1.

INTRODUCTION
Finance is the application of economic principles and concepts to business decision making
and problem solving. The field of finance broadly consists of three categories: Financial
Management, Investments and Financial Institutions.
i) Financial Management: This area is concerned with financial decision making within a
business entity. Financial management decisions, include maintaining optimum cash balance,
extending credit, mergers and acquisitions, raising of funds and the instruments to be used for
raising funds etc.
ii) Investments: This area of finance focuses on the behaviour of financial markets and
pricing of financial instruments.
iii) Financial Institutions: This area of finance deals with banks and other financial
institutions that specialises in bringing supplier of funds together with the users of funds.
There are three categories of financial institutions which act as an intermediary between
savers and users of funds, viz., banks, developmental financial institution and capital markets.
Financial management is broadly concerned with the acquisition and use of funds by a
business firm. The scope of financial management has grown in recent years, but traditionally
it is concerned with the following:
• How large should a firm be and how fast should it grow?
• What should be the composition of the firm’s assets?
• What should be the mix of the firm’s financing?
• How should the firm analyse, plan and control its financial affairs?
The past two decades have witnessed several rapid changes on the economic and corporate
front which have an important bearing on how firms are run and managed. On the one hand
we have witnessed economies of several countries opening up thereby throwing new
opportunities and on the other hand we have also witnessed that the growth rate of developed
countries is stagnating or even declining. The impact of these changes is that the firms must
move out of the saturated markets and explore new markets.

1.1 EVOLUTION OF FINANCIAL MANAGEMENT

The evolution of financial management may be divided into three broad phases:
i) The traditional phase
ii) The transitional phase
iii) The modern phase.
In the traditional phase the focus of financial management was on certain events which
required funds e.g., major expansion, merger, reorganisation etc. The traditional phase was
also characterised by heavy emphasis on legal and procedural aspects as at that point of time
the functioning of companies was regulated by a plethora of legislation. Another striking
characteristic of the traditional phase was that a financial management was designed and
practiced from the outsiders’ point of view mainly those of investment bankers, lenders,
regulatory agencies and other outside interests.
During the transitional phase the nature of financial management was the same, but more
emphasis was laid on problems faced by finance managers in the areas of fund analysis
planning and control.
The modern phase is characterised by the application of economic theories and the
application of quantitative methods of analysis. The distinctive features of the modern phase
are:
• Changes in macro-economic situation that has broadened the scope of financial
management. The core focus is how on the rational matching of funds to their uses in the
light of the decision criteria.
• The advances in mathematics and statistics have been applied to financial management
specially in the areas of financial modelling, demand forecasting and risk analysis.

1.2 SIGNIFICANCE OF FINANCIAL MANAGEMENT

The main objective of financial management is, to make optimum utilisation of resources
which results in maximum profits. The last five decades have witnessed rapid industrial
development and policies of globalisation and liberalisation because of which financial
activities have undergone tremendous changes. The success or the failure of business
operations largely depends upon the financial policies pursued by the firm; as Irwin Friend
has said “a firm’s success and even survival, its ability and willingness to maintain
production and to invest in fixed or working capital are to a very considerable extent
determined by its financial policies both past and present. In modern time where the
ownership of firms is more dispersed, there is a separation of ownership and management,
and the firms are focusing on social responsibility the role of financial management has
spanned beyond planning and control”. In the words of Ezra Soloman “Financial
management is properly viewed as an integral part of overall management rather than
as a staff specialty concerned with fund raising operations. In addition to raising funds,
financial management is directly concerned with production, marketing and other
functions within an enterprise where decisions are made about the acquisition or
distribution of assets”. The significance of financial management is discussed as follows:
1) Determination of Business Success: Sound financial management leads to optimum
utilization of resources which is the key factor for successful enterprises. If we analyse the
factors which lead to an enterprise turning sick one of the main factors would be
mismanagement of financial resources. Financial Management helps in preparation of plans
for growth, development, diversification and expansion and their successful execution.
 2) Optimum Utilisation of Resources: One of the basic objectives of financial management
is to measure the input and output in monetary terms. Since finance managers are responsible
for the allocation of resources, they are also responsible to ensure that resources are used in
an optimum manner. In fact, the failure of business enterprise is not due to inadequacy of
financial resources but is the result of defective management of financial resources. In a
country like India, where capital is scarce, effective utilisation of financial resources is of
great significance.
3) Focal Point of Decision Making: Financial management is the focal point of decision-
making as it provides various tools and techniques for scientific financial analysis. Some of
the techniques of financial management are comparative financial statement, budgets, ratio
analysis, variance analysis, cost- volume, profit analysis, etc. These tools help in evaluating
the profitability of the project.
4) Measurement of Performance: The performance of the firm is measured by its financial
results. The value of the firm is determined by the quantum of earnings and the associated
risk with these earnings. Financial decisions which increase earnings and reduces risk will
enhance the value of the firm.
5) Basis of Planning, Co-ordination and Control: Each and every activity of the firm
requires resource outlays which are ultimately measured in monetary terms. The finance
department being the nodal department is closely associated with the planning of most of the
activities of the various departments. Since most of the activities of the firm require co-
ordination among various departments, the finance department facilitates this co-ordination
by supplying the requisite information. Since the result of various activities are measured in
monetary terms, again the finance department is closely involved in control and monitoring
activities.
6) Advisory Role: The finance manager plays an important role in the success of any
organisations.
7) Information Generator for Various Stakeholders: In this modern era where business
managers are trustees of public money, it is expected that the firm provides information to the
various stakeholders about the functioning of the firm. One of the major objectives of
financial management is to provide timely information to various stakeholders.

