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CHAPTER 1 NATURE, PURPOSE,AND SCOPE OF FINANCIAL MANAGEMENT

NATURE OF FINANCIAL MANAGEMENT • Financial management also referred to managerial finance, corporate finance, and business finance is a decision making process concerned with planning, acquiring, and utilizing funds in a manner that achieves the firm’s desired goals. • It is also described as the process for and the analysis of making financial decisions in the business context.

• It is a part of a larger discipline called FINANCE which is a body of facts, principles, and theories relating to raising and using money by individuals, businesses, and governments. • This concerns both financial management of profit oriented business organizations particularly the corporate form of business, as well as, concepts and techniques that are applicable to individuals and to governments.

THE GOAL OF FINANCIAL MANAGEMENT • GENERAL GOAL - The general goal of financial management is to make money and add value for the owners. • SPECIFIC GOAL -The financial manager in a business enterprise must make a decision for the owners of the firm. He must act in the owners’ or shareholders’ best interest by making decisions that increase the value of the firm or the value of the stock.

• In conclusion, the main goal of financial management is: “The goal of financial management is to maximize the current value per share of the existing stock or ownership in a business firm.” • Because the goal of management is to maximize the value of the share(s), there is a need to learn how to identify investments, arrangements and distribute satisfactory amount of dividends or share in the profits that favorably impact the value ofshare(s).

SCOPE OF FINANCIAL MANAGEMENT • Traditionally, financial management is primarily concerned with acquisition, financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. The basic responsibility of the Finance Manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize the firms wealth, as well as, generating returns to the business concern.

• Financial Management looks into the following functions that a financial manager of a business firm will perform: 1. Procurement of short term as well as long term funds from financial institutions. 2. Mobilization of funds through financial instruments such as equity shares, debentures, bonds, notes and so forth. 3. Compliance with legal and regulatory provisions relating to funds procurement, use and distribution as well as coordination of the finance function with the accounting function.

In view of modern approach, the Finance Manager is expected to analyze the business firm and determine the following: a. The total funds requirements of the firm b. The assets or resources to be acquired and c. The best pattern of financing the assets.

TYPES OF FINANCIAL DECISIONS • The three major types of decisions that the Finance Manager of a modern business firm will be involved in are: 1. Investment Decisions 2. Financing Decisions 3. Dividend Decisions •. All these decisions aim to maximize the shareholders’ wealth through maximization of the firm’s wealth.

Investment Decisions • The investment decisions are those which determine how scarce or limited resources in terms offunds of the business firms are committed to projects. • Generally, the firm should elect only those capital investment proposals whose net present value is positive and the rate of return exceeding the marginal cost of capital.

• It should also consider the profitability of each individual proposal that will contribute overall profitability of the firm and lead to the creation of wealth.

Financing Decisions • Financing decisions assert the mix of debt and equity chosen to finance investments should maximize the value of investments made.

The finance decisions should consider the cost of finance available in different forms and the risks attached to it. The principle of financial leverage or trading on the equity should be considered when selecting the debt-equity mix or capital structure decision. If the cost of capital of each component is reduced, the overall weighted average cost of capital and minimization of risks in financing will lead to the profitability of the organization and create wealth to the owner.

Dividend Decisions • The dividend decision is concerned with the determination of quantum of profits to be distributed to the owners, the frequency of such payments and the amounts to be retained by the firm.

• The dividend distribution policies and retention ofprofits will have ultimate effect on the firm’s wealth. The business firm should retain its profits in the form of appropriations or reserves for financing its future growth and expansion schemes. If the firm, however, adopts a very conservative dividend payments policy, the firm’s share prices in the market could be adversely affected. An optimal dividend distribution policy therefore will lead to the maximization of shareholders’ wealth.

SUMMAR Y

• To summarize, the basic objective of the investment , financing and dividend decisions is to maximize the firm’s wealth. If the firm enjoys the stability and growth, its share prices in the market will improve and will lead to capital appreciation of shareholders’ investment and ultimately maximize the shareholders’ wealth.

SIGNIFICANCE OF FINANCIAL MANAGEMENT

Broad Applicability • The principles of finance are applicable wherever there is cash flow. The concept of cash flow is one of the central elements of financial analysis, planning, control, and resource allocate decisions. Cash flow is important because the financial health of the firm depends on its ability to generate sufficient amounts of cash to pay its employees, suppliers, creditors, and owners.

Reduction of Chances of Failure

• A firm having latest technology, sophisticated machinery, high caliber marketing and technical experts, and so forth may still fail unless its finances are managed on sound principles of financial management. The strength of business lies in its financial discipline. Therefore, finance function is treated as primordial which enables the other functions like production, marketing, purchase, and personnel to be effective in the achievement of organizational goal and objectives.

