Introduction: Financial management is that managerial activity
which is concerned with the planning and controlling of the firms
financial resources. It was a branch of economic till 1890, and as
a separate discipline, it is of recent origin. Still, it has no
unique body of knowledge of its own, and draws heavily on economics
for its theoretical concepts even today. The subject of financial
management is of immense interest to both academicians and
practicing managers. It is of great interest to academicians
because the subject is still developing, and there are still
certain areas where controversies exit for which no unanimous
solution have been reached as yet. practicing managers are
interested in this subject because among the most crucial decision
of the firm are those which relate to finance, and an understanding
of the theory of financial management provides them with conceptual
and analytical insights to make those decision skillfully. Finance
is the art and science of managing money. The major area of finance
is:Financial services: It is concerned with the design and delivery
of advice and financial products to individuals, business and
governments.
Financial management: It is concerned with the duties of the
financial managers in the business firm. Financial managers
actively manage the financial affairs of any type of business
namely, financial and non- financial, private and public, large and
small, profit seeking and not-for-profit.Finance function: It may
be difficult to separate the finance functions from production,
marketing and other functions, but the functions of raising funds,
investing them in assets to shareholders are respectively known as
financing decision, investment decision and dividend decision. Thus
finance functions or decision is divided into long-term and
short-term decision:I. Long term asset-mix or investment decision:
Long term asset-mix or investment decision Capital mix or financing
decision Profit allocation and dividend decision
II. Short term financing decision: Short term asset mix or
liquidity decision A firm performs finance functions simultaneously
andContinuously in the normal course of the business. They do not
necessarily occur in a sequence. Finance functions call for
skillful planning, control and execution of a firms activities.
I. LONG TERM FINANCE DECISION: The long term finance functions
or decisions have a longer time horizon, generally greater than a
year. They may affect the firms performance and value in the wrong
run. They also relate to the firms strategy and generally involve
senior management in taking the final decision. Investment
decision:A firms investment decisions involve capital expenditures.
They are therefore, referred as capital budgeting decisions. A
capital budgeting decision involves decision of allocation of
capital or commitment of funds to long term assets that would yield
benefits in the future.a. The evaluation of the prospective
profitability of new investment b. The measurement of a cut-off the
rate against which the prospective return of new investments could
be compared.
Financing decision: A financing decision is the second important
function to be performed by a financial manager broadly He/ She
must decide when, where from and how to acquire funds to meet the
firms investment needs. The central issue before him or her is to
determine the appropriate proportion of equity and debt. The mix of
debt and equity is known as the firms capital structure. The
financial manager must strive to obtain best financial mix or the
optimum capital structure for firm. The change in the share holders
return caused by the change in the profits is called the financial
leverage.
Dividend decision:A dividend decision is the third major
financial decision. The financial manager must decide 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 and
the retained portion of profit is known as the retention ratio.The
optimum dividend policy is one that maximizes the market value of
the firms shares. Bonus shares are shares issued to the existing
shareholders without any charge.
II. SHORT TERM FINANCE DECISION: It involves a period of less
than one year. These decisions are needed for managing the firms
day to day fund requirements.. Generally they relate to the
management of current assets and current liabilities, short term
borrowings and investment of surplus cash for short period.