2. ROLE OF A FINANCE MANAGER

Financial activities of a firm are one of the most important and complex activities of a firm.
Therefore, to take care of these activities a financial manager performs all the requisite
financial activities.
A financial manager is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness to ensure that the funds
are utilized in the most efficient manner.
Their actions directly affect the Profitability, growth and goodwill of the firm.
Following are the main functions of a Financial Manager:
1. Raising of Funds
To meet the obligation of the business it is important to have enough cash and liquidity. A
firm can raise funds by equity and debt.
It is the responsibility of a financial manager to decide the ratio between debt and equity. It is
important to maintain a good balance between equity and debt.
2. Allocation of Funds
Once the funds are raised through different channels the next important function is to allocate
the funds.
The funds should be allocated in such a manner that they are optimally used. In order to
allocate funds in the best possible manner the following point must be considered:
 The size of the firm and its growth capability
 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised
These financial decisions directly and indirectly influence other managerial activities. Hence
formation of a good asset mix and proper allocation of funds is one of the most important
activities.
3. Profit Planning
Profit earning is one of the prime functions of any business organization.
Profit earning is important for survival and sustenance of any organization. Profit planning
refers to proper usage of the profit generated by the firm.
Profit arises due to many factors such as pricing, industry competition, state of the economy,
mechanism of demand and supply, cost and output.
A healthy mix of variable and fixed factors of production can lead to an increase in the
profitability of the firm.
Fixed costs are incurred using fixed factors of production such as land and machinery. To
maintain a tandem, it is important to continuously value the depreciation cost of fixed cost of
production.
4. Understanding Capital Markets
Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important function
of a financial manager.
When securities are traded on stock market there involves a huge amount of risk involved.
Therefore, a financial manger understands and calculates the risk involved in this trading of
shares and debentures.
It’s on the discretion of a financial manager as to how to distribute the profits. Many investors
do not like the firm to distribute the profits amongst shareholders as dividend instead invest
in the business itself to enhance growth.
The practices of a financial manager directly impact the operation in capital market.

