1. CHAPTER ONE
Introduction to Financial
Management
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2. Understand the evolutionary concept of Finance:
Previously finance was part of Economics
What is Finance?
It’s hard to give clear and concise definition for finance
According to Khan and Jain, “Finance is the art and science of
managing money”.
According to Oxford dictionary, the word “finance” means
“management of money”.
Commonly finance can be defined as both arts and science of
managing funds of
◦ Local or international
◦ Private or Public
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3. Interrelated Discipline of finance
There are three interrelated areas of finance:
Financial market and institution
Investment
Financial management
◦ What is financial management?
◦ Financial Management is mainly concerned with the
effective funds management in the business.
◦ deals with both fund procurement and
◦ effective utilization
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4. SCOPE OF FINANCIAL MANAGEMENT
Financial management is not a revolutionary concept but an evolutionary.
The definition and scope of financial management has been changed
through time and applied various innovations.
Theoretical points of view, financial management approach may be
broadly divided into two major parts.
A. Traditional Approach
B. Modern Approach
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5. A. Traditional Approach
Traditional approach is the initial stage of financial management, which
was followed, in the early part of during the year 1920 to 1950.
Main part of the traditional approach is rising of funds for the business
concern.
Traditional approach consists of the following important area:
Arrangement of funds from lending body.
Arrangement of funds through various financial instruments.
Finding out the various sources of funds.
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6. B. Modern Approach
In the modern times, the financial management includes besides
procurement of funds, the three different kinds of decisions as well namely:
investment,
financing and
dividend.
Modern approach consists of the following important activity.
Determination of size of the enterprise and determination of rate of growth.
Determining the composition of assets of the enterprise.
Determining the mix of enterprises financing i.e. consideration of level of debt to
equity, etc.
Analyze, planning and control of financial affairs of the enterprise.
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7. FUNCTIONS OF FINANCIAL MANAGEMENT
Financial manger function has three broad categories:
1. Financial planning followed by implementation of financial decisions:
 Financing decision
 Investment decision
 Dividend decision
2. Financial Analysis
3. Financial Control
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8. Financial planning
Planning means deciding in advance.
Thus, financial planning is the act of deciding in advance the activities
related to financial decisions necessary to achieve the objectives of financial
management.
Financial forecasting includes preparation of:
 projected income statement,
 projected balance sheet,
 projected fund flow statement etc.
Financial planning leads to implementation of financial decisions.
 i.e., financing decision, investment decision and dividend decision.
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9. Financial decision
Ones financial planning is completed the next function is
dealing with financial decision
Financial decision includes:
◦ Financing decision: (Procurement of fund)
◦ Investment decision: (Application of fund)
◦ Dividend decision: (Distribution of fund)
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10. Financing decision: (procurement of fund)
Financing decision is categorized into two parts:
Working Capital (WC) financing i.e. financing of current asset components
Project financing i.e. financing for long term investment decision/capital
structure decision.
Both category of financing decision require following three key points to
take into consideration:
Sources
Sources mix
Cost and other consequences
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11. Investment decision: (Application of fund)
Investment decision is also categorized into two parts:
Working capital investment i.e. investment in current asset components
Long-term investment i.e. investment in project decision
Both categories of investment decision require following three key points to
take into consideration:
◦Assets
◦Assets mix
◦Profitability
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12. Dividend decision: (Distribution of fund)
Dividend is an amount paid from companies net earning to the
shareholders equity as a return for their investment.
A finance manager has to decide
what percentage of profit he has to distribute as dividend among shareholders and
how much to retain for further requirement.
This aspect of financial management is dealt under dividend
policy.
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13. Financial Analysis
The term ‘Financial Analysis’, also known as ‘analysis and interpretation
of financial statements.
Financial statement analysis’ refers to the process of determining financial
strengths and weaknesses of the firm by establishing strategic relationship
between the items of the financial statements.
Popular tools for financial analysis which in turn further helps in financial
planning for subsequent periods are:
Ratio Analysis,
Cost-Volume-Profit (CVP),
Fund Flow/Cash Flow Analysis
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14. Financial Control
Financial control refers to comparison of actual activities related to
financial decisions with planned activities.
In other words, it is reviewing financial performances as per planning
schedule in order to meet the set financial objective.
Budgetary control system, variance analysis are some popular tools, which
help in controlling activities related to financial decisions.
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15. OBJECTIVES OF FINANCIAL MANAGEMENT
Objectives of Financial Management may be broadly divided
into two parts such as:
◦ Profit maximization
◦ Wealth maximization.