Liquidity decision investment in current assets affects the firms
profitability and liquidity. The profitability- liquidity trade-off
requires that the financial manager should develop sound techniques
of managing current assets. Scope of financial management:
Financial management provides a conceptual and analytical frame
work for financial decision making . The finance function covers
both acquisition of funds as well as there allocations thus apart
from the issues involved in acquiring external funds , the main
concern of financial management is the efficient and wise
allocation of funds to various uses. Defined in a broad sense, it
is viewed as an integral part of overall management. The financial
management frame work is an analytical way of viewing the financial
problems of a firm the main content of this approach are: what is
the total volume of funds an enterprise should commit? what
specific assets should an enterprise acquire? How should the funds
required be financed? Alternatively, the principal contents of the
modern approach to financial management can be said to be:1) how
large should an enterprise be,and how fast should it grow? 2)in
what form should it hold assets? And 3)what should be the
composition of its liabilities ?The three question posed above
cover between them the financial problems of a firm. Firms create
manufacturing capacities for production of goods; some provide
services to customers . they sell their goods or services to earn
profit. They raise funds to acquire manufacturing and other
facilities. Thus , the three most important activities of a
business firm are:a) Productionb) Marketingc) FinanceA firms
secures whatever capital it needs and employees it (finance
activity) in activity, which generate returns on invested capital
(production and marketing activities).Objectives of financial
management To make wise decisions a clear understanding of the
objectives which are sought to be achieved is necessary. The
objective provide a framework for financial decision making. The
objective is used in the sense of a goal or decision criterion for
the three decisions involved in financial management. The focus in
financial literature is on what a firm should try to achieve and on
policies that should be followed if certain goals are to be
achieved. Firms in practice state their vision, mission and values
in broad terms and also concerned about technology.Agency problems:
A characteristic feature of a corporate enterprise is the
separation between ownership and management as a corollary of which
the latter enjoy substantial authority in regard to the affairs of
the firm. With widely diffused ownership scattered and
ill-organized shareholders hardly exercise a say or control over
the management which may be inclined to act in its own interest
other than that of the owners. However shareholders as owners of
the firm have the right to change the management .Due to the threat
of being dismissed for poor performance the management would have a
natural inclination to achieve a minimum acceptable level of
performance to satisfy the shareholders goals, while focusing
mainly on their own personal goals. Thus the management will aim at
satisfying, rather than maximizing the wealth of the
shareholders.Agency problem is therefore a conflict of interest
inherent in any relationship where one party is expected to act in
another's best interests. The problem is that the agent who is
supposed to make the decisions that would best serve the principal
is naturally motivated by self-interest, and the agent's own best
interests may differ from the principal's best interests. The
agency problem is also known as the "principalagent
problem."Resolving the agency problem:From this conflict of agency
objective of survival and maximizing owners value arise the agency
problem, that is the likelihood that the managers may place goals
ahead of corporate goals. The agency problem can be prevented by
acts of (1) Market forces and (2)Agency cost.1. Market forces:
Market forces act to prevent agency problems in two ways:I.
Behavior of security market participants andII. Hostile take
over
I. Behavior of security market participants: The security market
participants/shareholders in general and large institutional
investors like mutual funds insurance organizations financial
institutions and so on hold large block of stocks in thru corporate
in particular actively participate in management. to ensure
competent management and minimize agency problems they have in
recent years actively exercised voting rights to replace the more
competent management in the place of the underperforming
management. in addition to this the large institutional investors
also from time to time communicate and exert pressure on the
management to perform or face replacementII. Hostile takeover:
Another market force that has in recent years threatened corporate
management to perform in the best interest of the owner id the
possibility of hostile takeover, that is, the acquisition of the
target firm by another firm/group(i.e. acquirer)that is not
supported by the management. Such take overs typically occur when
the acquirer is of the view that the target firm is undervalued due
to the poor management and that its acquisition at its current low
price may yield in the enhancement of value through restructuring
of management, operations and financing. The constant threat of
takeover would motivate the management to act in the best interest
of the owners despite the fact that techniques are available to
defend against hostile takeover.2)Agency Cost: To respond to
potential market forces by preventing /maximizing agency problems
and contribute to maximization of the owners wealth/value the
shareholders have to incur four types of cost. I. Monitoring
costII. Bonding costIII. Opportunity costIV. Structuring cost
I. Monitoring cost: such expenses relate to monitoring the
activity of the management(agents)to prevent a satisfying in
contrast to share price maximization behavior by them . In
monitoring outlays relate to payment for audit and control
procedures to ensure that managerial behavior is tuned to actions
that tend to be in the best interest of the shareholder.II. Bonding
expenditure: They protect the owners against potential consequences
of dishonest acts by management/managers. The firm pays to obtain a
fidelity bond from the third party bonding company to the effect
that the latter will compensate the former up to a specified amount
for financial losses caused by dishonest acts of managers.III.
Opportunity cost: Such cost arise from the inability of the large
corporate from responding to new opportunities. Due to The
organizational structure, decision hierarchy, and control mechanism
the management may face difficulties in seizing upon the profitable
investment opportunities quickly.
IV. Structuring expenditure: These are the most popular,
powerful and expensive agency cost incurred by corporate. they
refer to structuring the managerial compensation to correspond with
the price maximization. the objective is to offer
incentives/compensation to management to act in the best interest
of the owners. The management compensation plans fall into two
groups they are (i) Incentive plans and (ii) Performance plansi.
