MBA 202A- Financial Management

UNIT-I- Foundations of Finance

Introduction

Finance is the life blood of business. Finance may be defined as the art and science of
managing money. Finance is also referred to as the provision of money at the time when
it is needed. Finance function is the procurement of funds and their effective utilization
in business concerns.

The term financial management has been defined by Solomon, “It is concerned with
the efficient use of an important economic resource namely, capital funds”. The most
popular and acceptable definition of financial management as given by S. C. Kuchal is
that “Financial Management deals with procurement of funds and their effective
utilization in the business. Financial management is the operational activity of a
business that is responsible for obtaining and effectively utilizing the funds necessary
for efficient operations. Thus, Financial Management is mainly concerned with
effective funds management in the business.

Financial management is that activity of management, which is concerned with the

planning, procuring, and controlling of the firm's financial resources. It means applying
general management principles to the financial resources of the institutions. Financial
activities of an institution are one of the most important and complex activities of a
firm. Therefore, in order 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 in order to ensure that the funds are utilized in the most
efficient manner. His actions directly affect the Profitability, growth, and goodwill of
the firm.

DEFINION

“Financial management is the activity concerned with planning, raising, controlling

and administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious

use of capital and a careful selection of the source of capital in order to enable a
spending unit to move in the direction of reaching the goals.” – J.F. Brandley
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“Financial management is the operational activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for efficient operations.”-
Massie

Nature of Financial Management

1.Financial Management is an integral part of overall management. Financial

considerations are involved in all business decisions. So financial management is
pervasive throughout the organization.

2.In most of the organizations, financial operations are centralized. This results in
economies.

3.Financial management involves data analysis for use in decision making.

4. The central focus of financial management is valuation of the firm. That is financial
decisions are directed at increasing/maximization/ optimizing the value of the firm.

5.Financial management essentially involves risk-return trade-off. Decisions on

investment involve choosing of types of assets which generate returns accompanied by
risks. Generally higher the risk, returns might be higher and vice versa. So, the

The financial manager has to decide the level of risk the firm can assume and satisfy
with the accompanying return.

6.Financial management affects the survival, growth, and vitality of the firm. Finance
is said to be the life blood of business. It is to business, what blood is to us. The amount,
type, sources, conditions, and cost of finance squarely influence the functioning of the
unit.

7.Finance functions, i.e., investment, rising of capital, distribution of profit, are

performed in all firms - business or non-business, big or small, proprietary, or corporate
undertakings.

8.Financial management is a sub-system of the business system which has other

subsystems like production, marketing, etc. In systems arrangement financial sub-
system is to be well-coordinated with others and other sub-systems.

9.Financial Management is the activity concerned with the control and planning of
financial resources.

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10.Financial management is multi-disciplinary in approach. It depends on other
disciplines, like Economics, Accounting etc., for better procurement and utilization of
finances.

Goals of Finance / Objectives of Finance

1.Profit maximization

It is commonly believed that a shareholder’s objective is to maximise profit. To achieve

the goal of profit maximisation, the financial manager takes only those actions that are
expected to make a major contribution to the firm's overall profits. The total earnings
available for the firm's shareholders is commonly measured in terms of earnings per
share (EPS). Hence the decisions and actions of finance managers should result in
higher earnings per share for shareholders.

Points in favour of profit maximisation:

• It is a parameter to measure the performance of a business

• It ensures maximum welfare to the shareholders, employees and

prompt payment to the creditors

• Increase the confidence of management in expansion and

diversification.

• It indicates the efficient use of funds for different requirements.

Points against profit maximisation:

• It is not a clear term like accounting profit, before tax or after tax
or net profit or gross profit.

• It encourages corrupt practices

• It does not consider the element of risk

• Time value of money is not reflected.

• Attracts cut throat competition

• Huge profits attract government intervention

• It invites problems from workers.

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 • It affects the long run liquidity of a company.

2.Wealth Maximisation

The goal of the finance function is to maximise the wealth of the owners for whom the
firm is being carried on. The wealth of corporate owners is measured by the share prices
of the stock, which is turn is based on the timing of return, cash flows and risk. While
taking decisions, only that action that is expected to increase share price should be
taken.

