FM -Theory (Module Wise)
Module- 01(Introduction to financial management)
According to John J Hampton, "The term Finance can be defined as the management of the
flows of money through an organization whether it will be a corporation, school or
government agency".
Finance functions:
1. Investment Decision
This involves decisions about where and how to allocate funds to generate returns.
• Capital Budgeting: Evaluating long-term investments like new projects, equipment, or
expansions.
Tools: NPV, IRR, Payback Period, Cost-Benefit Analysis.
• Working Capital Management: Managing short-term assets and liabilities to ensure
liquidity.
2. Financing Decision
This involves determining the best sources of funds for the organization.
• Capital Structure: Deciding the proportion of debt and equity financing.
• Metrics: Debt-to-Equity Ratio, Cost of Capital.
• Fundraising: Issuing shares, taking loans, or other financing options.
3. Dividend Decision
This involves decisions regarding the distribution of profits to shareholders.
• Dividend Policy: Deciding the percentage of profits to distribute vs. retain for
reinvestment.
• Types: Stable Dividend, Regular Dividend, Residual Dividend.
• Retention Ratio: The portion of earnings retained in the business.
Financial Management:
Financial Management refers to the process of planning, organizing, controlling, and
monitoring financial resources to achieve an organization’s objectives efficiently and
effectively.
Evolution of Financial Management
1. Traditional Phase (Before 1950s)
- Focus on procurement of funds.
- Emphasis on external financing and legal aspects.
- Narrow scope, primarily managing financial transactions.
2. Transitional Phase (1950s - 1970s)
- Shift towards efficient fund utilization.
- Introduction of capital budgeting and cost of capital.
- Focus on financial decision-making processes.
3. Modern Phase (1970s - Present)
- Emphasis on wealth maximization and shareholder value.
- Broader scope including risk management, capital structure, and strategic planning.
- Integration of technology and advanced financial tools.
4. Globalization and Technological Advancements
- Increased cross-border investments and global financial management.
- Use of AI, machine learning, and big data in financial analysis.
5. Sustainability and Ethical Focus (Recent Trends)
- Emphasis on environmental, social, and governance (ESG) factors.
- Sustainable finance and corporate social responsibility (CSR).
Scope/Approaches of FM:
A. Traditional School of Thought
o Focus on Procurement of Funds
- Emphasis on acquiring funds from external sources.
- Limited to raising capital for business needs.
o Narrow Scope
- Concerned primarily with financing issues, not utilization or allocation.
o Institutional and Legal Aspects
- Focus on contracts, terms of borrowing, and legal compliance.
o Short-Term Perspective
- Limited to maintaining liquidity and fulfilling immediate financial obligations.
B. Modern School of Thought
o Wealth Maximization Focus
- Aims to maximize shareholder wealth and firm value.
Broader Scope
- Includes investment, financing, dividend, and working capital decisions.
o Strategic Decision-Making
- Involves long-term planning and resource allocation.
o Risk and Return Management
- Balances profitability with associated risks.
o Internal and External Focus
- Addresses internal operational efficiency and external market conditions.
Functions of FM or financial decisions:
• Investment decision
• Financing decision
• Dividend policy decision
• Liquidity decision
Significance of FM:
• Finance is the controlling function
• Aid to managerial decision areas
• Wealth maximization
• Financial Management is an analytical tool
• Finance function of centralised
• Measures performance
Objectives of FM:
• Wealth Maximization
• Profit Maximization
• Capital Structure Optimization
• Liquidity Management
• Investment Decisions
• Risk Management
• Cost Control
Financial goals of the firm:
• Profit maximization
• Wealth maximization
Profit maximization:
Profit Maximization is the goal of a business to achieve the highest possible profit, typically
measured by the difference between total revenue and total costs, in the short term. This
objective focuses on increasing revenues while minimizing costs to maximize profits.
Limitations:
• Short-Term Focus: Profit maximization often emphasizes immediate gains, neglecting
long-term sustainability and growth.
• Ignores Risk: Profit maximization doesn't consider the risk involved in achieving
profits.
• Doesn't Account for Timing: Profit maximization doesn't consider the timing of
profits.
• No Consideration for Shareholder Wealth: This objective may not align with the
interests of shareholders, who are often more concerned with long-term value,
dividends, and stock price.
• External Factors: Profit maximization does not account for external factors like
market competition, economic conditions, and regulatory changes.
Wealth Maximization:
Refers to the goal of increasing the value of a firm's shares, thereby maximizing the wealth of
its shareholders. This is achieved by focusing on long-term growth, profitability, and
sustainable value creation, often measured by the market price of the company's stock.
Limitations of Wealth Maximization:
• Short-Term Market Fluctuations: Stock prices can be influenced by short-term market
fluctuations, which may not always reflect the company's true value, making wealth
maximization less stable in the short term.
• External Factors: Wealth maximization does not always account for external factors
like economic downturns, political instability, or regulatory changes, which can affect
the firm's value.
• Risk Considerations: Focusing solely on wealth maximization can sometimes lead to
taking excessive risks in the pursuit of high returns, which may harm the company's
long-term stability.
• Shareholder Focus: The emphasis on shareholder wealth may overlook other
stakeholders, such as employees, customers, and the community, potentially leading
to ethical concerns or social responsibility issues.
• Market Perception: The market's perception of a company's value may not always
align with its actual performance or long-term potential, causing volatility in wealth
maximization efforts.
Finance manager
Finance manager is the person he or she solely responsible for carrying out the finance
functions of a company.
Role of financial manager:
• Raising funds of company Finance
• International Financial decision
• Taking maximum benefits from leverage
• Investment decisions
• Risk Management
Agency problem:
An agency problem is a conflict of interest in a business relationship in which one party fails
to act in the best interest of another party.
Agency problems may arise because of the conflicts between the following persons:
• Shareholders vs managers
• Creditors versus shareholders
Agency cost:
Agency cost is regarded the cost incurred on the conflicts of interest among the stockholders
and management.
Some of the costs are:
• Indirect agency cost
• Direct agency cost
Resolving the agency problem:
• Market forces
• Behaviour of security market participants
• Hostile takeovers
• Agency cost
• Monitoring expenditure
• Bonding expenditures
• opportunity costs
