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Financial Management (An Introduction). Contents of the Chapter Meaning of Finance Meaning of Financial Management Three Major Decisions of Financial.

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Presentation on theme: "Financial Management (An Introduction). Contents of the Chapter Meaning of Finance Meaning of Financial Management Three Major Decisions of Financial."— Presentation transcript:

1 Financial Management (An Introduction)

2 Contents of the Chapter Meaning of Finance Meaning of Financial Management Three Major Decisions of Financial Management Evolution of financial Management Scope of Financial Management Objectives of Financial Management Agency Problem

3 Finance Finance is an art and science of managing money.

4 What is Financial Management? overall goal Concerns the acquisition, financing, and management of assets with some overall goal in mind.

5 Evolution of financial Management Evolution of Financial Management can be divided in three phases: – The traditional Phase – The modern Phase

6 The Traditional Phase(upto 1950) Finance function was concerned with procurement of funds only Finance function was viewed from the suppliers point of view only The focus of attention was on the long term resources and the long term sources was the major concern This approach was descriptive rather than analytical As concerned with procurement so the knowledge of pros and cons of the sources was needed. It is viewed only from outsider point of view.

7 The Modern Phase The scope of financial management was broadened means not only to procure the funds but also includes optimum utilize of that fund The approach of financial management has become more analytical and quantitative as knowledge of securities, financial markets and institution is also necessary. The point of view of the managerial decision(insider) maker has become dominant

8 Decisions of financial Management The function of raising funds, investing them in assets and distributing returns earned from assets to shareholders are respectively known as – Financing Decisions or capital Mix Decisions – Investment Decisions or Long Term Asset Mix Decision – Dividend Decisions or Profit Allocation Decision

9 Investment Decisions Most important of the three decisions. What is the optimal firm size? What specific assets should be acquired? What assets (if any) should be reduced or eliminated? – capital budgeting decisions – Working capital managent

10 Investment decision Which assets should be purchased out of different alternatives To buy or to get it on lease To produce a part or to procure it from supplier Proposal of merger of other groups to avail the synergies of consolidation Trade off b/w liquidity and profitability How much and what inventory to be maintained Whether and how much credit is to be given

11 Financing Decisions Determine how the assets (RHS of balance sheet) will be financed (LHS of balance sheet). What is the best type of financing? – Borrowed funds of owned funds What is the best financing mix (Capital Structure) How will the funds be physically acquired?

12 Dividend Decisions 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 the dividend pay-out ratio The retained portion of profits is known as the retention ratio. The optimum dividend policy is one that maximize the market value of the firm’s shares.

13 Financial Manager’s Role A financial Manager is one who is responsible to carry out the finance functions. Main Functions: – Financial forecasting and planning – Funds acquisition – Funds Allocation – Profit Planning – Understanding capital Markets – Maintaining proper Liquidity

14 Objectives of Financial Management The main aim of financial management is to use business funds in such a way that the firm’s value/ earnings are maximized. The objective can be achieved by – Profit Maximization – Wealth Maximization

15 Objective of Profit Maximization Profit Maximization Profit Maximization u Maximizing a firm’s earnings u Maximizing the Rupee Income of Firm Resources are efficiently utilized Appropriate measure of firm performance Serves interest of society also

16 Objections to Profit Maximization It is Vague It Ignores the Timing of Returns It Ignores Risk It widens the gap b/w mgt and shareholders In new business environment profit maximization is regarded as – Unrealistic – Difficult – Inappropriate – Immoral

17 Objective of Profit Maximization Maximizing Profit After Taxes – Profit means PAT but some times it results in increasing PAT and reducing EPS – Which will not maximize economic welfare of shareholders. Maximizing EPS – Market value is not a function of EPS. Hence maximizing EPS will not result in highest price for company's shares – Also ignores timing and risk of the expected profits

18 Objective of Wealth Maximization Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net present value is the difference between the present value of its benefits and the present value of its costs. A financial action that has positive NPV creates wealth for shareholders and is desirable and vice versa.

19 Features of Wealth Maximization It also incorporates the time value of money. It measures the benefit in terms of cash flow and avoids the ambiguity associated with the accounting profits. It takes care of the questions of the timing and risk of expected profits by selecting an appropriate rate for discounting the expected flow of future benefits. Fundamental objective—maximize the market value of the firm’s shares.

20 Agency problem Managers versus Shareholders Goals There is a principal agent relationship between shareholders and the managers In theory managers should act in best interest of the shareholders(increase shareholders wealth) but they may pursue their own personal goals. They may maximize their own wealth at the cost of shareholders or They may work for satisfactory wealth instead of maximum wealth The conflict between the shareholders and managers is called agency problem and results into agency costs.

21 How to resolve Agency Problem To give ownership rights through stock options to managers. To offer them monetary and non-monetary incentives to managers to act in their interest. Close monitoring by stakeholders may also help in reducing this problem.

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