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16. Profit maximization
Profit maximization is also the traditional and narrow approach, which
aims at, maximizes the profit of the concern.
Profit maximization consists of the following important features:
◦ Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.
◦ Ultimate aim of the business concern is earning profit; hence, it considers all the
possible ways to increase the profitability of the concern.
◦ Profit is the parameter of measuring the efficiency of the business concern. So it
shows the entire position of the business concern.
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17. Cont. …
If profit is given undue importance, a number of problems can arise.
Some of these have been discussed below:
The term profit is vague. It does not clarify what exactly it means.
For example, profit may be in short term or long term period; it may be total profit
or rate of profit etc.
Profit maximization has to be attempted with a realization of risks involved.
Profit maximization as an objective does not take into account the time
pattern of returns.
Profit maximization as an objective is too narrow.
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18. Wealth Maximization
Wealth maximization is one of the modern approaches, which involves
latest innovations and improvements in the field of the business concern.
Wealth maximization is also known as value maximization or net present
worth maximization.
This objective is an universally accepted concept in the field of business.
Value of a firm is represented by the market price of the company's
common stock which is determined by financial market participants.
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19. Cont.…
Favorable Arguments for Wealth Maximization
Wealth maximization is superior to the profit maximization.
It provides extract value of the business concern.
Wealth maximization considers both time and risk of the
business concern.
Wealth maximization provides efficient allocation of
resources.
It ensures the economic interest of the society.
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20. Cont.…
Unfavorable Arguments for Wealth Maximization
Wealth maximization leads to prescriptive idea of the business
concern but it may not be suitable to present day business
activities.
Wealth maximization creates ownership-management
controversy.
Wealth maximization can be activated only with the help of
the profitable position of the business concern.
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21. Related Fields of Financial Management
Financial management, as an integral part of management, is not
a totally independent area.
It draws heavily on related disciplines and fields of study in
multidimensional approaches.
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22. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly
applied with the financial management approaches.
Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager.
Financial management also uses the economic equations like
money value discount factor, economic order quantity etc.
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23. Financial Management andAccounting
 The relationship between finance and accounting, conceptually
speaking, has two dimensions:
(i) they are closely related to the extent that accounting is an important input in
financial decision making; and
(ii) there are key differences in viewpoints between them.
 Accounting function is a necessary input into the finance
function. That is, accounting is a sub-function of finance.
The finance (treasurer) and accounting (controller) activities are
typically within the control of finance director /Chief financial
officer (CFO).
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24. Cont…
These functions are closely related and generally overlap; indeed,
financial management and accounting are often not easily
distinguishable
But there are two key differences between finance and accounting.
The first difference relates to the treatment of funds, while the
second relates to decision making.
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25. Cont…
Treatment of Funds: The viewpoint of accounting relating to the funds of the
firm is different from that of finance.
The measurement of funds (income and expenses) in accounting is based on
the accrual principle/system.
For instance, revenue is recognized at the point of sale and not when
collected.
Similarly, expenses are recognized when they are incurred rather than when
actually paid.
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26. Cont…
The viewpoint of finance relating to the treatment of funds is based on cash
flows.
The revenues are recognized only when actually received in cash (i.e., cash
inflow) and expenses are recognized on actual payment (i.e., cash outflow).
Decision Making: Finance and accounting also differ in respect of their
purposes.
The purpose of accounting is collection and presentation of financial data.
It provides consistently developed and easily interpreted data on the past,
present and future operations of the firm.
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27. Cont…
The financial manager uses such data for financial decision making.
It does not mean that accountants never make decisions or financial
managers never collect data.
But the primary focus of the functions of accountants is on collection and
presentation of data while the financial manager's major responsibility relates
to financial planning, controlling and decision making.
Thus, in essence, finance begins where accounting ends.
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28. Financial Management and Mathematics
 Modern approaches of the financial management applied large
number of mathematical and statistical tools and techniques.
They are also called as econometrics. Time value of money, cost of
capital, ratio analysis and working capital analysis are used as
mathematical and statistical tools and techniques in the field of
financial management.
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29. The agency Relationship
If you are the sole owner of a business, then you make the
decisions that affect your own well-being.
But what if you are a financial manager of a business and you are
not the sole owner?
In this case, you are making decisions for owners other than yourself;
you, the financial manager, are an agent.
An agent is a person who acts for—and exerts powers of—
another person or group of persons.
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30. Cont…
The person (or group of persons) the agent represents is referred
to as the principal. The relationship between the agent and his or her
principal is an agency relationship.
There is an agency relationship between the managers and the
shareholders of corporations.
