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Financial Management:
Suppose you are planning to start your own business. No matter what the nature of your
proposed business is and how it is organised, you will have to address the following
questions:
■ What capital investments should you make? That is, what kinds of real estate, ma
chineries, R&D programmes, IT infrastructure, and so on should you invest in?
■ How will you raise money to pay for the proposed capital investments? That is, what will
be the mix of equity and debt in your financing plan?
How will you handle the day-to-day financial activities like collecting your receiv ables and
paying your suppliers?
While these are not the only concerns of financial management, they are certainly the
central ones.
This book discusses the theories, analytical methods, and practical considerations that
are helpful in addressing various issues in financial management, a discipline assumed great
significance in recent times.
Before we begin our odyssey, let us get a bird's eye view of financial management, also
referred to as corporate finance or managerial finance. This chapter provides such an
overview.
It is organised into twelve sections.
● Evolution of financial management
● Financial decisions in a firm Goal of financial management
● Fundamental principle of finance
● Risk-return tradeoff
● Forms of business organisation
● Agency problem
● Business ethics and social responsibility
● Organisation of the finance function
● Relationship of finance to economics and accounting
● Emerging role of the financial manager in India
● Outline of the book
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1.I EVOLUTION OF FINANCIAL MANAGEMENT
Financial management emerged as a distinct field of study at the turn of the 20th century. Its
evolution may be divided into three broad phases (though the demarcating lines between
these phases are somewhat arbitrary)-the traditional phase, the transitional phase, and the
modern phase.
The traditional phase lasted for about four decades. The following were its important.
features:
● The focus of financial management was mainly on certain episodic events like forma
tion, issuance of capital, major expansion, merger, reorganisation, and liquidation in
the life cycle of the firm.
● The approach was mainly descriptive and institutional. The instruments of financing,
the institutions and procedures used in capital markets, and the legal aspects of
financial events formed the core of financial management.
● The outsider's point of view was dominant. Financial management was viewed
mainly from the point of view of the investment bankers, lenders, and other outside
interests.
A typical work of the traditional phase is The Financial Policy of Corporations by Arthur S.
Dewing. This book discusses at length the types of securities, procedures used in issuing
these securities, bankruptcy, reorganisations, mergers, consolidations, and combinations.
The treatment of these topics is essentially descriptive, institutional, and legalistic.
The transitional phase began around the early 1940s and continued through the early
1950s. Though the nature of financial management during this phase was similar to that of
the traditional phase, greater emphasis was placed on the day-to-day problems faced by
financial managers in the areas of funds analysis, planning, and control. The focus shifted to
working capital management. A representative work of this phase is Essays on Business
Finance by Wilford J. Eitman et al.
The modern phase began in the mid 1950s and has witnessed an accelerated of
development with the infusion of ideas from economic theory and application of quantitative
methods of analysis. The distinctive features the modern phase are
● The central concern of financial management is considered to be a rational matching
of funds to their uses so as to maximise the wealth of current shareholders.
● The approach of financial management has become more analytical and quantitative.
Since the beginning of the modern phase many significant and seminal developments have
occurred in the fields of capital budgeting, asset pricing theory, capital structure theory,
efficient market theory, option pricing theory, agency theory, valuation models, dividend
policy, working capital management, financial modeling, and behavioral finance. Many more
exciting developments are in the offing making finance a fascinating and challenging field.
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1.2 FINANCIAL DECISIONS IN A FIRM
As mentioned in the beginning of this chapter, there are three broad areas of financial
decision making viz., capital budgeting, capital structure, and working capital management.
Capital Budgeting The first and perhaps the most important decision that any firm has to
make is to define the business or businesses that it wants to be. This is referred to as
strategic planning and it has a significant bearing on how capital is allocated in the firm. As
strategic planning calls for evaluating costs and benefits spread out over time, it is
essentially a financial decision making process.
Once the managers of a firm choose the business or businesses they want to be in, they
have to develop a plan to invest in buildings, machineries, equipments, research and
development, godowns, showrooms, distribution network, information infrastructure, brands,
and other long-lived assets. This the capital budgeting process. Considerable managerial
time, attention, and energy is devoted to identify, evaluate, and implement investment
projects. When you look at an investment project from the financial point of view, you should
focus on the magnitude, timing, and riskiness of cash flow associated with it. In addition,
consider the options embedded in the investment projects.
Capital Structure Once a firm has decided on the investment projects it wants to
undertake, it has to figure out ways and means of financing them.
The key issues in capital structure decision are: What is the optimal debt-equity ratio for the
firm? Which specific instruments of equity and debt finance should the firm employ?
Which capital markets should the firm access? When should the firm raise finances? At
what price should the firm offer its securities?
An allied issue is the distribution policy of the firm. What is the optimal dividend payout ratio
for the firm? Should the firm buyback its own shares?
Capital structure and dividend decisions should be guided by considerations of cost and
flexibility, in the main. The objective should be to minimise the cost of financing without
impairing the ability of the firm to raise finances required for value creating investment
projects.
Working Capital Management Working capital management, also referred to as short term
financial management, refers to the day-to-day financial activities that deal with current
assets (inventories, debtors, short-term holdings of marketable securities, and cash) and
current liabilities (short-term debt, trade creditors, accruals, and provisions). The key issues
in working capital management are: What is the optimal level of inventory for the operations
of the firm? Should the firm grant credit to its customers and, if so, on what terms? How
much cash should the firm carry on hand? Where should the firm invest its temporary cash
surpluses? What sources of short-term finance are appropriate for the firm?