Incentive plans: they tie management compensation to share price.
The most widely used incentive is the employee stock optioned which
confer n the management the right to acquire shares of the
corporate at a special/concessional price. A higher future price
would result in larger management compensation.ii. Performance
plans: These plans compensate on the basis of proven performance
measured by EPS, growth in EPS and other ratios to return. Based on
these performances shares may be given to the management for
meeting the stated performance goals. Another form of performance
based compensation is cash bonus, that is, cash payments to
achievement of certain performance goals.Changing role of financial
manager:The nancial manager plays a dynamic role in a modern
companys development. This has not always been the case. Until
around the rst half of the 1900s. nancial managers primarily raised
funds and managed their rms cash positions and that was pretty much
it. In the 1950s, the increasing acceptance of present value
concepts encouraged nancial managers to expand their
responsibilities and to become concerned with the selection of
capital investment projects.Today, external factors have an
increasing impact on the nancial manager. Heightened corporate
competition, technological change, volatility in ination and
interest rates, worldwide economic uncertainty, uctuating exchange
rates, tax law changes, and ethical concerns over certain nancial
dealings must be dealt with almost daily. As a result, nance is
required to play an ever more vital strategic role within the
corporation. The nancial manager has emerged as a team player in
the overall effort of a company to create value. The old ways of
doing things simply are not good enough in a world where old ways
quickly become obsolete. Thus todays nancial manager must have the
exibility to adapt to the changing external environment if his or
her rm is to survive1. Role of Finance Manager for Raising Funds of
CompanyFinance manager checks different sources of company. He did
not get fund from all sources. First, he check his need in short
term and in long term and after this he select best source of fund.
He has also power to change thecapital structureof company for
giving more benefit of company.
2. Role of Finance Manager for Taking Maximum Benefits from
Leverage: Finance manager uses both operating andfinancial
leverageand try to use it for taking maximum benefit from
leverage.
3. Role of Finance Manager for International Financial
DecisionFinance manager finds opportunities in international
financial decision. In these opportunities, he does the contracts
of credit default swap,interest rate swap and currency swap.
4. Role of Finance Manager in Investment DecisionsFinance
manager checksthe net present valueof each investment project
before actual investment in it. Net present value of project means
what net profit at discount rate, will company gets if company
invests him money in that project. High NPV project will be
accepted. So, due to high responsibility, role of finance manager
in this regard is very important.
5. Role of Finance Manager in Risk ManagementHappening of risks
means facing different losses. Finance manager is very serious on
risk and its management. He plays important role to find new and
new ways to control risk of company. Like other parts of
management, he estimates all his risks, heorganize the employees
who are responsible to control risk. He alsocalculates risk
adjusted NPV. He meets all risk controlling organizations like
insurance companies, rating agencies atpervasive level. He is able
to convert company'smisfortunes into fortunes. By good estimations
of adverse situations, he tries his best to safeguard the money of
company
ORGANIZATION OF THE FINANCIAL MANAGEMENT FUNCTION: As the head
of one of the three major functional areas of the firm, the vice
president of finance, or financial officer (CFO), generally reports
directly to the president, or chief executive officer (CEO). In
large firms, the financial operations overseen by the CFO will be
split into two branches, with one headed by a treasurer and the
other by a controller. The controllers responsibilities are
primarily accounting in nature. Cost accounting, as well as budgets
and forecasts, concerns internal consumption. External financial
reporting is provided to the IRS, the Securities and Exchange
Commission and stock holders.The treasurers responsibilities fall
into the decision areas most commonly associated with financial
management: investment (capital budgeting, pension management)
financing (commercial banking and investment banking relation,
investor relation, dividend disbursement) and Asset management
(cash management, credit management). The organization chart may
give you the false impression that a clear split exists between
treasurer and controller responsibilities. In a well-functioning
firm, information will flow easily back and forth between both
branches. In small firms the treasurer and controller functions may
be combined into one position with a resulting commingling of
activities.
