FINANCIAL MANAGEMENT (UNIT_1)
Introduction : Financial management is comprised of two words , finance and management. The management aspect relates to planning, sourcing, allocating& controlling, while finance relates to financial resources which are always limited, contain value & have alternative usuage. So, finance as a resource needs proper management so that out of a given input, maximum output value can be derived. Now, it will depend on the skill of experts & managers.
Financial management deals with procurement of funds & effective utilisation of funds in business.
Definition : According to I.M Pandey --- Financial Management is that managerial activity which is concerned with planning & controlling of the firm's financial resources.
The various characteristics of financial management are as follows :
1. Financial management involves management of financial resources.
2. It relates to planning, raising, acquiring, administering, allocating& controlling of finance.
3. It helps in meeting overall objectives of the organisation.
4. It pertains(relates) to making funds available as & when required.
5. Financial resources are utilised within constraints as they are a limited resources.
6. It is required at all levels from top to bottom of the organisation to keep the functioning in a smooth & harmonious(friendly) manner.
7. It provides a sense of finacial security & safety.
Thus, Financial Management is a blend (mixing together) of management & finance. The happy blending of the two provides a powerful tool to manage financial resources through application of various techniques& strategies.
Scope :
The scope of financial management extends to the following activities in the organisation.
1. Estimation of the finacial needs of the organisation.
2. Deciding the capital structure to optimise costs i.e source funds from debt (in the form of loans) / equity .
3. Selecting funding sources.
4.optimal cash management
5. Planning & implementing financial controls.
6. Reserves & surplus utilisation
7. Optimising value of the firm.
Goals of the firm :
Financial management is concerned with the procurement & utilization of funds. Its main aim is to use business funds in such a way that the firm's value/ earnings are maximized. The main objective of a business is to maximize the owner's economic welfare. This objective can be achieved by,
1. Profit maximisation 2. Wealth maximisation.
1. Profit Maximisation: Profit maximization is the main aim of any business & therefore it is also an objective of financial management. Profit maximization in financial management represents the process/approach by which profits (EPS) of the business are increased.
Profit maximization is the traditional approach & the primary objective of financial management. It implies( states) that every decision relating to business is evaluated in the light of profits. All the decisions with respect to new projects, acquisition of assets, raising capital, distributing dividends, etc are studied for their impact on profits & profitability. If the result of a decision is perceived to have a positive effect on the profits, the decision is taken further for implementation.
Arguments in favor of profit maximization:
1. profit is vague (not clear): The term profit is a vague term. This is because different mindsets will have different perceptions about profit. Ex: profits can be n/p, G/p, before tax profit / the rate of profit, etc. There is no clearly defined profit maximization rule about the profits.
2. Ignores time value of money: The profit maximization objective ignores the time value of money& does not consider the magnitude & timing of earnings. It treats all earnings as equal when they occur in different periods.
3. Ignores the risk: when profits increase, risk also increases & it becomes dangerous to the company in the course of time. Hence profit maximisation may not be accepted.
4. Ignores quality: The most problematic aspect of profit maximization as an objective is that it ignores the intangible benefits such as quality, image, technological advancement, etc.
5 Against long-term existence: profit maximization is suitable for sole trading/partnership firms that may exist for the short term. But it is not suitable for joint stock companies which have a very long-term existence.
So, profit maximization is discontinued( removed) in a modern approach to business& financial management i.e. why the wealth maximization concept is introduced.
Wealth Maximisation :
Wealth maximization is a modern approach to financial management. It involves creating & increasing shareholders' wealth. In other words, if a company performs above expectations then returns are given as dividends to shareholders.
Wealth maximization simply means maximization of shareholders' wealth. It is the combination of two words i.e. wealth & maximization. The wealth of a shareholder maximizes when the net worth of a company maximizes. A shareholder holds a share in the company & his wealth will improve if the share price in the market increases which in turn is a function of net-worth. This is because wealth maximization is also known as net-worth maximization.