1.3 GOAL OF FINANCIAL MANAGEMENT
Much of the theory in corporate finance is based on the assumption that the goal of the firm
should be to maximise the wealth of its current shareholders. This goal has been
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eloquently defended distinguished finance scholars, economists, and practitioners. Here is a
sampling of their views:
"In a market-based economy which recognises the rights of private property, the only
social responsibility of business is to create value and do so legally and with integrity. It is a
profound error to view increases in a company's value as a concern just for its shareholders.
Enlightened managers and public officials recognise that increases in stock prices reflect
improvement in competitiveness-an issue which affects everyone who has a stake in the
company or economy"
"Should a firm maximise the welfare of employees, or customers, or creditors? These are
bogus questions. The real question is: What should a firm do to maximise its contribution to
the society? The contribution to the society is maximised by maximising the value of the
firm"."
"The quest for value drives scarce resources to their most productive uses and their
most efficient users. The more effectively resources are deployed, the more robust will be
the economic growth and the rate of improvement in our standard of living. Adam Smith's
'invisible hand' is at work when investors' private gain is a public value".
"Those who regard shareholder wealth maximisation as irrelevant or immoral are forgetting
that shareholders are not merely the beneficiary of a corporation's financial successes, but
also the referee who determine management's financial power".
Despite the forceful arguments in favour of the goal shareholder wealth maximisation,
its supremacy has been challenged, among others, by the capital market skeptics, the
strategic visionaries, and the balancers. The arguments of these critics and the rebuttal by
the defendants of shareholder wealth maximisation principle are summarised below..
CRITIQUE DEFENCE
The capital market sceptics argue that the Based on extensive empirical evidence, fi
stock market displays myopic tendencies, nancial economists argue that in developed
often wrongly prices securities, and fails to capital markets, share prices are the least bi-
reflect long-term values. Managers, on the ased estimates of intrinsic values and man-
other hand, are well-informed and make agers are not generally better than investors
decisions based on more reliable and ro in assessing values.
bust measures of value creation. It is true that shareholder wealth is created
only through successful product market
strategies. For example, satisfied and loyal
Customers are essential for value creation.
However, beyond a certain point customer
satisfaction comes at the cost of shareholder
The strategic visionaries argue that the firmns should Based on extensive empirical evidence, fi
pursue a product market goal likemaximising the nancial economists argue that in developed
market share, or enhancing customer satisfaction, or capital markets, share prices are the least biased
minimising costsin relation to competitors, or achieving estimates of intrinsic values and man-
a agers are not generally better than investors
zero defect level. If the firm succeeds in in assessing values. It is true that shareholder
implementing its product market strategy, wealth is created only through successful product
investors would be amply rewarded market strategies. For example, satisfied and loyal
The balancers argue that a firm should seek Customers are essential for value creation.
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to "balance the interest of various stake- However, beyond a certain point customer
holders, viz. customers, employees, share- satisfaction comes at the cost of shareholder value.
holders, creditors, suppliers, community, When that happens, the conflict should be resolved
and others. in favour of shareholders to enhance the long-term
viability and com-petitiveness of the firm.
The balancers argue that a firm should seek Balancing the interest of various stakeholders
to "balance the interest of various stake- is not a practical governing objective. There is
holders, viz. customers, employees, share- no way to figure out what the right "balance
holders, creditors, suppliers, community, is. When managers confront complex prob.
and others. lems involving numerous tradeotts, they will
have no clear guidelines on how to resolve the
differences. Each manager would be left to his
own judgment. In a large organisation this
can lead to confusion and even chaos.
Alternative Goals Are there other goals, besides the goal of maximal shareholder wealth,
expressing the shareholders' viewpoint? Several alternatives have been suggested-
maximisation of profit, maximisation of earnings per share, maximisation of return on
equity (defined as equity earnings/net worth). Let us examine them.
Maximisation of profit is not as inclusive a goal as maximisation of shareholders' wealth.
It suffers from several limitations:
● Profit in absolute terms is not a proper guide to decision-making. It should be ex-
pressed either on a per share basis or in relation to investment.
● It leaves considerations of timing and duration undefined. There is no guide for
comparing profit now with profit in future or for comparing profit streams of differ-
ent durations.
● If profits are uncertain and described by a probability distribution, the meaning of
profit maximisation is not clear.
The goals of maximisation of earnings per share and maximisation of return on equity
do not suffer from the first limitation mentioned above. However, they do suffer from the
other limitations and hence are also not suitable.
In view of the shortcomings of the alternatives discussed above, maximisation of the
wealth of equity shareholders (as reflected in the market value of equity) appears to be the
most appropriate goal for financial decision-making. Though the strict validity of this goal
rests on certain rigid assumptions, it can be reasonably defended as a guide for financial
decision-making under fairly plausible assumptions about capital markets.
A Modification Given a certain number of outstanding shares, managers should act to
maximise the current share price of their firm. However, if managers believe that the
intrinsic value of their firm's share differs from the current market price of the share, then
an important issue arises: Should managers seek to maximise the current market price of
the share, which embeds only public information, or should they seek to maximise the
intrinsic value of the share, based on their private information? If they seek to maximise
