Fundamentals of Financial Management (BBS II Year)Chapter: 1 (Introduction to Financial Management)

Chapter Outlines: Introduction to Financial Management Importance of Financial Management Finance in the Organizational Structure of the Firm Finance Functions Role and Responsibilities of Financial Manager Goals of Corporation Financial Management and Related Departments The Agency Problem

1. Introduction to Financial Management Literally, finance refers to the funds or money. Finance basically deals with the procurement or acquisition of the required funds from the cost effective sources and utilize such funds productively creating the value for the organizations or firms. In other words, financial management is the managerial activity that ensures financing needs and options are met effectively and efficiently. Business finance, managerial finance, and corporate finance are synonymous to financial management. However, the term business finance is narrow and traditional. During the early stage of industrialization in the United States and other European countries, the term business finance was in use. On passage of time, corporate finance came into use because of corporate forms and structure of businesses. Traditionally, the business finance was focused only on assessing the requirements of funds and procuring it. However, the scope widened and the financial management now deals with the questions like what long term investment should be made? Where the firm will get the long term fund? How firm will manage its daily financial activities? And how the firm should compensate its shareholders and many more.

2. Importance of Financial ManagementFinancial Management has gained immense attention in todays modern world of business. Not only the funds related activities but other functions providing sustainable growth of the business is also assured by the proper financial management practices. To be specific and simple, followings are regarded as the primary importance of the financial management.

a. Setting clear Goal: The proper financial management practices enable managers to differentiate between the goal of profit maximization and stock price maximization. Managers can be clear on how stock price maximization is superior to profit maximization goal.

b. Effective Utilization of Resources: The acquired funds are always to be used in optimum way. However, the firms might face with the surplus and deficit of resources on various times. In such circumstances, the financial management enables the firm to make use of scarce use of resources in rational way and take the maximum possible advantages and return from excess resources.

c. Sources of Financing: The firms incorporating the proper financial management practices never have to be short on the required funds. It is because the financial planning and forecasting makes it easy for the managers to determine the amount of funds needed and the possible sources. It always ensures that the required funds are available at the time when it is actually needed. In addition, the managers can develop a low cost capital structure consisting definite portion of debt and equity. It further helps firm in reducing the overall cost of capital.

d. Dividend Decision: Among others, the financial management assists managers to decide on what and how the dividends to its shareholders should be paid. Financial management provides clear picture on the investment opportunities in the market, the liquidity condition of the firm, expectation of the shareholders etc. These factors are important in determining the dividend payout schemes for the firms. 3. Finance in the Organizational Structure It is not possible for the shareholders to run their business or firm due to large number of shareholders in large companies. So, the shareholders elect the Board of Directors (BoD) which represents the interests of the shareholders in the company. BoD frames the policies, strategies, makes decision and appoints the management to run the company. Usually, the top management of the company is Chief Executive Officer (CEO) or Managing Directors. Likewise, the finance function of a company comes under the responsibility of the Chief Financial Officer (CFO) assisted by the Treasurer (accounting function) and the Controller (finance function). CFO directly reports to CEO and is responsible in making financial plans, policy making and making decisions.

4. Finance FunctionsThere are two approaches of finance functions. The first approach is too narrow and traditional which relates to procurement or raising of funds. In other hand, second approach focuses on procurement of funds and their effective utilization. In addition, there are two types of finance function namely:

a. Executive finance functionsIt requires the managerial abilities and skills to perform the executive finance functions. Executive function includes the planning, execution and control. Major executive functions are:

Investment Decision: Managers need to assess the benefits of the certain projects in order to decide whether or not to invest in such projects. It uses the capital budgeting techniques in which the net present value of the project is computed.