It considers:

(a) Time value of money on investment decision

(b) The risk or uncertainty of future earnings and

(c) effects of dividend policy on the market price of shares.

Points In favour of Wealth Maximisation

• It is a clear term

• Net effect of investment and benefits can be measured clearly.

• It considers the time value for money.

• It should be accepted universally

• It guides the management in framing a consistent strong

dividend policy to reach maximum return to the equity holders

.Points against wealth maximisation:

• This concept is useful for equity share holders not for debenture
holders

• The expectations of workers, consumers and various interest

groups create a greater influence that must be respected to
achieve long run wealth maximization and also for their survival.

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Basis Wealth Maximization Profit Maximization

It is defined as the management of

financial resources aimed at
It is defined as the management of
increasing the value of the
financial resources aimed at
Definition stakeholders of the company.
increasing the profit of the company.

Focuses on increasing the value of

the stakeholders of the company in
Focus Focuses on increasing the profit of
the long term.
the company in the short term.

It considers the risks and uncertainty It does not consider the risks and
inherent in the business model of the uncertainty inherent in the business
company. model of the company.
Risk

It helps in achieving a larger value of It helps in achieving efficiency in the

a company’s worth which may reflect company’s day-to-day operations to
in the increased market share of the make the business profitable.
Usage company.

1.1 SCOPE OF FINANCIAL MANAGEMENT

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1.The Traditional Approach:

The traditional approach to the finance function relates to the initial stages of its
evolution during 1920s and 1930s. According to this approach, the scope, of finance
function was confined to only procurement of funds needed by a business on most
suitable terms.

The utilisation of funds was considered beyond the purview of finance function. It was
felt that decisions regarding the application of funds are taken somewhere else in the
organisation. However, institutions and instruments for raising funds were a part of
finance function.

The traditional approach suffers from many serious limitations:

1.It is outsider-looking in approach that completely ignores internal decision making as

to the proper utilisation of funds.

2.The focus of traditional approach was on procurement of long-term funds. Thus, it

ignored the important issue of working capital finance and management.

3.The issue of allocation of funds, which is so important today, is completely ignored.

2.The Modern Approach:

The modern approach views finance function in a broader sense. It includes both the
rising of funds as well as their effective utilisation under the purview of finance. The
finance function does not stop only by finding out sources of raising enough funds; their
proper utilisation is also to be considered. The cost of raising funds and the returns from
their use should be compared.

The funds raised should be able to give more returns than the costs involved in
procuring them. The utilisation of funds requires decision making. Finance must be
considered as an

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integral part of overall management. So finance functions, according to this approach,
cover financial planning, rising of funds, allocation of funds, financial control etc.

The modern approach considers the three basic management decisions, i.e., investment
decisions, financing decisions and dividend decisions within the scope of finance function.

Figure showing Scope of financial management

In organizations, managers in an effort to minimize the costs of procuring finance and using
it in the most profitable manner, take the following decisions:

Investment Decisions: Managers need to decide on the amount of investment available

out of the existing finance, on a long-term and short-term basis. They are of two types:
Long- term investment decisions or Capital Budgeting mean committing funds for a long
period of time like fixed assets. These decisions are irreversible and usually include the
ones pertaining to investing in a building and/or land, acquiring new plants/machinery or
replacing the old ones, etc. These decisions determine the financial pursuits and
performance of a business. Short-term investment decisions or Working Capital
Management means committing funds for a short period of time like current assets. These

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involve decisions pertaining to the investment of funds in the inventory, cash, bank
deposits, and other short- term investments. They directly affect the liquidity and
performance of the business.

Financing Decisions: Managers also make decisions pertaining to raising finance from
long- term sources and short-term sources. They are of two types:

Financial Planning decisions which relate to estimating the sources and application of
funds. It means pre-estimating the financial needs of an organization to ensure the
availability of adequate finance. The primary objective of financial planning is to plan and
ensure that the funds are available as and when required.

Capital Structure decisions which involve identifying sources of funds. They also involve
decisions with respect to choosing external sources like issuing shares, bonds, borrowing
from banks or internal sources like retained earnings for raising funds. The decisions are
made in the light of the cost of capital, risk factor involved and returns to the shareholders.