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31. Problems with the Agency
Relationship
In an agency relationship, the agent is charged with the
responsibility of acting for the principal.
Is it possible the agent may not act in the best interest of the
principal, but instead act in his or her own self-interest?
Yes—because the agent has his or her own objective of maximizing
personal wealth.
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32. Cont…
In a large corporation, for example, the managers may enjoy many
fringe benefits, such as access to private jets, and company cars.
These benefits (also called perquisites, or “perk (bonus)”) may
be useful in conducting business and may help attract or retain
management personnel, but there is room for abuse.
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33. Cont…
What if the managers start spending more time at the golf course than at
their desks?
What if they use the company jets for personal travel?
What if they buy company cars for their teenagers to drive?
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34. Cont…
The abuse of perquisites imposes costs on the firm—and
ultimately on the owners of the firm.
There is also a possibility that managers who feel secure in their
positions may not bother to expend their best efforts toward the
business.
This is referred to as shirking, and it too imposes a cost to the
firm.
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35. Cont…
Finally, there is the possibility that managers will act in their own
self-interest, rather than in the interest of the shareholders when
those interests clash.
For example, management may fight the acquisition of their firm by
some other firm even if the acquisition would benefit shareholders.
Why? In most takeovers, the management personnel of the
acquired firm generally lose their jobs.
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36. Cont…
Many managers faced this dilemma in the merger mania of the
1980s. So what did they do? Among the many tactics,
Some fought acquisition of their firms—which they labeled hostile
takeovers—by proposing changes in the corporate charter or even
lobbying for changes in state laws to discourage takeovers.
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37. Costs of agency relationship
There are costs involved with any effort to minimize the potential for
conflict between the principal’s interest and the agent’s interest.
Such costs are called agency costs, and they are for three types:
monitoring costs, bonding costs, and residual loss.
1. Monitoring costs: are costs by the principal to monitor or limit the
actions of the agent.
 In a corporation, shareholders may require managers to
periodically report on their activities via audited accounting
reports, which are sent to shareholders.
 The accountants’ fees and the management time lost in preparing
such report are monitoring costs.
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38. Cont…
 Another example is the implicit costs incurred when shareholders
limit the decision- making power of managers.
 By doing so, the owners may miss profitable investment
opportunities; the foregone profit is a monitoring cost.
 The board of directors of corporation has a fiduciary duty to
shareholders; that is the legal responsibility to make decisions (or
to see that decisions are made) that are in the best interests of
shareholders.
 Part of that responsibility is to ensure that managerial decisions
are also in the best interests of the shareholders.
 Therefore, at least part of the cost of having directors is a
monitoring cost.
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39. Cont…
2. Bonding costs: are incurred by agents to assure principals that they
will act in the principal’s best interest.
The name comes from the agent’s promise or bond to take certain
actions.
A manger may enter into a contract that requires him or her to stay on
with the firm even though another company acquires it; an implicit cost
is then incurred by the manager, who foregoes other employment
opportunities.
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40. Cont…
3. Residual loss: Despite using monitoring and bonding devices, their
may still be some divergence between the interests of principals and
those of agents.
The resulting cost, called the residual loss, is the implicit cost that
results because the principal’s and the agent’s interests cannot be
perfectly aligned.
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41. Motivating managers: Executive
compensation
 One way to encourage management to act in shareholders’ best
interests, and so minimize agency problems and costs, is through
executive compensation-how top management is paid.
 There are several different ways to compensate executives, including:
Salary: the direct payment of cash of a fixed amount per period
Bonus: a cash reward based on some performance measure, say
earnings of a division or the company.
Stock appreciation right: a cash payment based on the amount by which
the value of a specified number of shares has increased over a specified
period of time (supposedly due to the efforts of management).
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42. Cont…
Performance shares: Shares of stock given to the employees, in an
amount based on some measure of operating performance, such as
earnings per share.
Stock option: the right to buy a specified number of shares of stock in
the company as a stated price-referre to as an exercise price at some
time in the future.
◦ The exercise price may be above, at, or below the current market price of the
stock.
Restricted stock grant: the grant of shares of stock to the employee at
low or no cost, conditional on the shares not being sold for specified
time.
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43. Cont…
 The basic idea behind stock options and restricted stock grants is to make
managers owners, since the incentive to consume excessive perks and to
shirk are reduced if managers are also owners.
 As owners, managers not only share the costs of perks and shirks, but
they also benefit financially when their decisions maximize the wealth of
owners.
 Hence the key to motivation through stock is not really the value of the
stock, but rather ownership of the stock.
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44. End of the chapter!
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