitkara

Arguments in Favour of Profit Maximization:

Arguments in Favour of Profit Maximization When profit earning is the main aim of business then profit maximization should be the obvious objective. Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise. Economic and business conditions do not remain same at all the times. There may be adverse conditions like recession, depression, serve competition etc. a business will be able to serve under unfavorable situation, only if it has some past earnings to rely upon. Profits are the main source of finance for the growth of business. Profitability is essential for fulfilling social goals also. Neeraj Chitkara

Objections to Profit Maximization:

Objections to Profit Maximization Ambiguity : The term ‘profit’ is vague and it cannot be precisely defined. It means different things for different people. Should we consider short-term profits or long-term profits? Does it mean total profits or earning per share? Should we take profits before tax or after tax? Ignores Time Value of Money : Profit maximization objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all earnings as equal though they occur in different periods. It ignores the fact that cash received today is more important than the same amount of cash received after, say, three years Neeraj Chitkara

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Ignores Risk Factor : It does not take into consideration the risk of the prospective earnings stream. Some projects are more risky than others. The earning streams will also be risky in the former than the latter. Dividend Policy : The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximization. In case, earnings per share is the only objective then an enterprise may not think of paying dividend at all because retaining profits in business or investing them in the market may satisfy this aim. Neeraj Chitkara

Wealth Maximization:

Wealth Maximization Wealth maximization is the appropriate objective of an enterprise. Financial theory asserts that wealth maximizations is the single substitute for a stockholders utility. When the firm maximizes the stockholder’s wealth, the individual stockholder can use this wealth to maximize his individual utility. It means that maximizing stockholder’s wealth the firm is operating consistently towards maximizing stockholder’s utility. Stockholder’s current wealth in a firm= ( No. of shares owned) * ( Current stock price per share) Wo=NPo Maximum utility refers to Maximum stockholder’s wealth Maximum current stock price per share refers to Neeraj Chitkara

Implications of Wealth Maximization:

Implications of Wealth Maximization It serves the interests of owners as well as other stakeholders in the firm. It consistent with the objective of owners economic welfare. The objective of wealth maximization implies long-run survival and growth of the firm. It take into consideration the risk factor and the time value of money. The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of shares. The goal of wealth maximization leads towards maximizing stockholder’s utility or value maximization of equity shareholders through increase in the stock price per share. Neeraj Chitkara

Criticism of Wealth Maximization:

Criticism of Wealth Maximization It is a prescriptive idea. The objective is not descriptive of what the firms actually do. The objective of wealth maximization is not necessarily socially desirable. There is some controversy as to whether the objective is to maximize stockholders wealth or the wealth of firm. The objective of wealth maximization may also face difficulties when ownership and management are separated. Neeraj Chitkara

Measuring Shareholders value Creation : EVA and MVA:

Measuring Shareholders value Creation : EVA and MVA The two new measures used to determine whether an investment positively contributes to the shareholders wealth are: Economic Value Added (EVA) Market Value Added (MVA) Economic Value Added : Economic value added is a measure of performance evaluation that was originally employed by stern Stewart & Co. It measure the surplus value created by an investment or a portfolio of Investments. EVA= (Net Operating profit after tax - Cost of capital * Capital invested) Neeraj Chitkara

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According to this approach, an investment can be accepted only if the surplus (EVA) is positive. It is only the positive EVA that will add enhance the shareholders wealth. However, to calculate the economic value added we need tom estimate the net operating profit after tax and cost of funds invested. Suppose an investment generates net operating profit after tax Rs. 20 lakhs and the cost of financing investment is Rs. 16 laks. The economic value added by the investment shall be Rs. 4 lakh and it should be accepted. Market Value Added (MVA) : The market value added (MVA) is the sum of all the present values of future EVAs. MVA= EVA1/(1+C)1 + EVA2/(1+C)2+………. The MVA can also be defined as the difference between the current market value of the firm and the book value of capital employed by the firm. The market value of the firm is simply the sum of market value of its equity and debt. In case, the market value of firm exceeds the book value of capital employed, it is said to have a positive MVA. In the same manner, if the value of capital employed exceeds the market value of the firm, it is said to have a negative MVA. Neeraj Chitkara

Financial Decisions/ Finance Functions:

Financial Decisions/ Finance Functions Financial Decision refer to decisions concerning financial matters of a business firm. There are many kinds of financial management decisions that the firm makes in pursuit of maximizing shareholder’s wealth, viz., kind of assets to be required, pattern of capitalization, distribution of firm’s income etc. we can classify these decisions into Four major groups : Long-term asset-mix or Investment decisions. Capital-mix or Financing Decisions. Profit allocation or Dividend Decisions. Short-term asset-mix or Liquidity decision Neeraj Chitkara