Measurement of Return on Investment • Anybody who invests his money will expect to earn a reasonable return on his investment. The owners of business try to maximize their wealth. Financial management studies the risk-return perception of the owners and the time value of money. It considers the amount of cash flows expected to be generated for the benefit of owners, the timing of these cash flows. The greater the time and risk associated with the expected cash flow, the greater is the rate of return required by the owners.

RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT ACCOUNTING AND ECONOMICS

Financial Management and Accounting • In many organizations accounting and finance functions intertwined and the finance function is often considered as a part of the functions of the accountant. Accounting function discharges the function of systematic recording of transactions relating to the firm’s activities in the books of accounts and summarizing the same for presentation in the financial statements.

• The finance manager will make use of the accounting information in the analysis and review of the firm’s business position in decision making. • Financial management is the key function and many firms prefer to centralize the function to keep constant control on the finances of the firm.

Financial Management and Economics • Microeconomics deals with the economic decisions of individuals and firms. The concept of microeconomics helps the finance manager in decisions like pricing, taxation, determination of capacity and operating levels, break-even analysis, volume-cost profit analysis, capital structure decisions, dividend distribution decisions, profitable product-mix decisions, fixation of levels of inventory, setting the optimum cash balance, pricing of warrants and options, interest rate structure, present value of cash flows, and so forth.

• Macroeconomics looks at the economy as a whole in which a particular business concern is operating. Macroeconomics provides insight into policies by which economic activity is controlled. The success of the business firm is influenced by the economy and is dependent upon the money and capital markets, since the investible funds are to be procured from the financial markets.

Relationship of Financial Objectives to Organizational Strategy And Other Organizational Objectives

Introduction ฀

Finance permeates the entire business organizations by providing guidance for the firm’s strategic and day to day decisions.

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Objective Setting is an important phase in the business enterprise since upon correct objectives setting will the entire structure of strategies, policies, and plans of a company rest.

Example of Objectives in broad ฀ It is the goal of the company to be a leader terms in technology in the industry ฀ ฀

To achieve profit through a high level manufacturing efficiency To achieve a high degree of customer satisfaction

Strategic Financial ฀ Strategic planning is long range in scope and has Management its focus on the organization as whole. ฀

A company strategic or business plan reflects how it plans to achieve its goals and objectives.

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Historical financial statements provide insight into the success of a company’s strategic plan and are an important input of the planning process.

Short and Medium ฀ Maximization of return on capital employed or return Term on investment. ฀

Growth in earnings per share and price/earnings ratio through maximization of net income or profit and adoption of optimum lebvel of leverage

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Minimization of finance charges

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Efficient procurement and utilization of short term, medium term and long term funds.

Long ฀ Growth in the market value of the equity shares through Term maximization of the firm’s market share and sustained growth in dividend to shareholders ฀

Survival and sustained growth of the firm

Financial Objectives of the Business ฀ Viewpoints The owner’s perspective which hold that the only appropriate goal is to maximize shareholder or owner’s wealth. ฀

The stakeholder’s perspective which emphasizes social responsibility over profibility.

Adam Smith-was a Scottish moral philosopher pioneer of political economy and a key figure in the Scottish Enlightenment. He is also an 18th century economist and was one of the first and proponent of this viewpoint.

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Adam Smith argued that in capitalism an individual pursuing his own interest tends also to promote the good of his community.

Wealth Maximization Goal ฀

It consider the risk and time value of money

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It considers all future cash flow, dividends and earnings per share.

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It suggests the regular and consistent dividend payments to the shareholders.

Wealth Maximization Goal ฀

The financial decisions are taken with a view to improve the capital appreciation of the share price.

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Maximization of firm’s value is reflected in the market price of share since it depends on shareholder’s expectations regarding profitability long run prospects, timing difference of returns, risk distribution of returns of the firm.

Responsibilities to Achieve the Financial Objectives

Investing The finance manager is responsible for how determining scarce resources or funds are committed to projects. ฀

The investing function deals with managing the firm’s assets.

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This task requires both the mix and type of assets to hold.

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Investment decision should aim at investments in assets only when they are expected to earn greater than a minimum acceptable return, also called handle rate.

Investin Example of Investing Decisions of Financial managers g฀ Evaluation and selection of capital investment proposal ฀ Determination of the total amount of fund that a firm can ฀ ฀ ฀ ฀ ฀ ฀ ฀ ฀

commit for investment Prioritization of investment alternatives Funds allocation and rationing Determination of the levels of investments in working capital Determination of fixed assets to be acquired Asset replacement decision Purchase or lease decisions Restructuring reorganization mergers and acquisition Securities analysis and portfolio management

Financin ฀ gThe finance manager is concerned with the ways in which the firm obtain and manages the financing it needs to support its invention.

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Financing decisions call for good knowledge of cost of raising funds, procedures in hedging risk, different financial instrument and obligation attached to them.

