Financial management Scope

Object of financial management

Objective of financial management is to maximise shareholder wealth, it is measure by market capital of the company. Market capital is represented by number of share multiplied with share price.

Market capital = Number of share x Market share price

Shareholder is the owner of the company they appoint management the company, manager should manages the company in the best interest of shareholder. Management acquire fund at optimum cost and utilise it with the minimum risk to earn maximum return and distribute dividend to shareholder or retained earnings for further investment to generate maximum possible return.

Cost of capital

THE cost of capital of a firm is the minimum rate of return which the firm must earn on its investments in order to satisfy the expectations of investors who provide funds to the firm. 

It is the weighted average of the cost of various sources of finance used by it. The method of computing the cost of capital is to compute the cost of each type of capital and then find the weighted average of all types of costs of capital. 

In other words, two steps are involved in determination of cost of capital of a firm: 

(i) computation of cost of different sources of capital, and 

(ii) determining overall cost of capital of the firm by weighted average or total cost divided by total fund.

Kc- kc would be weighted average of effective cost of debt and equity

Kc = weight of debt x post-tax cost of debt + weight of equity x cost of equity.

Kc= wd x post-tax kd + we x ke

Cost of debt is to be calculated as follows.

Irredeemable debt:

Annual interest (1 - Tax rate)

Cost of debt =————————————------× 100

Net proceeds of debt

For debt redeemable after certain period

(iii)       Earning price ratio.

Price is how many times of Earning Per Share.

        Price= Earning Per Share X P/E ratio

P/E ratio = 1/ke, Ke = 1/PE ratio.

Component of interest (Required rate of return)

Rf ( Risk free real rate )= it is compensation for sacrifice of current consumption

Inflation premium = it is compensation for loss of Purchasing Power

Risk Premium = it is compensation for bearing risk.

All rate should be taken in to factor while calculation in below.

Risk free nominal rate = Rf ( Risk free real rate ) x Inflation Premium

Risk adjusted rate = Rf ( Risk free real rate ) x Risk Premium

Risk adjusted nominal rate = Rf ( Risk free real rate ) x Inflation Premium x Risk Premium

When we invest in a inflation protected security we donot demand inflation premium i.e, rate would be Rf real. When we invest in a corporate security, there is default risk involved therefor we demand risk premium.

All interest rate are combine in multiplication fashion except CAPM, RADR & Spread.

  

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Introduction to Financial Management

Introduction of financial management : Basics and Definitions 
The primary task of an Accountant is to deal with funds, 'Management of Funds' is an important aspect of financial management in a business undertaking or any other institution like hospital, art society, and so on.

The term 'Financial Management' has been defined differently by different authors.
According to Solomon "Financial Management is concerned with the efficient use of an important economic resource, namely capital funds."

Phillippatus has given a more elaborate definition of the term, as , "Financial Management, is concerned with the managerial decisions that results in the acquisition and financing of short and long term credits for the firm."

Thus, it deals with the situations that require selection of specific problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effect on managerial objectives.

The most acceptable definition of financial management is that given by S.C.Kuchhal as, "Financial management deals with procurement of funds and their effective utilisation in the business."




Thus, there are 2 basic aspects of financial management :

1) procurement of funds :
As funds can be obtained from different sources thus, their procurement is always considered as a complex problem by business concerns. These funds procured from different sources have different characteristics in terms of risk, cost and control that a manager must consider while procuring funds. The funds should be procured at minimum cost, at a balanced risk and control factors.

Funds raised by issue of equity shares are the best from risk point of view for the company, as it has no repayment liability except on winding up of the company, but from cost point of view, it is most expensive, as dividend expectations of shareholders are higher than prevailing interest rates and dividends are appropriation of profits and not allowed as expense under the income tax act. The issue of new equity shares may dilute the control of the existing shareholders.

Debentures are comparatively cheaper since the interest is paid out of profits before tax. But, they entail a high degree of risk since they have to be repaid as per the terms of agreement; also, the interest payment has to be made whether or not the company makes profits.

Funds can also be procured from banks and financial institutions, they provide funds subject to certain restrictive covenants. These covenants restrict freedom of the borrower to raise loans from other sources. The reform process is also moving in direction of a closer monitoring of 'end use' of resources mobilised through capital markets. Such restrictions are essential for the safety of funds provided by institutions and investors. There are other financial instruments used for raising finance e.g. commercial paper, deep discount bonds, etc. The finance manager has to balance the availability of funds and the restrictive provisions tied with such funds resulting in lack of flexibility.

In the globalised competitive scenario, it is not enough to depend on available ways of finance but resource mobilisation is to be undertaken through innovative ways or financial products that may meet the needs of investors. Multiple option convertible bonds can be sighted as an example, funds can be raised indigenously as also from abroad. Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major sources of finance from abroad along with American Depository Receipts (ADR's) and Global Depository Receipts (GDR's).

The mechanism of procuring funds is to be modified in the light of requirements of foreign investors. Procurement of funds inter alia includes:

• Identification of sources of finance
• Determination of finance mix
• Raising of funds
• Division of profits between dividends and retention of profits i.e. internal fund generation.

2) Effective use of such funds :
The finance manager is also responsible for effective utilisation of funds. He must point out situations where funds are kept idle or are used improperly. All funds are procured at a certain cost and after entailing a certain amount of risk. If the funds are not utilised in the manner so that they generate an income higher than cost of procurement, there is no meaning in running the business.

It is an important consideration in dividend decisions also, thus, it is crucial to employ funds properly and profitably. The funds are to be employed in the manner so that the company can produce at its optimum level without endangering its financial solvency. Thus, financial implications of each decision to invest in fixed assets are to be properly analysed.

For this, the finance manager must possess sound knowledge of techniques of capital budgeting and must keep in view the need of adequate working capital and ensure that while firms enjoy an optimum level of working capital they do not keep too much funds blocked in inventories, book debts, cash, etc.

Fixed assets are to financed from medium or long term funds, and not short term funds, as fixed assets cannot be sold in short term i.e. within a year, also a large amount of funds would be blocked in stock in hand as the company cannot immediately sell its finished goods.

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