Nature of Financial Management And Financial Markets PDF

# Nature of Financial Management And Financial Markets ## Chapter 01 ### Lecture Outline - Introduction to finance and financial markets - Objectives of Financial Management - The agency problem and functions of financial organizations - Financial Markets, instruments and institutions - The...

# Nature of Financial Management And Financial Markets ## Chapter 01 ### Lecture Outline - Introduction to finance and financial markets - Objectives of Financial Management - The agency problem and functions of financial organizations - Financial Markets, instruments and institutions - The Cost of Money/Interest Rates (expressed in percentages) ## What Is Finance? - "Finance” is a broad term that describes two related activities: the study of how money is managed and the actual process of acquiring needed funds. - Hence, the study and practice of making money-denominated decisions. - A branch of economics concerned with resource allocation and resource management, acquisition or investment. - Simply, finance deals with matters related to money and the markets. ## Main Fields of Finance - Business finance or Corporate finance (e.g., raising and managing business funds) - Personal finance (e.g., managing individual wealth and savings) - Public finance (e.g., government revenue and expenditure) - Financial markets and instruments (e.g., stocks, bonds, derivatives) ## Business Finance "Business finance is the business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise”. Business finance can broadly be defined as the activity concerned with planning, raising, controlling and administering of funds used in the business. ## What Is Financial Management? Concerns the acquisition, financing, and management of assets with some overall goal in mind. ## Key Decisions of Financial Management - Financing Decision - Investment Decision - Dividend Decision ## Key Decisions Cont. - **Financing Decisions** relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby. - **Investment Decisions** include investment in fixed assets (called as capital budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions. - **Dividend Decisions** comprise of decisions associated to the net profit distribution. Net profits are generally divided into two: - Dividend for shareholders - Dividend and the rate of it has to be decided. - Retained profits - Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise. ## Difference Between Financial Management and Accounting? - Accounting is generally record keeping; historical - Finance is generally about decision making; uses forecasts and therefore "forward-looking” ## Finance & Related Disciplines ### Financial Management and Accounting Accounting deals with recording, reporting and evaluating business transactions, whereas Finance is termed as a managerial or decision making process based on statements prepared by accountants. In the past, both financial management and accounting were treated as the same discipline and then it has been merged as Management Accounting because this part is very helpful to finance managers to take decisions. But nowadays financial management and accounting disciplinese are separated and interrelated. ## Financial Management | Accounting ------- | -------- Focus | Managing financial resources strategically | Recording and reporting financial transactions Orientation | Forward-looking | Historical Purpose | Decision-making for maximizing value | Compliance, accuracy, and reporting Tools | Financial analysis, risk management | Bookkeeping, financial statements ## Finance & Related Disciplines Cont. ### Financial Management and Economics Investment decisions and micro and macro environmental factors are closely associated with the functions of financial managers. He must also be alert about the consequences of varying levels of economic activities, and recognize and understand the effect of monetary policy on the cost and availability of funds. Microeconomics deals with the economic problems related to individual firms. Demand and supply analysis, profit maximization strategies, and pricing theories have practical applications in finance. ### Financial Management and Production Management The profit of an entity depends upon the production performance. Production performance needs finance because the production department requires raw materials, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to the production department. The financial manager must be aware of the operational process and finance required for each process of production activities. ### Financial Management and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible for allocating adequate finance to the marketing department. Hence, marketing and financial management are interrelated anddepends on each other. ### Financial Management and Human Resource The financial manager should carefully evaluate the requirement of manpower for each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the human resource department. Hence, financial management is directly related to human resource management. ## Main Goals Of Financial Management - Wealth Maximization - Profit Maximization ## 1) Profit Maximization - Maximizing a firm's earnings after taxes. - A business mainly functions for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. - It considers all the possible ways to increase the profitability of the business. ### Favorable Arguments - Main aim is earning profit - Parameter of the business operation - Main source of finance ### Unfavorable Arguments - Leads to exploiting workers and consumers - Creates immoral practices such as corrupt practice, unfair trade practice, etc. - Leads to inequalities among the stakeholders such as customers, suppliers, public shareholders, etc. ## Drawbacks Of Profit Maximization 1. **It is vague:** In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business. 2. **It ignores the time value of money:** Profit maximization does not consider the time value of money or the net present value of the cash inflow. Based on the concept of "bigger is better” not "earlier the better”. 