13-08-2020

OUTLINE
• Forms of Business Organisations
• Financial Decisions in a Firm
• Goal of Financial Management
Chapter 1 • The fundamental Principle of Finance
• Building Blocks of Modern Finance
FINANCIAL MANAGEMENT : AN
• Risk-return Tradeoff
OVERVIEW
• Agency problem
• Emerging Role of the Financial Manager in India

FORMS OF BUSINESS ORGANISATIONS FORMS OF ORGANISATION

TYPE PROPRIETORSHIP PARTNERSHIP LLP PVT OPC
Members Maximum 1 Feb-20 2- Unlimited 2-200 1 Public Limited Company
Not Considered as Not Considered Considered as Considered as Considered as
Legal Status
separate Legal as separate separate Legal separate Legal separate Legal
of Entity
entity Legal entity entity entity entity
• Many owners
Members Unlimited
Liability of its Limited to the Limited to the • Somewhat complex
Unlimited Liability members is extent of share extent of share
Liability Liability
limited capital capital • Limited liability
Optional/ Can
be Registered
Registered • Distinct legal person
Registered Registered Under MCA and
Registration Not Compulsory under
partnership Act
Under MCA Under MCA Companies Act • Free transferability of shares
2013
1932
Transferabilit
y Option
Not Allowed Not Allowed
Can Be
Transferred
Can Be
Transferred
Allowed to only
one person
Public Limited Company’s Attraction
30% of Profit 30% of Profit 30% of Profit • The potential for growth is immense because of access to
30% of Company Plus CESS and Plus CESS and Plus CESS and
Taxation As in Individual
Profit Surcharges Surcharges Surcharges substantial funds
applicable applicable applicable
• Investors enjoy liquidity because of free transferability of
Income Tax
Income Tax Returns Filed with the Filed with the Filed with the
Annual Filings with the Registrar
Returns with the
registrar of the registrar of the registrar of the
securities
Registrar of
of companies
companies
company company company • The scope for employing talented managers is greater
Source: https://legaldocs.co.in/one-person-company-opc-registration

DECISIONS, RETURN, RISK, ABBREVIATED COMPANY NAMES

AND MARKET VALUE
Private Public

Capital Budgeting
UK Ltd plc
Decisions
Germany GmbH AG
Return
Capital Structure
Decisions Japan YK KK
Market Value of
the Firm
Netherlands BV NV
Dividend
Decisions
Risk France Sarl SA
Working Capital
Decisions
Italy Srl SpA

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EVOLUTION OF FINANCIAL MANAGEMENT FINANCIAL DECISIONS IN A FIRM

• Financial management emerged as a distinct field of study at
the turn of the 20th century. Its evolution may be divided into • Capital Budgeting
three broad phases - the traditional phase, the transitional
phase, and the modern phase.
• Capital Structure
• The modern phase began in mid-1950s and has been marked
by infusion of ideas from economic theory and application of
quantitative methods • Working Capital Management

• The distinctive features of the modern phase are:

Central concern : Shareholder wealth Maximisation
Approach : Analytical and quantitative

GOAL OF FINANCIAL MANAGEMENT CRITIQUE AND DEFENCE OF SHAREHOLDER

WEALTH MAXIMISATION GOAL
Finance theory rests on the premise that managers should manage their
Critique Defence
firm’s resources with the objective of enhancing the firm’s market value.
• The capital market sceptics • Financial economists argue
argue that stock prices fail that stock prices are the
“The quest for value drives scarce resources to their most productive
to reflect true values least biased estimates of
uses and their most efficient users. The more effectively resources are intrinsic values in developed
deployed, the more robust will be the economic growth and the rate of markets
improvement in our standard of living. Adam Smith’s ‘invisible hand’ is • The balancers argue that a • Balancing the interests of
at work when investors’ private gain is a public value.” firm should seek to various stakeholders is not
‘balance’ the interests of a practical governing
various stakeholders objective

• Advocates of social • The only social

responsibility argue that a responsibility of business
business firm must assume is to create value and do so
wider social responsibilities legally and with integrity

SHAREHOLDER ORIENTATION IN INDIA ALTERNATIVE GOALS

Maximisation of Profit
In the wake of liberalisation, globalisation, and institutionalisation of the
capital market, there is a greater incentive to focus on creating value for This goal is not as inclusive a goal as maximisation of
shareholders. The following observations are clear indications. shareholders’ wealth. Its limitations are:
Dhirubai Ambani : In everything that we do, we have only one supreme • Profit in absolute terms is not a proper guide to decision
goal, that is to maximise your wealth as India's largest investor family. making. It should be expressed either on a per share basis or
Anand Mahindra : All of us are beginning to look at companies as owned in relation to investment.
by shareholders. The key is to raise shareholder returns • It leaves considerations of timing and duration undefined.
• It glosses over the factor of risk
Maximisation of EPS or ROE
While these goals do not suffer from the first limitation mentioned
above, they suffer from the other two limitations.