Financial managers are the agents of shareholders & their job is to look after the interest of the shareholders. The objective of any shareholder/ investor would be a good return on their capital & safety of their capital. Both these objectives are well served by wealth maximization as a decision criterion for business.
W = N×Po
W=wealth of shareholder
N=no.of equity shares
Po=present market price of the share
Implications of wealth maximization:
1. Suppliers of loan capital
2. Employees
3. Government
4. Management
5. Society
All 5 affect the cost of capital.
The cost is to be calculated after considering the expectations of various interested groups. Hence wealth maximisation is consistent with the objective of various groups. As a result, it is superior to profit maximization & followed by modern financial management.
Why wealth maximization is superior to profit maximization?
The wealth maximization model is superior because it obviates(prevent) all the drawbacks of profit maximization as a goal of a financial decision.
EVA=N/P after-tax--Cost of capital
In summary, wealth maximization as an objective of financial management& other business decisions enables the shareholders to achieve the objective & therefore is superior to profit maximization for financial managers, it is a decision criterion being used for all the decisions.
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AGENCY CONFLICT
Conflict between management & owners is agency conflict. The decision taking authority in a company lies in the hands of managers. Shareholders as owners of a company are the principles & managers are their agents. Thus, there is a principal - agent relationship between shareholders & managers. In theory, managers should act in the best interest of shareholder's , i.e their actions & decisions should lead shareholder wealth maximisation. In practice, manager may not necessarily act in the best interest of shareholder & they may persue their own personal goals. Managers may maximise their own wealth at the cost of shareholder's / may play safe & create satisfactory wealth for shareholder's than the maximum.
Shareholder's continously monitor modern company's that would help them to restrict managers, freedom to act in their own self-interest at the cost of shareholders. Employees, creditors, customers & government also keep an eye on managers activities. Thus, the possibility of managers persuing exclusively their own personal goals is reduced. Every group connected with the company will however evaluate management success from the point of view of the fulfillment of its own objective. The survival of management will be threatened(at risk ) if the objective of any of these groups remains unfulfilled. In reality, the wealth of shareholder's in the long run could be maximised only when customers & employees, along with other stakeholders of a firm , are fully satisfied.
The agency problem can be maximised/ prevented from the following :
Remedies to overcome these problems :
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Time value of money
A rupee today / value of rupee today is more compared to the value of a rupee to be received after one year / in future. This is known as time value of money because , today's money can be invested for a return & there will be an increase in the amount as a result of additional income. The preference for money now, as compared to future money , is known as 'Time preference of money'.
Reasons for Time preference of money :
(a) Risk : There are financial & non-financial risks involved overtime . Further , there is uncertainty about the receipt of money in future. The longer the time period of returns, the greater is the risk. Hence present money is preferred.
(b) preference for present consumption : Most persoons/ companies prefer present consumption than future consumption. Ex: Due to urgency of need/ otherwise( consumer durable)
(c) Inflation : Inflation erodes ( destroy) the value of money. In an inflationary situation, a rupee today represents a greater purchasing power than a rupee one year later.
(d) Investment opportunities : Present money is preferred due to availability of investment opportunities for earning additional cash flows. Ex: 1lakh available in hand now earns interest at the bank rate, rather than 1lakh received after 3 years time.
Methods of analysis : The concept of TVM helps in arriving at the comparable value of the different rupee amount arising at different points of time into equivalent( equal ) values of a particular point of time.
1. Compounding
2. Discounting
1. Compounding : Compounding is the process of incorporating time value of money. Under compounding , interest is calculated/ added to the principle amount for the purpose of calculating interest of the next year. Every year interest is calculated on the principle amount+ cumulative interest.
Ex: 10,000 principle amount= 10,000
1 yr 1000 Interest rate= 10%
-----------
11,000
2yr 1100
-------------
12100
Frequency of compounding : It is the no.of times interest is compounded in one year . If the frequency increases the amount of interest also increases.