Financing Decision: It deals with the source from where the required funds to be procured. It involves deciding upon needs and sources of funds and negotiation for external financing. The financial managers analyze the various options of financing like common stock, preferred stocks, bonds, commercial papers and bank loans etc. Decisions are made based on the cost effectiveness and the general market conditions. Dividend Decision: Dividend is return for the shareholders but not the obligation. The decision whether or not the dividend should be distributed are made by the financial managers based on various factors. The company may distribute all income as dividends, retain all income and distribute certain amount as dividends. While making such decisions, the financial managers need to analyze the available investment opportunities, practice of the company, legal requirements, expectation of the shareholders, profit condition of the company etc.

Working Capital Decision: Working capital is needed to carry out the day to day or short term activities of the company. So, company maintains cash balance, bills and account receivables, inventory etc. This decision is also known as the current asset management. Since the working capital decision affects the profitability, liquidity and risks, the financial managers should make the acceptable trade-off between all these factors. For example, excessive holdings of current asset may reduce the profits since the cash holdings does not earn high returns and may be much less than the cost of capital.

b. Routine functionsRoutine or incidental finance function involves the activities that support the executive finance functions. It does not require the managerial skills and abilities rather it is clerical and usually performed by operating level employees. It involves lot of paper work and time. Some of the routine finance functions are: Supervision of cash receipts and disbursements and cash balances. Custody and safeguarding the valuable documents like securities, contracts, insurance policies etc. Record keeping of financial transactions and other details. Supervision of the fixed and current assets and report the management.

5. Roles and Responsibilities of Financial ManagerAs it have already been discussed that the finance managers basically have to spare their time in making the investment, financing, asset management and others, there are some other vital roles and responsibilities that the financial managers need to perform. In performing such roles, the finance manager should always emphasize on increasing the value of the firm and the shareholders. Some of them are as follows:

a. Analysis of Financial Aspect of all Decisions: Financial managers are responsible for making the cost and benefit analysis of the plans and decisions made by other departments. It is finance managers who decide on whether or not to provide the funds for certain plans that other department have come up with? For example, the marketing department plans for aggressive marketing and advertisement of the products or services of firm. Such plans of marketing department requires fund. So, the finance managers need to analyze the cost and possible increase in sales revenue from such marketing campaigns.

b. Analysis of Investment Decision: Financial managers should always work closely with other departmental heads. So, the combined future plans of all departments bring about the investment opportunities for the firm. Thus, finance manager are responsible for the feasibility analysis of such investment. Furthermore, the finance managers should always stress on whether or not the investment is providing the expected return as predicted before the investment decision was made.

c. Analysis of Financing Decision: Once the required funds and sources of funds are located, the finance managers should devise the optimal capital structure to finance the investment opportunities. It is associated with the cost that the firm has to pay for borrowed funds and the return it gets from the investment made.

d. Analysis of Dividend Policy Decision: The firm has three alternatives regarding the earnings or profit. It can distribute all of its earnings as dividend to its shareholders, retain all of its earnings or distribute part of the earnings and retain remaining. In choosing the alternatives provided, the finance managers should analyze the shareholders dividend needs, cost of funds, investment opportunities, shareholders tax liability etc.

e. Analysis of Financial Condition of the Firm: The finance managers constantly need to watch the financial condition of the firm. In doing so, s/he is responsible for ensuring the profitability, leverage, liquidity, and risk conditions are under the standard acceptable levels. For this purpose, the managers can analyze the financial statements of the firm and compare it with the industry average periodically.f. Analysis of Financial Markets: Since the any required financing is borrowed from the financial markets, the mangers should understand the financial markets and its dynamics. Managers should analyze the interest rate changes in different securities, the stock price of own stock and of competitors stock, the effect of dividend and other decision on stock price of firm etc.

g. Analysis of Risk: The firm operates in both internal and external environment. The changes in the internal and external environment sometimes provide strength and opportunities but some other time threats and risks. The risks can be interest rate risk, market risk, foreign exchange risk, credit risk etc. Such risk should be assessed timely and feasible risk minimizing or hedging techniques should be adopted to minimize the possible loss.