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THE FUNDAMENTAL PRINCIPLE OF FINANCE BUILDING BLOCKS OF MODERN FINANCE

A business proposal-regardless of whether it is a new investment or
acquisition of another company or a restructuring initiative –raises  Efficient markets theory: Analysis of how prices change
the value of the firm only if the present value of the future stream over time in speculative markets.
of net cash benefits expected from the proposal is greater than the  Portfolio theory: Formation of an optimal portfolio of
initial cash outlay required to implement the proposal. securities.
CASH ALONE MATTERS
 Capital asset pricing theory: Determination of asset
prices under conditions of uncertainty.
Investors Investors provide the initial cash required The business proposal
 Option pricing theory: Determination of the prices of
• Shareholders to finance the business proposal contingent claims such as call options.
• Lenders  Agency theory: Analysis of incentive conflicts in
contractual relations.
The proposal generates
 Behavioural Finance : Consideration of social, cognitive,
cash returns to investors and emotional factors that influence decisions.

AGENCY PROBLEM ALL MANAGERS ARE FINANCIAL MANAGERS

• While there are compelling reasons for separation of • The engineer, who proposes a new plant, shapes the
ownership and management, a separated structure leads investment policy of the firm
to a possible conflict of interest between managers and • The marketing analyst provides inputs in the process of
shareholders. forecasting and planning
• The lack of perfect alignment between the interests of • The purchase manager influences the level of investment
managers and shareholders results in the agency problem. in inventories
• To mitigate the agency problem, effective monitoring has
• The sales manager has a say in the determination of the
to be done and appropriate incentives have to be offered. receivables policy
• Departmental managers, in general, are important links
in the finance control system of the firm

ORGANISATION OF FINANCE FUNCTION RELATIONSHIP OF FINANCE

TO ECONOMICS
Chief Finance
Officer
• Macroeconomic environment defines the setting within

Treasurer Controller
which the firm operates. GDP growth rate, savings rate,
fiscal deficit, interest rates, inflation rate, exchange
Financial Cost
Cash Credit
Manager Manager
Accounting
Manager
Accounting
Manager rates, tax rates, and so on have an impact on the firm
Capital Fund Tax Data
Budgeting
Manager
Raising
Manager
Manager Processing
Manager • Microeconomic theory provides the conceptual
underpinnings for the tools of financial decision making.
Portfolio
Manager
Internal
Auditor
Finance, in essence, is applied microeconomics

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RELATIONSHIP OF EMERGING ROLE OF THE

FINANCE TO ACCOUNTING FINANCIAL MANAGER IN INDIA

The job of the financial manager in India has become more important,
• Accounting is concerned with score keeping, whereas complex and demanding due to the following factors:
finance is aimed at value maximising. • Liberalisation
• Globalisation
• The accountant prepares the accounting reports based
• Technological developments
on the accrual method. The focus of the financial
• Volatile financial prices
manager is on cash flows.
• Economic uncertainty
• Accounting deals primarily with the past. Finance is • Tax law changes
concerned mainly with the future. • Ethical concerns over financial dealings
• Shareholder activism

EMERGING ROLE OF THE SUMMING UP

FINANCIAL MANAGER IN INDIA • There are three broad areas of financial decision making, viz., capital
budgeting, capital structure, and working capital management.
The key challenges for the financial manager appear to be in the
following areas: • Finance theory, in general, rests on the premise that the goal of financial
management should be to maximise the wealth of shareholders.
• Investment planning and resource allocation
• A business proposal raises the value of the firm only if the present value
• Financial structure of the future stream of net cash benefits expected from the proposal is
• Mergers, acquisitions, and restructuring greater than the initial cash outlay required to implement the proposal.

• Working capital management • A confluence of forces appears now to be prodding Indian companies to
accord greater importance to the goal of shareholder wealth
• Performance management maximisation.
• Risk management • In general, when you take a financial decision, you have to answer the
• Corporate governance following questions : What is the expected return ? What is the risk
exposure ? Given the risk-return characteristics of the decision, how
• Investor relations would it influence value ?

• The important forms of business organisation are : sole proprietorship, • Fraud involves violating the law, whereas unethical behaviour involves
partnership, private limited company, and public limited company. breaching the code of ethics or moral behaviour.
While each form of organisation has certain advantages and limitations,
the public limited company form of organisation generally appears to be • In general, ethical behaviour and long-term profitability are positively
the most appropriate form from the point of view of shareholder wealth correlated.
maximisation.
• Corporate social responsibility is the continuing commitment by business
• While there are compelling reasons for separation of ownership and to behave ethically and contribute to economic development while
management, a separated structure leads to a possible conflict of interest improving the quality of life of the workforce and their families as well as
between managers and shareholders. of the local community and society at large.
• The lack of perfect alignment between the interests of managers and
• Financial management is in many ways an integral part of the jobs of
shareholders results in the agency problem. To mitigate the agency
managers who are involved in planning, allocation of resources, and
problem, effective monitoring has to be done and appropriate incentives
control.
have to be offered.

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• The treasurer is responsible mainly for financing and investment

activities and the controller is concerned primarily with accounting
and control.

• Financial management has a close relationship to economics on the

one hand and accounting on the other.

• Thanks to the changes in the complexion of the economic and financial

environment in India from early 1990s, the job of the financial manager
in India has become more important complex, and demanding.