Principle amount=Po
Interest rate = i
Terminal value / amount at the end of one year ,
= Po +i
C1 =Po +(Po.i)
=Po(1+i )
Compound value at the end of 2nd year ,
C2= C1+C1.i
=C1(1+i)
=Po(1+i)(1+i)
=Po(1+i)2
Formula : Cn =Po(1+i)n
Compound value of annuity of Re. 1 : Annuity is an equal amount of deposit made every year / an equal amount received every year.
Compounding is the process of calculating future value from a present value at a given rate of interest & for a given no.of years.
Present value =Ao
Future value =An
Rate of interest =i
No.of years=n
Future value = present value (1+Rate of interest) n
An = Ao(1+i)n
2. Discounting method : It is a calculation of present value from future value for a given rate of interest & no.of years.
Ao(1+i)n =An
Ao=An/(1+i)n
Ao=An(1÷(1+i)n)
Time value : When cash outflows & cash inflows occurred at different timings there will be difference in their time value. To equate (equal) the time value of inflows& outflows discounting technique will be used by using at discounting rate (r).
Therefore, Cn=Po(1+i)n ----->Cn=Po(1+r)n
Ao=An(1÷(1+i)n)---->Ao=An(1÷(1+r)n)
Financial management deals with procurement of funds & effective utilisation of funds in business.
Definition : According to I.M Pandey --- Financial Management is that managerial activity which is concerned with planning & controlling of the firm's financial resources.
The various characteristics of financial management are as follows :
1. Financial management involves management of financial resources.
2. It relates to planning, raising, acquiring, administering, allocating& controlling of finance.
3. It helps in meeting overall objectives of the organisation.
4. It pertains(relates) to making funds available as & when required.
5. Financial resources are utilised within constraints as they are a limited resources.
6. It is required at all levels from top to bottom of the organisation to keep the functioning in a smooth & harmonious(friendly) manner.
7. It provides a sense of finacial security & safety.
Thus, Financial Management is a blend (mixing together) of management & finance. The happy blending of the two provides a powerful tool to manage financial resources through application of various techniques& strategies.
Scope :
The scope of financial management extends to the following activities in the organisation.
1. Estimation of the finacial needs of the organisation.
2. Deciding the capital structure to optimise costs i.e source funds from debt (in the form of loans) / equity .
3. Selecting funding sources.
4.optimal cash management
5. Planning & implementing financial controls.
6. Reserves & surplus utilisation
7. Optimising value of the firm.
Goals of the firm :
Financial management is concerned with the procurement & utilization of funds. Its main aim is to use business funds in such a way that the firm's value/ earnings are maximized. The main objective of a business is to maximize the owner's economic welfare. This objective can be achieved by,
1. Profit maximisation 2. Wealth maximisation.
1. Profit Maximisation: Profit maximization is the main aim of any business & therefore it is also an objective of financial management. Profit maximization in financial management represents the process/approach by which profits (EPS) of the business are increased.
Profit maximization is the traditional approach & the primary objective of financial management. It implies( states) that every decision relating to business is evaluated in the light of profits. All the decisions with respect to new projects, acquisition of assets, raising capital, distributing dividends, etc are studied for their impact on profits & profitability. If the result of a decision is perceived to have a positive effect on the profits, the decision is taken further for implementation.
Arguments in favor of profit maximization:
- When profit earning is the main aim of business then profit maximization should be the obvious (clear) objective.
- Profitability is a barometer (instrument) for measuring the efficiency & economic prosperity of a business enterprise.
- Economic & business conditions do not remain the same at all times. There may be adverse (unfavorable) business conditions like recession, depression, severe competition, etc. A business will be able to survive under unfavorable situations, only if it has some past earnings to rely (depend) upon. Therefore, a business should try to earn more & more when the situation is favorable.
- Profits are the main sources of finance for the growth of the business.
- Profitability is essential for fulfilling the goals.
1. profit is vague (not clear): The term profit is a vague term. This is because different mindsets will have different perceptions about profit. Ex: profits can be n/p, G/p, before tax profit / the rate of profit, etc. There is no clearly defined profit maximization rule about the profits.