Dividend Decisions: These involve decisions related to the portion of profits that will be
distributed as dividend. Dividend is that portion of divisible profits that is distributed to the
owners i.e. the shareholders. Retained earnings is the proportion of profits kept in, that is,
reinvested in the business for the business. Shareholders always demand a higher dividend,
while the management would want to retain profits for business needs. Dividend decision
is to whether to distribute earnings to shareholders as dividends or retain earnings to
finance long-term profits of the firm. It must be done keeping in mind the firm’s overall
objective of maximizing the shareholders wealth.

Risk Return Tradeoff

Risk-return tradeoff states that the potential return rises with an increase in risk. Using this
principle, individuals associate low levels of risk with low potential returns, and high levels
of risk with high potential returns. According to risk-return tradeoff, invested money can
render higher profits only if the investor will accept a higher possibility of losses.

Risk management: The trade-off provides a framework to investors for assessing

potential risks and rewards for different investment opportunities.

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● Return optimization: Investors can identify investments that offer the best potential
return for their level of risk tolerance. This allows them to optimize their portfolio for
investment objectives, such as capital preservation, growth, or income.

● Diversification: The risk-return trade-off formula explains the current risk exposure in
the investment instruments included in the portfolio. This can allow investors to manage
their portfolios and reduce risk by investing in low-risk investment instruments.

Agency relationship and Costs

The principal-agent relationship is a business arrangement where one entity authorizes

another to perform actions on its behalf. The entity doing the authorization is the principal,
and the entity receiving power is the agent. More simply, a principal hires or appoints an
agent to carry out a duty they can't or don't want to do.

In terms of business, the principal is considered to be a shareholder, while the agent is

considered to be a company executive. Although it may not seem like it, shareholders and
company executives are tightly connected. Each of their actions greatly affects the position
of one another.

Agency theory is also often referred to as the “agency dilemma” or the “agency problem.”

Different Agency Theory Relationships

When it comes to business and the concept of agency theory, there several types of
relationships that are closely intertwined and are faced with some sort of disagreement.

Shown below are some of the most in-depth and connected relationships in businesses that
involve a principal-agent relationship and qualify for the agency theory.

1. Shareholders and Company Executives

As mentioned, the shareholder is represented by the principal. It is because the shareholder

invests in an executive’s business, in which the executive is responsible for making
decisions that affect the shareholder’s investment.

If the company executive acts negatively and reduces the worth of the shareholder’s stock,
it will spark a disadvantageous relationship.

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On the other hand, if the company executive were to act ethically resulting in some sort of
financial boost in the shareholder’s stock, a positive connection will form.

2. Investor and Fund Manager

In such a case, the investor is the principal because they are giving a portion of their income
to the fund manager to allocate on their behalf.

If the fund manager were to invest in volatile stocks and yield a return less than expected
from the investor, a negative relationship begins to form.

Conversely, if the fund manager goes above and beyond and nets a profit outside of the
realm of expectation, the investor praises the fund manager and there is a healthy linkage.

3. Board of Directors and CEO

Up in the hierarchy, the board of directors is represented by the principal because their
financial position and status are decided by the CEO.

If the CEO were to make a wrong financial decision that put the organization at a deficit,
the board of directors is more likely to vote against the CEO in the next election.

Oppositely, if the CEO were to introduce a new business sector that provided
unprecedented innovation in the market, they would be praised by the board of directors
and would likely stay in power for years to come

The idea of agency theory is represented by the relationships expressed above.

All the interactions and disagreements faced by both the principal and agent are what make
up the entire exploration of the concept.

Causes of Agency Problems

As mentioned throughout the text, the agency theory explores the distinctive relationship
between a principal and their agent. Throughout the relationship, there is a number of
actions and decisions that are made by the agent on behalf of the principal.

The same actions and decisions are what generates disagreements and conflict between the
two parties. To explain in more depth, listed below are the main causes of agency problems:

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When a conflict of interest arises between the principal and the agent

When the agent is making decisions on behalf of the principal that is not in the best interest
of each associated party

The agent may act independently from the principal in order to obtain some sort of
previously agreed upon incentive or bonus

Confidentiality breach regarding the personal and financial information of the principal

Insider trading with the information provided by the principal

When the principal acts against the recommendations provided by the agent.