3. FINANCIAL DECISIONS
If carefully reviewed what constitutes a business, we will come to the conclusion that there
are two things that matter, money and decision. Without money, a company won’t survive
and without decisions, money can’t survive. An administration must take countless decisions
in the lifetime of the company. Thus, the most important ones are related to money. The
decisions related to money are called ‘Financing Decisions.’
There are three decisions that financial managers have to take:
 Investment Decision
 Financing Decision and
 Dividend Decision
Investment Decision
These are also known as Capital Budgeting Decisions. A company’s assets and resources are
rare and must be put to their utmost utilization. A firm should pick where to invest in order to
gain the highest conceivable returns. This decision relates to the careful selection of assets in
which funds will be invested by the firms. The firm puts its funds in procuring fixed assets
and current assets. When choice with respect to a fixed asset is taken it is known as capital
budgeting decision.
Factors Affecting Investment Decision
 Cash flow of the venture: When an organization starts a venture it invests a huge
capital at the start. Even so, the organization expects at least some form of income to
meet everyday day-to-day expenses. Therefore, there must be some regular cash flow
within the venture to help it sustain.
 Profits: The basic criterion for starting any venture is to generate income but
moreover profits. The most critical criteria in choosing the venture are the rate of
return it will bring for the organization in the nature of profit for, e.g., if venture A is
getting 10% return and venture В is getting 15% return then one must prefer project
B.
  Investment Criteria: Different Capital Budgeting procedures are accessible to
a business that can be utilized to assess different investment propositions. Above all,
these are based on calculations with regards to the amount of investment, interest
rates, cash flows and rate of returns associated with propositions. These procedures
are applied to the investment proposals to choose the best proposal.
Financing Decision
Financial decision is important to make wise decisions about when, where and how a
business should acquire fund. Because a firm tends to profit most when the market estimation
of an organization’s share expands, and this is not only a sign of development for the firm but
also it boosts investor’s wealth. Consequently, this relates to the composition of various
securities in the capital structure of the company.
Factors affecting Financing Decisions
 Cost: Financing decisions are all about allocation of funds and cost-cutting. The cost
of raising funds from various sources differ a lot. The most cost-efficient source
should be selected.
 Risk: The dangers of starting a venture with the funds from various sources differ.
Larger risk is linked with the funds which are borrowed, than the equity funds. This
risk assessment is one of the main aspects of financing decisions.
 Cash flow position: Cash flow is the regular day-to-day earnings of the company.
Good or bad cash flow position gives confidence or discourages the investors to
invest funds in the company.
 Control: In the situation where, existing investors need to hold control of the business
then finance can be raised through borrowing money, however, when they are
prepared for diluting control of the business, equity can be utilized for raising funds.
How much control to give up is one of the main financing decisions.
 Condition of the market: The condition of the market matter a lot for the financing
decisions. During boom period issue of equity is in majority but during a depression, a
firm will have to use debt. These decisions are an important part of financing
decisions.
Dividend Decision
Dividends decisions relate to the distribution of profits earned by the organization. The major
alternatives are whether to retain the earnings profit or to distribute to the shareholders.
Factors Affecting Dividend Decisions
 Earnings: Returns to investors are paid out of the present and past income.
Consequently, earning is a noteworthy determinant of the dividend.
 Dependability in Earnings: An organization having higher and stable earnings can
announce higher dividend than an organization with lower income.
  Balancing Dividends: For the most part, organizations attempt to balance out
dividends per share. A consistent dividend is given every year. A change is made, if
the organization’s income potential has gone up and not only the income of the
present year.
 Development Opportunity: Organizations having great development openings if they
hold more cash out of their income to fund their required investment. The dividend
announced in growing organizations is smaller than that in the non-development
companies.
Other Factors
 Cash flow: Dividends are an outflow of funds. To give the dividends, the organization
must have enough to provide them, which comes from regular cash flow.
 Shareholders’ Choices: While announcing dividends, the administration must
remember the choices of the investors. Some shareholders want at least a specific sum
to be paid as dividends. The organizations ought to consider the preferences of such
investors.
 Taxes: Compare tax rate on dividend with the capital gain tax rate that is applicable to
increase in market price of shares. If the tax rate on dividends is lower, shareholders
will prefer more dividends and vice versa.
 Stock market: For the most part, an expansion in dividends positively affects the stock
market, though, a lessening or no increment may negatively affect the stock market.
Consequently, while deciding dividends, this ought to be remembered.
 Access to Capital Market: Huge and organizations with a good reputation, for the
most part, have simple access to the capital market and, consequently, may depend
less on retained earnings to finance their development. These organizations tend to
pay higher dividends than the smaller organizations.
 Contractual and Legal Constraints: While giving credits to an organization, once in a
while, the lending party may force certain terms and conditions on the payback of
dividends in future. The organizations are required to guarantee that the profit payout
does not abuse the terms of the loan understanding in any manner.
Certain arrangements of the Companies Act put confinements on payouts as profit. Such
arrangements must be followed while announcing the dividends.