6. Goals of CorporationGoals are the desired end that any organization strives to achieve. It is the purposes for which various functions including finance function are carried out. Goals of an organization provide the guidelines for the decision making. Widely discussed financial goals of an organization are profit maximization and shareholders wealth maximization.

a. Profit MaximizationUnder this goal, the projects or investments that increase profits are undertaken and the one with fewer profits are rejected. The managers select such projects and assets that are sure to increase the profits of the organization. The supporters of this goal argue that profit is test of economic efficiency, effective utilization of resources and represents the total welfare. However, the profit maximization goal is not free from criticisms which are as follows: Ambiguity or Unclear: Profit maximization goal is unclear. It is not clear whether the after tax or before tax profit should be maximized, net profit or gross profit, earning per share or return on equity etc. So, this goal creates confusion in managerial decision makings.

Ignores Time Value of Money: Benefits received earlier are better since it can be reinvested that can increase the terminal wealth of investments. However, the profit maximization considers the total value of the benefit or profits but not the timing of cash flows.

Ignores the Quality of Benefits: If the benefits are certain, such benefits or profits are considered to be of quality. Profit maximization goal merely focuses on the amount of profit rather than its certainty or degree of risks associated with. Profit maximization goal some time may mislead the managers to select the projects with higher degree of risks.

Unsuitable in Modern Business Environment: Traditionally businesses were family owned and self financed. But todays business are characterized by separate ownership and management and market oriented. It has various stakeholders which creates the unsuitability of profit maximization goal. Profit maximization is considered as unethical, unrealistic and difficult.

b. Shareholders Wealth Maximization (Stock Price Maximization)Wealth maximization goal is widely accepted that seeks to maximize the wealth or net worth of the shareholders. Shareholders wealth is maximized when an investment decision generates the positive net present value. Net present value is the difference between the present value of benefits and present value of costs. The company undertaking the financially viable projects sends good information in the market pushing up demand for the shares of that company and drives up the price as well. So, shareholders wealth maximization is also called stock price maximization. Some advantages of this goal as opposed to profit maximization are as follows:

Clarity of Goal: Shareholder wealth maximization goal is clear since every decision are to be made based on evaluation of cash flows rather than accounting profit. Financial managers always try to make the cash flows to the shareholders as big as possible.

Considers the Time Value of Money: This goal considers the cash flow and its present value. The cash flows received in earlier period can be reinvested. So, this goal takes concern of time value of money.

Quality of Benefits: According to this goal, the cash flows with lower degree of risks are discounted with lower required rate of return while risky cash flows are subjected to higher required rate of return. It makes the difference in the net present value of the same project with equal cash flows. So, it is easier for managers to undertake the decisions.

Reduces the Conflicts: Wealth maximization goal can serve the interest of multiple stakeholders of the company like owners or shareholders, employees, customers, creditors and society. Under this goal, company allocates the resources efficiently that help in producing high quality goods and services at competitive price. It serves the interest of the customers. In addition, the wealth maximization can be ensured only when employee are fairly compensated. Moreover, to allocate the benefit for shareholders, the company should first settle the claim of creditors.

7. Financial Management and Related DepartmentsHaving said that the financial manager should analyze the financial aspects of the all decisions made by other departments, it is not difficult to understand how the finance is related with other departments. However, the relationship of financial management with following departments is of great importance.

a. Marketing Department: The activities of marketing department like product survey, demand forecasting, marketing campaign, new product development, pricing product etc. have financial implications. So, the finance managers should make the cost and benefit analysis in order to determine the financial viability of the marketing activities.

b. Production Department: Product development, product manufacturing, quality control, raw material purchase, inventories etc. are the function of the production department. The financial managers should always ensure the production process never interrupts due to shortage of funds and other resources.

c. Human Resource Department: HRM department wants to maintain the qualified and motivated pool of employees in the firm. For, this HRM department has to standardize its recruitment, selection, utilization, training and development, motivation, employee compensation, rewards process and practices. All of these activities require funds which come under the responsibilities of finance managers. Finance department can help HRM department to achieve its goals. 8. The Agency ProblemThe agency problem is the conflict of interest between the principal and the agent of the company. The basic reason behind the agency problem is the separation between the ownership (Principals) and management (agents) of the company. Basically, the agency problem is severe between the shareholders and managers. However, the agency problems between the shareholders (through managers) and creditors are persistent.