Considering there is power/trust allocation, it is not surprising that there is an entire theory
that explores the relationship and interactions between a principal and an agent.

Reducing Agency Problems

In order to reduce the likelihood of conflict, there are certain measures and principles that
can be followed by both the principal and agent.

1. Transparency

To reduce the potential influx of agency problems, it is crucial for both the principal and
the agent to be completely transparent with one another.

Decisions and transactions that will be implemented must be agreed upon by each party
and must be reasonably fair.

Once transparency is present, conflict is reduced due to the fact that there is less confusion
on decision-making and fewer implications that one party is against the other.

2. Restrictions

Imposing restrictions or abolishing negative restrictions is a good way to significantly

reduce the effect of agency loss.

Setting specific restrictions on factors such as agency power allows the principal to feel
more confident in their relative agent.

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Conversely, abolishing negative restrictions is beneficial because it instills trust within the
agent and allows them to make decisions freely on behalf of the principal.

3. Bonuses

Introducing and eradicating incentives and bonuses lessens the chances of a relationship
that consists of conflicts and disagreements.

Introducing bonuses is a good way to motivate an agent and will allow them to make
decisions with the best intentions of the principal in order to achieve their desired incentive.

Contrarily, bonuses may motivate the agent to make decisions just for financial gain,
disregarding the best intentions of the principal to only achieve the incentive.

Each relationship between a principal and agent is different, it is crucial to choose the best-
fitted methods for each specific situation to ensure a positive, healthy relationship

1.Direct Agency Cost

Monitoring Costs: When the activities of the company's management are aligned to the
benefits of the shareholders, and these restrict the activities of the administration. The direct
agency cost of maintaining the board of directors therefore to a certain extent, is also a part
of the monitoring costs. Other examples of the monitoring costs are the employee stock
options plan available for the employees of a company.

Bonding Costs: Contractual obligations are entered between the company and the agent. A
manager stays with a company even after it is acquired, who might forgo the employment
opportunities.

Residual Losses: If the monitoring bonding costs are not enough to diverge the principal
and agent interests, additional costs are incurred, called the residual costs.

2. Indirect Agency Cost

The indirect agency cost theory refer to the expenses incurred due to the opportunity lost.
For example, there is a project that the management can undertake which might result in
the termination of their jobs. However, the company's shareholders believe that if the
company undertakes the project, it will improve its values. If, however, the project is

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rejected, it will have to face a huge loss in terms of shareholders' stake. Since this expense
is not directly quantifiable but affects the interests of the management and shareholders, it
becomes a part of the indirect agency costs.

Role of Financial Manager

Some of the main financial management roles are mentioned below:

1.Planning and Forecasting

One of the major financial management roles is developing budgets to allocate resources
effectively. Also predicting future financial conditions and performance based on historical
data and market analysis.

2.Investment Decision-Making

Decision-making is one of the crucial financial management roles that evaluates and selects
investment projects that maximize shareholder value. Ensuring that the company’s assets
are used efficiently.

3.Financing Decisions

Financing Decisions are also a major financial management role that determines the
optimal mix of debt and equity financing and identifies appropriate sources of finance.

4.Dividend Decision

Dividend decision deals with the distribution of profits to shareholders and retaining
earnings in the for of reserves

5.Risk Management

Risk management is one of the crucial roles of financial management that is performed
using financial instruments to protect against adverse price movements. It is also used in
procuring insurance to mitigate risks related to operations and assets.

6.Cash Flow Management

The role of the financial manager in cash flow management helps in working capital
management by ensuring that the company has sufficient cash flow to meet its short-term

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liabilities and operating expenses. Cash flow management also includes liquidity
management by maintaining the ability to quickly convert assets to cash without significant
loss.

7.Financial Reporting and Analysis

Financial reporting and analysis include preparing accurate financial statements and
analyzing financial ratios to assess the company’s performance and financial health.

8.Cost Control and Profit Maximization

Cost control is necessary for monitoring and controlling expenses to ensure they remain
within budget. Financial managers identify areas where costs can be reduced without
compromising quality and implement cost-saving initiatives to improve operational
efficiency.

Profit maximization involves developing strategies to increase revenue and profitability.