THE TIME VALUE OF MONEY:The time value of money lies in that one
lives in a world in which it is overestimated.THE INTEREST
RATE:Which would you prefer-$1,000 today or $ 1000 ten years from
today? Commence tells us to take the $1,000 today because we
recognize that there is a time value of money. The immediate
receipt of $1,000 provides us with the opportunity tour money to
work and earn interest. In a time value of money. As we will so
discover, the rate of interest can be used to express the time
value of money.SIMPLE INTEREST:Simple interest is interest that is
paid (earned) on only the original amount or principal, borrowed
(lent). The dollar amount of simple interest is function of the
their time variables: the original amount borrowed (lent), or
principal; the interest rate per time period; and the number of
time periods for which the principal is borrowed (lent).COMPOUND
INTEREST: The compound interest has on an investments value over
time when compared to the effect of simple interest. Financial
assets: a major facet of financial management involves providing
the financing sources is available. Each has certain
characteristics as to cost, maturity, availability, claims on
assets, and other term imposed by the suppliers of capital. A MIXED
BAG: mergers, strategic alliances, divestitures, restructuring and
remedies for a failing company are explored. Growth of a company
can be internal, external, or both, domestic or international in
flavor. ANNUITIES: annuity is a series of equal payments or
receipts occurring over a specified number of periods.
Present value:Present value is the value today of a sum of money
to be received at a future point of time. In future value, we start
with a given amount (present value) at a specified compound rate of
interest to find its worth at the some point in the future. The
present value is the reserve of this- we try to determine todays
value of a sum of money to be received at some time in the future.
Using the compound interest formula, we can find the present value
of given amount to be received at the point in time in future as
follows:FV= PV(1+r)nPV= FV/(1+r)nThe current worth of a future sum
of money or stream of cash flows given a specified rate of return.
Future cash flows are discounted at the discount rate, and the
higher the discount rate, the lower the present value of the future
cash flows. Determining the appropriate discount rate is the key to
properly valuing future cash flows, whether they be earnings or
obligations.
Present value of an annuity: The current value of a set of cash
flows in the future, given a specified rate of return or discount
rate. The future cash flows of the annuity are discounted at the
discount rate, and the higher the discount rate, the lower the
present value of the annuity.PVAn= A/(1+r)+ A/(1+r)2+. A/(1+r)n-1+
A/(1+r)n The essence of this concept is that receiving money now is
worth more than receiving the same amount in the future. By the
same logic, receiving $5,000 today is worth more than getting
$1,000 per year for five years. This is because if you got the lump
sum today, you could invest it and receive an additional
return.
Using this example, and assuming a discount rate of 6%, the
present value of an annuity that pays $1,000 per year for five
years is $4,212 (1,000*[1-(1+0.06)-5/0.06]= 4,212). This means that
if you could get a return on your invested funds of 6% per year,
receiving $4,212 today would have the same value to you as
receiving $1,000 per year for five years.
COMPARISON OF FUTURE VALUE AND PRESENT VALUE: The concepts of
present value (PV) and future value (FV) are based on the time
value of money. The time value of money is the idea that, quite
simply, money received today is worth more than money to be
received one year from today (or at any other future date), because
it can be used to earn interest. If you invest $1,000 today at 10
percent, you will have $1,100 in one year. So $1,000 in one year is
worth $100 less than $1,000 today because you lose the opportunity
to earn the $100 in interest. In some business situations, you will
know the dollar amount of a cash ow that occurs in the future and
will need to determine its value now. This type of situation is
known as a present value problem. The opposite situation occurs
when you know the dollar amount of a cash ow that occurs today and
need to determine its value at some point in the future. These
situations are called future value problems. The value of money
changes over time because money can earn interest. Both the future
value and the present value take care of time value of money. The
process of determining future value is known as compounding whereas
for present value, the process is termed as discounting. The future
value and the present value can be determined by both compound
interest formula and time line analysis. There is inverse
relationship between the two- the future value increases over time
whereas the present value decline over time.Discounting and
Compounding Costs and benefits of projects analyzed using CBA
rarely occur within a short time period. It is more often the case
that at least some of the outcomes of a project occur over time.