Financin The finance manager will g finance decisions:

be involved in the ff.

฀ Determination of the financing pattern of the

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short-term, medium-term and long-term funds requirements Determination of the best capital structure or mixture of debt and equity financing Procurement of funds through the issuance of financial instrument Arrangement with bankers, suppliers and creditors for its working capital, medium-term and other long-term funds requirement Evaluation of alternative sources of funds.

Operatin g฀This third responsibility area of finance manager concerns working capital management. ฀

Managing the firm’s working capital is a day-to-day responsibility that ensures that the firm has sufficient resources.

Operatin gIssues that may have to be resolved in relation to managing a firms working capital ฀ The level of cash, securities and inventory that should

be kept on hand ฀ The credit policy ฀ Source of short-term financing ฀ Financing purchases of goods

TIONS FUNC OF CIAL FINAN GEMENT MANA

THE ROLE OF FINANCIAL MANAGER ฀

Analysis and Planning

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Acquisition of funds

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Utilization of funds

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Impact on Risk and Return

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Affect the Market Price of Common Stock

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Lead to Shareholder’s wealth maximization

THE FINANCE ORGANIZATION

CORPORATE GOVERNANCE

ETHICAL BEHAVIOR Ethics A moral philosophy ; that involves systematizing, defending, and recommending concepts of right and wrong conduct. examines ethical principles and moral or ethical problems that arise in a business environment. It applies to all aspects of business conduct and is relevant to the conduct of individuals and entire organizations. (Business Ethics)

ETHICAL BEHAVIOR Competence Finance managers must have skills, knowledge and proper certification to practice their trade.

Professionalism For ethical finance managers, professionalism is about business protocol, not just finance know-how.

Integrity Finance managers' first priority is to act in their clients' best interest and provide exceptional service that builds honest, trustful relationships.

Confidentiality Finance managers handle sensitive information that must be kept confidential.

Business Organizations and Trends

The organization of the business firm

The business firm is an entity designed to organized raw materials, labor and machines with the goal of producing goods and/or services. Firms: -purchase productive resources from household and other firms. -transform them into a different commodity, and -sell the transformed product or service to consumers. Every society, no matter what type of economy it has, relies on business firm to organize resources and transform them into products. In market economics, most firms choose their own price, output level, and methods of production. They get the benefit of sales revenue, but they also pay the costs of the resources they use. Business firms can be organized in one of three ways: -Proprietorship -Partnership -Corporation

Legal forms of business organization Proprietorship A sole proprietorship is a business owned by a “single” person who has complete control over business decision. This individual owns all the firm’s asset and is responsible for its liabilities. From a legal point of view, the owner of a proprietorship is not separable from the business and is personally liable for all debts of the business. The business itself does not pay any income taxes. The income or loss of the business is reported on the owner’s personal income tax return on a supporting schedule.

Advantage s -Ease of entry and exit -Full ownership and control -Tax savings -Free government regulation

Disadvantage s: -Unlimited liability -Limitation in raising capital -Lack of continuity

Partnershi p is a contract whereby two or more persons bind themselves to contribute money, property, industry to a common fund with the intention of dividing profits among themselves. Partnership may operate under varying degrees of formality.

Partnership may be either General or Limited: General Partnership it is one in which partner has unlimited liability for the debts incurred by the business. General partners usually manage the firms and may enter into contractual obligations on the firm’s behalf. Profit and asset ownership may be divided in any way agreed upon by the partners. Limited Partnership it is one containing one or more general partners and one or more limited partners. The personal liability of a general partner for the firm’s is unlimited while personal liability of limited partner is limited to their investment. Limited partners cannot be active in management.

Advantages of Partnership Ease of formation – Forming a partnership may acquire relatively ฀

little effort and know start-up with. ฀

Additional Sources of Capital – A partnership has the financial resources of several individuals.

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Management base - A partnership has a broader management base or expertise than a sole proprietorship.

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Tax implication – A partnership like a proprietorship does not pay any Income taxes. The income or loss of the business is distributed among the partners is accordance with the partnership and each partner reports his or her persons whether distributed or not on personal income returns.

Disadvantage of Partnership ฀

Unlimited liability- General partners have unlimited liability for the doubts and litigations of the business.

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Lack of Continuity- A partnership may dissolve upon the withdrawal or death of a general partner depending on the provision of partners.

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Difficulty of transferring ownership – It is difficult for a partner to liquidate or transfer ownership. It varies with conditions set forth in the partnership agreement.

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Limitations of raising capital- A partnership may have problems raising large amounts of investment or capital because many sources of funds available only to corporations.

Corporation ฀

Firm that meets certain legal requirements to be recognized as having a legal existence, as an entity separate and distinct from its owners. Corporations are owned by their stockholders (shareholders) who share in profit...