2. Ignores time value of money: The profit maximization objective ignores the time value of money& does not consider the magnitude & timing of earnings. It treats all earnings as equal when they occur in different periods.
3. Ignores the risk: when profits increase, risk also increases & it becomes dangerous to the company in the course of time. Hence profit maximisation may not be accepted.
4. Ignores quality: The most problematic aspect of profit maximization as an objective is that it ignores the intangible benefits such as quality, image, technological advancement, etc.
5 Against long-term existence: profit maximization is suitable for sole trading/partnership firms that may exist for the short term. But it is not suitable for joint stock companies which have a very long-term existence.
So, profit maximization is discontinued( removed) in a modern approach to business& financial management i.e. why the wealth maximization concept is introduced.
Wealth Maximisation :
Wealth maximization is a modern approach to financial management. It involves creating & increasing shareholders' wealth. In other words, if a company performs above expectations then returns are given as dividends to shareholders.
Wealth maximization simply means maximization of shareholders' wealth. It is the combination of two words i.e. wealth & maximization. The wealth of a shareholder maximizes when the net worth of a company maximizes. A shareholder holds a share in the company & his wealth will improve if the share price in the market increases which in turn is a function of net-worth. This is because wealth maximization is also known as net-worth maximization.
Financial managers are the agents of shareholders & their job is to look after the interest of the shareholders. The objective of any shareholder/ investor would be a good return on their capital & safety of their capital. Both these objectives are well served by wealth maximization as a decision criterion for business.
W = N×Po
W=wealth of shareholder
N=no.of equity shares
Po=present market price of the share
Implications of wealth maximization:
1. Suppliers of loan capital
2. Employees
3. Government
4. Management
5. Society
All 5 affect the cost of capital.
The cost is to be calculated after considering the expectations of various interested groups. Hence wealth maximisation is consistent with the objective of various groups. As a result, it is superior to profit maximization & followed by modern financial management.
Why wealth maximization is superior to profit maximization?
The wealth maximization model is superior because it obviates(prevent) all the drawbacks of profit maximization as a goal of a financial decision.
- Firstly, wealth maximization is based on cashflows& net profits. Unlike the profits, cashflows are exact &definite& therefore avoid any ambiguity associated with accounting profits.
- Secondly, profit maximization presents a short-term view as compared to wealth maximization Short-term profit maximization can be achieved by the managers at the cost of the long-term sustainability of the business.
- Thirdly, wealth maximization considers the time value of money.
- Fourthly, the wealth maximization criterion considers the risk & uncertainty factors while considering the discounting rate. The discounting rate reflects both time & risk. The higher the uncertainty, the discounting rate is higher & vice-versa.
EVA=N/P after-tax--Cost of capital
In summary, wealth maximization as an objective of financial management& other business decisions enables the shareholders to achieve the objective & therefore is superior to profit maximization for financial managers, it is a decision criterion being used for all the decisions.
------------------------------------------------------------------------------------
AGENCY CONFLICT
Conflict between management & owners is agency conflict. The decision taking authority in a company lies in the hands of managers. Shareholders as owners of a company are the principles & managers are their agents. Thus, there is a principal - agent relationship between shareholders & managers. In theory, managers should act in the best interest of shareholder's , i.e their actions & decisions should lead shareholder wealth maximisation. In practice, manager may not necessarily act in the best interest of shareholder & they may persue their own personal goals. Managers may maximise their own wealth at the cost of shareholder's / may play safe & create satisfactory wealth for shareholder's than the maximum.
Shareholder's continously monitor modern company's that would help them to restrict managers, freedom to act in their own self-interest at the cost of shareholders. Employees, creditors, customers & government also keep an eye on managers activities. Thus, the possibility of managers persuing exclusively their own personal goals is reduced. Every group connected with the company will however evaluate management success from the point of view of the fulfillment of its own objective. The survival of management will be threatened(at risk ) if the objective of any of these groups remains unfulfilled. In reality, the wealth of shareholder's in the long run could be maximised only when customers & employees, along with other stakeholders of a firm , are fully satisfied.