However, as the value of money changes over time due to the effects
of inflation etc. the value of a cost or benefit in the future may
not be representative of the actual worth of that cost or benefit
in present terms. For this reason, it is necessary to discount the
future values of costs and benefits occurring over time to common
metric present values. This also allows researchers to calculate
the net present value of a project.Discounting to present value
Discounting to present value involves calculating the current
equivalent value of a cost or benefit associated with a project,
given a prevailing interest (or discount) rate. The current
equivalent monetary value of a cost or benefit that will be
received in the future is called its present value. The formula
used to calculate the present value of a future cost or benefit in
monetary terms is:
Where,PV = present valueF = future value of cost or benefit in
monetary termsr = the rate of discountn = no. of periods under
consideration (e.g. years)
Discounting over multiple years In some cases the costs or
benefits associated with a project occur over multiple years. In
this case discounting the future values of any such costs and
benefits becomes a particularly important part of any CBA if it is
to provide an accurate net present value of a project. The formula
used to calculate the present value of future costs or benefits in
monetary terms over multiple years is:
Or,
Example Consider a project which produces an income of 2000 for
four years. At the end of this period a piece of machinery involved
in the project is then sold for scrap for 500. Assume a discount
rate of 10% (or 0.10). To calculate the present value of these
future benefits we use the above equation as follows:
Discounting Rates An important consideration when discounting
future costs and benefits to present value is the discount rate
applied. In the UK theGreen Book: Appraisal and Evaluation in
Central Governmentproduced by HM Treasury recommends a discount of
rate of 3.5% (HM Treasury, 2011, 26). TheGreen Bookdiscount rate is
generated using the following equation:r = + g Where,ris the
discount rate.is pure time preference (discount future consumption
over present consumption on the basis of no change in expected per
capita consumption).is elasticity of marginal utility of
consumptiongis annual growth in per capita consumption The time
preference comes from the principle that, generally, people prefer
to receive goods and services now rather than later. Meanwhile, the
latter part of the equation refers to the fact that growth means
people are better off and extra consumption worth less. This
reflects that future consumption will be plentiful relative to the
current position and thus will generate lower marginal utility (HM
Treasury, 2011, 97). HM Treasury assume that= 1.5%,= 1 andg= 2% so
that: 0.015 + (1*0.02) = 0.035 = 3.5% In addition, theGreen
Bookprovides recommendations for reducing the discount rate applied
for projects which exceed a 30 year period (HM Treasury, 2011, 99).
The long term discount rates recommended are as follows:Period (in
years)0-3031-7576-125126-200201-300301+
Discount rate3.5%3.0%2.5%2.0%1.5%1.0%
Note, also, that while the discount rate of 3.5% is recommended
by UK Government other discount rates are used commonly in
evaluation projects. TheStern Review of Climate Change(2006)
assumes=0.1%,=1 andg=1.3% generating a discount rate,r=1.4%. This
is controversial, but in essence applies a greater weighting to
future costs/benefits.Future Values or Compounding In some cases
estimates of the present value of costs or benefits may be known
and future values may be required. For example, if you wish to
estimate the value of an investment involved in a project in one
years time given a known rate of interest. To calculate the future
value of a cost or benefit you would use the following
equation:
Where,FV = future valueP = present value of cost or benefit in
monetary termsr = the rate of discountn = no. of periods under
consideration (e.g. years) The present value being considered,
denoted by P, is invested for n years with a compound interest rate
of r percent per period (usually years). In this equation the term
(1 + r)^n is sometimes referred to as the compound interest factor.
This term is used in textbooks and is included as a function on
most spreadsheet programs and some calculators.Problems with
Discounting A key concern involved in the use of discounting is the
value assigned to the discount rate. An incorrect value for the
discount rate could easily result in an inaccurate estimate of the
present value of a future cost or benefit, and equally could result
in the CBA of an entire project providing an inaccurate net present
value. Often government agencies provide a suggested discount rate
to use when performing discounting. For example, the rate specified
in the UK by HM Treasury for researchers to use when calculating
present values of costs and benefits. A second limitation in the
common method of discounting to present value is in the timing of
costs and benefits. The standard method of discounting future costs
and benefits to present values assumes that all costs and benefits
occur at the end of each year (or at least uses this timing for
ease of calculation). However, it may be that in some cases the
timing of costs and benefits needs to be considered more minutely.
If a cost occurs half way through a year its discounted value may
be different, albeit possibly not by that much, than if the value
is discounted at the end of the year. Depending on the overall
length of a project, in reference to the costs and benefits arising
from it, the timing of the discounting periods may need to be
adjusted. For example instead of using 1, 2, 3, 4, 5 etc. a
researcher may deem it more appropriate to use 1, 1.5, 2, 2.5, 3
etc.
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