CHAPTER 1 An Overview of Financial Management

1. CHAPTER 1An Overview of Financial Management Functions of Managerial Finance Issues of the New Millennium Forms of Businesses Goals of the Corporation

2. Functions of Managerial Finance • 1. Procurement of funds: There are alternative sources of fund like a company can take loan or it can issue common stock to raise the fund required. Taking loan can also be of different forms like bank loan, bond or debentures. Preference shares can also be another source. In case of debt, bond and debentures the company must pay a fixed rate of interest which is a compulsory obligation. In case of preference shares the preference dividends are fixed and compulsory payments for profitable firms. In case of ordinary stock the firm is expected to pay the return expected by the share holders. These kinds of payments of interest or dividends refer to the cost of capital. Cost minimization is the goal of financing. Finance managers need to select the best possible sources of funds among the different alternatives called Capital structure Decision. Ordinary stock holders are the owners of the firm (like they have voting rights) but debtors are not the owners. So, common stock is called Internal source; and bond, debenture and loan are called external sources. Purpose is also important in the choice of funds.

3. Functions of Managerial Finance (Contd) 2. Utilization of funds:Capital Budgeting decision. Long term investment decision is made on the basis of risk and return. The goal is profit maximization. This is the most important and challenging function of finance. To predict future profit is difficult as Profit=Total Revenue-Total Cost. TR=P.Q. TC=FC+TVC. 3. Short term asset management: Examples of current assets are cash, marketable securities, receivables, etc., and examples of current liabilities are accounts payable, notes payable, short term loans, etc. A unique feature of current assets is that (unlike fixed assets) current assets does not generate return. Most of the source of financing has some costs. So financing current assets by costly sources is not wise. Current liability is almost cost free. The part of current assets that is financed by current liability is not a problem. The excess of that is called working capital. So, Working capital management deserves attention. The principle is known as Liquidity vs. profitability. 4. Distribution of funds:Dividend policy decision. Dividend policy, repurchase of shares and amortization of debt.

4. Career Opportunities in Finance • Financial Market and Institution bridges the gap between net borrowers and net savers. Money and capital markets include bank, insurance & leasing, investment companies, development institutions, and stock exchange. • Investments: Investors are risk averse. Best possible risk-return combination can be found by financial analysis, security analysis and portfolio (optimal mix of securities) selection. • Managerial Finance: Financial aspects of all kinds of profit-seeking firms may it be manufacturing or trading firms.

5. Evolution of Finance • A study of mergers (1900-1920) • A study of bankruptcy & reorganization (1930s) • Institutional subject of cash budgeting & management (1940s-1950s) • Evaluation of profitable investments (1960s) • Modern Finance of risk-return approach (1970s) • Inflation and innovation effects, and deregulations. (1980s) • Globalization effects (1990s)

6. Alternative Forms of Business Organization • Sole proprietorship • Partnership • Corporation

7. Sole proprietorships & Partnerships • Advantages • Ease of formation • Subject to few government regulations • No corporate income taxes • Disadvantages • Difficult to raise capital • Unlimited liability • Limited life • Lack of liquidity

8. Corporation • Advantages • Unlimited life • Easy transfer of ownership • Limited liability • Raising huge capital • Formal monitoring by government agencies • Disadvantages • Double taxation • Cost of set-up and report filing

9. Financial Goals of the Corporation • The conventional goal of a firm is profit-maximization. However, since profit is reported by the management so it can be manipulated. Moreover, accounting profit is not estimated on cash basis. So, the modern goal of firm is shareholders’ wealth maximization, which refers to maximizing stock prices at the market.

10. A graphical approach to wealth maximization S2 S1 W2=P2 W1=P1 Market Price of Shares D2 D1 Q1 Quantity of stock

11. Determinants of wealth • CF means cash flow from the firm to the shareholder. This depends on profit, EPS and dividend policy. Tax plays a role as the shareholder is interested in after-tax income. • k is the cost of capital required by the shareholders to leave the share price unchanged. It is proportional to risk. If risk increases k increases and the contribution of CF to Po goes down. So, Po is inversely related with risk. • t or timing matters. A distant cash flow is less valuable than an immediate cash flow.

12. Goal of a firm: Profit Maximization Vs. Wealth Maximization • Vagueness in definition: There are many definitions of Profit and so it is vaguely defined. Wealth is the present value of all future dividends which is readily observed in current share price at the market. • Profit is an annual concept and so it is a short term concept but wealth is a long term concept. • Profit can be manipulated by the management (like window dressing) but wealth is beyond the direct manipulation of management. • Risk consideration. The theory of risk says that risk and return is proportional. Profit can not be increased without increasing risk.