a. Agency Problem between Shareholders and ManagersIn practice, the top management of the company is concerned with their personal wealth, prestige, salary, job security, life style, fringe benefits etc. So, it is uncertain that managers will work in best interest of the shareholders which results in eroding the shareholders wealth. In addition, managers have tendency to increase the size of firms in order to avoid the hostile takeovers that increase the power, status and salaries of the managers. Managers may practice Poison Pill in which managers poses the company unattractive to be taken over and Greenmail in which the management go for stock repurchases to gain control of the company. The agency problem between the shareholders and the managers can be reduced by following ways:

Managerial Compensation: Performance shares and Executive stock options may be provided to managers that motivate the managers to work in best interest of the shareholders. Better performing managers should be compensated well that creates the harmony in between the interest of shareholders and managers. However, financial viability of such compensation packages should be assessed.

Direct Intervention by Shareholders: Controlling and institutional shareholders holding more than 5 percent shares can pass the resolution calling for the discussion during the Annual General Meeting. Likewise, extra ordinary general meetings can be called where the discussion are carried out to resolve the conflicts.

Threat of Firing: Threat firing for poor performing managers can align managers to work in the best interest of shareholders since the firing deteriorates the career and the prestige of the managers.

Threats of Hostile Takeovers: If the share price of company is undervalued and facing the crisis in terms of financial viability and management performance, there is always risk of hostile takeovers of such companies. Hostile takeovers may punish the managers in the market and can be fired from job as well. So, managers may act in direction of shareholders interests.

b. Agency Problem between Shareholders and CreditorsWhen the managers make decisions to maximize the wealth of shareholders ignoring the interest of creditors, the conflict arises between the shareholders and the creditors. Shareholders seeks to increase their wealth using the debt borrowed from creditors while creditors always resists such decisions thinking that cannot participate in extra earning of the company i.e. the creditors do not entitle to extra income but they have to bear extra risks. Some ways by which the agency problem between the shareholders and creditors can be minimized are as follows:

Risk Premiums for Creditors: If the company is planning to undertake the risky projects, the creditors need to be compensated with the higher risk premiums.

Protective Terms and Covenants: Protective Terms can be provisioned in the indenture of the debts that restricts the company to undertake some risky activities. Such restrictions can be restructuring the capital structure, payment of dividend, sale of assets repurchase of shares, acquisition and merger etc.

9. Development of Financial Management Finance was the part of economics till late 1800s and emerged as the separate discipline during early 1900s. Industrialization in US and other European countries stimulated the need of corporate finance. The key financial issues were raising the new capital for formation of new business and expansion. Due to shortage of regulations and increased fraudulent activities during early period, investors were reluctant to invest in shares of the company. So, financial managers had to focus on legal aspects. (Outsiders Viewpoint) During the great depression 1930s, the focus shifted to the survival aspects rather than their expansion and modernization. Amendments in company law and regulation increased the investors confidence. Now, the finance was related with the day to day problems faced in the finance functions like fund analysis, planning and control. During 1950s various corporate finance theories and tools were developed that changed the emphasis to insiders viewpoint. After 1990s, two trends namely globalization and communication and technology restructured the finance functions. Multinational business finance emerged. Financial decision makings are made with the software and data based computer information systems. Today the corporate finance has become more analytical and quantitative. Development of capital structure theory, efficient market theory, capital budgeting technique, option pricing model, arbitrage pricing model etc.

Reference

Paudel, R. B., Baral, K. J., Gautam, R. R., Dahal, G. B., & Rana, S. B. (2012). Fundamentals of Financial Management (3rd ed.). Kathmandu: Asmita Book Publishers and Distributors P(Ltd.).

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