The agency problem can be maximised/ prevented from the following :
Remedies to overcome these problems :
- Agency cost : It include the less optimum sharevalue for shareholders & costs incurred by them to monitor the actions of managers & control their behaviour. The agency problem vanish (disappear) when managers own the company. Thus one way to mitigate (moderate) the agency problems is to give ownership rights through stockoptions to managers. Shareholder's can also offer attractive monetary & non-monetary incentives to managers to act in their interests. A close monitoring by other stakeholder's ,BOD & outside analyst also may help in reducing the agency problems.
- Shareholders interference : Sometimes big shareholder like institutional investors may interfere through their voting rights by electing their nominees in the board of directors to protect their interest.
- Take overs : When management is performing poorly, the other company may takeover , because market price falls when the company is performing poorly.
- Dismissal : If the management is not performing well continuously, the board of directors will dismiss the present team of managers & appoints a new team.
- Dis investment : The small investors who cannot do the above tasks simply sell their shares in that company & buy the share of the other profitable company.
------------------------------------------------------------------------------------
Time value of money
A rupee today / value of rupee today is more compared to the value of a rupee to be received after one year / in future. This is known as time value of money because , today's money can be invested for a return & there will be an increase in the amount as a result of additional income. The preference for money now, as compared to future money , is known as 'Time preference of money'.
Reasons for Time preference of money :
(a) Risk : There are financial & non-financial risks involved overtime . Further , there is uncertainty about the receipt of money in future. The longer the time period of returns, the greater is the risk. Hence present money is preferred.
(b) preference for present consumption : Most persoons/ companies prefer present consumption than future consumption. Ex: Due to urgency of need/ otherwise( consumer durable)
(c) Inflation : Inflation erodes ( destroy) the value of money. In an inflationary situation, a rupee today represents a greater purchasing power than a rupee one year later.
(d) Investment opportunities : Present money is preferred due to availability of investment opportunities for earning additional cash flows. Ex: 1lakh available in hand now earns interest at the bank rate, rather than 1lakh received after 3 years time.
Methods of analysis : The concept of TVM helps in arriving at the comparable value of the different rupee amount arising at different points of time into equivalent( equal ) values of a particular point of time.
1. Compounding
2. Discounting
1. Compounding : Compounding is the process of incorporating time value of money. Under compounding , interest is calculated/ added to the principle amount for the purpose of calculating interest of the next year. Every year interest is calculated on the principle amount+ cumulative interest.
Ex: 10,000 principle amount= 10,000
1 yr 1000 Interest rate= 10%
-----------
11,000
2yr 1100
-------------
12100
Frequency of compounding : It is the no.of times interest is compounded in one year . If the frequency increases the amount of interest also increases.
Principle amount=Po
Interest rate = i
Terminal value / amount at the end of one year ,
= Po +i
C1 =Po +(Po.i)
=Po(1+i )
Compound value at the end of 2nd year ,
C2= C1+C1.i
=C1(1+i)
=Po(1+i)(1+i)
=Po(1+i)2
Formula : Cn =Po(1+i)n
Compound value of annuity of Re. 1 : Annuity is an equal amount of deposit made every year / an equal amount received every year.
Compounding is the process of calculating future value from a present value at a given rate of interest & for a given no.of years.
Present value =Ao
Future value =An
Rate of interest =i
No.of years=n
Future value = present value (1+Rate of interest) n
An = Ao(1+i)n
2. Discounting method : It is a calculation of present value from future value for a given rate of interest & no.of years.
Ao(1+i)n =An
Ao=An/(1+i)n
Ao=An(1÷(1+i)n)
Time value : When cash outflows & cash inflows occurred at different timings there will be difference in their time value. To equate (equal) the time value of inflows& outflows discounting technique will be used by using at discounting rate (r).
Therefore, Cn=Po(1+i)n ----->Cn=Po(1+r)n
Ao=An(1÷(1+i)n)---->Ao=An(1÷(1+r)n)
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