Investment Decision:

Investment Decision A firm’s investment decision involve capital expenditures. They are, therefore, referred to capital budgeting decisions. A capital budgeting decision involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits (cash flows) in future. The investment proposals should be evaluated in terms of expected profitability, costs involved and the risks associated with the projects. The investment decision is important not only for the setting up of new units but also for the expansion of present units, replacement of permanent assets, research and development of project. Neeraj Chitkara

Financing Decision:

Financing Decision Once the firm has taken the investment decision and committed itself to new investment, it must decide the best means of financing and when, where from and how to acquire funds to meet the firm’s investment needs. A finance manager has to select such sources of funds which will make optimum capital structure. The mix of debt and equity is known as the firm’s capital structure. The debt-equity ratio should be fixed in such a way that it helps in maximizing the profitability of the firm. Neeraj Chitkara

Dividend Decision:

Dividend Decision The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance. The proportion of profits distributed as dividends is called dividend-payout ratio and the retained portion of profit known as the retention ratio. The optimum dividend policy is one that maximizes the market of the firm’s shares. Neeraj Chitkara

Liquidity Decision:

Liquidity Decision Investment in current assets affects the firm’s profitability and liquidity. Current assets management that affects firm’s liquidity is yet another important finance function. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme situations can lead to the firm’s insolvency. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky. Thus, a proper trade-off must be achieved between profitability and liquidity. Neeraj Chitkara

Factors Influencing Financial Decisions:

Factors Influencing Financial Decisions External Factors : State of economy Structure of capital and money markets. Requirements of investors. Government policy. Taxation policy. Lending policy of financial institutions Internal Factors : Nature and size of business. Expected return, cost and risk. Composition of assets. Structure of ownership. Trend of earnings. Age of the firm. Liquidity position. Working capital requirements. Conditions of debt agreements. Neeraj Chitkara

Risk-Return Trade-off:

Risk-Return Trade-off Financial decisions incur different degree of risk. Your decision to invest your money in government bonds has less risk as interest rate is known and the risk of default is very less. On the other hand, you would incur more risk if you decide to invest your money in shares, as return is not certain. However, you can expect a lower return from government bond and higher from shares. Financial decisions of the firm are guided by the risk-return trade-off. the relationship between return and risk can be expressed as flows: Return = Risk-free rate + Risk premium Neeraj Chitkara

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Risk-free rate is obtainable from a default risk-free government security. An investor assuming risk from her investment requires a risk premium above the risk-free rate. Higher the risk of an action, higher will be the risk premium leading to higher required return on an action. Expected Return Risk Risk Premium Risk-free Return Neeraj Chitkara

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A proper balance between return and risk should be maintained to maximize the market value of firm’s shares. Such balance is called risk-return trade-off, and every financial decision is involves this trade-off. Investment Decision -Capital Budgeting - Liquidity Decision Financing Decisions -Capital Structure Dividend Decisions -Dividend Policy Risk Market Value of Firm Return Neeraj Chitkara

Financial Management Process:

Financial Management Process The financial management process begins with the financial planning and decisions. While implementing these decisions, the firm has to acquire certain risk and return characteristics. These characteristics determine the market price of shares and shareholder wealth. The process must include feedback system to enable it take corrective measures, if required. Neeraj Chitkara

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Financial Planning and Control Financial Decisions Investment Financing Dividend Liquidity Feed back Risk and Return Characteristics Of Firm Market Price of Shares Po Share- Holder Wealth Wo=NPo Financial Management Process Neeraj Chitkara

Functional Areas of Financial Management:

Functional Areas of Financial Management Determining Financial Needs. Selecting the Sources of Funds. Financial Analysis and Interpretation. Cost-Volume-Profit Analysis. Capital Budgeting. Working Capital Management. Profit Planning and Control. Dividend Policy. Neeraj Chitkara

Functions of Financial Manager:

Functions of Financial Manager Financial Forecasting and Planning. Acquisition of Funds. Investment of Funds. Helping of Valuation Decisions. Maintain Proper Liquidity. Neeraj Chitkara

Financial Engineering:

Financial Engineering Developments in corporate and banking sector have given rise to a new concept of financial engineering. According to John Finnerty, “ Financial engineering involves the design, the development and the implementation of innovative financial instruments and problems and the formulation of creative solutions to problems in finance.” Neeraj Chitkara

Objectives of Financial Engineering:

Objectives of Financial Engineering Designing and developing new financial instruments/products. Formulating new processes. Formulating creative solutions to financial problems. Neeraj Chitkara