4. OBJECTIVES OF FINANCIAL MANAGEMENT

For optimal financial decisions, it is essential to define objectives of financial management.
These objectives serve as decision-criterion. Financing is a functional area of business and,
therefore, the objectives of financial management must be in tune with the overall objectives
of the business. The main objectives of business are survival and growth. In order to survive
in the business and to grow, a business must earn sufficient profits. It must also maintain
good relations with investors, employees, customers and other groups of society. Financial
management of an organisation may seek to achieve the following objectives:
• ensure adequate and regular supply of funds to the business,
• provide a fair rate of return to the suppliers of capital,
• ensure efficient utilisation of capital according to the principles of profitability, liquidity
and safety,
• devise a definite system for internal investment and financing,
• minimise cost of capital by developing a sound and economical combination of corporate
securities,
• co-ordinate the activities of the finance department with the activities of other departments
of the organisation.
Generally, maximisation of economic welfare of its owners is accepted as the financial
objective of the firm. But the question is, how does one maximise the owners’ economic
welfare? Financial experts differ while finding a solution to this problem. There are two well-
known criteria in this regard:
i) Profit Maximisation
ii) Wealth Maximisation.
Profit Maximisation
The basic objective of every business enterprise is the welfare of its owners. It can be
achieved by the maximisation of profits. Therefore, according to this criterion, the financial
decisions (investment, financing and dividend) of a firm should be oriented to the
maximisation of profits (i.e. select those assets, projects and decisions which are profitable
and reject those which are not profitable). In this we increase the earning capacity of the firm
by way of reducing cost or expenses or increasing the prices and likewise. In other words,
actions that increase profits are be undertaken and those that decrease profits are to be
avoided. Profit maximisation as an objective of financial management can be justified on the
following grounds:
1) Rational
2) Test of Business Performance
3) Main Source of Inspiration
4) Maximum Social Welfare
5) Basis of Decision-Making
Drawbacks of Profit Maximisation Concept
1) It is vague
2) It ignores time value of money
3) It ignores risks 4) It ignores social responsibility
From the above description, it can be easily concluded that profit maximisation criterion is
inappropriate and unsuitable as an operational objective of financial management. In
imperfect competition, the profit maximisation criterion will certainly encourage
concentration of economic power and monopolistic tendencies. That is why, the objective of
wealth maximisation is considered as the appropriate and feasible objective as against the
objective of profit maximisation.
We shall discuss this criterion in detail and arrive at a satisfactory conclusion to determine the
goals or objectives of financial management.
Wealth Maximisation
The objective of profit maximisation, as discussed above, is not only vague and ambiguous,
but it also ignores the two basic criteria of financial management i.e. (i) risk and (ii) time
value of money. Therefore, wealth maximisation is taken as the basic objective of financial
management, rather than profit maximisation. It is also known as ‘Value Maximisation’ or
‘Net Present Value Maximisation’. According to Ezra Soloman of Stanford University, the
ultimate objective of financial management should be the maximisation of wealth. Prof.
Irwin Friend has also supported this view.
Wealth Maximisation means to maximise the net present value (or wealth) (NPV) of a
course of action. NPV is the difference between the gross present value of the benefits of
that action and the amount of investment required to achieve those benefits. The gross present
value of a course of action is calculated by discounting or capitalising its benefits at a rate
which reflects their timings and uncertainty.
Superiority of Wealth Maximisation
We have discussed the goals or objectives of financial management. Now, the question arises
as to the choice i.e., which should be the goal of financial management in decision –making
i.e., profit maximisation or wealth maximisation. In present day changed circumstances,
wealth maximisation is a better objective because it has the following points in its favour:
• It measures income in terms of cash flows, and avoids the ambiguity now associated with
accounting profits as, income from investments is measured based on cash flows rather than
on accounting profits.
• It recognises time value of money by discounting the expected income of different years at
a certain discount rate (cost of capital).
• It analyses risk and uncertainty so that the best course of action can be selected from
different alternatives.
• It is not in conflict with other motives like maximisation of sales or market value of shares.
It helps rather in the achievement of all these other objectives.
Therefore, maximisation of wealth is the operating objective by which financial decisions
should be guided.
Difference Between Profit Maximisation and Wealth Maximisation

Factors Profit Maximisation Wealth Maximisation

Motive Maximising a company’s profits. Maximising the wealth of

shareholders.

Strategy Time Short term Long term

Period

Maximisation Increasing the business’s earning capacity. Enhancing stock value for
Procedure stakeholders and
shareholders.

Main Focus Increasing a company’s capacity to Improving the business’s share

generate maximum returns with the price.
minimum input.

Time Value of Does not acknowledge the time value of Takes into account the time
Money money. value of money.