Financial managers analyze profit margins and identify areas for improvement, ensuring
the effective utilization of resources to maximize profits. .

Time Value of Money

The time value of money (TVM) is a fundamental financial principle stating that a sum of
money has greater value today than it does in the future, given its potential earning capacity.
This concept underscores the importance of timing in financial transactions, as money can
be invested to earn returns, such as interest or dividends, over time.

TVM explains why financial decisions are sensitive to timing. It provides a framework for
understanding that the value of money changes over time due to its earning potential. By
considering TVM, individuals and businesses can make more accurate and effective
financial decisions.

Concept Of Time Value of Money

The concept of TVM is grounded in three main ideas:

Inflation: Over time, the purchasing power of money erodes due to inflation, making it less
valuable in the future than today.

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Opportunity Cost: Money can earn returns if invested, so there is a cost associated with
not having money available for investment at a given time.

Risk & Uncertainty: Future cash flows are uncertain; thus, a definite amount today is
often preferred over a potentially equivalent amount in the future.

Future Value

The future value is simply the expected future value of an investment made today. The
future value formula assumes the investment will grow at some rate over a specific time
period.

For example, assume we have Rs 1,000 today and we invest it at 5% for one year. In one
year, we will have Rs.1,050.00. In this simple example, the future value is calculated as the
present value*(1+the interest rate), or 1000*(1.05).

If we made the same investment for two years, the future value would be $1,102.50. In this
case, the initial investment compounded over two years, so the formula is 1000*(1+5%)^2.
Compound interest benefits investors as interest is earned on both the original investment
of Rs.1,000 and the first year’s interest of Rs.50.

Breaking this down further the original investment grows to Rs.1,050 in the second year.
However, the second year’s interest is $50 plus interest on the first year’s interest of Rs.50.
The interest on the first year’s interest is $2.50 ($50*5%). Adding all of this up is the same
Rs.1,102.50 mentioned earlier.

Of course, we don’t have to calculate interest on interest for every year… this could get
quite cumbersome if there are many years! Instead, we can rely on the future value formula:

FV = PV*(1+r)^n

Where:

FV is the future value of the investment, including growth/interest.

PV is the present value of the investment.

r is the annual interest rate.

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n is the number of years the money is invested.

Present Value

The present value determined from a future value is computed as the future value divided
by the discount rate. Very often, the discount rate used to determine present value is the
risk-free interest rate (e.g., T-bill) or the internal rate of return (if evaluating a corporate
investment option or alternative).

The formula for calculating present value is as follows:

PV = FV / (1 + r)^n

Where:

– PV is the present value

– FV is the future value

– r is the interest rate per period

– n is the number of periods

Single Flow

In finance, a "single flow" refers to a one-time movement of money, meaning a single cash
inflow or outflow occurring at a specific point in time, as opposed to a series of cash flows
over a period; essentially, a single financial transaction with no additional related cash
movements happening afterward.

Annuity Flow

An annuity flow is a series of cash payments made at regular intervals, such as monthly or
annually. Annuities can be used for a variety of purposes, including retirement income,
mortgages, and insurance.

Multiple Compound Periods

Multiple compounding periods occur when interest is compounded more than once a year.
This can happen on a daily, monthly, quarterly, semi-annual, or continuous basis.

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Doubling period

In financial management, the doubling period is the amount of time it takes for an
investment to double in value. The doubling period can be estimated using the Rule of 70
or the Rule of 72.

How to calculate doubling period Rule of 70

Divide 70 by the annual growth rate. For example, if an investment grows at 5% annually,
it will take 14 years to double.

Rule of 72 Divide 72 by the annual interest rate. For example, if an investment has a 6%
annual return, it will take about 12 years to double.

Sinking Fund Factor

A sinking fund factor (SFF) is a ratio that helps determine how much to save each period
to meet a future financial obligation. It's based on the idea that equal payments made at the
end of each period will compound to a future value of $1.

How to calculate SFF

The equation for SFF is SFF = i (1 + i)^n - 1, where "i" is the interest rate and "n" is the
number of years

For example, if the interest rate is 7% and the number of years is 5, the SFF is 0.1739

This means that five annual payments of $173.90 earning 7% interest will be worth $1,000
at the end of the fifth .

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