3. **It ignores risk:** Profit maximization does not consider risk of the business. Risks may be internal or external which will affect the overall operation of the business. ## 2) Wealth Maximization - This is considered the appropriate goal of financial management. - The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. - Wealth maximization is also known as the maximization of the current value per share of the existing stock. - This principle assumes that wealth is created lawfully and ethically - Value creation occurs when we maximize the share price for current shareholders. - An objective of maximizing earnings per share may not be the same as maximizing market price per share. The market price of a firm's stock represents the focal judgment of all market participants as to the value of the particular firm. - It takes into account present and expected future earnings per share; the timing, duration, and risk of these earnings; the dividend policy of the firm; and other factors that bear on the market price of the stock. - The market price serves as a barometer for business performance; it indicates how well management is doing on behalf of its shareholders. ## Case Study Tesla, Inc., a leader in electric vehicles (EVs) and clean energy solutions, has consistently focused on maximizing shareholder wealth through innovative strategies and long-term growth plans. In 2019, Tesla faced two options to allocate its capital: 1. Expand Gigafactories Globally to meet the growing demand for EVs. 2. Pay Dividends or Buy Back Shares to provide immediate returns to shareholders. Tesla opted to expand its Gigafactories, particularly focusing on establishing new plants in Shanghai and Berlin. The decision was guided by the potential for long-term revenue growth and market dominance in the EV sector. 1. The new factories allowed Tesla to produce vehicles closer to key markets, reducing costs and increasing market share globally. 2. As production capabilities and revenues grew, Tesla's stock price soared, increasing from around $50 per share in early 2019 to over $1,000 per share (post-split adjusted) by 2023. 3. Shareholders benefited significantly from the decision, as the stock price increase far exceeded the short-term gains they might have received from dividends or buybacks. ### Favorable Arguments - Superior to the profit maximization, main aim is to improve the value or wealth of the shareholders - Provides exact value of the business - Considers both time and risk of the business - Provides efficient allocation of resources ### Unfavorable Arguments - It is the indirect name of the profit maximization - Creates ownership-management controversy - Can be activated only with the help of the profitable position of the business ## Agency Relationship - The relationship that exists in an organization between shareholders and management known as agency relationship. - Agency relationship results when a principal hires an agent to perform part of his duties. - In this type of relationship there is a chance of conflicts to occur between the principal and the agent. This conflict is termed as Agency Problem/conflict. ## Agency Conflict (Managers Vs Shareholders) - Management is hired as the agent for stockholders, it's supposed to make decisions that will benefit stockholders, which in most cases is to maximize the stockholders' wealth. The dividends that stockholders receive and the value of their stock shares depend on the business's profit performance. - Dividends are paid out of the profit generated. Therefore, if dividends are increased, it may leads to decrease in the resources which are under the manager's control and also strict its growth. - When managers are evaluated on the basis of growth they might go for unproductive projects which cannot generate appropriate returns, which make the shareholders feel shocked. - Like most working individuals, managers want to maximize their own wealth, assure job security and gain power. When managers are paid based on their performance they will try to show fake information in financial statements. Because when they show high profits that will create high demand for its shares in the market. Thus, the shareholders' wealth will be increased resulting higher incentives to managers. ## Finance within an Organization - Board of Directors - Chief Executive Officer (CEO) - Chief Operating Officer (COO) - Marketing, Production, Human Resources, and Other Operating Departments - Chief Financial Officer (CFO) - Accounting, Treasury, Credit, Legal, Capital Budgeting, and Investor Relations ## Functions Of Finance Manager 1. **Forecasting Financial Requirements:** A finance manager has to make estimation with regards to capital requirements of the company. He should estimate, how much finances required to acquire fixed assets and forecast the amount needed to meet the working capital requirements in future. This will depend upon expected costs and profits and future programmes and policies of the entity. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. 2. **Determination of capital composition:** Once the estimation have been made, the capital structure have to be decided. This involves short-term and long-term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 3. **Acquiring Necessary Capital:** After deciding the financial requirement, the finance manager should concentrate how the finance is mobilized and where it will be available. A company has many choices like- Issue of shares and debentures, Loans to be taken from banks and financial institutions, Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. **Investment Decision:** The finance manager must carefully select best investment alternatives and consider the reasonable and stable return from the investment. He must be well versed in the field of capital budgeting techniques to determine the effective utilization of investment. The finance manager must concentrate to principles of safety, liquidity and profitability while investing capital. 5. **Disposal of surplus:** The net profits decision have to be made by the finance manager. This can be done in two ways: - **Dividend declaration** - It includes identifying the rate of dividends and other benefits like bonus. - **Retained profits** - The volume has to be decided depending upon expansion, innovation and diversification plans of the company. 6. **Cash Management:** Present days cash management plays a major role in the area of finance because proper cash management is not only essential for effective utilization of cash but it also helps to meet the short-term liquidity position of the entity like payment of wages and salaries, payment of bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc. ## Functions Of Finance Manager - Financing Decisions - Dividend Decisions - Investment Decisions - More - Debt Equity - Cash Management - Financial Forecasting - Financial Analysis